CH 14

INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 9TH ED.
CHAPTER 14
THE COST OF CAPITAL FOR FOREIGN INVESTMENTS
KEY POINTS
1. A project's cost of capital is a function of the riskiness of the project itself, not the risk of the firm undertaking
the project. Thus, if an investment's risk characteristics differ from those of the firm's average investment, it is
inappropriate to discount project cash flows at the firm's cost of equity capital.
2. Even if foreign investments are riskier than domestic investments that does not mean that those risks must lead
to a higher cost of capital for the former. The basic insight of the capital asset pricing model (CAPM) is that only
the systematic component of risk is priced; diversifiable risk must be borne at a zero price. The key question for the
MNC is whether systematic risk is measured in the context of a globally-diversified portfolio or only a
domestically-diversified portfolio.
There is strong evidence that much risk that is systematic from a domestic standpoint is unsystematic from a global
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stand-point. If risk is measured relative to a domestically-diversified portfolio, then foreign projects probably have
lower systematic risk than comparable domestic investments, and so should require lower returns. If risk is
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measured relative to a globally-diversified portfolio, foreign projects will likely still be less risky than domestic
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projects and require lower returns. But the gap between the required return on domestic and comparable foreign
investments should be less in the second case. The total risk of many foreign investments will probably exceed the
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total risk of their domestic counterparts. But because of the lower correlation between returns on domestic and
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foreign projects, foreign investing could still reduce the MNC's total risk.
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Hence, executives of multinational firms should seriously question the use of a risk premium to account for the
added political and economic risks of overseas operations, when evaluating prospective foreign investments. The
use of any risk premium ignores the fact that the risk of an overseas investment in the context of the firm's other
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investments, domestic as well as foreign, will be less than the project's total risk. How much less depends on how
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highly correlated are the outcomes of the firm's different investments. Some investments, however, are more
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risk-prone than are others, and these risks must be accounted for. This chapter shows how to adjust project discount
rates, using the CAPM, when those additional foreign risks are systematic in nature. Chapter 17 will show how to
conduct the necessary risk analysis for foreign investments when the foreign risks are unsystematic (through cash
flow adjustments).
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The chapter also explored the factors that are relevant in determining appropriate parent, affiliate, and worldwide
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capital structures--taking into account the unique attributes of being a multinational corporation. We saw that the
optimal global capital structure entails that mix of debt and equity for the parent entity and for all consolidated and
unconsolidated subsidiaries that maximizes shareholder wealth. At the same time, affiliate capital structures should
vary to take advantage of opportunities to minimize the MNC's cost of capital.
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SUGGESTED ANSWERS TO CHAPTER 14 QUESTIONS

1. What factors should be considered in deciding whether the cost of capital for a foreign affiliate should be
higher, lower, or the same as the cost of capital for a comparable domestic operation?
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ANSWER. Key factors include whether the cash flows of the affiliate are closely tied to the state of the local economy
or to the world economy, the correlation between the local and domestic economies, and the volatility of the foreign
affiliate's cash flows relative to that of the domestic operation. The greater (lesser) each of these factors, the higher
(lower) the foreign affiliate's cost of capital relative to that of the domestic operation. In general, the closer these
factors are to each other, the closer their costs of capital.
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CHAPTER 14: THE COST OF CAPITAL FOR FOREIGN INVESTMENTS
2. According to an article in Forbes, "American companies can and are raising capital in Japan at relatively low
rates of interest. Dow Chemical, for instance, has raised $500 million in yen. That cost the company over 50 percent
less than it would have at home." Comment on this statement.
ANSWER. Forbes is comparing apples with oranges. Borrowing in yen is not the same as borrowing in dollars. When
converting from yen into dollars Dow faces the possibility that the yen will appreciate, wiping out its apparent cost
savings. In fact, in less than one year after the article appeared, the yen had appreciated by over 35% relative to the
dollar, raising the dollar cost of repaying that $500 million yen borrowing to over $675 million.
3. In early 1990, major Tokyo Stock Exchange issues sell for an average 60 times earnings, more than four times
the 13.8 price-earnings ratio for the S&P 500. According to Business Week (February 12, 1990, p. 76), "Since p-e
ratios are a guide to a company's cost of equity capital, this valuation gap implies that raising new equity costs
Japanese companies less than 2 percent a year, vs. an average 7 percent for the U.S." Comment on this statement.
ANSWER. According to the dividend growth model,
ke = DIV1/P0 +g
where ke is the cost of equity capital, DIV 1/P0 is the projected dividend yield, and g is the expected dividend growth
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rate. The dividend yield equals the earnings yield (e/P) multiplied by the dividend payout rate. According to this
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formula, the e-P ratio is only an accurate guide to the cost of capital when earnings are expected to be stable.
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Conversely, the higher earnings (and, hence, dividend) growth is expected to be, the more downwards biased the e-P
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ratio will be as a measure of the cost of capital. The dividend growth model also tells us that the higher the earnings
growth rate, the higher the P-e ratio (and the lower the e-P ratio). Thus, one possible interpretation of the low e-P
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ratios for Japanese companies is that they reflect the expectation of high earnings growth rather than a low cost of
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equity capital. Of course, as we now know, these expectations have been dashed and the Japanese market has
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tumbled.
4. What are some of the advantages and disadvantages of having highly leveraged foreign subsidiaries?
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ANSWER. A more highly leveraged subsidiary may also be a more efficient firm because management is unable to
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turn to the parent for help.

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The disadvantages of high leverage include the following:
1. Local suppliers and customers may shy away from doing business with a new subsidiary operating on a
shoestring if that subsidiary is receiving minimal financial backing from its parent. Having a balance sheet with
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more equity demonstrates that the unit has greater staying power.
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2. The government might argue that the firm is overly leveraged and declare that certain debt payments are
constructive dividends and impose taxes on those payments.
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5. Compania Troquelados ARDA is a medium-sized Mexico City auto parts maker. It is trying to decide whether
to borrow dollars at 9 percent or Mexican pesos at 75 percent. What advice would you give it? What information
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would you need before you gave the advice?
ANSWER. To begin, it is necessary to recognize that 75% in pesos is not the same as 9% in dollars. In the absence of
government controls or access to subsidized financing, the expected before-tax cost of the two loans should be about
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the same. If there is some tax asymmetry (e.g., foreign exchange losses are not tax deductible), then the expected
after-tax costs of the two loans could diverge.
Regardless of the expected costs of the two loans, the risks for Compania Troquelados ARDA are quite different.
The dollar loan entails foreign exchange risk, while the peso loan entails inflation risk. A key question, therefore, is
how does the return on the firm's assets respond to inflation and changes in the dollar/peso exchange rate. The
answer to this question depends on where the company sells (domestic or abroad) and whether it faces import
competition on domestic sales. If the company is selling in the United States, the dollar loan will probably lower its
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exchange risk. If it is selling in Mexico without much import competition (because of trade barriers), then the
company's nominal operating profits will likely increase in line with inflation, making the peso loan the low-risk
loan. This assumes that the interest rate on the peso loan will adjust periodically. If the peso interest rate is fixed,
then the peso loan is the low-risk funding technique only if the firm's real operating profits move inversely with
Mexican inflation. Otherwise, the dollar loan is probably a lower-risk bet.
6. Boeing Commercial Airplane Co. manufactures all its planes in the United States and prices them in dollars,
even the 50 percent of its sales destined for overseas markets. What financing strategy would you recommend for
Boeing? What data do you need?
ANSWER. Boeing faces foreign exchange risk for two reasons: (1) It sells half its planes overseas and the demand for
these planes depends on the foreign exchange value of the dollar, and (2) Boeing faces stiff competition from Airbus
Industrie, a European consortium of companies that builds the Airbus. As the dollar appreciates, Boeing is likely to
lose both foreign and domestic sales to Airbus unless it cuts its dollar prices. One way to hedge this operating risk is
for Boeing to finance a portion of its assets in foreign currencies in proportion to its sales in those countries.
However, this tactic ignores the fact that Boeing is competing with Airbus. Absent a more detailed analysis, another
suggestion is for Boeing to finance at least half of its assets with ECU bonds as a hedge against depreciation of the
currencies of its European competitors. ECU bonds would also provide a hedge against appreciation of the dollar
against the yen and other Asian currencies since European and Asian currencies tend to move up and down together
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against the dollar (albeit imperfectly).
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7. United Airlines recently inaugurated service to Japan and now wants to finance the purchase of Boeing 747s to
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service that route. The CFO for United is attracted to yen financing because the interest rate on yen is 300 basis
points lower than the dollar interest rate. Although he doesn't expect this interest differential to be offset by yen
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appreciation over the ten-year life of the loan, he would like an independent opinion before issuing yen debt.
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a. What are the key questions you would ask in responding to UAL's CFO?
ANSWER. What's your business? Speculating on exchange rates or running an airline? Do you think you can
profitably outguess the financial markets? How do your operating cash flows respond to changes in the dollar/yen
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exchange rate?
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b. Can you think of any other reason for using yen debt?
ANSWER. Another reason for preferring yen financing could be to use this financing to hedge operating cash flows on
the Tokyo route against changes in the dollar/yen exchange rate.
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c. What would you advise him to do, given his likely responses to your questions and your answer to part b?
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ANSWER. The professed reason for preferring yen financing runs afoul of the international Fisher effect. Yen interest
rates are 300 basis points less than dollar interest rates because the market expects the dollar to depreciate by about
3% annually against the yen. This reason for borrowing yen is, therefore, a non-starter assuming that the CFO does
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not assert the ability to outguess financial markets.

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If United's dollar cash flow on its new route to Japan varies in line with the value of the dollar (that is, dollar cash
flow drops when the dollar appreciates against the yen and vice versa when the dollar depreciates against the yen),
then yen financing of its planes will reduce its exchange risk. Otherwise, dollar financing is the appropriate solution.
It is difficult to say exactly how United's cash flow will be affected by the exchange rate. A rising dollar will reduce
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tourism from Japan to the United States, but it might increase business travel involving purchases of less expensive
Japanese products. Conversely, a falling dollar will stimulate Japanese tourist travel to the United States, but could
hurt business travel between the two countries.
8. The CFO of Eastman Kodak is thinking of borrowing Japanese yen because of their low interest rate, currently
at 4.5 percent. The current interest rate on U.S. dollars is 9 percent. What is your advice to the CFO?
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ANSWER. My advice would be "Don't speculate." The international Fisher effect says that the 450 basis point
differential reflects a 4.5% expected annual appreciation of the yen against the dollar. Thus, the expected costs of
dollar and yen financing should be the same. Unless Kodak needs yen financing to offset a yen transaction or
operating exposure, it should stick to dollar financing.
9. Rohm & Haas, a Philadelphia-based specialty chemicals company, traditionally finances its Brazilian operations
from outside that country because it's "too expensive" to borrow local currency in Brazil. Brazilian interest rates
vary from 50 percent to over 100 percent. Rohm & Haas is now thinking of switching to cruzeiro financing because
of a pending cruzeiro devaluation. Assess Rohm & Haas's financing strategy.
ANSWER. One can't expect to gain from an expected currency change because interest rates already incorporate these
expectations. The real reason for using foreign currency financing (aside from the ability to use currency swaps to
access lower cost funds) is to offset exchange risk or political risk such as exchange controls. Because the odds are
that Rohm & Haas does face exchange risk and political risk in Brazil, it should probably use cruzeiro financing.
10. Nord Resource's Ramu River property in Papua New Guinea contains one of the world's largest deposits of
cobalt and chrome outside of the Soviet Union and South Africa. The cost of developing a mine on this property is
estimated to be around $150 million.
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a. Describe three major risks in undertaking this project.
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ANSWER. The three principal risks faced by Nord Resource's Ramu River project are the following:
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1. Political risk. The government of Papua New Guinea may seize the mine if it turns out to be highly
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profitable. The government may also block repatriation of profits.
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2. Reserve risk. There may be too few copper reserves or the ore may be too expensive to profitably mine.
3. Price risk. The price at which Nord can sell the ore may be too low.
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Exchange risk is unlikely to be a major risk. The price at which the copper can be sold is set in dollars. In addition,
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Nord's most important cost is the cost of developing the mine, which is largely set in dollar terms.
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b. How can Nord structure its financing so as to reduce these risks?
ANSWER. Nord can use financing to reduce these risks as follows:

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1. Political risk. The answer to this part is the same as that to question #13: Finance the project to the extent
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possible with funds from the host and other governments, international development agencies, overseas banks,
and from customers--with payment to be provided out of production--rather than supplying parent company-
raised or parent-guaranteed capital.
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2. Reserve risk. Use nonrecourse financing with a minimal amount of equity. In this way, the lenders bear the
risk of the mine being uneconomical.
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3. Price risk. Sell the ore in advance at a fixed price. Even if the price varies with the world market price, the
typical take-or-pay contract, Nord will have a guaranteed outlet for its ore and will not have to engage in price
cutting to sell more output.
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c. How can Nord use financing to add value to this project?
ANSWER. To the extent that Nord can access subsidized financing for the purchase of equipment and contractor
services to develop the mine, it should do so. In addition, Nord can add value to the project by using financing to
reduce the various operating risks it faces.
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ADDITIONAL CHAPTER 14 QUESTIONS AND ANSWERS

1. Comment on the following statement: "There is a curious contradiction in corporate finance theory: Since
equity is more expensive than debt, highly leveraged subsidiaries should be assigned a low hurdle rate. But when the
highly leveraged subsidiaries are in risky nations, country risk dictates just the opposite: a high hurdle rate."
ANSWER. Several points are relevant here. First, country risk is most likely to be an unsystematic source of risk and
hence should not affect the cost of capital for a project. The project will be penalized for higher unsystematic risk by
reducing the expected project cash flows below their most likely value. Second, as leverage rises, the cost of equity
capital rises as well, offsetting in whole or in part the advantage of debt. Thus, it is not clear that highly leveraged
subsidiaries should have a lower cost of capital. Third, it is not clear that subsidiaries have independent capital
structures, so it is difficult to talk about how their cost of capital varies with their leverage. Fourth, even if a highly
leverage sub has a lower cost of capital and country risk increases the appropriate cost of capital, there is no
contradiction: A highly leveraged sub in a risky nation would have a lower cost of capital than would a less highly
levered sub in that same nation.
2. Comment on the following statement: "Our conglomerate recognizes that foreign investments have a very low
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covariance with our domestic operations and, thus, are a good source of diversification. We do not `penalize'
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potential foreign investments with a high discount rate but, rather, use a discount rate just 3 percent above the
prevailing riskless rate."
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ANSWER. To repeat the answers to question 1, the cost of capital for a project depends on its systematic risk. This
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systematic risk must be measured relative to the market portfolio, not relative to the company's investment portfolio.
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Moreover, even if the foreign investment has a low covariance with the market portfolio, the selection of 3% is
arbitrary. However, this rule of thumb, which assigns a lower cost of capital to foreign projects, may be more
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appropriate than penalizing them with a higher cost of capital.
3. How has the Tax Reform Act of 1986 affected the capital structure choice for foreign subsidiaries?
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ANSWER. As noted in the chapter, the Tax Reform Act of 1986 has put many U.S.-based MNCs in a position of
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excess foreign tax credits. One approach to using up these FTCs is to push expenses overseas--and thus lower
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overseas profits--by increasing the leverage of foreign subsidiaries. Another is to shift toward leasing instead of
borrowing.
4. What financing problems might be associated with joint ventures?

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ANSWER. Unless the joint venture can be isolated from its partners' operations, there are likely to be some significant
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problems associated with this form of ownership. Transfer pricing on goods and services (including royalty and
licensing fees) and allocation of production and markets among plants are just some of the areas in which each
owner has an incentive to engage in activities that will harm its partners. These conflicts lead to increased operating
and monitoring expenses. In addition, where the MNC is substantially stronger financially than its partner, the MNC
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may wind up implicitly guaranteeing its weaker partner's share of any JV borrowings, as well as its own.
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5. Under what circumstances does it make sense for a company to not guarantee the debt of its foreign affiliates?
ANSWER. Here are some valid arguments against parent guarantees of foreign affiliate debt:
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• The protection against expropriation provided by an affiliate's borrowing may be lost if the parent
guarantees those debts.
• The U.S. IRS imputes income to the guarantor and levies a tax.
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• When a firm provides an affiliate with a loan guarantee, it may lose the bank as its partner in controls.
Since it will be repaid regardless of the subsidiary's profitability, the bank will have less incentive to
monitor the affiliate's activities.
6. How can financing strategy be used to reduce foreign exchange risk?
ANSWER. Firms can reduce their exposure to foreign exchange risk by financing assets that generate foreign currency
cash flows with liabilities denominated in those same foreign currencies.
7. How can financial strategy be used to reduce political risk?
ANSWER. Financing can be used to avoid or at least reduce the impact of certain political risks, like exchange
controls. Some financing mechanisms may actually change the risk itself, as in the case of expropriation or other
direct political acts.
Firms can sometimes reduce the risk of currency inconvertibility by investing parent funds as debt rather than
equity, arranging back-to-back and parallel loans, and using local financing to the maximum extent possible.
Multinational firms, especially those in the expropriation-prone extractive industries, can avoid political risk by
financing their foreign investments with funds from the host and other governments, international development
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agencies, overseas banks, and from customers--with payment to be provided out of production--rather than
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supplying parent company-raised or parent-guaranteed capital. Since repayment is tied to the project's success, the
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sponsoring firm(s) can create an international network of banks, government agencies, and customers with a vested
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interest in the faithful fulfillment of the host government's contract with the sponsoring firm(s). International leasing
is another financing technique that may help multinationals to reduce their political risk. This technique allows
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MNCs to limit the ownership of assets by subsidiaries in politically unstable countries and to more easily extract
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cash from affiliates located in countries where there are exchange controls.
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8. All-Nippon Airways, a Japanese airline, flies exclusively within Japan. It is looking to finance a recent purchase
of Boeing 737s. The director of finance for All-Nippon is attracted to dollar financing because he expects the yen to
keep appreciating against the dollar. What is your advice to him?
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ANSWER. Because All-Nippon Airways' yen cash flow will not vary in line with the dollar/yen exchange rate, using
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dollar financing will expose it to exchange risk. The implicit argument for using dollar financing is that yen
appreciation will make it cheaper to repay. But this argument ignores the international Fisher effect, which says that
a borrower should expect that any gain on loan repayment will be offset by the higher interest rate on a dollar loan.
The key question to ask here is: "What's your business? Is it speculating on the future course of the $/yen exchange
rate or is it providing aviation service at a reasonable price?"
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9. In order to develop large agricultural estates, the Republic of Coconutland offers the following financing deal:
If an investor agrees to purchase a plantation and put up half the cost in U.S. dollars, the government will make a
20-year, zero-interest loan of U.S. dollars to cover the other half.
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a. What risks does the scheme entail?

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ANSWER. The principal risk is that of expropriation. What will prevent the government from seizing the property
without compensation? Other risks include variations in agricultural prices, currency controls, increased taxes,
inflation risk, currency risk, and price controls.
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b. How can an investor use financing to reduce these risks?
ANSWER. First of all, the investor can take out political risk insurance to protect his portion of the investment against
political risks such as expropriation and currency controls. The risk of price controls is mitigated if the investor is
exporting the plantation's output, provided that the government does not force the investor to convert his currency
proceeds back into local currency at an artificially overvalued exchange rate. The real exchange risk that the investor
faces is that the local currency will become overvalued, raising the costs of local production without increasing the
price at which output can be exported. Another means of protecting against risks is to finance the purchase with
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loans from export-import banks (to the extent the investor must raise financing to buy goods and services overseas),
with payment to be made out of plantation earnings and no recourse to the investor.
SUGGESTED SOLUTIONS TO CHAPTER 14 PROBLEMS

1. A firm with a corporate-wide debt/equity ratio of 1:2, an after-tax cost of debt of 7 percent, and a cost of equity
capital of 15 percent is interested in pursuing a foreign project. The debt capacity of the project is the same as for the
company as a whole, but its systematic risk is such that the required return on equity is estimated to be about 12
percent. The after-tax cost of debt is expected to remain at 7 percent.
a. What is the project's weighted average cost of capital? How does it compare with the parent's WACC?
ANSWER. The weighted average cost of capital for the project is
kI = (1 - w) x ke' + w x id(1 - t)
where w is the ratio of debt to total assets, ke' is the required risk-adjusted return on project equity, and id(1 - t) is the
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after-tax cost of debt for the project. Substituting in the numbers provided yields
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kI = 2/3 x 12% + 1/3 x 7% = 10.33%
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b. If the project's equity beta is 1.21, what is its unlevered beta?
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ANSWER. The following approximation is usually used to unlever beta:
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Unlevered beta = levered beta/[1 + (1 - t)D/E]
where t is the firm's marginal tax rate and D/E is its debt/equity ratio. Without knowing the firm's marginal tax rate,
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we cannot unlever beta. Assuming that the marginal tax rate is about 40%, the unlevered beta is
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Unlevered beta = 1.21/[1 + (1 - .4)½] = .93

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2. Suppose that a foreign project has a beta of 0.85, the risk-free return is 12 percent, and the required return on the
market is estimated at 19 percent. What is the cost of capital for the project?
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ANSWER. The cost of capital for the project is

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k* = Rf + β*[E(Rm) - Rf]
where Rf is the risk-free required return, β* is the project beta, and E(Rm) is the expected return on the market.
Substituting in the numbers provided in the problem yields
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k* = .12 + .85(.19 - .12) = 17.95%
3. IBM is considering having its German affiliate issue a 10-year, $100 million bond denominated in euros and
priced to yield 7.5 percent. Alternatively, IBM’s German unit can issue a dollar-denominated bond of the same size
and maturity and carrying an interest rate of 6.7 percent..
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a. If the euro is forecast to depreciate by 1.7 percent annually, what is the expected dollar cost of the euro-
denominated bond? How does this compare to the cost of the dollar bond?
ANSWER. According to Chapter 14, the pre-tax dollar cost of borrowing in a foreign currency at an interest rate of
rL, where the currency is expected to appreciate (depreciate) against the dollar at an annual rate of c, is rL(1 + c) + c.
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Substituting the numbers in the problem to this formula yields an expected dollar cost of borrowing euros of 5.67%
[7.5% x (1 - 0.017) - 1.7%). This figure is substantially below the 6.7% cost of borrowing dollars.
b. At what rate of euro depreciation will the dollar cost of the euro-denominated bond equal the dollar cost of the
dollar-denominated bond?
ANSWER. The answer to this question is the solution to 7.5% x (1 + c) + c = 6.7%, or c = (6.7% - 7.5%)/1.075 =
-0.74%.
c. Suppose IBM’s German unit faces a 35 percent corporate tax rate. What is the expected after-tax dollar cost of
the euro-denominated bond?
ANSWER. According to Chapter 14, the effective after-tax dollar cost of borrowing a local currency at an interest rate
of rL, annual currency appreciation (depreciation) of c, and a corporate tax rate of ta, is r = rL(1 + c)(1 - ta) + c.
Substituting in the numbers from the question yields a solution of r = 7.5% x (1 - 0.017)(1 - 0.35) - 0.017 = 4.78%.
4. Suppose that the cost of borrowing restricted euros is 7 percent annually, whereas the market rate for these
funds is 12 percent. If a firm can borrow €10 million of restricted funds, how much will it save annually in before-
tax franc interest expense?
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ANSWER. The annual interest savings on €10 million of restricted funds at 7% when the market rate is 12% equals
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€10,000,000(0.12 - 0.07) or €500,000.
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5. Suppose that one of the inducements provided by Taiwan to woo Xidex into setting up a local production
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facility is a ten-year, $12.5 million loan at 8 percent interest. The principal is to be repaid at the end of the tenth
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year. The market interest rate on such a loan is about 15 percent. With a marginal tax rate of 40 percent, how
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much is this loan worth to Xidex?
ANSWER. By borrowing at 8% when the market rate is 15%, Xebec saves 8% annually. This translates into annual
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before-tax savings of $12,500,000(.15 - .08) = $875,000. With a marginal tax rate of 40%, this yields annual
after-tax savings of $525,000. The value of this ten-year annuity, discounted at Xebec's after-tax debt cost of 9%
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(15% x .6), is $525,000 x 6.4177 = $3,369,293.

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ADDITIONAL CHAPTER 14 PROBLEMS AND SOLUTIONS

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1. Although the one-year interest rate is 10% in the United States, one-year, yen-denominated corporate bonds in
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Japan yield only 5%.
a. Does this present a riskless opportunity to raise capital at low yen interest rates?
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ANSWER. No. According to the international Fisher effect, the 5% interest differential reflects the market's
expectations that the yen will appreciate by approximately 5% relative to the dollar over the coming year.
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b. Suppose the current exchange rate is ¥140 = $1. What is the lowest future exchange rate at which borrowing
yen would be no more expensive than borrowing U.S. dollars?
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ANSWER. The breakeven exchange rate is found as the solution to S = 140 x 1.05/1.10 = ¥133.64.
2. The manager of an English subsidiary of a U.S. firm is trying to decide whether to borrow, for one year, dollars
at 7.8% or pounds sterling at 12%. If the current value of the pound is $1.70, at what end-of-year exchange rate
would the firm be indifferent now between borrowing dollars and pounds?
ANSWER. The breakeven exchange rate change is
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c = (rus - rL)/(1 + rL) = (0.078 - 0.12)/1.12 = -3.75%
In other words, the pound would have to depreciate by 3.75% during the year for the two loans to have the same
dollar cost. A 3.75% pound depreciation would yield an end-of-year exchange rate equal to $1.63625 (1.70 x (1 -
0.0375)).
3. Suppose that Grand Metropolitan, a British multinational, is interested in issuing a 5-year zero-coupon bond
denominated in yen and with a ¥1.5 billion par value that is priced to yield 2.5% (a zero-coupon bond pays no
interest but is priced at a steep discount to par value such that the present value of the par value discounted at the
yield to maturity just equals the current selling price). If the current exchange rate is ¥150/£, at what future ¥/£
exchange rate will the pound cost of the yen zero just equal the cost of an equivalent pound-denominated zero-
coupon bond priced to yield 6.75%?
ANSWER. The present value of the 5-year yen zero-coupon bond (and, hence, the amount of yen actually borrowed) is
¥1,500,000,000/1.0255, or ¥1,325,781,431.42. At the current spot rate of ¥150/£, this figure translates into a current
pound value of £8,838,542.88 (1,325,781,431.42/150). If Grand Metropolitan issued a 5-year, pound-denominated
zero-coupon bond that provided this same amount of proceeds and was priced to yield 6.75%, it would have to pay
back £12,252,369.67 (£8,838,542.88 x 1.06755) in five years. Alternatively, it must repay ¥1,500,000,000 on the
zero-coupon yen issue. The breakeven ¥/£ exchange rate at the end of five years (the rate at which the yen cost of
m
repaying the pound zero-coupon bond just equals the yen cost of repaying the yen zero-coupon bond) is found as the
er as
solution e5 to 12,252,369.67e5 = ¥1,500,000,000, or e5 = ¥122.43.
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INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 9TH ED.

THE COST OF CAPITAL FOR FOREIGN INVESTMENTS

SUGGESTED ANSWERS TO CHAPTER 14 QUESTIONS

ANSWER. According to the dividend growth model,

turn to the parent for help.

The disadvantages of high leverage include the following:

would you need before you gave the advice?

not assert the ability to outguess financial markets.

b. How can Nord structure its financing so as to reduce these risks?

ANSWER. Nord can use financing to reduce these risks as follows:

c. How can Nord use financing to add value to this project?

ADDITIONAL CHAPTER 14 QUESTIONS AND ANSWERS

4. What financing problems might be associated with joint ventures?

6. How can financing strategy be used to reduce foreign exchange risk?

7. How can financial strategy be used to reduce political risk?

a. What risks does the scheme entail?

b. How can an investor use financing to reduce these risks?

SUGGESTED SOLUTIONS TO CHAPTER 14 PROBLEMS

ANSWER. The weighted average cost of capital for the project is

Unlevered beta = 1.21/[1 + (1 - .4)½] = .93

ANSWER. The cost of capital for the project is

k* = .12 + .85(.19 - .12) = 17.95%

(15% x .6), is $525,000 x 6.4177 = $3,369,293.

ADDITIONAL CHAPTER 14 PROBLEMS AND SOLUTIONS

Japan yield only 5%.

ANSWER. The breakeven exchange rate change is

c = (rus - rL)/(1 + rL) = (0.078 - 0.12)/1.12 = -3.75%

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