Small Business Dilemma Book Answers


Question 1

Small Business Dilemma

Long-Term Financing Decision by the Sports Exports Company

The Sports Exports Company continues to focus on producing footballs in the U.S. and exporting them to the United Kingdom. The exports are denominated in pounds, which has continually exposed the firm to exchange rate risk. It is now considering a new form of expansion where it would sell specialty sporting goods in the U.S. If it pursues this U.S. project, it would need to borrow long-term funds. The dollar-denominated debt has an interest rate that is slightly lower than the pound- denominated debt.

  1. Jim Logan, owner of the Sports Exports Company, needs to determine whether dollar- denominated debt or pound-denominated debt would be most appropriate for financing this expansion, if he does expand. He is leaning toward financing the U.S. project with dollar- denominated debt, since his goal is to avoid exchange rate risk. Is there any reason why he should consider using pound-denominated debt to reduce exchange rate risk?
  2. Assume that Jim decides to finance his proposed U.S. business with dollar-denominated debt if he does implement the U.S. business idea. How could he use a currency swap along with the debt to reduce the firm’s exposure to exchange rate risk?

Question 2

  1. Capital Budgeting Analysis.
    Zistine Co. considers a one-year project in New Zealand so that it can capitalize on its technology. It is risk-averse, but is attracted to the project because of a government guarantee. The project will generate a guaranteed NZ$8 million in revenue, paid by the New Zealand government at the end of the year. The payment by the New Zealand government is also guaranteed by a credible U.S. bank. The cash flows earned on the project will be converted to U.S. dollars and remitted to the parent in one year. The prevailing nominal one- year interest rate in New Zealand is 5% while the nominal one-year interest rate in the U.S. is 9%. Zistine’s chief executive officer believes that the movement in the New Zealand dollar is highly uncertain over the next year, but his best guess is that the change in its value will be in accordance with the international Fisher effect. He also believes that interest rate parity holds. He provides this information to three recent finance graduates that he just hired as managers and asks them for their input.

    1. The first manager states that due to the parity conditions, the feasibility of the project will be the same whether the cash flows are hedged with a forward contract or are not hedged. Is this manager correct? Explain.
    2. The second manager states that the project should not be hedged. Based on the interest rates, the IFE suggests that Zistine Co. will benefit from the future exchange rate movements, so the project will generate a higher NPV if Zistine does not hedge. Is this manager correct? Explain.
    3. The third manager states that the project should be hedged because the forward rate contains a premium, and therefore the forward rate will generate more U.S. dollar cash flows than the expected amount of dollar cash flows if the firm remains unhedged. Is this manager correct? Explain.