Exam 18: International Capital Budgeting

A French firm is considering a one-year investment in the United Kingdom with a pound-denominated rate of return of i_£ = 15%.The firm's local cost of capital is i_€ = 10%.The project costs £1,000 and will return £1,150 at the end of one year.The current exchange rate is €2.00 = £1.00. Suppose that the bank of England is considering either tightening or loosening its monetary policy.It is widely believed that in one year there are only two possibilities: S₁ (€/£)= €2.20 per £ S₁ (€/£)= €1.80 per £ Following revaluation,the exchange rate is expected to remain steady for at least another year. Your banker quotes the euro-zone risk-free rate at i_€ = 6% and the British risk free rate at i_£ = 6%.Find the value of the option and thereby the project.

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Question 1

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Using the risk-neutral valuation methods of chapter 7,the risk neutral probability is 1/2 ρ = $\frac { F _ { 1 } ( € / £ ) - d } { u - d }$ = $\frac { \frac { € 2 } { £ } - \frac { € 1.80 } { £ } } { \frac { € 2.2 } { £ } - \frac { € 1.80 } { £ } }$ = $\frac { .2 } { .4 }$ = 1/2 The value of the option is thereby €216.98 = 1/2 × €460 / 1.06 The NPV of the project if undertaken today is −€2,000 + $2,070/1.06 + €216.98 = €169.81

Consider the following international investment opportunity.It involves a gold mine that can be opened at a cost,then produces a positive cash flow,but then requires environmental clean-up. The current exchange rate is $1.55 = €1.00.The inflation rate in the U.S.is 6 percent and in the euro zone 2 percent.The appropriate cost of capital to a U.S.-based firm for a domestic project of this risk is 8 percent. Find the dollar cash flows to compute the dollar-denominated NPV of this project.

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−$957.09 There are two equally valid approaches each of these problems Convert the euro cash flows to dollars use i_$ = 8% as a discount rate $\mathrm { CF } _ { 0 }$ = −$40,000 = −€25,000 × $\frac { \$ 1.60 } { € 1.00 }$ $\mathrm { CF } _ { 1 }$ = $99,764 = €60,000 × $\frac { \$ 1.60 \times ( 1.06 ) } { €1.00 \times ( 1.02 ) }$ $\mathrm { CF } _ { 2 }$ = −$62,206.23 = −€36,000 × $\frac { \$ 1.60 \times ( 1.06 ) ^ { 2 } } { € 1.00 \times ( 1.02 ) ^ { 2 } }$ i_$ = 8% Compute NPV = −$957.09 Convert the interest rate from i_$ = 8% to i_€ = 3.92% using $\frac { 1 + i _ { \$ } } { 1 + \pi _ { \$ } }$ = $\frac { 1 + i_ { € } } { 1 + \pi _ { € } }$ CF₀ = −€25,000 CF₁ = €60,000 CF₂ = −€36,000 $i _ { \epsilon }$ = $\frac { 1.08 \times 1.02 } { 1.06 }$ − 1 i_€ = 3.92% Compute NPV = −€598.18 Convert to dollars at spot rate −$957.09 = -€598.18 × $\frac { \$ 1.60 } { € 1.00 }$

In the context of the capital budgeting analysis of an MNC that has strong foreign competitors,"lost sales" refers to

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Question 3

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Consider a project of the Cornell Haul Moving Company,the timing and size of the incremental after-tax cash flows (for an all-equity firm)are shown below in millions: The firm's tax rate is 34 percent; the firm's bonds trade with a yield to maturity of 8 percent; the current and target debt-equity ratio is 2; if the firm were financed entirely with equity,the required return would be 10 percent. What is the levered after-tax incremental cash flow for year 4?

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Question 4

Consider the following international investment opportunity.It involves a gold mine that can be opened at a cost,then produces a positive cash flow,but then requires environmental clean-up. The current exchange rate is $1.60 = €1.00.The inflation rate in the U.S.is 6 percent and in the euro zone 2 percent.The appropriate cost of capital to a U.S.-based firm for a domestic project of this risk is 8 percent. Find the euro-zone cost of capital to compute is the dollar-denominated NPV of this project.

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Question 5

The required return on assets is 18 percent.The firm can borrow at 12.5 percent; firm's target debt to value ratio is 3/5.The corporate tax rate is 34 percent,and the risk-free rate is 4 percent and the market risk premium is 9.2 percent. What is the weighted average cost of capital?

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Question 6

Consider the following international investment opportunity.It involves a gold mine that can be opened at a cost,then produces a positive cash flow,but then requires environmental clean-up. The current exchange rate is $1.60 = €1.00.The inflation rate in the U.S.is 6 percent and in the euro zone 2 percent.The appropriate cost of capital to a U.S.-based firm for a domestic project of this risk is 8 percent. What is the euro-denominated IRR of this project?

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Question 7

As of today,the spot exchange rate is €1.00 = $1.25 and the rates of inflation expected to prevail for the next three years in the U.S.is 2 percent and 3 percent in the euro zone.What spot exchange rate should prevail three years from now?

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Question 8

Assume that XYZ Corporation is a leveraged company with the following information: K_l = cost of equity capital for XYZ = 13% I = before-tax borrowing cost = 8% T = marginal corporate income tax rate = 30% Calculate the debt-to-total-market-value ratio that would result in XYZ having a weighted average cost of capital of 9.3 percent.

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Question 9

Tiger Towers,Inc.is considering an expansion of their existing business,student apartments.The new project will be built on some vacant land that the firm has just contracted to buy.The land cost $1,000,000 and the payment is due today.Construction of a 20-unit office building will cost $3 million; this expense will be depreciated straight-line over 30 years to zero salvage value; the pretax value of the land and building in year 30 will be $18,000,000.The $3,000,000 construction cost is to be paid today.The project will not change the risk level of the firm.The firm will lease 20 office suites at $20,000 per suite per year; payment is due at the start of the year; occupancy will begin in one year.Variable cost is $3,500 per suite.Fixed costs,excluding depreciation,are $75,000 per year.The project will require a $10,000 investment in net working capital. $r \text { debt }$ = 10.0% $r \text { WACC }$ = 11.20% $r \text { asset }$ = 15.0% tax rate = 34% $\frac { D } { E }$ = 3 $r _ { \text {equity } }$ = 24.9% $r \text { free }$ = 2% What is the unlevered after-tax incremental cash flow for year 0?

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Question 10

Consider the following international investment opportunity: The current exchange rate is $1.60 = €1.00.The inflation rate in the U.S.is 3 percent and in the euro zone 2 percent.The appropriate cost of capital to a U.S.-based firm for a domestic project of this risk is 8 percent. What is the euro-denominated IRR of this project?

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Question 11

The ABC Company,a U.S.-based MNC,plans to establish a subsidiary in Spain to manufacture and sell water pumps.ABC has total assets of $80 million,of which $60 million is equity financed.The remainder is financed with debt.ABC considers its current capital structure optimal.The construction cost of the facility in Spain is estimated to be €8,500 million,of which €6,500 million is to be financed at a below-market rate of interest arranged by the Spanish government.The proposed project will increase the borrowing capacity by

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Question 12

Tiger Towers,Inc.is considering an expansion of their existing business,student apartments.The new project will be built on some vacant land that the firm has just contracted to buy.The land cost $1,000,000 and the payment is due today.Construction of a 20-unit office building will cost $3 million; this expense will be depreciated straight-line over 30 years to zero salvage value; the pretax value of the land and building in year 30 will be $18,000,000.The $3,000,000 construction cost is to be paid today.The project will not change the risk level of the firm.The firm will lease 20 office suites at $20,000 per suite per year; payment is due at the start of the year; occupancy will begin in one year.Variable cost is $3,500 per suite.Fixed costs,excluding depreciation,are $75,000 per year.The project will require a $10,000 investment in net working capital. $r \text { debt }$ = 10.0% $r \text { WACC }$ = 11.20% $r \text { asset }$ = 15.0% tax rate = 34% $\frac { D } { E }$ = 3 $r _ { \text {equity } }$ = 24.9% $r \text { free }$ = 2% What is the unlevered after-tax incremental cash flow for year 30?

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Question 13

What is the expected return on equity for firm in the 40 percent tax bracket with a 15 percent expected return on assets that pays 12 percent on its debt,which totals 25 percent of assets?

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Question 14

Some of the factors (with selected explanations)used in calculating the basic "net present value" and the "incremental" cash flows of a capital project are: (i)expected after-tax terminal value,including recapture of working capital (ii)net income,which belongs to the equity holders of the firm (iii)initial investment at inception (iv)depreciation,and the fact that depreciation is a noncash expense (i.e.,it is removed from the calculation of net income,for tax purposes,but added back because it did not actually flow out of the firm)(v)weighted-average cost of capital (vi)the firm's after-tax payment of interest to debtholders (vii)economic life of the capital project in years The "net present value" of a capital project is calculated by using

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Question 15

A French firm is considering a one-year investment in the United Kingdom with a pound-denominated rate of return of i_£ = 15%.The firm's local cost of capital is i_€ = 10%.The project costs £1,000 and will return £1,150 at the end of one year.The current exchange rate is €2.00 = £1.00. Suppose that the bank of England is considering either tightening or loosening its monetary policy.It is widely believed that in one year there are only two possibilities: S₁ (€/£)= €2.20 per £ S₁ (€/£)= €1.80 per £ Following revaluation,the exchange rate is expected to remain steady for at least another year. The CFO who has a CFA notices the optionality in starting this project today.He asks you to comment and outline your valuation strategy.

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Question 16

Some of the factors (with selected explanations)used in calculating the basic "net present value" and the "incremental" cash flows of a capital project are: (i)expected after-tax terminal value,including recapture of working capital (ii)net income,which belongs to the equity holders of the firm (iii)initial investment at inception (iv)depreciation,and the fact that depreciation is a noncash expense (i.e.,it is removed from the calculation of net income,for tax purposes,but added back because it did not actually flow out of the firm)(v)weighted-average cost of capital (vi)the firm's after-tax payment of interest to debtholders (vii)economic life of the capital project in years The "incremental" cash flows of a capital project is calculated by using

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Question 17

Your firm is based in southern Ireland (and thereby operates in euro,not pounds)and is considering an investment in the United States. The project involves selling widgets: you project a sales volume of 50,000 widgets per year,sales price of $20 per widget with a contribution margin of $15 per widget. The project will last for 5 years,require an investment of $1,000,000 at time zero (which will be depreciated straight-line to $10,000 over the 5 years).Salvage value for the equipment is projected to be $10,000.The project will operate in rented quarters: $300,000 rent is due at the start of each year. The corporate tax rate is 12½ percent in Ireland and 40 percent in the U.S. For simplicity,assume that taxes are paid like sales taxes: immediately. The spot exchange rate is $1.50 = €1.00.The cost of capital to the Irish firm for a domestic project of this risk is 8 percent.The U.S.risk-free rate is 3 percent; the Irish risk-free rate is 2 percent. What is CF1 in dollars?

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Question 18

An American Hedge Fund is considering a one-year investment in an Italian government bond with a one-year maturity and a euro-denominated rate of return of i_€ = 5%.The bond costs €1,000 today and will return €1,050 at the end of one year without risk.The current exchange rate is €1.00 = $1.50.U.S.dollar-denominated government bonds currently have a yield to maturity of 4 percent.Suppose that the European Central Bank is considering either tightening or loosening its monetary policy.It is widely believed that in one year there are only two possibilities: S₁ ($/€)= €1.80 per € S₁ ($/€)= €1.40 per € Following revaluation,the exchange rate is expected to remain steady for at least another year. Find the NPV in dollars for the American firm if they wait one year to buy the bond after the exchange rate rises to S₁($/€)= $1.80 per €.Assume that i_€ doesn't change.

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Question 19

The financial manager's responsibility involves

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Question 20

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In the context of the capital budgeting analysis of an MNC that has strong foreign competitors,"lost sales" refers to

The required return on assets is 18 percent.The firm can borrow at 12.5 percent; firm's target debt to value ratio is 3/5.The corporate tax rate is 34 percent,and the risk-free rate is 4 percent and the market risk premium is 9.2 percent. What is the weighted average cost of capital?

As of today,the spot exchange rate is €1.00 = $1.25 and the rates of inflation expected to prevail for the next three years in the U.S.is 2 percent and 3 percent in the euro zone.What spot exchange rate should prevail three years from now?

What is the expected return on equity for firm in the 40 percent tax bracket with a 15 percent expected return on assets that pays 12 percent on its debt,which totals 25 percent of assets?

The financial manager's responsibility involves

International Monetary System

Globalization and the Multinational Firm

Balance of Payments

Corporate Governance Around the World

The Market for Foreign Exchange

International Parity Relationships and Forecasting Foreign Exchange Rates

Futures and Options on Foreign Exchange

Management of Transaction Exposure

Management of Economic Exposure

Management of Translation Exposure

International Banking and Money Market

International Bond Market

International Equity Markets

Interest Rate and Currency Swaps

International Portfolio Investment

Foreign Direct Investment and Cross-Border Acquisitions

International Capital Structure and the Cost of Capital

Multinational Cash Management

International Trade Finance

International Tax Environment and Transfer Pricing

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