Short-Term Financing 24 Lectu re

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.

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. MNCs may also issue Euro-commercial papers to obtain short-term financing. MNCs utilize direct Eurobank loans to maintain a relationship with Eurobanks too.

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

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 financing costs.

Short-Term Interest Rates as of February 2004

Determining the Effective Financing Rate 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.

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

The effective financing rate, r f, can be written as: r f = (1 + i f )(1 + e f ) – 1 where i f =the foreign currency interest rate e f =the %  in the foreign currency’s spot rate = S t +1 – S S Determining the Effective Financing Rate

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.

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 that are similar to those for domestic financing.

Implications of IRP for Financing

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

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

Source: Adopted from South- Western/Thomson Learning © 2006