575
Chapter 18
International Financial Management
LEARNING OBJECTIVES (Slide 18-2)
1. Understand cultural, business, and political differences in business practices.
2. Calculate exchange rates, cross rates, and forward rates.
3. Understand transaction exposure, operating exposure, and translation exposure.
4. Apply net present value to foreign projects.
IN A NUTSHELL…
With globalization here to stay and the Internet spreading its web across most cultures and
continents, financial managers and businessmen have to be well equipped with knowledge
about business practices, policies, and issues related to investing and managing funds across the
globe. This chapter starts out with a discussion of the cultural and political differences
permeating business practices in different countries. Next, the calculation of cross and forward
exchange rates is covered followed by the effects of fluctuating currencies on a firm’s
transaction, operating, and translation exposures. The chapter ends with a detailed explanation
of how capital budgeting is to be done in the context of foreign projects.
LECTURE OUTLINE
18.1 Managing Multinational Operations (Slides 18-3 to 18-8)
The complexity of managing multinational corporations increases significantly because of
differences in cultures, business practices, and political systems that they are faced with once
they operate in foreign countries.
Cultural Risk: Cultural risk arises from differences in customs, social norms, attitudes,
assumptions, and expectations of the local society in the host country.
Differences in ownership structure: Such norms include the requirement to set up joint
ventures in certain countries and the requirement to increase local participation and ownership.
Differences in human resource norms: Such norms include hiring and firing norms and different
cultural attitudes toward women and minorities in the workplace. Also, local promotions and
reward systems may not be consistent with those of the home office and would have to be
altered to maintain positive relations with local employees, customers, and government
officials.
Religious heritage of the host country: These can often can affect the way employees dress and
their holiday observances and have to be honored.
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Nepotism and corrupt practices in the host country: The requirement to hire relatives of
government officials as a condition of doing business (Indonesia) and bribery of officials to get
permits and licenses—considered to be illegal in the United States—are normal practices in
many foreign countries.
Intellectual property rights: Rights protected by copyrights and patents may not be honored in
some foreign countries (e.g., China) and become an issue when considering doing business
abroad.
Although attempts are being made to alter the landscape of differences in attitudes toward
intellectual property rights, e.g., 2001 treaty, much still needs to be done.
Business risk arises from economic factors such as inflation rates, recessions, and interest rate
and exchange rate fluctuations and can be more pronounced when operating in multiple
countries. Efficient diversification of such risk factors is key to success.
Political Risk stems from changing attitudes of the political leadership toward MNCs resulting
in loss of subsidies or risk of nationalization. MNCs can defend against such risks by doing the
following:
1. Keeping critical operations private: Maintain key or critical elements of operations safely
within the firm rendering the assets useless in case of nationalization.
2. Financing operations and assets with local money: Local creditors can put pressure on the
host government not to nationalize the business.
3. Receiving primary inputs outside the local economy: Otherwise, the assets and operations
would not be valuable.
18.2 Foreign Exchange (Slides 18-9 to 18-24)
With each sovereign nation having its own currency (except of course, the euro which is the
accepted currency in sixteen out of twenty-seven countries of the European Union (EU)), MNCs
have to keep track of the fluctuations in exchange rates of various currencies caused by
fluctuating economic factors such as interest rates, inflation rates, and productivity.
Purchasing Power Parity
Purchasing power parity means that the price of similar goods is the same regardless of which
currency one uses to buy the goods.
Table 18.1 is an example of how the price of a Big Mac in various countries can be used to keep
track of relative purchasing power and exchange rates in countries where McDonald’s operates.
Chapter 18 ◼ International Financial Management 577
In general, the rate at which we can exchange money between currencies should allow us to
purchase the same basket of goods in any country with the same dollars (except for local tariffs
etc.
Currency Exchange Rates, as shown in Table 18.2, can be expressed in direct (Amount of $
required to buy 1 unit of foreign money) or indirect (amount of foreign money required to buy 1
US$) form.
578 Brooks ◼ Financial Management: Core Concepts, 4e
Calculation of these rates is as follows:
Cross Rates are used to state the exchange rate between two non-U.S. currencies, e.g., the
exchange rate between the British pound and the yen.
We can use a three-step process to determine the rate:
1. We first convert British pounds into U.S. dollars. Using the direct rate from Table 18.2,
In Britain, this would be the indirect rate between the British pound and the Japanese yen, i.e.,
it would tell us how many units of yen can be bought with 1£.
Arbitrage opportunities exist when cross rates as determined by Equation 18.3 do not hold,
allowing traders the opportunity to exchange currencies simultaneously and make instant
profits without taking on any additional risk.
Example 1: Triangular arbitrage
Let’s say that you see that the direct rate for euro is 1.2922 and the indirect rate for the yen is
96.16. You check the Internet and find that the indirect rate for yen in euros is 130 yen. You
have $10,000 and are willing to make quick gains if possible. Is there an arbitrage opportunity
here?
First check to see if the indirect rate for yen in euros is correct or not, using Equation 18.3.
580 Brooks ◼ Financial Management: Core Concepts, 4e
YES! THIS WOULD BE AN ARBITRAGE OPPORTUNITY!
Forward rates or the exchange rates in the future, e.g., one year from now, depend to a large
extent on the current exchange rate and the relative expected inflation rates in the two
countries as shown in Equation 18.4.
Where inff = expected inflation rate in the foreign country
And infh = expected inflation rate in the host country.
If a country’s inflation rate increases relatively higher than that of another country, then its
currency’s exchange rate will get weaker, i.e., it will buy less units of the currency of the country
whose inflation rate did not increase as much.
Equation 18.4 applies to a one-year forward rate. A more general formula that can be used for
predicting forward rates for any future period is shown in Equation 18.5
Example 2: Calculating forward rates
Let’s say that the Australian $ is currently being quoted at A$1.3109/U.S.$. If inflation is likely to
be 8% in Australia and 4% in the United States, calculate the indirect forward rate for the
Australian dollar three months from now.
Using Forward Rates
Investors and companies can use forward contracts to essentially minimize their risk of losses
arising from having to convert money received in foreign currencies at lower rates. The forward
rate is the rate that is being committed to today for forward delivery of the currency. So if rates
go down, you still get the forward rate that was agreed upon.
According to the International Fisher Effect, the real interest rates are equal across all countries,
so if we get a higher rate in one country, it will be offset by a higher inflation in that country and
a weakening exchange rate.
Chapter 18 ◼ International Financial Management 581
Covered interest arbitrage is an attempt made by some investors to try and exploit variances in
inflation rates and interest rates across countries. Most often, however, the exchange rate
adjusts such that the arbitrage opportunities do not materialize.
18.3 Transaction, Operating,
and Translation Exposures (Slides 18-25 to 18-30)
Fluctuations in exchange rates cause a firm’s future cash inflows, either from remittances from
customers or from profits being sent home, to vary significantly leading to possible losses and
gains from transaction, operating, and translation exposure.
Transaction exposure is the potential loss in home currency value of future foreign currency
payments.
This loss would occur if the home currency gets stronger, meaning fewer units can be purchased
per unit of the foreign currency.
Operating exposure is the risk associated with the effect of unfavorable exchange rate
movements on the long-run viability of a foreign operation of a multinational business, primarily
driven by escalating inflation rates.
Tables 18.5 and 18.6 illustrate the effects of rising inflation rates on a country’s exchange rate
and the consequential negative effect on operating profits of a U.S. firm doing business in
Sweden.
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Translation Exposure is the risk of a negative effect on financial statements due to different
countries’ rules for translating foreign financial statements into consolidated reports of both
foreign and domestic operations.
18.4 Foreign Investment Decisions (Slides 18-31 to 18-40)
When evaluating multinational capital budgeting projects, the NPV analysis can be done with
either foreign currency cash flows or with domestic currency cash flows. Two main differences
between foreign and domestic investment decisions include (1) the use of an appropriate
discount rate which accounts for the relative inflation rates in the two countries and (2) the
conversion of cash flows using an appropriate exchange rate. Example 18.3 shown below is a
detailed illustration of how NPV analysis of foreign projects can be done in either a domestic
context or a foreign one.
Chapter 18 ◼ International Financial Management 583
EXAMPLE 18.3 Domestic currency and foreign currency approaches for an NPV
decision
Problem Surfboards U.S.A. wants to produce and sell surfboards in Mazatlan, Mexico. The
company has calculated the following after-tax incremental cash flow in pesos using a five-year
project window:
■ Initial investment of 120,000,000 pesos
■ Operating cash flow
■ Working capital increases or decreases
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Questions
1. What effect can cultural differences have on the ownership structure of a foreign
operation of a multinational business?
2. What are intellectual property rights? How have changes in technology impacted the
ability to protect intellectual property rights?
3. What does it mean to nationalize a business? How can a domestic company minimize the
risk of nationalization of its foreign operations?
protect against this type of loss:
1. Keep critical operations private.
4. Explain how purchasing power parity determines the exchange rate between two
currencies.
5. Why are currency exchange rates constantly changing over time?
6. What is a cross rate? How can you find the cross rate of two foreign currencies if you only
know the direct and indirect rates of those two foreign currencies with respect to your
home currency?
7. Why should a company be concerned about a change in future exchange rates if it has
already sold and delivered product in a foreign country?
8. How can a changing exchange rate affect a company’s profits on one of its foreign
operations?
9. Explain how translating a foreign balance sheet for inclusion in a multinational’s domestic
balance sheet can violate the accounting identity.
At issue here is the translation of different accounts with different exchange rates. It would
10. Is it better to calculate the net present value of a foreign project in the foreign currency or
in the domestic currency?
Prepping for Exams
1. d
Chapter 18 ◼ International Financial Management 589
Problems
1. Foreign exchange and commodity prices. While traveling in the following countries you see
twenty-ounce plastic bottles of Coca-Cola. You know the price in the United States for a
coke is $1.09, but the countries have the following prices:
Canada: C$ 1.50
Japan: ¥ 125
England: £ 0.60
Average Price across Europe: € 0.90
What is the implied exchange rate for U.S. dollars and these four currencies?
ANSWER
In-direct: Direct (1/In-direct):
$1.09
$1.09
$1.09
$1.09
2. Foreign exchange and commodity prices. While traveling in the following countries, you
occasionally resort to U.S. food. You pay the following prices for a Big Mac:
India: 210 rupees
Kuwait: 1.39 dinars
Sweden: 34.90 kronor
Ukraine: 133 rubles
If the price of a Big Mac is $4.59 in the United States, what are the implied exchange rates for
these currencies?
ANSWER
In-direct: Direct (1/In-direct):
$4.59
$4.59
3. Currency exchange rates. You are taking a trip to six European countries. It is a ten-day trip,
and you are taking $3,500. The current direct conversion rate is 1.2150 for euros. While in
Europe, you spend € 2638.30. You convert your remaining euros back to U.S. dollars upon
your return. If the exchange rates remained the same over your trip, how much do you have
left in U.S. dollars?
ANSWER
4. Currency exchange rates. On the day you arrive in England, the exchange rate for U.S.
dollars and British pounds is $1:£0.58. You have $4,200, which you convert to pounds. While
you remain in England for the next two weeks, the exchange rate falls to $1:£0.54. As you
leave England, you convert the £135 you have left to dollars. How much did you spend in
England in U.S. dollars? Did the movement in the exchange rate help or hurt you?
ANSWER
5. Cross rates. You travel to Japan and China on a business trip. You first stop in Japan, where
the current direct exchange rate is 0.0092. You will next stop in China, where the current
direct exchange rate is 0.1285. As you leave Japan, you have ¥980,000 and need to convert
to yuan. What is the cross rate for yuan? How many yuan do you get for your yen? Verify by
converting yen back to dollars and then dollars to yuan.
ANSWER
6. Cross rates. Fill in the missing cross rates and direct rates in the following table:
International Cross Rates
$
Euro
Pound
Peso
Yen
C$
Canada
1.3689
—
Japan
109.48
—
Mexico
11.3921
—
U.K.
0.5460
—
Euro
0.8222
—
U.S.
—
ANSWER:
International Cross Rates
$
Euro
Pound
Peso
Yen
C$
Canada
1.3689
1.6649
2.5071
0.1202
0.0125
—
Japan
109.48
9.6103
—
Mexico
—
0.1041
8.3195
U.K.
U.S.
—
1.2162
1.8315
0.0879
0.7305
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7. Triangular arbitrage. Great Exchanges, Inc. is a currency exchange company located at most
international airports. Today, a clerk has made a mistake on one of the currency exchanges
and has posted the following rates:
$ for £
£ for €
€ for $
£ for $
€ for £
$ for €
0.5310
1.4435
1.3046
1.8832
0.9628
0.7665
Which corresponding rates do not match? And if you had $1,000, how much could you make
on one pass through the currencies?
ANSWER
Direct Indirect Actual Indirect:
Chapter 18 ◼ International Financial Management 593
Arbitrage strategy: Need to use the mismatched euros to British pounds:
8. Triangular arbitrage. Using the data from Problem 7, determine what you would lose if you
went the wrong way for the arbitrage. Explain this result.
ANSWER
Direct Indirect Actual Indirect:
Arbitrage strategy:
9. Forward rates. Your company has posted you on an eighteen-month overseas assignment in
Budapest, Hungary. You will be living on the Buda side of the river, but will be spending much
of your time on the Pest side. The current indirect rate for the Hungarian forint is 187.90. If
the anticipated inflation rate in the United States is 3% and the anticipated rate in Hungary is
8.5% (annually), what exchange rate do you anticipate at the end of your assignment?
ANSWER
