Question

12. A U.S. MNC owns a subsidiary in France that generates substantial earnings in euros each year. One week ago, it received an offer from a company to purchase the subsidiary, and it has not yet responded. Since last week, long-term interest rates in the U.S. have decreased. Will the NPV of the divestiture be larger or smaller or stay the same as it was last week?

	a.	Smaller, because the PV of what the firm gives up has increased.
	b.	Larger, because the PV of what the firm gives up has decreased.
	c.	Smaller, because the PV of what the firm gives up has decreased.
	d.	Stay the same, because U.S. interest rates are unimportant in this analysis.

Answer 1

As the interest rate decreases cost of borrowing of the company will also decrease which will result in the decrease in cost of capital of the company.

The present value of cash flows of the subsidiary is calculated by discount the cash flows at cost of capital.

The decrease in cost of capital increases the present value of all the future cash flows which the firm will give up if it is divested in return of the same amount received.

Thus NPV of the divesture will be smaller as NPV will be the sum of present value of future cash flows given up plus the amount received for divestiture.

Hence option (a) is correct.