CHAPTER 17 Multinational Financial Management

1
CHAPTER 17Multinational Financial Management

• Multinational vs. domestic financial management
• Exchange rates and trading in foreign exchange
• International money and capital markets

2
What is a multinational corporation?

• A corporation that operates in two or more
  countries.
• Decision making within the corporation may be
  centralized in the home country, or may be
  decentralized across the countries the
  corporation does business in.

3
Why do firms expand into other countries?

• To seek new markets.
• To seek raw materials.
• To seek new technology.
• To seek production efficiency.
• To avoid political and regulatory hurdles.
  
• To diversify.
• To retain customers.
• To protect processes.

4
What factors distinguish multinational financial
management from domestic financial management?

• Different currency denominations.
• Political risk
• Economic and legal ramifications.
• Role of governments
• Language and cultural differences.

5
Consider the following exchange rates

• US to buy 1 unit
• Japanese yen 0.009
• Australian dollar 0.650
• Are these currency prices direct or indirect
  quotations?
• Since they are prices of foreign currencies
  expressed in dollars, they are direct quotations.

6
What is an indirect quotation?

• The number of units of a foreign currency needed
  to purchase one U.S. dollar, or the reciprocal of
  a direct quotation.
• Are you more likely to observe direct or indirect
  quotations?
• Most exchange rates are stated in terms of an
  indirect quotation.
• Except the British pound, which is usually in
  terms of a direct quotation.

7
Calculate the indirect quotations for yen and
Australian dollars

• of units of foreign
• currency per US
• Japanese yen 111.11
• Australian dollar 1.5385
• Simply find the inverse of the direct quotations.

8
What is a cross rate?

• The exchange rate between any two currencies.
  Cross rates are actually calculated on the basis
  of various currencies relative to the U.S.
  dollar.
• Cross rate between Australian dollar and the
  Japanese yen.
• Cross rate (Yen / US Dollar) x (US Dollar / A.
  Dollar)
• 111.11 x 0.650
• 72.22 Yen / A. Dollar
• The inverse of this cross rate yields
• 0.0138 A. Dollars / Yen

9
Orange juice projectSetting the appropriate
price

• A firm can produce a liter of orange juice and
  ship it to Japan for 1.75 per unit. If the firm
  wants a 50 markup on the project, what should
  the juice sell for in Japan?
• Price (1.75)(1.50)(111.11 yen / )
• 291.66 yen

10
Orange juice projectDetermining profitability

• The product will cost 250 yen to produce and ship
  to Australia, where it can be sold for 6
  Australian dollars. What is the U.S. dollar
  profit on the sale?
• Cost in A. dollars 250 yen (0.0138)
• 3.45 A. dollars
• A. dollar profit 6 3.45 2.55 A. dollars
• U.S. dollar profit 2.55 / 1.5385 1.66

11
What is exchange rate risk?

• The risk that the value of a cash flow in one
  currency translated to another currency will
  decline due to a change in exchange rates.
• For example, in the last slide, a weakening
  Australian dollar (strengthening dollar) would
  lower the dollar profit.

12
International monetary system

• The framework within which exchange rates are
  determined.
• The blueprint for international trade and capital
  flows.
• Exchange rate terminology
• Spot vs. forward exchange rate
• Fixed vs. floating exchange rate
• Devaluation and revaluation
• Depreciation and appreciation
• Soft, or weak, currency

13
Floating monetary agreements

• Freely floating
• Exchange rate determined by the markets supply
  and demand for the currency. Governments may
  occasionally intervene and buy or sell their
  currency to stabilize fluctuations.
• Managed floating
• Significant government intervention manages the
  exchange rate by manipulating the currencys
  supply and demand. The target exchange rates are
  kept secret to prevent currency speculators from
  profiting from it.

14
Fixed monetary agreements

• No local currency
• The country uses either another countrys
  currency as its legal tender (like the U.S.
  dollar in Ecuador) or else belongs to a group of
  countries that share a currency (like the euro).
• Currency board arrangement
• The country technically has its own currency but
  commits to exchange it for a specified foreign
  currency at a fixed exchange rate (like Argentina
  before its January 2002 crisis).
• Fixed peg arrangement
• The country pegs its currency to another (or a
  basket of currencies) at a fixed rate. Slight
  fluctuations are okay, but the rate must stay
  within a desired range. For example, the Chinese
  yuan is pegged to a basket of currencies.

15
What is difference between spot rates and forward
rates?

• Spot rates are the rates to buy currency for
  immediate delivery.
• Forward rates are the rates to buy currency at
  some agreed-upon date in the future.

16
When is the forward rate at a premium to the spot
rate?

• If the U.S. dollar buys fewer units of a foreign
  currency in the forward than in the spot market,
  the foreign currency is selling at a premium.
• In the opposite situation, the foreign currency
  is selling at a discount.
• The primary determinant of the spot/forward rate
  relationship is relative interest rates.

17
What is interest rate parity?

• Interest rate parity holds that investors should
  expect to earn the same return in all countries
  after adjusting for risk.

18
Evaluating interest rate parity

• Suppose one yen buys 0.0095 in the 30-day
  forward exchange market and rNOM for a 30-day
  risk-free security in Japan and in the U.S. is
  4.
• ft 0.0095
• rh 4 / 12 0.333
• rf 4 / 12 0.333

19
Does interest rate parity hold?

• Therefore, for interest rate parity to hold, e0
  must equal 0.0095, but we were given earlier
  that e0 0.0090.

20
Which security offers the highest return?

• The Japanese security.
• Convert 1,000 to yen in the spot market.
  1,000 x 111.111 111,111 yen.
• Invest 111,111 yen in 30-day Japanese security.
  In 30 days receive 111,111 yen x 1.00333
  111,481 yen.
• Agree today to exchange 111,481 yen 30 days from
  now at forward rate, 111,481/105.2632
  1,059.07.
• 30-day return 59.07/1,000 5.907, nominal
  annual return 12 x 5.907 70.88.

21
What is purchasing power parity?

• Purchasing power parity implies that the level of
  exchange rates adjusts so that identical goods
  cost the same amount in different countries.
• Ph Pf(e0)
• -OR-
• e0 Ph/Pf

22
If grapefruit juice costs 2.00 per liter in the
U.S. and PPP holds, what is the price of
grapefruit juice in Australia?

• e0 Ph/Pf
• 0.6500 2.00/Pf
• Pf 2.00/0.6500
• 3.0769 Australian dollars.

23
What impact does relative inflation have on
interest rates and exchange rates?

• Lower inflation leads to lower interest rates, so
  borrowing in low-interest countries may appear
  attractive to multinational firms.
• However, currencies in low-inflation countries
  tend to appreciate against those in
  high-inflation rate countries, so the effective
  interest cost increases over the life of the loan.

24
International credit markets

• Eurocredits
• Fixed term, floating rate bank loans with no
  early repayment.
• An example is a eurodollar deposit, which is U.S.
  dollars deposited in a bank outside the U.S.
• Eurobonds
• Medium- to long-term international market for
  fixed- and floating-rate debt.
• Underwritten by an international bank syndicate
  and sold to investors in countries other than the
  one in whose currency the bond is denominated.
• Foreign bonds
• Issued in a capital market other than the
  issuers.
• The only thing foreign about it is the borrowers
  nationality.

25
American Depository Receipts (ADRs)

• Certificates representing ownership of foreign
  stock held in trust.
• About 1,700 ADRs are now available in the United
  States, with most of them traded on the
  over-the-counter (OTC) market.
• However, more and more ADRs are being listed on
  the New York Stock Exchange.

26
To what extent do average capital structures vary
across different countries?

• Previous studies suggested that average capital
  structures vary among the large industrial
  countries.
• However, a recent study, which controlled for
  differences in accounting practices, suggests
  that capital structures are more similar across
  different countries than previously thought.

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Impact of multinational operations

• Cash management
• Distances are greater and cash is often
  denominated in different currencies.
• Access to more markets for loans and for
  temporary investments.
• Capital budgeting decisions
• Foreign operations are taxed locally, then
  repatriated funds may be taxed in the U.S.
• Foreign projects are subject to political risk.
• Repatriated funds must be converted to U.S.
  dollars (subject to exchange rate risk).

28
Impact of multinational operations

• Credit management
• Credit is more important, because commerce to
  lesser-developed countries often relies on
  credit.
• Credit for future payment may be subject to
  exchange rate risk.
• Inventory management
• Inventory decisions can be more complex,
  especially when inventory can be stored in
  locations in different countries.
• Should consider shipping times, carrying costs,
  taxes, import duties, and exchange rates.