UNIVERSITY OF ILLINOIS AT CHICAGO

College of Business

FINANCE 442
INTERNATIONAL CORPORATE FINANCIAL MANAGEMENT

FALL 2018

MIDTERM II EXAM

WRITE YOUR NAME BELOW

Instructions
There are 14 questions and 100 points. 10 questions are multiple choice questions worth 4 points each
for a total of 40 points. Please use the provided scantron for your answers. 4 questions are short answers
questions. Answer each of the problems below in the space provided.

You will need only your pens/pencils and your calculator. All other materials must be placed beneath
your seat (and remain there at all times) when you enter the room. All electronic devices must be put
away and may never be used during the test.

1. SHOW YOUR WORK! You must show all your work in a well-organized fashion if you wish
to be considered for any credit at all—partial or full. This applies only to the short answer
questions.
2. Be neat! If I can’t read what you have written, it doesn’t exist.
3. If you run out of space please use the back page.
4. Raise your hand if you have a clarifying question. If I think you are fishing for clues or answers
I’ll respond with “I can’t answer that.”
5. If you feel you need to MAKE an assumption to answer the question, please clearly state the
assumption as part of your answer.
6. Practice smart test taking. Do the easy problems first. Then spend time on the harder ones.
7. If you are caught cheating OR helping a cheater you will get an F for the course at the very least.
 MULTIPLE CHOICE QUESTIONS (10 questions: 40 points)

Choose the one alternative that best completes the statement or answers the question. If the
answer is numerical choose the answer that is closest to yours. Use the provided scantron
forms (4 points each)

The following information is relevant for Questions 1 and 2

Halsted Corp. has a capital structure of 35% debt and 65% equity. Its equity beta is 1.2. The
market risk premium and the risk-free rate are 8% and 3% respectively. Halsted pays 9% interest
on its debt, faces a marginal corporate tax rate of 40% and has an after tax cost of debt of 5.4%.

Question 1

What is Halsted Corp’s cost of capital (WACC)?

A) 9%
B) 10.1%
C) 11.2%
D) 12.6%
E) Not enough information

Question 2

Which of the following is likely to lower Halsted’s cost of capital?

A) More debt
B) Less debt
C) Lower tax rates
D) Higher Beta
E) Not enough information

Question 3

Logitech Inc. is considering building a keyboard factory in Indonesia. It will cost $ 2 billion to
build the factory. It has computed that the NPV is $5378.

A) Logitech should accept the project as the NPV is positive.

B) Logitech should conduct sensitivity analysis to see if the NPV is robustly positive before
accepting the project.
C) As the NPV is small relative to the cost of building the plant, Logitech should conduct
sensitivity analysis to justify rejecting the project.
D) Logitech should accept the project and conduct sensitivity analysis in a year.
E) None of the above

Question 4
An investor purchases a put option on the Euro with a strike price of 1.20 USD/EUR. At the
maturity of the put option the spot price is 1.15 USD/EUR. Which of the following statements
are definitely true?

I. The investor will exercise the put option.

II. The investors profit is 0.05 USD/EUR.
III. Buying the put option was a good idea.
IV. The investor will lose money by exercising the put option

A) I
B) I and II
C) I, II and III
D) IV
E) None of the above

Question 5

You should use a currency option to hedge when,

A) When you want upside gain but downside protection

B) When there is uncertainty about your exposure
C) Both A and B
D) When you have a definite view on the direction of exchange rate movement
E) A, B and D are all correct.

The following information is pertinent for Questions 6 and 7

Consider the following information for the U.S. Market as of September 2007. Assume
dividends grow at a constant growth rate g until the end of time.

S&P 500: 1540

Yield on 3-month Treasury bills: 4%

Question 6

The expected dividend in September 2008 is 31.68. The market risk premium is 8%. What is the
implied growth rate?

A) 5.87%
B) 6%
C) 9.9%
D) 21.9%
E) None of the above
Question 7

The expected growth rate is 3% and the dividend yield (excluding stock buybacks) is 1.87%.
What is the implied cost of capital?

A) 1.87%
B) 4.92%
C) 7%
D) 8.87%
E) None of the above

Question 8

General Motors has significant revenues in Euros. To reduce its exposure to the dollar-euro
exchange rate General Motors wants to borrow in euros. JP Morgan Chase (a US bank) is a
potential counterparty for a swap transaction. The interest rates at which these companies can
borrow in the respective markets are as follows:

Fixed-rate Euro Floating-rate Eurodollar

JP Morgan Chase 6.50% LIBOR+0.25%
General Motors (GM) 7.00% LIBOR+0.25%

Is a swap mutually beneficial to both parties? Assume they have equal bargaining power (i.e.,
they share any profits equally).

A) Yes, after the swap GM pays 6.5% fixed-rate in Euros while Chase pays LIBOR+0.25%
in dollars.
B) Yes, after the swap GM pays 6.75% fixed-rate in Euros while Chase pays LIBOR in
dollars.
C) Yes, after the swap GM pays 7% fixed-rate in Euros while Chase pays LIBOR-0.25% in
dollars.
D) Yes, after the swap GM pays 7.25% fixed-rate in Euros while Chase pays LIBOR in
dollars.
E) No, the swap is not mutually beneficial.
Question 9

In class we discussed Cemex’s plan to build a cement plant in Indonesia. It is important for
Cemex to consider the following factor(s) in computing the project’s NPV,

A) Foreign Exchange Movements

B) Financing
C) Political Risk
D) Cement Prices
E) All of the above

Question 10

Home bias is ________ among US investors, but _______ among investors in other countries.

A) prevalent, rare
B) rare, prevalent
C) rare, also rare
D) prevalent, also prevalent
E) progressive, regressive
 SHORT ANSWER QUESTIONS

Show your work. Partial credit is given if answers are partially correct. Provide your
answers in the space provided.

Question 11 - (9 points)

(a) (3 points) Referring to the following figure, give an argument in favor of hedging foreign
exchange risk.

(b) (3 points) “It is of critical importance to always hedge foreign exchange risk.” Do you
agree? Discuss.

(c) (3 points) In addition, to your answer to (a) give two additional arguments in favor of
hedging favor exchange rate risk.
Question 12 - (20 points) – This question continues onto the next page.

WRX Manufacturing is considering opening a sales outlet in Wisconsin. Startup costs are
$50,000. The sales outlet is expected to generate an extra $25,000 in sales net of costs for each of
the next three years. The startup costs depreciate straight-line over three years. WRX will finance
the project with 50% debt with the remainder being financed by equity. The interest rate on
WRX’s loans is expected to be 7%. WRX has an equity beta of 0.8. WRX expects to sell the
sales outlet for $3000 at the end of year 3. Other potentially relevant information is given below,

K u = return on assets = 10%

K l = return on equity = 15%
τ = Tax rate = 34%
Risk-free rate = 2%

(a) (5 points) To attract WRX Wisconsin agreed to not tax WRX for the life of the project.
Should WRX accept the project? Why or why not? Use the WACC methodology.

(b) (5 points) Does your decision to accept or reject the project change if Wisconsin instead
applies a 34% tax rate? Explain. Again use the WACC methodology.
Question 12 – Continued from the previous page.

(c) (6 points) Repeat (a), but use the APV methodology.

(d) (4 points) Explain the main differences between the WACC and APV methodologies.
Question 13 – (16 points)

Briefly answer the following,

(a) (4 points) When is it appropriate to use the global CAPM versus the domestic CAPM to
estimate the cost of equity?

(b) (4 points) Mention at least one advantage and one disadvantage of using options contracts
relative to futures or forward contracts to hedge foreign exchange exposure.

(c) (4 points) Briefly, how can swap contracts be used to hedge foreign exchange risk?

(d) (4 points) Your firm is going to pay a supplier in Britain in 3 months. You can hedge this
exposure by buying (going long) a put option on the British pound. True or false? Discuss.
Question 14 - (15 points) – This question continues onto the next page

The APV for a foreign project is given by:

T S t OCF t (1−τ ) T S t τD t T S t τI t S T TV T T St LPt

APV =∑ +∑ + ∑ + −S C
0 0 + S 0 RF 0 + S 0 CL 0 − ∑
t=1 ( 1+ K ud )t t
t =1 (1+i d ) t =1 (1+ i d )
t
( 1+ K ud )T t =1 (1+i d )
t

(a) (5 points) Briefly explain each term. In your answer refer to each term as 1 through 8. Focus
on the intuition of how each one contributes to the APV.

(b) (5 points) Yuppy Yup (YY) is a US based firm. YY is considering a two-year foreign project
to build a plant in Germany. The cost of the plant is 10,000 Euros. There is no incremental
depreciation. The current spot rate is 1.1 USD/EUR. The euro is expected to depreciate against
the US dollar by 5% per year. The project is all equity financed. There are no restricted funds.
Given the business risks associated with the project, YY’s unlevered cost of equity is 10% and
its cost of debt is 8%. The applicable tax rate is 30%. The plant is worthless after two years.
Incremental cash flows in year 1 and 2 are 6000 and 7000 Euros respectively.

Using the APV methodology should YY accept or reject the project. Why?
Question 14 - (15 points) – Continued from the previous page.

(c) (5 points) Does this project expose the parent to foreign exchange rate risk? Why? Can option
contracts be used to mitigate this risk? If you think this is the case, explain what would be your
hedging strategy. Include a figure in your answer. This figure does not have to be numerically
accurate. If you think options cannot be used to hedge this exposure, explain why that is.
Extra Page if you need it
 Formula Sheet

Percentage change in the exchange rate:

S ( t+ 1 )−S(t )
ΔS =
S (t )

Mean change in the exchange rate:

m(ΔS )=¿

Standard Deviation of the change in the exchange rate:

σ (Δ S)=√ ¿ ¿

Net Present Value (NPV)

n
C Ft
NPV =∑ −C F 0
t=1 ( 1+ r )t

T CF t TV T
NPV =∑ t
+ −C 0
t=1 ( 1+ K ) ( 1+ K )T

C F t =OC F t ( 1−τ ) +τ Dt

C F t =NO I t (1−t )+ D t

Adjusted Present Value (APV)

( )(
n
OC Ft (1−τ) τ Dt τ It T VT
APV =∑ t
+ t
+ t
+ −C0
t=1 ( 1+ K u ) ( 1+i ) ( 1+i ) 1+ K u )T

T S t OCF t (1−τ ) T T
S t τD tS t τI t S T TV T T St LPt
APV =∑ +∑ + ∑ + −S 0 C 0 + S 0 RF 0 + S 0 CL 0 − ∑
t=1 ( 1+ K ud )t t
t =1 (1+i d ) t =1 (1+ i d )
t
( 1+ K ud )T t =1 (1+i d )
t

Weighted Average Cost of Capital (WACC)

K= ( 1−λ ) K l + λ ( 1−t ) i
Capital Asset Pricing Model (CAPM)

E ( r i ) =r f + βi ¿

Cov(R i , R M )
β i=
Var ( R M )

cov ( R i , R M )
ρi , M =corr ( Ri , R M ) =
σi σ M

E ( r i ) =r f + βi ¿)

Equity Valuation
∞
C Ft
V 0= ∑
t =1 ( 1+ k )t

Dividend Discount model

∞
Dt
V 0= ∑
t =1 ( 1+ k )t

D0
V o=
k

D0 ( 1+ g)
V o=
k−g