CHAPTER 16 Multinational Financial Management

1
CHAPTER 16Multinational 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?

1. To seek new markets.
2. To seek raw materials.
3. To seek new technology.
4. To seek production efficiency.
5. To avoid political and regulatory hurdles.
   
6. To diversify.

4
What factors distinguish multinational financial
management from domestic financial management?

1. Different currency denominations.
2. Economic and legal ramifications.
3. Language differences.
4. Cultural differences.
5. Role of governments.
6. Political risk.

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 dollar

• 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 projectSetting 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)
• 291.66 yen

10
Orange juice projectDetermining 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.
• The current international monetary system is a
  floating rate system.

12
European Monetary Union

• In 2002, the full implementation of the euro
  was completed. The national currencies of the 12
  participating countries were phased out in favor
  of the euro. The newly formed European Central
  Bank controls the monetary policy of the EMU.

13
Member nations of the EMU

• Austria
• Belgium
• Finland
• France
• Germany
• Greece

• Ireland
• Italy
• Luxembourg
• Netherlands
• Portugal
• Spain

• Notable European Union countries not in the EMU
• Britain, Sweden, and Denmark

14
What is a convertible currency?

• A currency is convertible when the issuing
  country promises to redeem the currency at
  current market rates.
• Convertible currencies are traded in world
  currency markets.

15
What problems may arise when a firm operates in
a country whose currency is not convertible?

• It becomes 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.

16
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.

17
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.

18
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.

19
Evaluating interest rate parity

• Suppose one yen buys 0.0095 in the 30-day
  forward exchange market and kNOM for a 30-day
  risk-free security in Japan and in the U.S. is
  4.
• ft 0.0095
• kh 4 / 12 0.333
• kf 4 / 12 0.333

20
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.

21
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.

22
What is purchasing power parity (PPP)?

• 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

23
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.

24
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.

25
International money and capital markets

• Eurodollar markets
• a source of dollars outside the U.S.
• 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 the bonds are denominated.

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.
• Access to more markets for loans and for
  temporary investments.
• Cash is often denominated in different currencies.

28
Impact of multinational operations

• Capital budgeting decisions
• Foreign operations are taxed locally, and then
  funds repatriated may be subject to U.S. taxes.
• Foreign projects are subject to political risk.
• Funds repatriated must be converted to U.S.
  dollars, so exchange rate risk must be taken into
  account.

29
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.
• Some factors to consider are shipping times,
  carrying costs, taxes, import duties, and
  exchange rates.