1 Chapter 20 Short-Term Financing Lecture Outline Sources of Short-Term Financing Internal Financing by MNCs Why MNCs Consider Foreign Financing Foreign Financing to Offset Foreign Currency Inflows Foreign Financing to Reduce Costs Determining the Effective Financing Rate Criteria Considered for Foreign Financing Interest Rate Parity The Forward Rate as a Forecast Exchange Rate Forecasts Actual Results from Foreign Financing Financing with a Portfolio of Currencies Portfolio Diversification Effects Repeated Financing with a Currency Portfolio 338
2 Chapter 20: Short-Term Financing 339 Chapter Theme This chapter explains short-term liability management of MNCs. From this chapter, students should learn that correct financing decisions can reduce the firm s costs. While foreign financing costs cannot usually be perfectly forecasted, firms should evaluate the probability of reducing costs through foreign financing. Topics to Stimulate 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. 2. What is the risk of borrowing a low interest rate currency? 3. 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 (as opposed to borrowing all funds from one of these foreign currencies)? Explain. POINT/COUNTER-POINT: Do MNCs Increase Their Risk When Borrowing Foreign Currencies? POINT: Yes. MNCs should borrow the currency that matches their cash inflows. If they borrow a foreign currency to finance business in a different currency, they are essentially speculating on the future exchange rate movements. The results of their strategy are uncertain, which represents risk to the MNC and its shareholders. COUNTER-POINT: No. If MNCs expect that they can reduce the effective financing rate by borrowing a foreign currency, they should consider borrowing that currency. This enables them to achieve lower costs, and improves their ability to compete. If they take the most conservative approach by borrowing whatever currency matches their inflows, they may incur higher costs, and have a greater chance of failure. WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support? Offer your own opinion on this issue. ANSWER: If MNCs borrow in a low interest rate currency that is not matched with their inflow currencies, they may be able to reduce their effective financing rate. However, they increase their exposure to exchange rate risk. Their decision is based on a tradeoff of expected reduction in financing expenses versus the risk that the currency their borrow appreciates against their inflow currencies. Answers to End of Chapter Questions 1. Financing From Subsidiaries. Explain why an MNC parent would consider financing from its subsidiaries.
3 340 International Financial Management ANSWER: A parent may obtain funds at a lower cost from its subsidiaries than from a bank, since a bank will maintain a spread between what it offers depositors and charges on loans. 2. Foreign Financing. a. Explain how a firm s degree of risk aversion enters into its decision of whether to finance in a foreign currency or a local currency. ANSWER: A very risk-averse firm may prefer to borrow domestically since it knows with certainty the cost of financing in advance. Yet, other firms may feel that the potential cost savings from foreign financing outweighs the risk (uncertainty); this may motivate them to consider financing in a foreign currency. b. Discuss the use of specifying a break-even point when financing in a foreign currency. ANSWER: A break-even exchange rate percentage change will indicate to a firm the amount by which a low interest rate currency must appreciate to make its financing cost the same as a domestic currency. 3. Probability Distribution. a. Discuss the development of a probability distribution of effective financing rates when financing in a foreign currency. How is this distribution developed? ANSWER: First, a probability distribution of exchange rate changes is created. Using this along with the foreign currency s quoted interest rate, the probability distribution of effective financing rates can be developed. b. Once the probability distribution of effective financing rates from financing in a foreign currency is developed, how can this distribution be used in deciding whether to finance in the foreign currency or the home currency? ANSWER: A distribution of effective financing rates can be used to determine the probability that foreign financing will be more costly than domestic financing. Then, the final decision will depend on the firm s degree of risk aversion. 4. Financing and Exchange Rate Risk. How can a U.S. firm finance in euros and not necessarily be exposed to exchange rate risk? ANSWER: If it has inflows in euros, it could use a portion of the inflows to pay its financing expenses. 5. Short-term Financing Analysis. Assume that Tulsa Inc. needs $3 million for a one-year period. Within one year, it will generate enough U.S. dollars to pay off the loan. It is considering three options: (1) borrowing U.S. dollars at an interest rate of 6%, (2) borrowing Japanese yen at an interest rate of 3%, or (3) borrowing Canadian dollars at an interest rate of 4%. Tulsa Inc. expects that the Japanese yen will appreciate by 1% over the next year and that the Canadian dollar will appreciate by 3%. What is the expected effective financing rate for each of the three options? Which option appears to be most feasible? Why might Tulsa Inc. not necessarily choose the option reflecting the lowest effective financing rate?
4 Chapter 20: Short-Term Financing 341 ANSWER: Expected Interest Expected Percentage Effective Currency Rate Change in Currency Financing Rate Dollars 6% 6.00% Japanese yen 3% +1% 4.03% Canadian dollars 4% +3% 7.12% ANSWER: The Japanese yen option appears to be the most feasible option. Yet, the exchange rate percentage change is uncertain, which makes the effective financing rate uncertain. Thus, Tulsa Inc. will not necessarily choose this option. 6. Effective Financing Rate. How is it possible for a firm to incur a negative effective financing rate? ANSWER: If the currency borrowed substantially depreciates against the firm s home currency (by at least the interest rate percentage as a rough approximation), the effective financing rate will be negative. 7. IRP Application to Short-term Financing. If interest rate parity does not hold, what strategy should Connecticut Co. consider when it needs short-term financing? a. Assume that Connecticut Co. needs dollars. It borrows euros at a lower interest rate than that for dollars. If interest rate parity exists and if the forward rate of the euro is a reliable predictor of the future spot rate, what does this suggest about the feasibility of such a strategy? ANSWER: The firm could consider borrowing a foreign currency and purchasing the currency forward to lock in its financing cost. If the forward rate is a reliable predictor, the effective financing rate on the foreign financing would be the same as the domestic financing. So, foreign financing is not feasible. b. If Connecticut Co. expects the spot rate to be a more reliable predictor of the future spot rate, what does this suggest about the feasibility of such a strategy? ANSWER: If the expected spot is more reliable, the foreign financing should be less costly than domestic financing, because this implies that the expected percentage change in the euro s value is zero, so that the interest rate on euros represents the expected effective financing rate when financing with euros. 8. Break-even Financing. Akron Co. needs dollars. Assume that the local one-year loan rate is 15%, while a one-year loan rate on euros is 7%. By how much must the euro appreciate to cause the loan in euros to be more costly than a U.S.-dollar loan?
5 342 International Financial Management ANSWER: (1.15) 1 = 7.477% (1.07) The euro must appreciate by about 7.477% over the year in order to make the loan in euros as costly as a U.S. dollar loan. 9. IRP Application to Short-term Financing. Assume that interest rate parity exists. If a firm believes that the forward rate is an unbiased predictor of the future spot rate, will it expect to achieve lower financing costs by consistently borrowing a foreign currency with a low interest rate? ANSWER: No, because a foreign currency with a relatively low interest rate exhibits a forward premium that offsets the interest rate differential. Thus, if the forward rate is the expected future spot rate, this implies that the foreign currency will appreciate over the financing period by an amount that will offset the interest rate advantage. 10. Effective Financing Rate. Boca, Inc., needs $4 million for one year. It currently has no business in Japan but plans to borrow Japanese yen from a Japanese bank, because the Japanese interest rate is three percentage points lower than the U.S. rate. Assume that interest rate parity exists; also assume that Boca believes that the one-year forward rate of the Japanese yen will exceed the future spot rate one year from now. Will the expected effective financing rate be higher, lower, or the same as financing with dollars? Explain. ANSWER: Since the forward rate is expected to overestimate the future spot rate, this implies that the yen will not appreciate to the level that would fully offset the interest rate differential. Therefore, the expected effective financing rate of the yen is lower than the U.S. financing rate. 11. IRP Application to Short-term Financing. Assume that the U.S. interest rate is 7 percent and the euro s interest rate is 4 percent. Assume that the euro s forward rate has a premium of 4 percent. Determine whether the following statement is true: Interest rate parity does not hold; therefore, U.S. firms could lock in a lower financing cost by borrowing euros and purchasing euros forward for one year. Explain your answer. ANSWER: No. While interest rate parity does not hold, the financing with euros would result in an effective financing rate of: (1 + 4%)(1 + 4%) 1 = 8.16% This exceeds the U.S. rate. For a U.S. firm to be able to lock in a lower financing cost by borrowing euros and purchasing euros forward, the premium on the forward rate of the euro would have to be less than the interest rate differential. 12. Break-even Financing. Orlando, Inc., is a U.S.-based MNC with a subsidiary in Mexico. Its Mexican subsidiary needs a one-year loan of 10 million pesos for operating expenses. Since the Mexican interest rate is 70 percent, Orlando is considering borrowing dollars, which it would convert to pesos to cover the operating expenses. By how much would the dollar have to appreciate against the peso to cause such a strategy to backfire? (The one-year U.S. interest rate is 9%.)
6 Chapter 20: Short-Term Financing 343 ANSWER: % 1+9% -1 = 55.96% The dollar would have to appreciate by more than percent for the strategy to backfire. 13. Financing Since the Asian Crisis. Bradenton, Inc., has a foreign subsidiary in Asia that commonly obtained short-term financing from local banks prior to the Asian crisis. Explain why the firm may not be able to easily obtain funds from the local banks since the crisis. ANSWER: The foreign subsidiary may find that the local banks do not have adequate funding from depositors any more to provide credit. Alternatively, the banks may be concerned about the credit risk given the large number of defaults by firms. 14. Effects of September 11. Homewood Co. commonly finances some of its U.S. expansion by borrowing foreign currencies (such as Japanese yen) that have low interest rates. Describe how the potential return and risk of this strategy may have changed after the September 11, 2001 terrorist attack on the U.S. ANSWER: The attack on the U.S. caused short-term interest rates in the U.S. to decline, which reduced the cost of borrowing dollars. Thus, the appeal of borrowing funds denominated in foreign currencies was reduced. Furthermore, the decline in U.S. interest rates and the weak stock prices in the U.S. caused a decline in capital flows to the U.S. and could possibly cause a decline in the dollar. If the dollar weakens, the cost of financing in the foreign securities would increase. 15. Probability Distribution of Financing Costs. Missoula, Inc., decides to borrow Japanese yen for one year. The interest rate on the borrowed yen is 8 percent. Missoula has developed the following probability distribution for the yen s degree of fluctuation against the dollar: Possible Degree of Fluctuation Percentage of Yen Against the Dollar Probability 4% 20% 1% 30% 0% 10% 3% 40% Given this information, what is the expected value of the effective financing rate of the Japanese yen from the U.S. corporation s perspective?
7 344 International Financial Management ANSWER: Japanese Interest Rate Possible % Change in Yen Value Effective Financing Rate Based on That Change Computation of Expected Value Probability 8% 4% 3.68% 20%.736% 8% 1% 6.92% 30% 2.076% 8% 0% 8.00% 10%.800% 8% 3% 11.24% 40% 4.496% 8.108% Expected value = 8.108% 16. Analysis of Short-term Financing. Jacksonville Corp. is a U.S.-based firm that needs $600,000. It has no business in Japan but is considering one-year financing with Japanese yen, because the annual interest rate would be 5 percent versus 9 percent in the United States. Assume that interest rate parity exists. a. Can Jacksonville benefit from borrowing Japanese yen and simultaneously purchasing yen one year forward to avoid exchange rate risk? Explain. ANSWER: If Jacksonville borrows yen and simultaneously purchases yen one year forward, it will pay a forward premium that will offset the interest rate differential (given that interest rate parity exists). Based on interest rate parity, the forward premium is about 3.8%. The effective financing rate would be: (1 + 5%)( %) 1 = about 9% b. Assume that Jacksonville does not cover its exposure and uses the forward rate to forecast the future spot rate. Determine the expected effective financing rate. Should Jacksonville finance with Japanese yen? Explain. ANSWER: If it does not cover the exposure but uses the forward rate as a forecast, the expected percentage change in the Japanese yen s value is about 3.8 percent. Thus, the expected effective financing rate is 9%. Jacksonville should therefore finance with dollars rather than Japanese yen, since the expected cost of financing with dollars is not higher. c. Assume that Jacksonville does not cover its exposure and expects that the Japanese yen will appreciate by either 5 percent, 3 percent, or 2 percent, and with equal probability of each occurrence. Use this information to determine the probability distribution of the effective financing rate. Should Jacksonville finance with Japanese yen? Explain.
8 Chapter 20: Short-Term Financing 345 ANSWER: Possible % Effective Financing Change in Spot Rate of JY if that Rate of JY Percentage Change Occurs Probability 5% (1.05)(1.05) 1 = 10.25% 33.3% 3% (1.05)(1.03) 1 = % 2% (1.05)(1.02) 1 = % Given the probability, there is about a 67 percent chance that financing with Japanese yen will be less costly than financing with dollars. The choice of financing with yen or dollars in this case is dependent on Jacksonville s degree of risk aversion. 17. Financing With a Portfolio. Pepperdine, Inc., considers obtaining 40 percent of its one-year financing in Canadian dollars and 60 percent in Japanese yen. The forecasts of appreciation in the Canadian dollar and Japanese yen for the next year are as follows: Probability Possible Percentage of that Percentage Change in the Spot Change in the Currency Rate Over the Loan Life Spot Rate Occurring Canadian dollar 4% 70% Canadian dollar 7 30 Japanese yen 6 50 Japanese yen 9 50 The interest rate on the Canadian dollar is 9 percent, and the interest rate on the Japanese yen is 7 percent. Develop the possible effective financing rates of the overall portfolio and the probability of each possibility based on the use of joint probabilities. ANSWER: Effective Financing Interest Possible Rate Based on Currency Rate % Change that Change Probability Canadian dollar 9% 4% 13.36% 70% Canadian dollar Japanese yen Japanese yen Possible Joint Effective Financing Rate Joint Effective Financing C$ JY Probability Rate of Portfolio 13.36% 13.42% (70%)(50%) = 35%.4(13.36%) +.6(13.42%) = % (70%)(50%) = 35%.4(13.36%) +.6(16.63%) = % (30%)(50%) = 15%.4(16.63%) +.6(13.42%) = % (30%)(50%) = 15%.4(16.63%) +.6(16.63%) = %
9 346 International Financial Management Thus, there is a 35% probability that the portfolio s effective financing rate will be %, and so on. 18. Financing With a Portfolio. a. Does borrowing a portfolio of currencies offer any possible advantages over the borrowing of a single foreign currency? ANSWER: If a firm borrows a single foreign currency, it is especially vulnerable to that currency s exchange rate. The firm can lower its vulnerability to any single currency by borrowing a portfolio. b. If a firm borrows a portfolio of currencies, what characteristics of the currencies will affect the potential variability of the portfolio s effective financing rate? What characteristics would be desirable from a borrowing firm s perspective? ANSWER: Currencies which are volatile and highly correlated with each other could cause the effective financing rate of the portfolio to be very volatile over time. Ideally, the currencies comprising the portfolio would have a low degree of volatility or negative correlations. This would reduce the exchange rate risk of the portfolio. 19. Financing With a Portfolio. Raleigh Corp. needs to borrow funds for one year to finance an expenditure in the United States. The following interest rates are available: Borrowing Rate U.S. 10% Canada 6% Japan 5% The percentage change in the spot rates of the Canadian dollar and Japanese yen over the next year are as follows: Canadian Dollar Japanese Yen Percentage Change Percentage Change Probability in Spot Rate Probability in Spot Rate 10% 5% 20% 6% 90% 2% 80% 1% If Raleigh Corporation borrows a portfolio, 50 percent of funds from Canadian dollars and 50 percent of funds from yen, determine the probability distribution of the effective financing rate of the portfolio. What is the probability that Raleigh will incur a higher effective financing rate from borrowing this portfolio than from borrowing U.S. dollars?
10 Chapter 20: Short-Term Financing 347 ANSWER: Effective Financing Interest Possible Rate Based on Currency Rate % Change that Change Probability Canadian dollar 6% 5% 11.3% 10% Canadian dollar 6% 2% 8.12% 90% Japanese yen 5% 6% 11.3% 20% Japanese yen 5% 1% 6.05% 80% Possible Joint Effective Financing Rate Joint Effective Financing C$ JY Probability Rate of Portfolio 11.3% 11.3% (10%)(20%) = 2%.5(11.3%) +.5(11.3%) = 11.3% (10%)(80%) = 8%.5(11.3%) +.5(6.05%) = 8.675% (90%)(20%) = 18%.5(8.12%) +.5(11.3%) = 9.71% (90%)(80%) = 72%.5(8.12%) +.5(6.05%) = 7.085% There is a 2 percent chance that Raleigh will incur a higher effective financing rate from borrowing the portfolio. Solution to Continuing Case Problem: Blades, Inc. 1. What is the amount, in baht, that Blades needs to borrow to cover the payments due to the Thai suppliers? What is the amount, in yen, that Blades needs to borrow to cover the payments due to the Thai suppliers? ANSWER: Since Blades will purchase materials necessary to manufacture 120,000 pairs of Speedos, and since the cost per pair will approximately be 3,500 Thai baht, it will need to obtain a loan for the equivalent of 120,000 3,500 = 420,000,000 Thai baht. If Blades borrows in yen, the yen would be converted to Thai baht in order to pay the Thai supplier. Thus, Blades will have to obtain a loan for THB420,000,000/THB = 1,207,500, Given that Blades will use the receipts from the receivables in Thailand to repay the loan and that Blades plans to remit all baht-denominated cash flows back to the U.S. parent whether it borrows in baht or yen, does the future value of the yen with respect to the baht affect the cost of the loan if Blades borrows in yen? ANSWER: Given that all baht-denominated cash flows generated by Blades Thai subsidiary are remitted back to the U.S., Blades cost of the yen loan will be affected by the future value of the yen with respect to the baht. Blades will first borrow yen, convert the yen to baht to pay the suppliers, and then convert baht to yen in six months to repay the yen loan. If the yen appreciates relative to the baht over the life of the loan, Blades effective financing rate of borrowing in yen will increase.
11 348 International Financial Management 3. Using a spreadsheet, compute the expected amount (in U.S. dollars) that will be remitted back to the U.S. in six months if Blades finances its working capital requirements by borrowing baht versus borrowing yen. Based on your analysis, should Blades obtain a yen- or baht-denominated loan? ANSWER: (See spreadsheet attached.) If Blades borrows in Thai baht, the expected amount remitted back to the U.S. in six months is $3,501,653. If Blades borrow in Japanese yen, the expected amount remitted back to the U.S. in six months is $3,627,438. Thus, it appears that Blades should obtain a yen-denominated loan. Computation of Expected Change in Value of Thai Baht (Relative to the Dollar) (1) (2) (3) = (1) (2) Possible Rate of Change in the Probability of Thai Baht Over the Life of the Loan Occurrence Product 3% 30% 0.90% 2% 30% 0.60% 1% 20% 0.20% 0% 15% 0.00% 1% 5% 0.05% 1.65% = Expected Change Computation of Expected Change in Value of Japanese Yen (Relative to the Baht) (1) (2) (3) = (1) (2) Possible Rate of Change in the Probability of Japanese Yen Over the Life of the Loan Occurrence Product 2% 30% 0.60% 1% 30% 0.30% 0% 20% 0.00% 1% 15% 0.15% 2% 5% 0.10% 0.65% = Expected Change (1) Blades Borrows in Thai Baht Computation of Expected Baht-Dollar Exchange Rate in Six Months Current Spot Rate of Baht $ Expected Percentage Change in Baht 1.65% Expected Value of Baht in Six Months ($0.023 [1 1.65%]) $ Computation of Baht to Be Remitted to the U.S. Parent: Baht Receivables (120,000 pairs 5,000 baht per pair) THB 600,000,000 Baht Loan Repayment (420,000, ) THB 445,200,000 Baht to Be Remitted to the U.S. (600,000, ,200,000) THB 154,800,000 Expected Dollar Amount Remitted in Six Months (154,800,000 $ ) $3,501,653
12 Chapter 20: Short-Term Financing 349 (2) Blades Borrows in Japanese Yen Computation of Expected Yen-Baht Exchange Rate in Six Months Current Spot Rate of Yen THB Expected Percentage Change in Yen 0.65% Expected Value of Yen in Six Months (THB [ %]) THB Computation of Baht to Be Remitted to the U.S. Parent: Baht Receivables (120,000 pairs 5,000 baht per pair) THB 600,000,000 Yen Needed to Repay Loan (1,207,500,302 yen 1.04) 1,255,800,314 Baht Needed to Repay Loan (1,255,800,314 yen THB ) THB 439,639,365 Baht to Be Remitted to the U.S. (600,000, ,639,365) THB 160,360,635 Expected Dollar Amount Remitted in Six Months (160,360,635 $ ) $3,627,438 Solution to Supplemental Case: Flyer Company a. The optimal portfolio is dependent on your degree of risk aversion. By converting the information in the table above into 4 bar charts (showing the probability distribution), one above another, you can review the risk-return tradeoff. By using a spreadsheet format, the percentage changes in exchange rates can be easily computed. Using these percentage changes along with the interest rates, the effective financing rate can be computed for each currency under each scenario. The effective financing rates are provided below for each scenario, along with the expected value of the effective financing rate (using the probabilities assigned to each scenario): Somewhat Expected Value Strong $ Stable $ Weak $ of Effective Currency Scenario Scenario Scenario Financing Rate Australian dollar 0.56% 14.51% 28.07% 14.05% British pound Canadian dollar Japanese yen Mexican peso New Zealand dollar Singapore dollar South African rand U.S. dollar Venezuelan bolivar
13 350 International Financial Management Percentage of Funds Borrowed from: Type of Portfolio A$ BP C$ JY MXP NZ$ S$ SAR US$ VB Risk neutral Balanced Conservative Ultra-conservative Each portfolio s effective financing rates are determined as a sum of weighted effective financing rates under each scenario. Portfolio s Effective Financing Rate Based on a: Expected Value Strong $ Stable $ Weak $ of Effective Portfolio Scenario Scenario Scenario Financing Rate Risk neutral 4.60% 1.76% 10.24% 2.40% Balanced Conservative Ultra-conservative The decision of which portfolio to use would be based on your degree of risk aversion. By converting the table above into four bar charts, (showing the profitability distribution), one above another, you can review the tradeoff between lower financing costs and risk. Small Business Dilemma Short-Term Financing by the Sports Exports Company 1. Should Jim borrow dollars or pounds to finance his joint venture business? Why? ANSWER: Jim should borrow pounds. Although the British interest rate is slightly higher, Jim could offset part of his firm s exposure by borrowing British pounds. Jim can use some of his future receivables in pounds to repay the British loan, thereby reducing the amount of pounds that have to be converted into dollars. 2. Jim could also borrow euros at an interest rate that is lower than the U.S. or British rate. The values of the euro and pound tend to move in the same direction against the dollar but not always by the same degree. Would borrowing euros to support the British joint venture result in more exposure to exchange rate risk than borrowing pounds? Would it result in more exposure to exchange rate risk than borrowing dollars? ANSWER: Borrowing euros would result in more exchange rate risk than borrowing pounds, because the euros would have to be converted into pounds to support the British venture, but payment on the loan would be in euros. If the euro appreciated against the pound over time, it would take more pounds to pay off the loan.
14 Chapter 20: Short-Term Financing 351 Borrowing euros would be less risky (when using the funds to finance the British venture) than borrowing dollars, because the movements in the euro and the pound are highly correlated. If the pounds value declined against the dollar, so would the euro (in most cases), so that the amount of pounds needed to pay this loan would be less than the amount needed to pay a loan denominated in dollars.