Short-Term FinancingShort-Term Financing

2020 Chapter Chapter

South-Western/Thomson Learning © 2003

See c20.xls for spreadsheets to accompany this chapter.

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Chapter 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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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.

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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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Why MNCs ConsiderForeign 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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Short-Term Interest Rates

0

5

10

15

20

25

1978 1982 1986 1990 1994 1998 2002

0

5

10

15

20

25

1978 1982 1986 1990 1994 1998 2002

U.K.

Japan

Canada

Germany U.S.

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Determining theEffective Financing Rate

The actual cost of financing depends on

the interest rate on the loan, and

the movement in the value of the borrowed currency over the life of the loan.

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2. Converts to $500,000

Exchange rate = $0.50/NZ$

What is the effective financing rate?

3. Has to pay back

NZ$1,080,000

1 year later

1. Borrows NZ$1,000,000

at 8.00%for 1 year

At time t

4. Converts to $648,000

Exchange rate = $0.60/NZ$

Determining theEffective Financing Rate

$648k – $500k = 29.6%

$500k

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Effective financing rate, rf

= {( 1 + if ) St+1} – {1 St} = ( 1 + if )

St+1 – 1

{1 St} St

where if = the interest rate on the loanSt = beginning spot rate

St+1 = ending spot rate

Determining theEffective Financing Rate

The effective rate can be rewritten as rf = ( 1 + if ) ( 1 + ef ) – 1

where ef = the % in the spot rate

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• Current interest rates and exchange rates are available at http://www.bloomberg.com/.

• Interest rate and exchange rate forecasts can be found at http://biz.yahoo.com/ifc/.

Online Application

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Criteria Considered forForeign Financing

• There are various criteria an MNC must consider in its financing decision, including¤ interest rate parity,¤ the forward rate as a forecast, and¤ exchange rate forecasts.

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Criteria Considered forForeign Financing

Interest Rate Parity (IRP)

• If IRP holds, foreign financing with a simultaneous hedge of that position in the forward market will result in financing costs similar to those for domestic financing.

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Implications of IRP for FinancingIRP

holds?Financing

costs*Type of

financing

* as compared to the financing costs for domestic financing

Scenario

Yes Covered SimilarForward rate accuratelypredicts future spot rateYes Uncovered Similar

Forward rate over-estimates future spot rateYes Uncovered Lower

Forward rate under-estimates future spot rateYes Uncovered Higher

Forward premium(discount)exceeds (is less than)

interest rate differentialNo Covered Higher

Forward premium (discount)is less than (exceeds)

interest rate differentialNo Covered Lower

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The Forward Rate as a Forecast

• 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.

Criteria Considered forForeign Financing

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Exchange Rate Forecasts

• Firms may use exchange rate forecasts to forecast the effective financing rate of a foreign currency, or they may compute the break-even exchange rate that will equate the domestic and foreign financing rates.

• Sometimes, it may be useful to develop probability distributions, instead of relying on single point estimates.

Criteria Considered forForeign Financing

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Actual ResultsFrom Foreign Financing

• The fact that some firms utilize foreign financing suggests that they believe reduced financing costs can be achieved.

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Financing with Yens versus Dollars

-30

-20

-10

0

10

20

30

40

1990 1992 1994 1996 1998 2000 2002

0

0.2

0.4

0.6

0.8

1

1.2

1.4

Annualized interest rates (%) US$/100¥

U.S.

Effective rate

$/100¥

Japan

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Financing with a Portfolio of Currencies

• While foreign financing can result in significantly lower financing costs, the variance in the costs is higher.

• MNCs may be able to achieve lower financing costs without excessive risk by financing with a portfolio of currencies.

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Financing with a Portfolio of Currencies

• If the chosen currencies are not highly positively correlated, they will not be likely to experience a high level of appreciation simultaneously.

• Thus, the chances that the portfolio’s effective financing rate will exceed the domestic financing rate are reduced.

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• A firm that repeatedly finances in a currency portfolio will normally prefer to compose a financing package that exhibits a somewhat predictable effective financing rate on a periodic basis.

• When comparing different financing packages, the variance can be used to measure how volatile a portfolio’s effective financing rate is.

Financing with a Portfolio of Currencies

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For a two-currency portfolio,

E(rP) = wAE(rA) + wBE(rB)

where rP = the effective financing rate of the portfolio

rX = the effective financing rate of currency X

wX = the % of total funds financed from currency X

Financing with a Portfolio of Currencies

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Var(rP) = wA2A

2 + wB2B

2 + 2wAwBABCORRAB

X2 = the variance of

currency X’s effective financing rate

CORRAB = the correlation coefficient of the two currencies’ effective finance rates

Financing with a Portfolio of Currencies

For a two-currency portfolio,

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Impact of Short-Term Financing Decisionson an MNC’s Value

n

tt

m

jtjtj

k1=

1 , ,

1

ER ECF E

= Value

E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period tE (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period tk = weighted average cost of capital of the parent

Expenses Incurred from Short-Term Financing

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• Sources of Short-Term Financing¤ Euronotes¤ Euro-Commercial Paper¤ Eurobank Loans

• Internal Financing by MNCs

• Why MNCs Consider Foreign Financing¤ Foreign Financing to Offset Foreign

Receivables¤ Foreign Financing to Reduce Costs

Chapter Review

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Chapter Review

• 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

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Chapter Review

• Financing with a Portfolio of Currencies¤ Portfolio Diversification Effects¤ Repeated Financing with a Currency

Portfolio

• Impact of Short-Term Financing Decisions on an MNC’s Value