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The Centralia Corporation’s Currency Swap

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Question

The Centralia Corporation is a U.S. manufacturer of small kitchen electrical appliances. It has decided to construct a wholly owned manufacturing facility in Zaragoza, Spain, to manufacture microwave ovens for sale in the European Union. The plant is expected to cost €5,500,000, and to take about one year to complete. The plant is to be financed over its economic life of eight years. The borrowing capacity created by this capital expenditure is $2,900,000; the remainder of the plant will be equity financed. Centralia is not well known in the Spanish or international bond market; consequently, it would have to pay 7 percent per annum to borrow euros, whereas the normal borrowing rate in the euro zone for well-known firms of equivalent risk is 6 percent. Alternatively, Centralia can borrow dollars in the United States at a rate Of 8 percent.

Study Questions:

1. Suppose a Spanish MNC has a mirror-image situation and needs to finance a capital expenditure of one of its U.S. subsidiaries. It finds that it must pay a 9 percent fixed rate in the United States for dollars, whereas it can borrow euros at 6 percent. The exchange rate has been forecast to be S L .33/€1.00 in one year. Set up a currency swap that will benefit each counterparty.
2. Suppose that one year after the inception of the currency swap between Centralia and the Spanish MNC, the U.S. dollar fixed rate has fallen from 8 to 6 percent and the euro zone fixed rate for euros has fallen from 6 to 5.5 percent. In both dollars and euros, determine the market value of the swap if the exchange rate is S .5343/€1.00.

Solution

Presentation of case

  • The Centralia Corporation is a US-based manufacturing company, which deals with the small kitchen electrical appliances. It wants to construct a manufacturing plant in Spain to manufacture microwave ovens and to sell them in the European Union. The total capital investment required for this plant is €5,500,000. Out of this amount, the company is deciding to borrow $2,900,000 and remaining amount will be equity financed.
  • There is another company in Spain; Spanish MNC. It has planned to invest in one of its US subsidiaries. For this, it wants to borrow $2,900,000.
  • Both companies have a similar requirement but their home currencies are different. They have a competitive advantage in their home country.
  • Centralia Corporation has a competitive advantage in the US market. So it can borrow dollars in US at a rate of 8 percent while Spanish MNC has to pay a 9 percent fixed interest rate to borrow dollars in US.
  • The Spanish MNC has a competitive advantage in the Spain market. So it can borrow euros in Spain at a rate of 6 percent while Centralia Corporation has to pay a 7 percent fixed interest rate to borrow euros in Spain.
  • The exchange rate after one year has been forecasted as $1.33/€1.00.
  • The economic life of financing is eight years.
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