International Finance Homework Solution

FINC/ECON 3240 - International Finance Homework Solution
Chapter 1 2. Comparative Advantage. a. Explain how the theory of comparative advantage relates to the need for international business. ANSWER: The theory of comparative advantage implies that countries should specialize in production, thereby relying on other countries for some products. Consequently, there is a need for international business. b. Explain how the product cycle theory relates to the growth of an MNC.

ANSWER: The product cycle theory suggests that at some point in time, the firm will attempt to capitalize on its perceived advantages in markets other than where it was initially established. 4. International Opportunities.
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Do you think the acquisition of a foreign firm or licensing will result in greater growth for an MNC? Which alternative is likely to have more risk?

ANSWER: An acquisition will typically result in greater growth, but it is more risky because it normally requires a larger investment and the decision can not be easily reversed once the acquisition is made. b. Describe a scenario in which the size of a corporation is not affected by access to international opportunities. ANSWER: Some firms may avoid opportunities because they lack knowledge about foreign markets or expect that the risks are excessive. Thus, the size of these firms is not affected by the opportunities. c. Explain why MNCs such as Coca Cola and PepsiCo, Inc., still have numerous opportunities for international expansion. ANSWER: Coca Cola and PepsiCo still have new international opportunities because countries are at various stages of development. Some countries have just recently opened their borders to MNCs. Many of these countries do not offer sufficient food or drink products to their consumers. 7. Benefits and Risks of International Business. As an overall review of this chapter, identify possible reasons for growth in international business. Then, list the various disadvantages that may discourage international business. ANSWER: Growth in international business can be stimulated by (1) access to foreign resources which can reduce costs, or (2) access to foreign markets which boost revenues. Yet, international business is subject to risks of exchange rate fluctuations, and political risk (such as a possible host government takeover, tax regulations, etc.).
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8. Valuation of an MNC. Hudson Co., a U.S. firm, has a subsidiary in Mexico, where political risk has recently increased. Hudson’s best guess of its future peso cash flows to be received has not changed. However, its valuation has declined as a result of the increase in political risk. Explain. ANSWER: The valuation of the MNC is the present value of expected cash flows. The increase in risk results in a higher expected return, which reduces the present value of the expected future cash flows. 13. Methods Used to Conduct International Business. Duve, Inc., desires to penetrate a foreign market with either a licensing agreement with a foreign firm or by acquiring a foreign firm. Explain the differences in potential risk and return between a licensing agreement with a foreign firm, and the acquisition of a foreign firm. ANSWER: A licensing agreement has limited potential for return, because the foreign firm will receive much of the benefits as a result of the licensing agreement. Yet, the MNC has limited risk, because it did not need to invest substantial funds in the foreign country. An acquisition by the MNC requires a substantial investment. If this investment is not a success, the MNC may have trouble selling the firm it acquired for a reasonable price. Thus, there is more risk. However, if this investment is successful, all of the benefits accrue to the MNC. 14. International Business Methods. Snyder Golf Co., a U.S. firm that sells high-quality golf clubs in the U.S., wants to expand internationally by selling the same golf clubs in Brazil. a. Describe the tradeoffs that are involved for each method (such as exporting, direct foreign investment, etc.) that Snyder could use to achieve its goal. ANSWER: Snyder can export the clubs, but the transportation expenses may be high. If could establish a subsidiary in Brazil to produce and sell the clubs, but this may require a large investment of funds. It could use licensing, in which it specifies to a Brazilian firm how to produce the clubs. In this way, it does not have to establish its own subsidiary there. b. Which method would you recommend for this firm? Justify your recommendation.

ANSWER: If the amount of golf clubs to be sold in Brazil is small, it may decide to export. However, if the expected sales level is high, it may benefit from licensing. If it is confident that the expected sales level will remain high, it may be willing to establish a subsidiary. The wages are lower in Brazil, and the large investment needed to establish a subsidiary may be worthwhile. 15. Impact of Political Risk. Explain why political risk may discourage international business. ANSWER: Political risk increases the rate of return required to invest in foreign projects. Some foreign projects would have been feasible if there was no political risk, but will not be feasible because of political risk.

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17. International Joint Venture. Anheuser-Busch, the producer of Budweiser and other beers, has recently expanded into Japan by engaging in a joint venture with Kirin Brewery, the largest brewery in Japan. The joint venture enables Anheuser-Busch to have its beer distributed through Kirin’s distribution channels in Japan. In addition, it can utilize Kirin’s facilities to produce beer that will be sold locally. In return, Anheuser-Busch provides information about the American beer market to Kirin. a. Explain how the joint venture can enable Anheuser-Busch to achieve its objective of maximizing shareholder wealth. ANSWER: The joint venture creates a way for Anheuser-Busch to distribute Budweiser throughout Japan. It enables Anheuser-Busch to penetrate the Japanese market without requiring a substantial investment in Japan. b. Explain how the joint venture can limit the risk of the international business. ANSWER: The joint venture has limited risk because Anheuser-Busch does not need to establish its own distribution network in Japan. Thus, Anheuser-Busch may be able to use a smaller investment for the international business, and there is a higher probability that the international business will be successful. c. Many international joint ventures are intended to circumvent barriers that normally prevent foreign competition. What barrier in Japan is Anheuser-Busch circumventing as a result of the joint venture? What barrier in the United States is Kirin circumventing as a result of the joint venture? ANSWER: Anheuser-Busch is able to benefit from Kirin’s distribution system in Japan, which would not normally be so accessible. Kirin is able to learn more about how Anheuser-Busch expanded its product across numerous countries, and therefore breaks through an “information” barrier. d. Explain how Anheuser-Busch could lose some of its market share in countries outside Japan as a result of this particular joint venture. ANSWER: Anheuser-Busch could lose some of its market share to Kirin as a result of explaining its worldwide expansion strategies to Kirin. However, it appears that Anheuser-Busch expects the potential benefits of the joint venture to outweigh any potential adverse effects.

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Chapter 2 2. Inflation Effect on Trade. a. How would a relatively high home inflation rate affect the home country’s current account, other things being equal? ANSWER: A high inflation rate tends to increase imports and decrease exports, thereby increasing the current account deficit, other things equal. b. Is a negative current account harmful to a country? Discuss. ANSWER: This question is intended to encourage opinions and does not have a perfect solution. A negative current account is thought to reflect lost jobs in a country, which is unfavorable. Yet, the foreign importing reflects strong competition from foreign producers, which may keep prices (inflation) low. 9. Currency Effects. When South Korea’s export growth stalled, some South Korean firms suggested that South Korea’s primary export problem was the weakness in the Japanese yen. How would you interpret this statement? ANSWER: One of South Korea’s primary competitors in exporting is Japan, which produces and exports many of the same types of products to the same countries. When the Japanese yen is weak, some importers switch to Japanese products in place of South Korean products. For this reason, it is often suggested that South Korea’s primary export problem is weakness in the Japanese yen. 13. Exchange Rate Effects on Trade. a. Explain why a stronger dollar could enlarge the U.S. balance of trade deficit. Explain why a weaker dollar could affect the U.S. balance of trade deficit. ANSWER: A stronger dollar makes U.S. exports more expensive to importers and may reduce imports. It makes U.S. imports cheap and may increase U.S. imports. A weaker home currency increases the prices of imports purchased by the home country and reduces the prices paid by foreign businesses for the home country’s exports. This should cause a decrease in the home country’s demand for imports and an increase in the foreign demand for the home country’s exports, and therefore increase the current account. However, this relationship can be distorted by other factors.

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Chapter 3

4. Exchange Rate Effects on Borrowing. Explain how the appreciation of the Japanese yen against the U.S. dollar would affect the return to a U.S. firm that borrowed Japanese yen and used the proceeds for a U.S. project. ANSWER: If the Japanese yen appreciates over the borrowing period, this implies that the U.S. firm converted yen to U.S. dollars at a lower exchange rate than the rate at which it paid for yen at the time it would repay the loan. Thus, it is adversely affected by the appreciation. Its cost of borrowing will be higher as a result of this appreciation. 7. Bid/ask Spread. Compute the bid/ask percentage spread for Mexican peso retail transactions in which the ask rate is $.11 and the bid rate is $.10. ANSWER: [($.11 – $.10)/$.11] = .091, or 9.1%. 8. Forward Contract. The Wolfpack Corporation is a U.S. exporter that invoices its exports to the United Kingdom in British pounds. If it expects that the pound will appreciate against the dollar in the future, should it hedge its exports with a forward contract? Explain. ANSWER: The forward contract can hedge future receivables or payables in foreign currencies to insulate the firm against exchange rate risk. Yet, in this case, the Wolfpack Corporation should not hedge because it would benefit from appreciation of the pound when it converts the pounds to dollars.

10. Indirect Exchange Rate. If the direct exchange rate of the euro is worth $1.25, what is the indirect rate of the euro? That is, what is the value of a dollar in euros? ANSWER: 1/1.25 = .8 euros. 12. Syndicated Loans. Explain how syndicated loans are used in international markets. ANSWER: A large MNC may want to obtain a large loan that no single bank wants to accommodate by itself. Thus, a bank may create a syndicate whereby several other banks also participate in the loan. 16. International Diversification. Explain how the Asian crisis would have affected the returns to a U.S. firm investing in the Asian stock markets as a means of international diversification. [See the chapter appendix.] ANSWER: The returns to the U.S. firm would have been reduced substantially as a result of the Asian crisis because of both declines in the Asian stock markets and because of currency depreciation. For example, the Indonesian stock market declined by about 27% from June 1997 to June 1998. Furthermore, the Indonesian rupiah declined again the U.S. dollar by 84%. 18. Foreign Exchange. You just came back from Canada, where the Canadian dollar was worth $.70. You still have C$200 from your trip and could exchange them for dollars at the airport, but the airport foreign exchange desk will only buy them for $.60. Next week, you will be going to Mexico and will
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need pesos. The airport foreign exchange desk will sell you pesos for $.10 per peso. You met a tourist at the airport who is from Mexico and is on his way to Canada. He is willing to buy your C$200 for 1,300 pesos. Should you accept the offer or cash the Canadian dollars in at the airport? Explain. ANSWER: Exchange with the tourist. If you exchange the C$ for pesos at the foreign exchange desk, the cross-rate is $.60/$10 = 6. Thus, the C$200 would be exchanged for 1,200 pesos (computed as 200 × 6). If you exchange Canadian dollars for pesos with the tourist, you will receive 1,300 pesos. 22. International Financial Markets. Recently, Wal-Mart established two retail outlets in the city of Shanzen, China, which has a population of 3.7 million. These outlets are massive and contain products purchased locally as well as imports. As Wal-Mart generates earnings beyond what it needs in Shanzen, it may remit those earnings back to the United States. Wal-Mart is likely to build additional outlets in Shanzen or in other Chinese cities in the future. a. Explain how the Wal-Mart outlets in China would use the spot market in foreign exchange. ANSWER: The Wal-Mart stores in China need other currencies to buy products from other countries, and must convert the Chinese currency (yuan) into the other currencies in the spot market to purchase these products. They also could use the spot market to convert excess earnings denominated in yuan into dollars, which would be remitted to the U.S. parent.
b. Explain how Wal-Mart might utilize the international money market when it is establishing other Wal-Mart stores in Asia.

ANSWER: Wal-Mart may need to maintain some deposits in the Eurocurrency market that can be used (when needed) to support the growth of Wal-Mart stores in various foreign markets. When some Wal-Mart stores in foreign markets need funds, they borrow from banks in the Eurocurrency market. Thus, the Eurocurrency market serves as a deposit or lending source for Wal-Mart and other MNCs on a short-term basis. c. Explain how Wal-Mart could use the international bond market to finance the establishment of new outlets in foreign markets. ANSWER: Wal-Mart could issue bonds in the Eurobond market to generate funds needed to establish new outlets. The bonds may be denominated in the currency that is needed; then, once the stores are established, some of the cash flows generated by those stores could be used to pay interest on the bonds.

Recently, Wal-Mart established two retail outlets in the city of Shanzen, China, which has a population of 3.7 million. These outlets are massive and contain products purchased locally as well as imports. As Wal-Mart generates earnings beyond what it needs in Shanzen, it may remit those earnings back to the United States. Wal-Mart is likely to build additional outlets in Shanzen or in other Chinese cities in the future. a. Explain how the Wal-Mart outlets in China would use the spot market in foreign exchange. b. Explain how Wal-Mart might utilize the international money markets when it is establishing other Wal-Mart stores in Asia.
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c. Expalin how Wal-Mart could use the international bond market to finance the establishment of new outlets in foreign markets. My answers: a. Many foreign transactions do not require an exchange of currencies but allow a given currency to cross country borders therefore it will be easy for the US dollar to be exchanged on the spot market. b. When short term funds are needed, Wal-Mart will be able to utilize internation money markets to finance imports,etc. c. By utilizing the international bond market, Wal-Mart will have access to long-term funds in the foreign market to help with establishing new outlets within the foreign markets.
24. Interpreting Exchange Rate Quotations. Today you notice the following exchange rate quotations: *$1 is equal to 3.00 Argentine pesos *1 Argentine peso = 0.50 Canadian dollars You need to purchase 100,000 Canadian dollars with U.S. dollars. How many U.S. dollars will you need for your purchase? ANSWER: Value of AP = $.333 Value of C$ in AP = 2 Value of C$ in $ = $.666 So you need $66,666 to purchase C$100,000.
Chapter 4

2. Inflation Effects on Exchange Rates. Assume that the U.S. inflation rate becomes high relative to Canadian inflation. Other things being equal, how should this affect the (a) U.S. demand for Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of the Canadian dollar? ANSWER: Demand for Canadian dollars should increase, supply of Canadian dollars for sale should decrease, and the Canadian dollar’s value should increase. 3. Interest Rate Effects on Exchange Rates. Assume U.S. interest rates fall relative to British interest rates. Other things being equal, how should this affect the (a) U.S. demand for British pounds, (b) supply of pounds for sale, and (c) equilibrium value of the pound? ANSWER: Demand for pounds should increase, supply of pounds for sale should decrease, and the pound’s value should increase. 4. Income Effects on Exchange Rates. Assume that the U.S. income level rises at a much higher rate than does the Canadian income level. Other things being equal, how should this affect the (a) U.S. demand for Canadian dollars, (b) supply of Canadian dollars for sale, and (c) equilibrium value of the Canadian dollar?

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ANSWER: Assuming no effect on U.S. interest rates, demand for Canadian dollars should increase, supply of Canadian dollars for sale may not be affected, and the Canadian dollar’s value should increase. 12. Factors Affecting Exchange Rates. In the 1990s, Russia was attempting to import more goods but had little to offer other countries in terms of potential exports. In addition, Russia’s inflation rate was high. Explain the type of pressure that these factors placed on the Russian currency. ANSWER: The large amount of Russian imports and lack of Russian exports placed downward pressure on the Russian currency. The high inflation rate in Russia also placed downward pressure on the Russian currency. 14. Factors Affecting Exchange Rates. If the Asian countries experience a decline in economic growth (and experience a decline in inflation and interest rates as a result), how will their currency values (relative to the U.S. dollar) be affected? ANSWER: A relative decline in Asian economic growth will reduce Asian demand for U.S. products, which places upward pressure on Asian currencies. However, given the change in interest rates, Asian corporations with excess cash may now invest in the U.S. or other countries, thereby increasing the demand for U.S. dollars. Thus, a decline in Asian interest rates will place downward pressure on the value of the Asian currencies. The overall impact depends on the magnitude of the forces just described. 19. Aggregate Effects on Exchange Rates. Assume that the United States invests heavily in government and corporate securities of Country K. In addition, residents of Country K invest heavily in the United States. Approximately $10 billion worth of investment transactions occur between these two countries each year. The total dollar value of trade transactions per year is about $8 million. This information is expected to also hold in the future. Because your firm exports goods to Country K, your job as international cash manager requires you to forecast the value of Country K’s currency (the “krank”) with respect to the dollar. Explain how each of the following conditions will affect the value of the krank, holding other things equal. Then, aggregate all of these impacts to develop an overall forecast of the krank’s movement against the dollar. a. U.S. inflation has suddenly increased substantially, while Country K’s inflation remains low. ANSWER: Increased U.S. demand for the krank. Decreased supply of kranks for sale. Upward pressure in the krank’s value. b. U.S. interest rates have increased substantially, while Country K’s interest rates remain low. Investors of both countries are attracted to high interest rates. ANSWER: Decreased U.S. demand for the krank. Increased supply of kranks for sale. Downward pressure on the krank’s value. c. The U.S. income level increased substantially, while Country K’s income level has remained unchanged.
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ANSWER: Increased U.S. demand for the krank. Upward pressure on the krank’s value. d. The U.S. is expected to impose a small tariff on goods imported from Country K. ANSWER: The tariff will cause a decrease in the United States’ desire for Country K’s goods, and will therefore reduce the demand for kranks for sale. Downward pressure on the krank’s value. e. Combine all expected impacts to develop an overall forecast. ANSWER: Two of the scenarios described above place upward pressure on the value of the krank. However, these scenarios are related to trade, and trade flows are relatively minor between the U.S. and Country K. The interest rate scenario places downward pressure on the krank’s value. Since the interest rates affect capital flows and capital flows dominate trade flows between the U.S. and Country K, the interest rate scenario should overwhelm all other scenarios. Thus, when considering the importance of implications of all scenarios, the krank is expected to depreciate.

Chapter 6

6. Currency Effects on Economy. What is the impact of a weak home currency on the home economy, other things being equal? What is the impact of a strong home currency on the home economy, other things being equal? ANSWER: A weak home currency tends to increase a country’s exports and decrease its imports, thereby lowering its unemployment. However, it also can cause higher inflation since there is a reduction in foreign competition (because a weak home currency is not worth much in foreign countries). Thus, local producers can more easily increase prices without concern about pricing themselves out of the market. A strong home currency can keep inflation in the home country low, since it encourages consumers to buy abroad. Local producers must maintain low prices to remain competitive. Also, foreign supplies can be obtained cheaply. This also helps to maintain low inflation. However, a strong home currency can increase unemployment in the home country. This is due to the increase in imports and decrease in exports often associated with a strong home currency (imports become cheaper to that country but the country’s exports become more expensive to foreign customers).

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13. Effects of Indirect Intervention. Suppose that the government of Chile reduces one of its key interest rates. The values of several other Latin American currencies are expected to change substantially against the Chilean peso in response to the news. a. Explain why other Latin American currencies could be affected by a cut in Chile’s interest rates. ANSWER: Exchange rates are partially driven by relative interest rates of the countries of concern. When Chile’s interest rates decline, there is a smaller flow of funds to be exchanged into Chilean pesos because the Chile interest rate is not as attractive to investors. There may be a shift of investment into the other Latin American countries where interest rates have not declined. However, if these Latin American countries are expected to reduce their rates as well, they will not attract more capital and may even attract less capital flows in the future, which could reduce their values. b. How would the central banks of other Latin American countries likely adjust their interest rates? How would the currencies of these countries respond to the central bank intervention? ANSWER: The central banks would likely attempt to lower interest rates, which causes the currency to weaken. A weaker currency and lower interest rates can stimulate the economy. c. How would a U.S. firm that exports products to Latin American countries be affected by the central bank intervention? (Assume the exports are denominated in the corresponding Latin American currency for each country.) ANSWER: The exporter is adversely affected if the Chilean peso and other currencies depreciate. It is favorably affected by the appreciation of any Latin American currencies.

17. Effects of September 11. Within a few days after the September 11, 2001 terrorist attack on the U.S., the Federal Reserve reduced short-term interest rates in the U.S. to stimulate the U.S. economy. How might this action have affected the foreign flow of funds into the U.S. and affected the value of the dollar? How could such an effect on the dollar increase the probability that the U.S. economy would strengthen? ANSWER: The lower interest rates are expected to stimulate the U.S. economy, by encouraging more borrowing and spending. Lower U.S. interest rates may reduce the amount of foreign flows to the U.S., which could have reduced the value of the dollar. If the dollar weakened U.S. exports would be cheaper, which could have increased the demand for products produced by U.S. exporters. 18. Intervention Effects on Corporate Performance. Assume you have a subsidiary in Australia. The subsidiary sells mobile homes to local consumers in Australia, who buy the homes using mostly borrowed funds from local banks. Your subsidiary purchases all of its materials from Hong Kong. The Hong Kong dollar is tied to the U.S. dollar. Your subsidiary borrowed funds from the U.S. parent, and must pay the parent $100,000 in interest each month. Australia has just raised its interest rate in order to boost the value of its currency (Australian dollar, A$). The Australian dollar appreciates against the dollar as a result. Explain whether these actions would increase, reduce, or have no effect on:
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a. The volume of your subsidiary’s sales in Australia (measured in A$) b. The cost to your subsidiary of purchasing materials (measured in A$) c. The cost to your subsidiary of making the interest payments to the U.S. parent (measured in A$). Briefly explain each answer. ANSWER: a. The volume of the sales should decline as the cost to consumers who finance their purchases would rise due to the higher interest rates. b. The cost of purchasing materials should decline because the A$ appreciates against the HK$ as it appreciates against the U.S. dollar. c. The interest expenses should decline because it will take fewer A$ to make the monthly payment of $100,000.

Chapter 7

8. Effects of September 11. The terrorist attack on the U.S. on September 11, 2001 caused expectations of a weaker U.S. economy. Explain how such expectations could have affected U.S. interest rates, and therefore have affected the forward rate premium (or discount) on various foreign currencies. ANSWER: The expectations of a weaker U.S. economy resulted in a decline of short-term interest rates (in fact, the Fed expedited the movement by increasing liquidity in the banking system). The U.S. interest rate was reduced while foreign interest rates were not. Therefore, the forward premium on foreign currencies decreased, or the forward discount became more pronounced. 9. Interest Rate Parity. Explain the concept of interest rate parity. Provide the rationale for its possible existence. ANSWER: Interest rate parity states that the forward rate premium (or discount) of a currency should reflect the differential in interest rates between the two countries. If interest rate parity didn’t exist, covered interest arbitrage could occur (in the absence of transactions costs, and foreign risk), which should cause market forces to move back toward conditions which reflect interest rate parity. The exact formula is provided in the chapter.

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10. Inflation Effects on the Forward Rate. Why do you think currencies of countries with high inflation rates tend to have forward discounts? ANSWER: These currencies have high interest rates, which cause forward rates to have discounts as a result of interest rate parity. 14. Changes in Forward Premiums. Assume that the Japanese yen’s forward rate currently exhibits a premium of 6 percent and that interest rate parity exists. If U.S. interest rates decrease, how must this premium change to maintain interest rate parity? Why might we expect the premium to change?

ANSWER: The premium will decrease in order to maintain IRP, because the difference between the interest rates is reduced. We would expect the premium to change because as U.S. interest rates decrease, U.S. investors could benefit from covered interest arbitrage if the forward premium stays the same. The return earned by U.S. investors who use covered interest arbitrage would not be any higher than before, but the return would now exceed the interest rate earned in the U.S. Thus, there is downward pressure on the forward premium. 15. Changes in Forward Premiums. Assume that the forward rate premium of the euro was higher last month than it is today. What does this imply about interest rate differentials between the United States and Europe today compared to those last month? ANSWER: The interest rate differential is smaller now than it was last month.

21. Deriving the Forward Rate. Assume that annual interest rates in the U.S. are 4 percent, while interest rates in France are 6 percent. a. b. According to IRP, what should the forward rate premium or discount of the euro be? If the euro’s spot rate is $1.10, what should the one-year forward rate of the euro be?

ANSWER: (1.04 ) −1 = −.0189 = −1.89 % a. p = (1.06 ) b. F = $1.10 (1 −.0189 ) = $1.079 30. Testing IRP. The one-year interest rate in Singapore is 11 percent. The one-year interest rate in the U.S. is 6 percent. The spot rate of the Singapore dollar (S$) is $.50 and the forward rate of the S$ is $.46. Assume zero transactions costs. a. Does interest rate parity exist?

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ANSWER: No, because the discount is larger than the interest rate differential. b. Can a U.S. firm benefit from investing funds in Singapore using covered interest arbitrage? ANSWER: No, because the discount on a forward sale exceeds the interest rate advantage of investing in Singapore.

Chapter 8

4. Testing PPP. Inflation differentials between the U.S. and other industrialized countries have typically been a few percentage points in any given year. Yet, in many years annual exchange rates between the corresponding currencies have changed by 10 percent or more. What does this information suggest about PPP? ANSWER: The information suggests that there are other factors besides inflation differentials that influence exchange rate movements. Thus, the exchange rate movements will not necessarily conform to inflation differentials, and therefore PPP will not necessarily hold. 5. Limitations of PPP. Explain why PPP does not hold. ANSWER: PPP does not consistently hold because there are other factors besides inflation that influences exchange rates. Thus, exchange rates will not move in perfect tandem with inflation differentials. In addition, there may not be substitutes for traded goods. Therefore, even when a country’s inflation increases, the foreign demand for its products will not necessarily decrease (in the manner suggested by PPP) if substitutes are not available.

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11. PPP Applied to the Euro. Assume that several European countries that use the euro as their currency experience higher inflation than the United States, while two other European countries that use the euro as their currency experience lower inflation than the United States. According to PPP, how will the euro’s value against the dollar be affected?

ANSWER: The high European inflation overall would reduce the U.S. demand for European products, increase the European demand for U.S. products, and cause the euro to depreciate against the dollar. According to the PPP theory, the euro’s value would adjust in response to the weighted inflation rates of the European countries that are represented by the euro relative to the inflation in the U.S. If the European inflation rises, while the U.S. inflation remains low, there would be downward pressure on the euro.

18. Estimating Depreciation Due to PPP. Assume that the spot exchange rate of the British pound is $1.73. How will this spot rate adjust according to PPP if the United Kingdom experiences an inflation rate of 7 percent while the United States experiences an inflation rate of 2 percent? ANSWER: According to PPP, the exchange rate of the pound will depreciate by 4.7 percent. Therefore, the spot rate would adjust to $1.73 × [1 + (–.0467)] = $1.649.

26. IRP. The one-year risk-free interest rate in Mexico is 10%. The one-year risk-free rate in the U.S. is 2%. Assume that interest rate parity exists. The spot rate of the Mexican peso is $.14. a. What is the forward rate premium? b. What is the one-year forward rate of the peso? c. Based on the international Fisher effect, what is the expected change in the spot rate over the next year? d. If the spot rate changes as expected according to the IFE, what will be the spot rate in one year? e. Compare your answers to (b) and (d) and explain the relationship. ANSWER: a. According to interest rate parity, the forward premium is

(1 +.02 ) −1 = − 07273 . (1 +.10 )

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b. The forward rate is $.14 × (1 – .07273) = $.1298. c. According to the IFE, the expected change in the peso is:
(1 +.02 ) −1 = − 07273 . (1 +.10 )

or –7.273% d. $.14 × (1 – .07273) = $.1298 e. The answers are the same. When IRP holds, the forward rate premium and the expected percentage change in the spot rate are derived in the same manner. Thus, the forward premium serves as the forecasted percentage change in the spot rate according to IFE. 35. Implications of PPP. Today’s spot rate of the Mexican peso is $.10. Assume that purchasing power parity holds. The U.S. inflation rate over this year is expected to be 7%, while the Mexican inflation over this year is expected to be 3%. Wake Forest Co. plans to import from Mexico and will need 20 million Mexican pesos in one year. Determine the expected amount of dollars to be paid by the Wake Forest Co. for the pesos in one year. ANSWER: [(1.07)/(1.03)] – 1 = 0.03883495. So the expected future spot rate is 0.10x(1+0.03883495)=$.103883495. Carolina will need to pay $.103883495× 20 million pesos = $2,077,670. Chapter 5 1. Forward versus Futures Contracts. Compare and contrast forward and futures contracts. ANSWER: Because currency futures contracts are standardized into small amounts, they can be valuable for the speculator or small firm (a commercial bank’s forward contracts are more common for larger amounts). However, the standardized format of futures forces limited maturities and amounts. 2. Using Currency Futures. a. How can currency futures be used by corporations?

ANSWER: U.S. corporations that desire to lock in a price at which they can sell a foreign currency would sell currency futures. U.S. corporations that desire to lock in a price at which they can purchase a foreign currency would purchase currency futures. b. How can currency futures be used by speculators?

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ANSWER: Speculators who expect a currency to appreciate could purchase currency futures contracts for that currency. Speculators who expect a currency to depreciate could sell currency futures contracts for that currency. 3. Currency Options. Differentiate between a currency call option and a currency put option. ANSWER: A currency call option provides the right to purchase a specified currency at a specified price within a specified period of time. A currency put option provides the right to sell a specified currency for a specified price within a specified period of time. 4. Forward Premium. Compute the forward discount or premium for the Mexican peso whose 90-day forward rate is $.102 and spot rate is $.10. State whether your answer is a discount or premium. ANSWER: (F – S)/S = ($.102 – $.10)/$.10 × (360/90) = –.08, or –8%, which reflects a 8% discount 6. Hedging With Currency Options. When would a U.S. firm consider purchasing a call option on euros for hedging? When would a U.S. firm consider purchasing a put option on euros for hedging? ANSWER: A call option can hedge a firm’s future payables denominated in euros. It effectively locks in the maximum price to be paid for euros. A put option on euros can hedge a U.S. firm’s future receivables denominated in euros. It effectively locks in the minimum price at which it can exchange euros received. 7. Speculating With Currency Options. When should a speculator purchase a call option on Australian dollars? When should a speculator purchase a put option on Australian dollars? ANSWER: Speculators should purchase a call option on Australian dollars if they expect the Australian dollar value to appreciate substantially over the period specified by the option contract. Speculators should purchase a put option on Australian dollars if they expect the Australian dollar value to depreciate substantially over the period specified by the option contract. 10. Speculating with Currency Call Options. Randy Rudecki purchased a call option on British pounds for $.02 per unit. The strike price was $1.45 and the spot rate at the time the option was exercised was $1.46. Assume there are 31,250 units in a British pound option. What was Randy’s net profit on this option? ANSWER: Profit per unit on exercising the option Premium paid per unit Net profit per unit Net profit per option = 31,250 units × (–$.01) = $.01 = $.02 = –$.01 = –$312.50

11. Speculating with Currency Put Options. Alice Duever purchased a put option on British pounds for $.04 per unit. The strike price was $1.80 and the spot rate at the time the pound option was exercised

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was $1.59. Assume there are 31,250 units in a British pound option. What was Alice’s net profit on the option? ANSWER: Profit per unit on exercising the option Premium paid per unit Net profit per unit Net profit for one option = 31,250 units × $.17 = $.21 = $.04 = $.17 = $5,312.50

12. Selling Currency Call Options. Mike Suerth sold a call option on Canadian dollars for $.01 per unit. The strike price was $.76, and the spot rate at the time the option was exercised was $.82. Assume Mike did not obtain Canadian dollars until the option was exercised. Also assume that there are 50,000 units in a Canadian dollar option. What was Mike’s net profit on the call option? ANSWER: Premium received per unit Amount per unit received from selling C$ Amount per unit paid when purchasing C$ Net profit per unit Net Profit = 50,000 units × (–$.05) = $.01 = $.76 = $.82 = –$.05 = –$2,500

13. Selling Currency Put Options. Brian Tull sold a put option on Canadian dollars for $.03 per unit. The strike price was $.75, and the spot rate at the time the option was exercised was $.72. Assume Brian immediately sold off the Canadian dollars received when the option was exercised. Also assume that there are 50,000 units in a Canadian dollar option. What was Brian’s net profit on the put option? ANSWER: Premium received per unit Amount per unit received from selling C$ Amount per unit paid for C$ Net profit per unit = $.03 = $.72 = $.75 = $0

17. Price Movements of Currency Futures. Assume that on November 1, the spot rate of the British pound was $1.58 and the price on a December futures contract was $1.59. Assume that the pound depreciated during November so that by November 30 it was worth $1.51. a. What do you think happened to the futures price over the month of November? Why? ANSWER: The December futures price would have decreased, because it reflects expectations of the future spot rate as of the settlement date. If the existing spot rate is $1.51, the spot rate expected on the December futures settlement date is likely to be near $1.51 as well. b. If you had known that this would occur, would you have purchased or sold a December futures contract in pounds on November 1? Explain.

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ANSWER: You would have sold futures at the existing futures price of $1.59. Then as the spot rate of the pound declined, the futures price would decline and you could close out your futures position by purchasing a futures contract at a lower price. Alternatively, you could wait until the settlement date, purchase the pounds in the spot market, and fulfill the futures obligation by delivering pounds at the price of $1.59 per pound.

21. Speculating with Currency Call Options. Bama Corp. has sold British pound call options for speculative purposes. The option premium was $.06 per unit, and the exercise price was $1.58. Bama will purchase the pounds on the day the options are exercised (if the options are exercised) in order to fulfill its obligation. In the following table, fill in the net profit (or loss) to Bama Corp. if the listed spot rate exists at the time the purchaser of the call options considers exercising them.

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ANSWER: Possible Spot Rate at the Time Purchaser of Call Option Considers Exercising Them $1.53 1.55 1.57 1.60 1.62 1.64 1.68 Net Profit (Loss) per Unit to Bama Corporation if Spot Rate Occurs $.06 .06 .06 .04 .02 .00 –.04

22. Speculating with Currency Put Options. Bulldog, Inc., has sold Australian dollar put options at a premium of $.01 per unit, and an exercise price of $.76 per unit. It has forecasted the Australian dollar’s lowest level over the period of concern as shown in the following table. Determine the net profit (or loss) per unit to Bulldog, Inc., if each level occurs and the put options are exercised at that time. ANSWER: Possible Value of Australian Dollar $.72 .73 .74 .75 .76 Net Profit (Loss) to Bulldog, Inc. if Value Occurs –$.03 –.02 –.01 .00 .01

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Chapter 10 1. Transaction versus Economic Exposure. Compare and contrast transaction exposure and economic exposure. Why would an MNC consider examining only its “net” cash flows in each currency when assessing its transaction exposure? ANSWER: Transaction exposure is due only to international transactions by a firm. Economic exposure includes any form by which the firm’s cash flow will be affected. Foreign competition may increase due to currency fluctuations. This could affect the firm’s cash flow, but did not affect the value of any ongoing transactions. Thus, it represents a form of economic exposure but not transaction exposure. Transaction exposure is a subset of economic exposure. Consideration of all cash flows in a particular currency is not necessary when some inflows and outflows offset each other. Only net cash flows are necessary. 3. Factors That Affect a Firm’s Transaction Exposure. What factors affect a firm’s degree of transaction exposure in a particular currency? For each factor, explain the desirable characteristics that would reduce transaction exposure. ANSWER: Currency variability—low level is desirable. Currency correlations—low level is desirable for currencies that are net inflows, while a high level is desirable for pairs of currencies in which one currency shows future net inflows while the other currency shows future net outflows. 5. Currency Effects on Cash Flows. How should appreciation of a firm’s home currency generally affect its cash inflows? How should depreciation of a firm’s home currency generally affect its cash outflows? ANSWER: Appreciation of the firm’s home currency reduces inflows since the foreign demand for the firm’s goods is reduced and foreign competition is increased. Depreciation of the firm’s home currency should increase inflows since it will likely increase foreign demand for the firm’s goods and reduce foreign competition. 6. Transaction Exposure. Fischer Inc., exports products from Florida to Europe. It obtains supplies and borrows funds locally. How would appreciation of the euro likely affect its net cash flows? Why? ANSWER: Fischer Inc. should benefit from the appreciation of the euro, because it should experience a strong demand for its products when the euro has more purchasing power (can obtain dollars at a low price). 7. Exposure of Domestic Firms. Why are the cash flows of a purely domestic firm exposed to exchange rate fluctuations? ANSWER: If the firm competes with foreign firms that also sell in a given market, the consumers may switch to foreign products if the local currency strengthens.

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11. Transaction Exposure. Aggie Co. produces chemicals. It is a major exporter to Europe, where its main competition is from other U.S. exporters. All of these companies invoice the products in U.S. dollars. Is Aggie’s transaction exposure likely to be significantly affected if the euro strengthens or weakens? Explain. If the euro weakens for several years, can you think of any change that might occur in the global chemicals market? ANSWER: If the euro strengthens, European customers can purchase Aggie’s goods with fewer euros. Since Aggie’s competitors also invoice their exports in dollars, Aggie Company will not gain a competitive advantage. Nevertheless, the overall demand for the product could increase because the chemicals are now less expensive to European customers. If the euro weakens, European customers will need to pay more euros to purchase Aggie’s goods. Since Aggie’s competitors also invoice their exports in dollars, Aggie Company may not necessarily lose some of its market share. However, the overall European demand for chemicals could decline because the prices paid for them have increased. If the euro remained weak for several years, some companies in Europe may begin to produce the chemicals, so that customers could avoid purchasing dollars with weak euros. That is, the U.S. exporters could be priced out of the European market over time if the euro continually weakened. 12. Economic Exposure. Longhorn Co. produces hospital equipment. Most of its revenues are in the United States. About half of its expenses require outflows in Philippine pesos (to pay for Philippine materials). Most of Longhorn’s competition is from U.S. firms that have no international business at all. How will Longhorn Co. be affected if the peso strengthens? ANSWER: If the peso strengthens, Longhorn will incur higher expenses when paying for the Philippine materials. Because its competition is not affected in a similar manner, Longhorn Company is at a competitive disadvantage when the peso strengthens. 13. Economic Exposure. Lubbock, Inc., produces furniture and has no international business. Its major competitors import most of their furniture from Brazil and then sell it out of retail stores in the United States. How will Lubbock, Inc., be affected if Brazil’s currency (the real) strengthens over time? ANSWER: If the Brazilian real strengthens, U.S. retail stores will likely have to pay higher prices for the furniture from Brazil, and may pass some or all of the higher cost on to customers. Consequently, some customers may shift to furniture produced by Lubbock Inc. Thus, Lubbock Inc. is expected to be favorably affected by a strong Brazilian real.

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Chapter 12 2. Reducing Economic Exposure. UVA Co. is a U.S.-based MNC that obtains 40 percent of its foreign supplies from Thailand. It also borrows Thailand’s currency (the baht) from Thai banks and converts the baht to dollars to support U.S. operations. It currently receives about 10 percent of its revenue from Thai customers. Its sales to Thai customers are denominated in baht. Explain how UVA Co. can reduce its economic exposure to exchange rate fluctuations. ANSWER: UVA Company has periodic outflow payments in Thai baht that are substantially more than its Thai baht inflow payments. UVA could reduce its economic exposure by attempting to increase sales in Thailand, which would generate additional Thai baht inflows. 3. Reducing Economic Exposure. Albany Corp. is a U.S.-based MNC that has a large government contract with Australia. The contract will continue for several years and generate more than half of Albany’s total sales volume. The Australian government pays Albany in Australian dollars. About 10 percent of Albany’s operating expenses are in Australian dollars; all other expenses are in U.S. dollars. Explain how Albany Corp. can reduce its economic exposure to exchange rate fluctuations. ANSWER: Albany may ask the Australian government to provide payment in U.S. dollars. Alternatively, Albany could attempt to shift some of its expenses to Australia, by either purchasing Australian supplies or shifting part of the production process to Australia. These strategies will increase Australian dollar outflows, so that the Australian dollar inflows and outflows are more balanced.

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Chapter 13 1. Motives for DFI. Describe some potential benefits to an MNC as a result of direct foreign investment (DFI). Elaborate on each type of benefit. Which motives for DFI do you think encouraged Nike to expand its footwear production in Latin America? ANSWER: See the text exhibit in this chapter for a complete summary of the potential benefits. Regarding Nike’s motives, Latin America offers additional sources of demand, as Latin American consumers have shown an interest in Nike footwear (this is partially due to increased marketing targeted to Latin American markets). Second, Nike may be able to produce their athletic footwear at relatively low costs in some Latin American countries, as the production is labor-intensive and wages are low. Third, Nike may benefit from economies of scale by producing a large amount and exporting the additional shoes for sale to nearby countries. Fourth, the expansion into Latin America allows Nike to further diversify its business internationally. 2. Impact of a Weak Currency on Feasibility of DFI. Packer, Inc., a U.S. producer of computer disks, plans to establish a subsidiary in Mexico in order to penetrate the Mexican market. Packer’s executives believe that the Mexican peso’s value is relatively strong and will weaken against the dollar over time. If their expectations about the peso value are correct, how will this affect the feasibility of the project? Explain. ANSWER: If the peso’s value is relatively strong now, Packer Inc. will incur high costs of establishing a Mexican subsidiary. In addition, if the peso weakens, future remitted earnings by the subsidiary to the parent will be converted to fewer dollars. Packer will be adversely affected by the exchange rate movements (although the project may still be feasible). 3. DFI to Achieve Economies of Scale. Bear Co. and Viking, Inc., are automobile manufacturers that desire to benefit from economies of scale. Bear Co. has decided to establish distributorship subsidiaries in various countries, while Viking, Inc., has decided to establish manufacturing subsidiaries in various countries. Which firm is more likely to benefit from economies of scale? ANSWER: Bear Company is likely to benefit because it is maintaining all of its manufacturing in one area. If Viking Inc. spreads its production facilities, it will incur higher fixed costs of machinery. 4. DFI to Reduce Cash Flow Volatility. Raider Chemical Co. and Ram, Inc., had similar intentions to reduce the volatility of their cash flows. Raider implemented a long-range plan to establish 40 percent of its business in Canada. Ram, Inc., implemented a long-range plan to establish 30 percent of its business in Europe and Asia, scattered among 12 different countries. Which company will more effectively reduce cash flow volatility once the plans are achieved? ANSWER: Ram Inc. would likely be more effective because its international business is spread across several major countries, while Raider Chemical Company is concentrated in only one foreign country whose business cycles are related to the U.S. 7. Opportunities in Less Developed Countries. Offer your opinion on why economies of some less developed countries with strict restrictions on international trade and DFI are somewhat independent from economies of other countries. Why would MNCs desire to enter such countries? If these

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countries relaxed their restrictions, would their economies continue to be independent of other economies? Explain. 10. Risk Resulting from International Business. This chapter concentrates on possible benefits to a firm that increases its international business. a. What are some risks of international business that may not exist for local business? ANSWER: Some of the more common risks of DFI are a government takeover and changing tax laws. There are additional risks (discussed in other chapters) such as currency restrictions, high probability of war, and declining economic conditions. b. What does this chapter reveal about the relationship between an MNC’s degree of international business and its risk? ANSWER: Firms with more international business can reduce risk with diversification. Thus, firms could reduce their risk by increasing their degree of international business. However, there are some exceptions. A firm that pursues substantial international business in one country may increase its risk, especially if it does not fully understand the consumers and government laws in that country. In general, a firm becomes exposed to some types of risk that may not have existed before it pursued international business, but the diversification benefits may offset these types of risk. 12. Disney’s DFI Motives. What potential benefits do you think were most important in the decision of the Walt Disney Co. to build a theme park in France? ANSWER: There is no simple answer to this question, but the question usually leads to an interesting discussion. Some of the more likely motives as related to those discussed in this chapter are:
a. New sources of demand—another theme park in the U.S. would have less potential, since U.S.

tourists are willing to travel to California or Florida to see the theme parks.

b. Economies of scale should result from the new theme park, because much of the costs associated with planning a theme park have already been incurred. Also, the sales of Disney toys will increase, allowing for additional economies of scale in production. c. French labor may not necessarily be less costly than U.S. labor, but there may be a cost advantage to the land in France (due to land subsidies provided by the French government). d. Exploit monopolistic advantages—there are other theme parks in Europe. Yet, some tourists may feel that no other theme park is an adequate substitute for Disney. Thus, Disney can now attract tourists who are unwilling to travel to the U.S. e. Diversification—the Disney theme parks in the U.S. have experienced reduced sales when the dollar is strong because foreign tourism in the U.S. declines. A theme park in France may appeal to tourists who decide not to travel to the U.S. when the dollar is strong (euro is weak). In fact, it may even attract more tourists from the U.S. when the dollar is strong.

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Chapter 14 5. Impact of Exchange Rates on NPV. Describe in general terms how future appreciation of the euro

will likely affect the value (from the parent’s perspective) of a project established in Germany today by a U.S.-based MNC. Will the sensitivity of the project value be affected by the percentage of earnings remitted to the parent each year? ANSWER: a. Future appreciation of the euro would benefit the parent since the euro earnings would be worth more when remitted and converted to dollars. This is especially true when a large percentage of earnings are sent to the parent. b. Repeat this question, but assume the future depreciation of the euro. The future depreciation of the euro would hurt the parent since the euro earnings would be worth less when remitted and converted to dollars. This is especially true when a large percentage of earnings are sent to the parent. 10. Capital Budgeting Logic. Athens, Inc. established a subsidiary in the United Kingdom that was independent of its operations in the United States. The subsidiary’s performance was well above what was expected. Consequently, when a British firm approached Athens about the possibility of acquiring the subsidiary, Athens’ chief financial officer implied that the subsidiary was performing so well that it was not for sale. Comment on this strategy. ANSWER: Even if the performance is superior, the subsidiary may be worth selling if the price offered for it exceeds Athens’ perceived present value of the subsidiary. 11. Capital Budgeting Logic. Lehigh Co. established a subsidiary in Switzerland that was performing below the cash flow projections developed before the subsidiary was established. Lehigh anticipated that future cash flows would also be lower than the original cash flow projections. Consequently, Lehigh decided to inform several potential acquiring firms of its plan to sell the subsidiary. Lehigh then received a few bids. Even the highest bid was very low, but Lehigh accepted the offer. It justified its decision by stating that any existing project whose cash flows are not sufficient to recover the initial investment should be divested. Comment on this statement. ANSWER: Even if the project will not recover its initial outlay, it should only be divested if the price offered for it exceeds Lehigh’s estimation of its present value. 13. Capital Budgeting Example. Brower, Inc. just constructed a manufacturing plant in Ghana. The construction cost 9 billion Ghanian cedi. Brower intends to leave the plant open for three years. During the three years of operation, cedi cash flows are expected to be 3 billion cedi, 3 billion cedi, and 2 billion cedi, respectively. Operating cash flows will begin one year from today and are remitted back to the parent at the end of each year. At the end of the third year, Brower expects to sell the plant for 5 billion cedi. Brower has a required rate of return of 17 percent. It currently takes 8,700 cedi to buy one U.S. dollar, and the cedi is expected to depreciate by 5 percent per year.

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a.

Determine the NPV for this project. Should Brower build the plant?

ANSWER: Cash Flows: Year Investment Operating CF Salvage Value Net CF Exchange rate Cash flows to parent PV of parent cash flows NPV 0 –9 –9 8,700 –$1,034,483 –$1,034,483 –$1,034,483 1 3 3 9,135 $328,407.23 $280,689.94 –$753,793.06 2 3 3 9,592 $312,760.63 $228,475.88 –$525,317.18 3 2 5 7 10,071 $695,065.04 $433,978.15 –$91,339.03

Since the project has a negative net present value (NPV), Brower should not undertake it. b. How would your answer change if the value of the cedi was expected to remain unchanged from its current value of 8,700 cedis per U.S. dollar over the course of the three years? Should Brower construct the plant then? ANSWER:
If the cedi was expected to remain unchanged from its current value of 8700 cedis per U.S. dollar over the course of the three years:

Year Investment Operating CF Salvage Value Net CF Exchange rate Cash flows to parent PV of parent cash flows NPV

0 –9 –9 8,700 –$1,034,483 –$1,034,483 –$1,034,483

1 3 3 8,700 $344,827.59 $294,724.44 –$739,748.56

2 3 3 8,700 $344,827.59 $251,901.23 –$487,847.33

3 2 5 7 8,700 $804,597.70 $502,367.11 +$14,519.78

If the value of the cedi remains constant, the NPV is positive. Thus, Brower should undertake the project in this case. Of course, the NPV is only slightly positive. Whether or not Brower actually undertakes the project depends on the confidence it has in its exchange rate forecasts. 20. Capital Budgeting Analysis. A project in South Korea requires an initial investment of 2 billion South Korean won. The project is expected to generate net cash flows to the subsidiary of 3 billion and 4 billion won in the two years of operation, respectively. The project has no salvage value. The current value of the won is 1,100 won per U.S. dollar, and the value of the won is expected to remain constant over the next two years.
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a. What is the NPV of this project if the required rate of return is 13 percent? b. Repeat the question, except assume that the value of the won is expected to be 1,200 won per U.S. dollar after two years. Further assume that the funds are blocked and that the parent company will only be able to remit them back to the U.S. in two years. How does this affect the NPV of the project? ANSWER: Year Investment Operating CF Net CF Exchange rate Cash flows to parent PV of parent cash flows NPV The NPV is $3,443,139.99. ANSWER: Year Investment Operating CF Net CF Exchange rate Cash flows to parent PV of parent cash flows NPV 0 –2 –2 1,100 –$1,818,181.82 –$1,818,181.82 –$1,818,181.82 2 7 7 1,200 $5,833,333.33 $4,568,355.65 +$2,750,173.83 0 –2 –2 1,100 –$1,818,181.82 –$1,818,181.82 –$1,818,181.82 1 3 3 1,100 $2,727,272.73 $2,413,515.69 +$595,333.87 2 4 4 1,100 $3,636,363.64 $2,847,806.12 +$3,443,139.99

A situation where the funds are blocked and the won is expected to depreciate reduces the NPV by $692,966.16.

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Chapter 16

4. Diversifying Away Country Risk. Why do you think that an MNC’s strategy of diversifying projects internationally could achieve low exposure to overall country risk? ANSWER: If the MNC can set up foreign projects in countries whose country risk levels are not highly correlated over time, then it reduces the exposure to the possibility of high country risk in all of these areas simultaneously. 5. Monitoring Country Risk. Once a project is accepted, country risk analysis for the foreign country involved is no longer necessary, assuming that no other proposed projects are being evaluated for that country. Do you agree with this statement? Why or why not? ANSWER: Disagree! The country risk must be monitored continuously, since if risk becomes too high, the MNC should divest its subsidiaries in that country. 6. Country Risk Analysis. If the potential return is high enough, any degree of country risk can be tolerated. Do you agree with this statement? Why or why not? Do you think that a proper country risk analysis can replace a capital budgeting analysis of a project considered for a foreign country? Explain. ANSWER: Disagree! If country risk is so high that there is great danger to employees, no expected return is high enough to warrant the project. No. Country risk analysis is not intended to estimate all project cash flows and determine the present value of these cash flows. It is intended to identify forms of country risk and their potential impact. This is important information for capital budgeting but is not a substitute for capital budgeting. 9. Incorporating Country Risk in Capital Budgeting. How could a country risk assessment be used to adjust a project’s required rate of return? How could such an assessment be used instead to adjust a project’s estimated cash flows? ANSWER: For countries with a lower country risk rating (implying high risk), the project’s required rate of return could be increased (by increasing the discount rate on NPV analysis). To adjust cash flows, consider each key form of country risk and re-estimate cash flows if that form of risk occurs. For example, if the host government may block funds temporarily, estimate the NPV of the project if that occurs. Re-estimate the NPV for any other forms of country risk as well. This process results in a distribution of possible NPVs that can be assessed to determine whether a project should be accepted. 10. Reducing Country Risk. Explain some methods of reducing exposure to existing country risk, while maintaining the same amount of business within a particular country. ANSWER: Some of the more common methods to reduce country risk are: 1. 2. 3. 4. use a short-term horizon hire local labor borrow local funds obtain insurance
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5. create joint ventures These and other methods are discussed in the chapter. 18. J.C. Penney’s Country Risk Analysis. Recently, J.C. Penney decided to consider expanding into various foreign countries; it applied a comprehensive country risk analysis before making its expansion decisions. Initial screenings of 30 foreign countries were based on political and economic factors that contribute to country risk. For the remaining 20 countries where country risk was considered to be tolerable, specific country risk characteristics of each country were considered. One of J.C. Penney’s biggest targets is Mexico, where it planned to build and operate seven large stores. a. Identify the political factors that you think may possibly affect the performance of the J.C. Penney stores in Mexico. ANSWER: Perhaps the most likely political factor is the blockage of fund transfers or currency inconvertibility, because the currency (the peso) is sometimes volatile and could require special controls in some periods. b. Explain why the J.C. Penney stores in Mexico and in other foreign markets are subject to financial risk (a subset of country risk). ANSWER: The economy in Mexico is volatile, and if economic conditions deteriorate, the demand for many products sold at the J.C. Penney stores will decline. While some economies are more stable than Mexico’s economy, any country is subject to a possible weakening of the economy. Therefore, J.C. Penney stores in any country could experience weak sales due to financial risk. c. Assume that J.C. Penney anticipated that there was a 10 percent chance that the Mexican government would temporarily prevent conversion of peso profits into dollars because of political conditions. This event would prevent J.C. Penney from remitting earnings generated in Mexico and could adversely affect the performance of these stores (from the U.S. perspective). Offer a way in which this type of political risk could be explicitly incorporated into a capital budgeting analysis when assessing the feasibility of these projects. ANSWER: The expected cash flows of the project could be re-estimated based on the scenario that the Mexican government restricts the conversion of currencies. The net present value of the project can be re-estimated as well. Thus, the capital budgeting analysis results in a distribution of NPVs based on possible scenarios. d. Assume that J.C. Penney decides to use dollars to finance the expansion of stores in Mexico. Second, assume that J.C. Penney decides to use one set of dollar cash flow estimates for any project that it assesses. Third, assume that the stores in Mexico are not subject to political risk. Do you think that the required rate of return on these projects would differ from the required rate of return on stores built in the U.S. at that same time? Explain. ANSWER: If J.C. Penney generated a single set of cash flow estimates for the establishment of a given store in Mexico, it would likely use a required rate of return that is higher than that used for a proposed store in the U.S. The higher required rate of return on new stores in Mexico is attributed to the greater degree of uncertainty associated with the new stores in Mexico than new stores in the U.S. Even though there is more potential for profits from new stores in Mexico, there is more uncertainty about the future cash flows generated by those stores. The Mexican economy is more volatile than the U.S. economy, so the demand for products in Mexico is subject to more uncertainty. Also, the
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exchange rate movements will affect the dollar earnings that are generated by the stores in Mexico. Since the exchange rate movements are very uncertain, so are the dollar earnings that will be received by the U.S. parent. e. Based on your answer to the previous question, does this mean that proposals for any new stores in the U.S. have a higher probability of being accepted than proposals for any new stores in Mexico? ANSWER: No. The U.S. markets have less potential because J.C. Penney has stores in most U.S. markets (as mentioned in the case). Therefore, the estimated cash flows would be lower for U.S. projects. Even though the required rate of return may be higher for a proposed store in Mexico, the dollar cash flows should be much higher, which could result in a higher probability of accepting this type of project.

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Chapter 17

2. Optimal Financing. Wizard, Inc. has a subsidiary in a country where the government allows only a small amount of earnings to be remitted to the U.S. each year. Should Wizard finance the subsidiary with debt financing by the parent, equity financing by the parent, or financing by local banks in the foreign country? ANSWER: Wizard should use financing by local banks in the foreign country, so that the subsidiary can make use of its funds by paying off local debt. 5. Cost of Capital. Explain how characteristics of MNCs can affect the cost of capital. ANSWER: The following characteristics of MNCs can influence the cost of capital:
• •

Size. MNCs have more opportunities to grow, and larger, better known firms may receive preferential treatment by creditors. Access to international capital markets. MNCs have access to more sources of funds than domestic firms. To the extent that financial markets are segmented, MNCs may be able to obtain financing from various sources at a lower cost. International diversification. If MNCs can achieve more stable cash flows through their international diversification, their probability of bankruptcy is reduced. Creditors and shareholders may therefore accept a lower rate of return when providing funds to the MNCs, which reflects a lower cost of capital for MNCs. Exchange rate risk. MNCs that are highly exposed to exchange rate movements may be more likely to experience financial problems (if they do not hedge the risk). Thus, they may incur a higher cost of capital. Country risk. MNCs with subsidiaries in politically unstable countries may experience volatile cash flows over time and be more susceptible to financial problems. Thus, they may incur a higher cost of capital.

•

•

•

8. Financing Decision. Drexel Co. is a U.S.-based company that is establishing a project in a politically unstable country. It is considering two possible sources of financing. Either the parent could provide most of the financing, or the subsidiary could be supported by local loans from banks in that country. Which financing alternative is more appropriate to protect the subsidiary? ANSWER: Drexel should let local banks support the subsidiary since it would be in the interest of the banks to see that the subsidiary performs well. If the host government imposed restrictions that reduced the subsidiary’s profits, the banks could be adversely affected as well. Financing from the MNC parent would not provide such protection since the local banks would have less interest in protecting the subsidiary from host government restrictions.

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9. Financing Decision. Veer Co. is a U.S.-based MNC that has most of its operations in Japan. Since the Japanese companies with which it competes use more financial leverage, it has decided to adjust its financial leverage to be in line with theirs. With this heavy emphasis on debt, Veer should reap more tax advantages. It believes that the market’s perception of its risk will remain unchanged, since its financial leverage will still be no higher than that of its Japanese competitors. Comment on this strategy.

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ANSWER: Japanese corporations can use a higher degree of financial leverage because of their relationships with creditors and the government. The Japanese government may be willing to bail out a Japanese company whose shares are held by Japanese investors and institutions. Yet, it is less likely to bail out a subsidiary of a U.S. corporation. The Japanese subsidiary does not receive the same protection that other Japanese firms receive. Therefore, if this subsidiary attempts to use as much financial leverage, its risk will be higher than that of the Japanese competitors. 10. Financing Tradeoffs. Pullman, Inc., a U.S. firm, has been highly profitable, but prefers not to pay out higher dividends because its shareholders want the funds to be reinvested. It plans for large growth in several less developed countries. Pullman would like to finance the growth with local debt in the host countries of concern to reduce its exposure to country risk. Explain the dilemma faced by Pullman, and offer possible solutions. ANSWER: Pullman Inc. has retained earnings that it must reinvest. Yet, if it uses the retained earnings to finance the growth, it will be more exposed to country risk. Pullman may consider using retained earnings but allowing for other local institutions in the host countries to invest in their projects as well. In this way, retained earnings are used while tying some local institutions into the project for negotiating power in case the host government imposes severe restrictions on the subsidiaries. 11. Costs of Capital Across Countries. Explain why the cost of capital for a U.S.-based MNC with a large subsidiary in Brazil is higher than for a U.S.-based MNC in the same industry with a large subsidiary in Japan. Assume that the subsidiary operations for each MNC are financed with local debt in the host country. ANSWER: The risk-free interest rate is much higher in Brazil than in Japan. In addition, the risk premium on the business in Brazil may be higher than the risk premium on the business in Japan. 12. WACC. An MNC has total assets of $100 million and debt of $20 million. The firm’s before-tax cost of debt is 12 percent, and its cost of financing with equity is 15 percent. The MNC has a corporate tax rate of 40 percent. What is this firm’s weighted average cost of capital? ANSWER:
 D   E  kc =  k d (1 − t ) +  k e D+E D+E  $20   $80  = 12 %(1 − .4) +  15 % $100    $100  = .0144 + .12 = .1344 = 13 .44 %
19. Financing Decision. Forest Company produces goods in the U.S., Germany, and Australia, and

sells the goods in the areas where they are produced. Foreign earnings are periodically remitted to the U.S. parent. As the euro’s interest rates have declined to a very low level, Forest Company has decided to finance its German operations with borrowed funds in place of the parent’s equity investment. Forest will transfer the U.S. parent’s equity investment in the German subsidiary over to its Australian subsidiary. These funds will be used to pay off a floating-rate loan, as Australian interest rates have been high and are rising. Explain the expected effects of these actions on the consolidated capital structure and cost of capital of Forest Company.
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Given the strategy to be used by Forest, explain how its exposure to exchange rate risk may have changed. ANSWER: While the capital structure is now more equity-intensive in Australia and more debtintensive in Germany, its consolidated capital structure is not necessarily affected. The MNC’s cost of capital may have been reduced because of the transfer of debt to a country where interest rates were low. The exposure of Forest resulting from German operations may have decreased, because the euro inflows are now more offset by the euro outflows on the German debt. Thus, a smaller amount of earnings is remitted to the U.S. parent. The exposure of Forest resulting from Australian operations may have increased because the Australian dollars to be remitted to the U.S. will increase once the Australian dollar loan is paid off. 21. Cost of Foreign Debt Versus Equity. Carazona Inc. is a U.S. firm that has a large subsidiary in Indonesia. It wants to finance the subsidiary’s operations in Indonesia. However, the cost of debt is presently about 30 percent there for firms like Carazona or government agencies that have a very strong credit rating. A consultant suggests to Carazona that it should use equity financing there to avoid the high interest expense. He suggests that since Carazona’s cost of equity in the U.S. is about 14 percent, so the Indonesian investors should be satisfied with a return of about 14 percent as well. Clearly explain why the consultant’s advice is not logical. That is, explain why Carazona’s cost of equity in Indonesia would not be less than Carazona’s cost of debt in Indonesia. ANSWER: The cost of equity is based on a risk-free interest rate plus a risk premium. The risk-free interest rate is about 30 percent so Indonesian investors are not going to invest in Carazona Inc. for less than the risk-free rate.

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