Chapter
21
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Multinational corporations
Effect of exchange rates on profitability and
cash-flow
Hedging and reduction of foreign exchange
risk
Evaluating political risk in foreign investment
decisions
Financing international operations
21-2
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Integrates capital markets
 World events such as currency crisis, government defaults,
terrorism can cause stock and bond markets to suffer
emotional declines well beyond the expected economic
impact of a major event
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Currency markets
 Impact on trade between nations affecting sales and
earnings of international companies
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The advent of the Euro
 Sever impact on earnings of U.S. companies doing
significant business in Europe
21-3
21-4
21-5
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A firm carrying out its business activities
(often 30% or more) outside its national
borders
Can take several forms :
 Exporter
 Licensing agreement
 Joint venture
 Fully owned foreign subsidiary
21-6
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Exporter:
 Least risky method
 Reaping the benefits of foreign demand
 No long-term investment commitment
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Licensing agreement:
 License granted to a local manufacturer in foreign land to use firm’s
technology
 Effectively exporting technology
 Collects licensing fee or royalty
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Joint venture:
 Established with a local firm in foreign land
 Most preferred by business firms and foreign governments
 Least amount of political risk
21-7
 Fully owned foreign subsidiary
▪ Higher risks and complexities of operation
▪ Often more profitable than domestic firms
▪ Lowers combined portfolio risk of the parent
corporation
▪ Decisive factor in shaping the pattern of trade,
investment, and the flow of technology
▪ Exert significant impact on host country’s economic
growth, employment, trade, and balance of payments
21-8
21-9
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The following figure shows the amount of
foreign currency for one U.S. dollar
21-10
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Inflation:
 A parity between the purchasing power of two
currencies establishes the rate of exchange
between the two currencies
 Example: it takes $1.00 to buy one apple in New
York and 1.25 euros to buy apple in Germany.
Then the rate of exchange between the USD and
the Euro is €1.25/$1.00 or $.80/euro
21-11
 Purchasing power parity theory states
that:
▪ Currency exchange rates vary inversely
with their respective purchasing powers
▪ Exchange rates between two countries
adjust to inflation differential between
the two countries
21-12
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Interest rates:
 Short-term capital movements from low-yield
to high-yield markets
 Interest rate parity theory:
▪ The interplay between interest rate differentials and
exchange rates
▪ Interest rates and exchange rates adjust until the foreign
exchange market and the money market reach
equilibrium
21-13
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Balance of payments:
 A system of government accounts that catalog
flow of economic transactions between the
residents of one country and that of others
▪ Trade surplus or deficit determines strength of
currency
21-14
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Government policies:
 Direct or indirect intervention in the foreign
exchange market
▪ For maintenance of the undervalued currency
 Currency values set by government
 Restriction on inflow and outflow of funds
 Monetary and fiscal policies
▪ Result in inflation and change in value of currency
▪ Expansionary monetary policies
▪ Excessive government spending
21-15
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Other factors:
 Extended stock market rally
▪ Higher capital inflow and increase in currency value
 Significant drop in demand for a nation’s principal
exports globally
▪ Lower investment potential and decrease in value of
currency
 Political turmoil in a country
▪ Capital shift to more stable countries and decrease in
value of currency
 Widespread labor strikes
21-16
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Spot rate
 Exchange rate at which the currency is traded for immediate delivery
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Forward rates
 Trading of currencies for future delivery
 Reflects the expectations regarding the future value of a currency
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Forward Discount or premium:
 Expressed as an annualized percentage deviation from the spot rate
21-17
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Not all currencies are actively traded
Value for such currencies determined through
a cross rate
Example : Three currencies $, € and ¥
 $ and € are actively traded
 $ is 0.8384€ and € is 141.390¥
 Thus $ = 0.8384 × 141.390¥ = 118.541¥
21-18
21-19
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Foreign exchange risk
 Possibility of a drop in revenue or an increase in
cost in an international transaction due to
changes in foreign exchange rates
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Shift from fixed exchange rate regime to
freely-floating rate regime
Exchange risk of a multinational company:
 Accounting or translation exposure
 Transaction exposure
21-20
Consolidated figures of the parent include value of
foreign assets and liabilities converted and
expressed in home currency
 Treatment of such gains and losses depend on the
accounting rules established by the government of
parent company.
 Note: unrealized accounting gains and losses should
only be hedged if you are sure it is going to
influence the corporate cash flows! Do a value at
risk (VaR) analysis.
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21-21
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SFAS 52 says:
 All foreign currency-denominated assets and
liabilities to be converted at the rate of exchange
on date of balance sheet preparation
 Unrealized gain or loss to be held in equity reserve
account and realized gain or loss incorporated in
the consolidated income statement of the parent
company
21-22
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Foreign exchange gains or losses resulting
from international transactions (from the
time of agreement to time of payment)
 Volatility of reported earnings per share increases
 Strategies to minimize transaction exposure:
▪ Forward exchange market hedge
▪ Money market hedge
▪ Currency futures market hedge
21-23
21-24
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MNCs have developed foreign asset
management programs, involving strategies:
 Switching cash and other assets into strong
currencies
 Piling up debt and other liabilities in
depreciating currencies
 Quick collection of bills in weak currencies by
offering sizable discounts, while extending credit
in strong currencies
21-25
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Factors encouraging foreign affiliates:
 Avoid trade barriers
 Lower production costs overseas
 Superior technology enabled easy access to
resources in developing countries
 Tax advantage
 Motivated by strategic considerations in an
oligopolistic industry
 Diversification of risks internationally
21-26
21-27
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Government interference by imposition of
unfriendly foreign exchange restrictions
Limitation of foreign ownership to a small
percentage
Blocking repatriation of a subsidiary’s profit
to the parent firm
Expropriation of foreign subsidiary’s assets
by the host government
21-28
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Establish a joint venture with a local
entrepreneur (not totally risk free!)
Establish a joint venture with firms from
other countries
Insurance against perceived political-risk
level can be obtained
 Overseas Private Investment Corporation (OPIC)
and other private insurance companies sell
insurance policies
▪ Coverage is expensive in troubled countries
21-29
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Credit sales are influenced by:
 Relationship of the parties involved
 Political stability of countries involved
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Letter of credit issued by importer’s bank
reduces risk of nonpayment
 Credit risk to exporter is absorbed by the
importer’s bank
▪ Importer’s bank in a good position to evaluate the
creditworthiness of the importing firm
21-30
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Alternatives to avoid risk of loss of business:
 Obtaining export credit insurance
▪ The Foreign Credit Insurance Association (FCIA)
provides this kind of insurance
▪ A private association of 60 U.S. insurance firms
21-31
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Eximbank (Export-Import Bank)
 Direct loan program
 Discount program
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Loans from parent company or sister affiliate
 Parallel loans
 Fronting loans
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Eurodollar loans
 US dollars deposited in foreign banks
 Lending rates based on London Interbank Offer
Rate (LIBOR)
21-32
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Eurobond market
 Issues are sold in several national capital markets
 Widely used currency – U.S. dollar
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International equity markets
 Companies are listed on major stock exchanges
 Issue American Depository Receipts (ADRs)
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The International Finance Corporation (IFC)
 Approached by companies facing issues with
raising equity capital in a foreign country
21-33
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Nature of financial decisions for an MNC
are complex:
 Access to more sources of financing than a purely
domestic corporation
▪ Decision regarding level of leverage in the foreign affiliate
▪ Dividend policy decisions influenced by foreign government
regulations
 Differences in interest rates and market conditions
between domestic and foreign markets
 Differences in corporate financial practices
21-34