Multinational Corporate Finance by ocak

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									6/13/2004

Chapter 17. Tool Kit for Multinational Corporate Finance
At the beginning of this textbook, we stated that one of the driving forces in financial management today is globalization. This chapter explores the unique challenges of a multinational corporation (one that operates in an integrated fashion in a number of countries. In theory, the concepts and procedures introduced in the first 16 chapters of this text apply equally for both domestic and multinational operations. However, there are six major factors that distinguish a global corporation from a firm operating entirely within one nation. First, multinational corporations must deal with different currency denominations. For this reason, a thorough exchange rate analysis is essential for any financial analysis. Second, the firm must be aware of the economic and legal ramifications of their actions in all of the countries that they operate in. Third, language barriers often exist, which make effective communication a challenge. Fourth, cultural differences present possible complications when dealing with employees, risk, and defining goals. Fifth, multinational firms must make decisions that account for political and other non-economic factors, which result from the role of governments. Lastly, the firm must be concerned with the political risk of the countries it deals in. This chapter will address the manner in which multinational corporations try to cope with these challenges. EXCHANGE RATES An exchange rate specifies the number of units of a given currency that can be purchased with another currency. In the United States, we are generally accustomed to looking at exchange rates as the rate of a foreign currency relative to the U.S. dollar. Some examples of exchange rates can be seen below. Table 17-1 Exchange rates of select major currencies, relative to the U.S. dollar Direct Quotations (1) 0.7401 0.0090 0.0876 0.8070 1.8401 1.2290 Indirect Quotations (2) 1.3512 111.0371 11.4181 1.2392 0.5434 0.8137 Note: The pound and euro are quoted as direct quotations (column 1). Their indirect quotations (column 2) are found by taking the inverse of the direct quotations. All other currency are quoted as indirect quotations (column 2). Their direct quotations (column 1) are found by taking the inverse of their indirect quotations.

Canadian dollar Japanese yen Mexican peso Swiss franc British pound Euro

Source: The Wall Street Journal , online.wsj.com; quotes for June 4, 2004. Notice, that the exchange rates were quoted in two ways (direct and indirect). A direct quotation tells you how many U.S. dollars can be purchased per one unit of the foreign currency. The indirect quotation tells you how many units of foreign currency can be purchased per one U.S. dollar. Column 1 and column 2 are inverses, subject to rounding.

Notice, that the exchange rates were quoted in two ways (direct and indirect). A direct quotation tells you how many U.S. dollars can be purchased per one unit of the foreign currency. The indirect quotation tells you how many units of foreign currency can be purchased per one U.S. dollar. Column 1 and column 2 are inverses, subject to rounding. Currency exchange is relatively simple in this context of relating all foreign currencies to the U.S. dollar. Calculating the currency conversion is a relatively simple mathematical operation. However, multinational corporations often operate in multiple countries, which causes them to collect revenues and incur expenses in several different currencies. In such situations, where the flow of money may spread across several borders, firms will want to know the values of foreign currencies relative to each other. This introduces the idea of cross rates. CROSS RATES A cross rate allows you to express the value of one country's currency relative to a currency other than the U.S. dollar. For example, it allows you to express euros per pound, or yen per Swiss franc.

PROBLEM Suppose an American tourist will be vacationing for a couple weeks in Europe. She will be flying from New York to London, from London to Paris, from Paris to Geneva and then back to New York. For the purposes of this problem, assume that exchange rates will be constant, and that the rates she observes will be the rates given in the table above. Upon arriving in London, she will be converting all $3,000 of her spending money and converting it to British pounds. While in London, she spends all but 1000 British pounds. She then continues on her vacation to France. Naturally, she needs to obtain some of the local currency in order to make purchases. For that reason, she exchanges all of her remaining British pounds for euros. She spends all but 800 euros in Paris, travels to Geneva Switzerland and converts her remaining money to Swiss francs. Before ending her vacation she goes to Canada where she converts the remaining 500 Swiss francs to Canadian dollars. Upon arriving in New York, she tenders her remaining Canadian dollars in exchange for U.S.dollars. Chronicle the currency exchanges made in this scenario, and determine how many dollars she has at the end of her vacation. Starting dollars = Value in pounds Value in pounds Value in pounds $3,000 = = = Value in $ $3,000 1,630.35 1,000 / / Direct quotation of dollars per pounds 1.8401

Pounds remaining after London =

Now, she travels to Paris where she exchanges pounds for euros. Value in euros Value in euros Value in euros = = = Value (pounds) 1000 1,497.20 800 x x Crossrate of euros per pound 1.4972

Euros remaining after Paris =

Next, she goes to Geneva and must convert her euros to Swiss Francs. Value in SFr. Value in SFr. Value in SFr. = = = Value (euros) 800 1,218.40 x x Crossrate of SFr. per euro 1.5230

Swiss francs remaining after Geneva =

500

Next, she goes to Montreal and must convert her Swiss Francs to Canadian dollars. Value in Can. $ Value in Can. $ Value in Can. $ = = = Value (S francs) 500 545.20 x x Crossrate of Canadian dollar per SFr. 1.0904

Now, that she is back home in New York, she will convert all of her foreign currency back to U.S. dollars.

Canadian dollars remaining after Montreal = Value in U.S. dollars Value in U.S. dollars Value in U.S. dollars = = = Value (Fr.) 100 $74.01

100 / / Indirect quotation for Canadian dollars 1.3512

In this example, we made a couple of incorrect assumptions for the sake of simplicity. First, we assumed that currency exchange rates remain constant over time. Obviously, this is incorrect. We made this assumption because our intention with the exercise is to familiarize you with using exchange and cross rates. If we allowed time to evolve and rates to change, you can see how complicated this example could have become. Realistically, financial managers must address these kind of timing issues, but for now do not worry about it too much. In addition, we assumed that there were no transaction costs involved in currency exchange. In a retail situation, the store you are at will usually charge some sort of fixed or variable fee. Depending on the magnitude of the purchase, this fee may or may not be substantial.

CROSS RATE TABLES A cross rate allows you to express the value of one country's currency relative to a currency other than the U.S. dollar. Calculating cross rates does, however, involve using the U.S. dollar exchange rates of those currencies. For instance, to calculate the cross rate between euros and British pounds, we will use their direct quotations, since these currencies are quoted in direct quotations. Mathematically speaking, we want to construct a ratio that has euros in the numerator and British pounds in the denominator. Such a mathematical expression will tell us the cross rate for euros and pounds. Cross rate of euros per pound =

(

euros

/British pounds)

Once we have established what we are looking for, we can now determine how to get there. As mentioned in the text, most exchange rates are stated indirectly (except for the British pound and euro). For this reason, it will be easier to generate this construction using indirect quotations. If we take the indirect quotation of euros per dollar and divide it by the indirect quotation of British pounds per dollar, we will see: Cross rate of euros per pound = ($ / British pounds) / ($ / euro) = 1.4972 euros per pound

Below, we have a table of currency cross rates calculated from the direct quotations of British pounds and euros and the indirect quotations of all other currencies (since this is how the currencies are quoted in the financial markets). This table is read as the cross rate of the currency in the row of the left hand column relative to the currency designated by the appropriate column heading. The numbers in this table may differ slightly from those in published sources due to rounding. Table 17-2 Key Currency Cross-Exchange Rates

Dollar
Canada Japan Mexico Switzerland United Kingdom 1.3512 111.0371 11.4181 1.2392 0.5434

Euro
1.6606 136.4646 14.0328 1.5230 0.6679

Pound
2.4863 204.3194 21.0104 2.2803 ....

SFranc
1.0904 89.6039 9.2141 .... 0.4385 0.6566 0.8070

Peso
0.1183 9.7247 .... 0.1085 0.0476 0.0713 0.0876

Yen
0.0122 .... 0.1028 0.0112 0.0049 0.0073 0.0090

CdnDlr
.... 82.1767 8.4503 0.9171 0.4022 0.6022 0.7401

Euro 0.8137 .... 1.4972 United States .... 1.2290 1.8401 Source: Derived from Table 17-1; quotes for June 4, 2004.

TRADING IN FOREIGN EXCHANGE The exchange rates shown earlier are called spot rates, which means the rate paid for deliver of the currency "on the spot". In foreign currency trading, it is also possible to purchase currency at a predetermined price at some future date (30 days, 90 days, or 180 days). Forward rates for currencies is analogous to purchasing forward contracts on commodities. Essentially, they allow investors or firms to lock in a specified exchange rate for the currency, and it serves as a method of hedging exchange rate risk. If an individual can obtain more of the foreign currency in the forward market than can be obtained in the spot market, that currency is said to be selling at a discount. Likewise, if an investor can obtain more of a foreign currency in the spot market than the forward market, the currency is said to be selling at a premium. Below are some examples of spot forward rates for selected major currencies.

The exchange rates shown earlier are called spot rates, which means the rate paid for deliver of the currency "on the spot". In foreign currency trading, it is also possible to purchase currency at a predetermined price at some future date (30 days, 90 days, or 180 days). Forward rates for currencies is analogous to purchasing forward contracts on commodities. Essentially, they allow investors or firms to lock in a specified exchange rate for the currency, and it serves as a method of hedging exchange rate risk. If an individual can obtain more of the foreign currency in the forward market than can be obtained in the spot market, that currency is said to be selling at a discount. Likewise, if an investor can obtain more of a foreign currency in the spot market than the forward market, the currency is said to be selling at a premium. Below are some examples of spot forward rates for selected major currencies. Table 17-3: Selected spot and forward rates (indirect quotations) Forward Rates Spot Rate 30 days 90 days 180 days Britain (Pound) 0.5434 0.5449 0.5479 0.5521 Canada (Dollar) 1.3512 1.3523 1.3537 1.3554 Japan (Yen) 111.0371 110.9262 110.6317 110.0837 Switzerland (Franc) 1.2392 1.2382 1.2359 1.2318 Source: The Wall Street Journal , online.wsj.com; quotes for June 4, 2004. INTEREST RATE PARITY Market forces determine whether a currency sells at a forward premium or discount, and the relationship between spot and forward exchange rates is summarized in the concept called interest rate parity. Interest rate parity holds that investors should expect to earn the same return in all countries after adjusting for risk, and it recognizes that foreign investments are subject to two major forces, return on investment and changes in the exchange rate. Interest rate parity is expressed as follows: f t / e0 = (1+r h) / (1+r f) In this equation, f t is the forward exchange rate in the t-period, e0 is the spot exchange rate, r h and r f are the periodic interest rates in the home and foreign countries, respectively. Forward rate at a premium/discount Discount Discount Premium Premium

PROBLEM Suppose a U.S. investor buys a default-free 180-day Swiss bond that promises a 4 percent nominal return, denominated in Swiss francs. The indirect spot exchange rate and the 180-day direct forward rate are based on Table 17-3 as shown above. Data: foreign nominal interest rate 4% time to maturity on securities (in years) 0.5 rf, foreign periodic interest rate 2% 1. Convert $1,000 to Swiss francs at spot rate: Value in Swiss francs = U.S. dollars Value in Swiss francs = $1,000 Value in Swiss francs = 1,239.20 2. Invest in the Swiss bond Value in six months = Value in six months = Value in six months =

x x

Spot Indirect Exchange Rate (Swiss francs/dollar) 1.2392

Amount 1,239.20 1,263.98

x x

(1+Rate) 102%

3. Convert back to dollars at forward rate: Value in dollars = Swiss francs / Value in dollars = 1,263.98 / Value in dollars = $1,026.12 4. Find rate of return: Periodic return = Value Periodic return = $1,026.12 Periodic return = 2.612% Annual return = 5.22%

Forward Direct Forward Rate 1.2318

/ /

$1,000 $1,000

-

1 1

Using the Interest Rate Parity Equation e0, spot exchange rate (direct quotation) ft, forward exchange rate (direct quotation)

0.80697 0.81182

Semiannual

f t / e0 1.00601014 1.02613034 2.6130%

= = = =

(1+r h) 1+rh 1+rh rh

÷ ÷

(1+r f) 1.02

Annual

5.23%

=

rh

PURCHASING POWER PARITY Having discussed the relationship between spot and future rates, we now turn to the determinants of exchange rate levels in countries. Exchange rates are impacted by a multitude of factors, many of which are difficult to predict. However, market forces work to ensure that similar goods sell for similar prices in different countries, adjusted for exchange rates. This relationship is called purchasing power parity (also called the law of one price), and it implies that exchange rate levels adjust so that identical goods cost the same real amount in different countries. Purchasing power parity is illustrated by the following equation. Ph e0 = --OR-= ( P f ) ( e0 ) Ph / P f

For instance, suppose a pair of tennis shoes costs $150 in the United States, and 150 pounds in Britain. This would imply that the exchange rate would be $1.50 per pound. Consumers could purchase the shoes in Britain for 100 pounds, or exchange their 100 pounds for $150 and purchase the same shoes in the United States, at the same effective cost. PROBLEM Suppose a certain microwave oven is selling for $110 in the United States today. What price should this same microwave oven be selling for in Europe, if purchasing power parity holds? Use Table 17-1. Price in the US Euro/$ exchange rate = = Ph $110 135.18 $110 0.81370 = = = (Pf) (Pf) (Pf) x x ( e0 ) 0.81370

Price in euros

CAPITAL BUDGETING ANALYSIS A U.S. company is considering a three-year investment in Great Britain. The initial cost and expected future cash flows are shown below. The appropriate cost of capital for a project with this risk is also shown below. The U.S. and U.K. government bond rates and the current spot exchange rate are also shown below. Intital cost in million of pounds = Year 1 CF in pounds = Year 2 CF in pounds = Year 3 CF in pounds = £20 £7 £9 £11

U.S. project cost of capital = Current exchange rate = 1-Year U.S. bond interest rate = 2-Year U.S. bond interest rate = 3-Year U.S. bond interest rate = 1-Year U.K. bond interest rate = 2-Year U.K. bond interest rate = 3-Year U.K. bond interest rate =

10.0% 1.8000 $/pound 2.0% 2.8% 3.5% 4.6% 5.0% 5.2%

Use the interest rate parity relationship to estimate the future expected exchange rates: ft = e0 [(1+r h) / (1+r f)] Expected Spot rate forward rate ($/pounds) ($/pounds) 1.8000 1.7553 1.8000 1.7623 1.8000 1.7709

Maturity (in years) 1 2 3

rh 2.0% 2.8% 3.5%

rf 4.6% 5.0% 5.2%

Table 17-5: Net Present Value of International Investment (cash flows in millions) Year 0 1 2 3 Cash flows in pounds -£20 £7 £9 £11 Expected exchange rates 1.8000 1.7553 1.7623 1.7709 Cash flows in dollars -$36.00 $12.29 $15.86 $19.48 Project cost of capital = NPV =

10% $2.92


								
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