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e. What is a convertible currency? What problems arise when a multinational
company operates in a country whose currency is not convertible?
Answer: A currency is convertible when it is traded on the world currency exchanges and
when the issuing country stands ready to redeem the currency at market rates.
When a country’s currency is not convertible, it is difficult for multinational
f. What is the difference between spot rates and forward rates? When is the
forward rate at a premium to the spot rate? At a discount?
Answer: Spot rates are the rates paid to buy currency for immediate delivery (actually, two
If the forward currency is less valuable than the spot currency, the forward rate is
Firms use currency forward markets to hedge against adverse exchange rate
fluctuations that might occur before a transaction is completed. To illustrate, suppose
Mini Case: 17 - 1
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
g. What is interest rate parity? Currently, you can exchange 1 euro for 1.2700
dollars in the 180-day forward market, and the risk-free rate on 180-day
securities is 6 percent in the United States and 4 percent in France. Does interest
rate parity hold? If not, which securities offer the highest expected return?
Answer: Interest rate parity holds that investors should expect to earn the same return in all
countries after adjusting for risk. What is the implied forward rate, given the spot rate
of $1.2500?
h. What is purchasing power parity? If a package of jerky costs $2.00 a liter in the
United States and purchasing power parity holds, what should be the price of the
jerky package in France?
Answer: Purchasing power parity, sometimes referred to as the law of one price (LOP), implies
that the level of exchange rates adjusts so that identical goods cost the same amount
in different countries.
Purchasing power parity = Ph = Pf(Spot rate)
Spot rate = Ph/Pf
i. What impact does relative inflation have on interest rates and exchange rates?
Answer: To illustrate, consider the situation between Japan and the U. S. Japan has generally
had a lower inflation rate than the U. S., so Japanese interest rates have been lower
than U. S. interest rates. This might tempt treasurers of U. S. multinational firms to
Mini Case: 17 - 3
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
j. Briefly discuss the international capital markets.
Answer: Individuals buy securities issued by foreign governments and firms, and U. S. Firms
issue securities abroad. These transactions take place in the international capital
markets. Here is a brief description of the major international capital markets:
1. A eurodollar is a U. S. dollar deposited in a bank outside the United States. The
major difference between a “regular” dollar and a eurodollar is its location. This
Interest rates on eurodollars are tied to the London Interbank Offer Rate
(LIBOR), which is the rate of interest offered by the largest and strongest London
2. International bonds, which are any bond sold outside the country of the borrower,
fall into two categories. Foreign bonds are bonds sold by a foreign borrower, but
denominated in the currency of the country in which they are sold. Thus, when
Eurobonds are bonds sold in some country other than the one in whose
currency the bond is denominated. For example, when Mercedes-Benz (a
German company) sell bonds denominated in German marks in Switzerland, these
Mini Case: 17 - 4
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website, in whole or in part.
k. To what extent do average capital structures vary across different countries?
Answer: There is some evidence that average capital structures vary among the large industrial
A recent study attempts to control for differences in accounting practices. This
l. Briefly describe special problems that occur in multinational capital budgeting
and describe the process for evaluating a foreign project. Now consider the
following project. A U.S. company has the opportunity to lease a manufacturing
facility in Japan for two years. The company must spend ¥1 billion initially to
refurbish the plant. The expected net cash flows from the plant for the next two
years, in millions, are: CF1 = ¥500 and CF2 = ¥800. A similar project in the U.S.
would have a risk adjusted cost of capital of 10 percent. What is the project’s
NPV?
Answer: The same general principles which apply to domestic capital budgeting also apply to
foreign capital budgeting. However, foreign capital budgeting is complicated by the
following three primary factors:
1. Tax law differences. Foreign operations are usually taxed at the local level, and
2. Political risk. Foreign governments have the right to restrict the amount of funds
Mini Case: 17 - 5
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website, in whole or in part.
The first step is to estimate the future expected exchange rates using the
multi-year interest rate parity equation:
Expected t-year forward exchange rate = (Spot exchange rate)
t
f
h
r1
r1
The indirect spot exchange rate is 110 yen per dollar, so the direct rate is 1/110 =
0.009091 dollars per yen. The expected forward rates are:
Maturity (in years) rhrf
Spot rate
($/¥)
Expected
forward rate ($/
¥)
The current dollar cost of the project is £1,000(0.009091 $/¥) = $9.09 million.
The Year 1 cash flow in dollars is ¥500 (0.009268$/¥) = $12.29 million. The
complete time line and NPV are shown below.
Year
0 1 2
Cash flows in yen -¥1,000 ¥500 ¥800
Mini Case: 17 - 6
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website, in whole or in part.
m. What is the impact of multinational operations on each of the following financial
management topics?
1. Cash management.
Answer: Although multinational and domestic firms have the same objectives for cash
management and use similar procedures, the multinational firm faces a more complex
task. Since the distances involved are much greater, multinational firms tend to rely
m. 2. Credit management.
Answer: Granting credit is riskier for a multinational firm than for a domestic corporation
because, in addition to the normal risk of default, the credit granting corporation must
m. 3. Inventory management.
Answer: As with other aspects of financial management, inventory management in a
multinational setting is similar to but more complex than that in a purely domestic
Mini Case: 17 - 7
© 2017 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible
website, in whole or in part.
