Chapter 14 Multinational Capital Structure and Cost of Capital

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1 Sample Exam: Part IV Chapters Butler / Multinational Finance (5e) Multiple Choice Choose the best answer Chapter 12 Foreign Market Entry and Country Risk Management 1. Much of the 1990 s growth in political risk insurance was due to. a. increasing political uncertainty in developed countries b. increasing political uncertainty in developing countries c. the collapse of the Iron Curtain d. the withdrawal of private insurers from the market e. the growth in project finance Chapter 13 Multinational Capital Budgeting 2. If a project has a negative NPV from the project s perspective but a positive NPV from the parent s perspective, then the parent firm should. a. accept the project b. reject the project c. accept the project and try to capture the value in the foreign currency today d. reject the project and continue to look for positive-npv projects in the foreign country 3. If a project has a positive NPV but the NPV is greater from the project s than from the parent s perspective, then the parent firm should. a. accept the project b. reject the project c. accept the project and hedge the foreign currency cash flows d. reject the project and continue to look for positive-npv projects in the foreign country 4. The risk of expropriation in a developing country usually can be handled in a capital budgeting analysis by assuming that expropriation risk affects expected future cash flows, but not investors required return. Chapter 14 Multinational Capital Structure and Cost of Capital 5. According to the weighted average cost of capital approach to project valuation, operating cash flows are discounted at the required return of levered equity capital. 6. Discount rates on new investments should reflect the discount rates on the firm s existing assets and the firm s existing debt-equity mix. 7. Erb, Harvey, and Viskanta [ Political Risk, Financial Risk and Economic Risk, Financial Analysts Journal, 1996] found the higher volatilities of companies in emerging markets resulted in higher betas than on comparable assets in developed markets. 1 of 4

2 8. DanzWear Corp s debt-to-value ratio is 80 percent at book value and 50 percent at market value. Existing debt has a coupon rate of 6 percent. The pretax borrowing cost on new debt is 8 percent. DanzWear uses the CAPM security market line to estimate its cost of equity. DanzWear s equity beta is 1.4. The risk-free rate is 2 percent. The market risk premium over the risk-free rate is estimated to be 5 percent. The corporate income tax rate is 20 percent. What is DanzWear s weighted average cost of capital (WACC)? a. Less than 5% b. Between 5% and 5.99% c. Between 6% and 6.99% d. Between 7% and 7.99% e. 8% or more 9. Rajan and Zingales [What do we know about capital structure? Some evidence from international data, 1995] found that leverage tends to increase with and decrease with. a. firm size management turnover b. the level of profitability the tangibility of the firm s assets b. the presence of growth options the tangibility of the firm s assets d. the tangibility of the firm s assets the level of profitability e. the tangibility of the firm s assets firm size 10. Empirical studies find that emerging market returns tend to have a. lower volatilities than developed market returns b. lower correlations with the world market portfolio than developed market returns c. less political risk than developed market returns d. more than one of the above 11. Empirical studies find that financial market liberalizations tend to a. increase local firms cost of capital b. increase the correlation of emerging market returns with world market returns c. increase the volatility of emerging market returns d. more than one of the above Chapter 15 Taxes and Multinational Corporate Strategy 12. Tax rates in countries B and S are t B = 40% and t S = 25%, respectively. Pre-tax required returns in B are i B = 25%. What should be the pre-tax required return in S? a. 5% b. 10% c. 15% d. 20% 13. Relative to foreign competitors, a US firm s foreign-source income is most valuable when. a. income is from a low-tax country and the firm has excess foreign tax credits b. income is from a high-tax country and the firm has excess foreign tax credits c. income is from a low-tax country and the firm has no excess foreign tax credits d. income is from a high-tax country and the firm has no excess foreign tax credits 14. Blocked funds are a drain on project value when. a. a project suffers early losses b. they are blocked in the host economy c. they are generated by real assets d. they cannot be immediately repatriated to the parent corporation e. they cannot earn their required return in the host country 2 of 4

3 Chapter 17 Corporate Governance and the International Market for Corporate Control 15. China s business sectors include a state sector of partially privatized exchange-listed state-owned enterprises. 16. China s banks have been constrained by intrusive government regulation and do not yet have a large role in China s financial industry. 17. In studies of U.S. acquisitions of foreign firms, shareholders of target firms typically capture large positive gains at the time of the acquisition announcement whereas shareholders of acquiring firms typically do not gain. 18. In Japan, corporate takeovers typically. a. are aggressive, financially motivated, arms-length deals b. are managed by the corporation s main bank and business partners c. involve outside investors and other corporations d. all of the above 19. The strongest barrier against hostile foreign acquisitions of German companies is from. a. a cultural aversion to hostile and aggressive social behavior b. a requirement that foreign bidders notify the German Bundesbank of their intention to acquire a German company c. reciprocal share cross-holdings with other corporations d. the German predilection for order and cleanliness e. the structure of the supervisory board 20. Empirical evidence from cross-border acquisitions suggests that the gains to shareholders of acquiring firms is. a. negatively related to the profitability of the acquiring firm b. negatively related to the profitability of the target firm c. positively related to the profitability of the acquiring firm d. positively related to the profitability of the target firm e. independent of the profitability of the acquiring and target firms Problems Chapter 13 Subsidized financing problem - Show your work Suppose the government of Germany offers you a 3-year, non-amortizing DM50,000 loan to entice you to undertake a particular project within its borders. In addition, the government offers you an attractive rate of i DM = 10% when loans of similar risk yield an expected return of i DM = 15%. The German tax rate is 50%. What is the present value of the interest subsidy on this loan? 3 of 4

4 Chapter 13 Capital budgeting problem - Show your work Consider an investment in an euro-zone ( ) country. The international parity conditions hold. - The project lasts two years. Operating cash flows are received at year-end. - Land costs 10 million and is expected to retain its real value. Plant and equipment costs 5 million and is depreciated on a straight-line basis over two years to zero. The expected market value of the building in 2 years is 12 million. Inventory costs 1 million, grows in value with euro inflation, and is carried at book value. - Annual sales are 10 million units for 2 years. Each unit sells for 2 in nominal terms at time 1. This price will rise at the euro inflation rate in year 2. Variable operating costs are 40 percent of sales. Fixed operating costs are currently 1 million at time 1 and will rise at the euro inflation rate. - Local and domestic tax rates on income and capital gains are 40 percent. - The nominal euro discount rate on similar-risk projects is 12% per year. Annual inflation is 2% in euros and 3% in dollars. The spot rate is S 0 $/ = $ /. 1. Identify the euro cash flows of this project and value them at the appropriate euro discount rate. NPV = at i or NPV $ = at S 0 $/ = $ /. 2. Calculate the required return in U.S. dollars, i $, from the international parity conditions. 3. Fill in the following table by translating euro cash flows to dollars at expected spot exchange rates and calculating the dollar NPV by discounting in dollars. S 0 $/ = E[S 1 $/ ] = E[S 2 $/ ] = CF 0 $ = E[CF 1 $ ] = E[CF 2 $ ] = NPV $ = at i $ Chapter 16 Real option problem - Show your work You own land in Siberian on which five palladium mines could be constructed. Each mine costs 1 million Russian rubles (R). The yield of each mine will be either 1,000 or 2,000 ounces (oz) of palladium with equal probability. All the palladium will be extracted from the mine in the first year of operation, after which the mines will be worthless. (There are no exit costs.) Palladium sells at spot and one-year forward prices of R800/oz. Variable production costs are R100/oz. The appropriate discount rate is 0% per year. The government has agreed to a zero tax rate. Rather than investing in all five mines today, you could invest in one mine on an exploratory basis and then base subsequent investment on the outcome of the first mine. Once the exploratory mine is in operation, the output of the four additional mines will be known with certainty. Palladium s two-year forward price is R800/oz and variable cost is R100/oz. a. Calculate the NPV of investing in all 5 mines as a now-or-never alternative. b. Calculate the NPV (as of t = 0) of investing in a single mine and then waiting one year before considering investment in the other 4 mines. c. What is the opportunity cost of immediate investment in all five mines today? 4 of 4

5 Multiple choice key 1. e. the growth in project finance 2. d. reject the project and continue to look for positive-npv projects in the foreign country 3. c. accept the project and hedge the foreign currency cash flows 4. (Asset-specific risks are unsystematic in a diversified portfolio.) 5. (The discount rate must match the cash flows.) 6. (Target assets and debt capacities should be used instead.) 7. (Country-specific emerging market risks result in low correlations with world market.) 8. d. WACC = (B/V)i B (1-T C )+(S/V)i S = (0.5)(8%)(1-0.2)+(0.5)(2%+1.4*5%) = 7.70 percent 9. d. the tangibility of the firm s assets the level of profitability 10. b. lower correlations with the world market portfolio than developed market returns 11. b. increase the correlation of emerging market returns with world market returns 12. d. i S (1-T c S ) = i B (1-T c B ) i S = i B (1-T c B )/(1-T c S ) = 25%(1-0.40)/(1-0.25) = 20% 13. d. income is from a high-tax country and the firm has no excess foreign tax credits 14. d. they cannot be immediately repatriated to the parent corporation 15. (The listed sector contains partially-privatized Chinese firms.) 16. (Chinese banks are a major player in the Chinese market because of government support.) 17. (In contrast to developed market M&A, cross-border M&A often benefits acquiring equity.) 18. b. are managed by the corporation s main bank and business partners 19. e. the structure of the supervisory board 20. a. negatively related to the profitability of the acquiring firm Problem solutions Chapter 13 Subsidized financing problem Discount after-tax cash flows at the after-tax market rate of interest: (15%-10%) x x (1-50%) = 1250/year discounted at 15%x(1-50%)=7.5% DM Chapter 13 Capital budgeting problem Nominal Dollar discount rate Nominal Euro discount rate 0.12 Inflation Dollar 0.03 Inflation Euro 0.02 Spot $/euro Tax Land 10,000,000 Plant+Equipment 5,000,000 Inventory 1,000,000 Sales Q Sales P Sales 20,000,000 20,400,000 Variable Cost 8,000,000 8,160,000 Fixed Cost 1,000,000 1,020,000 Depreciation 2,500,000 2,500,000 Taxable Income 8,500,000 8,720,000 Tax 3,400,000 3,488,000 Net Income 5,100,000 5,232,000 +Depreciation 2,500,000 2,500,000 Net Cash Flow from Operations 7,600,000 7,732,000 Salvage Value of Land 10,404,000 Tax on Sale of Land 161,600 Sale of Inventory 1,040,400 Tax on Sale of Inventory 16,160 Salvage Value of Plant 12,000,000 Tax on Sale of Plant 4,800,000 5 of 4

6 Expected Cash Flows (in euros) (16,000,000) 7,600,000 26,198,640 PV of Cash Flows (16,000,000) 6,785,714 20,885,395 NPV in Euro 11,671,110 NPV in Dollar 10,527,924 Expected spot rates (dollar/euro) Expected cash flow (in dollars) (14,432,800) 6,922,792 24,098,137 PV of Cash Flows (14,432,800) 6,121,054 18,839,671 NPV in Dollar 10,527,924 Chapter 16 Real option problem a. At expected production level of 1500 oz, the NPV of immediate investment in a single mine is NPV(now-or-never) = [( )(1500 oz)] 1,000,000 = R NPV of investing in all 5 mines as a now-or-never decision is R b. If you invest in an exploratory mine and then reconsider your investment decision based on the revealed information about yield, then the NPV of the first mine is R The NPV of each additional mine can be calculated conditional on the yield of the first mine: NPV (Q=1000 oz) = [( )(1000 oz)] 1,000,000 = R and NPV (Q= 2000 oz) = [( )(2000 oz)] 1,000,000 = R so don t invest at the lower guano yield. Then, NPV(sequential investment) = (½)[(4x0)]+(½)(4x400000) = R c. The NPV of immediate investment in all 5 mines is R This is R less than the NPV of the sequential investment opportunity. The foregone time value of R is the opportunity cost of investing in all 5 mines today. 6 of 4

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