EFB240 - Discuss Three Theories that Justify International Business - Finance Assignment Help

Assignment Task

QUESTION 1

(a) Discuss three theories that justify international business.

(b)Outline the major cost related motives for direct foreign investment.
QUESTION 2

Assuming the following information, calculate the amount of arbitrage profit that can be made on a borrowing of $10,000,000 AUD or $8,000,000 USD.
Spot AUD = 0.80 USD
One Year Forward AUD = 0.85 USD
Australian Interest Rate = 4% pa
USA Interest Rate = 5% pa

QUESTION 3
(a) Outline how political risk factors may impact the firm’s cost of capital. 

(b) Discuss the reasons for why multinationals trade in financial markets.
QUESTION 4

(a) Assume AUD = 90 Yen and inflation is 2% pa in Australia and 1% pa in Japan. 
Estimate the AUD/Yen spot rate in one year’s time.

(b) Discuss the ways in which a government may directly intervene in currency markets.

QUESTION 5

(a) Explain how characteristics of MNCs can affect the cost of capital

(b) Outline the main users of derivative markets.
QUESTION 6

“Translation exposure is the least important of the three currency exposures.” Discuss.
QUESTION 7

(a) Discuss how good the forward rate is likely to be as a predictor of the future spot rate.

(b) Compare and contrast forward contracts and options as a way of hedging transaction currency exposure.

QUESTION 8

An Australian company, Jimmy Ltd, is examining a potential investment in New Zealand. The project is expected to cost NZD 20 billion and have a salvage value of NZD 7 billion at the end of its 4 year life. Revenues generated from the project are expected to be NZD 10 billion per year and expenses are expected to be NZD 5 billion per year.  The current exchange rate of AUD = 1.10NZD is expected to be maintained over the life of the project. The required return is 15% in AUD and tax can be ignored. Calculate the NPV of the project and determine whether it should be undertaken. 
 
Formulae Sheet

SOLUTIONS

Q1(a). The theory of comparative advantage implies that countries should specialize in production, thereby relying on other countries for some products.  Consequently, there is a need for international business.
The product cycle theory suggests that at some point in time, the firm will attempt to capitalize on its perceived advantages in markets other than where it was initially established.
Under the theory of imperfect markets, resources cannot be easily and freely retrieved by the MNC.  Consequently, the MNC must sometimes go to the resources rather than retrieve resources (such as land, labour, etc.).

Q1(b). Discussion of the following factors:
Fully benefit from economies of scale
Lower average cost per unit resulting from increased production.
Use foreign factors of production
Labor and land costs can vary dramatically among countries.
Use foreign raw materials
Develop the product in the country where the raw materials are located.
Use foreign technology
React to exchange rate movements
When a firm perceives that a foreign currency is undervalued, the firm may  consider DFI in that country, as the initial outlay should be relatively low.

Q2. (1 + if)/(1 + id) =  1.05/1.04 = 1.0096
But F/S = .85/.80 = 1.0625
As interest rate differential is less than forward differential, it is better to borrow internationally (USD) and invest domestically (AUD). 
Strategy – Covered Interest Arbitrage
Q3(a) Discussion of political risk factors such as (1) blocked funds, (2) changing tax laws, (3) public revolt against the firm, (4) war, and (5) a changing attitude of the host government toward the MNC.
As each of these factors increase risk there will be a corresponding increase in the cost of capital and hence a reduction in the NPV of the project.

Q3(b). Multinationals trade in financial markets for two main reasons:
To raise capital which may be
debt or equity
short term or long term
domestic or international
To hedge various risks, including
exchange rate risk
interest rate risk
commodity price risk

Q4(a).Expected Spot in one year = S x (1 + inflationf)/(1 + inflationd) 
= 90 x 1.01/1.02 = 89.12 Yen
Hence due to the higher inflation, the AUD is expected to depreciate against the Yen.

Q4(b) Direct intervention can include:
Smoothing exchange rate movements:
If a central bank is concerned that its economy will be affected by abrupt movements in its home currency’s value, it may attempt to smooth the currency movements over time.
Establishing implicit exchange rate boundaries:
Some central banks attempt to maintain their home currency rates within some unofficial, or implicit, boundaries.
Responding to temporary disturbances:
A central bank may intervene to insulate a currency’s value from a temporary disturbance.
Q5(a) The following characteristics of MNCs can influence the cost of capital:
Size. MNCs have more opportunities to grow, and larger, better known firms may receive preferential treatment by creditors.
Access to international capital markets.  MNCs have access to more sources of funds than domestic firms.  To the extent that financial markets are segmented, MNCs may be able to obtain financing from various sources at a lower cost.
International diversification.  If MNCs can achieve more stable cash flows through their international diversifi¬cation, their probability of bankruptcy is reduced.  Creditors and shareholders may therefore accept a lower rate of return when providing funds to the MNCs, which reflects a lower cost of capital for MNCs.

Q5(b) Categories of users include
Hedgers:-
use the market to lock in a future price and hence 
make their future cash flows more certain.
 have an underlying position in the asset.
Speculators
using the market to bet on a price change.
have no underlying position in the asset.
Arbitrageurs
trade on mispricing between the derivatives
and spot markets or between different 
derivative contracts to make a riskless profit.

Q6.True.
Transaction exposure can be defined as the sensitivity of the firm’s contractual transactions in foreign currencies to exchange rate movements.
Economic exposure can be defined as the sensitivity of the firm’s cash flows to exchange rate 
movements, sometimes referred to as operating exposure. 
Translation exposure can be defined as the exposure of the MNC’s consolidated financial statements to exchange rate fluctuations.
Transaction exposure is typically seen as the most important exposure as foreign currency transactions have direct cash flow implications. Thus most firms will hedge any significant transaction exposures. Economic exposure can also have a significant cash flow impact on the firm but can be more difficult to hedge. As translation exposure results from the translation of accounting information into the home currency, there may not be any cash flow implications. Thus translation exposure is the least important and the least likely to be hedged.
Q7(a). Under the theory of Unbiased Forward Rates
The expected future spot rate will be equal to the forward rate.
Empirical evidence suggests the forward rate not a very accuratepredictor of the future spot rate. There may be a number of reasons for this, but particularly that many other factors may intervene to change the spot rate (e.g. Political events, interest rate changes). It is hoped that the forward rate but may be unbiased, which means it is as likely to be an underestimate as an overestimate of the future spot rate. This would mean there is no risk premium in the forward rate.

Q7(b) Forward contracts are an over the counter instrument that can be used to hedge currency exposure. They can be used to hedge both payables and receivables. They create certainty with the hedge. They take out the downside risk, but also take out any upside gain. Call options can be used to hedge payables and put options can be used to hedge receivables. Options may be exchange traded or over the counter. Options cost money (the premium), but allow for an upside gain as well as protecting the downside. The outcome of the hedge isn’t known with certainty when an option is used. Options are preferred when there is uncertainty regarding the transaction.
Q8. NPV based on Cash Flows in billions

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