Chapter 13.3

Question 1

What types of operations do multinational firms have outside of their home countries?

Answer 1

Multinational firms have operations outside of their home countries that range from simple sales offices to large manufacturing operations.

Question 2

How are the operations of multinational firms typically structured across countries?

Answer 2

Most multinational firms set up separate foreign subsidiaries for each country in which they operate.

Question 3

When a multinational firm wants to consider overseas capital projects, what decision does the financial manager face?

Answer 3

The financial manager faces the decision of which capital projects should be accepted on a company-wide basis.

Question 4

What decision-making framework and computational methods apply to international capital projects?

Answer 4

The overall decision-making framework and computational methods developed for domestic capital budgeting in Chapters 10 through 13 apply to international capital projects as well.

Question 5

What is the financial manager’s goal when evaluating domestic and overseas capital projects?

Answer 5

The financial manager’s goal is to seek out domestic and overseas capital projects whose cash flows yield a positive net present value (NPV).

Question 6

What is the effect of accepting international projects with a positive NPV on the firm?

Answer 6

The decision to accept international projects with a positive NPV increases the value of the firm and is consistent with the fundamental goal of financial management, which is to maximize the value of stockholder equity.

Question 7

What two inputs must financial managers estimate when computing the NPV of an overseas capital project?

Answer 7

(1) The project’s incremental after-tax free cash flows and
(2) the appropriate discount rate.

Question 8

Although the same basic principles apply to both international and domestic capital budgeting, what must firms deal with?

Answer 8

Firms must deal with some differences.

Question 9

Why is it often more difficult to estimate the incremental after-tax free cash flows for foreign projects?

Answer 9

Some of the problems stem from the lack of firsthand knowledge by the parent company’s financial staff of procedures and systems used at the overseas operations; other problems arise because of differences in the accounting and legal systems, language, and cultural differences.

Question 10

In what ways can foreign subsidiaries remit cash flows to the parent firm?

Answer 10

(1) Cash dividends
(2) royalty payments or license agreement payments for use of patents or brand names
(3) management fees for services the parent provides to a subsidiary.

Question 11

What can complicate the forecasting of expected cash flows from foreign subsidiaries?

Answer 11

Problems can arise when foreign governments restrict the amount of cash that can be repatriated, or returned to the parent company, and therefore moved out of the country.

Question 12

What are patriation of earnings restrictions?

Answer 12

Re­­­­strictions placed by a foreign government on the amount of cash that can be repatriated, or returned to a parent company by a subsidiary doing business in the foreign country

Question 13

Why may repatriation of earnings restrictions arise?

Answer 13

Because foreign governments are politically sensitive to charges that large multinational companies are exploiting their countries and draining vital investment capital from their economies.

Question 14

What form do repatriation of earnings restrictions usually take?

Answer 14

A ceiling on the amount of cash dividends that a foreign subsidiary can pay to its parent.

Question 15

What is the typical basis for the ceiling imposed by repatriation of earnings restrictions?

Answer 15

The ceiling is typically some percentage of the firm’s net worth and is intended to force the parent to reinvest in the foreign subsidiary.

Question 16

Why can repatriation of project cash flows be a critical issue for the parent firm?

Answer 16

Because there may be significant delays in receiving the funds.

Question 17

From the parent firm’s perspective, what is the relevant cash flow for analysis of foreign capital investment opportunities?

Answer 17

The cash flow that the parent company expects to actually receive from its foreign subsidiary.

Question 18

What is the next issue that financial managers must deal with when evaluating international capital investments?

Answer 18

Foreign exchange rate risk.

Question 19

Why is foreign exchange rate risk a concern when analyzing overseas capital projects?

Answer 19

The cash flows from an overseas capital project will most likely be in a foreign currency that must eventually be converted to the parent company’s home currency.

Question 20

Why can’t analysts use the current spot rate to convert future project cash flows into the parent company’s currency?

Answer 20

Because most of the cash flows from capital projects are future cash flows.

Question 21

What must analysts do in order to convert a project’s future cash flows into another currency?

Answer 21

They must forecast exchange rates.

Question 22

Where can firms secure forecasts for exchange rates?

Answer 22

Forecasts for three or four years into the future can be obtained from most money center banks or from currency specialists on Wall Street.

Question 23

What is a major problem with using currency rate forecasts in capital project analysis?

Answer 23

Many projects have lives of 20 years or more, and it is difficult to forecast exchange rates far into the future.

Question 24

What must financial managers account for when evaluating foreign business activities?

Answer 24

Country risk.

Question 25

How does a relatively unstable political environment affect capital project evaluation?

Answer 25

Management will require a higher rate of return on capital projects as compensation for the additional risk.

Question 26

What is nationalization in the context of country risk?

Answer 26

It is the expropriation, or takeover, of a firm’s plant and equipment by the local government without giving any compensation.

Question 27

What are some ways a foreign government can increase the risk of a foreign project?

Answer 27

Change tax laws in a way that adversely impacts the firm. Impose laws related to labor, wages, and prices that are more restrictive than those applicable to domestic firms. Disallow any remittance of funds from the subsidiary to the parent firm for either a limited time or the duration of the project. Require that the subsidiary be headed by a local citizen or have a local firm as a major equity partner. Impose tariffs and quotas on any imports.

Question 28

How can firms assess the level of country risk?

Answer 28

Some private firms and government agencies rate nations for their relative level of country risk.

Question 29

What U.S. government agencies help provide country risk information to businesses?

Answer 29

The Department of Commerce and the Central Intelligence Agency (CIA).

Question 30

Once management has gauged a capital project's country risk, how can that risk be incorporated into capital budgeting analysis?

Answer 30

One way is to adjust the firm’s discount rate for the additional risk.

Question 31

If a firm’s cost of capital is 8 percent and the additional return required for country risk is 3 percent, what is the appropriate discount rate?

Answer 31

11 percent (8% + 3%)

Question 32

How should unsystematic country risk be reflected in capital budgeting?

Answer 32

Unsystematic risk should be reflected in the expected cash flows, not the discount rate.

Question 33

A U.S.-based manufacturing company is evaluating an overseas capital project in Barcelona, Spain. The expected incremental after-tax free cash flows are –€10.0 million in Year 0 and €3.00 million per year in Years 1 through 4. The current spot rate is $1.20/€, and forecasted exchange rates are $1.25/€, $1.30/€, $1.32/€, and $1.35/€ for Years 1 to 4, respectively. The firm’s cost of capital is 8%, and a 2% country risk premium is added, making the discount rate 10%. What is the NPV of the project in U.S. dollars? Should the project be done?

Answer 33

NPV = –12.00 + (3.75 / 1.10) + (3.90 / 1.10^2) + (3.96 / 1.10^3) + (4.05 / 1.10^4) = 0.38 The project should be accepted because its NPV is positive.