Gobal Financial Investment - Essay Example

Global Financial Investment - Case study & Alternative UAL, Inc. which is the parent company of United Airlines has a decision to make regarding raising funds for its acquisition of Hertz. The company has clearly two options for funding this new acquisition that are either funding the acquisition through its own equity or borrowing funds from external sources. In this report, two different possibilities of raising funds from external borrowing are considered and they are evaluated in terms of their future value of interest payments to be made under the agreement and settlement of the principal amount. The first option available to the company is to borrow the required investment amount of $500 million in the local currency that is US Dollars. At the initiating stage of the loan agreement the company has to pay an underwriting fee of 0.5% of the total principal amount and therefore, it is added to the cost of borrowing. This option does not involved in exchange rate risk however there is surely an element of the change in the inflation rate which could affect the time value of the currency over a period of 10 loan years. However, this element has been ignored for this report. The company can borrow $500 million at a rate of 11% with two semiannual interest payments due in June and December every year. This implies that the rate which is quoted annually needs to be adjusted for semiannual payments and the number of payment periods will also be adjusted for the same reason. The interest rate adjusted will be 11% divided by 2 which is equal to 5.5% of the total principal amount to be paid semiannually. The total number of payment periods will therefore be 20 as the loan period is for 10 years[Gro06]. Moreover, there are no principal repayments during the 10 years tenure and the whole amount of $500 million is to be settled at the end of the loan term. By placing the available information in the following table and calculating the future value it can be ascertained that the future value of borrowing under this option is $1,458,878,745. This value will be compared with the future value obtained under the second option. Description Present Value (PV) of Borrowing $500,000,000 Annual Interest Rate 11% Semiannual Interest Rate (r) 5.5% Number of Payment Periods (nper) 10 x 2 = 20 Underwriting Fee (0.5%) $2,500,000 Future value (FV) =FV(rate, nper, pmt, [pv], [type]) FV $1,458,878,745 The second option available to the company is to borrow $500 million denominated in Japanese Yen from the leading Japanese Bank. The current exchange rate between US Dollars and Japanese Yen is at 250 which will result in borrowing of JPY 125 billion at an annual interest rate of 5%. Since, the interest payments are semiannual therefore this rate has to be adjusted along with the number of payment periods as in the previous option. Based on the information provided in the following table the future value of the loan from a Japanese bank is JPY204,827,055,036 (US$819,308,220.15). This value is less than the future value of the loan under the local currency. Therefore, from the two options available to the company borrowing from the Japanese bank seems more feasible. Description Present Value (PV) of Borrowing $500,000,000 Present Value (PV) of Borrowing (@250) JPY125,000,000,000 Annual Interest Rate 5% Semiannual Interest Rate (r) 2.5% Number of Payment Periods (nper) 10 x 2 = 20 Future value (FV) =FV(rate, nper, pmt, [pv], [type]) FV $1,458,878,745 This option exposes the company to exchange rate risk which could make its interest payments and principal repayment more expensive than estimated in the present period[Bri11]. This could be elaborated by considering repayment of $500 million after completion of 10 years period. The current exchange rate between US Dollars and Japanese Yen is at 250 which will generate a loan amount of JPY 125 billion. However, if upon settlement the exchange rate falls to 200 then the company will have to pay more in US Dollars equivalent to JPY125 billion. In this case, the company will have to covert $625,000 to pay off the loan. In the same way, semiannual interest payments could be adversely affected due to fluctuations in the exchange rate and therefore make this option unfeasible. As an alternative it is recommended that the company raises this amount through its own equity. Based on the assessment of the future profits and cash flow to be generated from the business of Hertz the company can actually estimate time that will be required for reimbursement of the equity amount to be invested in the new business. This option is definitely cheaper than external borrowing as discussed above. Reference List Gro06: , (Groppelli & Nikbakht, 2006), Bri11: , (Brigham & Ehrhardt, 2011), Read More