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Financial Management ­ MGT201
VU
Lesson 44
INTERNATIONAL FINANCE (MULTINATIONAL FINANCE)
Learning Objectives:
After going through this lecture, you would be able to have an understanding of the following
topics:
·  International Finance (Multinational Finance)
In the lecture we shall cover three areas of International Finance:
·  Multinational Finance
·  Impact of Globalization and International Finance on different areas of financial management
like capital budgeting, capital structure and Capital asset pricing model
·  Foreign Exchange (F/x)
First we discuss the first area of Multinational Finance.
Issues of International Finance:
·  All Finance has become International
­  Financial Markets (Money and Capital Markets) of all countries are Linked by hi-speed
telecom satellite links, computer, and Internet
­  Butterfly Effect ­ "When New York Stock Exchange Sneezes, the Tokyo Stock
Exchange catches a cold". It explains the impact of capital markets that are linked all
over the world. As all the financial markets over the world are linked due to
international flow of money and international trade and transactions. So any change in
one part of the world has its affects on the other part of the world.
·  All Firms affected by International Factors
­  Even 100% Domestic Firm is affected by International Finance because it competes
with Importers and Foreign Franchises substitutes and competing products whose prices
change with Foreign Exchange Rate.
·  2 Fundamental Flows Determine a Country's Foreign Exchange Rate
­  International Flow or Trade of Real Physical Goods:
Trade Surplus / Deficit = Imports - Exports
­  International Flow of Capital or Money ­ Balance of Payments (BOP)
= Current Account + Capital Account + Foreign Exchange Reserves.  Current
Account includes Trade of Goods and Services.
Capital Account measures Capital coming in (FDI and Portfolio Investment) and
Going Out.
­  Domestic Macroeconomic Factors affecting Foreign Exchange:
1) Inflation
2) Fiscal Deficit (if government expenditures exceed their revenues through taxes etc.)
Why do Multinationals Do Business Internationally?
­  To Expand Market Share: USA and EU are about $ 10 Trillion Economies Each. And
each has about 300 million people.
­  Get Closer to End Users / Consumers i.e. Toyota of Japan in USA
­  Lower Production Costs, Shipping Costs, Raw Material Costs i.e. British BAT Tobacco
in NWFP, Union Texas in Badin
­  Bypass Trade Barriers and Import Tariffs i.e. Pakistanis set up textile units in Srilanka,
UAE and Mexico to legally bypass US Textile quota for exports from Pakistan.
­  Diversify and Reduce Sovereign (Country-Specific Political) Risk
·  Portfolio of Subsidiary Companies, Divisions, Projects, Investments diversified
across different countries can reduce the Sovereign (or Country-Specific
Political) Risk
·  Manage Foreign Exchange Rate Exposure. If your home currency is very weak
or Depreciating (because of Inflation, Deficits, Political Turmoil etc. ) then
invest abroad
·  Take advantage of Lower Costs of Debt (interest rates) in foreign countries or
lower Taxes.
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Financial Management ­ MGT201
VU
Major Issues Faced by Multinationals:
­  Foreign Exchange Risk i.e. Turkish Lira, Russian Ruble. Caused by Unexpectedly high
Inflation, Deficits, and Political Turmoil etc.
­  Sovereign and Political Risk i.e. South Africa, Afghanistan, Rwanda - risk of War, Civil
Unrest
­  Different Laws Business Contract, Property, Companies, Capital Flow & Different Tax
Rates, Different Government Involvement, and Different Maturity of Financial Markets
·  Saudi Arabia (Restricted property rights)
·  USA (strict Monopoly laws) vs. Bahamas (Lenient Laws and Tax)
·  Japan (MITI supports Japanese exporters abroad)
­  Different Cultures, Customer Awareness about their rights and Quality Standards,
Credit Cultures, and Business Practices and Ethics
·  Japanese Kereitsu (Bank is Business Partner and Shareholder) so in Japan large
companies like Sony have large of debt in their capital.
·  Korean Chaebols (Conglomerates with Monopoly power)
·  German Consumer Standards
·  Business Ethics i.e. Nigeria vs. Singapore
·  Central Asia (Barter economy and Long Credit Cycle)
Now we move to the second area of today discussion:
International Financial Management:
·  International Diversification
­  Bruno ­ Solnik: These two persons analyzed INTERNATIONAL Portfolio of 20 Stocks
has HALF as much risk as same portfolio containing stocks of just 1 country.
·  International CAPM Model for Integrated Global Market
r P = r RF + Beta (r W - r RF )
­  r W is the WORLD MARKET Required Rate of Return expected by all investors all
over the world
­  Assets are priced in LOCAL (or SEGMENTED) MARKETS so if an Investor can
diversify internationally, then he may attain RISK-RETURN above the Local Market
Capital Market Line.
­  Global Efficient Frontier (for Investment in World Markets) offers higher Risk-Return
combinations than Local Segmented Market Efficient Frontier.
Global Investing Makes the Efficient Frontier and the
CML (Capital Market Line) Rise Up
Higher Return for Same Level of Risk
Efficient Frontier (for
)
rP*
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Efficient Frontier
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Single Country)
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Financial Management ­ MGT201
VU
·
International Corporate Financing
­  Raise capital in the country where you can get the best price and yield.
­  Euro equities Example ADR's (American Depository receipts): Non-US firms can be
listed and traded on the NASDAQ Stock Exchange in USA. So Pakistani firms can
raise equity capital in America. Foreign firms can also be listed on Luxembourg stock
exchange to raise Equity capital in Euro currency.
­  Eurobonds: Currency of bond issue is different from the country of issue. Example:
Pakistani company selling US$-denominated Bonds in Luxembourg can raise Debt
capital in Euro currency.
·
International Capital Budgeting
PV = CF 1 / (1+r) + CF 2 / (1+r) 2 + CF 3 / (1+r) 3 + ...
­  CF or Cash Flows in foreign countries need to be converted into the Home Currency of
the Investor (or country where Head Office is located).
·  Transfer Pricing, Royalties, and Foreign Country's Inflation affect forecast of
cash flows
·  Opportunity Cost of Foreign Funds Blocked because of Remittance Restriction
·  Different taxes in different countries. Tax on Remitted Income.
­  Discount rate "r"
·  Discount the foreign cash flows in the nominal foreign currency discount rate.
Then convert the PV in foreign currency to home currency.
·  Use High Discount Rate if High Level of Country - specific Political or
Sovereign Risk
·  Impact of Concessionary Financing can affect choice of "r"
·
International Accounting Standards
­  Profit & Loss Statement (or Income Statement) ­ Convert foreign expenses and
revenues at the AVERAGE F/x Rate prevailing during the Accounting Period.
­  Balance Sheet ­ Foreign FIXED (Non-Financial) Asset values converted at
HISTORICAL F/x Rate prevailing at the time of purchase. But, Foreign FINANCIAL
Assets converted at AVERAGE F/x Rate prevailing during the Accounting Period.
Foreign Exchange Rate:
·  Currencies, like Goods, are bought and sold in markets. The price of a currency increases if the
financial, economic, and political health of that Country becomes stronger. Like price of cotton
from Pakistan which is different from China and Egypt and changes with quality and
Supply/Demand.
·  Currencies or F/x are traded in International F/x Markets which is the largest Financial Market
of all with trading in Trillions of Dollars. Banks, Firms, and Individuals can trade in Virtual
Electronic F/x Markets from their computer 24-hours a day. F/x rates are changing every
second!
·  The Demand / Supply of F/x affect the Value of the Currency.
·  3 F/x Markets:
­  F/x Spot Market : "Current" exchange rate for Delivery within 2 Days
­  F/x Forwards Market: Make contract today for Delivery in future. Forward Price
Determined by Interest Rate Yield Curve and Spot Rate. Contract size and delivery
date negotiated privately with banks.
­  F/x Futures Market: Derivative securities whose value is derived from Forward prices
and "Mark-to-market" risk premium for meeting minimum balance in Margin Account
for trading. Tradable in Exchanges because of Standardized contract size and fixed
future delivery dates.
­  F/x Options Market: Derivative securities. Spot Option values derived from Spot F/x
Rate. Future Option values derived from Futures F/x Rate. Options (unlike Forwards
and Futures) are not obligations. It is cheaper to buy an Option to buy a house than to
buy the house! Same for F/x. Also, you can decide not to buy and let the option expire.
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Financial Management ­ MGT201
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·
Call Option ­ Right to Buy something at a fixed Strike Price for a limited time
in the future
·
Put Option ­ Right to Sell something at a fixed Strike Price for a limited time in
the future
·
Valuation or Pricing of Options using famous BLACK & SCHOLES MODEL
or simpler Binomial Model
Relationship between Foreign Exchange Rate, Interest Rate & Inflation Rate:
·  Spot F/x Rate of 2 Countries determined by Prices of Real Goods:
­  Relative Prices of Same Good ­ Purchasing Power Parity Theorem (PPP)
·  Spot price (Rs. / US$) = Price (Pak) / Price (USA)
·  Example: Use Price of Levis Jeans made in Pakistan and USA to estimate the
theoretical Spot F/x Rate. Price of Levis 501 is US$50 in USA and Rs.3100 in
Pakistan so the Estimated Spot F/x Rate = S (Rs. / US$) = Rs.3100 / US$50 =
Rs.62 / US$1. This is close to the actual Spot F/x rate in range of Rs.50-60.
·  Nominal Interest Rate determined by Expected Inflation.
­  Relative Expected Inflation Rates ( g ) ­ Fischer Effect
·  (1+ i Rs.) / (1+ i US$ ) = (1+ g Pak ) / (1+g USA )
·  Forward F/x Rate determined by Interest Rate Yield Curve
­  Relative Interest Rates ( i ) - Interest Rate Parity Theorem (IRP)
·  F (Rs. /US$) / S (Rs. /US$)
= (1+ i RS) / (1+ i US$)
·  Example: Use 1 Year Estimate of Interest Rates in Pakistan and USA to
estimate the 1 Year Forward F/x Rate. Using Yield Curves, you know that the
interest on 1 Year Maturity in Pakistan is 10% and in USA 2%. You know that
the current (or Spot) Rate is Rs.60/US$1. So, the 1 Year Forward Rate
= F = S (Rs. /US$) (1+ i Rs.) / (1+ i US$)
= (60) (1+0.1) / (1+0.02)
= Rs.64.7 / US$1.
In other words, we have forecasted the F/x Rate after 1 Year.
·  2 Conventions for Quotation of F/x Rates used by Banks and F/x Dealers:
­  American: US$ / FCY i.e. US$0.9 / 1Euro (means "Bid US$ 0.9 / Ask 1 Euro")
­  European: FCY / US$ i.e. JY100 / US$1, Rs.60 / US$1.
­  Inverse Relationship: European = 1 / American.  So, Japanese Yen (JY) under
American Convention = 1 / 100 = US$0.01 / 1JY. Commonly written as 1.000.
In Pakistan generally we follow European convention.
·
PAIR of Market Prices for Every Currency in the F/x Market
­  BID Rate = Buying Price for Currency. Example: Bid Rs.60 / US$1
Means Bank
or Money Changer will Buy (or Bid) one US$ from you for Rs.60. This also means that
you (the Customer) are Selling Dollar to the Bank. Bid Rs.60 / US$1 means Bid Rs60 /
Ask US$1
­  ASK Rate = Selling Price for Currency. Example Ask Rs.61 / US$1 Means Bank or
Money Changer will Sell (or Ask) one US$ to you for Rs.61. This also means that you
(the Customer) are Buying Dollar from the Bank. Ex. If you are going to travel abroad
to USA.
­  Fundamental Principle for F/x Traders and "Money Changers": Buy Low and Sell
High. So, ASK > BID Rate.
­  Standard Quotation Format: Bid Rate / Ask Rate.
·  Ex 1. "US$ 60/61" means Money Changer will Buy 1 US$ from you (the
customer) for Rs.60 BUT they will Sell 1 US$ to you for Rs.61. Means a Profit
of Rs.1 for every US$ traded!
·  Ex2. If you see only 1 Quote i.e. "US$ 60" then it generally refers to the Bid
Quote i.e. Bid Rs60 / US$1.
·
Cross Rates (Transitivity of F/x Rates)
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Financial Management ­ MGT201
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­
Example with Either Bid OR Ask Rates: Suppose you want to convert your Euros into
US Dollars in Pakistan and you need to estimate the E/US$ F/x rate. Money Changers
and Banks in Pakistan show Spot F/x Rates in Rupee-Terms: Rs.60 / 1US$ and Rs.55 /
1Euro. Then Spot US$ / Euro = ( US$ / Rs. ) x ( Rs. / Euro) = ( 1US$ / Rs. 60) x
( Rs55 / 1 Euro) = US$ 0.9167 / 1Euro
­
If you are given Both Bid and Ask Rates, then Estimate the Cross Rate RANGE.
·  Bid Euro / Ask US$ < ( Bid Euro / Ask Rs. ) x ( Bid Rs. / Ask US$)
·  Ask Euro / Bid US$ > (Ask Euro / Bid Rs.) x ( Ask Rs. / Bid US$)
Global Investments
Make SML (for Efficient Stocks) Rise Up
Higher Return for Same Level of Risk
Required
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Beta Risk (
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183
Table of Contents:
  1. INTRODUCTION TO FINANCIAL MANAGEMENT:Corporate Financing & Capital Structure,
  2. OBJECTIVES OF FINANCIAL MANAGEMENT, FINANCIAL ASSETS AND FINANCIAL MARKETS:Real Assets, Bond
  3. ANALYSIS OF FINANCIAL STATEMENTS:Basic Financial Statements, Profit & Loss account or Income Statement
  4. TIME VALUE OF MONEY:Discounting & Net Present Value (NPV), Interest Theory
  5. FINANCIAL FORECASTING AND FINANCIAL PLANNING:Planning Documents, Drawback of Percent of Sales Method
  6. PRESENT VALUE AND DISCOUNTING:Interest Rates for Discounting Calculations
  7. DISCOUNTING CASH FLOW ANALYSIS, ANNUITIES AND PERPETUITIES:Multiple Compounding
  8. CAPITAL BUDGETING AND CAPITAL BUDGETING TECHNIQUES:Techniques of capital budgeting, Pay back period
  9. NET PRESENT VALUE (NPV) AND INTERNAL RATE OF RETURN (IRR):RANKING TWO DIFFERENT INVESTMENTS
  10. PROJECT CASH FLOWS, PROJECT TIMING, COMPARING PROJECTS, AND MODIFIED INTERNAL RATE OF RETURN (MIRR)
  11. SOME SPECIAL AREAS OF CAPITAL BUDGETING:SOME SPECIAL AREAS OF CAPITAL BUDGETING, SOME SPECIAL AREAS OF CAPITAL BUDGETING
  12. CAPITAL RATIONING AND INTERPRETATION OF IRR AND NPV WITH LIMITED CAPITAL.:Types of Problems in Capital Rationing
  13. BONDS AND CLASSIFICATION OF BONDS:Textile Weaving Factory Case Study, Characteristics of bonds, Convertible Bonds
  14. BONDS’ VALUATION:Long Bond - Risk Theory, Bond Portfolio Theory, Interest Rate Tradeoff
  15. BONDS VALUATION AND YIELD ON BONDS:Present Value formula for the bond
  16. INTRODUCTION TO STOCKS AND STOCK VALUATION:Share Concept, Finite Investment
  17. COMMON STOCK PRICING AND DIVIDEND GROWTH MODELS:Preferred Stock, Perpetual Investment
  18. COMMON STOCKS – RATE OF RETURN AND EPS PRICING MODEL:Earnings per Share (EPS) Pricing Model
  19. INTRODUCTION TO RISK, RISK AND RETURN FOR A SINGLE STOCK INVESTMENT:Diversifiable Risk, Diversification
  20. RISK FOR A SINGLE STOCK INVESTMENT, PROBABILITY GRAPHS AND COEFFICIENT OF VARIATION
  21. 2- STOCK PORTFOLIO THEORY, RISK AND EXPECTED RETURN:Diversification, Definition of Terms
  22. PORTFOLIO RISK ANALYSIS AND EFFICIENT PORTFOLIO MAPS
  23. EFFICIENT PORTFOLIOS, MARKET RISK AND CAPITAL MARKET LINE (CML):Market Risk & Portfolio Theory
  24. STOCK BETA, PORTFOLIO BETA AND INTRODUCTION TO SECURITY MARKET LINE:MARKET, Calculating Portfolio Beta
  25. STOCK BETAS &RISK, SML& RETURN AND STOCK PRICES IN EFFICIENT MARKS:Interpretation of Result
  26. SML GRAPH AND CAPITAL ASSET PRICING MODEL:NPV Calculations & Capital Budgeting
  27. RISK AND PORTFOLIO THEORY, CAPM, CRITICISM OF CAPM AND APPLICATION OF RISK THEORY:Think Out of the Box
  28. INTRODUCTION TO DEBT, EFFICIENT MARKETS AND COST OF CAPITAL:Real Assets Markets, Debt vs. Equity
  29. WEIGHTED AVERAGE COST OF CAPITAL (WACC):Summary of Formulas
  30. BUSINESS RISK FACED BY FIRM, OPERATING LEVERAGE, BREAK EVEN POINT& RETURN ON EQUITY
  31. OPERATING LEVERAGE, FINANCIAL LEVERAGE, ROE, BREAK EVEN POINT AND BUSINESS RISK
  32. FINANCIAL LEVERAGE AND CAPITAL STRUCTURE:Capital Structure Theory
  33. MODIFICATIONS IN MILLAR MODIGLIANI CAPITAL STRUCTURE THEORY:Modified MM - With Bankruptcy Cost
  34. APPLICATION OF MILLER MODIGLIANI AND OTHER CAPITAL STRUCTURE THEORIES:Problem of the theory
  35. NET INCOME AND TAX SHIELD APPROACHES TO WACC:Traditionalists -Real Markets Example
  36. MANAGEMENT OF CAPITAL STRUCTURE:Practical Capital Structure Management
  37. DIVIDEND PAYOUT:Other Factors Affecting Dividend Policy, Residual Dividend Model
  38. APPLICATION OF RESIDUAL DIVIDEND MODEL:Dividend Payout Procedure, Dividend Schemes for Optimizing Share Price
  39. WORKING CAPITAL MANAGEMENT:Impact of working capital on Firm Value, Monthly Cash Budget
  40. CASH MANAGEMENT AND WORKING CAPITAL FINANCING:Inventory Management, Accounts Receivables Management:
  41. SHORT TERM FINANCING, LONG TERM FINANCING AND LEASE FINANCING:
  42. LEASE FINANCING AND TYPES OF LEASE FINANCING:Sale & Lease-Back, Lease Analyses & Calculations
  43. MERGERS AND ACQUISITIONS:Leveraged Buy-Outs (LBO’s), Mergers - Good or Bad?
  44. INTERNATIONAL FINANCE (MULTINATIONAL FINANCE):Major Issues Faced by Multinationals
  45. FINAL REVIEW OF ENTIRE COURSE ON FINANCIAL MANAGEMENT:Financial Statements and Ratios