Chapter 22 - International Corporate Finance

Introducing Foreign Exchange

When engaging in business overseas, you must engage yourself in the buying and selling of money. In foreign exchange markets, every currency has a price in terms of other currencies. Foreign Exchange Rate is a price for a currency denominated in another currency. For example, it might cost you $2 to buy 1 British pound. The foreign exchange market is a large market where currencies are traded and has no central physical location. The main players in this market are the very large, global investment banks such as Deutsche Bank, UBS, and Citibank. These banks trade their own account as well as for client multinational firms. Along with them are some large multinaitonal firms that trade for themselves. Other players include government central banks, hedge funds, and other investment managers and retail brokers. The US dollar and the euro account for more than half of all trading volume in the foreign exchange market, despite the fact that there are 150 currencies in the world.
Exchange rates are quoted in print everywhere. For example, on Monday, August 23, 2010, the exchange rate for US dollars to Euros was 1 Euro = 1.264 US dollars. This means that, if you have 100 Euros, that amount would be worth (100 * 1.264) $126.40. Exchange rates are market prices and vary daily. This increases the risk of doing business abroad considerably.

Exchange Rate Risk

Many exchange rates are floating rates, which means they change constantly depending on the quantity supplied and demanded for each currency in the market. The supply and demand is driven by three factors:
  • Firm's trading goods - US dealer exchanges dollars for euros to buy cars from Germany's BMW.
  • Investor's trading securities - A German investor exchanges marks for dollars to pruchase US bonds.
  • The Actions of central banks in each country - The British Central bank may exchange pounds for euros in attempt to keep down the value of the pound.
Exchange rates are thus volatile, especially since supply and demand for currencies varies with global economic conditions. Fluctuating exchange rates cause the importer-exporter dillema, which is a known problem. We can illustrate it with the following example. Suppose I'm importing German car parts. If the German company sets its prices in euros, I face the risk of the dollar falling in value, making the parts for my car I'm building more expensive. If the German company sets its price in dollars, then they face the risk.
To combat this risk and reduce it, firms will hedge the transaction using currency forward contracts. These are contracts that set the exchange rate and an amount to exchange in advance. Usually, these are written between a bank and a firm, fixing the exchange rate for a transaction to occur down the road. The contract specifies the exchange rate, an amount of currency to be exchanged, and a delivery date on which the exchange will take place. Forward exchange rate is the exchange rate set in the currency forward contract. It applies to an exchange that will occur in the future. The forward contract takes the risk and places is on the bank. The bank is the one that is willing to exchange a certain amount at a certain date. Why are they willing to bear the risk? They are much larger organization and haver more captial to assume the risk without major reprecautions. However, in many cases, the bank will not hold the risk but will pass it to another third party willing to trade.

There exists an alternative method called the cash-and-carry strategy that enablesa firm to elimiate exchange rate risk. Currency Timeline indicates time horizontally by dates and currencies vertically. Dollars in one year would show in the upper right point and the euros in one year would be found in the lower right point. To convert the cash flows between points, we must convert them at an appropriate rate. Spot Exchange Rate is the current foreign exchange rate. Cash-and-carry strategy is a strategy used to lock in the future cost of an asset by buying the asset for cash today and storing it until a future date. It consists of the following three simultaneous trades:
  1. Borrow dollars today using a 1 yr. loan at the dollar interest rate.
  2. Exchange the dollars for euros today at the spot exchange rate.
  3. Deposit the euros today for 1 yr. at the euro interest rate.
Below is an illustration of the currency timeline showing forward contract and cash-and-carry strategy:

Because the forward contract and the cash-and-carry strategy accomplish the same conversion, by the Law of One Price, they must do so at the same rate. Covered Interest Parity Equation states that the difference between the forward and spot exchange rates is related to the interest rate differential between the currencies. It can be calculated by:Forward Rate (pounds in 1 yr / dollars in one yr) = Spot Rate (pounds today / dollars today) x ((1+Rpounds in 1 yr per pounds today) / (1 + Rdollars in one yr per dollars today))When the interest rate differs across countries, investors have an incentive to borrow in the low-interest rate currency and invest in the high-interest rate currency. If you wanted to decrease this risk, you could enter in a forward contract. To solve for this: Forward Rate(t yrs) = Spot rate x [ (1 + Rpounds)^t] / [ (1 + Rdollars)^t]. Another option to hedge risk is to engage in currency options. These are another method that firms commonly use to manage exchange rate risk. They give the holder the right, but not the obligation, to exchange currency at a given exchange rate. They allow firms to lock in a future exchange rate; currency options allow firms to insure themselves against the exchange rate moving beyond a certain level. So why may a firm want to hedge with options instead of forward contracts? Many managers want the firm to benefit if the exchange rate moves in its favor instead of being stuck paying an above-market rate. Also, options always have the "option" to withdraw from the deal if rates are unfavorable.

Internationally Integrated Capital Markets

Assuming that any investor can exchange either currency in any amount at the spot rate or forward rates, and is free to purchase or sell any security in any amount in either country at their market prices. These conditions are called internationally integrated capital markets. The value of the investment does NOT depend on the currency we use in the analysis with those conditions.

Valuing Foreign Currency Cash Flows

If a foreign project is owned by a domestic corporation, managers and shareholders need to determine the home currency value of the foreign currency cash flows. Two methods are available in an internationally integrated captial market for calculating NPV:
  1. Calculate the NPV in the foreign country and convert it to the local currency at the spot rate.
  2. Convert the cash flows of the foreign project into the local currency and then calculate the NPV of these cash flows.
The expected value of the future cash flows in dollars is the expected value in pounds multiplied by the forward exchange rate. Once you calculate the forward exchange rate, you can calculate the expected free cash flows in dollars by multiplying the expected cash flows in pounds by the forward exchange rate. This will express your foreign project in terms of dollars, allowing you to value the foreign project as if it were a domestic project. We can use the Law of One Price as a check, where the estimate for the foreign cost of capital must satisfy the Law of One Price. If it does not, then managers should be concerned that the simplifying assumptions in their analysis are not valid. Market frictions exist so that the market integration assumption is not a good approximation of reality, or perhaps tere is a significant correlation between spot exchange rates and cash flow. Rewriting the equation yields us:Spot Rate / Forward Rate = (1 + Rpounds) / (1 + Rdollars)From this equation and combined, we can put together the Foreign-Denominated Cost of Capital: r(pounds) = [(1 + r pounds) / (1 + r dollars)] x (1 + r dollars) - 1

Valuation and International Taxation

Determining the corporate tax rate on foreign income is complicated because corporate income taxes must be paid in two national governments, the host and the home government. If a foreign project is a separately incorporated subsidiary of the parent company, the amount of taxes a firm pays generally depends on the amount of profits repatriated or brought back to the home country. If a firm has a single foreign project and all foreign profits are repatriated immediately, the general international arrangement prevailing with respect to taxation of corporate profits is that the host country gets the first opportunity to tax income produced within its country borders. US tax policy requires US corporations to pay taxes on foreign income at the same rate as profits earned in the US. Also, a full tax credit is given for foreign taxes paid up to the amount of the US tax liability. It pays the foreign tax rate first and the additional amount due up to the US tax rate to the United States. If a firm has multiple projects and is pooling them, the US tax law states that a multinational corporation may use any excess tax credits generated in high-tax foreign countries to offset its net US tax liabilities on earnings in low-tax foreign countries. In this way it pools all foreign taxes together and compares the total to its US total. An opportunity to defer repatriation exists as well. This is very crucial since the foreign operation is set up as a separately incorporated subsidiary and the US tax liability is not incurred until the profits are brought back home. When foreign tax rate is less than US tax rate, deferral can provide significant benefits.

Internationally Segmented Capital Markets

Up until now, we assumed the international capital markets are integrated. In this section, we consider segmented capital markets, or markets that are not internationally integrated. Firms may face differential access to markets if there is any kind of asymmetry to information about them. For example, a firm may be better known in one country than in another. Because this, investors in the country where the firm is not known may require a higher rate of return to convince them to hold its stock. Because of the commonality of differential access to national capital markets, it explains why currency swaps exist. Currency swaps are contracts in which parties agree to exchange coupon payments and a final face value payment that are in different currencies. With this, a firm can borrow in the market where it has the best access to capital and then swap the coupon and principal payments to whichever currency it would prefer to make payments in.Important macroeconomic arguments for segmented capital markets involve capital controls and foreign exchange controls that create barriers to international capital flows. Many countries monitor and limit capital in and outflows. In addition, there are vast differences that exist in political, legal, socio-cultural characteristics.However, this implies that one country or currency has a higher rate of return than another country or currency, when the two rates are compared in the same currency. If the return difference is a result of a market friction like capital controls, corporations can exploit this by setting up projects in the high-return country and raise capital in the low return country. This extent is limited of course. The existence of segmented capital markets makes many decisions in international corporate finance more complicated but potentially more lucrative for a firm that is well positioned to exploit the market segmentation.

Capital Budgeting With Exchange Rate Risk

Finally, another issue that arises is the fact that the cash flows of the project are affected by exchange rate risk. The cash flow is affected by the future level of the exchange rate. Up until now, we assumed that the project's free cash flows are uncorrelated with spot rates. This makes sense if firms operate as a local firm in the foreign market . However, many firms use imported inputs in their production processes or export some of their output to foreign countries. When a project has cash flows that depend on the value of multiple currencies, the most convenient approach is to separate the cash flows according to the currency they depend on. If the revenues and costs are not affected by changes in the spot exchange rates, it makes sense to assume that changes in the free cash flows are uncorrelated with changes in the spot exchange rates. Thus, we can convert pound-denominated free cash flows to equivalent dollar amounts using forward exchange rate. Then, we add dollar-based cash flows to determine projects aggregate free cash flow in dollar terms.