20

Chapte

International Financial Management

Slides Developed by:

Terry Fegarty Seneca College

Chapter 20 Outline (1)

Growth in International Business
Multinational Corporations International Business is Different

Currency Exchange
The Foreign Exchange Market Exchange Rates Changing Exchange Rates and Exchange Rate Risk Spot and Forward Rates Hedging with Forward Exchange Rates Supply and DemandThe Source of Exchange Rate Movement
2006 by Nelson, a division of Thomson Canada Limited

Chapter 20 Outline (2)

Why the Exchange Rate Moves Government Influence on Exchange Rates International Monetary System Convertibility International Trade Credit Foreign Bank Loans Global Cash Management International Money Market Investments Foreign Receivables
2006 by Nelson, a division of Thomson Canada Limited

Managing International Working Capital

Chapter 20 Outline (3)

International Capital Markets
The International Bond Market The International Stock Market

Foreign Direct Investments

Why Make a Foreign Direct Investment? (FDI) Analyzing a Proposed FDI Political Risk Foreign Exchange Risks

2006 by Nelson, a division of Thomson Canada Limited

Growth in International Business

Canada does more business with other countries than ever before
Top 10 in exports and imports Canada/US trade is largest

Nature of our international business has changed

Now includes licensing and franchising, foreign joint ventures, foreign affiliates

Financial markets are increasingly international

Common to own foreign stocks and bonds (portfolio investments)
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Multinational Corporations
Many Canadian companies are now multinational corporations (MNCs)
May set up or buy a foreign affiliate to produce goods in another country Wholly owned subsidiaryMNC owns 100% of foreign affiliate Together with partners, may set up a foreign joint venture

Foreign affiliates and joint ventures are foreign direct investments

2006 by Nelson, a division of Thomson Canada Limited

Growth in International Business

Methods of Doing International Business
Import
Export Open a Foreign Branch Licensing, Franchising Arrangements Joint Ventures Foreign Affiliates

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International Business is Different

Differences in political systems, economic systems, legal systems, language, culture, economic development, local practices Government intervention Foreign exchange risks

2006 by Nelson, a division of Thomson Canada Limited

Currency Exchange
Companies operate and expect to be paid in currency of country in which theyre located
Anyone wanting to buy from firm in another country has to acquire some of that countrys currency For example, if a Canadian importer wants to buy from an American supplier, it has to pay the bill in U.S. dollars. May have to exchange some Canadian dollars for U.S. dollars (Canadian importer buys U.S. dollars with Canadian dollars)

2006 by Nelson, a division of Thomson Canada Limited

The Foreign Exchange Market

Canadian company would purchase U.S. dollars in foreign exchange market
Network of brokers and banks based in financial centres around world

Canadian banks participate in market and provide exchange services to clients

2006 by Nelson, a division of Thomson Canada Limited

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Exchange Rates
An exchange rate states the price of one currency in terms of another Direct quotenumber of Canadian dollars required to buy one unit of foreign currency Indirect quotehow many units of foreign currency it takes to buy one Canadian dollar The direct and indirect quotes are reciprocals of one another
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Exchange Rates
Currency Swiss Franc U.S. Dollar Euro Code CHF USD EUR GBP C$/ 1 Unit 1.0042 1.3237 1.5518 2.2130 Units/ 1 C$ 0.9958 0.7555 0.6444 0.4519 Represents an indirect quotethe inverse of a direct quotehow many units $1 Cdn. will buy.

Example

British Pound

Japanese Yen

JPY

0.01215

82.28

Exchange rates on Oct 13, 2003

Represents a direct quotehow many Cdn. dollars are required to buy one unit of foreign currency.

Q: If a Canadian company owed 35,000 U.S. dollars, how would this cost in Canadian dollars? A: 35,000 USD 1.3237 = $46,330
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much

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Exchange Rates
Cross Rates
It is possible to develop an exchange rate between any two currencies without going through Canadian dollars How many U.K. pounds will 1 U.S. dollar buy?
$1CAD = 0.4519 pounds $1CAD = 0.7555 USD 1 pound = (0.4519 / 0.7555=)0.5981 USD 1 U.S. dollar will buy about 0.6 pounds Example

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Changing Exchange Rates and Exchange Rate Risk

Exchange rates are constantly changing
Sometimes rapidly and significantly

Fluctuating exchange rates give rise to exchange rate risk Exchange rate risk is chance of gain or loss from exchange rate movements that occur during a transaction

2006 by Nelson, a division of Thomson Canada Limited

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Changing Exchange Rates and Exchange Rate Risk

The change in exchange rates affects profitability of firm
For a Canadian importer
If foreign currency strengthens/Cdn $ weakens $1 Cdn. will buy fewer units of foreign currency and profitability will decrease and vice versa

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Changing Exchange Rates and Exchange Rate RiskExample

Q: A Canadian company orders 500 sweaters from a French company at a cost of 35,000 euros with terms of n/60. The exchange rate on the order date $1.6521 CAD per euro. Calculate the gain or loss on the transaction if the bill was not paid for 60 days, when the exchange rate was $1.95 CAD per euro. A: If the bill had been paid on the order date at the then current exchange rate, the cost would have been (35,000 euros 1.6521 =) $57,824. However, if the bill was not paid for 60 days at the then current exchange rate, the price would have been (35,000 euros 1.95 =) $68,250. Thus, an $10,426 loss would have resulted due to the large shift in exchange rates over the two months.
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Example

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Spot and Forward Rates

The spot rate is exchange rate for immediate (on-the-spot) delivery of currency The forward rate is price for currencies to be delivered in the future
Major currencies have well-developed forward markets (1, 3 and 6 months forward)

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Spot and Forward Rates

Spot rates are a bit different from forward rates
This difference reflects the movement that banks expect in the future relationship of the currencies

When foreign currency is expected to become less (more) valuable in future, the forward currency said to be selling at a discount (premium) Terminology of Exchange Rate Movements
When a currency becomes more (less) valuable in terms of dollars, it is becoming stronger (weaker), or rising (falling) against the dollar
2006 by Nelson, a division of Thomson Canada Limited

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Hedging with Forward Exchange Rates

Exchange rate risk can be eliminated by hedging with a forward contract If company knows it will need a foreign currency in the future it can lock in an exchange rate
Eliminates the uncertainty as to the price that will be paid for the currency

Can be done by buying the currency at the forward rate

2006 by Nelson, a division of Thomson Canada Limited

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Hedging with Forward Exchange Rates

An importer has a US $100,000 payable coming due in 30 days. To reduce exchange rate risk, the importer can buy the US dollars forward today for delivery in 30 days time, at a price agreed upon today
Example

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Supply and DemandThe Source of Exchange Rate Movement

An exchange rate is just the price of a particular currency The price of that currency will fluctuate with supply & demand, like any other commodity What determines the supply and demand for exchange rates?
Primarily stems from trade and the flow of investment capital between nations
For example, a strong Canadian dollar means the demand for Chinese goods in Canada will rise (because Chinese goods will become cheaper in Canadian dollars) Imports from China to Canada will rise
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2006 by Nelson, a division of Thomson Canada Limited

Why the Exchange Rate Moves

Trade and investment flows are sensitive to:
Economic factors, for example:
Demand for our principal resources Canadian interest rates relative to those of other advanced economies Expansion or recession Speculation

Political factors, for example

Canadian government policies Direct government intervention Political turmoil

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Government Influence on Exchange Rates

Governments occasionally intervene to keep rates within reasonable limits
Bank of Canada buys/sells their Canadian dollars in foreign exchange market to slow decline/advance of Canadian dollar
In concert with U.S. and other G7 central banks Often occurs during periods of great speculation Ability to support a weakening currency is limited because government has to pay for purchases of its own money with limited resources of gold or foreign currencies
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Government Influence on Exchange Rates

As alternative to buying dollars, Bank of Canada may raise interest rates to attract foreign short-term investments
Must buy Cdn. $ when investing in Canada Increases demand for Cdn.$

2006 by Nelson, a division of Thomson Canada Limited

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International Monetary System

Floating exchange rate system
Exchange rates are allowed to fluctuate based on demand/supply in the free market
Little government intervention

Used for the major (hard) currencies

Including British pound sterling, the European euro, the Japanese yen, the Canadian dollar, and the U.S. dollar

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International Monetary System

Pegged exchange rate system
Some of the non-major currencies of the world are on a fixed or pegged exchange rate system (example: China) Try to maintain a fixed (or semi-fixed) relationship with respect to the U.S. dollar, one of the other major currencies, a combination of major currencies, or some type of international foreign exchange standard

Governments set the rates and attempt to maintain them against market pressures by buying and selling in the foreign exchange market
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International Monetary System

Pegged exchange rate system Sometimes impossible to keep pegged exchange rates constant.
Country might officially raise the value of its currency relative to the U.S. dollar ( a revaluation) or, more likely, lower its value (a devaluation).
China has recently revalued Several countries, including Mexico, have devalued in the last decade due to financial and monetary crises
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Convertibility
Not all currencies are convertible to other currencies
Inconvertible currency has restrictions on trading currency in foreign exchange markets
For example, Russian ruble

For example, some currencies you can buy at official exchange rate, but can not sell at that rate Inconvertibility is impediment to international trade
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International Trade Credit

Canadian importer with accounts payable denominated in a foreign currency is exposed to risk that Canadian dollar will depreciate against foreign currency
Hedge by buying currency in forward market

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International Trade Credit

Foreign supplier may ask Canadian importer for a letter of credit. Written by bank of (Canadian) importer to foreign supplier, stating that Canadian bank guarantees payment of suppliers invoice if all underlying agreements are met Letters of credit not used for imports from U.S., from affiliated companies, or from foreign suppliers well acquainted with Canadian exporter
In these cases, some form of open account arrangement (for example, net 30 days) is common

To reduce exporters credit risk, and to expedite payment

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Foreign Bank Loans

Multinational corporations (MNCs) often finance their operations, at least in part, in foreign financial markets MNC may borrow foreign currency either directly or through foreign subsidiary. MNC uses foreign currency in its foreign operations or converts it to Canadian dollars for use at home.

For example, a Canadian company operating a subsidiary in the United Kingdom may borrow pounds sterling at a British bank to acquire inventory in the U.K. There is foreign exchange risk with such loans
2006 by Nelson, a division of Thomson Canada Limited

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Foreign Bank Loans

Eurocurrency loans large short-term loans denominated in one or more major foreign currencies

Usually unsecured, made in multiples of $1 million, and for terms of one year or less Allow MNCs to arrange large loans quickly, confidentially, and at attractive interest rates Also available in Canadian dollars in foreign capital markets
2006 by Nelson, a division of Thomson Canada Limited

often the U.S. dollar (eurodollar loans) or the euro. If a British subsidiary borrowed U.S dollars in U.K., would constitute a eurodollar loan.

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Global Cash Management

Global cash management in the MNC complicated by:
Foreign tax systems Foreign government restrictions on outflow of funds, for example exchange controls
Mechanisms to repatriate funds include dividends, management fees, royalties, and repayment of loans and interest.

High rates of inflation and volatile exchange rates in foreign countries If funds are left overseas, MNC may hedge net exchange exposure by currency through forward contracts or other mechanisms
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Parent presumably will want to move cash back to Canada, or to other low inflation, stable currency locations

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International Money Market Investments

MNC can make short-term and safe foreign currency deposits at attractive interest rates Large companies may make eurocurrency deposits large sums of $ 1 million or more, converted to a foreign currency (often the U.S. dollar)
For example, if Canadian company deposited Canadian dollars in U.K. bank, would create a eurodollar deposit

Bank swapped depositsforeign currency deposits in Canadian or foreign banks

Earn a better return than Canadian dollar deposits. To protect against a rise in the Canadian dollar, the deposits are hedged using forward or future contracts.
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Foreign Receivables
Payments often received in foreign currency, particularly in U.S. dollars. To reduce foreign exchange risk, Canadian exporter may hedge receivables by selling currency in forward market To eliminate credit risk, Canadian exporter may ask foreign customer for letter of credit from customers bank Canadian exporter may accelerate receipt of cash by discounting guaranteed receivable at its own bank, or with a factor
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Foreign Receivables
For sales not guaranteed by letter of credit, exporter may check potential customers credit with international credit agencies such as D&B Canada Credit insurance for non-payment of receivables due to credit problems available (at a price) from Export Development Corporation of Canada (EDC) EDC also provides financing to foreign customers to purchase equipment and other capital goods from Canadian companies
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International Capital Markets

Many individuals and businesses invest in countries other than their own
Foreign direct investmentsin facilities Portfolio investmentsin foreign stocks and bonds

Require flow of capital funds among nations

Financing from international bond market, international stock market
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The International Bond Market

Companies can borrow internationally by selling bonds outside their own country
Called international bonds Usually denominated in hard currency: U.S. dollar, euro, pound sterling, yen Allow access to foreign capital markets
Greater availability of funds, lower financing costs

Exchange risk when denominated in foreign currency

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The International Bond Market

International bond can be denominated in
The currency of the country in which it is sold (foreign bond)
Example, Honda sells Canadian dollar bonds in Canada

The currency of the issuing companys home country (eurobond)

Example, Toyota sells bonds denominated in yen in Canada

A third currency
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The International Bond Market

Eurobonds
Most eurobonds are denominated in U.S. dollars or euros Securities regulations require lower levels of disclosurelowers issuing costs Eurobonds are issued in bearer formowner is not identified Most governments dont withhold income taxes on eurobond interest

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The International Stock Market

Means for Canadian multinationals to raise equity capital abroad Major centres for international share issues include the London, New York, Tokyo, Zurich and Frankfurt stock markets. Many large Canadian multinational corporations have listed their shares on multiple stock exchanges
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The International Stock Market

Why issue shares abroad?
Greater availability of capital and/or lower flotation costs in world markets
Torontos equity markets represent less than 2% of the worlds equity markets by capitalized value

Foreign government regulations on minimum levels of local ownership To increase loyalty of foreign employees towards firm To improve global image of the corporation Growing desire of investors to diversify their investment portfolios internationally
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Why Make a Foreign Direct Investment? (FDI)

Rate of return often higher than return on domestic investments.
Foreign investments may offer lower labour or other costs of production, lower tax rates, or special foreign government incentives.

Strategic reasons. Most Canadian FDI is in the U.S.

To locate production close to large regional U.S. markets Political stability, access to advanced technology, and continued economic growth in U.S.

Many companies have set up operations in Europe to avoid European Union (EU) import tariffs on Canadian exports Reduce risks by diversifying internationally
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Analyzing a Proposed FDI

Special case of capital budgeting Consider:
Costs of initial investment Expected cash flows from the investment Possible risks

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Analyzing a Proposed FDI

In forecasting future cash flows, consider:
Foreign government incentives to invest Double taxationforeign taxes and Canadian taxes on income earned in foreign country Foreign government restrictions on repatriating foreign income Exchange rate forecasts for converting cash flow estimates to Canadian dollars

Consider unique risks to FDI

Political risks, foreign exchange risks Increase discount rate for calculating NPV
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Political Risk
Political riskchance that foreign government will expropriate property or will impose rules and regulations that will impair operations
Examples include:
Raising taxes Limiting amount of profit that can be withdrawn from country Requiring key inputs to be purchased from local suppliers at arbitrary prices Limiting prices charged for product sold within the country Require part ownership by citizens of the host country

Terrorist activities, including kidnapping key executives, also included in political risk Risk smaller in industrialized countries
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Political Risk
To minimize political risk:
Before investing in a country, investigate its political stability, and its governments rules, regulations, and incentives regulating incoming foreign direct investment Establish joint venture with local interests Buy political risk insurance from Export Development Corporation (EDC) Diversify operations among countries
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2006 by Nelson, a division of Thomson Canada Limited

Foreign Exchange Risks

Include Transaction Risk, Economic Risk, Translation Risk Transaction RiskPotential for change in value of foreign-currency denominated transaction before transaction is finalized
Not unique to MNCs with FDI Transaction gains and losses are realized in cash as they happen

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Foreign Exchange Risks

Economic Riskpotential long-run impact of exchange rate fluctuations on value of foreign affiliate
In particular, potential long-run losses to affiliate (and its parent) from a steady decline in the local exchange rate
In capital budgeting terms, dollar value of future cash inflows can be dramatically reduced if local currency depreciates against dollar

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Foreign Exchange Risks

Translation Riskpotential gain or loss that arises from translating financial statements of foreign subsidiary into Canadian dollars for consolidation with Canadian parents financial statements
If local currency has weakened recently against dollar, translating statements at new rate gives lower dollar value for foreign subsidiary. Translation loss is reported in consolidated statements Accounting losses, not realized losses
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