Financial Management and International Finance.ppt

Financial Management

1. AG CHAPTER 7
INTERNATIONAL FINACE

2. 2AG
What are Multinational Corporations ?
Multinational corporations (MNCs):
–Businesses that operate in many countries around the world.
–MNC is an entity that conducts business in more than one jurisdiction;
–Firms that have international assets and operations in foreign markets and
draw part of their total revenue and profits from such markets
–Financial managers of MNCs require an understanding of the complexities
of international finance to make sound financial and investment decisions.
The commonly accepted goal of an MNC is to maximize shareholder
wealth.
The Goal of MNC

3. 3AG
Conflicts Against the MNC Goal
For corporations with shareholders who differ from their managers, a
conflict of goals can exist - the agency problem.
Agency costs are normally larger for MNCs than for purely domestic
firms.
–The sheer size of the MNC.
–The scattering of distant subsidiaries.
–The culture of foreign managers.
–Subsidiary value versus overall MNC value.

4. 4AG
Impact of Management Control
The magnitude of agency costs can vary with the management style of the
MNC.
A centralized management style reduces agency costs.
A centralized management style can reduce agency costs because it allows
managers of the parent to control foreign subsidiaries and therefore reduces
the power of subsidiary managers.
Alternatively, a decentralized style gives more control to those managers who
are closer to the subsidiary’s operations and environment.
This style is more likely to result in higher agency costs because subsidiary
managers may make decisions that do not focus on maximizing the value of the
entire MNC.
Yet, this style gives more control to those managers who are closer to the
subsidiary’s operations and environment.

5. 5AG
Centralized Multinational Financial Management
for an MNC with two subsidiaries, A and B
Financial
Managers
of Parent
Capital Expenditures
at A
Inventory and
Accounts
Receivable
Management at A
Cash
Management
at A
Financing at A
Capital Expenditures
at B
Inventory and
Accounts
Receivable
Management at B
Cash
Management
at B
Financing at B

6. 6AG
Decentralized Multinational Financial Management
for an MNC with two subsidiaries, A and B
Financial
Managers
of A
Capital Expenditures
at A
Inventory and
Accounts
Receivable
Management at A
Cash
Management
at A
Financing at A
Capital Expenditures
at B
Inventory and
Accounts
Receivable
Management at B
Cash
Management
at B
Financing at B
Financial
Managers
of B

7. 7AG
Why are firms motivated to expand their business?
Theory of Comparative Advantage
–Specialization by countries can increase production efficiency.
Imperfect Markets Theory
–The markets for the various resources used in production are
“imperfect.”
Product Cycle Theory
–As a firm matures, it may recognize additional opportunities outside
its home country.

8. 8AG
International Business Methods
There are several methods by which firms can conduct international business.
International trade is a relatively conservative approach involving exporting and/or
importing.
–The internet facilitates international trade by enabling firms to advertise and manage orders through
their websites.
Licensing is an arrangement in which a company (licensor) sells the right to use
intellectual property, or produce a company’s product to the licensee, for a negotiated
fee i.e. royalty.
Franchising is an arrangement in which the franchisor permits the franchisee to use business
model, brand name or process for a fee, to conduct business, as an independent branch of
the parent company (franchisor).

9. 9AG
International Business Methods…
Firms may also penetrate foreign markets by engaging in a joint venture
(joint ownership and operation) with firms that reside in those markets.
Acquisitions of existing operations in foreign countries allow firms to quickly
gain control over foreign operations as well as a share of the foreign market.
Firms can also penetrate foreign markets by establishing new foreign
subsidiaries.
In general, any method of conducting business that requires a direct
investment in foreign operations is referred to as a Foreign Direct
Investment (FDI).
The optimal international business method may depend on the
characteristics of the MNC.

10. 10AG
Exposure to International Risk
Exchange rate movements
–Exchange rate fluctuations affect cash flows and foreign demand.
Foreign economies
–Economic conditions affect demand.
Political risk
–Political actions affect cash flows.
International business usually increases an MNC’s exposure to:

11. 11AG
International Financial Management
Management-main objective is wealth maximization of shareholders:
–Investment decision
–Financing decision
–Risk management decision

12. 12AG
Role of International Financial institutions
International Monetary Fund (IMF)
The World Bank (IBRD)
International Finance Corporation (IFC)
Africa Development Bank (AfDB)

13. 13AG
International Monetary Fund
Established in 1944 as an element of the Breton Woods system
190 member countries;
It has the following objectives:
–Promote cooperation among countries on international monetary issues
–Promote stability of exchange rates
–Provide temporary funds to countries to correct international payment
imbalances

14. 14AG
International Monetary Fund
Objectives:
–Provide free mobility of capital across countries
–Promote free trade
–During the Breton woods era IMF would maintain fixed exchange rate system
–Post-Breton woods era, the fund engaged more on helping nations correct
payment balances
–It also extended loans to countries with difficulty in servicing their financial
obligations

15. 15AG
The World Bank
Established to provide long-term loans to promote economic growth
and also encourage international trade
The main sources of funds are sales of debt and other instrument to
private investors and governments
To become a member of the Bank, a country must first join the (IMF).
189 member countries;

16. 16AG
International Finance Corporation
Established in 1956 to promote private sector development across the
world
Comprises countries as its members
Provides loans to corporations and buys their shares;
186 member countries;

17. 17AG
African Development Bank (AfDB)
Established in 1964 in Khartoum
Membership of the AfDB Group at the end of May 2015, comprised 54
African countries and 27 non-African countries.
Provides loans aimed at alleviating poverty and enhancing economic
growth
Has ministers and high-level officials of economic and financial
institutions of member countries as board of governors

18. 18AG
Exchange Rates
An exchange rate is the relative price of two currencies;
Rather than write out the full name of these currencies, contractual
parties use abbreviations.
In banking and commercial transactions, it is important that all parties
understand which currencies are being used. Hence, there is a need for
standardization of the abbreviations.
The International Organization for Standardization (called ISO from the
Greek word for equal) sets these standards.

19. 19AG
Cont’d
In most cases, the abbreviation is the ISO two-digit country code plus a letter
from the name of the currency.
Country Currency ISO Currency Code
Ethiopia Birr ETB
Egypt Pound EGP
European Union Euro (€) EUR
India Rupee INR
Japan Yen (¥) JPY
Saudi Arabia Riyal SAR
South Korea Won KRW
United Kingdom Pound (£) GBP
United States Dollar ($) USD

20. 20AG
Exchange Rate Systems
Exchange rate: the price of one currency in terms of another currency.
Floating exchange rate: An exchange rate system in which a currency’s value is
allowed to fluctuate in response to market forces.
Fixed exchange rate: An exchange rate system in which the price of one
currency is fixed relative to all other currencies by government authorities.
Managed floating rate system:- A hybrid currency system in which a
government loosely fixes the value of the national currency.
Currency board arrangement:- An exchange rate system in which each unit of
the domestic currency is backed by a unit of some foreign currency.
In such an arrangement, the national currency continues to circulate, but every
unit of the currency is fully backed by government holdings of another currency
— usually the U.S. dollar.

21. 21AG
How a currency is quoted?
Direct quote: An exchange rate quoted in terms of units of domestic
currency per unit of foreign currency.
BIRR/USD = 52
Indirect quote: An exchange rate quoted in terms of foreign currency
per unit of domestic currency.
USD/BIRR = 0.0192

22. 22AG
Bid/Ask Price
A currency exchange rate is typically given as a bid price and an ask
price.
The Bid price is always lower than the ask price.
The bid price represents what will be obtained in the quote currency
when selling one unit of the base currency.
The Ask Price represents what has to be paid in the quote currency to
obtain one unit of the base currency.
A Spread is the amount by which the ask price exceeds the bid price for
an asset in the market.

23. 23AG
Foreign Exchange Market
Spot transaction
Currency forward
Currency future
Currency options
Currency swaps

24. 24AG
Spot and Forward markets
Spot trade is an agreement to exchange currency “on the spot,” which
actually means that the transaction will be completed or settled within
two business days.
A forward trade is an agreement to exchange currency at some time in
the future.
The exchange rate that will be used is agreed upon today and is called
the forward exchange rate.
A forward trade will normally be settled sometime in the next 12
months.

25. 25AG
Spot and Forward markets…
The spot rate is the exchange rate for immediate delivery of currencies
exchanged, while the forward rate is the exchange rate for later delivery
of currencies exchanged. For example, there may be a 90-day exchange
rate.
The forward exchange rate of a currency will be slightly different from
the spot rate at the current date because of future expectations and
uncertainties.
Forward rates may be greater than the current spot rate (premium) or
less than the current spot rate (discount).

26. 26AG
Spot and Forward markets…
Why does the forward market exist?
One answer is that it allows businesses and individuals to lock in a future
exchange rate today, thereby eliminating any risk from unfavorable shifts
in the exchange rate.

27. 27AG
A Future is a contract to buy or sell a standard quantity and quality of an
asset or security at a specified date and price.
Futures are similar to Forward Contracts, but are standardized and traded
on an exchange, and are valued daily.
Unlike Forward Contracts, the counterparty to the buyer or seller in a
Futures contract is the clearing corporation on the appropriate exchange.
Futures often are settled in cash or cash equivalents, rather than requiring
physical delivery of the underlying asset.
Futures

28. 28AG
A Swap is a simultaneous buying and selling of the same security or
obligation.
Currency swaps - substitution of one debt denominated in one currency by
another denominated in a different currency.
Financial institutions may act as a broker or a counterpart or an
intermediary.
Swaps may involve cross-currency payments (U.S. Dollars vs. Mexican
Pesos) and cross-market payments, e.g., U.S. short-term rates vs. U.K. short-
term rates.
Swaps

29. 29AG
The purchaser of an Option has rights (but not obligations) to buy or sell
the asset during a given time for a specified price (the "Strike" price). An
Option to buy is known as a "Call," and an Option to sell is called a "Put. "
The seller of a Call Option is obligated to sell the asset to the party that
purchased the Option. The seller of a Put Option is obligated to buy the
asset.
In a “Covered” Option, the seller of the Option already owns the asset. In
a “Naked” Option, the seller does not own the asset
Options are traded on organized exchanges and OTC.
Options

30. 30AG
Parity conditions in international finance and Currency Forecasting
Factors affecting exchange rate
–Rate of inflation (PPP)
–Interest rate (IRP)
–Balance of payment
–Foreign exchange reserve

31. 31AG
Purchasing Power Parity (PPP)
Purchasing power parity (PPP): The idea that the exchange rate adjusts
to keep purchasing power constant among currencies.
Purchasing power of a currency is determined by the amount of
goods/services that can be purchased with one unit of currency.
Levels of appreciations/depreciation
Deviations from PPP
–Difference in the components of the index
–Trade barriers
–Disregard capital movement
–Government intervention on the exchange market

32. 32AG
Interest Rate Parity relationship
John M. Keynes, in the 1920s
Premium or discount of one currency against another country reflects
interest rate differential between the two countries
Reasons for deviation from IRP
–Capital control
–Transaction cost

33. 33AG
Exchange rate and BoP
When a country is importing more than it exports, the demand for foreign
currency increases leading to deprecation of local currency
Conversely, when a country exports more than it imports, the demand for
foreign currency exceeds the supply leading to appreciation of local currency
In this process, apart from the trade flow, capital flow plays a role.

34. 34AG
Exchange rate & foreign exchange reserve
Reserves are kept to meet obligations; namely debt service and import
payments
The relationship can be explained by the “perception” of economic agents
Depletion of reserve below some level may be perceived as signs of some
sort of problem, subsequently leading to depreciation of domestic
currency
Building up of reserve may lead to a positive perception and is likely to
harden the domestic currency

35. 35AG
Concept Questions
1.Why Firms Pursue International Business?
2.Why might agency costs be larger for an MNC than for a purely
domestic firm?
3.How Firms Engage in International Business?
4.Would the agency problem be more pronounced for ABC Corp., which has
its parent company make most major decisions for its foreign subsidiaries, or
XYZ Corp., which uses a decentralized approach?

36. 36AG
Chapter End