Foreign Currency

1 USD = INR 80 - 81
Reading this quote from the bank's perspective
Bank will buy USD at 80 Bank will sell USD at 81

Rate at which bank buys foreign currency is 'Bid Rate'

Rate at which bank sells foreign currency is 'Ask / Offer Rate'

Example

Asim has received 100000 USD from his customer. He wants INR
in exchange

Asim will go to the bank

Asim will give USD at get INR in exchange

USD
Can we say : Asim is selling USD and Bank is buying USD 1
100,000
Bank buys USD at 1 USD = 80
Asim gave 100000 USD, so he must have received how much ?

Asim will get USD 100000, which is the same as INR 80,00,000

Example

Shivam buys a PS 5 from USA and has to pay 3000 USD

Shivam does not have any USD in his wallet. So, he will go to the bank
and buy USD by giving INR in exchange USD
1
Shivam buys USD, that means bank sells USD 3,000

Bank sells USD at 1 USD = INR 81

So, Shivam will have to give 243000 to the bank and in return, he will get
3000 USD
INR
80
8,000,000

INR
81
243,000
Direct Quote

Direct quotation is where the cost of one unit of foreign currency is given in units of local currency,

1 USD = INR 72

Indirect Quote

Indirect quotation is where the cost of one unit of local currency is given in units of foreign currency.

INR 1 = USD 0.01388

f local currency,

reign currency.
Today, 1 Nachos costs INR 140

After 3 months, the same Nachos costs INR 150

To buy the same Nachos, after 3 months you need more of INR
This means that purchasing power of INR has gone down
INR has become weaker in comparison to the item i.e. nachos

Replace Nachos with GBP

Initially, you could buy 1 GBP for INR 140

Now, to buy the same 1 GBP, you need INR 150
1 GBP 140 INR
Which means purchasing power of INR has fallen. 1 GBP 150 INR
INR has become weaker and GBP has become stronger
Transaction Risk

Transaction risk is the risk of an exchange rate changing between the

transaction date and the subsequent settlement date, i.e. it is the gain or
loss arising on conversion.

Economic Risk

Economic risk is the variation in the value of the business (i.e. the present value
of future cash flows) due to unexpected changes in exchange rates. It is the
long-term version of transaction risk.

Translation Risk

Where the reported performance of an overseas subsidiary in home-based

currency terms is distorted in consolidated financial statements because of
a change in exchange rates.

More of an accounting risk, less of a cash flow based risk

Number of students 100 150 200 250
Fees per student (in USD) for overseas student 800 800 800 800
Total fees in USD 80,000 120,000 160,000 200,000
Exhange rate at the time of making projections 75 75 75 75
Total fees in INR 6,000,000 9,000,000 12,000,000 15,000,000
[ This was used to calculate NPV, value of business etc. ]

When the funds started coming in, rate had undergone a change

Exhange rate at the time of receipt 71 70 76 69

Total fees received in INR 5,680,000 8,400,000 12,160,000 13,800,000

Difference 320,000 600,000 -160,000 1,200,000

Purchasing Power Parity Theory (PPPT)

Law of one price

If 1 starbucks has the same ingredients, same size, same presentation, then the price/ value of 1 starbucks should be the same in 2 countries

1 starbucks (In India) INR 140 a = b and b = c, then a = c

1 starbucks (In USA) USD 2 1 StarBucks = INR 140 and 1 StarBucks = USD 2
INR 140 = USD 2
2 USD = 140 INR
1 USD = 70 INR

If inflation rate in India is 10% 1 Starbucks = 140 + 10% of 140 = 154

If inflation rate in USA is 7% 1 Starbucks = 2 + 7% of 2 = 2.14 2.14

1 StarBucks = INR 154 and 1 StarBucks = USD 2.14

USD INR
2.14 USD = 154 INR 2.14 154.00
1 USD = INR 71.96 1.00 71.96

The exchange rate will adjust itself in such a way that the price of 1 starbucks in the two countries will be comparable

We can use this understanding to estimate future spot rates

S1 = S0 * (1 + Hc)/ (1 + Hb)

S0 - Current spot rate

S1 - Future Spot rate
Hb - Rate of inflation in base currency
Hc - Rate of inflation in counter currency

When I write 1 USD = INR 70 1 GBP = 1.8 USD

What is written for 1 is the base currency GBP - Base Currency
And its converted number is counter currency USD - Counter Currency

** The country which has a higher inflation, the currency of that country will become weaker
Question

The dollar and sterling are currently trading at $1.72 = £1.

Inflation in the US is expected to grow at 3% pa, but at 4% pa in the UK.

Predict the future spot rate in a year’s time.

Solution

Current spot rate 1 GBP = USD 1.72

Currency Inflation
Base Currency GBP 4%
Counter currency USD 3%

Using PPPT

S1 = S0 * [ 1 + Hc ] / [ 1 + Hb ]
S1 = 1.72 * [ 1 + 3% ] / [ 1 + 4 % ] 1.70

Future spot rate : 1 GBP = USD 1.70

Interest Rate Parity Theory (IRPT)

The IRPT claims that the difference between the spot and the forward exchange rates
is equal to the differential between interest rates available in the two currencies.

This theory helps you to predict the rates in future, with the help of interest rates in two countries

F0 = S0 * (1 + Ic)/ (1 + Ib)

F0 - Forward Rate
S0 - Spot rate
Ic - Rate of interest for counter currency
Ib - Rate of interest for base currency

* If the period is less than 1 year, calculate proportionate interest rates

** If the period is more than 1 year, say 2 years, apply the formula twice, don't double the rates
Question

A treasurer can borrow in Swiss francs at a rate of 3% pa or in the UK at a rate of 7% pa.

The current rate of exchange is 10 SF = £1.

What is the forward rate of exchange for delivery in a year’s time?

Solution

Spot rate 1 GBP = 10 SF

Base currency GBP 7%

Counter currency SF 3%

F0 = S0 * (1 + Ic)/ (1 + Ib) 9.63

F0 - Forward Rate
S0 - Spot rate
Ic - Rate of interest for counter currency
Ib - Rate of interest for base currency

1 GBP = 9.63 SF
Question

A company is based in the US. The domestic short-term US$ interest rate is 3% per year.
The equivalent rate in Euros is 6% per year. The current exchange rate is 0.94 Euros = $1

Calculate the forward rate predicted by interest rate parity in (a) 6 months,
(b) 2 years assuming that interest rates stay constant over these periods.

Solution

Spot Rate $ 1 = € 0.94 Case ( a )

Base currency $ 3.00% per annum F0 = S0 * (1 + Ic)/ (1 + Ib)

Counter currency € 6.00% per annum

Case ( b )
F0 = S0 * (1 + Ic)/ (1 + Ib)
Apply it once, get the rate at the end of 1
F0 - Forward Rate
S0 - Spot rate F0 = S0 * (1 + Ic)/ (1 + Ib)
Ic - Rate of interest for counter currency
Ib - Rate of interest for base currency To the answer you got above, apply agai

F0 = S0 * (1 + Ic)/ (1 + Ib)
 (1 + Ic)/ (1 + Ib) 0.95

nce, get the rate at the end of 1st year

(1 + Ic)/ (1 + Ib) 0.9674

swer you got above, apply again and get the rate at end of 2nd year

(1 + Ic)/ (1 + Ib) 0.9956

Question

The current exchange is given as [ $ … to GBP 1 ] 1.7025 - 1.7075

Expected inflation rates

Year USA UK
1 5% 2%
2 3% 4%
3 4% 4%

Calculate expected spot rate for next three years

Solution

In such cases, where bid rate and ask rate both are given and you are expected to predict rates in the future
you should take average of the two and then calculate

1 GBP = $ 1.7025 - 1.7075 Take average of the two rates = [ 1.7025 ( + ) 1.7075 ] / 2 = 1.7050 = S0

Bid Ask Base currency GBP

Counter Currency USD

For year 1

S1 = S0 * [ 1 + Hc ] / [ 1 + Hb ] 1.7551

For year 2

S1 = S0 * [ 1 + Hc ] / [ 1 + Hb ] 1.7383

For year 3

S1 = S0 * [ 1 + Hc ] / [ 1 + Hb ] 1.7383
redict rates in the future

+ ) 1.7075 ] / 2 = 1.7050 = S0
Question

The current exchange is given as € 1.5325 to GBP 1

Expected inflation rates

Year Europe UK
1 3% 1%
2 1% 4%
3 2% 3%

Calculate expected spot rate for next three years

Solution

1 GBP = € 1.5325

Base currency GBP

Counter Currency €

S1 = S0 * [ 1 + Hc ] / [ 1 + Hb ]

For year 1

S1 = S0 * [ 1 + Hc ] / [ 1 + Hb ] 1.5628

For year 2

S1 = S0 * [ 1 + Hc ] / [ 1 + Hb ] 1.5178

For year 3

S1 = S0 * [ 1 + Hc ] / [ 1 + Hb ] 1.5030
Question

Inflation is currently 80% in Brazil, although the government hopes to reduce it each year by 25%
of the previous year's rate.
What will the inflation rate be in Brazil over the next four years?

Solution

Inflation today 80%

Inflation after 1 year 60%

Inflation after 2 years 45%

Inflation after 3 years 34%

Inflation after 4 years 25%

ch year by 25%
Question

The current rate of inflation in Costovia is 65%. Government action is helping to reduce this rate each year by 10%
of the previous rate. The Costovian peso/ US dollar exchange rate is currently 144 pesos to 1 US dollar, and the
inflation rate in the US over the next three years is expected to be 4%, 3.5% and 3% respectively.

Required:
Calculate the exchange rate for the Costovian peso against the US dollar for the next three years.

Solution

Inflation in Costovia today 65%

Inflation after 1 year 58.50%

Inflation after 2 years 52.65%

Inflation after 3 years 47.39%

educe this rate each year by 10%
pesos to 1 US dollar, and the
% respectively.

xt three years.
Cross Rates

I want to visit Kazakhstan. The currency there is called KZT.

I want to buy KZT and I will have to give INR in exchange

But, because trade between these two countries is not frequent, there is no active market for KZT in India
and for INR in Kazakhstan

So, an exchange rate is not directly available

I need KZT urgently

Luckily, both currencies have a quote with $

1 $ = INR 80 and I $ = 120 KZT

a = b and a = c; that means b = c

INR KZT
80 INR = 120 KZT 80 120
1 1.5 [ 1.5 = 120 * 1 / 80 ]
1 INR = 1.5 KZT Cross multiplication

Question

A UK company has a Greek subsidiary which is to purchase materials costing $ 100000

The NPV of overseas cashflows is being calculated in euros. But, you have not been
provided with the Euro / Dollar exchange rate. Instead you have been given

1 GBP = 1.90 $ 1 GBP = 1.45 €

Approach I - Move stage by stage

Convert $ to GBP first

GBP $
1 1.9
52,632 100,000

52632 = 100000 * 1 / 1.90 [ Cross multiplication ]

Convert GBP to Euros

GBP €
1 1.45
52,632 76,316 Cross multiplication 76316 = 52632 * 1.45 / 1 ]
market for KZT in India

Approach I - Move stage by stage

Calculate cross rate

1 GBP = 1.90 $ 1 GBP = 1.45 €

a = b and a = c
So, b = c

1.90 $ = 1.45 €

$ €
1.9 1.45
100,000 76,316
Taxation

The level of taxation on a project's profits will depend on the relationship between the tax rates in the home and fore

There are three possible tax scenarios for an exam question.

The home country may have a tax rate that is:
- lower than
- the same as
- higher than the foreign country.

The question will always assume a double-tax treaty => project always taxed at the higher rate.

Example

Kushagra Ltd is a company incorporated in Bangalore, India

Kushagra Ltd sets up a branch office [ which is an extension of the company ] in Australia

In its branch office, the company earns 100000 worth of income

Since the branch office is a Permanent Establishment [ PE ] in Australia, the Australian government
will have a right to levy tax on the 100000 income earned there

But, Indian Government will also say that Kushagra Ltd is an indian company, so Indian government
also has a right to levy tax on any income earned by Kushagra Ltd, whether in India or abroad

Kushagra Ltd is getting taxed twice on the same income

To get rid of this problem of double taxation, what usually happens is that the two countries, Australia
and India in our case, enter into an agreement called as the 'Double Tax Avoidance Agreement' [ DTAA]
by which the income does not get taxed twice over

Situation I

Tax rate in Australia is 20%, Tax rate in India is 25%

Kushagra Ltd pays 20% tax on 100000, i.e. 20000 tax in Australia

In India, tax liability of Kushagra Ltd comes down to 25%, i.e. 25000
But, Kushagra Ktd has already paid 20000 tax in Australia
So, not required to pay tax again in India
Company has to pay only the difference of 5000

Situation II
Tax rate in Australia is 25%, tax rate in India is 20%

Kushagra Ltd pays 25% tax on 100000, i.e. 25000 tax in Australia

In India, tax liability of Kushagra Ltd comes down to 20%, i.e. 20000

So, Kushagra Ltd does not have to pay any tax in India

Basic Rule

Foreign tax rate > Domestic Tax rate Pay higher tax as per foreign rate in foreign country
No need to pay any additional tax in home country

Foreign tax rate < Domestic Tax rate Pay tax at lower rate in foreign country
Pay tax at differential rate in home country

** In the end, the company will end up paying tax at the higher rate
rates in the home and foreign country.

es, Australia
ment' [ DTAA]
 e in foreign country
ax in home country
Question

What will be the rate of tax on a project carried out in the US by a UK company in each of the following scenarios?

UK Tax US Tax
(a) 33% < 40%
(b) 33% = 33%
(c) 33% > 25%

Solution

Company is in the UK

Situation ( a ) Pay tax in the USA @ 40%

No tax payment required in UK

Situation ( b ) Pay tax in the USA @ 33%

No tax payment required in UK

Situation ( c ) Pay tax in the USA @ 25%

Pay tax in UK @ 8% [ differential rate ]
each of the following scenarios?
Inter company cash flows

Inter-company cash flows, such as transfer prices, royalties and management charges, can also affect the tax comput

Although complex in reality, in the exam:

- Assume inter-company cash flows are allowable for tax (and state it) unless the question says otherwise.

- If an inter-company cash flow is allowable for tax relief overseas, there wil be a corresponding tax liability on the
in the home country.

- Assume that the tax authorities will only allow 'arm's length'/open-market prices for tax relief and will not allow a
artificially high or low transfer price.
ges, can also affect the tax computations.

question says otherwise.

corresponding tax liability on the income

for tax relief and will not allow an

Transfer Pricing

The transfer price is the price charged by one part of a company when supplying goods or services to another part
of the company, e.g. overseas subsidiary.

Transfer prices are particularly problematical. By manipulating the transfer prices charged it may be possible to
minimise the global taxation cost for the group, i.e. to report low profits in countries with high taxes and high pro
in countries with low rates.

Example - Unrelated Parties

Platini is in UK Satyamedh is in India

Platini sells goods worth 100000 to Satyamedh

Because Platini and Satyamedh are not related to each other, there is no reason for anyone to assume that the
price is unduly influenced by the relation between the two, or by undue influence or by any other external reason
The 100000 that Platini has charged from Satyamedh has to be the Fair Market Value

So, when Platini records sale of 100000; tax authorities will not object and 100000 will be considered his income
When Satyamedh records expense of 100000; tax authorities will not object and 100000 will be considered his ex

Example - Related Parties

Platini is in UK Keagan is in India

They are siblings, i.e. related parties

Keagan has a very high taxable income, Platini is suffering from losses
Keagan wants to reduce his tax and Platini does not want to show a loss, otherwise investors will run away

So, what they do is, Platini makes a sale to Keagan

He sells some item, whose FMV is 100000
But, instead of selling for 100000, he sells it for 10,00,000

So, Platini is able to record an income and wipe of his losses

Keagan records an expense and thereby reduces his profits

Tax authorities, if they catch this, will ask both parties [ in their respective countries ] to make changes to
FS and tax returns

This 'Transfer Price' will be benchmarked against the FMV

ods or services to another part

harged it may be possible to

s with high taxes and high profits

anyone to assume that the

r by any other external reason

will be considered his income

0000 will be considered his expense

investors will run away

s ] to make changes to
Question

A project carried out by a US subsidiary of a UK company is due to earn revenues of $100m in the US
in Year 2 with associated costs of $30m.
Royalty payments of $10m will be made by the US subsidiary to the UK.
Assume tax is paid at 25% in the US and 33% in the UK; and assume a forecast $/£ spot rate of $1.50/£1.

Forecast cash flows for year 2

Solution

Parent Co is in UK Subsidiary Co

Forecast of cash flows for Year 2 - US Subsidiary

Particulars $ mn

Revenue 100
Less: Cost of the project -30
Less: Royalty payment expense -10

Pre-tax cashflows 60
Less: 25% tax -15

After tax cash flows [ remit to parent ] 45

When parent company receives 45 mn USD, it will have to be converted

to GBP at the rate prevailing at that time

Rate in year 2 is 1 GBP = 1.5 $

Particulars GBP mn
Amount received by Parent Co in UK 30.00
Add: Royalty income received 6.67

Total pre-tax cashflows in UK 36.67

Less: Tax in UK ** (5.40)

After tax cash flows in UK 31.27

nues of $100m in the US

ast $/£ spot rate of $1.50/£1.

is in USA

10 mn royalty paid by subsidiary is expense for subsidiary

But, the same is income for holding co

GBP $
1 1.5
30 45
6.67 10
40 60

Tax computation in UK

6.67 royalty income [ which was expense for US subsidiary ] did not
suffer tax in USA
So, full tax will have to be charged in UK at UK rates
6.67 * 33 % = 2.2

60 mn $ suffered tax in USA

So, UK govt would also want to tax the same 60 mn
60 mn USD is the same as 40 mn GBP [ 60 * 1 / 1.5 ]
This has already suffered tax in USA @ 25%
So, in UK, you will levy only the differential tax @ 8% [ 33% - 25% ]
40 mn * 8% = 3.2

Total tax = 2.2 ( + ) 3.2 = 5.4

Question

A UK company is appraising a new US project.

The forecast pre-tax US profit is as follows (Sm):

Year 0 1 2 3
3 4 6

In any one year, only 50% of profits generated can be remitted back to the parent. The blocked profits can be rele
back to the parent in the year after the end of the project.

The US tax rate is 15% and the UK tax rate is 25%. Assume that the exchange rate will be £1 = $1.30 for the fore

Required

Calculate additional UK tax payable for each year

Solution

Profit remittance working

Particulars Year 1 Year 2 Year 3

US Profit before tax 3,000,000 4,000,000 6,000,000
Less: US Tax @ 15% (450,000) (600,000) (900,000)

Profit after tax 2,550,000 3,400,000 5,100,000

Blocked funds [ 50% ] 1,275,000 1,700,000 2,550,000

Funds remitted to UK parent 1,275,000 1,700,000 2,550,000

[ amount in $ ]

Funds received in UK [ in GBP ] 980,769 1,307,692 1,961,538

Use the rate 1 GBP = 1.30 $
Less: Extra tax payable (115,385) (153,846) (230,769)
he blocked profits can be released

will be £1 = $1.30 for the foreseeable future.

Funds are blocked by the other country and will be released only
at the end of the project
So, in year 1, 2 and 3, the parent company in UK does not have a
right to collect the unremitted amount and hence, it cannot be
considered as 'income' of the parent company

Income of parent company is only the amount remitted

Year 1 Year 2 Year 3

PBT in US $ 3,000,000 4,000,000 6,000,000
Convert to GBP 2,307,692 3,076,923 4,615,385
[ use 1 GBP = 1.3 $]
Amount remitted 1,153,846 1,538,462 2,307,692
UK tax @ 10% 115,385 153,846 230,769
[ differential rate ]
Working Capital

It is normally assumed that the working capital requirement for the foreign project will increase by the annual rate
will increase by the annual rate of inflation in that country.
Question

Four million pesos are required in working capital immediately. The inflation rates in the South American country
are given as under

Year 1 2 3 4 5 6
6% 4% 5% 4% 3% 4%

Required

Identify working capital flows for the NPV calculation

Solution

Time Start of project Year 1 Year 2 Year 3

Working Capital requirement 4,000,000 4,240,000 4,409,600 4,630,080
Working capital flows (4,000,000) (240,000) (169,600) (220,480)
Timing of working capital flows T0 T1 T2 T3

Assuming that the project is wound up by end of year 6, the total amount of working capital in circulation will get
 South American country

Year 4 Year 5 Year 6

4,815,283 4,959,742 5,158,131
(185,203) (144,458) (198,390)
T4 T5 T6

ital in circulation will get released

Question

A manufacturing company based in the United Kingdom is evaluating an Investment project overseas - in REBM
a politically stable country. It will cost an initial 5.0 million REBMATT dollars (RM$) and it is expected to earn p
cash flows as follows:

Year 1 2 3 4
Cashflow RM$ '000 1,500 1,900 2,500 2,700

The following information is available:

Real interest rates in the two countries are the same. They are expected to remain the same for the period of the pr
The current spot rate is RM$ 2 per £1.
The risk-free rate of interest in REBMATT is 7% and in the UK 9%.
The company requires a UK return from this project of 16%.

Required:
Calculate the £ net present value of the project using the standard method i.e. by discounting annual cash flows

Solution

I cannot use the spot rate of 1 GBP = 2 RM$ for converting cash flows for each of the 4 years
Ideally, I must use the rate of exchange of each of these dates for conversion

For year 1

F0 = S0 * [ 1 + Ic ] / [ 1 + Ib ] 1.9633

For year 2

F0 = S0 * [ 1 + Ic ] / [ 1 + Ib ] 1.9273

For year 3

F0 = S0 * [ 1 + Ic ] / [ 1 + Ib ] 1.8919

For year 4

F0 = S0 * [ 1 + Ic ] / [ 1 + Ib ] 1.8572

Statement of Net Present Value [ NPV ]

Particulars T0 T1 T2 T3 T4
Post tax cash flow [ RM $ ] (5,000.00) 1,500.00 1,900.00 2,500.00 2,700.00
Exchange rate for conversion 2.0000 1.9633 1.9273 1.8919 1.8572

Post tax cash flow [ in GBP ] (2,500.00) 764.02 985.85 1,321.41 1,453.80
DF @ 16% 1.000 0.862 0.743 0.641 0.552
DCF in GBP (2,500.00) 658.64 732.64 846.57 802.92

Net Present Value 540.77

 ject overseas - in REBMATT
nd it is expected to earn post-tax

me for the period of the project.

ing annual cash flows

Base currency GBP 9%

Counter currency RM $ 7%

GBP RM $
1 2
2500 5000
Question

Wine Co is considering international expansion by taking over House Co, a manufacturing company based in a fo
(whose currency is the Foreign Dollar, FS).

According to the most recent accounts of House Co, its revenue and EBIT are F$356m and F$70m respectively. C
in the most recent year was F$33m and the depreciation charge was F$24m.

If Wine Co takes over House Co, it expects growth in revenue and profitability to be 3% per year, and capital exp
depreciation to stay constant. The tax rate in the foreign country is 30% per year.

The current exchange rate is F$2 = H$1 (HS is the home currency, the
Home Dollar), and this is expected to stay constant for the foreseeable future.

Required:
Estimate the free cash flow, in H $, for the first year after the takeover.

Solution

Calculation of free cash flow [ in F $ ]

Particulars Current Year 1

PBIT 70.00 72.10

Less: Tax @ 30% (21.00) (21.63)

Profit after tax 49.00 50.47

Add: Depreciation 24.00 24.00

Operating cash flow 73.00 74.47

Exchange rate is expected to
Capital expenditure (33.00) (33.00)
F$
Free cash flow 40.00 41.47 2
41.47
Free cash flow [ in H $ ] 20.74
ring company based in a foreign country

and F$70m respectively. Capital expenditure

% per year, and capital expenditure and

xchange rate is expected to remain the same

H$
1
20.74
 Standard format to be followed for international NPV
Particulars T0 T1 T2 T3 T4
In Foreign currency
a Initial Investment [ capex ]

b Sales / Receipts
c Less: Variable costs
d Contribution
e Less: Incremental fixed costs
f Less: Royalties / Management expenses
g Taxable cash flows [ d - e - f ]
h Foreign tax @ rate in foreign country
i Post tax cash flows

j Tax saving on depreciation **

k Working capital flows
l Scrap value
m Net foreign currency cash flows [ i+ j +/- k + l ]

n Exchange rate based on PPPT / IRPT

T0 T1 T2 T3 T4
o Home currency cash flows
p Adjust royalty / management fees
q Less: Domestic tax impact
[ On royalty / management fees, tax @
full rate in home country
Take Taxable cash flows from row 'g',
convert it to home currency and calculate
tax at differential rate ]

r Net home currency cash flows [ o + p - q ]

s DF @ _____
t DCF [ r * s ]
T5

T5