Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall 6-1 A Framework for...

Copyright © 2013 Pearson Education, Inc. publishing as Prentice Hall

6-16-1

A Framework for International Business

by Cavusgil, Knight, & Riesenberger

Chapter 6: The International Monetary Environment and

Financial Management in the Global Firm


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In this chapter, you’ll learn about:

1. Exchange rates and currencies

2. How exchange rates are determined

3. The monetary and financial systems

4. Financial management in the global firm

5. Managing currency risk

6. Managing accounting and tax practices

Learning Objectives


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Currencies & Exchange Rates

• International markets for foreign exchange/capital are much larger than those for goods & services

• Some 150 currencies are in use worldwide

• Exchange rate: Price of one currency expressed in terms of another

• Changes in exchange rates affect measures such as costs of inputs, sales performance, which market entry strategies to use, & more


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Recent Exchange Rates against the U.S. Dollar


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The Four Risks of International Business


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Foreign Exchange Markets

• Foreign exchange: All forms of internationally traded monies, including foreign currencies, bank deposits, checks, and electronic transfers

• Foreign exchange market: The global marketplace for buying and selling national currencies

Exchange rates are in constant flux. For example:• In 2007, the Japanese yen was trading at 116 yen to the U.S.

dollar. By 2009, it was trading at 85 yen to the dollar, an appreciation of over 25 percent.

• This made the yen more expensive for Americans, & the U.S. dollar cheaper for Japanese.


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Example: The Euro vs. the Dollar

• Suppose that last year the exchange rate was 1 = $1.

• Now, suppose the rate has gone to 1.50 = $1.

• What is the effect of this change on Europeans?

Effects on European firms: European firms pay more for inputs from the U.S. Higher costs reduce profitability; require higher prices. European firms can increase their exports to the U.S. European firms can raise their prices to the U.S. Increased exports to the U.S. lead to higher revenues

What is the effect on European consumers?What is the effect on European consumers?


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How Are Exchange Rates Determined?

In a free market, the “price” of any currency (the exchange rate) is determined by supply and demand.

The greater the supply of a currency, the lower its price.

The lower the supply of a currency, the higher its price.

The greater the demand for a currency, the higher its price.

The lower the demand for a currency, the lower its price.


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Factors that Influence the Supply and Demand for a Currency

Inflation refers to increases in the prices of goods & services • Some countries (e.g., Argentina, Israel, Russia) have experienced hyperinflation• High inflation erodes a currency’s purchasing power • Interest rates and inflation are positively related; high inflation forces banks to pay high interest • In other words, investors expect to be compensated for inflation- induced decline in the value of their money

Market Psychology refers to non-financial impacts• Herding – following the crowd; mimicking the investment patterns of others• Momentum – buying when prices rise & selling when they begin to fall

Example: If inflation is 10%, banks must pay more than 10% to attract deposits.

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Value of the Currency and Trade Surplus vs. Trade Deficit

• Trade surplus: Exports exceed imports; may result

when the exporter’s currency is undervalued, as in

China’s official policy regarding its currency

• Trade deficit: Imports exceed exports; the government may devaluethe nation’s currency to correct a trade deficit

• Balance of trade: the difference between the value of a nation’s exports and its imports


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Development of the Modern Exchange Rate System

• After the Great Depression and World War II, the world economy was in a sorry state

• At war’s end, seeking stability in the international monetary and financial systems, 44 countries signed the Bretton Woods agreement – Bretton Woods established a fixed exchange rate system in which the U.S.

dollar was pegged to a set value for gold ($35 per ounce), – Other major currencies were pegged to the dollar

• For nearly 30 years, the system kept exchange rates of major currencies at a fixed level

• Bretton Woods dissolved in 1971 because the world economy was evolving; governments could no longer maintain fixed exchange rates on the gold standard


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Legacy of Bretton Woods

Bretton Woods established:

• Concept of international monetary cooperation, especially

aimed at minimizing currency risk

• International Monetary Fund (IMF): Agency that promotes

exchange rate stability, monitors exchange systems, and

provides funding to developing economies

• World Bank: Agency that provides loans and technical

assistance to combat global poverty around the world


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The Exchange Rate System Today

• Today, advanced economy currencies (dollar, euro, pound, yen) float according to market forces, their value determined by supply and demand

• Conversely, most developing and emerging economies use fixed exchange rate systems

• In fixed regimes, the valueof a currency is pegged tothe value of another currencyor to a basket of currencies,

at a specified rate

Examples• China pegs its currency to a

basket of currencies.• Belize pegs its currency to the

dollar.


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The International Monetary and Financial Systems

• International monetary system: The institutional framework, rules, and procedures by which national currencies are exchanged for one another

• Global financial system: The collection of financial institutions that facilitate and regulate the flows of investment and capital funds worldwide. It includes the national and international banking systems, the international bond market, & national stock markets


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Globalization of Financial and Monetary Activities

Growing integration of financial and monetary global activity is due to:

• Evolution of monetary and financialregulations worldwide

• Emergence of new technologies andpayment systems in global finance; e.g., the Internet

• Increased global and regional interdependence of financial markets

• Growing role of single-currency systems, e.g., euro


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Key Participants and Relationships in the Global Monetary and Financial Systems


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Key Participants in the Monetary and Financial Systems

• Bank for International Settlements – based in Switzerland, works to foster cooperation among central banks & other gov. agencies

• IMF – based in Washington; provides framework of and code of behavior for international monetary system. Plays key role in monetary crises

• World Bank – goal is to reduce world poverty & is active in various dev. projects to provide good infrastructure (water, electricity, transport) to poor countries

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Key Participants in the Monetary and Financial Systems (cont.)

• Commercial Banks: Lend money to finance business activity, play a key role in nations’ money supplies, exchange foreign currencies

• Central Banks: Regulate money supply, issue currency, manage exchange rates, control national reserves


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International Financial Management

• It is the acquisition and use of funds for cross-border trade, investment, and other commercial activities

• Firms access funds from a variety of sources—foreign bond markets, local stock exchanges, foreign banks, venture capital firms, and intracorporate financing—based on wherever in the world capital is cheapest

• In a typical MNE, financial managers must be effective in 5 key areas


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5 Key International Financial Management Tasks

1. Raise funds for the firm: Acquire equity, debt, or intracorporate financing for funding activities and investments

2. Manage cash flow: Manage funds passing in and out of the firm’s value-adding activities

3. Perform capital budgeting: Assess financial attractiveness of major investment projects (e.g., foreign market expansion & entry)

4. Manage currency risk: Manage the multiple-currency transactions of the firm and its exposure to exchange-rate fluctuations

5. Manage accounting & tax practices: Learn to operate in a global environment with diverse accounting practices and international tax regimes


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Task #1: Raising Funds

• Global money market: Financial market where firms and governments raise short-term financing. It is the meeting point of those who want to invest money and those who want to raise funds

• Global capital market: Financial market where firms and governments raise intermediate-term and long-term financing

• Participating in the global capital market allows firms to access funds from a larger pool of capital at competitive interest rates. International investors access a much wider range of investment opportunities than are available in the domestic capital market


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Where to Get Funds: Financial Centers

• New York, London, and Tokyo are the major centers

• Frankfurt, Hong Kong, Paris, San Francisco, Sydney, Singapore, and Zurich are secondary centers

• Firms access major capital suppliers—banks, stock exchanges, and venture capitalists—at such centers

• Global capital markets have grown rapidly in the past decade due to a variety of reasons (government deregulation, innovations in comm. tech., realized cost savings from efficiencies, more)


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Sources of Funding: Equity Financing

• The firm obtains capital by selling shares of stock

• Main advantage is the firm obtains capital without incurring debt and having to repay funds to providers

• Main disadvantage is the firm’s ownership is diluted

• The global equity market is the worldwide market of funds for equity financing—the stock exchanges worldwide where investors and firms meet to buy and sell shares of stock


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Sources of Funding (cont.): Debt Financing

• The firm borrows money from a creditor in exchange for repayment of principal and interest

• The main advantage over equity financing is that the firm does not sacrifice any ownership interests

• Debt financing is obtained from two sources: Loans (usually from banks) and the sale of bonds

• The firm may borrow money from banks in its home market or in foreign markets

• Borrowing internationally is complicated by differences in banking laws and infrastructure, lack of loanable funds, and fluctuating exchange rates


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The Eurocurrency Market

• The Eurocurrency market, representing money deposited in banks outside its country of origin, is a key source of loanable funds. U.S. dollars account for the largest share of such funds

• Eurodollars are U.S. dollars held in banks outside the United States, including foreign branches of U.S. banks

• Other Eurocurrencies include euros, yen, and British pounds, as long as they are banked outside their home country


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Bonds are the Major Source of Debt Financing

• A bond is a debt instrument that enables the issuer (borrower) to raise capital by promising to repay the principal along with the interest on a specified date (maturity)

• Governments, states, and other institutions also sell bonds. Investors purchase bonds and redeem them at face value in the future

• The global bond market is the international marketplace in which bonds are bought and sold, primarily through banks and stockbrokers


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Foreign Bonds and Eurobonds

• Foreign bonds are sold outside the bond issuer’s country and denominated in the currency of the country in which they are issued. E.g., when Mexico’s Cemex sells dollar-denominated bonds in the United States, it is issuing foreign bonds

• Eurobonds are sold outside the bond issuer’s home country and denominated in its own currency. For example, when Toyota sells yen-denominated bonds in the United States, it is issuing Eurobonds


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Sources of Funding (cont.): Intracorporate Financing

• Intracorporate financing: Obtaining funds from within firm’s network of subsidiaries and affiliates

• In firms with extensive international operations, at times some units are cash rich while others are cash poor

• Usually has little effect on the parent’s balance sheet because the funds are simply transferred from one area of the firm to another

• Minimizes transaction costs of borrowing from banks and avoids the ownership-diluting effects of equity financing


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Task #2: Managing Cash Flow

• Cash flow needs arise from everyday business activities, such as paying for labor and materials or resources, servicing interest payments on debt, paying taxes, or paying dividends to shareholders

• Cash flow management ensures cash is available where and when it is needed

• Cash is generated from various sources, and needs to be transferred from one part of the MNE to another

• International financial managers devise strategies for transferring funds within the firm’s worldwide operations to optimize global operations


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Methods for Transferring Funds Within the MNE

• Through trade credit, a subsidiary defers payment for goods received from the parent firm

• Dividend remittances are commonly used to transfer funds from foreign subsidiaries to the parent, but vary depending on tax levels, currency risks, and other factors

• Royalty payments are compensation paid to owners of intellectual property. Assuming the subsidiary has licensed technology, trademarks, or other assets from the parent or other subsidiaries, royalties can be an efficient way to transfer funds


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Methods for Transferring Funds Within the MNE (cont.)

• In a fronting loan, the parent deposits a large sum in a foreign bank, which then transfers the funds to the subsidiary in the form of a loan

• Fronting allows the parent to circumvent restrictions that foreign governments impose on direct intracorporate loans

• Transfer pricing (also known as intracorporate pricing) refers to prices that subsidiaries and affiliates charge one another as they transfer goods and services within the same MNE

• Firms can use transfer pricing to shift profits out of high-tax countries into low-tax countries, optimizing cash flows


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Multilateral Netting & Central Depositories

• Multilateral netting: Strategic reduction of cash transfers within the MNE family through the elimination of offsetting cash flows:

o Multilateral netting involves three or more subsidiaries that hold accounts payable or accounts receivable with one other.

o MNEs with numerous subsidiaries usually establish a netting center that headquarters supervises.

• MNEs pool surplus funds into a central depository that functions either globally or for a region. The funds are then directed to needful subsidiaries or invested to generate income


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Task #3: Perform Capital Budgeting

• Managers use capital budgeting to decide which international projects are economically desirable

• Net present value (NPV) is the difference between the present value of a project’s incremental cash flows and its initial investment requirements

• Internationally, such decisions are complex because managers must consider many variables, each of which can strongly affect the potential profitability of a venture


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Task #4: Managing Currency Risk

• Currency risk concerns exchange rate fluctuations that harm business profits

• Transaction exposure is currency risk that firms face when outstanding accounts receivable or payable are denominated in foreign currencies

• Translation exposure is currency risk that results when a firm translates financial statements denominated in a foreign currency into the functional currency of the parent firm

• Economic exposure is currency risk that results from exchange rate fluctuations affecting the pricing of products, the cost of inputs, and the value of foreign investments


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Foreign Exchange Trading

• A relatively limited number of currencies facilitate cross-border trade and investment, mainly dollars, euros, yen, and British pounds

• In 2010, the daily volume of global trading in foreign exchange amounted to over $3 trillion - more than 100x the daily value of global trade in products and services

• Large banks are the primary dealers in currency

• Currency traders are especially active in major

financial centers such as London, New York,

& Tokyo

• Trading is increasingly done online


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Specialized Terminology in Currency Trading

• Spot rate: Exchange rate based on the current rate of exchange

• Forward rate: Exchange rate applicable at some future date, but specified at time of the transaction

• Direct quote: The number of units of the domestic currency needed to acquire one unit of the foreign currency; e.g., “It costs $1.42 to acquire one euro.”

• Indirect quote: The number of units of the foreign currency obtained for one unit of the domestic currency; e.g., “For $1, I can receive 0.74 euros.”


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Types of Currency Traders

• Hedgers seek to minimize the risk of exchange rate fluctuations, often by buying forward or similar financial instruments. They include MNEs who conduct international trade

• Speculators are currency traders who seek profits by investing in currencies with the expectation that they will rise in value

• Arbitragers are currency traders who buy and sell the same currency in two or more foreign-exchange markets to profit from differences in the currency’s exchange rate


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Management of Currency Risk Through Hedging

• Hedging refers to efforts to compensate for a possible loss from a bet or investment by making offsetting bets or investments

• In international business, it refers to using financial instruments and other measures to reduce or eliminate exposure to currency risk

• If the hedge is perfect, the firm is protected against the risk of adverse changes in currency prices • Banks offer various financial instruments to facilitate hedging


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Hedging Instruments

• Forward contract: A financial instrument to buy or sell a currency at an agreed-upon exchange rate at the initiation of the contract for future delivery

• Futures contract: An agreement to buy or sell a currency in exchange for another at a pre-specified price and on a pre-specified date

• Currency option: Gives the purchaser the right, but not the obligation, to buy a certain amount of foreign currency at a set exchange rate within a specified amount of time

• Currency swap: The exchange of one currency for another currency according to a specified schedule


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Managerial Guidelines for Minimizing Currency Risk


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Task #5: Manage Accounting & Tax Practices

• Developing accounting systems to identify, measure, & communicate financial information is especially challenging in firms with multi-country operations

• Dozens of approaches are used to determine cost of goods sold, return on assets, R&D expenditures, net profits, and other outcomes in different countries

• Balance sheets and income statements vary mainly in language, currency, format, and underlying accounting principles

• Financial statements prepared in one country may be difficult to compare with those prepared in another


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Transparency in Financial Reporting

• Transparency: Degree to which firms regularly and comprehensively reveal substantial information about their financial condition and accounting practices

• The more transparent a nation’s accounting systems, the more regularly and comprehensively its public firms report their financial results in a reliable manner

• Transparency improves the ability of investors to accurately evaluate company performance

• In many developing and emerging market economies, accounting systems have low transparency


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Consolidating Financial Statements of Subsidiaries

• A key challenge in international accounting is foreign currency translation, converting foreign currencies into the firm’s functional currency

• Translation is critical because subsidiaries’ financial records are normally maintained in the currencies of the countries where they are located

• When headquarters consolidates financial records, foreign currencies are translated into the functional currency by using one of two methods: The current rate method or the temporal method


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Current Rate Method

• Current rate method: All foreign currency balance sheet & income statement items are translated at current exchange rate—the spot exchange rate in effect on the day (in the case of balance sheets), or for the period (in the case of income statements), when statements are prepared

• Typically used when translating records of foreign subsidiaries that are considered separate entities, rather than part of the parent firm’s operations


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Temporal Method

• Temporal method: The choice of exchange rate depends on the underlying method of valuation

• Assets & liabilities normally valued at historical cost are translated at historical rates - the rates in effect when the assets were acquired

• Assets & liabilities normally valued at market cost are translated at the current exchange rate

• Thus, monetary items, such as cash, receivables, & payables, are translated at the current exchange rate

• Non-monetary items (inventory, plant, & equipment) are translated at historical rates


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International Taxation

• A direct tax is imposed on income derived from business profits, intracorporate transactions, capital gains, and sometimes royalties, interest, and dividends

• An indirect tax applies to firms that license or franchise products/services, or that charge interest. The government withholds a percentage of interest charges as tax

• A sales tax is a flat percentage tax on the value of goods or services sold, and is paid by the user


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International Taxation (cont.)

• A value-added tax (VAT) is payable at each stage of processing in the value chain of a product or service

• VAT is calculated as a percentage of the difference between the sale and purchase price of a good

• Common in Canada, Europe, & Latin America

• Each business in a product’s value chain is required to bill the VAT to its customers; the net result is a tax on the added value of the good


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Tax Havens

• Tax havens are countries hospitable to business & inward investment (with low corporate income taxes)

• The Bahamas, Luxembourg, Monaco, Singapore, & Switzerland are examples

• Tax havens exist because tax systems vary greatly worldwide. Thus, MNEs have an incentive to structure their global activities to minimize taxes

• MNEs take advantage of tax havens either by starting operations in them or by funneling business transactions through them


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