Intl Capital Budgeting Chapter 18

Chapter 18 - International Capital Budgeting
Chapter 18
International Capital Budgeting

Multiple Choice Questions

1. The financial manager's responsibility involves

A. increasing the per share price of the company's stock at any cost and by any means, ways
and fashion that is possible.
B. the shareholder wealth maximization.
C. which capital projects to select.
D. both b) and c)
2. Perhaps the most important decisions that confront the financial manager are
A. which capital projects to select.
B. the correct capital structure for the firm.
C. the correct capital structure for projects.
D. none of the above
3. Capital budgeting analysis is very important, because it

A. involves, usually expensive, investments in capital assets.
B. has to do with the productive capacity of a firm.
C. will determine how competitive and profitable a firm will be.
D. all of the above
18-1
Tiger Towers, Inc. is considering an expansion of their existing business, student apartments.
The new project will be built on some vacant land that the firm has just contracted to buy. The
land cost $1,000,000 and the payment is due today. Construction of a 20-unit office building
will cost $3 million; this expense will be depreciated straight-line over 30 years to zero
salvage value; the pretax value of the land and building in year 30 will be $18,000,000. The
$3,000,000 construction cost is to be paid today. The project will not change the risk level of
the firm. The firm will lease 20 offices suites at $20,000 per suite per year; payment is due at
the start of the year; occupancy will begin in one year. Variable cost is $3,500 per suite. Fixed
costs, excluding depreciation, are $75,000 per year. The project will require a $10,000
investment in net working capital.

4. What is the unlevered after-tax incremental cash flow for year 0?
A. -$3,660,000
B. -$5,100,000
C. -$4,000,000
D. -$4,010,000
E. None of the above
A. -$4,610
B. $102,300
C. $202,300
D. $255,000
A. $12,432,300
B. $12,225,390
C. $12,332,300
D. $12,485,000
18-2
Assume that the firm will partially finance the project with a $3,000,000 interest-only 30-
year loan at 10.0 percent APR with annual payments.
7. What is the levered after-tax incremental cash flow for year 0?
A. -$1,010,000
B. -$1,000,000
C. -$660,000
D. -$2,100,000
A. $4,300
B. -$202,610
C. -$95,700
D. $57,000
A. $9,027,390
B. $9,234,300
C. $9,134,300
D. $9,287,000
10. Assume that the firm will partially finance the project with a subsidized $3,000,000
interest only 30-year loan at 8.0 percent APR with annual payments. Note that eight percent is
less than the 10 percent that they normally borrow at. What is the NPV of the loan?
A. $198,469
B. $53,979.83
C. $102,727.55
D. $1,334,851.09
18-3
11. The firm's tax rate is 34%. The firm's pre-tax cost of debt is 8%; the firm's debt-to-equity
ratio is 3; the risk-free rate is 3%; the beta of the firm's common stock is 1.5; the market risk
premium is 9%. What is the firm's cost of equity capital?
A. 33.33%
B. 10.85%
C. 13.12%
D. 16.5%
premium is 9%. What is the required return on assets?
A. 33.33%
B. 10.85%
C. 13.12%
D. 16.5%
Consider a project with the following data:
The 5-year project requires equipment that costs $100,000. If undertaken, the shareholders
will contribute $20,000 cash and borrow $80,000 at 6% with an interest-only loan with a
maturity of 5 years and annual interest payments. The equipment will be depreciated straight-
line to zero over the 5-year life of the project. There will be a pre-tax salvage value of $5,000.
There are no other start-up costs at year 0. During years 1 through 5, the firm will sell 25,000
units of product at $5; variable costs are $3; there are no fixed costs.
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13. What is the NPV of the project using the WACC methodology?

A. $49,613.03
B. $58,028.68
C. $102,727.55
D. $315,666.16
14. What is the NPV of the project using the APV methodology?

A. $49,613.03
B. $198,469
C. $102,727.55
D. $149,580.12
will contribute $25,000 cash and borrow $75,000 with an interest-only loan with a maturity of
5 years and annual interest payments. The equipment will be depreciated straight-line to zero
over the 5-year life of the project. There will be a pre-tax salvage value of $5,000. There are
no other start-up costs at year 0. During years 1 through 5, the firm will sell 25,000 units of
product at $5; variable costs are $3; there are no fixed costs.

A. $58,028.68
B. $49,613.03
C. $48,300.47
D. $102,727.55
18-5
16. When using the APV methodology, what is the NPV of the depreciation tax shield?
A. $32,051.52
B. $25,777.35
C. $22,794.65
D. $97,152.98
17. When using the APV methodology, what is the NPV of the interest tax shield?
A. $9,666.51
B. $12,019.32
C. $9,377.31
D. $7,000.73
18. Today is January 1, 2009. The state of Iowa has offered your firm a subsidized loan. It
will be in the amount of $10,000,000 at an interest rate of 5% and have ANNUAL
(amortizing) payments over 3 years. The first payment is due today and your taxes are due
January 1 of each year on the previous year's income. The yield to maturity on your firm's
existing debt is 8%. What is the APV of this subsidized loan? If you rounded in your
intermediate steps, the answer may be slightly different from what you got. Choose the
closest.
A. -$3,497,224.43
B. $417,201.05
C. $840,797
D. None of the above
18-6
(amortizing) payments over 3 years. The first payment is due December 31, 2009 and your
taxes are due January 1 of each year on the previous year's income. The yield to maturity on
your firm's existing debt is 8%. What is the APV of this subsidized loan?
Note that I did not round my intermediate steps. If you did, your answer may be off by a bit.
Select the answer closest to yours.
A. -$3,497,224.43
B. $417,201.05
C. $840,797
20. The required return on assets is 18%. The firm can borrow at 12.5%; firm's target debt to
value ratio is 3/5. The corporate tax rate is 34%, and the risk-free rate is 4% and the market
risk premium is 9.2 percent. What is the weighted average cost of capital?
A. 12.15%
B. 13.02%
C. 14.33%
D. 23.45%
21. Your firm is in the 34% tax bracket. The yield to maturity on your existing bonds is 8%.
The state of Georgia offers to loan your firm $1,000,000 with a TWO year AMORTIZING
loan at a 5% rate of interest and ANNUAL payments due at the END OF THE YEAR.
The interest will be deductible at the time that you pay. What is the APV of this below-market
loan to your firm? I did not round any of my intermediate steps. You might be a little bit off.
Pick the answer closest to yours.
A. $64,157.38
B. $417,201.05
C. $840,797
18-7
premium is 9%.Calculate the weighted average cost of capital.
A. 33.33%
B. 8.09%
C. 9.02%
D. 16.5%
Consider a project of the Cornell Haul Moving Company, the timing and size of the
incremental after-tax cash flows (for an all-equity firm) are shown below in millions:
The firm's tax rate is 34%; the firm's bonds trade with a yield to maturity of 8%; the current
and target debt-equity ratio is 2; if the firm were financed entirely with equity, the required
return would be 10%.
23. Using the weighted average cost of capital methodology, what is the NPV? I didn't round
my intermediate steps. If you do, you're not going to get the right answer.
A. -$1,406,301.25
B. $12,494,643.75
C. $36,580,767.55
D. $108,994.618.20
E. $59,459,301.03
18-8
A. $185,796,000
B. $215,152,000
C. $267,952,000
D. $284,848,000
A. $281,704,000
B. $465,152,000
C. -$194,848,000
D. $460,796,000
26. Using the flow to equity methodology, what is the value of the equity claim?
A. -$1,540,000
B. $446,570,866.00
C. $36,580,767.55
D. $470,953,393.70
E. $30,716,236.13
27. Using the APV method, what is the value of this project to an all-equity firm?
A. -$46,502,288.10
B. $12,494,643.75
C. $36,580,767.55
D. -$67,163,445.12
E. $59,459,301.03
28. Using the APV method, what is the value of the debt side effects?
A. $239,072,652.70
B. $66,891,713.66
C. $59,459,301.03
D. $660,000,000
18-9
A. -$1,406,301.25
B. $12,494,643.75
C. $36,580,767.55
D. $108,994.618.20
E. $59,459,301.03
A. $185,796,000
B. $215,152,000
C. $267,952,000
D. $284,848,000
A. -$281,704,000
B. $465,152,000
C. -$194,848,000
D. $460,796,000
18-10
A. -$1,540,000
B. $446,570,866.00
C. $36,580,767.55
D. $470,953,393.70
E. $30,716,236.13
A. -$46,502,288.10
B. $12,494,643.75
C. $36,580,767.55
D. -$67,163,445.12
E. $59,459,301.03
A. $239,072,652.70
B. $66,891,713.66
C. $59,459,301.03
D. $660,000,000
35. In the APV model

A. interest tax shields are discounted at i.
B. operating cash flows are discounted at Ku.
C. depreciation tax shields are discounted at i.
D. all of the above
18-11
36. Your firm's existing bonds trade with a yield to maturity of eight percent. The state of
Missouri has offered to loan your firm $10,000,000 at zero percent for five years. Repayment
will be of the form of $2,000,000 per year for five years, the first payment is due in one year.
What is the value of this offer?
A. $4,729,622.75
B. $2,014,579.93
C. $0
D. $196,929.88
37. What proportion of the firm is financed by debt for a firm that expects a 15% return on
equity, a 12% return on assets, and a 10% return on debt? The tax rate is 25%.
A. 20%
B. 1/3
C. 60%
D. 2/3
E. 80%
38. The required return on equity for a levered firm is 10.60%. The debt to equity ratio is ½
the tax rate is 40%, the pre-tax cost of debt is 8%. Find the cost of capital if this firm were
financed entirely with equity.
A. 10%
B. 12%
C. 8.67%
39. The required return on equity for an all-equity firm is 10.0%. They are considering a
change in capital structure to a debt-to-equity ratio of ½ the tax rate is 40%, the pre-tax cost of
debt is 8%. Find the new cost of capital if this firm changes capital structure.
A. 14.93%
B. 8.67%
C. 7.40%
18-12
40. The required return on equity for an all-equity firm is 10.0%. They currently have a beta
of one and the risk-free rate is 5% and the market risk premium is 5%. They are considering a
debt is 8%. Find the beta if this firm changes capital structure.
A. 1.12
B. 1
C. 7.4%
41. What is the expected return on equity for a tax-free firm with a 15% expected return on
assets that pays 12% on its debt, which totals 25% of assets?
A. 24%
B. 15.60%
C. 16%
D. 20%
E. 15.75%
42. What is the expected return on equity for firm in the 40% tax bracket with a 15% expected
return on assets that pays 12% on its debt, which totals 25% of assets?
A. 24%
B. 15.60%
C. 16%
D. 20%
E. 15.75%
18-13
43. Assume that XYZ Corporation is a leveraged company with the following information:

Calculate the debt-to-total-market-value ratio that would result in XYZ having a weighted
average cost of capital of 9.3%.
A. 35%
B. 40%
C. 45%
D. 50%
existing debt is 8%. What is the APV of this subsidized loan? Note that I did not round my
intermediate steps. If you did, your answer may be off by a bit. Select the answer closest to
yours.
A. $406,023.10
B. $840,797
C. $64,157.38
D. $20,659.77
E. None of the other answers are within $100 of my answer
18-14
45. An Italian firm is considering selling its line of coin-operated cappuccino machines in the
U.K. The business risk will be identical to the firm's existing line of business in the euro zone,
the cost of capital in the euro zone is i€ = 10%. The expected inflation rate over the next two
years in the U.K. is 3% per year and 2% per year in the euro zone. The spot exchange rates
are $1.80 = £1.00 and $1.15 = €1.00.
The pound sterling denominated cash flows are as follows:

What is the €-denominated NPV of this project? I did not round my intermediate steps, if you
did, select the answer closest to yours.
A. €5,563.23
B. €2,270.79
C. €7,223.14
D. €3,554.29
E. There is not enough information (e.g. U.S. inflation) to do this problem.
46. The spot exchange rate is ¥125 = $1. The U.S. discount rate is 10%; inflation over the
next three years is 3% per year in the U.S. and 2% per year in Japan. Calculate the dollar NPV
of this project.

I did not round my intermediate steps, if you did, select the answer closest to yours.
A. $267,181.87
B. $14,176.67
C. $2,536.49
D. $2,137.46
18-15
Some of the factors (with selected explanations) used in calculating the basic "net present
value" and the "incremental" cash flows of a capital project are:
(i)- expected after-tax terminal value, including recapture of working capital

(ii)- net income, which belongs to the equity holders of the firm
(iii)- initial investment at inception
(iv)- depreciation, and the fact that depreciation is a noncash expense (i.e. it is removed from
the calculation of net income, for tax purposes, but added back because it did not actually
flow out of the firm)
(v)- weighted-average cost of capital
(vi)- the firm's after-tax payment of interest to debtholders
(vii)- economic life of the capital project in years
47. The "net present value" of a capital project is calculated by using:

A. (i), (ii), and (iii)
B. (ii), (iv), and (vi)
C. (i), (iii), (v), and (vii)
D. (iv), (v), (vi), and (vii)
48. The "incremental" cash flows of a capital project is calculated by using:

49. In the context of the capital budgeting analysis of an MNC that has strong foreign
competitors, "lost sales" refers to
A. the cannibalization of existing projects by new projects.
B. the entire sales revenue of a new foreign manufacturing facility representing the
incremental sales revenue of the new project.
C. both a) and b)
18-16
50. Which of the following statements is false about "borrowing capacity"?

A. It is an especially important point in international capital budgeting analysis because of the
frequency of large concessionary loans.
B. It creates tax shields for APV analysis regardless of how the project is actually financed.
C. It synonymous to the "project debt".
D. It based on the firm's optimal capital structure.
51. The adjusted present value (APV) model that is suitable for an MNC is the basic net
present value (NPV) model expanded to
A. distinguish between the market value of a levered firm and the market value of an
unlevered firm.
B. discern the blocking of certain cash flows by the host country from being legally remitted
to the parent.
C. consider foreign currency fluctuations or extra taxes imposed by the host country on
foreign exchange remittances.
D. all of the above
52. Sensitivity analysis in the calculation of the adjusted present value (APV) allows the
financial manager to
A. analyze all of the risks (business, economic, exchange rate uncertainty, political, etc.)
inherent in the investment.
B. more fully understand the implications of planned capital expenditures.
C. consider in advance actions that can be taken should an investment not develop as
anticipated.
D. all of the above
53. The ABC Company, a U.S.-based MNC, plans to establish a subsidiary in Spain to

manufacture and sell water pumps. ABC has total assets of $80 million, of which $60 million
is equity financed. The remainder is financed with debt. ABC considers its current capital
structure optimal. The construction cost of the facility in Spain is estimated to be €8,500
million, of which €6,500 million is to be financed at a below-market rate of interest arranged
by the Spanish government. The proposed project will increase the borrowing capacity by
A. €1,215 million.
B. €2,215 million.
C. €3,215 million.
D. €4,215 million.
18-17
54. Given the following information for a levered and unlevered firm, calculate the difference
in the cash flow available to investors. Assume the corporate tax rate is 40%.
(Hint: Calculate the tax savings arising form the tax deductibility of interest payments).

A. $8
B. $18
C. $78
D. $90
55. As of today, the spot exchange rate is €1.00 = $1.25 and the rates of inflation expected to
prevail for the next year in the U.S. is 2% and 3% in the euro zone. What is the one-year
forward rate that should prevail?
A. €1.00 = $1.2379
B. €1.00 = $1.2139
C. €1.00 = $0.9903
D. $1.00 = €1.2623
A. €1.00 = $1.5147
B. €1.00 = $1.4854
C. €1.00 = $0.6602
D. $1.00 = €0.6602
18-18
prevail for the next three years in the U.S. is 2% and 3% in the euro zone. What spot
exchange rate should prevail three years from now?
A. €1.00 = $1.2379
B. €1.00 = $1.2139
C. €1.00 = $0.9903
D. $1.00 = €1.2623

Short Answer Questions

Your firm is based in southern Ireland (and thereby operates in euro, not pounds) and is
considering an investment in the United States.
The project involves selling widgets: you project a sales volume of 50,000 widgets per year,
sales price of $20 per widget with a contribution margin of $15 per widget.
The project will last for 5 years, require an investment of $1,000,000 at time zero (which will
be depreciated straight-line to $10,000 over the 5 years). Salvage value for the equipment is
projected to be $10,000. The project will operate in rented quarters: $300,000 rent is due at
the start of each year.
The corporate tax rate is 12½% in Ireland and 40% in the U.S.
For simplicity, assume that taxes are paid like sales taxes: immediately.
The spot exchange rate is $1.50 = €1.00. The cost of capital to the Irish firm for a domestic
project of this risk is 8%. The U.S. risk-free rate is 3%; the Irish risk-free rate is 2%.
58. What is CF0 in dollars?

18-19


61. What is the NPV of the U.S.-based project to the Irish firm?

62. What is the dollar-denominated IRR?

18-20
63. What is the euro-denominated IRR?

64. Find the break-even price (in dollars) and break-even quantity for the U.S. project.

65. Repeat the above project analysis assuming that the Irish firm could replicate the project
in Ireland. (i.e. cash flow out the project in Ireland and find break-even price (in €), quantity,
NPV, IRR (in euro not dollars).

18-21
Consider the following international investment opportunity. It involves a gold mine that can
be opened at a cost, then produces a positive cash flow, but then requires environmental clean
up:

The current exchange rate is $1.60 = €1.00. The inflation rate in the U.S. is 6 percent and in
the euro zone 2 percent. The appropriate cost of capital to a U.S.-based firm for a domestic
project of this risk is 8 percent.
66. Find the euro-zone cost of capital to compute the dollar-denominated NPV of this project.

67. Find the dollar cash flows to compute the dollar-denominated NPV of this project.
Please note that your answer is worth ZERO POINTS if it does not contain currency
symbols.

18-22
68. What is the dollar-denominated IRR of this project?

69. What is the euro-denominated IRR of this project?

up:


18-23
Your answer is worth ZERO POINTS if it does not contain currency symbols such as $, £, €,
¥!



18-24
Consider the following international investment opportunity:




18-25

A French firm is considering a one-year investment in the United Kingdom with a pound-
denominated rate of return of i£ = 15%. The firm's local cost of capital is i€ = 10%
The project costs £1,000 and will return £1,150 at the end of one year.
The current exchange rate is €2.00 = £1.00
Suppose that the bank of England is considering either tightening or loosening its monetary
policy. It is widely believed that in one year there are only two possibilities:

Following revaluation, the exchange rate is expected to remain steady for at least another
year.
78. Find the ex post IRR in euro for the French firm if they undertake the project today and
then the exchange rate falls to S1(€|£) = €1.80 per £.

18-26
then the exchange rate rises to S1(€|£) = €2.20 per £.

80. Find the IRR in euro for the French firm if they wait one year to undertake the project
after the exchange rate rises to S1(€|£) = €2.20 per £.

81. Find the NPV in euro for the French firm if they wait one year to undertake the project

after the exchange rate falls to S1(€|£) = €1.80 per £.

18-27

84. The CFO who has a CFA notices the optionality in starting this project today. He asks you
to comment and outline your valuation strategy.

85. Your banker quotes the euro-zone risk-free rate at i€ = 6% and the British risk free rate at
i£ = 6%. Find the value of the option and thereby the project.

86. Using your results to the last question, make a recommendation vis-à-vis when to
undertake the project.

18-28
87. Using the notion of a hedge ratio, make a recommendation vis-à-vis how to undertake the
project today without "buying" the option.

An American Hedge Fund is considering a one-year investment in an Italian government

bond with a one-year maturity and a euro-denominated rate of return of i€ = 5%. The bond
costs €1,000 today and will return €1,050 at the end of one year without risk. The current
exchange rate is €1.00 = $1.50. U.S. dollar-denominated government bonds currently have a
yield to maturity of 4%. Suppose that the European Central Bank is considering either
tightening or loosening its monetary policy. It is widely believed that in one year there are
only two possibilities:

year.
88. Find the ex post IRR in euro for the American firm if they buy the bond today and then the
exchange rate falls to S1($|€) = $1.40 per €.

18-29
89. Find the ex post IRR in euro for the American firm if they buy the bond today and then
the exchange rate rises to S1($|€) = $1.80 per €.

90. Find the IRR in dollars for the American firm if they wait one year to buy the bond after
the exchange rate rises to S1($|€) = $1.80 per €. Assume that i€ doesn't change.

91. Find the NPV in dollars for the American firm if they wait one year to buy the bond after

the exchange rate falls to S1($|€) = $1.40 per €. Assume that i€ doesn't change.

18-30
93. Find the NPV in euro for the American firm if they wait one year to undertake the project
after the exchange rate falls to S1($|€) = $1.40 per €. Assume that i€ doesn't change.

94. The hedge fund manager notices the optionality in starting this project today. He asks you

95. Your banker quotes the euro-zone risk-free rate at i€ = 5% and the U.S. risk free rate at i$ =
4%. Find the value of the option and thereby the correct value of the bond to a U.S. investor.

96. Using your results to the last question, make a recommendation vis-à-vis when to buy the
bond.

18-31
97. Using the notion of hedging, make a recommendation vis-à-vis how to undertake the

The Strik-it-Rich Gold Mining Company is contemplating expanding its operations. To do so

it will need to purchase land that its geologists believe is rich in gold. Strik-it-Rich's
management believes that the expansion will allow it to mine and sell an additional 2,000 troy
ounces of gold per year. The expansion, including the cost of the land, will cost $500,000.
The current price of gold bullion is $425 per ounce and one-year gold futures are trading at
$450.50 = $425(1.06). Extraction costs are $375 per ounce. The firm's cost of capital is 10
percent.
Strik-it-Rich's management is, however, concerned with the possibility that large sales of gold
reserves by Russia and the United Kingdom will drive the price of gold down to $390 for the
foreseeable future. On the other hand, management believes there is some possibility that the
world will soon return to a gold reserve international monetary system. In the latter event, the
price of gold would increase to at least $460 per ounce. The course of the future price of gold
bullion should become clear within a year. Strik-it-Rich can postpone the expansion for a year
by buying a purchase option on the land for $25,000.
98. Compute the NPV at the current price of gold. Hint: think of the gold mine as a
perpetuity.

18-32
99. Compute the NPV at the two possible prices of gold.

100. Estimate the value of the option on the land to the management of the mine.

101. What should Strik-it-Rich's management do?

18-33
Chapter 18 International Capital Budgeting Answer Key

Multiple Choice Questions

1. The financial manager's responsibility involves

A. increasing the per share price of the company's stock at any cost and by any means, ways
and fashion that is possible.
B. the shareholder wealth maximization.
C. which capital projects to select.
D. both b) and c)
2. Perhaps the most important decisions that confront the financial manager are
A. which capital projects to select.
B. the correct capital structure for the firm.
C. the correct capital structure for projects.
3. Capital budgeting analysis is very important, because it

A. involves, usually expensive, investments in capital assets.
B. has to do with the productive capacity of a firm.
C. will determine how competitive and profitable a firm will be.
D. all of the above
18-34
Tiger Towers, Inc. is considering an expansion of their existing business, student apartments.
The new project will be built on some vacant land that the firm has just contracted to buy. The
land cost $1,000,000 and the payment is due today. Construction of a 20-unit office building
will cost $3 million; this expense will be depreciated straight-line over 30 years to zero
salvage value; the pretax value of the land and building in year 30 will be $18,000,000. The
$3,000,000 construction cost is to be paid today. The project will not change the risk level of
the firm. The firm will lease 20 offices suites at $20,000 per suite per year; payment is due at
the start of the year; occupancy will begin in one year. Variable cost is $3,500 per suite. Fixed
costs, excluding depreciation, are $75,000 per year. The project will require a $10,000
investment in net working capital.

A. -$3,660,000
B. -$5,100,000
C. -$4,000,000
D. -$4,010,000
Topic: Review of Domestic Capital Budgeting

A. -$4,610
B. $102,300
C. $202,300
D. $255,000

18-35
A. $12,432,300
B. $12,225,390
C. $12,332,300
D. $12,485,000

Assume that the firm will partially finance the project with a $3,000,000 interest-only 30-
year loan at 10.0 percent APR with annual payments.
A. -$1,010,000
B. -$1,000,000
C. -$660,000
D. -$2,100,000
Topic: The Adjusted Present Value Model

A. $4,300
B. -$202,610
C. -$95,700
D. $57,000

18-36
A. $9,027,390
B. $9,234,300
C. $9,134,300
D. $9,287,000

10. Assume that the firm will partially finance the project with a subsidized $3,000,000
interest only 30-year loan at 8.0 percent APR with annual payments. Note that eight percent is
less than the 10 percent that they normally borrow at. What is the NPV of the loan?
A. $198,469
B. $53,979.83
C. $102,727.55
D. $1,334,851.09

premium is 9%. What is the firm's cost of equity capital?
A. 33.33%
B. 10.85%
C. 13.12%
D. 16.5%

18-37
premium is 9%. What is the required return on assets?
A. 33.33%
B. 10.85%
C. 13.12%
D. 16.5%

will contribute $20,000 cash and borrow $80,000 at 6% with an interest-only loan with a
maturity of 5 years and annual interest payments. The equipment will be depreciated straight-
line to zero over the 5-year life of the project. There will be a pre-tax salvage value of $5,000.
There are no other start-up costs at year 0. During years 1 through 5, the firm will sell 25,000
units of product at $5; variable costs are $3; there are no fixed costs.

A. $49,613.03
B. $58,028.68
C. $102,727.55
D. $315,666.16

18-38
14. What is the NPV of the project using the APV methodology?

A. $49,613.03
B. $198,469
C. $102,727.55
D. $149,580.12

will contribute $25,000 cash and borrow $75,000 with an interest-only loan with a maturity of
5 years and annual interest payments. The equipment will be depreciated straight-line to zero
over the 5-year life of the project. There will be a pre-tax salvage value of $5,000. There are
no other start-up costs at year 0. During years 1 through 5, the firm will sell 25,000 units of
product at $5; variable costs are $3; there are no fixed costs.

A. $58,028.68
B. $49,613.03
C. $48,300.47
D. $102,727.55
Using the cash flow menu of a financial calculator: CF0 = -$100,000; C01 = $39,800; F01 =
4; C02 = $43,100; I = rWACC = 11.20; NPV = $48,300.47

18-39
16. When using the APV methodology, what is the NPV of the depreciation tax shield?
A. $32,051.52
B. $25,777.35
C. $22,794.65
D. $97,152.98

17. When using the APV methodology, what is the NPV of the interest tax shield?
A. $9,666.51
B. $12,019.32
C. $9,377.31
D. $7,000.73

existing debt is 8%. What is the APV of this subsidized loan? If you rounded in your
intermediate steps, the answer may be slightly different from what you got. Choose the
closest.
A. -$3,497,224.43
B. $417,201.05
C. $840,797

18-40
(amortizing) payments over 3 years. The first payment is due December 31, 2009 and your
taxes are due January 1 of each year on the previous year's income. The yield to maturity on
your firm's existing debt is 8%. What is the APV of this subsidized loan?
Note that I did not round my intermediate steps. If you did, your answer may be off by a bit.
Select the answer closest to yours.
A. -$3,497,224.43
B. $417,201.05
C. $840,797

20. The required return on assets is 18%. The firm can borrow at 12.5%; firm's target debt to
value ratio is 3/5. The corporate tax rate is 34%, and the risk-free rate is 4% and the market
risk premium is 9.2 percent. What is the weighted average cost of capital?
A. 12.15%
B. 13.02%
C. 14.33%
D. 23.45%

21. Your firm is in the 34% tax bracket. The yield to maturity on your existing bonds is 8%.
The state of Georgia offers to loan your firm $1,000,000 with a TWO year AMORTIZING
loan at a 5% rate of interest and ANNUAL payments due at the END OF THE YEAR.
The interest will be deductible at the time that you pay. What is the APV of this below-market
loan to your firm? I did not round any of my intermediate steps. You might be a little bit off.
Pick the answer closest to yours.
A. $64,157.38
B. $417,201.05
C. $840,797

18-41
premium is 9%.Calculate the weighted average cost of capital.
A. 33.33%
B. 8.09%
C. 9.02%
D. 16.5%

A. -$1,406,301.25
B. $12,494,643.75
C. $36,580,767.55
D. $108,994.618.20
E. $59,459,301.03

18-42
A. $185,796,000
B. $215,152,000
C. $267,952,000
D. $284,848,000
The firm will partially finance the project with an 8% interest-only 4-year loan.

A. $281,704,000
B. $465,152,000
C. -$194,848,000
D. $460,796,000

A. -$1,540,000
B. $446,570,866.00
C. $36,580,767.55
D. $470,953,393.70
E. $30,716,236.13

18-43
A. -$46,502,288.10
B. $12,494,643.75
C. $36,580,767.55
D. -$67,163,445.12
E. $59,459,301.03

A. $239,072,652.70
B. $66,891,713.66
C. $59,459,301.03
D. $660,000,000

18-44
A. -$1,406,301.25
B. $12,494,643.75
C. $36,580,767.55
D. $108,994.618.20
E. $59,459,301.03

A. $185,796,000
B. $215,152,000
C. $267,952,000
D. $284,848,000

A. -$281,704,000
B. $465,152,000
C. -$194,848,000
D. $460,796,000

18-45
A. -$1,540,000
B. $446,570,866.00
C. $36,580,767.55
D. $470,953,393.70
E. $30,716,236.13

A. -$46,502,288.10
B. $12,494,643.75
C. $36,580,767.55
D. -$67,163,445.12
E. $59,459,301.03

A. $239,072,652.70
B. $66,891,713.66
C. $59,459,301.03
D. $660,000,000

18-46
35. In the APV model

A. interest tax shields are discounted at i.
B. operating cash flows are discounted at Ku.
C. depreciation tax shields are discounted at i.
D. all of the above

36. Your firm's existing bonds trade with a yield to maturity of eight percent. The state of
Missouri has offered to loan your firm $10,000,000 at zero percent for five years. Repayment
will be of the form of $2,000,000 per year for five years, the first payment is due in one year.
What is the value of this offer?
A. $4,729,622.75
B. $2,014,579.93
C. $0
D. $196,929.88

37. What proportion of the firm is financed by debt for a firm that expects a 15% return on
equity, a 12% return on assets, and a 10% return on debt? The tax rate is 25%.
A. 20%
B. 1/3
C. 60%
D. 2/3
E. 80%

18-47
38. The required return on equity for a levered firm is 10.60%. The debt to equity ratio is ½
the tax rate is 40%, the pre-tax cost of debt is 8%. Find the cost of capital if this firm were
financed entirely with equity.
A. 10%
B. 12%
C. 8.67%

39. The required return on equity for an all-equity firm is 10.0%. They are considering a
debt is 8%. Find the new cost of capital if this firm changes capital structure.
A. 14.93%
B. 8.67%
C. 7.40%

40. The required return on equity for an all-equity firm is 10.0%. They currently have a beta
of one and the risk-free rate is 5% and the market risk premium is 5%. They are considering a
debt is 8%. Find the beta if this firm changes capital structure.
A. 1.12
B. 1
C. 7.4%

18-48
41. What is the expected return on equity for a tax-free firm with a 15% expected return on
assets that pays 12% on its debt, which totals 25% of assets?
A. 24%
B. 15.60%
C. 16%
D. 20%
E. 15.75%

42. What is the expected return on equity for firm in the 40% tax bracket with a 15% expected
return on assets that pays 12% on its debt, which totals 25% of assets?
A. 24%
B. 15.60%
C. 16%
D. 20%
E. 15.75%

43. Assume that XYZ Corporation is a leveraged company with the following information:

Calculate the debt-to-total-market-value ratio that would result in XYZ having a weighted
average cost of capital of 9.3%.
A. 35%
B. 40%
C. 45%
D. 50%

18-49
existing debt is 8%. What is the APV of this subsidized loan? Note that I did not round my
intermediate steps. If you did, your answer may be off by a bit. Select the answer closest to
yours.
A. $406,023.10
B. $840,797
C. $64,157.38
D. $20,659.77
E. None of the other answers are within $100 of my answer

45. An Italian firm is considering selling its line of coin-operated cappuccino machines in the
U.K. The business risk will be identical to the firm's existing line of business in the euro zone,
the cost of capital in the euro zone is i€ = 10%. The expected inflation rate over the next two
years in the U.K. is 3% per year and 2% per year in the euro zone. The spot exchange rates
are $1.80 = £1.00 and $1.15 = €1.00.
The pound sterling denominated cash flows are as follows:

What is the €-denominated NPV of this project? I did not round my intermediate steps, if you
did, select the answer closest to yours.
A. €5,563.23
B. €2,270.79
C. €7,223.14
D. €3,554.29
E. There is not enough information (e.g. U.S. inflation) to do this problem.
Topic: Capital Budgeting from the Parent Firm's Perspective

18-50
46. The spot exchange rate is ¥125 = $1. The U.S. discount rate is 10%; inflation over the
next three years is 3% per year in the U.S. and 2% per year in Japan. Calculate the dollar NPV
of this project.

I did not round my intermediate steps, if you did, select the answer closest to yours.
A. $267,181.87
B. $14,176.67
C. $2,536.49
D. $2,137.46

Some of the factors (with selected explanations) used in calculating the basic "net present
value" and the "incremental" cash flows of a capital project are:
(i)- expected after-tax terminal value, including recapture of working capital

(ii)- net income, which belongs to the equity holders of the firm
(iii)- initial investment at inception
(iv)- depreciation, and the fact that depreciation is a noncash expense (i.e. it is removed from
the calculation of net income, for tax purposes, but added back because it did not actually
flow out of the firm)
(v)- weighted-average cost of capital
(vi)- the firm's after-tax payment of interest to debtholders
(vii)- economic life of the capital project in years
18-51
47. The "net present value" of a capital project is calculated by using:


48. The "incremental" cash flows of a capital project is calculated by using:


49. In the context of the capital budgeting analysis of an MNC that has strong foreign
competitors, "lost sales" refers to
A. the cannibalization of existing projects by new projects.
B. the entire sales revenue of a new foreign manufacturing facility representing the
incremental sales revenue of the new project.
C. both a) and b)

50. Which of the following statements is false about "borrowing capacity"?

A. It is an especially important point in international capital budgeting analysis because of the
frequency of large concessionary loans.
B. It creates tax shields for APV analysis regardless of how the project is actually financed.
C. It synonymous to the "project debt".
D. It based on the firm's optimal capital structure.

18-52
51. The adjusted present value (APV) model that is suitable for an MNC is the basic net
present value (NPV) model expanded to
A. distinguish between the market value of a levered firm and the market value of an
unlevered firm.
B. discern the blocking of certain cash flows by the host country from being legally remitted
to the parent.
C. consider foreign currency fluctuations or extra taxes imposed by the host country on
foreign exchange remittances.
D. all of the above

52. Sensitivity analysis in the calculation of the adjusted present value (APV) allows the
financial manager to
A. analyze all of the risks (business, economic, exchange rate uncertainty, political, etc.)
inherent in the investment.
B. more fully understand the implications of planned capital expenditures.
C. consider in advance actions that can be taken should an investment not develop as
anticipated.
D. all of the above

53. The ABC Company, a U.S.-based MNC, plans to establish a subsidiary in Spain to

manufacture and sell water pumps. ABC has total assets of $80 million, of which $60 million
is equity financed. The remainder is financed with debt. ABC considers its current capital
structure optimal. The construction cost of the facility in Spain is estimated to be €8,500
million, of which €6,500 million is to be financed at a below-market rate of interest arranged
by the Spanish government. The proposed project will increase the borrowing capacity by
A. €1,215 million.
B. €2,215 million.
C. €3,215 million.
D. €4,215 million.

18-53
54. Given the following information for a levered and unlevered firm, calculate the difference
in the cash flow available to investors. Assume the corporate tax rate is 40%.
(Hint: Calculate the tax savings arising form the tax deductibility of interest payments).

A. $8
B. $18
C. $78
D. $90

A. €1.00 = $1.2379
B. €1.00 = $1.2139
C. €1.00 = $0.9903
D. $1.00 = €1.2623
Topic: Estimating the Future Expected Exchange Rate

A. €1.00 = $1.5147
B. €1.00 = $1.4854
C. €1.00 = $0.6602
D. $1.00 = €0.6602

18-54
prevail for the next three years in the U.S. is 2% and 3% in the euro zone. What spot
exchange rate should prevail three years from now?
A. €1.00 = $1.2379
B. €1.00 = $1.2139
C. €1.00 = $0.9903
D. $1.00 = €1.2623

Short Answer Questions

Your firm is based in southern Ireland (and thereby operates in euro, not pounds) and is
considering an investment in the United States.
The project involves selling widgets: you project a sales volume of 50,000 widgets per year,
sales price of $20 per widget with a contribution margin of $15 per widget.
The project will last for 5 years, require an investment of $1,000,000 at time zero (which will
be depreciated straight-line to $10,000 over the 5 years). Salvage value for the equipment is
projected to be $10,000. The project will operate in rented quarters: $300,000 rent is due at
the start of each year.
The corporate tax rate is 12½% in Ireland and 40% in the U.S.
For simplicity, assume that taxes are paid like sales taxes: immediately.
The spot exchange rate is $1.50 = €1.00. The cost of capital to the Irish firm for a domestic
project of this risk is 8%. The U.S. risk-free rate is 3%; the Irish risk-free rate is 2%.

18-55


18-56

61. What is the NPV of the U.S.-based project to the Irish firm?


62. What is the dollar-denominated IRR?


18-57
63. What is the euro-denominated IRR?

18-58
64. Find the break-even price (in dollars) and break-even quantity for the U.S. project.

18-59
65. Repeat the above project analysis assuming that the Irish firm could replicate the project
in Ireland. (i.e. cash flow out the project in Ireland and find break-even price (in €), quantity,
NPV, IRR (in euro not dollars).

18-60
up:

18-61

18-62
Please note that your answer is worth ZERO POINTS if it does not contain currency
symbols.

18-63


18-64
up:

18-65

18-66
Your answer is worth ZERO POINTS if it does not contain currency symbols such as $, £, €,
¥!

18-67


18-68
Consider the following international investment opportunity:

18-69

18-70

18-71


18-72
A French firm is considering a one-year investment in the United Kingdom with a pound-
denominated rate of return of i£ = 15%. The firm's local cost of capital is i€ = 10%
The project costs £1,000 and will return £1,150 at the end of one year.
The current exchange rate is €2.00 = £1.00
Suppose that the bank of England is considering either tightening or loosening its monetary
policy. It is widely believed that in one year there are only two possibilities:

year.
then the exchange rate falls to S1(€|£) = €1.80 per £.


18-73
then the exchange rate rises to S1(€|£) = €2.20 per £.




18-74




18-75


18-76
84. The CFO who has a CFA notices the optionality in starting this project today. He asks you

18-77


85. Your banker quotes the euro-zone risk-free rate at i€ = 6% and the British risk free rate at
i£ = 6%. Find the value of the option and thereby the project.

18-78
86. Using your results to the last question, make a recommendation vis-à-vis when to
undertake the project.

18-79
87. Using the notion of a hedge ratio, make a recommendation vis-à-vis how to undertake the
Feedback:

18-80
An American Hedge Fund is considering a one-year investment in an Italian government

bond with a one-year maturity and a euro-denominated rate of return of i€ = 5%. The bond
costs €1,000 today and will return €1,050 at the end of one year without risk. The current
exchange rate is €1.00 = $1.50. U.S. dollar-denominated government bonds currently have a
yield to maturity of 4%. Suppose that the European Central Bank is considering either
tightening or loosening its monetary policy. It is widely believed that in one year there are
only two possibilities:

year.
88. Find the ex post IRR in euro for the American firm if they buy the bond today and then the
exchange rate falls to S1($|€) = $1.40 per €.

18-81
89. Find the ex post IRR in euro for the American firm if they buy the bond today and then
the exchange rate rises to S1($|€) = $1.80 per €.




18-82
91. Find the NPV in dollars for the American firm if they wait one year to buy the bond after


the exchange rate falls to S1($|€) = $1.40 per €. Assume that i€ doesn't change.


18-83
93. Find the NPV in euro for the American firm if they wait one year to undertake the project
after the exchange rate falls to S1($|€) = $1.40 per €. Assume that i€ doesn't change.


18-84
94. The hedge fund manager notices the optionality in starting this project today. He asks you

18-85


95. Your banker quotes the euro-zone risk-free rate at i€ = 5% and the U.S. risk free rate at i$ =
4%. Find the value of the option and thereby the correct value of the bond to a U.S. investor.

18-86
96. Using your results to the last question, make a recommendation vis-à-vis when to buy the
bond.

18-87
97. Using the notion of hedging, make a recommendation vis-à-vis how to undertake the

18-88
The Strik-it-Rich Gold Mining Company is contemplating expanding its operations. To do so

it will need to purchase land that its geologists believe is rich in gold. Strik-it-Rich's
management believes that the expansion will allow it to mine and sell an additional 2,000 troy
ounces of gold per year. The expansion, including the cost of the land, will cost $500,000.
The current price of gold bullion is $425 per ounce and one-year gold futures are trading at
$450.50 = $425(1.06). Extraction costs are $375 per ounce. The firm's cost of capital is 10
percent.
Strik-it-Rich's management is, however, concerned with the possibility that large sales of gold
reserves by Russia and the United Kingdom will drive the price of gold down to $390 for the
foreseeable future. On the other hand, management believes there is some possibility that the
world will soon return to a gold reserve international monetary system. In the latter event, the
price of gold would increase to at least $460 per ounce. The course of the future price of gold
bullion should become clear within a year. Strik-it-Rich can postpone the expansion for a year
by buying a purchase option on the land for $25,000.
98. Compute the NPV at the current price of gold. Hint: think of the gold mine as a
perpetuity.

18-89
99. Compute the NPV at the two possible prices of gold.

100. Estimate the value of the option on the land to the management of the mine.

18-90
101. What should Strik-it-Rich's management do?

18-91

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Chapter 18 - International Capital Budgeting

Multiple Choice Questions

1. The financial manager's responsibility involves

3. Capital budgeting analysis is very important, because it

Consider a project with the following data:

13. What is the NPV of the project using the WACC methodology?

14. What is the NPV of the project using the APV methodology?

Consider a project with the following data:

15. What is the NPV of the project using the WACC methodology?

35. In the APV model

(i)- expected after-tax terminal value, including recapture of working capital

47. The "net present value" of a capital project is calculated by using:

48. The "incremental" cash flows of a capital project is calculated by using:

50. Which of the following statements is false about "borrowing capacity"?

53. The ABC Company, a U.S.-based MNC, plans to establish a subsidiary in Spain to

Short Answer Questions

58. What is CF0 in dollars?

59. What is CF1 in dollars?

60. What is CF5 in dollars?

61. What is the NPV of the U.S.-based project to the Irish firm?

62. What is the dollar-denominated IRR?

63. What is the euro-denominated IRR?

68. What is the dollar-denominated IRR of this project?

69. What is the euro-denominated IRR of this project?

72. What is the dollar-denominated IRR of this project?

73. What is the euro-denominated IRR of this project?

Consider the following international investment opportunity:

76. What is the dollar-denominated IRR of this project?

77. What is the euro-denominated IRR of this project?

An American Hedge Fund is considering a one-year investment in an Italian government

The Strik-it-Rich Gold Mining Company is contemplating expanding its operations. To do so

99. Compute the NPV at the two possible prices of gold.

101. What should Strik-it-Rich's management do?

Chapter 18 International Capital Budgeting Answer Key

Multiple Choice Questions

1. The financial manager's responsibility involves

3. Capital budgeting analysis is very important, because it

Topic: Review of Domestic Capital Budgeting

Topic: Review of Domestic Capital Budgeting

Topic: Review of Domestic Capital Budgeting

Topic: The Adjusted Present Value Model

Topic: The Adjusted Present Value Model

Topic: The Adjusted Present Value Model

Topic: The Adjusted Present Value Model

Topic: The Adjusted Present Value Model

Topic: The Adjusted Present Value Model

Consider a project with the following data:

13. What is the NPV of the project using the WACC methodology?

Topic: The Adjusted Present Value Model

14. What is the NPV of the project using the APV methodology?

Topic: The Adjusted Present Value Model

Consider a project with the following data:

15. What is the NPV of the project using the WACC methodology?

Topic: The Adjusted Present Value Model

Topic: The Adjusted Present Value Model

Topic: The Adjusted Present Value Model

Topic: The Adjusted Present Value Model

Topic: The Adjusted Present Value Model

Topic: The Adjusted Present Value Model

Topic: The Adjusted Present Value Model

Topic: The Adjusted Present Value Model

Topic: The Adjusted Present Value Model