Increasingly international financial management is involved in global products and financial markets. The globalization movement implies that all the financial decisions, that is, investment, liquidity, and dividend financing must be made in an international context. Companies that operate in two or more countries, multinational corporations (MNC’s) have greatly increased worldwide political and economic interdependence. Currently MNC’s make direct investments in fully integrated operators ranging from the extraction of raw materials through to manufacturing process and distribution of products to consumers throughout the world. The basic principles of financial management involve the raising of funds in an economic and effective way for both domestic and international concerns. However, multinational companies are faced by a high degree of risk and uncertainty in regards to foreign currencies as their operations involve exchange rates. Foreign exchange rate management is an extra aspect of international finance that occupies most managers in respect to international trade (i.e. export and imports).Saudi Fertilizers Company is a case in study. The firm produces and exports its products to others and is therefore prone to foreign exchange rate fluctuations. In coming up with the single payment of 13.93 billion Japanese yen, Mitsubishi company must have incorporated the initial cost of manufacturing the vessel and its expected rate of return of 8% on long term projects. Mitsubishi utilized the non-discounted cash flow analysis and specifically the average rate of return in formulating the single payment (Bacchetta et al., 2005).
The actual rate of return is an investment appraisal method that is determined by ignoring the change in value of money. The rate of return is calculated using expected accounting profits and not cash flows as is the case of Saudi Fertilizers Company since no pay back periods were provided. This investment appraisal technique is computed as follows:
- ARR= (Average accounting profits/Average investments)*100
- Average investments is equal to a half of (initial cost + Salvage value)
The alternative offered by Mitsubishi is a 4×4-payment plan in which the Saudi Fertilizers Company would make four equal payments of purchase price as per schedule. A critical evaluation of this alternative is required through the DCF analysis (discounted cash flow analysis).The analysis takes into account the change in value of money and recognizes the fact that cash flow generated or paid out in different time periods would differ in value and therefore are not directly comparable. Such cash flows are compared when they are adjusted for change in value of money, that is, when they equivalents are converted to present values.
Present value =future value x (1+r/100)n where n is the number of years and r is the required rate of return.In the following analysis, the forecast exchange rate for US dollar/Japanese yen has being estimated using historical data.
Expected Expected:
Year Cash flow Exchange rate dollars PVIFn, 8% Present value cash flow:
- 0 3,750,000 76.97 48,720 1 48,720
- 0.71 3,750,000 77.55 48,356 0.9468 45,784
- 1.21 3,750,000 82.63 45,383 0.911 41,344
- 1.88 3,750,000 76.86 48,790 0.8651 42,208
- PV in dollars 178,056
The spot rate US dollars/Japanese yens on 15 November 2011 was 76.97(source x-rates.com), so the value of the vessel in a single payment would be 13.93 billion Japanese yens divided by 76.97=$180,980. From the analysis it is clear that the single payment amount was not fair and Saudi Fertilizers should opt for the 4×4 payment plan instead of the alternative which has an elimination of credit risk that Saudi Fertilizers Company may default in its payments.
The financial managers in MNC’s face many challenges, one of them being differences in currency denominations. The cash flow in the various types of a multinational will be denominated in different currencies and therefore the finance manager must analyze the exchange rates changes and the effects of fluctuating currency values on the firm’s cash flows and value. Another challenge in international financial management is foreign exchange risk, which emerges whenever some country’s assets and liabilities are denominated in a currency different from that of the home country. In order to device a forex hedging strategy the finance manager must:(a)Identify those values that are exposed to the risk of loss should exchange by a significant margin (b)decide whether he believes exchange rates can be forecasted (c)choose on the best strategy for hedging the identified risks. Alayannis et al. (2001) paper enlightens managers on international capital budgeting processes and explicitly examines misapplications such as applying corporate wide weighted average cost of capital to foreign affiliate cash flows rather than considering the total effect on the total corporation. Block’s paper explores the latest practices in corporate policy, FDI, capital structure, cost of capital and operations considerations.
They are three forex exposures namely translation risk, transaction risk and economic/exposure risk. The company (Saudi Fertilizers Company) should hedge the exchange risk as it is exposed to the transaction risk, which arises when currency has to be converted to make or receive payments for goods and services, repay loan or pay interest as well pay or receive dividends, importers and exporters are commonly subjected to transactions risk. Consequently Saudi Fertilizers Company will have to convert US dollars to Japanese yen in order to purchase the ship.
Forward contracts and future contracts are some of the tools used in hedging. The company had the option of using any of the aforementioned choices. A forward contract represents an agreement between two parties to exchange an asset in foreign currency at a predetermined future date for an exchange rate that is agreed upon today. In a forward market hedge, a net asset (liability) position is covered by a liability (or asset) in the forward market. This technique eliminates the downward risks but locks out any upward potential associated with the contract.
- November 15, 2011 3,750,000/76.97=$48,720
- July 30, 2012 3,750,000/81.7=$45,900
- January, 2012 3,750,000/81.2=$46,182
- September 31, 2013 3,750,000/80.2=46,758
- Total $187,560
An alternative to hedge the exchange rate risk is to use the call options. This is a type of future contracts, which are standardized contracts that are traded or offered on organized stock exchanges. The contract provides the right but not the obligation to buy or sell an underlying asset at a particular price during a specified time period. Future contracts are only executed when it is profitable to do so hence they are more expensive as compared with forward contracts. The call options as is the case study grants the holder a right to buy an underlying asset at a specified price during a specified period. An option will be ‘in money’ if gains are realized and “out of money’ if losses are made. From the schedule all the call options are “in money” for the buyer and “out of money” for the seller, so the company should adapt the call option as it is more favorable. Value of call=max (mps-exercise price) where mps is the prevailing price of security. The total value of the call options at an exercise price of JP¥ 81.90/US$ is 1.75 million dollars. Based on the historical performance and future exchange rate fluctuations Saudi Fertilizers Company should opt for future contracts.
References
Alayannis, G., Ihrig, J., and Weston, J. (2001). Exchange Rate Hedging: Financial versus Operational Strategies, in: American Economic Review, 91(2), 391-395.
Bacchetta, P., and Wincoop, E. (2005).Exchange rate exposure, hedging, and the use of foreign currency derivatives, in: Journal of International Money and Finance, 20, 273-296.