FINC 445 International Financial Management

Homework Assignment III

You can provide your answers by expanding the space between questions.
You must show your work and/or explain your answers sufficiently to get credit.

Global Cost and Availability of Capital

Interest Rate and Currency Swaps

1. In November 1988, Nestlé decided to eliminate the ownership restrictions of its shares. Prior to the decision, Nestlé had two
classes of shares: Swiss investors and foreigners could own Bearer shares and only Swiss investors could own Registered
shares. After the elimination of restrictions prices of Registered shares rose more than 35% while Bearer shares fell about
25%.
a. How can you explain the market response?

b. Assume that the prior to the lifting of the restriction the Swiss market risk premium is 5.20% and the beta of Nestlé
is 0.90 and the Swiss risk-free rate is 4.50%. What is the cost of equity capital for Nestlé?

c. After the restriction, assume that the Beta of Nestlé relative to Global Index is 0.60, estimated World Market risk
premium is 6.00%, and the risk-free rate is the same as in (b). What is the cost of capital for Nestlé?

2. British subsidiary of a US based MNE borrows £10 million at a rate of 7.00% for one year. The current exchange rate is
$1.4400/£. In one year, the exchange rate becomes $1.5600/£. What is the percent dollar cost of the loan?

3. Datta is the largest and most successful specialty goods company based in India. It has not entered the North American
marketplace yet, but is considering establishing both manufacturing and distribution facilities in the United States through a
wholly owned subsidiary. It has approached two different investment banking advisors, Goldman Sachs and Bank of New
York, for estimates of what its costs of capital would be several years into the future when it planned to list its American
subsidiary on a U.S. stock exchange. Using the following assumptions by the two different advisors, calculate the
prospective after-tax costs of debt, beta, equity, and the WACC for Datta U.S.
Assumptions Symbol Goldman Sachs Bank of New York
Components of beta: β
Estimate of correlation between security and market ρjm 0.92 0.85
Estimate of standard deviation of Datta's returns σj 23.00% 30.00%
Estimate of standard deviation of market's return σm 19.00% 20.00%

Risk-free rate of interest krf 4.00% 4.00%

Estimate of Datta's cost of debt in US market kd 7.50% 7.80%
Estimate of market return, forward-looking km 11.00% 12.00%
Corporate tax rate t 34.00% 34.00%
Proportion of debt D/V 35.00% 35.00%
Proportion of equity E/V 65.00% 65.00%

4. Theoretically MNEs should be in a better position than their domestic counterparts to support higher debt ratios because their
cash flows are diversified internationally. However, recent empirical studies have come to the opposite conclusion. These
studies also concluded that MNEs have higher betas than their domestic counterparts.
a. According to these empirical studies why do MNEs have lower debt ratios than their domestic counterparts?
Explain.

b. According to these empirical studies why do MNEs have higher betas than their domestic counterparts? Explain.
5. Market liquidity:
a. Define what is meant by the term market liquidity.

b. What are the main disadvantages for a firm to be located in an illiquid market? Explain.

c. If a firm is limited to raising funds in its domestic capital market, what happens to its marginal cost of capital as it
expands? Explain.

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 d. If a firm can raise funds abroad what happens to its marginal cost of capital as it expands? Explain.
6. Market segmentation:
a. Define market segmentation. How can it be measured?

b. What are the six main causes of market segmentation? Explain.

c. What are the main disadvantages for a firm to be located in a segmented market? Explain.
7. Pearson Manufacturing and Adel Products are looking for lowest cost financing possible. Pearson prefers floating-rate
financing while Adel wishes to borrow at a fixed rate. Pearson is financially stronger than Adel and they face the following
rates.
Borrower Rating Fixed-Rate Floating-Rate
Pearson AAA 8.00% LIBOR + 1%
Adel BBB 12.00% LIBOR + 2%
Difference 4.00% 1.00%
What is the benefit of the swap to each party? Assume that swap is structured in a way that Adel pays 8.5% to Pearson and
Pearson pays LIBOR to Adel after they borrow where each has a relative advantage. Show net gains schematically.

8. Assume that the swap in the previous questions is for $10,000,000 principal for 4 years. What is the amount Adel has to pay
or receive to unwind the swap after two years? Assume a 10% discount rate for all future cash flows and a LIBOR of 6.5%
for the third year and 7.5% for the fourth year.

9. Janutis Co. has just issued fixed rate debt at 10%. Yet, it prefers to convert its financing to incur a floating rate on its debt. It
engages in an interest rate swap in which it swaps variable rate payments of LIBOR + 1% in exchange for fixed payments of
10%. The interest rates are applied to an amount that represents the principal from its recent debt issue in order to determine
the interest payments due at the end of each year for the next three years. Janutis Co. expects that the LIBOR will be 9% at
the end of the first year, 8.5% at the end of the second year, and 7% at the end of the third year. Determine the financing rate
that Janutis Co. expects to pay on its debt after considering the effect of the interest rate swap. Assume no third party
payments.

10. A US MNE desires to finance a capital expenditure of its subsidiary in Germany. The project is expected to generate € cash
flows over five years. The cost of the project is €20,000,000 or $21,000,000 given the current exchange rate of $1.0500/€.
The US firm can borrow US$ at 8% by issuing five-year bonds and then convert the proceeds to €. Alternatively, the US
firm could also issue five-year € denominated bonds at 7% which is 1% more than a well-known European firm would have
to pay. Luckily a swap dealer identifies a German firm operating in the US and trying to raise $21,000,000 in the US for five
years. The German firm could borrow in € at 6% per year and convert the proceeds to US$. Alternatively, since it is not well
known in the US, borrowing in US$ would cost the German firm 9%. Assume that firms are willing to enter into a currency
swap agreement by borrowing in currencies that they have relative advantage.

a. How would a swap dealer arrange a currency swap that would solve these firms’ problem? Show how the swap deal
could be constructed. Be as illustrative as possible. Explain as much as possible. What is the benefit of the swap to
each party? Ignore dealer’s profit.

Enter the currency and the amount each firm will borrow below.
Will Borrow
German Firm
US Firm

Enter the currencies and interest rates after the swap below.
Will Pay Will Receive
German Firm
US Firm

b. The companies enter into the swap as you describe in part (a). Assume that after one year the US interest rate
decreases from 8% to 6.75% percent and in Europe from 6% to 5%. Also the new exchange rate is $0.9800/€.
Analyze the situation from the US firm’s perspective and recommend a course of action as a financial analyst for the

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 US firm. (Clue: The analysis should be done after the first year’s payment is made leaving interest and principal
payments over the remaining four years.)

11.