Finance-Short Term

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Chapter

20
Short-Term Financing

South-Western/Thomson Learning © 2006

Slides by Yee-Tien (Ted) Fu

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.





20 - 2

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 Eurobanks too.
20 - 3

Internal Financing by MNCs
• Before an MNC’s 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.

20 - 4

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 financing costs.

20 - 5

Short-Term Interest Rates
as of February 2004

20 - 6

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.

20 - 7

Determining the Effective Financing Rate
At time t 1. Borrows NZ$1,000,000 at 8.00% for 1 year Exchange rate = $0.50/NZ$ 2. Converts to $500,000 What is the effective financing rate? $648k – $500k = 29.6%! $500k 1 year later 3. Has to pay back NZ$1,080,000 Exchange rate = $0.60/NZ$ 4. Converts to $648,000 20 - 8

Determining the Effective Financing Rate
• The effective financing rate, rf , can be
written as:

rf = (1 + if )(1 + ef ) – 1
where if = the foreign currency interest rate ef = the %∆ in the foreign currency’s spot rate = St+1 – S

S

20 - 9

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.

20 - 10

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 that are similar to those for domestic financing.

20 - 11

Implications of IRP for Financing

20 - 12

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.

20 - 13

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. 20 - 14

Probability Distribution of Effective Financing Rate

20 - 15

Probability Distribution of Effective Financing Rate

20 - 16

Actual Results From Foreign Financing
• The fact that some firms utilize foreign
financing suggests that they believe reduced financing costs can be achieved.

20 - 17

Financing with Swiss Francs versus Dollars

20 - 18

Financing with a Portfolio of Currencies
• While foreign financing can result in
significantly lower financing costs, the variance in costs over time is higher.

• MNCs may be able to achieve lower
financing costs without...
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