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INTERNATIONAL FINANCIAL MANAGEMENT CHAPTER 22 INTERNATIONAL FINANCIAL MANAGEMENT

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.

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.

Copyright © 2014 by Nelson Education Ltd.

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.

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.

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.

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.

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.

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.

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.

Cross Rates Between Euros and Swiss Franc Euros Dollars Dollar Swiss franc Swiss franc Dollars Dollar Euros × = 0.7641 x 1.0833 = 0.8277 euros/Swiss franc Cross Rate = = 0.9231 x 1.3088 = 1.2082 Swiss francs/euro Copyright © 2014 by Nelson Education Ltd.

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.

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.

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 price @ $1.3088/€ = ($2.625)/($1.3088) = € 2.01 Copyright © 2014 by Nelson Education Ltd.

The International Monetary System and Exchange Rate Policies From 1946-1971: 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.

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.

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.

Copyright © 2014 by Nelson Education Ltd. Freely, or Independently, Floating Rates: Currency Appreciation/Depreciation Suppose the exchange rate freely goes from 103.5 yen/dollar to 105.0 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.

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.

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.

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.

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.

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.

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.

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.

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 2002. The euro replaced their domestic currencies. Copyright © 2014 by Nelson Education Ltd.

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.

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.

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.

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.

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

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.

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.

Interest Rate Parity: Example (cont’d) If interest rate parity holds, the implied forward rate, 0.8294, would equal the observed forward rate, 0.8100; so parity doesn’t hold. Forward rate 0.8333 Spot rate = 1 + rh 1 + rf 1.045 1.050 Forward rate = 0.8294 Copyright © 2014 by Nelson Education Ltd.

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.

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. $0.8000 = $2.00/Pf Pf = $2.00/$0.8000 = 2.5 euros Do PPP and IRP hold exactly at any point in time? Copyright © 2014 by Nelson Education Ltd.

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.

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.

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.

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.

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.

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.

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.

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.

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.

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.

Expected Future Exchange Rates (cont’d) Direct spot rate = (1/110 ¥/$) = 0.009091 $/¥ 1-Year expected forward rate: = (spot rate)[(1 + rh)/(1 + rf)]1 = (0.009091)[(1 + 0.02)/(1 + 0.0005)] = 0.009268 Copyright © 2014 by Nelson Education Ltd.

Expected Future Exchange Rates (cont’d) 2-Year expected forward rate: = (spot rate)[(1 + rh)/(1 + rf)]2 = (0.009091)[(1 + 0.028)/(1 + 0.0026)]2 = 0.009557 Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Project Cash Flows 1 2 Cash flows in yen -¥1,000 ¥500 ¥800 Expected exchange rates 0.009091 0.009268 0.009557 Cash flows in dollars -$9.09 $4.63 $7.65 Copyright © 2014 by Nelson Education Ltd.

Copyright © 2014 by Nelson Education Ltd. Project NPV NPV = -$9.09 $4.63 $7.65 (1 + 0.10)2 (1 + 0.10) + NPV = $1.44 million Copyright © 2014 by Nelson Education Ltd.

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.

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.

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.

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.

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.

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.

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.