Ford\'s British subsidiary, Jaguar, needs to borrow 25 million in pound financin
ID: 2804016 • Letter: F
Question
Ford's British subsidiary, Jaguar, needs to borrow 25 million in pound financing for 5 years.
It is cheaper however for Ford US, the parent, to borrow in $ rather than in pounds.
Ford can borrow dollars by issuing 5 year dollar denominated bonds at 5.25% interest. Ford could also sell an equivalent amount of 5 year pound denominated bonds at an interest cost of 6.00%. Assume that the spot quote for the pound is $1.3300.
Cadbury-Schweppes needs dollars to expand its investment in U.S. candy production. They are looking to raise a similar amount of money as Ford for five years. It is cheaper for Cadbury however to raise pound financing. Cadbury can borrow pounds for five years by issuing pound denominated bonds at 5.20% interest or borrow dollars by issuing U.S. dollar denominated bonds at 6.15%.
Have each company borrow at their advantaged rate and then work a currency swap deal where both firms agree to swap initial borrowings and principal repayments at maturity at the current spot exchange rate. Ford will pay a 5.20% fixed rate of interest to Cadbury and Cadbury will pay a 5.10% fixed rate of interest to Ford. Model the currency swap and show the cash flows and then show how many basis points each firm saves in interest cost as a result of the swap by showing the difference in the IRRs of Cadbury and Ford once the swap cash flows are included.
Explanation / Answer
Ford
Cadbury
Difference
$ Finance
5.25
6.15
-0.9
€ Finance
6
5.2
0.8
Savings
-1.7
From the table above we can see that Ford should borrow in $, and Cadbury should borrow in €. In doing so both Ford and Cadbury will earn a total benefit of 1.7 %. How this 1.7% is distributed between Ford and Cadbury is shown in the later part of the problem.
Transactions:
Swap Cash Flows:
Year
€
$
0
25
-33.25
1
1.3
-1.70
2
1.3
-1.70
3
1.3
-1.70
4
1.3
-1.70
5
26.3
-34.95
Note: Notional Amount of 25 € and 33.25 $ will be exchange at the beginning of the swap, and notional plus interest cost at the end of the swap.
Interest Cost on €=5.20% of 25 M
Interest Cost on $ =5.10% of 33.25 M
Ford:
Ford Pays 5.20% (To Cadbury) on its € 25 loan
Ford Pays 5.25% on its $ 33.25 M loan
For Receives 5.10% (From Cadbury) on its $ 33.25 Loan
Hence, effective cost of Borrowing: (5.20+5.25-5.10)=5.35 % on its € 25 M loan
This is much lower than the interest rate of 6 % that Ford would have to incur if it directly borrows in €. This represents a saving of (6-5.35)= 0.65%
Cadbury:
Cadbury Pays 5.10% (To Ford) on its $ 33.25 loan
Cadbury Pays 5.20% on its €25 M loan
Cadbury Receives 5.20% (From Ford) on its €25 M Loan
Hence, effective cost of Borrowing: (5.10+5.20-5.20)=5.10 % on its $ 33.25 M loan
This is much lower than the interest rate of 6.15 % that Cadbury would have to incur if it directly borrows in $. This represents a saving of (6.15-5.10)= 1.15%
Conclusion: Therefore, total savings from swap transaction is 0.65+1.15=1.70% (same value as shown in the table above).
Ford
Cadbury
Difference
$ Finance
5.25
6.15
-0.9
€ Finance
6
5.2
0.8
Savings
-1.7