1. 26 - 1 Copyright © 2002 South-Western Factors that make multinational financial management different Exchange rates and trading International monetary system International financial markets Specific features of multinational financial management CHAPTER 26 Multinational Financial Management

2. 26 - 2 Copyright © 2002 South-Western What is a multinational corporation? A multinational corporation is one that operates in two or more countries. At one time, most multinationals produced and sold in just a few countries. Today, many multinationals have world-wide production and sales.

3. 26 - 3 Copyright © 2002 South-Western Why do firms expand into other countries? To seek new markets. To seek new supplies of raw materials. To gain new technologies. To gain production efficiencies. To avoid political and regulatory obstacles. To reduce risk by diversification.

4. 26 - 4 Copyright © 2002 South-Western What are the major factors that distinguish multinational from domestic financial management? Currency differences Economic and legal differences Language differences Cultural differences Government roles Political risk

5. 26 - 5 Copyright © 2002 South-Western Are these currency prices direct or indirect quotations? Since they are prices of foreign currencies expressed in U.S. dollars, they are direct quotations. Consider the following exchange rates: U.S. $ to buy 1 Unit Spanish peseta 0.0050 Swedish krona 0.0985

6. 26 - 6 Copyright © 2002 South-Western What is an indirect quotation? An indirect quotation gives the amount of a foreign currency required to buy one U.S. dollar. Note than an indirect quotation is the reciprocal of a direct quotation.

7. 26 - 7 Copyright © 2002 South-Western Calculate the indirect quotations for pesetas and kronas. # of Units of Foreign Currency per U.S. $ Spanish peseta200.00 Swedish krona 10.15 Peseta: 1/0.0050 = 200.00. Krona:1/0.0985 = 10.15.

8. 26 - 8 Copyright © 2002 South-Western What is a cross rate? A cross rate is the exchange rate between any two currencies not involving U.S. dollars. In practice, cross rates are usually calculated from direct or indirect rates. That is, on the basis of U.S. dollar exchange rates.

9. 26 - 9 Copyright © 2002 South-Western Cross rate = x = 200.00 x 0.0985 = 19.70 pesetas/krona. Cross rate= x = 10.15 x 0.0050 = 0.051 kronas/peseta. Calculate the two cross rates between pesetas and kronas. Pesetas Dollars Dollar Krona Kronas Dollars Dollar Peseta

10. 26 - 10 Copyright © 2002 South-Western The two cross rates are reciprocals of one another. They can be calculated by dividing either the direct or indirect quotations. Note:

11. 26 - 11 Copyright © 2002 South-Western Target price = ($1.75)(1.50)=$2.625 Spanish price = ($2.625)(200.00 pesetas/$) = 525.00 pesetas. Assume the firm can produce a liter of orange juice in the U.S. and ship it to Spain for $1.75. If the firm wants a 50% markup on the product, what should the juice sell for in Spain?

12. 26 - 12 Copyright © 2002 South-Western 240 pesetas = 240(0.051) = 12.24 kronas. 20 - 12.24 = 7.76 kronas profit. Dollar profit = 7.76 kronas(0.0985 dollars per krona) = $0.76. Now the firm begins producing the orange juice in Spain. The product costs 240 pesetas to produce and ship to Sweden, where it can be sold for 20 kronas. What is the dollar profit on the sale?

13. 26 - 13 Copyright © 2002 South-Western Exchange rate risk is the risk that the value of a cash flow in one currency translated from another currency will decline due to a change in exchange rates. For example, in the last slide, a weakening krona (strengthening dollar) would lower the dollar profit. What is exchange rate risk?

14. 26 - 14 Copyright © 2002 South-Western The current system is a floating rate system. Prior to 1971, a fixed exchange rate system was in effect. The U.S. dollar was tied to gold. Other currencies were tied to the dollar. Describe the current and former international monetary systems.

15. 26 - 15 Copyright © 2002 South-Western The European Monetary Union In 2002, the full implementation of the “euro” is expected to be complete. The national currencies of the 11 participating countries will be phased out in favor of the “euro.” The newly formed European Central Bank will control the monetary policy of the EMU.

16. 26 - 16 Copyright © 2002 South-Western The 11 Member Nations of the European Monetary Union Austria Belgium Finland France Germany Ireland Italy Luxembourg Netherlands Portugal Spain European Union countries not in the EMU: Britain Sweden Denmark Greece

17. 26 - 17 Copyright © 2002 South-Western A currency is convertible when the issuing country promises to redeem the currency at current market rates. Convertible currencies are traded in world currency markets. What is a convertible currency?

18. 26 - 18 Copyright © 2002 South-Western It becomes very difficult for multi- national companies to conduct business because there is no easy way to take profits out of the country. Often, firms will barter for goods to export to their home countries. What problems arise when a firm operates in a country whose currency is not convertible?

19. 26 - 19 Copyright © 2002 South-Western A spot rate is the rate applied to buy currency for immediate delivery. A forward rate is the rate applied to buy currency at some agreed-upon future date. What is the difference between spot rates and forward rates?

20. 26 - 20 Copyright © 2002 South-Western When is the forward rate at a premium to the spot rate? If the U.S. dollar buys fewer units of a foreign currency in the forward than in the spot market, the foreign currency is selling at a premium. In the opposite situation, the foreign currency is selling at a discount. The primary determinant of the spot/forward rate relationship is relative interest rates.

21. 26 - 21 Copyright © 2002 South-Western What is interest rate parity? Interest rate parity implies that investors should expect to earn the same return on similar-risk securities in all countries: Here, k h = periodic interest rate in the home country. k f = periodic interest rate in the foreign country. Forward rate Spot rate = 1 + k h 1 + k f.

22. 26 - 22 Copyright © 2002 South-Western Forward rate = $0.00505. k h = 6%/12 = 0.500%. k f = 4%/12 = 0.333%. (More...) Assume 1 peseta = $0.00505 in the 30-day forward market and and 30-day risk-free rate is 6% in the U.S. and 4% in Spain. Does interest rate parity hold?

23. 26 - 23 Copyright © 2002 South-Western 0.00505 Spot rate If interest rate parity holds, the computed spot rate would be 0.0055 dollars/peseta. However, the observed spot rate is 0.0050 dollars/peseta. Forward rate Spot rate = 1 + k h 1 + k f = 1.00500 1.00333 Spot rate = 0.00504.

24. 26 - 24 Copyright © 2002 South-Western A U.S. investor could directly invest in the U.S. security and earn an annualized rate of 6%. Alternatively, the U.S. investor could convert dollars to pesetas, invest in the Spanish security, and then convert profit back into dollars. If the return on this strategy is higher than 6%, then the Spanish security has the higher rate. Which 30-day security (U.S. or Spanish) offers the higher return?

25. 26 - 25 Copyright © 2002 South-Western What is the return to a U.S. investor in the Spanish security? Buy $1,000 worth of pesetas in the spot market: 1,000(200 $/peseta) = 200,000 pesetas. Spanish investment return (in pesetas): 200,000(1.00333)=200,666.67 pesetas. (More...)

26. 26 - 26 Copyright © 2002 South-Western Buy contract today to exchange 200,666.67 pesetas in 30 days at forward rate of 0.00505 dollars/peseta. At end of 30 days, convert peseta investment to dollars: 200,666.67(0.00505) = $1,013.37. Calculate the rate of return: $13.13/$1,000 = 1.313% per 30 days. (More...)

27. 26 - 27 Copyright © 2002 South-Western The Spanish security has the highest return, even though it has a lower interest rate. U.S. 30-day rate is 0.500%, so Spanish securities at 1.313% offer a higher rate of return to U.S. investors. But could such a situation exist for very long?

28. 26 - 28 Copyright © 2002 South-Western Arbitrage Traders could borrow at the U.S. rate, convert to pesetas at the spot rate, and simultaneously lock in the forward rate and invest in Spanish securities. This would produce arbitrage: a positive cash flow, with no risk and none of the traders own money invested.

29. 26 - 29 Copyright © 2002 South-Western Impact of Arbitrage Activities Traders would recognize the arbitrage opportunity and make huge investments. Their actions would tend to move interest rates, forward rates, and spot rates to parity.

30. 26 - 30 Copyright © 2002 South-Western What is purchasing power parity? Purchasing power parity implies that the level of exchange rates adjusts so that identical goods cost the same amount in different countries. P h = P f (Spot rate), or Spot rate = P h /P f.

31. 26 - 31 Copyright © 2002 South-Western If grapefruit juice costs $2.00/liter in the U.S. and purchasing power parity holds, what is price in Spain? Spot rate = P h /P f. $0.005= $2.00/P f P f = $2.00/$0.005 = 400 pesetas. Do interest rate and purchasing power parity hold exactly at any point in time?

32. 26 - 32 Copyright © 2002 South-Western Lower inflation leads to lower interest rates, so borrowing in low-interest countries may appear attractive to multinational firms. However, currencies in low-inflation countries tend to appreciate against those in high-inflation rate countries, so the true interest cost increases over the life of the loan. What impact does relative inflation have on interest rates and exchange rates?

33. 26 - 33 Copyright © 2002 South-Western Eurodollar markets Dollars held outside the U.S. Mostly Europe, but also elsewhere International bonds Foreign bonds: Sold by foreign borrower, but denominated in the currency of the country of issue. Eurobonds: Sold in country other than the one in whose currency it is denominated. Describe the international money and capital markets.

34. 26 - 34 Copyright © 2002 South-Western To what extent do capital structures vary across different countries? Early studies suggested that average capital structures varied widely among the large industrial countries. However, a recent study, which controlled for differences in accounting practices, suggests that capital structures are more similar across different countries than previously thought.

35. 26 - 35 Copyright © 2002 South-Western Distances are greater. Access to more markets for loans and for temporary investments. Cash is often denominated in different currencies. What is the impact of multinational operations on each of the following topics? Cash Management

36. 26 - 36 Copyright © 2002 South-Western Foreign operations are taxed locally, and then funds repatriated may be subject to U.S. taxes. Foreign projects are subject to political risk. Funds repatriated must be converted to U.S. dollars, so exchange rate risk must be taken into account. Capital Budgeting Decisions

37. 26 - 37 Copyright © 2002 South-Western Credit is more important, because commerce to lesser-developed countries often relies on credit. Credit for future payment may be subject to exchange rate risk. Credit Management

38. 26 - 38 Copyright © 2002 South-Western Inventory decisions can be more complex, especially when inventory can be stored in locations in different countries. Some factors to consider are shipping times, carrying costs, taxes, import duties, and exchange rates. Inventory Management

39. 26 - 39 Copyright © 2002 South-Western Capital Budgeting in Foreign Countries Country Singapore India & Thailand Method Average Accounting Return (AAR) Payback Period Comment Divides the average Net Income of a project by that project’s average book value of equity. Preferred by Indian and Thai financial managers because of relative simplicity.