Question

In order to hedge its Mexican peso earnings, All-American is considering borrowing MXN 25 million, but...

In order to hedge its Mexican peso earnings, All-American is considering borrowing MXN 25 million, but is concerned about losing its USD interest tax shield. The spot exchange rate is USD 0.4/MXN, rt,T = 8% and rt,T* = 6%. The tax rate is 35% and the forward rate is USD 0.40755/MXN

a) What is All-American’s tax shield from borrowing in USD?

b) What is All-American’s tax shield from borrowing in MXN?

c) What is the risk-adjusted expected tax shield from borrowing in MXN?

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Homework Answers

Answer #1

a. As spot exchange rate is USD 0.4/MXN, MXN 25 million = 25 * 0.4 = USD 10 million.

Interest Amount = USD Amount * Interest Rate or borrowing cost = USD 10 million * 0.08 = USD 0.8 million. Tax savings in USD = Interest Amount * Tax Rate = 0.8 * 0.35 = USD 280,000.

b. Interest Amount = MXN Amount * Interest Rate or borrowing cost = 25 million * 0.06 = MXN 1.5 million. Tax savings MXN = Interest Amount * Tax Rate = 1.5 * 0.35 = MXN 525,000.

c. The forward rate is provided as 0.40755/MXN. The tax shield from interest is worth MXN 525,000 * 0.40755 = USD 213,964. The 25 million MXN amount also appreciates by 25 million * (0.40755 - 0.4) = USD 188,750 and associated tax savings = USD 188,750 * 0.35 = USD 66,063.

The risk-adjusted expected tax shield from borrowing in MXN = USD 213,964 + USD 66,063 = USD 280, 027.

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