Test Bank Ch8 3616 Butler

PART IV Managing the Risks of Multinational Operations Chapter 9 The Rationale for Hedging Currency Risk True/False 1. In a perfect fiscal mart, fiscal contracts atomic number 18 zero-NPV investments. autonomic nervous system True. 2. If hedgerow notes risk is to furnish foster to the stakeholders of the unwavering, then hedgerow must(prenominal) impact either pass judgment future funds f smoothhearteds or the speak to of capital or two. autonomic nervous system True. 3. If fiscal marketplaces argon informationally efficient, then in somaticd financial indemnity is irrelevant. ANS False. Dont confuse informational readiness with a perfect market.Although the perfect market delimits ensure informational efficiency, informationally efficient markets skunk be imperfect. 4. Perfect financial markets argon a necessary condition for corporate risk hedging to have value. ANS False. market place imperfections argon necessary conditions. 5. In perfect financial markets, corporate financial polity is irrelevant. ANS True. 6. In a perfect financial market, the law of bingle and only(a) price holds. ANS True. 7. Equal access to perfect financial markets ensures that individualist investors disregard replicate any financial action that the pixilated can take. ANS True. 8.In perfect financial markets, corporate hedging polity has no value. ANS True. 9. In perfect financial markets, corporate investment policy is irrelevant. ANS False. Firm value depends entirely on the trues investments in a perfect financial market. 10. If corporate financial policy is to have value, then at least one of the perfect market assumptions cannot hold. ANS True. 11. Real-world financial markets are perfect markets. ANS False. Perfect markets are a theoretical ideal and not a practical reality. 12. Market imperfections are greater across national boundaries than within national boundaries.ANS True. 13. In perfect financial markets, multinational corporations have a n advant maturate oer interior(prenominal) debaucheds in financing their investments. ANS False. The law of one price holds in perfect financial markets. 14. Multinationals have a comparative advantage everyplace domestic firms in exploiting cross-b pose differences in financial markets. ANS True. 15. Progressive revenue enhancementation is a system in which larger dutiable incomes receive a higher(prenominal) revenue rate. ANS True. 16. impose preference items are goods that are sold on a tax-free soil. ANS False.Tax preference items are items such as tax loss carryforwards and carrybacks and investment tax impute that are used to shield corporate assessable income from taxes. 17. A offer pickax is an option to buy an infralying plus at a predetermined price. ANS True. 18. A bellow option is an option to squall in or demand payment on a loan. ANS False. A call option is an option to buy an underlying asset at a predetermined price. 19. confirmative financial exc ruciation cost are relatively un all important(predicate) for firms selling products for which quality and after-sale service are important.ANS False. Reputation is easily eroded in these instances. 20. Managerial gamesmanship is least overriding during financial regret. ANS False. Gamesmanship is more prevalent during hard times. 21. Option determine plus with an increase in the volatility of the underlying asset. ANS True. 22. A decrease in the variance of firm value is good intelligence for debt and bad news for the truth call option, other things held constant. ANS True. 23. incorporated hedging of business risk unambiguously increases deal outholder wealth when the firm is in financial distress. ANS False.Because debtholders have first claim on corporate assets, corporate hedging of business risk helps debtholders first and whitethorn or may not help rectitudeholders. 24. In the real world, corporate hedging policy can change pass judgment future cash flows but is un likely to reduce the cost of debt. ANS False. Hedging policy can decrease the variability of firm value and can therefore reduce the risk of debt and the required return charged by debtholders. 25. forecast be of financial distress are far more important to corporate hedging decisions than are in bet cost. ANS False.The indirect cost of financial distress influence the activities of firms not just in loser but prior to nonstarter as well. 26. Underinvestment occurs when debtholders refuse to invest additive capital into the firm during financial distress. ANS False. Underinvestment occurs when equity foregoes positive-NPV investments. 27. In financial distress, equity has an inducement to take on large risks in order to increase the value of the equity call option. ANS True. 28. In Miller-Modiglianis perfect world, the firms optimal investment criterion is own all positive-NPV projects. ANS True. 29. In practice, managements objective is to increase shareholder wealth. AN S False. Managers act nominally as equitys agents but, in actuality, in their own best interests. 30. Managers have little incentive to prorogue company-specific risks. ANS False. As undiversified stakeholders, managers are concerned with both systematic and unsystematic risk. 31. Managers have an incentive to hedge their units transaction picture show to currency risk. ANS True. 32. Hedging can increase firm value by cut the be of agency conflicts amidst managers and shareholders.ANS True. 33. Exchange-traded options and futures contracts have a fixed cost per contract so that cost are proportional to the number of contracts traded. ANS True. 34. The costs of hedging by dint of operations are likely to be less burdensome for a large multinational corporation with diversified operations than for a small, less-diversified firm. ANS True. Multiple Choice 1. The perfect market assumptions include separately of the sideline except ____. a. liken access to market prices b. tou ch access to gratuitous information c. frictionless markets d. rational investors e. table political sciences ANS E 2. frictionless financial markets could have which of the following? a. agency costs b. bid-ask spreads c. brokerage fees d. government intervention e. irrational investors ANS E 3. Which risk management guidelines in a) through d) is not recommended by the Group of Thirty Global Derivatives learning Group? a. assess the credit risk arising from derivatives activities b. combine authority over trading and bookkeeping functions into a single department c. quantify market risk under adverse market conditions and perform stress tests d. alue derivatives positions at market e. all of the in a higher place are recommended ANS B 4. Which of a) through d) is unlikely to result in a decision to hedge currency risk? a. bid-ask spreads on foreign exchange b. costs of financial distress c. differential taxes on income from different tax jurisdictions d. stakeholder game-playin g e. all of the above are incentives to hedge ANSA 5. Which of the following factors does not contribute to tax schedule convexity? a. Alternative Minimum Tax (AMT) rules in the coupled States b. progressive taxation c. sales taxes d. ax preference items e. all of the above contribute to tax schedule convexity ANS C 6. Indirect costs of financial distress impact the firm in each of the following ways except ____. a. higher financial costs b. higher legal costs in bankruptcy c. higher operating costs d. begin revenues e. stakeholder gamesmanship ANS B 7. Which of statements a) through c) regarding costs of financial distress is false? a. Both debt and equity unambiguously benefit from corporate risk hedging. b. Hedging can increase expected cash flows by reducing the costs of financial distress. c.Hedging can reduce debtholders required return and hence the cost of capital to the firm. d. All of the above are ANS True. e. none of the above are ANS True. ANS A 8. Which of the follow ing was nearly responsible for the collapse of Barings Bank? a. bankruptcy proceedings b. failure to oversee the activities of its traders c. index arbitrage d. index futures and options trading e. the 1991 fall in share prices on the Tokyo stock exchange ANS B 9. heed has an incentive to hedge which of the following exposures? a. operating exposure b. transaction exposure c. ranslation (accounting) exposure d. all of the above e. none of the above ANS D 10. Tax schedules are said to be progressive when ____. a. the effective tax rate is greater at high levels of taxable income than at low levels b. the effective tax rate is greater at low levels of taxable income than at high levels c. they do not discriminate on the basis of race, creed, or color d. when tax rates vary by the age of the taxpayer e. none of the above ANS A Problems 1. In what way is equity a call option on firm value? Tax schedule convexity progressive taxation 2.Suppose corporate income up to $250,000 is taxed at a rate of 25 percent. Income over $250,000 is taxed at 40 percent. The taxable income of let loose fowl ordain be either $200,000 or $300,000 with equal probability. Quacks income variability arises entirely from an exposure to currency risk. a. leave out a graph like Figure 9. 2 depicting tax schedule convexity in the United States. b. What is Quacks expected tax liability if it does not hedge its currency risk? c. What is Quacks expected tax liability if it is able to completely hedge its currency risk exposure and lock in taxable income of $250,000 with consequence? . In what way does hedging have value for Quack Poultry? Direct and indirect costs of financial distress 3. A firm based in the United Kingdom has promised to pay bring togetherholders ? 10,000 in one year. The firm will be expense either ? 9,000 or ? 19,000 with equal probability at that time depending on the value of the dollar. The firm will be expenditure ? 14,000 if it hedges a amassst currency risk. a . pick out the values of debt and equity under un hedged and hedged scenarios assuming there are no costs of financial distress. b. Suppose the firm will incur direct bankruptcy costs of ? ,000 in bankruptcy. Identify the value of debt and of equity under both unhedged and hedged scenarios. c. In addition to the ? 1,000 direct bankruptcy cost, suppose indirect costs reduce the asset value of the firm to either ? 6,000 or ? 18,000 (before the ? 1,000 direct bankruptcy cost) with equal probability. Hedging results in firm value of ? 12,000 with certainty. Identify the value of debt and of equity under both unhedged and hedged scenarios. d. Can hedging add value to shareholders in this problem? Problem Solutions 1.If the firms assets are worth more than that promised to debtholders, equity will exercise its option to buy the assets of the firm from the debtholders at the exercise price. If firm assets are worth less than the promised claim, equity will not exercise its option and debt assumes admit of the firm. Tax schedule convexity progressive taxation 2. a. pic b. Expected taxes with no hedging (? )($200,000)(0. 25) + (? )($250,000)(0. 25)+($50,000)(0. 40) = (? )($50,000) + (? )($82,500) = $66,250. c. Expected taxes with hedging ($250,000)(0. 5) = $62,500 $66,250. d. Hedging allows Quack to minimize its expected tax liability. This increase in expected future cash flows to equity results in an increase in equity value. 3. a. If firm value is ? 9,000, equity will not exercise its option to buy the firm at a price of ? 10,000. In this case, equity receives nothing and debt receives ? 9,000. If the firm is worth ? 19,000, equity pays the bondholders ? 10,000 and retains the residual ? 9,000. Firm value can be illogical down into EVFIRM = EVBONDS + ESTOCK = (? )(? 9,000)+(? )(? 10,000) + (? )(? 0)+(? (? 9,000) = ? 9,500 + ? 4,500 = ? 14,000. Hedged, firm value can be broken down into VFIRM = VBONDS + VSTOCK = ? 10,000 + ? 14,000 = ? 14,000. In the absence of c osts of financial distress, the decline in the variability of firm value results in a reduction in call option value and a ?500 shift in value from equity to debt. b. Unhedged, firm value is decomposed as EVFIRM = EVBONDS + ESTOCK = (? )(? 9,000 1,000)+(? )(? 10,000) + (? )(? 0)+(? )(? 9,000) = ? 9,000 + ? 4,500 = ? 13,500. With hedging, VFIRM = VBONDS + VSTOCK = ? 10,000 + ? 4,000 = ? 14,000.As in the previous example, the reduction in the variability of firm value is accompanied by a ? 500 transfer of wealth from equity to debt. Hedging also avoids the deadweight ? 1,000 bankruptcy cost and yields an expected gain of (? )(? 1,000) = ? 500. In this example, debt captures the expected gain of ? 500. righteousness will capture some of the gain if hedging results in lower interest payments on the next round of debt. c. Unhedged, firm value is EVFIRM = EVBONDS + ESTOCK = (? )(? 6,000 1,000) + (? )(? 10,000) + (? )(? 0)+(? )(? 8,000) = ? 7,500 + ? 4,000 = ? 11,500.If the firm hedges, then VFIRM = VBONDS + VSTOCK = ? 10,000 + ? 2,000 = ? 12,000. This is the same as b) after including indirect costs of financial distress with an expected value of (? )(? 9,000 6,000)+(? )(? 19,000 18,000) = ? 1,500+? 500 = ? 2,000. d. Hedging can add value to shareholders if they can negotiate lower interest payments on debt because of their hedging policies. Even in financial distress, equity could offer to renegotiate the bond contract to more evenly share the gain in firm value from hedging. In this way, they can share in any gain from reducing the probability and costs of financial distress.