Fins3616 Finals Paul Ye

lOMoARcPSD|1304502
Fins3616 Finals Paul Ye
International Business Finance (University of New South Wales)
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Paul Ye Fins3616 2009
Fins3616 - 2009
Paul Ye
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Chapter 19 – Week 5 International Capital Markets ........................ 6

Domestic and International bond markets ............................................................................ 6
Domestic and international stock markets ............................................................................ 6
International Differences in securities regulation ................................................................. 7
International investment vehicles, overcoming capital flow barriers ................................... 7
Portfolio investment styles .................................................................................................... 9
Chapter 8 – Week 7 The Rationale for Hedging Currency Risk ......... 9

Perfect market assumptions .................................................................................................. 9
Convexity in the tax schedule .............................................................................................. 10
Costs of financial distress..................................................................................................... 10
Agency Costs ........................................................................................................................ 12
Chapter 9 Treasury Management of International Transactions .... 13

Steps in setting financial goals & strategies ........................................................................ 13
Problems with international trade ...................................................................................... 13
Managing the costs and risks of international shipping ...................................................... 13
Managing the costs and risks of international payment ..................................................... 14
All in cost of trade finance ................................................................................................... 15
Counter Trade ...................................................................................................................... 15
Cash Management ............................................................................................................... 15
Relationship Management................................................................................................... 16
Currency Risk Management in the Multinational Corporation ........................................... 16
Types of exposure to currency risk ...................................................................................... 17
The 5 steps of a currency risk management program ......................................................... 18
Exchange rate forecasting for Active FX Risk Management ................................................ 18
Chapter 10 – Week 8 Managing Transaction Exposure to Currency

Risk.............................................................................................. 18
Managing transaction exposures internally ........................................................................ 18
External hedging, Managing transaction exposure in financial markets ............................ 20
Treasury management in practice ....................................................................................... 23
Summary .............................................................................................................................. 23
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Chapter 11 – week 8 Managing Operating Exposure to Currency

Risk.............................................................................................. 24
Operating exposure and the competitive environment ...................................................... 24
Market based measures of the exposure of shareholder’s equity ..................................... 26
Managing operating exposure in the financial markets ...................................................... 26
Managing operating exposure through operations ............................................................ 27
Pricing strategy and the firm’s competitive environment................................................... 28
Chapter 12 – week 9 Managing translation exposure and accounting

for financial transactions .............................................................. 29
Balance sheet translation exposures ................................................................................... 29
Translation accounting......................................................................................................... 29
Methods of translation ........................................................................................................ 29
Which translation method is the most realistic?................................................................. 31
Information based reasons for hedging translation exposure ............................................ 31
Cross country differences in hedging of translation exposure ............................................ 31
Policy recommendations ..................................................................................................... 32
Accounting for derivative instruments and hedging activities ............................................ 32
Chapter 13 – week 9 Foreign Market Entry and Country Risk

Management ............................................................................... 32
Strategic entry into international markets .......................................................................... 33
Modes of foreign market entry ........................................................................................... 33
Strategies for managing country risk ................................................................................... 35
Political risk insurance ......................................................................................................... 35
Planning for disaster recovery ............................................................................................. 36
Intellectual property rights .................................................................................................. 36
Ways to limit exposures to loss ........................................................................................... 37
Chapter 14 – week 10 Cross border capital budgeting ................... 37

Domestic capital budgeting recipe ...................................................................................... 37
Rules when estimating future cash flows ............................................................................ 38
Rules when risk adjusted discount rate ............................................................................... 38
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Calculate net present value 0 based on expected future cash flows and the appropriate
risk-adjusted discount rate .................................................................................................. 38
The international Parity Conditions & Cross border capital budgeting............................... 39
Disequilibria in the international parity conditions ............................................................. 41
Special circumstances in project valuation.......................................................................... 42
Chapter 15 – week 10 Multinational Capital Structure and Cost of

Capital ......................................................................................... 44
Capital structure and the cost of capital.............................................................................. 44
The 2 most popular approaches to project valuation and the cost of capital .................... 45
International evidence on capital structure: ....................................................................... 46
Financial market integration ................................................................................................ 46
Total vs systematic risk ........................................................................................................ 46
Returns and risks in emerging markets ............................................................................... 47
Estimating the cost of capital in a emerging market ........................................................... 47
Sources of funds for multinational operations .................................................................... 48
Chapter 16 – week 11 – Taxes and Multinational Corporate Strategy

.................................................................................................... 50
The objectives of national tax policy ................................................................................... 50
Violations of tax neutrality .................................................................................................. 50
Forms of taxation ................................................................................................................. 51
Foreign corporations............................................................................................................ 52
US foreign tax credits (FTCs) ................................................................................................ 52
Transfer pricing and tax planning ........................................................................................ 53
Offshore finance subsidiaries .............................................................................................. 53
Chapter 18 – week 11 – Corporate Governance and the

International Market for Corporate Control.................................. 54
Ways to obtain control ........................................................................................................ 54
Corporate governance systems ........................................................................................... 54
Measures of gains ................................................................................................................ 54
Japanese Keiretsu ................................................................................................................ 55
Korean Chaebol .................................................................................................................... 55
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Mergers and acquisition ...................................................................................................... 55

Cross border determinants of M&A .................................................................................... 56
The international evidence on M&A.................................................................................... 56
Privatisation of state-owned enterprises (SOEs) in transition economies .......................... 57
Executive turnover and firm performance .......................................................................... 57
Tunnelling and the value of corporate control benefits...................................................... 58
Caveat .................................................................................................................................. 58
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Chapter 19 – Week 5 International Capital Markets
Capital markets are markets for long term assets and liabilities, with maturities greater than
one year. The most important components of the capital markets are publicly traded stocks
and bonds. Investments in internationally traded stocks and bonds are attractive for 2
reasons. First although much of the world’s wealth reside in the developed markets,
emerging markets are more likely to experience above-average economic growth. Second,
international diversification results in lower portfolio risk than purely domestic
diversification because of the relatively low correlations between national market returns.
Domestic and International bond markets

Domestic Bonds: issued by a domestic company, traded within that country’s internal
market, and denominated in the functional currency of that country. i.e. 10 year corporate
bond denominated in AUD issued by Rio Tinto on the ASX
International Bonds: traded outside of the country of the issuer:
• Foreign bonds: are issued in a domestic (internal) market by a foreign borrower,

denominated in domestic currency, and regulated by domestic authorities. I.e. Dell 5
year corporate bond denominated in AUD listed on ASX
• Eurobonds: traded in external bond markets outside the borders of the country
issuing the currency in which the bond is denominated. i.e. Dell 5 year corporate
bond denominated in AUD to a British bank in UK
• Global Bonds: trade as Eurobonds, as well as in one or more domestic bond markets.
Well known borrowers: include MNCs, governments and their agencies, and the World Bank.
Domestic and international stock markets

Although each national market retains its unique character, markets are converging in many
ways. The most visible change is in the way information is processed and disseminated.
Trades and prices are now tracked by computer and relayed around the globe to other
markets nearly instantaneously via satellite.
Global equity offerings: Cross listing shares on more than one stock exchange can increase
demand and enhance share price. i.e. US companies listing abroad experience less of an
adverse price reaction than similar companies issuing equity in the US. Non-US companies
listing in the US often increase in value.
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International Differences in securities regulation

Securities regulation in the US: companies issuing debt or equity securities to the US public
in amounts greater than $1.5 million are required to file a registration statement with the
Securities and Exchange Commission (SEC) that discloses all relevant information regarding
the transaction. This is subjected to 2 exceptions:
• Loans maturing within nine months

• Private placements: i.e. shares sold to large and sophisticated investors, shares sold
to only a few investors etc.
Securities Regulation in Japan: new public issues in Japan must be approved by the
Japanese Ministry of Finance. The Japanese government takes an active role in determining
which companies are allowed to issue securities and in regulating trade in these issues.
The 1995 ‘Big Bang’ allowed banks into investment banking and securities trading industries.
Securities regulation in the European Union: the EU passed a series of directives designed
to harmonise securities regulation and market operation across its member states.
• Capital requirements directive (CRD): protects savers and investors by specifying

minimum standards governing the amount of market risk a bank or securities firm
can take in relation to its capital base.
• Investment securities directive (ISD) provides investment firms based in EU member
states a ‘single passport’ to operate in other EU countries if they have the approval
of regulatory authorities in their home country.
• Market in financial instruments directive (MiFID) widens the scope of the ‘single
passport’ to trade in other financial contracts, such as commodity and credit
derivatives.
International investment vehicles, overcoming capital flow barriers

Invest in individual foreign securities: foreign investors can buy debt and equity in many
national markets. The costs and benefits of this route to international diversification depend
on the assets and investment vehicles chosen, and on capital flow barriers between
domestic and foreign markets.
Direct purchase in the foreign market: this is the most straightforward way to diversify
internationally. However, for small investors, there a several problems:
• Higher information costs on foreign assets

o Geographic distances
o Language and cultural differences
o Differences in taxation, accounting measurement, and disclosure conventions
• Higher transaction costs on foreign assets
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o Commissions on foreign trades are often higher than on domestic

transactions
o Dividends and capital gains received in a foreign currency must be converted
from the foreign currency into investors’ domestic currencies
o Differences in tax systems and tax rates, particularly local withholding taxes
on dividend or interest income from some countries
Direct Purchase in the domestic market: a growing number of MNCs are issuing shares
directly in the well developed equity markets of Europe, North America, and southeast asia.
Companies can list their shares on foreign exchanges as global shares or depository receipts.
• Global shares: represent a claim on a single class of stock issued in multiple markets
around the world. Even though they trade in a domestic market, global shares are in
fact foreign shares because they are fungible one for one with global shares trading
in other markets.
• Depository receipts: derivative securities that represent a claim on a block of foreign
stock held by a domestic trustee. Depository receipts are denominated in the
domestic currency, regulated by domestic authorities, and usually sold through a
domestic broker.
Professionally managed funds specialising in international assets:
• Mutual funds: small investors face formidable information and transaction costs in
international markets. These costs can be reduced by concentrating funds from
many investors in a mutual fund managed by one or a few professional portfolio
managers.
o Open end fund: the amount of money under management grows (shrinks) as
investors invest in (disinvest) the fund. (named managed funds in Australia)
o Closed end fund: funds under management are fixed and shares are traded in
the market like a depository receipt.
*A fund’s net asset value (NAV) is the sum of the individual asset values in the fund.
• Hedge funds: private investment partnerships or limited liability companies with a
general manager and a small number of limited partners. A typical hedge fund pays
the general partner a 2% manage fee and 20% of profits.
• Private equity: is a type of hedge fund that specialises in private companies. Private
equity strategies include buyouts and venture capital investments.
Index Derivatives: Provide a way to buy or sell international stock indices.
• Stock index options: traded on many international stocks and stock indices.
• A stock index (equity) swap is possible if another party can be found that wants to
swap into or out of a foreign market for a period of time.
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Portfolio investment styles

Asset allocation policy: refers to the target weights given to various asset classes in an
investment portfolio. A mutual fund’s asset allocation policy is the single most important
decision made by fund management.
Investment philosophy:
• Passive fund management: many passive funds are index funds that try to hold the
same proportion of stocks as a major market index. They are less costly to
implement and less risky than an actively managed portfolio invested in similar
assets, at least for the investor without above average skill. The disadvantage is that
returns are likely to be not much better than returns on a benchmark portfolio of
comparable risk.
• Active fund management: successful active fund management holds out the promise
of higher portfolio return and, by avoiding assets that fall in value, lower portfolio
risk as well. Actively managed funds follow one or both of the following investment
strategies:
o Active asset allocation (market timing): funds are shifted between asset
classes in anticipation of market events
o Active security selection (stock picking): funds are invested in stocks or bonds
that are considered to be under-priced by the marketplace and not invested
(or sold short) in those securities that are over priced by the marketplace.
Chapter 8 – Week 7 The Rationale for Hedging

Currency Risk
Firm value is determined by: = ∑

[[
]/(1 + )
]
Where [
] represent the firm’s expected cash flow at time , and let be the
appropriate risk adjusted cost of capital.
Therefore, to add value, hedging must either:
• Increase the firm’s expected future cash flows

• Reduce risk of those cash flows
Perfect market assumptions

• Frictionless markets: no transaction costs, government intervention, taxes, costs of
financial distress, or agency costs
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• Equal access to market prices: Perfect competition with no barriers to entry

• Rational investors: more return is good and more risk is bad
• Equal access to costless information: instantaneous and costless access to all public
information
• M&M Irrelevance proposition:
o If financial markets are perfect, then corporate financial policy is irrelevant
o If financial policy is to increase firm value, then it must either increase the
firm’s expected future cash flows or decrease the discount rate in a way that
cannot be replicated by investors.
Convexity in the tax schedule

Tax schedules are said to be convex when the effective tax rate is greater at high levels than
at low levels of income. In the presence of a convex tax schedule, MNCs can reduce their
expected tax payment by reducing the variability of investment outcomes.
Tax preference items: items such as investment tax credits and tax loss carry-forwards, that
are used to shield taxable income from taxes. Deductions for tax preference items generally
should be taken as soon as possible to maximise the present value of the tax shields.
The biggest incentive to hedge currency risks comes from a tax-loss carryforwards,
particularly for firms with volatile incomes that alternate between gains and losses.
*Suppose a US MNC has a taxable income of $300,000 or $1,500,000 with equal probability.
If hedged, the income would be $900,000 for certain.
If the company remains unhedged: the tax liability would be
1 1
× (20% × 300000) + × (30% × 1500000) = 213000
2 2
If the company is hedged, the tax liability will be:
900000 × (25%) = 198000
There is a tax saving of $15,000.
Costs of financial distress

Equity as a call option on firm value: a call option is an option to buy an underlying asset at
a predetermined exercise price and on a predetermined expiration or maturity date. Equity
holds a claim on any residual value after the debt has been paid its promised claim. In the
event of bankruptcy, the firm’s assets go first to the bondholders and then any remaining
value goes to equity.
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• In the absence of a market imperfection such as costs of financial distress, hedging

does not create value for the firm
• Risk shifting: when there is debt outstanding, hedging transfers wealth from
shareholders to debtholders
• Instituting hedging plan prior to borrowing can benefit shareholders b reducing
borrowing costs.
*Suppose that the firm value, in the absence of hedging is either $750 or $1750 with equal
probability. You have to pay a debt of $1000.
Unhedged: [ ! ] = (0.5)($750) + (0.5)($1000) = $875
[%
&' ] = (0.5)(0) + (0.5)($750) = $375
Total [()*+ ] = (0.5)($750) + (0.5)($1750) = $1250
Hedged: [ ! ] = $1000
. [%
&' ] = $250
Total [()*+ ] = $1250
The value of the firm’s assets has not changed; there is still $1250 between debt and equity.
However, the distribution of this value between debt and equity does change; debt is
certain to receive its promised payment of $1000, and equity is certain to receive the
residual value of $250. When exposure to currency risk is hedged, the net effect of hedging
is to transfer $125 of value from equity to debt.
Direct costs of financial distress:
Suppose directs costs of $500 are incurred if the company defaults on its debt. Using
previous example:
If the assets of the firm are worth $750, and the firm stills has to pay a debt of $1000, then
the firm is bankrupted. Therefore the firm has to pay $500 bankruptcy cost, and $250 (left
over) to debt, leaving nothing for the shareholders.
However, if the firm is hedged, it will eliminate currency risk and lock in a firm value of
$1250 with certainty, then debt always receives its promised payment of $1000 and stock
receives the $250 residual value. The firm can avoid the potential of a $500 direct
bankruptcy cost by hedging its exposure to currency risk.
Indirect costs of financial distress: financial distress affects all of the firm’s stakeholders,
including customers, suppliers, and employees, as well as debt holders, shareholders, and
managers. Financial distress affects operations in several ways:
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• Lost credibility: firms find it more difficult to sell their produces once rumours of an
impending collapse become public. This is especially true of products for which
quality and aftersale services are important.
o Lower revenues
o Higher operating costs
o Higher financial costs
• Stakeholder gamesmanship (conflicts of interest among the firm’s stakeholders)
In summary:
• Hedging can increase firm value and the expected cash flows available to debt and
equity by reducing the direct and indirect costs of financial distress
• Generally increase the value of debt by reducing the variability of operating cash
flows and ensuring that debt receives its promised payment
• Equity may or may not benefit from hedging, depending on whether the increase in
firm value is more or less than the transfer of value to the debt from the reduction in
risk
Agency Costs
Conflicts of interest between Managers and Other Stakeholders: manager’s objectives are
naturally different from those of other stakeholders. This leads to agency conflicts as
managers act nominally as agents for the firm’s stakeholders, but in actuality in their own
interests. Typically, managers are seldom as diversified as other stakeholders, as their
livelihood are intimately tied to their employer’s prosperity. On the other hand, debt and
equity stakeholders is diversified across a variety of assets in their investment portfolios.
This means that managers are concerned with the total risk of the company, whereas debt
and equity are more concerned with the contribution of the company to the risk of their
portfolios. Managers thus have an incentive to hedge against currency risk even if these
risks are diversifiable to other stakeholders.
Agency costs are costs of ensuring that managers act in the interest of other stakeholders.
Hedging can increase value of the firm to shareholders by aligning managements’ incentive
with shareholder’s objectives and thereby reducing agency costs.
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Chapter 9 Treasury Management of International

Transactions
As corporations grow beyond their traditional domestic markets and become multinational
in scope, they must develop a financial system capable of managing the international
transactions and currency risk exposures of the individual operating divisions and the
corporation as a whole.
The treasury serves as a corporate bank that manages cash flows within the corporation and
between the corporation and its external partners. It performs several functions pertinent
to its international operations:
• Determine the MNC’s overall financial goals and strategies

• Manage domestic and international trade
• Finance domestic and international trade
• Consolidate and manage the financial flows of the firm
• Identify, measure, and manage the firm’s exposures to currency risks
Steps in setting financial goals & strategies

1. Identifying the firm’s core competencies and potential growth opportunities
2. Evaluate the business environment within which the firm operates
3. Formulate a strategic plan for turning the firm’s core competencies into sustainable
competitive advantages
4. Develop robust processes for implementing the strategic business plan
Problems with international trade

International trade can be riskier than domestic trade because of a variety of reasons:
• Exporters must assure timely payment

• Importers must assure timely delivery of quality goods
• Geographic and cultural distances between buyers and sellers
• Trade disputes span several jurisdictions
Managing the costs and risks of international shipping

Cross border trade can be cumbersome and time consuming because of the logistics
involved in international shipping. The use of Trade Documents is important as it reduces
exposures to operating and financial risks:
• Commercial invoice * Packing list

• Certificate of origin *Export Declaration
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• Export license *Bill of lading

• Dock receipt *Warehouse receipt
• Insurance certificate *Inspection certificate
The rise of international package delivery services such as federal express has greatly
reduced the costs and risks of international shipments for many businesses.
Managing the costs and risks of international payment

Exporters must have assurance they will receive payment on the goods that they deliver.
Importers must have assurance they will receive the goods they have purchased. There are
4 ways that exporters can arrange for payment:
• Open account
• Cash in advance
• Documentary collections
• Documentary credits
Time of payment Goods available Risk to seller Risk to buyer

to buyer
Cash in advance Before shipment After payment Non (unless legal Relies on the
action is taken seller to ship
goods as agreed
Open account After shipment is Before payment Relies on buyer Non (unless legal
received to pay account as action)
agreed
Documentary • Payable • After Buyer may refuse • Same as
collection when payment to pay when letter of
• Sight buyer • Before documents are credit
draft presents payment presented, in • Legal
• Time draft which case goods conseque
draft • On must be returned nces if an
maturity of • Relies on accepted
draft buyer to draft is
pay draft; not
otherwis honoured
e same by the
as sight buyer
draft
Documentary Payable when After payment Low risk if seller Relies on seller to
credits shipment is made meets terms of ship goods
Letter of credit L/C issued or described in
(L/C) confirmed by a trade documents;
credit worthy can take time to
bank arrange
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All in cost of trade finance

Internal rate of return of the incremental cash flows associated with a financing alternative.
/.-6/4- 015ℎ 82/9

,-./0 122 − 4 0/5 = −1
:50/;4- 1;2-
*Suppose a 0.5% acceptance fee is charged on a $1million banker’s acceptance that is due in
3 months, which is sold at a discount of 1%:
Solution:
- The 0.5% fee is deducted at maturity, so the acceptance returns $995,000 at

maturity
$<<=>>>
= $985,149
?.>?
- This acceptance can be sold today for
$?,>>>,>>>
The all in cost is then B $<C=,?D<
E − 1 = 1.51% F-. 3 G/4ℎ5, or
88-0H- I44. J1- = (1.0151)D − 1 = 6.17%
Counter Trade
Also called barter or reciprocal trade – refers to a variety of barter-like techniques used to
exchange goods and services without the use of cash. Example include:
• Counterpurchase: one contract is conditional upon fulfilment of another.

• Offset: required as a condition of trade.
Cash Management
To effectively manage its financial resources, the MNC’s treasury must implement a cash
management system that tracks cash receipts and disbursements within the company and
with the company’s external partners.
Multinational Netting: a tool in which intra firm transfers are minimised by ‘netting’
offsetting cash flows in carious currencies.
Forecasting Cash Flows and Funds Needs: by tracking cash flows to and from the firm’s
external suppliers and customers and serving as a central clearinghouse for intra-firm
transactions, the MNC’s treasury is in an excellent position to forecast the funding needs of
the corporation. With accurate forecasts of cash requirements, the treasury can ensure that
each operating division has sufficient funds to run its operations.
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Relationship Management
Credit management: managing international credit relations is a good deal harder than
domestic relations because of cross-border differences in laws, business and accounting
conventions, banking relations, and political systems.
Transfer Pricing: all else constant, the multinational corporation has a tax incentive to shift
revenues toward low-tax jurisdictions and shift expenses toward high tax jurisdictions.
Transfer pricing should be made to benefit the firm as a whole.
Identifying divisional costs of capital: finance theory states that managers should use a
discount rate that reflects the market’s opportunity cost of capital in order to maximise
shareholder wealth. Treasury must be in contract with capital markets on a continuing basis,
and so is in a good position to identify required returns on new investments.
Currency Risk Management in the Multinational Corporation

*Example of FX exposure:
A US firm expects to receive 40,000 Polish zlotys(Z) in 1 year. The spot rate expected to
prevail in 1 year is [L? $/M ] = $25/Z. What effect will an annual spot rate of L? $/M = $20/N
have on the firm?
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Types of exposure to currency risk

Economic exposure: change in the value of all future cash flows from unexpected changes in
exchange rates
• Transaction exposure: change in the value of contractual cash flows from

unexpected changes in FX rates
• Operating exposure: Change in the value of non-contractual cash flows from
unexpected changes in FX rates
Translation (Accounting) exposure: change in financial statements from unexpected

changes in exchange rates
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The 5 steps of a currency risk management program

1. Identify exposures: identify those currencies to which the firm is exposed, as well as
the distribution of possible future exchange rates for each of these currencies.
2. Estimate sensitivities: Estimate the firm’s sensitivities to changes in these currency
values
3. To hedge or not to hedge: Determine the desirability of hedging, given the firm’s
estimated risk exposures and risk management objectives.
4. Evaluate alternatives: evaluate the cost/benefit performance of each hedging
alternative, given the forecasted exchange rate distributions and the firm’s
exposures to these exchange rates. Select and implement the hedging instrument or
strategy
5. Monitor performance: monitor the evolving exposures and revisit these steps as
necessary
Exchange rate forecasting for Active FX Risk Management

Model based forecasts:
• Technical analysis: uses the recent history of exchange rates to predict exchange
rates (short term)
• Fundamental analysis: uses macroeconomic data to predict exchange rates (Longer
term)
Chapter 10 – Week 8 Managing Transaction Exposure

to Currency Risk
Transaction exposure to currency risk is defined as change in the value of monetary

(contractual) cash flows due to an unexpected change in exchange rates. Nearly every
foreign currency transaction is exposed to this risk at some time.
Managing transaction exposures internally

Geographically diversified operations can provide a natural hedge of currency risk. Inflows
and outflows within that organisation often offset one another.
Multinational Netting: currency risk management in a multinational corporation beings

with this process of multinational netting in which currency transactions from within the
firm are offset and then netted. The multinational treasury can identify the exposure of the
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corporation as a whole by consolidating and netting the exposures of the firm’s operating
units.
Cash Flow before netting:
Cash flows after netting:
Leading and Lagging: refers to altering the timing of cash flows within the firm to offset
foreign exchange exposures.
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• Leading: if a parent firm is short euros, it can accelerate euro payments from its
subsidiaries
• Lagging: if a parent firm is long euros, it can delay euro payments to its subsidiaries
Leading and lagging can be beneficial to the firm, but it can distort rates of return earned by
the various affiliates. Leading or lagging creates an internal loan from one unit of the firm to
another. The best alternative for solving the incentive problems created by leading or
lagging is for treasury to charge market rates of interest on these intra-company deposits
and loans.
External hedging, Managing transaction exposure in financial

markets
When the MNC’s transaction exposures to currency risk do not offset internally, treasury
must consider hedging its exposures in the financial markets. Financial market hedges can
be matched to those of the underlying foreign currency transactions.
Instruments Advantages Disadvantages

Currency forwards Provides an exact hedge of Bid ask spreads can be large,
transactions of known date and especially on small
amount (near term or long transactions, long maturities
term) and in infrequently traded
currencies
Currency futures Low-cost hedge if the amount Exchange traded futures come
and maturity match the in a limited number of
underlying exposure; low risk currencies and maturities; daily
hedge because of daily marking marking to market can cause a
to market cash flow mismatch with
underlying exposure
Money market hedges Forward positions can be built Relatively expensive hedge;
in currencies for which there may not be possible if there are
are no forward markets constraints on borrowing or
lending in the foreign currecy
Currency swaps Low cost switch into other Innovative swaps are costly;
currencies or payoff structures may not be best choice for near
(e.g. fixed vs floating) term exposures
Currency options Disaster hedge insures against Option premiums reflect option
unfavourable currency payoffs, so this hedging
movements instrument can be costly
Currency Forwards:
*A US firm will receive 1million British pounds in a year, and the expected exchange rate is
L = 1.5$/£. How should the firm financially hedge?
Using a forward currency hedge: Underlying pound exposure = +£1,000,000
Short £ forward position = +$1,500,000
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-£1,000,000
The combination of the underlying exposure and the forward market hedge results in no net
£ exposure.
Many MNCs choose to hedge only a fraction of their exposures. i.e. Partial hedges.
Currency Forwards vs Futures contracts
Forwards Futures
Counterparty Bank Futures exchange
clearinghouse
Maturity Negotiated Standardised
Amount Negotiated Standardised
Fees Bid-Ask Commissions
Collateral Negotiated Margin account
Options: A pound call is an option to buy pounds. A long pound call is an option to buy
pounds sterling at a contractual exercise price.
• Option holder gains if pound sterling rises

• Option holder does not lose if pound falls
A short option hedge:
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A currency put option is an option to sell pounds, a long pound put is an option to sell
pounds sterling at a contractual exercise price.
• Option holder gains if pound sterling falls

• Option holder does not lose if pound rises
A put option hedge:
Currency swaps: a currency swap is an agreement to exchange principal amount of 2

currencies and, after a pre-arranged length of time, re-exchange the original principal.
(interest payments are also usually swapped during the life of the contract)
*Suppose you want to lock in pound cash outflows of £1million per year for the next several
years. Suppose further that $ = £ , and that $/£ = L $/£ = $1.50/£
I’ll pay you £1million each period, if you pay me $1.5million each period.
Money market hedge:
*Suppose you want to hedge a £1,000,000 cash inflow due in one year with a short pound
forward contract. Suppose further that
$ = 2.68%, £ = 2.02%, L> $/£ = $1.5000/£
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From interest rate parity, the forward exchange rate must be

$
$ L> £ P1 + $ Q
? £ = = $1.509704/£
1 + £
To create this short pound hedge without using the forward market, we must
1. Borrow £1,000,000R1.0202 = £980,200 1 £ = 2.02%
2. Covert to ,> $ = ,> £ L $/£ = (£980,200) S$1.50R£T = $1,470,300
3. Invest at $ = 2.68% / U-2 ($1,470,300)(1.0268) = $1,509,704
Treasury management in practice

Derivative usage: forward contract is often the instrument of choice when the size and
timing of the contractual cash flow is known in advance. Over 90% of these financial
managers had used forward contracts.
Active management of currency risk: about 10% of US derivative users report that they
‘frequently’ alter the size or timing of their financial hedges based on their market
expectations.
Benchmarking the performance of an actively managed hedge: Firms that actively manage
their exposures need toe evaluate their performance against a benchmark. Forward rates
are a simple and appropriate benchmark, as they reflect the market’s view of future spot
rates through forward parity and the opportunity costs of capital in the foreign and
domestic currencies through interest rate parity.
Evaluating the performance of active risk management: once a benchmark is selected, the
performance of a hedge or of a hedging program must be evaluated according to some
criterion.
Summary
Active treasuries:
• Tend to be large firms with centralised risk management

• Use sophisticated valuation methodologies such as value at risk for managing their
exposures
• Derivatives positions are periodically marked to market to reflect their market values
Active treasuries manage their managers:
• Managers’ actions are closely monitored
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• Firms use compensation contracts to align managers’ objectives with those of other
stakeholders
• Firms use derivatives specific controls such as performance benchmarks to manage
potential abuses
Chapter 11 – week 8 Managing Operating Exposure to

Currency Risk
Operating exposure is less visible than transaction exposure, but is often the more
important exposure. Operating exposure to currency risk is defined as change in the value of
nonmonetary cash flows (that is, the noncontractual cash flows of the firm’s real assets) due
to unexpected changes in currency values.
*Transaction exposure: For Motor will receive £1million from its UK customer 3 months
later
*Operating exposure: Ford Motor’s sales to its UK customer over next 5 years.
Operating exposure and the competitive environment

Market Segmentation versus Integration: Operating exposure to currency risk depend on
the extent of market segmentation or integration for the firm’s inputs and outputs. In an
integrated market, purchasing power parity holds so that equivalent assets trade for the
same price regardless of where they are traded. If PPP does not hold, then the market is at
least partially segmented from other markets. Common causes of market segmentation
include transportation costs, information costs or barriers, legal or institutional frictions,
governmental intervention in the form of taxes or tariffs, and other barriers to the free flow
of goods or labour.
Market integration/segmentation and Price determination: the degree of market

integration determines the extent to which the values of the firm’s real assets move with
foreign exchange rates.
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Operating Exposures to FX risk (in parentheses)
Revenues
Local Global
Operating Expenses
Local Domestic Firms (0) Exporters (+)
Global Importers (-) Global MNCs&
Importers/exporters
in competitive global
markets (+,-,0)
Domestic firms with revenues and operating expenses that are locally determined are the
least sensitive to currency movements. This is the case when local factor and products
markets are segmented from foreign markets.
Exporters face an exposure that is opposite that of importers. i.e. MNC with international
involvement through its revenue stream. The exporter manufactures goods in a local
economy and sells into competitive global markets. If the local market is segmented from
other markets, the exporter is positively exposed to foreign currency values. If the
exporter’s goods are sold in competitive global markets, both costs and revenues move with
foreign currency values.
Foreign Currency Foreign currency Net monetary assets

Monetary assets (40%) monetary liabilities exposed to FX risk
(20%) (20%)
Domestic currency Domestic currency
monetary assets (25%) monetary liabilities
(40%)
Operating exposure of Real assets (35%) Equity 40%
real assets 35%
*Suppose the foreign currency unexpectedly appreciates by 10%, resulting in a 10%
appreciation in both nominal and real terms.
Foreign currency Foreign currency Net exposed monetary

monetary assets (44%) monetary liabilities assets (22%)
(22%)
Domestic currency Domestic currency
monetary assets (25%) monetary liabilities
(40%)
Real assets exposed to Real assets (38.5%) Equity (45.5%)
FX risk (38.5%) =40%+2%+3.5%
This exporter has invested 35% of every dollar in real assets. The real assets of a classic
exporter are positively exposed to foreign currency values. As the foreign currency
appreciates in real terms, the purchasing power of foreign customers increase, if the
exporter retains its sale price in the foreign currency, then its contribution margin will
increase on the same sales volume. Alternatively, if the exporter retains its existing sales
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price and contribution margin in the domestic currency, then a foreign currency
appreciation results in a drop in the foreign currency price and export volume should rise. In
either case, the value of the exporter in its domestic currency should rise.
Market based measures of the exposure of shareholder’s equity

Exposure as a regression coefficient: viewed from outside the firm, the exposure of equity
to currency risk can be estimated by the slope coefficient in a regression of stock returns on
changes in the spot exchange rate.
.
=∝ + W X 5
/X
+ Y
Where .
= equity return in the domestic currency d in period t
5
/X
= percentage change in the spot exchange rate during period t
Market based estimates of currency exposure
Managing operating exposure in the financial markets

Financial market hedging alternatives: transaction exposures are mostly short-term in
nature. In contrast, operating exposures typically have a very long time horizon. Financial
market hedges of operating exposures should be long lived – or at least renewable – to
match the maturities of the underlying exposures.
An exporter’s financial market hedging alternatives: exporters typically have operating

cash inflows denominated in one or more foreign currencies. These foreign currency inflows
can be at least partially hedged by securing foreign currency cash outflows through the
financial markets. Alternatives are:
• Sell the foreign currency with long dated forward contracts

• Finance foreign projects with foreign debt
• Use currency swaps to acquire financial liabilities in the foreign currency
• Use a rolling hedge to repeatedly sell the foreign currency forward
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An importer’s financial market hedging alternatives: importers buy their goods from
foreign suppliers and have obligations in foreign currencies. Alternatives are:
• Buy the foreign currency with long dated forward contracts

• Invest in long dated foreign bonds
• Use currency swaps to acquire financial assets in the foreign currency, such as with a
swap of existing foreign currency debt for domestic currency debt.
• Use a rolling hedge to repeatedly buy the foreign currency with a series of
consecutive short term forward or futures contracts.
Advantages and disadvantages of financial market hedges:
• Advantages
o Most financial market instruments are actively traded and liquid
o In efficient markets, financial transactions are zero-NPV transactions
• Disadvantages
o A financial market hedge provides an imperfect hedge of operating exposure
of currency risk
Managing operating exposure through operations

Types of operational hedges:
• Plant location: the MNCs can gain an advantage over domestic rivals by securing low
cost labour, capital, or resources through its plant location decisions. These decisions
must consider a number of local factors, including labour costs, labour and capital
productivities, taxes and tariffs, and legal, institutional and social infrastructures.
• Product sourcing: shift production to countries with low real costs Importers and
MNCs with a global manufacturing base or established networks of foreign suppliers
can respond more quickly than domestic competitors to real changes in currency
values. As local real costs or exchange rates change, MNCs can shift production
toward locations with the lowest real costs. Diversifying production across countries
also hedges against exposures to political risk.
• Market selection and promotion: shift marketing efforts toward countries with
higher demand or ‘over valued’ currencies when local markets are segmented
from global competition, local prices and costs are slow to adjust to real changes in
exchange rates. In these circumstances, a real appreciation of a foreign currency
benefits exporters by increasing the purchasing power of foreign customers. In the
presence of real exchange rate changes, globally diversified MNCs can shift their
marketing efforts towards countries with overvalued currencies and thus create a
spectrum of favourable pricing alternatives.
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Advantages:
• Operating hedges create a fundamental change in the way the MNC does business
and thus a long lasting change to the company’s currency risk exposure
• With established international relations, the MNC is in a good position to take
advantage of international opportunities as they arise
Disadvantages:
• Operating hedges are seldom zero-NPV transactions
Pricing strategy and the firm’s competitive environment

*an appreciation of the euro increases the purchasing power of euro-zone customers
A Japanese exporter’s pricing alternatives include:
• Hold the euro price constant: sell the same quantity at a bigger yen profit margin per
unit
• Hold the yen price constant: lower the euro price and capture higher sales volume
The price elasticity of demand:

∆[ ∆\
Optimal pricing depends on the price elasticity of demand = − B E B E
[ ]
•
• Measures the sensitivity of quantity sold to a percentage change in price
o Price elastic demand: a small change in price results in a large change in
quantity sold, so lower the price
o Price inelastic demand: a small change in price results in an even smaller
change in quantity sold, so hold the price constant.
Pricing strategy in international markets:
• The optimal pricing strategy for this Japanese exporter depends on the price
elasticity of demand for its products
o If demand is price elastic, then the firm is indifferent between maintaining
the $10 price or maintaining the S$20 price
o If demand is price inelastic, then the firm is better off maintaining the $10
price
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Chapter 12 – week 9 Managing translation exposure

and accounting for financial transactions
In its consolidated financial statements, a parent company with foreign operations must
translate the assets and liabilities of its foreign subsidiaries into its reporting currency.
Translation (accounting) exposures refers to the impact of exchange rate changes on the
parent firm’s consolidated financial statements.
Balance sheet translation exposures

• Foreign assets and liabilities translated at the current exchange rate have a
translation exposure to currency risk
o Foreign currency assets are positively exposed to the foreign currency value
o Foreign currency liabilities are negatively exposed to the foreign currency
value
• Foreign assets and liabilities translated at historical exchange rates do not have a
translation exposure to currency risk
Translation accounting
Financial accounting strives for 2 goals:
• Reliability: verifiable & accurate representation

• Relevance: timely & predictive in nature
These objectives can be in conflict when the market values of assets or liability are
unobservable.
Methods of translation
Current/noncurrent method in use in US prior to 1976
Monetary/nonmonetary or temporal method used in 1976
The current rate method used in 1982
Current/Noncurrent:
1. Current assets and liabilities are translated at the current exchange rate
2. Noncurrent assets and liabilities are translated at historical exchange rates
3. Most income statement items are related to current assets or current liabilities and
are translated at the average exchange rate over the reporting period
4. Depreciation is related to noncurrent assets and is translated at historical excahgne
rates.
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*current exchange rate is the one prevailing on the date of the financial statement.
Historical exchange rates are those that prevailed when items were first entered into the
accounts.
Temporal:
1. Monetary assets and liabilities are translated at the current exchange rate
2. All other assets and liabilities are translated at historical exchange rates
3. Most income statement items are related to current item and are translated at the
average exchange rate over the reporting period
4. Depreciation and COGS are related to real assets and translated at historical
exchange rates
*problems with this method: translation gains or losses were reflected in reported earnings
on the income statement
• Changes in translated balance sheet accounts could overwhelm operating

performance, sometimes resulting in operating losses even during profitable years
• This resulted in large swings in reported earnings.. swings over which managers had
no control
Current rate:
1. All assets and liabilities except common equity are translated at the current
exchange rate
2. Common equity is translated at historical exchange rates
3. Income statement items are translated at a current exchange rate
4. Any imbalance between the book value of assets and liabilities is recorded as a
separate equity account called the cumulative translation adjustment (CTA)
A comparison of translation methods
Current/noncurrent Temporal Current rate
Assets
Short term financial Current Current Current
Long tern financial Historical Current Current
Real assets Historical Historical Current
Liabilities/OE
Short term debt Current Current Current
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Long term debt Historical Current Current
Net worth (equity) Historical Historical Historical
Translation gains or Flowed through the Flowed through the Accumulated

losses income statement income statement as a CTA
Which translation method is the most realistic?

They issue whether the real assets of a foreign subsidiary should be translated at historical
exchange rates in temporal method or at the current exchange rage as in current rate. The
answer depends on the firm’s operating exposure to currency risk. The temporal method
assumes the real assets of a foreign subsidiary are unaffected by exchange rates. The
current rate method assumes real assets have a one to one exposure to exchange rates. For
most firms, its in between.
Information based reasons for hedging translation exposure

In a perfect financial market, the firm’s borrowing capacity and require return on
investment are determined in the marketplace by rational, informed investors. Managing
translation exposures that do not involve cash flows will not add value to firm
In the real world of imperfect markets, there are situations in which translation exposure to
currency risk can have valuation-relevant consequences above and beyond the firm’s
economic exposures.
3 practical reasons for hedging translation exposure to currency risk:
1. Satisfying loan covenants: loan covenants often require that a firm maintain certain
levels of performance, such as in operating profit or interest coverage. Violation of a
loan covenant can lead to a reduction in borrowing capacity. A hedge of translation
exposure can ensure that the corporation retains access to funds.
2. Meeting profit forecasts. A firm that has announced a profit forecast might wish to
retain its credibility with analysts and investors by hedging against a translation loss.
3. Retaining a credit rating: managers have an incentive to hedge translation exposure
if the firm’s credit rating depends on accounting profits and not just on its underlying
cash flows.
Cross country differences in hedging of translation exposure

There are cross country differences in the perceived importance of translation exposure to
currency risk. Reasons for these cross country differences in hedging policies appear to be
related to differences in national financial reporting standards, the relative importance of
financial accounting statements, and corporate policies controlling derivatives usage.
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Policy recommendations
• Only hedge economic exposures, unless there is an economic reason for hedging
translation exposure
• Use local sources of capital whenever possible
• Performance evaluation and compensation should be structured to insulate line
managers from FX risk
• If hedging translation exposure is deemed necessary, treasury should quote market
prices
o Net transaction or operating exposures can be hedged in external financial
markets
o Noncash exposures may be hedged internally, but typically should not be
hedged externally
Accounting for derivative instruments and hedging activities

1. Derivatives assets and liabilities that should be reported in financial statements, and
not hidden from the public
2. Fair (market) value is the most relevant measure of value
3. Only assets and liabilities should be reported as such. Income and expenses should
be reported on the income statement
4. Special accounting rules should be limited to qualifying hedge transactions
Chapter 13 – week 9 Foreign Market Entry and

Country Risk Management
One of the most important risks facing the multinational enterprise is country risk – the risk
that the business environment in a host country will change unexpectedly. The 2 most
important sources of country risk are:
• Political risk: the risk that a sovereign host government will unexpectedly change the
rules of the game under which businesses operate.
• Financial risk: refers to unexpected events in a country’s financial or economic
situation.
• Macro risks: affect all firms in a host country
• Micro risks: specific to an industry, firm or project in a country
• Business environment factors
o Local content/labour regulations
o Protection of IP rights
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o Protectionism
• Political environment factors
o Civil war
o Corruption
o Terrorism
o Racial/ethnic tensions
• Other factors:
o Loan defaults or loan restructurings
o Payment delays
o Cancellations of contracts by a host government
Examples of country risk:
• Expropriation: more likely after a regime change

• Disruptions in operation: often from changes in laws or regulations
• Protectionism: affects local consumption
• Blocked funds: cannot be immediately remitted to the parent
• Loss of IP rights: can be a problem in transitional economies
Strategic entry into international markets
The risks of multinational operations as a function of the MNC’s knowledge of, or

experience with, a foreign market. Unfamiliarity with a market is the biggest obstacle to
entry, so companies tend to first enter countries that are culturally close.
Modes of foreign market entry

Export or import entry: relies on domestic production and foreign sales or vice versa.
Exporters cannot rely on the sympathy of host governments, so import barriers and foreign
political risks can be high. On the other hand, exporters do not have to worry about barriers
to investment in the foreign market, and production technology is safely kept at home.
There are 2 effective approaches to market entry:
• Agents or distributors: a relatively low risk mode of export entry is to use a sales
agent or distributor to handle marketing and distribution in the foreign market.
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Hiring an agent requires little commitment in time or capital on the part of the
exporter.
• Foreign sales branches or subsidiaries: as they become more familiar with foreign
markets, exporters often take a more active role in marketing and distribution
through a foreign branch or foreign subsidiary. Foreign subsidiaries are incorporated
in the host country, whereas foreign branches are treaded as part of the parent
rather than as a separate legal entity in the host country.
Contract based entry: in an international license agreement, a domestic company (the

licensor) contracts with a foreign company (the licensee) to market the licensor’s product in
a foreign country in return for royalties, fees, or other compensation.
Licensing has several advantages for the MNC. It provides rapid and relatively painless entry
into foreign markets without a large resource commitment. Licensed products and services
are produced in host country, so import quotas or tariffs are not a hindrance and political
risk is low. However, returns can be limited.
Investment based foreign market entry: manufacturing firms typically use exports for their
initial entry into international markets. Unless the MNC already has experience exporting to
a particular market, investment based entry typically comes later in the product life cycle,
usually when the product is in the mature stage in its domestic market. Investment into
foreign markets can be accomplished in several ways:
• Foreign direct investment: building productive capacity directly in a foreign country

is called FDI. An important advantage of FDI is that it can provide a permanent
foothold in the foreign market. The principal disadvantage is the higher resource
commitment of the parent.
• Cross border mergers and acquisitions: in a cross border merger or acquisition, a
domestic parent acquires the use of a productive asset in foreign country through
one of 3 ways:
o Cross border acquisition of assets
o Cross border acquisition of stock: buy equity interest in a foreign company.
o Cross border merger: 2 firms pool their assets and liabilities to form a new
company.
• International joint venture: an investment based agreement in which 2 or more
companies pool their resources in order to execute a well defined mission. A new
company is usually created to achieve that mission. Once a foreign partner has
acquired the technology necessary for production, the incentive to act opportunistic
and violate the terms of the agreement can be great.
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Strategies for managing country risk

Negotiating the environment: before investment, the MNC must negotiate with the host
government to create an environment that maximises its expected return on investment
while minimising exposure to political and financial risks.
Things that should be negotiated:
• Tax rates, tariffs etc

• Concessions that grant the MNC privileged access to restricted markets (agreement
restricting competing firms)
• Obligations to undertake tie-in projects (infrastructure projects like airports,
shipyards, schools etc)
• Rights or restrictions on import from, or exports to, other markets.
• Provisions for planned divestiture of the investment
• Allowable uses of expatriate managers or technicians to run local operations
• Assurances of performance on the part of the MNC and the host government
Financial environment:
• Rules governing remittance of cash flows from affiliates to the parent corporation
o Transfer prices
o Management fees
o Royalties
o Loan repayments
o Dividends
• Access to capital markets in the host country
• The possibility of subsidised financing from the host government
• The corporate governance environment
o Host country restrictions on ownership of the local subsidiary
o Remedies in the case of non-performance or default by either party
o Provisions and venues for the international arbitration of disputes
Political risk insurance

Insurance contracts, such as insurance against political risk, are a form of put option, i.e. an
option to sell an underlying asset at a specified exercise price on or before a specified date.
MNCs that have geographically diversified operations and cash flows in a large number of
countries and currencies are, in essence, self-insuring. Less diversified companies have
greater need of political risk insurance.
Insurable Risks: an insurable risk would possess the following
• The loss is identifiable in time, place, cause and amount
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• A large number of individuals or businesses are exposed to the risk, ideally in a

independently and identically distributed manner.
• The expected loss over the life of the contract is estimable, so that the insurer can
set reasonable premiums
• The loss is outside the influence of the insured.
Insurable political risks include:
• Expropriation due to
o War
o Revolution
o Insurrection
o Civil disturbance
o Terrorism
• Repatriation restrictions
• Currency inconvertabilitiy
Political insurers:
• International agencies
o The world bank – Multilateral investment guarantee agency
• Government export credit agencies
• Private insurers (AIG etc)
Planning for disaster recovery

Once invested, the firm must work with its foreign partners in business and government to
minimise the adverse consequences of political or financial events. Country risks include
unexpected loss of foreign assets – including key personnel – from natural or man made
sources of risk.
*Recovery plans are commonplace in the IT industry, where failure of a server or database
can have disastrous consequences for business operations.
Intellectual property rights

At the root of the MNCs competitive advantages are its ownership specific IP rights. In order
to encourage innovation, most governments allow protection of specific IP rights for a fixed
length of time after their creation.
• Patent: government approved right to make, use, or sell an invention for a period of
time
• Copyright: prohibits the unauthorised reproduction of a creative work
• Trademark: is a distinctive name, word, symbol or device used to distinguish a
company’s goods or services
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• Trade secret: is an idea, process, formula, device, technique or information that a

company uses to its advantage.
Ways to limit exposures to loss

Find the right partner: develop and nurture your relationships with your foreign partners
Limit your risk/exposure:
• Limit the scope of technology transfer by contract, or to only nonessential parts

• Limit dependence on any single partner
• Use only assets near the end of their life cycle
• Use only assets with limited growth options
• Trade one technology for another
• Acquire the foreign partner
Chapter 14 – week 10 Cross border capital budgeting
In principle, capital budgeting for cross border investments is no different from capital
budgeting for domestic investments. From the viewpoint of the parent firm, project value is
still equal to the present value of expected future cash flows from the investment
discounted at an appropriate risk-adjusted cost of capital. Projects should be undertaken
only if the present value of the expected future cash flows from investment exceeds the
cost of the initial investment.
However, cross border projects usually involve one or more foreign currencies, involve
capital flow restrictions that block funds in a host country, project specific subsidies
provided by a host government, or project specific penalties imposed by a host government.
Cross border investments may have difference values to local investors than to domestic
investors if the international parity conditions do not hold.
Domestic capital budgeting recipe

1. Identify the expected future cash flows [
] generated over the life of the
investment, as well as the initial cost of investment > .
2. Identify the discounted rate appropriate for the risk of the cash flows
3. Discount the expected future cash flows at the risk-adjusted discount rate
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For a project that lasts T periods, net present value is given by

_
> = ^[[
]/(1 + )
]

`>
Rules when estimating future cash flows

• Include only incremental cash flows: cash flows that are associated with the project
in the capital budgeting analysis. Sunk costs that have already been spent, for
instance, should not be included in the analysis.
• Include all opportunity costs: if building a manufacturing plant in Malaysia reduces
sales from your Indonesian plant, then the cash flows associated with the reduction
in sales from the Indonesian plant should be incorporated into the decision to invest
in Malaysia.
Rules when risk adjusted discount rate

• Discount cash flows in a particular currency at a discount rate in that currency
• Discount nominal (real) cash flows at a nominal (real) discount rate
• Discount cash flows to equity (debt) at the cost of equity (debt)
• Discount cash flows to debt and equity at a weighted average cost of capital

Calculate net present value 0 based on expected future cash
flows and the appropriate risk-adjusted discount rate
There are 2 ways:
1. Discount in the foreign currency at X and convert the foreign currency NPV to a
domestic currency value > | X at the spot exchange rate L> /X
2. Convert foreign cash flows into the domestic currency at expected future spot rates
and then discount at the domestic rate to find |
Discount in foreign currency: Steps
1. Estimate future cash flows b

X c
2. Identify X
3. Calculate net present value > | X
o Calculate > X = ∑_
`>[[
X ]/(1 + X )
]
o Convert to the domestic currency
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Discount in the domestic currency: Steps

e
1. Estimate b
c = dL
f g b
X c
2. Identify
3. Calculate net present value > |
The international Parity Conditions & Cross border capital

budgeting
If the international parity conditions hold, the value of a foreign investment project is the
same whether discounting is done in the foreign or in the domestic currency.

hL
X i

X 1+ 1 + [F ]
=h i =h i =
1+ X 1 + [F X ]
L> X L> X
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Investment & Disinvestment cash flows (in Neverland crocs)
Operating cash flows (in Neverland crocs)
Discounting in crocs:
Discounting in pounds:
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Disequilibria in the international parity conditions

• The project’s (foreign) perspective
o Let > | X represent the value of a foreign project when discounted in the
foreign currency
• The parent’s (domestic) perspective
o Let > | represent the value of a foreign project when discounted in the
domestic currency
These 2 NPVs may not be equal when the international parity conditions do not hold
When parity doesn’t hold:
• > | X > 0 the project has value from the perspective of a foreign investor (that
is, relative to alternatives in local financial markets
• > | > 0 the project has value from the perspective of the parent
Different perspectives:
Parent’s Perspective in the domestic currency
> | < 0 > | > 0
Project’s > | X < 0 Reject Reject, but keep looking
Perspective This is a loser anyway you Favourable FX rates suggest

look at it that you keep looking for
In the
good investments in the
foreign
foreign currency
currency
> | X > 0 Accept & structure the Accept & Structure the deal
If > l > > l X , hedging

deal
Lock in the positive local yields lower risk & lower

value e.g. through FX expected return
hedging or foreign
currency financing If > l < > l X , hedging
yields lower risk & higher
expected return
Alternatives for capturing the time t=0 value of a foreign project
• In the asset markets

o Sell the project to a local investor
o Bring in a joint venture partner
• In the financial markets
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o Hedge the cash flows from the project against currency risk
o Finance the project with local currency debt or equity
• If foreign cash flows are certain, then you can create a perfect hedge
• If foreign cash flows are uncertain, then forward hedges are imperfect hedges
Special circumstances in project valuation

\*mn&
o)
p !) n nXXn&
= \*mn&
o)
pq
!) n nXXn&
+ !) n nXXn&
Side effects that are commonly attached to international projects include:
• Blocked funds: cash flows generated by a foreign project that cannot be

immediately repatriated to the parent firm because of capital flow restrictions
• Subsidised financing: mirror image of blocked funds, governments of developing
countries are sometimes willing to provide loans at subsidised rates in order to
stimulate foreign direct investment.
• Expropriation risk: extreme form of political risk in which a host government seizes a
company’s assets. Usually a country specific risk that is diversifiable in a global
portfolio.
• Tax holidays: developing countries are often willing to offer tax holidays to promote
investment. (in the form of reduced tax rate for a period of time on corporate
income from a project
• Negative NPV tie in projects: developing countries often require that foreign
companies take on additional negative NPV development or infrastructure projects
in order to gain access to positive NPV investments elsewhere in the economy
*Example of blocked funds
50% of operating CF is blocked in years 1-3

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After tax opportunity cost of blocked funds
= Cr28,226 – Cr20,816 = Cr 7410
]*mn&
o)
p !) n nXXn&
= \*mn&
o)
pq
!) n nXXn&
+ !) n nXXn&
= (-Cr137)+(-Cr7410)
= -Cr7547 < Cr0
Or -£1887 at L r*/£ = .4/£
*Example of subsidised financing
Market rate: Wendy can borrow Cr40000 for four years at the corporate bond rate of 40%
(0.4)(.40000) = .16000 in annual interest expense
Subsidised rate: Hook will loan Wendy Cr40000 for four years at Hook’s borrowing rate of
37.5%
(0.375)(.40000) = .15000 in annual interest expense
This yields Cr1000 in annual interest savings, or an after tax interest savings of
(.1000)(0.5) = .500
Value of financing subsidy
Annual after tax interest savings of Cr500
Valuing Wendy’s annual after tax interest savings at the 20% after tax cost of debt, this
subsidy is worth Cr1295 today.
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Expropriation risk
Suppose there is an 80% chance Hook will expropriate the asset at time t=4
The expected after tax loss is then
= (,./s1s2U /8 2/55)(10;12 − -tF-0-) = (0.8)(−.68700) = −.54960
The expected loss in value can be found by discounting in crocs or pounds
Chapter 15 – week 10 Multinational Capital Structure

and Cost of Capital
Capital structure refers to the proportions and forms of long term capital used to finance
the assets of the firm. Management must choose the amount of debt, its currency of
denomination, maturity, seniority, fixed or floating rates, convertibility or callability options,
and indenture provisions. Capital structure is an important determinant of the firm’s overall
cost of capital; that is, investors required return on long term debt and equity capital.
Capital structure and the cost of capital

Capital structure in a perfect world: MM began with an assumption of perfect markets
MM’s irrelevance proposition: with equal access to perfect financial markets, individuals can
replicate any financial action that the firm can take. This leads to MM’s famous irrelevance
proposition: if financial markets are perfect, then corporate financial policy is irrelevant.
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• Frictionless markets
• Equal access to market prices
• Rational investors
• Equal access to costless information
• Homogeneous business risk classes
• Homogeneous investor expectations
• Perpetual cash flows
The 2 most popular approaches to project valuation and the cost of

capital
1. WACC=Weighted average cost of capital
2. APV=Adjusted present value
• Always use an asset specific discount rate
o Discount nominal cash flows at a nominal discount rate
o Discount real cash flows at a real discount rate
o Discount domestic currency cash flows at a domestic currency discount rate
o Discount foreign currency cash flows at a foreign currency discount rate
Weighted average cost of capital (WACC)
E[CF{ ]
uvw = ^ h i
{ (1 + i}~ ){
%
.rr = B%E (1 − r ) + B%E %
B = the market value of corporate bonds
S = the market value of corporate stock
= required return on corporate bonds
% =required return on corporate stock
r = Marginal corporate tax rate
*Mount Gibson will issue $133 in debt and $67 in equity. The tax rate in the US is 50%.
The debt cost is 5% and the equity cost of capital is 25%

?
WACC = 5%(1 − 50%) B>>E + 25% B>>E = 10%
Adjusted present value (APV)
I, = + ,(8414046 5- -88-05) − 412 4H-5G-4
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Where
= The value of the unlevered, all equity project
PV(financing side effects) = value of tax shields from the use of debt, net of the expected
costs of financial distress
*Another mine in the US has an unlevered present value $190. The present value of
financial side effects is $60. The initial investment cost is $200
I, = $190 + $60 − $200 = $50
International evidence on capital structure:

• Leverage increases with
o Asset tangibility
o Firm size
• Leverage decreases with
o Growth opportunities
o Profitability, especially in emerging markets
Financial market integration

In an integrated financial market, real after tax rates of return on equivalent assets are
equal.
Factors leading to financial market segmentation:
• Different legal and political systems

• Prohibitive transactions costs
• Regulatory interferences
• Differential taxes
• Informational barriers
• Differential investor expectations
• Home asset bias
Total vs systematic risk

The total operating risks of foreign investment are greater than on similar domestic
investments because of additional cultural, political and financial risks. International
markets are never completely synchronous with the world market or with the MNC’s home
market. Consequently, an increase in total risk on foreign investment may or may not be
offset by a decrease in the correlation of investment returns with market returns.
• Only systematic or non-diversifiable operating risks should be reflected in capital

costs
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o Capital costs are increased if these risks are positively related to the market
portfolio
o Capital costs are decreased if these risks are negatively related to the market
portfolio
• Operating risks that are unsystematic or diversifiable should not be priced by
investors and should not be reflected in capital costs
Returns and risks in emerging markets

Country risks and equity returns
• Equity returns are related to country risks

o Prices go up (down) following a decrease (increase) in country risk
o Countries with high country risk tend to have more volatile returns
o Countries with high country risk tend to have lower betas (systematic risks)
this is due to the low correlations of emerging markets with the world
market portfolio tend to overcome the high volatilities of emerging markets,
resulting in lower systematic risks or betas in emerging markets than on
comparable assets in developed markets.
Liberalisations of emerging capital markets: a capital market liberalisation is a decision by a

government to allow foreigners to purchase local assets. They tend to
• Increase the correlation of emerging market and world market returns

• Have little impact on emerging market return volatility
• Decrease local firm’s capital costs by as much as 1%
Estimating the cost of capital in a emerging market

Emerging markets vary in their informational efficiency and integration with other markets.
No single theory has been able to successfully model required returns in all situations
• International CAPM: it is appropriate in a world where all capital markets are

integrated.
• Globally nested CAPM: required returns in this model are a function of a country’s
systematic risks relative to the world stock market portfolio plus the country’s
systematic risk relative to regional risk that is not included in the world market
portfolio return
• Country risk rating model: required returns are based on the world stock market
portfolio plus a country specific risk adjustment
• Relative standard deviation model: required returns are a function of a country’s
standard deviation of return relative to the standard deviation of US returns.
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Sources of funds for multinational operations

Corporation often follow a pecking order as they raise funds:
1. Internally generate funds from domestic or international operations are the

preferred source
2. External debt is the preferred external funding source
3. New external equity is used only as last resort
Internal sources of funds: cash flows from operations, including tax shields. They are
preferred because they are free cash flows; that is, cash flow in excess of that needed to
finance the firm’s positive NPV activities.
Vehicles for repatriating internal funds from a foreign affiliate to the parent include:
• Transfer prices on intra company sales

• Interest or lease payments to the parent on loans or lease agreements
• Royalties, management fees, or dividend payments paid to the parent
Problem: if the parent wants to withdraw funds from the foreign subsidiary, it can set high
transfer prices on intracompany sales to the subsidiary or low prices on the purchases from
the subsidiary. To avoid abuse of the tax code, most countries specify that transfer prices
be set at arm’s length or market prices. Many countries place a limit of 5% of sales on
royalties to the parent.
External sources of funds
Firms without internal sources of funds must tap external sources to fund their operations.
MNCs have access to international as well as domestic sources of debt and equity capital.
An international investor base can lead to several potential benefits:
• Enhanced visibility in foreign markets

• Reduced political risk (greater support from investors in their local markets)
• Greater liquidity for the MNCs debt and equity securities
• Greater access to local companies and assets
• A lower cost of capital
The costs and risks of international sources of funds include:
• Language differences and other information barriers

• Capital flow restrictions in some countries
• Greater disclosure requirement on some international exchanges
• Filing and listing fees
• Differences in legal systems, and exposure to judicial processes in foreign markets
• Dilution of domestic ownership and control
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Sources of funds for multinational operations
Internal sources External sources
MNC’s home country Cash flow from parent or affiliates New debt or equity financing
in the parent’s home country (perhaps issued or guaranteed
by the parent firm)
Foreign project’s host Cash flow from existing operations Local debt or equity from host
country in the host country country markets or institutions
International financing Cash flow from other foreign Project finance Eurobonds
sources affiliates euroequity
Registered vs bearer securities
Securities in the US and Japan are issued in registered form, while the convention in the
western European countries is to issue securities in bearer form.
Targeted registered offerings
This allows US corporations to issue bearer securities to international investors. 4

requirements must be satisfied:
1. The owner must be a financial institution

2. Interest or dividends are paid to the registered financial institution
3. The issuer certifies it has no knowledge of US taxpayers owning the security
4. Issuer and the registered foreign institutions must follow SEC certification
procedures
Global equity issues
Corporations increasingly appeal to investors by offering equity securities directly in foreign

markets. Equity issues that are offered directly to investors in international markets are
called global equity issues.
Domestic markets tend to reach negatively to equity issues, including IPOs & SEOs, in both
the short and long run.
• The usual explanation is that equity issues signal managers’ belief that equity is
overvalued
• Global equity offerings do no appear to suffer the same degree of post issuance
underperformance as domestic issues
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Project finance
Allows a project sponsor to raise external funds for a specific project, distinguishing
characteristics:
• The project is a separate legal entity and relies heavily on debt financing
• The debt is contractually linked to the cash flow generated by the project
• Governments participate through infrastructure support, operating or financial
guarantees, rights of way, or assurances against political risk
Chapter 16 – week 11 – Taxes and Multinational

Corporate Strategy
Multinational tax planning can be a major source of value for the MNC because of national
differences in tax rates and systems.
The objectives of national tax policy

National tax policy refers to the way in which a nation chooses to allocate the tax burden
across its residents.
Tax neutrality: There are 2 forms of tax neutrality for multinational corporations
• Domestic tax neutrality: is a situation in which incomes arising from the foreign and
domestic operations of a domestically based multinational corporation are taxed
similarly by the domestic government. I.e. GM’s US and European operations are
taxed at the same rate.
• Foreign tax neutrality: is a situation in which taxes imposed on the foreign
operations of domestic companies are similar to those facing local competitors in
the foreign countries. i.e. BMW’s US operations are taxed in the same rate as GM’s
US operations.
Tax neutrality preserves equality by ensuring that an undue tax burden is not differentially
imposed on foreign or domestic operations.
Violations of tax neutrality

In practice, tax neutrality is almost impossible to achieve because of cross border
differences in tax rates and systems. Differential taxes influence a number of corporate
decisions, including the firm’s choices of asset classes, financing instruments, and
organisational forms.
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• Different tax jurisdictions: income received from different tax jurisdictions is often
taxed at different rates.
• Different asset classes: income received from different types of assets in the same
tax jurisdiction, such as active business income vs passive investment income, is
often taxed at different rates or at different times.
• Different financing instruments: returns on financial securities are taxed differently
depending on whether the security is debt, equity, a debt equity hybrid or an equity
linked security.
• Different organisational forms: income received from different legal organisational
forms often is taxed at different rates or in different ways. (i.e. corporation vs
partnerships)
Forms of taxation
The major issues in international taxation revolve around the fact that foreign source
income falls in 2 or more tax jurisdictions. Countries apply 1 of 2 tax regimes to income
earned by firms incorporated within their borders.
1. Worldwide tax system: foreign source income is taxed by the home country as it is
repatriated to the parent. Income from foreign subsidiaries usually is not taxed until
it is repatriated, as long as it is reinvested in an active business outside of the home
country.
2. Territorial tax system: imposes a tax only on income that is earned within the
borders of the country, regardless of the location of the taxpayer’s incorporation or
operations.
Many countries follow a worldwide tax system for residents and territorial system fr non
residents.
Explicit taxes:
• Corporate and personal income taxes

• Withholding taxes on dividends, interest and royalties
• Sales or value added taxes
• Property or asset taxes
• Tariffs on cross border trade
Implicit taxes: equivalent assets sell for the same after tax expected return
This is the law of one price in its after tax form as a consequence, countries with low tax
rates tend to have low before tax expected required returns.
Effect of implicit taxes on required returns: *Suppose = 50% and X = 20%. Pre-tax
required return on an asset in the domestic currency is = 20%. If the law of one price
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holds in its after tax version, what is the pretax required return X on the asset in the foreign
currency?
Equal after-tax returns means: X (1 − X ) = (1 − )
X (1 − 0.2) = 20%(1 − 0.5) = 10%
X = 10%/(1 − 0.2) = 12.5%
A 20% pre-tax return at a 50% tax rate is equivalent to a 12.5% after tax return at a 20% tax
rate.
Foreign corporations
They are legal entities in the host country
• Most manufacturing companies conduct their foreign operations through foreign

corporations
• Foreign corporation income is taxed by domestic tax authorities as it is repatriated
to the parent
• Incorporation in the host country limits the parent’s legal liabilities
• Incorporation avoids host country disclosure requirements on the parent’s
worldwide operations.
Foreign branches: are legally a part of the parent, so branch income is taxed by the
domestic tax authority as it is earned:
• A possible advantage of a foreign branch: can be used for start up operations that
are expected to generate initial losses
• Possible disadvantage:
o can be tax disadvantaged if the branch is in a low tax country
o can expose the MNC to legal liabilities
US foreign tax credits (FTCs)

The US allows a foreign tax credit against domestic US income taxes up to the amount of
foreign taxes paid on foreign source income from a controlled foreign corporation.
The allocation of income rules: impose additional FTC limitations. In particular, interest
expense is allocated according to the proportion of foreign and domestic assets on the
corporation’s consolidated tax return
• An important exception is qualified non-recourse indebtedness that supports a

specific physical asset with a useful life of more than one year.
• Most other expenses are allocated according to either foreign sales or gross income
from foreign sources
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o Other expenses include research and experimentation expense

o General and administrative expenses
Transfer pricing and tax planning

Transfer prices: most countries require that transfer prices be set as arm’s length prices that
would be negotiated between independent parties.
MNCs have an incentive to shift taxable income toward low tax countries:
• Shift revenues to low tax countries

• Shift expenses to high tax countries
Aggressive transfer pricing can be advantageous when a firm has:
• Operations in more than one tax jurisdiction

• High gross operating margins (such as in the electronics and pharmaceutical
industries)
• Intangible assets resulting in intermediate or final products for which there is no
market price (e.g. patents or proprietary production processes)
Offshore finance subsidiaries

Many MNCs retain off-shore finance subsidiaries as reinvoicing centres located in countries
with:
• Low tax rates (income and withholding)

• A stable and convertible currency with access to international currency and
Eurocurrency markets
• Low political risk
• A sophisticated workforce
• Developed financial & economic infrastructures
Tax status of US buyer Host country tax rate
Low High
Excess FTCs Neutral Neutral
No excess FTCs Unattractive Attractive
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Chapter 18 – week 11 – Corporate Governance and

the International Market for Corporate Control
Corporate governance refers to the ways in which major stakeholder exert control over the
corporation and assures themselves a return on their investment. Each nation’s laws,
regulatory framework, and legal institutions and conventions determine stakeholder rights
in corporate governance. These national systems influence many aspects of economic life:
• The way in which capital is allocated within and between national economies
• The opportunities available to borrowers and investors
• Ownership and control of corporations
Ways to obtain control

1. Through acquisition of another firm’s assets
2. Through merger or consolidation
3. Through acquisition of another firm’s stock
4. Joint venture or strategic alliance
Corporate governance systems

Country (system) Bank ownership Supervisory board Hostile Executive
of equity acquisitions turnover
US (market No direct equity Insider managers Common through Forced by market
based) ownership & outside proxy contests or through proxy
directors tender offers contest or
takeover
Germany (Bank Unlimited equity Outside directors, Rare – approval Initiated &
based) ownership bankers, and of lead bank & managed by the
labour 75% of shares lead bank
representatives
Japan (bank Limited equity Inside managers, Rare – blocked by Initiated &
based) ownership (5% bankers, keiretsu share cross managed by main
max) or business holdings bank, keiretsu or
partners business partners
China (state run) Unlimited equity SOEs are Rare for SOEs; Initiated &
ownership politically occasionally for managed by the
connected others government for
SOEs
Measures of gains
Synergy: cross border mergers and acquisitions derive their value from more efficient
utilisation of the competitive advantages of the acquiring or acquired firm. This additional
value is canned synergy:
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LU4-.6U = _ − ( − _ )
Where and _ are the values of the acquiring firm (A) and the target firm (T) prior to the
announcement of the merger or acquisition, and _ is the post acquisition value of the
combined firm.
Acquisition premium: is the difference between the purchase price and the pre-acquisition
market value
I0;5/4 F.-G;G = ,;.0ℎ15- F.0- − _
Whether or not the acquiring firm wins or loses depends on whether the synergies created
by the merger or acquisition outweigh the acquisition premium paid to the target firm.
14 / 10;.46 8.G = _ − ( − _ + 10;5/4 F.-G;G)

= 5U4-.6U − I0;5/4 ,.-G;G
Japanese Keiretsu
Types:
• Horizontal keiretsu (industrially diversified, Eg. Sony, Hitachi, Toshiba)

• Vertical Keiretsu (along a supply-chain; e.g. Mitsubishi, Mitsui
Characteristics
• Extensive share cross holdings

• Personnel swaps
• Strategic coordination
• Commercial transactions
Korean Chaebol
• Chaebols are similar to Japanese Keiretsu
o Centred on a family rather than a bank
• Largest Chaebol are:
o Samsung, LG, Hyundai, SK, Daiwoo
• Daiwoo: split up in 1999 after Daewoo motors went bankrupt
o GM bought 42% of Daewoo in 2001
Mergers and acquisition

• Causes
o Synergy
o Removal of inefficient management
o Firm’s undervaluation
o Agency costs of free cash flow
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o Financial leverage
o Firm size
o Market share
o Economies of scale
• Types
o Friendly and hostile
o Disciplinary and non disciplinary
o Tender offer or a negotiated deal
Cross border determinants of M&A

Cross border M&A activity is influenced by
• Economic growth (GDP and GNP)

• Accounting standards
• Quality of legal and regulatory environment
• Strong shareholder protection
• Cultural differences
• Geographical differences
Targets are typically from countries with poorer investor protection than their acquirers
• Cross border transactions play a governance role by improving investor protection

within target firms
The international evidence on M&A

The winners and losers
• Target firms
o Target firms shareholders receive large gains during the announcement
period
• Acquiring firms
o Within the US market, shareholders of the acquirers may or may not win
o The shareholders of acquirers in non US markets are more likely to win
o The shareholders of acquirers in cross border M&A are more likely to win
Method of payment: a majority of acquisition offers are in cash, with the remainder in stock
or a combination of cash, stock, and other securities. *bidding firms making cash offers
typically do not see their shares fall in value as oppose to other methods.
Free cash flow: losses to acquiring firm shareholders are related to free cash flow, that is,
cash flow available to the firm after all positive NPV investments have been exhausted in
the firm’s main line of business.
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Returns to acquiring firms are negatively correlated with the profitability of the acquiring
firm in mergers and acquisition that cross the US border. The higher the acquiring firm’s
profitability, the lower the return to the shareholders of the acquiring firm.
The tax environment: tax laws influence a number of aspects of domestic and cross border
merger and acquisition activity. M&A can facilitate the transfer and realisation of tax
benefits
Real exchange rates: common sense says that domestic acquisition of foreign assets should
increase when the real value of the domestic currency is high, resulting in a competitive
advantage for domestic firms in international corporate control contests. finance theory
asserts corporate financial policy is irrelevant in a perfect capital market.
A strong domestic currency helps domestic acquirers
Privatisation of state-owned enterprises (SOEs) in transition

economies
Privatisation of state owned enterprises are usually conducted as a:
• Voucher program
• Management buyout (MBO)
• Divestiture
Effective legal and corporate governance systems are prerequisites for a successful
transition to a market economy
Executive turnover and firm performance

There is a built in tension between stakeholders in the corporation because each
stakeholder has an incentive to pursue his or her own selfish interest. An important test of a
corporate governance system is in how well it deals with poorly performing managers.
Replacing inefficient managers should increase the value of poorly performing firms.
Cross border similarities:
• Higher executive turnover in firms suffering a sharp decline in equity value

• Higher executive turnover in firms reporting poor earnings performance
Cross border differences
• Bank-based systems: turnover tends to be initiated by the lead bank (germany) or

the principal shareholders (japan)
• Market based systems: control contests are held through proxy contests or directly
in the marketplace through tender offers.
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When the turnover-performance relation breaks down
• China:
o Top executive turnover is related to performance, but only for firms in the
private sector
o Firms with politically connected CEOs under perform those without
politically connected CEOs
• Italy:
o Minority investors have few legal protections
o The relation between top executive turnover and firm performance is weak
when
Control is in the hands of one shareholder
The controlling shareholder is the top executive
Tunnelling and the value of corporate control benefits

Tunnelling refers to the expropriation of corporate assets from minority shareholders by
control shareholders, manage, or both. This can occur in both legal and illegal ways. (i.e. self
dealing transactions such as asset sales, excessive insider trading, and other transactions
that discriminate against minority shareholders.
Caveat
• Increasing competitiveness in the international market for corporate control is likely
to change some of these conclusions
• Further research will surely modify or extend these conclusions
Page 58 of 58

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International Business Finance (University of New South Wales)

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Paul Ye Fins3616 2009

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Paul Ye Fins3616 2009

Chapter 19 – Week 5 International Capital Markets ........................ 6

Chapter 8 – Week 7 The Rationale for Hedging Currency Risk ......... 9

Chapter 9 Treasury Management of International Transactions .... 13

Chapter 10 – Week 8 Managing Transaction Exposure to Currency

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Chapter 11 – week 8 Managing Operating Exposure to Currency

Chapter 12 – week 9 Managing translation exposure and accounting

Chapter 13 – week 9 Foreign Market Entry and Country Risk

Chapter 14 – week 10 Cross border capital budgeting ................... 37

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Chapter 15 – week 10 Multinational Capital Structure and Cost of

Chapter 16 – week 11 – Taxes and Multinational Corporate Strategy

Chapter 18 – week 11 – Corporate Governance and the

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Mergers and acquisition ...................................................................................................... 55

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Paul Ye Fins3616 2009

Chapter 19 – Week 5 International Capital Markets

Domestic and International bond markets

International Bonds: traded outside of the country of the issuer:

• Foreign bonds: are issued in a domestic (internal) market by a foreign borrower,

Domestic and international stock markets

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International Differences in securities regulation

• Loans maturing within nine months

• Capital requirements directive (CRD): protects savers and investors by specifying

International investment vehicles, overcoming capital flow barriers

• Higher information costs on foreign assets

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o Commissions on foreign trades are often higher than on domestic

Professionally managed funds specialising in international assets:

Index Derivatives: Provide a way to buy or sell international stock indices.

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Portfolio investment styles

Chapter 8 – Week 7 The Rationale for Hedging

Firm value is determined by: = ∑

Therefore, to add value, hedging must either:

• Increase the firm’s expected future cash flows

Perfect market assumptions

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Paul Ye Fins3616 2009

• Equal access to market prices: Perfect competition with no barriers to entry

Convexity in the tax schedule

If hedged, the income would be $900,000 for certain.

If the company remains unhedged: the tax liability would be

If the company is hedged, the tax liability will be:

900000 × (25%) = 198000

There is a tax saving of $15,000.

Costs of financial distress

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Unhedged: [ ! ] = (0.5)($750) + (0.5)($1000) = $875

Total [()*+ ] = (0.5)($750) + (0.5)($1750) = $1250

Hedged: [ ! ] = $1000

Total [()*+ ] = $1250

88-0H- I44. J1- = (1.0151)D − 1 = 6.17%

$ = 2.68%, £ = 2.02%, L> $/£ = $1.5000/£