978-1337269964 Chapter 12 Solution Manual Part 1

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POINT/COUNTER-POINT:

Can an MNC Reduce the Impact of Translation Exposure by Communicating?

POINT: Yes. Investors commonly use earnings to derive an MNC’s expected future cash flows. Investors

do not necessarily recognize how an MNC’s translation exposure could distort their estimates of the

MNC’s future cash flows. Therefore, the MNC could clearly communicate in its annual report and

elsewhere how the earnings were affected by translation gains and losses in any period. If investors have

this information, they will not overreact to earnings changes that are primarily attributed to translation

exposure.

COUNTER-POINT: No. Investors focus on the bottom line and should ignore to any communication

regarding the translation exposure. Moreover, they may believe that translation exposure should be

accounted for anyway. If foreign earnings are reduced because of a weak currency, the earnings may

continue to be weak if the currency remains weak.

WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support?

Offer your own opinion on this issue.

ANSWER: Both points have some merit. Some investors may believe that the bottom line earnings are the

Answers to End of Chapter Questions

1. Reducing Economic Exposure. Baltimore, Inc., is a U.S.-based MNC that obtains 10 percent of its

supplies from European manufacturers. Sixty percent of its revenues are due to exports to Europe,

where its product is invoiced in euros. Explain how Baltimore can attempt to reduce its economic

exposure to exchange rate fluctuations in the euro.

2. Reducing Economic Exposure. UVA Co. is a U.S.-based MNC that obtains 40 percent of its foreign

supplies from Thailand. It also borrows Thailand’s currency (the baht) from Thai banks and converts

the baht to dollars to support U.S. operations. It currently receives about 10 percent of its revenue

from Thai customers. Its sales to Thai customers are denominated in baht. Explain how UVA Co. can

reduce its economic exposure to exchange rate fluctuations.

3. Reducing Economic Exposure. Albany Corp. is a U.S.-based MNC that has a large government

contract with Australia. The contract will continue for several years and generate more than half of

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Managing Economic Exposure and Translation Exposure  2

Albany’s total sales volume. The Australian government pays Albany in Australian dollars. About 10

percent of Albany’s operating expenses are in Australian dollars; all other expenses are in U.S. dollars.

Explain how Albany Corp. can reduce its economic exposure to exchange rate fluctuations.

ANSWER: Albany may ask the Australian government to provide payment in U.S. dollars.

4. Tradeoffs When Reducing Economic Exposure. When an MNC restructures its operations to reduce

its economic exposure, it may sometimes forgo economies of scale. Explain.

ANSWER: An MNC may attempt to use several production plants. The production could be

5. Exchange Rate Effects on Earnings. Explain how a U.S.-based MNC’s consolidated earnings are

affected when foreign currencies depreciate.

ANSWER: A U.S.-based MNC’s consolidated earnings are reduced by the translation effect when

6. Hedging Translation Exposure. Explain how a firm can hedge its translation exposure.

7. Limitations of Hedging Translation Exposure. Bartunek Co. is a U.S.-based MNC that has

European subsidiaries and wants to hedge its translation exposure to fluctuations in the euro’s value.

Explain some limitations when it hedges translation exposure.

8. Effective Hedging of Translation Exposure. Would a more established MNC or a less established

MNC be better able to effectively hedge its given level of translation exposure? Why?

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Managing Economic Exposure and Translation Exposure  3

9. Comparing Degrees of Economic Exposure. Carlton Co. and Palmer, Inc., are U.S.-based MNCs

with subsidiaries in Mexico that distribute medical supplies (produced in the United States) to

customers throughout Latin America. Both subsidiaries purchase the products at cost and sell the

products at 90 percent markup. The other operating costs of the subsidiaries are very low. Carlton Co.

has a research and development center in the United States that focuses on improving its medical

technology. Palmer, Inc., has a similar center based in Mexico. Each firm subsidizes its respective

research and development center on an annual basis. Which firm is subject to a higher degree of

economic exposure? Explain.

10. Comparing Degrees of Translation Exposure. Nelson Co. is a U.S. firm with annual export sales to

Singapore of about S$800 million. Its main competitor is Mez Co., also based in the United States,

with a subsidiary in Singapore that generates about S$800 million in annual sales. Any earnings

generated by the subsidiary are reinvested to support its operations. Based on the information

provided, which firm is subject to a higher degree of translation exposure? Explain.

Advanced Questions

11. Managing Economic Exposure. St. Paul Co. does business in the United States and New Zealand. In

attempting to assess its economic exposure, it compiled the following information.

a. St. Paul’s U.S. sales are somewhat affected by the value of the New Zealand dollar (NZ$), because

it faces competition from New Zealand exporters. It forecasts the U.S. sales based on the

following three exchange rate scenarios:

Revenue from U.S. Business

Exchange Rate of NZ$ (in millions)

NZ$ = $.48 $100

NZ$ = .50 105

NZ$ = .54 110

b. Its New Zealand dollar revenues on sales to New Zealand invoiced in New Zealand dollars are

expected to be NZ$600 million.

c. Its anticipated cost of materials is estimated at $200 million from the purchase of U.S. materials

and NZ$100 million from the purchase of New Zealand materials.

d. Fixed operating expenses are estimated at $30 million.

e. Variable operating expenses are estimated at 20 percent of total sales (after including New Zealand

sales, translated to a dollar amount).

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Managing Economic Exposure and Translation Exposure  4

f. Interest expense is estimated at $20 million on existing U.S. loans, and the company has no

existing New Zealand loans.

Forecast net cash flows for St. Paul Co. under each of the three exchange rate scenarios. Explain how

St. Paul‘s projected net cash flows are affected by possible exchange rate movements. Explain how it

can restructure its operations to reduce the sensitivity of its net cash flows to exchange rate movements

without reducing its volume of business in New Zealand.

ANSWER:

12. Assessing Economic Exposure. Alaska Inc. plans to create and finance a subsidiary in Mexico that

produces computer components at a low cost and exports them to other countries. It has no other

international business. The subsidiary will produce computers and export them to Caribbean islands

and will invoice the products in U.S. dollars. The values of the currencies in the islands are expected to

remain very stable against the dollar. The subsidiary will pay wages, rent, and other operating costs in

Mexican pesos. The subsidiary will remit earnings monthly to the parent.

a. Would Alaska’s cash flows be favorably or unfavorably affected if the Mexican peso depreciates

over time?

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Managing Economic Exposure and Translation Exposure  5

b. Assume that Alaska considers partial financing of this subsidiary with peso loans from Mexican

banks instead of providing all the financing with its own funds. Would this alternative form of

financing increase, decrease, or have no effect on the degree to which Alaska is exposed to

exchange rate movements of the peso?

13. Hedging Continual Exposure. Consider this common real-world dilemma by many firms that rely on

exporting. Clearlake Inc. produces its products in its factory in Texas, and exports most of the

products to Mexico each month. The exports are denominated in pesos. Clearlake Inc. recognizes that

hedging on a monthly basis does not really protect against long-term movements in exchange rates. It

also recognizes that it could eliminate its transaction exposure by denominating the exports in dollars,

but that it still would have economic exposure (because Mexican consumers would reduce demand if

the peso weakened). Clearlake Inc. does not know how many pesos it will receive in the future, so it

would have difficulty even if a long-term hedging method were available. How can Clearlake

realistically deal with this dilemma and reduce its exposure over the long-term? [There is no perfect

solution, but in the real world, there rarely are perfect solutions.]

14. Sources of Supplies and Exposure to Exchange Rate Risk. Laguna Co. (a U.S. firm) will be

receiving 4 million British pounds in one year. It will need to make a payment of 3 million Polish zloty

in one year. It has no other exchange rate risk at this time. However, it needs to buy supplies and can

purchase them from Switzerland, Hong Kong, Canada, or Ecuador. Another alternative is that it could

also purchase one–fourth of the supplies from each of the 4 countries mentioned in the previous

sentence. The supplies will be invoiced in the currency of the country where they are imported from.

Laguna Co. believes that none of the sources of the imports would provide a clear cost advantage. As

of today, the dollar cost of these supplies would be about $6 million regardless of the source that will

provide the supplies.

The spot rates today are as follows:

British pound=$1.80

Swiss franc=$.60

Polish zloty=$.30

Hong Kong dollar=$.14

Canadian dollar =$.60

The movements of the pound and the Swiss franc and the Polish zloty against the dollar are highly

correlated. The Hong Kong dollar is tied to the U.S. dollar and you expect that it will continue to be

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Managing Economic Exposure and Translation Exposure  6

tied to the dollar. The movements in the value of Canadian dollar against the U.S. dollar are not

correlated with the movements of other currencies. Ecuador uses the U.S. dollar as its local currency.

Which alternative should Laguna Co. select in order to minimize its overall exchange rate risk?

ANSWER: After one year, assuming that today’s spot rates hold as the spot rates one year from now,

15. Minimizing Exposure. Lola Co. is (a U.S. firm) that expects to receive 10 million euros in one year. It

does not plan to hedge this transaction with a forward contract or other hedging techniques. This is its

only international business, and it is not exposed to any other form of exchange rate risk. Lola Co.

plans to purchase materials for future operations and it will send its payment for these materials in one

year. The value of the materials to be purchased is about equal to the expected value of the

receivables. Lola Co. can purchase the materials from Switzerland, Hong Kong, Canada, or the U.S.

Another alternative is that it could also purchase one-fourth of the materials from each of the 4

countries mentioned in the previous sentence. The supplies will be invoiced in the currency of the

country from which they are imported.

The movements of the euro and the Swiss franc against the dollar are highly correlated and will

continue to be highly correlated. The Hong Kong dollar is tied to the U.S. dollar and you expect that it

will continue to be tied to the dollar. The movements in the value of Canadian dollar against the U.S.

dollar are independent of (not correlated with) the movements of other currencies against the U.S.

dollar. Lola Co. believes that none of the sources of the imports would provide a clear cost advantage.

Which alternative should Lola Co. select for obtaining supplies that will minimize its overall exchange

rate risk?

16. Financing to Reduce Exchange Rate Exposure. Nashville Co. presently incurs costs of about 12

million Australian dollars (A$) per year for research and development expenses in Australia. It sells the

products that are designed each year, and all of the products sold each year are invoiced in U.S. dollars.

Nashville anticipates revenue of about $20 million per year, and about half of the revenue will be from

sales to customers in Australia. The Australian dollar is presently valued at $1 (1 U.S. dollar), but it

fluctuates a lot over time. Nashville Co. is planning a new project that will expand its sales to other

regions within the United States, and the sales will be invoiced in dollars. Nashville can finance this

project with a 5-year loan by (1) borrowing only Australian dollars, or (2) borrowing only U.S. dollars,

or (3) borrowing one-half of the funds from each of these sources. The 5-year interest rates on an

Australian dollar loan and a U.S. dollar loan are the same.

a. If Nashville wants to use the form of financing that will reduce its exposure to exchange rate risk

the most, what is the optimal form of financing? Briefly explain (one or two sentences should be

sufficient if your explanation is clear).

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Managing Economic Exposure and Translation Exposure  7

b. Now assume that Nashville expects that the Australian dollar will appreciate over time. Suppose

the company wants to maximize its expected net present value of its new project and is not

concerned about its exposure to exchange rate risk. Under these conditions, which financing

alternative is most appropriate? Briefly explain.

ANSWER:

CRITICAL THINKING

Creating Cash Outflows to Match Inflows in the Same Currency Consider MNCs that produce products

in the United States and export the products to developing countries. The MNCs could reduce their exposure

to exchange rate risk if they set up their operations in the countries to which they export. Such a restructuring

would cause a shift in expenses to the developing countries, and those expenses could be paid for with

revenue earned in the same currency. Write a short essay in which you explain the practical limitations of this

solution, which can help to explain why some MNCs do not pursue this strategy.

ANSWER

Solution to Continuing Case Problem: Blades, Inc.

1. How will Blades be negatively affected by the high level of inflation in Thailand if the Thai customer

renews its commitment for another three years?

2. Holt believes that the Thai importer will renew its commitment in two years. Do you think his

assessment is correct? Why or why not? Also, assume that the Thai economy returns to the high growth

level that existed prior to the recent unfavorable economic events. Under this assumption, how likely is

it that the Thai importer will renew its commitment in two years?

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Managing Economic Exposure and Translation Exposure  8

3. For each of the three possible values of the Thai baht and the British pound, use a spreadsheet to

estimate cash flows for the next year. Briefly comment on the level of Blades’ economic exposure.

Ignore possible tax effects.

THB=$0.0220 THB=$0.0209 THB=$0.0198

BP=$1.530 BP=$1.485 BP=$1.500

Sales

(1) U.S. (520,000 units × $120/pair) $ 62,400,000 $ 62,400,000 $ 62,400,000

(2) Thai (180,000 units × THB4,594 ×

$ 18,192,240 $ 17,282,628 $ 16,373,016

4. Now repeat your analysis in question 3 but assume that the British pound and the Thai baht are

perfectly correlated. For example, if the baht depreciates by 5 percent, the pound will also depreciate

by 5 percent. Under this assumption, is Blades subject to a greater degree of economic exposure? Why

or why not?

THB=$0.0220 THB=$0.0209 THB=$0.0198

BP=$1.50 BP=$1.425 BP=$1.350

Sales

Exchange Rate)

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Managing Economic Exposure and Translation Exposure  9

5. Based on your answers to the previous three questions, what actions could Blades take to reduce its

level of economic exposure to Thailand?

ANSWER: There are several actions Blades could take. The analysis above illustrates that economic

exposure can be reduced by conducting its international business in countries whose currencies are not

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