Chapter 18
Long-Term Debt Financing
Lecture Outline
Debt Denomination Decisions of Foreign Subsidiaries
Foreign Subsidiary Borrows Its Local Currency
Foreign Subsidiary Borrows Dollars
Debt Denomination Analysis: A Case Study
Analyzing Debt Denomination Alternatives
How Currency Swaps and Parallel Loans Facilitate Financing
Debt Maturity Decision
Assessment of the Yield Curve
Financing Costs of Loans with Different Maturities
Fixed-Rate Versus Floating-Rate Debt Decision
Financing Costs of Fixed Versus Floating-Rate Loans
Hedging Interest Payments with Interest Rate Swaps
Long-Term Debt Financing ❖ 2
Chapter Theme
When the MNC considers long-term debt financing, it must decide the currency for denominating its
debt. This is a critical decision for the MNC. While there is no clear-cut solution, this chapter illustrates
Topics to Stimulate Class Discussion
1. Why would U.S. firms consider issuing bonds denominated in a foreign currency?
POINT/COUNTER-POINT:
Will Currency Swaps Result in Low Financing Costs?
POINT: Yes. Currency swaps have created greater participation by firms that need to exchange their
currencies in the future. Thus, firms that finance in a low interest rate currency can more easily establish
an agreement to obtain the currency that has the low interest rate.
COUNTER-POINT: No. Currency swaps will establish an exchange rate that is based on market forces. If
a forward rate exists for a future period, the swap rate should be somewhat similar to the forward rate. If it
is not as attractive as the forward rate, the participants will use the forward market instead. If a forward
market does not exist for the currency, the swap rate should still reflect market forces. The exchange rate
at which a low-interest currency could be purchased will be higher than the prevailing spot rate, since
otherwise MNCs would borrow the low-interest currency and simultaneously purchase the currency
forward so that they could hedge their future interest payments.
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support?
Offer your own opinion on this issue.
Answers to End of Chapter Questions
1. Floating-Rate Bonds.
a. What factors should be considered by a U.S. firm that plans to issue a floating rate bond
denominated in a foreign currency?
Long-Term Debt Financing ❖ 3
b. Is the risk of issuing a floating rate bond higher or lower than the risk of issuing a fixed rate
Eurobond? Explain.
c. How would an investing firm differ from a borrowing firm in the features (i.e., interest rate and
currency’s future exchange rates) it would prefer a floating rate foreign currency-denominated
bond to exhibit?
ANSWER: An investing firm prefers a bond denominated in a currency that is expected to appreciate
2. Risk from Issuing Foreign Currency-Denominated Bonds. What is the advantage of using
simulation to assess the bond financing position?
3. Exchange Rate Effects.
a. Explain the difference in the cost of financing with foreign currencies during a strong-dollar
period, versus a weak-dollar period for a U.S. firm.
b. Explain how a U.S.-based MNC issuing bonds denominated in euros may be able to offset a
portion of its exchange rate risk.
4. Bond Offering Decision. Columbia Corp. is a U.S. company with no foreign currency cash flows. It
plans to either issue a bond denominated in euros with a fixed interest rate, or a bond denominated in
U.S. dollars with a floating interest rate. It estimates its periodic dollar cash flows for each bond.
Which bond do you think would have greater uncertainty surrounding these future dollar cash flows?
Explain.
5. Borrowing Combined with Forward Hedging. Cedar Falls Co. has a subsidiary in Brazil, where
local interest rates are high. It considers borrowing dollars and hedging the exchange rate risk by
Long-Term Debt Financing ❖ 4
selling the Brazilian real forward in exchange for dollars for the periods in which it would need to
make loan payments in dollars. Assume that forward contracts on the real are available. What is the
limitation of this strategy?
6. Financing That Reduces Exchange Rate Risk. Kerr, Inc., a major U.S. exporter of products to
Japan, denominates its exports in dollars and has no other international business. It can borrow
dollars at 9 percent to finance its operations or borrow yen at 3 percent. If it borrows yen, it will be
exposed to exchange rate risk. How can Kerr borrow yen and possibly reduce its economic exposure
to exchange rate risk?
7. Exchange Rate Effects. Katina, Inc., is a U.S. firm that plans to finance with bonds denominated in
euros to obtain a lower interest rate than is available on dollar-denominated bonds. What is the most
critical point in time when the exchange rate will have the greatest impact?
8. Financing Decision. Cuanto Corp. is a U.S. drug company that has attempted to capitalize on
opportunities to expand in Eastern Europe. The production costs in most Eastern European
countries are very low, often less than one-fourth of the costs in Germany or Switzerland.
Furthermore, there is a strong demand for drugs in Eastern Europe. Cuanto penetrated the
Eastern European market by purchasing a 60 percent stake in Galena, a Czech firm that
produces drugs.
a. Should Cuanto finance its investment in the Czech firm by borrowing dollars from a U.S.
bank that would then be converted into koruna (the Czech currency) or by borrowing
koruna from a local Czech bank? What information do you need to know to answer this
question?
ANSWER: Ivax would need to consider the interest rate in the U.S. versus the interest rate when
borrowing koruna (the Czech currency). It would also need to consider the potential change in the
b. How can borrowing koruna locally from a Czech bank reduce Cuanto’s exposure to
exchange rate risk?
Long-Term Debt Financing ❖ 5
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ANSWER: By borrowing koruna, the Czech subsidiary of Cuanto should make its interest payments
before remitting any funds to the parent. Therefore, there are less funds that have to be remitted (less
exposure) than if the funds are remitted to the U.S. before interest payments are paid to a U.S. bank.
c. How can borrowing koruna locally from a Czech bank reduce Cuanto’s exposure to
political risk caused by government regulations?
Advanced Questions
9. Bond Financing Analysis. Sambuka, Inc. can issue bonds in either U.S. dollars or in Swiss francs.
Dollar-denominated bonds would have a coupon rate of 15 percent; Swiss franc-denominated bonds
would have a coupon rate of 12 percent. Assuming that Sambuka can issue bonds worth $10,000,000
in either currency, that the current exchange rate of the Swiss franc is $.70, and that the forecasted
exchange rate of the franc in each of the next three years is $.75, what is the annual cost of financing
for the franc-denominated bonds? Which type of bond should Sambuka issue?
ANSWER:
If Sambuka issues Swiss franc-denominated bonds, the bonds would have a face value of
$10,000,000/$.70 = Sf14,285,714.
10. Bond Financing Analysis. Hawaii Co. just agreed to a long-term deal in which it will export
products to Japan. It needs funds to finance the production of the products that it will export. The
products will be denominated in dollars. The prevailing U.S. long-term interest rate is 9 percent
versus 3 percent in Japan. Assume that interest rate parity exists, and that Hawaii Co. believes that the
international Fisher effect holds.
a. Should Hawaii Co. finance its production with yen and leave itself open to the exchange rate
risk? Explain.
b. Should Hawaii Co. finance its production with yen and simultaneously engage in forward
contracts to hedge its exposure to exchange rate risk?
Long-Term Debt Financing ❖ 6
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ANSWER: No. The forward rate premium should reflect the interest rate differential, so the financing
rate would be 9% if Hawaii used this strategy.
c. How could Hawaii Co. achieve low-cost financing while eliminating its exposure to exchange
rate risk?
11. Cost of Financing. Assume that Seminole, Inc., considers issuing a Singapore dollar-denominated
bond at its present coupon rate of 7 percent, even though it has no incoming cash flows to cover the
bond payments. It is attracted to the low financing rate, since U. S. dollar-denominated bonds issued
in the United States would have a coupon rate of 12 percent. Assume that either type of bond would
have a four-year maturity and could be issued at par value. Seminole needs to borrow $10 million.
Therefore, it will either issue U. S. dollar denominated bonds with a par value of $10 million or bonds
denominated in Singapore dollars with a par value of S$20 million. The spot rate of the Singapore
dollar is $.50. Seminole has forecasted the Singapore dollar’s value at the end of each of the next
four years, when coupon payments are to be paid:
End of Year Exchange Rate of Singapore Dollar
1 $.52
2 .56
3 .58
4 .53
Determine the expected annual cost of financing with Singapore dollars. Should Seminole, Inc., issue
bonds denominated in U.S. dollars or Singapore dollars? Explain.
ANSWER:
End of Year:
1
2
3
4
S$ payment
S$1,400,000
S$1,400,000
S$1,400,000
S$21,400,000
Exchange rate
$.52
$.56
$.58
$.53
$ payment
$728,000
$784,000
$812,000
$11,342,000
The annual cost of financing with S$ is determined as the discount rate that equates the U.S. dollar
payments resulting from payments on the Singapore dollar-denominated bond to the amount of U.S.
12. Interaction Between Financing and Invoicing Policies. Assume that Hurricane, Inc., is a U.S.
company that exports products to the U.K., invoiced in dollars. It also exports products to Denmark,
invoiced in dollars. It currently has no cash outflows in foreign currencies, and it plans to issue bonds
in the near future. Hurricane could likely issue bonds at par value in (1) dollars with a coupon rate of
12 percent, (2) Danish kroner with a coupon rate of 9 percent, or (3) pounds with a coupon rate of 15
percent. It expects the kroner and pound to strengthen over time. How could Hurricane revise its
Long-Term Debt Financing ❖ 7
invoicing policy and make its bond denomination decision to achieve low financing costs without
excessive exposure to exchange rate fluctuations?
13. Swap Agreement. Grant, Inc., is a well-known U.S. firm that needs to borrow 10 million British
pounds to support a new business in the United Kingdom. However, it cannot obtain financing from
British banks because it is not yet established within the United Kingdom. The company decides to
issue dollar-denominated debt (at par value) in the U.S., for which it will pay an annual coupon rate
of 10%. It will then convert the dollar proceeds from the debt issue into British pounds at the
prevailing spot rate (the prevailing spot rate is one pound = $1.70). Over each of the next three years,
it plans to use the revenue in pounds from the new business in the United Kingdom to make its annual
debt payment. Grant, Inc., engages in a currency swap in which it will convert pounds to dollars at an
exchange rate of $1.70 per pound at the end of each of the next three years. How many dollars must
it borrowed initially to support the new business in the United Kingdom? How many pounds should
Grant, Inc., specify in the swap agreement that it will swap over each of the next three years in
exchange for dollars so that it can make its annual coupon payments to the U.S. creditors?
14. Interest Rate Swap. Janutis Co. has just issued fixed rate debt at 10 percent, but it wants to convert
its financing to incur a floating rate on its debt. It engages in an interest rate swap in which it swaps
variable rate payments of LIBOR plus 1% in exchange for payments of 10%. The interest rates are
applied to an amount that represents the principal from its recent debt issue so as to determine the
interest payments due at the end of each year for the next three years. Janutis Co. expects that the
LIBOR will be 9% at the end of the first year, 8.5% at the end of the second year, and 7% at the end
of the third year. Determine the financing rate that Janutis Co. expects to pay on its debt after
considering the effect of the interest rate swap.
ANSWER: The fixed rate of 10% to be received from the interest rate swap offsets the 10%
payments made on the debt. Therefore, the annual cost of financing on the debt over the next three
years is simply the variable rate that is paid out on the interest rate swap. This rate is derived below:
End of Year
Variable Rate Paid Due to Swap
1
9.0% + 1.0% = 10.0%
2
8.5% + 1.0% = 9.5%
3
7.0% + 1.0% = 8.0%
15. Financing and the Currency Swap Decision. Bradenton Co. is considering a project in which it
will export special contact lenses to Mexico. It expects that it will receive 1 million pesos after taxes
at the end of each year for the next 4 years, and after that time its business in Mexico will end as its
special patent will be terminated. The peso’s spot rate is presently $.20. The U.S. annual risk-free
interest rate is 6% and Mexico’s annual risk-free interest rate is 11%. Interest rate parity exists.
Long-Term Debt Financing ❖ 8
Bradenton Co. uses the one-year forward rate as a predictor of the exchange rate in one year.
Bradenton Co. also presumes that the exchange rates in each of the years 2 through 4 will also change
by the same percentage as it predicts for year 1. Bradenton searches for a firm with which it can swap
pesos for dollars over each of the next 4 years. Briggs Co. is an importer of Mexican products. It is
willing to take the 1 million pesos per year from Bradenton Co. and will provide Bradenton Co. with
dollars at an exchange rate of $.17 per peso. Ignore tax effects.
Bradenton Co. has a capital structure of 60% debt and 40% equity. Its corporate tax rate is 30%
combined federal and state). It borrows funds from a bank and pays 10% interest on its debt. It
expects that the U.S. annual stock market return will be 18% per year. Its beta is .9. Bradenton would
use its cost of capital as the required return for this project.
a. Determine the net present value (NPV) of this project if Bradenton engages in the currency swap.
b. Determine the NPV of this project if Bradenton does not hedge the future cash flows.
ANSWER:
a. First, determine exchange rates to convert MXP into U.S. dollars.
Year 1
Year 2
Year 3
Year 4
After tax profit
in MXP
MXP1,000,000
MXP1,000,000
MXP1,000,000
MXP1,000,000
Exchange Rate
0.1910
0.1824
0.1742
0.1664
Cash Flow to
parent
$191,000
$182,405
$174,196
$166,357
PV (discount
rate of 10.92%)
$172,196
$148,260
$127,644
$109,901
Long-Term Debt Financing ❖ 9
NPV
$558,003
b) Swap
Year 1
Year 2
Year 3
Year 4
After tax profit
in MXP
MXP1,000,000
MXP1,000,000
MXP1,000,000
MXP1,000,000
Exchange Rate
0.1700
0.1700
0.1700
0.1700
Cash Flow to
parent
$170,000
$170,000
$170,000
$170,000
PV (discount
rate of 10.92%)
$153,263
$138,177
$124,569
$112,307
NPV
528,318
16. Financing and Exchange Rate Risk. The parent of Nester Co. (a U.S. firm) has no international
business but plans to invest $20 million in a business in Switzerland. Since the operating costs of this
business are very low, Nester Co. expects this business to generate much cash flows in Swiss francs
that will be remitted to the parent each year.
Nester will finance half of this project with debt. It has these choices for financing the project:
* obtain half of the funds needed from parent equity and the other half by borrowing dollars
* obtain half of the funds needed from parent equity and the other half by borrowing Swiss francs
* obtain half of the funds that are needed from parent equity and obtain the remainder by borrowing
an equal amount of dollars and Swiss francs
The interest rate on dollars is the same as the interest rate on Swiss francs.
a. Which choice will result in the most exchange rate exposure?
b. Which choice will result in the least exchange rate exposure?
c. If the Swiss franc was expected to appreciate over time, which financing choice would result in
the highest expected net present value?
ANSWER:
17. Financing and Exchange Rate Risk. Vix Co. (of the U.S.) presently serves as a distributor of
products. It purchases these products from other U.S. firms and sells them in Europe. Vix Co. wants
to acquire a manufacturer in Thailand that could produce similar products at a low cost (due to low
labor costs in Thailand) and export the products to Europe. The operating expenses would be
denominated in Thai currency (the baht), and the products would be invoiced in euros. If Vix Co. can
acquire a manufacturer, it will discontinue its existing distributor business. If Vix Co. purchases a
company in Thailand, it expects that its revenue might not be sufficient to cover its operating
expenses during the first 8 years. Thus, it will need to borrow funds for an 8-year term to ensure that
it has enough funds to pay all of its operating expenses in Thailand. The company can borrow funds
denominated in U.S. dollars, in Thai baht, or in euros. Assuming that its financing decision will be
primarily intended to minimize its exposure to exchange rate risk, which currency should it borrow?
Briefly explain.
Long-Term Debt Financing ❖ 10
18. Financing and Exchange Rate Risk. Compton Co. has a subsidiary in Thailand that produces
computer components. The subsidiary sells the components to manufacturers in the U.S. The
components are invoiced in U.S. dollars. Compton pays employees of the subsidiary in Thai baht and
makes a large monthly lease payment in Thai baht. The parent financed the investment in the Thai
subsidiary by borrowing dollars from a U.S. bank. Compton has no other international business.
a. Given the conditions, is Compton affected favorably or unfavorably, or not affected by
depreciation of the Thai baht? Briefly explain.
b. Assume that interest rates in Thailand declined recently, so Compton subsidiary considers
obtaining a new loan in Thai baht. Compton would use the proceeds to pay off its existing loan
from a U.S. bank. Will this form of financing increase, reduce, or have no impact on its economic
exposure to exchange rate movements? Briefly explain.
19. Selecting a Loan Maturity. Omaha Co. has a subsidiary in Chile that wants to borrow from a local
bank at a fixed rate over the next 10 years.
a. Explain why Chile’s term structure of interest rates (as reflected in its yield curve) might cause
the subsidiary to borrow for a different term to maturity.
b. If Omaha is offered a more favorable interest rate for a term of 6 years, explain the potential
disadvantage compared to a 10-year loan.
c. Explain how the subsidiary can determine whether to select the 6-year loan versus the 10-year
loan.
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20. Project Financing. Dryden Co. is a U.S. firm that plans a foreign project in which it needs
$8,000,000 as an initial investment. The project is expected to generate cash flows of 10 million euros
in one year, after the complete repayment of the loan (including the loan interest and principal). The
project has zero salvage value and is terminated at the end of one year. Dryden considers financing
this project using the following options:
*all U.S. equity,
*all U.S. debt (loans) denominated in dollars provided by U.S. banks,
*all debt (loans) denominated in euros provided by European banks, or
*half of funds obtained from loans denominated in euros, and half obtained from loans denominated
in dollars.
Which form of financing will cause the project’s NPV to be the least sensitive to exchange rate risk?
CRITICAL THINKING
Financing Foreign Business with Foreign Debt An energy company based in Houston, Texas has
substantial operations in Canada, and generates much revenue in Canadian dollars. It borrows funds
denominated in Canadian dollars (rather than U.S. dollars) to finance its Canadian operations. Write a
short essay that explains the potential benefits from such a strategy. Explain the possible disadvantages
that might occur when some U.S.-based MNCs attempt this strategy in a country where interest rates are
high. Also, consider the alternative solutions such as selling forward contracts, or not hedging.
ANSWER
The financing with Canadian dollars allows the energy company to match its cash outflows (to repay
debt) with its cash inflows from revenue generated by operations in Canada. This strategy may not be as
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 exchange rate movements affect the effective financing cost
of the baht-denominated notes? Would exchange rate movements affect the effective
financing cost of the yen-denominated notes? How?
Long-Term Debt Financing ❖ 12
ANSWER: No, the effective financing cost of the baht-denominated notes would not be affected by
exchange rate movements. Blades will use the cash flows generated by the Thai subsidiary in order to
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?
ANSWER: (See spreadsheet below.) The annual effective financing percentage costs for the three
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
Payments in Japanese Yen
125,000,000
125,000,000
125,000,000
125,000,000
1,375,000,000
—
Forecasted Exchange Rate
of Japanese Yen in Baht
0.347826
0.347826
0.347826
0.347826
0.347826
—
Payments in Baht
43,478,250
43,478,250
43,478,250
43,478,250
478,260,750
10.00%
(2) Yen Value Changes
by 2 Percent
Annually Relative
to the Baht
End of
Year:
Annual Cost
1
2
3
4
5
of Financing
Payments in Japanese Yen
125,000,000
125,000,000
125,000,000
125,000,000
1,375,000,000
—
Forecasted Exchange Rate
Long-Term Debt Financing ❖ 14
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.
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. Its exports are denominated in pounds, which has continually exposed the firm to
exchange rate risk. The company is now considering a new form of expansion, in which 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?
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
Long-Term Debt Financing ❖ 15
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
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 (federal and state
combined). Gandor uses a capital structure composed of 60 percent debt and 40 percent equity. Gandor
1. Determine Gandor’s cost of capital. Also, determine Gandor’s required rate of return for the joint
venture in China.
ANSWER: Gandor’s weighted average cost of capital is:
( )
%13
%2.7%8.5
e
k
ED
E
t1
d
k
ED
D
c
k
=
+=
+
+−
+
=
2. Determine the probability distribution of Gandor’s net present values for the joint venture.
Long-Term Debt Financing ❖ 16
Apply capital budgeting analyses to these scenarios:
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
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%)
Long-Term Debt Financing ❖ 17
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
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
Long-Term Debt Financing ❖ 18
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
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%
Long-Term Debt Financing ❖ 19
Imposition of withholding tax
by Chinese government
–$844,020
20%
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 this kind of joint venture?
6. When Gandor was assessing this proposed joint venture, some of its managers of recommended that
Gandor borrow yuan 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.