Chapter 21

Discussion Questions
21-1. What risks does a foreign affiliate of a multinational firm face in today’s
business world?

In addition to the normal risks that a domestic firm faces (such as the risk
associated with maintaining sales and market share, the financial risk of
too much leverage, etc.), the foreign affiliate of a multinational firm is
exposed to foreign exchange risk and political risk.

21-2. What allegations are sometimes made against foreign affiliates of multi-national
firms and against the multinational firms themselves?

Some countries have charged that foreign affiliates subverted their governments
and caused instability for their currencies in international money and foreign
exchange markets. The less developed countries (LDC’s) have, at times, alleged
that foreign business firms exploit their labor with low wages. The multinational
companies are also under constant criticism in their home countries. The home
country’s labor unions charge the MNC’s with exporting jobs, capital, and
technology to foreign nations, while avoiding their fair share of taxes. In spite of all
these criticisms, the multinational companies have managed to survive and prosper.

21-3. List the factors that affect the value of a currency in foreign exchange markets.

Factors affecting the value of a currency are: inflation, interest rates, balance
of payments, and government policies. Other factors that have an influence
include the stock market, gold prices, demand for oil, political turmoil, and
labor strikes. All of the above factors will not affect each currency in the same
way at any given point in time.

21-4. Explain how exports and imports tend to influence the value of a currency.

When a country sells (exports) more goods and services to foreign countries
than it purchases (imports), it will have a surplus in its balance of trade.
Since foreigners are expected to pay their bills for the exporter’s goods in the
exporter’s currency, the demand for that currency and its value will go up.
On the other hand, continuous deficits in balance of payments are expected to
depress the value of the currency of a country because such deficits would
increase the supply of that currency relative to the demand. Of course, a number
of other factors may also influence these patterns such as the economic and
political stability of the country.

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21-5. Differentiate between the spot exchange rate and the forward exchange rate.

The spot rate for a currency is the exchange rate at which the currency is traded
for immediate delivery. An exchange rate established for a future delivery date
is a forward rate.

21-6. What is meant by translation exposure in terms of foreign exchange risk?

The foreign-located assets and liabilities of a multinational corporation are

denominated in their respective foreign currencies and need to be translated
back to their local currency. This is called accounting or translation exposure.
The amount of loss or gain resulting from this currency exposure and the
treatment of it in the parent company’s books, depends upon the accounting
rules established by the parent company’s government.

21-7. What factors influence a U.S. business firm to go overseas?

Factors that influence a U.S. business firm to go overseas are: avoidance

of tariffs; lower production and labor costs; usage of superior American
technology abroad in such area as oil exploration, mining, and manufacturing;
tax advantages such as postponement of U.S. taxes until foreign income is
repatriated, lower foreign taxes, and special tax incentives; defensive measures
to keep up with competitors going overseas; and the achievement of
international diversification. There also is the potential for higher returns than
on purely domestic investments.

21-8. What procedure(s) would you recommend for a multinational company in

studying exposure to political risk? What actual strategies can be used to guard
against such risk?

In studying exposure to political risk, a company may hire outside consultants

or form their own advisory committee consisting of top level managers from
headquarters and foreign subsidiaries.

Strategic steps to guard against such risks include:

a. Establish a joint venture with a local entrepreneur.

b. Enter into a joint venture with firms from other countries.
c. Purchase insurance.

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21-9. What factors beyond the normal domestic analysis go into a financial feasibility
study for a multinational firm?

An international financial feasibility study must go beyond domestic factors to

also consider the treatment of foreign tax credits, foreign exchange risk, and
remittance of cash flows.

21-10. What is a letter of credit?

A letter of credit is normally issued by the importer’s bank; in which the bank
promises to pay money for the merchandise when delivered.

21-11. Explain the functions of the following agencies:

Overseas Private Investment Corporation (OPIC).

Export-Import Bank (Eximbank).
Foreign Credit Insurance Association (FCIA).
International Finance Corporation (IFC).

Overseas Private Investment Corporation (OPIC)—A government agency that

sells insurance policies to qualified firms. This agency insures against losses
due to inconvertibility into dollars of amounts invested in a foreign country.
Policies are also available from OPIC to insure against expropriation and
against losses due to war or revolution.

Export-Import Bank (Eximbank)—An agency of the U.S. government that

facilitates the financing of U.S. exports through its miscellaneous programs.
In its direct loan program, the Eximbank lends money to foreign purchasers of
U.S. goods such as aircraft, electrical, equipment, heavy machinery, computers,
and the like. The Eximbank also purchases medium-term obligations of foreign
buyers of U.S. goods at a discount from face value. In these discount programs,
private banks and other lenders are able to rediscount (sell at a lower-price)
promissory notes and drafts acquired from foreign customers of U.S. firms.

Foreign Credit Insurance Association (FCIA)—An agency established by a

group of 60 U.S. insurance companies. It sells credit export insurance to
interested exporters. The FCIA promises to pay for the exported merchandises
if the foreign importer defaults on payment.

International Finance Corporation (IFC)—An affiliate of the World Bank

established with the sole purchase of providing partial seed capital for private
ventures around the world. Whenever a multinational company has difficulty
raising equity capital due to lack of adequate private capital, the firm may
explore the opportunity of selling equity or debt (totaling up to 25 percent)

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 to the International Finance Corporation.
21-12. What are the differences between a parallel loan and a fronting loan?

In a parallel loan, the exchange rate markets are avoided entirely—that is, the
funds do not enter the foreign exchange market at all. Also no financial institution
is involved. In contrast, a fronting loan involves funds moving into foreign
markets and the involvement of a financial institution to front for the loan.

21-13. What is LIBOR? How does it compare to the U.S. prime rate?

LIBOR (London Interbank Offered Rate) is an interbank rate applicable for

large deposits in the Eurodollar market. It is a bench mark rate just like the
prime rate in the United States. Interest rates on Eurodollar loans are
determined by adding premiums to this basic rate. Generally, Libor is lower
than the U.S. prime rate.

21-14. What is the danger or concern in floating a Eurobond issue?

When a multinational firm borrows money through the Eurobond market

(foreign currency denominated debt), it creates transaction exposure, a kind
of foreign exchange risk. If the foreign currency appreciates in value during
the bond’s life, the cost of servicing the debt could be quite high.

21-15. What are ADRs?

ADRs (American Depository Receipts) represent the ownership interest in a

foreign company’s common stock. The shares of the foreign company are put in
trust in a New York bank. The bank, in turn, issues its depository receipts of the
foreign firm to the American stockholders.

21-16. Comment on any dilemmas that multinational firms and their foreign affiliates
may face in regard to debt ratio limits and dividend payouts.

Debt ratios in many countries are higher than those in the United States.
A foreign affiliate faces a dilemma in its financing decision. Should it follow
the parent firm’s norm or that of the host country? Furthermore, should this be
decided at corporate headquarters or by the foreign affiliate? Dividend policy
may represent another difficult question. Should the parent company dictate
the dividends that the foreign affiliate must distribute or should it be left to the
discretion of the foreign affiliate?

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 Chapter 21
Problems
1. The Wall Street Journal reported the following spot and forward rates for the Swiss
franc ($/SF).

Spot............................................ $0.8202
30-day forward........................... $0.8244
90-day forward........................... $0.8295
180-day forward......................... $0.8343

a. Was the Swiss franc selling at a discount or premium in the forward market?
b. What was the 30-day forward premium (or discount)?
c. What was the 90-day forward premium (or discount)?
d. Suppose you executed a 90-day forward contract to exchange 100,000 Swiss francs into
U.S. dollars. How many dollars would you get 90 days hence?
e. Assume a Swiss bank entered into a 180-day forward contract with Bank of America to
buy $100,000. How many francs will the Swiss bank deliver in six months to get the
U.S. dollars?

21-1. Solution:
a. The Swiss franc was selling at a premium above the spot
rate.

Forward rate  Spot rate 12

b. 30-day forward premium    100
Spot rate 1

.8244  .8202
  12  100
.8202
.0042
  12  100
.8202
 .005121  12  100
 .061452  100  6.1452%

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21-1. (Continued)
Forward rate  Spot rate 12
c. 90-day forward premium    100
Spot rate 3

.8295  .8202
  4  100
.8202
.0093
  4  100
.8202
 .011339  4  100
 .045356  100  4.5356%

d. 90-day forward rate = $.8295

Dollar value of 100,000 Swiss francs
$.8295 × 100,000 = $82,950

e. 180-day forward rate = $.8343

$100,000
Swiss franc equivalent of $100,000   SF$119,860.96
$.8343

2. Suppose the Mexican peso is selling for $0.0909 and an Irish punt is selling for $1.5035.
What is the exchange rate (cross rate) of the Mexican peso to the Irish punt? That is, how
many Mexican pesos are equal to an Irish punt?

21-2. Solution:
One dollar is worth 11.001 Mexican pesos (1/0.0909) and one
Irish punt is worth 1.5035 dollars.
Thus: 11.001 Mexican pesos per dollar times 1.5035 dollars per
Irish punt equals 16.54 Mexican pesos per Irish punt The answer
is 16.54.

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3. From the base price level of 100 in 1979, Saudi Arabian and U.S. price levels in 2008
stood at 200 and 410, respectively. If the 1979 $/riyal exchange rate was $0.26/riyal, what
should the exchange rate be in 2008? Suggestion: Using purchasing power parity, adjust
the exchange rate to compensate for inflation. That is, determine the relative rate of
inflation between the United States and Saudi Arabia and multiply this times $/riyal of
0.26.

21-3. Solution:
$/riyal = $.26 in 1979.

United States 410

Comparative rate of inflation    2.05
Saudi Arabia 200

The value of the Saudi Arabian riyal to the dollar will rise in
proportion to the rate of inflation in the United States compared
to the rate of inflation in Saudi Arabia

$/riyal (2008) = $.26/riyal × 2.05 = .5330

4. In problem 3, if the United States had somehow managed no inflation since 1979,
what should the exchange rate be in 2008, using the purchasing power theory?

21-4. Solution:
United States 100
Comparative rate of inflation    .5
Saudi Arabia 200

$/riyal (2008) = $.26/riyal × .5 = $.13

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5. An investor in the United States bought a one-year Brazilian security valued at 195,000
Brazilian reals. The U.S. dollar equivalent was 100,000. The Brazilian security earned
16 percent during the year, but the Brazilian real depreciated 5 cents against the U.S. dollar
during the time period ($0.51 to $0.46). After transferring the funds back to the United
States, what was the investor’s return on her $100,000? Determine the total ending value
of the Brazilian investment in Brazilian reals and then translate this Brazilian value to
U.S. dollars. Then compute the return on the $100,000.

21-5. Solution:
Initial value × (1 + interest rate)
195,000 × 1.16 = 226,200 Brazilian reals
Brazilian reals × .46 = U.S. dollars equivalent
226,200 × .46 = 104,052 U.S. dollars equivalent
4,052*/$100,000 = 4.052% Rate of return

*$104,052 – $100,000 = $4,052 Change

6. A French investor buys 100 shares of Goodyear Corp. for $3,000 ($30 per share). Over the
course of a year, the stock goes up by 6 points.
a. If there is a 10 percent gain in the value of the dollar versus the euro, what will be the
total percentage return to the French investor? First determine the new dollar value of
the investment and multiply this figure by 1.10. Divide this answer by $3,000 and get a
percentage value, and then subtract 100 percent to get the percentage return.
b. Now assume that the stock increases by 8 points, but that the dollar decreases by
14 percent versus the euro. What will be the total percentage return to the French
investor? Use .86 in place of 1.10 in this case.

21-6. Solution:
a. Initial investment 100 × $30 = $3,000
Value after one year 100 × $36 = $3,600
Equivalent value to the
French investor $3,600 × 1.10 = $3,960

$3,960
 132.00%  100.00%  32.00%
$3,000

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21-6. (Continued)
b. Initial investment 100 × $30 = $3,000
Value after one year 100 × $38 = $3,800
Equivalent value to the
French investor $3,800 × .86 = $3,268

$3,268
 108.93%  100.00%  8.93%
$3,000

7. You are the vice president of finance for International Resources, Inc., headquartered in
Denver, Colorado. In January 2008 your firm’s Canadian subsidiary obtained a six-month
loan of 100,000 Canadian dollars from a bank in Denver to finance the acquisition of a
titanium mine in Quebec province. The loan will also be repaid in Canadian dollars. At the
time of the loan, the spot exchange rate was $0.8852/Canadian dollar and the Canadian
currency was selling at a discount in the forward market. The June 2008 futures contract
(Face value = $100,000 per contract) was quoted at U.S. $0.8817.
a. Explain how the Denver bank could lose on this transaction if it does not hedge.
b. If the bank does hedge, what is the maximum amount it can lose?

21-7. Solution:
a. The Denver bank has extended a loan denominated in
Canadian dollars and will be repaid in Canadian dollars.
If the Canadian dollar drops in the future (a possibility
implied by the futures contract price), the Denver bank will
be paid back in a currency that is worth less at the time it is
repaid than it was at the time it was borrowed.
b. Basically the bank is buying Canadian dollars now for
$.8852/CD and contracting to selling them in the future for
$.8817/CD. The most it can lose is $0035 on the $100,000
contract or $350.

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Appendix
21A-1. The Office Automation Corporation is considering a foreign investment. The initial
cash outlay will be $10 million. The current foreign exchange rate is 2 ugans = $1.
Thus the investment in foreign currency will be 20 million ugans. The assets have a
useful life of five years and no expected salvage value. The firm uses a straight-line
method of depreciation. Sales are expected to be 20 million ugans and operating cash
expenses 10 million ugans every year for five years. The foreign income tax rate is
25 percent. The foreign subsidiary will repatriate all aftertax profits to Office
Automation in the form of dividends. Furthermore, the depreciation cash flows (equal to
each year’s depreciation) will be repatriated during the same year they accrue to the
foreign subsidiary. The applicable cost of capital that reflects the riskiness of the cash
flows is 16 percent. The U.S. tax rate is 40 percent of foreign earnings before taxes.
a. Should the Office Automation Corporation undertake the investment if the foreign
exchange rate is expected to remain constant during the five-year period?
b. Should Office Automation undertake the investment if the foreign exchange rate is
expected to be as follows:
Year 0................................. $1 = 2.0 ugans
Year 1................................. $1 = 2.2 ugans
Year 2................................. $1 = 2.4 ugans
Year 3................................. $1 = 2.7 ugans
Year 4................................. $1 = 2.9 ugans
Year 5................................. $1 = 3.2 ugans

21A-1. Solution:
The Office Automation Corporation
(values in millions of ugans)
a.
Year 1 Year 2 Year 3 Year 4 Year 5
Revenue 20.00 20.00 20.00 20.00 20.00
– Operating expense 10.00 10.00 10.00 10.00 10.00
– Depreciation (20 M/5) 4.00 4.00 4.00 4.00 4.00
= Earnings before
foreign taxes 6.00 6.00 6.00 6.00 6.00
– Foreign income tax
(25%) 1.50 1.50 1.50 1.50 1.50
= Earnings after foreign
income taxes 4.50 4.50 4.50 4.50 4.50

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21A-1. (Continued)
Dividends repatriated* 4.50 4.50 4.50 4.50 4.50
Gross U.S. taxes
(40% of earnings
before foreign taxes) 2.40 2.40 2.40 2.40 2.40
– Foreign tax credit 1.50 1.50 1.50 1.50 1.50
= Net U.S. taxes payable .90 .90 .90 .90 .90
Aftertax dividend
received 3.60 3.60 3.60 3.60 3.60
Exchange rate
(2 ugans/$) 2.00 2.00 2.00 2.00 2.00
Aftertax dividend
(U.S. $) $1.80 $1.80 $1.80 $1.80 $1.80

PVIFA (16% for 5 years) 3.274

PV of dividends equals $1.80 × 3.274 = $5.893 million
Depreciation equals
4.00 ugans per year × $1/2 ugans = $2.00
PV of depreciation equals $2.00 × 3.274 = $6.548 million

The PV of all the cash inflows equals

$5.893 + $6.548 = $12.441 million
Cost of project 10.000 million
Net present value of the project $ 2.441 million

The net present value of the project is positive; the firm should invest.
* Dividends repatriated assumes all earnings after foreign income taxes
will be repatriated.

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21A-1. (Continued)
b. The change in foreign exchange values must be applied to
both aftertax dividends received (in ugans) and depreciation
(in ugans).

(in millions)
Year 1 Year 2 Year 3 Year 4 Year 5
Aftertax dividend
received 3.60 3.60 3.60 3.60 3.60
Depreciation 4.00 4.00 4.00 4.00 4.00
Total (in ugans) 7.60 7.60 7.60 7.60 7.60
Exchange rate (U/$1) 2.2 2.4 2.7 2.9 3.2
Cash inflow (U.S. $) 3.45 3.17 2.81 2.62 2.38
PVIF (16%) .862 .743 .641 .552 .476
PV (U.S. $) 2.97 +2.36 +1.80 +1.45 +1.13

Total = 9.71
PV of all the inflows equals $ 9.71 million
Cost of project 10.00 million
Net present value of the project ($ .29) million

On a purely economic basis, the investment should now be rejected.

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