Question

Fairfield Corp., a US firm, recently established a subsidiary in a less developed country that consistently experiences an annual inflation rate of 80% or more. The country does not have an established stock market, but loans by local banks are available with a 90% 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% interest rate?

Answer 1

Solution-

The local currency of the host company will likely depreciate consistently and substantially against the dollar because of the pressure caused by high inflation. Consequently, the cash flows remitted over time will be converted at an unfavorable exchange rate. If the subsidiary was fi nanced with local funds, the interest would be paid on loans prior to remitting funds to the U.S. so that a smaller amount of funds would be affected by the unfavorable exchange rate.