MSc IB EXAM July 08IntBus.doc

Calculators may be used in this examination provided that they are not capable of being used to store alphabetical information other than hexadecimal numbers.ANSWER THREE questions; at least ONE from each section.Section AQuestion 1(a)A UK company can borrow $10 million in the USA for one year at an interest rate of 8 per cent. The Financial Times indicates the spot market exchange rate is $2.00/. and the one year forward exchange rate is $1.96/, reflecting lower interest rates in the USA. However, there is a strong belief by the markets that the dollar is likely to continue its depreciation, in particular, against the euro and the yen, over the next year. Assume you are swayed by the preceding market views, and further, you believe the dollars slide will also extend to sterling. You think the exchange rate at the end of the year will be $2.05/.Calculate the effective cost of debt under the assumption that the spot market rate of exchange at the end of the year will be (i) todays forward exchange rate, and (ii) your forecast. (30 marks)(b)If the companys foreign operations are located mainly in the Far East, discuss the risks involved in borrowing money in the USA assuming: (i) the debt raised would be used in the USA.(ii) the debt raised would be used in Europe with no operations in the USA.(iii) the debt raised would be used in the UK with no operations in the USA.(40 marks)(c) Compare and contrast the floating exchange rate system with the fixed exchange rate system.(30 marks) Total Marks 100Question 2 (a)In 2007 it was expected that the inflation rate in the UK would be 3.5 % and in the US would be 2%. The real rate of interest in both countries is 1%. The spot market exchange rate at the beginning of 2007 was $1.90/. Required:(i) Use the Purchasing Power Parity (PPP) to project the expected US$ per 1 at the end of 2007 (the expected future spot rate of one US$ per one British pound).(10 marks) (ii) Use the Fisher relation to estimate the nominal interest rates in the USA and the UK that make it possible for investments in each country to earn the real rate of interest.(10 marks)(iii) Use the Interest Rate Parity (Fisher closed) to estimate the current (January 2007) six month forward rate of US$ per 1.(30 marks)(iv) What can you conclude from your results for parts (i) and (iii)?(15 marks)b)Discuss each of the following:Purchasing Power ParityUncovered interest arbitrage (35marks)Total Marks 100Question 3Tonnix plc imports components from a Japanese supplier. John Smith, the finance director believes the yen will strengthen against sterling and wants to hedge a purchase of components for Y 40,000,000 that has just been made. Payment is due in three months. He has obtained the following quotes from the Financial TimesSpot rate (Yen/) 207.134Three month forward rate (Yen/)204.719 Three months yen interest rate0.98% p.a.Six month UK sterling interest rate5.77% p.a.Tonnix weighted average cost of capital10.00%p.a.Three month call option on yen at Exercise price Yen204/) 4.00% of contract sizeThree month put option on yen at exercise priceYen 204/) 3.00% of contract size(a) Use the exchange rates, Yen200/, Yen204/, and Yen206/ to illustrate possible sterling receipts John Smiths company will receive. Draw a simple diagram to illustrate your results.(10 marks)(b)Use the above data to illustrate the different ways in which a hedge might be carried out. What recommendation would you make to John stating your assumptions and risks if any that might remain with any of your hedges? (60 marks) (c) Discuss the arguments for and against hedging currency exposure.(30 marks)Total marks 100Question 4(a)A US private company is considering building a manufacturing plant in Germany to produce a new product that will be sold in countries whose currency is the euro. The capital required to build the plant is estimated to be 30 million euros. In addition working capital is required which can be estimated according to the following relationship with sales:WC at time t -1 = 0.15 x Sales revenue at time tfor values of t = 1, 2 3, 4.And the change in working capital asChange in WC in year t = WC year t WC year (t-1) All capital will be supplied by the USA company.It is believed that the company can be sold at the end of year 4 sales as a going concern to European investors for 30 million euros.The following information has been collected. Sales revenues in millions are forecasted to be euros 20, 27.5, 32.5 and 35 in years 1, 2, 3, and 4 respectively. Operating expenses are expected to be 50 per cent of the sales revenue and fixed costs to be euros 3 million per year for each year of the four years. Plant depreciation for tax purposes can be taken to be 6 million euros per year.Assume that all of the cash flow generated in a year will be remitted to the US parent. The corporation tax rate in Germany can be taken to be 40 per cent and that of the USA as 30 per cent. You may assume there is no tax on any gains made on the sale of the plant and no withholding tax on dividends.The company requires a 20 per cent return on foreign investments in Europe.The spot exchange rate is $1.275/euro and for the next 4 years the following exchange rates have been estimated using purchasing power parity assuming a US inflation rate of 2.5 per cent and a European rate of 2 per cent Time$/euro 1 1.2813 2 1.2875 3 1.2938 4 1.3000You are required to determine whether the investment is worthwhile from the European perspective and also from the USA parents viewpoint. What recommendations would you make to the company. State the assumptions you have made and any reservations you might have concerning your calculations. (50 marks)(b)Briefly discuss how sensitivity analysis might be used in the above investment appraisal. (25 marks)(c)Briefly discuss the management of political risk subsequent to the investment has been made.(25 marks)Total marks 100Section BQuestion 5“Yen to have a big impact on Toyota” Every Yen 1 rise to the US dollar cuts Toyotas annual operating profits by Yen35 billion ($341 million) said the company.(Financial Times March 8th,2008)(i) Define the three types of currency exposure which a multinational company faces. (20 marks)(ii) Discuss the different ways a company such as Toyota might manage the economic (or competitive) exposure implied in the above article. (80 marks)Total Marks 100Ques