Chapter 21 International Financial Management Learning Objectives 1. Discuss how the basic principles of finance apply to international financial transactions. 2. Differentiate among the spot rate, the forward rate, and the cross rate in the foreign exchange markets; make foreign exchange and cross rate calculations; and be able to hedge an asset purchase where payment is made in a foreign currency. 3. Identify the major factors that distinguish international from domestic capital budgeting, explain how the capital budgeting process can be adjusted to account for these factors, and compute the NPV for a typical international capital project. 4. Discuss the importance of the Euromarkets to large U.S. multinational firms, and calculate the cost of borrowing in the Eurobond market. 1
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Chapter 21
International Financial Management
Learning Objectives
1. Discuss how the basic principles of finance apply to international financial
transactions.
2. Differentiate among the spot rate, the forward rate, and the cross rate in the foreign
exchange markets; make foreign exchange and cross rate calculations; and be able
to hedge an asset purchase where payment is made in a foreign currency.
3. Identify the major factors that distinguish international from domestic capital
budgeting, explain how the capital budgeting process can be adjusted to account for
these factors, and compute the NPV for a typical international capital project.
4. Discuss the importance of the Euromarkets to large U.S. multinational firms, and
calculate the cost of borrowing in the Eurobond market.
5. Explain how large U.S. money center banks make and price Eurocredit loans to
their customers, and compute the cost of a Eurocredit bank loan.
I. Chapter Outline
21.1 Introduction to International Finance Management
A. Globalization of the World Economy
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Globalization refers to the removal of barriers to free trade and the closer
integration of national economies.
Consumers in many countries buy goods that are purchased from a number of
countries, other than just their own.
The production of goods and services has also become highly globalized.
Like product markets, the financial system has also become highly integrated.
B. The Rise of Multinational Corporations
A multinational corporation is a business firm that operates in more than one
country but is headquartered or based in its home country.
Multinational corporations may purchase raw materials from one country, obtain
financing from a capital market in another country, produce finished goods with
labor and capital equipment from a third country, and sell finished goods in a
number of other countries.
Multinationals are owned by a mixture of domestic and foreign stockholders.
Transnational corporations, regardless of the location of their headquarters, are
managed from a global perspective rather than the perspective of a firm residing
in a particular country.
Exhibit 21.1 lists the top 15 multinational business firms ranked by total revenues.
C. Factors Affecting International Financial Management
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Six factors can cause international business transactions to differ from domestic
deals.
The uncertainty of future exchange rate movements is called foreign
exchange rate risk, or just exchange rate risk.
Differences in legal systems and tax codes can also impact the way firms
operate in foreign countries.
There are two important levels of communication in international business
deals: business communication and social communication.
o Although English is the official business language, it is not the
world’s social language.
The cultures of different countries, and even different regions within the
same country, can vary considerably.
o Cultural views also shape business practices and people’s attitudes
toward business.
An economic system determines how a country mobilizes its resources to
produce goods and services needed by society, as well as how the
production is distributed.
Country risk refers to political uncertainty associated with a particular
country.
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o At the extreme, a country’s government may even expropriate—
that is, take over—a business’s assets within the country.
o These types of actions clearly can affect a firm’s cash flows and,
thus, the value of the firm.
D. Goals of International Financial Management
Stockholder wealth maximization is the accepted goal for firms in the United
States, as well as in some other countries that share a similar heritage, such as the
United Kingdom, Australia, India, and Canada.
In Continental Europe, for example, countries such as France and Germany focus
on maximizing corporate wealth.
The European manager’s goal is to earn as much wealth as possible for the
firm while considering the overall welfare of all stakeholders.
In Japan, companies form tightly knit, interlocking business groups called
keiretsu, such as Mitsubishi, Mitsui, and Sumitomo, and the goal of the Japanese
business manager is to increase the wealth and growth of the keiretsu.
As a result, they might focus on maximizing market share rather than
stockholder wealth.
In China, which is making a transition from a command economy to a market-
based economy, there are sharp differences between state-owned companies and
emerging private-sector firms.
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The large state-owned companies have an overall goal that can best be
described as maintaining full employment in the economy while the new
private-sector firms fully embrace the Western standard of stockholder
wealth maximization.
E. Basic Principles Remain the Same
The basic principles of managerial finance remain the same whether a transaction
is domestic or international.
The time value of money is not affected by whether a business transaction
is domestic or international. Likewise, the same models are used for
valuing capital assets, bonds, stocks, and entire firms.
Exhibit 21.2 lists some of the important finance concepts and procedures and
indicates where there are differences between domestic and international
operations.
21.2 Foreign Exchange Markets
The foreign exchange market is a group of international markets connected
electronically where currencies are bought and sold in wholesale amounts.
Foreign exchange markets provide three basic economic benefits:
A mechanism to transfer purchasing power from individuals who deal in one
currency to people who deal in a different currency.
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A way for corporations to pass the risk associated with foreign exchange price
fluctuations to professional risk-takers.
A channel for importers and exporters to acquire credit for international business
transactions.
The market for foreign exchange is very large, and the daily volume was more
than $2 trillion in 2006.
London is by far the largest foreign exchange trading center, with an average
daily volume of $753 billion, while New York City is second with $461 billion,
and Tokyo is third with $199 billion.
A. Market Structure and Major Participants
Participants are linked by telephone, telegraph, and cable.
The major participants in the foreign exchange markets are multinational
commercial banks, large investment banking firms, and small currency boutiques
that specialize in foreign exchange transactions.
In addition, the central banks, which intervene in the markets primarily to smooth
out fluctuations in their exchange rates, also play a significant role.
B. Foreign Exchange Rates and the Equilibrium Exchange Rate
A foreign exchange rate is the price of one monetary unit.
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One of two parties in a transaction will be forced to deal in a foreign currency and
incur foreign exchange rate risk.
Exhibit 21.4 shows the equilibrium exchange rate, which is at the point where the
supply and demand curves intersect.
Equilibrium occurs at the price at which the quantity of the currency
demanded exactly equals the quantity supplied.
In general, whatever causes U.S. residents to buy more or fewer foreign
goods shifts the demand curve for the foreign currency.
Similarly, whatever causes foreigners to buy more or fewer U.S. goods
shifts the supply curve for the foreign currency.
C. Foreign Currency Quotations
Exhibit 21.5 shows selected exchange rate quotations from the Wall Street
Journal.
The spot rate is the cost of buying a foreign currency today, “on the spot.”
If the exchange rate is the price in dollars for a foreign currency, it is often
called the American or direct quote.
If the exchange rate is the price in foreign currency for a dollar, the quote
is called a European or an indirect quote.
Foreign exchange dealers quote two prices: bid and ask quotes.
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The bid quote represents the rate at which the dealer will buy foreign
currency.
The ask quote is the rate at which the dealer will sell foreign currency.
When one is given two quotes of foreign exchange rates involving three
currencies, it is possible to find the exchange rate between the third pair of
currencies, and this is known as the cross rate.
The forward rate is the rate at which one agrees to buy or sell a currency at some
future date.
Note that the forward rate is established at the date on which the
agreement is made and defines the exchange rate to be used when the
transaction is completed in the future.
By contracting now to buy or sell foreign currencies at some future date,
businesses can lock in the cost of foreign exchange at the beginning of the
transaction and do not have to worry about the risk of an unfavorable
movement in the exchange rate in the future.
The difference between the forward rate and the spot rate is called the forward
premium or forward discount.
21.3 International Capital Budgeting
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When a multinational firm wants to consider overseas capital projects, the financial
manager faces the decision of which capital projects should be accepted on a
companywide basis.
The decision to accept international projects with a positive NPV increases the value of
the firm and is consistent with the fundamental goal of financial management, which is to
maximize stockholder wealth.
Although the same basic principles apply to both international and domestic capital
budgeting, firms must deal with some differences.
A. Determining Cash Flows
A number of issues complicate the determination of cash flows from overseas
capital projects.
First, most companies find it more difficult to estimate the incremental cash flows
for foreign projects.
Second, problems with cash flows can arise when foreign governments restrict the
amount of cash that can be repatriated, or returned, to the parent company.
B. Exchange Rate Risk
Financial managers have to deal with foreign exchange rate risk on international
capital investments.
To convert the project’s future cash flows into another currency, we need to come
up with projected or forecast exchange rates.
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One of the problems with obtaining currency rate forecasts for use in analysis of
capital projects is that many projects have lives of 20 years or more.
C. Country Risk
Financial managers must also incorporate a country risk premium when
evaluating foreign business activities.
If a firm is located in a country with a relatively unstable political environment,
management will require a higher rate of return on capital projects as
compensation for the additional risk.
At the extreme, a local government could take over the plant and equipment of the
overseas operation without giving the company any compensation. This
expropriation of assets is called nationalization.
Some other ways that a foreign government can affect the risk of a foreign project
include:
Change tax laws in a way that adversely impacts the firm.
Impose laws related to labor, wages, and prices that are more restrictive
than those applicable for domestic firms.
Disallow any remittance of funds from the subsidiary to the parent firm for
either a limited period of time or the duration of the project.
Require that the subsidiary be headed by a local citizen or have a local
firm as a major equity partner.
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Impose tariffs and quotas on any imports.
Once management has gauged a capital project’s country risk, that risk must be
incorporated into the capital budgeting analysis by, for example, adjusting the
firm’s discount rate for the additional risk.
21.4 Global Money and Capital Markets
A. The Emergence of the Euromarkets
A Eurodollar is defined as a U.S. dollar deposited in a bank outside the United
States, primarily in Europe.
The banks accepting these deposits are called Eurobanks.
The Euromarkets are vast, largely unregulated money and capital markets with
major financial centers in Tokyo, Hong Kong, and Singapore.
B. The Eurocurrency Market
The Eurocurrency market is the short-term portion of the Euromarket.
A Eurocurrency is a time deposit of money held by corporations and
governments in a bank located in a country different from the country that issued
the currency.
The most widely quoted Eurocurrency interest rate is the London Interbank
Offer Rate, or LIBOR, which is the short-term interest rate that major banks in
London charge one another.
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C. The Eurocredit Market
The international banking system gathers funds from businesses and governments
in the Eurocurrency market and then allocates funds to banks that have the most
profitable lending opportunities.
These loans, which are short- to medium-term loans of a Eurocurrency to
multinational corporations and governments of medium to high credit quality, are
called Eurocredits.
Eurocredits are denominated in all major Eurocurrencies, although the dollar is
the overwhelming favorite.
D. International Bond Markets
International bonds fall into two generic categories: foreign bonds and Eurobonds.
Foreign bonds are long-term debt sold by a foreign firm to investors in another
country and denominated in that country’s currency.
Foreign bonds may have colorful nicknames: foreign bonds sold in the
United States are called Yankee bonds, and yen-denominated bonds sold in
Japanese financial markets by non-Japanese firms are called Samurai bonds.
Firms sell foreign bonds when they need to finance projects in a particular
foreign country.
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Eurobonds are long-term debt instruments sold by firms to investors in countries
other than the country in whose currency the bonds are denominated.
Multinational firms can use Eurobonds to finance international or
domestic projects.
Eurodollar and other Eurocurrency bonds have a number of characteristics
that differ from similar U.S corporate bonds.
Eurobonds are bearer bonds and do not have to be registered.
Eurobonds also pay interest annually.
While historically almost all Eurocurrency bonds were sold without credit
ratings, today, more than half of the Eurodollar bonds sold in Europe have
credit ratings.
21.5 International Banking
European governments fostered the growth of large international banks in their countries
and viewed them as engines of territorial and economic expansion.
To accommodate their customers’ needs, large U.S. banks established networks of
foreign branches and affiliates.
Exhibit 21.7 shows the 15 largest banks in the world in 2007, as ranked by Forbes in its
annual list of the 2000 Largest Public Companies in the World.
A. Risks Involved in International Bank Lending
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The principles of loan administration and credit analysis are similar for domestic
and overseas loans.
There are differences, however, including some additional risk exposures for
overseas lending.
Credit risk is the same whether a loan is domestic or international.
However, it may be more difficult to obtain or assess credit information
abroad.
Bank loans that have foreign exchange risk will carry an additional risk
premium.
If an international loan or investment is expected to suffer some loss in
value, the loan will carry an additional risk premium.
B. Eurocredit Bank Loans
Eurocredits are short- to medium-term loans of a Eurocurrency to multinational
corporations or governments.
They can have a high degree of credit risk and may be too large for a single bank
to handle.
The lending banks often form a syndicate to spread the risk.
The loan rate (k) is equal to a base rate, such as LIBOR, which represents the
bank’s cost of funds, plus a markup.
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The general equation for Eurocredit pricing is expressed in Equation 21.3.
Eurocredits typically are floating-rate loans structured as “rollovers.”
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II. Suggested and Alternative Approaches to the Material
The chapter begins with some background information about the globalization of the world
economy, the rise of multinational corporations, and the key factors that distinguish domestic
from international business transactions. Emphasis is placed on the fact that the basic principles
of finance remain valid for international business transactions, even though some of the variables
used to calculate financial models change. Two risks are introduced that are not present in
domestic business transactions: foreign exchange risk and country risk.
The markets for foreign exchange are discussed next, and the authors explain how firms
protect themselves from fluctuations in exchange rates. The discussion moves to how
multinational firms manage their overseas capital investments and compute the NPV for these
projects.
Finally, the discussion turns to global money and capital markets. Particular attention is
paid to the Euromarket, where large multinational companies adjust their liquidity, borrow short
term from banks in the Eurocredit market, and borrow long term in the international bond
markets. Finally, bank pricing and the structure of Eurocredits are discussed.
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III. Summary of Learning Objectives
1. Discuss how the basic principles of finance apply to international financial
transactions.
The basic principles of managerial finance remain the same whether a transaction is
domestic or international. For example, the time value of money calculations remain the
same, as do the models used to calculate asset values. What does change, however, are
some of the input variables. These variables may be affected by cultural or procedural
differences between countries, such as a country’s unique currency, or differences in tax
and accounting standards.
2. Differentiate among the spot rate, the forward rate, and the cross rate in the foreign
exchange markets; make foreign exchange and cross rate calculations; and be able
to hedge an asset purchase where payment is made in a foreign currency.
The spot rate is the exchange rate at which one currency can be converted to another
immediately, whereas the forward rate is a rate agreed on today for an exchange to take
place at a specified point in the future. Forward rates are usually different from spot rates
and are the market’s best estimate of what a future spot rate will be. The cross rate is
simply the exchange rate between two currencies. Learning by Doing Applications 21.1
through 21.3 are foreign exchange rate problems that you should be able to solve.
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3. Identify the major factors that distinguish international from domestic capital
budgeting, explain how the capital budgeting process can be adjusted to account for
these factors, and compute the NPV for a typical international capital project.
One issue that distinguishes international from domestic capital budgeting is the
difficulty in estimating the incremental cash flows from an international project. These
difficulties can stem from differences in operating, accounting, and legal practices, as
well as from the variety of ways in which a multinational firm can transfer profits and
funds from the subsidiary to the parent corporation. Furthermore, firms engaged in
international capital budgeting face two risks that domestic firms do not have to deal
with: foreign exchange rate risk and country risk. The Barcelona example in Section 21.3
and Learning by Doing Application 21.4 illustrate capital budgeting calculations.
4. Discuss the importance of the Euromarkets to large U.S. multinational firms, and
calculate the cost of borrowing in the Eurobond market.
The Eurocurrency markets are important to large multinational corporations around the
world. These corporations hold Eurocurrency time deposits as investments and finance
much of their business activity by borrowing in the Eurocredit market and selling debt in
the Eurobond market. The Euromarkets are popular with large multinational firms
because they are largely unregulated; thus, they offer more attractive borrowing and
lending rates and greater flexibility in conducting transactions. Learning by Doing
Application 21.5 illustrates the cost of issuing bonds in the domestic and Eurobond
markets.
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5. Explain how large U.S. money center banks make and price Eurocredit loans to
their customers, and compute the cost of a Eurocredit bank loan.
Eurocredit loans are made by large multinational banks. Eurocredits typically have fixed
maturities and variable, or floating, rates of interest. The loan rate is tied to a base interest
rate (BR), such as LIBOR. Thus, the rate charged on a Eurocredit is BR + X, where X is
the lending margin, which consists of risk premiums (credit, country, and currency risks)
and the lender’s profit margin. The Citibank example in Section 21.5 and Learning by
Doing Application 21.6 illustrate how loan costs are computed.