CH-17-18 Corporate Restructuring – Practical Financial Management : Book Guide

This Document Contains Chapters 17 to 18 CHAPTER 17 CORPORATE RESTRUCTURING FOCUS The first two thirds of this chapter provides a fairly comprehensive overview of merger activity in the United States. We begin with definitions and quickly move on to history and the economic effects of mergers. A good deal of attention is given to determining the maximum price an acquirer should be willing to pay for an acquisition and the tremendous latitude inherent in that calculation. At the end of the discussion, the reader understands why it's easy to pay too much for a company. A discussion of other restructuring forms briefly describes LBOs, proxy fights, and divestiture techniques including the spinoff. The last third of the chapter is an introduction to bankruptcy concepts and procedures. PEDAGOGY The discussion here is a practical, easy to read treatment of the procedures and implications of a variety of forms of restructure. We assume the student knows nothing about the field to start and develop all ideas from their beginning. The effort concentrates on mergers and bankruptcy. TEACHING OBJECTIVES Students should gain an understanding of the concepts and procedures involved in mergers and be able to make calculations that lead to a reasonable per share acquisition price. Importantly, they should understand how arbitrary that calculation can be. Students should also become familiar with the reasoning behind the federal bankruptcy laws and gain a basic understanding of the associated proceedings. OUTLINE I. MERGERS AND ACQUISITIONS A. Definitions, Terminology, and Procedure Mergers, acquisitions, and consolidations defined. Friendly and unfriendly procedures. Vertical, horizontal, congeneric, and conglomerate mergers. Strategic versus financial mergers. B. The Antitrust Laws The desirability of a competitive economy and the potentially anticompetitive effects of mergers. C. The Reasons Behind Mergers Synergy, growth, diversification, etc., and ego. D. Holding Companies The parent subsidiary relationship. E. The History of Merger Activity in the United States Seven merger waves from the turn of the century until 2015. Some characteristics of each. Some detail on recent activity. F. Merger Analysis and the Price Premium The merger as a capital budgeting project. Sensitivity of price to variation in assumptions. G. Defensive Tactics The things managements can do to avoid being acquired, before and during an attempt. White knights, poison pills, greenmail among others. II. OTHER KINDS OF TAKEOVER - LBOs AND PROXY FIGHTS A. Leveraged Buyouts (LBOs) Investors buy the company using a little equity and a lot of debt. Risks in LBOs. B. Proxy Fights A competition for stockholders’ votes. III. DIVESTITURES A. Reasons for Divesting Typically: a need for cash, lack of strategic fit, poor performance. B. Methods of Divesting Operations Sale, spinoff, and liquidation. IV. ACTIVIST INVESTORS A. Organization and Procedures Activist hedge funds buy a relatively small percentage of a public company’s stock and `agitate to force changes aimed at increasing the stock’s price and payments to shareholders. B. Positives – Corporate Boards are paying more attention to stockholders. C. Negatives- Companies have cut spending on capital to distribute more to stockholders. D. Two well-known recent cases. IV. BANKRUPTCY AND THE REORGANIZATION OF FAILED BUSINESSES A. Failure and Insolvency Economic versus commercial failure. If one creditor sues successfully, what happens to everyone else. B. Bankruptcy - Concept and Objectives A legal proceeding that keeps the firm operating until the best overall course of action is found. C. Bankruptcy Procedures - Reorganization, Restructuring, Liquidation The nature of a reorganization plan, the idea of debt restructuring through extension or composition, trading equity for debt. The approvals necessary. The priority of claims. QUESTIONS 1. The Highland Instrument Company has revenues of about $300 million per year. Its management is interested in expanding into a new type of product manufactured primarily by Lowland Gauge Inc., a firm with sales of about $200 million annually. Both firms are publicly held with a broad base of stockholders. That is, no single interest holds a large percentage of the shares of either firm. Describe the types of business combination that might be available for the two firms. Include ideas like merger, consolidation, acquisition, and friendly and hostile takeovers. How would Highland's management get started? Do the relative sizes of the two firms have any implications for the kinds of combination that are possible or likely? Answer: This could be a merger or a consolidation. Because the sizes aren't too different, a consolidation seems most reasonable. Similarly, the sizes imply that a hostile takeover would be difficult. The size issue, however, is only an indication, and any method is possible regardless of size. 2. Hostile acquisitions create real animosities between the stockholders of the acquired and acquiring companies. Comment on the truth of this statement. Answer: The hostility is between managements and boards of directors. The target's stockholders are generally only interested in the return on their investments. Therefore if an acquiring company offers a hefty premium, they're nothing but pleased. 3. Define vertical, horizontal, congeneric, and conglomerate mergers and describe the economic effects of each. Answer: A vertical merger is between companies at different places along the chain from raw material to finished product. For example, a baker acquiring a firm that processes grain into flour would be a vertical merger. The anticompetitive effects of such a merger tend to be indirect. In the example, it might limit competing bakers' supplies of flour but would not immediately affect the competition among bakers in the sale of their products. A horizontal merger is between direct competitors and obviously reduces competition in the industry. A congeneric merger is between firms in related but different industries, for example an airline acquiring an travel agency. Anticompetitive effects are initially mild but such mergers of large companies can lead to concentrations of economic power. A conglomerate merger is between firms in unrelated businesses and has little effect on competition. 4. Industry A is dominated by ten large firms each with sales of approximately $500 million per year. A proposal to merge two of these firms was approved by the Justice Department as not violating the antitrust laws. Industry B is locally defined and much smaller. It is dominated by three small firms, each selling about $50 million per year. A merger between two of these companies was prohibited under the antitrust laws. Explain the logic under which the merger of two $500 million giants can be allowed while the relatively insignificant merger of two small companies is disallowed. Answer: The competitive effect of mergers is defined relative to the industry in which the merging companies operate. The large merger leaves nine firms competing where there were ten, not a big decrease. The small merger leaves only two competitors where there were three, a larger relative change. 5. Suppose an industry is dominated by three firms, one of which is twice as large as the others, which are about the same size. Could a merger of the two smaller firms actually increase competition in the industry? Answer: Yes, the current industry structure could allow the large firm to dominate the industry because of its size advantage. It might, for example, be able to set prices at will. If the two smaller companies combine the resulting firm might be able to challenge the large one on an equal footing. That could bring about a competitive environment where there effectively was none before. 6. Clarington Corp has a division that's been performing well but doesn't fit into the company's long-term strategic plans. Describe the methods through which it can divest the operation. Answer: The division can be sold for cash to another company or to a group of investors in an LBO. It can also be spun off by issuing separate stock certificates for the division to the firm's existing shareholders. Liquidating probably isn't feasible because the division is doing well, and liquidating a going concern can be expected to result in a big loss. 7. The Blivitt Company has been losing money and experiencing serious cash flow problems lately. The main problem is a large debt to the First National Bank, which was used to purchase a computer that's now obsolete. Bill Blivitt, the firm's owner has stated his intention to declare bankruptcy to rid the company of the loan. He expects to go in and out of Chapter 11 in a few weeks and emerge essentially as before but without the loan. Write a note to Bill explaining bankruptcy procedures and why this is probably an unrealistic approach on his part. Answer: Bill: Voluntary bankruptcy may be an answer to your firm's current financial problems, but it's not likely to be an easy one. Once in bankruptcy, a court appointed trustee will essentially run the business. Therefore you won't be in control and won't be able to take much money out of the business from that time on. In order to emerge from Chapter 11, and continue after the bankruptcy proceeding, a bankrupt firm must go through a reorganization. That generally means some agreement has to be made with creditors that reduces or postpones the payment of the firm's obligations to them. It's important to understand that the agreement of creditors is essential to emerging from bankruptcy, and running the company again yourself. The First National Bank is unlikely to agree to anything that leaves the Blivitt Company whole at its own expense. It's likely to insist on part ownership or a strong voice in future management in return for any concessions it gives. It's also more likely to postpone debt repayment than forgive anything outright. Therefore, although bankruptcy may be an option, you should probably consider it a last resort. BUSINESS ANALYSIS 1. The Cranston Company would like to acquire the Lamont Company, but overtures made to management have been emphatically rebuffed. Five investors who were involved in the company's founding and continue to be active in its management own 45% of Lamont's stock. Charlie Hardnose, Cranston's Director of corporate development, has suggested a hostile takeover, which would bypass Lamont's management. Could this work and does it seem to be a very good idea in this situation? Answer: It's possible but unlikely. The major shareholders don't seem likely to sell so Cranston would have to get the approval of nearly all of the others to gain control. That's likely to be tough to do at any reasonable price. 2. You're a seasoned financial executive who's recently been hired as the CFO of the Pilaster Corporation. The firm has just finished two years in which its financial performance has been clearly subpar. The company isn't in danger of failing, but it's clear that earnings and growth could be much better. The market price of Pilaster's stock reflects this lukewarm performance. It is currently selling for $32, down substantially from its peak of $48 a little over two years ago. (The market has been generally flat in the last two years.) Several observers have blamed the lackluster performance on the firm's CEO, Gerald Bean weather, and his top assistants. Several years ago this team installed some new technological and managerial methods that haven't worked out well. Recently, they've been talking about returning to the old, time- tested methods which most people feel will bring the firm back to its usual performance levels. In fact, your hiring was part of the turnaround effort. It's currently 7AM on a cold, bleak Monday morning in February. On the previous evening, the CEO's secretary phoned the entire executive team calling an emergency meeting for this morning. The group is now assembled waiting to hear what's going on. At 7:01 Gerry walks into the room obviously upset. He says that on the previous afternoon he received a call from Harvey High roller, the CEO of Marble Inc., the leading firm in the industry. Marble is interested in acquiring Pilaster and is willing to offer $37 a share for its stock, a premium of more than 15%. Marble has a history of making both friendly and unfriendly acquisitions. a. What kind of combination is Marble currently proposing? b. What is likely to happen if Pilaster's management rejects Marble's offer? c. Is Marble likely to be successful over management's objections? d. Why is Gerry so personally upset? e. Should you be personally upset? f. Is Marble's offer a good deal for Pilaster's stockholders? g. What should Pilaster's management do to avoid acquisition by Marble? h. Do you think Marble is likely to be successful in an unfriendly merger attempt over Pilaster's defenses? i. If Marble is not successful, what can the Bean weather team do to reduce the chances of a similar attack in the future? Answer: a. A friendly merger. b. Marble will probably attempt an unfriendly merger by making a tender offer to stockholders at some price in excess of market price. c. Marble's chances are good because stockholders are upset with Pilaster's current performance and the stock's price. A 15% price premium, however, would be marginal. (There's no reason that the premium offered in an unfriendly bid has to be the same as the 15% currently on the table.) d. Gerry's management is seen as the cause of Pilaster's problems, so Marble isn't likely to think much of his abilities. He'd probably be fired along with his team if Marble takes over Pilaster. e. Probably. There isn't much reason to keep you around if Pilaster is folded into Marble's operations. f. This is a tough call. Marble's offer is above market so it's a good deal in the short run. In the long term, however, things aren't so clear. The stock is depressed and might return to its previous price level, which is substantially higher than Marble's offer. This makes the deal questionable especially in the light of Bean weather's intention to return to old methods. g. Pilaster's management's best hope is to convince the stockholders that the price decline is the temporary result of an unfortunate management experiment which didn't work but taught the company a lot. Therefore future performance should be even better than it was prior to two years ago, and the stock's price will soon rise above $48. h. Marble would probably have to offer more than a 15% premium, but would have a good chance if it did. i. Any of the pre-merger defensive tactics listed in the text. 3. The Blue Tag Company and the Pink Label Corporation both make packaging and labeling equipment. The following facts are relevant. a. Both firms use similar production and sales methods. b. Pink Label has been losing money for years, while Blue Tag has been and is expected to be profitable. c. There is a great deal of overhead in label making. d. The industry is dominated by the much larger Yellow Marker Co., which is difficult to compete with because of its size advantage. The managements of the two companies are considering a merger. What arguments can be made in favor of such a combination? Answer: a. A number of synergies are probably available by combining production and sales among other functions in the two similar companies. For example one factory might be closed by transferring all production to the more efficient of the two eliminating all of its overhead. It’s also likely that one sales force can carry both product lines allowing a reduction in sales people without a loss of volume. b. Taxes will be saved from Pink Label's tax loss carry-forward and from future losses until they're eliminated. c. There are probably opportunities to eliminate as well as spread overhead with larger production runs and economies of scale. d. The firms can grow large enough to compete with Yellow Marker faster by merging (external growth) than by growing themselves internally. In addition, the acquisition of Pink by Blue may represent the chance to pick up assets below cost because of Pink's poor financial condition. 4. The Phlanders Flange Co. has been doing quite well lately and would like to accelerate its growth within the flange industry. Harry Flatiron, the firm's CEO, has become interested in growth through acquisition because of some exciting articles in the business press. In particular he's interested in a friendly acquisition of the Framingham Flange Factory, whose general manager, Jack Daniels (a major stockholder in Framingham), he's known for some time. Harry is prone to quick action based on brief analyses that he does himself. In the past his instincts have been pretty good, and this style has not as yet caused any major mistakes. Harry has taken Framingham's own estimate of its future cash flows and long term growth rate along with synergies he and Jack have estimated to come up with a projected value for the company. All this has led to a proposal to offer Framingham's stockholders a 60% premium on the price of their stock. You're Phlanders' CFO, but Harry has done all this on his own. He's about ready to make a verbal offer to Framingham's management, and has asked you to check over his figures. His arithmetic is correct, but you're very concerned about the validity of his assumptions. Prepare a short memo to Harry outlining the risks associated with value estimates in mergers and the consequences of a mistake. Include advice on how to proceed. Answer: Harry: Your calculations are correct, but I have some concerns that the result may be overvaluing Framingham. A price sixty percent above market value represents a big premium to pay for a company, and we need to look very hard at the assumptions behind it. It's important to keep in mind that an overvaluation will result in a direct transfer of wealth from you and our other stockholders to Jack Daniels and Framingham's stockholders. Once that's done, you'll never get the money back. Value assessments in mergers are notorious for overestimating the worth of acquired companies. This is because the calculations turn out to be very sensitive to certain simple assumptions about an acquired firm's future cash flows. In other words different assumptions, within a reasonable range, can lead to vastly differing values for the firm. The long-term growth rate of the target firm is particularly critical in this respect. It's easy to construct an example in which an extra percent or two of growth leads to a doubling or tripling of the premium over market price to be paid. Synergies are another kind of problem. Reasonable, experienced people consistently estimate synergies in mergers that fail to materialize. The fact is that synergies are very hard to achieve, and often involve costs that weren't foreseen before the merger. Another major problem in any estimate of the future is bias, people don't look at the same things in the same ways. As a rule, most people tend to overvalue the things they own or are closely associated with. In this case, I'm concerned that Jack Daniels may have an honest but inflated opinion of Framingham's future prospects. I'd like to recommend that you and I and the rest of the executive staff meet and go over the assumptions in the Framingham estimate before you make them an offer. They shouldn't mind a short delay for such a large transaction. It might also be a good idea to have an impartial third party look at the deal. There are consulting firms that specialize in valuing companies. Using one of them could easily save more than it costs. 5. You're the CFO of the Littleton Lighting Company. Joan Bright way, the president, has approached you and the firm's other senior executives with a proposal to take the company private through an LBO. She says that this is a good time to do it because the economic outlook is shaky, and the firm's stock price is depressed. Therefore, it will take less money to acquire control. You agree that the weak outlook has depressed the stock's price, but aren't sure that this doesn't argue against an LBO at this time. You're also concerned that some fundamental weakness is developing in the demand for the firm's product. Certain successful LBOs have received a lot of favorable press lately, and you're concerned that Joan and the other nonfinancial executives may not appreciate the risks involved in the procedure. Prepare a memo outlining what's involved in an LBO and why the maneuver is risky, especially with respect to the business's performance in the immediate future. Make a recommendation on the analyses that should be undertaken prior to going forward. Answer: Joan and staff: An LBO to take over Littleton is an exciting idea, but it has to be examined carefully, because it's also a risky idea. A few successful LBOs have gotten a lot of publicity lately, and that has made the technique popular. However, a large number of others have failed. Failures generally don't get written up in the paper, so our perception of the probability of success may be distorted. An LBO to buy Littleton would involve investing a good deal, if not all, of our personal wealth in the company and borrowing the rest of the purchase price. In most LBOs, the borrowing is secured by the company's assets. That means the lender can take the assets if a default occurs. The resulting firm, which we would own, would have very little equity and a great deal of debt. As a result of the debt, it would be burdened with large interest payments. Such interest payments are important and the source of the trouble LBOs get into. If business falls off, cash flow deteriorates, and the firm can't pay the interest on LBO generated debt. The bank then takes the firm's assets without which it can't operate, and everything collapses, including the personal wealth of the investors. The crucial factor in most LBOs is that they can't tolerate any deterioration in business after the deal. In fact, many depend on an improvement to service their debt. All this is a concern in our current situation. On the one hand, Littleton's stock is depressed, and that might lead to our getting the firm at a relatively low price. However, it might not. If the current stockholders feel the price depression is temporary, they may not be willing to sell cheaply. More importantly, the current low stock price may reflect a general expectation of bad business conditions ahead. If that expectation turns out to be right, an LBO is likely to fail because of the company's inability to service the post-takeover debt. We need to make a very careful and conservative estimate of future business and the debt required to buy the company. Then we can determine whether or not we're likely to be able to pull off an LBO successfully. PROBLEMS Basic Merger Analysis: Concept Connection Example 17-1 (page 735) 1. The target of an acquisition generates cash flows of $8M per year with a risk level consistent with a return on equity of 16%. a. How much should an acquirer be willing to pay if it won’t consider more than five years of future earnings in setting a price? b. What is the per share price if the target has 300,000 shares of common stock outstanding? c. Assume the acquirer intends to pay for the acquisition with its own stock, which is currently selling for $36 per share. How many shares must be offered for each share of the target’s stock? Solution: a. The acquirer should be willing to pay the present value of the target’s future cash flows over the evaluation period. 2. Grandma's Cookies Inc. is considering acquiring Mother's Baked Goods Inc. After consideration of all benefits, synergies and tax effects, Grandma (originally a finance major) has estimated that the incremental cash flows from the acquisition will be about $150,000 per year for 15 years. (Grandma is financially conservative and reluctant to base decisions on benefits projected further into the future.) She has also estimated the project's discount rate, appropriately adjusted for risk, at 12%. Mother's is a privately owned firm with 20,000 shares of stock outstanding. Grandma is confident that the owners will sell for $50 a share, but not for less. Should Grandma acquire Mother? Solution: 3. Moser Materials Inc. is considering acquiring Newkirk Products, which produces a number of products that would enhance Moser’s product line. Last year Newkirk reported a $30 million loss. Moser has estimated that Newkirk will break even in the fourth year after acquisition. The improvement in performance will come in four equal steps. Assuming Moser can demonstrate that the acquisition is not simply for tax purposes, calculate the present value of the tax savings that will result during the four-year period at a 12% discount rate. Assume Moser has EBT far exceeding $30M and is subject to a 40% marginal tax rate. Solution: ($M) Merger Analysis with Terminal Values: Concept Connection Example 17-2 (736) 4. Harrison Ltd. is considering acquiring Pugs International Inc. Pugs had cash flows of $15 million last year and has 2.5 million shares outstanding which are currently selling at $29 per share. The discount rate for analysis has been correctly estimated at 14% a. How much should Harrison be willing to pay for Pugs in total and per share if the firm is not expected to grow significantly and management insists that acquisitions be justified by no more than ten years of projected cash flows? b. Make the same calculations assuming management will consider an indefinite stream of cash flows. c. Make the calculations once again assuming management is very aggressive and is willing to assume Pugs’ income will go on forever growing at a rate of 3% per year. d. Comment on the results of parts a, b, and c. Solution: a. The maximum in total is the present value of ten years of cash flow PVA = $15,000,000 [PVFA14,10] = $15,000,000 (5.2161) = $78,241,500 The maximum per share price is $78,241,500 / 2,500,000 = $31.30 Which represents a premium of (31.30 - $29.00) / $29.00 = 7.9% b. PVP = $15,000,000 / .14 = $107,142,857 Price per share = $107,142,857 / 2,500,000 = $42.86 Premium = (42.86 - $29.00) / $29.00 = 47.8% c. PVP = $15,000,000 / (.14-.03) = $136,363,636 Price per share = $136,363,636 / 2,500,000 = $54.55 Premium = (54.55 - $29.00) / $29.00 = 88.1% d. The pricing results vary tremendously, from approximately $31 to $55 per share. These figures represent a price premium anywhere from 8% to 88% of the current market price of the stock. Thus the calculations show how much a merger valuation can change as assumptions about terminal values become more aggressive even though they remain reasonable. The most conservative assumption generates a price that is unlikely to interest enough of Pugs’ stockholders to make the deal work. The most aggressive seems clearly to be paying too much to the detriment of Harrison’s stockholders. 5. The Johnson Machine Tool Company is thinking of acquiring Lansing Gear Works Inc. Lansing’s is a stable company that produces cash flows of $525,000 per year. That figure isn’t expected to change in the near future, and no synergies are expected from the acquisition. Johnson’s management has estimated that the appropriate risk adjusted discount rate for pricing calculations is 15%. Lansing has 200,000 shares of common stock outstanding. a. What is the most Johnson should be willing to pay for Lansing if management is financially conservative and insists that an acquisition must justify itself within ten years? State the price in total and per share. b. How much should Johnson be willing to pay, in total and per share, if management takes a more aggressive position and will consider Lansing’s income as continuing forever? (Hint: estimate Lansing’s value as a perpetuity starting immediately.) c. What total and per share prices are implied if Johnson’s executives are financially very aggressive and assume that their management will transform Lansing into a better company that will grow at 3% per year indefinitely? d. Comment briefly on the differences in your answers to a, b, and c. Solution: 6. Sourdough Mills has considered acquiring Mrs. Baird’s Bakery as an expansion strategy. Mrs. Baird’s Bakery generated positive cash flows of $5.3 million last year, and cash flows are expected to increase by 4% per year for the foreseeable future. Mrs. Baird’s has 1.3 million shares outstanding, and the appropriate discount rate is 11%. a. If Sourdough assumes this level of cash flow will continue forever, what is the most it should pay for each share of Mrs. Baird’s Bakery? b. If Sourdough wants the investment justifiable considering only five years of cash flow, what is the most it should pay for the stock? c. What if it will consider a 10-year planning period? d. If Mrs. Baird’s Bakery stock is currently selling for $35 per share, what would you do if you were Sourdough Mills? Solution: ($M) 7. Hirschler Motors is considering making a takeover bid for the chain of Richard’s Auto Superstores. Richard’s has 800,000 shares of stock outstanding that is trading at $18 per share. Richard’s generated $2.5 million in cash last year, and cash flows are expected to increase by 6% per year for at least 10 years. Assume the appropriate discount rate is 12%. What percent premium can Hirschler afford to offer for Richard’s stock if management wants to justify the investment over 10 years? Nine years? Eight years? Solution: ($M) 8. Benson's Markets is a five-store regional supermarket chain that has done very well by using modern management and distribution techniques. Benson competes with Foodland Inc., a larger chain with 10 stores. However, Foodland has not kept pace with technological and merchandising developments, and has been losing money lately. Foodland's owners are interested in retiring, and have approached Benson's with a proposal to sell the chain for $50 million. Within each chain, individual stores perform uniformly. Typical results for an average store in each company are as follows ($000). If Benson were to make the acquisition, it would immediately close three of Foodland's stores which are located close to its own markets, and sell the buildings for about $1 million each. The remaining stores would operate at their current loss levels for about two years during which time they would be upgraded to Benson's operating standards. The upgrades would cost $3 million per store spread over the first two years. After that, the acquired stores would have about the same operating performance as Benson's other stores. Benson's CFO feels that a discount rate of 12% is appropriate for the risk associated with the proposition. Benson's marginal tax rate is 40%. a. Calculate the value of the acquisition to Benson assuming there is no impact on any of Benson's five original stores. Assume that the incremental cash flow from the acquired stores goes on forever, but does not grow. Should Benson pay Foodland's price? If not, does the deal look good enough to negotiate for a better price? What is the most Benson should be willing to pay? b. (No calculations - just ideas.) Are there reasons beyond the calculations in part a. that argue in favor of the acquisition? (Hint: Think along two lines about the competitive situation: (1) What will happen if Benson doesn't buy Foodland? (2) What effect will the acquisition have on Benson's existing stores?) c. Could the ideas in part b. be quantified into adjustments to the results in part a.? Make your own estimate of the impact of such ideas on the price Benson should be willing to pay. Solution: ($000) b. There are some other fairly compelling reasons to acquire Foodland. (1) If Benson's doesn't do it, some other chain probably will. If that chain is an aggressive competitor, it could negatively impact Benson's other stores. (2) Closing three of Foodland's stores will probably have a favorable impact the nearby Benson's markets. Volume in those stores could increase significantly depending on the proximity of other competitors. c. (1) The first effect is quite arbitrary and difficult to quantify. Almost any amount could be thought of as a cost of not doing the acquisition. However an equally convincing argument can be made that Benson's will do as well against another chain as it did against Foodland. It's generally best to leave this kind of thing out of the numbers but keep it in mind. (2) The second effect is easier to quantify. Make a conservative assumption about the revenue to be picked up from the closed stores. For example, assume $5M from each closed store migrates to the nearby Benson's market where the gross margin on sales is 14.4%. Then the cash contribution that might reasonably be expected is $5M  .144  .6  3 = $1.3M per year indefinitely. That has a present value of $1.3M/.12 = $10.8M. Clearly this factor makes the acquisition much more attractive. 9. Frozen North Outfitters Inc. makes thermal clothing for winter sports and outdoor work, and is considering acquiring Downhill Fashions Corp. which manufactures and sells ski clothing. Downhill is about one quarter of Frozen's size and manufactures its entire product line in a small rented factory on a mountaintop in Colorado. It costs about $1 million a year in overhead to operate in the factory. Frozen produces its output in a less romantic but more practical southern location. Its factory has at least 50% excess capacity. Frozen's plan is to acquire Downhill, and combine production operations in its southern factory, but otherwise run the companies separately. Downhill's beta is 2.0, Treasury bills currently yield 5% and the S&P 500 Index is yielding 9%. The marginal combined federal and state income tax rate for both firms is 40%. Because Downhill will no longer be maintaining its own production facilities, it can be assumed that only a minimal amount of cash will have to be reinvested to keep its equipment current and for future growth. This amount is estimated at $100,000 per year. Selected financial information for Downhill follows. a. Calculate the appropriate discount rate for evaluating the Downhill acquisition. b. Determine the annual cash flow expected by Frozen from Downhill if the acquisition is made (don't forget to include the synergy). c. Calculate the value of the acquisition to Frozen assuming the benefits last for (1) five years, (2) 10 years, and (3) 15 years. d. Downhill has 250,000 shares of stock outstanding. Calculate the maximum price Frozen should be willing to pay per share to acquire the firm under the three assumptions in part c. e. If Frozen is willing to assume the benefits of the Downhill acquisition will last indefinitely but not grow, what should it be willing to pay per share? Solution: ($000) 10. In the last problem, assume that the cash flow from the Downhill acquisition grows at 10% from its initial value for one year and then grows at 5% indefinitely (starting in the third year). Calculate the value of the firm and the implied stock price under these conditions. Use a terminal value at the beginning of the period of 5% growth. What price premium is implied in dollars and as a percent of market price if Downhill's stock is currently selling at $62? Comment on the results of this and the last problem. Solution: ($000) 11. Lattig Corp. had a $2.0 million cash flow last year, and projects that figure to increase by $200,000 per year for the next five years (to $3.0 million). After that, Lattig expects an annual growth rate of 6% forever. If the discount rate is 12%, a. What percent of the total present value of Lattig’s projected cash flows comes from its terminal value assumption for cash flows after the first five years? b. Recalculate the result in part a. if Lattig raises its terminal value growth rate forecast to 7% and then to 8%. c. What other terminal value related issues should be considered by anyone thinking about acquiring Lattig? (Words only.) Solution: Use the NPV procedure on a financial calculator to find the PV the first five years of cash flows at 12% Co = 0, C1= 2.2, C2 = 2.4, C3 = 2.6, C4 = 2.8, C5 = 3.0, I = 12; NPV = 9.21 Leveraged Buyout (LBO): Concept Connection Example 17-3 (page 743) 12. Integrity Group, an association of venture capitalists, is considering using a leveraged buyout to purchase Schrag Co., a well-established hi-tech firm. Schrag has long-term debt with a book value of $15 million and a debt to equity ratio of 1:10. The firm’s stock is currently selling at 120% of book value. Integrity Group has $25 million to contribute to the buyout, and feels that it will have to offer a 25% premium over the stock’s current market price in order to make the deal work. Estimate Schrag’s capital structure after the leveraged buyout? Solution: A 1:10 debt/equity ratio means that Schrag has equity of ($15Mx10=) $150M. The current market value of the stock is $150M x 1.2 = $180M. Hence Integrity must offer $180M x 1.25 = $225M for the stock To raise that money, Integrity will contribute $25 million of its own equity and borrow an additional $200 million. The old debt will still be in place, so total debt after the LBO will be $15M + $200M = $215M. And the new capital structure will be Debt Restructuring in Bankruptcy: Concept Connection Example 17-4 (page 754) 13. Lee & Long, a clothing manufacturer, is considering filing for bankruptcy. The firm has EBIT of $1.4 million, and long-term debt of $40 million on which it pays interest at an average rate of 8.5%. It also has fixed assets (gross) totaling $60 million. Depreciation averages 5% of gross fixed assets per year, and the long-term debt matures evenly over the next 20 years. a. Calculate Lee & Long’s current cash flow. b. Assume that Lee & Long’s management can convince its creditors to convert 25% of its debt into equity by exchanging their bonds for newly issued stock at book value. Calculate Lee & Long’s cash flow after the debt restructure. Solution: ($M) 14. Garwood Industries has filed for bankruptcy and will probably be liquidated. The firm’s balance sheet is shown below: ($M) The administrative costs of bankruptcy total $1.6 million. Current assets can be sold for 60% of book value, and fixed assets for 25% of book value. Twenty percent of the long-term debt is secured. All of the remaining debt is unsecured. Assume there are no additional costs. How many cents on the dollar will unsecured creditors (including trade creditors) receive on the money owed them? Solution: ($M) 15. The Hamilton Corp has 35,000 shares of common stock outstanding with a book value of $20 per share. It owes creditors $1.5 million at an interest rate of 12%. Selected financial results are as follows. Restructure the financial line items shown assuming a composition in which creditors agree to convert two thirds of their debt into equity at book value. Assume Hamilton will pay tax at a rate of 15% on income after the restructuring, and that principal repayments are reduced proportionately with debt. Who will control the company and by how big a margin after the restructuring? Solution: After the restructuring there will be a total of (35,000+50,000=) 85,000 shares of common stock outstanding. The original shareholders will still own 35,000 shares (approximately 41%), while the creditors will own 50,000 shares (59%). Hence the creditors will control the company by a substantial majority. CHAPTER 18 INTERNATIONAL FINANCE FOCUS Our study of international finance centers on developing an understanding of foreign exchange markets and the mechanics of exchange rates. Attention is also given to the effect of exchange rates on the domestic economy and the derivation of supply and demand curves for foreign currencies. We also examine some of the uncertainties inherent in international business focusing on exchange rate risk and political risk. A brief description of government intervention in exchange markets and the international monetary system is also included. The chapter concludes with a fairly detailed discussion of current issues in the international business arena including the broad concept of globalization, outsourcing, immigration, China’s less than convertible currency, and the European debt crisis. PEDAGOGY In this practical treatment we assume the student has no prior knowledge of international operations. The material is straightforward and easy to read so no special pedagogy is required. TEACHING OBJECTIVES In this chapter, students should gain a working knowledge of exchange rates and international transactions. They should also become conversant with the concepts behind exchange rate risk, hedging, the international monetary system, international investments, and political risk. OUTLINE I. CURRENCY EXCHANGE A. The Foreign Exchange Market The concept of foreign exchange and the market in which it's traded. B. Exchange Rates The mechanics of exchange rates. How exchange rates affect the prices of foreign goods. C. Changing Exchange Rates and Exchange Rate Risk Risk associated with rate changes between order and payment. Hedging with forward contracts. D. Supply and Demand - The Source of Exchange Rate Movement How the supply and demand for currency derives from demand within each country for the other's products. Things that move the supply and demand curves and hence the exchange rate. E. Governments and the International Monetary System Why and how governments influence exchange rates. Fixed and floating rate systems. The problems of non-convertible currencies. The balance of trade and the problems created by long term deficits. The particular problem of Japan. II. INTERNATIONAL CAPITAL MARKETS A. The Unique Status of the U.S. Dollar The U.S. dollar as an "international currency." B. The Eurodollar Market Eurodollars defined. The market for Eurodollar debt and its uses. C. The International Bond Market International bonds, foreign bonds and Eurobonds. III. POLITICAL RISK The risk of loss due to the actions of sovereign governments and terrorist groups. IV. TRANSACTION AND TRANSLATION RISKS Paper losses on the translation of foreign subsidiary balance sheets. V. CURRENT ISSUES A. Globalization The theory of comparative advantage and the conflict between free trade and protectionism. Arguments for and against globalization. B. Outsourcing The migration of manufacturing to the world’s lowest cost labor. Intellectual labor flowing out of developed countries due to communications technology. C. Immigration The migration of low end labor, often illegally, from more developed to less developed countries. D. China’s Currency The negative impact of China’s economic explosion on the American job market and how the phenomenon is exacerbated by that country’s refusal to allow its currency to float freely on foreign exchange markets. E. The Continuing European (Greek) Sovereign Debt Crisis QUESTIONS 1. Describe the ways in which international business has changed over the last 60 years. Include the concepts of an MNC and the different types of foreign investment. Answer: The volume of both imports and exports has increased dramatically, but the U.S. is now a net importer rather than a net exporter as it was after World War II. The nature of international business has changed. Sixty years ago trade with other countries largely meant importing and exporting goods produced in the home countries. Today multinational companies (MNCs) are likely to have fully developed operations in foreign countries that include all facets of production and distribution. Building such businesses has involved direct investment in real assets in the foreign countries. There is also a great deal of portfolio investment in foreign securities today where there was little or none sixty years ago. 2. After World War II, the United States was the world's dominant economic power. We're still the largest economy, but the rest of the world has caught up significantly. In some areas we've lost the lead. The production of consumer electronic equipment, for example, is largely done in the Far East. Is this trend good or bad for Americans? Explain. Answer: It's good in the sense that free and open trade in the long run maximizes the efficiency of all economies. For example, labor-intensive manufacturing processes have moved off shore to countries where the labor is cheaper than it is in the U.S. That frees up our resources for more knowledge intensive work like design and more sophisticated manufacturing. In the short run, on the other hand, the migration of jobs out of the country economically devastates individual families as well as whole geographic areas. Since we all live in the short run, it's difficult to be overly enthusiastic about the trend. 3.When you want to buy something from another country, you have to find a seller who's willing to take dollars, but that isn't too hard because the U.S. dollar is widely accepted. Comment on this statement. Answer: It isn't true because of the existence of foreign exchange markets on which you can trade your dollars for most other currencies. The status of U.S. currency, however, does make it possible to pay in dollars in many cases. 4. Exchange transactions between two currencies neither of which is the U.S. dollar have to be made by changing one currency into dollars and then changing the dollars into the other currency. This procedure is necessary, because the exchange tables are all set up to convert between other currencies and dollars, the world's leading currency. True or false? Why? If false, how does the conversion work? Answer: False. Although the exchange tables are generally set up in terms of dollars, it's a simple matter to calculate a rate between any two currencies by dividing the two dollar rates. Currency brokers don't insist on an intermediate step into and then out of dollars. 5. What generates the supply of and the demand for foreign exchange? Why do the supply and demand curves have the shape they do? What makes the supply and demand curvesand hence the exchange ratemove around? Answer: The supply and demand for a foreign currency stem from trade and investment activity between the two nations. A demand in a foreign country for U.S. goods means importers there have to buy dollars to pay for those goods. When they buy dollars with their currency, that currency becomes available as a supply to U.S. importers. The reverse is true with respect to a U.S. demand for goods from the foreign country. The shape of the curves relates to the cost of imported goods in both countries as the exchange rate changes. As a foreign currency becomes stronger, goods from that country become more expensive here. That means we buy fewer of them, and our demand for the currency decreases. This is reflected in a down sloping of the U.S. demand for the foreign currency as their currency strengthens against the dollar. At the same time U.S. goods are cheaper in the foreign country so they want more of them. That means they have to buy more dollars to pay for their imports. That, in turn, makes more of their currency available on the exchange market. This is reflected in an up sloping of the supply curve for the foreign money as it strengthens against the dollar. The supply and demand curves move around because the demand for products, services, and investments changes constantly. 6. Why might the government be interested in influencing exchange rates from time to time? How would it go about moving the exchange rate? Answer: Foreign exchange rates affect the balance of import and export activity in a country. If a nation's currency is cheap in other countries, it tends to export a lot which means its factories produce more, which leads to jobs and prosperity. At the same time, however, foreign goods are more expensive at home, so the general cost of living increases. Governments are interested in keeping these opposing forces in balance. They are therefore interested in keeping exchange rates within reasonable limits. They do that by intervening in foreign exchange markets by buying and selling their own currencies. 7. Describe the difference between a floating and a fixed exchange rate system. Answer: In a floating rate system the forces of supply and demand determine exchange rates with little or no government intervention. In a fixed rate system nations agree to maintain their currency's exchange rate with the U.S. dollar within a narrow range. They do that by buying and selling their own currencies in the foreign exchange market. Major changes in the agreed range can be accomplished by periodic revaluations (up), or devaluations (down). 8. What is a trade deficit, and why does it hurt us to consistently run a deficit with another country? Answer: A trade deficit exists when we import more from another country than we export to it. If the deficit persists, the foreign country accumulates a pool of dollars which acts as a supply on the foreign exchange market weakening the dollar against its currency. That makes their goods more expensive here and ours cheaper there which should fix the problem unless our exports to them are artificially restricted by their government's import policies. The pool coupled with the weak dollar also makes it possible for investors in the foreign country to buy up productive assets here eventually gaining an inappropriate level of economic control. 9. How and why is the U.S. dollar unique among the world's currencies? Answer: Since World War II the U.S. has been both an economic and military superpower. That status has given people throughout the world a unique confidence in the long-term value of the dollar. That is, they are confident that it will not become worthless because of political or economic events. (In the short run its value against other currencies does change due to shifts in supply and demand.) This confidence has made the U.S. dollar something of an "international currency" in that it is widely accepted and even sought after. Contracts are often denominated in dollars even when none of the parties are American! 10. A British importer has to pay for American goods, but the exchange rate is temporarily very unfavorable from the British perspective. Describe the Eurodollar market and tell how it might help the importer. Answer: Eurodollars are American dollars on deposit in foreign banks. They are available to be borrowed in the "Eurodollar market." The British importer could borrow Eurodollars now to pay for the goods she has received. Then pay them back later when (hopefully) the exchange rate is more favorable from the British perspective. 11. Broadly define and describe globalization and its implications. Answer: Globalization refers to the trend in which the economic world is becoming a single worldwide or global market. Its main characteristic is an unprecedented increase in international trade. Another important element is the reduction or elimination of trade barriers imposed by nations. These include tariffs, import restrictions and limits on foreign ownership of businesses. A related issue is the increasingly pro trade posture of national governments and their policies. A negative effect of globalization is that it can lead to the exploitation of native populations by profit seeking corporations which pay subsistence wages and provide dismal working conditions for low cost labor in undeveloped counties. 12. China refuses to allow its currency, the yuan, to float on international currency exchanges. Why is that a problem for the United States? Answer: Over the last thirty years China has transformed itself into a market economy which produces a variety of products that compete with U.S. manufacturers. The Chinese government keeps the yuan grossly undervalued which makes Chinese products very cheap in the U.S. putting domestic industries at a disadvantage often driving them out of business. That’s damaging to our economy. The undervalued yuan also creates a huge trade deficit with China and an accumulation of American dollars in their hands. 13. Explain the concepts of sovereign debt and a sovereign debt crisis. Why is such a crisis different for a Eurozone country than for a country with a unique currency. Answer: Sovereign debt is the debt of an independent nation, usually incurred by selling government bonds to individuals, financial institutions such as banks, or other governments Ideally countries only borrow to fund special projects like dams and roads or wars. But today many national governments regularly spend more than they take in in taxes, and must borrow just to keep going. This kind of running on borrowed money is called deficit spending. A sovereign debt crisis refers to a situation in which it becomes apparent that a government will be unable to service (pay interest and principal in accordance with the bond contract) its debt without further borrowing which lenders refuse to provide. In such a case the country may default on its debt obligations which leads to a general loss of confidence in the government. BUSINESS ANALYSIS 1. You're the Treasurer of Warm Wear Inc., which imports wool sweaters from around the world. Kreploc, a company in the country of Slobodia, has a product your marketing department would like to carry, and doesn't require payment until 90 days after delivery. Unfortunately the Slobodian blivit tends to vary in value by as much as 30% over periods as short as three months. This makes you reluctant to do business with Kreploc because of exchange rate risk. The marketing department can't understand why you have any concerns at all. Prepare a brief explanation including an illustration of why you're concerned. Answer: Doing business in a currency whose value fluctuates widely exposes us to transaction risk. This is a risk that we'll incur losses on purchases from Kreploc due to exchange rate movements. For example, suppose we take delivery today on an order of sweaters promising to pay 1,000 blivits each in three months. Further suppose the exchange rate is now 30 blivits to the dollar so the sweaters are expected to cost us (1,000/30 =) $33.33 apiece. Since our mark up is about 35%, we'd expect to sell the sweaters to retailers for about $45. Now suppose that three months later the blivit strengthens to a rate of 20 to the dollar. That means when payment is due, each sweater will cost us (1,000/20 =) $50. Retailers probably won't pay any more than the planned $45, so we wind up losing $5 on every sweater. 2. You're the CFO of the Overseas Sprocket Company, which imports a great deal of product from Europe and the Far East and is continually faced with exchange rate exposure on unfilled contracts. Harry Byrite, the head of purchasing, has a plan to avoid exchange rate losses. He suggests that the firm borrow enough money from the bank to buy a six-month supply of foreign exchange, which would be kept in a safety deposit box until used. "We'd never have another unexpected exchange rate loss again," says Harry. Prepare a polite response to Harry's idea. Explain why you do or don't like it, and suggest an alternative if you feel one is appropriate. Answer: Buying foreign currency ahead seems to make sense, but it has a serious drawback in that money tied up in foreign exchange doesn't earn a return. In other words, we'll be out the interest on six months of purchases all the time, and that's a lot. However, there is an alternative. Financial markets provide the ability to buy forward contracts on currency. That means you can lock in an exchange rate today for a need expected in the future. There are some additional costs associated with doing this, but it does avoid unexpected exchange rate losses to the extent that we can predict our foreign currency needs. 3. You're the CFO of the Kraknee Roller Skate Company, which sells roller skates worldwide and also builds and operates roller rinks. Some time ago Archie Speedo, the head of international marketing proposed selling skates in Russia. Everyone thought he was crazy, but the idea turned out to be very successful. Archie lined up a talented Russian importer who managed to sell more skates than anyone imagined possible. Now Archie has proposed a new Russian venture. He wants to open and operate a roller rink in Moscow. He says that since the breakup of the Soviet Union, Russians are interested in Western pastimes and a roller rink in the capital city would make a fortune. Based on his earlier success in Russia, the rest of the executive team is in favor of the idea. You, however, have some concerns. Write a memo explaining how the roller rink proposal differs from exporting skates to Russia, and what problem is likely to exist even if the venture is as commercially successful as the skates. What other risk is involved? Answer: Archie and Staff: We need to be cautious about opening a rink in Moscow, because it involves some risks we haven't been exposed to before. Our sale of skates in Russia involved little or no exchange rate risk. The importer took care of getting dollars to pay for his purchases, and we didn't have to worry about the Russian ruble at all. This project is entirely different in that it involves operating a business in Russia as well as a direct investment in physical assets there. Profits on the project will be earned in rubles, which aren't convertible. That means we won't be able to exchange ruble earnings for dollars to get them back to the U.S. In general, the only way we'll be able to get money out of Russia will be to buy exportable product and sell it outside the country. That's a difficult and risky process that we have yet to look into. Another concern involves expropriation of our assets. The Russian economy is not stable and it's entirely possible that a change in government attitudes could occur. Hostile governments are perfectly capable of simply taking foreign owned assets without compensation. I don't think we should proceed with the proposal until a plan that addresses these issues has been developed. 4. Your friend James is an exchange student from an underdeveloped country. He comes from a privileged family that’s influential in the government, but the bulk of the nation’s population is very poor despite the fact that the people are frugal and hardworking. James is an idealistic young man who intends to return home after his education and spend his life working to improve the economic condition of his country and its people. You met him for lunch yesterday and noticed that he was unusually excited. He told you he’s taking a theoretical economics course and has been studying Ricardo’s Theory of Comparative Advantage, which he now feels is the answer to his people’s problems. He intends to return home a staunch advocate of free trade and attempt to get his government to open the nation’s borders to investment by any multinational companies that are interested in doing offshore production there. Write a short paragraph for James discussing globalization and explaining why his government should be cautious as it enters the world of international business. Answer: James: You may want to be somewhat careful before recommending unlimited free trade at home. Although the principle of comparative advantage works in that more production is possible if everyone specializes in what he or she does best, the distribution of the extra value isn’t always fair. In fact critics of this “globalization” process contend that it isn’t uncommon for multinational companies to set up factories in less developed nations and then exploit the local populations by barely paying subsistence wages. Basically that means the big corporation keeps all of the profit made on the low cost labor. To guard against this, the government should insist on contracts with the corporations that set up shop in your country guaranteeing fair wages and decent working conditions. Your officials should also be very wary about the level of influence in your country held by the executives of those companies. PROBLEMS Use the exchange rates in Table 18-1 for problems 1 and 2. Exchange Rates: Concept Connection Example 18-1, page 767 1. An American importer owes vendors the following sums a. 140,560 Canadian dollars b. 392,000 Australian dollars c. 1,362,000 Mexican pesos d. 680,540 British (U.K.) pounds e. 14,673 Euros State each debt in U.S. dollars. Solution: 2. A Japanese importer owes an American exporter $450,520. a. What is her bill in yen if she pays immediately? b. What would the bill be if the importer wanted to lock in an exchange rate today but pay in 3 months? The dollar is expected to strengthen by 2% against the yen in that time. Solution: a. $450,520  119.44 = 53,810,108 yen b. the dollar strengthening by 2% implies an increase in the indirect rate so that it takes 2% more yen to buy a dollar. Hence the 3 month forward rate is 119.44 x 1.02 = 121.83 yen/dollar. And $450,520  121.83 = 54,886,852 yen 3. Go to a currency exchange site on the internet and look up today's exchange rates for the currencies in problem 1. Resolve the problems using today's rates. Analyze how the rates have changed since May 6, 2015. Solution: Students should decide whether each currency has strengthened or weakened against the dollar, and calculate by how much. 4. The following direct quote exchange rates are found on the spot market today. a. Euro: $.9347 b. Israeli shekel: $.2586 c. British (U.K.) pound: $1.6544 d. Japanese yen: $0.009423 Calculate the price of a U.S. dollar in terms of each currency, the indirect quote. *//// Solution: 5. Bob and Chris received a grant through their University to travel to Germany to do research. The grant awarded them $2,000 for room and board during their stay. It was paid to them in U.S. dollars on May 31 at which time the dollar was worth €.77980. They spent the money in Germany during July when the dollar was worth €.78597. a. How many Euros were they awarded in May? b. Did the change in the Euro work to their advantage or disadvantage? Solution: a. $2,000 x .77980 = €1559.6 in May b. $2,000 x .78597 = €1571.94€ Since they could buy more Euros in July than in May, the change worked to their advantage (slightly). Changing Exchange Rates and Exchange Rate Risk (page 769) 6. Steve Harris, CFO of Alston Concrete Products, is currently evaluating the purchase of an innovative machine that tests the strength of concrete. The machine is sold only in England and Alston has a price quote at £52,500 from the manufacturer that’s good for 60 days. Steve has read that the British pound is expected to strengthen against the dollar by 15% during the next two months. Currently the pound is worth $1.88 U.S. dollars. If Steve believes the currency forecast is accurate, should Alston buy the machine now or wait until just before the price quote expires? How much difference might the decision make in dollars. Solution: The machine’s current price in dollars is: ₤52,500 x $1.88 / £ = $98,700 If the pound strengthens by 15%, it will be worth $1.88 x 1.15 = $2.162 And the machine will cost: ₤52,500 x $2.162 / £ = $113,505 Hence the machine is currently cheaper than it will be and buying now will save Alston $14,805. 7. The Cline family made a trip to Europe in 2015. They paid the following amounts in local currency for hotel, entertainment, and transportation. How much did the trip cost once they got to Europe? Use the exchange rates in Table 18.1. Solution: 8. Suppose a car manufactured in Japan in the mid-1980s, when there were 250 yen to the dollar, cost 2 million yen to produce, and was marked up 25% for sale in the United States. Assume the car's cost in yen and markup are the same today, but that the exchange rate is 100 yen to the dollar. a. What did the car sell for in dollars in the U.S. in the mid-1980s? b. What does it sell for now? Solution: a. 1980s: 2,500,000/250 = $10,000 b. Now: 2,500,000/100 = $25,000 9. The Green bay Motor Company ordered six German built engines at, €15,000 each when the direct exchange rate was $1.2500 per euro, and elected not to cover the obligation with a forward contract. When the bill was due three months later, the rate was $1.1500. Green bay's marginal tax rate is 40%. a. How much was the exchange rate gain or loss on the deal? b. What kind of exchange rate gain or loss was it? c. What was the tax impact? Solution: Cross Rates: Concept Connection Example 18-2 (page 768) 10. Hampshire Motors Ltd., a British manufacturing company, wants to buy a production machine that isn’t available in England. Comparable products are made by an American company and a French firm. The Americans have quoted Hampshire a price of $175,000 while the French want €192,000. How much is each price in British pounds? Calculate a cross rate to state the French quote in pounds. Use the exchange rates in Table 18-1. Solution: Hence the American firm is making a better offer if the machines are equivalent. Translation Gains and Losses: Concept Connection Example 18-3 (page 781) 11. The Latimore Company invested $8.5 million in a new plant in Italy when the exchange rate was 1.1500 euros to the dollar. At the end of the year, the rate was 1.2000 euros to the dollar (indirect quotes). a. Did Latimore make or lose money on the exchange rate movement? If so, how much? b. What kind of exchange rate gain or loss was it? c. What was the tax impact if Latimore’s marginal tax rate is 40%? Solution: b. The loss is an unrealized translation loss due to exchange rate movement. c. There is no tax impact, since unrealized translation losses are not recognized for tax purposes. 12. Hanover Inc. spent £11.5 million building a factory in England several years ago when the British Pound cost $1.5500. The plant operation was set up as a British subsidiary to manufacture Hanover’s product for sale and distribution in the U.K. and Europe. Hanover closed its consolidated books for the 2015 fiscal year on May 6, 2015. (Many companies keep their books on fiscal years that don’t coincide with calendar years.) Hanover is subject to a 40% tax rate in the U.S. and a 25% rate in the U.K. a. How much did Hanover make or lose on the value of its English factory due to exchange rate movements in the years since it was built? Use table 18.1. b. Explain the tax impact of the gain or loss? c. Where does the gain or loss show up in Hanover’s financial statements? Where doesn’t it show up in 2015 or in previous years. Solution: a. The factory’s original value in dollars was £11,500,000 x 1.5500 $/£ = $17,825,000 The pound weakened slightly against the dollar since the factory was built making assets denominated in pounds a little less valuable. In 2015 the factory was worth £11,500,000 x 1.5246 $/£ = $17,532,900 and Hanover had a loss of the dollar difference: $17,532,900 - $17,825,000 = ($292,100) b. This result is a translation loss that didn’t use any cash that could have been spent or distributed to shareholders. In order to realize such a loss the plant would have to be sold. Since that didn’t happen the loss does not reduce taxable income and there’s no tax impact in either country. c. Hanover’s translation loss shows up as a decrease in retained earnings on its balance sheet. Because the loss was never realized it was never included as income to the company and would not have appeared on any of its income statements in past years. Solution Manual for Practical Financial Management William R. Lasher 9781305637542