Suppose The CFO Of An American Corporation With Surpl 096052

Suppose The Cfo Of An American Corporation With Surplus Cash Flow H

Suppose the CFO of an American corporation with surplus cash flow had $50 million to invest last March 20, 2015, and the corporation did not believe it would need to utilize these funds to retool or expand production capacity for 1 year. The interest rate on 1-year CD deposits in US banks was 1%, while the rate on 1-year CD deposits in England (denominated in British Pounds) was 2% at the time. The exchange rate at that time was $1.55 per British pound. A year later, the exchange rate is $1.42 per British pound. What rate of return did the CFO earn on the investment in the British CD? What must the CFO have expected about the value of the British pound in dollars today to believe that investment in 1-year British CDs would be more profitable than investment in US CDs? Also, analyze the potential implications of exchange rate movements and expected currency values on investment decisions.

Paper For Above instruction

The decision-making process of corporate CFOs regarding international investments involves considering not only domestic interest rates but also the potential currency risk and expected exchange rate movements. In the scenario presented, the CFO had $50 million to invest on March 20, 2015, with options to invest either domestically in US bank certificates of deposit (CDs) or abroad in the UK. The key factors influencing this decision include the respective interest rates, initial and future exchange rates, and expectations about currency movements.

Calculating the Rate of Return on the UK Investment

Initially, the investment in a UK bank's one-year CD denominated in British Pounds offered an interest rate of 2%. At the outset, the exchange rate was $1.55 per British pound, meaning that the $50 million investment could purchase approximately 32.26 million British pounds ($50 million / $1.55). After one year, the exchange rate was $1.42 per British pound, meaning that the British Pound depreciated relative to the US dollar.

The total value of the British CD investment after one year depends on the interest earned and the then-current exchange rate. The interest earned in GBP is 2%, so the amount in GBP after one year becomes:

• Initial GBP: 32.26 million
• Interest: 2%, so new GBP amount = 32.26 million * 1.02 ≈ 32.91 million GBP

Converting this back to USD at the new exchange rate ($1.42 per GBP), the total USD value is:

• 32.91 million GBP * $1.42 ≈ $46.77 million

Thus, the CFO's rate of return on the British investment is calculated by comparing the final USD amount to the initial USD investment:

• Initial USD investment: $50 million
• Final USD value: approximately $46.77 million
• Return: ($46.77 million - $50 million) / $50 million ≈ -6.46%

Therefore, the CFO incurred a negative return of roughly 6.46%, primarily due to the depreciation of the British Pound from $1.55 to $1.42.

Expected Future Exchange Rate for Profitability

To determine the exchange rate expectation necessary for the British CD investment to be more profitable than a domestic investment, the CFO would compare the US interest rate to the foreign interest rate, adjusting for expected exchange rate movement. The foreign interest rate was 2%, and the US rate was 1%. According to interest rate parity (IRP), for the foreign investment to be equally or more attractive, the future exchange rate (E) should satisfy:

Estimated return from UK investment ≥ US investment

In mathematical terms:

(E / initial exchange rate) * (1 + foreign interest rate) ≥ (1 + US interest rate)

Plugging in the known values:

(E / 1.55) * 1.02 ≥ 1.01

Solving for E:

E ≥ (1.01 / 1.02) * 1.55 ≈ 1.53

Thus, the expected exchange rate in one year must be at least $1.53 per GBP to make the UK investment as profitable as the US investment, considering interest rates and expectations.

Given that the actual exchange rate after a year is $1.42 per GBP, the CFO's expectation was that the GBP would either depreciate further or remain below the level needed for the foreign investment to be advantageous.

Implications of Currency Expectations and Exchange Rate Movements

The case illustrates how currency fluctuations impact international investment returns significantly. The depreciation of the GBP against the USD led to a negative return for the UK investment, despite higher local interest rates. Expecting a stable or strengthening currency might have justified the investment, but in this scenario, the actual depreciation led to losses.

Foreign exchange risk is a major consideration, and firms often employ hedging strategies like forward contracts or options to mitigate potential adverse currency movements. Furthermore, understanding market forecasts and macroeconomic indicators can help firms better predict currency trends, improving investment decisions.

Interest rate differentials, geopolitical stability, inflation expectations, and monetary policy outlooks are crucial factors influencing currency movements. For instance, the Bank of England's monetary policy decisions, in response to economic growth or inflation concerns, directly affect GBP valuation. Theoretically, if markets anticipate that the UK will tighten monetary policy, the GBP might appreciate, making foreign investments more attractive, whereas anticipated easing or economic downturns could lead to depreciation.

Such fluctuations underscore the importance of incorporating currency risk into international investment evaluation, and firms should consider whether the potential gains from higher foreign interest rates outweigh the risks associated with currency depreciation. Appropriate analysis and hedging can help in aligning international investment strategies with corporate risk tolerance and financial goals.

Conclusion

In summary, the CFO's domestic versus international investment decision hinged on interest rates and currency expectations. The negative return realized highlights the risk of currency depreciation, which can erode gains from higher foreign interest rates. Accurate forecasts of exchange rates are complex but critical for effective international financial management. Managing currency risk through hedging tools and macroeconomic analysis is vital for CFOs aiming to optimize returns on surplus cash flows in an increasingly interconnected global economy.

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