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

Answer

What should be considered is how close cash flow of affiliates is if compared to local market economy. In addition to this correlation between country of operation and how volatile foreign operations are if compared to domestic economy. If the above figures are less, then there will be low foreign affiliates’ cost of capital as compared to domestic economy and vice versa. 

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

Answer

Advantage; it provides a good avenue for off balance sheet borrowing. It is also aids in tax write off.

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Disadvantages; it is expensive in that due to interest rates charged on loans and debt repayments. Also, it weakens a firm’s financial position at the international operations.

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The CFO of H&M is thinking of borrowing dollars because of their low interest rate, currently at 4.5%. The current interest rate on Swedish krona is 9%. What is your advice to the CFO?

Answer

The current interest rate of Swedish krona is twice the rate of dollar. This figure is bound to rise given that international currents rate is higher in Swedish krona. Any rise in dollar rates will negatively affect H & M’s real value in the future.

A firm with a corporate-wide debt/equity ratio of 1:2, an after-tax cost of debt of 8%, and a cost of equity capital of 20% is interested in pursuing a foreign project. The debt capacity of the project is the same as for the company as a whole, but its systematic risk is such that the required return on equity is estimated to be about 15%. The after-tax cost of debt is expected to remain at 8%.

What is the project's weighted average cost of capital?

 Answer

The weighted average cost of capital; kI = (1 - w) x ke' + w x id(1 - t): w; ratio of debt to assets, ke'; needed risk-adjusted return on equity, id(1 - t); is the after-tax cost of debt.

Therefore; kI = 2/3 x 15% + 1/3 x 8% = 12.67%

Suppose that a foreign project has a beta of 0.75, the risk-free return is 4%, and the required return on the market is estimated at 10%.

What is the cost of capital for the project?

Answer

Cost of Capital; k* = Rf + â*[E(Rm) - Rf] where Rf; risk-free needed return, â*; beta, and E(Rm); expected market return.

Therefore k* = 4% + 0.75(10% - 4%) = 8.5%

Problem 6

If Eriksson issues a Eurobond denominated in yen, the 8% interest rate on the SEK 10 million, one-year borrowing will be 2% less than rates in Sweden However, Eriksson would have to pay back the principal and interest in Japanese yen. Currently, the exchange rate is ¥12 =SEK 1.

By how much could the yen rise against the krona before the Euroyen bond would lose its advantage to Eriksson?

Answer

Breakeven exchange rate is evaluated as the solution to S = 12 x 1.02/1.08 = ¥13.33

Suppose that a firm located in Thailand can borrow dollars at 10% or Bhat at 15%.

If the Bhat is expected to depreciate from B 30 = $1 at the beginning of the year to B 40 = $1 at the end of the year.

What is the expected before-tax dollar cost of the Bhat loan?

Answer

Expected before –tax dollar cost of Bhat rus + c where rus is interest rate charged on dollar, c; change in dollar value.

Therefore pre-tax dollar cost of Baht loan expected = (1/30 – 1/40)/(1/40) = 33.33%

If the Thai corporate tax rate is 40%, what is the expected after-tax dollar cost of borrowing dollars, assuming the same currency change scenario?

Answer

After-tax dollar cost of borrowing LC is rL(1 + c)(1 - t) + c, where rL is the Local Currency interest rate.

Therefore after-tax dollar cost of borrowing = 10% (1-0.40) – 0.40 x 33.33% = -7.33%

During the year the price of British gilts (government bonds) went from £105 to £110, while paying a coupon of £9. At the same time, the exchange rate went from £1:$1.72 to £1:$1.60.

What was the total dollar return, in percent, on gilts for the year?

Answer

Dollar has appreciated from $1.72 to $1.60 = 6.98%

British government bonds appreciated from £105 to £110 = 4.76%

Dollar appreciation in percentage on gilts R$ = (1 + 0.0698) (1 + 0.0476) -1= 12.07%  

In 1990, Matsushita bought Svensson Systems AB for SEK 30 billion. At the time of the purchase, the exchange rate was about ¥20/SEK. By the time that Matsushita sold an 80% stake in Svensson Systems to Seagram for SEK 28 billion in 1995, the yen had appreciated to a rate of about ¥14/SEK.

a. Ignoring the time value of money, what was Matsushita's kronar gain or loss on its investment in Svensson Systems?

b. What was Matsushita's yen gain or loss on the sale?

The standard deviations of Swedish and Italian returns over the period 1989-1993 were 10.7% and 27.7%, respectively. In addition, the correlation between the Swedish and Italian markets over this period was 0.35.

Assuming that these data reflect the future as well, what is the Italian market beta relative to the Swedish market?

Answer

Italian beta = Correlation with Swedish market x SD Italian beta/SD Swedish market

                  = 0.35 x 0.277/0.107 = 0.906 as compared to 1.00 for Swedish beta

A portfolio manager is considering the benefits of increasing his diversification by investing overseas.

What is the expected return and standard deviation of return of a portfolio with 25% invested in the Norway and 75% in the Sweden?

Answers

Formulas rp = w1r1 + w2r2 and σp 2 = w1 2σ1 2 + w2 2σ2 2 + 2w1w2r12σ1σ2 to calculate the standard deviation

Early results on the Lexus, Toyota's upscale car, showed it was taking the most business from customers changing from BMW (15%), Mercedes (14%), Toyota (14%), General Motors' Cadillac (12%), and Ford's Lincoln (6%).

With what in the auto business is considered a high percentage of sales coming from its own customers, how badly is Toyota hurting itself with the Lexus?

Answer

Ford’s Lincolns since the rate of change is minimal and stands at 6%. Toyota and Lexus are badly hit since their customers rate of switching to the car models is high and stands at 14%.This greatly affects sales volume and in turn lowers the profits.

Suppose a firm has just made an investment in Italy that will generate SEK 15 million annually in depreciation,converted at today's spot rate. Projected annual rates of inflation in Italy and in the Sweden are 8% and 5%,respectively.

If the real exchange rate is expected to remain constant and the Italian tax rate is 50%, what is theexpected real value (in terms of today's kronor) of the depreciation charge in year 5, assuming that the tax write-offis taken at the end of the year?

Answer

Assuming real exchange remains constant, real SEK value of Italian currency should be expected to reduce in relation to real Italian value; 8% inflation in Italy. Therefore, the real SEK value of depreciation tax write-off will reduce at 8% per year. Further assuming tax rate of 50%, depreciation of SEK 15 million = SEK7.5 million today. Factoring an 8% SEK write-off of the real value of SEK, after five years then the real figure will be SEK 7,500,000/(1.08)5 = SEK1,388,888

SKF is worried that its production facility in China may be expropriated in 12 months. The government has however promised that in the event of expropriation a compensation of SEK 500 million will be paid to SKF. If expropriation does not occur the facility is expected to be worth SEK 1500 million at the end of the year. If expropriation does not take place this year it will not take place in the future. A local business man manufacturing ball bearings has offered SFK 640 million for the facility. If the risk adjusted discount rate for SKF is 22%, what is the probability of expropriation is indifferent between selling it now and holding the facility?

Answer

NPV- SEK 500 million

NFV- SEK 1500 million

Discounting rate-22%

P (A and B) = P (A) * P (B)

A=0.22, B=0.88

P= (0.22*0.88)

P=0.1936

A mining company is considering whether it should open a gold mine or not. The cost of opening the mine is SEK 6 million. It is estimated that 40000 ounces of gold remains to be mined. IF the mine is opened the gold can be removed for one year and the variable cost is SEK 2340/ounce. Assume that there are only 2 possibilities of gold prices SEK 1800/ounce and SEK 3000/ounce, each with probability 0.5. Mine gold only is the gold price is SEK 3000/ounce.

If the discount rate is 15% what is the NPV of the project?

Answer

Cost of mining = SEK 6 million

Variable cost = SEK 2340 x 40000 = SEK 93,600,000

Returns from gold = (3000 x 20000) = SEK 120,000,000

Profit = SEK 20,400,000

NPV at 15% discount 0.87 x 20,400,000 = SEK 17,748,000. (0.87 attained from NPV Tables)

Decision Case-Lufthansa

Basis of dismissal of Herr Heinz Ruhnau

The board of Lufthansa is charged with responsibility to ensure that the company is taken to the right direction of growth. The board should evaluate decisions made on behalf of the company to determine that they are economically viable. The board should guarantee that bosses (chairman not exceptional) of the company are committed to making real difference financial aspects by ensuring long term sustainability. 

Any transaction involving payment by company should be well researched by evaluating performance portfolio of the company with situation in current market.  A company should stand a chance of benefiting in the event of a transaction. This in line with core business of a company is making profit even in a competitive and fluctuating world market. A manager therefore has a responsibility to ensure that core value of a company is adhered to. It is on this ground that Lufthansa’s manager, Herr Heinz Ruhnau has a question to answer.

Heinz Ruhnau behaved more of a gambler than a manager by specifying the right time according to him purchase an aircraft. To speculate that Dollar weaken against Deutschemark by January thus would be best time to buy the aircraft was the greatest risk least expected from one of his caliber. Heinz Ruhnau had several better options which he deliberating ignored under the pretext that the exchange rate would. He even ignored the fact that exchange rates would not obviously be predicted since it is under influence of several factors, some of which are inevitable. Choosing to cover the entire exposure with forward contracts e which is a benchmark of comparison of actual currency by many firms, would better option as the risks involving exchange rate would have been eliminated.

The company would have paid for each aircraft based on its market price at that particular time. The other option at his disposal was to cover the exposure with foreign currency. This would be beneficial to the company as the total cost would be locked in at DM 1.6 billion even if the Dollar was to rise. If Dollar was to go down the chairman would still have an option to leave the option to expire and purchase the Dollar at a lower price. This option; therefore provided an opportunity where there is no loss at the end for the firm.

Based on the above ignored options, the board should not retain Ruhnau as chairman this because his action and strategies are not pro business. His decision was gravely wrong and therefore might jeopardize future business prospect of the company. Ruhnau aim was to save money and reduce cost which good but the long term business does not require such grievous decisions he made. Hence he should just go home.

Case Questions on Toyota European

  1. Why do you think Toyota waited so long to move much of its manufacturing for European sales to Europe?

Answer

This was because Toyota was number eight in sales in continental Europe.In this regard,it was still strategising on how to gain penetration into the European market before moving to manufacture locally in Europe.In most cases, it becames difficult for a company to penetrate a new market so qick and therefore the entry stretegies calls fdor graduall operation.This what the mangement of toyota Europe adopeted.It is also prudent to note that, busness oopotunituies are the yard stck measurement for any action which is geared ntowards gaining economies of scale.

  1. If Britain pound were to join the European Monetary Union, would the problem be resolved? How likely do you think this is?

Answer

The problem will not be solved based on the Britain pound joining  the European Monetary Union.Since economic problem is never solved by stability one currency a lone.It is likely since economic problem have got sevaral economic factors which direcly and indirectly influence global economy.Global currencies are major factors in in analysisng economic trened however, their stability are not the only pancea to to global economic problem.This is bacause there are several economic indicatorrs nwhch must all be addressed adequetely for a equlibrium to be acieved.With this priciple in mind, British pound joing Emuropean monitary union iis good for business but not a solution to Toyata’s problems.

3.If you were Mr. Shouhei, how wold you categorize your problems and solutions? What are a short-term and a long-term problems?

Answer

I would categorise my problem into;

  • Economic problem.These are probvlem associeted by global economic situation and the company should put measures which are geared towards their mitigation so as to reduce their negative impact in the market
  • Market penetration  problem.These are problem associeted by market structurre and competion  

Solution to the prblems

The company will put aggresive marketing coupled with development and manufacturing of motor vehecle which are Europe freinedly.This will go a long way in promoting sales and hence profits which in turn mitigate the economic preoblems.Economic problem can be mitigated by ensuring that nthe company concentrate in its core competence in the market.This will lower down the cost of promotions.

  1. What measures would you recommend Toyota Europe take to resolve the continuing operating losses?

Answer

Toyota Europe should concetrate in developing motor vehicles which are European market friendly.This will give them an upper edge over other competitors hence speed up market penetration and sales volumes.The global economic recessesion has gereatly dented and a huge hole in many peoeple pockets.This is because the problem resulted in loss of empoloyment opportunities across the globe.Towarsds this, many european would not prefer spending a lot of many in luxury cars but would rather buy affordable mosels which are pcket friendly.It is therefore effcetive for Toyota to take te opportunity to speed up their penetrateion in Europe motor market by bulding and selling Toyota car models which are market friendly at this particular peruiod.

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