International Financial Management

1. International Financial Management Chapter 18

2. International Financial Management: Topic Outline • Introduction • determining currency, methods of payment • Foreign exchange risk • identification of types, management of • Working capital management • complications, challenges and solutions • International Capital Budgeting • complications, alternative methods

3. Introduction • International business transactions not only require the buyer and seller to reach agreement on price, quantity, and delivery date, they also require buyers and sellers to negotiate and agree on which currency to use for the transaction, when and how to check credit, which form of payment to use, and how to arrange for financing.

4. Currency Selection • Exporters typically prefer to be paid in their home currency so that they know exactly how much they will be receiving from the importer. Importers, however, typically prefer to pay in their home currency so that they know exactly how much they will be paying the exporter. In some cases, a third country currency will be selected. For example, the U.S. dollar is generally used for transactions in the oil industry.

5. Checking Credit • It is important for firms to check the credit of their customers prior to completing a business transaction. In situations where the importer is financially healthy, exporters may choose to extend credit. However, if an importer is financially troubled, an exporter may demand payment in a way that reduces its risk.

6. Methods of Payment • There are several methods of payment for international business transactions including payment in advance, open account, documentary collection, letters of credit, and countertrade. Each form involves a different degree of cost and risk.

7. Methods of Payment • Payment in Advance • The safest method of payment from the exporter’s perspective is payment in advance, however this method of payment is very undesirable from the importer’s point of view.

8. Methods of Payment • Open Account • The safest method of payment from the importer’s perspective is the open account, whereby goods are shipped by the exporter and received by the importer prior to payment. In addition, the importer benefits from this form of payment because it avoids the fees that may be associated with other forms of payment, and requires less paperwork.

9. Methods of Payment • Open accounts are not desirable for exporters because the exporter must rely on the importer’s reputation to pay promptly, it cannot fall back on financial intermediaries in the case of a dispute, the lack of documentation may be disadvantageous if the importer refuses to pay, and working capital must be tied up to finance foreign accounts receivable.

10. Methods of Payment • Documentary collection is more complex and costly than the two previously mentioned options, and less complex and expensive than letters of credit (which are discussed next). • They will not be reviewed here, nor do they need to be understood or memorized for the exam.

11. Methods of Payment • Letters of Credit • International businesses may use letters of credit to arrange for payment. A letter of credit is a document that is issued by a bank and contains its promise to pay the exporter upon receiving proof that the exporter has fulfilled all requirements specified in the document. Exporters bear less risk by using a letter of credit than by relying on documentary collection.

12. Methods of Payment • An importer applies to its local bank for a letter of credit. In the bank’s assessment of the importer’s credit worthiness, various documentation may be required such as invoices, customs documents, a bill of lading, export licenses, certificates of product origin, and inspection certificates.

13. Fig 18.2 Using a Letter of Credit

14. Methods of Payment • After issuing the letter of credit, the importer’s bank sends it and the accompanying documents to the exporter’s bank, which then advises the exporter of the terms of the instrument, creating an advised letter of credit. The exporter could request its own bank to add a guarantee of payment to the letter of credit creating a confirmed letter of credit.

15. Methods of Payment • An irrevocable letter of credit cannot be altered without the written consent of both the importer and the exporter, while a revocable letter of credit may be altered at any time for any reason. • Since banks charge a fee for these services, companies must determine which are necessary forms of insurance and which are not.

16. Methods of Payment • Countertrade occurs when a firm accepts something other than money as payment for its goods and services. • Countertrade is widely used in international business, and may account for as much as 40 percent of world trade. • There are various forms of countertrade.

17. Methods of Payment • Firms may establish clearinghouse accounts to facilitate countertrade. Switching arrangements (countertrade obligations transferred from one firm to another) may be used by firms that enter into countertrade agreements in order to expand their international sales, without having experience in it or the desire to engage in countertrade.

18. Methods of Payment • Each method of payment has various costs and risks associated with it. In the end, the exporter must decide how much risk and cost to bear.

19. Relative costs and risks of 4 basic, different payment options • Lowest to highest risk (to exporter): prepayment, letter of credit, countertrade, open account • Highest to lowest cost (to exporter): • letter of credit, countertrade, open account, prepayment

20. Foreign Exchange Rate Risk • There are three types of foreign-exchange exposure that confront international firms: • 1. Transaction • 2. Translation • 3. Economic

21. Foreign Exchange Rate Risk • A firm faces transaction exposure when the financial benefits and costs of an international transaction can be affected by exchange-rate movements that occur after the firm is legally obligated to complete the transaction.

22. Foreign Exchange Rate Risk • Various transactions including the purchase of goods, services or assets, the sale of goods, services, or assets, the extension of credit, and borrowing money can lead to transaction exposure. • Firms can respond to transaction exposure by going naked, buying the required currency forward, buying the required currency in the currency options market, or acquiring an offsetting asset (or liability).

23. Foreign Exchange Rate Risk • Consider the following transaction for the discussion that follows. Saks has agreed to purchase some fashion goods from an Italian manufacturer. Saks will pay the full amount due in 90 days in Italian lira. Thus, Saks has a *liability* outstanding, due in 90 days, in a foreign currency. • What follows is a discussion of Saks’ options to manage the foreign exchange risk from this transaction.

24. Foreign Exchange Rate Risk • Go Naked • Saks can ignore transaction exposure by simply deciding to buy required currency when it is needed. An advantage to this method is that capital does not need to be tied up unnecessarily, nor does it have to pay fees to any intermediaries. Further, Saks may be able to benefit from exchange rate movements.

25. Foreign Exchange Rate Risk • Saks could buy the required foreign currency in the forward market, locking in the price it will pay for the currency. Like going naked, this strategy allows a company to keep its capital free for other uses, however, it also provides Saks with a guaranteed price it will pay for the foreign currency. Saks will miss any opportunity to capitalize on exchange-rate movements though.

26. Foreign Exchange Rate Risk • A similar strategy to buying in the forward market is buying in the futures market (see Ch 7). • The choice between the two markets will be affected by the price of the required currency and relative transaction costs.

27. Foreign Exchange Rate Risk • Saks could acquire a currency options contract, allowing it to buy the required currency (see Ch 7). This would give Saks the opportunity, but not the obligation, to buy the required currency at a given price in the future. Thus, this strategy gives companies the option of capitalizing on movements in exchange-rates. The main disadvantage to this strategy is that it is relatively more expensive than the others.

28. Foreign Exchange Rate Risk • Saks could also neutralize its exposure by acquiring an offsetting asset of equivalent size, denominated in the same currency. The primary disadvantage of this approach is that it may require Saks to tie up some of its capital.

29. Cost and risk for different options to manage transaction exposure • Lowest to highest risk: • buying in forward market, buying an offsetting asset, buying a currency option, going naked • Highest to lowest cost: • currency option, forward market, offsetting asset, going naked

30. Foreign Exchange Rate Risk • Translation exposure (also known as accounting exposure) is the impact on the firm’s consolidated financial statements of fluctuations in exchange rates that change the value of foreign subsidiaries as measured in the parent’s currency. International accounting is covered in Chapter 19.

31. Foreign Exchange Rate Risk • A firm’s translation exposure may be reduced through the use of a balance sheet hedge. A balance sheet hedge is created when an international firm matches its assets denominated in a given currency with its liabilities denominated in the same currency.

32. Foreign Exchange Rate Risk • It may be difficult to avoid both transaction and translation exposure. Since transaction exposure can result in real losses while translation exposure only results in paper losses, it is generally recommended that transaction exposure be avoided before translation exposure is.

33. Foreign Exchange Rate Risk • Economic exposure is the impact on the value of a firm’s operations of unanticipated exchange-rate changes. This type of exposure affects virtually every area of operations. • Long term investments in property, plant, and equipment are particularly vulnerable to economic exposure.

34. Foreign Exchange Rate Risk • There are other ways for dealing with economic exposure. For example, the text notes that the Walt Disney Corporation used a bond hedge to protect itself from changes in the yen-dollar relationship.

35. Foreign Exchange Rate Risk • It is also important for firms to analyze likely changes in exchange-rates, and consult with experts about long-term trends. For example, although there is a common perception that the dollar is losing value against most currencies, in reality it has actually appreciated against most currencies, and has depreciated against relatively few.

36. Changes in Currency Values versus the US$, 98/02 to 93/02

37. Changes in Foreign Exchange Rates

38. Working Capital Management • Working capital is held to facilitate day-to-day transactions and to cover the firm against unexpected demands for cash. However, since the return on working capital is low, financial managers generally try to minimize balances.

39. Working Capital Management • One means of minimizing working capital balances is centralized cash management which involves coordinating an MNC’s worldwide cash flows and pooling its cash reserves.

40. Working Capital Management • Because there is a lot of internal trade among the various units of some MNCs, firms may experience a constant need to transfer funds among the subsidiaries’ bank accounts. Cumulative bank charges for these transactions can be high, and consequently most MNCs use netting operations, where possible, to minimize the amount of funds that must be converted.

41. Working Capital Management • Bilateral netting is done between two business units, and multilateral netting is done among three or more business units. • Firms may use a leads and lags strategy to try to increase their net holdings of currencies that are expected to rise in value and decrease their net holdings of currencies that are expected to fall in value.

42. Figure 18.3 Payment Flows without Netting

43. International Capital Budgeting • The more common approaches to evaluate investment projects are net present value, internal rate of return and payback period.

44. International Capital Budgeting • Firms calculate the net present value of a project by estimating the cash flows the project will generate in each time period, and discounting them back to present. • When evaluating international projects, firms must also consider risk adjustment, currency selection, and choice of perspective for the calculations.

45. International Capital Budgeting • Risk Adjustment • Firms may adjust the discount rate upward, or the expected cash flows downward, to account for a higher level of risk that may be associated with a project in a particular country.

46. International Capital Budgeting • Choice of Currency • The choice of which currency the project should be evaluated in depends on the nature of the project. A project that is integral to a subsidiary’s strategy may be evaluated in the foreign currency for example, while a project that is central to the firm’s overall strategy might be evaluated in the home country’s currency.

47. International Capital Budgeting • Whose Perspective: Parent’s or Project’s? • A firm must decide whether to evaluate a project’s potential in terms of the cash flows of the individual project, in terms of its impact on the parent company, or in terms of both. • In addition, any governmental restrictions on currency movements that might affect the firm’s ability to repatriate profits must be considered.

48. International Capital Budgeting • A project can also be evaluated using the internal rate of return. This method requires that managers first estimate the cash flows generated by each project under consideration in each time period, then the interest rate, or the internal rate of return is calculated that makes the net present value of the project just equal to zero.

49. International Capital Budgeting • The project’s internal rate of return is then compared to the hurdle rate, the minimum rate of return the firm finds acceptable for its capital investments.

50. International Capital Budgeting • A firm can also calculate a project’s payback period, the number of years it will take to recover, or pay back, from the project’s earnings the original cash investment, when evaluating projects. This method is a simple one, however, it ignores the profits generated by the investment in the longer run.