financing short term
TRANSCRIPT
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Chapter Objectives
To explain why MNCs considerforeign financing;
To explain how MNCs determine whetherto 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 securitieswith typical maturities of 1, 3 or 6 months.
They are underwritten by commercialbanks.
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 MNCs parent or subsidiarysearches for outside funding, it should
determine if any internal funds areavailable.
Parents of MNCs may also raise funds by
increasing their markups on the suppliesthat they send to their subsidiaries.
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Why MNCs Consider
Foreign Financing
An MNC may finance in a foreign currencyto offset a net receivables position in that
foreign currency.
An MNC may also consider borrowingforeign currencies when the interest rates
on such currencies are attractive, so as toreduce the costs of financing.
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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.
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Effective financing rate, rf
=
{(1+if) v St+1} {1 v St}
=(1+if)
St+1
1{1 v St} Stwhere if = the interest rate on the loan
St = beginning spot rateSt+1 = ending spot rate
Determining the
Effective 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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Criteria Considered for
Foreign Financing
There are various criteria an MNC mustconsider 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)
IfIRP holds, foreign financing with asimultaneous hedge of that position in the
forward market will result in financing
costs similar to those for domestic
financing.
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The Forward Rate as a Forecast
If the forward rate is an unbiased predictorof 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 for
Foreign Financing
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Exchange Rate Forecasts
Firms may use exchange rate forecasts toforecast 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 for
Foreign Financing
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Financing with a
Portfolio of Currencies
While foreign financing can result insignificantly lower financing costs, the
variance in the costs is higher.
MNCs may be able to achieve lowerfinancing 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 highlypositively correlated, they will not be likely
to experience a high level of appreciationsimultaneously.
Thus, the chances that the portfolios
effective financing rate will exceed thedomestic financing rate are reduced.
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A firm that repeatedly finances in acurrency portfolio will normally prefer to
compose a financing package thatexhibits a somewhat predictable effective
financing rate on a periodic basis.
When comparing different financingpackages, the variance can be used tomeasure how volatile a portfolios
effective financing rate is.
Financing with a
Portfolio of Currencies
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For a two-currency portfolio,
E(rP
) =wA
E(rA
) + wB
E(rB
)
where rP = the effective financing rate of theportfolio
rX = the effective financing rate of
currency XwX = the % of total funds financed from
currency X
Financing with a
Portfolio of Currencies
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V
ar(rP) =wA2
WA2
+ wB2
WB2
+ 2wAwBWAWBCORR
AB
WX2 = the variance of currency Xseffective 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 MNCs Value
? A
!
n
tt
j
tjtj
k1=
1
,,
1
ERECFE
=V l
E (CFj,t) = expected cash flows in currencyjto be received
by the U.S. parent at the end of period t
E (ERj,t) = expected exchange rate at which currencyjcan
be converted to dollars at the end of period t
k = weighted average cost of capital of the parent
Expenses Incurred fromShort-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
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Chapter Review
Financing with a Portfolio of Currencies Portfolio Diversification Effects
Repeated Financing with a CurrencyPortfolio
Impact of Short-Term Financing Decisions
on an MNCsV
alue