CHAPTER 17 Multinational Financial

Management

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 Intrinsic Value in a Global Context
Currency
Regulatory exchange Culture
systems rates

Free cash flow

(FCF)

FCF1 FCF2 FCF∞

Value = + + ···+
(1 + WACC)1 (1 + WACC)2 (1 + WACC)∞

Weighted average
cost of capital
(WACC)

Cost of debt
Global financial markets Political risk
Cost of equity
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WHAT IS A
MULTINATIONAL
CORPORATION?
A multinational corporation is one that operates in two or more
countries.
At one time, most multinationals produced and sold in just a few
countries.
Today, many multinationals have world-wide production and sales.

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WHY DO FIRMS EXPAND
INTO
OTHER COUNTRIES?
To seek new markets.
To seek new supplies of raw materials.
To gain new technologies.
To gain production efficiencies.
To avoid political and regulatory obstacles.
To reduce risk by diversification.

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MAJOR FACTORS DISTINGUISHING
MULTINATIONAL FROM DOMESTIC
FINANCIAL MANAGEMENT
Currency differences
Economic and legal differences
Language differences
Cultural differences
Government roles
Political risk

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CONSIDER THE FOLLOWING
EXCHANGE RATES:
U.S. $ to buy 1 Unit
Euro 1.- US$ 1.2500
Swedish Krona 1.- US$ 0.1481

Are these currency prices direct or indirect quotations?

Since they are prices of foreign currencies expressed in U.S. dollars,
they are direct quotations (dollars per currency).

WHAT IS AN INDIRECT
QUOTATION?
An indirect quotation gives the amount of a foreign currency required
to buy one U.S. dollar (currency per dollar).
Note than an indirect quotation is the reciprocal of a direct quotation.
Euros and British pounds are normally quoted as direct quotations.
All other currencies are quoted as indirect.
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CALCULATE THE INDIRECT
QUOTATIONS FOR EUROS AND
KRONOR.
Euro: 1 / 1.2500 = 0.8000
Krona: 1 / 0.1481 = 6.7522
Indirect Quotes: # of
Direct Quote: U.S. $ Units of Foreign
per foreign currency Currency per U.S. $
Euro 1.2500 0.8000
Swedish krona 0.1481 6.7522

WHAT IS A CROSS RATE?

A cross rate is the exchange rate between any two currencies not
involving U.S. dollars.
In practice, cross rates are usually calculated from direct or indirect
rates. That is, on the basis of U.S. dollar exchange rates.
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CALCULATE THE TWO
CROSS RATES
BETWEEN EUROS AND
KRONOR.
Cross Rate = Kronor × Dollars
Dollar Euros
= 6.7522 x 1.2500
= 8.3334 Kronor/Euro

EUROS/KRONA CROSS RATE

Euros/Krona cross rate is reciprocal of the Kronor/Euro
cross rate:
Euros/Krona cross rate = 1/(8.3334) = 0.1185

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EXAMPLE OF
INTERNATIONAL
TRANSACTIONS
Assume a firm can produce a liter of orange juice in the
U.S. and ship it to Spain for $1.75. If the firm wants a
50% markup on the product, what should the juice sell for
in Spain?

Target price = ($1.75)(1.50)=$2.625

Spanish price = ($2.625)(0.8000 euros/$)
= € 2.10.

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EXAMPLE (CONTINUED)
Now the firm begins producing the orange juice
in Spain. The product costs 2.0 euros to produce
and ship to Sweden, where it can be sold for 20
kronor. What is the dollar profit on the sale?
2.0 euros (8.4403 kronor/euro) = 16.88 kronor.
20 – 16.88 = 3.12 kronor profit.
Dollar profit = 3.12 kronor(0.1481 $ per krona)
= $0.46.

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WHAT IS EXCHANGE RATE
RISK?
Exchange rate risk is the risk that the value of a cash flow in one currency
translated from another currency will decline due to a change in exchange
rates.
CURRENCY APPRECIATION AND
DEPRECIATION
Suppose the exchange rate goes from 6.7522 kronor per dollar to 8 kronor
per dollar.
A dollar now buys more kronor, so the dollar is appreciating, or
strengthening.
The krona is depreciating, or weakening.

AFFECT OF DOLLAR
APPRECIATION
Suppose the profit in kronor remains unchanged at 3.12 kronor, but
the dollar appreciates, so the exchange rate is now 10 kronor/dollar.
Dollar profit = 3.12 kronor / (10 kronor per dollar) = $0.312.
Strengthening dollar hurts profits from international sales.
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THE INTERNATIONAL
MONETARY SYSTEM FROM
1946-1971
Prior to 1971, a fixed exchange rate system was in effect.
The U.S. dollar was tied to gold.
Other currencies were tied to the dollar at fixed exchange
rates.
Central banks intervened by purchasing and selling
currency to even out demand so that the fixed exchange
rates were maintained.
Occasionally the official exchange rate for a country
would be changed.
Economic difficulties from maintaining fixed exchange
rates led to its end.
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THE CURRENT
INTERNATIONAL
MONETARY SYSTEM
The current system for most industrialized nations is a floating rate
system where exchange rates fluctuate due to changes in demand.
Currency demand is due primarily to:
Trade deficit or surplus
Capital movements to capture higher interest rates

THE EUROPEAN
MONETARY UNION
In 2002, the full implementation of the “euro” was completed (those
still holding former currencies have 10 years to exchange them at a
bank). The European Central Bank now controls the monetary policy
of the EMU countries using the euro.

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THE EUROPEAN MONETARY
UNION MEMBERS THAT USE
THE EURO
Austria France Italy Portugal
Belgium Germany Luxembourg Slovenia
Cyprus Greece Malta Spain
Finland Ireland Netherlands Slovakia*
*Joined in 2009.

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PEGGED EXCHANGE RATES
Many countries still used a fixed exchange rate that is
“pegged,” or fixed, with respect to another currency.
Examples of pegged currencies:
Chinese yuan, about 6.82 yuan/dollar (Spring 2009)
Chad uses CFA franc, pegged to French franc which is pegged to euro.
WHAT IS A CONVERTIBLE
CURRENCY?
A currency is convertible when the issuing country
promises to redeem the currency at current market rates.
Convertible currencies are freely traded in world currency
markets.
Residents and nonresidents are allowed to freely convert
the currency into other currencies at market rates.
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PROBLEMS DUE TO
NONCONVERTIBLE
CURRENCY
It becomes very difficult for multi-national companies to conduct business
because there is no easy way to take profits out of the country.
Often, firms will barter for goods to export to their home countries.

EXAMPLES OF
NONCONVERTIBLE
CURRENCIES
Chinese yuan
Venezuelan bolivar
Uzbekistan sum
Vietnamese dong

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WHAT IS THE DIFFERENCE
BETWEEN SPOT RATES
AND FORWARD RATES?
A spot rate is the rate applied to buy currency for immediate
delivery.
A forward rate is the rate applied to buy currency at some
agreed-upon future date.
Forward rates are normally reported as indirect quotations.

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WHEN IS FORWARD RATE AT A
PREMIUM TO SPOT RATE?
If the U.S. dollar buys fewer units of a foreign currency in the forward
than in the spot market, the foreign currency is selling at a premium.
For example, suppose the spot rate is 0.5 £/$ and the forward rate is 0.4
£/$.
The dollar is expected to depreciate, because it will buy fewer pounds.
SPOT RATE = 0.5 £/$ | FORWARD RATE =
0.4 £/$. is expected to appreciate, since it will buy more dollars in
The pound
the future.
So the forward rate for the pound is at a premium.

WHEN IS THE FORWARD RATE AT A

DISCOUNT TO THE SPOT RATE?
If the U.S. dollar buys more units of a foreign currency in the forward than
in the spot market, the foreign currency is selling at a discount (depreciate).
The primary determinant of the spot/forward rate relationship is the
relationship between domestic and foreign interest rates. 18
WHAT IS INTEREST RATE
PARITY?
Interest rate parity implies that investors should expect to
earn the same return on similar-risk securities in all
countries:
Forward rate 1 + rh
= 1+r
Spot rate f

Forward and spot rates are direct quotations.

rh = periodic interest rate in the home country.
rf = periodic interest rate in the foreign country.

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INTEREST RATE PARITY
EXAMPLE
Assume 1 euro = $1.27 in the 180-day forward market and and
180-day risk-free rate is 6% in the U.S. and 4% in Spain.
Does interest rate parity hold?
Spot rate = $1.25.
rh = 6%/2 = 3%.
rf = 4%/2 = 2%.
Forward rate 1 + rh
Spot rate = 1 + rf

Forward rate 1.03

1.25 = 1.02
Forward rate = 1.2623.
If interest rate parity holds, the the observed forward rate,
1.2700 would equal implied forward rate.
But, here the forward date is 1.2623; so parity doesn’t hold.
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WHICH 180-DAY SECURITY
(U.S. OR SPANISH) OFFERS
THE HIGHER RETURN?
A U.S. investor could directly invest in the U.S.
security and earn an annualized rate of 6%.
Alternatively, the U.S. investor could convert
dollars to euros, invest in the Spanish security,
and then convert profit back into dollars. If the
return on this strategy is higher than 6%, then the
Spanish security has the higher rate.

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WHAT IS THE RETURN TO A U.S.
INVESTOR IN THE SPANISH
SECURITY?
Buy $1,000 worth of euros in the spot market:
$1,000(0.80 euros/$) = 800 euros.
Spanish investment return (in euros):
800(1.02)= 816 euros.
Buy contract today to exchange 816 euros in 180 days at forward rate of
1.2700 dollars/euro.
At end of 180 days, convert euro investment to dollars:
€816 (1.2700 $/€) = $1,036.32.
Calculate the rate of return:
$36.32/$1,000 = 3.632% per 180 days
= 7.26% per year.
The Spanish security has highest return, even with lower interest rate.
U.S. rate is 6%, so Spanish securities at 7.26% offer a higher rate of return
to U.S. investors.
But could such a situation exist for very long?

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ARBITRAGE
Traders could borrow at the U.S. rate, convert to euros at
the spot rate, and simultaneously lock in the forward rate
and invest in Spanish securities.
This would produce arbitrage: a positive cash flow, with
no risk and none of the traders own money invested.
Impact of Arbitrage Activities:
Traders would recognize the arbitrage opportunity and make huge
investments.
Their actions would tend to move interest rates, forward rates, and
spot rates to parity.

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WHAT IS PURCHASING
POWER PARITY?
Purchasing power parity implies that the level of exchange rates adjusts so
that identical goods cost the same amount in different countries.
Ph = Pf(Spot rate),
or
Spot rate = Ph/Pf.
U.S. grapefruit juice is $2.00/liter. If purchasing power parity holds, what is
price in Spain?

Spot rate = Ph/Pf.

$1.2500= $2.00/Pf
Pf = $2.00/$1.2500
= 1.6 euros.

Do interest rate and purchasing power parity hold exactly at any point in
time?

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IMPACT OF RELATIVE
INFLATION ON INTEREST RATES
AND EXCHANGE RATES
Lower inflation leads to lower interest rates, so borrowing in
low-interest countries may appear attractive to multinational firms.
However, currencies in low-inflation countries tend to appreciate
against those in high-inflation rate countries, so the true interest cost
increases over the life of the loan.

DESCRIBE THE INTERNATIONAL

MONEY AND CAPITAL MARKETS.
Eurodollar markets
Dollars held outside the U.S.
Mostly Europe, but also elsewhere

International bonds
Foreign bonds: Sold by foreign borrower, but denominated in the currency of the
country of issue.
Eurobonds: Sold in country other than the one in whose currency it is denominated.
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TO WHAT EXTENT DO CAPITAL
STRUCTURES VARY ACROSS
DIFFERENT COUNTRIES?
Early studies suggested that average capital structures varied widely among the
large industrial countries.
However, a recent study, which controlled for differences in accounting
practices, suggests that capital structures are more similar across different
countries than previously thought.

MULTINATIONAL CAPITAL
BUDGETING DECISIONS
Foreign operations are taxed locally, and then funds repatriated may be
subject to U.S. taxes.
Foreign projects are subject to political risk.
Funds repatriated must be converted to U.S. dollars, so exchange rate risk
must be taken into account.

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FOREIGN PROJECT ANALYSIS
Project future expected cash flows, denominated in foreign currency
Use the interest rate parity relationship to convert the future expected
foreign cash flows into dollars.
Discount the dollar denominated cash flows at the risk-adjusted cost
of capital for similar U.S. projects.

CAPITAL BUDGETING EXAMPLE

U.S. company invests in project in Japan.
Expected future cash flows:
CF0 = - ¥1,000 million.
CF1 = ¥500 million.
CF2 = ¥800 million.

Risk-adjusted cost of capital for a similar U.S. project = 10%.

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INTEREST RATE AND
EXCHANGE RATE DATA
Current spot exchange rate = 110 ¥/$.
U.S. government bond rates:
1-year bond = 2.0%
2-year bond = 2.8%
Japan government bond rates:
1-year bond = 0.05%
2-year bond = 0.26%
MULTI-YEAR INTEREST RATE
PARITY RELATIONSHIP
Expected future
exchange rate 1 + rh t

Spot rate =
1 + rf

Exchanged rates are direct quotations.

rh = annual interest rate in the home country.
rf = annual interest rate in the foreign country.
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EXPECTED FUTURE
EXCHANGE
Direct spot rate = (1/110 ¥/$) = 0.009091 $/¥.
Expected exchange rate in 1 year:
= (Spot rate)[(1+rh)/(1+rf)]1
= (0.009091)(1+0.02)/(1+0.0005)
= 0.009268

Expected exchange rate in 2 years:

= (spot rate)[(1+rh)/(1+rf)]2
= (0.009091)[(1+0.028)/(1+0.0026)]2
= 0.009557

0 1 2
Cash flows in yen -¥1,000 ¥500 ¥800
Expected
0.009091 0.009268 0.009557
exchange rates
Cash flows in
-$9.09 $4.63 $7.65
dollars

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PROJECT NPV
$4.63 $7.65
NPV = -$9.09 + +
(1 + 0.10) (1 + 0.10)2
NPV = $1.44 million.
INTERNATIONAL CASH
MANAGEMENT
Distances are greater.
Access to more markets for loans and for temporary investments.
Cash is often denominated in different currencies.
MULTINATIONAL CREDIT
MANAGEMENT
Credit is more important, because commerce to lesser-developed
countries often relies on credit.
Credit for future payment may be subject to exchange rate risk.
Many companies buy export credit risk insurance when granting
credit to foreign customers.
MULTINATIONAL INVENTORY
MANAGEMENT
Inventory decisions can be more complex, especially when inventory can
be stored in locations in different countries.
Some factors to consider are shipping times, carrying costs, taxes, import
duties, and exchange rates. 30