07 Multinational Financial Management

8/19/2019 07 Multinational Financial Management

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MULTINATIONAL FINANCIAL

MANAGEMENT


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Multinational or Global Corporation

• A firm that operates in an integrated fashion

in a number of (two or more) countries.

• Decision making may be centralized in the

home country or decentralized across the

countries the corporation does business in.


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Reasons why companies expand into

other countries

• To broaden their markets (Seek new markets)

• To seek raw materials

• To seek new technology

• To seek production efficiency

Vertically IntegratedInvestment


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• To avoid political, trade, and regulatory

hurdles

• To diversify

• To take advantage of specialized skills

•To protect processes and products

• To retain customers

Reasons why companies expand into

other countries


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Cost Migration Opportunities


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Regional trends in cost migration


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Going global…

• Becomes essential to effectively compete

especially with the advent of globalization

• Used to be a competitive advantage before,

but now, it appears to be an inevitable move

especially for market leaders.


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Major factors that complicate financial

management in multinational firms

• Different currency denominations

• Economic and legal ramifications

• Language differences• Cultural differences

• Role of governments

• Political risks


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Monetary System

• Local (National) Monetary System and Authority

– Each nation has a monetary system and authority.

– Task is to:

• Hold down inflation

•Promote economic growth (raise living standards)

– For the US, the local monetary authority is the Federal

Reserve.

– For the Philippines, the local monetary authority is the BSP.

• International Monetary System

– Must be in place for smoothen trade and facilitate payments

between nations

– May be fixed or float


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International Monetary System

•A system designed to facilitate payments betweennations when they are engaging in trade, thus, it is the

framework within which exchange rates are

determined.

• It is the blueprint for international trade and capital

flows.

• Regulated by intergovernmental agreements and driven

by each country’s unique political and economic

objectives.

• Facilitates international trade, cross border investment

and the reallocation of capital between nations.


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International Monetary Terminology

•

Exchange Rate• Spot exchange rate

• Forward exchange rate

• Fixed exchange rate• Floating or flexible exchange rate

• Devaluation of Currency

• Revaluation of Currency

• Depreciation of Currency

• Appreciation of Currency

Applicable for Fixed

Currencies

Applicable for Floating

Currencies


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• End of WWII – August 1971: Fixed exchange rate system (by

IMF)

• Fixed exchange rate system

– Also known as pegged exchange rate

–

A type of exchange rate regime wherein a currency’s value ismatched to the value of another single currency or to a basket of

other currencies , or to another measure of value, such as gold.

– Done by buying and selling own currency in the open market (have

huge foreign reserves) or making it illegal to trade currency at any

other rate (may lead to black market, however it may be successful

due to government monopolies over all money conversion)

– Eg: China RMB (pegged to basket of currencies dollar, euro, Japanese yen,Korean won, Singapore dollar, sterling, Malaysian ringgit, Russian rouble,

Australian dollar, Thai baht and Canadian dollar.)


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• The current international monetary system is the FloatingExchange Rate System

• Floating Exchange Rate System

– A system under which exchange rates are not fixed by government

policy but are allowed to float up or down in accordance with supply

and demand.

– May cause exchange rate fluctuations and CB of each country needs

to intervene to smoothen out these fluctuations.

– Results to Exchange Rate Risk


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Broad Groups of Currency Regimes:• Floating Rates

–Freely Floating – Determined by supply and demand withoutsignificant government intervention.

– Managed Floating – Significant government intervention in themanipulation of the currency’s supply and demand.

• Fixed Rates

– No local currency – No local currency of its own and uses thecurrency of other countries. It surrenders the ability to use exchange

rate to tinker with its economy.

– Currency board arrangement – A country has local currencybut commits to exchange it for a specified foreign money unit at a

fixed exchange rate.

– Fixed-peg arrangement – A country locks its currency to aspecific currency or basket of currencies at a fixed exchange rate.


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Exchange Rates

•

Exchange rate – the number of units of a given currencythat can be purchased for one unit of another currency

• Direct Quotation – Number of domestic currency

required to purchase one unit of foreign currency (FXY

expressed in DXY) eg: 1 Sgd = 32 Php

• Indirect Quotation – Number of units of foreign

currency that can be purchased for one unit of

domestic currency (DXY expressed in FXY) eg: 1 Php =0.03125 Sgd

• Direct quotation is the reciprocal of indirect quotation.


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U.S. $ to buy1 Unit

Japanese yen 0.009

Australian dollar 0.650

• Assuming that domestic country is the US, are these

currency prices direct or indirect quotations? – Since they are prices of foreign currencies

expressed in dollars, they are direct quotations.

Consider the following exchange rates:


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Calculate the indirect quotations

for yen and Australian dollars.

# of Units of Foreign

Currency per U.S. $Japanese yen 111.11

Australian dollar 1.5385

Yen: 1/0.009 = 111.11. A. Dollar: 1/0.650 = 1.5385.


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Sample Problems on Simple Exchange

Rates

• If one Swiss franc can purchase $0.71 U.S.

dollar, how many Swiss francs can one U.S.

dollar buy?

• If one U.S. dollar buys 1.0279 euros, how

many dollars can you purchase for one euro?

C C R t (E


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Currency Cross Rates (European vs.

American terms)


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Cross Rate (European Terms)

• The exchange rate between any two

currencies.

• They are actually calculated on the basis of

various currencies relative to the USD.


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• Cross rate = x

= 111.11 x 0.650= 72.22 yen/A. dollar.

• Cross rate = x= 1.5385 x 0.009

= 0.0138 A. dollars/yen.

Calculate the two cross ratesbetween yen and Australian dollars.

Yen U.S. DollarsU.S. Dollar A. Dollar

A. Dollars U.S. Dollars

U.S. Dollar Yen


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• The two cross rates are reciprocals of

one another.

• They can be calculated by dividing either

the direct or indirect quotations.

Note:


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Sample Problems for Cross Exchange Rates

• A currency trader observes the following quotes in the spot

market:

122 Japanese yen = 1 U.S. dollar

2.28 Swiss francs = 1 British pound

1 British pound = 1.6542 U.S. dollars

Given this information, what is the exchange rate between

the Swiss franc (SF) and the Japanese yen?


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Sample Problems for Cross Exchange Rates

• Currently, in the spot market $1 = 106.45 Japanese yen, 1

Japanese yen = 0.00966 euro, and 1 euro = 9.0606 Mexican

pesos. What is the exchange rate between the U.S. dollar

and the Mexican peso?

•Suppose exchange rates between U.S. dollars and Swissfrancs is SF 1.6564 = $1.00 and the exchange rate between

the U.S. dollar and the euro is $1.00 = 1.0279 euros. What

is the cross rate of the Swiss franc to the euro?


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Why is the USD the basis for cross rates?

• Bretton Woods Agreement

– Attempt to rebuild the international economic system after WW2

– Done to regulate the international monetary system, BW planners

established IMF and IBRD (part of World Bank Group)

– Each country should adopt a monetary policy that maintained the

exchange rate of its currency within a fixed value in terms of gold.

– Gold was replaced by USD because there is inefficient supply of

gold (4.5 trillion) and there are also disadvantages and other

reasons (e.g. Soviet Union has a sizeable share of the world’s

known gold reserves, and it was later a Cold War Rival to US and

Western Europe)

– The US Dollar acted as a store value as it was the strongest reserve

currency, and also it was pegged to gold.


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Recall:

• 1 USD = 111.11 JPY 1 JPY = 0.009 USD

• 1 USD = 1.5385 AUD 1 AUD = 0.65 USD

• Using Cross Rate:

– 1 JPY = 0.01385 AUD

–1 AUD = 72.2220 JPY


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Setting the appropriate price

• A US firm can produce a liter of orange juiceand ship it to Japan for $1.75 per unit. If thefirm 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


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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 (or 2.55 x 0.65)


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Sample Problems – Exchange rates and

Profitability• The following exchange rates are quoted in the spot market:

$1 U.S. = 116.6 Japanese yen.

1 Canadian dollar = $0.66 U.S.

Crane Cola is a U.S. company with worldwide operations. The

company can produce a liter of cola in Canada at a cost of 0.45

Canadian dollars. The cola can be sold in Japan for 120 Japanese

yen. How much operating profit (measured in U.S. dollars) does

the company make on each liter of cola sold in the Japanese

market?


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Sample Problems – Exchange rates and

Profitability• Cypress Foods, a U.S. company, has a subsidiary that

produces lime juice in Brazil and sells it in Japan. The

exchange rates are such that 1 U.S. dollar equals 1.75

Brazilian real, and 1 U.S. dollar equals 120 Japanese yen.Cypress spends 1.2 real to produce one unit of lime juice

and sells it for 100 Japanese yen. What is the profit in U.S.

dollars realized from each unit of lime juice sold?


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What is exchange rate risk?

• The risk that the value of a cash flow in one currencytranslated to another currency will decline due to a

change in exchange rates.

• Risk inherent in a floating exchange rate system due

to exchange rate volatility.

• This causes a company’s consolidated cash flows to

fluctuate.


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Other Terms:• Pegged Exchange Rate

– Occurs when a country establishes a fixed exchange ratewith another major currency, consequently, values of

pegged currencies move together over time.

– Usually done for smaller countries

• Convertible Currency – A currency that may be readily exchanged for other

currencies

– A currency is convertible when the issuing country

promises to redeem the currency at current market rates

– These are traded in world currency markets


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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. (e.g. the communist

countries during the cold war. Hyperinflation,e.g. in Germany after the two world wars.


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Trading in Foreign Exchange

• Difference between spot rates and forwardexchange rates:

– Spot Rates

•

The effective exchange rate for a foreign currency fordelivery on (approximately) the current day.

• The rates to buy currency for immediate delivery.

– Forward Rates

• An agreed-upon price at which two currencies will beexchanged at some future date.

• The rates to buy currency at some agreed-upon date in

the future.


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Discount / Premium on Forward Rate

• Discount on Forward Rate (SLD, FGD)

– When spot rate < forward rate

– If the local currency (USD) buys more units of foreign

currency in the forward market than in the spot market

–

Forward less valuable than spot – because it takes moreunits of a fxy to buy 1 USD in the future

• Premium on Forward Rate (SGP, FLP)

– When spot rate > forward rate

– If the local currency (USD) buys more units of foreign

currency in the spot market than in the forward market

– Forward more valuable than spot – because it takes less

units of a fxy to buy 1 USD in the future


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Illustrative Problem:

Forward RatesSpot Rate 30 Days 60 Days 90 Days 180 Days

Philippine Peso 45.95 44.33 49.15 49.75 46.48

Which of the following statements is correct?a. There is a premium on the 30 day forward rate on the

Philippine peso.

b. There is a discount on the 60 day forward rate on the

Philippine peso.c. 1 USD is worth 45.95 Philippine pesos if traded

immediately.

d. All statements are correct.

e. None of the statements are correct.


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Interest Rate Parity

• Aka International Fisher Effect

• Specifies that investors should expect to earn the same returnin all countries after adjusting for risk.

• A theory that the interest rate differential between two

countries is equal to the differential between the forward

exchange rate and the spot exchange rate.

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I R P i S l P bl


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Interest Rate Parity Sample Problems:• In the spot market, 1 U.S. dollar can be exchanged for 121 Japanese yen.

In the 1-year forward market, 1 U.S. dollar can be exchanged for 125

Japanese yen. The 1-year, risk-free rate of interest is 5.2 percent in the

United States. If interest rate parity holds, what is the yield today on 1-

year, risk-free Japanese securities?

• The nominal rate of interest on six-month, risk-free U.S. securities is 6

percent. Currently in the spot market, $1 U.S. = 104.84 Japanese yen. Inthe six-month forward market, $1 U.S. = 104.84 Japanese yen. If

interest rate parity holds, what is the current nominal interest rate on

six-month, risk-free Japanese securities?

•

90-day investments in Great Britain have a 6 percent annualized returnand a 1.5 percent quarterly (90-day) return. In the U.S., 90-day

investments of similar risk have a 4 percent annualized return and a 1

percent quarterly (90-day) return. In the 90-day forward market, 1

British pound (£) = $1.65. If interest rate parity holds, what is the spot

exchange rate?


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Discount / Premium on Currency

• Currency is at Forward Premium

– Domestic interest rate > Foreign interest rate

• Currency is at Forward Discount

– Domestic interest rate < Foreign interest rate


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Purchasing Power Parity

• Aka Law of One Price

• The relationship in which the same products cost roughly thesame amount in different countries after taking into account

the exchange rate.

• It 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

Ph = price of the good in the home country

Pf = price of the good in the foreign country

e0 = today’s spot exchange rate


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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.


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Does PPP hold true?


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Country Local Price Dollar Exchange Dollar Price Dollar PPP Implied Dollar Valuation

Argentina 28 8.61 3.25 5.85 -32.11

Australia 5.3 1.23 4.32 1.11 -9.84

Britain 2.89 0.66 4.37 0.6 -8.81

Canada 5.7 1.23 4.64 1.19 -3.14

China 17.2 6.21 2.77 3.59 -42.19

Denmark 34.5 6.42 5.38 7.2 12.23

Egypt 16.93 7.35 2.3 3.53 -51.91

Hong Kong 18.8 7.75 2.43 3.92 -49.37

Hungary 860 271.39 3.17 179.54 -33.84

India 116.25 61.62 1.89 24.27 -60.61

Indonesia 27939 12480 2.24 5832.78 -53.26

Israel 17.5 3.93 4.45 3.65 -7.14

Japan 370 117.77 3.14 77.24 -34.41

Malaysia 7.63 3.62 2.11 1.59 -55.94

Mexico 49 14.63 3.35 10.23 -30.07

New Zealand 5.9 1.31 4.49 1.23 -6.21

Philippines 163 44.41 3.67 34.03 -23.37

Singapore 4.7 1.33 3.53 0.98 -26.4South Africa 25.5 11.48 2.22 5.32 -53.62

South Korea 4100 1083.3 3.78 855.95 -20.99

Switzerland 6.5 0.86 7.54 1.36 57.49

Taiwan 79 31.49 2.51 16.49 -47.63

Thailand 99 32.61 3.04 20.67 -36.61

Turkey 9.25 2.33 3.96 1.93 -17.24

United States 4.79 1 4.79 1 0


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PPP Illustrative Problem:

• For your 19th birthday, your parents decided to buy you a

Bugatti Veyron. This is a German-made car from German

manufacturer, the “Volkswagen Group”. They asked you to

canvass prices from different car dealers all over the world to

determine the best deal. After making several inquiries, you

have come up with a list below:

COUNTRY PRICE

USA USD 1,700,000

China Yuan 12,000,000Germany Euro 1,150,000

Japan Yen 140,000,000

Philippines Peso 80,000,000


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• You have also come up with a cross rate list, as follows:

• Requirement 1: Ignoring all other costs such as import duties,

taxes, shipping costs, and holding costs, and assuming that cross

rates hold true, how much is the percentage overvaluation or

undervaluation if you decide to buy the car in Japan?• Requirement 2: Ignoring all other costs such as import duties,

taxes, shipping costs, and holding costs, and assuming that cross

rates hold true, in which country would you buy the car from in

order to get the best deal?

Currency

Codes/Names Euro

Japanese

Yen

US

Dollar

Chinese

Yuan

Philippine

Peso

EUR 1 0.007533 0.6891 0.1011 0.01512

JPY 132.775 1 91.4869 13.4192 2.0079

USD 1.4513 0.010932 1 0.1467 0.02195

CNY 9.9236 0.07475 6.8376 1 0.1501

PHP 66.5126 0.501 45.8287 6.7221 1


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PPP Short Problems:

• A telephone costs $100 in the United States.

The same telephone costs 150 Canadian

dollars. Assume that purchasing power parity

holds. What is the exchange rate betweenU.S. and Canadian dollars?

• A box of candy costs 28.80 Swiss francs (SF) in

Switzerland and $20 in the United States.Assuming that purchasing power parity (PPP)

holds, what is the current exchange rate?


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Inflation, Interest Rates, and Exchange Rates

• What impact does relative inflation have on interest rates

and exchange rates? – Currencies with higher inflation than the US depreciates over

time against the USD. Currencies with lower inflation than the

US appreciate against the USD.

– Lower inflation leads the Fed to lower interest rates. – Borrowing in low interest countries may appear attractive to

multinational firms. But, is it a good strategy?

– As stated above, because currencies in low-inflation countriestend to appreciate against those in high-inflation rate countries,

so the effective interest cost increases over the life of the loan. – Therefore, the lower interest rate could be more than offset by

losses from currency appreciation.

International Money and Capital Markets


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International Money and Capital Markets• International Credit Markets

– Eurocredits

•

Floating-rate bank loans that are available in most major trading currencies andthat are tied to LIBOR. They tend to be issued for a fixed term with no early

repayment.

• Eurodollar – A source of dollars outside the US. USD deposited in a bank outside

US. Asian Dollar – USD deposited in banks based in Asian countries.

–

International Bond Markets• Foreign Bonds – sold by foreign borrower, but denominated in the currency of the

country of issue. Tend to be more regulated coz underwriter is subject to Phil. laws.

It is underwritten by investment banks from the same country. (China sells bonds to

Philippine companies and the bond is denominated in peso. Investment banks in the

Philippines underwrites the bonds. These bonds are from a different country). Eg:

Yankee, Bulldogs, Samurai Bonds, Matilda bonds

• Eurobonds (external bonds) – sold in the country other than the one in whose

currency the bonds are denominated. It is a bond issued in a currency other than

the currency of the country or market in which it is issued. It is underwritten by an

international syndicate. (China sells bonds to Philippine companies and the bond is

denominated in USD. An international syndicate underwrites the bonds. Thesebonds can’t be issued in the US

l d l k


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International Money and Capital Markets

• International Stock Markets

– A Philippine firm may sell its stock in Japan to tap a larger

source of capital that the home country.

– US firms may tap a foreign market to create an equity

market presence to accompany its operations in that

country.

– Large multinational companies can issue new stock

simultaneously in multiple countries. This can create

arbitrage opportunities for investors.

– American Depository Receipts (ADRs) – certificates

representing ownership of foreign stock held in trust. They

are mostly traded on the OTC market but more are being

listed in stock exchanges.

Multinational Capital Budgeting


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Multinational Capital Budgeting• Involves more complex cash flow estimation and analysis.

• Involves repatriation of earnings (the process of sending CFs

from foreign subsidiary back to the parent company), though

foreign government may restrict it.

• Foreign subsidiaries’ or branches’ cash flows are converted to

the parent company’s currency.• Must look at business climate – refers to a country’s social,

political, and economic environment.

• Involves higher risk, particularly:

– Country risk – the risk that arises from investing or doing business in aparticular country.

– Exchange rate risk – the risk that relates to what the basic CFs will be

worth in the parent company’s home currency.

–

Political risk – potential actions by a host government that would reducethe value of a com an ’s investment.

Current risk score

C t S t C t C t E i P liti l St t l C dit ti D bt A t


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Current

rank

Sept

'10

Country name Current

score

Economic

(30%

weight)

Political

(30%

weight)

Structural

(10%

weight)

Credit rating

(out of 10,

10% wt)

Debt

indicators

(out of 10,

10% wt)

Access to

capital markets

(out of 10, 10%

wt)

1 1 Norway 93.44 90.40 92.97 84.10 10.00 10.00 10.002 6 Luxembourg 91.03 81.00 93.67 86.25 10.00 10.00 10.00

3 2 Switzerland 89.59 82.50 87.23 86.71 10.00 10.00 10.00

29 25 Korea South 72.28 65.75 67.86 69.13 7.29 10.00 8.00

39 60 Malaysia 64.75 60.80 60.63 65.40 6.25 8.04 7.50

40 36 China 63.55 66.88 48.47 52.41 7.71 8.73 7.25

42 45 Thailand 63.00 65.33 52.89 66.00 5.42 9.03 6.50

52 61 Indonesia 58.27 62.75 51.72 53.38 3.33 8.50 6.75

60 66 Sri Lanka 54.86 56.33 52.01 71.00 1.88 8.41 5.00

61 58 Philippines 54.46 52.67 50.08 57.50 2.92 8.23 6.75

62 102 Botswana 54.00 47.00 50.96 33.33 6.56 8.69 6.00

70 91 Bermuda 49.48 0.00 69.00 0.00 8.96 10.00 9.75

71 75 Vietnam 49.46 46.00 44.26 50.83 2.29 8.27 6.75

95 110 Nigeria 42.05 45.56 33.67 45.75 2.19 9.54 2.00

98 96 Belarus 39.84 43.75 34.38 27.81 1.88 8.73 3.00

99 101 Algeria 39.50 45.80 37.40 50.60 0.00 5.50 4.00

100 100 Mozambique 38.79 41.00 47.00 0.00 1.56 8.74 2.00


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International Capital Structure

• Companies’ capital structures vary among

countries.

• Problems when comparing capital structures

among nations:

– Reporting assets on a historical cost versus a

replacement cost basis.

– Treating leased assets – Reporting pension plan liabilities

– Capitalizing versus expensing R&D costs.


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To what extent do average capital structures vary

across different countries?

• Previous studies suggested that average capitalstructures vary among the large industrialcountries.

• However, a recent study, which controlled fordifferences in accounting practices, suggeststhat capital structures are more similar across

different countries than previously thought.


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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.


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• 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 intoaccount.


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• 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, especiallywhen inventory can be stored in locations in different

countries. – Some factors to consider are shipping times, carrying

costs, taxes, import duties, and exchange rates.


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Currency Appreciation

• Suppose that 1 Kong Kong dollar could be

purchased in the foreign exchange market

today for $0.1290. if the Hong Kong dollar

appreciated 10% tomorrow against the dollar,how many HKD would a US dollar buy

tomorrow?


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Foreign Investment Analysis

• After all foreign and US taxes, a US corporation expects to

receive 3 Singapore dollars of dividends per share from a

Singaporean subsidiary this year. The exchange rate at the

end of the year is expected to be $0.7062 per SGD, and the

SGD is expected to depreciate 5% against the dollar each

year for an indefinite period. The dividend (in SGD) is

expected to grow at 10% a year indefinitely. The parent US

corporation owns 10 million shares of the subsidiary. Whatis the present value in dollars of its equity ownership of the

subsidiary? Assume a cost of equity capital of 15 percent

for the subsidiary.

07 Multinational Financial Management

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