The CFO of Vaimato Industries needs to borrow money (a one-year loan) in the coming months to support the start up of a new project. The interest rate in the U.S. for a dollar loan was quoted as 14 percent (before taxes). A euro loan is also available at an interest rate of 8.60 percent. In both cases the marginal tax rate is 40 percent. The spot exchange rate (American terms) is $1.2135/€ and the one-year forward rate is $1.2500/€. What is the after-tax cost of debt for the cheapest source of funds?

Question

Quizplus · Accepted Answer

The after-tax cost of debt for the euro loan is the cheapest. The after-tax cost of the euro loan can be calculated by considering the interest rate, the tax rate, and the change in the exchange rate due to the loan being in euros. The calculation for the euro loan's after-tax cost of debt takes into account the interest expense, the tax shield (savings due to interest expense being tax-deductible), and the effect of the currency exchange rate movement on the repayment amount. The result is lower than the after-tax cost of the dollar loan, making the euro loan the cheapest source of funds.

The CFO of Vaimato Industries Needs to Borrow Money (A