A

1. Financing Decision. Veer Co. is a U.S. based MNC that has most of its
operations in Japan. Since the Japanese companies with which it competes
use more financial leverage, it has decided to adjust its financial leverage to be
in line with theirs. With this heavy emphasis on debt, Veer should reap more
tax advantages. It believes that the markets perception of its risk will remain
unchanged, since its financial leverage will still be no higher than that of its
Japanese competitors. Comment on this strategy.
ANSWER: Japanese corporations can use a higher degree of financial leverage
because of their relationships with creditors and the government. The Japanese
government may be willing to bail out a Japanese company whose shares are held by
Japanese investors and institutions. Yet, it is less likely to bail out a subsidiary of a
U.S. corporation. The Japanese subsidiary does not receive the same protection
that other Japanese firms receive. Therefore, if this subsidiary attempts to use as
much financial leverage, its risk will be higher than that of the Japanese competitors.

2. Diversifying Away Country Risk.
Why do you think that an MNCs strategy of diversifying projects internationally
could achieve low exposure to country risk?
ANSWER online: If the MNC can set up foreign projects in countries whose country
risk levels are not highly correlated over time, then it reduces the exposure to the
possibility of high country risk in all of these areas simultaneously.
Answer by students: The country specific risks vary among different countries, which
suggests that MNCs may be able o reduce their exposure to country risk by spreading
their business among various economies.

3. Alternatives to International Acquisitions.
Rastell Inc., a U.S.-based MNC, is considering the acquisition of a Russian
target to produce personal computers (PCs) and market them throughout
Russia, where demand for PCs has increased substantially in recent years.
Assume that the stock market conditions are not favorable in Russia, as the
stock prices of most Russian companies rose substantially just prior to
Rastell's assessment of the target. What are some alternatives available to
Rastell?
ANSWER online: There are at least two alternatives available to Rastell Inc. First, it
could enter into a licensing agreement with the Russian target to manufacture and
distribute PCs with the Rastell name throughout Russia. Second, it could enter into a
joint venture with the potential Russian target. Both of these methods would allow
Rastell to access the Russian PC market. Furthermore, when stock prices in Russia
decline, Rastell could make a bid for the potential Russian target.

Answer by students:
1) Building a new subsidiary
Rastell can establish a new subsidiary in Russia. This allows Rastell to create a
subsidiary it desires without assuming the present targets existing facilities and
employees. And building a new subsidiary may be cheaper than the acquisition since
the prices of most Russian companies were rising.
However, the process of building a new subsidiary will take longer time than the
process of acquiring an existing foreign firm. And longer time may result in lost of
market share in the growing Russian market.
2) International Partial Acquisitions Rastell may purchase a substantial portion of the
existing stock of the Russian firm, so as to gain some control over the targets
management and operations. But it does not need to spend as much money as
buying the whole firm.
3) International Alliances
Rastell can engage in alliances, such as joint ventures and licensing agreements, with
the Russian firms.
The initial outlay is typically smaller, but the cash flows to be received will typically be
smaller too.
4) International Acquisitions of Privatized Businesses
Rastell can consider acquiring businesses from Russian government if the
government owns some PC manufature firms and if the government agrees.
But the businesses from government are usually difficult to value because the
transition entails many uncertainties - cash flows, benchmark data, economic and
political conditions, exchange rates, financing costs, etc.

4. Capital Budgeting and Financing
Cantoon Co, is considering the acquisition of a unit from the French
government. Its initial outlay would be $4 million. It will reinvest all the earnings
in the unit. It expects that at the end of 8 years, it will sell the unit for 12 million
euros after capital gains taxes are paid. The spot rate of the euro is $1.20 and is
used as the forecast of the euro in the future years. Cantoon has no plans to
hedge its exposure to exchange rate risk. The annualized U.S. risk-free interest
rate is 5 percent regardless of the maturity of debt, and the annualized risk-free
interest rate on euros is 7 percent, regardless of the maturity of debt. Assume
that interest rate parity exists. Cantoons cost of capital is 20 percent. It plans to
use cash to make the acquisition.
a. Determine the NPV under these conditions.
E(S8)=S0=$1.2
NPV=-4+12*1.2/[(1+20%)^8]=$-0.65million

b. Rather than use all cash, Cantoon could partially finance the acquisition. It
could obtain a loan of 3 million euros today that would be used to cover a
portion of the acquisition. In this case, it would have to pay a lump sum total
of 7 million euros at the end of 8 years to repay the loan. There are no
interest payments on this debt. The way in which this financing deal is
structured, none of the payment is tax-deductible. Determine the NPV if
Cantoon uses the forward rate instead of the spot rate to forecast the future
spot rate of the euro, and elects to partially finance the acquisition. You
need to derive the 8-year forward rate for this specific question.
Interest rate parity exists, then
r(us)=1.05^8-1=0.477 r(euro)=1.07^8-1=0.718
8year-forward rate=S0*[1+r(us)]/ [1+r(euro)]=1.2*1.477/1.718=$1.03
E(S8)=$1.03
NPV=-(4-1.2*3)+(12-7)*1.03/[(1+20%)^8]=$0.8 million

ANSWER online
a. Discount factor based on a required return of 20% for 8 years = .232
$ to be received in 8 years = 12,000,000 euros $1.2 = $14,400,000
PV = $14,400,000 (1 + .2)
8
= $3,340,800
NPV = $3,340,800 $4,000,000 = $659,200

b. The forward rate premium is:
p = (1 + .05)
8
1 = (1.48)/1.718) 1 = 13.85%
(1 + .07)
8

FR premium over 8 years = .13.85%
Forecast of euro in 8 years = $1.20 [1 + (13.85%)] = 1.0338.
Euros to be received in 8 years = 12 million euros 7 million euros = 5 million euros
Dollars to be received in 8 years = 5 million euros $1.0338 = $5,169,000
PV of $ to be received in 8 years = $5,169,000
(1 + .20)
8


= $1,202,144
If 3 million euros are borrowed, this covers the equivalent of $3,600,000, since the
euros spot rate is equal to $1.20. Therefore, the parent needs to provide an initial
outlay of $400,000 (computed as $4,000,000 $3,600,000).

NPV = $1,202,144 $400,000 = $802,144

5. Impact of a Weak Currency on Feasibility of DFI.
Packer, Inc., a U.S. producer of computer disks, plans to establish a subsidiary
in Mexico in order to penetrate the Mexican market. Packers executives believe
that the Mexican pesos value is relatively strong and will weaken against the
dollar over time. If their expectations about the peso value are correct, how will
this affect the feasibility of the project? Explain
ANSWER by students: If we invest in Mexico, the cost will be high because the peso
is relatively strong now. And the value of the cash flowing in later will be lower when
taking the peso will be weak into consideration. So the NPV may be lower or negative.
It is not a proper time to establish a subsidiary in Mexico.

ANSWER online: If the pesos value is relatively strong now, Packer Inc. will incur high
costs of establishing a Mexican subsidiary. In addition, if the peso weakens, future
remitted earnings by the subsidiary to the parent will be converted to fewer dollars.
Packer will be adversely affected by the exchange rate movements (although the
project may still be feasible).

6. Testing Interest Rate Parity.
Describe a method for testing whether interest rate parity exists. Why are
transactions costs, currency restrictions, and differential tax laws important
when evaluating whether covered interest arbitrage can be beneficial?
ANSWER: At any point in time, identify the interest rates of the U.S. versus some
foreign country. Then determine the forward rate premium (or discount) that should
exist according to interest rate parity. Then determine whether this computed forward
rate premium (or discount) is different from the actual premium (or discount).
Even if interest rate parity does not hold, covered interest arbitrage could be of no
benefit if transactions costs or tax laws offset any excess gain. In addition, currency
restrictions enforced by a foreign government may disrupt the act of covered interest
arbitrage.

7. Interest Rates.
Why do interest rates vary among countries? Why are interest rates normally
similar for those European countries that use the euro as their currency? Offer
a reason why the government interest rate of one country could be slightly
higher than that of the government interest rate of another country, even
though the euro is the currency used in both countries.
ANSWER: Interest rates in each country are based on the supply of funds and
demand for funds for a given currency. However, the supply and demand conditions
for the euro is dictated by all participating countries in aggregate, and do not vary
among participating countries. Yet, the government interest rate in one country that
uses the euro could be slightly higher than others that use the euro if it is subject to
default risk. The higher interest rate would reflect a risk premium.

8. Factors Affecting Exchange Rates.
Mexico tends to have much higher inflation than the United States and also
much higher interest rates than the United States. Inflation and interest rates
are much more volatile in Mexico than in industrialized countries. The value of
the Mexican peso is typically more volatile than the currencies of industrialized
countries from a U.S. perspective; it has typically depreciated from one year to
the next, but the degree of depreciation has varied substantially. The bid/ask
spread tends to be wider for the peso than for currencies of industrialized
countries.
a. Identify the most obvious economic reason for the persistent depreciation of
the peso.
ANSWER: The high inflation in Mexico places continual downward pressure on the
value of the peso.
b. High interest rates are commonly expected to strengthen a countrys
currency because they can encourage foreign investment in securities in that
country, which results in the exchange of other currencies for that currency.
Yet, the pesos value has declined against the dollar over most years even
though Mexican interest rates are typically much higher than U.S. interest rates.
Thus, it appears that the high Mexican interest rates do not attract substantial
U.S. investment in Mexicos securities. Why do you think U.S. investors do not
try to capitalize on the high interest rates in Mexico?
ANSWER: The high interest rates in Mexico result from expectations of high inflation.
That is, the real interest rate in Mexico may not be any higher than the U.S. real
interest rate. Given the high inflationary expectations, U.S. investors recognize the
potential weakness of the peso, which could more than offset the high interest rate
(when they convert the pesos back to dollars at the end of the investment period).
Therefore, the high Mexican interest rates do not encourage U.S. investment in
Mexican securities, and do not help to strengthen the value of the peso.
c. Why do you think the bid/ask spread is higher for pesos than for currencies
of industrialized countries? How does this affect a U.S. firm that does
substantial business in Mexico?
ANSWER: The bid/ask spread is wider because the banks that provide foreign
exchange services are subject to more risk when they maintain currencies such as
the peso that could decline abruptly at any time. A wider bid/ask spread adversely
affects the U.S. firm that does business in Mexico because it increases the
transactions costs associated with conversion of dollars to pesos, or pesos to dollars.

9. Intervention Effects on Corporate Performance.
Assume you have a subsidiary in Australia. The subsidiary sells mobile homes
to local consumers in Australia, who buy the homes using mostly borrowed
funds from local banks. Your subsidiary purchases all of its materials from
Hong Kong. The Hong Kong dollar is tied to the U.S. dollar. Your subsidiary
borrowed funds from the U.S. parent, and must pay the parent $100,000 in
interest each month. Australia has just raised its interest rate in order to boost
the value of its currency (Australian dollar, A$). The Australian dollar
appreciates against the dollar as a result. Explain whether these actions would
increase, reduce, or have no effect on:
a. The volume of your subsidiarys sales in Australia (measured in A$),
b. The cost to your subsidiary of purchasing materials (measured in A$)
c. The cost to your subsidiary of making the interest payments to the U.S.
parent (measured in A$). Briefly explain each answer.
ANSWER:
a. The volume of the sales should decline as the cost to consumers who finance their
purchases would rise due to the higher interest rates.
b. The cost of purchasing materials should decline because the A$ appreciates
against the HK$ as it appreciates against the U.S. dollar.
c. The interest expenses should decline because it will take fewer A$ to make the
monthly payment of $100,000.

10. Interpreting Changes in the Forward Premium.
Assume that interest rate parity holds. At the beginning of the month, the spot
rate of the Canadian dollar is $.70, while the one-year forward rate is $.68.
Assume that U.S. interest rates increase steadily over the month. At the end of
the month, the one-year forward rate is higher than it was at the beginning of
the month. Yet, the oneyear forward discount is larger (the one-year premium is
more negative) at the end of the month than it was at the beginning of the
month. Explain how the relationship between the U.S. interest rate and the
Canadian interest rate changed from the beginning of the month until the end of
the month.
ANSWER: The forward discount at the beginning of the month implies that the U.S.
interest rate is lower than the Canadian interest rate. During the month, the Canadian
interest rate must have increased by a greater degree than the U.S. interest rate. At
the end of the month, the gap between the Canadian dollar and the U.S. dollar is
greater than it was at the beginning of the month. This results in a more pronounced
forward discount.

11. Inflation and Interest Rate Effects.
The opening of Russia's market has resulted in a highly volatile Russian
currency (the ruble). Russia's inflation has commonly exceeded 20 percent per
month. Russian interest rates commonly exceed 150 percent, but this is
sometimes less than the annual inflation rate in Russia.
a. Explain why the high Russian inflation has put severe pressure on the value
of the Russian ruble.
ANSWER: As Russian prices were increasing, the purchasing power of Russian
consumers was declining. This would encourage them to purchase goods in the U.S.
and elsewhere, which results in a large supply of rubles for sale. Given the high
Russian inflation, foreign demand for rubles to purchase Russian goods would be low.
Thus, the rubles value should depreciate against the dollar, and against other
currencies.
b. Does the effect of Russian inflation on the decline in the rubles value
support the PPP theory? How might the relationship be distorted by political
conditions in Russia?
ANSWER: The general relationship suggested by PPP is supported, but the rubles
value will not normally move exactly as specified by PPP. The political conditions that
could restrict trade or currency convertibility can prevent Russian consumers from
shifting to foreign goods.
Thus, the ruble may not decline by the full degree to offset the inflation differential
between Russia and the U.S. Furthermore, the government may not allow the ruble to
float freely to its proper equilibrium level.
c. Does it appear that the prices of Russian goods will be equal to the prices of
U.S. goods from the perspective of Russian consumers (after considering
exchange rates)? Explain.
ANSWER: Russian prices might be higher than U.S. prices, even after considering
exchange rates, because the ruble might not depreciate enough to fully offset the
Russian inflation. The exchange rate cannot fully adjust if there are barriers on trade
or currency convertibility.
d. Will the effects of the high Russian inflation and the decline in the ruble
offset each other for U.S. importers? That is, how will U.S. importers of Russian
goods be affected by the conditions?
ANSWER: U.S. importers will likely experience higher prices, because the Russian
inflation may not be completely offset by the decline in the rubles value. This may
cause a reduction in the U.S. demand for Russian goods.