Multinational, Instructor's Manual

Chapter 1726 Multinational Financial Management ANSWERS TO END-OF-CHAPTER QUESTIONS

1726-1 a. A multinational corporation is one that operates in two or more countries.

b. The exchange rate specifies the number of units of a given currency that can be purchased for one unit of another currency. The fixed exchange rate system was in effect from the end of World War II until August 1971. Under the system, the U. S. dollar was linked to gold at the rate of $35 per ounce, and other currencies were then tied to the dollar. Under the floating exchange rate system, which is currently in effect, the forces of supply and demand are allowed to determine currency prices with little government intervention.

c. A country has a deficit trade balance when it imports more goods from abroad than it exports. Devaluation is the lowering, by governmental action, of the price of its currency relative to another currency. For example, in 1967 the British pound was devalued from $2.80 per pound to $2.50 per pound. Revaluation, the opposite of devaluation, occurs when the relative price of a currency is increased.

d. Exchange rate risk refers to the fluctuation in exchange rates between currencies over time. A convertible currency is one which can be traded in the currency markets and can be redeemed at current market rates. When an exchange rate is pegged, the rate is fixed against a major currency such as the U. S. dollar. Consequently, the values of the pegged currencies move together over time.

e. Interest rate parity holds that investors should expect to earn the same return in all countries after adjusting for risk. Purchasing power parity, sometimes referred to as the “law of one price,” implies that the level of exchange rates adjusts so that identical goods cost the same in different countries.

f. The spot rate is the exchange rate which applies to “on the spot” trades, or, more precisely, exchanges that occur two days following the day of trade. In other words, the spot rate is for current exchanges. The forward exchange rate is the prevailing exchange rate for exchange (delivery) at some agreed-upon future date, usually 30, 90, or 180 days from the day the transaction is negotiated. Forward exchange rates are analogous to future prices on commodity exchanges. Discounts (or premiums) on forward rates occur when the forward exchange rate differs from the spot rate. When the forward rate is below the spot rate, the forward rate is said to be at a discount. Conversely, when the forward rate is above the spot rate, it is said to be at a premium.

Answers and Solutions: 1726 - 1 g. Repatriation of earnings is the cash flow, usually in the form of dividends or royalties, from the foreign branch or subsidiary to the parent company. These cash flows must be converted to the currency of the parent, and thus are subject to future exchange rate changes. A foreign government may restrict the amount of cash that may be repatriated. Political risk refers to the possibility of expropriation and to the unanticipated restriction of cash flows to the parent by a foreign government.

h. A Eurodollar is a U. S. dollar on deposit in a foreign bank, or a foreign branch of a U. S. bank. Eurodollars are used to conduct transactions throughout Europe and the rest of the world. An international bond is any bond sold outside of the country of the borrower. There are two types of international bonds: Eurobonds and foreign bonds. A Eurobond is any bond sold in some country other than the one in whose currency the bond is denominated. Thus, a U. S. firm selling dollar bonds in Switzerland is selling Eurobonds. A foreign bond is a bond sold by a foreign borrower but denominated in the currency of the country in which the issue is sold. Thus, a U. S. firm selling bonds denominated in Swiss francs in Switzerland is selling foreign bonds.

i. The Euro is a currency used by the nations in the European Monetary Union who signed the Treaty of Mastricht.

1726-2 The U. S. dollar. The primary reason for using the dollar was that it provided a relatively stable benchmark, and it was accepted universally for transaction purposes.

1726-3 Under the fixed exchange rate system, the fluctuations were limited to +1% and -1%. Under the floating exchange rate system, there are no agreed-upon limits.

1726-4 A dollar will buy more Swiss francs.

1726-5 There will be an excess supply of dollars in the foreign exchange markets, and thus, will tend to drive down the value of the dollar. Foreign investments in the United States will increase.

1726-6 Taking into account differential labor costs abroad, transportation, tax advantages, and so forth, U. S. corporations can maximize long-run profits. There are also nonprofit behavioral and strategic considerations, such as maximizing market share and enhancing the prestige of corporate officers.

Answers and Solutions: 1726 - 2 1726-7 The foreign project’s cash flows have to be converted to U. S. dollars, since the shareholders of the U. S. corporation (assuming they are mainly U. S. residents) are interested in dollar returns. This subjects them to exchange rate risk, and therefore requires an additional risk premium. There is also a risk premium for political risk (mainly the risk of expropriation). However, foreign investments also help diversify cash flows, so the net effect on the required rate of return is ambiguous.

1726-8 A Eurodollar is a dollar deposit in a foreign bank, normally a European bank. The foreign bank need not be owned by foreigners--it only has to be located in a foreign country. For example, a Citibank subsidiary in Paris accepts Eurodollar deposits. The Frenchman’s deposit at Chase Manhattan Bank in New York is not a Eurodollar deposit. However, if he transfers his deposit to a bank in London or Paris, it would be. The existence of the Eurodollar market makes the Federal Reserve’s job of controlling U. S. interest rates more difficult. Eurodollars are outside the direct control of the U. S. monetary authorities. Because of this, interest rates in the U. S. cannot be insulated from those in other parts of the world. Thus, any domestic policies the Federal Reserve might take toward interest rates would be affected by the Eurodollar market.

1726-9 No, interest rate parity implies that an investment in the U. S. with the same risk as a similar investment in a foreign country should have the same return. Interest rate parity is expressed as:

Forwardrate 1 rh  . Spot rate 1 rf

Interest rate parity shows why a particular currency might be at a forward premium or discount. A currency is at a forward premium whenever domestic interest rates are higher than foreign interest rates. Discounts prevail if domestic interest rates are lower than foreign interest rates. If these conditions do not hold, then arbitrage will soon force interest rates back to parity.

1726-10 Purchasing power parity assumes there are neither transaction costs nor regulations which limit the ability to buy and sell goods across different countries. In many cases, these assumptions are incorrect, which explains why PPP is often violated. An additional complication, when empirically testing to see whether PPP holds, is that products in different countries are rarely identical. Frequently, there are real or perceived differences in quality, which can lead to price differences in different countries.

Answers and Solutions: 1726 - 3 SOLUTIONS TO END-OF-CHAPTER PROBLEMS

1726-1 $1 = 9 Mexican pesos; $1 = 111.23 Japanese yen; Cross exchange rate, yen/peso = ?

Dollar Yen Yen Cross Rate:  = . Peso Dollar Peso

Note that an indirect quotation is given for Mexican; however, the cross rate formula requires a direct quotation. The indirect quotation is the reciprocal of the direct quotation. Since $1 = 9 pesos, then 1 peso = $0.1111.

Yen/Peso = 0.1111 dollars per peso  111.23 yen per dollar = 12.358 yen per peso.

1726-2 rNom, 6-month T-bills = 7%; rNom of similar default-free 6-month Japanese bonds = 5.5%; Spot exchange rate, e0: 1 Yen = $0.009; 6-month forward exchange rate = ft = ?

f (1 r ) t  h . e0 (1 rf )

rf = 5.5%/2 = 2.75%.

rh = 7%/2 = 3.5%.

e0 = $0.009.

f 1.035 t = $0.009 1.0275

1.0275 ft = $0.00932

ft = $0.00907.

The 6-month forward exchange rate is 1 yen = $0.00907.

Answers and Solutions: 1726 - 4 1726-3 U. S. T.V. = $500; French T.V. = 550 euros; Spot rate between euro and dollar = ?

Ph = Pf(e0) $500 = 550 euros(e0) 500/550 = e0 $0.9091 = e0.

1 euro = $0.9091 or $1 = 1 / 0.9091 = 1.1000 euros.

1726-4 Dollars should sell for 1/1.50, or 0.6667 pounds per dollar.

1726-5 The price of Swiss francs is $0.60 today. A 10 percent appreciation will make it worth $0.66 tomorrow. A dollar will buy 1/0.66 = 1.5152 Swiss francs tomorrow.

1726-6 Cross rate = Swiss francs/dollars  dollars/pounds = Swiss francs/pounds = 1.6  1.5 = 2.4 Swiss francs per pound.

1726-7 Spot rate = 1 yen = $0.0086; ft = 1 yen = $0.0086; rNom of 90-day Japanese risk-free securities = 4.6%; rNom of 90-day U. S. risk-free securities = ?

f (1 r ) t  h . Spot rate (1 rf )

rf = 4.6%/4 = 1.15%; rh = ?

(1 rh ) 1 = 1.0115 1 + rh = 1.0115 rh = 0.0115.

rNom = 1.15%  4 = 4.6%.

Answers and Solutions: 1726 - 5 1726-8 $1 = 7.8 pesos; CD = $15.00; Price of CD in Mexico = ?

Ph = Pf(Spot rate).

1 Peso = 1/7.8 = $0.1282.

$15 = Pf($0.1282) $15 = 117 pesos. $0.1282

Check: Spot rate = $15/117 pesos = $0.1282 for 1 peso.

1726-9 The U. S. dollar liability of the corporation falls from $0.75(5,000,000) = $3,750,000 to $0.70(5,000,000) = $3,500,000, corresponding to a gain of 250,000 U. S. dollars for the corporation. However, the real economic situation might be somewhat different. For example, the loan is presumably a long-term loan. The exchange rate will surely change again before the loan is paid. What really matters, in an economic sense, is the expected present value of future interest and principal payments denominated in U. S. dollars. There are also possible gains and losses on inventory and other assets of the firm. A discussion of these issues quickly takes us outside the scope of this textbook.

1726-10 a. The automobile’s value has increased because the dollar has declined in value relative to the yen.

b. 245/108 = 2.2685, so $8,000  2.1491 = $18,148.00.

Note that this represents a 4.9% compound annual increase over 17 years.

Answers and Solutions: 1726 - 6 1726-11 a. SFr. 1,000,000 (1.6590 $/SFr.) = $1,659,000, or

SFr. 1,000,000 / $0.6028 = $1,658,925. (Difference is due to rounding.)

b. SFr. 1,000,000/SFr. 0.6075 = $1,646,091, or FF. 1,000,000  $1.6460 = $1,646,000.

c. If the exchange rate is SFr. 0.500 to $1 when payment is due in 3 months, the SFr. 1,000,000 will cost:

SFr. 1,000,000/SFr. 0.500 = $2,000,000,

which is more than the spot price today and more than purchasing a forward contract for 90 days.

1726-12 a. rNom of 90-day U. S. risk-free securities = 5%; of 90-day German risk-free securities = 5.3%; Spot rate = 1 euro = $0.80; ft selling at premium or discount = ?

f t (1 rh )  . Spot rate (1 rf )

rh = 5%/4 = 1.25%; rf = 5.3%/4 = 1.325%; Spot rate = $0.80.

f 1.0125 t = $0.80 1.01325 f t = 0.9993. $0.80

ft = $0.7994.

The forward rate is selling at a discount, since a euro buys fewer dollars in the forward market than it does in the spot. In other words, in the spot market $1 would buy 1/0.80 = 1.25 euros, but at the forward rate $1 would buy 1/0.7994 = 1.2509 euros; therefore, the forward currency is said to be selling at a discount.

b. The 90-day forward rate is ft = $0.7994.

Answers and Solutions: 1726 - 7 1726-13 D1 = 3 pounds; Exchange rate = $1.60/pound; Pound depreciates 5% against $1. Dividend grows at 10% and rs = 15%. 10 million shares outstanding.

1.10 g = – 1 = 4.7619%. 1.05

D1 P0 = rs  g 3  $1.60 = (0.15  0.047619) $4.80 = 0.102381 = $46.88372093.

Total equity = $46.88372093  10 million shares = $468,837,209.

1726-14 a. If a U.S. based company undertakes the project, the rate of return for the project is a simple calculation, as is the net present value.

NPV = -$1,000 + $1,200/1.14 = $52.63.

Rate of return = $1,200/$1,000 – 1 = 20%.

b. According to interest rate parity, the following condition holds:

Forward exchange rate 1 rSwiss = Spot exchange rate 1 rUS Forward exchange rate 1.045 = 1.62 1.0725 Forward exchange rate = 0.97436 1.62 Forward exchange rate = 1.5785 SF per U.S. $.

Answers and Solutions: 1726 - 8 c. First, we must adjust the cash flows to reflect Solitaire's home currency.

Year CF ($) CF (SFrancs) 0 -1,000 -1,620.00 1 1,200 1,894.15

Using the Swiss Franc-denominated cash flows, the appropriate NPV and rate of return can be found.

NPV = -1,620 + 1,894.15/1.14 = 41.54 Swiss Francs.

Rate of return = 1,894.15 SF/1,620 SF – 1 = 16.92%.

Answers and Solutions: 1726 - 9 SOLUTION TO SPREADSHEET PROBLEM 1726-15 The detailed solution for the spreadsheet problem, Solution for FM12 CF3 Ch 26 17 P15 Build a Model.xls, is available at the textbook’s Web site.

Answers and Solutions: 1726 - 10 MINI CASE

Citrus Products Inc. is a medium-sized producer of citrus juice drinks with groves in Indian River County, Florida. Until now, the company has confined its operations and sales to the United States, but its CEO, George Gaynor, wants to expand into Europe. The first step would be to set up sales subsidiaries in Spain and Sweden, then to set up a production plant in Spain, and, finally, to distribute the product throughout the European Common Market. The firm’s financial manager, Ruth Schmidt, is enthusiastic about the plan, but she is worried about the implications of the foreign expansion on the firm’s financial management process. She has asked you, the firm’s most recently hired financial analyst, to develop a 1-hour tutorial package that explains the basics of multinational financial management. The tutorial will be presented at the next board of director’s meeting. To get you started, Schmidt has supplied you with the following list of questions. a. What is a multinational corporation? Why do firms expand into other countries?

Answer: Use the examples given here when discussing why firms “go international.”

1. To seek new markets. Coca-Cola and McDonald’s have expanded around the world to seek new markets. Likewise, Sony, Toshiba, and other Japanese consumer electronics manufacturers have aggressively pushed into the u. S.

2. To seek raw materials. U. S. Oil companies have searched around the world for years for new sources of oil. It is not surprising that a large company like Chevron has oil production facilities not only in the continental U. S. and Alaska, but also in the North Sea, Nigeria, Angola, and Australia. Currently, the company is trying to get a foothold in the Soviet Union.

3. To seek new technology. No one country has the lead in all technologies, so many companies are going global to ensure access to new technologies. For example, in the last several years, there have been four joint ventures between Japanese and American chip manufacturers for the sole purpose of exchanging technology.

4. To avoid political and regulatory hurdles. The most prominent example here is the move by Toyota, Honda, Mazda, and Mitsubishi to produce cars and trucks in the U. S. to avoid import quotas.

Mini Case: 1726 - 11 5. To diversify. By establishing worldwide production facilities and markets, firms can cushion the impact of adverse economic trends in any single country. b. What are the six major factors which distinguish multinational financial management from financial management as practiced by a purely domestic firm?

Answer: 1. Different currency denominations. Cash flows in various parts of multinational corporate systems will be denominated in different currencies. Hence, an analysis of exchange rates, and the effect of fluctuating currency values, must be included in all financial analyses.

2. Economic and legal ramifications. Each country in which a firm operates will have its own unique political and economic institutions, and institutional differences can cause significant problems when the corporation tries to coordinate and control worldwide operations. For example, tax laws vary from country to country, and what makes sense in one country regarding taxes may not in another. Similarly, differences in legal systems, such as the common law of Great Britain versus French civil law, complicate legal matters.

3. Language differences. The ability to communicate is critical in all business matters, and U. S. business men and women have been notoriously poor in learning other languages. In effect, it is easier for foreign firms to invade our markets than for us to invade theirs. It is interesting to note, though, that English has become the international business language. Many business school programs in Europe, for example, Nijenrode in the Netherlands, are conducted in English rather than in the host country’s language. Also, some multinational companies, such as ABB, a large Swedish firm headquartered in Zurich, have adopted English as the language of corporate communication. Although English is now spoken by most international business people, knowledge of other languages remains critical to the success of multinational firms.

4. Cultural differences. Different countries, and even different regions in a single country, have unique cultural heritages that shape values and influence the role of business in the society. Such differences affect consumption patterns, defining the appropriate firm goals, attitudes toward risk taking, dealings with employees, and so on. For example, most Japanese workers view their jobs as a lifetime commitment, while many American workers view theirs as temporary until something better comes along. To give another illustration, consider PepsiCo’s move into the Japanese market by its Frito-Lay subsidiary. At first, Frito-Lay marketed popular American products such as Ruffles potato chips and Doritos corn chips. These products did poorly, and the Japanese venture almost failed,

Mini Case: 1726 - 12 but it was saved when the company began producing a chip with soy sauce and seaweed flavoring.

5. Role of governments. Except for certain industries, the role of government in the U. S. is to create an environment which promotes free enterprise and competition. However, in many countries, the government takes a much more active role in business affairs, and in some countries, a multinational firm must deal directly with the government to conduct business.

6. Political risk. Nations exercise sovereign rights over their people and property. Thus, a government can seize the assets of a multi-national corporation, or restrict the repatriation of earnings from the country, and the affected company has no recourse for recovery.

c. Consider the following illustrative exchange rates.

U. S. Dollars required to buy one unit of foreign currency Euro 0.80001.2500 Swedish krona 0.10001481

1. Are these currency prices direct quotations or indirect quotations?

Answer: Since they are the prices of foreign currencies expressed in dollars, they are direct quotations. c. 2. Calculate the indirect quotations for Euros and Kronasronor.

Answer: Indirect quotations, which are the number of units of foreign currency that can be purchased with one U. S. Dollar, are merely the reciprocal of the direct quotation. Here, the table is repeated with the indirect quotations added:

Direct quotation: Indirect quotation: U. S. Dollars required number of units of to buy one unit of foreign currency per foreign currency U. S. Dollar Euro 0.1.258000 10.802500 Swedish krona 0.1481000 106.75220000

Mini Case: 1726 - 13 c. 3. What is a cross rate? Calculate the two cross rates between euros and kronasronor.

Answer: The exchange rate between any two currencies which does not involve U. S. Dollars is a cross rate. Here are the two cross rates between euros and kronasronor:

Euros Dollars Cross rate =  Dollar Krona = 1.25  0.1000 = 0.125 euros per krona.

Kronor Dollars And, Cross rate =  Dollar Euros = 10.006.7522  0.80001.2500 = 8.440300 kronasronor per euro.

Euros per krona cross rate = 1/(8.4403 kronor per euro) = 0.1185 euros per krona.

Note that the two cross rates are reciprocals of one another. Also, note that the cross rates can be calculated by dividing either the direct or indirect quotations. Thus, there are numerous ways of calculating cross rates. c. 4. Assume citrus products can produce a liter of orange juice and ship it to Spain for $1.75. If the firm wants a 50 percent markup on the product, what should the orange juice sell for in Spain?

Answer: There are 200.00 pesetas0.8000 eurso per to the dollar, so the juice must sell for ($1.75)(1.50)(1.250.8000) = 3.282.10 euros. c. 5. Now assume Citrus Products begins producing the same liter of orange juice in Spain. The product costs 2.0 euros to produce and ship to Sweden, where it can be sold for 20 kronasronor. What is the dollar profit on the sale?

Answer: 2.0 euros are equal to 2.0(8.00 4403 kronasronor/euro) = 16.88 kronasronor, so the profit on the sale in Sweden is 20 – 16.88 = 4 3.12 kronasronor. Now, there are 0.1000 1481 dollars per krona, so the dollar profit is 43.12(0.10001481) = $0.4046.

Mini Case: 1726 - 14 c. 6. What is exchange rate risk?

Answer: The volatility inherent in a floating exchange rate system increases the uncertainty of cash flows that must be translated from one currency into another. This increase in uncertainty is exchange rate risk. d. Briefly describe the current International Monetary System. How does the current system differ from the system that was in place prior to August 1971?

Answer: Prior to 1971, the world operated on a fixed exchange rate system. The value of the U. S. Dollar was linked to gold at the fixed price of $35 per ounce, and the values of other currencies were then tied to the dollar. For example, in 1964, the British pound was fixed at $2.80 for 1 pound, with a 1 percent permissible fluctuation around this rate. Thus, the British government had to regularly intervene in the foreign exchange market to keep the pound in the range of $2.77 to $2.83. When the pound fell, the Bank of England had to buy pounds, offering either foreign currencies or gold in exchange. Conversely, if the pound reached the top of the range, the Bank of England would sell pounds. The official exchange rates were occasionally “reset” to reflect changing economic conditions. The current international monetary system for most industrialized nations is a floating rate system. In this system, currency exchange rates are allowed to fluctuate in response to market conditions with a minimum of governmental intervention. Changes in currency demand can be due to trade deficits (i.e., one nation imports more from another nation than it exports, causing there to be higher relative demand for the currency of the bigger exporter). It can also be due to capital movements. For example, if interest rates are relatively high in one country, then investors might seek to purchase that country’s securities, which increases demand for that country’s currency. Central banks, like the U. S. Federal Reserve and the Bank of England, do intervene in the currency markets to smooth out fluctuations, but it is impossible for a central bank to permanently prop up a weak currency. Also, governments do enter into agreements to try to keep currencies within predetermined ranges. However, if market forces move the exchange rate outside one of these ranges, there is little that the countries can do other than adjust the target range.

Twelve Fifteen participating countries in the European Monetary Union now (as of early 2008) use the “euro.” The newly formed European Central Bank will controls the monetary policy of the EMU nations using the Euro. Many countries still used a fixed exchange rate that is “pegged,” or fixed, with respect to another currency. Examples of pegged currencies are the Chinese yuan, which is pegged at about 8.3 yuan/dollar (in mid 2004)to the dollar and the Chad CFA franc, which is pegged to the French franc which is pegged to the euro.

Mini Case: 1726 - 15 When a currency increases in value relative to another currency, it is said to appreciate. Under the fixed exchange rate system, strong currencies had to be revalued occasionally, which changed the tie to other currencies to a new, higher rate. Conversely, a currency that loses value is said to depreciate, and such currencies had to be devalued under the old fixed rate system. e. What is a convertible currency? What problems arise when a multinational company operates in a country whose currency is not convertible?

Answer: A currency is convertible when it is traded on the world currency exchanges and when the issuing country stands ready to redeem the currency at market rates. When a country’s currency is not convertible, it is difficult for multinational companies to conduct business in that country, because there is no easy way to return profits earned to the company’s home country. Often, in this situation, it is necessary to engage in some kind of barter arrangement to promote investment. f. What is the difference between spot rates and forward rates? When is the forward rate at a premium to the spot rate? At a discount?

Answer: Spot rates are the rates paid to buy currency for immediate delivery (actually, two days after the date of the trade). Forward rates are the rates paid to buy currency for delivery at some agreed-upon date in the future (say, 90 days). If the forward currency is less valuable than the spot currency, the forward rate is said to be at a discount to the spot rate. Conversely, if the forward currency is more valuable than the spot currency, the forward currency is said to sell at a premium. Firms use currency forward markets to hedge against adverse exchange rate fluctuations that might occur before a transaction is completed. To illustrate, suppose a U. S. importer buys German appliances for sale in the U. S. The terms are net 90, so the importer must pay in German marksEuros in 90 days. The dollar could weaken against the mark Euro over the period, and hence force the importer to use more dollars to buy the merchandise. To guard against this possibility, the importer could buy marks Euros for delivery in 90 days, thus locking in the current forward rate.

Mini Case: 1726 - 16 g. What is interest rate parity? Currently, you can exchange 1 euro for 0.81001.2700 dollars in the 180-day forward market, and the risk-free rate on 180-day securities is 6 percent in the United States and 4 percent in Spain. Does interest rate parity hold? If not, which securities offer the highest expected return?

Answer: Interest rate parity holds that investors should expect to earn the same return in all countries after adjusting for risk. What is the implied forward rate, given the spot rate of 0.8000?

Spot rate = 1 euro = $1.25000.8000; rh = 6%/2 = 3.00%; rf = 4%/2 = 2.00%.

f 1 r t  h Spot rate 1 rf f 1.03 t  1.2500 1.02 ft  $1.2623.

If interest rate parity held, then ft = $0.80781.2623; however, ft = $0.81001.2700, so parity doesn’t hold.

The Spanish securities offer the highest return as calculated below:

1. Assume you convert $1,000 to pesetas in the spot market. In the spot market, spot 1 rate = or 0.8001.250 euros per dollar. Convert $1,000  1.250.8000 $0.8000 euros/dollar = 1,250800 euros.

2. Invest 1,250800 euros in the 180-day Spanish security which offers a semi-annual return of 4%/2 = 2%. So, in 180 days you will receive 1,250800 pesetas  1.02 = 816 1,275 euros.

3. Agree today to exchange the 1,275800 euros 180 days from now at a 180-day forward exchange rate of ft = 0.81001.2700 dollars per euro. Your dollar return after 180 days = 1,275800 euros x 0.81001.2700 dollars per euro= $1,032.75036.32.

4. The investment’s expected 180-day return = $32.7536.32/$1,000 = 0.03275 03632 = 3.2753.632%, or a nominal return of 2  3.2753.632% = 6.557.26%.

Mini Case: 1726 - 17 h. What is purchasing power parity? If grapefruit juice costs $2.00 a liter in the United States and purchasing power parity holds, what should be the price of grapefruit juice in Spain?

Answer: Purchasing power parity, sometimes referred to as the law of one price (LOP), implies that the level of exchange rates adjusts so that identical goods cost the same amount in different countries.

Purchasing power parity = Ph = Pf(Spot rate) Spot rate = Ph/Pf $0.80001.2500 = $2.00/Pf Pf = $2.00/$0.80001.2500 = 2.501.60 EUROSeuros. i. What impact does relative inflation have on interest rates and exchange rates?

Answer: To illustrate, consider the situation between Japan and the U. S. Japan has generally had a lower inflation rate than the U. S., so Japanese interest rates have been lower than U. S. interest rates. This might tempt treasurers of U. S. multinational firms to borrow in Japan rather than in the U. S. However, a foreign currency will, on average, depreciate (or appreciate) at a percentage rate approximately equal to the amount by which its inflation rate exceeds (or is less than) our own. Thus, the dollar has generally weakened against the yen over time, so it would take more and more dollars to pay back interest denominated in yen.

Mini Case: 1726 - 18 j. Briefly discuss the international capital markets.

Answer: Individuals buy securities issued by foreign governments and firms, and U. S. Firms issue securities abroad. These transactions take place in the international capital markets. Here is a brief description of the major international capital markets:

1. A eurodollar is a U. S. dollar deposited in a bank outside the United States. The major difference between a “regular” dollar and a eurodollar is its location. This places eurodollars outside the direct control of U. S. monetary authorities, so regulations such as fractional reserves and FDIC insurance premiums do not apply. Eurodollars are borrowed by U. S. and foreign individuals, corporations, and governments which need dollars for various purposes. Since the borrower must pay back the lender in dollars, eurodollar transactions are not used to convert currencies, but rather represent another source of dollar borrowing. Interest rates on eurodollars are tied to the London Interbank Offer Rate (LIBOR), which is the rate of interest offered by the largest and strongest London banks on eurodollar deposits. LIBOR rates are generally 0.5 to 1.0 percentage points higher than the rate on comparable deposits offered by domestic banks in the U. S. The eurodollar market deals mostly with short maturities, generally less than one year, although loans of up to 5 years have occurred.

2. International bonds, which are any bond sold outside the country of the borrower, fall into two categories. Foreign bonds are bonds sold by a foreign borrower, but denominated in the currency of the country in which they are sold. Thus, when Bell Canada sells bonds in the U. S. denominated in U. S. dollars, the firm is selling foreign bonds. In general, foreign bonds have to meet all the regulations of the country in which they are issued. Eurobonds are bonds sold in some country other than the one in whose currency the bond is denominated. For example, when Mercedes-Benz (a German company) sell bonds denominated in German marks in Switzerland, these bonds are eurobonds. In general, countries do not apply as stringent requirements on bonds denominated in a foreign currency as they do bonds denominated in the home currency. Further, most eurobonds are issued in bearer form, so buyers have anonymity, both for tax and other purposes. For these reasons, investors are usually willing to accept somewhat lower yields on eurobonds than on foreign bonds or “regular” bonds. Thus, U. S. firms can often sell eurobonds denominated in dollars at lower cost than similar domestic issues.

Mini Case: 1726 - 19 k. To what extent do average capital structures vary across different countries?

Answer: There is some evidence that average capital structures vary among the large industrial countries. One problem, however, when interpreting these numbers is that different countries often use very different accounting conventions, which makes it difficult to compare capital structures. A recent study attempts to control for differences in accounting practices. This study suggests that differences in accounting practices can explain much of the cross- country variation in capital structures. After adjusting for these accounting differences, capital structures are more similar across different countries than a previous study had suggested.

l. Briefly describe special problems that occur in multinational capital budgeting and describe the process for evaluating a foreign project. Now consider the following project. A U.S. company has the opportunity to lease a manufacturing facility in Japan for two years. The company must spend ¥1 billion initially to refurbish the plant. The expected net cash flows from the plant for the next two years, in millions, are: CF1 = ¥500 and CF2 = ¥800. A similar project in the U.S. would have a risk adjusted cost of capital of 10 percent. What is the project’s NPV?

Answer: The same general principles which apply to domestic capital budgeting also apply to foreign capital budgeting. However, foreign capital budgeting is complicated by the following three primary factors:

1. Tax law differences. Foreign operations are usually taxed at the local level, and then funds repatriated, or returned, to the parent corporation may be subject to additional U. S. taxes.

2. Political risk. Foreign governments have the right to restrict the amount of funds that can be repatriated. In extreme cases, foreign governments can even expropriate the assets owned by U. S. companies without offering any compensation.

3. Exchange rate risk. Funds repatriated from foreign operations have to be converted into dollars, so foreign capital projects are subject to exchange rate risk.

Mini Case: 1726 - 20 The first step is to estimate the future expected exchange rates using the multi- year interest rate parity equation: t 1 rh  Expected t-year forward exchange rate = (Spot exchange rate)   1 rf  where the exchange rates are expressed in direct quotations. The indirect spot exchange rate is 110 yen per dollar, so the direct rate is 1/110 = 0.009091 dollars per yen. The expected forward rates are:

Expected Spot rate forward rate ($/ Maturity (in years) rh rf ($/¥) ¥) 1 2.0% 0.05% 0.009091 0.009268 2 2.8% 0.26% 0.009091 0.009557

The current dollar cost of the project is £1,000(0.009091 $/¥) = $9.09 million. The Year 1 cash flow in dollars is ¥500 (0.009268$/¥) = $12.29 million. The complete time line and NPV are shown below.

Year 0 1 2

Cash flows in yen -¥1,000 ¥500 ¥800

Expected exchange rates 0.009091 0.009268 0.009557

Cash flows in dollars -$9.09 $4.63 $7.65

Project cost of capital = 10% NPV = $1.44

Mini Case: 1726 - 21 m. What is the impact of multinational operations on each of the following financial management topics?

1. Cash management.

Answer: Although multinational and domestic firms have the same objectives for cash management and use similar procedures, the multinational firm faces a more complex task. Since the distances involved are much greater, multinational firms tend to rely more on lockbox systems and wire transfers. Also, since multinational firms have access to more financial markets than do domestic firms, multinational companies are more likely to have global concentration banks, say in Tokyo, New York, London, and Zurich, and excess funds are transferred around the world to take advantage of the best rates available. Short-term borrowings are handled in the same way, with many more opportunities available to the firm. However, whenever the borrowing or lending takes place in a currency other than dollars, it is necessary to consider the possibility of adverse exchange rate movements. m. 2. Credit management.

Answer: Granting credit is riskier for a multinational firm than for a domestic corporation because, in addition to the normal risk of default, the credit granting corporation must also worry about exchange rate fluctuations between the time the credit is given and the time the payment must be made. In addition to being riskier, credit is more important for international business, because much of the commerce on which lesser- developed countries depend could not occur if the seller did not grant credit. Many companies buy export credit risk insurance when granting credit to foreign customers.

m. 3. Inventory management.

Answer: As with other aspects of financial management, inventory management in a multinational setting is similar to but more complex than that in a purely domestic firm. For example, where should Exxon store its inventories of crude oil and refined products, and how much should be stored at each location? The answer depends on many factors, including shipping times, carrying costs, import quotas and taxes, differential taxes on inventories, and expected exchange rate movements. These factors greatly complicate inventory decisions within multinational firms.

Mini Case: 1726 - 22