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Applied Financial Management

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Question 1
(a) Define expropriation
The taking of foreign property, with or without compensation, by a government. (b ) When expropriation does occur – how can a company respond? Broadly the company can offer to allow more local involvement in the project, offer to support the local government (legal issues?), work in political opposition to the local government, try to use local (due to sovereign immunity) legal solutions, lobby the firm’s home government or take action through the International Centre for Settlements of Investment Disputes. The last resort is insurance.

2. Impact of a Weak Currency on Feasibility of DFI. Packer, Inc., a U.S. producer of computer disks, plans to establish a subsidiary in Mexico in order to penetrate the Mexican market. Packer’s executives believe that the Mexican peso’s value is relatively strong and will weaken against the dollar over time. If their expectations about the peso value are correct, how will this affect the feasibility of the project? Explain. ANSWER: If the peso’s value is relatively strong now, Packer Inc. will incur high costs of establishing a Mexican subsidiary. In addition, if the peso weakens, future remitted earnings by the subsidiary to the parent will be converted to fewer dollars. Packer will be adversely affected by the exchange rate movements (although the project may still be feasible). 3. DFI to Achieve Economies of Scale. Bear Co. and Viking, Inc., are automobile manufacturers that desire to benefit from economies of scale. Bear Co. has decided to establish distributorship subsidiaries in various countries, while Viking, Inc., has decided to establish manufacturing subsidiaries in various countries. Which firm is more likely to benefit from economies of scale?

ANSWER: Bear Company is likely to benefit because it is maintaining all of its manufacturing in one area. If Viking Inc. spreads its production facilities, it will incur higher fixed costs of machinery.

4. DFI to Reduce Cash Flow Volatility. Raider Chemical Co. and Ram, Inc., had similar intentions to reduce the volatility of their cash flows. Raider implemented a long-range plan to establish 40 percent of its business in Canada. Ram, Inc., implemented a long-range plan to establish 30 percent of its business in Europe and Asia, scattered among 12 different countries. Which company will more effectively reduce cash flow volatility once the plans are achieved?

ANSWER: Ram Inc. would likely be more effective because its international business is spread across several major countries, while Raider Chemical Company is concentrated in only one foreign country whose business cycles are related to the U.S. 5. Impact of Import Restrictions. If the United States imposed long-term restrictions on imports, would the amount of DFI by non-U.S. MNCs in the United States increase, decrease, or be unchanged? Explain.

ANSWER: It would likely increase because the foreign firms would need to replace their exporting business with DFI in order to maintain their business in the U.S. 7. Opportunities in Less Developed Countries. Offer your opinion on why economies of some less developed countries with strict restrictions on international trade and DFI are somewhat independent from economies of other countries. Why would MNCs desire to enter such countries? If these countries relaxed their restrictions, would their economies continue to be independent of other economies? Explain.

ANSWER: Countries that are unrelated to other economies are desirable because business in these countries would not be subject to existing business cycles in other countries. Consequently, an MNC’s overall cash flow may be more stable. However, a typical reason why these countries’ economies are independent of other economies is government restrictions on international trade and DFI. Thus, their economies are insulated from other countries. Yet, this means that while these countries may be desirable to MNCs, they may also be off limits to MNCs. If the governments of these countries loosen restrictions, the MNCs could enter these countries, but the economies of these countries could no longer be as insulated from the rest of the world.

14. Host Government Incentives for DFI. Why would foreign governments provide MNCs with incentives to undertake DFI there?
ANSWER: Foreign governments sometimes expect that DFI will provide needed employment or technology for a country. For these reasons, they may provide incentives to encourage DFI.
1. Forms of Country Risk. List some forms of political risk other than a takeover of a subsidiary by the host government, and briefly elaborate on how each factor can affect the risk to the MNC.

Identify common financial factors for an MNC to consider when assessing country risk. Briefly elaborate on how each factor can affect the risk to the MNC. ANSWER: Forms of political risk include the possibility of (1) blocked funds, (2) changing tax laws, (3) public revolt against the firm, (4) war, and (5) a changing attitude of the host government toward the MNC. The forms of country risk mentioned here can cause reduced demand for the subsidiary’s product, higher taxes, or restrictions of fund transfers. Financial factors include inflation, interest rates, GNP growth, and labor costs. These factors can affect the cost of production or revenues to the subsidiary. 4. Diversifying Away Country Risk. Why do you think that an MNC’s strategy of diversifying projects internationally could achieve low exposure to overall country risk? ANSWER: If the MNC can set up foreign projects in countries whose country risk levels are not highly correlated over time, then it reduces the exposure to the possibility of high country risk in all of these areas simultaneously.

5. Monitoring Country Risk. Once a project is accepted, country risk analysis for the foreign country involved is no longer necessary, assuming that no other proposed projects are being evaluated for that country. Do you agree with this statement? Why or why not? ANSWER: Disagree! The country risk must be monitored continuously, since if risk becomes too high, the MNC should divest its subsidiaries in that country. 6. Country Risk Analysis. If the potential return is high enough, any degree of country risk can be
tolerated. Do you agree with this statement? Why or why not? Do you think that a proper country risk analysis can replace a capital budgeting analysis of a project considered for a foreign country? Explain.

ANSWER: Disagree! If country risk is so high that there is great danger to employees, no expected return is high enough to warrant the project. No. Country risk analysis is not intended to estimate all project cash flows and determine the present value of these cash flows. It is intended to identify forms of country risk and their potential impact. This is important information for capital budgeting but is not a substitute for capital budgeting.

9. Incorporating Country Risk in Capital Budgeting. How could a country risk assessment be used to adjust a project’s required rate of return? How could such an assessment be used instead to adjust a project’s estimated cash flows?

ANSWER: For countries with a lower country risk rating (implying high risk), the project’s required rate of return could be increased (by increasing the discount rate on NPV analysis). To adjust cash flows, consider each key form of country risk and re-estimate cash flows if that form of risk occurs. For example, if the host government may block funds temporarily, estimate the NPV of the project if that occurs. Re-estimate the NPV for any other forms of country risk as well. This process results in a distribution of possible NPVs that can be assessed to determine whether a project should be accepted.

10. Reducing Country Risk. Explain some methods of reducing exposure to existing country risk, while maintaining the same amount of business within a particular country. ANSWER: Some of the more common methods to reduce country risk are: 1. use a short-term horizon

2. hire local labor
3. borrow local funds
4. obtain insurance
5. create joint ventures
These and other methods are discussed in the chapter.
1. Motives for DFI. Describe some potential benefits to an MNC as a result of direct foreign investment (DFI). Elaborate on each type of benefit. Which motives for DFI do you think encouraged Nike to expand its footwear production in Latin America? ANSWER: See the text exhibit in this chapter for a complete summary of the potential benefits.

Regarding Nike’s motives, Latin America offers additional sources of demand, as Latin American consumers have shown an interest in Nike footwear (this is partially due to increased marketing targeted to Latin American markets). Second, Nike may be able to produce their athletic footwear at relatively low costs in some Latin American countries, as the production is labor-intensive and wages are low. Third, Nike may benefit from economies of scale by producing a large amount and exporting the additional shoes for sale to nearby countries. Fourth, the expansion into Latin America allows Nike to further diversify its business internationally.

6. Capitalizing on Low-Cost Labor. Some MNCs establish a manufacturing facility where there is a relatively low cost of labor. Yet, they sometimes close the facility later because the cost advantage dissipates. Why do you think the relative cost advantage of these countries is reduced over time? (Ignore possible exchange rate effects.)

ANSWER: As MNCs capitalize on low cost labor, they may create a strong demand for labor, which can cause labor shortages and increased wage rates, thereby reducing any cost advantage.

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