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PRIMARY GOAL OF A FIRM

Risk Reduce

GLOBAL FINANCE:
Introduction

Maximize Firm Value

(Stock Price)

Increase Profit

FUNCTIONS OF FINANCIAL MANAGEMEN

TO MAXIMIZE STOCK PRICE

MAJOR INTERNATIONAL TRANSACTION

1. Foreign Investment: direct and portfolio
2. Foreign Trade: exports and imports
3. Foreign Loan

1. Financial Planning and Control: Supportive Tools and

Reporting & Controlling
2. Financing
3. Investment
Supportive
Tools
(Chs. 1-10)

Financing
(Chs. 11-14)

Investment
(Chs. 15-19)
Reporting &
Controlling
(Chs. 20)

REASONS TO STUDY INTERNATIONAL

FINANCE

COMPANY GOALS AND FUNCTIONS

FINANCIAL MANAGEMENT

1. To understand a global economy in terms of:

OF

1. To maximize stockholder wealth (stock price)

on a global basis.

a. Industrialization and growth of the developing world

b. Increased globalization.

2. Functions of international financial manager:

a. Financial planning and control
b. Allocation of funds (investment)
c. Acquisition of funds (financing)

2. To understand the effect of global finance on business

3. To make intelligent personal decisions

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MULTINATIONALCOMPANIES AND
THEIR PERFORMANCE

AGENCY THEORY
1. MNC's value is subject to larger agency
cost.
2. Agency theory is a theory that deals with
the conflict of interest between
managers and stockholders.

MNCs have performed better than domestic performs

due to:
a)
b)
c)
d)
e)
f)
g)

Higher risk-return tradeoff

Market imperfections
Portfolio effect
Comparative advantage
Internationalization advantages
Larger economies of scale
Larger valuation.

a)
b)
c)
d)

Incentives
Monitoring
Agency costs
Agency costs are then compared

CORPORATE GOVERNANCE
1. Shareholder activism
2. Recent changes in the US corporate
governance
3. US corporate governance

CHAPTER 2
MOTIVES FOR WORLD
TRADE AND
FOREIGN INVESTMENT
9

MOTIVES FOR WORLD TRADE AND FOREIGN

INVESTMENT

TRADE THEORIES
Countries gain from trade by producing products
they have a comparative advantage.
Countries gain from specializing in the production
and export of any good that uses larger amounts of
their own abundant factors.
Explain trade patterns on the basis of stages in a
product's life.

INVESTMENT THEORIES

TRADE THEORIES
u. Comparative Advantage
v. Factor Endowment
w. Product Life Cycle

10

x. Product Life Cycle

y. Portfolio Theory
z. Oligopoly

Eclectic Theory

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ECLECTIC THEORY

INVESTMENT THEORIES
Explain changes in the location of production on the
basis of states in a product's life.
Improve its risk-return performance by holding an
internationally diversified portfolio of assets.
Invest abroad to exploit their quasi-monopoly
advantages.

Exploit foreign markets through exports first and

then invest abroad at some point in the future.
Location specific advantages, such as natural
resources and low labor cost.
Ownership specific advantages, such as capital
funds and technology.
Internationalization advantages are location and
ownership advantages magnified by international
investment.

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BENEFITS OF OPEN TRADE

14

PROTECTIONISM

Allocation efficiency is obtained because MNCs

devote more of their resources to producing those
products with a comparative advantage.
Increased competition stimulates efficiency and
growth.
Production efficiency is obtained because foreign
trade stimulates the flow of new ideas and
information across borders.
Expanded menu of goods.

Reasons for protectionism include national security,

unfair competition, infant industry argument,
domestic employment, and diversification.
Forms of protectionism are tariffs, quotas, and
other trade barriers.

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16

ECONOMIC INTEGRATION

ECONOMIC INTEGRATION

Trading blocs: Types of economic cooperation

World Trade Organization (WTO) replaced

GATT on January 1, 1995.

a) Free trade area: no internal tariffs.

b) Customs union: no internal tariffs and common external
tariffs.
c) Common market: customs-union features + free flow of
production factors.
d) Economic union: common-market features with
harmonization of economic policy.
e) Political union: economic-union features with political
harmony

a. Most favored nation clause: if a country grants a

tariff reduction to one country, it must grant the
same concession to all other WTO countries.
b. To join the WTO, countries must adhere to the
most favored nation clause.

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ECONOMIC INTEGRATION
Regional economic agreements:

CHAPTER 3

North American Free Trade Agreement of the US, Canada, and

Mexico on January 1, 1994.
European Union of 15 countries began its operations with a
single Central European Bank on January 1, 1999. The EU
accepted 10 new members on Mary 1, 2004.

THE BALANCE OF
PAYMENTS

Asian integration efforts consist of the

Association of
South East Asian Nations (ASEAN), The Asian Pacific Economic
Cooperation (APEC), and informal yen-trading bloc.

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20

ACCOUNTING TREATMENT

Numerical Example

A country's balance of payments is the record of

transactions between its residents and foreign
residents over a specified period.
The balance of payments is a sources-and-uses-offunds statement.
Transactions that earn foreign exchange are recorded
as credit, plus, or cash inflows (sources), such as
exports of goods and services.
Transactions that expend foreign exchange are
recorded as debit, minus, and cash outflows (uses),
such as imports of goods and services.

Debits (Outflows)
Example
3-1a
3-1b
3-1c
3-1d
3-1e
Reserves
Total

Credits (Inflows)

Expend Foreign Exchange Earn Foreign Exchange

$30,000
$ 5,000
20,000
5,000
10,000
10,000
$40,000
$40,000

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22

DEFICIT OR SURPLUS

BALANCE OF PAYMENTS ACCOUNTS

1. Autonomous transactions are those that occur because of

self-interests, while compensating transactions are those
that occur to eliminate the balance-of-payment
imbalance.
2. Surplus: autonomous receipts > autonomous payments.
3. Deficit: autonomous receipts < autonomous payments.
4. Balance of payments is used to:
a. predict pressures on foreign exchange rate.
b. anticipate government policy actions.
c. assess a country's credit and political risks.
d. evaluate a country's economic health.

Current Account: Group A, Consists of:

a)
b)
c)
d)

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Goods
Services
Income
Current transfers.

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BALANCE OF PAYMENTS ACCOUNTS

BALANCE OF PAYMENTS ACCOUNTS

Capital Account: Group B, Consists of:

Financial Account: Group C, Consists of :

a) Capital transfers
b) Acquisition or disposal of nonproduced,
nonfinancial assets.

a) Foreign direct investment

b) Foreign portfolio investment
c) Other investments.

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26

BALANCE OF PAYMENTS ACCOUNTS

BALANCE OF PAYMENTS ACCOUNTS

Balance of payment identity:

Net Errors and Omissions: Group D

This is a plug item designed to keep the
balance-of-payments accounts in balance.
Reserves and Related Items: Group E, Consists
of:
a) Official reserve assets
b) Use of IMF credits and loans
c) Exceptional financing.

a.

Flows of goods and services: current account.

Flows of financial assets (net foreign investment) =
capital account + financial account + net errors and
omissions + reserves and related items.

b.

Flows of goods and services + net foreign

investment = 0 or
current account + capital account + financial account
+ net errors and omissions + reserves and related
items = 0

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THE ACTUAL BALANCE OF PAYMENTS

THE ACTUAL BALANCE OF PAYMENTS

Major Country Balances in Financial Account
a. The US incurred massive financial- account
surpluses during the 1990s and early
2000s.
b. Japan incurred massive financial-account
deficits during the 1990s and early 2000s.

Major Countries on Current Account

a

28

The US incurred massive current-account

deficits during the 1990s and early 2000s.
Japan incurred massive current-account
surpluses during the 1990s and early 2000s.

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THE ACTUAL BALANCE OF PAYMENTS

INTERNATIONAL INVESTMENT POSITION

1. International investment position is a stock concept because
it summarizes a countrys assets and liabilities on a given
date.
2. The US is the largest net debtor nation in the world, while
Japan is the largest net creditor nation in the world.
3. Foreign direct investment (FDI) in the US accounts for 35
percent of foreign assets in the US, but FDI in Japan accounts
for 10 percent in foreign assets in Japan.
4. The USs other investment (mostly short-term capital flows)
accounts for 30 percent of its total foreign assets, while
Japans other investment amounts to more than 45 percent.

The World Balance of Payments

a. The expansion of world trade grew 6.4 percent per year
between 1991 and 1999, 13.1 percent in 2000, 0.4 percent
in 2001, and 3.0 percent in 2002, but it expected to grow by
about 7 percent per year from 2003 to 2005.
b. The expansion of world output grew 2.4 percent per year
between 1991 and 1999, 3.8 percent in 2000, 1.2 percent in
2001, and 1.7 percent in 2002, but it expected to grow
between 2 and 3 percent per year between 2003 and 2005.
c. Those statistics in a and b indicate the relative openness of
markets and the ongoing integration of the global economy.

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32

HOW TO REDUCE A TRADE DEFICIT

1. Deflate the economy through tight monetary and
fiscal policies.
2. Devalue the currency.
3. Establish public control.
4. J-Curve
a.

CHAPTER 4

J-curve is a theory designed to explain why a currency

depreciation may not improve the balance of trade.
The J-curve effect holds that a country's currency
depreciation causes its trade balance to deteriorate for a
short time, followed by a flattering out period, and then a
significant improvement occurs for an extended period.

b.

THE INTERNATIONAL MONETARY SYSTEM

33

FIXED EXCHANGE RATES

FLEXIBLE EXCHANGE RATE

1.

1. Fixed exchange rates are exchange rates which do not fluctuate

or which change within a predetermine band.
2. Fixed exchange rates provide the stability of exchange rate, but
their disadvantages include:

Flexible exchange rates are exchange rates,

which fluctuate according to market forces.
Advantages:

2.

a. Allow countries to maintain independent economic policies.

b. Permit a smooth adjustment to external shocks.
c. Don't need to maintain large international reserves.

3.

34

Disadvantages:
a.

Flexible exchange rates are highly unstable so that flows of foreign

trade and investment may be discouraged.
b. They are inherently inflationary.

35

a. Too rigid to take care of major upheavals.

b. Need large reserves to defend the fixed exchange rate.
c. May cause destabilizing speculations; most currency crises took place
under a fixed exchange system.

3. Currency board is a monetary institution that only issues

currency to the extent if it is fully backed by foreign reserves;
this system is a rather rigid form of fixed exchange rates.

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MARKET EQUILIBRIUM

MARKET EQUILIBRIUM

2. Assuming that the US dollar is a domestic

currency and the British pound is a foreign
currency, the demand curve for a foreign currency
could be shifted to the right because of:

1. The equilibrium exchange rate and quantity are

determined at the point where the demand curve
for and the supply curve of foreign exchange are
intersected.

a.
b.
c.
d.

A higher inflation rate in the US

Lower interest rates in the US
An increase in the US income level
US government purchase of British pounds.

37

HISTORY OF INTERNATIONAL MONETARY

SYSTEM

MARKET EQUILIBRIUM
3. The supply curve for a foreign currency could be
shifted to the right because of:
a.
b.
c.
d.

38

1914 Breakdown of gold standard and monetary

disorder began.
1934 US dollar pegged at $35 per ounce of gold.
1944 Conference of Bretton Woods, New Hampshire
established a fixed exchange system based on the US
dollar. IMF and World Bank created.
1958 European Economic Community established.

A higher inflation in Britain

Lower interest rates in Britain
An increase in the British income level
British government sale of US dollars.

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40

HISTORY OF INTERNATIONAL MONETARY

SYSTEM

HISTORY OF INTERNATIONAL MONETARY

SYSTEM

1971 On August 15, the US dollar floated; the

convertibility of the US dollar eliminated; an import
surcharge imposed. On December 17, Smithsonian
Agreement reached; the US dollar devalued from $35
per ounce of gold to $38.
1972 A snake (2.25%) within a tunnel (4.5%) established.
1973 The US dollar devalued from $38 to $42.22 in
March.
1973 Organization for Petroleum Exporting Countries
(OPEC) imposed oil embargo, eventually quadrupling
world prices of oil.

1963 The US levied "Interest Equalization Tax" on

foreign borrowings in US capital markets.
1963 The US imposed voluntary controls on capital
outflows from US banks and companies.
1968 The US imposed mandatory controls on foreign
investment by US companies.
1970 Special drawing rights (SDRs) created.

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HISTORY OF INTERNATIONAL MONETARY

SYSTEM

HISTORY OF INTERNATIONAL MONETARY

SYSTEM

1976 IMF meeting in Jamaica, known as "Jamaica

Agreement," legalized the existing floating system.
1978 The EEC established the European Monetary
System which officially replaced a snake within a
tunnel. This is a joint floating system.
1982 Latin American debt crisis began.
1985 Group of Five countries reached "Plaza
Agreement" to reduce the value of the US dollar.

1987 Major industrialized countries reached "Louvre

Accord" to support stability and exchange rates
around their current levels.
1992 High German interest rates caused "the
September 1992 currency crisis in Europe. Italy and
the United Kingdom withdrew from the European
Monetary System.
1993 The July 1993 currency crisis in Europe forced
the EEC to widen allowable deviation band to +15
percent.
1993 A Single European Community created. The
name of the EEC has changed to the European
Union (EU).
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44

HISTORY OF INTERNATIONAL MONETARY

SYSTEM

HISTORY OF INTERNATIONAL MONETARY

SYSTEM

1994 Mexican peso suffered major devaluation (40%)

and began to float.
1997 In July 1997, currency turmoil erupted in
Thailand and spread to Indonesia, South Korea, and
other South Asian countries.
1999 On January 1, 1999, 11 European
countries
launched a single European currency called the
euro, with a common monetary policy established
by an independent European Central Bank.

2002 On January 1, the euro began public circulation

and traded alongside the national currencies. On
July 1, the euro replaced the national currencies of
euro-zone countries.
2004 On May 1, the EU accepted 10 new members:
Cyprus, the Czech Republic, Estonia, Hungary,
Latvia, Lithuania, Malta, Poland, Slovakia, and
Slovenia.

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46

SPECIAL DRAWING RIGHTS (SDRs)

INTERNATIONAL MONETARY FUND

SPECIAL DRAWING RIGHTS (SDRs)

Created in 1944, its objectives are:

a.
b.
c.
d.
e.

1.
2.
3.
4.

IMF created SDRs in 1969.

1970-1974: SDR's value tied with the US dollar.
1974-1981: SDR's value tied with a basket of 16 currencies.
Since 1999, SDR's value tied with the US dollar, Japanese
yen, British pound, and euro.
5. IMF use SDRs in a variety of transactions and operations. In
addition, SDRs are used as means to determine a reference
interest rate, an international reserve asset, and a unit of
account.

To promote international monetary cooperation.

To facilitate the balanced growth of world trade.
To promote exchange stability.
To eliminate exchange restrictions.
To create standby reserves.

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NEW INTERNATIONAL MONETARY SYSTEM

1. Exchange rates are said to be "volatile" if their fluctuations
are wide and unpredictable. The world has experienced
more volatile exchange rates since the Bretton Wood
System collapsed in 1973.
2. Many economists recommend "crawling band"--a
combination of a crawling peg and a wider band as a new
monetary system:
a.

CHAPTER 5
FOREIGN EXCHANGE MARKET

Crawling peg is a regular modification of par value, and a wider

band is used to mean a band which is wider than a 4.5% allowed
under Smithsonian Agreement.

3. Advantages: this system will provide a discipline but a

flexibility to accommodate divergent economies.

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50

EXCHANGE MARKET PARTICIPANTS

EXCHANGE MARKET PARTICIPANTS

1. Actual participants are banks, central banks,
multinational companies, national governments,
individual investors, and other financial
institutions.

2. Purpose of Participation:
a.

Arbitragers: to cover the risk of loss from foreign currency proceeds

in taking advantages of differences of interest rates among
countries.
b. Traders: eliminate the risk of loss from export or import orders
denominated in foreign currencies.
c. Hedgers: to protect the home-currency value of foreign-currency
denominated balance-sheet items.
d. Speculators: expose themselves to currency risks. The first three
actually use foreign currency in their operations, but speculators
never use it in their operations.
e. In most cases, the term "hedgers" are used to mean functions of
both traders and hedgers.

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52

SPOT EXCHANGE QUOTATIONS

SPOT EXCHANGE QUOTATIONS

3. Cross rate is an exchange rate between two nonhome currencies, such as Mex$6.40 per for a US
resident.
4. Measuring a percentage change in spot rates:
a. Direct quote:

1. Spot rate is a foreign exchange rate paid for

immediate deliver of a currency.
2. Direct quote and indirect quote:
a. Direct quote is a home currency price per unit of a
foreign currency, such as $1.5 per for a US resident.
b. Indirect quote is a foreign currency price per unit of a
home currency, such as 0.67 per $ for a US resident.

% change = (ending rate beginning rate)/beginning

rate.
b. Indirect quote:
% change = (beginning rate ending rate)/ending rate.

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SPOT EXCHANGE QUOTATIONS

FORWARD EXCHANGE QUOTATION

1. Forward rate is a foreign exchange rate
for a
currency to be delivered at some future date.
2. Forward premium or discount

5. Bid-Ask Rates:
a. Bid price is the price at which the bank is ready to
buy a foreign currency.
b. Ask price is the price at which the bank is ready to
sell a foreign currency.
c. Bid-ask spread is the difference between bid and
ask rates.
d. Spread in direct quote = (ask price - bid
price)/ask price.

a. Quote in points:

One point is equal to 0.01 percent or $0.0001.

Forward quote in point = forward rate - spot
rate.

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56

FORWARD EXCHANGE QUOTATION

FORWARD EXCHANGE QUOTATION

4. Forward exchange transactions are used to eliminate

possible exchange losses on foreign-currency denominated
obligations.
5. Speculating in the spot market:

2. Forward premium or discount

b.

Premium or discount

n - day forward rate - spot rate

spot rate

360
n

Speculators buy a foreign currency at today's spot rate, will hold it

for some time, and will resell it at a higher spot rate.

6. Speculating in the forward market:

Speculators buy a foreign currency forward today, will hold it for

some time, and will resell it at a higher spot rate.

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58

INTERNATIONAL PARITY CONDITIONS

INTERNATIONAL PARITY CONDITIONS

1. Purchasing power parity:

2. Fisher effect: a higher inflation causes a higher nominal rate

because (a) nominal rate = real rate + inflation, and (b) real
rate is constant.

The spot rate for the currency of a country with a

higher inflation than its trading partner will
depreciate in the long run.

a.

Real interest rates should tend toward equality

everywhere in the world.
b.
Real interest rate in each country is thought to
be
stable over time.
c . Points a and b indicate that the nominal interest rate
differs from country to country because of
differences
in inflation rates.

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INTERNATIONAL PARITY CONDITIONS

INTERNATIONAL PARITY CONDITIONS

3. International Fisher effect:

4. Interest parity:
The forward rate for the currency of a country
with a higher interest rate than its trading
partner will fall, thereby resulting in a
forward discount.

a. The spot rate for the currency of a country with a

higher interest rate than its trading partner will
depreciate in the long run.
b. But the spot rate for the currency of a country
with a higher interest rate than its trading partner
will appreciate in the short run.

5. If the above four theories hold, then forward

rates will be unbiased predictors of future
spot rate.
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62

COVERED INTEREST ARBITRAGE

COVERED INTEREST ARBITRAGE

3. Any point above the parity line such as

point A has the two features:

1. Definition: the movement of short-term funds

between countries to take advantage of interest
differentials with exchange risk covered by
forward contracts.

a.

2 Interest parity line indicates that there are no

incentives for arbitrage transactions because on
this line, the interest differential is equal to the
forward premium or discount.

b.

Borrow in the home country, which is the first step in

the arbitrage process.
Arbitrage outflows, which means money will move
from the home country to the foreign country.

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64

COVERED INTEREST ARBITRAGE

COVERED INTEREST ARBITRAGE

Example 5-12:
Interest differential = 2%
Forward discount = 1%
a. Steps 1 and 2 will increase the forward
discount of 1% toward 2%.
b. Steps 3 and 4 will reduce the interest
differential of 2% toward 1%.
c. Thus, the forward discount and the interest
differential will meet somewhere between 1% and
2%, which will be a point
on the interest parity
line.

4. Any point below the parity line such as point B

has the two features:
a.
b.

65

Borrow in the foreign country.

Arbitrage inflows.

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CURRENCY FUTURES
1. A currency futures contract is a contract to buy or sell a
specified amount of a foreign currency for delivery at some
future date.
2.

CHAPTER 6

a.

Margin is some sort of deposit to ensure that each party fulfills its
commitment.
b. Initial Margin is the amount market participants must deposit at the
time of a futures contract.
c. Maintenance margin is a fixed minimum margin customers must
maintain in their account all the time, and it is about 70-80% of the
initial margin.
d. Margin calls are requests for additional deposits.

CURRENCY FUTURES AND

OPTIONS
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68

CURRENCY FUTURES

CURRENCY FUTURES

4. Three major differences between futures and

3. Positions

forwards:

a. Short--agreement to sell something. If an

American has yen receivables, she is likely to
have a short position.
b. Long--agreement to buy something. If an
American has yen payables, he is likely to have
a long position.

a. Futures are available in a predetermined

amount, have four maturity dates per year, and are
handled by exchanges.
b. Forwards are available in any amount
tailored to
customer needs, mature on any date, and are handled
by banks (OTC: over-the-counter).

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70

CURRENCY OPTIONS

CURRENCY OPTIONS

CURRENCY OPTIONS
1. Currency option is the right to buy
(call) or sell
(put) a specified amount of a foreign currency at
some future date.
2. Premium or purchase price = intrinsic value + time
value.

71

3. Intrinsic value (IV) is the difference between exchange rate

and strike price but cannot be lower than zero (0).
a.

In the money: If options have positive IV from investors'

viewpoints, they are in the money.
b. At the money: If options have zero IV from investors' viewpoints,
they are at the money.
c. Out of the money: If options have negative (theoretical or
mathematical) IV from investors viewpoints, they are out of the
money

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CURRENCY OPTIONS

CURRENCY OPTIONS
NUMERICAL EXAMPLE

5. Value of Volatility
a. Volatility affects both time value and intrinsic value.
b. Volatile currency options have higher premiums.
c. Options premiums are always higher than the intrinsic
value, because of the time value and value of volatility.

On October 23, the closing exchange rate of

British pounds was $1.70. Calls which would
mature the following January with a strike
price of $1.75 were traded at $0.05.

73

CURRENCY OPTIONS

74

CURRENCY OPTIONS

3. If the exchange rate of British pounds rises to $1.82

prior to the January option expiration date, what is
the percentage return on investment for an investor
who purchased a call on October 23?
(1.82 - 1.75 - 0.05)/0.05 = 0.40 or 40%
4. What is the break-even exchange rate for British
pounds?
Break-even point = 1.75 + 0.05 = $1.80 per pound.

1. Were the call options in the money, at the money, or out of

the money?
Mathematical or theoretical value = $1.70 - $1.75 = $0.05.Thus,these call options were out of the money.
2. Compute the intrinsic value. Why was the premium of the
call option higher than the intrinsic value?
The intrinsic value is zero because all the investor has to do
for the out-of-the money options is to let them expire
unexercised. The call premium ($0.05) was higher than the
intrinsic value ($0.00) because of the time value and the
value of volatility.

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76

ORIGIN OF THE SWAP MARKET

1. A swap is an agreement between two parties that
exchanges sets of cash flows over a period of time in
the future.
2. A parallel loan is a loan which involves an exchange of
currencies between four parties, with a promise to reexchange the currencies at a predetermined exchange
rate at some future date.
3. A back-to-back loan is identical with the parallel loan
except the fact that it involves only two parties rather
than four parties.

CHAPTER 7

FINANCIAL SWAPS

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PLAIN VANILLA SWAPS

ORIGIN OF THE SWAP MARKET

4. Drawbacks of parallel loans:
a. It is difficult to find counterparties with
matching needs.
b. One party is still obligated to comply with such an
agreement even if another party fails to do so.
c. Such loans show up on the books of the
participating parties.

1. The plain vanilla swap is the simplest kind of

a swap.
2. Swap banks:
a. A counterparty to both end-users.
b. Broker acts as an agent between buyers and sellers.
c. Dealer actually transacts for its own account to help
complete the swap.

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PLAIN VANILLA SWAPS

80

PLAIN VANILLA SWAPS

3. Interest rate swap:

a. Interest rate swap is an agreement between two parties
to exchange interest payments.
b. Two parties agree to exchange fixed interest rates for
floating interest rates or floating exchange rates for fixed
exchange rates.
c. Notional principal is the principal value on which
interest payments are based.
d. Parties A and B may agree on a swap in the same
country with the same currency, in the two different
countries with the two different currencies, and in other
variants.

4. Currency swaps usually involves

of cash flows:

three sets

a. Spot transaction: two parties swap two currencies now.

b. Only net interest payments are made.
c. Forward transaction: two parties reswap the two
currencies in the future.

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MOTIVATIONS

MOTIVATIONS

2. Commercial needs:

1. Currency risk management:

a.General Motors (GM) has yen accounts
receivable.
b.Toyota has dollar accounts receivable.
c. GM and Toyota swap yen and dollars with each
other.

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a. The swap may be used to eliminate the interest rate risk.

Assume a company has fixed rate assets and floating rate
liabilities. If interest rates rise, this company will face the
interest rate risk.
b. The company can eliminate the interest rate risk by: (1)
transforming fixed rate assets into floating rate assets
and (2) transforming floating rate liabilities into fixed rate
liabilities.

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7/25/2013

MOTIVATIONS
3. Comparative Advantage:
a. GM borrows dollars at a lower rate and transfers the
funds to a British firm.
b. British firm borrows pounds at a lower rate and
transfer the funds to GM.
c. This swap is possible because of market imperfections or
different risks.

CHAPTER 8
EXCHANGE RATE
FORECASTING

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FORECASTING NEEDS OF THE MULTI NATIONAL

COMPANY
Virtually all aspects of MNCs may be influenced by
changes in exchange rates. They include the hedging
decision, working capital management, long-term
investment analysis, long-term financing decision,
and other decisions.

EFFICIENT EXCHANGE MARKETS

1.

Assumptions for efficient exchange

markets are:
a.Very large number of sellers and buyers
b.Standard product
c. Given price
d.Free entry into and exit out of the market.

87

88

EFFICIENT EXCHANGE MARKETS

EFFICIENT EXCHANGE MARKETS

3. Forms of Efficient Exchange Market

3. Weak-form efficiency: historical data is useless.
a. Semi-strong form efficiency: current
information is useless.
b. Strong-form efficiency: inside information is
useless.

2. Consequences:
a. Spot rates reflect all current information and
will change in response to "random news.
b. Impossible for any market analyst to
consistently beat the market.
c. All currencies are fairly priced.

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FORECASTING FLOATING EXCHANGE

RATES

EFFICIENT EXCHANGE MARKETS

4.

If foreign exchange markets are perfectly

efficient, exchange rate forecasting is impossible
because:

1. Fundamental analysis:
a. Fundamental analysis depends on fundamental
economic conditions, such as inflation rate,
interest rate, and the rate of growth in money
supply.
b. Examples of this techniques are PPP and
multiple regression analysis.

All currencies are fairly priced and exchange rates will

change in response to "random news."

91

FORECASTING FLOATING EXCHANGE

RATES

92

FORECASTING FLOATING EXCHANGE

RATES
3. Market-based forecasts:

2. Technical analysis:

a. A market-based forecast is a forecast based on market

indicators such as forward rates.
b. Examples of this technique are spot rates, forward rates,
and interest rates.
c. Forecasting horizons are a few days for spot rates, a few
months for forward rates, and a few years for interest
rates.

a. Technical analysis depends on past prices and

volume movements.
b. Examples of this technique are charting and
mechanical rules.

93

94

FORECASTING FIXED EXCHANGE RATES

FORECASTING FIXED EXCHANGE RATES

1. Step one is to identify those countries whose

balance of payments are in fundamental
disequilibrium.
To identify these countries, one should look at:

2. Step two is to measure the magnitude of required

adjustment.
The degree of required adjustment can be
measured by:

a.
b.
c.
d.

International reserves
The balance of trade
Inflation rates
Money supply.

a. The application of PPP

b. Forward premium or discount
c. Free market or black market rates.

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FORECASTING FIXED EXCHANGE RATES

FORECASTING FIXED EXCHANGE RATES

3. Third step is to determine the timing of

adjustment.
The timing of adjustment depends on:

4. Fourth step is to predict the type of corrective

policies.
Corrective policies include:

a. The overall amount of international reserves

b. Ability to borrow hard currencies.

a. Adopt tight monetary and fiscal policies

b. Institute strict exchange controls.

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98

FORECASTING FIXED EXCHANGE RATES

CHAPTER 9

5. A country will devalue its currency if various

corrective policies prove economically ineffective
or politically unacceptable.

MANAGING TRANSACTION
EXPOSURE AND ECONOMIC
EXPOSURE

99

100

BASIC NATURE OF FOREIGN EXCHANGE

EXPOSURES

TRANSACTIONS THAT ARE SAID TO BE EXPOSED

1.

They are denominated in foreign currencies.

2.

They are translated at current exchange rates.

1.

101

Foreign exchange exposure refers to the

possibility that a firm will gain or lose because of
changes in exchange rates. Three types of
exchange exposures are translation, transaction,
and economic.

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BASIC NATURE OF FOREIGN EXCHANGE

EXPOSURES

TYPES OF EXPOSURES

2. The exchange exposure management requires an

MNC to:
1)
2)
3)
4)
5)

Develop exposure management strategy,

Forecast the degree of exposure,
Develop a reporting system to monitor exposure and
exchange rate movements,
Assign responsibility for hedging exposure, and
select appropriate hedging tools.

1. Accounting or translation exposure is the effect of

an exchange rate change on financial statement
items.
2. Transaction exposure is the effect of an exchange
rate change on outstanding obligations, such as
imports and exports.

103

TYPES OF EXPOSURES
3. Economic exposure is the effect of an exchange
rate change on the net present value of
expected net cash flows from direct investment
projects.
4. Translation exposure does not involve actual
cash flows, but transaction exposure involves
actual cash outflows, and economic exposure
involves potential cash flows.

104

TRANSACTION EXPOSURE MANAGEMENT FOR

A US FIRM
_________________________________________________
Techniques
Pound Payables
Pound Receivables
Futures (forward) long position (buy) short position (sell)
Options
call
put
Futures options
call
put____________
1. Forward market hedge involves the exchange of one currency for
another at a fixed rate one on some future date to hedge
transaction exposure.

105

TRANSACTION EXPOSURE MANAGEMENT FOR

A US FIRM
2. Money market hedge:
a. If a US firm has pound payables from imports, the firm
borrows dollars, converts the proceeds into pounds, buys
British Treasury bills, and pays the import bill with the funds
derived from the sale of the Treasury bills. The firm's dollar
loan is not subject to exchange rate risk.
b. If a US firm has pound receivables, the firm borrows pounds,
converts the proceeds into dollars, and buys US Treasury bills.
At maturity, the firm uses pound receivables to pay off its
pound loan and redeems the Treasury bills in dollars.

107

106

TRANSACTION EXPOSURE MANAGEMENT FOR

A US FIRM
3. Under the options-market hedge, the purchase of a call option
allows a US firm to lock in a maximum dollar price for its
foreign currency payables; the purchase of a put option allows
a US firm to lock in a minimum dollar price for its foreign
currency receivables.
4. Swap market hedge involves an exchange of cash flows in two
different currencies between two companies.
5. Use futures or forwards when the quantity of foreign currency
cash flows is known.
Use options when the quantity of a foreign currency cash flows
is unknown.

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TRANSACTION EXPOSURE MANAGEMENT FOR

A US FIRM
6. Cross hedging hedges exposure in one currency by the use of
futures or other contracts on another currency that is
correlated with the first currency.
7. A variety of swap agreements can be used for transaction
exposure management:
a) Currency swap is a simultaneous spot and forward transaction.
b) Credit swap is a simultaneous spot and forward transaction but
involves a bank.
c) Interest rate swap
d) Back-to-back loans
e) Credit Swap

EXAMPLE 9-7
(1).
(2).
(3).

The cost of direct loan is 20%.

The cost of credit swap is 30%.
which one to choose?

Direct Loan
Credit Swap_____
200,000y + (1,000,000y - 4,000,000) = 200,000y + 400,000
y = 4.4

109

EXAMPLE 9-7

110

EXAMPLE 9-7

If y = 4.4, direct loan = 1,280,000 shekels

credit swap = 1,280,000 shekels
Thus, both alternatives are equally costly,
but the credit swap is safer.

If y = 5, direct loan = 2,000,000 shekels

credit swap = 1,400,000 shekels

If y = 4, direct loan = 800,000 shekels

credit swap = 1,200,000 shekels
Thus, the direct loan is cheaper, but riskier than the
credit swap.

Rational decision-makers should choose the

credit swap because it is cheaper and less
risky.

111

ECONOMIC EXPOSURE
MANAGEMENT

112

ECONOMIC EXPOSURE
MANAGEMENT

1. Two broad hedging techniques are financial and

operational.
2. Problems of economic exposure management:

3. Hedging Techniques

a. Economic exposure covers the life of the project and all

aspects of operations.
b. The above two factors make it very difficult for MNCs to
find economically justifiable financial hedging techniques,
such as futures, forwards, and options.

113

a. Most MNCs use operational hedging techniques known

as strategic (operational) methods such as diversification
in production, marketing, and financing.
b. The biggest problem with the diversification strategy is
the loss of economies of scale.

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CURRENCY EXPOSURE MANAGEMENT

PRACTICES

CURRENCY EXPOSURE MANAGEMENT

PRACTICES
1. The relative importance of different exchange exposures
from the amount of attention given to each exposure and
hedging preference for each exposure are
(1) transaction exposure,
(2) economic exposure,
(3) translation exposure.

3.

Financial hedging instruments, known as

derivatives, such as futures, options, and swaps are
generally considered safe for short-term purposes,
but they are not risk-free either.

2. The most commonly used instrument to manage foreign

exchange risks was forward contract, followed by crosscurrency swaps, interest rate swaps, currency swaps, and
futures.

115

116

CURRENCY EXPOSURE MANAGEMENT

PRACTICES
Some have incurred large-derivative related
losses, which include:

CHAPTER 10

Showa Shell of Japan ($1.54 billion in 1993),

Metallgesellschaft of Germany ($1.3 billion in 1994),
Barings Bank of Britain (($1.4 billion in 1995),
Daiwa Bank of Japan ($1.1 billion in 1995),
Sumitomo Corp of Japan ($1.8 billion in 1996),
Orange County of California, the US($1.7 billion in 1994),
Long-Term Capital Management of the US
($3 billion in 1998).

MANAGING TRANSLATION
EXPOSURE

117

118

TRANSLATION RULES

TRANSLATION RULES
1. Translation exposure measures the effect of
an exchange rate change on published
financial statements of a firm.
2. Differences between current rate, temporal,
monetary/nonmonetary, and current /
noncurrent methods.

119

_______________________________________________________________
Current
Monetary/
Current/
Item
Rate
Temporal
Nonmonetary Noncurrent
Inventory at price exposed
exposed
not exposed
exposed
Inventory at cost exposed
not exposed not exposed
exposed
Net fixed assets exposed
not exposed not exposed
not exposed
Long-term debt
exposed
exposed
exposed
not exposed
*Those items that are translated at historical rates are not exposed.
Those items that are translated at current rates are exposed.

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FASB #8 (TEMPORAL METHOD) VS. FASB #52 (CURRENT RATE

METHOD)

1. Two major complaints about FASB #8

include:

FASB #8 (TEMPORAL METHOD) VS. FASB #52 (CURRENT RATE

METHOD)

2. Under FASB #52:

a. All gains and losses are treated as net worth.
b. All items are translated at current exchange rate
except net worth.

a. FASB #8 requires firms to show all gains and

losses in their current income statement.
b. FASB #8 requires firms to use different rates for
different balance-sheet items.

121

FASB #8 (TEMPORAL METHOD) VS. FASB #52 (CURRENT RATE

METHOD)

3. In 1982, GM earned $963 million and had a translation gain

of $348 million, while Ford lost $658 million and had a
translation loss of $220 million. 1982 was the year that US
companies were allowed to use either FASB #52 or #8.
GM used FASB #8 to include a translation gain of $348 million
in its income statement, while Ford used FASB #52 to
exclude a translation loss of $220 million from its income
statement.

122

HEDGING TECHNIQUES FOR TRANSLATION

EXPOSURE
1. Under the balance sheet hedge, assets and
liabilities in a particular currency company
maintains the same amount of exposed .
Hard currencies are those currencies whose
value is likely to appreciate, and soft
currencies are those currencies whose value
is likely to depreciate.

123

124

HEDGING TECHNIQUES FOR TRANSLATION

EXPOSURE

HEDGING TECHNIQUES FOR TRANSLATION

EXPOSURE

1) Increase hard-currency assets; for example,

increase dollar-denominated receivables.
2) Decrease hard-currency debts; for example, pay
off dollar-denominated debts.
3) Decrease soft-currency assets; for example, reduce
peso-denominated receivables.
4) Increase soft-currency debts; for example,
increase peso-denominated debts.

125

2. Indirect Fund Adjustment Methods

2.

a.
b.

Expose netting allows a firm to net certain exposures

from different operations so that it may hedge only its
next exposure.
Leading and lagging allows a firm to pay or collect
early (leading) and to pay or collect late (lagging).
Transfer pricing can adjusted to avoid foreign currency
exposure.

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EUROCURRENCY (EURODOLLAR)
MARKETS
1. Eurocurrency (Eurodollar) market consists of
banks that accept deposits and make loans in
foreign countries outside the country of issue.
2. Definitions of Eurodollars.

CHAPTER 11
INTERNATIONAL FINANCIAL
MARKETS

a. to the entire Eurocurrency market because do Narrow

definition: dollars banked in Europe.
b. Broad definition: dollars banked outside of the US.
c. Eurocurrency is any currency banked outside its country
of origin.
d. The term "Eurodollar" frequently refers dollars account
for most of the Eurocurrency market.

127

EUROCURRENCY (EURODOLLAR)
MARKETS

EURONOTE ISSUE FACILITIES (EIFs)

Why are deposit rates higher and lending rates lower in

the Eurodollar market than in the US?
a.
b.
c.
d.
e.

128

Euro banks are free of reserve requirements.

Euro banks have very little regulatory expenses.
Eurodollar loans are made to well known borrowers in
high volumes.
Eurodollar loans are made in tax haven countries.
Eurodollar loans are not made at concessionary rates.

1. EIFS are notes issued outside the country in whose

currency they are denominated.
2. Euro notes are short-term debt instruments
underwritten by a group of international banks.
3. Euro commercial papers are unsecured short-term
promissory notes sold by companies.
4. Euro-medium-term notes are medium-term funds
guaranteed by financial institutions with the shortterm commitment by investors.

129

130

EUROCURRENCY INTERBANK MARKET

EUROCURRENCY INTERBANK MARKET

3. Major concerns of the interbank market by
regulators and analysts:

1. The Interbank market consists of deposits and

loans among banks and accounts for most of the
entire Eurocurrency market.

a. Two major concerns are

(1) no collateral and
(2) inadequate central bank regulations.
b. Above two major factors may create a "contagion
effect." Problems at one bank may affect other
banks in the market.

2. Risks of participating banks include:

a. Credit or default risk
b. Liquidity risk
c. Sovereign risk
d. Foreign exchange rate risk
e. Settlement risk.
131

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7/25/2013

EUROCURRENCY INTERBANK MARKET

4. Minimum standards of international banks
a. Central bank governors of G-10 countries and the
Bank for International Settlements established a
minimum standard in 1988.
b. Globally active banks maintain capital equal to at
least 8 % of their assets.
5. Three Cs of central banking are consultation,
cooperation, and coordination.

EUROCURRENCY INTERBANK MARKET

6. The role of banks in corporate governance
a.Traditionally, the corporate governance of the US
used to be a market-based system; the corporate
governance of Japan used to be a bank-based
system.
b. In recent years, however, the role of banks in
the US corporate governance became stronger,
while the role of banks in Japan's corporate
governance became weaker.

133

ASIAN CURRENCY MARKET

134

ASIAN CURRENCY MARKET

1. In 1968, an Asian version of the Eurodollar came

into existence with
the acceptance of dollar-denominated deposits by
banks in Singapore.

3. An ACU is a section within a bank with authority

for Asian currency market operations.
4. This Asian currency market rivals the International
Banking Facilities of the US and the Japan
Offshore Market.

2. 150 banks have licenses from the government of

Singapore to operate Asian Currency Units (ACUs).

135

136

INTERNATIONAL BOND MARKET

INTERNATIONAL BOND MARKET

4. Global bonds are bonds sold inside as well as

outside the country of the borrower.
5. Currency denominations in international bonds
include currencies of most industrial countries.
Multiple currency bonds are

1.

Definition of international bonds: bonds, which

are initially sold outside the country of the
borrower.
2.
Foreign bonds are bonds sold in a particular
country by a foreign borrower.
3.
Eurobonds are bonds sold simultaneously in
many countries outside the country of the
borrower.

(1) currency option bonds that allow investors to choose

one among several predetermined currencies and
(2) currency cocktail bonds that are denominated in a
standard currency basket of several currencies such as
SDRs.

137

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7/25/2013

INTERNATIONAL BOND MARKET

6.

INTERNATIONAL EQUITY MARKET

Other types of international bonds

include:

New trends in stock markets:

a.
b.
c.
d.
e.

a.

Straight bonds
Floating-rate bonds
Convertible bonds
Bonds with warrants
Zero-coupon bonds.

b.
c.

Stock market alliances: some 150 stock exchanges in the

world scramble to align with each other.
Cross listing: a recent increase in cross border mergers
compel firms to cross list their stocks on different
exchanges around the world.
Stock market concentration: Stock markets have become
more integrated in recent years mainly due to the European
Union, market alliances, cross-listing, and other reasons.

139

INTERNATIONAL EQUITY MARKET

140

INTERNATIONAL EQUITY MARKET

Privatization

Long-term capital flows to developing countries

a. Privatization is a situation in which governmentowned assets are sold to private individuals or

groups.

a. Long term capital flows to developing countries

have declined since 1998 mainly due to the Asian
financial crisis of 1997 and the recent slowdown of
the global economy.

b. Why privatize? To develop capital markets, widen

share ownership, raise money, and change
corporate governance.

b. Long term capital flows shifted from debt to equity in

recent years.

141

142

DIFFERENCES BETWEEN DOMESTIC AND

FOREIGN LOANS
1. Foreign loans are subject to foreign exchange
fluctuations and controls. Possible solutions include
forward and futures contracts, swaps, and back-toback loans.

CHAPTER 12
INTERNATIONAL BANKING
ISSUES AND COUNTRY
RISK ANALYSIS

2. There are no legal systems and no ultimate

arbitrators for possible disputes between borrowers
and lenders. Possible solutions include prior
agreements and insurance purchases.

143

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INTERNATIONAL DEBT CRISIS OF THE

1980s

INTERNATIONAL DEBT CRISIS OF THE

1980s
2. Causes of the crisis include:

1.
a.
b.
c.

Mexico defaulted in August 1982.

Brazil and Argentina followed.
25 countries faced similar problems by
1983.
d. $68 billion swing by OPEC between 1980 and
1982.
In 1980, OPEC contributed $42 billion to
loanable funds, but in 1982 withdrew $26
billion from loanable funds.

a. Global economic dislocations and mismanagement by the

debtor countries.
b. Growth opportunities in these countries, which
motivated them to borrow too much too fast.
c. The 1973-74 oil shock that increased oil prices by four
times.
d. Large balance of payments deficits by debtor countries.
e. Large capital flights, which are defined as the transfer of
capital abroad in response to fears of political risk.

145

146

INTERNATIONAL DEBT CRISIS

OF THE 1980s

INTERNATIONAL DEBT CRISIS OF THE

1980s

4. Brady Bonds

3. Solutions:
a. Lenders, borrowers, and international organizations
worked together; they used rescheduling, refinancing,
additional loans, forgiveness, and restrictive economic
policies.
b. Lenders increased equity-capital base, increased loanloss reserves, reduced new loans, and sold exposed
assets.
c. Borrowers depended on increased exports, reduced
imports, more foreign investment, restrictive economic
policies, and debt-equity swaps.
d. Partial debt relief was provided by creditors and world
financial institutions.

a. The above four measures were not sufficient to solve the debt
crisis completely.
b. In 1989, US Treasury Secretary Brady offered to convert the
creditors' loans into new guaranteed loans with a reduced
interest rate of 6.5 percent. This plan has come to be called
"Brady bonds."
c. In 1992, 20 debtor countries had converted $100 billion in
bank debt into Brady bonds.
d. These Brady bonds are largely credited with solving the debt
crisis of the 1980s

147

148

THE ASIAN FINANCIAL CRISIS OF 1997

THE ASIAN FINANCIAL CRISIS OF 1997

1. Thailand faced a currency crisis in July 1997 due to

a huge foreign debt, trade deficits, and a banking
system weakened by the heavy burden of unpaid
loans.

3. In the 4th quarter of 1997, the IMF arranged rescue

packages of $18 billion for Thailand, $43 billion for
Indonesia, and $58 billion for Korea.
4. By the end of 1998, the Asian crisis spread to
Russia, Brazil, and many other countries. Again, the
IMF arranged bailout packages of $23 billion for
Russia and $42 billion for Brazil.

2. A Thai crisis spread to Philippines, Malaysia,

Indonesia, and Korea because investors and
companies in these countries shared all of
Thailand's problems.

5. The Asian crisis had pushed one-third of the globe

into recession during 1998.
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THE ASIAN FINANCIAL CRISIS OF 1997

6. Causes of the Asian Crisis: fundamental view vs.
panic view

THE ASIAN FINANCIAL CRISIS OF 1997

Several factors support the panic view:

a. The fundamental view holds that the Asian crisis

was caused by the maturity mismatch and the
currency mismatch-- the use of short-term debt for
fixed assets by crisis countries and their
unhedged external debt.
b. The panic view states that problems in Thailand
were turned into an Asian crisis because of
international investors irrational behavior.

1) no warning signs were visible;

2) international banks made substantial loans to private
firms;
3) even viable exporters with confirmed sales could not
get credit;
4) the sudden withdrawal of funds from
the region
triggered the crisis.

151

THE ASIAN FINANCIAL CRISIS OF 1997

Policy Responses
a. External payments were stabilized by IMF-led
rescue packages, the rescheduling of short-term loans,
and reductions in foreign borrowings through increased
exports and reduced imports.
b. Crisis countries closed many ailing banks, cleaned up
non-performing loans, and compelled banks to meet the
capital adequacy ratio set by the BIS.
c. Corporate sector reforms included debt reduction,
removal of excess capacity, reorientation of
conglomerates on core businesses, and enhanced
corporate governance.

152

SYNDICATED LOANS
A syndicated loan is a credit in which a group of
banks makes funds available on common terms and
conditions to a particular borrower.

153

SYNDICATED LOANS

154

COUNTRY RISK
1. Country risk is the possibility of default on foreign loans.

2. This type of loan is popular because of:

2. How to assess country risk:

a.
b.
c.
d.
e.

The increasing size of individual loans

The need to spread risks in large loans
The attractiveness of management fees
The publicity for participating banks
The need to form profitable working relationships
with other banks.

155

a.Debt ratios by the World Bank in 2003:

__________________________________________________________
Severely Indebted Moderately Indebted
Countries
Countries
Debt Ratio
Critical Value
Critical Value
Debt Service to GNP
80%
48%
Debt Service to Export
220
132
50 countries
41 countries______

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COUNTRY RISK
b.

Some publications, such as Euromoney,

determine overall creditworthiness of
most countries around the world.
Overall creditworthiness depends on
economic factors, political factors, and
foreign relations.
c. Moody's Investor Service and Standard &
Poor's assign letter ratings to indicate the
quality of bonds issued by most
sovereign
governments.

CHAPTER 13
FINANCING FOREIGN
TRADE

157

158

TYPES OF DOCUMENTS

OBJECTIVES OF DOCUMENTATION
1. Remove non-completion risk such as no or
delayed delivery and no or delayed payments.

1. Draft is an order to pay.

a. Trade acceptance is a draft accepted by a company
and it is non-negotiable.
b. Bankers' acceptance is a draft accepted by a bank
and it is negotiable.

2. Eliminate exchange rate risk through forward

contracts and others.
3. Documents enable banks to finance foreign trade

159

160

TYPES OF DOCUMENTS

TYPES OF DOCUMENTS
2.

3. Letters of credit are the bank's guarantee of

payment.

A bill of lading is a shipping document and is

simultaneously a:
a. Receipt
b. Contract
c. Document of title.

4.

161

Three additional documents include commercial

invoice (description of the merchandise),
insurance documents, and consular invoices
(documents issued by the consulate of the
importing country).

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COUNTERTRADE

COUNTERTRADE

1. Counter trade refers to world trade arrangements

that are variations on the idea of a barter.
2. Simple barter is the exchange of goods and
services without money.
3. Under a clearing arrangement, any account
imbalances at the end of an agreed-upon period of
time are cleared by a hard currency payment or by
the transfer of additional goods.

4. Under switch trading, a third party, called "switch

trader," purchases any account imbalances between
the two countries at the end of an agreed upon
period of time.
5. Under counter purchase, the exporter agrees to a
return purchase.

163

COUNTERTRADE

164

PRIVATE SOURCES OF EXPORT FINANCING

6. Under compensation, payment is made by

products arising out of the original sale.

1. Accounts receivable financing

a. Open account, accounts payable, is based on
pre-established accounts.
b. Promissory notes, notes payable, are notes that
officially evidence the debt.
c. Trade acceptances are drafts accepted by a
company.

7. Offset agreement holds that the seller is

required to use goods and services from the
buyer country in the final product.

165

PRIVATE SOURCES OF EXPORT FINANCING

d.In receivable financing, pledging uses receivables as
and factoring means outright sales of receivables.

collateral

166

PRIVATE SOURCES OF EXPORT FINANCING

2. Letters of credit.
3. Bankers' acceptances.

Major differences between the two are:

______________________________________________________________
Pledging
Factoring
Ownership does not change
Ownership from borrower to lender
Lender has recourse
Lender has no recourse

4. Short-term bank loans.

Nonnotification to borrower's customers Notification to borrower's

customers

167

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PRIVATE SOURCES OF EXPORT FINANCING

5. Export trading companies of the US:

PRIVATE SOURCES OF EXPORT FINANCING

6.

a. The Export Trading Company Act of 1982 relaxed

the banking holding company act and anti-trust
laws for export trading companies.
b. The Act enabled export-trading companies to
provide one-stop comprehensive services for
exporters and buy/sell on their own accounts for

Factoring: factors, such as financial institutions,

buy accounts receivable on a non-recourse basis.
7.
Forfaiting:
a. Similar to factoring.
b. Used to finance sales of big-ticket
items.
c. Lender has no recourse.
d. Involve three to five years.

exports.

169

THE US GOVERNMENT SOURCES OF EXPORT

FINANCING
1. Export-Import (Exim) Bank: triad demanded
exporters are:
a. Official loans
b. Loan guarantees
c. Insurance.

170

THE US GOVERNMENT SOURCES OF EXPORT

FINANCING

by

3. Foreign Credit Insurance Association insured all risks

in exports,but went out of business in 1983; the Exim
Bank took over its functions.

2. Private Export Funding Corporation is supported by

the US Treasury Department and the Exim Bank; its
membership includes 54 banks, 7 manufacturers,
and one investment banker.

171

172

INTERNAL SOURCES OF FUNDS

1. Internal sources of funds from parents include:
a. Equity contributions are necessary to own and
control foreign operations.
b. Direct loans from parents to their subsidiaries
are popular because of tax considerations and
easy repatriations.
c. The parent's loan guarantees enable
subsidiaries to borrow from local banks.

CHAPTER 14
FINANCING FOREIGN
INVESTMENT
173

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INTERNAL SOURCES OF FUNDS

2.

INTERNAL SOURCES OF FUNDS

3. Internal sources of funds from subsidiary include:

Internal sources of funds from operations

include:
a. Profits
b. Depreciation or other non-cash outlays.

a. Loans from sister subsidiaries

b. One subsidiary can increase its cash discount
from 2/10 to 3/10 to its sister subsidiary.
c. One subsidiary can extend its credit terms
from net 30 to net 40 to its sister subsidiary.

175

176

EXTERNAL SOURCES OF FUNDS

EXTERNAL SOURCES OF FUNDS

1. External sources of funds from commercial banks
include:
a.
b.
c.
d.
e.

2. Edge Act and Agreement Corporations of the US

a. Located in the US but engage in offshore banking
operations.
b. Edge Act Corporations are chartered by the Fed
Reserve Board, and Agreement Corporation are
chartered by individual states.

Overdrafts
Unsecured short-term loans
Bridge loans
Currency swaps
Link financing.

177

178

EXTERNAL SOURCES OF FUNDS

EXTERNAL SOURCES OF FUNDS

3.

d. Functions are:
International banking, which includes deposits, loans,
letters of credits, and other normal banking operations.

International Banking Facilities of the US

are:

a.
b.
c.
d.
e.

International financing, which includes long-term financing

such as investment in stocks of non-bank financial
institutions and development banks.

A popular innovation in off-shore banking

No physical facilities needed
No permission needed
Free from most regulations
Should not do business with US residents.

Holding company, which owns shares of foreign banking

subsidiaries and affiliates.

179

180

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EXTERNAL SOURCES OF FUNDS

EXTERNAL SOURCES OF FUNDS

4. Strategic alliances:

5. Project finance
a. Project finance refers to an arrangement where a project
sponsor finances a long-term capital project
(i.e., Alaska oil pipeline or Euro Disney) on a basis.

a. A strategic alliance is any collaborative

agreement between two companies that is
designed to attain some strategic goal.

b. Project finance is either a build-operate-own contract

(BOO) or build-operate-transfer (BOT) project.
In a BOO contract, the sponsor assumes ownership of
the project at the end of the contract life.

b. Types of strategic alliance are:

Licensing agreements
Marketing arrangements or management contracts
Joint ventures.

In a BOT project, ownership of the project is transferred

to the host government.

181

182

EXTERNAL SOURCES OF FUNDS

EXTERNAL SOURCES OF FUNDS

8. Development Banks are:

7. Guidelines for adequate capitalization

a. Several ratios can be used to determine an optimum
mix of debt and equity for overseas projects.

a.
b.

The investor's own resources should be sufficient to

cover its fixed costs.
Equal amounts of debts and equity investments should
be used to finance overseas projects
The projected earnings from the overseas project
should be a substantial multiple of its annual financing
costs.

Established to support the economic development of

developing countries.
International: i.e., World Bank Regional: i.e., InterAmerican Development Bank National : i.e., Agency for
International Development.

183

184

BASIC CONCEPT OF WORKING CAPITAL

MANAGEMENT
1. Economic constraints of working capital
management include:

CHAPTER 15

a. Foreign exchange constraints

b. Regulatory constraints
c. Tax constraints.

INTERNATIONAL
WORKING CAPITAL
MANAGEMENT
185

186

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BASIC CONCEPT OF WORKING CAPITAL

MANAGEMENT

BASIC CONCEPT OF WORKING CAPITAL

MANAGEMENT
3. Arbitrage opportunities:

2.
a. The ability to adjust fund flows among
180
countries is one of the biggest advantages to
MNCs.
b. Many fund transfer techniques are questionable
and there are many conflicts of interest.
c. Positioning of funds involves the choice
of
location and the choice of currency
denomination.

a. Tax arbitrage: different tax laws allow MNCS to

reduce tax burden by shifting profits from
country to country.
b. Financial market arbitrage: different financial
markets allow MNCs to earn more from
investment and to reduce costs from financing.
c. Regulatory arbitrage: different regulations allow
MNCS to circumvent exchange and price controls.

187

188

DIFFERENT CHANNELS TO MOVE FUNDS

DIFFERENT CHANNELS TO MOVE FUNDS

1. Multilateral netting is a method to reduce foreign exchange

cost through consolidation of accounts payable and
accounts receivable among related entities.
2. Leads and lags are payments of financial obligations earlier
(leads) or later (lags) than are expected or required.

4.

Reinvoicing centers are established in tax haven countries

and take titles to all goods sold to one corporate unit to
other affiliates or independent customers.

5.

Intracompany loans (as compared with equity

investments) provide MNCs with tax benefits and easy
repatriation.

3. MNCs can adjust transfer prices up or down to avoid

financial problems or improve financial conditions.

189

190

DIFFERENT CHANNELS TO MOVE FUNDS

DIFFERENT CHANNELS TO MOVE FUNDS

6. Payment adjustments can be made through:

a. Fees are compensations for managerial
services and technical assistance.
b. Royalties are paid to use certain
technologies, patents, and trademarks.

7.

Unbundling international fund transfers:

a. Categorization of remittances for each purpose

makes it easier for MNCs to recover funds from
their affiliates.
b. Unbundling fund transfers is useful for business
operations in countries where interest and dividend
profits are considered unfavorable.

191

192

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CASH MANAGEMENT
1.

CASH MANAGEMENT

Objectives are :

2.

a. To optimize cash flow movements

b. To invest excess funds.

Floats are used to reduce opportunity cost and exchange

rate risk by shortening the following types of floats.
a. Invoicing float
b. Mail float
c. Processing float
d. Transit float
e. Disbursing float.

193

194

INVESTING EXCESS FUNDS

CASH MANAGEMENT

1. Portfolio management:

3. To maximize cash availability, MNCs must accelerate

collections and delay payments.
a. To accelerate collections, MNCs use lock boxes, cable
remittances, electronic fund transfers, and SWIFT.
b. To delay payments, MNCs use mail, more frequent
requisitions, and floats.
c. MNCs use cash centers to invest more profitably, reduce
overall financing costs, and reduce the total pool of cash
without any loss in the level of production.

a. Under Policy 1, known as zero portfolio,

access funds are used to pay the parent's shortterm debt because any portfolio investment will
earn less than the parent cost of short-term loans.
b. Under Policy 2, MNCs centralize cash management
at headquarters.
c. Under Policy 3, MNCs centralize cash management
in a few regions.

195

INVESTING EXCESS FUNDS

196

ACCOUNTS RECEIVABLE MANAGEMENT

2. Portfolio guidelines include:

1. Important considerations are tradeoffs between

currency denomination and credit terms.

a. Diversification
b. Marketability
c. Maturity
d. Safety
e. Daily review.

a. If sales are denominated in a weak currency,

higher prices and shorter credit terms are
expected.
b. If sales are denominated in a strong currency,
lower prices and longer credit terms are
expected.
197

198

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ACCOUNTS RECEIVABLE MANAGEMENT

2.

ACCOUNTS RECEIVABLE MANAGEMENT

Credit policy:
a. Credit standards are used to determine the acceptability of
loan applications and credit limits. Credit standards depend
on five C's of credit factors: character, capital, collateral,
capacity, and economic condition.
b.Credit terms have to do with cash discount and credit
period, such as 2/10, net 30: the opportunity cost of
terms 2/10, net 30 = 2/(100 - 2) x 360/20 = 37%.
c. Collection policy has to do with overdue accounts.
To collect overdue accounts, MNCs use letters (fax and
cables), phone calls, personal visits, and last resorts
(forgiveness, legal action, and use of collection
agency).

3. How to avoid currency value problems:

a. For intrafirm sales, MNCs use leading and lagging.
b. For sales to independent customers, MNCs use
currency denominations and factors.

199

200

INVENTORY MANAGEMENT
1. The basic purpose is to minimize the investment
on inventory.

CHAPTER 16

2. Advance purchases and stockpiling are necessary:

a. From abroad: if devaluation and import restrictions
are imminent.
b. From local sources: if inflation and termination of
price controls are likely.

INTERNATIONAL PORTFOLIO
INVESTMENT
201

TERMINOLOGIES

202

TERMINOLOGIES

1. Systematic risk (undiversifiable risk) cannot be

reduced or eliminated through diversification.

Type of Risk
Systematic

Domestic
Common to all firms:
Ex.--a country's tax laws,
recessions, inflation
Unsystematic To a particular firm:
Ex--a firm's wildcat strike,
new competitor

Unsystematic risk (diversifiable risk) can be

reduced or eliminated through diversification.

203

International______
Common to all countries:
Ex.--worldwide wars, energy
situations, recessions
To a particular country:
Ex.--a country's recessions,
currency control, inflation

204

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CAPITAL ASSET PRICING MODEL (CAPM)

TERMINOLOGIES
2. Market portfolio is a fully diversified group of risky
securities such as Dow Jones Industrial Averages,
Standard & Poor's 500 stocks, or the Nikkei Index
of Japan.

205

CAPITAL ASSET PRICING MODEL (CAPM)

1. If capital markets are perfectly efficient, then

expected rate of return = required rate of return.
a. Security market line kj = Rf + (Rm - Rf) j (see
16-2)
b. If markets are not perfectly efficient, then we
have undervalued stocks or overvalued stocks:
Undervalued stocks: If kj > Rf + (Rm - Rf) j (see
16-2)
Overvalued stocks: If kj < Rf + (Rm - Rf) j (see
16-2)
c. Beta coefficient: j = [(kj - Rf)/(Rm - Rf)]

Figure
may
Figure
Figure

206

CAPITAL ASSET PRICING MODEL (CAPM)

3. Correlation coefficients:
a Correlation coefficient is the degree of correlation
between two securities and range from zero (no
correlation or independent) to 1 (perfect
correlation).
b Diversification is most effective under conditions
of perfectly negative correlation (correlation
coefficient = -1).
c Diversification does not reduce risk at all under
conditions of perfectly positive correlation
(correlation coefficient = +1).

2. Aggressive vs Defensive Stocks:

If j>1: aggressive stock.
If j<1: defensive stock.

207

208

BENEFITS OF INTERNATIONAL DIVERSIFICATION

(ID)

EFFICIENT FRONTIER
1. Efficient portfolio is a portfolio that gives the highest
return for a given level of risk (see point W in Figure
16-3) or the smallest risk for a given level of return
(see point A in Figure 16-3).
2. Efficient frontier is a locus of all efficient portfolios
(see curve AW in Figure 16-3).
3. Optimal portfolio is the tangency point between the
security market line and the efficient frontier (see
point M in Figure 16-4).

209

1. Intercountry correlations are low because countries

have different geographic locations, independent
economic policies, and different endowments of
natural resources.
2. Low intercountry correlations imply that much of the
stock market risk in an individual country is
unsystematic and so can be reduced by ID (see Figure
16-5).
3. ID could allow investors to earn more money at lower
risk because of low intercountry correlations (see
Figure 16-6).
210

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METHODS OF INTERNATIONAL
DIVERSIFICATION FOR US INVESTORS

METHODS OF INTERNATIONAL
DIVERSIFICATION FOR US INVESTORS

1. International mutual funds are mutual funds that

contain securities of foreign companies.
2. American depository receipts, traded in US stock
exchanges, are the ownership of underlying foreign
stocks which are held in custody by the bank that
issue them.
3. Hedge funds are private partnerships that bet on
cross-border mergers and acquisitions, securities, or
currencies.

4. Direct purchases of foreign securities.

5. Investment in US multinational companies.
6. Global investing: A domestic fund manager has just
one way to beat the competition, by making better
stock picks, but an international fund manager has
three ways to add value, by picking countries, by
picking currencies, and by picking stocks.

211

212

BENEFITS OF FOREIGN DIRECT

INVESTMENT
1. Company benefits include oligopoly-created
advantages, such as proprietary technology,
management know-how, international
distribution network, and access to scarce
raw materials, economies of scale, and
strong brand or trade name.

CHAPTER 17
CORPORATE STRATEGY AND
FOREIGN DIRECT INVESTMENT

213

BENEFITS OF FOREIGN DIRECT

INVESTMENT

214

MODES OF FOREIGN INVESTMENT

2. Company benefits of foreign investment

classified by Ferdows include those that are
intangible (i.e., ideas from foreign research
centers) and tangible (i.e., low wages).
3. Host-country benefits include transfer of
technology, higher employment, learning
management skills, and increased tax
revenues and exports.
215

1.
2.
3.
4.
5.
6.

Construction of new plants (internal growth)

Mergers and acquisitions (external growth)
Joint ventures
Licensing agreement
Franchising agreement
Contract manufacturing

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DIRECT INVESTMENT IN THE THIRD WORLD

1.

Investment in the Third World fell since 2001 because of:

DIRECT INVESTMENT IN THE THIRD WORLD

2. Obstacles for foreign investment:
a.

a.

b.

In 2003, China for the first time attracted more foreign

investment than the US, but the overall investment fell
because of a slowdown in privatization and mergers-andacquisitions transactions.
The dip in foreign investment flows in 2003 was almost
entirely due to the decline in the flows to Latin America
and the Caribbean.

b.

c.

Unavoidable obstacles include bad roads, poor port facilities,

and lack of skilled workers.
Under inadvertent obstacles, governments permit obstacles
to exist but for reasons other than their impact on foreign
investment; an example is communism in Cuba.
Unintended obstacles include excessive red tape, corruptions
in the courts, and different political systems.

217

CROSS-BORDER MERGERS AND ACQUISITIONS

218

CROSS-BORDER MERGERS AND ACQUISITIONS

2. Mergers and corporate governance

1.
a. Internal growth is natural and economical, but it

a.

is too slow.
b. External growth--mergers and acquisitions--is an
alternative to internal growth.

The market-based system of corporate governance used

in the US disciplines inefficient management through
either friendly takeovers or hostile takeovers because
this system is characterized by a highly diversified equity
ownership, a large portion of public debt and equity
capital, and an independent management team.

219

CROSS-BORDER MERGERS AND ACQUISITIONS

b.

c.

In the bank-based system of corporate governance used

in Japan, hostile acquisitions are almost non-existent
due to the concentration of equity ownership in the
hands of the main bank and other keiretsu members.
Cross-holdings in Japan are weakening because the
networks of mutual shareholdings have turned from
benefit to burden.

221

220

CROSS-BORDER MERGERS AND ACQUISITIONS

3. Some accounting aspects of mergers
a.

Under the pooling-of-interest method, the items on the

balance sheets of the two companies are added together
so that the merger would not create goodwill.

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CROSS-BORDER MERGERS AND ACQUISITIONS

FACTORS AFFECTING ACQUISTIONS: VALUE OF THE

FIRM
A company's acquisition of another firm is
economically justified only if it increases the total
value of the company.

b. Under the purchase-of-assets method, the acquired

assets or companies are recorded in the accounts of
the acquiring company at the market values of assets
given in exchange. Thus, this method could create
goodwill.

Value of the Firm

c.

Because the purchase-of-assets method can create

goodwill that may result in lower reported earnings, it
is not popular in practice.

earnings before taxes (1 - tax rate)

capitaliza tion rate

223

224

FACTORS AFFECTING ACQUISTIONS: VALUE OF THE

FIRM

FACTORS AFFECTING ACQUISTIONS: VALUE OF THE

FIRM

1. Acquisitions will increase earnings before taxes

because of synergistic effects and diversification.
2. Acquisitions will result in lower taxes because of
tax carry forward and carry backward and other
tax benefits.
3. Acquisitions will reduce the capitalization rate
(required rate of return or the cost of capital)
because of better marketability for securities and
better known among investors.

4. Acquisitions will increase debt capacity without

additional risk because of greater borrowing ability
and under use of debt by some firms.
The appropriate mix of debt and equity reduces the
overall cost of capital and thus raises the market value of
the firm.

5. Other considerations, such as favorable exchange

rate movements and removal of country barriers,
are likely to increase the value of the acquiring
company.

225

226

VARIABLES THAT REQUIRE FORECASTING

Because the foreign investment decision process
involves the entire process of planning capital
expenditures for many years to come, MNCs need
forecasts of many variables related to their foreign
project.

CHAPTER 18
INTERNATIONAL CAPITAL
BUDGETING DECISIONS

1. Initial investment includes project cost and working capital

to support the project over time.
2. Demand forecast should cover expected domestic and
export sales.
227

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VARIABLES THAT REQUIRE FORECASTING

3. Prices of the product to be produced by the project will
depend largely on competition and the host government
policy.
4. Variable cost (i.e, direct labor and material costs) forecast
will depend on the prevailing comparative costs of the
components and inflation rates.
5. Fixed costs are easier to forecast than variable costs for
two reasons: their time horizon is short and they are less
sensitive to changes in demand.

VARIABLES THAT REQUIRE FORECASTING

Every project has three lives: physical, economic, and
tax.
a. An engineer can forecast the physical life
b. A financial manager can forecast the economic life
(subjective).
c. The tax life of a project depends on tax laws (objective).
d. The economic life and the tax life are important in
project analysis.

229

VARIABLES THAT REQUIRE FORECASTING

7.

230

VARIABLES THAT REQUIRE FORECASTING

9.
Tax laws differ across countries and a variety of tax
abatements should be sought.

Salvage value:
a. Salvage value is the expected value of an asset at the
end of its life.
b. Salvage value depends on the project's success and the
government's attitude.

10. Exchange rates affect every international project. The

impact of exchange rate changes on a project's cash flows is
called economic exposure, which covers the entire project
life and all aspects of operations.

8.
Some governments impose restrictions on
earnings transfer from subsidiaries to the parent.

231

232

ECONOMIC EVALUATION

ECONOMIC EVALUATION

1. Under an accept-reject decision criterion,

a.
b.

2. Under a mutually exclusive choice criterion,

MNCs usually accept all profitable projects.

Those projects under consideration must be
independent projects and are not subject to capital
rationing constraints.

a.
b.

233

At most one project is accepted.

The project to be accepted must meet criterion 1 and have
the highest rate of return among competing projects.

234

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ECONOMIC EVALUATION

ECONOMIC EVALUATION
4.

3. Capital rationing constraints:

a.

b.

A capital rationing constraint is the upper ceiling on the

size of capital expenditures. MNCs accept projects from
the top of the list until the capital budget is exhausted.
Those projects to be accepted must meet criterion 1,
should be independent projects, and should not exceed
the capital budget.

Numerical example:
Project
A
B
C
D

IRR
25%
20
14
8

Investment
$1,000
1,000
1,000
1,000

Assumptions: Cost of capital = 10%

Capital budget = $2,000

a.
b.
c.

Under accept-reject decision criterion, accept projects A, B, and C.

Under mutually exclusive-choice criterion, accept project A.
Under capital-rationing constraints, accept projects A and B.

235

236

RISK ANALYSIS
1. Risk Assessment Techniques
Standard deviation
Coefficient of variation
Range

RISK ANALYSIS
2. Each of pairs 1, 2, and 3 in the following table consist of two
mutually exclusive projects:

Risk Adjustment Techniques

Risk adjusted discount rate
Certainty equivalent approach
Capital asset pricing model

Pair
1
2
3

Project
NPV
A
$1,000
B
1,000
C
900
D
600
E
500
F
300

Standard Deviation
$400
700
400
400
300
210________

237

RISK ANALYSIS

238

RISK ANALYSIS

a. Project A is better because it has same NPV, but lower risk.

b. Project C is better because it has same risk, but higher return.
c. If we compute the coefficient of variation (CV), we know that
project E is better because it has higher return and lower risk.

3. Utility Theory
a. Assumptions: diminishing marginal utility; many non-intersecting curves; and
higher expected utility for each higher curve.
b. The role of utility theory is to bridge the gap between risk assessment
techniques and risk adjustment techniques.

CV for E = 300/500 = 0.60

CV for F = 210/300 = 0.70
d. Unfortunately, most pairs are like projects X and Y, thus making it
difficult to know which one is better.
X: NPV = $500
CV = 0.80
Y: NPV = $400
CV = 0.60

239

c. Graph illustration: Graph I-K is called the least acceptable project so project 5
is unprofitable and projects 1 through 4 are profitable.
1) Under accept-reject decision criterion, projects 1, 2, 3, and 4
are
accepted.
2) Under mutually exclusive choice criterion, project 1 is
accepted.
3) Under capital rationing constraints, accept projects in the order
of 1,
2, 3, and 4 until capital budget has exhausted).
240

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PORTFOLIO THEORY

RISK ANALYSIS
1.

Project A: NPV = $152; Standard

Deviation = $1000
Project B: NPV = -$48; Standard Deviation
= $1000
B will be rejected because of its negative
NPV, and A will be rejected because of its
high risk.

241

242

POLITICAL RISK ANALYSIS

PORTFOLIO THEORY

1. Political risks can be divided into two broad categories:

2. Portfolio NPV = $104; Portfolio Standard

Deviation = $0
a. This portfolio will be accepted because it has
a positive NPV without risk.
b. MNCs invest in many risky foreign projects
but still make money because
international
diversification can eliminate
or substantially
reduce unsystematic risk.

a. Operational restrictions are actions that

restrict the
freedom of a foreign company to operate in a given host country
b. Expropriation includes sales of business assets to local
shareholders, compulsory
sales of business assets to host
governments, and confiscation of
business assets with or
without compensation.

243

POLITICAL RISK ANALYSIS

244

POLITICAL RISK ANALYSIS

3. Defensive measures before investment

2. Political assessment techniques

a. Concession agreements
b. Planned divestment
c. Adaptation to host country goals

a. Delphi technique
b. Grand tour
c. Old hand
d. Quantitative analysis

245

246

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POLITICAL RISK ANALYSIS

CHAPTER 19

4. Defensive measures after investment

a. Becoming a good citizen of the host country
b. Alleviating political risks
c. Joint ventures

THE COST OF CAPITAL FOR

FOREIGN PROJECTS
247

248

FACTORS AFFECTING THE COST OF

CAPITAL

FACTORS AFFECTING THE COST OF

CAPITAL

1. a. size of firm
b. access to international capital markets
c. international diversification
d. taxes
e. exchange rate risks
f. country risks.

2. Factors a through d favor MNCs. Factors e and f appear

to favor purely domestic companies, but this is not
necessarily true because international operations are less
correlated than purely domestic operations, thus making
MNCs to be less risky than companies which operate
strictly within the boundaries of any one country.

249

250

OPTIMUM CAPITAL STRUCTURE

OPTIMUM CAPITAL STRUCTURE

2.

1.

Optimum capital structure is the combination of

debt, preferred stock, and common equity that will
minimize the cost of capital.

Weighted average cost of capital is the same as the

cost of capital.

a. Cost of debt, cost of preferred stock, and cost of

common equity are computed first and then they are
weighted to determine the weighted average cost of
capital.
b. Once we compute the cost of each component of the
capital structure, we usually weigh them according to
three weights--book value, market value, and target
weights.
251

252

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OPTIMUM CAPITAL STRUCTURE

OPTIMUM CAPITAL STRUCTURE

3. Numerical Examples: Assumptions

a.
b.
c.

Capital

Net Proceed Weight After-Tax Cost Weighted Cost

Debt
Preferred
Common
Total

Before-tax interest = 9%; tax rate = 50%

Preferred dividend = $2 a share; price per share = $25
Common dividend in yr 1 = $4; price = $40;
growth rate = 4%

$ 60 million
20
120
$200 million

0.3 x 0.045
0.1 x 0.080
0.6 x 0.120
1.0

= 0.0135
= 0.0080
= 0.0720
0.0935

Normally, MNCs have a higher optimum capital

structure than domestic firms without added
risk
because MNCs have lower cost and lower
risk.

After-tax interest = 0.09(1 -0.50) = 0.045

Cost of preferred stock = dividend/price = 2/25 = 0.08
Cost of common stock = dividend in year 1/price +
growth rate
= 4/50 + 0.04 = 0.12
253

OPTIMUM CAPITAL BUDGET

1.

254

OPTIMUM CAPITAL BUDGET

Definition: the amount of investment that will

maximize a firm's total profits.

Optimum Capital Budget: Domestic Firm versus Multinational Firm

2. Optimum capital budget is obtained at the point

where the marginal cost of capital equals the marginal
rate of return.
3. The following graph shows that MNCs have a higher
optimum capital budget because of their lower cost of
capital and more profitable investment opportunities.
255

256

CULTURAL VALUES AND CAPITAL STRUCTURE

CHAPTER 20

1. Researchers found that cultural values (i.e., political, legal,

social, institutional, and tax environments) can be used to
predict capital structure across countries.
2. Researchers found low debt ratios in the Southeast Asia, Latin
American, and Anglo-American groups of countries. They found
high debt ratios in the Scandinavian, Mediterranean Europe,
Indian Peninsula groups.

CORPORATE PERFORMANCE OF
FOREIGN OPERATIONS

3. Countries with the cultural dimensions of conservatism and

mastery tend to have low corporate debt rations.

257

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GLOBAL CONTROL SYSTEM AND PERFORMANCE

EVALUATION

GLOBAL CONTROL SYSTEM AND PERFORMANCE

EVALUATION
3. Performance evaluation

1. Every control system establishes a standard

of performance and compares actual
performance with the standard.

a. Performance evaluation is a central feature of an

effective management information system.
c. Performance criteria consist of financial criteria
(i.e., return on investment and profits) and nonfinancial criteria (i.e., market share and sales
growth).

2. Inflation and exchange rate fluctuations

affect company performance.

259

260

GLOBAL CONTROL SYSTEM AND PERFORMANCE

EVALUATION

GLOBAL CONTROL SYSTEM AND PERFORMANCE

EVALUATION

4. Organizational structure

c.

a. The advantages of a centralized financial function

includes close control of financial issues at
headquarters, attention of top management to
key issues, and an emphasis on parent company
goals.
b. A decentralized financial function may reduce
data collection costs, enjoy flexibility, and exploit
many opportunities in foreign countries.

The ultimate choice of a particular organization

structure depends on several key decision variables:

1. transfer pricing and performance evaluation

2. tax planning
3. exchange exposure management
4. acquisition of funds
5. positioning of funds

261

GLOBAL CONTROL SYSTEM AND PERFORMANCE

EVALUATION

b.
c.

INTERNATIONAL TAXATION
1. Types of taxes:

5. Foreign Corrupt Practices Act (FCPA) of 1977

a.

262

FCPA makes it a criminal offense for US companies to

corruptly influence foreign officials or to make payments to
any person when they have reasons to know that part of
these payments will to a foreign official.
FCPA consists of two separate sections, antibribery and
accounting.
Penalties for violations include $2 million for corporations
and $100,000 and/or five years in jail for individuals.

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a. Income and capital gains taxes

b.Value added taxes
c. Tariffs
d.Withholding taxes

264

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INTERNATIONAL TAXATION

INTERNATIONAL TAXATION

2. Key issues in international taxation

3. Tax incentives for foreign investment

a.Many countries offer tax incentives to attract
foreign capital and know-how to
their countries.
b. The four types of tax incentive programs are:

a. Tax morality
b. Tax burdens
c. Tax neutrality
d. Tax treaties
e. Tax credits

(1) government concessions

(2) tax havens
(3) foreign trade zones
(4) other tax incentives
265

TRANSFER PRICING AND TAX PLANNING

266

TRANSFER PRICING AND TAX PLANNING

1. Transfer prices are prices of goods and

services sold between parent companies and
subsidiaries. MNCs can manipulate transfer
prices to increase their overall profits.

267

2. Transfer pricing objectives:

a. Income tax minimization
b. Import duty minimization
c. Avoidance of financial problems
d. Adjustment for currency fluctuations

268

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