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CHAPTER 17 Multinational Financial Management

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Title: CHAPTER 17 Multinational Financial Management


1
CHAPTER 17 Multinational Financial Management
  • Multinational vs. domestic financial management
  • Exchange rates and trading in foreign exchange
  • International money and capital markets

2
What is a multinational corporation?
  • A corporation that operates in two or more
    countries.
  • Decision making within the corporation may be
    centralized in the home country, or may be
    decentralized across the countries the
    corporation does business in.

3
Why do firms expand into other countries?
  • To seek new markets.
  • To seek raw materials.
  • To seek new technology.
  • To seek production efficiency.
  • To avoid political and regulatory hurdles.
  • To diversify.
  • To retain customers.
  • To protect processes.

4
What factors distinguish multinational financial
management from domestic financial management?
  • Different currency denominations.
  • Political risk
  • Economic and legal ramifications.
  • Role of governments
  • Language and cultural differences.

5
Consider the following exchange rates
  • US to buy 1 unit
  • Japanese yen 0.009
  • Australian dollar 0.650
  • Are these currency prices direct or indirect
    quotations?
  • Since they are prices of foreign currencies
    expressed in dollars, they are direct quotations.

6
What is an indirect quotation?
  • The number of units of a foreign currency needed
    to purchase one U.S. dollar, or the reciprocal of
    a direct quotation.
  • Are you more likely to observe direct or indirect
    quotations?
  • Most exchange rates are stated in terms of an
    indirect quotation.
  • Except the British pound, which is usually in
    terms of a direct quotation.

7
Calculate the indirect quotations for yen and
Australian dollars
  • of units of foreign
  • currency per US
  • Japanese yen 111.11
  • Australian dollar 1.5385
  • Simply find the inverse of the direct quotations.

8
What is a cross rate?
  • The exchange rate between any two currencies.
    Cross rates are actually calculated on the basis
    of various currencies relative to the U.S.
    dollar.
  • Cross rate between Australian dollar and the
    Japanese yen.
  • Cross rate (Yen / US Dollar) x (US Dollar / A.
    Dollar)
  • 111.11 x 0.650
  • 72.22 Yen / A. Dollar
  • The inverse of this cross rate yields
  • 0.0138 A. Dollars / Yen

9
Orange juice project Setting the appropriate
price
  • A firm can produce a liter of orange juice and
    ship it to Japan for 1.75 per unit. If the firm
    wants a 50 markup on the project, what should
    the juice sell for in Japan?
  • Price (1.75)(1.50)(111.11 yen / )
  • 291.66 yen

10
Orange juice project Determining profitability
  • The product will cost 250 yen to produce and ship
    to Australia, where it can be sold for 6
    Australian dollars. What is the U.S. dollar
    profit on the sale?
  • Cost in A. dollars 250 yen (0.0138)
  • 3.45 A. dollars
  • A. dollar profit 6 3.45 2.55 A. dollars
  • U.S. dollar profit 2.55 / 1.5385 1.66

11
What is exchange rate risk?
  • The risk that the value of a cash flow in one
    currency translated to another currency will
    decline due to a change in exchange rates.
  • For example, in the last slide, a weakening
    Australian dollar (strengthening dollar) would
    lower the dollar profit.

12
International monetary system
  • The framework within which exchange rates are
    determined.
  • The blueprint for international trade and capital
    flows.
  • Exchange rate terminology
  • Spot vs. forward exchange rate
  • Fixed vs. floating exchange rate
  • Devaluation and revaluation
  • Depreciation and appreciation
  • Soft, or weak, currency

13
Floating monetary agreements
  • Freely floating
  • Exchange rate determined by the markets supply
    and demand for the currency. Governments may
    occasionally intervene and buy or sell their
    currency to stabilize fluctuations.
  • Managed floating
  • Significant government intervention manages the
    exchange rate by manipulating the currencys
    supply and demand. The target exchange rates are
    kept secret to prevent currency speculators from
    profiting from it.

14
Fixed monetary agreements
  • No local currency
  • The country uses either another countrys
    currency as its legal tender (like the U.S.
    dollar in Ecuador) or else belongs to a group of
    countries that share a currency (like the euro).
  • Currency board arrangement
  • The country technically has its own currency but
    commits to exchange it for a specified foreign
    currency at a fixed exchange rate (like Argentina
    before its January 2002 crisis).
  • Fixed peg arrangement
  • The country pegs its currency to another (or a
    basket of currencies) at a fixed rate. Slight
    fluctuations are okay, but the rate must stay
    within a desired range. For example, the Chinese
    yuan is pegged to a basket of currencies.

15
What is difference between spot rates and forward
rates?
  • Spot rates are the rates to buy currency for
    immediate delivery.
  • Forward rates are the rates to buy currency at
    some agreed-upon date in the future.

16
When is the forward rate at a premium to the spot
rate?
  • If the U.S. dollar buys fewer units of a foreign
    currency in the forward than in the spot market,
    the foreign currency is selling at a premium.
  • In the opposite situation, the foreign currency
    is selling at a discount.
  • The primary determinant of the spot/forward rate
    relationship is relative interest rates.

17
What is interest rate parity?
  • Interest rate parity holds that investors should
    expect to earn the same return in all countries
    after adjusting for risk.

18
Evaluating interest rate parity
  • Suppose one yen buys 0.0095 in the 30-day
    forward exchange market and rNOM for a 30-day
    risk-free security in Japan and in the U.S. is
    4.
  • ft 0.0095
  • rh 4 / 12 0.333
  • rf 4 / 12 0.333

19
Does interest rate parity hold?
  • Therefore, for interest rate parity to hold, e0
    must equal 0.0095, but we were given earlier
    that e0 0.0090.

20
Which security offers the highest return?
  • The Japanese security.
  • Convert 1,000 to yen in the spot market.
    1,000 x 111.111 111,111 yen.
  • Invest 111,111 yen in 30-day Japanese security.
    In 30 days receive 111,111 yen x 1.00333
    111,481 yen.
  • Agree today to exchange 111,481 yen 30 days from
    now at forward rate, 111,481/105.2632
    1,059.07.
  • 30-day return 59.07/1,000 5.907, nominal
    annual return 12 x 5.907 70.88.

21
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(e0)
  • -OR-
  • e0 Ph/Pf

22
If grapefruit juice costs 2.00 per liter in the
U.S. and PPP holds, what is the price of
grapefruit juice in Australia?
  • e0 Ph/Pf
  • 0.6500 2.00/Pf
  • Pf 2.00/0.6500
  • 3.0769 Australian dollars.

23
What impact does relative inflation have 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 effective
    interest cost increases over the life of the loan.

24
International credit markets
  • Eurocredits
  • Fixed term, floating rate bank loans with no
    early repayment.
  • An example is a eurodollar deposit, which is U.S.
    dollars deposited in a bank outside the U.S.
  • Eurobonds
  • Medium- to long-term international market for
    fixed- and floating-rate debt.
  • Underwritten by an international bank syndicate
    and sold to investors in countries other than the
    one in whose currency the bond is denominated.
  • Foreign bonds
  • Issued in a capital market other than the
    issuers.
  • The only thing foreign about it is the borrowers
    nationality.

25
American Depository Receipts (ADRs)
  • Certificates representing ownership of foreign
    stock held in trust.
  • About 1,700 ADRs are now available in the United
    States, with most of them traded on the
    over-the-counter (OTC) market.
  • However, more and more ADRs are being listed on
    the New York Stock Exchange.

26
To what extent do average capital structures vary
across different countries?
  • Previous studies suggested that average capital
    structures vary 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.

27
Impact of multinational operations
  • Cash management
  • Distances are greater and cash is often
    denominated in different currencies.
  • Access to more markets for loans and for
    temporary investments.
  • Capital budgeting decisions
  • Foreign operations are taxed locally, then
    repatriated funds may be taxed in the U.S.
  • Foreign projects are subject to political risk.
  • Repatriated funds must be converted to U.S.
    dollars (subject to exchange rate risk).

28
Impact of multinational operations
  • 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.
  • Inventory management
  • Inventory decisions can be more complex,
    especially when inventory can be stored in
    locations in different countries.
  • Should consider shipping times, carrying costs,
    taxes, import duties, and exchange rates.
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