Chapter 19

MULTINATIONAL FINANCIAL MANAGEMENT

Multinational or Global Corporation

A firm that operates in an integrated fashion in a number of (two or more) countries. Decision making may be centralized in the home country or decentralized across the countries the corporation does business in.

Reasons why companies expand into other countries

To broaden their markets (Seek new markets) To seek raw materials Vertically Integrated Investment To seek new technology To seek production efficiency

Reasons why companies expand into other countries

To avoid political, trade, and regulatory hurdles To diversify To take advantage of specialized skills To protect processes and products To retain customers

Cost Migration Opportunities

Regional trends in cost migration

Going global
Becomes essential to effectively compete especially with the advent of globalization Used to be a competitive advantage before, but now, it appears to be an inevitable move especially for market leaders.

Major factors that complicate financial management in multinational firms

Different currency denominations Economic and legal ramifications Language differences Cultural differences Role of governments Political risks

Monetary System
Local (National) Monetary System and Authority
Each nation has a monetary system and authority. Task is to:
Hold down inflation Promote economic growth (raise living standards)

For the US, the local monetary authority is the Federal Reserve. For the Philippines, the local monetary authority is the BSP.

International Monetary System

Must be in place for smoothen trade and facilitate payments between nations May be fixed or float

International Monetary System

A system designed to facilitate payments between nations when they are engaging in trade, thus, it is the framework within which exchange rates are determined. It is the blueprint for international trade and capital flows. Regulated by intergovernmental agreements and driven by each countrys unique political and economic objectives. Facilitates international trade, cross border investment and the reallocation of capital between nations.

International Monetary Terminology

Exchange Rate Spot exchange rate Forward exchange rate Fixed exchange rate Floating or flexible exchange rate Devaluation of Currency Applicable for Fixed Currencies Revaluation of Currency Depreciation of Currency Applicable for Floating Currencies Appreciation of Currency

International Monetary System

End of WWII August 1971: Fixed exchange rate system (by IMF) Fixed exchange rate system
Also known as pegged exchange rate A type of exchange rate regime wherein a currencys value is matched to the value of another single currency or to a basket of other currencies , or to another measure of value, such as gold. Done by buying and selling own currency in the open market (have huge foreign reserves) or making it illegal to trade currency at any other rate (may lead to black market, however it may be successful due to government monopolies over all money conversion) Eg: China RMB (pegged to basket of currencies dollar, euro, Japanese yen,
Korean won, Singapore dollar, sterling, Malaysian ringgit, Russian rouble, Australian dollar, Thai baht and Canadian dollar.)

International Monetary System

The current international monetary system is the Floating Exchange Rate System Floating Exchange Rate System
A system under which exchange rates are not fixed by government policy but are allowed to float up or down in accordance with supply and demand. May cause exchange rate fluctuations and CB of each country needs to intervene to smoothen out these fluctuations. Results to Exchange Rate Risk

Broad Groups of Currency Regimes:

Floating Rates Freely Floating Determined by supply and demand without
significant government intervention.

Managed Floating Significant government intervention in the

manipulation of the currencys supply and demand.

Fixed Rates No local currency No local currency of its own and uses the
currency of other countries. It surrenders the ability to use exchange rate to tinker with its economy.

Currency board arrangement A country has local currency

but commits to exchange it for a specified foreign money unit at a fixed exchange rate.

Fixed-peg arrangement A country locks its currency to a

specific currency or basket of currencies at a fixed exchange rate.

Exchange Rates
Exchange rate the number of units of a given currency that can be purchased for one unit of another currency Direct Quotation Number of domestic currency required to purchase one unit of foreign currency (FXY expressed in DXY) eg: 1 Sgd = 32 Php Indirect Quotation Number of units of foreign currency that can be purchased for one unit of domestic currency (DXY expressed in FXY) eg: 1 Php = 0.03125 Sgd Direct quotation is the reciprocal of indirect quotation.

Consider the following exchange rates:

U.S. $ to buy 1 Unit 0.009 0.650

Japanese yen Australian dollar

Assuming that domestic country is the US, are these currency prices direct or indirect quotations? Since they are prices of foreign currencies expressed in dollars, they are direct quotations.

Calculate the indirect quotations for yen and Australian dollars.

Japanese yen Australian dollar

# of Units of Foreign Currency per U.S. $ 111.11 1.5385

Yen: A. Dollar:

1/0.009 = 111.11. 1/0.650 = 1.5385.

Sample Problems on Simple Exchange Rates

If one Swiss franc can purchase $0.71 U.S. dollar, how many Swiss francs can one U.S. dollar buy? If one U.S. dollar buys 1.0279 euros, how many dollars can you purchase for one euro?

Cross Rate (European Terms)

The exchange rate between any two currencies. They are actually calculated on the basis of various currencies relative to the USD.

Currency Cross Rates (American Terms) as of Feb. 25, 2012

Currency codes / names
GBP CAD EUR JPY CHF USD PHP SGD

United Canadian Kingdom Dollar Pound

1 1.5764 1.1784 127.077 1.4203 1.5794 67.7727 1.982 0.6346 1 0.7477 80.6263 0.9012 1.0021 43.0003 1.2575

Euro 0.8488 1.3379 1 107.844 1.2053 1.3404 57.5166 1.682

Japanese Yen 0.007871 0.012407 0.009274 1 0.011178 0.01243 0.5334 0.0156

Swiss Franc 0.7043 1.1101 0.8298 89.4842 1 1.1122 47.7259 1.3957

US Dollar 0.6332 0.9981 0.7461 80.4578 0.8993 1 42.9104 1.2549

Philippine Singapore Peso Dollar 0.01483 0.02338 0.01748 1.8844 0.02106 0.02342 1 0.02939 0.5048 0.7956 0.5948 64.1364 0.7169 0.7971 34.2057 1

Calculate the two cross rates between yen and Australian dollars. Yen U.S. Dollars = U.S. Dollar x A. Dollar = 111.11 x 0.650 = 72.22 yen/A. dollar.

Cross rate

Cross rate

A. Dollars U.S. Dollars = U.S. Dollar x Yen = 1.5385 x 0.009 = 0.0138 A. dollars/yen.

Note:
The two cross rates are reciprocals of one another. They can be calculated by dividing either the direct or indirect quotations.

Sample Problems for Cross Exchange Rates

A currency trader observes the following quotes in the spot market: 122 Japanese yen = 1 U.S. dollar 2.28 Swiss francs = 1 British pound 1 British pound = 1.6542 U.S. dollars Given this information, what is the exchange rate between the Swiss franc (SF) and the Japanese yen?

Sample Problems for Cross Exchange Rates

Currently, in the spot market $1 = 106.45 Japanese yen, 1 Japanese yen = 0.00966 euro, and 1 euro = 9.0606 Mexican pesos. What is the exchange rate between the U.S. dollar and the Mexican peso? Suppose exchange rates between U.S. dollars and Swiss francs is SF 1.6564 = $1.00 and the exchange rate between the U.S. dollar and the euro is $1.00 = 1.0279 euros. What is the cross rate of the Swiss franc to the euro?

Why is the USD the basis for cross rates?

Brettons Wood Agreement
Attempt to rebuild the international economic system after WW2 Done to regulate the international monetary system, BW planners established IMF and IBRD (part of World Bank Group) Each country should adopt a monetary policy that maintained the exchange rate of its currency within a fixed value in terms of gold. Gold was replaced by USD because there is inefficient supply of gold (4.5 trillion) and there are also disadvantages and other reasons (e.g. Soviet Union has a sizeable share of the worlds known gold reserves, and it was later a Cold War Rival to US and Western Europe) The US Dollar acted as a store value as it was the strongest reserve currency, and also it was pegged to gold.

Recall:
1 USD = 111.11 JPY 1 USD = 1.5385 AUD
Using Cross Rate: 1 JPY = 0.01385 AUD 1 AUD = 72.2220 JPY

1 JPY = 0.009 USD 1 AUD = 0.65 USD

Setting the appropriate price

A US firm can produce a liter of orange juice and ship it to Japan for $1.75 per unit. If the firm wants a 50% markup on the project, what should the juice sell for in Japan?
Price = (1.75)(1.50)(111.11) = 291.66 yen

Determining profitability
The product will cost 250 yen to produce and ship to Australia, where it can be sold for 6 Australian dollars. What is the U.S. dollar profit on the sale?
Cost in A. dollars = 250 yen (0.0138) = 3.45 A. dollars A. dollar profit = 6 3.45 = 2.55 A. dollars U.S. dollar profit = 2.55 / 1.5385 = $1.66 (or 2.55 x 0.65)

Sample Problems Exchange rates and Profitability

The following exchange rates are quoted in the spot market:
$1 U.S. = 116.6 Japanese yen. 1 Canadian dollar = $0.66 U.S. Crane Cola is a U.S. company with worldwide operations. The company can produce a liter of cola in Canada at a cost of 0.45 Canadian dollars. The cola can be sold in Japan for 120 Japanese yen. How much operating profit (measured in U.S. dollars) does the company make on each liter of cola sold in the Japanese market?

Sample Problems Exchange rates and Profitability

Cypress Foods, a U.S. company, has a subsidiary that produces lime juice in Brazil and sells it in Japan. The exchange rates are such that 1 U.S. dollar equals 1.75 Brazilian real, and 1 U.S. dollar equals 120 Japanese yen. Cypress spends 1.2 real to produce one unit of lime juice and sells it for 100 Japanese yen. What is the profit in U.S. dollars realized from each unit of lime juice sold?

What is exchange rate risk?

The risk that the value of a cash flow in one currency translated to another currency will decline due to a change in exchange rates. Risk inherent in a floating exchange rate system due to exchange rate volatility. This causes a companys consolidated cash flows to fluctuate.

Other Terms:
Pegged Exchange Rate
Occurs when a country establishes a fixed exchange rate with another major currency, consequently, values of pegged currencies move together over time. Usually done for smaller countries

Convertible Currency
A currency that may be readily exchanged for other currencies A currency is convertible when the issuing country promises to redeem the currency at current market rates These are traded in world currency markets

What problems may arise when a firm operates in a country whose currency is not convertible? It becomes very difficult for multi-national companies to conduct business because there is no easy way to take profits out of the country. Often, firms will barter for goods to export to their home countries. (e.g. the communist countries during the cold war. Hyperinflation, e.g. in Germany after the two world wars.

Trading in Foreign Exchange

Difference between spot rates and forward exchange rates:
Spot Rates
The effective exchange rate for a foreign currency for delivery on (approximately) the current day. The rates to buy currency for immediate delivery.

Forward Rates
An agreed-upon price at which two currencies will be exchanged at some future date. The rates to buy currency at some agreed-upon date in the future.

Discount / Premium on Forward Rate

Discount on Forward Rate (SLD, FGD)
When spot rate < forward rate If the local currency (USD) buys more units of foreign currency in the forward market than in the spot market Forward less valuable than spot because it takes more units of a fxy to buy 1 USD in the future

Premium on Forward Rate (SGP, FLP)

When spot rate > forward rate If the local currency (USD) buys more units of foreign currency in the spot market than in the forward market Forward more valuable than spot because it takes less units of a fxy to buy 1 USD in the future

Illustrative Problem:
Forward Rates Spot Rate 30 Days 60 Days 90 Days 180 Days Philippine Peso 45.95 44.33 49.15 49.75 46.48

Which of the following statements is correct? a. There is a premium on the 30 day forward rate on the Philippine peso. b. There is a discount on the 60 day forward rate on the Philippine peso. c. 1 USD is worth 44.93 Philippine pesos if traded immediately. d. All statements are correct. e. None of the statements are correct.

Interest Rate Parity

Aka International Fisher Effect Specifies that investors should expect to earn the same return in all countries after adjusting for risk. A theory that the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.
ft 1 k h e0 1 k f ft t - period forward exchange rate e 0 today' s spot exchange rate k h periodic interest rate in home country k f periodic interest rate in foreign country

Interest Rate Parity Sample Problems:

In the spot market, 1 U.S. dollar can be exchanged for 121 Japanese yen. In the 1-year forward market, 1 U.S. dollar can be exchanged for 125 Japanese yen. The 1-year, risk-free rate of interest is 5.2 percent in the United States. If interest rate parity holds, what is the yield today on 1year, risk-free Japanese securities? The nominal rate of interest on six-month, risk-free U.S. securities is 6 percent. Currently in the spot market, $1 U.S. = 104.84 Japanese yen. In the six-month forward market, $1 U.S. = 104.84 Japanese yen. If interest rate parity holds, what is the current nominal interest rate on six-month, risk-free Japanese securities? 90-day investments in Great Britain have a 6 percent annualized return and a 1.5 percent quarterly (90-day) return. In the U.S., 90-day investments of similar risk have a 4 percent annualized return and a 1 percent quarterly (90-day) return. In the 90-day forward market, 1 British pound () = $1.65. If interest rate parity holds, what is the spot exchange rate?

Discount / Premium on Currency

Currency is at Forward Premium
Domestic interest rate > Foreign interest rate

Currency is at Forward Discount

Domestic interest rate < Foreign interest rate

Purchasing Power Parity

Aka Law of One Price The relationship in which the same products cost roughly the same amount in different countries after taking into account the exchange rate. It implies that the level of exchange rates adjusts so that identical goods cost the same amount in different countries. Ph = Pf(e0) -ORe0 = Ph/Pf
Ph = price of the good in the home country Pf = price of the good in the foreign country e0 = todays spot exchange rate

If grapefruit juice costs $2.00 per liter in the U.S. and PPP holds, what is the price of grapefruit juice in Australia? e0 = Ph/Pf $0.6500 = $2.00/Pf Pf = $2.00/$0.6500 = 3.0769 Australian dollars.

Does PPP hold true?

Refer to Page 611 of your book The BIG MAC INDEX or refer to the following slide:

PPP Illustrative Problem:

For your 19th birthday, your parents decided to buy you a Bugatti Veyron. This is a German-made car from German manufacturer, the Volkswagen Group. They asked you to canvass prices from different car dealers all over the world to determine the best deal. After making several inquiries, you have come up with a list below:
COUNTRY USA China Germany Japan Philippines PRICE USD 1,700,000 Yuan 12,000,000 Euro 1,150,000 Yen 140,000,000 Peso 80,000,000

 You have also come up with a cross rate list, as follows:

Currency Codes/Names EUR JPY USD CNY PHP Euro 1 132.775 1.4513 9.9236 66.5126 Japanese Yen 0.007533 1 0.010932 0.07475 0.501 US Dollar 0.6891 91.4869 1 6.8376 45.8287 Chinese Yuan 0.1011 13.4192 0.1467 1 6.7221 Philippine Peso 0.01512 2.0079 0.02195 0.1501 1

Requirement 1: Ignoring all other costs such as import duties, taxes, shipping costs, and holding costs, and assuming that cross rates hold true, how much is the percentage overvaluation or undervaluation if you decide to buy the car in Japan? Requirement 2: Ignoring all other costs such as import duties, taxes, shipping costs, and holding costs, and assuming that cross rates hold true, in which country would you buy the car from in order to get the best deal?

PPP Short Problems:

A telephone costs $100 in the United States. The same telephone costs 150 Canadian dollars. Assume that purchasing power parity holds. What is the exchange rate between U.S. and Canadian dollars? A box of candy costs 28.80 Swiss francs (SF) in Switzerland and $20 in the United States. Assuming that purchasing power parity (PPP) holds, what is the current exchange rate?

Inflation, Interest Rates, and Exchange Rates

What impact does relative inflation have on interest rates and exchange rates?
Currencies with higher inflation than the US depreciates over time against the USD. Currencies with lower inflation than the US appreciate against the USD. Lower inflation leads the Fed to lower interest rates. Borrowing in low interest countries may appear attractive to multinational firms. But, is it a good strategy? As stated above, because currencies in low-inflation countries tend to appreciate against those in high-inflation rate countries, so the effective interest cost increases over the life of the loan. Therefore, the lower interest rate could be more than offset by losses from currency appreciation.

 International Credit Markets

Eurocredits

International Money and Capital Markets

Floating-rate bank loans that are available in most major trading currencies and that are tied to LIBOR. They tend to be issued for a fixed term with no early repayment. Eurodollar A source of dollars outside the US. USD deposited in a bank outside US. Asian Dollar USD deposited in banks based in Asian countries.

International Bond Markets

Foreign Bonds sold by foreign borrower, but denominated in the currency of the country of issue. It is underwritten by investment banks from the same country. (China sells bonds to Philippine companies and the bond is denominated in RMB. Investment banks in China underwrites the bonds. These bonds are from a different country). Eg: Yankee, Bulldogs, Samurai Bonds Eurobonds sold in the country other than the one in whose currency the bonds are denominated. It is a bond issued in a currency other than the currency of the country or market in which it is issued. It is underwritten by an international syndicate. (China sells bonds to Philippine companies and the bond is denominated in USD. An international syndicate underwrites the bonds. These bonds are not sold in China).

International Money and Capital Markets

International Stock Markets
A Philippine firm may sell its stock in Japan to tap a larger source of capital that the home country. US firms may tap a foreign market to create an equity market presence to accompany its operations in that country. Large multinational companies can issue new stock simultaneously in multiple countries. This can create arbitrage opportunities for investors. American Depository Receipts (ADRs) certificates representing ownership of foreign stock held in trust. They are mostly traded on the OTC market but more are being listed in stock exchanges.

Multinational Capital Budgeting

Involves more complex cash flow estimation and analysis. Involves repatriation of earnings (the process of sending CFs from foreign subsidiary back to the parent company), though foreign government may restrict it. Foreign subsidiaries or branches cash flows are converted to the parent companys currency. Must look at business climate refers to a countrys social, political, and economic environment. Involves higher risk, particularly:
Country risk the risk that arises from investing or doing business in a particular country. Exchange rate risk the risk that relates to what the basic CFs will be worth in the parent companys home currency. Political risk potential actions by a host government that would reduce the value of a companys investment.

Current risk score Current Sept Country name Current Economic Political Structural Credit rating Debt rank '10 score (30% (30% (10% (out of 10, indicators weight) weight) weight) 10% wt) (out of 10, 10% wt) 1 2 3 29 39 40 42 52 1 6 2 25 60 36 45 61 Norway Switzerland Korea South Malaysia China Thailand Indonesia 93.44 89.59 72.28 64.75 63.55 63.00 58.27 90.40 81.00 82.50 65.75 60.80 66.88 65.33 62.75 92.97 93.67 87.23 67.86 60.63 48.47 52.89 51.72 84.10 86.25 86.71 69.13 65.40 52.41 66.00 53.38 10.00 10.00 10.00 7.29 6.25 7.71 5.42 3.33 10.00 10.00 10.00 10.00 8.04 8.73 9.03 8.50 Luxembourg 91.03 Access to capital markets (out of 10, 10% wt) 10.00 10.00 10.00 8.00 7.50 7.25 6.50 6.75

60
61 62 70 71 95 98

66
58 102 91 75 110 96

Sri Lanka
Philippines Botswana Bermuda Vietnam Nigeria Belarus

54.86
54.46 54.00 49.48 49.46 42.05 39.84

56.33
52.67 47.00 0.00 46.00 45.56 43.75

52.01
50.08 50.96 69.00 44.26 33.67 34.38

71.00
57.50 33.33 0.00 50.83 45.75 27.81

1.88
2.92 6.56 8.96 2.29 2.19 1.88

8.41
8.23 8.69 10.00 8.27 9.54 8.73

5.00
6.75 6.00 9.75 6.75 2.00 3.00

99
100

101
100

Algeria

39.50

45.80
41.00

37.40
47.00

50.60
0.00

0.00
1.56

5.50
8.74

4.00
2.00

Mozambique 38.79

International Capital Structure

Companies capital structures vary among countries. Problems when comparing capital structures among nations:
Reporting assets on a historical cost versus a replacement cost basis. Treating leased assets Reporting pension plan liabilities Capitalizing versus expensing R&D costs.

To what extent do average capital structures vary across different countries? (Look at Page 621, Table 19-5)
Previous studies suggested that average capital structures vary among the large industrial countries. However, a recent study, which controlled for differences in accounting practices, suggests that capital structures are more similar across different countries than previously thought.

Impact of multinational operations

Cash management
Distances are greater. Access to more markets for loans and for temporary investments. Cash is often denominated in different currencies.

Impact of multinational operations

Capital budgeting decisions
Foreign operations are taxed locally, and then funds repatriated may be subject to U.S. taxes. Foreign projects are subject to political risk. Funds repatriated must be converted to U.S. dollars, so exchange rate risk must be taken into account.

Impact of multinational operations

Credit management
Credit is more important, because commerce to lesserdeveloped countries often relies on credit. Credit for future payment may be subject to exchange rate risk.

Inventory management
Inventory decisions can be more complex, especially when inventory can be stored in locations in different countries. Some factors to consider are shipping times, carrying costs, taxes, import duties, and exchange rates.

19-7: Currency Appreciation

Suppose that 1 Kong Kong dollar could be purchased in the foreign exchange market today for $0.1290. if the Hong Kong dollar appreciated 10% tomorrow against the dollar, how many HKD would a US dollar buy tomorrow?

19-16: Foreign Investment Analysis

After all foreign and US taxes, a US corporation expects to receive 3 Singapore dollars of dividends per share from a Singaporean subsidiary this year. The exchange rate at the end of the year is expected to be $0.7062 per SGD, and the SGD is expected to depreciate 5% against the dollar each year for an indefinite period. The dividend (in SGD) is expected to grow at 10% a year indefinitely. The parent US corporation owns 10 million shares of the subsidiary. What is the present value in dollars of its equity ownership of the subsidiary? Assume a cost of equity capital of 15 percent for the subsidiary.