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Solution to Continuing Case Problem: Blades, Inc.
1. Given that Blades expects to use the cash flows generated by the Thai subsidiary to pay the interest and
principal of the notes, would the effective financing cost of the baht-denominated notes be affected by
exchange rate movements? Would the effective financing cost of the yen-denominated notes be affected
by exchange rate movements? How?
ANSWER: No, the effective financing cost of the baht-denominated notes would not be affected by
2. Construct a spreadsheet to determine the annual effective financing percentage cost of the yen-
denominated notes issued in each of the three scenarios for the future value of the yen. What is the
probability that the financing cost of issuing yen-denominated notes is lower than the cost of issuing
baht-denominated notes?
Calculation of Interest Expense:
Annual Interest Expense of Yen-Denominated Notes
(1,250,000,000 × 10%) 125,000,000
(1) Yen Value Changes
by 0 Percent Annually
Relative to the Baht
End of Year:
Annual Cost
1 2 3 4 5 of Financing
Forecasted Exchange Rate
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Long-Term Debt Financing 2
(2) Yen Value Changes
by 2 Percent
Annually Relative
to the Baht
End of Year:
Annual Cost
1 2 3 4 5 of Financing
(3) Yen Value Changes
by 3 Percent Annually
Relative to the Baht
End of Year:
Annual Cost
1 2 3 4 5 of Financing
3. Using a spreadsheet, determine the expected annual effective financing percentage cost of issuing yen-
denominated notes. How does this expected financing cost compare with the expected financing cost of
the baht-denominated notes?
(1) (2) (3) = (1) × (2)
Exchange Rate Scenario
Effective Financing
Percentage Cost Probability Product
12.09%
4. Based on your answers to the previous questions, do you think Blades should issue yen- or baht-
denominated notes?
5. What is the tradeoff involved?
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Long-Term Debt Financing 3
Solution to Supplemental Case: Devil VCR Corporation
a. It can reduce its exposure to exchange rate risk, because it could convert the proceeds of the bond into
pounds to cover future production expenses and could use a portion of the revenue in Singapore dollars
each year to pay its coupon payments to bondholders.
b. This approach would increase Devil VCR’s exchange rate risk, because it already has expenses in
pounds and no revenue in pounds.
c. This approach would not reduce the exchange rate risk resulting from the exporting program, because
it is not offsetting the revenue received in Singapore dollars.
Small Business Dilemma
Long-Term Financing Decision by the Sports Exports Company
The Sports Exports Company continues to focus on producing footballs in the U.S. and exporting them to
the United Kingdom. The exports are denominated in pounds, which has continually exposed the firm to
exchange rate risk. It is now considering a new form of expansion where it would sell specialty sporting
goods in the U.S. If it pursues this U.S. project, it would need to borrow long-term funds. The dollar-
denominated debt has an interest rate that is slightly lower than the pound-denominated debt.
1. Jim Logan, owner of the Sports Exports Company, needs to determine whether dollar-denominated debt
or pound-denominated debt would be most appropriate for financing this expansion, if he does expand.
He is leaning toward financing the U.S. project with dollar-denominated debt, since his goal is to avoid
exchange rate risk. Is there any reason why he should consider using pound-denominated debt to
reduce exchange rate risk?
2. Assume that Jim decides to finance his proposed U.S. business with dollar-denominated debt if he does
implement the U.S. business idea. How could he use a currency swap along with the debt to reduce the
firm’s exposure to exchange rate risk?
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Long-Term Debt Financing 4
Part 4 — Integrative Problem
Long-Term Asset and Liability Management
Gandor Company is a U.S. firm that is considering a joint venture with a Chinese firm to produce and sell
DVDs. Gandor will invest $12 million in this project, which will help to finance the Chinese firm’s
production. For each of the first three years, 50 percent of the total profits will be distributed to the
Chinese firm, while the remaining 50 percent will be converted to dollars to be sent to the U.S. The
Chinese government intends to impose a 20 percent income tax on the profits distributed to Gandor. The
Chinese government has guaranteed that the after-tax profits (denominated in yuan, the Chinese currency)
can be converted to U.S. dollars at an exchange rate of CHY1 = $.20 per unit and sent to Gandor Company
each year. At the present time, no withholding tax is imposed on profits sent to the U.S. as a result of joint
ventures in China. Assume that even after considering the taxes paid in China, an additional 10 percent tax
imposed by the U.S. government on profits received by Gandor Company. After the first three years, all
profits earned are allocated to the Chinese firm.
The expected total profits resulting from the joint venture per year are as follows:
Year
Total Profits from Joint
Venture (in yuan, CHY)
1 CHY60 million
2 CHY80 million
3 CHY100 million
Gandor’s average cost of debt is 13.8 percent before taxes. Its average cost of equity is 18 percent.
Assume that the corporate income tax rate imposed on Gandor is normally 30 percent. Gandor uses a
capital structure composed of 60 percent debt and 40 percent equity. Gandor automatically adds 4
percentage points to its cost of capital when deriving its required rate of return on international joint
ventures. Though this project has particular forms of country risk that are unique, Gandor plans to account
for these forms of risk within its estimation of cash flows.
Gandor is concerned about two forms of country risk. First, there is the risk that the Chinese government
will increase the corporate income tax rate from 20 percent to 40 percent (20 percent probability). If this
occurs, additional tax credits will be allowed, resulting in no U.S. taxes on the profits from this joint
venture. Second, there is the risk that the Chinese government will impose a withholding tax of 10 percent
on the profits that are sent to the U.S. (20 percent probability). In this case, additional tax credits will not
be allowed, and Gandor will still be subject to a 10 percent U.S. tax on profits received from China.
Assume that the two types of country risk are mutually exclusive. This is, the Chinese government will
adjust only one of its taxes (the income tax or the withholding tax), if any.
1. Determine Gandor’s cost of capital. Also, determine Gandor’s required rate of return for the joint
venture in China.
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Long-Term Debt Financing 5
ANSWER: Gandor’s weighted average cost of capital is:
%13
%2.7%8.5
%18%40%70%8.13%60
e
k
ED
E
t1
d
k
ED
D
c
k
Since Gandor applied a premium of 4 percentage points to its cost of capital for joint ventures in
foreign countries, its required rate of return on this joint venture is 17 percent. Gandor also attempts to
explicitly capture some types of country risk in the estimated cash flows, as explained shortly.
2. Determine the probability distribution of Gandor’s net present values for the joint venture.
Capital budgeting analyses should be conducted for these scenarios:
Scenario 1 Based on original assumptions.
Scenario 2 Based on an increase in the corporate income tax by the Chinese government.
Scenario 3 Based on the imposition of a withholding tax by the Chinese government.
SCENARIO 1: BASED ON ORIGINAL ASSUMPTIONS
(Probability = 60%)
Year 0 Year 1 Year 2 Year 3
Total profits
(in CHY) CHY60,000,000 CHY80,000,000 CHY100,000,000
Profits allocated to
Gandor Co.
(50% of total) CHY30,000,000 CHY40,000,000 CHY150,000,000
Corporate income taxes
imposed by Chinese
government (20%) CHY6,000,000 CHY8,000,000 CHY10,000,000
Profits to Gandor after
paying corporate
income taxes in China CHY24,000,000 CHY32,000,000 CHY40,000,000
Gandor’s dollar profits
received from China
(based on exchange rate
of CHY1 = $.20) $4,800,000 $6,400,000 $8,000,000
U.S. taxes paid (10%) $480,000 $640,000 $8,000,000
Long-Term Debt Financing 6
Cash flows from joint
venture $4,320,000 $5,760,000 $7,200,000
PV of cash flows (using
a 17% discount rate) $3,692,308 $4,207,758 $4,495,468
Initial investment $12,000,000
Cumulative NPV of
cash flows –$8,307,692 –$4,099,934 $395,534
SCENARIO 2: BASED ON INCREASE IN CORPORATE INCOME TAX BY CHINESE GOVERNMENT
(Probability = 20%)
Year 0 Year 1 Year 2 Year 3
Total profits
(in CHY) CHY60,000,000 CHY80,000,000 CHY100,000,000
Profits allocated to
Gandor Co.
(50% of total)
CHY30,000,000 CHY40,000,000 CHY50,000,000
Corporate income
taxes imposed by
Chinese
government (40%)
CHY12,000,000 CHY16,000,000 CHY20,000,000
Profits to Gandor
after paying
corporate income
taxes in China CHY18,000,000 CHY24,000,000 CHY30,000,000
Gandor’s dollar
profits received
from China (based
on exchange rate
of CHY1 = $.20) $3,600,000 $4,800,000 $6,000,000
U.S. taxes paid
(0%) — — —
Cash flows from
joint venture $3,600,000 $4,800,000 $6,000,000
PV of cash flows
(using a 17%
discount rate) $3,076,923 $3,506,465 $3,746,223
Initial investment $12,000,000
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Long-Term Debt Financing 7
Cumulative NPV
of cash flows –$8,923,077 –$5,416,612 –$1,670,389
SCENARIO 3: IMPOSITION OF A WITHHOLDING TAX BY CHINESE GOVERNMENT
(Probability = 20%)
Year 0 Year 1 Year 2 Year 3
Total profits
(in CHY) CHY60,000,000 CHY80,000,000 CHY100,000,000
Profits allocated to
Gandor Co.
(50% of total) CHY30,000,000 CHY40,000,000 CHY50,000,000
Corporate income
taxes imposed by
Chinese government
(20%) CHY6,000,000 CHY8,000,000 CHY10,000,000
Profits to Gandor
after paying
corporate income
taxes in China CHY24,000,000 CHY32,000,000 CHY40,000,000
Withholding tax
(10%) CHY2,400,000 CHY3,200,000 CHY4,000,000
Profits to be sent to
the U.S. CHY21,600,000 CHY28,800,000 CHY36,000,000
Gandor’s dollar
profits received
from China (based
on exchange rate of
CHY1 = $.20) $4,320,000 $5,760,000 $7,200,000
U.S. taxes paid
(10%) $432,000 $576,000 $7,200,000
Cash flows from
joint venture $3,888,000 $5,184,000 $6,480,000
PV of cash flows
(using a 17%
discount rate) $3,323,077 $3,786,982 $4,045,921
Initial investment $12,000,000
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Long-Term Debt Financing 8
Cumulative NPV of
cash flows –$8,676,923 –$4,889,941 –$844,020
SUMMARY OF SCENARIOS
Scenario NPV for This Scenario
Probability that This
Scenario Will Occur
Original scenario $395,534 60%
Increase in corporate income tax
by Chinese government –$1,670,389 20%
Imposition of withholding tax by
Chinese government –$844,020 20%
Expected value of NPV = 60% ($395,534) + 20% (–$1,670,389) + 20% (–$844,020)
= $237,320 + (–$334,078) + (–$168,804)
= –$265,562
3. Would you recommend that Gandor participate in the joint venture? Explain.
4. What do you think would be the key underlying factor that would have the most influence on the profits
earned in China as a result of the joint venture?
5. Is there any reason for Gandor to revise the composition of its capital (debt and equity) obtained from
the U.S. when financing joint ventures like this?
6. When Gandor was assessing this proposed joint venture, some of its managers of recommended that
Gandor borrow the Chinese currency rather than dollars to obtain some of the necessary capital for its
initial investment. They suggested that such a strategy could reduce Gandor’s exchange rate risk. Do
you agree? Explain.
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