A toy-exporting company, has considred a variery of projects, but all of its business is still in Germany. Since most of its business comes from exporting wooden toys, it remains exposed to exchange rate risk. On the favorable side, the German demand for its toys has risen consistenly every month. NTG has retained more than $200,000 in earnings since it began its operation. At this point in time, NTG's capital structure is mostly its own equity, with very little debt. NTG has periodically considered establishing a very small subsidiary in Germany to produce its toys there If it does establish this subsidiary, it has several options for the capital structure that would be used to support it:
- Use all of its equity to invest in the firm,
- Use Euro-denominated long-term debt,
Or use dollar-denominated long-term debt. The interest rate on Euro long-term debt is slightly higher than the interest rate on U.S. long-term debt.You are hired as international financial management consultant to advise NTG's management in regard to the following questions:
1.What is the advantage of using equity to support the subsidiary? What is the disadvantage?
If NTG decides to use long-term debt as the primary form of capital to support this subsidiary, should it use dollar-denominated debt or Euro-denominated debt?
2.How can the equity proportions of this firm's capital structure increase over the time after it is established?
Assume that NTG decides to finance a new project to open a store in the U.S. with dollar-denominated debt. If it does implement the U.S. business idea, how could it use a currency swap along with the debt to reduce its exposure to exchange rate risk?