FINS 3616 International Business Finance Sample Final Examination Solutions Session 1, 2011

1.

* 2. *

Frictionless financial markets could have which of the following? a. agency costs b. bid-ask spreads c. brokerage fees d. costs of financial distress e. irrational investors Which of a) through d) is unlikely to result in a decision to hedge currency risk? a. bid-ask spreads on foreign exchange b. costs of financial distress c. tax convexity d. stakeholder game-playing e. All of the above are incentives to hedge The United Kingdom and the United States use a ____ law system that relies heavily on the decisions of judges in previous court cases. a. civil b. common c. laissez faire d. Napoleonic e. Teutonic With payment through ____, the seller delivers goods directly to the buyer and then bills the buyer for the goods under agreed-upon payment terms. a. b. c. d. e. a packing list cash in advance documentary collections documentary credits open account

3.

4.

* 5. *

Cash in advance is ____ for most exporters and ____ for most importers, all else constant. a. attractive; attractive b. attractive; unattractive c. unattractive; attractive d. unattractive; unattractive e. None of the above Internal methods of reducing the MNCs transaction exposure to currency risk include each of a) through c) except ____. a. multinational netting b. leading and lagging of intracompany transactions c. hedging in the currency forward markets d. Each of the above is a way to reduce transaction exposure internally e. None of the above are a way of reducing transaction exposure internally

6.

7. *

The preferred way to hedge transaction exposure to currency risk is ____. a. by offsetting exposures within the firm b. through forward currency contracts c. through futures contracts d. through swap contracts e. None of the above - exposures should be left unhedged Financial market hedges work best for ____ exposures to currency risk. a. accounting b. economic c. operating d. transaction e. translation A disaster hedge against adverse currency movements can be obtained with a ____. a. currency forward b. currency future c. money market hedge d. currency option e. currency swap

8.

9.

10. Change in financial accounting statements arising from unexpected changes in currency values is called ____ to currency risk. a. economic exposure b. operating exposure c. transaction exposure * d. translation exposure e. None of the above 11. When goods markets are segmented from other markets, goods prices are determined ____. a. in foreign markets b. in the global market * c. in the local market d. All of the above e. None of the above 12. The classic importer has ____. a. both revenues and expenses that are determined globally b both revenues and expenses that are determined locally * c revenues that are determined locally and expenses that are determined globally d revenues that are determined globally and expenses that are determined locally e None of the above 13. The domestic currency value of an expected future operating cash flow denominated in a foreign currency changes ____ with a change in the value of the foreign currency. a. disproportionately b. the currency of denomination c. not at all d. one for one e. None of the above

14. An exporters financial market hedging alternatives include each of a) through c) except ____. * a. Buy the foreign currency with long-dated forward contracts. b. Use currency swaps to acquire financial liabilities in the foreign currency. c. Use a rolling hedge to repeatedly sell the foreign currency.

d. More than one of the above e. None of the above 15. The main advantage of a financial market hedge of operating exposure to currency risk is that ____. a. financial market hedges can completely cancel operating exposures to currency risk b. financial market transactions allow firms to easily profit from mispricing in the currency market * c. the costs of buying or selling financial instruments are low compared to the costs of investing or disinvesting in real assets d. the uncertain cash flows of operating exposures to currency risk are exactly offset by the uncertain outcomes of a financial market hedge e. None of the above 16. FAS #8 assumes that the value of the firms real assets are ____ to currency risk. FAS #52 assumes that the value of the firms real assets are ____ to currency risk. a. fully exposed...partially exposed b. fully exposed...unexposed c. partially exposed...fully exposed d. partially exposed...unexposed * e. unexposed...fully exposed 17. Resource commitment is highest for which foreign market entry mode? a. exporting through foreign sales agents b. exporting through foreign sales branches * c. foreign direct investment d. foreign joint venture e. licensing 18. The fastest way to gain access to a foreign market is by ____. * a. exporting through foreign sales agents b. exporting through foreign sales branches c. foreign acquisition d. foreign direct investment e. foreign joint venture 19. The potential loss of production technology is greatest with ____. a. exporting through foreign sales agents b. exporting through foreign sales branches * c. licensing d. foreign direct investment e. foreign acquisition 20. Political risk includes each of the following except ____. a. expropriation b. potential loss of intellectual property rights c. protectionism * d. risks arising from dealing with an unfamiliar culture e. the risk of disruptions in operations 21. Macroeconomic factors that affect country risk assessments include each of the following except ____. a. currency risk * b. expropriation c. inflation

d. interest rate risk e. the current account balance 22. Expected future cash flows are estimated by ____ only incremental cash flows and ____ all opportunity costs. * a. including; including b. including; excluding c. excluding; including d. excluding; excluding e. None of the above 23. If a project has a positive NPV from the parents perspective but a negative NPV from the projects perspective, then the parent firm should ____. a. accept the project b. reject the project c. accept the project and try to capture the value in the foreign currency today * d. reject the project and continue to look for positive-NPV projects in the foreign currency e. None of the above 24. Suppose a project requires a cash outlay of 1,000 in year 0 and generates inflows of 10,000 in years 1 through 3. Assume the international parity conditions hold. The current spot rate is S0/ = 2/. If i = 7% and i = 5%, what is the expected future spot rate [E(S3/ )] at time t = 3? a. 1.890/ b. 1.963/ c. 2.020/ * d. 2.116/ e. 2.250/ 25. Suppose a project requires a cash outlay of 1,000 in year 0 and generates inflows of 10,000 in years 1 through 3. Assume the international parity conditions do not hold . Expected future spot rates are: E(S1/) = 2.060/, E(S2/) = 2.100/, and E(S3/) =2.220/. Calculate NPV by converting euros to pounds at the expected future spot rates and discounting in pounds. Assume S0/ = 2/ and i = 7%. a. NPV = 52,464.96 b. NPV = 52,978.31 c. NPV = 53,015.25 * d. NPV = 53,716.36 e. NPV = 54,142.84 26. A firms debt sells for 10 million and equity for 30 million. The firms before-tax cost of debt is 9%. Its cost of equity is 18%. The corporate tax rate is 33%. The firms weighted average cost of capital is closest to which of the following? a. 6% b. 9% c. 12% * d. 15% e. 18% 27. Each of a) through d) can be valued as a separate side effect except ____. a. blocked funds b. expropriation risk c. negative-NPV tie-in projects d. subsidized financing * e. Each of the above can be valued as a side effect

28. Stakeholders prefer internally generated funds to external funds because ____. a. internal funds avoid the discipline of the financial markets b. internal funds avoid the transactions costs of external issues c. they indicate the corporation has free cash flow * d. More than one of the above e. None of the above 29. Rajan and Zingales [ What Do We Know about Capital Structure? Some Evidence from International Data, 1995] found that leverage decreases with ____. a. the tangibility of the firms assets * b. profitability c. firm size d. All of the above are associated with higher leverage e. None of the above are associated with higher leverage 30. Implicit taxes include which of the following? a. asset taxes * b. higher pre-tax required returns in countries with high tax rates c. income taxes d. value-added taxes e. None of the above 31. Active income earned from a foreign branch is taxed by the U.S. government ____. a. after pooling this income with all other income sources b. as funds are repatriated to the U.S. parent corporation * c. as it is earned in the foreign country d. at the foreign tax rate e. None of the above 32. Foreign operations are more likely to be set up as a foreign branch when ____. a. bribes are a common business practice in the foreign country b. disclosure requirements in the foreign country are high * c. earnings are expected to be negative in the early years of operations d. the potential for litigation over foreign operations is high e. None of the above 33. Corporate governance refers to ____. a. b. c. d. e. the model corporation as characterized by the World Bank the role of top managers as the shepherds of the corporation the organizational chart the way in which stakeholders exert control over the corporation None of the above

34. Hostile acquisitions conducted through the financial markets are most common in ____. a. China b. Germany c. Japan d. Mexico * e. the United Kingdom 35. Impediments to purchase of foreign shares directly in a foreign market include each of a) through d) except ____. a. cross-border differences in accounting conventions and tax laws b. difficulty in obtaining or interpreting information, or both

c. higher transaction costs including commissions d. the inconvenience of receiving dividends in a foreign currency e. Each of the above is an impediment

Section BShort Answer Questions (20 marks) Question 1 (5 marks): You work for an importer from the Artic region and expect to pay 1 million in one year to a European supplier. You can trade at the following prices: Spot rate, Artic Australs per Euro One-year forward rate One-year Artic interest rate One-year Euro interest rate AA24.38/ AA24.96/ 5.050% 4.050%

a.

Form a forward market hedge. Identify which currency you are buying and which you are selling forward. (1 mark) You are paying 1 million to your supplier in one year, so buy 1 million and sell AA24.96 million one-year forward. In one year, youll receive 1 million and pay AA24.96 million on the forward contract. The 1 million receipt on the forward contract offsets the forward obligation to your supplier, leaving you with a net payment of AA24.96 million. You have eliminated your euro exposure.

b.

Replicate the payoff on the forward contract with a money market hedge by using the spot currency and Eurocurrency markets. Identify each contract in the hedge. (2 marks) The forward contract that you want to replicate is a forward purchase of 1 million. This can be replicated as follows: Find PV of 1,000,000 at 4.05%; (1,000,000)/(1.0405) = 961,076.41 Invest 961,076.41 = to yield 1 million at the euro interest rate in one year Convert to (961,076.41)(AA24.38/) = AA23,431,042.88 at the spot exchange rate Borrow AA23,431,042.88 to yield AA24,614,310.54 at the 5.05% Artic rate. The net result is a forward contract to purchase 1,000,000 with AA24,614,310.54.

c.

Are quoted prices in these currency and Eurocurrency markets in equilibrium? If not, how would you arbitrage the disequilibrium? (2 marks) No. The money market hedge is on more favorable terms than the forward contract, so forward prices are not in equilibrium with the interest rate differential. Interest rate parity

F1AA//S0AA/ = (1+iAA)/(1+i) (AA24.96/)/(AA24.38/) = 1.0238 >(1.0505)/(1.0405) = 1.0097 In this situation, it is cheaper to hedge through the money markets than through the forward market.

Question 2 (5 marks)
Exhibit T14.2 Wine production in Vino Nominal risk-free government T-bill rate Real required return on T-bills Expected future inflation Real required return on wine production Current spot exchange rate U.K. Vino iF = 7.1% iFV =12.2% qFV = 2.0% qF = 2.0% p = 5.0% pV = 10.0% i = 12.0% iV = 12.0% V/ S0 = V10/

The following information is known about the project: The project has a 3-year life. Assume all operating cash flows occur at year-end. An investment of V800,000 will purchase the vineyard. Its real value will remain constant throughout the investments life and the vineyard will be sold at the end of the project. The winery and wine presses will cost V425,000. In addition, the wine press supplier has given price quotes of V47,500 and V27,500 for the machinerys installation and modification, respectively. All cash outlays are payable at the start of the project. Annual depreciation for winery and wine presses is 33%, 45%, 15%, and 7% over the four-year project. (This happens to be identical to 3-year ACRS in the United States.) The winery and presses are expected to have a total market value of V45,000 in nominal terms at the end of the projects life in three years. No investment in net working capital is necessary. All of the businesss transactions are conducted in cash, and just-in-time inventory control will be used. Annual sales revenues are expected to be V700,000, V800,000, V900,000 in nominal terms over the next 3 years. Variable operating costs are 10% of sales. Fixed costs are V5,000 each year in nominal terms. Income and capital gains taxes are 50% in each country. You are a successful U.K. wine producer and are considering investing in a second operation in the country of Vino (with currency V). International parity conditions hold, and the investment will be 100 percent equity-financed. Interest and inflation rates and the characteristics of the investment project are as given in Exhibit T14.2. a. What is the nominal required return on wine investments in the U.K.? in Vino? (1 mark) b. Identify expected future cash flows on this foreign investment project. Discount these cash flows at the vino-unit discount rate from a) to find NPV0V. Use the current spot rate to transfer this value to NPV0. (2 marks) c. Translate vino-unit cash flows to pounds at expected future spot rates and discount at the pound discount rate from a) to find NPV0.. Is the answer the same as in b)? (2 marks) a. (1+i) = (1+p)(1+q) i = (1.12)(1.05) 1 = 0.176 or 17.6% (1+iV) = (1+pV)(1+qV) iV = (1.12)(1.10) 1 = 0.232 or 23.2% b. Initial Outlay = (V800,000) + (V425,000) + (V47,500) + (V27,500) = (V1,300,000) Depreciation tax shield calculation: (Depreciable base = V500,000)

Year 1 2 3 4

Beginning balance V500,000 V335,000 V110,000 V35,000

Depr % 33% 45% 15% 7%

Depr expense V165,000 V225,000 V75,000 V35,000

Ending balance V335,000 V110,000 V35,000 V0

Tax shield V82,500 V112,500 V37,500 V17,500

After-tax operating cash flows: CF1 = (V700,000 V70,000 V5,000)(10.5) + V82,500 = V395,000 CF2 = (V800,000 V80,000 V5,000)(10.5) + V112,500 = V470,000 CF3 = (V900,000 V90,000 V5,000)(10.5) + V37,500 = V440,000 Terminal Cash Flow = V800,000*(1.10)3 {[ V800,000*(1.10)3 V800,000]*0.5} + V45,000 [(V45,000 V35,000)*0.5] = V972,400
V395,000 V470,000 V1,412,400 yr 1 yr 2 yr 3 V1,300,000

NPVV = V85,367 at iV = 23.2% NPV = V85,367/(V10/) = 8,536.7 at V10/ c. E(S1 V/) = V10/ (1.232/1.176) = V10.47619/ E(S2 V/) = V10/ (1.232/1.176)2 = V10.97506/ E(S3 V/) = V10/ (1.232/1.176) 3 = V11.49768/
37,704 -130,000 t=1 42,824 t=2 122,807 t=3

NPV = 8,536.7 at i = 17.6% This is the same as in b) because the international parity conditions hold.

Question 3 (5 Marks) U.S.-based Crusty Creations, Inc. sells its prepackaged pastries in Cyprus and Japan. Each facility earns the equivalent of 10,000 in foreign-source income before tax. Cyprus has a 10 percent corporate income tax and no dividend withholding tax. Japan has corporate income taxes of 41 percent and dividend withholding taxes of 5 percent. The corporate tax rate in the US is 35%. a. Calculate the overall U.S. tax liability (or excess FTC) of Crusty Creations. (2 mark) b. If Crusty Creations can shift operations so that pre-tax income is 20,000 in Cyprus and zero in Japan, what is its U.S. tax liability (or excess FTC)? (1 mark) c. If Crusty Creations can shift operations so that pre-tax income is 20,000 in Japan and zero in Cyprus, what is its U.S. tax liability (or excess FTC)? (1 mark) d. How feasible is a tax-driven strategy of shifting revenues toward low-tax countries in the presence of implicit taxes? (1 mark) The table below has been provided to help you in computing taxes. You will need to complete this table for parts a, b, and c.

Dividend payout ratio Dividend tax rate Foreign tax rate Foreign income before tax Foreign income tax After-tax foreign earnings Declared as dividends Dividend tax Total foreign tax Dividend to U.S. parent Tentative U.S. income tax Foreign tax credit Net U.S. taxes payable Total taxes paid Net amount to U.S. parent Total taxes: separate subs 3. a b c d e f g h i j k l m n o p q Dividend payout ratio Foreign dividend withholding tax rate Foreign tax rate Foreign income before tax Foreign income tax (d*c) After-tax foreign earnings (de) Declared as dividends (f*a) Foreign dividend withholding tax (g*b) Total foreign tax (e+h) Dividend to U.S. parent (di) Gross foreign income before tax (line d) Tentative U.S. income tax (k*35%) Foreign tax credit (i) Net U.S. taxes payable [max(lm,0)] Total taxes paid (i+n) Net amount to U.S. parent (ko) Total taxes as separate subs (o)

Cyprus 100% 0%

Japan 100% 5%

Part a) Cyprus Japan 100% 100% 0% 5% 18% 41% 10000 10000 1800 4100 8200 5900 8200 5900 0 295 1800 4395 8200 5605 10000 10000 3500 3500 1800 4395 1700 0 3500 4395 6500 5605 7,895

Part b) Cyprus Japan 100% 100% 0% 5% 18% 41% 20000 3600 16400 16400 0 3600 16400 20000 7000 3600 3400 0 0 0 0 0 0 0 0 0 0 0

Part c) Cyprus Japan 100% 100% 0% 5% 18% 41% 0 0 0 0 0 0 0 20000 8200 11800 11800 590 8790 11210

0 20000 0 7000 0 8790 0 0 0 8790 0 11210 8,790

7000 0 13000 0 7,000

Parents consolidated tax statement r Overall FTC limitation (k*35%) s Total FTCs on a consolidated basis (i) t Additional U.S. taxes due [max(0, rs)] u Excess tax credits [max(0,sr)] (carried back 2 years or forward 5 years)

7,000 6,195 805 0

7,000 3,600 3,400 0

7,000 8,790 0 1,790

d. Implicit taxes will make it difficult to generate the same pretax returns in Cyprus as can be

generated in Japan. If pre-tax returns were equal in Cyprus and Japan, this would be a clear violation of the law of one price in its after-tax form and would suggest arbitrage profits are available.

Question 4 (5 Marks) You are the manger of large US car company. You primarily export cars to the UK and the price of these cars is denominated in British pounds. As a results the value of your production plant is very sensitive to the US/UK exchange rate. a. Is the value of the production plant positively or negatively exposed to the value of the foreign currency. Intuitively, explain why. (1 mark) b. Discuss two financial market hedges that the firm might use to hedge their operating exposure. What are the relative advantages/disadvantages of the two financial market options you mentioned? (2 points) c. Discuss a real asset (i.e. operating) hedge that the firm might use to hedge their operating exposure. (1 mark) d. Discuss one advantage and one disadvantage of using real asset hedges. (1 mark)

a. The value of the production plant is positively exposed to the value of the foreign currency. Intuitively, when the US car company sells a car, they receive a fixed amount of British pounds. As the pound appreciates, they can convert those British pounds into a greater amount of USD. b. The firm could buy a futures contract that allows it to sell British pounds at a fixed rate. The firm could also buy a put option that gives the firm the right, but not the obligation, to sell the pound at specific strike price. The biggest advantage of the option (relative to the future) is that it allows you to fully benefit from the British pound appreciation while still protects you from the pound depreciating. In contrast, with a futures contract, you lock in a specific exchange rate, so you are unable to fully benefit if the pound appreciates. One disadvantage of the option contract is that option premiums can be quite high. In contrast, future contracts tend to be relatively low cost. Note: this is just one possible answer. Other financial market hedges that you could have mentioned include forwards, swaps, or money market hedges. c. The firm could set up a production plant in the UK. Having both revenues and expenses denominated in pounds would reduce their operating exposure to the pound. d. One advantage of the operating hedge is that it creates a fundamental change in the way the firm does business and will thus provide a long-lasting hedge against operating exposure. One disadvantage is that the cost of a building a new production plant is high, so the potential for a large loss is much greater with operating hedges.