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2.
3.
Internal Financing by MNCs
• Before an MNC’s parent or subsidiary searches for outside funding, it should determine if any internal funds are available. • Parents of MNCs may also raise funds by increasing their markups on the supplies that they send to their subsidiaries.
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Implications of IRP for Financing
IRP holds? Scenario Type of financing Financing costs
Yes Yes
Yes Yes No No
Forward rate accurately predicts future spot rate Forward rate overestimates future spot rate Forward rate underestimates future spot rate
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Criteria Considered for Foreign Financing
The Forward Rate as a Forecast • If the forward rate is an accurate estimate of the future spot rate, the foreign financing rate will be similar to the home financing rate. • If the forward rate is an unbiased predictor of the future spot rate, then the effective financing rate of a foreign loan will on average be equal to the domestic financing rate. • Summary of the implications of a variety of scenarios relating to interest rate parity and forward rate.
Chapter 8
Short-Term Finan explains short-term liability management of MNCs, a part of multinational management that is often neglected in other textbooks. From this chapter, we should learn that correct financing decisions can reduce the firm’s costs and maximize the value of the MNC. While foreign financing costs cannot usually be perfectly forecasted, firms should evaluate the probability of reducing costs through foreign financing. The specific objectives are:
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Pre-class Discussion
1. If a firm consistently exports to a country with low interest rates and needs to consistently borrow funds, explain how it could coordinate its invoicing and financing to reduce its financing costs. What is the risk of borrowing a low interest rate currency? Assume that foreign currencies X,Y, and Z are highly correlated. If a firm diversifies its financing among these three currencies, will it substantially reduce its exchange rate exposure? Explain.
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Why MNCs Consider Foreign Financing
• An MNC may finance in a foreign currency to offset a net receivables position in that foreign currency. • An MNC may also consider borrowing foreign currencies when the interest rates on such currencies are attractive, so as to reduce the costs of financing.
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Objectives
• to explain why MNCs consider foreign financing; • to explain how MNCs determine whether to use foreign financing; and • to illustrate the possible benefits of financing with a portfolio of currencies.
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How to compute the effective financing rate (Example)
• Dearborn, Inc. (based in Michigan), obtains a one-year loan of $1,000,000 in New Zealand dollars (NZ$) at the quoted interest rate of 8 percent. When Dearborn receives the loan, it converts the NZ$ to US$ to pay a supplier for materials. The exchange rate at that time is $.50, so the NZ$1,000,000 is converted to $500,000 (1,000,000 * $.50). One year later, Dearborn pays back the loan of NZ$1,000,000 plus interest of NZ$80,000 (8%*NZ$1,000,000). Thus, the total amount in New Zealand dollars needed by Dearborn is NZ$1,080,000 (1,000,000+80,000). Assume the New Zealand dollar appreciates from $.50 to $.60 by the time the loan is to be repaid. Dearborn will need to convert $648,000
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How to compute the effective financing rate (Example)
(1,080,000*$.60) to have the necessary number of New Zealand dollars for loan repayment. To compute the effective financing rate, first determine the amount in U.S. dollars beyond the amount borrowed that was paid back. Then divide by the number of U.S. dollars borrowed (after converting the New Zealand dollars to U.S. dollars). Given that Dearborn borrowed the equivalent of $500,000 and paid back $648,000 for the loan, the effective financing rate in this case is $148,000 / $500,000 = 29.6%.
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Sources of Short-Term Financing
• Euronotes are unsecured debt securities with typical maturities of 1, 3 or 6 months. They are underwritten by commercial banks. • MNCs may also issue Euro-commercial papers to obtain short-term financing. • MNCs utilize direct Eurobank loans to maintain a relationship with the banks too.
The effective rate can be rewritten as
rf = (1+ if ) (1+ ef ) – 1 where ef = the % D in the spot rate
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Criteria Considered for Foreign Financing