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Chapter 24International

Financial

Management Pearson Education Limited 2004

Fundamentals of Financial Management, 12/eCreated by: Gregory A. Kuhlemeyer, Ph.D.

Carroll College, Waukesha, WI

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After s tudying Chapter 24,

you should be able to:

Explain why many firms invest in foreign operations.

Explain why foreign investment is different from domesticinvestment.

Describe how capital budgeting, in an international

environment, is similar or dissimilar to that in a domesticenvironment.

Understand the types of exchange-rate exposure and how tomanage exchange-rate risk exposure.

Compute domestic equivalents of foreign currencies giventhe spot or forward exchange rates.

Understand and illustrate the purchasing-power parity (PPP)and interest rate parity.

Describe the specific instruments and documents used instructuring international trade transactions.

Distinguish among countertrade, export factoring, and

forfaiting.

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International

Financ ial Management

Some Background

Types of Exchange-Rate RiskExposure

Management of Exchange-Rate

Risk Exposure Structuring International Trade

Transactions

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Some Background

Fill product gaps in foreign markets whereexcess returns can be earned.

To produce products in foreign marketsmore efficiently than domestically.

To secure the necessary raw materialsrequired for product production.

What is a companys motivation to

invest capital abroad?

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International

Cap i tal Budget ing

1. Estimate expected cash flows in the foreigncurrency.

2. Compute their U.S.-dollar equivalents at theexpected exchange rate.

3. Determine the NPV of the project using the U.S.required rate of return, with the rate adjustedupward or downward for any risk premium effectassociated with the foreign investment.

How does a firm make an internationalcapital budgeting decision?

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International


Only consider those cash flows that canbe repatriated (returned) to the home-

country parent. The exchange rate is the number of units

of one currency that may be purchasedwith one unit of another currency.

For example, the current exchange ratemight be 2.50 Freedonian marks per oneU.S. dollar.

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In ternational Cap ital

Budget ing Example

A firm is considering an investment in

Freedonia, and the initial cash outlay is 1.5million marks.

The project has 4-year project life with cashflows given on the next slide.

The appropriate required return forrepatriated U.S. dollars is 18%.

The appropriate expected exchange rates aregiven on the next slide.

International project details:

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International


International diversificationand risk

reduction U.S. Government taxation

Taxable income derived from non-domesticoperations through a branch or division is taxed

under U.S. code. Foreign subsidiaries are taxed under foreign tax

codes until dividends are received by the U.S.parent from the foreign subsidiary.

Related issues of concern:

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International


Tax codes and policies differ from country tocountry, but all countries impose income taxes

on foreign companies. The U.S. government provides a tax credit to

companies to avoid the double taxationproblem.

A credit is provided up to the amount of theforeign tax, but not to exceed the sameproportion of taxable earnings from the foreigncountry.

Excess tax credits can be carried forward.

Foreign Taxation

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International


Expropriation is the ultimate political risk.

Developing countries may provide financialincentives to enhance foreign investment.

Bottom line: Forecasting political instability.

Protect the firm by hiring local nationals, acting

responsibly in the eyes of the host government,entering joint ventures, making the subsidiaryreliant on the parent company, and/orpurchasing po l i t ical r isk insu rance.

Political Risk

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Important

Exchange-Rate Terms

Currency r isk can be thought of as the volatilityof the exchange rate of one currency foranother (say British pounds per U.S. dollar).

Spot Exchange Rate-- The rate today forexchanging one currency for another for

immediate delivery.Forward Exchange Rate -- The rate today

for exchanging one currency for another ata speci f ic fu ture date.

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Types of Exchange-

Rate Risk Exposure

Translation Exposure -- Relates to the change inaccounting income and balance sheet statements

caused by changes in exchange rates. Transactions Exposure -- Relates to settling a

particular transaction at one exchange rate whenthe obligation was originally recorded at another.

Economic Exposure -- Involves changes inexpected future cash flows, and hence economicvalue, caused by a change in exchange rates.

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Management of Exchange-

Rate Risk Exposure

Natural hedges

Cash management

Adjusting of intracompanyaccounts

International financing hedges Currency market hedges

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Natural Hedges -- Not!

Both of these scenarios are notnatural hedges andthus create a possible firm exposure to events thatimpact one market and notthe other market.

Globally DomesticallyDetermined Determined

Scenario 3

Pricing XCost X

Scenario 4

Pricing X

Cost X

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Cash Management

Exchange cash for real assets (inventories) whosevalue is in their use rather than tied to a currency.

Reduce or avoid the amount of trade credit that willbe extended as the dollar value that the firm willreceive is reduced and reduce any cash that doesarrive as quickly as possible.

Obtain trade credit or borrow in the local currencyso that the money is repaid with fewer dollars.

What should a firm do if it knew that a local foreigncurrency was going to fall in value (e.g., drop from

$.70 per peso to $.60 per peso)?

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Cash Management

Generally, the reinvoicing center is billed in the

selling units home currency and bills the purchasingunit in that units home currency.

Allows better management of intracompanytransactions.

Netting-- A system in which cross-borderpurchases among participating subsidiaries of

the same company are netted so that eachparticipant pays or receives only the net amountof its intracompany purchases and sales.

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International

Financing Hedges

Foreign commercial banks perform essentially the

same financing functions as domestic banks except: They allow longer term loans.

Loans are generally made on an overdraft basis.

Nearly all major commercial cities have U.S. bank

branches or offices available for customers.

The use of discounting trade bills is widely utilized

in Europe versus minimal usage in the United States.

1. Commercial Bank Loans and Trade Bills

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International

Financing Hedges

Eurodollars are bank deposits denominated in U.S.

dollars but not subject to U.S. banking regulations. This market is unregulated. Therefore, the

differential between the rate paid on deposits andthat charged on loans varies according to the risk ofthe borrower and current supply and demand forces.

Rates are typically quoted in terms of the LIBOR. It is a major source of short-term financing for the

working capital requirements of the multinationalcompany.

2. Eurodollar Financing

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International

Financing Hedges

AEurobond is a bond issued internationally outside

of the country in whose currency the bond isdenominated. The Eurobond is issued in a single currency, but is

placed in multiple countries. A foreign bond is issued by a foreign government or

corporation in a localmarket. For example, Yankeebonds, and Samurai bonds.

Many international debt issues are floating rate notesthat carry a variable interest rate.

3. International Bond Financing

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Currenc ies and the Euro

Each country has a representative currency likethe $ (dollar) in the United States or the (pound)in Britain.

On January 1, 1999, the euro started trading.

The eurois the common currency of theEuropean

Monetary Un ion(EMU), which currently includesthe following 12 European Union (EU) countries:

Austria, Belgium, Finland, France, Germany,Greece, Ireland, Italy, Luxembourg, theNetherlands, Portugal, and Spain.

EuroThe name given to the single Europeancurrency. Symbol is(much like the dollar, $).

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Currency Market Hedges

A forward contract is a contract for the delivery of acommodity, foreign currency, or financial instrument at a

price specified now, with delivery and settlement at aspecified future date.

Spot rate $.168 per EFr90-day forward rate .166 per EFr

As shown, the Elbonian franc (EFr) is said to sell at aforward discount as the forward price is less than thespot rate.

If the forward rate is $.171, the EFr is said to sell at aforward premium.

1. Forward Exchange Market

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The firm has the option of selling 1 million Elbonianfrancs forward 90 days. The firm will receive$166,000 in 90 days (1 million Elbonian francs x$.166).

Therefore, if the actual spot price in 90 days is lessthan .166, the firm benefited from entering into thistransaction.

If the rate is greater than .166, the firm would havebenefited from not entering into the transaction.

Fillups Electronics has just sold equipment worth1 million Elbonian francs with credit terms of net

90. How can the firm hedge the currency risk?

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Typical discount or premium ranges forstable currencies are from 0 to 8%, but maybe as high as 20% for unstable currencies.

How much does this insurance cost?

Annualized cost of protection= ( $.002 )/( $.168 ) X ( 365 days / 90 days)= .011905 X 4.0556= .0483 or 4.83%

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A futures contract is a contract for the delivery of acommodity, foreign currency, or financial instrument at

a specified price on a stipulated future date. A currency futures market exists for the major

currencies of the world.

Futures contracts are traded on organized exchanges.

The clearinghouse of the exchange interposes itselfbetween the buyer and the seller. Therefore,transactions are not made directly between two parties.

Very few contracts involve actual delivery at expiration.

2. Currency Futures

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Sellers (buyers) cancel a contract by purchasing(selling) another contract. This is an offsetting position

that closes out the original contract with theclearinghouse.

Futures contracts are marked-to-market daily. This isdifferent than forward contracts that are settled only at

maturity.

Contracts come in only standard-size contracts (e.g.,12.5 million yen per contract).

2. Currency Futures (continued)

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In a currency swap two parties exchange debtobligations denominated in different currencies. Each

party agrees to pay the others interest obligation. Atmaturity, principal amounts are exchanged, usually at arate of exchange agreed to in advance.

The exchange is notional -- only the cash flow

difference is paid.

Swaps are typically arranged through a financialintermediary, such as a commercial bank.

A variety of (complex) arrangements are available.

4. Currency Swaps

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Macro Facto rs Govern ing

Exchange-Rate Behav ior

The idea that a basket of goods should sell forthe same price in two countries, after exchange

rates are taken into account.

For example, the price of wheat in Canadianand U.S. markets should trade at the sameprice (after adjusting for the exchange rate). Ifthe price of wheat is lower in Canada, thenpurchasers will buy wheat in Canada as long asthe price is cheaper (after accounting fortransportation costs).

Purchasing-Power Parity (PPP)

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Thus, demand will fall in the U.S. and increase inCanada to bring prices back into equilibrium.

The price elasticity of exports and imports influencesthe relationship between a countrys exchange rate and

its purchasing-power parity.

Commodity items and products in mature industriesare more likely to conform to PPP.

Frictions such as government intervention andtrade barriers cause PPP not to hold.

Purchasing-Power Parity (PPP continued)

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It suggests that if interest rates are higher in onecountry than they are in another, the formers

currency will sell at a discount in the forward market.

Remember that the Fisher effectimplies that thenominal rate of interest equals the real rate ofinterest plus the expected rate of inflation.

The internat ion al Fisher effectsuggests thatdifferences in interest rates between two countriesserve as a proxy for differences in expected inflation.

Interest-Rate Parity

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F = current forward exchange-rate in foreigncurrency per dollar.

S = current spot exchange-rate in foreign currencyper dollar.

rforeign= foreign interbank Euromarket interest rate

rdollar= U.S. interbank Euromarket interest rate

Interest-Rate Parity (continued)

The internat ional Fisher effectsuggests:

FS

= 1 + rforeign1 + rdollar

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Interest-Rate

Pari ty Examp le

The current German 90-day interest rate is4%.

The current U.S. 90-day interest rate is 2%.

The current spot rate is .706 Freedonianmarks per U.S. dollar ($1.416 per mark).

What is the impl ied 90-day fo rward rate?

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Interest-Rate

Pari ty Examp le

F = (1.04) x (.706) / (1.02)

= .720Thus, the impl ied 90-day fo rward

rate is .720 marks per dollar.

The imp l ied 90-day fo rward rate is:

F.706

= 1 + .041 + .02

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Struc tur ing In ternat ional

Trade Transac t ions

In international trade, sellers often havedifficulty obtaining thorough and accurate

credit information on potential buyers. Channels for legal settlement in cases of

default are more complicated and costly topursue.

Key documents are (1) an order to pay(international trade draft), (2) a bill of lading,and (3) a letter of credit.

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In ternational Trade Draft

The internat ional trade draft (bi l l of exchange) is awritten statement by the exporter ordering the importerto pay a specific amount of money at a specified time.

Sight draftis payable on presentation to the party(drawee) to whom the draft is addressed.

Time draftis payable at a specified future date aftersight to the party (drawee) to whom the draft isaddressed.

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Time Draft Featu res

An unconditional order in writing signedby the drawer, the exporter.

It specifies an exact amount of moneythat the drawee, the importer, must pay.

It specifies the future date when this

amount must be paid.

Upon presentation to the drawee, it isaccepted.

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Time Draft Featu res

The acceptance can be by either thedraweeor a bank.

If the drawee accepts the draft, it isacknowledged in writing on the back ofthe draft the obligation to pay the amount

so many specified days hence. It is then known as a t rade draft (bankers

acceptance if a bank accepts the draft).

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B i ll of Lading

It serves as a receipt from the transportationcompany to the exporter, showing that specifiedgoods have been received.

It serves as a contract between the transportationcompany and the exporter to ship goods and deliverthem to a specific party at a specific destination.

It serves as a document of title.

Bill of Lading-- A shipping documentindicating the details of the shipment and

delivery of goods and their ownership.

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Letter o f Cred it

A letter of credit is issued by a bank on behalf of theimporter.

The bank agrees to honor a draft drawn on theimporter, provided the bill of lading and other detailsare in order.

The bank is essentially substituting its credit for thatof the importer.

Letter of Credit- A promise from a third party(usually a bank) for payment in the event that

certain conditions are met. It is frequently usedto guarantee payment of an obligation.

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Countertrade

Used effectively when exchange restrictions exist or

other difficulties prevent payment in hard currencies. Quality, standardization of goods, and resale of

goods that are delivered are risks that arise withcountertrade.

Countertrade -- Generic term for barter andother forms of trade that involve the

international sale of goods or services that arepaid for -- in whole or in part -- by the transferof goods or services from a foreign country.

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Forfai t ing

The forfaiter assumes the credit risk and collects

the amount owed from the importer. Most useful when the importer is in a less-

developed country or in an Eastern Europeannation.

Forfaiting -- The selling without recourse ofmedium- to long-term export receivables to a

financial institution, the forfaiter. A third party,usually a bank or governmental unit,guarantees the financing.

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