©2009 McGraw-Hill Ryerson Limited 1 of International Financial Management Prepared by: Michel Paquet SAIT Polytechnic ©2009 McGraw-Hill Ryerson Limited

2 of 27 Chapter 21 - Outline Canadian Involvement in International Trade and Capital Investment Reasons for a Foreign Investment Decision Risk Considerations in the Foreign Investment Decision Exchange Rates Foreign Exchange Risk Hedging Techniques Financing International Operations Summary and Conclusions

©2009 McGraw-Hill Ryerson Limited 3 of 27 Learning Objectives 1.Identify reasons for a foreign investment decision (later analyze). (LO1) 2.Identify the effects of exchange and political risk on the foreign investment decision. (LO2) 3.Discuss the effects of exchange rates on the firm’s profitability and cash flow. (LO3)

©2009 McGraw-Hill Ryerson Limited 4 of 27 Learning Objectives 4.Outline the factors influencing the exchange rates. (LO4) 5.Define spot and forward exchange rates and compute forward premiums and discounts. (LO5) 6.Evaluate techniques to hedge or reduce foreign exchange risk. (LO6) 7.Describe the purposes and nature of the multinational operations of the corporation. (LO7) 8.Outline potential ways to finance international operations. (LO8)

©2009 McGraw-Hill Ryerson Limited 5 of 27 Figure 21-1 World ’ s leading merchandise exporters, 2006 LO1 Source: Top ten: 53% of world total of $14 trillion.

©2009 McGraw-Hill Ryerson Limited 6 of 27 Figure 21-2 World ’ s leading merchandise importers, 2006 LO1 Source: Top ten: 56% of world total of $14 trillion.

©2009 McGraw-Hill Ryerson Limited 7 of 27 Figure 21-3 Canada ’ s 2007 merchandise exports and imports by region LO1 Note: Exports $463 billion, imports $415 billion, GDP $1,497 billion. Source: Bank of Canada, “Banking and Financial Statistics”, August 2008, series J3.

©2009 McGraw-Hill Ryerson Limited 8 of 27 Figure 21-4 Canada ’ s international balance of payments, current account, 2007 LO2 Source: Bank of Canada, “Banking and Financial Statistics”, August 2008, series J1.

©2009 McGraw-Hill Ryerson Limited 9 of 27 Figure 21-5 Canada ’ s international investment position, 2007 LO2 Source: Statistics Canada, Catalogue No , Table 1.

©2009 McGraw-Hill Ryerson Limited 10 of 27 Figure 21-6 Canada ’ s investment abroad by region, 2007 (assets) LO2 Source: Statistics Canada, Catalogue No , Tables (“Other” includes loans and deposits.)

©2009 McGraw-Hill Ryerson Limited 11 of 27 Figure 21-7 Foreign investment in Canada by region, 2007 (liabilities) LO2 Source: Statistics Canada, Catalogue No , Tables 2-6. (“Other” includes loans and deposits.)

©2009 McGraw-Hill Ryerson Limited 12 of 27 Reasons for a Capital Investment Decision Higher potential returns -Lower production costs due to: resource availability and ease of exploitation significantly lower wages -Better revenues due to: Larger and more concentrated markets -Lower corporate income tax rates -Delayed Canadian taxes on income Strategic advantages Broader diversification possibilities LO2

©2009 McGraw-Hill Ryerson Limited 13 of 27 Multinational Corporations (MNCs) Firm doing business in more than one country Often 30% or more of a firm’s business activities are carried out outside its national borders 4 basic forms of multinational corporations: 1.Exporter 2.Licensing Agreement 3.Joint Venture 4.Fully Owned Foreign Subsidiary LO3

©2009 McGraw-Hill Ryerson Limited 14 of 27 Number of stocks International stocks Canadian stocks Risk (percent) Figure 21-8 Risk reduction from international diversification 11.7 LO3

©2009 McGraw-Hill Ryerson Limited 15 of 27 Risk Considerations in a Foreign Investment Decision Political Risk: 1. an unfriendly foreign government  blocks profit repatriation  expropriate the foreign subsidiary’s assets 2. political risk assessment before making final decision 3. strategies to guard against political risk  set up a joint venture with a local entrepreneur  enter into a joint venture with firms from other countries  obtain insurance in advance Foreign Exchange Risk  volatile foreign currency values lead to fluctuating value of an international transaction or investment LO3

©2009 McGraw-Hill Ryerson Limited 16 of 27 Exchange Rates The exchange rate is the price of one currency in terms of another Published daily in the business press Rates are determined by the supply of and demand for each currency Factors Influencing Exchange Rates: –Relative Inflation Rates –Relative Interest Rates –Balance of Payments –Government Policies –Confidence in the Future Performance of the Economy LO4

©2009 McGraw-Hill Ryerson Limited 17 of 27 Table 21-1 Selected currencies and exchange rates (number of foreign currency units you can purchase with one Canadian dollar) LO4

©2009 McGraw-Hill Ryerson Limited 18 of 27 Spot Rates and Forward Rates Spot Rate: –the exchange rate between currencies for immediate delivery –“on-the-spot” rate Forward Rate: –the exchange rate that is established for delivery at a specified date in the future LO5

©2009 McGraw-Hill Ryerson Limited 19 of 27 Managing Foreign Exchange Risk Foreign Exchange Risk refers to the possible change in value of foreign exchange rates. Types of Foreign Exchange Risk: 1. Economic Exposure:  the market value of foreign currency-denominated assets and liabilities is subject to change 2. Accounting or Translation Exposure  the amount of loss or gain resulting from the accounting treatment of foreign investments 3. Transaction Exposure  the foreign exchange gains or losses resulting from realized international transactions LO6

©2009 McGraw-Hill Ryerson Limited 20 of 27 Foreign Exchange Risk Hedging Techniques Forward Exchange Market Hedge Money Market Hedge Currency Futures Market Hedge Options Market Hedge LO6

©2009 McGraw-Hill Ryerson Limited 21 of 27 The Multinational Corporation Exporter – produce locally and export to foreign markets Licensing Agreement – exporting firms grant a license to local producers to use the firms’ technology in return for a royalty or licensing fee. Joint Venture – establish a business partnership with a local foreign manufacturer Fully Owned Foreign Subsidiary – firms set up their own foreign operations LO7

©2009 McGraw-Hill Ryerson Limited 22 of 27 Financing International Operations There are several specialized financing arrangements for foreign transactions: –Letter of credit –Export Development Corporation –Loans from the Parent Company or a Sister Affiliate –Eurocurrency Loans –Eurobond Issues –International Stock Issues –The International Finance Corporation (IFC) LO8

©2009 McGraw-Hill Ryerson Limited 23 of 27 Canadian parent firm Dutch parent firm Dutch firm’s affiliate Canadian firm’s affiliate In Canada In the Netherlands $ loan Guilder loan Indirect loan Figure A parallel loan arrangement LO8

©2009 McGraw-Hill Ryerson Limited 24 of 27 Figure A fronting loan arrangement Dutch affiliate Amsterdam bank Amsterdam bank Canadian parent company Canadian parent company Deposits funds in Lends funds to LO8

©2009 McGraw-Hill Ryerson Limited 25 of 27 Table 21A-1 Cash flow analysis of a foreign investment APP-21A

©2009 McGraw-Hill Ryerson Limited 26 of 27 Summary and Conclusions Canadian economy is highly open to the rest of world through trade and capital investment. International trade and investment are carried out by multinational corporations (MNCs). Lower production costs overseas, tax deferral provisions, strategic advantages and benefits of international diversification are motives for MNCs to do business on a global scale. Together with higher returns from foreign investment come political risk and foreign exchange risk.

©2009 McGraw-Hill Ryerson Limited 27 of 27 Summary and Conclusions The rate at which one currency unit is converted into another is called the exchange rate. Volatile exchange rates result in economic exposure, accounting exposure and transaction exposure. Some hedging techniques are available for MNCs to reduce foreign exchange risk. Alternative sources available for MNCs to finance their international operations.