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Chapter

20
Short-Term Financing

South-Western/Thomson Learning 2003

Chapter 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.

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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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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.

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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.

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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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Determining the Effective Financing Rate


Effective financing rate, rf {(1+if ) v St+1} {1 v St} St+1 1 = = (1+if ) {1 v St} St where if = the interest rate on the loan St = beginning spot rate St+1 = ending spot 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 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 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.

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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.

Sometimes, it may be useful to develop


probability distributions, instead of relying on single point estimates.
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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.

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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) = wA2WA2 + wB2WB2 + 2wAwBWAWBCORRAB WX2 CORRAB = the variance of currency Xs effective financing rate = the correlation coefficient of the two currencies effective finance rates

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Impact of Short-Term Financing Decisions on an MNCs Value


Expenses Incurred from Short-Term Financing

V l

ER CF E j , t E j , t n !1 j = t 1  k t =1

E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent
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Chapter Review
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


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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 Currency Portfolio

Impact of Short-Term Financing Decisions


on an MNCs Value

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