Corporate finance 7e ross ch31

31-1 CHAPTER 31 International Corporate Finance McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 31-2 Chapter Outline 31.1 Terminology 31.2 Foreign Exchange Markets and Exchange Rates 31.3 The Law of One Price and Purchasing Power Parity 31.4 Interest Rates and Exchange Rates: Interest Rate Parity 31.5 International Capital Budgeting 31.6 International Financial Decisions 31.7 Reporting Foreign Operations 31.8 Summary and Conclusions McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 31-3 31.1 Terminology American Depository Receipt (ADR): a security issued in the U.S to represent shares of a foreign stock Cross rate: the exchange rate between two foreign currencies, e.g the exchange rate between £ and ¥ Euro (€): the single currency of the European Monetary Union which was adopted by 11 Member States on January 1999 These member states are: Belgium, Germany, Spain, France, Ireland, Italy, Luxemburg, Finland, Austria, Portugal and the Netherlands Eurobonds: bonds denominated in a particular currency and issued simultaneously in the bond markets of several countries McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 31-4 31.1 Terminology Eurocurrency: money deposited in a financial center outside the home country Eurodollars are dollar deposits held outside the U.S.; Euroyen are yen denominated deposits held outside Japan Foreign bonds: bonds issued in another nation’s capital market by a foreign borrower Gilts: British and Irish government securities LIBOR: the London Interbank Offer Rate is the rate most international banks charge on another for loans of Eurodollars overnight in the London market McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 31-5 31.2 Foreign Exchange Markets and Exchange Rates Without a doubt the foreign exchange market is the world’s largest financial market In this market one country’s currency is traded for another’s Most of the trading takes place in a few currencies: U.S dollar ($) British pound sterling (£) Japanese yen (¥) Euro (€) German deutschemark (DM) French franc (FF) McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 31-6 FOREX Market Participants The FOREX market is a two-tiered market: Interbank Market (Wholesale) About 700 banks worldwide stand ready to make a market in Foreign exchange Nonbank dealers account for about 20% of the market There are FX brokers who match buy and sell orders but not carry inventory and FX specialists Client Market (Retail) Market participants include international banks, their customers, nonbank dealers, FOREX brokers, and central banks McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 31-7 Correspondent Banking Relationships Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the forex market International commercial banks communicate with one another with: SWIFT: The Society for Worldwide Interbank Financial Telecommunications CHIPS: Clearing House Interbank Payments System ECHO Exchange Clearing House Limited, the first global clearinghouse for settling interbank FOREX transactions McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 31-8 Spot Rate Quotations The spot market is the market for immediate delivery (Settlement is due within two days.) Direct quotation the U.S dollar equivalent e.g “a Japanese Yen is worth about a penny” Indirect Quotation the price of a U.S dollar in the foreign currency e.g “you get 100 yen to the dollar” McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 31-9 Spot FX trading In the interbank market, the standard size trade is about U.S $10 million A bank trading room is a noisy, active place The stakes are high The “long term” is about 10 minutes McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 10 Cross Rates Suppose that S DM(0) = 50 i.e $1 = DM in the spot market and that S¥(0) = 100 i.e $1 = ¥100 What must the DM/¥ cross rate be? DM  $ DM since , ¥ ¥ $ DM $1 DM DM     ¥ ¥100 $1 ¥50  SDM / ¥ (0) .02 or DM1 Ơ50 McGraw-Hill/Irwin Corporate Finance, 7/e â 2005 The McGraw-Hill Companies, Inc All Rights 36 Reasons for Deviations from IRP Transactions Costs The interest rate available to an arbitrageur for borrowing, ib,may exceed the rate he can lend at, il There may be bid-ask spreads to overcome, F b/S a < F/S Thus (Fb/Sa)(1 + i ¥l)  (1 + i ¥ b)  Capital Controls Governments sometimes restrict import and export of money through taxes or outright bans McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 37 Equilibrium Exchange Rate Relationships E(e) IFE i$ – i¥ FP PPP F–S S IRP FE FRPPP $ – £ McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 38 31.5 International Capital Budgeting A recipe for international decision makers: Estimate future cash flows in foreign currency Convert to U.S dollars at the predicted exchange rate Calculate APV using the U.S cost of capital McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 39 International Capital Budgeting: Example Consider this European investment opportunity: – 600€ 200€ year i$ = 15% € = 3% $ = 6% 500€ 300€ years years Is this a good investment from the perspective of the U.S shareholders? S (0) = $.55265 McGraw-Hill/Irwin € Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 40 International Capital Budgeting: Example $331.56 – 600€ 200€ year 500€ years 300€ years CF0 = (€600)× S€(0) =(€600)×($.5526/€) = $331.56 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 41 International Capital Budgeting: Example $331.56 – 600€ $113.70 200€ year 500€ years 300€ years CF1 = (€200)×E[S€(1)] E[S€(1)] can be found by appealing to the interest rate differential: E[S€(1)] = [(1.06/1.03) S€(0)] = [(1.06/1.03)($.5526/€) ] = $.5687/€ so CF1 = (€200)×($.5687/€) = $113.7 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 42 International Capital Budgeting: Example $331.56 – 600€ $113.70 $292.60 $180.70 200€ 500€ 300€ year years years Similarly, CF2 = [(1.06)2/(1.03)2 ]× S€(0) (€500) = $292.6 CF3 = [(1.06)3/(1.03)3 ]× S€(0) (€300) = $180.7 APV = –$331.56 + McGraw-Hill/Irwin Corporate Finance, 7/e $113.70 (1.15) + $292.60 (1.15)2 + $180.70 (1.15)3 = $107.30 © 2005 The McGraw-Hill Companies, Inc All Rights 43 Risk Adjustment in the Capital Budgeting Process Clearly risk and return are correlated Political risk may exist along side of business risk, necessitating an adjustment in the discount rate McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 44 31.6 International Financial Decisions An international firm can finance foreign projects in three basic ways: It can raise cash in the home country and export it to finance the foreign project It can raise cash by borrowing in the foreign country where the project is located It can borrow in a third country where the cost of debt is lowest McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 45 31.7 Reporting Foreign Operations When a U.S multinational experiences favorable exchange rate movements, should this be reflected in the measurement of income? This is a controversial area Two issues seem to arise: What is the appropriate exchange rate to use for translating each balance-sheet account? How should the unrealized accounting gains and losses from foreign-currency translation be handled? Currency is currently translated under complicated rules set out in FASB 52 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 46 The Mechanics of FASB Statement 52 Functional Currency The currency that the business is conducted in Reporting Currency The currency in which the MNC prepares its consolidated financial statements McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 47 The Mechanics of FASB Statement 52 Two-Stage Process First, determine in which currency the foreign entity keeps its books If the local currency in which the foreign entity keeps its books is not the functional currency, remeasurement into the functional currency is required Second, when the foreign entity’s functional currency is not the same as the parent’s currency, the foreign entity’s books are translated using the current rate method McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 48 Current Rate Method All balance sheet items (except for stockholder’s equity) are translated at the current exchange rate A “plug” equity account named cumulative translation adjustment (CTA) is used to make the balance sheet balance McGraw-Hill/Irwin Corporate Finance, 7/e Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Currency DM2,100 DM1,500 DM3,000 DM6,600 DM1,200 DM1,800 DM2,700 DM900 -DM6,600 Current Rate $1,050 $750 $1,500 $3,300 $600 $900 $900 $360 $540 $3,300 © 2005 The McGraw-Hill Companies, Inc All Rights 49 The Mechanics of FASB Statement 52 Parent’s currency Foreign entity’s books kept in? Nonparent Currency Functional Currency? Local currency Parent’s Currency Third currency Temporal Remeasurement Current Rate Translation Parent’s Currency McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 50 31.8 Summary and Conclusions This chapter describes some fundamental theories of international finance: Purchasing Power Parity Expectations theory of exchange rates The interest-rate parity theorem This chapter also describes some of the problems of international capital budgeting We briefly describe international financial markets McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights ... high The “long term” is about 10 minutes McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 10 Cross Rates Suppose that S DM(0) = 50 i.e $1 = DM in the spot... $1 = ¥100 What must the DM/¥ cross rate be? DM  $ DM since , ¥ ¥ $ DM $1 DM DM     ¥ ¥100 $1 ¥50  SDM / ¥ (0) .02 or DM1 Ơ50 McGraw-Hill/Irwin Corporate Finance, 7/e â 2005 The McGraw-Hill... banks posting these exchange rates First calculate the implied cross rates to see if an arbitrage exists McGraw-Hill/Irwin Corporate Finance, 7/e $ Barclays S¥(0) = 120 Credit Lyonnais S£(0) = 1.50