Question

Is exchange rate is an important factor in capital decision making by Multinational Company?

Answer 1

Exchange rate plays a very important role in capital decision making. This can be answered through below points:

1. Optimization of cost of capital is the foremost objective of wealth maximization. Since, capital can be owned and debt. Role of interest on debt and divident payouts, retentions are the most essential factor. Being an MNC, considering it having a large number of shareholders etc theoughout the globe, dividend and debt payouts in foreign currency becomes most imperative.

2. The concept ot exchange rate parity plays in finance states that there is correlation between exchange and interest rate of currency/country. Generally, stronger the currency, lower the interest rate.

3. An MNC, would have operations and cash flows in multiple currencies, exchange rate plays a very important role in consolidation and reporting purposes.

4. Forecasting of exchange rate is a trillion dollar industry today, hedge and arbitrage have become life blood of today's MNCs.

5. The other factors which requires close monitoring of exchange rates are:

a) Impact for importers on raw materials

Suppose an engine costs €1000 to import from Germany. In 2007, this costs £666 (1,000/1.5). In 2009, with the fall in the value of the Pound, they will have to spend £909 (1,000/1.1) to buy the same German engine.

b) Fixed Contracts

Many business use fixed contracts for buying imported raw materials. This means temporary fluctuations in the exchange rate will have little effect. The price of buying imports will be set for up to 12 or 18 months ahead. Exporters may also use future options to hedge against dramatic movements in the exchange rate. These fixed contracts help to reduce the uncertainty around exchange rate movements and mean there can be time lags between changes in the exchange rate and changing costs for business