Question

please answer both, ratting will be given, much appreciated

1-

Currencies – U.S. dollar foreign-exchange rates. May 5, 2011

Country/currency………….in US$............per US$

British Pound……………....1.5347…………0.6516

Norwegian Kroner………...0.1690…………5.9173

Thai Baht…………………..0.0310………....32.250

The price of an ounce of gold in New York is $1,950, and the price of the same ounce of gold in London is 1,285 British Pounds. Using the exchange rates above, what would you predict would occur in well-functioning markets based upon this information?

	a.	The price of gold will fall in New York and rise in London
	b.	The price of gold will fall in New York and will stay the same in London
	c.	The price of gold will rise in New York and fall in London
	d.	The price of gold will stay the same in both New York and London
	e.	The price of gold will rise in New York and will stay the same in London

2- The chapter on financial leverage, as well as the discussion in class, used “risk units” to illustrate what about financial leverage?

	a.	That debt is risk free
	b.	That the risk of the firm’s assets cannot be changed by shifts in financial leverage
	c.	That firm value is maximized where the cost of capital is minimized
	d.	That for firms with leverage, the higher the EBIT, the higher is firm risk
	e.	That debt financing creates a tax shield and therefore lowers firm risk

Answer 1

Question 1.

We know from the table that the exchange rate between USD and British Pounds is:

1.5347$ / pound or 0.6516 pounds / $

Price of gold in New York - 1950$

Converted to Pounds - 1950*0.6516 = 1270.62 Pounds

Price in London - 1285 Pounds , which is higher than the exchange rate.

Thus, the price of gold must drop in London or rise in New York to be equal in terms of exchange rate. Both happening may again cause inequality.

Answer - e)

Question 2.

Financial leverage is said to be high when the firm takes on more debt than equity. Taking on debt comes with risks, as the cost of debt is higher than cost of equity and it needs to be paid back.

When a firms EBIT is high, it means the firm has the capacity to pay back its debt.

A tax shield protects the firm against paying too high a tax, it does not protect against risk.

The risk of the firms assets depends on the financial leverage, because if the firm is leveraged, it means the assets were bought using debt.

The lower the cost of capital, the lower the interest the firms have to pay for the capital they get, be it from equity or debt, thus it maximizes the firm value.

Answer - c)

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