3Learning ObjectivesDISCUSS HOW THE BASIC PRINCIPLES OF FINANCE APPLY TO INTERNATIONAL FINANCIAL TRANSACTIONS.DIFFERENTIATE AMONG THE SPOT RATE, THE FORWARD RATE, AND THE CROSS RATE IN THE FOREIGN EXCHANGE MARKETS, PERFORM FOREIGN EXCHANGE AND CROSS RATE CALCULATIONS, AND HEDGE AN ASSET PURCHASE WHERE PAYMENT IS MADE IN A FOREIGN CURRENCY.
4Learning ObjectivesIDENTIFY THE MAJOR FACTORS THAT DISTINGUISH INTERNATIONAL FROM DOMESTIC CAPITAL BUDGETING, EXPLAIN HOW THE CAPITAL BUDGETING PROCESS CAN BE ADJUSTED TO ACCOUNT FOR THESE FACTORS, AND COMPUTE THE NPV FOR A TYPICAL INTERNATIONAL CAPITAL PROJECT.DISCUSS THE IMPORTANCE OF THE EUROMARKETS TO LARGE U.S. MULTINATIONAL FIRMS AND CALCULATE THE COST OF BORROWING IN THE EUROBOND MARKET.
5Learning ObjectivesEXPLAIN HOW LARGE U.S. MONEY CENTER BANKS MAKE AND PRICE EUROCREDIT LOANS TO THEIR CUSTOMERS AND COMPUTE THE COST OF A EUROCREDIT BANK LOAN.
6Introduction to International Financial Management GLOBALIZATION OF THE WORLD ECONOMYRefers to removal of barriers to free trade and closer integration of national economies.Consumers in many countries buy goods that are purchased from a number of countries other than just their own.Today, on average, large corporations, whether they are based in the United States or another country, generate around half of their sales revenue overseas.
7Introduction to International Financial Management GLOBALIZATION OF THE WORLD ECONOMYThe production of goods and services has also become highly globalized.Like product markets, the financial system has also become highly integrated.
8Introduction to International Financial Management THE RISE OF MULTINATIONAL CORPORATIONSA multinational corporation is a business firm that operates in more than one country but is headquartered or based in its home country.Multinationals are owned by a mixture of domestic and foreign stockholders.
9Introduction to International Financial Management THE RISE OF MULTINATIONAL CORPORATIONSTransnational corporations are multinational firms that has widely dispersed ownership and that is managed from a global perspective rather than a firm residing in a particular country.Exhibit 21.1 lists the top 15 multinational business firms ranked by total revenues.
10Exhibit 21.1: The World’s Largest Multinational Firms Ranked by Revenue
11Introduction to International Financial Management FACTORS AFFECTING INTERNATIONAL FINANCIAL MANAGEMENTThe uncertainty of future exchange rate movements is called foreign exchange rate risk, or just exchange rate risk.Differences in legal systems and tax codes can also impact the way firms operate in foreign countries.
12Introduction to International Financial Management FACTORS AFFECTING INTERNATIONAL FINANCIAL MANAGEMENTWhile English is the official business language, it is not, however, the world’s social language.Cultural views also shape business practices and people’s attitudes toward business.An economic system determines how a country mobilizes its resources to produce goods and services needed by society, as well as how the production is distributed.
13Introduction to International Financial Management FACTORS AFFECTING INTERNATIONAL FINANCIAL MANAGEMENTDifferences in Country risk or political uncertainty associated with a particular country is also a factor.At the extreme, a country’s government may even expropriate—that is, take over—a business’s assets within the country.These types of actions clearly can affect a firm’s cash flows and, thus, the value of the firm.
14Introduction to International Financial Management GOALS OF INTERNATIONAL FINANCIAL MANAGEMENTStockholder value maximization is the accepted goal for firms in the United States, as well as in some other countries that share a similar heritage, such as the United Kingdom, Australia, India, and Canada.In Continental Europe, for example, countries such as France and Germany focus on maximizing corporate wealth.
15Introduction to International Financial Management GOALS OF INTERNATIONAL FINANCIAL MANAGEMENTThe European manager’s goal is to earn as much wealth as possible for the firm while considering the overall welfare of all stakeholders.In Japan, companies form tightly knit, interlocking business groups called keiretsu, such as Mitsubishi, Mitsui, and Sumitomo, and the goal of the Japanese business manager is to increase the wealth and growth of the keiretsu.As a result, they might focus on maximizing market share rather than stockholder wealth.
16Introduction to International Financial Management GOALS OF INTERNATIONAL FINANCIAL MANAGEMENTIn China, which is making a transition from a command economy to a market-based economy, there are sharp differences between state-owned companies and emerging private-sector firms.The large state-owned companies have an overall goal that can best be described as maintaining full employment in the economy while the new private-sector firms fully embrace the Western standard of stockholder value maximization.
17Introduction to International Financial Management BASIC PRINCIPLES REMAIN THE SAMEFor managerial finance whether a transaction is domestic or international.The time value of money is not affected by whether a business transaction is domestic or international.
18Introduction to International Financial Management BASIC PRINCIPLES REMAIN THE SAMELikewise, the same models are used for valuing capital assets, bonds, stocks, and entire firms .Exhibit 21.2 lists some of the important finance concepts and procedures and indicates where there are differences between domestic and international operations.
19Exhibit 21.2: The Basic Principles of Finance Apply in International Finance
20Foreign Exchange Markets Are a group of international markets connected electronically where currencies are bought and sold in wholesale amounts.Provide three basic economic benefits.A mechanism to transfer purchasing power from individuals who deal in one currency to people who deal in a different currency.A way for corporations to pass the risk associated with foreign exchange price fluctuations to professional risk-takers.A channel for importers and exporters to acquire credit for international business transactions.
21Foreign Exchange Markets MARKET STRUCTURE AND MAJOR PARTICIPANTSThe market for foreign exchange is very large, and the daily volume was more than $4 trillion in 2010.London is by far the largest foreign exchange trading center, with an average daily volume of $1.46 trillion, while New York City is second with $712 billion, and Tokyo is third with $247 billion.
22Foreign Exchange Markets MARKET STRUCTURE AND MAJOR PARTICIPANTSParticipants are linked by telephone, telegraph, and cable.The major participants in the foreign exchange markets are multinational commercial banks, large investment banking firms, and small currency boutiques that specialize in foreign exchange transactions.In addition, the central banks, which intervene in the markets primarily to smooth out fluctuations in their exchange rates, also play a significant role.
23Exhibit 21.3: Foreign Exchange Rates and the Price of Steel in International Markets
24Foreign Exchange Markets FOREIGN EXCHANGE RATESWhen U.S.-based firms buy raw materials or finished goods, they want to get the best possible deal—the quality they need at the lowest price.When the suppliers are not located in the United States, comparisons are more difficult.However, U.S.-based firms would prefer to pay for purchases in dollars, while the foreign supplier must pay employees and other local expenses with its domestic currency.
25Foreign Exchange Markets FOREIGN EXCHANGE RATESOne of two parties in a transaction will be forced to deal in a foreign currency and incur foreign exchange rate risk.We can easily compare prices stated in different currencies by checking the foreign exchange rate quotes in major newspapers or on the internet.A foreign exchange rate is the price of one monetary unit, such as the British pound, stated in terms of another currency, such as the U.S. dollar.
27Foreign Exchange Markets THE EQUILIBRIUM EXCHANGE RATEExhibit 21.4 shows the equilibrium exchange rate, which is at the point where the supply and demand curves intersect.Equilibrium occurs at the price at which the quantity of the currency demanded exactly equals the quantity supplied.
28Foreign Exchange Markets THE EQUILIBRIUM EXCHANGE RATEIn general, whatever causes U.S. residents to buy more or fewer foreign goods shifts the demand curve for the foreign currency.Similarly, whatever causes foreigners to buy more or fewer U.S. goods shifts the supply curve for the foreign currency.
29Foreign Exchange Markets FOREIGN CURRENCY QUOTATIONSExhibit 21.5 shows selected exchange rate quotations from the Wall Street Journal.The Spot RateIs the cost of buying a foreign currency today, “on the spot”.If the exchange rate is the price in dollars for a foreign currency, it is often called the American or direct quote.If the exchange rate is the price in foreign currency for a dollar, the quote is called an European or indirect quote.
31Foreign Exchange Markets FOREIGN CURRENCY QUOTATIONSBid and Ask Rate QuotationsForeign exchange dealers quote two prices: bid and ask quotes.The bid quote represents the rate at which the dealer will buy foreign currency.The ask quote is the rate at which the dealer will sell foreign currency.The difference between the bid and ask price is the dealer’s spread, which is often calculated in percent form.
32Foreign Currency Quotations Suppose a dealer is quoting a bid rate for euros of $1.4337/€ and an ask rate of /€. the bid-ask spread is:
33Foreign Exchange Markets FOREIGN CURRENCY QUOTATIONSCross RatesWhen one is given two quotes of foreign exchange rates involving three currencies, it is possible to find the exchange rate between the third pair of currencies, and this is known as the cross rate.People dealing with more than one foreign currency make use of a table of spot exchange rates called cross rates, which are simply exchange rates between two currencies.Exhibit 21.5 shows cross rates for seven different currencies.
34Foreign Exchange Markets FOREIGN CURRENCY QUOTATIONSForward RatesAre rates at which one agrees to buy or sell a currency on some future date.Note that the forward rate is established at the date on which the agreement is made and defines the exchange rate to be used when the transaction is completed in the future.
35Foreign Exchange Markets FOREIGN CURRENCY QUOTATIONSForward RatesBy contracting now to buy or sell foreign currencies at some future date, businesses can lock in the cost of foreign exchange at the beginning of the transaction and do not have to worry about the risk of an unfavourable movement in the exchange rate in the future.The difference between the forward rate and the spot rate is called the forward premium or forward discount.
36Foreign Exchange Markets Suppose the spot rate today on the British pound is $2.0172/£, while the three-month forward rate is $2.0113/£.
37Foreign Exchange Markets FOREIGN CURRENCY QUOTATIONSHedging a Currency TransactionMeans to engage in a financial transaction to reduce risk.Companies can use forward transactions to lock in (hedge) the cost of foreign exchange.Sometimes forward contracts may prevent the firm from receiving the benefits of a change in exchange rates. However, speculation is not a logical and legitimate nonfinancial businesses that import or export goods or services.
38International Capital Budgeting When a multinational firm wants to consider overseas capital projects, the financial manager faces the decision of which capital projects should be accepted on a company-wide basis.The decision to accept international projects with a positive npv increases the value of the firm and is consistent with the fundamental goal of financial management, which is to maximize stockholder wealth.
39International Capital Budgeting Although the same basic principles apply to both international and domestic capital budgeting, firms must deal with some differences.
40International Capital Budgeting DETERMINING CASH FLOWSA number of issues complicate the determination of cash flows from overseas capital projects.First, most companies find it more difficult to estimate the incremental cash flows for foreign projects.Second, problems with cash flows can arise when foreign governments restrict the amount of cash that can be repatriated, or returned, to the parent company.
41International Capital Budgeting EXCHANGE RATE RISKFinancial managers have to deal with foreign exchange rate risk on international capital investments.To convert the project’s future cash flows into another currency, we need to come up with projected or forecast exchange rates.One of the problems with obtaining currency rate forecasts for use in analysis of capital projects is that many projects have lives of 20 years or more.
42International Capital Budgeting COUNTRY RISKFinancial managers must also incorporate a country risk premium when evaluating foreign business activities.If a firm is located in a country with a relatively unstable political environment, management will require a higher rate of return on capital projects as compensation for the additional risk.At the extreme, a local government could take over the plant and equipment of the overseas operation without giving the company any compensation. This expropriation of assets is called nationalization.
43International Capital Budgeting COUNTRY RISKSome other ways that a foreign government can affect the risk of a foreign project include:Change tax laws in a way that adversely impacts the firm.Impose laws related to labor, wages, and prices that are more restrictive than those applicable for domestic firms.Disallow any remittance of funds from the subsidiary to the parent firm for either a limited period of time or the duration of the project.Require that the subsidiary be headed by a local citizen or have a local firm as a major equity partner.Impose tariffs and quotas on any imports.
44International Capital Budgeting COUNTRY RISKOnce management has gauged a capital project’s country risk, that risk must be incorporated into the capital budgeting analysis by, for example, adjusting the firm’s discount rate for the additional risk.
45Exhibit 21.6: Composite Country Risk Ratings for Selected Countries
46Global Money and Capital Markets THE EMERGENCE OF THE EUROMARKETSA Eurodollar is defined as a U.S. dollar deposited in a bank outside the United States, primarily in Europe.The banks accepting these deposits are called Eurobanks.The Euromarkets are vast, largely unregulated money and capital markets with major financial centers in Tokyo, Hong Kong, and Singapore.
47Global Money and Capital Markets THE EUROCURRENCY MARKETIs the short-term portion of the Euromarket.A Eurocurrency is a timed deposit of money held by corporations and governments in a bank located in a country different from the country that issued the currency.The most widely quoted Eurocurrency interest rate is the London Interbank Offer Rate, or LIBOR, which is the short-term interest rate that major banks in London charge one another.
48Global Money and Capital Markets THE EUROCREDIT MARKETThe international banking system gathers funds from businesses and governments in the Eurocurrency market and then allocates funds to banks that have the most profitable lending opportunities.These loans, which are short- to medium-term loans of a Eurocurrency to multinational corporations and governments of medium to high credit quality, are called Eurocredits.Is denominated in all major Eurocurrencies, although the dollar is the overwhelming favourite.
49Global Money and Capital Markets INTERNATIONAL BOND MARKETSFall into two generic categories:Foreign bondsEurobonds.
50Global Money and Capital Markets INTERNATIONAL BOND MARKETSForeign BondsAre long-term debt sold by a foreign firm to investors in another country and denominated in that country’s currency.Firms sell foreign bonds when they need to finance projects in a particular foreign country.May have colorful nicknames.Foreign bonds sold in the United States are called Yankee bonds.Yen-denominated bonds sold in Japanese financial markets by non-Japanese firms are called Samurai bonds.
51Global Money and Capital Markets INTERNATIONAL BOND MARKETSEurobondsAre long-term debt instruments sold by firms to investors in countries other than the country in whose currency the bonds are denominated.Are bearer bonds and do not have to be registered.Multinational firms can use Eurobonds to finance international or domestic projects.Eurodollar and other Eurocurrency bonds have a number of characteristics that differ from similar U.S corporate bonds.
52Global Money and Capital Markets INTERNATIONAL BOND MARKETSEurobondsEurobonds also pay interest annually.Historically almost all Eurocurrency bonds were sold without credit ratings.Today, more than half of the Eurodollar bonds sold in Europe have credit ratings.
53International Banking European governments fostered the growth of large international banks in their countries and viewed them as engines of territorial and economic expansion.To accommodate their customers’ needs, large U.S. Banks established networks of foreign branches and affiliates.Exhibit 21.7 shows the 15 largest banks in the world in 2007, as ranked by Forbes in its list of the 2000 largest public companies in the world.
55International Banking RISKS INVOLVED IN INTERNATIONAL BANK LENDINGThe principles of loan administration and credit analysis are similar for domestic and overseas loans.There are differences, however, including some additional risk exposures for overseas lending.Credit risk is the same whether a loan is domestic or international. However, it may be more difficult to obtain or assess credit information abroad
56International Banking RISKS INVOLVED IN INTERNATIONAL BANK LENDINGBank loans that have foreign-exchange risk will carry an additional risk premium.If an international loan or investment is expected to suffer some loss in value, the loan will carry an additional risk premium.
57International Banking EUROCREDIT BANK LOANSAre short-to medium-term loans of a Eurocurrency to multinational corporations or governments.Can have a high degree of credit risk and may be too large for a single bank to handle.The lending banks often form a syndicate to spread the risk.
58International Banking EUROCREDIT BANK LOANSThe loan rate is equal to a base rate, such as LIBOR, which represents the bank’s cost of funds, plus a markup.Eurocredits typically are floating-rate loans structured as “rollovers”.The general equation for Eurocredit pricing is expressed in the following equation:k = BR + DRP + FXR + CR + GPMAR (21.3)