Question

10. ABC Company plans to invest $45 million in Chile to expand its subsidiary's manufacturing output. ABC has two options. It can convert the $45 million at the current exchange rate of 435 pesos to a dollar (i.e., P435/$1), or it can engage in a debt-for-equity swap with its bank, City Bank, by purchasing Chilean debt and then swapping that debt into Chilean equity investments. a. If City Bank quotes bid-offer prices of 92-94 for Chilean loans, what is the bank expecting to receive from ABC Corporation (ignore taxes)? Why would City Bank want to dispose of this loan? b. If ABC decides to purchase the debt from City Bank and convert it to equity, it will have to exchange it at the official rate of P400/$1. Is this option better than investing directly in Chile at the free market rate of P435/S1? c. What official exchange rate will cause ABC to be indifferent between the two options?

Answer 1

Part a

Bid-offer price quoted by City bank is 92-94 --- which means, City Bank will buy 92 and sell at 94. Here, City Bank will sell the debt at 94. Hence, it will receive $42.3 Million ($45 million * 0.94) from ABC Company.

Here, City Bank is in possession of a foreign debt (Chilean debt). A foreign debt is impacted by multiple factors which also includes the socio-political environment of the foregin country. Sometimes, a change in foriegn policy (either internally within the country or in the foreign country), adversely impacts these foriegn loan. In case of Chile, recently in Feb 20, there were clashes and protests resulting in economic problems. Hence, banks always prefer to sell off their foriegn debts.

Part b

Free market rate - P435/$1

Debt-equity swap rate - P400/$1

If ABC company opts to invest directly, it will get $45 Million * P435 = P19,575 Million

If ABC company opts for debt equity, it will get $45 Million * P00 = P18,000 Million. In this case, as given in Part a, since ABC will only $42.3 Million, actual exchange rate works to P18,000 Million/$42.3 Million which is P425.53/$ which is still lower than free market rate of $435. Hence ABC company should not opt for Debt equity swap.

Part c

For ABC company to be indifferent between the two options, exchange rate has to be as follows:

P435 = ($45 Million * x rate) / $42.3 Million

x rate = P435 * 42.3 / 45 = 408.9

Thus, at the exchange rate of P408.9/$1, ABC company will be indifferent to both options