International Financial Management

C45.0030.001
Final Review (Chapters 1-18 – maybe also 19)
Thursday, August 5th – 3-6pm

Please review page 4 of your syllabus for grading guidelines and other relevant
information. This exam will count for 45% of your course grade.

The exam should take about 1.5-2 hours to complete but you will be given 3 hours. I’m
basing that time estimate on the fact that most students took 1 hour 20 minutes on the
midterm and that the maximum I allowed any student was 1.5 hours.

Note: My office is KMEC 7-176 (economics department, PhD office). My office hours
are Tuesday and Thursday 1-2pm and by appointment. If you want to meet w/me but
can’t make it during my office hours, shoot me an email and we can set up a mutually
convenient time. My email is ahornste@stern.nyu.edu and it is the best way to reach me.

A. Topics that we’ve covered so far

I’m listing them in chronological order. I’ve placed these topics in three categories (A) –
very important; (B) medium importance; (C) lower priority. Note that the topics placed in
category B must be understood in order to make sense of any of the A and C category
topics. I’ve also created a new class: A+ for concepts that I think are totally fundamental.
If you can’t do the A+ concepts, you can’t do anything in the other sections. I’m sure
you’d have figured that out on your own but it merits repetition.

Note, material covered on the midterm is fair game and you will be responsible for it. I
am not repeating the outline/importance levels for Chapters 1-10 – please refer back to
the Midterm Review document for that info. This outline only covers material studied
after the midterm. I’m including chapter 19 on this outline but I’m not yet sure how far
we’ll get w/that material. Wait ‘n see!

Chapter 11
1. WACC (A++)
2. World CAPM (A-)
3. Segmented/integrated CAPM (A-)
4. Cost of equity (A++)
5. Impact of capital market liquidity/segmentation on cost of capital (A)
6. WACC MNE vs. PDE (A-/B)

Chapter 12
1. Depositary receipts (ADRs/GDRs) (A+++) – know what they are, how they
work (price, listing), impact on firm (why they’d do one)
2. Market liquidity and turnover (B+)
3. Alternative instruments to source equity in global markets (B)

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Chapter 13
1. Optimal financial structure (A-)
2. Forex risk and debt (A)
3. Financial structure of subsidiaries (A-/B+)
4. Eurocurrency markets (B)
5. Syndicated credits (A/A-)
6. Other international bank loans (B)
7. Euronote market (C)
8. International bond market (C)
9. Project financing (B-/C)

Chapter 14
1. Management of interest rate risk (A)
a. Credit and repricing risk (A-)
b. Floating rate vs. fixed rate loans (A)
c. Forward rate agreements (A-)
d. Interest rate futures (A)
e. Interest rate swaps (A++)
2. Currency swaps (A+)
3. How to unwind a swap (A)
4. Counterparty risk (B) – just the general idea (1 sentence)
5. Swaptions (C)

Chapter 15
1. Theory of comparative advantage (B)
2. Market imperfections as rationale for MNE (B+)
3. Sustaining & transferring competitive advantage (B+)
4. OLI (B-)
5. Modes of FDI (B+/A---) – focus on WFOE vs. JV vs. anything else
6. Impact of FDI on host/home countries (B+)

Chapter 16
1. Why budgeting for foreign and domestic projects are different (A-)
2. Project vs. parent valuation (A+)
3. Understand key concepts demonstrated through the Cemex case study
(A/A+…note much of this is too time consuming for me to test but trust me,
I’ll find a way to get some of this on the exam!)
4. Sensitivity analysis (A-/B+)
5. Real option analysis (B/B+)

Chapter 17
1. Defining risk (B+)
2. Risk measurement (B)
3. FDI risks (B+/A---)
4. Business risks (B)
5. Governance risks (A--)

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 6. Transfer risk (A/A+?)
7. Cultural differences (A--/B+)

Chapter 18
1. Cross-border M&A – why & how (A)
2. Corporate governance & shareholder rights (A-)
3. Cross-border valuation (A+++)

Chapter 19
1. International diversification (A-)
2. Portfolio risk reduction (A-/A)
3. Optimal international portfolio (A/A-)
4. National equity market performance measures (Sharpe, Treynor) (A)
5. International CAPM

B. Exam Format/Structure
You will not be allowed a crib sheet. I will give you all the formulas we’ve learned in
this class. Your task is to be able to recognize each formula and understand when it is to
be used. As I just said above, if the formula is important enough you should know how
to apply it, we’ll have used it in a classroom example and/or homework question and
you’ll have practiced it. ☺

You will definitely need a calculator. I’ll bring as many spares as possible so that you’re
okay if you forget one and/or your calculator goes on the fritz. But no guarantees! (I
have yet to write the exam but I bet it’ll be about 2/3 calculations.)

C. Sample questions
First, I’ve posted two actual old final exams online at:
http://pages.stern.nyu.edu/~ahornste/Final-Sample1.doc
and
http://pages.stern.nyu.edu/~ahornste/Final-Sample2.doc

and the solutions can be found online at:

http://pages.stern.nyu.edu/~ahornste/Final-Sample1Answers.doc
and
http://pages.stern.nyu.edu/~ahornste/Final-Sample2Answers.doc

Note that the two versions are very, very similar – just a difference of #s and currencies.
So pick one and you really don’t need to waste time w/the other but it is there for you to
play with if you so desire. Also, I taught this class slightly differently in the past due to
the textbook and how we allocated time in response to student concerns/interests.
Accordingly, some questions may not be appropriate for y’all but were totally fair for
past students. And vice versa!

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Second, review all the homework questions. I picked them for a reason: I like the
concepts they cover and think they get right at the core of the issues we’ve tackled in a
meaningful manner.

Third, some sample questions that have been used in previous semesters.

1. What is a cross-currency swap (please describe in words – the intuition and

method)?

Cross-currency swaps are a technique to hedge against the currency exposure of

operating cash flows. It basically consists in offsetting an operating cash flow in a foreign
currency by incurring a debt obligation in the local currency and then swapping it with a
similar maturity & value foreign currency denominated debt obligation. An advantage of
this method is that, unlike the back-to-back loan, it does not appear on the company’s
balance sheet.

2. Volkswagen AG has a beta of 0.7. The company’s cost of debt is 8%, risk-free
rate is 3%, & expected return on market portfolio is 11%. Income taxes are 45%,
and company’s target financial mix is 60% debt, 40% equity (note the high
leverage). What is Volkswagen’s weighted average cost of capital, using the CAPM?

a. Know that the after-tax cost of debt is 8%*(1-0.45) = 4.4%.

b. Need to find out the cost of the equity. To find it out, use CAPM: ke =
expected return on equity = cost of equity; krf = risk free rate on bonds =
3%; km = expected rate of return on the market = 11%; β = coefficient of
firm’s systematic risk = 0.7. So, the cost of equity is equal to
3%+0.7*(11%-3%) = 8.6%.

c. Then, the WACC = 0.4*8.6% + 0.6*4.4% = 6.08%.

3. How would you compute the cost of equity using the world CAPM? Using
integrated-segmented CAPM?
a. World CAPM: The cost of equity is determined as the US risk free rate
plus the world risk premium times the estimate of the world beta (i.e. a
beta computed from a CAPM on the world portfolio, such as the MSCI).

b. Integrated-segmented CAPM: First we compute the world cost of capital

using a CAPM setup: the world cost of capital is equal to the US risk free
rate plus the world risk premium times the estimate of the world beta
(notice that this is a world beta, i.e. a beta computed from a CAPM on the
world portfolio, such as the ones of MSCI).

Then we compute the local cost of capital using a CAPM setup: the local
cost of capital is equal to the local risk free rate plus the local risk
premium times the estimate of the local beta (notice that this is a local

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 beta, i.e. a beta computed from a CAPM on the local market portfolio,
usually a portfolio representing 90+ % of the local stock market
capitalization).

Finally we average the world and local cost of capital. What weights to
use? If the country is only partially integrated with the rest of the world, it
will be better if we give more percentage weight on the local cost of
capital. Vice versa, if the country is highly integrated in the world
economy, then we have to give more weight on the world cost of capital.
So, we can use the ratio of the country’s size of international trade (can get
it from the BOP stats) to the total GDP (gross domestic product) as a
weight on the world cost of capital.

4. In class we have compared the cost of capital of MNEs and purely domestic firms
(PDEs). What do theory and empirical evidence say about capital structure and the
cost of capital for MNEs and PDEs?

In theory, MNEs should have a lower cost of capital (1 point). This is because of the
reduced risk borne by MNEs. MNEs should also be able to support greater amounts of
debt due to the reduced variability of cash flows brought about by diversification across
countries (1 point).

However, empirical research finds that MNEs tend to use lower amounts of short and
intermediate debt than do pure domestic firms (1 point). In addition, the cost of capital is
greater for MNEs for small levels of capital budgets due to increased agency costs,
political risk, exchange rate risk, and asymmetric information (1 point).

5. What is the main shortcoming of the world CAPM? How does the approach
developed by Goldman Sachs, that we have discussed in class, ameliorate this
problem (i.e., describe Goldman Sachs integrated and then comment on its
differences as compared w/ world CAPM)?

The main disadvantage of the CAPM is the low beta that results from it – in class we saw
that the empirically implied relationship between beta and expected returns is negative,
which contradicts the intuition from theory! To overcome this problem Goldman Sachs
integrated has adopted the following method: obtain the cost of equity for the company
based on the CAPM model, as if the company was a US company, and then adjust this
cost of capital by the sovereign yield spread.

In particular, first, we need to estimate the market beta of the stock. Then, we multiply
the obtained beta by the US equity premium. Finally, we add the sovereign yield spread
and the risk free interest rate to obtain the cost of equity.

(Note: we didn’t spend much time on this topic in class so I think this would be an
inappropriate question for this summer’s final exam.)

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6. Your choice: please briefly describe any three of the following ADRs: level I,
level II, level III, or ADR issued under Rule 144A.

ADRs are negotiable certificates that are created by a depository bank on underlying
stock held in trust in the company’s home market. Any three of the following would be
sufficient:
1. Level I ADR (over the counter, or pink sheet) is the one subject to the
least requirements. It is exempt from the SEC registration, and the issuer
need not adhere to the US GAAP. These ADRs are for existing shares.

2. Level II ADR is for existing shares and is traded on the NYSE, AMEX, or
NASDAQ. It is subject to meeting the full registration requirements by the
SEC, and subject to the US GAAP accounting requirements.

3. Level III ADRs represent new equity that is cross-listed on the NYSE and
the AMEX. It requires full registration and reporting that is consistent w/
US GAAP.

4. The fourth ADR instrument is ADRs under SEC Rule 144A. This
placement is for new equity and it does not require a SEC registration.
Furthermore, there is no requirement to adhere to the US GAAP for ADR
144A.

(Note: while this was an appropriate question for one class in the past, I don’t believe
this is appropriate for us. I think that it is more important to understand why a firm
would do an ADR and why an investor might want to purchase an ADR)

7. Hewlett Packard (US) is borrowing EUR 100,000,000 for one year at a time when
the exchange rate is $1.20/EUR. The principal is to be repaid one year from now,
and the interest rate is 6% per annum, paid at maturity in euros. The euro is
expected to depreciate to the US$ by 5% over the course of the year. What is the
effective cost of debt (in percentage interest rate terms) for Hewlett Packard? In
US$ terms, how much interest and principal will HP pay at maturity?

The effective cost of debt (in percentages) for Hewlett Packard is computed as

[( )
k $debt = 1 + k debt
EUR
]
x (1 + s ) − 1 = [(1 + 0.06 ) x (1 - 0.05)] − 1 = 0.007 , or 0.7% per annum.

The exchange rate at maturity is expected to be $1.20/EUR * (1-0.05) = $1.14/EUR,

since it is expected that the EUR will depreciate to the US$ by 5%. So, the amount to be
paid by HP at maturity in US$ is EUR106,000,000 × $1.14 / EUR = $120,840,000 .

8. Heineken NV of the Netherlands is borrowing US$ 200,000,000 via a syndicated

Eurocredit facility for 5 years at 200 basis points over LIBOR. LIBOR for the loan
will be reset every six months. The funds will be provided by an investment bank
syndicate, which will charge upfront fee of 2% of the principal amount. What is the

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effective cost of debt for the first year if LIBOR is 5% for the first six months and
4% for the second six months?

The solution is presented below.

Initial Issuance Value
Principal borrowed for five years, in US$ $ 200,000,000
Issuance fees 2%
Interest Costs First 6-months 2nd 6-months
LIBOR (per annum) 5.00% 4.00%
Spread over LIBOR (per annum) 2.00% 2.00%
Total interest cost (per annum) 7.00% 6.00%

Calculation of the effective cost of funds Issuance First 6-months 2nd 6-months

Face value of syndicated loan $ 200,000,000

Less fees for issuance (2% of notional principal) (4,000,000)
Net proceeds of syndicated loan $ 196,000,000

Interest payment due at end of 6-month period $ (7,000,000) $ (6,000,000)

(annual rate divided by 2 for 6-month period)
Total interest payments in first year of loan $ (13,000,000)

Effective interest cost (interest payment/proceeds) 6.633%

9. What is the difference between sponsored and non-sponsored ADR?

Sponsored ADRs are created at the request of a foreign issuer wanting its shares traded in
the United States. The company needs to apply to the SEC and to a U.S. – based bank for
registration and issuance.

If a foreign company does not seek to have its shares traded in the US, but U.S. investors
are interested, then a US financial institution may initiate the issuance of the non-
sponsored ADR. However, SEC still requires the approval of the foreign company itself.

10. In general, why is cross-listing a popular tool for tapping the foreign equity
markets (give me three different reasons)?

Reasons why cross listing could be a good tool to tap to international markets include:
1. expand investor base;
2. lower firm’s cost of capital;
3. increase stock price;
4. facilitate raising new capital overseas in subsequent rounds of securities issuance;
5. enhance the liquidity of the company’s stock trading overseas;
6. improve company’s visibility in the foreign market;

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 7. compensate local managers & employees w/ local stock;
8. improve the transparency & corporate governance of the company.

11. The following three different debt strategies are being considered by a
corporate borrower. Each is intended to provide $1,000,000 in financing for a
three-year period.
Strategy # 1: Borrow $1,000,000 for three years a fixed rate of interest of 7%.
Strategy # 2: Borrow $1,000,000 for three years at a floating rate of LIBOR
+2%, to be reset annually. The current LIBOR rate is 3.50%
Strategy # 3: Borrow $1,000,000 for one year at a fixed rate, and then renew
the credit annually. The current one-year rate is 5%.
Which strategy (strategies) will eliminate credit risk? Which one will eliminate
repricing risk?

First, credit risk is the possibility that creditworthiness of the borrower might be
reclassified by the lender at the time when the credit is renewed. Repricing risk is the risk
that interest rate charged might change at the time when a financial contract is reset. So,
strategy #1 does eliminate credit and repricing risks. Strategy #2 eliminates the credit risk
(2% credit risk spread is fixed) but not the repricing risk. Strategy #3 does not eliminate
neither credit risk nor repricing risk.

12. Suppose you, as a financial manager of a firm, have a variable rate loan
outstanding. If you wish to protect the firm against an unfavorable increase in
interest rates what could you do? Please describe one strategy involving use of
interest rate futures and one strategy involving use of interest rate swaps?

If an increase in the interest rate is expected, then one can assume a short futures position
to hedge against the unfavorable increase in the interest rates. Alternatively one can enter
into a “pay fixed/receive floating” swap, in order to hedge against interest rate risk.

13. Polaris is taking out a $5,000,000 one-year loan at a variable rate of LIBOR plus
1.00%. The current LIBOR rate is 4.00% per year. The loan has an upfront fee of
2.00%.
Year 0 Year 1
LIBOR (Floating) 4.00% 4.00%
Spread (Fixed) 1.00% 1.00%
Total Interest Payable 5.00% 5.00%
Interest Cash Flows on Loan
LIBOR (Floating) ($200,000)
Spread (Fixed) ($50,000)
Total Interest ($250,000)
Loan Proceeds (Repayment) $4,900,000 ($5,000,000)
Total Loan Cash Flows $4,900,000 ($5,250,000)
What is the all-in-cost (i.e., the internal rate of return) of the Polaris loan including
the LIBOR rate, fixed spread and upfront fee?

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The all-in-cost (or the IRR on the total cash flow) is determined by:
5,250,000
0 = 4,900,000 − . Solving for IRR, we obtain IRR=7.14%.
1 + irr

14. Why capital budgeting for a foreign project is more complex than for a domestic
project?

Possible explanations include:

1. Parent cash flows must be distinguished from project’s cash flow.

2. Parent cash flows often depend on the form of financing through the discount rate
makes it difficult to separate operating & financing cash flows.
3. Stand-alone subsidiary cash flow can have an NPV>0, but the project itself might
not add value to the overall enterprise.
4. Both financial & non-financial payments can generate cash flows to the parent,
(e.g., licensing fees, royalties, management fees, etc.).
5. One needs to account for political risk, forex risk & differing inflation rates.
6. Segmented national capital markets might create financial gains/losses.
7. Oftentimes host government subsidies complicate WACC computation.

15. Given a current spot rate of 8.10 Norwegian krona per dollar, expected inflation
rates of 6% in Norway and 3% per annum in the U.S., use the formula for relative
purchasing power parity estimate the one-year spot rate of krona per dollar?

Know that relative PPP implies an exchange rate of

(1 + 0.06) × 8.1 = 8.34 Krona / $ .
(1 + 0.03)
16. Provide at least three reasons why the parent’s viewpoint is superior to the local
viewpoint when preparing a capital budget and give an example of when the local
viewpoint fails to maximize the value of the firm.

First, a project might have a positive NPV from the local viewpoint, but fail to consider
relevant cash flows from the parent viewpoint. For example, a positive NPV project in
one country may result from the erosion of revenues in another. A local manager would
not necessarily be expected to be aware of such erosion.

Second, it may not be possible to remit all or part of the local cash flows to the parent
company and reinvestment opportunities in the local economy may be inferior to what
the parent could do elsewhere, so, a less than maximum use of funds.

Third, political and exchange rate risk add to the uncertainly of cash flows and so
increase the required rate of return by stockholders. Cash flows may be more difficult to
estimate especially long-term cash flows in lesser-developed countries.

17. How would you find out the international cost of equity using the Goldman
Sachs integrated approach?

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In essence the method obtains the cost of equity for the company based on the CAPM
model, as if the company was a US company, and then adjusts this cost of capital by the
sovereign yield spread. In particular, first, we need to estimate the market beta of the
stock in point, on S&P 500. Then, we multiply the obtained beta by the US equity
premium. Finally, we add the sovereign yield spread and the risk free interest rate to
obtain the cost of equity.

18. What is the difference between market segmentation and market liquidity?

Market segmentation refers to the difference in the required rates of returns to similar
assets (similar expected return and similar risk) due to differences in the information sets
of the investors in the local and the international market (which differences on their turn
result from institutional differences & government regulations across different markets),
while market liquidity refers to the impact of raising more capital in a given equity
market on the price (cost) at which one can do so.

19. We know that depository receipt is one of the main ways to source equity
globally. What other ways to source equity you are aware of? Please discuss briefly
two of these other methods.

Other methods of sourcing equity globally include: directed public share issue, Euro
equity public issue, private placements under SEC rule 144A, private equity funds, and
strategic alliances. So, for example, directed public share issues are targeted at investors
in single country. Euro equity public issues are occasions where firms can issue equity
underwritten & distributed n multiple foreign equity markets, sometimes simultaneously
w/ distribution in the domestic market.

(Note: probably not the best question for our class as we skipped this topic in class
discussions and I prefer to test concepts that were covered in the book and in class.)

20. What is the difference between a “Eurobond” and a “foreign bond”?

Eurobonds are sold to investors in national capital markets other than country of
denominating currency. Foreign bonds are sold within a country of denominated
currency, however issue is from another currency.

21. Which of the following are Eurodollars and which are not Eurodollars? Why?

a. A US $ deposit owned by a German corporation and held in Barclay’s Bank

of London.

Yes, this is a Eurodollar deposit held in a bank outside of the United States.

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 b. A US $ deposit owned by a German corporation and held in the New York
branch of Deutsche Bank.

No, this bank deposit is held in bank offices within the United States, and the fact that the
banking office is a branch of a European bank is irrelevant.

22. Unilever is borrowing US$10,000,000 for 3 years at 200 basis points over
LIBOR. LIBOR for the loan will be reset annually. An upfront fee of 2% is charged
when loan is extended. What is the effective interest cost of debt for the first year if
LIBOR is 5% for the first year?

So the net debt inflow is US$10,000, 000 * (1-0.02) = US$ 9,800,000.

However the LIBOR + 200 bp is still charged on the US$10m. So, the interest cost for
the first year would be

(LIBOR+200 bp) * US$ 10m = (5%+2%) * US$ 10m = $ 700,000.

As a percent of the total debt receipts, this is $ 700,000 / $ 9,800,000 = 7.14 %

23. Tropicana Inc. has just borrowed EUR 1,000,000 to make improvements to an
Italian processing plant. If the interest rate is 5.5% per year and the EUR
appreciates against the dollar from $1/EUR at the time the loan was made to
$1.05/EUR at the end of the first year, how much interest will Tropicana pay at the
end of the first year?

To compute interest rate, we use the formula I gave in class:

(1 + i d
EUR
)(1 + s ) − 1 , where (since we have direct quotations)
S 2 − S1 $1.05 / EUR − 1 EUR
s= = = 0.05 and id = 5.5% Substituting for these we obtain
S1 1
the interest expense as 1 + id ( )
(1 + s ) − 1 = (1 + 0.055)(1 + 0.05) − 1 = 0.1078 , or 10.78%.
EUR

In terms of US$, this is 10.78% * $ 1,000,000 = $ 107,800 (notice that I multiplied by

$1,000,000 – this is because I have used the initial $ equivalent of EUR 1,000,000).

24. Please argue briefly whether it is beneficial (or not) to cross-list stock. In your
discussion, please be sure to mention at least three reasons for why it would (or
would not) be beneficial to cross-list.

Pros:
Expand investor base, lower cost of capital, higher stock price, market timing, easy
raising new capital abroad, enhances liquidity, enhances visibility of company’s products,
use cross-listed shares as “acquisition currency” for takeover, compensating overseas
managers & employees w/ local stock, may improve transparency & corporate
governance

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Cons:
costly (disclosure, listing requirements), there can be volatility spillover, foreigners may
acquire a controlling interest, lowers liquidity in local markets.

(Note: if I were to include such a question on the final exam, I’d want you to list three
reasons (or whatever # I gave) and explain them. For example, if you said it was costly
to meet foreign disclosure requirements, I’d want you to say that it is costly because you
may release information that could help competitors, etc.)

25. If the cost advantage of interest rate swaps would likely be arbitraged away in
competitive markets, what other explanations exist to explain the rapid development
of the interest rate swap market?

All types of debt instruments are not always available to all borrowers. Interest rate
swaps can assist in market completeness. That is, a borrower may use a swap to get out
of one type of financing and to obtain a more desirable type of credit that is more suitable
for its asset maturity structure.

This is an extension of the term ‘comparative advantage’. A firm might have an

advantage in arranging a certain type of financing but prefer another type.

26. Centralia Corporation, a U.S. manufacturer, is investing in a wholly owned

manufacturing facility in Spain. The plant will cost Ptas620 mn (sorry, this is an old
question from before the intro of the euro) and will take 1 year to complete. The
plant is to be financed over its economic life of 8 years. The borrowing capacity
created by this capital expenditure is $1.7mn; the remainder of the plant is to be
equity financed. Centralia is not well known in the Spanish or international bond
markets. Consequently it will have to play 14% per annum to borrow pesetas,
whereas the normal borrowing rate in the Spanish capital market for well-known
firms of equivalent risk is 12.5%. Centralia could borrow in the U.S. at 8% per
annum.

a. Suppose a Spanish MNE has a mirror-image situation and needs $1.7 mn

to finance a capital expenditure of one of its U.S. subsidiaries. It finds
that it must pay a 9% fixed rate in the U.S. for dollars, whereas it can
borrow pesetas at 12.5%. The exchange rate has been forecast to be Ptas
145.44/$1 in one year. Set up a currency swap that will benefit each
counterparty. Note: no swap bank is involved in this transaction.

The Spanish MNE should issue Ptas247,250,000 of 12.5 percent fixed rate debt and
Centralia should issue $1,700,000 of fixed-rate 8 percent debt, since each counterparty
has a relative comparative advantage in their home market. This uses the exchange rate
of Ptas14.544/$1.00.

The two companies will exchange principal sums in one year. The contractual exchange
rate for the initial exchange is Ptas247,250,000/$1,700,000, or Ptas145.44/$1.00.

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Annually the counterparties will swap debt service: the Spanish MNE will pay Centralia
$136,000 (=$1,700,000 x .08) and Centralia will pay the Spanish MNC Ptas30,906,250
(=Ptas247,250,000 x .125). The contractual exchange rate of the first seven annual debt
service exchanges is Ptas30,906,250/$136,000, or Ptas227.25/$1.00.

At retirement, Centralia and the Spanish MNC will re-exchange the principal sums and
the final debt service payments. The contractual exchange rate of the final currency
exchange is Ptas278,156,250/$1,836,000 = (Ptas247,250,000 +
Ptas30,906,250)/($1,700,000 + $136,000), or Ptas151.50/$1.00.

b. Suppose that one year after the inception of the currency swap between
Centralia and the Spanish MNE, the U.S. dollar fixed-rate has fallen from
8% to 6% and the Spanish capital market fixed-rate for pesetas has fallen
from 12.5% to 11%. In both dollars and pesetas, determine the market
value of the swap if the exchange rate is Ptas 152.30/$1.

The market value of the dollar debt is the present value of a seven-year annuity of
$136,000 and a lump sum of $1,700,000 discounted at 6 percent. This present value is
$1,889,801.

Similarly, the market value of the peseta debt is the present value of a seven-year annuity
of Ptas30,906,250 and a lump sum of Ptas247,250,000 discounted at 11 percent. This
present value is Ptas264,726,358.

The dollar value of the swap is $1,889,801 - Ptas264,726,358/152.30 = $151,611.

The peseta value of the swap is Ptas264,726,358 - (152.30)$1,889,801 = -Ptas23,090,334.

27. Explain how exchange rate fluctuations affect the return from a foreign
market, measured in dollar terms. Discuss the empirical evidence on the effect of
exchange rate uncertainty on the risk of foreign investment.

We need to use one key equation: Ri$ = (1 + Ri) (1 + s) – 1 where Ri is the return on the
foreign stock in foreign currency terms and s is the change in the spot exchange rate.

To understand uncertainty, we need to use Var (Ri$) = Var(Ri) + Var(ei) + 2Cov(Ri,ei) +

∆var.

Exchange rate fluctuations mostly contribute to the risk of foreign investment through its
own volatility as well as its covariance with the local market returns. The covariance
tends to be positive in most of the cases, implying that exchange rate changes tend to add
to exchange risk, rather than offset it. Exchange risk is found to be much more significant
in bond investments than in stock investments.

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28. Would exchange rate changes always increase the risk of foreign investment?
Discuss the condition under which exchange rate changes may actually reduce the
risk of foreign investment.

Exchange rate changes need not always increase the risk of foreign investment. When the
covariance between exchange rate changes and the local market returns is sufficiently
negative to offset the positive variance of exchange rate changes, exchange rate volatility
can actually reduce the risk of foreign investment.

29. How do you think the existence of the EU – and soon, the eastward expansion –
have impacted investments in Europe? You may have a single overarching answer
or you might distinguish between European and non-European investors.

Firms that want to access the EU market may recognize that the cost of doing business is
lower in the eastern bloc of countries (EB). This means that investments in the EB are
more likely to have a positive NPV than in pricier Western countries. Moreover, some
European firms may shift their operations east and foreign firms may invest in the EB as
a means of tapping the EU market while circumventing possible trade barriers.

30. China is also an increasingly large source of FDI in recent years. (Sure, it isn’t
on the scale of the US but they’ve still got piles of money to invest abroad.) What
kinds of investments do you think they’d pursue?

Same logic as for why foreign firms invest in China. The Chinese firms invest abroad to
arbitrage market imperfections or leverage abilities. Early Chinese investments abroad
were in natural resources (e.g. oil in Africa and pipelines in the Middle East). Later
investments were in industries where there were market imperfections. For example, we
all have plenty of clothes that were made in China. But the US has strict quotas for
China-produced clothes. So, what is a Chinese firm to do when the US quota is used up?
One strategy is to shift production to other countries (e.g. Guam or Vietnam) and use
their quotas.

31. Suppose that your firm is operating in a segmented capital market. What
actions would you recommend to mitigate the negative effects?

Cross-listing would enable the firm to overcome market segmentation. The firm should
do so if and only if the benefits outweigh the costs.

32. In what sense do firms with nontradable assets get a free-ride from firms whose
securities are internationally tradable?

Due to the spillover effect, firms with nontradable securities can benefit in terms of
higher security prices and lower cost of capital, without incurring any costs associated
with making the securities internationally tradable.

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33. Discuss foreign equity ownership restrictions. Why do you think countries
impose these restrictions?

Many countries restrict foreign equity ownership in order to prevent (evil, untrustworthy,
etc.) foreigners from gaining influence over local markets. These restrictions ensure local
control over domestic firms.

34. Under what conditions will the foreign subsidiary’s financial structure become
relevant?

The subsidiary’s own financial structure will become relevant when the parent firm is not
responsible for the financial obligations of the subsidiary. So, if IBM said that each
foreign subsidiary was fully independent, then each subsidiary would determine what was
best for it given the local market conditions. But, in the real world IBM doesn’t do this
and so it requires each local subsidiary to take the basic IBM model and adapt it to fit
local market conditions. (If this isn’t true of IBM, then it should be.)

35. Under what conditions would you recommend that the foreign subsidiary
conform to the local norm of financial structure?

It may make sense for the subsidiary to confirm to the local norm if the parent is not
responsible for the subsidiary’s debt and the subsidiary has to depend on local financial
markets for raising capital.

36. Discuss the difference between performing the capital budgeting analysis from
the parent firm’s perspective as opposed to the project perspective.

The goal of the financial manager of the parent firm is to maximize its shareholders’
wealth. A capital project of a subsidiary of the parent may have a positive NPV (or APV)
from the subsidiary’s perspective yet have a negative NPV (or APV) from the parent’s
perspective if:

i. certain cash flows cannot be repatriated to the parent because of remittance

restrictions by the host country;

ii. the home currency is expected to appreciate substantially over the life of the
project, yielding unattractive cash flows when converted into the home
currency of the parent.

Additionally, a higher tax rate in the home country may cause the project to be
unprofitable from the parent’s perspective. Any of these reasons could result in the
project being unattractive to the parent and the parent’s stockholders.

37. Assume 3-month LIBOR is 2% and market pricing indicates the 3-month
LIBOR rate is expected to rise moderately to 2.25% by end-2003. If IBM believes 3-

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month LIBOR will actually be 7% at end-2003, should IBM buy or sell a December
2003 Eurodollar contract?

If the market expects LIBOR will be 2.25% in December 2003, then a December 2003
Eurodollar contract will sell for (100-2.25) or 97.75. If IBM believes 3-month LIBOR
will actually be 7% in December 2003 then they expect the Eurodollar contract should
instead be priced at 93. They would therefore believe the contract is over-valued and
would want to sell the contract.

38. Assume that on January 1, 2000 the June 2000 Eurodollar contract sold for 95
but in June 2000 the actual 3-month LIBOR was 8% (or try 2%). If British
Petroleum bought a contract in January 2000, did they make a profit or loss on the
contract?

If the actual 3-month LIBOR were 8% in June 2000, then the contract would be worth 92
and BP lost money on the contract. But if LIBOR were 2%, then the contract would be
worth 98 and BP would make a profit.

39. Why would two firms undertake an interest rate swap? Who benefits?

Each party has a comparative advantage in borrowing in one type of structure but prefers
the other. The two firms would undertake the swap in order to better match cash
inflows/outflows and/or to obtain cost savings.

For example, in problem 41 (below), McDonald’s might be preparing to issue Eurodollar

bonds that are priced at a floating-rate tied to LIBOR. They would therefore prefer to
match their cash inflows and outflows and would like to obtain the underlying financing
at a floating rate.

40. Please name and explain at least three risks that face swap banks.
- Interest rate risk – rates might change after one side of the swap is on the books
or if it has an unhedged position.

- Basis risk – if the floating rates of the counterparties are pegged to different
indices (e.g. US Treasury vs. LIBOR).

- Exchange rate risk – currency movements could affect the profitability of a

currency swap (think about the example we did in class on June 5th).

- Credit risk – one or both counterparties might default.

- Mismatch risk – perhaps it isn’t possible to find counterparties who want the same
amount of money for the same length of time.

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 - Sovereign risk – the possibility that a country would impose exchange rate
restrictions (or capital controls) that interfere with the counterparties’ obligations
under the swap.

41. Interest rate swap: Assume McDonald’s and British Telecom can borrow at the
following rates:

McDonald’s British Telecom Finance

Moody’s credit rating A2 Baaa1
(actual)
Fixed-rate borrowing 7.0% 8.5%
cost
(my projection)
Floating-rate borrowing LIBOR LIBOR + 1%
cost
(my projection)

a. Calculate the quality spread differential (QSD).

QSD = (Fixed-rateBT – Fixed-rateMcD) – (Floating-rateBT – Floating-rateMcD) = (8.5 - 7.0)

– (LIBOR + 1 – LIBOR) = 1.5 –1 = 0.5%.

b. Develop an interest rate swap in which both McDonald’s and British

Telecom Finance have an equal cost savings in their borrowing costs.
Assume McDonald’s desires floating-rate debt and British Telecom
Finance desires fixed-rate debt. Assume there is no swap bank in the
middle.

If each firm has an equal cost savings, then each firm will save ½ of 0.5% or 0.25% over
the best terms it could be offered in its desired structure.

Step 1: McDonald’s would issue fixed-rate debt at 7.0% and British Telecom would
issue floating-rate debt at LIBOR + 1%.

Step 2: We know each firm will save .25% over the best terms it could obtain on its own.
So let’s work backwards to figure out what rate BT would pay McD’s and vice-versa.
That must mean that McD’s will have an all-in cost of LIBOR – 0.25% and BT would
have an all-in cost of 8.5% -0.25% or 8.25%.

McD’s all-in cost will be 7.0 + (rate paid on floating rate debt = LIBOR) – (rate received
from BT) = LIBOR - .25 BT would pay McD 7.25%.

Confirm this: BT’s all-in cost will be LIBOR +1 – (rate received from McD = LIBOR) +
7.25 = 8.25.

FinalReview 17
42. Same problem as (41) but McDonald’s gets ¾ of the QSD. What would the
appropriate rate be for each borrower?

If McDonald’s gets ¾ of the QSD it will save ¾ of 0.5% or 0.375%. Then McDonald’s
would have an all-in cost of LIBOR – 0.375%. British Telecom would get ¼ of 0.5% or
0.125% and would therefore have an all-in cost of 8.375% for its debt.

43. Currency swap: Since McDonald’s is an American firm, they have an advantage
in borrowing in dollars. Shockingly, since British Telecom Finance is British they
have an advantage in borrowing pounds. But there’s a wrinkle: McDonald’s needs
pounds to finance a seemingly mad purchase of cow farms in England. Meanwhile
British Telecom Finance needs dollars to purchase an ailing telecom company in the
US (maybe it is WorldCom?). Both firms need the equivalent of £10mn. Their
borrowing opportunities are as shown:

McDonald’s British Telecom Finance

Moody’s credit rating A2 Baaa1
(actual)
Dollar debt cost 5.0% 7.0%
(my projection)
Pound debt cost 8.4% 9.0%
(my projection)

a. Please explain which firm has a comparative advantage in borrowing

which currency.

McD’s has a 2.0% advantage in dollars but 0.6% in pounds McD’s has an
advantage in borrowing dollars.

BT pays 2.0% more to borrow in dollars but just 0.6% more to borrow in pounds
BT has an advantage in borrowing in pounds.

b. Develop a currency swap in which both McDonald’s and British Telecom

Finance. Assume the exchange rate is $1.50/£. If the swap bank makes a
1% profit on the dollar debt financed with .75% of the pound loan, what
is their annual profit on the debt?

At the given exchange rate McD’s will end up with £10 mn and BT with $15mn.

In order to have the swap bank make a 1% profit on the dollar debt, we need to let McD’s
lend dollars to the swap bank at x% and have BT pay x+1%. McDonald’s will borrow
dollars externally at 5.0% and lend to the swap bank at 5.0%. Then the swap bank will
lend these dollars to BT at 6.0% (much better than the 7.0% rate BT could have obtained
on its own!).

FinalReview 18
The swap bank will pay 0.75% more interest for pounds than it can receive. This means
that it must pay BT y% but McD will pay y-0.75%. Since BT will borrow pounds
externally at 9.0%, that means McD will pay 8.25% (slightly better than the 8.4% rate
McD could have obtained on its own!).

c. If the pound depreciated, how would that affect the swap bank’s annual
profit?

The bank’s annual profit on this swap will be 1% on $15 mn – 0.75% on £10 mn =
$150,000 - £75,000. At the current exchange rate, this would yield a profit of $150,000 -
£75,000*$1.50/£ = $150,000 - $112,500 = $37,500. If the pound depreciated, then the
bank would make a higher profit.

44. Why do investors diversify their portfolios internationally?

Stock market returns are more highly concentrated within an individual market than
across markets. That is, the movements of US firms such as Microsoft, IBM and United
Airlines are more highly correlated than the movements of those stocks vis-à-vis foreign
firms such as HSBC (trades in UK and Hong Kong), Maersk (Danish shipping firm), etc.

Factors that affect security returns tend to vary significantly across countries. For
example, international business cycles are not perfectly correlated (example, Hong Kong
has been in the slump since ‘97/98 but the US didn’t start to slump until much later).

Reduced risk – as a portfolio contains a larger number of assets that do not move
together, the overall portfolio risk is reduced.

45. Assume a US investor sold shares of Foster’s beer (Australia) after holding
them for one year. Suppose the share price fell 4% in Australian dollars while the
Australian dollar appreciated 6% against the US$. What is the investor’s return in
US$?

Ri$ = (1+ Ri)*(1+s)-1 = (1-.04)*(1+.06)-1= .0176 = 1.76% gain.

46. Assume a French investor sold shares of Pemex (Mexican oil company) after
holding them for one year. Suppose the share price rose 5% in peso terms while the
Mexican peso depreciated 10% against the Euro. What is the investor’s return in
Euros?

Ri$ = (1+ Ri)*(1+s)-1 = (1+.05)*(1-.10)-1= -.055 = 5.5% loss.

The following questions are all “True/false/uncertain and why”.

47. When calculating the APV of a domestic investment vs. a foreign investment the
only difference between the two is the latter must reflect foreign interest rates.

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False – exchange rates (now and future); interest rates (domestic and foreign); tax rates
(domestic and foreign).

48. The only plausible explanation of FDI is that firms leverage comparative
advantages to circumvent market imperfections.

False/uncertain – empirical literature has yielded mixed evidence on this topic. Other
possible theories are to leverage firm strength or transfer ownership of assets to more
efficient owners.

49. Host countries always gain from FDI inflows.

True/uncertain – check out slide 21 from FDI chapter (file 9_0727).

50. Why does the cost of capital vary internationally?

Market segmentation.

51. Suppose IBM claims that by tapping global financial markets it can lower its
cost of capital and pass the savings on by lowering computer prices. Please use the
following information to determine which scenario would yield a lower required
rate of return for the firm.

Assume: βUSIBM = .07, βWorldIBM = .13,US Treasury rate is 6%, the US equity market
is expected to return 9% this year, and the international markets are expected to
generate 5% returns this year.

a. Please use the CAPM model to indicate a numerical solution for both
the US and world scenarios.

CAPM: RUSIBM = .06 + .07(.09-.06) = .0621 vs. RWorldIBM = .06 + .13(.05-.06) = .0587.

b. Please interpret your numerical results.

Implies IBM would lower its cost of capital by tapping international markets.

The next problem is a LONG one in many parts. It was given as homework last summer
but could be decomposed into numerous questions for an exam. That said, the
accounting part is too detailed for my exam-giving style.

By now I’m sure everyone has heard of the new contagious disease severe acute
respiratory syndrome (SARS) that has been wreaking havoc worldwide. The onset of
SARS has greatly disrupted normal economic and business activity in some parts of Asia.
Hong Kong has been hardest hit. Unfortunately for the purpose of this assignment, Hong
Kong has a pegged exchange rate. Ditto the second hardest hit place: China. So, we’ll
settle for #3: Singapore. Luckily the Singapore dollar is freely floating! (Note: the

FinalReview 20
 government does control the movement of the S$ quite a bit…we’re going to ignore that
a little bit. Reality is just a little troublesome sometimes.)

For this homework, the spot rate of the Singapore dollar is S$1.77 = US$1. (If you want
to be lazy, use S$ for Singapore and $ for the US or if that might be too confusing try
SGD for Singapore dollars and $ or US$ or USD for the US dollar.)

1. Economic Exposure: Why could we view SARS as a cause of economic

exposure?

SARS could be interpreted as a source of economic exposure inasmuch as the

disease has disrupted normal business operations. Any deviation from regular
business practices imposes a de facto cost on firms.

For example, one person from Intel’s finance department in Hong Kong was
hospitalized w/SARS. As a result the entire finance department staff was told
to work from home for two weeks as a safety precaution. But, in order for
those people to be effectively quarantined, all people who share a household
w/them must also be quarantined. So that means those peoples’ spouses,
children, etc. must also all stay home. This has a ripple effect that spreads
throughout the economy. Ultimately this means that the economy will take
quite a hit. But at the firm level this is an unanticipated event that is changing
their daily cost structure for expenses and revenues.

2. Economic Exposure:

The answers to (a) and (b) are in the following chart. (a) required you to solve the
right column. (b) required you to calculate the bottom two rows.

If S$1.77 = US$1 If S$1.90 = US$1

S$12,000,000 S$12,000,000
0 units at S$1,200/unit)
ble costs S$5,310,000 S$5,700,000
0 units at US$300 each – imported parts!)
overhead costs S$1,000,000 S$1,000,000
ciation allowances S$1,200,000 S$1,200,000
ofit before tax S$4,490,000 S$4,100,000
e tax (at 15%) S$673,500 S$615,000
after tax S$3,816,500 S$3,485,000
ack depreciation S$1,200,000 S$1,200,000
ting cash flow in S$ S$5,016,500 S$4,685,000
ting cash flow in US$ US$2,834,181 US$2,465,789
year present value (US$)1 US$8,091,525 US$7,039,774
ting gains/losses (US$) -US$1,051,751
1
How did I get this? The operating cash flow in US$ is for year 0. Calculate the rate for years 1-4 and
sum it up! So if year 0 is X then year 1 is X/1.15 and so forth.

FinalReview 21
 (c) Two possibilities: (1) The firm might try to renegotiate the contract for the imported parts
so that the S$ cost is reduced. (2) Or it might try to differentiate its product so that it can
charge a higher sales price and thereby increase revenue. Note, the firm might try different
strategies but they’d all have the same aim: maximizing firm profit by minimizing costs,
maximizing revenue, or both. They’d do this by changing their production process,
manufacturing technology, or firm strategy in order to better differentiate their products from
those of competitor firms.

3. Transaction exposure:

1. What tools could the firm use?

a. Forward market hedge: it needs US$ to pay for the parts but will
eventually want US$ for reporting its results. So the company might buy
US$ on the forward market to pay for the imported parts or it might sell
US$ forward to cover the final results.

b. Money market hedge: it will need US$300 *10,000 units = US$3,000,000.

Why not discount the US$3mn to the present value (using 3% interest
rate), convert it to S$ today (at S$1.77=US$1), and invest it in Singapore
(at 10.56%)? Given IRP, that should deliver exactly how much money the
firm needs in the future given the projected exchange rate of S$1.90. But,
if IRP doesn’t hold precisely the firm might gain/lose.

c. Options market hedge: buy a US$ call option to hedge its US$ payables.
Downside risk: lose the call premium; upside potential: if call is in-the-
money may make profit on exchange rate movement.

d. Cross-hedging: might be a possibility if the firm did business in other

Asian countries whose currencies had a predictable relationship vis-à-vis
the US$ and/or S$.

e. Invoice – terms or timing might be renegotiated if Singapore Computers

has leverage w/the other party.

4. Translation exposure:

(a) Functional currency = S$; (b) Reporting currency = US$.

Balance sheet Local Current/ Monetary/ Temporal Current

currency Noncurrent Nonmonetary (US$) Rate
(US$) (US$) (US$)
Cash S$2,100 1,105 1,105 1,105 1,105

FinalReview 22
 Inventory S$1,500 789 847 9472 789
Net fixed assets S$3,000 1,695 1,695 1,695 1,579
Total assets S$6,600 3,589 3,647 3,747 3,473
Current liabilities S$1,200 632 632 632 632
Long-term debt S$1,800 1,017 947 947 947
Common stock S$2,700 1,525 1,525 1,525 1,525
Retained earnings3 S$900 415 543 643 X
CTA — — — — 369 - X4
Total liabilities S$6,600 3,589 3,647 3,747 3,473
and equity

2
We’ll assume the current value of inventory is S$1,800.
3
Retained earnings are taken from the income statement (which we skipped!). So I cheated and just said
that retained earnings were whatever it took to make the liabilities equal assets. The only place I couldn’t
cheat was on the current rate method because we need to have a CTA.
4
CTA = Total liabilities and equity – (Current liabilities + long-term debt + common stock + retained
earnings). We have exact numbers for all the terms on the RHS of that equation except retained earnings,
X. Hence, CTA = 369 – X.

FinalReview 23