Chapter 17, Problem 19IC

MULTINATIONAL FINANCIAL MANAGEMENT Citrus Products Inc. is a medium-sized producer of citrus juice drinks with groves in Indian River County, Florida. Until now, the company has confined its operations and sales to the United States; but its CEO, George Gavnor, wants to expand into the Pacific Rim. The first step is to set up sales subsidiaries in Japan and Australia, then to set up a production plant in Japan, and finally to distribute the product throughout the Pacific Kim. The firm’s financial manager, Ruth Schmidt, is enthusiastic about tho plan, but she worries about the implications of the foreign expansion on the firm’s financial management process. She has ỏsked you, the firm’s most recently hired financial analyst, to develop a 1-hour tutorial package that explains the basics of multinational financial management. The tutorial will be presented at the next board of directors meeting. To get you started, Schmidt has given you the following list of questions.

1. a. What is a multinational corporation? Why do firms expand into other countries?
2. b. What are the five major factors that distinguish multinational financial management from financial management as practiced by a purely domestic firm?
3. c. Consider the following illustrative exchange rates:

	U.5. Dollars Required to Buy One Unit of Foreign Currency
Japanese yen	0.009
Australian dollar	0.650

1. 1. Are these currency prices direct quotations or indirect quotations?
2. 2. Calculate the indirect quotations for yen and Australian dollars.
3. 3. What is a cross rate? Calculate the two cross rates between yen and Australian dollars.
4. 4. Assume that Citrus Products can produce a liter of orange juice and ship it to Japan for $1.75. If the firm wants a 50% markup on the product, what should the orange juice sell for in Japan?
5. 5. Now assume that Citrus Products begins producing the same liter of orange juice in Japan. The product costs 250 yen to produce and ship to Australia, where it can be sold for 6 Australian dollars. What is the US. dollar profit on the sale?
6. 6. What is exchange rate risk?
7. d. Briefly describe the current international monetary system. What are the different types of exchange rate systems?
8. e. What is the difference between spot rates and forward rates? When is the forward rate at a premium to the spot rate? When is it at a discount?
9. f. What is interest rate parity? Currently, you can exchange 1 yen for 0.0095 U.S. dollar in the 30-day forward market, and the risk-free rate on 30-day securities is 4% in both Japan and the United States. Docs interest rate parity hold? If not, which securities offer the highest expected return?
10. g. What is purchasing power parity (PPP)? If grapefruit juice costs $2 a liter in the United States and purchasing power parity holds, what should be the price of grapefruit juice in Australia?
11. h. What effect does relative inflation have on interest rates and exchange rates?
12. i. 1. Briefly explain the three major types of international credit markets.

    2. Briefly explain how ADKs work.

13. j. What is the effect of multinational operations on capital budgeting decisions?
14. k. To what extent do average capital structures vary across different countries?

Summary Introduction

To explain: The Multinational Corporation and reasons behind to expand its business in foreign countries.

Multinational Corporation

It refers to that type of corporation, which maintains its operation in the home country and in other countries except for home country. Such corporation always establishes its headquarters in its home country.

Explanation of Solution

Multinational Corporation is that corporation which operates their works into the foreign country from their home country. They generate the revenue from the outside country.

The reasons behind to expand its business in foreign countries are mentioned below:

• Low-cost production
• Avoidance of government rules and regulations
• Large market
• Availability of raw material

Low-cost production: The companies can easily get the benefit by the establishment of manufacturing plants in such countries, which will be proved low-cost region because high production cost reduces the profits of the company. For example availability of cheap labor.

Avoidance of government rules and regulations: To avoid the strict policies or rules and regulations imposed by the government for manufacturing units, companies establish their manufacturing units in such countries, which have liberal business policies in comparison of domestic country.

Large market: A company can explore market of foreign countries to attract customers of that country and it utilizes this as an opportunity, which can help in the growth of the company.

Availability of raw material: The raw materials are diversified geographically in the whole world. So, to get the raw materials easily, the company needs to establish its manufacturing plant according to availability incurring the high cost to acquire raw material. This will keep the cost of raw material low.

Conclusion

Hence, the factors due to which company establish manufacturing units abroad include low cost of production, availability of market and raw material, and liberal government policies.

Summary Introduction

To Explain: Difference between multinational and domestic financial management

Multinational Corporation:

Multinational Corporation is that corporation which operates their works into the foreign country from their home country. They generate the revenue from the outside country.

Answer to Problem 19IC

There are five factor over which multinational and domestic financial management can be distinguished, which are as follows:

• Economic and legal structure
• Currency Denomination
• Language
• Government role
• Culture

Explanation of Solution

• If a corporation is working in the other country rather than home country then Multinational Corporation has to adopt the economic and legal structure of the foreign country.
• Multination Corporation has to deal with different currency depending upon the country in which they are operating their work.
• A multination corporation has to do deal with the several languages that is why a multination corporation has to get work carried out by that person who knows that language.
• If a multinational corporation is working in a foreign country then that corporation has to work according to the rule and regulation of the country which is made by that country government.
• A multinational corporation has to adopt the culture of the country in which that company is operating his work.

Conclusion

Hence, a multinational corporation has to work according to the subsidiary country.

Summary Introduction

To identify: The given prices of currencies are direct quotations or indirect quotations.

Exchange Rate:

The rate, which indicates the conversion rate for the currency of a country obtained through the exchange of currency of another country, is an exchange rate.

Answer to Problem 19IC

The given currency prices can be categorized as direct quotation.

Explanation of Solution

• The local currency of the given company is US dollar.
• When the quotation is given for single unit of foreign currency in terms of local currency will be considered as the direct quotation.
• So, here Japanese yen and Australian dollar both are foreign currencies, which are given in terms of US dollar (domestic currency).

Conclusion

Hence, the given price of currencies will be considered as direct quotation.

Summary Introduction

To determine: The indirect quotations for Japanese yen and Australian dollar.

Explanation of Solution

Given information:

The exchange rate of Japanese yen in US dollars is $0.009 per yen.

The exchange rate of Australian dollar in US dollars is $0.650per Australian dollar.

Formula to calculate the indirect quotations of yen:

$\text{Indirect quotation of Japanese Yen}=\frac{1}{\text{Exchange rate of yen in US dollar}}$

Substitute $0.009 for exchange rate of yen in US dollars in the above formula,

$\begin{array}{c}\text{Indirect quotation of Japanese Yen}=\frac{1}{0.009}\\ =111.11\end{array}$

Formula to calculate the indirect quotations of yen:

$\left[\begin{array}{l}\text{Indirect quotation}\\ \text{ of Australian dollar}\end{array}\right]=\frac{1}{\text{Exchange rate of Australian dollar in US dollar}}$

Substitute $0.650 for exchange rate of yen in US dollars in the above formula,

$\begin{array}{c}\text{Indirect quotation of Japanese Yen}=\frac{1}{0.650}\\ =1.538\end{array}$

Conclusion

The indirect quotations for Japanese yen and Australian dollar are 111.11 and 1.538 respectively.

Summary Introduction

To determine: The meaning of cross rate and cross rates between yen and Australian dollar.

Explanation of Solution

Cross Rate:

The rates, which indicate the conversion rate for currencies of two different countries, which can get in exchange for currency of the third country. Both different currencies are converted into common third currency for comparison purpose.

Calculated values,

The exchange rate of 1 US dollar in terms of yen is 111.11 yen.

The exchange rate of 1 US dollar in terms of Australian dollar is 1.538.

Formula to calculate the exchange rate of Australian dollar in yen with reference of US dollar:

$\text{Yen/Australian exchange rate}=\frac{\text{Yen/\$}}{\text{Australian dollar/\$}}$

Substitute 111.11 for exchange rate of US dollar in yen, and 1.583 for exchange rate of US dollar in Australian dollar in the above formula,

$\begin{array}{c}\text{Yen/Australian exchange rate}=\frac{111.11/\$1}{1.538/\$1}\\ =\frac{111.11}{1.538}\\ =72.243\end{array}$

The exchange rate of one Australian dollar in terms of yen is 72.243 yen.

Formula to calculate the exchange rate of yen in Australian dollar with reference of US dollar:

$\text{Australian exchange rate/Yen}=\frac{\text{Australian dollar/\$}}{\text{Yen/\$}}$

Substitute 1.583 for exchange rate of US dollar in Australian dollar and 111.11 for exchange rate of US dollar in yen, and in the above formula,

$\begin{array}{c}\text{Australian exchange rate/Yen}=\frac{1.538/\$1}{111.11/\$1}\\ =\frac{1.538}{111.11}\\ =0.0138\end{array}$

The exchange rate of one yen in terms of Australian dollar is 0.0138 Australian dollars.

Conclusion

The exchange rate of one Australian dollar in terms of yen is 72.243 yen and one yen in terms of Australian dollar is 0.0138 Australian dollars.

Summary Introduction

To determine: The selling price of juice in J Country.

Explanation of Solution

Given information:

The cost of juice is $1.75.

The percentage of profit is 50% or 0.50.

The exchange rate of yen in dollar is 0.009.

Profit:

Formula to calculate sale:

$\text{Sale price}=\text{Product cost}+\left(\text{Product cost}\times \text{Profit percentage}\right)$

Substitute 0.50 for profit percentage, and $1.75 for product cost in the above formula,

$\begin{array}{c}\text{Sale price}=\$1.75+\left(\$1.75\times 0.50\right)\\ =\$1.75+\$0.875\\ =\$2.625\end{array}$

Sale price:

Formula to calculate sale price in yen:

$\text{Sale price}\left(\text{yen}\right)=\frac{\text{Sale price}\left(\$\right)}{\text{Exchange rate}}$

Substitute $2.625 for sale price in dollars (calculated above), and 0.009 for exchange rate (given) in the above formula,

$\begin{array}{c}\text{Sale price}\left(\text{yen}\right)=\frac{\$2.625}{0.009}\\ =291.67\text{ yen}\end{array}$

Conclusion

Thus, the selling price of the product in yen is 291.67.

Summary Introduction

To determine: The amount of profit in terms of US dollar.

Explanation of Solution

Given information:

The cost of product is 250 yen.

The sale price of product in A Country is 6 Australian dollars.

The exchange rate of Australian dollar in terms of US dollar is 0.650.

Calculated info (refer part 3),

The exchange rate of yen in terms of Australian dollar is 0.0138.

Cost price (Australian dollar):

Formula to calculate sale price in dollars:

$\text{Cost price}\left(\text{Australian dollar}\right)=\text{Cost price}\left(\text{yen}\right)\times \text{Exchange rate}$

Substitute 250 yen for sale price in yen (given), and 0.0138 for exchange rate (working note) in the above formula,

$\begin{array}{c}\text{Cost price}\left(\text{Australian dollar}\right)=250\text{ yen}\times 0.0138\\ =3.45\end{array}$

The cost price of the product in Australian dollars is 3.45.

Profit:

Formula to calculate profit:

$\text{Profit}=\text{Sale price}-\text{Product cost}$

Substitute 6 for sale price, and 3.45 for product cost in the above formula,

$\begin{array}{c}\text{Profit}=6\text{ Australian dollar}-3.45\text{ Australian dollar}\\ =2.55\text{ Australian dollar}\end{array}$

Profit in US dollars:

Formula to calculate sale price in dollars:

$\text{Profit }\left(\text{US dollar}\right)=\text{Profit}\left(\text{Australian dollar}\right)\times \text{Exchange rate}$

Substitute 2.55 for profit in Australian dollar, and 0.675 for exchange rate in the above formula,

$\begin{array}{c}\text{Profit }\left(\text{US dollar}\right)=2.55\text{ Australian dollar}\times \text{0}\text{.650}\\ \text{=\$1}\text{.6575}\end{array}$

Conclusion

The amount of profit in US dollars is $1.6575.

Summary Introduction

To explain: The meaning of exchange rate risk.

Explanation of Solution

Exchange rate risk:

It indicates the risk that involves the financial transactions related to currency exchange. It arises due to variation in the exchange rate of currency.

• The exchange rate of currencies fluctuates on the basis of many factors.
• The fall in the value of domestic currency indicates loss on the exchange with foreign currency.

Conclusion

The exchange rate risk refers to the risk, which incurs due to uncertain change in exchange rate.

Summary Introduction

To explain: Current international monitory system and also explain the type of exchange rate system.

Explanation of Solution

The international monitory system is a system in which the exchange rates are determined for all the countries who are the participants of the international market. To maintain decorum among the countries this monitory system is organized.

The type of exchange rate system is as follows,

• Free floating system
• Managed system
• Fixed system

The international monitory system is the set of rules and regulation that each country has to follow. This system is basically for those countries who indulge mainly in export-import business.

The type of exchange rate system is as follows,

• Free-floating exchange rate is a system in which the market forces determine the exchange rate of demand and supply, and not any banking authority.
• Managed exchange rate system is a system in which there is the intervention of banking authority as the rate is decided by the banking authority of the country.
• Fixed exchange rate monitory policy is the system in which the monitory policy of the country will decide the exchange rate.

Conclusion

Thus, Current international monitory system and the type of exchange rate system are mentioned above.

Summary Introduction

To explain: The difference between spot rates and forward, when the forward rate is at a premium to the spot rate and when it is at a discount.

Interest Rate Parity:

It refers to the theory, which indicates the difference of interest rates provided by two different countries is to be same as the difference of two types of the exchange rate, which are forward exchange rate and spot exchange rate.

Explanation of Solution

Forward Exchange Rate:

This rate indicates the pre-decided rate of exchange for currencies of two countries for a date in nearby future.

Spot Exchange Rate:

This rate indicates that particular rate to get exchange the currency of foreign country at the current date.

Forward rate at premium:

The forward exchange rate will be traded at the premium price if it is higher in comparison of spot exchange rate.

Forward rate at discount:

The forward exchange rate will be traded at the discounted price if it is less in comparison of spot exchange rate.

• The less forward exchange rate in the relation of spot exchange rate indicates trading at discount.
• However, the higher less forward exchange rate in the relation of spot exchange rate indicates trading at the premium.

Conclusion

Thus, the forward rate is always higher than the spot exchange rate when it is at a discount but less in case of discount.

Summary Introduction

To determine: the rate of return of securities in S country.

Interest Rate Parity:

It refers to that theory which indicates the difference of interest rates provided by two different countries is to be same as the difference of two types of the exchange rate which are: forward exchange rate and spot exchange rate.

Explanation of Solution

Given information:

The risk-free rate of securities in both countries is 4% or 0.04.

The spot exchange rate is 0.009.

The 30-forward exchange rate is 0.0095.

Equation of interest rate parity:

$\frac{\text{Forwad exchange rate}}{\text{Spot exchange rate}}=\frac{\left(1+{\text{r}}_{\text{h}}\right)}{\left(1+{\text{r}}_{\text{f}}\right)}$

Where,

• ${\text{r}}_{\text{h}}$ is interest rate of securities in U.
• ${\text{r}}_{\text{f}}$ is interest rate of securities in S.

Substitute 0.009 for spot exchange rate, 0.0095 for forward exchange rate, and 0.04 for ${\text{r}}_{\text{h}}$ in the above formula,

$\begin{array}{l}\frac{0.0095}{\text{Spot exchange rate}}=\frac{\left(1+0.04\right)}{\left(1+0.04\right)}\\ \frac{0.0095}{\text{Spot exchange rate}}=\frac{\left(1.04\right)}{\left(1.04\right)}\\ \frac{0.0095}{\text{Spot exchange rate}}=1\\ \text{Spot exchange rate}=0.0095\end{array}$

Conclusion

Hence, the interest rate parity is holds in the given case.

Summary Introduction

To determine: The price of juice in the A Country.

Purchasing Power Parity (PPP):

It refers to that relationship, which indicates the same cost of same kinds of products in the market of various countries after adjustment of exchange rates of currencies. This relationship of common price can be termed as the law of one price.

Explanation of Solution

Given information:

The cost of juice in the U Country is $2.

The spot exchange rate of the one US dollar in the terms of the Australian dollar is $\frac{1}{0.650}$

Equation for purchasing power parity:

$\left({\text{P}}_{\text{h}}\right)=\left({\text{P}}_{\text{f}}\right)\times \text{Spot rate}$

Where,

• ${\text{P}}_{\text{h}}$ is price of product in home country.
• ${\text{P}}_{\text{f}}$ is price of product in foreign country.

Assume the home country in the given situation is the United States

Substitute $2 for ${\text{P}}_{\text{h}}$, $\frac{1}{0.650}$ for spot rate in the above formula.

$\begin{array}{c}\$2=\left({\text{P}}_{\text{f}}\right)\times \frac{1}{0.650}\\ {\text{P}}_{\text{f}}=\$2\times 0.650\\ =1.3\text{ Australian dollar}\end{array}$

Conclusion

Hence, the price of juice in the A Country is 1.3 Australian dollars.

Summary Introduction

To explain: The effect of relative inflation on interest rate and on exchange rate.

Answer to Problem 19IC

The inflation rate of the country will directly affect the interest rate as well as the exchange rate. If there is an increase in the inflation, there will be the direct impact on the rate of interest and on the exchange rate.

Explanation of Solution

• There is a direct relation between the inflation rate and the interest rate if inflation rate increase the interest rate will also increase.
• There is a direct relation between the inflation rate and the exchange rate if inflation rate increase the exchange rate will also increase.

Conclusion

Thus, the effect of relative inflation on interest rate and on the exchange rate is discussed above.

Summary Introduction

To explain: The three major types of international credit market.

International Credit Market:

The international credit market is the market that provides credit facility to the countries government as well as to the companies.

Answer to Problem 19IC

The three major types of international credit market.

• Euro credits
• Euro dollars
• Euro bond

Explanation of Solution

The three major types of international credit market.

• Euro credit is an international credit market that is also known as the floating rate bank loan market. This market offers floating rate bank loans in the major trading currency that is tied with London interbank offer rate.
• Eurodollar is a type of international credit market the market provides US dollars to the one who needs it.
• Euro bond it is an international bond issued by the international syndicate of banks and this is sold to the other currency countries.

Conclusion

Thus, the three major types of international credit market is euro credits, euro dollars and euro bonds.

Summary Introduction

To explain: the working of ADR.

American Depositary Receipts (ADR):

American depositary receipts are a type of negotiable security it represents the securities of the non-US companies that are used to trade in US financial market.

Answer to Problem 19IC

ADR is a type of certificate that represents the ownership of foreign stock. Those investors who want to invest in the international stock exchange with the help of ADR they can invest their money in the financial market.

Explanation of Solution

ADR is a type of financial resource; the investor who purchases ADR can use it and make money on it. The holder of ADR will always get dividend and capital gain in dollar currency.

Conclusion

Thus, ADR is work as a financial resource to the investors.

Summary Introduction

To explain: The effect of multinational operations on capital budgeting decisions.

Answer to Problem 19IC

The effects of multinational operations on capital budgeting decisions are as follows,

• Differences in tax laws
• Restriction on repatriation of funds
• Currency exchange rate risk

Explanation of Solution

The effects of multinational operations on capital budgeting decisions are as follows,

• There are different taxes in different countries so the difference of taxes effects the capital budgeting decision as the capital budgeting decision somehow depends on the tax rate.
• Every government has different rules related to the repatriation of funds so this factor also affects the capital budgeting decision.
• Currency exchange rate is the rate at which the two countries established a business ling between them exchange rate risk effects the capital budgeting decision.

Conclusion

Thus, effect of multinational operations on capital budgeting decisions is discussed above.

Summary Introduction

To explain: to what extent the average capital structure varies across different countries.

Answer to Problem 19IC

• The average capital structure of the company is change as it is based on the economic conditions of the countries.
• The companies of developed countries are having strong capital structure as compare to the developing countries.

Explanation of Solution

The companies that are of developed countries are having many resources as compare to the companies of developing countries, so the average capital structure varies across different countries.

Conclusion

Thus, average capital structure of the company is different from one country to another.