Suppose PNC needs funds for one year to support its Spanish operations, and it c
ID: 2791363 • Letter: S
Question
Suppose PNC needs funds for one year to support its Spanish operations, and it could borrow in Europe using debt denominated in euros at a rate of 7% or in the U.S. with dollar- denominated debt at a rate of 6%. The current exchange rate is 1.15 dollars per euro, but the dollar is expected to appreciate against the euro to 1.13 by year’s end. Should PNC borrow in Europe or in the U.S. to support its Spanish operations? If the planned expansion were in Iraq rather than Spain, how would that affect the decision as to where (not if) to finance the expansion?
Table 1. Data Used in the Analysis
a. Bond Data. Two dollar-denominated bonds are currently outstanding. Bond A has a 6.75 percent semiannual coupon, sells for 88.75 percent of par, matures on July 1, 2029, and can be called at a price of 105 on July 1, 2009. Bond B has a 9.0 percent semiannual coupon, sells for 112.25 percent of par, also matures on July 1, 2029, and can be called at a price of 107.50 on July 1, 2009. PNC’s federal-plus-state tax rate is 40 percent. Assume that the analysis is conducted on September 15, 2004, and use this as the settlement date, i.e., the day the bond will be purchased. New bonds carrying the prevailing rate could be sold to institutional investors, and no bond flotation cost would be involved.
b. Preferred Stock Data. PNC has one issue of preferred stock outstanding, a perpetual and non-callable preferred that pays a $6.25 annual dividend, has a $100 par value, and currently sells for $104 per share. Investment bankers have indicated that PNC could sell additional shares with a dividend rate that would provide the same market yield, but would incur a flotation cost of 2%. Also, it could sell at par an issue of sinking fund preferred with an annual coupon of 5.25%. The sinking fund would require the company to retire 10% of the original shares each year after issuance, and it too would have a 2 percent flotation cost.
c. Common Equity Cost Data
• Over Own Bond Risk Premium. The own-bond subjective risk premium is assumed to be in the range of 3% to 5%.
• CAPM. PNC’s estimated beta coefficient is 1.35, with a reasonable range of 1.15 to
1.55. The risk-free rate is 4.8%, and the market risk premium (RPM) is estimated to be 5.0%, with a range of 4.0% to 6.0%.
• DCF. PNC’s stock sells for $21 per share. The company currently does not pay a dividend, but its long-run business plan calls for a dividend of $0.50 per share to paid at the end of 2007. The plan also forecasts a growth rate of 75% in 2008, 40% in 2009, and 7.5% thereafter. These specific growth rates have not been reported to the public, but information that has been released provides guidance that has lead analysts to similar but not exact forecasts.
• Common Equity Flotation Costs and Market Pressure.
Amount of stock issued: fee applies to all equity raised up to this amount (thousands):
Common % flotation cost; includes market pressure
Net price with $21 base
$0
0%
$21.00
$5,000
10%
$18.90
$10,000
25%
$15.75
$20,000
40%
$12.60
d. Potential Capital Budgeting Projects
Project
Cost
Rate of IRR
Cumulative cost
a
$3000
15%
$3000
b
$5000
14%
$8000
c
$3000
13.5%
$11000
d
$4000
13%
$15000
e
$4000
12.5%
$19000
f
$2000
12%
$21000
g
$2000
11%
$23000
h
$2000
10%
$25000
i
$2000
9%
$27000
e. Euro Denominated Debt
Maturity: 1 year.
Amount borrowed: $115.
Rate on euro-denominated 1-year debt: 7.0%.
Rate on dollar denominated 1-year debt: 6.0%.
Current exchange rate: 1.15 dollars per euro.
Forecasted year-end exchange rate: 1.13 dollars per euro.
Amount of stock issued: fee applies to all equity raised up to this amount (thousands):
Common % flotation cost; includes market pressure
Net price with $21 base
$0
0%
$21.00
$5,000
10%
$18.90
$10,000
25%
$15.75
$20,000
40%
$12.60
Explanation / Answer
If PNC needs funds for one year to support its operations in Spain,they are better off borrowing the funds in Europe using debt denominated in euros.This suggestion is based on the fact that the cost of debt is less for debt denominated in Euros than it is for debt denominated in U S Dollars .For PNC ,this means that they will end up spending less in the long run if they obtain their funds to support its operations in Spain from Europe.
$100
If PNC planned their expansion in IRAQ rather than in Spain,The company would need to reevaluate where they will finance their expansion.Even though the after tax cost of debt is less if the company borrowed funds from EUROPE , PNC would most likely be better off financing an expansion in IRAQ using US dollars.The fees that would be involved to exchange the currency from US Dollars to EUROs to IRAI Dinar and the reverse would dramatically increase the cost of debt.
If the company had a choice between Spain and IRAQ ,PNC would be better off completing the expansion in Spain.The current economy in IRAQ is unstable.Civil war,regional territory fights and western countries staying away from doing business in IRAQ are all major concerns .The IRAQI dinar is often referred to as a scam currency and is hard to get a fair price .Both of these should be of concern to any company who is looking to do business in IRAQ.
U S Dollar EURO Amount Borrowed $ 115$100
Rate on 1 year debt 6% 7% Total $ 121.90 $ 107.00 Return $121.90 $ 120.91 cost of debt 6% 5.14% After Tax Cost of Debt 3.60% 3.08%Related Questions
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