Question 3 - Debt finance, bond valuation and foreign currency risk management Three years ago Boluje...

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Question 3 - Debt finance, bond valuation and foreign currency risk management Three years ago Boluje Co built a factory in its home country costing $3.2 million. To finance the construction of the factory, Boluje Co issued peso-denominated bonds in a foreign country whose currency is the peso. Interest rates at the time in the foreign country were historically low. The foreign bond issue raised 16 million pesos and the exchange rate at the time was 5.00 pesos/$. Each foreign bond has a par value of 500 pesos and pays interest in pesos at the end of each year of 6.1%. The bonds will be redeemed in five years' time at par. The current cost of debt of peso-denominated bonds of similar risk is 7%. In addition to domestic sales, Boluje Co exports goods to the foreign country and receives payment for export sales in pesos. Approximately 40% of production is exported to the foreign country. The spot exchange rate is 6.00 pesos/$ and the 12-month forward exchange rate is 6.07 pesos/$. Boluje Co can borrow money on a short-term basis at 4% per year in its home currency and it can deposit money at 5% per year in the foreign country where the foreign bonds were issued. Taxation may be ignored in all calculation parts of this question. Required: (a) (b) (c) (d) Briefly explain the reasons why a company may choose to finance a new investment by an issue of debt finance. (7 marks) Calculate the current total market value (in pesos) of the foreign bonds used to finance the building of the new factory. (4 marks) Assume that Boluje Co has no surplus cash at the present time: (i) Explain and illustrate how a money market hedge could protect Boluje Co against exchange rate risk in relation to the dollar cost of the interest payment to be made in one year's time on its foreign bonds. (4 marks) (ii) Compare the relative costs of a money market hedge and a forward market hedge. (2 marks) Describe other methods, including derivatives, that Boluje Co could use to hedge against exchange rate risk. (8 marks) (Total 25 marks) Question 3 - Debt finance, bond valuation and foreign currency risk management Three years ago Boluje Co built a factory in its home country costing $3.2 million. To finance the construction of the factory, Boluje Co issued peso-denominated bonds in a foreign country whose currency is the peso. Interest rates at the time in the foreign country were historically low. The foreign bond issue raised 16 million pesos and the exchange rate at the time was 5.00 pesos/$. Each foreign bond has a par value of 500 pesos and pays interest in pesos at the end of each year of 6.1%. The bonds will be redeemed in five years' time at par. The current cost of debt of peso-denominated bonds of similar risk is 7%. In addition to domestic sales, Boluje Co exports goods to the foreign country and receives payment for export sales in pesos. Approximately 40% of production is exported to the foreign country. The spot exchange rate is 6.00 pesos/$ and the 12-month forward exchange rate is 6.07 pesos/$. Boluje Co can borrow money on a short-term basis at 4% per year in its home currency and it can deposit money at 5% per year in the foreign country where the foreign bonds were issued. Taxation may be ignored in all calculation parts of this question. Required: (a) (b) (c) (d) Briefly explain the reasons why a company may choose to finance a new investment by an issue of debt finance. (7 marks) Calculate the current total market value (in pesos) of the foreign bonds used to finance the building of the new factory. (4 marks) Assume that Boluje Co has no surplus cash at the present time: (i) Explain and illustrate how a money market hedge could protect Boluje Co against exchange rate risk in relation to the dollar cost of the interest payment to be made in one year's time on its foreign bonds. (4 marks) (ii) Compare the relative costs of a money market hedge and a forward market hedge. (2 marks) Describe other methods, including derivatives, that Boluje Co could use to hedge against exchange rate risk. (8 marks) (Total 25 marks)

Answer rating: 100% (QA)

a Companies may choose to finance a new investment by issuing debt for various reasons such as Interest payments on debt are taxdeductible which reduces the companys tax liability Debt financing allow... View the full answer