Homework answers

1. You are evaluating the purchase of Charbridge, Inc. common stock which currently pays no dividend and is not expected to do so for
many years. Because of rapidly growing sales and profits, you believe the stock will be worth $51.50 in 3 years. If your required rate of
return is 16%, what is the stock worth today?
Answer: C $32.99
2. Little Feet Shoe Co. just paid a dividend of $1.65 on its common stock. This company's dividends are expected to grow at a constant rate
of 3% indefinitely. If the required rate of return on this stock is 11%, compute the current value of per share of LFS stock.
Answer: B $21.24
3. Acme Consolidated has a return on equity of 12%. If Acme distributes 60% of earnings as dividends, its expected growth rate will be
Answer: A new 4.80%.
4. A firm just paid $2.00 on its common stock and expects to continue paying dividends, which are expected to grow 5% each year, from
now to infinity. If the required rate of return for this stock is 9%, then the value of the stock is
Answer: D $52.50.
5.A share of common stock just paid a dividend of $3.25 per share. The expected long-run growth rate for this stock is 18%. If investors
require a rate of return of 24%, what should the price of the stock be?
Answer: D $63.92
6. Is the following common stock priced correctly? If no, what is the correct price?
Price= $26.25
Required rate of return = 13%
Dividend year 0 = $2.00
Dividend year 1 = $2.10
Answer:
Growth rate = 2.1-2)/2 = 5%
Vcs = 2.10 /(.13 - .05)= $26.25
The stock is priced correctly

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What did we learn last week?

• Stock valuation
• Stock characteristics
• Stock valuation
• Stock expected rate of return

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FINC6001- Financial Management
International business finance
Week 13
Chapter 16

Yanthi Hutagaol
[email protected]

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 Session Learning Outcomes
Upon completion of this session, students are expected to be able to
• Discuss the internationalization of business.
• Explain how to read foreign exchange rate quotes and why they
matter.
• Discuss the concept of interest rate parity.
• Explain the purchasing-power parity theory and the law of one price.
• Discuss the risk that are unique to the capital-budgeting analysis of
direct foreign investment.

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 The Globalization of Product and
Financial Markets
• Direct Foreign Investment (DFI) occurs when a company from one country makes
a physical investment, such building a manufacturing facility, in another country.
A major reason for increase in DFI by U.S. companies is the high rate of return
available in other countries.
• Capital flows (Portfolio Investment) between countries has also been increasing
and is motivated by the possibility of obtaining higher returns and/or reducing
portfolio risk through international diversification.

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FOREIGN EXCHANGE MARKETS AND
CURRENCY EXCHANGE RATES

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 The Foreign Exchange Market
• The foreign exchange (FX) market is by far the world’s largest financial
market, with daily trading volumes of more than $4 trillion.
• Trading in this market is dominated by few key currencies including
the U.S. dollar, the British pound sterling, the Japanese yen, the euro,
and the Renmimbi/Yuan

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 The Foreign Exchange Market
Market
Rank Name share
• The foreign exchange market is an
1  JP Morgan 10.78 %
over-the-counter market with 2  UBS 8.13 %
participants (buyers and sellers) 3  XTX Markets 7.58 %
located in major commercial and 4  Deutsche Bank 7.38 %
investment banks around the world. 5  Citi 5.50 %
6  HSBC 5.33 %
7  Jump Trading 5.23 %
8  Goldman Sachs 4.62 %
9  State Street Corporation 4.61 %
10   4.50 %
Bank of America Merrill L
ynch

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2013

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 Foreign Exchange Market
• Some of the major participants in foreign exchange trading include:
• Importers and exporters of goods and services
• Investors and portfolio managers who purchase foreign stocks and bonds
• Currency traders who make a market in one or more foreign currencies

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 Business Implications
• Exchange rates changed dramatically in 2014 and 2015. Possible reasons include:
• Relative strengthening of U.S. economy
• Expectations of interest rate changes in Europe
• Uncertainty surrounding a possible Greek default
• Plummeting of oil prices
• Exchange rates changed dramatically in 2019 and 2021. Possible reasons include:
• Covid19
• Sanctions during the Ukraine/Russian war
• Climate change
• The use of Yuan between newly formed group of countries (China, Russia, India, Iran)
• The use of home currency among ASEAN country members
• Stronger dollar means U.S. goods become more expensive for foreigners

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 Reading Exchange Rate Quotes
• Exchange rate
• The price of one currency stated in terms of another.
• For example, if the exchange rate of U.S. dollars for euro is 1.37 to 1, this
means that it would take $1.37 to purchase one euro.

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 Reading Exchange Rate Quotes
• Determinants of exchange rates are:
• A country’s relative economic strengths
• Trade balance
• Level of monetary activity
• Balance of payments (BOP)
• Short-term day-to-day fluctuations in exchange rates are caused by
changing supply and demand conditions in the foreign exchange
market.

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 Direct and Indirect Quote
• Direct Quote
• Indicates the number of units of the home currency required to buy one unit
of the foreign currency
• Example: 1.6288 dollars per British pound
• Indirect Quote
• Indicates the number of units of a foreign currency that can be bought for one
unit of the home currency. It is the reciprocal of direct quote.
• Example: 1/1.6288 = 0.6139 pounds per dollar

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 Exchange Rates and Arbitrage
• Foreign exchange quotes in two different countries must be in line
with each other.
• If the exchange rates are out of line, then a trader could make a profit
by buying in the market where the currency was cheaper and selling it
in the other.
• The process of buying and selling in more than one market to make a
riskless profit is called arbitrage. Such opportunities do not exist for a
long time due to arbitrage process.

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 Asked and Bid Rates
• Bid: Rate at which bank buys foreign currency from a customer
• Ask: Rate at which bank sells foreign currency to a customer
• The difference between the asked quote and the bid quote is known
as bid-asked spread.

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 Cross Rates
• A cross rate is the exchange rate between two foreign currencies,
neither of which is the currency of the domestic country.
• Ex: rupiah vs USD in Singapore

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Wherever you are, US$1 = CN$1.241

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 Spot Exchange Rate
• Exchange rates and transactions meant for immediate delivery are
called spot exchange rates.

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 Forward Rate
• A forward exchange contract requires delivery, at a specified future
date, of one currency for a specified amount of another currency.
• The exchange rate for the future is agreed today and is known as the
forward rate. The actual payment of one currency and receipt of
another currency take place on a future date called the delivery date.

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 Forward Contract Example
• Forward contracts are usually quoted for periods of 30, 90, and 180
days.
• If the 30-day forward quote for euros is $1.30, it means that the bank
is contractually bound to deliver a euro at $1.30 and the customer is
bound to buy a euro at $1.30, regardless of the actual spot rate.

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 Exchange Rate Risk
• The EXCHANGE RATE RISK is that tomorrow’s exchange rate will differ
from today’s rate.
• Exchange rate risk affects:
• international trade contracts
• foreign portfolio investments
• direct foreign investment

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 Exchange Rate Risk in International
Trade Contracts
• Example: You are expecting to receive €1m next year from exports.
• The future value of euros in dollars is uncertain and depends on
future exchange rate.
• If € = $1.25, you will receive $1.25m, but if the euro depreciates to
$0.90, your contract is worth only $0.9m.

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 Exchange Rate Risk in Foreign Portfolio
Investments
• The future return on portfolio is unknown as investments in securities
is a risky investment. Thus, investing in euro market securities could
yield –5% or +10%. In addition, investor is exposed to U.S. $/euro
exchange rate fluctuation.
• Thus, if the euro investment yields 10% but the euro depreciates
during the period, the net return will be less than 10%, depending
on the extent of euro depreciation.

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 Exchange Rate Risk in Direct Foreign
Investment
• In a DFI, parent company invests in assets denominated in foreign
currency. The U.S.-based parent company receives the repatriated (or
converted) profit stream from the subsidiary in dollars.
• Thus, exchange rate risk arises due to:
• Fluctuations in the dollar value of the assets located abroad
• Fluctuations in the home currency-denominated profit stream
• Possible effect on future profit stream

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INTEREST RATE PARITY

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 Interest Rate Parity
• IRP theory can be used to relate differences in the interest rates in
two countries to the ratio of spot and forward exchange rates of the
two countries’ currencies. The IRP condition can be stated as follows:

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PURCHASING-POWER PARITY
AND THE LAW OF ONE PRICE

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 Purchasing-Power Parity Theory
(PPP)
• According to PPP, exchange rates adjust so that identical goods cost
the same amount regardless of where in the world they were
purchased.
• For example, if an Apple iPad costs $399 in the U.S. and €353.10 in
France, according to PPP, the spot exchange rate should be $1.13 per
euro ($399/€353.10). Thus, an iPad will cost the same whether it is
bought in the U.S. or France.

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 Law of One Price
• The law one price implies that the same goods should sell for the
same price in different countries after making adjustment for the
exchange rate between the two currencies.
• Thus, if a Big Mac costs $2 in U.S. dollars and the exchange rate with
the British pound is £1 = $2, a Big Mac should cost £1 in the UK.

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 The International
Fisher Effect
• International Fisher Effect states that the real interest rate should be
the same all over the world, with the differences in nominal rate
resulting from differences in expected inflation rates.

• Thus, investing in a foreign bank with the highest interest rate may
simply mean investing in a country with the highest rate of inflation.

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 CAPITAL BUDGETING FOR
DIRECT FOREIGN INVESTMENT

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 Capital Budgeting for DFI
• The method used by multinational corporations to evaluate foreign
investments is very similar to the method used to evaluate domestic
investments. (payback period, net present value, the profitability
index, and the internal rate of return)

• Since there might be repatriation restrictions, evaluations of these

investments must focus on after-tax cash flows that can be
repatriated. Firms may be subject to taxes in both the home country
and foreign country.

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 Foreign Investment Risks
• The decision process for DFI is similar to capital budgeting decisions in the
domestic context.
• Risks in domestic capital budgeting arises from two sources:
• business risk
• financial risk
• In international capital budgeting problem, we also have to incorporate
political risk and exchange rate risk.
• business risk
• financial risk
• Political risk
• Exchange rate risk
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 Political Risk
• Political risk arises because the foreign subsidiary conducts
business in a political system different from that of the home
country.
• Some examples of such risk include:
• Expropriation of assets without compensation (Nationalization)
• Nonconvertibility of the subsidiary’s foreign earnings into the parent’s
currency
• Changes in the laws governing taxation
• Restrictions on sale price, wage rates, local borrowing, extent of local
ownership, hiring of personnel, transfer payments made to the parent

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 Exchange Rate Risk
• As observed before, exchange rate risks can have significant effect on
cash flows and earnings.

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Read Chap 13

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