Financing the working capital requirements of a multinational companies foreign affiliates poses a complex decision problem. This complexity stems from the large number of financing options available to the subsidiary of an MNC. Subsidiaries have access to funds from sister affiliates and the parent, as well as external sources. This article focuses on developing policies for borrowing from either within or without the companies when the risk of exchange rate changes is present and different tax rates and regulations are in effect.
There are four aspects of short-term overseas financing strategy namely;
- Identifying the key factors,
- Formulating and evaluating objectives,
- Describing available short-term borrowing options and
- Developing a methodology for calculating and comparing the effective after-tax dollar costs of these alternatives.
1. Identifying Key Factors
There are six key factors in short- term financing the MNCs they are deviations of interest rates, exchange risk, degree of risk aversion, borrowing strategy and currency risk, tax asymmetries and political risk.
- Deviations in the rate of interest are the first risk factor. If forward contracts are unavailable, the crucial issue is whether differences in nominal interest rates among currencies are matched by anticipated exchange rate changes. The key issue here is whether there are deviations from the international rate of interest. If deviations do exist, then expected dollar borrowing costs will vary by currency, leading to a decision problem. Trade–offs must then be made between the expected borrowing costs and the exchange risks associated with each financing option.
- The element of exchange risk is the second key factor. Many firms borrow locally to provide an offsetting liability for their exposed local currency assets. On the other hand, borrowing a foreign currency in which the firm has no exposure will increase its exchange risk. What matters is the co-variance between the operating and financing cash flows. That is the risk associated with borrowing in a specific currency is related to the firm’s degree of exposure in that currency.
- The Third essential element is the firm’s degree of risk aversion. The more risk averse the firm (or its management) is, the higher the price it should be wiling to pay reduces its currency exposure. Risk aversion affects the company’s risk-cost, trade-off and consequently, in the absence of forward contacts, influences the selection of currencies it will use to finance its foreign operations.
- Borrowing Strategy and currency risk of the MNCs are the fourth risk factor. If forward contracts are available, however, currency risk should not be a factor in the firm’s borrowing strategy. Instead, relative borrowing costs, calculated on a conversed basis, become the sole determinant of which currencies to borrow in. The key issue here is whether the nominal interest differential equals the forward differential–that is, whether interest rate parity holds, then in the absence of tax considerations, the currency denomination of the firm’s debt is irrelevant.
- Tax asymmetries are the next risk factor. That is even if interest rate parity does hold before tax, the currency denomination of corporate borrowing does matter where tax asymmetries are present. These tax asymmetries are based on the differential treatment of foreign exchange gains and losses on either forward contracts or loan repayments.
- The last risk is the political risk. Even if local financing is not the minimum cost option, multinationals will often still try to maximize their local borrowing if they believe that expropriation or exchange controls are serious possibilities. If either event occurs, an MNC has fewer assets at risk if it has used local, rather than external, financing.
2. Formulating and Evaluating Objectives
The following are the objectives of the short-term financing the MNCs.
- Minimize expected cost. By ignoring this objective reduces information requirements, allows borrowing options to be evaluated on an individual basis without considering the correlation between loan cash flows and operating cash flows, and lends itself readily to break-even analysis.
- Minimize risk without regard to cost. A firm that followed this advice to its logical conclusion would dispose of all its assets and invest the proceeds in government securities. In other words, this objective is impractical and contrary to shareholder interests.
- Trade of expected cost and systematic risk. The advantage of this objective is that, like the first objective, it allows a company to evaluate different loans without considering the relationship between loan cash flows and operating cash flows form operations. More over, it is consistent with shareholder preferences as described by the Capital Asset Pricing Model (CAPM). In Practical terms, however, there is probably little difference between expected borrowing cost adjusted for systematic risk and expected borrowing costs without that adjustment. This lack of difference is because the correlation between currency fluctuations and a well diversified portfolio of risky assets is likely to be quite small.
- Trade of expected cost and total risk. Basically, it relies on the existing of potentially substantial costs of financial distress. On a more practical level management generally prefers greater stability of cash flows (regardless of investor preferences). Management will typical self-insure against most losses, but might decide to use the financial markets to hedge against the risk of large losses.
3. Short-term Financing Options
The following are the options available to finance the MNCs.
- The inter-company,
- The local currency loan, and
- Euro notes and Euro-commercial paper.
This is the most common short term financing system among the MNCs. Here under this system, either the parent company or sister affiliate provide an inter-company loan. At times, however, these loans may be limited in amount or duration by official exchange, controls, etc. In addition, interest rates on inter-company loans are frequently required to fall within set limits. Normally, the lender’s government will want the interest rate on an intercompany loan to be set as high as possible for both tax an balance-of-payments purposes, while the borrower’s government will demand a low interest rate for similar reasons.
Local Currency Financing
This is another common system of financing the MNCs. Like the domestic firms, subsidiaries of multinational Companies generally attempt to finance their working capital requirements locally, for both convenience and exposure management purposes. Since all industrial nations have well-developed commercial banking systems, firms desiring local financing generally turn there first. The major forms of bank financing include overdrafts, discounting, line of credit, revolving credit and term loans.
- Term Loans: Loans from commercial banks are the dominant form of short-term interest-bearing financing used around the world. These loans are described as self-liquidating because they are usually used to finance temporary increases in accounts receivable and inventory. These increases in working capital are soon converted into cash, which is used to repay the loan. Short-term bank credits are typically unsecured. The borrower signs a note evidencing its obligation to repay the loan when it is due, along with accrued interest. Most notes are payable 90 days; the loan must, therefore, be repaid or renewed every 90 days. The need to periodically roll over bank loans gives substantial control over the use of its funds, credits are not being used for permanent financing, a bank will usually insert a cleanup clause requiring the company to be completely out of debt to the bank for a period of at least 30 days during the year.The interest rate on bank loans is based on personal negotiation between the banker and the borrower. The loan rate charged to a specific customer reflects that customer’s creditworthiness, previous relationship with the bank, the maturity of the loan, and other factors. Ultimately, of course, bank interest rates are based on the same factors as the interest rates on the financial securities issued by a borrower: the risk-free return, which reflects the time value of money, plus a risk premium based on the borrower’s credit risk. However, there are certain bank loan pricing conventions that you should be familiar with. Interest on a loan can be paid at maturity or in advance. Each payment method gives a different effective interest rate, even if the quoted is the same.
- Overdrafts: An overdrafts is simply a line of credit against which drafts (checks) can be drawn (written) upto a specified maximum amount. These overdraft lines are often extended and expanded year after year, thus providing in effect, a form of medium-term financing. The borrower pays interests on the debit balance only.
- Line of Credit: Arranging separate loans for frequent borrowers is a relatively expensive means of doing business. One way to reduce these transaction costs is to use a line of credit. This formal agreement permits the company to borrow up to a stated maximum amount from the bank. The firm can draw down its line of credit when it requires funds and pay back the loan balance when it has excess cash. Although the bank is not legally obligated to honour the line-of-credit agreement, it almost always does unless it or the firm encounters financial difficulties. A line of credit is usually good for one year, with renewals renegotiated every year.
- Revolving Credit Agreement: A revolving credit agreement is similar to a line of credit except that now the bank (or syndicated of banks) is legally committed to extend credit up to the stated maximum. The firm pays interest on its outstanding borrowings plus a commitment fee, ranging between 0.125% and 0.5% per annum, on the unused portion of the credit line. Revolving credit agreements are usually renegotiated every two or three years. The danger that short-term credits are being used to fund long-term requirements is particularly acute with a revolving credits line that is continuously renewed; inserting an out-of-debt period under a cleanup clause validates the temporary need for funds.
- Discounting: Discounting usually results from the following set of transactions. A manufacturer seller goods to a retailers on credit draws a bill on the buyer, payable in, say, 30 days. The buyer endorses (accepts) the bill or gets his or her bank to accept it, at which point it becomes a banker’s acceptance. The manufacturer then takes the bill to his or her bank, and the bank accepts it for a fee if the buyer’s bank has not already accepted it. The bill is then sold at a discount to the manufacturer’s banks or to a money maker dealer. The rate of interest varies with the term of the bill and the general level of local money market interest rates.
Euro Notes and Euro-Commercial Paper
A recent innovation in non-bank short-term credits that bears a strong resemblance to commercial paper is the so-called Euro note. Euro notes are short-term notes usually denominated in dollars and issued by Companies and governments. The prefix “Euro” indicates that the notes are issued outside the country in whose currency they are denominated. The interest rates are adjusted each time the notes are rolled over. Euro notes are often called Euro-commercial paper (ECP, for short). Typically, though, the same ECP is reserved for those Euro notes that are not underwritten.
There are some differences between the U.S. commercial paper and the ECP markets. For one thing, the average maturity of ECP is about twice as long as the average maturity of U.S. CP. Also, ECP is actively traded in a secondary market, but most U.S. CP is held to maturity by the original investors. Central banks, commercial banks, and Companies are important parts of the investor base for particular segments of the ECP market; the most important holders of U.S. CP are money market funds, which are not very important in the ECP market. In addition, the distribution of U.S. issuers in the ECP market is of significantly lower quality that the distribution of U.S. issuers in the U.S. CP market. An explanation of this finding may lie in the importance of banks as buyers of less-than-prime paper in the ECP market.
Read More: Euro Notes and Euro Commercial Paper
4. Alternative Financing Options
It gives the formulas to compute the effective dollar costs of a local currency loan and a dollar loan for both the no-tax and tax cases. These cost formulas can be used to calculate the least expensive financing source for each future exchange rate. This can be calculated through break-even analysis and determine the range of future exchange rates within which each particular financing option is cheapest. The logic of this break-even analysis can be extended to financing alternatives. In all situations, the cost of each source of funds must be calculated in terms of the relevant parameters and the expense compared with that of all other possibilities.