Chapter 18 International Financial Management

Chapter  18   International  Financial  Management     LEARNING  OBJECTIVES   (Slide  18-­‐2)   1. Understand cultural, business, and political diff...
Author: Ruby Curtis
73 downloads 2 Views 3MB Size
Chapter  18   International  Financial  Management     LEARNING  OBJECTIVES  

(Slide  18-­‐2)  

1. Understand cultural, business, and political differences in business practices. 2. Calculate exchange rates, cross rates, and forward rates. 3. Understand transaction exposure, operating exposure, and translation exposure. 4. Apply net present value to foreign projects.

IN  A  NUTSHELL…   With globalization here to stay and the internet spreading its web across most cultures and continents, financial managers and businessmen have to be well-equipped with knowledge about business practices, policies, and issues related to investing and managing funds across the globe. This chapter starts out with a discussion of the cultural and political differences permeating business practices in different countries. Next, the calculation of cross and forward exchange rates is covered followed by the effects of fluctuating currencies on a firm’s transaction, operating, and translation exposures. The chapter ends with a detailed explanation of how capital budgeting is to be done in the context of foreign projects.

LECTURE  OUTLINE   18.1  Managing  Multinational  Operations  

(Slides  18-­‐3  to  18-­‐7)  

The complexity of managing multinational corporations increases significantly because of differences in cultures, business practices, and political systems that they are faced with once they operate in foreign countries. 18.1  (A)  Cultural  Risk: Cultural risk arises from differences in customs, social norms,

attitudes, assumptions, and expectations of the local society in the host country. Differences in ownership structure: such as the requirement to set up joint ventures in certain countries and the requirement to increase local participation and ownership. Differences in human resource norms: such as hiring and firing norms and different cultural attitudes towards women and minorities in the workplace. Also, local promotions and reward systems may not be consistent with those of the home office and would have to be altered to maintain positive relations with local employees, customers, and government officials. Religious heritage of the host country: often can affect the way employees dress and their holiday observances and have to be honored.

613   ©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

614          Brooks  n  Financial  Management:  Core  Concepts,  2e  

Nepotism and corrupt practices in the host country: such as the requirement to hire relatives of government officials as a condition of doing business (Indonesia) and bribery of officials to get permits and licenses—considered to be illegal in the USA—are normal practices in many foreign countries. Intellectual property rights: such as those protected by copyrights and patents, may not be honored in some foreign countries (e.g. China) and become an issue when considering doing business abroad. Although attempts are being made to alter the landscape of differences in attitudes towards intellectual property rights e.g. 2001 treaty, much still needs to be done. 18.1  (B)  Business  Risk: arises from economic factors such as inflation rates, recessions,

and interest rate and exchange rate fluctuations and can be more pronounced when operating in multiple countries. Efficient diversification of such risk factors is key to success. 18.1  (C)  Political  Risk: stems from changing attitudes of the political leadership towards

MNCs resulting in loss of subsidies or risk of nationalization. MNCs can defend against such risks by: 1. Keeping critical operations private: i.e. maintain key or critical elements of operations safely within the firm rendering the assets useless in case of nationalization. 2. Financing operations and assets with local money: so that local creditors can put pressure on the host government not to nationalize the business. 3. Receiving primary inputs outside the local economy: without which the assets and operations would not be valuable.

18.2  Foreign  Exchange  

(Slides  18-­‐8  to  18-­‐23)  

With each sovereign nation having its own currency (except of course, the Euro which is the accepted currency in 16 out of 27 countries of the European Union (EU)), MNCs have to keep track of the fluctuations in exchange rates of various currencies caused by fluctuating economic factors such as interest rates, inflation rates and productivity. 18.2  (A)  Purchasing  Power  Parity   Purchasing power parity means that the price of similar goods is the same regardless of which currency one uses to buy the goods. Table 18.1 is an example of how the price of a Big Mac in various countries can be used to keep track of relative purchasing power and exchange rates in countries where McDonalds operates.

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

Chapter  18  n  International  Financial  Management          615  

Price in US $ = Price of a Big Mac in Foreign Currency/ HK$/1US$ For Hong Kong, Price in US$ è HK$15.1HK$7.79 = $1.94 Purchasing Power (Hong Kong) = Price in HK$/Price in US$=HK$15.1/$4.07è3.71 In the real world, exchange rates are based on the prices of a basket of goods, rather than on a single item, in different countries. In general, the rate at which we can exchange money between currencies should allow us to purchase the same basket of goods in any country with the same dollars (except for local tariffs etc. 18.2  (C)  Currency  Exchange  Rates: as shown in Table 18.2 can be expressed in direct

(Amount of $ required to buy 1 unit of foreign money) or indirect (amount of foreign money required to buy 1 US$) form.

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

616          Brooks  n  Financial  Management:  Core  Concepts,  2e  

Calculation of these rates is as follows:

So, 1 Mexican peso can buy roughly 8 US cents. If we divide the direct rate into 1 i.e. take its reciprocal we get the indirect or European rate, i.e. Indirect rate = 1/$0.0810è12.35 Mexican Pesos 1 US$ can buy 12.35 Mexican pesos. 18.2  (D)  Cross  Rates: are used to state the exchange rate between two non-US

currencies, e.g. the exchange rate between the British Pound and the Yen.

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

Chapter  18  n  International  Financial  Management          617  

In Britain, this would be the indirect rate between the British Pound and the Japanese Yen, i.e. it would tell us how many units on yen can be bought with 1£. To solve for the direct rate between the £ and the Yen, we simply take the reciprocal of the indirect rateè 1/125.2017è.0079868£ can be purchased with 1 Yen. Alternatively, we can solve for the indirect rate between 2 currencies e.g. the amount of Yen that 1 £ can buy by using the following process: Take the direct or American rate of the first foreign currency and multiply it by the indirect or European rate of the second foreign currency:

. 18.2  (E)  Arbitrage  Opportunities exist when cross rates as determined by Equation 18.3

do not hold, allowing traders the opportunity to exchange currencies simultaneously and make instant profits without taking on any additional risk. Example  1:  Triangular  arbitrage   Let’s say that you see that the direct rate for Euro is 1.2922 and the indirect rate for the Yen is 96.16. You check the internet and find that the indirect rate for Yen in Euros is 130 yen. You have $10,000 and are willing to make quick gains if possible. Is there an arbitrage opportunity here? First check to see if the indirect rate for Yen in Euros is correct or not using Equation 18.3 According to Equation 18.3, the indirect rate for Yen per Euro = Direct rate for Euros in US$* Indirect rate for Yen in US = $ 1.2922*96.16è124.26Y/Euro which is less than the internet rate so the Euro seems to be overvalued. I would convert my dollars into Euros, then buy Yen at the internet rate, and then convert Yen back to dollars as follows: Direct rate for Euro = 1.2922 è$1.2922$=1Euro or $1$ = 1/1.2922 Euro è0.773874 Euro $10,000*0.77387 Euros/$ è 7738.74 Euros 7738.74Euros * 130 Yen/Euro è1006036.22Yen 1006036.22Yen * .0104$/Yen=$10,462.77 So I would make a cool $462,77 before commissions. YES! THIS WOULD BE AN ARBITRAGE OPPORTUNITY!

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

618          Brooks  n  Financial  Management:  Core  Concepts,  2e  

18.2  (F)  Forward  Rates: or the exchange rates in the future e.g. one year from now,

depend to a large extent on the current exchange rate and the relative expected inflation rates in the 2 countries as shown in Equation 18.4.

Where inff = expected inflation rate in the foreign country And infh = expected inflation rate in the host country. If a country’s inflation rate increases relatively higher than that of another country, then its currency’s exchange rate will get weaker i.e. it will buy less units of the currency of the country whose inflation rate did not increase as much. Equation 18.4 applies to a 1 year forward rate. A more general formula that can be used for predicting forward rates for any future period is shown in Equation 18.5

Where T is time in years i.e. 9 months è= T= 9/12 = 0.75 and 3 years would have T = 3. Example  2:  Calculating  forward  rates   Let’s say that the Australian $ is currently being quoted at A$1.3109/US$. If inflation is likely to be 8% in Australia and 4% in the US, calculate the indirect forward rate for the Australian dollar 3 months from now. Forward indirect rate 3 months = A$ 1.3109 * (1.08/1.04)3/12 èA$1.3233 So, since inflation is expected to rise higher in Australia than in the USA, the Aussie $ is expected to get weaker i.e. 1US$ will buy more A$ than before. 18.2  (G)  Using  Forward  Rates    

Investors and companies can use forward contracts to essentially minimize their risk of losses arising from having to convert money received in foreign currencies at lower rates. The forward rate is the rate that is being committed to today for forward delivery of the currency. So if rates go down, you still get the forward rate that was agreed upon. According to the International Fisher Effect, the real interest rates are equal across all countries, so if we get a higher rate in one country, it will be offset by a higher inflation in that country and a weakening exchange rate. Covered interest arbitrage is an attempt made by some investors to try and exploit variances in inflation rates and interest rates across countries. Most often, however, the exchange rate adjusts such that the arbitrage opportunities do not materialize.

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

Chapter  18  n  International  Financial  Management          619  

18.3  Transaction,  Operating,     and  Translation  Exposure  

(Slides  18-­‐24  to  18-­‐28)  

Fluctuations in exchange rates cause a firm’s future cash inflows, either from remittances from customers or from profits being sent home to vary significantly leading to possible losses and gains from transaction, operating, and translation exposure. 18.3  (A)  Transaction  Exposure is the potential loss in home currency value of future

foreign currency payments. This loss would occur if the home currency gets stronger meaning fewer units can be purchased per unit of the foreign currency. This exposure can and must be hedged by selling the currency forward i.e. selling forward contracts whereby the forward selling price of the foreign currency to be received is being agreed upon today. 18.3  (B)  Operating  Exposure is the risk associated with the effect of unfavorable

exchange rate movements on the long-run viability of a foreign operation of a multinational business, primarily driven by escalating inflation rates Tables 18.4 and 18.5 illustrate the effects of rising inflation rates on a country’s exchange rate and the consequential negative effect on operating profits of a US firm doing business in Sweden.

18.3  (C)  Translation  Exposure: is the risk of a negative effect on financial statements

due to different countries’ rules for translating foreign financial statements into consolidated reports of both foreign and domestic operations.

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

620          Brooks  n  Financial  Management:  Core  Concepts,  2e  

18.4  Foreign  Investment  Decisions  

(Slides  18-­‐29  to  18-­‐34)  

When evaluating multinational capital budgeting projects, the NPV analysis can be done with either foreign currency cash flows or with domestic currency cash flows. Two main differences between foreign and domestic investment decisions include: (1) the use of an appropriate discount rate which accounts for the relative inflation rates in the two countries and (2) the conversion of cash flows using an appropriate exchange rate. Example 18.3 shown below is a detailed illustration of how NPV analysis of foreign projects can be done in either a domestic context or a foreign one.

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

Chapter  18  n  International  Financial  Management          621  

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

622          Brooks  n  Financial  Management:  Core  Concepts,  2e  

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

Chapter  18  n  International  Financial  Management          623  

Questions   1. What effect can cultural differences have on the ownership structure of a foreign operation of a multinational business? The cultural norms of a country may demand that a business be locally owned. Such norms may even work their way into laws and regulations so that the interests of the host country will take precedence over the interest of the foreign country, the original home of the business. Many times this means that in order to start a business operation in a foreign country, it will be necessary to utilize a joint venture business form. 2. What are intellectual property rights? How have changes in technology impacted the ability to protect intellectual property rights? Property rights, in general, refer to the right of an individual to use his or her talents and properties (assets) for personal gain. The use of physical property, such as one’s truck, is restricted to the owner of the truck so that he or she can generate revenue from utilizing this specific truck in a business. Others cannot legally use another’s property (the truck) without the permission of the owner. Intellectual property rights are similar, but refer to the product or service that is created by the talents of an individual. For instance, a composer receives compensation when his or her song is used by a performer. Typically, the composer receives a royalty when the sheet music is sold. Technology has made it more difficult to protect intellectual property as the ability to reproduce music, books, or other property is fast, efficient, and very easy via downloads and scanning information. 3. What does it mean to nationalize a business? How can a domestic company minimize the risk of nationalization of its foreign operations? Nationalization is when a local government “takes over” the assets of the company and nationalizes it. In this case, the original company is often not compensated for the loss of these assets to the ruling government. There are three basic defensive mechanisms that can protect against this type of loss: 1. Keep critical operations private. 2. Finance operations and assets with local money. 3. Receive primary inputs outside the local economy. 4. Explain how purchasing power parity determines the exchange rate between two currencies. Purchasing power parity (PPP) means that the price of similar goods is the same, regardless of which currency one uses to buy the goods. Thus, purchasing power becomes a constant (achieves “parity”) among currencies by setting the exchange rate between two currencies to make the cost of a good the same whether buying in the home currency, or exchanging the home currency for the foreign currency and buying in the foreign currency. 5. Why are currency exchange rates constantly changing over time? Currency exchange rates are constantly changing over time as inflation rates in countries are different. Rates change to reflect changes in purchasing power parity as prices change with inflation.

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

624          Brooks  n  Financial  Management:  Core  Concepts,  2e  

6. What is a cross rate? How can you find the cross rate of two foreign currencies if you only know the direct and indirect rates of those two foreign currencies with respect to your home currency? A cross rate is the exchange rate of two foreign currencies. If you know the indirect rate of one foreign currency in terms of the home currency and the direct rate of the other foreign currency in terms of the home country you can multiply the indirect and direct rate to find the cross rate. 7. Why should a company be concerned about a change in future exchange rates if it has already delivered and sold product in a foreign country? A company should be concerned about future rates when they have yet to collect on the foreign sales. If future exchange rates move against their home currency they could lose anticipated revenue as the foreign currency strengthens against the domestic currency. 8. How can a changing exchange rate impact a company’s profits on one of its foreign operations? Two problems can arise. First, anticipated cash inflows may fall in value if unexpected movements in the exchange rate hurt your ability to convert the foreign currency into domestic currency. Second, the future anticipated cash flows of the foreign business will now be producing less domestic currency upon conversion. The first problem -- reduction in the conversion of future currency -- is called transaction exposure. The second problem -- reduction in the value of future cash flow from operations -- is called operating exposure. 9. Explain how translating a foreign balance sheet for inclusion in a multinational’s domestic balance sheet can violate the accounting identity. At issue here is the translation of different accounts with different exchange rates. It would seem that the best way to translate foreign statements for consolidation with domestic statements is to use the current exchange rate on all accounts and then add them into the domestic account totals. Unfortunately, rules governing consolidation of foreign accounts are not that simple. Translation principles in many countries require the use of historical exchange rates for certain equity, fixed asset, and inventory accounts, but current exchange rates for current assets, current liabilities, and income accounts. Therefore, when the process is completed, it can produce an imbalance in the accounts. 10. Is it better to calculate the net present value of a foreign project in the foreign currency or in the domestic currency? It does not matter as you always reach the same decision, if a go in the foreign currency it is a go in the domestic currency and if a no-go in the foreign currency it is a no-go in the domestic currency.

Prepping  for  Exams   1. d 2. d 3. b

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

Chapter  18  n  International  Financial  Management          625  

4. a 5. c 6. a 7. b 8. d 9. c 10. b

Problems     1. Foreign exchange and commodity prices. While traveling in the following countries you see 20-ounce plastic bottles of Coca-Cola. You know the price in the United States for a coke is $1.09, but the countries have the following prices: Canada – C$ 1.50 Japan -- ¥ 125 England -- £ 0.60 Average Price across Europe -- € 0.90 What is the implied exchange rate for U.S. dollars and these four currencies? ANSWER   In-direct:

Direct (1/In-direct):

C$ 1.50 = $1.09

C$ 1.3761 per $1

$0.7267 per C$1.00

¥ 125.00 = $1.09

¥ 114.6789 per $1

$0.0087 per ¥1.00

£ 0.5505 per $1

$1.8167 per £1.00

€ 0.8257 per $1.00

$1.2111 per €1.00

£ 0.6000 = $1.09 € 0.9000 = $1.09

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

626          Brooks  n  Financial  Management:  Core  Concepts,  2e  

2. Foreign exchange and commodity prices. While traveling in various countries, you occasionally resort to U.S. food. You pay the following prices for a Big Mac: India – 210 rupee Kuwait – 1.39 dinar Sweden – 34.90 krona Ukraine – 133 rubles If the price of a Big Mac is $4.59 in the United States, what are the implied exchange rates for these currencies? ANSWER   In-direct:

Direct (1/In-direct):

210 Rupee = Rupees 45.7516 per $1.00 $4.59

$0.0219 per Rupee

1.39 Dinar = Dinar 0.3028 per $1.00 $4.59

$3.3022 per Dinar

34.90 Krona = Krona 7.6035 per $1.00 $4.59

$0.1315 per Krona

133 Rubles = Rubles 28.976 per $1.00 $4.59

$0.0345 per Ruble

3. Currency exchange rates. You are taking a trip to six European countries. It is a tenday trip, and you are taking $3,500. The current direct conversion rate is 1.2150 for euros. While in Europe, you spend € 2638.30. You convert your remaining euros back to U.S. dollars upon your return. If the exchange rates remained the same over your trip, how much do you have left in U.S. dollars? ANSWER   Convert $ to € $ 3,500 / (1.2150) =

€2,880.6584 € 242.3584 Remaining Convert € to $ € 242.3584 × (1.2150) = $294.4655

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

Chapter  18  n  International  Financial  Management          627  

4. Currency exchange rates. On the day you arrive in England, the exchange rate for U.S. dollars and British pounds is $1:£0.58. While you remain in England for the next two weeks, the exchange rate falls to $1:£0.54. When you entered England, you converted $4,200 to pounds. As you leave England, you have £135. How much did you spend in England in U.S. dollars? Did the movement in the exchange rate help or hurt you? ANSWER   Convert $ to £ $ 4,200 × (0.5800) = £ 2,436.00 Left in Pounds $2436.00 – £ 2,301.00 = £ 135.00 Dollars left after converting: £ 135 / (0.5400) = $ 250 Dollars Spent $4,200.00 – $250.00 = $3,950.00 Appreciation of the £:$ helped you: Bought the £ low and sold the £ high Initial value of $1.00 = £ 0.5800 Ending value of $ = £ 0.5800 / (£ 0.5400) = 1.074074 You gained about 7.4 cents per dollar while in England. 5. Cross rates. You plan on traveling to Japan and China on a business trip. You will first stop in Japan, where the current direct exchange rate is 0.0092. You will next stop in China, where the current direct exchange rate is 0.1285. As you leave Japan, you have ¥980,000 and need to convert to yuan. What is the cross rate for yuan? How many yuan do you get for your yen? Verify by converting yen back to dollars and then dollars to yuan. ANSWER   Direct rate: $0.0092 / ¥1.00 & $0.1285 / yuan1.00 Cross rate: ($0.0092 / ¥1.00) / ($0.1285 / yuan1.00) = yuan0.0716 / ¥1.00 Convert: ¥980,000 to yuan = ¥980,000 × (0.0716) = yuan 70,163.424 Verification: ¥980,000 × 0.0092 = $9,016 $9,016 / (0.1285) = yuan 70,163.424

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

628          Brooks  n  Financial  Management:  Core  Concepts,  2e  

6. Cross rates. Fill in the missing cross rates and direct rates in the table below: International Cross Rates $

Euro

Canada

1.3689

Japan

109.48

Mexico

11.3921

U.K.

0.5460

Euro

0.8222

U.S.

--

Pound

Peso

Yen

C$ --

-----

ANSWER:   International Cross Rates $

Euro

Pound

Peso

Yen

C$

Canada

1.3689

1.6649

2.5071

0.1202

0.0125

--

Japan

109.48

133.1550

200.5128

9.6103

--

79.9766

11.3921

13.8556

20.8647

--

0.1041

8.3195

U.K.

0.5460

0.6641

--

0.0479

0.0050

0.3989

Euro

0.8222

--

1.5059

0.0722

0.0075

0.6006

U.S.

--

1.2162

1.8315

0.0879

.0091

0.7305

Mexico

7. Triangular arbitrage. Great Exchanges, Inc. is a currency exchange company located at most international airports. Today, a clerk has made a mistake on one of the currency exchanges and has posted the following rates: $ for £

£ for €

€ for $

£ for $

€ for £

$ for €

0.5310

1.4435

1.3046

1.8832

0.9628

0.7665

Which corresponding rates do not match? And if you had $1,000, how much could you make on one pass through the currencies? ANSWER   Direct

Indirect

Actual Indirect:

£0.5310 = $1.00

$1.8832 £1.00

$1.8832 £1.00

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

Chapter  18  n  International  Financial  Management          629  

€1.4435 = £1.00

£0.6928 €1.00

£0.9628 è Mismatch €1.00

$1.3046 = €1.00

€0.7665 $1.00

€0.7665 $1.00

Arbitrage strategy: Need to use the mismatched Euros to British Pounds… 1. Convert $ to €, $1,000 × 0.7665 = €766.50 2. Convert € to £, €766.50 × 0.9628 = £737.9862 3. Convert £ to $, £737.9862x 1.8832 = $1,389.77 Profit: $ 389.77 8. Triangular arbitrage. Using the data from Problem 7, determine what you would lose if you went the wrong way for the arbitrage. Explain this result. ANSWER   Direct

Indirect

Actual Indirect:

£0.5310 = $1.00

$1.8832 £1.00

$1.8832 £1.00

€1.4435 = £1.00

£0.6928 €1.00

£0.9628 è Mismatch €1.00

$1.3046 = €1.00

€0.7665 $1.00

€0.7665 $1.00

Arbitrage strategy: 1. Convert $ to £, $1,000 × 0.5310 = £531.00 2. Convert £ to €, £531.00 × 1.4435 = €766.4985 3. Convert € to $, £766.4985 × 1.3046 = $999.97 You lose three cents, nothing really, because the all the rates used were correct and you did not take advantage of the mismatched Pounds to Euro rate nor did you use that mismatched rate in the wrong direction. 9. Forward rates. Your company has posted you on an eighteen-month overseas assignment in Budapest, Hungary. You will be living on the Buda side of the river, but will be spending much of your time on the Pest side. The current indirect rate for the Hungarian forint is 187.90. If the anticipated inflation rate in the United States is 3% and the anticipated rate in Hungary is 8.5% (annually), what exchange rate do you anticipate at the end of your assignment?

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

630          Brooks  n  Financial  Management:  Core  Concepts,  2e  

ANSWER   Current in-direct exchange rate: 187.90 HF Anticipated forward 18mo. (187.90 HF) × [(1+.085) / (1+.03)]1.5 = 203.1494 HF 10. Forward rates. The Wall Street Journal lists forward rates for Japanese yen. Say that the current listings are: 1-month forward rate (indirect) 103.17 3-month forward rate (indirect) 102.68 6-month forward rate (indirect) 101.88 First, is the anticipated inflation rate higher or lower in Japan compared to that in the United States? Second, if the current indirect rate is 103.37, what do the six-month rate and the current rate imply about the relative difference in the anticipated annual inflation rates? Finally, using the current indirect rate and the 6-month forward rate, determine the annual anticipated inflation rates for Japan if the U.S. inflation rate is anticipated to be 3.45%. ANSWER   Forward indirect rates: One month ¥103.17 / $ 1.00 Three months ¥102.68 / $ 1.00 Six months ¥101.88 / $ 1.00 A depreciating ¥ signifies lower inflation in the next six months for Japan versus the United States. Inflation: 101.88 = 103.37 × [(1 + infJAPAN) / (1 + infUS)]0.5 [(1 + infJAPAN) / (1 + infUS)] = (101.88 / 103.37)2 [(1 + infJAPAN) / (1 + infUS)] = 0.97137929 (1 + infJAPAN) = (1 + infUS) × 0.9713729 Therefore, (1 + infJAPAN) < (1 + infUS) and thus infJAPAN < infUS And if US. inflation is 3.45% then (1 + infJAPAN) = (1.0345) × 0.9713729 Inf JAPAN = 0.004891876 or 0.49% 11. Real rates. Determine what the real interest rates are in the following countries, given their nominal interest rates and inflation rates: Canada: inflation is 4.5%, and the nominal risk-free interest rate is 6.0%. Switzerland: inflation is 1.25%, and the nominal risk-free interest rate is 3.75%. United States: inflation is 3%, and the nominal risk-free interest rate is 4.50%. ANSWER:   Using the simple approximate approach

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

Chapter  18  n  International  Financial  Management          631  

Canada: .06 Nom RF – .045 INF= 0.015 or 1.5% real Switzerland: .0375 Nom RF – .0125 INF = 0.025 or 2.5% real U.S.: .045 Nom RF- .030 INF= 0.015 or 1.5% real Using the Fisher Effect approach Canada (1.06 / 1.045) – 1 = 0.01435 or 1.435% real Switzerland: (1.0375 / 1.0125) – 1 = 0.024691 or 2.469% real U.S.: (1.045 / 1.030) -1 = 0.01456 or 1.456 % real 12. Real rates. Determine the nominal rates for the three countries listed if they have the following inflation rates and the real rate the world over is 1.25%. Canada: inflation is 4.5%. Switzerland: inflation is 1.25%. United States: inflation is 3%. ANSWER   Using the simple approximate approach Canada: .0125 real + .045 INF = 0.0575 or 5.75% nominal Switzerland: .0125 real + .0125 INF = 0.0250 or 2.5% nominal U.S.: .0125 real + .030 INF = 0.0425 or 4.25% nominal Using the Fisher Effect approach Canada (1.0125 × 1.045) – 1 = 0.05806 or 5.806% real Switzerland: (1.0125 × 1.0125) – 1 = 0.025156 or 2.5156% real U.S. : (1.0125 × 1.030) -1 = 0.042875 or 4.2875 % real 13. Transaction exposure. International Products, Incorporated has ordered 10,000 leather coats from Argentina for delivery in six months. The contracted cost of a coat is 122 pesos. International Products will pay for the coats upon delivery. The current indirect exchange rate is $1 for 1.2902 pesos. The anticipated inflation rate in the United States is 3% and 7% in Argentina. In U.S. dollars, how much will the 10,000 leather coats cost International Products at delivery? ANSWER   Anticipated forward 6 mo. (Ps1.2902) × [(1+.07)/ (1+.03)](1/2) = Ps 1.3150 Cost of 10,000 coats: 10,000 × [Ps122 × ($1.00) / Ps 1.3150)] = $927,746.91 14. Transaction exposure. International Products has contracted for 5,000 winter hats from Russia. The contract price is 1,375 rubles per hat. The current direct exchange rate is 0.03562. The expected inflation rate for the next nine months is 5% in the United States and 2% in Russia. If International Products will pay for the hats at delivery and scheduled delivery is nine months away, what is the cost of the hats in U.S. dollars? Did waiting the nine months to pay increase or decrease the payment (in U.S. dollars)? If so, by how much?

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

632          Brooks  n  Financial  Management:  Core  Concepts,  2e  

ANSWER   Current cost of 5,000 winter hats: 5,000 × [Ru 1,375 × $0.03562] = $244,887.50 Anticipated forward 9mo. ($0.03562) × [(1+.05)/ (1+.02)]3/4 = $ 0.0364 per Ru1 New cost of 5,000 winter hats 5,000 × [Ru 1,375 × ($0.0364 / Ru 1.00)] = $ 250,269.81 Exposure loss: $ 5,382.3095 15. Operating exposure. Copy-Cat, Incorporated has signed a deal to make vintage Nissan 240-Z sports cars for the next three years. The cars will be built in Japan and shipped to the United States for sale. The current indirect rate is 103.50 for dollars and yen. The inflation rate for parts and labor in Japan is anticipated to be 2.5% over the next three years, and the overall inflation rate for Japan is anticipated to be 3.5% over the next three years. The overall inflation rate in the United States is expected to be 4.0% over the next three years. (Note: rates are stated on an annual basis.) If CopyCat plans on selling 500 cars a year at an initial cost price of $45,000 and the cost of production is ¥4,036,500, what is the annual profit in real dollars for Copy-Cat? Assume that it takes one year for production and that all sales revenues and production costs are at the end of the year. Is this profit rising or falling each year? Why? ANSWER   Assume the revenue and costs are from the start of the year and will inflate over the first year. Anticipated forwards; Yr 1. (¥103.50/$1.00) × (1.035/1.04) Yr 2. (¥103.50/$1.00) × (1.035/1.04)2 Yr 3. (¥103.50/$1.00) × (1.035/1.04)3 $ Profit per car Yr 1 Revenue $ 46,800.00 Cost $ 40,168.12 Profit $ 6,631.88

= ¥103.0024/$1.00 = ¥102.5072/$1.00 = ¥102.0144/$1.00

2 $48,672.00 $41,371.22 $ 7,300.78

3 $50,618.90 $42,610.35 $ 8,008.55

Profit end of year one : $6,631.88 × 500 = $3,315,940 Profit end of year two : $7,300.78 × 500 = $3,650,390 Profit end of year three : $8,008.55 × 500 = $4,004,275 Revenue: $ 45,000 (1.04) = $ 46,800.00 $ 45,000 (1.04)2 = $ 48,672.00 $ 45,000 (1.04)3 = $ 50,618.88

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

Chapter  18  n  International  Financial  Management          633  

Cost ¥ 4,036,500 (1.025) / 103.0024 = $40,168.12 ¥ 4,036,500 (1.025)2 / 102.5072 = $41,371.22 ¥ 4,036,500 (1.025)3 / 102.0144 = $42,610.35 $ Profits are rising as the revenue is growing at a higher inflation rate than the production costs despite the weakening dollar against the yen. 16. Operating exposure. Just before Copy-Cat, Incorporated starts the project outlined in Problem 15, the government announces new anticipated inflation numbers. For Japan, the estimate is a higher inflation rate of 5%. For the United States, the estimate is a lower projection of 3.0%. If the production cost inflation rate remains at 2.5%, will these new anticipated inflation rates impact the production of vintage 240-Zs?  ANSWER   Assume the revenue and costs are from the start of the year and will inflate over the first year. Anticipated forwards; Yr 1. (¥103.50/$1.00) × (1.05/1.03) = ¥105.5097/$1.00 Yr 2. (¥103.50/$1.00) × (1.05/1.03)2 = ¥107.55844/$1.00 Yr 3. (¥103.50/$1.00) × (1.05/1.03)3= ¥109.6469544/$1.00 $ Profit per car Yr Revenue Cost Profit

1 $ 46,350.00 $ 39,213.57 $ 7,136.43

2 $47,740.50 $39,428.33 $ 8,312.17

3 $49,172.715 $39,644.229 $ 9,528.49

Profit end of year one : $7,136.43 × 500 = $3,568,215 Profit end of year two : $8,312.17 × 500 = $4,156,085 Profit end of year three : $9,528.49 × 500 = $4,764,245 Revenue: $ 45,000 (1.03) = $ 46,350.00 $ 45,000 (1.03)2 = $ 47,740.50 $ 45,000 (1.03)3 = $ 49,172.715 Cost ¥ 4,036,500 (1.025) / 105.5097 = $39,213.57 ¥ 4,036,500 (1.025)2 / 107.5584 = $39,428.33 ¥ 4,036,500 (1.025)3 / 109.6469544 = $39,644.229 $ Profits are rising as the revenue is growing at higher inflation rate than the production costs and the weakening yen allows for the production costs to fall even more against the dollar.

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

634          Brooks  n  Financial  Management:  Core  Concepts,  2e  

17. Domestic NPV approach. Surfboards USA wants to expand its operations to Australia. The current indirect exchange rate is 1.45 for U.S. and Australian dollars. The anticipated inflation rate is 3% in the United States, but only 1.5% in Australia. The discount rate in the United States for the expansion project is 14%. If the following Australian dollars have been forecasted for the expansion project, should Surfboards USA expand to Australia? Use the domestic currency approach. Cash Flows:

Investment: A$ 40,000,000 Year 1 – A$ 5,000,000 Year 2 – A$ 9,000,000 Year 3 – A$ 16,000,000 Year 4 – A$ 20,000,000 Year 5 – A$ 8,000,000 Year 6 – A$ 3,000,000

ANSWER   Anticipated forwards: Yr 1. (Au$1.45/$1.00) × (1.015/1.03)= Au$1.4289/$1.00 Yr 2. (Au$1.45/$1.00) × (1.015/1.03)2 = Au$1.4081/$1.00 Yr 3. (Au$1.45/$1.00) × (1.015/1.03)3 = Au$1.3876/$1.00 Yr 4. (Au$1.45/$1.00) × (1.015/1.03)4 = Au$1.3674/$1.00 Yr 5. (Au$1.45/$1.00) × (1.015/1.03)5 = Au$1.3474/$1.00 Yr 6. (Au$1.45/$1.00) × (1.015/1.03)6 = Au$1.3278/$1.00 Cash Flows: $ value Au$ -40,000,000 / 1.45 = $ -27,586,207.0 Au$ 5,000,000 / 1.4289 = $ 3,499,235.6/ (1.14) Au$ 9,000,000 / 1.4081 = $ 6,391,707.2/ (1.14)2 Au$ 16,000,000 / 1.3876 = $ 11,530,962/ (1.14)3 Au$ 20,000,000 / 1.3674 = $ 14,626,712/ (1.14)4 Au$ 8,000,000 / 1.3474 = $ 5,937,148.3/ (1.14)5 Au$ 3,000,000 / 1.3278 = $ 2,259,333.5/ (1.14)6 NPV = ∑(PV Column)è $ 957,658.50, Expand

Present Value $ -27,586, 207.00 $ 3,069,504.90 $ 4,918,211.10 $ 7,783,070.70 $ 8,660,188.00 $ 3,083,568.80 $ 1,029,322.00

18. Domestic NPV approach. Farbucks is thinking of expanding to South Korea. The current indirect rate for dollars and South Korean won is 1025. The inflation rate in South Korea is expected to hover near 0.5% for the next five years. The U.S. inflation rate is expected to stay around 3.0%. The discount rate for expanding is 15% for Farbucks. Given the following projected cash flows for the expansion project and using the domestic NPV approach, should Farbucks expand to South Korea? Cash Flows: Year 0, initial investment costs Won 82,000,000 per coffee shop Year 1, – Won 25,000,000 Year 2, Won 30,000,000 Year 3, Won 70,000,000 Year 4, Won 90,000,000 ©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

Chapter  18  n  International  Financial  Management          635  

Year 5, Won 45,000,000 ANSWER   Anticipated forwards: Yr 1. (Won1025/$1.00) × (1.005/1.03) Yr 2. (Won1025/$1.00) × (1.005/1.03)2 Yr 3. (Won1025/$1.00) × (1.005/1.03)3 Yr 4. (Won1025/$1.00) × (1.005/1.03)4 Yr 5. (Won1025/$1.00) × (1.005/1.03)5

= Won1000.1214/$1.00 = Won 975.8466/$1.00 = Won 952.1610/$1.00 = Won 929.0503/$1.00 = Won 906.5005/$1.00

Cash Flows: $ value $ -82,000,000 / 1025.0000 = $ -80,000 $ 25,000,000 / 1000.1214 = $ 24,996.966/ (1.15) $ 30,000,000 / 975.8466 = $ 30,742.538/ (1.15)2 $ 70,000,000 / 952.1610 = $ 73,516.981/ (1.15)3 $ 90,000,000 / 929.0503 = $ 96,873.122/ (1.15)4 $ 45,000,000 / 906.5005 = $ 49,641.451/ (1.15)5 NPV = ∑(PV Column) $ 93,388.972 Expand

Present Value $ -80,000.00 $ 21,736.493 $ 23,245.775 $ 48,338.608 $ 55,387.522 $ 24,680.574

19. Foreign currency NPV approach. Verify your answer to Problem 17 using the foreign-currency approach. ANSWER   Foreign discount rate: [(1+ US discount rate) × ((1+ Inflation FC)/ (1+ Inflation US))] -1 (1.14 × (1.015/1.03)) 1 = 12.339806% PV A$ Cash Flows: Cost – A$ -40,000,000 A$ -40,000,000 Year 1 – A$ 5,000,000/(1+12.339806%) A$ 4,450,782.1 2 Year 2 – A$ 9,000,000/(1+12.339806%) A$ 7,131,406.2 Year 3 – A$ 16,000,000/(1+12.339806%)3 A$ 11,285,452 Year 4 – A$ 20,000,000/(1+12.339806%)4 A$ 12,557,273 Year 5 – A$ 8,000,000/(1+12.339806%)5 A$ 4,471,174.7 Year 6 – A$ 3,000,000/(1+12.339806%)6 A$ 1,492,516.8 NPV = ∑(PV Column) A$ 1,388,604.9 / 1.45 = $ 957,658.50 Expand 20. Foreign currency NPV approach. Verify your answer to Problem 18 using the foreign-currency approach. ANSWER   Foreign discount rate:

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

636          Brooks  n  Financial  Management:  Core  Concepts,  2e  

[(1+ US discount rate) × ((1+ Inflation FC)/ (1+ Inflation US))] -1 (1.15 × (1.005/1.03)) – 1 = 12.208738% PV Won Cost – Won -82,000,000 Won -82,000,000 Year 1 – Won 25,000,000/(1+12.208738%) Won 22,279,905 Year 2 – Won 30,000,000/(1+12.208738%)2 Won 23,826,920 Year 3 – Won 70,000,000/(1+12.208738%)3 Won 49,547,073 Year 4 – Won 90,000,000/(1+12.208738%)4 Won 56,772,210 Year 5 – Won 45,000,000/(1+12.208738%)5 Won 25,297,589 NPV = ∑(PV Column) , Won 95,723,697 / 1025 = $ 93,388.972 Expand Cash Flows:

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

Chapter  18  n  International  Financial  Management          637  

Solutions  to  Advanced  Problems  for  Spreadsheet  Application   1. Find the triangular arbitrage across six currencies (three way pairs). Triangular Arbitrage Currency Rate s Given from Problem U.S. $ CAN $ Peso Euro € HK $ AUS $ Jap ¥ Pound £

U.S. $ -0.7500 0.0625 1.3500 0.1545 0.6875 0.0102 1.5465

CAN $ 1.3333 -0.0833 1.8000 0.2060 0.9167 0.0136 2.0620

Peso 16.0000 12.0000 -21.6000 2.4720 14.0000 0.1632 24.7440

Euro € HK $ 0.7407 6.4725 0.5556 4.8544 0.0463 0.4045 -8.7379 0.1144 -0.5093 4.4498 0.0076 0.0660 1.1456 10.0097

Aus $ JAP ¥ Pound £ 1.4545 98.0392 0.6466 1.0909 73.5294 0.4850 0.0909 6.1275 0.0404 1.964 132.353 0.8729 0.225 15.1471 0.0999 -67.4020 0.4466 0.0148 -0.0066 2.2495 151.6176 --

U.S. $ CAN $ Peso Euro € HK $ AUS $ Jap ¥ Pound £

U.S. $ -0.7500 0.0625 1.3500 0.1545 0.6875 0.0102 1.5465

CAN $ 1.3333 -0.0833 1.8000 0.2060 0.9167 0.0136 2.0620

Peso 16.0000 12.0000 -21.6000 2.4720 11.0000 0.1632 24.7440

Euro € HK $ 0.7407 6.4725 0.5556 4.8544 0.0463 0.4045 -8.7379 0.1144 -0.5093 4.4498 0.0076 0.0660 1.1456 10.0097

Aus $ JAP ¥ Pound £ 1.4545 98.0392 0.6466 1.0909 73.5294 0.4850 0.0909 6.1275 0.0404 1.9636 132.3529 0.8729 0.2247 15.1471 0.0999 -67.4020 0.4446 0.0148 -0.0066 2.2495 151.6176 --

U.S. $ CAN $ Peso Euro € HK $ AUS $ Jap ¥ Pound £

U.S. $ -0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000

CAN $ Peso 0.0000 0.0000 -0.0000 0.0000 -0.0000 0.0000 0.0000 0.0000 0.0000 3.0000 0.0000 0.0000 0.0000 0.0000

Euro € HK $ 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 -0.0000 0.0000 -0.0000 0.0000 0.0000 0.0000 0.0000 0.0000

Aus $ JAP ¥ Pound £ 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 -0.0000 0.0020 0.0000 -0.0000 0.0000 0.0000 --

Calculate d Cross Rate s

Difference in Rate s

ARBITRAGE US $ to AUS $ To Peso To US $ U.S. $ $1000 to AUS $ AUS $ Peso U.S. $ Profit

$ 1,000.00 1,454.50 20,363.00 $ 1,272.69 $ 272.69

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

638          Brooks  n  Financial  Management:  Core  Concepts,  2e  

2: NPV in foreign and home currency.

O'Brien Athletic Equipment Inflation Rate Australia 3.7500% Inflation Rate United States 3.2500% WACC in US 16.0000% WACC in Australia 16.5617% Indirect Exchange Rate $ 1.4545

Net Present Value AUS $ Net Present Value US $

Year 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

CF in AUS $ PV in AUS $ Fwd. CF in US$ PV in US $ Indirect rates (325,000,000) (325,000,000) 1.455 (223,437,500) -223,437,500 12,000,000 10,294,973 1.462 8,210,241 7,077,794 36,000,000 26,496,617 1.469 24,512,021 18,216,424 58,000,000 36,623,504 1.476 39,301,268 25,178,659 74,000,000 40,087,372 1.483 49,901,344 27,560,068 81,000,000 37,644,787 1.490 54,358,504 25,880,791 86,000,000 34,289,586 1.497 57,435,828 23,574,091 92,000,000 31,469,916 1.505 61,146,868 21,635,567 95,000,000 27,878,881 1.512 62,836,494 19,166,730 97,000,000 24,421,224 1.519 63,850,166 16,789,591 99,000,000 21,383,306 1.527 64,852,608 14,701,023 102,000,000 18,900,957 1.534 66,495,825 12,994,408 104,000,000 16,533,353 1.541 67,472,919 11,366,680 105,000,000 14,320,588 1.549 67,793,400 9,845,404 94,000,000 10,998,751 1.556 60,398,746 7,561,641 63,000,000 6,324,119 1.564 40,284,927 4,347,832

26,343,815 18,111,373 Accept

Solutions  to  Mini-­‐Case   Scholastic Travel Services, Inc. This case requires students to consider business and political risks associated with international business operations. It requires them to use techniques illustrated in the chapter to solve basic but realistic foreign exchange problems. Finally, it requires practical application of hedging and risk management techniques discussed in the chapter. 1. In the summer of 2011, a budget crisis in Greece sparked occasionally violent protest demonstrations in Athens. A few weeks later, a right wing extremist in Norway bombed government buildings in Oslo and then went on a shooting spree, killing sixty-nine young campers. In early August, violent riots broke out in London after police shot and killed twenty-nine year old Mark Duggan while attempting to arrest him. Shortly before the start of the fall term, anxious families withdrew more than a third of the students enrolled in UK programs and requested full refunds, even though their contract with Scholastic Travel specified a 50% refund for withdrawals after June 30. Scholastic Travel also faced a higher than normal withdrawal rate from other programs in Western Europe. a. What types of risk are illustrated by this incident?

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

Chapter  18  n  International  Financial  Management          639  

Political risk: this incident exposed to Scholastic Travel’s customers the existence of political divisions and terrorist threats in Spain that they probably had not considered previously. Parents are typically anxious about their children going to distant, unfamiliar locations, so many of them would react more dramatically to such an incident in Spain than they might have if it had happened in a major U.S. city. Business risk: the incident illustrates how uncontrollable adverse events in a foreign country can have a major negative impact on sales and profits. b. How should Scholastic Travel respond to the requests for refunds? Scholastic Travel will need to find a solution that takes into account financial, legal, and public relations consequences. Perhaps they can place some of the students in another program in Europe or in a Latin American country such as Mexico. As a goodwill gesture, they might offer to refund all but their own irrecoverable costs incurred up to that point in the program. Scholastic Travel can reduce this kind of risks by diversifying its programs to include countries in other parts of the world such as Latin America, Australia, New Zealand, and Asia. 2. Ashley and Michaela are participating in a Scholastic college program in Turin, Italy. On a weekend trip to Switzerland, they stop at an outdoor café for coffee and pastry and to and observe the Geneva sidewalk scene. The two cafes au lait and two chocolate croissants came to 19.25 Swiss francs. Because they had not had a chance to exchange any currency, they ask if they can pay in euros or dollars. The server says the price will be the same either way, $14.50 or 10.26 euros. a. What exchange rates between dollars and Swiss francs and dollars and euros are implied by these prices? The price hot chocolate implies that $1.00 is exactly equivalent to 1 Swiss franc, and 6.70/10.50 = .638 euros. b. What is the implied cross rate between euros and Swiss francs? Since the price of hot chocolate implies equivalency between U.S. dollars and Swiss francs, the implied cross rate is the same as for dollars, .638 euros per Swiss franc. c. The actual exchange rates at the time were $1.00 equals €.705 or SF 1.374. Why might these rates differ slightly from the rates calculated in question a? The price for dollars and euros implied by the hot chocolate standard is a little bit low. The café might have built in a small commission for the inconvenience of having to exchange currency. It is also possible that the restaurant’s prices in common foreign currencies are only adjusted periodically and may be slightly out-of-date. Still another possibility is that the server’s mental calculations were imprecise. d. Should Ashley and Michaela pay in dollars or euros?

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

640          Brooks  n  Financial  Management:  Core  Concepts,  2e  

If the students pay in U.S. currency, the hot chocolate costs in dollars, SF10.50/ (1/ 1.044) =$10.962. If they pay in euros, the hot chocolate costs in dollars, SF10.50/ (.645/.638) = $10.386. So the students should pay in euros. e. At a Starbucks in the Boston, Massachusetts, suburb of Newton, Ashley and Michaela’s home town, a latte costs $3.50 and a chocolate croissant costs $2.50. If these orders are close substitutes for what they ordered at the Swiss café, does purchasing power parity prevail? Why or why not? Is arbitrage possible? The 2 coffees and croissants would have cost the students $12 at a Starbucks in Boston compared to $14.56 in Geneva. Arbitrage appears to be possible from an economic view, but you cannot substitute coffee from the US for that in Switzerland. The shipping costs would swamp the potential arbitrage profit and it would be impossible to keep the coffee hot. Besides, part of the higher Swiss cost is the ambiance of the Café in Geneva and the aroma and flavor of Swiss Chocolate! 3. On February 1, 2011, Scholastic received $25,000 in fees from students for a summer program in Angers, France. Directly related to these fees, Scholastic will have to pay €3,525 for facilities rental on June 1 and €7,050 in staff salaries at the end of August. The current exchange rates are the same as in question 2. The future inflation rate in France is estimated at .124% per month; the future U. S. inflation rate is estimated at .231% per month. a. What is the expected exchange rate on June 1 and on August 31 (use 5 months and 7 months to compute the forward rates)? Using the equation for foreign indirect rates, the indirect spot rate is €.645 to $1.00. The expected rate in 5 months is .645((1.00124)/(1.00231))^5= .642, and in 7 months .645((1.00124)/(1.00231))^7=.640. b. What is the cost of rents and salaries in dollars at the current exchange rate? Rents: €.3,225/.645 =$5,000.00 Salaries: €6,450/.645=$10,000.00 c. What will be the cost of rents and salaries in dollars if expected exchange rates equal actual exchange rates? Rents: €.3,225/.642 =$5,023.36 Salaries: €6,450/.640=$10,078.13 d. What will be the cost of salaries in dollars if the dollar unexpectedly strengthens to €.70 or weakens to €.60? What do your answers imply about transaction risk? Salaries: €6,450/.70=$9,214.29 Salaries: €6,450/.60=$10,750.00 The answers imply that the risk is symmetrical. There are opportunities for large gains, and also the potential for large losses. Scholastic Travel is in the travel

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

Chapter  18  n  International  Financial  Management          641  

business, not the currency speculation business, and should hedge all or most of its exchange rate exposure. 4. What measures can Scholastic Travel take to protect the business from exchange rate risk? Scholastic has several possibilities. It can immediately convert sufficient funds to cover future expenses to Euros (or the relevant foreign currency) and deposit them in a European bank account. If it can do so on a practical scale, it could also enter into contracts for the forward purchase of the foreign currencies and keep the money in a U.S. bank account. The difference in interest rates between the U.S. and the target country should offset any appreciation or depreciation in the target currency.

Additional  Problems  with  Solutions   1. Currency exchange rates. On the day you arrive in New Zealand, the exchange rate for U.S. dollars and New Zealand dollars is $1:2.25 NZ$. While you remain in New Zealand for the next few months, the exchange rate falls to $1:$1.75439 NZ$. When you entered New Zealand, you converted US$10,500 to NZ$. As you leave New Zealand, you have NZ$ 400. How much did you spend in New Zealand in U.S. dollars? Did the movement in the exchange rate help or hurt you? ANSWER  

(Slides  18-­‐35  to  18-­‐36)  

Convert US$ to NZ$ è $ 10,500 × 2.25 = NZ$23,625 Remaining NZ$ after trip is over = NZ$400; Amount spent è NZ$23,625-NZ$400 = NZ$ 23,225 Dollars left after converting: NZ$400 / 1.75439 = $ 228 Dollars Spent $10,500 – $228.00 = $10,272 Appreciation of the NZ$:$ helped you: Bought the NZ low and sold the NZ high Initial value of $1.00 = NZ$2.25 Ending value of $ = NZ$2.25 NZ$ 1.75439 = 1.2825 You gained about 28.25 cents per dollar while in New Zealand 2. Cross rates. You plan on traveling to South Korea and China on a business trip. You will first stop in Korea, where the current direct exchange rate is $1: 1243.78SK Won. You will next stop in China, where the current direct exchange rate is $1: Yuan 6.83013. As you leave South Korea, you have 825,000 Won and need to convert it to Yuan. What is the cross-rate for Yuan, and how many Yuan do you get for your won? Verify by converting won back to dollars and then dollars to Yuan.

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

642          Brooks  n  Financial  Management:  Core  Concepts,  2e  

ANSWER  

(Slides  18-­‐37  to  18-­‐38)  

Direct rate:$0.000804 / Won1.00 & $0.1464101 /Yuan1.00 Cross rate: ($0.000804 / Won1.00) / ($0.1464101/Yuan1.00) è Yuan0.00549142 / Won1.00 Convert: 125,000 Won to Yuan = Won 825,000x (0.00549142) è Yuan 4,530.42 Verification: 825,000Won= 825,000*.000804è$663.3 $663.3*6.83013Yuanè = Yuan 4,530.42 3. Triangular arbitrage. On-Line Currency, Incorporated is an online currency exchange company that will immediately convert and credit your bank account based on its published rates. Being the smart finance major that you are, you notice that one of the rates published below is incorrect, and you want to take advantage of it. Let’s say that you have $20,000 of next semester’s college funds sitting in your checking account and decide to take advantage of the error by doing a triangular arbitrage. Explain how you would go about doing it by first identifying the mismatched currency pair: $ for £

£ for €

€ for $

£ for $

€ for £

$ for €

0.5510

1.5235

1.3046

1.81488203

0.95683

0.7665

ANSWER  

(Slides  18-­‐39  to  18-­‐40)   Direct

Indirect

Actual Indirect:

£0.5510 = $1.00

$1.81488203 £1.00

$1.81488203 £1.00

€1.5235 = £1.00

£0.65638333 €1.00

$1.3046 = €1.00

€0.7665 $1.00

£0.95683 è Mismatch €1.00 €0.7665 $1.00

Arbitrage strategy: Need to use the mismatched Euros to British Pounds… 1. Convert $ to €, $20,000 × 0.7665 = €15,330 2. Convert € to £, €15,330 × 0.95683 = £14,668.20390 3. Convert £ to $, £14,668.20x 1.81488203 = $26,621.06 Profit: $ 6,621.06 4. Forward rates. The Wall Street Journal lists forward rates for Euros. Say that the current listings are:

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

Chapter  18  n  International  Financial  Management          643  

1-month forward rate (indirect) 0.7025 3-month forward rate (indirect) 0.7145 6-month forward rate (indirect) 0.7245 First, is the anticipated inflation rate higher or lower in Europe compared to that in the United States? Second, if the current indirect rate is 0.6994, what do the sixmonth rate and the current rate imply about the relative difference in the anticipated annual inflation rates? Finally, using the current indirect rate and the 6-month forward rate, determine the annual anticipated inflation rates for Europe if the U.S. inflation rate is anticipated to be 3.15%. ANSWER  

(Slides  18-­‐41  to  18-­‐42)  

Forward indirect rates: One month €0.7025 / $ 1.00 Three months €07145 / $ 1.00 Six months €0.7245 / $ 1.00 A depreciating € signifies higher inflation in the next six months for Europe versus the United States. Inflation: 0.7245 = 0.6994 × [(1 + infEUROPE) / (1 + infUS)]0.5 [(1 + infEUROPE) / (1 + infUS)] = (.7245 / .6994)2 [(1 + infEUROPE) / (1 + infUS)] = 1.07306375 (1 + infEUROPE) = (1 + infUS) × 1.07306375 Since inflation in US is 3.15% (1 + infEUROPE) = (1.0315) × 1.07306375è1.10686526 Inf EUROPE = 10.69%

5. Domestic NPV approach. Kalamazoo Marine wants to expand its operations to New Zealand. The current indirect exchange rate is 1.75 for U.S. and New Zealand dollars. The anticipated inflation rate is 3.8% in the United States, but only 1.75% in New Zealand. The discount rate in the United States for the expansion project is 16%. If the following after-tax cash flows have been forecasted for the expansion project in NZ$, should Surfboards USA expand to New Zealand: Investment: Cash Flows:

NZ$ 60,000,000 Year 1 – NZ$7,000,000 Year 2 – NZ$10,000,000 Year 3 – NZ$ 25,000,000 Year 4 – NZ$ 19,000,000 Year 5 – NZ$ 17,000,000 Year 6 – NZ$ 5,000,000

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall  

644          Brooks  n  Financial  Management:  Core  Concepts,  2e  

ANSWER  

(Slides  18-­‐43  to  18-­‐45)  

Anticipated forwards: Yr 1. (NZ$1.75/$1.00) × (1.0175/1.038) Yr 2. (NZ$1.75/$1.00) × (1.0175/1.038)2 Yr 3. (NZ$1.75/$1.00) × (1.0175/1.038)3 Yr 4. (NZ$1.75/$1.00) × (1.0175/1.038)4 Yr 5. (NZ$1.75/$1.00) × (1.0175/1.038)5 Yr 6. (NZ$1.75/$1.00) × (1.0175/1.038)6

= NZ$1.7154/$1.00 = NZ$1.6816/$1.00 = NZ$1.6483/$1.00 = NZ$1.6158/$1.00 = NZ$1.5839/$1.00 = NZ$1.5526/$1.00

Cash Flows: $ value Present Value NZ$ -60,000,000 / 1.75 = $ -34,285,714.29 $ -34,285,714.29 NZ$ 7,000,000 / 1.7154 = $ 4,080,680.89/ (1.16) $ 3,517,828.35 NZ$ 10,000,000 / 1.6816 = $ 5,946,717.41/ (1.16)2 $ 4,419,379.77 3 NZ$ 25,000,000 / 1.6483 = $ 15,167,141.90/ (1.16) $ 9,716,945.85 NZ$ 19,000,000 / 1.6158 = $ 11,758,881.05/ (1.16)4 $ 6,494,325.32 NZ$ 17,000,000 / 1.5839 = $ 10,733,000.82/ (1.16)5 $ 5,110,121.39 NZ$ 5,000,000 / 1.5526 = $ 3,220,404.48/ (1.16)6 $ 1,321,790.08 NPV = ∑(PV Column)è -$ 3,705,323.53, Do not expand…Negative NPV

©2013  Pearson  Education,  Inc.  Publishing  as  Prentice  Hall