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CHAPTER 21
International Financial Management
Chapter 6 – Multiple Cash Flows
1
Copyright 2008 John Wiley & Sons
Introduction to International
Finance Management
Globalization of the World Economy
 Globalization refers to the removal of barriers to free
trade and the closer integration of national
economies.
 Consumers in many countries buy goods that are
purchased from a number of countries other than
just their own.
Chapter 6 – Multiple Cash Flows
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Copyright 2008 John Wiley & Sons
Introduction to International
Finance Management
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.
Chapter 6 – Multiple Cash Flows
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Copyright 2008 John Wiley & Sons
Introduction to International
Finance Management
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.
Chapter 6 – Multiple Cash Flows
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Copyright 2008 John Wiley & Sons
Introduction to International
Finance 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.
Chapter 6 – Multiple Cash Flows
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Copyright 2008 John Wiley & Sons
Introduction to International
Finance 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.
Chapter 6 – Multiple Cash Flows
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Copyright 2008 John Wiley & Sons
Foreign Exchange Markets
 The foreign exchange market is a group of
international markets connected electronically where
currencies are bought and sold in wholesale
amounts.
Chapter 6 – Multiple Cash Flows
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Copyright 2008 John Wiley & Sons
Foreign Exchange Markets
These markets provide three basic economic benefits.
1. A mechanism to transfer purchasing power from
individuals who deal in one currency to people who
deal in a different currency.
2. A way for corporations to pass the risk associated with
foreign exchange price fluctuations to professional risktakers.
3. A channel for importers and exporters to acquire credit
for international business transactions.
Chapter 6 – Multiple Cash Flows
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Copyright 2008 John Wiley & Sons
Foreign Exchange Rates and the
Equilibrium Exchange Rate
 A foreign exchange rate is the price of one monetary
unit.
 One of two parties in a transaction will be forced to
deal in a foreign currency and incur foreign
exchange rate risk.
 Exhibit 21.4 shows the equilibrium exchange rate,
which is at the point where the supply and demand
curves intersect.
Chapter 6 – Multiple Cash Flows
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Copyright 2008 John Wiley & Sons
Exhibit 21.4: The Equilibrium
Exchange Rate
Foreign Exchange Rates and the
Equilibrium Exchange Rate
 Equilibrium occurs at the price at which the quantity of
the currency demanded exactly equals the quantity
supplied.
 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.
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Copyright 2008 John Wiley & Sons
Exhibit 21.5: Spot Foreign Exchange
Rates and Cross Rates
Foreign Currency 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.
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Copyright 2008 John Wiley & Sons
Foreign Currency Quotations
Ask rate - Bid rate
Bid  ask spread =
Ask rate
(21.1)
 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
 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.
Chapter 6 – Multiple Cash Flows
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Copyright 2008 John Wiley & Sons
Foreign Currency Quotations
 The forward rate is the rate 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.
Chapter 6 – Multiple Cash Flows
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Copyright 2008 John Wiley & Sons
Foreign Currency Quotations
 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 unfavorable 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.
Chapter 6 – Multiple Cash Flows
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Copyright 2008 John Wiley & Sons
Foreign Currency Quotations
Forward rate-Spot rate 360
Forward premium=

 100 (21.2)
Spot
rate
n
(discount)
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%
Chapter 6 – Multiple Cash Flows
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Copyright 2008 John Wiley & Sons
Hedging a Currency Transaction
 In finance, to hedge 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 function of businesses that import and
export goods and services.
Chapter 6 – Multiple Cash Flows
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Copyright 2008 John Wiley & Sons
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.
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Copyright 2008 John Wiley & Sons
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.
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Copyright 2008 John Wiley & Sons
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.
Chapter 6 – Multiple Cash Flows
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Copyright 2008 John Wiley & Sons
Global Money and Capital Markets
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.
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Copyright 2008 John Wiley & Sons
Global Money and Capital Markets
The Eurocurrency Market
 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.
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Copyright 2008 John Wiley & Sons
Global Money and Capital Markets
International Bond Markets
 International bonds fall into two generic categories:
foreign bonds and Eurobonds.
 Foreign bonds are long-term debt sold by a foreign firm
to investors in another country and denominated in that
country’s currency.
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Copyright 2008 John Wiley & Sons
Global Money and Capital Markets
 Firms sell foreign bonds when they need to finance
projects in a particular foreign country.
 Eurobonds are long-term debt instruments sold by
firms to investors in countries other than the country in
whose currency the bonds are denominated.
 Multinational firms can use Eurobonds to finance
international or domestic projects.
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Copyright 2008 John Wiley & Sons
Global Money and Capital Markets
 Eurodollar and other Eurocurrency bonds have a
number of characteristics that differ from similar U.S
corporate bonds.
 Eurobonds are bearer bonds and do not have to be
registered.
 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.
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Copyright 2008 John Wiley & Sons
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.
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Copyright 2008 John Wiley & Sons
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.
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Copyright 2008 John Wiley & Sons
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
Chapter 6 – Multiple Cash Flows
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(21.3)
Copyright 2008 John Wiley & Sons
Eurocredit Bank Loans
 Suppose Citibank is considering making a Eurocredit
loan to a Mexican manufacturer. The loan will be
structured as a six-month floating-rate loan. The bank’s
credit department believes the credit risk premium is 3
percent, the country risk for Mexico is an additional 1
percent, and the bank’s gross profit is 0.125 percent.
The bank can buy the funds in the Euromarket: the sixmonth LIBOR rate is 1.75 percent. The Eurocredit
pricing for this loan is:
k = 1.75% + 3.00% + 1.00% + 0.125% = 5.875%
Chapter 6 – Multiple Cash Flows
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Copyright 2008 John Wiley & Sons
Forward premium: Bank of America quoted the 180day forward rate on the Swiss franc at $0.7902. The
spot rate was quoted at $0.7737/SF. What is the
annualized forward premium or discount on the Swiss
franc?
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Forward premium or (discount) =
[(Forward rate - Spot rate) / Spot rate] x [360 / n] x 100
= [(0.7902 - 0.7737) / 0.7737] x [360 / 180]
= 4.27%
The Swiss franc is at a 4.27 percent forward premium
against the dollar.
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