Question 21.A.5: Eurodollar versus Domestic Bond Issue PROBLEM: Suppose Hewle...
Eurodollar versus Domestic Bond Issue
PROBLEM: Suppose Hewlett-Packard (HP) needs $3.5 million to build a new facility. The firm plans to finance the facility by selling bonds domestically or in the Eurodollar bond market. In either case, the bond issue will have a maturity of three years, a par value of $1,000, and coupon interest payments totaling $50 a year. After transaction costs and underwriters’ fees, the domestic bond issue will net $951.90 per bond, and the Eurodollar bonds will net $948.00 per bond. Which bonds—domestic or Eurodolla —should HP issue?
APPROACH: Fortunately, we know from Chapter 8 that the best deal is the alternative that offers the lowest interest cost. You may want to review the bond yield calculation formulas in Section 8.3 of Chapter 8. Drawing on those formulas, we calculate the yield to maturity for each alternative. Because bond issues pay coupon interest semiannually in the United States and annually in Europe, we must also compute the effective annual yield (EAY) for the domestic bonds in order to compare it with the yield on the Eurodollar bonds.
For the Eurodollar bond, the annual coupon payment is $50 per year, and the yield calculation is:
\$948.00=\frac{\$50}{1+i}+\frac{\$50}{(1+i)^2}+\frac{\$1.050}{(1+i)^3}Using our financial calculator, we find that the Eurodollar bond issue’s annual yield is 6.9808 percent.
For the domestic bond issue, the semiannual coupon payments are $25 ($50/2 = $25), and the semiannual bond yield calculation is:
The bond issue’s semiannual yield is 3.3997 percent. We now apply the EAY formula from Chapter 8 to find the effective annual yield for the domestic bonds:
\begin{matrix} EAY &=& (1+Quoted \ interest \ rate /m)^m -1 \\ &=& (1+0.033997)^2 -1 \\ &=& 1.0691 -1 \\ &=& 6.92\% \end{matrix}The domestic bond issue, with a 6.92 percent effective annual yield, will provide the lower interest cost, all other things being equal. Of course, the fact that the domestic bond nets a higher price per $1,000 owed tells us that this bond has a lower interest cost. We just did not know precisely how much lower without performing the calculations.