1 Chapter8 Short TermFinancing 2 Objectives Thischapterexplainsshort termliabilitymanagementofMNCs apartofmultinationalmanagementthatisoftenneglectedinothertextbooks Fromthischapter weshouldlearnthatcorrectfinancingdecisionscanreducethefirm scostsandmaximizethevalueoftheMNC Whileforeignfinancingcostscannotusuallybeperfectlyforecasted firmsshouldevaluatetheprobabilityofreducingcoststhroughforeignfinancing Thespecificobjectivesare 3 Objectives toexplainwhyMNCsconsiderforeignfinancing toexplainhowMNCsdeterminewhethertouseforeignfinancing andtoillustratethepossiblebenefitsoffinancingwithaportfolioofcurrencies 4 Pre classDiscussion Ifafirmconsistentlyexportstoacountrywithlowinterestratesandneedstoconsistentlyborrowfunds explainhowitcouldcoordinateitsinvoicingandfinancingtoreduceitsfinancingcosts Whatistheriskofborrowingalowinterestratecurrency AssumethatforeigncurrenciesX Y andZarehighlycorrelated Ifafirmdiversifiesitsfinancingamongthesethreecurrencies willitsubstantiallyreduceitsexchangerateexposure Explain 5 InternalFinancingbyMNCs BeforeanMNC sparentorsubsidiarysearchesforoutsidefunding itshoulddetermineifanyinternalfundsareavailable ParentsofMNCsmayalsoraisefundsbyincreasingtheirmarkupsonthesuppliesthattheysendtotheirsubsidiaries 6 SourcesofShort TermFinancing Euronotesareunsecureddebtsecuritieswithtypicalmaturitiesof1 3or6months Theyareunderwrittenbycommercialbanks MNCsmayalsoissueEuro commercialpaperstoobtainshort termfinancing MNCsutilizedirectEurobankloanstomaintainarelationshipwiththebankstoo 7 WhyMNCsConsiderForeignFinancing AnMNCmayfinanceinaforeigncurrencytooffsetanetreceivablespositioninthatforeigncurrency AnMNCmayalsoconsiderborrowingforeigncurrencieswhentheinterestratesonsuchcurrenciesareattractive soastoreducethecostsoffinancing 8 DeterminingtheEffectiveFinancingRate Theactualcostoffinancingdependsontheinterestrateontheloan andthemovementinthevalueoftheborrowedcurrencyoverthelifeoftheloan Example howtocomputetheeffectivefinancingrate 9 Howtocomputetheeffectivefinancingrate Example Dearborn Inc basedinMichigan obtainsaone yearloanof 1 000 000inNewZealanddollars NZ atthequotedinterestrateof8percent WhenDearbornreceivestheloan itconvertstheNZ toUS topayasupplierformaterials Theexchangerateatthattimeis 50 sotheNZ 1 000 000isconvertedto 500 000 1 000 000 50 Oneyearlater DearbornpaysbacktheloanofNZ 1 000 000plusinterestofNZ 80 000 8 NZ 1 000 000 Thus thetotalamountinNewZealanddollarsneededbyDearbornisNZ 1 080 000 1 000 000 80 000 AssumetheNewZealanddollarappreciatesfrom 50to 60bythetimetheloanistoberepaid Dearbornwillneedtoconvert 648 000 10 Howtocomputetheeffectivefinancingrate Example 1 080 000 60 tohavethenecessarynumberofNewZealanddollarsforloanrepayment Tocomputetheeffectivefinancingrate firstdeterminetheamountinU S dollarsbeyondtheamountborrowedthatwaspaidback ThendividebythenumberofU S dollarsborrowed afterconvertingtheNewZealanddollarstoU S dollars GiventhatDearbornborrowedtheequivalentof 500 000andpaidback 648 000fortheloan theeffectivefinancingrateinthiscaseis 148 000 500 000 29 6 11 DeterminingtheEffectiveFinancingRate Effectivefinancingraterf 1 if 1 St 1 S S 1whereif theinterestrateontheloanS beginningspotrateSt 1 endingspotrateTheeffectiveratecanberewrittenasrf 1 if 1 ef 1whereef the Dinthespotrate 12 CriteriaConsideredforForeignFinancing TherearevariouscriteriaanMNCmustconsiderinitsfinancingdecision includinginterestrateparity theforwardrateasaforecast andexchangerateforecasts 13 CriteriaConsideredforForeignFinancing InterestRateParity IRP IfIRPholds foreignfinancingwithasimultaneoushedgeofthatpositionintheforwardmarketwillresultinfinancingcostssimilartothosefordomesticfinancing 14 CriteriaConsideredforForeignFinancing TheForwardRateasaForecastIftheforwardrateisanaccurateestimateofthefuturespotrate theforeignfinancingratewillbesimilartothehomefinancingrate Iftheforwardrateisanunbiasedpredictorofthefuturespotrate thentheeffectivefinancingrateofaforeignloanwillonaveragebeequaltothedomesticfinancingrate Summaryoftheimplicationsofavarietyofscenariosrelatingtointerestrateparityandforwardrate 15 ImplicationsofIRPforFinancing IRPholds ScenarioTypeoffinancingFinancingcostsYesCoveredSimilarYesForwardrateaccuratelyUncoveredSimilarpredictsfuturespotrateYesForwardrateoverestimatesUncoveredLowerfuturespotrateYesForwardrateunderestimatesUncoveredHigherfuturespotrateNoForwardpremium discount CoveredHigherexceeds islessthan interestratedifferentialNoForwardpremium discount CoveredLowerislessthan exceeds interestratedifferential 16 CriteriaConsideredforForeignFinancing ExchangeRateForecastsFirmsmayuseexchangerateforecaststoforecasttheeffectivefinancingrateofaforeigncurrency ortheymaycomputethebreak evenexchangeratethatwillequatethedomesticandforeignfinancingrates Example Sarasota Inc needsfundsforoneyearandisawarethattheone yearinterestrateofU S dollaris12percentwhiletheinterestratefromborrowingSwissfrancsis8percent SarasotaforecaststhattheSwissFrancwillappreciatefromitscurrentrateof 45to 459 orby2percent