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Accessing international capital markets at SLC.(Instructor's Note)

CASE DESCRIPTION

The primary subject matter of this case is the cost of raising capital internationally. Secondary issues examined include assessing exchange rate exposure and computing the conditional cost of an international debt issue. The case requires students to have an introductory knowledge of accounting, statistics, finance and international business thus the case has a difficulty level of four (senior level) or higher. The case is designed to be taught in one class session of approximately 3 hours and is expected to require 3-4 hours of preparation time from the students.

CASE SYNOPSIS

St. Louis Chemical (SLC) is a regional chemical distributor, headquartered in St. Louis. Don Williams, the President and primary owner, began SLC ten years ago after a successful career in chemical sales and marketing. The company has gradually expanded it product line and network of manufactures. A recent economic downturn in Europe combined with the strengthening of the US dollar has presented an opportunity for SLC to participate in a joint venture with a German Chemical distributor. In order to raise capital for the venture, SLC will need to borrow about $50 million and has an opportunity to issue bonds denominated in US dollars, Euros or Euro/US dollar dual currencies.

INSTRUCTORS' NOTES

Tasks to Be Performed

1. Williams has asked Thorton to first prepare a series of spreadsheets showing the cash flows associated with each of the three bond issues expressed in terms of US dollars where applicable (using the forward rates provided by Zeutsche Bank). Both investment banks had explained that the up-front fees are deducted from the par value of the bonds. For the US dollar bond, a 1.25% up-front fee totals $625,000 (1.25% of the $50 million Par Value). If the bonds are sold at par value, SLC will only receive $49,375,000.

The first bond offering is a $50 million 8.25% semi-annual coupon bond with 5 years to maturity. There is a 1.25% up-front fee and the bond is expected to sell at Par Value. The initial cash received by SLC would be $49.375 million ($50 million minus the up-front fee of $625,000). The semi-annual interest payments are $2.0625 million (calculated as $50 million*8.25% / 2). The repayment at maturity is equal to the $50 million par value of the bond.

The second bond offering is a 40 million [euro] 7.0% annual coupon Euro denominated Eurobond with a five year maturity. There is a 0.90% up-front fee and the bonds are expected to sell at 101% of Par Value. The up-front fees will total 360,000 [euro] (40 million [euro] x 0.009) and the bonds are expected to sell for 40.40 million [euro] (40 million [euro] x 1.01). Using an exchange rate of $1.25/Euro, the Euro denominated Eurobond is expected to generate 40.04 million [euro] (net of fees) or the equivalent of $50.05 million today. The annual interest payments are 2.8 million [euro]. To convert the annual coupon payments into US dollars, the 2.8 million [euro] are multiplied by the forward exchange rate provided by Zeutsche Bank. For year 1 the US dollar equivalent would be $3.53416 million (2.8 million [euro] x $1.2622/1EUR). At maturity, the 40 million [euro] par value repayment in terms of US dollars would be $53.644 million (40 million [euro] x $1.3411/1EUR).

The third bond offering is a 40 million [euro] 7.5% annual coupon Euro/US dollar dual-currency Eurobond with a five year maturity. There is a 0.90% up-front fee and the bonds are expected to sell at 99% of Par Value. The up-front fees will total 360,000 [euro] (40 million [euro] x 0.009) and the bonds are expected to sell for 39.60 million [euro] (40 million [euro]x 0.99). Using an exchange rate of $1.25/Euro, the Euro denominated Eurobond is expected to generate 39.24 million [euro] (net of fees) or the equivalent of $49.05 million today. The annual interest payments are 3.0 million [euro]. To convert the annual coupon payments into US dollars, the 3.0 million [euro] are multiplied by the forward exchange rate provided by Zeutsche Bank. For year 1 the US dollar equivalent would be $3.7866 million (3.0 million [euro] x $1.2622/1EUR). Because of the dual-currency arrangement, $50 million is repaid at maturity.

2. Explain to Williams the primary factors influencing the differences among the initial cash flows for each proposed bond offering (in terms of US dollars) received by SLC.

The primary factors influencing the differences among the initial cash flows for each bond are the up-front fees charges by each investment bank and whether or not the bond is expected to be a premium, discount, or par value bond. The size of all three bond offerings are the same ($50 million is equivalent to 40 million [euro] at the stated exchange rate of $1.25/1EUR). However, the straight Euro denominated Eurobond has the largest initial cash flow as the up-front fee is low (0.90%) and the bond is expected to sell at a premium (101% or Par Value). The second largest initial cash flow is generated by the US dollar bond. Although it has a higher up-front fee (1.25% versus 0.90%) compared to the Euro/US dollar dual currency bond, it is expected to sell at Par while the dual currency bond is expected to sell at a discount.

3. Discuss the primary factors influencing the interest (coupon) payments and principle repayment in terms of US dollars made by SLC over the five year life of each bond.

Interest payments are made semi-annually for the US dollar denominated bond versus annually for the Eurobond offerings, but the primary difference would be the coupon rate (7% for the straight Eurobond, 7.5% for the dual currency Eurobond, and 8% for the US dollar bond) and corresponding forward exchange rate. Both Eurobond offerings would have lower annual coupon payments relative to the US dollar bond which has a constant annual payment of $4.125 million. However, the annual coupons payments of the Eurobonds expressed in US dollars are increasing due to the forward rate premiums. For example, the straight Eurobond pays 2.8 million [euro] in interest per year and dual-currency Eurobond pays 3.0 million [euro]. In year 1, the forward rate is given as $1.2622/1EUR corresponding to payments by SLC of $3.53416 million and $3.7866 million respectively. In year 5, the forward rate is $1.3411/1EUR and the US dollars needed to make the 2.8 million [euro] coupon payment and 3.0 million [euro] coupon payment increase to $3.75508 million and $4.0233 million respectively.

The principle repayment at maturity is fairly straight-forward for the US bond and the dual-currency Eurobond at $50 million. The straight Euro Eurobond requires a principle repayment of 40 million [euro]. When converted into US dollars at a 5-year forward rate of $1.3411/1EUR, the principle repayment on the straight Euro Eurobond issue is $53.644 million.

4. Compare the annualized all-in cost of each bond issue assuming exchange rate risk for the Eurobond issues is hedged using the forward rates provided by Zeutsche Bank. (The annualized all-in cost is the internal rate of return that equates the present value of the future US dollar outlays with today's US dollars received, net of fees.)

The US dollar bond has a periodic Internal Rate of Return of 4.28% per 6-months, so the nominal annual percentage rate (APR) is 8.56% (4.28%*2 = 8.56%). However, an effective annual rate comparison relative to the Eurobond issues would be more appropriate as both Eurobonds are annual coupon bonds. The effective annual rate (or annual percentage yield) is calculated as:

Annual Percentage Yield = (1 + APR/2)^2 - 1.

The annual percentage yield of the US bond is 8.74%. Therefore, the appropriate all-in cost of the US bond issue would be 8.74%.

The straight Euro Eurobond issue has an internal rate of return of 8.46%. No adjustment is needed as the coupons are paid annually; therefore the annualized all-in cost of the straight Eurobond is 8.46%.

The Euro/US dollar dual currency Eurobond has an internal rate of return of 8.25%. No adjustment is needed as the coupons are paid annually; therefore the annualized all-in cost of the straight Eurobond is 8.25%.

5. Make a recommendation to Williams assuming the exchange rate risk for the Eurobond issues is hedged using the forward rates provided by Zeutsche Bank.

Both the straight Euro and the Euro/US dollar dual currency bonds are cheaper than the US dollar alternative. The Euro/US dollar dual currency bond offers the lowest all-in annualized cost at 8.25%. The exchange rate risk associated with the interest payments are hedged using the forward rates provided by Zeutsche Bank. The lower up-front fees and the fact that the principle repayment is in US dollars (and not adversely affected by the Euro trading at a forward rate premium) make the dual currency Eurobond the most attractive option.

6. Discuss possible explanations for the difference in fees between the two investment banks.

The lower up-front fees charged by Zeutsche Bank may be part of a relationship banking strategy. Zeutsche Bank may be looking to establish a relationship with SLC via an attractive bond offering in an effort to do other more profitable business with SLC once the joint venture is completed.

7. Discuss the primary differences in the straight Euro Eurobond and Euro/US dollar dual currency Eurobond relative to the US dollar denominated bond from a European investor's point of view.

The relatively lower coupon rate offered on the Eurobond is expected, primarily due to the Euro trading at a forward premium relative to the US dollar. The 28 basis point difference between the US dollar and straight Euro Eurobond issue might be due to credit perceptions between European investors and US investors. The lower coupon rate on the Eurobond issue most likely reflects the Euro trading at a forward premium relative to the US dollar. However, the 49 basis point difference between the US dollar and Euro/US dollar dual currency Eurobond may reflect both differences in credit perspectives between US and European investors and the fact that European investors may want exposure to long-term US dollar risk. A European investor may be speculating that principal repayment in dollars may be worth more Euros than the forward rate implies. If the spot rate on the Euro does not strengthen by as much as the forward rate implies, the European investor's return will exceed the yield implied from the forward rate all-in cost. In exchange for the additional risk, the European investor is receiving a higher coupon relative to the straight Euro Eurobond issue.

8. Assume that Williams decided not to hedge the exchange rate risk with forward rate contracts, but left the Eurobond exposure un-hedged. Use the following exchange rate scenarios:

Scenario A: The Euro is currently trading at $1.25/1EUR but strengthens relative to the dollar by 3.75% each year for the next 5 years.

Scenario B: The Euro is currently trading at $1.25/1EUR but weakens by 3.75% each year for the next 5 years

Calculate the all-in cost of each bond issue under each scenario and describe the impact of un-hedged currency exposure on the all-in cost of the US dollar denominated bond, Euro denominated Eurobond and Euro/US dollar dual currency Eurobond.

Scenario A:
US$ Bond Offering

Year   US$ Cash Flow (millions)

 0              49.375
0.5            -2.0625
 1             -2.0625
1.5            -2.0625
 2             -2.0625
2.5            -2.0625
 3             -2.0625
3.5            -2.0625
 4             -2.0625
4.5            -2.0625
 5            -52.0625


All in cost of the US dollar bond issue is unaffected and remains at 8.75%

All in cost increases to 10.99% as the Euro strengthens and requires more US dollars to purchase Euro necessary to repay the bond issue.

All in cost of the Euro/US dollar dual currency Eurobond increases to 8.82% as the coupon payments are adversely affected by the strengthening of the Euro (the principle repayment is unaffected).

The US dollar bond issue is the most attractive under Scenario A

Scenario B:
US$ Bond Offering

Year   US$ Cash Flow (millions)

 0              49.375
0.5            -2.0625
 1             -2.0625
1.5            -2.0625
 2             -2.0625
2.5            -2.0625
 3             -2.0625
3.5            -2.0625
 4             -2.0625
4.5            -2.0625
 5            -52.0625


All in cost of the US dollar bond issue is unaffected and remains at 8.75%

All in cost decreases to 2.96% as the Euro weakens and requires fewer US dollars to purchase Euro necessary to repay the bond issue.

All in cost of the Euro/US dollar dual currency Eurobond decreases to 7.20% as the coupon payments are reduced by the weakening of the Euro (the principle repayment is unaffected).

The straight Euro Eurobond issue is the most attractive under Scenario B.

Benjamin L. Dow III, Southeast Missouri State University

David Kunz, Southeast Missouri State University
US$ Bond Offering

Year   US$ Cash Flow (millions)

 0             49.3750
0.5            -2.0625
 1             -2.0625
1.5            -2.0625
 2             -2.0625
2.5            -2.0625
 3             -2.0625
3.5            -2.0625
 4             -2.0625
4.5            -2.0625
 5            -52.0625

Straight Euro Eurobond

Year   Euro Cash Flows   Exchange Rate (US$/1   US$ Cash Flow
         (millions)              EUR)            (millions)

 0          40.04               1.2500            50.05000
 1          -2.80               1.2622            -3.53416
 2          -2.80               1.2775            -3.57700
 3          -2.80               1.2921            -3.61788
 4          -2.80               1.3186            -3.69208
 5         -42.80               1.3411           -57.39908

Euro-USDollar Dual Currency Eurobond

Year  Euro Cash Flows   Exchange Rate (US$/1   US$ Cash Flow
        (millions)              EUR)            (millions)

 0         39.24                1.25              49.0500
 1         -3.00               1.2622             -3.7866
 2         -3.00               1.2775             -3.8325
 3         -3.00               1.2921             -3.8763
 4         -3.00               1.3186             -3.9558
 5         -3.00               1.3411            -54.0233

Straight Euro Eurobond

Year   Euro Cash Flows   Exchange Rate (US$/1   US$ Cash Flow
         (millions)              EUR)            (millions)

 0          40.04               1.2500             50.0500
 1          -2.80               1.2969            -3.63125
 2          -2.80               1.3455            -3.76742
 3          -2.80               1.3960            -3.90870
 4          -2.80               1.4483            -4.05528
 5         -42.80               1.5026           -64.31234

Euro-USDollar Dual Currency Eurobond

Year   Euro Cash Flows   Exchange Rate (US$/1   US$ Cash Flow
           (millions)                   EUR)      (millions)

 0          39.24               1.2500             49.0500
 1          -3.00               1.2969             -3.8906
 2          -3.00               1.3455             -4.0365
 3          -3.00               1.3960             -4.1879
 4          -3.00               1.4483             -4.3449
 5          -3.00               1.5026            -54.5079

Straight Euro Eurobond

Year   Euro Cash Flows   Exchange Rate (US$/1   US$ Cash Flow
         (millions)              EUR)            (millions)

 0          40.04               1.2500             50.0500
 1          -2.80               1.2031            -3.36875
 2          -2.80               1.1580            -3.24242
 3          -2.80               1.1146            -3.12083
 4          -2.80               1.0728            -3.00380
 5         -42.80               1.0326           -44.19341

Euro-USDollar Dual Currency Eurobond

Year   Euro Cash Flows   Exchange Rate (US$/1   US$ Cash Flow
         (millions)              EUR)            (millions)

 0          39.24               1.2500             49.0500
 1          -3.00               1.2031             -3.6094
 2          -3.00               1.1580             -3.4740
 3          -3.00               1.1146             -3.3437
 4          -3.00               1.0728             -3.2184
 5          -3.00               1.0326            -53.0977
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Title Annotation:Instructor's Note
Author:Dow, Benjamin L., III; Kunz, David
Publication:Journal of the International Academy for Case Studies
Article Type:Case study
Geographic Code:1USA
Date:May 1, 2010
Words:2627
Previous Article:Getting from A to B: a case study of HE Delivers Unlimited, Inc.(Instructor's Note)
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