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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. a. 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.).
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.
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.
S. 13. For this reason. 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. thereby increasing the current account deficit. other things being equal? ANSWER: A high inflation rate tends to increase imports and decrease exports. balance of trade deficit. which is unfavorable. Explain why a stronger dollar could enlarge the U. Yet. When South Korea’s export growth stalled. How would you interpret this statement? ANSWER: One of South Korea’s primary competitors in exporting is Japan.S. the foreign importing reflects strong competition from foreign producers. it is often suggested that South Korea’s primary export problem is weakness in the Japanese yen. A negative current account is thought to reflect lost jobs in a country. When the Japanese yen is weak. ANSWER: This question is intended to encourage opinions and does not have a perfect solution. 9. imports cheap and may increase U.S. It makes U. which may keep prices (inflation) low. other things equal.S. However. 4 . Inflation Effect on Trade.Chapter 2 2. some South Korean firms suggested that South Korea’s primary export problem was the weakness in the Japanese yen. Exchange Rate Effects on Trade. b. ANSWER: A stronger dollar makes U. this relationship can be distorted by other factors. Currency Effects. imports. 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. some importers switch to Japanese products in place of South Korean products. a. exports more expensive to importers and may reduce imports. which produces and exports many of the same types of products to the same countries. a. balance of trade deficit. Is a negative current account harmful to a country? Discuss. How would a relatively high home inflation rate affect the home country’s current account. Explain why a weaker dollar could affect the U.S.
S. dollar would affect the return to a U. If the direct exchange rate of the euro is worth $1.] ANSWER: The returns to the U. Thus. this implies that the U. the Wolfpack Corporation should not hedge because it would benefit from appreciation of the pound when it converts the pounds to dollars. ANSWER: If the Japanese yen appreciates over the borrowing period. Explain how syndicated loans are used in international markets. what is the indirect rate of the euro? That is.S. firm that borrowed Japanese yen and used the proceeds for a U. Thus. ANSWER: The forward contract can hedge future receivables or payables in foreign currencies to insulate the firm against exchange rate risk. 7. Foreign Exchange. International Diversification.1%. You just came back from Canada. Indirect Exchange Rate.S. 12. where the Canadian dollar was worth $. [See the chapter appendix. 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. Furthermore.11 and the bid rate is $. Its cost of borrowing will be higher as a result of this appreciation. 18.S. dollars at a lower exchange rate than the rate at which it paid for yen at the time it would repay the loan. Syndicated Loans. The Wolfpack Corporation is a U. but the airport foreign exchange desk will only buy them for $. For example. project.S. dollar by 84%.25. You still have C$200 from your trip and could exchange them for dollars at the airport. Explain how the appreciation of the Japanese yen against the U. should it hedge its exports with a forward contract? Explain. Explain how the Asian crisis would have affected the returns to a U.11] = .70.S. you will be going to Mexico and will 5 . ANSWER: A large MNC may want to obtain a large loan that no single bank wants to accommodate by itself. in this case. 8. Compute the bid/ask percentage spread for Mexican peso retail transactions in which the ask rate is $.S.10)/$. or 9.S.60. Forward Contract. Bid/ask Spread. exporter that invoices its exports to the United Kingdom in British pounds. 10. firm investing in the Asian stock markets as a means of international diversification. 16. Next week. Exchange Rate Effects on Borrowing.25 = . the Indonesian stock market declined by about 27% from June 1997 to June 1998. ANSWER: [($. what is the value of a dollar in euros? ANSWER: 1/1. the Indonesian rupiah declined again the U.091.S.Chapter 3 4. a bank may create a syndicate whereby several other banks also participate in the loan.11 – $.8 euros.10. firm converted yen to U. If it expects that the pound will appreciate against the dollar in the future. Yet. it is adversely affected by the appreciation.
00 Argentine pesos *1 Argentine peso = 0. How many U. China. If you exchange Canadian dollars for pesos with the tourist. International Financial Markets.S. they borrow from banks in the Eurocurrency market. These outlets are massive and contain products purchased locally as well as imports. 6 . Thus. the C$200 would be exchanged for 1.S. which has a population of 3. once the stores are established. some of the cash flows generated by those stores could be used to pay interest on the bonds. dollars. b. ANSWER: The Wal-Mart stores in China need other currencies to buy products from other countries.10 per peso. Explain how Wal-Mart could use the international bond market to finance the establishment of new outlets in foreign markets.300 pesos.need pesos. The bonds may be denominated in the currency that is needed. As Wal-Mart generates earnings beyond what it needs in Shanzen.50 Canadian dollars You need to purchase 100. Recently. He is willing to buy your C$200 for 1. When some Wal-Mart stores in foreign markets need funds.333 Value of C$ in AP = 2 Value of C$ in $ = $.666 So you need $66. dollars will you need for your purchase? ANSWER: Value of AP = $. which would be remitted to the U.666 to purchase C$100. parent. ANSWER: Exchange with the tourist. Today you notice the following exchange rate quotations: *$1 is equal to 3. 24.S.000. Explain how Wal-Mart might utilize the international money market when it is establishing other Wal-Mart stores in Asia. c.000 Canadian dollars with U. Thus. They also could use the spot market to convert excess earnings denominated in yuan into dollars. The airport foreign exchange desk will sell you pesos for $. 22. Wal-Mart is likely to build additional outlets in Shanzen or in other Chinese cities in the future.200 pesos (computed as 200 × 6). If you exchange the C$ for pesos at the foreign exchange desk. the cross-rate is $. it may remit those earnings back to the United States. You met a tourist at the airport who is from Mexico and is on his way to Canada. you will receive 1. 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.300 pesos. Explain how the Wal-Mart outlets in China would use the spot market in foreign exchange. Should you accept the offer or cash the Canadian dollars in at the airport? Explain. Wal-Mart established two retail outlets in the city of Shanzen. Interpreting Exchange Rate Quotations. the Eurocurrency market serves as a deposit or lending source for Wal-Mart and other MNCs on a short-term basis. then.60/$10 = 6. and must convert the Chinese currency (yuan) into the other currencies in the spot market to purchase these products. ANSWER: Wal-Mart could issue bonds in the Eurobond market to generate funds needed to establish new outlets. a.7 million.
12. residents of Country K invest heavily in the United States. dollar) be affected? ANSWER: A relative decline in Asian economic growth will reduce Asian demand for U.S. and (c) equilibrium value of the pound? ANSWER: Demand for pounds should increase. how should this affect the (a) U. and the Canadian dollar’s value should increase. Assume that the United States invests heavily in government and corporate securities of Country K. 4. Assume that the U. 3. In addition. (b) supply of Canadian dollars for sale. In addition.S. demand for Canadian dollars. how should this affect the (a) U. or other countries. Factors Affecting Exchange Rates. Explain the type of pressure that these factors placed on the Russian currency. Assume U. interest rates. The overall impact depends on the magnitude of the forces just described. Thus. However. supply of pounds for sale should decrease. Inflation Effects on Exchange Rates. income level rises at a much higher rate than does the Canadian income level. Other things being equal. In the 1990s. Russia’s inflation rate was high. Interest Rate Effects on Exchange Rates. given the change in interest rates. Assume that the U.S. If the Asian countries experience a decline in economic growth (and experience a decline in inflation and interest rates as a result). The high inflation rate in Russia also placed downward pressure on the Russian currency. 19. supply of Canadian dollars for sale may not be affected. Russia was attempting to import more goods but had little to offer other countries in terms of potential exports.S. inflation rate becomes high relative to Canadian inflation. Approximately $10 billion worth of investment transactions occur between these two 7 . 14.Chapter 4 2. Income Effects on Exchange Rates.S. how should this affect the (a) U. which places upward pressure on Asian currencies. (b) supply of Canadian dollars for sale.S. dollars. demand for Canadian dollars. ANSWER: The large amount of Russian imports and lack of Russian exports placed downward pressure on the Russian currency. Other things being equal.S. demand for British pounds. Other things being equal. Factors Affecting Exchange Rates. how will their currency values (relative to the U. products. supply of Canadian dollars for sale should decrease. demand for Canadian dollars should increase. and (c) equilibrium value of the Canadian dollar? ANSWER: Assuming no effect on U. thereby increasing the demand for U. and (c) equilibrium value of the Canadian dollar? ANSWER: Demand for Canadian dollars should increase. (b) supply of pounds for sale. and the Canadian dollar’s value should increase.S. interest rates fall relative to British interest rates. a decline in Asian interest rates will place downward pressure on the value of the Asian currencies. and the pound’s value should increase. Asian corporations with excess cash may now invest in the U.S.S.S. Aggregate Effects on Exchange Rates.
ANSWER: Decreased U. This information is expected to also hold in the future.S. The interest rate scenario places downward pressure on the krank’s value. Because your firm exports goods to Country K. and trade flows are relatively minor between the U. e. and Country K.countries each year.S. a. inflation has suddenly increased substantially. Increased supply of kranks for sale. Combine all expected impacts to develop an overall forecast. demand for the krank. while Country K’s inflation remains low. b. Since the interest rates affect capital flows and capital flows dominate trade flows between the U. demand for the krank. Upward pressure in the krank’s value.S. Decreased supply of kranks for sale. d. and Country K. Thus. Downward pressure on the krank’s value. and will therefore reduce the demand for kranks for sale.S.S. holding other things equal. Upward pressure on the krank’s value.S. while Country K’s interest rates remain low. demand for the krank.S. while Country K’s income level has remained unchanged. The U. U. Downward pressure on the krank’s value. U. income level increased substantially. interest rates have increased substantially. Explain how each of the following conditions will affect the value of the krank.S. is expected to impose a small tariff on goods imported from Country K. c. The total dollar value of trade transactions per year is about $8 million. ANSWER: Increased U. when considering the importance of implications of all scenarios. ANSWER: Two of the scenarios described above place upward pressure on the value of the krank.S. Investors of both countries are attracted to high interest rates. However. ANSWER: The tariff will cause a decrease in the United States’ desire for Country K’s goods. 8 . the interest rate scenario should overwhelm all other scenarios. aggregate all of these impacts to develop an overall forecast of the krank’s movement against the dollar. The U. these scenarios are related to trade. the krank is expected to depreciate. ANSWER: Increased U. Then. your job as international cash manager requires you to forecast the value of Country K’s currency (the “krank”) with respect to the dollar.
How would a U. there is a smaller flow of funds to be exchanged into Chilean pesos because the Chile interest rate is not as attractive to investors. Thus. Local producers must maintain low prices to remain competitive. Explain why other Latin American currencies could be affected by a cut in Chile’s interest rates. 13. other things being equal? What is the impact of a strong home currency on the home economy. 9 . However. This also helps to maintain low inflation. However. 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). Currency Effects on Economy. foreign supplies can be obtained cheaply. There may be a shift of investment into the other Latin American countries where interest rates have not declined. since it encourages consumers to buy abroad. A strong home currency can keep inflation in the home country low. A weaker currency and lower interest rates can stimulate the economy. Suppose that the government of Chile reduces one of its key interest rates. they will not attract more capital and may even attract less capital flows in the future. ANSWER: Exchange rates are partially driven by relative interest rates of the countries of concern. local producers can more easily increase prices without concern about pricing themselves out of the market. if these Latin American countries are expected to reduce their rates as well. What is the impact of a weak home currency on the home economy. c. However. b. It is favorably affected by the appreciation of any Latin American currencies. other things being equal? ANSWER: A weak home currency tends to increase a country’s exports and decrease its imports. which could reduce their values. The values of several other Latin American currencies are expected to change substantially against the Chilean peso in response to the news. When Chile’s interest rates decline.S. a strong home currency can increase unemployment in the home country.) ANSWER: The exporter is adversely affected if the Chilean peso and other currencies depreciate. a. which causes the currency to weaken. Effects of Indirect Intervention. 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. 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). 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. Also.Chapter 6 6. thereby lowering its unemployment.
S. by encouraging more borrowing and spending. reduce. How might this action have affected the foreign flow of funds into the U.S.. c.S. Your subsidiary purchases all of its materials from Hong Kong. The subsidiary sells mobile homes to local consumers in Australia. Effects of September 11. The cost to your subsidiary of making the interest payments to the U. to stimulate the U.S. dollar. If the dollar weakened U. The Hong Kong dollar is tied to the U.S. Explain whether these actions would increase. Assume you have a subsidiary in Australia.S.S.000 in interest each month.. The Australian dollar appreciates against the dollar as a result.S. The interest expenses should decline because it will take fewer A$ to make the monthly payment of $100. economy. parent (measured in A$). The volume of the sales should decline as the cost to consumers who finance their purchases would rise due to the higher interest rates. exporters. b. which could have increased the demand for products produced by U.S. the Federal Reserve reduced short-term interest rates in the U. Lower U. Intervention Effects on Corporate Performance. ANSWER: a. Australia has just raised its interest rate in order to boost the value of its currency (Australian dollar. The cost of purchasing materials should decline because the A$ appreciates against the HK$ as it appreciates against the U. The volume of your subsidiary’s sales in Australia (measured in A$) b. and affected the value of the dollar? How could such an effect on the dollar increase the probability that the U.S.S. The cost to your subsidiary of purchasing materials (measured in A$) c. or have no effect on: a. interest rates may reduce the amount of foreign flows to the U. Within a few days after the September 11. 2001 terrorist attack on the U. dollar. Your subsidiary borrowed funds from the U. exports would be cheaper. parent.17. which could have reduced the value of the dollar. Briefly explain each answer. 18. 10 .S.S. economy would strengthen? ANSWER: The lower interest rates are expected to stimulate the U. who buy the homes using mostly borrowed funds from local banks.000. A$).S. economy. and must pay the parent $100.
Therefore. 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. there is downward pressure on the forward premium. We would expect the premium to change because as U. Explain how such expectations could have affected U. which cause forward rates to have discounts as a result of interest rate parity. on September 11. If interest rate parity didn’t exist. interest rate was reduced while foreign interest rates were not. and foreign risk).S. the Fed expedited the movement by increasing liquidity in the banking system). ANSWER: The expectations of a weaker U. Assume that the forward rate premium of the euro was higher last month than it is today.S.S.Chapter 7 8. 2001 caused expectations of a weaker U. investors who use covered interest arbitrage would not be any higher than before.S. interest rates decrease. U. 11 . 10. Thus. Explain the concept of interest rate parity. Inflation Effects on the Forward Rate. and therefore have affected the forward rate premium (or discount) on various foreign currencies. which should cause market forces to move back toward conditions which reflect interest rate parity. covered interest arbitrage could occur (in the absence of transactions costs. The terrorist attack on the U. 14. investors could benefit from covered interest arbitrage if the forward premium stays the same. The U.S. Interest Rate Parity.S. 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. but the return would now exceed the interest rate earned in the U. Changes in Forward Premiums. economy. 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.S. or the forward discount became more pronounced. Assume that the Japanese yen’s forward rate currently exhibits a premium of 6 percent and that interest rate parity exists. If U. 9. interest rates decrease. Changes in Forward Premiums. Why do you think currencies of countries with high inflation rates tend to have forward discounts? ANSWER: These currencies have high interest rates. The return earned by U. Effects of September 11. the forward premium on foreign currencies decreased. because the difference between the interest rates is reduced. 15.S. Provide the rationale for its possible existence.S. The exact formula is provided in the chapter.S. interest rates. economy resulted in a decline of short-term interest rates (in fact.
According to IRP. Does interest rate parity exist? ANSWER: No.89% a.0189 = −1.079 30. what should the forward rate premium or discount of the euro be? b.10.S.50 and the forward rate of the S$ is $. If the euro’s spot rate is $1. Assume that annual interest rates in the U.46. are 4 percent. a.10(1 −. p = (1. Can a U. F = $1. a. because the discount on a forward sale exceeds the interest rate advantage of investing in Singapore. The one-year interest rate in Singapore is 11 percent. b. what should the one-year forward rate of the euro be? ANSWER: (1. while interest rates in France are 6 percent.0189) = $1. because the discount is larger than the interest rate differential. The spot rate of the Singapore dollar (S$) is $. The one-year interest rate in the U.S. Deriving the Forward Rate. Testing IRP.06) b. Assume zero transactions costs.04) − 1 = −. firm benefit from investing funds in Singapore using covered interest arbitrage? ANSWER: No. 12 .S. is 6 percent.21.
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. According to the PPP theory.73 × [1 + (–. and other industrialized countries have typically been a few percentage points in any given year. while the U. inflation remains low. increase the European demand for U.S. Therefore. Therefore. exchange rates will not move in perfect tandem with inflation differentials.0467)] = $1. Inflation differentials between the U. the exchange rate of the pound will depreciate by 4.S. and therefore PPP will not necessarily hold. What does this information suggest about PPP? ANSWER: The information suggests that there are other factors besides inflation differentials that influence exchange rate movements. ANSWER: PPP does not consistently hold because there are other factors besides inflation that influences exchange rates. how will the euro’s value against the dollar be affected? ANSWER: The high European inflation overall would reduce the U. even when a country’s inflation increases.7 percent. there may not be substitutes for traded goods. there would be downward pressure on the euro. Explain why PPP does not hold. Thus. while two other European countries that use the euro as their currency experience lower inflation than the United States. Testing PPP.S. Assume that several European countries that use the euro as their currency experience higher inflation than the United States. the spot rate would adjust to $1. In addition. demand for European products. Estimating Depreciation Due to PPP. Yet.S. in many years annual exchange rates between the corresponding currencies have changed by 10 percent or more.S. According to PPP. PPP Applied to the Euro. the foreign demand for its products will not necessarily decrease (in the manner suggested by PPP) if substitutes are not available. 11. and cause the euro to depreciate against the dollar. 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.Chapter 8 4. Thus.73.649. Limitations of PPP. If the European inflation rises. 5. the exchange rate movements will not necessarily conform to inflation differentials. Assume that the spot exchange rate of the British pound is $1. products. 18. 13 .
Chapter 5 14 .S. the forward premium serves as the forecasted percentage change in the spot rate according to IFE. what is the expected change in the spot rate over the next year? d. So the expected future spot rate is 0.07273) = $.10) b.14 × (1 – . Based on the international Fisher effect. What is the one-year forward rate of the peso? c. a. c.S.1298 e.14. the forward rate premium and the expected percentage change in the spot rate are derived in the same manner.670. The forward rate is $. Assume that interest rate parity exists. what will be the spot rate in one year? e.103883495× 20 million pesos = $2. When IRP holds. Wake Forest Co.02) −1 = − . ANSWER: a. $.02) −1 = − .10. The U. plans to import from Mexico and will need 20 million Mexican pesos in one year. According to the IFE. What is the forward rate premium? b. Determine the expected amount of dollars to be paid by the Wake Forest Co.07273) = $.103883495.10) or –7. 35.03)] – 1 = 0.14 × (1 – . If the spot rate changes as expected according to the IFE. Today’s spot rate of the Mexican peso is $.26. is 2%.273% d. Carolina will need to pay $. IRP.1298. The one-year risk-free rate in the U. for the pesos in one year. The one-year risk-free interest rate in Mexico is 10%. while the Mexican inflation over this year is expected to be 3%. Assume that purchasing power parity holds. the forward premium is (1 +.07)/(1.07273 (1 +.03883495.03883495)=$. ANSWER: [(1. Implications of PPP. Thus. The spot rate of the Mexican peso is $.10x(1+0. According to interest rate parity. inflation rate over this year is expected to be 7%. Compare your answers to (b) and (d) and explain the relationship. the expected change in the peso is: (1 +.077.07273 (1 +. The answers are the same.
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. However. Speculators who expect a currency to depreciate could sell currency futures contracts for that currency. 2. A currency put option provides the right to sell a specified currency for a specified price within a specified period of time. corporations that desire to lock in a price at which they can sell a foreign currency would sell currency futures. b. Currency Options. 3. It effectively locks in the maximum price to be paid for euros.08. a. 4. ANSWER: Because currency futures contracts are standardized into small amounts. When would a U. How can currency futures be used by speculators? ANSWER: Speculators who expect a currency to appreciate could purchase currency futures contracts for that currency. It effectively locks in the minimum price at which it can exchange euros received.102 and spot rate is $. which reflects a 8% discount 6. Compare and contrast forward and futures contracts.1.S.S.10. Compute the forward discount or premium for the Mexican peso whose 90-day forward rate is $. the standardized format of futures forces limited maturities and amounts. or –8%. Differentiate between a currency call option and a currency put option. 7. 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. How can currency futures be used by corporations? ANSWER: U. they can be valuable for the speculator or small firm (a commercial bank’s forward contracts are more common for larger amounts).102 – $. Speculating With Currency Options. Forward Premium. State whether your answer is a discount or premium. firm’s future receivables denominated in euros. firm consider purchasing a call option on euros for hedging? When would a U. ANSWER: A currency call option provides the right to purchase a specified currency at a specified price within a specified period of time.10 × (360/90) = –. Forward versus Futures Contracts. corporations that desire to lock in a price at which they can purchase a foreign currency would purchase currency futures. Hedging With Currency Options. 15 .10)/$. U.S. ANSWER: (F – S)/S = ($.S. Using Currency Futures. A put option on euros can hedge a U.
76 = $.75.04 per unit.76.250 units in a British pound option. The strike price was $1.50 11.46. Alice Duever purchased a put option on British pounds for $.250 units × $. Speculating with Currency Call Options.000 units in a Canadian dollar option. Also assume that there are 50. Selling Currency Call Options. What was Mike’s net profit on the call option? ANSWER: Premium received per unit Amount per unit received from selling C$ Amount per unit paid when purchasing C$ Net profit per unit Net Profit = 50.000 units × (–$.17 = $.312.05) = $.02 per unit.250 units × (–$.04 = $.80 and the spot rate at the time the pound option was exercised was $1.03 = $.000 units in a Canadian dollar option. Assume there are 31.01) = $.01 = $. Assume there are 31. Brian Tull sold a put option on Canadian dollars for $.59.82.250 units in a British pound option. Also assume that there are 50.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. Assume Brian immediately sold off the Canadian dollars received when the option was exercised.45 and the spot rate at the time the option was exercised was $1. The strike price was $. The strike price was $. and the spot rate at the time the option was exercised was $. Speculating with Currency Put Options.72 16 .01 = $.500 13.72.01 per unit.21 = $. and the spot rate at the time the option was exercised was $.82 = –$.50 12.01 = –$312.03 per unit. Mike Suerth sold a call option on Canadian dollars for $. 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. 10. 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 = 31.05 = –$2. Randy Rudecki purchased a call option on British pounds for $. Selling Currency Put Options.02 = –$. Assume Mike did not obtain Canadian dollars until the option was exercised. The strike price was $1. What was Brian’s net profit on the put option? ANSWER: Premium received per unit Amount per unit received from selling C$ = $.17 = $5.
Then as the spot rate of the pound declined. purchase the pounds in the spot market.Amount per unit paid for C$ Net profit per unit = $. The option premium was $.51 as well. the spot rate expected on the December futures settlement date is likely to be near $1. and the exercise price was $1. has sold British pound call options for speculative purposes. In the following table. Bama Corp.58 and the price on a December futures contract was $1.58.51. Assume that the pound depreciated during November so that by November 30 it was worth $1. and fulfill the futures obligation by delivering pounds at the price of $1. a. If you had known that this would occur. 17 . If the existing spot rate is $1. What do you think happened to the futures price over the month of November? Why? ANSWER: The December futures price would have decreased. if the listed spot rate exists at the time the purchaser of the call options considers exercising them. Assume that on November 1. would you have purchased or sold a December futures contract in pounds on November 1? Explain. Price Movements of Currency Futures.06 per unit.59. Speculating with Currency Call Options.59. the futures price would decline and you could close out your futures position by purchasing a futures contract at a lower price.59 per pound. 21. because it reflects expectations of the future spot rate as of the settlement date. fill in the net profit (or loss) to Bama Corp.75 = $0 17. ANSWER: You would have sold futures at the existing futures price of $1. the spot rate of the British pound was $1. you could wait until the settlement date. Alternatively.51. Bama will purchase the pounds on the day the options are exercised (if the options are exercised) in order to fulfill its obligation. b.
01 18 .74 . It has forecasted the Australian dollar’s lowest level over the period of concern as shown in the following table. and an exercise price of $..68 Net Profit (Loss) per Unit to Bama Corporation if Spot Rate Occurs $. Speculating with Currency Put Options. Inc.64 1.06 .73 .02 –.02 .ANSWER: Possible Spot Rate at the Time Purchaser of Call Option Considers Exercising Them $1.06 . if Value Occurs –$.03 –.57 1.06 .76 Net Profit (Loss) to Bulldog. Bulldog.76 per unit.04 . ANSWER: Possible Value of Australian Dollar $.04 22.75 . Determine the net profit (or loss) per unit to Bulldog.55 1.01 per unit.01 .53 1.62 1. Inc. Inc.72 .60 1..00 –. if each level occurs and the put options are exercised at that time. has sold Australian dollar put options at a premium of $.00 .
explain the desirable characteristics that would reduce transaction exposure. 5. Currency correlations—low level is desirable for currencies that are net inflows. Thus. What factors affect a firm’s degree of transaction exposure in a particular currency? For each factor. 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. Economic exposure includes any form by which the firm’s cash flow will be affected. 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. Fischer Inc. but did not affect the value of any ongoing transactions. Consideration of all cash flows in a particular currency is not necessary when some inflows and outflows offset each other. ANSWER: Currency variability—low level is desirable. This could affect the firm’s cash flow. It obtains supplies and borrows funds locally. Factors That Affect a Firm’s Transaction Exposure. should benefit from the appreciation of the euro. 6.. 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. it represents a form of economic exposure but not transaction exposure. Transaction Exposure. How would appreciation of the euro likely affect its net cash flows? Why? ANSWER: Fischer Inc. 19 . 7. 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. because it should experience a strong demand for its products when the euro has more purchasing power (can obtain dollars at a low price). Exposure of Domestic Firms. Transaction versus Economic Exposure. exports products from Florida to Europe.Chapter 10 1. the consumers may switch to foreign products if the local currency strengthens. Foreign competi tion may increase due to currency fluctuations. Only net cash flows are necessary. 3. Transaction exposure is a subset of economic exposure. 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. Currency Effects on Cash Flows.
European customers will need to pay more euros to purchase Aggie’s goods. How will Longhorn Co. Aggie Co. About half of its expenses require outflows in Philippine pesos (to pay for Philippine materials). 13.S.S. dollars. Transaction Exposure. Lubbock Inc. 12. Aggie Company may not necessarily lose some of its market share. firms that have no international business at all. That is. produces furniture and has no international business. Inc. Nevertheless. Thus. Longhorn Company is at a competitive disadvantage when the peso strengthens. the overall European demand for chemicals could decline because the prices paid for them have increased. be affected if the peso strengthens? ANSWER: If the peso strengthens.S. Since Aggie’s competitors also invoice their exports in dollars. Economic Exposure. If the euro remained weak for several years. However. 20 . some companies in Europe may begin to produce the chemicals.S. Aggie Company will not gain a competitive advantage. Longhorn will incur higher expenses when paying for the Philippine materials. European customers can purchase Aggie’s goods with fewer euros. Is Aggie’s transaction exposure likely to be significantly affected if the euro strengthens or weakens? Explain. Since Aggie’s competitors also invoice their exports in dollars. Longhorn Co. produces chemicals.. Most of Longhorn’s competition is from U. exporters could be priced out of the European market over time if the euro continually weakened. the overall demand for the product could increase because the chemicals are now less expensive to European customers. so that customers could avoid purchasing dollars with weak euros. U. If the euro weakens. exporters. Lubbock. some customers may shift to furniture produced by Lubbock Inc. is expected to be favorably affected by a strong Brazilian real. If the euro weakens for several years. the U.11. where its main competition is from other U.. produces hospital equipment. Consequently. can you think of any change that might occur in the global chemicals market? ANSWER: If the euro strengthens. Because its competition is not affected in a similar manner. How will Lubbock. retail stores will likely have to pay higher prices for the furniture from Brazil. Inc.S. and may pass some or all of the higher cost on to customers. Its major competitors import most of their furniture from Brazil and then sell it out of retail stores in the United States. be affected if Brazil’s currency (the real) strengthens over time? ANSWER: If the Brazilian real strengthens. All of these companies invoice the products in U. Economic Exposure. It is a major exporter to Europe. Most of its revenues are in the United States.
21 .S.S. UVA could reduce its economic exposure by attempting to increase sales in Thailand. 3. Albany could attempt to shift some of its expenses to Australia.S. It currently receives about 10 percent of its revenue from Thai customers.-based MNC that has a large government contract with Australia. Reducing Economic Exposure. which would generate additional Thai baht inflows. operations. It also borrows Thailand’s currency (the baht) from Thai banks and converts the baht to dollars to support U. is a U. is a U. can reduce its economic exposure to exchange rate fluctuations. all other expenses are in U. ANSWER: Albany may ask the Australian government to provide payment in U. The contract will continue for several years and generate more than half of Albany’s total sales volume. so that the Australian dollar inflows and outflows are more balanced. dollars. by either purchasing Australian supplies or shifting part of the production process to Australia.S. The Australian government pays Albany in Australian dollars. ANSWER: UVA Company has periodic outflow payments in Thai baht that are substantially more than its Thai baht inflow payments. About 10 percent of Albany’s operating expenses are in Australian dollars. Explain how Albany Corp.-based MNC that obtains 40 percent of its foreign supplies from Thailand. Its sales to Thai customers are denominated in baht. These strategies will increase Australian dollar outflows. Explain how UVA Co. can reduce its economic exposure to exchange rate fluctuations. Reducing Economic Exposure. dollars.Chapter 12 2. Alternatively.S. UVA Co. Albany Corp.
. ANSWER: If the peso’s value is relatively strong now. producer of computer disks. as Latin American consumers have shown an interest in Nike footwear (this is partially due to increased marketing targeted to Latin American markets). and Ram. while Raider Chemical Company is concentrated in only one foreign country whose business cycles are related to the U. Packer’s executives believe that the Mexican peso’s value is relatively strong and will weaken against the dollar over time. Elaborate on each type of benefit. Latin America offers additional sources of demand. Second. future remitted earnings by the subsidiary to the parent will be converted to fewer dollars. a U. DFI to Reduce Cash Flow Volatility. Inc. Inc. Motives for DFI. as the production is labor-intensive and wages are low. implemented a long-range plan to establish 30 percent of its business in Europe and Asia.Chapter 13 1. 7. Regarding Nike’s motives. 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. Raider Chemical Co.. scattered among 12 different countries. Fourth. Raider implemented a long-range plan to establish 40 percent of its business in Canada. has decided to establish manufacturing subsidiaries in various countries. Nike may be able to produce their athletic footwear at relatively low costs in some Latin American countries. Inc. 2. If their expectations about the peso value are correct. Describe some potential benefits to an MNC as a result of direct foreign investment (DFI). Packer. had similar intentions to reduce the volatility of their cash flows. 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.. while Viking.S. Inc.. If Viking Inc. the expansion into Latin America allows Nike to further diversify its business internationally.S. Third. will incur high costs of establishing a Mexican subsidiary. Inc. 3. are automobile manufacturers that desire to benefit from economies of scale. 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. Nike may benefit from economies of scale by producing a large amount and exporting the additional shoes for sale to nearby countries. DFI to Achieve Economies of Scale. Opportunities in Less Developed Countries. Bear Co. it will incur higher fixed costs of machinery. Ram. Impact of a Weak Currency on Feasibility of DFI. has decided to establish distributorship subsidiaries in various countries. spreads its production facilities. and Viking. how will this affect the feasibility of the project? Explain. would likely be more effective because its international business is spread across several major countries. Packer will be adversely affected by the exchange rate movements (although the project may still be feasible). plans to establish a subsidiary in Mexico in order to penetrate the Mexican market. Bear Co. Why would MNCs desire to enter such countries? If these 22 . Which company will more effectively reduce cash flow volatility once the plans are achieved? ANSWER: Ram Inc.. Packer Inc. if the peso weakens. 4. In addition.
Also. some tourists may feel that no other theme park is an adequate substitute for Disney. A theme park in France may appeal to tourists who decide not to travel to the U. when the dollar is strong (euro is weak). since U. the sales of Disney toys will increase. A firm that pursues substantial international business in one country may increase its risk. Risk Resulting from International Business. In fact. Thus. 12. but there may be a cost advantage to the land in France (due to land subsidies provided by the French government). and declining economic conditions. tourists are willing to travel to California or Florida to see the theme parks. New sources of demand—another theme park in the U. Exploit monopolistic advantages—there are other theme parks in Europe. especially if it does not fully understand the consumers and government laws in that country.S. when the dollar is strong. 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. allowing for additional economies of scale in production. would their economies continue to be independent of other economies? Explain. 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. b. There are additional risks (discussed in other chapters) such as currency restrictions. there are some exceptions. d. because much of the costs associated with planning a theme park have already been incurred. Yet.S. have experienced reduced sales when the dollar is strong because foreign tourism in the U. 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. firms could reduce their risk by increasing their degree of international business. This chapter concentrates on possible benefits to a firm that increases its international business. In general. high probability of war.S. Disney’s DFI Motives.countries relaxed their restrictions. What potential benefits do you think were most important in the decision of the Walt Disney Co. 10. Disney can now attract tourists who are unwilling to travel to the U. it may even attract more tourists from the U. would have less potential. Economies of scale should result from the new theme park. 23 .S. However. labor. Thus. French labor may not necessarily be less costly than U. b. but the question usually leads to an interesting discussion.S. Diversification—the Disney theme parks in the U.S. a.S. Some of the more likely motives as related to those discussed in this chapter are: a. c. e. declines. to build a theme park in France? ANSWER: There is no simple answer to this question.S.
S. just constructed a manufacturing plant in Ghana. 3 billion cedi. respectively. ANSWER: Even if the performance is superior.700 cedi to buy one U. but assume the future depreciation of the euro. established a subsidiary in Switzerland that was performing below the cash flow projections developed before the subsidiary was established. This is especially true when a large percentage of earnings are sent to the parent.S. Consequently. Capital Budgeting Example. established a subsidiary in the United Kingdom that was independent of its operations in the United States. Athens’ chief financial officer implied that the subsidiary was performing so well that it was not for sale. the subsidiary may be worth selling if the price offered for it exceeds Athens’ perceived present value of the subsidiary. During the three years of operation. 24 . when a British firm approached Athens about the possibility of acquiring the subsidiary. cedi cash flows are expected to be 3 billion cedi. Inc. Comment on this statement. It justified its decision by stating that any existing project whose cash flows are not sufficient to recover the initial investment should be divested. 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.-based MNC. and the cedi is expected to depreciate by 5 percent per year. Brower intends to leave the plant open for three years. Operating cash flows will begin one year from today and are remitted back to the parent at the end of each year. Lehigh decided to inform several potential acquiring firms of its plan to sell the subsidiary. Consequently. The future depreciation of the euro would hurt the parent since the euro earnings would be worth less when remitted and converted to dollars. Repeat this question. Lehigh anticipated that future cash flows would also be lower than the original cash flow projections. Brower has a required rate of return of 17 percent. it should only be divested if the price offered for it exceeds Lehigh’s estimation of its present value. and 2 billion cedi. 10. Even the highest bid was very low. Future appreciation of the euro would benefit the parent since the euro earnings would be worth more when remitted and converted to dollars. 11. but Lehigh accepted the offer. The subsidiary’s performance was well above what was expected. Brower expects to sell the plant for 5 billion cedi. Will the sensitivity of the project value be affected by the percentage of earnings remitted to the parent each year? ANSWER: a. The construction cost 9 billion Ghanian cedi. Athens. At the end of the third year. Impact of Exchange Rates on NPV. b. Inc. Capital Budgeting Logic. 13.Chapter 14 5. Lehigh then received a few bids. Capital Budgeting Logic. Brower. ANSWER: Even if the project will not recover its initial outlay. dollar. Comment on this strategy. It currently takes 8. Lehigh Co. This is especially true when a large percentage of earnings are sent to the parent.
071 $695.59 $251.034.23 $280.44 –$739.483 –$1.23 –$487.793.724.63 $228.317.700 cedis per U.827.483 –$1. Brower should not undertake it.18 3 2 5 7 10.689. How would your answer change if the value of the cedi was expected to remain unchanged from its current value of 8. 20.597.367.700 –$1. the NPV is positive.475.847.94 –$753.827.S. Determine the NPV for this project.034.034. b.483 –$1.04 $433.748. The current value of the won is 1.a.034. Of course.135 $328. 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 8.760. Brower should undertake the project in this case. 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 8.33 3 2 5 7 8. dollar.483 1 3 3 8.06 2 3 3 9.S.700 $344.034.700 –$1.100 won per U.70 $502.15 –$91. A project in South Korea requires an initial investment of 2 billion South Korean won.519. The project has no salvage value. respectively. 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.483 –$1. Whether or not Brower actually undertakes the project depends on the confidence it has in its exchange rate forecasts.78 If the value of the cedi remains constant. Thus.065.59 $294. 25 .034.S.483 1 3 3 9.700 $344.901. Capital Budgeting Analysis. the NPV is only slightly positive.11 +$14.56 2 3 3 8.978. 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.592 $312.88 –$525.700 $804.339.03 Since the project has a negative net present value (NPV).407. and the value of the won is expected to remain constant over the next two years.
82 –$1. Further assume that the funds are blocked and that the parent company will only be able to remit them back to the U.69 +$595.966.S.82 –$1. 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 $3.73 $2.a.515.82 1 3 3 1.12 +$3.87 2 4 4 1.99 A situation where the funds are blocked and the won is expected to depreciate reduces the NPV by $692.200 won per U.847.181.443. Repeat the question.818.100 –$1.181.413.181. in two years.363.568.818.806. except assume that the value of the won is expected to be 1.82 –$1.100 $3.181.727.139.100 –$1.818.64 $2.99.272.355.818. dollar after two years.16.139.818.333.443.818.82 –$1. ANSWER: Year Investment Operating CF Net CF Exchange rate Cash flows to parent PV of parent cash flows NPV 0 –2 –2 1.65 +$2.181.83 0 –2 –2 1.S.636.82 2 7 7 1. What is the NPV of this project if the required rate of return is 13 percent? b.181.750.173.833. 26 .200 $5.333.33 $4.100 $2.
while maintaining the same amount of business within a particular country. 6. assuming that no other proposed projects are being evaluated for that country. any degree of country risk can be tolerated. estimate the NPV of the project if that occurs. country risk analysis for the foreign country involved is no longer necessary. 5. Reducing 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. 9. 2. No. 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. Monitoring Country Risk. Re-estimate the NPV for any other forms of country risk as well.Chapter 16 4. if the host government may block funds temporarily. 3. 10. If the potential return is high enough. then it reduces the exposure to the possibility of high country risk in all of these areas simultaneously. since if risk becomes too high. It is intended to identify forms of country risk and their potential impact. the project’s required rate of return could be increased (by increasing the discount rate on NPV analysis). ANSWER: Some of the more common methods to reduce country risk are: 1. Incorporating Country Risk in Capital Budgeting. For example. consider each key form of country risk and re-estimate cash flows if that form of risk occurs. 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). use a short-term horizon hire local labor borrow local funds obtain insurance 27 . Diversifying Away Country Risk. the MNC should divest its subsidiaries in that country. Country Risk Analysis. Country risk analysis is not intended to estimate all project cash flows and determine the present value of these cash flows. Do you agree with this statement? Why or why not? ANSWER: Disagree! The country risk must be monitored continuously. ANSWER: Disagree! If country risk is so high that there is great danger to employees. Once a project is accepted. no expected return is high enough to warrant the project. 4. This is important information for capital budgeting but is not a substitute for capital budgeting. This process results in a distribution of possible NPVs that can be assessed to determine whether a project should be accepted. Explain some methods of reducing exposure to existing country risk. To adjust cash flows.
While some economies are more stable than Mexico’s economy. so the demand for products in Mexico is subject to more uncertainty. economy. perspective). Penney decides to use dollars to finance the expansion of stores in Mexico. Penney stores will decline. create joint ventures These and other methods are discussed in the chapter.C. Thus. the 28 . any country is subject to a possible weakening of the economy.C. Identify the political factors that you think may possibly affect the performance of the J. ANSWER: If J. Initial screenings of 30 foreign countries were based on political and economic factors that contribute to country risk.C. 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. Penney from remitting earnings generated in Mexico and could adversely affect the performance of these stores (from the U.C. assume that the stores in Mexico are not subject to political risk. Third.5. This event would prevent J. the demand for many products sold at the J. 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.C.S. Assume that J. ANSWER: The economy in Mexico is volatile. 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. Second. it would likely use a required rate of return that is higher than that used for a proposed store in the U. Explain why the J. at that same time? Explain.C. The Mexican economy is more volatile than the U. assume that J. One of J. c. Penney decides to use one set of dollar cash flow estimates for any project that it assesses. where it planned to build and operate seven large stores. Also. Penney’s Country Risk Analysis.C. Recently. there is more uncertainty about the future cash flows generated by those stores. J. Penney generated a single set of cash flow estimates for the establishment of a given store in Mexico. Assume that J. Penney’s biggest targets is Mexico. because the currency (the peso) is sometimes volatile and could require special controls in some periods.S.C. b. 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. it applied a comprehensive country risk analysis before making its expansion decisions. a. ANSWER: Perhaps the most likely political factor is the blockage of fund transfers or currency inconvertibility.S. specific country risk characteristics of each country were considered. Penney decided to consider expanding into various foreign countries.C. 18. Therefore. Penney stores in Mexico.S.C. 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. d. J.C. For the remaining 20 countries where country risk was considered to be tolerable.C. the capital budgeting analysis results in a distribution of NPVs based on possible scenarios. and if economic conditions deteriorate. Penney stores in any country could experience weak sales due to financial risk. Even though there is more potential for profits from new stores in Mexico. Penney stores in Mexico and in other foreign markets are subject to financial risk (a subset of country risk). J.S.
Penney has stores in most U. projects. The U. parent.exchange rate movements will affect the dollar earnings that are generated by the stores in Mexico. e.S.C. does this mean that proposals for any new stores in the U. Since the exchange rate movements are very uncertain.S. 29 . markets (as mentioned in the case). have a higher probability of being accepted than proposals for any new stores in Mexico? ANSWER: No.S. Even though the required rate of return may be higher for a proposed store in Mexico.S. so are the dollar earnings that will be received by the U.S. Therefore. markets have less potential because J. the dollar cash flows should be much higher. the estimated cash flows would be lower for U. Based on your answer to the previous question. which could result in a higher probability of accepting this type of project.
To the extent that financial markets are segmented. and larger. Optimal Financing. Thus. or financing by local banks in the foreign country? ANSWER: Wizard should use financing by local banks in the foreign country. MNCs that are highly exposed to exchange rate movements may be more likely to experience financial problems (if they do not hedge the risk). Drexel Co. 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. If the host government imposed restrictions that reduced the subsidiary’s profits. Should Wizard finance the subsidiary with debt financing by the parent. Wizard. Creditors and shareholders may therefore accept a lower rate of return when providing funds to the MNCs. Country risk. has a subsidiary in a country where the government allows only a small amount of earnings to be remitted to the U. Thus. 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. Access to international capital markets.-based company that is establishing a project in a politically unstable country. • • • • 8. Cost of Capital. International diversification. 5.Chapter 17 2. their probability of bankruptcy is reduced. Inc. MNCs have access to more sources of funds than domestic firms. which reflects a lower cost of capital for MNCs. Financing Decision. It is considering two possible sources of financing. equity financing by the parent. better known firms may receive preferential treatment by creditors. so that the subsidiary can make use of its funds by paying off local debt. they may incur a higher cost of capital. MNCs have more opportunities to grow.S. Either the parent could provide most of the financing. ANSWER: The following characteristics of MNCs can influence the cost of capital: • Size. 30 . Explain how characteristics of MNCs can affect the cost of capital. each year. they may incur a higher cost of capital. MNCs with subsidiaries in politically unstable countries may experience volatile cash flows over time and be more susceptible to financial problems. MNCs may be able to obtain financing from various sources at a lower cost. is a U. or the subsidiary could be supported by local loans from banks in that country. Exchange rate risk.S. If MNCs can achieve more stable cash flows through their international diversification. the banks could be adversely affected as well.
is a U. It believes that the market’s perception of its risk will remain unchanged. Since the Japanese companies with which it competes use more financial leverage. Veer should reap more tax advantages.S. Comment on this strategy. With this heavy emphasis on debt.9. Financing Decision.-based MNC that has most of its operations in Japan. it has decided to adjust its financial leverage to be in line with theirs. Veer Co. 31 . since its financial leverage will still be no higher than that of its Japanese competitors.
Pullman.-based MNC in the same industry with a large subsidiary in Japan. Forest Company produces goods in the U. In this way.S.S. Foreign earnings are periodically remitted to the U. As the euro’s interest rates have declined to a very low level.S.S. Forest Company has decided to finance its German operations with borrowed funds in place of the parent’s equity investment. Pullman may consider using retained earnings but allowing for other local institutions in the host countries to invest in their projects as well. and Australia. Yet. The firm’s before-tax cost of debt is 12 percent. Pullman would like to finance the growth with local debt in the host countries of concern to reduce its exposure to country risk. Therefore. Germany.S. Costs of Capital Across Countries. its risk will be higher than that of the Japanese competitors. the risk premium on the business in Brazil may be higher than the risk premium on the business in Japan.44% 19. a U. Inc. it will be more exposed to country risk. Forest will transfer the U. parent. Explain the expected effects of these actions on the consolidated capital structure and cost of capital of Forest Company. 12. and offer possible solutions. if this subsidiary attempts to use as much financial leverage. corporation. It plans for large growth in several less developed countries. as Australian interest rates have been high and are rising. 10.0144 + .-based MNC with a large subsidiary in Brazil is higher than for a U.. Explain why the cost of capital for a U. parent’s equity investment in the German subsidiary over to its Australian subsidiary. it is less likely to bail out a subsidiary of a U. The Japanese government may be willing to bail out a Japanese company whose shares are held by Japanese investors and institutions.ANSWER: Japanese corporations can use a higher degree of financial leverage because of their relationships with creditors and the government. 11. has retained earnings that it must reinvest. but prefers not to pay out higher dividends because its shareholders want the funds to be reinvested. 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 = . The MNC has a corporate tax rate of 40 percent. Assume that the subsidiary operations for each MNC are financed with local debt in the host country. and sells the goods in the areas where they are produced. firm. has been highly profitable. Financing Tradeoffs.1344 = 13. WACC.. if it uses the retained earnings to finance the growth. ANSWER: The risk-free interest rate is much higher in Brazil than in Japan. An MNC has total assets of $100 million and debt of $20 million. ANSWER: Pullman Inc. These funds will be used to pay off a floating-rate loan. The Japanese subsidiary does not receive the same protection that other Japanese firms receive. In addition. Financing Decision.S. 32 . Explain the dilemma faced by Pullman.S. 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. and its cost of financing with equity is 15 percent. Yet.12 = .
A consultant suggests to Carazona that it should use equity financing there to avoid the high interest expense. a smaller amount of earnings is remitted to the U. because the euro inflows are now more offset by the euro outflows on the German debt. ANSWER: While the capital structure is now more equity-intensive in Australia and more debtintensive in Germany. will increase once the Australian dollar loan is paid off. That is. firm that has a large subsidiary in Indonesia. ANSWER: The cost of equity is based on a risk-free interest rate plus a risk premium. explain why Carazona’s cost of equity in Indonesia would not be less than Carazona’s cost of debt in Indonesia. explain how its exposure to exchange rate risk may have changed. is about 14 percent.S. its consolidated capital structure is not necessarily affected. 21. for less than the risk-free rate. The MNC’s cost of capital may have been reduced because of the transfer of debt to a country where interest rates were low. parent. The risk-free interest rate is about 30 percent so Indonesian investors are not going to invest in Carazona Inc. It wants to finance the subsidiary’s operations in Indonesia.S. The exposure of Forest resulting from German operations may have decreased. Carazona Inc. The exposure of Forest resulting from Australian operations may have increased because the Australian dollars to be remitted to the U.S. He suggests that since Carazona’s cost of equity in the U. However. 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.Given the strategy to be used by Forest. Thus. Cost of Foreign Debt Versus Equity.S. is a U. the cost of debt is presently about 30 percent there for firms like Carazona or government agencies that have a very strong credit rating. 33 .
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