This Document Contains Chapters 20 to 21 Discussion Questions Chapter 20 20-1. In the 60s and 70s diversification seemed the order of the day, and in the 80s divestitures were in vogue. By the 90s refocusing was the motivation with the impetus found in low interest rates, changing regulation, intense competition, evolving technology, and many other factors. The financial uncertainties of 21st century produced conservative management focused on value creation with strong balance sheets, low debt and record high liquidity. Economies of scale seemed also to be important in the new millennium. 20-2. The conglomerate type merger is most likely to provide risk reduction in that firms may be negatively correlated with each other. 20-3. The firm can achieve this by acquiring a company at a lower P/E ratio than its own. The firm with lower P/E ratio may also have a lower growth rate. The combined growth rate for the surviving firm may be reduced and long-term earnings growth diminished. 20-4. Under a ‘purchase of assets’, the difference between purchase price and adjusted book value (based on fair market value) is established on the balance sheet as goodwill and must be written off as the asset value is impaired, at the discretion of the firm and its accountants. Eligible capital expenditures have a CCA rate of 7% and 75% of expenditure is eligible. 20-5. a. Some combining of production facilities could reduce manufacturing expense. b. Some combining of marketing efforts could reduce expenses and improve effectiveness. c. There could be a sharing of engineering and other technological know-how. d. The combined larger size might increase financing capabilities. e. Need for only one corporate headquarters with reduction in corporate staff. 20-6. A cash buyout generally will not qualify as a tax-free exchange and there may be an immediate tax liability to the selling shareholder. For this reason the shareholder may demand a higher price. 20-7. (Primary answer) Low stock prices made potential acquisitions appear to be attractively priced to the acquiring company. It will happen again. (Possible answer) Also, selling shareholders may have an opportunity to transfer out of underpriced issues into cash or better recognized stock of other firms. 20-8. If earnings per share show an immediate appreciation, the acquiring firm may be buying a slower growth firm as reflected in relative P/E ratios. This immediate appreciation in earnings per share could be associated with a lower P/E ratio. The opposite effect could take place when there is an immediate dilution to earning per share. Obviously, a number of other factors will also come into play. 20-9. The unusually high premium may be attributed to the high replacement value of the assets and the high quality of the acquired companies. 20-10. An unfriendly takeover may be avoided by: a. turning to a second possible acquiring company: a "White Knight" b. establishing a shareholders’ rights plans c. buying back outstanding corporate stock d. encouraging employees to buy stock e. staggering the election of directors f. increasing dividends to keep shareholders happy g. buying up other companies to increase size and reduce vulnerability h. reducing the cash position to avoid a leveraged takeover 20-11. While management may wish to maintain their autonomy and perhaps keep their jobs, shareholders may wish the highest possible for their holdings. 20-12. Share prices are often bid upwards in a proposed merger. The individual may benefit if he or she gets in early. However mergers may be called off with a subsequent decline in share price. An investor will lose if purchases were made at the height of the market. In some cases, Canadian Tire for example, not all shares were purchased in the takeover attempt. 20-13. The arbitrageur buys the stock of the merger candidate in hopes of exchanging it at a profit for the stock of the acquiring company or for cash. He may also short-sell the stock of the acquiring company and buy the stock of the merger candidate in anticipation of exchanging it for acquiring company stock and covering the short position at a profit. The danger of being a merger arbitrageur is that the merger may be called off and the value of the merger candidate’s stock may go down dramatically. 20-14. All three concepts are the same. The objective is to magnify results with a given level of capital or asset commitment, supported by a high degree of borrowing. So far there is not multiple taxation of a holding company’s share dividend payment. 20-15. From the trusts of the 1890s, the U.S. has had huge companies with little concern for foreign competition. Many feared that these companies would corner their markets and exercise monopoly power. In Canada, without the history of mammoth manufacturing concerns we have had the problem of small companies of insufficient scale to be efficient. In the resource sector we have large companies but they have to be because they sell much of their product based on the pricing mechanisms of the international markets. On the foreign ownership front, our experience with failing to build the hoped-for efficiencies and scale in secondary manufacturing has been coupled with a high level of foreign ownership. In resource areas like oil and gas it is perceived that control over the pace and methods of exploration is an issue of strategic national interest. Internet Resources and Questions 1. Use the text suggested resources or perhaps your own to identify recent merger and acquisition activity. Problems 20-1. Charles Corporation Cost (cash outflow): Purchase price $2,000,000 Less tax shield benefit from tax loss carry-forward ($600,000 × 25%) – 150,000 Net cash outflow $1,850,000 Benefits (cash inflows): $260,000, N = 20, %I/Y = 12% (Appendix D) Calculator: PV =? FV = 0 %I/Y= 12% Compute: Cost Benefit Net present value PMT = $260,000 N = 20 PV = $1,942,055 $1,942,055 1,850,000 $ 92,055 The positive net present value indicates the merger should be undertaken. 20-2. McCoy Corporation Cost: Purchase price $2,600,000 Less tax shield benefit from tax loss carry-forward ($750,000 × 26%) – 195,000 Net cash outflow $2,405,000 Benefit: $380,000, N = 20, %I/Y = 14% (Appendix D) Calculator: PV =? FV = 0 %I/Y = 14% Compute: Cost Benefit Net present value PMT = $380,000 N = 20 PV = $2,516,790 $2,516,790 2,405,000 $ 111,790 The positive net present value indicates the merger should be undertaken. 20-3. Arrow Corporation a. Reduction in taxes due to tax loss carry-forward = loss × tax rate = $400,000 × 25% = $100,000 b. Arrow Corporation (with merger and associated tax benefits) Total Values 2012 2013 2014 Before tax income Tax loss carryforward $160,000 $200,000 $320,000 $680,000 160,000 200,000 40,000 400,000 Net taxable income 0 0 280,000 280,000 70,000 70,000 Taxes (25%) 0 . Income available to shareholders (before tax income – taxes) $160,000 * ** 0 . $200,000 $250,000* $610,000** Before-tax income – taxes ($320,000 – $70,000 = $250,000) Before-tax income – taxes ($680,000 – $70,000 = $610,000) 20-4. J & J Enterprises Cost (Purchase price) Years (1-5) Cash inflow Synergistic benefits Total benefit Calculator: $4,000,000 $440,000 40,000 $480,000 PV =? FV = 0 %I/Y = 12% Compute: Years (6-15) Cash inflow Synergistic benefits Total benefit Calculator: Compute: Calculator: PMT = $480,000 N=5 PV = $1,730,293 $600,000 60,000 $660,000 PV =? FV = 0 %I/Y= 12% PV = $3,729,147 PMT = $660,000 N = 10 PV =? FV= $3,729,147 %I/Y = 12% N=5 Compute: PV = $2,116,018 Years (16-20) Cash inflow Synergistic benefits Total benefit Calculator: Compute: Calculator: PMT = 0 $800,000 70,000 $870,000 PV =? FV= 0 %I/Y= 12% PV= $3,136,155 PMT = $870,000 N=5 PV =? FV= $3,136,155 %I/Y = 12% N = 15 Compute: Total present value of benefits: Cost Net present value PMT = 0 PV = $572,564 $4,419,275 – 4,000,000 $ 419,275 The positive net present value indicates the merger should be undertaken. 20-5. McGraw Trucking Company Cost (Purchase price) Years (1-5) Cash inflow Synergistic benefits Total benefit Calculator: $5,000,000 $200,000 30,000 $230,000 PV =? FV = 0 %I/Y = 9% Compute: Years (6-15) Cash inflow Synergistic benefits Total benefit Calculator: Compute: Calculator: PMT = $230,000 N=5 PV = $ 894,620 $240,000 50,000 $290,000 PV =? FV = 0 %I/Y= 9% PV = $1,861,121 PMT = $290,000 N = 10 PV =? FV= $1,861,121 %I/Y = 9% N=5 Compute: PV = $1,209,601 Years (16-20) Cash inflow Synergistic benefits Total benefit Calculator: Compute: Calculator: PMT = 0 $320,000 90,000 $410,000 PV =? FV= 0 %I/Y= 9% PV= $1,594,757 PMT = $410,000 N=5 PV =? FV= $1,594,757 %I/Y = 9% N = 15 Compute: Total present value of benefits: Cost Net present value PMT = 0 PV = $ 437,821 $2,542,042 – 3,000,000 $ (457,958) The negative net present value indicates the merger should not be undertaken. 20-6. Wolf Corporation and Lamb Enterprises (approach similar to Table 20-4) a. Total earnings: Shares outstanding (in surviving corporation): New earnings per share = Lamb + Wolf $ 500,000 125,000 $625,000 Old + New 500,000 100,000 600,000 Net income $625,000 = = $1.04 Shares outstanding 600,000 b. Earnings per share of Lamb Enterprises increased because it has a higher P/E ratio than Wolf Corporation (20 × versus 16 ×). Any time a firm acquires another company at a lower P/E ratio than its own there is an immediate increase in post-merger earnings per share. c. Although earnings per share for Lamb Enterprises went up, we can not automatically assume the firm is better off. We need to know whether the Wolf Corporation will increase or decrease the future growth in earnings per share for the Lamb Enterprises and how it will influence its post-merger P/E ratio. The goal of financial management is not just immediate growth in earnings per share, but maximization of shareholder wealth over the long-term. 20-7. Jeter and A-Rod Corporations a. $30 ×1.60 $48 current price 50% premium price paid b. $48 × 400,000 $19,200,000 price paid shares total market value c. d. Price $48 = = 19.2 P/E ratio EPS $2.50 $19,200,000 total market value of A - Rod Corp. = 640,000 new shares $30 Jeter Corp.' s share price e. 2,000,000 old shares + 640,000 new shares = 2,640,000 total shares f. A-Rod Corp. earnings Jeter Corp. earnings Total earnings New postmerger EPS = $1,000,000 4,000,000 $5,000,000 total earnings $5,000,000 = = $1.89 total shares 2,640,000 g. Jeter Corp. paid a higher P/E ratio (19.2) for A-Rod Corp. than its own (15). This will always cause a dilution in EPS. h. Through more rapid future growth in earnings. 20-8. Surgical, Inc. a. Sales amount: 200,000 shares × $40 = Purchase amount: 200,000 shares × $1.00 = Capital gain Capital gains exemption Capital gain after exemption Taxable capital gain (50%) Taxes (28%) Aftertax profit (capital gain – tax) b. Sales amount: 200,000 shares × $72.50 = Purchase amount: 200,000 shares × $1.00 = Capital gain Capital gains exemption Capital gain after exemption Taxable capital gain (50%) Taxes (28%) Aftertax profit (capital gain – tax) $8,000,000 200,000 7,800,000 500,000 7,300,000 3,650,000 1,022,000 $6,778,000 $14,500,000 200,000 14,300,000 500,000 13,800,000 6,900,000 1,932,000 $12,368,000 c. Discount back: $12,368,000 for 5 years at 11 percent Calculator: Compute: PV =? FV= $12,368,000 %I/Y= 11% PMT = 0 N=5 PV = $7,339,806 This value of $7,339,806 exceeds the value in part (a) of $6,778,000. Deferring the sale (and the tax) appears to be the more desirable alternative. 20-9. Lindbergh Airlines a. Market price of Flight Simulators, Inc. + Premium of 60% b. 18 Value offered per share $48 Value offered per share $48 Purchase price 42 Gain $ 6 Percentage gain c. $6 = $42 Value after cancellation (original value) Purchase price 14.29% $30 42 Loss $12 Percentage loss d. $30 $12 = $42 28.57% Return Probability Expected Value + 14.29% .75 + 10.72% – 28.57% .25 – 7.14 Expected value It appears to be a good investment 3.58% 20-10. Minnie & Mickey Corporations a. Total earnings Minnie ($800,000) + Mickey ($1,600,000) = $2,400,000 Shares outstanding in surviving company: The Mickey Corp. Old (800,000) + New (200,000) = 1,000,000 New earnings per share = b. $40.00 × 1.25 $50.00 $50.00 × 200,000 $10,000,000 Shares issued = Net income $2,400,000 = = $2.40 Shares outstanding 1,000,000 market price of Minnie (25% premium) exchange value shares total price Total price $10,000,000 = = 250,000 (Mickey) Market share price $40 Also 1.25 × 200,000 Minnie shares = 250,000 Mickey shares. This shortcut approach may also be used because the shares have an equal price before the merger. c. Total earnings Minnie ($800,000) + Mickey ($1,600,000) = $2,400,000 Shares outstanding in surviving company: The Mickey Corp. Old (800,000) + New (250,000) = 1,050,000 New earnings per share = Net income $2,400,000 = = $2.29 Shares outstanding 1,050,000 20-11. Mickey-Minnie Corporations (continued) $40.00 × 2.00 $80.00 × 200,000 $16,000,000 Shares issued = market price of Minnie (100% premium) exchange value shares total price Total price $16,000,000 = = 400,000 (Mickey) Market share price $40 Also 2.00 × 200,000 Minnie shares = 400,000 Mickey shares. Total earnings: $2,400,000 × 1.25 = $3,000,000 Shares outstanding in surviving company: The Mickey Corp. Old (800,000) + New (400,000) = 1,200,000 New earnings per share = Net income $3,000,000 = = $2.50 Shares outstanding 1,200,000 Earnings per share increase by $0.50. ($2.00 to $2.50) 20-12. Shelton Corporation a. Coefficient of variation (V) = Premerger Postmerger σ $1.20 = 0.40 $3.00 D = $1.89 = 0.63 $3.00 b. Risk averse investors are being offered less risk and may assign a higher P/E ratio to postmerger earnings. 20-13. General Meter a. Merger with A (answer in millions of dollars) D = ∑ DP D .30 .40 .30 40 50 60 P 12 20 18 50 DP = D σ = ∑ (D − D ) P 2 D 40 50 60 D 50 50 50 (D– D ) – 10 0 + 10 (D– D )2 100 0 100 P .30 .40 .30 σ = 60 = 7.75 Coefficient of variation (V ) = σ D = 7.75 = 0.155 50 (D– D )2P 30 0 30 60 Merger with B (answer in millions of dollars) D = ∑ DP D .25 .50 .25 10 50 90 P 2.5 25.0 22.5 50.0 DP = D σ = ∑ (D − D ) P 2 D 10 50 90 D 50 50 50 (D– D ) – 40 0 + 40 (D– D )2 1,600 0 1,600 P .25 .50 .25 (D– D )2P 400 0 400 800 σ = 800 = 28.28 Coefficient of variation (V ) = σ D = 28.28 = 0.566 50 b. Though both alternatives have an expected value of $50 (million), the lower coefficient of variation, and thus lower risk in merger A should call for a higher valuation by risk averse investors. 20-14. Scoring Corporation a. Purchase price Book value Goodwill $80,000,000 30,000,000 $50,000,000 Goodwill is now written off as the asset is impaired. Therefore the write off will be based on market forces and management discretion. b. Three quarters of the $50 million is eligible for a 7% per year, declining balance deduction as eligible capital property. This will create an annual tax saving equal to 7% times the tax rate times the remaining cumulative eligible capital (decreased by the amount of writ off taken each year). c. By using a pooling of interest treatment the recording of goodwill could have been avoided. However, it is generally not allowed. Under some circumstances assets may be written off. 20-15. Ontario Corporation a. Assets ( in millions of $) Common Stock Holdings Eastern Corp. $ 301 Central Corp. $ 402 Western Corp. $ 103 Total $ 80 1 25% × 120 = 30 2 20% × 200 = 40 3 10% × 100 = 10 Liabilities Long term debt Preferred stock Common equity $ 244 $ 165 $ 406 $ 80 4 30% × 80 = 24 20% × 80 = 16 6 50% × 80 = 40 5 b. Shareholders’ equity/ Total holding company assets = $80× 50% / ($200 + $300 + $300) = 0.05 or 5% MINI CASE National Brands vs. A-1 Holdings (Merger analysis) This case features a surprise attack tender offer. The acquisition candidate decides to counter with a Pac Man defense in which they make an offer for the potential acquiring company. Both firms are considering various financing packages to establish their strategy including heavy leverage and the use of acquired assets as collateral. Consider the feasibility of the plans and the impact on shareholder wealth maximization. Consider social responsibility (good guy versus bad guy) issues related to the merger as well. a. (1) (2) According to Figure 1, there are 113,640,000 shares of National Brands outstanding. But, A-1 already owns 5% of them, or 5,682,000, so it will only have to buy the remaining 107,958,000. A $55 each, the total price will be $5,937,690,000 (a little over $5.9 billion). The amount of liquid assets (i.e., cash and equivalents) on hand at National is $1,153,000,000. If A-1 can use this amount to offset the amount of borrowing required, the total amount it will have to borrow is: $5,937,690,000 – $1,153,000,000 = $4,784,690,000 (3) After the purchase, A-1's total debt will consist of: A-1's old debt: National debt: Amount borrowed: Total $1,899,500,000 2,110,300,000 4,784,690,000 $8,794,490,000 Since all the funds to make the purchase were borrowed, A-1's total equity remains $395,000,000 after the purchase. Its debt to equity ratio after the purchase, therefore, is: $8,794,490,000 / $395,000,000 = 22.26 to 1! This is astonishing. Such high debt to equity ratios are not normally encountered except in financial institutions, such as banks. (In fact, A1's balance sheet resembles that of a bank; over 75% of its assets are in cash and equivalents, lending credence to the charge that corporations such as A-1 aren't "real" corporations after all, merely shells, or deposit accounts used by their owners, to make acquisitions). Given such a high debt to equity ratio, it is difficult to imagine how Mr. O'Brien could finance the purchase of National using debt sources. (4) In (2), above, we computed that $4,784,690,000 was needed to make the purchase. If A-1 issues stock at $13 a share to raise the funds, it will need to issue 368,053,077 new shares. (5) The total number of shares outstanding at A-1 after the purchase will be the 61,800,000 old shares plus 368,053,077 newly issued ones. Total expected earnings are the $192,000,000 A-1 originally expected plus $500,000,000 from National. So, A-1's EPS after the purchase will be: ($192,000,000 + $500,000,000)/ 61,800,000 + 368,053,077 = $692,000,000/ 429,853,077 = $1.61 (6) b. (1) (2) $1.61 represents a 48% decline from A-1's previous expected EPS of $3.11 (the decline, of course, was caused by the fact that National's P/E is much higher than A-1's). A-1's shareholders will be not be pleased, unless Mr. O'Brien can convince them that they will be better off in the long run (unlikely-National's growth rate is not high enough), or he has some other plan in mind, such as selling off pieces of National at a profit. National shareholders, on the other hand, will realize an immediate 15% capital gain. ($7.12 / $47.88) = 15 percent. They may be more satisfied, though 15 percent is a relatively small premium. Employing the Pac Man defense will cost National $17 a share times the 61,800,000 shares of A-1 outstanding, or $1,050,600,000. A-1 has $1,736,800 of liquid assets available. Using this amount to offset the amount of National stock to be issued brings the total amount of cash needed to be raised down to: $1,050,600,000 – $1,736,800,000 = -$686,200,000 It's a rather surprising result that National could buy A-1 without spending any of its own money at all! The Cash and Equivalents balance on hand at A-1 is more than enough to cover the cost of the company. Of course, National will have to assume all of A-1's debt too, which is rather substantial. (3) National's total debt after the purchase will be its old debt plus A-1's debt: National's old debt: A-1's old debt: National’s new debt: $2,110,300,000 1,899,500,000 $4,009,800,000 National's total equity after the purchase will simply be its old equity, $3,050,000,000. Therefore, National's debt to equity ratio after the purchase will be: $4,009,800,000 / $3,050,000,000 = 1.31 to 1 The new ratio of 1.31 to 1 is nearly double National's old ratio of .69 to 1, so the company will probably want to use at least some of A-1's cash to reduce its debt load instead. This situation illustrates why companies with large cash balances (and little debt) are attractive takeover targets. (4) If National uses A-1's $1,736,800,000 cash and equivalents balance to pay down A-1's $1,899,500,000 debt balance, it will not have any left to apply to the stock issue. Therefore, National will have to issue enough of its own shares at $47.88 each to cover A-1's entire cost of $1,050,600,000 $1,050,600,000 / $47.88 = 21,942,356 shares (5) The total number of shares outstanding at National after the purchase will be the 113,640,000 old shares plus 21,942,356 newly issued ones. Total expected earnings are the $500,000,000 National originally expected plus $192,000,000 from A-1. So, National's EPS after the purchase will be: ($500,000,000 + $192,000,000)/ 113,640,000 + 21,942,356 = $692,000,000/ 135,582,356 = $5.10 (6) Mr. Hall is correct. The A-1 purchase will not dilute National's earnings, at least in the coming year. They actually increase from $4.40 to $5.10. c. If National's P/E remains at its previous value of 10.9, its stock price can be expected to rise to $5.10 × 10.9 = $55.59. Of course, it is highly unlikely that its P/E will remain at its previous value. A-1's old P/E was only 4.2, less than half that of National. It is likely, therefore, that investors will lower their expectations for National somewhat, despite its higher earnings. If National's P/E drops only as far as 9.4, its stock price will remain at $47.88. Note-students may question why A-1 has a higher growth rate than National, yet its P/E is much lower. The answer lies in the fact that the P/E ratio does not depend on investors' growth expectations alone. In this case the P/E is inhibited by A-1's extremely high debt ratio. d. (1) As a result of A-1's offer to buy National, National's shareholders stand to realize a 15% capital gain, but National's management is against the move and will try to convince the shareholders to reject it. On the other hand, A-1's shareholders stand to realize a 31% capital gain ($13 to $17) if National buys A-1, and nothing in the case indicates that Mr. Kelly O'Brien would resist such a deal. Therefore, it seems likely that National's bid to purchase A-1 will prevail. It is tough to dismiss the suggestion that he may have engineered the entire situation merely to elicit the Pac Man response from National. In fact, this suggestion was reported in the press concerning the companies upon which this case is based. (2) It is difficult to say whether or not National's shareholders are better off as a result of their company's employment of the Pac Man defense. On the one hand they have been denied the chance for a 15% capital gain. On the other, they have gained a set of assets which may or may not achieve an equal gain, even in the long term. Further, the assets were not purchased as a part of an integrated capital budgeting program, but were obtained under duress. On balance, it would appear that A-1's shareholders would be the big winners in this situation. (3) Those who take sides with the corporate "raiders" would say that they provide a valuable function in the economy; weeding out inefficiency. They do this by buying inefficiently managed companies and restructuring them into more effective units. In the long run, they say, the economy as a whole is strengthened. Opponents charge that the practice is unfair to employees who are uprooted and often lose their jobs in the restructurings, and they maintain that business ought to concentrate on making money by producing quality products rather than making it by trading companies. In the long run, they say, the economy as a whole is weakened. The issue goes far beyond a case in finance, essentially becoming one of ethics and point of view. The truth is probably a blend of the two views, or the classic ‘it depends’. At the very least we can probably say that such decisions should not be made purely on the basis of the financial aspects of the situation. Chapter 21 Discussion Questions 21-1. In addition to the normal risks that a domestic firm faces (such as the risk associated with maintaining sales and market share, the financial risk of too much leverage, etc.), the foreign affiliate of a multinational firm is exposed to foreign exchange risk and political risk. 21-2. Some countries have charged that foreign affiliates subverted their governments and caused instability for their currencies in international money and foreign exchange markets. The less developed countries (LDC's) have, at times, alleged that foreign business firms exploit their labour with low wages. The multinational companies are also under constant criticism in their home countries. The home country's labor unions charge the MNC's with exporting jobs, capital, and technology to foreign nations, while avoiding their fair share of taxes. In spite of all these criticisms, the multinational companies have managed to survive and prosper. 21-3. Factors affecting the value of a currency are: inflation, interest rates, balance of payments, and government policies. Other factors that have an influence include the stock market, gold prices, demand for oil, political turmoil, and labor strikes. All of the above factors will not affect each currency in the same way at any given point in time. 21-4. When a country sells (exports) more goods and services to foreign countries than it purchases (imports), it will have a surplus in its balance of trade. Since foreigners are expected to pay their bills for the exporter's goods in the exporter's currency, the demand for that currency and its value will go up. On the other hand, continuous deficits in balance of payments are expected to depress the value of the currency of a country because such deficits would increase the supply of that currency relative to the demand. Of course, a number of other factors may also influence these patterns. 21-5. The spot rate for a currency is the exchange rate at which the currency is traded for immediate delivery. An exchange rate established for future delivery is a forward rate. 21-6. The foreign-located assets and liabilities of a MNC, which are denominated in foreign currencies. Conversion by exchange rates to a home country is called accounting or translation exposure. The amount of loss or gain resulting from this form of exposure and the treatment of it in the parent company's books depends upon the accounting rules established by the parent company's government. 21-7. Factors that influence a Canadian business firm to go overseas are: avoidance of tariffs; lower production and labor costs; usage of superior Canadian technology abroad in such areas as oil exploration, mining, and manufacturing; tax advantages such as postponement of Canadian taxes until foreign income is repatriated, lower foreign taxes, and special tax incentives; defensive measures to keep up with competitors going overseas; and the achievement of international diversification. There also is the potential for higher returns. 21-8. In studying exposure to political risk, a company may hire outside consultants or form their own advisory committee consisting of top level managers from headquarters and foreign subsidiaries. Strategic steps to guard against such risks include: a. Establish a joint venture with a local entrepreneur. b. Enter into a joint venture with firms from other countries. c. Purchase insurance. 21-9. An international financial feasibility study must go beyond domestic factors to also consider the treatment of foreign tax credits, foreign exchange risk, and remittance of cash flows. 21-10. A letter of credit is normally issued by the importer's bank; in which the bank promises to pay money for the merchandise when delivered. 21-11. In a parallel loan, the exchange rate markets are avoided entirely: that is, the funds do not enter the foreign exchange market at all. Also no financial institution is involved. In contrast, a fronting loan involves funds moving into foreign markets and the involvement of a financial institution to front for the loan. 21-12. LIBOR (London Interbank Offered Rate) is an interbank rate applicable for large deposits in the Eurodollar market. It is a bench mark rate just like the prime rate in Canada. Interest rates on Eurodollar loans are determined by adding premiums to this basic rate. Generally, LIBOR is lower than the Canadian bank’s prime rate. 21-13. When a multinational firm borrows money through the Eurobond market (foreign currency denominated debt), it creates transaction exposure, a kind of foreign exchange risk. If the foreign currency appreciates in value during the bond's life, the cost of servicing the debt could be quite high. 21-14. ADRs (American Depository Receipts) represent the ownership interest in a foreign company's common stock. The shares of the foreign company are put in trust in a New York bank. The bank, in turn, issues its depository receipts to the American shareholders of the foreign firm. Many ADRs are listed on the NYSE and many more are traded in the OTC market. 21-15. Debt ratios in many countries are higher than those in Canada. A foreign affiliate faces a dilemma in its financing decision. Should it follow the parent firm's norm or that of the host country? Furthermore, should this be decided at corporate headquarters or by the foreign affiliate? Dividend policy may represent another difficult question. Should the parent company dictate the dividends that the foreign affiliate must distribute or should it be left to the discretion of the foreign affiliate? Internet Resources and Questions 1. 2. 3. 4. www.edc.ca www.ifc.org http://fx.sauder.ubc.ca/ www.cmegroup.com www.cmegroup.com Problems 21-1. Spot Rate Conversions (Sept 2011) Dollars required to buy a given amount of these currencies a. 10,000 10,000 b. 2,000 2,000 c. 100,000 100,000 d. 5,000 5,000 e. 20,000 20,000 f. 50,000 50,000 × Euros 1/ 0.7174 = $13,939 × Rupees 1/ 46.598 = $42.92 × Yen 1/ 78.247 = $1,278 × Swiss francs 1/ 0.8011 = $6,241 × Swedish krona 1/ 6.5274 = $3,064 × Thai baht 1/ 30.460 = $1,641 21-2. The answer to this question depends on the time period in which the values are calculated. 21-3. Forward Premiums/ Discounts a. The euro was selling relative to the Canadian dollar, at a discount at 30 and 90 days, but a premium at 180-days, based on the spot rate. b. Forward premium (discount) = = Forward - spot 12 × spot contract length (months) 1.6326 − 1.6327 12 × = −0.00006125 × 12 = −0.000735 = −0.07% 1.6327 1 c. Forward premium (discount) = = Forward - spot 12 × spot contract length (months) 1.6333 − 1.6327 12 × = 0.00036749 × 2 = +0.000735 = +0.07% 1.6327 6 d. Forward rate is 1.6326 ($/ euro) for 90 days: Therefore 100,000 Euros = 100,000 × 1.6326 = $163,260 Canadian e. Forward rate is 1.6333 ($/ Euro) for 180 days: Conversely the forward rate is 1/ 1.6333 = 0.61226 (Euro/ $) Therefore $100,000 = $100,000 × 0.61226 = 61,226 euros 21-4. Cross Rates 1 Egyptian pound 1 Jordanian dinar = $0.2169 Canadian = $1.8932 Canadian $1 Canadian = 1/0.2169 Egyptian pounds = 4.6104 Egyptian pounds $1 Canadian = 1/ 1.8932 Jordanian dinars = 0.5282 Jordanian dinars 4.6104 Egyptian pounds 1 Egyptian pound (0.5282/ 4.6104) OR: 1 Jordanian dinar (4.6104/ 0.5282) = 0.5282 Jordanian dinars = 0.5282/ 4.6104 Jordanian dinars = 0.1146 Jordanian dinars 21-5. = 4.6104/ 0.5282 Egyptian pounds = 8.728 Egyptian pounds Cross Rates 1 Mexican n peso 1 Brazilian real = $0.1164 Canadian = $0.4325 Canadian $1 Canadian = 1/0.1164 Mexican n pesos = 8.5911 Mexican n pesos $1 Canadian = 1/ 0.4325 Brazilian reals = 2.3121 Brazilian reals 8.5911 Mexican n pesos 1 Mexican n peso (2.3121/ 8.5911) OR: 1 Brazilian reals (8.5911/ 2.3121) = 2.3121 Brazilian reals = 2.3121/ 8.5911 Brazilian reals = 0.2691 Brazilian reals = 8.5911/ 2.3121 Mexican n pesos = 3.7157 Mexican n pesos 21-6. 21-7. Cross Rates 1 Thai Baht 1 Panamanian balboa = $0.03280 Canadian = $1.3404 Canadian $1 Canadian = 1/0.03280 Thai Bahts = 30.4878 Thai Bahts $1 Canadian = 1/ 1.3404 Panamanian balboas = 0.74605 Panamanian balboas 30.4878 Thai Bahts 1 Thai Baht (0.7460/ 30.4878) OR: 1 Panamanian balboa (30.4878/ 0.74605) = 0.7460 Panamanian balboas = 0.7460/ 30.4878 Panamanian balboas = 0.0245 Panamanian balboas = 30.4878/ 0.7460 Thai Bahts = 40.8656 Thai Bahts Purchasing Power Parity $/ Swiss Franc (S.F.) = 0.40 in 1974 Comparative inflation rate (to 2011) = 441 = 2.205 200 The value of the Swiss franc to the dollar will rise in proportion to the rate of inflation in Canada compared to the rate of inflation in Switzerland. $/SF (2011) = $0.40/SF × 2.205 = $0.882 21-8. Purchasing Power Parity Comparative inflation rate (to 2011) = $/SF (2011) = $0.40/SF × 0.50 = $0.20 100 = 0.50 200 21-9. Interest Rate Parity Initial value × (1 + interest rate) 150,000 × 1.10 = 165,000 Australian dollars Australian dollars × 0.9367 165,000 × 0.9367 Return = = Canadian dollars equivalent = 154,556Canadian dollars $154,556 − $145,000 = 0.0659 = 6.59% $145,000 21-10. French Investor a. Initial investment Value after one year = 100 × $45 = $4,500 = 100 × $53.65 = $5,365 Equivalent value to the French investor = $5,365 × 1.10 = $5,902 $5,902 − $4,500 Return = = 0.3116 = 31.16% $4,500 b. Initial investment Value after one year = 100 × $45 = $4,500 = 100 × $55 = $5,500 Equivalent value to the French investor = $5,500 × 0.90 = $4,950 4,950 − $4,500 Return = = 0.1000 = 10.0% $4,500 21-11. Canadian Investor a. Initial investment Value after one year = 100 × $370 = $37,000 = 100 × $352 = $35,200 Equivalent value to the Canadian investor = $35,200 × 1.04 = $36,608 Return = $36,608 − $37,000 = −0.0106 = −1.06% $37,000 b. Initial investment Value after one year = 100 × $370 = $37,000 = 100 × $334 = $33,400 Equivalent value to the Canadian investor = $33,400 × 0.98 = $32,732 Return = $32,732 − $37,000 = −0.1154 = −11.54% $37,000 21-12. Blue Moon Industries a. Receipts in one year’s time: 1. Take a chance on the spot rate(at the future date): 250,000,000 yen @ 0.012625 = $3,156,250 Canadian 2. Book a forward contract: 250,000,000 yen @ 0.012593 = $3,148,250 Canadian 3. Money market hedge: Borrow 1 year discounted: 250,000,000 yen Borrow 250,000,000/ 1.001 = 249,750,250 Convert to Canadian at the spot rate 249,750,250 @ 0.012255 = $3,060,689 Canadian Invest in Canada at the current interest rates $3,060,689 Canadian @ 1.03 = $3,152,510 Pay off the yen loan with the receipt of the 250,000,000 yen. b. Although the spot rate appears to produce the best return, it is uncertain and introduces risk. The money market hedge provides the best result with minimal risk. There is a risk-free arbitrage opportunity here: An arbitrageur who borrows 1,000,000 yen can invest $12,255 at 3%, which will return $12,622.65 after a year, time at which the arbitrageur will owe 1,001,000 yen. By entering into a forward contract, the amount owed after one year will be $12,605.59. This represents a risk-free profit of $17.06. The action of arbitrageurs (if bank fees and co-operation don’t get in the way) will drive out arbitrage opportunities, resulting in very similar results in the forward and money markets. 21-13. Royal Minty a. Purchase in six month’s time (180 days): 20,000 ounces @ $8.30 = $166,000 U.S. 1. Take a chance on the spot rate (at the future date): $166,000 @ 1/ £ 1.7915 = £ 92,660 2. Book a forward contract: $166,000 @ 1/ £ 1.7863 = £ 92,930 3. Money market hedge: Invest 180 day discounted: $166,000 (to meet contract) Invest $166,000/ 1+ (0.0115 × 180/ 365) = $165,064 Convert to £ (pounds) at the spot rate $165,064 @ 1/ 1.8127 = £ 91,060 Borrow in Britain at the current interest rates £ 91,060 @ 1 + (0.0470 × 180/ 365) = £ 93,171 owed in 180 days Pay off the pound (£) loan. b. Although the spot rate appears to produce the lowest, it is uncertain and introduces risk. The forward contract provides the best result with minimal risk, although very similar to the money market hedge. 21-14. Nickel Plains of Canada a. Purchase in three month’s time (90 days): 500,000 pounds @ $6.96 = $3,480,000 U.S. 1. Take a chance on the spot rate (at the future date): $3,480,000 @ 1.3333 = $4,639,884 Canadian 2. Book a forward contract: $3,480,000 @ 1.3421 = $4,670,508 Canadian 3. Money market hedge: Invest 90 day discounted: $3,480,000 (to meet contract) Invest $3,480,000/ [1+ (0.0160 × 90/ 365)] = $3,466,325 Convert to $ Canadian at the spot rate $3,466,325 @ 1.3404 = $4,646,262 Canadian Borrow in Canada at the current interest rates $4,646,262 @ [1 + (0.020 × 90/ 365)] = $4,669,175 owed in 90 days Pay off the loan. b. The money market contract provides the best result (slightly) for minimal risk. 21-15. Weese R. Grains of Canada a. Receipts in one year’s time: 5,000 tonnes of wheat @110 euros = 550,000 euros 1. Take a chance on the spot rate(at the future date): 550,000 euros @ 1.3485 = $741,675 Canadian 2. Book a forward contract: 550,000 euros @ 1.3676 = $752,180 Canadian 3. Money market hedge: Borrow 1 year discounted: 550,000 euros Borrow 550,000/ 1.0377 = 530,018 euros Convert to Canadian at the spot rate 530,018 euros @ 1.3805 = $731,690 Canadian Invest in Canada at the current interest rates $731,690 Canadian @ 1.0340 = $756,568 Pay off the euro loan with the receipt of the 550,000 euros. b. The money market hedge provides the best result with minimal risk. 21-16. Exploratory Resources a. The Calgary bank has extended a loan denominated in U.S. dollars and will be repaid in U.S. dollars. If the U.S. dollar increases in the future (a possibility implied by the futures contract price), the Calgary bank will be paid back in a currency that is worth more at the time it is repaid than it was at the time it was borrowed. b. Basically the bank is buying U.S. dollars now for 0.9877 (1/$1.0125) and expecting to sell them in the future for 0.9894 (1/$1.0107), if the future rate is a reliable predictor of the future spot rate. The expectation is for $0.0017 on the $1,000,000 or $1,700 Canadian, to be made on the exchange rate. c. By hedging the bank assures that the foreign exchange gain will be exactly $1,700. The extra $100 does not affect the decision much. Of course the bank could also raise the funds in the United States market that it needs to fund the loan. It would then essentially have a natural hedge and would only face exchange risk on repatriation of the interest margin earned. 21-17. Campbell Electronics Corporation a. Before tax earnings Foreign income tax @ 20% Earnings after foreign income taxes Dividends repatriated Gross Canadian taxes @ 25% of foreign earnings before taxes Foreign tax credit Net Canadian taxes payable $5,000,000 -1,000,000 4,000,000 4,000,000 1,250,000 -1,000,000 $ 50,000 Aftertax cash flow from dividend: = ($4,000,000 – $50,000) = $3,950,000 Problems: Appendix 21A 21A-1. Office Automation Corporation a. Revenue – Operating expenses – Amortization (20 M/5) = Earnings before foreign taxes – Foreign income tax (25%) = Earnings after foreign income taxes = Dividends repatriated Gross Canadian taxes (40% of foreign earnings before taxes) – Foreign tax credit = Net Can. taxes payable Aftertax dividend received Exchange rate (2 francs/$) Aftertax dividend (Can. $) Year 1 20.00 10.00 4.00 (values in millions of francs) Year 2 Year 3 Year 4 Year 5 20.00 20.00 20.00 20.00 10.00 10.00 10.00 10.00 4.00 4.00 4.00 4.00 6.00 1.50 6.00 1.50 6.00 1.50 6.00 1.50 6.00 1.50 4.50 4.50 4.50 4.50 4.50 4.50 4.50 4.50 4.50 4.50 2.40 2.40 2.40 2.40 2.40 1.50 0.90 3.60 1.50 0.90 3.60 1.50 0.90 3.60 1.50 0.90 3.60 1.50 0.90 3.60 2.00 $1.80 2.00 $1.80 2.00 $1.80 2.00 $1.80 2.00 $1.80 PV IFA (%I/Y = 16%; N = 5) of dividends Calculator: Compute: PV =? FV = 0 %I/Y = 16% PMT = $1.8 million N=5 PV = $5.893 million Amortization equals 4.00 million per year: 4.00/ 2 francs/$ = $2.00 Calculator: PV =? FV =0 %I/Y = 16% Compute: The PV of all the cash inflows =$5.893 + $6.549 = Cost of project Net present value of the project PMT = $2.0 m. N=5 PV = $6.549 million $12.442 million –10.000 million $ 2.442 million The net present value of the project is positive; the firm should invest. b. The change in foreign exchange values must be applied to both aftertax dividends received (in francs) and depreciation (in francs). Aftertax dividend received Amortization Total (in francs) Exchange rate (F/$1) Cash inflow (Can. $) PV IF (16%) PV (Can. $) Year 1 3.60 4.00 7.60 2.20 3.45 .862 +2.97 (in millions) Year 2 Year 3 Year 4 3.60 3.60 3.60 4.00 4.00 4.00 7.60 7.60 7.60 2.40 2.70 2.90 3.17 2.81 2.62 .743 .641 .552 + 2.36 + 1.80 + 1.45 Year 5 3.60 4.00 7.60 3.20 2.38 .476 + 1.13 Total = 9.71 PV of all the inflows equals Cost of project Net present value of the project $ 9.71 million 10.00 million ($0.29) million On a purely economic basis, the investment should now be rejected. Solution Manual for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley Danielsen, Doug Short, Michael Perretta 9780071320566, 9781259268892, 9781259261015
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