Small business dilemmas and management challenges

Small Business Dilemma

Should Jim borrow dollars or pounds to finance his joint venture business? Why?

Based on an analysis of the external factors affecting this scenario, including present and forecasted interest rates for the Unites States dollar and the British pound, it is clear that Jim should definitely borrow pounds to finance his joint venture business. This conclusion is based on the established fact that "the actual cost of financing by the debtor firm will depend on: (1) the interest rate charged by the bank that provided the loan, and (2) the movement in the borrowed currency's value over the life of the loan" (Madura & Fox, 2007). Despite the fact that the British interest rate is somewhat higher, Sports Exports Company would be able to offset a portion of the firm's exposure by electing to borrow British pounds because "the international Fisher effect (IFE) suggests that the currency will increase in value such that any saving in interest rates will be taken up entirely by the increase in value of the currency and hence the cost of repayment" (Madura & Fox, 2007). By choosing British pounds over American dollars, Jim is afforded the option of utilizing of some or all of his future receivables in pounds as repayment on the British loan, instantly reducing the amount of pounds which will later require conversion to dollars.

Jim could also borrow Euros at an interest rate that is lower than the U.S. Or British rate. The values of the euro and pound tend to move in the same direction against the dollar but not always by the same degree. Would borrowing Euros to support the British joint venture result in more exposure to exchange rate risk than borrowing pounds? Would it result in more exposure to exchange rate risk than borrowing dollars?

The decision to borrow Euros would produce an increased amount of exchange rate risk than borrowing pounds, as Euros would necessitate future conversion into pounds to assure continual support of the British venture, while any repayment made on the loan would remain in Euros. This conclusion is supported by the fact that, "when an MNC borrows funds in a specific currency, its choice of a maturity is partially based on expectations of future interest rates in that country" (Madura & Fox, 2007). In the event that the Euro appreciated in value against the pound in the future, a larger amount of pounds would be required to repay the loan. This means that electing to borrow Euros would result in a reduced amount of risk, when directing the funds towards financing the British venture, than borrowing dollars because any potential movements in the value of the euro and the pound have been found to be distinctly correlated. However, if the value of the pound eventually declined against the dollar, the euro would, in most cases, follow suit, so that the total sum of pounds necessary to repay the loan would be less than the amount required to repay a loan denominated in dollars.