ch14

192

CHAPTER 14 THE COST OF CAPITAL FOR FOREIGN INVESTMENTS K EY POINTS 1.

A project's cost of capital is a function of the riskiness of the project itself, not the risk of the firm undertaking the project. Thus, if an investment's risk characteristics differ from those of the firm's average investment, it is inappropriate to discount project cash flows at the firm's cost of equity capital.

2.

Even if foreign investments are riskier than domestic investments, that does not mean that those risks must lead to a higher cost of capital for the former. The basic insight of the capital asset pricing model (CAPM) is that only the systematic component of risk is priced; diversifiable risk must be borne at a zero price. The key question for the MNC is whether systematic risk is measured in the context of a globally-diversified portfolio or only a domestically-diversified portfolio.

There is strong evidence that much risk that is systematic from a domestic standpoint is unsystematic from a global standpoint. If risk is measured relative to a domestically-diversified portfolio, then foreign projects probably have lower systematic risk than comparable domestic investments, and so should require lower returns. If risk is measured relative to a globally-diversified portfolio, foreign projects will likely still be less risky than domestic projects and require lower returns. But the gap between the required return on domestic and comparable foreign investments should be less in the second case. The total risk of many foreign investments will probably exceed the total risk of their domestic counterparts. But because of the lower correlation between returns on domestic and foreign projects, foreign investing could still reduce the MNC's total risk. Hence, executives of multinational firms should seriously question the use of a risk premium to account for the added political and economic risks of overseas operations, when evaluating prospective foreign investments. The use of any risk premium ignores the fact that the risk of an overseas investment in the context of the firm's other investments, domestic as well as foreign, will be less than the project's total risk. How much less depends on how highly correlated are the outcomes of the firm's different investments. Some investments, however, are more risk-prone than are others, and these risks must be accounted for. This chapter shows how to adjust project discount rates, using the CAPM, when those additional foreign risks are systematic in nature. Chapter 17 will show how to conduct the necessary risk analysis for foreign investments when the foreign risks are unsystematic (through cash flow adjustments). The chapter also explored the factors that are relevant in determining appropriate parent, affiliate, and worldwide capital structures--taking into account the unique attributes of being a multinational corporation. We saw that the optimal global capital structure entails that mix of debt and equity for the parent entity and for all consolidated and unconsolidated subsidiaries that maximizes shareholder wealth. At the same time, affiliate capital structures should vary to take advantage of opportunities to minimize the MNC's cost of capital.

SUGGESTED ANSWERS TO CHAPTER 14 QUESTIONS 1.

What factors should be considered in deciding whether the cost of capital for a foreign affiliate should be higher, lower, or the same as the cost of capital for a comparable domestic operation?

ANSWER . Key factors include whether the cash flows of the affiliate are closely tied to the state of the local economy or to the world economy, the correlation between the local and domestic economies, and the volatility of the foreign affiliate's cash flows relative to that of the domestic operation. The greater (lesser) each of these factors, the higher

CHAPTER 14: THE COST OF CAPITAL FOR FOREIGN INVESTMENTS

193

(lower) the foreign affiliate's cost of capital relative to that of the domestic operation. In general, the closer these factors are to each other, the closer their costs of capital. 2.

Comment on the following statement: "There is a curious contradiction in corporate finance theory: Since equity is more expensive than debt, highly leveraged subsidiaries should be assigned a low hurdle rate. But when the highly leveraged subsidiaries are in risky nations, country risk dictates just the opposite: a high hurdle rate."

ANSWER . Several points are relevant here. First, country risk is most likely to be an unsystematic source of risk and hence should not affect the cost of capital for a project. The project will be penalized for higher unsystematic risk by reducing the expected project cash flows below their most likely value. Second, as leverage rises, the cost of equity capital rises as well, offsetting in whole or in part the advantage of debt. Thus, it is not clear that highly leveraged subsidiaries should have a lower cost of capital. Third, it is not clear that subsidiaries have independent capital structures, so it is difficult to talk about how their cost of capital varies with their leverage. Fourth, even if a highly leverage sub has a lower cost of capital and country risk increases the appropriate cost of capital, there is no contradiction: A highly leveraged sub in a risky nation would have a lower cost of capital than would a less highly levered sub in that same nation. 3.

Comment on the following statement: "Our conglomerate recognizes that foreign investments have a very low covariance with our domestic operations and, thus, are a good source of diversification. We do not `penalize' potential foreign investments with a high discount rate but, rather, use a discount rate just 3% above the prevailing riskless rate."

ANSWER . To repeat the answers to question 1, the cost of capital for a project depends on its systematic risk. This systematic risk must be measured relative to the market portfolio, not relative to the company's investment portfolio. Moreover, even if the foreign investment has a low covariance with the market portfolio, the selection of 3% is arbitrary. However, this rule of thumb, which assigns a lower cost of capital to foreign projects, may be more appropriate than penalizing them with a higher cost of capital. 4.

According to an article in Forbes, "American companies can and are raising capital in Japan at relatively low rates of interest. Dow Chemical, for instance, has raised $500 million in yen. That cost the company over 50% less than it would have at home." Comment on this statement.

ANSWER . Forbes is comparing apples with oranges. Borrowing in yen is not the same as borrowing in dollars. When converting from yen into dollars Dow faces the possibility that the yen will appreciate, wiping out its apparent cost savings. In fact, in less than one year after the article appeared, the yen had appreciated by over 35% relative to the dollar, raising the dollar cost of repaying that $500 million yen borrowing to over $675 million. 5.

In early 1990, major Tokyo Stock Exchange issues sell for an average 60 times earnings, more than four times the 13.8 price-earnings ratio for the S&P 500. According to Business Week (February 12, 1990, p. 76), "Since p-e ratios are a guide to a company's cost of equity capital, this valuation gap implies that raising new equity costs Japanese companies less than 2% a year, vs. an average 7% for the U.S." Comment on this statement.

ANSWER . According to the dividend growth model, ke = DIV1/P0 +g where ke is the cost of equity capital, DIV1/P0 is the projected dividend yield, and g is the expected dividend growth rate. The dividend yield equals the earnings yield (e/P) multiplied by the dividend payout rate. According to this formula, the e-P ratio is only an accurate guide to the cost of capital when earnings are expected to be stable. Conversely, the higher earnings (and, hence, dividend) growth is expected to be, the more downwards biased the e-P ratio will be as a measure of the cost of capital. The dividend growth model also tells us that the higher the earnings growth rate, the higher the P-e ratio (and the lower the e-P ratio). Thus, one possible interpretation of the low e-P ratios

194 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH ED. for Japanese companies is that they reflect the expectation of high earnings growth rather than a low cost of equity capital. Of course, as we now know, these expectations have been dashed and the Japanese market has tumbled. 6.

What are some of the advantages and disadvantages of having highly leveraged foreign subsidiaries?

ANSWER . A more highly leveraged subsidiary may also be a more efficient firm because management is unable to turn to the parent for help. The disadvantages of high leverage include the following:

7.

1.

Local suppliers and customers may shy away from doing business with a new subsidiary operating on a shoestring if that subsidiary is receiving minimal financial backing from its parent. Having a balance sheet with more equity demonstrates that the unit has greater staying power.

2.

The government might argue that the firm is overly leveraged and declare that certain debt payments are constructive dividends and impose taxes on those payments.

How has the Tax Reform Act of 1986 affected the capital structure choice for foreign subsidiaries?

ANSWER . As noted in the chapter, the Tax Reform Act of 1986 has put many U.S.-based MNCs in a position of excess foreign tax credits. One approach to using up these FTCs is to push expenses overseas --and thus lower overseas profits--by increasing the leverage of foreign subsidiaries. Another is to shift toward leasing instead of borrowing. 8.

What financing problems might be associated with joint ventures?

ANSWER . Unless the joint venture can be isolated from its partners' operations, there are likely to be some significant problems associated with this form of ownership. Transfer pricing on goods and services (including royalty and licensing fees) and allocation of production and markets among plants are just some of the areas in which each owner has an incentive to engage in activities that will harm its partners. These conflicts lead to increased operating and monitoring expenses. In addition, where the MNC is substantially stronger financially than its partner, the MNC may wind up implicitly guaranteeing its weaker partner's share of any JV borrowings, as well as its own. 9.

Under what circumstances does it make sense for a company to not guarantee the debt of its foreign affiliates?

ANSWER . Here are some valid arguments against parent guarantees of foreign affiliate debt: •

The protection against expropriation provided by an affiliate's borrowing may be lost if the parent guarantees those debts.

•

The U.S. IRS imputes income to the guarantor and levies a tax.

•

When a firm provides an affiliate with a loan guarantee, it may lose the bank as its partner in controls. Since it will be repaid regardless of the subsidiary's profitability, the bank will have less incentive to monitor the affiliate's activities.

10. How can financing strategy be used to reduce foreign exchange risk?

ANSWER. Firms can reduce their exposure to foreign exchange risk by financing assets that generate foreign currency cash flows with liabilities denominated in those same foreign currencies. 11. How can financial strategy be used to reduce political risk?

CHAPTER 14: THE COST OF CAPITAL FOR FOREIGN INVESTMENTS

195

ANSWER . Financing can be used to avoid or at least reduce the impact of certain political risks, like exchange controls. Some financing mechanisms may actually change the risk itself, as in the case of expropriation or other direct political acts. Firms can sometimes reduce the risk of currency inconvertibility by investing parent funds as debt rather than equity, arranging back- to-back and parallel loans, and using local financing to the maximum extent possible. Multinational firms, especially those in the expropriation-prone extractive industries, can avoid political risk by financing their foreign investments with funds from the host and other governments, international development agencies, overseas banks, and from customers--with payment to be provided out of production--rather than supplying parent company-raised or parent-guaranteed capital. Since repayment is tied to the project's success, the sponsoring firm(s) can create an international network of banks, government agencies, and customers with a vested interest in the faithful fulfillment of the host government's contract with the sponsoring firm(s). International leasing is another financing technique that may help multinationals to reduce their political risk. This technique allows MNCs to limit the ownership of assets by subsidiaries in politically unstable countries and to more easily extract cash from affiliates located in countries where there are exchange controls. 12. Compania Troquelados ARDA is a medium-sized Mexico City auto parts maker. It is trying to decide whether to borrow dollars at 9% or Mexican pesos at 75%. What advice would you give it? What information would you need before you gave the advice?

ANSWER . To begin, it is necessary to recognize that 75% in pesos is not the same as 9% in dollars. In the absence of government controls or access to subsidized financing, the expected before -tax cost of the two loans should be about the same. If there is some tax asymmetry (e.g., foreign exchange losses are not tax deductible), then the expected after-tax costs of the two loans could diverge. Regardless of the expected costs of the two loans, the risks for Compania Troquelados ARDA are quite different. The dollar loan entails foreign exchange risk, while the peso loan entails inflation risk. A key question, therefore, is how does the return on the firm's assets respond to inflation and changes in the dollar/peso exchange rate. The answer to this question depends on where the company sells (domestic or abroad) and whether it faces import competition on domestic sales. If the company is selling in the United States, the dollar loan will probably lower its exchange risk. If it is selling in Mexico without much import competition (because of trade barriers), then the company's nominal operating profits will likely increase in line with inflation, making the peso loan the low-risk loan. This assumes that the interest rate on the peso loan will adjust periodically. If the peso interest rate is fixed, then the peso loan is the low-risk funding technique only if the firm's real operating profits move inversely with Mexican inflation. Otherwise, the dollar loan is probably a lower-risk bet. 13. Boeing Commercial Airplane Co. manufactures all its planes in the United States and prices them in dollars, even the 50% of its sales destined for overseas markets. What financing strategy would you recommend for Boeing? What data do you need?

ANSWER . Boeing faces foreign exchange risk for two reasons: (1) It sells half its planes overseas and the demand for these planes depends on the foreign exchange value of the dollar, and (2) Boeing faces stiff competition from Airbus Industrie, a European consortium of companies that builds the Airbus. As the dollar appreciates, Boeing is likely to lose both foreign and domestic sales to Airbus unless it cuts its dollar prices. One way to hedge this operating risk is for Boeing to finance a portion of its assets in foreign currencies in proportion to its sales in those countries. However, this tactic ignores the fact that Boeing is competing with Airbus. Absent a more detailed analysis, another suggestion is for Boeing to finance at least half of its assets with ECU bonds as a hedge against depreciation of the currencies of its European competitors. ECU bonds would also provide a hedge against appreciation of the dollar against the yen and other Asian currencies since European and Asian currencies tend to move up and down together against the dollar (albeit imperfectly).

196 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH ED. 14. All-Nippon Airways, a Japanese airline, flies exclusively within Japan. It is looking to finance a recent purchase of Boeing 737s. The director of finance for All-Nippon is attracted to dollar financing because he expects the yen to keep appreciating against the dollar. What is your advice to him?

ANSWER . Because All-Nippon Airways' yen cash flow will not vary in line with the dollar/yen exchange rate, using dollar financing will expose it to exchange risk. The implicit argument for using dollar financing is that yen appreciation will make it cheaper to repay. But this argument ignores the international Fisher effect, which says that a borrower should expect that any gain on loan repayment will be offset by the higher interest rate on a dollar loan. The key question to ask here is: "What's your business? Is it speculating on the future course of the $/yen exchange rate or is it providing aviation service at a reasonable price?" 15. United Airlines recently inaugurated service to Japan and now wants to finance the purchase of Boeing 747s to service that route. The CFO for United is attracted to yen financing because the interest rate on yen is 300 basis points lower than the dollar interest rate. Although he doesn't expect this interest differential to be offset by yen appreciation over the ten-year life of the loan, he would like an independent opinion before issuing yen debt. a.

What are the key questions you would ask in responding to UAL's CFO?

ANSWER . What's your business? Speculating on exchange rates or running an airline? Do you think you can profitably outguess the financial markets? How do your operating cash flows respond to changes in the dollar/yen exchange rate? b.

Can you think of any other reason for using yen debt?

ANSWER . Another reason for preferring yen financing could be to use this financing to hedge operating cash flows on the Tokyo route against changes in the dollar/yen exchange rate. c.

What would you advise him to do, given his likely responses to your questions and your answer to part b?

ANSWER . The professed reason for preferring yen financing runs afoul of the international Fisher effect. Yen interest rates are 300 basis points less than dollar interest rates because the market expects the dollar to depreciate by about 3% annually against the yen. This reason for borrowing yen is, therefore, a non-starter assuming that the CFO does not assert the ability to outguess financial markets. If United's dollar cash flow on its new route to Japan varies in line with the value of the dollar (that is, dollar cash flow drops when the dollar appreciates against the yen and vice versa when the dollar depreciates against the yen), then yen financing of its planes will reduce its exchange risk. Otherwise, dollar financing is the appropriate solution. It is difficult to say exactly how United's cash flow will be affected by the exchange rate. A rising dollar will reduce tourism from Japan to the United States, but it might increase business travel involving purchases of less expensive Japanese products. Conversely, a falling dollar will stimulate Japanese tourist travel to the United States, but could hurt business travel between the two countries. 16. The CFO of Eastman Kodak is thinking of borrowing Japanese yen because of their low interest rate, currently at 4.5%. The current interest rate on U.S. dollars is 9%. What is your advice to the CFO?

ANSWER . My advice would be "Don't speculate." The international Fisher effect says that the 450 basis point differential reflects a 4.5% expected annual appreciation of the yen against the dollar. Thus, the expected costs of dollar and yen financing should be the same. Unless Kodak needs yen financing to offset a yen transaction or operating exposure, it should stick to dollar financing.

CHAPTER 14: THE COST OF CAPITAL FOR FOREIGN INVESTMENTS

197

17. Rohm & Haas, a Philadelphia-based specialty chemicals company, traditionally finances its Brazilian operations from outside that country because it's "too expensive" to borrow local currency in Brazil. Brazilian interest rates vary from 50% to over 100%. Rohm & Haas is now thinking of switching to cruzeiro financing because of a pending cruzeiro devaluation. Assess Rohm & Haas's financing strategy.

ANSWER . One can't expected to gain from an expected currency change because interest rates already incorporate these expectations. The real reason for using foreign currency financing (aside from the ability to use currency swaps to access lower cost funds) is to offset exchange risk or political risk such as exchange controls. Because the odds are that Rohm & Haas does face exchange risk and political risk in Brazil, it should probably use cruzeiro financing. 18. In order to develop large agricultural estates, the Republic of Coconutland offers the following financing deal: If an investor agrees to purchase a plantation and put up half the cost in U.S. dollars, the government will make a 20-year, zero-interest loan of U.S. dollars to cover the other half. a.

What risks does the scheme entail?

ANSWER . The principal risk is that of expropriation. What will prevent the government from seizing the property without compensation? Other risks include variations in agricultural prices, currency controls, increased taxes, inflation risk, currency risk, and price controls. b.

How can an investor use financing to reduce these risks?

ANSWER . First of all, the investor can take out political risk insurance to protect his portion of the investment against political risks such as expropriation and currency controls. The risk of price controls is mitigated if the investor is exporting the plantation's output, provided that the government does not force the investor to convert his currency proceeds back into local currency at an artificially overvalued exchange rate. The real exchange risk that the investor faces is that the local currency will become overvalued, raising the costs of local production without increasing the price at which output can be exported. Another means of protecting against risks is to finance the purchase with loans from export-import banks (to the extent the investor must raise financing to buy goods and services overseas), with payment to be made out of plantation earnings and no recourse to the investor. 19. Nord Resource's Ramu River property in Papua New Guinea contains one of the world's largest deposits of cobalt and chrome outside of the Soviet Union and South Africa. The cost of developing a mine on this property is estimated to be around $150 million. a.

Describe three major risks in undertaking this project.

ANSWER . The three principal risks faced by Nord Resource's Ramu River project are the following: 1.

Political risk. The government of Papua New Guinea may seize the mine if it turns out to be highly profitable. The government may also block repatriation of profits.

2.

Reserve risk. There may be too few copper reserves or the ore may be too expensive to profitably mine.

3.

Price risk. The price at which Nord can sell the ore may be too low.

Exchange risk is unlikely to be a major risk. The price at which the copper can be sold is set in dollars. In addition, Nord's most important cost is the cost of developing the mine, which is largely set in dollar terms. b. How can Nord structure its financing so as to reduce these risks?

ANSWER . Nord can use financing to reduce these risks as follows:

198 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH ED.

c.

1.

Political risk. The answer to this part is the same as that to question #13: Finance the project to the extent possible with funds from the host and other governments, international development agencies, overseas banks, and from customers--with payment to be provided out of production--rather than supplying parent companyraised or parent-guaranteed capital.

2.

Reserve risk. Use nonrecourse financing with a minimal amount of equity. In this way, the lenders bear the risk of the mine being uneconomical.

3.

Price risk. Sell the ore in advance at a fixed price. Even if the price varies with the world market price, the typical take-or-pay contract, Nord will have a guaranteed outlet for its ore and will not have to engage in price cutting to sell more output.

How can Nord use financing to add value to this project?

ANSWER . To the extent that Nord can access subsidized financing for the purchase of equipment and contractor services to develop the mine, it should do so. In addition, Nord can add value to the project by using financing to reduce the various operating risks it faces.

SUGGESTED SOLUTIONS TO CHAPTER 14 PROBLEMS 1.

A firm with a corporate-wide debt/equity ratio of 1:2, an after-tax cost of debt of 7%, and a cost of equity capital of 15% is interested in pursuing a foreign project. The debt capacity of the project is the same as for the company as a whole, but its systematic risk is such that the required return on equity is estimated to be about 12%. The after-tax cost of debt is expected to remain at 7%.

a.

What is the project's weighted average cost of capital? How does it compare with the parent's WACC?

ANSWER . The weighted average cost of capital for the project is kI = (1 - w) x ke ' + w x id (1 - t) where w is the ratio of debt to total assets, ke ' is the required risk-adjusted return on project equity, and id(1 - t) is the after-tax cost of debt for the project. Substituting in the numbers provided yields kI = 2/3 x 12% + 1/3 x 7% = 10.33% b.

If the project's equity beta is 1.21, what is its unlevered beta?

ANSWER . The following approximation is usually used to unlever beta: Unlevered beta = levered beta/[1 + (1 - t)D/E] where t is the firm's marginal tax rate and D/E is its debt/equity ratio. Without knowing the firm's marginal tax rate, we cannot unlever beta. Assuming that the marginal tax rate is about 40%, the unlevered beta is Unlevered beta = 1.21/[1 + (1 - .4)½] = .93 2.

Suppose that a foreign project has a beta of 0.85, the risk-free return is 12%, and the required return on the market is estimated at 19%. What is the cost of capital for the project?

CHAPTER 14: THE COST OF CAPITAL FOR FOREIGN INVESTMENTS

199

ANSWER . The cost of capital for the project is k* = Rf + â* [E( Rm ) - Rf] where Rf is the risk-free required return, â* is the project beta, and E( Rm ) is the expected return on the market. Substituting in the numbers provided in the problem yields k* = .12 + .85(.19 - .12) = 17.95% 3.

If Consolidated Corp. issues a Eurobond denominated in yen, the 7% interest rate on the $1 million, one-year borrowing will be 2% less than rates in the United States. However, ConCorp would have to pay back the principal and interest in Japanese yen. Currently, the exchange rate is ¥183 = $1. By how much could the yen rise against the dollar before the Euroyen bond would lose its advantage to ConCorp?

ANSWER . The breakeven exchange rate is found where the dollar cost of borrowing dollars just equals the dollar cost of borrowing yen. If ConCorp borrows dollars, it will owe 1.09 x $1,000,000 at the end of the year (the U.S. interest rate is 2% higher than the Japanese rate of 7%). The cost of borrowing yen equals 183 x 1,000,000 x 1.07/S, where S is the spot value of the dollar in one year. Setting these two figures equal and solving for S yields S = 183 x 1.07/1.09 = ¥179.64. Thus the yen must appreciate by (183 - 179.64)/179.64 = 1.87% before yen borrowing becomes more expensive than dollar borrowing. 4.

Although the one-year interest rate is 10% in the United States, one-year, yen-denominated corporate bonds in Japan yield only 5%.

a.

Does this present a riskless opportunity to raise capital at low yen interest rates?

ANSWER . No. According to the international Fisher effect, the 5% interest differential reflects the market's expectations that the yen will appreciate by approximately 5% relative to the dollar over the coming year. b.

Suppose the current exchange rate is ¥140 = $1. What is the lowest future exchange rate at which borrowing yen would be no more expensive than borrowing U.S. dollars?

ANSWER . Along the same lines of problem 4, the breakeven exchange rate is found as the solution to S = 140 x 1.05/1.10 = ¥133.64. 5. Ford de Mexico can borrow dollars at 12% or pesos at 80% for one year. The peso:dollar exchange rate is expected to move from $1 = Ps 3300 currently to $1 = Ps 4500 by year's end. a.

What is the expected after-tax dollar cost of borrowing dollars for one year if the Mexican corporate tax rate is 53%?

ANSWER . The after-tax dollar cost of borrowing dollars overseas equals rus(1 - t) + ct, where ru s is the dollar interest rate, t is the local tax rate and c is the change in the dollar value of the local currency (LC). Similarly, the after-tax dollar cost of borrowing LC is rL(1 + c)(1 - t) + c, where rL is the LC interest rate. In the situation facing Ford, the expected devaluation of the peso over the course of the year is (1/3300 - 1/4500)/(1/4500) = 22.67% The expected after-tax dollar cost of borrowing dollars for a year at 12% is .12(1 - 0.53) - 0.53 x 0.2667 = -8.50%. b.

What is Ford's expected after-tax dollar cost of borrowing pesos for one year?

200 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH ED.

ANSWER . The expected after-tax dollar cost of borrowing pesos at 80% for one year is 0.80(1 - 0.2667)(1 - 0.53) 0.2667 = 0.90%. c.

At what end-of-year exchange rate will the after-tax peso cost of borrowing dollars equal the after-tax peso cost of borrowing pesos?

ANSWER . The point at which the peso costs of borrowing dollars and pesos are identical is the same as the point at which their dollar costs are identical (one is just a linear multiple of the other). Using the formulas presented above, the breakeven amount of currency change d is found at the point at which rus (1 - t) + ct = rL(1 + c)(1 - t) + c or c = (r us - r L)/(1 + r L) = (0.12 - 0.80)/1.80 = -37.78% The relationship between the beginning exchange rate, e0, and the end-of-period exchange rate, e1 , is e1 = e0(1 - d). Here, e0 = 1/3300, so e1 = (1/3300) x (1 - 0.3778) = $0.00018855, or Ps 5300 = $1. 6.

The manager of an English subsidiary of a U.S. firm is trying to decide whether to borrow, for one year, dollars at 7.8% or pounds sterling at 12%. If the current value of the pound is $1.70, at what end-of-year exchange rate would the firm be indifferent now between borrowing dollars and pounds?

ANSWER . The breakeven exchange rate change is c = (ru s - rL )/(1 + rL ) = (0.078 - 0.12)/1.12 = -3.75% In other words, the pound would have to depreciate by 3.75% during the year for the two loans to have the same dollar cost. A 3.75% pound depreciation would yield an end-of-year exchange rate equal to $1.63625 (1.70 x (1 - 0.0375)). 7.

Suppose that a firm located in Belgium can borrow dollars at 8% or Belgian francs at 14%.

a.

If the Belgian franc is expected to depreciate from BF 58 = $1 at the beginning of the year to BF 61 = $1 at the end of the year, what is the expected before-tax dollar cost of the Belgian franc loan?

ANSWER . The before-tax expected dollar cost of borrowing LC is r L(1 - d) - d, where rL is the LC interest rate and d is the change in the dollar value of the local currency (LC). In the situation facing the firm in Belgium, the expected devaluation of the Belgian franc over the course of the year is (1/58 - 1/61)/(1/58) = 4.92%. Substituting in the numbers given in the problem, we find that the after-tax dollar cost of borrowing Belgian francs for the year is .14(1 - .0492) - .0492 = 8.39%. b.

If the Belgian corporate tax rate is 42%, what is the expected after-tax dollar cost of borrowing dollars, assuming the same currency change scenario?

ANSWER . Since the after-tax dollar cost of borrowing dollars overseas equals rus(1 - t) - dt, where ru s is the dollar interest rate, the Belgian firm's yearly expected after-tax dollar cost of borrowing dollars is .08(1 - .42) - .0492 x .42 = 2.57%.

MULTINATIONAL MANUFACTURING

201

SUGGESTED ANSWERS TO MULTINATIONAL MANUFACTURING, INC.: PART I 1.

Should MMI lower the hurdle rate in order to encourage the submission of more proposals, or should it drop the hurdle rate concept completely?

ANSWER . The basic problem facing MMI is that its investment evaluation criterion is inconsistent with value-maximizing behavior on the part of divisional and affiliate management. MMI does not recognize that the cost of capital is a function of the riskiness of the project being considered, rather than a function of the company undertaking the project. Riskier projects require higher expected returns and less risky projects require lower expected returns. Treating all projects the same ignores the likely differences in their riskiness. MMI should drop the use of a single hurdle rate and instead use individual hurdle rates tailored to the risk characteristics of each project. 2.

Should MMI invest in lower-return projects that are less risky and/or in high-risk projects that appear promising? What is the relevant measure of risk?

ANSWER . According to the CAPM, the required return for a project is Required return = Risk-free + Project beta x Market risk return premium where the market risk premium is the required return on the market less the risk-free return. The project beta is based on the systematic risk of the project. The CAPM suggests undertaking less risky projects even if they have lower returns, provided the returns are at least equal to the required return for an investment of that degree of risk. Similarly, high risk projects should be undertaken if their expected returns are high enough to compensate investors for the risks they are bearing. 3.

How should MMI factor in the additional political and economic risks it faces overseas in conducting these project analyses?

ANSWER . Because most of the additional political and economic risks MMI faces overseas are unlikely to be systematic in nature, it should not adjust the discount rate for foreign projects to account for them. Rather, it should adjust the project cash flows to reflect the expected impact of these risks on their expected values. MMI should also be cognizant of the fact that operating overseas is likely to lower its systematic risk because of the diversification associated with operating in countries with different business cycles. Such diversification is likely to lower MMI's cost of capital as well as reduce the variance of its cash flows. 4.

Why are projects at the extremes of risk and return not reaching top management for review?

ANSWER . The asymmetrical reward structure facing management explains why MMI doesn't get to see projects at the extremes of risk and return. Typically, a project with a high expected return will have high risk. If management is penalized severely when returns fall short of 15%, it's not surprising that they don't present such projects for review. Similarly, a low risk project is likely to have an expected return less than 15%. If MMI does not factor in a project's low risk when evaluating managerial performance, such projects will also not be presented for top management review. 5.

What actions, if any, should Mr. Black take to correct the situation?

ANSWER . The most appropriate action would be to vary the required returns by project according to each project's systematic risk. More companies are making these adjustments now, albeit in somewhat ad hoc ways. Management could also reward managers for project's with high returns, offsetting somewhat their tendency toward conservatism. The rewards can't be too large, of course, or they will take unreasonable high-risk bets.

202 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH ED.

SUGGESTED ANSWERS TO MULTINATIONAL MANUFACTURING, INC.: PART II 1.

What are the pros and cons of using the following sources of funds to finance the operations of the foreign affiliates: equity funds versus loans from MMI, retained earnings of the affiliates, and outside borrowings?

ANSWER . By investing parent funds as debt rather than equity, MMI can avoid U.S. tax on the repayment of principal. Interest payments are also tax deductible locally, even if they are taxable in the United States. By contrast, the payment of dividends--the return on an equity investment--will often lead to further taxes, especially if the foreign unit has a tax rate less than 34%. Also, principal and interest payments on parent company loans are less likely to be subject to currency controls than dividend payments. Retaining earnings rather than paying them out as dividends makes sense from a tax standpoint if dividend payments will lead to higher taxes. Alternatively, paying out earnings as dividends and replacing these funds with borrowed money lowers the affiliate's exposure to political risk. The trade-off depends on the tax consequences versus the degree of political risk faced. If structured properly, outside borrowing can simultaneously reduce both political and economic risk. In particular, currency risk can be reduced by borrowing in currencies liable to move in the same direction as the return on the affiliate's assets. Thus, a local currency devaluation will simultaneously lower the return on the unit's assets and lower the dollar cost of servicing the debt. In addition, as discussed above, borrowing can reduce the firm's susceptibility to the political risks of expropriation and currency controls. Local borrowings are even more attractive to the extent that the government is willing to provide subsidized financing. 2.

Given these considerations, under what circumstances, if any, should the capital structure of foreign affiliates include more or less debt than the 35% considered desirable for the firm as a whole?

ANSWER . The affiliate's capital structure is an accounting fiction that does not reflect economic reality, which is that affiliates do not have independent capital structures. Rather, an affiliate's true capital structure is the capital structure of the company overall, because it is usually the worldwide company that stands behind the affiliate's liabilities. From this perspective, it makes sense to have more than 35% debt in a unit's capital structure whenever this will lower taxes, allow the unit to access additional amounts of subsidized financing, or reduce political risk and exchange risk. A lower debt ratio is warranted when these factors are not in play. The idea is to balance off units having high debt ratios with other units having lower debt ratios so as to achieve the target debt ratio for MMI as a whole. 3.

How will the resultant capital structures affect the required rates of return on affiliate projects? the actual rates of return?

ANSWER . The required return for an affiliate is an increasing function of the riskiness of the investments undertaken by that affiliate. But its actual returns may well depend on the capital structure it chooses because of taxes, interest expenses, and political and economic risks. 4.

How should MMI's dividend policy be implemented at the affiliate level?

ANSWER . MMI should have affiliates remit dividends in such a way as to lower its global tax burden, consistent with the effect of this remittance policy on political risks. For example, MMI should remit dividends from a low-tax country if that country appears likely to block future dividend remittances.

PLANO CRUZADO

203

SUGGESTED ANSWERS TO PLANO CRUZADO 1.

What were the likely consequences for Brazil of controlling prices while gunning the money supply? Consider the effect on production and the availability of products in the stores.

ANSWER . The likely consequences for Brazil would be suppressed inflation, shortages, and a large black market. Because of the price freeze, many farmers and manufacturers would be unable to make a profit. They would stop producing and pull their products off the shelves. At the same time, consumers would demand more goods at the artificially low prices. High demand and decreased supply would combine to create shortages and spawn a large black market, which they did. 2.

How did the Plano Cruzado affect Brazil's huge trade surplus?

ANSWER . The huge increase in demand generated by the Plano Cruzado pulled in more imports. At the same time, domestic demand absorbed more domestic production, leaving less available for export. The confounding factor is that domestic price controls provided local manufacturers with added incentive to sell abroad. As it turned out, the former consequences outweighed the latter one and Brazil's trade surplus virtually evaporated. 3.

What would be your forecast of the plan's effect on Brazil's ability to service its foreign debts?

ANSWER . As exports were diverted to the domestic market and imports were drawn in, Brazil's ability to service its foreign debts decreased. On February 20, 1987, one year after Plano Cruzado was hatched, Brazil declared a debt moratorium and suspended interest payments on an estimated $67 billion in foreign bank debt. 4.

President Sarnay terminated Plano Cruzado in February 1987, one year after it began. What impact do you think the plan had in reducing inflation and inflation expectations? How would you go about measuring the effect of the plan on inflation expectations?

ANSWER . The Plano Cruzado suppressed inflation, rather than controlling it. As such, rational people would anticipate that the plan would end in a price explosion. Indeed, once controls were eased just after the election in November 1986, inflation hit an annual rate of 400%. By 1988, inflation was approaching 600%. The triple digit interest rates in Brazil at the time revealed people's beliefs that the plan would fail to check inflation. 5.

What was the likely price response to the removal of price controls?

ANSWER . The likely effect would be a price level explosion and a nation hovering on the brink of hyperinflation. 6.

If you were a banker, how would seeing such a plan put into effect affect your willingness to lend money to Brazil? Explain.

ANSWER . The Plano Cruzado would reveal to any sensible person, including bankers, that Brazil was unwilling to address the hard political work of economic restructuring. It needed to remove subsidies to state industries and encourage the private sector. Instead, Brazil chose to let the public sector run out of control with the gap between revenues and expenditures financed by printing money. It then dealt with the resulting inflation by imposing price controls rather than by limiting special interest groups' access to state funds. Under these circumstances, a banker would be hesitant to risk more money. More generally, this plan represents all that is wrong with the way Brazil attacks its basic economic problems--it attacks symptoms rather than real problems, the real problem being that Brazil runs huge government deficits which it finances by printing money. By one count, Brazil had during the decade of the 1980s, eight monetary-stabilization plans, four different currencies, 11 different indexes to measure inflation, five wage-and-price freezes, 14 different wage policies, 18 changes in foreign-exchange rules, 54 changes in price-control guidelines, 21 different foreign-debt negotiations proposals, and 19 decrees on fiscal austerity. It has tried curbing credit, curbing demand, and even confiscating money

204 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH ED. from companies and individuals. The upshot: Inflation just keeps worsening. In 1987 it was 365%. In 1988, 933%. In 1989, 1,764%. And in 1990, 1,794%. Just between 1986 and 1994 Brazil issued cruzeiros, cruzados, cruzados novos, cruzeiros (again), and cruzeiros reais. Brazil is caught in a vicious circle. in a mixture of inflationary memories and expectations that turn into self-fulfilling prophecies. Inflation rises to a politically-unacceptable level, so the government proposes a plan to reduce it. But since previous plans failed, confidence is low, and Brazilians find a way around the plan or speculate against it. The plan fails, and prices rise again. The renewed inflation relaunches indexation, which relaunches inflation. When it becomes too high again, the government imposes a new plan, which inspires even less confidence than the previous one. It fails, too. The net result is a vicious cycle, leading to a downward spiral of the Brazilian economy. This spiral was only broken in mid-1994 when Brazil introduced the Real Plan, named after the new currency, the real. At the time, Brazilian inflation was running at 50% a month, or 12,875% annually ([1.512 - 1] x 100). In introducing the Real Plan, then-Finance Minister (and later President) Fernando Cardoso (ironically, a left-wing sociologist who had spent his academic career pushing for the statist policies that created most of Brazil's economic problems) pledged to link the real's value to the dollar and to impose temporary controls on government spending. Within a year of its introduction, the Real Plan had reduced Brazil's monthly inflation rate to 2% and brought Brazil its greatest stability in a quarter century. The verdict on the new currency came quickly. Campaigning for president in Brazil's impoverished northeast ten days after the real's introduction, Mr. Cardoso was mobbed like a soccer star by people who had never had a dollar and now had a currency worth as much as a dollar. He won the election by a 2-to1 margin. However, Brazil is not home free yet. The new stability brought a flood of capital into the Brazilian stock market, which in turn led to a jump in the real's value. Faced with rising imports and slowing exports, President Cardoso devalued the real, scaring investors and leading to a $10 billion outflow of capital. In response, the government pushed up interest rates. As the tight money policy slowed Brazil's economy, President Cardoso lost his nerve and decided to stimulate the economy by imposing harsh quotas on automobiles and other products, nearly provoking a trade war with other Latin American countries. Facing a firestorm of protest from investors and others over this turn to protectionism and away from free-market policies, he backed away from the quotas. The key to long-lasting success in economic policy is for Brazil to fully embrace the free-market policies it has so far only flirted with. It must revamp its tax system, cutting tax rates and broadening the tax base; control the government spending that is at the heart of its budget deficits and high inflation rate; deregulate the economy; and privatize moneylosing state-run industries and thereby eliminate the losses that are driving much of the government deficit. Reluctant though President Cardoso and other Brazilian politicians are to engage in these tasks, many investors are nonetheless optimistic that Brazil is on the right track--finally. The reason is that pressure for free-market policies and stability is coming from foreign investors and public opinion and not politicians. It is hard to overstate the discipline being exerted by the capital markets. Every time President Cardoso has backslid, the stock and bond markets have reacted ferociously, forcing him to reconsider. For example, in August 1995, Banco Economico, Latin America's oldest bank, collapsed under a mountain of bad debts. After meeting with President Cardoso, a group of influential politicians with ties to the giant bank announced that the government would assume Economico's $3.5 billion debt. Both the stock market and the president's approval ratings tumbled at news of this inflation-feeding government giveaway. Calm wasn't restored until President Cardoso said that the politicians had misinterpreted him and flatly rejected the idea of a bailout. As of mid-December 1995, the government was exploring a possible sale of the bank to private investors. This case illustrates a fundamental truth about economic stabilization. It is a complex process that requires a number of institutional changes to implement: an independent monetary authority that is committed to price stability, a downsized state sector to reduce the demands on public funds, open capital markets, and a government in control of its spending so as to minimize the deficits that eventually become monetized.