Chapter 19

Multinational
Financial
Management
Learning Objectives

1. Identify the primary reasons companies

choose to go “global”.
2. Understand the nature and importance of
the foreign exchange market and learn to
read currency exchange rate quotes.
3. Describe interest rate and the purchasing
power parity.
4. Discuss the risks that are unique to the
capital budgeting analysis of direct
foreign investments.
Principles Used in This Chapter

• Principle 2:
– There is a Risk-Return Tradeoff.

• Principle 3:
– Cash Flows Are the Source of Value.
19.1 Multinational
or Global
Corporations
Multinational or Global Corporation

• A firm that operates in an integrated fashion

in a number of countries
• Multinational firms make direct investments in
fully integrated operations – from extraction
of raw materials through the manufacturing
process and finally to the distribution of
products to consumers throughout the world.
• Multinational corporate networks control a
large and growing share of the world’s
technological, marketing and productive
resources.
Why Companies Go “Global”?
• To seek production efficiency -lower cost of production
• To avoid political, trade, and regulatory hurdles
– To avoid government tariffs, quotas and other
restrictions on imported goods and services
• To broaden markets
– To satisfy foreign demand and to cut production and
transportation costs in order to remain competitive.
• To seek raw materials and new technology
• To protect processes and products (intangible assets)
• To diversify (firms can cushion the effect of adverse
economic conditions in a single country)
• To retain customers
19.2 Multinational
Versus Domestic
Financial Management
Five factors that complicate financial
management in multinational firms

• Different currency denomination

(Exchange rate risk)
• Political risk
• Economic and legal ramifications
– Ex. Differences in tax laws
• Role of governments
– Political and other noneconomic aspects
• Language and cultural differences
– Communication and values issues
Five factors that complicate financial
management in multinational firms

• Exchange rate risk is the risk that the

value of the firm’s operations and
investments will be adversely affected by
changes in exchange rates.

• For example, if the Japanese Yen

depreciates, it will translate to fewer
dollars when it is sent back to the U.S.
Five factors that complicate financial
management in multinational firms

• Political risk can arise if the business is

conducted in a country that is not
politically stable leading to changes in
policies with respect to businesses.
Five factors that complicate financial
management in multinational firms

• Some examples of political risk are as

follows:
– Expropriation of plants and equipment without
compensation.
– Non-convertibility of the subsidiary’s foreign
earnings into the parent’s currency.
– Substantial changes in tax rates.
– Requirements regarding the local ownership of
business.
19.3 International
Monetary System
International Monetary System
• International Monetary System
– The framework within which exchange rates are
determined. It is the blueprint for international
trade and capital flows.
• Exchange rate
– The number of units of a given currency that can be
purchased for one unit of another currency.
• Spot exchange rate
– The quoted price for a unit of foreign currency to be
delivered “on the spot” or within a very short period
of time.
International Monetary System
• Forward exchange rate
– The quoted price for a unit of foreign currency to be
delivered at a specified date in the future.
• Fixed exchange rate
– Is set by the government and is allowed to fluctuate
only slightly around the desired rate, which is called
the par value.
• Floating or flexible exchange rate
– Is not regulated by the government, so supply and
demand in the market determine the currency’s
value.
International Monetary System
• Devaluation or revaluation of a currency
– The decrease or increase in the stated par value of
a currency whose value is fixed.
– The decision is made by the government, usually
without warning
• Depreciation or appreciation of a currency
– A decrease or increase in the foreign exchange
value of a floating currency.
– These changes are caused by market forces rather
than by governments.
19.4 Foreign
Exchange Markets
and the Currency
Exchange Rates
Foreign Exchange Markets and the
Currency Exchange Rates

• The foreign exchange (FX) market:

– Largest financial market with daily trading
volumes of more than $4 trillion.
– Organized as over-the-counter market with
participants located in major commercial and
investment banks around the world.
– Trading dominated by few currencies including
U.S. dollar, the British pound sterling, the
Japanese Yen, and the Euro.
Foreign Exchange Markets and the
Currency Exchange Rates (cont.)

• Major participants in foreign exchange

trading include the following:
– Importers and exporters of goods and services,
– Investors and portfolio managers who
purchase foreign stocks and bonds, and
– Currency traders who make a market in one or
more foreign currencies.
Foreign Exchange Rates

• An exchange rate is simply the price of

one currency stated in terms of another.

• For example, if the exchange rate of U.S.

dollar for Euro was $1.35 to 1, it means
that it would take $1.35 to purchase one
Euro.
Foreign Exchange Rates (cont.)

• Direct quote

– It indicates the number of units of U.S. dollar

to buy 1 foreign currency unit.

– In the table we see that it took $0.97 to buy 1

Canadian dollar.
Foreign Exchange Rates (cont.)

• Indirect Quote

– It indicates the number of foreign currency

units to buy one American dollar.

– For example, in the table it shows that it will

take 6.8276 Chinese yuan to buy 1 U.S. dollar
Foreign Exchange Rates (cont.)

• We can compute the direct quote from the

indirect quote.
Foreign Exchange Rates (cont.)

• The direct quote for Canadian dollars is

$0.97. The related indirect quote will be:

• Indirect quote = 1÷ $0.97 = $1.03

Checkpoint 19.1

Exchanging Currencies
U.S. firm Claremont Steel ordered parts for a generator that
were made by a German firm. Claremont was required to pay
1,000 euros to the German firm on January 8, 2010. How
many dollars were required for this transaction?
Checkpoint 19.1
Checkpoint 19.1
Checkpoint 19.1: Check Yourself

Suppose an American firm had to pay $2,000 to a

British resident on January 8, 2010. How many
pounds did the British resident receive?
Step 1: Picture the Problem

• The key determinant of the number of

British pounds received by the British
resident is the exchange rate between
dollars and pounds.

• The chart (next slide) shows that the amount

received in Pounds varies depending on the
exchange rate. Thus if the exchange rate is
1$=£.8, the British resident will receive
only£1,600.
Step 1: Picture the Problem (cont.)
Exchange Rate Impact on
Pounds Received
2500

2000

1500
Pounds

1000

500

0
0 0.2 0.4 0.6 0.8 1 1.2
Pounds per Dollar
Step 2: Decide on a Solution
Strategy

• To determine the number of British pounds

that will be received by the British resident
for $2,000 we need to know the number of
pounds it takes to buy one dollar i.e.
indirect exchange rate quote.
Step 3: Solve

• Number of British Pounds received

= (£/$ × $) × $2,000
= Indirect quote × $2,000
= £ 0.8/$ × $2,000
= £1,600.00
Step 4: Analyze

• The British resident will receive £ 1,600

using the indirect quote.

• Had we used the direct quote, we would

have arrived at the wrong answer of
£2,500 (2000 × 1.25).
Exchange Rates and Arbitrage

• Arbitrage is the process of buying and

selling in more than one market to make a
riskless profit.

• Simple arbitrage eliminates exchange

rate differentials across the markets for a
single currency.
Exchange Rates and Arbitrage
(cont.)

• The asked rate (also known as the selling

rate or the offer rate) is the rate the bank
or the foreign exchange trader “asks” the
customer to pay in home currency for
foreign currency when the bank is selling
and the customer is buying.

• Table 19-1 contains the asked rate quotes.

Exchange Rates and Arbitrage
(cont.)

• The bid rate (also known as the buying

rate) is the rate at which the bank buys
the foreign currency from the customer by
paying in home currency.
Exchange Rates and Arbitrage
(cont.)

• The bank sells a unit of foreign currency

for more than it pays for it. The difference
between the asked quote and the bid
quote is known as the bid-asked spread.

– The spread will be relatively lower for popular

currencies that are frequently traded.
Cross Rates

• A cross rate is the computation of an

exchange rate for a currency from the
exchanges rates of two other currencies.
Types of Foreign Exchange
Transactions

• Spot exchange rate is the rate for

immediate delivery.

• Forward exchange rate is an exchange

rate agreed upon today but which calls for
delivery or payment at a future date.

• Spot and forward rate quotes are given in

Table 19-1.
Types of Foreign Exchange
Transactions (cont.)

• The forward rate is often quoted at a

premium to or a discount from the existing
spot rate. For example, the 30-day
Switzerland franc will be quoted as 0.0001
premium(0.9773-0.9772).

• This premium or discount is known as the

forward-spot differential.
Types of Foreign Exchange
Transactions (cont.)

• The forward-spot differential can be

expressed as:

• Where F= the forward rate, direct quote

S = the spot rate, direct quote
Types of Foreign Exchange
Transactions (cont.)

• The premium or discount can also be

expressed as an annual percentage rate,
computed as follows:
Checkpoint 19.2

Determining the Percent-per-Annum Premium or

Discount
You are in need of yen in six months, but before entering a forward
contract to buy them, you would like to know their premium or discount
from the existing spot rate. Calculate the premium or discount from the
existing spot rate for the 6-month yen as of January 8, 2010 using the
data given in Table 19.1.
Checkpoint 19.2
Checkpoint 19.2
Checkpoint 19.2: Check Yourself

Given the information provided above, what is the

premium or discount on from the existing spot rate
on the one-month yen?
Step 1: Picture the Problem

• To determine the premium or discount

from the existing spot rate, we need to
know the prices.
Step 1: Picture the Problem (cont.)

• Given spot and forward rates

0.010804
0.010803
0.010803

0.010802
Exchange Rate ($ to yen)

0.010801
0.0108
0.0108

0.010799
0.010798 0.010798
0.010798

0.010797

0.010796

0.010795
Spot rate 1-mos forward 3-mos forward 6-mos forward
Contract Months Forward
Step 2: Decide on a Solution
Strategy

• We can determine the size of the premium

or discount using the following equation
and then annualize it.
Step 3: Solve

• = (0.010798 - .010798)/.010798 × (12/1)

× 100

• = 0%
Step 4: Analyze

• Since the spot rate and 1-month forward

rate are equal, the premium or discount
percent is equal to zero.
• The degree of premium or discount is
determined by market forces. Generally,
the premium or discount is not equal to
zero.
19.5 Interest Rate
and Purchasing
Power Parity
Interest Rate Parity

• Interest rate parity is a theory that can be

used to relate differences in the interest
rates in two countries to the ratios of spot
and forward exchange rates of the two
countries’ currencies.

• Specifically,
Differences in interest rates = Ratio of the
forward and spot rates
Interest Rate Parity (cont.)
Interest Rate Parity (cont.)
• Interest rate parity means that you get the
same total return for the following two
options:

– Invest directly in the US; or

– Convert dollars to Japanese Yens,

– Invest Yens in the risk-free rate in Japan, and
– Convert Yens back to U.S. dollars.
Interest Rate Parity (cont.)

• Example 19.1 You have $1,000,000

to invest and you observe the following
quotes in the market:
1$ = ¥ 106
180-day forward rate = 103.50
U.S. 180-day risk-free interest rate = 4.4%
Japan 180-day risk-free interest rate = 2%

• Determine whether interest rate

parity holds.
Interest Rate Parity (cont.)
Option I: Invest directly in USA and earn 4.4%
1,000,000 * 1.044 = $1,044,000

Option II:
(a) Convert to Yen at spot rate = ¥ 106,000,000
(b) Invest at 2% = ¥106,000(1.02) = ¥ 108,120,000
(c) Convert to $ at the forward rate = 108,120,000 ÷103.5 =
$1,044,638

==> Difference of $638 ==> Interest Rate Parity does not hold
Purchasing Power Parity and the
Law of One Price

• According to the theory of purchasing

power parity (PPP), exchange rates
adjust so that identical goods cost the
same amount regardless of where in the
world they are purchased.
Purchasing Power Parity and the
Law of One Price (cont.)

• Underling PPP theory is the law of one

price, which states that the same good
should sell for the same price in different
countries after making adjustments for the
exchange rate between the two currencies.

• Figure 19-2 illustrates one example of

exception to the PPP theory.
Purchasing Power Parity and the
Law of One Price (cont.)

• The differences in prices around the world

could be explained by:
– Tax differences among countries
– Differences in labor costs
– Differences in raw material costs
– Differences in rental costs
Purchasing Power Parity and the
Law of One Price (cont.)
• In general, we expect PPP to hold for goods that
can be cheaply shipped between countries (for
example, expensive gold jewelry).

• PPP does not seem to hold for non-traded goods

like restaurant meals and haircuts.
The International Fisher Effect
• The International Fisher Effect (IFE) assumes
that real rates of return are the same across the
world, so that the differences in nominal returns
around the world arise because of differences in
inflation rates.

• Like purchasing power parity, IFE is just an

approximation that may not hold exactly.
The International Fisher Effect
(cont.)

• Example 19.2 Assume that the real rate of

interest is equal to 2% in all countries.
What will be the nominal interest rate in
UK and USA, if UK is expecting an inflation
rate of 6% and USA is expecting an
inflation rate of 3%.
The International Fisher Effect
(cont.)

• Interest rate (USA) = .03 + .02 +

[.03×.02]
= .0506 or 5.06%

• Interest rate (UK) = .06 + .02 + [.06×.02]

= .0812 or 8.12%
The International Fisher Effect
(cont.)

• IFE cautions us that we should not invest

in a country just because it offers the
highest interest rates.

• IFE notes that such high interest rate is an

indication of high inflation. Accordingly,
any gain in interest rates will be offset by
losses due to foreign currency
depreciation.
19.6 Capital
Budgeting for
Direct Foreign
Investment
Capital Budgeting for Direct Foreign
Investment

• Direct foreign investment occurs when

a company from one country makes a
physical investment into building a factory
in another country. A multinational
corporation (MNC) is one that has
control over this investment.
Capital Budgeting for Direct Foreign
Investment (cont.)
• A major reason for direct foreign
investment by U.S. companies is the
prospect of higher rates of return from
these investments.

• The method used to evaluate foreign

investments is very similar to the method
used to evaluate capital budgeting
decisions in a domestic context.
Checkpoint 19.6
International Capital Budgeting
You are working for an American firm that is looking at a new project that will
produce the following cash flows, which are expected to be repatriated to the
parent company and are measured in South African Rand (SAR),

In addition, the risk-free rate in the United States is 4 percent and this project is
riskier than most; as such, the firm has determined that it should require a 9
percent premium over the risk-free rate. Thus, the appropriate discount rate for
this project is 13 percent. In addition, let’s assume the current spot exchange rate
is .11SAR/$, and the 1-year forward exchange rate is .107SAR/$. Calculate the
expected cash flows for this project in U.S. dollars, and then use these cash flows
to calculate the project’s NPV.
Checkpoint 19.6
Checkpoint 19.6
Checkpoint 19.6
Checkpoint 19.6
Checkpoint 19.6: Check Yourself

The Problem
An American firm is looking for a new project that
will produce the following cash flows which are
expected to be repatriated to the parent company
and are measured in South African Rand (SAR).
Year Cash flow (in millions of SAR)
0 -20
1 10
2 10
3 6
4 6
The Problem (cont.)
• In addition, the risk-free rate in the United
States is 4 percent, and this project is
riskier than most, and as such, the firm has
determined that it should require a 10
percent premium over the risk-free rate.
Thus, the appropriate discount rate for this
project is 14 percent. In addition, the
current spot exchange rate is .11 SAR/$,
and the 1-year forward exchange rate is
.107SAR/$. What is the project’s NPV?
Step 1: Picture the Problem

i=14%
Time 0 1 2 3 4

Cash flow -20 10 10 6 6

(millions, SAR)

• The timeline illustrates the following:

– The discount rate is 14%.
– A cash outflow of -20 million SAR occurs at the beginning of
the first year (at time 0), followed by positive cash inflows
during the next four years.
Step 2: Decide on a Solution
Strategy

• To calculate the project’s NPV, we need to

convert South African Rand into U.S.
dollars. However, we only have 1-year
forward rates.

• We can use equation 19-5 and the given

forward rate and spot rate to determine
the interest rate differential in the two
countries.
Step 2: Decide on a Solution
Strategy (cont.)

• 1 year forward rate

= (interest rate differential)1 × (spot exchange
rate)

• We can then use the forward rate to

convert the cash flows measured in SARs
into U.S. dollars. Once we have the cash
flows, we can compute the NPV using a
14% discount rate.
Step 3: Solve

• Interest rate differential

= Forward rate/spot rate
= .107/.11
= 0.9727
• We can use the interest rate differential to
calculate the forward exchange rate and
then convert the SAR denominated cash
flows into U.S. dollars.
Step 3: Solve (cont.)

Year Spot Rate × (Interest Rate Forward rate for

Differential)n year n
0 0.11 0.11 SAR/$ or
$9.0909/SAR
1 0.11 SAR/$ x 0.9727 0.107 SAR/$ or
$9.3458/SAR
2 0.11 SAR/$ x (0.9727)2 0.10415 SAR/$ or
$9.6061/SAR
3 0.11 SAR/$ x (0.9727)3 0.1012 SAR/$ or
$9.8814/SAR
4 0.11 SAR/$ x (0.9727) 4 0.0985 SAR/$ or
$10.1523/SAR
Step 3: Solve (cont.)

• Solve using an Excel Spreadsheet

Cash flow Implied Cash flow
(in millions Forward (in millions
Year of SAR) Rate of $)
0 -20 $9.0909 -181.82
1 10 9.3458 93.46
2 10 9.6061 96.06
3 6 9.8814 59.29
4 6 10.1523 60.91

• NPV = -181.82 + npv (0.14; Input in Excel

93.46,96.06,59.29,60.91)
= $50.16 million
Step 3: Solve (cont.)

• Computing NPV using equation

• NPV = -$181.82m + $93.46m/(1.14) +

$96.06m/(1.14)2 + $59.29m/(1.14)3 +
$60.91m/(1.14)4

= $50.16 million
Step 4: Analyze

• Note, the only relevant cash flows are

those that are expected to be repatriated
back to the home country and the initial
cash outflow.

• Also, discount rate should be in the same

currency that the cash flows are measured
in. Here discount rate was in U.S. dollars,
so we converted the SAR cash flows into
U.S. dollars.
Foreign Investment Risks
• Risks in domestic capital budgeting arises
from two sources:

– Business risk related to the specific product or

service and the uncertainty associated with
that market.

– Financial risk is the risk imposed on the

investment as a result of how the project is
financed.
Foreign Investment Risks (cont.)

• Foreign direct investment includes both

business and financial risk, plus political
risk and exchange rate risk.
19.7 International
Capital Structures
International Capital Structures
• Capital structures vary across countries.
• Example: Average Debt to Total Assets
Japanese firms 85%
German firms 64%
US firms 55%
• One problem when interpreting these numbers is
that different countries often use different
accounting conventions such as reporting assets,
treating leased assets, reporting pension plan
liabilities and capitalizing versus expensing R&D
costs.
International Capital Structures
• These differences make it difficult to compare
capital structures
• But the International Financial Reporting
Standards (IFRS) constitute a standardized way
of describing the company’s financial performance
and position so that company financial statements
are understandable and comparable across
international boundaries