1. Forward versus Futures Contracts. Compare and contrast forward and futures contracts.

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1 Currency derivatives 1. Forward versus Futures Contracts. Compare and contrast forward and futures contracts. ANSWER: Because currency futures contracts are standardized into small amounts, they can be valuable for the speculator or small firm (a commercial bank s forward contracts are more common for larger amounts). However, the standardized format of futures forces limited maturities and amounts. 2. Currency Options. Differentiate between a currency call option and a currency put option. ANSWER: A currency call option provides the right to purchase a specified currency at a specified price within a specified period of time. A currency put option provides the right to sell a specified currency for a specified price within a specified period of time. 3. Hedging With Currency Options. When would a U.S. firm consider purchasing a call option on euros for hedging? When would a U.S. firm consider purchasing a put option on euros for hedging? ANSWER: A call option can hedge a firm s future payables denominated in euros. It effectively locks in the maximum price to be paid for euros. A put option on euros can hedge a U.S. firm s future receivables denominated in euros. It effectively locks in the minimum price at which it can exchange euros received. 4. Speculating with Currency Put Options. Alice Duever purchased a put option on British pounds for $.04 per unit. The strike price was $1.80 and the spot rate at the time the pound option was exercised was $1.59. Assume there are 31,250 units in a British pound option. What was Alice s net profit on the option? ANSWER: Profit per unit on exercising the option = $.21 Premium paid per unit = $.04 Net profit per unit = $.17 Net profit for one option = 31,250 units $.17 = $5, Selling Currency Call Options. Mike Suerth sold a call option on Canadian dollars for $.01 per unit. The strike price was $.76, and the spot rate at the time the option was exercised was $.82. Assume Mike did not obtain Canadian dollars until the option was exercised. Also assume that there are 50,000 units in a Canadian dollar option. What was Mike s net profit on the call option? ANSWER: Premium received per unit = $.01 Amount per unit received from selling C$ = $.76 Amount per unit paid when purchasing C$ = $.82 Net profit per unit = $.05 Net Profit = 50,000 units ( $.05) = $2,500

2 6. Hedging with Currency Derivatives. Assume that the transactions listed in the first column of the following table are anticipated by U.S. firms that have no other foreign transactions. Place an X in the table wherever you see possible ways to hedge each of the transactions. a. Georgetown Co. plans to purchase Japanese goods denominated in yen. b. Harvard, Inc., sold goods to Japan, denominated in yen. c. Yale Corp. has a subsidiary in Australia that will be remitting funds to the U.S. parent. d. Brown, Inc., needs to pay off existing loans that are denominated in Canadian dollars. e. Princeton Co. may purchase a company in Japan in the near future (but the deal may not go through). ANSWER: Forward Contract Futures Contract Options Contract Forward Forward Buy Sell Purchase Purchase Purchase Sale Futures Futures Calls Puts a. b. c. X X X d. X X X e. X 7. Hedging with Currency Derivatives. A U.S. professional football team plans to play an exhibition game in the United Kingdom next year. Assume that all expenses will be paid by the British government, and that the team will receive a check for 1 million pounds. The team anticipates that the pound will depreciate substantially by the scheduled date of the game. In addition, the National Football League must approve the deal, and approval (or disapproval) will not occur for three months. How can the team hedge its position? What is there to lose by waiting three months to see if the exhibition game is approved before hedging? ANSWER: The team could purchase put options on pounds in order to lock in the amount at which it could convert the 1 million pounds to dollars. The expiration date of the put option should correspond to the date in which the team would receive the 1 million pounds. If the deal is not approved, the team could let the put options expire. If the team waits three months, option prices will have changed by then. If the pound has depreciated over this three-month period, put options with the same exercise price would command higher premiums. Therefore, the team may wish to purchase put options immediately. The team could also consider selling futures contracts on pounds, but it would be obligated to exchange pounds for dollars in the future, even if the deal is not approved.

3 Defining and measuring foreign exchange exposure Practice problems 1. Currency Effects on Cash Flows. How should appreciation of a firm s home currency generally affect its cash inflows? How should depreciation of a firm s home currency generally affect its cash outflows? ANSWER: Appreciation of the firm s home currency reduces inflows since the foreign demand for the firm s goods is reduced and foreign competition is increased. Depreciation of the firm s home currency should increase inflows since it will likely increase foreign demand for the firm s goods and reduce foreign competition. 2. Transaction Exposure. Fischer Inc., exports products from Florida to Europe. It obtains supplies and borrows funds locally. How would appreciation of the euro likely affect its net cash flows? Why? ANSWER: Fischer Inc. should benefit from the appreciation of the euro, because it should experience a strong demand for its products when the euro has more purchasing power (can obtain dollars at a low price). 3. Exposure of Domestic Firms. Why are the cash flows of a purely domestic firm exposed to exchange rate fluctuations? ANSWER: If the firm competes with foreign firms that also sell in a given market, the consumers may switch to foreign products if the local currency strengthens. 4. Translation Exposure. Consider a period in which the U.S. dollar weakens against the euro. How will this affect the reported earnings of a U.S.-based MNC with European subsidiaries? Consider a period in which the U.S. dollar strengthens against most foreign currencies. How will this affect the reported earnings of a U.S.-based MNC with subsidiaries all over the world? ANSWER: The consolidated earnings will be increased due to the strength of the subsidiaries local currency (the euro). The consolidated earnings will be reduced due to the weakness of the subsidiaries local currencies. 5. Economic Exposure. Longhorn Co. produces hospital equipment. Most of its revenues are in the United States. About half of its expenses require outflows in Philippine pesos (to pay for Philippine materials). Most of Longhorn s competition is from U.S. firms that have no international business at all. How will Longhorn Co. be affected if the peso strengthens? ANSWER: If the peso strengthens, Longhorn will incur higher expenses when paying for the Philippine materials. Because its competition is not affected in a similar manner, Longhorn Company is at a competitive disadvantage when the peso strengthens. 6. Economic Exposure. Lubbock, Inc., produces furniture and has no international business. Its major competitors import most of their furniture from Brazil and then sell it out of retail

4 stores in the United States. How will Lubbock, Inc., be affected if Brazil s currency (the real) strengthens over time? ANSWER: If the Brazilian real strengthens, U.S. retail stores will likely have to pay higher prices for the furniture from Brazil, and may pass some or all of the higher cost on to customers. Consequently, some customers may shift to furniture produced by Lubbock Inc. Thus, Lubbock Inc. is expected to be favorably affected by a strong Brazilian real. 7. Economic Exposure. Sooner Co. is a U.S. wholesale company that imports expensive high-quality luggage and sells it to retail stores around the United States. Its main competitors also import high-quality luggage and sell it to retail stores. None of these competitors hedge their exposure to exchange rate movements. Why might Sooner s market share be more volatile over time if it hedges its exposure? ANSWER: If Sooner Company hedged its imports, then it would have an advantage over the competition when the dollar weakened (since its competitors would pay higher prices for the luggage), and could possibly gain market share or would have a higher profit margin. It would be at a disadvantage relative to the competition when the dollar strengthened and may lose market share or be forced to accept a lower profit margin. When Sooner Company does not hedge, the amount paid for imports would depend on exchange rate movements, but this is also true for all of its competitors. Thus, Sooner is more likely to retain its existing market share. 8. Impact of Exchange Rates on Earnings. Cieplak, Inc., is a U.S.-based MNC that has expanded into Asia. Its U.S. parent exports to some Asian countries, with its exports denominated in the Asian currencies. It also has a large subsidiary in Malaysia that serves that market. Offer at least two reasons related to exposure to exchange rates why Cieplak s earnings were reduced during the Asian crisis. ANSWER: First, its receivables from its exports were converted to fewer dollars due to the depreciation of the Asian currencies. Second, any funds remitted by the Malaysian subsidiary converted to fewer dollars for the parent. Third, the earnings generated by the Malaysian subsidiary were translated to fewer dollars on the consolidated income statement (translation exposure) even if it did not remit any earnings to the parent. 9. Changes in Economic Exposure. Walt Disney World built an amusement park in France that opened in How do you think this project has affected Disney s economic exposure to exchange rate movements? Think carefully before you give your final answer. There is more than one way in which Disney s cash flows may be affected. Explain. ANSWER: This is a good question for class discussion. The typical first reaction is that Walt Disney Company s exposure may increase, since this new park would generate revenue in French francs (now euros), which may someday be converted to dollars. If the euro weakens against the dollar, the revenue will be converted to fewer dollars. When European currencies (or the euro) weaken against the dollar, tourism by Europeans decreases and Disney s business in the U.S. declines. By having a European amusement park, it may be able to offset the declining U.S. business during strong dollar cycles, since more

5 European tourists may go to the Disney park in France during the periods. Overall, Disney may be less exposed to exchange rate movements because of the park. 10. Assessing Transaction Exposure. Your employer, a large MNC, has asked you to assess its transaction exposure. Its projected cash flows are as follows for the next year: Currency Total Inflow Total Outflow Current Exchange Rate in U.S. Dollars Danish krone (DK) DK50,000,000 DK40,000,000 $.15 British pound ( ) 2,000,000 1,000,000 $1.50 Assume that the movements in the Danish krone and the pound are highly correlated. Provide your assessment as to your firm s degree of transaction exposure (as to whether the exposure is high or low). Substantiate your answer. ANSWER: The net exposure to each currency in U.S. dollars is derived below: Foreign Currency Net Inflows in Foreign Currency Current Exchange Rate Value of Exposure Danish krone (DK) +DK10,000,000 $.15 $1,500,000 British pound ( ) + 1,000,000 $1.50 $1,500,000 The krone and pound values move in tandem against the dollar. Both the krone and the pound exposure show positive net inflows. Thus, their exposure should be magnified if their exchange rates against the U.S. dollar continue to be highly correlated. 11. Factors That Affect a Firm s Transaction Exposure. What factors affect a firm s degree of transaction exposure in a particular currency? For each factor, explain the desirable characteristics that would reduce transaction exposure. ANSWER: Currency variability low level is desirable. Currency correlations low level is desirable for currencies that are net inflows, while a high level is desirable for pairs of currencies in which one currency shows future net inflows while the other currency shows future net outflows. 12. Currency Correlations. Kopetsky Co. has net receivables in several currencies that are highly correlated with each other. What does this imply about the firm s overall degree of transaction exposure? Are currency correlations perfectly stable over time? What does your answer imply about Kopetsky Co. or any other firm using past data on correlations as an indicator for the future? ANSWER: Its exposure is high since all currencies move in tandem no offsetting effect is likely. If one of these currencies depreciates substantially against the firm s local currency, all others will as well, and this reduces the value of these net receivables. No! Thus, past correlations will not serve as perfect forecasts of future correlations.

6 Firms can not presume that past correlations will be perfectly accurate forecasts of future correlations. Yet, historical data may still be useful if the general ranking of correlations is somewhat stable. 13. Measuring Economic Exposure. Memphis Co. hires you as a consultant to assess its degree of economic exposure to exchange rate fluctuations. How would you handle this task? Be specific. ANSWER: Regression analysis can be used to determine the relationship between the firm s value and exchange rate fluctuations. Stock returns can be used as a proxy for the change in the firm s value. The time period can be segmented into two subperiods so that regression analysis can be run for each subperiod. The sign and magnitude of the regression coefficient will imply how the firm s value is influenced by each currency. Also, the coefficients can be compared among subperiods for each currency to determine how the impact of a currency is changing over time. 14. Factors That Affect a Firm s Translation Exposure. What factors affect a firm s degree of translation exposure? Explain how each factor influences translation exposure. ANSWER: The greater the percentage of business conducted by subsidiaries, the greater is the translation exposure. The greater the variability of each relevant foreign currency relative to the headquarters home (reporting) currency, the greater is the translation exposure. The type of accounting method employed can also affect translation exposure. 15. Measuring Changes in Economic Exposure. Toyota Motor Corp. measures the sensitivity of its exports to the yen exchange rate (relative to the U.S. dollar). Explain how regression analysis could be used for such a task. Identify the expected sign of the regression coefficient if Toyota primarily exports to the United States. If Toyota established plants in the United States, how might the regression coefficient on the exchange rate variable change? ANSWER: The dependent variable is a percentage change (from one period to the next) in Toyota s export volume to the U.S. The independent variables are (1) the percentage change in the yen s value with respect to the dollar, (2) a measure of the strength of the U.S. economy, and (3) any other factors that could affect the volume of Toyota s exports. The regression coefficient related to the exchange rate variable (as defined here) would be negative, since a decrease in the yen s value is likely to cause an increase in the U.S. demand for Toyotas built in Japan. If Toyota established plants in the U.S., dealers do not need to purchase Toyotas in Japan. Thus, the demand for Toyotas is less sensitive to the exchange rate, which should cause the regression coefficient for the exchange rate variable to decrease.

7 Practice problems Economic exposure 1. Comparing Degrees of Economic Exposure. Carlton Co. and Palmer, Inc., are U.S.-based MNCs with subsidiaries in Mexico that distribute medical supplies (produced in the United States) to customers throughout Latin America. Both subsidiaries purchase the products at cost and sell the products at 90 percent markup. The other operating costs of the subsidiaries are very low. Carlton Co. has a research and development center in the United States that focuses on improving its medical technology. Palmer, Inc., has a similar center based in Mexico. The parent of each firm subsidizes its respective research and development center on an annual basis. Which firm is subject to a higher degree of economic exposure? Explain. ANSWER: Carlton Company is subject to a higher degree of economic exposure because it does not have much offsetting cost in Mexico. Palmer Inc. incurs costs in Mexico for its research and development center. Translation exposure 1. Exchange Rate Effects on Earnings. Explain how a U.S.-based MNC's consolidated earnings are affected when foreign currencies depreciate. ANSWER: A U.S.-based MNC's consolidated earnings are reduced by the translation effect when foreign currencies depreciate. Foreign earnings are translated at the average exchange rate over the fiscal year, so low values of foreign currencies result in a low level of consolidated earnings. 2. Hedging Translation Exposure. Explain how a firm can hedge its translation exposure. ANSWER: A firm can hedge translation exposure by selling forward the currency of the firm's foreign subsidiary. Thus, if the foreign currency depreciates, the translation loss will be somewhat offset by the gain on the short position created by the forward contract. 3. Limitations of Hedging Translation Exposure. Bartunek Co. is a U.S.-based MNC that has European subsidiaries and wants to hedge its translation exposure to fluctuations in the euro s value. Explain some limitations when it hedges translation exposure. ANSWER: The limitations are as follows. First, Bartunek Inc. needs to forecast its foreign subsidiary earnings and may forecast inaccurately. Thus, it will hedge against a level of foreign earnings that differs from actual foreign earnings.

8 Second, forward contracts are not available for all currencies, although Bartunek will not be affected by this limitation since forward contracts in euros are available. Third, translation losses are not tax-deductible, while gains on forward contracts used to hedge translation exposure are taxed. Fourth, transaction exposure may be increased as a result of hedging translation exposure.

9 Practice problems 1. Forward versus Money Market Hedge on Payables. Assume the following information: 90-day U.S. interest rate = 4% 90-day Malaysian interest rate = 3% 90-day forward rate of Malaysian ringgit = $.400 Spot rate of Malaysian ringgit = $.404 Assume that the Santa Barbara Co. in the United States will need 300,000 ringgit in 90 days. It wishes to hedge this payables position. Would it be better off using a forward hedge or a money market hedge? Substantiate your answer with estimated costs for each type of hedge. ANSWER: If the firm uses the forward hedge, it will pay out 300,000($.400) = $120,000 in 90 days. If the firm uses a money market hedge, it will invest (300,000/1.03) = 291,262 ringgit now in a Malaysian deposit that will accumulate to 300,000 ringgit in 90 days. This implies that the number of U.S. dollars to be borrowed now is (291,262 $.404) = $117,670. If this amount is borrowed today, Santa Barbara will need $122,377 to repay the loan in 90 days (computed as $117, = $122,377). In comparison, the firm will pay out $120,000 in 90 days if it uses the forward hedge and $122,377 if it uses the money market hedge. Thus, it should use the forward hedge. 2. Forward versus Money Market Hedge on Receivables. Assume the following information: 180-day U.S. interest rate = 8% 180-day British interest rate = 9% 180-day forward rate of British pound = $1.50 Spot rate of British pound = $1.48

10 Assume that Riverside Corp. from the United States will receive 400,000 pounds in 180 days. Would it be better off using a forward hedge or a money market hedge? Substantiate your answer with estimated revenue for each type of hedge. ANSWER: If the firm uses a forward hedge, it will receive 400,000($1.50) = $600,000 in 180 days. If the firm uses a money market hedge, it will borrow (400,000/$1.09) = 366,972 pounds, to be converted to U.S. dollars and invested in the U.S. The 400,000 pounds received in 180 days will pay off this loan. The 366,972 pounds borrowed convert to about $543,119 (computed as 366,972 $1.48), which when invested at 8% interest will accumulate to be worth about $586,569. In comparison, the firm will receive $600,000 in 180 days using the forward hedge, or about $586,569 in 180 days using the money market hedge. Thus, it should use the forward hedge. 3. Currency Options. Can Brooklyn Co. determine whether currency options will be more or less expensive than a forward hedge when considering both hedging techniques to cover net payables in euros? Why or why not? ANSWER: No. The amount paid out when using a forward contract is known with certainty. However, the amount paid out when using currency options is not known until the period is over (since the firm has the flexibility to exercise the option only if it is feasible). Thus, the MNC cannot determine whether currency options will be more or less expensive than forward contracts when hedging net payables. 4. Hedging With Put Options. As treasurer of Tucson Corp. (a U.S. exporter to New Zealand), you must decide how to hedge (if at all) future receivables of 250,000 New Zealand dollars 90 days from now. Put options are available for a premium of $.03 per unit and an exercise price of $.49 per New Zealand dollar. The forecasted spot rate of the NZ$ in 90 days follows: Future Spot Rate Probability

11 $.44 30% Given that you hedge your position with options, create a probability distribution for U.S. dollars to be received in 90 days. ANSWER: Possible Spot Rate Put Option Premium Exercise Option? Amount per Unit Received Accounting for Premium Total Amount Received for NZ$250,000 Proba- bility $.44 $.03 Yes $.46 $115,000 30% $.40 $.03 Yes $.46 $115,000 50% $.38 $.03 Yes $.46 $115,000 20% The probability distribution represents a 100% probability of receiving $115,000, based on the forecasts of the future spot rate of the NZ$. 5. Continuous Hedging. Cornell Co. purchases computer chips denominated in euros on a monthly basis from a Dutch supplier. To hedge its exchange rate risk, this U.S. firm negotiates a three-month forward contract three months before the next order will arrive. In other words, Cornell is always covered for the next three monthly shipments. Because Cornell consistently hedges in this manner, it is not concerned with exchange rate movements. Is Cornell insulated from exchange rate movements? Explain. ANSWER: No! Cornell is exposed to exchange rate risk over time because the forward rate changes over time. If the euro appreciates, the forward rate of the euro will likely rise over time, which increases the necessary payment by Cornell.

12 6. Hedging During the Asian Crisis. Describe how the Asian crisis could have reduced the cash flows of a U.S. firm that exported products (denominated in U.S. dollars) to Asian countries. How could a U.S. firm that exported products (denominated in U.S. dollars) to Asia and anticipated the Asian crisis before it began, have insulated itself from any currency effects while continuing to export to Asia? ANSWER: The weakness of the Asian currencies would cause the Asian importers to reduce their demand for U.S. products, because these imports from the U.S. would have cost more due to the Asian currency depreciation. It might have invoiced the exports in the Asian currencies so that the Asian customers would not be subjected to higher costs when their currencies depreciated, but it would also have hedged its receivables over the Asian crisis period to insulate against the expected depreciation of the Asian currencies. 7. Comparison of Techniques for Hedging Receivables. Assume that Carbondale Co. expects to receive S$500,000 in one year. The existing spot rate of the Singapore dollar is $.60. The one-year forward rate of the Singapore dollar is $.62. Carbondale created a probability distribution for the future spot rate in one year as follows: Future Spot Rate Probability $.61 20% Assume that one-year put options on Singapore dollars are available, with an exercise price of $.63 and a premium of $.04 per unit. One-year call options on Singapore dollars are available with an exercise price of $.60 and a premium of $.03 per unit. Assume the following money market rates: U.S. Singapore

13 Deposit rate 8% 5% Borrowing rate 9 6 Given this information, determine whether a forward hedge, money market hedge, or a currency options hedge would be most appropriate. Then compare the most appropriate hedge to an unhedged strategy, and decide whether Carbondale should hedge its receivables position. ANSWER: Forward hedge Sell S$500,000 $.62 = $310,000 Money market hedge 1. Borrow S$471,698 (S$500,000/1.06 = S$471,698) 2. Convert S$471,698 to $283,019 (at $.60 per S$) 3. Invest the $283,019 at 8% to earn $305,660 by the end of the year Put option hedge (Exercise price = $.63; premium = $.04) Possible Spot Rate Option Premium per Unit Exercise Amount Received per Unit (also accounting for premium) Total Amount Received for S$500,000 Probability

14 $.61 $.04 Yes $.59 $295,000 20% $.63 $.04 Yes or No $.59 $295,000 50% $.67 $.04 No $.63 $315,000 30% The forward hedge is superior to the money market hedge and has a 70% chance of outperforming the put option hedge. Therefore, the forward hedge is the optimal hedge. Unhedged Strategy Possible Spot Rate Total Amount Received for S$500,000 Probability $.61 $305,000 20% $.63 $315,000 50% $.67 $335,000 30% When comparing the optimal hedge (the forward hedge) to no hedge, the unhedged strategy has an 80% chance of outperforming the forward hedge. Therefore, the firm may desire to remain unhedged. 8. Comparison of Techniques for Hedging Payables. SMU Corp. has future receivables of 4,000,000 New Zealand dollars (NZ$) in one year. It must decide whether to use options or a money market hedge to hedge this position. Use any of the following information to make the decision. Verify your answer by determining the estimate (or probability distribution) of dollar revenue to be received in one year for each type of hedge. Spot rate of NZ$ = $.54 One-year call option: Exercise price = $.50; premium = $.07 One-year put option: Exercise price = $.52; premium = $.03

15 U.S. New Zealand One-year deposit rate 9% 6% One-year borrowing rate 11 8 Rate Probability Forecasted spot rate of NZ$ $.50 20% ANSWER: Put option hedge (Exercise price = $.52; premium = $.03) Possible Spot Rate Put Option Premium Exercise Option? Amount per Unit Received Accounting for Premium Total Amount Received for NZ$4,000,000 Probability $.50 $.03 Yes $.49 $1,960,000 20% $.51 $.03 Yes $.49 $1,960,000 50% $.53 $.03 No $.50 $2,000,000 30% Money market hedge 1. Borrow NZ$3,703,704 (NZ$4,000,000/1.08 = NZ$3,703,704) 2. Convert NZ$3,703,704 to $2,000,000 (at $.54 per New Zealand dollar) 3. Invest $2,000,000 to accumulate $2,180,000 at the end of one year ($2,000, = $2,180,000)

16 The money market hedge is superior to the put option hedge.

17 Country risk analysis exercise problems 1. Country Risk Assessment. Describe the steps involved in assessing country risk once all relevant information has been gathered. ANSWER: First, a rating must be assigned to each factor. Then, a weight must be assigned. Finally, the weighted ratings can be consolidated to derive an overall political risk and financial risk rating, and (if desired) an overall country risk rating. 2. Diversifying Away Country Risk. Why do you think that an MNC s strategy of diversifying projects internationally could achieve low exposure to overall country risk? ANSWER: 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. 3. Country Risk Analysis. 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? ANSWER: 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. 4. Incorporating Country Risk in Capital Budgeting. 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? ANSWER: 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).

18 To adjust cash flows, consider each key form of country risk and re-estimate cash flows if that form of risk occurs. For example, if the host government may block funds temporarily, estimate the NPV of the project if that occurs. Re-estimate the NPV for any other forms of country risk as well. This process results in a distribution of possible NPVs that can be assessed to determine whether a project should be accepted. 5. Country Risk Analysis. 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. ANSWER: 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. 6. Reducing Country Risk. MNCs such as Alcoa, DuPont, Heinz, and IBM donated products and technology to foreign countries where they had subsidiaries. How could these actions have reduced some forms of country risk? ANSWER: 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. 7. J.C. Penney s Country Risk Analysis. Recently, JC Penney 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 JC Penney's biggest targets is Mexico, where it planned to build and operate seven large stores. a. Identify the political factors that you think may possibly affect the performance of the JC Penney stores in Mexico. ANSWER: 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. Explain why the JC Penney stores in Mexico and in other foreign markets are subject to financial risk (a subset of country risk).

19 ANSWER: The economy in Mexico is volatile, and if economic conditions deteriorate, the demand for many products sold at the JC Penney 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, JC Penney stores in any country could experience weak sales due to financial risk. c. Assume that JC Penney 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 JC Penney from remitting earnings generated in Mexico and could adversely affect the performance of these stores (from the U.S. perspective). Offer 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. ANSWER: 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. Assume that JC Penney decides to use dollars to finance the expansion of stores in Mexico. Second, assume that JC Penney 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. ANSWER: If JC Penney 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. Based on your answer to the previous question, does this mean that proposals for any new stores in the U.S. have a higher probability of being accepted than proposals for any new stores in Mexico?

20 ANSWER: No. The U.S. markets have less potential because JC Penney 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.