Parrino

Questions and Problems 667

20.23 Option valuation: You are considering buying a three-month put option on Wing and a Prayer
Construction stock. The company’s stock currently trades for $10 per share and its price will
either rise to $15 or fall to $7 in three months. The risk-free rate for three months is 2 percent.
What is the appropriate price for a put option with a strike price of $9?

20.24 Option valuation: You hold a European put option on Tubes, Inc., stock, with a strike price of $100.
Things haven’t been going too well for Tubes. The current stock price is $2, and you think that it will
either rise to $3 or fall to $1.50 at the expiration of your option. The appropriate risk-free rate is 5 per-
cent. What is the value of the option? If this were an American option, would it be worth more?

20.25 Other options: A golden parachute is a part of a manager’s compensation package that makes a
large lump-sum payment in the event that the manager is fired (or loses his or her job in a merger, for
example). Providing such payouts to managers seems ill advised to most people first hearing about it.
Explain how a golden parachute can help reduce agency costs between stockholders and managers.

20.26 Consider the following payoff diagram. < ADVANCED
Covered Call

Value $10

$40 $50 $60

Stock Price

Find a combination of calls, puts, risk-free bonds, and stock that has this payoff. (You need not
use all of these instruments, and there are many possible solutions.)

20.27 Consider the payoff structures of the following two portfolios:
a. Buying a one month call option on one share of stock at a strike price of $50 and saving the
present value of $50 (so that at expiration it will have grown to $50 with interest).
b. Buying a one month put option on one share of stock at a strike price of $50 and buying one
share of stock.

What conclusion can you draw about the relation between call prices and put prices from a com-
parison of these two portfolios?

20.28 One way to extend the binomial pricing model is by including multiple time periods. Suppose
Splittime, Inc., is currently trading for $100 per share. In one month, the price will either increase
by $10 (to $110) or decrease by $10 (to $90). The following month will be the same. The price will
either increase by $10 or decrease by $10. Notice that in two months, the price could be $120,
$100, or $80. The risk-free rate is 1 percent per month. Find the value today of an option to buy
one share of Splittime in two months for a strike price of $105. (Hint: To do this, first find the
value of the option at each of the two possible one-month prices. Then use those values as the
payoffs at one month and find the value today.)

20.29 SpinTheWheel Co. has assets currently worth $10 million in the form of one-year risk-free bonds that
will return 10 percent. The company has debt with a face value of $5.5 million due in one year. (No
interest payments will be made.) The stockholders decided to sell $8 million of the risk-free bonds
and to invest the money in a very risky venture. This venture consists of giving Mr. William Kid the
money now and, in one year, flipping a coin. If it comes up heads, Mr. Kid will pay SpinTheWheel
$17.6 million. If it is tails, SpinTheWheel gets nothing. This investment has an NPV of zero.
a. What is the value of the debt and equity before the stockholders make this”investment”?
b. Using the binomial pricing model, with the payoff to the equity holders representing the op-
tion and the assets of the company representing the underlying asset, estimate the value of the
equity after the stockholders make the investment.
c. What is the new value of the debt after the investment?

20.30 The price of a stock that does not pay dividends is currently $35, and the risk-free rate is 4 per-
cent. A European call option on the stock, with a strike price of $35 and which expires in six
months, sells for $3.04. A European put option on the same stock with the same strike price sells

668 CHAPTER 20 I Options and Corporate Finance

20.31 Two call options have been written on the same underlying stock. Call #1 has a strike price of
$42, and call #2 has a strike price of $52. Call #1 is selling for $5.00, and call #2 is selling for $6.00.
What arbitrage opportunity do these prices present investors? Show the potential payoffs from
this opportunity.

20.32 Husky Motors has two debt issues outstanding, both of which mature in five years. The senior debt
issue, which has a face value of $10 million, must be paid in full before any of the principal for the
junior debt issue is paid. The junior debt issue also has a face value of $10 million. Draw the payoff
diagrams for Husky’s equity and both debt issues as the value of the firm changes. Under what
circumstances would you expect to see conflicts between the senior and junior debt holders?

20.33 The payoff function for the holder of straight debt looks like that for the seller of a put option.
Convertible debt is straight debt plus a call option on a firm’s stock. How does the addition of
a call option to straight debt affect the concern that lenders have about the asset substitution
problem, and why?

Sample Test Problems

20.1 Draw the payoff diagram representing the payoff for a combination of buying a call with a strike
20.2 price of $40 and selling a call with a strike price of $50. What would the buyer of such an option
20.3 hope would happen to the stock price?

20.4 Of the five variables identified as affecting the value of an option, which will have the opposite
20.5 effects on the value of a put and the value of a call? That is, for which variables will a given change
increase the value of a call and decrease the value of a put (or vice versa)?

What kinds of real options are being described?
a. Fred’s Cheap Cars buys the empty field adjacent to its car lot.
b. Midway through construction, MiniMax, Inc., permanently stops construction of an office

building that it had planned to use as a corporate headquarters.
c. Major Deals, a discount retailer, opens its first new store in Mexico.

If you fail to account for the real options available in a given project, what error might you make
in your capital budgeting decision?

Suppose you are a corn farmer. Assuming that there is an active market in corn options, what
trades might you want to use to protect yourself against falling corn prices? What would be the
cost of using them?

COMPENSATION—How Much Is Enough?

On September 17, 2003, Richard CEOs of selected companies (which
included huge corporations like
A. Grasso resigned his position as Citigroup and AIG). This amount
was first reduced by 10 percent and
chairman and CEO of the New York then multiplied by a performance ETHICS CASE
score called the Chairman’s Award.
Stock Exchange (NYSE). At the time Grasso had a voice in determining
that score, which could cause
of his resignation, Grasso had not Mr. Grasso’s pay to exceed the
median pay earned by CEOs at
been charged with doing anything the selected companies.

illegal. Rather, he was forced to re- The bonus became even
more generous under the direc-
sign on the grounds that his com- tion of Ken Langone, whom Gras-
so himself appointed chair of the
pensation was excessive. In other compensation committee in 1999.
Langone’s philosophy was “you
words, Grasso was paid too much. can’t pay a great manager enough
money.” In 2000, for example, the
How did charges of overcom- board unanimously approved the
compensation committee’s recom-
pensation become grounds for res- mendation for a bonus award that
reportedly exceeded the bench-
ignation? After all, the NYSE board mark by $15.7 million. Grasso
made $26.8 million that year. After
had approved Grasso’s latest pay September 11, 2001, when Grasso was lauded as a hero
for getting the NYSE back in business soon after the terror-
package just 41 days earlier. The ist attacks, his total pay package was $30.6 million.
Meanwhile, Grasso’s retirement fund was growing at a
approved package allowed him to tremendous rate because of several unusual provisions. Se-
nior executives’ pension payouts usually depend on their
transfer $140 million in retirement tenure with the company and the average salaries they re-
ceive in their highest-earning years. Grasso not only was
and bonus money to his personal credited with extra years of service, but he earned pension
dollars based in part on his big cash bonuses. In contrast,
account before he retired. Critics the CEOs of large corporations—such as the CEOs who
made up his benchmark group—generally receive much of
of Grasso’s compensation package, their compensation in the form of stock grants and options,
which are not included in the computation of their pension
however, argue that the board’s benefits. As a result of beneficial provisions, during some
years, Grasso could actually earn as much as $6.8 million in
decision was based on Grasso’s de- retirement benefits for every $1 million in bonuses!
In January 2003, Grasso announced that he wanted to
ception as well as a series of errors Najlah Feanny/©Corbis take all the money out of his retirement account—nearly $140
million—in return for staying on as CEO through mid-2007.
in governance. (Normally, of course, he would have been entitled to his retire-
ment funds at the time he retired.) In August, the board agreed
Grasso was not born wealthy. and issued a press release announcing that Grasso would stay
on as CEO and disclosing the $140 million payout.
His father abandoned his mother when he was a very young
Greed or Merit?
child. Grasso dropped out of college and later began his
Once the payout became public, there was a firestorm of
career as an $80-a-week clerk for the chairman of the NYSE. outrage. The press was relentless, and there were many

In other words, he was a person who worked very hard his

entire life and overcame many obstacles to achieve success. If

anyone had a right to feel entitled, perhaps Grasso did. When

he resigned, Grasso had been at the NYSE for 36 years.

Compensation the Key Dispute Issue

A key issue in Grasso’s pay dispute was whether the CEO of
the NYSE should be paid a salary comparable to that of a
major corporate CEO. In 1995, the chairman of NYSE’s com-
pensation committee—who at the time was Stanley Gault,
the CEO of Goodyear—argued that the CEO’s pay should
be comparable to the pay of CEOs at major corporations.
Gault’s concern was that the NYSE would lose talented em-
ployees to the private sector if it was unable to match the
private sector’s compensation for comparable jobs. Gault
prevailed in spite of the fact that the NYSE is not really
comparable to a major for-profit corporation. Instead, it is
a relatively small not-for-profit organization whose primary
purpose is regulation. There are huge differences between
the NYSE and a large for-profit-corporation in terms of the
number of employees, responsibility, and revenues.

Grasso began his tenure as CEO of the NYSE in 1995. Under
Grasso’s 1995 contract, he received a base salary of $1.4 million
plus a bonus. The bonus amount was calculated as follows: As
a benchmark, consultants calculated the median pay for the

calls for Grasso’s resignation. On September 17, 2003, the had been involved in the process that calculated his pay
board, in a 13 to 7 vote, asked Grasso to resign, and he and benefits. As evidence, the report noted that Grasso
agreed. Then, in May 2004, New York State Attorney Gen- had “personally selected which board members served
eral Eliot Spitzer filed a civil suit against Grasso under New on the compensation committee, and some directors he
York State’s Not-for-Profit Corporation Law, which requires selected were those with whom he had friendships or per-
the compensation practices in nonprofit corporations to be sonal relationships.” The report was also willing to pass
“reasonable.” Spitzer also named Langone in the lawsuit moral judgment on the size of the benefits package, con-
but concluded that the rest of the NYSE board had been cluding that Grasso’s pension benefits were “several times
deceived when they approved various aspects of Grasso’s more than what a reasonable pension would have been.”
pay and benefits packages. Overall, there is general agreement that the report found
Grasso’s pay excessive.
What can we conclude about the fairness of Grasso’s
compensation? On the one hand, there is no question that Potentially more serious allegations also arose. SEC
the NYSE prospered under Grasso’s leadership. Listings lawyers asked Grasso if he had attempted to prop up the
had gone up and market share had increased, as had the price of stock of the AIG Corporation as a gesture of friend-
value of a chair on the exchange. New computer technol- ship for Maurice R. Greenberg, then chairman and CEO of
ogy that would have decreased profits had been rejected. AIG. Specifically, Grasso was asked if he had put pressure
And everyone admits that Grasso was heroic in getting the on AIG specialists at Spear, Leeds, and Kellogg, a unit of
NYSE reopened after the September 11 attacks. Goldman Sachs, to support the price of AIG stock, in part
by setting up a $17 million fund to buy AIG shares. The
On the other hand, some information might lead us to state was expected to argue that Grasso was motivated to
believe that greed also played a role. There are indica- do Greenberg favors because Greenberg was a member
tions that Grasso jealously guarded his benefits and perks. of the NYSE compensation committee from 1996 to 2002.
Although the board may not have known the full amount Spitzer contended that Grasso was guilty of a conflict of
of Grasso’s pension benefits, Grasso’s executive assistant interest because his position with the NYSE gave him regu-
testified that Grasso received regular updates from human latory authority over companies, like AIG, whose CEOs ap-
resources on the value of his pension. He once withdrew proved his pay.
$6 million in retirement savings to buy a new house. Each
year, he cashed out a week of unused vacation time, and Grasso’s trial was originally scheduled to begin October
he once charged a $759 pair of sunglasses to his expense 30, 2006, but it never happened. In June 2008 specula-
account with the justification that the sunglasses were tion began that the Grasso case was falling apart. Within a
needed to limit glare during on-camera interviews. month the entire case was dismissed and Grasso was able
to keep all of the money.
Subsequent Revelations
DISCUSSION QUESTIONS
After the scandal broke, the NYSE commissioned an inves-
tigation under the leadership of former federal prosecu- 1. Was Grasso justly paid for being a great manager and
tor Dan Webb. At first, the NYSE refused to make Webb’s protecting the interests of the NYSE, or was his com-
findings public or even to turn it over to Grasso’s defense pensation excessive? Defend your answer.
team. They argued that the report was protected under at-
torney-client privilege. Protracted court battles on release 2. Did the board of the NYSE act responsibly in this mat-
of the report did not end until early 2005, when a New York ter? Why or why not? Were the alleged conflicts of
court ruled that the report was not legal advice and thus interest real or merely apparent? Explain.
was not protected under attorney-client privilege.
3. Was Grasso simply a victim of certain character flaws?
The Webb report, as it is now known, was not favorable Of political forces that required more disclosure after
to Grasso. It contended that the New York Stock Exchange the Enron and other corporate scandals in late 2001?
had not used good governance practices, because Grasso Discuss your answer.

Sources: Landon Thomas, Jr., “Grasso’s Deal Is Said to Save $3.5 Million, Despite Payout,” New York Times,
September 2, 2003; Thor Valdmanis, “NYSE Faces Thursday without Richard Grasso,” USA Today, September
17, 2003; Carrie Johnson, “Spitzer Suit Includes Ex-NYSE Compensation Chairman,” Washington Post, May 25,
2004; Peter Elkind, “The Fall of the House of Grasso,” Fortune, October 18, 2004, pp. 284–312; David E. Javier,
“NYSE Report Says Grasso Pay Unreasonable, Flawed,” Reuters News, February 2, 2005; Jenny Andersen,
“S.E.C. Asked Grasso If He Buoyed Stock,” New York Times, June 15, 2006; Landon Thomas, Jr., “The Winding
Road to That Huge Payday,” New York Times, June 25, 2006; “Grasso Trial Judge Stays,” New York Post, March
12, 2008; “Grasso’s Grit May Win After All,” New York Times, June 3, 2008.

International

21Financial

Management

Learning Objectives

Mauritz Antin/epa/©Corbis

G 1 Discuss how the basic principles of finance
apply to international financial transactions.

eneral Electric Company (GE) was formed in 1892 from CHAPTER TWENTY ONE
the merger of Thomas Edison’s Edison Electric Company with 2 Differentiate among the spot rate, the
forward rate, and the cross rate in the
the Thomas-Houston Company. From this modest beginning in
foreign exchange markets, perform foreign
Schenectady, New York, GE has grown into one of the largest multi-
exchange and cross rate calculations, and
national corporations in the world, with annual revenues and profits
hedge an asset purchase where payment is
of more than $150 billion and $10 billion, respectively. The company
made in a foreign currency.
competes in the electricity generation, lighting, industrial automa-

tion, medical equipment, jet engine, and broadcasting (as co-owner 3 Identify the major factors that distinguish

of NBC Universal) industries, among others. It has customers in over international from domestic capital bud-

100 countries and employs approximately 300,000 people. geting, explain how the capital budgeting

Managing the financial side of such a large and complex mul- process can be adjusted to account for these

tinational organization poses tremendous challenges. For example, factors, and compute the NPV for a typical

GE routinely manufactures products in the United States that are international capital project.

sold in other countries. Manufacturing costs of these products are 4 Discuss the importance of the Euromar-
paid in U.S. dollars, but the revenues they generate are often re-
kets to large U.S. multinational firms and
ceived in other currencies. As a result, GE profits can change due to
calculate the cost of borrowing in the
fluctuations in exchange rates between the U.S. dollar and the other
Eurobond market.
currencies. If GE managers don’t take actions to limit the effects of

changing currency exchange rates on the company’s profits, fluctua- 5 Explain how large U.S. money center

tions in these rates can make financing the business more difficult banks make and price Eurocredit loans to

and can adversely affect the company’s stock price. their customers and compute the cost of a

Capital budgeting is also more demanding in a multinational Eurocredit bank loan.

firm. Forecasting sales in numerous countries is much more dif-

ficult than forecasting sales in a single country. An analyst must

understand the key factors that will drive product demand in the different countries, includ-

ing demographic, cultural, and regulatory factors, as well as general economic conditions. In

672 CHAPTER 21 I International Financial Management

addition, distribution, inventory management, and selling activities can be especially challeng-
ing for such projects, making costs more difficult to estimate. Finally, the effects of exchange
rates on the dollar value of cash flows and the business risks in different countries also make
estimating the appropriate discount rate more difficult.

Financing a multinational company like GE is also complex. Multinational firms raise capital
in different regions of the world. This requires that financial managers understand international
finance and have a working knowledge of foreign financial markets. Financial managers must
also manage banking relationships in the various countries in which they operate to insure that
their firms have adequate working capital and foreign currencies for their needs. This chapter
discusses these and other challenges that international financial managers face.

CHAPTER PREVIEW the variables used in financial models change. We also in-
troduce two risks that are not present in domestic business
So far, we have focused on doing business in the United transactions: foreign exchange risk and country risk.
States, yet a large proportion of U.S. companies today en-
gage in international business transactions. This chapter pro- We follow this with discussions of markets for foreign cur-
vides an introduction to international financial management. rency exchange and how firms protect themselves from
The goal of financial management is the same abroad as it is fluctuations in exchange rates. We then explain how multi-
at home—to maximize the value of the firm. Thus, the finan- national firms manage their overseas capital investments
cial manager’s job is to seek out international business op- and compute the NPVs for these projects.
portunities in which the value of the expected cash flows
exceeds their cost. If this is done, the firm’s international ac- We next turn our attention to global money and capital mar-
tivities will increase the overall value of the firm. kets. We pay particular attention to the Euromarket, where
large multinational companies adjust their liquidity, borrow
We start the chapter by providing some background informa- short term from banks in the Eurocredit market, and borrow
tion about the globalization of the world economy, the rise long term in the international bond markets. Finally, we dis-
of multinational corporations, and the key factors that distin- cuss how banks price and structure Eurocredits.
guish domestic from international business transactions. We
emphasize that the basic principles of finance remain valid
for international business transactions, even though some of

21.1 INTRODUCTION TO INTERNATIONAL FINANCIAL MANAGEMENT

LEARNING OBJECTIVE Businesses operate in a far different world today than they did only a generation or two ago.
Because of the globalization of the world economy, management—including financial man-
globalization agement—has changed in many respects. Yet, as you will see, the goals and principles of finan-
he removal of barriers to free cial management remain essentially the same.
rade and the integration of
national economies Globalization of the World Economy

Over the past 30 years, we have witnessed the globalization of business and financial markets.
Globalization refers to the removal of barriers to free trade and the integration of national
economies. Today, on average, large corporations, whether they are based in the United States
or another country, generate around half of their sales revenue overseas. As you read the Wall
Street Journal or the business section of any major newspaper, you will see numerous remind-
ers that we live in a globalized world economy.

For example, as consumers, Americans routinely purchase clothing and shoes made in

21.1 Introduction to International Finance Management 673

Italy, wines from France, coffee from Brazil, TV sets from Japan, and textiles from India. Read about current
Foreigners, in turn, purchase American-made jet engines, aircraft, medical technology, soft- issues in international
ware, movies, music CDs, wheat, beef, lumber, and numerous other products. financial management in
the International section
The production of goods and services has also become highly globalized. As large mul- of CNN News on: http://
tinational companies have emerged, the economies of the world have become increasingly money.cnn.com/news/
interdependent. Most multinational companies have integrated sales and production opera- international/index.html.
tions in a dozen or more countries. These firms seek to purchase components and locate
production where costs are lower to generate higher margins. For example, personal com-
puters manufactured by U.S.-based firms such as Dell and Compaq are sold worldwide and
may be assembled in Malaysia or China, with monitors and disk drives made in Taiwan,
computer chips made in the United States, keyboards made in Korea, and software packages
produced in India.

Like product markets, the financial system has also become highly integrated. Much
of the impetus for financial integration came from the governments of the major Asian
and Western nations as they began deregulating their foreign exchange markets, money
and capital markets, and banking systems. For example, in 1985, the Tokyo Stock Ex-
change began allowing foreign firms to become members. In 1986, the London Stock
Exchange also began admitting foreign firms as full members. Similar changes have been
taking place in the United States.

The Rise of Multinational Corporations multinational corporation
a business firm that operates
A major factor driving globalization of the world economy is direct investment by multina- in more than one country
tional corporations. According to a study by the United Nations, there are about 60,000
multinational companies worldwide with over 500,000 foreign affiliates. A multinational transnational corporation
corporation is a business firm that operates in more than one country. These corporations a multinational firm that has
engage in traditional lines of business such as manufacturing, mining, gas and oil, and agricul- widely dispersed ownership
ture, as well as consulting, accounting, law, telecommunications, and hospitality. They may and that is managed from a
purchase raw materials from one country, obtain financing from a capital market in another global perspective
country, produce finished goods with labor and capital equipment from a third country, and
sell finished goods in a number of other countries. Visit www.citigroup.com
for an overview of a
Multinationals are owned by a mixture of domestic and foreign stockholders. In fact, multinational banking
the ownership of some firms is so widely dispersed that they are known as transnational institution.
corporations. Transnational corporations, regardless of the location of their headquarters, are
managed from a global perspective rather than the perspective of a firm residing in a particular
country. This fact has made them politically controversial because they are viewed as stateless
corporations with no allegiance or social responsibility to any nation or region of the world. An
example of a transnational firm is Royal Dutch Shell.

Exhibit 21.1 lists the top 15 multinational firms ranked by their total worldwide
revenues in the year 2009. Wal-Mart is the largest, with $408.2 billion in revenues, fol-
lowed by Royal Dutch Shell, Exxon Mobil, BP, and Toyota Motor Company. As you can
see, most of the firms on the list are household names. By country of origin, six of the top
15 firms are headquartered in the United States, with the balance in Western Europe,
Japan, and China.

Factors Affecting International Financial Management

As we suggested earlier, most of the basic finance principles discussed in this book apply to
international financial management. However, six factors can cause international business
transactions to differ from domestic transactions. We look at these factors next.

Currency Differences foreign exchange rate risk,

Most sovereign nations have their own currencies. Thus, businesses that engage in interna- or exchange rate risk
tional transactions are likely to deal in two or more currencies. If this is the case, financial the uncertainty associated
managers need to know how unexpected fluctuations in currency exchange rates can affect the with future currency exchange
firm’s cash flows and, hence, the value of the firm. The uncertainty of future exchange rate
movements is called foreign exchange rate risk, or just exchange rate risk, and we discuss it

674 CHAPTER 21 I International Financial Management

EXHIBIT 21.1 The World’s Largest Multinational Firms Ranked by 2009 Revenue

Many of the world’s 15 largest multinational firms are household names; six of the top 15 are U.S. based, with the balance
located in Western Europe, Japan, and China.

Rank Company Country Revenue ($ billions) Profits ($ billions)

1 Wal-Mart Stores U.S.A. $408.2 $14.3
285.1 12.5
2 Royal Dutch Shell Netherlands/U.K. 284.7 19.3
246.1 16.6
3 Exxon Mobil U.S.A. 204.1 2.3
202.2 4.8
4 BP U.K. 187.5 5.8
184.5 (0.3)
5 Toyota Motor Company Japan 175.3 5.0
165.5 10.3
6 Japan Post Holdings Japan 163.5 10.5
163.2 (1.3)
7 Sinopec China 156.8 11.0
155.9 11.7
8 State Grid China 150.5 6.3

9 AXA France

10 China National Petroleum China

11 Chevron U.S.A.

12 ING Group U.S.A.

13 General Electric Company U.S.A.

14 Total France

15 Bank of America U.S.A.

ource: http://money.cnn.com/magazines/fortune/global500/2010/full_list/.

Differences in Legal Systems and Tax Codes

Differences in legal systems and tax codes can also impact the way firms operate in foreign
countries. Some countries, including the United States, Canada, and India, operate under legal
systems derived from British common law, whereas Western European countries such as
France, Germany, and Italy have legal systems derived from the French Napoleonic codes.
Chinese law and other Asian legal systems evolved over centuries, with an emphasis on moral
teaching and legally stipulated punishments.

What emerges from the world’s legal systems and tax codes is a patchwork of different
systems that can vary substantially from country to country and can affect how foreign busi-
ness firms are treated within a particular country’s borders. Legal systems can vary on simple
matters, such as the requirements for opening a business, selecting a site location, and hiring
employees, as well as more complex matters, such as the taxation of companies and dividends,
the rights and legal liabilities of ownership, and the resolution of business conflicts. Thus, legal
and tax differences can affect financial decisions on what assets to acquire, how to organize the
firm, and what capital structure to use.

Language Differences

There are two important levels of communication in international business: business commu-
nication and social communication. Most multinational negotiations and legal contracts use
English. English is the language of choice for international business throughout much of the
world. Thus, reading and speaking fluent English are necessary skills for anyone planning to be
a senior manager in a multinational corporation.

English is not, however, the world’s social language—the language spoken when impor-
tant social relationships that build trust are formed. Local languages are important for social
relationships. For example, suppose that you are the CEO of an American food-processing
firm and you are negotiating a deal to manufacture food products in Guangzhou, China (about
60 miles from Hong Kong). You are partnering with a Dutch firm that you know well. During
the day, business and contract negotiations are conducted in English. Most members of the
Chinese management team will probably speak English; indeed, some will have MBAs from
U.S.- or Hong Kong-based business schools.

At the traditional Chinese business dinner banquets, however, the preferred social lan-
guage will be Cantonese, a regional Chinese dialect, or French, which is a common second
language spoken by educated Chinese in Southeast Asia. Needless to say, those who speak only

21.1 Introduction to International Finance Management 675

spoke only English; however, this is changing rapidly as more U.S. executives receive overseas
assignments and business students recognize the importance of a second language.

Cultural Differences To learn about the
business environment
Culture is defined as the socially transmitted behavior patterns, beliefs, and attitudes of a group. and other information
Cultural views and attitudes are powerful forces that bind people together and define a par- about a country, you can
ticular society. The cultures of different countries, and even different regions within the same explore the CIA Web
country, can vary considerably. site at https://www.cia
.gov/library/publications/
Cultural views also shape business practices and people’s attitudes toward business. For the-world-factbook/
example, in Germany business firms are generally expected to carry more equity and less debt index.html.
in their capital structure than is typical for comparable firms in the United States. Other areas
of business that differ by culture are willingness to assume risk, management style, tolerance
for inflation, and attitude toward race, gender, and business failure.

Differences in Economic Systems

An economic system determines how a country mobilizes its resources to produce goods and
services needed by society, as well as how the production is distributed. In the twentieth century,
two basic economic systems competed for government endorsement: (1) centrally planned
economies and (2) market economies.

In a centrally planned economy, resources are allocated, produced, and distributed under
the direction of the central government, as in the former Soviet Union. These economies have
no financial markets or banking systems to allocate capital flows. The central government sets
interest rates and foreign exchange rates, and financial managers need not worry about capital
budgeting decisions because capital resources are allocated centrally.

In market economies, resources are allocated, produced, and distributed by market forces
rather than by government decree. Market economies have proven to be much more efficient
in producing goods and services than traditional centrally planned economies. This fact is
borne out by current trends in what once were the two largest communist countries in the
world, the Soviet Union and China. Both China and the nations that formerly made up the
Soviet Union are moving toward market-based economies.

Differences in Country Risk country risk
the political uncertainty
Sovereign nations are usually free to place or remove constraints on businesses.1 At the extreme, associated with a particular
a country’s government may even expropriate—that is, take over—a business’s assets within the country
country. These types of actions clearly can affect a firm’s cash flows and, thus, the value of
the firm. Country risk refers to political uncertainty associated with a particular country. We
discuss country risk in more detail later in the chapter.

Goals of International Financial Management

Throughout the book, we have argued that maximization of firm value is the proper goal for
management to pursue. If this strategy is executed well, it will generate the greatest amount of
wealth for the firm’s stockholders. Stockholder value maximization is the accepted goal for
firms in the United States, as well as in other countries that share a similar heritage, such as the
United Kingdom, Australia, India, and Canada. However, it is not a widely embraced goal in
other parts of the world. In Continental Europe, for example, countries such as France and
Germany focus on maximizing corporate wealth. This means that stockholders are treated no
differently from stakeholders, such as management, labor, suppliers, creditors, and even the
government. The European manager’s goal is to create as much wealth as possible while con-
sidering the overall welfare of both the stockholders and stakeholders. In Japan, companies
form tightly knit, interlocking business groups called keiretsu, such as Mitsubishi, Mitsui, and
Sumitomo, and the goal of the Japanese business manager is to increase the wealth and growth
of the keiretsu. As a result, they might focus on maximizing market share rather than stock-
holder value.

1Sovereign nations are nations that have the right of self-rule, which includes the right to regulate commerce within

676 CHAPTER 21 I International Financial Management

In China, which is making a transition from a command economy to a market-based
economy, there are sharp differences between state-owned companies and emerging private-
sector firms. Although their numbers are declining, the large state-owned companies have an
overall goal that can best be described as maintaining full employment in the economy. In
contrast, the new private-sector firms fully embrace the Western standard of stockholder value
maximization.

Basic Principles Remain the Same

In today’s globalized environment, financial managers must be prepared to handle interna-

tional transactions and all the complexities that those transactions involve. Fortunately, the

basic principles of finance remain the same whether a transaction is domestic or international.

The time value of money, for example, is not affected by whether a business transaction is do-

mestic or international. Likewise, we use the same models for valuing capital assets, bonds,

stocks, and entire firms.

The things that do change are some of the

THE BASIC PRINCIPLES OF FINANCE APPLY input variables used to make financial calculations.
For example, required rates of return often differ
BUILDING NO MATTER WHERE YOU DO BUSINESS between countries, and the appropriate rate must
be used. Similarly, cash flows may be stated in
INTUITION The principles of finance do not stop at inter- terms of home or foreign currency. Tax codes and
accounting standards also differ across countries.
national borders. They apply no matter where Exhibit 21.2 lists some of the important finance
the firm is headquartered or where it operates. concepts and procedures discussed in the first 20
Although basic finance principles do not change, international chapters of this book and indicates where there are
financial managers must contend with complications stemming differences between domestic and international
from factors such as differences in accounting standards and tax operations.
codes, differences in interest rates, the presence of foreign ex-
change rate risk and country risk, and cultural differences.

EXHIBIT 21.2 The Basic Principles of Finance Apply in International Finance

Most of the basic finance principles discussed in this book remain unchanged in the international context. Where there are
differences, they generally result from differences in accounting standards, tax codes, legal and regulatory systems, monetary
systems, interest rates, and cultural norms.

Finance Concepts and Procedures Differences Between Domestic and International Operations

Business risk Foreign exchange and country risk must be taken into account
Form of business organization Varies with countries’ legal and regulatory systems
Ethical norms Differ with countries’ cultural norms
Nominal rate of interest Affected by the rate of inflation in a given country
Accounting standards Vary by country

Financial statement analysis Financial statements must be adjusted for cross-country comparisons
Tax codes Vary by country
Concept of cash flows Cash is cash, but monetary units are different
Goal of maximizing shareholders’ wealth Proper goal for U.S.-based firms, but may vary by country
Time value of money No difference

Bond valuation Basic valuation concepts are the same, but market conditions differ
Valuation of equity Basic valuation concepts are the same, but market conditions differ
Net present value No difference
Operating and financial leverage No difference
Breakeven analysis No difference

Expected returns and variance No difference
Cost of debt and equity Basic concepts are the same, but market conditions and tax systems differ
Weighted average cost of capital Basic concepts are the same, but market conditions and tax systems differ
Optimal capital structure Basic concepts are the same, but market conditions and tax systems differ
Dividend policy Basic concepts are the same, but tax systems differ

Working capital management Basic concepts are the same, but market conditions differ
Business valuation Basic concepts are the same, but market conditions and tax systems differ

21.2 Foreign Exchange Markets 677

> BEFORE YOU GO ON
1 . What is globalization?
2 . What are multinational corporations?
3 . Explain the difference between American and European views on wealth

maximization.

21.2 FOREIGN EXCHANGE MARKETS

The foreign exchange markets are international markets where currencies are bought and LEARNING OBJECTIVE 2
sold in wholesale amounts. Foreign exchange markets provide three basic economic benefits:
foreign exchange market
1. A mechanism to transfer purchasing power from individuals who deal in one currency to international markets where
individuals who deal in a different currency, facilitating the import and export of goods currencies are bought and
and services. sold in wholesale amounts

2. A way for corporations to pass the risk associated with foreign exchange price fluctuations
to professional risk-takers. This hedging function is particularly important to corpora-
tions in the present era of floating, or variable, exchange rates.

3. A channel for importers and exporters to acquire credit for international business transac-
tions. The time span between shipment of goods by exporters and their receipt by import-
ers can be considerable. While the goods are in transit, they must be financed. Foreign
exchange markets provide a mechanism through which financing and currency conver-
sions can be accomplished efficiently and at low cost.

The foreign exchange markets are very large, with a daily volume of almost $4 trillion in
2010. This is more than the value of all the cars, wheat, oil, and other products sold daily in the
real economy. In 2010, London was by far the largest foreign exchange trading center, with an
average daily volume of $1.46 trillion. New York City was second with $712 billion, and Tokyo
was third with $247 billion. In this section, we examine how the foreign exchange markets are
structured and how they work.

Market Structure and Major Participants

There is no single formal foreign exchange market. Rather, as suggested earlier, there are a group
of informal markets closely interlocked through international banking relationships. Partici-
pants are linked by telephone and electronic networks. The market trades any time of day or
night and every day of the year. Virtually every country has some type of active foreign exchange
market.

The major participants in the foreign exchange markets are multinational commercial
banks, large investment banking firms, and small currency boutiques that specialize in foreign
exchange transactions. In the United States, the market is dominated by money center banks,
with about half of them located in the New York City area. The other major participants are the
central banks, which intervene in the markets primarily to smooth out fluctuations in the
exchange rates for their countries’ currencies.

Foreign Exchange Rates For foreign exchange
rate data, go to http://
When U.S.-based firms buy raw materials or finished goods, they want to get the best possible www.x-rates.com.
deal—the quality they need at the lowest price. When suppliers are located in the United States,
comparisons of the alternatives are quite easy. Both the supplier and the customer keep their
books and pay their bills in the same currency—U.S. dollars.

When the suppliers are not located in the United States, comparisons are more diffi-
cult. American buyers prefer to pay for purchases in dollars, but the foreign supplier must

678 CHAPTER 21 I International Financial Management

pay employees and other local expenses with its domestic currency. Hence, one of the two
parties in the transaction will be forced to deal in a foreign currency and incur foreign ex-
change rate risk (recall that this risk arises because of the uncertainty associated with future
exchange rate movements).

Fortunately, we can easily compare prices stated in different currencies by checking the
foreign exchange rate quotes in major newspapers or on the internet. A foreign exchange rate
is the price of one monetary unit, such as the British pound, stated in terms of another cur-
rency, such as the U.S. dollar.

As an example, assume that you are the CFO of a U.S.-based manufacturing firm and you
can buy American steel at $190 per ton and British steel for £116 per ton. Furthermore, a Japa-
nese company is willing to sell steel for ¥15,500 per ton. Which supplier should you choose? If
the exchange rate between dollars and pounds is $1.65/£, meaning that one British pound will
cost $1.65, the British steel will cost £116 ϫ $1.65/£ ϭ $191.40. At this dollar price, the Amer-
ican firm will prefer to buy steel from the American supplier at $190 per ton. If the exchange
rate between the yen and the dollar is ¥84/$, which means that one dollar costs ¥84, the Japa-
nese steel will cost ¥15,500/¥84/$ ϭ $184.52 per ton. This price is $5.48 per ton ($190.00 Ϫ
$184.52 ϭ $5.48) less than the American supplier’s price of $190 per ton. Assuming that
the price quotation of ¥15,500 includes all transportation costs and tariffs, or that the sum of
those costs is less than $5.48 per ton, the American manufacturer will find it cheaper to pur-
chase steel from the Japanese supplier. The first three rows in Exhibit 21.3 show the calculations
used to reach this conclusion.

Now suppose that the exchange rate between the dollar and the pound falls from $1.65/£
to $1.50/£. Because the exchange rates for the world’s major currencies float freely, based on
market forces, such fluctuations occur continuously. At this point, the British steel can be
bought for £116 ϫ $1.50/£ ϭ $174.00 (row 4 in Exhibit 21.3). The British firm has become the
low-cost supplier, even though it has done nothing itself to lower its price.

Notice that it now takes fewer dollars to buy one British pound and, conversely, more
pounds to purchase one U.S. dollar. It is correct to say that the value of the pound has fallen
against the dollar or that the value of the dollar has risen against the pound. Both state-
ments indicate that goods and services priced in pounds are now cheaper to someone
holding dollars and that purchases priced in dollars are now more expensive to someone
holding pounds.

Also notice that, other things remaining equal, the demand for a country’s products will
be higher when the value of the country’s currency declines relative to the value of other
currencies. In our example, the change in the exchange rate led to a reversal of the U.S. company’s
purchase decisions; at $1.65/£, British steel was the most expensive, but when the exchange
rate fell to $1.50/£, British steel was the cheapest.

LEARNING A P P L I C A T I O N 2 1 .1 Exchange Rates and the Blue Sweater
BY
DOING PROBLEM: While in a clothing store on Seville Street in London, you find the blue
cashmere sweater of your dreams. The sweater is on sale at 50 percent off, priced at
£250. “At 50 percent off, the sweater must be a bargain,” you say to yourself. “In the
states, a sweater like that costs about $300.” If the current exchange rate is $1.58/£, is
the sweater a bargain?

APPROACH: Of course, the relevant question is, 50 percent off of what? The shops on
Seville Street in London are very pricey. You will need to use the exchange rate to calcu-
late the price in dollars before comparing the price with that of a comparable sweater in
the United States.

SOLUTION: The price of the sweater in dollars is £250 ϫ $1.58/£ ϭ $395, which is
higher than the $300 price in the U.S. It is not such a good deal.

21.2 Foreign Exchange Markets 679

EXHIBIT 21.3 Foreign Exchange Rates and the Price of Steel in International Markets

The exhibit shows the calculations necessary to decide which steel supplier offers the best price: American, British, or Japanese. If
the exchange rate between the dollar and the pound is $1.65/£ and the exchange rate between the yen and the dollar is ¥84/$,
it makes economic sense to select the Japanese supplier. The situation changes when the exchange rate between pound and
dollar falls to $1.50/£.

Supplier Price in Local Foreign Conversion to Price Price of Steel
Currency Exchange Rate in U.S. Dollars in U.S. Dollars

American $190 – – $190.00
British £116 $1.65/£ £116 ϫ $1.65/£ ϭ $191.40
Japanese ¥15,500 ¥84/$ ¥15,500 / ¥84/$ ϭ $184.52

British £116 $1.50/£ £116 ϫ $1.50/£ ϭ $174.00

Exchange Rate Movement: Good or Bad News? DECISION
MAKING
SITUATION: You are the purchasing agent for the U.S.-based firm buying steel in the
example just discussed in the text. Your assistant, Omar, who is a British subject, runs E X A M P L E 2 1 .1
into the office and breathlessly says: “The pound is stronger against the dollar! The new
exchange rate is $1.70/£!” Is Omar’s report good news or bad news?

DECISION: The fact that the pound has risen in value against the dollar is good
news for Omar, because the British pounds he owns will now buy more U.S. goods.
But for your firm, the news is bad. It now takes more U.S. dollars to purchase one Brit-
ish pound. At the new exchange rate, the British steel costs $197.20 per ton (£116 ϫ
$1.70/£ ϭ $197.20).

The Equilibrium Exchange Rate

Exhibit 21.4 shows the supply and demand for British pounds and the equilibrium exchange rate
between the U.S. dollar and the pound. As you can see, the supply of and demand for pounds
move in opposite directions as the exchange rate changes. The demand for pounds increases as
the U.S. dollar appreciates in value against the pound. In other words, as pounds become less
expensive in relation to dollars, British products become less expensive for Americans to buy. We
import more British goods; therefore, we demand more British pounds to pay for those goods.
This is illustrated by the downward-sloping demand curve in Exhibit 21.4.

Dollar ($) price of pounds (£) The supply of EXHIBIT 21.4
pounds in exchange The Equilibrium Exchange
for dollars increases Rate
as the dollar price of
pounds increases. The supply of and demand

for pounds move in opposite

directions. The equilibrium

The equilibrium exchange exchange rate occurs at the
rate ($ for £) is the point at
$/£0 which the supply is equal to intersection of the supply and
the demand. demand curves. At this point,
the quantity of the currency

demanded equals the quantity

supplied.

The demand for

pounds in exchange
for dollars decreases

as the dollar price of

pounds decreases.

Q0
Quantity of pounds (£)

680 CHAPTER 21 I International Financial Management

At the same time, the supply of pounds decreases as the dollar price of pounds declines.
From the point of view of a British buyer, the lower the dollar price of pounds, the greater the
number of pounds that must be given up to obtain dollars to buy foreign (e.g., U.S.) goods. Thus,
the lower the dollar price of pounds, the more likely British residents are to switch from imported
to domestic products. When purchases are diverted in this way to domestic goods, British resi-
dents will supply fewer pounds to the foreign exchange markets because they no longer want to
buy as many imports. This is shown by the upward-sloping supply curve in the exhibit.

Exhibit 21.4 also shows the equilibrium exchange rate ($/£), which is at the point where the
supply and demand curves intersect and the quantity of the currency demanded exactly equals
the quantity supplied. At that rate of exchange, participants in the foreign exchange market will
neither be accumulating nor divesting a currency.

The key to understanding movements in exchange rates, then, is to identify factors that
cause shifts in the supply and demand curves for foreign currency. In general, whatever causes
U.S. residents to buy more or fewer foreign goods shifts the demand curve for the foreign cur-
rency. Similarly, whatever causes foreigners to buy more or fewer U.S. goods shifts the supply
curve for the foreign currency.

Foreign Currency Quotations

Exhibit 21.5 shows selected exchange rate quotations from the Wall Street Journal. As you can
see, there are several types of quotations, which we discuss next.

The Spot Rate

pot rate Look first at the lower (shaded) part of the exhibit. The quotations here (except the ones iden-
he exchange rate for tified as “forward,” which we discuss later) are spot rates. The spot rate is the cost of buying a
mmediate delivery foreign currency today, “on the spot.” In other words, it is the exchange rate that you would pay
for immediate delivery of a currency.

In the lower part of the exhibit, the first column shows the name of the country and the
name of its currency. Columns 2 and 3, labeled “USD Equivalent,” show how many U.S. dollars
it takes to buy one unit of the foreign currency. Because this rate is the price in dollars for a
foreign currency, it is often called the American or direct quote. For example, using the Friday
quote, it takes $1.6005 to buy one British (UK) pound, 59.65 cents to buy one Brazilian real,
and 2.192 cents to buy an Indian rupee.

Columns 4 and 5, labeled “Currency per USD,” show how much foreign currency
exchanges for one U.S. dollar. For example, $1 would get you 62.48 British pence, 1.6764
Brazilian reals, or 45.6204 Indian rupees. This quote is often called the European or indirect
quote because it is the amount of foreign currency per U.S. dollar (although the foreign cur-
rency may not be European). As you may have noted, the second exchange rate is the recipro-
cal (1/x) of the first. For example, the American quote for the British pound is $1.6005/£; the
European exchange rate, which is the reciprocal, is 1/1.6005 ϭ 0.6248, or £0.6248/$; that is,
$1 equals £0.6248.

Bid and Ask Rate Quotations

The foreign exchange rate quotes given in the Wall Street Journal are provided by foreign ex-
change dealers, most of whom operate in large money center banks. Like all dealers in financial
markets, foreign exchange dealers quote two prices: bid and ask quotes. The bid quote repre-
sents the rate at which the dealer will buy foreign currency, while the ask quote is the rate at
which the dealer will sell foreign currency. The prices quoted in the Wall Street Journal are ask
quotes for wholesale transactions ($1 million or more).

The difference between the bid and ask price is the dealer’s spread, which is often calcu-
lated in percent form, as follows:

Bid-ask spread ϭ Ask rate Ϫ Bid rate (21.1)
Ask rate

Suppose a dealer is quoting a bid rate for euros (the currency of the European Union) of $1.3507/€
and an ask rate of $1.3615/€. The bid-ask spread is 0.793 percent [(1.3615 Ϫ1.3507)/1.3615 ϭ
0.00793, or 0.793 percent]. Now assume that ABC Corporation decides to buy €1,000,000 to use in

21.2 Foreign Exchange Markets 681

pays the dealer a total of $1,361,500 (€1,000,000 ϫ $1.3615/€ ϭ $1,361,500). Later in the day, ABC To look up the current
Corporation finds it does not need the euros and decides to sell them back. The dealer buys the cross rates, go to:
euros from the firm at the bid rate of $1.3507/€. The firm receives $1,350,700 (€1,000,000 ϫ http://finance.yahoo
$1.3507/€ ϭ $1,350,700). This represents a loss of $10,800 or 0.793 percent ($10,800/$1,361,500 ϭ .com/currency-
0.00793, or 0.793 percent). investing#cross-rates.

Cross Rates

People who have to deal with more than one foreign currency often make use of a table of spot
exchange rates called cross rates, which are simply exchange rates between two currencies. The
top portion of Exhibit 21.5 shows cross rates for seven different currencies. Cross-rate tables
can be found in the Wall Street Journal and on many financial Web sites.

It is also possible to calculate cross rates, given enough information. Suppose, for example,
that a dealer is interested in finding the exchange rate between the Canadian dollar and the
euro but only knows the exchange rate between each of these currencies and the U.S. dollar:
C$0.9952/$ and €0.7345/$. The dealer can calculate the desired cross rate as follows:

C$/U.S.$ ϭ 0.9952 ϭ C$1.3549/€
€/U.S.$ 0.7345

Turning to Exhibit 21.5, you can find approximately the same value—1.3524—by looking down
the column for the euro and matching it with the Canadian dollar. The slight difference is due
to the fact that the spot and cross rates were recorded at different points in time.

EXHIBIT 21.5 Spot Foreign Exchange Rates

The top part of the exhibit shows the spot cross rates for seven currencies commonly dealt with in the United States. The
lower part of the exhibit lists spot rates: Columns 2 and 3 show how many U.S. dollars it takes to buy one unit of the foreign
currency, and Columns 4 and 5 show how much foreign currency it takes to purchase one U.S. dollar.

Key Currency Cross Rates

Canada Dollar Euro Pound SFranc Peso Yen CdnDlr
Japan 0.9932 1.3524 1.5887 1.0365 0.0824 0.0120 —
Mexico 82.5400 112.3900 132.0300 86.1410 6.8445
Switzerland 12.0590 16.4210 19.2900 12.5850 — 83.1050
U.K. 0.9582 1.3048 1.5327 — 0.1461 12.1420
Euro 0.6252 0.8513 — 0.0795 0.0116 0.9648
U.S. 0.7344 — 0.6524 0.0518 0.0076 0.6294
— 1.1747 0.7664 0.0609 0.0089 0.7394
— 1.3617 1.5996 1.0436 0.0829 0.0121 1.0068

Source: Thomson Reuters. Data are for Friday, January 21, 2011.

USD Equivalent Currency per USD

Country/currency Friday Thursday Friday Thursday

Americas: 0.2512 0.2512 3.9809 3.9809
Argentina peso* 0.5965 0.5974 1.6764 1.6739
Brazil real 1.0048 1.0029 0.9952 0.9971
Canada dollar 1.0042 1.0023 0.9958 0.9977
1-mos forward 1.0029 1.001 0.9971 0.999
3-mos forward 1.0003 0.9985 0.9997 1.0015
6-mos forward 0.002028 0.002022 493.1 494.56
Chile peso 0.0005424 0.0005416 1843.66 1846.38
Colombia peso
Ecuador US dollar 1 1 1 1
Mexico peso* 0.0829 0.0829 12.0569 12.0671
Peru new sol 0.3608 0.3604 2.7716 2.7747
Uruguay peso† 0.0508 0.0504
Venezuela b. fuerte 0.23285056 0.23285056 19.69 19.84
4.2946 4.2946

682 CHAPTER 21 I International Financial Management

EXHIBIT 21.5 Spot Foreign Exchange Rates (continued )

USD Equivalent Currency per USD

Country/currency Friday Thursday Friday Thursday

Asia-Pacific: 0.9899 0.9876 1.0102 1.0126
Australian dollar 0.1519 0.1518 6.5835 6.5857
China yuan 0.1284 0.1285 7.7908 7.7848
Hong Kong dollar 0.02192 0.02189 45.6204 45.683
India rupee 0.0001104 0.0001104
Indonesia rupiah 0.012112 0.012047 9058 9058
Japan yen 0.012114 0.01205 82.56 83.01
0.012122 0.01206 82.55 82.99
1-mos forward 0.012136 0.01207 82.49 82.93
3-mos forward 0.3266 0.3276 82.4 82.84
6-mos forward 0.7585 0.7588 3.0618 3.0525
Malaysia ringgit§ 0.01164 0.01166 1.3184 1.3179
New Zealand dollar 0.0225 0.0224 85.911 85.763
Pakistan rupee 0.7789 0.7765 44.444 44.643
Philippines peso 0.0008941 0.0008893 1.2839 1.2878
Singapore dollar 0.03437 0.03419 1118.44 1124.48
South Korea won 0.0326 0.03265 29.095 29.248
Taiwan dollar 0.00005 0.00005 30.675 30.628
Thailand baht 19498 19495
Vietnam dong 1.5546 1.5555
0.6433 0.6429
SDR†† 0.05604 0.05553
0.1826 0.1808 17.844 18.008
Europe: 1.3615 1.3475 5.4765 5.531
Czech Rep. koruna** 0.004963 0.004894 0.7345 0.7421
Denmark krone 0.172 0.1703 201.49 204.33
Euro area euro 0.3508 0.346 5.814 5.872
Hungary forint 0.3189 0.3158 2.8506 2.8902
Norway krone 0.03347 0.03335 3.1358 3.1663
Poland zloty 0.1518 0.1502 29.878 29.985
Romania leu 1.0434 1.0339 6.5876 6.6578
Russia ruble‡ 1.0436 1.034 0.9584 0.9672
Sweden krona 1.0441 1.0347 0.9582 0.9669
Switzerland franc 1.045 1.0357 0.9578 0.9665
0.6356 0.631 0.9569 0.9655
1-mos forward 1.6005 1.5897 1.5734 1.5848
3-mos forward 1.6001 1.5893 0.6248 0.629
6-mos forward 1.5992 1.5884 0.625 0.6292
Turkey lira** 1.5971 1.5863 0.6253 0.6296
UK pound 0.6261 0.6304
1-mos forward 2.6526 2.6526
3-mos forward 0.1722 0.1722 0.377 0.377
6-mos forward 0.2756 0.2765 5.8089 5.8089
1.4129 1.4109 3.6284 3.6166
Middle East/Africa: 0.01235 0.01235 0.7078 0.7088
Bahrain dinar 3.5704 3.5653
Eqypt pound* 0.0006664 0.0006664 81 81
Israel shekel 0.2667 0.2667 0.2801 0.2805
Jordan dinar 0.1417 0.1411 1500.6 1500.6
Kenya shilling 0.2723 0.2723 3.7495 3.7495
Kuwait dinar 7.0572 7.0872
Lebanon pound 3.6724 3.6724
Saudi Arabia riyal
South Africa rand
UAE dirham

ource: Wall Street Journal Online. Data are for Friday, January 22, 2011.
Floating rate; †Financial; §Government rate; ‡Russian Central Bank rate; **Commercial rate.
†Special Drawing Rights (SDR); from the International Monetary Fund; based on exchange rates for U.S., British, and Japanese currencies.
Note: Based on trading among banks of $1 million and more, as quoted at 4 p.m. ET by Thomson Reuters.

21.2 Foreign Exchange Markets 683

Cross Exchange Rates LEARNING
BY
PROBLEM: An American executive is going on a business trip to Japan and England. APPLICATION 21.2
Before she departs, the executive purchases $10,000 worth of Japanese yen at the pre- DOING
vailing rate of ¥82.54/$. After finishing her business in Japan, she departs for London,
where she converts her remaining yen to British pounds. She sells ¥512,375 at a rate of
¥132.03/£. She finally returns to the United States with £567.35, which she would like to
convert to U.S. dollars. Based only on the rates given, how many dollars will she receive
if she sells the pounds?

APPROACH: In order to solve this problem, you need to know the exchange rate, or
cross rate, between the U.S. dollar and the British pound. Given the other two exchange
rates, you can calculate this rate by dividing the ¥/£ rate by the ¥/$ rate.

SOLUTION:

Cross rate ϭ ¥132.03y£ ϭ $1.5996y£
¥82.54y$

Amount of dollars received ϭ £567.35 ϫ $1.5996y£ ϭ $907.53

Forward Rates forward rate
a rate agreed on today for an
For the major world currencies, such as the U.S. dollar, the British pound, and the Japanese exchange to take place on a
yen, the Wall Street Journal also lists the forward rates for one month, three months, and six specified date in the future
months (see Exhibit 21.5). As you recall, the spot rate is what you pay to buy money today. The
forward rate, as the name implies, is what you agree to pay for money in the future—that is,
you sign a contract today to buy the money on a date in the future, such as one month, three
months, or six months from now.

Forward contracts are important because foreign business transactions may extend over
long periods. This means that financial managers must anticipate their future needs for foreign
currencies. By contracting now to buy or sell foreign currencies at some future date, managers
can lock in the cost of foreign exchange at the beginning of a transaction, and do not have to
worry about the possibility of an unfavorable movement in the exchange rate before the trans-
action is completed. This is one way that forward contracts, like the options discussed in Chap-
ter 20, are used by companies to manage risk.

Note that the forward rate is established at the date on which the agreement is made and
defines the exchange rate to be used when the transaction is completed in the future. This
characteristic is extremely important for facilitating international business transactions,
because it permits the two parties to eliminate all uncertainty about the amount of currency to
be delivered or received in the future.

The forward rate quoted on a particular day is seldom the same as the spot rate on the
same day. Whether it is a one-month, three-month, or six-month quote, the forward rate is
the market’s best estimate of what the spot rate will be at that time in the future. The differ-
ence between the forward rate and the spot rate is called the forward premium or forward
discount. For example, suppose the spot rate today on the British pound is $1.6005/£, while
the three-month forward rate is $1.5992/£. According to the forward quote, the market
expects the British pound to cost $1.5992 three months in the future, a value that is less
than today’s spot rate of $1.6005. Thus, we say that the British pound is at a forward
discount against the U.S. dollar or that the dollar is at a forward premium against the
British pound.

This forward premium or discount can be measured as a percentage on an annualized
basis. Equation 21.2 shows this relation:

Forward premium 1discount2 ϭ Forward rate Ϫ Spot rate ϫ 360 ϫ 100 (21.2)

684 CHAPTER 21 I International Financial Management

Where n is the number of days in the forward agreement. Applying this equation to our
example, the forward discount on the pound is equal to:

Forward discount ϭ $1.5992/£ Ϫ $1.6005/£ ϫ 360 ϫ 100 ϭ Ϫ0.32%
$1.6005/£ 90

Where the negative sign indicates the discount on the pound.

LEARNING Forward Premium (Discount)
BY
DOING APPLICATION 21.3 PROBLEM: Ian Chappell is planning a trip from Sydney, Australia, to visit his
brother, who works in India. He plans to make the trip in six months. In preparing
hedge his budget for the trip, he finds that the spot rate for Indian rupees is Rs45.1596 per
a financial transaction Australian dollar (A$). He also finds the six-month forward rate to be Rs42.1913/A$.
ntended to reduce risk What is the forward premium or discount on the Indian rupees against the Australian
dollar?

APPROACH: Recognize that the Australian dollar will buy fewer Indian rupees in six
months than now. This means that the Indian rupee is at a forward premium against the
Australian dollar or that the Australian dollar is at a discount against the rupee. To find
out how much, we use Equation 21.2.

SOLUTION: Using Equation 21.2, we calculate the value as:

Forward Discount ϭ Rs42.1913/A$ Ϫ Rs45.1596/A$ ϫ 360 ϫ 100 ϭ Ϫ13.15%
Rs45.1596/A$ 180

Thus, the Australian dollar is at a forward discount of 13.15 percent against the
Indian rupee.

Hedging a Currency Transaction

In finance, to hedge means to engage in a financial transaction to reduce risk. In the discussion of
forward rates we briefly described how firms can lock in (hedge) the cost of foreign exchange.

Let’s take a look at an example of how a firm might hedge a transaction using a forward
contract. Suppose an American exporter sells farm equipment to a British firm for £100,000; the
equipment is to be delivered and paid for in 90 days. The English firm will pay for the purchase
in pounds. The American exporter wants to hedge the transaction. How will this hedging work?

If, at the time of the sale, the spot rate is £1 ϭ $1.60, the farm equipment is worth $160,000
(£100,000 ϫ $1.60/£ ϭ $160,000). However, the actual number of dollars to be received for the
machinery, which is the relevant price to the American firm, is not really certain. The Ameri-
can firm must wait 90 days to collect the £100,000 and then sell the pounds in the spot market
for dollars. There is a risk that the dollar price of the pound may have declined more than the
market expected. For instance, if in 90 days the pound is worth only $1.50, the American
exporter will receive only $150,000 (£100,000 ϫ $1.50/£ ϭ $150,000), a loss of $10,000
($160,000 Ϫ $150,000 ϭ $10,000).

To eliminate the foreign exchange rate risk and ensure a certain future price, the American
company can hedge by selling the £100,000 forward 90 days. If the forward rate at the time of
sale is £1 ϭ $1.58, the American exporter can enter into a forward contract in which it agrees
to deliver the £100,000 to the bank in 90 days and receive $158,000 (£100,000 ϫ $1.58/£ ϭ
$158,000) in return. Assume again that the spot rate on the day the exchange is made is £1 ϭ
$1.50. In this case, the “savings” from hedging is $8,000, since the firm has received $158,000
instead of the $150,000 it would have received if it had not entered into the forward contract.

Notice that, even with hedging, the firm has “lost” $2,000, because at the time of the sale,
when the exchange rate was £1 ϭ $1.60, the machine was worth $160,000. Can this kind of loss
be prevented? The answer is that forward contracts cannot protect against expected changes in
exchange rates, only against unexpected changes. At the time of sale, the 90-day forward rate is
£1 ϭ $1.58, and this is the market’s best estimate of what the rate will be in 90 days. Of course,

21.3 International Capital Budgeting 685

What would happen in our example if the spot rate in 90 days rose to $1.80/£? The unhedged
transaction would yield $180,000. However, the forward contract would again provide exactly
the number of dollars anticipated—$158,000. Although the company may have some regrets
because the forward contract prevented it from receiving the benefits of the strengthening pound,
most businesses would consider leaving the account receivable exposed (that is, unhedged) to be
“speculation.” It is generally believed that foreign exchange speculation is not a logical or legiti-
mate function of nonfinancial businesses that import or export goods or services.2

> BEFORE YOU GO ON

1 . What is foreign exchange rate risk?

2 . How is the equilibrium exchange rate determined?

3 . What does it mean to hedge a financial transaction?

21.3 INTERNATIONAL CAPITAL BUDGETING

Multinational firms have operations outside of their home countries that range from simple LEARNING OBJECTIVE 3
sales offices to large manufacturing operations. As a legal and practical matter, most multina-
tional firms set up separate foreign subsidiaries for each country in which they operate. When
a multinational firm wants to consider overseas capital projects, the financial manager faces
the decision of which capital projects should be accepted on a company-wide basis.

Fortunately, the overall decision-making framework and computational methods devel-
oped for domestic capital budgeting in Chapters 10 through 13 apply to international capital
projects as well. Thus, the financial manager’s goal is to seek out domestic and overseas capital
projects whose cash flows yield a positive net present value (NPV). The decision to accept
international projects with a positive NPV increases the value of the firm and is consistent
with the fundamental goal of financial management, which is to maximize the value of stock-
holder equity.

Furthermore, when financial managers evaluate a capital project overseas, they must esti-
mate the same inputs to compute the NPV for that project that they would for a domestic
project: (1) the project’s incremental after-tax free cash flows and (2) the appropriate discount
rate. Although the same basic principles apply to both international and domestic capital bud-
geting, firms must deal with some differences. We now focus on those differences.

Determining Cash Flows repatriation of earnings

A number of issues complicate the determination of cash flows from overseas capital projects. restrictions
First, it is often more difficult to estimate the incremental after-tax free cash flows for foreign restrictions placed by a foreign
projects. Some of the problems stem from the lack of firsthand knowledge by the parent com- government on the amount of
pany’s financial staff of procedures and systems used at the overseas operations; other prob- cash that can be repatriated,
lems arise because of differences in the accounting and legal systems, language, and cultural or returned to a parent
differences. company by a subsidiary
doing business in the foreign
Second, foreign subsidiaries can remit cash flows to the parent firm in a number of
ways, including: (1) cash dividends, (2) royalty payments or license agreement payments for
use of patents or brand names, and (3) management fees for services the parent provides to
a subsidiary. Problems with forecasting expected cash flows can arise when foreign govern-
ments restrict the amount of cash that can be repatriated, or returned to the parent company,
and therefore moved out of the country. These repatriation of earnings restrictions may
arise because foreign governments are politically sensitive to charges that large multina-
tional companies are exploiting their countries and draining vital investment capital from
their economies.

2There is a way for companies to avoid large losses and still make large gains without engaging in speculation. This

686 CHAPTER 21 I International Financial Management

Repatriation of earnings restrictions usually take the form of a ceiling on the amount of
cash dividends that a foreign subsidiary can pay to its parent. The ceiling is typically some
percentage of the firm’s net worth and is intended to force the parent to reinvest in the foreign
subsidiary. The repatriation of the project cash flows can be a critical issue if there are signifi-
cant delays in receiving the funds. From the parent firm’s perspective, the relevant cash flow for
analysis of foreign capital investment opportunities is the cash flow that the parent company
expects to actually receive from its foreign subsidiary.

Exchange Rate Risk

The next issue that financial managers must deal with when evaluating international cap-
ital investments is foreign exchange rate risk. The cash flows from an overseas capital
project will most likely be in a foreign currency that must eventually be converted to the
parent company’s home currency—the U.S. dollar in the case of an American firm. This is
not a simple task because most of the cash flows from capital project are future cash flows.
Thus, analysts cannot use the current spot rate to convert one currency to another. To
convert the project’s future cash flows into another currency, they must project or forecast
exchange rates.

Where can firms secure forecasts for exchange rates? Forecasts for three or four years into
the future can be obtained from most money center banks or from currency specialists on Wall
Street. However, one of the problems with obtaining currency rate forecasts for use in analysis
of capital projects is that many projects have lives of 20 years or more. Needless to say, it is dif-
ficult to forecast exchange rates that far into the future.

For country risk Country Risk
information, visit http://
www.prsgroup.com. Financial managers must also account for country risk when evaluating foreign business ac-
tivities. If a firm is located in a country with a relatively unstable political environment, man-
agement will require a higher rate of return on capital projects as compensation for the addi-
tional risk. At the extreme, a local government could expropriate, or take over, the plant and
equipment of the overseas operation without giving the company any compensation. This ex-
propriation of assets is called nationalization. Sometimes, nations will expropriate the assets
and offer some form of compensation. In other cases, they will offer no compensation. Other
ways that a foreign government can affect the risk of a foreign project include:

• Change tax laws in a way that adversely impacts the firm.
• Impose laws related to labor, wages, and prices that are more restrictive than those appli-

cable to domestic firms.

• Disallow any remittance of funds from the subsidiary to the parent firm for either a lim-

ited period of time, or the duration of the project.

• Require that the subsidiary be headed by a local citizen or have a local firm as a major

equity partner.

• Impose tariffs and quotas on any imports.

To help firms assess country risk, some private firms and government agencies rate na-
tions for their relative level of country risk. Exhibit 21.6 shows one such ranking for coun-
try risk by a private firm for 2010. In addition, U.S. governmental agencies such as the
Department of Commerce and Central Intelligence Agency (CIA) gather information on
countries continuously and are able to provide information on country risk to businesses to
help them make decisions regarding investing in, exporting to, or importing from a par-
ticular country.

Once management has gauged a capital project’s country risk, that risk must be incorpo-
rated into the capital budgeting analysis. One way to do this is to adjust the firm’s discount rate
for the additional risk. For example, if the firm’s cost of capital is 8 percent and the financial
manager’s staff estimates that investment in a particular country requires a 3 percent expected
return to compensate for the additional risk, the appropriate discount rate is 11 percent. Of
course, from Chapters 7 and 13, we know that adjustments like this should only be made to the
discount rate to reflect country risk that is systematic. Unsystematic risk should be reflected in

21.3 International Capital Budgeting 687

EXHIBIT 21.6 Composite Country Risk Ratings for Selected Countries in 2010

The composite risk for a country includes the country’s political risk, financial risk, and economic risk. A higher number means
lower risk. Are you surprised at the rank of the United States?

Rank Country Composite Riska Rank Country Composite Riska

1 Norway 91.00 23 Saudi Arabia 79.50
2 Switzerland 88.00 25 Australia 79.00
3 Brunei 87.50 29 New Zealand 77.50
4 Luxembourg 86.25 30 United States 76.75
5 Taiwan 83.75 34 United Kingdom 76.00
6 Canada 83.50 35 China, Peoples’ Rep. 75.75
7 Finland 83.25 41 France 74.50
8 Kuwait 83.00 42 Israel 74.25
9 Singapore 82.50 46 Brazil 73.75
9 Sweden 82.50 46 Mexico 73.75
11 Germany 82.25 48 Russia 73.25
12 Japan 82.00 58 Ireland 71.75
13 Netherlands 81.75 68 India 69.75
14 Austria 81.50 86 Cuba 67.00
14 Denmark 81.50 116 Greece 60.25
14 Oman 81.50 124 Iraq 58.75
17 Hong Kong 81.25 130 Korea, D.P.R. 53.25
17 Qatar 81.25 130 Venezuela 53.25
17 United Arab Emirates 81.25 137 Haiti 49.75
20 Libya 80.75 140 Somalia 36.00

aComposite risk consists of (1) political risk, (2) financial risk, and (3) economic risk. Rankings range from 1 (low risk) to 140 (high risk).
Source: PRS Group (www.prsgroup.com), January 22, 2011. Reprinted with permission.

The Barcelona Example

Suppose a U.S.-based manufacturing company is considering the possibility of establishing a
manufacturing operation overseas in Barcelona, Spain. The U.S. firm wants overseas capital
investment decisions to be based on the same criteria as domestic investment decisions. The
firm’s overseas financial staff forecasts the expected incremental after-tax free cash flows for the
Barcelona project in millions of euros, as shown in the following time line:

0 1 2 3 4 Year

Cash flow Ϫ€10.0 €3.00 €3.00 €3.00 €3.00

Assume that the current spot rate between the euro (€) and the U.S. dollar ($) is $1.20/€. The
parent company’s finance staff acquires forecasts from an analyst for the expected foreign
exchange (EFX) rates between the euro and the dollar. These forecasts and calculations for the
analysis of the project are shown in the following table:

Cash Flow Calculation Cash Flow
(€, $ millions) ($ millions)
Year (€ millions) EFX Rate
(4) (5)
(1) (2) (3)

0 Ϫ€10.00 $1.20/€ Ϫ€10.00 ϫ $1.20/€ Ϫ$12.00

1 3.00 1.25 3.00 ϫ 1.25 3.75

2 3.00 1.30 3.00 ϫ 1.30 3.90

3 3.00 1.32 3.00 ϫ 1.32 3.96

4 3.00 1.35 3.00 ϫ 1.35 4.05

Column (2) shows the project’s cash flows in euros. Column (3) shows the current spot rate
(t ϭ 0) and the forecast foreign exchange rates (t ϭ 1 to 4). In Column (4), the euro cash flows
are multiplied by the appropriate exchange rate (spot or forecast) to convert to dollar cash

688 CHAPTER 21 I International Financial Management

The firm’s cost of capital is 8 percent, and the financial manager estimates that the project
in Barcelona carries a 2 percent country risk premium. Thus, the appropriate discount rate for
the project is 10 percent.

With this information, the NPV for the project is computed by discounting the cash flows
by the country-risk-adjusted discount rate of 10 percent, as follows:

NPV ϭ Ϫ$12.00 ϩ $3.75 ϩ $3.90 ϩ $3.96 ϩ $4.05
1.10 11.1022 11.1023 11.1024

ϭ Ϫ$12.00 ϩ $3.41 ϩ $3.22 ϩ $2.98 ϩ $2.77

ϭ $0.38

The project should be accepted because its NPV is positive.

LEARNING International Capital Budgeting
BY
DOING APPLICATION 21.4 PROBLEM: A U.S. electronics firm is establishing a manufacturing plant in Taiwan to
produce components that will be sold to customers in Taiwan. The cost of the investment
is $10 million. The project is expected to last five years and then shut down. The com-
pany usually uses a discount rate of 7.5 percent for domestic projects like this, but for this
project, the financial manager adds a 2.5 percent country risk premium. The following
time line shows the expected cash flows in millions of Taiwanese dollars (TWD) and the
forecasted year-end exchange rates between the U.S. dollar and the Taiwanese dollar.

1 2 3 4 5 Year

Cash flows (millions of TWD) 64.3 71.2 93.6 121.8 109.6
Expected exchange rate (TWD/$) 32.031 33.632 36.155 32.221 33.670

What is the NPV of this project?

APPROACH: Since we know the expected cash flows in the foreign currency and the
expected exchange rates, we can calculate the expected cash flows to the parent firm in
U.S. dollars by dividing the TWD cash flows by the appropriate exchange rate. We also
must adjust the project discount rate for the 2.5 percent country risk premium.

SOLUTION: The following table shows the conversion of the cash flows the U.S. firm
expects to receive from Taiwanese dollars to U.S. dollars.3

Cash Flows Exchange Rate Cash Flows
Year (TWD millions) ($ millions)

0 Ϫ$10.00

1 64.3 TWD Ϭ 32.031 TWD/$ ϭ 2.01

2 71.2 Ϭ 33.632 ϭ 2.12

3 93.6 Ϭ 36.155 ϭ 2.59

4 121.8 Ϭ 32.221 ϭ 3.78

5 109.6 Ϭ 33.670 ϭ 3.26

The appropriate discount rate is 2.5 percent over the discount rate that the firm
normally uses for domestic capital budgeting projects. Thus, the discount rate to be used
is 10 percent (2.5 ϩ 7.5 ϭ 10). By discounting the cash flows at the risk-adjusted discount
rate of 10 percent, we can compute the NPV for this project.

$2.01 $2.12 $2.59 $3.78 $3.26
NPV ϭ Ϫ$10.00 ϩ 1.10 ϩ 11.1022 ϩ 11.1023 ϩ 11.1024 ϩ 11.1025

ϭ Ϫ$10.00 ϩ $1.83 ϩ $1.75 ϩ $1.95 ϩ $2.58 ϩ $2.02

ϭ $0.13 million

Since the NPV is positive, the project should be accepted.

3You may wonder why there was a currency conversion for the initial cash flow (t ϭ 0) in the Barcelona example and no
similar conversion for this problem. The reason is that for the current problem, the initial cash flow of Ϫ$10 million is

21.4 Global Money and Capital Markets 689

> BEFORE YOU GO ON
1 . What difficulties do firms face in estimating cash flows from an overseas project?
2 . Why is the repatriation of cash flows from an overseas project considered

critical to the project’s value?
3 . When do companies have to consider country or political risk?

21.4 GLOBAL MONEY AND CAPITAL MARKETS

Next, we focus on how multinational business firms use global money and capital markets to LEARNING OBJECTIVE 4
adjust their liquidity, to finance their domestic and international operations, and to raise equity
capital. The global financial markets operate and transact in securities denominated in all of
the world’s major currencies. However, the dollar portion of these global markets is the largest.
This is because international business contracts all over the world commonly require payment
in U.S. dollars.

The dollar has been a preferred medium of exchange because of the strength and size of
the U.S. economy and the government’s long history of political stability. As a result of these
factors, businesses, governments, and individuals throughout the world often choose to hold
and transact in dollars rather than their home currency.

However, the future strength of the U.S. dollar as a global currency is uncertain. The euro
is now the main currency used in the 17 countries that are part of the European Union. The
euro is second only to the dollar in its popularity as a reserve currency and in its volume as a
traded currency. The renminbi is the currency issued by the People’s Republic of China and is
denominated in yuan. The yuan is also an increasingly popular currency for worldwide
exchange as the Chinese economy continues to grow.

The Emergence of the Euromarkets Eurodollar
a U.S. dollar deposited in a
Before World War II, dollar-denominated deposits of multinational corporations and govern- bank outside the United States
ments were held in U.S. money center banks. When the cold war started in the 1950s, the So-
viet Union feared that for political reasons the U.S. government might temporarily freeze or
expropriate its deposits in the United States. Motivated by profits, a number of London-based
banks responded to the Soviets’ concern by offering to hold their dollar-denominated deposits
in British banks. The new accounts became quite popular and were soon dubbed Eurodollars.
A Eurodollar is defined as a U.S. dollar deposited in a bank outside the United States. The
banks accepting these deposits are called Eurobanks.

Over time, other major currencies, such as the Japanese yen and British pound, were
deposited offshore, and the Euromarkets emerged. Today, the Euromarkets are vast, largely
unregulated money and capital markets. London and New York City are the two most impor-
tant markets, but Euromarkets also exist in places like Tokyo, Hong Kong, and Singapore.
Though many of the market centers are not in Europe, the term Euromarket has become a
generic term.

The Eurocurrency Market Eurocurrency
a time deposit that is in a bank
The core of international financial markets is the Eurocurrency market, which is the short-term located in a country different
portion of the Euromarket. A Eurocurrency is a time deposit that is in a bank located in a from the country that issued
country different from the country that issued the currency. For example, a Japanese yen or an the currency
American dollar account in a British bank is a Eurocurrency account.4

The largest segment of the Eurocurrency market is interbank transactions, in which banks
borrow from and lend to one another overnight. Although short-term transactions dominate
the market, there is an active market for loans with maturities of up to six months. The impor-
tance of the Eurocurrency market lies in its role in allocating funds on a global basis. This means

690 CHAPTER 21 I International Financial Management

London Interbank Offer Rate that banks with strong loan demand can borrow Eurocurrencies, such as Eurodollars, and
make loans to multinational corporations, sovereign governments, or other large international
LIBOR) entities.
he interest rate British-based
banks charge each other for The most widely quoted Eurocurrency interest rate is the London Interbank Offer Rate,
hort-term loans. Also, or LIBOR, which is the short-term interest rate that major banks in London charge one an-
ommonly used as the base other. This rate is also commonly used as the base rate for Eurodollar loans other than those
ate for Eurodollar loans that between two banks. If the lending bank is located in another Euromarket financial center, such
are not between two banks as Singapore, the offer rate quoted is SIBOR, which is the Singapore Interbank Offer Rate; if the
bank is based in Hong Kong, the offer rate is HKIBOR; and so on. Because the various Euro-
markets are closely linked, the interbank rates for a particular Eurocurrency tend to be similar.
The LIBOR is also similar to the Fed funds rate, which is the rate that large U.S. banks charge
one another.

Eurocredits The Eurocredit Market
hort- to medium-term loans
of a Eurocurrency to The international banking system gathers funds from businesses and governments in the
multinational corporations and Eurocurrency market and then allocates funds to banks that have the most profitable lending
governments of medium to opportunities. These loans are called Eurocredits—short- to medium-term loans of a Euro-
high credit quality currency to multinational corporations and governments of medium to high credit quality.
Eurocredits are denominated in all major Eurocurrencies, although the dollar is the over-
whelming favorite. An example of a Eurocredit transaction would be an American firm bor-
rowing Eurodollars from a bank in Hong Kong.

International Bond Markets

International bonds fall into two generic categories: foreign bonds and Eurobonds.

Foreign Bonds

Foreign bonds are long-term debt sold by a foreign firm to investors in another country and
denominated in that country’s currency. They are called foreign bonds because the issuer is a
foreigner in the country where the bonds are sold. Foreign bonds may have colorful nick-
names: foreign bonds sold in the United States are called Yankee bonds, and yen-denominated
bonds sold in Japanese financial markets by non-Japanese firms are called Samurai bonds.

Firms sell foreign bonds when they need to finance projects in a particular foreign coun-
try. For example, the German car manufacturer BMW might decide to sell dollar-denominated
bonds in the United States to build an assembly plant in South Carolina. Similarly, Amazon.
com might need euros to build a new shipping depot in Germany. To raise the euros,
Amazon.com could sell euro-denominated bonds in Germany to German and other European
investors.

Eurobonds

Eurobonds are long-term debt instruments sold by firms to investors in countries other than the
country in whose currency the bonds are denominated. Multinational firms can use Eurobonds
to finance international or domestic projects. For example, suppose Ford Motor Company de-
cides to sell U.S.-dollar denominated bonds in Europe. Investors would call the bonds Eurodollar
bonds. What can Ford do with the dollars from the bond sales? It can spend them overseas to
finance a project, or it can spend them in the United States—after all, a dollar is a dollar.

The fact that the proceeds from a Eurodollar bond issue can be spent in the United States
raises an important point. During the 1980s, multinational firms discovered that they could
sell Eurodollar bond issues at interest cost savings as large as 50 to 150 basis points annually
(0.5 to 1.5 percent) compared with similar bond issues sold domestically. Needless to say, mul-
tinationals that needed to borrow dollars long term flocked to the Eurodollar bond market.
Although the large interest cost spreads we have mentioned no longer exist, today any multi-
national firm that needs to borrow dollars long term routinely evaluates whether it makes
more sense to sell the bond issue domestically or in the Eurodollar bond market.

Eurodollar and other Eurocurrency bonds have a number of characteristics that differ from

21.4 Global Money and Capital Markets 691

Because the bonds are not registered, there is no record of who owns them. As a result, some
Eurobond investors conveniently “forget” to pay taxes on the coupon income earned. This is no
secret, of course, and there is growing pressure to eliminate bearer bonds.

Eurobonds also differ from domestic bonds in that they pay interest, in the form of cou-
pon payments, annually, whereas U.S. corporate bonds make coupon payments twice a year.
Thus, the interest rate on Eurodollar bonds is not directly comparable to similar domestic
bonds because of the difference in compounding periods.

Finally, historically almost all Eurocurrency bonds were sold without credit ratings. The
reason for this practice was that almost all bond issues sold in Europe were purchased by insti-
tutional investors who relied on their own credit analyses, so there was no reason for the issuer
to purchase a credit rating for the bond issue. However, since the mid-1980s, the retail segment
of the equity and bond markets in Western Europe has grown significantly. Individual inves-
tors typically prefer to purchase bonds that have credit ratings. Today, more than half of the
Eurodollar bonds sold in Europe have credit ratings.

Eurodollar versus Domestic Bond Issue LEARNING
BY
PROBLEM: Suppose Hewlett-Packard (HP) needs $3.5 million to build a new facility. APPLICATION 21.5
The firm plans to finance the facility by selling bonds domestically or in the Eurodollar DOING
bond market. In either case, the bond issue will have a maturity of three years, a par value
of $1,000, and coupon interest payments totaling $50 a year. After transaction costs and
underwriters’ fees, the domestic bond issue will net $951.90 per bond, and the Euro-
dollar bonds will net $948.00 per bond. Which bonds—domestic or Eurodollar—should
HP issue?

APPROACH: Fortunately, we know from Chapter 8 that the best deal is the alterna-
tive that offers the lowest interest cost. You may want to review the bond yield calcu-
lation formulas in Section 8.3 of Chapter 8. Drawing on those formulas, we calculate
the yield to maturity for each alternative. Because bond issues pay coupon interest
semiannually in the United States and annually in Europe, we must also compute the
effective annual yield (EAY) for the domestic bonds in order to compare it with the yield
on the Eurodollar bonds.

SOLUTION: For the Eurodollar bond, the annual coupon payment is $50 per year, and
the yield calculation is:

$948.00 ϭ $50 ϩ $50 ϩ $1,050
1ϩi 11 ϩ i22 11 ϩ i23

Using our financial calculator, we find that the Eurodollar bond issue’s annual yield is
6.9808 percent.

For the domestic bond issue, the semiannual coupon payments are $25 ($50/2 ϭ $25),
and the semiannual bond yield calculation is:

$951.90 ϭ $25 ϩ $25 ϩ p $1,025
1ϩi 11 ϩ i22 ϩ 11 ϩ i26

The bond issue’s semiannual yield is 3.3997 percent. We now apply the EAY formula
from Chapter 8 to find the effective annual yield for the domestic bonds:

EAY ϭ 11 ϩ Quoted interest rate/m2m Ϫ 1
ϭ 11 ϩ 0.03399722 Ϫ 1

ϭ 1.0691 Ϫ 1

ϭ 6.92%

The domestic bond issue, with a 6.92 percent effective annual yield, will provide the
lower interest cost, all other things being equal. Of course, the fact that the domestic
bond nets a higher price per $1,000 owed tells us that this bond has a lower interest cost.
We just did not know precisely how much lower without performing the calculations.

692 CHAPTER 21 I International Financial Management

> BEFORE YOU GO ON
1 . Which currency is the most widely preferred currency of exchange in global

financial markets? Why?
2 . What is the difference between foreign bonds and Eurobonds?

21.5 INTERNATIONAL BANKING

LEARNING OBJECTIVE During the period when the major European countries were establishing their colonial em-
pires, British, Dutch, and Belgian banks developed a worldwide presence, and London emerged
as the center of international banking and finance. European governments fostered the growth
of large international banks in their countries and viewed them as engines of territorial and
economic expansion.

In the United States, it was quite a different story. National banks, which are chartered by
the federal government, were not permitted to establish branches or accept bills of exchange
outside the United States until passage of the Federal Reserve Act of 1913. However, even after
the act was passed, American banks did not rush overseas. Not until after World War II did
American banks begin to establish any significant foreign presence. The catalyst for growth
was the ambition of American corporations as they established sales offices overseas, imported
foreign goods, and acquired foreign manufacturing facilities. To accommodate their custom-
ers’ needs, large U.S. banks established networks of foreign branches and affiliates.

Exhibit 21.7 shows the 15 largest banks in the world ranked by total assets as of the end of
2010. These banks offer a full range of international and domestic banking services to busi-
nesses in their home countries and to multinational firms overseas. The services include pro-
viding transaction accounts, commercial loans, foreign exchange, underwriting of debt and
equity issues, and letters of credit.

Risks Involved in International Bank Lending

The principles of loan administration and credit analysis are similar for domestic and overseas loans.
There are differences, however, including some additional risk exposures for overseas lending.

EXHIBIT 21.7 World’s Largest Banks in 2010

The exhibit lists the 15 largest banks in the world ranked by total assets. BNP Paribas is the world’s largest bank with total
assets of $2,964 billion, followed by the Royal Bank of Scotland Group and HSBC Holdings. By country of origin, four of the
top 15 banks are headquartered in the United Kingdom, three in the United States, and two each in France and Japan.

Rank Bank Name Country Total Assets Revenue Profits
($ billion) ($ billion) ($ billion)

1 BNP Paribas France $2,964 $130.7 $8.1
2,747 91.8 (4.2)
2 Royal Bank of Scotland Group U.K. 2,364 103.7 5.8
2,243 106.5 1.6
3 HSBC Holdings U.K. 2,233 66.5 14.6
2,223 150.5 6.3
4 Credit Agricole France 2,196 54.3 4.2
2,162 59.0 6.9
5 Barclays U.K. 2,032 115.6 11.7
1,857 108.8 (1.6)
6 Bank of America U.S.A. 1,726 69.3 18.8
1,676 163.2 (1.3)
7 Mitsubishi UFJ Financial Group Japan 1,664 103.0 4.4
1,637 30.3 2.6
8 Deutsche Bank Germany 1,600 106.3 12.4

9 JPMorgan Chase U.S.A.

10 Citigroup U.S.A.

11 Industrial and Commercial Bank of China China

12 ING Group Netherlands

13 Lloyds Banking Group U.K.

14 Mizuho Financial Group Japan

15 Banco Santander Spain

ources: “The World’s 50 Biggest Banks 2010,” Global Finance Magazine (http://www.gfmag.com), September 13, 2010. Reprinted with permission. “The World’s
eading Companies,” http://www.Forbes.com, January 22, 2011. Reprinted with permission.

21.5 International Banking 693

Credit Risk

Credit risk involves assessing the probability that some part of the interest and/or principal of
a loan will not be repaid. The greater the probability of default, the higher the loan rate that the
bank must charge the borrower. Credit risk is the same whether a loan is domestic or interna-
tional. However, it may be more difficult to obtain or assess credit information abroad. U.S.
banks are less familiar with local economic conditions and business practices than are domes-
tic banks. It takes time and practice to develop appropriate sources of information and to
understand how to evaluate such information. As a result, many U.S. banks tend to restrict
their foreign lending to large, well-known companies or financial institutions.

Currency Risk A discussion on
managing foreign
We have already discussed foreign exchange rate risk. Fluctuations in exchange rates can affect exchange rate risk is
the cash flows associated with a loan or investment, and, hence, can affect their value. Some available at this New
loans made by U.S. banks are denominated in foreign currency rather than dollars, and if the York University Web site:
foreign currency is expected to lose value against the dollar during the course of the loan, the http://pages.stern.nyu
repayment will be worth fewer dollars. Thus, bank loans that have foreign exchange risk will .edu/~igiddy/fxrisk.htm.
carry an additional risk premium; the greater the foreign exchange risk, the higher the loan
rate the bank must charge the borrower.

Of course, if the foreign currency has a well-developed market and the maturity of the loan is
relatively short, the loan may be hedged. However, many world currencies, particularly those in
developing nations, do not have well-established foreign currency markets; consequently, these
international loans cannot always be hedged at a reasonable price to reduce the currency risk.

Country Risk

We have also discussed country risk, which is tied to political developments in a country that
could affect the cash flows associated with a loan or investment in that country. If an interna-
tional loan might suffer some loss in value due to political developments, the loan will carry an
additional risk premium; the greater the country risk of a loan, the higher the rate the bank
must charge the borrower.

Eurocredit Bank Loans

As noted earlier, Eurocredits are short- to medium-term loans of a Eurocurrency to multinational
corporations or governments. The loans are denominated in a currency that is different from the
bank’s home currency. Eurocredits can have a high degree of credit risk and may be too large for a
single bank to handle. As a result, the lending banks often form a syndicate to spread the risk. Each
bank in the lending syndicate participates by taking a portion of the loan. One bank acts as the lead
bank and is responsible for negotiating the price of the loan and its terms with the borrower.

The loan pricing for Eurocredits is similar to the loan pricing that U.S. money center banks
use for their largest domestic customers. The loan rate (k) is equal to a base rate, such as LIBOR,
which represents the bank’s cost of funds, plus a markup, which is the bank’s lending margin:

k ϭ Base rate ϩ X

where X is the lending margin. The lending margin depends on the borrower’s credit risk;
international risk factors, such as foreign exchange risk and country risk; and the bank’s gross profit
margin. From the gross profit margin, the bank must cover all its expenses in making the loan and
earn a profit. The general equation for Eurocredit pricing can thus be expressed as follows:

k ϭ BR ϩ DRP ϩ FXR ϩ CR ϩ GPMAR (21.3)

where:
k ϭ individual firm’s loan rate

BR ϭ Eurocurrency base rate, such as LIBOR
DRP ϭ default risk premium
FXR ϭ foreign exchange or currency risk premium

CR ϭ country risk premium

694 CHAPTER 21 I International Financial Management

Eurocredits typically are floating-rate loans structured as “rollovers.” Rollover pricing was
developed to protect banks against adverse interest rate movements so that lenders do not end
up paying more on the Eurocurrency time deposit than they earn from the loan. Banks are
vulnerable to taking such losses because the money to fund Eurocredits comes from short-
term deposits. As a result, a Eurocredit can be viewed as a series of short-term loans, where at
the end of each time period (three or six months), the loan is “rolled over” and repriced at the
current market interest rate.

Suppose, for example, that Citibank is considering making a Eurocredit loan to a Mexican
manufacturer that needs to borrow $1.5 million for three years. The bank lending officer wants
the loan to be structured as a six-month floating-rate loan. That means the loan is a three-year
loan priced as six successive six-month loans. The bank’s credit department believes the credit
risk premium is 3 percent, the country risk for Mexico is an additional 1 percent, and the
bank’s gross profit margin is 0.125 percent. The bank can buy the funds in the Euromarket: the
six-month LIBOR rate is 1.75 percent. Applying the loan pricing model (Equation 21.3), we
find that the Eurocredit pricing for this loan is:

k ϭ BR ϩ DRP ϩ CR ϩ GPMAR
ϭ 1.75% ϩ 3.00% ϩ 1.00% ϩ 0.125%
ϭ 5.875%

Note that the loan involves no foreign exchange risk (FXR) for the bank, because the loan is
in dollars.

We can also describe the loan rate in terms of the lending margin (X), which is the markup
used to reprice the loan when it rolls over. For the Mexican loan, the lending margin is as follows:

X ϭ DRP ϩ CR ϩ GPMAR
ϭ 3.00% ϩ 1.00% ϩ 0.125%
ϭ 4.125%

When the loan is repriced at the end of six months, if LIBOR at that point is 2.00 percent, the
new loan rate will be 6.125 percent (2.00 percent ϩ 4.125 percent ϭ 6.125 percent).

Lending margins are quite small for North American and Western European multina-
tional companies with good credit ratings. The margins are low because the credit risk and
country risk for these companies are low.

LEARNING APPLICATION 21.6 Interest on a Eurocredit Loan
BY
DOING PROBLEM: Siemens International can borrow $5 million from HSBC at LIBOR plus
a lending margin of 0.5 percent on a three-month rollover Eurocredit loan. Sup-
pose that the prevailing annualized LIBOR rate is 4.0 percent and that over the next
three-month period, the LIBOR rate is expected to increase to 4.125 percent. How
much interest will Siemens have to pay HSBC for the Eurocredit loan for the first six
months?

APPROACH: The total expected interest cost of the Siemens loan is the sum of the
interest paid for the first three months plus the expected interest paid over the next three
months.

SOLUTION: Siemens’s annualized borrowing cost is 4.5 percent (4.0 ϩ 0.5 ϭ 4.5)
for the first three-month period and is expected to be 4.625 percent (4.125 ϩ 0.5 ϭ
4.625) for the next three-month period; thus, the total interest cost for the six-month
period is as follows:

Total interest cost ϭ 1$5,000,000 ϫ 0.045 ϫ 0.25 year2 ϩ 1$5,000,000 ϫ 0.04625 ϫ 0.25 year2
ϭ $56,250.00 ϩ $57,812.50
ϭ $114,062.50

Summary of Key Equations 695

> BEFORE YOU GO ON
1 . Why is credit risk higher in international markets?
2 . List the inputs that are used in calculating a Eurocredit price.

S um m a ry of Learning Objectives

1 Discuss how the basic principles of finance apply to from differences in operating, accounting, and legal practices, as
international financial transactions. well as from the variety of ways in which a multinational firm
can transfer profits and funds from the subsidiary to the parent
The basic principles of finance remain the same whether a trans- corporation. Furthermore, firms engaged in international capital
action is domestic or international. For example, the time value budgeting face two risks that domestic firms do not have to deal
of money calculations remain the same, as do the models used with: foreign exchange rate risk and country risk. The Barcelona
to calculate asset values. What does change, however, are some example in Section 21.3 and Learning by Doing Application 21.4
of the input variables. These variables may be affected by cul- illustrate capital budgeting calculations.
tural or procedural differences between countries or differences
in tax and accounting standards. Exhibit 21.2 lists some of these 4 Discuss the importance of the Euromarkets to large
changes. U.S. multinational firms and calculate the cost of
borrowing in the Eurobond market.
2 Differentiate among the spot rate, the forward rate,
and the cross rate in the foreign exchange markets, The Eurocurrency markets are important to large multinational
perform foreign exchange and cross rate calculations, corporations around the world. These corporations hold Euro-
and hedge an asset purchase where payment is made currency time deposits as investments and finance much of their
in a foreign currency. business activity by borrowing in the Eurocredit market and sell-
ing debt in the Eurobond market. The Euromarkets are popular
The spot rate is the exchange rate at which one currency can with large multinational firms because they are largely unregu-
be converted to another immediately, whereas the forward lated; thus, they offer more attractive borrowing and lending
rate is a rate agreed on today for an exchange to take place at a rates and greater flexibility in conducting transactions. Learning
specified point in the future. Forward rates are usually differ- by Doing Application 21.5 illustrates how to calculate the cost of
ent from spot rates and are the market’s best estimate of what issuing bonds in the domestic and Eurobond markets.
a future spot rate will be. The cross rate is simply the exchange
rate between two currencies. Learning by Doing Applications 5 Explain how large U.S. money center banks make and
21.1 through 21.3 illustrate foreign exchange rate problems that price Eurocredit loans to their customers and compute
you should be able to solve. the cost of a Eurocredit bank loan.

3 Identify the major factors that distinguish internation- Eurocredit loans are made by large multinational banks.
al from domestic capital budgeting, explain how the Eurocredits typically have fixed maturities and variable, or
capital budgeting process can be adjusted to account floating, rates of interest. The loan rate is tied to a base interest
for these factors, and compute the NPV for a typical rate (BR), such as LIBOR. The total rate charged on a Euro-
international capital project. credit is BR ϩ X, where X is the lending margin, which consists
of risk premiums (credit, country, and currency risks) and the
One issue that distinguishes international from domestic capi- lender’s profit margin. The Citibank example in Section 21.5
tal budgeting is the difficulty in estimating the incremental cash and Learning by Doing Application 21.6 illustrate how loan
flows from an international project. These difficulties can stem costs are computed.

S um m a ry of Key Equations

Equation Description Formula
21.1 Bid-ask spread
Bid-ask spread ϭ Ask rate Ϫ Bid rate
21.2 Forward premium or discount Ask rate
21.3 Eurocredit bank loan pricing
Forward premium 1discount2 ϭ Forward rate Ϫ Spot rate ϫ 360 ϫ 100
Spot rate n

k ϭ BR ϩ DRP ϩ FXR ϩ CR ϩ GPMAR

696 CHAPTER 21 I International Financial Management

Self-Study Problems

21.1 If a Volkswagen Passat costs $26,350 in Baltimore and €21,675 in Frankfurt, what is the implied
exchange rate between the U.S. dollar and the euro?

21.2 Calculate the indicated exchange rates given the following information.

Given Compute
a. ¥86.3500/$ $/¥
b. $1.8694/£ £/$
c. $0.9981/C$ C$/$

21.3 Digital, Inc., an electronic games manufacturer, is planning to purchase flash memory from
one of two sources. Kyoto, Inc., quotes a price of ¥6,800 per gigabyte. The current exchange rate
is ¥84.30/$. Another Japanese manufacturer offers to supply the same flash memory at a price
of €58.46 per gigabyte. The spot rate available is ¥121.57/€. Which is the cheaper source of flash
memory for Digital?

21.4 Columbia Corp. has just made a sale to a British customer. The sale was for a total value of £135,000
and is to be paid 60 days from now. Columbia is concerned that the British pound will depreciate
against the U.S. dollar, and management plans to hedge. The company’s bank informs manage-
ment that the spot rate is $1.8133/£ and the 60-day forward rate is $1.7864/£. If Columbia sells its
pounds receivable at the forward rate, what is the dollar value of its receivables? If it does not enter
into a forward contract and the spot rate 60 days later is $1.7635/£, how much would the company
lose by not hedging?

21.5 American Bancorp is planning to make a $3.5 million loan to a French firm. Currently, LIBOR
is at 4.5 percent. American considers a default risk premium of 1.15 percent, a foreign exchange
risk premium of 0.35 percent, and a country risk premium of 0.13 percent to be appropriate for
this loan. What is the loan rate charged by American Bancorp?

Solutions to Self-Study Problems

21.1 Cost of the car in Baltimore ϭ $26,350
Cost of the car in Frankfurt ϭ
€21,675
Dollar to euro exchange rate ϭ
$26,350 ϭ $1.2157/€
€21,675

21.2 a. 1/¥86.3500/$ ϭ $0.11581/¥
b. 1/$1.8694/£ ϭ £0.5349/$
c. 1/$0.9981/C$ ϭ C$1.00190/$

21.3 Cost from Vendor 1: ¥6,800 per gigabyte
Flash memory price quote ϭ ¥84.30/$
Spot rate for U.S. dollar ϭ ¥6,800 ϭ $80.66 per gigabyte
¥84.30/$
Cost to Digital in dollars ϭ

Cost from Vendor 2: €58.46 per gigabyte
¥121.57/€
Flash memory price quote ϭ
Spot rate for U.S. dollar ϭ

To compute the dollar cost, we need to compute the cross rate between the euro and the dollar.

¥121.57/€ ϭ $1.4421/€
¥84.30/$

Cost to Digital in dollars ϭ €58.46 ϫ $1.4421/€
ϭ $84.31 per gigabyte

The first vendor has the cheaper quote for Digital.

21.4 Amount received by Columbia by selling at the forward rate:

ϭ £135,000 ϫ $1.7864/£ ϭ $241,164

Amount received by Columbia by selling at the spot rate 60 days later:

ϭ £135,000 ϫ $1.7635/£ ϭ $238,072.50

Questions and Problems 697

21.5 The loan rate charged by American Bancorp is calculated as follows:

k ϭ BR ϩ DRP ϩ FXR ϩ CR
ϭ 4.5% ϩ 1.15% ϩ 0.35% ϩ 0.13%
ϭ 6.13%

Critical Thinking Questions

21.1 Royal Dutch Shell, an oil company, has headquarters in both the Netherlands and the United
Kingdom. What type of firm is it?

21.2 International economic integration and technological changes in the last couple of decades have
dramatically increased globalization across many industries. Explain how a biotech firm or a
medical firm (for example, a hospital) can take advantage of these changes.

21.3 In the United States, managers are asked to focus on maximizing stockholder value. Is this
consistent with the goals of managers in Germany and Japan?

21.4 A Canadian cooperative of wheat farmers sold wheat to a grain company in Russia. Under what
circumstances will the Canadian farmers be exposed to foreign exchange risk? When will the
Russian importer be facing foreign exchange risk?

21.5 Stardust, Inc., is an exporter of plumbing fixtures. About 30 percent of its sales are made in
Canada. The sales department just found out that the Canadian dollar is at a premium against
the U.S. dollar based on the 90-day forward rate, while the 180-day forward rate indicates
that the Canadian dollar is at a forward discount. What is the likely impact of these rates on
the company’s sales to Canada?

21.6 Mello Wines, a California winery, grows its grapes locally, uses local labor, and sells its wines
only in the United States. Can this firm be exposed to foreign exchange risk?

21.7 A U.S. firm owns a subsidiary in Belgium. What kind of foreign exchange risk does the U.S.
firm face?

21.8 Ray Corp. is a U.S. electronics manufacturer with a production plant in Turkey. This morning,
the Turkish government introduced a new law prohibiting the repatriation of any funds from the
country for another two years. What type of risk does Ray Corp. face?

21.9 Suppose GE issues bearer bonds in France denominated in British pounds. What type of
bonds are these?

21.10 Give examples of U.S. banks facing different risks in international lending.

Questions and Problems

21.1 Spot rate: Ryan wants to buy a pair of leather shoes at Harrods in London that is priced at < BASIC
£113.60. If the exchange rate is $1.6177/£, what is Ryan’s cost in U.S. dollars?

21.2 Spot rate: Crescent Corporation’s recent sale to a firm in Mexico produced revenues of
13,144,800 Mexican pesos (MPs). If the firm sold the pesos to its bank and was credited with
$1,077,873.60, what was the spot rate at which the pesos were converted?

21.3 Spot rate: Given the following direct quotes, calculate the equivalent indirect quotes.
a. $0.0844/Mexican peso
b. £0.8513/€
c. Rs31.64/C$

21.4 Spot rate: Convert the following indirect quotes to the appropriate American quotes.
a. £0.6917/$
b. Rs43.37/$
c. SF 1.0769/$

21.5 Spot rate: Suppose a BMW 745i is priced at $57,750 in New York and €48,387 in Berlin. In
which place is the car more expensive if the spot rate is $1.1935/€?

21.6 Forward rate: Explain the relation between each pair of currencies.

Spot Rate Forward Rate

a. $1.655/£ $1.6001/£
b. ¥85.45/$ ¥82.33/$

698 CHAPTER 21 I International Financial Management

21.7 Forward rate: If the spot rate was $1.0413/C$ and the 90-day forward rate was $1.0507/C$,
how much more (in U.S. dollars) would you receive by selling C$1,000,000 at the forward rate
than at the spot rate?

21.8 Forward rate: Crane, Inc., sold equipment to an Irish firm and will receive €1,319,405 in 30
days. If the company entered a forward contract to sell at the 30-day forward rate of $1.3012/€,
what is the dollar revenue received?

21.9 Forward rate: Brilliant Equipment purchased machinery from a Japanese firm and must make
a payment of ¥313.25 million in 45 days. The bank quotes a forward rate of ¥83.46/$ to buy the
required yen. What is the cost to Brilliant in U.S. dollars?

21.10 Forward rate: Triumph Autos has contracted with an Indian software firm for design software.
The payment of 22,779,750 rupees (Rs) is due in 30 days. What is the cost in dollars if the 30-day
forward rate is Rs43.39/$.

21.11 Forward rate: Use the data in Exhibit 21.5 to answer these questions:
a. What is the six-month forward rate (in U.S. dollars) for Swiss francs? Is the Swiss franc selling
for a premium or a discount?
b. What is the six-month forward rate (in U.S. dollars) for the Japanese yen? Is the Japanese yen
selling for a premium or a discount?
c. Given the information above, what do you think will happen to the value of the U.S. dollar
relative to the Swiss franc and the Japanese yen ?

21.12 Bid-ask spread: Nova Scotia Bank offers quotes on the Canadian dollar as shown below. What
is the bid-ask spread based on these quotes?

Bid Ask
C$ 0.9973/$ C$ 0.9978/$

21.13 Bid-ask spread: A local community bank has requested foreign exchange quotes for the Swiss
Franc from Citibank. Citibank quotes a bid rate of $1.0934/SF and an ask rate of $1.0997/SF.
What is the bid-ask spread?

21.14 Bid-ask spread: A foreign exchange dealer is willing to buy the Danish krone (DKr) at $0.1556/DKr
and will sell it at a rate of $0.1563/DKr. What is the bid-ask spread on the Danish krone?

21.15 Cross rate: Given the following quotes, calculate the €/£ cross rate.

Bank of America $1.663/£
JP Morgan Chase $1.3914/€

21.16 Cross rate: Barclays Bank of London has offered the following exchange rate quotes:
¥134.64/£ and Korean won 13.8374/¥. What is the cross rate between the Korean won and the
British pound?

21.17 Cross rate: Bremer Corporation observes that the Swiss franc (SF) is being quoted at €0.7660/SF,
while the Swedish krona (SK) is quoted at €0.1114/SK. What is the SK/SF cross rate?

21.18 Country risk: Ford Motor Company maintains production facilities in many different countries
including Brazil, Taiwan, and the United States. Given the data in Exhibit 21.6, which production
plant is likely to face the greatest country risk and which will have the least? How does country
risk affect a firm’s capital budgeting decisions?

21.19 Foreign exchange risk: How is transaction exposure different from operating exposure?

21.20 International debt: What are Yankee bonds?

I N T E R M E D I AT E > 21.21 Forward premium: The spot rate on the London market is £0.5514/$, while the 90-day forward

rate is £0.5589/$. What is the annualized forward premium or discount on the British pound?

21.22 Forward premium: Bank of America quoted the 180-day forward rate on the Swiss franc at
$1.0407/SF. The spot rate was quoted at $1.0268/SF. What is the forward premium or discount
on the Swiss franc?

21.23 Forward premium: The foreign exchange department at Tokyo’s Daiwa Bank quoted the spot
rate on the euro at €0.007269/¥. The 90-day forward rate is quoted at a premium of 5.42 percent
on the euro. What is the 90-day forward rate?

21.24 Forward premium: State Bank of India has offered a spot rate quote on Indian rupees (Rs) of
Rs43.54/$. The Indian rupee is quoted at a 30-day forward premium of 8.79 percent against the
dollar. What is the 30-day forward quote?

21.25 Bid-ask spread: The foreign exchange department of Bank of India has a bid quote on Indian
rupees (Rs) of Rs43.21/$. If the bank typically tries to earn a bid-ask spread of 0.5 percent on

Questions and Problems 699

21.26 Bid-ask spread: Banco Santiago wants to make a bid-ask spread of 0.65 percent on its foreign
exchange transactions. If the ask rate on the Mexican peso (MP) is MP10.3092/$, what does the
bid rate have to be?

21.27 Cross rate: Alcor Pharma just received revenues of $3,165,300 in Australian dollars (A$).
Management has the following exchange rates: A$1.5490/£ and $1.5906/£. What is the U.S. dol-
lar value of the company’s revenues?

21.28 Cross rate: Flint Corp. recently purchased auto parts worth 17.5 million Mexican pesos (MP)
on credit. Management needs to find out the U.S. dollar cost of the payables. It has access to two
quotes for Canadian dollars (C$): C$1.0174/$ and C$0.0820/MP. What did it cost Flint to pur-
chase the auto parts?

21.29 Hedging: Tricolor Industries has purchased equipment from a Brazilian firm for a total cost of
272,500 Brazilian reals. The firm has to pay in 30 days. Citibank has given the firm a 30-day for-
ward quote of $0.4723/real. Assume that on the day the payment is due, the spot rate is $0.4917/
real. How much would Tricolor save by hedging with a forward contract?

21.30 Eurocredit loan: A Swiss sporting goods company borrows in yen in the Eurocredit market at
a rate of 4.35 percent from Bank of America using a three-month rollover loan. Bank of America
assigns a default risk premium of 2 percent on the loan, and the country risk is an additional 0.75
percent. The bank can borrow funds in the Euromarket at the three-month LIBOR rate of 0.40
percent. What is Bank of America’s gross profit margin on this loan?

21.31 Covington Industries just sold equipment to a Mexican firm. Payment of 11,315,000 pesos will < ADVANCED
be due to Covington in 30 days. Covington has the option of selling the pesos at a 30-day forward
rate of $0.09139/peso. If it waits 30 days to sell the pesos, the expected spot rate is $0.0907/peso.
In dollars, how much better off is Covington by selling the pesos in the forward market?

21.32 Barrington Fertilizers, Inc., exports its specialized lawn care products to Canada. It made a sale
worth C$1,150,000, with the payment due in 90 days. Its banker gave it a forward quote of
$1.0177/C$. By using the forward rate, the firm gained an additional $8,433.25 over what it
would have gotten if it had sold the Canadian dollars in the spot market 90 days later. What was
the spot rate at the time the payment was received?

21.33 Moon Rhee Auto Supply, a Korean supplier of parts to Kia Motors, is evaluating an opportunity
to set up a plant in Alabama, where Kia Motors has an auto assembly plant for its SUVs. The cost
of this plant will be $13.5 million. The current spot rate is 1,120.318 Korean won per U.S. dollar.
The firm is expected to use this plant for the next five years and is expecting to generate the fol-
lowing cash flows:

Cash flows ($ millions) 12 Year 4 5
Expected exchange rate $2.3 $4.2 3 $5.8 $7.6
(Korean won/$)
1,105.231 1,115.632 $3.6 1,110.670

1,146.155 1,120.221

The firm uses a discount rate of 9 percent for projects like this in the United States.

What is the NPV of this project? Should Moon Rhee Auto Supply take on this project?

21.34 The Boeing Company has two different debt issues, both maturing four years from now. The
domestic bond issue pays semiannual coupons and has a coupon rate of 4.80 percent. The cur-
rent price on the bond is $962.75. The Eurobond issue is priced at $964.33 and pays an annual
coupon of 4.95 percent. What is the yield to maturity for each bond?

21.35 Caterpillar, Inc. management is trying to decide between selling a new bond issue in the U.S. or
the Eurodollar bond market. In either market the bonds will be denominated in dollars and will
have a three-year maturity. The domestic bonds will have a coupon rate of 4.1 percent and sell at
a market price of $1,034.25. The Eurobonds will have a coupon rate of 4 percent and will sell at
$1,029.76. Which bond issue will have the lowest cost to the firm?

21.36 IBM’s German unit is looking to borrow €7.5 million from Deutsche Bank. Deutsche Bank
quotes a rate of three-month LIBOR plus 0.25 percent for the 90-day loan. Currently, the three-
month LIBOR is 3.875 percent. What is IBM’s interest cost on the loan in Euros? If the exchange

700 CHAPTER 21 I International Financial Management

21.37 Toyota is interested in borrowing $5 million for 90 days. Bank of America has quoted a rate
which is 1.125 percent under the prime rate of 6.25 percent. Daiwa Bank is offering Toyota a rate
which is 0.75 percent over the three-month LIBOR of 4.2 percent. Which is the better deal for
Toyota, and what is the lower interest cost in dollars?

Sample Test Problems

21.1 Creighton Industries purchased €1,234,970 worth of electrical supplies from a German store
three months ago. The payment in euros is due today, and the firm has been quoted a spot rate of
$1.3163/€ by its bank. What is the dollar cost of Creighton’s purchase?

21.2 Traynor Corp. made a sale worth 27.3 million yen (¥) today to a Japanese firm. The yen/dollar spot
rate on the Japanese yen today is ¥79.37/$. How much is the sale worth in dollars if the revenue is
to be received today? The firm expects to receive payment after 30 days. The one-month forward
rate is quoted as ¥81.45/$. How much will the firm receive in one month if the payment is con-
verted at the forward rate?

21.3 If the spot rate on the Canadian dollar is C$1.3357/€ and the 90-day forward rate is C$1.3614/€,
what is the forward premium or discount on the Canadian dollar against the euro?

21.4 Deutsche Bank has offered the following exchange rate quotes: Rs72.64/£ and $1.5734/£. What is
the cross rate between the Indian rupees and the U.S. dollar?

21.5 Tantrix Industries sold equipment to a Mexican firm. Payment of 27,556,000 pesos will be due to
Tantrix in 30 days. Tantrix has the option of selling the pesos at a 30-day forward rate of $0.08914/
peso. If the company waits 30 days to sell the pesos and the spot rate turns out to be $0.08857/peso,
in dollars, how much better off will Tantrix be if the pesos are sold in the forward market?

Future Value and APPENDIX

APresent Value Tables

Appendix Tables

A-1 Future Value Factors for $1 Com-
pounded at i Percent Per Period
for N Periods

A-2 Present Value Factors for $1
Received at the End of N Periods,
Discounted at i Percent Per Period

A-3 Future Value of Annuity Factors
for $1 Received Per Period for
Each of N Periods, Compounded
at i Percent Per Period

A-4 Present Value of Annuity Factors
for $1 Received Per Period for
Each of N Periods, Discounted
at i Percent Per Period

TABLE A-1 Future Value Factors for $1 Compounded at i Percent Per Period for N Periods 9% 10%
i
1.090 1.100
N 1% 2% 3% 4% 5% 6% 7% 8% 1.188 1.210
1.295 1.331
1 1.010 1.020 1.030 1.040 1.050 1.060 1.070 1.080 1.412 1.464
1.539 1.611
2 1.020 1.040 1.061 1.082 1.103 1.124 1.145 1.166 1.677 1.772
1.828 1.949
3 1.030 1.061 1.093 1.125 1.158 1.191 1.225 1.260 1.993 2.144
2.172 2.358
4 1.041 1.082 1.126 1.170 1.216 1.262 1.311 1.360 2.367 2.594
2.580 2.853
5 1.051 1.104 1.159 1.217 1.276 1.338 1.403 1.469 2.813 3.138
3.066 3.452
6 1.062 1.126 1.194 1.265 1.340 1.419 1.501 1.587 3.342 3.797
3.642 4.177
7 1.072 1.149 1.230 1.316 1.407 1.504 1.606 1.714 3.970 4.595
4.328 5.054
8 1.083 1.172 1.267 1.369 1.477 1.594 1.718 1.851 4.717 5.560
5.142 6.116
9 1.094 1. 195 1.305 1.423 1.551 1.689 1.838 1.999 5.604 6.727
6.109 7.400
10 1.105 1.219 1.344 1.480 1.629 1.791 1.967 2.159 6.659 8.140
7.258 8.954
11 1.116 1.243 1.384 1.539 1.710 1.898 2.105 2.332 7.911 9.850
8.623 10.835
12 1.127 1.268 1.426 1.601 1.796 2.012 2.252 2.518 13.268 17.449
20.414 28.102
13 1.138 1.294 1.469 1.665 1.886 2.133 2.410 2.720 31.409 45.259
48.327 72.890
14 1.149 1.319 1.513 1.732 1.980 2.261 2.579 2.937 74.358 117.390

15 1.161 1.346 1.558 1.801 2.079 2.397 2.759 3.172

16 1.173 1.373 1.605 1.873 2.183 2.540 2.952 3.426

17 1.184 1.400 1.653 1.948 2.292 2.693 3.159 3.700

18 1.196 1.428 1.702 2.026 2.407 2.854 3.380 3.996

19 1.208 1.457 1.754 2.107 2.527 3.026 3.617 4.316

20 1.220 1.486 1.806 2.191 2.653 3.207 3.870 4.661

21 1.232 1.516 1.860 2.279 2.786 3.400 4.141 5.034

22 1.245 1.546 1.916 2.370 2.925 3.604 4.430 5.437

23 1.257 1.577 1.974 2.465 3.072 3.820 4.741 5.871

24 1.270 1.608 2.033 2.563 3.225 4.049 5.072 6.341

25 1.282 1.641 2.094 2.666 3.386 4.292 5.427 6.848

30 1.348 1.811 2.427 3.243 4.322 5.743 7.612 10.063

35 1.417 2.000 2.814 3.946 5.516 7.686 10.677 14.785

40 1.489 2.208 3.262 4.801 7.040 10.286 14.974 21.725

45 1.565 2.438 3.782 5.841 8.985 13.765 21.002 31.920

50 1.645 2.692 4.384 7.107 11.467 18.420 29.457 46.902

11% 12% 13% 14% 15% i 25% 30% 35% 40%
20%
1.110 1.120 1.130 1.140 1.150 1.250 1.300 1.350 1.400
1.232 1.254 1.277 1.300 1.323 1.200 1.563 1.690 1.823 1.960
1.368 1.405 1.443 1.482 1.521 1.440 1.953 2.197 2.460 2.744
1.518 1.574 1.530 1.689 1.749 1.728 2.441 2.856 3.322 3.842
1.685 1.762 1.842 1.925 2.011 2.074 3.052 3.713 4.484 5.378
1.870 1.974 2.082 2.195 2.313 2.488 3.815 4.827 6.053 7.530
2.076 2.211 2.353 2.502 2.660 2.986 4.768 6.275 8.172 10.541
2.305 2.476 2.658 2.853 3.059 3.583 5.960 8.157 11.032 14.758
2.558 2.773 3.004 3.252 3.518 4.300 7.451 10.604 14.894 20.661
2.839 3.106 3.395 3.707 4.046 5.160 9.313 13.786 20.107 28.925
3.152 3.479 3.836 4.226 4.652 6.192 11.642 17.922 27.144 40.496
3.498 3.896 4.335 4.818 5.350 7.430 14.552 23.298 36.644 56.694
3.883 4.363 4.898 5.492 6.153 8.916 18.190 30.288 49.470 79.371
4.310 4.887 5.535 6.261 7.076 10.699 22.737 39.374 66.784 111.120
4.785 5.474 6.254 7.138 8.137 12.839 28.422 51.186 90.158 155.560
5.311 6.130 7.067 8.137 9.358 15.407 35.527 66.542 121.710 217.790
5.895 6.866 7.986 9.276 10.761 18.488 44.409 86.504 164.310 304.910
6.544 7.690 9.024 10.575 12.375 22.186 55.511 112.450 221.820 426.870
7.263 8.613 10.197 12.056 14.232 26.623 69.389 146.190 299.460 597.630
8.062 9.646 11.523 13.743 16.367 31.948 86.736 190.050 404.270 836.680
8.949 10.804 13.021 15.668 18.822 38.338 108.420 247.060 545.760 1171.300
9.934 12.100 14.714 17.861 21.645 46.005 135.520 321.180 716.780 1639.800
10.026 13.552 16.627 20.362 24.891 55.206 169.400 417.530 994.660 2297.800
12.239 15.179 18.788 23.212 28.625 66.247 211.750 542.800 1342.700 3214.200
13.585 17.000 21.231 26.462 32.919 79.497 264.690 705.640 1812.700 4499.800
22.892 29.960 39.116 50.950 66.212 95.396 807.790 2619.900 8128.500 24201.000
38.575 52.800 72.069 98.100 133.170 237.370 2465.100 9727.800 36448.000 130161.000
65.001 93.051 132.782 188.880 267.860 590.660 7523.100 36118.000 163437.000 700037.000
109.530 163.980 244.641 363.670 538.760 1469.700 22958.000 134106.000 732857.000
184.560 289.000 450.735 700.230 1083.600 3657.200 70064.000 497929.000
9100.400

TABLE A-2 Present Value Factors for $1 Received at the End of N Periods, Discounted at i Percent Per Period 10%
i
.909
N 1% 2% 3% 4% 5% 6% 7% 8% 9% .826
.751
1 .990 .980 .971 .962 .952 .943 .935 .926 .917 .683
2 .980 .961 .943 .925 .907 .890 .873 .857 .842 .621
3 .971 .942 .915 .889 .864 .840 .816 .794 .772 .564
4 .961 .924 .888 .855 .823 .792 .763 .735 .708 .513
5 .951 .906 .863 .822 .784 .747 .713 .681 .650 .467
6 .942 .888 .837 .790 .746 .705 .666 .630 .596 .424
7 .932 .871 .813 .760 .711 .665 .623 .583 .547 .386
8 .923 .853 .789 .731 .677 .627 .582 .540 .502 .350
9 .914 .837 .766 .703 .645 .592 .544 .500 .460 .319
10 .905 .820 .744 .676 .614 .558 .508 .463 .422 .290
11 .896 .804 .722 .650 .585 .527 .475 .429 .388 .263
12 .887 .788 .701 .625 .557 .497 .444 .397 .356 .239
13 .879 .773 .681 .601 .530 .469 .415 .368 .326 .218
14 .870 .758 .661 .577 .505 .442 .388 .340 .299 .198
15 .861 .743 .642 .555 .481 .417 .362 .315 .275 .180
16 .853 .728 .623 .534 .458 .394 .339 .292 .252 .164
17 .844 .714 .605 .513 .436 .371 .317 .270 .231 .149
18 .836 .700 .587 .494 .416 .350 .296 .250 .212 .135
19 .828 .686 .570 .475 .396 .331 .277 .232 .194 .123
20 .820 .673 .554 .456 .377 .312 .258 .215 .178 .112
21 .811 .660 .538 .439 .359 .294 .242 .199 .164 .102
22 .803 .647 .522 .422 .342 .278 .226 .184 .150 .092
23 .795 .634 .507 .406 .326 .262 .211 .170 .133 .057
24 .788 .622 .492 .390 .310 .247 .197 .158 .126 .036
25 .780 .610 .478 .375 .295 .233 .184 .146 .116 .022
30 .742 .552 .412 .308 .231 .174 .131 .099 .075 .014
35 .706 .500 .355 .253 .181 .130 .094 .068 .049 .009
40 .672 .453 .307 .208 .142 .097 .067 .046 .032
45 .639 .410 .264 .171 .111 .073 .048 .031 .021
50 .608 .372 .228 .141 .087 .054 .034 .021 .013

i
11% 12% 13% 14% 15% 20% 25% 30% 35% 40%

.901 .893 .885 .877 .870 .833 .800 .769 .741 .714
.812 .797 .783 .769 .756 .694 .640 .592 .449 .510
.731 .712 .693 .675 .658 .579 .512 .455 .406 .364
.659 .636 .613 .592 .572 .482 .410 .350 .301 .260
.593 .567 .543 .519 .497 .402 .328 .269 .223 .186
.535 .507 .480 .456 .432 .335 .262 .207 .165 .133
.482 .452 .425 .400 .376 .279 .210 .159 .122 .095
.434 .404 .376 .351 .327 .233 .168 .123 .091 .068
.391 .361 .333 .308 .284 .194 .134 .094 .067 .048
.352 .322 .295 .270 .247 .162 .107 .073 .050 .035
.317 .287 .261 .237 .215 .135 .086 .056 .037 .025
.286 .257 .231 .208 .187 .112 .069 .043 .027 .018
.258 .229 .204 .182 .163 .093 .055 .033 .020 .013
.232 .205 .181 .160 .141 .078 .044 .025 .015 .009
.209 .183 .160 .140 .123 .065 .035 .020 .011 .006
.188 .163 .141 .123 .107 .054 .028 .015 .008 .005
.170 .146 .125 .108 .093 .045 .023 .012 .006 .003
.153 .130 .111 .095 .081 .038 .018 .009 .005 .002
.138 .116 .098 .083 .070 .031 .014 .007 .003 .002
.124 .104 .087 .073 .061 .026 .012 .005 .002 .001
.112 .093 .077 .064 .053 .022 .009 .004 .002 .001
.101 .083 .068 .056 .046 .018 .007 .003 .001 .001
.091 .074 .060 .049 .040 .015 .006 .002 .001
.082 .066 .053 .043 .035 .013 .005 .002 .001
.074 .059 .047 .038 .030 .010 .004 .001 .001
.044 .033 .026 .020 .015 .004 .001
.026 .019 .014 .010 .008 .002
.015 .011 .008 .005 .004 .001
.009 .006 .004 .003 .002
.005 .003 .002 .001 .001

TABLE A-3 Future Value of Annuity Factors for $1 Received Per Period for Each of N Periods, Compounded
at i Percent Per Period

i

N 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000

2 2.010 2.020 2.030 2.040 2.050 2.060 2.070 2.080 2.090 2.100

3 3.030 3.060 3.091 3.122 3.152 3.184 3.215 3.246 3.278 3.310

4 4.060 4.122 4.184 4.246 4.310 4.375 4.440 4.506 4.573 4.641

5 5.101 5.204 5.309 5.416 5.526 5.637 5.751 5.867 5.985 6.105

6 6.152 6.308 6.468 6.633 6.802 6.975 7.153 7.336 7.523 7.716

7 7.214 7.434 7.662 7.898 8.142 8.394 8.654 8.923 9.200 9.487

8 8.286 8.583 8.892 9.214 9.549 10.897 10.260 10.637 11.028 11.436

9 9.369 9.755 10.159 10.583 11.027 11.491 11.978 12.488 13.021 13.579

10 10.462 10.950 11.464 12.006 12.578 13.181 13.816 14.487 15.193 15.937

11 11.567 12.169 12.808 13.486 14.207 14.972 15.784 16.645 17.560 18.531

12 12.683 13.412 14.192 15.026 15.917 16.870 17.888 18.977 20.141 21.384

13 13.809 14.680 15.618 16.627 17.713 18.882 20.141 21.495 22.953 24.523

14 14.947 15.971 17.086 18.292 19.599 21.015 22.550 24.215 26.019 27.975

15 16.097 17.291 18.599 20.024 21.579 23.276 25.129 27.152 29.361 31.722

16 17.258 18.639 20.157 21.825 23.657 25.673 27.888 30.324 33.003 35.950

17 18.430 20.012 21.762 23.698 25.840 28.213 30.840 33.750 36.974 40.545

18 19.615 21.412 23.414 25.645 28.132 30.906 33.999 37.450 41.301 45.599

19 20.811 22.841 25.117 27.671 30.539 33.760 37.379 41.446 46.018 51.159

20 22.019 24.297 26.870 29.778 33.066 36.786 40.995 45.762 51.160 57.275

21 23.239 25.783 28.676 31.969 35.719 39.993 44.865 50.423 56.765 64.002

22 24.472 27.299 30.537 34.248 38.505 43.392 49.006 55.457 62.873 71.403

23 25.716 28.845 32.453 36.618 41.430 46.996 53.436 60.893 69.532 79.543

24 26.973 30.422 34.426 39.083 44.502 50.816 58.177 66.765 76.790 88.497

25 28.243 32.030 36.459 41.646 47.727 54.865 63.249 73.106 84.701 98.347

30 34.785 40.568 47.575 56.085 66.439 79.058 94.461 113.280 136.300 164.490

35 41.660 49.994 60.462 73.652 90.320 111.430 138.230 172.310 215.710 271.020

40 48.886 60.402 75.401 95.026 120.800 154.760 199.630 259.050 337.880 442.590

45 56.481 71.893 92.720 121.020 159.700 212.740 285.740 386.500 525.850 718.900

50 64.463 84.579 112.790 152.660 209.340 290.330 406.520 573.770 815.080 1163.900

11% 12% 13% 14% 15% i 25% 30% 35% 40%
20%
1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
2.110 2.120 2.130 2.140 2.150 1.000 2.250 2.300 2.350 2.400
3.342 3.374 3.407 3.440 3.472 2.200 3.813 3.990 4.172 4.360
4.710 4.779 4.850 4.921 4.993 3.640 5.766 6.187 6.633 7.104
6.228 6.353 6.480 6.610 6.742 5.368 8.207 9.043 9.954 10.196
7.913 8.115 8.232 8.536 8.754 7.442 11.259 12.756 14.438 16.324
9.783 10.089 10.405 10.730 11.067 9.930 15.073 17.583 20.492 23.853
11.859 12.300 12.757 13.233 13.727 12.916 19.842 23.858 28.664 34.395
14.164 14.776 15.416 16.085 16.786 16.499 25.802 32.015 39.696 49.153
16.722 17.549 18.420 19.337 20.304 20.799 33.253 42.619 54.590 69.814
19.561 20.655 21.814 23.045 24.349 25.959 42.566 56.405 74.697 98.739
22.713 24.133 25.650 27.271 29.002 32.150 54.208 74.327 101.840 139.230
26.212 28.029 29.985 32.089 34.352 39.581 68.760 97.625 138.480 195.920
30.095 32.393 34.883 37.581 40.505 48.497 86.949 127.910 187.950 275.300
34.405 37.280 40.417 43.842 47.580 59.196 109.680 167.280 254.730 386.420
39.190 42.753 46.672 50.980 55.717 72.035 138.100 218.470 344.890 541.980
44.501 48.884 53.739 59.118 65.075 87.442 173.630 285.010 466.610 759.780
50.396 55.750 61.725 68.394 75.836 105.930 218.040 371.510 630.920 1064.600
56.939 63.440 70.749 78.969 88.212 128.110 273.550 483.970 852.740 1491.500
64.203 72.052 80.947 91.025 102.440 154.740 342.940 630.160 1152.200 2089.200
72.265 81.699 92.470 104.760 118.810 186.680 429.680 820.210 1556.400 2925.800
81.214 92.503 105.491 120.430 137.630 225.020 538.100 1067.200 2102.200 4097.200
91.148 104.600 120.205 138.290 159.270 271.030 673.620 1388.400 2839.000 5737.100
102.170 118.150 136.831 158.650 184.160 326.230 843.030 1806.000 3833.700 8032.900
114.410 133.330 155.620 181.870 212.790 392.480 1054.700 2348.800 5176.500 11247.000
199.020 241.330 293.199 356.780 434.740 471.980 3227.100 8729.900 23221.000 60501.000
341.590 431.660 546.681 693.570 881.170 1181.800 9856.700 32422.000 104136.000 325400.000
581.820 767.090 1013.704 1342.000 1779.000 2948.300 30088.000 120392.000 466960.000
986.630 1358.200 1874.165 2490.500 3585.100 7343.800 91831.000 447019.000
1668.700 2400.000 3459.507 4994.500 7217.700 18281.000 280255.000
45497.000

TABLE A-4 Present Value of Annuity Factors for $1 Received Per Period for Each of N Periods, Discounted at i Percent Per Period

i

N 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909

2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736

3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487

4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170

5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791

6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355

7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868

8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335

9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759

10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145

11 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495

12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814

13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103

14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367

15 13.865 12.849 11.938 11.118 10.380 9.712 9.108 8.559 8.061 7.606

16 14.718 13.578 12.561 11.652 10.838 10.106 9.447 8.851 8.313 7.824

17 15.562 14.292 13.166 12.166 11.274 10.477 9.763 9.122 8.544 8.022

18 16.398 14.992 13.754 12.659 11.690 10.828 10.059 9.372 8.756 8.201

19 17.226 15.678 14.324 13.134 12.085 11.158 10.336 9.604 8.950 8.365

20 18.046 16.351 14.877 13.590 12.462 11.470 10.594 9.818 9.129 8.514

21 18.857 17.011 15.415 14.029 12.821 11.764 10.836 10.017 9.292 8.649

22 19.660 17.658 15.937 14.451 13.163 12.042 11.061 10.201 9.442 8.772

23 20.456 18.292 16.444 14.857 13.489 12.303 11.272 10.371 9.580 8.883

24 21.243 18.914 16.936 15.247 13.799 12.550 11.469 10.529 9.707 8.985

25 22.023 19.523 17.413 15.622 14.094 12.783 11.654 10.675 9.823 9.077

30 25.808 22.396 19.600 17.292 15.372 13.765 12.409 11.258 10.274 9.427

35 29.409 24.999 21.487 18.665 16.374 14.498 12.948 11.655 10.567 9.644

40 32.835 27.355 23.115 19.793 17.159 15.046 13.332 11.925 10.757 9.779

45 36.095 29.490 24.519 20.720 17.774 15.456 13.606 12.108 10.881 9.863

50 39.196 31.424 25.730 21.482 18.256 15.762 13.801 12.233 10.962 9.915

11% 12% 13% 14% 15% i 25% 30% 35% 40%
20%
0.901 0.893 0.885 0.877 0.870 0.800 0.769 0.741 0.714
1.713 1.690 1.668 1.647 1.626 0.833 1.440 1.361 1.289 1.224
2.444 2.402 2.361 2.322 2.283 1.528 1.952 1.816 1.696 1.589
3.102 3.037 2.974 2.914 2.855 2.106 2.362 2.166 1.997 1.849
3.696 3.605 3.517 3.433 3.352 2.589 2.689 2.436 2.220 2.035
4.231 4.111 3.998 3.889 3.784 2.991 2.951 2.643 2.385 2.168
4.712 4.564 4.423 4.288 4.160 3.326 3.161 2.802 2.508 2.263
5.146 4.968 4.799 4.639 4.487 3.605 3.329 2.925 2.598 2.331
5.537 5.328 5.132 4.946 4.772 3.837 3.463 3.019 2.665 2.379
5.889 5.650 5.426 5.216 5.019 4.031 3.571 3.092 2.715 2.414
6.207 5.938 5.687 5.453 5.234 4.192 3.656 3.147 2.752 2.438
6.492 6.194 5.918 5.660 5.421 4.327 3.725 3.190 2.779 2.456
6.750 6.424 6.122 5.842 5.583 4.439 3.780 3.223 2.799 2.469
6.982 6.628 6.302 6.002 5.724 4.533 3.824 3.249 2.814 2.478
7.191 6.811 6.462 6.142 5.847 4.611 3.859 3.268 2.825 2.484
7.379 6.974 6.604 6.265 5.954 4.675 3.887 3.283 2.834 2.489
7.549 7.120 6.729 6.373 6.047 4.730 3.910 3.295 2.840 2.492
7.702 7.250 6.840 6.467 6.128 4.775 3.928 3.304 2.844 2.494
7.839 7.366 6.938 6.550 6.198 4.812 3.942 3.311 2.848 2.496
7.963 7.469 7.025 6.623 6.259 4.843 3.954 3.316 2.850 2.497
8.075 7.562 7.102 6.687 6.312 4.870 3.963 3.320 2.852 2.498
8.176 7.654 7.170 6.743 6.359 4.891 3.970 3.323 2.853 2.498
8.266 7.718 7.230 6.792 6.399 4.909 3.976 3.325 2.854 2.499
8.348 7.784 7.283 6.835 6.434 4.925 3.981 3.327 2.855 2.499
8.422 7.843 7.330 6.873 6.464 4.937 3.985 3.329 2.856 2.499
8.694 8.055 7.496 7.003 6.566 4.948 3.995 3.332 2.857 2.500
8.855 8.176 7.586 7.070 6.617 4.979 3.998 3.333 2.857 2.500
8.951 8.244 7.634 7.105 6.642 4.992 3.999 3.333 2.857 2.500
9.008 8.283 7.661 7.123 6.654 4.997 4.000 3.333 2.857 2.500
9.042 8.304 7.675 7.133 6.661 4.999 4.000 3.333 2.857 2.500
4.999

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Solutions to

BSelected Questions
and Problems

CHAPTER 1 the business community and local and national governments. Lower for- APPENDIX
eign investment has led to slower overall economic growth than the
1.1 The two basic sources of funds for all businesses are debt and equity. country might otherwise have enjoyed.

1.3 A profitable firm is able to generate enough cash flows from pro- 1.25 An information asymmetry exists when one party to a business
ductive assets to cover its operating expenses, taxes, and payments to transaction possesses information that is not available to the other parties
creditors. Unprofitable firms fail to do this, and therefore they may be in the transaction. If the parties with less information understand their
forced to declare bankruptcy. relative disadvantage, they are likely to pay lower prices for the goods or
services they purchase, or charge higher prices for the goods and services
1.5 A firm should undertake a capital project only if the value of its that they sell.
future cash flows exceeds the cost of the project.
CHAPTER 2
1.7 The financial manager must make working capital decisions re-
garding the level of inventory to hold, the terms of granting credit (ac- 2.1 The role of the financial system is to gather money from businesses
count receivables), and the firm’s policy on paying accounts payable. and individuals who have surplus funds and channel funds to those who
need them. The financial system consists of financial markets and finan-
1.9 Advantages: easiest business type to start; least regulated; owners cial institutions.
have full control; all income is taxed as personal income. Disadvantages:
unlimited liability of proprietor; initial capital limited to proprietor’s 2.3 Saver-lenders are those who have more money than they need right
wealth; difficult to transfer ownership. now. The principal saver-lenders in the economy are households. Bor-
rower-spenders are those who need the money saver-lenders are offering.
1.11 The owners of a corporation are its stockholders, and the evidence The main borrower-spenders in the economy are businesses and the fed-
of their ownership is represented by shares of common stock. eral government.

1.13 Double taxation occurs when earnings are taxed twice. The owners 2.5 Your security seems to be marketable, but not liquid. Liquidity im-
of a corporation are subject to double taxation—first at the corporate plies that when a security is sold, its value will be preserved, marketability
level when the firm’s earnings are taxed and then again at a personal level does not.
when the dividends they receive are taxed.
2.7 Trader, Inc., is more likely to go public because of its larger size.
1.15 The board of directors of a corporation is responsible for serving Though the cost of SEC registration and compliance is very high, larger
the interests of stockholders in managing the corporation. It is possible firms can offset these costs by the lower funding cost in public markets.
that the interests of managers may deviate from those of their stockhold- Smaller companies find the cost prohibitive for the dollar amount of se-
ers. The board’s objective is to hire and monitor managers to ensure that curities they sell.
they are acting in the best interests of the stockholders. Board duties in-
clude hiring and firing the CEO, setting CEO pay, and monitoring the 2.9 a. secondary; b. secondary; c. primary
investment decisions of managers.
2.11 a. $300,000; b. 3.05%; c. $9,850,000
1.17 Problems include: It is difficult to determine what is meant by
profits; it does not address the size and timing of cash flows (it does not 2.13 Financial intermediaries allow smaller companies to access the
account for the time value of money); and it ignores the uncertainty (risk) financial markets. They do this by converting securities with one set of
of cash flows. characteristics into securities with another set of characteristics that
meets the needs of smaller companies. By repackaging securities, they are
1.19 Factors that affect the stock price include: The characteristics of able to meet the needs of different clients.
the firm, the economy, economic shocks, the business environment,
expected cash flows, and current market conditions. 2.15 Money markets are markets where short-term debt instruments
with maturities of less than one year are bought and sold. Capital markets
1.21 If a firm’s stock price falls sustainably below its maximum potential are markets where equity securities and debt instruments with maturities
price, it might attract corporate raiders. These persons look for firms that of more than one year are sold.
are fundamentally sound but poorly managed, so that they can buy the
firm, turn it around, and sell it for a profit. 2.17 Treasury bills, Bank negotiable CDs, and Commercial paper

1.23 A lack of business ethics can lead to corruption, which, in turn, 2.19 The strong-form of market efficiency states that all information is
creates inefficiencies in an economy, inhibits the growth of capital mar- reflected in the security’s price. In other words, there is no private or in-
kets, and slows the rate of overall economic growth. For example, the side information that, if released, would potentially change the price. The
Russian economy has had a relatively difficult time attracting foreign semistrong-form of market efficiency holds that all public information
investment since the fall of the Soviet Union due, in part, to corruption in

712 Solutions to Selected Questions and Problems CHAPTER 4

vailable to investors is reflected in the security’s price. Therefore, insiders 4.1 The quick ratio provides a better measure of liquidity because it
with access to private information could potentially profit from trading includes only the most liquid of the current assets.
n this information before it becomes public. Finally, the weak form of 4.3 $1,627,579
market efficiency holds that there is both public and private information 4.5 2.87 times; 127.1 days
hat is not reflected in the security’s price and having access to it can en- 4.7 2.65; 0.623; 29.9%
ble an investor to earn abnormal profits. 4.9 29.93%
2.21 Yes. The last sentence in the Problem 2.20 problem statement sug- 4.11 a. Trademark is not doing as well as its competitors. The total
ests why this might happen. If, on the same day of the announcement,
ome very bad news about the future prospects for Zippy became public asset and inventory turnover ratios indicate that the firm either
r if the market went down substantially, Zippy’s stock price might also needs to increase its sales relative to its level of total assets and
have gone down despite the positive sales and earnings announcement. inventory or reduce its total assets and inventory relative to its level
2.23 Public markets are organized financial markets where the public of sales. In addition, the lower quick ratio indicates that Trademark
uys and sells securities through their stock brokers. The SEC regulates has less liquidity. The higher DSO indicates that accounts receiv-
able are relatively high.
ublic securities markets in the United States. In contrast, private markets b. Average industry ratios serve as benchmarks that management
nvolve direct transactions between two parties. These transactions lack can use to assess a firm’s performance. While no two firms are
EC regulation. identical in any industry, the average ratios across an industry are
2.25 The real rate of interest measures the return earned on savings, and generally good target ratios for a firm.
t represents the cost of borrowing to finance capital goods. The real rate 4.13 1.34
f interest is determined by the interaction between firms that invest in 4.15 $3,825,000
apital projects and the rate of return they expect to earn on those invest- 4.17 $843,863
ments, and individuals’ time preference for consumption. The rate of in- 4.19 2.27; 1.27
erest is determined when the desired level of savings equals the desired 4.21 51.2%; 19.1%; 12.6%
evel of investments in the economy. 4.23 0.41; 36.02%; 18.32%; 25.92%
2.27 The Fisher equation is an equation that shows how the expected, 4.25 34.4 times; 22.04 times
not the reported or actual, annualized change in commodity prices (⌬Pe) 4.27 $6,473,600; 5.7%
s related to the nominal and real rates of interest. It is used to determine 4.29 $10,226,559; $88,236,056; 0.82
he nominal rate that protects the buying power of a lender’s money 4.31 Current ratio ϭ 0.77; quick ratio ϭ 0.57, gross margin ϭ 51.2%;
rom changes in inflation. It is also used to determine the interest rate, by profit margin ϭ 12.6%; debt ratio ϭ 0.70; long-term debt to equity ϭ
ubtracting ⌬Pe from the nominal interest rate, that would exist in the 0.73; interest coverage ϭ 15.6; ROA ϭ 11.4%; ROE ϭ 37.5%
bsence of inflation. 4.33 Profit margin ϭ 12.61%; total asset turnover ϭ 0.90; equity mul-
2.29 Yes. The CD will be worth $1,067.50 at the end of the year, and the tiplier ϭ 3.30; return on equity ϭ 12.61% ϫ 0.90 ϫ 3.30 ϭ 37.5%
rice of the trip will be $1,066. 4.35 $292,756.63
4.37 Current ratio ϭ 1.81; quick ratio ϭ 1.19; inventory turnover ϭ
CHAPTER 3 3.50; accounts receivable turnover ϭ 5.16; DSO ϭ 70.76; total asset turn-
over ϭ 1.23; fixed asset turnover ϭ 7.15; total debt ratio ϭ 0.63; debt to
3.1 $97,118 equity ratio ϭ 1.72, equity multiplier ϭ 2.72; times interest earned ϭ
3.3 FIFO makes sense during times of rising prices because it allows 17.56; cash coverage ϭ 37.30, gross profit margin ϭ 0.36; net profit mar-
he firm to eliminate the lower-priced inventory first, which results in gin ϭ 0.08; ROA ϭ 0.10; ROE ϭ 0.27
higher profit margins.
3.5 $6,655,610 CHAPTER 5
3.7 $242,401.25
3.9 Ϫ$132.085 5.1 $53,973.12
3.11 Noncash expenses are expenses identified on income statement 5.3 $6,712.35
hat did not result in cash flows. Depreciation and amortization are ex- 5.5 $3,289.69
mples of such expenses. 5.7 $154,154.24; $154,637.37; $154,874.91; $154,883.03
3.13 $284,061 5.9 $16,108.92
3.15 The average tax rate is the total taxes paid divided by taxable 5.11 $6,507.05
ncome. The marginal tax rate is the tax rate that is paid on the last 5.13 $734.83
5.15 7.42%; You should borrow from the bank.
ollar of income earned, or the rate that will be paid on the next dol- 5.17 92,016; 101,218
ar earned. 5.19 1,045 members
3.17 $502,838.24 5.21 a. $2,246.57; b. $2,073.16;
3.19 $222,764
3.21 $137,263 c. $2,946.96; d. $2,949.88
3.23 $1,804,545.76 5.23 11 years
3.25 $621,178 5.25 3.8 years
3.27 $218,364.32; 34%; 34%
3.29 $715,719.75
3.31 $198,152
3.33 CFNWC ϭ Ϫ$16,467

Solutions to Selected Questions and Problems 713

5.29 The present value of $2,100 is $1,869. Since $1,869 is greater than security has no risk, and therefore requires no compensation for risk
$1,820, Caroline should wait two years unless she needs the money bearing. The expected return of your portfolio should therefore be greater
sooner. than the return from the risk-free security.
5.31 13.96%
5.33 Option 1: $26,803.77; Option 2: $23,579.48 7.23 The statement is false. A portfolio of all assets would only eliminate
5.35 Option C: $7,083,096.26 unsystematic risk. The systematic risk would remain. If you could elimi-
5.37 13.14% nate both systematic and unsystematic risk, the expected rate of return on
the market portfolio would be equal to the risk-free rate of return, and we
CHAPTER 6
know that this is not true.
6.1 $74,472.48
6.3 $3,185.40 7.25 0.124
6.5 $5,747.40
6.7 $5,652.06 7.27 0.185; 0.165
6.9 $247,609.95
6.11 $1,361,642.36 7.29 0.19
6.13 $4,221.07
6.15 a. $15,000; b. $6,000; c. $10,000 7.31 If all investors require returns that compensate them for the level
6.17 7% of risk that they bear, then undiversified investors will require a greater
6.19 $5,391,977.89 return for a given investment than diversified investors. In other words,
6.21 $1,496,377.71
6.23 $1,193,831.54 diversified investors will be willing to pay a higher price for an asset than
6.25 $7,000,000 undiversified investors. Therefore, a diversified investor is the marginal
6.27 $2,958,460 investor whose purchase will determine the price, and therefore the ex-
6.29 a. $17,857.14; b. $114,533.97; c. $4,250 pected return for an asset.
6.31 b. 8.57%
6.33 $20,495.15 7.33 Risk-free asset
6.35 $3,971.94
6.37 5% 7.35 The first security is underpriced, and the second is overpriced.
6.39 a. $1,906,071.48; b. $2,272,554.25;
7.37 ␴RA ϭ 0.06; ␤B ϭ 2.25; ␳RC,M ϭ 1.00; ␳RM,M ϭ 1.00; ␤M ϭ 1.00;
c. $212,889.63; d. $181,804.34 ␳RT-bill,M ϭ 0; ␤T-bill ϭ 0
6.41 $2,048.27
E(RA) ϭ 0.125; E(RB) ϭ 0.1625; E(RC) ϭ 0.075
CHAPTER 7
A comparison of the expected returns that are given in the problem
7.1 A holding period return is the total return over some investment or statement, with the returns that CAPM predicts (which are presented
“holding” period. It consists of a capital appreciation component and an
income component. A holding period return reflects past performance. above), indicates that you should buy stocks A and C and avoid stock B.
An expected return is the probability-weighted average of the possible
returns from an investment. It describes a possible return (or even a re- CHAPTER 8
turn that may not be possible) for a yet to occur investment period.
7.3 $78,000 8.1 $1,147.20
7.5 Stock B
7.7 Risk that cannot be diversified away is systematic risk. It is the only 8.3 $1,008.15
type of risk that exists in a diversified portfolio, and it is the only type of
risk that is rewarded in asset markets. 8.5 $975.91
7.9 Since a U.S. Treasury bill has no systematic risk, its beta should
equal 0. 8.7 $359.38
7.11 The CAPM describes the relation between systematic risk and the
expected return that investors require for bearing that risk. 8.9 6.58%; 6.69%
7.13 $1,250
7.15 0.145; 0.162 8.11 9.52%
7.17 0.125; 0.168
7.19 ␴12 ϭ 0.12, 0.1225; ␴12 ϭ 0, 0.0625; ␴12 ϭ Ϫ0.12, 0.0025 8.13 $1,000
7.21 Your portfolio contains no unsystematic risk but it does contain
systematic risk. Therefore, the market should compensate the holder of 8.15 $912.61; 1,370 contracts

8.17 $1,079.22

8.19 12.45%

8.21 7.23%; 7.36%

8.23 11.49% (EAY ϭ 11.82%)

8.25 8.65% (EAY ϭ 8.84%)

8.27 a. $924.75; b. 7.80% (EAY ϭ 7.95%)

8.29 a. $904.76; b. $1,086.46, $832.53;
c. Bond prices decrease when interest rates go up and increase

when interest rates go down.
d. $1,063.42, $866.65.

8.31 a. $25
b. The stock price would have to increase by two standard deviations

(2 ϫ $5 ϭ $10) for the price to increase to $25 and for conver-
sion to become attractive to the investors. From Chapter 7 we

know that 95% of possible outcomes fall within 1.96 standard
deviations of the mean (average) value in a normal distribution.

This means that there is approximately a 5 percent chance that
the stock price will move up or down by $10 or more. Since the

normal distribution is symmetric, this means that there is only
a 2.5 percent chance that Zippy’s stock price will increase

enough for it to become attractive for the investors to exercise

714 Solutions to Selected Questions and Problems The CFO’s decision to choose the golf belts project is the right choice
because it yields the higher net present value for Ancala’s investors.
CHAPTER 9 10.27 a. 9%; b. 12.3%; c. 16.3%.
10.29 a. 10.7%; 15%; b. No to Project 1, Yes to Project 2; The
9.1 A stock market index is an index which is used to measure the per- decision should be based on the project NPVs.
ormance of a stock market. These indexes reflect the value of the stocks 10.31 7.6%; 19.2%; 25.1%; Only projects 2 and 3 should be accepted.
n a particular market, such as the NYSE or the NASDAQ, or across mar- 10.33 18.8%, 20%; Both projects should be accepted.
ets and increase and decrease as the values of the stocks go up and down. 10.35 a. 3.8 years; b. $2,189,325; c. 20.3%.
Examples of stock market indexes include the Dow Jones Industrial Aver- 10.37 a. 3.21 years; b. 46.2%; c. $1,229,085; d. 32.5%.
ge, the New York Stock Exchange Index, the Standard & Poor’s 500 10.39 a. 6 years, 8.8 years; b. $116,980; c. 12.5%.
ndex, and the NASDAQ Composite Index.
9.3 National Association of Securities Dealers Automatic Quotation CHAPTER 11
ystem. NASDAQ is one of the world’s largest electronic markets, listing
ver three thousand companies. 11.1 The main reason is that accounting earnings generally differ from
9.5 $14.24 free cash flows, and free cash flows are what stockholders care about.
9.7 $27.39 11.3 Subtract depreciation from EBITDA, multiply by (1- tax rate), and
9.9 $8.50 add back depreciation. This enables us to account for the fact that depre-
9.11 $31.12 ciation reduces the taxes that must be paid.
9.13 12.15% 11.5 The average tax rate is the total amount of tax divided by total
9.15 $56.90 amount of money earned, while the marginal tax rate is the rate paid on
9.17 $2.46 the last dollar earned. Use the marginal tax rate when calculating incre-
9.19 $21.07 mental after-tax free cash flows.
9.21 $5.15 11.7 Variable costs vary directly with the number of units sold. Fixed
9.23 $23.35 costs do not vary with the number of units sold.
9.25 $32.34 11.9 $9,547.20
9.27 $25.95 11.11 $1,370
9.29 $2.15 11.13 The Equivalent Annual Cost (EAC) is the annual payment from
9.31 $73.94 an annuity that has a life equal to that of a project and that has the same
9.33 a. $34.45 NPV as the project.
11.15 $891.84
b. No, she should not buy more shares. This stock is overpriced 11.17 marginal ϭ 35%; averageϭ34.2%
with the stock selling at a higher price than what it is worth. 11.19 $168,020,000
She should sell her shares. 11.21 EACA ϭ Ϫ$6,569.55; EACB ϭ Ϫ$6,199.69; You should choose
machine B because it has the lowest equivalent annual cost.
9.35 a. $6.37; b. $62.03; c. $48.24 11.23 NPV1 ϭ $625,000; NPV2 ϭ $797,194; NPV3 ϭ $854,136; NPV4
9.37 a. $2.41; b. $37.86; c. $20.67 ϭ $826,174; Therefore, you should sell the company three years later.
11.25 NPVHyundai ϭ $20,387.59
d. No, the length of the holding period has no bearing on today’s
stock price. EACHyundai ϭ $1,707.8 Ͼ $1,500
Therefore, you should drive the 1993 Nissan for three more years
CHAPTER 10 and then buy a new Hyundai.
11.27 The rate of gold price appreciation is greater than the opportunity
10.1 $62,337 cost of capital for the next two years, and then it drops below the oppor-
10.3 Yes; NPV ϭ $134,986 tunity cost of capital. Therefore, Anaconda should sell the gold at the be-
10.5 Blanda should invest in System 2. The NPV of System 1 is ginning of the third year (or at the end of the second year).
22,969.42 and the NPV of System 2 is $36,001.43. 11.29 NPV ϭ $14,483,370; You should approve the project.
10.7 2.87 years 11.31 Yes; the NPV ϭ $38,356
10.9 3.45 years 11.33 $532,089.14
10.11 33.8% 11.35 Ϫ$363,814
10.13 $1,496,910; $1,084,734; The Alpha 8300 should be chosen.
10.15 $27,222; $732,228; Both projects should be chosen. CHAPTER 12
10.17 No; The payback for the investment is 4.33 years.
10.19 Type 2; Type 2 has the shortest payback period at 3.6 years. 12.1 Variable costs vary with the number of units of output. Fixed costs
10.21 20.1% cannot be changed in the short-term, regardless of how much output the
10.23 22.7% project produces.
10.25 The IRRs and NPVs of the belt and hat lines disagree because of 12.3 Yes. EBIT is $375,000 with the new technology and $250,000 with
he difference in the scale of the projects. The hats projects will deliver a the old.
higher IRR because it requires a lower initial investment. Thus, even with 12.5 0.392
ower cash inflows in the years after startup, the hats project is able to 12.7 Accounting operating leverage can be used to tell us how much a

eliver a higher return on the initial investment. While the golf belts proj-
ct costs more, it delivers a higher net present value for Ancala investors.
This NPV factors in the initial cost of the project and reflects the total net

Solutions to Selected Questions and Problems 715

firm’s accounting operating leverage is 3, then a 15% increase in revenue 13.19 4.63%, 6.27%
will result in a 45 percent (15% ϫ 3 ϭ 45%) increase in EBIT for the firm.
12.9 We must know the difference between unit price and unit variable 13.21 Pcs ϭ 1 D1 ϩ D111 ϩ g12 ϩ D111 ϩ g122 ϩ D111 ϩ g123
cost (the per-unit contribution) in order to determine how many units ϩ kcs 11 ϩ kcs22 11 ϩ kcs23 11 ϩ kcs24
must be sold to pay a firm’s fixed costs.
12.11 Simulation analysis is like scenario analysis except that in simu- ϩ D111 ϩ g124 ϩ D111 ϩ g12411 ϩ g22
lation analysis an analyst typically uses a computer to examine a large 11 ϩ kcs25 1kcs Ϫ g22 11 ϩ kcs25
number of scenarios in a short period of time.
12.13 Since depreciation and amortization is a non-cash item, the It is easy to see that in order to solve for a cost of capital, kcs, you
manufacturing firm should have the greatest discrepancy between FCF must have a good idea of what g1 and g2 are. If those growth rates are poor
and EBIT estimates, then the calculation for kcs, will also be a poor estimate.
12.15 Specialty should produce and sell the bulbs because EBIT for the
additional bulbs is positive (EBIT ϭ $1,000). 13.23 Markets adjust the cost of capital according to the level of sys-
12.17 15.9% tematic risk in a project. Therefore, the project with the greatest level of
12.19 340,000 units systematic risk will have the greatest positive impact on the cost of capital
12.21 While the business may be expected to have an accounting oper- for the firm, even if it has the lowest level of unsystematic risk.
ating loss, our focus should be on the expected operating cash flow gain
or loss. A business can produce an accounting operating loss at the same 13.25 Since Imaginary will be financing the project with the same mix
time it produces operating cash flow income because the depreciation of capital that the firm is currently utilizing for its projects, we will have
and amortization charges are not subtracted in the calculation of operat- met the first restriction concerning financing mix. In addition, the new
ing cash flow. Since depreciation and amortization are non-cash charges, project will have the same degree of systematic risk (in addition to being
the project could still be viable if it does not show a cash flow loss.
12.23 Since sensitivity analysis assumes independence among variables, in the same general line of business). Therefore, Imaginary can use the
this analysis will be most useful when this sort of independence exists. 9.26 percent cost of capital to evaluate its project.
12.25 Simulation analysis, because it is a very efficient way to evaluate
a large number of possible scenarios and estimate probabilities. 13.27 While the growth in dividends has been extremely constant for
12.27 You should choose projects A, C, and D. MacroSwift over the last 15 years, it is appropriate to assume a constant-
12.29 Cash Flow DOL will be less than Accounting DOL.
12.31 Changes in revenue and operating leverage. growth rate only if that same rate is expected to continue in the future.
12.33 CO ϭ 300,000 units Two factors will act to alter that growth in the future. MacroSwift will
12.35 PVx ϭ $2,650.78; NPVy ϭ $2,189.06; PIx ϭ 1.1325; PIy ϭ 1.1095 have competition for its current products in the near future, and that
could alter the firm’s growth rate. In addition, the firm is expanding its
Both methods rank Project X over Project Y. However, both projects
should be accepted under the NPV criteria. Therefore, both should be product line into an area that will probably not yield the same level of
accepted if they are independent and sufficient resources are available. If
the projects are mutually exclusive, the project with the higher NPV or PI, growth. It is, therefore, unlikely that MacroSwift’s dividend growth rate
which in this case is Project X, should be chosen. We can directly compare will continue at a 3 percent annual rate. This suggests that you should
the NPVs in this problem because both projects have four-year lives. consider something other than constant growth in your modeling.

CHAPTER 13 13.29 13.6%

13.1 $98 million 13.31 9.78%
13.3 When we calculate the cost of debt for a U.S. firm, we must
take into account the tax subsidy given in the United States for interest 13.33 Market returns are impounded in market prices. If those prices
payments on debt. For every dollar the firm pays in interest, the firm’s are ignored, then the efficiency of the market’s information process is also
tax bill will decline by ($1 ϫ t), where t is the firm’s marginal tax rate.
We adjust for this tax benefit by multiplying the pretax cost of debt by essentially ignored. Since the market adjusts securities prices according to
(1 Ϫ t). This calculation gives us the after-tax cost of debt. We use the the expected return for investing in a security, then ignoring that infor-
after-tax cost of debt for cost of capital calculations such as when we mation is the same as ignoring what the market deems to be an appropri-
calculate the WACC. ate cost of capital for the firm.
13.5 16%
13.7 10% 13.35 Since, collectively, the debt and equity holders are entitled to re-
13.9 15.8% ceive all of the cash flows that the assets of the firm are expected to pro-
13.11 9.4% duce, the systematic risk of the cash flows that they are entitled to receive
13.13 The owners of all of the securities that have been sold to finance must be the same as the systematic risk of the cash flows the assets are
a firm, collectively, own all of the cash flows that the assets of the firm
generate. The value of these securities must equal the value of these cash expected to produce.
flows and, therefore, the value of the firm.
13.15 $1,000 13.37 8.49%

CHAPTER 14

14.1 Wolfgang’s cash conversion cycle is 69 days. Since this is less than
the industry average of 75 days, the firm is more efficient than the average
firm in the industry in managing its working capital.
14.3 Ϫ3 days; the amount of time Devon takes to turn over its inventory
and to collect its receivables is less than the amount of time Devon takes to
pay its suppliers.
14.5 73 days
14.7 44.59%
14.9 $4,908.80
14.11 7.61%
14.13 21.42%
14.15 75.9 days. It takes nearly 76 days from the time the firm pays for
its raw materials to the time it realizes cash from its credit sales.

716 Solutions to Selected Questions and Problems 16.7 18%

14.19 36.5 days 16.9 $150,000,000
14.21 129.7 days
14.23 16 orders 16.11 10.5%
14.25 8.775%
14.27 5.54% 16.13 42%
14.29 $9,324
14.31 28.2 days 16.15 Information or transaction costs would reduce the total value
14.33 $7,500; 37.1% that is available for the debt holders and the stockholders and, therefore,
14.35 a. Increase, Increase; b. Increase, Increase; the value of the firm.

c. No change, Decrease; d. Increase, Increase; 16.17 $530,000,000
e. Increase, No change.
14.37 a. 67.9 days; b. 80.6 days; c. 105.7 days; 16.19 Lower productivity due to lower morale and job hunting and
d. 148.5 days; e. 42.8 days. higher recruiting costs are among the costs of financial distress that the
14.39 a. $30,000; b. 63.2%; c. 85.06% firm will incur.

CHAPTER 15 16.21 The managers expect to lose their jobs in one year whether
they take on the project and work hard or not. They have no incentive
15.1 As noted in Footnote 1, business plans (and their contents) are to take on the project. Declining it makes the shortage to the debt
iscussed in detail in Chapter 18. As explained in this chapter, in general holders greater, and any possible return to the stockholders smaller,
erms the business plan describes (1) what you want the business to be- than it would be if the firm followed the rule of always accepting pos-
ome, (2) why consumers will find your product(s) attractive (the value itive NPV projects.
roposition), (3) how you are going to accomplish your objectives, and
4) what resources you will need. 16.23 Given the information in the question we would expect that an
increase in the marginal tax rate will increase the value of the tax shield
15.3 Sell the business, take it public, or remain a private company. and increase the amount of debt in the optimal capital structure.
15.5 Examine comparable companies and see what prices their share
re trading for; A discounted cash flow analysis. 16.25 That internally generated equity is utilized first as a source of
15.7 Debt issues that are complex in nature or that are issued in uncertain financing does not mean that the internally generated funds are
imes often are sold through negotiated sales. This allows the underwriter to cheaper than debt. Internally generated funds belong to stockholders
and are therefore really equity financing, which we know to be more
etter control the conditions of the sale and to better explain the firm to expensive than debt.
otential investors, thereby keeping issue costs relatively low.
15.9 $34,367,351 16.27 Under these conditions, the value of the firm will increase with
15.11 The steps in a general cash offering are: (1) Decide what to the amount of debt financing that is used due to the interest tax shields.
ssue, (2) Approvals, (3) Registration statement, (4) Final price, and The conservative approach will not maximize firm value.
5) Closing.
15.13 As the size of a securities issue increases, the total flotation costs 16.29 $810,000,000
er security decline.
15.15 Nalco is probably better off choosing to sell debt in public mar- 16.31 If enough debt is used to finance this firm, then the challenges
et, given its size. of ensuring that the firm produces enough cash to make interest and
15.17 The borrowing cost will increase to 9.43% principal payments would provide managers of the firm with incen-
15.19 You can fund the project in stages. This will allow you to review tives to work on new positive NPV projects rather than spend their
he project’s profitability before you commit to further financing. You Fridays in Cancun.
an also require the entrepreneurs to invest some of their own capital,
which will tie them to the project by making it more costly for them to CHAPTER 17
bandon it.
15.21 $1,220,000 17.1 This reduction could indicate that management expects a lower
15.23 $68,700,000; $15,300,000 level of profitability in the future (negative signal). It could also indicate
15.25 a. $130 million; b. $109 million; c. $21 million that Poseidon requires additional money to invest in positive NPV proj-
15.27 6.52%; If the economy is supposed to improve (deteriorate), in- ects that were not previously available (positive signal).
erest rates are likely to go up (down) in the near future. This could make
he cost of borrowing more (less) expensive. 17.3 The proper cronological order is: (1) Declaration date, (2) Ex-
dividend date, (3) Record date, (4) Payment date
CHAPTER 16
17.5 Any cash paid to stockholders through a dividend reduces the
16.1 The assumption that there are no information or transaction costs. value of the assets that remain in the firm to secure the creditors’ claims.
16.3 The value of the firm is independent of the proportion of debt and
quity utilized by the firm under Modigliani and Miller’s Proposition 1. 17.7 $9.75

17.9 With a stock repurchase, stockholders can decide whether to par-
ticipate. If they choose to participate, there are tax advantages for the
stockholders, relative to a dividend.

17.11 Relaxing the no transaction cost assumption increases the cost
of producing a homemade dividend (or the cost of undoing unwanted
dividends). This makes a firm’s dividend policy a relevant factor when
valuing its shares.

17.13 The value of dividend paying stocks should decrease relative to
the value of non-dividend-paying stocks.

17.15 Reducing a dividend may indicate that a firm does not have suf-
ficient cash, which would be a negative signal. On the other hand, when a
high-growth firm increases its dividend, the increase may be interpreted
as indicating that the firm has fewer positive NPV projects and that its