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FINS5516 International Corporate Finance Term 3, 2023 Week 9 Homework Questions Chapters 15, 17 Cost of Capital & Capital Budgeting Student ID Professor Date

Chapter 15, Related Conceptual Question 1 Comment on the following statement: "There is a curious contradiction in corporate finance theory: Since equity is more expensive than debt, highly leveraged subsidiaries should be assigned a low hurdle rate. But when the highly leveraged subsidiaries are in risky nations, country risk dictates just the opposite: a high hurdle rate." The claim draws attention to a paradox in the theory of corporate finance. As a result of the perception that stock is more costly than debt, highly leveraged subsidiaries ought to have a low hurdle rate or discount rate. However, national risk necessitates a high hurdle rate to account for the additional risk when these subsidiaries operate in hazardous countries. The inconsistency emerges from the need to weigh the elevated risk in these settings against the Cost of capital. To resolve this conflict, financial managers actually employ a risk-adjusted discount rate that takes into account the Cost of capital as well as certain risks related to the subsidiary and the nation in which it operates. Depending on the situation, a different strategy may be taken, necessitating critical consideration and discretion while making decisions. Chapter 15, Related Conceptual Question 2 How has the Tax Reform Act of 1986 affected the capital structure choice for foreign subsidiaries? The 1986 Tax Reform Act had a big impact on U.S. multinational businesses' overseas subsidiaries' decisions about capital structures. It decreased the tax benefits of debt financing, discouraged the repatriation of profits, limited interest deductions, and set tight capitalization rules. As a result, foreign subsidiaries looked into more balanced financing solutions. They became more cautious about taking on excessive debt in order to preserve tax efficiency and avoid the negative tax effects of the Act. Chapter 15, Related Conceptual Question 3 How can financial strategy be used to reduce political risk? Financial techniques can be employed to lessen political risk or the possibility that political issues will affect a business. Diversity, local partnership formation, political risk insurance, currency hedging, supply chain diversity, conservative capital structure, risk assessment, backup plans, keeping an eye on political events, and strong legal agreements are some of these tactics. Political risk is difficult to eradicate, but there are ways to manage and lessen its effects, giving businesses that operate internationally a more stable and secure operating environment.

Chapter 15, Related Conceptual Question 4 All-Nippon Airways, a Japanese airline, flies exclusively within Japan. It is looking to finance a recent purchase of Boeing 737s. The director of finance for All-Nippon is attracted to dollar financing because he expects the yen to keep appreciating against the dollar. What is your advice to him? All-Nippon Airways' director of finance is thinking about financing a recent aircraft purchase with dollars because they anticipate the yen appreciating. The recommendation is to be wary of relying only on this expectation because foreign exchange rates are erratic and volatile. They should also monitor currency markets, analyze interest rate differentials, and look into a variety of financing options in order to minimize exchange rate risk. Finally, they should assess the company's risk tolerance and financial status in order to make well-informed decisions. Chapter 15, Question 1 1. A firm with a corporate-wide debt/equity ratio of 1:2, an after-tax cost of debt of 7 percent, and a cost of equity capital of 15 percent is interested in pursuing a foreign project. The debt capacity of the project is the same as for the company as a whole, but its systematic risk is such that the required return on equity is estimated to be about 12 percent. The after-tax Cost of debt is expected to remain at 7 percent. a. What is the project's weighted average Cost of capital? How does it compare with the parent's WACC? The project's WACC can be calculated using the following formula: WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc) Where: E/V = Proportion of equity financing Re = Cost of equity D/V = Proportion of debt financing Rd = Cost of debt Tc = Corporate tax rate Given that the debt/equity ratio is 1:2, the Proportion of equity financing (E/V) is 2/3, and the Proportion of debt financing (D/V) is 1/3. The after-tax Cost of debt (Rd * (1 - Tc)) is 7% * (1 - 35%) = 4.55%.

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Therefore, the project's WACC is: WACC = (2/3) * 12% + (1/3) * 4.55% = 9.33% Comparison with Parent's WACC The parent company's WACC can be calculated using the same formula: WACC = (E/V) * Re + (D/V) * Rd * (1 - Tc) Given that the debt/equity ratio is 1:2, the Proportion of equity financing (E/V) is 2/3, and the Proportion of debt financing (D/V) is 1/3. The after-tax Cost of debt (Rd * (1 - Tc)) is 7% * (1 - 35%) = 4.55%. Therefore, the parent company's WACC is: WACC = (2/3) * 15% + (1/3) * 4.55% = 10.67% The project's WACC (9.33%) is lower than the parent company's WACC (10.67%) due to the lower required return on equity for the project. b. If the project's equity beta is 1.21, what is its unlevered beta? The project's unlevered beta can be calculated using the following formula: Bu = Be / [1 + (1 - Tc) * D/E] Where:  Bu = Unlevered beta  Be = Levered beta  Tc = Corporate tax rate  D/E = Debt-to-equity ratio Given that the levered beta (Be) is 1.21, the debt/equity ratio (D/E) is 1/2, and the corporate tax rate (Tc) is 35%, the unlevered beta is: Bu = 1.21 / [1 + (1 - 0.35) * 1/2] = 0.82 Therefore, the project's unlevered beta is 0.82.

Chapter 15, Question 4 4. IBM is considering having its German affiliate issue a 10-year, $100 million bond denominated in euros and priced to yield 7.5 percent. Alternatively, IBM’s German unit can issue a dollar- denominated bond of the same size and maturity and carry an interest rate of 6.7 percent. a. If the euro is forecast to depreciate by 1.7 percent annually, what is the expected dollar cost of the euro-denominated bond? How does this compare to the Cost of the dollar bond? To calculate the expected dollar cost of the euro-denominated bond, we need to consider the euro's depreciation and the bond's interest payments.  Euro depreciation: If the euro is forecast to depreciate by 1.7 percent annually, then the euro will be worth 1/1.017 = 0.9833 times its initial value after one year. This means that for every euro IBM receives in interest payments, it will only be able to convert to 0.9833 dollars.  Bond interest payments: With a face value of €100 million and an interest rate of 7.5%, the bond will generate annual interest payments of €7.5 million. Taking both factors into account, the expected dollar cost of the euro-denominated bond can be calculated as follows: Expected dollar cost = Interest payments * (1 - Depreciation rate) In this case, the expected dollar cost is (€7.5 million * 0.9833) = $7,374,750. For comparison, the dollar-denominated bond with an interest rate of 6.7% will generate annual interest payments of $6.7 million. Therefore, the dollar cost of the dollar bond is $6.7 million. b. At what rate of euro depreciation will the dollar cost of the euro-denominated bond equal the dollar cost of the dollar-denominated bond? To determine the rate of euro depreciation at which the dollar cost of the euro-denominated bond equals the dollar cost of the dollar-denominated bond, we need to set their respective dollar costs equal to each other and solve for the depreciation rate. Expected dollar cost of euro bond = Dollar cost of dollar bond €7.5 million * (1 - Depreciation rate) = $6.7 million Dividing both sides by $6.7 million and rearranging, we get: (1 - Depreciation rate) = 0.9029 Depreciation rate = 1 - 0.9029 = 0.0971 = 9.71% Therefore, at a euro depreciation rate of 9.71%, the dollar cost of the euro-denominated bond will equal the dollar cost of the dollar-denominated bond.

c. Suppose IBM’s German unit faces a 35 percent corporate tax rate. What is the expected after-tax dollar cost of the euro-denominated bond? To calculate the expected after-tax dollar cost of the euro-denominated bond, we need to consider the corporate tax rate. After-tax dollar cost = Expected dollar cost * (1 - Tax rate) In this case, the after-tax dollar cost is $7,374,750 * (1 - 0.35) = $4,798,587.50. Therefore, the expected after-tax dollar cost of the euro-denominated bond is $4,798,587.50

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Chapter 15, Question 5 Suppose that the Cost of borrowing restricted euros is 7 percent annually, whereas the market rate for these funds is 12 percent. If a firm can borrow €10 million of restricted funds, how much will it save annually in before-tax franc interest expense? The Cost of borrowing restricted euros is 7 percent, so that the firm would save 12% - 7% = 5% on the interest expense. The firm can borrow €10 million of restricted funds so that the annual savings would be 5% * €10 million = €500,000. So the answer is 500000 Chapter 15, Question 6 Suppose that one of the inducements provided by Taiwan to woo Xidex into setting up a local production facility is a ten-year, $12.5 million loan at 8 percent interest. The principal is to be repaid at the end of the tenth year. The market interest rate on such a loan is about 15 percent. With a marginal tax rate of 40 percent, how much is this loan worth to Xidex? The present value of the loan at the market rate is $12.5 million / (1 + 0.15)^10 = $4.7 million. The present value of the loan at the restricted rate is $12.5 million / (1 + 0.08)^10 = $7.4 million. The difference in present values is $7.4 million - $4.7 million = $2.7 million. The tax savings are $2.7 million * 0.4 = $1.1 million. The total value of the loan to Xidex is $2.7 million + $1.1 million = $3.8 million. So the answer is 3800000 Chapter 15, Additional Question 1 The 1-year interest rate in the U.S. is 10%, and the 1-year interest rate in Japan is 5%. Does this present a riskless way to raise capital at a low-interest rate? Explain why or why not. Borrowing a foreign currency to invest in another country is not a riskless way to raise capital at a low- interest rate. This is because there is an exchange rate risk associated with this strategy. When you borrow in a foreign currency, you are subject to the risk that the currency will depreciate against your home currency. This means that when you repay the loan, you will need to sell more of your home currency to get enough foreign currency to repay the loan. In the case of borrowing in Japan and investing in the U.S., there is a risk that the yen will depreciate against the dollar. This means that when you repay the loan, you will need to sell more yen to get enough dollars to repay the loan. If the yen depreciates significantly, this could wipe out any interest rate savings you have achieved. In addition to exchange rate risk, there are also other risks associated with borrowing in a foreign currency, such as political risk and country risk. These risks can make it difficult to predict the future value of the foreign currency and the overall profitability of the investment. Therefore, while there may be an opportunity to raise capital at a lower interest rate by borrowing in Japan and investing in the U.S., this strategy comes with risk. Investors should carefully consider the exchange rate risk and other risks involved before making any investment decisions.

Chapter 15, Additional Question 2 The 1-year interest rate in the U.S. is 10%, and the 1-year interest rate in Japan is 5%. If the current spot exchange rate is JPY140/USD, what is the lowest future exchange rate at which borrowing in JPY is cheaper than borrowing in USD? To determine the lowest future exchange rate at which borrowing in JPY is cheaper than borrowing in USD, we need to consider the interest rate differential and the exchange rate movement. 1. Interest Rate Differential: The interest rate differential is the difference between the interest rates in the two countries. In this case, the interest rate differential is 10% (U.S.) - 5% (Japan) = 5%. 2. Exchange Rate Movement: The exchange rate movement refers to the change in the value of one currency relative to another over time. In this case, we are looking for the future exchange rate at which borrowing in JPY is cheaper than borrowing in USD. Let us assume the future exchange rate is JPYx/USD. We can set up an equation to represent the condition where borrowing in JPY is cheaper than borrowing in USD. (1 + 5%) * JPY140/USD < (1 + 10%) * JPYx/USD 1.05 * 140 < 1.10 * x 147 < 1.10x x = 133.63 Therefore, the lowest future exchange rate at which borrowing in JPY is cheaper than borrowing in USD is JPY133.63/USD. If the exchange rate depreciates to this level or lower, borrowing in JPY would be more advantageous. Chapter 15, Additional Question 3 The manager of a U.K. subsidiary of a U.S. firm is deciding whether to borrow for one year at USD 7.8% or GBP at 12%. If the current value of the GBP is USD1.70, at what end-of-year exchange rate would the manager be indifferent between borrowing USD and GBP? To determine the end-of-year exchange rate at which the manager would be indifferent between borrowing USD and GBP, we need to consider the interest rate differential and the exchange rate movement. 1. Interest Rate Differential: The interest rate differential is the difference between the interest rates in the two currencies. In this case, the interest rate differential is 12% (GBP) - 7.8% (USD) = 4.2%. 2. Exchange Rate Movement: The exchange rate movement refers to the change in the value of one currency relative to another over time. In this case, we are looking for the end-of-year exchange rate at which the manager would be indifferent between borrowing USD and GBP. Let us assume the end-of-year exchange rate is GBPx/USD. We can set up an equation to represent the condition where the manager would be indifferent between borrowing USD and GBP.

(1 + 7.8%) * USD1.70 < (1 + 12%) * GBPx/USD 1.078 * 1.70 < 1.12 * x 1.8396 < 1.12x x = 1.63625 Therefore, the end-of-year exchange rate at which the manager would be indifferent between borrowing USD and GBP is GBP1.6363/USD. If the exchange rate depreciates to this level or lower, borrowing in USD would be more advantageous. Chapter 17. Conceptual Question 1 Suppose the real value of the pound declines. How would this decline affect the economics of the IDC-U.K. project? A drop in the pound's real value could affect the IDC-U.K. project economically in a number of ways. It might raise import costs, bring exchange rate risk, cause inflation, impair export prospects, influence interest rates and investor mood, and force changes in government policy. The project's industry, sources of funding, exposure to import/export, and contractual agreements will all have an impact on how the project's economics are especially impacted by the falling pound. To comprehend and control these possible effects, a thorough risk assessment and financial analysis are necessary. Chapter 17. Conceptual Question 6 Some economists have stated that too many companies need to calculate the Cost of not investing in new technology, world-class manufacturing facilities, or market position overseas. What are some of these costs? How do these costs relate to the notion of growth options discussed in the chapter? Companies often need to pay more attention to the costs associated with investing in new technology, modern manufacturing facilities, or expanding their international market presence. These costs include lost market share, reduced innovation, outdated equipment, limited scalability, declining customer base, and the risk of disruption. These costs are closely related to the concept of growth options, where investing in these areas provides companies with the flexibility to seize future growth opportunities and adapt to changing market conditions. Failing to invest in these areas reduces a company's strategic flexibility and can lead to missed opportunities for long-term value creation.

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Chapter 17. Question 2 Suppose a firm projects a $5 million perpetuity from an investment of $20 million in Spain. If the required return on this investment is 20 percent, how large does the probability of expropriation in year 4 have to be before the investment has a negative NPV? Assume that all cash inflows occur at the end of each year and that the expropriation, if it occurs, will occur prior to the year-4 cash inflow or not at all. There is no compensation in the event of expropriation. The probability of expropriation in year four that makes the NPV negative is 1. To calculate this, we first need to calculate the NPV of the investment without expropriation. The NPV is the present value of all future cash flows, discounted back to the present at the required rate of return. In this case, the future cash flows are a perpetuity of $5 million, and the required rate of return is 20%. Therefore, the NPV without expropriation is: NPV without expropriation = $5 million / 0.20% = $25 million Next, we need to calculate the NPV of the investment with expropriation. The NPV with expropriation is the present value of all future cash flows, discounted back to the present at the required rate of return. However, this time, we also need to take into account the probability of expropriation. In this case, the probability of expropriation in year 4 is p, and the probability of no expropriation is 1-p. Therefore, the NPV with expropriation is: NPV with expropriation = (1-p) * $25 million Finally, we can set the NPV with expropriation equal to zero and solve for p: (1-p) * $25 million = 0 p = 1 Therefore, the probability of expropriation in year four that makes the NPV negative is 1.

Chapter 17. Question 3. Suppose a firm has just made an investment in France that will generate $2 million annually in depreciation converted at today's spot rate. Projected annual rates of inflation in France and the United States are 7 percent and 4 percent, respectively. If the real exchange rate is expected to remain constant and the French tax rate is 50 percent, what is the expected real value (in terms of today's dollars) of the depreciation charge in year 5, assuming that the tax write-off is taken at the end of the year? The expected real value of the depreciation charge in year five can be calculated as follows: 1. Depreciation in year 5: 2. depreciation_year_5 = 2000000 * (1 - 0.07)**5 This calculates the depreciation in year 5 in nominal terms, taking into account the 7% annual inflation in France. 3. Inflation in France: 4. inflation_france = (1 + 0.07)**5 This calculates the cumulative inflation in France from year 1 to year 5. 5. Inflation in the United States: 6. inflation_us = (1 + 0.04)**5 This calculates the cumulative inflation in the United States from year 1 to year 5. 7. Real exchange rate: 8. real_exchange_rate = 1 This assumes that the real exchange rate is expected to remain constant over five years. 9. French tax rate: 10. french_tax_rate = 0.5 This is the given French tax rate of 50%. 11. After-tax depreciation in year 5: 12. after_tax_depreciation_year_5 = depreciation_year_5 * (1 - french_tax_rate) This calculates the after-tax depreciation in year 5 by multiplying the depreciation in year 5 by (1 - french_tax_rate). 13. The real value of after-tax depreciation in year 5: real_value_after_tax_depreciation_year_5 = after_tax_depreciation_year_5 / (inflation_france * inflation_us * real_exchange_rate)

This calculates the real value of after-tax depreciation in year 5 by dividing the after-tax depreciation in year 5 by the product of inflation_france, inflation_us, and real_exchange_rate. Plugging in the given values, we get: depreciation_year_5 = 2000000 * (1 - 0.07)**5 = 1274482.04 inflation_france = (1 + 0.07)**5 = 1.40255 inflation_us = (1 + 0.04)**5 = 1.21665 french_tax_rate = 0.5 after_tax_depreciation_year_5 = 1274482.04 * (1 - french_tax_rate) = 637241.02 real_value_after_tax_depreciation_year_5 = 637241.02 / (inflation_france * inflation_us * real_exchange_rate) = 407689.15 Therefore, the expected real value of the depreciation charge in year 5, in terms of today's dollars, is approximately $407,689.15.

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