604 08-17solutionsmanual-130313081430-phpapp02

Solutions to End-of-Chapter Questions and Problems
Solutions
to
End-of-Chapter
Questions and Problems
in
Multinational
Finance
by Kirt C. Butler
1

Kirt C. Butler, Multinational Finance, 2nd
edition
Second Edition
2

PART I Overview and Background
Chapter 1 Introduction to Multinational Finance
Answers to Conceptual Questions
1.1 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 country risk? Describe several types of country risk one might face when
conducting business in another country.
Country risks refer to the political and financial risks of conducting business in a
particular foreign country. Country risks include foreign exchange risk, political risk, and
cultural risk.
1.3 What is foreign exchange risk?
Foreign exchange (or currency) risk is 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
enterprise to some group of stakeholders. The society in which business is conducted
determines who these stakeholders are. The relative importance of stakeholders varies by
country. Equity shareholders are important in every free-market country. Commercial
banks are more important in some countries (e.g., Germany and Japan) than in some other
countries (e.g., the United States and the United Kingdom). In socialist countries, the
welfare of employees and the general population assume a more prominent role.
1.7 List the MNC’s key stakeholders. How does each have a stake in the MNC?
Stakeholders narrowly defined include shareholders, debtholders, and management. More
broadly defined, stakeholders also would include employees, suppliers, customers, host
governments, and residents of host countries.
3

edition
Chapter 2 World Trade and the International Monetary System
2.1 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 more of their gross national product today than in years past.
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 on Tariffs and Trade, and e) advances in communication and in
transportation.
2.3 How has globalization in the world’s goods markets affected world trade? How has
globalization in the world’s financial markets affected world trade?
Some of the economic consequences of globalization in the world’s goods markets include:
a) an increase in cross-border investment in real assets (land, natural resource projects, and
manufacturing facilities), b) an increasing interdependence between national 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
attractive rates, b) an increasing number of cross-border partnerships including many
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).
4

2.5 Describe the International Monetary Fund’s balance-of-payments accounting system.
The IMF publishes a monthly summary of cross-border transactions that tracks each
country’s cross-border flow of goods, services, and capital.
2.6 How would an economist categorize systems for trading foreign exchange? How would
the IMF make this classification? In what ways are these the same? How are they
different?
Economists have traditionally classified exchange rate systems as either fixed rate or
floating rate systems. The IMF has adapted this system to the plethora of systems in
practice today. The IMF’s 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’
“gold exchange standard,” currencies were pegged to the price of gold (or to 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
artificially high levels. This depleted 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 and hence the behaviors of lenders, borrowers, and governments. For
example, lenders might underestimate the risks of lending to struggling economies if
there is an expectation that the IMF will intervene during difficult times.
Problem Solutions
2.1 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.
5

edition
PART II International Currency and Eurocurrency Markets
Chapter 3 The Foreign Exchange and Eurocurrency Markets
3.1 What is Rule #1 when dealing with foreign exchange? Why is it important?
Rule #1 says to “Keep track of your currency units.” It is important because foreign
exchange prices have a currency in both the numerator and the denominator. Most prices
(for instance, a $15,000/car price on a new car) 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
and other market frictions have on the operation of a market. Informational efficiency
refers to whether or not prices reflect value.
3.5 What is a forward premium? A forward discount? Why are forward prices for 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
forward market is higher than in the spot market. A currency is trading at a forward
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 Solutions
3.1 a. The bid rate is less than the offer rate, so Citicorp is quoting the currency in the
denominator. Citicorp is buying dollars at the FF5.62/$ bid rate and selling dollars
at the FF5.87/$ offer rate.
b. In American terms, 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.
6

d. Sell $1,000,000 (FF5.62/$) = FF5,620,000 = amount you receive
Buy $1,000,000 (FF5.87/$) = FF5,870,000 = amount you pay
Your 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
to buy or sell dollars (in the denominator). You’re selling dollars, so you’ll get the
bank’s dollar bid price. You need to pay SK10,000,000/(SK7.5050/$) =
$1,332,445.04.
3.3 The U.S. dollar (in the denominator) is selling at a forward premium, so the Canadian
dollar must be selling at a forward discount. Percent per annum on the Canadian dollar
from the U.S. perspective are as follows:
Bid Ask
One month forward -0.486% -1.456%
Three months forward -0.873% -1.034%
Six months forward -0.678% -0.758%
Annualized forward premia on the U.S. dollar are:
Bid Ask
One month forward +0.486% +1.457%
Three months forward +0.875% +1.036%
Six months forward +0.681% +0.761%
The premiums/discounts on the two currencies are opposite in sign and nearly equal in
magnitude. Forward premiums and discounts are of slightly different magnitude
because the bases (U$ vs. C$) on which they are calculated are different. Forward
premiums/discounts are as stated above regardless of where a trader resides.
3.4 Days Difference Basis point % premium/discount Annualized % forward
forward ($/¥) 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 $0.56/DM
1987 DM2.00/$ or $0.50/DM
1992 DM1.50/$ or $0.67/DM
1997 DM1.80/$ or $0.56/DM
a. 1984-87 The dollar appreciated 11.1%; ((DM2.0/$)-(DM1.8/$)/(DM1.8/$)=+0.111
1987-92 The dollar depreciated 25%; ((DM1.5/$)-(DM2.0/$)/(DM2.0/$)=-0.25
1992-97 The dollar appreciated 25%; ((DM1.8/$)-(DM1.5/$)/(DM1.5/$)=+0.20
b. 1984-87 The mark depreciated 10.7%; ($0.50/DM)/($0.56/DM) - 1= -0.107
1987-92 The mark appreciated 34.0%; ($0.67/DM)/($0.50/DM) - 1= +0.340
1992-97 The mark depreciated 16.4%; ($0.56/DM)/($0.67/DM) - 1 = -0.164
7

edition
3.6 a. FM5,000,000 / (FM4.0200/$) = $1,243,781. Tokyo’s bid price for FM is their ask
price for dollars. So, FM4.0200/$ is equivalent to $0.2488/FM.
b. FM20,000,000 / (FM3.9690/$) = $5,039,053
FM3.9690/$ is equivalent to $0.2520/FM
Payment is made on the second business day after the three-month expiration date.
3.7 You initially receive P0
$
= P0
¥
/S0
¥/$
= (¥104,000,000)/(¥1.04/$) = $1 million. When you
buy back the yen, you must pay P1
$
= P1
¥
/S1
¥/$
= (¥104,000,000)/(¥1.00/$) = $1.04
million. Your dollar loss is $40,000.
3.8 When buying one currency, you are simultaneously selling another. Hence, a bid price
for pesetas is an ask price for dollars. The peseta quotes yield SPts/$
= 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$/Rbl
= (1/11)-1 = -0.909, or a 90.9% depreciation.
3.10 The 90-day dollar forward price is 33 basis points below the spot price: F1
SFr/$
-S0
SFr/$
=
(SFr0.7432/$-SFr0.7465/$) = -SFr0.0033/$. The percentage dollar forward discount is
(F1
SFr/$
-S0
SFr/$
)/S0
SFr/$
= (SFr0.7432/$–SFr0.7465/$)/(SFr0.7465/$) = -0.442% per 90
days. This is (-0.442%)*4 = -1.768% on an annualized basis.
3.11 Banks make a profit on the bid-ask spread. A bank quoting $0.5841/DM BID and
$0.5852/DM ASK is buying marks (in the denominator) at $0.5841/DM and selling
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/DM BID and buying dollars at
$0.5841/DM ASK.
3.12 FF at a forward discount
30 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:
+BF40,000,000
8

b. The contractual payment is a positive cash flow in Belgian francs, so Dow is
positively exposed to the value of the Belgian franc.
∆V$/BF
∆V$/BF
Dow’s exposure
c. The expected cash flow in dollars is E[CF1
$
] = E[CF1
BF
] E[S1
$/BF
] = (BF40,000,000)
($0.025/BF) = $1,000,000. Actual dollar cash flow is CF1
$
= CF1
BF
S1
$/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
= $0.025/BF, or F1
BF/$
= BF40/$.
+$1,000,000
−BF40,000,000
The Belgian franc is being sold forward, so Dow’s exposure to the value of the
Belgian franc in this forward contract is negative. 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
$/BF
∆V
$/BF
Forward
exposure
3.15 (Ft
d/f
-S0
d/f
)/S0
d/f
= [(1/Ft
f/d
)-(1/S0
f/d
)]/(1/S0
f/d
) = [(S0
f/d
/Ft
f/d
)-(S0
f/d
/S0
f/d
)]/(S0
f/d
/S0
f/d
)
= [(S0
f/d
/Ft
f/d
) - 1] = (S0
f/d
- Ft
f/d
) / Ft
f/d
.
9

edition
Chapter 4 The International Parity Conditions
4.1 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.
Riskless arbitrage is a profitable 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 that A
Sf/d B
Sd/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 [(Ft
d/ f
) / (S0
d/ f
)] ≠ (1+id
) /
(1+if
)]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[St
d/f
]/S0
d/f
=
[(1+id
) / (1+if
)]t
.
4.5 How would you arrive at an estimate of a future spot exchange rate between two
currencies?
In theory, any of the international parity conditions could be used: E[St
d/f
] / S0
d/f
= [(1+id
) /
(1+if
)]t
= [(1+pd
) / (1+pf
)]t
= Ft
d/f
/ S0
d/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
.
10

Problem Solutions
4.1 a. S¥DM
= S¥/$
S$/DM
= (¥200/$)($0.50/DM) = ¥100/DM
b. S¥DM
= S¥/$
/SDM/$
=(¥100/$)/(DM1.60/$) = ¥62.5/DM.
4.2 SDM/$
S$/¥
S¥/DM
= 1.0326 > 1. Triangular arbitrage would yield a profit of 3.26 percent of
the starting amount. For triangular arbitrage to be profitable, transactions costs on a
“round turn” cannot be more than this amount.
4.3 The forward price is at a 9 basis point discount over six months, or 18 bps on an
annualized basis. The six-month percentage discount is (F1
£/$
/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/Ps–¥28.7356/Ps)/(¥28.7356/Ps) = 0.125%
Mexico City quote for yen: (Ps0.03420/¥–Ps0.03416/¥)/(Ps0.03416/¥) = 0.117%
b. The Mexican bank’s 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 yen
is equivalent to ¥29.240/Ps BID and ¥29.274/Ps ASK on the peso.
The winning strategy is to buy pesos (and sell yen) from the Tokyo bank at the
¥28.7715/Ps ask price and sell pesos (and buy yen) to the Mexican bank at the
¥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[P1
D
] = P0
D
(1+pD
) = D100(1.10) = D110
E[P1
F
] = P0
F
(1+pF
) = F1(1.21) = F1.21
E[S1
D/F
] = E[P1
D
] / E[P1
F
] = D110 / F1.21 = D90.91/F.
11

edition
b. E[P2
D
] = P0
D
(1+pD
)2
= D100(1.10)2
= D121
E[P2
F
] = P0
F
(1+pF
)2
= F1(1.21)2
= F1.4641
E[S2
D/F
] = E[P2
D
]/E[P2
F
] = D121/F1.4641
= S0
D/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, or 0.9603% per three months. Annualized, this is equivalent 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 $10,000,000 by borrowing FM40,200,000. Your obligation on
this contract will be (FM40,200,000)(1.009603) ≈ FM40,586,040 which is exactly
offset by the proceeds from your forward contract.
4.10 a. Ft
Bt/$
/S0
Bt/$
= (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. F1
Bt/$
/S0
Bt/$
= (Bt25.64/$)/(Bt24.96/$) = 1.027 < (1+iBt
)/(1+i$
) = (1.1)/(1.06125) =
1.037. So, borrow at i$
and lend at iBt
.
+Bt24,960,000
−$1,000,000
Convert to baht at the spot exchange rate
+Bt27,456,000
−Bt24,960,000
Invest at the 10% baht interest rate
−$1,061,250
+$1,000,000
Borrow at the 6.125% dollar interest rate
−Bt27,456,000
+$1,070,827
Cover baht forward
This leaves a net gain at time 1 of $1,070,827 - $1,061,250 = $9,577, which is worth
$9,577/1.06125 = $9,024 in present value.
12

4.11 F1
AA/$
/S0
AA/$
= (AA22/$)/(AA20/$) = 1.1 < 1.1132 = (1.18)/(1.06) = (1+ iAA
)/(1+i$
). The
ratio of interest rates is too high and must fall, so borrow at the relatively low dollar
rate and invest at the relatively high austral rate. The forward premium is too low and
must rise, so buy australs (and sell dollars) at the relatively low dollar forward rate and
sell dollars (and buy australs) at the relatively high dollar spot rate.
• Borrow $100,000 at the dollar interest rate so that $106,000 is due in six months.
• Buy AA2,000,000 at the relatively high spot price.
• Invest this in Argentina at 18% to yield AA2,360,000 at the end of six months.
• Cover by selling AA2,360,000 at the AA22/$ forward rate to yield $107,273.
This leaves a profit of $107,273-$106,000 = $1,272.73.
4.12 The Singapore dollar is at a forward premium; F1
$/S$
/S0
$/S$
= ($0.51/S$)/($0.50/S$) =
1.02, or 2% per year. This is less than is warranted by the difference in interest rates
(1+i$
)/(1+iS$
) = (1.06)/(1.04) = 1.019231, so F1
$/S$
/S0
$/S$
> (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, the ratio of interest rates is too low and must rise, so borrow at 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
+$1,000,000
Convert to S$2,000,000 = ($1,000,000)/($0.50/S$) at S0
$/S$
= $0.50/S$.
+S$2,000,000
-$1,000,000
Invest S$2,000,000 at the Singapore interest rate of iS$
= 4.0%.
+S$2,080,000
-S$2,000,000
Cover this S$ forward obligation by selling S$ in the forward market.
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edition
+$1,060,800
-S$2,080,000
The 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
-£100,000
Convert to (£89,638)($1.25/£) = $112,047 at S0
$/£
= $1.25/£.
+$112,047
-£89,638
Invest in dollars at the U.S. dollar rate of i$
= 9.82%.
-$112,047
+$123,050
The net result is a forward contract to buy dollars with pounds.
+£100,000
-$123,050
Note 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 <
14

=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 Finance
4A.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 wealth after two periods is the same as beginning wealth;
$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 by ι1 = ln(1+i1) = ln(2)
= +0.69315 and ι2 = ln(1+i2) = ln(0.5) = -0.69315. The (arithmetic) average return using
continuously compounded rates is (ι1+ι2)/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[P1
D
] = P0
D
e(0.09531)
= (D100)(1.10) = D110
E[P2
D
] = P0
D
e(2)(0.09531)
= (D100)(1.21) = D121
E[P1
F
] = P0
F
e(0.19062)
= (F1)(1.21) = F1.21
E[P2
F
] = P0
F
e(2)(0.19062)
= (F1)(1.4641) = F1.4641
E[S1
D/F
] = E[P1
D
] / E[P1
F
] = D110 / F1.21 = D90.91/F
E[S2
D/F
] = E[P2
D
] / E[P2
F
] = D121 / F1.4641 = D82.64/F
Chapter 5 The Nature of Foreign Exchange Risk
5.1 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
“transaction exposure.” The exposure of the firm’s real (noncontractual) or operating
assets is called “operating exposure.”
15

edition
5.4 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. Accounting exposure is important to shareholders if it is related to economic
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.
16

5.5 Will an appreciation of the domestic currency help or hurt a domestic exporter? 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
exporters by raising the price of domestic goods relative to foreign goods. 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?
In an informationally efficient 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
correctly priced, so that it is not possible to consistently make abnormal 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 the forward
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
parity when forward prices are unavailable. These forward predictions can be 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
17

edition
can be generated from technical analysis (analyzing patterns in exchange rates) or from
fundamental analysis (from a larger set of economic relationships).
Problem Solutions
5.1 a. E[P1
F
] = P0
F
(1+pF
) = 1.21
E[P1
D
] = P0
D
(1+pD
) = 1.10
E[S1
D/F
] = (S0
D/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[X1
D/F
] = (E[S1
D/F
]/S0
D/F
)((1+pF
)/(1+pD
)) = ((D90.91/F)/(D100/F))(1.21/1.10) = 1.00,
or 100%.
c. E[P2
F
]) = P0
F
(1+pF
)2
= F1.4641
E[P2
D
]) = P0
D
(1+pD
)2
= D121
E[P2
F
]) = P0
F
(1+pF
)2
= F1.4641
E[P2
D
]) = P0
D
(1+pD
)2
= D121
E[S2
D/F
]= S0
D/F
((1+pD
)/(1+pF
))2
=(D100/F)(1.10/1.21)2
≈ D82.64/F
The real exchange rate is not expected to change: E[X2
D/F
] = (E[S2
D/F
]/E[S0
D/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/¥
= ((S0
DM/¥
) / (S-1
DM/¥
)) ((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/$
= (S1
Fl/$
/S0
Fl/$
)-1 = (Fl
1.55/$)/(Fl
1.60/$)-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.
18

c. 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 σt
2
= (0.0034) + (0.40)(0.05)2
+ (0.20)(0.10)2
= 0.0064 ⇒ σt = 0.08, or 8%.
PART III The Multinational Corporation’s Investment Decisions
Chapter 6 Multinational Corporate Strategy
6.1 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
the marketplace, it must bring something that local firms cannot. 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 corporation that give it a competitive advantage over local 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 are firm-specific property rights 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-specific advantages arise from the MNC’s access to natural and man-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 advantages allow the multinational corporation to internalize or
exploit the failure of an arms-length market to efficiently accomplish a task. That is,
contracting to accomplish a task is more effective or less expensive when conducted
within the firm than through the markets.
6.6 Describe the evolution of the MNC using product cycle theory.
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edition
According to product cycle theory, the firm’s products evolve through four stages:
infancy, growth, maturity and decline. The MNC attempts to extend the lucrative mature
stage by enhancing revenues through access to new product markets and reducing
operating costs through access to new factor markets.
6.7 Describe three broad modes of entry into international markets. Which of these modes
requires the most resource commitment on the part of the MNC? Which has the
greatest risks? Which offers the greatest growth potential?
Export entry, contract-based entry, and investment entry. Investment entry requires the
most resource commitment and exporting the least. The other side of the coin is that
expected returns are often higher 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 the MNC relatively permanent access to foreign product and factor
markets. The cost of a new investment in an unfamiliar business culture can be high,
however.
b. Acquisitions of stock or 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 MNC’s 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
include seeking low-cost raw materials and labor, economies of scale, economies of
vertical integration, reduction of operating inefficiencies (process efficiency seekers),
knowledge seekers, and political safety seekers. Financial considerations include the
possibility of obtaining financial economies of scale, access to new capital markets, new
sources of low-cost financing, indirect diversification benefits, financial strength and
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 firm’s 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
20

transfer 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 Solutions
6.1 Rather than make up an entry strategy, let’s look at how Motorola has entered
Southeast Asia. In the 1960s, Motorola established sales agencies in Japan and Hong
Kong as its initial entry mode. In the early 1980s, Motorola decided that it needed
direct investment in the region in order to diversify its design and manufacturing
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 new markets and reduce the costs and risks of product innovation. Here is a
partial list of Motorola’s international joint ventures:
• Beginning in 1987, Motorola has had a joint venture with Toshiba to manufacture
semiconductors. Joint ventures help Motorola to keep research and development
costs down while keeping an eye on their Japanese competitors.
• In 1990, Motorola built a design and manufacturing facility in Hong Kong as a
platform to service the rest of Southeast Asia.
• Since late 1996, Motorola has manufactured Mac clones in a joint venture with
China’s 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 Budgeting
7.1 Describe the two recipes for discounting foreign currency cash flows. 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
no market frictions such as repatriation restrictions. These recipes can give different
values if PPP does not hold or if there are repatriation restrictions.
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edition
7.2 Discuss each cell in Figure 7.4. What should (or shouldn’t) 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
<0; if the firm wants to speculate on foreign exchange rates,
there must be better alternatives than the proposed project for taking a speculative
position.
Bottom left: NPVd
<0 but NPVf
>0; anticipated changes in exchange rates are likely to
hurt the firm. Try financing the project in the local currency, hedging forward (with
forwards or futures), or swapping into foreign currency debt.
Bottom right: There are two possibilities here. If NPVd
> 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 Solutions
Cross-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 yields
NPVRen
= -Ren600m+Ren200m/1.11745+Ren500m/(1.11745)2
+Ren300m/(1.11745)3
= Ren194.39 million
or 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 should appreciate by approximately 2.9% per year relative to the dollar
because of lower Chinese inflation. Expected future spot rates of exchange are then
E[S1
$/Ren
] = ($0.5526)[(1.06)/(1.03)]1
= $0.5687/Ren
E[S2
$/Ren
] = ($0.5526)[(1.06)/(1.03)]2
= $0.5853/Ren
E[S3
$/Ren
] = ($0.5526)[(1.06)/(1.03)]3
= $0.6023/Ren
Based on these spot exchange rates, expected dollar cash flows are:
22

E[CF0
$
] = (Ren600)($0.5526/Ren) = $331.56
E[CF1
$
] = (Ren200)($0.5687/Ren) = $113.74
E[CF2
$
] = (Ren500)($0.5853/Ren) = $292.63
E[CF3
$
] = (Ren300)($0.6024/Ren) = $180.69
The project should be accepted because
NPV$
= -$331.56m+$113.74m/(1.15)+$292.63m/(1.15)2
+$180.69m/(1.15)3
= $107.42 million > $0
7.2 a. Expected future cash flows in euros are as follows:
Investment cash flows 0 1 2
Land -100000 121000 grows at 10% inflation rate
tax on capital gain -8400
Plant -50000 25000 market value at t=2
NWC -50000 60500 grows at 10% inflation rate
Operating cash flows 0 1 2
Rev (Price=100, Q=5,000) 550000 605000 grows at 10% inflation rate
Variable cost (20%) -110000 -121000
FC (20,000 at t=0) -22000 -24200 grows at 10% inflation rate
Depreciation -25000 -25000
Earnings before tax 393000 434800
Tax (at 40%) -157200 -173920
Net income 235800 260880
Net cash flow (Euros) 260800 285880 CF = NI + Depreciation
Sum of investment/disinvestment and operating cash flows
Total net CFs -200000 260800 469780
NPV at iEuro
= 20% 343569.4
b. 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 $10/Euro. So,
Expected dollar CFs -2000000 2608000 4697800
NPV at i$
= 20% $3,435,694
7.3 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[S1
W/L
] = (S0
W/L
) [(1+pW
) / (1+pL
)]t
= (W100/L) [(1.50) / (1.00)] = W150/L
E[S2
W/L
] = (S0
W/L
) [(1+pW
) / (1+pL
)]t
= (W100/L) [(1.50) / (1.00)]2
= W225/L
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edition
c. All cash flows in work-units:
Investment cash flows 0 1 2
Land -200,000 450,000 grows at 50% inflation rate
tax on capital gain -125,000
Plant -200,000 0 market value at t=2
tax on capital gain 0
Operating cash flows 0 1 2
Rev (P0
W
=W200, Q=2,000) 600,000 900,000 grows at 50% inflation rate
Variable cost (20%) -120,000 -180,000
Fixed cost (W30,000 at t=0) -45,000 -67,500 grows at 50% inflation rate
Depreciation -100,000 -100,000
Earnings before tax 335,000 552,500
Tax (at 50%) -167,500 -276,250
Net income 167,500 276,250
Net operating CFW
267,500 376,250 CF = NI + Depreciation
Total NCFW
-400,000 267,500 701,250
NPVW
at 65% W19,697
NPVL
= NPVW
/ S0
W/L
= L197
d. E[CFt
L
] = E[CFt
W
] / E[St
W/L
] ⇒ E[CF0
L
] = (-W400,000) / (W100/L) = -L4,000
E[CF1
L
] = (W267,500) / (W150/L) = L1,783
E[CF2
L
] = (W701,250) / (W225/L) = L3,117
⇒ NPVL
= -L4,000 + (L1,783) / (1.10) + (L3,117) / (1.1)2
= L197
This is the same as in part c because the international parity conditions hold.
7.4 a.
t=1 Bt3.4m Bt3.4m Bt3.4m Bt6,913,840

−Bt4m t=2 t=3 t=4 t=5
iBt
= 20%
Initial outlay = (Bt4m)
After-tax cash flows over t=2,…,5
=(Bt100m-Bt90m-Bt5m)(1-0.40)+(Bt1m*.40)=Bt3,400,000
Terminal CF= (Bt4m*(1.10)4
) - {[(Bt4m*(1.10)4
) - 0]*.4} = Bt3,513,840
NPV0
Bt
= Bt5,413,548
b. (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(S1
Bt/¥
) = (Bt0.25/¥)(1.20/1.1454545) = Bt.2619048/¥
E(S2
Bt/¥
) = (Bt0.25/¥)(1.20/1.1454545)2
= Bt.2743764/¥
E(S3
Bt/¥
) = (Bt0.25/¥)(1.20/1.1454545)3
= Bt.2874420/¥
E(S4
Bt/¥
) = (Bt0.25/¥)(1.20/1.1454545)4
= Bt.3011297/¥
E(S5
Bt/¥
) = (Bt0.25/¥)(1.20/1.1454545)5
= Bt.3154692/¥
24

d. Recipe #1: NPV¥
= Bt5,413,548/(Bt0.25/¥) = ¥21,654,192
Recipe #2: NPV0
¥
= ¥21,654,192 at i¥
= 14.54545%
t=1 ¥12,391,736 ¥11,828,475 ¥11,290,817 ¥21,916,055

−¥15,272,727 t=2 t=3 t=4 t=5
The 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
= [Σt E[CFt
Ren
] / (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) = $107.42
Discount in dollars.
NPV$
= Σt {E[St
$/Ren
]E[CFt
Ren
] / (1+i$
)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 > $107.42
While the project has a positive NPV regardless of the perspective, the project has
more value from the parent’s perspective than from the project perspective. This is
because the expected future value of the dollar (renminbi) is less (more) than under
the equilibrium conditions. The parent company may choose to leave its cash
flows from the project unhedged in the hopes of benefiting from the expected
future spot exchange rates. This does expose the parent to currency risk.
b. Discount in renminbi.
NPVRen
= [Σt E[CFt
Ren
] / (1+iRen
)t
]
= [-Ren600 + Ren200/(1.1175) + Ren500/(1.1175)2
+Ren300/(1.1175)3
]
= Ren194.39
⇒ NPV$
= (S0
$/Ren
) (NPVRen
) = ($0.5526/Ren)(Ren194.39) = $107.42
Discount in $:
NPV$
= Σt {E[St
$/Ren
]E[CFt
Ren
] / (1+i$
)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 < $107.42
Although the project has a positive NPV from each perspective, the project has more
value in the local currency than it does in dollars. The parent should hedge the
renminbi cash flows either directly in the forward market, by borrowing a part of the
project in renminbi, or by swapping dollar debt for renminbi debt to hedge its
expected future renminbi cash flows from the project.
25

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26

Cross-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 +Ren300
1 yr 2 yrs 3 yrs 4 yrs
-Ren600
NPVren
= -Ren
600m+Ren
200m/(1.11745)2
+Ren
500m/(1.11745)3
+Ren
300m/(1.11745)4
= Ren
110.90 million, or
NPV$
= (Ren
110.90)($0.5526/ren) = $61.28 million at the spot exchange rate.
7.7 The after-tax cost of debt is (5.06%)(1-0.4) = 3.036%. The after-tax annual savings in
interest expense is (Ren
600m)(0.0506-0.0403)(1-0.4) = Ren
3.708 million. The present value
of a three-year annuity of Ren
3.708 million discounted at 3.036% is Ren
10.48 million.
7.8 NPVRen
= Ren
194.39 million without the side effect. The airport project reduces this value
by Ren
100 million, but the NPV is still positive. Accept the project even if the Chinese
authorities are not willing to renegotiate.
7.9 This is a cumulative risk in that, once expropriated, you will not receive any later cash
flows from your investment. The probability of receiving the cash flow in year t is
(0.9)t
times the expected cash flow in problem 7.1. So,
NPVren
= -Ren600m + Ren200m(0.9)1
/(1.11745) + Ren500m(0.9)2
/(1.11745)2
+ Ren300m(0.9)3
/(1.11745)3
= Ren42.15 million
or NPV$
= (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
have grown in value to Cr8,000(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 value of (Cr41,393) / (1.40)4
= Cr10,775 at the 40% required return. 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 Hook’s treasure chest is riskless.
27

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Chapter 8 Taxes and Multinational Corporate Strategy
8.1 What is tax neutrality? Why is 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. Foreign tax neutrality is intended to ensure that taxes imposed on the
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
include corporate and personal 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.
Income from foreign corporations that are between 10% and 50% owned by a U.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 How has the U.S. Internal Revenue Code limited the ability of the multinational
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
disadvantages such as a poor physical, legal or telecommunication infrastructure, an
uneducated workforce, or high political risk.
28

Problem Solutions
8.1 India’s currency is the rupee (Rp). Thailand’s 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 India HK
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 20000
e Foreign income tax (d*c) 1800 6500 3600 0 0 13000
f After-tax foreign earnings (d-e) 8200 3500 16400 0 0 7000
g Declared as dividends (f*a) 8200 3500 16400 0 0 7000
h Foreign dividend withholding tax (g*b) 0 700 0 0 0 1400
i Total foreign tax (e+h) 1800 7200 3600 0 0 14400
j Dividend to U.S. parent (d-i) 8200 2800 16400 0 0 5600
k Gross foreign income before tax (d) 10000 10000 20000 0 0 20000
l Tentative U.S. income tax (k*35%) 3500 3500 7000 0 0 7000
mForeign tax credit (i) 1800 7200 3600 0 0 14400
n Net U.S. taxes payable [max(l-m,0)] 1700 0 3400 0 0 0
o Total taxes paid (i+n) 3500 7200 7000 0 0 14400
p Net amount to U.S. parent (k-o) 6500 2800 13000 0 0 5600
q Total taxes as separate subs (sum(o)) $10,700 $7,000
$14,400
Parent’s consolidated tax statement
r Overall FTC limitation (sum(k)*35%) $7,000 $7,000 $7,000
s Total FTCs on a consolidated basis (sum(i)) $9,000 $3,600
$14,400
t Additional U.S. taxes due [max(0, r-s)] $0 $3,400 $0
u 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. Consolidated P.R. U.S. Consolidated
Revenue 100,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000
COGS 100,000 100,000 100,000 100,000 1,000,000 100,000
Taxable income 0 900,000 900,000 900,000 0 900,000
Taxes 0 315,000 315,000 45,000 0 45,000
Net income 0 585,000 585,000 855,000 0 855,000
Effective tax on consolidated revenues 31.5% 4.5%
Effective tax on taxable income 35.0% 5.0%
29

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30

b. If produced in the U.S., Quack’s 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 Risk
9.1 Define country risk? Define political risk? Define financial risk? Give an example of
each different type of country risk.
Country risk refers to the political and financial risks of conducting business in a
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 country’s
financial, economic, or business 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 Risk Services’ International Country Risk Guide (ICRG) rates countries on
political, economic, and financial factors. Political risk factors include a country’s
leadership, corruption, and political tensions. Economic risk factors include inflation,
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.
Micro country risks are specific to an industry, company, or project within a host
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 country’s tax rates.
9.4 How is expropriation included in a discounted cash flow analysis of a proposed
foreign investment? Does expropriation impact expected future cash flows? From a
discounted cash flow perspective, is it likely to impact the discount rate on foreign
investment?
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edition
Expropriation occurs when a government seizes foreign assets. This risk clearly
affects expected cash flows. It can affect the discount rate when investors cannot
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?
Protectionism refers to protection 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 repatriated to the parent firm. They most commonly arise from capital
flow restrictions imposed by the host government.
9.7 What are intellectual property rights? How are they at risk when the multinational
corporation has foreign operations?
Intellectual property rights include patents, copyrights, and proprietary technologies and
processes. Host governments sometimes protect local businesses at the expense of
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. The agreement should specify the investment and financial environments
including taxes, concessions, obligations, and restrictions on the multinational
corporation’s operations. It also should specify a jurisdiction for the arbitration of
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) A large number of individuals or businesses are exposed to the risk,
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 What operational 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.
32

9.11 Does country risk affect investors’ required return in emerging markets?
Erb, Harvey, and Viskanta [“Political Risk, Financial Risk and Economic Risk,”
Financial Analysts Journal 52, November/December, 1996] found that the low
correlations of emerging markets tend to overcome the higher volatilities of 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 Solutions
9.1 There is not always a clear distinction between political and financial risks. Indeed,
financial risks often result from political decisions. In Russia’s 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 Although the most obvious form of expropriation occurs when a host government
confiscates a company’s 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,
including protectionism, blocked funds, or theft or misappropriation of intellectual
property rights.
9.3 a. Total risk is conventionally measured by standard deviation of return. The foreign
asset with a standard deviation of σi
’
= 0.3 has greater total risk than the domestic
asset with a standard deviation of σi = 0.2.
b. The foreign asset also has greater systematic risk: βi
’
= ρiW
’
(σi
’
/σW) = (0.3)(0.3/0.1)
= 0.9 > βi = ρiW (σi /σW) = (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
factors include political risk (leadership, government corruption, internal or external
political tensions), economic risk (inflation, current account balance, or foreign trade
collection experience), and financial risk (currency controls, expropriations, contract
renegotiations, payment delays, loan restructurings or cancellations).
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edition
Chapter 10 Real Options and Cross-Border Investment
10.1 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
and changing market conditions. 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?
Managers must consider how they might respond to future events. Managers are not
acting irrationally if, through attempting 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
creates an incentive to delay investment whereas endogenous uncertainty creates 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 What is a 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.
34

10.8 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 firm’s 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
change in the value(s) of the underlying asset(s); and c) returns on options are not
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-
generating process of the underlying asset(s); and c) the fact that the values of real
options are not directly observable in the marketplace.
Problem Solutions
10.1 a. A decision tree represents possible paths to future states of the world as branches on a
tree. For Grolsch’s invest in Dubiety, the decision tree looks like:
Invest today
Invest in one year
Invest at Pbeer = D
75
Invest at Pbeer = D
25
NPV0
D
= ?
NPV0
D
Pbeer=D
75 = ?
NPV0
D
Pbeer= D
25 = ?
b. Equation (9.2) from the text must be modified to include fixed costs:
INVEST TODAY: NPV0 =
( )P - V Q - F
i 0I−
NPV(invest today)
= [((D
50/btl-D
10/btl)(1,000,000 btls) - D
10,000,000)/0.10] - D
200,000,000
= D
100,000,000 ⇒ invest today?
c. Equation (9.3) from the text must be modified to include fixed costs:
WAIT ONE YEAR: NPV0 =
( )P - V Q - F
i
(1 i) 0I





 + −
NPVPbeer=D
75
= [(((D
75/btl-D
10/btl)(1,000,000 btls)-D
10,000,000)/0.10)/(1.10)]-D
200,000,000
= D
300,000,000 ⇒ invest
NPVPbeer=D
25
= [(((D
25/btl-D
10/btl)(1,000,000 btls)-D
10,000,000)/0.10) / (1.10)]-D
200,000,000
35

edition
= -D
154,545,455 < $0 ⇒ don’t invest
NPV(wait one year)
= [Prob(P1=D
75)](NPVP1=D
75)+[Prob(P1=D
25)](NPVP1=D
25)
= (½) (D
300,000,000) + (½)(D
0)
= +D
150,000,000 > NPV(invest today) > D
0
d. Option Value = Intrinsic Value + Time Value
NPV(wait one year) = NPV(invest today) + Opportunity cost of investing today
D
150,000,000 = D
100,000,000 + D
50,000,000
e. Wait one period before deciding to invest.
10.2 a.
Abandon today
Abandon in one year
Abandon at Pbeer = D
35
Abandon at Pbeer = D
15
NPV0
D
= ?
NPV0
D
Pbeer=D
35 = ?
NPV0
D
Pbeer= D
15 = ?
b. The problem states that the current price of beer is D
15 in perpetuity. The statement
“in perpetuity” clearly cannot hold because prices in one year are stated to be
either D
15 or D
35 with equal probability. Let’s assume that the price is currently
D
15 per bottle and will either remain at D
15 or will rise to D
35 by time 1. For
simplicity, let’s also assume end-of-year beer prices and cash flows so that we
don’t have to worry about the path of beer prices during the year. In this setting,
the current price of D
15/bottle is irrelevant to the abandonment decision. The
expected future price of D
25 does matter. (If beer prices throughout the first year
either remain at D
15 or rise at a constant rate to D
35, then the expected price during
the first year is not D
25 but rather ½[D15+½(D15+D35)] = D
20.)
Note that if the project is abandoned today at a cost of D
10,000,000, 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 ½ (D
15/btl+D
35/btl) = D
25/btl, the NPV of the
“abandon today” alternative is:
NPV(abandon today)
= -[((D
25/btl-D
20/btl)(1,000,000 btls)-D
10,000,000)/0.10]-D10,000,000
= D
40,000,000 > D
0 ⇒ abandon today?
c. If Grolsch management waits one year before making its abandonment decision, beer
prices will be either D
15 or D
35 with certainty.
NPVP1=D
35
= -[(((D
35/btl-D
20/btl)(1,000,000 btls) -D
10,000,000) /0.10)/(1.10)]-D
10,000,000
= -D
55,454,545 ⇒ don’t abandon if price rises to D
35
36

NPVP1=D
15
= -[(((D
15/btl-D
20/btl)(1,000,000 btls) -D
10,000,000) /0.10)/(1.10)]-D
10,000,000
= D
126,363,636 ⇒ abandon if price falls to D
15
NPV(wait one year)=[Prob(P1=D
35)](NPVP1=D
35)+[Prob(P1=D
15)](NPVP1=D
15)
= (½) (D
126,363,636) + (½)($0)
= +D
63,181,818 > NPV(abandon today) > D
0
NPV(wait one year) =NPV(abandon today)+Opportunity cost of abandoning today
+D
63,181,818 = +D
40,000,000 + D
23,181,818
e. Wait one year before making the abandonment decision.
10.3 Let’s assume that there are in total five breweries, so there are four additional brewery
investments if we choose to construct an exploratory brewery.
We already know from Problem 9.1 that investment in a single brewery today 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 today
Invest in first brewery
NPV0
D
= D
?
If NPV0
D
> D
0, continue to invest
If NPV0
D
< D
0, don’t invest further
b. At the expected end-of-year price of ½(D
25/btl+D
75/btl) = D
50/btl, the NPV of a
single brewery is:
NPV(exploratory brewery)
= [((D
50/btl-D
10/btl)(1,000,000 btls)-D
10,000,000)/0.10] -D
200,000,000
= D
100,000,000
NPV(invest in all five breweries today) = (5) NPV(exploratory brewery)
= D
500,000,000
c. If Grolsch management waits one year before making its investment decision, beer
prices will be either D
25 or D
75 with certainty in this problem. Of course, it won’t
know this until it invests in the first brewery.
NPVPbeer=D
75
= [((D
75/btl-D
10/btl)(1,000,000 btls)-D
10,000,000)/0.10]-D
200,000,000
= D
350,000,000 ⇒ invest in additional capacity
If Pbeer=D
75, investment in four additional breweries at time t=1 yields a net present
37

edition
value at time zero of (4)( D
350,000,000/1.10) = D
1,272,727,273.
NPVPbeer=D
25
= [((D
25/btl-D
10/btl)(1,000,000 btls)-D
10,000,000)/0.10]-D
200,000,000
= -D
150,000,000 < $0 ⇒ don’t invest in additional capacity
If Pbeer=D
25, do not invest in additional capacity. (In fact, you should look into
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=D
75)] (NPVP1=D
75) + [Prob(P1=D
25)] (NPVP1=D
25)
= (½)[(D
350,000,000) +(4)(D
350,000,000/1.10)] + (½)(-D
150,000,000)
= +D
736,363,636 > NPV(invest in all five today) = +D
500,000,000 > D
0
NPV(wait one year) = NPV(invest today) + Opportunity cost of investing in
four additional breweries today
D
736,363,636 = D
500,000,000 + D
236,363,636
The NPV of investing in all five breweries today is -D
236,363,636. Grolsch would
not be taking advantage of the flexibility provided by the timing option on this
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)
= (½)(R150,000,000) + (½)(R0)
= +75,000,000 > NPV(invest today) =R50,000 > R0
The 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
million
NPV(invest in exploratory plant and continue to invest in 9 other plants if NPV>0)
= [Prob(C1=R12,000)](NPVC1=R12,000)
38

+ [Prob(C1=R18,000)](NPVC1=R18,000)
= (½)[(R150 million)+(9)(R150 million/1.20)] + (½)(-R100 million)
= +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 a real investment opportunity depends on whether it is firm-specific or
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.
In a situation in which the entire industry shares an investment option (such as
Grolsch’s proposed investment in Eastern Europe), investment returns are sensitive to
competitors’ actions. When exit costs are zero, the effect of a shared investment
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 Control
11.1 What does the term “corporate governance” mean? Why is it important in international
finance?
Corporate governance refers to the way in which major stakeholders influence and
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 team which manages the day-to-day operations of the
corporation. The form of corporate governance determines the particular stakeholders
that are represented on the board and has a major large influence on top executive
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 firm’s 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.
39

edition
11.3 What is synergy?
When the whole is greater than the sum of the parts in a corporate acquisition.
11.4 What is the difference between a private and a public capital market? Why is this
difference important in corporate governance?
Private capital markets place debt and equity through direct placements rather than
through public issues. Public capital markets include public issues of debt and equity.
Bank-based systems of corporate governance are usually dominated by private debt
markets. Market-based systems of corporate governance are dominated by relatively
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 in the U.S. have been constrained by the U.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 held in 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 Japan’s 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 Why are hostile acquisitions less common in Germany and Japan than in the United
Kingdom and the United States?
Corporate governance in Germany 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 offers in the U.K. and U.S. may or may not be in cooperation with current
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
in non-performing companies are likely to be replaced. The how of top executive
40

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
market 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?
Shareholders of the bidding firm are more likely to win in a cross-border merger or
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?
Jensen’s “free cash flow hypothesis” suggests that managers are more likely to waste
shareholders capital on poor investments when there is a lot of free cash flow (or
profitability) around. When things are tight, capital constraints are more likely to be
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 find that a strong domestic currency leads to both more foreign
acquisitions and to higher bidder returns.
Problem Solutions
11.1 a. E
b. D
c. F
d. A
e. B
f. G
g. C
11.2 The pre-acquisition value of the two firms is $3 billion + $1 billion = $4 billion. Synergy
is 10% of this value, or (0.1)($4 billion) = $400,000. After subtracting the (0.2)($1
billion) = $200,000 acquisition premium from the $400,000 synergy, Agile shareholders
41

edition
are likely to see a $200,000 appreciation in the value of their shares. Stated as a
percentage return in the combined firm, this is an increase of ($200,000)/($4,400,000) =
4.5% to Agile shareholders.
11.3 The BP-Amoco deal was lauded in the financial press for combining BP’s strengths in
oil exploration and development with Amoco’s refining and distribution capabilities.
Amoco stock jumped about 26 percent to a record high of 521/8
immediately after
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
flow also makes it more likely that management will waste resources on new
ventures in which it has no business (Jensen [1986]). When cash flow is scarce,
managers are more likely to pick winning ventures.
b. First-time entrants often have interesting opportunities but also face new risks.
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 VP’s 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 to access capital markets to fund acquisitions whereas
domestic companies can fund acquisitions with cash, then domestic companies enjoy
an advantage in the presence of this informational asymmetry.
11.6 Several deals were rumored in early 1999. Suitors for Nissan’s equity or Volvo’s
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
bank” law to assist troubled banks, so other mergers and acquisitions (either
privately arranged or forced by the government) are sure to follow.
42

b. It ain’t business as usual for Japanese companies. Several key keiretsu members
have recently refused to bail out their banking affiliates. Through 1998, Toyota
had declined to bail out Sakura Bank in the Mitsui keiretsu despite its long
relationship with the bank. Troubled companies are increasingly turning overseas
for additional investment rather than to their keiretsu partners. In 1998, 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 Corporation’s Financial Decisions
Chapter 12 Multinational Treasury Management
12.1 What is multinational treasury management?
Multinational treasury management involves five functions: 1) set overall financial
goals, 2) manage the risks of international transactions, 3) arrange financing for
international trade, 4) consolidate and manage the financial flows of the firm, and 5)
identify, measure, and manage the firm’s risk exposures.
12.2 What function does a firm’s strategic business plan perform?
The strategic business plan performs the following functions: 1) identify the firm’s
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 firm’s 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 trade is difficult largely because of information costs. Exporters must
ensure timely payment from far-away customers. Importers must ensure timely
delivery of 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.
The four methods are open account, cash in advance, drafts, and letters of credit.
Under an open account, the seller bills the buyer upon delivery of the goods. In cash in
advance, the buyer pays prior to receiving shipment. A draft is used to pay upon
delivery and is like a check or money order. A bank letter of credit guarantees
payment upon presentation of the specified trade documents.
43

edition
12.6 What is a banker’s acceptance, and how is it used in international trade?
44

A banker’s acceptance is a time draft drawn on a commercial bank in which the bank
promises to pay the holder of the draft a stated amount on a specified future date.
Banker’s acceptances are 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 maturities of six months or more.
12.9 What is countertrade? When is it most likely to be used?
Countertrade involves an exchange of goods or services without the use of cash. It is
commonly used in countries with inconvertible currencies, currency controls, or
limited reserves of hard currency. Large exporters with significant international
experience are more likely to use countertrade as a means of entry into new and
developing markets.
12.10 What is multinational netting?
In multinational netting, transactions that offset one another are identified within the
corporation. Once offsetting transactions are identified, only the net amount of funds
need be exchanged.
12.11 How can the treasury division assist in managing relations among the operating units
of the multinational corporation?
Treasury can serve as a “corporate bank” satisfying the financing requirements of the
operating units. This central role allows Treasury to net transactions within the
corporation and thereby minimize the number and size of external market transactions.
Treasury can also direct operating units on transfer pricing issues and identify hurdle
rates on new investments.
Problem Solutions
12.1 a. A 6% interest rate compounded quarterly is the same as a 1.5% quarterly rate. The
net amount payable at maturity is $9,990,000 after subtracting Paribas’ acceptance
fee. Fruit of the Loom will receive ($9,990,000)/(1.015) = $9,842,365 if it sells the
acceptance to its bank.
b. The all-in cost of the acceptance is ($10,000,000)/($9,842,365)-1 = 1.60% per quarter
or an effective annual rate of (1.0160)4
-1= 0.0656, or 6.56% per year.
12.2 a. The 2%/month factoring fee of ($10000,000)(0.02/month)(3 months) = $600,000 is
due at the time the receivables are factored. Fruit of the Loom is giving up accounts
receivable with a face amount of $10 million due in three months in exchange for a
net amount of $9,400,000.
45

edition
b. The all-in cost to Fruit of the Loom is ($10,000,000)/($9,400,000)-1 = 0.06383 per
quarter or an effective annual rate of (1.06383)4
-1 = 0.2808, or 28.08% per year.
While this all-in cost seems high, note that Fruit of the Loom has no collection
expenses or credit risk on this nonrecourse sale of receivables.
12.3 a. The net amount payable at maturity is $998,000 after subtracting the bank’s
acceptance fee. A 5% annual rate compounded quarterly is the same as a 1¼%
quarterly rate. Savvy Fare will receive ($998,000)/(1.0125)2
= $973,510 if it sells the
acceptance to its bank today.
b. The all-in cost of the acceptance to Savvy Fare is ($1,000,000)/($973,510)-1 = 2.72%
per six months or an effective annual rate of (1.0272)2
-1= 5.52% per year.
12.4 a. Cash flows faced by Savvy Fare include the following:
Face amount of receivable $1,000,000
Less 4% nonrecourse fee -$40,000
Less 1% monthly factoring fee over six months -$60,000
Net amount received $900,000
b. The all-in cost to Savvy Fare is ($1,000,000)/($900,000)-1 = 11.11% per six months
or an effective annual rate of (1.1111)2
-1 = 23.46% per year.
Chapter 13 The Rationale for Hedging Currency Risk
13.1 Describe the conditions that can lead to tax schedule convexity.
Tax schedule convexity can arise from any of the following: a) progressive taxation
in which larger taxable income receives a higher tax rate, b) tax-loss carryforwards or
carrybacks, c) Alternative Minimum Tax (AMT) rules, d) investment tax credits.
13.2 Define financial distress. Give examples of direct and indirect costs of financial
distress.
Financial distress refers to the additional financial troubles facing firms when the
value of equity approaches zero. Direct costs are incurred during bankruptcy
proceedings. Indirect costs include lower revenues or higher operating/financial costs.
13.3 What is an agency conflict? How can agency costs be reduced?
Agency conflicts arise as managers act in their own interests rather than those of
shareholders. Agency costs are the costs of aligning managers’ and shareholders’
objectives. Although currency risk may be diversifiable to shareholders, managers are
undiversified and care about currency risk. Allowing managers to hedge exposure to
currency risk may reduce agency conflicts.
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