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This chapter explains short term liability management of MNCs, a part of multinational management that is often neglected in other textbooks. From this chapter, students should learn that correct financing decisions can reduce the firm’s costs. While foreign financing costs cannot usually be perfectly forecasted, firms should evaluate the probability of reducing costs through foreign financing.
Lecture 24 Short-Term Financing Chapter Objectives To explain why MNCs consider foreign financing; To explain how MNCs determine whether to use foreign financing; and To illustrate the possible benefits of financing with a portfolio of currencies 20 - Sources of Short-Term Financing • Euronotes are unsecured debt securities with typical maturities of 1, or months They are underwritten by commercial banks • MNCs may also issue Euro-commercial papers to obtain short-term financing • MNCs utilize direct Eurobank loans to maintain a relationship with Eurobanks too 20 - Internal Financing by MNCs • Before an MNC’s parent or subsidiary searches for outside funding, it should determine if any internal funds are available • Parents of MNCs may also raise funds by increasing their markups on the supplies that they send to their subsidiaries 20 - Why MNCs Consider Foreign Financing • An MNC may finance in a foreign currency to offset a net receivables position in that foreign currency • An MNC may also consider borrowing foreign currencies when the interest rates on such currencies are attractive, so as to reduce financing costs 20 - Short-Term Interest Rates as of February 2004 20 - Determining the Effective Financing Rate The actual cost of financing depends on the interest rate on the loan, and the movement in the value of the borrowed currency over the life of the loan 20 - Determining the Effective Financing Rate At time t year later Borrows NZ$1,000,000 at 8.00% for year Has to pay back NZ$1,080,000 Exchange rate = $0.50/NZ$ Exchange rate = $0.60/NZ$ Converts to $500,000 What is the effective financing rate? $648k – $500k = 29.6% ! $500k Converts to $648,000 20 - Determining the Effective Financing Rate • The effective financing rate, rf , can be written as: rf = (1 + if )(1 + ef ) – where if = the foreign currency interest rate ef = the % in the foreign currency’s spot rate = St+1 – S S 20 - 20 - 10 Criteria Considered for Foreign Financing • There are various criteria an MNC must consider in its financing decision, including Ô interest rate parity, Ô the forward rate as a forecast, and Ô exchange rate forecasts 20 - 11 Criteria Considered for Foreign Financing Interest Rate Parity (IRP) • If IRP holds, foreign financing with a simultaneous hedge of that position in the forward market will result in financing costs that are similar to those for domestic financing 20 - 12 20 - 13 Implications of IRP for Financing 20 - 14 20 - 15 Criteria Considered for Foreign Financing The Forward Rate as a Forecast • If the forward rate is an unbiased predictor of the future spot rate, then the effective financing rate of a foreign loan will on average be equal to the domestic financing rate 20 - 16 Criteria Considered for Foreign Financing Exchange Rate Forecasts • Firms may use exchange rate forecasts to forecast the effective financing rate of a foreign currency, or they may compute the break-even exchange rate that will equate the domestic and foreign financing rates • Sometimes, it may be useful to develop probability distributions, instead of relying on single point estimates 20 - 17 • Source: Adopted from SouthWestern/Thomson Learning © 2006 20 - 18 ... financing costs that are similar to those for domestic financing 20 - 12 20 - 13 Implications of IRP for Financing 20 - 14 20 - 15 Criteria Considered for Foreign Financing The Forward Rate as... on such currencies are attractive, so as to reduce financing costs 20 - Short-Term Interest Rates as of February 2004 20 - Determining the Effective Financing Rate The actual cost of financing... 20 - Sources of Short-Term Financing • Euronotes are unsecured debt securities with typical maturities of 1, or months They are underwritten by commercial banks • MNCs may also issue Euro-commercial