Answers to End of Chapter Questions
1. MNC Parent’s Perspective. Why should capital budgeting for subsidiary projects be assessed
from the parent’s perspective? What additional factors that normally are not relevant for a purely
domestic project deserve consideration in multinational capital budgeting?
ANSWER: When a parent allocates funds for a project, it should view the project’s feasibility
2. Accounting for Risk. What is the limitation of using point estimates of exchange rates in the
capital budgeting analysis?
List the various techniques for adjusting risk in multinational capital budgeting. Describe any
advantages or disadvantages of each technique.
Explain how simulation can be used in multinational capital budgeting. What can it do that other
risk adjustment techniques cannot?
ANSWER: Point estimates of exchange rates lead to a point estimate of a project’s NPV. It is
more desirable to have a feel for a variety of outcomes (NPVs) that could occur.
The risk adjusted discount rate (RADR) is easy to use but generates only a single point estimate of
3. Uncertainty of Cash Flows. Using the capital budgeting framework discussed in this chapter,
explain the sources of uncertainty surrounding a proposed project in Hungary by a U.S. firm. In
what ways is the estimated net present value of this project more uncertain than that of a similar
project in a more developed European country?
ANSWER: The estimated NPV is more uncertain because cash flows are more uncertain. The
high degree of uncertainty surrounding the cash flows is attributed to uncertain economic
4. Accounting for Risk. Your employees have estimated the net present value of project X to be $1.2
million. Their report says that they have not accounted for risk, but that with such a large NPV,
Multinational Capital Budgeting 2
the project should be accepted since even a risk-adjusted NPV would likely be positive. You have
the final decision as to whether to accept or reject the project. What is your decision?
ANSWER: The decision should not be made until risk has been considered. If the project has a
Impact of Exchange Rates on NPV.
a. Describe in general terms how future appreciation of the euro will likely affect the value (from
the parent’s perspective) of a project established in Germany today by a U.S.-based MNC. Will
the sensitivity of the project value be affected by the percentage of earnings remitted to the parent
each year?
ANSWER: Future appreciation of the euro would benefit the parent since the euro earnings would
b. Repeat this question, but assume the future depreciation of the euro.
ANSWER: The future depreciation of the euro would hurt the parent since the euro earnings
6. Impact of Financing on NPV. Explain how the financing decision can influence the sensitivity of
the net present value to exchange rate forecasts.
7. September 11 Effects on NPV. In August 2001, Woodsen Inc. of Pittsburgh, PA considered the
development of a large subsidiary in Greece. In response to the September 11, 2001 terrorist attack
on the U.S., its expected cash flows and earnings from this acquisition were reduced only slightly.
Yet, the firm decided to retract its offer because of an increase in its required rate of return on the
project, which caused the NPV to be negative. Explain why the required rate of return on its
project may have increased after the attack.
ANSWER: Its cash flows were subject to more uncertainty, because the full economic effects of
8. Assessing a Foreign Project. Huskie Industries, a U.S.-based MNC, considers purchasing a small
manufacturing company in France that sells products only within France. Huskie has no other
existing business in France and no cash flows in euros. Would the proposed acquisition likely be
more feasible if the euro is expected to appreciate or depreciate over the long run? Explain.
ANSWER: The proposed acquisition is likely to be more feasible if the euro is expected to
9. Relevant Cash Flows in Disney’s French Theme Park. When Walt Disney World considered
establishing a theme park in France, were the forecasted revenues and costs associated with the
Multinational Capital Budgeting 3
French park sufficient to assess the feasibility of this project? Were there any other “relevant cash
flows” that deserved to be considered?
ANSWER: Other relevant cash flows are Walt Disney World’s existing cash flows. The
establishment of a theme park in France could reduce the amount of European customers that
10. Capital Budgeting Logic. Athens, Inc. established a subsidiary in the United Kingdom that was
independent of its operations in the United States. The subsidiary’s performance was well above
what was expected. Consequently, when a British firm approached Athens about the possibility of
acquiring the subsidiary, Athens’ chief financial officer replied that the subsidiary was performing
so well that it was not for sale. Comment on this strategy.
ANSWER: Even if the performance is superior, the subsidiary may be worth selling if the price
11. Capital Budgeting Logic. Lehigh Co. established a subsidiary in Switzerland that was performing
below the cash flow projections developed before the subsidiary was established. Lehigh
anticipated that future cash flows would also be lower than the original cash flow projections.
Consequently, Lehigh decided to inform several potential acquiring firms of its plan to sell the
subsidiary. Lehigh then received a few bids. Even the highest bid was very low, but Lehigh
accepted the offer. It justified its decision by stating that any existing project whose cash flows are
not sufficient to recover the initial investment should be divested. Comment on this statement.
ANSWER: Even if the project will not recover its initial outlay, it should only be divested if the
12. Impact of Reinvested Foreign Earnings on NPV. Flagstaff Corp. is a U.S.-based firm with a
subsidiary in Mexico. It plans to reinvest its earnings in Mexican government securities for the
next 10 years since the interest rate earned on these securities is so high. Then, after 10 years, it
will remit all accumulated earnings to the United States. What is a drawback of using this
approach? (Assume the securities have no default or interest rate risk.)
ANSWER: While the funds are reinvested at high rates, they may be worth less dollars ten years
13. Capital Budgeting Example. Brower, Inc. just constructed a manufacturing plant in Ghana. The
construction cost 9 billion Ghanian cedi. Brower intends to leave the plant open for three years.
During the three years of operation, cedi cash flows are expected to be 3 billion cedi, 3 billion
cedi, and 2 billion cedi, respectively. Operating cash flows will begin one year from today and are
remitted back to the parent at the end of each year. At the end of the third year, Brower expects to
sell the plant for 5 billion cedi. Brower has a required rate of return of 17 percent. It currently
takes 8,700 cedi to buy one U.S. dollar, and the cedi is expected to depreciate by 5 percent per
year.
Multinational Capital Budgeting 4
a. Determine the NPV for this project. Should Brower build the plant?
ANSWER:
Cash Flows:
Year 0 1 2 3
Investment –9
Since the project has a negative net present value (NPV), Brower should not undertake it.
b. How would your answer change if the value of the cedi was expected to remain unchanged
from its current value of 8,700 cedis per U.S. dollar over the course of the three years? Should
Brower construct the plant then?
ANSWER:
If the cedi was expected to remain unchanged from its current value of 8700 cedis per U.S. dollar
over the course of the three years:
Year 0 1 2 3
Investment –9
14. Impact of Financing on NPV. Ventura Corp., a U.S.-based MNC, plans to establish a subsidiary
in Japan. It is confident that the Japanese yen will appreciate against the dollar over time. The
subsidiary will retain only enough revenue to cover expenses and will remit the rest to the parent
each year. Will Ventura benefit more from exchange rate effects if its parent provides equity
financing for the subsidiary or if the subsidiary is financed by local banks in Japan? Explain.
ANSWER: Ventura would benefit more from exchange rate effects if its parent uses an equity
Multinational Capital Budgeting 5
If financing was provided by local banks in Japan, interest payments to these banks would reduce
15. Accounting for Changes in Risk. Santa Monica Co., a U.S.-based MNC, was considering
establishing a consumer products division in Germany, which would be financed by German
banks. Santa Monica completed its capital budgeting analysis in August. Then, in November, the
government leadership stabilized and political conditions improved in Germany. In response,
Santa Monica increased its expected cash flows by 20 percent but did not adjust the discount rate
applied to the project. Should the discount rate be affected by the change in political conditions?
ANSWER: The risk may have declined if there is less uncertainty surrounding cash flows.
16. Estimating the NPV. Assume that a less developed country called LDC encourages direct foreign
investment (DFI) in order to reduce its unemployment rate, currently at 15 percent. Also assume
that several MNCs are likely to consider DFI in this country. The inflation rate in recent years has
averaged 4 percent. The hourly wage in LDC for manufacturing work is the equivalent of about
$5 per hour. When Piedmont Co. develops cash flow forecasts to perform a capital budgeting
analysis for a project in LDC, it assumes a wage rate of $5 in Year 1 and applies a 4 percent
increase for each of the next 10 years. The components produced are to be exported to Piedmont’s
headquarters in the United States, where they will be used in the production of computers. Do you
think Piedmont will overestimate or underestimate the net present value of this project? Why?
(Assume that LDC’s currency is tied to the dollar and will remain that way.)
ANSWER: The net present value will likely be overestimated because the labor costs in LDC will
probably increase at a higher rate than 4 percent per year. As DFI increases, the demand for labor
17. PepsiCo’s Project in Brazil. PepsiCo recently decided to invest more than $300 million for
expansion in Brazil. Brazil offers considerable potential because it has 150 million people and
their demand for soft drinks is increasing. However, the soft drink consumption is still only about
one-fifth of the soft drink consumption in the U.S. PepsiCo’s initial outlay was used to purchase
three production plants and a distribution network of almost 1,000 trucks to distribute its products
to retail stores in Brazil. The expansion in Brazil was expected to make PepsiCo’s products more
accessible to Brazilian consumers.
a. Given that PepsiCo’s investment in Brazil was entirely in dollars, describe its exposure to
exchange rate risk resulting from the project. Explain how the size of the parent’s initial
investment and the exchange rate risk would have been affected if PepsiCo had financed much
of the investment with loans from banks in Brazil.
ANSWER: As the earnings in Brazil are remitted, they will be converted to dollars. If Brazil’s
Multinational Capital Budgeting 6
If PepsiCo Inc. borrowed funds from banks in Brazil, the parent’s initial investment would have
been smaller. Also, the payments by the subsidiary on loans in Brazil would cause less remitted
earnings over time, and therefore less exchange rate risk.
b. Describe the factors that PepsiCo likely considered when estimating the future cash flows of
the project in Brazil.
ANSWER: The demand in Brazil for the soft drinks and snacks produced by PepsiCo Inc. is
c. What factors did PepsiCo likely consider in deriving its required rate of return on the project
in Brazil?
ANSWER: PepsiCo planned to use $500 million for investment in Brazil. Its funds may have
been derived from retained earnings and loans from creditors. PepsiCo would have estimated a
d. Describe the uncertainty that surrounds the estimate of future cash flows from the perspective
of the U.S. parent.
ANSWER: There is some uncertainty about the demand for PepsiCo’s products in Brazil, because
it is difficult to estimate the impact of the expansion on the demand. These products would now
be more accessible to Brazil’s consumers, but the precise increase in the demand for PepsiCo’s
e. PepsiCo’s parent was responsible for assessing the expansion in Brazil. Yet, PepsiCo already
had some existing operations in Brazil. When capital budgeting analysis was used to
determine the feasibility of this project, should the project have been assessed from a Brazil
perspective or a U.S. perspective? Explain.
ANSWER: PepsiCo’s parent uses its own funds to support expansion. Thus, it should make
decisions from its own perspective. It does not make sense to assess the project from a Brazil
18. Impact of Asian Crisis. Assume that Fordham Co. was evaluating a project in Thailand (to be
financed with U.S. dollars). All cash flows generated from the project were to be reinvested in
Thailand for several years. Explain how the Asian crisis would have affected the expected cash
flows of this project and the required rate of return on this project. If the cash flows were to be
Multinational Capital Budgeting 7
remitted to the U.S. parent, explain how the Asian crisis would have affected the expected cash
flows of this project.
ANSWER: The Asian crisis would have reduced local currency cash flows (due to a weak
economy), and then those cash flows would have been remitted at weak exchange rates, which
19. Tax Effects on NPV. When considering the implementation of a project in one of various possible
countries, what types of tax characteristics should be assessed among the countries? (See the
chapter appendix)
ANSWER: Corporate taxes in the country should be considered by an MNC, along with
20. Capital Budgeting Analysis. A project in South Korea requires an initial investment of 2 billion
South Korean won. The project is expected to generate net cash flows to the subsidiary of 3 billion
and 4 billion won in the two years of operation, respectively. The project has no salvage value. The
current value of the won is 1,100 won per U.S. dollar, and the value of the won is expected to
remain constant over the next two years.
a. What is the NPV of this project if the required rate of return is 13 percent?
b. Repeat the question, except assume that the value of the won is expected to be 1,200 won per
U.S. dollar after two years. Further assume that the funds are blocked and that the parent
company will only be able to remit them back to the U.S. in two years. How does this affect
the NPV of the project?
ANSWER:
Year 0 1 2
Investment –2
ANSWER:
Year 0 2
Investment –2
Multinational Capital Budgeting 8
Operating CF 7
Net CF –2 7
Exchange rate 1,100 1,200
21. Accounting for Exchange Rate Risk. Carson Co. is considering a 10-year project in Hong Kong,
where the Hong Kong dollar is tied to the U.S. dollar. Carson Co. uses sensitivity analysis that
allows for alternative exchange rate scenarios. Why would Carson use this approach rather than
using the pegged exchange rate as its exchange rate forecast in every year?
ANSWER: Carson recognizes that the pegged exchange rate may not remain pegged over the
22. Decisions Based on Capital Budgeting. Marathon Inc. considers a one-year project with the
Belgian government. Its euro revenue would be guaranteed. Its consultant states that the
percentage change in the euro is represented by a normal distribution, and that based on a 95
percent confidence interval, the percentage change in the euro is expected to be between 0 percent
and 6 percent. Marathon uses this information to create three scenarios: 0%, 3%, and 6% for the
euro. It derives an estimated NPV based on each scenario, and then determines the mean NPV. The
NPV was positive for the 3% and 6% scenarios, but was slightly negative for the 0 percent
scenario. This led Marathon to reject the project. Its manager stated that it did not want to pursue a
project that had a one-in-three chance of having a negative NPV. Do you agree with the manager’s
interpretation of the analysis? Explain.
ANSWER: Marathon’s interpretation implies that each scenario has the same probability of
23. Estimating Cash Flows of a Foreign Project. Assume that Nike decides to build a shoe factory in
Brazil, half the initial outlay will be funded by the parent’s equity and half by borrowing funds in
Brazil. Assume that Nike wants to assess the project from its own perspective to determine
whether the project’s future cash flows will provide a sufficient return to the parent to warrant the
initial investment. Why will the estimated cash flows be different from the estimated cash flows
of Nike’s shoe factory in New Hampshire? Why will the initial outlay be different? Explain how
Nike can conduct multinational capital budgeting in a manner that will achieve its objective.
ANSWER: The net cash flows to the parent will be different because they are based on the
revenue received by the subsidiary in Brazil, minus the expenses incurred there (including the
interest payments), and the exchange rate when the funds are remitted to the U.S., plus any tax
Multinational Capital Budgeting 9
Advanced Questions
24. Break-even Salvage Value. A project in Malaysia costs $4,000,000. Over the next three years, the
project will generate total operating cash flows of $3,500,000, measured in today’s dollars using a
required rate of return of 14 percent. What is the break-even salvage value of this project?
ANSWER:
772,740$
)14.1)(000,500,3$000,000,4($
)1(
)1(
3
n
t
t
nk
k
CF
IOSV
25. Capital Budgeting Analysis. Zistine Co. considers a one-year project in New Zealand so that it
can capitalize on its technology. It is risk-averse, but is attracted to the project because of a
government guarantee. The project will generate a guaranteed NZ$8 million in revenue, paid by
the New Zealand government at the end of the year. The payment by the New Zealand government
is also guaranteed by a credible U.S. bank. The cash flows earned on the project will be converted
to U.S. dollars and remitted to the parent in one year. The prevailing nominal one-year interest rate
in New Zealand is 5% while the nominal one-year interest rate in the U.S. is 9%. Zistine’s chief
executive officer believes that the movement in the New Zealand dollar is highly uncertain over
the next year, but his best guess is that the change in its value will be in accordance with the
international Fisher effect. He also believes that interest rate parity holds. He provides this
information to three recent finance graduates that he just hired as managers and asks them for their
input.
a. The first manager states that due to the parity conditions, the feasibility of the project will be
the same whether the cash flows are hedged with a forward contract or are not hedged. Is this
manager correct? Explain.
b. The second manager states that the project should not be hedged. Based on the interest rates,
the IFE suggests that Zistine Co. will benefit from the future exchange rate movements, so the
project will generate a higher NPV if Zistine does not hedge. Is this manager correct? Explain.
c. The third manager states that the project should be hedged because the forward rate contains a
premium, and therefore the forward rate will generate more U.S. dollar cash flows than the
expected amount of dollar cash flows if the firm remains unhedged. Is this manager correct?
Explain.
ANSWER:
a. The first manager is wrong. The project is more feasible if it hedges, because the expected
dollar cash flows are the same whether Zistine hedges or not, and it can remove uncertainty
surrounding the dollar cash flows if it hedges.
Multinational Capital Budgeting 10
b. The second manager is wrong. The IFE suggests an expected appreciation of the New Zealand
26. Accounting for Uncertain Cash Flows. Blustream Inc. considers a project in which it will sell the
use of its technology to firms in Mexico. It already has received orders from Mexican firms that
will generate 3 million Mexican pesos (MXP) in revenue at the end of the next year. However, it
might also receive a contract to provide this technology to the Mexican government. In this case, it
will generate a total of MXP5,000,000 at the end of the next year. It will not know whether it will
receive the government order until the end of the year.
Today’s spot rate of the peso is $.14. The one-year forward rate is $.12. Blustream expects that the
spot rate of the peso will be $.13 one year from now. The only initial outlay will be $300,000 to
cover development expenses (regardless of whether the Mexican government purchases the
technology). It will pursue the project only if it can satisfy its required rate of return of 18 percent.
Ignore possible tax effects. It decides to hedge the maximum amount of revenue that it will receive
from the project.
a. Determine the NPV if Blustream receives the government contract.
ANSWER:
Revenue converted to $ = MXP5,000,000 × $.12 = $600,000
b. If Blustream does not receive the contract, it will have hedged more than it needed to and will
offset the excess forward sales by purchasing pesos in the spot market at the time the forward
sale is executed. Determine the NPV of the project assuming that Blustream does not receive
the government contract.
ANSWER:
Multinational Capital Budgeting 11
c. Now consider an alternative strategy in which Blustream only hedges the minimum peso
revenue that it will receive. In this case, any revenue due to the government contract would
not be hedged. Determine the NPV based on this alternative strategy and assume that
Blustream receives the government contract.
d. If Blustream uses the alternative strategy of only hedging the minimum peso revenue that it
will receive, determine the NPV assuming that it does not receive the government contract.
Revenue converted to $:
e. If there is a 50 percent chance that Blustream will receive the government contract, would you
advise Blustream to hedge the maximum amount or the minimum amount of revenue that it
may receive? Explain.
ANSWER: It should hedge the minimum amount of revenue. If it hedges the minimum, the NPV
f. Blustream recognizes that it is exposed to exchange rate risk whether it hedges the minimum
amount or the maximum amount of revenue it will receive. It considers a new strategy of
hedging the minimum amount it will receive with a forward contract and hedging the
additional revenue it might receive with a put option on Mexican pesos. The one-year put
option has an exercise price of $.125 and a premium of $.01. Determine the NPV if Blustream
uses this strategy and receives the government contract. Also, determine the NPV if Blustream
uses this strategy and does not receive the government contract. Given that there is a 50
percent probability that Blustream will receive the government contract, would you use this
new strategy or the strategy that you selected in question (e)?
ANSWER:
SCENARIO IF BLUSTREAM RECEIVES GOVERNMENT CONTRACT
Portion hedged with FR: MXP3,000,000 × $.12 = $360,000
Multinational Capital Budgeting 12
SCENARIO IF BLUSTREAM DOES NOT RECEIVE GOVERNMENT CONTRACT
Portion hedged with FR: MXP3,000,000 × $.12 = $360,000