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17: Problems 17, 18 and 28
between Financing and Investment. Charleston Corp. is considering
establishing a subsidiary in either Germany or the United Kingdom. The
subsidiary will be mostly financed with loans from the local banks in the host
country chosen. Charleston
has determined that the revenue generated from the British subsidiary will be
slightly more favorable than the revenue generated by the German subsidiary,
even after considering tax and exchange rate effects. The initial outlay
will be the same, and both countries appear to be politically stable. Charleston decides to establish the subsidiary in the United Kingdom
because of the revenue advantage. Do you agree with its decision?
Charleston neglected the cost of financing the
subsidiary. It may be more costly to finance a subsidiary in the United
Kingdom than a subsidiary in Germany when using the local debt of the host
country as the primary source of funds. When considering the cost of
financing, a subsidiary in the United Kingdom
could be less favorable than a subsidiary in Germany, based on the information
provided in this question.
Financing Decision. In recent years,
several U.S. firms have
market. One of the biggest challenges is the cost of capital to finance
businesses in Mexico.
Mexican interest rates tend to be much higher than U.S. interest rates. In some
periods, the Mexican government does not attempt to lower the interest rates
because higher rates may attract foreign investment in Mexican securities.
might U.S.-based MNCs expand in Mexico without incurring the high Mexican
interest expenses when financing the expansion? Are any disadvantages associated with
parents of the MNCs could provide funding for the subsidiaries by investing
their own capital. This involves converting
dollars to pesos for use in Mexico. In this case, the parent has more at
stake. As the Mexican subsidiary remits
funds back to the U.S.
parent, it will remit larger amounts if it does not finance with pesos because
the financing came from the U.S.
(no cash outflows are needed to cover interest payments in pesos). Thus, the MNC is exposed to a higher level of
exchange rate risk.
there any additional alternatives for the Mexican subsidiary to finance its
business itself after it has been well established? How might this strategy affect the
subsidiary’s capital structure?
subsidiary has generated earnings, it can retain the earnings and reinvest them
to finance future operations. This
strategy emphasizes equity financing and would result in an equity-intensive
capital structure for the subsidiary.
Portugal. Sandusky Co. has no other international business. It finances its
operations with 40% equity and the remainder of funds with dollar-denominated
debt. It borrows its funds from a U.S. bank at an interest rate of 9 percent
per year. The long-term risk-free rate in the U.S. is 6 percent. The long-term
risk-free rate in Portugal
is 11 percent. The stock market return in the U.S. is expected to be 13 percent
annually. Sandusky’s stock price typically moves
in the same direction and by the same degree as the U.S. stock market. Its earnings are
subject to a 20% corporate tax rate. Estimate the cost of capital to Sandusky
of equity =
of equity =
of equity = 13%
of debt = .09 x (1 -.2) = .072
of capital =
of capital = (.60)7.2% + (.40)13% = 9.52%
Chapter 18: Problems 9, 10 and 11
9. Bond Financing Analysis. Sambuka, Inc. can issue bonds in either U.S.
dollars or in Swiss francs. Dollar-denominated bonds would have a coupon rate
of 15 percent; Swiss franc-denominated bonds would have a coupon rate of 12
percent. Assuming that Sambuka can issue bonds worth $10,000,000 in either
currency, that the current exchange rate of the Swiss franc is $.70, and that
the forecasted exchange rate of the franc in each of the next three years is
$.75, what is the annual cost of financing for the franc-denominated bonds?
Which type of bond should Sambuka issue?
Sambuka issues Swiss franc-denominated bonds, the bonds would have a face value
of $10,000,000/$.70 = Sf14,285,714.
Year 1 Year 2 Year 3
Payment SF1,714,286 SF1,714,286 SF16,000,000
rate $.75 $.75 $.75
in $ $1,285,715 $1,285,715 $12,000,000
annual cost of financing is 14.92% for the franc-denominated bonds. Since the
annual cost of financing of the dollar-denominated bonds is 15%, Sambuka should
issue the franc-denominated bonds
10. Bond Financing Analysis. Hawaii Co. just agreed to a long-term deal in
which it will export products to Japan. It needs funds to finance
the production of the products that it will export. The products will be
denominated in dollars. The prevailing U.S.
long-term interest rate is 9 percent versus 3 percent in Japan. Assume that interest rate
parity exists, and that Hawaii Co. believes that the international Fisher
Hawaii Co. finance its production with yen and leave itself open to the
exchange rate risk? Explain.
No. The exchange rate of the yen is expected to
rise according to the IFE, which would offset the interest rate differential.
Hawaii Co. finance its production with yen and simultaneously engage in forward
contracts to hedge its exposure to exchange rate risk?
No. The forward rate premium should reflect the
interest rate differential, so the financing rate would be 9% if Hawaii used
could Hawaii Co. achieve low-cost financing while eliminating its exposure to
exchange rate risk?
could request that the Japanese importers pay for their imports in yen. It
could finance in yen at 3% and use a portion of the proceeds from its export
revenue to cover its finance payments.
11. Cost of Financing. Assume that Seminole, Inc., considers issuing a
dollar‑denominated bond at its present coupon rate of 7 percent, even though it
has no incoming cash flows to cover the bond payments. It is attracted to
the low financing rate, since U. S. dollar-denominated bonds issued in the United States
would have a coupon rate of 12 percent. Assume that either type of bond
would have a four‑year maturity and could be issued at par value.
Seminole needs to borrow $10 million. Therefore, it will either issue U.
S. dollar denominated bonds with a par value of $10 million or bonds
denominated in Singapore dollars with a par value of S$20 million. The
spot rate of the Singapore
dollar is $.50. Seminole has forecasted the Singapore dollar’s value at the end
of each of the next four years, when coupon payments are to be paid:
End of Year Exchange Rate of Singapore
Determine the expected annual cost of
financing with Singapore
dollars. Should Seminole, Inc., issue bonds denominated in U.S. dollars
annual cost of financing with $ is determined as the discount rate that equates
the U.S. dollar payments resulting from payments on the Singapore
dollar-denominated bond to the amount of U.S. dollars borrowed. Using a calculator, this discount rate is
8.97%. Thus, the expected annual cost of
financing with a Singapore
dollar-denominated bond is 8.97%, which is less than the 12% cost of financing
with U.S. dollars. However, there is
some uncertainty associated with Singapore dollar financing. Seminole Inc. must weigh the expected savings
from financing in Singapore
dollars with the uncertainty associated with such financing.