Question

You are the CFO of a mid-sized company in Germany. Investors in Germany are very risk averse, thus you are planning to get fresh money from the US Capital market. The investment need is: 120 Mio. € and the expected future net pay-offs of this investment are exactly +30 Mio. for each of the next 6 years. The 6 years fixed loan interest rate in US $ is: 3% + 2% for the credit risk spread of the company. The current Price of one dollar is exactly 1 €.

A. The CEO calculates quickly and says: "Oh, that is good, by this credit and investments our profits will increase by 24 Mio. this year and we can distribute this money to us and the shareholders." Explain why this quick calculation of the CEO does not work.
B. After your explanation of A the CEO says: "Now I understand the project has an internal rate of return of 8.33% , which is far above the 5% but not every $ in the future counts the same. But why do you want to buy an additional instrument or even more to hedge some risks? Is a derivative not speculative and against our (risk) policies?" Show him, how and which kind of instrument could reduce the risk.
C. Instead of using the 6 years instruments the majority of the board voted for a 3 years refinancing with a rate of 2.5% (adopted each 3 month on the 3 Month US Treasury Bill rate) and an additional spread of 1.5% for the credit risk. 1. What would be the forward rate of year 4-6 for your financing if there is no additional liquidity spread and the $ price is considered fixed? 2. What additional risk to you see in the new refinancing strategy and what instruments could reduce such a risk?
D. After 3 years a crisis between China and Taiwan leads to a significant increase in the government spending of the US. 1. Explain how the increase in the government yield rate influence refinancing costs also for private companies in US. 2. What are typical problems with inflation rate bonds and how does this influence a capital demanding company?

Answer 1

The CEO's calculation disregards the time value of money and future payments' net present value. Financial instruments like forwards and swaps can hedge risks and are not purely speculative when managing risks. The 3-year refinancing strategy introduces interest rate risk, which can be managed with swaps or futures, and increased government spending can hike up refinancing costs for companies.

Step-by-step explanation:

The quick calculation made by the CEO regarding the credit and investment increasing profits by 24 Mio. does not work because it fails to account for the time value of money. A financial investor would need to choose an interest rate that reflects the opportunity cost of investing financial capital and a risk premium. Therefore, future net pay-offs of +30 Mio. each year cannot be simply summed up to project profits.

To address the CEO's query on derivatives, one can explain that certain financial instruments, like forwards, futures, swaps, or options, can be used to hedge against the risk of interest rate fluctuations or currency exchange rate changes. These instruments are not necessarily speculative if used for hedging purposes, as they align with risk management policies.

Regarding the 3-year refinancing strategy at a rate adjusted every three months based on the 3 Month US Treasury Bill rate plus a credit risk spread, the forward rate for years 4-6 would traditionally be extrapolated from the current yield curve, but any forecast would be speculative. The risks in this strategy stem from interest rate volatility, which can be mitigated using interest rate swaps or futures.

Finally, an increase in the government yield rate due to increased government spending in the US would likely result in higher refinancing costs for private companies. Inflation rate bonds, such as TIPS in the US, offer protection against inflation but come with risks such as lower yields than nominal bonds and potential underestimation of actual inflation. These issues may influence a capital demanding company's financing strategy and costs.