Solutions Manual

CHAPTER 31

INTERNATIONAL ASPECTS
OF CORPORATE FINANCE

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS

I. Questions

1. The U.S. dollar. The primary reason why the dollar was used is that it
provided a relatively stable benchmark, and it was accepted universally
for transaction purposes.
2. Under the fixed exchange rate system, the fluctuations were limited to
+1% and − 1%. Under the floating exchange rate system, there are no
agreed-upon limits.
3. A dollar will buy more French francs.
4. There will be an excess supply of dollars in the foreign exchange
markets, and thus, will tend to drive down the value of the dollar. Foreign
investments in the United States will increase.
5. Taking into account differential labor costs abroad, transportation, tax
advantages, and so forth, Philippine corporations can maximize long-run
profits. There are also nonprofit behavioral and strategic considerations,
such as maximizing market share and enhancing the prestige of corporate
officers.
6. The foreign project’s cash flows have to be converted to local currency,
since the shareholders of the Philippine corporation (assuming they are
mainly Philippine residents) are interested in peso returns. This subjects
them to exchange rate risk, and therefore requires an additional risk
premium. There is also a risk premium for political risk (mainly the risk
of expropriation).
7. A Eurodollar is a dollar deposit in a foreign bank, normally a European
bank. The foreign bank need not be owned by foreigners – it only has to
be located in a foreign country. For example, a Citibank subsidiary in
Paris accepts Eurodollar deposits. The Frenchman’s deposit at Chase
Manhattan Bank in New York is not a Eurodollar deposit. However, if he
transfers his deposit to a bank in London or Paris, it would be. The
existence of the Eurodollar market makes the Federal Reserve’s job of
controlling U.S. interest rates more difficult. Eurodollars are outside the

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direct control of the U.S. monetary authorities. Because of this, interest

rates in the U.S. cannot be insulated from those in other parts of the
world. Thus, any domestic policies the Federal Reserve might take
toward interest rates would be affected by the Eurodollar market.
8. A dollar will buy more euros.
9. The foreign project’s cash flows have to be converted to Philippine peso,
since the shareholders of the Philippine corporation (assuming they are
mainly Philippine residents) are interested in peso returns. This subjects
them to exchange rate risk, and therefore requires an additional risk
premium. There is also a risk premium for political risk (mainly the risk
of expropriation) that should be included.
10. No, interest rate parity implies that an investment in the Philippines with
the same risk as a similar investment in a foreign country should have the
same return. Interest rate parity is expressed as follows:
Forward exchange rate 1  rh
 .
Spot exchange rate 1  rf
Interest rate parity shows why a particular currency might be at a forward
premium or discount. A currency is at a forward premium whenever
domestic interest rates are higher than foreign interest rates. Discounts
prevail if domestic interest rates are lower than foreign interest rates. If
these conditions do not hold, then arbitrage will soon force interest rates
back to parity.
11. Purchasing power parity assumes there are neither transactions costs nor
regulations that limit the ability to buy and sell goods across different
countries. In many cases, these assumptions are incorrect, which
explains why PPP is often violated. An additional complication, when
empirically testing to see whether PPP holds, is that products in different
countries are rarely identical. Frequently, there are real or perceived
differences in quality, which can lead to price differences in different
countries.

II. Multiple Choice Questions

1. A 6. B 11. D 16. A
2. B 7. B 12. C 17. D
3. C 8. C 13. B 18. A
4. A 9. C 14. A 19. D
5. D 10. C 15. C

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III. Problems

Problem 1

Dollars should sell for 1/1.50, or 0.6667 pound per dollar.

Problem 2

$1 = 4.0 Israeli shekels; $1 = 90 Japanese yen;

Cross-exchange rate, yen/shekel = ?

Cross Rate: Dollars Yen Yen

  .
Shekel Dollar Shekel

Note that an indirect quotation is given for Israeli shekel; however, the cross
rate formula requires a direct quotation. The indirect quotation is the
reciprocal of the direct quotation. Since $1 = 4.0 shekels, then 1 shekel =
$0.25.
Yen/Shekel = $0.25 per shekel  90 yen per dollar
= 22.50 yen per shekel

Problem 3

rNOM, 6-month T-bills = 4%; rNOM of similar default-free 6-month Japanese bonds
= 2.5%; Spot exchange rate: 1 yen = $0.010; 6-month forward exchange rate = ?

Forward exchange rate 1  rh

 .
Spot exchange rate 1  rf
rf = 2.5% / 2
= 1.25%

rh = 4% / 2
= 2%

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Spot exchange rate = $0.010

Forward exchange rate 1.02

=
$0.010 1.0125

1.0125 Forward exchange rate = $0.0102

Forward exchange rate = $0.010074

The 6-month forward exchange rate is 1 yen = $0.010074

Problem 4

The spot exchange rate between the euro and the dollar is:

U.S. T.V. = $500; EMU T.V. = 312.5 euros; Spot rate between euro and
dollar = ?
Ph = Pf (Spot rate)
$500 = 312.5 euros (Spot rate)
500 / 312.5 = Spot rate
$1.60 = Spot rate

1 euro = $1.60 or $1 = 0.625 euro

Problem 5

The dollars required to purchase 1,000 units for each of the following currency is
as follows:
U.S. Dollars
Required to
Buy One Unit of Purchase Price
Currency Foreign Currency  1,000 = in Dollars
British pound 1.5282  1,000 = $1,528.20
Canadian dollar 0.9569  1,000 = 956.90
EMU euro 1.2893  1,000 = 1,289.30
Japanese yen 0.011437  1,000 = 11.44
Mexican peso 0.0782  1,000 = 78.20
Swedish krona 0.1359  1,000 = 135.90

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Problem 6

The price of krones is $0.15 today. A 10% appreciation will make it worth
$0.1650 tomorrow. A dollar will buy 1 / 0.1650 = 6.0606 krones tomorrow.

Problem 7

The exchange rate between Swedish kronas and pounds is:

Kronas / pound = kronas / dollar  dollars / pound
= 7.5  1.5
= 11.25 kronas per pound

Problem 8

Spot rate: 1 yen = $0.0114; Forward rate: 1 yen = $0.0114; r NOM of 90-day
Japanese risk-free securities = 2%; r NOM of 90-day U.S. risk-free securities = ?

rf = 2.0% / 4
= 0.50%
rh = ?

Forward exchange rate 1  rh

=
Spot exchange rate 1  rf
$0.0114 1  rh
=
$0.0114 1.005
1  rh
1 =
1.005
1 + rh = 1.005
rh = 0.005

rNOM = 0.50%  4
= 2%

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Problem 9

a. rNOM of 90-day U.S. risk-free securities = 3%; r NOM of 90-day British risk-free
securities = 3.5%; Spot rate: 1 pound = $1.50; forward rate selling at
premium or discount = ?

Forward exchange rate 1  rh

=
Spot exchange rate 1  rf

rh = 3% / 4
= 0.75%

rf = 3.5% / 4
= 0.875%

Spot rate = $1.50

Forward exchange rate 1.0075

=
$1.50 1.00875
Forward exchange rate
= 0.99876
$1.50
Forward exchange rate = $1.4981

The forward rate is selling at a discount, since a pound buys fewer dollars in
the forward market than it does in the spot. In other words, in the spot
market $1 would buy 0.6667 British pounds, but at the forward rate $1 would
buy 0.6675 British pounds; therefore, the forward currency is said to be
selling at a discount.

b. The 90-day forward rate is $1.4981.

Problem 10

a. C$4,000,000 / C$1.0500 = $3,809,523.81  $3,809,524, or

C$4,000,000  $0.9524 = $3,809,600 (Difference is due to rounding.)

b. C$4,000,000 / C$1.0550 = $3,791,469.19  $3,791,469, or

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C$4,000,000  $0.9479 = $3,791,600

c. If the exchange rate is C$1.025 to $1 when payment is due in 3 months, the
C$4,000,000 will cost:
C$4,000,000 / C$1.025 = $3,902,439,
which is $92,915 more than the spot price today and $110,970 more than
purchasing a forward contract for 90 days.
Problem 11
The U.S. dollar liability of the corporation falls from $1.05(5,000,000) =
$5,250,000 to $0.95(5,000,000) = $4,750,000, corresponding to a gain of
500,000 U.S. dollars for the corporation. However, the real economic situation
might be somewhat different. For example, the loan is presumably a long-term
loan. The exchange rate will surely change again before the loan is paid. What
really matters, in an economic sense, is the expected present value of future
interest and principal payments denominated in U.S. dollars. There are also
possible gains and losses on inventory and other assets of the firm.
Problem 12
a. The automobile’s value has increased because the dollar has declined in
value relative to the yen.
b. 245 / 87.5 = 2.8000, so $9,000  2.8000 = $25,200.
Note that this represents a 3.887% compound annual increase over 27 years.
Problem 13
D1 = 3 pounds; Exchange rate = $1.50/pound; Pound depreciates 5% against
$1. Dividend grows at 10% and rs = 13%. 10 million shares outstanding.
1.10
g = – 1 = 4.7619%
1.05
D1
P0 =
rs  g
3  $1.50
=
(0.13  0.047619)
$4.50
=
0.082381
= $54.62424588
Total equity = $54.62424588  10 million shares

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= $546,242,459

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