week 10

Slide 1

Introduction

Welcome to Financial Management. In this lesson we will discuss multinational financial management.

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Slide 2

Topics

The following topics will be covered in this lesson:

Multinational, or global, corporations;

Multinational versus domestic financial management;

Exchange rates;

Exchange rates and international trade;

The international monetary system and exchange rate policies;

Trading in foreign exchange;

Interest rate parity;

Purchasing power parity;

Inflation, interest rates, exchange rates;

International money and capital markets;

Multinational capital budgeting;

International capital structures; and

Multinational working capital management.

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Slide 3

Multinational, or Global, Corporations

When the firm operates in another country it faces issues that it doesn’t face in its domestic country. Any time we talk about the firm operating in a foreign country we refer to it as a multinational, transnational or global corporation and these terms are used interchangeably. Firms choose to locate in a foreign country for a variety of reasons.

First, the firm wants to broaden its markets. This usually happens when the domestic market becomes saturated.

Second the firm may want to ensure a source of raw materials.

Third the firm may need a new form of technology.

Fourth it may shift production to a lower – cost country.

Fifth, the firm may want to avoid political and regulatory issues in its home country.

And sixth, the firm may want to diversify so it can have a cushion against any adverse impact of changing economic conditions in any one country.

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Slide 4

Multinational versus Domestic Financial Management

The concepts and procedures we’ve studied up to this point apply to domestic as well as multinational operations. There are however, six major factors that distinguish financial management in a purely domestic firm from one that operates globally.

First the global firm is affected by exchange rates because cash flows are denominated in different currencies.

Second, since each country has its own economic and legal systems it can make it difficult for the firm to deploy resources and make it difficult for executives trained in one country to move to another.

Third, language differences make it difficult to communicate.

Fourth, different countries have different cultural differences that shape the values and influence the firm’s ability to conduct business.

Fifth, sometimes in foreign countries governments negotiate directly with the firm. In this way, the marketplace does not determine the terms of trade on which transactions are determined.

And sixth, a foreign country may place restrictions or expropriate assets within its boundaries. This is referred to as political risk and it varies from country to country. Terrorism is another form of political risk faced by the global firm.

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Slide 5

Exchange Rates

The exchange rate specifies the number of units of the foreign currency that can be purchased for one unit of another currency. The Wall Street Journal and various online sources quote change rates. A direct quotation is the number of U.S. dollars required to purchase one unit of foreign currency. An indirect quotation is the number of units of a foreign currency that can be purchased for one U.S. dollar.

As a rule, trading centers use indirect quotations except for the British pound and the Euro which use direct quotations. The cross rate is the exchange rate between two currencies neither of which is the U.S. dollar. All foreign currencies in some way are tied to the U.S. dollar in a consistent manner. This ensures that all currencies are related to each other. If this situation did not exist, an arbitrage situation would arise where currency traders could profit by buying undervalued currencies and selling overvalued currencies and the equilibrium would be restored.

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Slide 6

Exchange Rates and International Trade

Exchange rate changes make it difficult for firms to estimate the amount of dollars overseas operations require. The demand for consumer goods translates into a demand for currency. One factor impacting currency demand is the balance of trade between two countries and another factor demand is capital movements.

In the case of the trade balance, U.S. importers must purchase foreign currency buy foreign goods and foreign importers must buy U.S. dollars to pay for U.S. goods. If U.S. imports from the foreign country exceed U.S. exports to the foreign country the U.S. has a trade deficit with the foreign country and the demand foreign currency is greater than the demand for dollars.

In the case of capital movements if interest rates in U.S. are higher than those in a foreign country, foreign banks, corporations, and other investors buy dollars with foreign currency and use the dollars to purchase high–yielding U.S. securities. This results in a higher demand for dollars. If governments did not intervene in the money markets the relative prices of currencies would fluctuate in response to supply and demand just as prices fluctuate for consumer goods.

However, governments do intervene in the money markets through the central banks. They can artificially shore up its currency using its gold reserves or foreign currencies to purchase its own currency in the open market.

Additionally, it can also keep its currency artificially low by selling its own currency in the open market. This results in an increase in the currency’s supply which reduces the price.

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Slide 7

The International Monetary System and Exchange Rate Policies

The International Monetary Fund, under Bretton Woods, administered the fixed exchange rate system that most of the world operated under from the end of World War II until nineteen seventy-one. The U.S. dollar was tied to gold and all other currencies were tied to the dollar.

However, many countries found it very difficult to maintain a fixed exchange rate and by the end of nineteen seventy–three Bretton Woods was abandoned and countries resorted to using different exchange rate systems. Many countries operated under a system of floating exchange rates in which currency prices sought their own levels with minimal intervention by the central bank to smooth out extreme exchange rate fluctuations.

A currency appreciation occurs when a particular currency is worth more than another. Currency depreciation occurs when a particular currency is worth less than another. Exchange rate risk refers to fluctuations in exchange rates between currencies over time.

Currency fluctuations increase the uncertainty of the firm’s cash flows because cash flows are generated in many countries and in many currencies. Changes in exchange rates result in changes in the dollar-equivalent value of the firm’s consolidated cash flows. A managed floating rate system is one in which there is a lot of government intervention to manage the exchange rate by controlling the currency’s supply and demand.

A pegged exchange rate is a system in which a country’s currency is pegged to the rate of another currency or a basket of currencies. The country targets an exchange rate but allow its currency to vary within a band or specific limits.

A devaluation occurs when government action reduces the target rate and a revaluation occurs when government action increase the targeted rate.

Just because a country has a pegged exchange rate it doesn’t necessarily mean the firm should be prevented from investing in that country. Under Bretton Woods, many pegged currencies were considered to be convertible since the country that issued the currency permitted it to be traded in the currency markets.

Some currencies are not traded on world markets but are allowed to float in a very narrow band against a basket of securities. Currencies of this type are called non-convertibles or soft currencies. These types of currencies cause problems for foreign firms wanting to make foreign direct investments. Some countries don’t have a local currency but use the currency of another country. For example Ecuador uses the U.S. dollar, some countries use the Euro, and some countries use other currency baskets as their local currency.

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Slide 8

Trading in Foreign Exchange

The spot exchange rate is the exchange rate that exists two days following the day of trade. The forward exchange rate is exchange rate prevailing, for delivery at some agreed–upon future date usually thirty, ninety, or one hundred eight days from the date the transaction is negotiated.

The firms trade foreign currency based upon their spot and forward exchange rates. The foreign currency sells at a forward discount if you can obtain more of the foreign currency for a dollar in the forward market vs. the spot market. In contrast, if the U.S. dollar buys fewer units of a foreign currency in the forward market than the spot market the foreign currency sells at a forward premium.

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Slide 9

Interest Rate Parity

The market determines whether a currency sells at a forward premium or discount. This concept is referred to as interest rate parity. It means that investors should expect to earn the same return on security investments after adjusting for risk. Foreign investments include two factors, the return on investment and changes in the exchange rate.

Then, if the foreign currency appreciates relative to the home currency the overall return on investment will be higher. Similarly, if the foreign currency depreciates the overall return will be lower. Interest rate parity explains why a currency may trade at a forward premium or discount.

When domestic interest rates are higher than foreign interest rates the currency trades at a forward premium. When domestic interest rates are lower than foreign interest rates the currency trades at a discount. Arbitrage forces interest rates and exchange rates back to parity if these conditions do not hold.

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Slide 10

Purchasing Power Parity

Sometimes referred to as the law of one price, purchasing power parity, PPP, says that price levels and exchange rate levels adjust so that identical goods sell for the same price in different countries. The theory assumes that market forces eliminate situations in which identical products sell for different prices. Another assumption underlying PPP is that there are no transactions or transportation costs and no restrictions on imports.

Realistically, many times these assumptions are not valid and this explains why PPP is violated. Additionally, real or perceived differences in the quality of products can result in price differences. Despite these drawbacks, companies and investors use interest rate parity and PPP to anticipate future conditions.

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Slide 11

Inflation, Interest Rates, Exchange Rates

The inflation rate in a foreign country versus the home country, also called the relative inflation rates impact financial decisions of the firm. They influence production costs at home as well as abroad and also influence relative interest rates and exchange rates. These factors impact the firm’s decision for financing of investments and the profitability of foreign investments.

Currencies of countries where inflation rates have been relatively higher than the United States depreciate against the U.S. dollar. Currencies appreciate relative to the U.S. dollar if their country’s inflation rate is lower relative to the inflation rate in the U.S. On average, a foreign currency appreciates against the U.S. dollar at a rate that is about equal to the amount by which the foreign inflation rate exceeds the U.S. inflation rate. The relative inflation rates also influence interest rates because countries with higher inflation rates tend to have higher interest rates. For countries with lower inflation rates the reverse is true.

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Slide 12

International Money and Capital Markets

Until the nineteen sixties the U.S. capital market dominated the world market. Now, U.S. securities are valued at less than one-quarter of the world’s total value. For this reason it is important that both managers and investors understand international markets.

When a U.S. dollar is deposited in a bank not located in the U.S. it is referred to as a Eurodollar. Most Eurodollar deposits are for at least five hundred thousand dollars and have maturities from one day to about one year. Since Eurodollars are deposited outside the U.S. they are outside the authority of U.S. monetary authorities and therefore are not subject to U.S. banking regulations. For this reason Eurodollar deposits can pay a higher interest rate when compared to equivalent U.S. investments.

The rate paid on Eurodollars depends on the bank’s lending rate and the rate of return paid on U.S. money market investments and is tied to the London Interbank Offered Rate or LIBOR. The LIBOR rate is similar to the U.S. prime rate because it is the interest rate charged by the largest and strongest London Banks on large dollar denominated deposits.

There are two types of significant international bonds, foreign bonds and Eurobonds. A foreign bond is one that is sold by a foreign borrower but it is denominated in the currency of the country in which it is sold. An example of a foreign bond is a French firm selling bonds denominated in U.S. dollars and sold in the U.S.

Since the bond issue is denominated in U.S. dollars it is referred to as a Yankee bond. When a bond is issued in one country but denominated in the currency of another it is called a Eurobond. An example of a Eurobond is a U.S. firm selling dollar denominated bonds in Switzerland. Over half the Eurobonds in the market are denominated in dollars.

Firms issue new equity in the international market for several reasons. Non-U.S. firms may issue stock in the U.S. market because it has access to a larger capital market than exists in its home country. A U.S.-based firm may issue stock in a foreign market because it has operations in that market. Sometimes firms issue new equity in multiple markets at the same time. Today, outstanding stocks of large multinational corporations listed on multiple international exchanges.

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Slide 13

Multinational Capital Budgeting

While there are similarities between domestic and foreign capital budgeting there are some important differences. The first is risk exposure. Risk exposure can lead to a higher cost of capital for foreign projects and is a result of exchange risk and political risk.

Exchange risk affects the cash flow in the firm’s home currency because foreign currency must be converted to say, U.S. dollars at the expected future exchange rate. It is important that the firm analyze the effect of variations in the exchange rate on the dollar and add an exchange rate premium to its domestic cost of capital.

Political risk is the possibility that host government actions will reduce the value of the firm’s investment. Examples of political risk include expropriation, higher taxes, currency controls, and restrictions on prices charged.

Cash flow estimation is more difficult for a foreign firm than for a foreign domestic one. Usually the firm sets up a subsidiary in each foreign country in which it wants to operate.

The cash flows consist of dividends and royalties paid by the subsidiaries to the parent company translated into dollars. They are tax both by the foreign country and the domestic country but sometimes the domestic country may allow tax credits for foreign taxes paid. Moreover, foreign governments may restrict the amount of funds that can be repatriated to the parent company.

Any cash flows that are blocked by the foreign country cannot be used to pay dividends to its shareholders or use for other investments. Firms sometimes use transfer pricing to circumvent repatriation restrictions. To use transfer pricing the subsidiary may purchase inputs from the parent corporation. If the price is high enough there may be little profit available for repatriation.

Project analysis is another area in which capital budgeting differs between domestic and foreign operations. A domestic firm may require raw materials or may sell its finished product in a foreign market.

In the short–run converting from foreign currency to dollars is not a problem. However, over the long–run it is difficult to estimate the exchange rate at which the firm will convert foreign cash flows into dollars because forward rates are not available for more than one hundred eighty days.

If a project is based in a foreign country most of its cash flows are denominated in foreign currency. There are two ways in which the firm can calculate the project’s NPV. One approach requires that the firm convert the expected future repatriations to dollars and then calculate the NPV using the firm’s cost of capital. The second approach requires that the firm take the projected repatriations denominated in the foreign currency and discount them at the foreign cost of capital. Then, the results can be converted to dollars at the spot exchange rate.

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Slide 14

International Capital Structures

The debt to total assets ratio varies from country to country. It is difficult to compare capital structures because different countries use different accounting conventions regarding the reporting of assets, the treatment of leased assets, pension fund planning, and capitalizing versus expensing R&D costs.

Empirical evidence suggests that the difference in accounting practices explains most of the variation in capital structures. It also suggests that firms in Germany and the United Kingdom tend to use less leverage than firms in the United States, France, Italy, and Japan. Moreover, firms with a lower times–interest–earned ratio tend to use more leverage. The ratio is highest in United Kingdom and Germany and lowest in Canada.

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Slide 15

Multinational Working Capital Management

Like domestic firms, the multinational has similar cash management goals. It wants to maximize net float, shift cash as quickly as possible, and to maximize the risk adjusted after–tax return on cash balances. Since foreign governments can place restrictions on transferring funds out of the country, cash management is more difficult. In the international market credit management is more complex than it is in the domestic market. In this case, the importer must finance the transaction from the time it pays the accounts payable until it collects on its sales.

From the exporter’s point of view, it is more difficult to analyze the foreign customer’s credit. To resolve these issues the importer can obtain a letter of credit from its bank which certifies that the importer will meet the terms of the accounts payable.

A second option is to issue a banker’s acceptance which is created when the importer’s bank agrees to accept a postdated check written by the importer to the exporter whether or not there are sufficient funds in the importer’s account.

A third option is for the exporter to buy export credit insurance in which the insurance company guarantees payment even if the importer defaults.

An area that is more complex is inventory management. One issue pertains to the physical location of inventories. A solution is to maintain inventories in a few strategic areas and ship goods when needed. Inventory policy is also influenced by exchange rates.

If the foreign currency were expected to rise against the dollar, a U.S. firm operating in a foreign country would want to increase inventories of local products and if the foreign currency were expected to decrease relative to the dollar the U.S. firm would want to decrease inventories of local products.

Another factor the firm must consider is the possibility of import or export quotas or tariffs. If there is a large threat of expropriation the firm would want to minimize inventory levels and only increase them when necessary.

Taxation has two effects on inventory management. Foreign countries usually impose taxes on assets including inventories and the tax is imposed as of a specific date. In this case it is advantageous for the firm to ensure that inventories are low on the assessment date and should the assessment dates vary store inventory in different countries at different times during the year.

Finally, the firm may choose to store inventory at sea. Doing this avoids the issues of expropriation, or minimizes property taxes and maximizes flexibility so the firm can ship to areas where they need is greatest or prices highest.

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Slide 16

Check Your Understanding

Slide 17

Summary

We have now reached the end of this lesson. Let’s review what we’ve covered.

First, we learned that when a firm operates in another country it faces issues that it doesn’t face in its domestic country. Any time we talk about the firm operating in a foreign country we refer to it as a multinational, transnational or global corporation and these terms are used interchangeably.

Next, we compared multinational versus domestic financial management. Surprisingly, the concepts and procedures that apply to domestic operations also apply to multinational operations.

Also, we defined exchange rates as specifying the number of units of the foreign currency that can be purchased for one unit of another currency.

Then, we discussed exchange rates and international trade. Exchange rate changes make it difficult for firms to estimate the amount of dollars overseas operations require. The demand for consumer goods translates into a demand for currency. One factor impacting currency demand is the balance of trade between two countries and another factor demand is capital movements.

Next, we learned about the international monetary system and exchange rate policies. Many countries operated under a system of floating exchange rates in which currency prices sought their own levels with minimal intervention by the central bank to smooth out extreme exchange rate fluctuations.

Also, we discussed trading in foreign exchange. Firms trade foreign currency based upon their spot and forward exchange rates. The foreign currency sells at a forward discount if you can obtain more of the foreign currency for a dollar in the forward market vs. the spot market.

Next, we defined the interest rate parity as the concept where the market determines whether a currency sells at a forward premium or discount.

Then, we learned that the law of one price, or purchasing power parity, says that price levels and exchange rate levels adjust so that identical goods sell for the same price in different countries.

Also, we covered inflation, interest rates, and exchange rates. The inflation rate in a foreign country versus the home country, also called the relative inflation rates impact financial decisions of the firm. They influence production costs at home as well as abroad and also influence relative interest rates and exchange rates.

Next, we discussed international money and capital markets.

There are two types of significant international bonds, foreign bonds and Eurobonds. A foreign bond is one that is sold by a foreign borrower but it is denominated in the currency of the country in which it is sold. When a bond is issued in one country but denominated in the currency of another it is called a Eurobond.

Also, we examined multinational capital budgeting. Some important differences between domestic and foreign capital budgeting. These include: risk exposure, exchange risk, and political risk.

Next, we learned that it is difficult to compare international capital structures because the debt to total assets ratio varies from country to country.

Finally, we learned about working capital management in the multinational environment. Like domestic firms, the multinational has similar cash management goals. It wants to maximize net float, shift cash as quickly as possible, and to maximize the risk adjusted after–tax return on cash balances.

This concludes this lesson.