1. Copyright © 2014 by Nelson Education Ltd.

2. INTERNATIONAL FINANCIAL MANAGEMENT
CHAPTER 22
INTERNATIONAL FINANCIAL MANAGEMENT

3. Copyright © 2014 by Nelson Education Ltd.
CHAPTER 22 OUTLINE
Multinational, or Global, Corporations
Multinational vs. Domestic Financial Management
Exchange Rates
Exchange Rates and International Trade
The International Monetary System and Exchange Rate Policies
Trading in Foreign Exchange
Interest Rate Parity
Copyright © 2014 by Nelson Education Ltd.

4. CHAPTER 22 OUTLINE (cont’d)
Purchasing Power Parity
Inflation, Interest Rates, and Exchange Rates
International Money and Capital Markets
Multinational Capital Budgeting
International Capital Structures
Multinational Working Capital Management
Copyright © 2014 by Nelson Education Ltd.

5. Copyright © 2014 by Nelson Education Ltd.

6. Multinational, or Global, Corporations
A corporation registered in one country but with integrated operations 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.
Copyright © 2014 by Nelson Education Ltd.

7. Copyright © 2014 by Nelson Education Ltd.
Companies “Go Global”
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
Copyright © 2014 by Nelson Education Ltd.

8. Multinational vs. Domestic Financial Management
Currency differences
Economic and legal differences
Language differences
Cultural differences
Government roles
Political risk
Copyright © 2014 by Nelson Education Ltd.

9. Exchange Rates
As of 12/31/2012
Cdn. $ required to buy 1 Unit
Unit Number for one Cdn.$
Euro
1.3088
0.7641
Swiss franc
1.0833
0.9231
The exchange rate is the price of one country’s currency for another’s.
Currency prices have direct or indirect quotations.
Copyright © 2014 by Nelson Education Ltd.

10. Direct vs. Indirect Quotation
Values of foreign currencies shown in Cdn. dollars are direct quotations: a dollar sign in these quotations stating the number of dollars per currency (i.e., $/₤)
An indirect quotation gives the amount of a foreign currency required to buy one Cdn. dollar (i.e., ₤/$).
Note that an indirect quotation is the reciprocal of a direct quotation.
Euros and British pounds are normally quoted as direct quotations. All other currencies are quoted as indirect.
Copyright © 2014 by Nelson Education Ltd.

11. Calculate the Indirect Quotations for Euros and Swiss Francs
Direct Quote: Cdn. $ per foreign currency
Indirect Quotes: # of Units of Foreign Currency per Cdn. $
Euro
1.3088
0.7641
Swiss franc
1.0833
0.9231
Copyright © 2014 by Nelson Education Ltd.

12. Copyright © 2014 by Nelson Education Ltd.
What is a Cross Rate?
A cross rate is the exchange rate between any two currencies not involving Cdn. dollars.
In practice, cross rates are usually calculated from direct or indirect rates; that is, on the basis of Cdn. dollar exchange rates.
Copyright © 2014 by Nelson Education Ltd.

13. Cross Rates Between Euros and Swiss Franc
Euros Dollars Dollar Swiss franc
Swiss franc Dollars Dollar Euros ×
= x = euros/Swiss franc
Cross Rate =
= x = Swiss francs/euro
Copyright © 2014 by Nelson Education Ltd.

14. Copyright © 2014 by Nelson Education Ltd.
Note: Cross Rates
The two cross rates are reciprocals of one another.
They can be calculated by dividing either the direct or indirect quotations.
Copyright © 2014 by Nelson Education Ltd.

15. Exchange Rates and International Trade
Artificially holding down the value of a currency stimulates exports but at the expense of potentially overheating and inflating the economy.
A currency that is artificially high has the opposites: inflation will be held down, people can purchase imported goods at low domestic prices, but exporting industries are hurt.
Copyright © 2014 by Nelson Education Ltd.

16. Example of International Trade Transactions
Assume a firm can produce a litre of orange juice in Canada 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?
Target price = ($1.75)(1.50)= $2.625
Spanish $1.3088/€
= ($2.625)/($1.3088) = € 2.01
Copyright © 2014 by Nelson Education Ltd.

17. The International Monetary System and Exchange Rate Policies
From :
Prior to 1971, a fixed exchange rate system was in effect.
The US dollar was tied to gold.
Other currencies (including Cdn. dollar) were tied to the US dollar at fixed exchange rates (and indirectly linked to gold).
Copyright © 2014 by Nelson Education Ltd.

18. The International Monetary System: 1946-71 (cont’d)
Central banks intervened by purchasing and selling currency to even out demand so that the fixed exchange rates were maintained.
Occasionally the official exchange rate for a country would be changed.
Economic difficulties from maintaining fixed exchange rates led to its end.
Copyright © 2014 by Nelson Education Ltd.

19. The Current International Monetary System
The current system for most industrialized nations is a floating rate system where exchange rates fluctuate due to changes in demand.
Currency demand is due primarily to:
trade deficit or surplus
capital movements to capture higher interest rates
Exchange rate fluctuations can have a profound effect on businesses.
Copyright © 2014 by Nelson Education Ltd.

20. Copyright © 2014 by Nelson Education Ltd.
Freely, or Independently, Floating Rates: Currency Appreciation/Depreciation
Suppose the exchange rate freely goes from yen/dollar to yen/dollar.
A dollar now buys more Japanese yen, so the dollar is appreciating, or strengthening.
Yen is depreciating (or weakening).
A strengthening dollar hurts exports.
Copyright © 2014 by Nelson Education Ltd.

21. Floating System: Exchange Rate Risk
The inherent volatility of the floating exchange rate system increases the uncertainty for the firms.
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.
Copyright © 2014 by Nelson Education Ltd.

22. Managed Floating Rates
There is significant government intervention to manage the exchange rate by manipulating the currency’s supply and demand.
Government rarely reveals its target exchange rate levels if it uses a managed-float regime to avoid currency speculation.
Copyright © 2014 by Nelson Education Ltd.

23. Copyright © 2014 by Nelson Education Ltd.
Pegged Exchange Rates
Many countries still use a fixed exchange rate that is “pegged,” or fixed, with respect to another currency or basket of currencies.
Examples of pegged currencies:
Chinese yuan
Chad uses CFA franc, pegged to French franc, which is pegged to the euro.
Copyright © 2014 by Nelson Education Ltd.

24. Currency Devaluation/Revaluation
Under a pegged exchange rate system, the government sets up and maintains a target fixed exchange rate.
When the government lowers the target rate, this is called devaluation.
When the target rate is increased, it is called revaluation.
Copyright © 2014 by Nelson Education Ltd.

25. Copyright © 2014 by Nelson Education Ltd.
Convertible Currency
A currency is convertible when the issuing country promises to redeem the currency at current market rates. Known as “hard’ currency.
Convertible currencies are freely traded in world currency markets.
Residents and nonresidents are allowed to freely convert the currency into other currencies at market rates.
Copyright © 2014 by Nelson Education Ltd.

26. Problems Due to Nonconvertible Currency
It becomes very difficult for multinational companies to conduct business or to invest directly 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.
Lack of convertibility significantly inhibits the ability of a country to attract foreign investment.
Copyright © 2014 by Nelson Education Ltd.

27. Nonconvertible Currency
When there are restrictions on convertibility, a black market will often arise.
Examples of nonconvertible currencies (a.k.a. soft currencies):
Chinese yuan
Venezuelan bolivar
Uzbekistan sum
Vietnamese dong
Copyright © 2014 by Nelson Education Ltd.

28. Copyright © 2014 by Nelson Education Ltd.
No Local Currency
Countries do not have their own separate legal tender but instead use the currency of another nation.
Examples: Ecuador has used the USD since September 2000, and the 17 EMU members have used the euro since The euro replaced their domestic currencies.
Copyright © 2014 by Nelson Education Ltd.

29. Trading in Foreign Exchange
Foreign exchange market is the world’s largest financial market where one country’s currency is traded for another’s.
Most of the trading takes place in a few currencies: US dollars ($), euro (€), British pound sterling (₤), Japanese yen (¥), and Swiss franc (SF).
Copyright © 2014 by Nelson Education Ltd.

30. Spot Rates and Forward Rates
A spot rate is the rate applied to trade currency for immediate delivery (“on the spot”).
A forward rate is the rate applied to buy currency at some agreed-upon future date (usually 30, 90, or 180 days).
Forward rates are normally reported as indirect quotations.
Copyright © 2014 by Nelson Education Ltd.

31. When is the Forward Rate at a Premium to the Spot Rate?
If the Cdn. dollar buys fewer units of a foreign currency in the forward than in the spot market, the foreign currency is selling at a premium.
For example, suppose the spot rate is 0.7 £/$ and the forward rate is 0.6 £/$.
The dollar is expected to depreciate because it will buy fewer pounds.
The pound is expected to appreciate since it will buy more dollars in the future.
So the forward rate for the pound is at a premium.
Copyright © 2014 by Nelson Education Ltd.

32. When is the Forward Rate at a Discount to the Spot Rate?
If the Cdn. dollar buys more units of a foreign currency in the forward than in the spot market, the foreign currency is selling at a discount.
The primary determinant of the spot/forward rate relationship is the relationship between domestic and foreign interest rates.
Copyright © 2014 by Nelson Education Ltd.

33. Spot and Forward Rates (Indirect Quotation)
Copyright © 2014 by Nelson Education Ltd.

34. Copyright © 2014 by Nelson Education Ltd.
Interest Rate Parity
Interest rate parity (IRP) implies that investors should expect to earn the same return on similar-risk securities in all countries:
Forward and spot rates are direct quotations.
rh = periodic interest rate in the home country
rf = periodic interest rate in the foreign country
Forward rate
Spot rate =
1 + rh
1 + rf
Copyright © 2014 by Nelson Education Ltd.

35. Interest Rate Parity: Example
Assume 1SF = $0.81 in the 90-day forward market. 90-day Canadian T-bills have a 1.125% interest rate, whereas a 1.25% in Switzerland. Does interest rate parity hold?
Spot rate: 1$ = 1.2SF or 1SF = $0.8333
rh = 1.125%(4) = 4.5%
rf = 1.25% (4) = 5.0%
(More...)
Copyright © 2014 by Nelson Education Ltd.

36. Interest Rate Parity: Example (cont’d)
If interest rate parity holds, the implied forward rate, , would equal the observed forward rate, ; so parity doesn’t hold.
Forward rate
0.8333
Spot rate =
1 + rh
1 + rf
1.045
1.050
Forward rate =
Copyright © 2014 by Nelson Education Ltd.

37. Purchasing Power Parity
Purchasing power parity (PPP) (law of one price) implies that the level of exchange rates adjusts so that identical goods cost the same amount in different countries. Ph = Pf(Spot rate), or Spot rate = Ph/Pf
Copyright © 2014 by Nelson Education Ltd.

38. Copyright © 2014 by Nelson Education Ltd.
PPP: Example
Cdn. grapefruit juice is $2.00/litre. If purchasing power parity holds, what is the price in Spain?
Spot rate = Ph/Pf.
$ = $2.00/Pf
Pf = $2.00/$ = 2.5 euros
Do PPP and IRP hold exactly at any point in time?
Copyright © 2014 by Nelson Education Ltd.

39. Inflation, Interest Rates, and Exchange Rates
Relative inflation rates influence relative interest rates and exchange rates.
A foreign currency will depreciate or appreciate at a percentage rate approximately equal to the amount by which its inflation rate exceeds or is less than the other country’s rate.
Copyright © 2014 by Nelson Education Ltd.

40. Relative Purchasing Power Parity
Interest rate in a country is largely determined by its inflation rate.
Relative PPP refers to the effect that differing inflation rates has on the change in exchange rates.
Expected spot rate
(1 + ih)
(1 + if) ×
Spot rate =
Copyright © 2014 by Nelson Education Ltd.

41. Interest Rates and Exchange Rates: International Financing Issues
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.
Copyright © 2014 by Nelson Education Ltd.

42. International Money and Capital Markets
Eurocurrency markets
Dollars held outside Canada (i.e. Euro-Canadian)
Mostly Europe, but also elsewhere
International bonds
Foreign bonds: Sold by foreign borrower but denominated in the currency of the country where bonds are sold.
Eurobonds: Sold in country but denominated in the currency some of other country
Copyright © 2014 by Nelson Education Ltd.

43. International Stock Markets
Multinational corporations sell new issues of stock simultaneously in stock markets in many countries.
In addition to new issues, outstanding stocks of multinationals are increasingly being listed in multiple international exchanges (for example, American Depository Receipts (ADRs) in the United States).
Copyright © 2014 by Nelson Education Ltd.

44. Multinational Capital Budgeting
Foreign operations are taxed locally, and then funds repatriated may be subject to Canadian taxes.
Foreign projects are subject to political risk.
Funds repatriated must be converted to Canadian dollars, so exchange rate risk must be taken into account.
Copyright © 2014 by Nelson Education Ltd.

45. Foreign Project Analysis
Project future expected cash flows, denominated in foreign currency.
Use the interest rate parity relationship to forecast expected exchange rates and convert the future expected foreign cash flows into dollars.
Discount the dollar denominated cash flows at the risk-adjusted cost of capital for similar Cdn. projects.
Copyright © 2014 by Nelson Education Ltd.

46. Capital Budgeting: Example
A Canadian company invests in a project in Japan.
Expected future cash flows:
CF0 = - ¥1,000 million
CF1 = ¥500 million
CF2 = ¥800 million
Risk-adjusted cost of capital in Canadian funds = 10%
Copyright © 2014 by Nelson Education Ltd.

47. Interest Rate and Exchange Rate Data
Current spot exchange rate = 110 ¥/$ using indirect quotation
Cdn. government bond rates:
1-year bond = 2.0%
2-year bond = 2.8%
Japan government bond rates:
1-year bond = 0.05%
2-year bond = 0.26%
Copyright © 2014 by Nelson Education Ltd.

48. Forecast Expected Future Exchange Rates
Multi-year interest rate parity relationship:
Forward and spot rates are direct quotations.
rh = annual interest rate in the home country
rf = annual interest rate in the foreign country
1 + rh t
1 + rf
Forward rate
Spot rate =
Copyright © 2014 by Nelson Education Ltd.

49. Expected Future Exchange Rates (cont’d)
Direct spot rate = (1/110 ¥/$) = $/¥
1-Year expected forward rate:
= (spot rate)[(1 + rh)/(1 + rf)]1
= ( )[( )/( )] =
Copyright © 2014 by Nelson Education Ltd.

50. Expected Future Exchange Rates (cont’d)
2-Year expected forward rate:
= (spot rate)[(1 + rh)/(1 + rf)]2
= ( )[( )/( )]2 =
Copyright © 2014 by Nelson Education Ltd.

51. Copyright © 2014 by Nelson Education Ltd.
Project Cash Flows 1 2
Cash flows in yen
-¥1,000
¥500
¥800
Expected exchange rates
Cash flows in dollars
-$9.09
$4.63
$7.65
Copyright © 2014 by Nelson Education Ltd.

52. Copyright © 2014 by Nelson Education Ltd.
Project NPV
NPV = -$9.09
$4.63
$7.65
( )2
( ) +
NPV = $1.44 million
Copyright © 2014 by Nelson Education Ltd.

53. International Capital Structures
Worldwide capital structure should not be piecemeal decisions; worldwide issues need to be considered in order to maximize firm value.
Implicit or explicit guarantees of subsidiary debt by the parent firm make the parent’s overall capital structure the primary concern.
Copyright © 2014 by Nelson Education Ltd.

54. International Capital Structures (cont’d)
The MNC’s object is to raise funds in the most cost-effective manner at the subsidiary level and then make adjustments at the firm level.
Because of exchange controls and tax effects, MNCs often use debt rather than equity to finance their investment in a subsidiary.
Copyright © 2014 by Nelson Education Ltd.
Copyright © 2014 by Nelson Education Ltd.

55. 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.
Copyright © 2014 by Nelson Education Ltd.

56. Median Capital Structures (Measured in Terms of Book Value)
Country
Raw
TL/TA
D/TA
Adjusted TL/TA
Adjusted D/TA
TIE
Canada
56%
32%
48%
1.55X
France 71 25 69 18
2.64
Germany 73 16 50 11
3.20
Italy 70 27 68 21
1.81
Japan 35 62
2.46
U.K. 54 47 10
4.79
U.S. 58 52
2.41
Mean
64%
26%
57%
20%
2.69X
Std. Dev. 8% 7%
10%
1.07X
Copyright © 2014 by Nelson Education Ltd.

57. Multinational Working Capital Management
MULTINATIONAL CASH MANAGEMENT
MNCs use the same procedures as domestic firms to achieve similar cash management goals.
Distances are greater with delays.
Access to more markets for loans and for temporary investments
Cash is often denominated in different currencies.
Copyright © 2014 by Nelson Education Ltd.

58. Multinational Credit Management
Credit is more important, as firms in lesser-developed countries often rely on credit.
Letter of credit (LC) and banker’s acceptance (BA) are common methods of payment in international trade.
Many companies buy export credit risk insurance (Canada’s Export Development Corporation (EDC)) when granting credit to foreign customers.
Credit for future payment may also be subject to exchange rate risk.
Copyright © 2014 by Nelson Education Ltd.

59. Multinational Inventory Management
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.
Copyright © 2014 by Nelson Education Ltd.