Airline Borrowing Case: May 1985

It is May 1985 and UAL, Inc., parent of United Airlines, needs to borrow $500 million to finance the purchase of Hertz. You are Assistant Treasurer and must make a recommendation about the choice between borrowing in the USA in U. S. Dollars or in Japan in Yen (¥). As background, UAL, Inc. owns United Airlines and Westin Hotels. It is buying Hertz from RCA. United Airlines will generate about 80% of the UAL revenue and the remainder will be evenly split between Hertz and Westin. United Airlines, Hertz, and Westin Hotels are worldwide service companies that generate revenue in many countries and currencies, mainly in the U.S., Canada, Latin America, and Europe. The Treasurer considers this to be a “No Brainer.”

If the loan is in U. S. Dollars in the USA, company policy requires the use of a specific investment banker. This firm describes the terms of the USA loan as follows: A coupon rate of 11% per year paid semi-annually in December and June for 10 years. The principal of $500 million would be repaid at the end of the 10-years. There would be a one-time underwriting fee of 0.5% (of the amount borrowed) to be paid when the loan funds are received.

A leading Japanese bank is offering a loan with the interest and principal denominated in Yen. The interest rate will be 5% and there are no upfront fees. Both loans require interest payments in December and in June. The entire principal is due in June 1995.

In May 1985, the exchange rate fluctuated between 250 and 252 yen to the dollar. For convenience, use 250 ¥ to the $ as the exchange rate in May 1985. Each student must recommend the best alternative and discuss why it is best.

Your analysis should consist of four parts:

First, create a schedule showing the interest, principal payments, and fees due for the dollar-denominated loan.

Second, for the yen-denominated loan, create a schedule showing the interest and principal payments due (in yen).

Third, right underneath your schedule for the yen-denominated loan, create another schedule showing those same interest and principal payments converted into dollars. In order to do this, link each payment in this schedule, via an Excel formula, to a cell that contains the average yen-dollar exchange-rate you forecast to occur over the term of the loan. If you’ve done this third schedule correctly, you should be able to plug in, say, 249 ¥ to the $, and see the third schedule update automatically. Remember: in May 1985, it was impossible to know for sure what the average yen-dollar exchange-rate over the term of the loan was going to be!

Fourth, use the tool you’ve just developed to find the exchange rate at which the two loans have the same NPV. To keep things simple, in your NPV calculation, you may assume that U.S. interest rates will remain at 11% for the term of the loans. Although you will be performing an NPV calculation for each loan separately–one for the U.S. loan, the other for the dollar-converted Japanese loan—each NPV calculation will use the same (U.S.) discount rate. Hint: in a loan, the initial cashflow is an inflow (i.e., the loan proceeds) and the subsequent cashflows are outflows (i.e., the loan payments)

In May 1985, the market for currency futures (a futures contract is an agreement struck today on the terms of an exchange of currencies in the future) was pricing dollars one year ahead at 235¥ to the $. Hint: Forward exchange rates are often considered a good proxy for market expectations of the future exchange rate.

Case Questions [Questions 1&2 are optional. Try them before starting the case itself. If you have any problems with questions 1&2, please email the professor!]: 1. [Optional] Mrs. Jones owns 100 shares of stock in Daimler-Benz valued at 16.5 Euros (€) per share. What is the value in $U.S. of her stock if: a. 0.90€ = $1 Answer: $1833.33 b. 0.70€ = $1 Answer: $2357.14 2. [Optional] John is planning on purchasing his German dream car for 65,000 Euros. How much does he need in $U.S. if there are 0.98 Euros to the $U.S.? Answer: $66326.53 3. Which loan alternative is best? Why? 4. What explains the large apparent difference between U.S. and Japanese interest rates in 1985? Hint: Think back to the lessons of Week 7.



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