Summarize the following in 2 to 3 pages: · Discuss issues raised concerning Sanders' approach in connection with the sale to Brown and Massey. · Include some of the other options that Sanders may have

21

International Financial Management

LEARNING OBJECTIVES

Today the world economy is more integrated than ever, and nations depend on one another for many valuable and scarce resources. The United States is dependent on China for textiles and Canada, Venezuela, and Saudi Arabia for oil; China is dependent on the United States and other Western countries for technology and heavy machinery. The World Trade Organization has made it easier for many countries to trade their goods and services without tariffs and import duties, and the economic laws of competitive advantage are at work. Countries like the United States, with a well-educated workforce, provide leading technological products while developing economies such as those in India and China, with large populations and low-cost labor, provide much of the world’s labor-intensive goods such as textiles, clothing, and assembled technology products. Additionally, the United States, Canada, and Mexico have instituted the North American Free Trade Association (NAFTA), which has increased trade among those three countries.

This growing interdependence necessitates the development of sound international business relations, which will enhance the prospects for future international cooperation and understanding. It is virtually impossible for any country to isolate itself from the impact of international developments in an integrated world economy. Therefore, world politics continue to play a role in economic development. Many Latin and South American countries are moving toward more socialist economies and are increasing trade with China while maintaining strong ties to their European trading partners. In an ever-more-connected world, international trade will become still more important.

We were reminded by the events of September 11, 2001, the occurrence of tsunamis and hurricanes, and the ebola outbreak of 2014 that terrorism, war, infectious disease, and weather can not only cause economic impacts for short periods of time, but can have catastrophic effects on localized economies or specific industries. With financial markets becoming more global, a major impact in one area of the world can affect economies thousands of miles away. The capital markets are so integrated that world events such as a currency crisis, government defaults on sovereign debt, or terrorism can cause stock and bond markets to suffer emotional declines well beyond the expected economic impact of a major event.

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Even when stock and bond markets are relatively stable and free of crisis, companies still have to pay attention to the currency markets. These currency markets impact imports and exports between countries and therefore affect sales and earnings of all companies doing business internationally, whether the company is Japan’s Sony, Germany’s Volkswagen, or the United States’ Intel. These companies do quite a bit of their business in the three largest and most liquid currencies in the world: the U.S. dollar, the euro, and the Japanese yen.

In January 1999, 11 countries from the European Union adopted the euro as their currency, which fully replaced their previous domestic currencies in January 2002. With the addition of Croatia in 2013, the European Union has grown to 28 countries, 19 of which use the euro as their official currency. These 19 countries are referred to as the “Eurozone.” In the past, it seemed certain that European Union members would continue to discard their national currencies and adopt the euro. However, economic crises in several European countries are leading some to question the practicality of remaining in the Eurozone. Greece, for example, found that one early benefit of participating in the Eurozone was easier access to international bond markets. However, just because it is easy to borrow does not mean that it is prudent to do so. Greece now finds it impossible to repay all of its euro debt, and it cannot devalue its currency. Unless other governments bail Greece out, the country is likely to default on its debt, and it may leave the Eurozone as well. Over the next few years, we will see whether monetary integration continues in Europe or whether some countries leave the Eurozone.

Figure 21-1 presents the value of the British pound against the dollar and also the value of the euro against the dollar. Even though Great Britain is a member of the European Union, it has not adopted the euro as its domestic currency but continues to use the pound.

Figure 21-1 shows that the British pound and the euro move up and down against the U.S. dollar in unison. Looking at the trend lines for the euro and the pound, understand that when the trend lines are falling, the dollar is rising. In other words, the dollar buys more euros or pounds. When the trend lines are rising, the dollar is falling. We can think about this in a different way. At the peak of the dollar (low for the euro) in 2001, one euro would buy about $0.84 and at the low of the dollar (peak of the euro) in April 2008, one euro would buy $1.60. This $0.76 swing was a 90.4 percent increase in the value of the euro relative to the dollar. From 1999 to 2002, U.S. companies doing business in Europe had to translate their euros into fewer and fewer dollars, so their foreign earnings in dollar terms were negatively affected by the falling euro. But as the euro rose against the dollar, the trend reversed itself.

Figure 21-1   One U.S. dollar to the British pound and euro

Sources: 2015 Federal Reserve Bank of St. Louis: research.stlouisfed.org.

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When financial panics occur, investors usually prefer to hold dollars because the dollar is widely viewed as a stable and safe currency. During the global financial panic that began in late 2008, the dollar rose dramatically in value relative to the British pound and the euro. Notice in Figure 21-1 that between July 2008 and March 2009, the British pound lost over 30 percent of its value relative to the dollar. Thus in early 2009, when U.S. companies began reporting their 2008 year-end earnings, U.S. companies reported a decrease in earnings from European operations because the euro was translated into fewer dollars. While the falling euro and pound (rising dollar) made European vacations more affordable to Americans, it also put U.S. companies who export to Europe at a competitive disadvantage. American-made goods became more expensive to Europeans who pay for their products in pounds or euros.

The significance of international business corporations becomes more apparent if we look at the size of foreign sales relative to domestic sales for major American corporations. Table 21-1 shows companies such as Coca-Cola with foreign sales of 57.0 percent, McDonald’s with foreign sales of 68.5 percent, and other companies with large percentages of foreign sales.

Table 21-1   International sales of selected U.S. companies

Just as foreign operations affect the performance of American businesses, developments in international financial markets also affect our lifestyles. If you took a trip to Europe in April 2011, you would have received about 0.68 euros per dollar. But if you took a second trip four years later, in April 2015, your dollar would get you 0.94 euros, an increase of almost 39 percent. On the other hand, Europeans traveling to the United States would have suffered a 39 percent decline in purchasing power. The value of currencies changes on a daily basis, occasionally by significant amounts, and often reversing directions. For example, after the euro rose against the dollar for several years, it plunged by 17 percent in the first months of 2010 over concerns that Greece and other European countries might default on their sovereign debt.

This chapter deals with the dimensions of doing business worldwide. We believe it provides a basis for understanding the complexities of international financial decisions. Such an understanding is important if you work for a multinational manufacturing firm, a large commercial bank, a major brokerage firm, or any firm involved in international transactions.

The Multinational Corporation: Nature and Environment

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The focus of international financial management has been the multinational corporation (MNC). One might ask, just what is a multinational corporation? Some definitions of a multinational corporation require that a minimum percentage (often 30 percent or more) of a firm’s business activities be carried on outside its national borders. For our understanding, however, any firm doing business across its national borders is considered a multinational enterprise. Multinational corporations can take several forms. Four are briefly examined.

Exporter An MNC could produce a product domestically and export some of that production to one or more foreign markets. This is perhaps the least risky method—reaping the benefits of foreign demand without committing any long-term investment to that foreign country.

Licensing Agreement A firm with exporting operations may get into trouble when a foreign government imposes or substantially raises an import tariff to a level at which the exporter cannot compete effectively with the local domestic manufacturers. The foreign government may even ban imports at times. When this happens the exporting firm may grant a license to an independent local producer to use the firm’s technology in return for a license fee or a royalty. In essence, then, the MNC will be exporting technology, rather than the product, to that foreign country.

Joint Venture As an alternative to licensing, the MNC may establish a joint venture with a local foreign manufacturer. The legal, political, and economic environments around the globe are more conducive to the joint venture arrangement than any of the other modes of operation. Historical evidence also suggests that a joint venture with a local entrepreneur exposes the firm to the least amount of political risk. This position is preferred by most business firms and by foreign governments as well.

Fully Owned Foreign Subsidiary Although the joint venture form is desirable for many reasons, it may be hard to find a willing and cooperative local entrepreneur with sufficient capital to participate. Under these conditions, the MNC may have to go it alone. For political reasons, however, a wholly owned foreign subsidiary is becoming more of a rarity. The reader must keep in mind that whenever we mention a foreign affiliate in the ensuing discussion, it could be a joint venture or a fully owned subsidiary.

As the firm crosses its national borders, it faces an environment that is riskier and more complex than its domestic surroundings. Sometimes the social and political environment can be hostile. Despite these difficult challenges, foreign affiliates often are more profitable than domestic businesses. A purely domestic firm faces several basic risks, such as the risk related to maintaining sales and market share, the financial risk of too much leverage, the risk of a poor equity market, and so on. In addition to these types of risks, the foreign affiliate is exposed to foreign exchange risk and political risk. While the foreign affiliate experiences a larger amount of risk than a domestic firm, it actually lowers the portfolio risk of its parent corporation by stabilizing the combined operating cash flows for the MNC. This risk reduction occurs because foreign and domestic economies are less than perfectly correlated.

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Foreign business operations are more complex because the host country’s economy may be different from the domestic economy. The rate of inflation (or deflation) in a foreign country will almost certainly be different than in the United States. The rules of taxation are different. The structure and operation of financial markets and institutions also vary from country to country, as do financial policies and practices. The presence of a foreign affiliate benefits the host country’s economy. Foreign affiliates have been a decisive factor in shaping the pattern of trade, investment, and the flow of technology between nations. They can have a significant positive impact on a host country’s economic growth, employment, trade, and balance of payments. The growth of MNCs has also reduced geopolitical risk and improved world peace. Countries with trade ties are less likely to go to war against one another. These positive contributions, however, are occasionally overshadowed by allegations of wrongdoing. For example, some host countries have charged that foreign affiliates subverted their governments and caused instability of their currencies. The less developed countries (LDCs) have, at times, alleged that foreign businesses exploit their labor with low wages.

The multinational companies are also under constant criticism in their home countries where labor unions charge the MNCs with exporting jobs, capital, and technology to foreign nations while avoiding their fair share of taxes. Despite all these criticisms, multinational companies have managed to survive and prosper. The MNCs are well positioned to take advantage of imperfections in the global markets. Furthermore, since current global resource distribution favors the MNCs’ survival and growth, it may be concluded that multinational corporations are here to stay.

Foreign Exchange Rates

Suppose you are planning to spend a semester in London studying the culture of England. To put your plan into operation you will need British currency—that is, British pounds (£)—so you can pay for your expenses during your stay. How many British pounds you can obtain for $1,000 will depend on the exchange rate at that time. The relationship between the values of two currencies is known as the exchange rate. The exchange rate between U.S. dollars and British pounds is stated as dollars per pound or pounds per dollar. For example, the quotation of $2.00 per pound is the same as £0.50 per dollar (1/$2.00). At this exchange rate you can purchase 500 British pounds with $1,000. A quick Internet search for “foreign exchange rates” or just “fx rates” will deliver multiple sources of up-to-the minute exchange rate data. Figure 21-2 depicts Canadian dollars, Japanese yen, Swiss francs, and Swedish kronor because they are used by some of the United States’ major trading partners. This figure shows the amount of each currency that one can exchange for one U.S. dollar.

There is no guarantee that any currency will stay strong relative to other currencies, and the dollar is no exception. Several factors have combined to strengthen the U.S. dollar relative to the euro and the British pound since 2007. The first factor was a “flight to quality” during the financial crisis that began late in that year. However, continued weak European growth and fear for the stability of many eurozone countries has continued to depress the euro (lift the dollar). This strengthening may only be temporary. Of particular concern is the unsustainably high U.S. budget deficit. On the other hand, the United States is not the only country that must address unsustainable policies. Many other countries run large budget deficits or have policies in place that may reduce future economic growth. Such policies may lead to a weakening of those countries’ currencies, and a relative strengthening of the dollar.

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Figure 21-2   Exchange rates to the dollar

Source: 2015 Federal Reserve Bank of St. Louis, research.stlouisfed.org.

Financial managers should always pay close attention to exchange rates and any changes that might be forecast.

Factors Influencing Exchange Rates

The present international monetary system consists of a mixture of “freely” floating exchange rates and fixed rates. The currencies of the major trading partners of the United States are traded in free markets. In such a market, the exchange rate between two currencies is determined by the supply of, and the demand for, those currencies. This activity, however, is subject to intervention by many countries’ central banks. Factors that tend to increase the supply or decrease the demand schedule for a given currency will bring down the value of that currency in foreign exchange markets. Similarly, the factors that tend to decrease the supply or increase the demand for a currency will raise the value of that currency. Since fluctuations in currency values result in foreign exchange risk, the financial executive must understand the factors causing these changes in currency values. Although the value of a currency is determined by the aggregate supply and demand for that currency, this alone does not help financial managers understand or predict the changes in exchange rates. Fundamental factors, such as inflation, interest rates, balance of payments, and government policies, are important in explaining both the short-term and long-term fluctuations of a currency value.

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Purchasing Power Parity In theory, a parity between the purchasing powers of two currencies should establish the rate of exchange between the two currencies. Suppose it takes $1.00 to buy one dozen apples in New York and 1.25 euros to buy the same apples in Frankfurt, Germany. Then the rate of exchange between the U.S. dollar and the euro should be €1.25/$1.00 or $0.80/euro. If prices of apples double in New York while the prices in Frankfurt remain the same, the purchasing power of a dollar in New York should drop 50 percent. Consequently, you should be able to exchange $1.00 for only €0.625 in foreign currency markets (or receive $1.60 per euro).

Currency exchange rates tend to vary inversely with their respective purchasing powers to provide the same or similar purchasing power in each country. This is called the purchasing power parity theory. When the inflation rate differential between two countries changes, the exchange rate also adjusts to correspond to the relative purchasing powers of the countries.

Interest Rates Another economic variable that has a significant influence on exchange rates is interest rates. As a student of finance, you should know that investment capital flows in the direction of higher yield for a given level of risk. This flow of short-term capital between money markets occurs because investors seek equilibrium through arbitrage buying and selling. If investors can earn 6 percent interest per year in Country X and 10 percent per year in Country Y, they will prefer to invest in Country Y, provided the inflation rate and risk are the same in both countries. Thus interest rates and exchange rates adjust until the foreign exchange market and the money market reach equilibrium. This interplay between interest rate differentials and exchange rates is called the interest rate parity theory.

Balance of Payments The term balance of payments refers to a system of government accounts that catalogs the flow of economic transactions between the residents of one country and the residents of other countries. (The balance of payments statement for the United States is prepared by the U.S. Department of Commerce quarterly and annually.) It resembles the cash flow statement presented in Chapter 2 and tracks the country’s exports and imports as well as the flow of capital and gifts. When a country sells (exports) more goods and services to foreign countries than it purchases (imports), it will have a surplus in its balance of trade. Over the last several decades, Japan, through its aggressive competition in world markets, has been exporting more goods than it imports and has been enjoying a trade surplus for quite some time. Since the foreigners who buy Japanese goods are expected to pay their bills in yen, the demand for yen and, consequently, its value, increases in foreign currency markets. On the other hand, continuous deficits in the balance of payments are expected to depress the value of a currency because such deficits would increase the supply of that currency relative to the demand.

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Government Policies A national government may, through its central bank, intervene in the foreign exchange market, buying and selling currencies as it sees fit to support the value of its currency relative to others. Sometimes a given country may deliberately pursue a policy of maintaining an undervalued currency to promote cheap exports. In some countries, the currency values are set by government decree. Even in some free market countries, the central banks fix the exchange rates, subject to periodic review and adjustment. Some nations affect the foreign exchange rate indirectly by restricting the flow of funds into and out of the country. Monetary and fiscal policies also affect the currency value in foreign exchange markets. For example, expansionary monetary policy and excessive government spending are primary causes of inflation, and continual use of such policies eventually reduces the value of the country’s currency. Sometimes government policies are at odds with economic reality. In early 2015 Venezuela had two official exchange rates of 6.3 or 12 bolivares to the dollar, depending on what goods were being purchased by the person seeking to exchange bolivares for dollars. In truth, only people with political connections could get these rates. On the black market, where most currency transactions actually took place, 190 bolivares were needed to buy a dollar.

Other Factors A pronounced and extended stock market rally in a country attracts investment capital from other countries, thus creating a huge demand by foreigners for that country’s currency. This increased demand is expected to increase the value of that currency. Similarly a significant increase in demand for a country’s principal exports worldwide is expected to result in a corresponding increase in the value of its currency. In recent years, Australia has enjoyed significantly increased exports to China and other Asian countries. In particular, coal, copper, and natural gas have been exported. While it once required 1.5 AUD to buy a U.S. dollar, in 2013 only 0.97 AUD were required to buy a U.S. dollar. As Asian economies slowed in 2014, Australian exports declined, and so did the AUD. By 2015 it required 1.3 AUD to purchase one U.S. dollar.

Political turmoil in a country often drives capital out of the country into stable countries. A mass exodus of capital, due to the fear of political risk, undermines the value of a country’s currency in the foreign exchange market. Venezuela’s bolivar lost almost two-thirds of its value against the dollar between 2010 and 2013 due to political turmoil.

Although a wide variety of factors that can influence exchange rates has been discussed, a few words of caution are in order. All of these variables will not necessarily influence all currencies to the same degree. Some factors may have an overriding influence on one currency’s value, while their influence on another currency may be negligible at that time.

Spot Rates and Forward Rates

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When you look into a major financial newspaper (e.g., The Wall Street Journal), you will discover that two exchange rates exist simultaneously for most major currencies— the spot rate and the forward rate. The spot rate for a currency is the exchange rate at which the currency is traded for immediate delivery. For example, you walk into a local commercial bank and ask for Swiss francs.1 The banker will indicate the rate at which the franc is selling, say SF 0.9727/$. If you like the rate, you buy 972.70 francs with $1,000 and walk out the door. This is a spot market transaction at the retail level. The trading of currencies for future delivery is called a forward market transaction. Suppose IBM Corporation expects to receive SF 97,270 from a Swiss customer in 30 days. It is not certain, however, what these francs will be worth in U.S. dollars in 30 days. To eliminate this uncertainty, IBM calls a bank and offers to sell SF 97,270 for U.S. dollars in 30 days. In their negotiation, the two parties may agree on an exchange rate of SF 0.9718/$. This is the same as $1.0290/SF. The 0.9718 quote is in Swiss francs per dollar. The reciprocal or 1.0290 is in dollars per Swiss franc.

Since the exchange rate is established for future delivery, it is a forward rate. After 30 days, IBM delivers SF 97,270 to the bank and receives $100,000. The difference between spot and forward exchange rates, expressed in dollars per unit of foreign currency, may be seen in the following typical values:

The forward exchange rate of a currency is slightly different from the spot rate prevailing at that time. Since the forward rate deals with a future time, the expectations regarding the future value of that currency are reflected in the forward rate. Forward rates may be greater than the current spot rate (premium) or less than the current spot rate (discount). The preceding table shows the forward rates on the Swiss franc were at a premium in relation to the spot rate, while the forward rates for the British pound were at a discount from the spot rate. This means the participants in the foreign exchange market expected the Swiss franc to appreciate relative to the U.S. dollar in the future and the British pound to depreciate against the dollar. The discount or premium is usually expressed as an annualized percentage deviation from the spot rate. The percentage discount or premium is computed with the following formula:

For example, the 90-day forward contract in Swiss francs, as previously listed, was selling at a 1.362 percent premium:

while the 90-day forward contract in British pounds was trading at a −0.244 percent discount:

Normally the forward premium or discount is between 0.1 percent and 5 percent.

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The spot and forward transactions are said to occur in the over-the-counter market. Foreign currency dealers (usually large commercial banks) and their customers (importers, exporters, investors, multinational firms, and so on) negotiate the exchange rate, the length of the forward contract, and the commission in a mutually agreeable fashion. Although the length of a typical forward contract may generally vary between one month and six months, contracts for longer maturities are not uncommon. The dealers, however, may require higher returns for longer contracts.

Cross Rates

Because currencies are quoted against the U.S. dollar in The Wall Street Journal, sometimes it may be necessary to work out the cross rates for currencies other than the dollar. For example, on April 13, 2015, the Swiss franc was selling for $1.0231 and the British pound was selling for $1.46596. The cross rate between the franc and the pound was 1.43294 (francs/pound). In determining this value, we show that one dollar would buy 0.97747 francs (1/1.0231) and a pound was equal to 1.46596 dollars. Thus 0.97747 Swiss francs per dollar times 1.46596 dollars per pound equaled 1.43293 Swiss francs per pound.

To determine if your answer is correct, you can check a currency cross rate table such as that shown in Table 21-2. There you will see the cross rate between the Swiss franc and the British pound was, in fact, 1.43294 on April 13, 2015. This very minor difference is normal. GBP along the side stands for British pound and CHF across the top stands for Swiss franc. As in this example, the cross rates for various currencies will not always be perfectly synchronized, but they will be very close because arbitrageurs would quickly buy and sell currencies that had cross rates that deviated from the relationship described. These arbitrageurs would earn risk-free returns while pushing the market back to equilibrium cross rates.

Table 21-2 has currency rates for two periods approximately five years apart (the top and middle of the table). Comparing the rates for the two time periods shows that the U.S. dollar (top line) rose against the world’s most important currencies (the euro, the British pound, and the Japanese yen) as well as against both the Canadian dollar and the Australian dollar. Only the Swiss franc rose significantly relative to the U.S. dollar. Low taxes, sound financial institutions, and high levels of public safety and education have made Switzerland a preferred place both to do business and to safeguard wealth for rich people from all over the world.

Managing Foreign Exchange Risk

When the parties associated with a commercial transaction are located in the same country, the transaction is denominated in a single currency. International transactions inevitably involve more than one currency (because the parties are residents of different countries). Since most foreign currency values fluctuate from time to time, the monetary value of an international transaction measured in either the seller’s currency or the buyer’s currency is likely to change when payment is delayed. As a result, the seller may receive less revenue than expected or the buyer may have to pay more than the expected amount for the merchandise. Thus the term foreign exchange risk refers to the possibility of a drop in revenue or an increase in cost in an international transaction due to a change in foreign exchange rates. Importers, exporters, investors, and multinational firms are all exposed to this foreign exchange risk.

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The international monetary system has undergone a significant change since 1971 when the free trading Western nations basically went from a fixed exchange rate system to a “freely” floating rate system. For the most part, the new system has proved its agility and resilience during the most turbulent years of oil price hikes and hyperinflation of the last two decades. The free market exchange rates have responded and adjusted well to these adverse conditions. Consequently, the exchange rates have fluctuated over a much wider range than before. The increased volatility of exchange markets has forced many multinational firms, importers, and exporters to pay more attention to the function of foreign exchange risk management.

Table 21-2   Key currency cross rates

USD = United States dollar

EUR = European monetary unit

GBP = Great Britain pound

JPY = Japanese yen

CHF = Swiss franc

CAD = Canadian dollar

AUD = Australian dollar

NZD = New Zealand dollar

HKD = Hong Kong dollar

SGD = Singaporean dollar

Source: www.fxstreet.com/rates-charts/exchange-rates/.

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The foreign exchange risk of a multinational company is divided into two types of exposure: accounting or translation exposure and transaction exposure. An MNC’s foreign assets and liabilities, which are denominated in foreign currency units, are exposed to losses and gains due to changing exchange rates. This is called accounting or translation exposure. The amount of loss or gain resulting from this form of exposure and the treatment of it in the parent company’s books depend on the accounting rules established by the parent company’s government. In the United States, the rules are spelled out in the Statement of Financial Accounting Standards (SFAS) No. 52. Under SFAS 52 all foreign currency–denominated assets and liabilities are converted at the rate of exchange in effect on the date of balance sheet preparation. An unrealized translation gain or loss is held in an equity reserve account while the realized gain or loss is incorporated in the parent’s consolidated income statement for that period. Thus SFAS 52 partially reduces the impact of accounting exposure resulting from the translation of a foreign subsidiary’s balance sheet on reported earnings of multinational firms.

Finance in ACTION Global Coca-Cola Manages Currency Risk

The Coca-Cola Company is the world’s largest beverage company. Based in Atlanta, Georgia, Coca-Cola had worldwide sales of over $46 billion in 2014. Nearly 60 percent of these sales were outside the United States. Coke’s sales are spread across North America, Latin America, Asia, Europe, and Africa. Although most of its sales and its costs are in foreign countries, Coke reports earnings to its mostly American shareholders in U.S. dollars. It is not surprising that Coke works hard to manage its foreign currency risk. The largest currency positions that it manages include the euro, Japanese yen, Mexican peso, and Brazilian real. Overall, Coke used 70 functional currencies along with the U.S. dollar in 2014. Coke has used derivatives such as forward currency contracts and currency options to buy these currencies in advance and to short them (meaning it has agreed in advance to deliver currency that it does not yet possess).

Sometimes these derivative positions are worth billions of dollars, but it would be an error to think of Coca-Cola as gambling. In a recent annual report, Coca-Cola states,

Our Company uses derivative financial instruments primarily to reduce our exposure to adverse fluctuations in foreign currency exchange rates, interest rates, commodity prices and other market risks. We do not enter into derivative financial instruments for trading purposes. As a matter of policy, all of our derivative positions are used to reduce risk by hedging an underlying economic exposure. Because of the high correlation between the hedging instrument and the underlying exposure, fluctuations in the value of the instruments are generally offset by reciprocal changes in the value of the underlying exposure. The Company generally hedges anticipated exposures up to 36 months in advance; however, the majority of our derivative instruments expire within 24 months or less. Virtually all of our derivatives are straightforward over-the-counter instruments with liquid markets.

We monitor our exposure to financial market risks using several objective measurement systems, including a sensitivity analysis to measure our exposure to fluctuations in foreign currency exchange rates, interest rates, and commodity prices.

From this statement, it is clear that a hedge is not meant to be speculative or to make money based on expectations of currency fluctuations. Coca-Cola hedges to protect cash flows that are arising in the ordinary course of its international business. Many other companies are in this same situation. It is important to distinguish between trading for a profit (speculating) and locking in a position (hedging). Derivative contracts often get a bad reputation as risky because a few financial officers have used them to speculate, rather than to hedge. However, large non-financial companies, like Coca-Cola, use derivatives mostly to minimize risk.

However, foreign exchange gains and losses resulting from international transactions, which reflect transaction exposure, are shown in the income statement for the current period. As a consequence of these transactional gains and losses, the volatility of reported earnings per share increases. Three different strategies can be used to minimize this transaction exposure.

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1. Hedging in the forward exchange market.

2. Hedging in the money market.

3. Hedging in the currency futures market.

Forward Exchange Market Hedge To see how transaction exposure can be covered in forward markets, suppose Electricitie de France, an electric company in France, purchases a large generator from the General Electric Company of the United States for 822,400 euros on February 21, 2017, and GE is promised the payment in euros in 90 days. Since GE is now exposed to exchange rate risk by agreeing to receive the payment in euros in the future, it is up to General Electric to find a way to reduce this exposure. One simple method is to hedge the exposure in the forward exchange market with a 90-day forward contract. On February 21, 2017, to establish a forward cover, GE sells a forward contract to deliver the 822,400 euros 90 days from that date in exchange for $1,000,000. On May 22, 2017,2 GE receives payment from Electricitie de France and delivers the 822,400 euros to the bank that signed the contract. In return, the bank delivers $1,000,000 to GE.

Money Market Hedge A second way to eliminate transaction exposure in the previous example would have been to borrow money in euros and then convert it to U.S. dollars immediately. When the account receivable from the sale is collected three months later, the loan is cleared with the proceeds. In this case, GE’s strategy consists of the following steps.

On February 21, 2017:

1. Borrow 806,275 euros—(822,400 euros/1.02) = 806,274.51 euros—at the rate of 8.0 percent per year for three months. You will borrow less than the full amount of 822,400 euros in recognition of the fact that interest must be paid on the loan. Eight percent interest for 90 days translates into 2.0 percent. Thus 822,400 euros is divided by 1.02 to arrive at the size of the loan before the interest payment.

2. Convert the euros into U.S. dollars in the spot market.

Then on May 22, 2014 (90 days later):

3. Receive the payment of 822,400 euros from Electricitie de France.

4. Clear the loan with the proceeds received from Electricitie de France.

The money market hedge basically calls for matching the exposed asset (account receivable) with a liability (loan payable) in the same currency. Some firms prefer this money market hedge because of the early availability of funds possible with this method.

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Currency Futures Market Hedge Transaction exposure associated with a foreign currency can also be covered in the futures market with a currency futures contract. The International Monetary Market (IMM) of the Chicago Mercantile Exchange began trading in futures contracts in foreign currencies on May 16, 1972. Trading in currency futures contracts also made a debut on the London International Financial Futures Exchange (LIFFE) in September 1982. Other markets have also developed around the world. Just as futures contracts are traded in corn, wheat, hogs, and beans, foreign currency futures contracts are traded in these markets. Although the futures market and forward market are similar in concept, they differ in their operations. To illustrate the hedging process in the currency futures market, suppose that in May Bank of America considers lending 500,000 pesos to a Mexican subsidiary of a U.S. parent company for seven months. The bank purchases the pesos in the spot market, delivers them to the borrower, and simultaneously hedges its transaction exposure by selling December contracts in pesos for the same amount. In December when the loan is cleared, the bank sells the pesos in the spot market and buys back the December peso contracts. The transactions are illustrated for the spot and futures market in Table 21-3:3

Table 21-3   Currency futures hedging

While the loan was outstanding, the peso declined in value relative to the U.S. dollar. Had the bank remained unhedged, it would have lost $1,950 in the spot market. By hedging in the futures market, the bank was able to reduce the loss to $1,300. A $650 gain in the futures market was used to cancel some of the $1,950 loss in the spot market.

These are not the only means companies have for protecting themselves against foreign exchange risk. Over the years, multinational companies have developed elaborate foreign asset management programs, which involve such strategies as switching cash and other current assets into strong currencies, while piling up debt and other liabilities in depreciating currencies. Companies also encourage the quick collection of bills in weak currencies by offering sizable discounts, while extending liberal credit in strong currencies.

Foreign Investment Decisions

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Literally thousands of U.S. firms operate in foreign countries through one or more foreign affiliates. Several explanations are offered for the moves to foreign soil. First, with the emergence of trading blocs in Europe, American firms feared their goods might face import tariffs in those countries. To avoid such trade barriers, U.S. firms started manufacturing in foreign countries. The second factor was the lower production costs overseas. Firms were motivated by the significantly lower wage costs prevailing in foreign countries. Firms in labor-intensive industries, such as textiles and electronics, moved some of their operations to countries where labor was cheap. Third, superior American technology gave U.S. firms easy access to oil exploration, mining, and manufacturing in many developing nations. A fourth advantage relates to taxes. The U.S.-based multinational firms can postpone payment of U.S. taxes on income earned abroad until such income is actually repatriated (forwarded) to the parent company. This tax deferral provision can be used by an MNC to minimize its tax liability. Some countries, like Israel, Ireland, and South Africa, offer special tax incentives for foreign firms that establish operations there.

The decision to invest in a foreign country by a firm operating in an oligopolistic industry is also motivated by strategic considerations. When a competitor undertakes a direct foreign investment, other companies quickly follow with defensive investments in the same foreign country. Foreign investments undertaken by U.S. soft drink companies are classic examples of this competitive reaction. Wherever you find a Coca-Cola subsidiary in a foreign country, you are likely to see a Pepsi affiliate also operating in that country.

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International diversification also reduces a company’s overall risk. The basic premise of portfolio theory in finance is that an investor can reduce the risk level of a portfolio by combining those investments whose returns are less than perfectly positively correlated. In addition to domestic diversification, it is shown in Figure 21-3 that further reduction in investment risk can be achieved by also diversifying across national boundaries. Portfolios with international stocks in Figure 21-3 show a lower standard deviation compared to pure U.S. stock portfolios. It is argued, however, that institutional and political constraints, language barriers, and lack of adequate information on foreign investments prevent investors from diversifying across nations. Multinational firms, on the other hand, through their unique position around the world, derive benefits from international diversification.4

Figure 21-3   Risk reduction from international diversification

While U.S.-based firms took the lead in establishing overseas subsidiaries during the 1950s and 1960s, European and Japanese firms started this activity in the 1970s and have continued into the new century. Chinese companies arrived later to the game, but these firms have also expanded into international markets. The flow of foreign direct investment into the United States has proceeded at a rapid rate. These investments employ millions of people. It is evident that the United States is an attractive site for foreign investment. In addition to the international diversification and strategic considerations, many other factors are responsible for this inflow of foreign capital into the United States. Increased foreign labor costs in some countries and saturated overseas markets in others are partly responsible. In Japan, an acute shortage of land suitable for industrial development and a near total dependence on imported oil prompted some Japanese firms to locate in the United States. In Germany, a large number of paid holidays, restrictions limiting labor layoffs, and worker participation in management decision making caused many firms to look favorably at the United States. Political stability, large market size, access to advanced technology, and a highly educated workforce are other primary motivating factors for firms to establish operations in the United States.

Not only do foreign investors make direct investments in U.S. commercial enterprises, foreign investors in the U.S. Treasury bond market have been bankrolling enormous budget deficits that the government has been running up. When the U.S. government began falling $150 to $200 billion into the red on an annual basis in the 1980s, many analysts thought this would surely mean high inflation, high interest rates, and perhaps a recession. They also were sure there would be a “shortage of capital” for investments because of large government borrowing to finance the deficits. For the most part, foreign investors from China, Japan, Western Europe, Canada, and elsewhere have bailed the government out by supplying the necessary capital. Of course, this means the United States is more dependent on flows of foreign capital into the country. We must satisfy our “outside” creditors or face the unpleasant consequences. During the last three decades, we have gone from being the largest lender in the world to the largest borrower. This debt places an enormous burden on future generations of American taxpayers.

Analysis of Political Risk

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Business firms tend to make direct investments in foreign countries for a relatively long time. This is because of the time necessary to recover the initial investment. The government may change hands several times during the foreign firm’s tenure in that country; and, when a new government takes over, it may not be as friendly or as cooperative as the previous administration. An unfriendly government can interfere with the foreign affiliate in many ways. It may impose foreign exchange restrictions, or the foreign ownership share may be limited to a set percentage of the total. Repatriation (transfer) of a subsidiary’s profit to the parent company may be blocked, at least temporarily; and, in the extreme case, the government may even expropriate (take over) the foreign subsidiary’s assets. The multinational company may experience a sizable loss of income or property, or both, as a result of this political interference. Many once well-known U.S. firms, like Anaconda, ITT, and Occidental Petroleum, have lost hundreds of millions of dollars in politically unstable countries. Over the last 30 years, more than 60 percent of U.S. companies doing business abroad suffered some form of politically inflicted damage. Therefore, analysis of foreign political risk is important to multinational firms.

The best approach to protection against political risk is to thoroughly investigate the country’s political stability long before the firm makes any investment in that country. Companies use different methods for assessing political risk. Some firms hire consultants to provide them with a report of political risk analysis. Others form their own advisory committees (little state departments) consisting of top-level managers from headquarters and foreign subsidiaries. After ascertaining the country’s political risk level, the multinational firm can use one of the following strategies to guard against such risk:

1. One strategy is to establish a joint venture with a local entrepreneur. By bringing a local partner into the deal, the MNC not only limits its financial exposure but also minimizes antiforeign feelings. Having a “politically connected” local partner can be very valuable.

2. Another risk management tactic is to enter a joint venture with larger firms from other countries. For example, an energy company may pursue its oil production operation in Zaire in association with Royal Dutch Petroleum and Nigerian National Petroleum as partners. The foreign government will be more hesitant to antagonize a number of partner firms of many nationalities at the same time.

3. When the perceived political risk level is high, insurance against such risks can be obtained in advance. Overseas Private Investment Corporation (OPIC), a federal government agency, sells insurance policies to qualified firms. OPIC promotes American investment in third world countries by insuring against losses due to inconvertibility into dollars of amounts received in a foreign country. Policies are also available from OPIC to insure against expropriation and against losses due to war or revolution. For example, OPIC insures the Rwanda properties of Westport, Connecticut–based Tea Importers Inc. During the five-year Rwandan civil war, the company’s tea-processing factory was destroyed, and OPIC paid claims on insurance against political violence. These payments allowed Tea Importers to rebuild and resume production after the war and helped to revive the Rwandan economy. Private insurance companies, such as Lloyds of London, American International Group Inc., CIGNA, and others, issue similar policies to cover political risk.

Political risk umbrella policies do not come cheaply. Coverage for projects in “fairly safe” countries can cost anywhere from 0.3 percent to 12 percent of the insured values per year. Needless to say, the coverage is more expensive or unavailable in troubled countries. OPIC’s rates are lower than those of private insurers, and its policies extend for up to 20 years, compared to three years or less for private insurance policies.

Financing International Business Operations

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When the parties to an international transaction are well known to each other and the countries involved are politically stable, sales are generally made on credit, as is customary in domestic business operations. However, if a foreign importer is relatively new or the political environment is volatile, or both, the possibility of nonpayment by the importer is worrisome for the exporter. To reduce the risk of nonpayment, an exporter may request that the importer furnish a letter of credit. The importer’s bank normally issues the letter of credit, in which the bank promises to subsequently pay the money for the merchandise. For example, assume Archer Daniels Midland (ADM) is negotiating with a South Korean trading company to export soybean meal. The two parties agree on price, method of shipment, timing of shipment, destination point, and the like. Once the basic terms of sale have been agreed to, the South Korean trading company (importer) applies for a letter of credit from its commercial bank in Seoul. The Korean bank, if it so desires, issues such a letter of credit, which specifies in detail all the steps that must be completed by the American exporter before payment is made. If ADM complies with all specifications in the letter of credit and submits to the Korean bank the proper documentation to prove that it has done so, the Korean bank guarantees the payment on the due date. On that date, the American firm is paid by the Korean bank, not by the buyer of the goods. Therefore, all the credit risk to the exporter is absorbed by the importer’s bank, which is in a good position to evaluate the creditworthiness of the importing firm.

The exporter who requires cash payment or a letter of credit from foreign buyers of marginal credit standing is likely to lose orders to competitors. Instead of risking the loss of business, American firms can find an alternative way to reduce the risk of nonpayment by foreign customers. This alternative method consists of obtaining export credit insurance. The insurance policy provides assurance to the exporter that should the foreign customer default on payment, the insurance company will pay for the shipment. The Foreign Credit Insurance Association (FCIA), a private association of U.S. insurance firms, provides this kind of insurance to exporting firms.

Funding of Transactions

Assistance in the funding of foreign transactions may take many forms.

Eximbank (Export-Import Bank) This agency of the U.S. government facilitates the financing of U.S. exports through its various programs. In its direct loan program, the Eximbank lends money to foreign purchasers of U.S. goods such as aircraft, electrical equipment, heavy machinery, computers, and the like. The Eximbank also purchases eligible medium-term obligations of foreign buyers of U.S. goods at a discount from face value. In this discount program, private banks and other lenders are able to rediscount (sell at a lower price) promissory notes and drafts acquired from foreign customers of U.S. firms.

Corporate subsidies are controversial, and Congressional authorization for the bank lapsed on July 1, 2015. Several companies like GE and Boeing began to move some production overseas, citing Congress’s failure to reauthorize the bank. These actions put pressure on Congress to renew the charter, but as of late 2015, the bank’s future remains uncertain.

Loans from the Parent Company or a Sister Affiliate Another source of funds for a foreign affiliate is its parent company or its sister affiliates. In addition to contributing equity capital, the parent company often provides loans of varying maturities to its foreign affiliate. Although the simplest arrangement is a direct loan from the parent to the foreign subsidiary, such a loan is rarely extended because of foreign exchange risk, political risk, and tax treatment. Instead the loans are often channeled through an intermediary to a foreign affiliate. Parallel loans and fronting loans are two examples of such indirect loan arrangements between a parent company and its foreign affiliate. A typical parallel loan arrangement is depicted in Figure 21-4.

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Figure 21-4   A parallel loan arrangement

In this illustration of a parallel loan, an American firm that wants to lend funds to its Dutch affiliate locates a Dutch parent firm, which needs to transfer funds to its U.S. affiliate. Avoiding the exchange markets, the U.S. parent lends dollars to the Dutch affiliate in the United States, while the Dutch parent lends guilders to the American affiliate in the Netherlands. At maturity, the two loans would each be repaid to the original lender. Notice that neither loan carries any foreign exchange risk in this arrangement. In essence both parent firms are providing indirect loans to their affiliates.

A fronting loan is simply a parent’s loan to its foreign subsidiary channeled through a financial intermediary, usually a large international bank. A schematic of a fronting loan is shown in Figure 21-5.

Figure 21-5   A fronting loan arrangement

In the example, the U.S. parent company deposits funds in an Amsterdam bank and that bank lends the same amount to the U.S. firm’s affiliate in the Netherlands. In this manner, the bank fronts for the parent by extending a risk-free (fully collateralized) loan to the foreign affiliate. In the event of political turmoil, the foreign government is more likely to allow the American subsidiary to repay the loan to a large international bank than to allow the same affiliate to repay the loan to its parent company. Thus the parent company reduces its political risk substantially by using a fronting loan instead of transferring funds directly to its foreign affiliate.

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Even though the parent company would prefer that its foreign subsidiary maintain its own financial arrangements, many banks are apprehensive about lending to a foreign affiliate without a parent guarantee. In fact, a large portion of bank lending to foreign affiliates is based on some sort of a guarantee by the parent firm. Usually, because of its multinational reputation, the parent company has a better credit rating than its foreign affiliates. The lender advances funds on the basis of the parent’s creditworthiness even though the affiliate is expected to pay back the loan. The terms of a parent guarantee may vary greatly, depending on the closeness of the parent–affiliate ties, parent–lender relations, and the home country’s legal jurisdiction.

Eurodollar Loans The Eurodollar market is an important source of short-term loans for many multinational firms and their foreign affiliates.

Eurodollars are simply U.S. dollars deposited in foreign banks. Although a substantial portion of these deposits are held by European banks or European-based branches of U.S. commercial banks, the prefix “euro” is somewhat misleading because the foreign bank does not need to be located in Europe.

Since the early 1960s, the Eurodollar market has established itself as a significant part of world credit markets. The participants in these markets are diverse in character and geographically widespread. Hundreds of corporations and banks, mostly from the United States, Canada, Western Europe, and Japan, are regular borrowers and depositors in this market.

U.S. firms have more than doubled their borrowings in the Eurodollar market during the last decade. The lower costs and greater credit availability of this market continue to attract borrowers. The lower borrowing costs in the Eurodollar market are often attributed to the smaller overhead costs for lending banks and the absence of a compensating balance requirement. Most Eurodollar transactions occur between large banks. Banks with an excess of deposits, relative to profitable lending opportunities, lend their excess funds to other banks who have an excess of opportunities but a shortage of funds. These interbank loans are often priced using the London Interbank Offered Rate (LIBOR). Other Eurodollar borrowers are typically charged a premium above the LIBOR. Interest rates on these loans are calculated by adding a premium to the basic rate. The size of this premium varies from 0.25 percent to 0.50 percent, depending on the customer, length of the loan period, size of the loan, and so on. For example, Northern Indiana Public Service Company obtained a $75 million, three-year loan from Merrill Lynch International Bank. The utility company paid 0.375 points above LIBOR for the first two years and 0.50 points above for the final year of the loan. Over the years, borrowing in the Eurodollar market has been one-eighth to seven-eighths of a percentage point cheaper than borrowing at the U.S. prime interest rate. For information on the LIBOR price fixing scandal, see Chapter 8.

Lending in the Eurodollar market is done almost exclusively by commercial banks. Large Eurocurrency loans are often syndicated by a group of participating banks. The loan agreement is put together by a lead bank, known as the manager, which is usually one of the largest U.S. or European banks. The manager charges the borrower a once-and-for-all fee or commission of 0.25 percent to 1 percent of the loan value. A portion of this fee is kept by the lead bank, and the remainder is shared by all the participating banks. The aim of forming a syndicate is to diversify the risk, which would be too large for any single bank to handle by itself. Multicurrency loans and revolving credit arrangements can also be negotiated in the Eurocurrency market to suit borrowers’ needs.

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Eurobond Market When long-term funds are needed, borrowing in the Eurobond market is a viable alternative for leading multinational corporations. The Eurobond issues are sold simultaneously in several national capital markets, but denominated in a currency different from that of the nation in which the bonds are issued. The most widely used currency in the Eurobond market is the U.S. dollar. These bonds are dollar-denominated, but they are issued outside the United States. Eurobond issues are underwritten by an international syndicate of banks and securities firms. Eurobonds of longer than seven years in maturity generally have a sinking-fund provision.

Disclosure requirements in the Eurobond market are much less stringent than those required by the Securities and Exchange Commission (SEC) in the United States. Furthermore, the registration costs in the Eurobond market are lower than those charged in the United States. In addition, the Eurobond market offers tax flexibility for borrowers and investors alike. In fact, many Eurobonds are unregistered bearer bonds. Since no record of the bond’s ownership is kept by the issuer, these bonds are attractive to foreign owners who wish to evade taxes in their home country. All these advantages of Eurobonds, and particularly bearer bonds, enable the borrowers to raise funds at a lower cost. Nevertheless, a caveat may be in order with respect to the effective cost of borrowing in the Eurobond market. When a multinational firm borrows by issuing a foreign currency–denominated debt issue on a long-term basis, it creates transaction exposure, a kind of foreign exchange risk. If the foreign currency appreciates in value during the bond’s life, the cost of servicing the debt could rise. Many U.S. multinational firms borrowed at an approximately 7 percent coupon interest by selling Eurobonds denominated in Deutsche marks and Swiss francs in the late 1980s and early 1990s. Nevertheless, these U.S. firms experienced an average debt service cost of approximately 13 percent, which is almost twice as much as the coupon rate. This increased cost occurred because the U.S. dollar fell with respect to these currencies. Therefore, currency selection for denominating Eurobond issues must be made with extreme care and foresight. To lessen the impact of foreign exchange risk, some recently issued Eurobond issues were denominated in multicurrency units.

International Equity Markets The entire amount of equity capital comes from the parent company for a wholly owned foreign subsidiary, but many foreign affiliates are not owned completely by their parent corporations. To avoid nationalistic reactions to wholly owned foreign subsidiaries, such multinational firms as ExxonMobil, General Motors, Ford, and IBM sell shares to worldwide stockholders. It is also believed that widespread foreign ownership of the firm’s common stock encourages the loyalty of foreign stockholders and employees toward the firm. Thus selling common stock to residents of foreign countries not only is an important financing strategy but is also a risk-minimizing strategy for many multinational corporations.

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As you have learned in Chapter 14, a well-functioning secondary market is essential to entice investors into owning shares. To attract investors from all over the world, reputable multinational firms list their shares on major stock exchanges around the world. Over 500 foreign companies are listed on the New York Stock Exchange. Even more foreign firms would sell stock issues in the United States and list on the NYSE and NASDAQ were it not for the tough and costly disclosure rules in effect in this country and enforced by the Securities and Exchange Commission. Many foreign corporations, such as BP, Unilever, Honda, Hitachi, Sony, Rio Tinto, DeBeers, and the like, accommodate American investors by issuing American Depository Receipts (ADRs). All the American-owned shares of a foreign company are placed in trust in a major U.S. bank. The bank, in turn, will issue its depository receipts to the American stockholders and will maintain a stockholder ledger on these receipts, thus enabling the holders of ADRs to sell or otherwise transfer them as easily as they transfer any American company shares. ADR prices tend to move in a parallel path with the prices of the underlying securities in their home markets.

Finance in ACTION Global Political Risk in Argentina

Companies face political as well as business and financial risks when they expand into foreign markets and invest internationally. Political risks include those associated with the policies of a current regime as well as those that may arise due to possible changes in leaders or direction. Investors want to maximize their returns for a given level of risk, so recognizing political risk is an important component of overall risk assessment.

An example of political risk affecting private businesses arose recently in Argentina, where the government decided to expropriate the assets of the country’s largest oil company, YPF. YPF is a subsidiary of Spanish multinational firm Repsol. President Cristina Fernandez de Kirchner, along with influential legislators, led the nationalization efforts. They contended YPF was under-investing in Argentina to keep supplies low and prices artificially high. Of course, this is something that YPF denies vehemently. The expropriation was a result of Argentine attitudes toward the profits and motives of foreign companies. This comes on the heels of the nationalization of Argentine Airlines and also the private pensions of Argentine companies and citizens. Furthermore, many in Argentina feel their sovereign debt default in 2001–2002 was a result of free-market policies, thus souring attitudes toward free enterprise.

This example shows that political risks may have major effects on capital flows globally. As one analyst asked regarding Argentina’s nationalization policy, “Who wants to invest in a country where the government expropriates private property from one day to the next?” Many multinational companies will probably avoid investing in Argentina because they are afraid that they may become the next Repsol. Clearly, political factors are a risk that needs to be assessed when analyzing the total risk-return trade-off that companies face—particularly when investing abroad.

Sources: http://www.nytimes.com/2012/04/19/world/americas/dismay-over-argentinas-nationalization-plan.html?_r51.

http://www.reuters.com/article/2012/05/04/us-argentina-ypf-idUSBRE8421GV20120504.

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Looking elsewhere around the world, U.S. firms have listed their shares on the Toronto Stock Exchange and the Montreal Exchange. Similarly, more than 50 U.S. firms have listed their shares on the London Stock Exchange. To obtain exposure in an international financial community, listing securities on world stock exchanges is a step in the right direction for a multinational firm. This international exposure also brings an additional responsibility for the MNC to understand the preferences and needs of heterogeneous groups of investors of various nationalities. The MNC may have to print and circulate its annual financial statements in many languages. Some foreign investors are more risk-averse than their counterparts in the United States and prefer dividend income over less certain capital gains. Common stock ownership among individuals in countries like Japan and Norway is relatively insignificant, with financial institutions holding substantial amounts of common stock issues. Institutional practices around the globe also vary significantly when it comes to issuing new securities. Unlike in the United States, European commercial banks play a dominant role in the securities business. They underwrite stock issues, manage portfolios, vote the stock they hold in trust accounts, and hold directorships on company boards. In Germany, the banks also run an over-the-counter market in many stocks.

The International Finance Corporation Whenever a multinational company has difficulty raising equity capital due to lack of adequate private risk capital in a foreign country, the firm may explore the possibility of selling partial ownership to the International Finance Corporation (IFC). This is a unit of the World Bank Group. The International Finance Corporation was established in 1956 and is owned by 184 member countries of the World Bank. Its objective is to further economic development by promoting private enterprises in developing countries. The profitability of a project and its potential benefit to the host country’s economy are the two criteria the IFC uses to decide whether to assist a venture. The IFC participates in private enterprise through buying equity shares of a business, providing long-term loans, or a combination of the two for up to 25 percent of the total capital. The IFC expects the other partners to assume managerial responsibility, and it does not exercise its voting rights as a stockholder. The IFC helps finance new ventures as well as the expansion of existing ones in a variety of industries. Once the venture is well established, the IFC sells its investment position to private investors to free up its capital.

Some Unsettled Issues in International Finance

As firms become multinational in scope, the nature of their financial decisions also becomes more complex. A multinational firm has access to more sources of funds than a purely domestic corporation. Interest rates and market conditions vary between the alternative sources of funds, and corporate financial practices may differ significantly between countries. For example, the debt ratios in many foreign countries are higher than those used by U.S. firms. A foreign affiliate of an American firm faces a dilemma in its financing decision: Should it follow the parent firm’s norm or that of the host country? Who must decide this? Will it be decided at the corporate headquarters in the United States or by the foreign affiliate? This is a matter of control over financial decisions. Dividend policy is another area of debate. Should the parent company dictate the dividends the foreign affiliate must distribute, or should it be left completely to the discretion of the foreign affiliate? Foreign government regulations may also influence the decision. Questions like these do not have clear-cut answers. The complex environment in which the MNCs operate does not permit simple solutions. Obviously each situation has to be evaluated individually, and specific guidelines for decision making must be established. Such coordination, it is to be hoped, will result in cohesive policies in the areas of working capital management, capital structure, and dividend decisions throughout the MNC network.

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SUMMARY

A significant proportion of earnings for many American companies comes from overseas markets. In general, international business operations have been more profitable than domestic operations, and this higher profitability is one factor that motivates business firms to go overseas to expand their markets. U.S. multinational firms have played a major role in promoting economic development and international trade for several decades, and now foreign firms have started to invest huge amounts of capital in the United States. Brand-name companies such as Sony, Coca-Cola, Heineken, McDonald’s, Nestlé, and BMW are famous the world over.

When a domestic business firm crosses its national borders to do business in other countries, it enters a riskier and more complex environment. A multinational firm is exposed to foreign exchange risk in addition to the usual business and financial risks. International business transactions are denominated in foreign currencies, and the rate at which one currency unit is converted into another is called the exchange rate. In today’s global monetary system, exchange rates of major currencies fluctuate freely and on occasion are volatile. For example on October 7, 1998, the Japanese yen fell over 6 percent versus the U.S. dollar due to adverse economic circumstances; this was a record one-day movement against the U.S. dollar. These floating exchange rates expose multinational business firms to foreign exchange risk.

To deal with this foreign currency exposure effectively, the financial executive of a MNC must understand foreign exchange rates and how they are determined. Foreign exchange rates are influenced by differences in inflation rates among countries, differences in interest rates, governmental policies, and the expectations of the participants in the foreign exchange markets. The international financial manager can reduce the firm’s foreign currency exposure by hedging in the forward exchange markets, in the money markets, and in the currency futures market.

Foreign direct investments are usually quite large, and many of them are exposed to enormous political risk. Although discounted cash flow analysis is applied to screen the projects in the initial stages, strategic considerations and political risk are often the overriding factors in reaching the final decisions about foreign investments. Political risk could involve negative policy decisions by a foreign government that discriminate against foreign firms. Political risk could also be the possibility of a country defaulting on sovereign debt—such as Russia did in 1998—or it could be a country’s economic policies that have negative impacts on the economy such as inducing high inflation or a recession, high unemployment, and social unrest. Political events are hard to forecast, and this makes analyzing a foreign investment proposal more difficult than analyzing a domestic investment project.

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Financing international trade and investments is another important area of international finance that one must understand to raise funds at the lowest cost possible. The multinational firm has access to both the domestic and foreign capital markets. The Export–Import Bank finances American exports to foreign countries. Borrowing in the Eurobond market may appear less expensive at times, but the effect of foreign exchange risk on debt servicing costs must be weighed carefully before borrowing in these markets. Floating common stock in foreign capital markets is also a viable financing alternative for many multinational companies. The International Finance Corporation, which is a subsidiary of the World Bank, also provides debt capital and equity capital to qualified firms. These alternative sources of financing may significantly differ with respect to cost, terms, and conditions. Therefore, the financial executive must carefully locate and use the proper means to finance international business operations.

LIST OF TERMS

euro 656

multinational corporation 657

exchange rate 659

purchasing power parity theory 661

interest rate parity theory 661

balance of payments 661

spot rate 662

forward rate 663

cross rates 664

foreign exchange risk 664

translation exposure 665

transaction exposure 666

currency futures contract 667

repatriation 670

expropriate 670

Overseas Private Investment Corporation (OPIC) 671

letter of credit 672

Foreign Credit Insurance Association (FCIA) 672

Eximbank 672

parallel loan 673

fronting loan 673

Eurodollars 674

London Interbank Offered Rate (LIBOR) 674

Eurobond 675

American Depository Receipts (ADRs) 676

International Finance Corporation (IFC) 677

DISCUSSION QUESTIONS

1. What risks does a foreign affiliate of a multinational firm face in today’s business world? (LO21-3 & 21-4)

2. What allegations are sometimes made against foreign affiliates of multinational firms and against the multinational firms themselves? (LO21-1)

3. List the factors that affect the value of a currency in foreign exchange markets. (LO21-2)

4. Explain how exports and imports tend to influence the value of a currency. (LO21-2)

5. Differentiate between the spot exchange rate and the forward exchange rate. (LO21-2)

6. What is meant by translation exposure in terms of foreign exchange risk? (LO21-2)

7. What factors would influence a U.S. business firm to go overseas? (LO21-1)

8. What procedure(s) would you recommend for a multinational company in studying exposure to political risk? What actual strategies can be used to guard against such risk? (LO21-4)

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9. What factors beyond the normal domestic analysis go into a financial feasibility study for a multinational firm? (LO21-4)

10. What is a letter of credit? (LO21-5)

11. Explain the functions of the following agencies: (LO21-5)

Overseas Private Investment Corporation (OPIC)

Export–Import Bank (Eximbank)

Foreign Credit Insurance Association (FCIA)

International Finance Corporation (IFC)

12. What are the differences between a parallel loan and a fronting loan? (LO21-5)

13. What is LIBOR? How does it compare to the U.S. prime rate? (LO21-5)

14. What is the danger or concern in floating a Eurobond issue? (LO21-5)

15. What are ADRs? (LO21-5)

16. Comment on any dilemmas that multinational firms and their foreign affiliates may face in regard to debt ratio limits and dividend payouts. (LO21-5)

PRACTICE PROBLEMS AND SOLUTIONS

Cross rates

(LO21-2)

1. Suppose a Swedish krona is selling for $0.1286 and a Maltan lira is selling for $2.8148. What is the exchange rate (cross rate) of the Swedish krona to the Maltan lira?

Adjusting returns for exchange rates

(LO21-2)

2. An investor in the United States bought a one-year New Zealand security valued at 200,000 New Zealand dollars. The U.S. dollar equivalent was $100,000. The New Zealand security earned 15 percent during the year, but the New Zealand dollar depreciated 5 cents against the U.S. dollar during the time period ($0.50/NZD to $0.45/NZD). After transferring the funds back to the United States, what was the investor’s return on his $100,000? Determine the total ending value of the New Zealand investment in New Zealand dollars and then translate this value to U.S. dollars by multiplying by $0.45. Then compute the return on the $100,000.

Solutions

1. One dollar is worth 7.776 Swedish kronor (1/0.1286), and one Maltan lira is worth 2.8148 dollars. Thus 7.776 Swedish kronor per dollar times 2.8148 dollars per Maltan lira equals 21.89 Swedish kronor per Maltan lira.

2. Initial value × (1 + earnings)

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PROBLEMS

 Selected problems are available with Connect. Please see the preface for more information.

Basic Problems

Spot and forward rates

(LO21-2)

1. The Wall Street Journal reported the following spot and forward rates for the Swiss franc ($/SF):

a. Was the Swiss franc selling at a discount or premium in the forward market?

b. What was the 30-day forward premium (or discount)?

c. What was the 90-day forward premium (or discount)?

d. Suppose you executed a 90-day forward contract to exchange 100,000 Swiss francs into U.S. dollars. How many dollars would you get 90 days hence?

e. Assume a Swiss bank entered into a 180-day forward contract with Bankers Trust to buy $100,000. How many francs will the Swiss bank deliver in six months to get the U.S. dollars?

Cross rates

(LO21-2)

2. Suppose a Polish zloty is selling for $0.3414 and a British pound is selling for 1.4973. What is the exchange rate (cross rate) of the Polish zloty to the British pound? That is, how many Polish zlotys are equal to a British pound?

Purchasing power theory

(LO21-2)

3. From the base price level of 100 in 1979, Saudi Arabian and U.S. price levels in 2008 stood at 200 and 410, respectively. If the 1979 $/riyal exchange rate was $0.26/riyal, what should the exchange rate be in 2008? Suggestion: Using purchasing power parity, adjust the exchange rate to compensate for inflation. That is, determine the relative rate of inflation between the United States and Saudi Arabia and multiply this times $/riyal of 0.26.

Continuation of purchasing power theory

(LO21-2)

4. From the base price level of 100 in 1981, Saudi Arabian and U.S. price levels in 2010 stood at 250 and 100, respectively. Assume the 1981 $/riyal exchange rate was $0.46/riyal. Suggestion: Using the purchasing power parity, adjust the exchange rate to compensate for inflation. That is, determine the relative rate of inflation between the United States and Saudi Arabia and multiply this times $/riyal of 0.46. What would the exchange rate be in 2010?

Intermediate Problems

Adjusting returns for exchange rates

(LO21-2)

5. An investor in the United States bought a one-year Brazilian security valued at 195,000 Brazilian reals. The U.S. dollar equivalent was 100,000. The Brazilian security earned 16 percent during the year, but the Brazilian real depreciated 5 cents against the U.S. dollar during the time period ($0.51 to $0.46). After transferring the funds back to the United States, what was the investor’s return on her $100,000? Determine the total ending value of the Brazilian investment in Brazilian reals and then translate this Brazilian value to U.S. dollars. Then compute the return on the $100,000.

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Adjusting returns for exchange rates

(LO21-2)

6. A Peruvian investor buys 150 shares of a U.S. stock for $7,500 ($50 per share). Over the course of a year, the stock goes up by $4 per share.

a. If there is a 10 percent gain in the value of the dollar versus the Peruvian nuevo sol, what will be the total percentage return to the Peruvian investor? First determine the new dollar value of the investment and multiply this figure by 1.10. Divide this answer by $7,500 and get a percentage value, and then subtract 100 percent to get the percentage return.

b. Instead assume that the stock increases by $7, but that the dollar decreases by 10 percent versus the nuevo sol. What will be the total percentage return to the Peruvian investor? Use 0.90 in place of 1.10 in this case.

Advanced Problem

Hedging exchange rate risk

(LO21-3)

7. You are the vice president of finance for Exploratory Resources, headquartered in Houston, Texas. In January 20X1, your firm’s Canadian subsidiary obtained a six-month loan of 150,000 Canadian dollars from a bank in Houston to finance the acquisition of a titanium mine in Quebec province. The loan will also be repaid in Canadian dollars. At the time of the loan, the spot exchange rate was U.S. $0.8995/Canadian dollar and the Canadian currency was selling at a discount in the forward market. The June 20X1 contract (face value = C$150,000 per contract) was quoted at U.S. $0.8930/Canadian dollar.

a. Explain how the Houston bank could lose on this transaction assuming no hedging.

b. If the bank does hedge with the forward contract, what is the maximum amount it can lose?

WEB EXERCISE

Chapter 21 deals with international finance and the decisions that companies have to make when operating in a foreign country. The Overseas Private Investment Corporation (OPIC) is a U.S. agency that helps U.S. companies that operate in developing economies. Its website has a great deal of information about doing business in a foreign country and excellent links to the 140 countries in which it has relationships.

1. Go to www.opic.gov. Go to “Who We Are” and click on “Overview.” Describe OPIC’s mission.

2. Go to “What We Offer” and click on “Political Risk Insurance.” Describe the types of political risks that can be covered.

3. Go back to “What We Offer” and click on “Financial Products.” Describe the business size that qualifies for “Small and Medium-Enterprise Financing” and then describe the types of projects that can be funded. May other co-lenders be involved?

4. Click on “Investment Funds.” Are equity funds targeted to firms in developing countries?

Note: Occasionally a topic we have listed may have been deleted, updated, or moved into a different location on a website. If you click on the site map or site index, you will be introduced to a table of contents that should aid you in finding the topic you are looking for.

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APPENDIX | 21A

Cash Flow Analysis and the Foreign Investment Decision

Direct foreign investments are often relatively large. As we mentioned in the chapter, these investments are exposed to some extraordinary risks, such as foreign exchange fluctuations and political interference, which are nonexistent for domestic investments. Therefore, the final decision is often made at the board of directors level after considering the financial feasibility and the strategic importance of the proposed investment. Financial feasibility analysis for foreign investments is basically conducted in the same manner as it is for domestic capital budgets. Certain important differences exist, however, in the treatment of foreign tax credits, foreign exchange risk, and remittance of cash flows. To see how these are handled in foreign investment analysis, let us consider a hypothetical illustration.

Tex Systems Inc., a Texas-based manufacturer of computer equipment, is considering the establishment of a manufacturing plant in Salaysia, a country in Southeast Asia. The Salaysian plant will be a wholly owned subsidiary of Tex Systems, and its estimated cost is 90 million ringgits (2 ringgits = $1). Based on the exchange rate between ringgits and dollars, the cost in dollars is $45 million. In addition to selling in the local Salaysian market, the proposed subsidiary is expected to export its computers to the neighboring markets in Singapore, Hong Kong, and Thailand. Expected revenues and operating costs are as shown in Table 21A-1. The country’s investment climate, which reflects the foreign exchange and political risks, is rated BBB (considered fairly safe) by a leading Asian business journal. After considering the investment climate and the nature of the industry, Tex Systems has set a target rate of return of 20 percent for this foreign investment.

Salaysia has a 25 percent corporate income tax rate and has waived the withholding tax on dividends repatriated (forwarded) to the parent company. A dividend payout ratio of 100 percent is assumed for the foreign subsidiary. Tex Systems’ marginal tax rate is 30 percent. It was agreed by Tex Systems and the Salaysian government that the subsidiary will be sold to a Salaysian entrepreneur after six years for an estimated 30 million ringgits. The plant will be depreciated over a period of six years using the straight-line method. The cash flows generated through depreciation cannot be remitted to the parent company until the subsidiary is sold to the local private entrepreneur six years from now. The Salaysian government requires the subsidiary to invest the depreciation-generated cash flows in local government bonds yielding an aftertax rate of 15 percent. The depreciation cash flows thus compounded and accumulated can be returned to Tex Systems when the project is terminated. Although the value of ringgits in the foreign exchange market has remained fairly stable for the past three years, the projected budget deficits and trade deficits of Salaysia may result in a gradual devaluation of ringgits against the U.S. dollar at the rate of 2 percent per year for the next six years.

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Note that the analysis in Table 21A-1 is primarily done in terms of ringgits. Expenses (operating, depreciation, and Salaysian income taxes) are subtracted from revenues to arrive at earnings after foreign income taxes. These earnings are then repatriated (forwarded) to Tex Systems in the form of dividends. Dividends repatriated thus begin at 5.25 ringgits (in millions) in year 1 and increase to 18.75 ringgits in year 6. The next item, gross U.S. taxes, refers to the unadjusted U.S. tax obligation. As specified, this is equal to 30 percent of foreign earnings before taxes (earnings before Salaysian taxes).1 For example, gross U.S. taxes in the first year are equal to:

Table 21A-1   Cash flow analysis of a foreign investment

From gross U.S. taxes, Tex Systems may take a foreign tax credit equal to the amount of Salaysian income tax paid. Gross U.S. taxes minus this foreign tax credit are equal to net U.S. taxes payable. Aftertax dividends received by Tex Systems are equal to dividends repatriated minus U.S. taxes payable. In the first year, the values are:

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The figures for aftertax dividends received by Tex Systems are all stated in ringgits (the analysis up to this point has been in ringgits). These ringgits will now be converted into dollars. The initial exchange rate is 2.00 ringgits per dollar, and this will go up by 2 percent per year.2 For the first year, 4.90 ringgits will be translated into 2.45 dollars. Since values are stated in millions, this will represent $2.45 million. Aftertax dividends in U.S. dollars grow from $2.45 million in year 1 to $7.92 million in year 6. The last two rows of Table 21A-1 show the present value of these dividends at a 20 percent discount rate. The total present value of aftertax dividends received by Tex Systems adds up to $15.45 million. Repatriated dividends will be just one part of the cash flow. The second part consists of depreciation-generated cash flow accumulated and reinvested in Salaysian government bonds at a 15 percent rate per year. The compound value of reinvested depreciation cash flows (10 million ringgits per year) is:

10 million ringgits 8.754* = 87.54 million ringgits after six years

*Future value at 15 percent for six years (from Appendix C at the end of the book).

These 87.54 million ringgits must now be translated into dollars and then discounted back to the present. Since the exchange rate is 2.21 ringgits per dollar in the 6th year (fourth line from the bottom in Table 21A-1), the dollar equivalent of 87.54 million ringgits is:

87.54 million ringgits ÷ 2.21 = $39.61 million

The $39.61 million can now be discounted back to the present by using the present value factor for six years at 20 percent (Appendix B).

The final benefit to be received is the 30 million ringgits when the plant is sold six years from now.3 We first convert this to dollars and then take the present value.

30 million ringgits ÷ 2.21 = $13.57 million

The present value of $13.57 million after six years at 20 percent is:

The present value of all cash inflows in dollars is equal to:

The cost of the project was initially specified as 90 million ringgits, or $45 million. In the following calculation, we see the total present value of inflows in dollars is less than the cost, and the project has a negative net present value.

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Problem

Cash flow analysis with a foreign investment

(LO21-2)

21A–1. The Office Automation Corporation is considering a foreign investment. The initial cash outlay will be $10 million. The current foreign exchange rate is 2 ugans = $1. Thus the investment in foreign currency will be 20 million ugans. The assets have a useful life of five years and no expected salvage value. The firm uses a straight-line method of depreciation. Sales are expected to be 20 million ugans and operating cash expenses 10 million ugans every year for five years. The foreign income tax rate is 25 percent. The foreign subsidiary will repatriate all aftertax profits to Office Automation in the form of dividends. Furthermore, the depreciation cash flows (equal to each year’s depreciation) will be repatriated during the same year they accrue to the foreign subsidiary. The applicable cost of capital that reflects the riskiness of the cash flows is 16 percent. The U.S. tax rate is 40 percent of foreign earnings before taxes.

a. Should the Office Automation Corporation undertake the investment if the foreign exchange rate is expected to remain constant during the five-year period?

b. Should Office Automation undertake the investment if the foreign exchange rate is expected to be as follows?

1 While Switzerland is a European country, it is not a member of the European Union, and it does not use the euro as its official currency.

2February 21, 2017, to May 22, 2017, represents 90 days.

3For purposes of this example, we assumed the peso was trading at a discount in the futures market. Had it been trading at a premium, the hedge would have been even more attractive.

4International mutual funds also have helped investors diversify across national borders.

1If foreign earnings had not been repatriated, this tax obligation would not be due.

2The 2 percent appreciation means the dollar is equal to an increasing amount of ringgits each year. The dollar is appreciating relative to ringgits, and ringgits are depreciating relative to the dollar. Since Tex Systems’ earnings are in ringgits, they are being converted at a less desirable rate each year. Big Tex may eventually decide to hedge its foreign exchange risk exposure.

3Capital gains taxes are not a necessary consideration in foreign transactions of this nature.