20 Short-Term Financing Chapter See c20.xls for spreadsheets to accompany this chapter. South-Western/Thomson Learning © 2003

Chapter Objectives To explain why MNCs consider foreign financing; To explain how MNCs determine whether to use foreign financing; and To illustrate the possible benefits of financing with a portfolio of currencies.

Sources of Short-Term Financing Euronotes are unsecured debt securities with typical maturities of 1, 3 or 6 months. They are underwritten by commercial banks. MNCs may also issue Euro-commercial papers to obtain short-term financing. MNCs utilize direct Eurobank loans to maintain a relationship with the banks too.

Internal Financing by MNCs Before an MNC’s parent or subsidiary searches for outside funding, it should determine if any internal funds are available. Parents of MNCs may also raise funds by increasing their markups on the supplies that they send to their subsidiaries.

Why MNCs Consider Foreign Financing An MNC may finance in a foreign currency to offset a net receivables position in that foreign currency. An MNC may also consider borrowing foreign currencies when the interest rates on such currencies are attractive, so as to reduce the costs of financing.

Short-Term Interest Rates U.K. Japan Canada Germany U.S.

Determining the Effective Financing Rate The actual cost of financing depends on the interest rate on the loan, and the movement in the value of the borrowed currency over the life of the loan.

Determining the Effective Financing Rate 1. Borrows NZ$1,000,000 at 8.00% for 1 year At time t 3. Has to pay back NZ$1,080,000 1 year later 2. Converts to $500,000 Exchange rate = $0.50/NZ$ 4. Converts to $648,000 Exchange rate = $0.60/NZ$ What is the effective financing rate? $648k – $500k = 29.6% $500k

Determining the Effective Financing Rate Effective financing rate, rf = {( 1 + if )  St+1} – {1  St} = ( 1 + if )St+1 – 1 {1  St} St where if = the interest rate on the loan St = beginning spot rate St+1 = ending spot rate The effective rate can be rewritten as rf = ( 1 + if ) ( 1 + ef ) – 1 where ef = the % D in the spot rate

Online Application Current interest rates and exchange rates are available at http://www.bloomberg.com/. Interest rate and exchange rate forecasts can be found at http://biz.yahoo.com/ifc/.

Criteria Considered for Foreign Financing There are various criteria an MNC must consider in its financing decision, including interest rate parity, the forward rate as a forecast, and exchange rate forecasts.

Criteria Considered for Foreign Financing Interest Rate Parity (IRP) If IRP holds, foreign financing with a simultaneous hedge of that position in the forward market will result in financing costs similar to those for domestic financing.

Implications of IRP for Financing holds? Financing costs* Type of financing * as compared to the financing costs for domestic financing Scenario Yes Covered Similar Forward rate accurately predicts future spot rate Yes Uncovered Similar Forward rate over- estimates future spot rate Yes Uncovered Lower Forward rate under- estimates future spot rate Yes Uncovered Higher Forward premium(discount) exceeds (is less than) interest rate differential No Covered Higher Forward premium (discount) is less than (exceeds) interest rate differential No Covered Lower

Criteria Considered for Foreign Financing The Forward Rate as a Forecast If the forward rate is an unbiased predictor of the future spot rate, then the effective financing rate of a foreign loan will on average be equal to the domestic financing rate.

Criteria Considered for Foreign Financing Exchange Rate Forecasts Firms may use exchange rate forecasts to forecast the effective financing rate of a foreign currency, or they may compute the break-even exchange rate that will equate the domestic and foreign financing rates. Sometimes, it may be useful to develop probability distributions, instead of relying on single point estimates.

Actual Results From Foreign Financing The fact that some firms utilize foreign financing suggests that they believe reduced financing costs can be achieved.

Financing with Yens versus Dollars Annualized interest rates (%) US$/100¥ U.S. Effective rate $/100¥ Japan

Financing with a Portfolio of Currencies While foreign financing can result in significantly lower financing costs, the variance in the costs is higher. MNCs may be able to achieve lower financing costs without excessive risk by financing with a portfolio of currencies.

Financing with a Portfolio of Currencies If the chosen currencies are not highly positively correlated, they will not be likely to experience a high level of appreciation simultaneously. Thus, the chances that the portfolio’s effective financing rate will exceed the domestic financing rate are reduced.

Financing with a Portfolio of Currencies A firm that repeatedly finances in a currency portfolio will normally prefer to compose a financing package that exhibits a somewhat predictable effective financing rate on a periodic basis. When comparing different financing packages, the variance can be used to measure how volatile a portfolio’s effective financing rate is.

Financing with a Portfolio of Currencies For a two-currency portfolio, E(rP) = wAE(rA) + wBE(rB) where rP = the effective financing rate of the portfolio rX = the effective financing rate of currency X wX = the % of total funds financed from currency X

Financing with a Portfolio of Currencies For a two-currency portfolio, Var(rP) = wA2A2 + wB2B2 + 2wAwBABCORRAB X2 = the variance of currency X’s effective financing rate CORRAB = the correlation coefficient of the two currencies’ effective finance rates

Impact of Short-Term Financing Decisions on an MNC’s Value E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent Expenses Incurred from Short-Term Financing

Chapter Review Sources of Short-Term Financing Euronotes Euro-Commercial Paper Eurobank Loans Internal Financing by MNCs Why MNCs Consider Foreign Financing Foreign Financing to Offset Foreign Receivables Foreign Financing to Reduce Costs

Chapter Review Determining the Effective Financing Rate Criteria Considered for Foreign Financing Interest Rate Parity The Forward Rate as a Forecast Exchange Rate Forecasts Actual Results From Foreign Financing

Chapter Review Financing with a Portfolio of Currencies Portfolio Diversification Effects Repeated Financing with a Currency Portfolio Impact of Short-Term Financing Decisions on an MNC’s Value