International Financial Management 8

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Chapter 8

Short-Term Financing

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Objectives

This chapter explains short-term liability management of MNCs, a part of multinational management that is often

neglected in other textbooks. From this chapter, we should learn that correct financing decisions can reduce the firm’s costs and maximize the value of the MNC.

While foreign financing costs cannot usually be perfectly

forecasted, firms should evaluate the probability of reducing costs through foreign financing. The specific objectives are:

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Objectives

• to explain why MNCs consider foreign

financing;

• to explain how MNCs determine whether

to use foreign financing; and

• to illustrate the possible benefits of

financing with a portfolio of currencies.

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Pre-class Discussion

1. If a firm consistently exports to a country with low interest rates and needs to consistently borrow funds, explain how it could coordinate its invoicing and financing to reduce its financing costs.2. What is the risk of borrowing a low interest rate currency?3. Assume that foreign currencies X,Y, and Z are highly correlated. If a firm diversifies its financing among these three currencies, will it substantially reduce its exchange rate exposure? Explain.

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Internal Financing by MNCs

• Before an MNC’s parent or subsidiary searches for outside funding, it should determine if any internal funds are available.

• Parents of MNCs may also raise funds by increasing their markups on the supplies that they send to their subsidiaries.

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Sources of Short-Term Financing

• Euronotes are unsecured debt securities with typical maturities of 1, 3 or 6 months. They are underwritten by commercial banks.

• MNCs may also issue Euro-commercial papers to obtain short-term financing.

• MNCs utilize direct Eurobank loans to maintain a relationship with the banks too.

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Why MNCs ConsiderForeign Financing

• An MNC may finance in a foreign currency to offset a net receivables position in that foreign currency.

• An MNC may also consider borrowing foreign currencies when the interest rates on such currencies are attractive, so as to reduce the costs of financing.

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Determining theEffective Financing Rate

The actual cost of financing depends onthe interest rate on the loan, andthe movement in the value of the borrowed

currency over the life of the loan.

Example: how to compute the effective

financing rate

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How to compute the effective financing rate (Example)

• Dearborn, Inc. (based in Michigan), obtains a one-year loan of $1,000,000 in New Zealand dollars (NZ$) at the

quoted interest rate of 8 percent. When Dearborn receives the loan, it converts the NZ$ to US$ to pay a supplier for materials. The exchange rate at that time is $.50, so the NZ$1,000,000 is converted to $500,000 (1,000,000 * $.50). One year later, Dearborn pays back the loan of NZ$1,000,000 plus interest of NZ$80,000 (8%*NZ$1,000,000). Thus, the total amount in New Zealand dollars needed by Dearborn is NZ$1,080,000 (1,000,000+80,000). Assume the New Zealand dollar appreciates from $.50 to $.60 by the time the loan is to be repaid. Dearborn will need to convert $648,000

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How to compute the effective financing rate (Example)

(1,080,000*$.60) to have the necessary number of New Zealand dollars for loan repayment. To compute the effective financing rate, first determine the amount in U.S. dollars beyond the amount borrowed that was paid back. Then divide by the number of U.S. dollars borrowed (after converting the New Zealand dollars to U.S. dollars). Given that Dearborn borrowed the equivalent of $500,000 and paid back $648,000 for the loan, the effective financing rate in this case is $148,000 / $500,000 = 29.6%.

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Determining theEffective Financing Rate

Effective financing rate rf = (1+if)[1+(St+1-S)/S]-1

where if = the interest rate on the loan S = beginning spot rate St+1 = ending spot rate

The effective rate can be rewritten as rf = ( 1 + if ) ( 1 + ef ) – 1

where ef = the % in the spot rate

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Criteria Considered forForeign Financing

• There are various criteria an MNC must consider in its financing decision, including– interest rate parity,– the forward rate as a forecast, and– exchange rate forecasts.

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Interest Rate Parity (IRP)• If IRP holds, foreign financing with a

simultaneous hedge of that position in the forward market will result in financing costs similar to those for domestic financing.

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The Forward Rate as a Forecast• If the forward rate is an accurate estimate of the

future spot rate, the foreign financing rate will be similar to the home financing rate.

• If the forward rate is an unbiased predictor of the future spot rate, then the effective financing rate of a foreign loan will on average be equal to the domestic financing rate.

• Summary of the implications of a variety of scenarios relating to interest rate parity and forward rate.

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Implications of IRP for Financing

IRP holds? Scenario Type of financing Financing costs

Yes Covered Similar Yes Forward rate accurately Uncovered Similar predicts future spot rate

Yes Forward rate overestimates Uncovered Lower future spot rate

Yes Forward rate underestimates Uncovered Higher future spot rate

No Forward premium(discount) Covered Higher exceeds (is less than) interest rate differential

No Forward premium (discount) Covered Lower is less than (exceeds) interest rate differential

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Exchange Rate Forecasts• Firms may use exchange rate forecasts to forecast the

effective financing rate of a foreign currency, or they may compute the break-even exchange rate that will equate the domestic and foreign financing rates.

Example: Sarasota, Inc. needs funds for one year and is aware

that the one-year interest rate of U.S. dollar is 12 percent while the interest rate from borrowing Swiss francs is 8 percent. Sarasota forecasts that the Swiss Franc will appreciate from its current rate of $.45 to $.459, or by 2 percent over the next year. The expected value for ef will therefore be 2 percent. Thus, the expected effective

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financing rate will be E (rf) = (1+ if) [1+E(ef)] – 1 = (1+.08)(1+.02) –1 = .1016(10.16%) Thus, financing is Swiss francs is expected to be

less expensive than financing in U.S. dollars, though still with uncertainty.

To determine what value of ef would make the effective rate from foreign financing the same as domestic financing, we could use the effective financing rate formula and solve for ef:

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ef = (1+ rf)/ (1+if) – 1

In this example, rf is 12 percent and if is 8 percent, so

ef = (1+.12)/ (1+.08) – 1 = .037037 (3.7037%) This suggests that the Swiss frank would have to appreciate by about 3.7 percent over

the loan period to make the Swiss franc loan as costly as a loan in U.S. dollar.

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• Sometimes, it may be useful to develop

probability distributions, instead of relying

on single point estimates. The firm can compare this distribution to the known financing rate of the home currency to make its financing decision.

( Example:P449)

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Actual ResultsFrom Foreign Financing

• The fact that some firms utilize foreign financing suggests that they believe reduced financing costs can be achieved.

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Financing with a Portfolio of Currencies

• While foreign financing can result in significantly lower financing costs, the variance in the costs is higher.

• MNCs may be able to achieve lower financing costs without excessive risk by financing with a portfolio of currencies.

(Example: P450-453)

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• If the chosen currencies are not highly positively correlated, they will not be likely

to experience a high level of appreciation simultaneously.

• Thus, the chances that the portfolio’s effective financing rate will exceed the domestic financing rate are reduced.

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• A firm that repeatedly finances in a currency portfolio will normally prefer to compose a financing package that exhibits a somewhat predictable effective financing rate on a periodic basis.

• When comparing different financing packages, the variance can be used to measure how volatile a portfolio’s effective financing rate is.

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For a two-currency portfolio,

E(rP) = wAE(rA) + wBE(rB)

where rP = the effective financing rate of

the portfolio

rX = the effective financing rate of currency X

wX = the % of total funds financed from currency X

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• For a two-currency portfolio,

Var(rP) = wA2A

2 + wB2B

2 + 2wAwBABCORRAB

X2 = the variance of currency X’s

effective financing rate

CORRAB = the correlation coefficient of the

two currencies’ effective finance rates

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Questions and Applications

1. Explain why an MNC parent would consider financing from its subsidiaries. 2. Explain how a firm’s degree of risk aversion enters into its decision of whether to finance in a foreign currency or a local currency. What motivates the firm to even consider financing in a foreign currency?

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3. Discuss the use of specifying a break-even point when financing in a foreign currency. 4. Boca, Inc., needs $4 million for one year. It currently has no business in Japan but plans to borrow Japanese yen from a Japanese bank because the Japanese interest rate is three percentage points lower than the U.S. rate. Assume that interest rate parity exists; also assume that Boca believes that the one- year forward rate of the Japanese yen will exceed the future spot rate one year from now. Will the expected effective financing rate be higher, lower, or the same as financing with dollars? Explain.

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5. Akron Co. needs dollars. Assume that the local one- year loan rate is 15 percent, while a one-year loan rate on euros is 7 percent. By how much must the euro appreciate to cause the loan in euros to be more costly than a U.S. dollar loan? 6. Missoula, Inc., decides to borrow Japanese yen for one year. The interest rate on the borrowed yen is 8 percent. Missoula has developed the following probability distribution for the yen’s degree of fluctuation against the dollar:

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Possible Degree of Fluctuation Percentage

of Yen Against the Dollar Probability

- 4% 20%

- 1% 30%

0 10%

3% 40%

Given this information, what is the expected value of the

effective financing rate of the Japanese yen from

Missoula’s perspective?

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Questions and Applications 7. Pepperdine, Inc., considers obtaining 40 percent of its one-year financing in Canadian dollars and 60 percent in Japanese yen.

The forecasts of appreciation in the Canadian dollar and Japanese yen for the next year are as follows: Possible Percentage Probability of change in the Spot That Percentage Rate Over the Change in the Spot Currency Loan Life Spot Rate Occurring Canadian dollar 4% 70% Canadian dollar 7% 30% Japanese yen 6% 50% Japanese yen 9% 50%

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The interest rate on the Canadian dollar is

9 percent and the interest rate on the

Japanese yen is 7 percent. Develop the

possible effective financing rates of the

overall portfolio and the probability of each

possibility based on the use of joint

probabilities.

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International Financial Management 8