ISBN: 0-03-028931-9
Chapter 19 Multinational Financial Management
This chapter discussed the most important differences between multinational and domestic financial management. Some of the key concepts are listed below:
International operations are becoming increasingly important to individual firms and to the national economy. A multinational, or global, corporation is a firm that operates in an integrated fashion in a number of countries.
Companies "go global" for six primary reasons: (1) to expand their markets, (2) to obtain raw materials, (3) to seek new technology, (4) to lower production costs, (5) to avoid trade barriers, and (6) to diversify.
Among the recent events that have dramatically changed the international financial environment include: (1) the disintegration of the former Soviet Union, (2) the reunification of Germany, (3) the European Community and the European Trade Association, (4) the North American Free Trade Agreement, and (5) the loosening of American bank regulation.
Six major factors distinguish financial management as practiced by domestic firms from that practiced by multinational corporations: (1) different currency denominations, (2) different economic and legal structures, (3) languages, (4) cultural differences, (5) role of governments, and (6) political risk.
An exchange rate is the number of units of a given currency that can be purchased for one unit of another currency. When discussing exchange rates, the number of U.S. dollars required to purchase one unit of a foreign currency is called a direct quotation, while the number of units of foreign currency that can be purchased for one U.S. dollar is an indirect quotation.
Financial forecasting is more difficult for multinational firms, because exchange rate fluctuations make it difficult to estimate the dollars that overseas operations will produce.
Prior to August 1971, the world was on a fixed exchange rate system whereby the U.S. dollar was linked to gold and other currencies were then tied to the dollar. After August 1971, the world monetary system changed to a floating system under which major world currency rates float with market forces, largely unrestricted by governmental intervention. The central bank of each country does operate in the foreign exchange market, buying and selling currencies to smooth out exchange rate fluctuations, but only to a limited extent.
Pegged exchange rates occur when a country establishes a fixed exchange rate with a major currency. Consequently, the values of pegged currencies move together over time.
It is important to recognize that not all currencies are convertible, which means that such a currency can not be readily exchanged for other currencies. Lack of convertibility is usually associated with countries that have volatile political and economic environments.
Spot rates are the rates paid for delivery of currency "on the spot", while the forward exchange rate is the rate paid for delivery at some agreed-upon future date, usually 30, 90, or 180 days from the day the transaction is negotiated. The forward rate can be at either a premium or a discount to the spot rate. If a dollar buys fewer units of foreign currency in the forward market than in the spot market, the foreign currency is said to be selling at a premium. If the opposite situation should hold, the foreign currency would be selling at a discount.
Interest rate parity holds that investors should expect to earn the same return in all countries after adjusting for risk. The condition that justifies interest rate parity can be expressed as:
(where, ft is the forward direct exchange rate, e0 is the spot rate, kh is the period interest rate in the home country, and kf is the period interest rate in the foreign country)
Purchasing power parity, sometimes referred to as the law of one price, implies that the level of exchange rates adjusts so that identical goods cost the same in different countries. Purchasing power parity can be expressed as:
- pk=( pf )( eo )
Granting credit is more risky in an international context because, in addition to the normal risks of default, the multinational firm must worry about exchange rate changes between the time a sale is made and the time a receivable is collected.
Credit policy is important for a multinational firm for two reasons: (1) Much trade is with less-developed nations, and in such situations granting credit is a necessary condition for doing business. (2) The governments of nations such as Japan whose economic health depends upon exports often help their firms compete by granting credit to foreign customers.
Foreign investments are similar to domestic investments, but political risk and exchange rate risk must be considered. Political risk is the risk that the foreign government will take some action which will decrease the value of the investment, while exchange rate risk is the risk of losses due to fluctuations in the value of the dollar relative to the values of foreign currencies.
Investments in international capital projects expose firms to exchange rate risk and political risk. The relevant cash flows in international capital budgeting are the dollars which can be turned over to the parent company.
Eurodollars are U.S. dollars deposited in banks outside the United States. Interest rates on Eurodollars are tied to LIBOR, the London interbank offer rate.
U.S. firms often find that they can raise long-term capital at a lower cost outside the United States by selling bonds in the international capital markets. International bonds may be either foreign bonds, which are exactly like regular domestic bonds except that the issuer is a foreign company, or Eurobonds, which are bonds sold in a foreign country but denominated in the currency of the issuing company's home country.
The repatriation of earnings is the process of sending cash flows from a foreign subsidiary back to the parent company.
Exchange rate risk is the risk that relates to what the basic cash flows will be worth in the parent company's home currency. Political risk is the potential action by a host government that would reduce the value of a company's investment.
Multinational financial management presents managers with additional challenges in the fields of capital budgeting, capital structure, and working capital management.
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