Short-Term Financing

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International Financial Management 11th Edition

by Jeff Madura

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20 Short-Term Financing

Identify sources of short-term financing for MNCs

Explain how MNCs determine whether to use foreign financing

Illustrate the possible benefits of financing with a portfolio of currencies

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Chapter Objectives


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Sources of Foreign Financing

Internal short-term financing Before an MNC’s parent or subsidiary in need

of funds searches for outside funding, it should check other subsidiaries’ cash flow positions to determine whether any internal funds are available.

Internal Control over Funds - An MNC should have an internal system that consistently monitors the amount of short-term financing by all subsidiaries.


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Sources of Foreign Financing

External short-term financing Short-term notes or unsecured debt securities: Short-

term notes typically have maturities of 1, 3, or 6 months with interest based on LIBOR.

Commercial paper (euro-commercial paper): The selling price is not guaranteed to the issuers. Maturities can be tailored to the issuer’s preferences.

Bank loans: Direct loans from banks maintain a relationship with banks.

MNCs had limited access to short-term funding during the credit crisis.


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Financing With a Foreign Currency

MNCs borrow foreign currency, sometimes to match future cash inflows.

Comparison of interest rates among currencies

Developing countries tend to have higher inflation and a low level of saving, causing interest rates to be relatively high.


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Exhibit 20.1 Comparison of Interest Rates among Countries (as of January 2009)

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Determining the Effective Financing Rate

The actual or “effective” financing rate will differ from the quoted rate based on:1. The interest rate charged by the bank.2. The movement in the borrowed currency’s value

over the time of the loan.

where rf = effective financing rate

S = spot rate if = interest rate of the foreign currency

11)1( 1

SSSir t

ff


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Criteria Considered in the Financing Decision

1. Interest Rate Parity: if interest rate parity exists, the currency will exhibit a forward premium that offsets the differential between its interest rate and the home interest rate.

2. The Forward Rate as a Forecast: If the forward rate is an unbiased predictor of the future spot rate, then the effective financing rate of a foreign currency will on average be equal to the domestic financing rate.

3. Exchange Rate Forecasts: the firm can use exchange rate forecast in conjunction with foreign interest rate to forecast the effective financing rate.


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Exhibit 20.2 Implications of Interest Rate Parity for Financing

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Use of Probability Distributions

Since forecasts are not always accurate, it is sometimes useful to develop a probability distribution instead of relying on a single point estimate.

Allows comparison of distribution to the known financing rate of the home currency in order to make its financing decision.


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Exhibit 20.3 Analysis of Financing with a Foreign Currency

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Exhibit 20.4 Probability Distribution of Effective Financing Rates

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Actual Results from Foreign Financing

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

Savings can be achieved if the foreign currency depreciates against the home currency.

Foreign financing can backfire if the foreign currency appreciates against the home currency.


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Exhibit 20.5 Comparison of Financing with Swiss Francs versus Dollars

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Financing with a Portfolio of Currencies

Financing with a Portfolio of Currencies Variance (risk) may be higher If low interest rates prevail, probability of lower

financing costs are possible Portfolio Diversification Effects

With diversification of currencies, lower financing costs are possible but currencies must not be highly correlated

Repeated Financing with a Currency Portfolio Estimating the variance of a portfolio’s effective

financing rate becomes more complex as more currencies are added


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Exhibit 20.6 Derivation of Possible Effective Financing Rates

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Exhibit 20.7 Analysis of Financing with Two Foreign Currencies

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Exhibit 20.8 Probability Distribution of the Portfolio’s Effective Financing Rate

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SUMMARY

MNCs may first consider internal sources of funds for short-term financing, including foreign subsidiaries that might have excess funds. They also commonly rely on external sources such as short-term notes, commercial paper, or bank loans.

When MNCs borrow a portfolio of currencies that have low interest rates, they can increase the probability of achieving relatively low financing costs if the currencies’ values are not highly correlated.


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SUMMARY

MNCs may use foreign financing in an attempt to reduce their financing costs. They can determine whether to use foreign financing by estimating the effective financing rate for any foreign currency over the period in which financing will be needed. The expected effective financing rate is dependent on the quoted interest rate of the foreign currency and the forecasted percentage change in the currency’s value over the financing period. It is typically low if the foreign interest rate is low or if the foreign currency borrowed depreciates over the financing period.

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Short-Term Financing