Risk Resulting from International Business This chapter concentrates on possible benefits to a firm that increases its international business.
- What are some risks of international business that may not exist for local business?
- What does this chapter reveal about the relation- ship between an MNC’s degree of international business and its risk?
Question 16 DFI Location Decision Decko Co. is a U.S. firm with a Chinese subsidiary that produces cell phones in China and sells them in Japan. This subsidiary pays its wages and its rent in Chinese yuan, which is stable relative to the dollar. The cell phones sold to Japan are denominated in Japanese yen. Assume that Decko Co. expects that the Chinese yuan will continue to stay stable against the dollar. The subsidiary’s main goal is to generate profits for itself and reinvest the profits. It does not plan to remit any funds to Decko, the U.S. parent.
- Assume that the Japanese yen strengthens against the U.S. dollar over time. How would this be expected to affect the profits earned by the Chinese subsidiary?
- If Decko Co. had established its subsidiary in Tokyo, Japan, instead of in China, would the subsidiary’s profits be more exposed or less exposed to exchange rate risk?
- Why do you think that Decko Co. established the subsidiary in China instead of Japan? Assume no major country risk barriers.
- If the Chinese subsidiary needs to borrow money to finance its expansion and wants to reduce its exchange rate risk, should it borrow U.S. dollars, Chinese yuan, or Japanese yen?
Capital Budgeting Example Borrower, Inc., just constructed a manufacturing plant in Ghana. The construction cost 9 billion Ghanaian cedi. Borrower intends to leave the plant open for 3 years. During the 3 years of operation, cedi cash flows are expected to be 3 billion cedi, 3 billion cedi, and 2 billion cedi, respectively. Operating cash flows will begin 1 year from today and are remitted back to the parent at the end of each year. At the end of the third year, Borrower expects to sell the plant for 5 billion cedi. Borrower has a required rate of return of 17 percent. It currently takes 8,700 cedi to buy 1 U.S. dollar, and the cedi is expected to depreciate by 5 percent per year.
- Determine the NPV for this project. Should Borrower build the plant?
- How would your answer change if the value of the cedi was expected to remain unchanged from its cur- rent value of 8,700 cedi per U.S. dollar over the course of the 3 years? Should Borrower construct the plant then?
Capital Budgeting Analysis Zistine Co. considers a 1-year project in New Zealand so that it can capitalize on its technology. It is risk averse but is attracted to the project because of a government guarantee. The project will generate a guaranteed NZ$8 million in revenue, paid by the New Zealand government at the end of the year. The payment by the New Zealand government is also guaranteed by a credible U.S. bank. The cash flows earned on the project will be converted to U.S. dollars and remitted to the parent in 1 year. The prevailing nominal 1-year interest rate in New Zealand is 5 percent, while the nominal 1-year interest rate in the United States is 9 percent. Zistine’s chief executive officer believes that the movement in the New Zealand dollar is highly uncertain over the next year, but his best guess is that the change in its value will be in accordance with the international Fisher effect (IFE). He also believes that interest rate parity holds. He provides this information to three recent finance graduates that he just hired as managers and asks them for their input.
- The first manager states that due to the parity conditions, the feasibility of the project will be the same whether the cash flows are hedged with a forward contract or are not hedged. Is this manager correct? Explain.
- The second manager states that the project should not be hedged. Based on the interest rates, the IFE suggests that Zistine Co. will benefit from the future exchange rate movements, so the project will generate a higher NPV if Zistine does not hedge. Is this manager correct? Explain.
- The third manager states that the project should be hedged because the forward rate contains a premium and, therefore, the forward rate will generate more U.S. dollar cash flows than the expected amount of dollar cash flows if the firm remains unhedged. Is this manager correct? Explain.