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Transcript of Fundamentals of Corporate Finance/3e,ch23
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-1
Chapter Twenty-three
International Corporate Finance
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-2
23.1 Terminology
23.2 Foreign Exchange Markets and Exchange Rates
23.3 Purchasing Power Parity
23.4 Interest Rate Parity, Unbiased Forward Rates and the International Fisher Effect
23.5 International Capital Budgeting
23.6 Exchange Rate Risk
23.7 Political Risk
23.8 Summary and Conclusions
Chapter Organisation
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-3
Chapter Objectives
• Be familiar with international finance terminology.• Apply exchange rates and cross rates.• Understand triangle arbitrage and covered interest
arbitrage.• Distinguish between purchasing power parity, interest
rate parity, unbiased forward rates, uncovered interest parity and the international Fisher effect.
• Calculate the NPV of a foreign operation in home currency terms.
• Explain exchange rate risk and political risk.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-4
Domestic versus International Financial Management
• Whenever transactions involve more than one currency, the levels of, and possible changes in, exchange rates need to be considered.
• The risk of loss associated with actions taken by foreign governments also needs to be considered. This political risk can be difficult to assess and difficult to hedge against.
• Financing opportunities encompass international capital markets and instruments, which can reduce the firm’s cost of capital.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-5
International Finance Terminology• Cross rate
– The implicit exchange rate between two currencies quoted in some third currency.
• Euro– The monetary unit for the European Monetary System
(EMS).
• Eurobonds– International bonds issued in multiple countries but
denominated in the issuer’s currency.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-6
International Finance Terminology
• Eurocurrency– Money deposited in a financial centre outside the country
whose currency is involved.
• Foreign bonds– International bonds issued in a single country usually
denominated in that country’s currency.
• Foreign exchange market– The market in which one country’s currency is traded for
another.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-7
International Finance Terminology
• Gilts– British and Irish government securities.
• London Interbank Offer Rate (LIBOR)– The rate most international banks charge one another for
overnight Eurodollar loans.
• Swaps– Agreements to exchange two securities or
currencies.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-8
Global Capital Markets
Asia/Pacific Region
Australian Stock ExchangeSydney Futures ExchangeNew Zealand Stock Exchange
Hong Kong Stock ExchangeHong Kong Futures Exchange
Shanghai Securities ExchangeShenzen Stock Exchange
Osaka Stock ExchangeTokyo Stock ExchangeTokyo Int’l Financial Futures Exchange
Singapore Stock Exchange
Kuala Lumpur Stock Exchange
Americas
New York Stock ExchangeAmerican Stock ExchangeBoston Stock ExchangeCincinnati Stock ExchangeChicago Stock ExchangePacific Stock ExchangePhiladelphia Stock ExchangeChicago Board of TradeKansas City Board of TradeToronto Stock Exchange
Europe and the UK
Frankfurt Stock ExchangeLondon Stock ExchangeParis BourseSwiss Stock ExchangeNasdaq
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-9
Participants in Foreign Exchange Market
• Importers• Exporters• Portfolio managers• Foreign exchange brokers• Traders• Speculators
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-10
Exchange Rates
Q: If you wish to exchange $100 for British pounds at an exchange rate of $A1/£0.337, how many pounds will you receive?
A: $A100 × (0.337) = £33.7
Q: You paid 20 French francs for a croissant in France. If the exchange rate is $A1/FF4.1184, how much did it cost in dollars?
A: FF20 4.1184 = $A4.8563
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-11
Exchange Rate Quotations
$US 0.5215 – 0.5190
Rate at which dealer BUYS $US or SELLS $A
Rate at which dealer SELLS $US or BUYS $A
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-12
Example—Exchange Rates• If you wish to convert $A1000 to $US at the above
exchange rates:– you SELL $A; therefore, the dealer BUYS $A– $A1000 × 0.5190 = $US519
• If you now convert $US519 back to $A:– you BUY $A; therefore, the dealer SELLS $A– $US519 0.5215 = $A995.21
• The difference is the dealer fee ($A1000 995.21 = $A4.79).
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-13
Triangle Arbitrage
You have observed the following exchange rates:
$A1/FF10 $A1/DM2.00 DM/FF4.00
Step 1
Buy 1000 francs for $100
Step 3
Exchange DM250 for $A125
Step 2
Buy DM250 for FF1000
You have just made $A25!
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-14
Cross Rates
• To prevent triangle arbitrage:– the $A can be exchanged for FF10 or DM2.00
• Cross rate must be:
FF5/DM1 DM2.00
FF10
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-15
Example—Cross Rates
The exchange rates for the British pound and the Japanese yen are:
$A1 = £0.3538
$A1 = ¥63.74
¥180.16/£ £0.3538
¥63.74 or
£0.0056/¥ ¥63.74
£0.3538 rate Cross
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-16
Types of Transactions
• Spot deal an agreement to trade currencies based on the exchange rate today for settlement within two business days.
• Spot exchange rate the exchange rate on a spot deal.
• Forward deal an agreement to exchange currency at some time in the future.
• Forward exchange rate the agreed-upon exchange rate to be used in a forward deal.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-17
Purchasing Power Parity
• The idea that the exchange rate adjusts to keep purchasing power constant among currencies.
• Absolute purchasing power parity (PPP)—a commodity costs the same regardless of what currency is used to purchase it or where it is selling.
• For absolute PPP to hold:– transaction costs must be zero– there must be no barriers to trade– the items purchased must be identical in all locations.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-18
Relative Purchasing PowerParity
• The idea that the change in the exchange rate between two currencies is determined by the difference in inflation rates between the two countries.
• Relative PPP, therefore, explains the changes in exchange rates over time rather than the absolute levels of exchange rates.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-19
Relative PPP Equation
h
h
S
t SE
h h S SE
FC
A
t
tAFCt
rateinflation country foreign
Australiain rateinflation
rate exchangespot 0) (timecurrent
at time rate exchange expected
where
1
0
0
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-20
Example—Relative PPP
The German exchange rate is currently 1.3 DM per dollar. The inflation rate in Germany over the next five years is estimated to be 5 per cent per year, while the Australian inflation rate is estimated to be 3 per cent per year. What will be the estimated exchange rate in five years?
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-21
Solution—Relative PPP
• The DM will become less valuable; $A will become more valuable.
• The exchange rate change will be 5% – 3% = 2% per year.
43531
020131 55
.
. . SE
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-22
Example—Covered Interest Arbitrage (CIA)
Assume: S0 = $A1/¥66.42 F1 = $A1/¥64.80
RA = 7% RJ = 5%
$A1 000 000 @ 7% $A1 070 000
$A1 076 250
@ ¥66.42 1 year @ ¥64.80
¥66 420 000 @ 5% ¥69 741 000
Profit
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-23
Interest Rate Parity (IRP)
The interest rate differential between two countries is equal to the percentage difference between the forward exchange rate and the spot exchange rate.
Australiain rate free-risk nominal
countryforeign in rate free-risk nominal
rate exchangespot current
at time settlementfor rate exchange forward
where
1
0
0
R
R
S
t F
R R S F
A
FC
t
tAFCt
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-24
Unbiased Forward Rates (UFR)
• The current forward rate is an unbiased predictor of the future spot exchange rate.
• On average, the forward exchange rate is equal to the future spot exchange rate.
tt SE F
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-25
Uncovered Interest Parity (UIP)
• The expected percentage change in the exchange rate is equal to the difference in interest rates.
• Combines IRP and UFR.
tAFCt R R S SE 10
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-26
International Fisher Effect (IFE)
• Real interest rates are equal across countries.
• Combines PPP and UFR.
• Ignores risk and barriers to capital movements.
FCFCAA h R h R
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-27
Example—International Capital Budgeting
Pizza Shack is considering opening a store in Mexico. The store would cost $A500 000 or 3 million pesos (at an exchange rate of $A1/6.000 pesos). They hope to operate the store for two years and then sell it to a local franchisee. Assume that the expected cash flows are 250 000 pesos in the first year and 5 million pesos in year 2 (including the selling price of the store and fixtures). The Australian risk-free rate is 7 per cent and the Mexican risk-free rate is 10 per cent. The required return in Australia is 12 per cent. Ignore taxes.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-28
Example—Method 1: Home Currency Approach
Using the interest rate parity relationship:
312 $162
1.12
497 785
1.12
453 40 000 500 NPV
2
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-29
Example—Method 2: Foreign Currency Approach
Using a 3 per cent inflation premium: (1.12 × 1.03) – 1 = 15.36%
312 $162 6.0000
871 973 NPV
pesos 871 973
1.1536
000 000 5
1.1536
000 250 000 000 3 - NPV
Dollars
2Pesos
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-30
Exchange Rate Risk
• The risk related to having international operations in a world where currency values vary.
• Short-run exposure—uncertainty arising from day-to-day fluctuations in exchange rates.
• Long-run exposure—potential losses due to long-run, unanticipated changes in the relative economic conditions in two or more countries.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-31
Translation Exposure
• Uncertainty arising from the need to translate the results from foreign operations (in foreign currency) to home currency for accounting purposes.
• What is the appropriate exchange rate to use for transferring each balance sheet account?
• How should balance sheet accounting gains and losses from foreign currency translation be handled?
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-32
Political Risk• Changes in value due to political actions in the foreign
country.• Investment in countries that have unstable governments
should require higher returns.• The extent of political risk depends on the nature of the
business:– The more dependent the business is on other operations within
the firm, the less valuable it is to others.– Natural resource development can be very valuable to others,
especially if much of the ground work in developing the resource has already been done.
• Local financing can often reduce political risk.
Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright
23-33
Types of Political Risk
Risk Nature of Loss
Currency devaluation Loss in value of cash flows interms of home currency
Increased taxation Reduction in total cash flowsrepatriated
Funds blockage Reduction or elimination ofcash flows repatriated
Expropriation of assets Loss of firm property and futurecash flows
Terrorism/sabotage Danger to employees and/orloss of future cash flows