Use of Long-Term Financing
Recall that Blades, Inc., is considering the establishment of a subsidiary in Thailand to manufacture Speedos, Blade’s primary roller blade product. Alternatively, Blades could acquire an existing manufacturer of roller blades in Thailand. Skate’n’Stuff. At the most recent meeting of the board of directors of Blades, Inc., the directors voted to establish a subsidiary in Thailand because of the relatively high level of control it would afford Blades. The Thai subsidiary is expected to begin production by early next year, and the construction of the plant in Thailand and the purchase of necessary equipment to manufacture Speedos are to commence immediately. Initial estimates of the plant and equipment required to establish the subsidiary in Bangkok indicate costs of approximately 550 million Thai baht. Since the current exchange rate of the baht is $ 0.023, this translates to a dollar cost of $ 12.65 million. Blades currently has $ 2.65 million available in cash t cover a portion of the costs. The remaining $ 10 million (438,782,609 baht), however, will have to be obtained from other sources.
The board of directors has asked Ben Holt, Blades’ financial officer, to line up the necessary financing to cover the remaining construction costs and purchase of equipment. Holt realizes that Blades is a relatively small company whose stock is not widely held. Furthermore, he believes that Blades’ stock is currently undervalued because the company’s expansion into Thailand has not been widely publicized at this point. Because of these considerations, Holt would prefer debt to equity financing to raise the funds necessary to complete construction of the Thai plant.
Holt has identified two alternatives for debt financing: issue the equivalent of $10 million yen-denominated notes or issue the equivalent of approximately $ 10 million baht-denominated notes. Both types of notes would have a maturity of 5 years. In the fifth year, the face value of the notes will repaid together with the last annual interest payment. Notes denominated in yen (¥) are available in increments of ¥125,000, while baht-denominated notes are issued in increments of 50,000 baht. Since the baht-denominated notes are issued in increments of 50,000 baht (THB), Blades needs to issue THB434,782,609/50,000 = 8,696 baht-denominated notes. Furthermore, since the current exchange rate of the yen in baht is THB0.347826/¥, Blades need to obtain THB434,782,609/THB0.347826 = ¥1,250,000,313. Since yen-denominated notes would be issued in increments of 125,000 yen, Blades would have to issue ¥1,250,000,313/¥125,000 = 10,000 yen-denominated notes.
Due to recent unfavorable economic events in Thailand, expansion into Thailand is viewed as relatively risky; Holt’s research indicates that Blades would have to offer a coupon rate of approximately 10 percent on the yen-denominated notes to induce investors to purchase these notes. Blades could issue baht-denominated notes at a coupon rate of 15 percent. Whether Blades decides to issue baht-or yen-denominated notes, it would use the cash flows generated by the Thai subsidiary to pay the interest on the notes and to repay the principal in 5 years. For example, if Blades decides to issue yen-denominated notes, it would convert baht into yen to pay the interest on these notes and to repay the principal in 5 years. Although Blades can finance with a lower coupon rate by issuing yen-denominated notes, Holt suspects that the effective financing rate for the yen-denominated notes may actually be higher than for the baht-denominated notes. This is because forecast for the future value of the yen indicate an appreciation of the yen (versus the baht) in the future. Although the precise future value of the yen is uncertain. Holt has compiled the following probability distribution for the annual percentage change of the yen versus the baht:
Annual % Change in Yen (against the Baht) Probability
0% 20%
2 50
3 30
Holt suspects that the effective financing cost of the yen-denominated notes may actually be higher than for the baht-denominated notes once the expected appreciation of the yen (against the baht) is taken into consideration.
Holt has asked you, a financial analyst at Blades, Inc., to answer the following questions for him:
- Given that Blades expects to use the cash flows generated by the Thai subsidiary to pay the interest and principal of the notes, would the effective financing cost of the baht-denominated notes be affected by exchange rate movements? Would the effective financing cost of the yen-denominated notes be affected by exchange rate movements? How? Construct a spreadsheet to determine the annual effective financing percentage cost of the yen-denominated notes issued in each of the three scenarios for the future value of the yen. What is the probability that the financing cost of issuing yen-denominated notes is higher than the cost of issuing baht-denominated notes
- Using a spreadsheet, determine the expected annual effective financing percentage cost of issuing yen-denominated notes. How does this expected financing cost compare with the expected financing cost of the baht-denominated notes?
- Based on your answers to the previous questions, do you think Blades should issue yen-or baht-denominated notes?
- What is the trade-off involved?
