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Currency appreciation and interest rates

A) Microsoft, whose global sales are generally dollar denominated, finds it has excess cash of $750,000,000, which it can invest for up to three years. It has determined that its best options are either a three-year Euro-dollar ($) deposit paying 4.5% or a three-year Euro denominated deposit paying 5.5% since it expects the Euro to depreciate 1% per annum against the dollar over the next three years. Using cash flow analysis, determine in which currency Microsoft should invest. Be sure to show your complete calculations of the annual return and conversion of Euro back to dollars at the end of the three-year term. Assume that the annual interest amount is reinvested, i.e. compounds, at the same annual interest rates. Would your answer change if Microsoft revised its outlook for the Euro to depreciate 1.25% per year?

b) British Oxygen whose global sales are generally dollar denominated needs to borrow $50,000,000 for working capital and intends using a 5-year multi-currency revolving credit. It can borrow in US$ at 8.5% p.a. or in SFr at 5.5% p.a. However, it expects the SFr to appreciate on average 4% p.a. over the next five years. Using a cash-flow analysis determine in which currency BOC should borrow. Would your answer change if BOC could issue SFr commercial paper supported by the revolving credit at 3.5%?

In computing the actual cost of a loan or the value of an investment, it is important to actually make the complete computation on a cash flow basis and not just add the interest rate to the rate of appreciation or depreciation. You should thus first calculate the benchmark cost of the dollar loan after five years, which can be done either on a compounded or simple interest basis. For comparative purposes compounding is probably easiest. At the end of the first year the amount owed in dollars would then be $50 million X (1.085) and at the end of the second year $50 million X (1.085) X (1.085), etc. Then you need to do the same total five-year repayment calculation in dollar terms for the Swiss Franc option. That is, you must allow for currency appreciation as well as compounding interest costs, e.g. $50 million X (1.055) X (1.04) at the end of the first year, etc., etc. Then compare the total amount that has to be repaid in dollars allowing for appreciation with the benchmark repayment amount and see which is less. Do the same thing for when the SF interest rate drops to 3.5% and see if there is a change in the relative cost of the two options

Solution Preview

a) Using compounding, the amount that Microsoft would get at the end of 3 years when is uses a Euro dollar deposit at 4.5% would be
Amount in 3 years = 750,000,000 X 1.045^3 = $ 855,874,593.75
If the same amount is kept as Euro denominated deposit at 5.5%, along with currency depreciation of 1%, the amount in $ at the end of 3 years ...

Solution Summary

Currency appreciation and interest rates are examined.