Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. International Financial Management 21

21-2 Chapter Outline The multinational corporation. Effect of exchange rates. Hedging and reduction of foreign exchange risk. Evaluating political risk in foreign investments. Ways of financing international operations.

21-3 Introduction Integrated global economy and increased interdependence. Trade Organizations and removal of trade barriers: WTO, NAFTA. Enhanced prospects for international understanding. Role of world politics in economic development.

21-4 Growing Interdependency Integrated nature of capital markets –Possible declines beyond the expected economic impact of an event. Currency markets –Impact trade between nations affecting sales and earnings of international companies. The advent of Euro. –Impact on earnings of U.S companies doing significant business in Europe.

21-5 One Euro to the U.S. Dollar and the British Pound

21-6 International Sales of Selected U.S. Companies

21-7 The Multinational Corporation: Nature and Environment A firm doing business across its national borders. Can take on various forms. –Exporter. –Licensing Agreements. –Joint Venture. –Fully Owned Foreign Subsidiary.

21-8 The Multinational Corporation: Nature and Environment (cont’d) Exporter –Least risky method. –Reap of benefits of foreign demand. –No long-term investments commitment required. Licensing Agreements –License granted to an independent, local manufacturer. –Returns include licensing fee or royalty. –Effective exporting technology.

21-9 The Multinational Corporation: Nature and Environment (cont’d) Joint Venture –Established with a local foreign firm. –Most conducive environment - legal, political and economic. Fully owned foreign subsidiary –Higher risks and complexities of operation. –Lowers portfolio risk of the parent corporation. –More profitable than domestic firms. –Decisive factor in shaping the pattern of trade, investment, and the flow of technology.

21-10 Factors Influencing Exchange Rates The currencies of major trading partners of the United States are traded in free markets. –Exchange rate is determined by the supply of, and demand for, those currencies. –This activity is subject to intervention by many countries’ central banks.

21-11 Exchange Rates to the Dollar

21-12 Other Factors Influencing Exchange Rates Inflation: –Purchasing power parity theory: Exchange rates vary inversely with their respective purchasing powers. Provides the same or similar purchasing power in each country. Interest rates: –Interest rate parity theory: The interplay between interest rates differentials and exchange rates.

21-13 Other Factors Influencing Exchange Rates (cont’d) Balance of payments: –Government accounts that catalogue flow of economic transactions between countries. Trade surplus and trade deficit. Government policies: –Intervention in the foreign exchange market. –Maintenance of undervalued currency. –Currency values set by government decree. –Restriction of the inflow and outflow of funds. –Monetary and fiscal policies.

21-14 Other Factors Influencing Exchange Rates (cont’d) Other factors: –Extended stock market rally. –Significant drop in demand for a nation’s principal exports globally. –Political turmoil in a country. –Widespread labor strikes.

21-15 Spot Rates and Forward Rates Spot rate –Exchange rate at which the currency is traded for immediate delivery. Forward rates –Trading of currencies for future delivery. –Reflects the expectations regarding the future value of a currency. Discount or premium: –Expressed as an annualized percentage deviation from the spot rate.

21-16 Cross Rates – Key Currency Cross Rates as of February 21, 2006

21-17 Managing Foreign Exchange Risk Foreign exchange risk –Possibility of a drop in revenue or an increase in cost in an international transaction due to changes in foreign exchange rates. Free trading - freely floating rate system. –Increased volatility forced the attention towards foreign exchange risk management. Exchange risk of a multinational company: –Accounting or translation exposure –Transaction exposure

21-18 Translation Exposure MNC’s foreign assets and liabilities are exposed to losses and gains due to changing exchange rates. The SFAS 52: –Requires all foreign currency-denominated assets and liabilities to be converted at the rate of exchange. –Partially reduces the impact of accounting exposure.

21-19 Transaction Exposure Foreign exchange gains or losses resulting from international transactions. –Volatility of reported earnings per share increases. –Different strategies can be used to minimize transaction exposure: Forward exchange market hedge. Money market hedge. Current futures market hedge.

21-20 Other Forms of Protection against Foreign Exchange Risk MNC’s have developed foreign asset management programs, involving strategies: –Switching cash and other assets into strong currencies. –Piling up debt and other liabilities in depreciating currencies. –Quick collection of bills in weak currencies by offering sizable discounts, while extending liberal credit in strong currencies.

21-21 Foreign Investment Decisions Factors encouraging foreign affiliates: –Avoid the imposition of trade barriers. –Lower production costs overseas. –American technology enabled exploitation of resources in developing countries. –Advantages related to taxes. –Motivation of working in a oligopolistic industry. –International diversification of risks.

21-22 Risk Reduction from International Diversification

21-23 Foreign Investment Decisions (cont’d) Deterrents: –Government interference by imposition of unfriendly foreign exchange restrictions. –Limitation of foreign ownership to a small percentage. –Repatriation of a subsidiary’s profits to the parent firm may be blocked temporarily. –Government may expropriate the foreign subsidiary’s assets.

21-24 Guarding Against Political Risk Investigate the countries political stability - methods include: –Establish a joint venture with a local entrepreneur. –Establish a joint venture with firms from other countries. –Insurance against perceived political-risk level can be obtained. Overseas Private Investment Corporation (OPIC). Insurance or political-risk umbrella is not cheap.

21-25 Financing International Business Operations Credit sales are influenced by: –Relationship of the parties involved. –Political stability of countries involved. Risk of nonpayment induces importer’s banks to issue letter of credit. –Credit risk to exporter is absorbed by the importer’s bank. –Exporters requiring cash payment or a letter of credit generally loses out on further orders.

21-26 Financing International Business Operations (cont’d) Alternatives to avoiding loss of business: –Obtaining export credit insurance. The Foreign Credit Insurance Association (FCIA) provides this kind of insurance.

21-27 Funding of Transactions Eximbank (Export-Import Bank) –Direct loan program. –Discount program. Loans from the parent company. –Parallel loans. –Fronting loans. Eurodollar loan –US dollars deposited in foreign banks. –Lending rates based on London Interbank Offered Rate (LIBOR).

21-28 Funding of Transactions (cont’d) Eurobond market –Issues are sold in several national capital markets. –Widely used currency – U.S. dollar. International equity markets –Companies are listed on major stock exchanges. –Issue American Depository receipts (ADRs). The International Finance Corporation (IFC) –Approached by companies facing issues with raising equity capital in a foreign country.

21-29 Some Unsettled Issues in International Finance Nature of financial decisions for an MNC are complex: –Access to more sources of funds than a purely domestic corporation. –Interest rates and market conditions may differ. –Corporate financial factors may differ. –Control over financial decisions is a factor. –Dividend policy decisions may be influenced by foreign government regulations.

21-30 Cash Flow Analysis of a Foreign Investment