Chapter 20 International Trade Finance Questions 20-1. Unaffiliated Buyers. Why might different documentation be used for an export to a nonaffiliated foreign buyer who is a new customer, as compared with an export to a nonaffiliated foreign buyer to whom the exporter has been selling for many years? A new nonaffiliated buyer presents a credit risk for the exporter, because the exporter may be unable to assess the creditworthiness of that importer due to geographic distance, language, culture, or lack of a record of payments to other suppliers. A letter of credit, accompanied by other documents, allows the exporter to rely on the credit standing of a bank, which is presumed to be of greater creditworthiness than just an unknown manufacturing firm. After successful trade goes on for some time the importer becomes a known entity, in which case the exporter will have more faith in the importer s willingness and ability to pay. Because the letter of credit and other documents have both a financial cost and a cost for the time and energy involved in handling the documents, direct billing for exports is easier, faster, and lowers the final end-cost to the ultimate customer. 20-2. Affiliated Buyers. For what reason might an exporter use standard international trade documentation (letter of credit, draft, order bill of lading) on an intrafirm export to its parent or sister subsidiary? An export to a parent or sister subsidiary has no credit risk because both exporter and importer are part of the same corporate unit. Non-payment to an exporter in this situation is just a matter of keeping the firm s cash in another corporate account. In fact, very late payment for an export to an affiliated importer might be desirable, because the firm wants to keep cash in one location and not in another. (This is referred to as leads and lags, a topic explained in Chapter 12.) Nevertheless, an export to an affiliated buyer might pass through the standard documentation as a way to obtain financing that is easy to obtain, is possibly cheaper than alternative sources of short-term financing, or provides some protection against political or countrybased interruption to payment for the transaction. 20-3. Related Party Trade. What reasons can you give for the observation that intrafirm trade is now greater than trade between nonaffiliated exporters and importers? The globalization of world business means that multinational firms manufacture, as well as sell, in many international markets simultaneously. Firms that move part of their manufacturing operation abroad to lower costs and thus enable them to compete more effectively in the home and other markets, find themselves specializing in certain products or components in one location, and then exporting those items to sister subsidiaries in other countries. The globalization of enterprise means that an ever-greater portion of a firm s products are produced in one country and sold in another. (This is no different than large domestic U.S. firms manufacturing in one state and selling in another.) 20-4. Documents. Explain the difference between a letter of credit (L/C) and a draft. How are they linked? A Letter of Credit (L/C) is a document issued by a bank promising to pay if certain documents are delivered to that bank. A draft is an order sent to that bank written by a business firm ordering the bank to make payment. (A personal check is a simple form of a bank draft.) L/Cs and drafts are linked because the L/C states the conditions under which the bank promises to honor a draft drawn on (e.g., directed to) that bank. 105
106 Eiteman/Stonehill/Moffett Multinational Business Finance, Thirteenth Edition 20-5. Risks. What is the major difference between currency risk and risk of noncompletion? How are these risks handled in a typical international trade transaction? Currency risk is the risk that the currency designated for payment of the import changes in value relative to the other currency. A U.S. firm exporting to France wants dollars, while the French importer wants to pay euros. If the sale contract specifies payment in dollars, the French importer has a currency risk more euros than expected might be needed when payment is due. If the sales contract specifies payment in euros, the U.S. exporter has a currency risk fewer dollars than expected might be received when the euros are exchanged for dollars. Risk of noncompletion is the risk that one of the parties fails to fulfill its obligations. The importer may refuse to pay for the goods, or the exporter may fail to ship the goods. Events not under the control of the parties to the trade, such as major storms, disease epidemics, terrorist acts, or war, may make completion of the trade impossible. The several documents involved in international trade are intended to reduce financial loss from noncompletion. 20-6. Letter of Credit. Identify each party to a letter of credit (L/C), and indicate its responsibility. A bank issues a letter of credit, promising to pay for an international trade transaction if certain documents are presented to the bank. The applicant for the letter of credit (usually the importer) applies to the bank for the letter of credit. The beneficiary of the letter of credit (usually the exporter) is to receive payment under a set of conditions specified in the letter of credit. 20-7. Confirming a Letter of Credit. Why would an exporter insist on a confirmed letter of credit? Most letters of credit are unconfirmed, meaning the exporter relies on the credit quality of the issuing bank, rather than that of the importer. However, the exporter may be uncertain of the quality of the issuing bank, especially if that bank is in a remote country about which the importer knows little. The confirmation of the letter of credit is done by a better-known bank in a major country. For example, a U.S. exporter with an order from Morocco accompanied by an L/C from a Casablanca bank may not know if the bank in Casablanca is dependable. The exporter may then ask a Paris bank to guarantee (i.e., confirm ) the L/C of the Casablanca bank. The confirming bank may be acquainted with the Casablanca bank because it has had long-standing correspondent banking relationships going back to earlier French control of parts of Morocco, and so be willing for a fee to guarantee the L/C of the Casablanca bank. 20-8. Documenting an Export of Hard Drives. List the steps involved in the export of computer hard disk drives from Penang, Malaysia, to San Jose, California, using an unconfirmed letter of credit authorizing payment on sight. 1. San Jose importer applies for a letter of credit (L/C) from its California bank. 2. California bank issues an L/C in favor of the San Jose importer and sends the L/C to exporter s Malaysian bank. 3. Malaysian bank advises the Penang exporter of the opening of the L/C. 4. Penang exporter ships the hard drives to the San Jose importer, shipping on an order bill of lading made deliverable to itself; i.e., deliverable to the exporter itself, so that the exporter retains legal title to the merchandise at this stage of the transaction. 5. Penang exporter draws a sight draft against the California bank in accordance with the terms of the L/C, and presents the draft, along with any other required documents, to its own Malaysian bank. 6. Malaysian bank forwards the draft, accompanied by the order bill of lading and any other required documents, to the California bank. 7. California bank pays the Malaysian bank for the sight draft, receiving the order bill of lading, now endorsed by the Malaysian bank. At this point the California bank has legal title to the merchandise.
Eiteman/Stonehill/Moffett Multinational Business Finance, Thirteenth Edition 107 8. Malaysian bank, having received the proceeds from the sale (via the sight draft paid by the California bank), pays the Penang exporter (less any fees). 9. California bank collects the proceeds of the sale from the San Jose importer and endorses the order bill of lading over to the importer so the importer, in turn, can collect the merchandise from the shipper. (The California bank could endorse the order bill of lading over to the San Jose importer without collecting at that time. In such an instance, the California bank is making an unsecured loan to the importer, a lending transaction entirely separate from the import/export transaction.) 20-9. Documenting an Export of Lumber from Portland to Yokohama. List the steps involved in the export of lumber from Portland, Oregon, to Yokohama, Japan, using a confirmed letter of credit, payment to be made in 120 days. 1. Yokohama importer applies for a letter of credit (L/C) from its Japanese bank. 2. Japanese bank issues an L/C in favor of the Yokohama importer and sends the L/C to exporter s Oregon bank, asking the Oregon bank to confirm (i.e., guarantee) the letter of credit. 3. Oregon bank confirms the L/C and advises Portland exporter of the opening of the L/C. 4. Portland exporter ships the lumber to the Yokohama importer, shipping on an order bill of lading made deliverable to itself; i.e., deliverable to the exporter itself, so that the exporter retains legal title to the merchandise at this stage of the transaction. 5. Portland exporter draws a 120-day time draft against the Yokohama bank in accordance with the terms of the L/C and presents the draft, along with any required documents, to its own Oregon bank. 6. Oregon bank endorses (i.e., applies its own guarantee) to the 120-day draft and forwards it, accompanied by the order bill of lading and any other required documents, to the Japanese bank. 7. Japanese bank accepts the time draft, which at this point becomes a banker s acceptance, and returns the accepted time draft to the exporter. The exporter may (1) hold the acceptance to maturity, or (2) discount it in the acceptance market. At this point the Japanese bank has legal title to the lumber. 8. Japanese bank retains the order bill of lading and other documents for the moment. The Japanese bank collects the funds from the Yokohama importer, and then gives the order bill of lading to the importer so the importer may obtain both legal title and physical possession of the shipment of lumber. Several other possibilities exist, depending on the security arrangements between the Japanese bank and the Yokohama importer. 9. At maturity (120 days after the Japanese bank accepted the time draft) the holder of the acceptance presents it to the Japanese bank. The holder might be the exporter, or it might be an investor in bankers acceptances. If the acceptance is still held by the Portland exporter, that exporter presents it to its Oregon bank, which in turn forwards it to the Japanese bank for collection. When the Oregon bank receives funds it credits the account of the Portland exporter. 20-10. Inca Breweries of Peru. Inca Breweries of Lima, Peru, has received an order for 10,000 cartons of beer from Alicante Importers of Alicante, Spain. The beer will be exported to Spain under the terms of a letter of credit issued by a Madrid bank on behalf of Alicante Importers. The letter of credit specifies that the face value of the shipment, $720,000, will be paid 90 days later, after the Madrid bank accepts a draft drawn by Inca Breweries in accordance with the terms of the letter of credit. The current discount rate on a three-month banker s acceptance is 8% per annum, and Inca Breweries estimates its weighted average cost of capital to be 20% per annum. The commission for selling a banker s acceptance in the discount market is 1.2% of the face amount. How much cash will Inca Breweries receive from the sale if it holds the acceptance until maturity? Do you recommend that Inca Breweries hold the acceptance until maturity, or discount it at once in the U.S. banker s acceptance market?
108 Eiteman/Stonehill/Moffett Multinational Business Finance, Thirteenth Edition Alternative 1: If Inca Breweries holds the draft for 90 days after the bank accepts it, Inca Breweries will receive the face amount of $720,000. The present value of $720,000 received 90 days hence, discounted at Inca s WACC of 20% per annum (5% for 90 days) is $685,714.29: $720,000 1+ 0.20! 90 = $685,714.29 ( " % + * # $ 360& ' - ), Alternative 2: Inca Breweries can sell the banker s acceptance in today s money market at an 8% per annum discount: Face amount $ 720,000 Less 1.2% commission 8,640 Less 8% p.a. discount rate (2% for 90 days) 14,400 Amount received at once $ 696,960 Discussion: The amount of cash received today (i.e., $696,960) is greater than the present value of the full $720,000 (i.e., $685,714.29) discounted at Inca s WACC. Inca should sell the acceptance in today s banker s acceptance market and take the cash at once. 20-11. Swishing Shoe Company. Swishing Shoe Company of Durham, North Carolina, has received an order for 50,000 cartons of athletic shoes from Southampton Footware, Ltd., of Great Britain, payment to be in British pounds sterling. The shoes will be shipped to Southampton Footware under the terms of a letter of credit issued by a London bank on behalf of Southampton Footware. The letter of credit specifies that the face value of the shipment, 400,000, will be paid 120 days after the London bank accepts a draft drawn by Southampton Footware in accordance with the terms of the letter of credit. The current discount rate in London on 120-day bankers acceptances is 12% per annum, and Southampton Footware estimates its weighted average cost of capital to be 18% per annum. The commission for selling a banker s acceptance in the discount market is 2.0% of the face amount. Alternative 1: If Southampton Footware holds the draft for 120 days after the bank has accepted it, Swishing Footware will receive the face amount of 400,000. The present value of 400,000 received 120 days hence, discounted at Swishing s WACC of 18% per annum (6% for 120 days) is 377,358.49. 400,000 1+ 0.18! 120 = 377,358.49 ( " % + * # $ 360& ' - ), Alternative 2: Swishing Shoes can sell the banker s acceptance in today s London money market at a 12% per annum discount: Face amount 400,000 Less 2.0% commission 8,000 Less 12% p.a. discount rate (4% for 120 days) 16,000 Amount received at once 376,000 1. Swishing s gain should be calculated in present value terms. Swishing will receive 376,000 today by discounting the banker s acceptance. The present value of the 400,000 to be received in 120 days, discounted at Swishing s WACC of 18%, is 377,358.49. The difference is 1,358.49. Swishing would gain, in terms of present value cash, 1,358.49 by waiting 120 days to receive the face amount of the acceptance. 2. In this transaction Swishing has assumed the foreign exchange transaction risk; that is, the risk that the pounds sterling to be received from the export will be worth fewer dollars when received. In part this risk is a function of the time that Swisher must wait to exchange the pounds sterling for dollars. If Swishing discounts the banker s acceptance at the time of sale, it receives dollars at once at the
Eiteman/Stonehill/Moffett Multinational Business Finance, Thirteenth Edition 109 exchange rate then in effect. If Swishing waits 120 days to receive the pounds sterling, Swisher assumes the added risk that the exchange rate will deteriorate between the time of sale and the time of collection. (Of course, Swishing might gain if the pound would buy more, rather than less, dollars in 120 days.) 20-12. Going Abroad. Assume that Great Britain charges a duty of 10% on shoes imported into the United Kingdom. Swishing Shoe Company, in question 11, discovers that it can manufacture shoes in Ireland and import them into Great Britain free of any import duty. What factors should Swishing consider in deciding to continue to export shoes from North Carolina versus manufacture them in Ireland? If Swishing shifts manufacturing to Ireland from North Carolina, it avoids the 10% import duty and the discount on such bankers acceptances as it now might be incurring. Alternatively, Swishing would avoid waiting 120 days for its cash and undertaking the associated translation risk. Note that the solution to problem 2, above, in which Swishing found it advantageous to wait 120 days for the cash, is unique to that moment in time. A week or a month later discount rates might change, and the alternative would then be preferable. If Swishing decides to open a plant and manufacture in Ireland, the following factors must be considered: a. Corporate income tax rates in Ireland and the United States. b. Present and possible future changes in shipping costs. (If Swishing had been using air freight before the terrorist attack on the Twin Towers in New York and the Pentagon, it might encounter a sharp rise in air freight rates afterward. Terrorists attacks and their aftermath cannot be easily predicted, but to gauge the success of a foreign manufacturing venture versus exporting, a firm must consider the possibility of any kind of unpredictable structural changes.) c. Expected production volume in Ireland relative to the designed manufacturing capacity of the new factory there. The cost of manufacturing shoes in Ireland will depend both on the volume for which that plant is designed,, and the percent of capacity expected to be used in the near future. d. The cost of labor and material in Ireland, versus North Carolina; and the availability and level of education of potential workers. e. The existence, or nonexistence, of excess capacity in the North Carolina factory, both at present and in terms of expected future growth. f. The political risk of investing in Ireland for the British market, should the type of political terrorism and anti-british feelings currently in Northern Ireland spread to the Republic of Ireland itself. g. The possibility that valuable technology of a proprietary nature would be stolen. (This might seem unlikely in the Irish and British context, but for other countries it could be a significant factor.) Such a list as above cannot possibly identify all the subjective factors that might go into a decision to invest rather than export, but it provides a starting point for consideration of the global strategy of a firm. 20-13. Governmentally Supplied Credit. Various governments have established agencies to insure against nonpayment for exports and/or to provide export credit. This shifts credit risk away from private banks and to the citizen taxpayers of the country whose government created and backs the agency. Why would such an arrangement be of benefit to the citizens of that country? The cost to local taxpayers is a contingent loss, to be covered by the government s tax revenues in case the foreign importer fails to pay the exporter. Failure could be deliberate by the importer, but it could also be imposed because of wars, natural disasters, or other international events. The benefits to the exporting country are the current jobs created by the manufacturing process, and any future jobs that might follow from recurring exports by the same firm. The government has determined that these benefits outweigh the possibility of loss.