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International Corporate Finance Prof. Edith Littich-Nemec

International Corporate Finance Prof. Edith Littich-Nemec. Financial Decisions of MNC’s. Investment (Capital Budgeting) Assessment Criteria and Selection of Assets Selection Among Competing Projects Growth Strategy (Natural Growth vs. M&A) Assets Management Financing Capital Structure

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International Corporate Finance Prof. Edith Littich-Nemec

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  1. International Corporate FinanceProf. Edith Littich-Nemec

  2. Financial Decisions of MNC’s • Investment (Capital Budgeting) • Assessment Criteria and Selection of Assets • Selection Among Competing Projects • Growth Strategy (Natural Growth vs. M&A) • Assets Management • Financing • Capital Structure • Cost and Risk • Funding Considerations • Dividend Policy • Payout Ratio • Retained Earnings

  3. Investment Decision Firm’ s CEO Simulation Model Financial Resources PARENT COMPANY FOREIGN AFFILIATE Know-How Taxes Foreign Tax Authority Input Market Consumer Market HOME TAX AUTHORITY Interest Payments, Dividends, License Fees, Loan Repayment

  4. Foreign Direct Investment • Why investing abroad? • risk-minimizing explanation • profit-maximizing explanation • How to invest abroad • Joint Venture • Merger&Acquisition • Licensing and Management Contract • Strategic Alliance • Foreign Subsidiary • Where to invest abroad? Political Risk Assessment

  5. Political Risk • Definition • possible occurence of political events of any kind (such as war, revolution, expropriation, taxation, devaluation, exchange control and import restriction) at home or abroad that cause a loss of profit potential and/or assets in international business operations (Root,1968) • Forms • Macro Risk • affects all foreign firms • Micro Risk • affects specific firms/industries

  6. Political Risk Assessment • macro techniques (scoring models, indexes) • Euromoney’s Country Risk Rankings • Frost and Sullivan’s World Political Risk Forecasts • Business International ‘s Country Assessment Service • micro techniques • inspection visits, “the grand tour” • old hands • delphi techniques • quantitative methods (sensitivity analisis, simulation models, decision trees)

  7. Dimensions of Managerial Risk-Adjustment • Parent/project viewpoint • Role of investment in MNE‘s portfolio • Cash Flow/Discounting Rate Adjustments

  8. The EUROMONEY Country Risk Evaluation • polls a cross-section of experts • categories • economic data (25%) • political risk (25%) • subjective scores made by risk analysts, risk insurance brokers and bank credit officers • debt indicators (20%) • debt service record, external debt, ease of rescheduling • credit ratings (10%) • Moody’s, S&P • market indicators (20%) • access to bank finance, access to short-term fiance, access to capital markets, access to forfaiting market (discount rates) • monthly published, extended annual analysis

  9. Host Government Intervention • Non-discriminatory regulations • e.g. Blocked Funds (limitation of transfers of foreign exchange out of the country) • Discriminatory regulations • e.g. Joint Venture Minorities • Wealth deprivation • e.g. nationalization of an entire industry • e.g. expropriation of a single firm

  10. Berger GmbH is a German firm located in Dortmund considering the establishment of a joint venture abroad which would produce and sell bricks. Two managers have been assigned the task of assessing the country risk (political and exchange transfer risk). The decision on whether to undertake this project will be made only once this country risk analysis is completed. Since Berger GmbH has focused exclusively on domestic business in the past, it is not accustumed to country risk analysis. In order to get first information, the country risk is analysed on the basis of published information. Compare the risk situation of three different countries, respectively, based on the assumption that Berger wants to enter a market in one of the following regions: • South-East Asia • Arabia • North Africa • Central-America • Latin America • Baltic States

  11. Assignment 1 Case Study IBM Thailand due: 15/12 • IMPORTANT STEPS • DEFINE THE PROBLEM(S) INVOLVED • GENERATE ALTERNATIVES AND EVALUATE THEM • MAKE A DECISION AND EXPLAIN WHY • SUGGESTIONS HOW TO PROCEED • READ THE CASE ONCE AND MAKE NOTES • DEFINE THE PROBLEM(S) AND DISCUSS YOUR RESULTS WITH COLLEGUES • READ THE CASE A SECOND TIME AND CREATE ALTERNATIVES (GROUP WORK) • MAKE A DECISION AND DO THE INDIVIDUAL (!) WRITE-UP • CASES HAVE NO SINGLE SOLUTION !!!

  12. EXPORT CREDIT INSURANCE protects exporters against the risk of nonpayment by a foreign buyer as a result of political or default risk GUARANTEES repayment of export loans extended by US banks to foreign borrowers LOANS loans to foreign buyers or financial intermediaries FOREIGN CREDIT INSURANCE (FCIA ), OVERSEAS PRIVATE INVESTMENT Corp (OPIC) PRIVATE EXPORT FUNDING CORP. (PEFCO) EXIMBANK EXPORT CREDITS GUARANTEE DEPARTMENT (ECGD) HERMES KREDITVERSICHERUNGS AG COMPAGNIE FRANCAISE D’ASSURANCE POUR LE COMMERCE EXTERIEUR (COFACE) OESTERREICHISCHE KONTROLLBANK (OKB) Government Programs to Motivate International Trade

  13. Political Risk/Pre-Investment Phase • Political Risk Insurance • Export Credit Institutions • Private Insurance companies • Host Government Arrangements (‘concession agreements’), Unconditional Guarantees • capital transfer policy • access to local capital markets • ownership and control • transfer pricing • social and economic obligations • price controls • taxation • employment of expatriate personnel

  14. PR II/Operating and Financial Strategies • Keep the host country dependent • local sourcing (e.g. gearing) • Create benefits for the host country • hire and train local employees • develop relationships (shareholders, creditors, suppliers) • support government programmes • Plan an exit-strategy • short-term profit maximization • quick withdrawal of profits, no reinvestment • deferring maintenance expenditures • maximize payments in the form of • royalties, dividends, licence fees, transfer prices, etc. • planned divestment

  15. The EMS 79-92 • PRIMARY GOALS • establishment of a zone of exchange rate stability to foster trade and growth • accelerating the integration within the EU • EMS MECHANISM IN THE PAST • exchange rate movements between EMS members within +/- 2.5%, ESP and PTE +/- 6% • interventions to prevent participating currencies to exceed these margins • EUROPEAN CURRENCY UNIT (ECU) • basket of fixed amounts of EU currencies • actual use • settlement between central banks within EU • international credit and bond market

  16. Recent Developments - the EMU • PRIMARY GOAL • replacement of national currencies by a single EU currency (“EURO”) managed by a sole central bank starting in 1999. • STEPS TO CREATE THE EMU • Maastricht Treaty to set convergence criteria • inflation rate within 1.5 percentage points of the average of three lowest inflation rate countries • interest rates within 2 pp of the average of three lowest interest rate countries • budget deficit below 3% of GNP • national debt below 60% of GNP • no currency devaluations in the last 2 years.

  17. EMU- Timetable DEM/XEU FRF/XEU GBP/XEU CHF/XEU DEM/EURO FRF/EURO GBP/EURO CHF/EURO spring 1998 31.12.1998 1.7.2002 • selection of 11 EMU members • Austria, Belgium, Finland, France, • Germany, Ireland, Italy, Luxembourg • Netherlands, Portugal, Spain*) • establishment of bilateral conversion rates establishment of e.g. DEM/EURO conversion rates with 1 ECU=1 EURO *) UK, Sweden and Denmark chose to keep their currencies, Greece did not meet convergence criteria

  18. What happens on .... • January 1st, 1999 • exchange rates between Euro and national member currencies were set • contracts, securities, deposits, loans atc. denominating in ECU were transferred into Euro • books and accounts may be kept in Euro • January 1st, 2002 • national currencies do no longer exist as ‚book money‘ • money transfers only in Euro • accounting only in Euro • Euro in cash available • July 1st, 2002 • national currencies no longer exist in cash transactions

  19. Euro- Effects on International Corporate Finance • Exchange Rate Risk • no further risk with Euro members (e.g. France, Italy) • limited risk with several non-members (e.g. Slovakia, Hungary, Poland, Bulgaria) • New Money Market Reference Interest rate (EURIBOR= Euro Interbank Offered Rate) replaces VIBOR and other rates • quoted by a panel of 57 European banks • daily quotation • 1 week-12 months • better access to international loans

  20. FX Rate Determinants • Parity Conditions • Relative inflation rates (PPP) • relative interest rates (Fisher effect) • Forward exchange rates • Exchange rate regimes • Efficial monetary regimes • Infrastructure • Banking system • Securities markets • Outlook for growth and profitability SPOT RATE • Speculation • Currencies • Securities • Uncovered Interest • Arbitrage • Real estate • Commodities • Cross-Border • Investment • FDI • Portfolio • investment • Political Risk • Capital controls • Black market • Exchange Rate spreads • Risk premium

  21. The Purchasing Power Parity (PPP) P(USD) P(EURO) USD/EURO EXCHANGE RATE

  22. The Purchasing Power Parity (PPP) Concept • changes in the ratio of domestic prices of internationally traded goods should be offset by exchange rate differentials. EV(Exchange Rate) in % = EV(Relative Prive Levels) in % • Example: • inflation 8% in the US • inflation 12% in Italy • expected exchange rate movement: • 0.08-0.12 = -0.036 (3.6% lira decrease in terms of dollars) 1.12 • Is PPP valid to forcast exchange rate movements?

  23. Empiricism and PPP • Hypothesis: PPP should hold if • changes in the economy originate from monetary sector • internal relative price structures remain relatively stable • no structural changes occur in the economy • Empirically • PPP is substantially violated in the short run • markets are not functioning perfectly • international price segmentation • local goods and services • there is some (!) evidence it might hold in the long run

  24. Interest rates and inflation rates • Irving Fisher • “Nominal domestic interest rates reflect anticipated real returns adjusted for local inflation expectations” • internationally: interest rate differentials should be offset by expected inflation differentials • + Expectations Theory • differences between forward and spot rates should be equal to expected change in spot rate • = International Fisher Effect • links interest rate differential with expected spot rates • differences in domestic interest rates should be equal to expected change in spot rate

  25. FX Market Participants • Bank and Nonbank FX Dealers • Individuals and Firms • Speculators • Arbitragers • Central Banks and Treasuries • FX brokers

  26. Arbitrage and Speculation • ARBITRAGE • Process of simultaneously buying and selling to take advantage of a price and yield differential • SPECULATION • Process of taking an open position and hoping that e.g. exchange rates will move towards the expected direction • spot market speculation • forward market speculation • option market speculation

  27. Equivalence in the FX Market FISHER EFFECT Difference in interest rates difference in ex- pected inflation equals PURCHASINGPOWERPARITY INTERESTRATEPARITY INTERN. FISHEREFFECT equals equals equals Difference between spot and forward expected change in spot rates equals EXPECTATIONS THEORY

  28. Interest rate parity theory (IRP) • prediction: • differences in national interest rates of securities with similar risk and maturity should be equal to opposite forward rate discount/premium • real-world-consequences • if IRP does not hold, profits from interest rate arbitrage become possible • interest arbitragers activities ensure quick reactions to deviations from IRP • strict enforcement of IRP is often limited • exchange restrictions impede the flow of arbitrage funds • transaction costs reduce full capital mobility • commercial and country risk of default are also reflected in exchange rate premia and discounts • limited supply of arbitrage funds

  29. Australia New Zealand current spot rates A$0.7415/NZ$ NZ$1.3488/A$ A$1.2601/US$ NZ$1.6695/US$ 12 mo-forward rates A$0.7106/NZ$ A$1.3163/US$ interest rates 15%p.a. 20% p.a. Comparable US-interest rates are 12% p.a. Covered Interest Arbitrage • investing in a foreign exchange on a covered basis with the objective to earn net profits

  30. The Australian Challenge A$ 5,000.000 x 1.15 A$ 5,750.000 Australia 12 months New Zealand sell forward for A$ 5,749.966 convert to NZ$ NZ$ 6, 743.088 x 1.20 NZ$ 8,091.705

  31. A$ 5,000.000 x 1.15 A$ 5,750.000 Australia 12 months USA sell forward for A$ 5,849.758 convert to US$ US$ 3,967.939 x 1.12 US$ 4,444.092 The Australian Challenge/2

  32. Characteristics of the Global FX Market • LARGEST MARKET IN THE WORLD (900 bn $ per day) • WIDE SPECTRUM OF PARTICIPANTS, CURRENCIES AND TRANSACTION TYPES • BREADTH • DEPTH • ABILITY TO ABSORB LARGE TRANSACTIONS • ABILITY TO RECOVER QUICKLY FROM PRICE DISTORTIONS • USE OF SOPHISTICATED COMMUNICATION AND INFORMATION MEDIA • TELERATE • REUTER’S • BLOOMBERG • WORLDWIDE 24-HOUR-TRADING

  33. Foreign Exchange Rate Quotations • BID/OFFER(ASK) RATE • bid: indicates the price at which the trader is willing to purchase the foreign currency in terms of local currency • offer (ask): indicates the price at which the trader is willing to sell foreign currency in terms of local currency • DETERMINANTS OF SPREAD • currency involved • volume of trade (market depth) • market stability • location of the market • DIRECT/INDIRECT METHOD • indirect: number of foreign units to one local unit • direct: number of local units to one foreign unit

  34. Currency Cross Rates Mex.Peso 3.3715/USD USD 0.915/EURO 3.3715 MP = 1/0.915 EURO 3.3715 MP = 1.0929 EURO 1 EURO = 3.0849 MP

  35. Forward transaction Requires delivery - at a future date - of a specified amount of one currency - for a specified amount of another currency

  36. Forward Exchange Market • maturity • typically 1, 2, 3, 6, 9 and 12 months in major traded currencies • odd maturities possible at a higher cost • premium • if the forward rate is higher than the current spot rate • discount • if the forward rate is lower than the current spot rate • quotations • points • outright forward rates • percentages (swap rates)

  37. Forward quotation • POINT QUOTATION • USD 0.9050/0.915 per 1 EURO (Indirect quotation) • “USD premium of 6 to 3 points” • forward quotation • bid: 0.9050-0.0006= 0.9044 • offer: 0.9150-0.0003=0.9147 • OUTRIGHT QUOTATION • 3 months: 0.9044/ 0.9147 • PERCENTAGE QUOTATION (SWAP RATES) • indirect quotation: • 0.9050-0.9044 x 360 x 100 = 0.27% p.a. premium 0.9044 90

  38. Assignment 2 • EITEMAN/STONEHIL/MOFFETT (9th EDITION!) • Chapter3 • Question 1: Polish Zloty • Question 4: Covered Interest Arbitrage • Question 5: London and New York

  39. Foreign Exchange Exposure • Translation (accounting) exposure: measures accounting-based changes in a firm´s consolidated financial statements resulting from a change in exchange rates • Transaction exposure: gains or losses arising from the settlement of transactions stated in foreign currency • Economic exposure: Possibility of cash flow changes due to an unexpected change in exchange rates

  40. Measurement of Economic Exposure • Quantifying the effect of a currency devaluation (revaluation) is non-trivial because it influences • Export sales • become more competitive when home currency is devaluated • Domestic sales • margins and cash flows are endangered in the import competing sector • Costs of imported inputs • should rise in response to a devaluation

  41. Internal Techniques of Exposure Management • Netting • reduces inter-company payments and receipts • Pooling • internal “netting” of related currencies (e.g. EMS member currencies) • Leading and lagging • Pricing Policy • Asset and Liability Management (Natural Heding) • Applicable for MNC’s to reduce transaction exposure • Establishment of specialized netting centers or use of banks • Legal and tax limitations due to foreign exchange controls

  42. Internal Netting • Bilateral Netting Multilateral Netting UK subsidiary netting arrangement Swiss subsidiary French subsidiary UK subsidiary Group treasury netting arrangement Swiss subsidiary French subsidiary

  43. Leads and lags Expected Depreciation of Foreign Currency Expected Appreciation of Foreign Currency leading of accounts receivable denominated in this currency lagging of accounts payable denominated in this currency lagging of accounts receivable denominated in this currency leading of accounts payable denominated in this currency

  44. Austrian Company Natural Hedging Matching of Currency Cash Flows RISK purchases security annual payments for a JPY loan receives interest or dividend in JPY

  45. External Techniques of Exposure Management • Forward/Futures Market Hedge • Money Market Hedge • based on a short term borrowing or depositing • future value of loan proceeds/? • Option Market Hedge • involves a forward (or futures) contract and a source to fulfil this contract • locks in a forward rate • covered (perfect) hedge • uncovered (open) hedge • cost is a function of forward rate quotation (e.g. discount or premium on spot exchange rate) • can be extended

  46. FX Risk - FMH vs. MMH

  47. Assignment 3 • EITEMAN/STONEHIL/MOFFETT (9th EDITION!) • Chapter4 • Question 3: Forward Rates on the CAD • Question 4: Currency Cross Rates

  48. Currency Options • Definition: gives the buyer the right to buy or sell a given amount of foreign exchange at a fixed price (strike price) per unit for a specified time period from the seller. • European vs. American Options • Put and Call • Exercise Price, Expiration Date • Premium • in, at, out-of-the money • standardized options (Philadelphia, London, Amsterdam) • OTC-options • all major currencies • any time period up to 12 months

  49. Put and Call - Terminology Buyer (Holder) Seller (Writer) right to BUY for a specified price right to SELL for a specified price duty to SELL for a specified price duty to BUY for a specified price CALL PUT

  50. Call Option-Buyer Profit/Loss (cents/CHF) Profit=Spot Rate-(Strike price+premium) Strike price ITM OOM ATM 0,5 Unlimited Profit LimitedLoss -0,5 Spot price (cents/CHF) 57.5 58 58.5 59 59.5 60 Break-Even-Price

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