CHAPTER 19Multinational Financial Management

Multinational vs. domestic financial management

Exchange rates and trading in foreign exchange

International money and capital markets

What is a multinational corporation?

A corporation that operates in two or more countries.

Decision making within the corporation may be centralized in the home country, or may be decentralized across the countries the corporation does business in.

Why do firms expand into other countries?

1. To seek new markets.

2. To seek raw materials.

3. To seek new technology.

4. To seek production efficiency.

5. To avoid political and regulatory hurdles.

6. To diversify.

What factors distinguish multinational financial management from domestic financial management?

1. Different currency denominations.

2. Economic and legal ramifications.

3. Language differences.

4. Cultural differences.

5. Role of governments.

6. Political risk.

Consider the following exchange rates

US $ to buy 1 unit

Japanese yen 0.009

Australian dollar 0.650

Are these currency prices direct or indirect quotations? Since they are prices of foreign

currencies expressed in dollars, they are direct quotations.

What is an indirect quotation? The number of units of a foreign

currency needed to purchase one U.S. dollar, or the reciprocal of a direct quotation.

Are you more likely to observe direct or indirect quotations? Most exchange rates are stated in

terms of an indirect quotation. Except the British pound, which is

usually in terms of a direct quotation.

Calculate the indirect quotations for yen and Australian dollar

# of units of foreign

currency per US $

Japanese yen 111.11

Australian dollar 1.5385

Simply find the inverse of the direct quotations.

What is a cross rate? The exchange rate between any two

currencies. Cross rates are actually calculated on the basis of various currencies relative to the U.S. dollar.

Cross rate between Australian dollar and the Japanese yen. Cross rate = (Yen / US Dollar) x (US Dollar / A. Dollar)

= 111.11 x 0.650= 72.22 Yen / A. Dollar

The inverse of this cross rate yields: 0.0138 A. Dollars / Yen

Orange juice project:Setting the appropriate price A firm can produce a liter of

orange juice and ship it to Japan for $1.75 per unit. If the firm wants a 50% markup on the project, what should the juice sell for in Japan?

Price = (1.75)(1.50)(111.11)= 291.66 yen

Orange juice project:Determining profitability The product will cost 250 yen to

produce and ship to Australia, where it can be sold for 6 Australian dollars. What is the U.S. dollar profit on the sale? Cost in A. dollars = 250 yen (0.0138)

= 3.45 A. dollars A. dollar profit = 6 – 3.45 = 2.55 A. dollars U.S. dollar profit = 2.55 / 1.5385 = $1.66

What is exchange rate risk? The risk that the value of a cash flow in

one currency translated to another currency will decline due to a change in exchange rates.

For example, in the last slide, a weakening Australian dollar (strengthening dollar) would lower the dollar profit.

The current international monetary system is a floating rate system.

European Monetary Union In 2002, the full implementation

of the “euro” was completed. The national currencies of the 12 participating countries were phased out in favor of the “euro.” The newly formed European Central Bank controls the monetary policy of the EMU.

Member nations of the EMU

Austria Belgium Finland France German

y Greece

Ireland Italy Luxembourg Netherlands Portugal Spain

Notable European Union countries not in the EMU: Britain, Sweden, and

Denmark

What is a convertible currency?

A currency is convertible when the issuing country promises to redeem the currency at current market rates.

Convertible currencies are traded in world currency markets.

What problems may arise when a firm operates in a country whose currency is not convertible?

It becomes very difficult for multi-national companies to conduct business 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.

What is difference between spot rates and forward rates?

Spot rates are the rates to buy currency for immediate delivery.

Forward rates are the rates to buy currency at some agreed-upon date in the future.

When is the forward rate at a premium to the spot rate? If the U.S. dollar buys fewer units of a

foreign currency in the forward than in the spot market, the foreign currency is selling at a premium.

In the opposite situation, the foreign currency is selling at a discount.

The primary determinant of the spot/forward rate relationship is relative interest rates.

What is interest rate parity? Interest rate parity holds that investors

should expect to earn the same return in all countries after adjusting for risk.

country foreign in rateinterest periodic kcountry home in rateinterest periodic k

rate exchangespot stoday' erate exchange forward period-t f

k 1k 1

ef

f

h

0

t

f

h

0

t

Evaluating interest rate parity Suppose one yen buys $0.0095 in the

30-day forward exchange market and kNOM for a 30-day risk-free security in Japan and in the U.S. is 4%. ft = 0.0095 kh = 4% / 12 = 0.333% kf = 4% / 12 = 0.333%

Does interest rate parity hold?

Therefore, for interest rate parity to hold, e0 must equal $0.0095, but we were given earlier that e0 = $0.0090.

1 e

0.0095

1.00331.0033

e0.0095

0

0

Which security offers the highest return?

The Japanese security. Convert $1,000 to yen in the spot market.

$1,000 x 111.111 = 111,111 yen. Invest 111,111 yen in 30-day Japanese security.

In 30 days receive 111,111 yen x 1.00333 = 111,481 yen.

Agree today to exchange 111,481 yen 30 days from now at forward rate, 111,481/105.2632 = $1,059.07.

30-day return = $59.07/$1,000 = 5.907%, nominal annual return = 12 x 5.907% = 70.88%.

What is purchasing power parity (PPP)?

Purchasing power parity implies that the level of exchange rates adjusts so that identical goods cost the same amount in different countries.

Ph = Pf(e0)

-OR-e0 = Ph/Pf

If grapefruit juice costs $2.00 per liter in the U.S. and PPP holds, what is the price of grapefruit juice in Australia?

e0 = Ph/Pf

$0.6500 = $2.00/Pf

Pf = $2.00/$0.6500

= 3.0769 Australian dollars.

What impact does relative inflation have on interest rates and exchange rates?

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 effective interest cost increases over the life of the loan.

International money and capital markets Eurodollar markets

a source of dollars outside the U.S. International bonds

Foreign bonds – sold by foreign borrower, but denominated in the currency of the country of issue.

Eurobonds – sold in country other than the one in whose currency the bonds are denominated.

To what extent do average capital structures vary across different countries?

Previous studies suggested that average capital structures vary 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.

Impact of multinational operations

Cash management Distances are greater. Access to more markets for loans

and for temporary investments. Cash is often denominated in

different currencies.

Impact of multinational operations

Capital budgeting decisions Foreign operations are taxed

locally, and then funds repatriated may be subject to U.S. taxes.

Foreign projects are subject to political risk.

Funds repatriated must be converted to U.S. dollars, so exchange rate risk must be taken into account.

Impact of multinational operations

Credit management Credit is more important, because commerce to

lesser-developed countries often relies on credit. Credit for future payment may be subject to

exchange rate risk. 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.