Finance

C2.pptx

Home >Business & Finance homework help >Economics homework help >Finance

Multinational Financial Management

CHAPTER 17

© 2020 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Topics in Chapter

Factors that make multinational financial management different

Exchange rates and trading

International monetary system

International financial markets

Specific features of multinational financial management

Intrinsic Value in a Global Context

What is a multinational corporation?

A multinational corporation is one that operates in two or more countries.

At one time, most multinationals produced and sold in just a few countries.

Today, many multinationals have world-wide production and sales.

Why do firms expand into other countries?

To seek new markets.

To seek new supplies of raw materials.

To gain new technologies.

To gain production efficiencies.

To avoid political and regulatory obstacles.

To reduce risk by diversification.

Major Factors Distinguishing Multinational from Domestic Financial Management

Currency differences

Language differences

Cultural differences

Economic systems

Legal systems

Taxation

Government intervention

Political risk

Terrorism and crime

Consider the following exchange rates:

	U.S. Dollars Required to Buy One Unit of Foreign Currency	Units of Foreign Currency Required to Buy One U.S. Dollar
Euro	1.2500	--
Swedish krona	--	7.0000

Notation (1 of 3)

The notation EUR/USD and SEK/USD use the currency labels designated by the international Organization for Standardization (ISO)

A quote has two currencies: The left-hand currency and the right-hand currency. A quote of LEFT/RIGHT is for the value of the LEFT currency expressed in units of the RIGHT currency.

EUR/USD is a quote for euros expressed in dollars.

SEK/USD is a quote for Swedish kronor expressed in dollars.

USD/SEK is a quote for dollars expressed in kronor.

Notation (2 of 3)

IMPORTANT NOTE:

The “/” in the quote for EUR/USD does not mean “per” or “divided by.” This is a source of great confusion for students! It actually means the opposite!

The quote EUR/USD = 1.25 means 1 euro is equal to 1.25 dollars or $1.25.

To express this using “per” you would say the rate is “1.25 dollars per euro.”

To avoid confusion, we will avoid using the “/” to mean “per” with currency names and instead, spell out “per” when appropriate.

Notation (3 of 3)

The quotes in the first column of the table express the relative value of the euro to the dollar and the krona to the dollar.

EUR/USD = 1.25

The press would report the euro trading at $1.25.

The quotes in the second column express the relative value of the dollar to the foreign currency.

USD/SEK = 7

Or one U.S. dollar is worth 7 Swedish kronor.

Direct Quotations

From a U.S. perspective, the quotes in the first column are called direct quotes because they are number of units of a foreign currency that can be purchased by 1 unit of the home currency.

Direct quote = Dollars per foreign currency

What is an indirect quotation?

An indirect quotation gives the amount of a foreign currency required to buy one unit of home currency. In our example, the U.S. dollar is the home (currency per dollar).

The second column in the previous table shows the indirect quotations.

Standardizing Quotes

Euros and British pounds are normally quoted as direct quotations.

Most other currencies are quoted as indirect.

Calculate the indirect quotation for euros and the direct quotation for kronor.

Indirect Euro:1 / 1.2500 = 0.8000

Direct Krona: 1 / 7.000 = 0.1429

	Direct Quote: U.S. $ per foreign currency	Indirect Quotes: # of Units of Foreign Currency per U.S. $
Euro	1.2500	0.8000
Swedish krona	0.1429	7.0000

What is a cross rate?

A cross rate is the exchange rate between any two currencies not involving U.S. dollars.

In practice, cross rates are usually calculated on the basis of U.S. dollar exchange rates.

Calculate the Kronor per euro cross rate.

Euros/Krona Cross Rate

Euros per Krona cross rate is reciprocal of the Kronor per Euro cross rate:

Euros per Krona cross rate = 1/(8.750) = 0.1143

Example of International Transactions

Assume a firm can produce a package of jerky in the U.S. and ship it to France for $1.75. If the firm wants a 50% markup on the product, what should the jerky sell for in France?

Target price = ($1.75)(1.50)=$2.625

Use the reported exchange rate, which is the direct quote of dollars per euro.

Could you use the calculated indirect rate for euros per dollar?

Yes, for this particular example:

$2.625 × 0.8 € per $ = €2.10

But this is only true if the indirect rate that is calculated from the reported direct rate is not rounded.

Example (1 of 4)

Now the firm begins producing the jerky in France. The product costs 2.0 euros to produce and ship to Sweden, where it can be sold for 20 kronor. What is the dollar profit on the sale?

We can use the kronor per euro cross rate to find the Swedish sales revenue because the cross rate has not been rounded (otherwise, we would need to calculate the cross rate ourselves).

Example (2 of 4)

Revenue =(2.0 euros)(8.50 kronor per euro)

Revenue = 17.5 kronor.

The profit in kronor is:

20 – 17.50 = 2.50 kronor

Example (3 of 4)

Example (4 of 4)

In this example, we need to use the reported 7 kronor per dollar indirect exchange rate or we must calculate the direct rate ourselves and not round it at all.

What is exchange rate risk?

Exchange rate risk is the risk that the value of a cash flow in one currency translated from another currency will decline due to a change in exchange rates.

Currency Appreciation

Suppose the exchange rate goes from 7 kronor per dollar to 9 kronor per dollar.

A dollar now buys more kronor. The percentage increase in kronor per dollar is:

(9 − 7)/7 = 28.6%

We would say that the dollar appreciated against the krona by 28.6%.

The dollar has appreciated, but what about the krona?

Express the exchange rate as dollars per krona to determine how much more or less valuable the krona has become.

Kronor per dollar: 7 ⟹ 9

Dollars per krona: 0.1429 ⟹ 0.1111

The percentage change in dollars per krona:

(0.1429 − 0.1111)/0.1111 = −0.222

Kronor has depreciated against the dollar by 22.2%.

What to Remember about Currency Appreciation and Depreciation

To determine whether currency X has appreciated or depreciated against currency Y:

Write the exchange rate as the number of units of Y per unit of X.

Comparing the old rate with the new rate shows how much more (or less) of currency Y that X can purchase.

The percentage that X appreciates against Y is not the same as the percentage that Y depreciates against X.

Effect of Dollar Appreciation

Suppose the profit in kronor remains unchanged at 2.5 kronor, but the dollar appreciates, so the exchange rate is now 10 kronor/dollar.

Dollar profit = 2.5 kronor / (10 kronor per dollar) = $0.25.

Strengthening dollar hurts profits from international sales.

International Monetary Systems: Gold Standard

Paper currency issued by each country

Could be for gold from country’s treasury

Gold was worth:

$20.67 an ounce in the U.S.

£4.24 in the U.K.

Required international cooperation

Redemption price local currencies

Free flow from one country to another of:

Gold

Trade

Failed! Lack of international cooperation:

World War I

Depressions

World War II

Bretton Woods Agreement

Meeting of industrialized countries in 1944 establish new international monetary system

Created International Monetary Fund (IMF) to promote international:

Trade

Prosperity

IMF works to:

Stabilize exchange rates.

Reduce restrictions on currency exchanges.

Provide short-term financial help to countries with financial crises.

Now has over 180 member nations.

International Monetary System from 1946-1971: Fixed Exchange Rates

U.S. dollar was tied to gold at $35 per ounce.

Other currencies were tied to U.S. dollar at fixed exchange rates.

Central banks intervened by purchasing and selling currency to even out demand so that the fixed exchange rates were maintained.

Occasionally the official exchange rate for a country would be changed.

Failed due to economic difficulties from maintaining fixed exchange rates.

Current International Monetary Systems

Floating

Pegged systems

Other arrangements

Monetary unions

See following slides for more on each system.

Floating Rate Systems

Very little government intervention when currency demand changes due to:

Trade deficit or surplus

Capital movements to capture higher interest rates

About 70 industrialized nations

About 30 are “free floating” with virtually no government intervention.

About 40 have minor government intervention.

Pegged Exchange Rates

Exchange rate that is “pegged,” or fixed, with respect to another currency.

About 70 countries

Examples of pegged currencies:

To U.S. dollar: Belize, Barbados, Saudi Arabia.

To euro: Denmark

Managed Arrangements

Managed currency

Country doesn’t report its currency as pegged.

But it behaves like it is pegged.

Other Managed Arrangement

Doesn’t fit into any other IMF category

Includes China

Pegged to basket of currencies

Doesn’t tell world what currencies are in basket

Sometimes lets exchange rate float

Sometimes manages it more actively

Monetary Unions

Monetary union

Multiple countries

No individual currencies

Use a common currency

European Monetary Union (EMU)

Began in 2002

Largest monetary union

Uses the euro

European Central Bank controls the monetary policy

The European Monetary Union Members that Use the Euro

Austria	France	Latvia	Portugal
Belgium	Germany	Lithuania	Slovenia
Cyprus	Greece	Luxembourg	Spain
Estonia	Ireland	Malta	Slovakia
Finland	Italy	Netherlands

What is a freely convertible currency?

A currency is convertible when the issuing country promises to redeem the currency at current market rates.

Convertible currencies are freely traded in world currency markets.

Residents and nonresidents are allowed to freely convert the currency into other currencies at market rates.

Also know as fully convertible currency or a hard currency.

All countries with free floating currencies have fully convertible currency.

What is a partially convertible currency?

Actively trades in international FOREX markets.

Has significant government imposed restrictions, including:

Limiting FOREX trading in country to small group of currencies

Limits on the amounts of its currency that may be converted to foreign currencies for purposes of investing abroad

Limits on amounts foreigners may invest inside the country

Most currencies fall into this category, including India and China.

What is a nonconvertible currency?

Not traded in FOREX markets due to government restrictions

Also called a soft currency or a blocked currency.

Only Cuba and North Korea have nonconvertible currencies.

Problems When Currency Is Not Fully Convertible

Can be very difficult for multi-national companies to conduct business because there is no easy way to take profits out of the country.

Often, firms will barter for goods to export to their home countries.

What is the difference between spot rates and forward rates?

A spot rate is the rate to buy currency for immediate delivery.

A forward rate is the rate to buy currency at some agreed-upon future date.

Forward rates are normally reported as indirect quotes.

When is a foreign currency selling at a premium in the forward market?

Suppose the indirect spot rate > forward rate.

Home currency buys less of the foreign currency in the forward market.

The foreign currency is appreciating.

Therefore, the foreign currency is selling at a premium in the forward market.

Example of Forward Currency Selling at a Premium

Spot rate = 110 yen per dollar and forward rate = 100 yen per dollar.

Dollar buys fewer yen in the future.

Yen is appreciating.

Yen is selling for a premium in the forward market.

When is a foreign currency selling at a discount in the forward market?

Suppose the indirect spot rate < forward rate.

Home currency buys more of the foreign currency in the forward market.

The foreign currency is depreciating.

Therefore, the foreign currency is selling at a discount in the forward market.

What is interest rate parity?

Interest rate parity implies that investors should expect to earn the same return on similar-risk securities in all countries:

Forward and spot rates are direct quotations.

rh = periodic interest rate in the home country.

rf = periodic interest rate in the foreign country.

Interest Rate Parity Example (1 of 2)

Assume 1 euro = $1.27 in the 180-day forward market and the 180-day risk-free rate is 6% in the U.S. and 4% in France. Does interest rate parity hold?

Spot rate = $1.25.

rh = 6%/2 = 3%.

rf = 4%/2 = 2%.

Interest Rate Parity Example (2 of 2)

If interest rate parity holds, the implied forward rate, 1.2623, would equal the observed forward rate, 1.2700; so parity doesn’t hold.

Which 180-day security (U.S. or French) offers the higher return?

A U.S. investor could directly invest in the U.S. security and earn an annualized rate of 6%.

Alternatively, the U.S. investor could convert dollars to euros, invest in the French security, and then convert profit back into dollars. If the return on this strategy is higher than 6%, then the French security has the higher rate.

What is the return to a U.S. investor in the French security?

Buy $1,000 worth of euros in the spot market:

$1,000(0.80 euros per $) = 800 euros.

French investment return (in euros):

800(1.02)= 816 euros.

U.S. Return

Buy contract today to exchange 816 euros in 180 days at forward rate of 1.2700 dollars/euro.

At end of 180 days, convert euro investment to dollars:

€816 (1.2700 $ per €) = $1,036.32.

Calculate the rate of return:

$36.32/$1,000 = 3.632% per 180 days

= 7.26% per year.

The French security has highest return, even with lower interest rate.

U.S. rate is 6%, so French securities at 7.26% offer a higher rate of return to U.S. investors.

But could such a situation exist for very long?

Impact of Arbitrage Activities (1 of 2)

Traders could borrow at the U.S. rate, convert to euros at the spot rate, and simultaneously lock in the forward rate and invest in French securities.

This would produce arbitrage: a positive cash flow, with no risk and none of the traders own money invested.

Impact of Arbitrage Activities (2 of 2)

Traders would recognize the arbitrage opportunity and make huge investments.

Their actions would tend to move interest rates, forward rates, and spot rates to parity.

What is purchasing power parity?

Purchasing power parity implies that the level of exchange rates adjusts so that identical goods cost the same amount in different countries.

Ph = Pf(Spot rate),

Spot rate = Ph/Pf.

U.S. jerky is $2.00/package. If purchasing power parity holds, what is price in France?

Spot rate = Ph/Pf.

$1.2500= $2.00/Pf

Pf = $2.00/$1.2500

= 1.6 euros.

Do interest rate and purchasing power parity hold exactly at any point in time?

Impact of relative Inflation on Interest Rates and Exchange Rates

Lower inflation leads to lower interest rates, so borrowing in low-interest countries may appear attractive to multinational firms.

However, currencies in low-inflation countries tend to appreciate against those in high-inflation rate countries, so the true interest cost increases over the life of the loan.

Describe the international money and capital markets.

Eurodollar markets

Dollars held outside the U.S.

Mostly Europe, but also elsewhere

International bonds

Foreign bonds: Sold by foreign borrower, but denominated in the currency of the country of issue.

Eurobonds: Sold in country other than the one in whose currency it is denominated.

To what extent do capital structures vary across different countries?

Early studies suggested that average capital structures varied widely among the large industrial countries.

However, a recent study, which controlled for differences in accounting practices, suggests that capital structures are more similar across different countries than previously thought.

Risk Exposure Due to Investment in Foreign Projects: Exchange Rate Risk

Exchange rate risk

Can be mitigated for short-term cash flows by using forward contracts.

Longer-term cash flows still have exchange risk.

Political Risk Due to the Host Country

Curbs on currency conversion can make it difficult to repatriate profits.

Restrictions on product prices charged by the subsidiary.

The host country may expropriate the subsidiary’s assets

Corrupt government officials may require bribes.

Taxation Risk

Prior to 2018, repatriated earnings (less foreign taxes) were subject to U.S. taxes.

U.S. corporate tax rates were higher than rates in most countries, making repatriation very costly.

U.S. occasionally had grace periods with lower tax rates on repatriated earnings.

But grace periods were brief and unpredictable.

Foreign subsidiaries held about $2.6 trillion in unrepatriated earnings.

2017 Tax Cuts and Jobs Act (TCJA)

Imposed a one-time tax on foreign earnings accumulated since 1986 even if they were left overseas.

15.5% on accumulated earnings held in cash and cash equivalents

8% on the remainder

To be paid over 8-year period

No taxes on future foreign earnings

Foreign Project Analysis

Project future expected cash flows, denominated in foreign currency

Use the interest rate parity relationship to convert the future expected foreign cash flows into dollars.

Discount the dollar denominated cash flows at the risk-adjusted cost of capital for similar U.S. projects.

Capital Budgeting Example

U.S. company invests in project in Japan.

Expected future cash flows:

CF0 = - ¥1,000 million.

CF1 = ¥500 million.

CF2 = ¥800 million.

Risk-adjusted cost of capital for a similar U.S. project = 10%.

Interest Rate and Exchange Rate Data

Current spot exchange rate = 110 ¥ per $.

U.S. government bond rates:

1-year bond = 2.0%

2-year bond = 2.8%

Japan government bond rates:

1-year bond = 0.05%

2-year bond = 0.26%

Multi-year Interest Rate Parity Relationship

Exchange rates are direct quotations.

rh = annual interest rate in the home country.

rf = annual interest rate in the foreign country.

Expected Future Exchange Rates (1 of 2)

Direct spot rate = (1/110 ¥ per $) = 0.009091 $ per ¥.

Expected exchange rate in 1 year:

= (Spot rate)[(1+rh)/(1+rf)]1

= (0.009091)(1+0.02)/(1+0.0005)

= 0.009268

Expected Future Exchange Rates (2 of 2)

Expected exchange rate in 2 years:

= (spot rate)[(1+rh)/(1+rf)]2

= (0.009091)[(1+0.028)/(1+0.0026)]2

= 0.009557

Project Cash Flows

	0	1	2
Cash flows in yen	-¥1,000	¥500	¥800
Expected exchange rates	0.009091	0.009268	0.009557
Cash flows in dollars	-$9.09	$4.63	$7.65

Project NPV

International Cash Management

Distances are greater.

Access to more markets for loans and for temporary investments.

Cash is often denominated in different currencies.

Multinational Credit Management

Credit is more important, because commerce to lesser-developed countries often relies on credit.

Credit for future payment may be subject to exchange rate risk.

Many companies buy export credit risk insurance when granting credit to foreign customers.

Multinational Inventory Management

Inventory decisions can be more complex, especially when inventory can be stored in locations in different countries.

Some factors to consider are shipping times, carrying costs, taxes, import duties, and exchange rates.

KronorDollars

Cross Rate

DollarEuros

7.0001.2500

8.750 Kronor per Euro

=´

Forword rate

Spot rate1r

Forward rate1rh

Spot rate1rh

Forward rate1.03

1.251.02

Forward rate1.2623.

Expected future

exchange rate

Spot rate1r

éù

êú

ëû

(

)

(

)

$4.63$7.65

NPV$9.09

1+0.10

NPV$1.44 million.

=-++