Download Fundamentals of Corporate Finance

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 Management
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 International
Financial 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.
Introduction to International
Financial Management
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.
Introduction to International
Financial Management
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
Introduction to International
Financial Management
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.
Introduction to International
Financial Management
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.
Introduction to International
Financial Management
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.
Introduction to International
Financial Management
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.
Introduction to International
Financial Management
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.
Introduction to International
Financial Management
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 privatesector firms fully embrace the Western standard of
stockholder value maximization.
Introduction to International
Financial Management
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.
Introduction to International
Financial Management
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.
Foreign Exchange Markets
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.
Foreign Exchange Markets
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
Foreign Exchange 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.
Foreign Exchange Markets
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
Foreign Exchange Markets
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.
Foreign Exchange Markets
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.
Foreign Exchange Markets
o FOREIGN CURRENCY QUOTATIONS
• Exhibit 21.5 shows selected exchange rate
quotations from the Wall Street Journal.
• The Spot Rate
Is 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
Foreign Exchange Markets
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
Ask rate - Bid rate
Bid  ask spread =
Ask rate
(21.1)
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:
1.4423 - 1.4337
Bid  ask spread =
= 0.596%
1.4423
Foreign Exchange Markets
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.
Foreign Exchange Markets
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.
Foreign Exchange Markets
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.
Foreign Exchange Markets
Forward premium=
(discount)
Forward rate-Spot rate 360

 100 (21.2)
Spot rate
n
o Suppose the spot rate today on the British
pound is $2.0172/£, while the three-month
forward rate is $2.0113/£.
$2.0113/£-$2.0172/£ 360
Forward premium =

 100
$2.0172/£
90
= -1.17%
Foreign Exchange Markets
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.
International Capital Budgeting
o Although the same basic principles apply to
both international and domestic capital
budgeting, firms must deal with some
differences.
International Capital Budgeting
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.
International Capital Budgeting
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 Budgeting
o 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.
International Capital Budgeting
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.
International Capital Budgeting
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.
Global Money and Capital Markets
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.
Global Money and Capital Markets
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.
Global Money and Capital Markets
o INTERNATIONAL BOND MARKETS
• Fall into two generic categories:
Foreign bonds
Eurobonds.
Global Money and Capital Markets
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.
Global Money and Capital Markets
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.
Global Money and Capital Markets
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
International Banking
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
International Banking
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.
International Banking
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.
International Banking
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)