1. 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

2. 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

3. 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.

4. 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?

5. 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?

6. 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.

7. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin 22- 7 Exchange Rate Relationships  Basic Relationships equals

8. 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.

9. 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

10. 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!

11. 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.

12. 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.

13. 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.

14. 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

15. 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

16. 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

17. 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)

18. 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

19. 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.

20. 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

21. 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

22. 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

23. 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