20 Chapter International Financial Management Slides Developed by: Terry Fegarty Seneca College.

2020Chapt

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Chapt

er International Financial Management

International Financial Management

Slides Developed by:

Terry FegartySeneca College

© 2006 by Nelson, a division of Thomson Canada Limited 2

Chapter 20 – Outline (1)

• Growth in International Business Multinational Corporations International Business is Different

• Currency Exchange The Foreign Exchange Market Exchange Rates Changing Exchange Rates and Exchange Rate Risk Spot and Forward Rates Hedging with Forward Exchange Rates Supply and Demand—The Source of Exchange Rate

Movement



Why the Exchange Rate Moves Government Influence on Exchange Rates International Monetary System Convertibility

• Managing International Working Capital International Trade Credit Foreign Bank Loans Global Cash Management International Money Market Investments Foreign Receivables



• International Capital Markets The International Bond Market The International Stock Market

• Foreign Direct Investments Why Make a Foreign Direct Investment? (FDI) Analyzing a Proposed FDI Political Risk Foreign Exchange Risks


Growth in International Business

• Canada does more business with other countries than ever before Top 10 in exports and imports Canada/US trade is largest

• Nature of our international business has changed Now includes licensing and franchising, foreign joint

ventures, foreign affiliates

• Financial markets are increasingly international Common to own foreign stocks and bonds (portfolio

investments)


Multinational Corporations

• Many Canadian companies are now multi-national corporations (MNCs) May set up or buy a foreign affiliate to produce

goods in another country Wholly owned subsidiary—MNC owns 100% of

foreign affiliate Together with partners, may set up a foreign joint

venture

• Foreign affiliates and joint ventures are foreign direct investments


Methods of Doing International Business

Growth in International Business

Licensing, Franchising Arrangements

Joint Ventures

Foreign Affiliates

Import

Export

Open a Foreign Branch


International Business is Different

• Differences in political systems, economic systems, legal systems, language, culture, economic development, local practices

• Government intervention• Foreign exchange risks


Currency Exchange

• Companies operate and expect to be paid in currency of country in which they’re located Anyone wanting to buy from firm in another country

has to acquire some of that country’s currency For example, if a Canadian importer wants to buy

from an American supplier, it has to pay the bill in U.S. dollars. May have to exchange some Canadian dollars for U.S. dollars (Canadian importer buys U.S. dollars with Canadian dollars)


The Foreign Exchange Market

• Canadian company would purchase U.S. dollars in foreign exchange market Network of brokers and banks based in

financial centres around world

• Canadian banks participate in market and provide exchange services to clients


Exchange Rates

• An exchange rate states the price of one currency in terms of another

• Direct quote—number of Canadian dollars required to buy one unit of foreign currency

• Indirect quote—how many units of foreign currency it takes to buy one Canadian dollar

• The direct and indirect quotes are reciprocals of one another


Exchange Rates

Currency CodeC$/

1 Unit

Units/

1 C$

Swiss Franc CHF 1.0042 0.9958

U.S. Dollar USD 1.3237 0.7555

Euro EUR 1.5518 0.6444

British Pound GBP 2.2130 0.4519

Japanese Yen JPY 0.01215 82.28

Exchange rates on Oct 13, 2003

Represents an indirect quote—the inverse of a direct quote—how many units $1 Cdn. will buy.

Represents a direct quote—how many Cdn. dollars are required to buy one unit of foreign

currency. Q: If a Canadian company owed 35,000 U.S. dollars, how much

would this cost in Canadian dollars?

A: 35,000 USD 1.3237 = $46,330

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Exchange Rates

• Cross Rates It is possible to develop an exchange rate between

any two currencies without going through Canadian dollarsHow many U.K. pounds will 1 U.S. dollar buy?

• $1CAD = 0.4519 pounds• $1CAD = 0.7555 USD• 1 pound = (0.4519 / 0.7555=)0.5981 USD• 1 U.S. dollar will buy about 0.6 pounds

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Changing Exchange Rates and Exchange Rate Risk• Exchange rates are constantly changing

Sometimes rapidly and significantly

• Fluctuating exchange rates give rise to exchange rate risk

• Exchange rate risk is chance of gain or loss from exchange rate movements that occur during a transaction


Changing Exchange Rates and Exchange Rate Risk• The change in exchange rates affects

profitability of firm For a Canadian importer

• If foreign currency strengthens/Cdn $ weakens—$1 Cdn. will buy fewer units of foreign currency and profitability will decrease and vice versa


Changing Exchange Rates and Exchange Rate Risk—Example

Q: A Canadian company orders 500 sweaters from a French company at a cost of 35,000 euros with terms of n/60. The exchange rate on the order date $1.6521 CAD per euro. Calculate the gain or loss on the transaction if the bill was not paid for 60 days, when the exchange rate was $1.95 CAD per euro.

A: If the bill had been paid on the order date at the then current exchange rate, the cost would have been (35,000 euros 1.6521 =) $57,824. However, if the bill was not paid for 60 days at the then current exchange rate, the price would have been (35,000 euros 1.95 =) $68,250.

Thus, an $10,426 loss would have resulted due to the large shift in exchange rates over the two months.

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Spot and Forward Rates

• The spot rate is exchange rate for immediate (on-the-spot) delivery of currency

• The forward rate is price for currencies to be delivered in the future Major currencies have well-developed

forward markets (1, 3 and 6 months forward)


Spot and Forward Rates

• Spot rates are a bit different from forward rates This difference reflects the movement that banks

expect in the future relationship of the currencies

• When foreign currency is expected to become less (more) valuable in future, the forward currency said to be selling at a discount (premium)

• Terminology of Exchange Rate Movements When a currency becomes more (less) valuable in

terms of dollars, it is becoming stronger (weaker), or rising (falling) against the dollar


Hedging with Forward Exchange Rates• Exchange rate risk can be eliminated by

hedging with a forward contract• If company knows it will need a foreign

currency in the future it can lock in an exchange rate Eliminates the uncertainty as to the price that will be

paid for the currency

• Can be done by buying the currency at the forward rate


Hedging with Forward Exchange Rates

An importer has a US $100,000 payable coming due in 30 days. To reduce exchange rate risk, the importer can buy the US dollars forward today for delivery in 30 days time, at a price agreed upon today

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Supply and Demand—The Source of Exchange Rate Movement• An exchange rate is just the price of a particular

currency• The price of that currency will fluctuate with

supply & demand, like any other commodity• What determines the supply and demand for

exchange rates? Primarily stems from trade and the flow of

investment capital between nations• For example, a strong Canadian dollar means the demand

for Chinese goods in Canada will rise (because Chinese goods will become cheaper in Canadian dollars)

• Imports from China to Canada will rise


Why the Exchange Rate Moves

• Trade and investment flows are sensitive to: Economic factors, for example:

• Demand for our principal resources• Canadian interest rates relative to those of other advanced

economies• Expansion or recession• Speculation

Political factors, for example• Canadian government policies• Direct government intervention• Political turmoil


Government Influence on Exchange Rates• Governments occasionally intervene to

keep rates within reasonable limits Bank of Canada buys/sells their Canadian

dollars in foreign exchange market to slow decline/advance of Canadian dollar• In concert with U.S. and other G7 central banks• Often occurs during periods of great speculation• Ability to support a weakening currency is limited

because government has to pay for purchases of its own money with limited resources of gold or foreign currencies


Government Influence on Exchange Rates

As alternative to buying dollars, Bank of Canada may raise interest rates to attract foreign short-term investments•Must buy Cdn. $ when investing in Canada•Increases demand for Cdn.$


International Monetary System

• Floating exchange rate system Exchange rates are allowed to fluctuate

based on demand/supply in the free market• Little government intervention

Used for the major (“hard”) currencies • Including British pound sterling, the European

euro, the Japanese yen, the Canadian dollar, and the U.S. dollar



• Pegged exchange rate system Some of the non-major currencies of the world are

on a fixed or pegged exchange rate system (example: China)

Try to maintain a fixed (or semi-fixed) relationship with respect to the U.S. dollar, one of the other major currencies, a combination of major currencies, or some type of international foreign exchange standard

• Governments set the rates and attempt to maintain them against market pressures by buying and selling in the foreign exchange market



• Pegged exchange rate system• Sometimes impossible to keep pegged

exchange rates constant. Country might officially raise the value of its

currency relative to the U.S. dollar ( a revaluation) or, more likely, lower its value (a devaluation). • China has recently revalued• Several countries, including Mexico, have

devalued in the last decade due to financial and monetary crises


Convertibility

• Not all currencies are convertible to other currencies Inconvertible currency has restrictions on

trading currency in foreign exchange markets• For example, Russian ruble

• For example, some currencies you can buy at official exchange rate, but can not sell at that rate

• Inconvertibility is impediment to international trade


International Trade Credit

• Canadian importer with accounts payable denominated in a foreign currency is exposed to risk that Canadian dollar will depreciate against foreign currency Hedge by buying currency in forward

market


International Trade Credit

• Foreign supplier may ask Canadian importer for a letter of credit. Written by bank of (Canadian) importer to foreign supplier, stating that Canadian bank guarantees payment of supplier’s invoice if all underlying agreements are met To reduce exporter’s credit risk, and to expedite payment

• Letters of credit not used for imports from U.S., from affiliated companies, or from foreign suppliers well acquainted with Canadian exporter In these cases, some form of “open account” arrangement (for

example, net 30 days) is common


Foreign Bank Loans

• Multinational corporations (MNCs) often finance their operations, at least in part, in foreign financial markets

• MNC may borrow foreign currency either directly or through foreign subsidiary. MNC uses foreign currency in its foreign operations or converts it to Canadian dollars for use at home. For example, a Canadian company operating a

subsidiary in the United Kingdom may borrow pounds sterling at a British bank to acquire inventory in the U.K.

There is foreign exchange risk with such loans


Foreign Bank Loans

• Eurocurrency loans— large short-term loans denominated in one or more major foreign currencies often the U.S. dollar (eurodollar loans) or the euro. If a British subsidiary borrowed U.S dollars in U.K.,

would constitute a eurodollar loan.• Usually unsecured, made in multiples of $1

million, and for terms of one year or less • Allow MNCs to arrange large loans quickly,

confidentially, and at attractive interest rates• Also available in Canadian dollars in foreign

capital markets


Global Cash Management

• Global cash management in the MNC complicated by: Foreign tax systems Foreign government restrictions on outflow of funds,

for example exchange controls• Mechanisms to repatriate funds include dividends,

management fees, royalties, and repayment of loans and interest.

High rates of inflation and volatile exchange rates in foreign countries

• Parent presumably will want to move cash back to Canada, or to other low inflation, stable currency locations

If funds are left overseas, MNC may hedge net exchange exposure by currency through forward contracts or other mechanisms


International Money Market Investments• MNC can make short-term and safe foreign currency

deposits at attractive interest rates • Large companies may make eurocurrency deposits—

large sums of $ 1 million or more, converted to a foreign currency (often the U.S. dollar) For example, if Canadian company deposited Canadian dollars

in U.K. bank, would create a eurodollar deposit

• Bank swapped deposits—foreign currency deposits in Canadian or foreign banks Earn a better return than Canadian dollar deposits. To protect against a rise in the Canadian dollar, the deposits

are hedged using forward or future contracts.


Foreign Receivables

• Payments often received in foreign currency, particularly in U.S. dollars. To reduce foreign exchange risk, Canadian exporter may hedge receivables by selling currency in forward market

• To eliminate credit risk, Canadian exporter may ask foreign customer for letter of credit from customer’s bank

• Canadian exporter may accelerate receipt of cash by discounting guaranteed receivable at its own bank, or with a factor


Foreign Receivables

• For sales not guaranteed by letter of credit, exporter may check potential customer’s credit with international credit agencies such as D&B Canada

• Credit insurance for non-payment of receivables due to credit problems available (at a price) from Export Development Corporation of Canada (EDC)

• EDC also provides financing to foreign customers to purchase equipment and other capital goods from Canadian companies


International Capital Markets

• Many individuals and businesses invest in countries other than their own Foreign direct investments—in facilities Portfolio investments—in foreign stocks and

bonds

• Require flow of capital funds among nations Financing from international bond market,

international stock market


The International Bond Market

• Companies can borrow internationally by selling bonds outside their own country Called international bonds Usually denominated in hard currency: U.S.

dollar, euro, pound sterling, yen Allow access to foreign capital markets

• Greater availability of funds, lower financing costs

Exchange risk when denominated in foreign currency



• International bond can be denominated in The currency of the country in which it is sold

(foreign bond)• Example, Honda sells Canadian dollar bonds in

Canada

The currency of the issuing company’s home country (eurobond)• Example, Toyota sells bonds denominated in yen

in Canada

A third currency



• Eurobonds Most eurobonds are denominated in U.S.

dollars or euros Securities regulations require lower levels of

disclosure—lowers issuing costs Eurobonds are issued in bearer form—owner

is not identified Most governments don’t withhold income

taxes on eurobond interest


The International Stock Market

• Means for Canadian multinationals to raise equity capital abroad

• Major centres for international share issues include the London, New York, Tokyo, Zurich and Frankfurt stock markets.

• Many large Canadian multinational corporations have listed their shares on multiple stock exchanges


The International Stock Market

• Why issue shares abroad? Greater availability of capital and/or lower flotation

costs in world markets • Toronto’s equity markets represent less than 2% of the

world’s equity markets by capitalized value

Foreign government regulations on minimum levels of local ownership

To increase loyalty of foreign employees towards firm

To improve global image of the corporation Growing desire of investors to diversify their

investment portfolios internationally


Why Make a Foreign Direct Investment? (FDI)• Rate of return often higher than return on domestic

investments. • Foreign investments may offer lower labour or other costs of

production, lower tax rates, or special foreign government incentives.

• Strategic reasons. Most Canadian FDI is in the U.S. To locate production close to large regional U.S. markets Political stability, access to advanced technology, and

continued economic growth in U.S.

• Many companies have set up operations in Europe to avoid European Union (EU) import tariffs on Canadian exports

• Reduce risks by diversifying internationally


Analyzing a Proposed FDI

• Special case of capital budgeting• Consider:

Costs of initial investment Expected cash flows from the investment Possible risks


Analyzing a Proposed FDI

• In forecasting future cash flows, consider: Foreign government incentives to invest Double taxation—foreign taxes and Canadian taxes

on income earned in foreign country Foreign government restrictions on repatriating

foreign income Exchange rate forecasts for converting cash flow

estimates to Canadian dollars

• Consider unique risks to FDI Political risks, foreign exchange risks Increase discount rate for calculating NPV


Political Risk

• Political risk—chance that foreign government will expropriate property or will impose rules and regulations that will impair operations

• Examples include: Raising taxes Limiting amount of profit that can be withdrawn from country Requiring key inputs to be purchased from local suppliers at

arbitrary prices Limiting prices charged for product sold within the country Require part ownership by citizens of the host country

• Terrorist activities, including kidnapping key executives, also included in political risk

• Risk smaller in industrialized countries


Political Risk

• To minimize political risk: Before investing in a country, investigate its

political stability, and its government’s rules, regulations, and incentives regulating incoming foreign direct investment

Establish joint venture with local interests Buy political risk insurance from Export

Development Corporation (EDC) Diversify operations among countries


Foreign Exchange Risks

• Include Transaction Risk, Economic Risk, Translation Risk

• Transaction Risk—Potential for change in value of foreign-currency denominated transaction before transaction is finalized Not unique to MNCs with FDI Transaction gains and losses are realized in

cash as they happen



• Economic Risk—potential long-run impact of exchange rate fluctuations on value of foreign affiliate In particular, potential long-run losses to

affiliate (and its parent) from a steady decline in the local exchange rate• In capital budgeting terms, dollar value of future

cash inflows can be dramatically reduced if local currency depreciates against dollar



• Translation Risk—potential gain or loss that arises from translating financial statements of foreign subsidiary into Canadian dollars for consolidation with Canadian parent’s financial statements If local currency has weakened recently

against dollar, translating statements at new rate gives lower dollar value for foreign subsidiary. Translation loss is reported in consolidated statements

Accounting losses, not realized losses

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20 Chapter International Financial Management Slides Developed by: Terry Fegarty Seneca College.

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