# Chapter 19: Multinational financial Management

Management

Nov 9, 2013 (4 years and 6 months ago)

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CHAPTER 19

Multinational Financial
Management

Multinational vs. domestic financial
management

Exchange rates and trading in foreign
exchange

International money and capital markets

What is a multinational corporation?

A corporation that
operates in two or more
countries.

Decision making within
the corporation may be
centralized in the home
country, or may be
decentralized across the
countries the corporation

Why do firms expand into
other countries?

1.
To seek new markets.

2.
To seek raw materials.

3.
To seek new technology.

4.
To seek production efficiency.

5.
To avoid political and regulatory
hurdles.

6.
To diversify.

What factors distinguish multinational
financial management from domestic
financial management?

1.
Different currency denominations.

2.
Economic and legal ramifications.

3.
Language differences.

4.
Cultural differences.

5.
Role of governments.

6.
Political risk.

Consider the following
exchange rates

US \$ to buy 1 unit

Japanese yen

0.009

Australian dollar

0.650

Are these currency prices direct or indirect
quotations?

Since they are prices of foreign
currencies expressed in dollars, they are
direct quotations.

What is an indirect quotation?

The number of units of a foreign
currency needed to purchase one U.S.
dollar, or the reciprocal of a direct
quotation.

Are you more likely to observe direct or
indirect quotations?

Most exchange rates are stated in terms of
an indirect quotation.

Except the British pound, which is usually in
terms of a direct quotation.

Calculate the indirect quotations
for yen and Australian dollar

# of units of foreign

currency per US \$

Japanese yen

111.11

Australian dollar

1.5385

Simply find the inverse of the direct
quotations.

What is a cross rate?

The exchange rate between any two
currencies. Cross rates are actually calculated
on the basis of various currencies relative to
the U.S. dollar.

Cross rate between Australian dollar and the
Japanese yen.

Cross rate

= (
Yen
/
US Dollar
) x (
US Dollar

/
A. Dollar
)

= 111.11 x 0.650

= 72.22 Yen / A. Dollar

The inverse of this cross rate yields:

0.0138 A. Dollars / Yen

Orange juice project:

Setting the appropriate price

A firm can produce a liter of orange
juice and ship it to Japan for \$1.75 per
unit. If the firm wants a 50% markup
on the project, what should the juice
sell for in Japan?

Price

= (1.75)(1.50)(111.11)

= 291.66 yen

Orange juice project:

Determining profitability

The product will cost 250 yen to produce and
ship to Australia, where it can be sold for 6
Australian dollars. What is the U.S. dollar
profit on the sale?

Cost in A. dollars = 250 yen (0.0138)

= 3.45 A. dollars

A. dollar profit = 6

3.45 = 2.55 A. dollars

U.S. dollar profit

= 2.55 / 1.5385 = \$1.66

What is exchange rate risk?

The risk that the value of a cash flow in
one currency translated to another
currency will decline due to a change in
exchange rates.

For example, in the last slide, a weakening
Australian dollar (strengthening dollar)
would lower the dollar profit.

The current international monetary system
is a floating rate system.

European Monetary Union

In 2002, the full implementation of
the “euro” was completed. The
national currencies of the 12
participating countries were phased
out in favor of the “euro.” The
newly formed European Central
Bank controls the monetary policy of
the EMU.

Member nations of the EMU

Austria

Belgium

Finland

France

Germany

Greece

Ireland

Italy

Luxembourg

Netherlands

Portugal

Spain

Notable European Union
countries not in the EMU:

Britain, Sweden, and
Denmark

What is a convertible currency?

A currency is convertible when the
issuing country promises to redeem
the currency at current market rates.

world currency markets.

What problems may arise when a
firm operates in a country whose
currency is not convertible?

It becomes very difficult for multi
-
national companies to conduct
business because there is no easy way
to take profits out of the country.

Often, firms will barter for goods to
export to their home countries.

What is difference between
spot rates and forward rates?

Spot rates are the rates to buy
currency for immediate delivery.

Forward rates are the rates to buy
currency at some agreed
-
upon date
in the future.

When is the forward rate at a

If the U.S. dollar buys fewer units of a
foreign currency in the forward than in the
spot market, the foreign currency is selling

In the opposite situation, the foreign
currency is selling at a discount.

The primary determinant of the
spot/forward rate relationship is relative
interest rates.

What is interest rate parity?

Interest rate parity holds that investors
should expect to earn the same return in all

country

foreign

in

rate
interest

periodic

k
country

home

in

rate
interest

periodic

k
rate

exchange
spot

s
today'

e
rate

exchange

forward

period
-
t

f
k

1
k

1

e
f

f
h
0
t
f
h
0
t

Evaluating interest rate parity

Suppose one yen buys \$0.0095 in the 30
-
day forward exchange market and k
NOM

for
a 30
-
day risk
-
free security in Japan and in
the U.S. is 4%.

f
t

= 0.0095

k
h

= 4% / 12 = 0.333%

k
f

= 4% / 12 = 0.333%

Does interest rate parity hold?

Therefore, for interest rate parity to hold,
e
0

must equal \$0.0095, but we were given
earlier that e
0

= \$0.0090.

1

e
0.0095
1.0033
1.0033

e
0.0095
0
0

Which security offers the
highest return?

The Japanese security.

Convert \$1,000 to yen in the spot market.

\$1,000 x 111.111 = 111,111 yen.

Invest 111,111 yen in 30
-
day Japanese security.
In 30 days receive 111,111 yen x 1.00333 =
111,481 yen.

Agree today to exchange 111,481 yen 30 days
from now at forward rate, 111,481/105.2632 =
\$1,059.07.

30
-
day return = \$59.07/\$1,000 = 5.907%,
nominal annual return = 12 x 5.907% = 70.88%.

(PPP)?

Purchasing power parity implies that the
level of exchange rates adjusts so that
identical goods cost the same amount
in different countries.

P
h

= P
f
(e
0
)

-
OR
-

e
0

= P
h
/P
f

If grapefruit juice costs \$2.00 per liter
in the U.S. and PPP holds, what is the
price of grapefruit juice in Australia?

e
0

= P
h
/P
f

\$0.6500

= \$2.00/P
f

P
f

= \$2.00/\$0.6500

= 3.0769 Australian dollars.

What impact does relative inflation have
on interest rates and exchange rates?

Lower inflation leads to lower interest
rates, so borrowing in low
-
interest
countries may appear attractive to
multinational firms.

However, currencies in low
-
inflation
countries tend to appreciate against those
in high
-
inflation rate countries, so the
effective interest cost increases over the
life of the loan.

International money and
capital markets

Eurodollar markets

a source of dollars outside the U.S.

International bonds

Foreign bonds

sold by foreign
borrower, but denominated in the
currency of the country of issue.

Eurobonds

sold in country other
than the one in whose currency the
bonds are denominated.

To what extent do average capital
structures vary across different countries?

Previous studies suggested that
average capital structures vary among
the large industrial countries.

However, a recent study, which
controlled for differences in accounting
practices, suggests that capital
structures are more similar across
different countries than previously
thought.

Impact of multinational operations

Cash management

Distances are greater.

for temporary investments.

Cash is often denominated in different
currencies.

Impact of multinational operations

Capital budgeting decisions

Foreign operations are taxed locally, and
then funds repatriated may be subject
to U.S. taxes.

Foreign projects are subject to political
risk.

Funds repatriated must be converted to
U.S. dollars, so exchange rate risk must
be taken into account.

Impact of multinational operations

Credit management

Credit is more important, because commerce to
lesser
-
developed countries often relies on credit.

Credit for future payment may be subject to
exchange rate risk.

Inventory management

Inventory decisions can be more complex,
especially when inventory can be stored in
locations in different countries.

Some factors to consider are shipping times,
carrying costs, taxes, import duties, and
exchange rates.