International Finance Question Paper

International Finance

Institution: Kabarak University question papers

Exam Year:2010

COURSE CODE: FNCE 425
COURSE TITLE: INTERNATIONAL FINANCE
STREAM: Y4S2

INSTRUCTIONS:
i. The paper contains FOUR questions
ii. Answer ALL the questions
iii. All the questions carry EQUAL marks
iv. Marks are allocated at the end of each question

QUESTION ONE
(a) Explain some methods of reducing exposure to existing country risk, while maintaining the
same amount of business within a particular country. (5 marks)

(b) When NYU Corp. considered establishing a subsidiary in Zenland; it performed a country
risk analysis to help make the decision. It first retrieved a country risk analysis performed
about one year earlier, when it had planned to begin a major exporting business to Zenland
farms. Then it updated the analysis by incorporating all current information on the key
variables that were used in that analysis, such as Zenland’s willingness to accept exports, its
existing quotas, and existing tariff laws. Is this country risk analysis adequate? Explain.
(6 marks)

(c) What are the benefits of international investment for two main parties involved, the
Multinational Corporation (MNC) and the host country? (4 marks)

(d) Write short explanatory notes on each of the following financial derivatives:
i. Forward contracts, (4 marks)
ii. Future contracts, (4 marks)
iii. Interest rate swaps (2 marks)

QUESTION TWO:
Wolverine Corp. currently has no existing business in New Zealand but is considering
establishing a subsidiary there. The following information has been gathered to assess this
project:
• The initial investment required is

$50 million in New Zealand dollars (NZ$ ). Given the
existing spot rate of

$.50 per New Zealand dollar, the initial investment in U.S. dollars is$ 25 million. In addition to the NZ

$50 million initial investment for plant and equipment, NZ$ 20 million is needed for working capital and will be borrowed by the subsidiary from
a New Zealand bank. The New Zealand subsidiary will pay interest only on the loan each
year, at an interest rate of 14 percent. The loan principal is to be paid in 10 years.
• The project will be terminated at the end of year 3, when the subsidiary will be sold.
• The price, demand, and variable cost of the product in New Zealand are as follows:

Year Price Demand Variable Cost
1 NZ

$500 40,000 units NZ$ 30
2 NZ

$511 50,000 units NZ$ 35
3 NZ

$530 60,000 units NZ$ 40

• The fixed costs, such as overhead expenses, are estimated to be NZ

$6 million per year. • The exchange rate of the New Zealand dollar is expected to be$ .52 at the end of Year 1,

$.54 at the end of Year 2, and$ .56 at the end of Year 3.
• The New Zealand government will impose an income tax of 30 percent on income. In
addition, it will impose a withholding tax of 10 percent on earnings remitted by the
subsidiary. The U.S. government will allow a tax credit on the remitted earnings and will
not impose any additional taxes.
• All cash flows received by the subsidiary are to be sent to the parent at the end of each

year. The subsidiary will use its working capital to support ongoing operations.
• The plant and equipment are depreciated over 10 years using the straight-line depreciation
method. Since the plant and equipment are initially valued at NZ

$50 million, the annual depreciation expense is NZ$ 5 million.
• In three years, the subsidiary is to be sold. Wolverine plans to let the acquiring firm
assume the existing New Zealand loan. The working capital will not be liquidated but will
be used by the acquiring firm when it sells the subsidiary. Wolverine expects to receive
NZ

$52 million after subtracting capital gains taxes. Assume that this amount is not subject to a withholding tax. • Wolverine requires a 20 percent rate of return on this project. Required: a. Determine the net present value of this project. Should Wolverine accept this project? b. Assume that Wolverine is also considering an alternative financing arrangement, in which the parent would invest an additional$ 10 million to cover the working capital
requirements so that the subsidiary would avoid the New Zealand loan. If this
arrangement is used, the selling price of the subsidiary (after subtracting any capital gains
taxes) is expected to be NZ

$18 million higher. Is this alternative financing arrangement more feasible for the parent than the original proposal? Explain. (25 marks) QUESTION THREE: (a) Discuss why international diversification reduces portfolio risk. (4 marks) (b) Some investors believe that investing internationally introduces additional risks. Explain those risks and how they affect the investor’s returns. (4 marks) (c) The following are the expected interest rates and inflation rates in Canada and Britain over the next six months: Country Interest rate Inflation rate Canada 9% 4% Britain 7% 2% The current exchange rate between Canadian dollar (C$ ) and the British pound (£) is 2C

$= 1£. Required: Determine the six months forward exchange rate between the two currencies in using the following approaches: i. Interest rate parity (IRP) approach, (5 marks) ii. Purchasing Power Parity (PPP) approach (5 marks) (d) Sonko Ltd is a company based in Kenya, where the currency is Shilling (Sh). The company imported 13000 watches from India where the currency is Rupee (R). Each watch cost 1,800 Rupees. A three month credit period was extended to the company. The following additional information is available: i. The three month interest rate in India for investing purposes is 3% ii. The three month interest rate in Kenya for borrowing purposes is 4% iii. The relevant exchange rates are: Rupee Kenya Spot rate 1 2.890 3 month forward 1 2.995 The shilling is expected to depreciate against the Rupee at the rate of 24% per annum Required: i. Determine the amount Sonko Ltd would pay in Kenya shillings without hedging, (1 mark) ii. Show how Sonko Ltd can hedge against the exchange rate risk through a forward contract and through a money market hedge (6 marks) QUESTION FOUR: (a) Briefly explain four types of restrictions faced by multinational corporations (MNCs) when investing in a foreign market (8 marks) (b) Outline three reasons why a government may intervene in the foreign exchange market (6 marks) (c) Pembeni Ltd is a Kenyan multinational corporation with obligations denominated in US dollars. The finance manager is interested in forecasting the exchange rate between the Kenya shillings (Ksh.) and the USA dollar (US$ ). He believes that the interest rate differential can be
used in a linear regression function as follows:

Y = a + bx; where: Y is the direct quote.
X = is the interest rate differential.
a = and b are constants.

The following historical data have been collected for the last seven months of the year 2009.
Month Interest rate differential Direct quote (Ksh/US$)
June 10 74
July 13 77
August 9 70
September 15 80
October 16 79
November 11 78
December 10 77

Required:
i. Determine the forecasting equation using the cost squares method. (4mks)
ii. Compute the direct quote for a period when the interest rate is 19% in Kenya and 6% in
the USA (3mks)
iii. Using the coefficient of determination (r2
), explain the reliability of the function
established in (i) above. (4mks)

International Finance Question Paper

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