Nominal Versus effective cost of debt: Black & Decker–a U.S. multinational manufacturer of small power tools–is considering financing a plant expansion in France with euro(¤) Eurobonds. The issue would be a five-year maturity instrument with a coupon rate of 7 percent to be paid semiannually, whereas the principal repayment occurs at maturity. A comparable financing in U.S.($) would cost the borrower a coupon rate of 10 percent.
a. Assuming the U.S. dollars depreciates at a rate of 1 percent(0.5 percent semiannually), the effective tax rate of Black & Decker U.S. is 35 percent, and the exchange losses on principal repayments are tax-deductible, which long-term financing option should be selected? On the date of the issue, ¤1 = $1.34.
b. Would your answer change if exchange losses on principal repayment were not tax-deductibles?
c. A similar financing arrangement with bonds denominated in pound sterling at a coupon rate of 8.5 percent annually is possible. Should Black & Decker U.S. consider such a financing?