© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. International Financial Management 11 th Edition by Jeff Madura 1

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use Short-Term Financing Identify sources of short-term financing for MNCs Explain how MNCs determine whether to use foreign financing Illustrate the possible benefits of financing with a portfolio of currencies 2 Chapter Objectives

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 Sources of Foreign Financing Internal short-term financing Before an MNC’s parent or subsidiary in need of funds searches for outside funding, it should check other subsidiaries’ cash flow positions to determine whether any internal funds are available. Internal Control over Funds - An MNC should have an internal system that consistently monitors the amount of short-term financing by all subsidiaries.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4 Sources of Foreign Financing External short-term financing Short-term notes or unsecured debt securities: Short- term notes typically have maturities of 1, 3, or 6 months with interest based on LIBOR. Commercial paper (euro-commercial paper): The selling price is not guaranteed to the issuers. Maturities can be tailored to the issuer’s preferences. Bank loans: Direct loans from banks maintain a relationship with banks. MNCs had limited access to short-term funding during the credit crisis.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5 Financing With a Foreign Currency MNCs borrow foreign currency, sometimes to match future cash inflows. Comparison of interest rates among currencies Developing countries tend to have higher inflation and a low level of saving, causing interest rates to be relatively high.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 6 Exhibit 20.1 Comparison of Interest Rates among Countries (as of January 2009) 6

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7 Determining the Effective Financing Rate The actual or “effective” financing rate will differ from the quoted rate based on: 1.The interest rate charged by the bank. 2.The movement in the borrowed currency’s value over the time of the loan. where r f = effective financing rate S = spot rate i f = interest rate of the foreign currency

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 8 Criteria Considered in the Financing Decision 1.Interest Rate Parity: if interest rate parity exists, the currency will exhibit a forward premium that offsets the differential between its interest rate and the home interest rate. 2.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 currency will on average be equal to the domestic financing rate. 3.Exchange Rate Forecasts: the firm can use exchange rate forecast in conjunction with foreign interest rate to forecast the effective financing rate.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9 Exhibit 20.2 Implications of Interest Rate Parity for Financing 9

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 10 Use of Probability Distributions Since forecasts are not always accurate, it is sometimes useful to develop a probability distribution instead of relying on a single point estimate. Allows comparison of distribution to the known financing rate of the home currency in order to make its financing decision.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 11 Exhibit 20.3 Analysis of Financing with a Foreign Currency 11

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 12 Exhibit 20.4 Probability Distribution of Effective Financing Rates 12

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 13 Actual Results from Foreign Financing The fact that some firms utilize foreign financing suggests that they believe reduced financing costs can be achieved. Savings can be achieved if the foreign currency depreciates against the home currency. Foreign financing can backfire if the foreign currency appreciates against the home currency.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 14 Exhibit 20.5 Comparison of Financing with Swiss Francs versus Dollars 14

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 15 Financing with a Portfolio of Currencies  Variance (risk) may be higher  If low interest rates prevail, probability of lower financing costs are possible Portfolio Diversification Effects  With diversification of currencies, lower financing costs are possible but currencies must not be highly correlated Repeated Financing with a Currency Portfolio  Estimating the variance of a portfolio’s effective financing rate becomes more complex as more currencies are added

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 16 Exhibit 20.6 Derivation of Possible Effective Financing Rates 16

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 17 Exhibit 20.7 Analysis of Financing with Two Foreign Currencies 17

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 18 Exhibit 20.8 Probability Distribution of the Portfolio’s Effective Financing Rate 18

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 19 SUMMARY  MNCs may first consider internal sources of funds for short- term financing, including foreign subsidiaries that might have excess funds. They also commonly rely on external sources such as short-term notes, commercial paper, or bank loans.  When MNCs borrow a portfolio of currencies that have low interest rates, they can increase the probability of achieving relatively low financing costs if the currencies’ values are not highly correlated.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 20 SUMMARY  MNCs may use foreign financing in an attempt to reduce their financing costs. They can determine whether to use foreign financing by estimating the effective financing rate for any foreign currency over the period in which financing will be needed. The expected effective financing rate is dependent on the quoted interest rate of the foreign currency and the forecasted percentage change in the currency’s value over the financing period. It is typically low if the foreign interest rate is low or if the foreign currency borrowed depreciates over the financing period.