978-1259277160 Chapter 21 Lecture Note

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International Financial Management

Author’s Overview

The instructor should stress the importance of international financial management (and

international trade) to the class. The students can easily appreciate the everyday events that

bring the world closer together. An important point is that international finance has the same

elements as domestic financial management only the issues tend to be more involved. The firm

must not only make a profit on a transaction, but convert that profit into the appropriate

currency in a satisfactory manner. With the U.S. becoming a mature economy, it is increasingly

important that students understand how to conduct business across international borders. The

rise of the euro as a world currency has changed the way Europe does business. With 162

countries in the World Trade Organization, international trade will continue with the WTO

trying to maintain an even playing field.

While we have attempted to integrate international material throughout the book, this chapter

concentrates only on international issues and is a good introduction to the complexities of

international financial decision making for those instructors wanting more depth in this area.

Chapter Concepts

LO1. The multinational corporation is one that crosses international borders to gain expanded

markets.

LO2. A company operating in many foreign countries must consider the effect of exchange

rates on its profitability and cash flow.

LO3. Foreign exchange risk can be hedged or reduced.

LO4. Political risk must carefully assessed in making a foreign investment decision.

LO5. The potential ways for financing international operations are much greater than for

domestic operations and should be carefully considered.

Annotated Outline and Strategy

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I. Introduction

A. Many factors have contributed to greater economic interaction among the

world’s nations.

1. Advances in communication and transportation.

2. Adaptation of political systems.

a. Post World War II rebuilding programs

b. European Common Market

c. NAFTA

3. International flows of capital and technology.

4. International currency: U.S. dollar vs. the euro.

5. Interdependence for scarce resources.

B. International business operations are complex and risky and require special

understanding.

PPT One U.S. Dollar to the British Pound and Euro (Figure 21-1)

PPT International Sales of Selected U.S. Companies (Table 21-1)

II. The Multinational Corporation (MNC): Nature and Environment

A. Basic forms of MNC

1. Exporter — exportation to foreign markets of domestically produced

products.

2. Licensing Agreement — granting of a license to an independent local (in

the foreign country) firm to use the “exporting” firm’s technology.

3. Joint Venture — cooperative business operation with a firm (or firms) in

the foreign country.

4. Fully Owned Foreign Subsidiary

B. International Environment versus Domestic Environment

1. More risky — in addition to normal business risks, the MNC is faced with

foreign exchange risk and political risk. The portfolio risk of the parent

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company, however, may be reduced if foreign and domestic operations

are not correlated.

2. Potentially more profitable.

3. More complex — the laws, customs, and economic environment of the

host country may vary in many respects:

a. Rates of inflation

b. Tax rules

c. Structure and operation of financial institutions

d. Financial policies and practices

e. Work habits and wages of laborers

III. Foreign Exchange Rates

A. To facilitate international trade, currencies must be exchanged. For example, an

exporter will usually desire payment in the currency of his home country. The

importer must swap his domestic currency for the currency desired by the

exporter in order to pay his bill.

1. Examine Figure 21-2 and some of the currencies vs. the dollar.

2. Currencies are not stable over time.

Perspective 21-1: Use Figure 21-2 to show how currencies move up and down over time.

PPT Exchange Rates to the Dollar (Figure 21-2)

B. Factors affecting exchange rates

1. Supply of and demand for the currencies of the various countries.

2. The degree of central bank intervention.

3. Inflation rate differentials (Purchasing Power Parity Theory).

4. Interest rate differentials (Interest Rate Parity Theory).

5. Balance of payments

6. Government policies

7. Other factors

a. Capital market movements

b. Changes in supply of and demand for the products and services of

individual countries

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c. Labor disputes

C. Many variables affect currency exchange rates. The importance of each variable

or set of variables will change as economics and political conditions change

throughout the world.

D. Spot Rates, Forward Rates, and Cross Rates

Perspective 21-2: There are a number of easily understood examples in the text on spot and

forward rates as well as cross rates.

1. Spot rate — the exchange rate between currencies with immediate

delivery

2. Forward rate — the rate of exchange between currencies when delivery

will occur in the future.

3. Cross rates — the exchange rate between currencies such as Danish krone

and British pounds based on their exchange rate with another currency

such as U.S. dollars.

PPT Key Currency Cross Rates (Table 21-2)

IV. Managing Foreign Exchange Risk

A. Three types of foreign exchange risk exposure

1. Accounting or translation exposure — depends upon accounting rules

established by the parent company’s government. Under FASB #52, all

foreign currency denominated assets and liabilities are converted at the

rate of exchange in effect on the date of balance sheet preparation.

2. Transaction exposure — in the U.S., foreign exchange gains and losses are

reflected in the income statement for the current period — this increases

the volatility of earnings per share.

3. Economic Exposure to different county GDP performance.

Perspective 21-3: The instructor might wish to discuss the different ways foreign exchange

risk can be reduced.

B. There are three strategies used to minimize transaction exposure:

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1. Hedging in the forward exchange market — the recipient (seller) of

foreign currency in an international transaction sells a forward contract

to assure the amount that will be received in domestic currency.

2. Hedging in the money market — the recipient borrows foreign currency in

the amount to be received and then immediately converts to domestic

currency. When the receivable is collected, the loan is paid off.

3. Hedging in the currency futures market — futures contracts in foreign

currencies began trading in the International Monetary Market (IMM) of

the Chicago Mercantile Exchange on May 16, 1972 and on the London

International Financial Futures Exchange (LIFFE) in September 1982.

Finance in Action: Coca-Cola Manages Currency Risk

As a large MNC, Coca-Cola, with over $50 billion in sales, must manage billions of dollars in

currency risk. Coke uses 70 functional currencies in 2014 along with the U.S. dollar. The

company uses derivatives to manage these risks. One of the critical elements the firm uses to

determine its hedging needs is the amount of accounts receivable outstanding in each currency.

This box demonstrates that the primary use of derivatives is to reduce risk exposures, rather

than to speculate.

V. Foreign Investment Decisions

A. Reasons for U.S. firms to invest in foreign countries

1. Fear of import tariffs (in foreign countries)

2. Lower production costs particularly with regard to labor costs

3. Ease of entry because of advanced American technology

4. Tax advantages

5. Strategic considerations — competition

6. International diversification

PPT Risk Reduction from International Diversification (Figure 21-3)

B. Foreign firms are expanding their investment in the United States

1. Foreign investments in the United States provide employment for

millions of people.

2. Reasons for foreign expansion in the U.S.

a. International diversification

b. Strategic considerations

c. Increasing labor costs

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d. Saturated markets

e. Shortage of land for development

f. Large market in U.S.

g. Labor restrictions overseas

h. Access to advanced technology

i. Political stability

Perspective 21-4: This is a good place to talk about current political risk.

C. Analysis of Political Risk

1. The structure of the foreign government and/or those in control may

change many times during the lengthy period necessary to recover an

investment. “Unfriendly” changes may result in:

a. Foreign exchange restriction

b. Foreign ownership limitations

c. Blockage of repatriation of earnings

d. Expropriation of foreign subsidiary’s assets

2. Safeguards against political risk

a. A thorough investigation of the country’s political stability prior

to investment.

b. Joint ventures with local (foreign) companies

c. Joint ventures with multiple companies representing multiple

countries.

d. Insurance through the federal government agency, Overseas

Private Investment Corporation (OPIC).

VI. Financing International Business Operations

A. Letters of credit — in order to reduce the risk of non-payment, an exporter may

require an importer to furnish a letter of credit. The letter of credit is normally

issued by the importer’s bank and guarantees payment to the exporter upon

delivery of the merchandise if the specified conditions are met.

B. Export credit insurance — a private association of 60 U.S. insurance firms, the

Foreign Credit Insurance Association (FCIA), may provide insurance against

non-payment by foreign customers.

C. Funding of transactions

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1. Export-Import Bank (Eximbank) — facilitates the financing of U.S.

exports through several programs.

2. Loans from the parent company or sister affiliate. See Figure 21-4.

a. Parallel loans — an arrangement where two parent firms in

different countries each make a loan to the affiliate of the other

parent. The procedure eliminates foreign exchange risk.

b. Fronting loans — loans from a parent firm to a foreign subsidiary

via a bank located in the foreign country. See Figure 21-5.

3. Eurodollar loans — loans from foreign banks that are denominated in

dollars.

a. There are many participants in the Eurodollar market from

throughout the world particularly the U.S., Canada, Western

Europe and Japan.

b. Lower borrowing costs and the absence of compensating balance

requirements are significant incentives for U.S. firms.

c. The lending rate is based on the London Interbank Offered Rate

(LIBOR).

d. Lending in the Eurodollar market is almost exclusively done by

commercial banks. Large Euro-currency loans are frequently

syndicated and managed by a lead bank.

4. Eurobond market — long-term funds may be secured by issuing

Eurobonds. These bonds are sold throughout the world but are

denominated primarily in U.S. dollars.

a. Disclosure requirements are less stringent.

b. Registration costs are lower than in U.S.

c. Some tax advantages exist.

d. Caution must be exercised because of the exposure to foreign

exchange risk.

5. International equity markets — selling common stock to residents of a

foreign country provides financing and also reduces political risk.

Perspective 21-5: The instructor may wish to indicate the importance of international equity

markets in the current age of the MNC.

a. Multinational firms list their shares on major stock exchanges

around the world. Half the stocks listed on the Amsterdam stock

exchange are foreign.

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b. Marketing securities internationally requires firms to adjust their

procedures. For example, commercial banks have a dominant role

in the securities business throughout Europe.

c. Over 200 Foreign companies are listed on the NYSE.

d. American Depository Receipts (ADRs) are a common way for

foreign firms to list shares in the U.S.

Finance in Action: Political Risk in Argentina

This box provides an opportunity to discuss the risk of expropriation. The government of

Argentina decided to expropriate the assets of the country’s largest oil company, YPF, which

was a subsidiary of the Spanish multinational firm Repsol. While not mentioned in this

discussion, the professor can bring up Venezuela’s expropriation of U.S. oil company assets.

6. International Finance Corporation (IFC) — the IFC was established in

1956 and is a unit of the World Bank. Its objective is to promote

economic development in the 119 member countries of the World Bank.

a. A multinational firm may be able to raise equity capital by selling

partial ownership to the IFC.

b. The IFC decides to participate in the venture on the basis of

profitability and the potential benefit to the host country.

c. Once the venture is well established, the IFC frees up its capital

by selling its ownership interest.

VII. Unsettled Issues in International Finance

A. The complexity of the multinational business environment generates questions

for which there are no easy answers.

1. Should a foreign affiliate design a capital structure similar to that of the

parent firm or one that fits the acceptable pattern of the host country?

2. Who should determine the dividend policy of a foreign affiliate — the

affiliate management or the parent management?

B. Successful participation in the international business environment requires

cohesive, coordinated financial management.

VIII. Appendix 21A: Cash Flow Analysis and the Foreign Investment Decision

Perspective 21-6: The appendix represents a reasonably complicated consideration of a

foreign investment decision by a corporation. Because adequate coverage requires an hour or

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more, it is relegated to the appendix.

A. Cash Flow Analysis

B. Tax Factors

C. Foreign Exchange Considerations

D. Present Value Analysis

E. The Risk Factor

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