The Centralia Corporation is a U.S. manufacturer of small kitchen electrical appliances. It has decided to construct a wholly owned manufacturing facility in Zaragoza, Spain, to manufacture microwave ovens for sale in the European Union. The plant is expected to cost 5,500,000 with an economic life of 8 years. The borrowing capacity created by this capital expenditure is $2,900,000. Centralia decides to borrow up to its borrowing capacity. As a result, the remainder of the plant will be equity financed.

Centralia is not well known in the Spanish or international bond market. Consequently, it would have to pay 7% per annum to borrow euro, whereas the normal borrowing rate in the euro zone for well-known firms of equivalent risk is 6%. Alternatively, Centralia can borrow dollar in the U.S. at a rate of 8%.

A Spanish MNC has a mirror-image situation and needs $2,900,000 to finance a capital expenditure of its U.S. subsidiary. It has to pay 9% for dollar borrowing, whereas it can borrow euro at 6%.

The current spot rate is $1.33/.

QUESTIONS: 2 questions

(1) Set up a currency swap that will benefit both companies. Conduct a cash flow analysis of the currency. (2) Suppose that one year after the inception of the currency swap between Centralia and the Spanish MNC, the dollar interest rate has fallen from 8% to 6% and the euro interest rate has fallen from 6% to 5.50%. Calculate the market value of the swap if the exchange rate is $1.3343/. Which company would be willing to unwind the swap contract? Explain.