1. Short-Term Financing 20 Chapter South-Western/Thomson Learning © 2003

2. C20 - 2 Chapter Objectives To explain why MNCs consider foreign financing; To explain how MNCs determine whether to use foreign financing; and To illustrate the possible benefits of financing with a portfolio of currencies.

3. C20 - 3 Sources of Short-Term Financing Euronotes are unsecured debt securities with typical maturities of 1, 3 or 6 months. They are underwritten by commercial banks and often purchased by the bank for their investment portfolios. MNCs may also issue Euro-commercial papers to obtain short-term financing. Maturities is tailored to the issuers preference. Without backing by underwriting syndicate. Dealers may make a secondary market by offering to repurchase commercial paper before maturity. MNCs utilize direct Eurobank loans to maintain a relationship with the banks too.

4. C20 - 4 Internal Financing by MNCs Retained earnings: Before an MNC’s parent or subsidiary searches for outside funding, it should determine if any internal funds are available. Supplies: Parents of MNCs may also raise funds by increasing their markups on the supplies that they send to their subsidiaries.

5. C20 - 5 Why MNCs Consider Foreign Financing An MNC may finance in a foreign currency to offset a net receivables position in that foreign currency. An MNC may also consider borrowing foreign currencies when the interest rates on such currencies are attractive, so as to reduce the costs of financing.

6. C20 - 6 Determining the Effective Financing Rate Since MNC collect finance from different country they get reduced cost but suffer from the exchange rate fluctuation which case higher cost of financing i.e., EFR become higher. The actual cost of financing depends on  the interest rate on the loan, and  the movement in the value of the borrowed currency over the life of the loan.

7. C20 - 7 2. Converts to $500,000 Exchange rate = $0.50/NZ$ What is the effective financing rate? 3. Has to pay back NZ$1,080,000 1 year later 1. Borrows NZ$1,000,000 at 8.00% for 1 year At time t 4. Converts to $648,000 Exchange rate = $0.60/NZ$ Determining the Effective Financing Rate $648k – $500k = 29.6% $500k

8. C20 - 8 Effective financing rate, r f =(1+ i f ) [1+(S t+1 -S)/S]-1 wherei f =the interest rate on the loan S t =beginning spot rate S t+1 = ending spot rate Determining the Effective Financing Rate The effective rate can be rewritten as r f = ( 1 + i f ) ( 1 + e f ) – 1 wheree f =the %  in the spot rate

9. C20 - 9 Example-1 (diagram): i f = the interest rate on the loan= 8%, The %  in the spot rate (e f )= (S t+1 -S)/S = (.60-.50)/.50 = 0.20 So, Effective Financing Rate, r f = ( 1 + i f ) ( 1 + e f ) – 1 = (1+.08)(1+.20) -1 = 29.6%.

10. C20 - 10 Example Assuming that the quoted interest rate for the New Zealand dollar is 8% and that the New Zealand dollar depreciate from $.50 to $.45, what is the effective financing Rate of a one-year loan from Dearborn’s viewpoint? r f = ( 1 + i f ) ( 1 + e f ) – 1 = (1+.08)[1+ (-.10] -1 = - 2.8%. A negative effective financing rate indicates that Dearborn actually paid fewer dollar to repay the loan than it borrowed.

11. C20 - 11 Problem-1 (For Homework ) discussion Assume that the interest rate in New Zealand is 9 percent. A U.S. firm plans to borrow New Zealand dollars, convert them to U.S. dollars, and re-pay the loan in one year. What will be the effective financing rate if the New Zealand dollar depreciates by 6 percent? If the New Zealand depreciates by 3 percent?

12. C20 - 12 Possible rate of change in the Swiss Franc over the life of the loan (e f ) Probability of Occurrence - 6 %5% - 4 %10 -1 %15 +1 %20 + 4 %20 +6 %15 +8%10 +10%5 Rate of interest on loan is 8% in Swiss Franc Example-2:

13. C20 - 13 Possible rate of change in the Swiss Franc over the life of the loan (e f ) Probability of Occurrence Effective financing rate if the rate of change in the Swiss Franc does occur (r f ) - 6 %5%(1.08)[1+(-6%)]-1=1.52 - 4 %10(1.08)[1+(-4%)]-1=3.68 -1 %15(1.08)[1+(-1%)]-1=6.92 +1 %20(1.08)[1+(1%)]-1=9.08 + 4 %20(1.08)[1+(4%)]-1=12.32 +6 %15(1.08)[1+(6%)]-1=14.48 +8%10(1.08)[1+(8%)]-1=18.64 +10%5(1.08)[1+(10%)]-1=18.80 Expected EFR, E(R)= 5%(1.52)+10%(3.68)+15%(6.92)+20%(9.08)+20% (12.32)+15%(14.48)+10%(18.64)+5%(18.80). = 10.538%

14. C20 - 14 Criteria Considered for Foreign Financing There are various criteria an MNC must consider in its financing decision, including ¤ interest rate parity, ¤ the forward rate as a forecast, and ¤ exchange rate forecasts.

15. C20 - 15 Criteria Considered for Foreign Financing Interest Rate Parity (IRP) If IRP holds, foreign financing with a simultaneous hedge of that position in the forward market will result in financing costs similar to those for domestic financing.

16. C20 - 16 Implications of IRP for Financing IRP holds? Financing costs* Type of financing *(e f ) as compared to the financing costs for domestic financing Scenario Yes Covered Similar Forward rate accurately predicts future spot rate Yes Uncovered Similar Forward rate over- estimates future spot rate Yes Uncovered Lower Forward rate under- estimates future spot rate Yes Uncovered Higher Forward premium(discount) exceeds (is less than) interest rate differential No Covered Higher Forward premium (discount) is less than (exceeds) interest rate differential No Covered Lower

17. C20 - 17 Interest arbitrage  refers to the process of capitalizing on the difference between interest rate of two countries. Covered interest arbitrage  is interpreted to mean that the funds to be invested are borrowed locally.

18. C20 - 18 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 loan will on average be equal to the domestic financing rate. Criteria Considered for Foreign Financing

19. C20 - 19 Exchange Rate Forecasts Firms may use exchange rate forecasts to forecast the effective financing rate of a foreign currency, or they may compute the break-even exchange rate that will equate the domestic and foreign financing rates. Sometimes, it may be useful to develop probability distributions, instead of relying on single point estimates. Criteria Considered for Foreign Financing

20. C20 - 20 Actual Results From Foreign Financing The fact that some firms utilize foreign financing suggests that they believe reduced financing costs can be achieved.

21. C20 - 21 Financing with Yens versus Dollars Annualized interest rates (%) US$/100¥ U.S. Effective rate $/100¥ Japan

22. C20 - 22 Financing with a Portfolio of Currencies While foreign financing can result in significantly lower financing costs, the variance in the costs is higher. MNCs may be able to achieve lower financing costs without excessive risk by financing with a portfolio of currencies.

23. C20 - 23 Financing with a Portfolio of Currencies If the chosen currencies are not highly positively correlated, they will not be likely to experience a high level of appreciation simultaneously. Thus, the chances that the portfolio’s effective financing rate will exceed the domestic financing rate are reduced.

24. C20 - 24 A firm that repeatedly finances in a currency portfolio will normally prefer to compose a financing package that exhibits a somewhat predictable effective financing rate on a periodic basis. When comparing different financing packages, the variance can be used to measure how volatile a portfolio’s effective financing rate is. Financing with a Portfolio of Currencies

25. C20 - 25 For a two-currency portfolio, E(r P ) = w A E(R A ) + w B E(R B ) wherer P =the effective financing rate of the portfolio r X =the effective financing rate of currency X w X =the % of total funds financed from currency X Financing with a Portfolio of Currencies

26. C20 - 26 Var(r P ) = w A 2  A 2 + w B 2  B 2 + 2w A w B  A  B C ORR AB  X 2 =the variance of currency X’s effective financing rate C ORR AB =the correlation coefficient of the two currencies’ effective finance rates Financing with a Portfolio of Currencies For a two-currency portfolio,

27. C20 - 27 Example: Suppose Missoula, Inc. extend its borrowing option with Swiss Franc and British pound to finance its operation. Company wants to finance for 3 months in a portfolio basis consisting two currencies where half of the needed fund would come from each currency. Assume the following information based on historical information of several three months periods: CurrenciesExpected effective financing rate E(R) Standard Deviation (σ ) Japanese Yen2%0.04 Swiss Franc3%0.09 British Pound4% 0.10 Correlation coefficient : Yen and Franc =.10, Yen and Pound =.30 Franc and Pound=.40

28. C20 - 28 Impact of Short-Term Financing Decisions on an MNC’s Value E (CF j,t )=expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ER j,t )=expected exchange rate at which currency j can be converted to dollars at the end of period t k=weighted average cost of capital of the parent Expenses Incurred from Short-Term Financing

29. C20 - 29 Sources of Short-Term Financing ¤ Euronotes ¤ Euro-Commercial Paper ¤ Eurobank Loans Internal Financing by MNCs Why MNCs Consider Foreign Financing ¤ Foreign Financing to Offset Foreign Receivables ¤ Foreign Financing to Reduce Costs Chapter Review

30. C20 - 30 Chapter Review Determining the Effective Financing Rate Criteria Considered for Foreign Financing ¤ Interest Rate Parity ¤ The Forward Rate as a Forecast ¤ Exchange Rate Forecasts Actual Results From Foreign Financing