Chapter 25 international financial management
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2002 Prentice Hall Publishing Chapter 25 - PowerPoint PPT Presentation


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Chapter 25 International Financial Management . Motivation for International Investment. Provide a return in excess of that required Expansion into foreign markets Produce more efficiently Lower operating costs Secure necessary raw materials. International Capital Budgeting.

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Chapter 25 international financial management l.jpg
Chapter 25International Financial Management


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Motivation for International Investment

  • Provide a return in excess of that required

    • Expansion into foreign markets

    • Produce more efficiently

    • Lower operating costs

    • Secure necessary raw materials


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International Capital Budgeting

  • Estimate expected cash flows in foreign currency

    • Repatriated

    • Nonremittable - investment unlikely

  • Compute U.S. dollar equivalents at the expected exchange rate

  • Determine the NPV of the project using the U.S. required rate of return, adjusted for any risk premium

  • Critical assumptions


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Risk Factors

  • Diversification will reduce risk if global markets are partially segmented

  • With an integrated market for securities, the investor is able to reduce risk more quickly and further by diversifying across international stocks as opposed to only domestic ones


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What Makes Direct Foreign Investment Different?

  • Complex taxation

  • Political risk

  • Exchange rate risk


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Taxation

  • U.S. government

    • Income from a branch or division is taxed in the same way as domestic income

    • Income from a foreign subsidiary is not taxed in the U.S. until it is distributed to the parent as dividends

    • Gives a federal tax credit for foreign taxes

  • Foreign governments

    • Type of tax imposed varies between income distributed to stockholders and undistributed income

    • Less-developed countries frequently have lower taxes

    • Definitions for what constitutes taxable income are different for different countries


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Political Risk

  • Assessing political risk realistically

    • Forecasting political instability

    • Take steps to protect investment by cooperating with the host country

      • Joint venture

    • Make subsidiary dependent on the parent for technology, markets, and/or supplies


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Types of Exchange Rate Exposure

  • Translation exposure is the effect of an exchange-rate change on the accounting balance sheet and income statement

  • Transaction exposure is the effect of an exchange-rate change upon the value of a single transaction

  • Economic exposure is the effect of an unanticipated change in exchange rates on the economic value of the firm

    • Most important exposure


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Degrees of Exposure on Existing Assets and Liabilities

  • Hekman has derived a framework for categorizing assets and liabilities as to their degree of exposure

  • Coefficient of 1.0 means the market value of the balance sheet item is entirely exposed

  • Coefficient of 0.0 means the market value is unexposed

  • Coefficients between 0 and 1 means the item is partially exposed


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Aggregate Economic Exposure

=

Net aggregate market-value exposure

Market value of equity

  • Measures the degree and sensitivity of economic exposure

  • Typically the more global the market served, the less the overall exposure

  • Framework used to assess the economic exposure of the existing balance sheet of the foreign subsidiary


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Exposure of Expected Future Cash Flows

  • Natural hedge exists whenever the effect of an exchange-rate change is offset by an opposite change in local currency margins

  • Degree of exchange-rate exposure of a foreign subsidiary is that which remains after any natural hedge

  • Exposure can be approximated by determining whether pricing and costs are more sensitive to local-market or global-market conditions

  • Residual exposure remains after we take account of any natural hedge that represents exchange-rate risk

  • Management needs to decide whether it wishes to hedge the residual risk


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Operating Hedges

  • Cash management among countries through intracompany accounts

  • If a company knew a currency were going to fall in value

    • Reduce cash to a minimum by purchasing inventories or other real assets

    • Avoid extended trade credit

    • As quick a turnover as possible of receivables

    • Obtain extended terms on its accounts payable

    • Borrow the local currency


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Currency Strategies

  • Balance monetary assets against monetary liabilities in order to neutralize the effects of exchange-rate fluctuations

  • Accelerating the timing of payments made or received in foreign currencies is called leading, and decreasing the timing is called lagging

  • Adjust intracompany dividends and royalty payments

  • Establish a reinvoicing center to manage intracompany and third-party foreign trade

    • Centralize and manage all exposure

    • Facilitates the netting of obligations among units

    • Allows for more coordinated control over leading or lagging arrangements between affiliates


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International Financing

  • Asset sensitive exposure would be balanced with borrowing

  • Sources of external financing

    • Commercial bank loans and trade bills

    • Eurodollar financing

    • Bond financing

      • Eurobond market

      • Foreign bond

    • Currency-options

    • Conversion option

    • Currency cocktail

    • Dual currency bond


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Currency Market Hedges

  • Forward contracts

  • Futures contracts

  • Currency options

  • Currency swaps


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Forward Exchange Market

  • Well suited for hedging transactions exposure

  • Forward contract provides assurance of being able to convert into a desired currency at a price set in advance

  • Foreign currency sells at a forward discount if its forward price is less than its spot price

  • Sells at a forward premium if its forward price exceeds the spot price

  • Euro is a common currency for the European Monetary Union (EMU)


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Foreign Exchange Market (FX)

  • Worldwide network of traders, connected by telephone lines and computer screens

  • Centers of trading

    • Great Britain

    • United States

    • Japan

    • Singapore

    • Switzerland

    • Hong Kong

    • Germany

    • France

    • Australia

  • Trading goes on 24 hours a day

Half of all FX transactions



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Currency Futures

  • Markets exist for major currencies

  • Futures contract is a standardized agreement that calls for delivery of a currency at some specified future date

  • Transactions are with a clearinghouse

  • Very few contracts involve actual delivery at expiration

  • Futures contract is marked-to-market


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Currency Options

  • Enable the hedging of “one sided” risk

  • Holder has the right to buy or sell the currency over the life of the contract

  • For this protection, one pays a premium


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Currency Swaps

  • Long-term hedging vehicle

  • Two parties exchange debt obligations denominated in different currencies

  • Each party agrees to pay the other’s interest obligation

  • Only cash-flow differences are paid

  • There is not an actual exchange of principal

  • Currency swaps can be combined with interest-rate swaps


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Should Exposure be Managed?

  • A case can be made for the various hedging strategies if imperfections and incompleteness occur in international product and financial markets

  • Most companies manage their currency-risk exposure

  • Few companies are willing to risk everything on future exchange rates

  • Real issue is the degree of management

  • Shareholders would be better off with a degree of self-insurance

  • 100 percent hedging does not produce superior investment results


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Macro Factors Governing Exchange-Rate Behavior

  • Purchasing power parity (PPP) works through differences in inflation between countries

  • With interest-rate parity (IRP), forward discounts and premiums are driven by differences in interest rates

  • International Fisher effect (IFE) suggests that differences in interest rates between two countries serve as a proxy for differences in expected inflation

  • Arbitrage actions will continue until interest-rate parity is established


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Principal Documents Involved in International Trade

  • The draft is an order by the exporter to the importer to pay a specified amount of money either upon presentation of the draft or a certain number of days after presentation

  • A bill of lading is a shipping document that can serve as a receipt, as a shipping contract, and as title to the goods involved

  • A letter of credit is an agreement by a bank to honor a draft drawn on the importer


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Financing Trade

  • Countertrading is where the selling party accepts payment in the form of goods as opposed to currency

  • Factoring is where the factor assumes the credit risk, so the exporter is assured of being paid

  • Forfaiting is where an exporter who is owed money evidenced by a longer-term note, as opposed to a receivable, sells the note to a financial institution at a discount


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