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ANSWER: It should hedge the minimum amount of revenue. If it hedges the minimum, the NPV for
either scenario is higher than if it had hedged the maximum amount of revenue.
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
SCENARIO IF BLUSTREAM DOES NOT RECEIVE GOVERNMENT CONTRACT
Portion hedged with FR: MXP3,000,000 × $.12 = $360,000
27. Capital Budgeting Analysis. Wolverine Corp. currently has no existing business in New Zealand but
is considering establishing a subsidiary there. The following information has been gathered to assess
this project:
The initial investment required is $50 million in New Zealand dollars (NZ$). Given the existing
spot rate of $.50 per New Zealand dollar, the initial investment in U.S. dollars is $25 million. In
addition to the NZ$50 million initial investment for plant and equipment, NZ$20 million is
needed for working capital and will be borrowed by the subsidiary from a New Zealand bank.
The New Zealand subsidiary will pay interest only on the loan each year, at an interest rate of 14
percent. The loan principal is to be paid in 10 years.
The project will be terminated at the end of Year 3, when the subsidiary will be sold.
Multinational Capital Budgeting 2
The price, demand, and variable cost of the product in New Zealand are as follows:
Year Price Demand Variable Cost
1 NZ$500 40,000 units NZ$30
2 NZ$511 50,000 units NZ$35
3 NZ$530 60,000 units NZ$40
The fixed costs, such as overhead expenses, are estimated to be NZ$6 million per year.
The exchange rate of the New Zealand dollar is expected to be $.52 at the end of Year 1, $.54 at
the end of Year 2, and $.56 at the end of Year 3.
The New Zealand government will impose an income tax of 30 percent on income. In addition, it
will impose a withholding tax of 10 percent on earnings remitted by the subsidiary. The U.S.
government will allow a tax credit on the remitted earnings and will not impose any additional
taxes.
All cash flows received by the subsidiary are to be sent to the parent at the end of each year. The
subsidiary will use its working capital to support ongoing operations.
The plant and equipment are depreciated over 10 years using the straight-line depreciation
method. Since the plant and equipment are initially valued at NZ$50 million, the annual
depreciation expense is NZ$5 million.
In three years, the subsidiary is to be sold. Wolverine plans to let the acquiring firm assume the
existing New Zealand loan. The working capital will not be liquidated but will be used by the
acquiring firm when it sells the subsidiary. Wolverine expects to receive NZ$52 million after
subtracting capital gains taxes. Assume that this amount is not subject to a withholding tax.
Wolverine requires a 20 percent rate of return on this project.
a. Determine the net present value of this project. Should Wolverine accept this project?
Capital Budgeting Analysis: Wolverine Corporation
Year 0 Year 1 Year 2 Year 3
1. Demand 40,000 50,000 60,000
2. Price per unit NZ$500 NZ$511 NZ$530
3. Total revenue = (1) × (2) NZ$20,000,000 NZ$25,550,000 NZ$31,800,000
4. Variable cost per unit NZ$30 NZ$35 NZ$40
5. Total variable cost = (1) × (4) NZ$1,200,000 NZ$1,750,000 NZ$2,400,000
6. Fixed cost NZ$6,000,000 NZ$6,000,000 NZ$6,000,000
7. Interest expense of New
Zealand loan NZ$2,800,000 NZ$2,800,000 NZ$2,800,000
8. Noncash expense (depreciation) NZ$5,000,000 NZ$5,000,000 NZ$5,000,000
9. Total expenses = (5)+(6)+(7)+(8) NZ$15,000,000 NZ$15,550,000 NZ$16,200,000
10. Before-tax earnings of subsidiary
= (3)–(9) NZ$5,000,000 NZ$10,000,000 NZ$15,600,000
11. Host government tax (30%) NZ$1,500,000 NZ$3,000,000 NZ$4,680,000
12. After-tax earnings of subsidiary NZ$3,500,000 NZ$7,000,000 NZ$10,920,000
13. Net cash flow to subsidiary
Multinational Capital Budgeting 3
= (12)+(8) NZ$8,500,000 NZ$12,000,000 NZ$15,920,000
14. NZ$ remitted by sub.
(100% of CF) NZ$8,500,000 NZ$12,000,000 NZ$15,920,000
15. Withholding tax imposed on
remitted funds (10%) NZ$850,000 NZ$1,200,000 NZ$1,592,000
16. NZ$ remitted after withholding
taxes NZ$7,650,000 NZ$10,800,000 NZ$14,328,000
17. Salvage value NZ$52,000,000
18. Exchange rate of NZ$ $.52 $.54 $.56
19. Cash flows to parent $3,978,000 $5,832,000 $37,143,680
20. PV of parent cash flows
(20% of discount rate) $3,315,000 $4,050,000 $21,495,185
21. Initial investment by parent –$25,000,000
22. Cumulative NPV of cash flows –$21,685,000 –$17,635,000 $3,860,185
b. Assume that Wolverine is also considering an alternative financing arrangement, in which the parent
would invest an additional $10 million to cover the working capital requirements so that the
subsidiary would not need the New Zealand loan. If this arrangement is used, the selling price of the
subsidiary (after subtracting any capital gains taxes) is expected to be NZ$18 million higher. Is this
alternative financing arrangement more feasible for the parent than the original proposal? Explain.
Capital Budgeting Analysis with an Alternative
Financing Arrangement: Wolverine Corporation
Year 0 Year 1 Year 2 Year 3
1. Demand 40,000 50,000 60,000
2. Price per unit NZ$500 NZ$511 NZ$530
3. Total revenue = (1)×(2) NZ$20,000,000 NZ$25,550,000 NZ$31,800,000
4. Variable cost per unit NZ$30 NZ$35 NZ$40
5. Total variable cost = (1)×(4) NZ$1,200,000 NZ$1,750,000 NZ$2,400,000
6. Fixed cost NZ$6,000,000 NZ$6,000,000 NZ$6,000,000
7. Interest expense of New Zealand
loan NZ$0 NZ$0 NZ$0
8. Noncash expense (depreciation) NZ$5,000,000 NZ$5,000,000 NZ$5,000,000
9. Total expenses = (5)+(6)+(7)+(8) NZ$12,200,000 NZ$12,750,000 NZ$13,400,000
10. Before-tax earnings of subsidiary
= (3)–(9) NZ$7,800,000 NZ$12,800,000 NZ$18,400,000
11. Host government tax (30%) NZ$2,340,000 NZ$3,840,000 NZ$5,520,000
12. After-tax earnings of subsidiary NZ$5,460,000 NZ$8,960,000 NZ$12,880,000
13. Net cash flow to subsidiary
= (12)+(8) NZ$10,460,000 NZ$13,960,000 NZ$17,880,000
14. NZ$ remitted by sub.
(100% of CF) NZ$10,460,000 NZ$13,960,000 NZ$17,880,000
Multinational Capital Budgeting 4
15. Withholding tax imposed on
remitted funds (10%) NZ$1,046,000 NZ$1,396,000 NZ$1,788,000
16. NZ$ remitted after withholding
taxes NZ$9,414,000 NZ$12,564,000 NZ$16,092,000
17. Salvage value NZ$70,000,000
18. Exchange rate of NZ$ $.52 $.54 $.56
19. Cash flows to parent $4,895,280 $6,784,560 $48,211,520
20. PV of parent cash flows
(20% discount rate) $4,079,400 $4,711,500 $27,900,185
21. Initial investment by parent –$35,000,000
22. Cumulative NPV of cash flows –$30,920,600 –$26,209,100 $1,691,085
The analysis shows that this alternative financing arrangement is expected to generate a lower net
present value than the original financing arrangement.
c. From the parent’s perspective, would the NPV of this project be more sensitive to exchange rate
movements if the subsidiary uses New Zealand financing to cover the working capital or if the parent
invests more of its own funds to cover the working capital? Explain.
d. Assume Wolverine used the original financing proposal and that funds are blocked until the
subsidiary is sold. The funds to be remitted are reinvested at a rate of 6 percent (after taxes) until the
end of Year 3. How is the project’s NPV affected?
Year 1 Year 2 Year 3
13. Net cash flow to subsidiary
=(12)+(8) NZ$8,500,000 NZ$12,000,000 NZ$ 15,920,000
NZ$ 12,720,000
NZ$ 9,550,600
14. NZ$ remitted by subsidiary NZ$0 NZ$0 NZ$ 38,190,600
15. Withholding tax imposed on
remitted funds (10%) NZ$ 3,819,060
16. NZ$ remitted after withholding
taxes NZ$ 34,371,540
17. Salvage value NZ$ 52,000,000
18. Exchange rate of NZ$ $.56
19. Cash flows to parent $48,368,062
20. PV of parent cash flows
(20% discount rate) NZ$0 NZ$0 $27,990,777
21. Initial investment by parent –$25,000,000
22. Cumulative NPV of cash flows $0 $0 $2,990,777
e. What is the break-even salvage value of this project if Wolverine uses the original financing proposal
and funds are not blocked?
Multinational Capital Budgeting 5
First, determine the present value of cash flows when excluding salvage value:
End of Present Value of Cash Flows
Year (excluding salvage value)
1 $ 3,315,000
2 4,050,000
3 4 ,643,333*
$ 12,008,333
*This number is determined by converting the third year NZ$ cash flows excluding salvage value
(NZ$14,328,000) into dollars at the forecasted exchange rate of $.56 per New Zealand dollar:
NZ$14,328,000 × $.56 = $8,023,680
The present value of the $8,023,680 received 3 years from now is $4,643,333.
Then determine the break-even salvage value:
Break-even
Salvage = [IO – (present value of cash flows)](1+k)n
Value
= [$25,000,000 – $12,008,333](1+.20)3
= $22,449,601
f. Assume that Wolverine decides to implement the project, using the original financing proposal.
Also assume that after one year, a New Zealand firm offers Wolverine a price of $27 million after
taxes for the subsidiary and that Wolverine’s original forecasts for Years 2 and 3 have not
changed. Compare the present value of the expected cash flows it Wolverine keeps the subsidiary
to the selling price. Should Wolverine divest the subsidiary? Explain.
ANSWER:
Divestiture Analysis One Year After
the Project Began
End of Year 2 End of Year 3
(one year from now) (two years from now)
Cash flows to parent $5,832,000 $37,143,680
Multinational Capital Budgeting 6
28. Capital Budgeting With Hedging. Baxter Co. considers a project with Thailand’s government. If it
accepts the project, it will definitely receive one lump sum cash flow of 10 million Thai baht in five
years. The spot rate of the Thai baht is presently $0.03. The annualized interest rate for a 5-year
period is 4% in the U.S. and 17% in Thailand. Interest rate parity exists. Baxter plans to hedge its
cash flows with a forward contract. What is the dollar amount of cash flows that Baxter will receive
in five years if it accepts this project?
ANSWER: The forward rate premium is:
29. Capital Budgeting and Financing. Cantoon Co. is considering the acquisition of a unit from the
French government. Its initial outlay would be $4 million. It will reinvest all the earnings in the unit.
It expects that at the end of 8 years, it will sell the unit for 12 million euros after capital gains taxes
are paid. The spot rate of the euro is $1.20 and is used as the forecast of the euro in the future years.
Cantoon has no plans to hedge its exposure to exchange rate risk. The annualized U.S. risk-free
interest rate is 5% regardless of the maturity of the debt, and the annualized risk-free interest rate on
euros is 7%, regardless of the maturity of debt. Assume that interest rate parity exists. Cantoon’s cost
of capital is 20%. It plans to use cash to make the acquisition.
a. Determine the NPV under these conditions.
b. Rather than use all cash, Cantoon could partially finance the acquisition. It could obtain a loan of
3 million euros today that would be used to cover a portion of the acquisition. In this case, it
would have to pay back a lump sum total of 7 million euros at the end of 8 years to repay the
loan. There are no interest payments on this debt. This financing deal is structured such that none
of the payment is tax-deductible. Determine the NPV if Cantoon uses the forward rate instead of
the spot rate to forecast the future spot rate of the euro, and elects to partially finance the
acquisition. [You need to derive the 8-year forward rate for this question.]
ANSWER:
a. Discount factor based on a required return of 20% for 8 years = .232
Multinational Capital Budgeting 7
b. The forward rate premium is:
30. Sensitivity of NPV to Conditions. Burton Co., based in the U.S., considers a project in which it
has an initial outlay of $3 million and expects to receive 10 million Swiss francs (SF) in one year. The
spot rate of the franc is $.80. Burton Co. decides to purchase put options on Swiss francs with an
exercise price of $.78 and a premium of $.02 per unit to hedge its receivables. It has a required rate of
return of 20 percent.
a. Determine the net present value of this project for Burton Co. based on the forecast that the Swiss
franc will be valued at $.70 at the end of one year.
b. Assume the same information in part (a), but with the following adjustment. While Burton
expected to receive 10 million Swiss francs, assume that there were unexpected weak economic
conditions in Switzerland after Burton initiated the project. Consequently, Burton received only
6 million Swiss francs at the end of the year. Also assume that the spot rate of the franc at the end
of the year was $.79. Determine the net present value of this project for Burton Co. if these
conditions occur.
ANSWER:
Multinational Capital Budgeting 8
31. Hedge Decision on a Project. Carlotto Co. (a U.S. firm) will definitely receive 1 million British
pounds in one year based on a business contract it has with the British government. Like most firms,
Carlotto Co. is risk averse and only takes risk when the potential benefits outweigh the risk. It has no
other international business, and is considering various methods to hedge its exchange rate risk.
Assume that interest rate parity exists. Carlotto Co. recognizes that exchange rates are very difficult to
forecast with accuracy, but it believes that the one-year forward rate of the pound yields the best
forecast of the pound’s spot rate in one year. Today the pound’s spot rate is $2.00, while the one-year
forward rate of the pound is $1.90. Carlotto Co. has determined that a forward hedge is better than
alternative forms of hedging. Should Carlotto Co. hedge with a forward contract or should it remain
unhedged? Briefly explain.
32. NPV of Partially Hedged Project. Sazer Co. (a U.S. firm) is considering a project in which it
produces special safety equipment. It will incur an initial outlay of $1 million for the research and
development of this equipment. It expects to receive 600,000 euros in one year from selling the
products in Portugal where it already does much business. In addition, it also expects to receive
300,000 euros in one year from sales to Spain, but these cash flows are very uncertain because it has
no existing business in Spain. Today’s spot rate of the euro is $1.50 and the one-year forward rate is
$1.50. It expects that the euro’s spot rate will be $1.60 in one year. It will pursue the project only if it
can satisfy its required rate of return of 24 percent. It decides to hedge all the expected receivables
due to business in Portugal, and none of the expected receivables due to business in Spain. Estimate
the net present value (NPV) of the project.
ANSWER:
33. Project Financing Strategy. Konk Co., a U.S. firm, considers a project in which it would build a
subsidiary in Belgium that would generate net cash flows of about 10 million euros per year for 5
years and would remit that amount to the parent each year. It has no other international business. It
needs about 20 million euros as the initial outlay to establish the subsidiary. It can finance this initial
outlay in the following ways and the subsidiary would repay the amount of the investment evenly
over the next 5 years: (a) the parent can borrow dollars from a U.S. bank and convert them to euros,
(b) the parent can borrow euros from a Belgian bank, (c) the parent can use its equity (retained
earnings from existing business in the U.S.) and convert the funds into euros, (d) the parent can
borrow dollars from a Belgian bank and convert them to euros, and (e) the parent can diversify its
financing by obtaining one-fourth of the funds from each of the preceding sources. Assume that there
is no cost advantage to any financing method. If Konk Co. wants to use a financing method to
minimize its project’s exposure to exchange rate risk, which method should it use? Briefly explain.
34. NPV and Financing. Louisville Co. is a U.S. firm considering a project in Austria which it has an
initial cash outlay of $7 million. Louisville will accept the project only if it can satisfy its required
Multinational Capital Budgeting 9
rate of return of 18 percent. The project would definitely generate 2 million euros in one year from
sales to a large corporate customer in Austria. In addition, it also expects to receive 4 million euros in
one year from sales to other customers in Austria. Louisville's best guess is that the euro’s spot rate
will be $1.26 in one year. Today, the spot rate of the euro is $1.40, while the one-year forward rate of
the euro is $1.34. If Louisville accepts the project, it would hedge all the receivables resulting from
sales to the large corporate customer, and none of the expected receivables due to expected sales to
other customers.
a. Estimate the net present value (NPV) of the project.
b. Assume that Louisville considers alternative financing for the project, in which it would use $5
million cash, and the remaining initial outlay would come from borrowing euros. In this case, it
would need 1,600,000 euros to repay the loan (principal plus interest) at the end of one year.
Assume no tax effects due to this alternative financing. Estimate the NPV of the project under
these conditions.
c. Do you think the Louisville's exposure to exchange rate risk due to the project if it uses the
alternative financing (explained in part b) is higher, lower, or the same as if it has an initial cash
outlay of $7 million (and does not borrow any funds)? Briefly explain.
ANSWER:
a.
b. Revise the previous answer in part (a) by reducing the CF in euros by 1,600,000 and reducing the
initial outlay from $7 million to $5 million.
Cash flows (hedged): 2,000,000 euros × $1.34 = $2,680,000.
35. Influence of Tax Laws on Cash Flow to MNC Parents The appendix to this chapter explains how
tax laws can affect how much earnings the subsidiaries remit to parents. Explain how U.S. tax laws
may encourage foreign subsidiaries to reinvest their earnings in their location rather than remit the
earnings to the U.S.
Multinational Capital Budgeting 10
remitted earnings in order to raise the total corporate income taxes on those earnings to the level
required by U.S. tax law. The MNC can avoid this tax as long as the subsidiaries do not remit the
earnings back to the U.S.
36. Influence of Tax Laws on MNC’s Choice of Home Base Explain how U.S. corporate income tax
laws have encouraged some U.S.-based MNCs to consider moving their parent to another country.
CRITICAL THINKING
Influence of Tax Laws on MNC’s Choice of Home Base As explained in the appendix, U.S. tax
laws have encouraged U.S.-based MNCs to consider moving their parent to another country in order
to reduce their taxes. Write a short essay that presents your opinion of this issue. Should U.S.-based
MNCs be allowed to move their parent without consequences? Should the U.S. government lower the
corporate income tax rate? For whatever solution you propose, explain the possible adverse effects as
well.
ANSWER
There is no perfect answer here, but students are challenged to consider the tradeoffs. One possible
answer is that parents of U.S.-based MNCs should be allowed to move to other countries, because
Solution to Continuing Case Problem: Blades, Inc.
1. Should the sales and the associated costs of 180,000 pairs of roller blades to be sold in Thailand under
the existing agreement be included in the capital budgeting analysis to decide whether Blades should
establish a subsidiary in Thailand? Should the sales resulting from a renewed agreement be included?
Why or why not?
ANSWER: The sales from the existing agreement should not be included in the capital budgeting
Multinational Capital Budgeting 11
2. Using a spreadsheet, conduct a capital budgeting analysis for the proposed project assuming that
Blades renews the agreement with Entertainment Products. Should Blades establish a subsidiary in
Thailand under these conditions?
3. Using a spreadsheet, conduct a capital budgeting analysis for the proposed project assuming that
Blades does not renew the agreement with Entertainment Products. Should Blades establish a
subsidiary in Thailand under these conditions? Should Blades renew the agreement with
Entertainment Products?
4. Since future economic conditions in Thailand are uncertain, Ben Holt would like to know how critical
the salvage value is in the alternative you think is most feasible.
5. The future value of the baht is highly uncertain. Under a worst case scenario, the baht may depreciate
by as much as 5 percent annually. Revise your spreadsheet to illustrate how this would affect Blades’
decision to establish a subsidiary in Thailand (Use the capital budgeting analysis you have identified
as the most favorable from questions 2 and 3 to answer this question.)
