CHAPTER 14

THE COST OF CAPITAL FOR FOREIGN INVESTMENTS

KEY POINTS
1. A project's cost of capital is a function of the riskiness of the project itself, not the risk of the firm undertaking
the project. Thus, if an investment's risk characteristics differ from those of the firm's average investment, it is
inappropriate to discount project cash flows at the firm's cost of equity capital.

2. Even if foreign investments are riskier than domestic investments, that does not mean that those risks must
lead to a higher cost of capital for the former. The basic insight of the capital asset pricing model (CAPM) is
that only the systematic component of risk is priced; diversifiable risk must be borne at a zero price. The key
question for the MNC is whether systematic risk is measured in the context of a globally-diversified portfolio
or only a domestically-diversified portfolio.

There is strong evidence that much risk that is systematic from a domestic standpoint is unsystematic from a global
standpoint. If risk is measured relative to a domestically-diversified portfolio, then foreign projects probably have
lower systematic risk than comparable domestic investments, and so should require lower returns. If risk is
measured relative to a globally-diversified portfolio, foreign projects will likely still be less risky than domestic
projects and require lower returns. But the gap between the required return on domestic and comparable foreign
investments should be less in the second case. The total risk of many foreign investments will probably exceed the
total risk of their domestic counterparts. But because of the lower correlation between returns on domestic and
foreign projects, foreign investing could still reduce the MNC's total risk.

Hence, executives of multinational firms should seriously question the use of a risk premium to account for the
added political and economic risks of overseas operations, when evaluating prospective foreign investments. The
use of any risk premium ignores the fact that the risk of an overseas investment in the context of the firm's other
investments, domestic as well as foreign, will be less than the project's total risk. How much less depends on how
highly correlated are the outcomes of the firm's different investments. Some investments, however, are more
risk-prone than are others, and these risks must be accounted for. This chapter shows how to adjust project discount
rates, using the CAPM, when those additional foreign risks are systematic in nature. Chapter 17 will show how to
conduct the necessary risk analysis for foreign investments when the foreign risks are unsystematic (through cash
flow adjustments).

The chapter also explored the factors that are relevant in determining appropriate parent, affiliate, and worldwide
capital structures--taking into account the unique attributes of being a multinational corporation. We saw that the
optimal global capital structure entails that mix of debt and equity for the parent entity and for all consolidated and
unconsolidated subsidiaries that maximizes shareholder wealth. At the same time, affiliate capital structures should
vary to take advantage of opportunities to minimize the MNC's cost of capital.

SUGGESTED ANSWERS TO CHAPTER 14 QUESTIONS

1. What factors should be considered in deciding whether the cost of capital for a foreign affiliate should be
higher, lower, or the same as the cost of capital for a comparable domestic operation?
2 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 10TH ED.

ANSWER. Key factors include whether the cash flows of the affiliate are closely tied to the state of the local
economy or to the world economy, the correlation between the local and domestic economies, and the volatility of
the foreign affiliate's cash flows relative to that of the domestic operation. The greater (lesser) each of these factors,
the higher (lower) the foreign affiliate's cost of capital relative to that of the domestic operation. In general, the
closer these factors are to each other, the closer their costs of capital.

2. According to an article in Forbes, "American companies can and are raising capital in Japan at relatively low
rates of interest. Dow Chemical, for instance, has raised $500 million in yen. That cost the company over 50
percent less than it would have at home." Comment on this statement.

ANSWER. Forbes is comparing apples with oranges. Borrowing in yen is not the same as borrowing in dollars.
When converting from yen into dollars Dow faces the possibility that the yen will appreciate, wiping out its
apparent cost savings. In fact, in less than one year after the article appeared, the yen had appreciated by over 35%
relative to the dollar, raising the dollar cost of repaying that $500 million yen borrowing to over $675 million.

3. In early 1990, major Tokyo Stock Exchange issues sell for an average 60 times earnings, more than four times
the 13.8 price-earnings ratio for the S&P 500. According to Business Week (February 12, 1990, p. 76), "Since
p-e ratios are a guide to a company's cost of equity capital, this valuation gap implies that raising new equity
costs Japanese companies less than 2 percent a year, vs. an average 7 percent for the U.S." Comment on this
statement.

ANSWER. According to the dividend growth model,

ke = DIV1/P0 +g

where ke is the cost of equity capital, DIV 1/P0 is the projected dividend yield, and g is the expected dividend growth
rate. The dividend yield equals the earnings yield (e/P) multiplied by the dividend payout rate. According to this
formula, the e-P ratio is only an accurate guide to the cost of capital when earnings are expected to be stable.
Conversely, the higher earnings (and, hence, dividend) growth is expected to be, the more downwards biased the e-
P ratio will be as a measure of the cost of capital. The dividend growth model also tells us that the higher the
earnings growth rate, the higher the P-e ratio (and the lower the e-P ratio). Thus, one possible interpretation of the
low e-P ratios for Japanese companies is that they reflect the expectation of high earnings growth rather than a low
cost of equity capital. Of course, as we now know, these expectations have been dashed and the Japanese market
has tumbled.

4. What are some of the advantages and disadvantages of having highly leveraged foreign subsidiaries?

ANSWER. A more highly leveraged subsidiary may also be a more efficient firm because management is unable to
turn to the parent for help.

The disadvantages of high leverage include the following:

1. Local suppliers and customers may shy away from doing business with a new subsidiary operating on a
shoestring if that subsidiary is receiving minimal financial backing from its parent. Having a balance sheet
with more equity demonstrates that the unit has greater staying power.

2. The government might argue that the firm is overly leveraged and declare that certain debt payments are
constructive dividends and impose taxes on those payments.

5. Compania Troquelados ARDA is a medium-sized Mexico City auto parts maker. It is trying to decide whether
to borrow dollars at 9 percent or Mexican pesos at 75 percent. What advice would you give it? What
information would you need before you gave the advice?
CHAPTER 14: THE COST OF CAPITAL FOR FOREIGN INVESTMENTS 3
4 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 10TH ED.

ANSWER. To begin, it is necessary to recognize that 75% in pesos is not the same as 9% in dollars. In the absence
of government controls or access to subsidized financing, the expected before-tax cost of the two loans should be
about the same. If there is some tax asymmetry (e.g., foreign exchange losses are not tax deductible), then the
expected after-tax costs of the two loans could diverge.

Regardless of the expected costs of the two loans, the risks for Compania Troquelados ARDA are quite different.
The dollar loan entails foreign exchange risk, while the peso loan entails inflation risk. A key question, therefore, is
how does the return on the firm's assets respond to inflation and changes in the dollar/peso exchange rate. The
answer to this question depends on where the company sells (domestic or abroad) and whether it faces import
competition on domestic sales. If the company is selling in the United States, the dollar loan will probably lower its
exchange risk. If it is selling in Mexico without much import competition (because of trade barriers), then the
company's nominal operating profits will likely increase in line with inflation, making the peso loan the low-risk
loan. This assumes that the interest rate on the peso loan will adjust periodically. If the peso interest rate is fixed,
then the peso loan is the low-risk funding technique only if the firm's real operating profits move inversely with
Mexican inflation. Otherwise, the dollar loan is probably a lower-risk bet.

6. Boeing Commercial Airplane Co. manufactures all its planes in the United States and prices them in dollars,
even the 50 percent of its sales destined for overseas markets. What financing strategy would you recommend
for Boeing? What data do you need?

ANSWER. Boeing faces foreign exchange risk for two reasons: (1) It sells half its planes overseas and the demand
for these planes depends on the foreign exchange value of the dollar, and (2) Boeing faces stiff competition from
Airbus Industrie, a European consortium of companies that builds the Airbus. As the dollar appreciates, Boeing is
likely to lose both foreign and domestic sales to Airbus unless it cuts its dollar prices. One way to hedge this
operating risk is for Boeing to finance a portion of its assets in foreign currencies in proportion to its sales in those
countries. However, this tactic ignores the fact that Boeing is competing with Airbus. Absent a more detailed
analysis, another suggestion is for Boeing to finance at least half of its assets with ECU bonds as a hedge against
depreciation of the currencies of its European competitors. ECU bonds would also provide a hedge against
appreciation of the dollar against the yen and other Asian currencies since European and Asian currencies tend to
move up and down together against the dollar (albeit imperfectly).

7. United Airlines recently inaugurated service to Japan and now wants to finance the purchase of Boeing 747s to
service that route. The CFO for United is attracted to yen financing because the interest rate on yen is 300
basis points lower than the dollar interest rate. Although he doesn't expect this interest differential to be offset
by yen appreciation over the ten-year life of the loan, he would like an independent opinion before issuing yen
debt.

a. What are the key questions you would ask in responding to UAL's CFO?

ANSWER. What's your business? Speculating on exchange rates or running an airline? Do you think you can
profitably outguess the financial markets? How do your operating cash flows respond to changes in the dollar/yen
exchange rate?

b. Can you think of any other reason for using yen debt?

ANSWER. Another reason for preferring yen financing could be to use this financing to hedge operating cash flows
on the Tokyo route against changes in the dollar/yen exchange rate.

c. What would you advise him to do, given his likely responses to your questions and your answer to part b?
CHAPTER 14: THE COST OF CAPITAL FOR FOREIGN INVESTMENTS 5

ANSWER. The professed reason for preferring yen financing runs afoul of the international Fisher effect. Yen
interest rates are 300 basis points less than dollar interest rates because the market expects the dollar to depreciate
by about 3% annually against the yen. This reason for borrowing yen is, therefore, a non -starter assuming that the
CFO does not assert the ability to outguess financial markets.
If United's dollar cash flow on its new route to Japan varies in line with the value of the dollar (that is, dollar cash
flow drops when the dollar appreciates against the yen and vice versa when the dollar depreciates against the yen),
then yen financing of its planes will reduce its exchange risk. Otherwise, dollar financing is the appropriate
solution. It is difficult to say exactly how United's cash flow will be affected by the exchange rate. A rising dollar
will reduce tourism from Japan to the United States, but it might increase business travel involving purchases of
less expensive Japanese products. Conversely, a falling dollar will stimulate Japanese tourist travel to the United
States, but could hurt business travel between the two countries.

8. The CFO of Eastman Kodak is thinking of borrowing Japanese yen because of their low interest rate, currently
at 4.5 percent. The current interest rate on U.S. dollars is 9 percent. What is your advice to the CFO?

ANSWER. My advice would be "Don't speculate." The international Fisher effect says that the 450 basis point
differential reflects a 4.5% expected annual appreciation of the yen against the dollar. Thus, the expected costs of
dollar and yen financing should be the same. Unless Kodak needs yen financing to offset a yen transaction or
operating exposure, it should stick to dollar financing.

9. Rohm & Haas, a Philadelphia-based specialty chemicals company, traditionally finances its Brazilian
operations from outside that country because it's "too expensive" to borrow local currency in Brazil. Brazilian
interest rates vary from 50 percent to over 100 percent. Rohm & Haas is now thinking of switching to cruzeiro
financing because of a pending cruzeiro devaluation. Assess Rohm & Haas's financing strategy.

ANSWER. One can't expected to gain from an expected currency change because interest rates already incorporate
these expectations. The real reason for using foreign currency financing (aside from the ability to use currency
swaps to access lower cost funds) is to offset exchange risk or political risk such as exchange controls. Because the
odds are that Rohm & Haas does face exchange risk and political risk in Brazil, it should probably use cruzeiro
financing.

10. Nord Resource's Ramu River property in Papua New Guinea contains one of the world's largest deposits of
cobalt and chrome outside of the Soviet Union and South Africa. The cost of developing a mine on this
property is estimated to be around $150 million.

a. Describe three major risks in undertaking this project.

ANSWER. The three principal risks faced by Nord Resource's Ramu River project are the following:

1. Political risk. The government of Papua New Guinea may seize the mine if it turns out to be highly
profitable. The government may also block repatriation of profits.

2. Reserve risk. There may be too few copper reserves or the ore may be too expensive to profitably mine.

3. Price risk. The price at which Nord can sell the ore may be too low.

Exchange risk is unlikely to be a major risk. The price at which the copper can be sold is set in dollars. In addition,
Nord's most important cost is the cost of developing the mine, which is largely set in dollar terms.

b. How can Nord structure its financing so as to reduce these risks?

6 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 10TH ED.

ANSWER. Nord can use financing to reduce these risks as follows:

1. Political risk. The answer to this part is the same as that to question #13: Finance the project to the extent
possible with funds from the host and other governments, international development agencies, overseas
banks, and from customers--with payment to be provided out of production--rather than supplying parent
company- raised or parent-guaranteed capital.

2. Reserve risk. Use nonrecourse financing with a minimal amount of equity. In this way, the lenders bear
the risk of the mine being uneconomical.

3. Price risk. Sell the ore in advance at a fixed price. Even if the price varies with the world market price, the
typical take-or-pay contract, Nord will have a guaranteed outlet for its ore and will not have to engage in
price cutting to sell more output.

c. How can Nord use financing to add value to this project?

ANSWER. To the extent that Nord can access subsidized financing for the purchase of equipment and contractor
services to develop the mine, it should do so. In addition, Nord can add value to the project by using financing to
reduce the various operating risks it faces.

ADDITIONAL CHAPTER 14 QUESTIONS AND ANSWERS

1. Comment on the following statement: "There is a curious contradiction in corporate finance theory: Since
equity is more expensive than debt, highly leveraged subsidiaries should be assigned a low hurdle rate. But
when the highly leveraged subsidiaries are in risky nations, country risk dictates just the opposite: a high
hurdle rate."

ANSWER. Several points are relevant here. First, country risk is most likely to be an unsystematic source of risk and
hence should not affect the cost of capital for a project. The project will be penalized for higher unsystematic risk
by reducing the expected project cash flows below their most likely value. Second, as leverage rises, the cost of
equity capital rises as well, offsetting in whole or in part the advantage of debt. Thus, it is not clear that highly
leveraged subsidiaries should have a lower cost of capital. Third, it is not clear that subsidiaries have independent
capital structures, so it is difficult to talk about how their cost of capital varies with their leverage. Fourth, even if a
highly leverage sub has a lower cost of capital and country risk increases the appropriate cost of capital, there is no
contradiction: A highly leveraged sub in a risky nation would have a lower cost of capital than would a less highly
levered sub in that same nation.

2. Comment on the following statement: "Our conglomerate recognizes that foreign investments have a very low
covariance with our domestic operations and, thus, are a good source of diversification. We do not `penalize'
potential foreign investments with a high discount rate but, rather, use a discount rate just 3 percent above the
prevailing riskless rate."

ANSWER. To repeat the answers to question 1, the cost of capital for a project depends on its systematic risk. This
systematic risk must be measured relative to the market portfolio, not relative to the company's investment
portfolio. Moreover, even if the foreign investment has a low covariance with the market portfolio, the selection of
3% is arbitrary. However, this rule of thumb, which assigns a lower cost of capital to foreign projects, may be more
appropriate than penalizing them with a higher cost of capital.

3. How has the Tax Reform Act of 1986 affected the capital structure choice for foreign subsidiaries?
CHAPTER 14: THE COST OF CAPITAL FOR FOREIGN INVESTMENTS 7

ANSWER. As noted in the chapter, the Tax Reform Act of 1986 has put many U.S.-based MNCs in a position of
excess foreign tax credits. One approach to using up these FTCs is to push expenses overseas--and thus lower
overseas profits--by increasing the leverage of foreign subsidiaries. Another is to shift toward leasing instead of
borrowing.

4. What financing problems might be associated with joint ventures?

ANSWER. Unless the joint venture can be isolated from its partners' operations, there are likely to be some
significant problems associated with this form of ownership. Transfer pricing on goods and services (including
royalty and licensing fees) and allocation of production and markets among plants are just some of the areas in
which each owner has an incentive to engage in activities that will harm its partners. These conflicts lead to
increased operating and monitoring expenses. In addition, where the MNC is substantially stronger financially than
its partner, the MNC may wind up implicitly guaranteeing its weaker partner's share of any JV borrowings, as well
as its own.

5. Under what circumstances does it make sense for a company to not guarantee the debt of its foreign affiliates?

ANSWER. Here are some valid arguments against parent guarantees of foreign affiliate debt:

• The protection against expropriation provided by an affiliate's borrowing may be lost if the parent guarantees
those debts.

• The U.S. IRS imputes income to the guarantor and levies a tax.

• When a firm provides an affiliate with a loan guarantee, it may lose the bank as its partner in controls. Since it
will be repaid regardless of the subsidiary's profitability, the bank will have less incentive to monitor the
affiliate's activities.

6. How can financing strategy be used to reduce foreign exchange risk?

ANSWER. Firms can reduce their exposure to foreign exchange risk by financing assets that generate foreign
currency cash flows with liabilities denominated in those same foreign currencies.

7. How can financial strategy be used to reduce political risk?

ANSWER. Financing can be used to avoid or at least reduce the impact of certain political risks, like exchange
controls. Some financing mechanisms may actually change the risk itself, as in the case of expropriation or other
direct political acts.

Firms can sometimes reduce the risk of currency inconvertibility by investing parent funds as debt rather than
equity, arranging back- to-back and parallel loans, and using local financing to the maximum extent possible.
Multinational firms, especially those in the expropriation-prone extractive industries, can avoid political risk by
financing their foreign investments with funds from the host and other governments, international development
agencies, overseas banks, and from customers--with payment to be provided out of production--rather than
supplying parent company-raised or parent-guaranteed capital. Since repayment is tied to the project's success, the
sponsoring firm(s) can create an international network of banks, government agencies, and customers with a vested
interest in the faithful fulfillment of the host government's contract with the sponsoring firm(s). International
leasing is another financing technique that may help multinationals to reduce their political risk. This technique
allows MNCs to limit the ownership of assets by subsidiaries in politically unstable countries and to more easily
extract cash from affiliates located in countries where there are exchange controls.
8 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 10TH ED.

8. All-Nippon Airways, a Japanese airline, flies exclusively within Japan. It is looking to finance a recent
purchase of Boeing 737s. The director of finance for All-Nippon is attracted to dollar financing because he
expects the yen to keep appreciating against the dollar. What is your advice to him?

ANSWER. Because All-Nippon Airways' yen cash flow will not vary in line with the dollar/yen exchange rate,
using dollar financing will expose it to exchange risk. The implicit argument for using dollar financing is that yen
appreciation will make it cheaper to repay. But this argument ignores the international Fisher effect, which says
that a borrower should expect that any gain on loan repayment will be offset by the higher interest rate on a dollar
loan. The key question to ask here is: "What's your business? Is it speculating on the future course of the $/yen
exchange rate or is it providing aviation service at a reasonable price?"

9. In order to develop large agricultural estates, the Republic of Coconutland offers the following financing deal:
If an investor agrees to purchase a plantation and put up half the cost in U.S. dollars, the government will make
a 20-year, zero-interest loan of U.S. dollars to cover the other half.

a. What risks does the scheme entail?

ANSWER. The principal risk is that of expropriation. What will prevent the government from seizing the property
without compensation? Other risks include variations in agricultural prices, currency controls, increased taxes,
inflation risk, currency risk, and price controls.

b. How can an investor use financing to reduce these risks?

ANSWER. First of all, the investor can take out political risk insurance to protect his portion of the investment
against political risks such as expropriation and currency controls. The risk of price controls is mitigated if the
investor is exporting the plantation's output, provided that the government does not force the investor to convert his
currency proceeds back into local currency at an artificially overvalued exchange rate. The real exchange risk that
the investor faces is that the local currency will become overvalued, raising the costs of local production without
increasing the price at which output can be exported. Another means of protecting against risks is to finance the
purchase with loans from export-import banks (to the extent the investor must raise financing to buy goods and
services overseas), with payment to be made out of plantation earnings and no recourse to the investor.

SUGGESTED SOLUTIONS TO CHAPTER 14 PROBLEMS

1. A firm with a corporate-wide debt/equity ratio of 1:2, an after-tax cost of debt of 7 percent, and a cost of equity
capital of 15 percent is interested in pursuing a foreign project. The debt capacity of the project is the same as
for the company as a whole, but its systematic risk is such that the required return on equity is estimated to be
about 12 percent. The after-tax cost of debt is expected to remain at 7 percent.

a. What is the project's weighted average cost of capital? How does it compare with the parent's WACC?

ANSWER. The weighted average cost of capital for the project is

kI = (1 - w) x ke' + w x id(1 - t)

where w is the ratio of debt to total assets, k e' is the required risk-adjusted return on project equity, and i d(1 - t) is
the after-tax cost of debt for the project. Substituting in the numbers provided yields

kI = 2/3 x 12% + 1/3 x 7% = 10.33%

b. If the project's equity beta is 1.21, what is its unlevered beta?

CHAPTER 14: THE COST OF CAPITAL FOR FOREIGN INVESTMENTS 9

ANSWER. The following approximation is usually used to unlever beta:

Unlevered beta = levered beta/[1 + (1 - t)D/E]

where t is the firm's marginal tax rate and D/E is its debt/equity ratio. Without knowing the firm's marginal tax rate,
we cannot unlever beta. Assuming that the marginal tax rate is about 40%, the unlevered beta is
Unlevered beta = 1.21/[1 + (1 - .4)½] = .93

2. Suppose that a foreign project has a beta of 0.85, the risk-free return is 12 percent, and the required return on
the market is estimated at 19 percent. What is the cost of capital for the project?

ANSWER. The cost of capital for the project is

k* = Rf + β*[E(Rm) - Rf]

where Rf is the risk-free required return, β* is the project beta, and E(Rm) is the expected return on the market.
Substituting in the numbers provided in the problem yields

k* = .12 + .85(.19 - .12) = 17.95%

3. IBM is considering having its German affiliate issue a 10-year, $100 million bond denominated in euros and
priced to yield 7.5 percent. Alternatively, IBM’s German unit can issue a dollar-denominated bond of the same
size and maturity and carrying an interest rate of 6.7 percent..

a. If the euro is forecast to depreciate by 1.7 percent annually, what is the expected dollar cost of the euro-
denominated bond? How does this compare to the cost of the dollar bond?

ANSWER. According to Chapter 14, the pre-tax dollar cost of borrowing in a foreign currency at an interest rate of
rL, where the currency is expected to appreciate (depreciate) against the dollar at an annual rate of c, is rL(1 + c) +
c. Substituting the numbers in the problem to this formula yields an expected dollar cost of borrowing euros of
5.67% [7.5% x (1 - 0.017) - 1.7%). This figure is substantially below the 6.7% cost of borrowing dollars.

b. At what rate of euro depreciation will the dollar cost of the euro-denominated bond equal the dollar cost of the
dollar-denominated bond?

ANSWER. The answer to this question is the solution to 7.5% x (1 + c) + c = 6.7%, or c = (6.7% - 7.5%)/1.075 = -
0.74%.

c. Suppose IBM’s German unit faces a 35 percent corporate tax rate. What is the expected after-tax dollar cost of
the euro-denominated bond?

ANSWER. According to Chapter 14, the effective after-tax dollar cost of borrowing a local currency at an interest
rate of rL, annual currency appreciation (depreciation) of c, and a corporate tax rate of ta, is r = rL(1 + c)(1 - ta) + c.
Substituting in the numbers from the question yields a solution of r = 7.5% x (1 - 0.017)(1 - 0.35) - 0.017 = 4.78%.

4. Suppose that the cost of borrowing restricted euros is 7 percent annually, whereas the market rate for these
funds is 12 percent. If a firm can borrow €10 million of restricted funds, how much will it save annually in
before-tax franc interest expense?
10 INSTRUCTORS MANUAL: MULTINATIONAL FINANCIAL MANAGEMENT, 10TH ED.

ANSWER. The annual interest savings on €10 million of restricted funds at 7% when the market rate is 12% equals
€10,000,000(0.12 - 0.07) or €500,000.

5. Suppose that one of the inducements provided by Taiwan to woo Xidex into setting up a local production
facility is a ten-year, $12.5 million loan at 8 percent interest. The principal is to be repaid at the end of the
tenth year. The market interest rate on such a loan is about 15 percent. With a marginal tax rate of 40
percent, how much is this loan worth to Xidex?

ANSWER. By borrowing at 8% when the market rate is 15%, Xebec saves 8% annually. This
translates into annual before-tax savings of $12,500,000(.15 - .08) = $875,000. With a marginal
tax rate of 40%, this yields annual after-tax savings of $525,000. The value of this ten-year
annuity, discounted at Xebec's after-tax debt cost of 9% (15% x .6), is $525,000 x 6.4177 =
$3,369,293.

ADDITIONAL CHAPTER 14 PROBLEMS AND SOLUTIONS

1. Although the one-year interest rate is 10% in the United States, one-year, yen-denominated corporate bonds in
Japan yield only 5%.

a. Does this present a riskless opportunity to raise capital at low yen interest rates?

ANSWER. No. According to the international Fisher effect, the 5% interest differential reflects the market's
expectations that the yen will appreciate by approximately 5% relative to the dollar over the coming year.

b. Suppose the current exchange rate is ¥140 = $1. What is the lowest future exchange rate at which borrowing
yen would be no more expensive than borrowing U.S. dollars?

ANSWER. The breakeven exchange rate is found as the solution to S = 140 x 1.05/1.10 = ¥133.64.

2. The manager of an English subsidiary of a U.S. firm is trying to decide whether to borrow, for one year,
dollars at 7.8% or pounds sterling at 12%. If the current value of the pound is $1.70, at what end-of-year
exchange rate would the firm be indifferent now between borrowing dollars and pounds?

ANSWER. The breakeven exchange rate change is

c = (rus - rL)/(1 + rL) = (0.078 - 0.12)/1.12 = -3.75%

In other words, the pound would have to depreciate by 3.75% during the year for the two loans to have the same
dollar cost. A 3.75% pound depreciation would yield an end-of-year exchange rate equal to $1.63625 (1.70 x (1 -
0.0375)).

3. Suppose that Grand Metropolitan, a British multinational, is interested in issuing a 5-year zero-coupon bond
denominated in yen and with a ¥1.5 billion par value that is priced to yield 2.5% (a zero-coupon bond pays no
interest but is priced at a steep discount to par value such that the present value of the par value discounted at
the yield to maturity just equals the current selling price). If the current exchange rate is ¥150/£, at what future
¥/£ exchange rate will the pound cost of the yen zero just equal the cost of an equivalent pound-denominated
zero-coupon bond priced to yield 6.75%?
CHAPTER 14: THE COST OF CAPITAL FOR FOREIGN INVESTMENTS 11

ANSWER. The present value of the 5-year yen zero-coupon bond (and, hence, the amount of yen actually borrowed)
is ¥1,500,000,000/1.0255, or ¥1,325,781,431.42. At the current spot rate of ¥150/£, this figure translates into a
current pound value of £8,838,542.88 (1,325,781,431.42/150). If Grand Metropolitan issued a 5-year, pound-
denominated zero-coupon bond that provided this same amount of proceeds and was priced to yield 6.75%, it
would have to pay back £12,252,369.67 (£8,838,542.88 x 1.0675 5) in five years. Alternatively, it must repay
¥1,500,000,000 on the zero-coupon yen issue. The breakeven ¥/£ exchange rate at the end of five years (the rate at
which the yen cost of repaying the pound zero-coupon bond just equals the yen cost of repaying the yen zero-
coupon bond) is found as the solution e5 to 12,252,369.67e5 = ¥1,500,000,000, or e5 = ¥122.43.