Question

Mini Case

With the growth in demand for exotic foods, Possum Products’s CEO Michael Munger is considering expanding the geographic footprint of its line of dried and smoked low-fat opossum, ostrich, and venison jerky snack packs. Historically, jerky products have performed well in the southern United States, but there are indications of a growing demand for these unusual delicacies in Europe. Munger recognizes that the expansion carries some risk. Europeans may not be as accepting of opossum jerky as initial research suggests, so the expansion will proceed in steps. The first step will be to set up sales subsidiaries in France and Sweden (the two countries with the highest indicated demand), and the second is to set up a production plant in France with the ultimate goal of product distribution throughout Europe.

Possum Products’s CFO, Kevin Uram, although enthusiastic about the plan, is nonetheless concerned about how an international expansion and the additional risk that entails will affect the firm’s financial management process. He has 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, Uram has supplied you with the following list of questions:

Solution

a.What is a multinational corporation? Why do firms expand into other countries?

b.What are the six major factors that distinguish multinational financial management from financial management as practiced by a purely domestic firm?

c.Consider the following illustrative exchange rates.

(1)What is a direct quotation? What is the direct quote for euros?

(2)What is an indirect quotation? What is the indirect quotation for kronor (the plural of krona is kronor)?

(3)The euro and British pound usually are quoted as direct quotes. Most other currencies are quoted as indirect quotes. How would you calculate the indirect quote for a euro? How would you calculate the direct quote for a krona?

(4)What is a cross rate? Calculate the two cross rates between euros and kronor.

(5)Assume Possum Products can produce a package of jerky and ship it to France for $1.75. If the firm wants a 50% markup on the product, what should the jerky sell for in France?

(6)Now assume that Possum Products begins producing the same package of jerky in France. The product costs 2 euros to produce and ship to Sweden, where it can be sold for 20 kronor. What is the dollar profit on the sale?

(7)What is exchange rate risk?

d.Briefly describe the current international monetary system. How does the current system differ from the system that was in place prior to August 1971?

e.What is a convertible currency? What problems arise when a multinational company operates in a country whose currency is not convertible?

f.What is the difference between spot rates and forward rates? When is the forward rate at a premium to the spot rate? At a discount?

g.What is interest rate parity? Currently, you can exchange 1 euro for 1.25 dollars in the 180-day forward market, and the risk-free rate on 180-day securities is 6% in the United States and 4% in France. Does interest rate parity hold? If not, which securities offer the highest expected return?

h. What is purchasing power parity? If a package of jerky costs $2 in the United States and purchasing power parity holds, what should be the price of the jerky package in France?

i.What effect does relative inflation have on interest rates and exchange rates?

j. Briefly discuss the international capital markets.

k.To what extent do average capital structures vary across different countries?

l.Briefly describe special problems that occur in multinational capital budgeting, and describe the process for evaluating a foreign project. Now consider the following project: A U.S. company has the opportunity to lease a manufacturing facility in Japan for 2 years. The company must spend ¥1 billion initially to refurbish the plant. The expected net cash flows from the plant for the next 2 years, in millions, are CF1 ¥500 and CF2 ¥800. A similar project in the United States would have a risk-adjusted cost of capital of 10%. In the United States, a 1-year government bond pays 2% interest and a 2-year bond pays 2.8%. In Japan, a 1-year bond pays 0.05% and a 2-year bond pays 0.26%. What is the project’s NPV?

m.Briefly discuss special factors associated with the following areas of multinational working capital management:

(1) Cash management

(2) Credit management

(3) Inventory management

Answer 1

a]

A multi-national corporation is a company with operations in more than one country. Firms expand into other countries for these reasons :

• Increasing sales by tapping new markets for growth
• Taking advantage of lower costs of production in other countries
• Diversification of geographical risk
• Certain countries can be gateways for growth in entirely regions.
• Availability of human capital in other countries, which is not so easily available in the home country
• Attractive incentives for investing in other countries, such as tax benefits or cheap infrastrucure

b]

Six major factors that distinguish multinational financial management from domestic financial management are :

• Cost of capital for international investments
• Managing transaction exposure
• Forecasting exchange rates
• Hedging foreign exchange risk
• Transfer pricing and international tax management
• Managing economic and political risk across countries

c]

(1)

A direct currency quote is where the quote is in terms of number of units of domestic currency per unit of foreign currency.

The direct quote for Euro is 1.12 USD per Euro

(2)

An indirect currency quote is where the quote is in terms of number of units of foreign currency per unit of domestic currency.

The direct quote for Norwegian Kronor is 8.61 Kronor per USD