FNE306 International Finance Chu Hai College of Higher Education Spring Semester 2011-2012 Assignment 6

1. Rankine Corporation of Australia seeks to borrow US$30,000,000 in the Eurodollar market. Funding is needed for two years. Investigation leads to three possibilities: a. Rankine Corporation could borrow the US$30,000,000 for two years at a fixed 5% rate of interest. b. Rankine Corporation could borrow the US$30,000,000 at LIBOR + 1.5%. LIBOR is currently 3.5%, and the rate would be reset every six months. c. Rankine Corporation could borrow the US$30,000,000 for one year only at 4.5%. At the end of the first year Rankine Corporation would have to negotiate for a new one-year loan. Compare the alternatives and make a recommendation. Ans.

Rankine Corporation

Compare the alternatives and make a recommendation. Assumptions Principal borrowing need Maturity needed, in years Fixed rate, 2 years Floating rate, six-month LIBOR + spread Current six-month LIBOR Spread Fixed rate, 1 year, then re-fund 3.500% 1.500% 4.500% First 6months #1: Fixed rate, 2 years Interest cost per year Certainty over access to capital Certainty over cost of capital #2: Floating rate, six-month LIBOR + spread Interest cost per year Certainty over access to capital Certainty over cost of capital #3: Fixed rate, 1 year, then re-fund Interest cost per year Certainty over access to capital Certainty over cost of capital Certain Certain $1,350,000.00 Certain Certain ??? Uncertain Uncertain ??? Uncertain Uncertain $750,000.0 0 Certain Certain $750,000.00 Certain Uncertain $750,000.00 Certain Uncertain $750,000.00 Certain Uncertain Certain Certain $1,500,000 Certain Certain Certain Certain $1,500,000 Certain Certain Second 6months Third 6months Fourth 6months Values $30,000,00 0 2.00 5.000%

Only alternative #1 has a certain access and cost of capital for the full 2 year period. Alternative #2 has certain access to capital for both years, but the interest costs in the final 3 of 4 periods is uncertain. Alternatvie #3, possessing a lower interest cost in year 1, has no guaranteed access to capital in the second year. Depending on the companys business needs and tolerance for interest rate risk, it should choose between #1 and #2.

2. Raid Gauloises is rapidly growing French sporting goods and adventure racing outfitter. The company has decided to borrow 20,000,000 via a Euroeuro floating rate loan for four years. Raid must decide between two competing loan offerings from two of its banks. Banque de Paris has offered the four-year debt at euro LIBOR + 2.00% with an up-front initiation fee of 1.8%. Banque de Sorbonne, however, has offered euro LIBOR + 2.5%, a higher spread, bur with no loan initiation fees up front, for the same term and principal. Both banks reset the interest rate at the end of each year. Euro LIBOR is currently 4.00%. Raids economist forecasts that LIBOR will rise by 0.5% each year. Banque de Sorbonne, however, officially forecasts euro LIBOR to begin trending upward at the rate of 0.25% per year. Raid Gauloisess cost of capital is 11%. Which loan proposal do you recommend for Raid Gauloises? Ans.

Raid Gauloises Given interest rate expectations, which loan is the best deal? Assumptions Principal borrowing need Maturity needed, in years Current euro-LIBOR Banque de Paris spread & expectation Banque de Paris initiation fee Banque de Sorbonnes spread & expectation Banque de Sorbonnes initiation fee Values 20,000,000 4.00 4.000% 2.000% 1.800% 2.500% 0.000% Expected Chg in LIBOR

0.500% 0.250%

Raid Gauloises must evaluate both loan proposals under both potential interest rate scenarios. Banque de Paris Loan Proposal Expected interest rates & payments: Expected euro-LIBOR Bank spread Interest rate Funds raised, net of fees Expected interest costs Repayment of principal Total cash flows All-in-cost of funds if: euro-LIBOR rises 0.500% per year euro-LIBOR rises 0.250% per year Year 0 4.000% 2.000% 6.000% 19,640,000 1,300,000 19,640,000 1,300,000 1,400,000 1,400,000 1,500,000 1,500,000 1,600,000 20,000,000 21,600,000 Year 1 4.500% 2.000% 6.500% Year 2 5.000% 2.000% 7.000% Year 3 5.500% 2.000% 7.500% Year 4 6.000% 2.000% 8.000%

Chapter 14Interest Rate and Currency Swaps267

7.7438% 7.1365%

Found by plugging in .250% in expectations above. (Continued)

Raid Gauloises (Continued) Banque de Sorbonne Loan Proposal Expected interest rates & payments: Expected euro-LIBOR Bank spread Interest rate Funds raised, net of fees Expected interest costs Repayment of principal Total cash flows All-in-cost of funds if: euro-LIBOR rises 0.500% per year euro-LIBOR rises 0.250% per year Year 0 4.000% 2.500% 6.500% 20,000,000 1,350,000 20,000,000 1,350,000 1,400,000 1,400,000 1,450,000 1,450,000 1,500,000 20,000,000 21,500,000 Year 1 4.250% 2.500% 6.750% Year 2 4.500% 2.500% 7.000% Year 3 4.750% 2.500% 7.250% Year 4 5.000% 2.500% 7.500%

7.0370% 7.1036%

Found by plugging in .500% in expectations above.

The Banque de Sorbonne loan proposal is actually lower all-in-cost under either interest rate scenario.

3. Citigroup regularly performs a U.S. dollar-based discount cash flow (DCF) valuation of Petrobrs in its coverage. That DCF analysis requires the use of a discount rate which they base on the company's weighted average cost of capital. Evaluate the methodology and assumptions used in the 2003 Actual and 2004 Estimates of Petrobras's WACC below.

Capital Cost Components Risk free rate Levered Beta Risk Premium Cost of equity Cost of debt Tax rate Cost of debt, after-tax Debt/capital ratio Equity/capital ratio WACC

July 28, 2005 2003A 9.400% 1.07 5.500% 15.285% 8.400% 28.500% 6.006% 32.700% 67.300% 12.20%

2004E 9.400% 1.09 5.500% 15.395% 8.400% 27.100% 6.124% 32.400% 67.600% 12.30%

March 8, 2005 2003A 9.000% 1.08 5.500% 14.940% 9.000% 28.500% 6.435% 32.700% 67.300% 12.10%

2004E 9.000% 1.10 5.500% 15.050% 9.000% 27.100% 6.561% 32.400% 67.600% 12.30%

Ans.

Capital Cost Components Risk free rate Levered Beta Risk Premium Cost of equity Cost of debt Tax rate Cost of debt, after-tax Debt/capital ratio Equity/capital ratio WACC WACC (calculated)

July 28, 2005 2003A 9.400% 1.07 5.500% 15.285% 8.400% 28.500% 6.006% 32.700% 67.300% 12.20% 12.25%

2004E 9.400% 1.09 5.500% 15.395% 8.400% 27.100% 6.124% 32.400% 67.600% 12.30% 12.39%

March 8, 2005 2003A 9.000% 1.08 5.500% 14.940% 9.000% 28.500% 6.435% 32.700% 67.300% 12.10% 12.16%

2004E 9.000% 1.10 5.500% 15.050% 9.000% 27.100% 6.561% 32.400% 67.600% 12.30% 12.30%

This approach uses a relatively high assumed value for the risk free rate of interest in the cost of equity calculation, without expressly charging the company a country risk premium. Since the U.S. dollar risk-free rate at this time was somewhere around 4%, this risk-free rate must implicitly include a country risk premium. The cost of debt, before-tax, is actually below the risk-free rate, which is difficult to understand or rationalize.
Source: "Petrobras," Citigroup SmithBarney, March 8, 2005, and July 28, 2005.

4. Grupo Modelo, a brewery out of Mexico that exports such well-known varieties as Corona, Modelo and Pacifico, is Mexican by incorporation. However, the company evaluates all business results, including financing costs, in U.S. dollars. The company needs to borrow $10,000,000 or the foreign currency equivalent for four years. For all issues, interest is payable once per year, at the end of the year. Available alternatives are: a. Sell Japanese yen bonds at par yielding 3% per annum. The current exchange rate is 106/$, and the yen is expected to strengthen against the dollar by 2% per annum. b. Sell euro-denominated bonds at par yielding 7% per annum. The current exchange rate is $1.1960/, and the euro is expected to weaken against the dollar by 2% per annum. c. Sell U.S. dollar bonds at par yielding 5% per annum. Which course of action do you recommend Grupo Modelo take and why?

Ans.
Japanese yen bonds 3.000% 106.00 $ 2.000% 100,000,000 Year 0 euro bonds 7.000% 1.1960 -2.000% US dollar bonds 5.000% 0.000%

Alternatives Coupon rate Current spot rate, yen/$ Expected change in the value of the foreign currency Principal needed by Grupo Modelo Calculation of the dollar cost debt alternatives Japanese yen bonds: Proceeds and principal and interest payments Expected exchange rate (yen/$) US dollar equivalent in expected cash flows IRR of US$ cash flow stream (cost of funds) euro-denominated bonds: Proceeds and principal and interest payments Expected exchange rate (yen/$) US dollar equivalent in expected cash flows IRR of US$ cash flow stream (cost of funds) US dollar bonds: Proceeds and principal and interest payments IRR of US$ cash flow stream (cost of funds)

Year 1

Year 2

Year 3

Year 4

10,600,000,000 106.00 100,000,000 $ 5.060%

(318,000,000) 103.92 (3,060,000) $

(318,000,000) 101.88 (3,121,200) $

(318,000,000) 99.89 (3,183,624) $

(10,918,000,000) 97.93 (111,490,512)

83,612,040 1.1960 100,000,000 $ 4.860%

- 5,852,843 1.1721 (6,860,000) $

- 5,852,843 1.1486 (6,722,800) $

- 5,852,843 1.1257 (6,588,344) $

- 89,464,883 1.1032 (98,693,393)

100,000,000 $ 5.000%

(5,000,000) $

(5,000,000) $

(5,000,000) $

(105,000,000)

Given the expected exchange rate changes, the euro-denominated bonds have the lowest all-in-cost of funds for the Mexico-based company, Grupo Modelo. (Note that it is the expected changes in exchange rates which determine this outcome. In the event that all currencies were expected to remain fixed, an expected change of 0%, then the Japanese yen bonds are clearly the cheapest source of capital.)

5. Finisterra, S.A., located in the state of Baja California, Mexico, manufactures frozen Mexican food which enjoys a large following in the U.S. states of California and Arizona to the north. In order to be closer to its U.S. market, Finisterra is considering moving some of its manufacturing operations to southern California. Operations in California would begin in Year 1 and have the following attributes.
Assumptions Sales price per unit, Year 1 (US$) Sales price increase, per year Initial sales volume, Year 1, units Sales volume increase, per year Production costs per unit, Year 1 Production cost per unit increase, per year General and administrative expenses per year Depreciation expenses per year Finisterra's WACC (pesos) Terminal value discount rate $ Value 5.00 3.00% 1,000,000 10.00% 4.00 4.00% 100,000 80,000 16.00% 20.00%

$ $ $

The operations in California will pay 80% of its accounting profit to Finisterra as an annual cash dividend. Mexican taxes are calculated on grossed up dividends from foreign countries, with a credit for host country taxes already paid. What is the maximum U.S. dollar price Finisterra should offer in Year 1 for the investment?

Ans.
Capital Budgeting Analysis Sales price, US$ Sales volume Revenue Costs per package Total costs Gross profit Less general & administration expenses Less depreciation expenses Operating profit before tax Less U.S. corporate income taxes Net income Dividends distributed ($) (80% of net income) Exchange rate (Ps/$) Dividends remitted to parent (pesos) Additional taxes due in Mexico Dividend received, after-tax (pesos) Terminal value, US$ (discounted @ 20%) (dividend in Year 3/.20) Terminal value, pesos Total cash flows for discounting (pesos) Present value factor (@ 16%) Present value of total cash flows (pesos) Cumulative present value (pesos) in US dollars 4,132,800 0.8333 3,444,000 5,090,400 0.6944 3,535,000 $
30%

Year 0 $ $ $ $

Year 1 5.00 1,000,000 5,000,000 (4.00) (4,000,000) 1,000,000 (100,000) (80,000) 820,000 (246,000) 574,000 459,200 9.00 4,132,800 0 4,132,800

$ $ $ $

Year 2 5.15 1,100,000 5,665,000 (4.16) (4,576,000) 1,089,000 (100,000) (80,000)

$ $ $ $

Year 3 5.30 1,210,000 6,418,445 (4.33) (5,234,944) 1,183,501 (100,000) (80,000)

$ $ $

$
80%

909,000 (272,700) 636,300 509,040 10.00 5,090,400 0 5,090,400

$ $ $

1,003,501 (301,050) 702,451 561,961 11.00 6,181,566 0 6,181,566

$ 8.00

2,809,803 30,907,831 37,089,397 0.5787 21,463,771

1.0000

28,442,771 3,555,346

6. Doohickey Devices, Inc., manufactures design components for personal computers. Until the present, manufacturing has been subcontracted to other companies, but for reasons of quality control Doohicky has decided to manufacture itself in Asia. Analysis has narrowed the choice to two possibilities, Penang, Malaysia, and Manila, the Philippines. At the moment only the following summary of expected, after tax, cash flows is available. Although most operating outflows would be in Malaysian ringgit or Philippine pesos, some additional U.S. dollar cash outflows would be necessary, as shown in the table below. The Malaysia ringgit currently trades at RM3.80/$ and the Philippine peso trades at Ps50.00/$. Doohicky expects the Malaysian ringgit to appreciate 2.0% per year against the dollar, and the Philippine peso to depreciate 5.0% per year against the dollar. If the weighted average cost of capital for Doohicky Devices is 14.0%, which project looks most promising?

Doohicky in Penang (after-tax) Net ringgit cash flows Dollar cash outflows Doohicky in Manila (after-tax) Net peso cashflows Dollar cash outflows

2012 (26,000) 2012 (560,000)

2013 8,000 (100) 2013 190,000 (100)

2014 6,800 (120) 2014 180,000 (200)

2015 7,400 (150) 2015 200,000 (300)

2016 9,200 (150) 2016 210,000 (400)

2017 10,000 2017 200,000 -

Ans.
Assumptions Current spot rate (ringgit/$) Current spot rate (pesos/$) Malaysian ringgit expectation (% change) Phillippine peso expectation (% change) WACC for Doohicky Devices Values 3.80 50.00 2.000% -5.000% 14.000% 0 2012 (26,000) 3.8000 $ $
14%

Doohicky in Penang (after-tax) Net ringgit cash flows Expected exchange rate (ringgit/$) (spot / (1+.02)) Ringgit cash flows in dollars Dollar cash outflows Net total cash flows (US$) Present value factor Present value of cash flow Net present value (NPV)

1 2013 8,000 3.7255 2,147 $ (100) 2,047 $ 0.8772 1,796

2 2014 6,800 3.6524 1,862 $ (120) 1,742 $ 0.7695 1,340

3 2015 7,400 3.5808 2,067 $ (150) 1,917 $ 0.6750 1,294

4 2016 9,200 3.5106 2,621 $ (150) 2,471 $ 0.5921 1,463

5 2017 10,000 3.4418 2,905 2,905 0.5194 1,509

(6,842) $ (6,842) $ 1.0000 (6,842) $ 560 0 2012 (560,000) 50.00

$ $

Doohicky in Manila (after-tax) Net peso cashflows Expected exchange rate (pesos/$) (spot / ( 1 - .05)) Net peso cashflows in dollars Dollar cash outflows Net dollar cashflows, total Present value factor Present value of cash flow Net present value (NPV)
14%

1 2013 190,000 52.63 3,610 $ (100) 3,510 $ 0.8772 3,079

2 2014 180,000 55.40 3,249 $ (200) 3,049 $ 0.7695 2,346

3 2015 200,000 58.32 3,430 $ (300) 3,130 $ 0.6750 2,112

4 2016 210,000 61.39 3,421 $ (400) 3,021 $ 0.5921 1,789

5 2017 200,000 64.62 3,095 3,095 0.5194 1,608

$ $

(11,200) $ (11,200) $ 1.0000 (11,200) $ (266)

$ $

Neither project looks very promising. Doohicky Penang does, however, possess a positive NPV.