Chapter 14: Multinational Capital Budgeting
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Chapter 14
Answers to End of Chapter Questions
1. MNC Parent’s Perspective. Why should capital budgeting for subsidiary projects be assessed
from the parent’s perspective? What additional factors that normally are not relevant for a purely
domestic project deserve consideration in multinational capital budgeting?
ANSWER: When a parent allocates funds for a project, it should view the project’s feasibility
from its own perspective. It is possible that a project could be feasible from a subsidiary’s
perspective but be infeasible when considering a parent’s perspective (due to foreign withholding
taxes or exchange rate changes affecting funds remitted to the parent).
Some of the more obvious factors are (1) exchange rates, (2) whether currency restrictions may
exist, (3) probability of a host government takeover, and (4) foreign demand for the product.
2. Accounting for Risk. What is the limitation of using point estimates of exchange rates in the
capital budgeting analysis?
List the various techniques for adjusting risk in multinational capital budgeting. Describe any
advantages or disadvantages of each technique.
Explain how simulation can be used in multinational capital budgeting. What can it do that other
risk adjustment techniques cannot?
ANSWER: Point estimates of exchange rates lead to a point estimate of a project’s NPV. It is
more desirable to have a feel for a variety of outcomes (NPVs) that could occur.
The risk adjusted discount rate (RADR) is easy to use but generates only a single point estimate
of the NPV. It may be more desirable to develop a distribution of possible NPVs in order to
assess the probability that NPV will be positive. Sensitivity analysis and simulation could be very
useful because they generate a distribution of NPVs.
To use simulation, develop a range of possible values that each input variable (such as price,
quantity sold, exchange rates) may take on, and apply the simulation model to these ranges to
generate a distribution of NPVs.
3. Uncertainty of Cash Flows. Using the capital budgeting framework discussed in this chapter,
explain the sources of uncertainty surrounding a proposed project in Hungary by a UK firm. In
what ways is the estimated net present value of this project more uncertain than that of a similar
project in a more developed European country?
ANSWER: The estimated NPV is more uncertain because cash flows are more uncertain. The
high degree of uncertainty surrounding the cash flows is attributed to uncertain economic
conditions (especially given the shift to a market-oriented economy), and to an uncertain degree
of competition (the competitive structure is changing substantially because of the removal of
barriers).
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International Financial Management
4. Accounting for Risk. Your employees have estimated the net present value of project X to be
£1.2 million. Their report says that they have not accounted for risk, but that with such a large
NPV, the project should be accepted since even a risk-adjusted NPV would likely be positive.
You have the final decision as to whether to accept or reject the project. What is your decision?
ANSWER: The decision should not be made until risk has been considered. If the project has a
risk of a government takeover, for example, a large estimated NPV may not be a sufficient reason
to accept the project.
5. Impact of Exchange Rates on NPV.
a. Describe in general terms how future appreciation of the euro will likely affect the value (from
the parent’s perspective) of a project established in Germany today by a UK-based MNC.
Will the sensitivity of the project value be affected by the percentage of earnings remitted to
the parent each year?
b. Repeat this question, but assume the future depreciation of the euro.
ANSWER:
a. Future appreciation of the euro would benefit the parent since the euro earnings would be
worth more when remitted and converted to dollars. This is especially true when a large
percentage of earnings are sent to the parent.
b. The future depreciation of the euro would hurt the parent since the euro earnings would be
worth less when remitted and converted to dollars. This is especially true when a large
percentage of earnings are sent to the parent.
6. Impact of Financing on NPV. Explain how the financing decision can influence the sensitivity
of the net present value to exchange rate forecasts.
ANSWER: By financing the project with the same currency that is received from the project, the
firm can reduce the sensitivity of a foreign project’s NPV.
7. Impact of events. A MNC in the euro area is thinking of investing outside the area. For each
continent, think of events outside the the project that might adversely affect cash flows.
ANSWER: An opportunity to relate events of the day to risk and return
8. Assessing a Foreign Project. Huskie SA, a French-based MNC, considers purchasing a small
manufacturing company in the US that sells products only within the States. Huskie has no other
existing business in the US and no cash flows in dollars. Would the proposed acquisition likely be
more feasible if the dollar is expected to appreciate or depreciate over the long run? Explain.
ANSWER: The proposed acquisition is likely to be more feasible if the dollar is expected to
appreciate over the long run. Huskie would like to purchase the firm when the dollar is weak.
Then, after the purchase, a strengthened dollar will convert the French firm’s earnings remitted to
the parent into a larger amount of euros.
Chapter 14: Multinational Capital Budgeting
3
9. Relevant Cash Flows in Disney’s French Theme Park. When Walt Disney World considered
establishing a theme park in France, were the forecasted revenues and costs associated with the
French park sufficient to assess the feasibility of this project? Were there any other “relevant
cash flows” that deserved to be considered?
ANSWER: Other relevant cash flows are Walt Disney World’s existing cash flows. The
establishment of a theme park in France could reduce the amount of European customers that
would have visited Disney’s U.S. theme parks. These forgone cash flows should be considered
when assessing the feasibility of the theme park in France.
10. Capital Budgeting Logic. Athens GmbH (Germany) established a subsidiary in the United
Kingdom that was independent of its operations in the Germany. The subsidiary’s performance
was well above what was expected. Consequently, when a British firm approached Athens about
the possibility of acquiring the subsidiary, Athens’ chief financial officer implied that the
subsidiary was performing so well that it was not for sale. Comment on this strategy.
ANSWER: Even if the performance is superior, the subsidiary may be worth selling if the price
offered for it exceeds Athens’ perceived present value of the subsidiary.
11. Capital Budgeting Logic. Lehigh SA (France) established a subsidiary in Switzerland that was
performing below the cash flow projections developed before the subsidiary was established.
Lehigh anticipated that future cash flows would also be lower than the original cash flow
projections. Consequently, Lehigh decided to inform several potential acquiring firms of its plan
to sell the subsidiary. Lehigh then received a few bids. Even the highest bid was very low, but
Lehigh accepted the offer. It justified its decision by stating that any existing project whose cash
flows are not sufficient to recover the initial investment should be divested. Comment on this
statement.
ANSWER: Even if the project will not recover its initial outlay, it should only be divested if the
price offered for it exceeds Lehigh’s estimation of its present value.
12. Impact of Reinvested Foreign Earnings on NPV. Greet BV is a Dutch-based firm with a
subsidiary in Mexico. It plans to reinvest its earnings in Mexican government securities for the
next 10 years since the interest rate earned on these securities is so high. Then, after 10 years, it
will remit all accumulated earnings to the Netherlands. What is a drawback of using this
approach? (Assume the securities have no default or interest rate risk.)
ANSWER: While the funds are reinvested at high rates, they may be worth fewer euros ten years
from now. Flagstaff may have been better off if the earnings were remitted in the year they were
generated. Even though the funds could not be invested at as high an interest rate in Mexico, the
exchange rate risks are reduced when the earnings are remitted each year.
13. Capital Budgeting Example. Cleto Srl (Spain) has just constructed a manufacturing plant in
Ghana. The construction cost 9 billion Ghanian cedi. Cleto intends to leave the plant open for
three years. During the three years of operation, cedi cash flows are expected to be 3 billion cedi,
3 billion cedi, and 2 billion cedi, respectively. Operating cash flows will begin one year from
today and are remitted back to the parent at the end of each year. At the end of the third year,
Cleto expects to sell the plant for 5 billion cedi. Cleto has a required rate of return of 17 percent.
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International Financial Management
It currently takes 8,700 cedi to buy one euro, and the cedi is expected to depreciate by 5 percent
per year.
a. Determine the NPV for this project. Should Cleto build the plant?
b. How would your answer change if the value of the cedi was expected to remain unchanged from its
current value of 8,700 cedi per euro over the course of the three years? Should Cleto construct
the plant then?
ANSWER:
Cash Flows:
Year
Investment
Operating CF
Salvage Value
Net CF
Exchange rate
Cash flows to parent
PV of parent cash flows
NPV
0
–9
–9
8,700
–£1,034,483
–£1,034,483
–£1,034,483
1
2
3
3
3
3
9,135
£328,407.23
£280,689.94
–£753,793.06
3
9,592
£312,760.63
£228,475.88
–£525,317.18
2
5
7
10,071
£695,065.04
£433,978.15
–£91,339.03
Since the project has a negative net present value (NPV), Brower should not undertake it.
b. How would your answer change if the value of the cedi was expected to remain unchanged
from its current value of 8,700 cedis per U.S. dollar over the course of the three years? Should
Brower construct the plant then?
ANSWER:
If the cedi was expected to remain unchanged from its current value of 8700 cedis per U.S. dollar
over the course of the three years:
Year
Investment
Operating CF
Salvage Value
Net CF
Exchange rate
Cash flows to parent
PV of parent cash flows
NPV
0
–9
–9
8,700
–£1,034,483
–£1,034,483
–£1,034,483
1
2
3
3
3
3
8,700
£344,827.59
£294,724.44
–£739,748.56
3
8,700
£344,827.59
£251,901.23
–£487,847.33
2
5
7
8,700
£804,597.70
£502,367.11
+£14,519.78
If the value of the cedi remains constant, the NPV is positive. Thus, Brower should undertake the
project in this case. Of course, the NPV is only slightly positive. Whether or not Brower actually
undertakes the project depends on the confidence it has in its exchange rate forecasts.
14. Impact of Financing on NPV. Ventura plc a UK-based MNC, plans to establish a subsidiary in
Japan. It is very confident that the Japanese yen will appreciate against the pound over time. The
subsidiary will retain only enough revenue to cover expenses and will remit the rest to the parent
Chapter 14: Multinational Capital Budgeting
5
each year. Will Ventura benefit more from exchange rate effects if its parent provides equity
financing for the subsidiary or if the subsidiary is financed by local banks in Japan? Explain.
ANSWER: Ventura would benefit more from exchange rate effects if its parent uses an equity
investment in the subsidiary. This would result in a larger remittance that would be favorably
affected by the appreciation of the Japanese yen (as the yen are converted to pounds).
If financing was provided by local banks in Japan, interest payments to these banks would reduce
the amount remitted to the UK each year. Therefore, the effect of the yen would be less favorable
because it would be applied to a smaller amount of funds.
15. Accounting for Changes in Risk. Santa Monica SA (Portugal) was considering establishing a
consumer products division in Germany, which would be financed by German banks. Santa
Monica completed its capital budgeting analysis in August. Then, in November, the government
leadership stabilized and political conditions improved in Germany. In response, Santa Monica
increased its expected cash flows by 20 percent but did not adjust the discount rate applied to the
project. Should the discount rate be affected by the change in political conditions?
ANSWER: The risk may have declined if there is less uncertainty surrounding cash flows.
However, if the political conditions also encourage more firms to do business in Germany, there
may be more intense competition from other firms that could penetrate the market, which results
in more risk.
16. Estimating the NPV. Assume that a less developed country called LDC encourages foreign
direct investment (FDI) in order to reduce its unemployment rate, currently at 15 percent. Also
assume that several MNCs are likely to consider FDI in this country. The inflation rate in recent
years has averaged 4 percent. The hourly wage in LDC for manufacturing work is the equivalent
of about $5 per hour. When Piedmont SpA (Italy) develops cash flow forecasts to perform a
capital budgeting analysis for a project in LDC, it assumes a wage rate of 5 euros in Year 1 and
applies a 4 percent increase for each of the next 10 years. The components produced are to be
exported to Piedmont’s headquarters in Italy, where they will be used in the production of
computers. Do you think Piedmont will overestimate or underestimate the net present value of this
project? Why? (Assume that LDC’s currency is tied to the euro and will remain that way.)
ANSWER: The net present value will likely be overestimated because the labour costs in LDC
will probably increase at a higher rate than 4 percent per year. As DFI increases, the demand for
labor will be much greater than in previous years, and future wage rates will reflect the strong
demand. This example is analogous to situations in South Korea, Hong Kong, and Singapore, in
which the desire by MNCs to capitalize on low-cost labour caused wage rates to increase
substantially in some periods.
17. PepsiCo’s Project in Brazil. PepsiCo recently decided to invest more than $300 million for
expansion in Brazil. Brazil offers considerable potential because it has 150 million people and
their demand for soft drinks is increasing. However, the soft drink consumption is still only about
one-fifth of the soft drink consumption in the U.S. PepsiCo's initial outlay was used to purchase
three production plants and a distribution network of almost 1,000 trucks to distribute its products
to retail stores in Brazil. The expansion in Brazil was expected to make PepsiCo's products more
accessible to Brazilian consumers.
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International Financial Management
a. Given that PepsiCo's investment in Brazil was entirely in dollars, describe its exposure to
exchange rate risk resulting from the project. Explain how the size of the parent’s initial
investment and the exchange rate risk would have been affected if PepsiCo had financed
much of the investment with loans from banks in Brazil.
ANSWER: As the earnings in Brazil are remitted, they will be converted to dollars. If Brazil’s
currency depreciates against the dollar over time, there will be less dollar earnings received.
If PepsiCo Inc. borrowed funds from banks in Brazil, the parent’s initial investment would have
been smaller. Also, the payments by the subsidiary on loans in Brazil would cause less remitted
earnings over time, and therefore less exchange rate risk.
b. Describe the factors that PepsiCo likely considered when estimating the future cash flows of
the project in Brazil.
ANSWER: The demand in Brazil for the soft drinks and snacks produced by PepsiCo Inc. is
dependent on the economy in Brazil, consumer habits, country regulations, and the competition.
PepsiCo apparently expects an increased demand for soft drinks and snacks as the economy
improves.
c. What factors did PepsiCo likely consider in deriving its required rate of return on the project
in Brazil?
ANSWER: PepsiCo planned to use $500 million for investment in Brazil. Its funds may have
been derived from retained earnings and loans from creditors. PepsiCo would have estimated a
cost of each source of funds and determined the weighted average cost of those funds. It would
have attached a risk premium onto the cost to reflect the risk of investment in Brazil.
d. Describe the uncertainty that surrounds the estimate of future cash flows from the perspective
of the U.S. parent.
ANSWER: There is some uncertainty about the demand for PepsiCo’s products in Brazil,
because it is difficult to estimate the impact of the expansion on the demand. These products
would now be more accessible to Brazil’s consumers, but the precise increase in the demand for
PepsiCo’s products cannot be easily forecasted. This demand is affected by future economic
conditions and future competition (The Coca-Cola Company planned some expansion shortly
after PepsiCo began its expansion in Brazil). In addition to these factors, there is much
uncertainty about the future exchange rate at which the funds will be converted into dollars. The
value of Brazil’s currency (called “the real”) has been very volatile over time and has typically
depreciated substantially against the dollar. Thus, it would be natural to estimate the dollar cash
flows by assuming some degree of depreciation in Brazil’s currency, but there would still be
much uncertainty regarding the degree of depreciation.
e. PepsiCo’s parent was responsible for assessing the expansion in Brazil. Yet, PepsiCo already
had some existing operations in Brazil. When capital budgeting analysis was used to
determine the feasibility of this project, should the project have been assessed from a Brazil
perspective or a U.S. perspective? Explain.
Chapter 14: Multinational Capital Budgeting
7
ANSWER: PepsiCo’s parent uses its own funds to support expansion. Thus, it should make
decisions from its own perspective. It does not make sense to assess the project from a Brazil
perspective, when the dollars are used by the parent to support the project in Brazil. The project
is only worthwhile if the return (from a U.S. perspective) is sufficiently large so that it exceeds
the return that is required by the U.S parent that invested those dollars.
18. Impact of Asian Crisis. Assume that Fordham plc was evaluating a project in Thailand (to be
financed with British pounds). All cash flows generated from the project were to be reinvested in
Thailand for several years. Explain how the Asian crisis would have affected the expected cash
flows of this project and the required rate of return on this project. If the cash flows were to be
remitted to the UK parent, explain how the Asian crisis would have affected the expected cash
flows of this project.
ANSWER: The Asian crisis would have reduced local currency cash flows (due to a weak
economy), and then those cash flows would have been remitted at weak exchange rates, which
would reduce the dollar cash flows received by the parent. The required rate of return would be
higher to capture the higher degree of uncertainty surrounding future cash flows.
19. Tax Effects on NPV. When considering the implementation of a project in one of various
possible countries, what types of tax characteristics should be assessed among the countries?
(See the chapter appendix)
ANSWER: Corporate taxes in the country should be considered by an MNC, along with
withholding taxes, and even individual tax rates imposed on the potential employees. Excise
taxes are also relevant.
20. Capital Budgeting Analysis. A project in South Korea requires an initial investment of 2
billion South Korean won. The project is expected to generate net cash flows to the subsidiary
of 3 billion and 4 billion won in the two years of operation, respectively. The project has no
salvage value. The current value of the won is 1,800 won per pound, and the value of the won
is expected to remain constant over the next two years.
a. What is the NPV of this project if the required rate of return is 13 percent?
b. Repeat the question, except assume that the value of the won is expected to be 2,000 won per
pound after two years. Further assume that the funds are blocked and that the parent company
will only be able to remit them back to the United Kingdom in two years. How does this
affect the NPV of the project?
ANSWER:
Year
Investment
Operating CF
Net CF
0
–2
–2
1
2
3
3
4
4
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International Financial Management
Exchange rate
Cash flows to parent
PV of parent cash flows
NPV
1,800
–£1,111,111
–£1,111,111
–£1,111,111
1,800
£1,666,667
£1,474,927
+£363,816
1,800
£2,222,222
£1,740,325
+£2,104,141
The NPV is +£2,104,141
ANSWER:
Year
Investment
Operating CF
Net CF
0
–2
–2
2
7
7
(we should really ascribe a rate of return for blocked funds)
Exchange rate
Cash flows to parent
PV of parent cash flows
NPV
1,800
–£1,111,111
–£1,111,111
–£1,111,111
2,000
£3,500,000
+£2,741,013
+£1,629,902
A situation where the funds are blocked and the won is expected to depreciate reduces the NPV by
£474,239.
21. Accounting for Exchange Rate Risk. Carson ltd is considering a 10-year project in Hong Kong,
where the Hong Kong dollar is tied to the US dollar. Carson ltd uses sensitivity analysis that
allows for alternative exchange rate scenarios. Why would Carson use this approach rather than
using the pegged exchange rate as its exchange rate forecast in every year?
ANSWER: Carson recognizes that the pegged exchange rate may not remain pegged over the 10year period. It should account for this risk by considering other exchange rate scenarios.
22. Decisions Based on Capital Budgeting. Marathon plc considers a one-year project with the
Belgian government. Its euro revenue would be guaranteed. Its consultant states that the
percentage change in the euro is represented by a normal distribution and that based on a 95
percent confidence interval, the percentage change in the euro is expected to be between 0 percent
and 6 percent. Marathon uses this information to create five scenarios: 0 percent, 3 percent, and 6
percent for the euro. It derives an estimated NPV based on each scenario and then determines the
mean NPV. The NPV was positive for the 3 percent and 6 percent scenarios, but was slightly
negative for the 0 percent scenario. This led Marathon to reject the project. Its manager stated that
it did not want to pursue a project that had a one-in-three chance of having a negative NPV. Do
you agree with the manager’s interpretation of the analysis? Explain.
ANSWER: Marathon’s interpretation implies that each scenario has the same probability of
occurring. Yet, the probability distribution is presumed to be normal, implying a lower probability
for the extremes than the middle of the range. The manager overestimated the likelihood that the
NPV will be negative.
Chapter 14: Multinational Capital Budgeting
9
23. Estimating Cash Flows of a Foreign Project. Assume that Nike decides to build a shoe factory
in Brazil, half the initial outlay will be funded by the parent’s equity and half by borrowing funds
in Brazil. Assume that Nike wants to assess the project from its own perspective to determine
whether the project’s future cash flows will provide a sufficient return to the parent to warrant the
initial investment. Why will the estimated cash flows be different from the estimated cash flows
of Nike’s shoe factory in New Hampshire? Why will the initial outlay be different? Explain
how Nike can conduct multinational capital budgeting in a manner that will achieve its objective.
ANSWER: The net cash flows to the parent will be different because they are based on the
revenue received by the subsidiary in Brazil, minus the expenses incurred there (including the
interest payments), and the exchange rate when the funds are remitted to the U.S., plus any tax
effects. The initial outlay is dependent on the cost of creating a factory in Brazil and the amount
of equity invested in the project and the exchange rate at the time of the initial outlay (only the
equity investment is considered here in order to determine the project’s feasibility for the parent).
The debt in Brazil will be recognized within the cash flow estimates. Nike can determine whether
the present value of the cash flows received by the parent (measured in the manner explained
above) exceeds the initial outlay (measured in the manner explained above) of the project.
Advanced Questions
24. Break-even Salvage Value. A project in Malaysia costs £4,000,000. Over the next three years,
the project will generate total operating cash flows of £3,500,000, measured in today’s dollars
using a required rate of return of 14 percent. What is the break-even salvage value of this project?
ANSWER:

CFt 
SV n =  IO − ∑
(1 + k ) n
t 
(1 + k ) 

=
−
= (£4,000,000 - £3,500,000)(1.14)
= £740,772
3
3
25. Capital Budgeting Analysis. Zistine plc considers a one-year project in New Zealand so that
it can capitalize on its technology. It is risk-averse, but is attracted to the project because of a
government guarantee. The project will generate a guaranteed NZ$8 million in revenue, paid by
the New Zealand government at the end of the year. The payment by the New Zealand
government is also guaranteed by a credible UK bank. The cash flows earned on the project will
be converted to British pounds and remitted to the parent in one year. The prevailing nominal oneyear interest rate in New Zealand is 8 percent while the nominal one-year interest rate in the
United Kingdom is 2 percent. Zistine’s chief executive officer believes that the movement in the
New Zealand dollar is highly uncertain over the next year, but his best guess is that the change in
its value will be in accordance with the international Fisher effect (IFE). He also believes that
interest rate parity holds. He provides this information to three recent finance graduates that he
just hired as managers and asks them for their input.
a. The first manager states that due to the parity conditions, the feasibility of the project will be
the same whether the cash flows are hedged with a forward contract or are not hedged. Is this
manager correct? Explain.
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International Financial Management
b. The second manager states that the project should not be hedged. Based on the interest rates,
the IFE suggests that Zistine will benefit from the future exchange rate movements, so the project
will generate a higher NPV if Zistine does not hedge. Is this manager correct? Explain.
c. The third manager states that the project should be hedged because the forward rate contains a
premium and, therefore, the forward rate will generate more British pound cash flows than the
expected amount of pound cash flows if the firm remains unhedged. Is this manager correct?
Explain.
ANSWER:
a. The first manager is wrong. The project is more feasible if it hedges, because the expected
pound cash flows are the same whether Zistine hedges or not, and it can be sure of the pound
cash flows if it hedges.
b. The second manager is wrong. The IFE does suggest an expected level of appreciation of the
New Zealand dollar, but it is exactly the same percentage as the forward premium. Thus, the
pound cash flows are just as high when hedged, and there is no uncertainty.
c. The third manager’s reasoning is wrong. The forward rate does contain a premium but the
forward hedge is not expected to generate more pound cash flows than if there is no hedge.
The amount of pound cash flows from hedging is equal to the expected pound cash flows
from not hedging. The decision to hedge is correct, but not because of this manager’s
reasoning.
26. Accounting for Uncertain Cash Flows. Blustream ltd considers a project in which it will sell
the use of its technology to firms in South Africa. It already has received orders from South
African firms that will generate R2,000,000 in revenue at the end of the next year. However, it
might also receive a contract to provide this technology to the South African government. In this
case, it will generate a total of R5,000,000 at the end of the next year. It will not know whether it
will receive the government order until the end of the year.
Today’s spot rate of the rand is £0.11. The one-year forward rate is £0.09. Blustream expects that
the spot rate of the peso will be £0.10 one year from now. The only initial outlay will be £200,000
to cover development expenses (regardless of whether the South African government purchases
the technology). Blustream will pursue the project only if it can satisfy its required rate of return
of 18 percent. Ignore possible tax effects. It decides to hedge the maximum amount of revenue
that it will receive from the project.
a. Determine the NPV if Blustream receives the government contract.
b. If Blustream does not receive the contract, it will have hedged more than it needed to and will
offset the excess forward sales by purchasing rand in the spot market at the time the forward sale
is executed. Determine the NPV of the project assuming that Blustream does not receive the
government contract.
c. Now consider an alternative strategy in which Blustream only hedges the minimum rand
revenue that it will receive. In this case, any revenue due to the government contract would not be
hedged. Determine the NPV based on this alternative strategy and assume that Blustream receives
the government contract.
d. If Blustream uses the alternative strategy of only hedging the minimum rand revenue that it will
receive, determine the NPV assuming that it does not receive the government contract.
Chapter 14: Multinational Capital Budgeting
11
e. If there is a 50 percent chance that Blustream will receive the government contract, would you
advise Blustream to hedge the maximum amount or the minimum amount of revenue that it may
receive? Explain.
f. Blustream recognizes that it is exposed to exchange rate risk whether it hedges the minimum
amount or the maximum amount of revenue it will receive. It considers a new strategy of hedging
the minimum amount it will receive with a forward contract and hedging the additional revenue it
might receive with a put option on South African rand. The one-year put option has an exercise
price of £0.11 and a premium of £0.01. Determine the NPV if Blustream uses this strategy and
receives the government contract. Also, determine the NPV if Blustream uses this strategy and
does not receive the government contract. Given that there is a 50 percent probability that
Blustream will receive the government contract, would you use this new strategy or the strategy
that you selected in question (e)?
ANSWER:
a. Revenue converted to £ = 5,000,000R × £0.09 = £450,000 assuming that it takes out the
forward contract (see b)
NPV = £450,000/(1.18) – £200,000 = 181,356
If Blustream does not receive the contract, it will have hedged more than it needed to and will
offset the excess forward sales by purchasing pesos in the spot market at the time the forward sale
is executed. Determine the NPV of the project assuming that Blustream does not receive the
government contract.
b. Revenue converted to £: 2,000,000R × £0.09 = £180,000
Blustream would have an additional 3,000,000R in forward sales. It would need to buy
3,000,000R in one year at the expected spot rate, which would be used to offset the excess
forward sale position. This would mean that a loss would be incurred of £0.10 - £0.09 = £0.01 per
rand a total loss of 0.01 x 3mR = £30,000
c. 2mR would be converted at the forward rate of 0.09 and the government portion of 3mR would
be converted at the expected rate of 0.10 a total of £480,000, discounting this back to the present
and deducting the initial outlay gives 480,000 / 1.18 - £200,000 = 206,780
d. In this case it will convert the 2mR at the forward rate of 0.09 and discount it and deduct the
initial outlay ie (2m x 0.09) / 1.18 – 200,000 = -£47,458
e. It should hedge the minimum amount of revenue. If it hedges the minimum, the NPV for either
scenario is higher than if it had hedged the maximum amount of revenue. This is based on ts
belief that the forward rate is less than the expected spot.
f.
Blustream recognizes that it is exposed to exchange rate risk whether it hedges the minimum
amount or the maximum amount of revenue it will receive. It considers a new strategy of
hedging the minimum amount it will receive with a forward contract and hedging the
additional revenue it might receive with a put option on Mexican pesos. The one-year put
12
International Financial Management
option has an exercise price of $.125 and a premium of $.01. Determine the NPV if Blustream
uses this strategy and receives the government contract. Also, determine the NPV if
Blustream uses this strategy and does not receive the government contract. Given that there is
a 50 percent probability that Blustream will receive the government contract, would you use
this new strategy or the strategy that you selected in question (e)?
f. Scenario if blustream receives government contract and exercises the put option. This would be
the same as part c as the net receipt of the put option would be 0.11 – 0.01 = 0.10 the same as the
expected spot. Of course, the option would be better as more protection is given. So the answer is
£206,780.
If it does not receive the Government contrat then the answer will be the same as in part (d) less
the premium paid for the put contract. That is to say, -£47,458 – 0.01 x 3m = -£77,458.
The expected value of the outcomes is of course positive being 0.5 x-£77,458 + 0.5 x £206,780=
£64,661 but really the risk is very non normal depending as it does on the government contract so
taking the expected value is not particularly appropriate.
27. Capital Budgeting Analysis. Wolverine GmbH (Germany) currently has no existing business in
New Zealand but is considering establishing a subsidiary there. The following information has
been gathered to assess this project:
☐ The initial investment required is 50 million euros in New Zealand dollars (NZ$). Given the
existing spot rate of 0.50 euros per New Zealand dollar, the initial investment in US dollars is 25
million euros. In addition to the NZ$50 million initial investment for plant and equipment, NZ$20
million is needed for working capital and will be borrowed by the subsidiary from a New Zealand
bank. The New Zealand subsidiary will pay interest only on the loan each year, at an interest rate
of 14 percent. The loan principal is to be paid in 10 years.
☐ The project will be terminated at the end of Year 3, when the subsidiary will be sold.
☐ The price, demand, and variable cost of the product in New Zealand are as follows:
Year
Price
Demand
1
2
3
NZ$500
NZ$511
NZ$530
40,000 units
50,000 units
60,000 units
Variable
Cost
NZ$30
NZ$35
NZ$40
☐ The fixed costs, such as overhead expenses, are estimated to be NZ$6 million per year.
☐ The exchange rate of the New Zealand dollar is expected to be 0.52 euros at the end of Year 1,
0.54 euros at the end of Year 2, and 0.56 euros at the end of Year 3.
☐ The New Zealand government will impose an income tax of 30 percent on income. In addition, it
will impose a withholding tax of 10 percent on earnings remitted by the subsidiary. The US
government will allow a tax credit on the remitted earnings and will not impose any additional
taxes.
☐ All cash flows received by the subsidiary are to be sent to the parent at the end of each year. The
subsidiary will use its working capital to support ongoing operations.
☐ The plant and equipment are depreciated over 10 years using the straight-line depreciation
method. Since the plant and equipment are initially valued at NZ$50 million, the annual
depreciation expense is NZ$5 million.
Chapter 14: Multinational Capital Budgeting
13
☐ In three years, the subsidiary is to be sold. Wolverine plans to let the acquiring firm assume the
existing New Zealand loan. The working capital will not be liquidated but will be used by the
acquiring firm that buys the subsidiary. Wolverine expects to receive NZ$52 million after
subtracting capital gains taxes. Assume that this amount is not subject to a withholding tax.
☐ Wolverine requires a 20 percent rate of return on this project.
a. Determine the net present value of this project. Should Wolverine accept this project?
b. Assume that Wolverine is also considering an alternative financing arrangement, in which the
parent would invest an additional 10 million euros to cover the working capital requirements so
that the subsidiary would avoid the New Zealand loan. If this arrangement is used, the selling
price of the subsidiary (after subtracting any capital gains taxes) is expected to be NZ$18 million
higher. Is this alternative financing arrangement more feasible for the parent than the original
proposal? Explain.
c. From the parent’s perspective, would the NPV of this project be more sensitive to exchange rate
movements if the subsidiary uses New Zealand financing to cover the working capital or if the
parent invests more of its own funds to cover the working capital? Explain.
d. Assume Wolverine used the original financing proposal and that funds are blocked until the
subsidiary is sold. The funds to be remitted are reinvested at a rate of 6 percent (after taxes) until
the end of Year 3. How is the project’s NPV affected?
e. What is the break-even salvage value of this project if Wolverine uses the original financing
proposal and funds are not blocked?
f. Assume that Wolverine decides to implement the project, using the original financing proposal.
Also assume that after one year, a New Zealand firm offers Wolverine a price of 27 million euros
after taxes for the subsidiary and that Wolverine’s original forecasts for Years 2 and 3 have not
changed. Compare the present value of the expected cash flows if Wolverine keeps the subsidiary
to the selling price. Should Wolverine divest the subsidiary? Explain.
a. Determine the net present value of this project. Should Wolverine accept this project?
Capital Budgeting Analysis: Wolverine Corporation
Year 0
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
Demand
Price per unit
Total revenue = (1) × (2)
Variable cost per unit
Total variable cost = (1) × (4)
Fixed cost
Interest expense of New
Zealand loan
Noncash expense (depreciation)
Total expenses = (5)+(6)+(7)+(8)
Before-tax earnings of subsidiary
= (3)–(9)
Host government tax (30%)
After-tax earnings of subsidiary
Net cash flow to subsidiary
= (12)+(8)
Year 1
Year 2
Year 3
40,000
50,000
60,000
NZ$500
NZ$511
NZ$530
NZ$20,000,000 NZ$25,550,000 NZ$31,800,000
NZ$30
NZ$35
NZ$40
NZ$1,200,000 NZ$1,750,000 NZ$2,400,000
NZ$6,000,000 NZ$6,000,000 NZ$6,000,000
NZ$2,800,000 NZ$2,800,000 NZ$2,800,000
NZ$5,000,000 NZ$5,000,000 NZ$5,000,000
NZ$15,000,000 NZ$15,550,000 NZ$16,200,000
NZ$5,000,000 NZ$10,000,000 NZ$15,600,000
NZ$1,500,000 NZ$3,000,000 NZ$4,680,000
NZ$3,500,000 NZ$7,000,000 NZ$10,920,000
NZ$8,500,000 NZ$12,000,000 NZ$15,920,000
14
International Financial Management
14. NZ$ remitted by sub.
(100% of CF)
15. Withholding tax imposed on
remitted funds (10%)
16. NZ$ remitted after withholding
taxes
17. Salvage value
18. Exchange rate of NZ$
19. Cash flows to parent
20. PV of parent cash flows
(20% of discount rate)
21. Initial investment by parent –Є25,000,000
22. Cumulative NPV of cash flows
NZ$8,500,000 NZ$12,000,000 NZ$15,920,000
NZ$850,000
NZ$1,200,000
NZ$1,592,000
NZ$7,650,000 NZ$10,800,000 NZ$14,328,000
NZ$52,000,000
Є.52
Є.54
Є.56
Є3,978,000
Є5,832,000
Є37,143,680
Є3,315,000
Є4,050,000
Є21,495,185
–Є21,685,000
–Є17,635,000
Є3,860,185
ANSWER: The net present value of this project is Є3,860,185. Therefore, Wolverine should
accept this project.
b. Assume that Wolverine is also considering an alternative financing arrangement, in which the
parent would invest an additional Є10 million to cover the working capital requirements so that
the subsidiary would avoid the New Zealand loan. If this arrangement is used, the selling price of
the subsidiary (after subtracting any capital gains taxes) is expected to be NZ$18 million higher.
Is this alternative financing arrangement more feasible for the parent than the original proposal?
Explain.
ANSWER: This alternative financing arrangement will have the following effects. First, it will
increase the dollar amount of the initial outlay to Є35 million. Second, it avoids the annual
interest expense of NZ$2,800,000. Third, it will increase the salvage value from NZ$52,000,000
to NZ$70,000,000. The capital budgeting analysis is revised to incorporate these changes.
Capital Budgeting Analysis with an Alternative
Financing Arrangement: Wolverine Corporation
Year 0
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
Demand
Price per unit
Total revenue = (1)×(2)
Variable cost per unit
Total variable cost = (1)×(4)
Fixed cost
Interest expense of New Zealand
loan
Noncash expense (depreciation)
Total expenses = (5)+(6)+(7)+(8)
Before-tax earnings of subsidiary
= (3)–(9)
Host government tax (30%)
After-tax earnings of subsidiary
Net cash flow to subsidiary
= (12)+(8)
NZ$ remitted by sub.
Year 1
Year 2
Year 3
40,000
50,000
60,000
NZ$500
NZ$511
NZ$530
NZ$20,000,000 NZ$25,550,000 NZ$31,800,000
NZ$30
NZ$35
NZ$40
NZ$1,200,000 NZ$1,750,000 NZ$2,400,000
NZ$6,000,000 NZ$6,000,000 NZ$6,000,000
NZ$0
NZ$0
NZ$0
NZ$5,000,000 NZ$5,000,000 NZ$5,000,000
NZ$12,200,000 NZ$12,750,000 NZ$13,400,000
NZ$7,800,000 NZ$12,800,000 NZ$18,400,000
NZ$2,340,000 NZ$3,840,000 NZ$5,520,000
NZ$5,460,000 NZ$8,960,000 NZ$12,880,000
NZ$10,460,000 NZ$13,960,000 NZ$17,880,000
Chapter 14: Multinational Capital Budgeting
15.
16.
17.
18.
19.
20.
21.
22.
15
(100% of CF)
NZ$10,460,000 NZ$13,960,000 NZ$17,880,000
Withholding tax imposed on
remitted funds (10%)
NZ$1,046,000 NZ$1,396,000 NZ$1,788,000
NZ$ remitted after withholding
taxes
NZ$9,414,000 NZ$12,564,000 NZ$16,092,000
Salvage value
NZ$70,000,000
Exchange rate of NZ$
Є.52
Є.54
Є.56
Cash flows to parent
Є4,895,280
Є6,784,560
Є48,211,520
PV of parent cash flows
(20% discount rate)
Є4,079,400
Є4,711,500
Є27,900,185
Initial investment by parent
–Є35,000,000
Cumulative NPV of cash flows
–Є30,920,600 –Є26,209,100
Є1,691,085
The analysis shows that this alternative financing arrangement is expected to generate a lower net
present value than the original financing arrangement.
c. From the parent’s perspective, would the NPV of this project be more sensitive to exchange rate
movements if the subsidiary uses New Zealand financing to cover the working capital or if the
parent invests more of its own funds to cover the working capital? Explain.
ANSWER: The NPV would be more sensitive to exchange rate movements if the parent uses its
own financing to cover the working capital requirements. If it used New Zealand financing, a
portion of NZ$ cash flows could be used to cover the interest payments on debt. Thus, there
would be less NZ$ to be converted to euros and less exposure to exchange rate movements.
d. Assume Wolverine used the original financing proposal and that funds are blocked until the
subsidiary is sold. The funds to be remitted are reinvested at a rate of 6 percent (after taxes) until
the end of Year 3. How is the project’s NPV affected?
ANSWER: The effects of the blocked funds are shown below:
Year 1
13. Net cash flow to subsidiary
=(12)+(8)
14. NZ$ remitted by subsidiary
15. Withholding tax imposed on
remitted funds (10%)
16. NZ$ remitted after withholding
taxes
17. Salvage value
18. Exchange rate of NZ$
19. Cash flows to parent
20. PV of parent cash flows
(20% discount rate)
21. Initial investment by parent
22. Cumulative NPV of cash flows
Year 2
Year 3
NZ$8,500,000 NZ$12,000,000
→
→
NZ$0
NZ$0
NZ$
NZ$
NZ$
NZ$
15,920,000
12,720,000
9,550,600
38,190,600
NZ$ 3,819,060
NZ$ 34,371,540
NZ$ 52,000,000
Є.56
Є48,368,062
NZЄ0
NZЄ0
Є0
Є0
Є27,990,777
–Є25,000,000
Є2,990,777
16
International Financial Management
e. What is the break-even salvage value of this project if Wolverine uses the original financing
proposal and funds are not blocked?
First, determine the present value of cash flows when excluding salvage value:
End of
Present Value of Cash Flows
Year
(excluding salvage value)
1
Є
3,315,000
2
4,050,000
3
4,643,333*
Є
12,008,333
*This number is determined by converting the third year NZ$ cash flows excluding salvage value
(NZ$14,328,000) into euros at the forecasted exchange rate of Є.56 per New Zealand dollar:
NZ$14,328,000 × Є.56 = $8,023,680
The present value of the Є8,023,680 received 3 years from now is Є4,643,333.
Then determine the break-even salvage value:
Break-even
Salvage
= [IO – (present value of cash flows)](1+k)n
Value
= [Є25,000,000 – Є12,008,333](1+.20)3
= Є22,449,601
ANSWER: Since the NZ$ is expected to be Є.56 in Year 3, this implies that the break-even
salvage value in terms of New Zealand dollars is:
Є22,449,601/Є.56 = NZ$40,088,573
f.
Assume that Wolverine decides to implement the project, using the original financing proposal.
Also assume that after one year, a New Zealand firm offers Wolverine a price of Є27 million after
taxes for the subsidiary and that Wolverine’s original forecasts for Years 2 and 3 have not
changed. Compare the present value of the expected cash flows it Wolverine keeps the subsidiary
to the selling price. Should Wolverine divest the subsidiary? Explain.
Chapter 14: Multinational Capital Budgeting
17
ANSWER:
Divestiture Analysis One Year After
the Project Began
Cash flows to parent
PV of parent cash
flows forgone if
project is divested
End of Year 2
(one year from now)
Є5,832,000
End of Year 3
(two years from now)
Є37,143,680
Є4,860,000
Є25,794,222
The present value of forgone cash flows is Є30,654,222. Since this exceeds the Є27,000,000 in
proceeds from the divestiture, the project should not be divested.
28. Capital B udgeting With Hedging. Baxter Co. considers a project with Thailand’s government.
If it accepts the project, it will definitely receive one lump sum cash flow of 10 million Thai baht
in five years. The spot rate of the Thai baht is presently $0.03. The annualized interest rate for a
5-year period is 4% in the U.S. and 17% in Thailand. Interest rate parity exists. Baxter plans to
hedge its cash flows with a forward contract. What is the dollar amount of cash flows that Baxter
will receive in five years if it accepts this project?
ANSWER: The forward rate premium is:
p = (1 + .04)5 – 1 = (1.216 / 2.192) – 1 = –44%
(1 + .17)5
Forward rate = Spot rate × (1 + premium)
= $.03 × (.56)
= $.0168
So the amount to be received is 10,000,000 units × $.0168 = $168,000.
29. Capital Budgeting and Financing. Cantoon plc is considering the acquisition of a unit from
the French government. Its initial outlay would be £2.6 million. It will reinvest all the
earnings in the unit. It expects that at the end of 8 years, it will sell the unit for 12 million
euros after capital gains taxes are paid. The spot rate of the euro is £0.8 and is used as the
forecast of the euro in the future years. Cantoon has no plans to hedge its exposure to
exchange rate risk. The annualized UK risk-free interest rate is 5 percent regardless of the
maturity of the debt, and the annualized risk-free interest rate on euros is 7 percent, regardless
of the maturity of debt. Assume that interest rate parity exists. Cantoon’s cost of capital is 20
percent. It plans to use cash to make the acquisition.
a. Determine the NPV under these conditions.
b. Rather than use all cash, Cantoon could partially finance the acquisition. It could obtain a loan
of 3 million euros today that would be used to cover a portion of the acquisition. In this case,
it would have to pay a lump sum total of 7 million euros at the end of 8 years to repay the
loan. There are no interest payments on this debt. The way in which this financing deal is
structured, none of the payment is tax-deductible. Determine the NPV if Cantoon uses the
forward rate instead of the spot rate to forecast the future spot rate of the euro, and elects to
18
International Financial Management
partially finance the acquisition. You need to derive the 8-year forward rate for this specific
question.
ANSWER
a. Discount factor based on a required return of 20% for 8 years = .232
£s to be received in 8 years = 12,000,000 euros × £0.8 = 9,600,000
PV = 9,600,000
(1 + .2)8
= £2,227,200
NPV = £2,227,200– £2,600,000
= -£372,800
One might read the question as implying that the forward rate discount should be applied (see
part (b) in which case 2,227,200 x (1-0.1385) – 2,600,000 = -£681,276
b. The forward rate premium is:
p = (1 + .05)8 – 1 = (1.48)/1.718) – 1 = –13.85%
(1 + .07)8
FR premium over 8 years = –.13.85%
Forecast of euro in 8 years = £0.80 × [1 + (–13.85%)] = £0.6892
Euros to be received in 8 years = 12 million euros – 7 million euros = 5 million euros
Pounds to be received in 8 years = 5 million euros × £0.6892= £3,446,000
PV of £s to be received in 8 years =
£3,446,000
(1 + .20)8
= £801,429
If 3 million euros are borrowed, this covers the equivalent of £2,400,000, since the euro’s spot
rate is equal to £0.80. Therefore, the parent needs to provide an initial outlay of £200,000
(computed as £2,600,000 – £2,400,000).
NPV = £801,429– £200,000 = £601,429
Chapter 14: Multinational Capital Budgeting
19
Small Business Dilemma
Jim Logan, owner of the Sports Exports Company (Ireland), has been pleased with his success in
the United Kingdom. He began his business by producing basketballs and exporting them to the
United Kingdom. While American-style basketball is still not nearly as popular in the United
Kingdom as it is in the United States, his firm controls the market in the United Kingdom. Jim is
considering an application of the same business in the US. He would produce the basketballs in
Ireland and export them to a distributor of sporting goods in the US, who would sell the basketballs to
retail stores. The distributor likely would want to pay for the product each month in dollars. Jim
would need to hire one full-time employee in Ireland to produce the basketballs. He would also need
to lease one more warehouse.
1. Describe the capital budgeting steps that would be necessary to determine whether this proposed
project is feasible, as related to this specific situation.
2. Explain why there is uncertainty surrounding the cash flows of this project.
Small Business Dilemma
Multinational Capital Budgeting by the Sports Exports Company
1. Describe the capital budgeting steps that would be necessary to determine whether this proposed
project is feasible, as related to this specific situation.
ANSWER: Jim would need to estimate the amount of basketballs that would be sold to the
distributor in the US each month. The revenue to be received would be equal to the number of
basketballs sold times the price (in dollars) per football. This revenue would be converted into
euros, at the prevailing exchange rate. The value of the dollar can change over time. The dollar’s
value must be forecasted for each month, so that the euro cash inflows can be estimated.
The cash outflows are the expenses of hiring a full-time employee to perform the production and
the leasing of one more warehouse. These cash outflows are in euros and therefore are not
directly affected by a change in the value of the dollar.
Once the euro cash inflows and outflows are estimated, they can be used to derive the net cash
flows. Then the net cash flows can be discounted to determine the present value of net cash
flows. This project does not have an initial outlay, other than initial lease payment on the
warehouse and perhaps a bulk purchase of material to produce the basketballs. The present value
of cash flows would be compared to any initial expenses that represent the initial outlay, so that
the net present value of the project could be determined.
20
International Financial Management
2. Explain why there is uncertainty surrounding the cash flows of this project.
ANSWER: First, the number of basketballs to be sold is very uncertain. The firm is attempting
to sell a product in a country where it has little experience. The quantity of basketballs demanded
affects the dollar revenue and the cost of production. Also, the value of the dollar is uncertain. If
the dollar’s value is lower than anticipated in the future, the euro revenue to be received would
likely be less than anticipated.