Chapter 13
Global Financial
Management
1
Key issues in global finance
Currency exchange variations
• Strategic exposure (long -term )
• Transaction exposure (short-term)
• Translation exposure (book valuation effect)
Investment
• Project valuation
Financing
• Equity financing and cross-listing
• Debt financing
• Trade financing
• Project finance
2
Currency exchange variations
3
Strategic effects of forex variations
Markets
Domestic
Domestic
Global
Increases
competitiveness
against imports
Increases
competitiveness
of domesticaly
produced products
Firms
Global
Markets
Domestic
Domestic
Global
Decreases
competitiveness
Decreases
competitiveness
Increase
competitiveness
No effects
Firms
Decreases
competitiveness
of products with
high global content
No effects
Global
Effects of a ‘domestic’
revaluation
Effects of a ‘domestic’
devaluation
4
Strategic effects: what to do?
• Move production:
 to low cost countries
 to countries with weak currencies?
• Differentiate to make products less price-sensitive
• Balance production-sales by currency zones
5
Transaction exposure
• Hedging techniques:
• Forward contracts
• Money markets contracts
• Future contracts
• Options
• Swap
• Netting
• Leading and lagging
6
Hedging with forward contract
Example: a US machinery company sells to a paper
machine to a Finnish company for 10 million Euros
payable in one year
US interest rate: 1%
Euro interest rate: 2%
Spot exchange rate: 1.30 $/€
Forward rate (1 Year): 1.287$/£
7
Example: The paper machinery transaction
Forward hedge
Money market hedge
Spot rate at
Maturity
1,20
1,25
1,29
1,30
1,35
1,40
Unhedged
receipt US$
12,00
12,50
12,87
13,00
13,5
14,00
Forward
hedge US$
12,87
12,87
12,87
12,87
12,87
12,87
Gain losses
from
hedging
0,87
0,37
0,00
-0,13
-0,63
-1,13
US Company borrows 10€ at 2% rate and gets
Uses borrowing to buy US$ at spot rate =9.8/1.3
Invest 12,745 US$ at 1%
At maturity gets 80 m€ used to repay loan
9,80 € €
12745 US$
12872 US$
Both hedging technics brings the same results 12872 US$ US$
representing a cost of hedging of 13000-12872
128 US$
8
Netting
Example: Cash receipts and disbursements matrix for Teltrex ($000)
Payments
Receipts
US
Germany
Australia
UK
External
Total inter
Subsidiaries
Total payments
US (US$)
50
25
30
100
Germany (€)
40
10
40
120
Australia
(AUD)
30
45
20
150
105
205
90
210
95
245
UK (£)
60
80
35
80
175
255
Teltrex’s interaffiliates foreign exchange
transactions without netting (000 $)
External
120
90
60
80
-
Total inter
Subsidiaries
130
175
70
90
Total
Receipts
250
265
130
170
450
465
350
1265
Bilateral netting of Teltrex’s interaffiliates
foreign exchange transactions (000 $)
+30
US
GER
+20
+10
+35
+15
+25
+40
+25
+20
+30
GER
+10
+30
+10
+60
AUS
US
+10
+20
+40
UK
AUS
9
+10
UK
Netting cont.
Example
Payments
Receipts
US
Germany
Australia
UK
External
Total inter
subsidiaries
Total payments
US (US$)
50
25
30
100
Germany (€)
40
10
40
120
Australia
(AUD)
30
45
20
150
105
205
90
210
95
245
US
Intersubsidiaries
netting
UK (£)
60
80
35
80
175
255
465
350
GER
+10
+35
+5
+40
+30
AUS
UK
+15
10
External
120
90
60
80
-
Total inter
subsidiaries Total receipts
130
250
175
265
70
130
90
170
450
1265
Global financing
Cross-listing
If cost of capital is different (fragmented) across countries there is a potential advantage
of arbitrage (assuming similar risks).
But also:
• Higher liquidity
• Larger investor base
• Higher visibility
• Less vulnerable to hostile take-over
However:
• Costs of compliance
• Higher dependance on volatility of international markets
11Eun and Resnick: International Financial Management, 2001
Source:
Global financing cont.
Source : NYSE Factbook, 1999.
12
Project finance
‘Financing of a particular economic unit in which the providers
of funds look primarily to the cash flow from the project as the
source of funds to service their loans or provide a return on equity
and to the assets of the economic unit as collateral for the loans.’*
Involves:
• Private sponsors
• Multinational development agencies (IFC, ADB, EBRD, AFDB..)
• Bilateral development agencies (CDC, AFD, Finnfunds, OECF..)
• Commercial banks
• Export credit agencies (Coface, Hermes, ECGD…)
*Nevitt & Fabozzi (2000) and Finnerty (1996)
13
Project valuation
Objectives
To look at the costs and benefits of a project from the point of view:
I.R.R
• of the fund providers (financial risks and return)
• of the stakeholders (economic and social risks and return)
This applies to:
• Infrastructure projects
• Industrial projects
14
E.R.R
The points of view of the providers of funds
Project cash flow based evaluation:
• NPV
• IRR
• Pay back
• Project sponsor
• Other equity providers
• Loan providers
Issues:
• Evaluation of the risks for the funds providers
• How to incorporate risks into the calculation
15
Risks in project evaluation
Construction risks
Technology
Complexity or untested
technology may lead to
cost overruns or
construction delays.
Timing
Failure to complete on time may
induce penalties and jeopardize
cash flows
Operating risks
Supply
Quantity and quality of
resources
Market
Price and quantity of output
Throughput
Efficiency of process
Operating Costs
Absence of qualified
contractors and supporting
services
Staibilty of cost factors
Difficulties in custom clearance
transport of materials and
personnel
Expropriation
Direct
Creeping
Legal
Supporting industries
Logistics and red tape
Sovereign risks
Force majeure
‘Acts of god’
Environmental
Wars, terrorism
Disruption
Strikes
16
Lack of law enforcement
Price control
Inflation
Foreign exchange
Convertibilty and
transferability
Mitigating risks in projects
Construction risks
Technology
Proven technology
Appropriate technology
Experience in projects
Project management
Timing
Project management
Supporting industries
Suppliers training
Piggy backing
Logistics and red
tape
Local knowledge
Operating risks
Supply
Supplier training
International suppliers
Integrated projects (power,
water, etc.)
Market
Sovereign risks
Expropriation
Multilateral agency as
shareholder
Host country assets in home
country
Take-off contracts
Exports
Legal
Proven process
Experience
Management
Price control
Quality of management
Long-term contracts
Pricing
Throughput
Lobbying
Lobbying
Operating costs
Force majeure
Inflation
Foreign exchange
Insurance
Output priced in hard currency
Disruption
Convertibilty and
transferability
Fairness
Human resource management
17
Offshore proceeds account
Accounting for risks in projects evaluation
2 methods:
Adjusting the cost of equity with a ‘risk’ premium
Country βeta (Lessard):
CoE= Risk free rate + country risk premium + asset βeta *market equity premium*
Country βeta
Risk premium :
a) based on bond spread
= (yield on host country bonds - yield on home country bonds)
b) Export credits agency credit risk premium
Adjusting the cash flows
Adjust each element of cash flow according to expected occurrence of adverse events
18
Adjusting the cost of equity (Donald Lessard - MIT)
1.
Calculate the risk premium due to market risk (offshore project βeta) to be included in the
cost of equity
Offshore project βeta = βeta of comparable project in home country * country βeta
Where country βeta = volatility of the host country stock market (correlation of changes with
home country) (or GDP)/ to the home country
2.
Add a political risk premium
Bond risk premium
3.
Adjust WACC accordingly
4.
Cost of equity in a foreign investment:
= Risk-free home country + country risk (bond risk premium) + market risk premium*
(company βeta * country market βeta)
19
Adjusting the cost of equity (Donald Lessard - MIT) cont.
Example:
Investment of Australian Mining Co. (AMC) in Brazil, entirely financed with equity
Cash flow in Brazilian Real (BRL):
(1 AUS$ = 1.9 BRL)
Year
Cash flow
0
-175
1
40
2
45
3
50
4
55
5
145
(AMC cost of equity: 12% (5% risk free + 5% market risk + 2% company risk)
10 year government bond rates: Australia = 5.5%; Brazil= 12.4%)
GDP variation βeta BRZ/AUS= 1.04
NPV without risks (cost of equity: 12%) =
IRR =
NPV with risks (cost of equity: 12% + (12.4% - 5.5%) + (5%*1.04) =
IRR =
20
Adjusting the cash flows (Hawawini & Viallet - INSEAD)
1. Identify the elements of cash flow subject to country risk variation
(revenues, costs)
2. Assign a probability of occurrence to those elements
3. Take the expected value [likely cash flow * (1-probability of adverse
event)]
4. Possibility to run a Monte Carlo simulation if various probabilities
affect various elements
5. Calculate NPV with global cost of capital
21
Trade finance
22