1. The CFO of Vaimato Industries needs to borrow money (a one-year loan) in the
ID: 2791294 • Letter: 1
Question
1. The CFO of Vaimato Industries needs to borrow money (a one-year loan) in the coming months to support the start up of a new project. The interest rate in the U.S. for a dollar loan was quoted as 14 percent (before taxes). A euro loan is also available at an interest rate of 8.60 percent. In both cases the marginal tax rate is 40 percent. The spot exchange rate (American terms) is $1.2135/€ and the one-year forward rate is $1.2500/€. What is the after-tax cost of debt for the cheapest source of funds?
a. 14.00%
b. 13.87%
c. 10.55%
d. 8.40%
e. 8.32%
Explanation / Answer
If loan is taken in US Dollar,
The after tax interest rate has to be paid = 14*(1 - 0.40) = 8.40%
If loan is taken in Euro,
The interest rate applied = 8.60%
The cost of loan due to change in exchange rate = (1.25 - 1.2135)/1.2135 = 3.01%
Total cost of debt = 8.60 + 3.01 = 11.01%
Hence, the cheapest loan will have cost of 8.40% (i.e. loan in US dollar)
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