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eturn of 10% on its investments in the United States and 16% on its investments in China. We will
discuss the reasons for the 16% required return later in this section.
Before you invest, your (simplified) balance sheet might look like Exhibit 7.7.
We pick a date of October 23, 1995, for the investment, and your balance sheet looks like Exhibit
7.8 at the end of October:
Exhibit 7.7 Small Co. balance sheet, September 30, 1995 (in millions).
Exhibit 7.8 Small Co. balance sheet, October 31, 1995 (in millions).
Actually, the value of the investment will be in Chinese yuan renminbi (CNY), the currency of
China. The accountants will convert that investment to dollars at the prevailing exchange rate at the
end of each accounting period. If the $100 million were invested in China on October 31, 1995, it
would buy CNY 831.490 million, and that would become the value of the plant. The exchange rate
was CNY 8.31490 to one U.S. dollar on October 31, 1995. The balance sheet is important because
public companies will report any gains or losses on investments on their income statements. So both
the balance sheet and the income statement will change as a result of exchange rate movements. Of
course, the major reason for this investment is to obtain goods for sale in the United States and in
other countries at lower prices. Unlike Rodney‟s investment in England, the government of China had
a policy to hold the exchange rate constant with the dollar. This effectively created one currency for
China and the United States for 10 years. This was a huge advantage to companies doing business
with China.
Look at the exchange rate of the yuan to the dollar in Exhibit 7.9.
As you can see, there has been a 10-year period of very stable exchange rates. Let‟s value your
$100 million plant on December 31, 2004. Recall that the plant was actually valued at CNY 831.490
million on October 31, 1995. Assume no depreciation and no plant additions to allow us to see what
happened because of exchange rates. We see that CNY 831.490 million divided by the December 31,
2004, exchange rate of 8.28650 converts to $100.34 million (Exhibit 7.10).
The change since 1995 is so small as to be insignificant. I‟m sure Rodney wishes that his
investment in England had had this stability. However, from 2005 onward, the yuan has strengthened
against the dollar. The effect from a change in the rate from 8.3 to 6.9 has been to raise prices of
Chinese goods by 20%, assuming that all else is equal. By now you should be able to tell what