École Supérieure Libre des Science

Commerciales Appliquées

Program: MIBA
Group: Eslsca 31-D
Dr. Shamel El.Hamawy
Citrus Product Int. Case Analysis – International
Finance
Presented by: Ahmed Mohamed Atef Selim
Beram.

1
Citrus Products Inc. is a medium-sized producer of citrus juice drinks
with groves in Indian River County, Florida. Until now, the company has
confined its operations and sales to the United States; but its CEO,
George Gaynor, wants to expand into the Pacific Rim. The first step is
to set up sales subsidiaries in Japan and Australia, then to set up a
production plant in Japan, and finally to distribute the product
throughout the Pacific Rim. The firm’s financial manager, Ruth
Schmidt, is enthusiastic about the plan; but she is worried about the
implications of the foreign expansion on the firm’s financial
management process. She has asked you, the firm’s most recently
hired financial analyst, to develop a 1-hour tutorial package that
explains the basics of multinational financial management. The tutorial
will be presented at the next board of directors meeting. To get you
started, Schmidt has given you the following list of questions.

2
A. What is a multinational corporation? Why do firms expand into
other countries?

Answer

A Multinational Enterprise is a corporation that has operating subsidiaries and branches

located in foreign countries (Coca-Cola, McDonalds), It also includes firms in service
activities such as banking (Barclays), telecommunication (Vodafone) and lodging (Marriott)

THE MNE, A BEHAVIORAL VIEW: State of mind: committed to producing, undertaking

investment and marketing, and financing globally.

Main Objective of MNE is:

A. Maximize shareholder wealth
B. Ability to Link via affiliate transfer mechanisms

Decision making within the corporation may be centralized in the home country, or may be
decentralized across the countries the corporation does business in.

Strategic motives: drive the decision to invest abroad in order to become an MNE, these
motives can be divided into five categories:

1. Market Seekers: produce in foreign markets to satisfy local demand or exports

(example: US Automakers)

2. Raw Material Seekers such as oil and mining companies

3. Production efficiency seekers which produces in countries where productions factors

are underpriced relative to their productivities ( (Electronics in Taiwan and China)

4. Knowledge Seekers which operates in countries to gain access to technology or

managerial expertise. No one country has the lead in all technologies, so many
companies are going global to ensure access to new technologies.

5. Political safety seekers where it acquire or establish facilities in stable countries

3
6. To diversify: By establishing worldwide production facilities and markets, firms can
cushion the impact of adverse economic trends in any single country.

C. What are the 5 major factors that distinguish multinational financial management
from financial management as practiced by a purely domestic firm?

Answer

The globalization process is the structural and managerial changes and challenges
experienced by a firm as it moves from domestic to global in operations

MNE must respond to globalization factors and the demands of financial management
increases over and above the traditional requirements of the domestic-only business

THE MULTINATIONAL FINANCIAL SYSTEM is characterized by:

• Mode of Transfer: Reflects freedom to select a variety of financial channels.

• Timing Flexibility: Most MNC have some flexibility in timing of fund flows.
• Value: building the firm value pyramid (The expansion and development of the 3 sides of
the global pyramid (An open market place, high quality strategic management and
access to affordable capital)

THE GLOBAL MANAGER

• Understands political and economic differences

• Searches for most cost- effective suppliers

• Evaluates changes on value of the firm

The 5 major factors that distinguish multinational financial management from

financial management as practiced by a purely domestic firm are:

First: Different currency denominations.

• Direct foreign exchange risks are now borne by the firm

• Pricing and payments may be in different currencies

4
• The value of these foreign currency receipts and payments can change, creating a new
source of risk

• Cash flows in various parts of multinational corporate systems will be denominated in

different currencies. Hence, an analysis of exchange rates, and the effect of fluctuating
currency values, must be included in all financial analyses.

Second: Cultural differences

Different countries, and even different regions in a single country, have unique cultural
heritages that shape values and influence the role of business in the society. Such
differences affect consumption patterns, defining the appropriate firm goals, attitudes
toward risk taking, dealings with employees.
Third: Economic and legal ramifications.

Each country in which a firm operates will have its own unique political and economic
institutions, and institutional differences can cause significant problems when the
corporation tries to coordinate and control worldwide operations. For example, tax laws
vary from country to country, and what makes sense in one country regarding taxes may
not in another. Similarly, differences in legal systems, such as the common law of Great
Britain versus French civil law, complicate legal matters.
Forth: Language differences.

The ability to communicate is critical in all business matters, and U. S. business men and
women have been notoriously poor in learning other languages. In effect, it is easier for
foreign firms to invade our markets than for us to invade theirs. It is interesting to note,
though, that English has become the international business language.

Fifth: Role of governments and Political risk.

Except for certain industries, the role of government is to create an environment which
promotes free enterprise and competition. However, in many countries, the government
takes a much more active role in business affairs, and in some countries, a multinational
firm must deal directly with the government to conduct business.
Nations exercise sovereign rights over their people and property. Thus, a government can
seize the assets of a multi-national corporation, or restrict the repatriation of earnings from
the country, and the affected company has no recourse for recovery.

5
C. Consider the following illustrative exchange rates.

U.S. Dollars Required to Buy

One Unit of Foreign Currency

Japanese yen 0.009

Australian dollar 0.650

Answer

(1) Are these currency prices direct quotations or indirect quotations?

Direct quotations: 1 foreign currency unit = x home currency units

Indirect quotations: 1 home currency unit = x foreign currency units

• Most exchange rates are stated in terms of an indirect quotation.

Since the above prices of foreign currencies expressed in dollars, they are direct
quotations

C. (2)Calculate the indirect quotations for yen and Australian dollars.

Answer

Indirect quotations: are the numbers of units of foreign currency that can be purchased
with one U. S. Dollar.

# of units of foreign

Currency per US $

Japanese yen 111.11

6
Australian dollar 1.5385

This is by finding the inverse of the direct quotations.

C. (3)what is a cross rate? Calculate the two cross rates between yen and Australian
dollars.

Answer

• Cross rate is the exchange rate between any two currencies. Cross rates are actually
calculated on the basis of various currencies relative to the U.S. dollar.

• Cross rate between Australian dollar and the Japanese yen.

 Cross rate = (Yen / US Dollar) x (US Dollar / A. Dollar)

= 111.11 x 0.650 = 72.22 Yen / A. Dollar

• The inverse of this cross rate yields: 0.0138 A. Dollars / Yen

C. (4) Assume that Citrus Products can produce a liter of orange juice and ship it to
Japan for $1.75. If the firm wants a 50% markup on the product, what should the
orange juice sell for in Japan?

Answer

Price = (1.75) (1.50) (111.11) = 291.66 yen

C. (5)now assumes that Citrus Products begins producing the same liter of orange
juice in Japan. The product costs 250 yen to produce and ship to Australia, where it
can be sold for 6 Australian dollars. What is the U.S. dollar profit on the sale?

Answer

• Cost in A. dollars = 250 yen (0.0138) = 3.45 A. dollars

• A. dollar profit = 6 – 3.45 = 2.55 A. dollars

7
• U.S. dollar profit = 2.55 / 1.5385 = $1.66

C. (6)what is exchange rate risk?

Answer

• The risk that the value of a cash flow in one currency translated to another currency
will decline due to a change in exchange rates.

• The volatility inherent in a floating exchange rate system increases the uncertainty of
cash flows that must be translated from one currency into another. This increase in
uncertainty is exchange rate risk.

D. Briefly describe the current international monetary system. What are the different
types of exchange rate systems?

Answer

The rules and procedures for exchanging national currencies are collectively known as the
international monetary system. This system doesn't have a physical presence, it consists
of interlocking rules and procedures and is subject to the foreign exchange market, and
therefore to the judgments of currency traders about a currency.

When a currency increases in value relative to another currency, it is said to appreciate.

Under the fixed exchange rate system, strong currencies had to be revalued occasionally,
which changed the tie to other currencies to a new, higher rate. Conversely, a currency
that loses value is said to depreciate, and such currencies had to be devalued under the
old fixed rate system.

The current international monetary system is a floating exchange rate system.

The three main categories of exchange rate system are:

8
1. Flexible exchange rate systems (also known as floating exchange rate systems.)
2. Managed floating rate systems.
3. Fixed exchange rate systems (also known as pegged exchange rate systems).

Flexible Exchange Rate Systems

• In a flexible exchange rate system, the value of the currency is determined by the
market, i.e.by the interactions of thousands of banks, firms and other institutions
seeking to buy and sell currency for purposes of transactions clearing, hedging,
arbitrage and speculation.
• So higher demand for a currency, all else equal, would lead to an appreciation of the
currency.
• Lower demand, all else equal, would lead to a depreciation of the currency. An
increase in the supply of a currency, all else equal, will lead to a depreciation of that
currency while a decrease in supply, all else equal, will lead to an appreciation.
• Essentially, we can characterize the equilibrium exchange rate under a flexible
exchange rate system as the value that is consistent with covered and uncovered
interest rate parity given values for the expected future spot rate and the forward
exchange rate.
Managed Floating Rate Systems
• A managed floating rate systems is a hybrid of a fixed exchange rate and a flexible
exchange rate system.
• In a country with a managed floating exchange rate system, the central bank becomes
a key participant in the foreign exchange market.
• Unlike in a fixed exchange rate regime, the central bank does not have an explicit set
value for the currency; however, unlike in a flexible exchange rate regime, it doesn’t
allow the market to freely determine the value of the currency.
• Instead, the central bank has either an implicit target value or an explicit range of target
values for their currency: it intervenes in the foreign exchange market by buying and
selling domestic and foreign currency to keep the exchange rate close to this desired
implicit value or within the desired target values.
Fixed (Pegged) Exchange Rate Systems
• This type of system, were the central bank fixes the value of the currency, but has
the ability to change the value of the currency when it so desires is known as an
adjustable pegged exchange rate system
• The basic motivation for keeping exchange rates fixed is the belief that a stable
exchange rate will help facilitate trade and investment flows between countries by
reducing fluctuations in relative prices and by reducing uncertainty.

9
• In order to do this exchange the Central Bank must hold stocks of both foreign and
domestic currency.
In any market, there will be situations of excess demand and excess supply.
 Under a flexible exchange rate system, these changes cause appreciation or
depreciation of the currency respectively.
 Under a fixed exchange rate system the Central Bank remains prepared to absorb the
excess demand or supply.

E. What is the difference between spot rates and forward rates? When is the forward
rate at a premium to the spot rate? At a discount?

Answer

Spot rates are the rates to buy currency for immediate delivery. (Actually, two days after
the date of the trade).
Forward rates are the rates to buy currency at some agreed-upon date in the future. Firms
use currency forward markets to hedge against adverse exchange rate fluctuations that
might occur before a transaction is completed thus locking in the current forward rate.

When is the forward rate at a premium to the spot rate? At a discount?

If the forward currency is less valuable than the spot currency, the forward rate is said to
be at a discount to the spot rate. Conversely, if the forward currency is more valuable
than the spot currency, the forward currency is said to sell at a premium.
• If the U.S. dollar buys fewer units of a foreign currency in the forward than in the spot
market, the foreign currency is selling at a premium. In the opposite situation, the foreign
currency is selling at a discount.

• The primary determinant of the spot/forward rate relationship is relative interest rates.

10
F. What is interest rate parity? Currently, you can exchange 1 yen for 0.0095 U.S.
dollar in the 30-day forward market, and the risk-free rate on 30-day securities is
4% in both Japan and the United States. Does interest rate parity hold? If not,
which securities offer the highest expected return?

Answer

Interest rate parity holds that investors should expect to earn the same return in all
countries after adjusting for risk.

ft 1 + kh
=
e0 1 + k f

f t = t - period forward exchange rate

e 0 = today' s spot exchange rate
k h = periodic interest rate in home country
k f = periodic interest rate in foreign country

ft = 0.0095 - kh = 4% / 12 = 0.333% - kf = 4% / 12 =
0.333%

0.0095 1.0033
=
e0 1.0033

0.0095
=1
e0

Therefore, for interest rate parity to hold, e0 must equal $0.0095 but we were given earlier
that e0 = $0.0090.

Which securities offer the highest expected return?

The Japanese security

11
• Convert $1,000 to yen in the spot market.
$1,000 x 111.111 = 111,111 yen.

• Invest 111,111 yen in 30-day Japanese security. In 30 days receive 111,111 yen x
1.00333 = 111,481 yen.

• Agree today to exchange 111,481 yen 30 days from now at forward rate,
111,481/105.2632 = $1,059.07.

• 30-day return = $59.07/$1,000 = 5.907%, nominal annual return = 12 x 5.907% =

70.88%

G. What is purchasing power parity (PPP)? If grapefruit juice costs $2.00 a liter in
the United States and purchasing power parity holds, what should be the price of
grapefruit juice in Australia?

Answer

Purchasing power parity implies that the level of exchange rates adjusts so that identical
goods cost the same amount in different countries.

Purchasing power parity, sometimes referred to as the law of one price (LOP)

The price of grapefruit juice in Australia is:

Ph = Pf (e0)

-OR-

e0 = Ph/Pf

$0.6500 = $2.00/Pf

Pf = $2.00/$0.6500 = 3.0769 Australian dollars.

H. What effect does relative inflation have on interest rates and exchange rates?

12
Answer

Lower inflation leads to lower interest rates, so borrowing in low-interest countries may
appear attractive to multinational firms.

However, currencies in low-inflation countries tend to appreciate against those in

high-inflation rate countries, so the effective interest cost increases over the life of the
loan.

I.1 Identify explain the three major types of international credit markets.

Answer

Three major types of international credit markets.

• Euronote market

 A source of dollars outside the U.S.

 Collective term for medium and short term debt instruments sourced in the
Eurocurrency market

 Two major groups

• Underwritten facilities and non-underwritten facilities

• Non-underwritten facilities are used for the sale and distribution of Euro-
commercial paper (ECP) and Euro Medium-term notes (EMTNs)

 Interest rates on euronotes are tied to the London Interbank Offer Rate (LIBOR),
which is the rate of interest offered by the largest and strongest London banks on
eurodollar deposits.
• International Bonds market

 Falls within 2 categories:

• Foreign bonds – sold by foreign borrower, but denominated in the currency of the
country of issue.

13
 • Eurobonds – sold in country other than the one in whose currency the bonds are
denominated.

 The distinction between categories is based on whether the borrower is a domestic or

foreign resident and whether the issue is denominated in a local or foreign currency

 In general, countries do not apply as stringent requirements on bonds denominated in

a foreign currency as they do bonds denominated in the home currency.

 Most eurobonds are issued in bearer form, so buyers have anonymity, both for tax
and other purposes. For these reasons, investors are usually willing to accept
somewhat lower yields on eurobonds than on foreign bonds or “regular” bonds.

• Bank loan and syndicated credits

 Traditionally sourced in euro currency markets

 Also called euro dollar credits or euro credits

• Euro credits are bank loans denominated in euro currencies and extended by
banks in countries other than in whose currency the loan is denominated

 Syndicated credits

• Enables banks to risk lending large amounts

• Arranged by a lead bank with participation of other bank

 Narrow spread, usually less than 100 basis points

14
I.2 briefly explains how ADRs work.

Answer

Besides obtaining a direct listing on an US stock exchange, foreign firms can and typically
prefer to participate in a so called American Depository Receipt (ADR) Program.

Depository Receipts are certificates issued by a US Depository Bank and represent a non-
US company’s traded equity or debt. The company’s original shares are held in custody by
the issuing bank in the company’s home country.

In return, the foreign company must provide detailed financial information to the sponsor
bank. The depositary bank sets the ratio of U.S. ADRs per home-country share. This ratio
can be anything less than or greater than 1. This is done because the banks wish to price
an ADR high enough to show substantial value, yet low enough to make it affordable
for individual investors.
15
ADRs were introduced as a result of the complexities involved in buying shares in foreign
countries and the difficulties associated with trading at different prices and currency
values. For this reason, U.S. banks simply purchase a bulk lot of shares from the
company, bundle the shares into groups, and reissues them on the New York Stock
Exchange (NYSE), American Stock Exchange (AMEX) or the Nasdaq.

There are three different types of ADR issues:

• Level 1 - This is the most basic type of ADR where foreign companies either don't
qualify or don't wish to have their ADR listed on an exchange. Level 1 ADRs are found
on the over-the-counter market and are an easy and inexpensive way to gauge
interest for its securities
• Level 2 - This type of ADR is listed on an exchange or quoted on Nasdaq. Level 2 ADRs
have slightly more requirements, but they also get higher visibility trading volume.
• Level 3 - The most prestigious of the three, this is when an issuer floats a public
offering of ADRs on a U.S. exchange. Level 3 ADRs are able to raise capital and gain
substantial visibility in the U.S. financial markets.

The advantages of ADRs are twofold. For individuals, ADRs are an easy and cost-effective
way to buy shares in a foreign company. They save money by reducing administration
costs and avoiding foreign taxes on each transaction. Foreign entities like ADRs
because they get more U.S. exposure, allowing them to tap into the wealthy North
American equities markets.

Thereof, only Level II and III ADRs allow firms to be listed on an US stock exchange, and
only a Level III issue allows firms to raise new capital. Accordingly, level II and level III
issues have very high informational requirements with firms having to register with the US
Securities and Exchange Commission and comply with US GAAP disclosure requirements

There are some risks associated with buying ADRs, including inflationary
risk, political risk and exchange rate risk.

J. To what extent do average capital structures vary across different countries?

Answer

There is some evidence that average capital structures vary among the large industrial
countries. One problem, however, when interpreting these numbers is that different
countries often use very different accounting conventions, which makes it difficult to
compare capital structures.
16
A recent study attempts to control for differences in accounting practices. This study
suggests that differences in accounting practices can explain much of the cross-country
variation in capital structures. After adjusting for these accounting differences, capital
structures are more similar across different countries than a previous study had
suggested.

k. What is the effect of multinational operations on capital budgeting decisions?

Answer

The same general principles which apply to domestic capital budgeting also apply to
foreign capital budgeting. However, foreign capital budgeting is complicated by the
following three primary factors:

1. Tax law differences. Foreign operations are usually taxed at the local level, and then
funds repatriated, or returned, to the parent corporation may be subject to additional
other country taxes.

2. Political risk. Foreign projects are subject to political risk. Foreign governments have
the right to restrict the amount of funds that can be repatriated. In extreme cases,
foreign governments can even expropriate the assets owned by U. S. companies without
offering any compensation.

3. Exchange rate risk. Funds repatriated from foreign operations have to be converted
into dollars, so foreign capital projects are subject to exchange rate risk, so exchange
rate risk must be taken into account.

17