2. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-0 CHAPTER 31 International Corporate Finance

3. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-1 Chapter Outline 31.1 Terminology 31.2 Foreign Exchange Markets and Exchange Rates 31.3 The Law of One Price and Purchasing Power Parity 31.4 Interest Rates and Exchange Rates: Interest Rate Parity 31.5 International Capital Budgeting 31.6 International Financial Decisions 31.7 Reporting Foreign Operations 31.8 Summary and Conclusions 31.1 Terminology 31.2 Foreign Exchange Markets and Exchange Rates 31.3 The Law of One Price and Purchasing Power Parity 31.4 Interest Rates and Exchange Rates: Interest Rate Parity 31.5 International Capital Budgeting 31.6 International Financial Decisions 31.7 Reporting Foreign Operations 31.8 Summary and Conclusions

4. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-2 31.1 Terminology American Depository Receipt (ADR): a security issued in the U.S. to represent shares of a foreign stock. Cross rate: the exchange rate between two foreign currencies, e.g. the exchange rate between £ and ¥. Euro (€): the single currency of the European Monetary Union which was adopted by 11 Member States on 1 January 1999. These member states are: Belgium, Germany, Spain, France, Ireland, Italy, Luxemburg, Finland, Austria, Portugal and the Netherlands. Eurobonds: bonds denominated in a particular currency and issued simultaneously in the bond markets of several countries. American Depository Receipt (ADR): a security issued in the U.S. to represent shares of a foreign stock. Cross rate: the exchange rate between two foreign currencies, e.g. the exchange rate between £ and ¥. Euro (€): the single currency of the European Monetary Union which was adopted by 11 Member States on 1 January 1999. These member states are: Belgium, Germany, Spain, France, Ireland, Italy, Luxemburg, Finland, Austria, Portugal and the Netherlands. Eurobonds: bonds denominated in a particular currency and issued simultaneously in the bond markets of several countries.

5. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-3 31.1 Terminology Eurocurrency: money deposited in a financial center outside the home country. Eurodollars are dollar deposits held outside the U.S.; Euroyen are yen denominated deposits held outside Japan. Foreign bonds: bonds issued in another nation’s capital market by a foreign borrower. Gilts: British and Irish government securities. LIBOR: the London Interbank Offer Rate is the rate most international banks charge on another for loans of Eurodollars overnight in the London market. Eurocurrency: money deposited in a financial center outside the home country. Eurodollars are dollar deposits held outside the U.S.; Euroyen are yen denominated deposits held outside Japan. Foreign bonds: bonds issued in another nation’s capital market by a foreign borrower. Gilts: British and Irish government securities. LIBOR: the London Interbank Offer Rate is the rate most international banks charge on another for loans of Eurodollars overnight in the London market.

6. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-4 31.2 Foreign Exchange Markets and Exchange Rates Without a doubt the foreign exchange market is the world’s largest financial market. In this market one country’s currency is traded for another’s. Most of the trading takes place in a few currencies: U.S. dollar ($) British pound sterling (£) Japanese yen (¥) Euro (€) German deutschemark (DM) French franc (FF) Without a doubt the foreign exchange market is the world’s largest financial market. In this market one country’s currency is traded for another’s. Most of the trading takes place in a few currencies: U.S. dollar ($) British pound sterling (£) Japanese yen (¥) Euro (€) German deutschemark (DM) French franc (FF)

7. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-5 FOREX Market Participants The FOREX market is a two-tiered market: Interbank Market (Wholesale) About 700 banks worldwide stand ready to make a market in Foreign exchange. Nonbank dealers account for about 20% of the market. There are FX brokers who match buy and sell orders but do not carry inventory and FX specialists. Client Market (Retail) Market participants include international banks, their customers, nonbank dealers, FOREX brokers, and central banks. The FOREX market is a two-tiered market: Interbank Market (Wholesale) About 700 banks worldwide stand ready to make a market in Foreign exchange. Nonbank dealers account for about 20% of the market. There are FX brokers who match buy and sell orders but do not carry inventory and FX specialists. Client Market (Retail) Market participants include international banks, their customers, nonbank dealers, FOREX brokers, and central banks.

8. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-6 Correspondent Banking Relationships Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the forex market. International commercial banks communicate with one another with: SWIFT: The Society for Worldwide Interbank Financial Telecommunications. CHIPS: Clearing House Interbank Payments System ECHO Exchange Clearing House Limited, the first global clearinghouse for settling interbank FOREX transactions. Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the forex market. International commercial banks communicate with one another with: SWIFT: The Society for Worldwide Interbank Financial Telecommunications. CHIPS: Clearing House Interbank Payments System ECHO Exchange Clearing House Limited, the first global clearinghouse for settling interbank FOREX transactions.

9. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-7 Spot Rate Quotations The spot market is the market for immediate delivery. (Settlement is due within two days.) Direct quotation the U.S. dollar equivalent e.g. “a Japanese Yen is worth about a penny” Indirect Quotation the price of a U.S. dollar in the foreign currency e.g. “you get 100 yen to the dollar” The spot market is the market for immediate delivery. (Settlement is due within two days.) Direct quotation the U.S. dollar equivalent e.g. “a Japanese Yen is worth about a penny” Indirect Quotation the price of a U.S. dollar in the foreign currency e.g. “you get 100 yen to the dollar”

10. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-8 Spot FX trading In the interbank market, the standard size trade is about U.S. $10 million. A bank trading room is a noisy, active place. The stakes are high. The “long term” is about 10 minutes. In the interbank market, the standard size trade is about U.S. $10 million. A bank trading room is a noisy, active place. The stakes are high. The “long term” is about 10 minutes.

11. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-9 Cross Rates Suppose that S DM (0) =.50 i.e. $1 = 2 DM in the spot market and that S ¥ (0) = 100 i.e. $1 = ¥100 What must the DM/¥ cross rate be? Suppose that S DM (0) =.50 i.e. $1 = 2 DM in the spot market and that S ¥ (0) = 100 i.e. $1 = ¥100 What must the DM/¥ cross rate be?, $¥ $ ¥ since DM  ¥50 DM1or.02 )0( ¥50 1 1$ 2 ¥100 1$ ¥ ¥/   DM S

12. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-10 Triangular Arbitrage $ £ ¥ Credit Lyonnais S £ (0) = 1.50 Credit Agricole S ¥/£ (0) = 85 Barclays S ¥ (0) = 120 Suppose we observe these banks posting these exchange rates. First calculate the implied cross rates to see if an arbitrage exists.

13. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-11 Triangular Arbitrage $ £ ¥ Credit Lyonnais S £ (0) = 1.50 Credit Agricole S ¥/£ (0) = 85 Barclays S ¥ (0) = 120 The implied S(¥/£) cross rate is S(¥/£) = 80 Credit Agricole has posted a quote of S(¥/£)=85 so there is an arbitrage opportunity. So, how can we make money? £1.50 $1 × ¥120 = £1 ¥80

14. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-12 Triangular Arbitrage $ £ ¥ Credit Lyonnais S £ (0) = 1.50 Credit Agricole S ¥/£ (0) = 85 Barclays S ¥ (0) =120 As easy as 1 – 2 – 3: 1. Sell our $ for £, 2. Sell our £ for ¥, 3. Sell those ¥ for $.

15. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-13 Triangular Arbitrage Sell $100,000 for £ at S £ (0) = 1.50 receive £150,000 Sell our £ 150,000 for ¥ at S ¥/£ (0) = 85 receive ¥12,750,000 Sell ¥ 12,750,000 for $ at S ¥ (0) = 120 receive $106,250 profit per round trip = $ 106,250 – $100,000 = $6,250

16. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-14 The Forward Market A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. If you have ever had to order an out-of-stock textbook, then you have entered into a forward contract. A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. If you have ever had to order an out-of-stock textbook, then you have entered into a forward contract.

17. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-15 Forward Rate Quotations The forward market for FOREX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today. Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts. Longer-term swaps are available. The forward market for FOREX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today. Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts. Longer-term swaps are available.

18. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-16 Forward Rate Quotations Suppose you observe that for Japanese yen, the spot rate is ¥115.75 = $1.00 While the 180-day forward rate is ¥ 112.80 = $1.00 What’s up with that? The forex market clearly thinks that the yen is going to be worth more in six months (the yen is expected to appreciate) because one dollar will buy fewer yen. Suppose you observe that for Japanese yen, the spot rate is ¥115.75 = $1.00 While the 180-day forward rate is ¥ 112.80 = $1.00 What’s up with that? The forex market clearly thinks that the yen is going to be worth more in six months (the yen is expected to appreciate) because one dollar will buy fewer yen.

19. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-17 Long and Short Forward Positions If you have agreed to sell anything (spot or forward), you are “short”. If you have agreed to buy anything (forward or spot), you are “long”. If you have agreed to sell forex forward, you are short. If you have agreed to buy forex forward, you are long. If you have agreed to sell anything (spot or forward), you are “short”. If you have agreed to buy anything (forward or spot), you are “long”. If you have agreed to sell forex forward, you are short. If you have agreed to buy forex forward, you are long.

20. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-18 31.3 The Law of One Price and Purchasing Power Parity The exchange rate between two currencies should equal the ratio of the countries’ price levels. S £ (0) = P $  P £ Relative PPP states that the rate of change in an exchange rate is equal to the differences in the rates of inflation. e =  $ -  £ If U.S. inflation is 5% and U.K. inflation is 8%, the pound should depreciate by 3%. The exchange rate between two currencies should equal the ratio of the countries’ price levels. S £ (0) = P $  P £ Relative PPP states that the rate of change in an exchange rate is equal to the differences in the rates of inflation. e =  $ -  £ If U.S. inflation is 5% and U.K. inflation is 8%, the pound should depreciate by 3%.

21. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-19 Evidence on PPP PPP probably doesn’t hold precisely in the real world for a variety of reasons. Haircuts cost 10 times as much in the developed world as in the developing world. Film, on the other hand, is a highly standardized commodity that is actively traded across borders. Shipping costs, as well as tariffs and quotas can lead to deviations from PPP. PPP-determined exchange rates still provide a valuable benchmark. PPP probably doesn’t hold precisely in the real world for a variety of reasons. Haircuts cost 10 times as much in the developed world as in the developing world. Film, on the other hand, is a highly standardized commodity that is actively traded across borders. Shipping costs, as well as tariffs and quotas can lead to deviations from PPP. PPP-determined exchange rates still provide a valuable benchmark.

22. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-20 31.4 Interest Rates and Exchange Rates: Interest Rate Parity IRP is an arbitrage condition. If IRP did not hold, then it would be possible for an astute trader to make unlimited amounts of money exploiting the arbitrage opportunity. Since we don’t typically observe persistent arbitrage conditions, we can safely assume that IRP holds. IRP is an arbitrage condition. If IRP did not hold, then it would be possible for an astute trader to make unlimited amounts of money exploiting the arbitrage opportunity. Since we don’t typically observe persistent arbitrage conditions, we can safely assume that IRP holds.

23. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-21 Interest Rate Parity Defined Suppose you have $100,000 to invest for one year. You can either 1. Invest in the U.S. at i $. Future value = $100,000×(1 + i $ ) 2. Trade your dollars for yen at the spot rate, invest in Japan at i ¥ and hedge your exchange rate risk by selling the future value of the Japanese investment forward. Suppose you have $100,000 to invest for one year. You can either 1. Invest in the U.S. at i $. Future value = $100,000×(1 + i $ ) 2. Trade your dollars for yen at the spot rate, invest in Japan at i ¥ and hedge your exchange rate risk by selling the future value of the Japanese investment forward. F S × (1 + i ¥ ) = (1 + i $ ) F S × (1 + i ¥ ) Future value = $100,000 × Since both of these investments have the same risk, they must have the same future value:

24. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-22 Interest Rate Parity Defined Formally, IRP is sometimes approximated as F S × (1 + i ¥ ) = (1 + i $ ) F S = (1 + i $ ) (1 + i ¥ ) or if you prefer, i $ – i ¥ = F – S S

25. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-23 IRP and Covered Interest Arbitrage If IRP failed to hold, an arbitrage would exist. It’s easiest to see this in the form of an example. Consider the following set of foreign and domestic interest rates and spot and forward exchange rates. If IRP failed to hold, an arbitrage would exist. It’s easiest to see this in the form of an example. Consider the following set of foreign and domestic interest rates and spot and forward exchange rates. Spot exchange rateS £ (0)=$1.25/£ 360-day forward rateF £ (360)=$1.20/£ U.S. discount ratei$i$ =7.10% British discount rate i £ =11.56%

26. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-24 IRP and Covered Interest Arbitrage A trader with $1,000 to invest could invest in the U.S., in one year his investment will be worth $1,071 = $1,000  (1+ i $ ) = $1,000  (1.071) Alternatively, this trader could: 1. exchange $1,000 for £800 at the prevailing spot rate, (note that £800 = $1,000÷$1.25/£) 2. invest £800 at i £ = 11.56% for one year to achieve £892.48. 3. Translate £892.48 back into dollars at F £ (360) = $1.20/£, the £892.48 will be exactly $1,071. A trader with $1,000 to invest could invest in the U.S., in one year his investment will be worth $1,071 = $1,000  (1+ i $ ) = $1,000  (1.071) Alternatively, this trader could: 1. exchange $1,000 for £800 at the prevailing spot rate, (note that £800 = $1,000÷$1.25/£) 2. invest £800 at i £ = 11.56% for one year to achieve £892.48. 3. Translate £892.48 back into dollars at F £ (360) = $1.20/£, the £892.48 will be exactly $1,071.

27. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-25 IRP and Covered Interest Arbitrage Can invest in the U.S. In one year his investment will be worth $1,071 = $1,000  (1.071) = $1,000  (1+ i $ ) A trader with $1,000 to invest

28. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-26 IRP and Covered Interest Arbitrage Invest £800 at i £ = 11.56% $1,000 £800 £800 = $1,000× £1 $1.25 In one year £800 will be worth £892.48 = $1,000  (1+ i £ ) $1,071 =£892.48 × £1 $1.20 Bring it on back to the U.S.A. Domestic FV = $1,071 and British FV = $1,071

29. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-27 According to IRP only one 360-day forward rate, F £ (360), can exist. It must be the case that F £ (360) = $1.20/£ Why? If F £ (360)  $1.20/£, an astute trader could make money with one of the following strategies: According to IRP only one 360-day forward rate, F £ (360), can exist. It must be the case that F £ (360) = $1.20/£ Why? If F £ (360)  $1.20/£, an astute trader could make money with one of the following strategies: IRP & Exchange Rate Determination

30. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-28 Arbitrage Strategy I If F £ (360) > $1.20/£ i. Borrow $1,000 at t = 0 at i $ = 7.1%. ii. Exchange $1,000 for £800 at the prevailing spot rate, (note that £800 = $1,000÷$1.25/£) invest £800 at 11.56% (i £ ) for one year to achieve £892.48 iii. Translate £892.48 back into dollars, if F £ (360) > $1.20/£, £892.48 will be more than enough to repay your dollar obligation of $1,071. If F £ (360) > $1.20/£ i. Borrow $1,000 at t = 0 at i $ = 7.1%. ii. Exchange $1,000 for £800 at the prevailing spot rate, (note that £800 = $1,000÷$1.25/£) invest £800 at 11.56% (i £ ) for one year to achieve £892.48 iii. Translate £892.48 back into dollars, if F £ (360) > $1.20/£, £892.48 will be more than enough to repay your dollar obligation of $1,071.

31. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-29 Arbitrage I Invest £800 at i £ = 11.56% $1,000 £800 £800 = $1,000× $1.25 £1 In one year £800 will be worth £892.48 = £800  (1+ i £ ) $1,071 <£892.48 × £1 F £ (360) Step 4: repatriate to the U.S.A. If F £ (360) > $1.20/£, £892.48 will be more than enough to repay your dollar obligation of $1,071 the excess is your profit. Step 1: borrow $1,000 Step 2: buy pounds Step 3: Step 5: Repay your dollar loan with $1,071. £892.48 More than $1,071

32. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-30 Arbitrage Strategy II If F £ (360) < $1.20/£ i. Borrow £800 at t = 0 at i £ = 11.56%. ii. Exchange £800 for $1,000 at the prevailing spot rate, invest $1,000 at 7.1% for one year to achieve $1,071. iii. Translate $1,071 back into pounds, if F £ (360) < $1.20/£, $1,071 will be more than enough to repay your £ obligation of £892.48. If F £ (360) < $1.20/£ i. Borrow £800 at t = 0 at i £ = 11.56%. ii. Exchange £800 for $1,000 at the prevailing spot rate, invest $1,000 at 7.1% for one year to achieve $1,071. iii. Translate $1,071 back into pounds, if F £ (360) < $1.20/£, $1,071 will be more than enough to repay your £ obligation of £892.48.

33. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-31 Arbitrage II $1,000 £800 $1,000 = £800× £1 $1.25 In one year $1,000 will be worth $1,071 >£892.48 × £1 F £ (360) Step 4: repatriate to the U.K. If F £ (360) < $1.20/£, $1,071 will be more than enough to repay your dollar obligation of £892.48. Keep the rest as profit. Step 1: borrow £800 Step 2: buy dollars Invest $1,000 at i $ Step 3: Step 5: Repay your pound loan with £892.48. $1,071 More than £892.48

34. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-32 You are a U.S. importer of British woolens and have just ordered next year’s inventory. Payment of £100,000,000 is due in one year. IRP and Hedging Currency Risk IRP implies that there are two ways that you fix the cash outflow a)Put yourself in a position that delivers £100M in one year—a long forward contract on the pound. You will pay (£100,000,000)×($1.2/£) = $120,000,000 b)Form a forward market hedge as shown below. Spot exchange rateS £ (0)=$1.25/£ 360-day forward rateF £ (360)=$1.20/£ U.S. discount ratei$i$ =7.10% British discount rate i £ =11.56%

35. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-33 IRP and a Forward Market Hedge To form a forward market hedge: Borrow $112.05 million in the U.S. (in one year you will owe $120 million). Translate $112.05 million into pounds at the spot rate S £ (0) = $1.25/£ to receive £89.64 million. Invest £89.64 million in the UK at i £ = 11.56% for one year. In one year your investment will have grown to £100 million—exactly enough to pay your supplier.

36. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-34 Forward Market Hedge Where do the numbers come from? We owe our supplier £100 million in one year—so we know that we need to have an investment with a future value of £100 million. Since i £ = 11.56% we need to invest £89.64 million at the start of the year. How many dollars will it take to acquire £89.64 million at the start of the year if S £ (0) = $1.25/£? £89.64 = £100 1.1156 $112.05 = £89.64 × $100 £1.25

37. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-35 Reasons for Deviations from IRP Transactions Costs The interest rate available to an arbitrageur for borrowing, i b,may exceed the rate he can lend at, i l. There may be bid-ask spreads to overcome, F b /S a < F/S Thus (F b /S a )(1 + i ¥ l )  (1 + i ¥ b )  0 Capital Controls Governments sometimes restrict import and export of money through taxes or outright bans. Transactions Costs The interest rate available to an arbitrageur for borrowing, i b,may exceed the rate he can lend at, i l. There may be bid-ask spreads to overcome, F b /S a < F/S Thus (F b /S a )(1 + i ¥ l )  (1 + i ¥ b )  0 Capital Controls Governments sometimes restrict import and export of money through taxes or outright bans.

38. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-36 Equilibrium Exchange Rate Relationships $ – £$ – £ IRP PPP FEFRPPP IFEFP i$ – i¥ i$ – i¥ F – S S E(e)E(e)

39. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-37 A recipe for international decision makers: 1. Estimate future cash flows in foreign currency. 2. Convert to U.S. dollars at the predicted exchange rate. 3. Calculate APV using the U.S. cost of capital. A recipe for international decision makers: 1. Estimate future cash flows in foreign currency. 2. Convert to U.S. dollars at the predicted exchange rate. 3. Calculate APV using the U.S. cost of capital. 31.5 International Capital Budgeting

40. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-38 Consider this European investment opportunity: International Capital Budgeting: Example Is this a good investment from the perspective of the U.S. shareholders? i $ = 15%  € = 3%  $ = 6% S € (0) = $.55265 – 600€ 200€500€ 300€ 0 1 year 2 years3 years

41. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-39 International Capital Budgeting: Example – 600€ 200€500€ 300€ 0 1 year 2 years3 years CF 0 = (€600)× S € (0) =(€600)×($.5526/€) = $331.56 $331.56

42. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-40 International Capital Budgeting: Example – 600€ 200€500€ 300€ 0 1 year 2 years3 years CF 1 = (€200)×E[ S € (1) ] E[ S € (1) ] can be found by appealing to the interest rate differential: E[ S € (1) ] = [(1.06/1.03)  S € (0) ] = [(1.06/1.03)  ($.5526/€) ] = $.5687/€ so CF 1 = (€200)×($.5687/€) = $113.7 $331.56$113.70

43. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-41 International Capital Budgeting: Example – 600€ 200€500€ 300€ 0 1 year 2 years3 years Similarly, CF 2 = [(1.06) 2 /(1.03) 2 ]× S € (0)  (€500) = $292.6 CF 3 = [(1.06) 3 /(1.03) 3 ]× S € (0)  (€300) = $180.7 $331.56$113.70$292.60$180.70 APV = –$331.56 + $113.70 (1.15) $292.60 (1.15) 2 $180.70 (1.15) 3 ++= $107.30

44. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-42 Risk Adjustment in the Capital Budgeting Process Clearly risk and return are correlated. Political risk may exist along side of business risk, necessitating an adjustment in the discount rate. Clearly risk and return are correlated. Political risk may exist along side of business risk, necessitating an adjustment in the discount rate.

45. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-43 31.6 International Financial Decisions An international firm can finance foreign projects in three basic ways: 1. It can raise cash in the home country and export it to finance the foreign project. 2. It can raise cash by borrowing in the foreign country where the project is located. 3. It can borrow in a third country where the cost of debt is lowest. An international firm can finance foreign projects in three basic ways: 1. It can raise cash in the home country and export it to finance the foreign project. 2. It can raise cash by borrowing in the foreign country where the project is located. 3. It can borrow in a third country where the cost of debt is lowest.

46. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-44 31.7 Reporting Foreign Operations When a U.S. multinational experiences favorable exchange rate movements, should this be reflected in the measurement of income? This is a controversial area. Two issues seem to arise: 1. What is the appropriate exchange rate to use for translating each balance-sheet account? 2. How should the unrealized accounting gains and losses from foreign-currency translation be handled? Currency is currently translated under complicated rules set out in FASB 52. When a U.S. multinational experiences favorable exchange rate movements, should this be reflected in the measurement of income? This is a controversial area. Two issues seem to arise: 1. What is the appropriate exchange rate to use for translating each balance-sheet account? 2. How should the unrealized accounting gains and losses from foreign-currency translation be handled? Currency is currently translated under complicated rules set out in FASB 52.

47. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-45 The Mechanics of FASB Statement 52 Functional Currency The currency that the business is conducted in. Reporting Currency The currency in which the MNC prepares its consolidated financial statements. Functional Currency The currency that the business is conducted in. Reporting Currency The currency in which the MNC prepares its consolidated financial statements.

48. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-46 The Mechanics of FASB Statement 52 Two-Stage Process First, determine in which currency the foreign entity keeps its books. If the local currency in which the foreign entity keeps its books is not the functional currency, remeasurement into the functional currency is required. Second, when the foreign entity’s functional currency is not the same as the parent’s currency, the foreign entity’s books are translated using the current rate method. Two-Stage Process First, determine in which currency the foreign entity keeps its books. If the local currency in which the foreign entity keeps its books is not the functional currency, remeasurement into the functional currency is required. Second, when the foreign entity’s functional currency is not the same as the parent’s currency, the foreign entity’s books are translated using the current rate method.

49. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-47 Current Rate Method All balance sheet items (except for stockholder’s equity) are translated at the current exchange rate. A “plug” equity account named cumulative translation adjustment (CTA) is used to make the balance sheet balance All balance sheet items (except for stockholder’s equity) are translated at the current exchange rate. A “plug” equity account named cumulative translation adjustment (CTA) is used to make the balance sheet balance

50. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-48 The Mechanics of FASB Statement 52 Current Rate Translation Parent’s Currency Foreign entity’s books kept in? Functional Currency? Local currency Temporal Remeasurement Parent’s currency Nonparent Currency Third currency Parent’s Currency

51. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 31-49 31.8 Summary and Conclusions This chapter describes some fundamental theories of international finance: Purchasing Power Parity Expectations theory of exchange rates The interest-rate parity theorem This chapter also describes some of the problems of international capital budgeting. We briefly describe international financial markets. This chapter describes some fundamental theories of international finance: Purchasing Power Parity Expectations theory of exchange rates The interest-rate parity theorem This chapter also describes some of the problems of international capital budgeting. We briefly describe international financial markets.