Question Details

What is a key disadvantage of using this strategy that may cause Fairfield 



1. Financing Decision. Forest Company produces goods in the U.S., Germany, and Australia, and
sells the goods in the areas where they are produced. Foreign earnings are periodically remitted to
the U.S. parent. As the euro- interest rates have declined to a very low level, Forest Company has
decided to finance its German operations with borrowed funds in place of the parent- equity
investment. Forest will transfer the U.S. parent- equity investment in the German subsidiary over
to its Australian subsidiary. These funds will be used to pay off a floating-rate loan, as Australian
interest rates have been high and are rising. Explain the expected effects of these actions on the
consolidated capital structure and cost of capital of Forest Company.
Given the strategy to be used by Forest, explain how its exposure to exchange rate risk may have
changed.
2. Financing in a High Interest Rate Country. Fairfield Corp., a U.S. firm, recently established a
subsidiary in a less developed country that consistently experiences an annual inflation rate of 80
percent or more. The country does not have an established stock market, but loans by local banks
are available with a 90 percent interest rate. Fairfield has decided to use a strategy in which the
subsidiary is financed entirely with funds from the parent. It believes that in this way it can avoid
the excessive interest rate in the host country. What is a key disadvantage of using this strategy that may cause Fairfield to be no better off than if it paid the 90 percent interest rate?



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