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1、CHAPTER 18 INTERNATIONAL CAPITAL BUDGETINGCHAPTER 18 INTERNATIONAL CAPITAL BUDGETINGSUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTERSUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTERQUESTIONS AND PROBLEMSQUESTIONS AND PROBLEMSQUESTIONS1.Why is capital budgeting analysis so important to the firm?Answ
2、er:The fundamental goal of the financial manager is to maximize shareholder wealth.Capitalinvestments with positive NPV or APV contribute to shareholder wealth.Additionally,capitalinvestments generally represent large expenditures relative to the value of the entire firm.Theseinvestments determine h
3、ow efficiently and expensively the firm will produce its product.Consequently,capital expenditures determine the long-run competitive position of the firm in the product marketplace.2.What is the intuition behind the NPV capital budgeting framework?Answer:The NPV framework is a discounted cash flow
4、technique.The methodology compares thepresent value of all cash inflows associated with the proposed project versus the present value of allproject outflows.If inflows are enough to cover all operating costs and financing costs,the project addswealth to shareholders.3.Discuss what is meant by the in
5、cremental cash flows of a capital project.Answer:Incremental cash flows are denoted by the change in total firm cash inflows and cash outflowsthat can be traced directly to the project under analysis.4.Discuss the nature of the equation sequence,Equation 18.2a to 18.2f.Answer:The equation sequence i
6、s a presentation of incremental annual cash flows associated with acapital expenditure.Equation 18.2a presents the most detailed expression for calculating these cash flows;it is composed of three terms.Equation 18.2b shows that these three terms are:i)incremental net profitassociated with the proje
7、ct;ii)incremental depreciation allowance;and,iii)incremental after-tax interestexpense associated with the borrowing capacity created by the project.Note,the incremental“net profit”is not accounting profit but rather net cash actually available for shareholders.Equation 18.2c cancels outthe after-ta
8、x interest term in 18.2a,yielding a simpler formula.Equation 18.2d shows that the first termin 18.2c is generally called after-tax net operating income.Equation 18.2e yields yet a computationallysimpler formula by combining the depreciation terms of 18.2c.Equation 18.2f shows that the first term in1
9、8.2e is generally referred to as after-tax operating cash flow.5.What makes the APV capital budgeting framework useful for analyzing foreign capital expenditures?Answer:The APV framework is a value-additivity technique.Because international projects frequentlyhave cash flows not encountered in domes
10、tic projects,the APV technique easily allows the analyst to addterms to the model that represent the special cash flows.6.Relate the concept of lost sales to the definition of incremental cash flow.Answer:When a new capital project is undertaken it may compete with an existing project(s),causingthe
11、old project(s)to experience a loss in sales revenue.From an incremental cash flow standpoint,thenew projects incremental revenue is the total sales revenue associated with the new project minus the lostsales revenue from the old project(s).7.What problems can enter into the capital budgeting analysi
12、s if project debt is evaluated instead of theborrowing capacity created by the project?Answer:If project debt is greater(less)than the borrowing capacity created by the capital project,andtax shields on the actual new debt are used in the analysis,the APV will be overstated(understated)making the pr
13、oject unjustly appear more(less)attractive than it actually is.8.What is the nature of a concessionary loan and how is it handled in the APV model?Answer:A concessionary loan is a loan offered by a governmental body at below the normal market rateof interest as an enticement for a firm to make a cap
14、ital investment that will economically benefit thelender.The benefit to the MNC is the difference between the face value of the concessionary loanconverted into the home currency and the present value of the similarly converted concessionary loanpayments discounted at the MNCs normal domestic borrow
15、ing rate.The loan payments will yield apresent value less than the face amount of the concessionary loan when they are discounted at the highernormal rate.This difference represents a subsidy the host country is willing to extend to the MNC if theinvestment is made.The benefit to the MNC of the conc
16、essionary loan is handled in the APV model via aseparate term.9.What is the intuition of discounting the various cash flows in the APV model at specific discount rates?Answer:The APV model is a value-additivity technique where total value is determined by the sum ofthe present values of the individu
17、al cash inflows and outflows.Each cash flow will not necessarily havethe same amount of risk associated with it.To account for risk differences in the analysis,each cash flowis discounted at a rate commensurate with the inherent riskiness of the cash flow.10.In the Modigliani-Miller equation,why is
18、the market value of the levered firm greater than themarket value of an equivalent unlevered firm?Answer:The levered firm has a greater market value because less money is taken from the firm by thegovernment in taxes due to tax-deductible interest payments.Thus,there is more cash left for investorgr
19、oups than when the firm is financed with all-equity funds.11.Discuss the difference between performing the capital budgeting analysis from the parent firmsperspective as opposed to the project perspective.Answer:The goal of the financial manager of the parent firm is to maximize its shareholders wea
20、lth.Acapital project of a subsidiary of the parent may have a positive NPV(or APV)from the subsidiarysperspective yet have a negative NPV(or APV)from the parents perspective if certain cash flows cannotbe repatriated to the parent because of remittance restrictions by the host country,or if the home
21、 currencyis expected to appreciate substantially over the life of the project,yielding unattractive cash flows whenconverted into the home currency of the parent.Additionally,a higher tax rate in the home country maycause the project to be unprofitable from the parents perspective.Any of these reaso
22、ns could result inthe project being unattractive to the parent and the parents stockholders.12.Define the concept of a real option.Discuss some of the various real options a firm can be confrontedwith when investing in real projects.Answer:A positive APV project is accepted under the assumption that
23、 all future operating decisions willbe optimal.The firms management does not know at the inception date of a project what futuredecisions it will be confronted with because all information concerning the project has not yet beenlearned.Consequently,the firms management has alternative paths,or optio
24、ns,that it can take as newinformation is discovered.The application of options pricing theory to the evaluation of investmentoptions in real projects is known as real options.The firm is confronted with many possible real options over the life of a capital asset.Forexample,the firm may have a timing
25、 option as when to make the investment;it may have a growth optionto increase the scale of the investment;it may have a suspension option to temporarily cease production;and,it may have an abandonment option to quit the investment early.13.Discuss the circumstances under which the capital expenditur
26、e of a foreign subsidiary might have apositive NPV in local currency terms but be unprofitable from the parent firms perspective.Answer:The project NPV might be negativefrom the parent firms perspective when it is positive inlocal currency terms if all foreign cash flows cannot be legally repatriate
27、d to the parent firm.Additionally,if the PPP assumption does not hold,such that the actual future real exchange rate hasdepreciated in foreign currency terms,the after-tax cash flows will yield less units of home currency fromthe parent firms perspective than expected,possibly resulting in a negativ
28、e NPV.PROBLEMS1.The Alpha Company plans to establish a subsidiary in Hungary to manufacture and sell fashionwristwatches.Alpha has total assets of$70 million,of which$45 million is equity financed.Theremainder is financed with debt.Alpha considered its current capital structure optimal.The construct
29、ioncost of the Hungarian facility in forints is estimated at HUF2,400,000,000,of which HUF1,800,000,000 isto be financed at a below-market borrowing rate arranged by the Hungarian government.Alpha wonderswhat amount of debt it should use in calculating the tax shields on interest payments in its cap
30、italbudgeting analysis.Can you offer assistance?Solution:The Alpha Company has an optimal debt ratio of .357(=$25 million debt/$70 million assets)or 35.7%.The project debt ratio is.75(=HUF1,800/HUF2,400)or 75%.Alpha will overstate the taxshield on interest payments if it uses the 75%figure because t
31、he proposed project will only increaseborrowing capacity by HUF856,800,000(=HUF2,400,000,000 x.357).2.The current spot exchange rate is HUF250/$1.00.Long-run inflation in Hungary is estimated at 10percent annually and 3 percent in the United States.If PPP is expected to hold between the two countrie
32、s,what spot exchange should one forecast five years into the future?Solution:HUF250(1+.10)5/(1+.03)5=HUF347.31/$1.00.3.The Beta Corporation has an optimal debt ratio of 40 percent.Its cost of equity capital is 12 percentand its before-tax borrowing rate is 8 percent.Given a marginal tax rate of 35 p
33、ercent,calculate(a)theweighted-average cost of capital,and(b)the cost of equity for an equivalent all-equity financed firm.Solution:(a)(b)4.Zeda,Inc.,a U.S.MNC,is considering making a fixed direct investment in Denmark.The Danishgovernment has offered Zeda a concessionary loan of DKK15,000,000 at a
34、rate of 4 percent per annum.The normal borrowing rate is 6 percent in dollars and 5.5 percent in Danish krone.The loan scheduleK =(1-.40).12+(.40).08(1-.35)A weighted-average cost of capital of 9.28%for a levered firm implies:=.0928 or 9.28%K =.0928=Ku(1-(.35)(.40).Solving for Ku yields.1079 or 10.7
35、9%.calls for the principal to be repaid in three equal annual installments.What is the present value of thebenefit of the concessionary loan?The current spot rate is DKK5.60/$1.00 and the expected inflation rateis 3%in the U.S.and 2.5%in Denmark.Solution:Year(t)123The dollar value of the concessiona
36、ry loan is$2,678,574=DKK15,000,000 5.60.The dollar presentvalue of the concessionary loan payments is$2,605,366.Therefore,the present value of the benefit of theconcessionary loan is$73,208=$2,678,574 2,605,366.5.Suppose that in the illustrated mini case in the chapter the APV for Centralia had been
37、-$60,000.Howlarge would the after-tax terminal value of the project need to be before the APV would be positive andCentralia would accept the project?Solution:Centralia should not go ahead with its plans to build a manufacturing plant in the Spain unlessthe terminal value is likely to be large enoug
38、h to yield a positive APV.The terminal value of the projectmust be$299,010 in order for the APV to equal zero.This is calculated as follows.SetSTTVT/(1+Kud)T=$60,000.This impliesTVT=($60,000/ST)(1+Kud)T =($60,000/.7261)(1.11)8=190,431.6.With regards to the Centralia illustrated mini case in the chap
39、ter,how would the APV change if:a.The forecast ofdand/orf are incorrect?St(a)5.575.555.52PrincipalPayment(b)DKK5,000,0005,000,0005,000,00015,000,000It(c)DKK600,000400,000200,000StLPt(a)x(b+c)1,005,386972,973942,029StLPt/(1+id)t948,477865,943790,9462,605,366Answer:A larger or smallerd will not have a
40、ny effect because a change will affect the numerator anddenominator of each APV term in an offsetting manner.Note that imbedded in each domestic discountrate is the inflation premiumd.A larger(smaller)f,however,will decrease(increase)the project APVbecause the foreign currency received will buy less
41、(more)parent country currency upon repatriation.b.Deprecation cash flows are discounted atKudinstead of id?Answer:The APV would be less favorable becauseKudis a larger discount rate than id.c.The host country did not provide the concessionary loan?Answer:The APV would be less favorable because the p
42、roject would have to cover a higher financecharge,i.e.,there would be no benefit received from below market financing.MINI CASE ONE:DORCHESTER,LTD.Dorchester Ltd.,is an old-line confectioner specializing in high-quality chocolates.Through itsfacilities in the United Kingdom,Dorchester manufactures c
43、andies that it sells throughout WesternEurope and North America(United States and Canada).With its current manufacturing facilities,Dorchester has been unable to supply the U.S.market with more than 225,000 pounds of candy per year.This supply has allowed its sales affiliate,located in Boston,to be
44、able to penetrate the U.S.market nofarther west than St.Louis and only as far south as Atlanta.Dorchester believes that a separatemanufacturing facility located in the United States would allow it to supply the entire U.S.market andCanada(which presently accounts for 65,000 pounds per year).Dorchest
45、er currently estimates initialdemand in the North American market at 390,000 pounds,with growth at a 5 percent annual rate.Aseparate manufacturing facility would,obviously,free up the amount currently shipped to the UnitedStates and Canada.But Dorchester believes that this is only a short-run proble
46、m.They believe theeconomic development taking place in Eastern Europe will allow it to sell there the full amount presentlyshipped to North America within a period of five years.Dorchester presently realizes 3.00 per pound on its North American exports.Once the U.S.manufacturing facility is operatin
47、g,Dorchester expects that it will be able to initially price its product at$7.70 per pound.This price would represent an operating profit of$4.40 per pound.Both sales price andoperating costs are expected to keep track with the U.S.price level;U.S.inflation is forecast at a rate of 3percent for the
48、next several years.In the U.K.,long-run inflation is expected to be in the 4 to 5 percentrange,depending on which economic service one follows.The current spot exchange rate is$1.50/1.00.Dorchester explicitly believes in PPP as the best means to forecast future exchange rates.The manufacturing facil
49、ity is expected to cost$7,000,000.Dorchester plans to finance this amountby a combination of equity capital and debt.The plant will increase Dorchesters borrowing capacity by2,000,000,and it plans to borrow only that amount.The local community in which Dorchester hasdecided to build will provide$1,5
50、00,000 of debt financing for a period of seven years at 7.75 percent.The principal is to be repaid in equal installments over the life of the loan.At this point,Dorchester isuncertain whether to raise the remaining debt it desires through a domestic bond issue or a Eurodollarbond issue.It believes i