4-1 Chapter 24 International International Financial Financial Management Management © Pearson Education Limited 2004 Fundamentals of Financial Management, 12/e Created by: Gregory A Kuhlemeyer, Ph.D Carroll College, Waukesha, WI 4-2 After studying Chapter 24, you should be able to: Explain why many firms invest in foreign operations Explain why foreign investment is different from domestic investment Describe how capital budgeting, in an international environment, is similar or dissimilar to that in a domestic environment Understand the types of exchange-rate exposure and how to manage exchange-rate risk exposure Compute domestic equivalents of foreign currencies given the spot or forward exchange rates Understand and illustrate the purchasing-power parity (PPP) and interest rate parity Describe the specific instruments and documents used in structuring international trade transactions Distinguish among countertrade, export factoring, and forfaiting 4-3 International Financial Management Some Background Types of Exchange-Rate Risk Exposure Management of Exchange-Rate Risk Exposure Structuring International Trade Transactions 4-4 Some Background What is a company’s motivation to invest capital abroad? Fill product gaps in foreign markets where excess returns can be earned To produce products in foreign markets more efficiently than domestically To secure the necessary raw materials required for product production 4-5 International Capital Budgeting How does a firm make an international capital budgeting decision? Estimate expected cash flows in the foreign currency Compute their U.S.-dollar equivalents at the expected exchange rate Determine the NPV of the project using the U.S required rate of return, with the rate adjusted upward or downward for any risk premium effect associated with the foreign investment 4-6 International Capital Budgeting Only consider those cash flows that can be “repatriated” (returned) to the homecountry parent The exchange rate is the number of units of one currency that may be purchased with one unit of another currency For example, the current exchange rate might be 2.50 Freedonian marks per one U.S dollar 4-7 International Capital Budgeting Example International project details: A firm is considering an investment in Freedonia, and the initial cash outlay is 1.5 million marks The project has 4-year project life with cash flows given on the next slide The appropriate required return for repatriated U.S dollars is 18% 18% The appropriate expected exchange rates are given on the next slide 4-8 International Capital Budgeting Example End of Year Expected Cash Flow (marks) Exchange Rate (marks to U.S dollar) Expected Cash Flow (U.S dollars) -1,500,000 2.50 -600,000 -600,000 500,000 2.54 196,850 166,822 800,000 2.59 308,880 221,833 700,000 2.65 264,151 160,770 600,000 2.72 220,588 113,777 Net Present Value = Present Value of Cash Flows at 18% 63,202 4-9 International Capital Budgeting Related issues of concern: International diversification and risk reduction U.S Government taxation Taxable income derived from non-domestic operations through a branch or division is taxed under U.S code Foreign subsidiaries are taxed under foreign tax codes until dividends are received by the U.S parent from the foreign subsidiary 4-10 International Capital Budgeting Foreign Taxation Tax codes and policies differ from country to country, but all countries impose income taxes on foreign companies The U.S government provides a tax credit to companies to avoid the double taxation problem A credit is provided up to the amount of the foreign tax, but not to exceed the same proportion of taxable earnings from the foreign country Excess tax credits can be carried forward 4-31 Currency Market Hedges Currency Swaps In a currency swap two parties exchange debt obligations denominated in different currencies Each party agrees to pay the other’s interest obligation At maturity, principal amounts are exchanged, usually at a rate of exchange agreed to in advance The exchange is notional only the cash flow difference is paid Swaps are typically arranged through a financial intermediary, such as a commercial bank A variety of (complex) arrangements are available 4-32 Macro Factors Governing Exchange-Rate Behavior Purchasing-Power Parity (PPP) The idea that a basket of goods should sell for the same price in two countries, after exchange rates are taken into account For example, the price of wheat in Canadian and U.S markets should trade at the same price (after adjusting for the exchange rate) If the price of wheat is lower in Canada, then purchasers will buy wheat in Canada as long as the price is cheaper (after accounting for transportation costs) 4-33 Macro Factors Governing Exchange-Rate Behavior Purchasing-Power Parity (PPP continued) Thus, demand will fall in the U.S and increase in Canada to bring prices back into equilibrium The price elasticity of exports and imports influences the relationship between a country’s exchange rate and its purchasing-power parity Commodity items and products in mature industries are more likely to conform to PPP Frictions such as government intervention and trade barriers cause PPP not to hold Macro Factors Governing Exchange-Rate Behavior Interest-Rate Parity It suggests that if interest rates are higher in one country than they are in another, the former’s currency will sell at a discount in the forward market Remember that the Fisher effect implies that the nominal rate of interest equals the real rate of interest plus the expected rate of inflation The international Fisher effect suggests that differences in interest rates between two countries serve as a proxy for differences in expected inflation 4-34 4-35 Macro Factors Governing Exchange-Rate Behavior Interest-Rate Parity (continued) The international Fisher effect suggests: F S F= = + rforeign + rdollar current forward exchange-rate in foreign currency per dollar S= current spot exchange-rate in foreign currency per dollar rforeign = foreign interbank Euromarket interest rate rdollar = U.S interbank Euromarket interest rate 4-36 Interest-Rate Parity Example The current German 90-day interest rate is 4% The current U.S 90-day interest rate is 2% The current spot rate is 706 Freedonian marks per U.S dollar ($1.416 per mark) What is the implied 90-day forward rate? 4-37 Interest-Rate Parity Example The implied 90-day forward rate is: F 706 = + 04 + 02 F = (1.04) x (.706) 706 / (1.02) = 720 Thus, the implied 90-day forward rate is 720 marks per dollar dollar 4-38 Structuring International Trade Transactions In international trade, sellers often have difficulty obtaining thorough and accurate credit information on potential buyers Channels for legal settlement in cases of default are more complicated and costly to pursue Key documents are (1) an order to pay (international trade draft), (2) a bill of lading, and (3) a letter of credit 4-39 International Trade Draft The international trade draft (bill of exchange) is a written statement by the exporter ordering the importer to pay a specific amount of money at a specified time Sight draft is payable on presentation to the party (drawee) to whom the draft is addressed Time draft is payable at a specified future date after sight to the party (drawee) to whom the draft is addressed 4-40 Time Draft Features An unconditional order in writing signed by the drawer, the exporter It specifies an exact amount of money that the drawee, the importer, must pay It specifies the future date when this amount must be paid Upon presentation to the drawee, it is accepted accepted 4-41 Time Draft Features The acceptance can be by either the drawee or a bank bank If the drawee accepts the draft, it is acknowledged in writing on the back of the draft the obligation to pay the amount so many specified days hence It is then known as a trade draft (banker’s acceptance if a bank accepts the draft) 4-42 Bill of Lading Bill of Lading A shipping document indicating the details of the shipment and delivery of goods and their ownership It serves as a receipt from the transportation company to the exporter, showing that specified goods have been received It serves as a contract between the transportation company and the exporter to ship goods and deliver them to a specific party at a specific destination It serves as a document of title 4-43 Letter of Credit Letter of Credit - A promise from a third party (usually a bank) for payment in the event that certain conditions are met It is frequently used to guarantee payment of an obligation A letter of credit is issued by a bank on behalf of the importer The bank agrees to honor a draft drawn on the importer, provided the bill of lading and other details are in order The bank is essentially substituting its credit for that of the importer 4-44 Countertrade Countertrade Generic term for barter and other forms of trade that involve the international sale of goods or services that are paid for in whole or in part by the transfer of goods or services from a foreign country Used effectively when exchange restrictions exist or other difficulties prevent payment in hard currencies Quality, standardization of goods, and resale of goods that are delivered are risks that arise with countertrade 4-45 Forfaiting Forfaiting The selling “without recourse” of medium- to long-term export receivables to a financial institution, the forfaiter A third party, usually a bank or governmental unit, guarantees the financing The forfaiter assumes the credit risk and collects the amount owed from the importer Most useful when the importer is in a lessdeveloped country or in an Eastern European nation ... and documents used in structuring international trade transactions Distinguish among countertrade, export factoring, and forfaiting 4-3 International Financial Management Some Background... caused by a change in exchange rates 4-14 Management of ExchangeRate Risk Exposure Natural hedges Cash management Adjusting of intracompany accounts International financing hedges Currency... requirements of the multinational company 4-22 International Financing Hedges International Bond Financing A Eurobond is a bond issued internationally outside of the country in whose