Nashville Co. presently incurs costs of about 12 million Australian dollars (A$) per year due to research and development expenses in Australia. The parent company sells the products that are designed each year, and all of products sold each year would be invoiced in U.S. dollars. Nashville anticipates revenue of about $20 million per year and about half of the revenue would be from sales to customers in Australia. An Australian dollar is presently valued at $1 (1 U.S. dollar), but it fluctuates a lot over time. Nashville Co. is planning a new project in which it will expand its sales to other regions within the U.S. and the sales will be invoiced in dollars. Nashville can finance this project with a 5-year loan by (1) borrowing only Australian dollars, or (2) borrowing only U.S. dollars, or (3) borrowing one-half of the funds from each of these sources. The 5-year interest rates on an Australian dollar loan and U.S. dollar loan are the same.
a. If Nashville wants to use the form of financing that will reduce its exposure to exchange rate risk the most, what is the optimal form of financing? Briefly explain (this means that one or two sentences should be sufficient if your explanation is clear).
b. Now assume that Nashville expects that the Australian dollar will appreciate over time. Suppose the company wants to maximize its expected net present value of this project and is not concerned about its exposure to exchange rate risk. Under these conditions, which financing alternative is most appropriate. Briefly explain.