Chapter 20
Short-Term Financing
Lecture Outline
Sources of Foreign Financing
Internal Short-term Financing
External Short-term Financing
Financing with a Foreign Currency
Motivation for Financing with a Foreign Currency
Potential Cost Savings from Financing with a Foreign Currency
Risk of Financing with a Foreign Currency
Financing with a Portfolio of Currencies
Short-Term Financing ❖ 2
Chapter Theme
This chapter explains short-term liability management of MNCs. Financing with a foreign currency can
reduce the MNC’s costs, but it can expose the MNC to exchange rate risk. While foreign financing costs
cannot usually be perfectly forecasted, firms should evaluate the probability of reducing costs through
foreign financing.
Topics to Stimulate Class Discussion
2. What is the risk of borrowing a low interest rate currency?
3. Assume that foreign currencies X, Y, and Z are highly correlated. If a firm diversifies its financing
among these three currencies, will it substantially reduce its exchange rate exposure (as opposed to
borrowing all funds from one of these foreign currencies)? Explain.
POINT/COUNTER-POINT:
Do MNCs Increase Their Risk When Borrowing Foreign Currencies?
POINT: Yes. MNCs should borrow the currency that matches their cash inflows. If they borrow a foreign
currency to finance business in a different currency, they are essentially speculating on the future
exchange rate movements. The results of this strategy are uncertain, which represents a source of risk for
the MNC and its shareholders.
COUNTER-POINT: No. If MNCs expect that they can reduce the effective financing rate by borrowing a
foreign currency, they should consider borrowing that currency. This approach enables them to achieve
lower costs and improves their ability to compete. If they take the most conservative approach by
borrowing whatever currency matches their inflows, they may incur higher costs, and have a greater
chance of failure.
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support?
Offer your own opinion on this issue.
Answers to End of Chapter Questions
1. Financing from Subsidiaries. Explain why an MNC parent would consider financing from its
subsidiaries.
2. Foreign Financing.
a. Explain how a firm’s degree of risk aversion enters into its decision of whether to finance in a
foreign currency or a local currency.
b. Assume that interest rate parity exists. If the forward rate is an unbiased forecast of the future spot
rate, explain the implications of borrowing a foreign currency (versus local financing) over time.
ANSWER: A very risk-averse firm may prefer to borrow domestically since it knows with certainty
the cost of financing in advance. Yet, other firms may feel that the potential cost savings from
3. Probability Distribution.
a. Discuss the development of a probability distribution of effective financing rates when financing
in a foreign currency. How is this distribution developed?
b. Once the probability distribution of effective financing rates from financing in a foreign currency
is developed, how can this distribution be used to decide whether to finance in the foreign
currency or the home currency?
4. Financing and Exchange Rate Risk. How can a U.S. firm finance in euros and not necessarily be
exposed to exchange rate risk?
5. Short-term Financing Analysis. Assume that Davenport Inc. needs $3 million for a one-year
period. Within one year, it will generate enough U.S. dollars to pay off the loan. It is considering
three options: (1) borrowing U.S. dollars at an interest rate of 6%, (2) borrowing Japanese yen at an
interest rate of 3%, or (3) borrowing Canadian dollars at an interest rate of 4%. Davenport Inc.
expects that the Japanese yen will appreciate by 1% over the next year and that the Canadian dollar
will appreciate by 3%. What is the expected “effective” financing rate for each of the three options?
Which option appears to be most feasible? Why might Davenport Inc. not necessarily choose the
option reflecting the lowest effective financing rate?
Short-Term Financing ❖ 4
ANSWER:
Expected
Interest Expected Percentage Effective
Currency Rate Change in Currency Financing Rate
6. Effective Financing Rate. How is it possible for a firm to incur a negative effective financing rate?
7. IRP Application to Short-term Financing. Connecticut Co. plans to finance its operations in
the U.S. It can borrow euros on a short-term basis at a lower interest rate than if it borrowed
dollars. If interest rate parity does not hold, what strategy should Connecticut Co. consider when it
needs short-term financing?
a. Assume that Connecticut Co. needs dollars. It borrows euros at a lower interest rate than the
interest rate for dollars. If interest rate parity exists and if the forward rate of the euro is a reliable
predictor of the future spot rate, what does this suggest about the feasibility of such a strategy?
b. If Connecticut Co. expects the spot rate to be a more reliable predictor of the future spot rate,
what does this suggest about the feasibility of such a strategy?
ANSWER: The firm could consider borrowing a foreign currency and purchasing the currency
forward to lock in its financing cost.
8. IRP Application to Foreign Financing. Seabreeze Co. needs to finance some dollar-denominated
expenses for one year. It can borrow euros cheaper than it can borrow dollars. Interest rate partiy
exists. The one-year forward rate of the euro contains a premium of 4%. If it believes the euro will
appreciate by 6% over the next year, would its expected financing expense be lower if it borrowed
dollars or euros.
9. IRP Application to Short-term Financing. Assume that interest rate parity exists. If a firm believes
that the forward rate is an unbiased predictor of the future spot rate, will it expect to achieve lower
financing costs by consistently borrowing a foreign currency with a low interest rate?
10. Effective Financing Rate. Greensboro, Inc., needs $4 million for one year. It currently has no
business in Japan but plans to borrow Japanese yen from a Japanese bank, because the Japanese
interest rate is three percentage points lower than the U.S. rate. Assume that interest rate parity
exists; also assume that Greensboro believes that the one-year forward rate of the Japanese yen will
exceed the future spot rate one year from now. Will the expected effective financing rate be higher
than, lower than, or the same as financing with dollars? Explain.
11. IRP Application to Short-term Financing. Assume that the U.S. interest rate is 7 percent and the
euro’s interest rate is 4 percent. Assume that the euro’s forward rate has a premium of 4 percent.
Determine whether the following statement is true: “Interest rate parity does not hold; therefore, U.S.
firms could lock in a lower financing cost by borrowing euros and purchasing euros forward for one
year.” Explain your answer.
ANSWER: No. While interest rate parity does not hold, the financing with euros would result in an
effective financing rate of:
12. Implications of the Forward Rate for Foreign Financing. Mizner, Inc., is a U.S.-based MNC with
a subsidiary in Mexico. Its Mexican subsidiary needs a one-year loan of 10 million pesos to cover its
operating expenses. The subsidiary can borrow pesos at 11% and can use peso revenues to be
received over the year to repay the loan. Alternatively, it can borrow dollars at 6%. Interest rate parity
exists. The forward rate of the peso is expected to overestimate the spot rate of the peso in one year.
Should the subsidiary borrow pesos or dollars?
13. Financing During a Crisis. Bradenton, Inc., has a foreign subsidiary in Asia that commonly obtains
short-term financing from local banks. If Asia suddenly experiences an economic crisis, explain why
Bradenton may not be able to easily obtain funds from the local banks.
Short-Term Financing ❖ 6
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ANSWER: The foreign subsidiary may find that the local banks do not have adequate funding from
depositors any more to provide credit. Alternatively, the banks may be concerned about the credit
risk given the large number of defaults by firms.
14. Impact of Credit Crisis on Risk of Financing. Homewood Co. commonly finances some of its
U.S. expansion by repeatedly borrowing on a short-term basis. Explain how a global credit crisis
might limit the firm’s ability to repeatedly borrow short-term funds and increase the cost of
borrowing.
15. Probability Distribution of Financing Costs. Missoula, Inc., decides to borrow Japanese yen for
one year. The interest rate on the borrowed yen is 8 percent. Missoula has developed the following
probability distribution for the yen’s degree of fluctuation against the dollar:
Possible Degree of
Fluctuation of Percentage
Yen Against the Dollar Probability
–4% 20%
–1% 30%
0% 10%
3% 40%
Given this information, what is the expected value of the effective financing rate of the Japanese yen
from the U.S. corporation’s perspective?
ANSWER:
Japanese
Interest Rate
Possible %
Change in
Yen Value
Effective
Financing Rate
Based on
That Change
Probability
Computation of
Expected Value
8%
–4%
3.68%
20%
.736%
8%
–1%
6.92%
30%
2.076%
8%
0%
8.00%
10%
.800%
8%
3%
11.24%
40%
4.496%
8.108%
Expected value = 8.108%
16. Analysis of Short-term Financing. Jacksonville Corp. is a U.S.-based firm that needs $600,000.
It has no business in Japan but is considering one-year financing with Japanese yen, because the
annual interest rate would be 5 percent versus 9 percent in the United States. Assume that interest
rate parity exists.
a. Can Jacksonville benefit from borrowing Japanese yen and simultaneously purchasing yen one
year forward to avoid exchange rate risk? Explain.
Short-Term Financing ❖ 7
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ANSWER: If Jacksonville borrows yen and simultaneously purchases yen one year forward, it will
pay a forward premium that will offset the interest rate differential (given that interest rate parity
exists). Based on interest rate parity, the forward premium is about 3.8%. The effective financing
rate would be:
(1 + 5%)(1 + 3.8%) – 1 = about 9%
b. Assume that Jacksonville does not cover its exposure and uses the forward rate to forecast the
future spot rate. Determine the expected effective financing rate. Should Jacksonville finance
with Japanese yen? Explain.
c. Assume that Jacksonville does not cover its exposure and expects that the Japanese yen will
appreciate by either 5 percent, 3 percent, or 2 percent, and with each scenario having an equal
probability of occurrence. Use this information to determine the probability distribution of the
effective financing rate. Should Jacksonville finance with Japanese yen? Explain.
ANSWER:
Possible % Effective Financing
Change in Spot Rate of JY if that
Rate of JY Percentage Change Occurs Probability
5% (1.05)(1.05) – 1 = 10.25% 33.3%
17. Financing With a Portfolio. Pepperdine, Inc., considers obtaining 40 percent of its one-year
financing in Canadian dollars and 60 percent in Japanese yen. The forecasts of appreciation in the
Canadian dollar and Japanese yen for the next year are as follows:
Probability
Possible Percentage of that Percentage
Change in the Spot Change in the
Currency Rate Over the Loan Life Spot Rate Occurring
Canadian dollar 4% 70%
Canadian dollar 7 30
Japanese yen 6 50
Japanese yen 9 50
The interest rate on the Canadian dollar is 9 percent, and the interest rate on the Japanese yen is 7
percent. Develop the possible effective financing rates of the overall portfolio and the probability of
each possibility based on the use of joint probabilities.
ANSWER:
Short-Term Financing ❖ 8
Effective
Financing
Interest Possible Rate Based on
Currency Rate % Change that Change Probability
Canadian dollar 9% 4% 13.36% 70%
Possible Joint
Effective
Financing Rate Joint Effective Financing
C$ JY Probability Rate of Portfolio
13.36% 13.42% (70%)(50%) = 35% .4(13.36%) + .6(13.42%) = 13.396%
18. Financing With a Portfolio.
a. Does borrowing a portfolio of currencies offer any possible advantages over the borrowing of a
single foreign currency?
ANSWER: If a firm borrows a single foreign currency, it is especially vulnerable to that currency’s
b. If a firm borrows a portfolio of currencies, what characteristics of the currencies will affect the
potential uncertainty of the portfolio’s effective financing rate? What characteristics would be
desirable from a borrowing firm’s perspective?
ANSWER: Currencies which are volatile and highly correlated with each other could cause the
19. Financing with a Portfolio. Raleigh Corp. needs to borrow funds for one year to support its
operations in the United States. The following interest rates are available:
Country Borrowing Rate
U.S. 10%
Canada 6%
Japan 5%
The percentage change in the spot rates of the Canadian dollar and Japanese yen over the next year
are as follows:
Canadian Dollar Japanese Yen
Percentage Change Percentage Change
Short-Term Financing ❖ 9
Probability in Spot Rate Probability in Spot Rate
10% 5% 20% 6%
90% 2% 80% 1%
If Raleigh Corporation borrows a portfolio that has 50 percent of funds from Canadian dollars and 50
percent of funds from yen, determine the probability distribution of the effective financing rate of the
portfolio. What is the probability that Raleigh will incur a higher effective financing rate from
borrowing this portfolio than from borrowing U.S. dollars?
ANSWER:
Effective
Financing
Interest Possible Rate Based on
Currency Rate % Change that Change Probability
Canadian dollar 6% 5% 11.3% 10%
Possible Joint
Effective
Financing Rate Joint Effective Financing
C$ JY Probability Rate of Portfolio
11.3% 11.3% (10%)(20%) = 2% .5(11.3%) + .5(11.3%) = 11.3%
CRITICAL THINKING
MNC’s Use of Dollar-Denominated Short-term Debt In recent years, U.S. short-term interest rates have
been low. Write a short essay describing your opinion on whether you (as a manger of an MNC) might be
more willing to use dollar-denominated short-term debt to cover short-term funding needs for subsidiaries in
foreign countries that generate positive earnings. Explain the possible tradeoffs involved.
ANSWER
Solution to Continuing Case Problem: Blades, Inc.
1. What is the amount, in baht, that Blades needs to borrow to cover the payments due to the Thai
suppliers? What is the amount, in yen, that Blades needs to borrow to cover the payments due to the
Thai suppliers?
Short-Term Financing ❖ 10
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ANSWER: Since Blades will purchase materials necessary to manufacture 120,000 pairs of
“Speedos,” and since the cost per pair will approximately be 3,500 Thai baht, it will need to obtain a
loan for the equivalent of 120,000 × 3,500 = 420,000,000 Thai baht.
If Blades borrows in yen, the yen would be converted to Thai baht in order to pay the Thai supplier.
Thus, Blades will have to obtain a loan for THB420,000,000/THB0.347826 = ¥1,207,500,302.
2. Given that Blades will use the receipts from the receivables in Thailand to repay the loan and that the
subsidiary plans to remit all baht-denominated cash flows back to the U.S. parent whether it borrows
in baht or yen, does the future value of the yen with respect to the baht affect the cost of the loan if
Blades borrows in yen?
3. Using a spreadsheet, compute the expected amount (in U.S. dollars) that will be remitted back to the
U.S. in six months if Blades finances its working capital requirements by borrowing baht versus
borrowing yen. Based on your analysis, should Blades obtain a yen- or baht-denominated loan?
ANSWER: (See spreadsheet attached.) If Blades borrows in Thai baht, the expected amount remitted
Computation of Expected Change in Value of Thai Baht (Relative to the Dollar)
(1)
(2)
Possible Rate of Change in the
Probability of
Thai Baht Over the Life of the Loan
Occurrence
–3%
30%
–2%
30%
–1%
20%
0%
15%
1%
5%
Computation of Expected Change in Value of Japanese Yen (Relative to the Baht)
(1)
(2)
Possible Rate of Change in the
Probability of
Japanese Yen Over the Life of the Loan
Occurrence
2%
30%
1%
30%
0%
20%
–1%
15%
–2%
5%
(1) Blades Borrows in Thai Baht
Short-Term Financing ❖ 11
Computation of Expected Baht-Dollar Exchange Rate in Six Months
Current Spot Rate of Baht
$0.0230
Expected Percentage Change in Baht
–1.65%
Expected Value of Baht in Six Months ($0.023 × [1 – 1.65%])
$0.0226205
Computation of Baht to Be Remitted to the U.S. Parent:
Baht Receivables (120,000 pairs × 5,000 baht per pair)
THB 600,000,000
Baht Loan Repayment (420,000,000 × 1.06)
THB 445,200,000
Baht to Be Remitted to the U.S. (600,000,000 – 445,200,000)
THB 154,800,000
Expected Dollar Amount Remitted in Six Months (154,800,000 ×
$0.0226205)
$3,501,653
(2) Blades Borrows in Japanese Yen
Computation of Expected Yen-Baht Exchange Rate in Six Months
Current Spot Rate of Yen
THB 0.347826
Expected Percentage Change in Yen
0.65%
Expected Value of Yen in Six Months (THB0.347826 × [1 + 0.65%])
THB 0.350087
Computation of Baht to Be Remitted to the U.S. Parent:
Baht Receivables (120,000 pairs × 5,000 baht per pair)
THB 600,000,000
Yen Needed to Repay Loan (1,207,500,302 yen × 1.04)
1,255,800,314
Baht Needed to Repay Loan (1,255,800,314 yen × THB0.350087)
THB 439,639,365
Baht to Be Remitted to the U.S. (600,000,000 – 439,639,365)
THB 160,360,635
Expected Dollar Amount Remitted in Six Months (160,360,635 ×
$0.0226205)
$3,627,438
Solution to Supplemental Case: Flyer Company
a. The optimal portfolio is dependent on your degree of risk aversion. By converting the information in
the table above into 4 bar charts (showing the probability distribution), one above another, you can
review the risk-return tradeoff.
By using a spreadsheet format, the percentage changes in exchange rates can be easily computed.
Using these percentage changes along with the interest rates, the effective financing rate can be
Somewhat Expected Value
Strong $ Stable $ Weak $ of Effective
Currency Scenario Scenario Scenario Financing Rate
Australian dollar –0.56% 14.51% 28.07% 14.05%
British pound 4.56 14.48 21.10 13.49
New Zealand dollar –5.48 5.22 12.35 4.14
Singapore dollar –4.60 1.76 10.24 2.40
Short-Term Financing ❖ 12
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Venezuelan bolivar 2.20 10.60 20.40 11.02
Percentage of Funds Borrowed from:
Type of Portfolio
A$
BP
C$
JY
MXP
NZ$
S$
SAR
US$
VB
Risk neutral
0
0
0
0
0
0
100
0
0
0
Balanced
0
0
0
0
25
25
25
25
0
0
Conservative
0
0
0
0
10
10
10
10
60
0
Ultra-conservative
0
0
0
0
0
0
0
0
100
0
Each portfolio’s effective financing rates are determined as a sum of weighted effective financing rates
under each scenario.
Portfolio’s Effective
Financing Rate Based on a Expected Value
Strong $ Stable $ Weak $ of Effective
Portfolio Scenario Scenario Scenario Financing Rate
Risk neutral –4.60% 1.76% 10.24% 2.40%
The decision of which portfolio to use would be based on your degree of risk aversion. By converting the
Small Business Dilemma
Short-Term Financing by the Sports Exports Company
1. Should Logan borrow dollars or pounds to finance his joint venture business? Why?
2. Logan could also borrow euros at an interest rate that is lower than the U.S. or British rate. The
values of the euro and pound tend to move in the same direction against the dollar, although not
always by the same degree. Would borrowing euros to support the British joint venture result in more
exposure to exchange rate risk than borrowing pounds? Would it result in more exposure to exchange
rate risk than borrowing dollars?
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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.