Short-Term FinancingShort-Term Financing

2424 Lecture Lecture

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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.

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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.

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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.

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Why MNCs ConsiderForeign 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.

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Short-Term Interest Ratesas of February 2004

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Determining theEffective 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.

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2. 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 theEffective Financing Rate

$648k – $500k = 29.6% !

$500k

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• The effective financing rate, rf , can be written as:

rf = (1 + if )(1 + ef ) – 1

where if = the foreign currency interest rate

ef = the % in the foreign currency’sspot rate

= St+1 – S S

Determining theEffective Financing Rate

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Criteria Considered forForeign 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.

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Criteria Considered forForeign 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.

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Implications of IRP for Financing

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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 forForeign Financing

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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 forForeign Financing

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