Chapter 8

Short-Term Financing

Objectives
This chapter explains short-term liability management of MNCs, a part of multinational management that is often neglected in other textbooks. From this chapter, we should learn that correct financing decisions can reduce the firms costs and maximize the value of the MNC. While foreign financing costs cannot usually be perfectly forecasted, firms should evaluate the probability of reducing costs through foreign financing. The specific objectives are:

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.

Pre-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. What is the risk of borrowing a low interest rate currency? 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? Explain.
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2. 3.

Internal Financing by MNCs

Before an MNCs 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.

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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Why MNCs Consider Foreign 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.

Determining the Effective 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. Example: how to compute the effective financing rate

How to compute the effective financing rate (Example)

Dearborn, Inc. (based in Michigan), obtains a one-year loan of $1,000,000 in New Zealand dollars (NZ$) at the quoted interest rate of 8 percent. When Dearborn receives the loan, it converts the NZ$ to US$ to pay a supplier for materials. The exchange rate at that time is $.50, so the NZ$1,000,000 is converted to $500,000 (1,000,000 * $.50). One year later, Dearborn pays back the loan of NZ$1,000,000 plus interest of NZ$80,000 (8%*NZ$1,000,000). Thus, the total amount in New Zealand dollars needed by Dearborn is NZ$1,080,000 (1,000,000+80,000). Assume the New Zealand dollar appreciates from $.50 to $.60 by the time the loan is to be repaid. Dearborn will need to convert $648,000
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How to compute the effective financing rate (Example)

(1,080,000*$.60) to have the necessary number of New Zealand dollars for loan repayment. To compute the effective financing rate, first determine the amount in U.S. dollars beyond the amount borrowed that was paid back. Then divide by the number of U.S. dollars borrowed (after converting the New Zealand dollars to U.S. dollars). Given that Dearborn borrowed the equivalent of $500,000 and paid back $648,000 for the loan, the effective financing rate in this case is $148,000 / $500,000 = 29.6%.

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Determining the Effective Financing Rate

Effective financing rate rf = (1+if)[1+(St+1-S)/S]-1 where if = the interest rate on the loan
S = beginning spot rate St+1 = ending spot rate

The effective rate can be rewritten as

r f = ( 1 + if ) ( 1 + e f ) 1 where ef = the % D in the spot rate
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Criteria Considered for Foreign 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 for Foreign 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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Criteria Considered for Foreign Financing

The Forward Rate as a Forecast If the forward rate is an accurate estimate of the future spot rate, the foreign financing rate will be similar to the home financing rate. 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. Summary of the implications of a variety of scenarios relating to interest rate parity and forward rate.
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Implications of IRP for Financing

IRP holds? Scenario Type of financing Financing costs

Yes Yes
Yes

Forward rate accurately predicts future spot rate Forward rate overestimates future spot rate

Covered Uncovered
Uncovered

Similar Similar
Lower

Yes
No

Forward rate underestimates future spot rate

Forward premium(discount) exceeds (is less than) interest rate differential

Uncovered
Covered

Higher
Higher

No

Forward premium (discount) is less than (exceeds) interest rate differential

Covered

Lower

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Criteria Considered for Foreign Financing

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. Example: Sarasota, Inc. needs funds for one year and is aware that the one-year interest rate of U.S. dollar is 12 percent while the interest rate from borrowing Swiss francs is 8 percent. Sarasota forecasts that the Swiss Franc will appreciate from its current rate of $.45 to $.459, or by 2 percent over the next year. The expected value for ef will therefore be 2 percent. Thus, the expected effective
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Criteria Considered for Foreign Financing

financing rate will be E (rf) = (1+ if) [1+E(ef)] 1 = (1+.08)(1+.02) 1 = .1016(10.16%) Thus, financing is Swiss francs is expected to be less expensive than financing in U.S. dollars, though still with uncertainty. To determine what value of ef would make the effective rate from foreign financing the same as domestic financing, we could use the effective financing rate formula and solve for ef:
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Criteria Considered for Foreign Financing

ef = (1+ rf)/ (1+if) 1 In this example, rf is 12 percent and if is 8
percent, so ef = (1+.12)/ (1+.08) 1 = .037037 (3.7037%) This suggests that the Swiss frank would have to appreciate by about 3.7 percent over the loan period to make the Swiss franc loan as costly as a loan in U.S. dollar.
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Criteria Considered for Foreign Financing

Sometimes, it may be useful to develop probability distributions, instead of relying on single point estimates. The firm can compare this distribution to the known financing rate of the home currency to make its financing decision. ( Example:P449)
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Actual Results From 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 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. (Example: P450-453)

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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 portfolios effective financing rate will exceed the domestic financing rate are reduced.

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Financing with a Portfolio of Currencies

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 portfolios effective financing rate is.

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Financing with a Portfolio of Currencies

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
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Financing with a Portfolio of Currencies

For a two-currency portfolio,
Var(rP) = wA2A2 + wB2B2 + 2wAwBABCORRAB

X2 CORRAB

= the variance of

currency Xs

effective financing rate = the correlation coefficient of the two currencies effective finance rates
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Questions and Applications

1. Explain why an MNC parent would consider financing from its subsidiaries. 2. Explain how a firms degree of risk aversion enters into its decision of whether to finance in a foreign currency or a local currency. What motivates the firm to even consider financing in a foreign currency?
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Questions and Applications

3. Discuss the use of specifying a break-even point when financing in a foreign currency. 4. 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 oneyear 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.
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Questions and Applications

5. Akron Co. needs dollars. Assume that the local oneyear loan rate is 15 percent, while a one-year loan rate on euros is 7 percent. By how much must the euro appreciate to cause the loan in euros to be more costly than a U.S. dollar loan? 6. 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 yens degree of fluctuation against the dollar:
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Questions and Applications

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 Missoulas perspective?

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Questions and Applications

7. 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:
Possible Percentage change in the Spot Rate Over the Currency Loan Life Canadian dollar 4% Canadian dollar 7% Japanese yen 6% Japanese yen 9% Probability of That Percentage Change in the Spot Spot Rate Occurring 70% 30% 50% 50%

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Questions and Applications

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.
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