Suppose that IBM would like to borrow fixed-rate yen, whereas Korea Development Bank (KDB) would like to borrow floating-rate dollars. IBM can borrow fixed-rate yen at 4.5% or floating-rate dollars at LIBOR + 0.25%. KDB can borrow fixed-rate yen at 4.9% or floating-rate dollars at LlBOR + 0.8%.

Assignment # 2

1. A proposed foreign investment involves a plant with its entire output of 1 million units per annum to be exported. With a selling price of $10 per unit, the yearly revenue from this investment equals $10 million. At the present rate of exchange, dollar costs of local production equal $6 per unit. A 10% devaluation is expected to lower unit costs by $0.30, while a 15% devaluation will reduce these costs by an additional $0.15. Suppose a devaluation of either 10% or 15% is likely, with respective probabilities of OA and 0.2 (the probability of no currency change is OA). Depreciation at the current exchange rate equals S 1 million annually, and the local tax rate is 40%. (10.2)

a. What will annual dollar cash flows be if no devaluation occurs?

b. Given the currency scenario described above, what is the expected value of annual after-tax dollar cash flows assuming no repatriation of profits to the United States?

2. During 1993, the japanese yen appreciated by 11% against the dollar. In response to the lower cost of the main imported ingredients-beef, cheese, potatoes, and wheat for burger buns-McDonald’s japanese affiliate reduced the price on certain set menus. For example, a cheeseburger, soda, and a small order of french fries were marked down to ¥ 410 from ¥530. Suppose the higher yen lowered the cost of ingredients for this meal by ¥30. (10.8)

a. How much of a volume increase is necessary to justify the price cut from ¥530 to ¥ 410? Assume that the previous profit margin (contribution to overhead) for this meal was ¥220. What is the implied price elasticity of demand associated with this necessary rise in demand?

b. Suppose sales volume of this meal rises by 60%. What will be the percentage change in McDonald’s dollar profit from this meal?

c. What other reasons might McDonald’s have had for cutting price besides raising its profits?

3. In the early 1990s, China decided that by 2000 it would boost its electricity-generating capacity by more than half. To do that, it is planning on foreigners’ investing at least $20 billion of the roughly $100 billion tab. However, Beijing has informed investors that, contrary to their expectations, they ‘hill not be permitted to hold majority stakes in large power-plant or equipmentmanufacturing ventures. In addition, Beijing has insisted on limiting the rate of return that foreign investors can earn on power projects. Moreover, this rate of return will be in local currency without official guarantees that the local currency can be converted into dollars, and it will not be permitted to rise with the rate of inflation. Beijing says that if foreign investors fail to invest in these projects, it will raise the necessary capital by issuing bonds overseas. However, these bonds will not carry the “full faith and credit of the Chinese government.” (11.3)

a. What problems do you foresee for foreign investors in China’s power industry?

b. What options do potential foreign investors have to cope with these problems?

c. How credible is the Chinese government’s fallback position of issuing bonds overseas to raise capital in lieu of foreign direct investment?

4. The president of Mexico has asked you to advise him on the likely economic consequences of the following five policies designed to improve Mexico’s economic environment. Describe the consequences of each policy, and evaluate the extent to which these proposed policies will achieve their intended objective. (11.5)

a. Expand the money supply to drive down interest rates and stimulate economic activity.

b. Increase the minimum wage to raise the incomes of poor workers.

c. Impose import restrictions on most products to preserve the domestic market for local manufacturers and thereby increase national income.

d. Raise corporate and personal tax rates from SO% to 70% to boost tax revenues and reduce the Mexican government deficit.

e. Fix the nominal exchange rate at its current level in order to hold down the cost to Mexican consumers of imported necessities (assume that inflation is currently 100% annually in Mexico).

5. A European company issues common shares that pay taxable dividends and bearer shares that pay an identical dividend but offer an opportunity to evade taxes: Bearer shares come with a large supply of coupons that can be redeemed anonymously at banks for the current value of the dividend. (12.1)

a. Suppose taxable dividends are taxed at the rate of 10%. What is the ratio between market of taxable and bearer shares? If a new issue is planned, should taxable or bearer shares be sold?

b. Suppose, in addition, that it costs 10% of proceeds to issue a taxable dividend, whereas it costs 20% of the proceeds to issue bearer stocks because of the expense of distribution and coupon printing. What type of share will the company prefer to issue?

c. Suppose now that individuals pay 10% taxes on dividends, and corporations pay no taxes, but bear an administrative cost of 10% of the value of any bearer dividends. Can you determine the relative market prices for the two types of shares?

6. Citibank offers to syndicate a Eurodollar credit for the government of Poland with the following terms: (12.3)

Principal U.S.$1 billion

Maturity 7 years

Interest rate LIBOR + 1.5%, reset every 6 months Syndication fee 1.75%

a. What are the net proceeds to Poland from this syndicated loan?

b. Assuming that 6-month LIBOR is currently at 6.35%, what is the effective annual interest cost to Poland for the first 6 months of this loan?


1. On june 14, 2001, Domingo Cavallo, Argentina’s trea’ ·J secretary announced a new exchange rate policy designed to stimulate Argentina’s slumping economy Under the new policy, exporters and importers would be able to convert between dollars and pesos at an exchange rate that was an average of the dollar and the euro exchange rates, that is, P1 = $0.50 + €0.50. At that time, the euro was trading at $0.85.

a. How many pesos would an exporter receive for one dollar under the new system?

b. How many dollars would an importer receive for one peso under the new system?

2. What are the five basic mechanisms for establishing exchange rates?

a. How does each mechanism work?

b. What costs and benefits are associated with each mechanism?

c. Have exchange rate movements under the current system of managed floating been excessive? Explain.

3. Suppose that IBM would like to borrow fixed-rate yen, whereas Korea Development Bank (KDB) would like to borrow floating-rate dollars. IBM can borrow fixed-rate yen at 4.5% or floating-rate dollars at LIBOR + 0.25%. KDB can borrow fixed-rate yen at 4.9% or floating-rate dollars at LlBOR + 0.8%.

a. What is the range of possible cost savings that IBM can realize through an interest rate/currency swap with KDB?

b. Assuming a notional principal equivalent to $125 million and a current exchange rate of ¥105/$, what do these possible cost savings translate into in yen terms?

c. Redo Parts (a) and (b) assuming that the parties use Bank of America, which charges a fee of 8 basis points to arrange the swap.

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