Question

4. IBM needs to raise $1 billion and is trying to decide between a domestic dollar bond issue and a Eurobond issue. The U.S. bond can be issued at a coupon of 6.75 percent, paid semiannually, with underwriting and other expenses totaling 0.95 percent of the issue size. The Eurobond would cost only 0.55 percent to issue but would bear an annual coupon of 6.88 percent. Both issues would mature in 10 years. Assuming all else is equal, which is the least expensive issue for IBM? (10 marks)

Answer 1

issue Size: 1 Billion

Calculation of Effective Cost of each Bond:

	US Bond	Euro Bond
Coupan Rate %	6.75	6.88
Compounding	Semi Anually	Anually
Underwriting Expense	0.95 percent of issue Size	0.55 percent of issue Size
Term	10 year	10 year
Effective Int Rate (refer calculation as given below)*	6.86	6.88
Cost of Issue (In billion) $	0.0095	0.0055
Issue Cost Per Year= Cost of Issue/ years $	0.00095	0.00055
Interest Per Year $	0.0686	0.0688
Total Cost per year $= Issue Cost per year+Interest Cost Per year	0.06955	0.06935
Effective Cost of Bond per Year in %	6.955	6.935

The Effective cost is less in Euro Bond, therefore, the company should raise the money from Euro Bond.

* Effective Interest Rate for US Bond as the compounding done quarterly:

effective Interest Rate (r) = (1 + i/n)^n - 1

r= (1+0.0675/2)^2-1

r= 0.0686 say 6.86%