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Lecture Multinational financial management: Lecture 22 - Dr. Umara Noreen

Since MNCs commonly invest in long-term projects, they rely heavily on long-term financing. Once the capital structure decision has been made, the MNC must consider the possible sources of equity or debt, and the costs and risks associated with each source. Many MNCs obtain equity funding in their home country, and engage in debt financing in foreign countries. | Long-Term Financing 22 Lecture Reducing Exchange Rate Risk Offsetting cash inflows Foreign currency receipts can help offset bond payments in the same currency. In particular, an MNC can aggregate its cash inflows from all euro-zone countries to cover the payments for its euro-denominated bonds. The exchange rate risk from financing with bonds in foreign currencies can be reduced in various ways. Reducing Exchange Rate Risk Forward contracts A firm may hedge its exchange rate risk through the forward market. However, the firm may not be able to save costs due to interest rate parity. Currency swaps A currency swap enables firms to exchange currencies at periodic intervals. It can be a useful alternative to forward or futures contracts. Reducing Exchange Rate Risk Parallel loans In a parallel (or back-to-back) loan, two parties simultaneously provide loans to each other (or to a subsidiary of the other party) with an agreement to repay at a specified point in the future. Subsidiary of | Long-Term Financing 22 Lecture Reducing Exchange Rate Risk Offsetting cash inflows Foreign currency receipts can help offset bond payments in the same currency. In particular, an MNC can aggregate its cash inflows from all euro-zone countries to cover the payments for its euro-denominated bonds. The exchange rate risk from financing with bonds in foreign currencies can be reduced in various ways. Reducing Exchange Rate Risk Forward contracts A firm may hedge its exchange rate risk through the forward market. However, the firm may not be able to save costs due to interest rate parity. Currency swaps A currency swap enables firms to exchange currencies at periodic intervals. It can be a useful alternative to forward or futures contracts. Reducing Exchange Rate Risk Parallel loans In a parallel (or back-to-back) loan, two parties simultaneously provide loans to each other (or to a subsidiary of the other party) with an agreement to repay at a specified point in the future. Subsidiary of U.K.- based MNC that is located in the U.S. Provision of loans Subsidiary of U.S.- based MNC that is located in the U.K. British Parent U.S. Parent Repayment of loans in the currency that was borrowed Illustration of A Parallel Loan Reducing Exchange Rate Risk Diversifying among currencies A firm may issue bonds in several foreign currencies for diversity. To avoid the higher transaction costs associated with multiple bond issues, the firm may develop a currency cocktail bond. One popular currency cocktail is the Special Drawing Right (SDR). Interest Rate Risk from Debt Financing An MNC must also decide on the maturity that it should use for its debt. If the bond term is too short, the MNC may have to refinance at a higher interest rate. However, if the bond term matches the expected business life, the MNC is obligated to continue paying interest at the same rate even when market interest rates fall. The Debt Maturity Decision Before making the debt maturity decision, MNCs may want