fundamentals of corporate finance, 2/e

Fundamentals of Corporate Finance, 2/e

ROBERT PARRINO, PH.D.DAVID S. KIDWELL, PH.D.THOMAS W. BATES, PH.D.

Chapter 21: International Financial Management

Learning Objectives

1. DISCUSS HOW THE BASIC PRINCIPLES OF FINANCE APPLY TO INTERNATIONAL FINANCIAL TRANSACTIONS.

2. DIFFERENTIATE AMONG THE SPOT RATE, THE FORWARD RATE, AND THE CROSS RATE IN THE FOREIGN EXCHANGE MARKETS, PERFORM FOREIGN EXCHANGE AND CROSS RATE CALCULATIONS, AND HEDGE AN ASSET PURCHASE WHERE PAYMENT IS MADE IN A FOREIGN CURRENCY.

Learning Objectives

3. IDENTIFY THE MAJOR FACTORS THAT DISTINGUISH INTERNATIONAL FROM DOMESTIC CAPITAL BUDGETING, EXPLAIN HOW THE CAPITAL BUDGETING PROCESS CAN BE ADJUSTED TO ACCOUNT FOR THESE FACTORS, AND COMPUTE THE NPV FOR A TYPICAL INTERNATIONAL CAPITAL PROJECT.

4. DISCUSS THE IMPORTANCE OF THE EUROMARKETS TO LARGE U.S. MULTINATIONAL FIRMS AND CALCULATE THE COST OF BORROWING IN THE EUROBOND MARKET.

Learning Objectives

5. EXPLAIN HOW LARGE U.S. MONEY CENTER BANKS MAKE AND PRICE EUROCREDIT LOANS TO THEIR CUSTOMERS AND COMPUTE THE COST OF A EUROCREDIT BANK LOAN.

Introduction to International

Financial Managem

ent

o GLOBALIZATION OF THE WORLD ECONOMY• Refers to removal of barriers to

free trade and closer integration of national economies.

• Consumers in many countries buy goods that are purchased from a number of countries other than just their own.

• Today, on average, large corporations, whether they are based in the United States or another country, generate around half of their sales revenue overseas.

Introduction to InternationalFinancial Management

o GLOBALIZATION OF THE WORLD ECONOMY• The production of goods and

services has also become highly globalized.

• Like product markets, the financial system has also become highly integrated.


o THE RISE OF MULTINATIONAL CORPORATIONS• A multinational corporation is a

business firm that operates in more than one country but is headquartered or based in its home country.

• Multinationals are owned by a mixture of domestic and foreign stockholders.


o THE RISE OF MULTINATIONAL CORPORATIONS• Transnational corporations are

multinational firms that has widely dispersed ownership and that is managed from a global perspective rather than a firm residing in a particular country.

• Exhibit 21.1 lists the top 15 multinational business firms ranked by total revenues.

Exhibit 21.1: The World’s Largest Multinational Firms Ranked by Revenue


o FACTORS AFFECTING INTERNATIONAL FINANCIAL MANAGEMENT• The uncertainty of future exchange

rate movements is called foreign exchange rate risk, or just exchange rate risk.

• Differences in legal systems and tax codes can also impact the way firms operate in foreign countries.


o FACTORS AFFECTING INTERNATIONAL FINANCIAL MANAGEMENT• While English is the official business

language, it is not, however, the world’s social language.

• Cultural views also shape business practices and people’s attitudes toward business.

• An economic system determines how a country mobilizes its resources to produce goods and services needed by society, as well as how the production is distributed.


o FACTORS AFFECTING INTERNATIONAL FINANCIAL MANAGEMENT• Differences in Country risk or

political uncertainty associated with a particular country is also a factor.

At the extreme, a country’s government may even expropriate—that is, take over—a business’s assets within the country.These types of actions clearly can affect a firm’s cash flows and, thus, the value of the firm.


o GOALS OF INTERNATIONAL FINANCIAL MANAGEMENT• Stockholder value maximization is the

accepted goal for firms in the United States, as well as in some other countries that share a similar heritage, such as the United Kingdom, Australia, India, and Canada.

• In Continental Europe, for example, countries such as France and Germany focus on maximizing corporate wealth.


o GOALS OF INTERNATIONAL FINANCIAL MANAGEMENT• The European manager’s goal is to earn as

much wealth as possible for the firm while considering the overall welfare of all stakeholders.

• In Japan, companies form tightly knit, interlocking business groups called keiretsu, such as Mitsubishi, Mitsui, and Sumitomo, and the goal of the Japanese business manager is to increase the wealth and growth of the keiretsu.

• As a result, they might focus on maximizing market share rather than stockholder wealth.


o GOALS OF INTERNATIONAL FINANCIAL MANAGEMENT• In China, which is making a transition from

a command economy to a market-based economy, there are sharp differences between state-owned companies and emerging private-sector firms.

• The large state-owned companies have an overall goal that can best be described as maintaining full employment in the economy while the new private-sector firms fully embrace the Western standard of stockholder value maximization.


o BASIC PRINCIPLES REMAIN THE SAME• For managerial finance whether a

transaction is domestic or international.

• The time value of money is not affected by whether a business transaction is domestic or international.


o BASIC PRINCIPLES REMAIN THE SAME• Likewise, the same models are used

for valuing capital assets, bonds, stocks, and entire firms .

• Exhibit 21.2 lists some of the important finance concepts and procedures and indicates where there are differences between domestic and international operations.

Exhibit 21.2: The Basic Principles of Finance Apply in International Finance

Foreign Exchange Markets

o Are a group of international markets connected electronically where currencies are bought and sold in wholesale amounts.

o Provide three basic economic benefits.• A mechanism to transfer purchasing power

from individuals who deal in one currency to people who deal in a different currency.

• A way for corporations to pass the risk associated with foreign exchange price fluctuations to professional risk-takers.

• A channel for importers and exporters to acquire credit for international business transactions.


o MARKET STRUCTURE AND MAJOR PARTICIPANTS• The market for foreign exchange is

very large, and the daily volume was more than $4 trillion in 2010.

• London is by far the largest foreign exchange trading center, with an average daily volume of $1.46 trillion, while New York City is second with $712 billion, and Tokyo is third with $247 billion.


o MARKET STRUCTURE AND MAJOR PARTICIPANTS• Participants are linked by telephone,

telegraph, and cable.• The major participants in the foreign

exchange markets are multinational commercial banks, large investment banking firms, and small currency boutiques that specialize in foreign exchange transactions.

• In addition, the central banks, which intervene in the markets primarily to smooth out fluctuations in their exchange rates, also play a significant role.

Exhibit 21.3: Foreign Exchange Rates and the Price of Steel in International Markets


o FOREIGN EXCHANGE RATES• When U.S.-based firms buy raw materials or

finished goods, they want to get the best possible deal—the quality they need at the lowest price.

• When the suppliers are not located in the United States, comparisons are more difficult.

• However, U.S.-based firms would prefer to pay for purchases in dollars, while the foreign supplier must pay employees and other local expenses with its domestic currency.


o FOREIGN EXCHANGE RATES• One of two parties in a transaction will be

forced to deal in a foreign currency and incur foreign exchange rate risk.

• We can easily compare prices stated in different currencies by checking the foreign exchange rate quotes in major newspapers or on the internet.

• A foreign exchange rate is the price of one monetary unit, such as the British pound, stated in terms of another currency, such as the U.S. dollar.

Exhibit 21.4: The Equilibrium Exchange Rate


o THE EQUILIBRIUM EXCHANGE RATE• Exhibit 21.4 shows the equilibrium

exchange rate, which is at the point where the supply and demand curves intersect.

• Equilibrium occurs at the price at which the quantity of the currency demanded exactly equals the quantity supplied.


o THE EQUILIBRIUM EXCHANGE RATE• In general, whatever causes U.S.

residents to buy more or fewer foreign goods shifts the demand curve for the foreign currency.

• Similarly, whatever causes foreigners to buy more or fewer U.S. goods shifts the supply curve for the foreign currency.


o FOREIGN CURRENCY QUOTATIONS• Exhibit 21.5 shows selected exchange

rate quotations from the Wall Street Journal.

• The Spot RateIs the cost of buying a foreign currency today, “on the spot”.If the exchange rate is the price in dollars for a foreign currency, it is often called the American or direct quote.If the exchange rate is the price in foreign currency for a dollar, the quote is called an European or indirect quote.

Exhibit 21.5: Key Currency Cross Rates


o FOREIGN CURRENCY QUOTATIONS• Bid and Ask Rate Quotations

Foreign exchange dealers quote two prices: bid and ask quotes.The bid quote represents the rate at which the dealer will buy foreign currency.The ask quote is the rate at which the dealer will sell foreign currency.The difference between the bid and ask price is the dealer’s spread, which is often calculated in percent form.

Foreign Currency Quotations

o Suppose a dealer is quoting a bid rate for euros of $1.4337/€ and an ask rate of 1.4423/€. the bid-ask spread is:

Ask rate - Bid rateBid ask spread = (21.1)

Ask rate

1.4423 - 1.4337Bid ask spread = = 0.596%

1.4423


o FOREIGN CURRENCY QUOTATIONS• Cross Rates

When one is given two quotes of foreign exchange rates involving three currencies, it is possible to find the exchange rate between the third pair of currencies, and this is known as the cross rate.People dealing with more than one foreign currency make use of a table of spot exchange rates called cross rates, which are simply exchange rates between two currencies.Exhibit 21.5 shows cross rates for seven different currencies.


o FOREIGN CURRENCY QUOTATIONS• Forward Rates

Are rates at which one agrees to buy or sell a currency on some future date.Note that the forward rate is established at the date on which the agreement is made and defines the exchange rate to be used when the transaction is completed in the future.


o FOREIGN CURRENCY QUOTATIONS• Forward Rates

By contracting now to buy or sell foreign currencies at some future date, businesses can lock in the cost of foreign exchange at the beginning of the transaction and do not have to worry about the risk of an unfavourable movement in the exchange rate in the future.The difference between the forward rate and the spot rate is called the forward premium or forward discount.


o Suppose the spot rate today on the British pound is $2.0172/£, while the three-month forward rate is $2.0113/£.

Forward rate-Spot rate 360Forward premium= 100 (21.2)

Spot rate n (discount)

$2.0113/£-$2.0172/£ 360Forward premium = 100

$2.0172/£ 90 = -1.17%


o FOREIGN CURRENCY QUOTATIONS• Hedging a Currency Transaction

Means to engage in a financial transaction to reduce risk.Companies can use forward transactions to lock in (hedge) the cost of foreign exchange.Sometimes forward contracts may prevent the firm from receiving the benefits of a change in exchange rates. However, speculation is not a logical and legitimate nonfinancial businesses that import or export goods or services.

International Capital Budgeting

o When a multinational firm wants to consider overseas capital projects, the financial manager faces the decision of which capital projects should be accepted on a company-wide basis.

o The decision to accept international projects with a positive npv increases the value of the firm and is consistent with the fundamental goal of financial management, which is to maximize stockholder wealth.


o Although the same basic principles apply to both international and domestic capital budgeting, firms must deal with some differences.


o DETERMINING CASH FLOWS• A number of issues complicate the

determination of cash flows from overseas capital projects.

• First, most companies find it more difficult to estimate the incremental cash flows for foreign projects.

• Second, problems with cash flows can arise when foreign governments restrict the amount of cash that can be repatriated, or returned, to the parent company.


o EXCHANGE RATE RISK• Financial managers have to deal with

foreign exchange rate risk on international capital investments.

• To convert the project’s future cash flows into another currency, we need to come up with projected or forecast exchange rates.

• One of the problems with obtaining currency rate forecasts for use in analysis of capital projects is that many projects have lives of 20 years or more.

International Capital Budgetingo COUNTRY RISK

• Financial managers must also incorporate a country risk premium when evaluating foreign business activities.

• If a firm is located in a country with a relatively unstable political environment, management will require a higher rate of return on capital projects as compensation for the additional risk.

• At the extreme, a local government could take over the plant and equipment of the overseas operation without giving the company any compensation. This expropriation of assets is called nationalization.


o COUNTRY RISK• Some other ways that a foreign

government can affect the risk of a foreign project include:

Change tax laws in a way that adversely impacts the firm.Impose laws related to labor, wages, and prices that are more restrictive than those applicable for domestic firms.Disallow any remittance of funds from the subsidiary to the parent firm for either a limited period of time or the duration of the project.Require that the subsidiary be headed by a local citizen or have a local firm as a major equity partner.Impose tariffs and quotas on any imports.


o COUNTRY RISK• Once management has gauged a

capital project’s country risk, that risk must be incorporated into the capital budgeting analysis by, for example, adjusting the firm’s discount rate for the additional risk.

Exhibit 21.6: Composite Country Risk Ratings for Selected Countries

Global Money and Capital Markets

o THE EMERGENCE OF THE EUROMARKETS• A Eurodollar is defined as a U.S.

dollar deposited in a bank outside the United States, primarily in Europe.

• The banks accepting these deposits are called Eurobanks.

• The Euromarkets are vast, largely unregulated money and capital markets with major financial centers in Tokyo, Hong Kong, and Singapore.


o THE EUROCURRENCY MARKET• Is the short-term portion of the

Euromarket.• A Eurocurrency is a timed deposit of money

held by corporations and governments in a bank located in a country different from the country that issued the currency.

• The most widely quoted Eurocurrency interest rate is the London Interbank Offer Rate, or LIBOR, which is the short-term interest rate that major banks in London charge one another.


o THE EUROCREDIT MARKET• The international banking system gathers

funds from businesses and governments in the Eurocurrency market and then allocates funds to banks that have the most profitable lending opportunities.

• These loans, which are short- to medium-term loans of a Eurocurrency to multinational corporations and governments of medium to high credit quality, are called Eurocredits.

• Is denominated in all major Eurocurrencies, although the dollar is the overwhelming favourite.


o INTERNATIONAL BOND MARKETS• Fall into two generic categories:

Foreign bondsEurobonds.


o INTERNATIONAL BOND MARKETS• Foreign Bonds

Are long-term debt sold by a foreign firm to investors in another country and denominated in that country’s currency.Firms sell foreign bonds when they need to finance projects in a particular foreign country.May have colorful nicknames.– Foreign bonds sold in the United States are called Yankee

bonds.– Yen-denominated bonds sold in Japanese financial markets by

non-Japanese firms are called Samurai bonds.


o INTERNATIONAL BOND MARKETS• Eurobonds

Are long-term debt instruments sold by firms to investors in countries other than the country in whose currency the bonds are denominated.Are bearer bonds and do not have to be registered.Multinational firms can use Eurobonds to finance international or domestic projects.Eurodollar and other Eurocurrency bonds have a number of characteristics that differ from similar U.S corporate bonds.


o INTERNATIONAL BOND MARKETS• Eurobonds

Eurobonds also pay interest annually.Historically almost all Eurocurrency bonds were sold without credit ratings.Today, more than half of the Eurodollar bonds sold in Europe have credit ratings.

International Banking

o European governments fostered the growth of large international banks in their countries and viewed them as engines of territorial and economic expansion.

o To accommodate their customers’ needs, large U.S. Banks established networks of foreign branches and affiliates.

o Exhibit 21.7 shows the 15 largest banks in the world in 2007, as ranked by Forbes in its list of the 2000 largest public companies in the world.

Exhibit 21.7: World’s Largest Banks


o RISKS INVOLVED IN INTERNATIONAL BANK LENDING• The principles of loan administration

and credit analysis are similar for domestic and overseas loans.

• There are differences, however, including some additional risk exposures for overseas lending.

• Credit risk is the same whether a loan is domestic or international. However, it may be more difficult to obtain or assess credit information abroad


o RISKS INVOLVED IN INTERNATIONAL BANK LENDING• Bank loans that have foreign-

exchange risk will carry an additional risk premium.

• If an international loan or investment is expected to suffer some loss in value, the loan will carry an additional risk premium.


o EUROCREDIT BANK LOANS• Are short-to medium-term loans of a

Eurocurrency to multinational corporations or governments.

• Can have a high degree of credit risk and may be too large for a single bank to handle.

• The lending banks often form a syndicate to spread the risk.


o EUROCREDIT BANK LOANS• The loan rate is equal to a base rate,

such as LIBOR, which represents the bank’s cost of funds, plus a markup.

• Eurocredits typically are floating-rate loans structured as “rollovers”.

• The general equation for Eurocredit pricing is expressed in the following equation:

k = BR + DRP + FXR + CR + GPMAR (21.3)

fundamentals of corporate finance, 2/e

Documents

multinational business

foreign exchange rate

foreign countries

foreign exchange markets

revenue introduction

forward rate

spot rate

financial system