Exam CND Notes PDF

7: Measuring and Managing Exchange rate Exposure I. Overview MNCs must recognise the importance of exchange rate movements to total revenue, profit and share price. To hedge exchange rate exposure, an MNC must determine the extent of its exposure ○ Transaction expo...

7: Measuring and Managing Exchange rate Exposure I. Overview MNCs must recognise the importance of exchange rate movements to total revenue, profit and share price. To hedge exchange rate exposure, an MNC must determine the extent of its exposure ○ Transaction exposure ○ Economic Exposure ○ Translation Exposure II. Transaction Exposure Sensitivity of the firm’s contractual transactions in foreign currencies to exchange rate movements ○ cash inflows or outflows ○ EG. companies exporting and importing Concerns: pricing, quantity, competitive advantage To assess exposure: ○ i. estimate its net cash flows in each currency, and ○ ii. measure the possible effects of its exposure to the whole portfolio of currencies Standard deviation of the portfolio (how far away is it to the average value - measure of volatility) Value at Risk (VaR) measures the potential maximum 1-day loss on the value of positions of an MNC that is exposed to exchange rate movements Certain confidence of level: 95% Conservative confidence interval: 99% Factors that affect the maximum 1-day loss: ○ Expected percentage change in the currency for the next day ○ Confidence level used ○ Standard deviation of the daily percentage changes in the currency ○ Based on 95% confidence interval:  1.65 standard deviations from the expected change in ER - Z-score 95% probability Factors affecting MNC’s transaction exposure ○ Currency variability: low is desirable Bigger volatility of each currency against the home currency, the bigger the volatility for the whole market ○ Currency correlations: (-1/1 - perfectly linear relationship, 0 - No relationship) Positive net cash flows in various currencies and are highly correlated = exposed to a high-level exchange rate risk May have some negative cash flow positions in some currencies to complement positive net cash flows in other currencies PAY ATTENTION TO THE SIZE & MAGNITUDE OF THE CORRELATION Hedging Policies for Transaction Exposure Hedging Most of the Exposure: MNCs can more accurately forecast future cash flows (in home currency) to make better decisions about the amount of financing needed. ○ So its home currency cash flow is not strongly influenced by by exchange rate movements. Selective Hedging: Each transaction is considered separately and the MNC will hedge those where the ER movements will negatively affect the net cash flows. Maturity matched hedging: Banks seek to hedge a contract for the same amount of time as the maturity to avoid rollover risk: ○ a derivative will expire and a loss would incur when replacing it with another forward contract ○ a derivative will not be able to replace during periods of stress in financial markets Payables MNC may hedge part or all of its known payables transactions using: ○ i. Forward or futures hedge: Allows an MNC to lock in a specific exchange rate at which it can purchase a currency and hedge payables (recall Topic 4).  ii. Currency option hedge (as discussed in Topic 4) iii. Money market hedge ○ Involves taking a money market position to cover a future payables position. ○ If a firm has excess cash, it can create a simplified money market hedge by converting the home currency into foreign currency and investing in the foreign money market. ○ If a firm prefers to hedge payables without using its cash balances, then it must: Borrow funds in the home currency and Invest in the foreign currency. ○ Call options doesn’t provide the same degree of certainty as the forward hedge, and the money market hedge but it does offer flexibility and possible upside gains so choosing an optimal hedging technique depends on the company’s expectation of future exchange rate and its philosophy on whether it is conservative or aggressive. Receivables:  ○ Optimal technique to hedge depends on specific quotation rates such as the forward rate on forward contracts, the interest rate quoted on a money market loan and the premium quoted on a put option and the expected futures exchange rate ○ If the company opts for absolute certainty, it could use either a forward or money market hedge ○ In the specific example here, hedging with the forward contract is the better choice than the money market hedge because the company ends up with more US dollar revenue. ○ However, if the company wants some flexibility and probably to enjoy some possible upside, it could hedge with a put option. ○ If the company doesn’t worry about exchange rate exposure at all, or it has shown belief that the swiss franc is going to appreciate or no change, against the US dollar, so it would do nothing and sell the foreign currency receivables at the actual future spot exchange rate Limitations: Hedging an uncertain amount of foreign currency receivables or payables = overhedging or under hedging.  ○ EG. Amazon has sales from multiple foreign markets and currencies. Sales depends on customer orders/demand at different points in time. So to hedge foreign currency receivables, Amazon has to estimate what would be the amount of receivables in a quarter. Repeated short term hedging may have limited effectiveness ○ EG. Receivable in 3 yrs - hedge with three 1 yr forward contracts. Each renewable period the forward exchange rate will update = source of risk. Alternatives to reduce transaction exposure Leading: Adjusting the timing of a payment or disbursement to reflect the expectations about future currency movements. ○ By making payments earlier, before the foreign currency appreciates Lagging: Making payments later before the foreign currency depreciates. Cross-hedging: Using a currency that serves as a proxy for the currency where the MNC is exposed to risk. ○ Identify a currency has an opposite correlation with the foreign currency. You then sell the forward contract at the future spot rate Currency Diversification: reduce exposure by diversifying business among numerous countries. III. Economic (Operating) Exposure sensitivity of the company’s cash flows to exchange rate movements ○ Despite having no international exposure, all businesses are affected by it ○ There is an indirect effect on the company’s price and quantity ○ Harder or measure and estimate → continuously rolling from one year to the next MNCs with foreign sales should offset it with foreign costs - eg. borrowing in the foreign currency or buying materials in the foreign market to reduce exposure Appreciation in home currency - reduction in cash inflows and outflows - impact on MNC net cash flow depends on whether the inflow transactions are affected than the outflow. Depreciation of home currency - increase in cash inflows and outflows Measuring Economic Exposure ○ Sensitivity analysis: Consider how sales and expense categories are affected by various exchange rate scenarios EG: ○ The cashflow decreased by nearly 20% this means that it is very sensitive to the changes in New Zealand dollars from 0.75 to 0.8  ○ Regression analysis Slope coefficient: represents the sensitivity of a company cash flows depending on exchange rate changes of the home currency Positive: appreciation of foreign currency = MNC has higher net cash inflows Negative: appreciation of home currency = MNC has lower net cash inflows SP = b0 + (b1 x e) + u SP represents the percentage change in the company’s stock price per quarter e represents the percentage change in the Argentine peso’s value per quarter u is an error term b0 and b1 are regression coefficients Managing Economic Exposure ○ Hard to hedge w/ derivative contract - economic risk varies every day (exchange rate changes and competition in the market) The more you hedge, the more power to negotiate with the bank ○ Operational Hedge: ○ Natural Hedge: Overseas diversification, operational matching of revenues and expenditure (marry/netting) ○ Restructuring - shifting the sources of costs or revenue to other locations in order to match cash inflows and outflows in foreign currencies. Increase sensitivity of revenues to exchange rate movements Decrease sensitivity of expenses to exchange rate movements. Once you make structural changes, it is hard to reverse it - costs money and effort  IV. Translation Exposure exposure of the MNC’s consolidated financial statements to exchange rate fluctuations ○ EG. foreign subsidiaries need to convert their financial statements to the parent company’s local currency for reporting and consolidating Determinants of translation exposure: ○ Proportion of business by foreign subsidiaries: The greater the percentage conducted by its foreign subsidiaries = larger the percentage of a given financial statement item that is susceptible to translation exposure. ○ Locations of foreign subsidiaries: Some foreign currencies are more volatile ○ Accounting Methods ○ Exposure of an MNC’s Stock Price to Translation Effects ○ Translation exposure affects MNC consolidated earnings = affect MNC’s valuation  If a company is listed on the stock exchange, a major change in its reported earnings could move the company’s stock price quite dramatically ○ Signals that complement translation effects: exchange rate conditions that cause a translation effect can also signal changes in expected cash flows in future years. Such changes could also influence the stock price. ○ Exposure of managerial compensation to translation effects: Since an MNC’s stock may be subject to translation effects and since managerial compensation is often tied to the MNC’s stock price, it follows that managerial compensation is affected by translation effects. How Translation Exposure Can Affect the MNC’s Stock Price ○ Cochlear (AU), subsidiary in the UK and it earned 10m pounds in each year. ○ ER in year 1 = A$1.70 per pound; year 2 = A$1.50. ○ Assume it has 10m shares of stock outstanding (and no earnings in Australia) ○ Managing Translation Exposure ○ Hedged using forward or futures contracts EG. selling forward the currency of the company's foreign subsidiary. If the foreign currency depreciates, the translation loss will be somewhat offset by the gain on the short position created by the forward contract. Loss on translation is paper loss or unrealised loss and it is normally nondeductible ○ Limitations: Inaccurate earnings forecasts - earnings in a future period are uncertain. Forward contracts are not available for all currencies. - especially for many emerging markets currencies Accounting distortions – translation losses are not tax-deductible, while gains on forward contracts used to hedge translation exposure are taxed. Gains may not be enough to offset the loss Increased transaction exposure – the MNC may be increasing its transaction exposure. 8: Management of long-term assets and liabilities Multinational capital budgeting I. Subsidiary versus Parent Perspective Feasibility of international project: depends on angle Parent: ○ Tax Differentials: different tax rates may make a project feasible from a subsidiary’s perspective, but not from a parent’s perspective. ○ Restrictions on Remitted Earnings: Host governments may place restrictions on whether earnings must remain in the country. ○ Exchange Rate Movements: earnings converted to the currency of the parent company will be affected by exchange rate movements. Subsidiary: ○ Rare II. Inputs for Multinational Capital Budgeting MNC will normally require forecasts of the financial characteristics that influence the initial investment or cash flows of the project Initial investment – Funds initially invested – capital necessary to start the project and additional funds, such as working capital, to support the project over time. Price and consumer demand – Future demand is usually influenced by economic conditions, which are uncertain. Costs – Variable-cost forecasts can be developed from comparative costs of the components. (labour costs, material costs, utilities) Tax laws – International tax effects must be determined on any proposed foreign projects. Remitted funds – The MNC policy for remitting funds to the parent influences estimated cash flows. Exchange rates – These movements are often very difficult to forecast. Salvage (liquidation) values – Depends on several factors, including the success of the project and the attitude of the host government toward the project. ○ Value at the time when the company decides to shut down the operation overseas and sells everything and takes the money home Required rate of return – The MNC should first estimate its cost of capital, and then it can derive its required rate of return on a project based on the risk of that project. ○ ○ Where: IO = initial outlay (investment) CFt = cash flow in period t SVn = salvage value k = required rate of return on the project n = lifetime of the project (number of periods) ○ As a rule of thumb - positive NPV = green light on the project  But it makes a lot of simple assumptions - eg no exchange rate risks, political risk, and other risks III. Other factors to consider Exchange rate fluctuations Difficult to forecast - MNCs incorporate other scenarios ie pessimistic scenario and an optimistic scenarios Exchange Rates Tied to Parent Currency – Some MNCs consider projects in countries where the local currency is tied to the dollar. Hedged Exchange Rates – Some MNCs may hedge the expected cash flows of a new project, so they should evaluate the project based on hedged exchange rates. Inflation Affects costs and revenue in the same direction Exchange rates of highly inflated countries tend to weaken over time. The joint impact of inflation and exchange rate fluctuations may be partially offsetting effect from the viewpoint of the parent. Financing arrangement Subsidiary financing ○ Subsidiary will make interest payments on this loan Parent financing ○ parent uses its own funds to purchase the offices Blocked funds Host country may block funds that the subsidiary attempts to send after tax earnings to the parent Even if it can be remitted, but every year, they only allow to remit half of the retained earnings - it would affect the net cash flow the parent receives each year. Uncertain salvage value The salvage value of an MNC’s project typically has a significant impact on the project’s NPV ○ Consider scenario analysis to estimate NPV at various salvage values. ○ Consider estimating break-even salvage value at zero NPV. Breakeven Salvage Value: Impact of project on prevailing cash flows Can be favourable if sales volume of parent increases following establishment of project. Can be unfavourable if existing cash flows decline following establishment of project. If the subsidiary country currency depreciates, the amount the parent company will receive will depreciate as well. Host government incentives Low-rate host government loans Reduced tax rates for subsidiary Government subsidies of initial investment. Real options Opportunity to obtain or eliminate real assets. Value is influenced by: ○ Probability that real option will be exercised ○ NPV that will result from exercising the real option. IV. Adjusting Project Assessment for Risk Risk-adjusted discount rate – Greater the uncertainty about a project’s forecasted cash flows = larger discount rate applied to cash flows. ○ You need a discount rate to calculate the PV - normally use the prevailing market interest rate at the point in time but we are doing a projection into the future, and the future is uncertain, we don’t know what would be the prevailing interest rate then so they need to make a prediction for the discount rate Sensitivity analysis – can be more useful than simple point estimates because it reassesses the project based on various circumstances that may occur. ○ Once the the MNC has estimated the NPV of a potential project at a specific value for each input, it may want to consider alternative estimates for input variables to examine how sensitive or how responsive the NPV is to a change in an input value ○ If the NPV is consistently positive, regardless of changes in input values, then the MNC could feel more comfortable about the project Simulation – can be used for a variety of tasks, including the generation of a probability distribution for NPV based on a range of possible values for one or more input variables. Simulation is typically performed with the aid of a computer package. ○ Use software such as mad lab to write codes for the model ○ The more complex, the higher the accuracy of the projection V. Country risk The potentially adverse impact of a country’s environment on an MNC’s cash flows. Used to determine whether to implement a new project in a particular country or to continue conducting business in a particular country. Expropriation: where a host country will take over an MNC subsidiary or affiliate completely Attitude of consumers in the host country – a tendency of residents to purchase only locally produced goods ○ Eg tesla has a manufacturing unit in china to produce electric cars and sell to chinese consumers. Gov may encourage local consumers to purchase cars from local manufacturers so it may affect tesla’s sales Actions of the host government – A host government might impose pollution control standards, tightened rules and additional corporate taxes, as well as withholding taxes and fund transfer restrictions Blockage of fund transfers – A host government may block fund transfers, which could force subsidiaries to undertake projects that are not optimal (just to make use of the funds) Currency inconvertibility – Some governments do not allow the home currency to be exchanged into other currencies or allow a limited amount ○ All currencies are freely convertible, but in some countries like the Cuban Peso or the North Korean Won are completely unconvertible ○ The currencies of emerging market countries they are partially convertible War – Conflicts with neighbouring countries or internal turmoil can affect the safety of employees hired by an MNC’s subsidiary or by salespeople who attempt to establish export markets for the MNC  ○ Eg. Mcdonalds exit out of Russia Inefficient bureaucracy – Bureaucracy can delay an MNC’s efforts to establish a new subsidiary or expand business in a country. ○ https://www.doingbusiness.org/en/rankings Corruption – Corruption can occur at the company level or with company-government interactions. Transparency International has derived a corruption index for most countries. ○ https://www.transparency.org/en/cpi Incorporating country risk in capital budgeting analysis Adjustment of the discount rate: lower country risk rating implies higher risk and higher discount rate. Adjustment of the estimated cash flows: adjust estimates for the probability that cash flows may not be realised. ○ Eg. if there is 15% probability, the host government will temporarily block funds from the subsidiary to the parent, or if there is a change that the host country will change the tax laws like raising corporate tax then the MNC should estimate the project’s NPV under these possibilities so overall possible adverse conditions would lower the MNC’s net ah flows thus reducing the project NPV Analysis of Existing Projects ○ An MNC should not only consider country risk when assessing a new project but should also review the country risk periodically after a project has been implemented. ○ If an MNC has a subsidiary in a country that experiences adverse political conditions, it may need to reassess the feasibility of maintaining this subsidiary. Strategies to reduce exposure to a host government takeover include: Use a short-term horizon Rely on unique supplies or technology Hire local labour Borrow local funds Purchase insurance ○ Pitfall - insurance premium could be costly as the company may need to purchase it for the entire life of the project and it may not cover the entire losses due to the takeover Use project finance ○ Infrastructure or industrial project based on projected cashflows ○ Aus MNC invests in Kenya setting up subsidiaries and exploit rare materials as it suspects it may have good amount of rare deposits but there is no certainty so it makes an investment to take a risk ○ Initial investment is large eg $500m and it doesn’t want to use its own funds so it can insulate itself from any risk of failure of the project 8: Part 2 - Multinational capital structure and cost of capital I. Sources of funds for MNCs Internal - retained earnings External – debt/equity/loans All 3 can be raised domestically or internationally.  ○ Equity and bond markets dominate the U.S. ○ Bond market dominates in Japan. Interest rate in japan is really low so companies just need to add the risk premium on top of the current interest paid by the Japanese Government ○ Loans dominate in Europe. MNC foreign subsidiaries can also raise money from within the MNC Tradeoffs between debt and equity Equity Debt No mandatory fixed payments Interest payments (typically) (dividends are discretionary) Fixed repayment schedule No maturity dates (no capital Covenants and financial performance repayment) metrics that must be met Ownership and control over the business; Voting rights (typically) First claim on the firm’s assets in the Last claim on the firm’s assets in the event of liquidation event of liquidation Expects a lower rate of return than Expect a high rate of return (dividends equity and capital appreciation) Lower cost than equity ○ Features of not getting money back - needs high compensation for that High implied cost of capital Major capital structure theories Trade off theory (TOT): all firms have an optimal debt ratio at which the tax shield equals the financial distress cost. ○ Pros - have to make interest payment which is tax deductible bc it is the cost of doing business ○ Cons – if it takes too much debt - how to pay off and service the debt Eg. evergrant - property developer in China by 2021 it had $300 billion liabilities - chinese gov decided to change the limit of debt the company can take on - it had to file for bankruptcy in America The cost of issuing too much debt is a financial distress and cause of bankruptcy Pecking order theory (POT): firms prefer internal financing over debt capital (ie., firms prefer to finance new investments with internally generated funds first, then with debt capital, and as the last resort they would go for equity issue). ○ Creates a hierarchical order on the sources of financing ○ Reasoning - because of asymmetric information Conflict between principles, traders, managers, shareholders they would know more about the company so if the cost (asymmetric information) is very large and if they are seeking external financing so the cost of capital would be very high, in order to reduce asymmetric information costs, they should use internal sources first or retained earnings. ○ Outsiders like bond holders, when they purchase bonds, they know they don’t have intimate knowledge about the company so they have the strong incentive to monitor the company to make sure that they don’t venture into bad investment Market timing theory (MTT): firms issue new equity when their share price is overvalued and use debt following a decline of stock prices. II. Factors influencing capital structure decision External factors: mostly macroeconomic variables such as inflation, interest rate, exchange rate, monetary policy, and country risk factors. Internal (firm-specific) factors: Profitability: Highly profitable MNCs may be able to finance most of their investment with retained earnings (POT) and therefore use an equity-intensive capital structure. On the other hand, MNCs with more stable profits can handle more debt (TOT) because there is a constant stream of cash inflows to cover periodic interest payments on debt, therefore a debt-intensive capital structure. ○ POT - if the company has high level of profits, therefore it should use profit to finance the investment activity first - it minimises asymmetric information and minimises the cost ○ TOT - signifies to investors that they are strong and take on more debt; high profits it helps the company raise more debt issuing more bonds ○ It seems that companies prefer the POT in Australia Tangibility of assets: The more tangible the firm's assets, the greater its ability to issue secured debt, the higher the leverage (TOT). ○ If a company is issuing bonds or getting long term loans from the bank, they should have secured assets as collateral ○ A lot of tangible assets - using them as security so they can use that to raise more debt as well and from a creditors perspective, they look at ok if we buy secure debt, thats good in case the company goes into bankruptcy that asset can be sold to recover the debt Size: Leverage increases with size (TOT) because larger firms are less likely to face possibility of financial distress and have lower expected bankruptcy costs. The POT indicates that there is a negative relationship between leverage and firm size. ○ Size can be measured as total assets, sales or net income - it depends on what data is available ○ POT - it predicts a negative relationship - it argues that firms with large size, large assets they should create enough internal inflows, cash inflows so therefore high amount of retain earnings so companies should use the internal financing not external Age: According to the TOT, age is foundational to a firm's reliability, thus enhancing the firm’s ability to borrow more. The POT indicates that aged companies have a large amount of accumulated retained earnings and less reliance on external financing. ○ Once a company has existed for a century - it has built up its reputation, doesn’t want to jeopardise its prestige Growth opportunities: issuing equity is acceptable (MTT) when the price to book ratio is high which implies a company's growth potential. According to the POT, firms with a constant level of profitability and high growth potential should use more debt (i.e. debt is preferred to equity). Liquidity: companies with higher liquidity have resources to service the debt, thus they should borrow more money (TOT). On the contrary, firms using more current assets can generate internal inflows to finance its investments activities (POT). III. Multinational Cost of capital  MNC’s Cost of Debt: An MNC’s cost of debt is dependent on the interest rate that it pays when borrowing funds. MNC’s Cost of Equity: An MNC creates equity by retaining earnings or by issuing new stock. An MNC’s cost of equity contains a risk premium (above the risk free interest rate) that compensates the equity investors for their willingness to invest in the equity. ○ Small firms - very low credit rating so the risk premium could be a few percentage points above the risk free rate ○ Harder to evaluate https://www.wsj.com/market-data/quotes/AAPL/financials Estimating an MNC’s Cost of Capital ○ Kc - weighted average cost of capital D - amount of the firm’s debt Kd - before-tax cost of its debt t - corporate tax rate E - firm’s equity Ke - cost of financing with equity Comparing Costs of Debt and Equity ○ ○ Because the interest rate on debt is tax deductible on the other hand, debt also has some financial distress cost so therefore, if we start from low level debt it is expected that the benefit from debt shield would be higher than the financial distress if the firm can service the debt ○ New investors and shareholders may require higher level expected returns in order for the firm to issue more debt - the cost of debt (KD) is getting higher over time, the expected cost of financing is higher overtime so therefore, the cost of capital is higher as well. Cost of Capital for MNCs vs. Domestic Firms may differ because of: ○ Size of firm — An MNC that often borrows substantial amounts may receive preferential treatment from creditors, thereby reducing its cost of capital. As MNCs are more likely to use it for other purposes too ie issuing payroll ○ Access to international capital markets — MNC’s access to the international capital markets may allow it to obtain funds at a lower cost than that paid by domestic firms.  Often conducts businesses in multiple locations and subsidiaries or affiliates so they have the opportunity to access that local market where they are operating, they can bargain with the banks ○ International diversification — If a firm’s cash inflows come from sources all over the world, those cash inflows may be more stable because the firm’s total sales will not be highly influenced by a single economy. If a country goes through recession, and another country doesn’t they still maintain a stable level of income ○ Exposure to exchange rate risk — An MNC’s cash flows could be more volatile than those of a domestic firm in the same industry if it is highly exposed to exchange rate risk. ○ Exposure to country risk — An MNC that establishes foreign subsidiaries is subject to the possibility that a host country government may seize a subsidiary’s assets. Cost of Equity Comparison Using the CAPM ○ ○ Where ke = required return on stock Rf = risk-free rate of return Rm = market return If it is high, investors expect to receive a higher return B = beta of stock Sensitivity of the stock’s return to the market Positive - moves with the market ○ The CAPM suggests that a stock’s required rate of return positively correlated with: The risk-free rate of interest The market rate of return The stock’s beta - only depends on the market MNCs may be able to reduce its beta by increasing its international business. Because many projects of MNCs are in foreign countries, their cash flows are less sensitive to general MNCs’ market conditions leading lower project betas. A world market may be more appropriate than a home market for determining the betas of MNCs. IV. Cost of capital across countries Country differences in the cost of debt ○ Differences in the risk-free rate — The risk-free rate is the interest rate charged on loans to a country’s government that is perceived to have no risk of defaulting on the loans. ○ Differences in the Credit Risk Premium — The credit risk premium paid by an MNC must be large enough to compensate creditors for taking the risk that the MNC may not meet its payment obligations. It must be large enough to compensate for credits for taking the risk that the MNC may not be able to meet its payment obligations So if an MNC has a history of default in the past, so therefore no doubt that credit risk premium would be very large for that Swap - you swap the credit risks you bear for a premium and the counter party takes the credit risks in exchange for a premium  Higher premium - you see an increase there is a good signal the probability for default is getting higher and higher. ○ Comparative costs of debt across countries — There is some positive correlation between country cost-of-debt levels over time. Country differences in the cost of equity ○ Differences in the risk-free rate — When the country’s risk-free interest rate is high, local investors would only invest in equity if the potential return is sufficiently higher than that they can earn at the risk-free rate. In the capm the risk free rate is an important input - the Correlation between the two variables is positive implying when country’s risk free rate is high, local investors would only invest in equity if the potential return is sufficiently higher than the risk free rate ○ Differences in the Equity Risk Premium — Based on investment opportunities in the country of concern; a second factor that can influence the equity risk premium is the country risk. Part 3: Debt Financing Contents: I. Debt denomination ○ Local currency where the subsidiary of the MNC operates II. Debt maturity III. Debt interest payments Convertible bond new issuance in global markets ○ ○ https://www.lseg.com/en/insights/data-analytics/convertible-bonds-make-a- comeback ○ As far as debt is sustainable regardless of the amount, so that should be fine, however, if there’s a small change in one of the variables - interest rate higher or especially change in policies so that could lead to the bankruptcy of a very big corporation I. Debt denomination  When an MNC’s foreign subsidiary needs to borrow funds, it considers the following choices: ○ Borrow funds denominated in the local currency where the subsidiary is located, and use funds generated from its local sales to repay the debt. This is called decentralized debt denomination, i.e., borrow in different currencies of subsidiaries. Balance-sheet hedge – balance foreign assets/liabilities (i.e., match foreign assets with foreign liabilities). ○ Borrow funds denominated in the parent currency (i.e., in dollars) and convert the dollars into the local currency to support the subsidiary operations. This approach is called centralized debt denomination (i.e., borrow in the parent corporation’s currency). Comparison of Subsidiary Financing with Its Local Currency versus Borrowing from Parent ○ ○ Interest rate difference of 5% - means as far as the sri lankan rupee is not going to depreciate over the lifetime of the loan by more than 5% it means it is still good, it is still cheaper to finance the project via the second alternative here but if the sri lankan rupee appreciates, it's even better for Australia MNC ○ MNCs typically use a matching strategy to reduce the subsidiary’s exposure to exchange rate movements because it allows the subsidiary to use a portion of its cash inflows to cover the cash outflows to repay its debt. ○ The matching strategy is especially desirable when the foreign subsidiaries are based in countries where interest rates are relatively low. ○ When interest rates in a foreign subsidiary’s host country are high, they might consider borrowing in the parent’s currency to avoid the high cost of local debt but facing a remarkable disadvantage. Comparison of two loans with different debt denominations for the foreign subsidiary  ○ ○ Change in debt that mostly can be explained by changes in policies and regulation ○ Americans tend to hold this amount of free cash flow in the host country, reinvest it and make more returns than bring it back to america because they have to pay the gap of tax between 35%  Strategies to hedge foreign financing ○ An MNC may not be able to borrow a currency that matches its invoice currency. Thus, it may want to hedge by engaging in a currency swap or a parallel loan to execute the matching strategy. ○ In a parallel loan, two companies provide simultaneous loans to the other company’s subsidiary with an agreement to repay at a specified future time. ○ A currency swap specifies the exchange of currencies at periodic intervals and may allow the MNC to have cash outflows in the same currency in which it receives most or all of its revenue. Parallel Loans ○ ○ They borrow from the other parent ○ In case of default, they have to obey and carry forward regardless if one of the contracts default - counter party risk is high - need to be able to find a counter party Using Currency Swaps to Execute the Matching Strategy ○ ○ Purple - swap contract ○ Two companies agree that every year miller co would use the payment from its subsidiary in the euro to make payment to beck co and beck co would make payment to miller in the dollar II. Debt maturity An MNC must decide on the maturity for its debt. The shape of the yield curve can vary among countries. An upward sloping yield curve may indicate that investors require compensation for illiquidity associated with long-term debt. https://markets.ft.com/data/bonds https://fred.stlouisfed.org/release?rid=402 ○ Must assess the yield curve of the country in which they need funds and afterwards, the sloping yield curve such as that creditors or investors prefer to lend funds for a shorter period of time, therefore, they require a high premium for longer maturity loans. An MNC must decide whether to obtain a loan with a maturity that perfectly fits its needs or one with a shorter maturity if it has a more favourable interest rate and then additional financing when this loan matures. Firms try to avoid bunching of repayments. In most of the world, business borrowings are mostly on a short-term rollover basis. US bonds can have quite long maturities (20-30 years). ○ First loan - there is certainty on how much interest is there ○ Second loan - you need to forecast for year 4 and 5 since it is a three year loan ○ IRR - cashflows in excel then use =IRR function III. Debt interest payments Depends on a number of factors ○ When interest rates below long term interest rate, so firms may be tempted to conclude that the MNC should choose floating to reduce the immediate funding costs, however, higher long term interest rate likely reflects investors expectations about short term interest rate going to rise, so it is not at all clear that the company will save on financing costs Fixed rate bonds have a set maturity date at which the issuer promises to repay the principal or face value of the bond. During the life of the bond, fixed coupon payments which are a percentage of the face value are paid as interest. ○ Zero-coupon bonds ○ Investors aim to preserve their capital during an economic downturn, this would create a good environment for the government to borrow at zero interest rate, meaning that they don’t have to service the debt at all during the lifetime - however, they may have to sell these bonds at a discount Floating rate bonds: repayments based on the prevailing reference rate, typically a short term borrowing rate in the interbank market, such as LIBOR. ○ If an MNC considers financing with floating-rate bonds it can first forecast the rate for each year, and that would determine the expected interest rate it would pay per year allowing it to derive forecasted interest payments for all years of the debt. ○ Getting harder when the maturity of the bonds is 10/20 years  ○ LIBOR or equivalent has been terminated in America, Australia, Equity related bonds: ○ Convertibles are straight bond that are convertible into equity before or at the time of maturity. ○ Bonds with warrants grant the bondholder the right to buy a certain amount of the common stock of the company at a specified price. Like an auction attached to the bonds Dual-currency bond: a straight fixed-rate bond issued in one currency (eg: Yen), which pays coupon interest in the same currency, but the promised repayment of principal at maturity is denominated in another currency (eg: US$). ○ Can be viewed as a straight bond plus a long-term forward contract. ○ Often used by japanese firms - a way to establish or expand their operation in the US Alternative Financing Arrangement with a Floating Rate Loan ○ ○ Hedging Interest Payments with Interest Rate Swaps ○ If MNCs are concerned that interest rates will rise, they may complement their floating rate debt with interest rate swaps to hedge the risk of rising interest rates. ○ Financial institutions such as commercial and investment banks and insurance companies often act as dealers in interest rate swaps. ○ In a plain vanilla interest rate swap, one participating firm makes fixed rate payments periodically in exchange for floating rate payments. ○ The payments are based on a notional value.  ○ They don’t pay two interest rate payment - only one after they factor in terms of the debtor ○ Quality has a comparative advantage in borrowing in a fixed rate ○ Risky has a comparative advantage in borrowing with a variable rate ○ So the reason quality is willing to pay the difference to risk because the rate equality could borrow directly in the financial market if it sells floating rate bonds ○ Exhibit 18.8 Illustration of an Interest Rate Swap ○ Exhibit 18.9 Expected Payments Resulting from Interest Rate Swap Limitations of Interest Rate Swaps ○ There is a cost of time and resources associated with searching for a suitable swap candidate and negotiating the swap terms. ○ One of the counterparties incurs interest rate risk. The counter party receiving a fixed rate stream gains if interest rates falls and loses if interest rates rise (inverse relationship) Counter party default ○ Each swap participant faces the risk that the counter participant could default on payments. 9: Management of Short-term assets and liabilities Contents: ○ I. Methods of export financing ○ II. Short-term financing decisions ○ III. International cash management ○ I. Methods of export financing Accounts receivable financing: If the exporter needs funds immediately, it may obtain financing from a bank or a finance company, secured by the account receivable. ○ Banks receive these as collateral because it is already locked in, payment would happen in 30 days Factoring: The exporter sells the accounts receivable, often, without recourse to a third party, hence virtually eliminating the risk of non payment. ○ Discount rate could be higher than receivables ○ Factoring is quicker if it is not at a bank - they have a lot of regulations so therefore, they have to do the due diligence in a much stringent than other finance companies Forfaiting: allows exporters to obtain cash by selling their medium-term account receivables to a bank on a non-recourse basis, thus avoiding all the risk. ○ Similar to factoring - medium to long term account ○ Risk is higher than factoring Export Working Capital Financing: allows exporters to purchase capital goods, commodities, and services they need to support their export sales  ○ Eg in periods of high demand like christmas, woolies and coles need to increase their order so the sudden increase will put the exporter a position to look for working capital to buy materials, inputs L/C (Letters of Credit, aka Documentary Credit) ○ An L/C is useful when reliable credit information about a foreign buyer is difficult to obtain or if the foreign buyer’s credit is unacceptable, but the exporter is satisfied with the creditworthiness of the importer’s bank. ○ The importer asks its bank to write a letter to the exporter, in which the bank indicates that the payment will be made to the exporter provided that the terms and conditions stated in the L/C have been met. ○ The exporter then can use this L/C to obtain a loan from its bank or the bank issuing the L/C. Banker’s acceptance (B/A): A time draft (a written order by the importer’s bank to pay the exporter) drawn on and accepted by a bank. The accepting bank has obligation to pay the holder of the draft at maturity. ○ Provides another layer of security of guarantee to the exporter II. Short-Term Financing Decisions Sources of short-term financing: ○ Internal: retain profits ○ External: Commercial papers are unsecured short term promissory notes with typical maturities of less than a year, in practice mostly not exceeding 270 days, often issued by large corporations. Higher the rating, the lower the discount Commercial paper outstanding in the USA Money market spread spiked in Mar-Apr 2020  ○ ○ https://www.icmagroup.org/assets/documents/Regulatory/CP/ICMA-CPC-white- paper-The-European-Commercial-Paper-and-Certificates-of-Deposit-Market- September-2021-290921.pdf ○ Companies needed to pay employees but they couldn’t sell that much before so they need to borrow capital - spike External: ○ Bank line of credit: allows an MNC to draw up to a pre-specified maximum amount during a given time period at a stated interest rate. Generally renewable, usually annually. ○ Short-term bank loans: MNCs utilize direct bank loans to maintain a relationship with banks too. 3-6 months after up to a year loan Can be secured or unsecured ○  ○ They set up a relationships with banks and they have the bargaining power - so banks often provide them a loan with a much lower interest than smaller corporations When MNCs obtain short-term financing, they usually borrow the currency that matches their future cash inflows or receivables. While foreign financing can result in significantly lower financing costs, the variance in costs over time is higher. MNCs may be able to achieve lower financing costs without excessive risk by financing with a portfolio of currencies. ○ If the chosen currencies are not highly positively correlated, they will not be likely to experience a high level of appreciation simultaneously. Thus, the chance that the portfolio’s effective financing rate will exceed the domestic financing rate is reduced. Implications of IRP for Financing  2. If they believe the spot rate is the same as the future spot rate, then there is no need to hedge the position bc the cost of borrowing would be the same regardless 3. Forward rate offered would make foreign currency appreciate at a greater amount than the future spot rate III. International Cash Management An MNC may have multiple subsidiaries across many countries, thus large cash inflows and outflows in various currencies, and those cash inflows and outflows are not necessarily balance in any currency in any given month. MNCs often use centralized cash management to monitor and manage the parent- subsidiary and intersubsidiary cash flows. International cash management can be segmented into two functions ○ optimizing cash flow movements, and ○ investing excess cash. Techniques to Optimize Cash Flows ○ 1. Accelerating cash inflows: The more quickly the cash inflows are received, the more quickly they can be invested or used for other purposes. Common methods include the establishment of lockboxes around the world (to reduce mail float before the MNC receives payment) and preauthorized payments (charging a customer’s bank account directly). Money has a time value - if you earn it earlier you can deploy it earlier ○ 2. Minimizing currency conversion costs Netting reduces administrative and transaction costs through the accounting of all transactions that occur over a period to determine one net payment. A bilateral netting system involves transactions between two units, while a multilateral netting system usually involves more complex interchanges. Intersubsidiary Payments Matrix & Netting Schedule  ○ They have contracts between each other ○ Eg. france - canada - france owes 60 to the subsidiary in canada, so they cancel on netting out these two so theres no need for canada to transfer the 40 to france, so when you net it out, france would only need to pay the 20 to canada ○ Saves transaction costs and time ○ 3. Managing blocked funds A government may require that funds remain within the country in order to create jobs and reduce unemployment. An MNC can shift cost-incurring activities (like R&D) to the host country, adjust the transfer pricing policy (such that higher fees have to be paid to the parent), borrow locally rather than from the parent, etc. ○ 4. Managing intersubsidiary cash transfers Leading: A subsidiary with excess funds can provide financing by paying for its supplies earlier than is necessary. Eg. thai buys from malaysian subsidiary Lagging: A subsidiary in need of funds can be allowed to lag its payments. Eg. thai buys from malaysian subsidiary Investing Excess Cash ○ Excess funds can be invested in domestic or foreign short-term securities, such as deposits, Treasury bills, and commercial papers. ○ Sometimes, foreign short-term securities have higher interest rates. However, firms must also account for the possible exchange rate movements. Short term interest rates ^ Long term interest rates v  Current yields in US money markets it is high, so it would be safe and easy for US companies with excess funds to invest in their own money market than invest overseas. Foreign short term securities is appealing, more attractive , they have to offer much higher interest rates to cover any difference in terms of inflation and possible depreciation of the foreign currency Unlike the long run, a big fluctuation or volatility in the short run would be rarer than in the long run ○ Centralized cash management allows for more efficient usage of funds and possibly higher returns. Subsidiaries are often allowed to invest their ffcf ○ When multiple currencies are involved, a separate pool may be formed for each currency. Funds can also be invested in securities that are denominated in the currencies needed in the future. ○ Given the current online technology, MNCs should be able to efficiently create a multinational communications network among their subsidiaries to ensure that information about their cash positions is continually updated. CFO of subsidiaries inform one another about their short term holdings, investments and cash positions so that they can lend to one another instead fo borrowing from an external creditor to maximise investment return Implications of Interest Rate Parity (IRP): ○ A foreign currency with a high interest rate will normally exhibit a forward discount that reflects the differential between its interest rate and the investor’s home interest rate. ○ However, short-term foreign investing on an uncovered basis may still result in a higher effective yield. ○ If IRP exists, the forward rate can be used as a break-even point to assess the short-term investment decision. ○ The effective yield will be higher than the domestic yield if the spot rate at maturity is more than the forward rate at the time the investment was undertaken. Diversifying Cash Across Currencies: ○ If an MNC is not sure of how exchange rates will change over time, it may prefer to diversify its cash among securities that are denominated in different currencies. As far as they are independent or they move in the opposite direction ○ The degree to which such a portfolio will reduce risk depends on the correlations among the currencies. Use of Dynamic Hedging to Manage Cash:  ○ Dynamic hedging refers to the strategy of hedging when the currencies held are expected to depreciate, and not hedging when they are expected to appreciate. Supposed to protect from downside risk, but at the same time benefiting from favourable movement of extreme rates ○ The overall performance is dependent on the firm’s ability to accurately forecast the direction of exchange rate movements.