Griffin & Pustay: Ch.18: International Financial Management.

OPENING CASE: KLM'S WORLDWIDE FINANCIAL MANAGEMENT

KLM is the national Dutch airline and 15^th largest airline in the world flying to more than 150 cities on six continents. Because the Netherlands is so small and its cities so close together, almost all of its revenues are earned outside Holland. About 30% of its sales come from Holland-EU travel, 1/4 Holland-US and 1/4 Holland-Asia travel. US carriers hold 34% of the Dutch market. KLM has a strategic alliance with Northwest, using coordinated flight scheduling to attract US-EU passengers. Because of its international business focus, KLM deals in over 180 currencies on a regular basis.

• Where do all these currencies come from and go to?
• Give examples of the various international financial issues facing KLM: financing international trade (method of payment), foreign exchange risk (three types of risk exposure), working capital (multinational netting, transactions and precautionary balances), capital budgeting (NPV, IRR), and sources of investment capital (internal and external sources)?

1. MANAGING FOREIGN EXCHANGE RISK

Three types of foreign exchange (FOREX) risk facing international firms are:

* transaction exposure: Exchange rate movements affect the financial benefits and costs of an international transaction after the firm is legally obligated to complete the transaction.

* translation exposure: The impact on the firm's consolidated financial statements of exchange rate changes that affect the value of the foreign subsidiaries measured in the parent's currency. Also called accounting exposure.

* economic exposure: The impact of unanticipated exchange rate changes on the value of a firm's operations.

1.1. Transaction Exposure

Transaction exposure: Exchange rate movements affect the financial benefits and costs of an international transaction after the firm is legally obligated to complete the transaction.

Example: In April 1996, Saks Fifth Avenue (the importer) agrees to buy 5 million Swiss francs's worth of Rolex watches from Rolex (the exporter), payable in October 1996. Either Saks or Rolex must bear the FOREX risk; both are subject to transaction exposure.

There are at least three possible solutions to transaction exposure:

* go naked: Saks could ignore the transaction exposure. Means importer assumes the foreign exchange risk.

* buy forward: Saks could hedge its transaction risk by buying Swiss francs in the forward market. This locks in the Swiss franc price it must pay for the watches. Saks would benefit from any appreciation of the dollar-franc rate but would lose if the dollar-franc rate falls. Must pay fees to bank.

* buy currency options: Saks could also hedge its risk by purchasing an options contract, giving Saks the opportunity but not the obligation to buy francs at a given price in the future. Saks can exercise the option or let it expire. Provides a guarantee that the importer will pay no more than the price stated on the options contract. Saks would exercise the option if the US dollar falls, but let it expire if the US dollar rises. Similar to "Heads I win, tails I don't lose". Options normally cost 3-5.5 percent of the transaction's value. Benefits: eliminates transaction exposure, allows potential for capital gain if home currency rises in value. Cost: must buy option.

* acquire an offsetting asset: Saks could neutralize its transaction exposure by acquiring an offsetting assets of the same size in Swiss francs (e.g. buy a certificate of deposit in Switzerland in francs so has asset to match its liability). Its net transaction exposure is the difference between its assets and liabilities denominated in each foreign currency. The amount at risk is the net transaction exposure.

1.2. Translation Exposure

Translation exposure: the impact on the firm's consolidated financial statements of exchange rate changes that affect the value of the foreign subsidiaries measured in the parent's currency. Also called accounting exposure.

For accounting and tax purposes, the MNE must consolidate the financial statements of all its foreign affiliates with the parent's statements. Problem: each set of statements in a different local currency. Questions:

• Which currency should be used for a benchmark?
• How should currencies be translated into this currency?

Which is more serious: transaction or translation exposure? Transaction exposure can produce true/real cash losses. Translation exposure can produce accounting/paper losses. So transaction exposure is more serious.

1.3. Economic Exposure

Economic exposure: the impact of unanticipated exchange rate changes on the value of a firm's operations.

Example: Yen-dollar rise over late 1980s meant production in Japan became very costly relative to production in US. Affected Japanese sales in US. Raised costs of imported parts by Japanese firms in US. Response of Japanese MNEs:

• price to market in short run (bear FOREX costs)
• short run: focus on cost cutting in Japan
• long run: shift production out of Japan to US, SE Asia, Europe and Mexico (diversify production)
• long run: buy more local parts in US or from SE Asia
• try to anticipate exchange rate changes

Class Example:

In your Major Project due at the end of the semester, can you find examples of firms facing each of these three different kinds of exposure to foreign exchange risks? How did firms respond to these three forms of FOREX exposure?

• For example, in the Euro project, how has introduction of the euro affected FOREX exposure for firms inside the Euro-11 zone (e.g. France) versus for firms outside the zone (e.g. the UK)? How has the drop in the euro since its introduction in 1/1/99 created any forms of FOREX exposure?
• The Asian currency crisis is perhaps the best example (at least since the collapse of the peso in December 1994) of firms being faced with FOREX exposure. Can you give examples of each type of exposure and how firms responded to it?
• Similarly, in the case of Russia, the ruble has collapsed relative to other currencies. How have firms, both Russian and foreign firms dealing with Russia, handled the various types of FOREX exposure?

2. MANAGEMENT OF WORKING CAPITAL

Firms must manage their working capital (cash) balances. Cash includes actual cash, checking account balances and highly liquid marketable securities that carry low yields.

Working balances are held for two reasons:

• transactions balances: to facilitate day-to-day transactions
• precautionary balances: to cover the firm against unexpected demands for cash.

• The MNE must consider working capital position of each affiliate as well as for MNE as a whole.
• The MNE's financial officers must balance three corporate financial goals:

• minimize working capital balances
• minimize currency conversion costs
• minimize foreign exchange risks

Need cash on hand for day-to-day transactions, but earn very little return on working balances, so want to minimize cash balances.

Could use a centralized cash depository (CCD) - an affiliate that coordinates the MNE's worldwide cash flows and pools its cash reserves - a CCD is normally located in an international financial center (New York, London, Tokyo).

How a centralized cash depository works: Each affiliate sends reports and projections to the depository, holds excess cash there, and borrows if necessary. Depository plans short run investment & borrowing strategies for MNE. Benefits: Reduces MNE's overall needs for working balances & for financial staff in each subsidiary. Increases financial expertise & allows long run strategic planning in one location.

2.2. Minimizing Currency Conversion Costs

Heavy intrafirm transactions among affiliates of an MNE means enormous currency conversion costs as banks charge to convert funds. One solution is to use netting operations (bilateral, multilateral) to minimize amount of necessary fund transfers.

Netting operations compare amount of gross trade (exports + imports) among the subsidiaries with the amount of net trade (exports - imports). Instead of performing foreign exchange transactions on the total amount of gross trade, the MNE can save transactions costs by determining the amount of net trade and then only doing currency conversions on the net trade flows.

Example: If the gross amount of trade is $15 million and transactions costs are 1/10 of one percent of total currency conversions, the transactions cost is $15 million x .001 = $.015 million or $15,000. If the net amount of trade is $5 million, the transactions cost falls to $5 million x .001 = $ .005 million = $5,000.

Case Example: Multinational Netting in Action  (based on Samsung case in Griffin & Pustay pp.678-9)

Sony has three affiliates in Korea, Mexico and the UK. Because of the extensive intrafirm trade flows among the affiliates, all three affiliates regularly receive payment and make payments to the other affiliates. If each time currency has to be converted into either the exporter's or the importer's home currency (or even a third currency - Sony is a Japanese MNE so it could require all payments be made in yen, for example, or in US dollars), the total currency conversion costs could be astronomical. However, by using multinational netting (making the currency conversion only on the NET amount of trades) these costs can be substantially reduced.

The table below shows the receipts and payments, all in US dollars (to make comparisons easier) of each SONY subsidiary. Note that the Korean subsidiary is earning a surplus of $1 million; the Mexican affiliate has a deficit of $1 million and the UK subsidiary has a net balance of zero. Therefore, if the Mexican affiliate pays the Korean affiliate $1 million, all three affiliates have received the correct amount. The gross amount of trade is $21 million; the net amount is $1 million. Be sure you can explain this.
 
 

	South Korea	Mexico	UK	Total
Receipts	$4m + $5m = $9m	$2m + $3m = $5m	$1m + $6m = $7m	$21m
Payments	$2m + $6m = $8m	$5m + $1m = $6m	$3m + $4m = $7m	$21m
Balance	surplus = $1m	deficit = $1m	balance = 0	0

Assuming the transactions cost is ½ of one percent of the total transaction, what is the total saving from using multinational netting?
Answer: The transactions cost on the gross amount of trades is .005 x $21 million = $.105 million or $105,000. The transactions cost on the net amount of trades is .005 x $1 million = $.005 million or $5,000. Thus the saving from multinational netting is $105,000 - $5,000 = $100,000.
 

2.3. Minimizing Foreign Exchange Risks

The MNE has a basket of foreign currencies in its working capital balances. The MNE wants to minimize its foreign exchange risk (i.e. risk that some will depreciate over time), but needs to keep sufficient balances on hand for transactions and precautionary reasons.

The firm can do this by leading and lagging its transactions in foreign currencies:

* lead (speed up) payments in currencies expected to appreciate; lag (slow down) payments if expected to depreciate

* lead receipt collection in currencies expected to depreciate; lag receipt collection if expected to appreciate

Going Global (text, page 677): Colefax and Fowler's Case Flow Solution

This case provides answers to two parts of this question: How can small businesses that export their products to a variety of countries (1) save on their currency conversion costs (2) reduce their working capital balances and (3) minimize their foreign exchange risks? Explain which parts and how. Why is the third so difficult to achieve for a small business?

Case example: Can you find examples in your Major Project, where fluctuations in exchange rates caused firms to manage working capital by :

• minimizing working capital balances through a centralized cash depository?
• minimizing currency conversion costs through multinational netting?
• minimize FOREX risks through leading and lagging?

3. INTERNATIONAL CAPITAL BUDGETING

Capital budgeting is used to develop, screen and select investment projects. Three common methods for evaluating investment projects are: net present value (NPV), internal rate of return (IRR) and payback period.

3.1. Net Present Value

NPV = stream of expected revenues net of expected costs, discounted back to the present.

NPV = SUM [ ( R(t) - C(t) ) / ( 1 + i ) ^t  ]      from t=0 to t=n

where the time period of the whole investment is t years where t goes from 0 to n, R(t) is the total revenue received in year t. C(t) is the total cost in year t, and i is the discount rate used by the firm to discount future revenues and costs back to present dollars. The general rule is to go ahead with the project if the NPV is positive.

How is NPV different for international business and its FDI decisions than for domestic investment decisions?

• risk adjustment (foreign projects may be riskier)
• choice of currency (home? host?)
• should project be valued in terms of benefit to MNE or to the individual project? Should ignore overhead costs (e.g. mgmt fees) in assessing benefit/cost to MNE.

The IRR method is as follows:

Step 1: Calculate NPV =   SUM   [  ( R(t) - C(t) ) / ( 1 + r ) ^t  ]    from t=0 to t=n

where r is the internal rate of return to the investment.

Step 2: Set NPV = 0 and solve for the Internal Rate of Return (r) that makes NPV = zero.

Step 3: Compare IRR to the hurdle rate (the minimum rate of return MNE finds acceptable for capital investments).

Step 4: Accept projects where IRR exceeds hurdle rate.

3.3. Payback Period

The payback period is the number of years it will take the firm to recover, or pay back, the original cash investment from the project's earnings. If the firm has a cutoff rate in terms of years, then any projects with a payback period less than the cutoff date, should be approved. Problems: ignores earnings profile after payback date. Benefits: simplicity, "quick and dirty" screening method.
 

4. SOURCES OF INTERNATIONAL INVESTMENT CAPITAL

Where does the MNE secure its financial resources to fund the projects it has approved? Can use internal or external sources.

The goals of the firm are to:

• minimize worldwide cost of capital
• minimize foreign exchange risk
• minimize political risk
• minimize the firm's global tax burden

Internal sources are cash flows generated inside the firm (e.g. retained earnings, dividend receipts, royalty receipts, licensing fees). The MNE has an advantage over domestic firm: Can pool cash flows of parent and all subsidiaries, and use pooled funds to finance projects throughout the MNE group. Economies of scale. Also, internal funds are normally seen as cheaper to the firm than using external funds.

Other methods of shifting funds between MNE affiliates:

• intracorporate loans and advances
• manipulation of transfer prices for intrafirm transfers of goods (finished, materials, parts) See lecture on transfer pricing for more details.
• over/under invoicing of fees (management, licensing, royalties)

Governments have rules to prevent such shifting (where the shifting reduces tax revenues): the firm must set its transfer price at arm's length (i.e. the price two unrelated parties in the same circumstances would choose).

4.2. External Sources

MNE can borrow from a variety of external sources and in a large number of countries. Greater variety than available to domestic firm. Can also develop own innovative financial techniques to take advantage of different countries and currencies. One innovative financial technique is the swap market:

* financial swaps: two firms can exchange their financial obligations. Used to change cost and/or nature of firm's interest obligations. Allows firms to manage their interest costs.

* currency swaps: change currency in which debt is denominated. Allows firms to manage their exposure to exchange rate fluctuations.

International banks often act as intermediaries in swap transactions. World swap market totals $4.3 trillion.

Note: Most FDI projects are financed using local sources (internal funds, external borrowing), not by capital inflows from the parent firm.

BUILDING GLOBAL SKILLS: BELGIAN LACE PRODUCTS (based on Griffin & Pustay, pp. 688-89)

Belgian Lace Products (BLP) is a table linens manufacturer. The firm consists of a parent corporation, a wholly owned manufacturing subsidiary in Belgium, and two wholly owned distributors in Belgium and Germany. Its manufacturing subsidiary buys inputs from various arm's length suppliers, manufactures lace tablecloths, and sells them to the BLP distributors. The distributors in turn sell the products to local retail customers. The distributors buy inputs (labor, warehouse space, electricity) from outside suppliers in addition to their purchases from the BLP manufacturing affiliate.

Assume the exchange rates are BF 20 = DM 1, BF 30  = $1.00 and BF1 = 3 yen.

Costs and revenues for the affiliates are as follows:

Belgian Manufacturing Subsidiary (Bel-Man)

• Sales to Belgian distributor BF 600,000
• Sales to German distributor BF 500,000
• Sales to Japanese distributor BF 700,000
• Sales to US distributor BF 450,000
• Inputs purchased from Belgian suppliers BF 300,000
• Inputs purchased from German suppliers DM 50,000
• Inputs from Japanese suppliers 3,000,000 yen
• Inputs purchased from US suppliers $5,000

• Sales to retail customers BF 2,000,000
• Inputs purchased from BLP manufacturing subsidiary (Bel-Man) BF 600,000
• Inputs purchased from Belgian arm's length suppliers BF 30,000
• Inputs purchased from German arm's length suppliers DM 20,000

• Sales to retail customers DM 150,000
• Inputs purchased from BLP manufacturing subsidiary (Bel-Man) BF 500,000
• Inputs purchased from German arm's length suppliers DM 10,000
• Inputs purchased from Belgian arm's length suppliers BF 40,000
• Inputs purchased from US arm's length suppliers $9,000

• Sales to retail customers 5,000,000 yen
• Inputs purchased from BLP manufacturing subsidiary (Bel-Man) BF 700,000
• Inputs purchased from Japanese arm's length suppliers 3,000,000 yen
• Inputs purchased from US arm's length suppliers $8,000

• Sales to retail customers $40,000
• Inputs purchased from BLP manufacturing subsidiary (Bel-Man) BF 450,000
• Inputs purchased from US arm's length suppliers $10,000
• Inputs purchased from Japanese arm's length suppliers 300,000 yen

[1] Calculate the profits of each of BLP's affiliates in terms of Belgian Francs. What are the consolidated profits of BLP? [10 points]

[2]. Would you recommend closing any of BLP's affiliates? Why or why not? [5 points]

[3]. Suppose it costs each affiliate one percent of the transaction amount each time the affiliate converts its local currency into another currency in order to pay its suppliers. How could this amount be reduced? [5 points] NOTE: You do NOT need to perform the calculations; just suggest the method.

[4]. Assume this is April 1999. How would the introduction of the euro have affected BLP's international financial policies and costs?

CLOSING CASE: JANASSEN PHARMACEUTICA CURES ITS CURRENCY ILLS

This case study deals with innovation in the management of financial operations. In 1983, Belgium government passed law authorizing MNEs to set up coordination centers in Belgium. To qualify: firms had to have affiliates in at least 4 countries, sales of at least $300 million and employ at least 10 people in the coordination center. Benefits: Belgium corporate income tax rate close to zero.

Janassen (a Belgium division of J&J) set up one in 1984 as a wholly owned subsidiary of Janassen. The initial goals of the CC were:

• identify short and medium term financial risks on a worldwide basis
• quantify these risks and recommend how Janssen should handle them
• manage and control these financial exposures on a worldwide basis (J&J encourages hedging but discourages speculation)

• centralized cash depository
• performs currency netting operations for Janssen group (lowering cash balances & reducing foreign currency conversion costs).
• Provides accounting statements for each subsidiary: Each month sends a single check/invoice in local currency that reflects subsidiary's net position.
• performs all currency and interest rate exposure management & hedging activities of Janssen group (managed FOREX risk in Belgium francs, then shifted to dollars when took over all J&J financial services).
• taken over bank management function by setting up checking accounts in each country where Janssen does business. Increases prediction of timing of expenses and receipts; reduces currency conversion costs.
• acts as internal bank for Janssen group - seeks highest short run interest rates on excess cash balances, locates lowest cost source of external loans, offers 24 hour turnaround time on loan approvals, watches for tax implications of lending/borrowing activities.

© by Lorraine Eden (April 1999). Do not reproduce without permission of author.