Global Energy Management Institute
International Financial Risk Management
R.J. Reynolds International Financing HBS Case 9-287-057
The case is set in the context of RJR’s 1985 financing of its $4.9 billion acquisition of
Nabisco Brands Inc. To finance the acquisition, RJR was proposing the issue of $1.2
billion of 12 year notes and the same amount in preferred stock. It had already funded
$1.5 billion of the acquisition leaving $1 billion more to finance.
Challenges facing RJR: Of the $1.5 billion that had been funded, $500 million came
from cash and the remaining was through bank borrowings and commercial paper. These
borrowings added to the debt that RJR had issued in 1984 and brought their debt ratings
down to A. The remaining $1 billion financing would have to keep this in mind as well
as the $1.2 billion of 12 year notes to be funded. To determine the financing, we need to
consider the following choices:
Debt vs. Equity: RJR is a mature company whose cash flows (> 1.5 billion in 1984) can
support debt.
Short term vs. Medium to long term: Given their commercial paper and short term debt,
and their long term debt, what is ideal for them at this juncture would be an issue of
intermediate term (3-5 year) debt.
Fixed vs. Floating rate: The short term and commercial paper debt that they already have
suggests using fixed rate debt.
Currency of financing: They do not have significant yen exposure that calls for exposure
to yen liabilities
Domestic vs. foreign markets: Their current issues of debt have been in the domestic
market so the foreign markets if attractive should certainly be considered.
Alternatives under consideration and their costs: (Refer to the spreadsheet gemi-rjr.xls for
details on the calculations)
1. Eurodollar bonds: Most straightforward method that had an all-in cost of 10.59%.
(This is the IRR of the cash flows associated with the bond issue to RJR taking
into account the price (100.125% of par) and the investment banking fees of
1.875% and the annual coupon of 10.125%). The cost of 10.59% was at a 45 bp
spread against U.S. Treasuries which was not a bad deal in itself.
2. Euroyen bonds: Since RJR would not have significant yen exposure, this bond
made sense only when combined with some hedging tool that converted the yen
payments to dollar payments. This can be done in two ways:
a. Forward contracts arranged through a dealer such as Nikko Securities).
The cash flows in yen and dollars via issue of a Euroyen bond and forward
contracts to hedge the yen exposure are given below (also see
spreadsheet): (initial cash inflows to RJR are converted using the offer rate
and interest and principal payments or outflows are calculated using the
bid rate from Exhibit 8)
Euroyen bond
Yen 25,000,000,000.00
Year
Cash flows in Yen
Cash flows in dollars
0
24,593,750,000.00
103,814,900.80
1
-1,593,750,000.000
-
6,890,402.08
2
-1,593,750,000.000
-
7,118,133.10
3
-1,593,750,000.000
-
7,392,161.41
4
-1,593,750,000.000
-
7,695,557.70
5
-26,593,750,000.000
- 134,583,755.06
The all-in cost (IRR) of this option in dollars is 10.64% and 6.769% in yen
b. Swap contracts arranged by MGL: MGL offers a yen-dollar currency
swap where MGL pays 7.1% (yen) fixed to RJR in return for $ LIBOR
(see Exhibit 9) (Currency swap fixed for floating). MGL does another
swap with RJR where they pay $ LIBOR to RJR in return for fixed dollar
cash flows at 10.92% from MGL (Floating for fixed dollars). Effectively
this implies (using Exhibit 9) that MGL pays fixed 7.1% yen to RJR and
receives fixed dollars at 10.92% from RJR. The dollar cash flows in this
case from RJR to MGL would be estimated as follows:
RJR needs yen cash flows in years 1-5 given above. To convert these at a
7.1% swap rate into dollar cash flows at 10.92% :
1. Take the PV of these yen cash flows at 7.1% This equals Yen
24,258,824,814.179
2. At the current spot rate (ask) of 236.90 this converts to $
$102,401,117.83 This is the present value of the yen cash flows at 7.1%.
RJR’s dollar payments are then set at 10.92% of this value. These numbers
are shown below:
Euroyen bonds(swapped)
Year
0
25,000,000,000.00
Cash flows
24,593,750,000.00
Dollars
$102,401,117.83
1
2
3
4
5
1,593,750,000.000
1,593,750,000.000
1,593,750,000.000
1,593,750,000.000
26,593,750,000.000
- 11,182,202.07
- 11,182,202.07
- 11,182,202.07
- 11,182,202.07
- 113,583,319.90
Another way to think of this is: PV of yen = 1,593,750, 000 /1.071 +
1,593,750, 000 / (1.071)^2 + …. (1,593,750,000 + 25,000,000,000) /
(1.071)^5 which converted to dollars at the spot should equal the present
value of dollar receipts discounted at 10.92% so the dollar payments are
determined by solving for: PV of yen (from above) converted into dollars at
the spot rate of 236.90 = $ Payment / 1.1092 + $Payment / (1.1092)^2 + …. +
($Payment + PV of yen converted into dollars) / (1.1092)^5)
Effectively this means that RJR receives 24,593,750,000 / 236.90 = $
103,814,900.80 (which is different from the dollar value in year 0 shown
above) and pays $11,182,202.07 for 5 years and in addition repays the $
102,401,117.83 in year 5. The all-in cost (IRR) of this option is 10.55%.
(The case points out on page 5 that one way to think about this is to see that
compared to the yen cost of 6.769% for Euroyen bonds, the 7.1% that RJR is
receiving is 33 bp higher, so the dollar cost of 10.92% should be reduced by
the 33 bp to give us the comparable dollar cost of close to 10.59%).
3. Dual currency bonds: These bonds would pay interest in one currency and would
be redeemable (par value paid) in another currency. The 1985 Ford Motor Credit
yen/dollar dual currency bonds paid higher coupon rates than ten year Japanese
govt. bonds and currency risk at redemption. These bonds were targeted at
Japanese institutions that were willing to take the currency risk at redemption and
would be compensated by higher coupon rates. The coupon rate on this dual
currency bond was 7.75% to be paid in yen but the redemption was set in dollars
at $115.956 million.
a. If RJR hedged the yen interest payments using forward contracts through
Nikko then the cash flows would be:
Dual currency bonds
Hedged using forwards
0
1
2
3
4
25,000,000,000.00
Cash flows in Yen
24,906,250,000.00
1,937,500,000.000
1,937,500,000.000
1,937,500,000.000
1,937,500,000.000
Cash flows in $
$105,134,022.79
8,376,567.23
8,653,416.70
8,986,549.17
9,355,383.87
5
26,937,500,000.000
- 125,761,161.94
Year
The year 5 dollar payment in this case ($125,761,161.94) is the last
interest payment of Yen 1,937,500,000 hedged using the rate of 197.60 plus
the dollar repayment of $115.956 million. The all-in cost (IRR) of this option
in dollars is 10.21%
b. RJR could also hedge the yen payments using the swap rates. To do
this again use the rates in Exhibit 9. RJR would receive 7.1% in yen fixed
from MGL and pay 10.92% in dollars fixed. To calculate the payments, first
consider the PV of yen payments at 7.1% which equals Yen
7,922,907,158.776. This is equal to $33,444,099.45 at the current spot rate of
236.90. Now calculate the payments based on this present value using the
dollar swap rate of 10.92%. This equals $9,030,776.95. The dollar cash
flows in this case to and from RJR are:
Year
0
1
2
3
4
5
Cash flows in $
$105,134,022.79
9,030,776.95
9,030,776.95
9,030,776.95
9,030,776.95
- 124,986,776.95
The last cash outflow in year five is the interest payment of $9,030,776.95
+ $ 115.956 million. The all-in cost (IRR) of this option to RJR in dollars is
10.27%
c. Alternatively, RJR could also hedge its repayment by locking in a yen
rate for the dollars to be repaid. Using the forward rates, this translates into a
repayment value of 115.956 million x 202.70 = Yen 23,504,281,200.00 When
this is added to the interest payment of Yen 1,937,500,000 the year 5 payment
in yen is Yen 25,441, 781,200. The yen cash flows are:
Year
0
Cash flows Yen
24,906,250,000.00
1
2
3
4
1,937,500,000.000
1,937,500,000.000
1,937,500,000.000
1,937,500,000.000
5
25,441,781,200.000
These payments are then swapped into dollars using the same 7.1% fixed
yen for 10.92% fixed dollar payments. To get the dollar payments, calculate
the present value of the year 1-5 yen cash flows from above at 7.1% and
convert this into dollars at the current dollar spot rate of 236.90. This is equal
to $103,854,134.32. Then calculate the interest payments in dollars as
10.92% of $103,854,134.32. This gives us dollar cash flows for RJR as
follows:
Year
0
1
Cash flows Yen
24,906,250,000.00
1,937,500,000.000
Cash flows in $
105,134,022.79
- 11,340,871.47
2
3
4
5
1,937,500,000.000
1,937,500,000.000
1,937,500,000.000
25,441,781,200.000
- 11,340,871.47
- 11,340,871.47
- 11,340,871.47
- 115,195,005.78
The time 0 dollar cash inflow to RJR is the Yen cash flow converted at the
current spot rate. The all-in cost (IRR) of this option is 10.59%.
Hence the various alternatives and their associated all-in costs are:
Alternative
All-in cost in dollars
Eurodollar bond
10.59%
Euroyen bond hedged into dollars using
10.64%
forward contracts
Euroyen bond hedged into dollars using
10.55%
currency swaps
Dual currency bond hedged into dollars
10.21%
using forward contracts
Dual currency bond hedging interest
10.27%
payments only
Dual currency bond by hedging principal
repayment also
10.59%