27

CHAPTER 18
International Financial Management
After studying this chapter, students should be able to:

> Discuss the major forms of payment in international trade.

> Identify the primary types of foreign-exchange risk faced by international
businesses.
> Describe the techniques used by firms to manage their working capital.
> Evaluate the various capital budgeting techniques used for international
investments.
> Discuss the primary sources of investment capital available to international
businesses.

LECTURE OUTLINE

OPENING CASE: KLM’s Worldwide Financial Management

The opening case details KLM Royal Dutch Airlines’ international operations. The
company is successful but has a very complex international financial challenge as it
tries to manage its holdings of over 180 different currencies.

Key Points

• KLM Royal Dutch Airlines (KLM) depends on the international market for its
livelihood. In fact, it competes head-to-head against other major carriers such as
American, United, and Lufthansa.

• KLM’s competitive advantage based on high-quality service has allowed the

company to capture a large share of the critical U.S.-Netherlands market. In
addition, KLM bought 22 percent of Northwest Airlines, and the two companies
coordinate their flight schedules to encourage travelers to use Northwest for their
American trips, and KLM for transatlantic flights.

• KLM services more than 150 cities on six continents. The company’s
international success, however, brings a major financial challenge. The company
must manage approximately 180 currencies that are used as part of its normal day-
to-day business.
28 > Chapter 18

• The company not only receives payment in different currencies, but it must pay
for local services in the local currency, and pay U.S. dollars for its aircraft. In fact, to
fund its aircraft purchases, the company has borrowed a variety of currencies.

• The challenge to KLM as it manages its currency holdings is to maintain local-

currency balances in each country, find low-cost sources of capital for new aircraft,
and protect the company from exchange-rate fluctuations.

Case Questions

1. What types of financial exposure might KLM face?

There are three types of financial exposure. Transaction exposure occurs when an
international transaction is affected by exchange-rate movements that occur after
the firm is legally obligated to complete the transaction. Translation exposure
occurs when fluctuations in exchange-rates impact the firm’s consolidated financial
statements, and effectively change the value of foreign subsidiaries as measured in
the parent’s currency. Finally, economic exposure occurs when the value of a firm’s
operations are impacted by unanticipated exchange-rate movements. Most
students will probably suggest that KLM faces all three types of exposure.

2. What challenges does KLM face as it manages its financial holdings?

KLM faces three intertwined challenges as it manages its financial holdings. First,
the company must minimize working capital balances, yet maintain large enough
balances to facilitate day-today transactions and cover any unexpected demands
for cash. Second, the company must minimize currency conversion costs, perhaps
via netting. Third, the company must minimize its foreign-exchange risks, perhaps
by employing a leads and lags strategy.

Additional Case Application

KLM faces an enormous challenge as it manages its complex holdings of different
currencies. Instructors may wish to allow students to experience (at least in part)
the enormity of this challenge by asking students to act as the firm’s financial
managers. Instructors can develop a set of problems that include various
transactions such as customers in different countries purchasing airline tickets,
demands for payment for ground services in different locations, and a need for
capital to finance new aircraft. Instructors can also develop a situation (real or
hypothetical) in which currencies are fluctuating greatly against each other.
Students, working in groups, can develop a financial strategy for the firm, and
present their strategies to the rest of the class.

CHAPTER SUMMARY

Chapter Eighteen explores international financial management. The chapter begins by

considering the different issues that international financial managers must face, and
then goes on to discuss the management of foreign-exchange risk and working capital.
The chapter concludes with a discussion of international capital budgeting and sources
of investment capital.
 International Financial Management > 29

I. FINANCIAL ISSUES IN INTERNATIONAL TRADE

International business transactions not only require the buyer and seller to reach
agreement on price, quantity, and delivery date, they also require buyers and sellers to
negotiate and agree on which currency to use for the transaction, when and how to
check credit, which form of payment to use, and how to arrange for financing.

Choice of Currency

• Exporters typically prefer to be paid in their home currency so that they know
exactly how much they will be receiving from the importer. Importers, however,
typically prefer to pay in their home currency so that they know exactly how much
they will be paying the exporter. In some cases, a third country currency will be
selected. For example, the text notes that the U.S. dollar is used for transactions in
the oil industry.

Credit Checking

• It is important for firms to check the credit of their customers prior to completing
a business transaction. In situations where the importer is financially healthy,
exporters may choose to extend credit. However, if an importer is financially
troubled, an exporter may demand payment in a way that reduces its risk.
• Firms should aim to build long-term, trusting relationships with customers.

Method of Payment

• There are several methods of payment for international business transactions

including payment in advance, open account, documentary collection, letters of
credit, credit cards, and countertrade. Each form involves a different degree of cost
and risk.

• Payment in Advance. The safest method of payment from the exporter’s

perspective is payment in advance, however this method of payment is very
undesirable from the importer’s point of view.

• Open Account. The safest method of payment from the importer’s perspective
is the open account, whereby goods are shipped by the exporter and received by
the importer prior to payment. In addition, the importer benefits from this form of
payment because it avoids the fees that may be associated with other forms of
payment, and requires less paperwork.
• Open accounts are not desirable for exporters because the exporter must rely
on the importer’s reputation to pay promptly, it cannot fall back on financial
intermediaries in the case of a dispute, the lack of documentation may be
disadvantageous if the importer refuses to pay, and working capital must be tied up
to finance foreign accounts receivable.
• Firms may engage in specialized international lending called factoring whereby
they buy foreign accounts receivable at a discount from face value.
• Documentary Collection. Documentary collection is a method to finance
transactions in which commercial banks serve as agents to facilitate the payment
process. An exporter draws up a document called a draft (or Bill of Exchange) in
which payment is demanded from the buyer at a specified time.
30 > Chapter 18

• After the goods have been shipped, the exporter submits the packing list and
the bill of lading among other documents to its local bank. The bill of lading serves
as both a contract for transportation between the exporter and the carrier and as
title to the goods in question. The exporter’s bank then authorizes its
correspondent bank in the importer’s country to release the bill of lading when the
importer honors the terms of the exporter’s draft. Show Figure 18.1 here.
• There are three forms of drafts. A sight draft requires payment upon the
transfer of title to the goods from the exporter to the importer. A time draft extends
credit to the importer by requiring payment at some specified time after the importer
receives the goods. A date draft specifies a particular date on which payment must
be made.
• To obtain title to the goods, the importer must accept the time draft (and incur a
legal obligation to pay it). An accepted time draft is called a trade acceptance.
The importer’s bank may also accept a time draft, adding its own obligation to pay
the draft. The draft then becomes a banker’s acceptance.
• If the exporter chooses to sell its draft at a discount in order to receive
immediate payment, it may be sold without recourse, meaning that the buyer of
the acceptance is stuck with the loss if the importer does not pay, or with recourse,
meaning that the exporter will have to pay the buyer of the acceptance if the
importer does not pay.
• Documentary collection has several advantages for exporters. First, the fees
involved are reasonable since the banks involved are acting as agents rather than
risk takers. Second, a trade acceptance or banker’s acceptance is a legally
enforceable debt instrument in most countries. Third, using banks facilitates the
collection process. Finally, financing for foreign accounts receivable is easier and
less expensive when documentary collection is used rather than open accounts
since acceptances are legally enforceable.
• Importers may still refuse a shipment and decline to accept the draft, or may
default on the time draft when it comes due. Either situation could be costly for
exporters.

Teaching Note:
Students frequently become confused when discussing
the process of documentary collection and letters of credit
(see next section). When discussing these concepts,
instructors may wish to develop a chart showing each step of the process so that
students can follow the process more clearly.

• Letters of Credit. International businesses may use letters of credit to arrange

for payment. A letter of credit is a document that is issued by a bank and contains
its promise to pay the exporter upon receiving proof that the exporter has fulfilled all
requirements specified in the document. Exporters bear less risk by using a letter
of credit than by relying on documentary collection.
• An importer applies to its local bank for a letter of credit. In the bank’s
assessment of the importer’s credit worthiness, various documentation may be
required such as invoices, customs documents, a bill of lading, export licenses,
certificates of product origin, and inspection certificates.
• After issuing the letter of credit, the importer’s bank sends it and the
accompanying documents to the exporter’s bank, which then advises the exporter
of the terms of the instrument, creating an advised letter of credit. The exporter
 International Financial Management > 31

could request its own bank to add a guarantee of payment to the letter of credit
creating a confirmed letter of credit.

Discuss Venturing Abroad: What Your Advising Fee Buys

This Box describes the services a bank provides prior to
advising a letter of credit. The Box fits in well with the
discussion on letters of credit and with Review Question 3, and
Discussion Question 2.

• An irrevocable letter of credit cannot be altered without the written consent of

both the importer and the exporter, while a revocable letter of credit may be
altered at any time for any reason.
• Since banks charge a fee for these services, companies must determine which
are necessary forms of insurance and which are not. Show Figure 18.2 here.

• Credit Cards. Firms may use credit cards for small international transactions,
particularly those between international merchants and foreign retail customers.

• Countertrade. Countertrade occurs when a firm accepts something other than

money as payment for its goods and services. There are various forms of
countertrade including barter (each party simultaneously swaps its products for the
products of the other), counterpurchase (one firm sells its products to another at
one point in time and is compensated in the form of the other’s products at some
future time), buy-back (one firm sells capital goods to a second firm and is
compensated in the form of output generated as a result of their use), and offset
purchases (part of an exported good is produced in an importing country). The
text provides examples of each type of countertrade arrangement.
• Firms may establish clearinghouse accounts to facilitate countertrade.
Switching arrangements (countertrade obligations transferred from one firm to
another) may be used by firms that enter into countertrade agreements in order to
expand their international sales, without having experience in it or the desire to
engage in countertrade.
• Countertrade is widely used in international business, and may account for as
much as 40 percent of world trade. The text provides an example of Marc Rich &
Co.’s use of countertrade. Show Map 18.1 here.
• Each method of payment has various costs and risks associated with it. In the
end, the exporter must decide how much risk and cost to bear. Discuss Table 18.1
here.

Financing Trade

• International firms must be ready to offer financing arrangements to foreign

customers. Exporters must, however, be aware of the risk of default and balance
that risk against the possibility of increased sales.
• Many developed countries offer financing programs to stimulate exports. For
example, the text notes that in the U.S., Eximbank offers a working capital
guarantee loan program.

Discuss Bringing the World into Focus:

The Three Gorges Dam: It’s Not a Feast for U.S. Firms
32 > Chapter 18

This Box discusses the Three Gorges Dam currently under construction in China.
Environmentalists are deeply concerned about the negative effect the dam may
have on surrounding lakes, homes and rivers. They have successfully pressured
the World Bank to refuse to provide financing for the project. However, some
governments have chosen to sponsor the project. The Box fits in well with the
discussion of Financing Trade and with Discussion Question 5.

II. MANAGING FOREIGN-EXCHANGE RISK

There are three types of foreign-exchange exposure, transaction, translation, and

economic, that confront international firms.

Transaction Exposure

• A firm faces transaction exposure when the financial benefits and costs of an
international transaction can be affected by exchange-rate movements that occur
after the firm is legally obligated to complete the transaction.
• Various transactions including the purchase of goods, services or assets, the
sale of goods, services, or assets, the extension of credit, and borrowing money
can lead to transaction exposure. The text provides an example of transaction
exposure involving Saks Fifth Avenue.
• Firms can respond to transaction exposure by going naked, buying the required
currency forward, buying the required currency in the currency options market, or
acquiring an offsetting asset.
• Go Naked. A company can ignore transaction exposure by simply deciding to
buy required currency when it is needed. An advantage to this method is that
capital does not need to be tied up unnecessarily, nor does it have to pay fees to
any intermediaries. Further, the company may be able to benefit from exchange
rate movements.
• Buy Swiss Francs Forward. A company (the text continues to use the example
of Saks) could buy the required foreign currency in the forward market, and lock in
the price it will pay for the currency. Like going naked, this strategy allows a
company to keep its capital free for other uses, however, it also provides a
company with a guaranteed price it will pay for the foreign currency. The company
will miss any opportunity to capitalize on exchange-rate movements though.
• A similar strategy to buying in the forward market is buying in the futures market.
The choice between the two markets will be affected by the price of the required
currency and relative transaction costs.
• Buy Swiss Francs in the Currency Options Market. A company could acquire
a currency options contract allowing it to buy the required currency (see Chapter 5).
This would give the company the opportunity, but not the obligation, to buy the
required currency at a given price in the future. Thus, this strategy gives companies
the option of capitalizing on movements in exchange-rates. The main disadvantage
to this strategy is that it is relatively more expensive than the others.
• Acquire an Offsetting Asset. A company could also neutralize its exposure by
acquiring an offsetting asset of equivalent size, denominated in the same currency.
The primary disadvantage of this approach is that it may require a firm to tie up
some of its capital. The text continues to use Saks to illustrate this concept.
Discuss Table 18.2 here.

Translation Exposure
 International Financial Management > 33

• Translation exposure (also known as accounting exposure) is the impact on

the firm’s consolidated financial statements of fluctuations in exchange rates that
change the value of foreign subsidiaries as measured in the parent’s currency.
International accounting is covered in Chapter 19. The text does provide a simple
example of translation exposure involving GM, however.
• A firm’s translation exposure may be reduced through the use of a balance
sheet hedge. A balance sheet hedge is created when an international firm
matches its assets denominated in a given currency with its liabilities denominated
in the same currency. The text provides an example of the process involving
AFLAC.
• It may be difficult to avoid both transaction and translation exposure. Since
transaction exposure can result in real losses while translation exposure only results
in paper losses, it is generally recommend that transaction exposure be avoided
before translation exposure is.

Economic Exposure

• Economic exposure is the impact on the value of a firm’s operations of

unanticipated exchange-rate changes. This type of exposure affects virtually every
area of operations. The text provides an example of how Sony has tried to limit its
economic exposure.
• Long term investments in property, plant, and equipment are particularly
vulnerable to economic exposure. In fact, the text notes that both Daimler-Benz
and BMW have had to alter their strategies and build assembly plants in the U.S. to
cope with this problem.
• There are other ways for dealing with economic exposure. For example, the
text notes that the Walt Disney Corporation used a bond hedge to protect itself from
changes in the yen-dollar relationship. It is also important for firms to analyze likely
changes in exchange-rates, and consult with experts about long-term trends. For
example, although there is a common perception that the dollar is losing value
against most currencies, in reality it has actually appreciated against most
currencies, and has depreciated against relatively few. Show Map 18.3 here.

III. MANAGEMENT OF WORKING CAPITAL

• The management of working capital is more complicated for international firms

than purely domestic ones because the working capital position for each subsidiary
(in each currency) must be considered in addition to the firm’s position as a whole.
• Three corporate financial goals must be balanced: minimizing working capital
balances; minimizing currency conversion costs; and minimizing foreign-exchange
risks.
34 > Chapter 18

Minimizing Working Capital Balances

• Working capital is held to facilitate day-to-day transactions and to cover the firm
against unexpected demands for cash. However, since the return on working
capital is low, financial managers generally try to minimize balances.
• One means of minimizing working capital balances is centralized cash
management, which involves coordinating an MNC’s worldwide cash flows and
pooling its cash reserves.

Discuss Going Global:

Colefax and Fowler’s Cash Flow Solution
This Going Global Box examines how Colefax and Fowler, a
wallpaper and fabric store, manages its working capital and
currency conversion costs. In the past, the company had simply passed the costs
along to customers, but now Colefax and Fowler has established bank accounts in
each country where it has customers, and allows customers to pay in their local
currencies. Colefax and Fowler then converts the local balances into its home
currency when they reach a certain level. This Box fits in well with a discussion on
managing working capital and currency conversion costs, as well as with Review
Question 1 and Discussion Question 6.

Minimizing Currency Conversion Costs

• Because there is a lot of internal trade among the various units of some MNCs,
firms may experience a constant need to transfer funds among the subsidiaries’
bank accounts. Cumulative bank charges for these transactions can be high, and
consequently most MNCs use netting operations, where possible, to minimize the
amount of funds that must be converted.
• Bilateral netting is done between two business units, and multilateral netting
is done among three or more business units. The text provides and example of a
multilateral netting operation. Show Figure 18.3 and Table 18.3 here.

Minimizing Foreign-Exchange Risk

• Firms may use a leads and lags strategy to try to increase their net holdings of
currencies that are expected to rise in value and decrease their net holdings of
currencies that are expected to fall in value. The text provides an example of the
strategy.

IV. INTERNATIONAL CAPITAL BUDGETING

The more common approaches to evaluate investment projects are net present value,
internal rate of return and payback period.

Net Present Value

• Firms calculate the net present value of a project by estimating the cash flows
the project will generate in each time period, and discounting them back to present.
When evaluating international projects, firms must also consider risk adjustment,
currency selection, and choice of perspective for the calculations.
 International Financial Management > 35

• Risk Adjustment. Firms may adjust the discount rate upward, or the expected
cash flows downward, to account for a higher level of risk that may be associated
with a project in a particular country.
• Choice of Currency. The choice of which currency the project should be
evaluated in depends on the nature of the project. A project that is integral to a
subsidiary’s strategy may be evaluated in the foreign currency for example, while a
project that is central to the firm’s overall strategy might be evaluated in the home
country’s currency.
• Whose Perspective: Parent’s or Project’s? A firm must decide whether to
evaluate a project’s potential in terms of the cash flows of the individual project, in
terms of its impact on the parent company, or in terms of both. In addition, any
governmental restrictions on currency movements that might affect the firm’s ability
to repatriate profits must be considered.

Internal Rate of Return

• A project can also be evaluated using the internal rate of return. This method
requires that managers first estimate the cash flows generated by each project
under consideration in each time period, then the interest rate, or internal rate of
return is calculated that makes the net present value of the project just equal to
zero.
• The project’s internal rate of return is then compared to the hurdle rate, the
minimum rate of return the firm finds acceptable for its capital investments.

Payback Period

• A firm can also calculate a project’s payback period, the number of years it will
take to recover, or pay back, the project’s earnings from the original cash
investment, when evaluating projects. This method is a simple one, however, it
ignores the profits generated by the investment in the longer run.

V. SOURCES OF INTERNATIONAL INVESTMENT CAPITAL

Firms must secure sufficient capital to fund promising projects. Whether funds come
from internal sources or external ones, firms want to minimize the worldwide cost of
capital, foreign-exchange risk, political risk, and their global tax burden.

Investment Sources of Capital

• One source of investment capital is the cash that a firm generates internally. A
firm can use the cash flow generated by any subsidiary to fund the investment
projects of any other subsidiary, subject to legal constraints. Discuss Figure 18.4
here.
• There are two legal constraints that could affect the parent’s ability to shift funds
among its various affiliates. First, in cases where the subsidiary is not wholly one,
the rights of other shareholders must be considered. Second, intracorporate
transfer of funds may be limited by restrictions on the repatriation of profits. The
text provides several examples of how firms can avoid this latter constraint.

External Sources of Investment Capital

36 > Chapter 18

• Various debt and equity alternatives exist for firms that want to raise external
capital. For example, the text notes that KLM lists its shares in both New York and
Amsterdam. Funds may also be borrowed on a short or long term basis. Firms
could also enter the swap market and exchange financial obligations with another
firm.

CA

OS
SE

CL
IN
G
Janssen Pharmaceutica Cures Its Currency Ills

The closing case explores how the establishment of a financial coordination center has
facilitated the international financial management process for Janssen Pharmaceutica.

Key Points

• Janssen Pharmaceutica, a subsidiary of Johnson & Johnson (J&J) is a

multinational company headquartered in Belgium. The company’s competitive
strength is in product development. In fact, since 1970, only one firm in the world
ranked higher than Janssen in the development of new drugs.

• Janssen has also been an innovator in the management of corporate treasury

operations. Prior to 1984, the company tied up a considerable amount of working
capital because each of its 32 subsidiaries needed to maintain their own balances.
Moreover, currency conversion costs were high.

• In 1983, Belgium passed a new law that allowed companies to create

coordination centers to reduce the costs of corporate treasury activities. Janssen
established its coordination center in 1984 to provide a variety of financial services.

• The initial focus of the center was on treasury management--the management

of financial flows and of the currency and interest-rate risks associated with the
flows. The mission had three objectives: identify short-and medium-term financial
risks on a worldwide basis; quantify the risks and recommend appropriate
responses, and manage and control these financial exposures on a worldwide basis
subject to J&J’s corporate policies and procedures.

• The center not only acts as a centralized cash depository, it also performs
currency netting activities, and performs all currency and interest-rate exposure
management and lending activities for Janssen.

• Today, the center provides financial services for the entire J&J family. The
center manages exchange-rate risk in terms of the U.S. dollar.
 International Financial Management > 37

Case Questions

1. In essence, to qualify for the tax breaks offered to a Belgian coordination center, a
firm must be an MNC. Why would Belgium limit these tax breaks to multinationals?
Are Belgian authorities happy that Janssen’s coordination center is benefiting all of
J&J’s worldwide operations?

Belgium’s goal in changing its laws to allow for the establishment of coordination
centers was to improve the competitiveness of its firms that did business on an
international basis. The objective of the law was to lower the costs of corporate
treasury activities. Had Belgium left the establishment of coordination centers open
to all firms, it would probably have seen a drop in tax revenues since the corporate
tax burden for coordination centers is near zero. Most students will probably agree
that Belgian authorities are probably not happy that all of J&J’s operations are
benefiting from Janssen’s coordination center since it implies that Belgium is in
effect subsidizing an American company.

2. What are the advantages of having the Janssen coordination center act for J&J
worldwide? Are there any disadvantages?

A clear advantage of having the Janssen coordination center act for J&J worldwide
is the reduction of currency conversion costs that has occurred. In addition, the
center can locate lower-cost loans, and seek high short-term interest rates on a
worldwide basis. However, from J&J’s perspective, a disadvantage of using
Janssen’s coordination center is the fact that it is located in Belgium. Should
Belgian law change, J&J may be left without a coordination center.

3. Can you think of any other strategies for reducing currency conversion costs that
could be used by firms operating in Europe?

Most students will probably recommend that firms operating in Europe could reduce
their currency conversion costs by using a netting strategy. Netting involves
minimizing the amount of funds that must be converted in the foreign-exchange
market to settle transactions between subsidiaries. Netting can be done on either a
bilateral or on a multilateral basis.

Additional Case Application

The focus of this case is the new law in Belgium that permits firms to establish
coordination centers. The law was passed in the hopes that it would increase the
international competitiveness of Belgian firms, however, it is clear from the case that
foreign firms may be able to benefit from the legislation as well. Students can be
asked to debate the merits of such a law, and the implications it has for both
domestic and foreign firms.
38 > Chapter 18

VI

R
R

A
H
C
E

P
T
1. What special problems arise in financing and arranging payment for international
transactions?

There are several special problems in financing and arranging payment for international
transactions. First, the parties involved in the transaction must decide which currency will
be used. Second, the question of when and how to check credit arises. Third, the exporter
and importer must agree on which form of payment will be used. Finally, the financing
terms must be determined.

2. What are the major methods of payment used for international transactions?

The major methods of payment used for international transactions are payment in advance,
open account, documentary collection, letters of credit, credit cards, and countertrade.
Each form has a different degree of risk and cost.

3. What are the different types of letters of credit?

A letter of credit is a document issued by a bank that contains a promise to pay the
exporter upon receiving proof that the exporter has fulfilled all requirements specified in the
document. A confirmed letter of credit includes a guarantee by the exporter’s bank that it
will pay the exporter, should the other bank fail to. An irrevocable letter of credit cannot be
altered without the written consent of both parties to the transaction. A revocable letter of
credit may be altered any time, for any reason.

4. How do a time draft and a sight draft differ? A trade acceptance and a banker’s
acceptance?

A draft is a document in which payment is demanded from the buyer at a specified time. A
time draft extends credit to the importer by requiring payment at some specified time in the
future, while a sight draft requires payment upon the transfer of title to the goods from the
exporter to the importer. A trade acceptance is an accepted time draft, or a draft that the
importer has a legal obligation to pay when it comes due. A banker’s acceptance is a time
draft that has been accepted by the importer’s bank, and thus, has the bank’s obligation to
pay the draft.

5. How do the various types of countertrade arrangements differ from each other?

Countertrade occurs when a firm accepts something other than money as payment for its
goods and services. There are four types of countertrade: barter, counterpurchase, buy-
back, and offset purchase. A barter agreement involves each party simply swapping its
products for the other party’s products. A counterpurchase agreement involves one firm
selling its products to another at one point in time, and compensation in the form of the
other firm’s products coming at some future time. A buy-back arrangement involves one
firm selling capital goods to a second firm, with compensation coming in the form of output
generated as a result of their use. Finally, an offset purchase involves part of an exported
good being produced in the importing country.
6. What techniques are available to reduce transaction exposure? Discuss each.
 International Financial Management > 39

A firm has several options for reducing transaction exposure. First, a company could buy
the required foreign currency in the forward market, and thereby lock in the price it will pay
for it. Second, a firm could buy the required foreign currency in the currency options
market, which would give the company the opportunity, but not the obligation, to buy the
currency at a specified price in the future. Finally, a company could acquire an offsetting
asset.

7. What is translation exposure? What effect does a balance sheet hedge have on
translation exposure?

Translation exposure is the impact on the firm’s consolidated financial statements of

fluctuations in exchange rates that change the value of foreign subsidiaries as measured in
the parent’s currency. A balance sheet hedge is created when a firm matches its assets
denominated in a given currency with its liabilities in that currency. A balance sheet hedge
serves to eliminate translation exposure because it equalizes a firm’s assets and liabilities
for a given currency on a consolidated basis.

8. Why do MNCs engage in currency netting operations?

MNCs engage in currency netting operations to minimize the amount of funds that must be
converted in the foreign-exchange market to settle transactions between subsidiaries.
Netting may be done on a bilateral basis between two business units or on a multilateral
basis between three or more business units.

9. What capital budgeting techniques are available in international business?

The most common capital budgeting techniques used in international business are net
present value, internal rate of return, and payback period. The net present value approach
involves estimating the cash flows a project will generate in future time periods and
discounting them back to the present value. The internal rate of return method involves
estimating the cash flows generated by a project, calculating the internal rate of return that
makes the net present value of the project equal to zero, and comparing that rate to the
firm’s hurdle rate (minimum acceptable rate of return). Finally the payback period
approach involves calculating the number of years it will take the firm to recover from the
project’s earnings the original cash investment.

10. What is the difference between an interest rate swap and a currency swap?

An interest rate swap allows firms to change the nature and cost of a firm’s interest
obligations, while a currency swap is undertaken to change the currency in which the firm’s
debt is denominated.
40 > Chapter 18

Questions for Discussion

1. What are the advantages and disadvantages of each method of payment for international
transactions from the exporter’s perspective?

The most desirable form of payment from the exporter’s perspective is payment in advance
in the exporter’s currency. (A credit card may also be acceptable.) An open account, the
first choice of an importer, would be considered much less desirable because the importer
may fail to pay the account balance. Documentary collection is common, and involves a
legally enforceable debt instrument, however the exporter faces the risk that the importer
might default or fail to accept a draft. This risk can be minimized by the use of a letter of
credit, however, there are fees associated with buying this kind of “insurance against failure
to pay.” Countertrade may be appropriate if the exporter acquires goods that are easily
resold, but could be problematic if the countertraded goods are not sellable.

2. Which type of letter of credit is most preferable from the exporter’s point of view?

Most students will probably agree that from the exporter’s point of view an irrevocable
confirmed letter of credit is most preferable because not only does the exporter have its
own bank’s guarantee of payment, but the letter cannot be changed without the written
consent of both the importer and the exporter.

3. Why do firms use countertrade? What problems do they face when they do?

Countertrade occurs when a firm accepts something other than money as payment for its
goods or services. Firms frequently use countertrade when they are dealing with a country
that lacks a convertible currency, or when they are trying to expand their international sales
and need access to a foreign distribution network. There is very little risk for the importer in
a countertrade arrangement, but an exporter may be stuck will goods that are not easy to
sell.

4. How does capital budgeting for international projects differ from that for domestic projects?

While many of the same methods of project evaluation are used, capital budgeting for
international projects differs from that for domestic projects in several ways. First, a
company that uses the net present value technique for evaluating projects must consider
risk adjustment, currency selection, and the choice of perspective for the calculations.
Second, a firm that uses the internal rate of return method of evaluation will probably have
different hurdle rates to account for differences in risk among countries while a domestic
firm would have just one.

5. The "Bringing the World into Focus" box noted that some U.S. companies are losing
contracts to supply the Three Gorges Dam to European competitors because of the lack of
support from the U.S. Export-Import Bank. Should the Ex-Im Bank change its policy to aid
U.S. exporters? Or should the Ex-Im Bank maintain its pro-environment stance?

This is a difficult question to answer, and on that is sure to spark much debate among
students. Some students will argue that the U.S., in not supporting the Three Gorges Dam
effort, is overstepping its boundaries and interfering with the normal flow of free trade
markets. Others, however, will likely applaud the U.S. response to the project, and may
suggest that those governments that have provided support for the construction of the dam
 International Financial Management > 41

are ignoring long term, perhaps irreversible damage to the environment in favor of a few
fast bucks.

6. The government of Colefax and Fowler’s home country, the United Kingdom, has chosen
not to be a charter participant in the EU’s single currency scheme. Will this put Colefax
and Fowler at a disadvantage in competing for business in other EU countries? If so, is
there anything they can do to reduce their disadvantage?

Most students will probably agree that the U.K. decision to stay out of the single currency
scheme in the EU will probably put Colefax and Fowler at some disadvantage when
competing against other European wallpaper and fabric firms. The company presently
bears the cost of currency conversions, however, it has managed to effectively streamline
the process. It is likely that the firm will have to continue to absorb currency conversion
costs in the future, which will, of course, cut into profit margins.

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Essence of the exercise

This exercise asks students to test their skills on the Internet and expand their understanding
of export financing by assuming the role of a member of the marketing staff of a regional bank.
The bank has decided to target small businesses conducting foreign transactions, and would
like to set up a website that provides the necessary information to customers. Students are
asked to consider what information should be included in the site, and examine what other
banks have provided in their sites.
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Essence of the exercise

This exercise provides typical monthly transactions for the operating units of Belgian Lace
Products (BLP). The exercise asks students to examine BLP’s profit picture, develop a
currency conversion strategy, and evaluate the impact of a single European currency on BLP.

Answers to the follow-up questions.

1. Calculate the profitability of each of BLP’s five subsidiaries. (Because BLP is Belgian,
perform the calculations in terms of Belgian francs.) Are any of the subsidiaries
unprofitable? On the basis of the information provided, would you recommend shutting
down an unprofitable subsidiary? Why or why not?
42 > Chapter 18

Manufacturing Subsidiary:

Sales 15,000 €
Sales 12,500 €
Sales 17,5000 €
Sales 11,250 €
Costs (7,500) €
Costs ₤ 25,000 (33,250) €
Costs ¥3,000,000 (25,000) €
Costs $5,000 (5,000) €
(14,500) €

Belgian Distribution Subsidiary:

Sales 50,000 €
Payments (15,000) €
Payments (750) €
Payments ₤10,000 (13,300) €
20,950 €

British Distribution Subsidiary:

Sales ₤75,000 99,750 €
Payments (12,500) €
Payments ₤5,000 (6,650) €
Payments 1,000€(1,000) €
Payments $9,000 (9,000) €
70,600 €

Japanese Distribution Strategy:

Sales ¥5,000,000 41,667 €
Payments (17,500) €
Payments ¥3,000,000 (25,000) €
Payments $8,000 (8,000) €
(8,833) €

U.S. Distribution Subsidiary:

Sales $40,000 40,000 €
Payments (11,250) €
Payments $10,000 (10,000) €
Payments ¥300,000 (2,500) €
16,250 €

The above calculations indicate that both the BLP production facility and the Japanese
Distribution subsidiary were unprofitable in the time period for which figures were given.
Most students will probably agree that neither subsidiary should be shut without further
information. Students will probably suggest that BLP determine whether the product
manufactured at the production plant could be bought more cheaply elsewhere. In
addition, students will probably recognize that transfer prices may have affected profitability
figures, and that the firm may want to investigate the possibility of finding new distributors.
Finally, it should be pointed out that the figures given reflect the firm’s activity for only one
month.
 International Financial Management > 43

2. Suppose it costs each subsidiary 1 percent of the transaction each time it converts its
home currency into another currency in order to pay its suppliers. Develop a strategy by
which BLP as a corporation can reduce its total currency conversion costs. Suppose your
strategy costs BLP BF 15,000 per month to implement? Should the firm still adopt your
approach?

Most students will probably respond to this question by developing some sort of netting
strategy, and will conclude that even if BLP must spend 400 euros to implement the netting
strategy it would still be a worthwhile endeavor.

3. If the United Kingdom decided to join the EU's single currency bloc and use the euro, what
effect would this have on BLP? On the benefits and costs of the strategy you developed to
reduce its currency conversion costs?

Most students will probably recognize that the Britain's joining the single European
currency will be beneficial to BLP. With England as part of the single European currency,
conversion costs on the British pound would be eliminated for BLP’s European
subsidiaries, reducing the complexity of BLP’s financial management.

Other Applications
This Building Global Skills exercise focuses on the profitability of BLP’s various subsidiaries
and on the company’s currency conversion costs. Students may find it interesting to
consider the firm’s transaction exposure at any one point in time. Students, working in
groups, can be asked to develop a chart outlining each subsidiary’s exposure to exchange
rates and the various options available to both BLP and the distributors for dealing with
their exposure.