Ton Duc Thang University
Finance and Banking Faculty
Corporate Finance Department
FINTERNATIONAL FINANCIAL
MANAGEMENT
CHAPTER 0
INTRODUCTION
Course Code: B02039
Prepared by: Corporate Finance Department
8/8/2020
B02039 – Chapter 0: Introduction
1
ACKNOWLEDGEMENT
• The contents of this slide are the
supplemental teaching material of the book:
• Jeff Madura, [2015], International Financial
Management, Cengage Learning, Stamford
• The purpose of this teaching material is to
serve for the subject “International Financial
Management” at Faculty of Finance and
Banking, Ton Duc Thang University.
8/8/2020
B02039 – Chapter 0: Introduction
2
POLICIES FOR STUDENTS
• These contents are only used for
students PERSONALLY.
• Students are NOT allowed to modify or
deliver these contents to anywhere or
anyone for any purpose.
8/8/2020
B02039 – Chapter 0: Introduction
3
COURSE INTRODUCTION
Course Name
INTERNATIONAL FINANCIAL
MANAGEMENT
Course Code
B02039
No. of credits
3 (3.0)
Time
allocation
8/8/2020
Theory
45 teaching
hours
Self – study
90 hours
B02039 – Chapter 0: Introduction
4
REQUIREMENTS
Prerequisite:
World English 6
INTERNATIONAL
FINANCIAL
MANAGEMENT
Priorcompletion:
Financial
Management
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B02039 – Chapter 0: Introduction
5
COURSE OBJECTIVES
Objectives
8/8/2020
• This course studies the foreign
exchange markets such as the balance
of payments, the arbitrage, the
purchasing power parity, the interest
rate parity, the foreign exchange
derivative markets and the international
financial market…
• This course also studies how corporate
make wealth – maximizing decisions.
Besides that, this subject study “hot”
topics, such as international finance
crisis and the problem of sovereign
debt…, which are affecting the
international finance.
B02039 – Chapter 0: Introduction
6
COURSE LEARNING
OUTCOMES
No.
Outcomes
01
Students can recall the concepts, definitions of the international
financial market..
02
Students should be able to understand the institutional and
organizational structure of international financial market.
Students will be able to practice various derivative instruments,
03 including futures, forwards, swaps, option to hedge foreign currency
transaction exposure.
04
Students can analysis activities dealing with international financial
management.
05
Students comply with the principles, ethics in the task and scientific
research dealing with international financial management
8/8/2020
B02039 – Chapter 0: Introduction
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COURSE CONTENT
Chapter 1: Multinational Financial
Management: An Overview
Chapter 2: International Flow of Funds
Chapter 3: International Financial Markets
Chapter 4: Direct foreign investment
8/8/2020
B02039 – Chapter 0: Introduction
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COURSE CONTENT
Chapter 5: Multinational capital budgeting
Chapter 6: Multinational cost of capital and
capital structure
Chapter 7: Financing international trade
Chapter 8: International cash management
8/8/2020
B02039 – Chapter 0: Introduction
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TEACHING MATERIALS
Textbook
• [1]. Jeff Madura, [2015], International
Management, Cengage Learning, Stamford
Financial
Supplementary
Readings
• [2]. Cheol Eun, Bruce Resnick, [2015], International
Financial Management, McGraw-Hill, New York.
[3]. Nguyễn Văn Tiến chủ biên, [2018], Giáo trình tài
chính quốc tế, NXB Thống kê, Hà Nội.
8/8/2020
B02039 – Chapter 0: Introduction
10
TEACHING MATERIALS
Additional Readings
• [4]. Nguyễn Văn Tiến chủ biên, [2013], Giáo
trình tài chính quốc tế hiện đại, NXB Thống kê,
Hà Nội
[5]. Lê Phan Diệu Thảo chủ biên, [2015], Giáo
trình tài chính quốc tế, NXB Phương Đông, Tp
Hồ Chí Minh.
8/8/2020
B02039 – Chapter 0: Introduction
11
ASSESSMENT SCHEME
Evaluation Category
Weight
Type of questions
Process evaluation 1
10%
Process Exercise
Process evaluation 2
20%
Process Exercise
Mid-term test
20%
Multiple choice question
50%
Multiple choice question,
Constructed response
test
Final examination
8/8/2020
B02039 – Chapter 0: Introduction
12
STUDENT’S TASKS
• Being on-time and in your seat when class starts
and staying until the end of class;
• Being constructive to the learning environment;
• Being “present” in the class and focused on class
material;
• Coming prepared to contribute to the class;
• Communicating with the lecturer;
• Attending at least 80% of course requirement (if
this regulation is not fulfilled, students are not
eligible to take their final exam).
8/8/2020
B02039 – Chapter 0: Introduction
13
International Corporate Finance
11th Edition
by Jeff Madura
1
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Part 1
The International Financial Environment
2
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1Multinational Financial Management: An Overview
Chapter Objectives
1
2
3
4
3
• Management goal of the Multinational Corporation (MNC).
• Organizational structure of the Multinational Corporation (MNC).
• The key theories that justify international business
• Common methods used to conduct international business
• Model for valuing the MNC
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Managing the MNC
1. Managers are expected to make decisions that
will maximize the stock price.
2. Focus of this text: MNCs whose parents fully
own foreign subsidiaries (U.S. parent is sole
owner of subsidiary.)
3. Finance decisions are influenced by other
business discipline functions:
◼
◼
◼
4
Marketing
Management
Accounting and information systems
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Typical Management Decisions
Shareholders
Customers
Suppliers
5
Employees
Competitors
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Agents and Principals Relationship
1. Who is the real owner of the firms?
2. Why shareholders don’t manage their firms?
6
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Agency Problems
The conflict of goals between managers and
shareholders
7
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Group Activities: Agency Problems
1
2
3
8
• What is the main reasons of
agency cost?
• Example of agency cost?
• Could we completely solve agency
costs by firing the manager?
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Agency Costs
1. Definition: Cost of ensuring that managers
maximize shareholder wealth
2. Costs are normally higher for MNCs than for purely
domestic firms for several reasons:
▪
▪
▪
▪
9
Monitoring managers of distant subsidiaries in foreign
countries is more difficult.
Foreign subsidiary managers raised in different cultures
may not follow uniform goals.
Sheer size of larger MNCs can create large agency
problems.
Some non-U.S. managers tend to downplay the shortterm effects of decisions.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Control of Agency Problems
Parent
control of
agency
problems
Corporate
control of
agency
problems
SarbanesOxley Act
(SOX)
Control
Agency
Costs
10
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
SOX Methods to Improve Reporting
▪ Establishing a centralized database of information
▪ Ensuring that all data are reported consistently
among subsidiaries
▪ Implementing a system that automatically checks for
unusual discrepancies relative to norms
▪ Speeding the process by which all departments and
subsidiaries have access to all the data they need
▪ Making executives more accountable for financial
statements
11
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 1.1a Management Styles of MNCs
Allows managers of the parent to control foreign
subsidiaries and therefore reduce the power of
subsidiary managers
12
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 1.1b Management Styles of MNCs
Gives more control to subsidiary managers who are
closer to the subsidiary’s operation and environment
13
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Group Activity 2: Compare 2 Management
Structure of an MNC
14
Centralize
Structure
Decentralize
Structure
Pros
Pros
Cons
Cons
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Why Firms Pursue International Business
15
Competitive
Advantage
• Specialization by countries can increase production
efficiency
• Some countries focus on production
• Some countries focus on services
Imperfect
Markets
Theory
• Factors of productions are somewhat immobile
• There are costs and restriction related to the transfer of
labor and other resources used for production
Product Cycle
Theory
• As firms matures, it may recognize additional
opportunities outside its home country
• The success of foreign business depends on maintaining
competitive advantages against competitors
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 1.2 International Product Life Cycles
16
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
How Firms Engage in International Business
1. International trade
2. Licensing
3. Franchising
4. Joint Ventures
5. Acquisitions of existing operations
6. Establishing new foreign subsidiaries
17
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
International Trade
◼
18
Relatively conservative approach that
can be used by firms to
◼
penetrate markets (by exporting)
◼
obtain supplies at a low cost (by
importing).
◼
Minimal risk – no capital at risk
◼
The internet facilitates international
trade by allowing firms to advertise
their products and accept orders on
their websites.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Licensing
19
◼
Obligates a firm to provide its technology
(copyrights, patents, trademarks, or trade names)
in exchange for fees or some other specified
benefits.
◼
Allows firms to use their technology in foreign
markets without a major investment and without
transportation costs that result from exporting
◼
Major disadvantage: difficult to ensure quality
control in foreign production process
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Franchising
20
◼
Obligates firm to provide a
specialized sales or service
strategy, support
assistance, and possibly an
initial investment in the
franchise in exchange for
periodic fees.
◼
Allows penetration into
foreign markets without a
major investment in
foreign countries.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Joint Ventures
21
◼
A venture that is jointly
owned and operated by two
or more firms. A firm may
enter the foreign market by
engaging in a joint venture
with firms that reside in
those markets.
◼
Allows two firms to apply
their respective cooperative
advantages in a given
project.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Acquisitions of Existing Operations
22
◼
Acquisitions of firms in
foreign countries allows firms
to have full control over their
foreign businesses and to
quickly obtain a large portion
of foreign market share.
◼
Subject to the risk of large
losses because of larger
investment.
◼
Liquidation may be difficult
if the foreign subsidiary
performs poorly.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Establishing New Foreign Subsidiaries
23
◼
Firms can penetrate markets by
establishing new operations in
foreign countries.
◼
Requires a large investment
◼
Acquiring new as opposed to
buying existing allows operations
to be tailored exactly to the firms
needs.
◼
May require smaller investment
than buying existing firm.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Summary of Methods
24
◼
Any method of increasing international business
that requires a direct investment in foreign
operations is referred to as direct foreign
investment (DFI)
◼
International trade and licensing usually not
included
◼
Foreign acquisition and establishment of new
foreign subsidiaries represent the largest portion of
DFI.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Group Activities 3: Planning your MNCs
Create an idea for your own MNC to conduct international business.
Your idea should be simplified to the degree that you could possibly
implement it someday. However, your idea should also be sufficiently
creative to be successful if done properly. Your idea should be for a
small MNC instead of a large MNC because even most large MNCs
began as small firms. The following questions will help you define your
MNC idea:
▪ What is the product that you plan to sell?
▪ What foreign country do you plan to target?
▪ How will you sell the product in that country? (i.e., through a
distributor? by mail?)
▪ Is there some evidence that consumers in that country would buy
this type of product?
▪ Will any expenses you incur from producing the product be in some
other currency?
25
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 1.3 Cash Flow Diagrams for MNCs
26
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 1.3 Cash Flow Diagrams for MNCs
27
◼
The first diagram reflects an MNC that engages in
international trade. International cash flows result from
paying for imports or receiving cash flow from exports.
◼
The second diagram reflects an MNC that engages in some
international arrangements. Outflows include expenses
such as expenses incurred from transferring technology or
funding partial investment in a franchise or joint venture.
Inflows are receipts from fees.
◼
The third diagram reflects an MNC that engages in direct
foreign investment. Cash flows exist between the parent
company and the foreign subsidiary.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Valuation Model for an MNC:
Domestic Model
 E (CF$,t )
V = 

t
t =1  (1 + k )

n
Where
▪ V represents present value of expected cash flows
▪ E(CF$,t) represents expected cash flows to be received at the
end of period t,
▪ n represents the number of periods into the future in which
cash flows are received, and
▪ k represents the required rate of return by investors.
28
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Valuation Model for an MNC:
Multinational Model


E (CF$,t ) =  E (CF j ,t ) E (S j ,t )
m
j =1
Where
▪ CFj,t represents the amount of cash flow denominated in a
particular foreign currency j at the end of period t,
▪
29
Sj,t represents the exchange rate at which the foreign currency
(measured in dollars per unit of the foreign currency) can be
converted to dollars at the end of period t.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Example of Expected CF in Foreign Currency
FORD exports cars to
Japan, it expects to
receive 10 mil. Yen in
3 months later
Exchange rate today:
1USD= 100Yen
30
3 months later
1USD = 90 Yen
Profit / loss = ? USD
3 months later
1USD = 120 Yen
Profit /Loss = ? USD
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Valuation Model for an MNC
An MNC that uses two or more currencies


E (CF$,t ) =  E (CF j ,t ) E (S j ,t )
m
j =1
▪
▪
31
Derive an expected dollar cash flow value for each currency
Combine the cash flows among currencies within a given
period
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Uncertainty Surrounding MNC Cash Flows
1. Exposure to international economic conditions – If
economic conditions in a foreign country weaken, purchase
of products decline and MNC sales in that country may be
lower than expected.
2. Exposure to international political risk – A foreign
government may increase taxes or impose barriers on the
MNC’s subsidiary.
3. Exposure to exchange rate risk – If foreign currencies
related to the MNC subsidiary weaken against the U.S.
dollar, the MNC will receive a lower amount of dollar cash
flows than was expected.
32
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
How Uncertainty Affects the MNC’s cost of Capital
A higher level of uncertainty increases the return on
investment required by investors and the MNC’s
valuation decreases.
33
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 1.4 How an MNC’s Valuation is Exposed to
Uncertainty
34
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Summary
◼
35
The main goal of an MNC is to maximize shareholder
wealth. When managers are tempted to serve their own
interests instead of those of shareholders, an agency
problem exists. MNCs tend to experience greater agency
problems than do domestic firms. Proper incentives and
communication from the parent may help to ensure that
subsidiary managers focus on serving the overall MNC.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Summary
International business is justified by three key theories.
1. The theory of comparative advantage suggests that each
country should use its comparative advantage to
specialize in its production and rely on other countries to
meet other needs.
2. The imperfect markets theory suggests that because of
imperfect markets, factors of production are immobile,
which encourages countries to specialize based on the
resources they have.
3. The product cycle theory suggests that after firms are
established in their home countries, they commonly
expand their product specialization in foreign countries.
36
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Summary
◼
37
The most common methods by which firms conduct
international business are international trade, licensing,
franchising, joint ventures, acquisitions of foreign firms, and
formation of foreign subsidiaries. Methods such as licensing
and franchising involve little capital investment but
distribute some of the profits to other parties. The
acquisition of foreign firms and formation of foreign
subsidiaries require substantial capital investments but offer
the potential for large returns.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Summary
◼
38
The valuation model of an MNC shows that the MNC’s
value is favorably affected when its expected foreign cash
inflows increase, the currencies denominating those cash
inflows increase, or the MNC’s required rate of return
decreases. Conversely, the MNC’s value is adversely
affected when its expected foreign cash inflows decrease,
the values of currencies denominating those cash flows
decrease (assuming that they have net cash inflows in
foreign currencies), or the MNC’s required rate of return
increases.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
International Corporate Finance
11th Edition
by Jeff Madura
1
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
2 International Flow of Funds
Chapter Objectives
 Explain the key components of the balance of payments,
 Explain the growth in international trade activity over time,
 Explain how international trade flows are influenced by
economic factors and other factors,
 Explain how international capital flows are influenced by
country characteristics,
 Introduce the agencies that facilitate the international flow of
funds.
2
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
2 International Flow of Funds
Chapter Objectives
1
2
3
3
3
3
• Key components of the balance of payments
• The growth in international trade activity over time
• How international trade flows are influenced by economic factors and
other factors
• How international capital flows are influenced by country characteristics
• The agencies that facilitate the international flow of funds
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Balance of Payments
BOP is summary of
transactions between
domestic and foreign
residents for a specific
country over a specified
period of time.
Component of BOP:
 Current account
 Capital account
 Investment account
4
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Components of the Balance of Payments
Statement:
Current account
• flow of funds due to purchases of goods or
services or the provision of income on financial
assets
Capital account
• flow of funds resulting from the sale of assets
between one specified country and all other
countries over a specified period of time
Investment account
• Special types of investment, including FDI and
portfolio investment
5
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Current Account
1. Payments for merchandise and services
Merchandise exports and imports represent tangible
products that are transported between countries. Service
exports and imports represent tourism and other services.
The difference between total exports and imports is referred
to as the balance of trade.
2. Factor income payments
Represents income (interest and dividend payments)
received by investors on foreign investments in financial
assets (securities).
3. Transfer payments
Represent aid, grants, and gifts from one country to
another.
6
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 2.1 Examples of Current Account Transactions
7
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Exhibit 2.2 Summary of Current Account in the year 2010
(in billions of $)
8
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Capital and Financial Accounts
1. Direct foreign investment
Investments in fixed assets in foreign countries
2. Portfolio investment
Transactions involving long term financial assets (such as
stocks and bonds) between countries that do not affect the
transfer of control.
3. Other capital investment
Transactions involving short-term financial assets (such as
money market securities) between countries.
4. Errors and omissions
Measurement errors can occur when attempting to measure the
value of funds transferred into or out of a country.
9
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Events That Increased Trade Volume
Removal of
Berlin Wall
Single
European Act
of 1987
North
American Free
Trade
Agreement
10
Inception of the
Euro Currency
Expansion of
European Union
Other Free Trade
Agreements
General
Agreement on
Tariffs and Trade
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Events That Increased Trade Volume
1. Removal of the Berlin Wall: Led to reductions in trade
barriers in Eastern Europe.
2. Single European Act of 1987: Improved access to
supplies from firms in other European countries.
3. North American Free Trade Agreement
(NAFTA): Allowed U.S. firms to penetrate product and
labor markets that previously had not been accessible.
4. General Agreement on Tariffs and Trade
(GATT): Called for the reduction or elimination of trade
11
restrictions on specified imported goods over a 10-year period
across 117 countries.
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Events That Increased Trade Volume (cont.)
5. Inception of the Euro: Reduced costs and risks
associated with converting one currency to another.
6. Expansion of the European Union: reduced
restrictions on trade with Western Europe.
7. Other Trade Agreements: The United States has
established trade agreements with many other countries.
12
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ASEAN Free Trade Area
13
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Impact of Outsourcing on Trade
14
Definition
• The process of subcontracting to a third party in
another country to provide supplies or services
that were previously produced internally.
Advantages
• Increased international trade activity
• Lower cost of operations and job creation in
countries with low wages
Disadvantages
• Outsourcing may reduce jobs in the United
States
• the possible bad publicity or bad morale that
could occur among the U.S. workers
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Managerial Decisions About Outsourcing
1. Managers of a U.S.–based MNC may argue that
they create jobs for U.S. workers.
2. Shareholders may suggest that the managers are not
maximizing the MNC’s value as a result of their
commitment to creating U.S. jobs.
3. Managers should consider the potential savings that
could occur as a result of outsourcing.
4. Managers must also consider the possible bad
publicity or bad morale that could occur among the
U.S. workers.
15
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Trade Volume Among Countries
1. The annual international trade volume of the United
States is between 10 and 20 percent of its annual
GDP.
2. Trade volume between the United States and Other
Countries:
1. About 20 percent of all U.S. exports are to Canada,
while 13 percent are to Mexico.
2. Canada, China, Mexico, and Japan are the key
exporters to the United States. Together, they are
responsible for more than half of the value of all U.S.
imports.
16
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The Net Trade Deficits of US in 2017
17
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Trading Partners of Vietnam in 2016-2017
18
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Exhibit 2.3 Distributions of U.S. Exports Across
Countries (in billions of $)
19
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Exhibit 2.4 2008 Distribution of U.S. Exports and Imports
20
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Trend in U.S. Balance of Trade
1. The U.S. balance of trade deficit increased
substantially from 1997 until 2008.
2. In the 2008–2009 period, U.S. economic
conditions weakened and the U.S. demand for
foreign products and services decreased.
3. In recent years, the U.S. annual balance of trade
deficit with China has exceeded $200 billion.
4. Any country’s balance of trade can change
substantially over time.
21
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Exhibit 2.5 U.S. Balance of Trade Over Time
(Quarterly)
22
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US Trade Deficits and Trade Partners in 20162017
23
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Factors Affecting International Trade Flows
National
income
Government
policies
Inflation
Cost of
labor
24
Trade
flows
Exchange
rate
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Factors Affecting International Trade Flows
1. Cost of Labor: Firms in countries
where labor costs are low
commonly have an advantage
when competing globally,
especially in labor intensive
industries
2. Inflation: Current account
decreases if inflation increases
relative to trade partners.
3. National Income: Current account
decreases if national income
increases relative to other
countries.
25
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Factors Affecting International Trade Flows (cont.)
4. Government Policies: can increase imports through:
a. Restrictions on imports
b. Subsidies for exporters
c. Lack of Restriction on piracy
d. Environmental restrictions
e. Labor laws
f. Tax breaks
g. Country security laws
5. Exchange Rates: current account decreases if
currency appreciates relative to other currencies.
26
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Group Discussion: Can A Strong Dollar a Bad Thing?
27
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Group Discussion: Can A Strong Dollar a Bad Thing?
1
28
• Is it good to have strong currency?
2
• How could trade barrier drive dollar
down?
3
• What is the effect of free trade agreement
on value of USD
4
• What are possible strategy for USA to
weaken its currency?
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Impact of Government Policies
1. Restrictions on Imports: Taxes (tariffs) on imported goods
increase prices and limit consumption. Quotas limit the
volume of imports.
2. Subsidies for Exporters: Government subsidies help firms
produce at a lower cost than their global competitors.
3. Restrictions on Piracy: A government can affect
international trade flows by its lack of restrictions on
piracy.
4. Environmental Restrictions: Environmental restrictions
impose higher costs on local firms, placing them at a global
disadvantage compared to firms in other countries that are
not subject to the same restrictions.
29
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Impact of Government Policies (cont.)
5. Labor Laws: countries with more restrictive laws will
incur higher expenses for labor, other factors being
equal.
6. Business Laws: Firms in countries with more restrictive
bribery laws may not be able to compete globally in
some situations.
7. Tax Breaks: Though not necessarily a subsidy, but still a
form of government financial support that might benefit
many firms that export products.
8. Country Security Laws: Governments may impose
certain restrictions when national security is a concern,
which can affect on trade.
30
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Impact of Exchange Rates
 How exchange rates may correct a balance of trade
deficit:
When a home currency is exchanged for a foreign currency
to buy foreign goods, then the home currency faces
downward pressure, leading to increased foreign demand for
the country’s products.
 Why exchange rates may not correct a balance of
trade deficit:
Exchange rates will not automatically correct any
international trade balances when other forces are at work.
31
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Limitations of a Weak Home Currency Solution
1. Competition: foreign companies may lower their prices to
remain competitive.
2. Impact of other currencies: a country that has balance of
trade deficit with many countries is not likely to solve all
deficits simultaneously.
3. Prearranged international trade transactions: international
transactions cannot be adjusted immediately. The lag is
estimated to be 18 months or longer, leading to a J-curve
effect.
4. Intracompany trade: Many firms purchase products that are
produced by their subsidiaries. These transactions are not
necessarily affected by currency fluctuations.
32
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Exhibit 2.6 J-Curve Effect
33
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Friction Regarding Exchange Rates
1. All governments cannot weaken their home
currencies simultaneously.
2. Actions by one government to weaken its currency
causes another country’s currency to strengthen.
3. Government attempts to influence exchange rates
can lead to international disputes.
34
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Friction Regarding Exchange Rates
1. All governments cannot
weaken their home
currencies simultaneously.
2. Actions by one government
to weaken its currency
causes another country’s
currency to strengthen.
3. Government attempts to
influence exchange rates
can lead to international
disputes.
35
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Friction Regarding Exchange Rates
36
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Group Discussion
1
2
37
• What is currency devaluation?
• Why countries devaluate their currency?
3
• What are the possible way to counter
currency devaluation?
4
• In your opinion, should Vietnam follow
China to devaluate its currency?
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Factors Affecting Direct Foreign Investing (DFI)
1. Changes in Restrictions
 New opportunities have arisen from
the removal of government barriers.
2. Privatization
 DFI is stimulated by new business
opportunities associated with
privatization.
 Managers of privately owned
businesses are motivated to ensure
profitability, further stimulating
DFI.
38
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Factors Affecting Direct Foreign Investing (DFI) (Cont.)
4. Potential Economic Growth
 Countries with greater potential for economic
growth are more likely to attract DFI.
5. Tax Rates
 Countries that impose relatively low tax rates on
corporate earnings are more likely to attract DFI.
6. Exchange Rates
 Firms typically prefer to pursue DFI in countries
where the local currency is expected to strengthen
against their own.
39
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Direct Foreign Investing In Asean , 2012
40
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Factors Affecting International Portfolio Investment
1. Tax Rate on Interest or Dividends
Investors normally prefer to invest in a country where taxes
are relatively low.
2. Interest Rates
Money tends to flow to countries with high interest rates, as
long as the local currencies are not expected to weaken.
3. Exchange Rates
Investors are attracted to a currency that is expected to
strengthen.
41
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Impact of International Capital Flows
1. The United States relies heavily on foreign
investment in:



U.S. manufacturing plants, offices, and other
buildings.
Debt securities issued by U.S. firms.
U.S. Treasury debt securities
2. Foreign investors are especially attracted to the U.S.
financial markets when the interest rate in their home
country is substantially lower than that in the United
States.
42
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Exhibit 2.7 Impact of the International Flow of Funds on U.S.
Interest Rates and Business Investment in the United States
43
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Agencies that Facilitate International Flows
International Monetary Fund (IMF)
1. Major Objectives of the IMF
i. promote cooperation among countries on international
monetary issues,
ii. promote stability in exchange rates
iii. provide temporary funds to member countries attempting
to correct imbalances of international payments
iv. promote free mobility of capital funds across countries
v. promote free trade. It is clear from these objectives that
the IMF’s goals encourage increased internationalization
of business
2. Its compensatory financing facility (CFF) attempts to
reduce the impact of export instability on countries.
3. Financing is measured in special drawing rights (SDRs)
44
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Agencies that Facilitate International Flows
World Bank (International Bank for Reconstruction and Development)
1. Major Objective- Make loans to countries to enhance
economic development.
2. Structural Adjustment Loans (SALs) are intended to
enhance a country’s long-term economic growth.
3. Funds are distributed through cofinancing agreements:



45
Official aid agencies
Export credit agencies
Commercial banks
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Agencies that Facilitate International Flows
World Trade Organization (WTO)
1. Major Objective - Provide a forum for multilateral trade
negotiations and to settle trade disputes related to the GATT
accord.
2. Member countries are given voting rights that are used to
make judgments about trade disputes and other issues.
46
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Agencies that Facilitate International Flows
International Financial Corporation (IFC)
1. Major Objective - promote private enterprise within
countries.
2. Provides loans to corporations and purchases stock
3. It traditionally has obtained financing from the
World Bank but can borrow in the international
financial markets.
47
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Agencies that Facilitate International Flows
International Development Association (IDA)
1. Major Objectives - extends loans at low interest rates
to poor nations that cannot qualify for loans from the
World Bank.
48
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Agencies that Facilitate International Flows
Bank for International Settlements (BIS)
1. Major Objectives - facilitate cooperation among
countries with regard to international transactions.
2. Provides assistance to countries experiencing a
financial crisis.
3. Sometimes referred to as the “central banks’
central bank” or the “lender of last resort.”
49
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Agencies that Facilitate International Flows
Organization for Economic Cooperation and Development (OECD)
1. Major Objective - Facilitate governance in
governments and corporations of countries with
market economics.
2. It has 30 member countries and has relationships
with numerous countries.
3. Promotes international country relationships that
lead to globalization.
50
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Agencies that Facilitate International Flows
Regional Development Agencies
1. Inter-American Development Bank: focusing on the
needs of Latin America
2. Asian Development Bank: established to enhance
social and economic development in Asia
3. African Development Bank: focusing on
development in African countries
4. European Bank for Reconstruction and
Development: created in 1990 to help the Eastern
European countries adjust from communism to
capitalism.
51
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SUMMARY
 The key components of the balance of payments are the
current account and the capital account. Current account broad measure of the country’s international trade balance.
Capital account - measure of the country’s long-term and
short-term capital investments.
 International trade activity has grown over time. Outsourcing,
subcontracting with a third party in a foreign country for
supplies or services they previously produced themselves, has
increased. Thus increasing international trade activity.
 A country’s international trade flows are affected by inflation,
national income, government restrictions, and exchange rates.
52
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SUMMARY (Cont.)
 A country’s international capital flows are affected by any
factors that influence direct foreign investment or portfolio
investment. Direct foreign investment tends to occur in those
countries that have no restrictions and much potential for
economic growth. Portfolio investment tends to occur in those
countries where taxes are not excessive, where interest rates
are high, and where the local currencies are not expected to
weaken.
 Several agencies facilitate the international flow of funds by
promoting international trade and finance, providing loans to
enhance global economic development, settling trade disputes
between countries, and promoting global business
relationships between countries.
53
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International Corporate Finance
11th Edition
by Jeff Madura
1
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3 International Financial Markets
Chapter Objectives
Describe the background and corporate use of the
following International Financial Markets:
 Foreign exchange market
 International money market
 International credit market
 International bond market
 International stock markets
2
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Foreign Exchange Market
1. Allows for the exchange of one currency for
another.
2. Exchange rate specifies the rate at which one
currency can be exchanged for another.
3
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History of Foreign Exchange
1. Gold Standard (1876 – 1913)
Each currency was convertible into gold at a specified
rate. When World War I began in 1914, the gold
standard was suspended.
2. Agreements on Fixed Exchange Rates
a.Bretton Woods Agreement 1944 - 1971
b.Smithsonian Agreement 1971 - 1973
3. Floating Exchange Rate System
Widely traded currencies were allowed to fluctuate in
accordance with market forces
4
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Foreign Exchange Transactions
1. The over-the-counter market is the
telecommunications network where companies
normally exchange one currency for another.
2. Foreign exchange dealers serve as intermediaries
in the foreign exchange market
3. A foreign exchange transaction for immediate
exchange is said to trade in the spot market. The
exchange rate in the spot market is the spot rate.
4. Trading between banks occurs in the interbank
market.
5
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Spot Market
1. The U.S. Dollar is the commonly accepted
medium of exchange in the spot market.
2. Spot market time zones - Foreign exchange
trading is conducted only during normal business
hours in a given location. Thus, at any given time
on a weekday, somewhere around the world a
bank is open and ready to accommodate foreign
exchange requests.
3. Spot market liquidity: More buyers and sellers
means more liquidity.
6
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Attributes of Banks That Provide Foreign Exchange
1. Competitiveness of quote
2. Special relationship with the bank
3. Speed of execution
4. Advice about current market conditions
5. Forecasting advice
7
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Foreign Exchange Quotations
1. At any given point in time, a bank’s bid (buy) quote
for a foreign currency will be less than its ask (sell)
quote.
2. The bid/ask spread covers the bank’s cost of
conducting foreign exchange transactions
Ask rate  Bid rate
Bid / ask spread 
Ask rate
8
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Exhibit 3.1 Computation of the Bid Ask Spread
9
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Factors That Affect the Spread
1. Order costs: Costs of processing orders, including
clearing costs and the costs of recording transactions.
2. Inventory costs: Costs of maintaining an inventory of a
particular currency.
3. Competition: The more intense the competition, the
smaller the spread quoted by intermediaries.
4. Volume: Currencies that have a large trading volume
are more liquid because there are numerous buyers and
sellers at any given time.
5. Currency risk: Economic or political conditions that
cause the demand for and supply of the currency to
change abruptly.
10
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Interpreting Foreign Exchange Quotations
1. Direct Quotation represents the value of a
foreign currency in dollars (number of dollars
per currency).
Example: $1.40 per Euro
2. Indirect quotation represents the number of
units of a foreign currency per dollar.
Example: €0.7143 per Dollar
Indirect quotation = 1 / Direct quotation
11
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Exhibit 3.2 Direct and Indirect Exchange Rate Quotations
12
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Interpreting Changes in Exchange Rates
1. When the euro is appreciating against the
dollar (based on an upward movement of the
direct exchange rate of the euro), the indirect
exchange rate of the euro is declining.
2. When the euro is depreciating (based on a
downward movement of the direct exchange
rate) against the dollar, the indirect exchange
rate is rising.
13
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Exhibit 3.3 Relationship Between the Direct and
Indirect Exchange Rates Over Time
14
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Cross Exchange Rates
1. Cross exchange rate is the amount of one foreign currency
per unit of another foreign currency
2. Example
Value of peso = $0.07
Value of Canadian dollar = $0.70
15
Value of peso in C$ =
Value of peso in $
Value of C$ in $
=
$0.07 = C$ 0.10
$0.70
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Currency Derivatives
1. Forward Contracts: agreements between a
foreign exchange dealer and an MNC that
specifies the currencies to be exchanged, the
exchange rate, and the date at which the
transaction will occur.
 The forward rate is the exchange rate
specified by the forward contract.
 The forward market is the over-thecounter market where forward contracts are
traded.
16
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Currency Derivatives
2. Futures Contracts: similar to forward
contracts but sold on an exchange
 Specifies a standard volume of a particular
currency to be exchanged on a specific settlement
date.
 The futures rate is the exchange rate at which one
can purchase or sell a specified currency on the
specified settlement date.
 The future spot rate is the spot rate that will exist
at a future point in time and is uncertain as of
today.
17
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Currency Derivatives
3. Currency Options Contracts
a. Currency Call Option: provides the right to buy
currency at a specified strike price within a
specified period of time.
b. Currency Put Option: provides the right to sell
currency at specified strike price within a specified
period of time.
18
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International Money Market
1. Corporations or governments need short-term
funds denominated in a currency different from
their home currency.
2. The international money market has grown because
firms:
a. May need to borrow funds to pay for imports
denominated in a foreign currency.
b. May choose to borrow in a currency in which the
interest rate is lower.
c. May choose to borrow in a currency that is expected to
depreciate against their home currency
19
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Origins and Development
1. European Money Market: Dollar deposits in banks in
Europe and other continents are called Eurodollars or
Eurocurrency. Origins of the European money market can
be traced to the Eurocurrency market that developed
during the 1960s and 1970s.
2. Asian Money Market: Centered in Hong Kong and
Singapore. Originated as a market involving mostly
dollar-denominated deposits, and was originally known as
the Asian dollar market.
20
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Money Market Interest Rates Among Currencies
1. The money market interest rates in any particular
country are dependent on the demand for shortterm funds by borrowers, relative to the supply of
available short-term funds that are provided by
savers.
2. Money market rates vary due to differences in the
interaction of the total supply of short-term funds
available (bank deposits) in a specific country
versus the total demand for short-term funds by
borrowers in that country.
21
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Exhibit 3.4 Comparison of Money Market Interest Rates
22
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Global Integration of Money Market Interest Rates
1. Money market interest rates among countries tend
to be highly correlated over time.
2. When economic conditions weaken, the
corporate need for liquidity declines, and
corporations reduce the amount of short term
funds they wish to borrow.
3. When economic conditions strengthen, there is
an increase in corporate expansion, and
corporations need additional liquidity to support
their expansion.
23
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Risk of International Money Market Securities
1. International Money Market Securities are
debt securities issued by MNCs and government
agencies with a short-term maturity (1 year or
less)
2. Normally, these securities are perceived to be
very safe from the risk of default.
3. Even if the international money market securities
are not exposed to credit risk, they are exposed
to exchange rate risk when the currency
denominating the securities differs from the home
currency of the investors.
24
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International Credit Market
1. MNCs sometimes obtain medium-term funds
through term loans from local financial
institutions or through the issuance of notes
(medium-term debt obligations) in their local
markets.
2. Loans of 1 year or longer extended by banks to
MNCs or government agencies in Europe are
commonly called Eurocredits or Eurocredit
loans.
3. To avoid interest rate risk, banks commonly use
floating rate loans with rates tied to the London
Interbank Offer Rate (LIBOR).
25
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Regulations in the Credit Market
1. Single European Act:
 Capital can flow freely throughout Europe.
 Banks can offer a wide variety of lending, leasing, and
securities activities in the EU.
 Regulations regarding competition, mergers, and taxes are
similar throughout the EU.
 A bank established in any one of the EU countries has the
right to expand into any or all of the other EU countries.
2. Basel Accord - Banks must maintain capital equal to at
least 4 percent of their assets. For this purpose, banks’ assets
are weighted by risk.
26
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Regulations in the Credit Market (Cont.)
3. Basel II Accord - Attempts to account for differences in
collateral among banks. In addition, this accord encourages
banks to improve their techniques for controlling
operational risk, which could reduce failures in the banking
system. Also plans to require banks to provide more
information to existing and prospective shareholders about
their exposure to different types of risk.
4. Basel III Accord - Called for new methods of estimating
risk-weighted assets that would increase the level of riskweighted assets, and therefore require banks to maintain
higher levels of capital.
27
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Syndicated Loans in the Credit Market
1. Sometimes a single bank is unwilling or unable to
lend the amount needed by an MNC or
government agency.
2. A syndicate of banks can be formed to
underwrite the loans and the lead bank is
responsible for negotiating the terms with the
borrower.
28
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Impact of the Credit Crisis on the Credit Market
1. The credit crisis of 2008 triggered by defaults in
subprime loans led to a halt in housing
development, which reduced income, spending,
and jobs.
2. Financial institutions became cautious with their
funds and were less willing to lend funds to
MNCs
29
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International Bond Market
1. Foreign bonds are issued by borrower
foreign to the country where the bond is
placed.
2. Eurobonds are bonds sold in countries other
than the country of the currency denominating
the bond
 Partially a result of the Interest Equalization Tax
(EIT) imposed by the U.S. government in 1963 to
discourage U.S. investors from investing in
foreign securities.
30
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Eurobonds
1. Features:
 Bearer bonds
 Annual coupon payments
 Convertible or callable
2. Denominations

commonly denominated in a number of currencies
3. Underwriting Process
 multinational syndicate; simultaneously placed in many
countries
4. Secondary Market

31
market makers are in many cases the same underwriters
who sell the primary issues
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Development of Other Bond Markets
1. Bond markets have developed in Asia and
South America
2. Bond market yields among countries tend to be
highly correlated over time.
3. When economic conditions weaken, aggregate
demand for funds declines with the decline in
corporate expansion.
4. When economic conditions strengthen,
aggregate demand for funds increases with the
increase in corporate expansion.
32
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Risk of International Bonds
1. Credit Risk - represents the potential for default.
2. Interest Rate Risk - potential for the value of
bonds to decline in response to rising long-term
interest rates.
3. Exchange Rate Risk - represents the potential for
the value of bonds to decline (from the investor’s
perspective) because the currency denominating the
bond depreciates against the home currency.
4. Liquidity Risk - represents the potential for the
value of bonds to decline because there is not a
consistently active market for the bonds.
33
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Impact of the Greek Crisis on Bonds
1. Spring 2010: Greece experienced weak
economic conditions and large increase in the
government budget deficit.
2. Concern spread to other European countries
such as Spain, Portugal, and Ireland that had
large budget deficits.
3. May 2010: many European countries and the
IMF agreed to provide Greece with new loans.
34
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International Stock Markets
1. Issuance of Stock in Foreign Markets - Some
U.S. firms issue stock in foreign markets to enhance
their global image.
2. Issuance of Foreign Stock in the U.S.
a. Yankee stock offerings - Non-U.S. corporations
that need large amounts of funds sometimes issue
stock in the United States
b. American Depository Receipts (ADR) Certificates representing bundles of stock. ADR
shares can be traded just like shares of a stock.
35
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Non-U.S. Firms Listing on U.S.
Exchanges
1. Non-U.S. firms have their shares listed on the
New York Stock Exchange or the Nasdaq
market so that the shares can easily be traded
in the secondary market.
2. Effect of Sarbanes-Oxley Act on Foreign
Stock Listings - Many non-U.S. firms decided to
place new issues of their stock in the United Kingdom
instead of in the United States so that they would not
have to comply with the law.
36
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Investing in Foreign Stock Markets
1. Many investors purchase stocks outside of the
home country.
2. Recently, firms outside the U.S. have been
issuing stock more frequently.
37
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Exhibit 3.5 Comparison of Stock Exchanges (as of 2008)
38
Source: World Federation of Exchanges
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How Market Characteristics Vary among Countries
1. Stock market participation and trading activity are
higher in countries where managers are encouraged to
make decisions that serve shareholder interests, and
where there is greater transparency.
2. Factors that influence trading activity:





39
Voting power
Legal protection of shareholders
Government enforcement of securities laws
Corporate corruption
Level of financial disclosure
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Exhibit 3.6 Impact of Governance on Stock Market
Participation and Trading Activity
40
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How Financial Markets Serve MNCs
1. Corporate functions that require foreign exchange
markets.
 Foreign trade with business clients.
 Direct foreign investment, or the acquisition of foreign
real assets.
 Short-term investment or financing in foreign securities.
 Longer-term financing in the international bond or stock
markets.
41
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Exhibit 3.7 Foreign Cash Flow Chart of an MNC
42
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Summary
 The foreign exchange market allows currencies to be
exchanged in order to facilitate international trade or
financial transactions. Commercial banks serve as financial
intermediaries in this market.
 The international money markets are composed of several
large banks that accept deposits and provide short-term
loans in various currencies. This market is used primarily by
governments and large corporations.
 The international credit markets are composed of the same
commercial banks that serve the international money
market. These banks convert some of the deposits received
into loans (for medium-term periods) to governments and
large corporations.
43
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Summary (Cont.)
 The international bond markets facilitate international
transfers of long-term credit, thereby enabling governments
and large corporations to borrow funds from various
countries. The international bond market is facilitated by
multinational syndicates of investment banks that help to
place the bonds.
 International stock markets enable firms to obtain equity
financing in foreign countries. Thus, these markets help
MNCs finance their international expansion.
44
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International Corporate Finance
11th Edition
by Jeff Madura
1
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5 Currency Derivatives
Chapter Objectives
2
1
▪ Explain how forward contracts are used to
hedge based on anticipated exchange rate
movements
2
▪ Describe how currency futures contracts are
used to speculate or hedge based on
anticipated exchange rate movements
3
▪ Explain how currency option contracts are
used to speculate or hedge based on
anticipated exchange rate movements
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
What is a Currency Derivative?
Definition
• A currency derivative is a contract whose price is
derived from the value of an underlying currency.
Functions
• Speculate on future exchange rate movements
• Hedge exposure to exchange rate risk
Example
• Forwards/futures contracts
• Options contracts
3
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Forward Market
◼ A forward contract is an agreement between a
corporation and a financial institution:
▪
▪
▪
4
To exchange a specified amount of currency
At a specified exchange rate called the forward rate
On a specified date in the future
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How MNCs Use Forward Contracts
1
2
3
3
5
• Hedge their imports by locking in the rate at which they can obtain
the currency
• Bid/Ask Spread is wider for less liquid currencies
• May negotiate an offsetting trade if an MNC enters into a forward
sale and a forward purchase with the same bank
• Non-deliverable forward contracts (NDF) can be used for emerging
market currencies where no currency delivery takes place at
settlement, instead one party makes a payment to the other party
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Premium or Discount on the Forward Rate
F = S(1 + p)
where:
F is the forward rate
S is the spot rate
p is the forward premium, or the percentage by
which the forward rate exceeds the spot rate.
6
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Exhibit 5.1 Computation of Forward Rate Premiums or
Discounts
7
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Premium or Discount on the Forward Rate
Arbitrage – If the forward rate was the same as the spot rate,
arbitrage would be possible.
Movements in the Forward Rate over Time – The forward
premium is influenced by the interest rate differential
between the two countries and can change over time.
Offsetting a Forward Contract – An MNC can offset a
forward contract by negotiating with the original counterparty
bank.
Non-deliverable forward contracts (NDF) can be used for
emerging market currencies where no currency delivery takes
place at settlement; instead one party makes a payment to the
other party.
8
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Currency Futures Market
◼ Similar to forward contracts in terms of obligation to
purchase or sell currency on a specific settlement date
in the future.
◼ Differ from forward contracts because futures have
standard contract specifications:
a. Standardized number of units per contract (See Exhibit 5.2)
b. Offer greater liquidity than forward contracts
c. Typically based on U.S. dollar, but may be offered on crossrates.
d. Commonly traded on the Chicago Mercantile Exchange
(CME).
9
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Exhibit 5.2 Currency Futures Contracts Traded on the
Chicago Mercantile Exchange
10
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Trading Currency Futures
◼ Firms or individuals can execute orders for currency
futures contracts by calling brokerage firms.
◼ Electronic trading platforms facilitate the trading of
currency futures. These platforms serve as a broker,
as they execute the trades desired.
◼ Currency futures contracts are similar to forward
contracts in that they allow a customer to lock in the
exchange rate at which a specific currency is
purchased or sold for a specific date in the future.
11
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Exhibit 5.3 Comparison of the Forward and Futures Market
12
Source: Chicago Mercantile Exchange
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Trading Currency Futures (cont.)
◼ Pricing Currency Futures - The price of currency
futures will be similar to the forward rate
◼ Credit Risk of Currency Futures Contracts To minimize its risk, the CME imposes margin
requirements to cover fluctuations in the value of a
contract, meaning that the participants must make a
deposit with their respective brokerage firms when
they take a position.
13
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How Firms Use Currency Futures
◼ Purchasing Futures to Hedge Payables - The
purchase of futures contracts locks in the price at
which a firm can purchase a currency.
◼ Selling Futures to Hedge Receivables - The
sale of futures contracts locks in the price at which a
firm can sell a currency.
14
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Closing Out a Futures Position
◼ Sellers (buyers) of currency futures can close
out their positions by buying (selling)
identical futures contracts prior to settlement.
◼ Most currency futures contracts are closed out
before the settlement date.
15
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Exhibit 5.4 Closing Out a Futures Contract
16
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Speculation with Currency Futures
1. Currency futures contracts are sometimes purchased
by speculators attempting to capitalize on their
expectation of a currency’s future movement.
2. Currency futures are often sold by speculators who
expect that the spot rate of a currency will be less than
the rate at which they would be obligated to sell it.
17
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Exhibit 5.5 Source of Gains from Buying Currency
Futures
18
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Currency Futures Market Efficiency
1. If the currency futures market is efficient, the futures
price should reflect all available information.
2. Thus, the continual use of a particular strategy to take
positions in currency futures contracts should not lead
to abnormal profits.
3. Research has found that the currency futures market
may be inefficient. However, the patterns are not
necessarily observable until after they occur, which
means that it may be difficult to consistently generate
abnormal profits from speculating in currency futures.
19
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Currency Options Markets
◼ Currency options provide the right to purchase or sell
currencies at specified prices.
◼ Options Exchanges
▪
▪
▪
1982 - exchanges in Amsterdam, Montreal, and Philadelphia first
allowed trading in standardized foreign currency options.
2007 – CME and CBOT merged to form CME group
Exchanges are regulated by the SEC in the U.S.
◼ Over-the-counter market - Where currency options are
offered by commercial banks and brokerage firms. Unlike the
currency options traded on an exchange, the over-the-counter
market offers currency options that are tailored to the specific
needs of the firm.
20
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Currency Call Options
◼ Grants the right to buy a specific currency at a
designated strike price or exercise price within a
specific period of time.
◼ If the spot rate rises above the strike price, the owner of
a call can exercise the right to buy currency at the strike
price.
◼ The buyer of the option pays a premium.
◼ If the spot exchange rate is greater than the strike price,
the option is in the money. If the spot rate is equal to
the strike price, the option is at the money. If the spot
rate is lower than the strike price, the option is out of
the money.
21
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Factors Affecting Currency Call Option Premiums
The premium on a call option (C) is affected by three factors:
◼ Spot price relative to the strike price (S – X): The higher
the spot rate relative to the strike price, the higher the option
price will be.
◼ Length of time before expiration (T): The longer the time
to expiration, the higher the option price will be.
◼ Potential variability of currency (σ): The greater the
variability of the currency, the higher the probability that the
spot rate can rise above the strike price.
22
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How Firms Use Currency Call Options
Firms can use call options to:
◼ hedge payables
◼ hedge project bidding to lock in the dollar cost of
potential expenses.
◼ hedge target bidding of a possible acquisition.
◼ Speculate on expectations of future movements in a
currency.
23
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Currency Put Options
1. Grants the right to sell a currency at a specified strike
price or exercise price within a specified period of time.
2. If the spot rate falls below the strike price, the owner of a
put can exercise the right to sell currency at the strike
price.
3. The buyer of the options pays a premium.
4. If the spot exchange rate is lower than the strike price,
the option is in the money. If the spot rate is equal to the
strike price, the option is at the money. If the spot rate is
greater than the strike price, the option is out of the
money.
24
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Factors Affecting Put Option Premiums
Put option premiums are affected by three factors:
◼ Spot rate relative to the strike price (S–X): The lower
the spot rate relative to the strike price, the higher the
probability that the option will be exercised.
◼ Length of time until expiration (T): The longer the
time to expiration, the greater the put option premium
◼ Variability of the currency (σ): The greater the
variability, the greater the probability that the option
may be exercised.
25
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Hedging with Currency Put Options
1. Corporations with open positions in foreign currencies
can use currency put options in some cases to cover these
positions.
2. Some put options are deep out of the money, meaning
that the prevailing exchange rate is high above the
exercise price. These options are cheaper (have a lower
premium), as they are unlikely to be exercised because
their exercise price is too low.
3. Other put options have an exercise price that is currently
above the prevailing exchange rate and are therefore more
likely to be exercised. Consequently, these options are
more expensive.
26
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Speculating with Currency Put Options
1. Individuals may speculate with currency put options
based on their expectations of the future movements in a
particular currency.
2. Speculators can attempt to profit from selling currency
put options. The seller of such options is obligated to
purchase the specified currency at the strike price from
the owner who exercises the put option.
3. The net profit to a speculator is based on the exercise
price at which the currency can be sold versus the
purchase price of the currency and the premium paid for
the put option..
27
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Exhibit 5.6 Contingency Graphs for Currency Options
28
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Conditional Currency Options
1. A currency option can be structured with a conditional
premium, meaning that the premium paid for the option is
conditioned on the actual movement in the currency’s value
over the period of concern.
2. Firms also use various combinations of currency options.
29
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Exhibit 5.7 Comparison of Conditional and Basic
Currency Options
30
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European Currency Options
◼ European-style currency options must be exercised on the
expiration date if they are to be exercised at all.
◼ They do not offer as much flexibility; however, this is not
relevant to some situations.
◼ If European-style options are available for the same
expiration date as American-style options and can be
purchased for a slightly lower premium, some corporations
may prefer them for hedging.
31
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SUMMARY
▪ A forward contract specifies a standard volume of a
particular currency to be exchanged on a particular date.
Such a contract can be purchased by a firm to hedge
payables or sold by a firm to hedge receivables.
▪ Futures contracts on a particular currency can be purchased
by corporations that have payables in that currency and wish
to hedge against the possible appreciation of that currency.
Conversely, these contracts can be sold by corporations that
have receivables in that currency and wish to hedge against
the possible depreciation of that currency.
32
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SUMMARY (Cont.)
▪ Currency options are classified as call options or put
options. Call options allow the right to purchase a specified
currency at a specified exchange rate by a specified
expiration date. Put options allow the right to sell a specified
currency at a specified exchange rate by a specified
expiration date. Currency call options are commonly
purchased by corporations that have payables in a currency
that is expected to appreciate. Currency put options are
commonly purchased by corporations that have receivables
in a currency that is expected to depreciate.
33
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arbitrage
action to capitalize on a discrepancy in quoted prices; in many cases, there
is no investment of funds tied up for any length of time.
contingency graph
graph showing the net profit to a speculator in currency options under
various exchange rate scenarios.
currency call option contract that grants the right to purchase a specific currency at a specific
price (exchange rate) within a specific period of time.
currency futures
contracts
contract specifying a standard volume of a particular currency to be
exchanged on a specific settlement date.
currency option
combination
the use of simultaneous call and put option positions to construct a unique
position to suit the hedger’s or speculator’s needs. Two of the most popular
currency option combinations are straddles and strangles.
currency put option contract granting the right to sell a particular currency at a specified price
(exchange rate) within a specified period of time.
exercise price
(strike price)
34
price (exchange rate) at which the owner of a currency call option is
allowed to buy a specified currency; or the price (exchange rate) at which
the owner of a currency put option is allowed to sell a specified currency.
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forward contract agreement between a commercial bank and a client about an
exchange of two currencies to be made at a future point in time at a
specified exchange rate.
forward rate
rate at which a bank is willing to exchange one currency for another
at some specified date in the future.
non-deliverable like a forward contract, represents an agreement regarding a position
forward contract in a specified currency, a specified exchange rate, and a specified
(NDF)
future settlement date, but does not result in delivery of currencies.
Instead, a payment is made by one party in the agreement to the
other party based on the exchange rate at the future date.
35
straddle
combination of a put option and a call option.
straddles
combination of a put option and a call option.
strangles
a currency option combination; similar to a straddle.
strike price
See exercise price.
writer
seller of an option.
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14 Multinational Capital Budgeting
Chapter Objectives
1
1
▪ Compare the capital budgeting analysis of an
MNC’s subsidiary versus its parent
2
▪ Demonstrate how multinational capital
building can be applied to determine whether
an international project should be
implemented
3
▪ Show how multinational capital budgeting
can be adapted to account for special
situations such as alternative exchange rate
scenarios or when subsidiary financing is
considered
4
▪ Explain how the risk of international projects
can be assessed
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Subsidiary versus Parent Perspective
Tax Differentials
• different tax rates may make a project
feasible from a subsidiary’s perspective, but
not from a parent’s perspective
Restrictions on
Remitted
Earnings
• governments may place restrictions on
whether earnings must remain in country
Excessive
Remittances
• if the parent company charges fees to the
subsidiary, then a project may appear
favorable from a parent perspective, but not
from a subsidiary’s perspective
Exchange Rate
Movements
• earnings converted to the currency of the
parent company will be affected by
exchange rate movements
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3
Chapter 14
Multinational Capital Budgeting
net operating loss practice of applying losses to offset earnings in
carrybacks
previous years.
net operating loss practice of applying losses to offset earnings in
carryforwards
future years.
sensitivity analysis technique for assessing uncertainty whereby
various possibilities are input to determine
possible outcomes.
simulation
technique for assessing the degree of
uncertainty. Probability distributions are
developed for the input variables; simulation
uses this information to generate possible
outcomes.
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Exhibit 14.1 Process of Remitting Subsidiary Earnings to Parent
4
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Subsidiary versus Parent Perspective
1. The parent’s perspective is appropriate when evaluating a
project since the parent’s shareholders are the owners and any
project should generate sufficient cash flows to the parent to
enhance shareholder wealth.
2. One exception is when the foreign subsidiary is not wholly
owned by the parent and the foreign project is partially
financed with retained earnings of the parent and of the
subsidiary.
◼ The foreign subsidiary has a group of shareholders that it
must satisfy
◼ The foreign subsidiary has a group of shareholders that it
must satisfy
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Input for Multinational Capital Budgeting
Initial investment (Initial Outlay)
• Funds initially invested include whatever is necessary to start the
project and additional funds
Price and consumer demand
• Future demand is usually influenced by economic conditions,
which are uncertain
Costs
• Variable-cost forecasts can be developed from comparative costs
of the components
• Fixed costs can be estimated without an estimate of consumer
demand
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Input for Multinational Capital Budgeting
Tax law
• International tax effects must be determined
on any proposed foreign projects
Remitted funds
• The MNC policy for remitting funds to the
parent influences estimated cash flows
Exchange rates
• These movements are often very difficult to
forecast.
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Input for Multinational Capital Budgeting
Salvage (liquidation) values
• Depends on several factors, including
the success of the project and the
attitude of the host government toward
the project
Required rate of return
• The MNC should first estimate its cost
of capital, and then it can derive its
required rate of return on a project
based on the risk of that project
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MULTINATIONAL CAPITAL BUDGETING EXAMPLE
Background
▪ Spartan, Inc., is considering the development of a subsidiary
in Singapore that would manufacture and sell tennis rackets
locally.
▪ Spartan’s financial managers have asked the manufacturing,
marketing, and financial departments to provide them with
relevant input so they can apply a capital budgeting analysis
to this project.
▪ In addition, some Spartan executives have met with
government officials in Singapore to discuss the proposed
subsidiary.
▪ The project would end in 4 years. All relevant information
follows.
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Input for Multinational Capital Budgeting
Initial investment (Initial Outlay)
• S$ 20 million (S$ = Singapore dollars)
Price and consumer demand
• Year 1 and 2: 60,000 units @ S$350/unit
• Year 3: 100,000 units @ S$360/unit
• Year 4: 100,000 units @ S$380/unit
Costs
• Variable costs: Years 1 & 2 S$200/unit, Year 3
S$250/unit, Year 4 S$260/unit
• Fixed costs: S$2 million per year
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Input for Multinational Capital Budgeting
Tax law
• 20 percent income tax
Remitted funds
• 10 percent withholding tax on remitted
funds
Exchange rates
• Spot exchange rate of $0.50 for Singapore
dollar
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Input for Multinational Capital Budgeting
Salvage (liquidation)
values
• S$12 million
Required rate of
return
• 15 percent
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MULTINATIONAL CAPITAL BUDGETING EXAMPLE
Analysis
▪ The capital budgeting analysis is conducted from
the parent’s perspective, based on the assumption
that the subsidiary would be wholly owned by the
parent and created to enhance the value of the
parent.
▪ The capital budgeting analysis to determine
whether Spartan, Inc., should establish the
subsidiary is provided in Exhibit 14.2.
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Exhibit 14.2 Capital Budgeting Analysis: Spartan, Inc.
14
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MULTINATIONAL CAPITAL BUDGETING EXAMPLE
Calculation of NPV
n
CFt
SVn
NPV = − IO + 
+
t
n
(1 + k )
t =1 (1 + k )
Where:
IO = initial outlay (investment)
CFt = cash flow in period t
SVn = salvage value
k = required rate of return on the project
n = lifetime of the project (number of periods)
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MULTINATIONAL CAPITAL BUDGETING EXAMPLE
Spartan, Inc. NPV = $2,229,867
Results
▪ Because the NPV is positive, Spartan, Inc., may
accept this project if the discount rate of 15 percent
has fully accounted for the project’s risk.
▪ If the analysis has not yet accounted for risk,
however, Spartan may decide to reject the project.
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MULTINATIONAL CAPITAL BUDGETING EXAMPLE
Brower, Inc., just constructed a manufacturing plant in Ghana. The
construction cost 9 billion Ghanaian cedi. Brower intends to leave
the plant open for 3 years. During the 3 years of operation, cedi
cash flows are expected to be 3 billion cedi, 3 billion cedi, and 2
billion cedi, respectively. Operating cash flows will begin 1 year
from today and are remitted back to the parent at the end of each
year. At the end of the third year, Brower expects to sell the plant
for 5 billion cedi. Brower has a required rate of return of 17%. It
currently takes 8,700 cedi to buy 1 U.S. dollar, and the cedi is
expected to depreciate by 5% per year.
a. Determine the NPV for this project. Should Brower build the plant?
b. How would your answer change if the value of the cedi was expected to
remain unchanged from its current value of 8,700 cedi per U.S. dollar over the
course of the 3 years? Should Brower construct the plant then?
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Other Factors to Consider
1
Exchange rate fluctuations
Inflation
2
6
7
18
3
Inflation Blocked funds
4
Uncertain salvage value
5
Impact of project on prevailing cash flows
Host government incentives
Real options
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Other Factors to Consider
Exchange Rate Fluctuations
• Though exchange rates are difficult to forecast, a
multinational capital budgeting analysis could incorporate a
pessimistic scenario and an optimistic scenario
Exchange Rates Tied to Parent Currency
• Some MNCs consider projects in countries where the local
currency is tied to the dollar.
Hedged Exchange Rates
• Some MNCs may hedge the expected cash flows of a new
project, so they should evaluate the project based on hedged
exchange rates
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Exhibit 14.3 Analysis Using Different Exchange Rate
Scenarios: Spartan, Inc.
20
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Exhibit 14.4 Sensitivity of the Project’s NPV to Different
Exchange Rate Scenarios: Spartan, Inc.
21
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Example of Analysis Using Different Exchange Rate
Scenarios
A project in South Korea requires an initial investment of 2 billion
South Korean won. The project is expected to generate net cash
flows to the subsidiary of 3 billion and 4 billion won in the 2 years
of operation, respectively. The project has no salvage value. The
current value of the won is 1,100 won per U.S. dollar, and the
value of the won is expected to remain constant over the next 2
years.
a. What is the NPV of this project if the required rate of return is
13 percent?
b. Repeat the question, except assume that the value of the won is
expected to be 1,200 won per U.S. dollar after 2 years. Further
assume that the funds are blocked and that the parent company will
only be able to remit them back to the United States in 2 years.
How does this affect the NPV of the project?
22
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Exhibit 14.5 Analysis When a Portion of the Expected
Cash Flows Are Hedged: Spartan Inc.
23
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Other Factors to Consider: Inflation
Negative
impact
• Affect both costs and revenues
• The local economy’s inflation will
most likely have a stronger effect on
revenues than on costs in such cases
Positive
impact
• Exchange rates of highly inflated
countries tend to weaken over time
Conclusion
• The joint impact of inflation and
exchange rate fluctuations may be
partially offsetting effect from the
viewpoint of the parent.
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Other Factors to Consider: Financing Arrangement
Many foreign projects are partially financed
by foreign subsidiaries.
1. Subsidiary financing
2. Parent company financing
3. Financing with other subsidiaries’
retained earnings
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Financing Arrangement – Subsidiary Financing
Assume, subsidiary borrows S$10 million to purchase the
previously leased offices. Subsidiary will make interest
payments on this loan (of S$1 million) annually and will pay the
principal (S$10 million) at the end of Year 4, at termination.
Singapore government permits a maximum of S$2 million per
year in depreciation for this project, the subsidiary’s depreciation
rate will remain unchanged. Assume the offices are expected to
be sold for S$10 million after taxes at the end of Year 4.
1. The annual cash outflows for the subsidiary are still the same.
2. The subsidiary must pay the S$10 million in loan principal at
the end of 4 years. However, since it receives S$10 million
from the sale of the offices, it can use the proceeds of the sale
to pay the loan principal.
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Other Factors to Consider
Financing Arrangement – Parent Company Financing
Instead of the subsidiary leasing or purchasing with borrowed
funds, the parent uses its own funds to purchase the offices.
Thus, its initial investment is $15 million, composed of the
original $10 million investment, plus an additional $5 million to
obtain an extra S$10 million to purchase the offices.
1. The subsidiary will not have any loan or lease payments.
2. The parent’s initial investment is $15 million instead of $10
million.
3. The salvage value to be received by the parent is S$22
million instead of S$12 million because the offices are
assumed to be sold for S$10 million after taxes at the end of
Year 4.
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Exhibit 14.6 Analysis with an Alternative Financing
Arrangement: Spartan, Inc.
28
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Other Factors to Consider
Blocked Funds
◼ In some cases, the host
country may block funds that
the subsidiary attempts to send
to the parent.
◼ Some countries require that
earnings generated by the
subsidiary be reinvested
locally for at least 3 years
before they can be remitted.
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Exhibit 14.7 Capital Budgeting with Blocked Funds:
Spartan, Inc.
30
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Other Factors to Consider: Uncertain Salvage Value
The salvage value of an MNC’s project typically has a
significant impact on the project’s NPV.
1. Consider scenario analysis to estimate NPV at various
salvage values.
2. Consider estimating break-even salvage value at zero NPV.
Breakeven Salvage Value:

CFt 
n
SVn =  IO − 
(1 + k )
t 
(1 + k ) 

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Uncertain Salvage Value Example
◼A project in Malaysia costs $4 million. Over
the next 3 years, the project will generate
total operating cash flows of $3.5 million,
measured in today’s dollars using a required
rate of return of 14 percent. What is the
break-even salvage value of this project?
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Impact of Project on Prevailing Cash Flows
Favorable
impact
Unfavorable
impact
• if sales volume of parent
increases following
establishment of project
• If existing cash flows
decline following
establishment of project
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Exhibit 14.8 Capital Budgeting When Prevailing Cash
Flows Are Affected: Spartan, Inc.
34
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Other Factors to Consider: Host Government
Incentives
Reduced tax
rates for
subsidiary
Low-rate
host
government
loans
Government
subsidies of
initial
investment
Host
Government
Incentives
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Other Factors to Consider: Real Options
1. Opportunity to obtain or eliminate real
assets
2. Value is influenced by:
a. Probability that real option will be
exercised
b. NPV that will result from exercising the
real option
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Adjusting Project Assessment for Risk
Risk• The greater the uncertainty about a project’s
forecasted cash flows, the larger should be
adjusted
the discount rate applied to cash flows.
discount rate
Sensitivity
analysis
• Can be more useful than simple point
estimates because it reassesses the project
based on various circumstances that may
occur
Simulation
• Generation of a probability distribution for
NPV based on a range of possible values for
one or more input variables.
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SUMMARY
▪ Capital budgeting may generate different results and a different
conclusion depending on whether it is conducted from the
perspective of an MNC’s subsidiary or the MNC’s parent.
When a parent is deciding whether to implement an
international project, it should determine whether the project is
feasible from its own perspective.
▪ The risk of international projects can be accounted for by
adjusting the discount rate used to estimate the project’s net
present value. However, the adjustment to the discount rate is
subjective. An alternative method is to estimate the net present
value based on various possible scenarios for exchange rates or
any other uncertain factors. This method is facilitated by the
use of sensitivity analysis or simulation.
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SUMMARY (Cont.)
▪ Multinational capital budgeting requires any input that will
help estimate the initial outlay, periodic cash flows, salvage
value, and required rate of return on the project. With these
factors, the international project’s net present value can be
estimated, just as if it were a domestic project. However, it is
normally more difficult to estimate these factors for an
international project. Exchange rates create an additional
source of uncertainty because they affect the cash flows
ultimately received by the parent as a result of the project.
Other international conditions that can influence the cash flows
ultimately received by the parent include the financing
arrangement (parent versus subsidiary financing of the project),
blocked funds by the host government, and host government
incentives.
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17 Multinational Cost of Capital and Capital Structure
Chapter Objectives
Describe the key components of an MNC’s capital
Identify the factors that affect an MNC’s capital structure
Interaction between a subsidiary and parent in capital structure
decisions
Explain how the cost of capital is estimated
Explain why the cost of capital varies among countries
1
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Components of Capital
Parent
Subsidiary
2
• Inject Cash to Subsidiary → equity
investment
• The subsidiary uses the cash
infusion to develop its business
operations in the host country
• Which the subsidiary can build
more equity is to offer its own
stock to the public
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External Sources of Debt
Loans from Financial Institutions
• An MNC’s parent commonly borrows funds from financial
institutions
Private Placement of Bonds
• MNCs may offer a private placement of bonds to financial
institutions in their home country or in the foreign country
Bond Offering
• Domestic bond offering: the funds are denominated in
their local currency
• Global bond offering: simultaneously sell bonds
denominated in the currencies of multiple countries
3
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External Sources of Debt
Private Placement of Equity
• Offer a private placement of equity to financial
institutions in their home country or in the
foreign country where they are expanding
Domestic Equity Offering
• Domestic equity offering in their home country
in which the funds are denominated in their
local currency
Global Equity Offering
• Global equity offering: simultaneously access
equity from multiple countries
4
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Influence of Corporate Characteristics on
The MNC’s Capital Structure Decision
MNC’s
Credit Risk
Stability of
MNC’s
Cash Flows
5
MNC’s
Access to
Retained
Earnings
The MNC’s
Capital
Structure
Decision
MNC’s
Guarantees
on Debt
MNC’s
Agency
Problems
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Influence of Corporate Characteristics on
The MNC’s Capital Structure Decision
6
◼
Stability of MNC’s Cash Flows - MNCs with more stable cash flows
can handle more debt because there is a constant stream of cash
inflows to cover periodic interest payments on debt.
◼
MNC’s Credit Risk - MNCs that have lower credit risk have more
access to credit.
◼
MNC’s Access to Retained Earnings - Highly profitable MNCs may
be able to finance most of their investment with retained earnings and
therefore use an equity-intensive capital structure.
◼
MNC’s Guarantees on Debt - If the parent backs the debt of its
subsidiary, the subsidiary’s borrowing capacity might be increased.
◼
MNC’s Agency Problems - If a subsidiary in a foreign country cannot
easily be monitored by investors from the parent’s country, agency
costs are higher.
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Influence of Host Country’s Characteristics on
The MNC’s Capital Structure Decision
Strength of
Host
Country
Currencies
Interest
Rates in
Host
Countries
7
Country
Risk in Host
Countries
The MNC’s
Capital
Structure
Decision
Tax Laws in
Host
Countries
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Influence of Host Country’s Characteristics on
The MNC’s Capital Structure Decision
◼ Interest Rates in Host Countries – The cost of loanable funds
may be lower in some countries.
◼ Strength of Host Country Currencies - If an MNC expects
weakness of the currencies in its subsidiaries’ host countries, it may
borrow in those currencies rather than rely on parent financing. If
the subsidiary’s local currency is expected to appreciate, then the
subsidiary may retain and reinvest its earnings.
◼ Country Risk in Host Countries - If an MNC’s subsidiary is
exposed to the risk that the host government might confiscate its
assets, the subsidiary may use much debt financing in that host
country..
◼ Tax Laws in Host Countries - Foreign subsidiaries may be subject
to a withholding tax when they remit earnings.
8
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Response to Changing Country
Characteristics
The country
characteristics
9
Ideal capital
structure
vary among
countries
vary among
countries
change over time
change within
any particular
country over
time
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Subsidiary Versus Parent Capital Structure
Decisions
Increased Subsidiary Debt Financing
• Relies heavily on debt financing
• Reduces its need for its internal equity financing
(retained earnings)
Reduced Subsidiary Debt Financing
• Need to use more internal financing
• Reduce the amount of internal funds available to remit to
the parent.
Limitations in Offsetting a Subsidiary’s
Leverage
• Foreign creditors may charge higher loan rates to a
subsidiary that uses a highly leveraged local capital
structure due to higher credit risk
10
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Estimating an MNC’s Cost of Capital
 D 
 E 
kc = 
k d (1 − t ) + 
ke
D+E
D+E
where
kc
D
kd
t
E
ke
11
weighted average cost of capital
amount of the firm’s debt
before-tax cost of its debt
corporate tax rate
firm’s equity
cost of financing with equity
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Estimating an MNC’s Cost of Capital Examples
1.An MNC has total assets of $100 million and debt
of $20 million. The firm’s before tax cost of debt is
12 percent, and its cost of financing
with equity is 15 percent. The MNC has a corporate
tax rate of 40 percent. What is this firm’s cost of
capital?
2.Werner Corporation has a target capital structure
that consists of 40% debt and 60% equity. Werner
can borrow at an interest rate of 10%. Also, Werner
has determined its cost of equity to be 14%.
Werner's tax rate is 40%. What is Werner's weighted
average cost of capital?
12
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Multinational Cost of Capital: Equity vs Debt
Financing
13
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Exhibit 17.1 Searching for the Appropriate Capital
Structure
14
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Cost of Capital for MNCs versus Domestic Firms
Size of firm
Access to global capital markets
International diversification
Exposure to exchange rate risk
Exposure to country risk
15
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Cost of Capital for MNCs versus Domestic Firms
Cost of capital for MNCs may differ because of:
1. Size of firm - An MNC that often borrows substantial
amounts may receive preferential treatment from
creditors, thereby reducing its cost of capital.
2. Access to international capital markets - MNC’s access to
the international capital markets may allow it to obtain
funds at a lower cost than that paid by domestic firms.
3. International diversification - If a firm’s cash inflows
come from sources all over the world, those cash inflows
may be more stable because the firm’s total sales will not be
highly influenced by a single economy.
16
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Cost of Capital for MNCs versus Domestic Firms
Cost of capital for MNC may differ because of:
4. Exposure to exchange rate risk - An MNC’s cash flows
could be more volatile than those of a domestic firm in the
same industry if it is highly exposed to exchange rate risk.
5. Exposure to country risk - An MNC that establishes
foreign subsidiaries is subject to the possibility that a host
country government may seize a subsidiary’s assets.
17
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Exhibit 17.2 Summary of Factors that Cause the Cost of
Capital of MNCs to Differ from that of Domestic Firms
18
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Cost of Equity Comparison Using
the CAPM
ke = Rf + B(Rm – Rf)
Where
ke = required return on stock
Rf = risk-free rate of return
Rm = market return
B = beta of stock
The CAPM suggests that required return is a positive function of:
◼ The risk-free rate of interest
◼ The market rate of return
◼ The stock’s beta
19
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Cost of Capital: Exercises
20
1.
Wiley, Inc., an MNC, has a beta of 1.3. The U.S. stock market is
expected to generate an annual return of 11 percent. Currently,
Treasury bonds yield 2 percent. Based on this information, what is
Wiley’s estimated cost of equity?
2.
Blues, Inc., is an MNC located in the United States. Blues would
like to estimate its cost of capital (WACC). On average, bonds
issued by Blues yield 9 percent. Currently, Treasury security rates
are 3 percent. Furthermore, Blues’ stock has a beta of 1.5, and the
return on the Wilshire 5000 stock index is expected to be 10 percent.
Blues’ target capital structure is 30 percent debt and 70 percent
equity. If Blues is in the 35 percent tax bracket, what is its cost of
capital?
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Cost of Capital: Exercises (Cont.)
1. Ford is a U.S. firm that conducts major importing and exporting
business in Japan, and all transactions are invoiced in dollars. It obtained
debt in the United States at an interest rate of 10 percent per year. The
long-term risk-free rate in the United States is 8 percent. The stock
market return in the United States is expected to be 14 percent annually.
Ford’s beta is 1.2. Its target capital structure is 30 percent debt and 70
percent equity. Ford is subject to a 25 percent corporate tax rate. Estimate
the cost of capital to Ford
2. Messan Co. (a U.S. firm) borrows U.S. funds at an interest rate of 10
percent per year. Its beta is 1.0. The long-term annualized risk-free rate in
the United States is 6 percent. The stock market return in the United
States is expected to be 16 percent annually. Messan’s target capital
structure is 40 percent debt and 60 percent equity. Messan Co. is subject
to a 30 percent corporate tax rate. Estimate the cost of capital to Messan
Co.
21
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Cost of Equity Comparison Using the CAPM
1. Implications of the CAPM for an MNC’s risk:
U.S. based MNC may be able to reduce its beta by
increasing its international business.
2. Implications of the CAPM for an MNC’s projects
Because many projects of U.S.-based MNCs are in
foreign countries, their cash flows are less sensitive to
general U.S. market conditions leading lower project
betas.
3. Applying CAPM with a World Market Index:
A world market may be more appropriate than a U.S.
market for determining the betas of U.S.–based MNCs.
22
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Costs of Capital Across Countries
1. Country differences in the cost of debt
◼ Differences in the risk-free rate - The risk-free rate is
the interest rate charged on loans to a country’s
government that is perceived to have no risk of defaulting
on the loans.
◼ Differences in the Credit Risk Premium - The credit
risk premium paid by an MNC must be large enough to
compensate creditors for taking the risk that the MNC
may not meet its payment obligations.
◼ Comparative costs of debt across countries – There is
some positive correlation between country cost-of-debt
levels over time.
23
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Exhibit 17.3 Costs of Debt across Countries
24
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Costs of Capital Across Countries (Cont.)
2. Country differences in the cost of equity
◼ Differences in the risk-free rate - When the
country’s risk-free interest rate is high, local investors
would only invest in equity if the potential return is
sufficiently higher than that they can earn at the riskfree rate.
◼ Differences in the Equity Risk Premium - Based on
investment opportunities in the country of concern. A
second factor that can influence the equity risk
premium is the country risk.
25
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Home works
1. Slater Co. is a U.S.-based MNC that finances all operations with debt
and equity. It borrows U.S. funds at an interest rate of 11 percent per
year. The long-term risk-free rate in the United States is 7 percent. The
stock market return in the United States is expected to be 15 percent
annually. Slater’s beta is 1.4. Its target capital structure is 20 percent debt
and 80 percent equity. Slater Co. is subject to a 30 percent corporate tax
rate. Estimate the cost of capital to Slater Co
2. Slater Co. is a U.S.-based MNC that finances all operations with debt
and equity. It borrows U.S. funds at an interest rate of 11 percent
per year. The long-term risk-free rate in the United States is 7 percent.
The stock market return in the United States is expected to be 15 percent
annually. Slater’s beta is 1.4. Its target capital structure is 20 percent debt
and 80 percent equity. Slater Co. is subject to a 30 percent corporate tax
rate. Estimate the cost of capital to Slater Co
26
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SUMMARY
◼ An MNC’s capital consists of debt and equity. MNCs
can access debt through domestic debt offerings, global
debt offerings, private placements of debt, and loans
from financial institutions. They can access equity by
retaining earnings and by issuing stock through
domestic offerings, global offerings, and private
placements of equity.
◼ If an MNC’s subsidiary’s financial leverage deviates
from the global target capital structure, the MNC can
still achieve the target if another subsidiary or the
parent take an offsetting position in financial leverage.
However, even with these offsetting effects, the cost of
capital might be affected.
27
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SUMMARY (Cont.)
◼ An MNC’s capital structure decision is influenced by
corporate characteristics such as the stability of the MNC’s
cash flows, its credit risk, and its access to earnings. The
capital structure is also influenced by characteristics of the
countries where the MNC conducts business, such as
interest rates, strength of local currencies, country risk, and
tax laws. Some characteristics favor an equity-intensive
capital structure because they discourage the use of debt.
Other characteristics favor a debt-intensive structure
because of the desire to protect against risks by creating
foreign debt.
28
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SUMMARY (Cont.)
◼ The cost of capital may be lower for an MNC than for a
domestic firm because of characteristics peculiar to the
MNC, including its size, its access to international capital
markets, and its degree of international diversification.
Yet some characteristics peculiar to an MNC can increase
the MNC’s cost of capital, such as exposure to exchange
rate risk and to country risk.
◼ Costs of capital vary across countries because of country
differences in the components that comprise the cost of
capital. Specifically, there are differences in the risk-free
rate, the risk premium on debt, and the cost of equity
among countries. Countries with a higher risk-free rate
tend to exhibit a higher cost of capital.
29
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International Corporate Finance
11th Edition
by Jeff Madura
1
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Part 5 Short-Term Asset and Liability Management
2
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19 Financing International Trade
Chapter Objectives
▪ Describe methods of payment for international trade
▪ Explain common trade finance methods
▪ Describe the major agencies that facilitate international
trade with export insurance and/or loan programs
3
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Payment Methods for International Trade
Five basic methods of payment are used to settle
international transactions, each with a different
degree of risk to the exporter and importer:
■ Prepayment
■ Letters of credit
■ Drafts (sight/time)
■ Consignment
■ Open account
4
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Exhibit 19.1 Comparison of Payment Methods
5
5
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Payment Methods for International Trade
Prepayment
1. Same as cash in advance
2. Payment usually by wire transfer
3. Method offers exporter greatest degree of
protection
4. Usually requested when
◼ First time buyer
◼ Danger of pre-shipment cancellation
◼ Importer country has high political risk
6
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Payment Methods for International Trade
Letters of Credit (L/C2)
◼ An instrument issued by a bank on behalf of the
importer (buyer) promising to pay the exporter
(beneficiary) upon presentation of shipping
documents in compliance with the terms
stipulated therein.
◼ In effect, the bank is substituting its credit for that
of the buyer.
7
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Payment Methods for International Trade
Drafts (or bill of exchange)
◼ An unconditional promise drawn by one party,
usually the exporter, instructing the buyer to pay
the face amount of the draft upon presentation.
◼ Draft represents the exporter’s formal demand for
payment from the buyer.
◼ Draft affords the exporter less protection than an
L/C because the banks are not obligated to honor
payments on the buyer’s behalf.
8
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Payment Methods for International Trade
Consignment
1. Exporter ships the goods to the importer while still
retaining actual title to the merchandise.
2. The importer has access to the inventory but does not
have to pay for the goods until they have been sold to a
third party.
3. The exporter is trusting the importer to remit payment
for the goods sold at that time.
4. If the importer fails to pay, the exporter has limited
recourse because no draft is involved and the goods
have already been sold.
9
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Payment Methods for International Trade
Open Account
◼ The opposite of prepayment - the exporter ships the
merchandise and expects the buyer to remit
payment according to the agreed-upon terms.
◼ The exporter is relying fully upon the financial
creditworthiness, integrity, and reputation of the
buyer.
◼ Method is used when the seller and buyer have
mutual trust and a great deal of experience with
each other.
10
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Payment Methods for International Trade
Impact of Credit Crisis on the Payment Methods
◼When the credit crisis intensified in the fall of
2008, international trade transactions stalled.
◼Many financial institutions experienced financial
problems. Consequently, exporters lost trust in
commercial banks.
◼The crisis illustrated how international trade is so
reliant on the soundness and integrity of
commercial banks.
11
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Trade Finance Methods
◼ Accounts receivable financing
◼ Factoring
◼ Letters of credit (L/Cs)
◼ Banker’s acceptances
◼ Working capital financing
◼ Medium-term capital goods financing
(forfaiting)
◼ Countertrade
12
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Trade Finance Methods
Accounts Receivable Financing
Could take the form of an open account
shipment or a time draft the bank will provide a
loan to the exporter secured by an assignment of
the account receivable.
Factoring
The exporter sells the accounts receivable
without recourse.
13
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Trade Finance Methods
Letters of Credit ( L/C )
◼ Types of Letters of Credit - Known as commercial letters of
credit or import/export letters of credit.
a. Revocable letter of credit can be canceled or revoked at any
time without prior notification to the beneficiary, but it is no
longer used.
b. Irrevocable letter of credit cannot be canceled or amended
without the beneficiary’s consent.
◼ Use of Drafts - Also known as a bill of exchange, a draft is
an unconditional promise drawn by one party, usually the
exporter, requesting the importer to pay the face amount of
the draft at sight or at a specified future date.
14
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Exhibit 19.2 Example of an Irrevocable Letter
of Credit
15
15
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Exhibit 19.3 Documentary Credit Procedure
16
16
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Trade Finance Methods
Letters of Credit ( L/C ) (Cont.)
◼ Bill of Lading (B/L) - serves as a receipt for shipment and a
summary of freight charges. It conveys title to the
merchandise. A B/L includes the following provisions:
▪
▪
▪
▪
▪
▪
▪
17
A description of the merchandise
Identification marks on the merchandise
Evidence of loading (receiving) ports
Name of the exporter (shipper)
Name of the importer
Status of freight charges (prepaid or collect)
Date of shipment
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Trade Finance Methods
Letters of Credit ( L/C ) (Cont.)
◼ Commercial Invoice (currency) - exporter’s (seller’s)
description of the merchandise being sold to the buyer is the
commercial invoice, which contains:
▪
▪
▪
▪
▪
▪
▪
18
Name and address of seller
Name and address of buyer
Date
Terms of payment
Price, including freight, handling, and insurance if
applicable
Quantity, weight, packaging, etc.
Shipping information
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Trade Finance Methods
Variations of the L/C
Standby letter of credit - can be used to guarantee invoice
payments to a supplier. It promises to pay the beneficiary if the
buyer fails to pay as agreed.
Transferable letter of credit allows the first beneficiary to
transfer all or a part of the original L/C to a third party.
Assignment of proceeds – original beneficiary of the L/C
pledges (or assigns) the proceeds under an L/C to the end
supplier.
19
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Trade Finance Methods
Banker’s Acceptance
Bill of exchange, or time draft, drawn on and accepted by a
bank. It is the accepting bank’s obligation to pay the holder of
the draft at maturity.
Working Capital Financing
The bank may provide short-term loans beyond the banker’s
acceptance period.
Medium-Term Capital Goods Financing (Forfaiting)
20
Similar to factoring in that the forfaiter (or factor) assumes
responsibility for the collection of payment from the buyer,
the underlying credit risk, and the risk pertaining to the
countries involved.
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Exhibit 19.4 Banker’s Acceptance
21
21
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Exhibit 19.5 Life Cycle of a Typical Banker’s
Acceptance (B/A)
22
22
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Trade Finance Methods
Countertrade
▪ Denotes all types of foreign trade transactions
in which the sale of goods to one country is
linked to the purchase or exchange of goods
from that same country.
▪ Some types of countertrade, such as barter,
have been in existence for thousands of years.
▪ Recently countertrade gained popularity and
importance.
23
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Agencies That Motivate International Trade
24
Export-Import Bank of the United States
◼ Established in 1934 goal of facilitating SovietAmerican trade.
◼ Today, its mission is to finance and facilitate the
export of American goods and services and maintain
the competitiveness of American companies in
overseas markets.
◼ Offers programs that are classified as
a) Guarantee programs
b) Loan programs
c) Bank insurance programs
d) Export credit insurance
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Agencies That Motivate International Trade
Private Export Funding Co. (PEFCO)
◼ Is owned by a consortium of commercial banks and
industrial companies.
◼ Provides medium and long-term fixed rate financing to
foreign buyers.
Overseas Private Investment Corporation (OPIC)
◼ A self-sustaining federal agency responsible for insuring
direct U.S. investments in foreign countries against the
risks of currency inconvertibility, expropriation, and
other political risks.
25
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SUMMARY
▪ The common methods of payment for international trade are
(1) prepayment (before goods are sent), (2) letters of credit,
(3) drafts, (4) consignment, and (5) open account.
▪ The most popular methods of financing international trade
are (1) accounts receivable financing, (2) factoring, (3) letters
of credit, (4) banker’s acceptances, (5) working capital
financing, (6) medium-term capital goods financing
(forfaiting), and (7) countertrade.
▪ The major agencies that facilitate international trade with
export insurance and/or loan programs are (1) the ExportImport Bank, (2) the Private Export Funding Corporation,
and (3) the Overseas Private Investment Corporation.
26
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International Corporate Finance
11th Edition
by Jeff Madura
1
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13 Direct Foreign Investment
Chapter Objectives
Describe common motives
for initiating foreign direct
investment
Illustrate the benefits of
international diversification
2
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5 Revenue Related Motives
Motives for Direct Foreign Investment:
Revenues Related Motives
3
Attract new sources of
demand
Enter profitable markets
Exploit monopolistic
advantages
React to trade restrictions
Diversity Internationally
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Motives for Direct Foreign Investment:
Revenues Related Motives
Attract new sources of demand
• pursue DFI in countries experiencing economic
growth so that they can benefit from the
increased demand for products and services there
Enter profitable markets
• When similar industries are generating very high
earnings in a particular country, an MNC may
decide to sell its own products in those markets.
Exploit monopolistic advantages
• Firms possessing resources or skills not available
to competing firms may attempt to exploit it
internationally.
4
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Motives for Direct Foreign Investment:
Revenues Related Motives (Cont.)
React to trade restrictions
• MNCs may pursue DFI to circumvent
trade barriers
Diversity Internationally
• By diversifying sales (and possibly
even production) internationally, a
firm can make its net cash flows less
volatile.
5
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5 Costs Related Motives
Motives for Direct Foreign Investment:
Costs Related Motives
6
Fully benefit from economies
of scale
Use foreign factors of
production
Use foreign raw materials
Use foreign technology
React to exchange rate
movements
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Motives for Direct Foreign Investment:
Cost Related Motives
Fully benefit from economies of scale
• Lower average cost per unit resulting from
increased production
Use foreign factors of production
• Labor and land costs can vary dramatically
among countries
Use foreign raw materials
• Develop the product in the country where the
raw materials are located.
7
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Motives for Direct Foreign Investment:
Cost Related Motives (Cont.)
Use foreign technology
• MNCs use FDI to learn about unique technologies
in foreign countries.
• This technology is then used to improve their own
production processes and increase production
efficiency at all subsidiary plants around the world
React to exchange rate movements
• When a firm perceives that a foreign currency is
undervalued, the firm may consider DFI in that
country, as the initial outlay should be relatively
low.
8
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Benefits of DFI
◼ Though disadvantages of DFI may exist, MNCs can compare
benefits of DFI among countries and use DFI to achieve those
benefits (Exhibit 13.1).
◼ MNCs measure the benefits of DFI by following the steps in
Exhibit 13.2
▪ MNCs apply a multinational capital budgeting process to compare the
benefits and costs of international projects.
▪ This capital budgeting analysis commonly involves international
restructuring and an assessment of risk characteristics in the country
where the proposed projects are to be implemented.
▪ It also requires an assessment of the cost of capital and debt financing
possibilities.
9
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Exhibit 13.1 Summary of Motives for Direct Foreign Investment
10
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Exhibit 13.2 Steps Taken by MNCs to Determine Whether to
Pursue Direct Foreign Investment
11
Identify Motives
• Review the revenue and cost-related motives for DFI, and
determine which motives may apply
Capital Budgeting
• Identify a particular international project that may be feasible
• Estimate the cash flows and the initial investment associated
with that project
International
Corporate Control.
• Assess existing corporate control within the firm and potential
corporate control targets in foreign countries that could be
acquired
Country Risk
Analysis
• Analyze the country risk of countries where the MNC presently
does business as well as in countries where the MNC plans to
expand
Capital Structure
• Assess the existing capital structure, and determine whether it is
suitable based on the MNC’s existing operations and its ability
to repay debt.
Capital Structure
• Assess the existing capital structure, and determine whether it is
suitable based on the MNC’s existing operations and its ability
to repay debt.
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Exhibit 13.3 Evaluation of Proposed Projects in Alternative
Locations
Merrimack Co., a U.S. firm, plans to invest in a new project in either the United
States or the United Kingdom. Once the project is completed, it will constitute 30
percent of the firm’s total funds invested in itself. The remaining 70 percent of its
investment in its business is exclusively in the United States. Characteristics of
the proposed project are forecasted for a five-year period for both a U.S. and a
British location
12
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Exhibit 13.3 Evaluation of Proposed Projects in Alternative
Locations
Invest in US
• 70% of its total funds are invested in
its prevailing U.S. business
• 30% invested in a new project
located in the United States
Invest in UK
• 70% of its total funds are invested in
its prevailing U.S. business
• 30% invested in a new project
located in the UK
13
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Expected return of two project
How about the expected
return when this
company invests in UK?
14
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Variance of two project
15
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Exhibit 13.4 Risk-Return Analysis of International Projects
Conservative MNCS will
probably prefer one that
exhibits low risk (near the
bottom of the frontier).
A
more
aggressive
strategy would be to
implement a portfolio of
projects that exhibits
risk–
return
characteristics such as
those near the top of the
frontier.
16
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Exhibit 13.5 Risk-Return Advantage of a Diversified MNC
17
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Exhibit 13.6 Comparison of Expected Economic Growth among
Countries: Annual Stock Market Return
18
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Host Government View of DFI
◼ Incentives to encourage
DFI
▪ The ideal DFI solves
problems such as
unemployment and lack of
technology without taking
business away from local
firms.
▪ Governments are particularly
willing to offer incentives for
DFI that will result in the
employment of local citizens
or an increase in technology.
19
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Host Government View of DFI: Barriers to FDI
Environmental
barriers
Industry
barriers
Regulatory
barriers
Red tape
barriers
Protective
barriers
20
Ethical
differences
FDI
Political
instability
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Host Government View of DFI (Cont.)
◼ Barriers to DFI
a. Protective barriers - agencies may prevent an MNC from
acquiring companies if they believe employees will be laid off.
b. Red tape barriers - procedural and documentation requirements
c. Industry barriers - local firms may have substantial influence on
the government and may use their influence to prevent competition
from MNCs
d. Environmental barriers - building codes, disposal of production
waste materials, and pollution controls.
e. Regulatory barriers - each country enforces its own regulatory
constraints pertaining to taxes, currency convertibility, earnings
remittance, employee rights, and other policies
21
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Host Government View of DFI (Cont.)
f. Ethical differences - a business practice that is perceived to be
unethical in one country may be ethical in another.
g. Political instability - if a country is susceptible to abrupt changes in
government and political conflicts, the feasibility of DFI may be
dependent on the outcome of those conflicts.
◼ Government-imposed conditions to engage in DFI
Some governments allow international acquisitions but impose
special requirements on MNCs that desire to acquire a local firm.
22
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SUMMARY
▪ MNCs may be motivated to initiate direct foreign investment
in order to attract new sources of demand or to enter markets
where superior profits are possible. These two motives are
normally based on opportunities to generate more revenue in
foreign markets. Other motives for using DFI are typically
related to cost efficiency, such as using foreign factors of
production, raw materials, or technology. In addition MNCs
may engage in DFI to protect their foreign market share, to
react to exchange rate movements, or to avoid trade
restrictions.
23
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SUMMARY (Cont.)
▪ International diversification is a common motive for direct
foreign investment. It allows an MNC to reduce its exposure to
domestic economic conditions. In this way, the MNC may be
able to stabilize its cash flows and reduce its risk. Such a goal
is desirable because it may reduce the firm’s cost of financing.
International projects may allow MNCs to achieve lower risk
than is possible from only domestic projects without reducing
their expected returns. International diversification tends to be
better able to reduce risk when the DFI is targeted to countries
whose economies are somewhat unrelated to an MNC’s home
country economy.
24
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