Lecture Notes for International Finance (FIN 435)CH2. INTERNATIONAL MONETARY SYSTEM* FORECASTING EXCHANGE RATESCH 8, 9, 10, EXCAHGE RATE RISK EXPOSURES AND MANAGEMENTLecture Notes for International Finance (FIN 435)CH 1. GLOBALIZATION AND THE MULTINATIONAL FIRM* WHY BUSINESS?To make money* WHAT NEEDED?2) Money = Capital = ResourcesNeed money to make money? Sounds contradictory? Capitalism – Capital = Ism according to Rev Jesse Jackson. In Communism, the government provides resources, but less incentive to do a project. Here, strong incentives, but difficult to get started.1) Idea(s) = Project(s)* MAJOR FINANCIAL DECISIONS?1) Examine whether the idea(s) you have is “good” or which one(s) is the best= Capital Budgeting. Capital Budgeting techniques: NPV (take +NPV projects or the highest NPV), IRR (or MIRR) (take if IRR>WACC, or the one with the highest IRR(?)), Payback Period (take if PB < the maximum period allowed or the one with the shortest PB).2) How to come up with the money = how to finance (fund) the project(s) = how much from Equity (owner’s contribution) and Debt = Capital StructureEx. $50 million, 40% equity => $30 million from debt.3) Short-term (working capital) and long-term (investment) managementWorking capital management is for day to day activities like A/R, A/P, Inventory, etcStrategic investment is M&As, issuing new shares, etc4) What to do with profits (net earnings)? Dividends or addition to retained earnings? = Dividend PolicyEx. $5 million net earnings, $3 million dividends => 60% dividend payout ratio Aside) (Net)Sales=Revenue > Gross Margin>EBIT>EBT>Net earnings(=Net income)Aside) EBITDA=EBIT+DA or GM-Cash Expenses. Ex. GM=$10m, Cash exp=$6m, Non-cash exp=$1m, then EBIT=$10-($6+$1)=$3m. EBITDA=$3+$1=$4m or $10-$6=$4m. This is similar to have a discounted price or regular price + a rebate.*finance.yahoo.com* WHY INTERNATIONAL BUSINESS? – MORE OPPORTUNITIES: INCREASED REVENUE AND/OR REDUCED COSTS =>MULTI-NATIONAL CORPORATIONS (MNCs)* WHAT MAKES INTERNATIONAL BUSINESS UNIQUE?1. EXPANDED OPPORTUNITY SET and COMPARATIVE ADVANTAGE (DavidRicardo)- Gains from trade are from the Absolute Advantage (which country is moreefficient in the production of a particular product – one industry at a time)according to Adam Smith vs. Gains are from the Comparative Advantage basedon the production efficient across industries. Eg., Country A may be moreefficient in both textiles and food. Yet, gains of trade exist as Country A is muchstronger in textiles. Another example can be found in the relationship betweena lawyer and a secretary as the lawyer may be better in both legal expertiseand typing. 2. ADDITIONAL RISKS2.1 EXCHANGE RISK: AN ELEMENT OF CASHFLOW VARIABILITY THAT ISDUE TO CURRENCY FLUCTUATIONS. $ VALUE OF FOREIGN CURRENCYDENOMINATED CASHFLOWS CHANGES (amount of money in FC (#TWs)is unchanged, but the $ amount changes) ASIDE: EXCH. RATE? : Relative value of two currencies Also note the difference between American terms ($/FC) andEuropean terms (FC/$) Example: 800 won/$ IN NOVEMBER 1997 AND 1600 won/$ INDECEMBER 1997. IF A US FIRM MADE A $ 1M SALE (=800 MILLION won) INNOVEMBER, 1997 AND RECEIVED AN A/R DENOMINATED IN won THATMATURED IN DECEMBER 1997, THEN HOW MUCH DID THE COMPANY LOSE?2.2 POLITICAL RISK: ARISES SINCE A SOVERIGN COUNTRY CAN CHANGETHE “RULES OF THE GAME”3. MARKET IMPERFECTIONS: INTERNATIONAL MARKET IS NOT PERFECT INTHE SENSE THERE ARE MANY MARKET FLICTIONS SUCH AS TRANSACTIONSCOSTS (E.G., TRANSPORTATION COSTS), GOVERNMENT REGULATIONS,DIFFERENT TAXES, TARIFFS, AND RESTRICTIONS ON FOREIGN INVESTMENTS.Example: Nestlé HAS BEARER SHARES AND REGISTERED SHARES.* MNC GOAL: MAXIMIZING THE VALUE OF THE ENTIRE MNC! - AGENCY CONFLICTS: The agent (managers) may not work in the best interest of the principal (owners)-What to do to mitigate the conflict? 1) active monitoring=direct shareholder intervention, performancebased incentives such as stock shares or stock options (to buy shares), hostile takeover threats whenmarket value (price) is less than the intrinsic value.* WORLD ECONOMY: RECENT TRENDS - EMERGENCE OF GLOBALIZED MARKETS - LIBERALIZATION - ECONOMIC INTEGRATION - PRIVATIZATION - TECHNOLOGY (Internet)* MNC: A most advanced form of the multinational enterprise, incorporated inone country and doing business in several other countries via globalcoordination by a single centralized management. Examples: GE, FORD,ROYAL DUTCH/SHELL, - - - * MULTINATIONAL FINANCIAL MGT - FIRMS HAVE TO MAKE THE FOLLOWING DECISIONS: CAPITAL BUDGETING AND INVESTMENTS, CAPITAL STRUCTURE, WORKING CAPITAL MGT, DIVIDENDPOLICY AND REINVESTMENT. MNCs DO THE SAME, BUT ALL SUBJECT TO UNIQUE ASPECTS OF INTERNATIONAL BUSINESS:* MNC PATTERNS: 1. RAW-MATERIALS SEEKERS: 2. MARKET SEEKERS: OFTEN IN RESPONSE TO ANY RESTRICTIONS ON THEIREXPORTS TO THE MKT. 3.COST MINIMIZERS: PRODUCE GOODS IN LOWER-COST AREAS OVERSEAS INORDER TO BE COST-COMPETITIVE.* EVOLUTION: INTL TRADE (IMPORT/EXPORT) => SETTING UP A FOREIGN SALES SUBSIDIARYFOR DISTRIBUTION => SECURING LICENSING AGREEMENTS => FRANCHISING=> JOINT VENTURES => EVENTUALLY ESTABLISHING A FOREIGN SUBSIDIARYREF) MOVING TO NEXT STAGE => RISKIER, BUT MORE OPPORTUNITIES* IMPORTANT CONCEPTS OF FINANCIAL MGT (FIN331-333) 1. ARBITRAGE; ACTIONS TO MAKE PROFITS WITHOUT TAKING ADDITIONALRISK => IF THE MKT IS PERFECT, THERE IS NO ARBITRAGE IE, LAW OF ONEPRICE PREVAILS. 2. MKT EFFICIENCY: NEW INFO IS READILY INCORPORATED IN SECURITYPRICES. => NO ABNORMAL RETURNS 3. CAPITAL ASSET PRICING: SECURITIES ARE VALUED IN TERMS OF THEIREXPECTED RISKS AND RETURNS.* MULTINATIONAL FINANCIAL MGT 1. MECHANISM OF FINANCIAL TRANSACTIONS WITHIN THE MNC: IT CANEASILY MOVE GOODS, SERVICES, CAPITAL, AND PROFITS AMONG ITS VARIOUSAFFILIATES AND SUBSIDIARIES THROUGH THE INTERNAL INTERNATIONALTRANSFER MECHANISM TO MAXIMIZE THE GLOBAL VALUE OF THE FIRM.1) MODE OF TRANSFER: Freedom in the selection of financial channels.2) TIMING FLEXIBILITY: Payment schedule can be accelerated or delayed.3) REDUCTION OF GLOBAL TAX PAYMENTS: Shifting profits from high-taxto lower-tax nations to reduce its global tax payments. 2. FACTORS TO CONSIDER AS A CFO IN MNC – UNIQUE ASPECTS OF INTLBUSINESS* INTL OPPORTUNITIES AND EXPOSURE TO INTL RISKS* VALUATION MODEL FOR AN MNC