International Financial Management FINA 4836 Rauli Susmel Spring 2017 Third Midterm Exam

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Leslie Henderson
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1 International Financial Management FINA 4836 Rauli Susmel Spring 2017 Third Midterm Exam No points will be given by simply writing down formulas, and writing down definitions or irrelevant statements from the book, or saying "yes," will get you zero points. Justify all your answers. If you cannot prove something give some intuition. Good luck. Reminder: this is an open book exam, but no open notes. Time: 1hr 25 minutes. I. Problems (15 points each). 1. Mac Inc., a U.S. firm, plans to invest in a new project that will be located either in Venezuela or in Colombia. Assume the U.S. risk free rate is 3%. You have the following data on expected returns, volatility, correlations, and weights for each project: Mac Venezuela Colombia Expected return 11% 21% 35% Standard deviation 12% 22% 50% Correlation with existing Mac s portfolio Weight on overall portfolio Beta A. Based on the Sharpe Ratio, which project would you recommend to Mac? B. Based on the Treynor Ratio, which project would you recommend to Mac? C. Is Mac, under both criteria, better off without adding any project? A. Colombia E[r BOYD+Col ] = w EP *E[r MAC ] + (1- w EP )*E[r col ] =.85* *.35 = σ 2 MAC+Col = w MAC 2 (σ MAC 2 ) + w Col 2 (σ Col 2 ) + 2 w MAC w Col MAC,Col σ MAC σ Col = (.85) 2 *(.12) 2 + (.15) 2 *(.50) 2 + 2*.85*.15*0.10*.10*.50 = => σ MAC+Col =sqrt( ) SR MAC+Col = E[r MAC+Col - r r ]/ σ MAC+Col = ( )/.1325 = Venezuela E[r MAC+Ven ] =.70 * *.22 =.14 σ MAC+Ven = SR MAC+Ven = ( )/ = > SR MAC+Col B. MAC+Col => Venezuela! = w MAC * MAC + (1- w Col )* Col =.85* *1.40 = TR MAC+Col = E[r MAC+Col - r r ]/ β MAC+Col = ( )/0.975 = MAC+Ven = 0.99 TR MAC+Ven = ( )/.99 = <>TR MAC+Col => Venezuela! C. SR MAC = ( )/.12 =.667 < SR MAC+Col & SR MAC+Ven TR MAC = ( )/.90 =.089 < TR MAC+Col &TR MAC+Ven => No! Mac is not better off without adding any project.

2 2. Dennis Corporation, a U.S.-based MNC, has a subsidiary in Nicaragua that manages coffee fields. The subsidiary believes it could also enter into the sugar export business. The following data has been compiled for the analysis (in cordobas (NIO), Nicaragua s currency): Initial outlay: NIO 80 million Life of the project: 3 years Revenue per year: NIO 45 million Cost of Goods per year: NIO 10 million Depreciation: 10% of initial outlay Salvage value: NIO 10 million Exchange rate: 25 NIO/USD Forecasted exchange rates: E[S t+1 ]=22 NIO/USD; E[S t+2 ]=20 NIO/USD; E[S t+3 ]=18 NIO/USD. The Nicaraguan government imposes a 20% tax on profits. The Nicaraguan government also imposes a 10% withholding tax on funds remitted to the U.S. parent house (including salvage value). The U.S. government imposes a 10% tax on remitted funds, excluding salvage value. There is no tax credit allowed. All the cash flows will be remitted to the parent company. The required rate of return is 12%. i.- What is the evaluation of the project for Dennis Corporation's Nicaraguaan subsidiary? ii.- What is the evaluation of the project for Dennis Corporation? iii. Does Dennis s decision depend on salvage value? (Calculate SV BE ) iv.- Would you recommend the project to Dennis Corporation? i) (in millions) Year 1 Year 2 Year 3 SV Gross Profit NIO 35 NIO 35 NIO 35 Depreciation NIO 8 NIO 8 NIO 8 Earnings Before Taxes NIO 27 NIO 27 NIO 27 Tax (25%) NIO 5.4 NIO 5.4 NIO 5.4 Earnings After Taxes NIO 21.6 NIO 21.6 NIO Depreciation NIO 8 NIO 8 NIO 8 Free Cash Flows (EAF + Dep) NIO 29.6 NIO 29.6 NIO NPV (discount rate=12%) = NIO M < 0 => No! ii) (in millions) Cash Flows in NIO NIO 29.6 NIO 29.6 NIO withholding tax (10%) NIO 2.96 NIO 2.96 NIO 2.96 Net CFs to be remitted NIO NIO NIO US tax (10%) NIO NIO NIO After-tax Net CFs NIO NIO NIO Exchange Rate of NIO USD 1/22 USD 1/20 USD 1/18 USD 1/18 After-tax Net CFs (in USD) USD USD USD USD.3559 NPV (discount rate=12%) = USD M >0 => Yes! iii) Yes! SV BE = USD M (or NIO M). High & close to reported SV by subsidiary. iv) The NPV is small, but positive => Yes; but the dependence on SV is worrisome.

3 3. Charlie Kelly, an Irish design company, wants to refinance debt amounting to USD 200 million. An investment bank suggests issuing a straight bond, with annual coupon payments. The investment bank has the following data available: Irish government bond yields: 4-year 5.75 % (p.a.) U.S. Treasury government bond yield: 4-year 1.85 % (s.a.) German government bond yield: 4-year 2.25 % (s.a.) Kelly Euro-Eur bond yield (outstanding debt): German government bonds bps (s.a.) Given the current tight market conditions, an investment bank suggests: a 5-year full-coupon USD Eurobond and an issue price of 100% (P=100). (1) Following usual market practices, set the coupon and the yield of the new Kelly bond. YTM = risk free rate + spread =.0185 (s.a) (s.a.) =.0530 (s.a.) YTM (p.a.) = ( /2) 2 = => since P=100 => Coupon = YTM = 5.37% (2) A year from now, there is a big debt crisis in Europe. What would the effect of this crisis be on the value of the bond? Briefly explain your logic. CR Europe YTM Europe P bond (3) Two years from now, the Irish government has a budget surplus. What would the effect of this budget surplus be on the value of the bond? Briefly explain your logic. Budget surplus = good news : CR Ireland YTM Irelande P bond (4) Three years from now, Kelly wants to buy back the bond. If the yield to maturity for similar bonds is 8% and S t = 1.20 USD/EUR, how much does Kelly have to pay (in EUR) for the bond buyback? P = /1.08 * USD 200 M *1.20 USD/EUR = EUR M

4 II. CASE (25 points). Note: No points will be given by simply writing lines from the article. Briefly justify your answers. Read the attached Bloomberg article (Arpil 24, 2017) and briefly answer the following questions: 1) According to what you learned in class, why is Fresenius buying Akorn? What kind of additional risks is Bayer taking? * Diversification * Country Risk & FX Risk 2) Assume the USD cost of debt for big U.S. pharmaceutical companies is 100 bps over government riskfree rate, which is 1%. Last month, Fresenius borrowed at 2.25% in the U.S., while Akorn borrowed at 1.90% in the U.S. What would be the cost of debt of the Fresenius s acquisition of Akorn? Briefly justify your answer. k d = 2.25% 3) Does the acquisition of Akorn decrease, stay the same or increase Fresenius s cost of capital? Briefly explain (saying increase or decrease without justification will get you zero points). From the reaction of the stock market, it looks like there is no significant change in k c. (the value of diversification i.e., lower beta- compensates for the increase in the bankruptcy cost).

5 4) You want to determine the cost of capital for Akorn. Use the data from question 2. Akorn has a beta equal to 1.7. The U.S. stock market risk premium is 3.6%, while the German stock market risk premium has an average return of 4.1%. Akorn s U.S. effective tax rate is 20%. D = USD 450 M V = D + E = USD 4.3 B => E = USD 3.85 B k d = k e = x(.036) = k c = D/(E+D) k d (1-t) + E/(E+D) k e = (.450/4.3) x.019 x (.80) + (3.85/4.3) x = (4.76%) 5) Based on past performance, an analyst estimates the long-run rate of return for Akorn is 8.5%, while the rate of return for Fresenius (in EUR) is 6.2%. Assuming the historical rates of returns are a good forecast for future rates of return. By how much does the USD have to change relative to the EUR to make Fresenius s investment in Akorn unattractive? Akorn s expected rate of return (in USD) = 8.5% Fresenius s expected rate of return (in EUR) = 6.2% Let s calculate the Break-even change in S t, using IFE: (1+r f ) x (1+e f,t(be) ) = (1+r d ) e f,t(be) ) = (1+r d )/ (1+r f ) 1 = 1.062/ = (2.12% appreciation of the EUR against USD). => The EUR has to appreciate by more than 2.12% a year to make the Akorn acquisition unattractive.

International Financial Management FINA 4836 Rauli Susmel Fall 2012 Third Midterm Exam

International Financial Management FINA 4836 Rauli Susmel Fall 2012 Third Midterm Exam No points will be given by simply writing down formulas, and writing down definitions or irrelevant statements from