Financial Management (Fin-man) De La Salle Lipa

Module 6
INTERNATIONAL CORPORATE FINANCE

Multinational Corporations

Corporations that engage in some form of international business are called multinational corporations
or international corporations. The main goal of these corporations is to maximize shareholder wealth.
Managers are expected to make decisions that will maximize the stock price.

Why Firms Pursue International Business

International business is justified by three key theories.

1. Theory of competitive advantage. Each country that specializes in the production of goods can
produce with relative efficiency and rely on other countries to meet other needs.

2. Imperfect markets theory. Factors of production are somewhat immobile. Firms can capitalize on
imperfect markets by exploiting foreign opportunities.

3. Product cycle theory. After firms are established in their home countries, they commonly expand
their product specialization in foreign countries.

How Firms Engage in International Business

The most common methods by which firms conduct international business are as follows:

1. International trade is a relatively conservative approach that can be used by firms to penetrate
markets (by exporting) or to obtain supplies at a low cost (by importing). This is minimal risk in
international trade as there is no capital at risk. The internet facilitates international trade by allowing
firms to advertise their products and accept orders on their websites.

1
Financial Management (Fin-man) De La Salle Lipa

2. Licensing obligates a firm to provide its technology in exchange for fees or some other specified
benefits. It allows firms to use their technology in foreign markets without a major investment and
without transportation costs that result from exporting. A major disadvantage, however, is that it is
difficult to ensure quality control in foreign production process.

3. Franchising obligates a firm to provide a specialized sales or service strategy, support assistance,
and possibly an initial investment in the franchise in exchange for periodic fees. It allows penetration
into foreign markets without a major investment in foreign countries.

4. A joint venture is a venture that is jointly owned and operated by two or more firms. A firm may enter
the foreign market by engaging in a joint venture with firms that reside in those markets. It allows two
firms to apply their respective cooperative advantages in a given project.

5. Acquisitions of existing operations. Acquisitions of firms in foreign countries allow firms to have
full control over their foreign businesses and to quickly obtain a large portion of foreign market share.
It is subject to the risk of large losses because of larger investment. Likewise, liquidation may be
difficult if the foreign subsidiary performs poorly.

6. Establishing new foreign subsidiaries. Firms can penetrate markets by establishing new
operations in foreign countries. It requires a large investment. Acquiring new companies as opposed
to buying existing allows operations to be tailored exactly to the firm’s needs.

Any method of increasing international business that requires a direct investment in foreign operations
normally is referred to as a foreign direct investment. It includes franchising, joint ventures,
acquisitions, and foreign subsidiaries.

Foreign Exchange Market

Foreign exchange market allows for the exchange of one currency for another. An exchange rate
specifies the rate at which one currency can be exchanged for another. If a US dollar can be exchanged
for 50.74 Philippine pesos, it can be written as USD1 = PHP50.74 or $1.00 = P50.74 or PHP50.74 per
USD or ₱50.74/$.

Some of the most traded currencies in the world are US dollar (USD or $), Euro (EUR or €), Japanese
yen (JPY or ¥), Pound sterling (GBP or £), Australian dollar (AUD or A$), Canadian dollar (CAD or
CAD$), Swiss franc (CHF or SFr), Chinese renminbi (CNY or RMB or ¥), Swedish krona (SEK or kr), and
New Zealand dollar (NZD or NZ$).

A direct exchange rate (or direct quotation) quotes the price of one unit of foreign currency in terms of
the home currency. For example, an exchange rate of 50.74 between the US dollar and Philippine peso
would be interpreted as USD1.00 is worth PHP50.74.

In contrast to the direct quote, an indirect exchange rate (or indirect quotation) states the price of one
unit of home currency in terms of the foreign currency. Using the previous example, since USD1.00 is
equal to PHP50.74, then PHP1.00 is equal to USD1/50.74 or USD0.02.

Cross exchange rate (or cross rate) is the amount of one foreign currency per unit of another foreign
currency. For example, if USD1.00 is equal to PHP50.74 and EUR1.00 is equal to PHP55.88, then
EUR1.00 is equal to USD55.88/50.74 or USD1.10. Alternatively, USD1.00 is equal to EUR50.74/55.88 or
EUR0.91.

2
Financial Management (Fin-man) De La Salle Lipa

The bid price is the rate at which a foreign-exchange dealer is willing to buy the currency. The offer (or
ask) price is the rate at which a foreign-exchange dealer is willing to sell the currency. For example,
suppose the bid price of one unit of US Dollar is PHP50.70, and the ask price is PHP50.78, a dealer buy
a dollar for PHP50.70 and sell it for PHP50.78. The difference between bid price and the offer price,
covering dealers’ costs and profit, is called the spread.

Interpreting Changes in Exchange Rates

Currency appreciation is the increase in the value of one currency in terms of another currency. For
example, if there is a change in the exchange rate from ₱50.74/$ to ₱50.70/$, then the Philippine peso
has appreciated against the US dollar because it takes less peso to exchange for a dollar. If the value of
a nation’s currency rises, its imports and foreign goods become cheaper while its exports and domestic
goods become more expensive. On the other hand, currency depreciation is a decrease in the value of
one currency relative to another. If one country’s currency is appreciating, another country’s currency is
depreciating.

Types of Foreign Currency Transactions

There are two basic types of trades in the foreign exchange market: spot trades and forward trades.

A spot trade is an agreement to exchange currency “on the spot,” which actually means that the
transaction will be completed or settled within two business days. The exchange rate on a spot trade is
called the spot exchange rate.

A forward trade is an agreement to exchange currency at some time in the future. The exchange rate
that will be used is agreed upon today and is called the forward exchange rate. A forward trade will
normally be settled sometime in the next 12 months.

For example, the spot exchange rate for the US dollar is PHP50.74. The one-year forward exchange rate
is PHP51.53. This means you can buy a US dollar today for PHP50.74, or you can agree to take delivery
of a US dollar in one year and pay PHP51.53 at that time.

Notice that the US dollar is more expensive in the forward market than the sport market (PHP51.53
versus PHP50.74). Because the US dollar is more expensive in the future than it is today, it is said to be
selling at a premium relative to the Philippine peso. For the same reason, the Philippine peso is said to
be selling at a discount relative to the US dollar.

Currency Derivative

A currency derivative is a contract whose price is derived from the value of an underlying currency. The
types of currency derivatives are:

1. Forward contracts are an agreements that specifies the currencies to be exchanged, the exchange
rate, and the date at which the transaction will occur. Forward contracts do not trade on a centralized
exchange and are therefore regarded as over-the-counter (OTC) instruments.

2. Futures contracts are similar to forward contracts but sold on an exchange. It specifies a standard
volume of a particular currency to be exchanged on a specific settlement date.

3
Financial Management (Fin-man) De La Salle Lipa

3. Currency Options Contracts

a. A currency call option grants the right to buy a specific currency at a designated price (known
as the exercise price or strike price) within a specific period of time.
b. A currency put option grants the right to sell a currency at a specified strike price or exercise
price within a specified period of time.

Other Instruments in International Markets

Eurocurrencies are domestic currencies of one country on deposit outside the country of issue. For
example, US dollars deposited in the Manila are called Eurodollars, British pounds deposited in New
York are called Eurosterling, and Japanese yen deposited in London are called Euroyen.

Foreign bonds are issued by borrower foreign to the country where the bond is placed and are
denominated in the currency of that country. Eurobonds are bonds sold in countries other than the
country of the currency denominating the bond. Global bonds are bonds sold inside as well as outside
the country in whose currency they are denominated.

END