MBF1223 Financial Management Prepared by Dr Khairul Anuar

Transcription

1 MBF1223 Financial Management Prepared by Dr Khairul Anuar L11 - International Financial Management

2 Learning Objectives Understand cultural, business, and political differences in business practices. Calculate exchange rates, cross rates, and forward rates. Understand transaction exposure, operating exposure, and translation exposure. Apply net present value to foreign projects.

3 1. Managing Multinational Operations The complexity of managing multinational corporations increases significantly because of differences in: cultures, business practices, and political systems that firms are faced with once they operate in foreign countries.

4 2. Cultural Risk Cultural risk arises from differences in customs, social norms, attitudes, assumptions, and expectations of the local society in the host country. Differences in ownership structure: such as the requirement to set up joint ventures in certain countries and the requirement to increase local participation and ownership. Differences in human resource norms: such as hiring and firing norms different cultural attitudes towards women and minorities in the workplace. local promotions and reward systems may not be consistent with those of the home office and would have to be altered to maintain positive relations with local employees, customers, and government officials. Religious heritage of the host country: the way employees dress holiday observances

5 2. Cultural Risk Nepotism and corrupt practices in the host country: such as the requirement to hire relatives of government officials as a condition of doing business and bribery of officials to get permits and licenses considered to be illegal in the USA are normal practices in many foreign countries. Intellectual property rights: such as those protected by copyrights and patents, may not be honored in some foreign countries (e.g. China) and become an issue when considering doing business abroad. Although attempts are being made to alter the landscape of differences in attitudes towards intellectual property rights e.g treaty, much still needs to be done.

6 3. Business Risk Arises from economic factors such as inflation rates, recessions, and interest rate movements and exchange rate fluctuations Tend to be more pronounced when operating in multiple countries. Efficient diversification of such risk factors is key to success.

7 4. Political Risk Arises from changing attitudes of the political leadership towards MNCs resulting in loss of subsidies or risk of nationalization. MNCs can defend against such risks by: Keeping critical operations private: i.e. maintain key or critical elements of operations safely within the firm rendering the assets useless in case of nationalization. Financing operations and assets with local money: so that local creditors can put pressure on the host government not to nationalize the business. Receiving primary inputs outside the local economy: without which the assets and operations would not be valuable.

8 5. Foreign Exchange With each sovereign nation having its own currency (except of course, the Euro which is the accepted currency in 16 out of 27 countries of the European Union (EU)), MNCs have to keep track of the fluctuations in exchange rates of various currencies caused by fluctuating economic factors such as interest rates, inflation rates and productivity.

9 6. Purchasing Power Parity Purchasing power parity - the price of similar goods is the same regardless of which currency one uses to buy the goods. Table 1: how the price of a Big Mac in various countries can be used to keep track of relative purchasing power and exchange rates in countries where McDonalds operates.

10 6. Purchasing Power Parity Price in US $ = Price of a Big Mac in Foreign Currency/ HK$/1US$ For Hong Kong, Price in US$ HK$15.1/HK$7.79 = $1.94 Purchasing Power(Hong Kong) = Price in HK$/Price in US$=HK$15.1/$ Table 1: Big Mac Index

11 6. Purchasing Power Parity In the real world, exchange rates are based on the prices of a basket of goods, rather than on a single item, in different countries. In general, the rate at which we can exchange money between currencies should allow us to purchase the same basket of goods in any country with the same dollars (except for local tariffs etc.)

12 7. Currency Exchange Rates Currency exchange rates can be expressed in direct form (amount of $ required to buy 1 unit of foreign money); or indirect form (amount of foreign money required to buy 1 US$).

13 7. Currency Exchange Rates Table 2 Exchange Rates on August 9, 2011

14 7. Currency Exchange Rates Calculation of these rates is as follows: So, 1 Mexican peso can buy roughly 8 US cents. If we divide the direct rate into 1 i.e. take its reciprocal we get the indirect or European rate, i.e. Indirect rate = 1/$ Mexican Pesos 1 US$ can buy Mexican pesos.

15 8. Cross Rates Cross rates state the exchange rate between two non-us currencies, e.g. the exchange rate between the British Pound and the Yen.

16 8. Cross Rates In Britain, this would be the indirect rate between the British Pound and the Japanese Yen, i.e. it would tell us how many units on yen can be bought with 1. To solve for the direct rate between the and the Yen, we simply take the reciprocal of the indirect rate 1/ can be purchased with 1 Yen. Alternatively, we can solve for the indirect rate between 2 currencies e.g. the amount of Yen that 1 can buy by using the following process: Take the direct or American rate of the first foreign currency and multiply it by the indirect or European rate of the second foreign currency:

17 9. Arbitrage Opportunities Arbitrage opportunities exist when cross rates as determined by Equation 18.3 do not hold, allowing traders the opportunity to exchange currencies simultaneously and make instant profits without taking on any additional risk.

18 9. Arbitrage Opportunities Example 1: Triangular arbitrage. Let s say that you see that the direct rate for Euro is and the indirect rate for the Yen is You check the internet and find that the indirect rate for Yen in Euros is 130 yen. You have $10,000 and are willing to make quick gains if possible. Is there an arbitrage opportunity here? Answer First check to see if the indirect rate for Yen in Euros is correct or not using Equation According to Equation 18.3, the indirect rate for Yen per Euro = Direct rate for Euros in US$* Indirect rate for Yen in US = $ * Y/Euro which is less than the internet rate so the Euro seems to be overvalued.

19 9. Arbitrage Opportunities Example 1 Answer (continued) Convert dollars into Euros, buy Yen at the internet rate, and convert Yen back to dollars as follows: $10,000* Euros/$ Euros Euros * 130 Yen/Euro Yen Yen *.0104$/Yen=$10, So make a cool $462,77 before commissions. YES! THIS WOULD BE AN ARBITRAGE OPPORTUNITY!

20 10. Forward Rates Forward rate - the exchange rates in the future e.g. one year from now, depend to a large extent on the current exchange rate and the relative expected inflation rates in the 2 countries as shown in Equation Where inf f = expected inflation rate in the foreign country And inf h = expected inflation rate in the host country.

21 10. Forward Rates If a country s inflation rate increases relatively higher than that of another country, then its currency s exchange rate will get weaker i.e. it will buy less units of the currency of the country whose inflation rate did not increase as much. Equation 18.4 applies to a 1 year forward rate. A more general formula that can be used for predicting forward rates for any future period is shown in Equation 18.5 Where T is time in years i.e. 9 months = T= 9/12 = have T = and 3 years would

22 10. Forward Rates Example 2: Calculating forward rates: Let s say that the Australian $ is currently being quoted at A$1.3109/US$. If inflation is likely to be 8% in Australia and 4% in the US, calculate the indirect forward rate for the Australian dollar 3 months from now. Forward indirect rate --3 months = A$ * (1.08/1.04) 3/12 A$ So, since inflation is expected to rise higher in Australia than in the USA, the Aussie $ is expected to get weaker i.e. 1US$ will buy more A$ than before.

23 11. Using Forward Rates Investors and companies can use forward contracts to minimize their risk of losses arising from having to convert money received in foreign currencies at lower rates. The forward rate is the rate that is being committed to today for forward delivery of the currency. So if rates go down, you still get the forward rate that was agreed upon. According to the International Fisher Effect, the real interest rates are equal across all countries, so if we get a higher rate in one country, it will be offset by a higher inflation in that country and a weakening exchange rate. Covered interest arbitrage is an attempt made by some investors to try and exploit variances in inflation rates and interest rates across countries. Most often, however, the exchange rate adjusts such that the arbitrage opportunities do not materialize.

24 12. Transaction, Operating, and Translation Exposures Fluctuations in exchange rates cause a firm s future cash inflows, either from remittances from customers or from profits being sent home to vary significantly leading to possible losses and gains from transaction, operating, and translation exposure.

25 13. Transaction Exposure This exposure can and must be hedged by selling the currency forward i.e. selling forward contracts whereby the forward selling price of the foreign currency to be received is being agreed upon today. Transaction exposure is the potential loss in home currency value of future foreign currency payments. This loss would occur if the home currency gets stronger meaning fewer units can be purchased per unit of the foreign currency.

26 14. Operating Exposure Unfavorable exchange rate movements Operating Exposure: i.e. threat to the longrun viability of a foreign operation of a multinational business Escalating inflation rates

27 14. Operating Exposure Tables 4 and 5 illustrate the effects of rising inflation rates on a country s exchange rate and the consequential negative effect on operating profits of a US firm doing business in Sweden. Table 4: Dollar Profit per Swedish Bicycle Sale: No Change in Exchange Rate (inflation the same in both countries)

28 14. Operating Exposure Table 5: Dollar Profit per Swedish Bicycle Sale: Increase in Exchange Rate Due to Different Inflation Rates

29 15. Translation Exposure Differences in rules for translating foreign financial statements. Affects the way consolidated statements are reported. Leading to a risk of negative effects on a firm s financial statements

30 16. Foreign Investment Decisions When evaluating multinational capital budgeting projects, the NPV analysis can be done with either foreign currency cash flows or with domestic currency cash flows. Two main differences between foreign and domestic investment decisions include: 1. the use of an appropriate discount rate which accounts for the relative inflation rates in the two countries and 2. the conversion of cash flows using an appropriate exchange rate.