International Finance CH 16 Questions

During a conflict in the Middle East, some MNCs capitalized on opportunities to rebuild the damaged areas. However, some of their employees were kidnapped by local militant groups. How should an MNC account for this potential risk when it considers direct foreign investment (DFI) in any particular country? Should it avoid DFI in any country in which such an event could occur? If so, how would it screen the countries to determine which countries have acceptable risk? For whatever countries the MNC is willing to consider, should it adjust its feasibility analysis to account for the possibility of kidnapping? Should it attach a cost to reflect this possibility or increase the discount rate when estimating the net present value? Explain.

This question can lead to an interesting class discussion. Some students will suggest that an MNC should never pursue opportunities in countries where such events could occur. Yet, this could occur anywhere, so the students must attempt to decide how much risk they should be willing to take. The question is complicated because human lives are involved. MNCs may consider the potential cost of paying kidnappers, but there are some other costs such as the moral of the company and the long-term effect on kidnapped employees (even if they are rescued) that are difficult to measure.

MNCs such as Alcoa, DowDuPont, Kraft Heinz, and IBM have donated products and technology to foreign countries where they had subsidiaries. How could these actions have reduced some forms of country risk?

When MNCs donate products and/or technology to foreign countries where they have subsidiaries, they may receive more favorable treatment from the consumers in that country, their employees that work for their subsidiaries, and the host governments.

Assume that interest rate parity exists. At 10:30a.m., the media reported news that the Mexican government political problems had been solved, which reduced the expected volatility of the Mexican peso against the dollar over the next month. However, this news had no effect on the prevailing one-month interest rates of the U.S. dollar or Mexican peso, and also had no effect on the expected exchange rate of the Mexican peso in one month. The spot rate of the Mexican peso was $.13 as of 10 a.m. and remained at that level all morning. a. At 10 a.m., Piazza Co. purchased a call option at the money on 1 million Mexican pesos with a December expiration date. At 11:00 a.m., Corradetti Co. purchased a call option at the money on 1 million pesos with a December expiration date. Did Corradetti Co. pay more than, less than, or the same as Piazza Co. for the options? Briefly explain. b. Teke Co. purchased futures contracts on 1 million Mexican pesos with a December settlement date at 10 a.m. Malone Co. purchased futures contracts on 1 million Mexican pesos with a December settlement date at 11 a.m. Did Teke Co. pay more than, less than, or the same as Malone Co. for the futures contracts. Briefly explain.

a. Corradetti Co. paid less than Piazza, because the expected volatility of the call option declined by the time that Corradetti purchased options. b. The same. The spot rate did not change. The interest rate differential did not change. So based on IRP, the premium of the forward rate did not change.

Recently, Best Bargain Co., a U.S. retailer, decided to consider expanding into various foreign countries; it applied a comprehensive country risk analysis before making its expansion decisions. Initial screenings of 30 foreign countries were based on political and economic factors that contribute to country risk. For the remaining 20 countries where country risk was considered to be tolerable, specific country risk characteristics of each country were considered. One of Best Bargain's biggest targets is Mexico, where it plans to build and operate seven large stores. a. Identify the political factors that you think might potentially affect the performance of the Best Bargain stores in Mexico. a. Identify the political factors that you think might potentially affect the performance of the Best Bargain stores in Mexico. b. Explain why the Best Bargain stores in Mexico and in other foreign markets are subject to financial risk (a subset of country risk). c. Assume that Best Bargain anticipated that there was a 10 percent chance that the Mexican government would temporarily prevent conversion of peso profits into dollars because of political conditions. This event would prevent Best Bargain from remitting earnings generated in Mexico and could adversely affect the performance of these stores (from the U.S. perspective). Describe a way in which this type of political risk could be explicitly incorporated into a capital budgeting analysis when assessing the feasibility of these projects. d. Assume that Best Bargain decides to use dollars to finance the expansion of stores in Mexico. Second, assume that Best Bargain decides to use one set of dollar cash flow estimates for any project that it assesses. Third, assume that the stores in Mexico are not subject to political risk. Do you think that the required rate of return on these projects would differ from the required rate of return on stores built in the U.S. at that same time? Explain. e. Based on your answer to the previous question, does this mean that Best Bargain is more likely to accept proposals for any new stores in the U.S. than proposals for any new stores in Mexico?

a. Perhaps the most likely political factor is the blockage of fund transfers or currency inconvertibility, because the currency (the peso) is sometimes volatile and could require special controls in some periods. b. The economy in Mexico is volatile, and if economic conditions deteriorate, the demand for many products sold at the Best Bargain stores will decline. While some economies are more stable than Mexico's economy, any country is subject to a possible weakening of the economy. Therefore, Best Bargain stores in any country could experience weak sales due to financial risk. c. The expected cash flows of the project could be re-estimated based on the scenario that the Mexican government restricts the conversion of currencies. The net present value of the project can be re-estimated as well. Thus, the capital budgeting analysis results in a distribution of NPVs based on possible scenarios. d. If Best Bargain generated a single set of cash flow estimates for the establishment of a given store in Mexico, it would likely use a required rate of return that is higher than that used for a proposed store in the U.S. The higher required rate of return on new stores in Mexico is attributed to the greater degree of uncertainty associated with the new stores in Mexico than new stores in the U.S. Even though there is more potential for profits from new stores in Mexico, there is more uncertainty about the future cash flows generated by those stores. The Mexican economy is more volatile than the U.S. economy, so the demand for products in Mexico is subject to more uncertainty. Also, the exchange rate movements will affect the dollar earnings that are generated by the stores in Mexico. Since the exchange rate movements are very uncertain, so are the dollar earnings that will be received by the U.S. parent. e. No. The U.S. markets have less potential because Best Bargain has stores in most U.S. markets (as mentioned in the case). Therefore, the estimated cash flows would be lower for U.S. projects. Even though the required rate of return may be higher for a proposed store in Mexico, the dollar cash flows should be much higher, which could result in a higher probability of accepting this type of project.

Atro Co. (a U.S. firm) considers a foreign project in which itexpects to receive 10 million euros at the end of one year. While it realizes that its receivables are uncertain, it decides to hedge receivables of 10 million euros with a forward contract today. As of today, the spot rate of the euro is $1.20, while the one-year forward rate of the euro is presently $1.24, and the expected spot rate of the euro in one year is $1.19. The initial outlay of this project is $7 million. Atro has a required return of 18%. a. Estimate the NPV of this project based on the expectation of 10 million euros in receivables. b. Now estimate the NPV based on the possibility that country risk could cause a reduction in foreign business, such that Atro Co. only receives only 4 million euros instead of 10 million euros at the end of one year. Estimate the net present value of the project if this form of country risk occurs.

a. Using forward rate after 1 year: euros 10,000,000 x $1.24 = $12,400,000 NPV = $12,400,000 / (1 + 0.18) - $7,000,000 = NPV = $ 3,508,474 b. Using forward rate after 1 year = euros 10,000,000 x $1.24 - $6,000,000 x 1.19= = $5,260,000NPV = $5,260,000 / (1 + 0.18) - $7,000,000 = -$2,542,373

. Explain some methods of reducing exposure to existing country risk, while maintaining the same amount of business within a particular country.

1. use a short-term horizon 2. hire local labor 3. borrow local funds 4. obtain insurance 5. create joint ventures

Explain the micro-assessment of country risk.

A micro-assessment of country risk assesses risk factors as related to the firm's particular projects.

Explain how the capital budgeting analysis in question 16 would need to be adjusted if there were three possible outcomes for the British pound along with the possible outcomes for the British economy and corporate tax rate.

A simplification of the example provided is that only one expectation for the British pound's value was assumed. In reality, Hoosier Inc. may create a probability distribution for the pound's value one year from now. If Hoosier Inc. used three possible outcomes for the pound, this would expand the number of possible scenarios. For each of the four scenarios in the previous question, there would now be three possible outcomes for the pound's value, resulting in a total of 12 possible scenarios.

Slidell Co. (a U.S. firm) considers a foreign project inwhich it expects to receive 10 million euros at the end of this year. It plans to hedge receivables of 10 million euros with a forward contract. Today, the spot rate of the euro is $1.20, the one-year forward rate of the euro is presently $1.24, and the expected spot rate of the euro in one year is $1.19. The initial outlay is $7 million. Slidell has a required return of 18%.There is a 20% chance that political problems will cause a reduction in foreign business, such that Slidell would only receive only 4 million euros at the end of one year. Determine the expected value of the net present value of this project.

ANSWER: Normal conditions Dollar cash flows = 10,000,000 euros x $1.24 = $12,400,000 NPV = ($12,400,000/1.18) - $7,000,000= $3,508,474 Political problem Dollar cash flows = 4,000,000 x $ 1.24 = $4,960,000 but forward contract on remaining 6,000,000 euros converts to ($1.24 - $1.19) x 6,000,000 = $300,000 So total cash flow is $5,260,000 NPV = $5,260,000/1.18 = $4,457,627 - $7,000,000 = -$2,542,373E(NPV) = [.8 x ($3,508,474) + .2 x ($2,542,373)] = $2,298,305

Arkansas, Inc., exports to various less developed countries, and its receivables are denominated in the foreign currencies of the importers. It considers reducing its exchange rate risk by establishing small subsidiaries to produce products. By incurring some expenses in the countries where it generates revenue, this firm can reduce its exposure to exchange rate risk. In recent months, several countries to which it exports have experienced terrorist attacks. Now Arkansas is questioning whether it should restructure its operations. Its CEO believes that its cash flows may be less exposed to exchange rate risk but more exposed to other types of risk as a result of the restructuring. What is your opinion?

Arkansas Inc. could be more exposed to political risk as a result of establishing subsidiaries in other countries. Thus, its cash flows may be subject to more uncertainty with the exposure to political risk than if it continues to export and is subject to exchange rate risk.

Assauer Inc. would like to assess the country risk of Glovanskia. Assauer has identified various political and financial risk factors, as shown in the table. Assauer has assigned an overall rating of 80 percent to political risk factors and of 20 percent to financial risk factors. Assauer is not willing to consider Glovanskia for investment if the country risk rating is less than 4.0. Should Assauer consider Glovanskia for investment?

Determine the combined country risk rating:Political risk rating = (5 × 40%) + (3 × 60%) = 3.8 Financial risk rating = (1 × 10%) + (4 × 20%) + (5 × 30%) + (4 × 20%) + (5 × 20%) = 4.2 Weighted rating = (3.8 × 80%) + (4.2 × 20%) = 3.88 Since the weighted rating is below 4.0, Assauer will probably not consider the investment.

If the potential return is high enough, any degree of country risk can be tolerated. Do you agree with this statement? Why or why not? Do you think that a proper country risk analysis can replace a capital budgeting analysis of a project considered for a foreign country? Explain.

Disagree! If country risk is so high that there is great danger to employees, no expected return is high enough to warrant the project.

Once a project is accepted, country risk analysis for the foreign country involved is no longer necessary, assuming that the MNC is not evaluating any other projects for that country. Do you agree with this statement? Why or why not?

Disagree! The country risk must be monitored continuously, since if risk becomes too high, the MNC should divest its subsidiaries in that country.

Describe the possible errors involved in assessing country risk. In other words, explain why country risk analysis is not always accurate.

Errors occur due to (1) assigning inaccurate ratings to factors and (2) weighting the importance of the factors improperly.

How could a country risk assessment be used to adjust a project's required rate of return? How could such an assessment be used instead to adjust a project's estimated cash flows?

For countries with a lower country risk rating (implying high risk), the project's required rate of return could be increased (by increasing the discount rate on NPV analysis).

Why do you think that an MNC's strategy of diversifying projects internationally could achieve low exposure to overall country risk?

If the MNC can set up foreign projects in countries whose country risk levels are not highly correlated over time, then it reduces the exposure to the possibility of high country risk in all of these areas simultaneously.

Niagara, Inc., has decided to call a well-known country risk consultant to conduct a country risk analysis in a small country where it plans to develop a large subsidiary. Niagara prefers to hire the consultant since it plans to use its employees for other important corporate functions. The consultant uses a computer program that has assigned weights of importance linked to the various factors. The consultant will evaluate the factors for this small country and insert a rating for each factor into the computer. The weights assigned to the factors are not adjusted by the computer, but the factor ratings are adjusted for each country that the consultant assesses. Do you think Niagara, Inc. should use this consultant? Why or why not?

No! The consultant's program has not allowed for the weights on importance for each rating to be flexible, depending on the country or firm project of concern. Therefore, the program will definitely assign improper weights to some factors.

When NYU Corp. considered establishing a subsidiary in Zealand, it performed a country risk analysis to help make the decision. It first retrieved a country risk analysis performed about one year earlier, when it had planned to begin a major exporting business to Zenland firms. Then it updated the analysis by incorporating all current information on the key variables that were used in that analysis, such as Zenland's willingness to accept exports, its existing quotas, and existing tariff laws. Is this country risk analysis adequate? Explain.

No. A country risk analysis used for an exporting project incorporates different information than an analysis used to assess the feasibility of establishing a subsidiary.

Hoosier, Inc., is planning a project in the United Kingdom. It would lease space for one year in a shopping mall to sell expensive clothes manufactured in the U.S. The project would end in one year, when all earnings would be remitted to Hoosier, Inc. Assume that no additional corporate taxes are incurred beyond those imposed by the British government. Since Hoosier, Inc., would rent space, it would not have any long-term assets in the United Kingdom, and expects the salvage (terminal) value of the project to be about zero. Assume that the project's required rate of return is 18 percent. Also assume that the initial outlay required by the parent to fill the store with clothes is $200,000. The pretax earnings are expected to the £300,000 at the end of one year. The British pound is expected to be worth $1.60 at the end of one year, when the after-tax earnings are converted to dollars and remitted to the United States. The following forms of country risk must be considered: The British economy may weaken (probability = 30%), which would cause the expected pretax earnings to be £200,000. The British corporate tax rate on income earned by U.S. firms may increase from 40 percent to 50 percent (probability = 20 percent). These two forms of country risk are independent. Calculate the expected value of the project's net present value (NPV) and determine the probability that the project will have a negative NPV.

Sensitivity analysis can be used to measure the net present value under each possible scenario, as shown in the attached exhibit. There are four possible scenarios. The most favorable scenario is a strong British economy and a relatively low (40%) British tax rate. This scenario results in after-tax dollar earnings of $288,000 in one year. The NPV is determined by obtaining the present value of these earnings (discounted at the required rate of return of 18%) and subtracting the initial outlay of $200,000. The NPV resulting from the most favorable scenario is $44,068. The joint probability of a strong British economy and the 40% tax rate is the product of the probabilities of these two situations (assuming that the situations are independent). Given a 70 percent probability for the strong British economy and an 80 percent probability for the 40% British tax rate, the joint probability is 70% × 80% = 56%. The NPV and joint probability for each of the other three scenarios are also estimated in the exhibit, following the same process as discussed above. The expected value of the project's NPV can be determined as the sum of the products of each scenario's NPV and joint probability, as shown below: E(NPV) = ($44,068) (56%) + ($3,390) (14%) + (-$37,288) (24%) + (-$64,407) (6%)= ($24,678) + ($475) + (-$8,949) + (-$3,864)= $12,340 The expected net present value of the project is positive. Yet, the NPV is expected to be negative for two of the four possible scenarios that could occur. Since the joint probabilities of these two scenarios add up to 30 percent, this implies that there is a 30 percent chance that the project will result in a negative NPV.

Why do some subsidiaries maintain a low profile as to where their parents are located?

Some subsidiaries are concerned that the public in the country where they are located will harm their employees or damage the facilities as an act of protest against the home country of subsidiaries.