chapter 15 financing and controlling multinational corporations

Chapter 15

Financing and Controlling Multinational Corporations

Chapter 15: Financing and Controlling Multinational Corporations 2

Chapter 15 Outline

A. Payment Terms in International Trade

B. Documents in International Trade

C. Financing Techniques in International Trade

D. Government Sources of Export Financing and Credit Insurance

E. Countertrade

F. Short-Term Financing


15.A Payment Terms in International Trade (1)

Five principal methods of payment in international trade (in order of increasing risk to the exporter)

1. Cash in advance

2. Letter of credit

3. Draft

4. Consignment

5. Open account

Generally, the greater the protection afforded the exporter, the less convenient the terms are for the importer.



Five principal means of payment in international trade, continued

1. Cash in advance – provides the exporter the greatest protection because

– Payment is received either before shipment or on arrival of the goods;

– Exporter’s funds are not tied up in receivables.

Used if importer’s country is politically unstable or importer’s credit is poor.

2. Letter of credit (L/C) – a letter addressed to the seller, written and signed by a bank acting on behalf of the buyer. Satisfies both the exporter and importer because

– The importer’s promise of payment is backed by a bank;

– The importer may not want to pay for the goods until after receipt and inspection.

The bank promises to honor drafts drawn on itself if the seller conforms to the conditions set forth in the L/C.




2. Letter of credit (L/C), continued

– Advantages to the exporter

– Eliminates credit risk if the issuing bank is of undoubted standing.

– Because countries generally permit local banks to honor L/Cs, reduces the danger of delayed or withheld payment due to exchange controls or other political acts.

– Reduces uncertainty because all requirements are stipulated in the L/C.

– Guards against preshipment cancellations.

– Facilitates financing by ensuring a ready buyer for the exporter’s product.





– Advantages to the importer

– The importer can require an inspection certificate and ascertain that the merchandise is shipping on or before the stipulated date by requiring an on-board bill of lading.

– Documents are carefully inspected by experienced clerks.

– An L/C is as good as cash in advance, enabling the importer to secure more advantageous credit terms and/or prices.

– Some exporters will sell only on an L/C.

– Because the L/C substitutes for cash in advance, cash is not tied up.

– If prepayment is required, the importer is better off depositing its funds with the bank than with the exporter because funds are easier to recover if the exporter fails to ship the goods.





– Mechanics of an L/C – example: USA importers purchases goods from Japan Exporters

2. Request L/C9. Send payment

USAImporters

JapanExporters

Wells FargoBank

Bank ofTokyo

1. Issue purchase order

3. Deliver L/C

4. Notify of L/C

5. Ship goods

6. Send draft and shipping docs

7. Send L/C, draft, shipping docs

8. Accept draft, remit funds

10. Forward shipping docs

11. Pay L/C at maturity





– Types of L/Cs

– Documentary – the seller must submit necessary invoices and other documentation with the draft

– Nondocumentary (“clean”) – L/C used for noncommercial transactions

– Revocable – L/C does not guarantee payment

– Irrevocable – payment cannot be revoked without permission of all parties

– Confirmed – issued by one bank and confirmed by another, obligating both banks to honor drafts drawn on the L/C.

– Unconfirmed – the obligation of the issuing bank only

– Transferable – the beneficiary has the right to instruct the paying bank to make the credit available to one or more secondary beneficiaries

– Assignment – assigns part or all of the proceeds to another party but does not transfer the required documents to the party.




3. Draft (bill of exchange) – an unconditional order in writing signed by the exporter ordering the importer or importer’s agent to pay on demand or at a fixed or determinable future date the amount specified.

– Key functions of a draft

– Provides written evidence of a financial obligation

– Enables both parties to potentially reduce their costs of financing

– Provides a negotiable and unconditional instrument

– Enables an exporter to employ its bank as a collection agent (the bank forwards the draft to the importer, collects the funds, and remits the proceeds to the exporter)

– Key parties to a draft

– Drawer – the party that signs and sends the draft to the second party

– Drawee – the party to whom the draft is addressed

– Payee – the party that receives the payment (often the same party as the drawer)




3. Draft, continued

– Mechanics of a draft – example: USA importers purchases goods from Japan Exporters

USAImporters

JapanExporters

Drawer

Wells FargoBank

Drawee*

Bank ofTokyoPayee

1. Signs and sends draft

2. Makes payment

3. Remits proceeds

4. Pays at maturity

*In this example, in which an L/C is used, the drawee is the confirming bank.




3. Draft, continued

– Types of drafts

– Sight draft – must be paid on presentation or else dishonored

– Time draft – payable at a specified future date

– Usance or tenor – the maturity of a time draft

– A time draft becomes an banker’s acceptance after being accepted by the drawee.

– Banker’s acceptance (B/A) – a draft accepted by a bank

– Trade acceptance – a draft drawn on and accepted by a commercial enterprise

– Clean draft – a draft unaccompanied by other papers, normally used for nontrade remittances

– Documentary draft – a draft accompanied by other papers and can be either a sight or time draft




4. Consignment

– Goods are shipped but not sold to the importer.

– Exporter (consignor) retains title to the goods until the importer (consignee) sells them to a third party.

5. Open account

– Goods are shipped and the importer is billed later.

– No specific payment dates are set.

– Fewer bank charges than with other methods of payment.




– Summary of payment methods

Payment Method Risk Chief Advantage to Exporter Chief Disadvantage(s) to Exporter

Cash in advance L No credit extension required Can limit sales potential

Draft

Sight draft M/L Retain control and title; payment before goods are delivered

Unaccepted goods remain at port of entry and no payment is due

Time draft M/H Lowers customer resistance by allowing extended payment

Same as sight draft, plus goods are delivered before payment is due

Letter of credit

Irrevocable

Revocable

M

M/H

Banks accept responsibility to pay; payment on presentation of papers; costs go to buyer

If revocable, terms can change during contract work

Consignment M/H Facilitates delivery; lowers customer resistance

Capital tied up until sale; credit check on distributor; political risk insurance in some countries; increased risk from currency controls

Open account H Simplified procedure; no customer resistance

High risk; seller must finance production; increased risk from currency controls


15.B Documents in International Trade (1)

Bill of lading (B/L)

– The most important shipping document

– Three primary functions

• Contract between the carrier and shipper (exporter)

• Shipper’s receipt for the goods

• Establishes control over the goods

– Types of B/Ls

• Straight – goods are consigned to a specific party, usually the importer, and is not negotiable.

• Order – goods are consigned to a specific party, usually the exporter.

• On-board – certifies that the goods have been placed on board the vessel.

• Received-for-shipment – acknowledges that the carrier has received the goods for shipment.

• Clean – indicates that the goods were received in good condition.

• Foul – a clean B/L becomes foul when shipment has been damaged.


15.B Documents in International Trade (2)

Commercial invoice

– Contains a detailed description of the goods shipped, names and addressees of exporter and importer, number of packages, distinguishing external marks, payment terms, other expenses, fees collectible from the importer, name of vessel, ports of departure and destination.

Insurance certificate

– All foreign shipments are insured.

– An open (floating) policy covers all shipments made by the exporter.

– Insurance certificate is evidence of insurance for a shipment under an open policy.

Consular invoice

– Presented to the local consul in exchange for a visa


15.C Financing Techniques in International Trade (1)

Banker’s acceptance (B/A)

– Time draft drawn on a bank

– By accepting the draft, the bank makes an unconditional promise to pay the holder of the draft a stated amount on a specified day and creates a B/A.

– The bank thus substitutes its own credit for that of the borrower.

– A B/A is a negotiable instrument.

– The accepting bank may either buy (discount) the B/A and hold it in its own portfolio or sell (rediscount) it in the money market.



Banker’s acceptance, continued

9. Make payment

USAImporters

JapanExporters

Wells FargoBank

Bank ofTokyo

1. Issue purchase order

2. Request L/C

3. Deliver L/C

4. Notify of L/C

5. Ship goods

6. Send draft and shipping docs

7. Send L/C, draft, shipping docs

8. Accept draft (B/A created and discounted) and remit funds

10. Forward shipping docs

13. Pay L/C at maturity

MoneyMarket

Investor

11. Rediscount B/A

12. Remit payment for B/A

14. Present B/A at maturity

15. Send payment



Banker’s acceptance, continued– The accepting bank receives a commission for accepting the draft and an

additional fee if an L/C is involved.

– Evaluating costs of B/A financing – Example: assume a 90-day, $1,000,000 B/A with a 2% annual commission fee and 9.8% 90-day discount rate

– To understand options, compute opportunity cost of holding B/A. Example: exporter’s opportunity cost of money is 10.2%:

• PV of holding B/A = $995,000 / [1 + (0.102/4) = $970,258

Face amount of B/A =Less 2% commission = $1,000,000 * (.02/4) =Amount received in 90 days =

$1,000,000 -$5,000

$995,000

Face amount of B/A =Less 2% commission = $1,000,000 * (.02/4) =Less 9.8% annual discount = $1,000,000 * (0.98/4) = Amount received now =

$1,000,000-$5,000

-$24,500$970,500

Option 1: Hold the B/A for 90 days

Option 2: Sell the B/A in the money market

Proceeds from sale of B/A > PV of holding B/A



Discounting

– Even if a draft is not accepted by a bank, the exporter can convert the draft into cash through discounting.

– Exporter places draft with a bank and receives the face value of the draft less interest and commissions.

– If draft is insured against political and commercial risks, the interest rate may be reduced.

– The insurer pays covered losses to exporter or any institution to which the exporter transfers the draft.

– Discounting with recourse – the bank can collect from the exporter if the importer fails to pay the bill when due.

– Discounting without recourse – the bank bears the risk of collection.

– Discounting is most useful for the occasional exporter and for the exporter with a geographically diverse portfolio of receivables.



Factoring

– An exporter sells its accounts receivable to a factor at a discount plus fees for nonrecourse financing.

– Because most factoring is nonrecourse (i.e., factor assumes all credit and political risks) factors may insist on purchasing all of an exporter’s receivables to avoid a selection bias (i.e., purchasing only receivables of risky customers).

– Evaluating the cost of factoring – Example: A factor buys an exporter’s receivables at a 2.5% per month discount and 1.75% fee for nonrecourse financing.

1. Compute the amount received by an exporter for factoring $1 million in 90-day receivables without recourse.

Face amount of receivable =Less 1.75% nonrecourse fee = $1,000,000 * .0175 =Less 2.5% monthly discount = $1,000,000 * (0.025*3) = Amount received now =

$1,000,000-$17,500

-$75,000$907,500



Factoring, continued

– Evaluating the cost of factoring – Example: A factor buys an exporter’s receivables at a 2.5% per month discount and 1.75% fee for nonrecourse financing, continued.

2. Compute annualized cost of factoring.

$17,500 + $75,000

$1,000,000 - $17,500 - $75,000

365

90* = 41.34%

• Despite the high costs, the cost of bearing credit risk associated with receivables can be substantially lower to a factor than to the exporter, because

– A factor’s greater credit information gives it more knowledge about the actual versus perceived risks involved and thus reduces its risk premium; and

– By holding a well-diversified portfolio of receivables, the factor can eliminate some of the risks associated with individual receivables.



Forfaiting

– Discounting at a fixed rate without recourse of medium-term export receivables denominated in fully convertible currencies (U.S. dollar, Swiss franc, euro).

– Generally used for capital-goods exports with a five-year maturity and repayment in semiannual installments.

– Fixed-rate discount ≈ 1.25% above local cost of funds.


15.D Government Sources of Export Financing and Credit Insurance (1)

Most governments of developed countries provide their domestic exporters with low-cost export financing and concessionary rates on political and economic risk insurance.

Export financing

– Programs extending supplier credits

• Supplier passes credit on to the importer.

• Supplier bears the credit risk.

– Programs extending buyer credits

• Buyer uses credits to pay the supplier.

• Buyer bears the credit risk.

– Export-Import Bank (Eximbank)

• U.S. government agency dedicated solely to financing and facilitating U.S. exports.

• Provides competitive, fixed-rate financing for U.S. export sales facing foreign competition backed with subsidized official financing.



Export financing, continued

– Export-Import Bank (Eximbank), continued

• Eximbank operations

– Eximbank covers up to 100% of the U.S. component content of exports, provided that the total amount financed does not exceed 85% of the total contract price of the item and the total U.S. content accounts for at least half of the contract price.

– Eximbank provides financing only when private capital is unavailable.

– Loans must have reasonable assurance of repayment and must be for projects that have a favorable impact on the country’s economic and social well being.

– Fees and premiums for guarantees and insurance are based on the risks covered.

– In authorizing loans, Eximbank takes into account any potential adverse effects on the U.S. economy or balance of payments.



Export financing, continued

– Private Export Funding Corporation (PEFCO)

• Purchases medium- to long-term debt obligations of importers of U.S. products at fixed rates.

• Finances loans through the sale of its own securities.

• Eximbank guarantees repayment of all PEFCO foreign obligations.

– Trends in public-source export financing

• Shift from supplier to buyer credits

• Growing emphasis on acting as catalysts to attract private capital

• Public agencies as a source of refinancing

• Attempts to limit competition among agencies



Export-credit insurance

– Provides protection against losses from political and commercial risks.

– Results in lowering the cost of borrowing from private institutions because the government agency is bearing those risks set forth in the insurance policy.

– Foreign Credit Insurance Association (FCIA)

• Administers the U.S. export-credit program

• Cooperative effort of Eximbank and a group of ~50 insurance companies.

• Short-term insurance available for export credits up to 180 days

– Comprehensive coverage covers 90% to 100% of political risks and 90% to 95% of commercial risks.

– Political-only coverage covers 90% to100% of political risks.

• Medium-term insurance covers big-ticket credits from 181 days to five years.

– Coverage is only for that portion of the value added that originated in the U.S.



Taking advantage of government-subsidized export financing

– Export financing strategy

• Foreign countries in which the MNC has plants are both markets AND potential sources of financing exports to Third-World countries.

• E.g., Massey-Ferguson wants to sell 7,200 tractors to Turkey but is unwilling to assume risk of currency inconvertibility. Solution:

– Massey manufactured the tractors at its Brazilian subsidiary and sold them to Brazil’s Interbras.

– Interbras paid Massey in cruzeiros and sold the tractors to Turkey.

– Banco do Brazil underwrote all political, commercial, and exchange risks for Interbras’ cruzeiro financing.

– Import financing strategy

• Many countries provide credit to foreign purchasers at below-market interest rates and long repayment periods.

• Loans are typically tied to procurement in the agency’s country.

• If an importer can source its needs from many countries, it will have leverage to extract more favorable financing terms from various export-credit agencies.


15.E Countertrade

Countertrade – a country requires exporters to purchase local products in order to sell their products in that market.

– Countertrade results in an MNC acquiring goods that a country cannot or will not sell in international markets.

– Goods may be unrelated to goods the MNC sells.

– An MNC must usually sell the goods acquired in countertrade at a discount and thus may sell its exports to the country with which it engages in countertrade at a premium to offset price reductions.

– Forms of countertrade

• Barter – a direct exchange of goods between two parties without the use of money. E.g., oil for guns.

• Counterpurchase (parallel barter) – the sale and purchase of goods that are unrelated to each other. E.g., soft drinks for vodka.

• Buyback – repayment of the original purchase price through the sale of a related product. E.g., provide materials for the construction of a gas pipeline in exchange for purchasing a certain amount of gas each year.


15.F Short-Term Financing (1)

Four aspects of developing a short-term foreign financing strategy

1. Identify key factors

2. Formulate and evaluate objectives

3. Describe available short-term borrowing options

4. Develop a methodology for calculating and comparing the effective dollar costs of options



1. Identify key factors – the basic determinants of any funding strategy are strongly influenced by six key factors.

i. If forward contracts are unavailable

– Determine whether differences in nominal interest rates among currencies are matched by anticipated exchange changes (i.e., whether IFE holds; see Chapter 4).

– If there is a deviation in IFE, expected dollar borrowing costs will vary by currency, leading to tradeoffs between the expected borrowing costs and the exchange risks associated with each financing option.

ii. Exchange risk

– Borrowing locally can provide an offsetting liability if currency exposure exists.

– Borrowing in a local currency in which an MNC has no exposure increases exchange risk.



1. Identify key factors, continued

iii. MNC’s degree of risk aversion

– The more risk averse, the higher the price an MNC should be willing to pay to reduce its currency exposure.

iv. If forward contracts are available

– Currency risk should not be a factor in the MNC’s borrowing strategy.

– Relative borrowing costs are the sole determinant of which currencies to borrow in.

– Determine whether the nominal interest differential equals the forward differential (i.e., whether IRP holds; see Chapter 4).

– If IRP holds, the currency denomination is irrelevant.

– Given the existence or threat of government capital controls, the forward discount or premium may not offset the difference between the interest rate on the local currency loan versus the dollar loan (i.e., IRP will not hold).



1. Identify key factors, continued

v. If IRP holds before taxes

– Currency denomination of MNC borrowings does matter when tax asymmetries exist.

– Tax asymmetries are based on the differential treatment of foreign exchanges gains and losses on forward contracts and loan repayments.

– Thus, MNCs must compute relative borrowing costs on an after-tax basis.

vi. Political risk

– Even if local financing is not the minimum cost option, MNCs should maximize local borrowings if they believe expropriation or exchange controls are serious possibilities.



2. Formulate and evaluate objectives – four possible objectives

i. Minimize expected cost and ignore risk – reduces information requirements, allows borrowing options to be evaluated without considering the correlation between loan cash flows and operating cash flows, and facilitates break-even analysis.

ii. Minimize risk without regard to cost – this objective is impractical and contrary to maximizing shareholder value.

iii. Trade off expected cost and systematic risk – allows the MNC to evaluate loans without considering the relationship between loan cash flows and operating cash flows. Probably little difference between expected borrowing costs adjusted for systematic risk and unadjusted borrowing costs, because the correlation between currency fluctuations and a well-diversified portfolio is likely to be small.

iv. Trade off expected cost and total risk – provides management with greater cash flow stability. Should be used only when forward contracts are unavailable.



3. Describe available short-term borrowing options – three principal short-term financing options

i. Intercompany loan – interest rate must fall within set limits. Relevant factors in establishing the interest rate include the lender’s opportunity cost of funds, tax rates and regulations, currency denomination of loan, and expected exchange movements over the term of the loan.

ii. Local currency loan

– MNCs prefer local currency financing for convenience and exposure management.

– Bank financing

– Term loans – straight loans, often unsecured, made for a fixed period

– Line of credit (LOC) – an MNC draws down funds when required.

– Overdrafts – LOC against which drafts can be drawn.

– Revolving credit agreement – similar to an LOC except the bank is legally committed to extend credit up to the stated maximum. The MNC pays interest on its outstanding balance, plus a fee on the unused portion of the credit line.

– Discounting

– Nonbank financing – commercial paper and factoring



3. Describe available short-term borrowing options, continued

ii. Local currency loan, continued

– Determining interest rates

Effective interest rate =Annual interest paid

Funds received

– Example 1 – effective rate = stated rate: an MNC borrows $10,000 for one year at 11%, with interest paid at maturity.

Effective interest rate =$1,100

$10,000= 11%

– Example 2 – effective rate ≠ stated rate: an MNC borrows MXP10,000 for one year at 70%, with interest paid in advance.

Effective interest rate =MXP7,000

MXP3,000= 233%




ii. Local currency loan, continued

– Compensating balance requirement – banks require borrowers to hold 10% to 20% of outstanding loan balances in a non-interest-bearing account.

Effective interest rate =Annual interest paid

Usable funds

– Example 1 – an MNC borrows $10,000 for one year at 11%, with interest paid at maturity. Compensating balance requirement = 15%.


$8,500= 12.9%

– Example 2 – an MNC borrows $10,000 for one year at 11%, with interest paid in advance. Compensating balance requirement = 15%.


$7,400= 14.9%




iii. Commercial paper (CP)

– Short-term promissory note generally sold by large corporations on a discount basis to institutional investors and other corporations.

– A favored alternative to bank borrowing.

– Average maturities vary from 20 to 25 days.

– By going directly to the market, MNCs can save as much as 1% in interest costs and avoid SEC registration requirements.

– Three major non-interest costs

– Backup LOCs – because CP maturities are very short, the issuer may not be able to pay off or roll over maturing paper. Backup LOCs provide insurance against this occurrence.

– Fees to banks – MNCs must pay fees to commercial and investment banks that act as issuing and paying agents.

– Rating service fees – credit ratings are not legally required by any country but are often necessary for placing CPs.



4. Develop a methodology for calculating and comparing the effective dollar costs of options

– Break-even analysis determines the effective dollar costs of a local currency loan or dollar loan.

– Example break-even analysis: an MNC can borrow pesos at 45% or dollars at 11%; peso expected to depreciate by 20%

• Analysis 1 – assume no taxes and forward contracts

– Cost of debt kd =

kd = rL(1 + c) + c

1. Compute cost of local currency loan

kd = 0.45(1 – 0.20) – 0.20 = 16%

2. Cost of dollar loan – the cost of a dollar loan to the affiliate is the interest rate on the dollar = 11%.



4. Develop a methodology for calculating and comparing the effective dollar costs of options, continued

– Example break-even analysis: an MNC can borrow pesos at 45% or dollars at 11%; peso expected to depreciate by 20%, continued

• Analysis 1 – assume no taxes and forward contracts, continued

3. Set local currency and dollar interest rates equal to determine break-even rate of currency depreciation (break-even c) at which the dollar cost of peso borrowing is equal to the cost of dollar financing.

kd = 0.45(1 + c) + c = 11%

• c = -23.45%

• Thus, the peso must devalue by 23.45% before it is less expensive to borrow pesos at 45% than dollars at 11%.

• If c is expected to be -20%, borrow dollars.




– Example break-even analysis : an MNC can borrow pesos at 45% or dollars at 11%; peso expected to depreciate by 20%, continued

• Analysis 2 – assume taxes

– Cost of debt kd =

kd = 0.45(1 + c) + c = 11%

1. Compute cost of local currency loan given a 40% affiliate tax rate

kd = 0.45(1 + c)(1 – 0.40) + c = 0.27 + 1.27c

2. Compute cost of dollar loan – when taxes are considered, the cost of a dollar loan to the affiliate is the after-tax interest less tax gain/loss cta.

kd = 0.11(1 – 0.40) – (-0.4c) = 6.6% + 0.4c




– Example analysis: an MNC can borrow pesos at 45% or dollars at 11%; peso expected to depreciate by 20%, continued

• Analysis 2 – assume taxes, continued

3. Set local currency and dollar interest rates equal to determine break-even rate of currency depreciation at which the dollar cost of peso borrowing is equal to the cost of dollar financing.

• c = -23.45%

• The break-even exchange rate is the same as in Analysis 1.

• Thus, although taxes affect the after-tax costs of the dollar and local currency loans, if one loan has a lower cost before tax, it will also be less costly on an after-tax basis.

0.066 + 0.4c = 0.27 + 1.27c




– Example analysis: an MNC can borrow pesos at 45% or dollars at 11%; peso expected to depreciate by 20%, continued

• Analysis 2 – assume taxes, continued

• Thus, in general, the break-even rate of currency appreciation or depreciation can be found by equating the dollar costs of local currency and dollar financing and solving for c:

rH(1 – ta) + cta = rL(1 + c)(1 – ta) + c

chapter 15 financing and controlling multinational corporations

Documents

international trade

international trade

international trade

letter of credit lc

shortterm financing

apayment terms

financing techniques

importers credit