Chapter 27 MINI CASE: With the growth in demand for exotic foods, Possum Product

Question

Chapter 27 MINI CASE:

With the growth in demand for exotic foods, Possum Products's CEO Michael Munger is considering expanding the geographic footprint of its line of dried and smoked low-fat opossum, ostrich, and venison jerky snack packs. Historically, jerky products have performed well in the southern United States, but there are indications of a growing demand for these unusual delicacies in Europe. Munger recognizes that the expansion carries some risk—Europeans may not be as accepting of opossum jerky as initial research suggests—so the expansion will proceed in steps. The first step will be to set up sales subsidiaries in France and Sweden (the two countries with the highest indicated demand), and the second is to set up a production plant in France with the ultimate goal of product distribution throughout Europe.

Possum Products's CFO, Kevin Uram, although enthusiastic about the plan, is nonetheless concerned about how an international expansion and the additional risk that entails will affect the firm's financial management process. He has asked you, the firm's most recently hired financial analyst, to develop a 1-hour tutorial package that explains the basics of multinational financial management. The tutorial will be presented at the next board of directors meeting. To get you started, Uram has supplied you with the following list of questions. Answer all questions a thur h completely and as accurate as possible please! ASP!

a. What is a multinational corporation? Why do firms expand into other countries?

b. What are the six major factors that distinguish multinational financial management from financial management as practiced by a purely domestic firm?

c. Consider the following illustrative exchange rates.

U.S. Dollars Required to Buy 1 Unit of Foreign Currency

Euro                      1.2500

Swedish krona       0.1481

(1) Are these currency prices direct quotations or indirect quotations?

(2) Calculate the indirect quotations for euros and kronor (the plural of krona is kronor).

(3) What is a cross rate? Calculate the two cross rates between euros and kronor.

(4) Assume Possum Products can produce a package of jerky and ship it to France for $1.75. If the firm wants a 50% markup on the product, what should the jerky sell for in France?

(5) Now assume that Possum Products begins producing the same package of jerky in France. The product costs 2 euros to produce and ship to Sweden, where it can be sold for 20 kronor. What is the dollar profit on the sale?

(6) What is exchange rate risk?

d. Briefly describe the current international monetary system. How does the current system differ from the system that was in place prior to August 1971?

e. What is a convertible currency? What problems arise when a multinational company operates in a country whose currency is not convertible?

f. What is the difference between spot rates and forward rates? When is the forward rate at a premium to the spot rate? At a discount?

g. What is interest rate parity? Currently, you can exchange 1 euro for 1.25 dollars in the 180-day forward market, and the risk-free rate on 180-day securities is 6% in the United States and 4% in France. Does interest rate parity hold? If not, which securities offer the highest expected return?

h. What is purchasing power parity? If a package of jerky costs $2 in the United States and purchasing power parity holds, what should be the price of the jerky package in France?

i. What effect does relative inflation have on interest rates and exchange rates?

j. Briefly discuss the international capital markets.

k. To what extent do average capital structures vary across different countries?

l. Briefly describe special problems that occur in multinational capital budgeting, and describe the process for evaluating a foreign project. Now consider the following project: A U.S. company has the opportunity to lease a manufacturing facility in Japan for 2 years. The company must spend ¥1 billion initially to refurbish the plant. The expected net cash flows from the plant for the next 2 years, in millions, are CF1 = ¥500 and CF2 = ¥800. A similar project in the United States would have a riskadjusted cost of capital of 10%. In the United States, a 1-year government bond pays 2% interest and a 2-year bond pays 2.8%. In Japan, a 1-year bond pays 0.05% and a 2-year bond pays 0.26%. What is the project's NPV?

m. Briefly discuss special factors associated with the following areas of multinational working capital management:

(1) Cash management

(2) Credit management

(3) Inventory management

Answer questions a thur h as completely and accurate as possible please! ASP!

Explanation / Answer

a. A multinational corporation is a company that has its operations spread in more than one country. In other words a multinational company operates in one or more country besides its home country. Firms expand in other countries to seek new markets for their product and service offerings and to diversify.

b. The six major factors are - (i) currency differences - as a multinational firm operates in several countries it has to deal with currency differences and rate fluctuations. (ii) political risk - multinational financial management is exposed to political risk of other countries in which it is operating besides its home country. (iii) government roles - this will determine the rules and regulations in different countries. (iv) economic and legal differences - the differences in the economic and legal environment between the home country and other countries will have to be incorporated in the multinational financial management. (v) language differences - different countries speak different languages and this will have to be incorporated in the multinational financial management. (vi) cultural differences - different countries have different cultures and this will have to be incorporated  in the multinational financial management.

c1. This is a direct quote as quoting is fixed units of foreign currency against variable amounts of the domestic currency.

2. Indirect quote for Euro = 1/direct quote = 1/1.25 = 0.80

Indirect quote for swedish krona = 1/direct quote = 1/0.1481 = 6.7522

3. Cross rate is the exchange rate between two currencies that are based on the currency rate of another country. For example cross rate will be the rate between Currency A and C, that is derived from the actual exchange rate of currency A and B, exchange rate of currency B and C.

cross rate = 6.7522*1.25 = 8.4403 (kronor/euro)

cross rate (euro/krona) = 0.80*0.15 = 0.1185 (euro/krona)

4. cost in USD = $1.75. 50% markup = 50% of 1.75 = $0.875 Selling price = cost+mark up = 1.75+0.875 = $2.625

Now 1 USD = 1/1.25 euros. Thus $2.625 will be = 2.625/1.25 euros = 2.10 euros. This will be the selling price in France.

5. 2 euros = 2*1.25 USD = $2.5. This is cost.

20 kronor = 20*0.1481 USD = $2.9620 . This is selling price.

dollar profit = selling price in $ - cost in $ = 2.9620 - 2.5 = $0.4620

6. Exchange rate risk is the risk of losing money due to changes in the relative value of currencies.

d. The current international monetary system allows the determination of value of foreign currencies on the basis of economic performance of a country and on the basis of market forces. Many countries keeps volatility (in rate fluctuations) in check through open market operations.

Prior to 1971, the currencies of most of the countries was pegged to dollar and dollar was pegged to gold. This was different from the current system of managed floating exchange rate.

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