402. Plam Co (March 2016 – Amended)
The directors of Plam Co expect that interest rates will fall over the next year and they are looking forward to paying less interest on the company’s debt finance. The dollar is the domestic currency of Plam Co. The company has a number of different kinds of debt finance, as follows:
|
Loan notes |
Loan notes |
Bank loan |
Overdraft |
Denomination |
Dollar |
Peso |
Dollar |
Dollar |
Nominal value |
$20m |
300m pesos |
$4m |
$3m |
Interest rate |
7% per year |
10% per year |
8% per year |
10% per year |
Interest type |
Fixed rate |
Fixed rate |
Variable rate |
Variable rate |
Interest due |
6 months’ time |
6 months’ time |
6 months’ time |
monthly |
Redemption |
8 years’ time at nominal value |
8 years’ time at nominal value |
Instalments |
Continuing at current level |
The 7% loan notes were issued domestically while the 10% loan notes were issued in a foreign country.
The interest rate on the long-term bank loan is reset to bank base rate plus a fixed percentage at the end of each year. The annual payment on the bank loan consists of interest on the year-end balance plus a capital repayment.
Relevant exchange rates are as follows:
|
Offer |
Bid |
Spot rate (pesos/$) |
58.335 |
58.345 |
Six-month forward rate (pesos/$) |
56.585 |
56.597 |
Plam Co can place pesos on deposit at 3% per year and borrow dollars at 10% per year. The company has no cash available for hedging purposes.
Required:
A. Evaluate the risk faced by Plam Co on its peso-denominated interest payment in six months’ time and advise how this risk might be hedged.
Plam Co needs to make an interest payment of 30 million pesos in six months’ time. The current dollar cost of this interest payment is 30/58.335 = $514,271. In six months’ time the dollar cost of the interest payment will be 30/56.585 = $530,176. This is an increase in cost of $15,905.
Plam Co could lock into the six-month forward exchange rate of 56.585 pesos/$ by entering into a forward exchange contract with a bank. This would fix the cost of the interest payment at $530,176 and protect Plam Co against any unexpected deterioration in the exchange rate. However, Plam Co could not benefit if the future spot were more favourable than the current forward exchange rate.
Plam Co could use a money market hedge by placing pesos on deposit now, financed by borrowing dollars for repayment in six months’ time. The six-month interest rate for placing pesos on deposit is 1.5% (3%/2) and the six-month interest rate for borrowing dollars is 5% (10%/2). The dollar cost of hedging the peso interest payment would be $532,005:
30m pesos/1.015 = 29,556,650 pesos to be deposited now.
$ cost of buying pesos = 29,556,650/58.335 = $506,671 to borrow now.
$ borrowing to pay off after 6 months = $506,671 × 1.05 = $532,005.
On financial grounds, the forward market hedge would be recommended.