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21 Chapter. 21-2  Multinational corporations  Effect of exchange rates on profitability and cash-flow  Hedging and reduction of foreign exchange risk.

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Presentation on theme: "21 Chapter. 21-2  Multinational corporations  Effect of exchange rates on profitability and cash-flow  Hedging and reduction of foreign exchange risk."— Presentation transcript:

1 21 Chapter

2 21-2  Multinational corporations  Effect of exchange rates on profitability and cash-flow  Hedging and reduction of foreign exchange risk  Evaluating political risk in foreign investment decisions  Financing international operations

3 21-3  Integrates capital markets  World events such as currency crisis, government defaults, terrorism can cause stock and bond markets to suffer emotional declines well beyond the expected economic impact of a major event  Currency markets  Impact on trade between nations affecting sales and earnings of international companies  The advent of the Euro  Sever impact on earnings of U.S. companies doing significant business in Europe

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6 21-6  A firm carrying out its business activities (often 30% or more) outside its national borders  Can take several forms :  Exporter  Licensing agreement  Joint venture  Fully owned foreign subsidiary

7 21-7  Exporter:  Least risky method  Reaping the benefits of foreign demand  No long-term investment commitment  Licensing agreement:  License granted to a local manufacturer in foreign land to use firm’s technology  Effectively exporting technology  Collects licensing fee or royalty  Joint venture:  Established with a local firm in foreign land  Most preferred by business firms and foreign governments  Least amount of political risk

8 21-8  Fully owned foreign subsidiary ▪ Higher risks and complexities of operation ▪ Often more profitable than domestic firms ▪ Lowers combined portfolio risk of the parent corporation ▪ Decisive factor in shaping the pattern of trade, investment, and the flow of technology ▪ Exert significant impact on host country’s economic growth, employment, trade, and balance of payments

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10 21-10  The following figure shows the amount of foreign currency for one U.S. dollar

11 21-11  Inflation:  A parity between the purchasing power of two currencies establishes the rate of exchange between the two currencies  Example: it takes $1.00 to buy one apple in New York and 1.25 euros to buy apple in Germany. Then the rate of exchange between the USD and the Euro is €1.25/$1.00 or $.80/euro

12 21-12  Purchasing power parity theory states that: ▪ Currency exchange rates vary inversely with their respective purchasing powers ▪ Exchange rates between two countries adjust to inflation differential between the two countries

13 21-13  Interest rates:  Short-term capital movements from low-yield to high-yield markets  Interest rate parity theory: ▪ The interplay between interest rate differentials and exchange rates ▪ Interest rates and exchange rates adjust until the foreign exchange market and the money market reach equilibrium

14 21-14  Balance of payments:  A system of government accounts that catalog flow of economic transactions between the residents of one country and that of others ▪ Trade surplus or deficit determines strength of currency

15 21-15  Government policies:  Direct or indirect intervention in the foreign exchange market ▪ For maintenance of the undervalued currency  Currency values set by government  Restriction on inflow and outflow of funds  Monetary and fiscal policies ▪ Result in inflation and change in value of currency ▪ Expansionary monetary policies ▪ Excessive government spending

16 21-16  Other factors:  Extended stock market rally ▪ Higher capital inflow and increase in currency value  Significant drop in demand for a nation’s principal exports globally ▪ Lower investment potential and decrease in value of currency  Political turmoil in a country ▪ Capital shift to more stable countries and decrease in value of currency  Widespread labor strikes

17 21-17  Spot rate  Exchange rate at which the currency is traded for immediate delivery  Forward rates  Trading of currencies for future delivery  Reflects the expectations regarding the future value of a currency  Forward Discount or premium:  Expressed as an annualized percentage deviation from the spot rate

18 21-18  Not all currencies are actively traded  Value for such currencies determined through a cross rate  Example : Three currencies $, € and ¥  $ and € are actively traded  $ is 0.8384€ and € is 141.390¥  Thus $ = 0.8384 × 141.390¥ = 118.541¥

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20 21-20  Foreign exchange risk  Possibility of a drop in revenue or an increase in cost in an international transaction due to changes in foreign exchange rates  Shift from fixed exchange rate regime to freely-floating rate regime  Exchange risk of a multinational company:  Accounting or translation exposure  Transaction exposure

21 21-21  Consolidated figures of the parent include value of foreign assets and liabilities converted and expressed in home currency  Treatment of such gains and losses depend on the accounting rules established by the government of parent company.  Note: unrealized accounting gains and losses should only be hedged if you are sure it is going to influence the corporate cash flows! Do a value at risk (VaR) analysis.

22 21-22  SFAS 52 says:  All foreign currency-denominated assets and liabilities to be converted at the rate of exchange on date of balance sheet preparation  Unrealized gain or loss to be held in equity reserve account and realized gain or loss incorporated in the consolidated income statement of the parent company

23 21-23  Foreign exchange gains or losses resulting from international transactions (from the time of agreement to time of payment)  Volatility of reported earnings per share increases  Strategies to minimize transaction exposure: ▪ Forward exchange market hedge ▪ Money market hedge ▪ Currency futures market hedge

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25 21-25  MNCs have developed foreign asset management programs, involving strategies:  Switching cash and other assets into strong currencies  Piling up debt and other liabilities in depreciating currencies  Quick collection of bills in weak currencies by offering sizable discounts, while extending credit in strong currencies

26 21-26  Factors encouraging foreign affiliates:  Avoid trade barriers  Lower production costs overseas  Superior technology enabled easy access to resources in developing countries  Tax advantage  Motivated by strategic considerations in an oligopolistic industry  Diversification of risks internationally

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28 21-28  Government interference by imposition of unfriendly foreign exchange restrictions  Limitation of foreign ownership to a small percentage  Blocking repatriation of a subsidiary’s profit to the parent firm  Expropriation of foreign subsidiary’s assets by the host government

29 21-29  Establish a joint venture with a local entrepreneur (not totally risk free!)  Establish a joint venture with firms from other countries  Insurance against perceived political-risk level can be obtained  Overseas Private Investment Corporation (OPIC) and other private insurance companies sell insurance policies ▪ Coverage is expensive in troubled countries

30 21-30  Credit sales are influenced by:  Relationship of the parties involved  Political stability of countries involved  Letter of credit issued by importer’s bank reduces risk of nonpayment  Credit risk to exporter is absorbed by the importer’s bank ▪ Importer’s bank in a good position to evaluate the creditworthiness of the importing firm

31 21-31  Alternatives to avoid risk of loss of business:  Obtaining export credit insurance ▪ The Foreign Credit Insurance Association (FCIA) provides this kind of insurance ▪ A private association of 60 U.S. insurance firms

32 21-32  Eximbank (Export-Import Bank)  Direct loan program  Discount program  Loans from parent company or sister affiliate  Parallel loans  Fronting loans  Eurodollar loans  US dollars deposited in foreign banks  Lending rates based on London Interbank Offer Rate (LIBOR)

33 21-33  Eurobond market  Issues are sold in several national capital markets  Widely used currency – U.S. dollar  International equity markets  Companies are listed on major stock exchanges  Issue American Depository Receipts (ADRs)  The International Finance Corporation (IFC)  Approached by companies facing issues with raising equity capital in a foreign country

34 21-34  Nature of financial decisions for an MNC are complex:  Access to more sources of financing than a purely domestic corporation ▪ Decision regarding level of leverage in the foreign affiliate ▪ Dividend policy decisions influenced by foreign government regulations  Differences in interest rates and market conditions between domestic and foreign markets  Differences in corporate financial practices

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