International Financial Management C45.0030.001

Final Review (Chapters 1-18 – maybe also 19) Thursday, August 5th – 3-6pm

Please review page 4 of your syllabus for grading guidelines and other relevant information. This exam will count for 45% of your course grade. The exam should take about 1.5-2 hours to complete but you will be given 3 hours. I’m basing that time estimate on the fact that most students took 1 hour 20 minutes on the midterm and that the maximum I allowed any student was 1.5 hours. Note: My office is KMEC 7-176 (economics department, PhD office). My office hours are Tuesday and Thursday 1-2pm and by appointment. If you want to meet w/me but can’t make it during my office hours, shoot me an email and we can set up a mutually convenient time. My email is ahornste@stern.nyu.edu and it is the best way to reach me. A. Topics that we’ve covered so far I’m listing them in chronological order. I’ve placed these topics in three categories (A) – very important; (B) medium importance; (C) lower priority. Note that the topics placed in category B must be understood in order to make sense of any of the A and C category topics. I’ve also created a new class: A+ for concepts that I think are totally fundamental. If you can’t do the A+ concepts, you can’t do anything in the other sections. I’m sure you’d have figured that out on your own but it merits repetition. Note, material covered on the midterm is fair game and you will be responsible for it. I am not repeating the outline/importance levels for Chapters 1-10 – please refer back to the Midterm Review document for that info. This outline only covers material studied after the midterm. I’m including chapter 19 on this outline but I’m not yet sure how far we’ll get w/that material. Wait ‘n see! Chapter 11

1. WACC (A++) 2. World CAPM (A-) 3. Segmented/integrated CAPM (A-) 4. Cost of equity (A++) 5. Impact of capital market liquidity/segmentation on cost of capital (A) 6. WACC MNE vs. PDE (A-/B)

Chapter 12

1. Depositary receipts (ADRs/GDRs) (A+++) – know what they are, how they work (price, listing), impact on firm (why they’d do one)

2. Market liquidity and turnover (B+) 3. Alternative instruments to source equity in global markets (B)

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Chapter 13 1. Optimal financial structure (A-) 2. Forex risk and debt (A) 3. Financial structure of subsidiaries (A-/B+) 4. Eurocurrency markets (B) 5. Syndicated credits (A/A-) 6. Other international bank loans (B) 7. Euronote market (C) 8. International bond market (C) 9. Project financing (B-/C)

Chapter 14

1. Management of interest rate risk (A) a. Credit and repricing risk (A-) b. Floating rate vs. fixed rate loans (A) c. Forward rate agreements (A-) d. Interest rate futures (A) e. Interest rate swaps (A++)

2. Currency swaps (A+) 3. How to unwind a swap (A) 4. Counterparty risk (B) – just the general idea (1 sentence) 5. Swaptions (C)

Chapter 15

1. Theory of comparative advantage (B) 2. Market imperfections as rationale for MNE (B+) 3. Sustaining & transferring competitive advantage (B+) 4. OLI (B-) 5. Modes of FDI (B+/A---) – focus on WFOE vs. JV vs. anything else 6. Impact of FDI on host/home countries (B+)

Chapter 16

1. Why budgeting for foreign and domestic projects are different (A-) 2. Project vs. parent valuation (A+) 3. Understand key concepts demonstrated through the Cemex case study

(A/A+…note much of this is too time consuming for me to test but trust me, I’ll find a way to get some of this on the exam!)

4. Sensitivity analysis (A-/B+) 5. Real option analysis (B/B+)

Chapter 17

1. Defining risk (B+) 2. Risk measurement (B) 3. FDI risks (B+/A---) 4. Business risks (B) 5. Governance risks (A--)

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6. Transfer risk (A/A+?) 7. Cultural differences (A--/B+)

Chapter 18

1. Cross-border M&A – why & how (A) 2. Corporate governance & shareholder rights (A-) 3. Cross-border valuation (A+++)

Chapter 19

1. International diversification (A-) 2. Portfolio risk reduction (A-/A) 3. Optimal international portfolio (A/A-) 4. National equity market performance measures (Sharpe, Treynor) (A) 5. International CAPM

B. Exam Format/Structure You will not be allowed a crib sheet. I will give you all the formulas we’ve learned in this class. Your task is to be able to recognize each formula and understand when it is to be used. As I just said above, if the formula is important enough you should know how to apply it, we’ll have used it in a classroom example and/or homework question and you’ll have practiced it. ☺ You will definitely need a calculator. I’ll bring as many spares as possible so that you’re okay if you forget one and/or your calculator goes on the fritz. But no guarantees! (I have yet to write the exam but I bet it’ll be about 2/3 calculations.) C. Sample questions First, I’ve posted two actual old final exams online at: http://pages.stern.nyu.edu/~ahornste/Final-Sample1.docand http://pages.stern.nyu.edu/~ahornste/Final-Sample2.doc and the solutions can be found online at: http://pages.stern.nyu.edu/~ahornste/Final-Sample1Answers.docand http://pages.stern.nyu.edu/~ahornste/Final-Sample2Answers.doc Note that the two versions are very, very similar – just a difference of #s and currencies. So pick one and you really don’t need to waste time w/the other but it is there for you to play with if you so desire. Also, I taught this class slightly differently in the past due to the textbook and how we allocated time in response to student concerns/interests. Accordingly, some questions may not be appropriate for y’all but were totally fair for past students. And vice versa!

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Second, review all the homework questions. I picked them for a reason: I like the concepts they cover and think they get right at the core of the issues we’ve tackled in a meaningful manner. Third, some sample questions that have been used in previous semesters. 1. What is a cross-currency swap (please describe in words – the intuition and method)? Cross-currency swaps are a technique to hedge against the currency exposure of operating cash flows. It basically consists in offsetting an operating cash flow in a foreign currency by incurring a debt obligation in the local currency and then swapping it with a similar maturity & value foreign currency denominated debt obligation. An advantage of this method is that, unlike the back-to-back loan, it does not appear on the company’s balance sheet. 2. Volkswagen AG has a beta of 0.7. The company’s cost of debt is 8%, risk-free rate is 3%, & expected return on market portfolio is 11%. Income taxes are 45%, and company’s target financial mix is 60% debt, 40% equity (note the high leverage). What is Volkswagen’s weighted average cost of capital, using the CAPM?

a. Know that the after-tax cost of debt is 8%*(1-0.45) = 4.4%. b. Need to find out the cost of the equity. To find it out, use CAPM: ke =

expected return on equity = cost of equity; krf = risk free rate on bonds = 3%; km = expected rate of return on the market = 11%; β = coefficient of firm’s systematic risk = 0.7. So, the cost of equity is equal to 3%+0.7*(11%-3%) = 8.6%.

c. Then, the WACC = 0.4*8.6% + 0.6*4.4% = 6.08%.

3. How would you compute the cost of equity using the world CAPM? Using integrated-segmented CAPM?

a. World CAPM: The cost of equity is determined as the US risk free rate plus the world risk premium times the estimate of the world beta (i.e. a beta computed from a CAPM on the world portfolio, such as the MSCI).

b. Integrated-segmented CAPM: First we compute the world cost of capital

using a CAPM setup: the world cost of capital is equal to the US risk free rate plus the world risk premium times the estimate of the world beta (notice that this is a world beta, i.e. a beta computed from a CAPM on the world portfolio, such as the ones of MSCI).

Then we compute the local cost of capital using a CAPM setup: the local cost of capital is equal to the local risk free rate plus the local risk premium times the estimate of the local beta (notice that this is a local

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beta, i.e. a beta computed from a CAPM on the local market portfolio, usually a portfolio representing 90+ % of the local stock market capitalization).

Finally we average the world and local cost of capital. What weights to use? If the country is only partially integrated with the rest of the world, it will be better if we give more percentage weight on the local cost of capital. Vice versa, if the country is highly integrated in the world economy, then we have to give more weight on the world cost of capital. So, we can use the ratio of the country’s size of international trade (can get it from the BOP stats) to the total GDP (gross domestic product) as a weight on the world cost of capital.

4. In class we have compared the cost of capital of MNEs and purely domestic firms (PDEs). What do theory and empirical evidence say about capital structure and the cost of capital for MNEs and PDEs? In theory, MNEs should have a lower cost of capital (1 point). This is because of the reduced risk borne by MNEs. MNEs should also be able to support greater amounts of debt due to the reduced variability of cash flows brought about by diversification across countries (1 point). However, empirical research finds that MNEs tend to use lower amounts of short and intermediate debt than do pure domestic firms (1 point). In addition, the cost of capital is greater for MNEs for small levels of capital budgets due to increased agency costs, political risk, exchange rate risk, and asymmetric information (1 point). 5. What is the main shortcoming of the world CAPM? How does the approach developed by Goldman Sachs, that we have discussed in class, ameliorate this problem (i.e., describe Goldman Sachs integrated and then comment on its differences as compared w/ world CAPM)? The main disadvantage of the CAPM is the low beta that results from it – in class we saw that the empirically implied relationship between beta and expected returns is negative, which contradicts the intuition from theory! To overcome this problem Goldman Sachs integrated has adopted the following method: obtain the cost of equity for the company based on the CAPM model, as if the company was a US company, and then adjust this cost of capital by the sovereign yield spread. In particular, first, we need to estimate the market beta of the stock. Then, we multiply the obtained beta by the US equity premium. Finally, we add the sovereign yield spread and the risk free interest rate to obtain the cost of equity. (Note: we didn’t spend much time on this topic in class so I think this would be an inappropriate question for this summer’s final exam.)

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6. Your choice: please briefly describe any three of the following ADRs: level I, level II, level III, or ADR issued under Rule 144A. ADRs are negotiable certificates that are created by a depository bank on underlying stock held in trust in the company’s home market. Any three of the following would be sufficient:

1. Level I ADR (over the counter, or pink sheet) is the one subject to the least requirements. It is exempt from the SEC registration, and the issuer need not adhere to the US GAAP. These ADRs are for existing shares.

2. Level II ADR is for existing shares and is traded on the NYSE, AMEX, or

NASDAQ. It is subject to meeting the full registration requirements by the SEC, and subject to the US GAAP accounting requirements.

3. Level III ADRs represent new equity that is cross-listed on the NYSE and

the AMEX. It requires full registration and reporting that is consistent w/ US GAAP.

4. The fourth ADR instrument is ADRs under SEC Rule 144A. This

placement is for new equity and it does not require a SEC registration. Furthermore, there is no requirement to adhere to the US GAAP for ADR 144A.

(Note: while this was an appropriate question for one class in the past, I don’t believe this is appropriate for us. I think that it is more important to understand why a firm would do an ADR and why an investor might want to purchase an ADR) 7. Hewlett Packard (US) is borrowing EUR 100,000,000 for one year at a time when the exchange rate is $1.20/EUR. The principal is to be repaid one year from now, and the interest rate is 6% per annum, paid at maturity in euros. The euro is expected to depreciate to the US$ by 5% over the course of the year. What is the effective cost of debt (in percentage interest rate terms) for Hewlett Packard? In US$ terms, how much interest and principal will HP pay at maturity? The effective cost of debt (in percentages) for Hewlett Packard is computed as

( ) ( )[ ] ( ) ( )[ ] 007.010.05-1 x 06.0111 x k1k EURdebt

$debt =−+=−++= s , or 0.7% per annum.

The exchange rate at maturity is expected to be $1.20/EUR * (1-0.05) = $1.14/EUR, since it is expected that the EUR will depreciate to the US$ by 5%. So, the amount to be paid by HP at maturity in US$ is 000,840,120$/14.1$000,000,106 =× EUREUR . 8. Heineken NV of the Netherlands is borrowing US$ 200,000,000 via a syndicated Eurocredit facility for 5 years at 200 basis points over LIBOR. LIBOR for the loan will be reset every six months. The funds will be provided by an investment bank syndicate, which will charge upfront fee of 2% of the principal amount. What is the

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effective cost of debt for the first year if LIBOR is 5% for the first six months and 4% for the second six months? The solution is presented below. Initial Issuance Value Principal borrowed for five years, in US$ $ 200,000,000 Issuance fees 2% Interest Costs First 6-months 2nd 6-monthsLIBOR (per annum) 5.00% 4.00% Spread over LIBOR (per annum) 2.00% 2.00% Total interest cost (per annum) 7.00% 6.00% Calculation of the effective cost of funds Issuance First 6-months 2nd 6-months Face value of syndicated loan $ 200,000,000 Less fees for issuance (2% of notional principal) (4,000,000) Net proceeds of syndicated loan $ 196,000,000 Interest payment due at end of 6-month period $ (7,000,000) $ (6,000,000) (annual rate divided by 2 for 6-month period) Total interest payments in first year of loan $ (13,000,000) Effective interest cost (interest payment/proceeds) 6.633% 9. What is the difference between sponsored and non-sponsored ADR? Sponsored ADRs are created at the request of a foreign issuer wanting its shares traded in the United States. The company needs to apply to the SEC and to a U.S. – based bank for registration and issuance. If a foreign company does not seek to have its shares traded in the US, but U.S. investors are interested, then a US financial institution may initiate the issuance of the non-sponsored ADR. However, SEC still requires the approval of the foreign company itself. 10. In general, why is cross-listing a popular tool for tapping the foreign equity markets (give me three different reasons)? Reasons why cross listing could be a good tool to tap to international markets include:

1. expand investor base; 2. lower firm’s cost of capital; 3. increase stock price; 4. facilitate raising new capital overseas in subsequent rounds of securities issuance; 5. enhance the liquidity of the company’s stock trading overseas; 6. improve company’s visibility in the foreign market;

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7. compensate local managers & employees w/ local stock; 8. improve the transparency & corporate governance of the company.

11. The following three different debt strategies are being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period.

Strategy # 1: Borrow $1,000,000 for three years a fixed rate of interest of 7%. Strategy # 2: Borrow $1,000,000 for three years at a floating rate of LIBOR +2%, to be reset annually. The current LIBOR rate is 3.50% Strategy # 3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%.

Which strategy (strategies) will eliminate credit risk? Which one will eliminate repricing risk? First, credit risk is the possibility that creditworthiness of the borrower might be reclassified by the lender at the time when the credit is renewed. Repricing risk is the risk that interest rate charged might change at the time when a financial contract is reset. So, strategy #1 does eliminate credit and repricing risks. Strategy #2 eliminates the credit risk (2% credit risk spread is fixed) but not the repricing risk. Strategy #3 does not eliminate neither credit risk nor repricing risk. 12. Suppose you, as a financial manager of a firm, have a variable rate loan outstanding. If you wish to protect the firm against an unfavorable increase in interest rates what could you do? Please describe one strategy involving use of interest rate futures and one strategy involving use of interest rate swaps? If an increase in the interest rate is expected, then one can assume a short futures position to hedge against the unfavorable increase in the interest rates. Alternatively one can enter into a “pay fixed/receive floating” swap, in order to hedge against interest rate risk. 13. Polaris is taking out a $5,000,000 one-year loan at a variable rate of LIBOR plus 1.00%. The current LIBOR rate is 4.00% per year. The loan has an upfront fee of 2.00%. Year 0 Year 1 LIBOR (Floating) 4.00% 4.00% Spread (Fixed) 1.00% 1.00% Total Interest Payable 5.00% 5.00% Interest Cash Flows on Loan LIBOR (Floating) ($200,000) Spread (Fixed) ($50,000) Total Interest ($250,000) Loan Proceeds (Repayment) $4,900,000 ($5,000,000) Total Loan Cash Flows $4,900,000 ($5,250,000)

What is the all-in-cost (i.e., the internal rate of return) of the Polaris loan including the LIBOR rate, fixed spread and upfront fee?

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The all-in-cost (or the IRR on the total cash flow) is determined by:

irr+−=

1000,250,5000,900,40 . Solving for IRR, we obtain IRR=7.14%.

14. Why capital budgeting for a foreign project is more complex than for a domestic project? Possible explanations include:

1. Parent cash flows must be distinguished from project’s cash flow. 2. Parent cash flows often depend on the form of financing through the discount rate

makes it difficult to separate operating & financing cash flows. 3. Stand-alone subsidiary cash flow can have an NPV>0, but the project itself might

not add value to the overall enterprise. 4. Both financial & non-financial payments can generate cash flows to the parent,

(e.g., licensing fees, royalties, management fees, etc.). 5. One needs to account for political risk, forex risk & differing inflation rates. 6. Segmented national capital markets might create financial gains/losses. 7. Oftentimes host government subsidies complicate WACC computation.

15. Given a current spot rate of 8.10 Norwegian krona per dollar, expected inflation rates of 6% in Norway and 3% per annum in the U.S., use the formula for relative purchasing power parity estimate the one-year spot rate of krona per dollar?

Know that relative PPP implies an exchange rate of ( )( ) $/34.81.8

03.0106.01 Krona=×

++ .

16. Provide at least three reasons why the parent’s viewpoint is superior to the local viewpoint when preparing a capital budget and give an example of when the local viewpoint fails to maximize the value of the firm. First, a project might have a positive NPV from the local viewpoint, but fail to consider relevant cash flows from the parent viewpoint. For example, a positive NPV project in one country may result from the erosion of revenues in another. A local manager would not necessarily be expected to be aware of such erosion. Second, it may not be possible to remit all or part of the local cash flows to the parent company and reinvestment opportunities in the local economy may be inferior to what the parent could do elsewhere, so, a less than maximum use of funds. Third, political and exchange rate risk add to the uncertainly of cash flows and so increase the required rate of return by stockholders. Cash flows may be more difficult to estimate especially long-term cash flows in lesser-developed countries. 17. How would you find out the international cost of equity using the Goldman Sachs integrated approach?

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In essence the method obtains the cost of equity for the company based on the CAPM model, as if the company was a US company, and then adjusts this cost of capital by the sovereign yield spread. In particular, first, we need to estimate the market beta of the stock in point, on S&P 500. Then, we multiply the obtained beta by the US equity premium. Finally, we add the sovereign yield spread and the risk free interest rate to obtain the cost of equity. 18. What is the difference between market segmentation and market liquidity? Market segmentation refers to the difference in the required rates of returns to similar assets (similar expected return and similar risk) due to differences in the information sets of the investors in the local and the international market (which differences on their turn result from institutional differences & government regulations across different markets), while market liquidity refers to the impact of raising more capital in a given equity market on the price (cost) at which one can do so. 19. We know that depository receipt is one of the main ways to source equity globally. What other ways to source equity you are aware of? Please discuss briefly two of these other methods. Other methods of sourcing equity globally include: directed public share issue, Euro equity public issue, private placements under SEC rule 144A, private equity funds, and strategic alliances. So, for example, directed public share issues are targeted at investors in single country. Euro equity public issues are occasions where firms can issue equity underwritten & distributed n multiple foreign equity markets, sometimes simultaneously w/ distribution in the domestic market. (Note: probably not the best question for our class as we skipped this topic in class discussions and I prefer to test concepts that were covered in the book and in class.) 20. What is the difference between a “Eurobond” and a “foreign bond”? Eurobonds are sold to investors in national capital markets other than country of denominating currency. Foreign bonds are sold within a country of denominated currency, however issue is from another currency. 21. Which of the following are Eurodollars and which are not Eurodollars? Why?

a. A US $ deposit owned by a German corporation and held in Barclay’s Bank of London.

Yes, this is a Eurodollar deposit held in a bank outside of the United States.

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b. A US $ deposit owned by a German corporation and held in the New York branch of Deutsche Bank.

No, this bank deposit is held in bank offices within the United States, and the fact that the banking office is a branch of a European bank is irrelevant. 22. Unilever is borrowing US$10,000,000 for 3 years at 200 basis points over LIBOR. LIBOR for the loan will be reset annually. An upfront fee of 2% is charged when loan is extended. What is the effective interest cost of debt for the first year if LIBOR is 5% for the first year? So the net debt inflow is US$10,000, 000 * (1-0.02) = US$ 9,800,000. However the LIBOR + 200 bp is still charged on the US$10m. So, the interest cost for the first year would be (LIBOR+200 bp) * US$ 10m = (5%+2%) * US$ 10m = $ 700,000. As a percent of the total debt receipts, this is $ 700,000 / $ 9,800,000 = 7.14 % 23. Tropicana Inc. has just borrowed EUR 1,000,000 to make improvements to an Italian processing plant. If the interest rate is 5.5% per year and the EUR appreciates against the dollar from $1/EUR at the time the loan was made to $1.05/EUR at the end of the first year, how much interest will Tropicana pay at the end of the first year? To compute interest rate, we use the formula I gave in class: ( )( ) 111 −++ si EUR

d , where (since we have direct quotations)

05.01

1/05.1$

1

12 =−

=−

=EUR

SSSs and Substituting for these we obtain

the interest expense as

%5.5=EURdi

( )( ) ( )( ) 1078.0105.01055.01111 =−++=−++ si EURd , or 10.78%.

In terms of US$, this is 10.78% * $ 1,000,000 = $ 107,800 (notice that I multiplied by $1,000,000 – this is because I have used the initial $ equivalent of EUR 1,000,000). 24. Please argue briefly whether it is beneficial (or not) to cross-list stock. In your discussion, please be sure to mention at least three reasons for why it would (or would not) be beneficial to cross-list. Pros: Expand investor base, lower cost of capital, higher stock price, market timing, easy raising new capital abroad, enhances liquidity, enhances visibility of company’s products, use cross-listed shares as “acquisition currency” for takeover, compensating overseas managers & employees w/ local stock, may improve transparency & corporate governance

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Cons: costly (disclosure, listing requirements), there can be volatility spillover, foreigners may acquire a controlling interest, lowers liquidity in local markets. (Note: if I were to include such a question on the final exam, I’d want you to list three reasons (or whatever # I gave) and explain them. For example, if you said it was costly to meet foreign disclosure requirements, I’d want you to say that it is costly because you may release information that could help competitors, etc.) 25. If the cost advantage of interest rate swaps would likely be arbitraged away in competitive markets, what other explanations exist to explain the rapid development of the interest rate swap market?

All types of debt instruments are not always available to all borrowers. Interest rate swaps can assist in market completeness. That is, a borrower may use a swap to get out of one type of financing and to obtain a more desirable type of credit that is more suitable for its asset maturity structure. This is an extension of the term ‘comparative advantage’. A firm might have an advantage in arranging a certain type of financing but prefer another type. 26. Centralia Corporation, a U.S. manufacturer, is investing in a wholly owned manufacturing facility in Spain. The plant will cost Ptas620 mn (sorry, this is an old question from before the intro of the euro) and will take 1 year to complete. The plant is to be financed over its economic life of 8 years. The borrowing capacity created by this capital expenditure is $1.7mn; the remainder of the plant is to be equity financed. Centralia is not well known in the Spanish or international bond markets. Consequently it will have to play 14% per annum to borrow pesetas, whereas the normal borrowing rate in the Spanish capital market for well-known firms of equivalent risk is 12.5%. Centralia could borrow in the U.S. at 8% per annum.

a. Suppose a Spanish MNE has a mirror-image situation and needs $1.7 mn to finance a capital expenditure of one of its U.S. subsidiaries. It finds that it must pay a 9% fixed rate in the U.S. for dollars, whereas it can borrow pesetas at 12.5%. The exchange rate has been forecast to be Ptas 145.44/$1 in one year. Set up a currency swap that will benefit each counterparty. Note: no swap bank is involved in this transaction.

The Spanish MNE should issue Ptas247,250,000 of 12.5 percent fixed rate debt and Centralia should issue $1,700,000 of fixed-rate 8 percent debt, since each counterparty has a relative comparative advantage in their home market. This uses the exchange rate of Ptas14.544/$1.00. The two companies will exchange principal sums in one year. The contractual exchange rate for the initial exchange is Ptas247,250,000/$1,700,000, or Ptas145.44/$1.00.

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Annually the counterparties will swap debt service: the Spanish MNE will pay Centralia $136,000 (=$1,700,000 x .08) and Centralia will pay the Spanish MNC Ptas30,906,250 (=Ptas247,250,000 x .125). The contractual exchange rate of the first seven annual debt service exchanges is Ptas30,906,250/$136,000, or Ptas227.25/$1.00. At retirement, Centralia and the Spanish MNC will re-exchange the principal sums and the final debt service payments. The contractual exchange rate of the final currency exchange is Ptas278,156,250/$1,836,000 = (Ptas247,250,000 + Ptas30,906,250)/($1,700,000 + $136,000), or Ptas151.50/$1.00.

b. Suppose that one year after the inception of the currency swap between

Centralia and the Spanish MNE, the U.S. dollar fixed-rate has fallen from 8% to 6% and the Spanish capital market fixed-rate for pesetas has fallen from 12.5% to 11%. In both dollars and pesetas, determine the market value of the swap if the exchange rate is Ptas 152.30/$1.

The market value of the dollar debt is the present value of a seven-year annuity of $136,000 and a lump sum of $1,700,000 discounted at 6 percent. This present value is $1,889,801. Similarly, the market value of the peseta debt is the present value of a seven-year annuity of Ptas30,906,250 and a lump sum of Ptas247,250,000 discounted at 11 percent. This present value is Ptas264,726,358. The dollar value of the swap is $1,889,801 - Ptas264,726,358/152.30 = $151,611. The peseta value of the swap is Ptas264,726,358 - (152.30)$1,889,801 = -Ptas23,090,334. 27. Explain how exchange rate fluctuations affect the return from a foreign market, measured in dollar terms. Discuss the empirical evidence on the effect of exchange rate uncertainty on the risk of foreign investment. We need to use one key equation: Ri$ = (1 + Ri) (1 + s) – 1 where Ri is the return on the foreign stock in foreign currency terms and s is the change in the spot exchange rate. To understand uncertainty, we need to use Var (Ri$) = Var(Ri) + Var(ei) + 2Cov(Ri,ei) + ∆var. Exchange rate fluctuations mostly contribute to the risk of foreign investment through its own volatility as well as its covariance with the local market returns. The covariance tends to be positive in most of the cases, implying that exchange rate changes tend to add to exchange risk, rather than offset it. Exchange risk is found to be much more significant in bond investments than in stock investments.

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28. Would exchange rate changes always increase the risk of foreign investment? Discuss the condition under which exchange rate changes may actually reduce the risk of foreign investment. Exchange rate changes need not always increase the risk of foreign investment. When the covariance between exchange rate changes and the local market returns is sufficiently negative to offset the positive variance of exchange rate changes, exchange rate volatility can actually reduce the risk of foreign investment. 29. How do you think the existence of the EU – and soon, the eastward expansion – have impacted investments in Europe? You may have a single overarching answer or you might distinguish between European and non-European investors. Firms that want to access the EU market may recognize that the cost of doing business is lower in the eastern bloc of countries (EB). This means that investments in the EB are more likely to have a positive NPV than in pricier Western countries. Moreover, some European firms may shift their operations east and foreign firms may invest in the EB as a means of tapping the EU market while circumventing possible trade barriers. 30. China is also an increasingly large source of FDI in recent years. (Sure, it isn’t on the scale of the US but they’ve still got piles of money to invest abroad.) What kinds of investments do you think they’d pursue? Same logic as for why foreign firms invest in China. The Chinese firms invest abroad to arbitrage market imperfections or leverage abilities. Early Chinese investments abroad were in natural resources (e.g. oil in Africa and pipelines in the Middle East). Later investments were in industries where there were market imperfections. For example, we all have plenty of clothes that were made in China. But the US has strict quotas for China-produced clothes. So, what is a Chinese firm to do when the US quota is used up? One strategy is to shift production to other countries (e.g. Guam or Vietnam) and use their quotas. 31. Suppose that your firm is operating in a segmented capital market. What actions would you recommend to mitigate the negative effects? Cross-listing would enable the firm to overcome market segmentation. The firm should do so if and only if the benefits outweigh the costs. 32. In what sense do firms with nontradable assets get a free-ride from firms whose securities are internationally tradable? Due to the spillover effect, firms with nontradable securities can benefit in terms of higher security prices and lower cost of capital, without incurring any costs associated with making the securities internationally tradable.

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33. Discuss foreign equity ownership restrictions. Why do you think countries impose these restrictions? Many countries restrict foreign equity ownership in order to prevent (evil, untrustworthy, etc.) foreigners from gaining influence over local markets. These restrictions ensure local control over domestic firms. 34. Under what conditions will the foreign subsidiary’s financial structure become relevant? The subsidiary’s own financial structure will become relevant when the parent firm is not responsible for the financial obligations of the subsidiary. So, if IBM said that each foreign subsidiary was fully independent, then each subsidiary would determine what was best for it given the local market conditions. But, in the real world IBM doesn’t do this and so it requires each local subsidiary to take the basic IBM model and adapt it to fit local market conditions. (If this isn’t true of IBM, then it should be.) 35. Under what conditions would you recommend that the foreign subsidiary conform to the local norm of financial structure? It may make sense for the subsidiary to confirm to the local norm if the parent is not responsible for the subsidiary’s debt and the subsidiary has to depend on local financial markets for raising capital. 36. Discuss the difference between performing the capital budgeting analysis from the parent firm’s perspective as opposed to the project perspective. The goal of the financial manager of the parent firm is to maximize its shareholders’ wealth. A capital project of a subsidiary of the parent may have a positive NPV (or APV) from the subsidiary’s perspective yet have a negative NPV (or APV) from the parent’s perspective if:

i. certain cash flows cannot be repatriated to the parent because of remittance restrictions by the host country;

ii. the home currency is expected to appreciate substantially over the life of the

project, yielding unattractive cash flows when converted into the home currency of the parent.

Additionally, a higher tax rate in the home country may cause the project to be unprofitable from the parent’s perspective. Any of these reasons could result in the project being unattractive to the parent and the parent’s stockholders. 37. Assume 3-month LIBOR is 2% and market pricing indicates the 3-month LIBOR rate is expected to rise moderately to 2.25% by end-2003. If IBM believes 3-

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month LIBOR will actually be 7% at end-2003, should IBM buy or sell a December 2003 Eurodollar contract? If the market expects LIBOR will be 2.25% in December 2003, then a December 2003 Eurodollar contract will sell for (100-2.25) or 97.75. If IBM believes 3-month LIBOR will actually be 7% in December 2003 then they expect the Eurodollar contract should instead be priced at 93. They would therefore believe the contract is over-valued and would want to sell the contract. 38. Assume that on January 1, 2000 the June 2000 Eurodollar contract sold for 95 but in June 2000 the actual 3-month LIBOR was 8% (or try 2%). If British Petroleum bought a contract in January 2000, did they make a profit or loss on the contract? If the actual 3-month LIBOR were 8% in June 2000, then the contract would be worth 92 and BP lost money on the contract. But if LIBOR were 2%, then the contract would be worth 98 and BP would make a profit. 39. Why would two firms undertake an interest rate swap? Who benefits? Each party has a comparative advantage in borrowing in one type of structure but prefers the other. The two firms would undertake the swap in order to better match cash inflows/outflows and/or to obtain cost savings.

For example, in problem 41 (below), McDonald’s might be preparing to issue Eurodollar bonds that are priced at a floating-rate tied to LIBOR. They would therefore prefer to match their cash inflows and outflows and would like to obtain the underlying financing at a floating rate. 40. Please name and explain at least three risks that face swap banks.

- Interest rate risk – rates might change after one side of the swap is on the books or if it has an unhedged position.

- Basis risk – if the floating rates of the counterparties are pegged to different

indices (e.g. US Treasury vs. LIBOR).

- Exchange rate risk – currency movements could affect the profitability of a currency swap (think about the example we did in class on June 5th).

- Credit risk – one or both counterparties might default.

- Mismatch risk – perhaps it isn’t possible to find counterparties who want the same

amount of money for the same length of time.

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- Sovereign risk – the possibility that a country would impose exchange rate restrictions (or capital controls) that interfere with the counterparties’ obligations under the swap.

41. Interest rate swap: Assume McDonald’s and British Telecom can borrow at the following rates:

McDonald’s British Telecom Finance Moody’s credit rating (actual)

A2 Baaa1

Fixed-rate borrowing cost (my projection)

7.0% 8.5%

Floating-rate borrowing cost (my projection)

LIBOR LIBOR + 1%

a. Calculate the quality spread differential (QSD).

QSD = (Fixed-rateBT – Fixed-rateMcD) – (Floating-rateBT – Floating-rateMcD) = (8.5 - 7.0) – (LIBOR + 1 – LIBOR) = 1.5 –1 = 0.5%.

b. Develop an interest rate swap in which both McDonald’s and British Telecom Finance have an equal cost savings in their borrowing costs. Assume McDonald’s desires floating-rate debt and British Telecom Finance desires fixed-rate debt. Assume there is no swap bank in the middle.

If each firm has an equal cost savings, then each firm will save ½ of 0.5% or 0.25% over the best terms it could be offered in its desired structure. Step 1: McDonald’s would issue fixed-rate debt at 7.0% and British Telecom would issue floating-rate debt at LIBOR + 1%.

Step 2: We know each firm will save .25% over the best terms it could obtain on its own. So let’s work backwards to figure out what rate BT would pay McD’s and vice-versa. That must mean that McD’s will have an all-in cost of LIBOR – 0.25% and BT would have an all-in cost of 8.5% -0.25% or 8.25%.

McD’s all-in cost will be 7.0 + (rate paid on floating rate debt = LIBOR) – (rate received from BT) = LIBOR - .25 BT would pay McD 7.25%.

Confirm this: BT’s all-in cost will be LIBOR +1 – (rate received from McD = LIBOR) + 7.25 = 8.25.

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42. Same problem as (41) but McDonald’s gets ¾ of the QSD. What would the appropriate rate be for each borrower? If McDonald’s gets ¾ of the QSD it will save ¾ of 0.5% or 0.375%. Then McDonald’s would have an all-in cost of LIBOR – 0.375%. British Telecom would get ¼ of 0.5% or 0.125% and would therefore have an all-in cost of 8.375% for its debt. 43. Currency swap: Since McDonald’s is an American firm, they have an advantage in borrowing in dollars. Shockingly, since British Telecom Finance is British they have an advantage in borrowing pounds. But there’s a wrinkle: McDonald’s needs pounds to finance a seemingly mad purchase of cow farms in England. Meanwhile British Telecom Finance needs dollars to purchase an ailing telecom company in the US (maybe it is WorldCom?). Both firms need the equivalent of £10mn. Their borrowing opportunities are as shown:

McDonald’s British Telecom Finance Moody’s credit rating (actual)

A2 Baaa1

Dollar debt cost (my projection)

5.0% 7.0%

Pound debt cost (my projection)

8.4% 9.0%

a. Please explain which firm has a comparative advantage in borrowing

which currency. McD’s has a 2.0% advantage in dollars but 0.6% in pounds McD’s has an advantage in borrowing dollars. BT pays 2.0% more to borrow in dollars but just 0.6% more to borrow in pounds BT has an advantage in borrowing in pounds.

b. Develop a currency swap in which both McDonald’s and British Telecom Finance. Assume the exchange rate is $1.50/£. If the swap bank makes a 1% profit on the dollar debt financed with .75% of the pound loan, what is their annual profit on the debt?

At the given exchange rate McD’s will end up with £10 mn and BT with $15mn. In order to have the swap bank make a 1% profit on the dollar debt, we need to let McD’s lend dollars to the swap bank at x% and have BT pay x+1%. McDonald’s will borrow dollars externally at 5.0% and lend to the swap bank at 5.0%. Then the swap bank will lend these dollars to BT at 6.0% (much better than the 7.0% rate BT could have obtained on its own!).

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The swap bank will pay 0.75% more interest for pounds than it can receive. This means that it must pay BT y% but McD will pay y-0.75%. Since BT will borrow pounds externally at 9.0%, that means McD will pay 8.25% (slightly better than the 8.4% rate McD could have obtained on its own!).

c. If the pound depreciated, how would that affect the swap bank’s annual

profit? The bank’s annual profit on this swap will be 1% on $15 mn – 0.75% on £10 mn = $150,000 - £75,000. At the current exchange rate, this would yield a profit of $150,000 - £75,000*$1.50/£ = $150,000 - $112,500 = $37,500. If the pound depreciated, then the bank would make a higher profit. 44. Why do investors diversify their portfolios internationally? Stock market returns are more highly concentrated within an individual market than across markets. That is, the movements of US firms such as Microsoft, IBM and United Airlines are more highly correlated than the movements of those stocks vis-à-vis foreign firms such as HSBC (trades in UK and Hong Kong), Maersk (Danish shipping firm), etc. Factors that affect security returns tend to vary significantly across countries. For example, international business cycles are not perfectly correlated (example, Hong Kong has been in the slump since ‘97/98 but the US didn’t start to slump until much later). Reduced risk – as a portfolio contains a larger number of assets that do not move together, the overall portfolio risk is reduced. 45. Assume a US investor sold shares of Foster’s beer (Australia) after holding them for one year. Suppose the share price fell 4% in Australian dollars while the Australian dollar appreciated 6% against the US$. What is the investor’s return in US$? Ri$ = (1+ Ri)*(1+s)-1 = (1-.04)*(1+.06)-1= .0176 = 1.76% gain. 46. Assume a French investor sold shares of Pemex (Mexican oil company) after holding them for one year. Suppose the share price rose 5% in peso terms while the Mexican peso depreciated 10% against the Euro. What is the investor’s return in Euros? Ri$ = (1+ Ri)*(1+s)-1 = (1+.05)*(1-.10)-1= -.055 = 5.5% loss. The following questions are all “True/false/uncertain and why”. 47. When calculating the APV of a domestic investment vs. a foreign investment the only difference between the two is the latter must reflect foreign interest rates.

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False – exchange rates (now and future); interest rates (domestic and foreign); tax rates (domestic and foreign). 48. The only plausible explanation of FDI is that firms leverage comparative advantages to circumvent market imperfections. False/uncertain – empirical literature has yielded mixed evidence on this topic. Other possible theories are to leverage firm strength or transfer ownership of assets to more efficient owners. 49. Host countries always gain from FDI inflows. True/uncertain – check out slide 21 from FDI chapter (file 9_0727). 50. Why does the cost of capital vary internationally? Market segmentation. 51. Suppose IBM claims that by tapping global financial markets it can lower its cost of capital and pass the savings on by lowering computer prices. Please use the following information to determine which scenario would yield a lower required rate of return for the firm. Assume: βUS

IBM = .07, βWorldIBM = .13,US Treasury rate is 6%, the US equity market

is expected to return 9% this year, and the international markets are expected to generate 5% returns this year.

a. Please use the CAPM model to indicate a numerical solution for both

the US and world scenarios. CAPM: RUS

IBM = .06 + .07(.09-.06) = .0621 vs. RWorldIBM = .06 + .13(.05-.06) = .0587.

b. Please interpret your numerical results.

Implies IBM would lower its cost of capital by tapping international markets. The next problem is a LONG one in many parts. It was given as homework last summer

but could be decomposed into numerous questions for an exam. That said, the accounting part is too detailed for my exam-giving style.

By now I’m sure everyone has heard of the new contagious disease severe acute respiratory syndrome (SARS) that has been wreaking havoc worldwide. The onset of SARS has greatly disrupted normal economic and business activity in some parts of Asia. Hong Kong has been hardest hit. Unfortunately for the purpose of this assignment, Hong Kong has a pegged exchange rate. Ditto the second hardest hit place: China. So, we’ll settle for #3: Singapore. Luckily the Singapore dollar is freely floating! (Note: the

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government does control the movement of the S$ quite a bit…we’re going to ignore that a little bit. Reality is just a little troublesome sometimes.) For this homework, the spot rate of the Singapore dollar is S$1.77 = US$1. (If you want to be lazy, use S$ for Singapore and $ for the US or if that might be too confusing try SGD for Singapore dollars and $ or US$ or USD for the US dollar.)

1. Economic Exposure: Why could we view SARS as a cause of economic exposure?

SARS could be interpreted as a source of economic exposure inasmuch as the disease has disrupted normal business operations. Any deviation from regular business practices imposes a de facto cost on firms.

For example, one person from Intel’s finance department in Hong Kong was hospitalized w/SARS. As a result the entire finance department staff was told to work from home for two weeks as a safety precaution. But, in order for those people to be effectively quarantined, all people who share a household w/them must also be quarantined. So that means those peoples’ spouses, children, etc. must also all stay home. This has a ripple effect that spreads throughout the economy. Ultimately this means that the economy will take quite a hit. But at the firm level this is an unanticipated event that is changing their daily cost structure for expenses and revenues.

2. Economic Exposure:

The answers to (a) and (b) are in the following chart. (a) required you to solve the

right column. (b) required you to calculate the bottom two rows.

If S$1.77 = US$1 If S$1.90 = US$1

0 units at S$1,200/unit) S$12,000,000 S$12,000,000

ble costs 0 units at US$300 each – imported parts!)

S$5,310,000 S$5,700,000

overhead costs S$1,000,000 S$1,000,000ciation allowances S$1,200,000 S$1,200,000ofit before tax S$4,490,000 S$4,100,000e tax (at 15%) S$673,500 S$615,000after tax S$3,816,500 S$3,485,000ack depreciation S$1,200,000 S$1,200,000ting cash flow in S$ S$5,016,500 S$4,685,000ting cash flow in US$ US$2,834,181 US$2,465,789year present value (US$)1 US$8,091,525 US$7,039,774ting gains/losses (US$) -US$1,051,751

1 How did I get this? The operating cash flow in US$ is for year 0. Calculate the rate for years 1-4 and sum it up! So if year 0 is X then year 1 is X/1.15 and so forth.

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(c) Two possibilities: (1) The firm might try to renegotiate the contract for the imported parts so that the S$ cost is reduced. (2) Or it might try to differentiate its product so that it can charge a higher sales price and thereby increase revenue. Note, the firm might try different strategies but they’d all have the same aim: maximizing firm profit by minimizing costs, maximizing revenue, or both. They’d do this by changing their production process, manufacturing technology, or firm strategy in order to better differentiate their products from those of competitor firms.

3. Transaction exposure: 1. What tools could the firm use?

a. Forward market hedge: it needs US$ to pay for the parts but will eventually want US$ for reporting its results. So the company might buy US$ on the forward market to pay for the imported parts or it might sell US$ forward to cover the final results.

b. Money market hedge: it will need US$300 *10,000 units = US$3,000,000.

Why not discount the US$3mn to the present value (using 3% interest rate), convert it to S$ today (at S$1.77=US$1), and invest it in Singapore (at 10.56%)? Given IRP, that should deliver exactly how much money the firm needs in the future given the projected exchange rate of S$1.90. But, if IRP doesn’t hold precisely the firm might gain/lose.

c. Options market hedge: buy a US$ call option to hedge its US$ payables.

Downside risk: lose the call premium; upside potential: if call is in-the-money may make profit on exchange rate movement.

d. Cross-hedging: might be a possibility if the firm did business in other

Asian countries whose currencies had a predictable relationship vis-à-vis the US$ and/or S$.

e. Invoice – terms or timing might be renegotiated if Singapore Computers

has leverage w/the other party.

4. Translation exposure:

(a) Functional currency = S$; (b) Reporting currency = US$.

Balance sheet Local

currency Current/ Noncurrent(US$)

Monetary/ Nonmonetary(US$)

Temporal (US$)

Current Rate (US$)

Cash S$2,100 1,105 1,105 1,105 1,105

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Inventory S$1,500 789 847 9472 789Net fixed assets S$3,000 1,695 1,695 1,695 1,579Total assets S$6,600 3,589 3,647 3,747 3,473Current liabilities S$1,200 632 632 632 632Long-term debt S$1,800 1,017 947 947 947Common stock S$2,700 1,525 1,525 1,525 1,525Retained earnings3 S$900 415 543 643 XCTA — — — — 369 - X4

Total liabilities and equity

S$6,600 3,589 3,647 3,747 3,473

2 We’ll assume the current value of inventory is S$1,800. 3 Retained earnings are taken from the income statement (which we skipped!). So I cheated and just said that retained earnings were whatever it took to make the liabilities equal assets. The only place I couldn’t cheat was on the current rate method because we need to have a CTA. 4 CTA = Total liabilities and equity – (Current liabilities + long-term debt + common stock + retained earnings). We have exact numbers for all the terms on the RHS of that equation except retained earnings, X. Hence, CTA = 369 – X.

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