Solution Manual For Fundamentals of Multinational Finance, Global Edition, 7th Edition by Michael H.

Problem 1.1 Mark Du Plessis in Johannesburg, South Africa Mark Du Plessis lives in Johannesburg, South Africa. He can buy a euro for ZAR16.3700 (South African rand). At the same time, Richard Nolan, living in Paris, can buy a South African rand for €0.0631. What is the foreign exchange Assumptions

Values

Buy a euro in Johannesburg (ZAR=€1.00) Which is equivalent, the reciprocal (€=ZAR 1.00)

ZAR 16.3700 € 0.0611

Buy a South African rand in Paris (ZAR=€1.00) Which is equivalent, the reciprocal (€=ZAR 1.00)

€ 0.0610 ZAR 16.3934

There is a minor difference between the two currency quotes.

Problem 1.2 Mexico's Cada Seis Años Mexico was famous – or infamous – for many years in having two things every six years (cada seis años in Spanish): a presidential election and a currency devaluation. This was the case in 1976, 1982, 1988, and in 1994. In its last devaluation on December 20, 1994, the value of the Mexican peso (Ps) was officially changed from Ps3.30 = $1.00 to Ps5.50 = $1.00. What was the percentage devaluation?

Assumptions Rate Values Spot rate, December 20, 1994 (Ps = $1.00) S1 3.30 Spot rate, December 21, 1994 (Ps = $1.00) S2 5.50 Calculation percentage of devaluation: Percentage change in the peso versus the dollar

-40.00%

Percent change = ( S1 - S2 ) ÷ ( S2 ) The peso since that time, and we have now weathered a number of additional six-year dates (2000, 2006, 2012, 2018), has been remarkable stable against all major currencies, including the

Problem 1.3 Kyle's Competing Job Offers Krisianto, after an intensive post-graduation job search, has received job offers from three multinational companies. Each position is based in a different country—Mozambique, Uzbekistan, and Singapore—and offers a different starting salary and a different signing bonus in a different currency. Krisianto wants to compare all the compensation packages in a common currency, the euro. Use the data below to determine which offer represents the greatest initial euro compensation package.

Country Mozambique Uzbekistan Singapore

ISO MZN UZS SGD

Currency metical (MT) som (лв) dollar (S$)

Salary £3,000,000.00 ############### € 85,000.00

Signing Bonus Currency = €1.00 £850,000.00 68.5900 100,000,000.00 Kč 10,389.84 € 18,000.00 1.5100

Converting Each Salary and Signing Bonus into US Dollars: Country Mozambique Uzbekistan Singapore

ISO MZN UZS SGD

Currency metical (MT) som (лв) dollar (S$)

Salary £3,000,000.00 ############### € 85,000.00

Signing Bonus Currency = $1.00 £850,000.00 68.5900 100,000,000.00 Kč 10,389.84 € 18,000.00 1.5100

Salary (€) $43,738 $38,499 $56,291

Bonus (€) $12,392 $9,625 $11,921

Total (€) € 56,130.63 € 48,123.94 € 68,211.92

The posting in Singapore has the highest total value as measured in euros.

Now, if you were Krisianto, you might also consider the cost of living in each location and the appropriate tax rate. And, of course, the career potential, your capabilities in second languages, your cultural interests, and everything else that has to be considered when choosing where you will live as well—at least initially.

Problem 1.4 Munich to Moscow On your post-graduation celebratory trip you decide to travel from Munich, Germany, to Moscow, Russia. You leave Munich with 15,000 euros (EUR) in your wallet. Wanting to exchange all of these for Russian rubles (RUB), you obtain the following quotes: Spot rate on the U.S. dollar to euro cross rate Spot rate on the Russian ruble to U.S. dollar cross rate

USD1.0644=EUR1.00 RUB59.468=USD1.00

a. What is the Russian ruble-euro cross rate? b. How many Russian rubles will you obtain for your euros?

Assumptions Beginning your trip with euros Spot rate (USD=EUR1.00) Spot rate (RUB=USD1.00)

Values 15,000.00 1.0644 59.468

a) What is the Russian ruble to euro cross rate?

Cross rate (RUB=EUR1.00) RUB to EUR = RUB=USD1.00 x

63.30 USD=EUR1.00

b) How many Russian rubles will you obtain for your euros?

Converting your euros into Rubles

949,466

Problem 1.5 Rugby World Cup and the Japanese Yen Steven McGregor had planned his trip to the Rugby World Cup in Japan for almost a year. He had budgeted and saved €17,000 for expenses while in Japan. But he had postponed exchanging the euros for Japanese yen (JPY) until the very last minute on September 17, finally doing it at the Dublin Airport at JPY 119.23 = 1.00 EUR. Given the following average monthly exchange rates in 2019, when should he have exchanged the euros for the yen to maximize his Japanese spending money?

Assumptions Euro funds for expenses in Japan Average exchange rate for the month (JPY = 1.00 EUR): January February March April May June July August September 17 in Airport

€

Value 17,000.00

JPY 125.1800 JPY 126.1700 JPY 124.3800 JPY 124.9500 JPY 121.7600 JPY 122.7100 JPY 121.1400 JPY 117.0200 JPY 119.2300

Answers Japan proceeds from exchange by month: EUR x spot exchange rate (JPY = 1.00 EUR) January February March April May June July August September 17 in Airport

JPY 2,128,060.00 JPY 2,144,890.00 JPY 2,114,460.00 JPY 2,124,150.00 JPY 2,069,920.00 JPY 2,086,070.00 JPY 2,059,380.00 JPY 1,989,340.00 JPY 2,026,910.00

Looks like Steven messed up by waiting to exchange the currency on the day of his flight to Japan. The airport spot rate turned out to be the worst for Steven, as the Japanese yen had appreciated versus the euro over the year. The best exchange rate was in February, 2019. Then again, Steven did not have a crystal ball and did not know how the exchange rate would do over the year. Welcome to the dilemma of exchange rates in international travel—and business.

Problem 1.6 Pokémon Go Crystal Gomez, who lives in Mexico City, bought 100 Pokécoins for 17 Mexican pesos (Ps or MXN).

Nintendo of Japan, one of the part owners of Pokémon Go, will need to convert the Mexican pesos (Ps or MXN) into its home currency, the Japanese yen, in order to record the financial proceeds. The current spot exchange rate between the Mexican peso and the U.S. dollar is MXN18.00 = 1.00 USD, and the current spot rate between the dollar and the Japanese yen (¥ or JPY) is JPY100.00 = USD1.00. What are the yen proceeds of Crystal Gomez's purchase?

Assumptions Price of 100 Pokecoins in Mexico City (Mexican pesos, MXN or Ps) Spot exchange rate between the peso and the dollar (MXN = 1.00 USD) Spot exchange rate between the dollar and the yen (JPY = 1.00 USD)

Value MXN 17 MXN 18.00 ¥100.00

Answers a. What are the US dollar proceeds of the sale in Mexican pesos?

Proceeds in Mexican pesos (MXN) / Spot exchange rate (MXN/$)

$0.9444

b. What are the Japanes yen proceeds of the US dollar proceeds of the sale?

Proceeds in U.S. dollars x Spot exchange rate (¥/$)

¥94.44

Problem 1.7 Isaac Díez of Brazil Isaac Díez Peris lives in Rio de Janeiro, Brazil. While attending school in Spain he meets Juan Carlos Cordero from Guatemala. Over the summer holiday Isaac decides to visit Juan Carlos in Guatemala City for a couple of weeks. Isaac's parents give him some spending money, 4,500 Brazilian real (BRL). Isaac wants to exchange it for Guatemlan quetzals (GTQ). He collects the following rates: Spot rate on the GTQ=EUR1.00: Spot rate on the EUR=BRL1.00:

GTQ 10.5799=EUR1.00 EUR0.4462=BRL1.00

a. What is the Brazilian reais to Guatemalan quetzal cross rate? b. How many Guatemalan quetzals will Isaac get for his Brazlian reais?

Assumptions Amount of Brazlian reais from parents Spot rate (BRL=EUR1.00) Spot rate (EUR=GTQ1.00)

Values 4,500.00 10.5799 0.4462

a. What is the BRL to GTQ cross rate?

Cross rate (BRL=GTQ1.00)

4.72

BRL to GTQ = BRL=EUR1.00 x EUR=GTQ1.00 b. How many Guatemalan quetzals will he get for his Brazilian reais?

Converting your reais into quetzals

21,243

Problem 1.8 Moscow to Tokyo After spending a week in Moscow you get an email from your friend in Japan. He can get you a really good deal on a plane ticket and wants you to meet him in Tokyo next week to continue your post-graduation celebratory trip. You have 450,000 Russian rubles (RUB) left in your money pouch. In preparation for the trip you want to exchange your Russian rubles for Japanese yen (JPY), so you get the following quotes:

Spot rate on the Russian rubles to U.S. dollar cross rate Spot rate on the Japanese yen to U.S. dollar cross rate

RUB 30.96=USD1.00 JPY84.02=USD1.00

a. What is the Russian ruble/ yen cross rate? b. How many Japanese yen will you obtain for your Russian rubles?

Assumptions Beginning your trip with rubles Spot rate (RUB=1.00 USD) Spot rate (JPY=1.00 USD)

Values 450,000.00 30.96 84.02

a. What is the Russian ruble to Japanese yen cross rate?

Cross rate (RUB=JPY1.00)

0.3685

RUB to JPY = RUB=USD1.00 ÷ JPY=USD1.00 b. How many Japanese yen will you obtain for your Russian rubles?

Converting your Rubles into yen

1,221,177

Problem 1.9 Comparing Cheap Dates around the World Comparison of prices or costs across different country and currency environments requires the translation of the local currency into a single common currency. This is most meaningful when the comparison is for the identical or near-identical product or service across countries. Deutsche Bank has recently started publishing a comparison of cheap dates -- and evening on the town for two to eat at McDonald's, see a movie, and have a drink. Once all costs are converted to a common currency, the U.S. dollar in this case, the cost of the date can be compared across cities relative to the base case of a cheap date in USD in New York City.

After completing the table below, answer the following questions. a. Which city in the table is truly the cheapest date? b. Which city in the table is the most expensive cheap date? c. If the exchange rate in Moscow on the Russian ruble (RUB) was 0.04200, instead of 0.0283, what would be the USD price? d. If the exchange rate in Shangahi was CNY 6.66 = 1 USD, what would be its cost in USD and relative to a cheap date in New York City?

Country Australia Brazil Canada China France Germany Hong Kong India Indonesia Japan Malaysia Mexico New Zealand Phillipines Russia Singapore South Africa United Kingdom United States United States

City Sydney Rio de Janeiro Ottawa Shanghai Paris Berlin Hong Kong Mumbai Jakarta Tokyo Kuala Lumpur Mexico City Auckland Manila Moscow Singapore Cape Town London New York City San Francisco

Cheap Date in Local Currency AUD 111.96 BRL 135.43 CAD 78.33 CNY 373.87 EUR 75.57 EUR 76.49 HKD 467.03 INR 1,379.64 IDR 314,700 JPY 10,269.07 MYR 117.85 MXN 423.93 NZD 111.52 PHP 1,182.88 RUB 2,451.24 SGD 77.89 ZAR 388.58 GBP 73.29 USD 93.20 USD 88.72

Exchange Rate Quote USD = 1 AUD USD = 1 BRL USD = 1 CAD USD = 1 CNY USD = 1 EUR USD = 1 EUR USD = 1 HKD USD = 1 INR USD = 1 IDR USD = 1 JPY USD = 1 MYR USD = 1 MXN USD = 1 NZD USD = 1 PHP USD = 1 RUB USD = 1 SGD USD = 1 ZAR USD = 1 GBP 1 USD 1 USD

Exchange Rate 7 April 2014 0.9290 0.4363 0.9106 0.1619 1.3702 1.3702 0.1289 0.0167 0.0001 0.0097 0.3048 0.0769 0.8595 0.0222 0.0283 0.7939 0.0946 1.6566 1.0000 1.0000

Cheap Date in In USD 104.01 59.09 71.33 60.53 103.55 104.81 60.20 23.04 31.47 99.61 35.92 32.60 95.85 26.26 69.37 61.84 36.76 121.41 93.20 88.72

Relative to NYC 112% 63% 77% 65% 111% 112% 65% 25% 34% 107% 39% 35% 103% 28% 74% 66% 39% 130% 100% 95%

Source: Data drawn from The Random Walk, Mapping the World's Prices 2014 , Deutsche Bank Research, 09 May 2014, Figures 30 and 32, with author calculations.

'Relative NYC' isthe calculated as = Cheap Date in USD/93.20.

Note: The cheap date to combines local currency cost of a cab ride for two, two McDonald's hamburgers, two soft drinks, two movie tickets, and two beers. In 2013 Deutsche Bank had included sending a bouquet of roses in the date, but did not include that in the 2014 index, making the two years not directly comparable. a. The truly cheapest cheap date could be had in Mumbai, India, at only 25% of what it costs in New York City. b. The most expensive cheap date would be London at 130% of the cost of New York City. c. If the Russian ruble was actually trading at 0.042 instead of 0.0283, Moscow would be 110% of the cost of a cheap date in New York City. d. If the exchange rate in Shangahi was CNY6.66=USD1.00, a cheap date would cost USD 56.14, only 60% of the cost in New York City.

Problem 1.10 Blundell Biotech Blundell Biotech is a U.S.-based biotechnology company with operations and earnings in a number of foreign countries. The company's profits by subsidiary, in local currency (in millions), are shown in the following table for 2013 and 2014.

Net Income 2013 2014

Japanese Subsidiary JPY 1,500 JPY 1,460

Britih Subsidiary GBP 100.00 GBP 106.40

European Subsidiary EUR 204.00 EUR 208.00

Chinese Subsidiary CNY 168.00 CNY 194.00

Russian Subsidiary RUB 124.00 RUB 116.00

United States Subsidiary USD 360.00 USD 382.00

The average exchange rate for each year, by currency pairs, was the following. Use this data to answer the following questions.

Exchange Rate 2013 2014

JPY = 1 USD 97.57 105.88

USD = 1 GBP 1.5646 1.6473

USD = 1 EUR 1.3286 1.3288

CNY = 1 USD 6.1484 6.1612

RUB = 1 USD 31.86 38.62

USD 1.0000 1.0000

a. What was Blundell Biotech's consolidated profits in U.S. dollars in 2013 and 2014? b. If the same exchange rates were used for both years --what is often called a "constant currency basis -- what was the change in corporate earnings? c. Using the results of the constant currency analysis in part b, is it possible to separate Blundell's growth in earnings between local currency earnings and foreign exchange rate impacts on a consolidated basis? a. Consolidated profits or earnings is found by consolidating the converted profits in each foreign currency to U.S. dollars for that period. (This is simplified. Actual accounting practices would require the additional netting of any intra-company transactions resulting to eliminate any doublecounting of profits.)

Net Income (USD) 2013 2014

Japanese Subsidiary USD 15.37 USD 13.79

Britih Subsidiary USD 156.46 USD 175.27

European Subsidiary USD 271.03 USD 276.39

Chinese Subsidiary USD 27.32 USD 31.49

Russian Subsidiary USD 3.89 USD 3.00

United States Subsidiary USD 360.00 USD 382.00

Consolidated Earnings USD 834.08 USD 881.94 5.74%

b. If the exchange rates for 2013 are used for both years, earnings from individual subsidiaries and consolidation appear as follows.

Net Income (USD) 2013 2014 Change Percent change

Japanese Subsidiary USD 15.37 USD 14.96 (USD 0.41) -2.7%

Britih Subsidiary USD 156.46 USD 166.47 USD 10.01 6.4%

European Subsidiary USD 271.03 USD 276.35 USD 5.31 2.0%

Chinese Subsidiary USD 27.32 USD 31.55 USD 4.23 15.5%

Russian Subsidiary USD 3.89 USD 3.64 (USD 0.25) -6.5%

United States Subsidiary USD 360.00 USD 382.00 USD 22.00 6.1%

Consolidated Earnings USD 834.08 USD 874.98 USD 40.90 4.90%

On a constant currency basis, all subsidiaries showed growth in profits except for the Japanese and Russian subsidiaries. Fortunately for Blundell, neither of those subsidiaries is a major contributor to total profits. c. Blundell Biotech's consolidated earnings grew 5.7%. Since 4.9% of that was on an actual results basis (using constant currency assumption), the exchange rate-based change in earnings can be solved for: Total percent change = (1 + Actual percent change) x (1 + Foreign exchange percent change) -1 When rearranged to solve for the FX percent change: FX percent change = (1.0574)/(1.0490) - 1

=

0.80%

Problem 1.11 Peng Plasma Pricing Peng Plasma is a privately held Chinese business. It specializes in the manufacture of plasma cutting torches. Over the past eight years it has held the Chinese renminbi price of the PT350 cutting torch fixed at Rmb 18,000 per unit. Over that same period it has worked to reduce costs per unit, but has struggled of late due to higher input costs. Over that same period the renminbi has continued to be revalued against the U.S. dollar by the Chinese government. After completing the table – assuming the same price in renminbi for all years – answer the following questions. a. What has been the impact of Peng's pricing strategy on the US$ price? How would you expect their U.S. dollar-based customers to have reacted to this? b. What has been the impact on Peng's margins from this pricing strategy?

Fixed Rmb Pricing of the PT350 Plasma Cutting Torch

Year 2007 2008 2009 2010 2011 2012 2013 2014 Cumulative

Cost (Rmb) 16,000 15,400 14,800 14,700 14,200 14,400 14,600 14,800

Margin (Rmb) 2,000 2,600 3,200 3,300 3,800 3,600 3,400 3,200

Price (Rmb) 18,000 18,000 18,000 18,000 18,000 18,000 18,000 18,000

Margin Average Rate (percent) (Rmb/US$) 11.1% 7.61 14.4% 6.95 17.8% 6.83 18.3% 6.77 21.1% 6.46 20.0% 6.31 18.9% 6.15 17.8% 6.16

Price (US$) 2,365 2,590 2,635 2,659 2,786 2,853 2,927 2,922

Percent Chg in US$ Price --9.50% 1.76% 0.89% 4.80% 2.38% 2.60% -0.16% 23.54%

Problem 1.12 Andreas Delon’s Compensation Agreement Andreas Delon is a French citizen who has been offered the position of CEO of LakePharma, a large French pharmaceuticals firm. LakePharma produces high-quality chemicals used by pharmaceutical firms around the world.

Much of the production of LakePharma is sold in Switzerland, which means that Andreas Delon will spend most of his time there helping to market LakePharma’s products to Swiss pharmaceutical firms. He wishes to be paid in euros, not Swiss francs (CHF). LakePharma has agreed to pay Andreas’ base salary in euros, but insists on paying his sales commission and bonus (amounting to 25% of his base salary) in Swiss francs. Andreas is unable to decide whether to agree to this suggestion or to insist on receiving all his remuneration in euros. He constructs the table on the next page showing the sales revenue to help him decide. As a close friend and colleague, what advice would you give him based on your completion of the following table?

Year 2015 2016 2017 2018

Delon's French Sales (millions of USD) € 1,000 € 1,100 € 1,250 € 1,300

Percent Change 10.0% 13.6% 4.0%

Annual Avg Rate CHF = 1 EUR CHF 1.05 CHF 1.06 CHF 1.07 CHF 1.08

Delon's French Sales (millions of CHF) CHF 1,050 CHF 1,166 CHF 1,338 CHF 1,404

Percent Change 11.0% 14.7% 5.0%

Based on French sales, in both euros and francs, you should recommend that Andreas continue to argue for his performance bonus to be based on the euro value, not the translated franc value.

First, euro sales measured both ways were volatile. The volatility, however, was larger in Swiss francs than in euros. If that was the only concern, then it would only be up to Andreas to choose his “risk tolerance”—how much volatility he is willing to bear in his annual performance bonus.

But more importantly, if his performance was based on the euro value of the European sales, he would be measured on the actual sales, over which he had direct control. Changes in that exchange rate could potentially destroy all growth in the European sales.

EuroVirtual Problems 13 through 17 are based on EuroVirtual, a France-based multinational IT firm. In addition to its home operations in France, EuroVirtual owns and operates subsidiaries in Switzerland, the United Kingdom, and Denmark. Currently, it has 650,000 shares outstanding on the pan-European stock exchange, Euronext. The following table summarizes the business performance of EuroVirtual:

French Parent Company (€) $2,500 33% ------

Business Performance (000s, loccal currency) Earnings before taxes (EBT) Corporate income tax rate Average exchange rate for the period

Swiss Subsidiary (CHF) 400.00 25% CHF1.0335/€

British Subsidiary (£) € 2,100 20% £0.7415/€

Denmark Subsidiary (DKK) 4,500.00 23% DKK7.4642/€

Swiss Subsidiary (CHF)

British Subsidiary (GBP, £)

Denmark Subsidiary (DKK)

Problem 1.13 EuroVirtual’s Consolidated Earnings EuroVirtual pays different tax rates for each of its country’s operations. a. What are its earnings per share in euros after deducting taxes? b. What is the proportion of EuroVirtual’s consolidated EBT that arises from each country? c. What is the proportion of income generated outside France?

French Parent Company (euros, €)

Business Performance (000s) Earnings before taxes, EBT (local currency) Less corporate income taxes Net profits of individual subsidiary Avg exchange rate for the period (fc/$) Net profits of individual subsidiary (€)

2,500.00 (832.50) 1,667.50

33%

$

-----1,667.50

Consolidated profits (total across units) Total diluted shares outstanding (000s)

$

4,687.67 650.00

a. Consolidated earnings per share (EPS)

$

7.21

b. Proportion of total profits originating by country

35.6%

c. Proportion of total profits originating from outside France

64.4%

400.00 (100.00) 300.00

25%

$

20%

2,100.00 (420.00) 1,680.00

1.0335 290.28

0.74 $ 2,265.68

6.2%

48.3%

23%

4,500.00 (1,035.00) 3,465.00

$

7.4642 464.22

9.9%

Problem 1.14 NexusTech's EPS Sensitivity to Exchange Rates (A) On January 15, 2015, the Swiss National Bank (SNB) decided to unpeg the franc, which had been fixed at CHF1.20/€ since 2011. Suppose the SNB was to reverse its decision and readopt the previous peg. How would this affect the consolidated EPS of EuroVirtual, if all other exchange rates, tax rates, and earnings remain unchanged?

French Parent Company (€)

Business Performance (000s) Earnings before taxes, EBT (local currency) Less, corporate income taxes Net profits of the individual subsidiary (€)

€ 33%

2,500.00 (832.50) 1,667.50

Average exchange rate for the period Net profits of the individual subsidiary (€)

— 1667.50

Consolidated profits (total across units, €) Total diluted shares outstanding (000s)

4,687.67 650.00

Baseline EPS (€)

Swiss Subsidiary (CHF)

25%

400.00 CHF (100.00) 300.00

British Subsidiary (£) £ 20%

1.0335 290.28

2,100.00 (420.00) 1,680.00

Denmark Subsidiary (DKK)

23%

0.74 2265.68

DKK 4,500.00 (1,035.00) 3,465.00 7.4642 464.22

7.21 CHF against the euro French Parent Company (euros, €)

Business Performance (000s) Earning before taxes, EBT (local currency) Less, corporate income taxes Net profits of the individual subsidiary (€)

35%

2500.00 (875.00) 1,625.00

Average exchange rate for the period Net profits of the individual subsidiary (€)

— 1625.00

Consolidated profits (total across units, €) Total diluted shares outstanding (000s)

4,604.89 650.00

“New” EPS (€)

7.08

EPS change from the baseline

-1.8%

Swiss Subsidiary (CHF)

25%

400.00 CHF (100.00) 300.00 1.2000 250.00

British Subsidiary (GBP, £)

20%

2100.00 (420.00) 1,680.00 0.74 2265.68

Denmark Subsidiary (DKK)

23%

4500.00 (1,035.00) 3,465.00 7.4642 464.22

Problem 1.15 EuroVirtual’s EPS Sensitivity to Exchange Rates (B) Assume a major weather crisis hits Switzerland, reducing its agricultural and food industries and, subsequently, leading to a macroeconomic recession and, by extension, weakening the Swiss franc. What would be the impact on EuroVirtual’s consolidated EPS if, in addition to the fall in the value of the franc to CHF 1.2/€, EBT in Switzerland fell by half as a result of the recession?

French Parent Company (€)

Business Performance (000s) EBT (local currency) Less, corporate income taxes Net profits of the individual subsidiary (€)

€ 33%

2,500.00 (832.50) 1,667.50

Average exchange rate for the period Net profits of the individual subsidiary (€)

— 1,667.50

Consolidated profits (total across units, €) Total diluted shares outstanding (000s)

4,687.67 650.00

Baseline EPS (€)

€ 33%

2,500.00 (832.50) 1,667.50 — 1,667.50

Consolidated profits (total across units, €) Total diluted shares outstanding (000s)

4,633.44 650.00

Change in the EPS from both changes

400.00 CHF (100.00) 300.00

£ 20%

1.03 290.28

French Parent Company (euros, €)

Average exchange rate for the period Net profits of the individual subsidiary (€)

Revised EPS (€)

25%

British Subsidiary (£) 2,100.00 (420.00) 1,680.00

Denmark Subsidiary (DKK)

23%

0.74 2,265.68

DKK 4,500.00 (1,035.00) 3,465.00 7.46 464.22

7.21

Business Performance (000s) Earnings before taxes, EBT (local currency) Less, corporate income taxes Net profits of the individual subsidiary (€)

Swiss Subsidiary (CHF)

7.13 -1.2%

Swiss Subsidiary (CHF)

25%

200.00 (50.00) 150.00 1.2000 125.00

British Subsidiary (GBP, £) £ 20%

2,100.00 (420.00) 1,680.00 0.7018 2,393.84

Denmark Subsidiary (DKK)

23%

DKK 4,500.00 (1,035.00) 3,465.00 7.7500 447.10

Problem 1.16 EuroVirtual’s EPS and Euro Appreciation/Depreciation Since its introduction in 2003, the euro has been fluctuating against major global currencies. a. What is the impact of a 15% appreciation of all major currencies against the euro on the consolidated EPS of EuroVirtual? b. What is the impact of a 20% depreciation of all major currencies against the euro on the consolidated EPS of EuroVirtual?

—

Baseline exchange rate Percent change (+ appreciation, - depreciation) New exchange rate Appreciation Case

French Parent Company (euros, €)

Business Performance (000s) Earnings before tax, EBT (local currency) Less, corporate income taxes Net profits of the individual subsidiary (€)

1.0335 15% 0.8987

€ 33%

2,500.00 (832.50) 1,667.50

Average exchange rate for the period Net profits of the individual subsidiary (€)

— 1,667.50

Consolidated profits (total across units, €) Total diluted shares outstanding (000s)

5,140.69 650.00

Baseline EPS (€)

14.77

EPS, if foreign currencies appreciate

7.91

Depreciation Case

25%

€ 33%

400.00 CHF (100.00) 300.00

£ 20%

EPS has changed by

Average exchange rate for the period Net profits of the individual subsidiary (€)

— 1,667.50

Consolidated profits (total across units, €) Total diluted shares outstanding (000s)

4,083.64 650.00

Baseline EPS (€)

14.77

EPS, if foreign currencies depreciate

6.28

400.00 CHF (100.00) 300.00 1.2919 232.22

EPS has changed by

2,100.00 (420.00) 1,680.00

Denmark Subsidiary (DKK)

23%

DKK 4,500.00 (1,035.00) 3,465.00 6.4906 533.85

-46.5%

0.74 -20% 0.9269

Swiss Subsidiary (CHF)

25%

7.4642 15% 6.4906

0.64 2,605.53

1.0335 -20% 1.2919

2,500.00 (832.50) 1,667.50

0.74 15% 0.6448 British Subsidiary (GBP, £)

0.8987 333.82

French Parent Company (euros, €)

Business Performance (000s) EBT (local currency) Less, corporate income taxes Net profits of the individual subsidiary (€)

Swiss Subsidiary (CHF)

—

Baseline exchange rate Percent change (+ appreciation, - depreciation) New exchange rate

£

7.4642 -20% 9.3303

British Subsidiary (GBP, £) £ 20%

2,100.00 (420.00) 1,680.00 0.9269 1,812.54

-57.5%

Denmark Subsidiary (DKK)

23%

DKK 4,500.00 (1,035.00) 3,465.00 9.3303 371.37

Problem 1.17 EuroVirtual’s Global Taxation and Effective Tax Rate All MNEs attempt to minimize their global tax liabilities. Return to the original set of baseline assumptions and answer the following questions regarding Euro Virtual’s global tax liabilities:

a. What is the total corporate income tax that EuroVirtual pays for all its operations in euros? b. What is its effective tax rate (total taxes paid as a percentage of pre-tax earnings)? c. Suppose the U.K. decides to reduce its corporate tax rate to 10%, leading to a rise in EuroVirtual’s British subsidiary’s earnings before tax to £3,000,000.

What would be the impact on EuroVirtual’s EPS? French Parent Company (€)

Business Performance (000s) Earnings before tax, EBT (local currency) Less, corporate income taxes Net profits of the individual subsidiary (€)

€ 33%

2,500.00 (832.50) 1,667.50

Average exchange rate for the period Net profits of the individual subsidiary (€)

— 1,667.50

Consolidated profits (total across units, €) Total diluted shares outstanding (000s)

4,970.88 650.00

Consolidated EPS (€)

Swiss Subsidiary (CHF) 400.00 CHF (100.00) 300.00

25%

British Subsidiary (£) £ 10%

2,100.00 (210.00) 1,890.00

Denmark Subsidiary (DKK)

23%

DKK 4,500.00 (1,035.00) 3,465.00

1.0335 290.28

0.74 2,548.89

7.4642 464.22

96.76

283.21

138.66

7.65

Tax payments by each country (€)

832.50

a. Total global tax bill, US$

$

1,351.13

EBT by country, US$

$

2,500.00

Consolidated EBT Total tax bill Effective tax rate

$ $

6,322.01 1,351.13 21.4%

b. What is Americo's effective tax rate? $

387.03

$

2,832.10

$

602.88

c. What would be the impact on Americo's EPS and global effective tax rate if Germany instituted a tax cut to 28% and German subsidiary earnings rose to 5 million euros?

U.S. Parent Brazilian German Chinese Company Subsidiary Subsidiary Subsidiary Business Performance (000s) (US$) (reais, R$) (euros, €) (yuan, Y) Earnings before taxes, EBT (local currency) Less corporate income taxes Net profits of individual subsidiary Avg exchange rate for the period (fc/$) Net profits of individual subsidiary (US$)

4,500.00 (1,575.00) 2,925.00

35%

$

-----2,925.00

6,250.00 (1,562.50) 4,687.50

25%

5,000.00 (1,400.00) 3,600.00

28%

2,500.00 (750.00) 1,750.00

30%

$

1.8000 2,604.17

$

0.7018 5,129.67

$

7.7500 225.81

Consolidated profits (total across units) Total diluted shares outstanding (000s)

$

Consolidated earnings per share (EPS)

$

16.75

$

4,500.00

$

3,472.22

$

7,124.54

$

322.58

$

1,575.00

$

868.06

$

1,994.87

$

96.77

$ $

15,419.34 4,534.70 29.4%

EBT by country, US$ Tax payments by country in US dollars Consolidated EBT Total tax bill Effective tax rate

10,884.64 650.00

Problem 2.1 Albert’s Trip to Canada Albert visits Toronto and buys 1.74 Canadian dollars (CAD) for 1 British pound (GBP). When he returns home to the U.K., he converts CAD1 into GBP0.59. Is the new exchange rate favorable or unfavorable?

Assumptions

Values

Buy Canadian dollars (CAD/£) Which is equivalent, the reciprocal (£/CAD)

1.7400 £0.5747

Buyback pounds (£/CAD) Which is equivalent, the reciprocal (CAD/£)

£0.5900 1.6949

It is better to convert his remaining Canadian dollars to GBP when he reaches back home.

Problem 2.2 Euro 2021 Ticket Prices Tickets for the Euro 2020 Championship match between Germany and France, to be held in Munich on June 15, 2021 (Euro 2020 was canceled due to the global pandemic, so 2020 championships were held in 2021), were on sale for £349 per seat. If current spot exchange rates were $1.2127 = €1.00 and €1.1645= £1.00, what was the U.S. dollar price of a seat for the match?

Answer: Convert the British pound price per seat into euros, then euros into US dollars.

Price of a seat in British pounds (£) Spot rate, euros per pound (€=£1.00) Price of seat in euros Spot rate, dollars per euro ($=€1.00) Price of seat in U.S. dollars

Value 349.00 1.1647 406.48 1.2127 492.94

Problem 2.3 Gilded Question In 1923, one ounce of gold costs 380 French francs (FRF). If, at the same time, one ounce of gold could be purchased in Britain for £4.50, what was the exchange rate between the French franc and the British pound?

Assumptions Price of an ounce of gold in French francs (FRF/oz) Price of an ounce of gold in sterling pounds (GBP/oz) What is the implied GBP/FRF rate?

(GBP price of an ounce/FRF price of an ounce) Or, if expressed as FRF/GBP

Values FRF 380.00 4.50 0.01

FRF 84.4444

Problem 2.4 Brent Oil In 2015, one barrel of Brent oil traded for GBP42.5 and South Africa rands (ZAR) 790. What is the exchange rate between the pound and the rand? How would the exchange rate change if the oil price jumps to £50 per barrel (assuming no change in the price in South Africa)?

Assumptions Price of one barrel of Brent oil in GBP (£/barrel) Price of one barrel of Brent oil in South African rands (ZAR/barrel) What is the implied £/ZAR exchange rate?

(GBP price of one barrel/ZAR price of one barrel)

Gold Standard Values 42.50 790.00

What If 50.00 790.00

£0.0538

£0.0633

Problem 2.5 Ukraine Imports Mitsubishi manufactures in Japan most of the pick-up trucks it sells in Ukraine. The base platform for the Mitsubishi Triton truck line is ¥1,350,000. The spot rate of the Japanese yen against the Ukrainian hryvnia has recently moved from ¥4.47/₴ to ¥4.40/₴. How does this change the price of the Triton to Mitsubishi’s Ukrainian subsidiary in Ukrainian hryvnia?

Assumptions Original spot rate (¥/₴) New spot rate (¥/₴) Export price of a Mitsubishi Triton truck (¥)

Values 4.47 4.40 1,350,000

Original import price (₴)

302,013.42

Export price in yen/Original spot rate (¥/₴) New import price (₴)

306,818.18

Export price in yen/New spot rate (¥/₴) Percentage change in the price of the imported truck

1.59%

New price/Old price-1 Because the price of the truck itself did not change, the percentage change in the import price, as expressed in Ukrainian hryvnia, is the same percentage change in the value of the Japanese yen against the Ukrainian hryvnia itself.

Problem 2.6 Online Shopping Tamara lives in Egypt and has placed a bundle of items in her Amazon.co.uk account basket. She has the choice to pay in Egyptian pounds (EGP1,844) or in British pounds (£151.17).

What is the exchange rate between both currencies? In which Assumptions Egyptian pound price of the basket (EGP) British pound price of the basket (£)

Values 1,844.00 151.17

Implied exchange rate (EGP/£)

12.1982

Many emerging markets that suffer from foreign exchange shortages have more than one exchange rate. The official exchange rate is the one officially transacted by the banking system. However, there is usually a parallel foreign exchange market where the foreign currency is usually cheaper. Tamara should weigh both of these rates before making her decision.

Problem 2.7 Israeli Shekel Changes Value One British pound traded against Israeli shekels (ILS) 5.82 in 2013 but the exchange rate rose to 6.78 in late 2014. What is the percentage change of the ILS? Has the shekel depreciated or appreciated?

Calculation of Percentage Change in Value Initial exchange rate (ILS/£) New exchange rate (ILS/£) Percentage change in the shekel’s value (ending rate-beginning rate)/(beginning rate)

As the exchange rate rises, the British pound is able to buy more shekels. Thus, the shekel has depreciated by 16.49%.

Values 5.82 6.78 16.49%

Problem 2.8 Dollar Peg for Hong Kong The Hong Kong dollar (HKD) has long been pegged to the U.S. dollar (USD) at HKD7.80=USD1.00. When the Chinese yuan (CNY) was revalued in July 2005 against the U.S. dollar from CNY8.28=USD1.00 to CNY8.11=USD1.00, how did the value of the Hong Kong dollar change against the yuan?

Assumptions Original Chinese yuan peg to the dollar, CNY=USD1.00 Revalued Chinese yuan to the dollar, CNY=USD1.00 Hong Kong dollar peg to the US dollar, HKD=USD1.00

Values 8.28 8.11 7.80

Original HKD per CNY cross rate HKD per CNY = (HKD=USD1.00) x (USD=CNY1.00)

0.9420

New HKD per CNY cross rate HKD per CNY = (HKD=USD1.00) x (USD=CNY1.00)

0.9618

As a result of the revaluation of the Chinese yuan, the Hong Kong dollar has fallen in value against the Chinese yuan.

Problem 2.9 Renminbi Revaluation Many experts believe that the Chinese currency should not only be revalued against the U.S. dollar as it was in July 2005, but also be revalued by 20% or 30%. What would be the new exchange rate value if the yuan was revalued an additional 20% or 30% from its initial post-revaluation rate of Yuan 8.11=$1.00?

Calculation of Percentage Change in Value Initial exchange rate, post official revaluation (Yuan=$1.00) Percentage revaluation against the US dollar Revalued exchange rate (Yuan=$1.00)

Values 8.11 20.00% 6.76

Initial exchange rate, post official revaluation (Yuan=$1.00) Percentage revaluation against the US dollar Revalued exchange rate (Yuan=$1.00)

8.11 30.00% 6.24

As painfully obvious, it is clear why so many critics of the Chinese yuan policy were not particularly happy with the revaluation of only 2.1%.

Problem 2.10 TEXPAK in the United Kingdom TEXPAK is a Pakistani-based textile firm that is facing increasing competition from other manufacturers in emerging markets selling in Europe. All garments are produced in Pakistan, with costs and pricing initially stated in Pakistani rupees (PKR) but converted to British pounds (£) for distribution and sale in the U.K. In 2014, one suit was priced at PKR11,000 with a British pound price set at £95. In 2015, the GBP appreciated versus the PKR, averaging PKR120/£. In order to preserve the GBP price and profit margin in PKR, what should the new PKR price be set at?

Assumptions Original (2014) unit price (PKR) Original (2014) British pound price for sale and distribution (£) Average spot rate for 2015, (PKR/£)

Values 11,000.00 95.00 120.00

First, the implied spot exchange rate for the previous year (2014) must be found by dividing the PKR price by the GBP price selected for distribution and sale.

Implied original spot rate (PKR/£)

115.79

Assuming that TEXPAK wishes to preserve the British price for competitiveness, the same GBP price must be converted back into PKR, with the new spot exchange rate in PKR per GBP. Recalculated PKR price of the product (Original £ price × Average spot rate for 2015)

11,400.00

Because the Pakistani rupee depreciated against the GBP, the implied PKR price is higher than it was the previous year. This means that TEXPAK can keep the same British pound price and either enjoy a much larger profit margin in PKR or, potentially, keep the PKR price the same as the previous year and reduce the GBP price.

Problem 2.11 Canadian Loonie If the price of former Chairman of the U.S. Federal Reserve Alan Greenspan’s memoir, The Age of Turbulence, is listed on Amazon.ca as C$26.33, but costs just US$23.10 on Amazon.com, what exchange rate does that imply between the two currencies?

Assumptions Canadian dollar list price of book (C$) US dollar list price of book ($)

Values 26.33 23.10

Implied exchange rate (C$=$1.00)

1.1398

This simple book price is representative of what so many Canadians were unhappy about after the Canadian dollar -- the Loonie -- gained parity with the dollar in 2007. Although the Canadian dollar was quoted in the currency markets at equal value with the US dollar (C$1.00 = $1.00), the prices of many of the same goods and services in the marketplace still implied a much weaker Canadian dollar.

Problem 2.12 Vietnamese Coffee Coyote Many people were surprised when Vietnam became the second-largest coffee producing country in the world in recent years, second only to Brazil. The Vietnamese dong (VND or d) is managed against the U.S. dollar but is not widely traded. If you were a traveling coffee buyer for the wholeale market -- a "coyote" by industry terminology -- which of the following currency rates and exchange commission fees would be in your best interest if traveling to Vietnam on a buying trip?

Currency Exchange Vietnamese bank rate Saigon Airport exchange bureau rate Hotel exchange bureau rate Assuming an intial cash amount for exchange to dong of: Assumptions Vietnamese bank rate (dong=$1.00) Bank commission (%) Saigon Airport Exchange Bureau rate (dong=$1.00) Airport comission (%) Hotel Exchange Bureau rate (dong=$1.00) Hotel comission (%)

Rate d19,800 d19,500 d19,400

Commission 2.50% 2.00% 1.50%

$10,000.00 Values 19,800 2.50% 19,500 2.00% 19,400 1.50%

Vietnamese dong proceeds 193,050,000 191,100,000 191,090,000

The combined exchange rate and commission offered in the commercial banks in Vietnam is the better rate. In the case of the Hotel Exchange Bureau rate, although its exchange rate is slightly weaker than the airport, its lower comission makes it preferable over the combined airport rate.

Problem 2.13 Chunnel Choices The Channel Tunnel or "Chunnel" passes underneath the English Channel between Great Britain and France, a land link between the Continent and the British Isles. One side is therefore an economy of British pounds (GBP), the other euros (EUR). If you were to check the Chunnel's rail ricket Internet rates you would find that they would be denominated in U.S. dollars (USD). For example, a first-class round-trip fare for a single adult from London to Paris via the Chunnel through RailEurope may cost USD170.00. This currency neutrality, however, means that customers on both ends of the Chunnel pay differing rates in their home currencies from day to day. What is the British pound and euro denominated prices for the USD170.00 round-trip fare in local currency if purchased on the following dates at the accompanying spot rates drawn from the Financial Times ?

Round trip RailEurope train fare (USD)

Date of Spot Rate Monday Tuesday Wednesday

170.00 British pound Spot Rate (GBP=USD1.00) 0.5702 0.5712 0.5756

Euro Spot Rate (EUR=USD1.00) 0.8304 0.8293 0.8340

British pound train fare (GBP) 96.93 97.10 97.85

Continental train fare (EUR) 141.17 140.98 141.78

In an attempt to be neutral or impartial in its currency of pricing, the Chunnel has actually introduced a degree of currency risk to all customers either British or Continental, as neither group counts the U.S. dollar as its home or domestic currency. The day-today fluctuations in the dollar against the pound and the euro may seem relatively small over a threeday period, but over several weeks or months in recent years, the changes could have been significant in the eyes of potential customers.

2.14 Samsung, South Korea Samsung Electronics, South Korea, sells 2,50,00,000 Chilean pesos worth of semiconductors to Empresa Nacional de Telecomunicaciones SA, Chile, on January 1, 2019. The sale is invoiced in Chilean pesos (contract for settlement). The spot exchange rate on January 1, 2019, was CLP0.62351.0/KRW, so a sale of 2,50,00,000 Chilean pesos is recorded on Samsung’s financial statements as KRW40,096,230.95.

If Empresa Nacional de Telecomunicaciones SA pays two months later, on March 1, the spot rate is CLP0.58291.0/KRW. If it did not pay until April 1 (90 days), the spot rate is CLP0.59831.0/KRW. a. Complete the sale and settlement worksheet below

Sale (CLP) Chilean pesos per South Korean won Sales (KRW) Cost (KRW) Expected gross margin (KRW) Expected gross margin (%) Change from booked

Booked January 1, 2019 25,000,000.00 0.6235 KRW 40,096,230.95 -15,000,000.00 25,096,230.95 62.6%

If settled on ….

March 1, 2019 25,000,000.00 0.5829 KPW 42,889,003.26 -15,000,000.00 27,889,003.26 65.0% KRW 2,792,772.31

If settled on ….

April 1, 2019 25,000,000.00 0.5983 KPW 41,785,057.66 -15,000,000.00 26,785,057.66 64.1% KRW 1,688,826.71

b. How would the gross margin on the sale change over the three different settlement dates?

The expected gross margin by management, on the date of the contractual sale, was 62.6%. If the sale was settled by Empresa Nacional de Telecomunicaciones SA on March 1, the margin would have been 65.0%. If it had settled on April 1, however, the margin would have been greater than expected—64.1%.

c. If the total sale was settled on April 1, 2019, what would be the foreign exchange gain (or loss) recorded on the sale?

If settled on April 1, the foreign exchange gain (or loss) would be of KRW1,688,826.71, increasing the gross margin on the sale from 62.6% to 64.1%.

Problem 2.15 Tsar Alexander's Russian Gold Loan a. What is the value of the total bond as originally issued in French francs, German marks, British pounds, Dutch florins, and U.S. dollars? b. Create a chart that shows the fixed rate of exchange implied by the coupon for the six different currencies.

a. The value of the bond is its Par Value, as stated on the bond, assuming that the rates of interest by currency were current at the time of its issuance. From that we can also calculate the value of each coupon (interest) payment by currency on both an annual and quarterly basis.

Currency Russian gold roubles French francs British pounds sterling German marks Dutch florins US gold dollars

Par Value 125.00 500.00 19.775 404.00 239.00 96.25

Annual Coupon Rate 4.000% 4.000% 4.000% 4.000% 4.000% 4.000%

Annual Coupon (4% of Par) 5.0000 20.0000 0.7910 16.1600 9.5600 3.8500

Quarterly Coupon (coupon/4) 1.2500 5.0000 0.1978 4.0400 2.3900 0.9625

As described on the coupon In St. Petersburg 1.25 Roubles.

In Paris 5 Francs.

In London 3 Schill. 11 and 1/2 P. In Berlin 4 Mark 4 Pf. In Amsterdam 2 Flor. 39 C. In New York 96 1/4 Cents.

Of all the currencies, the British pound sterling is the most difficult for calculation. At this time 12 pence = 1 schilling, 20 schiling = 1 pound sterling. b. The chart or matrix of implied exchange rates is found by dividing the par values by currency. For example, French francs/Russian roubles is found by dividing Rbl 125 by FF 500, giving an implied exchange rate of Rbl 0.2500/FF.

Currency units Russian gold roubles French francs British pounds sterling German marks Dutch florins US gold dollars

Russian roubles (per rouble) ----------4.0000 0.1582 3.2320 1.9120 0.7700

French francs (per franc) 0.2500 ----------0.0396 0.8080 0.4780 0.1925

Pounds sterling (per pound) 6.3211 25.2845 ----------20.4298 12.0860 4.8673

German marks (per mark) 0.3094 1.2376 0.0489 ----------0.5916 0.2382

Dutch florins (per florin) 0.5230 2.0921 0.0827 1.6904 ----------0.4027

US gold dollars (per dollar) 1.2987 5.1948 0.2055 4.1974 2.4831 -----------

These exchange rates can then be used to calculate the total issuance value in each of the respective currencies.

Total issue value Russian gold roubles French francs British pounds sterling German marks Dutch florins US gold dollars

Currency per rouble ----------4.0000 0.1582 3.2320 1.9120 0.7700

Total Bond Issuance

By Currency 113,600,000 454,400,000 17,971,520 367,155,200 217,203,200 87,472,000

These total issuance values are found by multiplying the exchange rate (Currency per rouble) by the bond's issuance value in Russian gold roubles (113,600,000).

Problem 2.16 Quartzite The spot rate for Mexican pesos is Ps12.42 = $1.00. If U.S.-based company Quartzite Inc. buys Ps500,000 spot from its bank on Monday, how much must Quartzite pay and on what date?

Assumptions Spot rate on Mexican peso (pesos=$1.00) Amazing Inc. buys this amount of pesos What is the cost in US$? (the peso amount divided by the spot exchange rate)

Values 12.4200 500,000.00 $

40,257.65

Spot transactions are settled in two business days, so in this case, Wednesday.

Problem 2.17 Scania Heavy Machinery AB Scania Heavy Machinery AB, a manufacturer of heavy-duty machinery and vehicles near Stockholm, ships an order to a buyer in Lebanon. The purchase price is SEK375,000. Lebanon imposes a 15% import duty on heavy machinery products purchased from the European Union.

The Lebanese importer then re-exports the equipment to an Iraqi importer but only after imposing its own resale fee of 20%. Given the following spot exchange rates on September 16, 2019, what is the total cost to the Iraqi importer in Iraqi dinar and what is the euro equivalent of Currency Crossrate Lebanese pound per krona Lebanese pound per euro Iraqi dinar per euro

Spot Rate LBP154.13/SEK LBP1,668.38/€ IQD1,314.42/€

Assumptions Purchase price (SEK) Spot rate of exchange (LBP/€) Spot rate of exchange (IQD/€) Spot rate of exchange (IQD/LBP) Lebanese import duty on EU products Lebanese resale fees Spot rate of exchange (IQD/€)

Values 375,000 kr 1,668.38 1,314.12 1.0002 15.00% 20.00% 1,314.420

What is the dollar price after all exchanges and fees?

Purchase price (LBP) Additional fees due on importation Total cost (LBP)

625,642,500.00 93,846,375.00 719,488,875.00

Resale fee (LBP) Resale price to Iraq (LBP)

143,897,775.00 863,386,650.00

Price paid in Iraqi dinar (converting LBP to IQD) (spot rate (SRI/JD) × Resale price to Iraq (LBP))

863,583,752.24

Euro equivalent of the final price paid

€

657,007.47

Australia's Current Account Use the following balance of payments data for Australia from the International Monetary Fund to answer questions 3.1 through 3.4.

3.1 What is Australia's balance on goods?

3.2 What is Australia's balance on services?

3.3 What is Australia's balance on goods and services?

3.4 What is Australia's current account balance?

Millions of US dollars Goods: credit (exports) Goods: debit (imports) Balance on goods

2010 213,810 202,474 11,335

2011 271,926 249,182 22,744

2012 258,390 266,665 -8,276

2013 254,181 246,871 7,311

Services: credit (exports) Services: debit (imports) Balance on services

46,440 51,590 -5,150

52,215 62,395 -10,181

53,596 66,763 -13,167

53,077 67,808 -14,731

Primary income: credit Primary income: debt Balance on primary income

40,050 89,343 -49,293

47,974 102,753 -54,780

47,604 88,415 -40,811

46,230 84,769 -38,539

Secondary income: credit Secondary income: debt Balance on secondary income

5,864 7,470 -1,607

7,524 9,739 -2,215

7,572 9,802 -2,230

7,454 9,366 -1,912

Questions

2010

2011

2012

2013

3.1 What is Australia's balance on goods? (goods exports - goods imports)

11,335

22,744

-8,276

7,311

3.2 What is Australia's balance on services? (services credit - services debit)

-5,150

-10,181

-13,167

-14,731

3.3 What is Australia's balance on goods and services? (balance on goods + balance on services)

6,186

12,563

-21,443

-7,421

3.4 What is Australia's current account balance? (the sum of the four balances listed above, goods, services, income, and current transfers)

-44,714

-44,431

-64,483

-47,872

questions 3.1 through 3.4.

2014 240,671 238,481 2,190

2015 188,212 207,225 -19,013

2016 192,907 198,703 -5,795

2017 231,566 221,064 10,503

2018 257,849 236,906 20,943

2019 271,441 223,427 48,014

2020 250,660 210,721 39,940

56,506 67,780 -11,274

54,894 63,656 -8,762

58,024 62,466 -4,442

65,174 68,474 -3,300

69,470 73,319 -3,849

70,990 72,035 -1,045

48,382 38,347 10,035

46,699 79,435 -32,735

39,413 67,763 -28,350

39,530 69,556 -30,026

42,603 84,511 -41,907

48,543 94,786 -46,243

49,866 88,067 -38,201

45,613 60,852 -15,239

7,516 9,095 -1,580

6,586 7,419 -834

6,567 7,339 -772

6,946 8,192 -1,247

7,159 7,796 -637

7,047 7,782 -735

6,722 7,629 -907

2014

2015

2016

2017

2018

2019

2020

2,190

-19,013

-5,795

10,503

20,943

48,014

39,940

-11,274

-8,762

-4,442

-3,300

-3,849

-1,045

10,035

-9,084

-27,775

-10,238

7,202

17,094

46,969

49,975

-43,398

-56,959

-41,035

-35,952

-29,786

8,033

33,829

India's Current Account

Use the following balance of payments data for India from the IMF (all items are for the current account) to answer questions 3.5 thro 3.5 What is India's balance on goods?

3.6 What is India's balance on services?

3.7 What is India's balance on goods and services?

3.8 What is the balance on goods, services and income?

3.9 What is India's current account balance?

Millions of US dollars Goods: credit (exports) Goods: debit (imports) Balance on goods

2010 230,967 324,320 -93,353

2011 307,847 475,304 -167,457

2012 298,321 499,989 -201,668

2013 319,110 481,686 -162,576

2014 328,387 472,434 -144,047

Services: credit (exports) Services: debit (imports) Balance on services

117,068 114,739 2,329

138,528 77,758 60,770

145,525 79,920 65,605

149,164 78,722 70,441

157,196 81,119 76,078

Primary income: credit Primary income: debt Balance on primary income

9,961 25,563 -15,602

10,147 26,191 -16,043

9,899 30,742 -20,843

11,230 33,032 -21,802

12,637 37,581 -24,945

Secondary income: credit Secondary income: debt Balance on secondary income

54,380 2,270 52,110

62,735 2,523 60,212

68,611 3,176 65,435

69,441 4,626 64,815

69,906 4,306 65,600

2010

2011

2012

2013

2014

3.5 What is India's balance on goods?

-93,353

-167,457

-201,668

-162,576

-144,047

3.6 What is India's balance on services?

2,329

60,770

65,605

70,441

76,078

3.7 What is India's balance on goods and services?

-91,024

-106,687

-136,063

-92,135

-67,970

3.8 What is the balance on goods, services and primary income?

-106,626

-122,730

-156,906

-113,937

-92,914

3.9 What is India's current account balance?

-54,516

-62,518

-91,471

-49,123

-27,314

Questions

to answer questions 3.5 through 3.9.

2015 272,353 409,237 -136,884

2016 268,615 376,090 -107,476

2017 304,107 452,241 -148,134

2018 332,087 518,779 -186,692

2019 331,272 488,950 -157,678

2020 281,701 376,946 -95,246

156,278 82,643 73,635

161,819 95,922 65,896

185,294 109,371 75,923

204,956 124,182 80,774

214,762 130,535 84,226

203,253 116,230 87,023

14,533 37,894 -23,360

15,485 42,846 -27,361

18,547 44,970 -26,423

21,381 51,137 -29,757

23,348 52,725 -29,378

22,783 54,671 -31,887

67,806 3,653 64,153

61,545 4,718 56,827

67,068 6,601 60,467

76,763 6,688 70,075

80,742 7,675 73,067

79,973 6,856 73,117

2015

2016

2017

2018

2019

2020

-136,884

-107,476

-148,134

-186,692

-157,678

-95,246

73,635

65,896

75,923

80,774

84,226

87,023

-63,249

-41,579

-72,212

-105,918

-73,452

-8,223

-86,610

-68,940

-98,635

-135,674

-102,830

-40,110

-22,457

-12,114

-38,168

-65,599

-29,763

33,007

China's (Mainland) Balance of Payments Use the following balance of payments data for China (Mainland) from the IMF to answer questions 3.10 through 3.13.

3.10 3.11 3.12 3.13 3.14

Is China experiencing a net capital inflow or outflow?

What is China's total for Groups A and B? What is China's total for Groups A through C? What is China's total for Groups A through D? Does China's BOP balance?

Assumptions (millions of US dollars)

2010

2011

2012

2013

2014

237,810 4,630 282,234 -53,016 -471,658

136,097 5,446 260,024 -13,768 -387,799

215,392 4,272 -36,038 -87,071 -96,555

148,204 3,052 343,048 -62,922 -431,382

236,047 -33 -51,361 -66,869 -117,783

2010

2011

2012

2013

2014

3.10 Is China experiencing a net capital inflow or outflow?

286,864 "inflow"

265,470 "inflow"

-31,766 "outflow"

346,100 "inflow"

-51,394 "outflow"

3.11 What is China's total for Groups A and B?

242,440

141,543

219,664

151,256

236,014

3.12 What is China's total for Groups A through C?

524,674

401,567

183,626

494,304

184,653

3.13 What is China's total for Groups A through D?

471,658

387,799

96,555

431,382

117,783

0 Yes

0 Yes

0 Yes

0 Yes

0 Yes

A. Current account balance B. Capital account balance C. Financial account balance D. Net errors and omissions E. Reserves and related items Questions

3.14 Does China's BOP balance?

0 through 3.13.

2015

2016

2017

2018

2019

2020

293,022 316 -434,462 -201,817 342,941

191,337 -344 -416,070 -218,547 443,625

188,676 -91 109,537 -206,595 -91,526

24,131 -569 172,682 -177,368 -18,877

102,910 -327 7,308 -129,178 19,288

273,980 -77 -77,759 -168,134 -28,011

2015

2016

2017

2018

2019

2020

-434,146 "outflow"

-416,415 "outflow"

109,445 "inflow"

172,114 "inflow"

6,980 "inflow"

-77,836 "outflow"

293,338

190,993

188,585

23,562

102,583

273,904

-141,124

-225,078

298,121

196,245

109,890

196,144

-342,941

-443,625

91,526

18,877

-19,288

28,011

0 Yes

0 Yes

0 Yes

0 Yes

0 Yes

0 Yes

Russia's Balance of Payments Use the following balance of payments data for the Russian Federation from the IMF to answer questions 3.14 through 3.17.

3.15 Is Russia experiencing a net capital inflow?

3.16 What is Russia's total for Groups A and B? 3.17 What is Russia's total for Groups A through C? 3.18 What is Russia's total for Groups A through D? 3.19 Does Russia's BOP balance?

Assumptions (millions of US dollars)

2010

2011

2012

2013

67,452 -41 -21,526 -9,135 -36,750

97,274 130 -76,118 -8,647 -12,638

71,282 -5,218 -25,675 -10,370 -30,020

33,428 -395 -46,213 -8,898 22,078

2005

2006

2007

2008

3.15 Is Russia experiencing a net capital inflow?

-21,567 "outflow"

-75,988 "outflow"

-30,893 "outflow"

-46,608 "outflow"

3.16 What is Russia's total for Groups A and B?

67,411

97,404

66,065

33,033

3.17 What is Russia's total for Groups A through C?

45,885

21,286

40,390

-13,180

3.18 What is Russia's total for Groups A through D?

36,750

12,638

30,020

-22,078

0 Yes

0 Nearly

0 Yes

0 Yes

A. Current account balance B. Capital account balance C. Financial account balance D. Net errors and omissions E. Reserves and related items Questions

3.19 Does Russia's BOP balance?

s 3.14 through 3.17.

2014

2015

2016

2017

2018

2019

2020

57,513 -42,005 -130,992 7,939 107,545

67,777 -309 -68,624 2,858 -1,702

24,469 -764 -10,063 -5,400 -8,242

32,179 -192 -11,941 2,582 -22,628

115,680 -1,104 -78,489 2,110 -38,197

64,806 -684 3,868 -1,506 -66,484

33,949 -522 -49,951 2,770 13,754

2009

2010

2011

2012

2013

2014

2015

-172,997 "outflow"

-68,933 "outflow"

-10,827 "outflow"

-12,133 "outflow"

-79,593 "outflow"

3,184 "inflow"

-50,473 "outflow"

15,508

67,468

23,705

31,986

114,576

64,122

33,427

-115,484

-1,156

13,641

20,045

36,087

67,990

-16,524

-107,545

1,702

8,242

22,628

38,197

66,484

-13,754

0 Yes

0 Yes

0 Yes

0 Nearly

0 Yes

0 Yes

0 Yes

Iceland Balance of Payments Use the following balance of payments data for Iceland from the IMF to answer questions 3.20 through 3.24.

3.20 Is Iceland experiencing a net capital inflow?

3.21 What is Iceland's total for Groups A and B? 3.22 What is Iceland's total for Groups A through C? 3.23 What is Iceland's total for Groups A through D? 3.24 Does Iceland's BOP balance?

Assumptions (billions of US dollars)

2010

2011

2012

-845 -11 -9,358 189 10,025

-716 -13 -5,865 1,472 5,122

-518 -10 -66 -397 991

2006

2007

2008

3.20 Is Iceland experiencing a net capital inflow?

-9,370 "outflow"

-5,878 "outflow"

-76 "outflow"

3.21 What is Iceland's total for Groups A and B?

-856

-729

-528

3.22 What is Iceland's total for Groups A through C?

-10,215

-6,594

-594

3.23 What is Iceland's total for Groups A through D?

-10,025

-5,122

-991

0 Yes

0 Yes

0 Yes

A. Current account balance B. Capital account balance C. Financial account balance D. Net errors and omissions E. Reserves and related items Questions

3.24 Does Iceland's BOP balance?

2013

2014

2015

2016

2017

2018

2019

2020

1,010 -11 -957 90 -132

776 -14 2,894 -68 -3,588

986 -11 70,325 -123 -71,177

1,717 -12 582 138 -2,425

1,055 -13 -1,269 -603 830

986 -16 -1,419 483 -34

1,579 -16 -1,135 124 -553

236 -18 -1,429 988 223

2009

2010

2011

2012

2013

2013

2013

2013

-968 "outflow"

2,880 "inflow"

70,314 "outflow"

570 "inflow"

-1,282 "outflow"

-1,435 "outflow"

-1,150 "outflow"

-1,446 "outflow"

999

762

975

1,705

1,042

970

1,563

218

42

3,656

71,301

2,287

-227

-449

429

-1,211

132

3,588

71,177

2,425

-830

34

553

-223

0 Yes

0 Yes

0 Yes

0 Yes

0 Yes

0 Yes

0 Yes

0 Yes

Problem 3.25 Trade Deficits and J-Curve Adjustment Paths Assume the United States has the following import/export volumes and prices. It undertakes a major "devaluation" of the dollar, say 18% on average against all major trading partner' currencies. What is the pre-devaluation and post-devaluation trade balance?

Assumptions Initial spot exchange rate, $=fc1.00 Price of exports, dollars ($) Price of imports, foreign currency (fc) Quantity of exports, units Quantity of imports, units Percentage devaluation of the dollar Price elasticity of demand, imports

Values 2.00 20.0000 12.0000 100 120 18.00% (0.900)

a. What is the pre-devaluation trade balance?

Revenues from exports, $ Expenditures on imports, fc Expenditures on imports, $ Pre-devaluation trade balance

$2,000 1,440 $2,880 ($880)

b. Resulting trade balance immediately after devaluation?

Revenues from exports, $ Expenditures on imports, fc New spot exchange rate, after devaluation Expenditures on imports, $ Post-devaluation trade balance (currency contract period)

$2,000 1,440 2.36 $3,398 ($1,398)

Problem 4.1 Tencent Holdings Limited Tencent Holdings Limited is a Chinese multinational conglomerate holding company. If its share price rises from HKD318 to HKD324 within one year, what is the rate of return to a shareholder if: a. The company paid no dividends. b. The company paid a dividend of HKD2.50 per share. c. The company paid the dividend, and the total return to the shareholder is separated into the dividend yield and the capital gain.

Assumptions Share price (P1) Share price (P2) Dividend paid (D2)

Value (HKD) 318.00 324.00 0.00

a. If the company paid no dividends (plugging 0 for the dividend): Total shareholder return = (D2/P1) + (P2-P1)/P1

1.887%

b. If the company paid a HK$2.50/share dividend: Assumptions Share price (P1) Share price (P2) Dividend paid (D2) Total shareholder return = (D2/P1) + (P2-P1)/P1

Value (HKD) 318.00 324.00 2.50 2.673%

c. If the company paid the dividend and the shareholder’s total return is separated into the dividend yield and the capital gain: Dividend yield = D2/P1

0.786%

Capital gain = (P2-P1)/(P1)

1.887%

Total shareholder return is the sum of the two

2.673%

Problem 4.2 Carty's Choices Brian Carty, a prominent investor, is evaluating investment alternatives.

If he believes an individual equity will rise in price from $59 to $71 in the coming one-year period, and the share is expected to pay a dividend of $1.75 per share, and he expects at least a 15% rate of return on an investment of this type, should he invest in this particular equity?

Assumptions Share price, P1 Share price, P2 Dividend paid, D2 Total shareholder return for the period is

$ $ $

Value 59.00 71.00 1.75 23.31%

Return = (P2 - P1 + D2) / (P1) The share's expected return of 23.31% far exceeds the required return

by Mr. Carty of 15%. He should therefore make the investment.

Problem 4.3 Hercule Poirot and Vaniteux (A) Hercule Poirot is a New York-based investor. He has been closely following his investment in 100 shares of Vaniteux, a French firm that went public in February 2010. When he purchased his 100 shares at €17.25 per share, the euro was trading at $1.360=€1.00. Currently, the share is trading at €28.33 per share, and the dollar has fallen to $1.4170=€1.00. a. If Hercule sells his shares today, what percentage change in the share price would he receive? b. What is the percentage change in the value of euro versus the dollar over this same period? c. What would be the total return Hercule would earn on his shares if he sold them at these rates?

Assumptions Prices when Hercule purchased his shares Prices Hercule sees in the market today

Share Price € 17.25 € 28.33

Exchange Rate ($=€1.00) 1.3600 1.4170

a. If Hercule sold his shares today, what is the percentage change in the share price he would receive?

Return = (P2 - P1) / (P1)

64.23%

b. What has been the percentage change in the value of euro versus the dollar over this same period?

Percentage change ($=€1.00) = ( S2 - S1 ) / (S1)

4.19%

c. What would be the total return Hercule would earn on his shares if he sold them at these rates?

If he sold his shares today, it would yield the following amount in euros: These euros would in turn be worth the following in US dollars:

€ 2,833.00 $4,014.36

The amount he invested in the beginning can be determined by tracing backwards the cost of 100 shares of Vaniteux at the original price, and then finding what that amount would have been in U.S. dollars.

Original investment (cost) of 100 shares in Vaniteux in euros: Original investment (cost) of shares in U.S. dollars, calculated at original spot rate: The rate of return on Hercule's investment, proceeds divided by initial investment: (Remember to subtract 1, the value of the initial investment, when calculating return.)

€ 1,725.00 $2,346.00 71.12%

Alternatively, the total return which Hercule could earn if he sold his shares now, can be calculated by finding compound rate of return of the change in the share price and the change in the value of the euro.

Percentage return = ( 1 + percent change in share price) x (1 + percent change in spot rate) - 1 Percentage return = ( 1 + .6423 ) x ( 1 + .0419 ) - 1 =

71.12%

Problem 4.4 Hercule Poirot and Vaniteux (B) Hercule Poirot chooses not to sell his shares at the time described in Problem 4.3. He waits, expecting the share price to rise further after the announcement of quarterly earnings. His expectations prove correct; the share price rises to €31.14 per share after the announcement. He now wishes to recalculate his returns. The current spot exchange rate is $1.3110=€1.00.

Assumptions Prices when Hercule purchased his shares Prices Hercule sees in the market today

Share Price 17.25 31.14

Exchange Rate ($=€1.00) 1.3600 1.3110

a. If Hercule sold his shares today, what is the percentage change in the share price he would receive?

Return = (P2 - P1) / (P1)

80.52%

b. What has been the percentage change in the value of euro versus the dollar over this same period?

Percentage change ($=€1.00) = ( S2 - S1 ) / (S1)

-3.60%

Note that the dollar has now actually appreciated versus the euro from Hercule's initial purchase date. This results in a negative percentage change in the value of the euro, and therefore a negative percentage change. c. What would be the total return Hercule would earn on his shares if he sold them at these rates?

If he sold his shares today, it would yield the following amount in euros: These euros would in turn be worth the following in U.S. dollars:

3,114.00 $4,082.45

The amount he invested in the beginning can be determined by tracing backwards the cost of 100 shares of Vaniteux at the original price, and then finding what that amount would have been in U.S. dollars.

Original investment (cost) of 100 shares in Vaniteux in euros: Original investment (cost) of shares in U.S. dollars, calculated at original spot rate: The rate of return on Hercule's investment, proceeds divided by initial investment: (Remember to subtract 1, the value of the initial investment, when calculating return.)

1,725.00 $2,346.00 74.02%

Alternatively, the total return which Hercule could earn if he sold his shares now, can be calculated by finding compound rate of return of the change in the share price and the change in the value of the euro.

Percentage return = ( 1 + percent change in share price) x (1 + percent change in spot rate) - 1 Percentage return = ( 1 + .8052 ) x ( 1 + -.0360 ) - 1 =

74.02%

Ironically, although the share price has risen considerably more, the fall in the value of the euro has offset that gain, resulting in nearly the identical same total return as in the previous problem.

Problem 4.5 Vaniteux's Returns ( C ) Using the same prices and exchange rates as in Problem 4.4, Hercule Poirot and Vaniteux (B), what would be the total return on the Vaniteux investment by Laurent Vuagnoux, a Paris-based investor?

Assumptions Prices when Hercule purchased his shares Prices Hercule sees in the market today

Share Price 17.25 31.14

Exchange Rate ($=€1.00) 1.3600 1.3110

There is no currency risk, therefore Laurent earns rate of return on the share price change, the capital gain on the Vaniteux shares alone.

Return = (P2 - P1) / (P1)

80.52%

Problem 4.6 Microsoft's Dividend Yield In January 2003, Microsoft announced that it would begin paying a dividend of $0.16 per share. Given the following share prices for Microsoft stock in the recent past, how would a constant dividend of $0.16 per share per year have changed the company’s average annual return to its shareholders over this period?

Date 1998 (January 2) 1999 (January 4) 2000 (January 3) 2001 (January 2) 2002 (January 2) 2003 (January 2)

$ $ $ $ $ $

Closing Share Price 131.13 141.00 116.56 43.38 67.04 53.72

$ $ $ $ $

a. Average annual shareholder return for the period is Return = (P2 - P1) / (P1) b. Average annaul shareholder return if Microsoft had paid a constant dividend: Return = (P2 - P1 + D) / (P1)

If Dividend Paid

Shareholder Return (without Div)

Shareholder Return (with Div)

0.16 0.16 0.16 0.16 0.16

7.53% -17.33% -62.78% 54.54% -19.87%

7.65% -17.22% -62.65% 54.91% -19.63%

-7.58%

-7.39%

Problem 4.7 Sasquatch Corporation (A) Dual classes of common stock are common in a number of countries. Assume that Sasquatch Corporation has the following capital structure at book value and that the A-shares have 15 votes per share and the B-shares have 3 votes per share:

Sasquatch Corporation Long-term debt Retained earnings Paid-in common stock: 1,000,000 A-shares Paid-in common stock: 3,000,000 B-shares Total long-term capital

Local Currency (millions) 250 350 200 600 1,400

Votes per Share

Total Votes

15.00 3.00

3,000 1,800 4,800

a. What proportion of the total long-term capital has been raised by the A-shares?

A-shares/Total long-term capital

200/1,400

14.29%

3,000/4,800

62.50%

200/(200 + 600)

25.00%

b. What proportion of voting rights is represented by the A-shares?

A-share total votes/Total votes c. What proportion of the dividends should the A-shares receive?

A-shares in the local currency/Total equity shares in the local currency

Problem 4.8 Sasquatch Corporation (B) Assume all the same debt and equity values for Sasquatch Corporation in Problem 4.9, with the sole exception that both Ashares and B-shares have the same voting rights (5 votes per share).

Sasquatch Corporation Long-term debt Retained earnings Paid-in common stock: 1,000,000 A-shares Paid-in common stock: 3,000,000 B-shares Total long-term capital

Local Currency (millions) 250 350 200 600 1,400

Votes per Share

Total Votes

5.00 5.00

1,000 3,000 4,000

a. What proportion of the total long-term capital has been raised by the A-shares?

A-shares/Total long-term capital

200/1,400

14.29%

1,000/4,000

25.00%

200/(200 + 600)

25.00%

b. What proportion of voting rights is represented by the A-shares?

A-share total votes/Total votes c. What proportion of the dividends should the A-shares receive?

A-shares in the local currency/Total equity shares in the local currency

`

Problem 4.9 Transnational Corporation of Nigeria During the 1960s, many conglomerates were created by firms that were enjoying a high price to earnings ratio (P/E). These firms then used their highly valued stock to acquire other firms that had lower P/E ratios, usually in unrelated domestic industries. Conglomerates went out of fashion during the 1980s when their P/E ratios significantly declined, thus making it more difficult to find other firms with lower P/E ratios to acquire.

During the 1990s, the same acquisition strategy was possible for firms located in countries where high P/E ratios were common compared to firms in countries where low P/E ratios were common. Consider the two hypothetical firms shown in the following table: Market Total Number Value Market Company P/E ratio of Shares per Share (NGN) Earnings (NGN) EPS (NGN) Value (NGN) Julius Berger Nigeria Plc 7 20,000,000 20.00 60,000,000 3 400,000,000 Transnational Corporation of Nigeria 13 20,000,000 40.00 60,000,000 3 800,000,000 Transnational Corporation of Nigeria wants to acquire Julius Berger Nigeria Plc. For all of Julius Berger’s shares, it offers 7,500,000 shares of Transnational Corporation of Nigeria, with a current market value of 300,000,000, and a 12% premium on Julius Berger Nigeria Plc’s shares.

Rate of exchange -- Modern American shares offered: 7,500,000

a. How many shares would Transnational Corporation of Nigeria have outstanding after the acquisition of Julius Berger?

20,000,000 + 7,500,000

27,500,000

Because Julius Berger Nigeria Plc shares are worth ₦20 per share, they are only worth one-half the value per share of Transnational Corporation of Nigeria's ₦40 per share. Thus, on a straight exchange, 1 Transnational Corporation of Nigeria share is worth 2 Julius Berger Nigeria Plc shares. However, since the Transnational Corporation of Nigeria also needs to pay a premium for gaining control of Julius Berger Nigeria Plc, it pays 12% over the market additionally.

Therefore, the Transnational Corporation of Nigeria pays: 20,000,000/2 × (1 + 12% premium) b. What would be the consolidated earnings of the combined Transnational Corporation of Nigeria and Julius Berger Nigeria Plc? Transnational Corporation of Nigeria earnings + Julius Berger Nigeria Plc earnings

₦ 120,000,000

c. If the market continues to capitalize on Transnational Corporation of Nigeria’s earnings at a P/E ratio of 13, what would be the new market value of Transnational Corporation of Nigeria?

P/E × Consolidated earnings = 13 × ₦120,000,000

₦ 1,600,000,000

d. What would be the new earnings per share of the Transnational Corporation of Nigeria? ₦120,000,000/27,500,000 shares

₦ 4.36

e. What would be the new market value of a share of the Transnational Corporation of Nigeria?

New market value/Total shares outstanding = ₦1,600,000,000/27,500,000

₦ 58.18

f. How much would Transnational Corporation of Nigeria’s stock price increase?

The share price would increase to ₦58.18 from ₦4.36

₦ 18.18

Percentage increase

45.45%

g. Assume that the market takes a negative view of the acquisition and lowers the Transnational Corporation of Nigeria’s P/E ratio to 8.

What would be the new market price per share? What would be the percentage loss?

New market value = Total earnings × P/E = ₦20,000,000 × 8

₦ 960,000,000

New market price per share = Total market value/shares outstanding

₦ 34.91

Percentage loss to the original Transnational Corporation of Nigeria shareholders = (₦34.91 - ₦40.00)/(₦40.00)

-12.73%

Problem 4.10 Corporate Governance: Overstating Earnings A number of firms around the world have had to lower their previously reported earnings due to accounting errors or fraud. Assume that the Transnational Corporation of Nigeria (Problem 4.7) had to lower its earnings to ₦30,000,000 from the previously reported ₦60,000,000. What might be its new market value prior to the acquisition? Could it still go through the acquisition?

Company Julius Berger Nigeria Plc Transnational Corporation of Nigeria

P/E ratio

Number of Shares

Market Value per Share (NGN)

Earnings (NGN)

EPS (NGN)

Total Market Value (NGN)

7 13

20,000,000 20,000,000

20.00 20.00

60,000,000 30,000,000

3.00 1.50

400,000,000.00 400,000,000.00

If earnings were lowered to ₦30,000,000 from the previously reported ₦60,000,000, could the Transnational Corporation of Nigeria still make the acquisition?

To make the acquisition, the Transnational Corporation of Nigeria's shareholders need to be paid their market value plus a 12% premium At the new market rates for the Transnational Corporation of Nigeria, this would require an offer of ₦448,000,000/₦20 per share These 2,24,00,000 million shares would exceed Transnational Corporation of Nigeria's existing outstanding shares, effectively giving Julius Berger Nigeria Plc the control.

Therefore, the acquistion would probably not take place.

₦ 448,000,000 22,400,000 shares

Problem 4.11 Maori Beer (A): European Sales Maori Beer is a New Zealand-based brewery and files all of its financial statements in New Zealand dollars (NZD). The company’s European sales director, Kieran Barrett, has been criticized for his performance. He disagrees, arguing that sales in Europe have grown steadily in recent years. Who is correct?

Total net sales (in NZD) Percent of total sales from Europe Total European sales (in NZD) Average exchange rate (NZD/€) Total European sales (in €) Growth rate of European sales

2017 180,900 49% ________ 1.95 ________ ________

2018 195,275 43% ________ 1.85 ________ ________

2019 250,500 38% ________ 1.75 ________ ________

Analysis of European Sales Total net sales, NZD Percent of total sales from Europe Total European sales (in NZD)

2017 180,900 49% 88,641

2018 195,275 43% 83,968

2019 250,500 38% 95,190

Average exchange rate (NZD/€) Total European sales (€)

1.95 45,457

1.85 45,388

1.75 54,394

-0.2%

19.8%

Growth rate of European sales

The analysis of European sales indicates that when the reported NZD value of European sales is remeasured back in euros at the average exchange rate of NZD/€ each year, actual European sales shrunk in 2018 and grew in 2019. All things considered, when compared with sales in 2017, sales in 2019 did increase.

Problem 4.12 Maori Beer (B): Hong Kong Dollar Debt Maori Beer of New Zealand borrowed Hong Kong dollars under a long-term loan agreement several years ago. The company’s new CFO believes, however, that what was originally thought to have been relatively “cheap debt” is no longer true. What do you think?

Analysis of Hong Kong dollar-Denominated Debt 2017 Annual Hong Kong dollar payments on debt agreement (HKD) 90,000,000 Average exchange rate (HKD/NZD) 5.20

2018 90,000,000 5.10

2019 90,000,000 4.98

Annual Hong Kong dollar debt service (NZD)

17,647,059

18,072,289

17,307,692

The analysis of debt service payments on the Hong Kong-denominated, long-term loan indicates that for the past two years, the effective cost of repaying the loan in New Zealand dollars has been rising steadily, as the New Zealand dollar has fallen in value against the Hong Kong dollar. In fact, the Hong Kong dollar debt has not proven to be as cheap as thought.

Problem 4.13 Mattel's Global Sales Performance Mattel (U.S.) achieved significant sales growth in its major international regions between 2001 and 2004. In its filings with the United States Security and Exchange Commission (SEC), it reported both the amount of regional sales and the percentage change in those sales resulting from exchange rate changes..

Answer to a) Answer to b) (1) (2) (3) Percent Impact of Net 2001 2002 Change in Change in Change in (thousands of US$) Sales ($) Sales ($) Gross Sales Currency Rates Sales Europe $ 933,450 $ 1,126,177 20.6% 7.0% 13.6% Latin America 471,301 466,349 -1.1% -9.0% 7.9% Canada 155,791 161,469 3.6% 0.0% 3.6% Asia Pacific 119,749 136,944 14.4% 3.0% 11.4% Total International $ 1,680,291 $ 1,890,939 12.5% United States 3,392,284 3,422,405 0.9% Sales Adjustments (384,651) (428,004) 11.3% Total Net Sales $ 4,687,924 $ 4,885,340 4.2%

(thousands of US$) Europe Latin America Canada Asia Pacific Total International United States Sales Adjustments Total Net Sales

(thousands of US$) Europe Latin America Canada Asia Pacific Total International United States Sales Adjustments Total Net Sales

$

$

$

$

$

$

2002 Sales ($) 1,126,177 466,349 161,469 136,944 1,890,939 3,422,405 (428,004) 4,885,340

2003 Sales ($) 1,356,131 462,167 185,831 171,580 2,175,709 3,203,814 (419,423) 4,960,100

$

$

$

$

$

$

2003 Sales ($) 1,356,131 462,167 185,831 171,580 2,175,709 3,203,814 (419,423) 4,960,100

(1) Percent Change in Gross Sales 20.4% -0.9% 15.1% 25.3% 15.1% -6.4% -2.0% 1.5%

(2) Impact of Change in Currency Rates 15.0% -6.0% 11.0% 13.0%

(3) Net Change in Sales 5.4% 5.1% 4.1% 12.3%

2004 Sales ($) 1,410,525 524,481 197,655 203,575 2,336,236 3,209,862 (443,312) 5,102,786

(1) Percent Change in Gross Sales 4.0% 13.5% 6.4% 18.6% 7.4% 0.2% 5.7% 2.9%

(2) Impact of Change in Currency Rates 8.0% -2.0% 5.0% 6.0%

(3) Net Change in Sales -4.0% 15.5% 1.4% 12.6%

Note: The "net change in sales" by global region is determined by netting the change in currency rates from the calcualted percent change in gross sales. Column (3) = Column (1) + Column (2).

Answer to c) Over the 2001 to 2004 period, Mattel benefited greatly from the change in exchange rates. Only in the case of Latin America, where exchange rate changes were actually negative in impact on sales levels for the entire period, did the exchange rate changes not positively impact regional sales.

Problem 4.14 Idris Hydraulics and the Thai Baht Idris Hydraulics of Kuala Lumpur, Malaysia, purchases all of its hydraulic drills from manufacturers in Thailand. The company has recently completed a corporate-wide initiative in six sigma/lean manufacturing. Completed oil field hydraulic system costs were reduced by 5% over a one-year period, from MYR900,000 to MYR855,000. The company is now worried that all of the hydraulic drills that go into the systems (making up 30% of their total costs) will be hit by an increasingly stronger Thai baht due to the robust Thai economy. If the current exchange rate is THB7.18/MYR, how would a 14% revaluation of the Thai baht against the Malaysian ringgit impact total systems costs?

Assumptions Total system cost (MYR) Cost savings from six sigma/lean Total system cost (MYR) Hydraulic drill (% of total) Hydraulic drill (MYR)

Original/Current MYR 900,000.00 5.0% MYR 855,000.00 30.0% MYR 256,500.00

Revaluation?

Future?

MYR 292,410.00

A 14% revaluation of the Thai Bhat would be calculated as: THB7.18/(1 + % change) Exchange rate (THB/MYR) Hydraulic tubing (THB)

7.18 1,841,670.00

Cost increase as a result of revaluation Total system cost after revaluation

14.0%

6.30 1,841,670.00 MYR 35,910.00 MYR 890,910.00

a. The revaluation of the Thai Bhat by 14% would completely nullify all of the cost reduction benefits achieved via the six sigma/lean manufacturing initiatives recently completed. b. The percentage change in the cost of the total hydraulic system can be calculated by multiplying the percentage increase in the exchange rate times the percent of total cost made up by the hydraulic drill: Hydraulic drill (% of total) Percent revaluation of the Thai Bhat Total system cost impact (%) New total system cost (MYR) Old total system cost (MYR) Percent change

30.0% 14.0% 4.20% MYR 890,910.00 MYR 855,000.00 4.20%

Problem 4.15 Sydney Stock Exchange Equity Returns The Australian equity market has delivered very different returns over the past 90 years. Use the data from the table below to answer the following questions about these Australian equity investment returns: a. Which period shown had the highest and lowest total returns? b. Which decade had the highest dividend returns? When were dividends not a priority for publicly traded companies? c. The 1980s was a boom period for Australian equity returns. How did firms react in terms of their dividend distributions? d. How have the 2000s fared? How do you think publicly traded companies have started changing their dividend distribution habits as a result?

Sydney Stock Exchange Equity Returns, 1930–2019 (average annual return, %) Period Capital appreciation Dividend yield Total return

1930s -9.2% 5.1% -4.1%

1940s 8.0% 3.0% 11.0%

1950s 8.4% 2.5% 10.9%

1960s 7.2% 2.0% 9.2%

1970s 5.0% 2.2% 7.2%

1980s 20.3% 2.0% 22.3%

1990s 15.3% 1.5% 16.8%

2000s -5.5% 1.7% -3.8%

1930 to 2019 5.7% 3.5% 9.2%

a. Which period shown had the highest and lowest total returns?

The 1980s had the highest total returns and the 1930s had the lowest total returns. b. Which decade had the highest dividend returns? When were dividends not a priority for publicly traded companies?

Dividend returns were the highest in the 1930s. Since the 1980s, dividend yields seem to have been a lower priority. c. The 1980s was a boom period for Australian equity returns. How did firms react in terms of their dividend distributions?

Dividend distributions/yields were down during this period. d. How have the 2000s fared? How do you think publicly traded companies have started changing their dividend distribution habits as a result?

A negative return for 2000s shows significantly awful performance. Companies are finally increasing dividends now, as a result.

S&P 500 Equity Returns, 1926-2014 (average annual return, percent) Period Capital appreciation Dividend yield Total return

1930s -5.3% 5.4% 0.1%

1940s 3.0% 6.0% 9.0%

1950s 13.6% 5.1% 18.7%

1960s 4.4% 3.3% 7.7%

Source: Data drawn from "JP Morgan Guide to the Markets, 2015," JP Morgan Asset Management.

1970s 1.6% 4.2% 5.8%

1980s 12.6% 4.4% 17.0%

1990s 15.3% 2.5% 17.8%

2000s -2.7% 1.8% -0.9%

1926 to 2014 5.9% 4.0% 9.9%

Problem 5.1 Study Abroad: Paris to Moscow On your summer study abroad program in Europe you stay an extra two weeks to travel from Paris to Moscow. You leave Paris with 2,000 euros (EUR) in your belt pack. Wanting to exchange all of these for Russian rubles (RUB), you obtain the following quotes: Spot rate: EUR1.1280 = USD1.00 Spot rate: RUB62.40 = USD1.00 Assumptions Beginning your trip with euros (EUR) Spot rate: USD =EUR1.00 Spot rate: RUB=USD1.00

Values 15,000.00 1.1280 62.40

a. What is the Russian ruble to euro cross rate? b. How many rubles will you obtain for your euros? a) What is the Russian ruble/euro cross rate?

70.39 RUB per EUR = (RUB per USD) x (USD per EUR) b) How many rubles will you obtain for your euros?

RUB 1,055,808 Converting your euros into Rubles at RUB per EUR cross rate

Problem 5.2 Summer Abroad: Moscow to Mumbai After spending a week in Moscow, you get an email from your friend in India. He can get you a really good deal on a plane ticket and wants you to meet him in Mumbai next week to continue your global studies. You have RUB450,000 left in your money pouch. In preparation for the trip, you want to exchange your Russian rubles for Indian rupees at the Moscow airport: Assumptions Beginning your trip with rubles Spot rate: Russian rubles per US dollar or RUB/$ = 1.00 USD Spot rate: Indian rupee per US dollar or INR/$ = 1.00 USD

Values 450000 64.60 66.80

a. What is the Russian ruble to Indian rupee cross rate? b. How many Indian rupees will you obtain for your rubles? a) What is the Russian ruble to Indian rupee cross rate?

Rubles/rupee = Rubles/$ ÷ Rupee/$

0.9671

b) How many Indian rupees will you obtain for your rubles?

Converting your rubles into rupees

INR 465,325

Problem 5.3 Anne Dietz in Changi #3 (Singapore) Anne Dietz lives in Singapore, but is making her first business trip to Sydney, Australia. Standing in Singapore’s new terminal #3 at Changi Airport, she looks at the foreign exchange quotes posted over the FX trader’s booth. She wishes to exchange 1,000 Singapore dollars (S$ or SGD) for Australian dollars (A$ or AUD). What Anne sees: Spot rate: SGD1.34 = USD1.00 Spot rate: USD0.7640 = AUD1.00 a. What is the Singapore dollar to Australian dollar cross rate? b. How many Australian dollars will Anne get for her Singapore dollars?

Assumptions Singapore dollars to be exchanged Spot rate: SGD = USD1.00 Spot rate: USD = AUD1.00

Values SGD 1,000.00 1.3400 0.7640

a. What is the SGD per AUD cross rate?

1.0238 SGD per AUD = SGD per USD x USD per AUD b. How many Australian dollars will Anne get?

AUD 1,024 Converting SGD to AUD at the calculated cross rate.

Problem 5.4 Konbanwa Sushi (Japan) The Japanese sushi franchise, Konbanwa Sushi, will be receiving six payments of €2,500,000 starting now up to 12 months in the future. Since the company keeps cash balances in Japanese yen as well as U.S. dollars, it can choose which currency to exchange the euros for at the end of the various periods. Which currency appears to offer the better rates in the forward market?

Period Spot 1 month 2 months 3 months 6 months 12 months

Period Spot 1 month 2 months 3 months 6 months 12 months

Period Spot 1 month 2 months 3 months 6 months 12 months

Days Forward 30 60 90 180 360 Days Forward 30 60 90 180 360

Days Forward 30 60 90 180 360

¥/€ 0.0083 0.0084 0.0086 0.0088 0.0089 0.0090

¥/€ 120.4800 119.0500 116.2800 113.6300 112.3600 111.1100

USD/€ 1.1079 1.1100 1.1123 1.1151 1.1214 1.1337

USD/€ 1.1079 1.1100 1.1123 1.1151 1.1214 1.1337 Forward Premium on the ¥/€ -14.243% -20.916% -22.742% -13.479% -7.777%

Forward Premium on the USD/€ 2.275% 2.383% 2.600% 2.437% 2.329%

¥ Proceeds of € 2,500,000.00 301,200,000.00 297,625,000.00 290,700,000.00 284,075,000.00 280,900,000.00 277,775,000.00

Difference Over Spot -¥3,575,000.00 -¥10,500,000.00 -¥17,125,000.00 -¥20,300,000.00 -¥23,425,000.00

USD Proceeds of € 2,500,000.00 $2,769,750.00 $2,775,000.00 $2,780,750.00 $2,787,750.00 $2,803,500.00 $2,834,250.00

Difference Over Spot $5,250.00 $11,000.00 $18,000.00 $33,750.00 $64,500.00

The Japanese exporter will be receiving six payments of €2,500,000, ranging from now to 12 months in the future. Since the company keeps cash balances in Japanese yen and U.S. dollars, it can choose which currency to change the euros to at the end of the various periods. And since the company wishes to lock in the forward rate for each and every payment, the company should lock in forward rates in USD for all payments. Since the euro is selling forward at a discount against the Japanese yen and the euro is selling forward at a premium against the U.S. dollar, the resulting dollar proceeds are higher.

Problem 5.5 Japanese Yen Forward Use the following spot and forward bid-ask rates for the Japanese yen/U.S. dollar (¥/$) exchange rate from September 16, 2010, to answer the following questions: Period Spot 1 month 2 months 3 months 6 months 12 months 24 months

¥=$1.00 Bid Rate 85.41 85.02 84.86 84.37 83.17 82.87 81.79

¥=$1.00 Ask Rate 85.46 85.05 84.90 84.42 83.20 82.91 81.82

a. What is the mid-rate for each maturity? b. What is the annual forward premium for all maturities? c. Which maturities have the smallest and largest forward premiums?

Since the exchange rate quotes are indirect quotes on the dollar (¥/$), the proper forward premium calculation is: Forward premium = (Spot-Forward)/(Forward) × (360/days)

Period Spot 1 month 2 months 3 months 6 months 12 months 24 months

Days Forward 30 60 90 180 360 720

¥=$1.00 Bid Rate 85.41 85.02 84.86 84.37 83.17 82.87 81.79

¥=$1.00 Ask Rate 85.46 85.05 84.90 84.42 83.20 82.91 81.82

a.

Calculated Mid-Rate 85.43500 85.03500 84.88000 84.39500 83.18500 82.89000 81.80500

b.

Forward Premium 5.6447% 3.9232% 4.9292% 5.4096% 3.0703% 2.2187%

The forward rates progressively require fewer and fewer Japanese yen per dollar than the current spot rate. Therefore, the yen is selling forward at a premium and the dollar is selling forward at a discount. c. Which maturities have the smallest and largest forward premiums?

The 24-month forward rate has the smallest premium, while the 1-month forward possesses the largest premium.

Problem 5.6 Andreas Broszio (Geneva) Andreas Broszio just started as an analyst for Credit Suisse in Geneva, Switzerland. He receives the following quotes for Swiss francs (CHF) against the dollar (USD) for spot, 1 month forward, 3 months forward, and 6 months forward.

Spot exchange rate: Bid rate Ask rate One-month forward 3-months forward 6-months forward

CHF 1.2575=USD1.00 CHF 1.2585=USD1.00 10 to 15 14 to 22 20 to 30

a. Calculate outright quotes for bid and ask and the number of points spread between each. b. What do you notice about the spread as quotes evolve from spot toward 6 months? c. What is the 6-month Swiss bill rate?

Assumptions Spot exchange rate: Bid rate (CHF=USD1.00) Ask rate (CHF=USD1.00) One-month forward 3-months forward 6-months forward

Values 1.2575 1.2585 10 to 15 14 to 22 20 to 30

a. Calculate outright quotes One-month forward 3-months forward 6-months forward

Bid 1.2585 1.2589 1.2595

b. What do you notice about the spread?

It widens, most likely a result of thinner and thinner trading volume. c. Added/optional question: What is the 6-month Swiss bill rate?

Spot rate, midrate (SF/$) 1.2580 Six-month forward rate, midrate (SF/$) 1.2605 Maturity (days) 180 6-month US dollar treasury rate (yield) 4.200% Solving for implied SF interest rate 6.450% Check calculation: the six-month forward 1.2719

Ask 1.2600 1.2607 1.2615

Spread 0.0015 0.0018 0.0020

Problem 5.7 Swissie Triangular Arbitrage The following exchange rates are available to you. (You can buy or sell at the stated rates.)

Mt. Fuji Bank Mt. Rushmore Bank Mt Blanc Bank

¥92.00/$ SF1.02/$ ¥90.00/SF

Assume you have an initial SF12,000,000. Can you make a profit via triangular arbitrage?

If so, show the steps and calculate the amount of profit in Swiss francs (Swissies).

Assumptions Beginning funds in Swiss francs (SF) Mt. Fuji Bank (yen/$) Mt. Rushmore Bank (SF/$) Matterhorn Bank (yen/SF) Try Number 1: Start with SF to $ Step 1: SF to $ Step 2: $ to yen Step 3: yen to SF Profit?

Try Number 2: Start with SF to yen Step 1: SF to yen Step 2: yen to $ Step 3: $ to SF Profit?

Values 12,000,000.00 92.00 1.0200 90.00

11,764,705.88 1,082,352,941.18 12,026,143.79 26,143.79 A profit.

1,080,000,000.00 11,739,130.43 11,973,913.04 (26,086.96) A loss.

Problem 5.8 Asian Pacific Crisis (1997) The Asian financial crisis which began in July 1997 wreaked havoc throughout the currency markets of East Asia. a. Which of the currencies in the table had the largest depreciations or devaluations during the July to November period? b. Which seemingly survived the first five months of the crisis with the least impact on their currencies?

Country China Hong Kong Indonesia Korea Malaysia Philippines Singapore Taiwan Thailand

Currency yuan dollar rupiah won ringgit peso dollar dollar baht

July 1997 (currenc per USD) 8.40 7.75 2,400 900 2.50 27 1.43 27.80 25.0

November 1997 (currenc per USD) 8.40 7.73 3,600 1,100 3.50 34 1.60 32.70 40.0

Part a.

Percentage Change vs dollar 0.0% 0.3% -33.3% -18.2% -28.6% -20.6% -10.6% -15.0% -37.5%

Part b.

The Chinese yuan's value against the US dollar, as a result of the Chinese government maintaining its peg to the dollar, did not change at all during the crisis. The Thai baht, however, fell 37.5% in only five months, with the Indonesian rupiah a close second with a loss of 33.3%.

n in July 1997 wreaked havoc throughout the currency markets of East Asia.

Problem 5.9 Vienna Corporate Treasury A corporate treasury working out of Vienna, with operations in New York, simultaneously calls Citibank in New York City and Barclays in London.

The two banks give the following quotes on the euro at the same time: Citibank NYC Bid: USD0.7551=EUR1.00 Ask: USD0.7561=EUR1.00

Barclays London Bid: USD0.7545=EUR1.00 Ask: USD0.7575=EUR1.00

Using $1,000,000 or its euro equivalent, show how the corporate treasury could make geographic arbitrage profit with the two exchange rate quotes.

Assumptions Beginning funds

$

Citibank, NYC, quotes: Bid ($/€) Ask ($/€) Barclays, London, quotes: Bid ($/€) Ask ($/€)

Values 1,000,000.00

0.7551 0.7561 0.7545 0.7575

Arbitrage Strategy #1 Initial investment $ Buy euros from Barclays (at the ask rate) Sell euros to Citibank (at the bid rate) $ Arbitrage profit (loss) $

1,000,000.00 € 1,320,132.01 996,831.68 (3,168.32)

Arbitrage Strategy #2 Initial investment $ Buy euros from Citibank (at the ask rate) Sell euros to Barclays (at the bid rate) $ Arbitrage profit (loss) $

1,000,000.00 € 1,322,576.38 997,883.88 (2,116.12)

The arbitrager cannot make a profit using these quotes.

Problem 5.10 Bloomberg Cross Rates Use the table from Bloomberg below to calculate each of the following: Currency HKD AUD CAD CHF GBP JPY EUR USD

USD 7.8402 1.4669 1.307 0.9952 0.7802 108.75 0.9027

a. Japanese yen per U.S. dollar? b. U.S. dollars per Japanese yen? c. U.S. dollars per euro? d. Euros per U.S. dollar? e. Japanese yen per euro? f. Euros per Japanese yen? g. Canadian dollars per U.S. dollar? h. U.S. dollars per Canadian dollar? i. Australian dollars per U.S. dollar? j. U.S. dollars per Australian dollar? k. British pounds per U.S. dollar? l. U.S. dollars per British pound? m. U.S. dollars per Swiss franc? n. Swiss francs per U.S. dollar?

EUR 8.6854 1.6251 1.4479 1.1025 0.8643 120.4732 1.1078

JPY 0.0721 0.0135 0.012 0.0092 0.0072 0.0083 0.0092 Quote 108.75 0.0092 1.1078 0.9027 120.4732 0.0083 1.307 0.7651 1.4669 0.6818 0.7802 1.2818 1.0047 0.9952

GBP 10.0497 1.88 1.6753 1.2758 139.3958 1.157 1.2818 Calculated 0.0092 0.9027 0.0083 0.7651 0.6817 1.2817 0.9953

CHF 7.8773 1.4736 1.3132 0.7838 109.2635 0.9069 1.0047

CAD 5.9987 1.1222 0.7615 0.5969 83.2058 0.6906 0.7651

AUD 5.3455 0.8911 0.6786 0.5319 74.1457 0.6154 0.6818

HKD 0.1871 0.1667 0.1269 0.0995 13.8706 0.1151 0.1275

Problem 5.11 Bid/Ask on Swiss Franc/Euro Forwards Use the following spot and forward bid-ask rates for the Swiss franc/euro (CHF/€) from October 28, 2019, to answer the following questions:

Period Spot 1 month 2 months 3 months 6 months 12 months 24 months

CHF/€ Bid Rate 1.1027 1.1030 1.1033 1.1038 1.1049 1.1068 1.1109

CHF/€ Ask Rate 1.1033 1.1035 1.1071 1.1042 1.1050 1.1068 1.1093

a. What is the mid-rate for each maturity? b. What is the annual forward premium for all maturities? c. Which maturities have the smallest and largest forward premiums?

Since the exchange rate quotes are direct quotes on the dollar (CHF/€), the proper forward premium calculation is: Forward premium = (F-S)/(S) × (360/days)

Period Spot 1 month 2 months 3 months 6 months 12 months 24 months

Days Forward 30 60 90 180 360 720

CHF/€ Bid Rate 1.1027 1.1030 1.1033 1.1038 1.1049 1.1068 1.1109

CHF/€ Ask Rate 1.1033 1.1035 1.1071 1.1042 1.1050 1.1068 1.1093

a) Calculated Mid-rate 1.10300 1.10325 1.10520 1.10400 1.10495 1.10680 1.11010

b) Forward Premium 0.2720% 1.1967% 0.3626% 0.3536% 0.3445% 0.3218%

The forward rates progressively require more and more Swiss francs per euro than the current spot rate. Therefore, the Swiss franc is selling forward at a discount and the euro is selling forward at a premium. c) Which maturities have the smallest and largest forward premiums?

The 1-month forward rate has the smallest premium, while the 2-month forward possesses the largest premium.

Problem 5.12 Bid/Ask on Aussie Dollar Forward Use the following spot and forward bid-ask rates for the U.S. dollar to Australian dollar (USD = AUD1.00) exchange rate to answer the following questions

Period spot 1 month 2 months 3 months 6 months 12 months 24 months

US$/A$ Bid Rate 0.98510 0.98131 0.97745 0.97397 0.96241 0.93960 0.89770

US$/A$ Ask Rate 0.98540 0.98165 0.97786 0.97441 0.96295 0.94045 0.89900

a. What is the midrate for each maturity? b. What is the annual forward premium for all maturities? c. Which maturities have the smallest and largest forward premiums?

Since the exchange rate quotes are direct quotes on the dollar (US$/A$), the proper forward premium calculation is: Forward premium = ( Forward - Spot ) / (Spot) x (360 / days)

Period spot 1 month 2 months 3 months 6 months 12 months 24 months

Days Forward 30 60 90 180 360 720

US$/A$ Bid Rate 0.98510 0.98131 0.97745 0.97397 0.96241 0.93960 0.89770

US$/A$ Ask Rate 0.98540 0.98165 0.97786 0.97441 0.96295 0.94045 0.89900

a.

Calculated Mid-Rate 0.98525 0.98148 0.97766 0.97419 0.96268 0.94003 0.89835

b.

Forward Premium -4.5917% -4.6252% -4.4902% -4.5816% -4.5902% -4.4100%

The forward rates progressively require fewer and fewer US dollars per Australian dollar than the current spot rate. Therefore the US dollar is selling forward at a premium and the Australian dollar is selling forward at a discount. c. Which maturities have the smallest and largest forward premiums?

The 24 month forward rate has the smallest premium, while the 2 month forward possesses the largest premium.

Problem 5.13 Venezuelan Bolivar (A) The Venezuelan government officially floated the Venezuelan bolivar (Bs) in February 2002.

Within weeks, its value had moved from the pre-float fix of BS778 = $1.00 to Bs1025 = $1.00. a. Is this a devaluation or depreciation? b. By what percentage did its value change?

Assumptions Fixed rate of exchange, Bs=$1.00 New freely floating rate (2 weeks later), Bs=$1.00

Values 778 1,025

a. Is this a devaluation or depreciation?

This is a case in which a government has changed its currency from a governmentally determined fixed rate, to a regime in which the currency is allowed to change in value based on supply and demand forces in the market. As a result of the move, the currency's value in this case was a "depreciation" against the U.S. dollar.

Devaluation then Depreciation

b. By what percentage did its value change?

-24.10% Percentage devaluation is: % Chg = (S1 - S2) / (S2)

Problem 5.14 Venezuelan Bolivar (B) The Venezuelan political and economic crisis deepened in late 2002 and early 2003. On January 1, 2003, the bolivar was trading at Bs1400 = $1.00. By February 1, its value had fallen to Bs1950 = $1.00. Many currency analysts and forecasters were predicting that the bolivar would fall an additional 40% from its February 1 value by early summer 2003. a. What was the percentage change in January? b. What is the forecast value for June 2003?

Assumptions Exchange rate, January 1, 2003 (Bs=$1.00) Exchange rate, February 1, 2003 (Bs=$1.00) Forecast fall in value from Feb 1 to early summer, 2003

Values 1,400 1,950 -40.0%

a) What was the percentage change in January? % chg = (S1 - S2)/(S2)

-28.21%

b) What is forecast value for June 2003?

We are actually solving the equation for S2 (Bs=$1.00) S2 = (S1)/(1+%chg) = (1950)/(1-.40)

3,250

Problem 5.15 Indirect Forward Premium on the Australian Dollar Calculate the forward premium on the Australian dollar (the home currency) if the spot rate is €0.6151/AUD and the 3-month forward rate is €0.6216/AUD.

Assumptions Days forward European euro (€/AUD)

Quoted Spot rate € 0.6151

90-day Forward rate 90 € 0.6216

Percent premium or discount on euro

Calculation formula for the indirect quote on the dollar: Percent premium = (S-F)/(F) × (360/90)

-4.1828%

The euro would be selling forward at a premium against the Australian dollar or, equivalently, the Australian dollar is selling forward against the euro at a discount.

In a way, the terminology is a bit tricky. One might say that the “forward premium is a premium.”

Check calculation One way to check percentage change calculations is to invert each of the currency quotes (1/(€/AUD)) and recalculate the quote using the direct quotation formula.

Australian dollar (AUD/€) Percent discount = (F-S)/(S) × (360/90)

$1.6258

$1.6088 -4.1828%

Problem 5.16 Direct Forward Discount on the Dollar Calculate the forward discount on the dollar (the dollar is the home currency) if the spot rate is $1.5800 = £1.00 and the 6-month forward rate is $1.5550 = £1.00.

Assumptions Days forward Exchange rate, $ per pound

Quoted Spot rate $

1.5800

$

180-day Forward rate 180 1.5550

Percent premium or discount

Calculation formula for the direct quote on the dollar: -3.1646%

Percent premium = ( Forward - Spot ) / ( Spot ) x ( 360 / 180 )

The forward rate requires fewer US dollars in exchange for pounds than the current spot rate. The dollar is therefore selling forward at a premium against the pound (and the pound is simultaneously selling forward at a discount versus the US dollar).

Check calculation Inverting the quotes (pounds per dollar)

£0.6329

Percent forward premium = ( Spot - Forward ) / ( Forward ) x ( 360 / 180 )

£0.6431 -3.1646%

Problem 5.17 Great Pyramids Inspired by his recent trip to the Great Pyramids, Citibank trader Ruminder Dhillon wonders if he can make an intermarket arbitrage profit using Libyan dinars (LYD) and Saudi riyals (SAR). He has USD1,000,000 to work with so he gathers the following quotes. Is there an opportunity for an Citibank quotes U.S. dollar per Libyan dinar: National Bank of Kuwait quotes Saudi riyal per Libyan dinar: Barclay quotes U.S. dollar per Saudi riyal:

USD1.9324 = LYD1.00 SAR 1.9405 = LYD1.00 USD0.2667 = SAR1.00

Assumptions Citibank quotes U.S. dollar per Libyan dinar: National Bank of Kuwait quotes Saudi riyal per Libyan dinar: Barclay quotes U.S. dollar per Saudi riyal: Initial investment

Exchange rate 1.9324 1.9405 0.2667 USD 1,000,000.00

Path #1: US$ to riyals to dinars to US$ Start with USD Convert to riyals at Barclay quote Convert riyals to dinars at NatBank of Kuwait quote Convert dinars to USD at Citibank quote Arbitrage gain (loss)

USD 1,000,000.00 SAR 3,749,953.13 LYD 1,932,467.47 USD 3,734,300.14 USD 2,734,300.14

Path #2: US$ to dinars to riyals to US$ Start with USD Convert to dinars at Citibank quote Convert dinars to riyals at NatBank of Kuwait quote Convert riyals to USD at Barclay quote Arbitrage gain (loss)

USD 1,000,000.00 LYD 517,491.20 SAR 1,004,191.68 USD 267,787.79 (USD 732,212.21)

Triangular arbitrage path #1 yields a positive profit.

Problem 5.18 Mexican Peso–European Euro Cross Rate Calculate the cross rate between the Mexican peso (Ps) and the euro (€ ) from the following two spot rates: Ps12.45 = $1.00 and €0.7550 = $1.00.

Assumptions Mexican peso, pesos/dollar (Ps=$1.00) European euro, euros/dollar (€=$1.00) Calculated cross rate, Mexican pesos per euro

Exchange rate 12.45 0.7550 16.4901

Mexican pesos per euro = (Ps=$1.00) / (€=$1.00) or equivalently, euros per Mexican peso (€=Ps1.00)

0.0606

Problem 5.19 Pura Vida Calculate the cross rate between the Costa Rican colón (CRC) and the Canadian dollar (CAD) from the following spot rates: CRC500.29 = USD1.00 and CAD1.02 = Assumptions Costa Rican colón per US dollar (CRC=USD1.00) Canadian dollars per US dollar (CAD=USD1.00)

Exchange rate 500.29 1.0200

Calculated cross rate, Colon per Canadian dollar

490.4804

Colónes per Canadian dollar = (CRC=USD1.00) / (CAD=USD1.00) or equivalently, Canadian dollars per Cost Rican colón

0.0020

Problem 5.20 Around the Horn Assuming the following quotes, calculate how a market trader at Citibank with $1,000,000 can make an intermarket arbitrage profit.

Citibank quotes U.S. dollar per pound: National Westminster quotes euros per pound: Deutschebank quotes U.S. dollar per euro: Assumptions Citibank quotes U.S. dollar per pound: National Westminster quotes euros per pound: Deutschebank quotes U.S. dollar per euro: Initial investment Path #1: US$ to euros to pounds to US$ Start with US$ Convert to euros at Deutschebank quote Convert euros to pounds at NatWest quote Convert pounds to US$ at Citibank quote Arbitrage gain (loss) Path #2: US$ to pounds to euros to US$ Start with US$ Convert to pounds at Citibank quote Convert pounds to euros at NatWest quote Convert euros to US$ at Deutschebank quote Arbitrage gain (loss) Triangular arbitrage path #1 yields a positive profit.

$1.5900 = £1.00 €1.2000 = £1.00 $0.7550 = €1.00

$

$

$ $

$

$ $

Exchange rate 1.5900 1.2000 0.7550 1,000,000.00

1,000,000.00 € 1,324,503.31 £1,103,752.76 1,754,966.89 754,966.89

1,000,000.00 £628,930.82 € 754,716.98 569,811.32 (430,188.68)

Problem 5.21 Bangkok Obligation The Siam Cement Group of Bangkok borrowed EUR12.5 million for one year on February 14, 2020, short-term financing provided by a European customer. The interest rate was a low 6.500%. The problem, however, was that the exchange rate between the Thai baht (THB) and the euro (EUR) changed from THB33.860 = EUR1.00 on February 14, 2020 to THB36.327 = EUR1.00 on February 16, 2021, when the loan repayment was due. In the end, what was the interest rate paid by Siam Cement in its own currency, Thai Assumptions Loan principal (EUR) Loan interest rate, percent per annum Spot rate, February 14, 2020, THB=EUR1.00 Spot rate, February 16, 2021, THB=EUR1.00

Values 12,500,000.00 6.500% 33.860 36.327

What Siam Cement Group borrowed: Initial loan principal in euros Spot rate, Feb 14, 2020 (THB=EUR1.00) Initial loan principal in Thai baht

EUR 12,500,000.00 33.860 THB 423,250,000.000

What Siam Cement Group had to repay: Initial loan principal in euros Plus interest Principal and interest due on Feb 16, 2021 Spot rate, Feb 16, 2021 (THB=EUR1.00) Principal and interest due on Feb 16, 2021

EUR 12,500,000.00 812,500.000 EUR 13,312,500.00 36.327 THB 483,603,187.500

Effective rate of interest on EUR loan (Repayment in THB / Borrowed in THB) - 1

14.259%

Problem 6.1 Chile Copper Mining Group (Chile) Chile Copper Mining Group, headquartered in Santiago, Chile, is one of the largest copper mining firms in the world. On January 1, when the spot exchange rate is CLP930.25/£, the company borrows £3,00,00,000 from a London bank for one year at a 1.75% interest (Chilean banks had quoted 5.68% for an equivalent loan in Chilean pesos). During the year, the U.K. inflation rate is 2.1% and Chilean inflation rate is 4.71%. At the end of the year, the firm repays the pound loan. a. If Chile Copper Mining Group expected the spot rate at the end of one year to be equal to purchasing power parity, what would be the cost to Chile Copper Mining Group of its pound loan in Chilean peso-denominated interest? b. What is the real interest cost (adjusted for inflation) to Chile Copper Mining Group, in Chilean peso-denominated terms, of borrowing the pounds for one year, again, assuming purchasing power parity? c. If the actual spot rate at the end of the year turned out to be CLP900.15/£, what was the actual Chilean peso-denominated interest cost of the loan?

Borrowing principal (£) Current spot rate (CLP/£) Chilean inflation (actual) U.K. pound inflation (actual) PPP forecast of spot rate (CLP/£) Actual spot rate at the end of the year (CLP/£)

30,000,000 930.250 4.71% 2.10% 954.03 900.15

Ps $ Spot (PPP) = S * (1+π )/(1+π )

U.S. dollar borrowing rate (one year) 1.750% £30,000,000 ↓ ↓ ↓ ↓ ↓ Spot (CLP/£) 930.25 ↓ ↓ ↓ 27,907,500,000 Chilean pesos

→

→

1.0175

→

→

---------------> 360 days ---------------->

£30,525,000 ↓ ↓ ↓ ↓ ↓ EOY Spot (CLP/£) 954.03 ↓ ↓ 29,121,770,085 Chilean peso needed to repay pound loan

5.680% Quoted Chilean peso borrowing rate (one year) Implied cost = (Repaid/Initial proceeds)-1

4.351%

a. If the ending spot rate was CLP954.03/£ as PPP would predict, the actual peso-based interest cost would be 4.351%. b. The real peso-denominated interest cost (corrected for inflation) would be: The calculation shown at right is the precise or exact answer. The approximate form, found simply by subtracting inflation from nominal interest, would be 0.3589%.

Nominal interest Actual inflation Real peso-interest

4.3511% 4.7100% -0.3428%

b. If the actual end of year spot rate was CLP900.15/£ (just plug it into the spreadsheet for the EOY spot rate), the actual Chilean pesodenominated interest cost would be -1.542%. Yes, a negative interest rate.

Problem 6.2 Dalin's Luggage: Sydney to Denver Dalin Chen owns homes in Sydney, Australia, and Denver, United States. She travels between the two cities at least twice a year. Because of her frequent trips, she wants to buy some new highquality luggage. She has done her research and has decided to purchase a Briggs and Riley threepiece luggage set. There are retail stores in Denver and Sydney. Dalin was a finance major and wants to use purchasing power parity to determine if she is paying the same price regardless of where she makes her purchase. a. If the price of the three-piece luggage set in Denver is USD850 and the price of the same threepiece set in Sydney is AUD930, using purchasing power parity, is the price of the luggage truly equal if the spot rate is AUD1.0941 = USD1.00? b. If the price of the luggage remains the same in Denver one year from now, determine what the price of the luggage should be in Sydney in one year's time if PPP holds true. The U.S. inflation rate is 1.15%, and the Australian inflation rate is 3.13%.

Assumptions Price of 3-Piece Luggage set in USD Price of 3-Piece Luggage set in AUD Spot exchange rate, (AUD=USD1.00) US inflation for year (per annum) Australian inflation for year (per annum)

Value 850.00 930.00 1.0941 1.15% 3.13%

a. Is the spot rate accurate given both luggage prices?

Price of 3-Piece Luggage set in USD Price of 3-Piece Luggage set in AUD Spot rate as determined by PPP

850.00 930.00 1.0941

Spot rate = Price in AUD / Price in USD b. What should be the price of the luggage set in AUD in one year if PPP holds?

Beginning spot rate (AUD=USD1.00) Australian inflation US inflation PPP exchange rate Price of 3-Piece Luggage set in USD PPP exchange rate Price of 3-piece luggage set in Sydney (AUD) However, purchasing power parity is not always an accurate predictor of exchange rate movements, particularly in the short-term.

1.0941 3.13% 1.15% 1.1155 850.00 1.1155 948.19

Problem 6.3 Hyundai’s Pass-through Assume that the export price of a Hyundai Sonata from Seoul, South Korea, is KRW23,460,000. It exports the car to Malaysia. The exchange rate is KRW279.48/MYR. The forecast inflation rate in Malaysia is 2.0% per year and in South Korea, it is 1.5% per year. Use these data to answer the following questions on exchange rate pass-through. a. What was the export price for the Sonata at the beginning of the year when expressed in Malaysian ringgit? b. Assuming purchasing power parity holds, what should be the exchange rate at the end of the year? c. Assuming a 100% exchange rate pass-through, what will be the Malaysian ringgit price of a Sonata at the end of the year? d. Assuming a 60% exchange rate pass-through, what will be the Malaysian ringgit price of a Sonata at the end of the year?

Steps Initial spot exchange rate (KRW/MYR) Initial price of a Hyundai Sonata (KRW) Expected Malaysian ringgit inflation rate for the coming year Expected Korean won inflation rate for the coming year Rate of pass-through desired by Hyundai

Value 279.48 23,460,000 2.000% 1.500% 60.000%

a. What was the export price for the Sonata at the beginning of the year?

Year-beginning price of a Sonata (KRW) Spot exchange rate (KRW/MYR) Year-beginning price of a Sonata (MYR)

23,460,000 279.48 83,941.61

b. What is the expected spot rate at the end of the year assuming PPP? Initial spot rate (KRW/MYR) Expected Malaysian ringgit inflation Expected Korean won inflation Expected spot rate at end of year assuming PPP (KRW/MYR)

279.48 2.00% 1.50% 278.11

c. Assuming complete pass-through, what will the price be in MYR in one year?

Price of a Sonata at the beginning of the year (KRW) Korean won inflation over the year Price of a Sonata at the end of the year (KRW) Expected spot rate one year from now assuming PPP (KRW/MYR) Price of a Sonata at the end of the year (KRW)

23,460,000 1.500% 23,811,900 278.11 85,620.44

d. Assuming partial pass-through, what will be the price in MYR in one year?

Price of a Sonata at end of year (KRW) Amount of expected exchange rate change (from PPP, %) Proportion of exchange rate change passed-through by Hyundai Proportional percentage change Effective exchange rate used by Hyundai to price in Malaysian ringgit for the end of the year Price of a Sonata at the end of the year (MYR)

23,811,900 0.493% 60.000% 0.296% 278.656 85,452.55

Problem 6.4 Malaysian Island Resort Theresa Nunn is planning a 30-day vacation in Penang, Malaysia, one year from now. The present charge for a luxury suite plus meals in Malaysian ringgit is MYR1,045/day. The Malaysian ringgit presently trades at MYR3.1350/$. She figures the dollar cost today for a 30-day stay would be $10,000. The hotel informed her that any increase in its room charges will be limited to any increase in the Malaysian cost of living. Malaysian inflation is expected to be 2.75% per annum, while U.S. inflation is expected to be only 1.25%. a. How many dollars might Theresa expect to need one year hence to pay for her 30-day vacation? b. By what percent has the dollar cost gone up? Why? Assumptions Charge for suite plus meals in Malaysian ringgit (RM) Spot exchange rate (RM=$1.00) U.S. dollar cost today for a 30-day stay Expected Malaysian ringgit inflation rate Expected U.S. dollar inflation rate

Value 1,045.00 3.1350 $10,000.00 2.750% 1.250%

a. How many dollars might Theresa expect to need one year hence for her 30-day vacation?

Spot exchange rate (RM=$1.00) Expected Malaysian ringgit inflation rate Expected U.S. dollar inflation rate

3.1350 2.750% 1.250%

Spot (expected in 1 year) = Spot x ( 1 + RM inflation) / ( 1 + US inflation) Expected spot rate one year from now based on PPP (RM=$1.00)

3.181444

Hotel charges expected to be paid one year from now for a 30-day stay (RM)

32,212.13

US dollars needed on the basis of these two expectations:

$10,125.00

b. By what percent has the dollar cost gone up? Why? New dollar cost Original dollar cost Percent change in US$ cost

$10,125.00 $10,000.00 1.250%

The dollar cost has risen by the US dollar inflation rate. This is a result of Theresa's estimation of the future suite costs and the exchange rate changing in proportion to inflation (relative purchasing power parity).

Problem 6.5 Argentine Float The Argentine peso was fixed through a currency board at Ps1.00 = $1.00 throughout the 1990s.

In January 2002, the Argentine peso was floated. On January 29, 2003, it was trading at Ps3.20 = $1.00. During that one-year period, Argentina's inflation rate was 20% on an annualized basis.

Inflation in the United States during that same period was 2.2% annualized. a. What should have been the exchange rate in January 2003 if PPP held? b. By what percentage was the Argentine peso undervalued on an annualized basis? c. What were the probable causes of undervaluation?

Assumptions Spot exchange rate, fixed peg, early January 2002 (Ps=$1.00) Spot exchange rate, January 29, 2003 (Ps=$1.00) US inflation for year (per annum) Argentine inflation for year (per annum)

Value 1.0000 3.2000 2.20% 20.00%

a. What should have been the exchange rate in January 2003 if PPP held?

Beginning spot rate (Ps=$1.00) Argentine inflation US inflation PPP exchange rate

1.00 20.00% 2.20% 1.17

b. By what percentage was the Argentine peso undervalued on an annulized basis?

Actual exchange rate (Ps=$1.00) PPP exchange rate (Ps=$1.00) Percentage overvaluation (positive) or undervaluation (negative)

3.20 1.17 -63.307%

c. What were the probable causes of undervaluation?

The rapid decline in the value of the Argentine peso was a result of not only inflation, but also a severe crisis in the balance of payments (see Chapter 4).

Problem 6.6 Caleb Fajardo and Yen-Dollar Parity Caleb Fajardo is attempting to determine whether U.S./Japanese financial conditions are at parity. The current spot rate is a flat ¥89.00 = $1.00, while the 360-day forward rate is ¥84.90 = $1.00. Forecast inflation is 1.100% for Japan, and 5.900% for the United States. The 360-day euroyen deposit rate is 4.700%, and the 360-day eurodollar deposit rate is 9.500%. a. Diagram and calculate whether international parity conditions hold between Japan and the United States. b. Find the forecasted change in the Japanese yen to U.S. dollar (¥ = $1.00) exchange rate one year from now.

Assumptions Forecast annual rate of inflation for Japan Forecast annual rate of inflation for United States One-year interest rate for Japan One-year interest rate for United States Spot exchange rate (¥=$1.00) One-year forward exchange rate (¥=$1.00)

Value 1.100% 5.900% 4.700% 9.500% 89.00 84.90

a.

Approximate Form

Forward rate as an unbaised predictor (E) ↕ ↕ ↕ ↕

↔

↔

Forecast change in spot exchange rate 4.8% (Dollar expected to weaken) ↕ ↕ ↕ ↕ ↕ International Fisher Effect (C) ↕ ↕ ↕ ↕

Forward premium on foreign currency 4.8% (Japanese yen at a premium) ↕ ↕ ↕ Interest rate parity (D)

↔

↔

↔

Difference in nominal interest rates -4.8% (higher in United States)

↔

Purchasing power parity (A) ↕ ↕ ↕ ↕

Forecast difference in rates of inflation -4.8% (US higher than Japan) ↕ ↕ ↔

↔

Fisher effect (B)

As is the always the case with parity conditions, the future spot rate is implicitly forecast to be equal to the forward rate, the implied rate from the international Fisher effect, and the rate implied by purchasing power parity. According to Yazzie's calculations, the markets are indeed in equilibrium -- parity.

b.

Spot exchange rate (¥=$1.00) One-year forward exchange rate (¥=$1.00) Forcasted change in exchange rates

89.00 84.90 4.8%

(Current Spot Rate - Forward Exchange Rate) / (Forward Exchange Rate)

Problem 6.7 Trans-Atlantic Quotes Separated by more than 3,000 nautical miles and five time zones, money and foreign exchange markets in both London and New York are very efficient. The following information has been collected from the respective areas: Assumptions Spot exchange rate (USD=EUR1.00) 1-year Treasury bill rate Expected inflation rate

London 1.3264 3.900% Unknown

New York 1.3264 4.500% 1.250%

a. What do the financial markets suggest for inflation in Europe next year? b. Estimate today's one-year forward exchange rate between the dollar and the euro.

a. What do the financial markets suggest for inflation in Europe next year?

According to the Fisher effect, real interest rates should be the same in both Europe and the US. Since the nominal rate = [ (1+real) x (1+expected inflation) ] - 1: 1 + real rate = (1 + nominal) / (1 + expected inflation) 1 + nominal rate 1 + expected inflation So 1 + real = and therefore the real rate in the US is:

103.900% ?

103.210%

The expected rate of inflation in Europe is then:

0.669%

←

b. Estimate today's 1-year forward exchange rate between the dollar and the euro.

Spot exchange rate (USD=EUR1.00) US dollar one-year Treasury bill rate European euro one-year Treasury bill rate 1 year forward rate (USD=EUR1.00)

1.3264 4.500% 3.900% 1.3341

104.500% 101.250% 103.210% 3.210%

Problem 6.8 Starbucks (Croatia) Starbucks opened its first store in Zagreb, Croatia, in October 2010. In Zagreb, the price of a tall vanilla latte is 25.70 Croatian kuna (kn). In New York City, the price of a tall vanilla latte is $2.65. The exchange rate bewteen Croatian kuna and U.S. dollars is kn5.6288 = $1.00.

According to purchasing power parity, is the Croatian kuna overvalued or undervalued?

Assumptions Spot exchange rate (kn=$1.00) Price of vanilla latter in Zagreb (kn) Price of vanilla latter in NYC ($) Actual price of Croatian latte in $ Implied PPP of Croatian latte in $ Percentage overvaluation (positive) or undervaluation (negative)

Value 5.6288 25.70 2.65 4.57 9.70 112.408%

Problem 6.9 Kamada: CIA Japan (A) Takeshi Kamada, a foreign exchange trader at Credit Suisse (Tokyo), is exploring covered interest arbitrage possibilities. He wants to invest $5,000,000 or its yen equivalent, in a covered interest arbitrage between U.S. dollars and Japanese yen. He faced the following exchange rate and interest rate quotes. Is CIA profit possible? If Value $5,000,000 118.60 117.80 4.800% 3.400%

Assumptions Arbitrage funds available Spot rate (¥=$1.00) 180-day forward rate (¥=$1.00) 180-day U.S. dollar interest rate 180-day Japanese yen interest rate

Yen Equivalent 593,000,000

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates ( i ¥ - i $) Forward premium on the yen CIA profit potential

-1.400% 1.358% -0.042%

This tells Takeshi Kamada that he should borrow yen and invest in the higher yielding currency, the U.S. dollar, to lock-in a covered interest arbitrage (CIA) profit.

U.S. dollar interest rate (180 days) 4.800% $

5,000,000 ↑ ↑ ↑ ↑ ↑ Spot (¥=$1.00) 118.60 ↑ ↑ ↑ 593,000,000.00 Japanese yen START

→

→

1.0240

→

→

---------------> 180 days ---------------->

→

→

1.0170

→

3.400% Japanese yen interest rate (180 days)

→

$

5,120,000 ↓ ↓ ↓ ↓ ↓ Forward-180 (¥=$1.00) 117.80 ↓ ↓ 603,136,000 603,081,000 55,000 END

Takeshi Kamada generates a CIA profit by investing in the higher interest rate currency, the dollar, and simultaneously selling the dollar proceeds forward into yen at a forward premium which does not completely negate the interest differential.

Problem 6.10 Kamada: UIA Japan (B) Takeshi Kamada, Credit Suisse (Tokyo), observes that the yen–dollar spot rate has been holding steady, and both dollar and yen interest rates have remained relatively fixed over the past week. Takeshi wonders if he should try an uncovered interest arbitrage (UIA) and thereby save the cost of forward cover. Many of Takeshi's research associates -- and their computer models -- are predicting the spot rate to remain close to ¥118.00 = $1.00 for the coming 180 days. Using the same data as in Problem 6.9, analyze the UIA potential.

Assumptions Arbitrage funds available Spot rate (¥=$1.00) 180-day forward rate (¥=$1.00) Expected spot rate in 180 days (¥=$1.00) 180-day U.S. dollar interest rate 180-day Japanese yen interest rate

Value $5,000,000 118.60 117.80 118.00 4.800% 3.400%

Yen Equivalent 593,000,000

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates ( i ¥ - i $) Expected gain (loss) on the spot rate UIA profit potential

-1.400% 1.017% -0.383%

This tells Takeshi Kamada that he should borrow yen and invest in the higher yielding currency, the U.S. dollar, to potentially gain on an uncovered basis (UIA).

U.S. dollar interest rate (180 days) 4.800% $5,000,000 ↑ ↑ ↑ ↑ ↑ Spot (¥=$1.00) 118.60 ↑ ↑ ↑ 593,000,000.00 Japanese yen START

→

→

1.0240

→

→

---------------> 180 days ---------------->

→

→

1.0170

→

3.400% Japanese yen interest rate (180 days)

→

$5,120,000 ↓ ↓ ↓ ↓ Expected Spot Rate in 180 days (¥=$1.00) 118.00 ↓ ↓ 604,160,000 603,081,000 1,079,000 END

a) Takeshi Kamada generates an uncovered interest arbitrage (UIA) profit of ¥1,079,000 if his expectations about the future spot rate, the one in effect in 180 days, prove correct. b) The risk Takeshi is taking is that the actual spot rate at the end of the period can theoretically be anything, better or worse for his speculative position. He in fact has very little "wiggle room," as they say. A small movement will cost him a lot of money. If the spot rate ends up any stronger than about ¥117.79=$1.00 (a smaller number), he will lose money. (Verify by inputting ¥117.70=$1.00 in the expected spot rate cell under assumptions.)

Problem 6.11 Chamonix Rentals You are planning a ski vacation to Mt. Blanc in Chamonix, France, one year from now. You are negotiating over the rental of a chateau. The chateau's owner wishes to preserve his real income against both inflation and exchange rate changes, and so the present weekly rent of €9,800 (Christmas season) will be adjusted upward or downward for any change in the French cost of living between now and then. You are basing your budgeting on purchasing power parity (PPP).

French inflation is expected to average 3.5% for the coming year, while U.S. dollar inflation is expected to be 2.5%. The current spot rate is $1.3620 = €1.00. What should you budget as the U.S. dollar cost of the 1-week rental?

Assumptions Spot exchange rate ($=€1.00) Expected US inflation for coming year Expected French inflation for coming year Current chateau nominal weekly rent (€)

Value $1.3620 2.500% 3.500% € 9,800.00

Forecasting the future rent amount and exchange rate:

Value

Purchasing power parity exchange rate forecast ($=€1.00)

1.3488

Spot (one year) = Spot x ( 1 + US$ inflation ) / ( 1 + French inflation ) Nominal monthly rent, in euros, one year from now

€ 10,143.00

Rent now x ( 1 + inflation France ) Cost of rent one year from now in US dollars

$

13,681.29

Rent one year from now in USD = Rent inflated x PPP forecasted spot rate Note: students may inquire as to whether the euro, a currency for a multitude of countries which may actually have substantial differencies in inflation locally, really will react to inflationary pressures and differentials as PPP would predict. A good question.

Problem 6.12 Copenhagen Covered (A) Heidi Høi Jensen, a foreign exchange trader at JPMorgan Chase, can invest $5 million or the Danish kroner (kr) equivalent, of the bank’s short-term funds in a covered interest arbitrage with Denmark. Using the following quotes, can Heidi make a covered interest arbitrage (CIA) profit?

Assumptions Arbitrage funds available Spot exchange rate (kr=$1.00) 3-month forward rate (kr=$1.00) US dollar 3-month interest rate Danish kroner 3-month interest rate

Value $5,000,000 6.1720 6.1980 3.000% 5.000%

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates (ikr - i$) Forward discount on the krone CIA profit potential

2.000% -1.678% 0.322%

This tells Heidi Høi Jensen that he should borrow dollars and invest in the higher yielding currency the Danish kroner, for CIA profit.

U.S. dollar interest rate (3-month) 3.000%

START $

5,000,000.00 ↓ ↓ ↓ ↓ ↓ Spot (kr=$1.00) 6.1720 ↓ ↓ ↓ kr 30,860,000.00

→

→

1.0075

→

END →

---------------> 90 days ---------------->

→

→

1.0125

→

→

$

5,037,500.00 5,041,263.31 $ 3,763.31 ↑ ↑ ↑ Forward-90 (kr=$1.00) 6.1980 ↑ ↑ ↑ kr 31,245,750.00

5.000% Danish kroner interest (3-month)

Heidi Høi Jensen generates a covered interest arbitrage (CIA) profit because she is able to generate an even higher interest return in Danish kroner than she "gives up" by selling the proceeds forward at the forward rate.

Problem 6.13 Copenhagen Covered (B) Heidi Høi Jensen is now evaluating the arbitrage profit potential in the same market after interest rates change.

(Note that anytime the difference in interest rates does not exactly equal the forward premium, it must be possible to make CIA profit one way or another.)

Assumptions Arbitrage funds available Spot exchange rate (kr=$1.00) 3-month forward rate (kr=$1.00) US dollar 3-month interest rate Danish kroner 3-month interest rate

Value $5,000,000 6.1720 6.1980 4.000% 5.000%

kr Equivalent kr 30,860,000

a) a)

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates (ikr - i$) Forward discount on the krone CIA profit potential

1.000% -1.678% -0.678%

This tells Heidi that she should borrow Danish kroner and invest in the LOWER interest rate currency, the dollar, gaining on the re-exchange of dollars for kroner at the end of the period.

U.S. dollar interest rate (3-month) 4.000% $

5,000,000.00 ↑ ↑ ↑ ↑ ↑ Spot (kr=$1.00) 6.1720 ↑ ↑ ↑ kr 30,860,000.00

START

→

→

1.0100

→

→

---------------> 90 days ---------------->

→

→

1.0125

→

5.000% Danish kroner interest (3-month)

→

$

5,050,000.00 ↓ ↓ ↓ ↓ ↓ F-90 (kr=$1.00) 6.1980 ↓ ↓ kr 31,299,900.00 kr 31,245,750.00 kr 54,150.00 END

a) Heidi Høi Jensen generates a covered interest arbitrage profit of kr54,150 because, although U.S. dollar interest rates are lower, the U.S. dollar is selling forward at a premium against the Danish krone.

Problem 6.14 Copenhagen Covered (C) Heidi Høi Jensen is now evaluating the arbitrage profit potential in the same market after interest rates change.

(Note that anytime the difference in interest rates does not exactly equal the forward premium, it must be possible to make CIA profit one way or another.)

Assumptions Arbitrage funds available Spot exchange rate (kr=$1.00) 3-month forward rate (kr=$1.00) US dollar 3-month interest rate Danish kroner 3-month interest rate

Value $5,000,000 6.1720 6.1980 3.000% 6.000%

kr Equivalent kr 30,860,000

b) b)

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates (ikr - i$) Forward discount on the krone CIA profit potential

3.000% -1.678% 1.322%

This tells Heidi Høi Jensen that she should borrow US dollars and invest in the HIGHER interest rate currency, the kroner, gaining on the re-exchange of kroner for dollars at the end of the period.

U.S. dollar interest rate (3-month) 3.000% START $5,000,000 ↓ ↓ ↓ ↓ ↓ Spot (kr=$1.00) 6.1720 ↓ ↓ ↓ kr 30,860,000.00

→

→

1.0075

→

→

---------------> 90 days ---------------->

→

→

1.0150

→

→

END $ 5,037,500.00 $ 5,053,710.87 $ 16,210.87 ↑ ↑ ↑ F-90 (kr=$1.00) 6.1980 ↑ ↑ ↑ kr 31,322,900.00

6.000% Danish kroner interest (3-month)

b) If the Danish kroner interest rate increases to 6.00%, while the U.S. dollar interest rate stays at 3.00% and spot and forward rates remain the same, Heidi Høi Jensen's CIA profit is $16,210.87.

Problem 6.15 East Asiatic--Thailand The East Asiatic Company (EAC), a Danish company with subsidiaries all over Asia, has been funding its Bangkok subsidiary primarily with U.S. dollar debt because of the cost and availability of dollar capital as opposed to Thai baht-denominated (THB) debt. The treasuer of EAC-Thailand is considering a 1-year bank loan for USD250,000. The current spot rate is THB32.06 = USD1.00, and the dollar-based interest is 6.75% for the 1-year period. One year loans are 12.00% in baht. a. Assuming expected inflation rates for the coming year of 4.3% and 1.25% in Thailand and the United States, repectively, according to purchase power parity, what would the effective cost of funds be in Thai baht terms? b. If EAC's foreign exchange advisers believe strongly that the Thai government wants to push the value of the baht down against the dollar by 5% over the coming year (to promote its export competitiveness in dollar markets), what might be the effective cost of funds in baht terms? c. If EAC could borrow Thai baht at 13% per annum, would this be cheaper than either part (a) or part (b)?

Value 32.06 4.300% 1.250% $250,000 12.000% 6.750%

Assumptions Current spot rate, THB=USD1.00 Expected Thai inflation Expected dollar inflation Loan principal in U.S. dollars Thai baht interest rate, 1-year loan US dollar interest rate, 1-year loan

First, it is necessary to forecast the future spot exchange rate for the baht to dollar.

PPP forecast of THB=USD1.00

33.0258

Different expectations of the future spot exchange rate, either PPP for part a), or an expected devaluation for part b), allow the isolation of exactly how many Thai baht would be required to repay the dollar loan.

U.S. dollar borrowing rate (one year) 6.750% USD 250,000 ↓ ↓ ↓ ↓ ↓ Spot (THB=USD1.00) 32.0600 ↓ ↓ ↓ THB 8,015,000.00 Thai baht

→

→

1.06750

→

→

---------------> 360 days ---------------->

12.000% Thai baht borrowing rate (one year) Implied cost = (Repaid/Initial proceeds) - 1

USD 266,875 ↓ ↓ ↓ ↓ ↓ Expected Spot (THB=USD1.00) 33.0258 ↓ ↓ THB 8,813,760.38 Baht needed to repay U.S. dollar loan

9.966%

a) Assuming a purchasing power parity forecast of the future spot rate, THB33.0258=USD1.00, it will take 8,813,760 baht to repay the U.S. dollar loan. The implied cost of funds, in baht terms, is 9.966%. b) Assuming a future spot rate for the baht which is 5% weaker than the current spot rate (THB32.06/$ ÷ (1-.05)), THB33.7474/$, the implied cost is 12.369%. (This is found by plugging in this new forecast spot rate in the expected spot rate cell on the right-hand-side of the box.)

Current 32.0600 Pct Chg -5.00% New spot = old spot ÷ ( 1 - .05) Forecast 33.7474 c) Part a and part b are both cheaper than borrowing at 13.00%. However, both are highly risky given that the future spot rate is not known until a full year has passed.

Problem 6.16 Casper Landsten: CIA (A) Casper Landsten is a foreign exchange trader for a bank in New York. He has $10,00,000 (or its Swiss franc equivalent) for a short-term money market investment and wonders if he should invest in U.S. dollars for three months or make a covered interest arbitrage (CIA) investment in the Swiss franc. He faces the following quotes: Assumptions Arbitrage funds available Spot exchange rate (CHF=USD1.00) 3-month forward rate (CHF=USD1.00) U.S. dollar 3-month interest rate Swiss franc 3-month interest rate

Value USD 1,000,000 1.2810 1.2740 4.800% 3.200%

Swiss franc equivalent CHF 1,281,000

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates ( i CHF - i USD) Forward premium on the Swiss franc CIA profit potential

-1.600% 2.198% 0.598%

This tells Casper Landsten he should borrow U.S. dollars and invest in the lower-yielding currency, the Swiss franc, in order to earn CIA profits.

U.S. dollar interest rate (3-month) 4.800%

START USD 1,000,000 ↓ ↓ ↓ ↓ ↓ Spot (CHF=USD1.00) 1.2810 ↓ ↓ ↓ CHF 1,281,000

→

→

1.0120

→

END →

---------------> 90 days ---------------->

→

→

1.0080

→

→

USD 1,012,000 USD 1,013,538 USD 1,538.46 ↑ ↑ ↑ Forward-90 (CHF=USD1.00) 1.2740 ↑ ↑ ↑ CHF 1,291,248

3.200% Swiss franc interest rate (3-month)

a) Peder makes a net profit, a covered interest arbitrage profit, of USD1,538.46 on each million he invests in the Swiss franc market (by going around the box). He should therefore take advantage of it and perform covered interest arbitrage. b) Assuming a USD1 million investment for the 90-day period, the annual rate of return on this near risk-less investment is:

0.62%

Problem 6.17 Casper Landsten: UIA (B) Casper Landsten, using the same values and assumptions as in the previous question, now decides to seek the full 4.800% return available in U.S. dollars by not covering his forward dollar receipts—an uncovered interest arbitrage (UIA) transaction. Assess this decision.

Assumptions Arbitrage funds available Spot exchange rate (CHF=USD1.00) 3-month forward rate (CHF=USD1.00) Expected spot rate in 90 days (CHF=USD1.00) U.S. dollar 3-month interest rate Swiss franc 3-month interest rate

Value USD 1,000,000 1.2810 1.2740 1.2759 4.800% 3.200%

Swiss franc equivalent CHF 1,281,000

Since Casper is in the U.S. market (starting point), if he were to undertake uncovered interest arbitrage, he would first exchange dollars for Swiss francs, invest in the Swiss francs for 90 days, and then exchange the Swiss franc proceeds (principle and interest) back into U.S. dollars at whatever the spot rate of exchange is at that time. In this case Casper will have to—at least in his mind—make some assumption as to what the exchange rate will be at the end of the 90-day period.

START

USD 1,000,000 ↓ ↓ ↓ ↓ Spot (CHF=USD1.00) 1.2810 ↓ ↓ ↓ CHF 1,281,000

U.S. dollar interest rate (3-month) 4.800% →

→

1.0120

→

END

→

↑ ↑ ↑ Expected Spot (CHF=USD1.00) 1.2759 ↑ ↑

---------------> 90 days ---------------->

→

→

1.0080

→

USD 1,012,000 USD 1,012,029 USD 29.16

→

CHF 1,291,248

3.200% Swiss franc interest rate (three months)

If Casper assumed the spot rate at the end of 90 days would be the same as the current spot rate (CHF1.2810/$), the UIA transaction would not make much sense. The lower Swiss franc interest rate would yield final dollar proceeds of only $1,008,000—a full $4,000 less than simply investing in the U.S. (straight across the top of the box).

For a UIA transaction to result in higher dollar proceeds at the end of the 90-day period, the ending spot rate of exchange would have to be CHF1.2759/$ or less (a stronger and stronger Swiss franc resulting in more and more U.S. dollars when exchanged).

Should Casper do it? Well, depends on his bank’s policies on uncovered transactions and his beliefs about the future spot exchange rate.

But, given that he has invested in a foreign currency with a lower interest rate, not a higher one, so he is placing all of his “bets” on the exchange rate, it is not a speculation for the weak of heart.

Problem 6.18 Casper Landsten: Thirty Days Later One month after the events described in the previous two questions, Casper Landsten once again has $10,00,000 (or its Swiss franc equivalent) to invest for three months. He now faces the following rates. Should he enter into a covered interest arbitrage (CIA) investment again?

Assumptions Arbitrage funds available Spot exchange rate (CHF=USD1.00) 3-month forward rate (CHF=USD1.00) U.S. dollar 3-month interest rate Swiss franc 3-month interest rate

Value USD 1,000,000 1.3392 1.3286 4.750% 3.625%

Swiss franc equivalent CHF 1,339,200

Arbitrage rule of thumb: If the difference in interest rates is greater than the forward premium/discount, or expected change in the spot rate for UIA, invest in the higher interest-yielding currency. If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower interest-yielding currency.

Difference in interest rates ( i CHF - i USD) Forward premium on the Swiss france CIA profit

-1.125% 3.191% 2.066%

This tells Casper Landsten he should borrow U.S. dollars and invest in the lower-yielding currency, the Swiss franc, and then sell the Swiss francs (principal and interest) forward three months, locking in a CIA profit.

U.S. dollar interest rate (3-month) 4.750%

START USD 1,000,000 ↓ ↓ ↓ ↓ ↓ Spot (CHF=USD1.00) 1.3392 ↓ ↓ ↓ CHF 1,339,200

→

→

1.011875

→

END →

---------------> 90 days ---------------->

→

→

1.0090625

→

→

USD 1,011,875 USD 1,017,113 USD 5,238.13 ↑ ↑ ↑ F-90 (CHF=USD1.00) 1.3286 ↑ ↑ ↑ CHF 1,351,336.50

3.625% Swiss franc interest rate (three months)

Yes, Casper should undertake the CIA transaction, as it would yield a risk-less profit (exchange rate risk is eliminated with the forward contract but counterparty risk still exists if one of his counterparties failed to actually make good on their contractual commitments to deliver the forward or pay the interest) of $5,238.13 on each $10,00,000 invested.

Problem 6.19 Equinor's Corporate Arbitrage Equinor, the national oil company of Norway, is a large, sophisticated, and active participant in both the currency and petrochemical markets. Although it is a Norwegian company, because it operates within the global oil market, it considers the U.S. dollar, rather than the Norwegian krone (Nok), as its functional currency. Ari Karlsen is a currency trader for Equinor and has immediate use of either $3 million or the Norwegian krone equivalent. He is faced with the following market rates and wonders whether he can make some arbitrage profits in the coming 90 days.

Assumptions Arbitrage funds available Spot exchange rate (Nok=$1.00) 3-month forward rate (Nok=$1.00) U.S. dollar 3-month interest rate Norwegian krone 3-month interest rate

Value $3,000,000 6.0312 6.0186 5.000% 4.450%

Krone Equivalent 18,093,600

Arbitrage Rule of Thumb: If the difference in interest rates is greater than the forward premium/discount, or expected change in the spot rate for UIA, invest in the higher interest yielding currency. If the difference in interest rates is less than the forward premium (or expected change in the spot rate), invest in the lower yielding currency.

Difference in interest rates ( i Nok - i $) Forward premium on the krone CIA profit

-0.550% 0.835% 0.285%

This tells Ari Karlsen he should borrow U.S. dollars and invest in the lower yielding currency, the Norwegian krone, selling the dollars forward 90 days, and therefore earn covered interest arbitrage (CIA) profits.

Norwegian krone interest rate (3-month) 4.450% 18,093,600.00 ↑ ↑ ↑ ↑ ↑ Spot (Nok=$1.00) 6.0312 ↑ ↑ ↑ $3,000,000.00 Borrow US$

START

→

→

1.0111250

→

→

---------------> 90 days ---------------->

→

→

1.01250000

→

5.000% U.S. dollar interest rate (3-month)

→

18,294,891.30 ↓ ↓ ↓ ↓ ↓ Forward-90 (Nok=$1.00) 6.0186 ↓ ↓ $3,039,710.25 $3,037,500.00 $2,210.25

END

Ari Karlsen can make $2,210.25 for Statoil on each $3 million he invests in this covered interest arbitrage (CIA) transaction.

Note that this is a very slim rate of return on an investment of such a large amount.

Annualized rate of return:

0.2947%

Problem 6.20 Maltese Falcon: The Black Bird Imagine that the mythical solid gold falcon, initially intended as a tribute by the Knights of Malta to the King of Spain in appreciation for his gift of the island of Malta to the order in 1530, has recently been recovered. The falcon is 14 inches high and solid gold, weighing approximately 48 pounds. Assume that gold prices have risen to $440/ounce, primarily as a result of increasing political tensions. The falcon is currently held by a private investor in Istanbul, who is actively negotiating with the Maltese government on its purchase and prospective return to its island home. The sale and payment are to take place one year from now in March 2004, and the parties are negotiating over the price and currency of payment. The investor has decided, in a show of goodwill, to base the sales price only on the falcon's specie value – its gold value.

The current spot exchange rate is 0.39 Maltese lira (ML) per 1.00 U.S. dollar. Maltese inflation is expected to be about 8.5% for the coming year, while U.S. inflation, on the heels of a double-dip recession, is expected to come in at only 1.5%. If the investor bases value in the U.S. dollar, would he be better off receiving Maltese lira in one year (assuming purchasing power parity) or receiving a guaranteed dollar payment (assuming a gold price of $420 per ounce one year from now)?

Weight of falcon, in pounds Total number of ounces in weight Price of gold, $/ounce Falcon value based on price of gold

$ $

Now 48 768 440.00 337,920.00

$ $

In One Year 48 768 420.00 322,560.00

The purchasing power parity forecast of the Maltese lira/dollar exchange rate: Current spot rate, Maltese lira/$ Expected Maltese inflation Expected dollar inflation PPP forecast of Maltese lira/$

0.3900 8.500% 1.500% 0.4169

If the investor bases his gross sales proceeds in U.S. dollars, the guaranteed dollar payment at $420/ounce yields a larger amount ($322,560) than accepting Maltese lira assuming PPP ($316,116).

Current Value $337,920 ↓ ↓ ↓ ↓ ↓ Spot (ML=$1.00) 0.3900 ↓ ↓ ↓ 131,788.80 Maltese lira

---------------> 360 days ---------------->

Investor Receives in March 2004 Assuming PPP $ 316,116 ↑ ↑ ↑ ↑ ↑ Expected Spot (ML=$1.00) 0.4169 ↑ ↑ ↑ 131,788.80

Problem 6.21 African Beer Standard Years ago The Economist reported the creation of an index, or standard, for the evaluation of African currency values using the local prices of beer. Beer, instead of Big Macs, was chosen as the product for comparison because McDonald's had not peneterated the African continent beyond South Africa and beer met most of the same product and market characteristics required for the construction of a proper currency index. Investec, a South African investment banking firm, has replicated the process of creating a measure of purchasing power parity (PPP) like that of the Big Mac Index of The Economist , for Africa.

The index compares the cost of a 375-milliliter bottle of clear lager beer across Sub-Sahara Africa. As a measure of PPP, the beer needs to be relatively homogeneous in quality across countries and must possess substantial elements of local manufacturing, inputs, distribution, and service in order to actually provide a measure of relative purchasing power. The beer is first priced in local currency (purchased in the taverns of the locals, and not in the high-priced tourist centers). The price is then converted to South African rand and the rand-price compared to the local currency price as one measure of whether the local curency is undervaluded or overvalued versus the South African rand. Use the data in the table and complete the calculation of whether the individual currencies are undervalued or overvalued.

Country South Africa Botswana Ghana Kenya Malawi Mauritius Namibia Zambia Zimbabwe

Beer Castle Castle Star Tusker Carlsberg Phoenix Windhoek Castle Castle

Local currency Rand Pula Cedi Shilling Kwacha Rupee N$ Kwacha Z$

Beer Prices Local currency 2.30 2.20 1,200.00 41.25 18.50 15.00 2.50 1,200.00 9.00

Notes: 1. Beer price in South African rand = Price in local currency / spot rate on 3/15/99.

2. Implied PPP exchange rate = Price in local currency / 2.30.

3. Under or overvalued to rand = (Implied PPP rate / spot rate) - 1.

In rand ---2.94 3.17 4.02 2.66 3.72 2.50 3.52 1.46

Implied PPP rate ---0.96 521.74 17.93 8.04 6.52 1.09 521.74 3.91

Spot rate (3/15/99) ---0.75 379.10 10.27 6.96 4.03 1.00 340.68 6.15

Under or overvalued to rand (%) ---27.9% 37.6% 74.6% 15.6% 61.8% 8.7% 53.1% -36.4%

Problem 6.22 Volvo of Sweden’s XC90 Export Pricing Analysis Volvo Sweden, a leading auto manufacturer in Sweden, was scheduled to launch a new variant of the XC90 SUV in 2013 and was generating a complete pricing analysis of the car for sales in Sweden and export. The new variant of the XC90 would be initially priced at SEK6,19,900 in Sweden and if exported to Australia, the price would be AUD92,985 in Australian dollars at the current spot rate of SEK 6.65 = AUD 1.00. Volvo intends to raise the price domestically with the rate of Swedish inflation over time but is worried about how that compares to the export price given Australian dollar inflation and the future exchange rate. Use the following data table to answer the pricing analysis questions.

Calendar year XC90 price (SEK) Swedish inflation (forecast) Australian inflation (forecast) Exchange rate (SEK = AUD 1.00)

2013 619,900

2014

2015

2016

2017

2018

0.28% 2.51%

0.88% 1.51%

1.64% 1.25%

3.45% 1.97%

0.90% 1.96%

6.65

a. If the domestic price of the XC90 increases with the rate of inflation, what would be its price over the 2013–2018 period? b. Assuming the forecasts of Australian and Swedish inflation prove accurate, what would be the value of the Swedish krona over the coming years if its value versus the Australian dollar followed purchasing power parity? c. If the export price of the XC90 were set using the purchasing power parity forecast of the Swedish krona–Australian dollar exchange rate, what would the export price be over the 2013–2018 period? d. How would the XC90’s export price evolve over time if it followed Swedish inflation and the exchange rate of the Swedish krona versus the Australian dollar remained relatively constant over this period? e. Stefan, one of the newly hired pricing strategists, believes that prices of automobiles in both domestic and export markets will increase with the rate of inflation and that the Swedish krona–Australian dollar exchange rate will remain fixed. What would this imply or forecast for the future export price of the XC90? f. If you were Volvo, what would you hope to happen to the Swedish krona’s value versus the Australian dollar over time given your desire to export the XC90?

Now if you combined that “hope” with some assumptions about the competition—other automobile sales prices in Australian dollar markets over time—how might your strategy evolve? g. What did the Swedish krona end up doing over the 2013–2018 period?

Calendar year

2013

2014

2015

2016

2017

2018

a. XC90 price with Swedish inflation (SEK)

619,900

621,636

627,106

637,391

659,381

665,315

b. Exchange rate (SEK = AUD 1.00) if PPP holds

6.65

6.51

6.46

6.49

6.58

6.52

c. Export price if using PPP (AUD)

93,218.05

95,557.82

97,000.74

98,213.25

100,148.05

102,110.95

d. Export price at the fixed exchange rate (AUD)

93,218.05

93,479.06

94,301.67

95,848.22

99,154.98

100,047.38

An added note is to recognize that if this was the case, PPP is not “holding” in the academic sense. e. Stefan is not saying anything different than what questions (c) and (d) address. If the export price is based on the initial price of AUD93,218.05, then rising with dollar inflation, it reaches AUD102,110.95 in 2018 (same as (c)). Alternatively, if the pricing follows the price in the domestic market, Swedish krona, rising with Swedish inflation, reaches SEK665,315 in 2018 and when converted to Australian dollars at an assumed fixed rate of exchange of SEK 6.65 = AUD 1.00, it is AUD100,047.38, same as (d).

If the export price rises at Australian dollar inflation (AUD) 93,218.05

95,557.82

97,000.74

98,213.25

100,148.05

102,110.95 679,037.84

f. Exporters generally prefer that their currency weakens over time versus the currency of the customer—making their product increasingly affordable (cheaper) and increasing sales volume. Since Volvo’s costs are in Swedish krona, earning a hard currency like the Australian dollar, which would slowly weaken against the Swedish krona, might decrease profit margins, depending on what happens to costs over time from other factors.

If most of the competition in the target Australian markets were Australian dollar–based manufacturers, their costs and prices might be rising with Australian dollar inflation. The answers to (c) and (d) provide some ideas or possible boundaries on what you might consider. At fixed exchange rates, the Australian dollar price would rise quite high by 2018 (to AUD100,047.38), whereas if the rate of exchange had remained fixed, the export price would be much higher in 2018 (AUD102,110.95). Of course, pricing strategies can and should be changed over time with changing market conditions but the consensus of analysts would be to expect to increase at a rate somewhere between (c) and (d) forecasts.

Problem 6.23 Clayton Moore's Money Fund Clayton Moore is the manager of an international money market fund managed out of London. Unlike many money funds that guarantee their investors a near risk-free investment with variable interest earnings, Clayton Moore's fund is a very aggressive fund that searches out relatively high interest earnings around the globe, but at some risk. The fund is pound-denominated. Clayton is currently evaluating a rather interesting opportunity in Malaysia. Since the Asian Crisis of 1997, the Malaysian government enforced a number of currency and capital restrictions to protect and preserve the value of the Malaysian ringgit. The ringgit was fixeded to the U.S. dollar at RM3.80 = $1.00 for seven years. In 2005, the Malaysian government allowed the currency to float against several major currencies. The current spot rate today is RM3.1345 = $1.00. Local currency time deposits of 180-day maturities are earning 8.900% per annum. The London eurocurrency market for pounds is yielding 4.200% per annum on similar 180-day maturities. The current spot rate on the British pound is $1.5820=£1.00, and the 180-day forward rate is $1.5561=£1.00. What would you recommend Clayton do?

Assumptions Principal investment, British pounds Spot exchange rate ($=£1.00) 180-day forward rate ($=£1.00) Malaysian ringgit 180-day yield Spot exchange rate (RM=$1.00)

$ $

Values £1,000,000.00 1.5820 1.5561 8.900% 3.13450

The initial pound investment implicitly passes through the dollar into Malaysian ringgit. The ringgit is fixed against the dollar, hence the ending Malaysian ringgit=$1.00 rate is the same as the current spot rate. The pound, however, is not fixed to either the dollar or ringgit. Clayton Moore can purchase a forward against the dollar, allowing him to cover the dollar to pound exchange rate.

Return = (Proceeds/Initial investment) - 1 Initial Investment £1,000,000.00 ↓ ↓ ↓ ↓ Spot ($=£1.00) 1.5820 ↓ ↓ ↓ $1,582,000 ↓ ↓ ↓ ↓ Spot (RM=$1.00) 3.13450 ↓ ↓ ↓ 4,958,779.00 Malaysian ringgit

British pounds versus US dollars ---------------> 180 days ---------------->

U.S. dollar values

Malaysian ringgit versus US dollars ---------------> 180 days ---------------->

→

→

1.0445

→

→

6.188% Investment Proceeds £1,061,884.84 ↑ ↑ ↑ ↑ Fwd-180 ($=£1.00) 1.5561 ↑ ↑ ↑ $1,652,399 ↑ ↑ ↑ ↑ Expected Spot (RM=$1.00) 3.13450 ↑ ↑ ↑ 5,179,444.67 Ringgit proceeds

8.900% Malaysian ringgit deposit rate (180 days)

If Clayton Moore invests in the Malaysian ringgit deposit, and accepts the uncovered risk associated with the RM=$1.00 exchange rate (managed by the government), and sells the dollar proceeds forward, he should expect a return of 6.188% on his 180-day pound investment. This is better than the 4.200% he can earn in the euro-pound market.

Interestingly, if Clayton chose to NOT sell the dollars forward, and accepted the uncovered risk of the $=£1.00 exchange rate as well, he may or may not do better than 6.188%. For example, if the spot rate remained unchanged at $1.5820 = £1.00, Clayton's return would only be 4.450%. This demonstrates that much of the added return Clayton is earning is arising from the forward rate itself, and not purely from the nominal interest differentials.

Problem 7.1 Yize Chen at Sumatra Funds Yize Chen trades currencies for Sumatra Funds in Jakarta. She focuses nearly all of her time and attention on the U.S. dollar (USD) to Singapore dollar (SGD) cross-rate. The current spot rate is USD0.6000 = SGD1.00. After considerable study, she has concluded that the Singapore dollar will appreciate versus the U.S. dollar in the coming 90 days, probably to about USD0.7000 = SGD1.00. She has the following options on the Singapore dollar to choose from: Option Put on SGD Call on SGD

Strike Price USD0.6500=SGD1.00 USD0.6500=SGD1.00

Premium USD0.00003 per SGD USD0.00046 per SGD

a. Should Yize buy a put on Singapore dollars or a call on Singapore dollars? b. What is Yize's break-even price on the option purchased in part (a)? c. Using your answer from part (a), what is Yize's gross profit and net profit (including premium) if the spot rate at the end of 90 days is indeed USD0.7000 = SGD1.00? d. Using your answer from part (a), what is Yize's gross profit and net profit (including premium) if the spot rate at the end of 90 days is USD0.8000 = SGD1.00?

Option choices on the Singapore dollar: Strike price (USD=SGD1.00) Premium (USD per SGD)

Call on SGD USD 0.65 USD 0.00046

Assumptions Current spot rate (USD=SGD1.00) Days to maturity Expected spot rate in 90 days (USD=SGD1.00)

Values USD 0.6000 90 USD 0.7000

Put on SGD USD 0.65 USD 0.00003

a. Should Yize buy a put on Singapore dollars or a call on Singapore dollars?

Since Yize expects the Singapore dollar to appreciate versus the US dollar, she should buy a call on Singapore dollars. This gives her the right to BUY Singapore dollars at a future date at USD0.65 each, and then immediately resell them in the open market at USD0.70 each for a profit. (If her expectation of the future spot rate proves correct.) b. What is Yize's breakeven price on the option purchased in part a)?

Note this does not include any interest cost on the premium.

Strike price Plus premium Breakeven

Per S$ USD 0.6500 USD 0.0005 USD 0.65046

c. What is Yize's gross profit and net profit (including premium) if the ending spot rate is USD0.70?

Spot rate Less strike price Less premium Profit

Gross profit (USD=SGD1.00) USD 0.7000 -USD 0.6500 USD 0.0500

Net profit (USD=SGD1.00) USD 0.7000 -USD 0.6500 -USD 0.0005 USD 0.0495

d. What is Yize's gross profit and net profit (including premium) if the ending spot rate is USD0.80?

Spot rate Less strike price Less premium Profit

Gross profit (USD=SGD1.00) USD 0.8000 -USD 0.6500 USD 0.1500

Net profit (USD=SGD1.00) USD 0.8000 -USD 0.6500 -USD 0.0005 USD 0.1495

Problem 7.2 Hoffman Bank, Basel (A) Stefan Boerig trades currency for the Hoffman Bank in Basel, Switzerland. Stefan has 1,00,00,000 Swiss francs (CHF) to begin with, and he must state all profits at the end of any speculation while the 30-day forward rate is CHF1.1027/€. a. If Stefan believes the euro will continue to rise against the Swiss franc and expects the spot rate to be CHF1.1375/€ at the end of 30 days, what should he do? b. If Stefan believes the euro will depreciate against the Swiss franc and expects the spot rate to be CHF1.0925/€ at the end of 30 days, what should he do?

Assumptions Initial investment (funds available, CHF) 30-day forward rate (CHF/€) Expected spot rate in 30 days (CHF/€)

a.

Values 10,000,000.00 1.1027 CHF 1.1375 CHF

b.

Values 10,000,000.00 1.1027 CHF 1.0927 CHF

Strategy for (a) One of the more interesting dimensions of speculating in the forward market is that if the speculator has access to the forward market (bank lines or relationships when working on behalf of an established firm), many forward speculation strategies require no actual cash flow position up-front. In this case, Stefan believes the Swiss franc will be trading at CHF1.1375/€ in the open market at the end of 30 days but he can buy or sell Swiss francs at a forward rate of CHF1.1375/€. He should therefore buy euros forward 30 days (requires no actual cash flow up-front) and at the end of 30 days, take delivery of those euros and sell them in the spot market at the higher Swiss franc–rate for profit.

Initial investment principle (CHF) 30-day forward rate (CHF/€) Euros bought forward (investment/forward rate) Spot rate in the open market at end of 30 days (CHF/€) CHF proceeds (euros bought forward and exchanged into CHF on spot) Profit in CHF

10,000,000.00 1.1027 CHF 9,068,649.68 1.1375 CHF 10,315,589.01 315,589.01

Strategy for (b) Again, a profitable strategy can be executed without any actual cash flow changing hands at the beginning of the period. Since Stefan believes that the Swiss franc will strengthen to CHF1.0927 in 30 days, he should sell euros forward now at the higher Swiss franc–rate, wait 30 days, and buy the euros needed on the open market at CHF1.0925 and, then, immediately use those euros to fulfill his forward contract to sell euros for Swiss francs at CHF1.1027 for a profit.

Investment funds needed in 30 days (CHF) Spot rate in open market at end of 30 days (CHF/€) Euros bought in the open market in 30 days (investment/spot rate)

10,000,000.00 CHF 1.0927 9,151,642.72

Stefan had sold these euros forward at the start of the 30-day period.

30-day forward rate (CHF/€) CHF proceeds (euros sold forward and exchanged into CHF) Profit in CHF

1.1027 CHF 10,091,516.43 91,516.43

Problem 7.3 Hoffman Bank, Basel (B) Stefan Boerig of Hoffman Bank now believes that the Swiss franc will appreciate against the British pound in the coming 3-month period. He has £250,000 to invest. The current spot rate is £0.7829/CHF, the 3-month forward rate is £0.7640/CHF, and he expects the spot rates to reach £0.7995/CHF in three months. a. Calculate Stefan’s expected profit, assuming a pure spot market speculation strategy. b. Calculate Stefan’s expected profit, assuming he buys and sells Swiss francs three months forward.

Assumptions Initial investment (funds available, £) Current spot rate (£/CHF) 3-month forward rate (£/CHF) Expected spot rate in three months (£/CHF) Strategy for (a) 1. Use the £250,000 today to buy CHF at the spot rate (CHF) 2. Hold the CHF indefinitely 3. At the end of three months, convert CHF at the expected rate 4. Expected British pound revenues 5. Realize profit (revenues, less the initial investment, £) Strategy for (b) 1. Buy CHF forward six months (no cash outlay required) 2. Fulfill the six months forward in six months (CHF) Cost (£) 3. Convert the CHF into pounds at the expected spot rate (£) 4. Realize profit (£)

a.

Values 250,000.00 £0.7829 £0.7640 £0.7995

b.

Values 250,000.00 £0.7829 £0.7640 £0.7995

319,325.58 £0.7995 255,300.80 5,300.80

327,225.13 -250,000.00 261,616.49 11,616.49

Problem 7.4 Mariko Fujimoto at Sakura Bank Mariko Fujimoto, a currency trader for the Tokyo-based Sakura Bank, uses the following futures quotes on the British pound (£) to speculate on the value of the pound.

British pound futures, ¥/£ (CME) Maturity December, 2019 March, 2020

Open 139.8000 138.8000

High 140.8000 139.8000

Low 139.7000 138.9000

Settle 139.7500 139.3000

Change 0.0500 0.1000

a. If Mariko buys five March-pound futures, and the spot rate at maturity is ¥139.95/£, what is the value of her position? b. If Mariko sells twelve December-pound futures, and the spot rate at maturity is ¥138.90/£, what is the value of her position? c. If Mariko buys three December-pound futures, and the spot rate at maturity is ¥138.90/£, what is the value of her position? d. If Mariko sells twelve March-pound futures, and the spot rate at maturity is ¥139.95/£, what is the value of her position? a) Values 125,000 March 5 buys

b) Values 125,000 December 12 sells

c) Values 125,000 December 3 buys

d) Values 125,000 March 12 sells

Ending spot rate (¥/£) Pound futures contract, settle price (¥/£) Spot-Futures

¥139.9500 ¥139.9000 ¥0.0500

¥138.9000 ¥139.7500 -¥0.8500

¥138.9000 ¥139.7500 -¥0.8500

¥139.9500 ¥139.9000 ¥0.0500

Value of the position at maturity (¥) buys: Notional × (Spot-Futures) × Contracts sells: -Notional × (Spot-Futures) × Contracts

31,250.00

1,275,000.00

-318,750.00

-75,000.00

Assumptions Pounds (£) per futures contract Maturity month Number of contracts Did she buy or sell the futures?

Interpretation Buys a futures: Mariko buys at the futures price and sells at the ending spot price. She, therefore, profits when the futures price is less than the ending spot price.

Sells a future: Mariko buys at the ending spot price and sells at the futures price. She, therefore, profits when the futures price is greater than the ending spot price.

Contract = 125,000 pounds Open High Interest 140.4300 8,090 141.3000 4,300

Problem 7.5 Pratama Arhan Pratama Arhan, the currency investor we met earlier in the chapter, sells ten June futures contracts for 500,000 Indian Rupees (INR) at the closing price of INR 60 = SGD1.00. a. What is the value of her position at maturity if the ending spot rate is INR 65.5 = SGD1.00? b. What is the value of her position at maturity if the ending spot rate is INR 55.2 = SGD1.00? c. What is the value of her position at maturity if the ending spot rate is INR 61.1 = SGD1.00? a.

Values 500,000 10.00 sells

b.

Values 500,000 10.00 sells

c.

Values 500,000 10.00 sells

Ending spot rate (INR = SGD1.00) June futures settle price (INR = SGD1.00) Spot-Futures

65.50 60.00 5.50

55.20 60.00 (4.80)

61.10 60.00 1.10

Value of total position at maturity (INR) Value = -Notional × (Spot-Futures) × 10

(27,500,000.00)

24,000,000.00

(5,500,000.00)

Assumptions Number of Indian Rupees per futures contract (INR) Number of contracts Did she buy or sell the futures?

Interpretation Pratama buys at the spot price and sells at the futures price. If the futures price is greater than the ending spot price, she makes a profit.

Problem 7.6 Yoshi Mitsume Yoshi Mitsume writes a put option on Japanese yen with a strike price of €0.008000 = ¥1.00 (¥125.00 = €1.00) at a premium of 0.0080¢/yen, with an expiration date of six months from now. The option is for ¥12,500,000. What is Kiko’s profit or loss at maturity, if the ending spot rates are ¥110, ¥115, ¥120, ¥125, ¥130, ¥135, and ¥140 per euro?

Assumptions Notional principal (¥) Maturity (days) Strike price (€ = ¥1.00) Premium (€ = ¥1.00) Ending spot rate (¥ = €1.00) in € = ¥1.00 Gross profit on the option Less, premium Net profit (€ = ¥1.00) Total net profit (€)

a) Values 12,500,000 180 0.008000 0.000080

b) Values 12,500,000 180 0.008000 0.000080

c) Values 12,500,000 180 0.008000 0.000080

d) Values 12,500,000 180 0.008000 0.000080

e) Values 12,500,000 180 0.008000 0.000080

f) Values 12,500,000 180 0.008000 0.000080

g) Values 12,500,000 180 0.008000 0.000080

110.00 0.009091

115.00 0.008696

120.00 0.008333

125.00 0.008000

130.00 0.007692

135.00 0.007407

140.00 0.007143

€ 0.000000 (€ 0.000080) (€ 0.000080)

€ 0.000000 (€ 0.000080) (€ 0.000080)

€ 0.000000 (€ 0.000080) (€ 0.000080)

€ 0.000000 (€ 0.000080) (€ 0.000080)

€ 0.000308 (€ 0.000080) € 0.000228

€ 0.000593 (€ 0.000080) € 0.000513

€ 0.000857 (€ 0.000080) € 0.000777

(1,000.00)

(1,000.00)

(1,000.00)

(1,000.00)

2,846.15

6,407.41

9,714.29

Problem 7.7 Alcasa of Caracas Alcasa of Caracas, a Venezuelan company, wishes to borrow $8,000,000 for eight weeks. A rate of 6.250% per annum is quoted by potential lenders in New York, Great Britain, and Switzerland using, respectively, international, British, and the Swiss-eurobond definitions of interest (day count conventions). Although all three currency markets assume a 360-day year for interest rate calculations, the U.S. and British markets use the exact number of days in the period in question, 56 days in this case, while the Swiss market assumes a standardized 30-day month. From which source should Alcasa borrow?

Assumptions Principal borrowing need Maturity needed, in weeks Rate of interest charged by ALL potential lenders New York interest rate practices Interest calculation uses: Exact number of days in period Number of days in financial year So the interest charge on this principal is Great Britain interest rate practices Interest calculation uses: Exact number of days in period Number of days in financial year So the interest charge on this principal is Swiss interest rate practices Interest calculation uses: Assumed 30 days per month for two months Number of days in financial year So the interest charge on this principal is

$

Values 8,000,000 8 6.250%

$

56 360 77,777.78

$

56 360 77,777.78

$

60 360 83,333.33

Alcasa should borrow in the U.S. or Great Britain. Both have the same interesst cost, a cost lower than that offered by the Swiss market.

Problem 7.8 Valdor Capital Baradan Kuppusamy works as a currency speculator for Valdor Capital, which is headquartered in Kuala Lumpur. His most recent speculative position is to profit from his expectation that the Thai baht will rise significantly against the Malaysian ringgit. The current spot rate is MYR0.1382/THB. He must choose between the following 90-day options on the Malaysian ringgit: Option Put on Malaysian ringgit Call on Malaysian ringgit

Strike Price MYR0.1600/THB MYR0.1600/THB

Premium THB0.005 THB0.0025

a. Should Baradan buy a put on Malaysian Ringgit or a call? b. What is Baradan’s breakeven price on the option purchase in (a)? c. Using your answer from (a), what are Baradan’s gross profit and net profit (including premium), if the spot rate at the end of 90 days is MYR0.2000/THB? Assumptions Current spot rate (MYR/THB) in THB/MYR Maturity (days) Expected ending spot rate in 90 days (MYR/THB) in THB/MYR

Values 0.1382 THB 7.23589 90 0.2000 THB 5.00000

Strike price (MYR/THB) in THB/MYR Premium (THB/MYR)

Call on MYR MYR 0.1600 THB 6.25000 THB 0.00500

Put on MYR MYR 0.1600 THB 6.25000 THB 0.00250

a. Should Baradan buy a put on Malaysian Ringgit or a call?

Baradan should buy a put on Malaysian ringgit to profit from the rise of the Thai bhat (the fall of the ringgit). b. What is Baradan’s breakeven price on the option purchase in (a)?

Baradan buys a put on Malaysian ringgit and pays the premium today.

In 90 days, he exercises the put, receiving Thai bhat.

Strike price Less, premium Breakeven

THB 6.25000 -THB 0.00250 THB 6.24750

c. What are Baradan’s gross and net profit (including premium), if the spot rate at the end of 90 days is MYR0.2000/THB? Gross Profit (THB/MYR) Strike price THB 6.25000 Less, spot rate -THB 5.00000 Less, premium Profit THB 1.25000

in THB/MYR 0.1600 0.1601

Net Profit (THB/MYR) THB 6.25000 -THB 5.00000 -THB 0.00250 THB 1.24750

Problem 7.9 Anna’s Options Assume Anna writes a call option on euros with a strike price of GBP1.2500 = 1.00 EUR at a premium of 3.80 cents per euro (£0.0380/€), with an expiration date three months from now. The option is for €100,000. Calculate Anna’s profit or loss should he exercise the call option before maturity, at a time when the euro is traded spot at strike prices beginning at GBP1.10 = 1.00 EUR and rising to GBP1.40 = 1.00 EUR, in increments of £0.05.

Assumptions Notional principal (€) Maturity (days) Strike price (£ = €1.00) Premium (£ = €1.00) Ending spot rate (£ = €1.00) Gross profit on the option Less, premium Net profit (£ = €1.00) Total net profit

a.

Values 100,000.00 90.00 1.25 0.04 1.10

b.

Values 100,000.00 90.00 1.25 0.04 1.15

c.

Values 100,000.00 90.00 1.25 0.04 1.20

d.

Values 100,000.00 90.00 1.25 0.04 1.25

e.

Values 100,000.00 90.00 1.25 0.04 1.30

f.

Values 100,000.00 90.00 1.25 0.04 1.35

g.

Values 100,000.00 90.00 1.25 0.04 1.40

0.00 -0.04 -0.04

0.00 -0.04 -0.04

0.00 -0.04 -0.04

0.00 -0.04 -0.04

0.05 -0.04 0.01

0.10 -0.04 0.06

0.15 -0.04 0.11

-3,800.00

-3,800.00

-3,800.00

-3,800.00

1,200.00

6,200.00

11,200.00

Problem 7.10 Baker Street Arthur Doyle is a currency trader for Baker Street, a private investment house in London. Baker Street’s clients are a collection of wealthy private investors who, with a minimum stake of £250,000 each, wish to speculate on the movement of currencies. The investors expect annual returns in excess of 25%. Although officed in London, all accounts and expectations are based in U.S. dollars.

Arthur is convinced that the British pound will slide significantly—possibly to $1.3200 = £1.00—in the coming 30 to 60 days. The current spot rate is $1.4260 = £1.00. Arthur wishes to buy a put on pounds, which will yield the 25% return expected by his investors. Which of the following put options would you recommend he purchase? Prove your choice is the preferable combination of strike price, maturity, and up-front premium expense.

Assumptions Current spot rate ($=£1.00) Expected ending spot rate in 30 to 60 days ($=£1.00) Minimum investment requirement Strike Price ($=£1.00) 1.36 1.34 1.32 1.36 1.34 1.32

Maturity 30 days 30 days 30 days 60 days 60 days 60 days

Values $1.4260 $1.3200 £250,000.00 Premium $0.00081 per £ $0.00021 per £ $0.00004 per £ $0.00333 per £ $0.00150 per £ $0.00060 per £

The rate of return on an option may be so extreme in magnitude that we ordinarily do not calculate them. Since the maximum loss to the buyer of an option is the option premium alone, the maximum loss is actually 100%. The maximum gain, however, is nearly unlimited when speaking of a purchasing a put option. The reason rates of return may be so large is that option premiums, the actual initial investment, are typically so very small. Since we are only interested in the rate of return prospects, the amount of the profit or loss, or even the total pound or dollar investment is immaterial.

Below we calculate the rates of return on the three 60-day put options by ending spot rate.

Strike Rate 1.32

1.34

1.36

Option Premium $0.00060 per £

$0.00150 per £

$0.00333 per £

Cost of 1 pound $0.00060

$0.00150

$0.00333

Gross Return Less Premium Net Return Rate of Return Gross Return Less Premium Net Return Rate of Return Gross Return Less Premium Net Return Rate of Return

$ $

$ $

$ $

1.26 0.0600 $ (0.0006) 0.0594 $ 9900%

1.27 0.0500 $ (0.0006) 0.0494 $ 8233%

1.28 0.0400 $ (0.0006) 0.0394 $ 6567%

Ending Spot Rate ($=£1.00) 1.29 1.30 1.31 0.0300 $ 0.0200 $ 0.0100 $ (0.0006) (0.0006) (0.0006) 0.0294 $ 0.0194 $ 0.0094 $ 4900% 3233% 1567%

1.32 $ (0.0006) (0.0006) $ -100%

1.33 $ (0.0006) (0.0006) $ -100%

1.34 (0.0006) (0.0006) -100%

0.0800 $ (0.0015) 0.0785 $ 5233%

0.0700 $ (0.0015) 0.0685 $ 4567%

0.0600 $ (0.0015) 0.0585 $ 3900%

0.0500 $ (0.0015) 0.0485 $ 3233%

0.0400 $ (0.0015) 0.0385 $ 2567%

0.0300 $ (0.0015) 0.0285 $ 1900%

0.0200 $ (0.0015) 0.0185 $ 1233%

0.0100 $ (0.0015) 0.0085 $ 567%

(0.0015) (0.0015) -100%

0.1000 $ (0.0033) 0.0967 $ 2903%

0.0900 $ (0.0033) 0.0867 $ 2603%

0.0800 $ (0.0033) 0.0767 $ 2302%

0.0700 $ (0.0033) 0.0667 $ 2002%

0.0600 $ (0.0033) 0.0567 $ 1702%

0.0500 $ (0.0033) 0.0467 $ 1402%

0.0400 $ (0.0033) 0.0367 $ 1101%

0.0300 $ (0.0033) 0.0267 $ 801%

0.0200 (0.0033) 0.0167 501%

Althoug the rate of return depends specifically on the ending spot exchange rate, if we assume that 1.32 is the very specific ending spot rate of interest, we can see that the rate of return will be significant -- if that is indeed what the ending spot rate ends up at. These 60-day maturity options allow a longer period of time for a profitable outcome. If the explicit ending spot rate of 1.32 is firm, then the 1.34 or 1.36 strike rates are the most logical and possibly profitable choices.

Problem 7.11 Bambang Pamungkas at CCB Bank Bambang Pamungkas works for CCB Bank Currency Trading Desk in Montreal, Canada. Bambang is something of a contrarian—as opposed to most of the forecasts, he believes the Canadian dollar (CAD) will appreciate versus the British pound over the coming 90 days. The current spot rate is £0.5931/CAD. Bambang may choose between the following options Option Put on CAD Call on CAD

Strike Price £0.6500 £0.6500

Premium £0.0035 £0.0055

a. Should Bambang buy a put on Canadian dollars or a call? b. What is Bambang’s breakeven price on the option purchased in (a)? c. Using your answer from (a), what are Bambang’s gross profit and net profit (including premium), if the spot rate at the end of 90 days is indeed £0.7300? d. Using your answer from (a), what are Bambang’s gross profit and net profit (including premium), if the spot rate at the end of 90 days is indeed £0.7850?

Assumptions Current spot rate (£/CAD) Maturity (days)

Values £0.5931 90

Option choices on the Canadian dollar Strike price (£/CAD) Premium (£/CAD)

Call on CAD £0.6500 £0.0055

Put on CAD £0.6500 £0.0035

a) Which option should Bambang buy?

Since Bambang expects the Canadian dollar to appreciate versus the pound, he should buy a call on Canadian dollars. b) What is Bambang’s breakeven price on the option purchased in (a)?

Strike price (£) Plus, premium (£) Breakeven (£)

0.6500 0.0055 0.6555

c) What is Bambang’s gross profit and net profit (including premium), if the ending spot rate is £0.730/CAD?

Spot rate (£) Less, strike price Less, premium Profit (£)

Gross Profit (£/CAD) 0.7300 (0.6500) 0.0800

Net Profit (£/CAD) 0.7300 (0.6500) (0.00550) 0.0745

d) What is Bambang’s gross profit and net profit (including premium), if the ending spot rate is £0.7850/CAD?

Spot rate (£) Less, strike price Less, premium Profit (£)

Gross Profit (£/CAD) 0.7850 (0.6500) 0.1350

Net Profit (£/CAD) 0.7850 (0.6500) (0.00550) 0.1295

Problem 7.12 U.S. Dollar-Euro Pricing Currency Options on the Euro A U.S.-based firm wishing to buy or sell euros (the foreign currency)

Variable S0 X rd rf T

s

Value $1.2480 $1.2500 1.453% 2.187% 1.000 365.00 12.000%

s

Value € 0.8013 € 0.8000 2.187% 1.453% 1.000 365.00 12.000%

Call option premium (per unit fc) Put option premium (per unit fc) (European pricing)

c p

$0.0534 $0.0643

c p

€ 0.0412 € 0.0342

Call option premium (%) Put option premium (%)

c p

4.28% 5.15%

c p

5.15% 4.27%

Spot rate (domestic/foreign) Strike rate (domestic/foreign) Domestic interest rate (% p.a.)

Foreign interest rate (% p.a.)

Time (years, 365 days) Days equivalent Volatility (% p.a.)

Variable S0 X rd rf T

A European firm wishing to buy or sell dollars (the foreign currency)

When the volatility is increased to 12.000% from 10.500%, the premium on the call option on euros rises to $0.0412 = €1.00, or 5.15%.

Problem 7.13 U.S. Dollar-Japanese Yen Pricing Currency Options on the Japanese yen A Japanese firm wishing to buy or sell dollars (the foreign currency)

s

Value ¥105.64 ¥100.00 0.089% 1.453% 1.000 365.00 12.000%

Call option premium (per unit fc) Put option premium (per unit fc) (European pricing)

c p

Call option premium (%) Put option premium (%)

c p

Spot rate (domestic/foreign) Strike rate (domestic/foreign) Domestic interest rate (% p.a.)

Foreign interest rate (% p.a.)

Time (years, 365 days) Days equivalent Volatility (% p.a.)

Variable S0 X rd rf T

A U.S.-based firm wishing to buy or sell yen (the foreign currency) Variable S0 X rd rf T s

Value $0.0095 $0.0100 1.453% 0.089% 1.000 365.00 12.000%

¥7.27 ¥3.06

c p

$0.0003 $0.0007

6.88% 2.90%

c p

3.06% 7.27%

A Japanese firm wishing to sell U.S. dollars would need to purchase a put on dollars. The put option premium listed above is ¥3.06 per $.

Put option premium (¥=$1.00) Notional principal (¥=$1.00) Total cost (¥)

¥3.06 $750,000 ¥2,297,242.69

Problem 7.14 Euro-Japanese Yen Pricing Currency Options on the Euro/Yen Crossrate A Japanese firm wishing to buy or sell euros (the foreign currency)

s

Value ¥133.89 ¥136.00 0.088% 2.187% 0.247 90.00 10.000%

Call option premium (per unit fc) Put option premium (per unit fc) (European pricing)

c p

Call option premium (%) Put option premium (%)

c p

Spot rate (domestic/foreign) Strike rate (domestic/foreign) Domestic interest rate (% p.a.)

Foreign interest rate (% p.a.)

Time (years, 365 days) Days equivalent Volatility (% p.a.)

Variable S0 X rd rf T

A European firm wishing to buy or sell yen (the foreign currency) Variable S0 X rd rf T s

Value € 0.0072 € 0.0074 2.187% 0.088% 0.247 90.00 10.000%

¥1.50 ¥4.30

c p

€ 0.0001 € 0.0002

1.12% 3.21%

c p

1.30% 2.90%

A European-based firm like Legrand (France) would need to purchase a put option on the Japanese yen. The company wishes a strike rate of 0.0072 euro for each yen sold (the strike rate) and a 90-day maturity. Note that the "Time" must be entered as the fraction of a 365 day year, in this case, 90/365 = 0.247.

Put option premium (euro/JPY) Notional principal (JPY) Total cost (euro)

€ 0.0002 ¥10,400,000.00 € 2,167.90

Problem 7.15 U.S. Dollar-British Pound Pricing Currency Options on the British pound A U.S.-based firm wishing to buy or sell pounds (the foreign currency)

Variable S0 X rd rf T

s

Value $1.8674 $1.8000 1.453% 4.525% 0.493 180.00 9.400%

s

Value £0.5355 £0.5556 4.525% 1.453% 0.493 180.00 9.400%

Call option premium (per unit fc) Put option premium (per unit fc) (European pricing)

c p

$0.0696 $0.0306

c p

£0.0091 £0.0207

Call option premium (%) Put option premium (%)

c p

3.73% 1.64%

c p

1.70% 3.87%

Spot rate (domestic/foreign) Strike rate (domestic/foreign) Domestic interest rate (% p.a.)

Foreign interest rate (% p.a.)

Time (years, 365 days) Days equivalent Volatility (% p.a.)

Variable S0 X rd rf T

A British firm wishing to buy or sell dollars (the foreign currency)

Call option premiums for a U.S.-based firm buying call options on the British pound: 180-day maturity ($=£1.00) 90-day maturity ($=£1.00) Difference ($=£1.00)

$0.0696 $0.0669 $0.0027

The maturity doubled while the option premium rose only about 4%.

Problem 7.16 Euro-British Pound Pricing Currency Options on the British pound/Euro Crossrate A European firm wishing to buy or sell pounds (the foreign currency)

Variable S0 X rd rf T

s

Value € 1.4730 € 1.5000 4.000% 4.160% 0.247 90.00 11.400%

s

Value £0.6789 £0.6667 4.160% 4.000% 0.247 90.00 11.400%

Call option premium (per unit fc) Put option premium (per unit fc) (European pricing)

c p

€ 0.0213 € 0.0487

c p

£0.0220 £0.0097

Call option premium (%) Put option premium (%)

c p

1.45% 3.30%

c p

3.24% 1.42%

Spot rate (domestic/foreign) Strike rate (domestic/foreign) Domestic interest rate (% p.a.)

Foreign interest rate (% p.a.)

Time (years, 365 days) Days equivalent Volatility (% p.a.)

Variable S0 X rd rf T

A British firm wishing to buy or sell euros (the foreign currency)

When the euro's interest rate rises from 2.072% to 4.000%, the call option premium on British pounds rises: Call option on pounds when euro interest is 4.000% Call option on pounds when euro interest is 2.072% Change, an increase in the premium

€ 0.0213 € 0.0189 € 0.0213

Problem 9.1 Naira's Nightmare On Friday June 17, 2016, the Central Bank of Nigeria (CBN) abandoned the Nigerian naira’s (NGN or N) fixed exchange rate and allowed the currency to float. Previously fixed against the U.S. dollar at NGN196.50 = USD1.00, the naira closed at NGN279.50 = USD1.00 on Monday June 20, the first day of trading following the float. The naira quickly quickly floated (sunk) to NGN324.50 = USD1.00 by August 18. Similarly, the naira fell from NGN221.2001 = EUR1.00 to NGN316.7294 on June 20 and NGN347.7721 = EUR1.00 on August 18. a. What was the percentage change in the value of the Nigerian naira versus the dollar the first trading day? b. What was the percentage change in the value of the naira versus the dollar by August 18, 2016? c. What was the percentage change in the value of the Nigerian naira verus the euro the first trading day? d. What was the percentage change in the value of the naira versus the euro by August 18, 2016?

NGN per USD 196.50 279.50 324.50

NGN per EUR 221.2001 316.7294 347.7721

a) and c) Percentage change in the first day of trading

-29.70%

-30.16%

b) and d) . Percentage change by August 17

-39.45%

-36.40%

Assumptions Initial spot rate, June 17 Closing spot rate, June 20 Closing spot rate, August 17

Rate S1 S2 S3

Calculation of percentage change:

Percent change = ( S1 - S2 ) ÷ ( S2 )

Problem 9.2 The Turkish Turbulence The Turkish lira (TRY) weakened from TRY 11.68 = 1.00 EUR on November 22, 2021 due to unconventional monetary policy. What was the percentage devaluation of the lira?

Assumptions

Rate

Opening spot rate, November 22, 2021 (TRY = EUR 1.00)

S1

Closing spot rate, November 22, 2021 (TRY = EUR 1.00)

S2

Values 11.68 14.41

Calculation of percentage change: Percentage change in the lira versus the euro

Percent change = (S1-S2)/(S2)

-18.95%

Problem 9.3 Yen devaluation The Japanese Yen (JPY) had a value of JPY 125.5 to 1.00 EUR March 4, 2022. It then plunged in value to JPY136 to 1.00 EUR on March 28, 2022.

What was the percentage change in its value?

Assumptions

Spot rate, March 4, 2022, JPY = EUR 1.00 Spot rate, March 28, 2022, JPY = EUR 1.00

Values 125.50 136.00

Calculation percentage appreciation or depreciation

Percentage change versus the euro Because the yen fell in value Percent change = ( S1-S2 )/( S2 )

-7.72% Depreciation

Problem 9.4 Ecuadorian Sucre The Ecuadorian sucre (S) suffered from hyperinflationary forces throughout 1999. Its value moved from S5,000/$ to S25,000/$. What was the percentage change in its value?

Assumptions Initial spot rate, 1999 (Sucre=$1.00) Ending spot rate, 1999 (Sucre=$1.00) Calculation of percentage change: Percentage change in the sucre versus the dollar Percent change = ( S1 - S2 ) ÷ ( S2 )

Rate S1 S2

Values 5,000 25,000

-80.00%

Problem 9.5 Zimbabwean Devaluation As illustrated in the graph, the Zimbabwean dollar depreciated against the euro from ZWD 460.52 to ZWD 515.49 in a span of three months. After a brief period of high volatility, the Zimbabwean dollar appeared to settle down into a range varying from ZWD501 to ZWD515 per euro. If you were forecasting the Zimbabwean dollar further into the future, to December 5, 2010, how would you use the information in the graph—the value of the Zimbabwean dollar freely floating in the weeks following devaluation—to forecast its future value?

Problem 9.5: Zimbabwe Devaluation ZWD = 1.00 EUR (€) 1 0.9 0.8 0.7

Date October 1st November 4th

“Eye-balled” Values 496.740307 515.490775

Percent change

-3.64%

0.6 0.5

If ZWD continued to fall at same rate for 1 month:

0.4

December 1st

515.49

Percent change

-3.64%

December 31st

534.95

0.3 0.2 0.1 0

The period immediately following the peso's devaluation was highly volatile and a period of transition. Most forecasters would view the February period as a period in which the new exchange rate is beginning to "stabilize" in its trading.

Problem 9.6 Canadian Dollar/USD Dollar The Canadian dollar’s value against the U.S. dollar has seen some significant changes over recent history. Using the following graph of the C$/US$ exchange rate for the 30 year period between 1980 and end-of-year 2010 to estimate the percentage change in the Canadian dollar’s value (its affectionately known as the "loonie") versus the dollar for the following periods.

a. January 1980 - December 1985 b. January 1986 - December 1991 The following values are taken from the graph.

Time Period January 1980 - January 1986 January 1986 - October 1991 October 1991 - December 2001 October 2001 - April 2011 April 2011 - January 2015

Starting Value (C$/US$) 1.16 1.41 1.13 1.60 0.96

Ending Value (C$/US$) 1.41 1.13 1.60 0.96 1.25

Change in the value of the loonie (percent) -17.7% 24.8% -29.4% 66.7% -23.2%

Percent change = (Starting Value - Ending Value ) / (Ending Value) The "spike" in the Loonie in 2008–2009, was dramatic, but was considered by many a nervous reaction to the financial crisis which was largely experienced in the United States at the time, and not in Canada.

Problem 9.7 Istanbul's Issues The Turkish lira (TL) was officially devalued by the Turkish government in February 2001 during a severe political and economic crisis. The Turkish government announced on February 21 that the lira would be devalued by 20%. The spot exchange rate on February 20 was TL68,000 = $1.00.

Assumptions Spot rate, February 20, 2001 (TL=$1.00) Turkish government announces a devaluation of: Spot rate, February 24, 2001 (TL=$1.00)

Values 68,000 -20.00% 100,000

a. What was the exchange rate after devaluation?

Spot rate after devaluation

85,000

Check calculation: percentage change in values

-20.0%

b. What was percentage change after falling to TL100,000 = $1.00?

Percentage change from initial value

-32.0%

Percentage change from "devalued" value

-15.0%

Problem 9.8 Conchita’s Dilemma Conchita Marquez is a famous Mexican entrepreneur with a multi-million-dollar business dealing in copper. In 1994, she decided to take Switzerland as part of her long-term retirement plans, which included transferring all her wealth.

In November 1994, Conchita held a portfolio of USD 450,000,000 and CHF 200,000,000 in Swiss banks, in addition to accounts in Mexi 950,000,000. Using the exchange rate table, answer the following: a. What is the value of Conchita’s portfolio as measured in Mexican pesos? b. What is the value of Conchita’s portfolio as measured in Swiss francs? c. What is the value of Conchita’s portfolio as measured in U.S. dollars? d. Which currency demonstrated the greatest fluctuation in total value over the six dates?

Conchita’s Balances by Currency U.S. dollars Swiss francs Mexican pesos Exchange Rates Mexican pesos per U.S. dollar Mexican pesos per Swiss franc U.S. dollars per Swiss franc

(in millions) USD 450 CHF 200 MXN 950 11/3/1993 3.150 2.104 0.6679

11/3/1994 3.433 2.707 0.7880

12/5/1994 3.443 2.596 0.7540

12/16/1994 3.464 2.598 0.7500

12/5/1994 950 689 1,168 2,807

12/16/1994 950 693 1,169 2,812

12/5/1994 276 200 597 1,073

12/16/1994 274 200 600 1,074

12/5/1994 366 151 450 967

12/16/1994 366 150 450 966

a. What is the value of Conchita’s portfolio as measured in Mexican pesos?

Portfolio Value as Measured in MXN Mexican pesos account balance Swiss francs account balance U.S. dollars account balance Total

11/3/1993 950 630 947 2,527

11/3/1994 950 687 1,218 2,855

b. What is the value of Conchita’s portfolio as measured in Swiss francs?

Portfolio Value as Measured in CHF Mexican pesos account balance Swiss francs account balance U.S. dollars account balance Total

11/3/1993 302 200 674 1,175

11/3/1994 277 200 571 1,048

c. What is the value of Conchita’s portfolio as measured in U.S. dollars?

Portfolio Value as Measured in USD Mexican pesos account balance Swiss francs account balance U.S. dollars account balance Total

11/3/1993 452 134 450 1,035

11/3/1994 351 158 450 959

d. Which currency demonstrated the greatest fluctuation in total value over the six dates?

In 1994, she decided to take up residence in

addition to accounts in Mexico holding MXN

12/30/1994 5.000 3.820 0.7640

1/30/1995 6.300 4.974 0.7890

12/30/1994 950 1,000 1,719 3,669

1/30/1995 950 1,260 2,238 4,448

12/30/1994 190 200 589 979

1/30/1995 151 200 570 921

12/30/1994 249 153 450 851

1/30/1995 191 158 450 799

Problem 9.9 La Conquista—The Mexican Dance Calculate the percentage change in the value of the peso for the three cross-rates shown in the table for six dates. Did the peso fall further against the U.S. dollar or the Swiss franc?

Exchange Rates Mexican pesos per U.S. dollar Mexican pesos per Swiss franc U.S. dollars per Swiss franc

11/3/1993 3.150 2.104 0.6679

11/3/1994 3.433 2.707 0.7880

12/5/1994 3.443 2.596 0.7540

12/16/1994 3.464 2.598 0.7500

12/30/1994 5.000 3.820 0.7640

1/30/1995 6.300 4.974 0.7890

Percentage Change Mexican pesos against the Swiss franc Mexican pesos against the U.S. dollar

11/3/1993

11/3/1994 -8.2% -22.3%

12/5/1994 -0.3% 4.3%

12/16/1994 -0.6% -0.1%

12/30/1994 -30.7% -32.0%

1/30/1995 -20.6% -23.2%

MXN vs CHF MXN vs USD

11/3/1993–12/16/1994 -45.5% -45.6%

Problem 9.10 BP and Mexicana Oil 1995 BP (U.K.) and Mexicana Oil (Mexico) severed a long-term joint venture in 1993, with Mexicana buying out BP with $75,00,00,00,000 in cash and a 30% interest (equity interest) in Mexicana. Mexicana financed a large part of the buyout by borrowing heavily. The following year, in November 1994, BP received a dividend on its ownership interest in Mexicana, for MXN30,00,00,00,000.

However, Mexicana’s performance had been declining, as was the Mexican peso. The winter of 1994–1995 in Europe was a relatively mild one and Europe’s purchases of Mexicana’s oil output had fallen, as had the price of oil. Mexicana’s total sales were down and the peso had fallen dramatically.

Adding debt to injury, Mexicana was due to make a payment of USD22,50,00,00,000 in 1995 on its debt from the BP buyout. a. Assuming a spot rate of MXN3.443 = USD1.00 in November 1994, how much was the dividend paid to BP in U.S. dollars? b. If Mexicana were to pay the same dividend to BP in January 1995, and the spot rate at that time was MXN6.30 = USD1.00, what would BP receive in U.S. dollars? c. If the combination of Western trade tariffs against Mexico and lower oil prices truly sent the Mexican economy into recession, and the spot rate was MXN7.50 = USD1.00 in November 1995, what might BP's dividend be in November 1995?

a. Dividend received in USD in November 1994 Dividend Spot rate, November 1994, MXN = 1 USD

Values MXN 30,000,000,000.00 3.443 USD 8,713,331,397.04

b. Dividend received in USD in January 1995 Dividend Spot rate, January 1995, MXN = 1 USD

Values MXN 30,000,000,000.00 6.30 USD 4,761,904,761.90

b. Dividend received in USD in November 1995 Dividend Spot rate, November 1995, MXN = 1 USD

Values MXN 30,000,000,000.00 7.50 USD 4,000,000,000.00

Forecasting the Pan-Pacific Pyramid: Use the following data in answering problems 9.11-9.16.

Country Australia Japan United States

Latest Qtr 4.3% 1.6% 1.9%

Gross Domestic Product Forecast Qtr* 2007e 3.8% 4.1% -1.2% 2.0% 3.8% 2.0% Consumer Prices

Country Australia Japan United States

Year Ago 4.0% 0.9% 2.1%

Country Australia Japan United States

Trade Balance Last 12 mos (billion $) -13.0 98.1 -810.7

Latest 2.1% -0.2% 2.8%

Forecast 2007e 2.4% 0.0% 2.8%

Curent Account Last 12 mos Forecast 07 (billion $) (% of GDP) -$47.0 -5.7% $197.5 4.6% -$793.2 -5.6%

Forecast 2008e 3.5% 1.9% 2.2%

Industrial Production Recent Qtr 4.6% 4.3% 1.9%

Unemployment Rate Latest 4.2% 3.8% 4.7%

Interest Rates 3-month 1-yr Govt Latest Latest 6.90% 6.23% 0.73% 1.65% 4.72% 4.54% Current Units (per US$) Oct 17th 1.12 117 1.00

Year Ago 1.33 119 1.00

Source: Data abstracted from The Economist , October 20, 2007, print edition. Unless otherwise noted, percentages are percentage changes over oneyear. Rec Qtr = recent quarter. Values for 2007e are estimates or forecasts.

Problems 9.11-9.14 Forecasting the Pan-Pacific Pyramid

Country Australia Japan United States

Latest Qtr 4.3% 1.6% 1.9%

Gross Domestic Product Forecast Qtr* 2007e 3.8% 4.1% -1.2% 2.0% 3.8% 2.0% Consumer Prices

Country Australia Japan United States

Year Ago 4.0% 0.9% 2.1%

Country Australia Japan United States

Trade Balance Last 12 mos (billion $) -13.0 98.1 -810.7

Latest 2.1% -0.2% 2.8%

Forecast 2007e 2.4% 0.0% 2.8%

Current Account Last 12 mos Forecast 07 (billion $) (% of GDP) -$47.0 -5.7% $197.5 4.6% -$793.2 -5.6%

Forecast 2008e 3.5% 1.9% 2.2%

Industrial Production Recent Qtr 4.6% 4.3% 1.9%

Unemployment Rate Latest 4.2% 3.8% 4.7%

Interest Rates 3-month 1-yr Govt Bond Latest Latest 6.90% 6.23% 0.73% 1.65% 4.72% 4.54% Current Units (per US$) Oct 17th 1.12 117 1.00

Year Ago 1.33 119 1.00

Source: Data abstracted from The Economist, October 20, 2007, print edition. Unless otherwise noted, percentages are percentage changes over oneyear. Rec Qtr = recent quarter. Values for 2007e are estimates or forecasts.

9.11 Current Spot Rates. What are the current spot exchange rates for the following cross rates? a. Japanese yen to U.S. dollar exchange rate b. Japanese yen to Australian dollar exchange rate c. Australian dollar to U.S. dollar exchange rate

= ¥=$1.00 = ¥=$1.00 / A$=$1.00 = A$=$1.00

117.00 104.46 1.1200

9.12 Purchasing Power Parity Forecasts. Assuming purchasing power parity, and assuming that the forecasted change in consumer prices is a good proxy of predicted inflation, forecast the following cross rates: a. Japanese yen to U.S. dollar in 1 year b. Japanese yen to Australian dollar in 1 year c. Australian dollar to U.S. dollar in 1 year

= Spot (¥/$) x (1 + ¥-inflation) / (1 + $-inflation) = Spot (¥/A$) x (1 + ¥-inflation) / (1 + A$-inflation) = Spot (A$/$) x (1 + A$-inflation) / (1 + $ inflation)

113.81 102.02 1.1156

9.13 International Fischer Forecasts. Asssuming International Fisher -- one version of purchasing power parity -- applies to the coming year, forecast the following future spot exchange rates using the government bond rates for the respective country currencies: a. Japanese yen to U.S. dollar in 1 year b. Japanese yen to Australian dollar in 1 year c. Australian dollar to U.S. dollar in 1 year

= Spot (¥/$) x (1 + i-¥) / (1 + i-$) = Spot (¥/A$) x (1 + i-¥) / (1 + i-A$) = Spot (A$/$) x (1 + i-A$) / (1 + i-$)

113.77 99.96 1.1381

9.14 Implied Real Interest Rates. If the nominal interest rate is the government bond rate, and the current change in consumer prices is used as expected inflation, calculate the implied "real" rates of interest by currency. a. Australian dollar "real" rate b. Japanese yen "real" rate c. U.S. dollar "real" rate

= (1 + nominal) / (1 + A$ consumer price change) - 1 = (1 + nominal) / (1 + ¥ consumer price change) - 1 = (1 + nominal) / (1 + $ consumer price change) - 1

3.74% 1.65% 1.69%

Problems 9.15-9.16 Forecasting the Pan-Pacific Pyramid

Country Australia Japan United States

Latest Qtr 4.3% 1.6% 1.9%

Gross Domestic Product Forecast Qtr* 2007e 3.8% 4.1% -1.2% 2.0% 3.8% 2.0% Consumer Prices

Country Australia Japan United States

Year Ago 4.0% 0.9% 2.1%

Country Australia Japan United States

Trade Balance Last 12 mos (billion $) -13.0 98.1 -810.7

Forecast 2007e 2.4% 0.0% 2.8%

Latest 2.1% -0.2% 2.8%

Current Account Last 12 mos Forecast 07 (billion $) (% of GDP) -$47.0 -5.7% $197.5 4.6% -$793.2 -5.6%

Forecast 2008e 3.5% 1.9% 2.2%

Industrial Production Recent Qtr 4.6% 4.3% 1.9%

Unemployment Rate Latest 4.2% 3.8% 4.7%

Interest Rates 3-month 1-yr Govt Bond Latest Latest 6.90% 6.23% 0.73% 1.65% 4.72% 4.54% Current Units (per US$) Oct 17th 1.12 117 1.00

Year Ago 1.33 119 1.00

Source: Data abstracted from The Economist , October 20, 2007, print edition. Unless otherwise noted, percentages are percentage changes over oneyear. Rec Qtr = recent quarter. Values for 2007e are estimates or forecasts.

15. Forward Rates. Using the spot rates and three-month interest rates in the table, calculate the 90-day forward rates for: a. Japanese yen to U.S. dollar exchange rate b. Japanese yen to Australian dollar exchange rate c. Australian dollar to U.S. dollar exchange rate

115.85 102.88 1.1260

= Spot (¥/$) x (1 + i¥ 3 month) / (1 + i$ 3 month) = Spot (¥/A$) x (1 + i¥ 3 month) / (1 + iA$ 3 month) = Spot (A$/$) x (1 + A$ 3 month) / (1 + i$ 3 month)

Note: All interest rates need to be adjusted for a 90-day period of a 360-day year for the calculation.

16. Real Economic Activity and Misery. Calculate the country's Misery Index (unemployment + inflation) and then use it like interest differentials to forecast the future spot exchange rate, one year into the future.

Australia's Misery Index Japan's Misery Index United States's Misery Index

6.60% 3.80% 7.50%

Forecast spot = Spot x ( 1 + Misery-1) / ( 1 + Misery-2)

a. Japanese yen to U.S. dollar exchange rate in one year b. Japanese yen to Australian dollar exchange rate in one year c. Australian dollar to U.S. dollar exchange rate in one year

Starting Spot Rate 117.00 104.46 1.1200

Forecast Spot Rate 112.97 101.72 1.1106

Problem 9.17 The Rising Sun and Europe The Japanese yen-euro cross rate is one of the more significant currency values for global trade and commerce. The graphic at right shows this cross-rate from when the euro was launched in January 1999 through January of 2015. Estimate the change in the value of the yen over the following four trend periods.

Time Period a. Jan 1999 - Sept 2000 b. Sept 2000 - Sept 2008 c. Sept 2008 - Sept 2012 d. Sept 2012 - Jan 2015

Starting Value (¥=€1.00) 132 92 168 96

Ending Value (¥=€1.00) 92 168 96 146

Percent change = ( S1 - S2 ) ÷ ( S2 ) Monthly average exchange rates

Change in the value of the yen (percent) 43.5% -45.2% 75.0% -34.2%

Problem 10.1 Gray Wolf Gray Wolf, Ltd., a Canadian manufacturer of raincoats, does not selectively hedge its transaction exposure. Instead, if the date of the transaction is known with certainty, all foreign currency-denominated cash flows must utilize the following mandatory forward contract cover formula: Gray Wolf's Manadatory Forward Cover Paying the points forward Receiving the points forward

0-90 days 75% 100%

91-180 days 60% 90%

> 180 days 50% 50%

Gray Wolf expects to receive multiple payments in Danish kroner over the next year. DKr3,000,000 is due in 90 days; DKr2,000,000 is due in 180 days; and DKr1,000,000 is due in one year. Using the following spot and forward exchange rates, what would be the amount of forward cover required by company policy by period?

Assumptions Spot rate 3-month forward rate 6-month forward rate 12-month forward rate South Face's Exposures A/R due in 3 months, DKr A/R due in 6 months, DKr A/R due in 12 months, DKr

DKr=C$1.00 4.70 4.71 4.72 4.74 0-90 days 3,000,000

Forward Discount -0.85% -0.85% -0.84% 91-180 days

> 180 days

2,000,000 1,000,000

Analysis & Exposure Management The Danish krone is selling forward at a discount versus the Canadian dollar: it takes more DKr/C$ forward.

Gray Wolf is receiving foreign currency, DKr, at future dates ("long DKr").

Gray Wolf is therefore expecting to PAY THE POINTS FORWARD. Required Forward Cover for Gray Wolf: A/R due in 3 months, DKr A/R due in 6 months, DKr A/R due in 12 months, DKr DKr Forward Cover A/R due in 3 months, DKr A/R due in 6 months, DKr A/R due in 12 months, DKr Expected Canadian dollar value of DKr sold forward

0-90 days 75%

91-180 days

> 180 days

60% 50%

2,250,000 1,200,000 C$477,707.01

C$254,237.29

500,000 C$105,485.23

Problem 10.2 Kraftangan Ornamentals Kraftangan Ornamentals, a Malaysian, 100% privately-owned, ornamentals company, has signed an agreement to acquire a 60% ownership share of Taiwan Ornamentals, a Taiwan-based, privately-owned, ornamental company specializing in customized figurines from Thailand and Indonesia. The acquisition price is 9 million Taiwan dollars (TWD), payable in cash in three months.

Ahmad Chik, the owner of Kraftangan Ornamentals, believes the Taiwan dollar will either remain stable or decline slightly over the next three months. At the present spot rate of TWD7.35/MYR, the amount of cash required is only MYR1,224,490 but even this relatively modest amount will need to be borrowed by Ahmad Chik. The Taiwanese interest-bearing deposits by non-residents are regulated by the government and are currently set at 1.7% per year. He has a credit line with Malaysian Entrepreneurial Bank for MYR1,224,490, with a current borrowing interest rate of 6.5% per year. He does not believe that he can calculate a credible weighted average cost of capital since the company is not listed and neither are his closest competitors. Since the acquisition would use up all his available credit, he wonders if he should hedge the transaction exposure. He has the following quotes from the Malaysian Entrepreneurial Bank:

Spot rate (TWD/MYR) 3-month forward rate (TWD/MYR) 3-month Taiwan dollar deposit rate 3-month Malaysian ringgit borrowing rate 3-month call option on TWD

7.35 6.95 1.700% 6.500% Not available

Analyze the cost and risks of each alternative and make a recommendation as to which alternative Ahmad Chik should choose.

Assumptions Acquisition price and 3-month A/P, New Taiwan dollars (TWD) Spot rate (TWD/MYR) 3-month forward rate (TWD/MYR) 3-month Taiwan dollar deposit rate 3-month Malaysian ringgit borrowing rate 3-month call option on TWD Ahmad Chik’s credit line with Malaysian Entrepreneurial Bank

MYR

Evaluation of Alternatives

Values 9,000,000 7.35 6.95 1.700% 6.500% not available 1,224,490.00 Cost

Certainty

1. Do nothing: Wait for three months and buy TWD on the spot If the spot rate is the same as the current spot rate

MYR

1,224,489.80

Risky

If the spot rate is the same as the 3-month forward rate

MYR

1,294,964.03

Risky

MYR

1,294,964.03

Certain

Although this would do nothing to cover the currency risk, there would be no required payment or borrowing for three months.

2. Buy TWD at the 3-month forward rate Assured cost of TWD at the 3-month forward rate

The purchase of a forward contract would not require any cash up-front but the Malaysian Entrepreneurial Bank would reduce his available credit line by the amount of the forward. This is a non-cash expense.

3. Money market hedge: Exchanging MYR for TWD now and depositing for three months until the payment Acquisition price in TWD needed in three months Discounted back 3-months at the TWD deposit rate Amount of MYR needed now for deposit Spot rate, TWD/MYR MYR needed now for the exchange MYR carry-forward rate (3-month MYR borrowing rate) Carry-forward factor of the MYR for the 3-month period Total cost in MYR of settling A/P in 3-months with Money market hedge

MYR

9,000,000 0.9958 8,961,912 7.35 1,219,307.74

MYR

6.500% 1.0163 1,239,121.49

Certain

The currency risk is eliminated but since Ahmad Chik would have to exchange the money up-front, it would require him to borrow the money, increasing his outstanding debt for the entire three months.

This is a difficult decision. The forward contract appears to be the preferable choice, protecting him against an appreciating TWD and creating a certain cash purchase payment. The problem, however, will be whether the Malaysian Entrepreneurial Bank will allow him to purchase a forward for the full MYR1,294,964.03, which is slightly above his credit line currently in place. If his relationship is good with the bank, they will most likely increase his line sufficiently to allow the forward contract.

Problem 10.3 Elan Pharmaceuticals Elan Pharmaceuticals, a U.S.-based multinational pharmaceutical company, is evaluating an export sale of its cholesterol-reduction drug with a prospective Indonesian distributor. The purchase would be for 1,650 million Indonesian rupiah (Rp), which at the current spot exchange rate of Rp9,450 = $1.00, translates into nearly $175,000.

Although not a big sale by company standards, company policy dictates that sales must be settled for at least a minimum gross margin, in this case, a cash settlement of $168,000. The current 90-day forward rate is Rp9,950 = $1.00. Although this rate appeared unattractive, Elan had to contact several major banks before even finding a forward quote on the rupiah. The consensus of currency forecasters at the moment, however, is that the rupiah will hold relatively steady, possibly rising to Rp9,400 = $1.00 over the coming 90 to 120 days. Analyze the prospective sale and make a hedging recommendation.

Assumptions Receivable due in 3 months, in Indonesian rupiah (Rp) Spot rate (Rp=$1.00) Expected spot rate in 90 days (Rp=$1.00) 3-month forward rate (Rp=$1.00) Minimum dollar amount acceptable at settlement

Alternatives

Values Rp1,650,000,000 9,450 9,400 9,950 $168,000.00

Values

At Spot $174,603.17

Risk Assessment

1. Remain Uncovered.

Settle A/R in 90 days at current spot rate.

If spot rate in 90 days is same as current (Rp 1,650,000,000 / Rp 9,450=$1.00)

$174,603.17

Risky

If spot rate in 90 days is Rp9,400=$1.00 (Rp 1,650,000,000 / Rp 9,400=$1.00)

$175,531.91

Risky

If spot rate in 90 days is Rp9,800=$1.00 (Rp 1,650,000,000 / Rp 9,950=$1.00)

$165,829.15

Risky

A/R sold forward 90 days

$165,829.15

Certain

"Cost of cover" is the forward discount on Rp

-20.1%

2. Sell Indonesian rupiah forward.

Analysis The Indonesian rupiah has been highly volatile in recent years. This means that during the 90-day period, any variety of economic or political or social events could lead to an upward bounce in the exchange rate, reducing the dollar proceeds at settlement to an unacceptable level.

Unfortunately, the forward contract does not result in dollar proceeds that meet the minimum margin.

The cost of forward cover, 20.1%, is indicative of the "artificial interest rates" used by some financial institutions while pricing derivatives in emerging, illiquid, and volatile markets.

In the end, Elan will have to decide whether making the sale into this specific market is worth breaking a company policy on minimum proceeds (forward cover) or taking significant currency risk by not using a forward cover.

Problem 10.4 Embraer of Brazil Embraer of Brazil is one of the two leading global manufacturers of regional jets. (Bombardier of Canada is the other).

Regional jets are smaller than the traditional civilian airliners produced by Airbus and Boeing, seating between 50 and 100 people on average. Embraer has concluded an agreement with a regional U.S. airline to produce and deliver four aircraft one year from now for USD80 million.

Although Embraer will be paid in U.S. dollars, it also possesses a currency exposure of inputs -- it must pay foreign suppliers USD20 million for inputs one year from now (but they will be delivering the subcomponents throughout the year).

The current spot rate on the Brazilian real (BRL) is BRL1.8240 = USD1.00, but it has been steadily appreciating against the U.S. dollar over the past three years. Forward contracts are difficult to acquire and are considered expensive. Citibank Brasil has not explicitly provided Embraer a forward rate quote, but has stated that it will probably be pricing a forward off the current 4.00% U.S. dollar eurocurrency rate and the 10.50% Brazilian government bond rate. Advise Embraer on its currency Assumptions Receivable due in one year, U.S. dollars Payable due in one year, U.S. dollars Spot rate, reais per dollar (BRL=USD1.00) One-year U.S. dollar eurocurrency interest rate One-year Brazilian govt deposit note Implied one year forward rate = spot x ( 1 + iBRL ) / ( 1 + iUSD )

Analysis

Values USD 80,000,000 USD 20,000,000 1.8240 4.00% 10.50% 1.9380

Values

Risk Assessment

Net exposure at time of cash settlements: One year A/R due One year A/P due Net exposure

USD 80,000,000 (USD 20,000,000) USD 60,000,000

Certain

This is a net long position, meaning, Embraer will be receiving U.S. dollars on net. Given the history of the Brazilian reais, that it has traditionally suffered from rapid depreciation and occasional devaluation, a net long position in dollars by most Brazilian companies is considered a very good thing.

Cash settlement of the net position: Brazilian reais in one year at current spot rate

BRL 109,440,000.00

Risky

Brazilian reais in one year at one year forward rate

BRL 116,280,000.00

Certain

In this case, however, because the reais is selling forward at a considerable discount, the net long position -- if sold forward -yields considerably more reais than the current spot rate. It should also be noted, however, that if the reais were to fall considerably over the coming year, by remaining unhedged Embraer would enjoy greater reais returns.

Problem 10.5 BioTron Medical, Inc. Brent Bush, CFO of a medical device manufacturer, BioTron Medical, Inc., was approached by a Japanese customer, Numata, with a proposal to pay cash (in yen) for its typical orders of ¥12,500,000 every other month if it were given a 4.5% discount. Numata's current terms are 30 days with no discounts. Using the following quotes and estimated cost of capital for Numata, Bush will compare the proposal with covering yen payments with forward contracts. Should Brent Bush accept Numata's proposal?

Spot rate 30-day forward rate 90-day forward rate 180-day forward rate Numata's WACC BioTron Medical's WACC

¥111.40=$1.00 ¥111.00=$1.00 ¥110.40=$1.00 ¥109.20=$1.00 8.850% 9.200%

How much in U.S. dollars will BioTron Medical receive 1) with the discount and 2) with no discount but fully covered with a forward contract?

Assumptions BioTron's 30-day account receivable, Japanese yen Spot rate, ¥=$1.00 30-day forward rate, ¥=$1.00 90-day forward rate, ¥=$1.00 180-day forward rate, ¥=$1.00 Numata's WACC BioTron Medical's WACC Desired discount on purchase price by Numata

Values ¥12,500,000 111.40 111.00 110.40 109.20 8.850% 9.200% 4.500%

Brent Bush should compare two basic alternatives, both of which eliminate the currency risk.

1. Allow the discount and receive payment in Japanese yen in cash Account recievable (yen) Discount for cash payment up-front (4.500%) Amount paid in cash net of discount

¥12,500,000 (562,500) ¥11,937,500

$

111.40 107,158.89

Account receivable (yen) 30-day forward rate (¥=$1.00) Amount received in cash in dollars, in 30 days

$

¥12,500,000 111.00 112,612.61

Discount factor for 30 days @ Seattle's WACC Present value of dollar cash received

$

0.9924 111,755.82

Current spot rate (¥=$1.00) Amount received in U.S. dollars by Seattle Scientific 2. Not offer any discounts for early payment and cover exposure with forwards

Brent Bush should politely decline Numata's offer to pay cash in exchange for the requested discount.

111

Problem 10.6 Bobcat Company Bobcat Company, a U.S.-based manufacturer of industrial equipment, just purchased a Korean company that produces plastic nuts and bolts for heavy equipment. The purchase price was KRW7,50,00,00,000. KRW1,000,000,000 has already been paid, and the remaining KRW6,50,00,00,000 is due in six months. The current spot rate is KRW1,110/$ and the 6-month forward rate is KRW1,175/$. The sixmonth Korean won interest rate is 16% per annum and the six-month U.S. dollar rate is 4% per annum. Bobcat can invest at these interest rates or borrow at 2% per annum above them. A six-month call option on KRW with a 1,200/$ strike rate has a 3.0% premium while the sixmonth put option at the same strike rate has a 2.4% premium.

Bobcat's weighted average cost of capital is 10%. Compare alternate ways that Bobcat might deal with its foreign exchange exposure. What do you recommend and why?

Assumptions Purchase price of the Korean manufacturer (in KRW) Less initial payment (in KRW) Net settlement needed in six months (in KRW) Current spot rate (KRW/$) Six-month forward rate (KRW/$) Bobcat’s cost of capital (WACC)

Values 7,500,000,000 (1,000,000,000) 6,500,000,000 1,110 1,175 10.00%

Options on Korean won: Strike price (in KRW) Option premium (percent)

Call Option 1,200.00 3.000%

Put Option 1,200.00 2.400%

Six-month investment (not borrowing) interest rate (per annum) Borrowing premium of 2.000% Six-month borrowing rate (per annum)

United States 4.000% 2.000% 6.000%

Korea 16.000% 2.000% 18.000%

Values

Certainty

1. Remain uncovered, making the KRW payment in six months at the spot rate in effect at that date Account payable (KRW) Possible spot rate in six months: Current spot rate (KRW/$) Cost of settlement in six months ($)

6,500,000,000 1,110 5,855,855.86

Uncertain

Account payable (KRW) Possible spot rate in six months: forward rate (KRW/$) Cost of settlement in six months ($)

6,500,000,000 1,175 5,531,914.89

Uncertain

6,500,000,000 1,175.00 5,531,914.89

Certain

$

6,500,000,000 1.080 6,018,518,518.52 1,110.00 5,422,088.76 1.050 5,693,193.19

Certain

$

If exercised 6,500,000,000 1,110.00 3.000% 175,675.68

Risk management alternatives

2. Forward market hedge: Buy KRW at the 6-months forward rate Account payable (KRW) Forward rate (KRW/$) Cost of settlement in six months ($) 3. Money market hedge: Exchange dollars for won now and invest for six months Account payable (KRW) Discount factor at the KRW interest rate for six months KRW needed now (payable/discount factor) Current spot rate (KRW/$) U.S. dollars needed now Carry forward rate for six months (WACC) U.S. dollar cost of settlement in six months

$

4. Call option hedge: Need to buy KRW (call on KRW) Option principal Current spot rate (KRW/$) Premium cost of option (%) Option premium (principal/spot rate × % per month) If option is exercised/not exercised, dollar cost of KRW Premium carried forward six months (per month × 1.125, WACC) Total net cost of call option hedge if exercised

$ $

5,416,666.67 184,459.459 5,601,126.13 Maximum

If not exercised 1,300.00

$ $

5,000,000.00 184,459.46 5,184,459.46

The forward contract provides the lowest certain cost hedging method for payment settlement. If, however, the firm believes the ending spot rate will be a weaker KRW, KRW1,200/$ or higher, then the call option would be a lower-cost alternative. This would still require that the firm accept foreign exchange risk and be willing to suffer the higher cost of the call option in the event that the KRW does not fall to the needed level.

Problem 10.7 Siam Cement Siam Cement, the Bangkok-based cement manufacturer, suffered enormous losses with the coming of the Asian crisis in 1997. The company had been pursuing a very aggressive growth strategy in the mid-1990s, taking on massive quantities of foreign-currency-denominated debt (primarily U.S. dollars). When the Thai baht (B) was devalued from its pegged rate of THB25.0 = USD1.00 in July 1997, Siam's interest payments alone were over USD900 million on its outstanding dollar debt (with an average interest rate of 8.40% on its U.S. dollar debt at that time). Assuming Siam Cement took out USD50 million in debt in June 1997 at 8.40% interest and had to repay it in one year when the spot exchange rate had stabilized at THB42.0 = USD1.00, what was the foreign exchange loss incurred on the transaction?

Assumptions US dollar debt taken out in June 1997 US dollar borrowing rate on debt Initial spot exchange rate, THB=USD1.00, June 1997 Average spot exchange rate, THB=USD1.00, June 1998

Value USD 50,000,000 8.400% 25.00 42.00

Calculation of Foreign Exhange Loss on Repayment of Loan At the time the loan was acquired, the scheduled repayment of dollar and baht amounts would have been as follows: Scheduled Repayment: Repayment of US dollar debt: Principal Repayment of US dollar debt: Interest Total repayment Exchange rate at time of repayment, THB=USD1.00 Total repayment in Thai baht Total proceeds from loan, up-front, in Thai baht Net interest to be paid, in Thai baht Actual Repayment: Repayment of US dollar debt: Principal Repayment of US dollar debt: Interest Total repayment Exchange rate at time of repayment, THB=USD1.00 Total repayment in Thai baht Less what Siam had EXPECTED or SCHEDULED to be repaid Amount of foreign exchange loss on debt

USD 50,000,000 4,200,000 USD 54,200,000 25.00 THB 1,355,000,000 1,250,000,000 THB 105,000,000

USD 50,000,000 4,200,000 USD 54,200,000 42.00 THB 2,276,400,000 (1,355,000,000) THB 921,400,000

Problem 10.8 P&G India Procter and Gamble's affiliate in India, P&G India, procures much of its toiletries product line from a Japanese company. Because of the shortage of working capital in India, payment terms by Indian importers are typically 180 days or longer. P&G India wishes to hedge an 8.5 million Japanese yen (JPY) payable. Although options are not available on the Indian rupee (INR), forward rates are available against the yen.

Additionally, a common practice in India is for companies like P&G India to work with a currency agent who will, in this case, lock in the current spot exchange rate in exchange for a 4.85% fee. Using the following exchange rate and interest rate data, recommend a hedging strategy. (All rates of interest are stated on a per annum basis.)

Assumptions 180-day account payable, Japanese yen Spot rate (JPY=USD1.00) Spot rate, rupees/dollar (INR=USD1.00) Calculated spot rate (JPY=INR1.00) 180-day forward rate (JPY=INR1.00) Expected spot rate in 180 days (JPY=INR1.00) 180-day Indian rupee investing rate 180-day Japanese yen investing rate Currency agent's exchange rate fee P & G India's cost of capital

Values JPY 8,500,000 120.60 47.75 2.5257 2.4000 2.6000 8.000% 1.500% 4.850% 12.00%

(120.60 / 47.75)

Values

Spot Rate (JPY=INR1.00)

If spot rate in 180 days is same as current spot

INR 3,365,464.34

2.5257

Risky

If spot rate in 180 days is same as forward rate

INR 3,541,666.67

2.4000

Risky

If spot rate in 180 days is expected spot rate

INR 3,269,230.77

2.6000

Risky

Settlement amount at forward rate

INR 3,541,666.67

2.4000

Certain

Principal A/P (JPY) discount factor for yen investing rate for 180 days Principal needed to meet A/P in 180 days (JPY)

JPY 8,500,000.00 0.9926 JPY 8,436,724.57

Current spot rate (JPY=INR1.00) Indian rupee, current amount (INR) P&G India's WACC carry-forward factor for 180 days Future value of money market hedge (INR)

2.5257 INR 3,340,411.26 1.0600 INR 3,540,835.94

Hedging Alternatives

Risk Assessment

1. Remain Uncovered, settling A/P in 180 days at spot rate

2. Buy Japanese yen forward 180 days

3. Money Market Hedge

Certain

4. Indian Currency Agent Hedge Principal A/P (JPY) Current spot rate (JPY=INR1.00) Current A/P (INR)

JPY 8,500,000.00 2.5257 INR 3,365,464.34

Plus agent's fee (4.850%) P & G India's WACC carry-forwad factor for 180 days on fee Total future value of agent's fee (INR)

INR 163,225.02 1.0600 INR 173,018.52

Total A/P, future value, A/P + fee (INR)

INR 3,538,482.87

Evaluation of Alternatives The currency agent is the lowest total cost, in CERTAIN future rupee value, of all certain alternatives.

Certain

Problem 10.9 Singflux Singflux is a Singapore-based company that manufactures, sells, and installs water-treatment plants. On June 1, the company sold a water-treatment plant to the City of Hiroshima, Japan, for installation in Hiroshima’s famous cherry blossom gardens. The sale was priced in yen, at ¥100,000,000, with payment due in three months. ¥=$1.00 ¥80.310 ¥79.960 ¥79.140 ¥74.870

Spot exchange rate: One-month forward rate: Three-month forward: One-year forward: Money Rates 1 month 3 months 12 months

United States 5.9850% 6.1895% 7.9515%

¥80.31/$ (closing mid-rates) 5.25% 5.91% 7.27% Japan 0.06950% 0.06950% 0.15050%

Differential 5.91550% 6.12000% 7.80100%

Note: The interest rate differentials vary slightly from the forward discounts on the yen because of time differences for the quotes. The spot ¥80.31/SGD, for example, is a mid-point range. On June 1, the spot yen traded in London from ¥80.36/SGD to ¥79.86/SGD. Singflux’s Japanese competitors are currently borrowing from Japanese banks at a spread of one percentage point above the Japanese money rate. Singflux’s weighted average cost of capital is 10% and the company wishes to protect the Singapore dollar value of this receivable.

Three-month options from Kokoda Bank: *Call option on ¥100,000,000 at an exercise price of ¥80.00/SGD: A 1% premium. *Put option on ¥100,000,000, at an exercise price of ¥80.00/SGD: A 3% premium. a) What are the costs and benefits of alternative hedges? Which would you recommend and why? b) What is the breakeven reinvestment rate when comparing forward and money market alternatives?

Assumptions Amount of receivable (¥) Spot exchange rate at the time of sale (¥/SGD) Booked value of the sale (amount/spot rate) Days receivable due Singflux’s WACC Competitor borrowing premium (¥)

Values 100,000,000 80.310 1245174.95 90 10.0% 1.0%

Forward rates and premiums One-month forward rate (¥/SGD) Three-month forward rate (¥/SGD) One-year forward rate (¥/SGD)

Forward Rate 79.960 79.140 74.870

Premium 5.25% 5.91% 7.27%

Investment rates (% per annum) 1 month 3 months 12 months

Singapore 5.9850% 6.1895% 7.9515%

Japan 0.06950% 0.06950% 0.15050%

Strike (¥/SGD) 80.000 80.000

Premium 1.0% 3.0%

Values

Certainty

Purchased options 3-month call option on yen 3-month put option on yen a. Alternative Hedges 1. Remain uncovered Account receivable (¥) Possible spot rate in 90 days (¥/SGD) Cash settlement in 90 days (SGD)

100,000,000 80.310 1,245,174.95

Uncertain

100,000,000 79.140 1,263,583.52

Certain

2. Forward market hedge Account receivable (¥) Forward rate (¥/SGD) Cash settlement in 90 days (SGD) 3. Money market hedge Account receivable (¥) Discount factor for 90 days Yen proceeds up-front Current spot rate (¥/SGD) SGD received now Carry forward at Singflux’s WACC Proceeds in 90 days (SGD)

100,000,000 1.00267 99,733,338 80.310 1,241,854.54 1.0250 1,272,900.90

4. Put option hedge: Need to sell yen (put on yen) Option principal Current spot rate (¥/SGD) Premium cost of option (%) Option per month (principal/spot rate x % per month, SGD)

100,000,000 80.310 3.000% 37,355.25

If option is exercised, SGD proceeds Less, per-month carried forward for 90 days Net proceeds in 90 days (SGD)

1,250,000.00 (38,289.130) 1,211,710.87

1 + ((.000695+.01) × 90/360)

1 + (.10 × 90/360) Certain

1.025 carry-forward rate Minimum

The put option does not guarantee the company of settling for the booked amount.

The money market and forward hedges do; the money market yields the higher proceeds. b) Breakeven rate between the money market and the forward hedge is determined by the reinvestment rate: Money market, SGD up-front 1,241,854.54 Forward contract at the end of 90 days (SGD) 1,263,583.52 (1+x) 101.750% SGD1,241,854.54 (1+x) = SGD1,263,583.52 x 1.74972% For 90 days Breakeven rate (% per annum, SGD) 0.06999

Problem 10.10 Mattel Toys Mattel is a U.S.-based company whose sales are roughly two-thirds in dollars (Asia and the Americas) and one-third in euros (Europe). In September, Mattel delivers a large shipment of toys (primarily Barbies and Hot Wheels) to a major distributor in Antwerp. The receivable, €30 million, is due in 90 days, standard terms for the toy industry in Europe. Mattel's treasury team has collected the following currency and market quotes. The company's foreign exchange advisors believe the euro will be at about $1.4200 = €1.00 in 90 days. Mattel's management does not use currency options in currency risk management activities. Advise Mattel on which hedging alternative is probably preferable.

Current spot rate ($=€1.00) Credit Suisse 90-day forward rate ($=€1.00) Barclays 90-day forward rate ($=€1.00) Mattel Toys WACC ($) 90-day eurodollar interest rate 90-day euro interest rate 90-day eurodollar borrowing rate 90-day euro borrowing rate Assumptions 90-day A/R (€) Current spot rate ($=€1.00) Credit Suisse 90-day forward rate ($=€1.00) Barclays 90-day forward rate ($=€1.00) Expected spot rate in 90 days ($=€1.00) 90-day eurodollar interest rate 90-day euro interest rate Implied 90-day forward rate (calculated, $=€1.00) 90-day eurodollar borrowing rate 90-day euro borrowing rate Mattel Toys weighted average cost of capital ($)

Hedging Alternatives

$1.4158 $1.4172 $1.4195 9.600% 4.000% 3.885% 5.000% 5.000% Values € 30,000,000.00 $1.4158 $1.4172 $1.4195 $1.4200 4.000% 3.885% $1.4162 5.000% 5.000% 9.600%

Values

Risk Assessment

1. Remain Uncovered, settling A/R in 90 days at market rate (20 million euros / future spot rate) If spot rate in 90 days is same as current

$42,474,000.00

Risky

If spot rate in 90 days is same as Credit Suisse forward rate

$42,516,000.00

Risky

If spot rate in 90 days is same as Barclays forward rate

$42,585,000.00

Risky

If spot rate in 90 days is expected spot rate

$42,600,000.00

Risky

Settlement amount at Credit Suisse forward rate

$42,516,000.00

Certain

Settlement amount at Barclays forward rate

$42,585,000.00

Certain

Principal A/R in euros discount factor for euro borrowing rate for 90 days Borrow euros against 90-day A/R

€ 30,000,000.00 0.9877 € 29,629,629.63

Current spot rate, $ per euro US dollar current value Mattel's WACC carry-forward factor for 90 days

$1.4158 $41,949,629.63 1.0240

Future value of money market hedge

$42,956,420.74

2. Sell euros forward 90 days

3. Money Market Hedge 1/(1 + (.05 x 90/360))

1 + (.0960 x 90/360) Certain

Evaluation of Alternatives The money market hedge guarantees Mattel the greatest dollar value for the A/R when using the cost of capital as the reinvestment rate (carry-forward rate).

Problem 10.11 Chronos Time Pieces Chronos Time Pieces of Boston exports watches to many countries, selling in local currencies to stores and distributors. Chronos prides itself on being financially conservative. At least 70% of each individual transaction exposure is hedged, mostly in the forward market, but occasionally with options. Chronos' foreign exchange policy is such that the 70% hedge may be increased up to a 120% hedge if devaluation or depreciation appears imminent. Chronos has just shipped to its major North American distributor. It has issued a 90-day invoice to its buyer for €1,560,000. The current spot rate is $1.2224 = €1.00, the 90-day forward rate is $1.2270 = €1.00.

Chronos' treasurer, Manny Hernandez, has a very good track record in predicting exchange rate movements. He currently believes the euro will weaken against the dollar in the coming 90 to 120 days, possibly to around $1.16 = €1.00.

Assumptions Account recievable in 90 days (€) Initial spot exchange rate ($=€1.00) Forward rate, 90 days ($=€1.00) Expected spot rate in 90 to 120 days ($=€1.00): Case #1 Expected spot rate in 90 to 120 days ($=€1.00): Case #2

Values € 1,560,000 $1.2224 $1.2270 $1.1600 $1.2600 Hedged the Minimum

Hedged the Maximum

Proportion of exposure to be hedged Total exposure (€) hedged proportion Minimum hedge in euros (exposure x min prop) at the forward rate ($=€1.00) locking in ($)

70% € 1,560,000 70% € 1,092,000 $1.2270 $1,339,884

120% € 1,560,000 120% € 1,872,000 $1.2270 $2,296,944

Case #1: Ending spot rate Proportion uncovered (short) If ending spot rate is ($=€1.00) Value of uncovered proportion ($)

€ 468,000 $1.1600 $542,880

(€ 312,000) $1.1600 ($361,920)

Value of covered proportion (from above)

$1,339,884

$2,296,944

Total net proceeds, covered + uncovered

$1,882,764

$1,935,024

Case #2: Ending spot rate Proportion uncovered (short) If ending spot rate is ($=€1.00) value of uncovered proportion ($)

€ 468,000 $1.2600 $589,680

(€ 312,000) $1.2600 ($393,120)

If Chronos Time Pieces ……

Value of covered position (from above) Total net proceeds, covered + uncovered Benchmark: Full (100%) forward cover

$

1,339,884

$

2,296,944

$1,929,564

$1,903,824

$1,914,120

$1,914,120

c. What would be considered the most conservative transaction hedging policy? In general, conservatism in transaction exposure hedging means the use of forward contracts on 100% of the total exposure. A firm choosing to hedge more than the actual exposure amount is effectively speculating on that percentage of currency greater than 100%. At the same time, many firms do believe it is more prudent (conservative) to hedge slightly less than the total exposure, as amounts change between exposure creation and settlement.

Problem 10.12 Wing Sang Jeans Limited Wing Sang Jeans Limited of Hong Kong is completing a new assembly plant near Bangkok, Thailand. A final construction payment of THB28,200,000 is due in six months. Wing Sang uses 15% per annum as its weighted average cost of capital. Today’s foreign exchange and interest rate quotations are as follows: Construction payment due in six months (A/P, THB) Present spot rate (THB/HKD) Six-month forward rate (THB/HKD) Thai six-month interest rate (per annum) Hong Kong dollar six-month interest rate (per annum) Wing Sang’s cost of capital (WACC)

28,200,000 3.8800 3.9800 2.500% 1.750% 15.000%

Wing Sang’s treasury manager, concerned about the overheating Thai economy, wonders if Wing Sang should be hedging its foreign exchange risk. The manager’s forecast is as follows: Expected spot rate in six months (THB/HKD) Highest expected rate (reflecting a significant devaluation) Expected rate Lowest expected rate (reflecting a strengthening appreciation)

4.5000 4.0000 3.2000

What realistic alternatives are available for Wing Sang for making payments? Which method would you select and why?

What realistic alternatives are available to Wing Sang?

Cost

Certainty

1. Wait for six months and make the payment at the spot rate Highest expected rate

HKD

6,266,666.67

Risky

Expected rate

HKD

7,050,000.00

Risky

Lowest expected rate

HKD

8,812,500.00

Risky

HKD

7,085,427.14

Certain

27,851,851.85 7,178,312.33 1.075 7,716,685.76

Certain

2. Purchase Thai baht at the 6-months forward rate (A/P divided by the forward rate) 3. Transfer dollars to Thai baht today and invest for six-months THB needed today (A/P discounted 180 days) Cost in HKD today (THB to HKD at spot rate) Factor to carry HKD forward 180 days (1 + (WACC/2)) Cost in HKD in six months (dollars carried forward 180 days )

HKD HKD

The second choice, the forward contract, results in the lowest-cost alternative among certain alternatives.

Problem 10.13 RadioEdison Manufacturing Carla Surz is the director of finance for RadioEdison Manufacturing, a U.S.-based manufacturer of handheld computer systems for inventory management. RadioEdison's system combines a low-cost active radio frequency identification (RFID) tag that is attached to inventory items (the tag emits an extremely low-grade radio frequency) with custom designed hardware and software that tracks the low-grade emissions for inventory control. RadioEdison has completed the sale of an inventory management system to a British firm, Pegg Metropolitan (UK), for a total payment of £1,000,000. The exchange rates that follow were available to Burton on the dates shown, corresponding to the events of this specific export sale. Assume each month is 30 days. a. What will be the amount of foreign exchange gain (loss) upon settlement? b. If Carla hedges the exposure with a forward contract, what will be the net foreign exchange gain (loss) on settlement?

Date February 1 March 1 June 1 August 1 September 1

Event Price quotation for Pegg Contract signed for sale Contract amount, pounds Product shipped to Pegg Product received by Pegg Pegg makes payment

Spot Rate ($=£1.00) 1.7850 1.7465 £1,000,000 1.7689 1.7840 1.7290

Forward Rate ($=£1.00) 1.7771 1.7381

Days Forward of Forward Rate 210 180

1.7602 1.7811 ---------

90 30 ---------

Analysis a. The sale is booked at the exchange rate existing on June 1, when the product is shipped to Pegg Metropolitan, and the shipment is categorized as an account receivable. This sale is then compared to that value in effect on the date of cash settlement, the difference being the foreign exchange gain (loss).

Value as settled Value as booked FX gain (loss)

1 million pounds @ $1.7290 per pound 1 million pounds @ $1.7689 per pound

$1,729,000 $1,768,900 ($39,900)

b. The value of the foreign exchange gain (loss) will depend upon when Jason actually purchases the forward contract. Because many firms do not define an "exposure" as arising until the date that the product is shipped (loss of physical control over the goods) and the sale is booked on the income statement, which is a common date for the purchase of the forward contract.

Forward contract purchased on June 1 Value of forward settlement 1 million pounds @ $1.7602 per pound Value as booked 1 million pounds @ $1.7689 per pound FX gain (loss)

$1,760,200 $1,768,900 ($8,700)

A more aggressive alternative is for Carla to purchase the forward contract on the date that the contract was signed, March 1, locking-in the U.S. dollar settlement amount a full 90 days earlier in the transaction exposure's life span.

Forward contract purchased on March 1 Value of forward settlement 1 million pounds @ $1.7381 per pound Value as booked 1 million pounds @ $1.7689 per pound FX gain (loss)

$1,738,100 $1,768,900 ($30,800)

Note that in this case if Carla had covered forward on March 1 rather than June 1, the amount of the foreign exchange loss would have been even greater, although "fully hedged." The difference is of course the result of the forward rate changing with spot rates and interest

Problem 10.14 Micca Metals, Inc. Micca Metals, Inc. is a specialty materials and metals company located in Detroit, Michigan. The company specializes in specific precious metals and materials that are used in a variety of pigment applications in many industries including cosmetics, appliances, and a variety of high tinsel metal fabricating equipment. Micca just purchased a shipment of phosphates from Morocco for 6,000,000 dirhams, payable in six months.

Six-month call options on 6,000,000 dirhams at an exercise price of 10.00 dirhams per dollar are available from Bank AlMaghrub at a premium of 2%. Six-month put options on 6,000,000 dirhams at an exercise price of 10.00 dirhams per dollar are available at a premium of 3%. Compare and contrast alternative ways that Micca might hedge its foreign exchange transaction exposure. What is your recommendation?

Assumptions Shipment of phosphates from Morocco, Moroccan dirhams Micca's cost of capital (WACC) Spot exchange rate, dirhams per $ 6-month forward rate, dirhams per $

Values 6,000,000 14.000% 10.00 10.40

Options on Moroccan dirhams: Strike price, dirhams per $ Option premium (percent)

Call Option 10.00 2.000%

Put Option 10.00 3.000%

Six-month interest rate for borrowing (per annum) Six-month interest rate for investing (per annum)

United States 6.000% 5.000%

Morocco 8.000% 7.000%

Values

Certainty

Risk Management Alternatives 1. Remain uncovered, making the dirham payment in six months at the spot rate in effect at that date Account payable (dirhams) Possible spot rate in six months -- the current spot rate (dirhams per $) Cost of settlement in six months ($)

$

6,000,000 10.00 600,000.00

Uncertain.

$

6,000,000 10.40 576,923.08

Uncertain.

$

6,000,000 10.40 576,923.08

Certain.

3. Money market hedge. Exchange dollars for dirhams now, invest for six months.

Account payable (dirhams) 6,000,000.00 Discount factor at the dirham investing rate for 6 months 1.035 Dirhams needed now for investing (payable/discount factor) 5,797,101.45 Current spot rate (dirhams per $) 10.00 U.S. dollars needed now $ 579,710.14 Carry forward rate for six months (WACC) 1.070 U.S. dollar cost, in six months, of settlement $ 620,289.86

Certain.

Account payable (dirhams) Possible spot rate in six months -- forward rate (dirhams per $) Cost of settlement in six months ($) 2. Forward market hedge. Buy dirhams forward six months.

Account payable (dirhams) Six month forward rate, dirhams per $ Cost of settlement in six months ($)

4. Call option hedge. (Need to buy dirhams, a call on dirhams) Option principal Current spot rate, dirhams per $ Premium cost of option Option premium (principal/spot rate x % pm) If option exercised, dollar cost at strike price of 10.00 dirhams per $ Plus premium carried forward six months (pm x 1.07, WACC) Total net cost of call option hedge if exercised

$ $ $

6,000,000.00 10.00 2.000% 12,000.00 600,000.00 12,840.000 612,840.00

Maximum.

The lowest cost certain alternative is the forward. If Micca were to expect the dirham to depreciate significantly over the next six months, it may choose the call option.

Problem 10.15 Terry McDermott and Aidan Aidan—the Ireland-based company discussed in this chapter—has concluded another large sale of telecommunications equipment to Regency (U.K.). The total payment of £3,000,000 is due in 90 days. Terry McDermott has also learned that Aidan will only be able to borrow in the United Kingdom at 14% per annum (due to credit concerns of British banks). Given the following exchange rates and interest rates, what transaction exposure hedge is now in Aidan’s best interest?

Assumptions 90-day A/R (£) Spot rate, euro per pound (€/£) 90-day forward rate (€/£) 3-month euro investment rate 3-month euro borrowing rate 3-month U.K. investment interest rate 3-month U.K. borrowing interest rate Put options on the British pound: Strike rates (€/£) Strike rate (€/£) Put option premium Strike rate (€/£) Put option premium Aidan’s WACC Terry McDermott’s expected spot rate in 90 days (€/£) Alternative 1: Remain uncovered Value of A/R will be (£3,000,000 x ending spot rate) If the spot rate is the same as the current spot rate If the ending spot rate is the same as the current forward rate If the ending spot rate is the expected spot rate Alternative 2: Forward contract hedge Sell the pounds forward three months, locking in the forward rate Pound A/R at the forward rate (pounds × forward) Alternative 3: Money market hedge Borrows against the A/R, receiving the pounds up-front, exchanging into euros Amount of A/R in 90 days (£) Discount factor, pound borrowing rate, for three months Proceeds of borrowing, up-front (£) Exchanged into euros at the current spot rate of Euros received against A/R, up-front Euros needed to be carried forward for comparison Carry-forward rate, WACC for 90 days Money market hedge at end of 90 days (€)

€ €

€

€

Proceeds from the put option, if exercised Less, cost of premium, including time value Net proceeds from put options in 90 days (minimum) Ending spot rate needed to be superior to the forward rate Proceeds from exchanging pounds for euros on the spot Less, cost of option (allowed to expire OTM) Net proceeds from put option, if unexercised

1.750 1.500% $1.71 1.000% 12.000% 1.785 Rate (€/£)

€ € €

1.092 1.075 1.785

Proceeds € € €

Rate (€/£) €

1.0750

3,276,000.00 3,225,000.00 5,355,000.00 Proceeds

€

Rate (€/£)

3,225,000.00 Proceeds 3,000,000.00 0.9662 2,898,550.72

€

1.0920 €

3,165,217.39 1.0300 3,260,173.91

Alternative 4: Put option hedges Option premium Notional principal of option (£) Spot rate (€/£) Option premium Carry-forward factor, WACC, for 90 days Total premium cost in 90 days

Value £3,000,000.00 1.092 1.075 6.000% 8.000% 8.000% 14.000%

€ € € € € € € €

Strike Rate (€/£) 1.75 1.500% 3,000,000.00 1.0920 49,140.00 1.0300 50,614.20 5,250,000.00 (50,614.20) 5,199,385.80 1.7825 5,347,500.00 (50,614.20) 5,296,885.80

€ € € € € € €

Strike Rate (€/£) 1.71 1.000% 3,000,000.00 $1.0920 32,760.00 1.0300 33,742.80 5,130,000.00 (33,742.80) 5,096,257.20 1.7732 5,319,600.00 (33,742.80) 5,285,857.20

Terry McDermott would receive the most certain euros from the forward contract, €5,265,000; the money market hedge is less attractive as a result of the higher borrowing costs in the U.K. now. The two put options yield unattractive amounts if they are exercised. As shown, the €1.75 strike price put option would be superior to the forward if the ending spot rate was €1.7825 or higher; the €1.71 strike price would be superior to the forward if the ending spot rate were €1.7732 or higher.

Problem 10.16 ABB Group On May 1, ABB Group, a wholly owned subsidiary of Asia Power Generation Corporation (Philippines), sold a 20-megawatt transformer to Roma Italia SpA of Italy for €5,000,000, payable as €2,500,000 on September 1 and €2,500,000 on December 1. ABB derived its price quote of €5,000,000 on April 1 by dividing its normal Philippine peso sales price of PHP279,750,000 by the then-current spot rate of PHP55.9500/€.

By the time the order was received and booked on June 1, the euro had strengthened to PHP56.0500/€, so the sale was in fact worth €5,000,000 × PHP56.0500/€ = PHP280,250,000. ABB had already gained an extra PHP500,000 from the favorable exchange rate movements.

Nevertheless, ABB’s vice president of finance now wondered if the firm should hedge against a reversal of the most recent trend of the euro.

Four approaches were possible: 1. Hedge in the forward market: The 3-month forward exchange quote was PHP56.1500/€ and the 6-month forward quote was PHP57.0500/€.

2. Hedge in the money market: ABB could borrow euros from the Munich branch of its Philippine bank at 6.00% per annum.

3. Hedge with foreign currency options: September put options were available at a strike price of PHP56.0500/€ for a premium of 1.5% per contract and December put options were available at PHP56.0500/€ for a premium of 1.1%. September call options at PHP56.0500/€ could be purchased at a premium of 2.0% and December call options at PHP56.0500/€ were available at a 1.7% premium.

4. Do nothing: ABB could wait until the sales proceeds were received in September and December, hope the recent strengthening of the euro would continue, and sell the euros receives for Philippine pesos in the spot market.

ABB estimates the cost of equity capital to be 10% per annum. As a moderate-sized firm, ABB is unable to raise funds with long-term debt.

Average euro-denominated government bonds yield 1.0% per annum. What should ABB do?

Assumptions 90-day forward rate (PHP/€) 180-day forward rate (PHP/€) Average euro government bonds rate ABB’s borrowing rate per annum (€) ABB’s cost of equity Options on euros September maturity options December maturity options

Values 56.1500 57.0500 1.000% 6.000% 10.000% Strike (PHP/€) 56.05 56.05

Valuation of alternative hedges Amount of receivable (€)

Today is June 1 Exchange Rate (PHP/€) 55.95 56.05

Date May 1 June 1

Call Option 2.0% 1.7%

Put Option 1.5% 1.1%

September Receivable 2,500,000.00

December Receivable 2,500,000.00

a. Hedge in the forward market Amount of receivable (€) Respective forward rates (PHP/€) Philippine peso proceeds as hedged (PHP) Carry forward to December 1 at WACC Total Philippine peso proceeds on December 1 Total of both payments

2,500,000.00 2,500,000.00 56.15 57.05 140,375,000.00 142,625,000.00 1.03 ----143,884,375.00 142,625,000.00 PHP 286,509,375.00

Amount of receivable (€) Discount factor for euro funds, period Current proceeds from discounting (€) Current spot rate (PHP/€) Current Philippine peso proceeds Carry forward rate for the period Philippine peso proceeds on a future date Total of both payments

2,500,000.00 2,500,000.00 1.02 1.03 2,463,054.19 2,427,184.47 56.05 56.05 138,054,187.19 136,043,689.32 1.05 1.05 144,956,896.55 142,845,873.79 PHP 287,802,770.34

b. Hedge in the money market

c. Hedge with options Amount of receivable (€) Buy put options for maturities (% × spot value) Carry forward rate for the period Premium cost carried forward to December 1 Gross put option value, if exercised Carried forward three months to December 1 Gross proceeds on December 1 Total net proceeds after premium deduction on December 1

2,500,000.00 (PHP 2,101,875) 1.0500 (PHP 2,206,969)

2,500,000.00 (PHP 1,541,375) 1.0500 (PHP 1,618,444)

PHP 140,125,000 PHP 140,125,000 1.03 ---PHP 143,628,125 PHP 140,125,000 PHP 279,927,712.50

d. Do nothing: Remain uncovered Amount of receivable (€) Ending spot exchange rate (PHP/€)

2,500,000 ???

2,500,000 ???

The money market hedge provides the highest certain outcome. If the ABB Group believes the euro will strengthen versus the Philippine peso over the coming months, and it is willing to take the currency risk, the put option hedges could be considered.

Problem 10.17 Milan Pharmaceuticals SpA’s Intra-Company Hedging Milan Pharmaceuticals SpA is an Italian multinational that has developed a vaccine for the Ebola virus. It recently established a new subsidiary in Cape Town, South Africa, and is now in the process of establishing operating rules for transactions between the Italian parent company and the Cape Town subsidiary. Alberto Fognini was the international treasurer for Milan and was leading the effort at establishing commercial policies for the new subsidiary.

Milan’s first shipment of products to South Africa was upcoming. The first shipment would carry an intracompany invoice amount of €2,000,000. The company was trying to decide whether to invoice the South African subsidiary in euros or South African rand (ZAR) and, in turn, whether the resulting transaction exposure should be hedged. Alberto’s idea was to take a recent historical period of exchange rate quotes and simulate the invoicing and hedging alternatives available to Milan to try and characterize the choices.

Alberto looked at the 90-day period, which had ended the previous Friday (the standard intra-company payment terms for transcontinental transactions was 90 days). The quarter had opened with a spot rate of ZAR16.43/€, with the 90-day forward rate quoted at ZAR15.95/€ the same day. The quarter closed with a spot rate of ZAR17.85/€.

a. Which unit would have suffered the gain (loss) on currency exchange if intra-company sales were invoiced in South African rand (ZAR), assuming both were completely unhedged and fully hedged? b. Which unit would have suffered the gain (loss) on currency exchange if intra-company sales were invoiced in euros (€), assuming both were completely unhedged and fully hedged?

Italian Parent Company Sells Product to a South African Subsidiary Parameters Sales price (€) Spot rate, day 0 (ZAR/€) Spot rate, day 90 (ZAR/€) Forward rate, 90 days (ZAR/€)

Value 2,000,000.00 ZAR 16.4300 ZAR 17.8500 ZAR 15.9500

a) If the product was invoiced in euros, the parent has no direct exposure but the South African subsidiary in Cape Town does.

Cape Town P&L: No hedge Payable as booked (initial spot) Payable as settled (ending spot) FX gain (loss)

Rate (ZAR/€) 16.4300 17.8500

Entry ZAR 32,860,000.00 ZAR 35,700,000.00 -ZAR 2,840,000.00

Cape Town P&L: Forward hedge Payable as booked (initial spot) Payable as settled (forward rate) FX gain (loss)

Rate (ZAR/€) 16.4300 15.9500

Entry ZAR 32,860,000.00 ZAR 31,900,000.00 ZAR 960,000.00

b) If the product was invoiced in South African rands, the Cape Town subsidiary has no exposure but the Italian parent company does.

Italian P&L: No Hedge Receivable (€) A/R as invoiced in South African rand A/R as settled at the ending spot rate FX gain (loss)

Rate (ZAR/€)

Italian P&L: Forward hedge Receivable (€) A/R as invoiced in South African rand A/R as settled at the forward rate FX gain (loss)

Rate (ZAR/€)

16.4300 17.8500 -

16.4300 15.9500

Entry 2,000,000.00 32,860,000.00 1,840,896.36 € 159,103.64 €

Entry 2,000,000.00 32,860,000.00 2,060,188.09 € 60,188.09 €

Problem 10.18 KAL and Boeing Korean Airlines (KAL) has just signed a contract with Boeing to purchase two new 747-400's for a total of USD60,000,000, with payment in two equal tranches. The first tranche of $30,000,000 has just been paid. The next $30,000,000 is due three months from today. KAL currently has excess cash of 25 billion won (KRW) in a Seoul bank, and it is from these funds that KAL plans to make its next payment.

The current spot rate is won KRW800 = USD1.00, and permission has been obtained for a forward rate (90 days), won KRW794= USD1.00. The 90-day eurodollar interest rate is 6.000%, while the 90-day Korean won deposit rate (there is no euro-won rate) is 5.000%. KAL can borrow in Korea at 6.250% and can probably borrow in the U.S. dollar market at 9.375%.

A three-month call option on dollars in the over-the-counter market, for a strike price of won KRW790 = USD1.00 sells at a premium of 2.9%, payable at the time the option is purchased. A 90-day put option on dollars, also at a strike price of won KRW790/$, sells at a premium of 1.9% (assuming a 12% volatility). KAL's foreign exchange advisory service forecasts the spot rate in three months to be KRW792 = USD1.00.

How should KAL plan to make the payment to Boeing if KAL's goal is to maximize the amount of won cash left in the bank at the end of the three month period? Make a recommendation and defend it.

Forward Cover $30,000,000 794 800

Money Market $30,000,000 792 800

5.000%

5.000%

6.000% 9.375% 5.000%

Call Option $30,000,000 790 800 2.900% 6.000% 9.375% 5.000%

Bank Balance Beginning balance Initial deductions balance for interest

Uncovered 25,000,000,000 0 25,000,000,000

Forward Cover 25,000,000,000 0 25,000,000,000

Money Market 25,000,000,000 -23,645,320,197 1,354,679,803

Call Option 25,000,000,000 -696,000,000 24,304,000,000

Interest earnings Balance at day 89

312,500,000 25,312,500,000

312,500,000 25,312,500,000

16,933,498 1,371,613,300

303,800,000 24,607,800,000

Settlement of payment Final Balance

-23,760,000,000 1,552,500,000

-23,820,000,000 1,492,500,000

1,371,613,300

-23,700,000,000 907,800,000 If exercised.

Total cost

23,760,000,000 Very Risky.

23,820,000,000 Certain.

23,940,886,700 Certain.

Payment (exposure) Effective ending rate (Won/$) Current spot rate (Won/$) Option premium (call) Eurodollar interest US dollar interest borrow Korean won interest

Uncovered $30,000,000 792 800

Pm

704,700,000 24,404,700,000 Worst case.

Could be better.

KAL Money Market Hedge The challenge with the Korean Money Market Hedge is that it is a payable -- a payable form a Korean won cash balance. A MM Hedge for a payable is to simply transfer money into the target currency at the start of the period (the front end of the box), and then to have that money earn interest on deposit for the time period until payment is due.

In this problem, that means transfering enough Korean won at the start to fund a dollar deposit which will yield a total of $30 million at the end of 90 days. The dollar deposit earns a deposit rate (not a borrowing rate). The won transferred out of the account at the beginning of the period then reduces the account balance, which then earns the Korean interest rate for the 90 days to get to an ending cash balance.

Eurodollar deposit rate 6.000% $

29,556,650 ↓ ↓ ↓ ↓ ↓ Spot (Won/$) 800.00 ↓ ↓ ↓ 23,645,320,197

Korean bank balance 25,000,000,000 (23,645,320,197) 1,354,679,803

↔

↔

1.0150

↔

↔

US dollars for Payable $ 30,000,000

---------------> 90 days ---------------->

Amount to be withdrawn from Korean bank balance

→

This is the remaining balance which is then carried forward

→

1.0125 5.000% Korean won interest

→

→

Bank Balance at end 1,371,613,300

Problem 11.1 Ganado Europe (A) Using facts in the chapter for Ganado Europe, assume the exchange rate on January 2, 2006, in Exhibit 11.5 dropped in value from $1.2000 = €1.00 to $0.9000 = €1.00 (rather than to $1.0000 = €1.00. Recalculate Ganado Europe’s translated balance sheet for January 2, 2020, with the new exchange rate using the current rate method. a. What is the amount of translation gain or loss? b. Where should the translation gain or loss appear in the financial statements?

Translation Using the Current Rate Method: euro depreciates from $1.2000/euro to $0.9000/euro.

Assets Cash Accounts receivable Inventory Net plant & equipment Total

Euros Statement 1,600,000 3,200,000 2,400,000 4,800,000 12,000,000

Liabilities & Net Worth Accounts payable Short-term bank debt Long-term debt Common stock Retained earnings CTA account (loss) Total

800,000 1,600,000 1,600,000 1,800,000 6,200,000 12,000,000

Just before devaluation Translated Exchange Rate Accounts (US$/euro) US dollars 1.2000 $ 1,920,000 1.2000 3,840,000 1.2000 2,880,000 1.2000 5,760,000 $ 14,400,000

1.2000 1.2000 1.2000 1.2760 1.2000

$

$ $

960,000 1,920,000 1,920,000 2,296,800 7,440,000 (136,800) 14,400,000

Just after devaluation Exchange Rate (US$/euro) 0.9000 0.9000 0.9000 0.9000

$

$

0.9000 0.9000 0.9000 1.2760 1.2000

$

$ $

$ a. The translation gain (loss) is ---------------------------------------------------------------------------------------------------------------->

$

Translated Accounts US dollars 1,440,000 2,880,000 2,160,000 4,320,000 10,800,000

720,000 1,440,000 1,440,000 2,296,800 7,440,000 (2,536,800) 10,800,000

(2,536,800) 136,800 (2,400,000)

b. The translation gain (loss) for the year is added to the balance in the Cumulative Translation adjustment account, which is carried as a separate balance sheet account within the equity section of the consolidated balance sheet. The loss does not pass through the income statement under the Current Rate Method, in which the currency of the foreign subsidiary is local currency functional.

Problem 11.2 Ganado Europe (B) Using facts in the chapter for Ganado Europe, assume as in Problem 11.1 that the exchange rate on January 2, 2020, in Exhibit 11.5 dropped in value from $1.2000 = €1.00 to $0.9000 = €1.00 (rather than to $1.0000/€). Recalculate Ganado Europe’s translated balance sheet for January 2, 2020, with the new exchange rate using the temporal rate method.

Translation Using the Temporal Method: euro depreciates from $1.2000/euro to $0.9000/euro.

Assets Cash Accounts receivable Inventory Net plant & equipment Total

Euros Statement 1,600,000 3,200,000 2,400,000 4,800,000 12,000,000

Liabilities & Net Worth Accounts payable Short-term bank debt Long-term debt Common stock Retained earnings Translation gain (loss) Total

800,000 1,600,000 1,600,000 1,800,000 6,200,000 12,000,000

Just before devaluation Translated Exchange Rate Accounts (US$/euro) (US dollars) 1.2000 $ 1,920,000 1.2000 3,840,000 1.2180 2,923,200 1.2760 6,124,800 $ 14,808,000

1.2000 1.2000 1.2000 1.2760 1.2437

$

$ $

960,000 1,920,000 1,920,000 2,296,800 7,711,200 (0) 14,808,000

Just after devaluation Exchange Rate (US$/euro) 0.9000 0.9000 1.2180 1.2760

$

$

0.9000 0.9000 0.9000 1.2760 1.2437

$

$ $

$ a. The translation gain (loss) is: --------------------------------------------------------------------------------------------------------------->

$

b. Under the Temporal Method, the translation loss of $240,000 would be closed into retained earnings through the income statement, rather than as a separate line item. It is shown as a separate line item above for pedagogical purposes only. Actual year-end retained earnings would be $7,711,200 - $240,000 = $7,471,200. c. The translation gain (loss) differs from the Current Rate Method because "exposed assets" under the Current Rate Method are larger than under the temporal method by the amount of inventory and net plant & equipment.

Translated Accounts (US dollars) 1,440,000 2,880,000 2,923,200 6,124,800 13,368,000

720,000 1,440,000 1,440,000 2,296,800 7,711,200 (240,000) 13,368,000

(240,000) 0 (240,000)

Problem 11.3 Ganado Europe ( C ) Using facts in the chapter for Ganado Europe, assume the exchange rate on January 2, 2020, in Exhibit 11.5 appreciated from $1.2000 = €1.00 to $1.500 = €1.00 Calculate Ganado Europe's translated balance sheet for January 2, 2020, with the new exchange rate using the current rate method.

Translation Using the Current Rate Method: euro appreciates from $1.2000/euro to $1.5000/euro.

Assets Cash Accounts receivable Inventory Net plant & equipment Total

Euros Statement 1,600,000 3,200,000 2,400,000 4,800,000 12,000,000

Liabilities & Net Worth Accounts payable Short-term bank debt Long-term debt Common stock Retained earnings CTA account (loss) Total

800,000 1,600,000 1,600,000 1,800,000 6,200,000 12,000,000

Just before revaluation Translated Exchange Rate Accounts (US$/euro) US dollars 1.2000 $ 1,920,000 1.2000 3,840,000 1.2000 2,880,000 1.2000 5,760,000 $ 14,400,000

1.2000 1.2000 1.2000 1.2760 1.2000

$

$ $

960,000 1,920,000 1,920,000 2,296,800 7,440,000 (136,800) 14,400,000

Just after revaluation Exchange Rate (US$/euro) 1.5000 1.5000 1.5000 1.5000

$

$

1.5000 1.5000 1.5000 1.2760 1.2000

$

$ $

$ a. The translation gain (loss) is: --------------------------------------------------------------------------------------------------------------->

$

Translated Accounts US dollars 2,400,000 4,800,000 3,600,000 7,200,000 18,000,000

1,200,000 2,400,000 2,400,000 2,296,800 7,440,000 2,263,200 18,000,000

2,263,200 136,800 2,400,000

b. The translation gain for the year is added to the balance in the Cumulative Translation adjustment account, which is carried as a separate balance sheet account within the equity section of the consolidated balance sheet. The gain does not pass through the income statement under the current rate method in which the currency of the foreign subsidiary is a local currency functional.

Problem 11.4 Ganado Europe (D) Using facts in the chapter for Ganado Europe, assume that the exchange rate on January 2, 2020, in Exhibit 11.5 appreciated from $1.2000 = €1.00 to $1.5000 = €1.00. Calculate Ganado Europe’s translated balance sheet for January 2, 2020, with the new exchange rate using the temporal method.

Translation Using the Temporal Method: euro appreciates from $1.2000/euro to $1.5000/euro.

Assets Cash Accounts receivable Inventory Net plant & equipment Total

Euros Statement 1,600,000 3,200,000 2,400,000 4,800,000 12,000,000

Liabilities & Net Worth Accounts payable Short-term bank debt Long-term debt Common stock Retained earnings CTA account (loss) Total

800,000 1,600,000 1,600,000 1,800,000 6,200,000 12,000,000

Just before revaluation Translated Exchange Rate Accounts (US$/euro) (US dollars) 1.2000 $ 1,920,000 1.2000 3,840,000 1.2180 2,923,200 1.2760 6,124,800 $ 14,808,000

1.2000 1.2000 1.2000 1.2760 1.2437

$

$ $

960,000 1,920,000 1,920,000 2,296,800 7,711,200 (0) 14,808,000

Just after revaluation Exchange Rate (US$/euro) 1.5000 1.5000 1.2180 1.2760

$

$

1.5000 1.5000 1.5000 1.2760 1.2437

a. The translation gain (loss) is:

$

$ $

$ $

b. Under the Temporal Method, the translation gain of $240,000 would be closed into retained earnings through the income statement, rather than as a separate line item. It is shown as a separate line item above for pedagogical purposes only. Actual year-end retained earnings would be $7,711,200 + $240,000 = $7,951,200.

Translated Accounts (US dollars) 2,400,000 4,800,000 2,923,200 6,124,800 16,248,000

1,200,000 2,400,000 2,400,000 2,296,800 7,711,200 240,000 16,248,000

240,000 0 240,000

Problem 11.5 Tristan Narvaja, S.A. (A) Tristan Narvaja, S.A., is the Uruguayan subsidiary of a U.S. manufacturing company. Its balance sheet for January 1 follows. The January 1 exchange rate between the U.S. dollar and the peso Uruguayo ($U) is $U20 = $1.00.

Determine Tristan Narvaja’s contribution to the translation exposure of its parent on January 1, using the current rate method.

Balance Sheet (thousands of pesos Uruguayo, $U) Assets Cash Accounts receivable Inventory Net plant & equipment

Liabilities & Net Worth Current liabilities Long-term debt Capital stock Retained earnings

Calculation of Accounting Exposures: Exposed assets (all assets) Less exposed liabilities (curr liabs + lt debt) a) Net exposure

Exchange Rate ($U/US$) 20.00 20.00 20.00 20.00

January 1st 60,000 120,000 120,000 240,000 540,000

30,000 90,000 300,000 120,000 540,000

$U (000s) 540,000 (120,000) 420,000

20.00 20.00 15.00 15.00

$ $

b) Translation January 1st $U/US$ 20.00 27,000 (6,000) 21,000

Problem 11.6 Tristan Narvaja, S.A. (B) Using the same balance sheet as in Problem 11.5, calculate Tristan Narvaja’s contribution to its parent’s translation loss if the exchange rate on December 31st is $U22 = $1.00. Assume all peso accounts remain as they were at the beginning of the year.

Balance Sheet (thousands of pesos Uruguayo, $U) Assets Cash Accounts receivable Inventory Net plant & equipment

Liabilities & Net Worth Current liabilities Long-term debt Capital stock Retained earnings

Calculation of Accounting Exposures: Exposed assets (all assets) Less exposed liabilities (curr liabs + lt debt) Net exposure

Exchange Rate ($U/US$) 20.00 20.00 20.00 20.00

January 1st 60,000 120,000 120,000 240,000 540,000

30,000 90,000 300,000 120,000 540,000

$U (000s) 540,000 (120,000) 420,000

20.00 20.00 15.00 15.00

$ $

December 31 $U/US$ 22.00 24,545 (5,455) 19,091

Problem 11.7 Tristan Narvaja, S.A. (C) Calculate Tristan Narvaja’s contribution to its parent’s translation gain or loss using the current rate method if the exchange rate on December 31 is $U12 = $1.00. Assume all peso accounts remain as they were at the beginning of the year.

Balance Sheet (thousands of pesos Uruguayo, $U) Assets Cash Accounts receivable Inventory Net plant & equipment

Liabilities & Net Worth Current liabilities Long-term debt Capital stock Retained earnings

Calculation of Accounting Exposures: Exposed assets (all assets) Less exposed liabilities (curr liabs + lt debt) Net exposure

Exchange Rate ($U/US$) 20.00 20.00 20.00 20.00

January 1st 60,000 120,000 120,000 240,000 540,000

30,000 90,000 300,000 120,000 540,000

$U (000s) 540,000 (120,000) 420,000

20.00 20.00 15.00 15.00

$ $

December 31 $U/US$ 12.00 45,000 (10,000) 35,000

Problem 11.8 Bangkok Instruments, Ltd (A) Bangkok Instruments, Ltd., the Thai subsidiary of a U.S. corporation, is a seismic instrument manufacturer. Bangkok Instruments manufactures the instruments primarily for the oil and gas industry globally, though with recent commodity price increases of all kinds including copper, its business has begun to grow rapidly.

Sales are primarily to multinational companies based in the United States and Europe. Bangkok Instruments’ balance sheet in thousands of Thai bahts (B) as of March 31 is as follows.

Using the data presented, assume that the Thai baht dropped in value from B30/$ to B40/$ between March 31st and April 1st. Assuming no change in balance sheet accounts between these two days, calculate the gain or loss from translation by both the current rate method and the temporal method. Explain the translation gain or loss in terms of changes in the value of exposed accounts.

TRANSLATION BY THE CURRENT RATE METHOD Balance Sheet (thousands)

Before Devaluation

Assets Cash Accounts receivable Inventory Net plant & equipment Total

Thai baht Statement ฿24,000 36,000 48,000 60,000 ฿168,000

Exchange Rate (Baht/US$) 30 30 30 30

Liabilities & Net Worth Accounts payable Bank loans Common stock Retained earnings CTA account (loss) Total

฿18,000 60,000 18,000 72,000 0 ฿168,000

30 30 20 34

$

$

After Devaluation Translated Accounts US dollars 800 1,200 1,600 2,000 5,600

$

Exchange Rate (Baht/US$) 40 40 40 40

$

600 2,000 900 2,100 5,600

$

$

40 40 20 34

$

$ $

Translated Accounts US dollars 600 900 1,200 1,500 4,200

450 1,500 900 2,100 (750) 4,200

Note: Dollar retained earnings before devaluation are the cumulative sum of additions to retained earnings of all prior years, translated at exchange rates in effect in each of those years.

This cumulative translation account (CTA) loss of $750,000 would be entered into the company's consolidated balance sheet under equity.

TRANSLATION BY THE TEMPORAL METHOD Balance Sheet (thousands)

Before Devaluation

Assets Cash Accounts receivable Inventory Net plant & equipment Total

Thai baht Statement ฿24,000 36,000 48,000 60,000 ฿168,000

Exchange Rate (Baht/US$) 30 30 30 20

Liabilities & Net Worth Accounts payable Bank loans Common stock Retained earnings CTA account (loss) Total

฿18,000 60,000 18,000 72,000 0 ฿168,000

30 30 20 23

$

$

After Devaluation Translated Accounts US dollars 800 1,200 1,600 3,000 6,600

$

$

Exchange Rate (Baht/US$) 40 40 30 20

600 2,000 900 3,100 6,600

$

$

40 40 20 23

$

$ $

Note a: Dollar retained earnings before devaluation are the cumulative sum of additions to retained earnings of all prior years, translated at exchange rates in effect in each of those years.

Note b: Retained earnings after devaluation are translated at the same effective rate (see Note a) as before devaluation.

The translation gain of $150,000 would be passed-through to the consolidated income statement.

EXPLANATION OF DIFFERENT OUTCOME BY TRANSLATION METHODOLOGY The Temporal Method results in a translation gain, as opposed to the CTA loss found under the Current Rate Method, because of the different exchange rates used against Net plant & equipment and the inventory line items. This gain would be impossible under the Current Rate Method because ALL assets are exposed under that method, whereas the Temporal Method carries Net plant & equipment and inventory at relevant historical exchange rates.

Translated Accounts US dollars 600 900 1,600 3,000 6,100

450 1,500 900 3,100 150 6,100

Problem 11.9 Bangkok Instruments, Ltd (B) Using the original data provided for Bangkok Instruments, assume that the Thai baht appreciated in value from B30 = $1.00 to B25 = $1.00 between March 31 and April 1. Assuming no change in balance sheet accounts between those two days, calculate the gain or loss from translation by both the current rate method and the temporal method. Explain the translation gain or loss in terms of changes in the value of exposed accounts.

TRANSLATION BY THE CURRENT RATE METHOD Balance Sheet (thousands)

Before Devaluation

Assets Cash Accounts receivable Inventory Net plant & equipment Total

Thai baht Statement ฿24,000 36,000 48,000 60,000 ฿168,000

Exchange Rate (Baht/US$) 30 30 30 30

Liabilities & Net Worth Accounts payable Bank loans Common stock Retained earnings CTA account (loss) Total

฿18,000 60,000 18,000 72,000 0 ฿168,000

30 30 20 34

$

$

After Devaluation Translated Accounts US dollars 800 1,200 1,600 2,000 5,600

$

Exchange Rate (Baht/US$) 25 25 25 25

$

600 2,000 900 2,100 5,600

$

$

25 25 20 34

$

$ $

Translated Accounts US dollars 960 1,440 1,920 2,400 6,720

720 2,400 900 2,100 600 6,720

Note: Dollar retained earnings before devaluation are the cumulative sum of additions to retained earnings of all prior years, translated at exchange rates in effect in each of those years.

This cumulative translation account (CTA) gain of $600,000 would be entered into the company's consolidated balance sheet under equity.

TRANSLATION BY THE TEMPORAL METHOD Before Devaluation

Balance Sheet (thousands)

Assets Cash Accounts receivable Inventory Net plant & equipment Total

Thai baht Statement ฿24,000 36,000 48,000 60,000 ฿168,000

Exchange Rate (Baht/US$) 30 30 30 20

Liabilities & Net Worth Accounts payable Bank loans Common stock Retained earnings CTA account (loss) Total

฿18,000 60,000 18,000 72,000 0 ฿168,000

30 30 20 23

$

$

After Devaluation Translated Accounts US dollars 800 1,200 1,600 3,000 6,600

$

$

Exchange Rate (Baht/US$) 25 25 30 20

600 2,000 900 3,100 6,600

$

$

25 25 20 23

$

$ $

Note a: Dollar retained earnings before devaluation are the cumulative sum of additions to retained earnings of all prior years, translated at exchange rates in effect in each of those years.

Note b: Retained earnings after devaluation are translated at the same effective rate (see Note a) as before devaluation.

The translation loss of $120,000 would be passed-through to the consolidated income statement.

EXPLANATION OF DIFFERENT OUTCOME BY TRANSLATION METHODOLOGY The Temporal Method results in a translation gain, as opposed to the CTA loss found under the Current Rate Method, because of the different exchange rates used against Net plant & equipment and the inventory line items. This gain would be impossible under the Current Rate Method because ALL assets are exposed under that method, whereas the Temporal Method carries Net plant & equipment and inventory at relevant historical exchange rates.

Translated Accounts US dollars 960 1,440 1,600 3,000 7,000

720 2,400 900 3,100 (120) 7,000

Problem 11.10 Cairo Ingot, Ltd. Cairo Ingot, Ltd., is the Egyptian subsidiary of Trans-Mediterranean Aluminum, a British multinational enterprise that fashions automobile engine blocks from aluminum.

Trans-Mediterranean’s home reporting currency is the British pound. Cairo Ingot’s December 31 balance sheet is shown in the following table. At the date of this balance sheet, the exchange rate between Egyptian pounds and British pounds sterling was £E5.50 = UK£1.00.

What is Cairo Ingot’s contribution to the translation exposure of Trans-Mediterranean on December 31, using the current rate method? bCalculate the translation exposure loss to Trans-Mediterranean if the exchange rate at the end of the following quarter is £E6.00 = £1.00. Assume all balance sheet accounts are the same at the end of the quarter as they were at the beginning.

Balance Sheet of Cairo Ingot, Ltd. Assets Cash Accounts receivable Inventory Net plant & equipment Total Liabilities & Net Worth Accounts payable Long-term debt Invested capital CTA account (loss) Total

Calculation of Actg Exposures: Exposed assets (all assets) Less exposed liabilities (c.liabs + lt debt)

Net exposure

Egyptian pounds Statement 16,500,000 33,000,000 49,500,000 66,000,000 165,000,000

24,750,000 49,500,000 90,750,000 165,000,000

Egyptian pounds 165,000,000 (74,250,000) 90,750,000

Before Exchange Rate Change Translated Exchange Rate Accounts (Egyptian £/UK£) British pounds 5.50 £3,000,000.00 5.50 6,000,000 5.50 9,000,000 5.50 12,000,000 £30,000,000.00

5.50 5.50 5.50

£4,500,000.00 9,000,000 16,500,000 £30,000,000.00 December 31st 5.50 £30,000,000.00 (13,500,000) £16,500,000.00

After Exchange Rate Change Translated Exchange Rate Accounts (Egyptian £/UK£) British pounds 6.00 £2,750,000.00 6.00 5,500,000 6.00 8,250,000 6.00 11,000,000 £27,500,000.00

6.00 6.00 5.50

£4,125,000.00 8,250,000 16,500,000 -£1,375,000.00 £27,500,000.00 End of Quarter 6.00 £27,500,000.00 (12,375,000) £15,125,000.00

Change in translation exposure: Gain (Loss)

-£1,375,000.00

Alternatively, the translation loss arising from the fall in the value of the Egyptian pound can be found as follows: Net exposed assets (£) Percentage change in the value of the British pound Translation gain (loss)

£16,500,000.00 -8.3% -£1,375,000.00

Problem 12.1 Mauna Loa Macadamia Mauna Loa, a macadamia nut subsidiary of Hershey's with plantations on the slopes of its namesake volcano in Hilo, Hawaii, exports Macadamia nuts worldwide. The Japanese market is its biggest export market, with average annual sales invoiced in yen to Japanese customers of ¥1,200,000,000. At the present exchange rate of ¥125 = $1.00, this is equivalent to $9,600,000. Sales are relatively equally distributed throughout the year. They show up as a ¥250,000,000 account receivable on Mauna Loa’s balance sheet. Credit terms to each customer allow for 60 days before payment is due. Monthly cash collections are typically ¥100,000,000.

Mauna Loa would like to hedge its yen receipts, but it has too many customers and transactions to make it practical to sell each receivable forward. It does not want to use options because they are considered to be too expensive for this particular purpose. Therefore, they have decided to use a “matching” hedge by borrowing yen. Mauna Loa can borrow Japanese yen at 4.00% per annum. a. How much should Mauna Loa borrow in yen? b. What should be the terms of payment on the yen loan? a. How much should Mauna Loa borrow in yen?

Mauna Loa receives ¥100,000,000 per month. If it is to use a balance sheet hedge, a financial hedge, it needs to create a debt service obligation that would be equal to that same ¥100,000,000 per month. As shown below, if Mauna Loa borrows ¥1.175 billion for one year at 4%, in the form of an amortized loan with monthly payments, the combined principal an interest monthly payment effectively equals the Japanese yen cash inflow. Therefore, the yen inflows would go directly to servicing the Japanese yen loan. Since the loan was arranged when the spot rate was 125 to the dollar, that same exchange rate would be effectively locked in for the one-year period.

Month Cash received monthly Spot rate (JPY=USD1.00)

1 ¥100,000,000 125.00

Loan principal JPY interest rate Loan term

¥1,175,000,000 4.00% 1 year

Monthly principal payment Monthly interest payment Monthly total payment

2 ¥100,000,000

3 ¥100,000,000

4 ¥100,000,000

5 ¥100,000,000

6 ¥100,000,000

7 ¥100,000,000

8 ¥100,000,000

9 ¥100,000,000

10 ¥100,000,000

11 ¥100,000,000

12 ¥100,000,000

Cumulative ¥1,200,000,000

-¥96,134,471 -¥96,454,919 -¥96,776,435 -¥97,099,024 -¥97,422,687 -¥97,747,429 -¥98,073,254 -¥98,400,165 -¥98,728,165 -¥99,057,259 -¥99,387,450 -¥99,718,742 -¥3,916,667 -¥3,596,218 -¥3,274,702 -¥2,952,114 -¥2,628,451 -¥2,303,708 -¥1,977,883 -¥1,650,973 -¥1,322,972 -¥993,878 -¥663,687 -¥332,396 -¥100,051,137 -¥100,051,137 -¥100,051,137 -¥100,051,137 -¥100,051,137 -¥100,051,137 -¥100,051,137 -¥100,051,137 -¥100,051,137 -¥100,051,137 -¥100,051,137 -¥100,051,137

-¥1,175,000,000 -¥25,613,649

b. What should be the terms of payment on the yen loan?

By constructing the loan to have monthly payments, the Japanese yen cash inflows can go directly to servicing the loan. When Mauna Loan first takes out the loan it will convert the ¥1.175 billion to U.S. dollars at the current spot rate. It then has the use of those funds for its generally corporate funding needs. This explicitly locks in the spot exchange rate for the year. Assuming Mauna Loa's business continues into the future, it will need to renew the loan at the end of each year. When it does it renews the loan at the current spot rate in effect on that date for the year that follows. In practice, the loan might be structured to have quarterly rather than monthly payments, requiring that Mauna Loa accumulate Japanese yen proceeds for longer prior to each quarterly loan payment. The final choice may depend on bank preferences.

Problem 12.2 Acuña Leather Goods DeMagistris Fashion Company, based in New York City, imports leather coats from Acuña Leather Goods, a reliable and longtime supplier, based in Buenos Aires, Argentina. Payment is in Argentine pesos. When the peso lost its parity with the U.S. dollar in January 2002, it collapsed in value to Ps4.0 = $1.00 by October 2002. The outlook was for a further decline in the peso’s value. Since both DeMagistris and Acuña wanted to continue their longtime relationship, they agreed on a risk-sharing arrangement. As long as the spot rate on the date of an invoice is between Ps3.5 = $1.00 and Ps4.5 = $1.00, DeMagistris will pay based on the spot rate. If the exchange rate falls outside this range, DeMagistris will share the difference equally with Acuña Leather Goods. The risk-sharing agreement will last for six months, at which time the exchange rate limits will be reevaluated. DeMagistris contracts to import leather coats from Acuña for Ps8,000,000 or $2,000,000 at the current spot rate of Ps4.0 = $1.00 during the next six months. a. If the exchange rate changes immediately to Ps6.00 = $1.00, what will be the dollar cost of six months of imports to DeMagistris? b. At Ps6.00 = $1.00, what will be the peso export sales in Acuña Leather Goods to DeMagistris Fashion Company? a. If the exchange rate changes immediately to Ps6.00 = $1.00, what will be the dollar cost of six months of

The allowable range of exchange rates is (Ps=$1.00)

Bottom 3.50

Top 4.50

Outside of this range the trading partners will share the extra risk equally.

New exchange rate (Ps=$1.00) Allowable exchange rate (Ps=$1.00) Difference to be shared (Ps=$1.00) DeMagistris' share Acuña's share

6.00 4.50 1.50 0.75 0.75

Therefore, DeMagistris will use the following effective exchange rate after risk-sharing: Top of range DeMagistris' share Effective total of risk-sharing

4.50 0.75 5.25

Assuming that 6 months of imports will still be (Ps) Effective exchange rate for DeMagistris (Ps=$1.00) DeMagistris' cost in US dollars

8,000,000 5.25 $1,523,809.52

However, the lower cost of importing might lead to higher DeMagistris' sales and therefore a higher import total than Ps 8 million. b. At Ps6.00 = $1.00, what will be the peso export sales in Acuña to DeMagistris?

The export sales of Acuña would remain at Ps 8 million, unless the lower dollar cost encourages DeMagistris to import more from Acuña.

Problem 12.3 Richland Crane (A) Richland Crane (U.S.) exports heavy crane equipment to several Chinese dock facilities. Sales are currently 10,000 units per year at the yuan equivalent of USD24,000 each. The Chinese yuan (CNY) has been trading at CNY8.20 = USD1.00, but a Hong Kong advisory service predicts the yuan will drop in value next week to CNY9.00 = USD1.00, after which it will remain unchanged for at least a decade. Accepting this forecast as a given, Richland Crane must make a pricing decision in the face of the impending devaluation. It may either (1) maintain the same yuan price and in effect sell for fewer dollars, in which case Chinese volume will not change; or (2) maintain the same dollar price, raise the yuan price in China to offset the devaluation, and experience a 10% drop in unit volume. Direct costs are 75% of the U.S. sales price. a. What would be the short-run (one year) impact of each pricing strategy? b. Which do you recommend?

Assumptions Sales volume per year US dollar price per unit Direct costs as % of US$ sales price Direct costs per unit Spot exchange rate, CNY=USD1.00 Expected spot rate, CNY=USD1.00 Unit volume decrease if price increased

Sales to China US dollar price per unit Unit volume Sales revenue Less direct costs Gross profits

Values 10,000 USD 24,000 75% USD 18,000 8.2000 9.0000 -10% Case 1 Same CNY Price USD 21,867 10,000 USD 218,666,667 (180,000,000) USD 38,666,667

Case 2 Same USD Price USD 24,000 9,000 USD 216,000,000 (162,000,000) USD 54,000,000 Better.

Problem 12.4 Richland Crane (B) Assume the same facts as in Problem 12.3. Additionally, financial management believes that if it maintains the same yuan sales price, volume will increase at 12% per annum for eight years. Dollar costs will not change. At the end of 10 years, Richland’s patent expires and it will no longer export to China. After the yuan is devalued to CNY9.20 = USD1.00, no further devaluations are expected. If Richland Crane raises the yuan price so as to maintain its dollar price, volume will increase at only 1% per annum for eight years, starting from the lower initial base of 9,000 units. Again, dollar costs will not change, and at the end of eight years Richland Crane will stop exporting to China. Richland’s weighted average cost of capital is 10%. Given these considerations, what should be Richland’s pricing policy?

Assumptions Sales volume per year US dollar price per unit Direct costs as % of USD price Direct costs per unit Spot exchange rate, CNY=USD1.00 Expected spot rate, CNY=USD1.00

Values 10,000 USD 24,000 75% USD 18,000 8.2000 9.2000

Assumptions Volume change (if price increased) Volume growth (same Rmb price) WACC

Values 1% 12% 10%

Alternative 1: Keep Same Chinese Sales Price Year 1 2 3 4 5 6 7 8 Cum PV of Gross Margin

Volume 10,000 11,200 12,544 14,049 15,735 17,623 19,738 22,107

Revenue USD 213,913,043 239,582,609 268,332,522 300,532,424 336,596,315 376,987,873 422,226,418 472,893,588

Direct Costs USD 180,000,000 201,600,000 225,792,000 252,887,040 283,233,485 317,221,503 355,288,083 397,922,653

Gross Margin USD 33,913,043 37,982,609 42,540,522 47,645,384 53,362,830 59,766,370 66,938,335 74,970,935

Present Value Factor 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645 0.5132 0.4665

Present Value of Margin USD 30,830,040 31,390,586 31,961,324 32,542,439 33,134,119 33,736,558 34,349,950 34,974,494 USD 262,919,509

Volume 9,000 9,090 9,181 9,273 9,365 9,459 9,554 9,649

Revenue USD 216,000,000 218,160,000 220,341,600 222,545,016 224,770,466 227,018,171 229,288,353 231,581,236

Direct Costs USD 162,000,000 163,620,000 165,256,200 166,908,762 168,577,850 170,263,628 171,966,264 173,685,927

Gross Margin USD 54,000,000 54,540,000 55,085,400 55,636,254 56,192,617 56,754,543 57,322,088 57,895,309

Present Value Factor 0.9091 0.8264 0.7513 0.6830 0.6209 0.5645 0.5132 0.4665

Present Value of Margin USD 49,090,909 45,074,380 41,386,476 38,000,310 34,891,194 32,036,460 29,415,295 27,008,589 USD 296,903,613

Alternative 2: Raise Chinese Sales Price Year 1 2 3 4 5 6 7 8 Cum PV of Gross Margin

Richland Crane is better off raising the Chinese sales price to maintain the U.S. dollar price, and suffering the lower volumes. The volume decrease does not offset the stronger U.S. dollar price per unit received.

Problem 12.5 MacLoren Automotive MacLoren Automotive manufactures British sports cars, a number of which are exported to New Zealand for payment in pounds sterling. The distributor sells the sports cars in New Zealand for New Zealand dollars. The New Zealand distributor is unable to carry all of the foreign exchange risk, and would not sell MacLoren models unless MacLoren shared some of the foreign exchange risk. MacLoren has agreed that sales for a given model year will initially be priced at a “base” spot rate between the New Zealand dollar and pound sterling set to be the spot mid-rate at the beginning of that model year. As long as the actual exchange rate is within that base rate, payment will be made in pounds sterling.

That is, the New Zealand distributor assumes all foreign exchange risk. However, if the spot rate at time of shipment falls outside of this range, MacLoren will share equally (i.e., 50/50) the difference between the actual spot rate and the base rate. For the current model year the base rate is NZ$1.6400 = £1.00. a. What are the outside ranges within which the New Zealand importer must pay at the then current spot rate? b. If MacLoren ships 10 sports cars to the New Zealand distributor at a time when the spot exchange rate is NZ$1.7000 = £1.00, and each car has an invoice cost £32,000, what will be the cost to the distributor in New Zealand dollars? How many pounds will MacLoren receive, and how does this compare with MacLoren’s expected sales receipt of £32,000 per c. If MacLoren Automotive ships the same 10 cars to New Zealand at a time when the spot exchange rate is NZ$1.6500 = £1.00, how many New Zealand dollars will the distributor pay? How many pounds will MacLoren Automotive receive? d. Does a risk-sharing agreement such as this shift the currency exposure from one party of the transaction to the other? e. Why is such a risk-sharing agreement of benefit to MacLoren? Why is it of benefit to the New Zealand distributor?

Assumptions Invoice price of car Spot exchange rate, NZ$=£1.00 Risk-sharing band, percentage +/Sales to New Zealand Distributors a. What are the outside ranges? (initial spot rate + or - 5%)

Values £32,000 1.6400 5.00% Lower Band

Upper Band

1.7220

1.5580

b. Cost to the Kiwi distributor for 10 cars New current spot rate (N$=£1.00) Is this within the band?

Cost of 10 cars at this exchange rate (NZ$)

1.7000 Yes 544,000

Receipts to MacLoren in British pounds (Within the band MacLoren receives £12,000/car, as expected)

£320,000

c. Cost to the Kiwi distributor for 10 cars New current spot rate (N$=£1.00) Is this within the band?

Cost of 10 cars at this exchange rate (NZ$)

1.6500 Yes 528,000

Receipts to MacLoren in British pounds (Within the band MacLoren receives £12,000/car)

£320,000

d. How does this shift the currency risk?

MacLoren bears no risk within the 5% range. The distributor carries all of the risk within 5%. If the exchange rate falls outside the 5% range, MacLoren shares the risk with the distributor. e. Who benefits from this risk-sharing agreement?

Both parties in practice. The manufacturer has predictable revenues within the range, while the distributor bears a moderate level of currency risk within the 5% range. The distributor will hopefully be able to provide a more stable pricing to pass on to the customer, which will also benefit the manufacturer through a more stable and sustinable distributor sales outlet.

Exhibit 12.6 Aidan Turkey—All Domestic Competitors Using the Aidan Turkey analysis in Exhibits 12.5 and 12.6 where the Turkish lira depreciates, how would prices, costs, and volumes change if Aidan Turkey was operating in a nearly purely domestic mature market with major domestic competitors?

Assumptions Sales volume (units) Sales price per unit (TRY) Direct cost per unit (TRY) Turkish corporate tax rate Exchange rate (₺/€) Income Statement Sales Revenue (TRY) Direct cost of goods sold Cash operating expenses (fixed) Depreciation Pretax profit (TRY) Income tax expense Net income (TRY) Cash flows from Valuation Net income (TRY) Add back depreciation Changes in net working capital Free cash flow for valuation (TRY) Cash flow from operations (€) Present value @ 15% Cash flow from operations (€) Present Value @ 15%

Net Working Capital Calculations Day of sales Day of direct COGS Accounts receivable days A/R Inventory days Inventory Accounts payable days A/P Net Working Capital

€

2014 1,000,000 80.50 60.50 20% 6.4

2015 1,000,000 80.50 60.50 20% 6.4

2016 1,000,000 80.50 60.50 20% 6.4

2017 1,000,000 80.50 60.50 20% 6.21

2018 1,000,000 80.50 60.50 20% 6.4

80,500,000 -60,500,000 -5,600,000 -3,770,000 10,630,000 -2,126,000 8,504,000

80,500,000 -60,500,000 -5,600,000 -3,770,000 10,630,000 -2,126,000 8,504,000

80,500,000 -60,500,000 -5,600,000 -3,770,000 10,630,000 -2,126,000 8,504,000

80,500,000 -60,500,000 -5,600,000 -3,770,000 10,630,000 -2,126,000 8,504,000

80,500,000 -60,500,000 -5,600,000 -3,770,000 10,630,000 -2,126,000 8,504,000

8,504,000 3,770,000 0 12,274,000 1,917,813 € 6,462,354

8,504,000 3,770,000 0 12,274,000 1,917,813

8,504,000 3,770,000 0 12,274,000 1,917,813

8,504,000 3,770,000 0 12,274,000 1,976,490

8,504,000 3,770,000 0 12,274,000 1,917,813

41,359,064

0

0

0

0

-€ 165,753 € 15,342 45 (7,458,904) 10 153,425 38 (6,298,630) (1,006,849)

-€ 165,753 € 15,342 45 (7,458,904) 10 153,425 38 (6,298,630) (1,006,849)

-€ 165,753 € 15,342 45 (7,458,904) 10 153,425 38 (6,298,630) (1,006,849)

-€ 165,753 € 15,342 45 (7,458,904) 10 153,425 38 (6,298,630) (1,006,849)

35,964,403

-€ 165,753 € 15,342 45 (7,458,904) 10 153,425 38 (6,298,630) (1,006,849)

Exhibit 12.7 Aidan Turkey—All Foreign Competitors Aidan Turkey is now competing in a number of international (export) markets, growth markets, in which most of its competitors are foreign. Now how would you expect Aidan Turkey’s operating exposure to respond to the depreciation of the Turkish lira?

Aidan Turkey would most likely try to profit from its now weak-currency home country, and would try and increase sales volumes dramatically in a growth market by keeping the price in liras the same. The result is something like case 2 in the chapter discussion, where volume could jump dramatically (thinking positive).

Assumptions Sales volume (units) Sales price per unit (TRY) Direct cost per unit (TRY) Turkish corporate tax rate Exchange rate (TRY/€) Income Statement Sales Revenue (TRY) Direct cost of goods sold Cash operating expenses (fixed) Depreciation Pretax profit (TRY) Income tax expense Net income (TRY) Cash flows from Valuation Net income (TRY) Add back depreciation Changes in net working capital Free cash flow for valuation (TRY) Cash flow from operations (€) Present value @ 15%

2014 1,400,000 80.50 60.50 20% 6.4

2015 1,400,000 80.50 60.50 20% 6.4

2016 1,400,000 80.50 60.50 20% 6.4

2017 1,400,000 80.50 60.50 20% 6.21

2018 1,400,000 80.50 60.50 20% 6.4

112,700,000 -84,700,000 -5,600,000 -3,770,000 18,630,000 -3,726,000 14,904,000

112,700,000 -84,700,000 -5,600,000 -3,770,000 18,630,000 -3,726,000 14,904,000

112,700,000 -84,700,000 -5,600,000 -3,770,000 18,630,000 -3,726,000 14,904,000

112,700,000 -84,700,000 -5,600,000 -3,770,000 18,630,000 -3,726,000 14,904,000

112,700,000 -84,700,000 -5,600,000 -3,770,000 18,630,000 -3,726,000 14,904,000

14,904,000 3,770,000 0 18,674,000 2,917,813 € 9,832,002

14,904,000 3,770,000 0 18,674,000 2,917,813

14,904,000 3,770,000 0 18,674,000 2,917,813

14,904,000 3,770,000 0 18,674,000 3,007,085

14,904,000 3,770,000 0 18,674,000 2,917,813

Cash flow from operations

€

62,924,813

Present Value @ 15%

€

54,717,229

Net Working Capital Calculations Day of sales Day of direct COGS Accounts receivable days A/R Inventory days Inventory Accounts payable days A/P Net Working Capital Baseline NWC

-€ 232,055 € 15,342 45 (10,442,466) 10 153,425 38 (8,818,082) (1,470,959) 508,493

€

-

-€ 232,055 € 15,342 45 (10,442,466) 10 153,425 38 (8,818,082) (1,470,959) 508,493

€

-

-€ 232,055 € 15,342 45 (10,442,466) 10 153,425 38 (8,818,082) (1,470,959) 508,493

€

-

-€ 232,055 € 15,342 45 (10,442,466) 10 153,425 38 (8,818,082) (1,470,959) 508,493

€

-

-€ 232,055 € 15,342 45 (10,442,466) 10 153,425 38 (8,818,082) (1,470,959) 508,493

Problem 12.8 Rolls-Royce Turbine Engines Rolls-Royce is struggling with its pricing strategy with a number of its major customers in Continental Europe, particularly Airbus. Since Rolls-Royce is a British company with most manufacturing of the Airbus engines in the United Kingdom, costs are predominantly denominated in British pounds. But in the period shown, 2007-2009, the pound steadily weakened against the euro. Rolls-Royce has traditionally denominated its sales contracts with Airbus in Airbus' home currency, the euro. After completing the following tables answer that questions that follow. a. Assuming each Rolls-Royce engine marketed to Airbus costs £22.5 million each, how has the price of that engine changed over the period shown when priced in euros at the current spot rate?

Date Price (millions of pounds, £) Spot rate (€=£1.00) Price (millions of euros, €)

1Q 2007 £22.50 1.4918 € 33.57

2Q 2007 £22.50 1.4733 € 33.15

3Q 2007 £22.50 1.4696 € 33.07

4Q 2007 £22.50 1.4107 € 31.74

1Q 2008 £22.50 1.3198 € 29.70

2Q 2008 £22.50 1.2617 € 28.39

3Q 2008 £22.50 1.2590 € 28.33

4Q 2008 £22.50 1.1924 € 26.83

1Q 2009 £22.50 1.1017 € 24.79

2Q 2009 £22.50 1.1375 € 25.59

3Q 2009 £22.50 1.1467 € 25.80

4Q 2009 £22.50

1.1066 € 24.90

b. What is the cumulative percentage change in the price of the engine in euros for the three-year period?

Using the basic percentage change formula of (P2 - P1)/(P1), the percentage change is:

-25.8%

c. If the price elasticity of demand for Rolls-Royce turbine sales to Airbus is relatively inelastic, and the price of the engine in British pounds never changes over the period, what does this price change mean for Rolls-Royce's total sales revenue on sales to Airbus of this engine?

If the price inelasticity of demand is inelastic (ep < 1), then a large percentage change in the price -- in this case in euros -- does not generate an increase in sales quantity to offset the decline in price. d. Compare the prices and volumes for the first quarter of each of the three years shown. Who has benefited the most from the exchange rate changes?

1Q 2007

1Q 2008

1Q 2009

% Chg

Price (in millions of £)

£22.50

£22.50

£22.50

0.0%

Spot rate (€=£1.00)

1.4918

1.3198

1.1017

Price (in millions of €)

€ 33.57 200 € 6,713.10 £4,500.00

€ 29.70 220 € 6,533.01 £4,950.00

€ 24.79 240 € 5,949.18 £5,400.00

Sales volume (engines) Total cost to Airbus (millions of €) Total revenue to RR (millions of £)

The price of the RR engines as sold by RR is unchanged over the period.

The British pound steadily weakened against the euro over the period.

-26.1% 20.0% -11.4% 20.0%

The price of each engine in euros fell 26%.

Engine sales volumes grew 20%.

Total costs in euros to Airbus fell 11.4%.

Total revenues accruing to RR rose 20%, equal to the volume growth.

If volumes had not grown, RR revenues would not have changed.

Clearly Airbus has captured the majority of the benefits as its cost per engine (-26.1%) and total costs of purchases have fell dramatically (-11.4%).

Problem 12.9 Hurte-Paroxysm Products, Inc. (A) Hurte-Paroxysm Products, Inc. (HP) of the United States, exports computer printers to Brazil, whose currency, the reais (BRL) has been trading at BRL3.40=USD1.00. Exports to Brazil are currently 50,000 printers per year at the reais-equivalent of $200 each. A rumor exists that the reais will be devalued against the dollar to BRL$4.00 within two weeks by the Brazilian government. Should the devaluation take place, the reais is expected to remain unchanged for another decade.

Accepting this forecast as given, HP faces a pricing decision that must be made before any actual devaluation: HP may either (1) maintain the same reais price and, in effect, sell for fewer dollars, in which case Brazilian volume will not change; or (2) maintain the same dollar price, raise the reais price in Brazil to compensate for the devaluation, and experience a 20% drop in volume. Direct costs in the United States are 60% of the U.S. sales price. What would be the short-run (1-year) implication of each pricing strategy? Which do you recommend?

→

Exchange rate (BRL=USD1.00) 3.4000

→

Prices in Brazilian reais 680

$170.00

←

4.0000

←

680

If the USD price is changed to keep USD price: New reais price is current US$ price at new exchange rate:

$200.00

→

4.0000

→

800

Direct cost per unit in the US, percent of price Direct cost per unit in the US

60% $120.00

Unit volume Decrease in unit volume from price increase New lower unit volume

50,000 -20.0% 40,000

Assumptions Existing sales price per unit

US dollar prices $200.00

If the reais falls in value, the new implied USD price: New dollar price if no reais price change

3.4000

408

Alternative #1: Maintain same price in reais: Sales revenue (BRL680 x 50,000 ) / (BRL4.00=USD1.00) Less direct costs (USD120 x 50,000) Contribution margin in US dollars

USD 8,500,000 6,000,000 USD 2,500,000

Alternative #2: Raise price in reais (and accept lower volume): Sales revenue (BRL800 x 40,000 ) / (BRL4.00=USD1.00) Less direct costs (USD120 x 40,000) Contribution margin in US dollars

USD 8,000,000 4,800,000 USD 3,200,000

Discussion Alternative #2 is preferable. In the short run (one year), HP Products would be better off to increase its sales price in reais in Brazil and accept the lower sales volume. The contribution margin if reais prices are raised is USD3,200,000, whereas if the price in reais is left unchanged HP Product's contribution margin is only USD2,500,000. This is a short-run solution and does not consider possible longer-run effects that might come from raising the local price and/or accepting a smaller market share.

Problem 12.10 Hurte-Paroxysm Products, Inc. (B) Assume the same facts as in Problem 12.9. HP also believes that if it maintains the same price in Brazilian reais as a permanent policy, volume will increase at 10% per annum for six years, costs will not change. At the end of six years, HP’s patent expires and it will no longer export to Brazil. After the reais is devalued to BRL4.00 = USD1.00, no further devaluation is expected. If HP raises the price in reais so as to maintain its dollar price, volume will increase at only 4% per annum for six years, starting from the lower initial base of 40,000 units. Again, dollar costs will not change, and at the end of six years, HP will stop exporting to Brazil. HP’s weighted average cost of capital is 12%. Given these considerations, what do you recommend for HP’s pricing policy? Justify your recommendation.

Assumptions Initial sales volume Sales volume growth Sales price, USD Direct cost per unit

End of year 1 2 3 4 5 6

Value 50,000 10% USD 170.00 USD 120.00

Alternative #1: Maintain current Brazilian sales price and volume grows 10% per annum Contribution 12% Sales volume USD Revenue Direct Costs Margin PV Factor 50,000 USD 8,500,000 USD 6,000,000 USD 2,500,000 0.8929 55,000 USD 9,350,000 USD 6,600,000 USD 2,750,000 0.7972 60,500 USD 10,285,000 USD 7,260,000 USD 3,025,000 0.7118 66,550 USD 11,313,500 USD 7,986,000 USD 3,327,500 0.6355 73,205 USD 12,444,850 USD 8,784,600 USD 3,660,250 0.5674 80,526 USD 13,689,335 USD 9,663,060 USD 4,026,275 0.5066 Present value of contribution margins

Assumptions Initial sales volume Sales volume growth Sales price, USD Direct cost per unit

End of year 1 2 3 4 5 6

Present Value USD 2,232,143 USD 2,192,283 USD 2,153,135 USD 2,114,686 USD 2,076,924 USD 2,039,836 USD 12,809,008

Value 40,000 4% USD 200.00 USD 120.00

Alternative #2: Raise Brazilian sales price to R$400 and volume grows only 4% per annum from a lower volume base Contribution 12% Sales volume USD Revenue Direct Costs Margin PV Factor 40,000 USD 8,000,000 USD 4,800,000 USD 3,200,000 0.8929 41,600 USD 8,320,000 USD 4,992,000 USD 3,328,000 0.7972 43,264 USD 8,652,800 USD 5,191,680 USD 3,461,120 0.7118 44,995 USD 8,998,912 USD 5,399,347 USD 3,599,565 0.6355 46,794 USD 9,358,868 USD 5,615,321 USD 3,743,547 0.5674 48,666 USD 9,733,223 USD 5,839,934 USD 3,893,289 0.5066 Present value of contribution margins

Alternative #2 is preferable, yielding a higher present value of total contribution margin over the expected remaining life of the export sales.

Present Value USD 2,857,143 USD 2,653,061 USD 2,463,557 USD 2,287,589 USD 2,124,189 USD 1,972,462 USD 14,358,000

Problem 12.11 Truckee Tec's Japanese Yen Exposure Truckee Tec is a privately held battery manufacturer located just outside of Reno, Nevada. The company is one of the leading manufacturers of lithium-ion batteries, specifically for the automobile market. Truckee has been in intense contract negotiations with a Japanese automaker for months. It was late December 2016, and both sides wanted to conclude a deal before the new year.

The Japanese automaker wanted a two-year supply agreement for 18,000 Lithium-ion 12V battery packs per year. Battery prices had been dropping dramatically for years, but Truckee’s current sales price of $1,100 per battery for the 12V model (1342OR) had held firm for months. The buyer was pushing for a lower unit price, but Truckee wanted a longer contract with higher volumes in return. After months of negotiations, the buyer agreed to increase the contract to a three years, and increase annual purchases to 20,000 units. But in return, the buyer wanted a price of $990 per unit, and it wanted to pay in Japanese yen. Truckee had countered with the following proposal. Assuming 20,000 units per year at an average price of $995 per unit, and a current spot exchange rate of ¥115.00 = $1.00, the contract purchase amount per year would be: Units (packs) per year Price per battery pack Current spot rate (¥=$1.00) Annual Contract Value

20,000 $995.00 115.00 ¥2,288,500,000

The buyer accepted the counterproposal in 24 hours and a sale agreement signed and posted. The deal was done. Almost immediately the corporate treasury group at Truckee was upset about the contract. They argued that the Japanese yen had began to plummet in value against the dollar in the past two months, so accepting payment in Japanese yen was too risky. Also, the quote had been based on a spot rate value of ¥115 = $1.00, but the rate had already moved to ¥117 = a. Given the final contract value, what does the Japanese buyer believe they are paying per battery pack?

Contract value per year Units per year Unit cost in Japanese yen Spot rate at contract date (¥=$1.00) Unit cost in US dollars

¥2,288,500,000 20,000 ¥114,425 117.00 $977.99

This is even less than what the Japanese buyer had been pursuing ($990 per unit).

b. What is the amount of the currency exposure to Truckee Tec? Contract value per year Quarterly payment to Truckee Period (quarter number) Date JPY cash inflow (millions)

¥2,288,500,000 ¥572,125,000 1 2017 Q1 ¥572.13

Truckee will receive a payment of 572.125 million Japanese yen ever quarter for three years.

2 2017 Q2 ¥572.13

3 2017 Q3 ¥572.13

4 2017 Q4 ¥572.13

5 2018 Q1 ¥572.13

6 2018 Q2 ¥572.13

7 2018 Q3 ¥572.13

8 2018 Q4 ¥572.13

9 2019 Q1 ¥572.13

10 2019 Q2 ¥572.13

11 2019 Q3 ¥572.13

12 2019 Q4 ¥572.13

10 -¥18.88 -¥553.25 -¥572.13

11 -¥12.66 -¥559.47 -¥572.13

12 -¥6.36 -¥565.77 -¥572.13

c. If the swap agreement is for a three-year loan at 4.500%, paid quarterly, what is the principal amount of the loan obligation (notional principal)?

Contract term (years) Contract and loan payment quarters Japanese loan interest (per annum) Interest per quarter Japanese loan principal

3.00 12.00 4.500% 1.125% ¥6,388.8

Amortizing JPY Loan Quarter number Japanese loan interest payment Japanese loan principal payment Japanese loan, total quarterly payment

1 -¥71.87 -¥500.26 -¥572.13

You can simply use trial and error to find the principal that will equal the desired quarterly payment of ¥572 million.

2 -¥66.25 -¥505.88 -¥572.13

3 -¥60.55 -¥511.58 -¥572.13

4 -¥54.80 -¥517.33 -¥572.13

5 -¥48.98 -¥523.15 -¥572.13

6 -¥43.09 -¥529.04 -¥572.13

7 -¥37.14 -¥534.99 -¥572.13

8 -¥31.12 -¥541.01 -¥572.13

9 -¥25.04 -¥547.09 -¥572.13

d. The sales team had clearly not updated their exchange rate assumption prior to making the final contractual offer. As a result, assuming the swap was executed the same day as the closing spot rate quote, what was the actual exchange rate locked-in for the three-year period?

The actual exchange rate locked in was the current spot rate when the cross currency swap was executed: ¥117.00 = $1.00 e. In retrospect, what do you think Truckee should have done to manage the currency risk more effectively?

There is in fact nothing wrong with the cross-currency swap hedge, other than it was executed at a slightly weaker yen rate (¥117, not ¥115, to the dollar) than what the company had intended. The cross-currency swap is in principle the same as a series of forward contracts for all indiviudal quarterly payments. If this was considered a 'mistake' or error in the company, it is a managerial pricing mistake, not a hedging error. In a perfect world the best currency management solution for Truckee would have been to require payment in US dollars, not Japanese yen, shifting the transaction exposure to the customer. But that was not what the customer wanted, and in this case, the customer got what they wanted.

Problem 13.1 Electrolux of Sweden Kristian Thalen has just joined the corporate treasury group at Electrolux of Sweden, a multinational Swedish appliance maker. Electrolux is considering making an offer for GE's appliance business and wants to revise its weighted average cost of capital for its analysis in its home currency, the Swedish kroner (SEK).

Kristian has been assigned the task. Using the following assumptions, he goes step by step through the following questions. a. What is Electrolux's cost of debt, after-tax, in SEK? b. What is Electrolux's cost of equity in SEK? c. What is the Electrolux's market capitalization? d. What is Electrolux's total value of equity outstanding? e. What proportion of Electrolux's capital structure is debt? f. What proportion of Electrolux's capital structure is equity? g. What is Electrolux's weighted average cost of capital?

Assumptions Swedish kroner, government bond rate (10-year) Electrolux credit risk premium Swedish corporate tax rate Electrolux beta Swedish equity market risk premium (equity return over risk-free) Electrolux shares outstanding Electrolux share price Electrolux debt outstanding (SEK)

Values 4.30% 1.20% 26.00% 1.30 4.00% 286,130,000 SEK 182.00 SEK 11,532,000,000

a. Electrolux's cost of debt, after-tax, in SEK kd = ( krf + credit risk premium ) x ( 1 - tax rate )

4.070%

b. Electrolux's cost of equity in SEK ke = krf + ( km - krf ) β

9.500%

c. Electrolux's market capitalization Share price x shares outstanding

SEK 52,075,660,000

d. Electrolux's total value of equity outstanding Share price x shares outstanding

SEK 52,075,660,000

e. What proportion of Electrolux's capital structue is debt?

Debt / ( Debt + Equity )

18.130%

f. What proportion of Electrolux's capital structure is equity?

81.870%

g. What is Electrolux's weighted average cost of capital?

8.5155%

Problem 13.2 Ferrari's IPO and WACC Ferrari, the famous high-performance automotive group, launched its initial public offering (IPO) on October 20, 2015.

Although the share price had initially risen to over 57 per share, by the end of the year it had settled to 48. Ferrari had been owned by Fiat (Italy) and had never calculated its own cost of capital before, one independent of Fiat. It now needed to, and one of its first challenges was estimating its beta. With only two months of trading to base it on, the corporate treasury group had started with what were considered "comparable firms," which, for Ferrari, meant firms in the luxury goods industry, not automotive. Luxury goods were historically less volatile than the market, so the initial guess on Ferrari's beta was 0.90. Using the following assumptions, answer the questions. a. What is Ferrari's cost of debt, after-tax, in euros? b. What is Ferrari's cost of equity in euros? c. What is Ferrari's market capitalization? d. What is Ferrari's total value of equity outstanding? e. What proportion of Ferrari's capital structure is equity? f. What proportion of Ferrari's capital structure is debt? g. What is Ferrari's weighted average cost of capital? h. What is Ferrari's WACC if its beta was higher, like other automotive companies, say 1.20?

Assumptions Italian risk-free cost of debt in euros (€) Ferrari's cost of debt in euros (€) Italian corporate income tax rate Ferrari's prospective beta Italian equity market risk premium (equity return over risk-free) Ferrari's shares outstanding Ferrari's share price in euros Ferrari's debt outstanding in euros a. Ferrari's cost of debt, after-tax, in euros kd = ( krf + credit risk premium ) x ( 1 - tax rate )

Values 4.00% 3.99% 33.50% 0.90 5.50% 189,000,000 € 48.00 € 510,000,000 2.653%

You might notice that Ferrari's cost of debt is actually cheaper than that of the Italian government. This was true, and reflected Ferrari's greater-than-Italy reach for its financial security, while also reflecting Italy's continuing challenge with sovereign debt. b. Ferrari's cost of equity in euros ke = krf + ( km - krf ) β

8.940%

c. Ferrari's market capitalization Share price x shares outstanding

€ 9,072,000,000

d. Ferrari's total value of equity outstanding Share price x shares outstanding

€ 9,072,000,000

e. What proportion of Ferrari's capital structure is equity?

Equity / ( Debt + Equity )

94.68%

f. What proportion of Ferrari's capital structue is debt?

Debt / ( Debt + Equity )

5.32%

g. What is Ferrari's weighted average cost of capital?

WACC = ( kd (1-tax) * D/(D+E)) + ( ke * E/(D+E))

8.61%

h. What is Ferrari's WACC if bet is higher, say 1.20?

Replacing the beta value above, and using the calculations that follow.

10.17%

It will be interesting to see over time whether Ferrari's beta will emulate that of a luxury good or an automotive company.

Problem 13.3 Ganado's Cost of Capital Maria Gonzalez now estimates Ganado's risk-free rate to be 3.60%, the company's credit risk premium is 4.40%, the domestic beta is estimated at 1.05, the international beta at 0.85, and the company's capital structure is now 30% debt. All other values remain the same as those presented in the chapter. For both the domestic CAPM and ICAPM, calculate: a. Ganado's cost of equity b. Ganado's cost of debt c. Ganado's weighted average cost of capital Domestic CAPM 1.05 3.60% 4.40% 8.00% 35% 9.00%

International ICAPM 0.85 3.60% 4.40% 8.00% 35% 8.00%

30% 70%

30% 70%

a) Ganado's cost of equity ke = krf + ( km - krf ) β

9.270%

7.340%

b) Ganado's cost of debt, after tax kd x ( 1 - t )

5.200%

5.200%

c) Ganado's weighted average cost of capital WACC = [ ke x E/V ] + [ ( kd x ( 1 - t ) ) x D/V ]

8.049%

6.6980%

Assumptions Ganado's beta, β Risk-free rate of interest, krf Company credit risk premium Cost of debt, before tax, kd Corporate income tax rate, t General return on market portfolio, km Optimal capital structure: Proportion of debt, D/V Proportion of equity, E/V

Problem 13.4 Ganado and Equity Risk Premiums Using the original weighted average cost of capital data for Ganado used in the chapter, calculate both the CAPM and ICAPM weighted average costs of capital for the following equity risk premium estimates. a. 8.00% b. 7.00%

c. 5.00% d. 4.00%

Assumptions Ganado's beta, β Risk-free rate of interest, krf Company credit risk premium Cost of debt, before tax, kd Corporate income tax rate, t Equity risk premium General return on market portfolio, km Optimal capital structure: Proportion of debt, D/V Proportion of equity, E/V

Answer for part a Domestic International CAPM ICAPM 1.05 0.85 4.00% 4.00% 4.40% 4.40% 8.00% 8.00% 35% 35% 8.00% 8.00% 12.00% 12.00% 30% 70%

30% 70%

a) Ganado's cost of equity ke = krf + ( km - krf ) β

12.400%

10.800%

b) Ganado's cost of debt, after tax kd x ( 1 - t )

5.200%

5.200%

c) Ganado's weighted average cost of capital WACC = [ ke x E/V ] + [ ( kd x ( 1 - t ) ) x D/V ]

10.240%

9.120%

CAPM

ICAPM

a. 8.00%

10.318%

9.198%

b. 7.00%

9.583%

8.603%

c. 5.00%

8.113%

7.413%

d. 4.00%

7.378%

6.818%

Differing Equity Risk Premiums

Problem 13.5 Eni S.p.A. Eni S.p.A. is an Italian oil company. Its current cost of debt is 3.8%, and the 10-year German bond yield, the proxy for the risk-free rate of interest, is 1.4%. The expected return on the market portfolio is 8%.

The company's effective tax rate is 24%. Its optimal capital structure is 60% debt and 40% equity.

a. If Eni's beta is estimated at 1.1, what is its weighted average cost of capital? b. If Eni's beta is estimated at 0.8, significantly lower because of the continuing profit prospects in the global energy sector, what is Eni's weighted average cost of capital?

Assumptions Eni's beta

Cost of debt, before tax Risk-free rate of interest Corporate income tax rate General return on market portfolio Optimal capital structure: Proportion of debt, D/V Proportion of equity, E/V

a)

Values 1.10 3.800% 1.400% 24.000% 8.000%

b)

Values 0.80 3.800% 1.400% 24.000% 8.000%

60% 40%

60% 40%

Cost of debt, after-tax kd x ( 1 - t )

2.888%

2.888%

Cost of equity, after-tax ke = krf + ( km - krf ) β

8.660%

6.680%

WACC

5.197%

4.405%

Calculation of the WACC

WACC = [ ke x E/V ] + [ ( kd x ( 1 - t ) ) x D/V ]

Problem 13.6 Nestle of Switzerland Revisited Nestle of Switzerland is revisiting its cost of equity analysis. As a result of extraordinary actions by the Swiss Central Bank, the Swiss bond index yield (10-year maturity) has dropped to a record low of 0.520%. The Swiss equity markets have been averaging 8.400% returns, while the Financial Times global equity market returns, indexed back to Swiss francs, is at 8.820%. Nestle's corporate treasury staff has estimated the company's domestic beta at 0.825 but its global beta (against the larger global equity market portfolio) at .515. a. What is Nestle's cost of equity based on the domestic portfolio of a Swiss investor? b. What is Nestle's cost of equity based on a global portfolio for a Swiss investor?

Assumptions Swiss bond index yield, the risk-free rate Swiss equity market return, in Swiss francs Global equity yield, in Swiss francs Nestle's beta versus Swiss equity market Nestle's beta versus Global equity market Nestle's cost of equity using CAPM

Domestic Portfolio 0.520% 8.400%

Global Portfolio 0.520% 8.820%

0.825 0.515 7.0210%

4.7945%

Problem 13.7 Corcovado Pharmaceuticals Corcovado Pharmaceutical’s cost of debt is 7%. The risk-free rate of interest is 3%. The expected return on the market portfolio is 8%. After effective taxes, Corcovado’s effective tax rate is 25%. Its optimal capital structure is 60% debt and 40% equity. a. If Corcovado’s beta is estimated at 1.1, what is its weighted average cost of capital? b. If Corcovado’s beta is estimated at 0.8, significantly lower because of the continuing profit prospects in the global pharma sector, what is its weighted average cost of capital?

Assumptions Corcovado's beta Cost of debt, before tax Risk-free rate of interest Corporate income tax rate General return on market portfolio Optimal capital structure: Proportion of debt, D/V Proportion of equity, E/V

a.

Values 1.10 7.000% 3.000% 25.000% 8.000%

b.

Values 0.80 7.000% 3.000% 25.000% 8.000%

60% 40%

60% 40%

Cost of debt, after-tax kd x ( 1 - t )

5.250%

5.250%

Cost of equity, after-tax ke = krf + ( km - krf ) β

8.500%

7.000%

WACC WACC = [ ke x E/V ] + [ ( kd x ( 1 - t ) ) x D/V ]

6.550%

5.950%

Calculation of the WACC

Problem 13.8 WestGas Conveyance, Inc. WestGas Conveyance, Inc., is a large U.S. natural gas pipeline company that wants to raise $120 million to finance expansion. WestGas wants a capital structure that is 50% debt and 50% equity. Its corporate combined federal and state income tax rate is 40%. WestGas finds that it can finance in the domestic U.S. capital market at the rates listed below. Both debt and equity would have to be sold in multiples of $20 million, and these cost figures show the component cost of debt and equity, if raised half by equity and half by debt.

A London bank advises WestGas that U.S. dollars could be raised in Europe at the following costs, also in multiples of $20 million, while maintaining the 50/50 capital structure.

Each increment of cost would be influenced by the total amount of capital raised. That is, if WestGas first borrowed $20 million in the European market at 6% and matched this with an additional $20 million of equity, additional debt beyond this amount would cost 12% in the U.S. and 10% in Europe. The same relationship holds for equity financing. a. Calculate the lowest average cost of capital for each increment of $40 million of new capital, where WestGas raises $20 million in the equity market and an additional $20 in the debt market at the same time.

b. If WestGAs plans an expansion of only $60 million, how should that expansion be financed?

Assumptions Combined federal and state tax rate Desired capital structure: Proportion debt Proportion equity Capital to be raised

Costs of Raising Capital in the Market Up to $40 million of new capital $41 million to $80 million of new capital Above $80 million

a. To raise $120,000,000 First $40,000,000 Second $40,000,000 Third $40,000,000

Values 40% 50% 50% $ 120,000,000 Cost of Domestic Equity 12% 18% 22%

Cost of Domestic Debt 8% 12% 16%

Cost of European Equity 14% 16% 24%

Cost of European Debt 6% 10% 18%

Debt Market

Debt Cost

Equity Market

Equity Cost

Incremental WACC

European European Domestic

6.00% 10.00% 16.00%

Domestic European Domestic

12.00% 16.00% 22.00%

7.80% 11.00% 15.80%

16.67% (equal weights)

11.53%

Weighted average cost

b. To raise $60,000,000 First $40,000,000 Additional $20,000,000 Weighted average cost

10.67% (equal weights)

Debt Market

Debt Cost

Equity Market

European European

6.00% 10.00%

Domestic European

7.33% (2/3 & 1/3 weights)

Equity Cost

Incremental WACC

12.00% 16.00%

7.80% 11.00%

13.33% (2/3 & 1/3 weights)

8.87%

Problem 13.9 Kashmiri's Cost of Capital Kashmiri is the largest and most successful specialty goods company based in Bangalore, India. It has not yet entered the North American marketplace, but is considering establishing both manufacturing and distribution facilities in the U.S. through a wholly owned subsidiary. It has approached two different investment banking advisors, Goldman Sachs and Bank of New York, for estimates of what its costs of capital would be several years into the future when it planned to list its American subsidiary on a U.S. stock exchange. Using the following assumptions by the two different advisors (shown in th table), calculate the prospective costs of debt, equity, and the WACC for Kashmiri (U.S.), Assumptions Components of beta: Estimate of correlation between security and market Estimate of standard deviation of Kashmiri's returns Estimate of standard deviation of market's return

Symbol β ρjm σj σm

Goldman Sachs

Bank of New York

0.90 24.0% 18.0%

0.85 30.0% 22.0%

krf kd km t D/V E/V

3.0% 7.5% 9.0% 35.0% 35% 65%

3.0% 7.8% 12.0% 35.0% 40% 60%

Estimated beta β = ( ρjm x σj ) / ( σm )

β

1.20

1.16

Estimated cost of equity ke = krf + (km - krf) β

ke

10.200%

13.432%

Estimated cost of debt kd ( 1 - t )

kd (1-t)

4.875%

5.070%

Estimated weighted average cost of capital WACC = (ke x E/V) + ( (kd x (1-t)) x D/V)

WACC

8.336%

10.087%

Risk-free rate of interest Estimate of Kashmiri's cost of debt in US market Estimate of market return, forward-looking Corporate tax rate Proportion of debt Proportion of equity Estimating Costs of Capital

Problem 13.10 Cargill's Cost of Capital Cargill is generally considered to be the largest privately held company in the world. Headquartered in Minneapolis, Minnesota, the company has been averaging sales of over $113 billion per year over the past five-year period. Although the company does not have publicly traded shares, it is still extremely important for it to calculate its weighted average cost of capital properly in order to make rational decisions on new investment proposals.

Assuming a risk-free rate of 4.50%, an effective tax rate of 48%, and a market risk premium of 5.50%, estimate the weighted average cost of capital first for companies A and B, and then make a ‘guestimate’ of what you believe a comparable WACC would be for Cargill.

Assumptions Total sales Company's beta Company credit rating Risk-free rate of interest Market risk premium Weighted average cost of debt Corporate tax rate Debt to total capital ratio Equity to total capital ratio International sales as % of total sales

Symbol Sales β S&P krf km-krf kd t D/V E/V

Comparables Company A Company B $10.5 billion $45 billion 0.83 0.68 AA A 4.5% 4.5% 5.5% 5.5% 6.885% 7.125% 48.0% 48.0% 34% 41% 66% 59% 11% 34%

Estimating Costs of Capital

Symbol

Company A

Company B

Cargill

Cargill $113 billion 0.90 AA 4.5% 5.5% 6.820% 48.0% 28% 72% 54%

Cost of equity ke = krf + (km - krf) β

ke

9.065%

8.240%

9.450%

Cost of debt, after-tax

kd ( 1 - t )

3.580%

3.705%

3.546%

Weighted average cost of capital WACC = (ke x E/V) + ( (kd x (1-t)) x D/V)

WACC

7.200%

6.381%

7.797%

Once the data are organized, the absence of a beta for Cargill is the obvious data deficiency.

A series of observations is then helpful: 1. Note that beta and credit ratings do not necessarily parallel one another.

2. Credit rating and cost of debt do follow expected norms; lower the rating, the higher the cost.

3. Both comparable companies, in the same industry as Cargill (commodities), possess relatively low betas.

4. Cargill's sales are twice that of the next largest firm.

5. Cargill's sales are significantly more internationally diversified than either of the other two companies; the question is whether this is a positive or negative factor for the estimation of Cargill's cost of equity.

If we take the approach that the beta for Cargill has to pick up all the incremental information, the beta would then fall between say 0.80 and 1.00. If the higher degree of international sales was interpreted as increasing risk, beta would be on the higher end; yet being a commodity firm in the current market, its beta would rarely surpass 1.0. A value of 0.90 is shown here giving a WACC of 7.797%. A series of sensitivities would find a WACC between 7.1% and 7.9%.

Problem 13.11 The Tombs You have joined your friends at the local watering hole, The Tombs, for your weekly debate on international finance. The topic this week is whether the cost of equity can ever be cheaper than the cost of debt. The group has chosen Brazil in the mid-1990s as the subject of the debate. One of the group members has torn the following table of data out of a book (shown below), which is then the subject of the analysis.

Larry argues, “It's all about expected versus delivered. You can talk about what equity investors expect, but they often find that what is delivered for years at a time is so small – even sometimes negative – that in effect the cost of equity is cheaper than the cost of debt.”

Moe interrupts, “But you’re missing the point. The cost of capital is what the investor requires in compensation for the risk taken going into the investment.

If he doesn’t end up getting it, and that was happening here, then he pulls his capital out and walks.”

Curly is the theoretician. “Ladies, this is not about empirical results; it is about the fundamental concept of risk-adjusted returns. An investor in equities knows he will reap returns only after all compensation has been made to debt providers. He is therefore always subject to a higher level of risk to his return than debt instruments, and as the capital asset pricing model states, equity investors set their expected returns as a risk-adjusted factor over and above the returns to risk-free instruments.”

At this point both Larry and Mo simply stare at Curly -- pause -- and order more beer. Using the Brazilian data presented, comment on this week’s debate at The Tombs.

Brazilian Economic Performance Inflation rate (IPC) Bank lending rate Exchange rate (BRL=USD1.00) Equity returns (Sao Paulo Bovespa)

1995 23.20% 53.10% 0.972 16.0%

1996 10.00% 27.10% 1.039 28.0%

1997 4.80% 24.70% 1.117 30.2%

1998 1.00% 29.20% 1.207 33.5%

1999 10.50% 30.70% 1.700 151.9%

All three are on the right track. It is mostly a matter of finding the linkages beween their individual arguments.

1. Theoretically, Curly is correct in that CAPM assumes that all equity returns are over and above risk-free rates. These are of course, expected returns, and are the investor's expectations or requirements going INTO the investment.

2. Mo is also correct in arguing that regardless of what investors may EXPECT, the results are often quite different, sometimes disappointing.

Theoretically, when the investment does not yield at least the expected return, the investor should indeed liquidate their position. However, in reality, many investors for a variety of reasons (tax implications, investment horizon, etc.), may stay in the investment and just complain about the past and hope for the future.

3. Larry also is on the right track arguing that actual market returns will often result in less than various interest or debt instruments. One of the more helpful arguments here is that equity returns and interest returns arise from very different economic and financial processes. Most interest rate charges are stated and contracted for up-front, and represent lenders' perception of an adequate risk-adjusted return over the expected rate of inflation for the coming period. Equity returns, however, are that mystical process of equity markets in which the many different motives of equity investors combine to move markets in sometimes mysterious ways, independent of interest rates, inflation rates, or any other fundamental money price.

Mean 9.90% 32.96% 120.7% 51.92%

Problem 13.12 Genedak-Hogan Cost of Equity Use the following information to answer questions 12 through 14. Genedak-Hogan is an American conglomerate that is actively debating the impacts of international diversification of its operations on its capital structure and cost of capital. The firm is planning on reducing consolidated debt after diversification.

Senior management at Genedak-Hogan is actively debating the implications of diversification on its cost of equity. Although both parties agree that the company’s returns will be less correlated with the reference market return in the future, the financial advisors believe that the market will assess an additional 3.0% risk premium for "going international" to the basic CAPM cost of equity.

Calculate Genedak-Hogan's cost of equity before and after international diversification of its operations, with and without the hypothetical additional risk premium, and comment on the discussion.

Before After Assumptions Symbol Diversification Diversification Correlation between G-H and the market ρ jm 0.88 0.76 Standard deviation of G-H's returns σj 28.0% 26.0% 18.0% 18.0% Standard deviation of market's returns σm 3.0% 3.0% Risk-free rate of interest k rf Additional equity risk premium for internationalization RPM 0.0% 3.0% Estimate of G-H's cost of debt in US market kd 7.2% 7.0% 5.5% 5.5% Market risk premium k m - k rf Corporate tax rate t 35.0% 35.0% Proportion of debt D/V 38% 32% Proportion of equity E/V 62% 68% Estimating Costs of Capital Estimated beta β = ( ρjm x σj ) / ( σm )

β

1.37

1.10

Estimated cost of equity ke = krf + (km - krf) β

ke

10.529%

9.038%

ke + RPM

10.529%

12.038%

Estimated cost of equity with additional risk premium ke* = krf + (km - krf) β + RPM

This may be a case where everyone is correct. When G-H's beta is recalculated, it falls in value as a result of the reduced correlation of its returns with the home market (diversification benefit). This then creates a standard cost of equity which is cheaper at 9.038% (previous cost of equity was 10.529%).

If, however, the market were to add an additional risk premium to the firm's cost of equity as a result of internationally diversifying operations, and if that risk premium were on the order of 3.0%, the final risk-adjusted cost of equity is indeed higher, 12.038% to the before value of 10.529%.

Problem 13.13 Genedak-Hogan's WACC Calculate the weighted average cost of capital for Genedak-Hogan for before and after international diversification. a. Did the reduction in debt costs reduce the firm’s weighted average cost of capital? How would you describe the impact of international diversification on its costs of capital? b. Adding the hypothetical risk premium to the cost of equity introduced in Problem 13.8 (an added 3.0% to the cost of equity because of international diversification), what is the firm’s WACC?

Assumptions Correlation between G-H and the market Standard deviation of G-H's returns Standard deviation of market's returns Risk-free rate of interest Additional equity risk premium for internationalization Estimate of G-H's cost of debt in US market Market risk premium Corporate tax rate Proportion of debt Proportion of equity

Symbol ρjm σj σm krf RPM kd km-krf t D/V E/V

Estimating Costs of Capital

Before Diversification 0.88 28.0% 18.0% 3.0% 0.0% 7.2% 5.5% 35.0% 38% 62%

After Diversification 0.76 26.0% 18.0% 3.0% 3.0% 7.0% 5.5% 35.0% 32% 68%

Before Diversification

After Diversification

Estimated beta β = ( ρjm x σj ) / ( σm )

β

1.37

1.10

Estimated cost of equity ke = krf + (km - krf) β

ke

10.529%

9.038%

ke + RPM

10.529%

12.038%

4.680%

4.550%

8.306%

7.602%

8.306%

9.642%

Estimated cost of equity with additional risk premium ke* = krf + (km - krf) β + RPM Cost of debt, after-tax kd ( 1 - t )

kd (1-t)

Weighted average cost of capital WACC = (ke x E/V) + ( (kd x (1-t)) x D/V)

WACC

Weighted average cost of capital with RPM WACC = (ke* x E/V) + ( (kd x (1-t)) x D/V)

WACC*

There are a number of different factors at work here. First, as a result of international diversification, their access to debt has improved, resulting in a lower cost of debt capital. This is not fully appreciated, however, as the firm has chosen to reduce its overall use of debt post-diversification (common among MNEs).

The firm's WACC does indeed drop for the standardized case. If, however, the market assesses an additional equity risk premium of 3.0%, the benefits are swamped by the higher required return on equity by the market.

Problem 13.14 Genedak-Hogan's WACC and Effective Tax Rate Many MNEs have greater ability to control and reduce their effective tax rates when expanding international operations. If Genedak-Hogan were able to reduce its consolidated effective tax rate from 35% to 32%, what would be the impact on its WACC?

Assumptions Correlation between G-H and the market Standard deviation of G-H's returns Standard deviation of market's returns Risk-free rate of interest Additional equity risk premium for internationalization Estimate of G-H's cost of debt in US market Market risk premium Corporate tax rate Proportion of debt Proportion of equity

Symbol ρjm σj σm krf RPM kd km-krf t D/V E/V

Estimating Costs of Capital

Before Diversification 0.88 28.0% 18.0% 3.0% 0.0% 7.2% 5.5% 35.0% 38% 62%

After Diversification 0.76 26.0% 18.0% 3.0% 3.0% 7.0% 5.5% 32.0% 32% 68%

Before Diversification

After Diversification

Estimated beta β = ( ρjm x σj ) / ( σm )

β

1.37

1.10

Estimated cost of equity ke = krf + (km - krf) β

ke

10.529%

9.038%

ke + RPM

10.529%

12.038%

4.680%

4.760%

8.306%

7.669%

8.306%

9.709%

Estimated cost of equity with additional risk premium ke* = krf + (km - krf) β + RPM Cost of debt, after-tax kd ( 1 - t )

kd (1-t)

Weighted average cost of capital WACC = (ke x E/V) + ( (kd x (1-t)) x D/V)

WACC

Weighted average cost of capital with RPM WACC = (ke* x E/V) + ( (kd x (1-t)) x D/V)

WACC*

The reduction in the effective tax rate obviously impacts WACC through the cost of debt. This does have substantial benefits in the company's WACC -- as long as additional equity risk premiums are not assessed. Then, even the lower effective tax rate does not offset the higher equity costs associated with the international risk premium.

Problem 14.1 Sagard Private Equity (France) Sagard Private Equity, a private equity firm headquartered in Paris borrows £2,000,000 for one year at 5.25% interest. a. What is the euro cost of this debt if the pound depreciates from €1.1837 = £1.00 to €1.1000 = £1.00 over the year? b. What is the euro cost of this debt if the pound appreciates from €1.1837 = £1.00 to €1.2540 = £1.00 over the year?

Assumptions Principal borrowed (£) Pound interest rate, one year (percent per annum) Beginning of year spot rate, €/£ End of year spot rate, €/£ Calculation of Principal and Interest Pound-denominated debt (£) Principal Interest Principal and interest due at end of year Cost of funds if pound depreciates versus dollar Repayment cost of pounds, ending spot rate (€) Divided by value in the euros of initial pound debt proceeds (€) (at beginning of period spot rate) Equals Minus 1 Equals the implied Euro cost of pound-denominated debt Euro cost of pound (£) debt

a) Depreciating £ 2,000,000.00 5.250% 1.1837 1.1000

b) Appreciating £ 2,000,000.00 5.250% 1.1837 1.2540

2,000,000.00 105,000.00 £2,105,000.00

2,000,000.00 105,000.00 £2,105,000.00

2,315,500.00 2,367,400.00

2,639,670.00 2,367,400.00

0.97808 1.00000 (0.02192)

1.11501 1.00000 0.11501

-2.192%

11.501%

Problem 14.2 Swissie Debt Costs The chapter demonstrated that a firm borrowing in a foreign currency could potentially end up paying a very different effective rate of interest than what it expected. Using the same baseline values of a debt principal of CHF1.5 million, a one-year period, an initial spot rate of CHF1.5000 = $1.00, a 5.000% cost of debt, and a 34% tax rate, what is the effective cost of debt for one year for a U.S. dollar-based company if the exchange rate at the end of the period was: a. CHF1.5000/$ b. CHF1.4400/$ c. CHF1.3860/$ d. CHF1.6240/$ Debt principal (Swiss francs) Initial spot rate Cost of debt Tax rate

Values 1,500,000 1.5000 5.000% 34.00% Answer

a. If the exchange remains the same

S2

We first calculate the percentage change in the exchange rate, s s = ( S1 - S2 ) / (S2) x 100

1.5000

0.000%

We then calculate the effective cost of debt after exchange rate changes kd = [ ( 1 + kdSF ) x ( 1 + s ) ] - 1 b. If the exchange ends the period at CHF1.4400/$:

5.000% S2

We first calculate the percentage change in the exchange rate, s s = ( S1 - S2 ) / (S2) x 100

1.4400

4.167%

We then calculate the effective cost of debt after exchange rate changes kd = [ ( 1 + kdSF ) x ( 1 + s ) ] - 1 c. If the exchange ends the period at CHF1.3860/$:

9.375% S2

We first calculate the percentage change in the exchange rate, s s = ( S1 - S2 ) / (S2) x 100

1.3860

8.225%

We then calculate the effective cost of debt after exchange rate changes kd = [ ( 1 + kdSF ) x ( 1 + s ) ] - 1 d. If the exchange ends the period at CHF1.6240/$:

13.636% S2

We first calculate the percentage change in the exchange rate, s s = ( S1 - S2 ) / (S2) x 100

1.6240

-7.635%

We then calculate the effective cost of debt after exchange rate changes kd = [ ( 1 + kdSF ) x ( 1 + s ) ] - 1

-3.017%

Problem 14.3 Trigone Capital Finance (Switzerland)

Trigone Capital Finance S.A, a Swiss-based investment partnership, borrows €50,000,000 at a time when the exchange rate is CHF1.1 €1.00. The entire principal is to be repaid in three years, and interest is 3.250% per annum, paid annually in euros. The euro is expecte depreciate vis à vis the swiss franc at 2% per annum. What is the effective cost of this loan for Trigone?

Assumptions Principal borrowed for three years (€) Interest rate on loan, percent per annum Beginning spot rate, CHF/euro Expected % change in the euro versus the franc

Value 50,000,000 3.250% 1.1000 -2.000%

Calculation of the dollar cost of euro debt

Year 0

Proceeds from borrowing euros (€) Interest payment due (€) Repayment of principal in year 3 (€) Total cash flows of euro-denominated debt (€)

Year 2

-1,625,000

-1,625,000

-1,625,000

-1,625,000

50,000,000

50,000,000

Note: One way to check this calculaton is to find the internal rate of return, IRR of this cash flow stream: This shows it is truly a 3.25% loan.

Expected exchange rate, CHF/euro (spot rate x (1 - .02))

Year 1

3.250%

$

1.1000

Swiss Franc equivalent of euro-denominated cash flows

55,000,000.00

IRR of cash flow stream (the implied Swiss franc cost)

1.185%

$

1.0780

(1,751,750.00)

$

1.0564

(1,716,715.00)

The internal rate of return, IRR, of any stream of cash flows will determine the rate of discount (interest) which results in a NPV of the cash flow stream of exactly zero.

e exchange rate is CHF1.10 = euros. The euro is expected to

Year 3

-1,625,000 -50,000,000 -51,625,000

$

1.0353

(53,447,940.70)

ich results in a NPV

Problem 14.4 Morning Star Air (China) Morning Star Air, headquartered in Kunming, China, needs US$25,000,000 for one year to finance working capital. The airline has two alternatives for borrowing: a. Borrow US$25,000,000 in eurodollars in London at 7.250% per annum b. Borrow HK$195,000,000 in Hong Kong at 7.00% per annum, and exchange these Hong Kong dollars at the present exchange rate of HK$7.8 = US$ for U.S. dollars.

At what ending exchange rate would Morning Star Air be indifferent between borrowing U.S. dollars and borrowing Hong Kong dollars?

Assumptions Working capital debt needed for one year Borrowing US dollars in London: Interest rate, percent per annum Principal borrowed Borrow Hong Kong dollars in Hong Kong Interest rate, percent per annum Initial spot rate, HK$/US$ Principal borrowed

$

Value 25,000,000

$

7.250% 25,000,000 7.000% 7.8000 195,000,000

Calculation of the breakeven exchange rate Cost of repaying the Hong Kong dollar loan in HK$ Cost of repaying the US dollar loan in US$ Breakeven exchange rate (HK$ cost/US$ cost) Breakeven is the equivalent of "indifferent."

$

208,650,000 26,812,500 7.7818

Problem 14.5 Pantheon Capital, S.A. If Pantheon Capital, S.A., is raising funds via a medium-term euronote with the following characteristics, how much in dollars will Pantheon receive for each $1,000 note sold?

Coupon rate: 8.00% payable semiannually on June 30 and December 31 Coupon rate: 8.00% payable semiannually on June 30 and December 31 Date of issuance: February 28, 2011 Maturity: August 31, 2013 Assumptions Face value of each note sold Annual coupon Semi-annual coupon (paid June 30th and December 31st) Date of issuance Maturity

Cash payment (payment date) First coupon (30 June 2011) Second coupon (31 December 2011) Third coupon (30 June 2012) Fourth coupon (31 December 2012) Fifth coupon (30 June 2013) Sixth and final coupon (31 August 2013) Principal repayment

$

Value 1,000.00 8.00% 4.00%

February 28, 2011 August 31, 2013

Days Since Previous Date

Cumultive Days From Start

122 180 180 180 180 62

122 302 482 662 842 904 904

Cash Flows (par x coupon x days/180) $ $ $ $ $ $ $

27.11 40.00 40.00 40.00 40.00 13.78 1,000.00

Discount Factor Calculation Compound Factor Discount Factor (cum days/180) (1.04) compounded 0.6778 1.6778 2.6778 3.6778 4.6778 5.0222 5.0222

1.0269 1.0680 1.1107 1.1552 1.2014 1.2177 1.2177

Note: That the reason these medium term euronotes each have a market value that exceeds their face value is because the first coupon is paid sooner than the six-month period separating coupon payments. For example, if all coupons payments were made in 180 days increments ("days since previous date"), the market value of notes would be at the par value of $1,000.

Discounted Cash Flows (US dollars) $ $ $ $ $ $ $ $

26.40 37.45 36.01 34.63 33.30 11.31 821.21 1,000.31

Problem 14.6 Westminster Insurance Company Westminster Insurance Company plans to sell $2,000,000 of eurocommercial paper with a 60-day maturity and discounted to yield 4.60% per annum. What will be the immediate proceeds to Westminster Insurance?

Assumptions Principal of Euro Commercial Paper issuance Maturity (days) Yield to maturity at issuance

$

Proceeds of issuance Face value Discount rate (1 + ((days/360) x (ytm))) Proceeds equal (Face value / Discount rate)

Value 2,000,000 60 4.600%

Value $ $

2,000,000.00 1.00767 1,984,783.33

Problem 14.7 Styrene Polymers (U.S.) Styrene Polymers, Inc., a U.S. medical plastics manufacturer, has the following debt components in its consolidated capital section.

Styrene’s finance staff estimates their cost of equity to be 20%. Current exchange rates are also listed below. Income taxes are 30% around the world after allowing for credits. Calculate Sunrise’s weighted average cost of capital. Are any assumptions implicit in your Assumption Tax rate 10-year euro bonds (euros) 20-year yen bonds (yen) Spot rate ($/euro) Spot rate ($/pound) Spot rate (yen/$)

Value 30.00% € 6,000,000 750,000,000 1.2400 1.8600 109.00

Styrene Polymer's Capital Structure

Component 25 year US dollar bonds 5 year US dollar euronotes 10 year euro bonds 20 year yen bonds Shareholders' equity Total

$

$

US Dollar Amount 10,000,000 4,000,000 7,440,000 6,880,734 50,000,000 78,320,734

Percent of Total 12.77% 5.11% 9.50% 8.79% 63.84% 100.00%

Pre-tax Cost (%) 6.000% 4.000% 5.000% 2.000% 20.000%

Post-tax Cost (%) 4.200% 2.800% 3.500% 1.400% 20.000% WACC =

Weighted Component Cost (%) 0.5363% 0.1430% 0.3325% 0.1230% 12.7680% 13.9027%

The component coupon costs (for example the 6% coupon on the 25-year U.S. dollar bonds) are the same as the current yields to maturity that would be needed to sell similar bonds in the marketplace today. Current yields to maturity is the proper rate to use. The interest costs used for the euro and yen bonds reflect actual expected interest costs after any exchange rate changes. This calculation assumes there is no expected change in the exchange rate over the life of the debt issue (which is indeed highly unlikely).

Problem 14.8 Petrol Ibérico Petrol Ibérico, a European gas company, is borrowing US$650 million via a syndicated eurocredit for six years at 80 basis points over LIBOR. LIBOR for the loan will be reset every six months. The funds will be provided by a syndicate of eight leading investment bankers, which will charge up-front fees totaling 1.2% of the principal amount. What is the effective interest cost for the first year if LIBOR is 4.00% for the first six months and 4.20% for the second six months?

Initial Issuance Principal borrowed for six years, in US$ Issuance fees

$

Value 650,000,000 1.20%

Interest Costs LIBOR Spread over LIBOR Total interest cost Calculation of the effective cost of funds Face value of syndicated loan less fees for issuance Net proceeds of syndicated loan Interest payment due at end of 6-month period (annual rate divided by 2 for 6-month period) Total interest payments in first year of loan Effective interest cost (interest payment/proceeds)

$ $

Issuance 650,000,000 (7,800,000) 642,200,000 $

$

(31,850,000) 4.960%

First 6-months 4.000% 0.800% 4.800%

2nd 6-months 4.200% 0.800% 5.000%

First 6-months

2nd 6-months

(15,600,000)

$

(16,250,000)

Problem 14.9 Adamantine Architectonics Adamantine Architectonics consists of a U.S. parent and wholly owned subsidiaries in Malaysia (A-Malaysia) and Mexico (A-Mexico). Selected portions of their non-consolidated balance sheets, translated into U.S. dollars, are shown below.

What are the debt and equity proportions in Adamantine’s consolidated balance sheet?

Assumptions A-Malaysia (in ringgits): Long-term debt Shareholders' equity A-Mexico (in pesos): Long-term debt Shareholders' equity Adamantine Architectonics (non-consolidated) Investment in subsidiaries (US dollars): in A-Malaysia in A-Mexico Parent long-term debt Common stock Retained earnings Current exchange rates: Malaysian ringgit per dollar (RM/$) Mexican pesos per dollar (Ps/$) Consolidated Balance Sheet (US$) Debt: Malaysian ringgit debt (RM converted to US$) Mexican peso debt (Ps converted to US$) Parent company debt Consolidated long-term debt

Value 11,400,000 15,200,000 20,000,000 60,000,000

$ $ $ $ $

4,000,000 6,000,000 12,000,000 5,000,000 20,000,000 3.80 10.00 Value

Percent

$

3,000,000 2,000,000 12,000,000 17,000,000

40.48%

Shareholders' equity (common + retained)

$

25,000,000

59.52%

Total capital

$

42,000,000

100.00%

$

Note that the equity accounts of the subsidiaries are matched by "investment in subsidiaries" asset account held in the non-consolidated books of the parent company. In consolidation these two accounts cancel each other out.

Problems 14.10–14.15 Petrobrás of Brazil: Estimating its Weighted Average Cost of Capital Petrobrás Petróleo Brasileiro S.A. or Petrobras is the national oil company of Brazil. It is publicly traded, but the government of Brazil holds the controlling share. It is the largest company in the Southern Hemisphere by market capitalization and the largest in all of Latin America. As an oil company, the primary product of its production has a price set on global markets—the price of oil—and much of its business is conducted the global currency of oil, the U.S. dollar.

Problems 14.10–14.15 examine a variety of different financial institutions’ attempts to estimate the company’s cost of capital.

Problem 14.10 JPMorgan JPMorgan’s Latin American Equity Research department produced the following WACC calculation for Petrobrás of Brazil versus Lukoil of Russia. Evaluate the methodology and assumptions used in the calculation. Assume a 28% tax rate for both companies.

Capital Cost Components Risk Free Rate Sovereign Risk Equity Risk Premium Market Cost of Equity

Petrobrás (Brazil) 4.800% 7.000% 4.500% 16.300%

Lukoil (Russia) 4.800% 3.000% 5.700% 13.500%

Beta (relevered) Cost of equity

0.87 18.981%

1.04 18.840%

Cost of Debt Tax rate Cost of debt, after-tax

8.400% 28.000% 6.048%

6.800% 28.000% 4.896%

Debt/Capital ratio Equity/Capital ratio

33.300% 66.700%

47.500% 52.500%

WACC (calculated)

14.674%

12.217%

WACC (I-Bank report)

14.700%

12.300%

This approach applies the sovereign risk premium to the cost of equity for both companies, but not to their cost of debt. Since the comparison is for two oil companies from two different countries, and the same risk free rate is used for both, it is implied, though not stated, that the WACC calculation is based in US dollars.

Source: "Petrobras: A Diamond in the Rough," JP Morgan, Latin American Equity Research, June 18, 2004, p. 24.

Problem 14.11 UNIBANCO UNIBANCO estimated the weighted average cost of capital for Petrobrás to be 13.2% in Brazilian reais. Evaluate the methodology and assumptions used in the calculation.

Capital Cost Components Risk Free Rate Levered Beta Risk Premium Country Risk Premium Cost of equity (US$)

2004 4.500% 0.99 6.000% 5.500% 15.940%

Exchange Rate Cost of equity (R$)

2.000% 18.259%

Cost of Debt Tax rate Cost of debt, after-tax (R$)

8.600% 34.000% 5.676%

Debt/Capital ratio Equity/Capital ratio

40.000% 60.000%

WACC (R$) calculated

13.23%

WACC (R$) (I-bank report)

13.20%

This calculation adds the country risk premium to the risk free rate in the cost of equity, but not the cost of debt (as was the case in the previous problem). This cost of equity in US$, however, is then compounded by a percentage change in the expected exchange rate of the reais against the dollar to arrive at a cost of equity in reais. The cost of debt, which indicates reais-denomination, is not adjusted for the country risk premium or the expected currency movement.

Source: "Petrobras: Reinitiation of Coverage," UNIBANCO, August 12, 2004, p.4.

Problem 14.12 Citigroup SmithBarney (Dollar) Citigroup regularly performs a U.S. dollar-based discount cash flow (DCF) valuation of Petrobrás in its coverage. That DCF analysis requires the use of a discount rate on which they base on the company's weighted average cost of capital. Evaluate the methodology and assumptions used in the estimates of Petrobras WACC below.

Capital Cost Components Risk free rate Levered Beta Risk Premium Cost of equity

July 28, 2005 2003A 9.400% 1.07 5.500% 15.285%

2004E 9.400% 1.09 5.500% 15.395%

March 8, 2005 2003A 9.000% 1.08 5.500% 14.940%

2004E 9.000% 1.10 5.500% 15.050%

Cost of debt Tax rate Cost of debt, after-tax

8.400% 28.500% 6.006%

8.400% 27.100% 6.124%

9.000% 28.500% 6.435%

9.000% 27.100% 6.561%

Debt/capital ratio Equity/capital ratio

32.700% 67.300%

32.400% 67.600%

32.700% 67.300%

32.400% 67.600%

WACC

12.20%

12.30%

12.10%

12.30%

WACC (calculated)

12.25%

12.39%

12.16%

12.30%

This approach uses a relatively high assumed value for the risk free rate of interest in the cost of equity calculation, without expressly charging the company a country risk premium. Since the U.S. dollar risk-free rate at this time was somewhere around 4%, this risk-free rate must implicitly include a country risk premium. The cost of debt, before-tax, is actually below the riskfree rate, which is difficult to understand or rationalize.

Source: "Petrobras," Citigroup SmithBarney, March 8, 2005, and July 28, 2005.

Problem 14.13 Citigroup SmithBarney (Reais) Citigroup SmithBarney calculated a WACC for Petrobrás denominated in Brazilian reais (R$). Evaluate the methodology and assumptions used in this cost of capital calculation.

Petrobras Cost of Equity Risk-free rate (Brazilian C-Bond) Petrobras levered beta (β) Market risk premium Cost of equity

June 2003 9.90% 1.40 5.50% 17.60%

Petrobras Cost of Debt Petrobras cost of debt Brazilian corporate tax rate Cost of debt, after-tax

10.00% 34.00% 6.60%

WACC Calculation (in R$) Petrobras cost of debt, after-tax Long-term debt ratio (% of capital) Petrobras cost of equity Long-term equity ratio (% of capital)

6.60% 50.60% 17.60% 49.40%

WACC (I-bank report)

12.00%

WACC (calculated)

12.03%

Identifying the risk-free rate as the Braizilian C-Bond rate, and using a relatively high value of beta compared to other analyst estimates, the cost of equity is relatively high. The cost of debt, also high compared to the other estimates, results in a final WACC calculation, in Brazilian reais, which is similar in value to other estimates.

Source: "Petroleo Brasileiro S.A.,Citigroup Smith Barney, June 17, 2003, p.17.

Problem 14.14 BBVA Investment Bank BBVA utilized a rather innovative approach to dealing with both country and currency risk in their report on Petrobras. Evaluate the methodology and assumptions used in this cost of capital calculation.

Cost of Capital Component US 10-year risk-free rate (in US$) Country risk premium (in US$) Petrobras premium "adjustment" Petrobras risk-free rate (in US$)

2003 Estimate 4.10% 6.00% -1.00% 9.10%

2004 Estimate 4.40% 4.00% -1.00% 7.40%

9.10% 0.80 6.00% 13.90% 2.50% 16.75%

7.40% 0.80 6.00% 12.20% 2.00% 14.44%

Petrobras Cost of Debt Petrobras cost of debt (in R$) Brazilian corporate tax rate Cost of debt, after-tax (in US$)

8.50% 35.00% 5.53%

8.50% 35.00% 5.53%

WACC Calculation (in R$) Petrobras cost of debt, after-tax Long-term debt ratio (% of capital) Petrobras cost of equity Long-term equity ratio (% of capital)

5.53% 31.00% 16.75% 69.00%

5.53% 28.00% 14.44% 72.00%

WACC (calculated)

13.27%

11.95%

WACC (I-Bank report)

13.30%

12.00%

Petrobras Cost of Equity Petrobras risk-free rate (in US$) Petrobras beta (β) Market risk premium (in US$) Cost of equity (in US$) Projected 10-year currency devaluation Cost of equity (in R$)

1

2 3

This analysis clearly begins with a U.S. dollar-based risk-free rate, 4.1% and 4.4%, adds a country risk premium to it, and then adjusts the sum downward for a Petrobras premium. The Petrobras premium is the analyst's opinion that Petrobras is an oil and gas company, and therefore operates in a global dollar market which is in many ways less risky than a pure-play on a Brazilian firm. The resulting cost of equity is then converted from reais to dollars with the application of a currency devaluation multiplier, a stated average expectation for the coming decade.The cost of debt assumed is very low -- 5.53% -- which is clearly a dollar cost and not a reais cost as stated. The final WACC in reais terms is roughly equivalent to the various estimates from the previous problems.

Notes: 1 Petrobras premium adjustment is the reduction in country risk given an oil and gas company operating in a global industry which operates in a market of US dollar denominated returns.

2 Cost of equity in US$ = risk free rate + ( beta x market risk premium ) 3 Cost of equity in R$ = [ (1 + cost of equity in US$) x (1 + projected devaluation) ] - 1 Source: "Petrobras," BBVA Securities, Latin American Research, December 20, 2004, p. 7.

Problem 14.15 Petrobras WACC Comparison The various estimates of the cost of capital for Petrobras of Brazil appear to be very different, but are they? Reorganize your answers to Problems 14.10 through 14.14 into those costs of capital which are in U.S. dollars versus Brazilian reais. Use the estimates for 2004 as the basis of comparison.

Capital Cost Components Risk Free Rate Sovereign/Country Risk Premium Petrobras Company Premium "Adjusted" Risk Free Rate Levered Beta Market/Equity Risk Premium Cost of equity (US$)

U.S. dollar WACCs JPMorgan Citigroup ($) (June 18, 2004) (March 8, 2005) 4.800% 9.400% 7.000% 0.000% 0.000% 0.000% 11.800% 9.400% 0.87 1.09 4.500% 5.500% 18.981% 15.395%

Exchange Rate Cost of equity (R$)

UNIBANCO (Aug 12, 2004) 4.500% 5.500% 0.000% 10.000% 0.99 6.000% 15.940%

Brazilian reais WACCs Citigroup (R$) (June 17, 2003) 9.900% 0.000% 0.000% 9.900% 1.40 5.500% 17.600%

BBVA (Dec 20, 2004) 4.400% 4.000% -1.000% 7.400% 0.80 6.000% 12.200%

2.000% 18.259%

0.000% 17.600%

2.000% 14.444%

Cost of Debt Tax rate Cost of debt, after-tax

8.400% 28.000% 6.048%

8.400% 27.100% 6.124%

8.600% 34.000% 5.676%

10.000% 34.000% 6.600%

8.500% 35.000% 5.525%

Debt/Capital ratio Equity/Capital ratio

33.300% 66.700%

32.400% 67.600%

40.000% 60.000%

50.600% 49.400%

28.000% 72.000%

WACC (calculated)

14.7%

12.4%

13.2%

12.0%

11.9%

WACC (I-bank report)

14.7%

12.3%

13.2%

12.0%

12.0%

Problem 14.16 Fonterra Fonterra is New Zealand's largest company. It is a dairy nutrition company, and controls a large part of dairy exports worldwide. The company evaluates all business results, including financing costs, in New Zealand dollars. The company needs to borrow NZ$1 million or the foreign currency equivalent for four years. For all issues, interest is payable once per year, at the end of the year. Available alternatives are as follows: a. Sell Japanese yen bonds at par yielding 3% per annum. The current exchange rate is ¥85/NZ$, and the yen is expected to strengthen against the New Zealand b. Sell euro-denominated bonds at par yielding 7% per annum. The current exchange rate is NZ$1.6034/€, and the euro is expected to weaken against the New c. Sell New Zealand dollar bonds at par yielding 5% per annum. d. Which course of action do you recommend Fonterra take and why?

Japanese yen bonds 3.000% 85.00 2.000% 1,000,000.00

Euro bonds 7.000% 1.6034 -2.000%

NZ dollar bonds 5.000%

Year 0

Year 1

Year 2

Year 3

Year 4

Japanese yen bonds: Proceeds and principal and interest payments Expected exchange rate (¥/NZ$) New Zealand dollar equivalent in expected cash flows IRR of NZ$ cash flow stream (cost of funds)

85,000,000 85.00 1,000,000.00 5.060%

(2,550,000) 83.33 (30,600.00)

(2,550,000) 81.70 (31,212.00)

(2,550,000) 80.10 (31,836.24)

(87,550,000) 78.53 (1,114,905.12)

Euro-denominated bonds: Proceeds and principal and interest payments (€) Expected exchange rate (NZ$/€) New Zealand dollar equivalent in expected cash flows IRR of NZ$ cash flow stream (cost of funds)

623,675 1.6034 1,000,000.00 4.860%

-43,657 1.5713 (68,600.00)

-43,657 1.5399 (67,228.00)

-43,657 1.5091 (65,883.44)

-667,332 1.4789 (986,933.93)

NZ dollar bonds: Proceeds and principal and interest payments IRR of NZ$ cash flow stream (cost of funds)

1,000,000.00 5.000%

(50,000.00)

(50,000.00)

(50,000.00)

(1,050,000.00)

Alternatives Coupon rate Current spot rate, ¥/NZ$ Expected change in the value of the foreign currency Principal needed by Fonterra Calculation of the dollar cost debt alternatives

0.000%

Given the expected exchange rate changes, the euro-denominated bonds have the lowest all-in-cost of funds for the New Zealand-based company, Fonterra.

(Note that it is the expected changes in exchange rates which determine this outcome. In the event that all currencies were expected to remain fixed, an expected change of 0%, then the Japanese yen bonds are clearly the cheapest source of capital.)

Problem 15.1 Avon's Foreign-Source Income Avon is a U.S.-based direct seller of a wide array of products for women. Avon markets leading beauty, fashion, and home products in more than 100 countries. As part of the training in its corporate treasury offices, it has its interns build a spreadsheet analysis of the following hypothetical subsidiary earnings/distribution analysis. Use the spreadsheet presented in Exhibit 15.6 for your basic structure. a. What is the total tax payment, foreign, and domestic combined, for this income? b. What is the effective tax rate paid on this income by the U.S.-based parent company? c. What would be the total tax payment and effective tax rate if the foreign corporate tax rate was 45%, and there were no withholding taxes on dividends?

Baseline Values a Foreign corporate income tax rate b U.S. corporate income tax rate c Foreign dividend witholding tax rate d U.S. ownership in foreign firm e Dividend payout rate of foreign firm Foreign Subsidiary Tax Computation 1 Taxable income of foreign subsidiary 2 Foreign corporate income tax 3 Net income available for distribution 4 Retained earnings 5 Distributed earnings 6 Distribution to U.S. parent company 7 Withholding taxes on dividends 8 Net remittance to U.S. parent U.S. Corporate Tax Computation on Foreign-Source Income 9 Dividend received (before withholding) 10 Add-back foreign deemed-paid tax 11 Grossed-up foreign dividend 12 Tentative U.S. tax liability 13 Less credit for foreign taxes a. foreign income taxes paid b. foreign withholding taxes paid c. total 14 Additional U.S. taxes due 15 Excess foreign tax credits 16 After-tax income from foreign subsidiary Tax Burden Measurement 17 Total taxes paid on remitted income 18 Effective tax rate on foreign income

Case 1 28% 35% 15% 100% 100%

$ $

$

$ $

$

$

$

3,400,000 (952,000) 2,448,000 2,448,000 2,448,000 367,200 2,080,800

2,448,000 952,000 3,400,000 1,190,000 (952,000) (367,200) (1,319,200) 129,200 2,080,800

1,319,200 38.8%

Case 2 45% 35% 0% 100% 100%

$ $

$

$ $

$

$

$

3,400,000 (1,530,000) 1,870,000 1,870,000 1,870,000 1,870,000

1,870,000 1,530,000 3,400,000 1,190,000 (1,530,000) (1,530,000) 340,000 1,870,000

1,530,000 45.0%

Problem 15.2 Pacific Jewel Airlines (Hong Kong) Pacific Jewel Airlines is a U.S.-based air-freight firm with a wholly owned subsidiary in Hong Kong. The subsidiary, Jewel Hong Kong, has just completed a long-term planning report for the parent company in San Francisco, in which it has estimated the following expected earnings and payout rates for the years 2011–2014.

The current Hong Kong corporate tax rate on this category of income is 16.5%. Hong Kong imposes no withholding taxes on dividends remitted to U.S. investors (per the Hong Kong–United States bilateral tax treaty). The U.S. corporate income tax rate is 35%. The parent company wants to repatriate 75% of net income as dividends annually. a. Calculate the net income available for distribution by the Hong Kong subsidiary for the years 2011–2014. b. What is the amount of the dividend expected to be remitted to the U.S. parent each year? c. After gross-up for U.S. tax liability purposes, what is the total dividend after tax (all Hong Kong and U.S. taxes) expected each year? d. What is the effective tax rate on this foreign-sourced income per year?

Country Corporate income tax rate Dividend payout rate Withholding tax on dividends Jewel Hong Kong Income Items (millions US$) Earnings before interest and taxes (EBIT) Less interest expenses Earnings before taxes (EBT) Less Hong Kong corporate income taxes a. Net income Retained earnings Dividend remitted to U.S. parent United States Taxation: Grossup Gross dividend remitted Less withholding taxes b. Net dividend remitted Add back proportion of corp income tax Add back withholding taxes paid Grossed-up dividend for US tax purposes Theoretical U.S. tax liability Foreign tax credits (FTCs) Additional U.S. taxes due?

Excess foreign tax credits? c. Net dividend, after-tax

$ $ $ $

$

Hong Kong 16.5% 75.0% 0.0%

United States 35.0%

2011 8,000 (800) 7,200 (1,188) 6,012 1,503 4,509

2012 10,000 (1,000) 9,000 (1,485) 7,515 1,879 5,636

2013 12,000 (1,200) 10,800 (1,782) 9,018 2,255 6,764

2014 14,000 (1,400) 12,600 (2,079) 10,521 2,630 7,891

2011

2012

2013

2014

4,509 4,509 891 5,400 (1,890) (891) (999) 3,510

$ $ $ $

$

5,636 5,636 1,114 6,750 (2,363) (1,114) (1,249) 4,388

$ $ $ $

$

6,764 6,764 1,337 8,100 (2,835) (1,337) (1,499) 5,265

$ $ $ $

$

7,891 7,891 1,559 9,450 (3,308) (1,559) (1,748) 6,143

Total taxes paid on this income Income before tax

1,890 5,400

2,363 6,750

2,835 8,100

3,308 9,450

d. Effective tax rate (taxes paid/income before tax)

35.0%

35.0%

35.0%

35.0%

Problem 15.3 Kraftstoff of Germany Kraftstoff is a German-based company that manufactures electronic fuel-injection carburetor assemblies for several large automobile companies in Germany, including Mercedes, BMW, and Opel. The firm, like many firms in Germany today, is revising its financial policies in line with the increasing degree of disclosure required by firms if they wish to list their shares publicly in or out of Germany. The company’s earnings before tax (EBT) is €483,500,000.

Kraftstoff’s primary problem is that the German corporate income tax code applies a different income tax rate to income depending on whether it is retained (45%) or distributed to stockholders (30%).

a. If Kraftstoff planned to distribute 50% of its net income, what would be its total net income and total corporate tax bills? b. If Kraftstoff was attempting to choose between a 40% and 60% payout rate to stockholders, what arguments and values would management use in order to convince stockholders which of the two pay-outs is in everyone’s best interest?

Assumptions Dividend payout rate Corporate income tax rate, retained Corporate income tax rate, distributed Added tax for retained over distributed

Part a) 50.0% 45.0% 30.0% 15.0%

Part b) 40.0% 45.0% 30.0% 15.0%

Part b) 60.0% 45.0% 30.0% 15.0%

€ 483,500,000 (145,050,000) € 338,450,000

€ 483,500,000 (145,050,000) € 338,450,000

€ 483,500,000 (145,050,000) € 338,450,000

Distributed income Less any added corporate tax Distributed income after-tax

€ 169,225,000 € 169,225,000.0

€ 135,380,000 € 135,380,000.0

€ 203,070,000 € 203,070,000.0

Retained income Less added tax Retained income after-tax

€ 169,225,000 (25,383,750) € 143,841,250

€ 203,070,000 (30,460,500) € 172,609,500

€ 135,380,000 (20,307,000) € 115,073,000

Total net income, after-tax

€ 313,066,250

€ 307,989,500

€ 318,143,000

Total taxes paid

€ 170,433,750

€ 175,510,500

€ 165,357,000

Kraftstoff's Income Items (€) Earnings before taxes (EBT) Less corporate income taxes @ 30% Net income (preliminary)

If Kraftstoff's payout was 60%, it would reduce the total tax liability of shareholders and increase total net income after-tax.

Problem 15.4 Gamboa's Tax Averaging Gamboa, Incorporated is a relatively new U.S.-based retailer of specialty fruits and vegetables. The firm is vertically integrated with fruit and vegetable-sourcing subsidiaries in Central America and distribution outlets throughout the southeastern and northeastern regions of the United States. Gamboa's two Central American subsidiaries are in Belize and Costa Rica. Maria Gamboa, the daughter of the firm's founder, is being groomed to take over the firm's financial management in the near future. Like many firms of Gamboa's size, it has not possessed a very high degree of sophistication in financial management simply out of time Maria, however, has recently finished her MBA and is now attempting to put some specialized knowledge of U.S. taxation practices to work to save Gamboa money. Her first concern is tax averaging for foreign tax liabilities arising from the two Central American subsidiaries.

Costa Rican operations are slightly more profitable than Belize, which is particularly good since Costa Rica is a relatively low-tax country. Costa Rican corporate taxes are a flat 30%, and there are no withholding taxes imposed on dividends paid by foreign firms with operations there. Belize has a higher corporate income tax rate, 40%, and imposes a 10% withholding tax on all dividends distributed to foreign investors. The current U.S. corporate income tax rate is 35%. a. If Maria Gamboa assumes a 50% payout rate from each subsidiary, what are the additional taxes due on foreign-sourced income from Belize and Costa Rica individually? How much in additional U.S. taxes would be due if Maria averaged the tax credits/liabilities of the two units? b. With the same payout rate from the Belize subsidiary at 50%, how should Maria change the payout rate of the Costa Rican subsidiary in order to most efficiently manage her total foreign tax bill? c. What is the minimum effective tax rate which Maria can achieve on her foreign-sourced income?

Subsidiary Income Statement Earnings before taxes Less corporate income tax Net income Retained earnings Distributed earnings Less withholding taxes on dividends Net dividend remitted to U.S. parent

BELIZE $ 40%

$ 50.0% 10%

1,000,000 (400,000) 600,000 300,000 300,000 (30,000) 270,000

COSTA RICA $ 30%

$ 50.0% 0%

1,500,000 (450,000) 1,050,000 525,000 525,000 525,000

U.S. Tax Calculation (individually) Net dividend remitted Gross-up: Withholding taxes paid Foreign corporate income tax paid Grossed-up dividend Theoretical U.S. tax liability Foreign tax credits Additional US taxes due?

Excess foreign tax credits?

$

270,000

$

30,000 200,000 500,000 175,000 230,000

35%

$ $

55,000

$

525,000

$

225,000 750,000 262,500 225,000

35%

$ $

37,500 -

TAX AVERAGING (combined) Total additional U.S. taxes due after averaging Excess FTCs to carry forward/back?

Effective tax rate on foreign source income a. As seen above, with 50% payouts, after gross-up and tax averaging (cross-crediting), Maria owes no additional taxes to the U.S. tax authorities. She has a $17,500 tax credit to carry forward. The effective tax rate on foreign source income is then 36.4%. b. If Maria changes the payout rate for the Costa Rican subsidiary to 73.33% (found by trial and error), the cross-credits are equal on the U.S. parent company level and no additional U.S. taxes are due on the remittance and repatriation. The effective tax rate on foriegn source income is then 35% -- the statutory U.S. corporate income tax rate. c. The minimum Maria can reach on her foreign source income, assuming something is repatriated from abroad, is the U.S. corporate rate of 35%, like that achieved in part b.

firm is vertically integrated the southeastern and and Costa Rica. Maria gement in the near future. Like management simply out of time

ledge of U.S. taxation s arising from the two Central

ta Rica is a relatively low-tax dividends paid by foreign withholding tax on all

due on foreign-sourced f Maria averaged the tax

ut rate of the Costa Rican

Total Income

$

795,000

$

1,250,000

$ $

437,500 455,000

$ $

37,500 55,000

$ $

17,500 36.4%

no additional taxes to the U.S. e income is then 36.4%.

or), the cross-credits are equal tion. The effective tax rate on

om abroad, is the U.S.

Problem 15.5 Chinglish Dirk (A) Use the following company case to answer Problems 15.5 through 15.7. Chinglish Dirk Company (Hong Kong) exports razor blades to its wholly owned parent company, Torrington Edge (Great Britain). Hong Kong tax rates are 16%, and British tax rates are 30%. Chinglish calculates its profit per container as follows (all values in British pounds).

Corporate management of Torrington Edge is considering repositioning profits within the multinational company. What happens to the profits of Chinglish Dirk and Torrington Edge, and the consolidated results of both, if the markup at Chinglish was increased to 20% and the markup at Torrington was reduced to 10%? What is the impact of this repositioning on consolidated tax payments?

Baseline Analysis Assumptions Corporate income tax rate Desired markup on transfers Volume Constructing Transfer (Sales) Price Per Unit Direct costs Overhead Total costs Desired markup Transfer price (sales price) Income Statement (prices x volume) Sales price Less total costs Taxable income Less taxes Profit, after-tax

Hong Kong 16.0% 15.0% 1,000

Great Britain 30.0% 15.0%

Chinglish Dirk (British pounds) £10,000 4,000 £14,000 2,100 £16,100

Torrington Edge (British pounds) £16,100 1,000 £17,100 2,565 £19,665

£16,100,000 (14,000,000) £2,100,000 (336,000) £1,764,000

£19,665,000 (17,100,000) £2,565,000 (769,500) £1,795,500

Consolidated (British pounds)

£1,105,500 £3,559,500

Repositioned Profits Assumptions Corporate income tax rate Desired markup on transfers Volume Constructing Transfer (Sales) Price Per Unit Direct costs Overhead Total costs Desired markup Transfer price (sales price) Income Statement (prices x volume) Sales price Less total costs Taxable income Less taxes Profit, after-tax

Hong Kong 16.0% 20.0% 1,000

Great Britain 30.0% 10.0%

Chinglish Dirk (British pounds) £10,000 4,000 £14,000 2,800 £16,800

Torrington Edge (British pounds) £16,800 1,000 £17,800 1,780 £19,580

£16,800,000 (14,000,000) £2,800,000 (448,000) £2,352,000

£19,580,000 (17,800,000) £1,780,000 (534,000) £1,246,000

Consolidated (British pounds)

£982,000 £3,598,000

By increasing the markup in Hong Kong, the company has repositioned more of its profits in the lower tax environment, Hong Kong, where the tax rate is 16% compared to Great Britain's 30%. Note that the final sales price has actually fallen.

Consolidated profits, after-tax Consolidated tax payments

Baseline £3,559,500 £1,105,500

Repositioned £3,598,000 £982,000

Change 1.08% -11.17%

Problem 15.6 Chinglish Dirk (B) Encouraged by the results from the previous problem’s analysis, corporate management of Torrington Edge wishes to continue to reposition profit in Hong Kong. It is, however, facing two constraints. First , the final sales price in Great Britain must be £20,000 or less to remain competitive. Secondly, the British tax authorities -- in working with Torrington Edge’s cost accounting staff -- has established a maximum transfer price allowed (from Hong Kong) of £17,800. What combination of markups do you recommend for Torrington Edge to institute? What is the impact of this repositioning on consolidated profits on after-tax and total tax payments?

Baseline Analysis Assumptions Corporate income tax rate Desired markup on transfers Volume Constructing Transfer (Sales) Price Per Unit Direct costs Overhead Total costs Desired markup Transfer price (sales price) Income Statement (prices x volume) Sales price Less total costs Taxable income Less taxes Profit, after-tax

Hong Kong 16.0% 15.0% 1,000

Great Britain 30.0% 15.0%

Chinglish Dirk (British pounds) £10,000 4,000 £14,000 2,100 £16,100

Torrington Edge (British pounds) £16,100 1,000 £17,100 2,565 £19,665

£16,100,000 (14,000,000) £2,100,000 (336,000) £1,764,000

£19,665,000 (17,100,000) £2,565,000 (769,500) £1,795,500

Consolidated (British pounds)

£1,105,500 £3,559,500

Repositioned Profits Assumptions Corporate income tax rate Desired markup on transfers Volume

Hong Kong 16.0% 25.0% 1,000

Great Britain 30.0% 8.1%

Constructing Transfer (Sales) Price Per Unit Direct costs Overhead Total costs Desired markup Transfer price (sales price)

Chinglish Dirk (British pounds) £10,000.00 £4,000.00 £14,000.00 £3,500.00 £17,500.00

Torrington Edge (British pounds) £17,500.00 £1,000.00 £18,500.00 £1,498.50 £19,998.50

Income Statement (prices x volume) Sales price Less total costs Taxable income Less taxes Profit, after-tax

£17,500,000.00 -£14,000,000.00 £3,500,000.00 -£560,000.00 £2,940,000.00

£19,998,500.00 -£18,500,000.00 £1,498,500.00 -£449,550.00 £1,048,950.00

Consolidated (British pounds)

£1,009,550 £3,988,950

The company is working with two constraints. First, the final sales price by Torrington Edge needs to be 20,000 or less. Secondly, the British tax authorities have established a maximum transfer price on the blades at 17,800.

The optimal combination appears to be a 25.0% markup in Hong Kong, resulting in a transfer price of 17,500. This in turn allows Torrington Edge to impose an 8.1% markup on its sales and still stay under a sales price of 20,000.

Consolidated profits, after-tax Consolidated tax payments

Baseline £3,559,500 £1,105,500

Repositioned £3,988,950 £1,009,550

Change 12.06% -8.68%

Problem 15.7 Chinglish Dirk (C) Not to leave any potential tax repositioning opportunities unexplored, Torrington Edge wants to combine the components of Problem 15.6 with a redistribution of overhead costs. If overhead costs could be reallocated between the two units, but still total £5,000 per unit and maintain a minimum of £1,750 per unit in Hong Kong, what is the impact of this repositioning on consolidated profits after-tax and total tax payments?

Baseline Analysis Assumptions Corporate income tax rate Desired markup on transfers Volume Constructing Transfer (Sales) Price Per Unit Direct costs Overhead Total costs Desired markup Transfer price (sales price) Income Statement (prices x volume) Sales price Less total costs Taxable income Less taxes Profit, after-tax

Hong Kong 16.0% 15.0% 1,000

Great Britain 30.0% 15.0%

Chinglish Dirk (British pounds) £10,000 4,000 £14,000 2,100 £16,100

Torrington Edge (British pounds) £16,100 1,000 £17,100 2,565 £19,665

£16,100,000 (14,000,000) £2,100,000 (336,000) £1,764,000

£19,665,000 (17,100,000) £2,565,000 (769,500) £1,795,500

Consolidated (British pounds)

£1,105,500 £3,559,500

Repositioned Profits Assumptions Corporate income tax rate Desired markup on transfers Volume

Hong Kong 16.0% 35.0% 1,000

Great Britain 30.0% 4.64%

Constructing Transfer (Sales) Price Per Unit Direct costs Overhead Total costs Desired markup Transfer price (sales price)

Chinglish Dirk (British pounds) £10,000.00 £1,750.00 £11,750.00 £4,112.50 £15,862.50

Torrington Edge (British pounds) £15,862.50 £3,250.00 £19,112.50 £886.82 £19,999.32

(Still under 20,000)

Income Statement (prices x volume) Sales price Less total costs Taxable income Less taxes Profit, after-tax

£15,862,500.00 -£11,750,000.00 £4,112,500.00 -£658,000.00 £3,454,500.00

£19,999,320.00 -£19,112,500.00 £886,820.00 -£266,046.00 £620,774.00

£924,046 £4,075,274

Consolidated (British pounds) 5,000

By both increasing the markup in Hong Kong (and decreasing it in Great Britain) and reallocating overhead cost to Great Britain, Torrington's consolidated profits improve once again by positioning profits (losses) in the low-tax (high-tax) environments. Note that this is an extreme result. A 35% markup in Hong Kong with only a 4.64% markup in Great Britain would probably in the end raise the attention of the British tax authorities.

Consolidated profits, after-tax Consolidated tax payments

Baseline £3,559,500 £1,105,500

Repositioned £4,075,274 £924,046

Change 14.49% -16.41%

Problem 16.1 Nakatomi Toyota NakatomiToyota buys its cars from Toyota Motors-USA, and sells them to U.S. customers. One of its customers is EcoHire, a car rental firm which buys cars from Nakatomi Toyota at a wholesale price. Final payment is due to Nakatomi Toyota in 6 months. EcoHire has bought $200,000 worth of cars from Nakatomi, with a cash down payment of $40,000 and the balance due in 6 months without any interest charged as a sales incentive. Nakatomi Toyota will have the EcoHire receivable accepted by Alliance Acceptance for a 2% fee, and then sell it at a 3% per annum discount to Wells Fargo Bank.

a. What is the annualized percentage all-in-cost to Nakatomi Toyota? b. What are Nakatomi’s net cash proceeds, including the cash down payment?

Assumptions Face amount of sale (first payment of 5) Down payment, 20% of payment Period for financing, days Trade acceptance fee Discount rate on sale of acceptance, per annum

$ $

All-in-Cost of Trade Acceptance Face amount of sale Less cash down-payment Amount for financing Less trade acceptance fee (amount financed x acceptance fee x (days/360) ) Less discount for the period (amount financed x discount rate x (days/360)) Proceeds to Nakatomi Toyota

$ $

Values 200,000 40,000 180 2.000% 3.000%

200,000.00 (40,000.00) 160,000.00 (1,600.00)

$

a. Annualized percentage all-in-cost (AIC) (acceptance fee + discount) / (amount received) x (360/180)

(2,400.00) 156,000.00

5.128%

b. Net cash proceeds to Nakatomi Toyota Down payment Proceeds of acceptance Total cash proceeds

$ $

40,000 156,000.00 196,000.00

Problem 16.2 Motoguzzie (A) Motoguzzie exports large-engine motorcycles (greater than 700cc) to Australia and invoices its customers in U.S. dollars. Sydney Wholesale Imports has purchased $3,000,000 of merchandise from Motoguzzie, with payment due in 6 months. The payment will be made with a bankers’ acceptance issued by Charter Bank of Sydney at a fee of 1.75% per annum. Motoguzzie has a weighted average cost of capital of 10%. If Motoguzzie holds this acceptance to maturity, what is its annualized percentage all-in cost?

Assumptions Value of shipment Credit terms, days Bankers' acceptance fee Motoguzzie's WACC, per annum All-in-cost of Bankers' Acceptance Face amount of bankers' acceptance Less acceptance fee for 6-month maturity ( face amount x acceptance fee x (term/360)) Amount received by Indian Opportunity cost of capital @ Motoguzzie's WACC (amount received x WACC x 180/360) Annualized percentage all-in-cost (AIC) (acceptance fee +opportunity cost) / (amount received) x (360/180)

$

Values 3,000,000 180 1.750% 10.000%

$

3,000,000.00 (26,250.00)

$

2,973,750.00

$

148,687.50

11.765%

Problem 16.3 Motoguzzie (B) Assuming the facts in problem 3, Bank of America is now willing to buy Motoguzzie’s bankers’ acceptance for a discount of 6% per annum. What would be Motoguzzie’s annualized percentage all-in-cost of financing its $3,000,000 Australian receivable?

Assumptions Value of shipment Credit terms, days Bankers' acceptance fee Motoguzzie's WACC, per annum Discount rate on sale of acceptance, per annum All-in-Cost of Bankers' Acceptance Face amount of bankers' acceptance Less acceptance fee for 6-month maturity Less discount on sale of acceptance Amount received by Motoguzzie Annualized percentage all-in-cost (AIC) (acceptance fee + discount) / (amount received) x (360/180)

$

$

$

Values 3,000,000 180 1.750% 10.000% 6.000%

3,000,000.00 (26,250.00) (90,000.00) 2,883,750.00 8.062%

Problem 16.4 San Mateo Servers (A) San Mateo Servers (U.S.) has sold Internet servers to Telecom España for EUR700,000. Payment is due in three months and will be made with a trade acceptance from Telecom España Acceptance.

The acceptance fee is 1.0% per annum of the face amount of the note. This acceptance will be sold at a 4% per annum discount. What is the annualized percentage all-in cost in euros of this method of trade financing?

Assumptions Face amount of sale Maturity, days Trade acceptance fee, per annum Discount rate on sale of acceptance, per annum All-in-Cost of Trade Acceptance Face amount of the receivable Less trade acceptance fee (amount financed x acceptance fee x (days/360) ) Less discount on the sale of acceptance (amount financed x discount rate x (days/360)) Net proceeds Annualized percentage all-in-cost (AIC) (acceptance fee + discount) / (amount received) x (360/180)

Values EUR 700,000 90 1.000% 4.000%

EUR 700,000 (1,750) (7,000) EUR 691,250 5.063%

Problem 16.5 San Mateo Servers (B) Assume that San Mateo Servers prefers to receive U.S. dollars rather than euros for the trade transaction described in Problem 16.4. It is considering two alternatives: (1) sell the acceptance for euros at once and convert the euros immediately to U.S. dollars at the spot rate of exchange of USD1.00 = EUR1.00 or (2) hold the euro acceptance until maturity but at the start sell the expected euro proceeds forward for dollars at the 3-month forward rate of USD1.02 = EUR1.00. a. What are the U.S. dollar net proceeds received at once from the discounted trade acceptance in alternative 1? b. What are the U.S. dollar net proceeds received in three months in alternative 2? c. What is the break-even investment rate that would equalize the net U.S. dollar proceeds from both alternatives? d. Which alternative should San Mateo choose?

Assumptions Face amount of sale Maturity, days Spot exchange rate, USD=EUR1.00 Forward exchange rate, 3-months, USD=EUR1.00 Trade acceptance fee, per annum Discount rate on sale of acceptance, per annum

Values EUR 700,000 90 1.00 1.02 1.000% 4.000%

a. What are the US dollar proceeds received at once?

Face amount of the receivable Less trade acceptance fee Discount on sale of acceptance Euro proceeds Spot exchange rate, USD=EUR1.00 US dollar proceeds, now

EUR 700,000 (1,750) (7,000) EUR 691,250 1.00 USD 691,250

b. What are the dollar proceeds received in 3 months under alternative 2?

Face amount of the receivable Less trade acceptance fee (face amount x acceptance fee x (days/360) ) Euro net proceeds 3-month forward exchange rate, USD=EUR1.00 US dollar net proceeds received in 3-months

EUR 698,250 1.02 USD 712,215

c. Breakeven reinvestment rate US dollars received now, part a) US dollars received at end of 90 days, part b) Breakeven reinvestment rate of USD now to equal USD in 3 months (per annum)

USD 691,250 USD 712,215 12.132%

EUR 700,000 (1,750)

d. Which alternative should San Mateo choose?

If San Mateo's opportunity cost of capital is 8%, it should be indifferent financially between the two alternatives. However, selling the acceptance at once, alternative 1, improves San Mateo's liquidity and removes the debt that otherwise would be financing the acceptance from it's balance sheet.

Problem 16.6 Forfaiting at Umaru Oil (Nigeria) Umaru Oil of Nigeria has purchased $1,000,000 of oil drilling equipment from Gunslinger Drilling of Houston, Texas. Umaru Oil must pay for this purchase over the next five years at a rate of $200,000 per year due on March 1 of each year.

Bank of Zurich, a Swiss forfaiter, has agreed to buy the five notes of $200,000 each at a discount. The discount rate would be approximately 8% per annum based on the expected 3-year LIBOR rate plus 200 basis points, paid by Umaru Oil. Bank of Zurich also would charge Umaru Oil an additional commitment fee of 2% per annum from the date of its commitment to finance until receipt of the actual discounted notes issued in accordance with the financing contract. The $200,000 promissory notes will come due on March 1 in successive years.

The promissory notes issued by Umaru Oil will be endorsed by their bank, Lagos City Bank, for a 1% fee and delivered to Gunslinger Drilling. At this point, Gunslinger Drilling will endorse the notes without recourse and discount them with the forfaiter, Bank of Zurich, receiving the full $200,000 principal amount. Bank of Zurich will sell the notes by re-discounting them to investors in the international money market without recourse. At maturity, the investors holding the notes will present them for collection at Lagos City Bank. If Lagos City Bank defaults on payment, the investors will collect on the notes from Bank of Zurich. a. What is the annualized percentage all-in cost to Umaru Oil of financing the first $200,000 note due March 1, 2011? b. What might motivate Umaru Oil to use this relatively expensive alternative for financing?

Assumptions Face amount of the note due March 1, 2011 issued by Kaduna 3-year LIBOR rate, per annum Basis point spread, per annum Total discount rate, per annum Bank of Zurich commitment fee, per annum Lagos City Bank endorsement fee, per annum

What is the all-in-cost of forfaiting?

Face amount of note Less Lagos City bank endorsement fee Less Bank of Zurich commitment fee for one year Less discount on note at LIBOR plus spread Net proceeds

$

$

$

Annualized all-in-cost of forfaiting ( total interest and fee costs / face amount of note ) Umaru Oil would probably be motivated to use a forfaiter because its credit worth is too low to qualify for more normal financing. Note that the 11% annual costs are paid by Umaru Oil itself -- the importer, rather than by Gunslinger Drilling, the exporter.

Values 200,000 6.000% 2.000% 8.000% 2.000% 1.000%

200,000 (2,000) (4,000) (16,000) 178,000 11.000%

Problem 16.7 Sunny Coast Enterprises (A) Sunny Coast Enterprises has sold a combination of films and DVDs to Hong Kong Media Incorporated for US$100,000, with payment due in 6 months. Sunny Coast Enterprises has the following alternatives for financing this receivable: 1) Use its bank credit line. Interest would be at the prime rate of 5% plus 150 basis points per annum. Sunny Coast Enterprises would need to maintain a compensating balance of 20% of the loan’s face amount. No interest will be paid on the compensating balance by the bank; or 2) Use its bank credit line but purchase export credit insurance for a 1% fee. Because of the reduced risk, the bank interest rate would be reduced to 5% per annum without any points. a. What are the annualized percentage all-in-costs of each alternative? b. What are the advantages and disadvantages of each alternative? c. Which alternative would you recommend?

Assumptions Face amount of receivable Maturity, days Bank prime rate Spread over prime rate on credit line Bank interest (prime + spread), per annum Compensating balance requirement for bank credit line Export credit insurance fee Alternative 1: Bank Credit Line Face amount of receivable Less bank interest expense on receivable Less compensating balance requirement Net proceeds

$

$

$

Annualized all-in-cost of alternative 1

Alternative 2: Bank Credit Line + Export Credit Insurance Face amount of receivable Less credit insurance fee Less bank interest expense on receivable Less compensating balance requirement Net proceeds Annualized all-in-cost of alternative 2 Note: The reason the compensating balance is deducted from net proceeds is that Sunny Coast Enterprises does not get that cash and does not earn interest on it.

Values 100,000 180 5.000% 1.500% 6.500% 20.000% 1.000%

100,000 (3,250) (20,000) 76,750 8.469%

$

$

100,000 (1,000) (2,500) (20,000) 76,500 9.150%

Problem 16.8 Sunny Coast Enterprises (B) Sunny Coast Enterprises has been approached by a factor that offers to purchase the Hong Kong Media Imports receivable at a 16% per annum discount plus a 2% charge for a non-recourse clause. a. What is the annualized percentage all-in-cost of this factoring alternative? b. What are the advantages and disadvantages of the factoring alternative compared to the alternatives in Sunny Coast Enterprises (A)?

Assumptions Face amount of receivable ($) Maturity, days Factor discount rate, percent per annum Charge for non-recourse clause: "factor fee"

Values 100,000 180 16.000% 2.000%

a. What is the annualized all-in-cost of factoring?

Face amount of receivable ($) Less cost of factoring, discount rate Less non-recourse clause Net proceeds from factoring ($)

100,000 (8,000) (2,000) 90,000

Annualized all-in-cost of factoring

22.222%

Although the costs of factoring are clearly higher than using bank credit lines, factoring removes the receivable from the balance sheet, both as an asset and the associated debt to finance it using the bank credit line. Factoring also provides the cash at the start of the time period compared to waiting 6 months later under the bank credit line.

Problem 16.9 United Sports (A) United Sports (United) is considering bidding to sell $100,000 of ski equipment to Phang Family Enterprises of Seoul, Korea. Payment would be due in 6 months. Since United cannot find good credit information on Phang, United wants to protect its credit risk. It is considering the following financing solution.

Phang’s bank issues a letter of credit on behalf of Phang and agrees to accept BlackComb’s draft for $100,000 due in six months. The acceptance fee would cost BlackComb $500, plus reduce Phang’s available credit line by $100,000. The bankers’ acceptance note of $100,000 would be sold at a 2% per annum discount in the money market. What is the annualized percentage all-in cost to BlackComb of this bankers’ acceptance financing?

Assumptions Principal of note Maturity of note, days Acceptance fee to be paid by BlackComb Discount on sale of note, per annum Reduction in Phang's available credit-line All-in-cost to BlackComb: Face amount of note Less acceptance fee Less interest Net proceeds Annualized all-in-cost of factoring ( total interest and fee costs / net proceeds ) x (360/maturity)

$ $ $

$

$

Values 100,000 180 500 2.000% 100,000

100,000 (500) (1,000) 98,500 3.046%

Problem 16.10 United Sports (B) United could also buy export credit insurance from FCIA for a 1.5% premium. It finances the $100,000 receivable from Phang from its credit line at 6% per annum interest. No compensating bank balance would be required. a. What is United’s annualized percentage all-in-cost of financing? b. What are Phang’s costs? c. What are the advantages and disadvantages of this alternative compared to the bankers’ acceptance financing in United (A)? Which alternative would you recommend?

Assumptions Principal of note Maturity of note, days Acceptance fee to be paid by BlackComb FCIA export credit insurance fee Interest on credit line, per annum

a. All-in-cost to BlackComb: Face amount Less credit insurance fee Less interest on credit line Net proceeds Annualized all-in-cost of factoring ( total interest and fee costs / net proceeds ) x (360/term of note)

$ $

$

$

Values 100,000 180 500 1.500% 6.000%

Values 100,000 (1,500) (3,000) 95,500 9.424%

b. What is the cost to Phang?

Phang has no costs under this alternative, and it preserves its credit line. c. What are the advanatges and disadvantages of this alternative?

The cost of using its credit line would cost BlackComb 9.42% compared to only 3.05% with the bankers' acceptance. However, Phang would avoid the $500 cost of getting a letter of credit and reducing its available credit line. It could be that the sale of ski equipment itself could be jeopardized if Phang really needs the lost availabilty of its credit line. It might be possible for BlackComb to increase its bid to reflect some or all of the financing cost difference.

Problem 16.11 Inca Breweries of Peru Inca Breweries of Lima, Peru, has received an order for 10,000 cartons of beer from Alicante Importers of Alicante, Spain. The beer will be exported to Spain under the terms of a letter of credit issued by a Madrid bank on behalf of Alicante Importers. The letter of credit specifies that the face value of the shipment, $720,000, will be paid 90 days later after the Madrid bank accepts a draft drawn by Inca Breweries in accordance with the terms of the letter of credit.

The current discount rate on 3-month banker's acceptances is 8% per annum, and Inca Breweries estimates its weighted average cost of capital to be 20% per annum. The commission for selling a banker's acceptance in the discount market is 1.2% of the face amount. a. What is the difference, in present value terms, between holding the acceptance to maturity versus selling the banker's acceptance today in the money market? b. What would you recommend Inca Breweries do?

Assumptions Invoice Inca Breweries WACC (per annum) Invoice payable in full (total days) Banker's acceptance discount rate (per annum) Commission for sale of bankers acceptance

$

Alternative 1

Values 720,000 20.00% 90 8.00% 1.20% Values

If Inca Breweries holds the draft for 90 days after the bank accepts it, Inca Breweries will receive the face amount of $720,000. The present value of $720,000 received 90 days hence, discounted at Inca's WACC of 20% per Face amount of invoice Discount rate at WACC for 90 days of a 360 day year Present value of invoice (PV = Face amount x Discount rate)

$ $

Alternative 2

720,000.00 0.9524 685,714.29 Values

Inca Breweries can sell the banker's acceptance in today's money market at an 8% per annum discount: Face amount of invoice Less commission (Commission rate x Face amount) Less banker's acceptance discount rate for period (90 days) Amount received now

$

$

720,000.00 (8,640.00) (14,400.00) 696,960.00

a. Difference between alternatives

$

(11,245.71)

b. Analysis The amount of cash received today (i.e., $696,960) is greater than the present value of the full $720,000 (i.e., $685,714.29) discounted at Inca's WACC. Inca should sell the acceptance in today's banker's acceptance market and take the cash at once.

Problem 16.12 Sézane Footware (A) Sézane of Paris, has received an order for 50,000 cartons of athletic shoes from Southampton Footware, Ltd., of England, payment to be in British pounds sterling. The shoes will be shipped to Southampton Footware under the terms of a letter of credit issued by a London bank on behalf of Southampton Footware. The letter of credit specifies that the face value of the shipment, £400,000, will be paid 120 days after the London bank accepts a draft drawn by Southampton Footware in accordance with the terms of the letter of credit.

The current discount rate in London on 120-day bankers' acceptances is 12% per annum, and Southhampton Footware estimates its weighted average cost of capital to be 18% per annum. The commission for selling a banker's acceptance in the discount market is 2.0% of the face amount. a. Would Sezane gain by holding the acceptance to maturity, as compared to discounting the bankers' acceptance at once? b. Does Sezane incur any other risks in this transaction?

Assumptions Face value of the shipment Sezane WACC (per annum) Letter of credit specification on payment after acceptance (days) Banker's acceptance discount rate, 120-day maturity (per annum) Commission for sale of bankers acceptance Alternative 1

Values £400,000.00 18.00% 120 12.00% 2.00% Values

If Southampton Footware holds the draft for 120 days after the bank has accepted it, Sezane will receive the face amount of £400,000. The present value of £400,000 received 120 days hence, discounted at Sezane's WACC of 18% per annum (6% for 120 days) is £377,358.49.

Face amount of invoice Discount rate at WACC for 120 days of a 360 day year Present value of invoice (PV = Face amount x Discount rate) Alternative 2

£400,000.00 0.9434 £377,358.49 Values

Sezane can sell the banker's acceptance in today's London money market at a 12% per annum discount: Face amount of invoice Less commission (Commission rate x Face amount) Less banker's acceptance discount rate for period (90 days) Amount received now Difference between alternatives

£400,000.00 (8,000.00) (16,000.00) £376,000.00 £1,358.49

Analysis Point 1. Sezane's gain should be calculated in present value terms. Sezane will receive £376,000 today by discounting the banker's acceptance. The present value of the £400,000 to be received in 120 days, discounted at Sezane's WACC of 18%, is £377,358.49. The difference is £1,358.49. Sezane would gain, in terms of present value cash, £1,358.49 by waiting 120 days to receive the face amount of the acceptance.

Point 2. In this transaction Sezane has assumed the foreign exchange transaction risk; that is, the risk that the pounds sterling to be received from the export will be worth fewer dollars when received. In part this risk is a function of the time that Sezane must wait to exchange the pounds sterling for dollars. If Sezane discounts the banker's acceptance at the time of sale, it receives dollars at once at the exchange rate then in effect. If Sezane waits 120 days to receive the pounds sterling, Sezane assumes the added risk that the exchange rate will deteriorate between the time of sale and the time of collection. (Of course, Sezane might gain if the pound would buy more, rather than less, dollars in 120 days.)

Problem 16.13 Sézane Footware (B) Assume that Great Britain charges a duty of 10% on shoes imported into the United Kingdom. Sezane, in Problem 16.12, discovers that it can manufacture shoes in Northern Ireland and import them into Britain free of any import duty. What factors should Sezane consider in deciding to continue to export shoes from France versus manufacture them in Northern Ireland?

If Sezane shifts manufacturing to Northern Ireland from France, it avoids the 10% import duty and the discount on such banker's acceptances as it now might be incurring. Alternatively, Sezane would avoid waiting 120 days for its cash and undertaking the associated translation risk. Note that the solution to Problem 16.12, in which Sezane found it advantageous to wait 120 days for the cash is unique to that moment in time. A week or a month later discount rates might change and the alternative would then be preferable.

If Sezane decides to open a plant and manufacture in Northern Ireland, the following factors must be considered: 1. Corporate income tax rates in Northern Ireland and France.

2. Present and possible future changes in shipping costs. (If Sezane had been using air freight before a major spike in oil and fuel prices, it might encounter a sharp rise in air freight rates afterward. Price or costs spikes, even terrorist events, cannot be easily predicted, but success of a foreign manufacturing venture versus exporting must consider the possibility of any kind of unpredictable structural changes.)

3. Expected production volume in Northern Ireland relative to the designed manufacturing capacity of the new factory there. The cost of manufacturing shoes in Northern Ireland will depend both on the volume for which that plant is designed and the percent of capacity expected to be used in the near future.

4. The cost of labor and material in Northern Ireland versus France and the availability and level of education of potential workers.

5. The existence, or nonexistence, of excess capacity in the France factory, both at present and in terms of expected future growth.

6. The risk of additional taxes and fees due to the United Kingdom leaving the European Union after Brexit.

7. The risk of a trade war between the United Kingdom and the European Union due to unilateral changes of rules and regulations agreed from the Brexit deal.

Such a list as above cannot possibly identify all the subjective factors that might go into a decision to invest rather than export, but it provides a starting point for consideration of the global strategy of a firm.

Mini-Case: Crosswell International's Precious Ultra-Thin Diapers Price / case Cases per container Export to Brazil Costs & Pricing FOB price per case (US$) Freight, loading, & documentation CFR price

Calculation

4180

$4180 per container

% of CFR

$

34.00 4.32 38.32 0.86 39.18

2.250%

$

Exchange rate (R$=US$1.00) CIF price/case to distributor (R$)

2.50 R$97.95

2.50

Brazilian Importation Costs Import duties (ID) Merchant marine renovation fee (MMRF) Port storage Port handling fees Additional handling tax Customs brokerage fees Import license Local transportation Total cost to distributor (R$)

1.96 2.70 1.27 0.01 0.26 1.96 0.05 1.47 R$107.63

2.000% 25.00% 1.300% 14.00 20.000% 2.000% 50.00 1.500%

% of CIF % of freight % of CIF R$12 per container % of storage & handling % of CIF R$50 per container % of CIF

Distributor's Costs & Pricing Storage cost Cost of financing diaper inventory Distributor's margin Price to retailer (R$)

1.47 6.86 23.19 139.15

1.500% 7.000% 20.000%

% of CIF * months % of CIF * months % of Price + storage + cc

Brazilian Retailer Costs & Pricing Industrial product tax (IPT-2) Tax on merc circulation services (ICMS-2) Retailer costs and markup Price per case to consumer (R$)

20.87 28.80 56.65 245.48

15.000% 18.000% 30.000%

% of price to retailer % of price + IPT2 % of price + IPT2 + ICMS2

Bags of 8 per case

Diapers per case

Price to Consumer (R$/diaper)

44 32 24 22

352 256 192 176

R$0.70 R$0.96 R$1.28 R$1.39

Export insurance CIF/case to distributor (US$)

DIAPER PRICES

Small Medium Large Extra Large

$

Rate 968

Problem 18.1 Finisterra, S.A. Finisterra, S.A., located in the state of Baja California, Mexico, manufactures frozen Mexican food, which enjoys a large following in the U.S. states of California and Arizona to the north. In order to be closer to its U.S. market, Finisterra is considering moving some of its manufacturing operations to southern California. Operations in California would begin in year 1 and have the following attributes.

The operations in California will pay 80% of its accounting profit to Finisterra as an annual cash dividend. Mexican taxes are calculated on grossed up dividends from foreign countries, with a credit for host country taxes already paid. What is the maximum U.S. dollar price Finisterra should offer in year 1 for the investment?

Assumptions Sales price per unit, Year 1 (US$) Sales price increase, per year Initial sales volume, Year 1, units Sales volume increase, per year Production costs per unit, Year 1 Production cost per unit increase, per year General and administrative expenses per year Depreciation expenses per year Spot exchange rate, Peso=$1.00: Finisterra's WACC (pesos) Terminal value discount rate

$

$ $ $

Capital Budgeting Analysis Sales price, US$ Sales volume Revenue

Value 5.00 3.00% 1,000,000 10.00% 4.00 4.00% 100,000 80,000 Year 0: 8.00 16.00% 20.00%

Year 1: 9.00

Year 0 $ $

Costs per package Total costs Gross profit

$ $

Less general & administration expenses Less depreciation expenses Operating profit before tax Less U.S. corporate income taxes Net income Dividends distributed ($) (80% of net income) Exchange rate (Ps=$1.00)

Year 1 5.00 1,000,000 5,000,000 (4.00) (4,000,000) 1,000,000

Year 2: 10.00

$ $ $ $

(100,000) (80,000) $ $

820,000 (246,000) 574,000

$

459,200

30%

80%

8.00

Dividends remitted to parent (pesos) Additional taxes due in Mexico Dividend received, after-tax (pesos)

Year 2 5.15 1,100,000 5,665,000 (4.16) (4,576,000) 1,089,000

$ $ $ $

(100,000) (80,000) $

Year 3 5.30 1,210,000 6,418,445 (4.33) (5,234,944) 1,183,501 (100,000) (80,000)

$

909,000 (272,700) 636,300

$

1,003,501 (301,050) 702,451

$

509,040

$

561,961

$

9.00

10.00

11.00

4,132,800 0 4,132,800

5,090,400 0 5,090,400

6,181,566 0 6,181,566

Terminal value, US$ (discounted @ 20%) (dividend in Year 3/.20) Terminal value, pesos

$

2,809,803 30,907,831

Total cash flows for discounting (pesos) Present value factor (@ 16%) Present value of total cash flows (pesos) Cumulative present value (pesos) in U.S. dollars

Year 3: 11.00

1.0000

$

28,442,771 3,555,346

4,132,800 0.8333 3,444,000

5,090,400 0.6944 3,535,000

37,089,397 0.5787 21,463,771

Problem 18.2 Schism Systems Schism Systems Inc., manufactures design components for personal computers. Until the present, manufacturing has been subcontracted to other companies, but for reasons of quality control Schism has decided to manufacture itself in Asia. Analysis has narrowed the choice to two possibilities, Penang, Malaysia, and Manila, the Philippines. At the moment only the summary of expected, after-tax, cash flows displayed below is available. Although most operating outflows would be in Malaysian ringgit or Philippine pesos, some additional U.S. dollar cash outflows (expenses) would be necessary, also shown in the table. The Malaysia ringgit currently trades at MYR4.20 = USD1.00 and the Philippine peso trades at PHP50.00 = USD1.00. Schism expects the Malaysian ringgit to appreciate 2.0% per year against the dollar, and the Philippine peso to depreciate 5.0% per year against the dollar. If the weighted average cost of capital for Schism Systems is 14.0%, which project looks most promising on the basis of present value?

Assumptions Current spot rate (MYR=USD1.00) Current spot rate (PHP=USD) Malaysian ringgit expectation (% change) Phillippine peso expectation (% change) WACC for Schism Systems

Values MYR 4.20 PHP 50.00 2.000% -5.000% 14.000% 0 2022 (MYR 26,000)

1 2023 MYR 8,000

2 2024 MYR 6,800

3 2025 MYR 7,400

4 2026 MYR 9,200

5 2027 MYR 10,000

Expected exchange rate (MYR=USD)

MYR 4.20

MYR 4.12

MYR 4.04

MYR 3.96

MYR 3.88

MYR 3.80

Ringgit cash flows in dollars Dollar cash outflows Net total cash flows (USD)

(USD 6,190) (USD 6,190)

USD 1,943 (100) USD 1,843

USD 1,684 (120) USD 1,564

USD 1,870 (150) USD 1,720

USD 2,371 (150) USD 2,221

USD 2,629 USD 2,629

1.0000 (USD 6,190)

0.8772 USD 1,617

0.7695 USD 1,204

0.6750 USD 1,161

0.5921 USD 1,315

0.5194 USD 1,365

0 2012 (PHP 560,000)

1 2013 PHP 190,000

2 2014 PHP 180,000

3 2015 PHP 200,000

4 2016 PHP 210,000

5 2017 PHP 200,000

PHP 50.00

PHP 52.63

PHP 55.40

PHP 58.32

PHP 61.39

PHP 64.62

(USD 11,200) (USD 11,200)

USD 3,610 (100) USD 3,510

USD 3,249 (200) USD 3,049

USD 3,430 (300) USD 3,130

USD 3,421 (400) USD 3,021

USD 3,095 USD 3,095

1.0000 (USD 11,200)

0.8772 USD 3,079

0.7695 USD 2,346

0.6750 USD 2,112

0.5921 USD 1,789

0.5194 USD 1,608

Schism in Penang (after-tax) Net ringgit cash flows

Present value factor Present value of cash flow

14%

Present value (PV)

USD 471

Schism in Manila (after-tax) Net peso cashflows Expected exchange rate (PHP=USD) (spot / ( 1 - .05)) Net peso cashflows in dollars Dollar cash outflows Net total cash flows (USD) Present value factor Present value of cash flow Present value (PV)

14%

(USD 266)

Neither project looks very promising. Schism Penang does, however, possess a positive PV.

Problem 18.3 Grenouille Properties Grenouille Properties (U.S.) expects to receive cash dividends from a French joint venture over the coming three years. The first dividend, to be paid one year from now on December 31, is expected to be €720,000. The dividend is then expected to grow 10.0% per year over the following two years. The current exchange rate is $1.1940 = €1.00. Grenouille’s weighted average cost of capital is 12%. a. What is the present value of the expected euro dividend stream if the euro is expected to appreciate 4.00% per annum against the dollar? b. What is the present value of the expected dividend stream if the euro were to depreciate 3.00% per annum against the dollar?

Assumptions Cash dividends to be received (euros) Expected dividend growth rate per year Current spot exchange rate ($=€1.00) Grenouille's weighted average cost of capital

$

a. PV of dividend stream if euro appreciates 4% Dividend stream expected from investment, in euros Current and expected spot rate ($=€1.00) : spot x ( 1 + .04) Dividends, in U.S. dollars Present value factor Present value of dividends, in U.S. dollars Cumulative NPV

0

4.0%

$

1.1940

$ $

1.0000 $

1 € 720,000

2 € 792,000

3 € 871,200

1.2418 894,067 0.8929 798,274

$ 1.2914 $ 1,022,813 0.7972 $ 815,380

$ 1.3431 $ 1,170,098 0.7118 $ 832,853

1 € 720,000

2 € 792,000

3 € 871,200

$ 2,446,507

b. PV of dividend stream if euro depreciates 3% Dividend stream expected from investment, in euros Current and expected spot rate ($=€1.00) : spot x ( 1 - .03) Dividends, in U.S. dollars Present value factor Present value of dividends in U.S. dollars Cumulative NPV

Values € 720,000 10.0% 1.1940 12.0%

0

-3.0%

$

1.1940

$ $

1.0000 $ $ 2,129,601

1.1582 833,890 0.8929 744,544

$ $ $

1.1234 889,760 0.7972 709,311

$ $ $

1.0897 949,374 0.7118 675,746

Problem 18.4 Natural Mosaic Natural Mosaic Company (U.S.) is considering investing INR50,000,000 in India to create a wholly owned tile manufacturing plant to export to the European market. After five years the subsidiary would be sold to Indian investors for INR100,000,000. A pro forma income statement for the Indian operation predicts the generation of INR7,000,000 of annual cash flow, is listed below.

The initial investment will be made on December 31, 2021, and cash flows will occur on December 31st of each succeeding year. Annual cash dividends to Natural Mosaic Composite from India will equal 75% of accounting income. The U.S. corporate tax rate is 21% and the Indian corporate tax rate is 50%. Because the Indian tax rate is greater than the U.S. tax rate, annual dividends paid to Natural Mosaic will not be subject to additional taxes in the United States. There are no capital gains taxes on the final sale. Natural Mosaic uses a weighted average cost of capital of 14% on domestic investments, but will add 6 percentage points for the Indian investment because of perceived greater risk. Natural Mosaic forecasts the Indian rupee to U.S. dollar exchange rate for December 31st on the next six years are listed below.

What is the net present value and internal rate of return on this investment?

Assumptions Initial investment in India (INR)

Values INR 50,000,000 50.00% 100,000,000 14.00%

Indian corporate tax rate Sale price in year 5 (Rs) Natural Mosaic's WACC Pro forma income and cash flow (December 31st)

0 2021

Values 75.00% 21.00% 6.00%

US corporate tax rate India risk premium to WACC

1 2022 INR 30,000,000 (17,000,000) 13,000,000 (1,000,000) 12,000,000 (6,000,000) 6,000,000 1,000,000 INR 7,000,000

2 2023 INR 30,000,000 (17,000,000) 13,000,000 (1,000,000) 12,000,000 (6,000,000) 6,000,000 1,000,000 INR 7,000,000

3 2024 INR 30,000,000 (17,000,000) 13,000,000 (1,000,000) 12,000,000 (6,000,000) 6,000,000 1,000,000 INR 7,000,000

4 2025 INR 30,000,000 (17,000,000) 13,000,000 (1,000,000) 12,000,000 (6,000,000) 6,000,000 1,000,000 INR 7,000,000

5 2026 INR 30,000,000 (17,000,000) 13,000,000 (1,000,000) 12,000,000 (6,000,000) 6,000,000 1,000,000 INR 7,000,000

(50,000,000)

7,000,000

7,000,000

7,000,000

7,000,000

107,000,000

1.0000 (50,000,000)

0.8333 5,833,333

0.6944 4,861,111

0.5787 4,050,926

0.4823 3,375,772

0.4019 43,000,900

2022

2023

2024

2025

2026

INR 4,500,000

INR 4,500,000

INR 4,500,000

INR 4,500,000

INR 4,500,000

Sales revenue Less cash operating expenses Gross income Less depreciation expenses Earnings before interest and taxes Less Indian taxes

Net income Add back depreciation Annual cash flow Initial investment Terminal value, sales Cash flows for discounting Present value factor Present value of cash flow

Assumptions Dividend distribution per year

(50,000,000) 100,000,000 20%

NPV of India investment (project view) IRR of Indian investment (project view)

INR 11,122,042 25.96%

Cash inflows & outflows to US Initial investment (INR) Dividends received in the US (INR) Sales value (INR) Net cash flows to parent after-tax (INR)

2021 (INR 50,000,000)

(INR 50,000,000)

INR 4,500,000

INR 4,500,000

INR 4,500,000

INR 4,500,000

INR 104,500,000

Expected exchange rate (INR=USD1.00)

INR 76

INR 80

INR 84

INR 88

INR 92

INR 96

(USD 657,895) 1.0000 (USD 657,895)

USD 56,250 0.8333 USD 46,875

USD 53,571 0.6944 USD 37,202

USD 51,136 0.5787 USD 29,593

USD 48,913 0.4823 USD 23,588

USD 1,088,542 0.4019 USD 437,460

100,000,000

Net cash flows to parent after-tax (USD)

Present value factor Present value of cash flow NPV of cash flows (parent viewpoint) IRR of cash flows (parent viewpoint)

20%

(USD 83,176) 16.34%

Problem 18.5 Carambola de Honduras Slinger Wayne, a U.S.-based private equity firm, is trying to determine what it should pay for a tool manufacturing firm in Honduras named Carambola. Slinger Wayne estimates that Carambola will generate a free cash flow of 13 million Honduran lempiras (Lp) next year (2022) and that this free cash flow will continue to grow at a constant rate of 8.0% per annum indefinitely A private equity firm like Slinger Wayne, however, is not interested in owning a company for long, and plans to sell Carambola at the end of three years for approximately 10 times Carambola’s free cash flow in that year. The current spot exchange rate is Lp23.90 = $1.00, but the Honduran inflation rate is expected to remain at a relatively high rate of 16.0% per annum compared to the U.S. dollar inflation rate of only 2.0% per annum. Slinger Wayne expects to earn at least a 20% annual rate of return on international investments like Carambola. a. What is Carambola worth if the Honduran lempira were to remain fixed over the three-year investment period? b. What is Carambola worth if the Honduran lempira were to change in value over time according to purchasing power parity?

Assumptions Expected free cash flow in 2003 Expected growth rate in free cash flow Assumed sale multiple of FCF in year 3 Spot exchange rate, Lempiras/$ (2021) US dollar inflation rate Honduran lempira inflation rate Slinger Wayne required return (annual rate)

Values 13,000,000 8.00% 10 23.90 2.0% 16.0% 20.0% 0 2021

a. Carambola's value if exchange rate fixed Carambola's expected free cash flow (Lp) Expected sale value in year 3 Total expected free cash flow (Lp) Expected exchange rate (Lp=$1.00) Carambola's expected FCF in US$ Present value factor Present value of expected FCF in US$ Cumulative present value in US$

23.9000 $ 1.0000 $ $

Carambola's expected free cash flow (Lp) Expected sale value in year 3 Total expected free cash flow (Lp) Expected exchange rate (Lp=$1.00) (PPP: spot * (1+inf in Lp) / (1 + inf in $)

23.9000

Carambola's expected FCF in US$ Present value factor Present value of expected FCF in US$ Cumulative present value in US$

$ 1.0000 $ $

2 2023

3 2024

13,000,000

14,040,000

13,000,000

14,040,000

15,163,200 151,632,000 166,795,200

23.9000

23.9000

23.9000

543,933 0.8333 453,278

$ $

587,448 0.6944 407,950

$ $

6,978,879 0.5787 4,038,703

4,899,930 0 2012

b. Carambola's value assuming PPP

1 2022

3,459,790

1 2013

2 2014

3 2015

13,000,000

14,040,000

13,000,000

14,040,000

15,163,200 151,632,000 166,795,200

27.1804

30.9110

35.1537

478,286 0.8333 398,572

$ $

454,207 0.6944 315,421

$ $

4,744,738 0.5787 2,745,797

Problem 18.6 Wenceslas Refining Company Privately owned Wenceslas Refining Company is considering investing in the Czech Republic so as to have a refinery source closer to its European customers. The original investment in Czech korunas (CZK) would amount to CZK250 million, or USD11,627,907 at the current exchange rate of CZK21.50 = USD1.00, all in fixed assets, which will be depreciated over 10 years by the straight-line method. An additional CZK100,000,000 will be needed for working capital. Wenceslas does not believe it can forecast exchange rates so assumes they will remain fixed at the current spot rate over the entire period.

For capital budgeting purposes Wenceslas assumes sale as a going concern at the end of the third year at a price, after all taxes, equal to the net book value of fixed assets alone (not including working capital). All free cash flow, basically net income, will be repatriated to the United States as a dividend each year. In evaluating the venture, the U.S. dollar forecasts are shown in the table Variable manufacturing costs are expected to be 50% of sales. No additional funds need be invested in the U.S. subsidiary during the period under consideration. The Czech Republic imposes no restrictions on repatriation of any funds of any sort. The Czech corporate tax rate is 19% and the United States rate is 21%. Both countries allow a tax credit for taxes paid in other countries.

Wenceslas uses 12% as its weighted average cost of capital, and its objective is to maximize present value. Is the investment attractive to Wenceslas Refining?

Assumptions Original investment (Czech korunas, CZK) Spot exchange rate (CZK=USD1.00) Unit demand Unit sales price Fixed cash operating expenses Depreciation Investment in working capital (CZK)

0 CZK 250,000,000 CZK 21.50

1

2

3

CZK 21.50 700,000 USD 32.00 USD 1,000,000 USD 500,000

CZK 21.50 900,000 USD 33.00 USD 1,030,000 USD 500,000

CZK 21.50 1,000,000 USD 34.00 USD 1,060,000 USD 500,000

Project Viewpoint (in USD) Initial investment Revenues Less costs of manufacturing Gross profit Less fixed cash operating expenses Less depreciation Earnings before taxes Less Czech corporate income taxes Net income

0 (USD 11,627,907)

1

2

3

USD 22,400,000 (11,200,000) USD 11,200,000 (1,000,000) (1,162,791) USD 9,037,209 (1,717,070) USD 7,320,140

USD 29,700,000 (14,850,000) USD 14,850,000 (1,030,000) (1,162,791) USD 12,657,209 (2,404,870) USD 10,252,340

USD 34,000,000 (17,000,000) USD 17,000,000 (1,060,000) (1,162,791) USD 14,777,209 (2,807,670) USD 11,969,540

USD 1,162,791

USD 1,162,791

USD 1,162,791

(USD 16,279,070)

USD 8,482,930

USD 11,415,130

12,790,698 USD 25,923,028

1.0000 (USD 16,279,070) USD 18,846,546

0.8929 USD 7,574,045

0.7972 USD 9,100,072

0.7118 USD 18,451,499

0

1

2

3

Dividends remitted to US parent Add back Czech taxes deemed paid Grossed up dividend

USD 7,320,140 1,717,070 USD 9,037,209

USD 10,252,340 2,404,870 USD 12,657,209

USD 11,969,540 2,807,670 USD 14,777,209

Tentative US tax liability 21% Less credit for Czech taxes paid Additional US taxes due on foreign income

(USD 1,897,814) 1,717,070 (USD 180,744)

(USD 2,658,014) 2,404,870 (USD 253,144)

(USD 3,103,214) 2,807,670 (USD 295,544)

USD 7,500,884

USD 10,505,484

USD 12,265,084

(USD 16,279,070)

USD 7,500,884

USD 10,505,484

12,790,698 USD 25,055,781

1.0000 (USD 16,279,070) USD 16,627,265

0.8929 USD 6,697,218

0.7972 USD 8,374,907

0.7118 USD 17,834,210

CZK 100,000,000

50%

### 19%

Add back depreciation Less additional working capital investment Plus sale value at end of 3 years Free cash flow for discounting Present value factor Present value of cash flows Cumulative NPV

(USD 4,651,163)

12%

Parent Viewpoint (USD)

Cash dividend less added US taxes Initial investment & working capital Plus sale value at end of 3 years Parent cash flows (US$) Present value factor Present value of cash flow Cumulative NPV

(USD 16,279,070)

12%

Problem 18.7 Hermosa Components: Baseline Analysis Hermosa Beach Components, Inc., of California exports 24,000 sets of low-density light bulbs per year to Argentina under an import license that expires in five years.

In Argentina, the bulbs are sold for the Argentine peso equivalent of $60 per set. Direct manufacturing costs in the United States and shipping together amount to $40 per set. The market for this type of bulb in Argentina is stable, neither growing nor shrinking, and Hermosa holds the major portion of the market.

The Argentine government has invited Hermosa to open a manufacturing plant so imported bulbs can be replaced by local production. If Hermosa makes the investment, it will operate the plant for five years and then sell the building and equipment to Argentine investors at net book value at the time of sale plus the value of any net working capital. (Net working capital is the amount of current assets less any portion financed by local debt.) Hermosa will be allowed to repatriate all net income and depreciation funds to the United States each year. Hermosa traditionally evaluates all foreign investments in U.S. dollar terms.

Evaluate the proposed investment in Argentina by Hermosa Components (U.S.). Hermosa’s management wishes the baseline analysis to be performed in U.S. dollars (and implicitly also assumes the exchange rate remains fixed throughout the life of the project). Create a project viewpoint capital budget and a parent viewpoint capital budget. What do you conclude from your analysis?

Assumptions Light bulb export volume to Argentina, per year Sales price per set in Argentina Material costs per set in Argentina Material and shipping costs of imports per set Direct & indirect cost per set Depreciable investment (buildings & equipment) Initial investment in net working capital Discount rate in Argentina

$ $ $ $ $ $

Value 24,000 60.00 20.00 10.00 5.00 1,000,000 1,000,000 15.00%

Growth 0.00% 0.00% 0.00% 0.00% 0.00%

The capital budgeting analysis needs to be performed on both the Project Level (Project Viewpoint) and the Parent Level (Parent Viewpoint).

Year

0

Project Cash Flows in Argentina: Project Viewpoint Annual units sold (sets) Sales price in Argentina per set

1

$

Sales revenue Less direct manufacturing and shipping costs Less cost of US components @ $10/set Gross profit Less depreciation Pre-tax profit Less Argentine corporate taxes Net income Add back depreciation Annual project cash flow Return of net working capital Initial investment, total Free cash flow for discounting

$

(2,000,000) (2,000,000)

Internal rate of return (IRR) Net present value (NPV)

$

22.3% 422,655

28%

24,000 60.00

2

$

24,000 60.00

3

$

24,000 60.00

4

$

24,000 60.00

5

$

24,000 60.00

$ 1,440,000 (480,000) (240,000) 720,000 (200,000) 520,000 (145,600) 374,400 200,000 574,400

$ 1,440,000 (480,000) (240,000) 720,000 (200,000) 520,000 (145,600) 374,400 200,000 574,400

$ 1,440,000 (480,000) (240,000) 720,000 (200,000) 520,000 (145,600) 374,400 200,000 574,400

$ 1,440,000 (480,000) (240,000) 720,000 (200,000) 520,000 (145,600) 374,400 200,000 574,400

$ 1,440,000 (480,000) (240,000) 720,000 (200,000) 520,000 (145,600) 374,400 200,000 574,400 1,000,000

$

$

$

$

574,400

$ 1,574,400

$

$

240,000 (120,000) 120,000 (33,600) 86,400

$

574,400

$

(480,000) 192,000 (288,000)

574,400

574,400

574,400

The Parent Viewpoint needs to consider all incremental cash flow impacts including loss on export sales to Argentina (current practice).

Cash Flows to Hermosa in US: Parent Viewpoint Sales revenue on exports to Argentina Less direct and indirect costs on exported sets Profit on Hermosa's component sales Less US taxes on component profits a) Net profit on component sales after-tax

$

$

240,000 (120,000) 120,000 (33,600) 86,400

$

574,400

$

(480,000) 192,000 (288,000)

$ 28%

b) Cash flow from Argentina to Hermosa (US$) Cash flow loss on Hermosa's loss of exports Less US taxes on export losses c) Net cash flow reduction after-tax

40%

$

$

240,000 (120,000) 120,000 (33,600) 86,400

$

574,400

$

(480,000) 192,000 (288,000)

$

$

$

240,000 (120,000) 120,000 (33,600) 86,400

$

240,000 (120,000) 120,000 (33,600) 86,400

$

574,400

$

574,400

$

(480,000) 192,000 (288,000)

$

(480,000) 192,000 (288,000)

$

$ $

d) Recapture of NWC in Argentina (no tax)

$

$ 1,000,000

Total parent cash flow, after-tax (a+b+c+d) Initial investment Free cash flow to parent for discounting

$

(2,000,000) (2,000,000)

372,800

Internal rate of return (IRR) Net present value (NPV)

$

10.5% (253,140)

$

372,800

372,800 $

372,800

372,800 $

372,800

$

372,800

1,372,800

372,800

$ 1,372,800

Although the investment has a positive NPV on the project level, the prospective investment from the parent's viewpoint is negative. The project should be rejected.

Problem 18.8 Hermosa Components: Revenue Growth Scenario As a result of their analysis in Problem 18.7, Hermosa wishes to explore the implications of being able to grow sales volume by 4% per year. Argentine inflation is expected to average 5% per year, so sales price and material cost increases of 7% and 6% per year, respectively, are thought reasonable. Although material costs in Argentina are expected to rise, U.S.-based costs are not expected to change over the five-year period. Evaluate this scenario for both the project and parent viewpoints. Is the project under this revenue growth scenario acceptable?

Assumptions Light bulb export volume to Argentina, per year Sales price per set in Argentina Material costs per set in Argentina Material and shipping costs of imports per set Direct & indirect cost per set Depreciable investment (buildings & equipment) Initial investment in net working capital Discount rate in Argentina

$ $ $ $ $ $

Value 24,000 60.00 20.00 10.00 5.00 1,000,000 1,000,000 15.00%

Growth 4.00% 7.00% 6.00% 0.00% 0.00%

The capital budgeting analysis needs to be performed on both the Project Level (Project Viewpoint) and the Parent Level (Parent Viewpoint).

Year

0

Project Cash Flows in Argentina: Project Viewpoint Annual units sold (sets) Sales price in Argentina per set

1

$

Sales revenue Less direct manufacturing and shipping costs Less cost of US components @ $10/set Gross profit Less depreciation Pre-tax profit Less Argentine corporate taxes Net income Add back depreciation Annual project cash flow Return of net working capital Initial investment, total Free cash flow for discounting

$

(2,000,000) (2,000,000)

Internal rate of return (IRR) Net present value (NPV)

$

29.4% 906,428

28%

24,000 60.00

2

$

24,960 64.20

3

$

25,958 68.69

4

$

26,997 73.50

5

$

28,077 78.65

$ 1,440,000 (480,000) (240,000) 720,000 (200,000) 520,000 (145,600) 374,400 200,000 574,400

$ 1,602,432 (529,152) (249,600) 823,680 (200,000) 623,680 (174,630) 449,050 200,000 649,050

$ 1,783,186 (583,337) (259,584) 940,265 (200,000) 740,265 (207,274) 532,991 200,000 732,991

$ 1,984,330 (643,071) (269,967) 1,071,291 (200,000) 871,291 (243,962) 627,330 200,000 827,330

$ 2,208,162 (708,921) (280,766) 1,218,475 (200,000) 1,018,475 (285,173) 733,302 200,000 933,302 1,000,000

$

$

$

$

827,330

$ 1,933,302

$

$

280,766 (140,383) 140,383 (39,307) 101,076

$

933,302

$

(561,532) 224,613 (336,919)

574,400

649,050

732,991

The Parent Viewpoint needs to consider all incremental cash flow impacts including loss on export sales to Argentina (current practice).

Cash Flows to Hermosa in US: Parent Viewpoint Sales revenue on exports to Argentina Less direct and indirect costs on exported sets Profit on Hermosa's component sales Less US taxes on component profits a) Net profit on component sales after-tax

$

$

$

240,000 (120,000) 120,000 (33,600) 86,400

$

574,400

$

(480,000) 192,000 (288,000)

$ 28%

b) Cash flow from Argentina to Hermosa (US$) Cash flow loss on Hermosa's loss of exports Less US taxes on export losses c) Net cash flow reduction after-tax

40%

$

$

249,600 (124,800) 124,800 (34,944) 89,856

$

649,050

$

(499,200) 199,680 (299,520)

$

$

$

259,584 (129,792) 129,792 (36,342) 93,450

$

269,967 (134,984) 134,984 (37,795) 97,188

$

732,991

$

827,330

$

(519,168) 207,667 (311,501)

$

(539,935) 215,974 (323,961)

$

$

d) Recapture of NWC in Argentina (no tax)

$

$ 1,000,000

Total parent cash flow, after-tax (a+b+c+d) Initial investment Free cash flow to parent for discounting

$

(2,000,000) (2,000,000)

372,800

Internal rate of return (IRR) Net present value (NPV)

$

17.9% 182,302

The investment is acceptable financially on both the project and parent level.

$

372,800

439,386 $

439,386

514,940 $

514,940

$

600,557

1,697,458

600,557

$ 1,697,458

Problem 18.9 Hermosa Components: Revenue Growth and Sales Price Scenario In addition to the assumptions employed in Problem 18.8, Hermosa now wishes to evaluate the prospect of being able to sell the Argentine subsidiary at the end of year 5 at a multiple of the business’s earnings in that year. Hermosa believes that a multiple of six is a conservative estimate of the market value of the firm at that time. Evaluate the project and parent viewpoint capital budgets.

Assumptions Light bulb export volume to Argentina, per year Sales price per set in Argentina Material costs per set in Argentina Material and shipping costs of imports per set Direct & indirect cost per set Depreciable investment (buildings & equipment) Initial investment in net working capital Discount rate in Argentina

$ $ $ $ $ $

Value 24,000 60.00 20.00 10.00 5.00 1,000,000 1,000,000 15.00%

Growth 4.00% 7.00% 6.00% 0.00% 0.00%

Assumptions Sales multiple in year 5

Value 6.00

The capital budgeting analysis needs to be performed on both the Project Level (Project Viewpoint) and the Parent Level (Parent Viewpoint).

Year

0

Project Cash Flows in Argentina: Project Viewpoint Annual units sold (sets) Sales price in Argentina per set

1

$

Sales revenue Less direct manufacturing and shipping costs Less cost of US components @ $10/set Gross profit Less depreciation Pre-tax profit Less Argentine corporate taxes Net income Add back depreciation Annual project cash flow Return of net working capital Sales value in year 5 (multiple of earnings) Initial investment, total Free cash flow for discounting

$

(2,000,000) (2,000,000)

Internal rate of return (IRR) Net present value (NPV)

$

47.5% 3,093,911

28%

24,000 60.00

2

$

24,960 64.20

3

$

25,958 68.69

4

$

26,997 73.50

5

$

28,077 78.65

$ 1,440,000 (480,000) (240,000) 720,000 (200,000) 520,000 (145,600) 374,400 200,000 574,400

$ 1,602,432 (529,152) (249,600) 823,680 (200,000) 623,680 (174,630) 449,050 200,000 649,050

$ 1,783,186 (583,337) (259,584) 940,265 (200,000) 740,265 (207,274) 532,991 200,000 732,991

$ 1,984,330 (643,071) (269,967) 1,071,291 (200,000) 871,291 (243,962) 627,330 200,000 827,330

$ 2,208,162 (708,921) (280,766) 1,218,475 (200,000) 1,018,475 (285,173) 733,302 200,000 933,302 1,000,000 4,399,811

$

$

$

$

827,330

$ 6,333,113

$

$

280,766 (140,383) 140,383 (39,307) 101,076

$

933,302

$

(561,532) 224,613 (336,919)

574,400

649,050

732,991

The Parent Viewpoint needs to consider all incremental cash flow impacts including loss on export sales to Argentina (current practice).

Cash Flows to Hermosa in US: Parent Viewpoint Sales revenue on exports to Argentina Less direct and indirect costs on exported sets Profit on Hermosa's component sales Less US taxes on component profits a) Net profit on component sales after-tax

$

$

$

240,000 (120,000) 120,000 (33,600) 86,400

$

574,400

$

(480,000) 192,000 (288,000)

$ 28%

b) Cash flow from Argentina to Hermosa (US$) Cash flow loss on Hermosa's loss of exports Less US taxes on export losses c) Net cash flow reduction after-tax

40%

$

$

249,600 (124,800) 124,800 (34,944) 89,856

$

649,050

$

(499,200) 199,680 (299,520)

$

$

$

259,584 (129,792) 129,792 (36,342) 93,450

$

269,967 (134,984) 134,984 (37,795) 97,188

$

732,991

$

827,330

$

(519,168) 207,667 (311,501)

$

(539,935) 215,974 (323,961)

$

$

d) Cash flow from sale of Argentine subsidiary (not taxed)

$

$ 4,399,811

Total parent cash flow, after-tax (a+b+c+d) Initial investment Free cash flow to parent for discounting

$

(2,000,000) (2,000,000)

372,800

Internal rate of return (IRR) Net present value (NPV)

$

35.8% 1,872,608

The investment is acceptable financially on both the project and parent level.

$

372,800

439,386 $

439,386

514,940 $

514,940

$

600,557

5,097,269

600,557

$ 5,097,269

Problem 18.10 Hermosa Components: Revenue Growth, Sales Price, and Currency Risk Scenario Melinda Deane, a new analyst at Hermosa and a recent MBA graduate, believes that it is a fundamental error to evaluate the Argentine project’s prospective earnings and cash flows in dollars, rather than first estimating their Argentine peso (Ps) value and then converting cash flow returns to the United States in dollars.

She believes the correct method is to use the end-of-year spot rate in 2012 of Ps3.50 = $1.00 and assume it will change in relation to purchasing power. (She is assuming U.S. inflation to be 1% per annum and Argentine inflation to be 5% per annum.) She also believes that Hermosa should use a risk-adjusted discount rate in Argentina which reflects Argentine capital costs (20% is her estimate) and a risk-adjusted discount rate for the parent viewpoint capital budget (18%) on the assumption that international projects in a risky currency environment should require a higher expected return than other lower-risk projects. How do these assumptions and changes alter Hermosa’s perspective on the proposed investment?

Assumptions Value Growth Assumptions Value Light bulb export volume to Argentina, per year 24,000 4.00% Sales multiple in year 5 6.00 Sales price per set in Argentina $ 60.00 7.00% Spot rate, 2003 (Pesos=US$1.00) 3.50 Material costs per set in Argentina $ 20.00 6.00% US inflation rate, per annum 1.00% Material and shipping costs of imports per set $ 10.00 0.00% Argentine inflation rate, per annum 5.00% Direct & indirect cost per set $ 5.00 0.00% Discount rate in United States 18.00% Depreciable investment (buildings & equipment) $ 1,000,000 Initial investment in net working capital $ 1,000,000 Discount rate in Argentina 20.00% The capital budgeting analysis needs to be performed on both the Project Level (Project Viewpoint) and the Parent Level (Parent Viewpoint).

Year PPP Expected Spot Exchange Rate (Pesos=US$1.00)

0 3.50

Project Cash Flows in Argentina: Project Viewpoint Annual units sold (sets) Sales price in Argentina per set in US$ Sales price in Argentina per set in Argentine pesos

$

Sales revenue (pesos) Less direct manufacturing and shipping costs Less cost of U.S. components @ $10/set Gross profit Less depreciation Pre-tax profit Less Argentine corporate taxes Net income Add back depreciation Annual project cash flow Sales value in year 5 (multiple of earnings) Initial investment, total Free cash flow for discounting (pesos) Internal rate of return (IRR) Net present value (NPV)

1 3.64

28%

(7,000,000) (7,000,000)

$

24,000 60.00 218.32

2 3.78

$

24,960 64.20 242.85

3 3.93

$

25,958 68.69 270.14

4 4.09

$

26,997 73.50 300.50

5 4.25

$

28,077 78.65 334.27

5,239,604 (1,746,535) (873,267) 2,619,802 (700,000) 1,919,802 (537,545) 1,382,257 700,000 2,082,257

6,061,547 (2,001,632) (944,166) 3,115,749 (700,000) 2,415,749 (676,410) 1,739,339 700,000 2,439,339

7,012,430 (2,293,990) (1,020,821) 3,697,619 (700,000) 2,997,619 (839,333) 2,158,286 700,000 2,858,286

8,112,479 (2,629,048) (1,103,700) 4,379,731 (700,000) 3,679,731 (1,030,325) 2,649,406 700,000 3,349,406

9,385,094 (3,013,046) (1,193,307) 5,178,741 (700,000) 4,478,741 (1,254,048) 3,224,694 700,000 3,924,694 19,348,162

2,082,257

2,439,339

2,858,286

3,349,406

23,272,855

50.3% 9,051,400

The Parent Viewpoint needs to consider all incremental cash flow impacts including loss on export sales to Argentina (current practice).

Cash Flows to Hermosa in U.S.: Parent Viewpoint Sales revenue on exports to Argentina Less direct and indirect costs on exported sets Profit on Hermosa's component sales Less U.S. taxes on component profits a) Net profit on component sales after-tax

$

$

$

240,000 (120,000) 120,000 (33,600) 86,400

$

572,267

$

(480,000) 192,000 (288,000)

$ 28%

b) Cash flow from Argentina to Hermosa (US$) Cash flow loss on Hermosa's loss of exports Less U.S. taxes on export losses c) Net cash flow reduction after-tax

40%

$

$

249,600 (124,800) 124,800 (34,944) 89,856

$

644,864

$

(499,200) 199,680 (299,520)

$

$

$

259,584 (129,792) 129,792 (36,342) 93,450

$

726,832

$

(519,168) 207,667 (311,501)

$

$

$

269,967 (134,984) 134,984 (37,795) 97,188

$

280,766 (140,383) 140,383 (39,307) 101,076

$

819,272

$

923,417

$

(539,935) 215,974 (323,961)

$

(561,532) 224,613 (336,919)

$

d) Cash flow from sale of Argentine subsidiary (not taxed)

$

$ 4,552,312

Total parent cash flow, after-tax (a+b+c+d) Initial investment Free cash flow to parent for discounting

$

(2,000,000) (2,000,000)

370,667

Internal rate of return (IRR) Net present value (NPV)

$

36.2% 1,297,072

$

370,667

435,200 $

435,200

508,781 $

508,781

$

592,499

5,239,886

592,499

$ 5,239,886

The project is acceptable on both levels, despite the deteriorating peso scenario and the higher discount rates.

Note: One way of checking the accuracy of your spreadsheet solution is to assume that the initial spot rate is Ps1.00=$1.00, and the inflation rates in both countries are zero. The results should be identical to those in the previous problem.