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If the only violation of the M&M assumptions is that investors face one tax rate for interest income and another tax rate for equity income, what is the implication for the optimal capital structure of a corporation?
Cost of Capital. An MNC has total assets of $100 million and debt of $20 million. The firm’s before-tax cost of debt is 12%, and its cost of financing with equity is 15%. The MNC has a corporate tax rate of 40%. What is this firm’s cost of capital?
| 15.56% | ||
| 11.39% | ||
| 13.44% |
Optimal Financing. Wizard, Inc., has a subsidiary in a country where the government allows only a small amount of earnings to be remitted to the United States each year. Should Wizard finance the subsidiary with debt financing by the parent, equity financing by the parent, or financing by local banks in the foreign country?
| Wizard should use financing by local banks in the foreign country. | ||
| Wizard should use debt financing by local banks in the foreign country. | ||
| Wizard should use equity financing by local banks in the foreign country. |
Change in Cost of Capital. Assume that Naperville Co. will use equity to finance a project in Switzerland, while Lombard Co. will rely on a dollar-denominated loan to finance a project in Switzerland, and Addison Co. will rely on a Swiss franc-denominated loan to finance a project in Switzerland. The firms will arrange their financing in one month. This week, the U.S. risk-free long-term interest rate declined, but interest rates in Switzerland did not change. Do you think the estimated cost of capital for the projects by each of these three U.S. firms increased, decreased, or remained unchanged?
| Naperville decreased, Lombard Co. decreased, and Addison Co. remains unchanged. | ||
| Naperville increased, Lombard Co. increased, and Addison Co. remains unchanged. | ||
| Naperville remains unchanged, Lombard Co. remains unchanged, and Addison Co. decreased. | ||
| Naperville decreased, Lombard Co. increased, and Addison Co. remains unchanged. |
Financing Decision. Drexel Co. is a United States–based company that is establishing a project in a politically unstable country. It is considering two possible sources of financing. Either the parent could provide most of the financing, or the subsidiary could be supported by local loans from banks in that country. Which financing alternative is more appropriate to protect the subsidiary?
| The parent could provide most of the financing. | ||
| The subsidiary could be supported by local loans from banks in that country. |
Financing With Foreign Equity. Orlando Co. has its U.S. business funded in dollars with a capital structure of 60% debt and 40% equity. It has its Thailand business funded in Thai baht with a capital structure of 50% debt and 50% equity. The corporate tax rate on U.S. earnings and on Thailand earnings is 30%. The annualized 10-year risk-free interest rate is 6% in the United States and 21% in Thailand. The annual real rate of interest is about 2% in the United States and in Thailand. Interest rate parity exists. Orlando pays 3 percentage points above the risk-free rates when it borrows, so its before-tax cost of debt is 9% in the United States and 24% in Thailand. Orlando expects that the U.S. annual stock market return will be 10% per year, and the Thailand annual stock market return will be 28% per year. Its business in the United States has a beta of .8 relative to the U.S. market, while its business in Thailand has a beta of 1.1 relative to the Thai market. The equity used to support Orlando’s Thai business was created from retained earnings by the Thailand subsidiary in previous years. However, Orlando Co. is considering a stock offering in Thailand that is denominated in Thai baht and targeted at Thai investors. Estimate Orlando’s cost of equity in Thailand that would result from issuing stock in Thailand.
| 28.70% | ||
| 26.92% | ||
| 24.61% | ||
| 22.89% |
Cost of Equity. Wiley, Inc., an MNC, has a beta of 1.3. The U.S. stock market is expected to generate an annual return of 11%. Currently, Treasury bills yield 2%. Based on this information, what is Wiley’s estimated cost of equity?
| 14.95% | ||
| 13.70% | ||
| 12.19% | ||
| 10.84% |
Cost of Capital and Risk of Foreign Financing. Nevada Co. is a U.S. firm that conducts major importing and exporting business in Japan, and all transactions are invoiced in dollars. It obtained debt in the United States at an interest rate of 10% per year. The long-term risk-free rate in the United States is 8%. The stock market return in the United States is expected to be 14% annually. Nevada’s beta is 1.2. Its target capital structure is 30% debt and 70% equity. Nevada Co. is subject to a 25% corporate tax rate. Estimate the cost of capital to Nevada Co.
| 15.93% | ||
| 14.72% | ||
| 13.51% | ||
| 12.89% |
Debt Financing Decision. Marks Co. (a U.S. firm) considers a project in which it will establish a subsidiary in Zinland, and it expects that the subsidiary will generate large earnings in zin (the currency). However, it is the Zinland government’s policy to block all funds so that earnings cannot be remitted to the U.S. parent for at least 10 years; furthermore, the blocked funds cannot earn interest. The zin is expected to weaken by 20% per year against the dollar over time. Marks Co. will borrow some funds to finance the subsidiary. Should the company (a) obtain a dollar-denominated loan and convert the loan into zin, (b) obtain a zin-denominated loan, or (c) obtain half of the funds needed from each possible source? (Assume that the interest rate from borrowing zin is the same as the interest rate from borrowing dollars).
| Obtain a dollar-denominated loan and convert the loan into zin | ||
| Obtain a zin-denominated loan | ||
| Obtain half of the funds needed from each possible source |
Cost of Capital. Blues, Inc., is an MNC located in the United States. Blues would like to estimate its weighted average cost of capital. On average, bonds issued by Blues yield 9%. Currently, Treasury security rates are 3%. Furthermore, Blues’ stock has a beta of 1.5, and the return on the Wilshire 5000 stock index is expected to be 10%. Blues’ target capital structure is 30% debt and 70% equity. If Blues is in the 35% tax bracket, what is its weighted average cost of capital?
| 15.30% | ||
| 13.45% | ||
| 11.21% | ||
| 9.32% |
Cost of Equity. Illinois Co. is a U.S. firm that plans to expand its business overseas. It plans to use all equity to be obtained in the United States to finance a new project. The project’s cash flows are not affected by U.S. interest rates. Just before Illinois Co. obtains new equity, the risk-free interest rate in the United States rises. Will the change in interest rates increase, decrease, or have no effect on the required rate of return on the project?
| Decrease | ||
| Increase | ||
| Have no effect |
Your firm is considering exporting to two countries: Kenya and Vietnam. However, management’s knowledge about these countries’ trade policies and barriers is limited. Conduct a search using GlobalEdge ( http://globaledge.msu.edu/ ) and other sources to identify the current import policies, tariffs, and restrictions in these countries. What recommendations would you make to management? Develop a 4–5 slide presentation that outlines what you learned and your recommendations to the firm’s management.
HOMEWORK PROBLEMS
Which of the following is an example of economic exposure but not an example of transaction exposure?
| An increase in the dollar’s value hurts a U.S. firm’s domestic sales because foreign competitors are able to increase their sales to U.S. customers. | ||
| An increase in the pound’s value increases the U.S. firm’s cost of British pound payables. | ||
| A decrease in the peso’s value decreases a U.S. firm’s dollar value of peso receivables. | ||
| A decrease in the Swiss franc’s value decreases the dollar value of interest payments on a Swiss deposit sent to a U.S. firm by a Swiss bank. |
When evaluating international project cash flows, which of the following factors is relevant?
| future inflation. | ||
| blocked funds. | ||
| exchange rates. | ||
| all of the above |
It is generally least difficult to effectively hedge various types of:
| translation exposure. | ||
| transaction exposure. | ||
| economic exposure. | ||
| A and C |
In general, increased investment by the parent in the foreign subsidiary causes more exchange rate exposure to the parent over time because the cash flows remitted to the parent will be larger.
True
False
Springfield Co., based in the U.S., has a cost from orders of foreign material that exceeds its foreign revenue. All foreign transactions are denominated in the foreign currency of concern. This firm would ____ a stronger dollar and would ____ a weaker dollar.
| benefit from; be unaffected by | ||
| benefit from; be adversely affected by | ||
| be unaffected by; be adversely affected by | ||
| be unaffected by; benefit from | ||
| benefit from; benefit from |
Depreciation of the euro relative to the U.S. dollar will cause a U.S.-based multinational firm’s reported earnings (from the consolidated income statement) to ____. If a firm desired to protect against this possibility, it could stabilize its reported earnings by ____ euros forward in the foreign exchange market.
| be reduced; purchasing | ||
| be reduced; selling | ||
| increase; selling | ||
| increase; purchasing |
Any restructuring of operations that ____ the difference between a foreign currency’s inflows and outflows may ____ economic exposure.
| reduces; increase | ||
| increases; reduce | ||
| reduces; reduce | ||
| A and B | ||
| none of the above |
When assessing a German project administered by a German subsidiary of a U.S.-based MNC solely from the German subsidiary’s perspective, which variable will most likely influence the capital budgeting analysis?
| the withholding tax rate. | ||
| the euro’s exchange rate. | ||
| the U.S. tax rate on earnings remitted to the U.S. | ||
| the German government’s tax rate. | ||
| A and C |
Laketown Co. has some expenses and revenue in euros. If its expenses are more sensitive to exchange rate movements than revenue, it could reduce economic exposure by ____. If its revenues are more sensitive than expenses, it could reduce economic exposure by ____.
| decreasing foreign revenues; decreasing foreign expenses | ||
| decreasing foreign revenues; increasing foreign expenses | ||
| increasing foreign revenues; decreasing foreign revenues | ||
| decreasing foreign expenses; increasing foreign revenues |
Sycamore (a U.S. firm) has no subsidiaries and presently has sales to Mexican customers amounting to MXP98 million, while its peso-denominated expenses amount to MXP41 million. If it shifts its material orders from its Mexican suppliers to U.S. suppliers, it could reduce peso-denominated expenses by MXP12 million and increase dollar-denominated expenses by $800,000. This strategy would ____ the Sycamore’s exposure to changes in the peso’s movements against the U.S. dollar. Regardless of whether the firm shifts expenses, it is likely to perform better when the peso is valued ____ relative to the dollar.
| reduce; high | ||
| reduce; low | ||
| increase; low | ||
| increase; high |
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