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FINS 3616 International Business Finance Sample Final Examination Solutions Session 1, 2011

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Frictionless financial markets could have which of the following? a. agency costs b. bid-ask spreads c. brokerage fees d. costs of financial distress e. irrational investors Which of a) through d) is unlikely to result in a decision to hedge currency risk? a. bid-ask spreads on foreign exchange b. costs of financial distress c. tax convexity d. stakeholder game-playing e. All of the above are incentives to hedge The United Kingdom and the United States use a ____ law system that relies heavily on the decisions of judges in previous court cases. a. civil b. common c. laissez faire d. Napoleonic e. Teutonic With payment through ____, the seller delivers goods directly to the buyer and then bills the buyer for the goods under agreed-upon payment terms. a. b. c. d. e. a packing list cash in advance documentary collections documentary credits open account

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Cash in advance is ____ for most exporters and ____ for most importers, all else constant. a. attractive; attractive b. attractive; unattractive c. unattractive; attractive d. unattractive; unattractive e. None of the above Internal methods of reducing the MNC’s transaction exposure to currency risk include each of a) through c) except ____. a. multinational netting b. leading and lagging of intracompany transactions c. hedging in the currency forward markets d. Each of the above is a way to reduce transaction exposure internally e. None of the above are a way of reducing transaction exposure internally

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c. operating d. economic exposure b. not at all d. None of the above 12. Change in financial accounting statements arising from unexpected changes in currency values is called ____ to currency risk. Buy the foreign currency with long-dated forward contracts. one for one e. a. When goods markets are segmented from other markets. through forward currency contracts c. * 9. Use currency swaps to acquire financial liabilities in the foreign currency. a. economic c. goods prices are determined ____. a. . in foreign markets b. the currency of denomination c. through futures contracts d.7. a. * 10. translation exposure e. by offsetting exposures within the firm b. transaction e. transaction exposure * d. through swap contracts e. None of the above * 14. a. b. The classic importer has ____. accounting b. All of the above e. operating exposure c. * The preferred way to hedge transaction exposure to currency risk is ____. disproportionately b. in the global market * c. The domestic currency value of an expected future operating cash flow denominated in a foreign currency changes ____ with a change in the value of the foreign currency. currency option e. money market hedge d. None of the above 11. both revenues and expenses that are determined globally b both revenues and expenses that are determined locally * c revenues that are determined locally and expenses that are determined globally d revenues that are determined globally and expenses that are determined locally e None of the above 13. a. None of the above . currency forward b. * a. An exporter’s financial market hedging alternatives include each of a) through c) except ____. currency swap 8.exposures should be left unhedged Financial market hedges work best for ____ exposures to currency risk. in the local market d. translation A “disaster hedge” against adverse currency movements can be obtained with a ____. currency future c. a. Use a rolling hedge to repeatedly sell the foreign currency.

exporting through foreign sales agents b. a.. Resource commitment is highest for which foreign market entry mode? a.. foreign direct investment d.. foreign joint venture e. foreign joint venture 19.unexposed * e. the uncertain cash flows of operating exposures to currency risk are exactly offset by the uncertain outcomes of a financial market hedge e. licensing 18. a. The potential loss of production technology is greatest with ____. None of the above 15. foreign acquisition 20. None of the above 16. inflation . exporting through foreign sales agents b. foreign acquisition d. a. exporting through foreign sales branches c.. unexposed. Political risk includes each of the following except ____... licensing d. fully exposed. expropriation c. exporting through foreign sales branches * c.. financial market hedges can completely cancel operating exposures to currency risk b.fully exposed 17. exporting through foreign sales agents b.d. the risk of disruptions in operations 21.. foreign direct investment e. fully exposed. potential loss of intellectual property rights c.. risks arising from dealing with an unfamiliar culture e.partially exposed b. partially exposed. currency risk * b. More than one of the above e. expropriation b. financial market transactions allow firms to easily profit from mispricing in the currency market * c. foreign direct investment e. exporting through foreign sales branches * c. FAS #52 assumes that the value of the firm’s real assets are ____ to currency risk. partially exposed. protectionism * d. The main advantage of a financial market hedge of operating exposure to currency risk is that ____. the costs of buying or selling financial instruments are low compared to the costs of investing or disinvesting in real assets d. * a. a. Macroeconomic factors that affect country risk assessments include each of the following except ____. a.fully exposed d.unexposed c. FAS #8 assumes that the value of the firm’s real assets are ____ to currency risk.. The fastest way to gain access to a foreign market is by ____.

12% * d.000 in years 1 through 3. excluding c. NPV£ = £53.84 26. what is the expected future spot rate [E(S3£/€ )] at time t = 3? a.716. expropriation risk c. A firm’s debt sells for £10 million and equity for £30 million. None of the above 24.020/€ * d.000 in year 0 and generates inflows of €10. Assume the international parity conditions do not hold .060/€. Expected future spot rates are: E(S1£/€) = £2. excluding e. Assume S0£/€ = £2/€ and i£ = 7%.000 in year 0 and generates inflows of €10. NPV£ = £53.142. £2. then the parent firm should ____. a. excluding. If a project has a positive NPV from the parent’s perspective but a negative NPV from the project’s perspective. £1.000 in years 1 through 3.25 * d. Assume the international parity conditions hold. The firm’s before-tax cost of debt is 9%.116/€ e. a.d. Suppose a project requires a cash outlay of €1.31 c. the current account balance 22. £2.250/€ 25.963/€ c.464.96 b. 6% b. NPV£ = £52. £1. reject the project c. a. accept the project b. 15% e. E(S2£/€) = £2. subsidized financing * e. If i£ = 7% and i€ = 5%.100/€.015. NPV£ = £54. excluding. interest rate risk e. 18% 27. Each of the above can be valued as a side effect . Suppose a project requires a cash outlay of €1. * a.978. £2. Expected future cash flows are estimated by ____ only incremental cash flows and ____ all opportunity costs. including. Each of a) through d) can be valued as a separate side effect except ____. accept the project and try to capture the value in the foreign currency today * d. including d. and E(S3£/€) =£2. The current spot rate is S0£/€ = £2/€. The corporate tax rate is 33%. Its cost of equity is 18%.220/€. None of the above 23. The firm’s weighted average cost of capital is closest to which of the following? a. including b. blocked funds b.890/€ b. 9% c. negative-NPV tie-in projects d. NPV£ = £52. Calculate NPV£ by converting euros to pounds at the expected future spot rates and discounting in pounds. including.36 e. reject the project and continue to look for positive-NPV projects in the foreign currency e.

d. government ____. the potential for litigation over foreign operations is high e. Corporate governance refers to ____. None of the above 33. a. Active income earned from a foreign branch is taxed by the U. they indicate the corporation has free cash flow * d. a. at the foreign tax rate e. China b. as funds are repatriated to the U. b. asset taxes * b. Hostile acquisitions conducted through the financial markets are most common in ____. All of the above are associated with higher leverage e. More than one of the above e. Mexico * e. the United Kingdom 35. or both . Impediments to purchase of foreign shares directly in a foreign market include each of a) through d) except ____.” 1995] found that leverage decreases with ____. None of the above 29. Foreign operations are more likely to be set up as a foreign branch when ____. a. higher pre-tax required returns in countries with high tax rates c.28. None of the above are associated with higher leverage 30. Rajan and Zingales [ “What Do We Know about Capital Structure? Some Evidence from International Data. disclosure requirements in the foreign country are high * c. profitability c. Germany c. after pooling this income with all other income sources b. None of the above 32. c. Japan d. firm size d. value-added taxes e. Stakeholders prefer internally generated funds to external funds because ____. earnings are expected to be negative in the early years of operations d.S. e. cross-border differences in accounting conventions and tax laws b. as it is earned in the foreign country d. a. a. a. parent corporation * c. difficulty in obtaining or interpreting information. the model corporation as characterized by the World Bank the role of top managers as the shepherds of the corporation the organizational chart the way in which stakeholders exert control over the corporation None of the above * 34. internal funds avoid the discipline of the financial markets b. a. internal funds avoid the transactions costs of external issues c. None of the above 31.S. Implicit taxes include which of the following? a. the tangibility of the firm’s assets * b. income taxes d. bribes are a common business practice in the foreign country b.

614.41)(AA24. (€1. The money market hedge is on more favorable terms than the forward contract.41 Invest €961. Identify which currency you are buying and which you are selling forward.431.000. Replicate the payoff on the forward contract with a money market hedge by using the spot currency and Eurocurrency markets.0405) = €961.54.000. The net result is a forward contract to purchase €1. so forward prices are not in equilibrium with the interest rate differential.310. how would you arbitrage the disequilibrium? (2 marks) No.431.310.050% 4.* c. Artic Australs per Euro One-year forward rate One-year Artic interest rate One-year Euro interest rate AA24. This can be replicated as follows: Find PV of €1.88 to yield AA24. higher transaction costs including commissions d.000. Interest rate parity .042. (1 mark) You are paying €1 million to your supplier in one year.000 with AA24. In one year.96 million one-year forward. the inconvenience of receiving dividends in a foreign currency e.000)/(1. The €1 million receipt on the forward contract offsets the forward obligation to your supplier.05% Artic rate.41 = to yield €1 million at the euro interest rate in one year Convert to (€961. Each of the above is an impediment Section B—Short Answer Questions (20 marks) Question 1 (5 marks): You work for an importer from the Artic region and expect to pay €1 million in one year to a European supplier. Are quoted prices in these currency and Eurocurrency markets in equilibrium? If not. Form a forward market hedge.54 at the 5.38/€) = AA23. Identify each contract in the hedge. leaving you with a net payment of AA24.614. b.042.000 at 4. c.050% a.076.076. You have eliminated your euro exposure. (2 marks) The forward contract that you want to replicate is a forward purchase of €1 million.88 at the spot exchange rate Borrow AA23.96 million.38/€ AA24. You can trade at the following prices: Spot rate.05%. you’ll receive €1 million and pay AA24.96/€ 5. so buy €1 million and sell AA24.076.96 million on the forward contract.

Initial Outlay = (V800..K.0097 In this situation. (1+i£) = (1+p£)(1+q£) ⇒ i£ = (1.000.0% iV = 12. • An investment of V800. and just-in-time inventory control will be used.000 in nominal terms over the next 3 years.F1AA/€/S0AA/€ = (1+iAA)/(1+i€) (AA24. it is cheaper to hedge through the money markets than through the forward market.000) + (V425.000 each year in nominal terms.0% £ p = 5.000) Depreciation tax shield calculation: (Depreciable base = V500.96/€)/(AA24.300. All of the business’s transactions are conducted in cash.000 will purchase the vineyard.10) – 1 = 0. International parity conditions hold. Interest and inflation rates and the characteristics of the investment project are as given in Exhibit T14.2.000) + (V47. V900. (This happens to be identical to 3-year ACRS in the United States.K.000. Assume all operating cash flows occur at year-end.K. Is the answer the same as in b)? (2 marks) a.2% qFV = 2.2 Wine production in Vino Nominal risk-free government T-bill rate Real required return on T-bills Expected future inflation Real required return on wine production Current spot exchange rate U. In addition.0405) = 1. You are a successful U. 15%.000 in nominal terms at the end of the project’s life in three years.12)(1.500 and V27.500) = (V1. Fixed costs are V5.38/€) = 1.1% iFV =12. wine producer and are considering investing in a second operation in the country of Vino (with currency V). the wine press supplier has given price quotes of V47. What is the nominal required return on wine investments in the U.0238 >(1. and 7% over the four-year project. V800. • The winery and wine presses will cost V425. and the investment will be 100 percent equity-financed. All cash outlays are payable at the start of the project.? in Vino? (1 mark) b.0% qF£ = 2. • Annual depreciation for winery and wine presses is 33%.05) – 1 = 0. • Annual sales revenues are expected to be V700. • No investment in net working capital is necessary.2% b. (2 marks) c.6% (1+iV) = (1+pV)(1+qV) ⇒ iV = (1. Translate vino-unit cash flows to pounds at expected future spot rates and discount at the pound discount rate from a) to find NPV0£.000. Use the current spot rate to transfer this value to NPV0£. • Income and capital gains taxes are 50% in each country.12)(1. respectively.176 or 17. Identify expected future cash flows on this foreign investment project.500) + (V27. Variable operating costs are 10% of sales.) The winery and presses are expected to have a total market value of V45.0% V/£ S0 = V10/£ The following information is known about the project: • The project has a 3-year life.500 for the machinery’s installation and modification.0% £ i = 12. 45%.0505)/(1.000) . Question 2 (5 marks) Exhibit T14. Vino iF£ = 7. Its real value will remain constant throughout the investment’s life and the vineyard will be sold at the end of the project. a.0% pV = 10. Discount these cash flows at the vino-unit discount rate from a) to find NPV0V.232 or 23.

500 V37. b.000 V335.000 V225.000)(1–0. a.5] = V972. Cyprus has a 10 percent corporate income tax and no dividend withholding tax.000 – [(V45. tax liability (or excess FTC) of Crusty Creations.000 t=1 £42.412. what is its U.400 V395.000 V110.536.000 V470.824 t=2 £122.500 V112.400  yr 1 yr 2 yr 3 −V1.5) + V37.5} + V45.000 V0 Tax shield V82.000 – V70.7 at V10/£ c. If Crusty Creations can shift operations so that pre-tax income is £20.232/1.000)(1–0. How feasible is a tax-driven strategy of shifting revenues toward low-tax countries in the presence of implicit taxes? (1 mark) The table below has been provided to help you in computing taxes. tax liability (or excess FTC)? (1 mark) d.000 Terminal Cash Flow = V800. The corporate tax rate in the US is 35%.000 in Japan and zero in Cyprus.000 Ending balance V335.S.000]*0.6% This is the same as in b) because the international parity conditions hold.704 -£130. You will need to complete this table for parts a.000 V35.000 – V90.367 at iV = 23.000 in Cyprus and zero in Japan.000)(1–0.000)*0. Question 3 (5 Marks) U.2% NPV£ = V85. and c.000 – V80.500 = V470. what is its U.500 = V440.000*(1. If Crusty Creations can shift operations so that pre-tax income is £20.5) + V112.000 V35. .97506/£ E(S3 V/£) = V10/£ (1.807 t=3 NPV£ = £8.000 NPVV = V85.176) 3 = V11.000 – V5.49768/£ £37.176) = V10. Each facility earns the equivalent of £10. Japan has corporate income taxes of 41 percent and dividend withholding taxes of 5 percent. Calculate the overall U.500 = V395. Inc.000 V1.500 After-tax operating cash flows: CF1 = (V700.232/1.232/1.000 V35. E(S1 V/£) = V10/£ (1.300. (2 mark) b. sells its prepackaged pastries in Cyprus and Japan.-based Crusty Creations.367/(V10/£) = £8.5) + V82.000 – V5.500 V17.176)2 = V10.000 in foreign-source income before tax.000 CF3 = (V900.10)3 – V800.S.S.000*(1.000 Depr % 33% 45% 15% 7% Depr expense V165. tax liability (or excess FTC)? (1 mark) c.S.536.000 – V5.7 at i£ = 17.000 V110.000 CF2 = (V800.10)3 – {[ V800.Year 1 2 3 4 Beginning balance V500.000 V75.000 –V35.47619/£ E(S2 V/£) = V10/£ (1.

Dividend payout ratio Dividend tax rate Foreign tax rate Foreign income before tax Foreign income tax After-tax foreign earnings Declared as dividends Dividend tax Total foreign tax Dividend to U.790 d.790 7000 0 13000 0 £7.S. parent Tentative U.0)] Total taxes paid (i+n) Net amount to U.S.S. taxes due [max(0.S. income tax (k*35%) Foreign tax credit (i) Net U.600 £3.000 £6. parent (d–i) Gross foreign income before tax (line d) Tentative U. r–s)] u Excess tax credits [max(0. taxes payable [max(l–m. taxes payable Total taxes paid Net amount to U. Implicit taxes will make it difficult to generate the same pretax returns in Cyprus as can be . a b c d e f g h i j k l m n o p q Dividend payout ratio Foreign dividend withholding tax rate Foreign tax rate Foreign income before tax Foreign income tax (d*c) After-tax foreign earnings (d–e) Declared as dividends (f*a) Foreign dividend withholding tax (g*b) Total foreign tax (e+h) Dividend to U. parent (k–o) Total taxes as separate subs (∑o) Cyprus 100% 0% Japan 100% 5% Part a) Cyprus Japan 100% 100% 0% 5% 18% 41% 10000 10000 1800 4100 8200 5900 8200 5900 0 295 1800 4395 8200 5605 10000 10000 3500 3500 1800 4395 1700 0 3500 4395 6500 5605 £7.400 £0 £7.s–r)] (carried back 2 years or forward 5 years) £7.S.000 Parent’s consolidated tax statement r Overall FTC limitation (∑k*35%) s Total FTCs on a consolidated basis (∑i) t Additional U. parent Total taxes: separate subs 3.000 £8.S.S.895 Part b) Cyprus Japan 100% 100% 0% 5% 18% 41% 20000 3600 16400 16400 0 3600 16400 20000 7000 3600 3400 0 0 0 0 0 0 0 0 0 0 0 Part c) Cyprus Japan 100% 100% 0% 5% 18% 41% 0 0 0 0 0 0 0 20000 8200 11800 11800 590 8790 11210 0 20000 0 7000 0 8790 0 0 0 8790 0 11210 £8.S.S.790 £0 £1.000 £3.195 £805 £0 £7. income tax Foreign tax credit Net U.

The biggest advantage of the option (relative to the future) is that it allows you to fully benefit from the British pound appreciation while still protects you from the pound depreciating. b. so the potential for a large loss is much greater with operating hedges. Intuitively. with a futures contract. As the pound appreciates. Discuss a real asset (i. they receive a fixed amount of British pounds. so you are unable to fully benefit if the pound appreciates. What are the relative advantages/disadvantages of the two financial market options you mentioned? (2 points) c. (1 mark) a. One advantage of the operating hedge is that it creates a fundamental change in the way the firm does business and will thus provide a long-lasting hedge against operating exposure. but not the obligation. Intuitively. (1 mark) b. or money market hedges. future contracts tend to be relatively low cost. Note: this is just one possible answer. explain why. (1 mark) d. If pre-tax returns were equal in Cyprus and Japan. Having both revenues and expenses denominated in pounds would reduce their operating exposure to the pound. You primarily export cars to the UK and the price of these cars is denominated in British pounds. this would be a clear violation of the law of one price in its after-tax form and would suggest arbitrage profits are available. The value of the production plant is positively exposed to the value of the foreign currency. Discuss one advantage and one disadvantage of using real asset hedges. In contrast. One disadvantage is that the cost of a building a new production plant is high.e. Is the value of the production plant positively or negatively exposed to the value of the foreign currency. a. In contrast. The firm could buy a futures contract that allows it to sell British pounds at a fixed rate. to sell the pound at specific strike price. Other financial market hedges that you could have mentioned include forwards. The firm could set up a production plant in the UK. when the US car company sells a car. they can convert those British pounds into a greater amount of USD.generated in Japan. . Discuss two financial market hedges that the firm might use to hedge their operating exposure. swaps. operating) hedge that the firm might use to hedge their operating exposure. you lock in a specific exchange rate. One disadvantage of the option contract is that option premiums can be quite high. As a results the value of your production plant is very sensitive to the US/UK exchange rate. Question 4 (5 Marks) You are the manger of large US car company. The firm could also buy a put option that gives the firm the right. c. d.