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Chapter 13 Global Financial Management

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Key issues in global finance

Currency exchange variations

• Strategic exposure (long -term )• Transaction exposure (short-term)• Translation exposure (book valuation effect)

Investment• Project valuation

Financing

• Equity financing and cross-listing• Debt financing• Trade financing• Project finance

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Currency exchange variations

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Strategic effects of forex variations

Domestic Domestic

DomesticDomestic

Global

GlobalGlobal

Global

Effects of a ‘domestic’devaluation

Effects of a ‘domestic’revaluation

Increasescompetitivenessagainst imports

Decreasescompetitivenessof products withhigh global content

Increasescompetitivenessof domesticalyproduced products

No effects

Decreasescompetitiveness

Increasecompetitiveness

Decreasescompetitiveness

No effects

Markets Markets

Firms Firms

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Strategic effects: what to do?

• Move production: to low cost countries to countries with weak currencies?

• Differentiate to make products less price-sensitive

• Balance production-sales by currency zones

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Transaction exposure

• Hedging techniques:

• Forward contracts• Money markets contracts• Future contracts• Options• Swap• Netting• Leading and lagging

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Hedging with forward contract

Example: a US machinery company sells to a paper machine to a Finnish company for 10 million Euros payable in one year

US interest rate: 1%Euro interest rate: 2%Spot exchange rate: 1.30 $/€Forward rate (1 Year): 1.287$/£

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Example: The paper machinery transaction

Forward hedge Spot rate at

Maturity Unhedged receipt US$

Forward hedge US$

Gain losses from

hedging1,20 12,00 12,87 0,871,25 12,50 12,87 0,371,29 12,87 12,87 0,001,30 13,00 12,87 -0,131,35 13,5 12,87 -0,631,40 14,00 12,87 -1,13

Money market hedge US Company borrows 10€ at 2% rate and gets 9,80 € €Uses borrowing to buy US$ at spot rate =9.8/1.3 12745 US$Invest 12,745 US$ at 1% 12872 US$At maturity gets 80 m€ used to repay loan

Both hedging technics brings the same results 12872 US$ US$representing a cost of hedging of 13000-12872 128 US$

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NettingExample: Cash receipts and disbursements matrix for Teltrex ($000)

Payments

Receipts US (US$) Germany (€)Australia

(AUD) UK (£) ExternalTotal inter

SubsidiariesTotal

ReceiptsUS - 40 30 60 120 130 250Germany 50 - 45 80 90 175 265Australia 25 10 - 35 60 70 130UK 30 40 20 - 80 90 170External 100 120 150 80 - 450

Total inter Subsidiaries 105 90 95 175 465Total payments 205 210 245 255 350 1265

Teltrex’s interaffiliates foreign exchange transactions without netting (000 $)

US

AUS

GER

UK

+40

+60

+30

+35

US

AUS

GER

UK

+10

+10

+20

+15

+10

+25

+30

+20

+10

+25

+30+10

+20

+40

Bilateral netting of Teltrex’s interaffiliates foreign exchange transactions (000 $)

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Netting cont.Example

Payments

Receipts US (US$) Germany (€)Australia

(AUD) UK (£) ExternalTotal inter

subsidiaries Total receiptsUS - 40 30 60 120 130 250Germany 50 - 45 80 90 175 265Australia 25 10 - 35 60 70 130UK 30 40 20 - 80 90 170External 100 120 150 80 - 450

Total inter subsidiaries 105 90 95 175 465Total payments 205 210 245 255 350 1265

Intersubsidiaries netting

US

AUS

GER

UK

+10

+40+30

+35

+15

+5

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Global financing

Cross-listing

If cost of capital is different (fragmented) across countries there is a potential advantage of arbitrage (assuming similar risks).

But also:• Higher liquidity • Larger investor base• Higher visibility• Less vulnerable to hostile take-over

However:• Costs of compliance• Higher dependance on volatility of international markets

Source: Eun and Resnick: International Financial Management, 2001

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Global financing cont.

Source : NYSE Factbook, 1999.

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Project finance

‘Financing of a particular economic unit in which the providersof funds look primarily to the cash flow from the project as the source of funds to service their loans or provide a return on equityand to the assets of the economic unit as collateral for the loans.’*

*Nevitt & Fabozzi (2000) and Finnerty (1996)

Involves:

• Private sponsors• Multinational development agencies (IFC, ADB, EBRD, AFDB..)• Bilateral development agencies (CDC, AFD, Finnfunds, OECF..)• Commercial banks• Export credit agencies (Coface, Hermes, ECGD…)

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Objectives

To look at the costs and benefits of a project from the point of view:

• of the fund providers (financial risks and return)

• of the stakeholders (economic and social risks and return)

This applies to:

• Infrastructure projects

• Industrial projects

I.R.R

E.R.R

Project valuation

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The points of view of the providers of funds

• Project sponsor• Other equity providers• Loan providers

Project cash flow based evaluation:• NPV• IRR• Pay back

Issues:

• Evaluation of the risks for the funds providers

• How to incorporate risks into the calculation

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Risks in project evaluationConstruction risks

Operating risks Sovereign risksTechnology

Timing

Supporting industries

Logistics and red tape

Complexity or untestedtechnology may lead tocost overruns orconstruction delays.

Failure to complete on time may induce penalties and jeopardize cash flows

Absence of qualified contractors and supporting services

Difficulties in custom clearancetransport of materials andpersonnel

Supply

Market

Quantity and quality ofresources

Price and quantity of output

Throughput Efficiency of process

Operating Costs

Staibilty of cost factors

Force majeure ‘Acts of god’EnvironmentalWars, terrorism

Disruption Strikes

Expropriation

Legal

Direct Creeping

Lack of law enforcement

Inflation

Foreign exchange

Convertibilty and transferability

Price control

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Mitigating risks in projects Construction risks Operating risks Sovereign risks

Technology

Timing

Supporting industries

Logistics and red tape

Proven technologyAppropriate technologyExperience in projectsProject management

Project management

Suppliers trainingPiggy backing

Local knowledge

Supply

Market

Supplier trainingInternational suppliersIntegrated projects (power,water, etc.)

Take-off contractsExportsThroughput Proven processExperienceManagementOperating costs Quality of managementLong-term contractsForce majeure InsuranceDisruption FairnessHuman resource management

Expropriation

Legal

Multilateral agency as shareholderHost country assets in home country

Lobbying

Inflation

Foreign exchange

Convertibilty and transferability

Price controlLobbying

Output priced in hard currency

Pricing

Offshore proceeds account

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Accounting for risks in projects evaluation

Adjusting the cost of equity with a ‘risk’ premium

Adjusting the cash flows

Adjust each element of cash flow according to expected occurrence of adverse events

Country βeta (Lessard): CoE= Risk free rate + country risk premium + asset βeta *market equity premium*

Country βeta

Risk premium :a) based on bond spread

= (yield on host country bonds - yield on home country bonds)

b) Export credits agency credit risk premium

2 methods:

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1. Calculate the risk premium due to market risk (offshore project βeta) to be included in the cost of equity

Offshore project βeta = βeta of comparable project in home country * country βetaWhere country βeta = volatility of the host country stock market (correlation of changes with

home country) (or GDP)/ to the home country

2. Add a political risk premiumBond risk premium

3. Adjust WACC accordingly

4. Cost of equity in a foreign investment:

= Risk-free home country + country risk (bond risk premium) + market risk premium*(company βeta * country market βeta)

Adjusting the cost of equity (Donald Lessard - MIT)

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Adjusting the cost of equity (Donald Lessard - MIT) cont.

Example:Investment of Australian Mining Co. (AMC) in Brazil, entirely financed with equityCash flow in Brazilian Real (BRL):

Year 0 1 2 3 4 5Cash flow -175 40 45 50 55 145

(1 AUS$ = 1.9 BRL)

(AMC cost of equity: 12% (5% risk free + 5% market risk + 2% company risk)

10 year government bond rates: Australia = 5.5%; Brazil= 12.4%) GDP variation βeta BRZ/AUS= 1.04

NPV without risks (cost of equity: 12%) =IRR =

NPV with risks (cost of equity: 12% + (12.4% - 5.5%) + (5%*1.04) =IRR =

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1. Identify the elements of cash flow subject to country risk variation (revenues, costs)

2. Assign a probability of occurrence to those elements

3. Take the expected value [likely cash flow * (1-probability of adverse event)]

4. Possibility to run a Monte Carlo simulation if various probabilities affect various elements

5. Calculate NPV with global cost of capital

Adjusting the cash flows (Hawawini & Viallet - INSEAD)

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Trade finance