2009 mcgraw-hill ryerson limited 1 of 27 21 international financial management prepared by: michel...
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©2009 McGraw-Hill Ryerson Limited 3 of 27 Learning Objectives 1.Identify reasons for a foreign investment decision (later analyze). (LO1) 2.Identify the effects of exchange and political risk on the foreign investment decision. (LO2) 3.Discuss the effects of exchange rates on the firm’s profitability and cash flow. (LO3)TRANSCRIPT
©2009 McGraw-Hill Ryerson Limited1 of 27
21International Financial Management
Prepared by:
Michel PaquetSAIT Polytechnic
©2009 McGraw-Hill Ryerson Limited
©2009 McGraw-Hill Ryerson Limited2 of 27
Chapter 21 - Outline• Canadian Involvement in International Trade
and Capital Investment• Reasons for a Foreign Investment Decision• Risk Considerations in the Foreign
Investment Decision• Exchange Rates• Foreign Exchange Risk Hedging Techniques• Financing International Operations• Summary and Conclusions
©2009 McGraw-Hill Ryerson Limited3 of 27
Learning Objectives
1. Identify reasons for a foreign investment decision (later analyze). (LO1)
2. Identify the effects of exchange and political risk on the foreign investment decision. (LO2)
3. Discuss the effects of exchange rates on the firm’s profitability and cash flow. (LO3)
©2009 McGraw-Hill Ryerson Limited4 of 27
Learning Objectives4. Outline the factors influencing the exchange rates.
(LO4)5. Define spot and forward exchange rates and
compute forward premiums and discounts. (LO5)6. Evaluate techniques to hedge or reduce foreign
exchange risk. (LO6)7. Describe the purposes and nature of the
multinational operations of the corporation. (LO7)8. Outline potential ways to finance international
operations. (LO8)
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Figure 21-1World’s leading merchandise exporters, 2006
LO1
Source: www.wto.org. Top ten: 53% of world total of $14 trillion.
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Figure 21-2World’s leading merchandise importers, 2006
LO1
Source: www.wto.org. Top ten: 56% of world total of $14 trillion.
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Figure 21-3Canada’s 2007 merchandise exports and imports by region
LO1
Note: Exports $463 billion, imports $415 billion, GDP $1,497 billion.Source: Bank of Canada, “Banking and Financial Statistics”, August 2008, series J3.
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Figure 21-4Canada’s international balance of payments, current account, 2007
LO2
Source: Bank of Canada, “Banking and Financial Statistics”, August 2008, series J1.
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Figure 21-5Canada’s international investment position, 2007
LO2
Source: Statistics Canada, Catalogue No. 67-202, Table 1.
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Figure 21-6Canada’s investment abroad by region, 2007 (assets)
LO2
Source: Statistics Canada, Catalogue No. 67-202, Tables 3-10. (“Other” includes loans and deposits.)
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Figure 21-7Foreign investment in Canada by region, 2007 (liabilities)
LO2
Source: Statistics Canada, Catalogue No. 67-202, Tables 2-6. (“Other” includes loans and deposits.)
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Reasons for a Capital Investment Decision
• Higher potential returns- Lower production costs due to:
• resource availability and ease of exploitation • significantly lower wages
- Better revenues due to: • Larger and more concentrated markets
- Lower corporate income tax rates- Delayed Canadian taxes on income• Strategic advantages• Broader diversification possibilities
LO2
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Multinational Corporations (MNCs)
• Firm doing business in more than one country• Often 30% or more of a firm’s business
activities are carried out outside its national borders
• 4 basic forms of multinational corporations:1. Exporter2. Licensing Agreement3. Joint Venture4. Fully Owned Foreign Subsidiary
LO3
©2009 McGraw-Hill Ryerson Limited14 of 27 Number of stocks
20
40
60
80
100
10 20 30 40 50
International stocks
Canadian stocks
Risk (percent)
Figure 21-8Risk reduction from international diversification
11.7
LO3
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Risk Considerations in a Foreign Investment Decision
Political Risk:1. an unfriendly foreign government
blocks profit repatriation expropriate the foreign subsidiary’s assets
2. political risk assessment before making final decision3. strategies to guard against political risk
set up a joint venture with a local entrepreneur enter into a joint venture with firms from other countries obtain insurance in advance
Foreign Exchange Risk volatile foreign currency values lead to fluctuating value of an
international transaction or investment
LO3
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Exchange Rates• The exchange rate is the price of one currency in terms
of another• Published daily in the business press• Rates are determined by the supply of and demand for
each currency• Factors Influencing Exchange Rates:
– Relative Inflation Rates– Relative Interest Rates– Balance of Payments– Government Policies– Confidence in the Future Performance of the Economy
LO4
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Table 21-1Selected currencies and exchange rates (number of foreign currency units you can purchase with one Canadian dollar)
LO4
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Spot Rates and Forward Rates
Spot Rate:– the exchange rate between currencies for immediate delivery– “on-the-spot” rate
Forward Rate: – the exchange rate that is established for delivery at a specified
date in the future
12( )( )
Forward spotForwardpremium discountspot contractlength months
LO5
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Managing Foreign Exchange Risk Foreign Exchange Risk refers to the possible
change in value of foreign exchange rates.Types of Foreign Exchange Risk:
1. Economic Exposure: the market value of foreign currency-denominated assets and
liabilities is subject to change 2. Accounting or Translation Exposure
the amount of loss or gain resulting from the accounting treatment of foreign investments
3. Transaction Exposure the foreign exchange gains or losses resulting from realized
international transactions
LO6
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Foreign Exchange Risk Hedging Techniques
• Forward Exchange Market Hedge• Money Market Hedge• Currency Futures Market Hedge• Options Market Hedge
LO6
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The Multinational Corporation
• Exporter – produce locally and export to foreign markets
• Licensing Agreement – exporting firms grant a license to local producers to use the firms’ technology in return for a royalty or licensing fee.
• Joint Venture – establish a business partnership with a local foreign manufacturer
• Fully Owned Foreign Subsidiary – firms set up their own foreign operations
LO7
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Financing International Operations
There are several specialized financing arrangements for foreign transactions:– Letter of credit– Export Development Corporation– Loans from the Parent Company or a Sister Affiliate– Eurocurrency Loans– Eurobond Issues– International Stock Issues
– The International Finance Corporation (IFC)
LO8
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Canadian parent firm Dutch parent firm
Dutch firm’s affiliate Canadian firm’s affiliate
In Canada In the Netherlands$
loan
Gui
l der
l oan
Indirect loanIndirect loan
Figure 21-10A parallel loan arrangement
LO8
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Figure 21-11A fronting loan arrangement
Dutch affiliateAmsterdam bank
Canadian parent company
Deposits funds in
Lends funds to
LO8
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Table 21A-1Cash flow analysis of a foreign investment
Projected Cash Flows (millions ringitts unless otherwise stated)
Year 1 Year 2 Year3 Year 4 Year 5 Year 6
Revenues -Operating expenses
45.00 28.00
50.00 30.00
55.00 30.00
60.00 32.00
65.00 35.00
70.00 35.00
-Amortization 10.00 10.00 10.00 10.00 10.00 10.00 Earnings before Salaysian taxes 7.00 10.00 15.00 18.00 20.00 25.00 -Salaysian income tax (25%) 1.75 2.50 3.75 4.50 5.00 6.25 Earnings after foreign income taxes 5.25 7.50 11.25 13.50 15.00 18.75
= Dividends repatriated 5.25 7.50 11.25 13.50 15.00 18.75 Gross Canadian taxes (46% of foreign earnings before taxes)
3.22
4.60
6.90
8.28
9.20
11.50
-Foreign tax credit Net Canadian taxes payable
1.75 1.47
2.50 2.10
3.75 3.15
4.50 3.78
5.00 4.20
6.25 5.25
Aftertax dividend received by Q Systems 3.78 5.40 8.10 9.72 10.80 13.50 Exchange rate (ringitts / $) Aftertax dividend
2.00 1.89
2.04 2.65
2.08 3.89
2.12 4.58
2.16 5.00
2.21 6.11
PV of dividends ($) (at 20%) 1.58 + 1.84 + 2.25 + 2.21 + 2.01 + 2.05 = $11.94
APP-21A
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Summary and Conclusions• Canadian economy is highly open to the rest of world
through trade and capital investment.• International trade and investment are carried out by
multinational corporations (MNCs).• Lower production costs overseas, tax deferral
provisions, strategic advantages and benefits of international diversification are motives for MNCs to do business on a global scale.
• Together with higher returns from foreign investment come political risk and foreign exchange risk.
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Summary and Conclusions
• The rate at which one currency unit is converted into another is called the exchange rate.
• Volatile exchange rates result in economic exposure, accounting exposure and transaction exposure.
• Some hedging techniques are available for MNCs to reduce foreign exchange risk.
• Alternative sources available for MNCs to finance their international operations.