Chapter

20
Short-Term Financing

See c20.xls for spreadsheets to

accompany this chapter.

South-Western/Thomson Learning 2003

 Chapter Objectives

To explain why MNCs consider

foreign financing;
To explain how MNCs determine whether
to use foreign financing; and
To illustrate the possible benefits of
financing with a portfolio of currencies.

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 Sources of Short-Term Financing

Euronotes are unsecured debt securities

with typical maturities of 1, 3 or 6 months.
They are underwritten by commercial
banks.
MNCs may also issue Euro-commercial
papers to obtain short-term financing.
MNCs utilize direct Eurobank loans to
maintain a relationship with the banks too.

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 Internal Financing by MNCs

Before an MNCs parent or subsidiary

searches for outside funding, it should
determine if any internal funds are
available.
Parents of MNCs may also raise funds by
increasing their markups on the supplies
that they send to their subsidiaries.

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 Why MNCs Consider
Foreign Financing
An MNC may finance in a foreign currency
to offset a net receivables position in that
foreign currency.
An MNC may also consider borrowing
foreign currencies when the interest rates
on such currencies are attractive, so as to
reduce the costs of financing.

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 Short-Term Interest Rates

25
25 Canada
20
20

15
15
U.K.
10
10

55 Japan
Germany U.S.
00
1978
1978 1982
1982 1986
1986 1990
1990 1994
1994 1998
1998 2002
2002

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 Determining the
Effective Financing Rate
The actual cost of financing depends on
the interest rate on the loan, and
the movement in the value of the
borrowed currency over the life of the
loan.

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 Determining the
Effective Financing Rate
At time t 1 year later
1. Borrows 3. Has to pay
NZ$1,000,000 back
at 8.00% NZ$1,080,000
for 1 year
Exchange rate Exchange rate
= $0.50/NZ$ = $0.60/NZ$
What is the effective
2. Converts financing rate? 4. Converts
to $500,000 to $648,000
$648k $500k = 29.6%
$500k
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 Determining the
Effective Financing Rate
Effective financing rate, rf
{(1+if ) St+1} {1 St} S
= = (1+if ) t+1 1
{1 St} St
where if = the interest rate on the loan
St = beginning spot rate
St+1 = ending spot rate
The effective rate can be rewritten as
rf = (1+if ) (1+ef ) 1
where ef = the % D in the spot rate
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 Online Application

Current interest rates and exchange rates

are available at http://www.bloomberg.com/.
Interest rate and exchange rate forecasts
can be found at http://biz.yahoo.com/ifc/.

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 Criteria Considered for
Foreign Financing
There are various criteria an MNC must
consider in its financing decision,
including
interest rate parity,
the forward rate as a forecast, and
exchange rate forecasts.

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 Criteria Considered for
Foreign Financing
Interest Rate Parity (IRP)
If IRP holds, foreign financing with a
simultaneous hedge of that position in the
forward market will result in financing
costs similar to those for domestic
financing.

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 Implications of IRP for Financing
IRP Type of Financing
holds? Scenario financing costs*
Yes Covered Similar
Forward rate accurately
Yes predicts future spot rate Uncovered Similar
Forward rate over-
Yes estimates future spot rate Uncovered Lower
Forward rate under-
Yes estimates future spot rate Uncovered Higher
Forward premium(discount)
No exceeds (is less than) Covered Higher
interest rate differential
Forward premium (discount)
No is less than (exceeds) Covered Lower
interest rate differential
* as compared to the financing costs for domestic financing
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 Criteria Considered for
Foreign Financing
The Forward Rate as a Forecast
If the forward rate is an unbiased predictor
of the future spot rate, then the effective
financing rate of a foreign loan will on
average be equal to the domestic
financing rate.

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 Criteria Considered for
Foreign Financing
Exchange Rate Forecasts
Firms may use exchange rate forecasts to
forecast the effective financing rate of a
foreign currency, or they may compute the
break-even exchange rate that will equate
the domestic and foreign financing rates.
Sometimes, it may be useful to develop
probability distributions, instead of relying
on single point estimates.
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 Actual Results
From Foreign Financing
The fact that some firms utilize foreign
financing suggests that they believe
reduced financing costs can be achieved.

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 Financing with Yens versus Dollars
Annualized
interest rates (%) US$/100
40 1.4
30 1.2
20 $/100 1
10 U.S. 0.8
0 0.6
Japan
-10 0.4
-20 0.2
Effective rate
-30 0
1990 1992 1994 1996 1998 2000 2002

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 Financing with a
Portfolio of Currencies
While foreign financing can result in
significantly lower financing costs, the
variance in the costs is higher.
MNCs may be able to achieve lower
financing costs without excessive risk by
financing with a portfolio of currencies.

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 Financing with a
Portfolio of Currencies
If the chosen currencies are not highly
positively correlated, they will not be likely
to experience a high level of appreciation
simultaneously.
Thus, the chances that the portfolios
effective financing rate will exceed the
domestic financing rate are reduced.

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 Financing with a
Portfolio of Currencies
A firm that repeatedly finances in a
currency portfolio will normally prefer to
compose a financing package that
exhibits a somewhat predictable effective
financing rate on a periodic basis.
When comparing different financing
packages, the variance can be used to
measure how volatile a portfolios
effective financing rate is.
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 Financing with a
Portfolio of Currencies
For a two-currency portfolio,
E(rP) = wAE(rA) + wBE(rB)
where rP = the effective financing rate of the
portfolio
rX = the effective financing rate of
currency X
wX = the % of total funds financed from
currency X

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 Financing with a
Portfolio of Currencies
For a two-currency portfolio,
Var(rP) = wA2A2 + wB2B2 + 2wAwBABCORRAB
X2 = the variance of currency Xs
effective financing rate
CORRAB = the correlation coefficient of the two
currencies effective finance rates

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Impact of Short-Term Financing Decisions
on an MNCs Value
Expenses Incurred from
Short-Term Financing

m
n
E CFj , t E ER j , t
j 1
Value =
t =1 1 k t


E (CFj,t ) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = weighted average cost of capital of the parent
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 Chapter Review

Sources of Short-Term Financing

Euronotes
Euro-Commercial Paper
Eurobank Loans
Internal Financing by MNCs
Why MNCs Consider Foreign Financing
Foreign Financing to Offset Foreign
Receivables
Foreign Financing to Reduce Costs
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 Chapter Review

Determining the Effective Financing Rate

Criteria Considered for Foreign Financing
Interest Rate Parity
The Forward Rate as a Forecast
Exchange Rate Forecasts
Actual Results From Foreign Financing

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 Chapter Review

Financing with a Portfolio of Currencies

Portfolio Diversification Effects
Repeated Financing with a Currency
Portfolio
Impact of Short-Term Financing Decisions
on an MNCs Value

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