Chapter 10: Questions and Applications

1. Transaction versus Economic Exposure

Question: Compare and contrast transaction exposure and economic exposure. Why would an
MNC consider examining only its “net” cash flows in each currency when assessing its
transaction exposure?

Answer:

 Transaction Exposure: This is the risk faced by a multinational corporation (MNC) due
to exchange rate fluctuations impacting the value of specific, short-term financial
obligations, such as accounts receivable or payable, denominated in foreign currencies. It
occurs between the time a transaction is agreed upon and when it is settled. For example,
a U.S. firm selling goods to a European customer for €1 million, with payment due in 90
days, faces transaction exposure if the euro weakens against the dollar, reducing the USD
value of the payment. This exposure is typically short-term (within a year) and tied to
specific, contracted cash flows, making it measurable and hedgeable through financial
instruments like forward contracts.
 Economic Exposure: This is a broader, long-term risk that exchange rate fluctuations
pose to an MNC’s overall market value, competitiveness, and future cash flows. It
encompasses the impact of currency movements on a firm’s pricing, sales volume, and
operational profitability across markets. For instance, if the euro weakens, a U.S. firm’s
products may become more expensive in Europe, potentially reducing demand and
market share compared to local competitors. Economic exposure affects not only
immediate cash flows but also the long-term strategic position, asset values, and future
revenue streams, making it harder to quantify and hedge.
 Why Examine Net Cash Flows?: An MNC focuses on “net” cash flows (inflows minus
outflows) in each currency to assess transaction exposure because this isolates the actual
exposure to exchange rate fluctuations. If inflows and outflows in a currency are closely
balanced, the net exposure is minimal, reducing the need for costly hedging. For
example, if an MNC has €10 million in receivables and €9 million in payables, the net
exposure is only €1 million, allowing targeted hedging of this smaller amount. This
approach avoids over-hedging, minimizes costs, and helps prioritize currencies with
significant net imbalances for efficient risk management.

2. Assessing Transaction Exposure

Question: Your employer, a large MNC, has asked you to assess its transaction exposure. Its
projected cash flows are as follows for the next year: Danish krone inflows equal DK50,000,000,
while outflows equal DK40,000,000; British pound inflows equal £2,000,000, while outflows
equal £1,000,000. The spot rate of the krone is $0.15, and the spot rate of the pound is $1.50.
Assume that the movements in the Danish krone and the British pound are highly correlated.
Provide your assessment of your firm’s degree of transaction exposure (that is, whether the
exposure is high or low). Substantiate your answer.

Answer:

 Given Data:
o Danish Krone (DKK): Inflows = DK50,000,000; Outflows = DK40,000,000;
Spot rate = $0.15.
o British Pound (GBP): Inflows = £2,000,000; Outflows = £1,000,000; Spot rate =
$1.50.
o Currencies are highly correlated.
 Calculations:
o DKK Net Exposure: DK50M – DK40M = DK10M.
 USD Value: DK10M × $0.15 = $1,500,000.
o GBP Net Exposure: £2M – £1M = £1M.
 USD Value: £1M × $1.50 = $1,500,000.
o Total Net Exposure in USD: $1.5M (DKK) + $1.5M (GBP) = $3,000,000.
 Assessment: The firm faces moderate-to-high transaction exposure. The net long
position in DKK (DK10M, $1.5M) and GBP (£1M, $1.5M) totals $3M in USD, meaning
the firm benefits if these currencies appreciate but risks losses if they depreciate. The
high correlation between DKK and GBP amplifies this risk, as a simultaneous
depreciation (e.g., due to a European economic downturn) could significantly reduce the
USD value. For example, a 10% depreciation (DKK to $0.135, GBP to $1.35) reduces
the total value to $2.7M ($1.35M DKK + $1.35M GBP), a $300,000 loss. The significant
net exposure and currency correlation suggest a moderate-to-high risk level, warranting
hedging strategies like forward contracts or options to lock in current rates and mitigate
potential losses.

3. Factors That Affect a Firm’s Transaction Exposure

Question: What factors affect a firm’s degree of transaction exposure in a particular currency?
For each factor, explain the desirable characteristics that would reduce transaction exposure.

Answer:
Several factors influence an MNC’s transaction exposure in a specific currency, with desirable
characteristics to minimize risk:

1. Volume of Foreign Currency Transactions: Larger transaction volumes amplify

exposure, as exchange rate changes have a greater financial impact. Desirable
Characteristic: Reduce the proportion of foreign currency transactions relative to total
operations, minimizing the impact of rate fluctuations on overall cash flows.
2. Currency Volatility: Currencies with high volatility (e.g., emerging market currencies
like the Brazilian real) increase exposure due to unpredictable rate swings. Desirable
Characteristic: Operate in stable currencies (e.g., USD, EUR, JPY) to limit exposure to
significant fluctuations.
 3. Time Horizon: Longer periods between transaction agreement and settlement increase
exposure, as there is more time for exchange rates to change. Desirable Characteristic:
Negotiate shorter settlement periods or use immediate payment terms to reduce the
window for rate fluctuations.
4. Hedging Practices: Lack of hedging leaves exposure unmitigated, increasing risk.
Desirable Characteristic: Actively use financial instruments like forward contracts,
futures, or options to lock in exchange rates, stabilizing cash flows.
5. Operational Flexibility: Limited ability to adjust sourcing, pricing, or operations
increases vulnerability to rate changes. Desirable Characteristic: Implement natural
hedging by matching inflows and outflows in the same currency (e.g., EUR revenues
with EUR costs) or shift operations to regions with favorable currency dynamics.

By addressing these factors, an MNC can strategically reduce transaction exposure, balancing
operational efficiency with financial stability.

8. Measuring Economic Exposure

Question: Memphis Co. hires you as a consultant to assess its degree of economic exposure to
exchange rate fluctuations. How would you handle this task? Be specific.

Answer:
To assess Memphis Co.’s economic exposure to exchange rate fluctuations, a comprehensive and
systematic approach is required to quantify and mitigate long-term risks:

1. Identify Currency-Denominated Operations: Map all revenue streams, costs, and

assets denominated in foreign currencies across Memphis Co.’s global operations. This
includes sales in foreign markets, material purchases, labor costs, and investments in
subsidiaries, identifying key currencies like EUR, JPY, or GBP.
2. Quantify Financial Sensitivity: Use financial modeling to estimate how a 1% change in
key exchange rates (e.g., EUR/USD) impacts revenues, costs, and net profits. For
example, calculate the effect of a weaker euro on European sales margins or cost
increases for imported materials.
3. Evaluate Competitive Position: Analyze how rate changes affect Memphis Co.’s
pricing and market share relative to competitors. A stronger USD could make Memphis’s
products less competitive in Europe, reducing demand compared to local firms with euro-
based costs.
4. Regression Analysis: Conduct statistical analysis to correlate historical exchange rate
movements with financial performance metrics (e.g., revenue, EBITDA, or net income).
This quantifies the degree of exposure and identifies which currencies have the most
significant impact.
5. Assess Asset Values: Evaluate how exchange rate shifts affect the USD value of foreign
subsidiaries or fixed assets, using discounted cash flow (DCF) models under different
rate scenarios to estimate changes in net present value.
6. Scenario Analysis: Construct detailed scenarios (e.g., ±5% or ±10% change in key
currencies) to project impacts on cash flows, profitability, and market position. Include
 best-case (currency appreciation), worst-case (depreciation), and expected outcomes to
assess risk ranges.
7. Propose Mitigation Strategies: Recommend operational adjustments, such as sourcing
materials locally to match currency revenues, adjusting pricing strategies to maintain
competitiveness, or relocating production to lower-risk currency zones. Additionally,
suggest financial hedges like forward contracts, currency options, or foreign currency
debt to stabilize cash flows.

Conclusion: Memphis Co.’s economic exposure requires a holistic analysis combining direct
financial impacts (revenues, costs) with indirect effects on competitiveness and asset values. By
integrating quantitative modeling, competitive analysis, and strategic recommendations, the firm
can effectively manage long-term currency risks.

Chapter 11: Questions and Applications

11. Hedging Decision on Payables
Question: Assume the following information: 90-day U.S. interest rate: 4%; 90-day Malaysian
interest rate: 3%; 90-day forward rate of Malaysian ringgit: $0.400; Spot rate of Malaysian
ringgit: $0.404. Assume that the Santa Barbara Co. in the United States will need 300,000 ringgit
in 90 days. It wishes to hedge this payables position. Would it be better off using a forward
hedge or a money market hedge? Substantiate your answer with estimated costs for each type of
hedge.

Answer:

 Given: Santa Barbara Co. needs 300,000 MYR in 90 days. US interest rate: 4%, MYR
interest rate: 3%, Forward rate: $0.400/MYR, Spot rate: $0.404/MYR.
 Forward Hedge:
o Lock in the forward rate to buy 300,000 MYR in 90 days.
o Cost: 300,000 MYR × $0.400 = $120,000.
o Total cost in 90 days: $120,000.
 Money Market Hedge:
o Borrow MYR today to cover the 300,000 MYR payable in 90 days, accounting
for interest.
o Amount to borrow: 300,000 / (1 + 0.03 × 90/360) = 300,000 / 1.0075 =
297,561.51 MYR.
o Convert to USD at spot rate: 297,561.51 MYR × $0.404 = $120,214.67.
o Invest this USD amount at the US rate (4%) for 90 days: $120,214.67 × (1 + 0.04
× 90/360) = $120,214.67 × 1.01 = $121,416.82.
o Total cost in 90 days: $121,416.82.
 Conclusion: The forward hedge costs $120,000, while the money market hedge costs
$121,416.82. The forward hedge is cheaper and simpler to execute, as it avoids
borrowing and investing steps. Therefore, Santa Barbara Co. should use the forward
hedge to minimize costs.
12. Hedging Decision on Receivables
Question: Assume the following information: 180-day U.S. interest rate: 8%; 180-day British
interest rate: 9%; 180-day forward rate of British pound: $1.50; Spot rate of British pound:
$1.48. Assume that Riverside Corp. from the United States will receive 400,000 pounds in 180
days. Would it be better off using a forward hedge or a money market hedge? Substantiate your
answer with estimated revenue for each type of hedge.

Answer:

 Given: Riverside Corp. receives £400,000 in 180 days. US interest rate: 8%, UK interest
rate: 9%, Forward rate: $1.50/GBP, Spot rate: $1.48/GBP.
 Forward Hedge:
o Lock in the forward rate to sell £400,000 in 180 days.
o Revenue: £400,000 × $1.50 = $600,000.
o Total revenue in 180 days: $600,000.
 Money Market Hedge:
o Borrow GBP today to cover the £400,000 receivable in 180 days.
o Amount to borrow: £400,000 / (1 + 0.09 × 180/360) = £400,000 / 1.045 =
382,775.12 GBP.
o Convert to USD at spot rate: 382,775.12 GBP × $1.48 = $566,507.18.
o Invest this USD amount at the US rate (8%) for 180 days: $566,507.18 × (1 +
0.08 × 180/360) = $566,507.18 × 1.04 = $589,167.47.
o Total revenue in 180 days: $589,167.47.
 Conclusion: The forward hedge yields $600,000, while the money market hedge yields
$589,167.47. The forward hedge provides higher revenue and is simpler, avoiding
borrowing and investing complexities. Therefore, Riverside Corp. should use the forward
hedge to maximize revenue.

19. Hedging with Put Options

Question: As treasurer of Tucson Corp. (a U.S. exporter to New Zealand), you must decide how
to hedge (if at all) future receivables of 250,000 New Zealand dollars 90 days from now. Put
options are available for a premium of $0.03 per unit and an exercise price of $0.49 per New
Zealand dollar. The forecasted spot rate of the NZ$ in 90 days follows: $0.44 (30%), $0.40
(50%), $0.38 (20%). Given that you hedge your position with options, create a probability
distribution for U.S. dollars to be received in 90 days.

Answer:

 Given: Tucson Corp. expects 250,000 NZD in 90 days. Put option: $0.03 premium/NZD,
$0.49 exercise price. Forecasted spot rates: $0.44 (30%), $0.40 (50%), $0.38 (20%).
 Calculation:
o Premium Cost: Paid upfront, 250,000 NZD × $0.03 = $7,500 (not deducted from
future receipts, as it’s a sunk cost).
 o Scenarios (put option allows selling NZD at $0.49; exercise in all cases since spot
< $0.49):
 Spot $0.44 (30%): Exercise option, receive 250,000 × $0.49 = $122,500.
 Spot $0.40 (50%): Exercise option, receive 250,000 × $0.49 = $122,500.
 Spot $0.38 (20%): Exercise option, receive 250,000 × $0.49 = $122,500.
o Probability Distribution: $122,500 with 100% probability, as the option is
exercised in all scenarios.
 Conclusion: By hedging with put options, Tucson Corp. guarantees $122,500 in 90 days,
regardless of the future spot rate. This eliminates downside risk from NZD depreciation,
though the upfront premium ($7,500) is a cost incurred today.

Chapter 12: Questions and Applications

6. Hedging Translation Exposure
Question: Explain how a firm can hedge its translation exposure.

Answer:
Translation exposure arises when an MNC converts foreign subsidiaries’ financial statements
(e.g., balance sheets, income statements) into the parent’s currency for reporting purposes,
impacting consolidated earnings due to exchange rate fluctuations. To hedge this exposure, a
firm can use the following strategies:

1. Forward Contracts: Enter contracts to sell or buy the foreign currency at a fixed rate,
locking in the exchange rate for future earnings. For example, a U.S. MNC with a
European subsidiary expecting EUR earnings can sell those EUR forward to fix the USD
value, stabilizing reported profits.
2. Money Market Hedges: Borrow in the foreign currency, convert to the parent’s currency
today, and use future earnings to repay the loan. This offsets translation risk by matching
currency flows at a known rate.
3. Foreign Currency Debt: Issue debt in the subsidiary’s currency (e.g., EUR for a
European subsidiary) to match the currency of assets and liabilities. A weaker EUR
reduces both asset values and debt obligations, minimizing net exposure on the balance
sheet.
4. Currency Options: Purchase put options to sell foreign currency at a favorable rate,
providing flexibility to benefit from favorable rate movements while capping losses from
depreciation.
5. Natural Hedges: Align revenues and expenses in the same currency within the
subsidiary (e.g., EUR sales and EUR costs in Europe). This reduces the net amount
subject to translation, as currency fluctuations affect both sides equally.

These strategies stabilize reported financials, ensuring consistency in consolidated statements

despite exchange rate volatility.
7. Limitations of Hedging Translation Exposure
Question: Bartunek Co. is a U.S.-based MNC that has European subsidiaries and wants to hedge
its translation exposure to fluctuations in the euro’s value. Explain some limitations when this
MNC hedges translation exposure.

Answer:
Hedging translation exposure for Bartunek Co.’s European subsidiaries involves challenges that
limit effectiveness:

1. Inaccurate Earnings Forecasts: Translation hedges rely on predicting subsidiary

earnings in euros. If actual earnings deviate significantly (e.g., due to unexpected sales
changes), the hedge may be misaligned, either over- or under-hedging the exposure,
leading to ineffective risk mitigation.
2. Limited Instrument Availability: Forward contracts or options may not be readily
available or cost-effective for less liquid currencies. While EUR is widely traded,
subsidiaries in smaller markets (e.g., Eastern Europe) may face limited hedging options,
restricting Bartunek’s ability to hedge comprehensively.
3. Hedging Costs: Financial instruments like forwards or options involve costs, such as
premiums, fees, or bid-ask spreads. Frequent or large-scale hedging can erode
profitability, especially if the euro’s movements are minor or favorable, making the
hedge unnecessary in hindsight.
4. Accounting Mismatches: Translation exposure is based on average exchange rates over
a reporting period, while hedge gains/losses (e.g., from forwards) are based on spot vs.
forward rates at specific points. This timing mismatch can lead to accounting distortions,
where hedge gains do not fully offset translation losses in financial statements.
5. Increased Transaction Risk: Hedging translation exposure with forwards may lock in a
rate that becomes unfavorable if the euro appreciates. This creates transaction exposure,
as the firm could have benefited from converting earnings at a better spot rate, resulting
in opportunity costs.

These limitations require Bartunek Co. to carefully balance hedging costs, forecasting accuracy,
and accounting implications to ensure effective risk management.

8. Effective Hedging of Translation Exposure

Question: Would a more established MNC or a less established MNC be better able to
effectively hedge its given level of translation exposure? Why?

Answer:
A more established MNC is better equipped to effectively hedge its translation exposure
compared to a less established MNC due to several advantages:

1. Larger Scale and Resources: Established MNCs have larger, more diversified
operations, enabling them to use multiple hedging instruments (e.g., forwards, options,
 foreign debt) across various currencies. Their scale allows cost-effective hedging, as
fixed costs are spread over larger transaction volumes.
2. Access to Financial Markets: Larger MNCs have established relationships with global
financial institutions, securing better terms for forward contracts, options, or loans. They
can access sophisticated instruments that smaller firms may find costly or unavailable.
3. Risk Management Expertise: Established MNCs typically have dedicated treasury or
risk management teams with deep expertise in currency markets. These teams can design
tailored hedging strategies, optimizing for specific exposure profiles and market
conditions.
4. Financial Stability: Greater capital reserves and cash flow stability allow established
MNCs to absorb hedging costs (e.g., option premiums) without compromising operations,
unlike smaller firms with tighter budgets.
5. Diversified Operations: Operating in multiple countries and currencies provides natural
hedges. For example, losses from euro depreciation may be offset by gains in other
currencies (e.g., JPY or GBP), reducing the need for financial hedges.

In contrast, a less established MNC faces challenges like limited financial resources, less access
to hedging instruments, and lower expertise, making it harder to implement complex or costly
hedges. Their operations are often less diversified, increasing reliance on specific currencies and
amplifying exposure. Therefore, a more established MNC can hedge translation exposure more
effectively due to its scale, access, and expertise.

11. Managing Economic Exposure

Question: St. Paul Co. does business in the United States and New Zealand. In attempting to
assess its economic exposure, it compiled the following information:

 St. Paul’s U.S. sales are somewhat affected by the value of the New Zealand dollar (NZ$)
because it faces competition from New Zealand exporters. It forecasts the U.S. sales
based on the following three exchange rate scenarios:
o NZ$ = $0.48: $100 million
o NZ$ = $0.50: $105 million
o NZ$ = $0.54: $110 million
 Its New Zealand dollar revenues on sales to New Zealand invoiced in New Zealand
dollars are expected to be NZ$600 million.
 Its anticipated cost of materials is estimated at $200 million from the purchase of U.S.
materials and NZ$100 million from the purchase of New Zealand materials.
 Fixed operating expenses are estimated at $30 million.
 Variable operating expenses are estimated at 20 percent of total sales (after including
New Zealand sales, translated to a dollar amount).
 Interest expense is estimated at $20 million on existing U.S. loans, and the company has
no existing New Zealand loans.
Forecast net cash flows for St. Paul Co. under each of the three exchange rate scenarios.
Explain how St. Paul’s net cash flows are affected by possible exchange rate movements.
Explain how it can restructure its operations to reduce the sensitivity of its net cash flows
to exchange rate movements without reducing its volume of business in New Zealand.
Answer:

 Given:
o US Sales: $100M (NZ$0.48), $105M (NZ$0.50), $110M (NZ$0.54).
o NZ Revenue: NZ$600M.
o Costs: US materials $200M, NZ materials NZ$100M.
o Expenses: Fixed $30M, Variable 20% of total sales (US + NZ in USD), Interest
$20M (US loans).
 Net Cash Flow Calculations:
o Scenario 1: NZ$0.48:
 NZ Revenue: NZ$600M × $0.48 = $288M.
 Total Sales: $288M (NZ) + $100M (US) = $388M.
 Variable Expenses: 0.2 × $388M = $77.6M.
 NZ Costs: NZ$100M × $0.48 = $48M.
 Total Costs: $200M (US materials) + $48M (NZ materials) + $77.6M
(variable) + $30M (fixed) + $20M (interest) = $375.6M.
 Net Cash Flow: $388M – $375.6M = $12.4M.
o Scenario 2: NZ$0.50:
 NZ Revenue: NZ$600M × $0.50 = $300M.
 Total Sales: $300M (NZ) + $105M (US) = $405M.
 Variable Expenses: 0.2 × $405M = $81M.
 NZ Costs: NZ$100M × $0.50 = $50M.
 Total Costs: $200M + $50M + $81M + $30M + $20M = $381M.
 Net Cash Flow: $405M – $381M = $24M.
o Scenario 3: NZ$0.54:
 NZ Revenue: NZ$600M × $0.54 = $324M.
 Total Sales: $324M (NZ) + $110M (US) = $434M.
 Variable Expenses: 0.2 × $434M = $86.8M.
 NZ Costs: NZ$100M × $0.54 = $54M.
 Total Costs: $200M + $54M + $86.8M + $30M + $20M = $390.8M.
 Net Cash Flow: $434M – $390.8M = $43.2M.
 Impact of Exchange Rate Movements:
o As the NZD appreciates (from $0.48 to $0.54), net cash flows increase
significantly ($12.4M to $43.2M). This is because NZD revenues (NZ$600M) are
much larger than NZD costs (NZ$100M), so appreciation boosts USD revenue
more than costs. Additionally, US sales rise with NZD appreciation, as NZ
exporters’ products become more expensive, improving St. Paul’s
competitiveness.
o A weaker NZD reduces net cash flows, as NZ revenues translate to fewer USD,
and US sales drop due to cheaper NZ competition.
 Restructure Strategies:
o Increase US Sales Focus: Expand marketing or production in the US to reduce
reliance on NZD-denominated revenues, maintaining NZ sales volume but
diversifying income sources.
o Source US Materials: Shift from NZ materials (NZ$100M) to US suppliers,
reducing NZD-denominated costs and exposure to NZD fluctuations.
 o Currency Matching: Borrow in NZD to match NZD revenues, creating a natural
hedge where loan repayments offset revenue fluctuations.
o Financial Hedges: Use forward contracts or options to lock in favorable NZD
rates, stabilizing USD cash flows without altering NZ operations.

These strategies maintain St. Paul’s NZ business volume while reducing sensitivity to NZD
exchange rate movements.

Chapter 13: Questions and Applications

1. Motives for DFI
Question: 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:
Benefits of Direct Foreign Investment (DFI):

 Revenue-Related Benefits:
1. Attract New Sources of Demand: DFI allows MNCs to tap into growing
markets, especially in emerging economies with rising incomes. Establishing
local operations captures consumer demand directly, avoiding export barriers.
2. Enter Profitable Markets: Markets with low competition or high margins (e.g.,
due to brand loyalty) offer higher profits. Local production can enhance market
penetration and pricing power.
3. Exploit Monopolistic Advantages: MNCs with unique technologies, brands, or
processes can dominate markets where local competitors lack similar capabilities,
securing higher market share.
4. React to Trade Barriers: DFI bypasses tariffs, quotas, or import restrictions by
producing locally, reducing costs and improving market access.
5. Diversify Internationally: Operating in multiple countries with uncorrelated
economies stabilizes cash flows, as downturns in one market may be offset by
growth in others.
 Cost-Related Benefits:
1. Economies of Scale: Local production increases output, spreading fixed costs
over more units, lowering per-unit costs.
2. Use Foreign Factors of Production: Access to cheaper labor, land, or
infrastructure in foreign markets reduces production costs compared to high-cost
home countries.
3. Access Foreign Raw Materials: DFI in resource-rich countries secures materials
at lower costs, avoiding import expenses and supply chain risks.
4. Use Foreign Technology: Adopting advanced local technologies or processes
enhances production efficiency, improving competitiveness.
 5. React to Exchange Rate Movements: Investing in countries with undervalued
currencies can yield higher USD profits when earnings are repatriated after
currency appreciation.

Nike’s Expansion in Latin America:

Nike likely pursued DFI in Latin America for:

 Revenue-Related Motives: The growing middle class and increasing disposable income
in countries like Brazil and Mexico created new demand for athletic footwear, making
Latin America an attractive market for sales growth.
 Cost-Related Motives: Lower labor costs in Latin America compared to developed
markets allowed Nike to produce footwear more cheaply, achieving economies of scale
and reducing overall production costs. Local production also avoided import tariffs,
enhancing cost competitiveness.

2. Impact of a Weak Currency on Feasibility of DFI

Question: Packer, Inc., a U.S. producer of tablet computers, plans to establish a subsidiary in
Mexico in an effort 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’s value are correct, how will this trend affect the feasibility of the
project? Explain.

Answer:

 Impact of a Weakening Peso:

o Initial Investment: A weak peso reduces the USD cost of establishing the
Mexican subsidiary. For example, if MXN 100M is needed for setup, a peso at
$0.05/MXN costs $5M, but at $0.04/MXN, it costs $4M, making the project more
affordable initially.
o Future Cash Flows: A weakening peso reduces the USD value of MXN revenues
when repatriated to the US. For instance, MXN 10M in annual revenue at $0.05
yields $500,000, but at $0.04, it drops to $400,000, lowering profitability.
o Competitive Effects: A weaker peso may make Packer’s tablets more expensive
for Mexican consumers if priced in USD, but local production in MXN could
maintain price competitiveness against imports.
 Feasibility Analysis: The lower initial investment enhances the project’s feasibility by
reducing upfront capital requirements. However, the reduced USD value of future
revenues could challenge long-term profitability, especially if repatriation is a primary
goal. If Packer can leverage local cost savings (e.g., cheaper labor) or expects peso
recovery, the project remains viable. Strategic pricing in MXN or reinvesting profits
locally can further mitigate the impact of a weakening peso.

3. DFI to Achieve Economies of Scale

Question: Bear Co. and Viking, Inc., are automobile manufacturers that desire to benefit from
economies of scale. Bear has decided to establish distributorship subsidiaries in various
countries, whereas Viking has decided to establish manufacturing subsidiaries in various
countries. Which firm is more likely to benefit from economies of scale?

Answer:

 Viking, Inc. (Manufacturing Subsidiaries): Establishing manufacturing subsidiaries

increases production volume, spreading fixed costs (e.g., factory setup, equipment) over
more units. This reduces per-unit production costs, achieving economies of scale. For
example, producing 100,000 cars locally vs. 50,000 reduces average costs, enhancing
profitability.
 Bear Co. (Distributorship Subsidiaries): Distributorships expand market reach and
sales volume but do not directly increase production scale. While they may improve
revenue, they have limited impact on reducing per-unit manufacturing costs, as
production remains centralized.
 Conclusion: Viking is more likely to benefit from economies of scale, as manufacturing
subsidiaries directly lower production costs through increased output, unlike Bear’s
distribution-focused approach.

4. DFI to Reduce Cash Flow Volatility

Question: 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 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
its cash flow volatility once its plans are achieved?

Answer:

 Ram, Inc. (30% in 12 Countries): By diversifying operations across 12 countries in

Europe and Asia, Ram reduces cash flow volatility through exposure to uncorrelated
economies. Economic downturns or currency fluctuations in one country (e.g., Japan)
may be offset by stability or growth in others (e.g., Germany, Singapore). This
geographic and currency diversification minimizes the impact of localized risks.
 Raider Chemical Co. (40% in Canada): Concentrating 40% of business in Canada ties
cash flows to a single economy and currency (CAD). Economic or currency shocks in
Canada (e.g., CAD depreciation) directly impact a large portion of Raider’s cash flows,
increasing volatility.
 Conclusion: Ram, Inc. will more effectively reduce cash flow volatility due to its broader
diversification across multiple uncorrelated markets, compared to Raider’s concentrated
exposure to Canada’s economy and currency.