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# Problem 1.

1 Production and Consumption
Comparative Advantage. Problems 1 - 5 illustrate an example of trade induced by comparative advantage. They assume that China and France each have 1,000 production units. With one unit of production (a mix of land, labor, capital and technology), China can produce either 10 containers of toys or 7 cases of wine. France can produce either 2 containers of toys or 7 cases of wine. Thus, a production unit in China is five times as efficient compared to France when producing toys, but equally efficient when producing wine. Assume at first that no trade takes place. China allocates 800 production units to building toys and 200 production units to producing wine. France allocates 200 production units to building toys and 800 production units to producing wine. What is the production and consumption of China and France without trade? Toys (containers/unit) 10 2 1,000 1,000 Wine (cases/unit) 7 7

Assumptions China -- output per unit of production input France -- output per unit of production input China -- total production inputs France -- total production inputs

Production if there is no trade CHINA Allocated production units to Produces and consumes (output per unit x units allocated) FRANCE Allocated production units to Produces and consumes (output per unit x units allocated) Total production and consumption across both countries

Toys

Wine

800 8,000

200 1,400

200 400 8,400

800 5,600 7,000

000 Wine (cases/unit) 7 7 Assumptions China -.000 7.000 The combined production of both countries is 10.600 more containers of toys than before specialization.output per unit of production input France -. .000 - 10.output per unit of production input China -.total production inputs France -.000 1. What would be the effect on total production? Toys (containers/unit) 10 2 1.000 10.000 containers of toys.000 1.2 Specialization Assume complete specialization. with wine production remaining unchanged. where China produces only toys and France produces only wine. 1.Problem 1.total production inputs Production if there is complete specialization CHINA Allocated production units to Produces and consumes (output per unit x units allocated) FRANCE Allocated production units to Produces and consumes (output per unit x units allocated) Total production and consumption across both countries Toys Wine 1.000 7.

total production inputs Trade at China's domestic price (10 toys = 7 wine) CHINA Allocated production units to Produces and consumes (output per unit x units allocated) FRANCE Allocated production units to Produces and consumes (output per unit x units allocated) Total production and consumption across both countries Toy Production TOYS Exports (-)/ Imports (+) Domestic Consumption Wine Production WINE Exports (-)/ Imports (+) Domestic Consumption 1.600 7.000 containers to France.000 1.000 containers after trade.000 (2. Assume China produces 10. Toy production and consumption in France increases from 400 containers of toys before trade to 2.000 2.000 2.output per unit of production input China -.000 - 1. a gain in consumption of 1. Hence all of the benefits of trade have gone to France.total production inputs France -.000 10.Problem 1.400 cases to China. China is now consuming 8.400 10.000 containers of toys and exports 2.000 containers of toys and 1.400 1.output per unit of production input France -.400 cases of wine.000 1.000 10.000) 8. toy production in total is increased as in Problem 2.400) 5.600 containers. Assume France produces 7.000 7.000 With complete specialization.000 (1. . the same levels of both as prior to trade.000 Wine (cases/unit) 7 7 Assumptions China -.000 7.000 cases of wine and exports 1. Wine production and consumption remains the same as before trade. What happens to total production and consumption? Toys (containers/unit) 10 2 1.3 Trade at China's Domestic Price China’s domestic price is 10 containers of toys equals 7 cases of wine.

Thus the full benefit of trade goes to China when trading at France's domestic prices. Wine production and consumption remains the same as before trade.000 containers of toys and exports 400 containers to France. What happens to total production and consumption? Toys (containers/unit) 10 2 1.000 400 400 10.output per unit of production input France -.600 - 1.600 containers -.000 1.600 7.400 10. .000 cases of wine and exports 1.000 Toy production and consumption in China increases from 8.400) 5.1.after trade.400 cases to China.600 more containers -.000 10.output per unit of production input China -.Problem 1.000 7.000 containers of toys before trade to 9.000 (400) 9.400 1.total production inputs France -.000 Wine (cases/unit) 7 7 Assumptions China -. Assume France in turn produces 7.000 (1.000 1.4 Trade at France's Domestic Price France’s domestic price is 2 containers of toys equals 7 cases of wine.total production inputs Trade at France's domestic price (2 toys = 7 wine) CHINA Allocated production units to Produces and consumes (output per unit x units allocated) FRANCE Allocated production units to Produces and consumes (output per unit x units allocated) Total production and consumption across both countries Toy Production TOYS Exports (-)/ Imports (+) Domestic Consumption Wine Production WINE Exports (-)/ Imports (+) Domestic Consumption 1.000 7. Assume China produces 10.

000 Wine (cases/unit) 7 7 Assumptions China -.000 pre-trade). Wine production therefore remains the same as before trade.200 1.200 10.output per unit of production input China -.5 Trade at Negotiated Mid-price The mid-price for exchange between France and China can be calculated as follows: Toys (containers/unit) 10 2 1.600).400 10.400).400 1. and enjoys the same level of wine consumption (5.400) 5.800 post-trade compared to 8. but now the 1. France gains 800 more containers of toys (1.000 1.000 TOYS Exports (-)/ Imports (+) Domestic Consumption Wine Production - WINE Exports (-)/ Imports (+) Domestic Consumption (1.total production inputs France -.Problem 1.000 1.800 1.200) 8.000 7.200 post-trade compared to 400 pre-trade). .000 (1. and enjoys the same level of wine consumption (1.000 China gains 800 more containers of toys (8.output per unit of production input France -.600 increased production of toys is split evenly between the two countries.600 7.000 1.000 10.000 7.total production inputs What happens to total production and consumption? Trade at Negotiated Mid-Price (6 toys = 7 wine) CHINA Allocated production units to Produces and consumes (output per unit x units allocated) FRANCE Allocated production units to Produces and consumes (output per unit x units allocated) Total production and consumption across both countries Toy Production 1.

with wholly owned subsidiaries in Brazil. The basic operating characteristics of the various business units are as follows: Business Performance (000s) Earnings before taxes.800.00 7.22 650.604.700.1% 2.8000 2.50) 4.00 0.-based multinational manufacturing firm. Luzon is traded on the NADSAQ. Luzon is a U.575.925.7500 225.00 (750.7018 3.00 14. and China.00 (1.5% .S. R\$) 6.00) 1. Proportion of total profits originating by country c. in addition to domestic operations in the United States. EBT (local currency) Less corporate income taxes Net profits of individual subsidiary Avg exchange rate for the period (fc/\$) Net profits of individual subsidiary (US\$) Consolidated profits (total across units) Total diluted shares outstanding (000s) a.00 9. Garrison currently has 650.81 35% 25% 40% 30% \$ \$ \$ \$ \$ \$ 30.00 (1.750.1% 40.77 Brazilian Subsidiary (reais.000 shares outstanding.25 Chinese Subsidiary (yuan.847.925.687.562.250. Germany.4% 69.00 -----2.602.500.50 1. €) 4.6 Luzon Industries' Consolidated Results Problems 6 through 10 are based on Luzon Industries.Problem 1. Proportion of total profits originating from outside the United States US Parent Company (US\$) 4.17 German Subsidiary (euros. Y) 2.00 (1.500.5% 27.500.00) 2. Consolidated earnings per share (EPS) b.00) 2.

00 -----2.7500 225.50 1.700. R\$) 6.562. EBT (local currency) Less corporate income taxes Net profits of individual subsidiary Avg exchange rate for the period (fc/\$) Net profits of individual subsidiary (US\$) Consolidated profits (total across units) Total diluted shares outstanding (000s) Baseline earnings per share (EPS) 35% 25% 40% 30% \$ \$ \$ \$ \$ \$ Brazilian reais falls in value against the U.50) 4.00) 1.17 -10.81 Business Performance (000s) Earnings before taxes.925.687.77 Brazilian Subsidiary (reais.00 (1.7018 3.500.750.562.00 8.800.925. Y) 2.602.56 650.500.00) 2.0000/\$.8% Brazilian Subsidiary (reais.22 650.00 (1.50 3.7018 3. dollar US Parent Company (US\$) 4.0000 1.00 (1.687.7500 225.00 13.00) 2.500.00 (1.00 9.575.7 Luzon's EPS Sensitivity to Exchange Rates (A) Assume a major political crisis wracks Brazil.17 German Subsidiary (euros.00) 2.00 0.00) 1. EBT (local currency) Less corporate income taxes Net profits of individual subsidiary Avg exchange rate for the period (fc/\$) Net profits of individual subsidiary (US\$) Consolidated profits (total across units) Total diluted shares outstanding (000s) "New" earnings per share (EPS) EPS change from baseline: 35% 25% 40% 30% \$ \$ \$ \$ \$ \$ .925.00) 2.25 Chinese Subsidiary (yuan.00 7.00 (1.81 Business Performance (000s) Earnings before taxes.250.00 (750.00 (1.50 German Subsidiary (euros.500.50) 4.00 -----2. Y) 2.500.847.Problem 1. €) 4. €) 4. R\$) 6.562.S.750.500.00 (750.847. How are Luzon's consolidated global earnings affected by the fall in the value of the Brazilian reais? US Parent Company (US\$) 4.25 Chinese Subsidiary (yuan.925.700.250.604.8000/\$ to R\$3.560.8000 2.00 14.575. The Brazilian reais falls in value from R\$1.00 7.800.00 0.

500.500.00 -----2.00 8.00 (1.00 7.00) 2. R\$) 6. The result is a serious reduction in sales in the Brazilian subsidiary.06 650.00) 4.925.Problem 1.700. dollar and Luzon's Brazilian sales decline US Parent Company (US\$) 4.602.25 million to R\$5.81 Business Performance (000s) Earnings before taxes.7500 225. Y) 2.00 7.7018 3.8 million.800.575.00 0.800.00 (750.750.00 0.925.S.00 (750.00 (1.750.00 (1.7500 225.800.00) 2.500.00) 2.575.847.500.25 Chinese Subsidiary (yuan.22 650. sales in Brazil fall from R\$6.0% Brazilian Subsidiary (reais.17 German Subsidiary (euros.250.00 -12.S.25 Chinese Subsidiary (yuan.562.7018 3. R\$) 5.500.00 -----2. EBT (local currency) Less corporate income taxes Net profits of individual subsidiary Avg exchange rate for the period (fc/\$) Net profits of individual subsidiary (US\$) Consolidated profits (total across units) Total diluted shares outstanding (000s) Revised earnings per share (EPS) Change in EPS from both changes: 35% 25% 40% 30% \$ \$ \$ \$ \$ \$ . US Parent Company (US\$) 4. dollar.450.00 14.77 Brazilian Subsidiary (reais. €) 4.8 Luzon's EPS Sensitivity to Exchange Rates (B) Assume that subsequent to the fall of the Brazilian reais versus the U.925.687.00 (1.925. EBT (local currency) Less corporate income taxes Net profits of individual subsidiary Avg exchange rate for the period (fc/\$) Net profits of individual subsidiary (US\$) Consolidated profits (total across units) Total diluted shares outstanding (000s) Baseline earnings per share (EPS) 35% 25% 40% 30% \$ \$ \$ \$ \$ \$ Brazilian reais falls in value against the U.0000 1.350.00) 2.00 3.50) 4.500. the Brazilian economy falls into recession.00 (1.604.847.00 (1.00 13.50 1. €) 4.700.00 German Subsidiary (euros.450.00) 1.00) 1.8000 2. Y) 2.00 9.448.81 Business Performance (000s) Earnings before taxes.

00 -----2.00 9.800. €) 4.8000 -20% 2.S.575.750. €) 4.925.00 -----2.00) 1.4583 270.50 2.9% .50) 4.S.925.800.67 650.50) 4.78 650.00 (1. R\$) 6.00) 2.00 (1.depreciation) New exchange rate (fc/\$) Depreciation Case Business Performance (000s) Earnings before taxes.700.77 12.500.00 14. .00 8.5000 3. Y) 2.8773 German Subsidiary (euros.00 6.33 0.00 (1.00 (1.500.750.00 0. EBT (local currency) Less corporate income taxes Net profits of individual subsidiary Avg exchange rate for the period (fc/\$) Net profits of individual subsidiary (US\$) Consolidated profits (total across units) Total diluted shares outstanding (000s) Baseline earnings per share (EPS) EPS if foreign currencies appreciate ----1.7018 20% 0.7500 20% 6.00 0.77 16.687.700.266.80 7.00 0.70 7.500.00 (750.2500 Brazilian Subsidiary (reais.00) 1.65 US Parent Company (US\$) 4. dollar? Baseline exchange rate (fc/\$) Percent change (+ appreciation.250.125.5000 Brazilian Subsidiary (reais.500.562.500. . EBT (local currency) Less corporate income taxes Net profits of individual subsidiary Avg exchange rate for the period (fc/\$) Net profits of individual subsidiary (US\$) Consolidated profits (total across units) Total diluted shares outstanding (000s) Baseline earnings per share (EPS) EPS if foreign currencies depreciate ----- 1.687.250.6875 Chinese Subsidiary (yuan. Y) 2. R\$) 6.4583 Chinese Subsidiary (yuan.9 Luzon's Earnings and the Fall of the Dollar The U.925.8773 3.5848 German Subsidiary (euros.925.00 14.575.00 10.00 (1.616.077.8000 20% 1.9% Baseline exchange rate (fc/\$) Percent change (+ appreciation.00) 2.00) 2. What would be the impact on Luzon’s consolidated EPS if all foreign currencies were to appreciate 20% or depreciate 20% against the U.72 35% 25% 40% 30% \$ \$ \$ \$ \$ \$ \$ EPS has changed by: -13.7018 -20% 0.Problem 1.5848 4.50 1.6875 180.00) 2.depreciation) New exchange rate (fc/\$) Appreciation Case Business Performance (000s) Earnings before taxes.83 35% 25% 40% 30% \$ \$ \$ \$ \$ \$ \$ EPS has changed by: 13.00 (750.562.97 US Parent Company (US\$) 4.00 (1.500.2500 2.7500 -20% 9. dollar has experienced significant swings in value against most of the world's currencies in recent years.937.083.

604.00 \$ 868.847. €) 4.Problem 1.412.22 650.500.7018 3.54 \$ 322. Return to the original set of baseline assumptions and answer the following questions regarding Luzon’s global tax liabilities.77 1.500.925.00 7.687. Y) 2.4% \$ 3.50) 4. What is Luzon's effective tax rate? EBT by country.562.00 (1.00 7.00 (1.00 -----2.83 \$ 96.600.S.000? US Parent Company (US\$) 4.500. US\$ Consolidated EBT Total tax bill and the effective tax rate would be 35% 25% 28% 30% \$ \$ \$ \$ \$ \$ \$ \$ \$ \$ .00 (750. and Luzon’s earnings before tax in Germany rose to €5.22 \$ 7.50 1.7500 225.58 \$ 868. R\$) 6. EBT (local currency) Less corporate income taxes Net profits of individual subsidiary Avg exchange rate for the period (fc/\$) Net profits of individual subsidiary (US\$) Consolidated profits (total across units) Total diluted shares outstanding (000s) Consoldiated earnings per share (EPS) Tax payments by country in US dollars 35% 25% 40% 30% \$ \$ \$ \$ \$ \$ \$ a.00) 2.500.00 0.89 5.7% \$ 3.687. What would be the impact on Luzon's EPS and global effective tax rate if Germany instituted a tax cut to 28% and German subsidiary earnings rose to 5 million euros? US Parent Company (US\$) 4.77 Brazilian Subsidiary (reais.472.564.00 16.400.104.00 (1.500.64 650. €) 5.00 9.00 (1. What is the total amount – in U.00 10.00) 2.10 Luzon's Earnings and Global Taxation All MNEs attempt to minimize their global tax liabilities.129.7018 5.250.81 Business Performance (000s) Earnings before taxes.66 34.925.706.750.500. Total global tax bill.70 29.00 15.000.17 German Subsidiary (euros.00) 3.00 -----2.08 \$ 322.8000 2.925. dollars – which Luzon is paying across its global business in corporate income taxes? What is Luzon's effective tax rate (total taxes paid as a proportion of pre-tax profit)? What would be the impact on Luzon’s EPS and global effective tax rate if Germany instituted a corporate tax reduction to 28%.575.00 0.22 \$ 6.604.575.575.77 Brazilian Subsidiary (reais.00 1.67 Chinese Subsidiary (yuan.800.250.700.06 \$ 1.8000 2.884.50) 4.00) 1.34 4.00 (750.00) 1.00) 2.419.7500 225. US\$ \$ 5.994.500.602. Y) 2.00 (1.58 c.562.87 \$ 96. EBT (local currency) Less corporate income taxes Net profits of individual subsidiary Avg exchange rate for the period (fc/\$) Net profits of individual subsidiary (US\$) Consolidated profits (total across units) Total diluted shares outstanding (000s) Tax payments by country in US dollars After plugging in the new values.000. R\$) 6.00 (1.50 1.104.66 b.81 Business Performance (000s) Earnings before taxes.925. US\$ Consolidated EBT Total tax bill Effective tax rate \$ \$ \$ 4.00 14.575.534.75 4.124.25 Chinese Subsidiary (yuan.00 14.17 German Subsidiary (euros.472. EPS is EBT by country.750.06 \$ 2.