1. A firm with dollar revenues is considering borrowing $22 million (or the equivalent) for 5 years. They are considering procuring a 5 year loan with annual installment (amortizing) payments. They are considering borrowing in dollars or British pounds which are currently worth $1.2350. The firm can borrow dollars at a 4.25% interest rate and a 3% flotation cost or borrow the pound at a 4.75% interest rate with a 2% flotation cost.
a) If they decide to borrow in pounds, which alternative is likely to expose them to more risk, the loan or the bond alternative? Explain.
b) If there are no flotation costs which alternative (pound or dollar borrowing) do you expect to be cheaper (lower IRR) if UIP holds? Mathematically demonstrate this.
c) Given that there are flotation costs, what do you actually recommend and why? Mathematically show the borrowing costs.
2. Redo part c. of #1 assuming that UIP does not hold with respect to the future exchange rate (You still have the flotation costs). Suppose that the pound instead decreases in value by 2.50% per year.
What are the pound and dollar expected borrowing cost rates (IRRs) now?
Which do you now recommend? Explain.