Sensitivity of Foreign Project Risk to Capital Structure
Response to the following problem:
Texas Co. produces drugs and plans to acquire a subsidiary in Poland. This subsidiary is a lab that would perform biotech research. Texas Co. is attracted to the lab because of the cheap wages of scientists in Poland. The parent of Texas Co. would review the lab research ?ndings of the subsidiary in Poland when deciding which drugs to produce and would then produce the drugs in the United States. The expenses incurred in Poland will represent about half of the total expenses incurred by Texas Co. All drugs produced by Texas Co. are sold in the United States, and this situation would not change in the future. Texas Co. has consid- ered three ways to ?nance the acquisition of the Polish subsidiary if it buys it. First, it could use 50 percent equity funding (in dollars) from the parent and 50 percent borrowed funds in dollars. Second, it could use 50 percent equity funding (in dollars) from the parent and 50 percent borrowed funds in Polish zloty. Third, it could use 50 percent equity funding by selling new stock to Polish investors denominated in Polish zloty and 50 percent borrowed funds denominated in Polish zloty.
Assuming that Texas Co. decides to acquire the Polish subsidiary, which ?nancing method for the Polish subsidiary would minimize the exposure of Texas to exchange rate risk? Explain.