Chapter 25 International Financial Management

1. Chapter 25International Financial Management

2. Motivation for International Investment • Provide a return in excess of that required • Expansion into foreign markets • Produce more efficiently • Lower operating costs • Secure necessary raw materials

3. International Capital Budgeting • Estimate expected cash flows in foreign currency • Repatriated • Nonremittable - investment unlikely • Compute U.S. dollar equivalents at the expected exchange rate • Determine the NPV of the project using the U.S. required rate of return, adjusted for any risk premium • Critical assumptions

4. Risk Factors • Diversification will reduce risk if global markets are partially segmented • With an integrated market for securities, the investor is able to reduce risk more quickly and further by diversifying across international stocks as opposed to only domestic ones

5. What Makes Direct Foreign Investment Different? • Complex taxation • Political risk • Exchange rate risk

6. Taxation • U.S. government • Income from a branch or division is taxed in the same way as domestic income • Income from a foreign subsidiary is not taxed in the U.S. until it is distributed to the parent as dividends • Gives a federal tax credit for foreign taxes • Foreign governments • Type of tax imposed varies between income distributed to stockholders and undistributed income • Less-developed countries frequently have lower taxes • Definitions for what constitutes taxable income are different for different countries

7. Political Risk • Assessing political risk realistically • Forecasting political instability • Take steps to protect investment by cooperating with the host country • Joint venture • Make subsidiary dependent on the parent for technology, markets, and/or supplies

8. Types of Exchange Rate Exposure • Translation exposure is the effect of an exchange-rate change on the accounting balance sheet and income statement • Transaction exposure is the effect of an exchange-rate change upon the value of a single transaction • Economic exposure is the effect of an unanticipated change in exchange rates on the economic value of the firm • Most important exposure

9. Degrees of Exposure on Existing Assets and Liabilities • Hekman has derived a framework for categorizing assets and liabilities as to their degree of exposure • Coefficient of 1.0 means the market value of the balance sheet item is entirely exposed • Coefficient of 0.0 means the market value is unexposed • Coefficients between 0 and 1 means the item is partially exposed

10. Aggregate Economic Exposure = Net aggregate market-value exposure Market value of equity • Measures the degree and sensitivity of economic exposure • Typically the more global the market served, the less the overall exposure • Framework used to assess the economic exposure of the existing balance sheet of the foreign subsidiary

11. Exposure of Expected Future Cash Flows • Natural hedge exists whenever the effect of an exchange-rate change is offset by an opposite change in local currency margins • Degree of exchange-rate exposure of a foreign subsidiary is that which remains after any natural hedge • Exposure can be approximated by determining whether pricing and costs are more sensitive to local-market or global-market conditions • Residual exposure remains after we take account of any natural hedge that represents exchange-rate risk • Management needs to decide whether it wishes to hedge the residual risk

12. Operating Hedges • Cash management among countries through intracompany accounts • If a company knew a currency were going to fall in value • Reduce cash to a minimum by purchasing inventories or other real assets • Avoid extended trade credit • As quick a turnover as possible of receivables • Obtain extended terms on its accounts payable • Borrow the local currency

13. Currency Strategies • Balance monetary assets against monetary liabilities in order to neutralize the effects of exchange-rate fluctuations • Accelerating the timing of payments made or received in foreign currencies is called leading, and decreasing the timing is called lagging • Adjust intracompany dividends and royalty payments • Establish a reinvoicing center to manage intracompany and third-party foreign trade • Centralize and manage all exposure • Facilitates the netting of obligations among units • Allows for more coordinated control over leading or lagging arrangements between affiliates

14. International Financing • Asset sensitive exposure would be balanced with borrowing • Sources of external financing • Commercial bank loans and trade bills • Eurodollar financing • Bond financing • Eurobond market • Foreign bond • Currency-options • Conversion option • Currency cocktail • Dual currency bond

15. Currency Market Hedges • Forward contracts • Futures contracts • Currency options • Currency swaps

16. Forward Exchange Market • Well suited for hedging transactions exposure • Forward contract provides assurance of being able to convert into a desired currency at a price set in advance • Foreign currency sells at a forward discount if its forward price is less than its spot price • Sells at a forward premium if its forward price exceeds the spot price • Euro is a common currency for the European Monetary Union (EMU)

17. Foreign Exchange Market (FX) • Worldwide network of traders, connected by telephone lines and computer screens • Centers of trading • Great Britain • United States • Japan • Singapore • Switzerland • Hong Kong • Germany • France • Australia • Trading goes on 24 hours a day Half of all FX transactions

18. EMU

19. Currency Futures • Markets exist for major currencies • Futures contract is a standardized agreement that calls for delivery of a currency at some specified future date • Transactions are with a clearinghouse • Very few contracts involve actual delivery at expiration • Futures contract is marked-to-market

20. Currency Options • Enable the hedging of “one sided” risk • Holder has the right to buy or sell the currency over the life of the contract • For this protection, one pays a premium

21. Currency Swaps • Long-term hedging vehicle • Two parties exchange debt obligations denominated in different currencies • Each party agrees to pay the other’s interest obligation • Only cash-flow differences are paid • There is not an actual exchange of principal • Currency swaps can be combined with interest-rate swaps

22. Should Exposure be Managed? • A case can be made for the various hedging strategies if imperfections and incompleteness occur in international product and financial markets • Most companies manage their currency-risk exposure • Few companies are willing to risk everything on future exchange rates • Real issue is the degree of management • Shareholders would be better off with a degree of self-insurance • 100 percent hedging does not produce superior investment results

23. Macro Factors Governing Exchange-Rate Behavior • Purchasing power parity (PPP) works through differences in inflation between countries • With interest-rate parity (IRP), forward discounts and premiums are driven by differences in interest rates • International Fisher effect (IFE) suggests that differences in interest rates between two countries serve as a proxy for differences in expected inflation • Arbitrage actions will continue until interest-rate parity is established

24. Principal Documents Involved in International Trade • The draft is an order by the exporter to the importer to pay a specified amount of money either upon presentation of the draft or a certain number of days after presentation • A bill of lading is a shipping document that can serve as a receipt, as a shipping contract, and as title to the goods involved • A letter of credit is an agreement by a bank to honor a draft drawn on the importer

25. Financing Trade • Countertrading is where the selling party accepts payment in the form of goods as opposed to currency • Factoring is where the factor assumes the credit risk, so the exporter is assured of being paid • Forfaiting is where an exporter who is owed money evidenced by a longer-term note, as opposed to a receivable, sells the note to a financial institution at a discount