Velocity publishes regular 'model answers to practice questions' to help you revise. This question and answer is for P9.
To answer it, you first need to read the article Management accounting ' financial strategy (PDF 78KB) from the study notes section of May 2008 Financial Management magazine.
This article was written by Douglas Haste, education specialist at BPP Professional Education.
Question
Since eurobonds are a major source of finance, they commonly feature in exam questions.
A recent exam question from the May 2007 Financial Strategy exam concerned an organisation from the fictional country of Esco (currency Esco $), which was looking at the following three options to finance an overseas investment resulting in cash flows in currency Midco $ using:
(i) a 15-year commercial loan taken out in Esco $ at 10% a year
(ii) a 15-year interest-free, non-repayable Midco $ government loan, but for the duration of the loan the Midco government would take a 'dividend' each year of 20% of the profits earned
(iii) a euro-denominated eurobond. Borrowing rates in this market appear very favourable at the present time and are below the rates for both Esco $ bonds and US$ bonds.
Requirement
Discuss the advantages and disadvantages of the three methods of funding outlined in the scenario. (11 marks)
Answer outline
Methods of funding
(i) Borrow in the currency of the home country
For any income generating foreign investment there is an economic risk that the foreign currency depreciates, resulting in a reduced value of income when converted to the home currency. This is particularly damaging if borrowing is in the home currency as such risk is not hedged.
There may also be problems if the Midco government puts restrictions on repatriation of cash flows.
A lender may not be prepared to lend with the new foreign assets as security, so existing assets may need to be valued so that they can be used as security for the debt. This can be expensive and time consuming.
(ii) Borrow in the currency of the host country
The Midco government is effectively accepting a transfer of the economic risk by making the loan interest-free and requiring a share of profits. Further information would be required on what would happen if profits fell to nil or a very low level. For example, assets could be seized if the 'dividend' was too low.
(iii) Borrow in the most favourable market
Borrowing markets are becoming increasingly internationalised, particularly for larger organisations. A eurobond is a long-term loan raised by international organisations and sold to investors in several countries at the same time. The term of a eurobond is typically five to 15 years.
Eurobond funds may be raised at lower cost than direct borrowing from banks.
The current favourable borrowing rates compared to Esco $ bonds and US $ bonds are presumably due to expectations of low inflation and a strong currency. This means that the future debt repayment in Esco $ will be greater than when the debt was first taken out.
Borrowings can be taken out in the same currency as that in which the income is generated in order to hedge against unfavourable currency movements. This could mean that borrowing in US $ could be a better option but no further information is available to enable a cost comparison.
Recommendations
If a decision is made to invest, the Midco government's offer of funding should be used as it is probably the cheapest option and minimises the risks of borrowing.
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