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International Finance

3. Mucho Macho is the leading beer in Patagonia, with a 65 percent share of the market. Because of trade barriers, it faces essentially no import competition. Exports account for less than 2 percent of sales. Although some of its raw material is bought overseas, the large majority of the value added is provided by locally supplied goods and services. Over the past five years, Patagonian prices have risen by 300 percent, and U.S. prices have risen by about 10 percent. During this time period, the value of the Patagonian peso has dropped from P 1 = $1.00 to P 1 = $0.50.

a. What has happened to the real value of the peso over the past five years? Has it gone up or down? A little or a lot?

b. What has the high inflation over the past five years likely done to Mucho Macho's peso profits? Has it moved profits up or down? A lot or a little? Explain.

c. Based on your answer to part a, what has been the likely effect of the change in the peso's real value on Mucho Macho's peso profits converted into dollars? Have dollar equivalent profits gone up or down? A lot or a little? Explain.

d. Mucho Macho has applied for a dollar loan to finance its expansion. Were you to look solely at its past financial statements in judging its creditworthiness, what would be your likely response to Mucho Macho's dollar loan request?

e. What foreign exchange risk would such a dollar loan face? Explain.

Solution Preview

a. What has happened to the real value of the peso over the past five years? Has it gone up or down? A little or a lot?

ANSWER. The real value of the Patagonian peso, relative to its value five years ago, is now $0.50 x 4/1.1 = $1.82. Thus, the real value of the peso has risen by 82 percent. As discussed in the chapter, an increase in the real value of the local currency should boost dollar profits for those firms selling locally and not subject to import competition.

b. What has the high inflation over the past five years likely done to Mucho Macho's peso profits? Has it moved profits up or down? A lot or a little? Explain.

ANSWER. A reasonable assumption is that both Mucho Macho's sales and costs have risen at least at the rate of Patagonian inflation. This means that its peso profits, which equal the difference between the two, have risen at least 300% over the past five years. In fact, ...

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