Answers to End of Chapter 12s Questions

1. Baltimore Inc. could reduce its economic exposure by shifting some of its U.S. expenses to Europe. This may involve shifting its sources of materials or even part of its production process to Europe. It could also reduce its European revenue but this is probably not desirable. 3. Albany may ask the Australian government to provide payment in U.S. dollars. Alternatively Albany could attempt to shift some of its expenses to Australia by either purchasing Australian supplies or shifting part of the production process to Australia. These strategies !ill increase Australian dollar outflo!s so that the Australian dollar inflo!s and outflo!s are more balanced. 6. A firm can hedge translation exposure by selling for!ard the currency of the firm"s foreign subsidiary. Thus if the foreign currency depreciates the translation loss !ill be some!hat offset by the gain on the short position created by the for!ard contract. 7. The limitations are as follo!s. #irst Bartunek Inc. needs to forecast its foreign subsidiary earnings and may forecast inaccurately. Thus it !ill hedge against a level of foreign earnings that differs from actual foreign earnings. Second for!ard contracts are not available for all currencies although Bartunek !ill not be affected by this limitation since for!ard contracts in euros are available. Third translation losses are not tax$deductible !hile gains on for!ard contracts used to hedge translation exposure are taxed. #ourth transaction exposure may be increased as a result of hedging translation exposure. 8. This %uestion is intended to stimulate class discussion. There is no perfect ans!er. &ne opinion is that a more established '() can better predict its level of foreign earnings because its foreign business is stabili*ed. Therefore it is more able to hedge the appropriate amount of foreign earnings. 9. )arlton )ompany is sub+ect to a higher degree of economic exposure because it does not have much offsetting cost in 'exico. ,almer Inc. incurs costs in 'exico for its research and development center.

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10. Since (elson )ompany does not have any subsidiaries its exposure to exchange rate fluctuations !ould not be classified as translation exposure. )onversely 'e* )ompany is sub+ect to translation exposure. 11. #orecasted Income Statements for St. ,aul )ompany 4#igures are in millions5 (67 8 7..9 Sales U.S. (e! 6ealand Total )ost of goods sold U.S. (e! 6ealand Total <ross profit &perating expenses U.S.2 #ixed U.S.2 =ariable 4/0> of total sales5 Total Earnings before interest and taxes Interest expense U.S. (e! 6ealand Total Earnings before taxes 7300 (67:00 8 /99 7;99 7/00 (67300 8 .9 7/.9 73.0 (67 8 7..9 7 ;0 ?9 7309 7 ;/ 7 /0 0 7 /0 7 3/ (67 8 7.10 7301 (67:00 8 ;00 7.01 7/00 (67300 8 10 7/10 7311 (67 8 7.10 7 ;0 93 7333 7 .. 7 /0 0 7 /0 7 /. (67 8 7.1. 7330 (67:00 8 ;/. 7.;. 7/00 (67300 8 1. 7/1. 7390 (67 8 7.1. 7 ;0 9? 733? 7 :; 7 /0 0 7 /0 7 .;

(670 8

(670 8

(670 8

The forecasted income statements sho! that St. ,aul )ompany is favorably affected by a strong (e! 6ealand dollar 4since its (67 inflo! payments exceed its (67 outflo! payments5. St. ,aul )ompany could reduce its economic exposure !ithout reducing its (e! 6ealand revenues by shifting expenses from the U.S. to (e! 6ealand. In this !ay its (67 outflo! payments !ould be more similar to its (67 inflo! payments.

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13. )learlake Inc. could consider producing its products !ithin 'exico and selling them locally. It may be able to reduce its costs and no! !ould have some expenses denominated in pesos that offset a portion of the revenue in pesos. Thus its exposure !ould be reduced. A limitation of this strategy is that it may have to close its factory in Texas and lay off its employees if it creates a plant in 'exico. An alternative strategy is that it obtains loans denominated in pesos that it can use to finance its existing operations. Its interest expenses in pesos !ould offset a portion of the peso revenue it receives and !ould therefore reduce exchange rate risk. @o!ever it may have to pay a higher interest rate in 'exico than !hat it pays in the U.S. because interest rates are typically higher in 'exico.

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