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Chapter 22 Fundamentals of Corporate Finance Fifth Edition Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved International Financial Management
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 22- 2 Topics Covered Foreign Exchange Markets Some Basic Relationships Hedging Exchange Rate Risk International Capital Budgeting
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 22- 3 Foreign Exchange Markets Exchange Rate - Amount of one currency needed to purchase one unit of another. Spot Rate of Exchange - Exchange rate for an immediate transaction. Forward Exchange Rate - Exchange rate for a forward transaction.
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 22- 4 Foreign Exchange Markets Forward Premiums and Forward Discounts Example - The yen spot price is 103.155 yen per dollar and the 1 year forward rate is 99.93yen per dollar, what is the premium and discount relationship?
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 22- 5 Foreign Exchange Markets Forward Premiums and Forward Discounts Example - The yen spot price is 103.155 yen per dollar and the 1 year forward rate is 99.93yen per dollar, what is the premium and discount relationship?
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 22- 6 Foreign Exchange Markets Forward Premiums and Forward Discounts Example - The yen spot price is 103.155 yen per dollar and the 1 year forward rate is 99.93yen per dollar, what is the premium and discount relationship? Answer - The dollar is selling at a 3.23% premium, relative to the yen. The yen is selling at a 3.23% discount, relative to the dollar.
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 22- 7 Exchange Rate Relationships Basic Relationships equals
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 22- 8 Exchange Rate Relationships 1) Interest Rate Parity Theory The ratio between the risk free interest rates in two different countries is equal to the ratio between the forward and spot exchange rates.
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 22- 9 Exchange Rate Relationships Example - You are doing a project in South Africa which has an initial cost of $1,000,000. All other things being equal, you have the opportunity to obtain a 1 year South African Rand loan @ 7.875% or a 1 year US dollar loan @ 3.25%. The spot rate of exchange is R6.0813: $1 U.S. The 1 year forward rate is R6.3518:$1 U.S. Which loan will you prefer and why? Ignore transaction costs
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 22- 10 Exchange Rate Relationships Cost of US loan = $1,000,000 x 1.0325 = $1,032,500 Example - You are doing a project in South Africa which has an initial cost of $1,000,000. All other things being equal, you have the opportunity to obtain a 1 year South African Rand loan @ 7.875% or a 1 year US dollar loan @ 3.25%. The spot rate of exchange is R6.0813: $1 U.S. The 1 year forward rate is R6.3518:$1 U.S. Which loan will you prefer and why? Ignore transaction costs Cost of South African Loan = $1,00,000 x 6.0813= R6,081,300 exchange R6,081,300 x 1.07875 = R 6,560,202 loan pmt R 6,560,202 / 6.3518 = $1,032,810 exchange If the two loans created a different result, arbitrage exists!
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 22- 11 Exchange Rate Relationships 2) Expectations Theory of Exchange Rates Theory that the expected spot exchange rate equals the forward rate.
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 22- 12 Exchange Rate Relationships 3) Purchasing Power Parity The expected change in the spot rate equals the expected difference in inflation between the two countries.
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 22- 13 Exchange Rate Relationships Example If inflation in the US is forecasted at 5.0% this year, and 2.0% in South Africa, what do we now about the expected spot rate? Given a spot rate ofR 6.0813 : $1 U.S.
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 22- 14 Exchange Rate Relationships Example - If inflation in the US is forecasted at 5.0% this year, and 2.0% in South Africa, what do we now about the expected spot rate? Given a spot rate ofR 6.0813 : $1 U.S. solve for E E = 6.2602
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 22- 15 Exchange Rate Relationships 4) International Fisher effect The expected difference in inflation rates equals the difference in current interest rates. Also called common real interest rates
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 22- 16 Exchange Rate Risk Example - Honda builds a new car in Japan for a cost + profit of 1,715,000 yen. At an exchange rate of 101.18:$1 the car sells for $16,950 in Indianapolis. If the dollar rises in value, against the yen, to an exchange rate of 105:$1, what will be the price of the car? Conversely, if the yen is trading at a forward discount, Japan will experience a decrease in purchasing power. 1,715,000 = $16,333 105
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 22- 17 Exchange Rate Risk Example - Harley Davidson builds a motorcycle for a cost plus profit of $12,000. At an exchange rate of 101.18:$1, the motorcycle sells for 1,214,160 yen in Japan. If the dollar rises in value and the exchange rate is 105:$1, what will the motorcycle cost in Japan? $12,000 x 105 = 1,260,000 yen (3.78% rise)
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 22- 18 Exchange Rate Risk Currency Risk can be reduced by using various financial instruments Currency forward contracts, futures contracts, and even options on these contracts are available to control the risk
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 22- 19 Capital Budgeting Techniques 1) Exchange to $ and analyze 2) Discount using foreign cash flows and interest rates, then exchange to $. 3) Choose a currency standard ($) and hedge all non dollar CF.
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 22- 20 Capital Budgeting KW Corporation manufactures flat-packed kit wardrobes. It is considering building a manufacturing facility in Narnia. The company is expected to produce Narnian cash flows as follows. The US risk free rate is 5% and the Narnian rate is 10%. The current spot rate is 2.0Leos:$1 and KW expects a 15% return on its investment. What is the NPV of the project? Cash Flow Forecasts (in millions of Leos) year 0 12345 -7.6 2.02.53.03.54.0
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 22- 21 Capital Budgeting KW Corporation manufactures flat-packed kit wardrobes. It is considering building a manufacturing facility in Narnia. The company is expected to produce Narnian cash flows as follows. The US risk free rate is 5% and the Narnian rate is 10%. The current spot rate is 2.0Leos:$1 and KW expects a 15% return on its investment. What is the NPV of the project? Cash Flow Forecasts (in millions of Leos) year 0 12345 -7.6 2.02.53.03.54.0 Q: What are the 1, 2, 3, 4, 5 year forward rates? Forward rates = 2.095 2.1952.3002.4092.524
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 22- 22 Capital Budgeting Q: Convert the CF to $ using the forward rates. 012345 CF L -7.62.02.53.03.54.0 F(r) 2.02.0952.1952.3002.4092.524 CF$-3.8.951.141.301.451.58 KW Corporation manufactures flat-packed kit wardrobes. It is considering building a manufacturing facility in Narnia. The company is expected to produce Narnian cash flows as follows. The US risk free rate is 5% and the Narnian rate is 10%. The current spot rate is 2.0Leos:$1 and KW expects a 15% return on its investment. What is the NPV of the project? Cash Flow Forecasts (in millions of Leos) year 0 12345 -7.6 2.02.53.03.54.0
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 22- 23 KW Corporation manufactures flat-packed kit wardrobes. It is considering building a manufacturing facility in Narnia. The company is expected to produce Narnian cash flows as follows. The US risk free rate is 5% and the Narnian rate is 10%. The current spot rate is 2.0Leos:$1 and KW expects a 15% return on its investment. What is the NPV of the project? Cash Flow Forecasts (in millions of Leos) year 0 12345 -7.6 2.02.53.03.54.0 Capital Budgeting What is the PV of the project in dollars at a risk premium of 10.0%? $ discount rate = 5% + 10% = 15% PV = $360,000
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