®2002 Prentice Hall Publishing 1 Chapter 25 International Financial Management

1®2002 Prentice Hall Publishing

Chapter 25International Financial

Management


Motivation for International Investment

• Provide a return in excess of that requiredProvide a return in excess of that required

– Expansion into foreign marketsExpansion into foreign markets

– Produce more efficientlyProduce more efficiently

– Lower operating costsLower operating costs

– Secure necessary raw materialsSecure necessary raw materials


International Capital Budgeting

• Estimate expected cash flows in foreign currencyEstimate expected cash flows in foreign currency– RepatriatedRepatriated– Nonremittable - investment unlikelyNonremittable - investment unlikely

• Compute U.S. dollar equivalents at the expected Compute U.S. dollar equivalents at the expected exchange rateexchange rate

• Determine the NPV of the project using the U.S. Determine the NPV of the project using the U.S. required rate of return, adjusted for any risk required rate of return, adjusted for any risk premiumpremium

• Critical assumptions Critical assumptions


Risk Factors

• Diversification will reduce risk if global Diversification will reduce risk if global markets are partially segmentedmarkets are partially segmented

• With an integrated market for securities, the With an integrated market for securities, the investor is able to reduce risk more quickly investor is able to reduce risk more quickly and further by diversifying across and further by diversifying across international stocks as opposed to only international stocks as opposed to only domestic onesdomestic ones


What Makes Direct Foreign Investment Different?

• Complex taxationComplex taxation

• Political riskPolitical risk

• Exchange rate riskExchange rate risk


Taxation• U.S. governmentU.S. government

– Income from a branch or division is taxed in the same Income from a branch or division is taxed in the same way as domestic incomeway as domestic income

– Income from a foreign subsidiary is not taxed in the Income from a foreign subsidiary is not taxed in the U.S. until it is distributed to the parent as dividendsU.S. until it is distributed to the parent as dividends

– Gives a federal tax credit for foreign taxesGives a federal tax credit for foreign taxes• Foreign governmentsForeign governments

– Type of tax imposed varies between income Type of tax imposed varies between income distributed to stockholders and undistributed incomedistributed to stockholders and undistributed income

– Less-developed countries frequently have lower taxesLess-developed countries frequently have lower taxes– Definitions for what constitutes taxable income are Definitions for what constitutes taxable income are

different for different countriesdifferent for different countries


Political Risk

• Assessing political risk realisticallyAssessing political risk realistically

– Forecasting political instabilityForecasting political instability

– Take steps to protect investment by Take steps to protect investment by cooperating with the host countrycooperating with the host country

• Joint venture Joint venture

– Make subsidiary dependent on the parent Make subsidiary dependent on the parent for technology, markets, and/or suppliesfor technology, markets, and/or supplies


Types of Exchange Rate Exposure

• Translation exposure is the effect of an exchange-Translation exposure is the effect of an exchange-rate change on the accounting balance sheet and rate change on the accounting balance sheet and income statementincome statement

• Transaction exposure is the effect of an Transaction exposure is the effect of an exchange-rate change upon the value of a single exchange-rate change upon the value of a single transactiontransaction

• Economic exposure is the effect of an Economic exposure is the effect of an unanticipated change in exchange rates on the unanticipated change in exchange rates on the economic value of the firmeconomic value of the firm– Most important exposureMost important exposure


Degrees of Exposure on Existing Assets and Liabilities

• Hekman has derived a framework for Hekman has derived a framework for categorizing assets and liabilities as to their categorizing assets and liabilities as to their degree of exposure degree of exposure

• Coefficient of 1.0 means the market value of the Coefficient of 1.0 means the market value of the balance sheet item is entirely exposedbalance sheet item is entirely exposed

• Coefficient of 0.0 means the market value is Coefficient of 0.0 means the market value is unexposedunexposed

• Coefficients between 0 and 1 means the item is Coefficients between 0 and 1 means the item is partially exposedpartially exposed


Aggregate Economic ExposureNet aggregate market-value exposureNet aggregate market-value exposure

Market value of equityMarket value of equity

• Measures the degree and sensitivity of economic Measures the degree and sensitivity of economic exposureexposure

• Typically the more global the market served, the Typically the more global the market served, the less the overall exposureless the overall exposure

• Framework used to assess the economic exposure of Framework used to assess the economic exposure of the existing balance sheet of the foreign subsidiary the existing balance sheet of the foreign subsidiary

=


Exposure of Expected Future Cash Flows

• Natural hedge exists whenever the effect of an Natural hedge exists whenever the effect of an exchange-rate change is offset by an opposite exchange-rate change is offset by an opposite change in local currency marginschange in local currency margins

• Degree of exchange-rate exposure of a foreign Degree of exchange-rate exposure of a foreign subsidiary is that which remains after any natural subsidiary is that which remains after any natural hedgehedge

• Exposure can be approximated by determining Exposure can be approximated by determining whether pricing and costs are more sensitive to whether pricing and costs are more sensitive to local-market or global-market conditionslocal-market or global-market conditions

• Residual exposure remains after we take account of Residual exposure remains after we take account of any natural hedge that represents exchange-rate riskany natural hedge that represents exchange-rate risk

• Management needs to decide whether it wishes to Management needs to decide whether it wishes to hedge the residual riskhedge the residual risk


Operating Hedges• Cash management among countries through Cash management among countries through

intracompany accountsintracompany accounts• If a company knew a currency were going to fall in If a company knew a currency were going to fall in

valuevalue– Reduce cash to a minimum by purchasing inventories or Reduce cash to a minimum by purchasing inventories or

other real assetsother real assets– Avoid extended trade creditAvoid extended trade credit– As quick a turnover as possible of receivables As quick a turnover as possible of receivables – Obtain extended terms on its accounts payableObtain extended terms on its accounts payable– Borrow the local currencyBorrow the local currency


Currency Strategies• Balance monetary assets against monetary Balance monetary assets against monetary

liabilities in order to neutralize the effects liabilities in order to neutralize the effects of exchange-rate fluctuationsof exchange-rate fluctuations

• Accelerating the timing of payments made Accelerating the timing of payments made or received in foreign currencies is called or received in foreign currencies is called leading, and decreasing the timing is called leading, and decreasing the timing is called lagginglagging

• Adjust intracompany dividends and royalty Adjust intracompany dividends and royalty paymentspayments

• Establish a reinvoicing center to manage Establish a reinvoicing center to manage intracompany and third-party foreign tradeintracompany and third-party foreign trade– Centralize and manage all exposureCentralize and manage all exposure– Facilitates the netting of obligations among unitsFacilitates the netting of obligations among units– Allows for more coordinated control over leading Allows for more coordinated control over leading

or lagging arrangements between affiliates or lagging arrangements between affiliates


International Financing• Asset sensitive exposure would be balanced with Asset sensitive exposure would be balanced with

borrowingborrowing• Sources of external financingSources of external financing

– Commercial bank loans and trade billsCommercial bank loans and trade bills– Eurodollar financingEurodollar financing– Bond financingBond financing

• Eurobond marketEurobond market• Foreign bondForeign bond

– Currency-optionsCurrency-options– Conversion optionConversion option– Currency cocktailCurrency cocktail– Dual currency bondDual currency bond


Currency Market Hedges

• Forward contractsForward contracts

• Futures contractsFutures contracts

• Currency optionsCurrency options

• Currency swapsCurrency swaps


Forward Exchange Market• Well suited for hedging transactions exposureWell suited for hedging transactions exposure

• Forward contract provides assurance of being able to Forward contract provides assurance of being able to convert into a desired currency at a price set in advanceconvert into a desired currency at a price set in advance

• Foreign currency sells at a forward discount if its Foreign currency sells at a forward discount if its forward price is less than its spot priceforward price is less than its spot price

• Sells at a forward premium if its forward price exceeds Sells at a forward premium if its forward price exceeds the spot pricethe spot price

• Euro is a common currency for the European Monetary Euro is a common currency for the European Monetary Union (EMU)Union (EMU)


Foreign Exchange Market (FX)• Worldwide network of traders, connected by Worldwide network of traders, connected by

telephone lines and computer screenstelephone lines and computer screens• Centers of tradingCenters of trading

– Great BritainGreat Britain– United StatesUnited States– JapanJapan– SingaporeSingapore– SwitzerlandSwitzerland– Hong KongHong Kong– Germany Germany – FranceFrance– AustraliaAustralia

• Trading goes on 24 hours a dayTrading goes on 24 hours a day

Half of all FX transactions


EMU

Germany Netherlands Austria

France Belgium Portugal

Italy Spain Ireland


Currency Futures

• Markets exist for major currencies Markets exist for major currencies • Futures contract is a standardized agreement Futures contract is a standardized agreement

that calls for delivery of a currency at some that calls for delivery of a currency at some specified future datespecified future date

• Transactions are with a clearinghouseTransactions are with a clearinghouse• Very few contracts involve actual delivery at Very few contracts involve actual delivery at

expirationexpiration• Futures contract is marked-to-marketFutures contract is marked-to-market


Currency Options

• Enable the hedging of “one sided” riskEnable the hedging of “one sided” risk

• Holder has the right to buy or sell the Holder has the right to buy or sell the currency over the life of the contractcurrency over the life of the contract

• For this protection, one pays a premiumFor this protection, one pays a premium


Currency Swaps

• Long-term hedging vehicleLong-term hedging vehicle• Two parties exchange debt obligations denominated Two parties exchange debt obligations denominated

in different currenciesin different currencies• Each party agrees to pay the other’s interest Each party agrees to pay the other’s interest

obligationobligation• Only cash-flow differences are paidOnly cash-flow differences are paid• There is not an actual exchange of principalThere is not an actual exchange of principal• Currency swaps can be combined with interest-rate Currency swaps can be combined with interest-rate

swaps swaps


Should Exposure be Managed?• A case can be made for the various hedging strategies A case can be made for the various hedging strategies

if imperfections and incompleteness occur in if imperfections and incompleteness occur in international product and financial marketsinternational product and financial markets

• Most companies manage their currency-risk exposureMost companies manage their currency-risk exposure• Few companies are willing to risk everything on future Few companies are willing to risk everything on future

exchange ratesexchange rates• Real issue is the degree of managementReal issue is the degree of management• Shareholders would be better off with a degree of self-Shareholders would be better off with a degree of self-

insuranceinsurance• 100 percent hedging does not produce superior 100 percent hedging does not produce superior

investment resultsinvestment results


Macro Factors Governing Exchange-Rate Behavior

• Purchasing power parity (PPP) works through Purchasing power parity (PPP) works through differences in inflation between countriesdifferences in inflation between countries

• With interest-rate parity (IRP), forward discounts and With interest-rate parity (IRP), forward discounts and premiums are driven by differences in interest ratespremiums are driven by differences in interest rates

• International Fisher effect (IFE) suggests that International Fisher effect (IFE) suggests that differences in interest rates between two countries differences in interest rates between two countries serve as a proxy for differences in expected inflationserve as a proxy for differences in expected inflation

• Arbitrage actions will continue until interest-rate Arbitrage actions will continue until interest-rate parity is establishedparity is established


Principal Documents Involved in International Trade

• The draft is an order by the exporter to the importer to The draft is an order by the exporter to the importer to pay a specified amount of money either upon pay a specified amount of money either upon presentation of the draft or a certain number of days presentation of the draft or a certain number of days after presentationafter presentation

• A bill of lading is a shipping document that can serve A bill of lading is a shipping document that can serve as a receipt, as a shipping contract, and as title to the as a receipt, as a shipping contract, and as title to the goods involved goods involved

• A letter of credit is an agreement by a bank to honor a A letter of credit is an agreement by a bank to honor a draft drawn on the importer draft drawn on the importer


Financing Trade• Countertrading is where the selling party accepts Countertrading is where the selling party accepts

payment in the form of goods as opposed to payment in the form of goods as opposed to currencycurrency

• Factoring is where the factor assumes the credit Factoring is where the factor assumes the credit risk, so the exporter is assured of being paidrisk, so the exporter is assured of being paid

• Forfaiting is where an exporter who is owed Forfaiting is where an exporter who is owed money evidenced by a longer-term note, as money evidenced by a longer-term note, as opposed to a receivable, sells the note to a opposed to a receivable, sells the note to a financial institution at a discount financial institution at a discount