12

Financing of Global Operations

INTRODUCTION

Financial management for global operations is an indispensable yet complex aspect of international business because managers must learn to deal with different financial environments, markets and systems. Financial management of TNCs’ global operations occurs in an environment characterized by volatile foreign exchange rates, a variety of restrictions on capital flows, various levels of country risk, different tax systems and a wide spectrum of institutional settings. Increasing globalization of financial markets, the rise of global e-commerce and increasing pressure for acting locally while thinking globally have fundamental implications for TNC corporate finance. In this environment, the management's ability to seize opportunities and avoid unnecessary risk depends on its knowledge of the international environment and its financial management skills.

Basic financial management is concerned with two major issues: the sources and the uses of funds. At the international level, exchange risk management must be added to the study of financial management. In this context, the chapter deals with the following major issues:

• Investment decisions for a TNC
• Financing global operations
• Sources of international trade finance
• Financing sources for a global business firm
• Managing foreign exchange risk and exposure
• Working capital management

MULTINATIONAL FINANCIAL MANAGEMENT

Financial management has two traditional functions: the acquisition of funds and the investment of funds. Acquisition of funds, also known as the financing decision, is the process of generating funds from internal and external sources at the lowest possible cost. The investment decision is concerned with the allocation of these funds in order to maximize shareholder value.

Capital Budgeting

The process of quantifying the costs, benefits and risks of investment options is called capital budgeting. Capital budgeting for a foreign project is basically the same as for a domestic project. The firm estimates the cash flow from the project, applies an appropriate discount rate of return (DRR) to determine the project's net present value (NPV) and proceeds with the project if the net present value of the discounted cash flow (DCF) is greater than zero.

 

Some important considerations in multinational financial management are:

• The choice between raising funds in the global capital market versus the domestic capital market.
• The decision regarding the source of funds—debt versus equity.
• This in turn is determined by the cost of capital, which refers to the price paid by a firm for the use of funds in business activities.
• Recognizing the link between the source of finance (which are fundamentally private or institutional investors) and cash flow to the parent company.
• Host countries may require, or at least prefer, TNCs to use local debt financing or local sales of equity.
• The discount rate must reflect the cost of capital, so the higher the cost of capital to a TNC, the higher the discount rate.
• Depreciation of the local currency has no effect on local interest payments and retirement of local debt, but if foreign debt obligations exist, this will effectively raise the cost of capital.

Generally it is the parent company that provides the initial cash for the foreign project, but the cash generated by the investment flows to the project and not to the parent. This can adversely affect the NPV of the parent company if there are restrictions on repatriation of profits or dividends because of host country tax or reinvestment policies. Capital budgeting of foreign investment opportunities must keep in mind the interests of investors who are concerned with dividends received, not with cash generated by the project.

Financial executives in TNCs face diverse issues which their domestic counterparts do not have to deal with. These include exchange rate and inflation risks, international differences in tax rates, multiple money markets, currency controls and political risks such as sudden or creeping expropriation. International financial management decisions are affected by political and economic risks unique to the world of international business. Changing political situations such as the collapse of the Soviet Bloc create opportunities for financial management. Similarly, changes in inflation rates and currency exchange rates are economic events that have a similar bearing on a firm's financial operations. The ability of the TNC to move people, money and material on a global basis enables it to benefit from the synergistic effects of the whole being greater than the sum of its parts. It helps the TNC to have access to segmented capital markets and lower its overall cost of capital, shift profits to lower its taxes, and take advantage of international diversification of markets and production sites to reduce the risk of its earnings.

In recent years, three concepts have emerged as having particular importance in international corporate finance. These are the concepts of arbitrage, market efficiency and capital asset pricing.

Arbitrage

Arbitrage refers to the purchase of assets or commodities in one market for immediate resale in another to benefit from the difference in price. In recent years, there has been increasing usage of the term “tax arbitrage”, which refers to the process of the profits arising out of activities in different tax jurisdictions and tax rates. Similarly, “risk arbitrage” or speculation is the process of taking advantage of risk-adjusted returns on different securities. The concept of arbitrage is of significance in international finance as relationships between domestic and international financial markets, exchange rates, inflation rates and interest rates depend on this process. The process of arbitrage in turn ensures market efficiency.

Market Efficiency

An efficient market is one in which all available information is reflected in the prices of traded securities. This results in markets having predictive power based on information collected from around the world. However, markets are prone to making mistakes and exhibiting herd behaviour, or indulging in optimistic lending, leading to crises. Increasing global interconnectedness has increased the propensity of the transmission of the contagious effects of crises and the dangers in the world of international finance.

Capital Asset Pricing

The valuation of securities according to the risks and return inherent in them is known as the capital asset pricing model. Research during the last three decades has indicated that the risk in any financial decision is on account of two factors: systematic or undiversifiable risk, which is inherent in systemic variables of which the security is a part, and cannot be reduced or eliminated. Unsystematic risk, on the other hand, arises due to factors that are outside the realm of the security's system and can therefore be reduced through diversification. These explanations of risk are embodied in the capital asset pricing model (CAPM) and the arbitrage price theory (APT), and are the foundation of financial decision-making for the TNC.

 

Global Business Finance

Compared to financing for foreign trade activities, financing for the TNCs’ global productions, investments and operations involves more choices, and is more complex. It involves making a choice between the global capital market versus the domestic capital market, and about the firm's financial structure. Broadly, the sources of financing for global investments and operations include intercompany financing, equity financing, debt financing, and local currency financing.

Intercompany Financing

Intercompany financing from the parent company or sister subsidiaries is a common means of financing for overseas subsidiaries or affiliates. This could be finance from the parent company in the form of equity, loans or trade credit; inter-subsidiary trade credit; and through retained earnings of the subsidiary. Affiliates often prefer loans from the parent company compared to equity financing for the following reasons:

• Intercompany loan re-payments are easier to make compared to dividends.
• Interest on loans helps to reduce the tax burden. A subsidiary borrowing these loans will pay lower local corporate income tax after deducting interest expenses from the total taxable incomes.
• Inter-subsidiary loans as well as loans from a parent to a subsidiary are eliminated in the process of consolidation of accounts without any cash changing hands.
• Short-term intercompany loans may be used to stabilize the subsidiary's working capital structure, and long-term intercompany loans may be used to reduce its dependence on external banks.

Equity Financing

Financing through equity markets can be realized in the TNC's home country, a foreign affiliate's host country, and/or a third country. The TNC's equity financing can take the form of either crosslisting shares abroad or selling new shares to foreign investors.

Crosslisting of shares on foreign stock exchanges have the following advantages:

• It helps to improve the liquidity of existing shares by making it easier for foreign shareholders to trade in their home markets and currencies.
• It helps to improve the share price, especially if the home market is segmented or illiquid.
• It leads to greater global acceptance of the firm.
• It results in the creation of a secondary market for shares that can be used to compensate local management and employees in foreign affiliates.

Crosslisting is frequently accompanied by depositary receipts. In the United States, foreign shares are usually traded through American depositary receipts (or ADRs). These are negotiable certificates issued by a US bank in the United States to represent the underlying shares of stock that are held in trust at a foreign custodian bank. ADRs are sold, registered and transferred in the United States in the same manner as any share of stock. Because ADRs can be exchanged for the underlying foreign shares or vice versa, arbitrage keeps foreign and US prices of any given share the same. To crosslist stocks abroad, a TNC must make a full disclosure of operating results and balance sheets. Today, the major ADR markets where a TNC may decide to crosslist are London, New York (NYSE), Tokyo, Frankfurt and Paris.

Debt Financing

In Chapter 11, we looked at international capital markets, which are in fact the major source of a TNC's debt financing. Debt financing for global operations can be made through international bank loans, the Euronote market, and the international bond market. International bank loans are often sourced in the Eurocurrency markets, that is, in countries not using the denomination currency (for example, a Japanese firm obtaining yen loans from banks in the United States and Europe). As such, international bank loans are often called Eurocredits. Because of the large size of these loans, they are usually dispersed through a syndicate in order to diversify their risk. The basic borrowing interest rate for Eurocurrency loans has been tied to the London Interbank Offered Rate (LIBOR), which is the deposit rate applicable to interbank loans within London.

The Euronote market is the collective term used to describe short-to-medium-term debt instruments sourced in the Eurocurrency markets. The Euronote is generally a less expensive source of short-term funds than syndicate loans, because the notes are placed directly with the investor public. Euronotes can be underwritten or non-underwritten. In an underwritten Euronote, there are normally one to three lead banks that organize a group of participating banks to take shares of the total commitment. The lead and participating banks stand ready to buy the borrower's notes in the event the notes could not be placed in the market at previously guaranteed rates. The non-underwritten Euronotes include Euro-Commercial Paper (ECP) and Euro-Medium-Term Notes (EMTNs). ECP is a short-term debt obligation of a corporation or bank. Maturity is typically one, three and six months, while EMTNs’ typical maturity ranges from as short as nine months to a maximum of ten years.

The international bond market consists of Eurobonds and foreign bonds. A Eurobond is underwritten by an international syndicate of banks and other securities firms, and is sold exclusively in countries other than the country in whose currency the issue is denominated (for example, a bond issued by a Japanese firm residing in Tokyo, denominated in Japanese yen but sold to investors in Europe and the United States). Most Eurobonds use the straight fixed rate with a fixed coupon, set maturity date, and full principal repayment upon final maturity. Recently, convertible Eurobonds have emerged. These bonds resemble the straight fixed rate issue in practically all price and payment characteristics, with the added feature that they are convertible to stock prior to maturity at a specified price per share.

Financial Structure of the TNC

Financial structure refers to the proportion of debt and equity in the capital structure of a business firm. It has been observed that the financial structure of the business firm varies across nations. For instance, Japanese firms use more debt as compared to their Indian counterparts. A possible reason for this is the tax effect of the two sources of capital. As interest on debt is tax-deductible, it determines the profit of the firm available for distribution. This often becomes a dilemma for the TNC regarding whether to adopt local financial structure norms or continue to use those of the parent firm. The advantage of using local norms is that it enables firms to easily compare its returns with domestic firms in the same industry. It also creates the impression of the TNC conforming to local practice, which is favourable for policymakers.

INTERNATIONAL TRADE PAYMENT AND FINANCE

There are two major issues in the process of the financing of international trade: the methods of payment used and the sources of finance for the exporter.

International Trade Payment

The widely used payment methods in international trade include (1) cash in advance, (2) letter of credit (L/C), (3) documentary collection, and (4) open account terms. The risk of bad debts for the exporter increases along this sequence.

Cash in Advance

Cash in advance refers to payment that is received either before shipment or upon arrival of the goods. It is a desired mode of payment when the credit standing of the buyer is not known or is uncertain, or if he belongs to a country that has political or economic instability. It is also used where the production needs a huge initial capital investment specifically for the product under contract. However, buyers are usually reluctant to accept payment through this mode because it blocks a large amount of their working capital till sale of goods takes place. The method is popular only where there is an order for custom made goods.

 

Letter of Credit (L/C)

The letter of credit is the most commonly used payment method in international trade. It is a letter addressed to the seller, written and signed by a bank acting on behalf of the buyer in which the bank promises to honour drafts drawn on itself if the seller meets the specific conditions that are given in the letter of credit. These conditions are usually the same as those specified in an export contract or sales agreement. Through an L/C, the bank substitutes its own commitment to pay for that of its customer (the importer).

 

An L/C has the following implications for an exporter:

• It eliminates credit risk arising out of non-payment and reduces the risk of delayed payment due to exchange controls or other political reasons.
• It reduces uncertainty for the exporter as all requirements for payment are clearly given in the L/C itself.
• It helps to stabilize production for the exporter who has the assurance of payment even if the contract is cancelled for some reason.
• It is a safe and assured source of export financing if the L/C is irrevocable and confirmed.

An L/C has the following implications for an importer:

• The L/C issuance often requires an importer to pre-deposit or have a saving account in the issuing bank, which implies that they have to forgo interest earnings in another investment.
• The importer is assured of the goods having actually been loaded on the ship and of their quality and quantity being in accordance with regulations.
• Any discrepancies in documentation are the responsibility of the bank, especially in the case of commercial L/Cs, for which banks deal in documents and not in goods.
• The L/C increases the importer's bargaining power, and allows the importer to ask for a price reduction from the exporter.

There are several types of L/Cs:

• Documentary L/Cs: They are issued in connection with commercial transactions. For this, the exporter must submit, together with the draft, any necessary invoices and other documents such as the custom invoice, certificate of commodity inspection, packing list and certificate of country of origin.
• Clean L/Cs: They are those which do not require any documents. A clean L/C may be used for overseas bank guarantees, escrow arrangements, and security purchases.
• Revocable L/Cs: They are a means of arranging payment that can be revoked without notice at any time up to the moment a draft is presented to the issuing bank. It does not carry any guarantee with it.
• Irrevocable L/Cs: They cannot be revoked without the specific permission of all parties concerned, including the exporter. Most credits between unrelated parties are irrevocable.
• Confirmed L/Cs: They are issued by one bank and confirmed by another, making it obligatory for both banks to honour any drafts drawn in compliance.
• Unconfirmed L/Cs: They are the obligation of only the issuing bank. Naturally, an exporter will prefer an irrevocable letter of credit by the importer's bank with confirmation by another (domestic or foreign) bank.
• Transferable L/Cs: They are those under which the beneficiary has the right to instruct the paying bank to make the credit available to one or more secondary beneficiaries. No L/C is transferable unless specifically authorized in the letter of credit; moreover, it can be transferred only once. The stipulated documents are transferred along with the L/C. In effect, the exporter is the intermediary in a transferable credit, and usually has the credit transferred to one or more of its own suppliers. When the credit is transferred, the exporter is actually using the creditworthiness of the opening bank, thus avoiding having to borrow or use its own funds to buy the goods from its own suppliers.
• Back-to-back L/Cs: They are where the exporter, as beneficiary of the first L/C, offers their credit as security in order to finance the opening of a second credit in favour of the exporter's own supplier of the goods needed for shipment under the first or original credit from the advising bank. The bank that issues a back-to-back L/C not only assumes the exporter's risk but also the risk of the bank issuing the primary L/C. If the exporter is unable to produce documents or the documents contain discrepancies, the bank issuing the back-to-back L/C may be unable to obtain payment under the credit because the importer is not obligated to accept discrepant documents of the ultimate supplier under the back-to-back L/C. Thus, many banks are reluctant to issue this type of L/C.
• Revolving L/Cs: They exist where the tenor (maturity) or amount of the L/C is automatically renewed pursuant to its terms and conditions. An L/C with a revolving maturity may be either cumulative or non-cumulative. When cumulative, any amount not utilized during a given period may be applied or added to the subsequent period. If non-cumulative, any unused amount is simply no longer available. If a revolving L/C is used, it must be explicitly stipulated in the export contract.

Documentary Collection

The documentary collection is a payment mechanism under which the exporters retain ownership of the goods until payment is received or there is certainty that it will be received. In this method of payment, the bank, acting as the exporter's agent, regulates the timing and sequence of the exchange of goods for value by holding the title documents until the importer either pays the draft, termed documents against payment (D/P), or accepts the obligation to do so, termed documents against acceptance (D/A). The two principal documents used in the process of documentary collections are a draft and a bill of lading (B/L).

 

The draft is written by the drawer (exporter) to the drawee (importer) and requires payment of a fixed amount at a specific date to the payee (usually the exporter himself). A draft is a negotiable instrument that normally requires physical presentation as a condition for payment. A draft may be either a sight draft (payable upon presentation) or a time draft (payable on a specified future date).

A bill of lading is a document of title of the goods being shipped along with the documents for shipment and the carrier's receipt for the goods being shipped. A sight draft is commonly used for D/P payment. Nevertheless, for export sales that take several months in ocean transportation, exporters and importers may agree to use D/P at 30, 60, 90 or 180 days.

 

In practice, D/A are usually accompanied with a time draft ranging from 30 days up to perhaps two years, which is why time draft-based collections are also viewed as an important commercial or corporate financing approach that is granted by the exporter to the importer. The flip side of this method is the high risk of receivable collection for the exporter. D/A is a riskier collection method than D/P because the importer can claim the title of goods under the “promise” of payment rather than actual payment. For this reason, most bad debts accumulated in international trade have been transactions that used D/A as terms of payment.

Open Account

Under this method of payment, goods to be sold are first shipped and the importer is billed for them later. The method can be used only if the customer is reliable, as there is no guarantee of payment from the buyer and all risk is borne by the seller. Very often exporters who prefer less risky modes of payment lose business to competitors. Large global firms such as Mercedes Benz prefer to use the open account method as against the more expensive letters of credit. However, open account sales have greatly expanded because of the major increase in international trade, more accurate credit information about importers, and the greater familiarity with exporting in general.

International Trade Finance

External sources of export financing include both private sources and governmental sources. These sources offer different types of financing for exporters.

Private Sources

In the case of private sources, the institutions that provide trade financing include commercial banks, export finance companies, factoring houses, forfeit houses, international leasing companies, in-house finance companies and private insurance companies.

Bank finance   Banks as a source of trade credit play an important role in the world of global finance in several different ways. Commercial bank financing for foreign trade business includes bank guarantees, bank line of credit and buyer credit.

 

• A bank guarantee is a financial instrument that guarantees a specified sum of payment to either the exporter or importer. Apart from regular bank guarantees, there are three other types of guarantees used in international trade. These include (1) the loan guarantee, in which a loan is granted conditional on security provided by the borrower; (2) a distraint guarantee, which helps a debtor to recover his seized assets; and (3) a bill of lading guarantee, which ensures that the carrier will hand over the goods to the consignee when individual bills of lading are lost.
• A bank line of credit is a sum of money allocated to an exporter by a bank to finance its export business. This could also be meant to finance a specific export transaction from the foreign customer's side, and allows the exporter to extend competitive credit terms to foreign customers.
• Buyer credit refers to credit extended by one or more financial institutions in the exporter's country. This form of finance is mostly used to finance capital equipment purchases, but other goods with payment terms of up to one year can also be financed by buyer credits. Buyer credits are normally arranged under an export credit insurance programme.

Export factoring   Export factoring is particularly suited for small and medium-sized exporters as it enables them to be more competitive by selling on open account rather than using more costly methods such as letters of credit. It involves the sale of export accounts receivable to a third party that assumes the credit risk. This technique proceeds through factoring houses that not only provide financing but also perform credit investigations, guarantee commercial and political risks, assume collection responsibilities, and finance accounts receivable. In addition, these houses can perform such services as letters of credit, term loans, marketing assistance, and all other necessary services a small-to-medium-sized exporter cannot afford to handle. Often, a factoring house's service charges are quoted on a commission basis. Commissions can range anywhere between 1 and 3 per cent of total transaction value. While factoring is a well-known export financing technique in the United States, forfaiting has been widely used for export financing in Europe.

 

Forfaiting   This term is derived from the French term a forfeit, and means a transaction in which an exporter transfers responsibility of commercial and political risks for the collection of a trade-related debt to a forfaiter (often a financial institution), and in turn receives immediate cash after the deduction of its interest charge (the discount). The purchase of obligations arising out of the sale of goods and services where payment is due beyond the 90 to 180 days is covered in a factoring agreement. Therefore, forfaiting is purchasing an account receivable where the credit term exceeds the permissible limit for factoring.

 

The forfait market has two segments—a primary and secondary market. The primary market consists of banks and forfait houses that buy properly executed and documented debt obligations directly from exporters. The secondary market consists of trading these forfait debt obligations among themselves.

In general, a forfait financing transaction involves at least four parties to the transaction: an exporter, the forfaiter, the importer and the importer's guarantor. The financial instruments in forfaiting are usually time drafts or bills of exchange and promissory notes. Forfaiting is used to finance the export of capital equipment where transactions are usually medium term (that is, three to eight years) at fixed rate financing. The discount used by the forfaiter is based on its cost of funds plus a premium, which can range anywhere from 0.5 to 5 per cent, depending on the country of importation and level of risks involved.

Banker's acceptance   The banker's acceptance (BA) is a time draft drawn on and accepted by one bank on another one. It is a method of interbank financing in which one branch is the financer and the other is the investor. The bank first creates the BA by accepting a draft presented by its customer (that is, the drawer), which it then discounts (it pays the drawer a sum less than the face value of the draft), and resells the BA to an investor in the acceptance market. A banker's acceptance is a time draft (30, 60, 90 to 180 days after sight or date) drawn on and accepted by a bank. The fee charged by the accepting bank varies depending on the maturity of the draft as well as the creditworthiness of the borrower. BA is mainly used for export trade in raw materials, components and general commodity financing. A deep, secondary market for banker's acceptances combined with the lack of reserve requirements often enables the bank to obtain funding for eligible transactions at a cost significantly lower than alternative sources.

 

Corporate guarantee   A corporate guarantee is a method of finance where one company undertakes to pay the principal debts of another corporate house. The method is used when creditors ask the corporate or parent company to guarantee an obligation of one or more of its overseas subsidiaries or offshore affiliates that the creditor may consider not creditworthy for the export-related financing or credit limit.

 

Governmental Sources

Government sources include export–import bank financing and foreign credit insurance.

Export–import bank financing   Many countries have put in place export–import financing programmes to provide finance for exports, imports and overseas investments. The loans are low-cost for a medium-to-long-term period arranged in collaboration with larger commercial banks throughout the world. Their purpose is to encourage the export of capital goods and services, overseas investment, and major resource development. For example, South Korea's Exim Bank offers such services as direct lending to both suppliers and buyers, re-lending facilities to foreign financial institutions, and the issuance of guarantees and export insurance.

In the United States, the primary function of its Exim Bank is to give US exporters the necessary financial backing to compete in other countries. Today, this is done through a variety of different export financing and guarantee programmes (for example, direct loans, discount loans, guarantees and export credit insurance) to meet specific needs. All are designed to be in direct support of US exports, whether the eventual recipient of the loans or guarantees are foreign or domestic firms. Generally, export–import banks do not compete with private sources of export financing. Their main purpose is to step in where private credit is not available in sufficiently large amounts at low rates or long terms to allow home country exporters to compete in a foreign market.

Foreign credit insurance   Many industrialized and developing countries have set up foreign credit insurance or guarantee programmes to assist their exporting companies. These programmes are usually run by and dependent on the government. In the Unites States, such insurance programmes are offered by both Exim Bank and the Foreign Credit Insurance Association. In Canada, these services are provided by Export Credits Insurance Corporation (ECIC). In Asia, Japan's International Trade Bureau (Export Insurance Section), Hong Kong's Export Credit Insurance Corporation, India's Export Credit & Guarantee Corporation Ltd, and Taiwan's Central Trust of China all offer such programmes. In Latin America, similar programmes can be found, including in Compania Argentina de Seguros de Credito a la Exportacion in Argentina and Instituto de Resseguros do Brasil in Brazil. Europe has an even longer history in providing export credit insurance. Les Assurances du Credit in Belgium, Export Credit Council in Denmark, Finnish Guarantee Board in Finland, Compagnie Francaise D'Assurance pour le Commerce Exterieur in France, Hermes Kreditversicherungs in Germany, and Istituto Nazionale delle Assicurazioni in Italy, for example, are all leading institutions offering foreign credit insurance, and are backed by their respective governments.

INTERNATIONAL TRADE CREDIT

The time lag between receipt of an order and receipt of actual payment makes the exporter look for different sources of credit. He needs credit for expenses on purchase of materials and components, processing, packaging and warehousing among various other kinds of cost. Very often he has to extend credit to his overseas buyer and arrange for credit during this period. In order to meet these credit needs of the exporter, there are provisions for both pre-shipment and post-shipment credit.

Pre-shipment credit is extended to enable the exporter to meet his working capital requirements for the purchase of raw materials and components, processing, packing, transportation and warehousing. It is a form of short-term finance and may be given in advance against an export order. In India, commercial banks who are members of the Foreign Exchange Dealers Association extend this form of credit under the Packing Credit Scheme of the Reserve Bank of India.

Post-shipment credit is provided to the exporter to enable him to extend credit to his buyers in the international market. It therefore acts as an export promotion measure that enhances the exporter's competitiveness. Post-shipment credit could be extended as buyer's credit or as a line of credit.

Under the buyer's credit system, an overseas buyer gets credit from either one or a consortium of financial institutions. This enables him to pay for the goods he imports without any actual transfer of funds taking place. The exporter may obtain the payment directly from the bank on presentation of relevant export documents. Buyer's credit is generally advanced for capital goods.

In a situation where the exporter has several buyers, the financial institution in the home country extends a line of credit to another institution instead of dealing with each buyer separately. The credit is disbursed through the host country institution to the parties involved. This not only saves time in having to deal with individual buyers, it also puts the onus of judging the creditworthiness of the buyers on the home country institution.

FOREIGN EXCHANGE RISK AND EXPOSURE

Foreign exchange risk is a critical issue in international business. Any company that operates in more than one market or currency area or has cash flows across nations will face foreign exchange risk and foreign exchange exposure, which are different but related concepts. Foreign exchange risk concerns the variance or change in the domestic-currency value of an asset, liability or operating income that takes place due to unanticipated changes in exchange rates. This means that foreign exchange risk is not the unpredictability of foreign exchange rates themselves, but rather the uncertainty of values of a firm's assets, liabilities or operating incomes owing to uncertainty in exchange rates. Therefore, volatility or fluctuation in exchange rates is responsible for exchange-rate risk only if it translates into volatility in the real values of assets, liabilities or operating incomes.

 

Foreign exchange risk in turn depends on foreign exchange exposure. A firm may not face foreign exchange risks unless it is “exposed” to foreign exchange fluctuations. For example, General Electric (GE) and Hitachi both invest and operate in Mexico. Unlike Hitachi, which imports many parts for its production plants in Mexico, GE has built up its own supply base within Mexico. In this case, GE faces lower foreign exchange risks than Hitachi because GE is not exposed to fluctuations of the Mexican peso in the process of supply procurement.

Foreign exchange exposure refers to the sensitivity of changes in the real domestic-currency value of assets, liabilities or operating incomes to unanticipated changes in exchange rates. This means that exposure involves the extent to which the home currency value of assets, liabilities or incomes is changed by variations in exchange rates. The “real” domestic currency value means the value that has been adjusted by the nation's inflation. Domestic currency-denominated assets can be exposed to exchange rates if, for example, unanticipated depreciation of the country's currency causes its central bank to increase interest rates.

 

The difference between foreign exchange risk and foreign exchange exposure is as follows:

• Foreign exchange risk is the variability in the domestic currency price of an asset, liability or operating income caused by exchange rate fluctuations. Foreign exchange exposure, on the other hand, is the degree to which an asset, liability or income is affected by changes in foreign exchange rates.
• Variability in foreign exchange rates leads to foreign exchange risk only if there is foreign exchange exposure. Foreign exchange exposure leads to foreign exchange risk only when exchange rates are unpredictable and keep changing.
• Foreign exchange risk is a positive function of both foreign exchange exposure and the variance of unanticipated changes in exchange rates. Uncertainty of exchange rates does not mean foreign exchange risk for items that are not exposed. Similarly, exposure on its own will not lead to foreign exchange risk if exchange rates are perfectly predictable.
• The levels of foreign exchange risk and exposure often differ between asset/liability items and operating income. Because current asset and current liability items, especially accounts receivable and payables, have fixed face value and are short-term oriented, they are extremely sensitive to the uncertainty of foreign exchange rates. Unlike these asset or liability items, operating incomes do not have fixed face values. Exposure of operating incomes depends not only on unexpected changes of exchange rates but also on such factors as the elasticity of demand for imports or exports, and the flexibility of production to respond to changes in exchange rate movements.

Since foreign exchange risk is determined by foreign exchange exposure (along with the uncertainty of foreign exchange rates), it is important for managers to analyse and manage it. For this they need to know the different types of exposure that may lead to risk. TNCs encounter three types of foreign exchange exposure:

1. Transaction exposure
2. Economic (or operating) exposure
3. Translation (or accounting) exposure

Transaction Exposure

Transaction exposure is the change in income levels as a result of changes in exchange rates for transactions that the business has already entered into, including the borrowing or lending of funds. It leads to a change in value of anticipated cash flows because commitments are subject to settlement at a later date. This essentially means that a business may realize a different amount than anticipated by it due to changes in the value of a currency for future settlements. Suppose, for example, an Indian exporter ships goods worth USD 2000 when the spot rate is USD 1 = INR 40. The settlement for this is equivalent to INR 80,000. On the day of settlement, however, if the spot rate is USD 1 = INR 38, the exporter's earnings are INR 76,000. The exporter suffers a loss of INR 4,000 if he does not manage his exposure and risk. He can manage his risk in several different ways called hedging.

 

Transaction exposure can arise due to the following:

• Purchasing or selling goods and services on credit
• Borrowing or depositing funds denominated in foreign currencies
• Transacting a foreign-exchange contract
• Various transactions denominated in foreign exchange

Accordingly, transaction exposure can be on a variety of foreign currency-denominated assets (export receivables or bank deposits), liabilities (account payable or loans), revenues (expected future sales), expenses (expected purchase of goods) or income (dividends).

Hedging with Financial Instruments

The four financial instruments used include:

1. Forward contract: A forward contract refers to a financial contractual arrangement under which the buyer and seller agree to buy or sell an asset at a future date at a price that is agreed upon today. Forward markets are available in most major currencies of the world. Suppose an Indian exporter enters into a contract for the export of readymade garments worth USD 10,000 for which payment is to be received after four months. The spot rate of the dollar is INR 40 but the exporter expects that the value will depreciate. To hedge against such a loss he enters into a forward contract at INR 40/USD. At the time of maturity of his contract, we find the dollar has depreciated to INR 39/USD. In the absence of a forward contract, the exporter's realizations would have been INR 390,000 only, but having entered into the forward contract saves him from a loss of INR 10,000. Similarly, an importer of goods can hedge against a loss that may arise due to an impending appreciation of the INR/USD. If the importer signs a contract for import of goods worth USD 1,000 at INR 40/USD he can hedge against losses through a forward contract entered at the spot rate. On the date of settlement, if the rate is INR 45/USD, the importer will pay only INR 40,000 and save himself from a loss of INR 5,000.

    

   A forward contract refers to a financial contractual arrangement under which the buyer and seller agree to buy or sell an asset at a future date at a price which is agreed upon today.

2. Futures contract: The futures contract is a standardized forward contract which is traded through a stock exchange. Hedging via the futures market is similar to forward hedging. The difference is that in the forward market all the payment is made at the end, whereas with the futures market some of the payment is made through the margin account before the end.

    

   The futures contract is a standardized forward contract which is traded through a stock exchange.

3. Options contract: An options contract is a contract that gives the holder the right to buy or sell a specified quantity of an underlying asset at a fixed price on or before a specified date. In the options market, a call option is to purchase a stated number of units of the underlying foreign currency at a specific price per unit during a specified period of time. Alternatively, a put option is to sell a stated number of units of the underlying foreign currency at a specific price per unit during a specific period of time. The striking (or exercise) price in this market refers to the price at which the option holder has the right to purchase or sell the price-underlying currency. A call whose strike price is above the current spot price of the underlying currency or a put option whose strike price is below the current spot price of the underlying currency is called out-of-the-money. The reverse situation is called in-the-money. Although out-of-the-money options have no intrinsic value, in-the-money options have intrinsic value (which reflects the extent to which an option would currently be profitable to exercise). Similar to forward and futures markets, an option holder has to pay risk premium and transaction cost to the banks offering options service. Buying options, however, is more costly than using forwards and futures.

    

   An options contract is a contract that gives the holder the right to buy or sell a specified quantity of an underlying asset at a fixed price on or before a specified date.

4. Swaps: Swaps involve the exchange of interest or foreign currency exposures or a combination of both by two or more borrowers. It is a transformation of one stream of future cash flows into another stream of future cash flows with different features. An interest rate swap is an exchange between two parties of interest obligations (payments of interest) or receipts (investment income) in the same currency on an agreed amount of the principal for an agreed period of time. Swaps can be used for different purposes, such as investment, speculation and hedging.

    

   Swaps involve the exchange of interest or foreign currency exposures or a combination of both by two or more borrowers.

Hedging Through Invoicing

The three kinds of invoicing used are:

1. Home currency invoicing: Transaction exposure can also be managed by invoicing of goods in either the own (home) currency or a third-country currency whose value is stable and also acceptable to both parties. For example, if the Indian exporter to the United States can negotiate the price of its imported denim fabrics in terms of US dollars, or if he can manage the export contract by invoicing in rupees, there is no foreign exchange transaction exposure on their imports or exports. In general, when a business convention or the power that a firm holds in negotiating its purchases and sales results in agreement on price in terms of the home currency, the firm that trades abroad will not face foreign exchange risk and exposure.
2. Mixed-currency invoicing: It is quite normal for both the importer and the exporter to prefer invoicing using their respective home currencies. As a compromise, both parties may agree to denominate the contract partly in the importer's currency and partly in the exporter's currency. As mentioned earlier, the invoicing for Indian exports to the United States can be done partly in rupees and partly in dollars. This reduces the exposure of both the exporter and the importer. Additionally, international trading companies often use composite currency units such as the Special Drawing Right (or SDR) and the euro to denominate the export contract. Because these composite units are constructed by taking a weighted average of a number of major world currencies, their values are considerably more stable than that of any single currency.
3. Price escalation clause: A price escalation clause is a term agreed upon by both parties to adjust the sales price in full or in a certain proportion to fluctuations in which the invoice has been made. When the weak currency denominated in the contract depreciates 1 per cent, for example, the contract price will automatically increase by 1 per cent or another percentage agreed upon by both. This clause is often applied in export contracts denominated in an importer's currency that is highly volatile and will continue to depreciate in the global foreign exchange market. A similar technique to this clause is a risk-sharing arrangement between a buyer and a supplier for long-term collaborations. Both parties agree to adjust the price or share the foreign currency risk when the contracted currency fluctuates beyond a certain reasonable range.

Economic Exposure

Economic exposure, also called operating exposure, refers to the change in the present value of the firm due to changes in the future operating cash flows caused by unexpected changes in exchange rates and macroeconomic factors. The change in value depends on the effect of the exchange rate change on future sales volume, prices or costs. In contrast to transaction exposure, which is concerned with pre-existing cash flows that will occur in the near future, economic exposure emphasizes expected future cash flows that are likely to be affected by unanticipated changes of exchange rates and macroeconomic conditions (such as unexpected changes in interest rates and inflation rates).

 

The TNC's economic exposure is determined by several economic factors:

• Export orientation: The higher an economy's export orientation, the more it is likely to be affected by changes in exchange rate. A currency devaluation will have a lower impact if a TNC sources its supplies locally than if they are imported. The higher the import content of production inputs, the higher the cost of production. A TNC that uses its foreign subsidiary as an export platform will benefit from a host-country currency depreciation. Thus, it is better to export products made of localized supplies as far as risk minimization is concerned.
• Pricing flexibility: This refers to the firm's ability to raise its foreign currency selling price by a large enough margin to be able to preserve its profit margin in the case of foreign currency depreciation. This in turn depends on price elasticity of demand, which in turn is determined by the level of competition in the market and the degree of product differentiation provided by the firm. For example, Motorola's subsidiaries in Indonesia and Thailand successfully maintained their US dollar gross profit margin for producing and selling cellular phones in these markets during the Asian financial crisis because of a local price increase, which was made possible by the high quality and superior innovation of their products.
• Production/outsourcing flexibility: This refers to the TNC's ability to shift the production and outsourcing of inputs among different nations. TNCs with worldwide production systems can cope with currency changes by shifting production to a low-cost location whose currency has undergone a real devaluation.

Financial initiatives such as the use of leads and lags, risk-sharing arrangements and intra-company netting are techniques used to minimize foreign exchange risk and exposure. As transaction exposure and economic exposure may occur simultaneously, these financial initiatives can also be used to lower transaction exposure in some circumstances.

Leads and lags changes in the timing of the transfer of funds can help to reduce a firm's operating exposure. To lead is to pay early; to lag is to pay late. Leads exist when a firm holding a soft currency with hard currency debts speeds up payment by using the soft currency to pay the hard currency debts before the soft currency drops in value. Lags exist when a firm holding a hard currency with debts in a soft currency reduces the speed of payment by paying those debts late. Leads and lags may also be used to reduce transaction exposure. An international trading company can collect soft foreign currency receivables early or collect hard foreign currency receivables later. For instance, if the Indian exporter mentioned previously expects that the US dollar will depreciate against the pound sterling, it may ask its American importer to lead in paying its export sales. Intra-company leads and lags within the TNC network are easier to implement than those between two independent companies. Under parent control and by sharing common goals, TNC subsidiaries can rely on this financial technique to improve their respective foreign exchange position and optimize local currency cash flow.

Netting is a practice by which subsidiaries of affiliates within the TNC network settle inter-subsidiary debts for the net amount owed during the post-transaction period. In this method, gross intra-TNC trade receivables and payables are netted out. This approach not only reduces transaction and fund transfer cost and provides an opportunity for subsidiaries to manipulate their financial position, but also helps foreign subsidiaries bypass the foreign exchange control barriers in their respective countries. Netting could be either bilateral or multilateral. Bilateral netting exists when two sister subsidiaries cancel out their receivables and payables and settle only the net payment. Multilateral netting involves three or more sister subsidiaries’ inter-group debt and makes it necessary for coordination from headquarters’ treasury. For example, suppose that Adidas's UK subsidiary buys USD 6 million worth of goods from the Swiss sister subsidiary, and the UK subsidiary sells USD 2 million worth of goods to the French sister subsidiary. During the same netting period, the Swiss subsidiary buys USD 2 million worth of goods from the French subsidiary. In this triangular case, the settlement of the inter-subsidiary debt within the three subsidiaries ends up involving a payment equivalent to USD 4 million from the UK subsidiary to the Swiss subsidiary.

For diversified TNCs, it is important to establish the netting centre supervised by the headquarters’ treasury. Philips, for example, established what is called the Philips Multilateral Clearing (PMC) system in its headquarters to facilitate netting among affiliates. Participating subsidiaries report all intra-TNC balances to the group treasury on an agreed date and the treasury subsequently advises all subsidiaries of amounts to be paid to and received from other subsidiaries on a specified date.

Matching is a mechanism whereby a company matches its foreign currency inflows with its foreign currency outflows in respect to amount, timing, and the currency unit. The process of matching is often used for balancing accounts receivable and payable. However, it is different from netting because it is used to match currency cash flows with firms outside the TNC network and occurs on the basis of the same foreign currency (whereas netting may occur for different currencies). The prerequisite for a matching operation, either within or beyond the TNC network, is a two-way cash flow in the same foreign currency.

Intra-company reinvoicing involves the setting up of a reinvoicing centre within a TNC in the form of a separate corporate subsidiary that may be located in the TNC headquarters or in the country that is the centre of financial intelligence for the TNC. A reinvoicing centre manages all currency exposure for all intra-company transactions from a single location. Thus, the reinvoicing centre may be combined with the netting centre for some TNCs. The reinvoicing centre often takes legal title of products but does not get involved in the physical movement of goods. In other words, it handles paperwork but has no inventory. For example, the Korean subsidiary of Yum Foods Limited may ship goods directly to the Japanese sales affiliate. The invoice by the Korean subsidiary, which is denominated in Korean won, is passed on to Yum's reinvoicing centre located in Singapore. The Singapore reinvoicing centre takes legal title to the goods, then subsequently invoices the Japanese sales affiliate in Japanese yen. As a result, all operating subsidiaries deal only in their own currency, and all operating exposure lies with the reinvoicing centre. In practice, such reinvoicing centres not only manage foreign exchange exposure for intra-company sales from one place but also oversee intra-company cash flows, including leads and lags. With a reinvoicing centre, all subsidiaries settle intra-company accounts in their local currencies.

Some production initiatives can also be taken. A firm can reduce its exposure through input outsourcing in the same currency as the one used in exports. To reduce the risk from the economic downturn in the 1990s, Japanese automakers protected themselves against the rising yen by purchasing a significant percentage of intermediate components from suppliers in Taiwan and South Korea, whose currencies are closely linked to the US dollar. This made the prices of the intermediate goods move in line with the declining dollar and reduced the impact of depreciation of the USD on the cost of Japanese cars sold in the United States.

A TNC with worldwide production systems can adjust the quantity of its production in a specific location to respond to foreign exchange risk and exposure. It may increase production in a nation whose currency has been devalued and decrease production in a country whose currency has been revalued. This strategy works better for TNCs whose products are standardized in the global market. However, the benefits of using multiple production plants to reduce currency risk must be weighed against the extra capital investment and operating costs.

Translation Exposure

Foreign financial statement translation is a two-step process. First, the accounts must be made consistent by being restated according to the same accounting principles (for example, Australian or American), such as those relating to the valuing of inventories and assets, and determining depreciation. After the basis of the accounts has been adjusted for consistency, the foreign currency amounts in the results are converted into the reporting or home currency.

Translation must not be confused with conversion. Translating is merely the restating of currencies, while conversion refers to the actual physical trade or exchange of units of one currency for another. There are four methods of translating statements to the reporting or home currency:

1. The current rate method
2. The temporal method
3. The monetary/non-monetary method
4. The current/non-current method

Current Rate Method

Under the current rate method, the exchange rate used is that which is “current” at the date of the balance sheet. For Australian TNCs this would be the exchange rate in effect on 30 June; for most American TNCs it would be 31 December because they tend to use the calendar year, and for Indian TNCs it would be 31 March. It need not concern us here, but the income statement in both countries uses the average exchange rate for the year.

The main problem with the current rate method is that it is inconsistent with the historic cost principle. For example, if an Australian TNC invests AUD 100,000 in its Indian subsidiary when the exchange rate is INR 40 to the Australian dollar, the subsidiary has four million rupees to spend. If the subsidiary spends the money to buy land and the rupee subsequently depreciates against the Australian dollar to, say, 39, the land is then worth only 3.9 million rupees and the TNC would appear to have lost AUD 10,000, although in reality the “loss” is simply a function of the change in the exchange rate. The value of the land in India has not changed, but the consolidated accounts of the TNC would present a misleading picture of that real value.

Temporal Method

The temporal method translates the accounts of a foreign operation whereby non-monetary assets are translated at the exchange rates current at the date of acquisition (hence “temporal”, meaning “time”). Capital/equity acquisitions and revenue and expense items are translated at the date of the transaction. Dividends, paid or proposed, are translated at the date they were proposed, and monetary items are translated at the exchange rate current at balance date.

The temporal method ensures that the value of assets does not fluctuate because of changes in the exchange rate, but it may lead to a situation where the TNC's balance sheet does not balance.

Monetary/Non-Monetary Method

Monetary/non-monetary method translates monetary assets and liabilities at the current rate. Non-monetary items like fixed assets, long-term investments and inventories are translated at historical rates. Income statement items are translated according to the current/non-current method.

Current/Non-Current Method

In the current/non-current method, current assets and liabilities are translated at the current rate and non-current assets and liabilities at the historical rates. Income statement items excepting depreciation and amortization are translated at average rates applicable to each month of operation.

WORKING CAPITAL MANAGEMENT

Working capital refers to a firm's current assets minus the amount of current liabilities. In practice, working capital management is concerned with the efficient use of current assets such as cash, accounts receivable and inventory.

Cash Management

The global cash management system includes three basic elements: home-country cash management, host-country cash management, and cross-border cash management. It has to function in a regime of financial regulations, cash flow restrictions and diverse tax structures. Most TNCs keep the activities of borrowing, global liquidity management, international banking relations and foreign exchange exposure management to be managed domestically, whereas local disbursement and collection, local banking relationships, payroll or management of trade credit and purchasing are generally managed overseas.

TNC cash management, known as pooling, takes place in two stages. In the first stage, cash is collected and pooled in local currency and used for local expenses. If a company has several subsidiaries in a single country, it very often uses cash surpluses from one to fund the cash deficits of another. Siemens, for example, carefully manages national cash pools in each currency, using cash excesses from some units to fund the cash needs of others within the same host country.

Another approach for global cash management is to build an efficient account structure, which also helps to reduce banking fees and float. For example, Merck, a major US pharmaceutical producer, uses a network of accounts held within a single bank's global network to transfer funds between national pools and the Merck treasury centre in London.

Today, many diversified large TNCs have found that their financial resources and needs are either too large or too sophisticated for the financial services available in many locations where they operate. They, therefore, establish in-house banks to manage not only currency exposure but also cash flows. Such an in-house bank is not a separate corporation; rather, it is a set of functions performed by the existing treasury department. Acting as an independent entity, the central treasury of the firm transacts with its various business units. The purpose of the in-house bank is to provide bank-like services to the various units of the firm. The in-house bank may be able to provide services not available in many country markets, and may do so at a lower cost when available.

Foreign Receivable Management

A firm's operating cash flows come from its accounts receivable. This requires the efficient management of foreign receivables at three stages: pre-transaction stage, transaction stage and post-transaction stage. In the pre-transaction stage, a firm must investigate the buyer or importer's corporate credibility and financial capability. This is particularly important when dealing with new clients. Many large international companies categorize foreign clients into different categories such as superior customers, priority customers, normal customers and risky customers, based upon a client's previous record, company size, corporate image, financial strengths and targeted markets. This categorization and related client information is then relayed to sales managers and treasury managers.

While carrying out the transaction, the exporter needs to decide the currency in which the transaction should be denominated and what the terms of payment should be. Ideally, the exporting transaction should be denominated in a hard currency together with a letter of credit at sight. In practice, however, this is largely determined by the exporter's bargaining power vis-à-vis the importer. The hedging instruments, hedging clauses and invoicing techniques introduced earlier are useful during this stage.

Finally, the firm should have adequate systems for tracking, managing and collecting foreign accounts receivable in the post-transaction stage. Systems managers in the accounting or treasury department should be able to track the collection record and coordinate with the international sales or marketing department (if a D/P or D/A is used) or the bank (when an L/C is used).

Bank guarantee

Banker's acceptance

Bill of lading

Capital asset pricing model

Capital budgeting

Cash in advance

Corporate guarantee

Documentary collection

Economic exposure

Export factoring

Foreign exchange exposure

Foreign exchange risk

Forfaiting

Forward contract

Futures contract

Letter of credit

Option contract

Swaps

Transaction exposure

Working capital management

1. What is international financial management? How does it differ from financial management of the domestic firm?
2. What are the sources of funds for a TNC?
3. What do you understand by foreign exchange risk? How would you distinguish it from foreign exchange exposure?
4. Enumerate the different techniques of managing foreign exchange exposure.
5. What are the different issues in the working capital management of a TNC?
6. An Indian business house is considering setting up its first overseas subsidiary in Brazil. As a consultant to the firm, prepare a report analysing both the home country and the host country capital markets.

1. The market potential index for emerging markets (http://globaledge.msu.edu/resourcedesk/mpi/) consists of eight dimensions to measure the market potential of a country. Compare the top five countries listed in the index for 2009 with the five at the bottom and make a comparative report listing important factors of difference in the capital market context.
2. You are the manager of a fishing exporter based in Kerala, desirous of setting up operations in Russia (http://www.openrussia.ru/), which recently lost its monopoly over the harvesting of caviar in the Caspian Sea area. Examine the rules and regulations for trade in the area to prepare a feasibility report.