【正文】 and if interest rates are lower domestically, the foreign currency will be selling at a discount in the forward market. We need some notation to develop the interestrate–parity theorem. Let S(0) be the current domesticcurrency price of spot foreign exchange (current time is denoted by 0). If the domestic currency is the dollar and the foreign exchange is the deutschemark, we might observe S(0) $(0) is in direct or . terms. Let F(0,1) be the current domestic currency price of forward exchange for a contract that matures in one month. Thus, the contract is for forward exchange one month hence. Let i and i* be the yearly rates of interest paid on Eurocurrency deposits denominated in the domestic (i) and foreign (i*) currencies, respectively. Of course, the maturity of the deposits can be chosen to coincide with the maturity of the forward contract. Now consider a trader who has access to the interbank market in foreign exchange and Eurocurrency deposits. Suppose the trader has some dollars to invest for one month. The trader can make a dollar loan or a deutschemark loan. The annual interest rate is 10 percent in deutschemarks and 6 percent in dollars. Which is better? 5 International Capital Budgeting Kihlstrom Equipment, a international pany, is evaluating an investment in France. Kihlstrom’s exports of drill bits have increased to such a degree that the pany is considering operating a plant in France. The project will cost FF20 million, and it is expected to produce cash flows of FF8 million a year for the next three years. The current spotexchange rate for French francs is S(0)=$projects in . dollars? Nothing about the fact that the investment is made abroad alters Kihlstrom’s NPV criterion. Kihlstrom must identify incremental cash flows and discount them at the appropriate cost of capital. After making the required discounted cash flow calculations,Kihlstrom should undertake projects with a positive NPV. However, two major factors that plicate such international NPV calculations are foreign exchange conversion and repatriation of funds. Foreign Exchange Conversion The simplest way for Kihlstrom to calculate the NPV of the investment is to convert all Frenchfranc cash flows to . dollars. This involves a threestep process: Step 1. Estimate future cash flows in French francs. Step 2. Convert to . dollars at the predicted exchange rate. Step 3. Calculate NPV using the cost of capital in . dollars. Unremitted Cash Flows The previous example assumed that all aftertax cash flows from the foreign investment were remitted to the parent firm. The remittance decision is similar to the dividend for a purely domestic firm. Substantial differences can exist between the cash flows of a project and the amount that is actually remitted to the parent firm. Of course, the present value of a project will not be changed by deferred remittance if the unremitted cash flows are reinvested at a rate of return equal (as adjusted for exchange rates) to the domestic cost of capital. A foreign subsidiary can remit funds to a parent in many ways, including the following: (1)Dividends. (2)Management fees for central services. (3)Royalties on the use of trade names and patents. International firms must pay special attention to remittance for two reasons. First, there may be present and future exchange controls. Many governments are sensitive to the charge of being exploited by foreign firms. Therefore, governments are tempted to limit the ability of international firms to remit cash flows. Another reason is taxes. It is always necessary to determine what taxes must be paid on profits generated in a foreign country. International 。, then forces would be set in motion to change the rate and/or the price of apples. In our example, there would be a whole lot of apples flying from New York to London. Thus, demand for apples in New York would raise the dollar price for apples there, and the supply in London would lower the poundsterling price. The apple traders converting pounds sterling into dollars, that is, supplying pounds sterling and demanding dollars, would also put pressure on the excha nge rate to fall from $2/163。 yielding a total of $5 for $1 ($5 $4) gain. The rationale of the LOP is that if the exchange rate is not $163。 .That is, the LOP implied spotexchange rate is $ per is, the LOP implied spotexchange rate is $ per pound. Suppose instead that the actual exchange rate is $ per pound. Starting with $4, a trader could buy a bushel of apples in New York, ship it to London, and sell it there for163。 and S163。 per bushel. Then the law of one price implies that $4 =S163。(t) be the spotexchange rate, that is,the number of dollars needed to purchase a British pound at ti me PUS(t) and PUK(t)be the current . and British prices of a particular modity, say, apples. The law of one price says that PUS(t)=S163。1 and $ DM1 are in direct terms. The financial press frequently quotes the foreign currency price of a . dollar. If the quoted price is the foreign currency price of a . dollar, the quotation is indirect (or European). For example, 163。), Japanese yen (165。like domestic panies, they seek to invest in projects that create more value for the shareholders than they cost and to arrange financing that raises cash at the lowest possible cost. That is, the present value principle holds for both foreign and domestic operations. However, it is usually more plicated to apply the NPV principle to foreign operations. Perhaps the most important plication of international finance is foreign foreign exchange markets provide information and opportunities for an international corporation when it undertakes capitalbudgeting and financing decisions. The relationship among foreign exchange, interest rates, and inflation is defined by the basic t