Question

On September 30, 2017, Ericson Company negotiated a two-year, 1,800,000 dudek loan from a foreign bank at an interest rate of 4 percent per year. It makes interest payments annually on September 30 and will repay the principal on September 30, 2019. Ericson prepares U.S.-dollar financial statements and has a December 31 year-end.

September 30, 2017	$	0.180
December 31, 2017		0.185
September 30, 2018		0.200
December 31, 2018		0.205
September 30, 2019		0.230

Taking the exchange rate effect on the cost of borrowing into consideration, determine the effective interest rate in dollars on the loan in each of the three years 2017, 2018, and 2019.

Effective Cost of Borrowing201720182019

Effective Cost of Borrowing
2017
2018
2019

Answer 1

Using the formula for Effective Cost of Borrowing:

Rf = (1 + if)(1 + ef) - 1 Where Rf = is the effective financing rate. if = is the market interest rate. I.e., 4% P.A. ef = is the expected (percentage) change in the foreign currency against the firm’s home currency. Expected change = (forecast - current)/current), or Forecast currenct rate for2019=$0.23 Current currency rate2017=$0.18   =(0.23-0.18)/0.18 = 0.277778 0r 27.78% Now EBC for 2017 = (1+0.04)X(1+0.277778)-1 = 0.328889 or 32.89% Now EBC for 2018 ef= (0.23-0.2)/0.2 =0.15 EBCfor 2018 =(1+0.04)X(1+0.15)-1 =0.1960 or 19.60% and for 2019 = 4.00% Effective Cost of Borrowing        2017 32.89% 2018 19.60% 2019 4.00%