Solutions to End-of-Chapter Questions and ProblemsSolutionstoEnd-of-Chapter Questions and ProblemsinMultinationalFinanceby Kirt C. Butler1Kirt C. Butler, Multinational Finance, 2nd editionSecond Edition2Solutions to End-of-Chapter Questions and ProblemsPART I Overview and BackgroundChapter 1 Introduction to Multinational FinanceAnswers to Conceptual Questions1.1 Describe the ways in which multinational financial management is different from domestic financial management.Multinational financial management is conducted in an environment that is influenced by more than one cultural, social, political, or economic environment. 1.2 What is countryrisk?Describeseveral typesof countryriskonemight facewhen conducting business in another country.Countryrisks refer tothe political andfinancial risks of conducting business ina particular foreigncountry. Country risks include foreign exchange risk, political risk, and cultural risk.1.3 What is foreign exchange risk?Foreign exchange (or currency) riskis the risk of unexpected changes in foreign currency exchange rates.1.4 What is political risk? Political risk is the risk that a sovereign host government will unexpectedly change the rules of the game under which businesses operate. 1.5 In what ways do cultural differences impact the conduct of international business?Because they define the rules of the game, national business and popular cultures impact each of the functional disciplines of business from research and development right through to marketing, production, and distribution. 1.6 What is the goal of financial management? How might this goal be different in different countries? How might the goal of financial management be different for the multinational corporation than for the domestic corporation?The goal of financial management is to make decisions that maximize the value of the enterprisetosomegroupofstakeholders. Thesocietyinwhichbusinessisconducted determines who these stakeholders are. The relative importance of stakeholders varies by country. Equityshareholders areimportant ineveryfree-market country. Commercial banks are more important in some countries (e.g., Germany and Japan) than in some other countries(e.g., theUnitedStatesandtheUnitedKingdom). Insocialist countries, the welfare of employees and the general population assume a more prominent role. 1.7 List the MNCs key stakeholders. How does each have a stake in the MNC?Stakeholders narrowly defined include shareholders, debtholders, and management. More broadlydefined, stakeholdersalsowouldincludeemployees,suppliers,customers,host governments, and residents of host countries. 3Kirt C. Butler, Multinational Finance, 2nd editionChapter 2 World Trade and the International Monetary SystemAnswers to Conceptual Questions2.1 List one or more trade pacts in which your country is involved. Do these trade pacts affect all residents of your country in the same way? On balance, are these trade pacts good or bad for residents of your country?Figure 2.1 lists the major international trade pacts. The World Trade Organization (WTO) is a supranational organization that oversees the General Agreement on Tariffs and Trade (GATT). Important regional trade pacts include the North American Free Trade Agreement (NAFTA includes the U.S., Canada, and Mexico), the European Union (EU), and the Asia-Pacific Economic Cooperation pact (APEC encompasses most countries around the Pacific Rim including Japan, China, and the United States). Trade pacts are designed to promote trade, but industries that have been protected by local governments can find that they are uncompetitive when forced to compete in global markets. 2.2 Do countries tend to export more or less of their gross national product today than in years past? What are the reasons for this trend?Most countries export moreof their grossnational product todaythaninyearspast. Reasons include: a) the global trend toward free market economies, b) the rapid industrialization of some developing countries, c) the breakup of the former Soviet Union and the entry of China into international trade, d) the rise of regional trade pacts and the General Agreement onTariffs andTrade, ande) advances incommunicationandin transportation.2.3 Howhasglobalizationintheworldsgoodsmarketsaffectedworldtrade?Howhas globalization in the worlds financial markets affected world trade?Some of the economic consequences of globalization in the worlds goods markets include: a) an increase in cross-border investment in real assets (land, natural resource projects, and manufacturingfacilities), b)anincreasinginterdependencebetweennational economies leading to global business cycles that are shared by all nations, and c) changing political risk for multinational corporations as nations redefine their borders as well as their national identities.The demise of capital flow barriers in international financial markets has had several consequences including: a) an increase in cross-border financing as multinational corporations raise capital in whichever market and in whatever currency offers the most attractiverates, b) anincreasingnumber of cross-border partnerships includingmany international mergers, acquisitions, and joint ventures, and c) increasingly interdependent national financial markets.2.4 What distinguishes developed, less developed, and newly industrializing economies?Developed economies have a well-developed manufacturing base. Less developed countries (LDCs) lack this industrial base. Countries that have seen recent growth in their industrial base are called newly industrializing countries (NICs). 4Solutions to End-of-Chapter Questions and Problems2.5 Describe the International Monetary Funds balance-of-payments accounting system.TheIMFpublishes amonthlysummaryof cross-border transactions that tracks each countrys cross-border flow of goods, services, and capital.2.6 How would an economist categorize systems for trading foreign exchange? How would theIMFmakethisclassification?Inwhat waysarethesethesame?Howarethey different?Economists havetraditionallyclassifiedexchangeratesystems aseither fixedrateor floatingratesystems. TheIMFhasadaptedthissystemtotheplethoraof systemsin practice today. The IMFs classification scheme includes more flexible, limited flexibility, and pegged exchange rate systems.2.7 Describe the Bretton Woods agreement. How long did the agreement last? What forced its collapse?After World War II, representatives of the Allied nations convened at Bretton Woods, New Hampshire to stabilize financial markets and promote world trade. Under Bretton Woods goldexchangestandard,currencieswerepegged totheprice of gold (orto the U.S. dollar). Bretton Woods also created the International Monetary Fund and the International Bank for Reconstruction and Development (the World Bank). The Bretton Woods fixed exchange rate system lasted until 1970, when high U.S. inflation relative to gold prices and to other currencies forced the dollar off the gold exchange standard.2.8 What factors contributed to the Mexican peso crisis of 1995 and to the Asian crises of 1997?In each instance, the government tried to maintained the value of the local currency at artificiallyhighlevels. Thisdepleted foreign currency reserves. Local businesses and governments were also borrowing in non-local currencies (primarily the dollar), which heavily exposed them to a drop in the value of the local currency.2.9 What is moral hazard and how does it relate to IMF rescue packages?Moral hazard occurs when the existence of a contract changes the behaviors of parties to the contract. When the IMF assists countries in defending their currencies, it changes the expectations andhencethe behaviors of lenders, borrowers, andgovernments. For example, lendersmightunderestimate the risks of lending to struggling economies if there is an expectation that the IMF will intervene during difficult times. Problem Solutions2.1 This problem will take a bit of research for the student. Places to start include the Russian ruble crisis of 1998 and continuing currency troubles in South America.5Kirt C. Butler, Multinational Finance, 2nd editionPART II International Currency and Eurocurrency MarketsChapter 3 The Foreign Exchange and Eurocurrency MarketsAnswers to Conceptual Questions3.1 What is Rule #1 when dealing with foreign exchange? Why is it important? Rule#1saystoKeeptrackof your currencyunits.It isimportant becauseforeign exchange prices have a currency in both the numerator and the denominator. Most prices (for instance, a $15,000/car price on a newcar) have a non-currency asset in the denominator and a currency in the numerator.3.2 What is Rule #2 when dealing with foreign exchange? Why is it important?Rule #2 says to Always think of buying or selling the currency in the denominator of a foreign exchange quote. The importance of this rule is related to that of Rule #1. Foreign exchange quotes have a currency in both the numerator and the denominator. The rule buy low and sell high only works for the currency in the denominator. 3.3 What are the functions of the foreign exchange market?Currency markets transfer purchasing power from one currency to another, either today (in the spot market) or at a future date (in the forward market). When used with Eurocurrency markets, foreign exchange markets allow investors to move value both across currencies and over time. Foreign exchange markets also facilitate hedging and speculation.3.4 Define allocational, operational, and informational efficiency.Allocational efficiency refers to how efficiently a market channels capital toward its most productive uses. Operational efficiency refers to how large an influence transactions costs andothermarket frictionshaveontheoperationofamarket. Informational efficiency refers to whether or not prices reflect value.3.5 Whatisaforwardpremium?A forwarddiscount? Whyareforward pricesfor foreign currency seldom equal to current spot prices?A currency is trading at a forward premium when the nominal value of that currency in the forwardmarket ishigherthaninthespot market. Acurrencyistradingat aforward discount when the nominal value of that currency in the forward market is lower than in the spot market. Forward exchange rates will be different than spot exchange rates whenever investors expect currency values to change in nominal terms. Problem Solutions3.1 a. Thebidrateislessthantheofferrate, soCiticorpis quotingthe currencyin the denominator. Citicorp is buying dollars at the FF5.62/$ bid rate and selling dollars at the FF5.87/$ offer rate.b. InAmericanterms,the bid is $0.1704/FF and the ask is $0.1779/FF. Citicorp is buying and selling French francs at these quotes.c. In direct terms, the bid quote for the dollar is $0.1779/FF and the ask is $0.1704/FF.6Solutions to End-of-Chapter Questions and Problemsd. Sell $1,000,000 (FF5.62/$) = FF5,620,000 = amount you receiveBuy $1,000,000 (FF5.87/$) = FF5,870,000 = amount you payYour net loss is FF 250,000. What you lose, Citicorp gains.3.2 The ask price is higher than the bid, so these are the rates at which the bank is willing tobuyorselldollars(inthedenominator). Youresellingdollars, soyoullgetthe banks dollar bid price. You need to pay SK10,000,000/(SK7.5050/$) = $1,332,445.04.3.3 The U.S. dollar (in the denominator) is selling at a forward premium, so the Canadian dollar must be selling at a forward discount. Percent per annum on the Canadian dollar from the U.S. perspective are as follows:Bid AskOne month forward -0.486% -1.456%Three months forward -0.873% -1.034%Six months forward -0.678% -0.758%Annualized forward premia on the U.S. dollar are: BidAskOne month forward +0.486% +1.457%Three months forward +0.875% +1.036%Six months forward +0.681% +0.761%The premiums/discounts on the two currencies are opposite in sign and nearly equal in magnitude. Forward premiums and discounts are of slightly different magnitude becausethebases(U$vs. C$)onwhichtheyarecalculatedaredifferent. Forward premiums/discounts are as stated above regardless of where a trader resides. 3.4 Days Difference Basis point % premium/discount Annualized % forwardforward ($/) spread per period premium or discount 30 -0.00008895 -0.8895 -0.9820% -11.7845% 90 -0.00028441 -2.8441 -3.1401% -12.5604%180 -0.00056825 -5.6825 -6.2740% -12.5479%360 -0.00113707 -11.3707 -12.5541% -12.5541%3.5 1984 DM1.80/$or$0.56/DM1987 DM2.00/$or$0.50/DM1992 DM1.50/$or$0.67/DM1997 DM1.80/$or$0.56/DMa. 1984-87 The dollar appreciated 11.1%; ((DM2.0/$)-(DM1.8/$)/(DM1.8/$)=+0.1111987-92 The dollar depreciated 25%; ((DM1.5/$)-(DM2.0/$)/(DM2.0/$)=-0.251992-97 The dollar appreciated 25%; ((DM1.8/$)-(DM1.5/$)/(DM1.5/$)=+0.20b. 1984-87 The mark depreciated 10.7%; ($0.50/DM)/($0.56/DM) - 1= -0.1071987-92 The mark appreciated 34.0%; ($0.67/DM)/($0.50/DM) - 1= +0.3401992-97 The mark depreciated 16.4%; ($0.56/DM)/($0.67/DM) - 1 = -0.1647Kirt C. Butler, Multinational Finance, 2nd edition3.6 a. FM5,000,000 / (FM4.0200/$) = $1,243,781. Tokyos bid price for FM is their ask price for dollars. So, FM4.0200/$ is equivalent to $0.2488/FM.b. FM20,000,000 / (FM3.9690/$) = $5,039,053FM3.9690/$ is equivalent to $0.2520/FMPayment is made on the second business day after the three-monthexpiration date. 3.7 You initially receive P0$ = P0/S0/$ = (104,000,000)/(1.04/$) = $1 million. When you buybacktheyen, youmust payP1$=P1/S1/$=(104,000,000)/(1.00/$) =$1.04 million. Your dollar loss is $40,000.3.8 When buying one currency, you are simultaneously selling another. Hence, a bid price for pesetasisanaskpricefor dollars. ThepesetaquotesyieldSPts/$=1/S$/Pts=1/($0.007634/Pts) = Pts130.99/$ and SPts/$= 1/($0.007643/Pts) = Pts130.84/$, so quotes for the dollar (in the denominator) are Pts130.84/$ BID and Pts130.99/$ ASK.3.9 a. (1+s/$) = 0.90 = 1/(1+s$/)s$/ = (1/0.90)-1 = +0.111, or an 11.1% appreciation.b. (1+sRbl/$) = 11 = 1/(1+sRbl/)s$/Rbl = (1/11)-1 = -0.909, or a 90.9% depreciation.3.10 The 90-day dollar forward price is 33 basis points below the spot price: F1SFr/$-S0SFr/$ = (SFr0.7432/$-SFr0.7465/$) = -SFr0.0033/$. The percentage dollar forward discount is (F1SFr/$-S0SFr/$)/S0SFr/$= (SFr0.7432/$SFr0.7465/$)/(SFr0.7465/$) = -0.442%per 90 days. This is (-0.442%)*4 = -1.768% on an annualized basis.3.11 Banksmakeaprofit onthebid-askspread. Abankquoting$0.5841/DMBIDand $0.5852/DMASKisbuyingmarks(in thedenominator)at$0.5841/DMandselling marks at $0.5852/DM ASK. A bank quoting $0.5852/DM BID and $0.5841/DM ASK is selling dollars (in the numerator) at $0.5852/DMBIDand buying dollars at $0.5841/DM ASK.3.12 FF at a forward discount30 day: ($0.18519/FF-$0.18536/FF)/$0.18536/FF = -0.092%90 day: ($0.18500/FF-$0.18536/FF)/$0.18536/FF = -0.194%180 day: ($0.18498/FF-$0.18536/FF)/$0.18536/FF = -0.205%3.13 a. S1$/ = S0$/ (1+ s$/) = ($0.0100/)(1.2586) = ($0.012586/)b. (1+ s/$) = S1/$/S0/$ = (1/S1$/) / (1/S0$/) = 1 / (S1$//S0$/) = 1 / (1+ s$/)= 1 / (1.2586) = 0.7945, so s$/ = 0.7945 - 1 = -.2055, or = -20.55%3.14 a. The sale is invoiced in Belgian francs, so the expected future cash flow is:+BF40,000,0008Solutions to End-of-Chapter Questions and Problemsb. Thecontractual payment is apositivecashflowinBelgianfrancs, soDowis positively exposed to the value of the Belgian franc. V$/BFV$/BFDows exposurec. The expected cash flow in dollars is E[CF1$] = E[CF1BF] E[S1$/BF] = (BF40,000,000)($0.025/BF) = $1,000,000. Actual dollar cash flowis CF1$= CF1BFS1$/BF= (BF40,000,000)($0.04/BF) = $1,600,000. This leaves an unexpected gain of $600,000, or 60% of the expected value. As the value of the BF rises by 60% from $0.025/BF to $0.040/BF, so too does the value of this Belgian franc cash inflow. d. Sell 40 million Belgian francs forward and buy $1,000,000 at the forward price of F1$/BF = $0.025/BF, or F1BF/$ = BF40/$.+$1,000,000BF40,000,000TheBelgianfrancisbeingsoldforward, so Dows exposure to the value of the Belgianfrancinthisforward contract isnegative. The negative exposure on the forward contract offsets the positive exposure on the underlying position. The net result is no exposure to the Belgian franc exchange rate. V$/BFV$/BFForwardexposure3.15 (Ftd/f-S0d/f)/S0d/f = [(1/Ftf/d)-(1/S0f/d)]/(1/S0f/d) = [(S0f/d/Ftf/d)-(S0f/d/S0f/d)]/(S0f/d/S0f/d) = [(S0f/d /Ftf/d) - 1] =(S0f/d - Ftf/d) / Ftf/d.9Kirt C. Butler, Multinational Finance, 2nd editionChapter 4 The International Parity ConditionsAnswers to Conceptual Questions4.1 What is the law of one price? What does it say about asset prices?The law of one price states that identical assets must have the same price wherever they are bought or sold. The law of one price is enforced by arbitrage activity between identical assets. In a perfect market without transaction costs, the law of one price must hold for there to be no arbitrage opportunities.4.2 Describe riskless arbitrage. Risklessarbitrageisaprofitable position obtained with no net investment and no risk. Riskless arbitrage will drive the prices of identical assets into equilibrium and enforce the law of one price. 4.3 What is the difference between locational, triangular, and covered interest arbitrage?Locational arbitrage is conducted between two physical locations, such as between currency prices at two different banks (such thatASf/d BSd/f 1 for banks A and B and currencies d and f). Triangular arbitrage is conducted across three different cross exchange rates (such that Sd/e Se/f Sf/d 1 for currencies d, e, and f). Covered interest arbitrage takes advantage of a disequilibrium in the interest rate parity condition [(Ftd/ f) / (S0d/ f)] (1+id) / (1+i f)]t between currency and Eurocurrency markets. 4.4 What is relative purchasing power parity?Relative purchasing power parity is a form of the law of one price in which the expected change in the spot rate is influenced by inflation differentials according to E[Std/f]/S0d/f= [(1+id) / (1+if)]t.4.5 Howwouldyouarrive at anestimate of a future spot exchange rate betweentwo currencies?In theory, any of the international parity conditions could be used: E[Std/f] / S0d/f = [(1+id) / (1+if)]t= [(1+pd) / (1+pf)]t= Ftd/f/ S0d/f. In practice, forward exchange rates are used to predict future spot rates.4.6 What does the international Fisher relation say about interest rate and inflation differentials?If the law of one price holds and real interest rates are constant across currencies, nominal interest rates reflect inflation differentials according to [(1+id) / (1+if)]t = [(1+pd) / (1+pf)]t.10Solutions to End-of-Chapter Questions and ProblemsProblem Solutions4.1 a. SDM = S/$S$/DM = (200/$)($0.50/DM) = 100/DMb. SDM = S/$/SDM/$ =(100/$)/(DM1.60/$) = 62.5/DM.4.2 SDM/$ S$/ S/DM = 1.0326 > 1. Triangular arbitrage would yield a profit of 3.26 percent of thestartingamount. Fortriangular arbitrage to be profitable,transactions costs on a round turn cannot be more than this amount.4.3 Theforwardpriceisat a9basispoint discount over sixmonths, or 18bpsonan annualized basis. The six-month percentage discount is (F1/$/S0/$)-1=(0.6352/$)/(0.6361/$)-1=0.9986-1=0.14%, or 0.28% on an annualized basis. Because Ft/$= E[St/$] according to forward parity (the unbiased forward expectations hypothesis), the spot rate is expected to depreciate by 0.14% over the next six months.4.4 a. The percentage bid-ask spread depends on which currency is in the denominator.Tokyo quote for the peso: (28.7715/Ps28.7356/Ps)/(28.7356/Ps) = 0.125%Mexico City quote for yen: (Ps0.03420/Ps0.03416/)/(Ps0.03416/) = 0.117%b. The Mexican banks yen quote can be converted into a peso quote as follows:S/Ps = 1/(Ps0.03416/) = 29.2740/Ps bid on the yen and ask on the peso.S/Ps = 1/(Ps0.03420/) = 29.2398/Ps ask on the yen and bid on the peso.So Ps0.03416/ BID and Ps0.03420/ ASK on the yenis equivalent to 29.240/Ps BID and 29.274/Ps ASK on the peso.The winningstrategyisto buy pesos (and sell yen) from the Tokyo bank at the 28.7715/Psaskpriceandsell pesos(andbuyyen)totheMexicanbankatthe 29.240/Ps bid price. Buying pesos in Tokyo yields (1,000,000)/(28.7715/Ps) = Ps34,757. Selling pesos in Mexico City yields (Ps34,757)(29.2398/Ps) = 1,016,287. Your arbitrage profit is 16,287.4.5 In this circumstance, the international parity conditions do not have anything to say about the U.K. inflation rate. Nominal interest rates will adjust to expected inflation according to the Fisher relation; (1+i) = (1+p)(1+r).4.6 a. From interest rate parity, (210/$)/(190/$) = (1+i)/(1.15) i = 27.11%.b. Because the forward rate of 210/$ is greater than the spot rate of 190/$, the dollar is at a forward premium. If forward rates are unbiased predictors of future spot rates, the dollar is likely to appreciate against the yen by (210/$)/(190/$)-1 = 10.526%.4.7 a. In this problem, we know the spot and forward rates and U.S. inflation. The real and nominal interest rates are not needed: F1/$/S0/$=(1.20/$)/(1.25/$) =0.96 = E(1+p$)/E(1+p) = (1.05)/E(1+p) =>E(p) = (1.05/0.96)-1 = 9.375%b. From the Fisher equation: i = (1+p)(1+r)-1 = (1.09375)(1.02)-1 = 11.56%.4.8 a. E[P1D] = P0D(1+pD) = D100(1.10) = D110 E[P1F] = P0F(1+pF) = F1(1.21) = F1.21E[S1D/F] = E[P1D] / E[P1F] = D110 / F1.21 = D90.91/F.11Kirt C. Butler, Multinational Finance, 2nd editionb. E[P2D] = P0D(1+pD)2 = D100(1.10)2 = D121E[P2F] = P0F(1+pF)2 = F1(1.21)2 = F1.4641E[S2D/F] = E[P2D]/E[P2F] = D121/F1.4641 = S0D/F[(1+pD)/(1+pF)]2 = (D100/F)(1.10/1.21)2 = D82.64/F.4.9 a. A 7% annualized rate with quarterly compounding is equivalent to 7%/4 = 1.75% per quarter. From interest rate parity, the 3-month Finnish markka interest rate is FFM/$/SFM/$= (FM3.9888/$)/(FM4.0200/$) = (1+iFM)/(1+i$) = (1+iFM)/(1+0.0175) => iFM=0.009603, or0.9603%per threemonths. Annualized, thisisequivalent to (0.9603%)*4 = 3.8412% per year with quarterly compounding. Alternatively,the annual percentage rate is (1.009603)4-1 = 0.03897, or 3.897% per year.b. $10,000,000 invested at the three-month U.S. rate yields $10,175,000. Changed into FM at the forward rate, this is worth ($10,175,000)(FM3.9888/$) = FM40,586,040. You can finance your $10,000,000 by borrowing FM40,200,000. Your obligation on this contract will be (FM40,200,000)(1.009603) FM40,586,040 which is exactly offset by the proceeds from your forward contract. 4.10 a. FtBt/$/S0Bt/$ = (1 + iBt)t/(1 + i$)t = (Bt 25.64/$)/(Bt 24.96/$) = (1 + iBt)/(1.06125)1.02724 = (1 + iBt)/1.06125 iBt = 9.02%b. F1Bt/$/S0Bt/$=(Bt25.64/$)/(Bt24.96/$) =1.027 (1+i$)/(1+iS$). The forward/spot ratio is too high and must fall, so sell S$ (and buy dollars) at the relatively high S$ forward rate and buy S$ (and sell dollars) at the relatively low S$ spot rate. Conversely, theratioof interest rates is toolowandmust rise, soborrowat the relatively low dollar interest rate and invest at the relatively high S$ rate. (Even though S$ interest rates are lower than dollar interest rates in nominal terms, S$ interest rates are high and dollar interest rates are low relative to the forward/spot ratio.) Suppose you borrow ($1,000,000)/(1+i$) = $1,060,000 at the i$ = 6.0% dollar interest rate. -$1,060,000+$1,000,000Convert to S$2,000,000 = ($1,000,000)/($0.50/S$) at S0$/S$ = $0.50/S$.+S$2,000,000-$1,000,000Invest S$2,000,000 at the Singapore interest rate of iS$ = 4.0%.+S$2,080,000-S$2,000,000Cover this S$ forward obligation by selling S$ in the forward market.13Kirt C. Butler, Multinational Finance, 2nd edition+$1,060,800-S$2,080,000The result is a dollar profit of $1,060,800-$1,060,000 = $800. These transactions are worth undertaking only if the costs of executing the four transactions is less than $800. 4.13 a. You are receiving 100,000 in one year, so sell 100,000 forward and buy dollars. In one year, you will receive 100,000 from your album sale. You can then convert this amount into (100,000)($1.20/) = $1,200,000 through the forward contract. You have eliminated your exposure to the value of the pound.b. A money market hedge borrows in one currency, invests in another, and nets the transactions in the spot market. The result is the equivalent of a forward contract. The forward contract that you want to replicate is a forward sale of 100,000. This can be replicated as follows:Borrow (100,000)/(1+i) = 89,638 at the i = 11.56% pound sterling interest rate. +89,638-100,000Convert to (89,638)($1.25/) = $112,047 at S0$/ = $1.25/.+$112,047-89,638Invest in dollars at the U.S. dollar rate of i$ = 9.82%.-$112,047+$123,050The net result is a forward contract to buy dollars with pounds.+100,000-$123,050Note that this is on more favorable terms than the forward contract. Forward prices are not in equilibrium with the interest rate differential. In this situation, it is cheaper to hedge through the money markets than through the forward market. c. These markets are not in equilibrium. F1$//S0$/ = ($1.20/)/($1.25/) = 0.96 < 14Solutions to End-of-Chapter Questions and Problems=0.98440 = (1.0982)/(1.1156) = (1+i$)/(1+i), so you should buy pounds at the relatively low forward price, sell pounds at the relatively high spot price, invest in dollars at the relatively high dollar interest rate, and borrow pounds at the relatively low pound interest rate. Appendix 4-A Continuous Time Finance4A.1 Total two-period return is [V2/V0]-1 = [(1+i1)(1+i2)]-1. Mean geometric return is iavg= [(1+i1)(1+i2)]1/2-1. Total wealthafter twoperiods is thesameasbeginningwealth; $100(1+1)(1-0.5) = $100. Notice that the order of the rates of return does not matter. A loss of 50% followed by a gain of 100% leaves your initial value unchanged. For the pair of returns (100%,-50%), the average period return is iavg = [(1+1)(1-0.5)]1/2-1 = 0. With continuously compounded returns, periodic rates are given by1= ln(1+i1) = ln(2)=+0.69315and2=ln(1+i2)= ln(0.5)= -0.69315.The (arithmetic)average return using continuously compounded rates is (1+2)/2 = (+0.69315-0.69315)/2 = 0. Either way, your ending value is the same as your beginning value. These methods are equivalent. 4A.2 Inflation rates are pD= ln(1+pD) = ln(1.10) = 9.531% and pF= ln(1+pF) = ln(1.21) = 19.062% in continuously compounded returns. Expected price levels and spot rates are:E[P1D] = P0D e(0.09531) = (D100)(1.10) = D110 E[P2D] = P0D e(2)(0.09531) = (D100)(1.21) = D121 E[P1F] = P0F e(0.19062) = (F1)(1.21) = F1.21 E[P2F] = P0F e(2)(0.19062) = (F1)(1.4641) = F1.4641E[S1D/F] = E[P1D] / E[P1F] = D110 / F1.21 = D90.91/FE[S2D/F] = E[P2D] / E[P2F] = D121 / F1.4641 = D82.64/FChapter 5 The Nature of Foreign Exchange RiskAnswers to Conceptual Questions5.1 What is the difference between currency risk and currency risk exposure?Risk exists whenever actual outcomes can deviate from expected outcomes. Currency risk is the risk that currency values will change unexpectedly. Exposure to currency risk refers to change in the value of an asset (such as an individual investment portfolio or the stock price of a multinational corporation) with unexpected changes in currency values. 5.2 What are monetary assets and liabilities? What are nonmonetary assets and liabilities?Monetary assets and liabilities have contractual payoffs. Nonmonetary assets (e.g., plant and equipment) and liabilities have noncontractual payoffs. 5.3 What are the two components of economic exposure to currency risk?Monetary (contractual) assets and liabilities can be exposed to currency risk. This is called transactionexposure.Theexposureofthefirmsreal (noncontractual) oroperating assets is called operating exposure. 15Kirt C. Butler, Multinational Finance, 2nd edition5.4 Under what conditions is accounting exposure to currency risk important to shareholders?Accounting (or translation) exposure is the exposure of financial statements to currency risk. Accountingexposureis important toshareholders if it is related toeconomic exposure (that is, related to expected future cash flows). It is also important if managers change their actions (and thereby firm cash flow) in response to accounting exposure. 16Solutions to End-of-Chapter Questions and Problems5.5 Will anappreciationofthedomesticcurrencyhelpor hurt adomesticexporter?An importer?A nominal appreciation in the domestic currency is likely to have little effect on domestic importers and exporters. A real appreciation of the domestic currency can hurt domestic exportersbyraisingthepriceof domesticgoodsrelativetoforeigngoods. Domestic importers will see their purchasing power increase relative to foreign competitors, and so are likely to be helped by a real appreciation of the domestic currency. 5.6 What does the efficient market hypothesis say about market prices?Inaninformationallyefficient market,assets are correctly priced. It is not possible to consistently earn abnormal returns (beyond that obtainable by chance) on assets of similar risk. The efficient market hypothesis says that spot and forward exchange rates should be correctlypriced, sothat it is not possibletoconsistentlymakeabnormal returns by speculating in foreign exchange. 5.7 What are real (as opposed to nominal) changes in currency values?Real exchange rate changes reflect changes in currencies relative purchasing power. 5.8 Are real exchange rates in equilibrium at all times?Real exchange rates show large and persistent deviations from purchasing power parity. These deviations can last for several years. 5.9 What is the effect of a real appreciation of the domestic currency on the purchasing power of domestic residents?A real appreciation of the domestic currency increases the wealth and purchasing power of domestic residents relative to foreign residents. It can also hurt the economy by raising the price of domestic goods relative to foreign goods.5.10 Describe the behavior of nominal exchange rates.For daily measurement intervals, both nominal and real exchange rate changes are random with a nearly equal probability of rising or falling. As the forecast horizon is lengthened, the correlation between interest and inflation differentials and nominal spot rate changes rises. Eventually, the international parity conditions exert themselves and theforward rate begins to dominate the current spot rate as a predictor of future nominal exchange rates. Finally, exchange rate volatility is not constant. Instead, volatility comes in waves.5.11 Describe the behavior of real exchange rates.Although real exchange rates tend to revert to their long run average, in the short run there can be substantial deviations from purchasing power parity and from the long run average.5.12 What methods can be used to forecast future spot rates of exchange?Market-based forecasts are obtained from forward exchange rates or from interest rate paritywhenforwardpricesare unavailable. These forwardpredictions canbe slightly improved by adjusting them for persistent deviations from forward parity or from interest rate parity. Forecasts can also be based on econometric models. Model-based forecasts 17Kirt C. Butler, Multinational Finance, 2nd editioncan be generated from technical analysis (analyzing patterns in exchange rates) or from fundamental analysis (from a larger set of economic relationships). Problem Solutions5.1 a. E[P1F] = P0F(1+pF) = 1.21 E[P1D] = P0D(1+pD) = 1.10 E[S1D/F] = (S0D/F)(1+pD)/(1+pF) = (D110/F)(1.10/1.21) D90.91/F.b. Because nominal exchange rates should adjust to reflect changes in relative purchasing power, the expected real exchange rate is 100% of the beginning rate: E[X1D/F] = (E[S1D/F]/S0D/F)((1+pF)/(1+pD)) = ((D90.91/F)/(D100/F))(1.21/1.10) = 1.00, or 100%.c. E[P2F]) = P0F(1+pF)2 = F1.4641 E[P2D]) = P0D(1+pD)2 = D121 E[P2F]) = P0F(1+pF)2 = F1.4641 E[P2D]) = P0D(1+pD)2 = D121E[S2D/F] = S0D/F((1+pD)/(1+pF))2 = (D100/F)(1.10/1.21)2 D82.64/F Thereal exchangerateis not expectedtochange: E[X2D/F] =(E[S2D/F]/E[S0D/F]) [(1+pF)/(1+pD)]2= ((D82.64/F)(D100/F)) / (1.21/1.10)2 = 1.00, or 100%.5.2 a. s/DM = (S0/DM)/(S-1/DM)-1 = (155/DM)/(160/DM) -1 = -3.125%.b. From relative purchasing power parity, the spot rate should have been:E[S0/DM] = (S-1/DM) [(1+p)/(1+pDM)] = (160/DM) [(1.02)/(1.03)] = 158.45.c. As a difference from the expectation, the real change in the spot rate is:x/DM= (Actual-Expected)/(Expected) = (S0/DM -E[S0/DM])/E[S0/DM])= (155/DM-158.45/DM)/158.45/DM = -2.18%.Alternatively, from equation (5.2), change in the real exchange rate is equal to:x/DM= ((S0/DM)/(S-1/DM)) ((1+pDM)/(1+p)) - 1 = ((155/DM)/(160/DM)) ((1.03)/(1.02)) - 1 = -2.18%.d. The deutsche mark depreciated by 2.18% in purchasing power. e. In real terms, the yen rose by xDM/ = ((S0DM/) / (S-1DM/)) ((1+p) / (1+pDM)) - 1 = ((S0/DM)-1 / (S-1/DM)-1) ((1+p) / (1+pDM)) - 1 = ((155/DM)-1 / (160/DM)-1 ) ((1.02)/(1.03)) - 1 = +2.23%= ((DM.0064516/)/(DM.00625000/)) ((1.02)/(1.03)) - 1 = +2.23%.Because the DM fell by 2.18% in real terms, the yen rose by 1/(1-0.0218) 2.23%.5.3 a. The percentage change in the dollar is sFl/$ = (S1Fl/$/S0Fl/$)-1 = (Fl1.55/$)/(Fl1.60/$)-1 = -0.03125, or 3.125%. The price elasticity of demand is equal to -( Q/Q)/( P/P) = -(+10%)/(-3.125%) = 3.2.b. A 10% real depreciation in the export sales price (in this case, in the value of the dollar) would result in a 32% increase in export sales if the price elasticity does not change. Note that price elasticity is unlikely to be constant across such a wide range of price changes. 18Solutions to End-of-Chapter Questions and Problemsc. Dollar revenues would go up by 32% with a 32% increase in volume. Letting initial quantity sold and export price be Q and P, respectively, the guilder value of export sales would increase by (Rnew)/(Rold)-1 = ((1.32Q)(0.90P) / (Q)(P))-1 = +18.8%.5.4 t2 = (0.0034) + (0.40)(0.05)2 + (0.20)(0.10)2 = 0.0064 t = 0.08, or 8%. PART III The Multinational Corporations Investment DecisionsChapter 6 Multinational Corporate StrategyAnswers to Conceptual Questions6.1 Why are product or factor market imperfections preconditions for foreign direct investment?Without some sort of product or factor market imperfection, the multinational corporation cannot enjoy an advantage over local firms. For the MNC to add value to themarketplace, itmustbring somethingthat localfirmscannot.These competitive advantages are protected by market imperfections. 6.2 Describe the elements of the eclectic paradigm. What does the eclectic paradigm attempt to do?The eclectic paradigm attempts to categorize the types of advantages enjoyed by the multinational corporationthat giveit acompetitiveadvantageoverlocal firms. The major categories are ownership-specific advantages, location-specific advantages, and market internalization advantages. 6.3 What are ownership-specific advantages?Ownership-specific advantages arefirm-specific propertyrights or intangible assets including patents, trademarks, organizational and marketing expertise, production technology and management, and the general organizational abilities of employees.6.4 What are location-specific advantages?Location-specificadvantages arisefromtheMNCsaccess tonatural andman-made resources, high labor productivity and low real wage costs, transportation and communication systems, governmental investment incentives, and preferential tax treatments that are specific to a particular location or locale.6.5 What are market internalization advantages?Market internalization advantagesallow the multinational corporation to internalize or exploit thefailureofanarms-lengthmarket toefficientlyaccomplishatask. That is, contractingtoaccomplishataskismoreeffectiveorlessexpensivewhenconducted within the firm than through the markets. 6.6 Describe the evolution of the MNC using product cycle theory. 19Kirt C. Butler, Multinational Finance, 2nd editionAccordingtoproduct cycle theory, the firms products evolve throughfour stages: infancy, growth, maturity and decline. The MNC attempts to extend the lucrative mature stage byenhancing revenues throughaccess to newproduct markets andreducing operating costs through access to new factor markets. 6.7 Describe three broad modes of entry into international markets. Which of these modes requires themost resourcecommitment onthepart of theMNC?Whichhas the greatest risks? Which offers the greatest growth potential?Export entry,contract-based entry, and investment entry. Investment entry requires the mostresourcecommitment andexportingthe least. The othersideof thecoinisthat expectedreturnsareoftenhigher with investment-based entry than with exporting (so long as the project is positive-NPV and the MNC can pull it off). The advantages and disadvantages of contract-based entry depend on the particular contract. 6.8 What are the relative advantages and disadvantages of foreign direct investment, acquisitions/mergers, and joint ventures?The resource commitments of FDI and foreign acquisition are generally higher than joint ventures. a. FDI allows theMNCrelativelypermanent access toforeignproduct andfactor markets. The cost of a new investment in an unfamiliar business culture can be high, however. b. Acquisitionsof stockor of assets may be difficult or impossible in countries with investment restrictions or ownership structures (such as the German banking system or the Japanese keiretsu industrial structure) that impede foreign acquisitions. Acquisition premiums can also be prohibitive. c. Joint ventures can allow the MNC to gain quick access to foreign markets and to new production technologies. It can also come with risks, such as the risk of losing control of the MNCs intellectual property rights to the joint venture partner. 6.9 Describe several defensive strategies that MNCs use during the mature stage of their products life cycles.Strategies to preserve and enhance revenues include preservation of market share, follow the leader, follow the customer, and lead the customer. Strategies to reduce operating costs includeseekinglow-cost rawmaterialsandlabor, economiesof scale, economies of vertical integration, reductionof operatinginefficiencies (process efficiencyseekers), knowledgeseekers, andpolitical safetyseekers. Financial considerations includethe possibility of obtaining financial economies of scale, access to new capital markets, new sources of low-cost financing, indirect diversificationbenefits, financial strengthand lower risk through international asset diversification, and reduced taxes through multinational operations.6.10 How can the MNC protect its competitive advantages in the international marketplace?The text lists several ways to protect competitive advantages such as the firms intellectual property rights. The most important of these protections lies in finding the right partner. Other ways that the MNC can protect itself include: i) limit the scope of the technology 20Solutions to End-of-Chapter Questions and Problemstransfer to include only non-essential parts of the production process, ii) limit the transferability of the technology by contract, iii) limit dependence on any single partner, iv) use only assets near the end of their product life cycle, v) use only assets with limited growth options, vi) trade one technology for another, vii) remove the threat by acquiring the stock or assets of the foreign partner.Problem Solutions6.1 Rather than make up an entry strategy, lets look at howMotorola has entered Southeast Asia. In the 1960s, Motorola established sales agencies in Japan and Hong Kongasitsinitial entrymode. Intheearly1980s, Motoroladecidedthatit needed direct investment intheregioninorder todiversifyits designandmanufacturing capabilities. Development costs are high in the semiconductor industry and economies of scale on a successful product can be substantial. For this reason, Motorola and other semiconductor manufacturers have favored the international joint venture as a way to enter newmarketsandreducethecostsandrisksofproduct innovation. Hereisa partial list of Motorolas international joint ventures: Beginning in 1987, Motorola has had a joint venture with Toshiba to manufacture semiconductors. Joint ventureshelpMotorolatokeepresearchanddevelopment costs down while keeping an eye on their Japanese competitors. In1990, MotorolabuiltadesignandmanufacturingfacilityinHongKongasa platform to service the rest of Southeast Asia. Sincelate1996, MotorolahasmanufacturedMacclonesinajoint venturewith Chinas state-owned Nanjing Power Computing of China based on its Power PC chip. Motorola has joined a strategic alliance called Iridium with Globalstar, Loral, and Qualcomm to place satellites in very low orbits around the earth. These low-orbit satellites will provide hand-held mobile telephone service around the globe. Cellular communication is particularly important to countries such as China without a network of phone lines in place.Motorola currently derives more than 50% of its sales from outside the United States.Chapter 7 Cross-Border Capital BudgetingAnswers to Conceptual Questions7.1 Describethetworecipes for discountingforeigncurrencycashflows. Under what conditions are these recipes equivalent?Recipe #1: Discount foreign currency cash flows at a foreign currency discount rate.Recipe #2: Discount domestic currency cash flows at a domestic currency discount rate.These two recipes are equivalent if the international parity conditions hold and there are nomarket frictionssuchasrepatriationrestrictions. Theserecipescangivedifferent values if PPP does not hold or if there are repatriation restrictions.21Kirt C. Butler, Multinational Finance, 2nd edition7.2 Discuss each cell in Figure 7.4. What should (or shouldnt) a firm do when faced with a foreign project that fits the description in each cell?Top left: Both NPVs are negative so reject the foreign project. Top right: NPVd>0 but NPVf NPVf> 0, then changes in exchange rates are expected to help the parent. The home office may choose to leave the foreign currency cash flows unhedged, although this captures the higher expected return (NPVd > NPVf) but also exposes the firm to currency risk. If 0 < NPVd < NPVf, then the parent can capture a higher expected return (NPVf > NPVd) and lower currency risk by hedging its expected future foreign currency cash flows and locking in the relatively high local-currency value of the project.7.3 Why is it important to separately identify the value of any side effects that accompany foreign investment projects?Separately identifying the value of a project from the value of any side effects (such as blocked funds, subsidized financing, or tax holidays) allows the firm to negotiate with host governments and other parties on a more informed basis. Problem SolutionsCross-border capital budgeting when the international parity conditions hold.7.1 a. Note that relative purchasing power parity holds. (1+i$)/(1+iRen) = (1.15)/( 1.11745) (1+p$)/(1+pRen) = (1.06)/(1.03) 1.0291.Discounting renminbi cash flows at the renminbi discount rate yieldsNPVRen = -Ren600m+Ren200m/1.11745+Ren500m/(1.11745)2+Ren300m/(1.11745)3 = Ren194.39 millionor NPV$= (Ren194.39m)($0.5526/Ren) = $107.42 million at the spot exchange rate. b. Relative purchasing power parity states that the spot rate should change according to E[St$/Ren]/E[S0$/Ren] = [(1+E[p$])/(1+E[pRen])]t= (1.06/1.03)t= (1.029)t. That is, renminbi shouldappreciatebyapproximately2.9%per yearrelativetothedollar because of lower Chinese inflation. Expected future spot rates of exchange are thenE[S1$/Ren] = ($0.5526)[(1.06)/(1.03)]1 = $0.5687/RenE[S2$/Ren] = ($0.5526)[(1.06)/(1.03)]2 = $0.5853/RenE[S3$/Ren] = ($0.5526)[(1.06)/(1.03)]3 = $0.6023/RenBased on these spot exchange rates, expected dollar cash flows are:22Solutions to End-of-Chapter Questions and ProblemsE[CF0$] = (Ren600)($0.5526/Ren) = $331.56E[CF1$] = (Ren200)($0.5687/Ren) = $113.74E[CF2$] = (Ren500)($0.5853/Ren) = $292.63E[CF3$] = (Ren300)($0.6024/Ren) = $180.69The project should be accepted because NPV$= -$331.56m+$113.74m/(1.15)+$292.63m/(1.15)2+$180.69m/(1.15)3 = $107.42 million > $07.2 a. Expected future cash flows in euros are as follows:Investment cash flows 0 1 2Land -100000 121000 grows at 10% inflation ratetax on capital gain -8400Plant -50000 25000 market value at t=2tax on capital gain -10000NWC -50000 60500 grows at 10% inflation ratetax on capital gain -4200Operating cash flows 0 1 2Rev (Price=100, Q=5,000) 550000 605000 grows at 10% inflation rateVariable cost (20%) -110000 -121000FC (20,000 at t=0) -22000 -24200 grows at 10% inflation rateDepreciation -25000 -25000Earnings before tax 393000 434800Tax (at 40%) -157200 -173920Net income 235800 260880Net cash flow (Euros) 260800 285880 CF = NI + DepreciationSum of investment/disinvestment and operating cash flows Total net CFs -200000 260800 469780NPV at iEuro = 20% 343569.4b. If the international parity conditions hold, then 20% interest rates in both the foreign and domestic currencies imply that forward (and expected future spot) prices will equal the current spot rate of $10/Euro. So, Sum of investment/disinvestment and operating cash flows Expected dollar CFs -2000000 2608000 4697800NPV at i$ = 20% $3,435,6947.3 a. iW = (1+pW)(1+rW) -1 = (1.50)(1.10)-1 = 65%iL = (1+pL)(1+rL)-1 = (1.00)(1.10)-1 = 10%b. E[S1W/L] = (S0W/L) [(1+pW) / (1+pL)]t = (W100/L) [(1.50) / (1.00)] = W150/LE[S2W/L] = (S0W/L) [(1+pW) / (1+pL)]t = (W100/L) [(1.50) / (1.00)]2 = W225/L23Kirt C. Butler, Multinational Finance, 2nd editionc. All cash flows in work-units:Investment cash flows 0 1 2Land -200,000 450,000 grows at 50% inflation ratetax on capital gain -125,000Plant -200,000 0 market value at t=2tax on capital gain 0Operating cash flows 0 1 2Rev (P0W=W200, Q=2,000) 600,000 900,000 grows at 50% inflation rateVariable cost (20%) -120,000 -180,000Fixed cost (W30,000 at t=0) -45,000 -67,500 grows at 50% inflation rateDepreciation -100,000 -100,000Earnings before tax 335,000 552,500Tax (at 50%) -167,500 -276,250Net income 167,500 276,250Net operating CFW267,500 376,250 CF = NI + DepreciationSum of investment/disinvestment and operating cash flows Total NCFW-400,000 267,500 701,250NPVW at 65% W19,697NPVL = NPVW / S0W/L = L197d. E[CFtL] = E[CFtW] / E[StW/L] E[CF0L] = (-W400,000) / (W100/L) = -L4,000E[CF1L] = (W267,500) / (W150/L) = L1,783E[CF2L] = (W701,250) / (W225/L) = L3,117NPVL = -L4,000 + (L1,783) / (1.10) + (L3,117) / (1.1)2 = L197This is the same as in part c because the international parity conditions hold.7.4 a.t=1 Bt3.4m Bt3.4mBt3.4m Bt6,913,840| | | | |Bt4mt=2 t=3 t=4 t=5iBt = 20%Initial outlay = (Bt4m)After-tax cash flows over t=2,,5=(Bt100m-Bt90m-Bt5m)(1-0.40)+(Bt1m*.40)=Bt3,400,000Terminal CF= (Bt4m*(1.10)4) - {[(Bt4m*(1.10)4) - 0]*.4} = Bt3,513,840NPV0Bt = Bt5,413,548b.(1+iBt)=(1+rBt)(1+pBt) rBt = (1.20/1.10)-1=0.0909091 r = 9.09091%i = (1.0909091)(1.05) - 1 = 0.1454545, or 14.54545%c. E(S1Bt/) = (Bt0.25/)(1.20/1.1454545) =Bt.2619048/E(S2Bt/) = (Bt0.25/)(1.20/1.1454545)2 = Bt.2743764/E(S3Bt/) = (Bt0.25/)(1.20/1.1454545)3 = Bt.2874420/E(S4Bt/) = (Bt0.25/)(1.20/1.1454545)4 = Bt.3011297/E(S5Bt/) = (Bt0.25/)(1.20/1.1454545)5 = Bt.3154692/24Solutions to End-of-Chapter Questions and Problemsd. Recipe #1:NPV = Bt5,413,548/(Bt0.25/) = 21,654,192Recipe #2:NPV0 =21,654,192 at i = 14.54545%t=1 12,391,736 11,828,475 11,290,817 21,916,055|||||15,272,727t=2 t=3 t=4t=5The answers are the same because the international parity conditions hold. Cross-border capital budgeting when international parity conditions do not hold.7.5 a. Discount in renminbi. NPVRen= [t E[CFtRen] / (1+iRen)t ]= [-Ren600+Ren200/(1.1175)+Ren500/(1.1175)2+Ren300/(1.1175)3 ]= Ren194.39NPV$= (S0$/Ren) (NPVRen) = ($0.5526/Ren)(Ren194.39) = $107.42Discount in dollars. NPV$= t {E[St$/Ren]E[CFtRen] / (1+i$)t }= [(-Ren600)($0.5526/Ren)+(Ren200)($0.5801/Ren)/(1.15) + (Ren500)($0.6089/Ren)/(1.15)2+ (Ren300)($0.6392/Ren)/(1.15)3 ]= $125.61 > $107.42While the project has a positive NPV regardless of the perspective, the project has more value from the parents perspective than from the project perspective. This is because the expected future value of the dollar (renminbi) is less (more) than under theequilibriumconditions. Theparent companymaychoosetoleaveitscash flowsfromtheproject unhedgedinthehopesofbenefitingfromtheexpected future spot exchange rates. This does expose the parent to currency risk. b. Discount in renminbi.NPVRen= [t E[CFtRen] / (1+iRen)t ]= [-Ren600 + Ren200/(1.1175) + Ren500/(1.1175)2+Ren300/(1.1175)3]= Ren194.39 NPV$= (S0$/Ren) (NPVRen) = ($0.5526/Ren)(Ren194.39) = $107.42Discount in $: NPV$= t {E[St$/Ren]E[CFtRen] / (1+i$)t }= [(-Ren600)($0.5526/Ren)+(Ren200)($0.5575/Ren)/(1.15) + (Ren500)($0.5625/Ren)/(1.15)2+ (Ren300)($0.5676/Ren)/(1.15)3 ]= $90.04 < $107.42Although the project has a positive NPV from each perspective, the project has more valueinthelocal currencythanit doesindollars. Theparent shouldhedgethe renminbi cash flows either directly in the forward market, by borrowing a part of the project inrenminbi, or byswappingdollar debt for renminbi debt tohedgeits expected future renminbi cash flows from the project.25Kirt C. Butler, Multinational Finance, 2nd edition26Solutions to End-of-Chapter Questions and ProblemsCross-border capital budgeting when there are investment or financial side effects.7.6 Expected future cash flows are not received until one year later, so +Ren200 +Ren500 +Ren3001 yr2 yrs 3 yrs 4 yrs-Ren600NPVren = -Ren600m+Ren200m/(1.11745)2+Ren500m/(1.11745)3+Ren300m/(1.11745)4 = Ren110.90 million, or NPV$= (Ren110.90)($0.5526/ren) = $61.28 million at the spot exchange rate. 7.7 The after-tax cost of debt is (5.06%)(1-0.4) = 3.036%. The after-tax annual savings in interest expense is (Ren600m)(0.0506-0.0403)(1-0.4) = Ren3.708 million. The present value of a three-year annuity of Ren3.708 million discounted at 3.036% is Ren10.48 million. 7.8 NPVRen = Ren194.39 million without the side effect. The airport project reduces this value by Ren100 million, but the NPV is still positive. Accept the project even if the Chinese authorities are not willing to renegotiate. 7.9 This is a cumulative risk in that, once expropriated, you will not receive any later cash flows from your investment.The probability of receiving the cash flow in year t is (0.9)t times the expected cash flow in problem 7.1. So,NPVren = -Ren600m + Ren200m(0.9)1/(1.11745) + Ren500m(0.9)2/(1.11745)2 + Ren300m(0.9)3/(1.11745)3 = Ren42.15 millionor NPV$= (Ren42.15)($0.5526/Ren) = $23.29 million at the spot exchange rate. 7.10 Step 1: Calculate the value of blocked funds assuming they are not blocked.If blocked funds had been invested at the risky croc rate of 40% per year, they would havegrowninvaluetoCr8,000(1.40)3+Cr13,819.5(1.40)2+Cr19,573.5(1.40) Cr76,441. Discounted at the 40% rate, this would have been worth Cr19,898 in present value.This is equivalent to discounting blocked funds back to the beginning of the project at the 40% risky croc discount rate, so this is a zero-NPV investment at the 40% croc interest rate.Step 2: Calculate the opportunity cost of blocked funds.With blocked funds earning no interest, the accumulated balance of Cr41,393 has a present valueof (Cr41,393) / (1.40)4=Cr10,775at the40%requiredreturn. The opportunity cost of blocked funds is then Cr19,898-Cr10,775 = Cr9,123. Step 3: Calculate project value including the opportunity cost of blocked funds.Vproject with side effect = Vproject without side effect + Vside effect = -Cr137 - Cr9,123 =-Cr9,260.At the 40% (foregone) risky discount rate, the opportunity cost of blocked funds is higher than the Cr9,077 value in the text example. At the 40% risky rate, blocked funds make the Neverland project look even worse than when Hooks treasure chest is riskless. 27Kirt C. Butler, Multinational Finance, 2nd editionChapter 8 Taxes and Multinational Corporate StrategyAnswers to Conceptual Questions8.1 Whatistax neutrality? Whyis it important to the multinational corporation? Is tax neutrality an achievable objective?A neutral tax is one that does not interfere with the natural flow of capital toward its most productive use. Domestic tax neutrality is intended to ensure that incomes arising from operations (whether foreign or domestic) are taxed similarly by the domestic government. Foreigntaxneutralityisintendedtoensurethat taxesimposedonthe foreign operations of domestic companies are similar to those facing local competitors in the host countries.8.2 What is the difference between an implicit and an explicit tax? In what way do before-tax required returns react to changes in explicit taxes?Explicit taxes are taxes that are explicitly assessed on income of various forms. Examples includecorporateandpersonal income taxes, dividend taxes, interest taxes, sales and property taxes, and so forth. Implicit taxes come in the form of higher pre-tax required returns in higher tax jurisdictions. 8.3 How are foreign branches and foreign subsidiaries taxed in the United States?Income from foreign branches is taxed as it is earned. Income from a controlled foreign corporation (a subsidiary that is incorporated in a foreign country and more than 50% owned by a U.S. parent) is taxed only when funds are repatriated to the U.S. parent. Incomefromforeigncorporationsthat arebetween10%and50%ownedbyaU.S. parent is called Subpart F income and is taxed as it is earned on a pro rata basis according to sales or gross profit. 8.4 Howhas theU.S. Internal RevenueCodelimitedtheabilityof themultinational corporation to reduce taxes through multinational tax planning and management?There are two principal limitations on multinational tax planning: the overall foreign tax credit (FTC) limitation and the use of income baskets for active and passive income and other kinds of income. The overall FTC limitation is equal to total foreign-source income times the U.S. tax rate. Excess foreign tax credits may be carried two years back or five years forward. Income baskets limit the usefulness of excess FTCs, because FTCs from one income basket may not be used to reduce taxes in another income basket.8.5 Are taxes the most important consideration in global location decisions? If not, how should these decisions be made?Locations that are tax-advantaged usually come with disadvantages in other areas. For example,low explicit tax rates generally result in low pre-tax rates of return because investors demand for high after-tax rates imposes an implicit tax on income from low-tax jurisdictions. Governments also use low tax rates to overcome locational disadvantagessuchasapoor physical, legal ortelecommunicationinfrastructure, an uneducated workforce, or high political risk.28Solutions to End-of-Chapter Questions and ProblemsProblem Solutions8.1 Indias currency is the rupee (Rp). Thailands currency is the bhat (Bt).From equation (8.1), interest rates in India are iRp = (iBt)(1-tBt)/(1-tRp) = (10%)(1-0.30)/(1-0.65) = 20%.8.2 Parts a, b, and c follow: Part a. Part b. Part c.HK India HK IndiaHK India a Dividend payout ratio 100% 100% 100% 100% 100% 100%b Foreign dividend withholding tax rate 0% 20% 0% 20% 0% 20%c Foreign tax rate 18% 65% 18% 65% 18% 65%d Foreign income before tax 10000 10000 20000 0 0 20000e Foreign income tax (d*c) 1800 6500 3600 0 0 13000f After-tax foreign earnings (d-e) 8200 3500 16400 0 0 7000g Declared as dividends (f*a) 8200 3500 16400 0 0 7000h Foreign dividend withholding tax (g*b) 0 700 0 0 0 1400i Total foreign tax (e+h) 1800 7200 3600 0 0 14400j Dividend to U.S. parent (d-i)8200 2800 16400 0 0 5600k Gross foreign income before tax (d) 10000 10000 20000 0 0 20000l Tentative U.S. income tax (k*35%) 3500 3500 7000 0 0 7000mForeign tax credit (i) 1800 7200 3600 0 0 14400n Net U.S. taxes payable [max(l-m,0)] 1700 0 3400 0 0 0o Total taxes paid (i+n) 3500 7200 7000 0 0 14400p Net amount to U.S. parent (k-o) 6500280013000005600 q Total taxes as separate subs (sum(o)) $10,700$7,000 $14,400Parents consolidated tax statementr Overall FTC limitation (sum(k)*35%) $7,000$7,000$7,000s Total FTCs on a consolidated basis (sum(i)) $9,000$3,600 $14,400t Additional U.S. taxes due [max(0, r-s)] $0$3,400$0u Excess tax credits [max(0,s-r)] $2,000$0$7,400(carried back 2 years or forward 5 years)8.3 a. Low transfer price ($1/btl) High transfer price ($10/btl) P.R. U.S. ConsolidatedP.R.U.S. ConsolidatedRevenue 100,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000COGS100,000 100,000100,000100,000 1,000,000100,000 Taxable income 0 900,000 900,000 900,000 0 900,000Taxes 0315,000 315,00045,0000 45,000Net income 0585,000 585,000 855,000 0 855,000Effective tax on consolidated revenues 31.5% 4.5%Effective tax on taxable income 35.0% 5.0%29Kirt C. Butler, Multinational Finance, 2nd edition30Solutions to End-of-Chapter Questions and Problemsb. If produced in the U.S., Quacks U.S. tax liability would be:(Revenue-Expenses)(tax rate) = ($1,000,000-$50,000)(0.35) = $332,500, or 33.25% of consolidated revenues.After-tax earnings are then $617,500.Based only on tax considerations, Quack will pay less in taxes and have more after-tax cash flow if it produces Metafour in Puerto Rico. This is true even if it uses the relatively unaggressive transfer price of $1/btl on sales to the U.S. parent corporation. Chapter 9 Country RiskAnswers to Conceptual Questions9.1 Define country risk? Define political risk? Define financial risk? Give an example of each different type of country risk.Countryriskreferstothepolitical andfinancial risksof conductingbusinessina particular foreign country. Political risk is the risk that a host government will unexpectedly change the rules of the game under which businesses operate, such as through an election outcome.Financial risk refers to unexpected events in a countrys financial,economic,orbusiness life that impact financial prices, such as an oil price shock in an oil-producing country. 9.2 What factors might contribute to political and to financial risk in a country according to the ICRG country risk rating system? Political RiskServicesInternational CountryRiskGuide(ICRG)ratescountrieson political, economic, andfinancial factors. Political riskfactors include a countrys leadership, corruption, andpolitical tensions. Economicriskfactorsincludeinflation, current account balance, and foreign trade collection experience. Financial risk factors include currency controls, expropriations, contract renegotiations, payment delays, and loan restructurings.9.3 What is the difference between a macro and a micro country risk? Give an example of each different type of country risk.Microcountryrisksarespecifictoanindustry, company, orproject withinahost country, such as a ruling that a particular company is dumping its products (selling below cost) in another country. Macro country risks affect all foreign firms within a host country, such as an unexpected change in a host countrys tax rates.9.4 Howis expropriationincludedinadiscountedcashflowanalysis of aproposed foreign investment? Doesexpropriation impact expected future cash flows? From a discounted cashflow perspective,is it likely to impact the discount rate on foreign investment?31Kirt C. Butler, Multinational Finance, 2nd editionExpropriation occurs when a government seizes foreign assets. This risk clearly affectsexpectedcashflows. It canaffect thediscount ratewheninvestorscannot diversify their investment portfolios against this risk; that is, when it is a systematic risk. 9.5 What is protectionism and how can it impact the multinational corporation?Protectionismrefers toprotection of local industries through tariffs, quotas, and regulations in ways that discriminate against foreign businesses.9.6 What are blocked funds? How might they arise? Blocked funds are cash flows generated by a foreign project that cannot be immediately repatriatedto the parent firm. They most commonly arise from capital flow restrictions imposed by the host government. 9.7 What areintellectual propertyrights?Howaretheyatriskwhenthemultinational corporation has foreign operations?Intellectual property rights include patents, copyrights, and proprietary technologies and processes. Host governmentssometimesprotect local businessesat theexpenseof foreign firms. The multinational corporation must work to minimize the exposure of its intellectual property rights to theft or expropriation by foreign firms or governments. 9.8 What is an investment agreement? What conditions might it include?An investment agreement specifies the rights and responsibilities of a host government and a corporation in the structure and operation of an investment project in the host country. Theagreement shouldspecifytheinvestment andfinancial environments including taxes, concessions, obligations, and restrictions on the multinational corporations operations.It alsoshouldspecifyajurisdictionfor thearbitrationof disputes.9.9 What constitutes an insurable risk? List several insurable political risks. Insurable risks have four elements: (a) The loss is identifiable in time, place, cause, and amount. (b) Alargenumber of individuals or businessesareexposedtotherisk, ideally in an independently and identically distributed manner. (c) The expected loss over the life of the contract is estimable, so that reasonable premiums can be set by the insurer. (d) The loss is outside the influence of the insured.9.10 Whatoperational strategies does the multinational corporation have to protect itself against political risk?In addition to negotiating the environment (perhaps through an investment agreement), the MNC can (a) limit the scope of technology transfer to foreign affiliates, (b) limit dependence on a single partner, (c) enlist local partners to represent the firm in the local environment, (d) use more stringent investment criteria when appropriate, and (e) plan for disaster recovery. 32Solutions to End-of-Chapter Questions and Problems9.11 Does country risk affect investors required return in emerging markets?Erb, Harvey, and Viskanta [Political Risk, Financial Risk and Economic Risk, Financial Analysts Journal52, November/December,1996]found that the low correlationsof emergingmarketstendtoovercomethehigher volatilitiesof these markets, resulting in lower systematic risks than on comparable assets in developed markets. 9.12 Complete the following sentence: Equity returns from a country with high country risk are likely to be _____ (more, less) volatile and have a _____ (higher, lower) beta than those from a country with low country risk. Equity returns from a country with high country risk are likely to be more volatile and have a lower beta than those from a country with low country risk.Problem Solutions9.1 There is not always a clear distinction between political and financial risks. Indeed, financial risks often result from political decisions. In Russias case, the financial risks of investment in Russian have been acerbated by the inability of the Russian government to establish and enforce laws and regulations for the orderly conduct of business. Organized crime and corruption have contributed to poor political, economic,financial country risk ratings in Russia. Governments make a convenient scapegoats, and this hedge fund manager clearly holds the Russian government responsible for his losses. 9.2 Althoughthemost obviousformof expropriationoccurswhenahost government confiscates a companys assets, in fact each type of political risk can be thought of as a form of expropriation. Host governments can appropriate foreign assets for themselves or for local companies through actions that differentially impair nonlocal firms, includingprotectionism, blockedfunds, or theft or misappropriationof intellectual property rights.9.3 a. Total risk is conventionally measured by standard deviation of return. The foreign asset with a standard deviation of i = 0.3 has greater total risk than the domestic asset with a standard deviation of i = 0.2. b. Theforeignassetalsohasgreatersystematicrisk:i= iW(i/W)=(0.3)(0.3/0.1) = 0.9 > i = iW (i /W) = (0.4)(0.2/0.1) = 0.8.9.4 Although the answer to this question will be specific to the chosen country, country risks that turn up usually include factors from the ICRG political risk categories. These factorsincludepolitical risk(leadership, government corruption, internal or external political tensions), economicrisk(inflation, current account balance, orforeigntrade collectionexperience), andfinancial risk(currencycontrols, expropriations, contract renegotiations, payment delays, loan restructurings or cancellations).33Kirt C. Butler, Multinational Finance, 2nd editionChapter 10 Real Options and Cross-Border InvestmentAnswers to Conceptual Questions10.1 What is a real option?A real option is an option on a real asset.10.2 In what ways can managers actions seem inconsistent with the accept all positive-NPV projects rule? Are these actions truly inconsistent with the NPV decision rule?The text discusses three apparent violations of the NPV rule: 1) use of inflated hurdle rates, 2) failure to abandon investments that are losing money, and 3) entry into new or emerging markets and technologies. Each of these apparent violations arises when the NPV decision rule is applied naively - without considering all of the opportunity costs of investing and without considering managerial flexibility in the face of high uncertainty andchangingmarketconditions. The inconsistencies arise from a failure to take into account all of the opportunity costs of investing. Once all opportunity costs are included, managers actions are less likely to be inconsistent with the NPV rule. 10.3 Are managers who do not appear to follow the NPV decision rule irrational?Managersmustconsiderhowthey mightrespond tofuture events.Managers are not actingirrationallyif, throughattempting to value their flexibility in responding to an uncertain world, their actions appear to be inconsistent with the NPV decision rule. They are irrational (or at least near-sighted) if they apply the NPV decision rule in an inflexible way that does not take into account all of the opportunity costs of investing. 10.4 Why is the timing option important in investment decisions?Investments must compete not only with other projects but with versions of themselves initiated at each future date. 10.5 What is exogenous uncertainty? What is endogenous uncertainty? What difference does the form of uncertainty make to the timing of investment?Exogenous uncertainty is outside the control of the firm. Endogenous uncertainty exists when the act of investing reveals information about price or cost. Exogenous uncertainty createsanincentivetodelayinvestment whereasendogenousuncertaintycreates an incentive to speed up investment. 10.6 In what ways are the investment and abandonment options similar?The abandonment option is the flip side of the investment option. Each entails an upfront investment that changes the stream of future cash flows.10.7 Whatisa switching option?What is hysteresis? In what way is hysteresis a form of switching option? A switching option is a sequence of alternating puts and calls. For example, hysteresis occurs when firms fail to enter apparently profitable markets and, once entered, persist in operating at a loss. Hysteresis is a combination of an option to invest and an option to abandon and as such is a form of switching option. 34Solutions to End-of-Chapter Questions and Problems10.8 What are assets-in-place? What are growth options? Assets-in-place are those assets in which the firm has already invested. Growth options are the firms opportunities to lever its existing assets-in-place (including human assets and core competencies) into new products and markets. 10.9 Why does the NPV decision rule have difficulty in valuing managerial flexibility?The biggest difficulty lies in identifying the appropriate discount rate on investment. The discount rate is difficult to determine because: a) options are always more volatile than the asset or assets on which they are based; b) the volatility of an option changes with changeinthevalue(s) of theunderlyingasset(s); andc) returnsonoptionsarenot normally distributed. 10.10 What are the shortcomings of option pricing methods for valuing real assets?Difficulties include: a) identifying the underlying asset or assets; b) specifying the return-generatingprocessoftheunderlyingasset(s); andc)thefact that thevaluesofreal options are not directly observable in the marketplace. Problem Solutions10.1 a. A decision tree represents possible paths to future states of the world as branches on a tree. For Grolschs invest in Dubiety, the decision tree looks like:Invest todayInvest in one yearInvest at Pbeer = D75Invest at Pbeer = D25NPV0D = ?NPV0D |Pbeer=D75 = ?NPV0D |Pbeer= D25 = ? b. Equation (9.2) from the text must be modified to include fixed costs:INVEST TODAY: NPV0=( ) P - V Q- Fi0 INPV(invest today) = [((D50/btl-D10/btl)(1,000,000 btls) - D10,000,000)/0.10] - D200,000,000 = D100,000,000 invest today?c. Equation (9.3) from the text must be modified to include fixed costs:WAIT ONE YEAR: NPV0=( ) P- V Q- Fi(1 i)0 I

]]]+ NPV|Pbeer=D75 = [(((D75/btl-D10/btl)(1,000,000 btls)-D10,000,000)/0.10)/(1.10)]-D200,000,000 = D300,000,000 investNPV|Pbeer=D25= [(((D25/btl-D10/btl)(1,000,000 btls)-D10,000,000)/0.10) / (1.10)]-D200,000,000 35Kirt C. Butler, Multinational Finance, 2nd edition= -D154,545,455 < $0 dont investNPV(wait one year)= [Prob(P1=D75)](NPV|P1=D75)+[Prob(P1=D25)](NPV|P1=D25)= () (D300,000,000) + ()(D0)= +D150,000,000>NPV(invest today)> D0d. Option Value = Intrinsic Value + Time ValueNPV(wait one year) = NPV(invest today) + Opportunity cost of investing todayD150,000,000 =D100,000,000 +D50,000,000e. Wait one period before deciding to invest.10.2 a.Abandon todayAbandon in one yearAbandon at Pbeer =D35Abandon at Pbeer =D15NPV0D = ?NPV0D|Pbeer=D35 = ?NPV0D|Pbeer= D15 = ?b. The problem states that the current price of beer is D15 in perpetuity. The statement inperpetuityclearlycannot holdbecausepricesinoneyear arestatedtobe eitherD15 orD35 with equal probability. Lets assume that the price is currently D15perbottleandwilleitherremainatD15orwill risetoD35bytime1. For simplicity, letsalsoassumeend-of-yearbeerpricesandcashflowssothat we dont have to worry about the path of beer prices during the year. In this setting, thecurrent priceofD15/bottleis irrelevant totheabandonment decision. The expected future price of D25 does matter. (If beer prices throughout the first year either remain at D15 or rise at a constant rate to D35, then the expected price during the first year is not D25 but rather [D15+(D15+D35)] = D20.) Note that if the project is abandoned today at a cost ofD10,000,000, future profits (and cash flow) from the project will be foregone. Hence, there is a minus sign in front of operating cash flow in the NPV equations that follow.At the expected end-of-year price of (D15/btl+D35/btl) = D25/btl, the NPV of the abandon today alternative is:NPV(abandon today)= -[((D25/btl-D20/btl)(1,000,000 btls)-D10,000,000)/0.10]-D10,000,000= D40,000,000 > D0 abandon today?c. If Grolsch management waits one year before making its abandonment decision, beer prices will be either D15 or D35 with certainty.NPV|P1=D35= -[(((D35/btl-D20/btl)(1,000,000 btls)-D10,000,000) /0.10)/(1.10)]-D10,000,000 = -D55,454,545 dont abandon if price rises to D3536Solutions to End-of-Chapter Questions and ProblemsNPV|P1=D15= -[(((D15/btl-D20/btl)(1,000,000 btls)-D10,000,000) /0.10)/(1.10)]-D10,000,000 = D126,363,636 abandon if price falls to D15NPV(wait one year)=[Prob(P1=D35)](NPV|P1=D35)+[Prob(P1=D15)](NPV|P1=D15)= () (D126,363,636) + ()($0)= +D63,181,818>NPV(abandon today)> D0d. Option Value = Intrinsic Value + Time ValueNPV(wait one year) =NPV(abandon today)+Opportunity cost of abandoning today+D63,181,818 = +D40,000,000 + D23,181,818e. Wait one year before making the abandonment decision.10.3 Lets assume that there are in total five breweries, so there are four additional brewery investments if we choose to construct an exploratory brewery. WealreadyknowfromProblem 9.1 thatinvestmentina singlebrewerytoday has value. The issue is whether to invest in all five breweries today or invest in a single exploratory brewery and then make a decision on the four additional breweries in one year after receiving information about the price of beer. a. Decision tree:Invest in all five breweries todayInvest in first breweryNPV0D = D ?If NPV0D > D0, continue to investIf NPV0D < D0, dont invest furtherb. At theexpectedend-of-yearpriceof(D25/btl+D75/btl)=D50/btl, theNPVofa single brewery is:NPV(exploratory brewery)= [((D50/btl-D10/btl)(1,000,000 btls)-D10,000,000)/0.10] - D200,000,000 = D100,000,000 NPV(invest in all five breweries today) = (5) NPV(exploratory brewery) = D500,000,000c. If Grolsch management waits one year before making its investment decision, beer prices will be eitherD25 orD75 with certainty in this problem. Of course, it wont know this until it invests in the first brewery.NPV|Pbeer=D75 = [((D75/btl-D10/btl)(1,000,000 btls)-D10,000,000)/0.10]-D200,000,000= D350,000,000 invest in additional capacityIf Pbeer=D75, investment in four additional breweries at time t=1 yields a net present value at time zero of (4)( D350,000,000/1.10) = D1,272,727,273.37Kirt C. Butler, Multinational Finance, 2nd editionNPV|Pbeer=D25 = [((D25/btl-D10/btl)(1,000,000 btls)-D10,000,000)/0.10]-D200,000,000 = -D150,000,000 < $0 dont invest in additional capacityIf Pbeer=D25, donot invest inadditional capacity. (Infact, youshouldlookinto abandoning this losing venture. But that is a different problem.)NPV(invest in exploratory brewery and continue to invest if it is positive-NPV)= [Prob(P1=D75)] (NPV|P1=D75) + [Prob(P1=D25)] (NPV|P1=D25)= ()[(D350,000,000) +(4)(D350,000,000/1.10)] + ()(-D150,000,000)= +D736,363,636>NPV(invest in all five today)= +D500,000,000 > D0d. Option Value = Intrinsic Value + Time ValueNPV(wait one year) = NPV(invest today) + Opportunity cost of investing infour additional breweries todayD736,363,636 =D500,000,000 +D236,363,636The NPV of investing in all five breweries today is -D236,363,636. Grolsch would not betakingadvantageof theflexibilityprovidedbythetimingoptiononthis sequential investment.e. Invest in an exploratory brewery today and continue to invest if warranted by the quality (and hence market price) of the output.10.4 a. NPV(invest today) = [((R18,000/car-R15,000/car)(10,000cars))/0.20]-R100 million= R50 million invest today?If you wait one year before deciding, then NPV will be either:NPV|C1=R12,000 = [((R18,000/car-R12,000/car)(10,000cars)/0.20]/1.20]-R100 million = R150 million invest, or NPV|C1=R18,000 = [((R18,000/car-R18,000/car)(10,000cars)/0.20]/1.20]-R100 million = -R100 million do not invest (so that NPV = R0). NPV(wait one year)= [Prob(C1=R12,000)](NPV|C1=R12,000) + [Prob(C1=R18,000)](NPV|C1=R18,000)= ()(R150,000,000) + ()(R0) = +75,000,000>NPV(invest today) =R50,000 > R0The time value of this real option reflects the opportunity cost of investing today:Time value = option value less intrinsic value = R75 million - R50 million = R25 million.b. NPV(invest in all 10 plants today) = 10*NPV(invest in one plant today) = R500 millionNPV(invest in exploratory plant and continue to invest in 9 other plants if NPV>0)= [Prob(C1=R12,000)](NPV|C1=R12,000) + [Prob(C1=R18,000)](NPV|C1=R18,000)= ()[(R150 million)+(9)(R150 million/1.20)] + ()(-R100 million) 38Solutions to End-of-Chapter Questions and Problems= +R587.5 million > NPV(invest in all ten today) = R500 million > R0 The opportunity cost of investing in all ten plants today is equal to the time value of this real investment option: time value = option value less intrinsic value = R587.5 million - R500 million = R87.5 million.10.5 This provocative question goes beyond the material in the chapter. It turns out that the impact of areal investment opportunitydependsonwhether it isfirm-specificor shared with other firms in the industry. If a firm has a real investment option that only it can exercise, such as a drug that effectively combats prostate cancer and for which only it has patent approval, then the analysis in this chapter is appropriate. There will be an optimal time to invest and perhaps to exit, and it may pay to make a sequential investment to gain more information. Inasituationinwhichtheentire industryshares aninvestment option(suchas Grolschs proposed investment in Eastern Europe), investment returns are sensitive to competitors actions. Whenexit costs arezero, theeffect of asharedinvestment opportunity is spread across all firms in the industry and results in a lower value to each firm. When there are exit costs, competitive response to uncertainty is asymmetric and firms must be more cautious in their investment decisions. As in the case of hysteresis, firms may stay invested in unprofitable situations in the hope that other less-profitable firms will exit first. Chapter 11 Corporate Governance and the International Market for Corporate ControlAnswers to Conceptual Questions11.1 What does the term corporate governance mean? Why is it important in international finance? Corporategovernancereferstothewayinwhichmajor stakeholders influenceand control the modern corporation. Typically, there is a supervisory board (e.g., the Board of Directors in the U.S.) that represents the most influential stakeholders (debtholders in bank-based systems and equity in market-based systems). The supervisory board monitors the management teamwhich manages the day-to-day operations of the corporation. Theformofcorporate governance determines the particular stakeholders that arerepresentedontheboardandhasamajor largeinfluenceontopexecutive turnover and the market for corporate control. 11.2 In what ways can one firm gain control over the assets of another firm? Direct means of acquiring control over another firms assets include an outright purchase of those assets, a purchase of equity, and through merger or consolidation. Indirect means include joint ventures and collaborative alliances. 11.3 What is synergy? 39Kirt C. Butler, Multinational Finance, 2nd editionWhen the whole is greater than the sum of the parts in a corporate acquisition. 11.4 What isthedifferencebetweenaprivateandapubliccapital market?Whyisthis difference important in corporate governance? Privatecapital markets placedebt andequitythroughdirect placements rather than through public issues. Public capital markets include public issues of debt and equity. Bank-basedsystemsof corporategovernanceareusuallydominatedbyprivatedebt markets. Market-basedsystemsof corporategovernancearedominatedbyrelatively anonymous public debt and equity markets. Private capital markets often lead to concentrations of debt and equity ownership and facilitate the influence of commercial banks. Public capital markets result in dispersed ownership and relatively anonymous owners. This frees management from scrutiny by a single stakeholder. 11.5 Describe several differences in the role of commercial banks in corporate governance in Germany, Japan, and the United States. Commercial governance in the United States is dominated by the public debt and equity capital markets. Commercial banks intheU.S. havebeenconstrainedbytheU.S. Congress in the influence that they can exert over U.S. corporations. For example, the Glass-Steagall Act of 1933 prohibited banks from owning stock except in trust, actively voting shares heldin trust for their clients,or acting as investment bankers or equity brokers. Banks in Germany are not constrained in any of these ways. While banks in Japan cannot own more than 5% of the equity of any single company, the share cross-holdings in Japans keiretsu place Japanese banks in a more prominent role than their counterparts in the United States. For these reasons, German banks are more influential in corporate governance than Japanese banks and Japanese banks are more influential than U.S. banks in corporate governance. 11.6 Whyarehostileacquisitionsless common in Germany and Japan than in the United Kingdom and the United States? Corporate governance inGermany and Japan is characterized by debt and equity ownership that is concentrated in the hands of one or more major stakeholders. Management in Germany and Japan is much more closely tied to this major stakeholder than their counterparts in the U.K. and the U.S. Consequently, acquisitions in Germany and Japan are difficult to accomplish without the consent and cooperation of this major stakeholder or stakeholders. The relatively dispersed equity ownership in the U.K. and U.S. allow hostile suitors to appeal directly to the public markets through a tender offer. Tender offersintheU.K. andU.S. mayormaynotbeincooperationwithcurrent management. 11.7 How is turnover in the ranks of top executives similar in Germany, Japan and the United States? How is it different?The why and when of top executive turnover is similar in these countries. Top executives innon-performingcompanies arelikelytobereplaced. Thehowof topexecutive turnover differs, however. Top executive turnover is initiated and executed by the lead bank in Germany, by the keiretsu (perhaps by the main bank) in Japan, and by the public 40Solutions to End-of-Chapter Questions and Problemsmarket for corporate control in the United States.11.8 Who are the likely winners and losers in domestic mergers and acquisitions that involve two firms incorporated in the United States? Target shareholders gain while bidding firm shareholders may or may not win. Bidding firm shareholders are more likely to win: a) when cash is offered rather than stock, b) when the firm does not have a lot of free cash flow, and c) when management has a large ownership stake in the firm.11.9 In what ways are the winners and losers in cross-border mergers and acquisitions the same as in domestic mergers and acquisitions? In what ways do they differ?Shareholdersofthebiddingfirmare more likely towininacross-border mergeror acquisition. Target firm shareholders win in either case. As with domestic acquisitions, bidders are more likely to win if the bidding firm does not have a great deal of free cash flow or profitability. Empirical evidence also suggests that bidding firms are more likely to win in a cross-border acquisition if: a) the firm has intangible assets (e.g., patents) that can be exploited in new markets, b) the firm has prior international experience, c) the firm is acquiring a firm in a related business, and d) the firm is entering a market for the first time. 11.10 Why might the shareholders of bidding firms lose when the bidding firm has excess free cash flow or profitability? Jensens free cash flow hypothesis suggests that managers are more likely to waste shareholders capital onpoor investments whenthereis alot of freecashflow(or profitability) around. Whenthingsaretight, capital constraintsaremorelikelytobe imposed by the market and managers cannot as easily rationalize wasteful expenditures.11.11 How are gains to bidding firms related to exchange rates? Empirical studies findthat astrongdomesticcurrencyleads tobothmoreforeign acquisitions and to higher bidder returns.Problem Solutions11.1 a.Eb.Dc.Fd.Ae.Bf.Gg.C11.2 The pre-acquisition value of the two firms is $3 billion + $1 billion = $4 billion. Synergy is10%ofthisvalue, or(0.1)($4billion) =$400,000. After subtractingthe(0.2)($1 billion) = $200,000 acquisition premium from the $400,000 synergy, Agile shareholders arelikelytoseea$200,000appreciationinthevalueof their shares. Statedas a percentage return in the combined firm, this is an increase of ($200,000)/($4,400,000) = 41Kirt C. Butler, Multinational Finance, 2nd edition4.5% to Agile shareholders.11.3 The BP-Amoco deal was lauded in the financial press for combining BPs strengths in oil exploration and development with Amocos refining and distribution capabilities. Amocostockjumpedabout 26percent toarecordhighof521/8immediatelyafter announcement of the deal. BP stock price rose modestly, along with other oil issues. This share price behavior is typical of a domestic acquisition in that the target firm was a clear winner while the acquiring firm neither gained nor lost. 11.4 a. Managers like free cash flow because it makes expansion possible without resort to external capital markets for financing. Unfortunately, the existence of free cash flowalsomakesit morelikelythat management will wasteresourcesonnew ventures in which it has no business (Jensen [1986]). When cash flow is scarce, managers are more likely to pick winning ventures. b. First-timeentrantsoftenhaveinterestingopportunitiesbut alsofacenewrisks. Returns are not significantly different from zero for firms entering the international arena through a foreign acquisition for the first time (Doukas and Travlos [1988]). c. Acquisitions into unrelated businesses in other countries tend to result in losses for the shareholders of acquiring firms (Markides and Ittner [1994]). If you want to increase your international operations, stick to what you know best - chemicals. d. Although prior international experience is valuable, you have to start somewhere. Acquisitions of companies in related businesses tend to result in gains to acquiring firms (Markides and Ittner [1994]). Experience in southern Europe will also prove useful in Portuguese-speaking Brazil and the rest of Spanish-speaking Latin America. Not all of your VPs ideas are bad.11.5 A real increase in the value of the domestic currency increases the purchasing power of domestic residents. Froot and Stein [1991] suggest that an informational asymmetry between inside managers and outside investors can make outside capital more expensive than inside capital, which can preferentially benefit bidders that see their currency rise in real terms. If an increase in the real value of the domestic currency forces foreign companies toaccess capital markets to fundacquisitions whereas domestic companies can fund acquisitions with cash, then domestic companies enjoy an advantage in the presence of this informational asymmetry. 11.6 Several dealswererumoredinearly1999. Suitorsfor Nissansequityor Volvos assets included Ford Motor Company of the U.S., Daimler-Chrysler of Germany, and Renault of France. A search of your library database will reveal whether any of these deals actually came to fruition. 11.7 a. Recent restructurings include the 1995 merger of Mitsubishi Bank with the Bank of Tokyo, the 1998 merger of Sumitomo Trust with Long-Term Credit Bank, and the 1998 merger of Mitsui Trust with Chuo Trust. Japan recently passed a bridge banklawtoassist troubledbanks, soother mergers andacquisitions (either privately arranged or forced by the government) are sure to follow. b. It aint business as usual for Japanese companies. Several key keiretsu members haverecentlyrefusedtobail out their banking affiliates. Through 1998, Toyota 42Solutions to End-of-Chapter Questions and Problemshaddeclinedtobail out SakuraBankintheMitsui keiretsudespiteits long relationship with the bank. Troubled companies are increasingly turning overseas for additional investment rather thantotheir keiretsupartners. In1998, Zexel Corp. (a supplier to Isuzu Motor of diesel engines and air conditioners) obtained new equity investment and technology from the German auto parts supplier Bosch. Cross-border investments into Japan are increasingly easy to document. c. This revered convention is gradually disappearing as Japanese companies struggle for flexibility in their cost structures. PART IV The Multinational Corporations Financial DecisionsChapter 12 Multinational Treasury ManagementAnswers to Conceptual Questions12.1 What is multinational treasury management?Multinational treasurymanagement involvesfivefunctions: 1)set overall financial goals, 2) manage the risks of international transactions, 3) arrange financingfor international trade, 4) consolidate and manage the financial flows of the firm, and 5) identify, measure, and manage the firms risk exposures. 12.2 What function does a firms strategic business plan perform?Thestrategicbusinessplanperforms the following functions: 1) identify the firms core competencies and potential growth opportunities, 2) evaluate the business environment within which the firm operates, 3) formulate a comprehensive strategic plan for turning the firms core competencies into sustainable competitive advantages, 4) develop robust processes for implementing the strategic business plan.12.3 Why is international trade more difficult than domestic trade?International tradeisdifficult largelybecauseofinformationcosts. Exportersmust ensure timely payment fromfar-away customers. Importers must ensure timely deliveryof quality goods or services. Also, dispute resolution is difficult across multiple jurisdictions. 12.4 Why use a freight forwarder?A freight shipper coordinates the logistics of transportation and documentation, which can be formidable on international shipments. 12.5 Describe four methods of payment on international sales.Thefourmethodsareopenaccount, cashinadvance, drafts, andlettersofcredit. Under an open account, the seller bills the buyer upon delivery of the goods. In cash in advance, thebuyer payspriortoreceivingshipment. Adraft isusedtopayupon deliveryandis like acheckor moneyorder. Abankletter of credit guarantees payment upon presentation of the specified trade documents.12.6 What is a bankers acceptance, and how is it used in international trade? 43Kirt C. Butler, Multinational Finance, 2nd editionA bankers acceptance is a time draft drawn on a commercial bank in which the bank promisestopaytheholderofthe drafta stated amountona specified futuredate. Bankersacceptancesare negotiable and so may be sold by the exporter to finance working capital. 12.7 What is discounting, and how is it used in international trade?Discounting is the purchase of a promised payment at a discount from face value.12.8 How is factoring different from forfaiting?Factoring is the sale of accounts receivable. Forfaiting is a form of factoring involving medium- to long-term receivables with maturitie