This Document Contains Chapters 20 to 21 Chapter 20 External Growth through Mergers Discussion Questions 20-1. Name three industries in which mergers have been prominent. Computers, telecommunications, public utilities, pharmaceuticals, and energy. 20-2. What is the difference between a merger and a consolidation? In a merger, two or more companies are combined, but only the identity of the acquiring firm is maintained. In a consolidation, an entirely new entity is formed from the combined companies. 20-3. Why might the portfolio effect of a merger provide a higher valuation for the participating firms? If two firms benefit from opposite phases of the business cycle, their variability in performance may be reduced. Risk-averse investors may then discount the future performance of the merged firms at a lower rate and thus assign a higher valuation than was assigned to the separate firms. 20-4. What is the difference between horizontal integration and vertical integration? How does antitrust policy affect the nature of mergers? Horizontal integration is the acquisition of competitors, and vertical integration is the acquisition of companies that produce goods and services used by the company. Antitrust policy generally precludes the elimination of competition. For this reason, mergers are often with companies in allied but not directly related fields. 20-5. What is synergy? What might cause this result? Is there a tendency for management to over- or underestimate the potential synergistic benefits of a merger? Synergy is said to occur when the whole is greater than the sum of the parts. This “2 + 2 = 5” effect may be the result of eliminating overlapping functions in production and marketing as well as meshing together various engineering capabilities. In terms of planning related to mergers, there is often a tendency to overestimate the possible synergistic benefits that might accrue. 20-6. If a firm wishes to achieve immediate appreciation in earnings per share as a result of a merger, how can this be best accomplished in terms of exchange variables? What is a possible drawback to this approach in terms of long-range considerations? The firm can achieve this by acquiring a company at a lower P/E ratio than its own. The firm with a lower P/E ratio may also have a lower growth rate. It is possible that the combined growth rate for the surviving firm may be reduced and long-term earnings growth diminished. 20-7. It is possible for the post merger P/E ratio to move in a direction opposite to that of the immediate post merger earnings per share. Explain why this could happen. 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. 20-8. How is goodwill now treated in a merger? It is placed on the books of the acquiring company, but it is not amortized. It is only written down if it is impaired. 20-9. Suggest some ways in which firms have tried to avoid being part of a target takeover. An unfriendly takeover may be avoided by: a. Turning to a second possible acquiring company—a “White Knight.” b. Moving corporate offices to states with tough pre-notification and protection provisions. c. Buying back outstanding corporate stock. d. Encouraging employees to buy stock. e. Staggering the election of directors. f. Increasing dividends to keep stockholders happy. g. Buying up other companies to increase size and reduce vulnerability. h. Reducing the cash position to avoid a leveraged takeover. 20-10. What is a typical merger premium paid in a merger or acquisition? What effect does this premium have on the market value of the merger candidate and when is most of this movement likely to take place? Typically, a merger premium of 40–60 percent is paid over the premerger price of the acquired company. The effect of the premium is to increase the price of the merger candidate, and most of this movement is likely to take place before public announcement. 20-11. Why do management and stockholders often have divergent viewpoints about the desirability of a takeover? While management may wish to maintain their autonomy and perhaps keep their jobs, stockholders may wish to get the highest price possible for their holdings. 20-12. What is the purpose(s) of the two-step buyout from the viewpoint of the acquiring company? The two-step buy-out provides a strong inducement to target stockholders to quickly react to the acquiring company’s initial offer. Also, it often allows the acquiring company to pay a lower total price than if a single offer is made. Chapter 20 Problems 1. Tax loss carryforward (LO20-1) The Clark Corporation desires to expand. It is considering a cash purchase of Kent Enterprises for $3 million. Kent has a $700,000 tax loss carryforward that could be used immediately by the Clark Corporation, which is paying taxes at the rate of 30 percent. Kent will provide $420,000 per year in cash flow (aftertax income plus depreciation) for the next 20 years. If the Clark Corporation has a cost of capital of 13 percent, should the merger be undertaken? 20-1. Solution: The Clark Corporation Cash outflow: Purchase price $ 3,000,000 Less tax shield benefit from tax Loss carryforward ($700,000 × 30%) – 210,000 Net cash outflow $ 2,790,000 Cash inflows: $420,000, n = 20, i = 13% (Appendix D) $420,000 × 7.025 = $ 2,950,500 Cash inflows $ 2,950,500 Cash outflow –2,790,000 Net present value $ 160,500 The positive net present value indicates the merger should be undertaken. 2. Tax loss carryforward (LO20-1) Assume that Western Exploration Corp. is considering the acquisition of Ogden Drilling Company. The latter has a $470,000 tax loss carryforward. Projected earnings for the Western Exploration Corp. are as follows: Total 2011 2012 2013 Values Before-tax income $185,000 $250,000 $370,000 $805,000 Taxes (35%) 64,750 87,500 129,500 281,750 Income available to stockholders $120,250 $162,500 $240,500 $523,250 a. How much will the total taxes of Western Exploration Corp. be reduced as a result of the tax loss carryforward? b. How much will the total income available to stockholders be for the three years if the acquisition occurs? Use the same format as that in the text. 20-2 Solution: Western Exploration Corp. a. Reduction in taxes due to tax loss carryforward = Loss × Tax rate $470,000 × 35% = $164,500 b. Western Exploration Corp.(with merger and associated tax benefits) 2011 2012 2013 Total Before tax income $185,000 $250,000 $370,000 $805,000 Tax loss carryforward 185,000 250,000 35,000 470,000 Net taxable income 0 0 335,000 335,000 Taxes (40%) 0 0 117,250 117,250 After tax income available to stockholders $185,000 $250,000 $252,750* $687,750** * Before-tax income – Taxes ($370,000 – $117,250 = $252,750) ** Before-tax income – Taxes ($805,000 – $117,250 = $687,750) 3. Cash acquisition with deferred benefits (LO20-2) J & J Enterprises is considering a cash acquisition of Patterson Steel Company for $4,500,000. Patterson will provide the following pattern of cash inflows and synergistic benefits for the next 20 years. There is no tax loss carryforward. Years 1–5 6–15 16–20 Cash inflow (after tax) $490,000 $650,000 $850,000 Synergistic benefits (after tax) 45,000 65,000 75,000 The cost of capital for the acquiring firm is 12 percent. Compute the net present value. Should the merger be undertaken? (If you have difficulty with deferred time value of money problems, consult Chapter 9.) 20-3 Solution: J & J Enterprises Cash outflow (Purchase price) $4,500,000 Cash inflows PV factors for the analysis (12%) (Appendix D) Years (1–5) (6–15) (16–20) 3.605 1–15 6.811 1–20 7.469 –1–5 –3.605 –1–15 –6.811 6 to 15 3.206 16 to 20 .658 Year (1–5) Cash inflow $490,000 Synergistic benefits 45,000 Total cash inflow $535,000 PV $535,000 × 3.605 = $1,928,675 Years (6–15) Cash inflow $650,000 Synergistic benefits 65,000 Total cash inflow $715,000 PV $715,000 × 3.206 = $2,292,290 20-3. (Continued) Years (16–20) Cash inflow $850,000 Synergistic benefits 75,000 Total cash inflow $925,000 PV $925,000 × .658 = $ 608,650 Total present value of inflows $4,829,615 Cash inflows $4,829,615 Cash put flow 4,500,000 Net present value $ 329,615 The positive net present value indicates the merger should be undertaken. 4. Cash acquisition with deferred benefits (LO20-2) Worldwide Scientific Equipment is considering a cash acquisition of Medical Labs for $1.6 million. Medical Labs will provide the following pattern of cash inflows and synergistic benefits for the next 25 years. There is no tax loss carryforward. Years 1–5 6–15 16–25 Cash inflow (after tax) $150,000 $170,000 $210,000 Synergistic benefits (after tax) 20,000 30,000 50,000 The cost of capital for the acquiring firm is 11 percent. Compute the net present value. Should the merger be undertaken? 20-4 Solution: Worldwide Scientific Equipment Cash outflow (Purchase price) $1,600,000 Cash inflows PV factors for the analysis (11%) (Appendix D) Years (1–5) (6–15) (16–25) 3.696 1–15 7.191 1–25 8.422 1–5 –3.696 1–15 –7.191 6 to 15 3.495 15 to 20 1.231 Year (1–5) Cash inflow $150,000 Synergistic benefits 20,000 Total cash inflow $170,000 PV $170,000 × 3.696 = $ 628,320 Years (6–15) Cash inflow $170,000 Synergistic benefits 30,000 Total cash inflow $200,000 PV $200,000 × 3.495 = $699,000 20-4. (Continued) Years (16–20) Cash inflow $210,000 Synergistic benefits 50,000 Total cash inflow $260,000 PV $260,000 × 1.231 = $ 320,060 Total present value of inflows $ 1,647,380 Cash inflows $ 1,647,380 Cash outflow 1,600,000 Net present value $47,380 The positive net present value indicates the merger should be undertaken. 5. Impact of merger on earnings per share (LO20-3) Assume the following financial data for Rembrandt Paint Co. and Picasso Art Supplies: Rembrandt Paint Co. Picasso Art Supplies Total earnings $1,200,000 $3,600,000 Number of shares of stock outstanding 600,000 2,400,000 Earnings per share $2.00 $1.50 Price-earnings ratio (P/E) 24× 32× Market price per share $48 $48 a. If all the shares of Rembrandt Paint Co. are exchanged for those of Picasso Art Supplies on a share-for-share basis, what will post merger earnings per share be for Picasso Art Supplies? Use an approach similar to that in Table 20-3. b. Explain why the earnings per share of Picasso Art Supplies changed. c. Can we necessarily assume that Picasso Art Supplies is better off after the merger? 20-5. Solution: Rembrandt Paint Co. and Picasso Art Supplies (approach similar to Table 20-3) a. Total earnings Rembrandt $1,200,000 + Picasso $3,600,000 Combined earnings $4,800,000 Shares outstanding Original Rembrandt shares 2,400,000 + New Rembrandt shares 600,000 Post merger shares outstanding 3,000,000 New earnings per share for Picasso Enterprises 20-5. (Continued) b. Earnings per share of Picasso increased because it has a higher P/E ratio than Rembrandt (32x versus 24x). 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 Picasso went up, we cannot automatically assume the firm is better off. We need to know whether Rembrandt will increase or decrease the future growth in earnings per share for Picasso 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 stockholder wealth over the long term. 6. Impact of merger on earnings per share (LO20-3) Assume the following financial data for the Noble Corporation and Barnes Enterprises: Noble Barnes Corporation Enterprises Total earnings $1,820,000 $5,620,000 Number of shares of stock outstanding 650,000 2,810,000 Earnings per share $2.80 $2.00 Price-earnings ratio (P/E) 20× 28× Market price per share $56 $56 a. If all the shares of the Noble Corporation are exchanged for those of Barnes Enterprises on a share-for-share basis, what will post merger earnings per share be for Barnes Enterprises? Use an approach similar to that in Table 20–3. b. Explain why the earnings per share of Barnes Enterprises changed. c. Can we necessarily assume that Barnes Enterprises is better off after the merger? 20-6 Solution: Noble Corporation and Barnes Enterprises (approach similar to Table 20–3) a. Total earnings: Noble $ 1,820,000 + Barnes $ 5,620,000 Combined earnings $ 7,440,000 Shares outstanding: Orig. Noble shares 2,810,000 + New Noble shares 650,000 Post merger shares outstanding 3,460,000 New earnings per share for Barnes Enterprises b. Earnings per share of Barnes Enterprises increased because it has a higher P/E ratio than Noble Corporation (20x versus 29x). 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 Barnes Enterprises went up, we cannot automatically assume the firm is better off. We need to know whether Noble Corporation will increase or decrease the future growth in earnings per share for Barnes 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 stockholder wealth over the long term. 7. Mergers and dilution (LO20-3) The Jeter Corporation is considering acquiring the A-Rod Corporation. The data for the two companies are as follows: A-Rod Corp. Jeter Corp. Total earnings $1,000,000 $4,000,000 Number of shares of stock outstanding 400,000 2,000,000 Earnings per share $2.50 $2.00 Price-earnings ratio (P/E) 12 15 Market price per share $30 $30 a. The Jeter Corp. is going to give A-Rod Corp. a 60 percent premium over A-Rod’s current market value. What price will it pay? b. At the price computed in part a, what is the total market value of A-Rod Corp.? (Use the number of A-Rod Corp. shares times price.) c. At the price computed in part a, what is the P/E ratio Jeter Corp. is assigning A-Rod Corp? d. How many shares must Jeter Corp. issue to buy the A-Rod Corp. at the total value computed in part b? (Keep in mind that Jeter Corp.’s price per share is $30.) e. Given the answer to part d, how many shares will Jeter Corp. have after the merger? f. Add together the total earnings of both corporations and divide by the total shares computed in part e. What are the new post-merger earnings per share? g. Why has Jeter Corp.’s earnings per share gone down? h. How can Jeter Corp. hope to overcome this dilution? 20-7 Solution: Jeter Corp. A-Rod Corp. a. $30 Current price ×1.60 60% premium $60 Price paid b. $40 Price paid ×400,000 Shares $12,200,000 Total market value c. d. e. 2,000,000 old shares + 640,00 new shares = 2,640,000 total shares f. A-Rod Corp. earnings $1,000,000 Jeter Corp. earnings 4,000,000 Total earnings $5,000,000 New post-merger EPS = 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 8. Two-step buyout (LO20-2) The Hollings Corporation is considering a two-step buyout of the Norton Corporation. The latter firm has 2.5 million shares outstanding and its stock price is currently $40 per share. In the two-step buyout, Hollings will offer to buy 51 percent of Norton’s shares outstanding for $62 per share in cash and the balance in a second offer of 840,000 convertible preferred stock shares. Each share of preferred stock would be valued at 40 percent over the current value of Norton’s common stock. Mr. Green, a newcomer to the management team at Hollings, suggests that only one offer for all of Norton’s shares be made at $59.25 per share. Compare the total costs of the two alternatives. Which is better in terms of minimizing costs? 20-8. Solution: Hollings Corporation Two-Step Offer 1. 51% × 2,500,000 shares = $1,275,000 shares 1,275,000 shares × $62 cash = $79,050,000 2. 840,000 shares of convertible preferred stock × $40 (1.40) = 840,000 × $56 = $47,040,000 Cost of two-step offer = $126,090,000 Single Offer 2,500,000 shares at $59.25 $148,125,000 The two-step offer is preferred because its cost is $22,035,000 less. 9. Future tax obligation to selling stockholder (LO20-1) Al Simpson helped start Excel Systems in 2010. At the time, he purchased 116,000 shares of stock at $1 per share. In 2015, he has the opportunity to sell his interest in the company to Folsom Corp. for $50 a share in cash. His capital gains tax rate would be 15 percent. a. If he sells his interest, what will be the value for before-tax profit, taxes, and after tax profit? b. Assume, instead of cash, he accepts Folsom Corp. stock valued at $50 per share. He pays no tax at that time. He holds the stock for five years and then sells it for $82.50 (the stock pays no cash dividends). What will be the value for before-tax profit, taxes, and after tax profit in 2020? His capital gains tax is once again 15 percent. c. Using a 9 percent discount rate, calculate the after tax profit. That is, discount back the answer in part b for five years and compare it to the answer in part a. 20-9 Solution: Excel Systems a. Sales amount 116,000 Shares × $50 $5,800,000 Purchase amount 116,000 Shares × $1 116,000 Before-tax profit $ 5,684,000 Capital gains taxes (15%) 852,600 After tax profit $ 4,831,400 b. Sales amount 116,000 shares × $82.50 $9,570,000 Purchase amount 116,000 shares × $1 116,000 Before-tax profit $9,454,000 Capital gains taxes (15%) 1,418,100 After tax profit $8,035,900 c. Discount back $8,035,900 for five years at 9 percent. $8,035,900, n = 5, i = 9% (Appendix B) $8,035,900 × .650 = $5,223,335 This value of $5,223,335 clearly exceeds the value in part (a) of $4,831,400. Deferring the tax appears to be the more desirable alternative. 10. Premium offers and stock price movement (LO20-1) Chicago Savings Corp. is planning to make an offer for Ernie’s Bank & Trust. The stock of Ernie’s Bank & Trust is currently selling for $44 a share. a. If the tender offer is planned at a premium of 50 percent over market price, what will be the value offered per share for Ernie’s Bank & Trust? b. Suppose before the offer is actually announced, the stock price of Ernie’s Bank & Trust goes to $60 because of strong merger rumors. If you buy the stock at that price and the merger goes through (at the price computed in part a), what will be your percentage gain? c. Because there is always the possibility that the merger could be called off after it is announced, you also want to consider your percentage loss if that happens. Assume you buy the stock at $60 and it falls back to its original value after the merger cancellation. What will be your percentage loss? d. If there is an 80 percent probability that the merger will go through when you buy the stock at $60 and only a 20 percent chance that it will be called off, does this appear to be a good investment? Compute the expected value of the return on the investment. 20-10. Solution: Chicago Savings Corp. a. Market price of Ernie’s Bank & Trust $44 + Premium of 50% 22 Value offered per share $66 b. Value offered per share $66 Purchase price 60 Gain $ 6 Percentage gain c. Value after cancellation (original value) $44 Purchase price 60 Loss $16 Percentage loss d. Return Probability Expected Value +10.00 .80 $8.00% –26.67 .20 – 5.33% Expected value of return 2.67% It appears to be a good investment. 11. Portfolio effect of a merger (LO20-4) Assume the Knight Corporation is considering the acquisition of Day Inc. The expected earnings per share for the Knight Corporation will be $4.00 with or without the merger. However, the standard deviation of the earnings will go from $2.40 to $1.60 with the merger because the two firms are negatively correlated. a. Compute the coefficient of variation for the Knight Corporation before and after the merger (consult Chapter 13 to review statistical concepts if necessary). b. Discuss the possible impact on Knight’s post-merger P/E ratio, assuming investors are risk-averse. 20-11. Solution: Knight Corporation a. Premerger Post merger b. Risk-averse investors are being offered less risk and may assign a higher P/E ratio to post merger earnings. Portfolio consideration and risk aversion (LO20-4) General Meters is considering two mergers. The first is with Firm A in its own volatile industry, the auto speedometer industry, while the second is a merger with Firm B in an industry that moves in the opposite direction (and will tend to level out performance due to negative correlation). a Compute the mean, standard deviation, and coefficient of variation for both investments (refer to Chapter 13 if necessary). General Meters Merger General Meters Merger with Firm A with Firm B Possible Possible Earnings Earnings ($ in millions) Probability ($ millions) Probability $40 .30 $40 . .25 60 .40 60 . .50 80 . .30 80 . .25 b. Assuming investors are risk-averse, which alternative can be expected to bring the higher valuation? 20-12. Solution: General Meters a. Merger with A (answer in millions of dollars) D P DP 40 .30 12.0 60 .40 24.0 80 .30 24.0 60.0 = D (D – ) (D – )2 P (D – )2P 40 60 –20 400 .30 120 60 60 0 0 .40 0 80 60 +20 400 .30 120 240 Coefficient of Variation = Merger with B (answer in millions of dollars) D P DP 40 .25 10.0 60 .50 30.0 80 .25 20.0 60.0 = D (D – ) (D – )2 P (D – )2P 40 60 –20 400 .25 100 60 60 0 0 .50 0 80 60 +20 400 .25 100 200 20-12. (Continued) Coefficient of variation = b. Though both alternatives have an expected value of $50 (million), the lower coefficient of variation, and thus the lower risk in merger A, should call for a higher valuation by risk-averse investors. Chapter 21 International Financial Management Discussion Questions 21-1. What risks does a foreign affiliate of a multinational firm face in today’s business world? 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, and so on), the foreign affiliate of a multinational firm is exposed to foreign exchange risk and political risk. 21-2. What allegations are sometimes made against foreign affiliates of multinational firms and against the multinational firms themselves? 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 (LDCs) have, at times, alleged that foreign business firms exploit their labor with low wages. The multinational companies are also under constant criticism in their home countries. The home country’s labor unions charge the MNCs 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. List the factors that affect the value of a currency in foreign exchange markets. 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. Explain how exports and imports tend to influence the value of a currency. 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 such as the economic and political stability of the country. 21-5. Differentiate between the spot exchange rate and the forward exchange rate. The spot rate for a currency is the exchange rate at which the currency is traded for immediate delivery. An exchange rate established for a future delivery date is a forward rate. 21-6. What is meant by translation exposure in terms of foreign exchange risk? The foreign-located assets and liabilities of a multinational corporation are denominated in their respective foreign currencies and need to be translated back to their local currency. This is called accounting or translation exposure. The amount of loss or gain resulting from this currency 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. What factors influence a U.S. business firm to go overseas? Factors that influence a U.S. business firm to go overseas are avoidance of tariffs; lower production and labor costs; usage of superior American technology abroad in such areas as oil exploration, mining, and manufacturing; tax advantages such as postponement of U.S. 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 than on purely domestic investments. 21-8. What procedure(s) would you recommend for a multinational company in studying exposure to political risk? What actual strategies can be used to guard against such risk? 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. What factors beyond the normal domestic analysis go into a financial feasibility study for a multinational firm? 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. What is a letter of credit? A letter of credit is normally issued by the importer’s bank, where the bank promises to pay money for the merchandise when delivered. 21-11. Explain the functions of the following agencies. Overseas Private Investment Corporation (OPIC) Export-Import Bank (Exim bank) Foreign Credit Insurance Association (FCIA) International Finance Corporation (IFC) Overseas Private Investment Corporation (OPIC)—A government agency that sells insurance policies to qualified firms. This agency insures against losses due to inconvertibility into dollars of amounts invested in a foreign country. Policies are also available from OPIC to insure against expropriation and against losses due to war or revolution. Export-Import Bank (Exim bank)—An agency of the U.S. government that facilitates the financing of U.S. exports through its miscellaneous programs. In its direct loan program, the Exim bank lends money to foreign purchasers of U.S. goods such as aircraft, electrical, equipment, heavy machinery, computers, and the like. The Exim bank also purchases medium-term obligations of foreign buyers of U.S. goods at a discount from face value. In these discount programs, private banks and other lenders are able to rediscount (sell at a lower price) promissory notes and drafts acquired from foreign customers of U.S. firms. Foreign Credit Insurance Association (FCIA)—An agency established by a group of 60 U.S. insurance companies. It sells credit export insurance to interested exporters. The FCIA promises to pay for the exported merchandises if the foreign importer defaults on payment. International Finance Corporation (IFC)—An affiliate of the World Bank established with the sole purpose of providing partial seed capital for private ventures around the world. Whenever a multinational company has difficulty raising equity capital due to lack of adequate private capital, the firm may explore the opportunity of selling equity or debt (totaling up to 25 percent) to the International Finance Corporation. 21-12. What are the differences between a parallel loan and a fronting loan? 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. 21-13. What is LIBOR? How does it compare to the U.S. prime rate? LIBOR (London Interbank Offered Rate) is an interbank rate applicable for large deposits in the Eurodollar market. It is a benchmark rate just like the prime rate in the United States. Interest rates on Eurodollar loans are determined by adding premiums to this basic rate. Generally, LIBOR is lower than the U.S. prime rate. 21-14. What is the danger or concern in floating a Eurobond issue? 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. 21-15. What are ADRs? 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 of the foreign firm to the American stockholders. 21-16. Comment on any dilemmas that multinational firms and their foreign affiliates may face in regard to debt ratio limits and dividend payouts. Debt ratios in many countries are higher than those in the United States. 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? Chapter 21 Problems 1. Spot and forward rates (LO21-2) The Wall Street Journal reported the following spot and forward rates for the Swiss franc ($/SF). Spot $0.8202 30-day forward $0.8244 90-day forward $0.8295 180-day forward $0.8343 a. Was the Swiss franc selling at a discount or premium in the forward market? b. What was the 30-day forward premium (or discount)? c. What was the 90-day forward premium (or discount)? d. Suppose you executed a 90-day forward contract to exchange 100,000 Swiss francs into U.S. dollars. How many dollars would you get 90 days hence? e. Assume a Swiss bank entered into a 180-day forward contract with Bankers Trust to buy $100,000. How many francs will the Swiss bank deliver in six months to get the U.S. dollars? 21-1. Solution: a. The Swiss franc was selling at a premium above the spot rate. b. 21-1. (Continued) c. d. 90-day forward rate = $.8295 Dollar value of 100,000 Swiss francs $.8295 × 100,000 = $82,950 e. 180-day forward rate = $.8343 2. Cross rates (LO21-2) Suppose a Polish zloty is selling for $0.3414 and a British pound is selling for 1.4973. What is the exchange rate (cross rate) of the Polish zloty to the British pound? That is, how many Polish zlotys are equal to a British pound? 21-2. Solution: One dollar is worth 2.929 Polish zloty ($1/0.3414) and one British pound is worth 1.4973 dollars. Thus, 2.929 Polish zlotys per dollar times 1.4973 dollars per British pound equals 4.39 Polish zlotys per British pound. The answer is 4.39. 3. Purchasing power theory (LO21-2) From the base price level of 100 in 1979, Saudi Arabian and U.S. price levels in 2008 stood at 200 and 410, respectively. If the 1979 $/riyal exchange rate was $0.26/riyal, what should the exchange rate be in 2008? Suggestion: Using purchasing power parity, adjust the exchange rate to compensate for inflation. That is, determine the relative rate of inflation between the United States and Saudi Arabia and multiply this times $/riyal of 0.26. 21-3. Solution: $/riyal = $.26 in 1979 The value of the Saudi Arabian riyal to the dollar will rise in proportion to the rate of inflation in the United States compared to the rate of inflation in Saudi Arabia. $/riyal (2008) = $.26/riyal × 2.05 = .5330 4. Continuation of Purchasing power theory (LO21-2) From the base price level of 100 in 1981, Saudi Arabian and U.S. price levels in 2010 stood at 250 and 100, respectively. Assume the 1981 $/riyal exchange rate was $.46/riyal. Suggestion: Using the purchasing power parity, adjust the exchange rate to compensate for inflation. That is, determine the relative rate of inflation between the United States and Saudi Arabia and multiply this times $/riyal of .46. What should the exchange rate be in 2010? 21-4. Solution: $/riyal = $.46 in 1981 This is what the riyal should be if the purchasing power parity theory holds. $/riyal (2010) = $.46/riyal × 0.4 = .18 5. Adjusting returns for exchange rates (LO21-2) An investor in the United States bought a one-year Brazilian security valued at 195,000 Brazilian reals. The U.S. dollar equivalent was 100,000. The Brazilian security earned 16 percent during the year, but the Brazilian real depreciated 5 cents against the U.S. dollar during the time period ($0.51 to $0.46). After transferring the funds back to the United States, what was the investor’s return on her $100,000? Determine the total ending value of the Brazilian investment in Brazilian reals and then translate this Brazilian value to U.S. dollars. Afterward, compute the return on the $100,000. 21-5. Solution: Initial value × (1 + Interest rate) 195,000 × 1.16 = 226,200 Brazilian reals Brazilian reals × .46 = U.S. dollars equivalent 226,200 × .46 = 104,052 U.S. dollars equivalent 4,052*/$100,000 = 4.052% rate of return *$104,052 – $100,000 = $4,052 change 6. Adjusting returns for exchange rates (LO21-2) A Peruvian investor buys 150 shares of a U.S. stock for $7,500 ($50 per share). Over the course of a year, the stock goes up by $4 per share. a. If there is a 10 percent gain in the value of the dollar versus the nuevo sol, what will be the total percentage return to the Peruvian investor? First, determine the new dollar value of the investment and multiply this figure by 1.10. Divide this answer by $7,500 and get a percentage value, and then subtract 100 percent to get the percentage return. b. Instead assume that the stock increases by $7, but that the dollar decreases by 10 percent versus the nuevo sol. What will be the total percentage return to the Peruvian investor? Use 0.90 in place of 1.10 in this case. 21-6. Solution: a. Initial investment 150 × $50 = $7,500 Value after one year 150 × $54 = $8,100 Equivalent value to the Peruvian investor $8,100 × 1.10 = 8,910 b. Initial Investment 150 × $50 = $7,500 Value after one year 150 × $57 = $8,550 Equivalent value to the Peruvian investor $8,550 × .90 = 7,695 r = 1.0260 – 1 = 2.60% 7. Hedging exchange rate risk (LO21-3) You are the vice president of finance for Exploratory Resources, headquartered in Houston, Texas. In January 2010, your firm’s Canadian subsidiary obtained a six-month loan of 150,000 Canadian dollars from a bank in Houston to finance the acquisition of a titanium mine in the province of Quebec. The loan will also be repaid in Canadian dollars. At the time of the loan, the spot exchange rate was U.S. $.8995/Canadian dollar and the Canadian currency was selling at a discount in the forward market. The June 2010 contract (Face value = C$150,000 per contract) was quoted at U.S. $0.8930/Canadian dollar. a. Explain how the Houston bank could lose on this transaction assuming no hedging. b. If the bank does hedge with the forward contract, what is the maximum amount it can lose? 21-7. Solution: a. The Houston bank has extended a loan denominated in Canadian dollars and will be repaid in Canadian dollars. If the Canadian dollar drops in the future (a possibility implied by the futures contract price), the Houston bank will be paid back in a currency that is worth less at the time it is repaid than it was at the time it was borrowed. b. If the bank hedges by buying Canadian dollars now for US$.8995/CD and contracting to sell them in the future for US$.8930/CD, the most it can lose is US$975 on the C$150,000 contract or US$.0065/CD. Problem 21A-1. Cash flow analysis with a foreign investment (LO21-2) The Office Automation Corporation is considering a foreign investment. The initial cash outlay will be $10 million. The current foreign exchange rate is 2 ugans = $1. Thus the investment in foreign currency will be 20 million ugans. The assets have a useful life of five years and no expected salvage value. The firm uses a straight-line method of depreciation. Sales are expected to be 20 million ugans and operating cash expenses 10 million ugans every year for five years. The foreign income tax rate is 25 percent. The foreign subsidiary will repatriate all aftertax profits to Office Automation in the form of dividends. Furthermore, the depreciation cash flows (equal to each year’s depreciation) will be repatriated during the same year they accrue to the foreign subsidiary. The applicable cost of capital that reflects the riskiness of the cash flows is 16 percent. The U.S. tax rate is 40 percent of foreign earnings before taxes. a. Should the Office Automation Corporation undertake the investment if the foreign exchange rate is expected to remain constant during the five-year period? b. Should Office Automation undertake the investment if the foreign exchange rate is expected to be as follows: Year 0 $1 = 2.0 ugans Year 1 $1 = 2.2 ugans Year 2 $1 = 2.4 ugans Year 3 $1 = 2.7 ugans Year 4 $1 = 2.9 ugans Year 5 $1 = 3.2 ugans 21A-1. Solution: The Office Automation Corporation (Values in millions of ugans) a. Year 1 Year 2 Year 3 Year 4 Year 5 Revenue 20.00 20.00 20.00 20.00 20.00 – Operating expense 10.00 10.00 10.00 10.00 10.00 – Depreciation (20 M/5) 4.00 4.00 4.00 4.00 4.00 = Earnings before foreign taxes 6.00 6.00 6.00 6.00 6.00 – Foreign income tax (25%) 1.50 1.50 1.50 1.50 1.50 = Earnings after foreign income taxes 4.50 4.50 4.50 4.50 4.50 Dividends repatriated* 4.50 4.50 4.50 4.50 4.50 Gross U.S. taxes (40% of earnings before foreign taxes) 2.40 2.40 2.40 2.40 2.40 – Foreign tax credit 1.50 1.50 1.50 1.50 1.50 = Net U.S. taxes payable .90 .90 .90 .90 .90 After tax dividend received 3.60 3.60 3.60 3.60 3.60 Exchange rate (2 ugans/$) 2.00 2.00 2.00 2.00 2.00 After tax dividend (U.S. $) $1.80 $1.80 $1.80 $1.80 $1.80 * Dividends repatriated assumes all earnings after foreign income taxes will be repatriated. PVIFA (16% for 5 years) 3.274 PV of dividends equals $1.80 × 3.274 = $5.893 million Depreciation equals 4.00 per year $4.00/2 = $2.00 Exchange rate = Depreciation 2 ugans/$ per year PV of depreciation equals $2.00 × 3.274 = $6.548 million The PV of all the cash inflows equals $5.893 + $6.548 = $12.441 million Cost of project 10.000 million Net present value of the project $ 2.441 million Since NPV is positive, accept the project! b. The change in foreign exchange values must be applied to both after tax dividends received (in ugans) and depreciation (in ugans). (in millions) Year 1 Year 2 Year 3 Year 4 Year 5 After tax dividend received 3.60 3.60 3.60 3.60 3.60 Depreciation 4.00 4.00 4.00 4.00 4.00 Total (in ugans) 7.60 7.60 7.60 7.60 7.60 Exchange rate (ug/$1) 2.2 2.4 2.7 2.9 3.2 Cash inflow (U.S. $) 3.45 3.17 2.81 2.62 2.38 PVIF (16%) .862 .743 .641 .552 .476 PV (U.S. $) 2.97 +2.36 +1.80 +1.45 +1.13 PV of all the inflows equals $ 9.71 million Cost of project 10.00 million Net present value of the project ($ .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 R. Danielsen 9780077861612, 9781260013917, 9781259277160
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