Chapter 18 - Long-Term Financing

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Chapter 18
Long-Term Financing
Lecture Outline
Long-Term Financing Decision
Sources of Equity
Sources of Debt
Cost of Debt Financing
Measuring the Cost of Financing
Actual Effects of Exchange Rate Movements on Financing Costs
Assessing the Exchange Rate Risk of Debt Financing
Use of Exchange Rate Probabilities
Use of Simulation
Reducing Exchange Rate Risk
Offsetting Cash Inflows
Forward Contracts
Currency Swaps
Parallel Loans
Diversifying Among Currencies
Interest Rate Risk from Debt Financing
The Debt Maturity Decision
The Fixed Versus Floating-rate Decision
Hedging With Interest Rate Swaps
Plain Vanilla Swap
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Chapter Theme
This chapter introduces the long-term sources of funds available to MNCs. Should the MNC choose
bonds as a medium to attract long-term funds, a currency for denomination must be chosen. This is a
critical decision for the MNC. While there is no clear-cut solution, this chapter illustrates how such a
problem can be analyzed. A suggested method of presenting this analysis is to run through an example
under assumed exchange rates. Then stress that future exchange rates are not known with certainty.
Therefore, the firm should consider the possible costs of financing under a variety of exchange rate
scenarios.
Topics to Stimulate Class Discussion
1. Why would U.S. firms consider issuing bonds denominated in a foreign currency?
2. What are the desirable characteristics related to a currency’s interest rate (high or low) and value
(strong or weak) that would make the currency attractive from a borrower’s perspective?
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 was not as attractive as the forward rate, the participants would 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.
ANSWER: The swap rates will be in line with forward rates, so that MNCs will not benefit from
borrowing low interest rate currencies and simultaneously hedging.
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?
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ANSWER: A U.S. firm should consider the interest rate for each possible currency as well as
forecasts of the exchange rate relative to the firm’s home currency. The firm should also determine
whether it has future cash inflows in any foreign currencies that could denominate the bond.
Finally, the firm should forecast the future path of the coupon rate.
b. Is the risk of issuing a floating rate bond higher or lower than the risk of issuing a fixed rate
Eurobond? Explain.
ANSWER: The risk from issuing a floating rate bond is that the interest rate may rise over time.
The risk from issuing a fixed rate bond is that the firm is obligated to pay that coupon rate even if
interest rates decline. Some firms may feel that a fixed rate bond is less risky since at least they
know with certainty the coupon rate they must pay in the future. This question is somewhat
open-ended.
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 currencydenominated bond to exhibit?
ANSWER: An investing firm prefers a bond denominated in a currency that is expected to
appreciate and with an interest rate that is high and expected to increase. A borrowing firm prefers
a bond denominated in a currency that is expected to depreciate and with an interest rate that is
low and expected to decrease.
2. Risk From Issuing Foreign Currency-Denominated Bonds. What is the advantage of using
simulation to assess the bond financing position?
ANSWER: Unlike point forecasts, simulation provides a distribution of possible outcomes. Thus,
the firm can determine the probability that a particular foreign issued bond will be a less expensive
source of funds than a locally issued bond.
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.
ANSWER: The cost of financing with foreign currencies is low when the dollar strengthens, and
high when the dollar weakens.
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.
ANSWER: It may offset some exchange rate risk if it has cash inflows in euros. These euros could
be used to make coupon payments.
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.
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ANSWER: Exchange rates are generally more volatile than interest rates over time. Therefore the
dollar payments made on euro-denominated bonds would likely be more uncertain than the dollar
payments made on floating-rate bonds denominated in dollars. Also, the principal payment is
subject to exchange rate risk but not to interest rate risk.
5. Currency Diversification. Why would a U.S. firm consider issuing bonds denominated in
multiple currencies?
ANSWER: The firm may issue bonds in multiple currencies to reduce exchange rate risk. This is
especially possible when the currencies used to denominate bonds are not highly correlated.
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?
ANSWER: Kerr could invoice its exports in yen and use the proceeds to pay back loans. Its
economic exposure would be reduced because Japanese consumers would not be subjected to
exchange rate swings.
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?
ANSWER: The most critical time is maturity, since the principal will be paid back at that time.
8. Financing Decision. Ivax Corp. (based in Miami) is a U.S. drug company that has attempted to
capitalize on new opportunities to expand in Eastern Europe. The production costs in most Eastern
European countries are very low, often less than one-fourth of the cost in Germany or Switzerland.
Furthermore, there is a strong demand for drugs in Eastern Europe. Ivax penetrated Eastern
Europe by purchasing a 60 percent stake in Galena AS, a Czech firm that produces drugs.
a. Should Ivax 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
koruna currency against the dollar. If it finances the project in dollars, it is more exposed to
exchange rate risk, because the funds would be remitted to the U.S. before paying the interest
expenses on the loan. Conversely, if it finances the project in koruna, it could use some of its local
funds to pay off its interest expenses before remitting any funds to the U.S. parent. Another reason
for borrowing from a local Czech bank is that the bank may help Ivax avoid any excessive
regulatory restrictions that could be imposed on foreign firms in the drug industry. These potential
advantages of borrowing locally must be weighed against the potentially higher interest rate when
borrowing locally.
b. How can borrowing koruna locally from a Czech bank reduce the exposure of Ivax to
exchange rate risk?
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ANSWER: By borrowing koruna, the Czech subsidiary of Ivax 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 the exposure of Ivax to political
risk caused by government regulations?
ANSWER: By borrowing from a local Czech bank, Ivax may be able to avoid excessive
regulations that could be imposed on foreign firms by the local government. Also, there is less
chance of any extreme action to be taken on a foreign firm when that firm’s failure would cause
defaults on loans provided by local lenders.
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 francdenominated 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.
Year 1
SF Payment
SF1,714,286
Exchange rate $.75
Payments in $ $1,285,715
Year 2
SF1,714,286
$.75
$1,285,715
Year 3
SF16,000,000
$.75
$12,000,000
The annual cost of financing is 14.92% for the franc-denominated bonds. Since the annual cost of
financing of the dollar-denominated bonds is 15%, Sambuka should issue the franc-denominated
bonds.
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.
ANSWER: No. The exchange rate of the yen is expected to rise according to the IFE, which
would offset the interest rate differential.
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International Financial Management
b. Should Hawaii Co. finance its production with yen and simultaneously engage in forward
contracts to hedge its exposure to exchange rate risk?
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?
ANSWER: Hawaii could request that the Japanese importers pay for their imports in yen. It could
finance in yen at 3% and use a portion of the proceeds from its export revenue to cover its finance
payments.
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
1
2
3
4
Exchange Rate of Singapore Dollar
$.52
.56
.58
.53
Determine the expected annual cost of financing with Singapore dollars. Should Seminole, Inc.,
issue bonds denominated in U.S. dollars or Singapore dollars? Explain.
ANSWER:
End of Year:
S$ payment
Exchange rate
$ payment
1
S$1,400,000
$.52
$728,000
2
S$1,400,000
$.56
$784,000
3
S$1,400,000
$.58
$812,000
4
S$21,400,000
$.53
$11,342,000
The annual cost of financing with S$ 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. dollars borrowed. Using a calculator, this discount rate is 8.97%. Thus, the expected annual
cost of financing with a Singapore dollar-denominated bond is 8.97%, which is less than the 12%
cost of financing with U.S. dollars. However, there is some uncertainty associated with Singapore
dollar financing. Seminole Inc. must weigh the expected savings from financing in Singapore
dollars with the uncertainty associated with such financing.
Chapter 18: Long-Term Financing
319
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 invoicing policy and make its bond denomination decision to achieve low
financing costs without excessive exposure to exchange rate fluctuations?
ANSWER: Hurricane could invoice goods exported to Denmark in kroner instead of dollars. Thus,
it would now have inflows in kroner that could be used to make coupon payments on bonds
denominated in kroner that it could issue. This strategy achieves a cost of financing of 9 percent,
which is lower than the cost of other financing alternatives. To the extent that the inflows in
kroner can cover bond payments, this strategy is not exposed to exchange rate risk.
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. It 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 then will 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 be 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?
ANSWER: Since Grant Inc. needs 10 million pounds, Grant will need to issue debt amounting to
$17 million (computed as 10 million pounds × $1.70 per pound). Grant Inc. will pay 10% on the
principal amount of $17 million annually as a coupon rate, which is equal to $1.7 million. It
should specify that 1 million pounds are to be swapped for dollars in each of the next three years
(computed as $1.7 million dollars divided by $1.70 per pound = 1 million pounds).
14. Interest Rate Swap. Janutis Co. has just issued fixed rate debt at 10 percent. Yet, it prefers 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 in order 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:
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International Financial Management
End of Year
1
2
3
LIBOR
9.0%
8.5%
7.0%
Variable Rate Paid Due to Swap
9.0% + 1.0% = 10.0%
8.5% + 1.0% = 9.5%
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% while Mexico’s annual risk-free interest rate is 11%. Interest rate
parity exists. 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%. 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 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.
P = (1 + ih)/(1 + if) – 1 = –0.045 or 4.5% discount.
The Mexican Peso is expected to depreciate 4.5% in each of the next four years.
End of Year 1 = 0.20 × 0.955 = 0.191
End of Year 2 = 0.191 × 0.955 = 0.1824
End of Year 3 = 0.1824 × 0.955 = 0.1742
End of Year 4 = 0.1742 × 0.955 = 0.1664
Bradenton Co.’s cost of debt is 10%.
Bradenton’s cost of equity is:
Ke = Rf + B(Rm – Rf)
= 0.06 + 0.9 (0.18 – 0.06) = 0.168 or 16.8%
Given the tax rate of 30% and the 60%/40% debt to equity ratio, the cost of capital is:
Kc = [D/(D + E) × Kd × (1 – t)] + [E/(D + E) × Ke]
= [0.6 × 0.1 × 0.7] + [0.4 × 0.168]
= 0.1092 or 10.92%
Chapter 18: Long-Term Financing
Year 1
After-tax profit in
MXP
Exchange rate
Cash flow to parent
PV (discount rate
of 10.92%)
NPV
321
Year 2
Year 3
Year 4
MXP1,000,000
0.1700
$170,000
MXP1,000,000
0.1700
$170,000
MXP1,000,000
0.1700
$170,000
MXP1,000,000
0.1700
$170,000
$153,263
$138,177
$124,569
$112,307
$528,318
b.
Year 1
After-tax profit in
MXP
Exchange rate
Cash flow to parent
PV (discount rate
of 10.92%)
NPV
Year 2
Year 3
Year 4
MXP1,000,000
0.1910
$191,000
MXP1,000,000
0.1824
$182,405
MXP1,000,000
0.1742
$174,196
MXP1,000,000
0.1664
$166,357
$172,196
$148,260
$127,644
$109,901
$558,003
Solution to Continuing Case Problem: Blades, Inc.
1. Given that Blades expects to use the cash flows generated by the Thai subsidiary to pay the
interest and principal of the notes, would the effective financing cost of the baht-denominated
notes be affected by exchange rate movements? Would the effective financing cost of the yendenominated notes be affected by exchange rate movements? How?
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 pay the interest and principal of these notes. Consequently, Blades’ financing cost of the
baht-denominated notes will be the coupon rate of these notes (15 percent).
The effective financing cost of the yen-denominated notes will be affected by exchange rate
movements, since Blades would convert baht into yen in order to pay the interest and principal on
these notes. For example, if the yen appreciates versus the baht, Blades needs more baht in order
to pay the interest and principal on the yen-denominated notes. Thus, Blades’ effective financing
rate for the yen-denominated notes would increase and may be higher than the 10 percent coupon
rate on these notes.
2. Construct a spreadsheet to determine the annual effective financing percentage cost of the yendenominated 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?
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International Financial Management
ANSWER: (See spreadsheet below.) The annual effective financing percentage costs for the three
scenarios of no change in the value of the yen, an appreciation of 2 percent, and an appreciation of
3 percent are, respectively, 10 percent, 12.20 percent, and 13.30 percent. Thus, the probability that
the effective financing cost associated with issuing yen-denominated notes is higher than the
financing cost of baht-denominated notes (15 percent) is 0.
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:
Payments in Japanese Yen
Forecasted Exchange Rate
of Japanese Yen in Baht
Payments in Baht
Annual Cost
1
2
3
4
5
of Financing
125,000,000 125,000,000 125,000,000 125,000,000 1,375,000,000
—
0.347826
0.347826
0.347826
43,478,250 43,478,250 43,478,250
0.347826
43,478,250
0.347826
478,260,750
—
10.00%
(2) Yen Value Changes
by 2 Percent Annually
Relative to the Baht
End of
Year:
Payments in Japanese Yen
Forecasted Exchange Rate
of Japanese Yen in Baht
Payments in Baht
Annual Cost
1
2
3
4
5
of Financing
125,000,000 125,000,000 125,000,000 125,000,000 1,375,000,000
—
0.3547825
0.361878
0.369116
44,347,815 45,234,771 46,139,467
0.376498
47,062,256
0.384028
528,038,513
—
12.20%
(3) Yen Value Changes
by 3 Percent Annually
Relative to the Baht
End of
Year:
Payments in Japanese Yen
Forecasted Exchange Rate
of Japanese Yen in Baht
Payments in Baht
Annual Cost
1
2
3
4
5
of Financing
125,000,000 125,000,000 125,000,000 125,000,000 1,375,000,000
—
0.358261
0.369009
0.380079
44,782,598 46,126,075 47,509,858
0.391481
48,935,153
0.403226
554,435,288
—
13.30%
Chapter 18: Long-Term Financing
323
3. Using a spreadsheet, determine the expected annual effective financing percentage cost of issuing
yen-denominated notes. How does this expected financing cost compare with the expected
financing cost of the baht-denominated notes?
ANSWER: (See spreadsheet below.) The expected annual effective financing cost of issuing yendenominated notes is 12.09 percent, which is lower than the cost associated with issuing bahtdenominated notes.
Exchange Rate Scenario
Scenario 1: No Change in Yen Value
Scenario 2: Annual Appreciation of Yen by
2 Percent
Scenario 3: Annual Appreciation of Yen by
3 Percent
(1)
Effective Financing
Percentage Cost
10.00%
(2)
(3) = (1) × (2)
Probability
20%
Product
2.00%
12.20%
50%
6.10%
13.30%
30%
3.99%
12.09%
4. Based on your answers to the previous questions, do you think Blades should issue yen- or bahtdenominated notes?
ANSWER: Based on the answers to the previous questions, it appears that Blades should issue
yen-denominated notes in order to partially finance the cost of establishing a subsidiary in
Thailand.
5. What is the tradeoff involved?
ANSWER: The cost of financing in baht is known with certainty, because Blades could use bahtdenominated revenue to cover the financing costs. The cost of financing with yen is uncertain
because Blades will have to obtain yen to cover the interest or principal payments of the yen loan.
Solution to Supplemental Case: Devil VCR Corporation
a. It can reduce its exposure to exchange rate risk, because it could convert the proceeds of the
bond into pounds to cover future production expenses and could use a portion of the revenue
in Singapore dollars each year to pay its coupon payments to bondholders.
b. This approach would increase Devil VCR’s exchange rate risk, because it already has
expenses in pounds and no revenue in pounds.
c. This approach would not reduce the exchange rate risk resulting from the exporting program,
because it is not offsetting the revenue received in Singapore dollars.
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International Financial Management
Small Business Dilemma
Long-Term Financing Decision by the Sports Exports Company
The Sports Exports Company continues to focus on producing footballs in the U.S. and exporting
them to the United Kingdom. The exports are denominated in pounds, which has continually exposed
the firm to exchange rate risk. It is now considering a new form of expansion where it would sell
specialty sporting goods in the U.S. If it pursues this U.S. project, it would need to borrow long-term
funds. The dollar-denominated debt has an interest rate that is slightly lower than the pounddenominated debt.
1. Jim Logan, owner of the Sports Exports Company, needs to determine whether dollardenominated 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 dollardenominated 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?
ANSWER: Yes. Jim’s existing export business results in pound receivables. He could use some of
those receivables to make interest payments on pound-denominated debt that was used to support
his U.S. business. The U.S. business will generate dollar revenue. Thus, the firm’s exposure to
exchange rate risk could be reduced when considering all parts of his business.
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?
ANSWER: The Sports Exports Company could borrow long-term funds denominated in dollars to
support its U.S. expansion. It could engage in a currency swap arrangement, in which pounds are
exchanged for dollars. As its existing export business generates pounds (as receivables), those
pounds could be exchanged for dollars, which are then used to pay interest on the U.S. debt.
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 videocassettes. Gandor will invest $12 million in this project, which will help to finance the
Chinese firm’s production. For each of the first three years, 50 percent of the total profits will be
distributed to the Chinese firm, while the remaining 50 percent will be converted to dollars to be sent
to the U.S. The Chinese government intends to impose a 20 percent income tax on the profits
distributed to Gandor. The Chinese government has guaranteed that the after-tax profits (denominated
in yuan, the Chinese currency) can be converted to U.S. dollars at an exchange rate of CHY1 = $.20
per unit and sent to Gandor Company each year. At the present time, no withholding tax is imposed on
profits sent to the U.S. as a result of joint ventures in China. Assume that even after considering the
taxes paid in China, an additional 10 percent tax imposed by the U.S. government on profits received
by Gandor Company. After the first three years, all profits earned are allocated to the Chinese firm.
The expected total profits resulting from the joint venture per year are as follows:
Chapter 18: Long-Term Financing
325
Total Profits from Joint
Venture (in yuan, CHY)
CHY60 million
CHY80 million
CHY100 million
Year
1
2
3
Gandor’s average cost of debt is 13.8 percent before taxes. Its average cost of equity is 18 percent.
Assume that the corporate income tax rate imposed on Gandor is normally 30 percent. Gandor uses a
capital structure composed of 60 percent debt and 40 percent equity. Gandor automatically adds 4
percentage points to its cost of capital when deriving its required rate of return on international joint
ventures. Though this project has particular forms of country risk that are unique, Gandor plans to
account for these forms of risk within its estimation of cash flows.
Gandor is concerned about two forms of country risk. First, there is the risk that the Chinese
government will increase the corporate income tax rate from 20 percent to 40 percent (20 percent
probability). If this occurs, additional tax credits will be allowed, resulting in no U.S. taxes on the
profits from this joint venture. Second, there is the risk that the Chinese government will impose a
withholding tax of 10 percent on the profits that are sent to the U.S. (20 percent probability). In this
case, additional tax credits will not be allowed, and Gandor will still be subject to a 10 percent U.S.
tax on profits received from China. Assume that the two types of country risk are mutually exclusive.
This is, the Chinese government will adjust only one of its taxes (the income tax or the withholding
tax), if any.
1. Determine Gandor’s cost of capital. Also, determine Gandor’s required rate of return for the joint
venture in China.
ANSWER: Gandor’s weighted average cost of capital is:
⎛ D ⎞
⎛ E ⎞
⎟k ( 1 − t ) + ⎜
⎟k
k =⎜
c ⎝D+ E⎠ d
⎝D+ E⎠ e
= ( 60% )( 138%
. )( 70% ) + ( 40% )( 18% )
= 58%
. + 7.2%
= 13%
Since Gandor applied a premium of 4 percentage points to its cost of capital for joint ventures in
foreign countries, its required rate of return on this joint venture is 17 percent. Gandor also
attempts to explicitly capture some types of country risk in the estimated cash flows, as explained
shortly.
326
International Financial Management
2. Determine the probability distribution of Gandor’s net present values for the joint venture.
Capital budgeting analyses should be conducted for these scenarios:
•
•
•
Scenario 1 Based on original assumptions.
Scenario 2 Based on an increase in the corporate income tax by the Chinese government.
Scenario 3 Based on the imposition of a withholding tax by the Chinese government.
SCENARIO 1: BASED ON ORIGINAL ASSUMPTIONS
(Probability = 60%)
Year 0
Year 1
Year 2
Year 3
Total profits
(in CHY)
CHY60,000,000
CHY80,000,000
CHY100,000,000
Profits allocated to
Gandor Co.
(50% of total)
CHY30,000,000
CHY40,000,000
CHY150,000,000
CHY6,000,000
CHY8,000,000
CHY10,000,000
CHY24,000,000
CHY32,000,000
CHY40,000,000
$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
–$8,307,692
–$4,099,934
$395,534
Corporate income taxes
imposed by Chinese
government (20%)
Profits to Gandor after
paying corporate
income taxes in
China
Gandor’s dollar profits
received from China
(based on exchange
rate of CHY1 = $.20)
Initial investment
Cumulative NPV of
cash flows
$12,000,000
Chapter 18: Long-Term Financing
327
SCENARIO 2: BASED ON INCREASE IN CORPORATE INCOME TAX BY CHINESE GOVERNMENT
(Probability = 20%)
Year 0
Year 1
Year 2
Year 3
Total profits
(in CHY)
CHY60,000,000
CHY80,000,000
CHY100,000,000
Profits allocated to
Gandor Co.
(50% of total)
CHY30,000,000
CHY40,000,000
CHY50,000,000
Corporate income taxes
imposed by Chinese
government (40%)
CHY12,000,000
CHY16,000,000
CHY20,000,000
Profits to Gandor
after paying
corporate income
taxes in China
CHY18,000,000
CHY24,000,000
CHY30,000,000
$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
–$8,923,077
–$5,416,612
–$1,670,389
Gandor’s dollar
profits
received from China
(based on exchange
rate of CHY1 = $.20)
Initial investment
Cumulative NPV of
cash flows
$12,000,000
328
International Financial Management
SCENARIO 3: IMPOSITION OF A WITHHOLDING TAX BY CHINESE GOVERNMENT
(Probability = 20%)
Year 0
Year 1
Year 2
Year 3
Total profits
(in CHY)
CHY60,000,000
CHY80,000,000
CHY100,000,000
Profits allocated to
Gandor Co.
(50% of total)
CHY30,000,000
CHY40,000,000
CHY50,000,000
CHY6,000,000
CHY8,000,000
CHY10,000,000
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
–$8,676,923
–$4,889,941
–$844,020
Corporate income taxes
imposed by Chinese
government (20%)
Profits to Gandor after
paying corporate
income taxes in
China
Initial investment
Cumulative NPV of
cash flows
$12,000,000
Chapter 18: Long-Term Financing
329
SUMMARY OF SCENARIOS
Scenario
Original scenario
Increase in corporate income tax
by Chinese government
Imposition of withholding tax
by Chinese government
Expected value of NPV
NPV for This Scenario
$395,534
Probability that This
Scenario Will Occur
60%
–$1,670,389
20%
–$844,020
20%
=
(60% × $395,534) + (20% × –$1,670,389) + (20% × –$844,020)
=
$237,320 + (–$334,078) + (–$168,804)
=
–$265,562
3. Would you recommend that Gandor participate in the joint venture? Explain.
ANSWER: The expected value of the NPV is negative. In addition, there is a 40 percent chance
that the joint venture will have a negative NPV for Gandor. Thus, the project does not appear to be
feasible for Gandor.
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?
ANSWER: The key influential factor in this joint venture is probably the future economic
conditions in China, which affects the demand for video cassettes and therefore affects profits to
be received. Since economic conditions in most countries (especially those that are not fully
developed) are uncertain, there is much uncertainty about the profit estimates used in this example.
5. Is there any reason for Gandor to revise the composition of its capital (debt and equity) obtained
from the U.S. when financing joint ventures like this?
ANSWER: Gandor may consider using more equity if it believes that the cash flows from joint
ventures like this are very uncertain, in order to ensure that it maintains sufficient cash flows to
cover its debt.
6. When Gandor was assessing this proposed joint venture, some of its managers of recommended
that Gandor borrow the Chinese currency rather than dollars to obtain some of the necessary
capital for its initial investment. They suggested that such a strategy could reduce Gandor’s
exchange rate risk. Do you agree? Explain.
ANSWER: In this case, the exchange rate is guaranteed by the government, so the concept of
borrowing in the foreign currency to reduce exchange rate risk does not apply here.
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