978-1133947837 Chapter 21 Solution Manual Part 1

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Answers to End of Chapter Questions

1. International Cash Management. Discuss the general functions involved in international cash

management. Explain how the MNC’s optimization of cash flow can distort the profits of each

subsidiary.

ANSWER: The general functions of international cash management are optimizing cash flows and

When subsidiaries adjust their cash transactions between each other to reduce taxes or financing

costs, their individual performances are distorted. For example, a subsidiary that makes a late

2. Netting. Explain the benefits of netting. How can a centralized cash management system be

beneficial to the MNC?

ANSWER: Netting is a centralized compilation of inter-subsidiary cash flows. It is designed to

A centralized cash management system is beneficial in that it allows for netting, which can reduce

3. Leading and Lagging. How can an MNC implement leading and lagging techniques to help

subsidiaries in need of funds?

ANSWER: A subsidiary in need of funds would receive cash inflows from another subsidiary sooner

4. International Fisher Effect. If a U.S. firm believes that the international Fisher effect holds, what

are the implications regarding a strategy of continually attempting to generate high returns from

investing in currencies with high interest rates?

ANSWER: High interest rate currencies will typically depreciate to offset their interest rate

5. Investing Strategy. Tallahassee Co. has $2 million in excess cash that it has invested in Mexico at an

annual interest rate of 60 percent. The U.S. interest rate is 9 percent. By how much would the

Mexican peso have to depreciate to cause such a strategy to backfire?

1 + 9%

1 + 60% –1 = – 31.875%

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International Cash Management  2

ANSWER: If the peso depreciates by more than 31.875 percent, the effective yield on the Mexican

6. Investing Strategy. Why would a U.S. firm consider investing short-term funds in euros even when it

does not have any future cash outflows in euros?

ANSWER: The interest rate on the euro may be higher, or the euro may have a high probability of

7. Covered Interest Arbitrage. Evansville, Inc. has $2 million in cash available for 90 days. It is

considering the use of covered interest arbitrage, since the euro’s 90-day interest rate is higher than

the U.S. interest rate. What will determine whether this strategy is feasible?

ANSWER: If interest rate parity exists, then the forward rate of the euro contains a discount that

8. Effective Yield. Fort Collins, Inc. has $1 million in cash available for 30 days. It can earn 1% on a

30-day investment in the U.S. Alternatively, if it converts the dollars to Mexican pesos, it can earn 1

1/2% on a Mexican deposit. The spot rate of the Mexican peso is $.12. The spot rate 30 days from

now is expected to be $.10. Should Ft. Collins invest its cash in the U.S. or in Mexico? Substantiate

your answer.

ANSWER: If Fort Collins Inc. invests in a Mexican deposit, it will convert $1 million to 8,333,333

pesos, which will accumulate to 8,458,333 pesos after one month (due to the 1 1/2% interest rate). If

9. Effective Yield. Rollins, Inc., has $3 million in cash available for 180 days. It can earn 7% on a U.S.

Treasury bill or 9% on a British Treasury bill. The British investment does require conversion of

dollars to British pounds. Assume that interest rate parity holds and that Rollins believes the 180-day

forward rate is a reliable predictor of the spot rate to be realized 180 days from now. Would the

British investment provide an effective yield that is below, above, or equal to the yield on the U.S.

investment? Explain your answer.

ANSWER: If the forward rate is an accurate forecast of the future spot rate, then the return on a

10. Effective Yield. Repeat question 9, but this time assume that Rollins, Inc., expects the 180-day

forward rate of the pound to substantially overestimate the spot rate to be realized in 180 days.

ANSWER: In this case, the future spot rate will be less than the forward rate. If it was equal to the

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International Cash Management  3

11. Effective Yield. Repeat question 9, but this time assume that Rollins, Inc., expects the 180-day

forward rate of the pound to substantially underestimate the spot rate to be realized in 180 days.

ANSWER: In this case, Rollins Inc. will receive more when converting the pounds back to dollars

12. Effective Yield. Assume that the one-year U.S. interest rate is 10% and the one-year Canadian

interest rate is 13%. If a U.S. firm invests its funds in Canada, by what percentage will the Canadian

dollar have to depreciate to make its effective yield the same as the U.S. interest rate from the U.S.

firm’s perspective?

ANSWER:

13. Investing in a Currency Portfolio. Why would a firm consider investing in a portfolio of foreign

currencies instead of just a single foreign currency?

ANSWER: A portfolio of currencies reduces the probability of the foreign investment backfiring due

14. Interest Rate Parity. Dallas Co. has determined that the interest rate on euros is 16 percent while the

U.S. interest rate is 11 percent for one-year Treasury bills. The one-year forward rate of the euro has

a discount of 7 percent. Does interest rate parity exist? Can Dallas achieve a higher effective yield

by using covered interest arbitrage than by investing in U.S. Treasury bills? Explain.

ANSWER: If interest rate parity (IRP) existed, the forward rate of the euro should have a discount

reflecting the interest rate differential:

15. Diversified Investments. Hofstra, Inc., has no European business and has cash invested in six

European countries, each of which uses the euro as its local currency. Are Hofstra’s short-term

investments well diversified and subject to a low degree of exchange rate risk? Explain.

ANSWER: The short-term investments are not well diversified, because the entire portfolio of

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International Cash Management  4

16. Investing Strategy. Should McNeese Co. consider investing funds in Latin America countries where

it may expand facilities? The interest rates are high and the proceeds from the investment could be

used to help support the investment. When would this strategy backfire?

ANSWER: McNeese could benefit from investing at a high interest rate. However, this strategy could

17. Impact of September 11. Palos Co. commonly invests some of its excess dollars in foreign

government short-term securities in order to earn a higher short-term interest rate on its cash.

Describe how the potential return and risk of this strategy may have changed after the September 11,

2001 terrorist attack on the U.S.

ANSWER: The attack on the U.S. caused short-term interest rates in the U.S. to decline, which made

Advanced Questions

18. Investing in a Portfolio. Pittsburgh Co. plans to invest its excess cash in Mexican pesos for one

year. The one-year Mexican interest rate is 19%. The probability of the peso’s percentage change in

value during the next year is shown below:

Possible Rate of Change

in the Mexican Peso Over Probability of

the Life of the Investment Occurrence

–15% 20%

–4% 50%

0% 30%

What is the expected value of the effective yield based on this information? Given that the U.S.

interest rate for one year is 7%, what is the probability that a one-year investment in pesos will

generate a lower effective yield than could be generated if Pittsburgh Co. simply invested

domestically?

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International Cash Management  5

ANSWER:

Effective Yield if this

Possible Rate of Rate of Change in the

Change in Peso Probability Peso Does Occur

–15% 20% (1.19) [1 + (–15%)] – 1 =1.15%

19. Effective Yield of Portfolio. Ithaca Co. considers placing 30% of its excess funds in a one-year

Singapore dollar deposit and the remaining 70% of its funds in a one-year Canadian dollar deposit.

The Singapore one-year interest rate is 15%, while the Canadian one-year interest rate is 13%. The

possible percentage changes in the two currencies for the next year are forecasted as follows:

Possible % Change in Probability of that

the Spot Rate Over Change in the Spot

Currency the Investment Horizon Rate Occurring

Singapore dollar –2% 20%

Singapore dollar 1% 60%

Singapore dollar 3% 20%

Canadian dollar 1% 50%

Canadian dollar 4% 40%

Canadian dollar 6% 10%

Given this information, determine the possible effective yields of the portfolio and the probability

associated with each possible portfolio yield. Given a one-year U.S. interest rate of 8%, what is the

probability that the portfolio’s effective yield will be lower than the yield achieved from investing in

the U.S.? (See Appendix 21.)

ANSWER:

Possible % Change Effective Yield Based on the

in the Singapore Dollar % Change in the Singapore Dollar

–2% (1.15) [1 + (–2%)] – 1 =12.7%

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International Cash Management  6

Possible % Change in Effective Yield Based on the

the Canadian Dollar % Change in the Canadian Dollar

1% (1.13) [1 + (1%)] – 1 =14.13%

Solution to Continuing Case Problem: Blades, Inc.

1. There is a tradeoff between the higher interest rates in Thailand and the delayed conversion of baht

into dollars. Explain what this means.

ANSWER: If the net baht-denominated cash flows are converted into dollars today, Blades is not

2. If the net baht received from the Thailand subsidiary are invested in Thailand, how will U.S.

operations be affected?

ANSWER: If the cash flows generated in Thailand are invested in Thailand, then Blades will have to

borrow additional funds in the U.S. at an interest rate of 10 percent in order to support its U.S.

3. Construct a spreadsheet that compares the cash flows resulting from two plans. Under the first plan,

net baht-denominated cash flows (received today) will be invested in Thailand at 15 percent for a

one-year period, after which the baht will be converted to dollars. Under the second plan, net

baht-denominated cash flows are converted to dollars immediately and 60 percent of the funds will be

used to support U.S. operations, while 40 percent are invested in the U.S. for one year at 8 percent.

Which plan is superior given the expectation of the baht’s value in one year?

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International Cash Management  7

ANSWER: (See spreadsheet attached.) The cash flow generated in one year if the funds are invested

in Thailand exceed the cash flows generated if the funds are remitted back to the U.S. today and

Plan 1—Invest Funds in Thailand

Calculation of baht-denominated revenues:

Repayment of baht-denominated loan:

Principal THB 420,000,000

Calculation of interest on U.S. dollar loan needed to support U.S. operations:

Dollar receipts if baht were remitted now:

Calculation of dollar receipts due to conversion of baht into dollars in one year:

Plan 2—Convert Funds Immediately

Calculation of baht-denominated revenues:

Repayment of baht-denominated loan:

Calculation of dollar receipts due to conversion of baht into dollars:

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International Cash Management  8

Calculation of dollar difference between the two plans:

Plan 1 $ 3,596,198

Plan 2 3,594,456

Solution to Supplemental Case: Islander Corporation

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

each scenario. Using these percentage changes along with the interest rates, the effective yield can be

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

scenario, along with the expected value of the effective yield (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%

Based on the expected values of effective yields for the currencies, the optimal composition of each

portfolio is disclosed in the following table:

Percentage of Funds Invested in:

Type of Portfolio A$ BP C$ JY US$

Risk neutral 100 0 0 0 0

The effective yields for each portfolio can be determined on the spreadsheet by creating a compute

statement that sums weighted effective yields based on the weights assigned above. These yields are

disclosed below:

Portfolio’s Effective

Yield Under a: Expected Value

Strong $ Stable $ Weak $ of Effective

Portfolio Scenario Scenario Scenario Financing Rate

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International Cash Management  9

Small Business Dilemma

Cash Management at the Sports Exports Company

1. If Logan invests the excess cash in U.S. Treasury bills, would this reduce the firm’s exposure to

exchange rate risk?

ANSWER: No. At the present time, the Sports Exports Company receives more pounds than it uses.

2. Logan decided to use the excess cash to pay off the British loan. However, a friend advised him to

invest the cash in British Treasury bills, stating that “the loan provides an offset to the pound

receivables, so you would be better off investing in British Treasury bills than paying off the loan.” Is

his friend correct? What should Logan do?

ANSWER: Jim’s friend is incorrect. By investing in British Treasury bills, Jim would not be any less

Part 5—Integrative Problem

Short-Term Asset and Liability Management

Kent Company is a large U.S. firm with no international business. It has two branches within the U.S., an

eastern branch and a western branch. Each branch presently makes investing or financing decisions

independently, as if it was a separate entity. The East branch has excess cash of $15 million to invest for

the next year. It can invest its funds in Treasury bills denominated in dollars or any of four foreign

currencies. The only restriction enforced by the parent is that a maximum of $5 million can be invested

or financed in any single foreign currency.

The western branch needs to borrow $15 million over one year to support its U.S. operations. It can

borrow funds in any of these same currencies (although any foreign funds borrowed need to be converted

to dollars to finance the U.S. operations). The only restriction enforced by the parent is that a maximum

equivalent of $5 million can be borrowed in any single currency.

A large bank serving the international money market has offered Kent Company the following terms:

Currency

Annual Interest

Rate on Deposits

Annual Interest Rate

Charged on Loans

U.S. dollar 6% 9%

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International Cash Management  10

Australian dollar 11 14

Kent Company has created one-year forecasts of each currency (shown below) that can be used by the

branches in making their investing or financing decisions:

Currency Spot Exchange Rate

Forecasted Annual

Percentage Change

in Exchange Rates

Australian dollar $.70 –4%

1. Determine the investment portfolio composition for Kent’s eastern branch that would maximize the

expected effective yield, while satisfying the restriction imposed by the parent.

When accounting for the interest rate and forecasted exchange rates, the expected effective yields are

listed below:

Currency

Expected Effective

Yield on Investment

U.S. dollar 6.00%

Australian dollar 6.56

Canadian dollar 4.86

New Zealand dollar 12.27

Japanese yen 8.00

ANSWER:

Given these expected effective yields, the investment should be allocated as follows:

2. What is the expected effective yield of the investment portfolio?

ANSWER: Based on 33.3% allocated to each of three currencies (NZ$, JY, A$), the portfolio’s

expected effective yield is:

3. Based on the expected effective yield for the portfolio and the initial investment amount of $15

million, determine the annual interest to be earned on the portfolio.

ANSWER: The expected interest earned is the portfolio’s expected effective yield times the initial

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International Cash Management  11

4. Determine the financing portfolio composition for Kent’s western branch that would minimize the

expected effective financing rate, while satisfying the restriction imposed by the parent.

When accounting for the interest rate and forecasted exchange rate, the expected effective financing

rates are listed below:

Currency

Expected Effective

Financing Rate

U.S. dollar 9.00%

Australian dollar 9.44

Canadian dollar 7.80

New Zealand dollar 15.36

Japanese yen 11.00

ANSWER:

Given these expected financing rates, the financing should be allocated as follows:

5. What is the expected effective financing rate of the total amount of funds borrowed?

ANSWER: Based on 33.3% financed with each of three currencies (C$, U.S.$, A$), the expected

financing rate for the entire portfolio of funds borrowed is:

6. Based on the expected effective financing rate for the portfolio and the total amount of $15 million

borrowed, determine the expected loan repayment amount beyond the principal borrowed.

ANSWER: The expected loan repayment amount beyond the principal borrowed is the portfolio’s

7. When the expected interest received by the eastern branch and paid by the western branch of Kent

Company are consolidated, what is the net amount of interest received?

ANSWER:

Net = Interest received – Interest paid

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International Cash Management  12

8. If the eastern branch and western branch worked together, the eastern branch could loan its $15

million to the western branch. Nevertheless, one could argue that the branches could not have taken

advantage of interest rate differentials or expected exchange rate effects among currencies. Given the

data provided in this example, would you have recommended that the two branches make their

short-term investment and financing decisions independently, or should the eastern branch lend its

excess cash to the western branch? Explain.

ANSWER: If one branch lends to another, the interest received by one branch will be exactly equal

However, there is much exchange rate risk involved in the investing and financing in foreign

currencies, especially when considering that $15 million was to be invested by one branch and

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