Chapter.8 Exam Prep Multinational Treasury Management

PART III Managing the Risks of Multinational Operations

Chapter 8 Multinational Treasury Management

Notes to instructors:

Answers to non-numeric multiple choice questions are arranged alphabetically, so that answers are randomly assigned to the five outcomes.

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1. A freight forwarder is a shipping agent used to select the best mode of transportation and arrange for a carrier to handle the physical shipment of goods.

2. An open account is most convenient for the buyer.

3. An open account provides the seller with the greatest protection against nonpayment.

Cash in advance provides the greatest protection for the exporter.

4. An open account is most often used when the buyer has a poor credit history.

Cash in advance or another more secure payment mechanism should be used.

5. A site draft is the most common method of international payment, and is payable at a particular site.

There is no such thing as a site draft. (Don’t confuse this with a sight draft.)

6. Countertrade is defined as trade conducted “over-the-counter” rather than through an export agent.

Countertrade is the exchange of goods or services without exchanging money.

7. A banker’s acceptance is a time draft drawn on and accepted by a commercial bank.

8. Commercial banks will not accept trade drafts.

Commercial banks are willing to accept trade drafts at a discount to their face value.

9. Factoring refers to the purchase of a firm’s accounts receivable.

10. Factoring refers to the purchase of a firm’s inventory at a discount to book value.

Factoring is the purchase of accounts receivables.

11. Forfaiting resembles factoring but involves medium- to long-term receivables and larger transactions.

12. Technical analysis is a passive approach to currency risk management.

Technical analysis uses exchange rate history to predict future exchange rates.

13. Risk exists whenever actual outcomes can deviate from expected outcomes.

14. The multinational corporation is exposed to currency risk when the value of its assets and liabilities changes with unexpected changes in currency values.

15. Exposure to currency risk depends on exchange rate variability, but not on how much is at risk.

Exposure to currency risk depends on how much is at risk.

16. If an investor’s wealth is dependent on foreign currency movements, then the investor is exposed to foreign currency risk.

17. Monetary contracts can be denominated either in the domestic or in a foreign currency.

18. Monetary assets have contractual payoffs.

19. Real assets are only exposed to currency risk if they are located in a foreign country.

For example, the value of an exporter depends on its competitors from foreign markets.

20. Transaction exposure to currency risk refers to changes in the value of monetary assets and liabilities due to unexpected changes in foreign currency exchange rates.

21. Operating exposure to currency risk includes transaction exposure and accounting exposure.

Economic exposure includes transaction exposure and operating exposure. Accounting exposure is the exposure of financial statements to currency risk.

22. Economic exposure to currency risk refers to changes in the value of monetary assets and liabilities due to unexpected changes in foreign currency exchange rates.

23. Economic exposure refers to changes in contractual cash flows due to unexpected changes in foreign currency exchange rates.

Economic exposure refers to changes in all future cash flows due to unexpected changes in foreign currency exchange rates. Transaction exposure is the exposure of contractual cash flows.

24. Monetary contracts denominated in a foreign currency are fully exposed to changes in the value of that currency.

25. Monetary assets and liabilities denominated in a domestic currency are not exposed to domestic inflation risk.

The real value of monetary assets depends on realized inflation.

26. Operating exposure refers to the exposure of the firm’s real assets to currency risk.

27. A parent firm has translation exposure to the extent that unexpected changes in foreign currency values change the parent’s financial accounting statements.

28. Translation exposure to currency risk necessarily reflects changes in the market value of the firm’s assets and liabilities.

Accounting exposure may or may not reflect changes in market values.

29. Translation exposure to currency risk is of direct concern to equity investors in the multinational corporation.

Shareholders are concerned with cash flows and values. Translation exposure may or may not be related to value.

30. Surveys find that financial managers believe transaction exposure is the most important currency exposure.

Multiple Choice Select the BEST ANSWER

1. The modern corporate treasury typically performs each of the following functions EXCEPT ____.

a. arranging financing for domestic and international trade

b. consolidating and managing the financial flows of the firm

c. identifying, measuring, and managing the firm’s risk exposures

d. managing the risks of domestic and international financial transactions

e. setting sales targets and monitoring progress toward these targets

2. The process of creating a strategic business plan includes each of (a) through (d) EXCEPT ____.

a. developing robust processes for implementing the strategic business plan

b. evaluating the business environment within which the firm operates

c. formulating a comprehensive strategic plan for turning the firm’s core competencies into sustainable competitive advantages

d. identifying the firm’s core competencies and potential growth opportunities

e. All of the above are elements of a strategic business plan.

3. Most of the nations in Western Europe and Latin America use a ____ legal system in which laws are codified as a set of rules.

a. civil

b. common

c. laissez faire

d. Sharia

e. Teutonic

4. The United Kingdom and the United States use a ____ law system that relies heavily on the decisions of judges in previous court cases.

a. civil

b. common

c. laissez faire

d. Napoleonic

e. Teutonic

5. Ways that exporters can arrange for payment include each of the following EXCEPT ____.

a. cash in advance

b. drafts

c. freight forwarding

d. letters of credit

e. open account

6. With payment through ____, the seller delivers goods directly to the buyer and then bills the buyer for the goods under agreed-upon payment terms.

a. a packing list

b. cash in advance

c. draft

d. letter of credit

e. open account

7. Sales on open account are ____ for most exporters and ____ for most importers, all else constant.

a. attractive; attractive

b. attractive; unattractive

c. unattractive; attractive

d. unattractive; unattractive

e. none of the above

8. A payment method in which the buyer pays for goods prior to shipment is called ____.

a. a draft

b. a letter of credit

c. a freight forwarding arrangement

d. an open account

e. cash in advance

9. Cash in advance is ____ for most exporters and ____ for most importers, all else constant.

a. attractive; attractive

b. attractive; unattractive

c. unattractive; attractive

d. unattractive; unattractive

e. none of the above

10. ____ is the instrument most frequently used as an international payment mechanism.

a. A certificate of origin

b. Cash in advance

c. The bill of lading

d. The draft

e. The packing list

11. Which of the following is not used in international trade?

a. sight draft

b. time draft

c. trade acceptance

d. banker’s acceptance

e. Each of the above is used in international trade.

12. A time draft that is drawn on and accepted by the buyer is called a ____.

a. banker’s acceptance

b. banker’s bourse

c. bill of lading

d. certificate of deposit

e. trade acceptance

13. A time draft that is drawn on and accepted by a commercial bank is called a ____.

a. banker’s acceptance

b. banker’s bourse

c. bill of lading

d. certificate of deposit

e. trade acceptance

14. The letter of credit substitutes the credit standing of the ____ for that of the buyer.

a. carrier

b. exporter

c. government

d. issuing bank

e. none of the above

15. ____ is a technique for exchanging goods or services without exchanging money.

a. Countertrade

b. International trade

c. Soft trade

d. Unconventional trade

e. none of the above

16. How can an exporter finance the sale of goods include?

a. Borrow against an asset such as accounts receivable or inventory.

b. Sell a banker’s acceptance at a discount to face value.

c. Sell accounts receivable to a factor or forfaiter such as a commercial bank.

d. Any of the above are acceptable ways to finance the sale of goods.

e. Only b and c are acceptable ways to finance the sale of goods.

17. Which of the following is a component of Treasury management of currency risk exposure?

a. Identify those currencies to which the firm is exposed.

b. Estimate the firm’s sensitivity to changes in these currency values.

c. Decide whether to hedge currency exposures in accordance with the firm’s overall risk management policy.

d. Select an appropriate hedging instrument or hedging strategy.

e. Lock in the hedge and then wait until expiration to evaluate performance.

18. A forecasting approach that uses past exchange rate movements to predict the direction of future exchange rate movements is called ____.

a. expert analysis

b. fundamental analysis

c. market-based analysis

d. technical analysis

e. temporal analysis

19. A forecasting approach that uses macroeconomic data to predict long-term exchange rates is called ___.

a. expert opinion

b. fundamental analysis

c. market-based analysis

d. spectral analysis

e. technical analysis

20. The firm’s monetary assets include each of the following EXCEPT ____.

a. accounts receivable

b. cash and money market securities

c. domestic bank deposits

d. Eurocurrency deposits

e. intangible assets

21. Monetary liabilities include each of the following EXCEPT ____.

a. accounts payable

b. common equity

c. domestic loans

d. Eurocurrency loans

e. taxes payable

22. Which of the following is about real assets?

a. Real assets include inventory.

b. Real assets include the firm’s employees.

c. Real assets include the firm’s production technologies.

d. Real assets include all of the above.

e. Real assets include none of the above.

Problems (Some of these can be converted into ‘Multiple Choice’ questions.)

1. Victor’s Secret has a bankers’ acceptance drawn on Union Bank of Switzerland (UBS) with a face value of $10 million due in six months. UBS receives an acceptance fee of $10,000 at maturity. Citigroup is willing to buy the acceptance at a discount rate of 4 percent compounded quarterly.

a. How much will Victor’s Secret receive if it sells the bankers’ acceptance?

b. What is the all-in cost of the acceptance, including the acceptance fee?

2. Victor’s Secret sells $10 million in accounts receivable to a factor. The receivables are due in three months. The factor charges an upfront (time zero) fee of 2 percent for purchasing the receivables on a nonrecourse basis. The factor also charges a fee of 1 percent per month for every month outstanding on the receivables. The 1 percent per month factoring fee is paid at the time the receivables are sold to the factor.

a. Identify Victor’s total upfront factoring fees?

b. What is the all-in cost of the acceptance to Victor’s Secret?

3. Is translation exposure important to shareholders?

Problem Solutions

1. a. The net amount payable at maturity is $9,990,000 after subtracting the acceptance fee. A 4 percent rate compounded quarterly is the same as a 1% quarterly rate. Victor’s Secret will receive ($9,990,000)/(1.01)² = $9,793,157 if it sells the acceptance today.

b. The all-in cost of the acceptance to Victor’s Secret is ($10,000,000)/($9,793,157) – 1 = 2.112 per six months or an effective annual rate of (1.02112)² – = 0.0427, or 4.27 percent per year.

2. a. Victor’s Secret pays a total of $500,000 in upfront factoring fees; $200,000 as a 2 percent nonrecourse fee and $300,000 as a 1 percent per month (over three months) factoring fee. The net amount received on sale of the receivables is $9,500,000.

b. The all-in cost to Victor’s Secret is ($10,000,000)/($9,500,000) – 1 = 5.263 percent per three months, or an effective annual rate of (1.05263)⁴ – 1 = 22.774 percent per year.

3. Shareholders are primarily concerned with cash flows and values. Hence, shareholders care more about how the firm’s economic exposure is related to the economic exposure of other assets in their portfolio. Shareholders will be concerned with accounting exposure if it affects the value of their investments indirectly through the impact of accounting exposures on the actions of the managers.

Appendix 8-A The Rationale for Hedging Currency Risk

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1. If hedging currency risk is to add value to the stakeholders of the firm, then hedging must impact either expected future cash flows or the cost of capital.

2. If financial markets are informationally efficient, then corporate financial policy is irrelevant.

Don’t confuse informational efficiency with a perfect market. Although the perfect market conditions ensure informational efficiency, informationally efficient markets can be imperfect.

3. Perfect financial markets are a necessary condition for corporate risk hedging to have value.

Market imperfections are necessary conditions.

4. In perfect financial markets, corporate financial policy is irrelevant.

5. Equal access to perfect financial markets ensures that individual investors can replicate any financial action that the firm can take.

6. In perfect financial markets, corporate hedging policy has no value.

7. In perfect financial markets, corporate investment policy is irrelevant.

Firm value depends entirely on the firm’s investments in a perfect financial market.

8. If corporate financial policy is to have value, then at least one of the perfect market assumptions cannot hold.

9. Real-world financial markets are perfect markets.

Perfect markets are a theoretical ideal and not a practical reality.

10. Multinationals have a comparative advantage over domestic firms in exploiting cross-border differences in financial markets.

11. A call option is an option to buy an underlying asset at a predetermined price.

12. A call option is an option to “call in” or demand payment on a loan.

A call option is an option to buy an underlying asset at a predetermined price.

13. Indirect financial distress costs are relatively unimportant for firms selling products for which quality and after-sale service are important.

Reputation is easily eroded in these instances.

14. Managerial gamesmanship is least prevalent during financial distress.

Gamesmanship is more prevalent during hard times.

15. Option values increase with an increase in the volatility of the underlying asset.

16. A decrease in the variability of firm value is good news for debt and bad news for the equity call option, other things held constant.

17. Corporate hedging of business risk unambiguously increases shareholder wealth when the firm is in financial distress.

Because debtholders have first claim on corporate assets, corporate hedging of business risk helps debtholders first and may or may not help equityholders.

18. In the real world, corporate hedging policy can change expected future cash flows but is unlikely to reduce the cost of debt.

Hedging policy can decrease the variability of firm value and can thus reduce the risk of debt and the required return charged by debtholders.

19. Direct costs of financial distress are more important than indirect costs to corporate hedging decisions.

The indirect costs of financial distress influence the activities of firms not just in bankruptcy but prior to bankruptcy as well.

20. Underinvestment occurs when debtholders refuse to invest additional capital into the firm during financial distress.

Underinvestment occurs when equity forgoes positive-NPV investments.

21. In financial distress, equity has an incentive to take on large risks in order to increase the value of the equity call option.

22. In practice, management’s objective is to maximize shareholder wealth.

Managers act nominally as equity’s agents but, in actuality, in their own best interests.

23. Managers have little incentive to hedge company-specific risks.

As undiversified stakeholders, managers are concerned with both systematic and unsystematic risk.

24. Managers have an incentive to hedge their unit’s transaction exposure to currency risk.

25. Hedging can increase firm value by reducing the costs of agency conflicts between managers and shareholders.

26. Exchange-traded options and futures contracts have a fixed cost per contract so that costs are proportional to the number of contracts traded.

27. The costs of hedging through operations are likely to be less burdensome for a large multinational corporation with diversified operations than for a small, less-diversified firm.

Multiple Choice Select the BEST ANSWER

1. Which of the following is unlikely to result in a decision to hedge currency risk?

a. bid-ask spreads on foreign exchange

b. costs of financial distress

c. differential taxes on income from different tax jurisdictions

d. stakeholder game-playing

e. All of the above are incentives to hedge.

2. Indirect costs of financial distress impact the firm in each of the following ways EXCEPT ____.

a. higher financial costs

b. higher legal costs in bankruptcy

c. higher operating costs

d. lower revenues

e. stakeholder gamesmanship

3. Which of statements (a) through (c) regarding costs of financial distress is ?

a. Both debt and equity unambiguously benefit from corporate risk hedging.

b. Hedging can increase expected cash flows by reducing the costs of financial distress.

c. Hedging can reduce debtholders’ required return and hence the cost of capital to the firm.

d. All of the above are

e. None of the above is

4. Management has an incentive to hedge which of the following exposures?

a. operating exposure

b. transaction exposure

c. translation (accounting) exposure

d. all of the above

e. none of the above

Problems

1. In what way is equity a call option on firm value?

Direct and indirect costs of financial distress

2. A firm based in the United Kingdom has promised to pay bondholders £10,000 in one year. The firm will be worth either £9,000 or £19,000 with equal probability at that time depending on the value of the dollar. The firm will be worth £14,000 if it hedges against currency risk.

a. Identify the values of debt and equity under unhedged and hedged scenarios assuming there are no costs of financial distress.

b. Suppose the firm will incur direct bankruptcy costs of £1,000 in bankruptcy. Identify the value of debt and of equity under both unhedged and hedged scenarios.

c. In addition to the £1,000 direct bankruptcy cost, suppose indirect costs reduce the asset value of the firm to either £6,000 or £18,000 (before the £1,000 direct bankruptcy cost) with equal probability. Hedging results in firm value of £12,000 with certainty. Identify the value of debt and of equity under both unhedged and hedged scenarios.

d. Can hedging add value to shareholders in this problem?

Problem Solutions

1. If the firm’s assets are worth more than that promised to debtholders, equity will exercise its option to buy the assets of the firm from the debtholders at the exercise price. If firm assets are worth less than the promised claim, equity will not exercise its option and debt assumes control of the firm.

2. a. If firm value is £9,000, equity will not exercise its option to buy the firm at a price of £10,000. In this case, equity receives nothing and debt receives £9,000. If the firm is worth £19,000, equity pays the bondholders £10,000 and retains the residual £9,000. Firm value can be broken down into E[V_FIRM] = E[V_BONDS] + E[_STOCK] = [(½)(£9,000) + (½)(£10,000)] + [(½)(£0) + (½)(£9,000)] = £9,500 + £4,500 = £14,000.

Hedged, firm value can be broken down into V_FIRM = V_BONDS + V_STOCK = £10,000 + £4,000 = £14,000. In the absence of costs of financial distress, the reduction in the variability of firm value results in a reduction in call option value and a £500 shift in value from equity to debt.

b. Unhedged, firm value is decomposed as: E[V_FIRM] = E[V_BONDS] + E[_STOCK] = [(½)(£9,000 £1,000) + (½)(£10,000)] + [(½)(£0) + (½)(£9,000)] = £9,000 + £4,500 = £13,500. With hedging, V_FIRM = V_BONDS + V_STOCK = £10,000 + £4,000 = £14,000. As in the previous example, the reduction in the variability of firm value is accompanied by a £500 transfer of wealth from equity to debt. Hedging also avoids the deadweight £1,000 bankruptcy cost and yields an expected gain of (½)(£1,000) = £500. In this example, debt captures the expected gain of £500. Equity will capture some of the gain if hedging results in lower interest payments on the next round of debt.

c. Unhedged, firm value is E[V_FIRM] = E[V_BONDS] + E[_STOCK] = [(½)(£6,000 £1,000) + (½)(£10,000)] + [(½)(£0) + (½)(£8,000)] = £7,500 + £4,000 = £11,500. If the firm hedges, then V_FIRM = V_BONDS + V_STOCK = £10,000 + £2,000 = £12,000. This is the same as (b) after including indirect costs of financial distress with an expected value of [(½)(£9,000 £6,000) + (½)(£19,000 £18,000)] = £1,500 + £500 = £2,000.

d. Hedging can add value to shareholders if they can negotiate lower interest payments on debt because of their hedging policies. Even in financial distress, equity could offer to renegotiate the bond contract to more evenly share the gain in firm value from hedging. In this way, they can share in any gain from reducing the probability and costs of financial distress.