978-1133947837 Chapter 20 Solution Manual

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Answers to End of Chapter Questions

1. Financing From Subsidiaries. Explain why an MNC parent would consider financing from its

subsidiaries.

ANSWER: A parent may obtain funds at a lower cost from its subsidiaries than from a bank, since a

2. Foreign Financing.

a. Explain how a firm’s degree of risk aversion enters into its decision of whether to finance in a

foreign currency or a local currency.

b. Discuss the use of specifying a break-even point when financing in a foreign currency.

ANSWER: A very risk-averse firm may prefer to borrow domestically since it knows with certainty

A break-even exchange rate percentage change will indicate to a firm the amount by which a low

interest rate currency must appreciate to make its financing cost the same as a domestic currency.

3. Probability Distribution.

a. Discuss the development of a probability distribution of effective financing rates when financing

in a foreign currency. How is this distribution developed?

b. Once the probability distribution of effective financing rates from financing in a foreign currency

is developed, how can this distribution be used in deciding whether to finance in the foreign

currency or the home currency?

ANSWER: First, a probability distribution of exchange rate changes is created. Using this along

A distribution of effective financing rates can be used to determine the probability that foreign

4. Financing and Exchange Rate Risk. How can a U.S. firm finance in euros and not necessarily be

exposed to exchange rate risk?

ANSWER: If it has inflows in euros, it could use a portion of the inflows to pay its financing

5. Short-term Financing Analysis. Assume that Davenport Inc. needs $3 million for a one-year period.

Within one year, it will generate enough U.S. dollars to pay off the loan. It is considering three

options: (1) borrowing U.S. dollars at an interest rate of 6%, (2) borrowing Japanese yen at an

interest rate of 3%, or (3) borrowing Canadian dollars at an interest rate of 4%. Davenport Inc.

expects that the Japanese yen will appreciate by 1% over the next year and that the Canadian dollar

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Short-Term Financing  2

will appreciate by 3%. What is the expected “effective” financing rate for each of the three options?

Which option appears to be most feasible? Why might Davenport Inc. not necessarily choose the

option reflecting the lowest effective financing rate?

ANSWER:

Expected

Interest Expected Percentage Effective

Currency Rate Change in Currency Financing Rate

Dollars 6% — 6.00%

ANSWER: The Japanese yen option appears to be the most feasible option. Yet, the exchange rate

6. Effective Financing Rate. How is it possible for a firm to incur a negative effective financing rate?

ANSWER: If the currency borrowed substantially depreciates against the firm’s home currency (by

7. IRP Application to Short-term Financing. Connecticut Co. plans to finance its operations in

the U.S. It can borrow euros on a short-term basis at a lower interest rate than if it borrowed

dollars. If interest rate parity does not hold, what strategy should Connecticut Co. consider when it

needs short-term financing?

a. Assume that Connecticut Co. needs dollars. It borrows euros at a lower interest rate than that for

dollars. If interest rate parity exists and if the forward rate of the euro is a reliable predictor of the

future spot rate, what does this suggest about the feasibility of such a strategy?

b. If Connecticut Co. expects the spot rate to be a more reliable predictor of the future spot rate,

what does this suggest about the feasibility of such a strategy?

ANSWER: The firm could consider borrowing a foreign currency and purchasing the currency

If the forward rate is a reliable predictor, the effective financing rate on the foreign financing would

8. Break-even Financing. Providence Co. needs dollars. Assume that the local one-year loan rate is

15%, while a one-year loan rate on euros is 7%. By how much must the euro appreciate to cause the

loan in euros to be more costly than a U.S.-dollar loan?

ANSWER:

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Short-Term Financing  3

9. IRP Application to Short-term Financing. Assume that interest rate parity exists. If a firm believes

that the forward rate is an unbiased predictor of the future spot rate, will it expect to achieve lower

financing costs by consistently borrowing a foreign currency with a low interest rate?

ANSWER: No, because a foreign currency with a relatively low interest rate exhibits a forward

10. Effective Financing Rate. Greensboro, Inc., needs $4 million for one year. It currently has no

business in Japan but plans to borrow Japanese yen from a Japanese bank, because the Japanese

interest rate is three percentage points lower than the U.S. rate. Assume that interest rate parity exists;

also assume that Greensboro believes that the one-year forward rate of the Japanese yen will exceed

the future spot rate one year from now. Will the expected effective financing rate be higher, lower, or

the same as financing with dollars? Explain.

ANSWER: Since the forward rate is expected to overestimate the future spot rate, this implies that

11. IRP Application to Short-term Financing. Assume that the U.S. interest rate is 7 percent and the

euro’s interest rate is 4 percent. Assume that the euro’s forward rate has a premium of 4 percent.

Determine whether the following statement is true: “Interest rate parity does not hold; therefore, U.S.

firms could lock in a lower financing cost by borrowing euros and purchasing euros forward for one

year.” Explain your answer.

ANSWER: No. While interest rate parity does not hold, the financing with euros would result in an

effective financing rate of:

12. Break-even Financing. Lakeland, Inc., is a U.S.-based MNC with a subsidiary in Mexico. Its

Mexican subsidiary needs a one-year loan of 10 million pesos for operating expenses. Since the

Mexican interest rate is 70 percent, Lakeland is considering borrowing dollars, which it would

convert to pesos to cover the operating expenses. By how much would the dollar have to appreciate

against the peso to cause such a strategy to backfire? (The one-year U.S. interest rate is 9%.)

ANSWER:

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Short-Term Financing  4

1 + 70%

1 + 9% –1 = 55.96%

The dollar would have to appreciate by more than 55.96 percent for the strategy to backfire.

13. Financing During a Crisis. Bradenton, Inc., has a foreign subsidiary in Asia that commonly obtains

short-term financing from local banks. If Asian suddenly experiences a crisis, explain why Bradenton

may not be able to easily obtain funds from the local banks.

ANSWER: The foreign subsidiary may find that the local banks do not have adequate funding from

14. Impact of Credit Crisis on Risk of Financing. Homewood Co. commonly finances some of its

U.S. expansion by borrowing foreign currencies (such as Japanese yen) that have low interest rates.

Describe how the potential return and risk of this strategy may have changed as a result of the credit

crisis in 2009.

ANSWER: The credit crisis caused more volatile exchange rate movements and therefore may

15. Probability Distribution of Financing Costs. Missoula, Inc., decides to borrow Japanese yen for

one year. The interest rate on the borrowed yen is 8 percent. Missoula has developed the following

probability distribution for the yen’s degree of fluctuation against the dollar:

Possible Degree of

Fluctuation of Percentage

Yen Against the Dollar Probability

–4% 20%

–1% 30%

0% 10%

3% 40%

Given this information, what is the expected value of the effective financing rate of the Japanese yen

from the U.S. corporation’s perspective?

ANSWER:

Japanese

Interest Rate

Possible %

Change in

Yen Value

Effective

Financing Rate

Based on

That Change Probability

Computation of

Expected Value

8% –4% 3.68% 20% .736%

8.108%

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Short-Term Financing  5

16. Analysis of Short-term Financing. Jacksonville Corp. is a U.S.-based firm that needs $600,000.

It has no business in Japan but is considering one-year financing with Japanese yen, because the

annual interest rate would be 5 percent versus 9 percent in the United States. Assume that interest

rate parity exists.

a. Can Jacksonville benefit from borrowing Japanese yen and simultaneously purchasing yen one

year forward to avoid exchange rate risk? Explain.

ANSWER: If Jacksonville borrows yen and simultaneously purchases yen one year forward, it will

b. Assume that Jacksonville does not cover its exposure and uses the forward rate to forecast the

future spot rate. Determine the expected effective financing rate. Should Jacksonville finance

with Japanese yen? Explain.

ANSWER: If it does not cover the exposure but uses the forward rate as a forecast, the expected

percentage change in the Japanese yen’s value is about 3.8 percent. Thus, the expected effective

c. Assume that Jacksonville does not cover its exposure and expects that the Japanese yen will

appreciate by either 5 percent, 3 percent, or 2 percent, and with equal probability of each

occurrence. Use this information to determine the probability distribution of the effective

financing rate. Should Jacksonville finance with Japanese yen? Explain.

ANSWER:

Possible % Effective Financing

Change in Spot Rate of JY if that

Rate of JY Percentage Change Occurs Probability

5% (1.05)(1.05) – 1 =10.25% 33.3%

17. Financing With a Portfolio. Pepperdine, Inc., considers obtaining 40 percent of its one-year

financing in Canadian dollars and 60 percent in Japanese yen. The forecasts of appreciation in the

Canadian dollar and Japanese yen for the next year are as follows:

Probability

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Short-Term Financing  6

Possible Percentage of that Percentage

Change in the Spot Change in the

Currency Rate Over the Loan Life Spot Rate Occurring

Canadian dollar 4% 70%

Canadian dollar 7 30

Japanese yen 6 50

Japanese yen 9 50

The interest rate on the Canadian dollar is 9 percent, and the interest rate on the Japanese yen is 7

percent. Develop the possible effective financing rates of the overall portfolio and the probability of

each possibility based on the use of joint probabilities.

ANSWER:

Effective

Financing

Interest Possible Rate Based on

Currency Rate % Change that Change Probability

Canadian dollar 9% 4% 13.36% 70%

Possible Joint

Effective

Financing Rate Joint Effective Financing

C$ JY Probability Rate of Portfolio

13.36% 13.42% (70%)(50%) = 35% .4(13.36%) + .6(13.42%) = 13.396%

18. Financing With a Portfolio.

a. Does borrowing a portfolio of currencies offer any possible advantages over the borrowing of a

single foreign currency?

ANSWER: If a firm borrows a single foreign currency, it is especially vulnerable to that currency’s

b. If a firm borrows a portfolio of currencies, what characteristics of the currencies will affect the

potential variability of the portfolio’s effective financing rate? What characteristics would be

desirable from a borrowing firm’s perspective?

ANSWER: Currencies which are volatile and highly correlated with each other could cause the

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Short-Term Financing  7

19. Financing With a Portfolio. Raleigh Corp. needs to borrow funds for one year to finance an

expenditure in the United States. The following interest rates are available:

Country Borrowing Rate

U.S. 10%

Canada 6%

Japan 5%

The percentage change in the spot rates of the Canadian dollar and Japanese yen over the next year

are as follows:

Canadian Dollar Japanese Yen

Percentage Change Percentage Change

Probability in Spot Rate Probability in Spot Rate

10% 5% 20% 6%

90% 2% 80% 1%

If Raleigh Corporation borrows a portfolio that has 50 percent of funds from Canadian dollars and 50

percent of funds from yen, determine the probability distribution of the effective financing rate of the

portfolio. What is the probability that Raleigh will incur a higher effective financing rate from

borrowing this portfolio than from borrowing U.S. dollars?

ANSWER:

Effective

Financing

Interest Possible Rate Based on

Currency Rate % Change that Change Probability

Canadian dollar 6% 5% 11.3% 10%

There is a 2 percent chance that Raleigh will incur a higher effective financing rate from borrowing

the portfolio.

Solution to Continuing Case Problem: Blades, Inc.

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Short-Term Financing  8

1. What is the amount, in baht, that Blades needs to borrow to cover the payments due to the Thai

suppliers? What is the amount, in yen, that Blades needs to borrow to cover the payments due to the

Thai suppliers?

ANSWER: Since Blades will purchase materials necessary to manufacture 120,000 pairs of

2. Given that Blades will use the receipts from the receivables in Thailand to repay the loan and that the

subsidiary plans to remit all baht-denominated cash flows back to the U.S. parent whether it borrows

in baht or yen, does the future value of the yen with respect to the baht affect the cost of the loan if

Blades borrows in yen?

ANSWER: Given that all baht-denominated cash flows generated by Blades’ Thai subsidiary are

remitted back to the U.S., Blades cost of the yen loan will be affected by the future value of the yen

3. Using a spreadsheet, compute the expected amount (in U.S. dollars) that will be remitted back to the

U.S. in six months if Blades finances its working capital requirements by borrowing baht versus

borrowing yen. Based on your analysis, should Blades obtain a yen- or baht-denominated loan?

ANSWER: (See spreadsheet attached.) If Blades borrows in Thai baht, the expected amount remitted

yen-denominated loan.

Computation of Expected Change in Value of Thai Baht

(Relative to the Dollar)

(1) (2) (3) = (1) × (2)

Possible Rate of Change in the Probability of

Thai Baht Over the Life of the Loan Occurrence Product

–3% 30% –0.90%

–1.65% = Expected Change

Computation of Expected Change in Value of Japanese Yen

(Relative to the Baht)

(1) (2) (3) = (1) × (2)

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Short-Term Financing  9

Possible Rate of Change in the Probability of

Japanese Yen Over the Life of the Loan Occurrence Product

2% 30% 0.60%

1% 30% 0.30%

0.65% = Expected Change

(1) Blades Borrows in Thai Baht

Computation of Expected Baht-Dollar Exchange Rate in Six Months

Current Spot Rate of Baht $0.0230

Computation of Baht to Be Remitted to the U.S. Parent:

Baht Receivables (120,000 pairs × 5,000 baht per pair) THB 600,000,000

(2) Blades Borrows in Japanese Yen

Computation of Expected Yen-Baht Exchange Rate in Six Months

Current Spot Rate of Yen THB 0.347826

Solution to Supplemental Case: Flyer Company

a. The optimal portfolio is dependent on your degree of risk aversion. By converting the information in

the table above into 4 bar charts (showing the probability distribution), one above another, you can

review the risk-return tradeoff.

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Short-Term Financing  10

By using a spreadsheet format, the percentage changes in exchange rates can be easily computed.

Using these percentage changes along with the interest rates, the effective financing rate can be

computed for each currency under each scenario. The effective financing rates are provided below

for each scenario, along with the expected value of the effective financing rate (using the probabilities

assigned to each scenario):

Somewhat Expected Value

Strong $ Stable $ Weak $ of Effective

Currency Scenario Scenario Scenario Financ ing Rate

Australian dollar –0.56% 14.51% 28.07% 14.05%

Percentage of Funds Borrowed from:

Type of Portfolio A$ BP C$ JY MXP NZ$ S$ SAR US$ VB

Risk neutral 0 0 0 0 0 0 100 0 0 0

Portfolio’s Effective

Financing Rate Based on a Expected Value

Strong $ Stable $ Weak $ of Effective

Portfolio Scenario Scenario Scenario Financing Rate

Risk neutral –4.60% 1.76% 10.24% 2.40%

Small Business Dilemma

Short-Term Financing by the Sports Exports Company

1. Should Logan borrow dollars or pounds to finance his joint venture business? Why?

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Short-Term Financing  11

ANSWER: Jim should borrow pounds. Although the British interest rate is slightly higher, Jim could

2. Logan could also borrow euros at an interest rate that is lower than the U.S. or British rate. The

values of the euro and pound tend to move in the same direction against the dollar but not always by

the same degree. Would borrowing euros to support the British joint venture result in more exposure

to exchange rate risk than borrowing pounds? Would it result in more exposure to exchange rate risk

than borrowing dollars?

ANSWER: Borrowing euros would result in more exchange rate risk than borrowing pounds,

Borrowing euros would be less risky (when using the funds to finance the British venture) than

borrowing dollars, because the movements in the euro and the pound are highly correlated. If the

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