Textbook Problem

Financing to Reduce Exchange Rate Exposure Nashville Co. presently incurs costs of approximately 12 million Australian dollars (AS) per year for research and development expenses in Australia. It sells the products that are designed each year, and all of the products sold each year are invoiced in U.S. dollars. Nashville anticipates revenues of $20 million per year, with half of those revenues coming from sales to customers in Australia. The Australian dollar is presently valued at $1 (1 U.S. dollar), but it fluctuates a lot over time. Nashville is planning a new project that will expand its sales to other regions within the United States, and the sales will be invoiced in dollars. Nashville can finance this project with a five-year loan by (1) borrowing only Australian dollars, (2) borrowing only U.S. dollars, or (3) bor rowing one-half of the funds from each of these sources. The five-year interest rates on an Australian dollar loan and a U.S. dollar loan are the same.

1. If Nashville wants to use the form of financing that will reduce its exposure to exchange rate risk the most, what is the optimal form of financing? Briefly explain (one or two sentences should be sufficient if your explanation is clear).
2. Now assume that Nashville expects the Australian dollar to appreciate over time. Suppose the company wants to maximize the expected net present value of its new project and is not concerned about its exposure to exchange rate risk. Under these conditions, which financing alternative is most appropriate? Briefly explain.