Raid Gauloises is a rapidly growing French sporting goods and adventure racing o
ID: 2762531 • Letter: R
Question
Raid Gauloises is a rapidly growing French sporting goods and adventure racing outfitter. The company has decided to borrow €20,000,000 via a euro-euro floating rate loan for four years. Raid must decide between two competing loan offers from two of its banks. Banque de Paris has offered the 4-year debt with an up-front initiation fee of 1.8%. Banque de Sorbonne, however, has offered a higher spread, but with no loan initiation fees up front, for the same term and principal. Both banks reset the interest rate at the end of each year. Euro-LIBOR is currently 4.00%. Raid’s economist forecasts that LIBOR will rise by 0.5 percentage points each year. Banque de Sorbonne, however, officially forecasts euro-LIBOR to begin trending upward at the rate of 0.25 percentage points per year. Raid Gauloises’ cost of capital is 11%. Which loan proposal do you recommend for Raid Gauloises?
Consider it a cash flow problem in order to determine the IRR using the information provided.
Eiteman, David K.; Stonehill, Arthur I.; Moffett, Michael H. (2015-08-05). Multinational Business Finance (Pearson Series in Finance) (Page 239). Pearson Education. Kindle Edition.
Explanation / Answer
We assume that Banque de Paris has offered LIBOR + 2%, whereas Banque de Sorbonne has offered LIBOR + 2.5%.
Expected Chg Assumptions Values in LIBOR Principal borrowing need € 20,000,000 Maturity needed, in years 4.00 Current euro-LIBOR 4.000% Banque de Paris' spread & expectation 2.000% 0.500% Banque de Paris' initiation fee 1.800% Banque de Sorbonne's spread & expectation 2.500% 0.250% Banque de Sorbonne's initiation fee 0.000% Raid Gauloises must evaluate both loan proposals under both potential interest rate scenarios. Banque de Paris Loan Proposal Year 0 Year 1 Year 2 Year 3 Year 4 Expected interest rates & payments: Expected euro-LIBOR 4.000% 4.500% 5.000% 5.500% 6.000% Bank spread 2.000% 2.000% 2.000% 2.000% 2.000% Interest rate 6.000% 6.500% 7.000% 7.500% 8.000% Funds raised, net of fees € 19,640,000 Expected interest costs -€ 1,300,000 -€ 1,400,000 -€ 1,500,000 -€ 1,600,000 Repayment of principal -€ 20,000,000 Total cash flows € 19,640,000 -€ 1,300,000 -€ 1,400,000 -€ 1,500,000 -€ 21,600,000 All-in-cost of funds if: euro-LIBOR rises 0.500% per year 7.7438% euro-LIBOR rises 0.250% per year 7.1365% Found by plugging in .250% in expectations above. Banque de Sorbonne Loan Proposal Year 0 Year 1 Year 2 Year 3 Year 4 Expected interest rates & payments: Expected euro-LIBOR 4.000% 4.250% 4.500% 4.750% 5.000% Bank spread 2.500% 2.500% 2.500% 2.500% 2.500% Interest rate 6.500% 6.750% 7.000% 7.250% 7.500% Funds raised, net of fees € 20,000,000 Expected interest costs -€ 1,350,000 -€ 1,400,000 -€ 1,450,000 -€ 1,500,000 Repayment of principal -€ 20,000,000 Total cash flows € 20,000,000 -€ 1,350,000 -€ 1,400,000 -€ 1,450,000 -€ 21,500,000 All-in-cost of funds if: euro-LIBOR rises 0.500% per year 7.0370% Found by plugging in .500% in expectations above. euro-LIBOR rises 0.250% per year 7.1036% The Banque de Sorbonne loan proposal is actually lower all-in-cost under either interest rate scenario.Related Questions
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