The Centralia Corporation is a U.S. manufacturer of small kitchen electrical app
ID: 2748804 • Letter: T
Question
The Centralia Corporation is a U.S. manufacturer of small kitchen electrical appliances. It has decided to construct a wholly owned manufacturing facility in Zaragoza, Spain, to manufacture microwave ovens for sale in the European Union. The plant is expected to cost €5,500,000 with an economic life of 8 years. The borrowing capacity created by this capital expenditure is $2,900,000. Centralia decides to borrow up to its borrowing capacity. As a result, the remainder of the plant will be equity financed.
Centralia is not well known in the Spanish or international bond market. Consequently, it would have to pay 7% per annum to borrow euro, whereas the normal borrowing rate in the euro zone for well-known firms of equivalent risk is 6%. Alternatively, Centralia can borrow dollar in the U.S. at a rate of 8%.
A Spanish MNC has a mirror-image situation and needs $2,900,000 to finance a capital expenditure of its U.S. subsidiary. It has to pay 9% for dollar borrowing, whereas it can borrow euro at 6%.
The current spot rate is $1.33/€.
QUESTIONS: 2 questions
(1) Set up a currency swap that will benefit both companies. Conduct a cash flow analysis of the
currency.
(2) Suppose that one year after the inception of the currency swap between Centralia and the Spanish MNC, the dollar interest rate has fallen from 8% to 6% and the euro interest rate has fallen from 6% to 5.50%. Calculate the market value of the swap if the exchange rate is $1.3343/€. Which company would be willing to unwind the swap contract? Explain.
Explanation / Answer
Centralia – Borrows in USD at 8%
Loan Amount = $ 2,900,000
Interest rate = 8%
Annual Interest amount = $ 2,900,000 * 8% = $ 232,000
Spanish MNC – Borrows in EUR at 6%
Current Eur/USD spot rate = 1.33
Loan Amount = $ 2,900,000 /1.33 = € 2,180,451.1278 or € 2,180,451 (rounded off)
Interest rate = 6%
Annual interest amount = € 2,180,451 * 6% = € 130,827.06
Cash flows in the initial period
Centralia – Transfer the borrowed amount of $ 2,900,000 to Spanish MNC
Amount transferred = $ 2,900,00 / $1.33/€ = € 2,180,451
Spanish MNC – Transfer the borrowed amount € 2,180,451 to Centralia
Amount transferred = € 2,180,451 * $ 1.33/€ = $ 2,900,000
Annual Cash flows
Centralia – transfers € 130,827.06 at a future rate to Spanish MNC
Spanish MNC – transfers $ 232,000 at a future rate to Centralia
Cash flows at the end of the period
Centralia – Receives $ 2,900,000 from Spanish MNC at a future spot rate
Spanish MNC – Receives € 2,180,451 from Centralia at a future spot rate
As per interest rate parity
Swap Points are the differential payable by borrower of one currency to borrower of another currency to make the transaction beneficial or indifferent to both parties
Swap points = Forward rate - Spot rate = Spot rate * (interest rate in US – interest rate in EURO)
Swap Points = 1.33 * (0.08 – 0.06) = 1.33 * 0.02 = 0.0266%
Based on the swap points
Centralia Pays 0.08 – 0.0266 = 0.0534 or 5.34% to Spanish MNC and
Spanish MNC pays 0.06 + 0.0266 = 0.0866 or 8.66% to Centralia
Answer (2)
Based on the above, the interest payable to Centralia is 8.66% and interest payable to Spanish MNC is 5.34%
Present Value of USD Amount = 232000 * [(1-(1/(1+0.0866)^8))/0.0866] + 2,900,000/(1+0.0866)^8
= 232,000 * [(1-(1/1.943379)/0.0866] + 2,900,000/1.943379
= 232,000 * ((1-0.514568)/0.0866) + 2,900,000 * 0.514568
=232,000 *(0.485432/0.0866) + 2,900,000 * 0.514568
= 232,000 * 5.605456 + 2,900,000*0.514568
= 1300466 + 1492246
= $ 2,792,712
Present Value of Euro Payments = 130827.06 * [(1-(1/(1+0.0534)^8))/0.0534] + 2,180,451/(1+0.0534)^8
= 130827.06 * [(1-(1/1.516165)/0.0534] + 2,180,451/1.516165
= 130827.06 *[(1-0.659559)/0.0534] + 2180451 * 0.659559
= 130827.06 * (0.340441/0.0534) + 2180451 * 0.659559
= 130827.06 * 6.375304 + 2180451 * 0.659559
= 834062.30 + 1438136
= € 2,272197.85
Present value of Swap for Centralia = $ 2,792,712 – € 2,272,197.85 * 1.33
= $ 2,792,712 - $ 3,022,023.14
= -$229,311.14
Present Value of Swap for Spanish MNC = € 2,272,197.85 - $ 2,792,712/1.33
= € 2,272,197.85 – € 2,099,783..46
= € 172,414.39
If after 1 year the US interest rate falls by 2% and Euro interest rate has fallen by 0.5% to 5.5%
Interest rate payable by Centralia = 0.06 - 0.0266 = 0.0466 or 4.66%
Difference in interest receivable by Spanish MNC = 0.0466 – 0.0534 = - 0.0068 or -0.68%
Interest rate payable by Spanish MNC = 0.055 + 0.0266 = 0.0816 or 8.16%
Difference in interest payable by Spanish MNC = 0.0816 – 0.0866 = -0.005 or -0.50%
Since the net present value for Spanish MNC is positive and reduction in interest receivable is by Spanish MNC is higher than reduction in interest payable by Spanish MNC, they will be interested in unwinding the swap transaction.
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