Question
Citrus Products Inc. is a medium-sized producer of
citrus juice drinks with groves in River County, Florida. Until now, the
company has confined its operation and sales to the United States, but its CEO,
George Gaynor, wants to expand to Europe. The first step would be to set up sales
subsidiaries in Spain and Sweden, then to step a set a production plant in
Spain and finally to distribute the product throughout the European Common
Market. 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 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 supplied
you with the following list of questions.
a) Explain the
reasons that firms expand to other countries?
There are several reason that firms expands to
another country, namely looking for new markets, looking for new technology,
diversify the business risk, avoid political and regulation barrier, and seek
for raw material.
First reason is looking for new markets. For
companies in mature industries, breaking into new markets can expand the full
potential of their business. For example, Berjaya Land Berhad, Malaysia company
which is building the world’s biggest integrated mall complex estimated to be
worth RM 7.5 billion on a 32ha site in China’s Hebei Province (Business Times, 2012). In the same way,
according to (Asiaone, 2011) Deputy Prime Minister Tan Sri Muhyiddin
Yassin said there were more than 120 companies in various industries with
Chinese interest operating in Malaysia at the moment. The Chinese
telecommunication company, Huawei also proposed making Malaysia its global
centre for training and education. Actually, by looking for a new market, the
multinational company can fill product gap in foreign market where excess
return can be earn.
Second reason is looking for new technologies. No
one country has lead in all technologies, so many companies are going global to
ensure access to new technologies. For example, Microsoft has to share
information about their products to the appropriate technical community within
the Microsoft Technology Centre, such as Hitachi, Polycom, Shunra, and others.
On the other hand, the conglomerate company, Hitachi also needs to share the
technology information with Microsoft to encourage the development in
technology to improve the efficiency and effectiveness.
Next, it is diversification of business risk. A
study of diversification histories shows that a firm usually arrives at a
decision to make a particular move through a multistep process. Related to the
cases, Citurs Products Inc wants to diversify by applying geographical
diversification. By diversifying geographically, you can minimize your local
downturn and cushion the impact of adverse economic events.
Fourth is to avoid political and regulation barrier.
Some type of governments will impose trade barriers, regulatory measurements of
governments, import quota and high taxes for import goods. For example,
Malaysia government imposes import duty for passenger cars at the flat rate of
120% (Autoworld, 2000) due to protection of the national car.
Therefore, if Japan making car company wants to increase the sales in Malaysia,
they need to set up a company in Malaysia to avoid the high taxes of import
car. In addition, multinational company want to establish facilities or
subsidiaries in stable countries.
The fifth reason is to seek for new material.
Multinational secure the necessary raw materials required to sustain primary
business line. For example, the U.S oil company, Exxon seeks to obtain easy
access to oil exploration in many developing nations. Therefore, it is not
surprising if the subsidiaries are located around the world, namely China,
Indonesia, Malaysia, Nigeria, and others.
b) Briefly
describe the major factors which distinguish multinational financial management
from financial management as practiced by a purely domestic firm.
Multinational Corporation is a corporation that
operates in two or more countries. Decision making of within the corporation
may be centralized in the home country or may be decentralized across the
countries the corporation does business in.
There are several factors that distinguish
multinational financial management and purely domestic firm financial
management.
Firstly, the political risk. Broadly, the political
risk refers to the complication businesses and governments may face as a result
of what are commonly referred to political decision or any political change
that alters the expected outcome and value of a given economic action by
changing the probability of achieving business objective. For a business, the
implication of political risk is that there is measure likelihood that
political events may complicate its pursuit of earnings though direct impacts
such as taxes and fees or indirect impact such as opportunity cost foregone.
Nations exercise sovereign rights over their people
and property. Thus, a government can seize the asset of multinational corporation
or restrict the repatriation of earning from the country and the affected company
has no recourse for recovery.
Next, it is language differences. The ability to
communicate is critical in all business matters. At the moment, U.S multinational
company is expanding to another country especially to a country which is not
using English for medium of communication. The company will find difficulties
in communication. However, it is interesting to note that English had become
the international business language. Also, some multinational company such as
Petronas, the larger Malaysian oil company has adopted English as the language
of corporate communication. Although English is now spoken by most international
business people, knowledge of other language remains critical to the success of
multinational firms. For example, Carrefour opened its first store at China in
1995 (Child, 2010).
Before setting up the company in China, Carrefour hired the store manager who
has the ability to speak and write in Mandarin fluently in order to have good
communication skill with the employees and customers.
Thirdly, it is different currency denominations.
Cash flows in various parts of multinational corporate systems will be
denominated by different currency, especially when the company is setting up in
more than 5 countries. Hence, an analysis of exchange rate and the effect of
fluctuating currency value must be included in all financial analysis. For
example, in the consolidation account of Wal-Mart Stores Inc, there is note
provided that the assets and liabilities of all international subsidiaries are
translated from the respective local currency to U.S dollar using exchange
rate. Therefore the exchange rate risk will be stated and evaluated in
preparing the consolidation account.
Fourth, it is economic and legal ratification. Each
country in which a firm operates will have its own unique economic institution
and institutional differences can cause significant problems when the
corporation tries to coordinate and control worldwide operation. For example,
company corporate tax is different from country to country, for the comparison
Malaysia corporate tax rate is 25% and Australia corporate tax rate is 30% (Tax Rates, 2012). As the result,
company would like to open factory in Malaysia compare in Australia due to low
corporate tax.
Fifth, it is cultural differences. Different
countries, and even different region 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
goal, attitudes toward risk taking, dealing with employees, and others. For
example, Wal-Mart in China is learned to do things in Chinese way, starting
with food which consumer insist be freshly harvested or even killed in front of
them (Naughton, 2009). Initially, Wall-Mart offended Chinese
customer by trying to sell them dead fish, as well as meat package in Styrofoam
and cellophane. Shoppers turned up their noses as what they saw as old
merchandise. So, Wall-Mart began displaying the meat uncovered, installed fish
tank and began to selling live tortoise for turtle soup. However, it feels more
like you have walked into the pet department of a U.S mart if you applying the
above concept in U.S.
c) Consider the
following illustrative exchange rates
|
Currency
|
US Dollars
required to buy one unit of foreign currency
|
|
Euro
|
1.22
|
|
Swedish Kronor
(krona)
|
0.144
|
i)
State whether
these currency prices are direct quotations or indirect quotations?
Because the prices of foreign currency
express in dollars (number of dollars per currency), the currency are direct
quotation.
ii)
Assume Citrus
Products can produce a liter of orange juice and ship it to Spain for $1.75. If
the firm wants a 50 percent markup on the product, calculate the selling price
of the juice in Spain?
|
Target Price in USD
|
$ 1.75
|
|
Markup Percentage 50%
|
$ 0.875
|
|
Total Selling Price in USD
|
$ 2.625
|
Direct
quotation = 1/Indirect quotation
= 1/1.22
= € 0.82
|
Total Selling Price in USD
|
$ 2.625
|
|
EURO/USD
|
0.82
|
|
|
[$ 2.525 x 0.82]
|
|
Total Selling Price in Euro
|
€ 2.15
|
Hence, the
selling price of the juice in Spain is € 2.15
iii)
Now assume
Citrus Products begins producing the same liter of orange juice in Spain. The
product costs 2.0 Euro to produce and ship to Sweden, where it can be sold for
20 Kronor. Determine the dollar profit on the sale?
|
Product
Cost of Citrus Product producing in Spain
|
€ 2
|
|
USD/EURO
|
1.22
|
|
Product Cost in USD
|
$ 2.44
|
|
Selling Price of Citrus Product in
KRONA
|
kr 20
|
|
USD/KRONA
|
0.144
|
|
Selling Price in USD
|
$ 2.88
|
|
Selling Price in USD
|
$ 2.88
|
|
Product Cost in USD
|
$ 2.44
|
|
Profit in USD
|
$ 0.44
|
|
|
[$ 2.88-$ 2.44]
|
So, the profits that
can be generated by Citrus Product when selling the product in Sweden and
producing in Spain is $ 0.44.
d) Critically
analyze the exchange rate risk involved for Citrus Products? How its valuation
can be affected by exchange rate risk?
A common definition of exchange rate risk relates to
the effect of unexpected rate changes on the value of the firm (Madura, 1989). In particular, it
is defined as the possible direct loss (as a result of an unhedged exposure) or
indirect loss in the firm’s cash flows, assets and liabilities, net profit and
in turn, its stock market value from an exchange rate move. To manage the exchange
rate risk inherent in every multinational firm’s operations, a firm needs to
determine the specific type of current risk exposure, the hedging strategy and
the available instruments to deal with these currency risks.
Multinational firms are participants in currency
markets by virtue of their international transactions. To measure the impact of
exchange rate movements on a firm that is involved in foreign-currency
denominated operations, i.e., the implied value at risk (VaR) from exchange
rate moves, we need to identify the type of risks that the firm is exposed to
and the amount of risk encountered (Hakala & Wystup, 2002). The three main
types of exchange rate risk that we consider are (Shapiro, 1996; Madura, 1989):
1. Transaction risk is basically cash flow risk and
deals with the effect of exchange rate moves on transactional account exposure
related to receivables (export contract), payables (import contract) or
repatriation of dividends. An exchange rate change in the currency of
denomination of any such contract will result in a direct quotation exchange
risk to the firm.
Applying to the case, Citrus Products Inc set up a
production plant and sales subsidiaries in Spain and set up sales subsidiaries
in Sweden in order to distribute the product throughout the European Common
Market. Therefore, Citrus Products Inc will not expose to the transaction risk
as long as the product distribution is distributed in the country which using
Euro and Kronor as their currency. Furthermore, as the company is set up its
operations in U.S, the company also will not exposed to the transaction risk as
long the product distributed or sales inside the U.S.
2. Translation risk which is basically a balance
sheet exchange rate risk and relates exchange rates moves to the valuation of a
foreign subsidiary and, in turn, to the consolidation of a foreign subsidiary
to the parent company’s balance sheet. Translation risk for a foreign
subsidiary is usually measured by the exposure of net assets (assets less
liabilities) to potential exchange rates moves. In consolidating financial
statements, the translation could be done either at the end of the period exchange
rate or at the average exchange rate of the period, depending on the accounting
regulations affecting the parent company. Thus, while income statements are
usually translated at the average exchange rate over the period, balance sheet
exposure of foreign subsidiaries are often translated at the prevailing current
exchange rate at the time of consolidation.
Related to the case, headquarter or parent company
of Citrus Products Inc is located in Florida, U.S. Moreover, the company is
expanding by opening sales subsidiaries in Spain and Sweden. It means that the
value of the company as a whole will be valued in U.S dollars, therefore the
value of the company subsidiaries in Spain and Sweden that using Euro and
Kronor as their currency in valuation will be converted to U.S dollars. As the
result, the company will be exposed to translation risk due to the movement of
exchange rate between U.S dollars and Euro as well as U.S dollars and Kronor.
3. Economic risk reflects basically the risk to the
firm’s present value of future operating cash flows from exchange rate
movements. In essence, economic risk concerns the effect of exchange rate
changes on revenues (domestic sales and exports) and operating expenses (cost
of domestic inputs and imports). Economic risk is usually applied to the
present value of future cash flow operations of a firm’s parent company and
foreign subsidiaries. Identification of the various types of currency risk,
along with their measurement, is essential to develop a strategy for managing
currency risk.
Based on the case, as the Citrus Products Inc
expanding in Spain and Sweden, the economic condition in those two countries
will be affected the present value of future cash flows operation. For example,
recently based (The New York Times, 2012) by April, Spain had
been downgraded by Standard and Poor’s for the second time in the year and its
unemployment rate reached 24.4% the highest in Europe. As the results, the
purchasing power of customer in Spain will be reduced that will be affected the
cash inflows or revenues of the company. Furthermore, the Balassa-Samuelson
theory provides a common framework in explaining the relationship between real
exchange rate and some of its economic factors (Wihlborg, Willett, & Zhang, 2009). The
Balassa-Samuelson effect implies that the price level of the country with
higher productivity tends to be higher and its real exchange rate goes in the
same direction, that is, the country will rapidly expanding economies and
growth rate will have more rapidly appreciation exchange rate. Therefore, as
the Spanish economy began to slow in late 2007 and entered into recession in
second quarter 2008 (CIA: The World Fact Book, 2012). The euro show
negative trend or weaken toward U.S dollars hence the company valuation as a
whole will be reduced or lower.
e) Briefly
described the different types of current exchange rate systems.
There are three different types of current exchange
rate systems, such as flexible exchange rates systems also known as floating
exchange rate system, managed floating rate systems and fixed exchange rate
systems also known as pegged 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 thousand
banks, firms and other institutions seeking to buy and sell currency for
purposes of transaction clearing, hedging, arbitrage and speculation. So higher
demand for a currency, all else equal, would lead to an appreciation of the
currency. An increase in the supply of a currency, all else equal, will lead to
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. Since 1971, economies
have been moving towards flexible exchange rate systems although only
relatively few currencies are classifiable as truly floating exchange rates. Most
OECD countries have flexible exchange rate systems, namely the U.S., Canada,
Australia, Britain, and the European Monetary Union.
Next, a managed floating rate systems is a hybrid of
a fixed exchange rate and 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
system, 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. For example, suppose that Indonesia had a
managed floating rate system and that the Indonesia central bank wants to keep
the value of the Rupiah close to 8900 Rupiah/$. In a managed floating rate
system, the Indonesia central bank is willing to tolerate small fluctuation in
the exchange rate (say from 8760 to 9200) without getting involved in the
market. If, however, there is excess demand for Rupiah in the rest of the
market causing appreciation below the 8760 level the Central Bank increases the
supply of Rupiah by selling Rupiah for dollars and acquiring holdings of U.S
dollars. Similarly if there is excess supply of Rupiah causing depreciation
above the 9200 level, the Central Bank increases the demand for Rupiah by
exchanging dollars for Rupiah and running down its holdings of U.S dollars.
So under a managed floating rate system, the central
bank holds stocks of foreign currency. These holdings are known as foreign
exchange reserves. It is important to realize that a managed float can only
work when the implicit target is close to the equilibrium rate that would
prevail in the absence of central bank intervention. Otherwise, the central
bank will deplete its foreign exchange reserves and the country will be in a flexible
exchange rate system because they can no longer intervene.
Last, it is fixed or pegged exchange rate system. Prior
to the 1970’s most countries operated under a fixed exchange rate system known
as the Bretton-Woods system. We will discuss Bretton-Woods in more detail
later, for now think of it as a system whereby the exchange rates of the member
countries were fixed against the U.S. dollar, with the dollar in turn worth a fixed
amount of gold. 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 fluctuation in relative prices and by reducing
uncertainty.
One important concept to keep in mind is the market
equilibrium exchange rate, the rate at which supply and demand will be equal,
i.e. markets will clear. In a flexible exchange rate system, this is the spot
rate. In a fixed exchange rate system, the pre-announced rate may not coincide
with the market equilibrium exchange rate. For example, suppose that the Thai
central bank wants to fix the value of the Baht at 25 Baht/$. Suppose that the equilibrium
exchange rate (the rate that would equate supply and demand) was 24 Baht/$. At
a rate of 25 Baht/$ there is an excess supply of dollars; people who have
dollars prefer to exchange them at the central bank since each dollar buys 25
Baht when it is really worth only 24 Baht. The Central Bank absorbs the excess
supply of dollars by selling Baht in exchange for dollars. In the process it
acquires reserves of U.S dollars.
Now suppose that the economic climate changes so
that the equilibrium exchange rate becomes 26 Baht/$. At the fixed rate of 25
Baht/$ there is now an excess demand for dollars; people want to buy dollars
from the central bank because it only costs them 25 Baht rather than the 26
Baht that each dollar is worth. In order to maintain the price of the Baht at 25
Baht/$ the Central Bank absorbs the excess demand for dollars by exchanging
dollars for Baht and runs down its foreign exchange reserves.
Note however that this can only be done if the gap
between the equilibrium rate and the fixed rate are small; if the equilibrium
rate climbed to 35 Baht/$, for example, the Central Bank does not have sufficient
reserves to keep the exchange rate at 25
Baht/$. If it tried to do so the substantial excess demand for dollars would
quickly deplete their foreign exchange reserves.
f) Discuss the
impact that relative inflation has on interest rates and exchange rates?
Inflation is the rate of increase in the general
price level, so a 3% inflation rates mean prices overall are 3% higher than a
year ago. Interest rate is the cost of borrowing or the price of money. Higher
interest rate discourage borrowing and encourage saving and will tend to slow
the economy. Lower rates encourage borrowing and have the opposite effect.
Comparison between United States of America (U.S)
and Indonesia will be elaborated to show the relationship the above variables.
According to (Bank Indonesia, 2012), the inflation rate
of Indonesia on the month of March 2012 is 3.97% and the interest rate is
5.75%. On the other hand, according to (American Central Bank, 2012), the inflation rate
of U.S on the month of April 2012 is 2.65% and the interest rate is 0.25%. From
the example above, the relationship between inflation rate and interest rate
can be identify when there is high inflation rate, there is high interest rate.
The above situation will causing the multinational
company or investor in Indonesia in order to finance their business will borrow
in USD rather than in Rupiah because of low interest rate. As the result, the
purchasing power increases relative to USD. Thus, the rupiah has generally
weakened against the dollar, so it would take more and more rupiah to pay back
the interest rate denominated in dollar. In conclusion, when a country has high
inflation, the government will interfere through monetary policy by increasing
the interest rate to control the spending and increasing of prices in the
market and tends to decrease exchange rate, the opposite effect apply.
g) Briefly
explain the international capital markets.
International capital market is the financial market
or world financial center where shares, bond, debentures, currencies, hedge
funds, mutual funds and other long term securities are purchased and sold. The
large international capital market investors have global choices and
perspectives, possesses long term outlook and make research based investments.
For example, the international bond market, international bond market
facilitates international transfer of long-term credit, thereby enabling
governments and large corporations to borrow funds from various countries. The
term Euro denotes a currency outside its home country. Eurobonds are the bonds
issue and sold outside the home country. Eurobonds are bearer securities. There
are also very active secondary markets in the Eurobonds, the Eurobonds market
accounted for annual issue of $ 200 billion every year in last 30 years. In
domestic markets, the regulatory requirements with registration of an issue,
disclosure of interest, credit rating, and others, are far more stringent than
in the Europe bond market. The low level of regulatory requirements is an
interesting of the Euro market.
Regulatory requirements on private placement are
less rigid to a public invitation. These are professional institutional
investors that are capable of making the risk assessment on their own and
therefore not needing protection of stringent regulatory safeguards in the same
scale as the public. One key innovation in the Eurobond market is the issue of
medium-term securities carrying floating rate of interest. It is reset regular
intervals, say quarterly or half yearly on the basis of London Interbank Offer
Rate (LIBOR). Bonds are fixed rate instruments. In the floating rate method,
the interest rate risk can be transferred from the investors to the issue of
the bonds. These bonds are termed as floating rate notes (FRNs) or bonds. The
term bond is used to denote long-term instruments. The term note is used to
denote short-term instruments. In the Eurobond market, interest payments on
fixed rates are made at annual intervals. Interest payments on floating rate
note International capital market are made half yearly or quarterly. Moreover,
Eurobonds are issued at fixed rate as well as floating rate.
REFERENCES
American Central Bank. (2012, March). FED Federal Funds Rate,
American central bank’s interest rate. Retrieved May 1, 2012, from Global
Rates:
http://www.global-rates.com/interest-rates/central-banks/central-bank-america/fed-interest-rate.aspx
Asiaone. (2011, April 22). DPM: Malaysia wooing big money from
Chinese investors. Retrieved April 30, 2012, from Asiaone:
http://www.asiaone.com/News/AsiaOne%2BNews/Malaysia/Story/A1Story20110422-275032.html
Autoworld. (2000). Import Duties on Motor Vehicles Sold
in Malaysia. Retrieved May 2, 2012, from Autoworld:
http://www.autoworld.com.my/aw/resources/duty.htm
Bank Indonesia. (2012, March). CPI Inflation.
Retrieved May 1, 2012, from Bank Indonesia: http://www.bi.go.id/web/en
Business Times. (2012, April 20). Berjaya’s Great Mall of China to be
ready by 2017. Retrieved April 30, 2012, from Business Times:
http://www.btimes.com.my/articles/20120420014532/Article/
Child, P. N. (2010, June 26). Carrefour China: Lessons
From A Global Retailer. Retrieved May 2, 2012, from Forbes:
http://www.forbes.com/2006/10/25/carrefour-china-chereau-qanda-biz-cx_pnc_1025mckinsey.html
CIA: The World Fact Book. (2012, April 13). Economic:
Spain. Retrieved May 1, 2012, from CIA: The World Fact Book:
https://www.cia.gov/library/publications/the-world-factbook/geos/sp.html
Hakala, J., & Wystup, U. (2002). Foreign Exchange
Risk: Models, Instruments, and Strategies. London: Risk Publications.
Madura, J. (2010). International Corporate Finance.
China: South Western.
Madura, J. (1989). International Financial Mangement.
Minnesota: West Publising Company.
Naughton, K. (2009, October 29). The Great Wal-Mart Of
China. Retrieved May 2, 2012, from The Daily Beast:
http://www.thedailybeast.com/newsweek/2006/10/29/the-great-wal-mart-of-china.html
Shapiro, A. C. (1996). Multinational Financial
Management. New Jerse: John Wiley and Sons.
Tax Rates. (2012). Malaysia and Australia Tax Rates.
Retrieved May 2, 2012, from Tax Rates:
http://www.taxrates.cc/html/australia-tax-rates.html
The New York Times. (2012, April 27). Spain.
Retrieved May 1, 2012, from The New York Times:
http://topics.nytimes.com/top/news/international/countriesandterritories/spain/index.html
Wihlborg, C., Willett, T. D., & Zhang, N. (2009). Real
Exchange Rate Movements and Endogenous OCA Analysis: Lessons from the Euro
Area for Asia. EUSA International Conference.
