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Chapter 21: International Financial Management
21-8
3. Purchasing power theory (LO2) From the base price level of 100 in 1981, Saudi Arabian
and U.S. price levels in 2010 stood at 200 and 412, respectively. If the 1981 $/riyal
exchange rate was $0.26/riyal, what should the exchange rate be in 2010? Suggestion:
Using purchasing power parity, adjust the exchange rate to compensate for inflation. That
is, determine the relative rate of inflation between the United States and Saudi Arabia and
multiply this times $/riyal of 0.26.
21-3. Solution:
$/riyal = $.26 in 1981.
United States 412
Comparative rate of inflation 2.06
Saudi Arabia 200
= = =
theory holds.
4. Continuation of Purchasing power theory (LO2) In Problem 3, if the United States had
somehow managed no inflation since 1981, what should the exchange rate be in 2010,
using the purchasing power theory?
21-4. Solution:
$/riyal = $.26 in 1981.
United States 100
Comparative rate of Inflation .5
Saudi Arabia 200
= = =
theory holds.
Chapter 21: International Financial Management
5. Adjusting returns for exchange rates (LO2) An investor in the United States bought a
one-year Singapore security valued at 150,000 Singapore dollars. The U.S. dollar
equivalent was $100,000. The Singapore security earned 15 percent during the year but the
Singapore dollar depreciated 5 cents against the U.S. dollar during the same time period
($0.67/SD to $0.62/SD). After transferring the funds back to the United States, what was
the investor’s return on his $100,000? Determine the total ending value of the Singapore
investment in Singapore dollars and then translate this value to U.S. dollars by multiplying
by $0.62. Then compute the return on the $100,000.
21-5. Solution:
Initial value × (1 + percentage return)
150,000 × 1.15 = 172,500 Singapore dollars
Chapter 21: International Financial Management
a. Initial investment 100 × $40 = $4,000
Value after one year 100 × $46 = $4,600
Equivalent value to the
Chapter 21: International Financial Management
21-11
21-7. Solution:
a. The Houston bank has extended a loan denominated in
Canadian dollars and will be repaid in Canadian dollars. If
the Canadian dollar drops in the future (a possibility implied
Problem
21A-1. Cash flow analysis with a foreign investment (LO2) The Office Automation
Corporation is considering a foreign investment. The initial cash outlay will be
$10 million. The current foreign exchange rate is 2 ugans = $1. Thus the investment in
foreign currency will be 20 million ugans. The assets have a useful life of five years
and no expected salvage value. The firm uses a straight-line method of depreciation.
Sales are expected to be 20 million ugans and operating cash expenses 10 million ugans
every year for five years. The foreign income tax rate is 25 percent. The foreign
subsidiary will repatriate all aftertax profits to Office Automation in the form of
dividends. Furthermore, the depreciation cash flows (equal to each year’s depreciation)
will be repatriated during the same year they accrue to the foreign subsidiary. The
applicable cost of capital that reflects the riskiness of the cash flows is 16 percent. The
U.S. tax rate is 40 percent of foreign earnings before taxes.
a. Should the Office Automation Corporation undertake the investment if the foreign
exchange rate is expected to remain constant during the five-year period?
b. Should Office Automation undertake the investment if the foreign exchange rate is
expected to be as follows:
Chapter 21: International Financial Management
Year 0 ................................
$1 = 2.0 ugans
Year 1 ................................
$1 = 2.2 ugans
Year 2 ................................
$1 = 2.4 ugans
Year 3 ................................
$1 = 2.7 ugans
Year 4 ................................
$1 = 2.9 ugans
Year 5 ................................
$1 = 3.2 ugans
21A-1. Solution:
The Office Automation Corporation
(values in millions of ugans)
a.
Year 1
Year 2
Year 3
Year 4
Year 5
Revenue
20.00
20.00
20.00
20.00
20.00
– Operating expense
10.00
10.00
10.00
10.00
10.00
– Depreciation (20 M/5)
4.00
4.00
4.00
4.00
4.00
= Earnings before
foreign taxes
6.00
6.00
6.00
6.00
6.00
– Foreign income tax
(25%)
1.50
1.50
1.50
1.50
1.50
= Earnings after foreign
income taxes
4.50
4.50
4.50
4.50
4.50
Dividends repatriated*
4.50
4.50
4.50
4.50
4.50
Gross U.S. taxes
(40% of earnings
before foreign taxes)
2.40
2.40
2.40
2.40
2.40
– Foreign tax credit
1.50
1.50
1.50
1.50
1.50
= Net U.S. taxes payable
.90
.90
.90
.90
.90
Aftertax dividend
received
3.60
3.60
3.60
3.60
3.60
Exchange rate
(2 ugans/$)
2.00
2.00
2.00
2.00
2.00
Aftertax dividend
(U.S. $)
$1.80
$1.80
$1.80
$1.80
$1.80
Chapter 21: International Financial Management
21-13
* Dividends repatriated assumes all earnings after foreign income
taxes will be repatriated.
21A-1. (Continued)
PVIFA (16% for 5 years) 3.274
PV of dividends equals $1.80 × 3.274 = $5.893 million
Depreciation equals
The PV of all the cash inflows equals
$5.893 + $6.548 = $12.441 million
Since NPV is positive, accept the project!
21A-1. (Continued)
b. The change in foreign exchange values must be applied to
Chapter 21: International Financial Management
21-14
(in millions)
Year 1
Year 2
Year 3
Year 4
Year 5
Aftertax dividend
received
3.60
3.60
3.60
3.60
3.60
Depreciation
4.00
4.00
4.00
4.00
4.00
Total (in ugans)
7.60
7.60
7.60
7.60
7.60
Exchange rate (ug/$1)
2.2
2.4
2.7
2.9
3.2
Cash inflow (U.S. $)
3.45
3.17
2.81
2.62
2.38
PVIF (16%)
.862
.743
.641
.552
.476
PV (U.S. $)
2.97
+2.36
+1.80
+1.45
+1.13
