HW 9-Chapter 17-18 Questions

Chapter 17 Questions:

6. Capital Structure and Agency Issues Explain why managers of a wholly owned subsidiary may be more likely to satisfy the shareholders of the MNC.

Managers of a wholly owned subsidiary are compensated with shares of stocks from the parent company to stimulate them so that they are encouraged to maximize shareholders’ wealth. However, this can have a negative impact on the MNC especially if the subsidiary company is partially financed by issuing stocks to managers. The parent company runs the risk that minority local investors can take actions that can benefit the subsidiary company such as retaining equity and not issuing stocks which may not be in agreement with the parent company’s shareholders. This will imply MNC’s agency problems.

12. Cost of Capital An MNC has total assets of $100 million and debt of $20 million. The firm’s before tax cost of debt is 12 percent, and its cost of financing with equity is 15 percent. The MNC has a corporate tax rate of 40 percent. What is this firm’s cost of capital?

= 0.024(0.6) + 0.12 =0.1344


18. Financing Decision In recent years, several U.S. firms have penetrated Mexico’s market. One of the biggest challenges is the cost of capital to finance businesses in Mexico. Mexican interest rates tend to be much higher than U.S. interest rates. In some periods, the Mexican government does not attempt to lower the interest rates because higher rates may attract foreign investment in Mexican securities.

a. How might U.S.-based MNCs expand in Mexico without incurring the high Mexican interest

expenses when financing the expansion? Are any disadvantages associated with this strategy?

First, it all depends on the cost of debt. If the cost of financing is extremely high compared to the parent country, it would be wiser for MNC to use its own equity to expand in the subsidiary. If the parent guarantees the financial debt for the subsidiary, then the subsidiary may be able to obtain more loans in Mexico at a lower rate than use it equity financing to pay at a higher interest cost. The disadvantage is that by borrowing in Mexican pesos, the subsidiary will remit fewer earnings because they need make interest payments on the debt.

b. Are there any additional alternatives for the Mexican subsidiary to finance its business itself

after it has been well established? How might this strategy affect the subsidiary’s capital structure?

A Mexican subsidiary may finance its business itself if the currency is expected to appreciate in Mexico against the parent’s currency. If so be the case, the subsidiary can retain earnings and reinvest and the earnings can pay off any local debt.

24. Assessing Foreign Project Funded with Debt and Equity Nebraska Co. plans to pursue a project in Argentina that will generate revenue of 10 million Argentine pesos (AP) at the end of each of the next 4 years. It will have to pay operating expenses of AP 3 million per year. The Argentine government will charge a 30 percent tax rate on profits. All after-tax profits each year will be remitted to the U.S. parent and no additional taxes are owed. The spot rate of the AP is presently $.20. The AP is expected to depreciate by 10 percent each year for the next 4 years. The salvage value of the assets will be worth AP 40 million in 4 years after capital gains taxes are paid. The initial investment will require $12 million, half of which will be in the form of equity from the U.S. parent and half of which will come from borrowed funds. Nebraska will borrow the funds in Argentine pesos. The annual interest rate on the funds borrowed is 14 percent. Annual interest (and zero principal) is paid on the debt at the end of each year, and the interest payments can be deducted before determining the tax owed to the Argentine government. The entire principal of the loan will be paid at the end of year 4. Nebraska requires a rate of return of at least 20 percent on its invested equity for this project to be worthwhile. Determine the NPV of this project. Should Nebraska pursue the project?

Present value of cash flows

Amount borrowed in AP =

Annual interest =

The following information can be depicted as follows:

IO= $12 M

=AP 60 M ( 1__ x 12 M )


K = 0.20

CFt = Revenue – Operating Expenses – Interest – Tax

= AP 10 M – AP 3 M – AP 4.2 M – AP 0.84 M

= AP 1.96 M

SV4 = AP 40 M

Net present value (NPV) or net present worth (NPW) is defined as the sum of the present values (PVs) of incoming and outgoing cash flows over a period of time.

NPV = ∑ {Net Period Cash Flow/(1+R)^T} – Initial Investment

NPV = 1.96 ___ + 1.96 ___ + 1.96 ___ + 1.96____ + 40_____ – 60

(1+0.20) (1+0.20)2 (1+0.20)3 (1+0.20)4 (1+0.20)4

NPV = (1.96 x 2.589) + (40 x 0.482) – 60

NPV = -35.646

Nebraska should not pursue the project because the NPV is negative

Chapter 18 Questions:

3. Exchange Rate Effects

a. Explain the difference in the cost of financing with foreign currencies during a strong-dollar period versus a weak-dollar period for a U.S. firm.

When the dollar is strong it means that one dollar can buy more of a currency. However it also means that it can stagnate growth of emerging bond investment because the price will be higher and the return on foreign bonds will fall with respect to the returns on US Bonds. However, a weaker dollar can also seem higher for US firms when financing with foreign currency but this can be offset by having more foreign firms financing more from US firms to capitalize from the currency devaluation which would quantify earnings. In addition, when the dollar is weak, foreign companies will purchase more US currency to capitalize when the dollar rises.

b. Explain how a U.S.-based MNC issuing bonds denominated in euros may be able to offset a portion of its exchange rate risk.

The matching strategy will apply in this case because it will reduce the subsidiary exposure to exchange rate fluctuations. A US based MNC can issue bonds in a foreign currency and use the proceeds to make payments on interest and principal payment therefore matching its cash inflows and outflows in a particular currency and reducing the exchange rate risk by not converting the currency and avoiding losses in case the foreign currency depreciates.

6. Financing That Reduces Exchange Rate Risk Kerr, Inc., a major U.S. exporter of products to Japan, denominates its exports in dollars and has no other international business. It can borrow dollars at 9 percent to finance its operations or borrow yen at 3 percent. If it borrows yen, it will be exposed to exchange rate risk. How can Kerr borrow yen and possibly reduce its economic exposure to exchange rate risk?

Kerr should borrow yen at 3% to finance its operations, and should invoice its receivables in Yens and use the proceeds to repay the loan, this strategy is called the matching strategy and it is used to reduce the effects of changes in the exchange rate. This way, if the Yen depreciates there is no effect because Kerr is not using the earnings to convert the money and make a loss in profit.

13. Swap Agreement Grant, Inc., is a well-known U.S. firm that needs to borrow 10 million British pounds to support a new business in the United Kingdom. However, it cannot obtain financing from British banks because it is not yet established within the United Kingdom. It decides to issue dollar-denominated debt (at par value) in the United States, for which it will pay an annual coupon rate of 10 percent. It then will convert the dollar proceeds from the debt issue into British pounds at the prevailing spot rate (the prevailing spot rate is one pound = $1.70). Over each of the next 3 years, it plans to use the revenue in pounds from the new business in the United Kingdom to make its annual debt payment. Grant, Inc., engages in a currency swap in which it will convert pounds to dollars at an exchange rate of $1.70 per pound at the end of each of the next 3 years. How many dollars must be borrowed initially to support the new business in the United Kingdom? How many pounds should Grant, Inc., specify in the swap agreement that it will swap over each of the next 3 years in exchange for dollars so that it can make its annual coupon payments to the U.S. creditors?

Amount borrowed in $ =

Coupon amount =

Coupon amount in pounds = 1,700,000

Since the coupon will be paid annually then the currency swap specifications should be that 1million pounds are swapped for dollars in each of the three years.

14. Interest Rate Swap Janutis Co. has just issued fixed rate debt at 10 percent. Yet, it prefers to convert its financing to incur a floating rate on its debt. It engages in an interest rate swap in which it swaps variable rate payments of LIBOR plus 1 percent in exchange for payments of 10 percent. The interest rates are applied to an amount that represents the principal from its recent debt issue in order to determine the interest payments due at the end of each year for the next 3 years. Janutis Co. expects that the LIBOR will be 9 percent at the end of the first year, 8.5 percent at the end of the second year, and 7 percent at the end of the third year. Determine the financing rate that Janutis Co. expects to pay on its debt after considering the effect of the interest rate swap.

Financing rate =

Year 1 =

Year 2 =

Year 3 =