Fundamentals of Financial ManagementX

Chapter 19 Multinational Financial Management 617

production process, the availability of labor with the requisite skills, and the
adequacy of transportation infrastructure, companies that operate in high-cost
countries have strong incentives to shift production to lower-cost regions. For
example, GE has production and assembly plants in Mexico, South Korea,
and Singapore, and even Japanese manufacturers have started to shift some
of their production to lower-cost countries in the Pacific Rim and the Americas.
BMW, in response to high production costs in Germany, built assembly plants
in the United States, among other countries. These examples illustrate how
companies strive to remain competitive by locating manufacturing facilities
wherever in the world they can produce and transport their products to meet
the demand in their major markets at the lowest total unit landed costs.
2. To avoid political, trade, and regulatory hurdles. Governments sometimes impose
tariffs, quotas, and other restrictions on imported goods and services. They
often do so to raise revenue, protect domestic industries, and pursue various
political and economic policy objectives. To circumvent these government
hurdles, firms often develop production facilities abroad. For instance, the
primary reason Japanese auto companies moved production to the United
States was to get around U.S. import quotas. Now, Honda, Nissan, Toyota,
Mazda, and Mitsubishi are all assembling vehicles in the United States. This
was also the situation with India in the 1970s when it was following a devel-
opment strategy to compete domestically with imported products. One of
the factors that prompted U.S. pharmaceutical maker SmithKline and
Britain’s Beecham to merge was that they wanted to avoid licensing and reg-
ulatory delays in their largest markets, western Europe and the United
States. GlaxoSmithKline (the result of a 2000 merger between Glaxo Well-
come and SmithKline Beecham) now identifies itself as an inside player in
both Europe and the United States.
3. To broaden their markets. After a company’s home market matures and compe-
tition becomes more intense, growth opportunities are often better in foreign
markets. According to Vernon’s product life-cycle theory, a firm first produces
in its home market, where it can better develop its product and satisfy local
customers.2 This attracts competitors, but when the home market is expand-
ing rapidly, new customers provide the sales growth desired. However, as the
home market matures, and the growth of total demand slows, competition
becomes more intense. At the same time, demand for the product develops
abroad, and this creates conditions favoring production in foreign countries
both to satisfy foreign demand and to cut production and transportation costs
so that the company can remain competitive. Thus, such homegrown firms as
IBM, Coca-Cola, and McDonald’s are aggressively expanding into overseas
markets, and foreign firms such as Sony and Toshiba now dominate the U.S.
consumer electronics market. Also, as products become more complex, and
development becomes more expensive, it is necessary to sell more units to
cover overhead costs, so larger markets are critical.
4. To seek raw materials and new technology. Supplies of many raw materials that
are important for industrial societies are geographically dispersed, so compa-
nies must go where the materials are found, no matter how challenging it
may be to operate in some of the locations. For example, major deposits of
oil are located on the northern coast of Alaska, in Siberia, and in the deserts
of the Middle East, all of which present unique challenges. This is why many
U.S. oil companies, such as ExxonMobil, have major production facilities
around the world to ensure access to the basic input resources needed to sus-
tain the companies’ primary business line. Because ExxonMobil has refineries,

2 Raymond Vernon, “International Investment and International Trade in the Product Cycle,”
Quarterly Journal of Economics Vol. 80 (1966), pp. 190–207.

618 Part 7 Special Topics in Financial Management

Vertically Integrated distribution facilities, and oil production fields, this type of investment is
referred to as a vertically integrated investment, whereby the firm under-
Investment takes an investment to secure its supply of inputs at stable prices.
5. To protect the secrecy of their processes and products. Firms often possess special
Occurs when a firm intangible assets such as brand names, technological and marketing know-
undertakes an how, managerial expertise, and superior research and development (R&D)
investment to secure capabilities among others. Unfortunately, property rights in intangible assets
its input supply at are often difficult to protect, particularly in foreign markets. Firms some-
stable prices. times invest abroad rather than license local foreign firms in order to protect
the secrecy of their production process, distribution system, or the product
itself. Once a firm’s formula or production process is revealed to other local
firms, they may then more easily develop similar products or processes,
which will hurt firm sales. For example, to protect their formula, Coke builds
bottling plants and distribution networks in foreign markets but imports the
concentrate or syrup required to make the product from the United States. In
the 1960s, Coke faced strong pressure from the Indian government to reveal
its formula in order to continue its operations in India. Rather than reveal its
formula, Coke withdrew its operations from India until the foreign invest-
ment climate improved.
6. To diversify. By establishing worldwide production facilities and markets,
firms can cushion the effect of adverse economic trends in any single country.
For example, General Motors softened the blow of poor sales in the United
States during a recent recession with strong sales by its European sub-
sidiaries. Also, oil companies were able to weather the recent disruption in
Venezuelan oil production by increasing production in Mexico and elsewhere
in the world. In general, geographic diversification of inputs and outputs
works because the economic fluctuations or political vagaries of different
countries are not perfectly correlated. Therefore, companies investing over-
seas can benefit from diversification in the same way that individuals benefit
from investing in a broad portfolio of stocks. However, because individual
shareholders can diversify their investments internationally on their own, it
makes less sense for firms to undertake foreign investments solely for diversi-
fication purposes. Note, though, that in countries that place constraints on
foreign stock ownership or that do not have internationally traded compa-
nies, corporate diversification might make sense because then companies can
do something that shareholders cannot duplicate easily in their individual
portfolios.
7. To retain customers. If a company goes abroad and establishes production or
distribution operations, it will need inputs and services at these new loca-
tions. If it can obtain what it needs from a single supplier that also operates
in the same set of countries, then managing the relationship is much easier,
and it is likely that economies of scale and other synergies will be obtained.
Therefore, from the perspective of the supplier of inputs or services, it makes
good business sense to follow customers abroad to retain the business. Large
U.S. banks, such as Citibank and Chase, initially expanded abroad to supply
banking services to their long-time customers, although they quickly capital-
ized on their global network to develop new customer relationships. The
same history is also true for accounting, law, and advertising firms and other
similar service providers.

Over the past 10 to 15 years, there has been an increasing amount of invest-
ment in the United States by foreign corporations, and in foreign nations by U.S.
corporations. This trend is shown in Figure 19-1, and it is important because of its
implications for eroding the traditional doctrine of independence and self-reliance
that has been a hallmark of U.S. policy. Just as U.S. corporations with extensive
overseas operations are said to use their economic power to exert substantial

Chapter 19 Multinational Financial Management 619

F I G U R E 1 9 - 1 Direct Investment Positions on a Current-Cost
Basis, 1982–2004

Billions U.S. Direct Investment Abroad
($) Foreign Direct Investment in United States

2,500

2,000

1,500

1,000

500

0 1986 1990 1994 1998 2002
1982 Year

Sources: Elena L. Nguyen, “The International Investment Position of the United States at Yearend
2002,” Survey of Current Business, July 2003, pp. 12–21; Patricia E. Abaroa, “The International
Investment Position of the United States at Yearend 2003,” Survey of Current Business, July 2004,
pp. 30–39; and Bureau of Economic Analysis, “U.S. Net International Investment Position at Yearend
2004,” BEA News, June 30, 2005.

economic and political influence over host governments in many parts of the
world, it is feared that foreign corporations are gaining similar sway over U.S.
policy. These developments suggest an increasing degree of mutual influence and
interdependence among business enterprises and nations, to which the United
States is not immune.

What is a multinational corporation?

Why do companies “go global”?

19.2 MULTINATIONAL VERSUS DOMESTIC
FINANCIAL MANAGEMENT

In theory, the concepts and procedures discussed in the first 18 chapters are
valid for both domestic and multinational operations. However, some additional
factors need to be considered when firms operate globally. Five of these factors
are listed here:

1. Different currency denominations. Cash flows in various parts of a multina-
tional corporate system will be denominated in different currencies. Hence,
an analysis of exchange rates must be included in all financial analyses.

2. Political risk. Nations are free to place constraints on the transfer or use of
corporate resources, and they can change regulations and tax rules at any

620 Part 7 Special Topics in Financial Management

time. At one extreme, they can even expropriate assets within their bound-
aries. Therefore, political risk can take on many subtle to more extreme
forms. Of course, political risk is also present for companies operating in a
single country, but the important reality for a multinational enterprise is that
political risk not only exists but also varies from country to country, and it
must be addressed explicitly in any financial analysis.
3. Economic and legal ramifications. Each country has its own unique economic
and legal systems, and these differences can cause significant problems when
a corporation tries to coordinate and control its worldwide operations. For
example, differences in tax laws among countries can cause a given economic
transaction to have strikingly different after-tax consequences, depending on
where the transaction occurs. Similarly, differences in legal systems of host
nations, such as the Common Law of Great Britain versus the French Civil
Law, complicate matters ranging from the simple recording of business
transactions to the role played by the judiciary in resolving conflicts. Such
differences can restrict multinational corporations’ flexibility in deploying
resources and make procedures that are required in one part of the company
illegal in others. These differences also make it difficult for executives trained
in one country to move easily to another.
4. Role of governments. Most financial models developed in the United States
assume the existence of a competitive marketplace in which the participants
determine the terms of trade. The government, through its power to estab-
lish basic ground rules, is involved in the process, but other than taxes, its
role is minimal. Thus, the market provides the primary barometer of success,
and it gives the best clues about what must be done to remain competitive.
This view of the process is reasonably correct for the United States and west-
ern Europe, but it does not accurately describe the situation in the rest of the
world. Although market imperfections can complicate the decision process,
they can also be valuable to the extent that they can be overcome by one firm
but still serve as barriers to entry by competitors. Frequently, the terms
under which companies compete, the actions that must be taken or avoided,
and the terms of trade on various transactions are determined not in the
marketplace but by direct negotiation between host governments and multi-
national enterprises. This is essentially a political process, and it must be
treated as such. Thus, our traditional financial models have to be recast to
include political and other noneconomic aspects of the decision. The ultimate
outcome of such negotiations can provide access to additional profitable
opportunities for the firm.
5. Language and cultural differences. The ability to communicate is critical in all
business transactions. In this regard, U.S. citizens are often at a disadvan-
tage because they are generally fluent only in English, while European and
Japanese businesspeople are usually fluent in several languages, including
English, hence they can operate in U.S. markets more easily than Americans
can operate in their countries. At the same time, even within geographic
regions that are considered relatively homogenous, different countries have
unique cultural heritages that shape values and influence the conduct of
business. Multinational corporations find that matters such as defining the
appropriate goals of the firm, attitudes toward risk, decision processes,
performance evaluation and compensation system design, interactions with
employees, and the ability to curtail unprofitable operations vary dramatically
from one country to the next.

These five factors complicate financial management, and they increase the risks
faced by multinational firms. However, the prospects for high returns and other
factors make it worthwhile for firms to accept these risks and learn how to
manage them.

Chapter 19 Multinational Financial Management 621

Identify and briefly discuss five major factors that complicate finan-
cial management in multinational firms.

19.3 THE INTERNATIONAL MONETARY International
SYSTEM Monetary System
The framework within
Every nation has a monetary system and a monetary authority. In the United which exchange rates
States, the Federal Reserve is our monetary authority, and its task is to hold are determined. It is
down inflation while promoting economic growth and raising our national stan- the blueprint for
dard of living. Moreover, if countries are to trade with one another, we must international trade and
have some sort of system designed to facilitate payments between nations. The capital flows.
international monetary system is the framework within which exchange rates
are determined. Because exchange rates are a function of the supply and Exchange Rate
demand for various national currencies, the international monetary system is The number of units of
also the blueprint for international trade and capital flows. Thus, the interna- a given currency that
tional monetary system ties together global currency, money, capital, real estate, can be purchased for
commodity, and real asset markets into a network of institutions and instru- one unit of another
ments, regulated by intergovernmental agreements, and driven by each coun- currency.
try’s unique political and economic objectives.3
For a listing of world
International Monetary Terminology currencies, currency
symbols, and their
When discussing the international monetary system, it is useful to introduce regimes, go to the
some important concepts and terminology: University of British
Columbia Sauder School
1. An exchange rate is the price of one country’s currency in terms of another of Business Pacific
currency. For example, on Monday, July 25, 2005, one U.S. dollar would buy Exchange Rate Service
0.5724 British pound, 0.8286 euro, 1.2186 Canadian dollars, or 8.1097 Chinese Web site, http://
yuan. fx.sauder.ubc.ca/
currency_table.html.
2. A spot exchange rate is the quoted price for a unit of foreign currency to be
delivered “on the spot,” or within a very short period of time. The rate quoted
above, £0.5724/$, is a spot rate as of the close of business on July 25, 2005.

3. A forward exchange rate is the quoted price for a unit of foreign currency to be
delivered at a specified date in the future. If today were July 25, 2005, and we
wanted to know how many pounds we could expect to receive for our dol-
lars on January 25, 2006, we would look at the six-month forward rate, which
was £0.5740/$. Note that a forward exchange contract on July 25 would lock in
this exchange rate, but no currency would change hands until January 25,
2006. The spot rate on January 25 might be quite different from £0.5740, in
which case we would have a profit or a loss on the forward purchase.

4. A fixed exchange rate for a currency is set by the government and allowed to
fluctuate only slightly (if at all) around the desired rate, called the par value.
For example, Belize has fixed the exchange rate for the Belizean dollar at
BZD 2.00/$1, and it has maintained this fixed rate for the past few years.

3 For a comprehensive history of the international monetary system and details of how it has
evolved, consult one of the many economics books on the subject, including Robert Carbaugh,
International Economics (Mason, OH: Thomson/South-Western, 2004); Mordechai Kreinin, Interna-
tional Economics: A Policy Approach, 9th edition (Mason, OH: Thomson/South-Western, 2002); and
Joseph P. Daniels and David D. Van Hoose, International Monetary and Financial Economics, 2nd
edition (Mason, OH: Thomson/South-Western, 2002).

622 Part 7 Special Topics in Financial Management

Freely-Floating 5. A floating or flexible exchange rate is one that is not regulated by the govern-
Regime ment, so supply and demand in the market determine the currency’s value.
Occurs when the The U.S. dollar and the euro are examples of free-floating currencies. Note,
exchange rate is though, that central banks do from time to time intervene in the market to
determined by supply nudge exchange rates up or down, even though they basically float.
and demand for the
currency. 6. Devaluation or revaluation of a currency is the technical term referring to the
decrease or increase in the par value of a currency whose value is fixed. This
Managed-Float decision is made by the government, usually without warning. For example,
Regime on July 21, 2005, the Chinese government suddenly announced that it was
Occurs when there is revaluing the yuan to make it 2.1 percent stronger against the U.S. dollar.
significant government Even though it was widely believed that the yuan was significantly under-
intervention to control valued, this revaluation caught many by surprise since the exchange rate had
the exchange rate via been pegged at a fixed rate of CNY 8.2781/$ for nearly a decade.
manipulation of the
currency’s supply and 7. Depreciation or appreciation of a currency refers to a decrease or increase in the
demand. foreign exchange value of a floating currency. These changes are caused by
market forces rather than by governments.

8. A soft or weak currency is one that is expected to depreciate against most other
currencies or else is being artificially maintained at an unrealistically high
fixed rate by the government through open market purchases. A hard or
strong currency is expected to appreciate against most other currencies or else
is being artificially maintained by the government at an unrealistically low
fixed rate. The revaluation of the Chinese yuan suggests that it is a strong
currency.

Current Monetary Arrangements

At the most basic level, we can divide currency regimes into two broad
groups: floating rates and fixed rates. Within the two regimes, there are gradu-
ations among subregimes in terms of how rigidly they adhere to the basic posi-
tions. Looking first at the floating-rate category, the two main subgroups are as
follows:

1. Freely floating. Here the exchange rate is determined by the supply and
demand for the currency. Under a freely-floating regime, governments may
occasionally intervene in the market to buy or sell their currency to stabilize
fluctuations, but they do not attempt to alter the absolute level of the rate.
This policy exists at one end of the continuum of exchange rate regimes. For
example, the currencies of Australia, Brazil, and the Philippines are allowed
to float.

2. Managed floating. Here there is significant government intervention to manage
the exchange rate by manipulating the currency’s supply and demand. The
government rarely reveals its target exchange rate levels if it uses a managed-
float regime because this would make it too easy for currency speculators to
profit. For example, the governments of Colombia, Israel, and Poland manage
their respective currency’s float.

Most developed countries follow either a freely-floating or a managed-float
regime. A few developing countries do as well, often reluctantly and as a result
of a market that forces them to abandon a fixed-rate regime.

Types of fixed-exchange-rate regimes include the following:

1. No local currency. The most extreme position is for the country to have no
local currency of its own. The country either uses another country’s currency
as its legal tender (such as the U.S. dollar in the Panama Canal Zone,
Ecuador, and the Turks and Caicos Islands) or else belongs to a group of

Chapter 19 Multinational Financial Management 623

countries that share a common currency (such as the euro). With this Currency Board
arrangement, the local government surrenders economic regulation. Arrangement
2. Currency board arrangement. Under a variation of the first subregime, a coun- Occurs when a country
try technically has its own currency but commits to exchange it for a speci- has its own currency
fied foreign money unit at a fixed exchange rate. This requires it to impose but commits to
domestic currency restrictions unless it has the foreign currency reserves to exchange it for a speci-
cover requested exchanges. This is called a currency board arrangement. fied foreign money unit
Argentina had a currency board arrangement before its crisis of January at a fixed exchange
2002, when it was forced to devalue the peso and default on its debt. rate and legislates
3. Fixed peg arrangement. In a fixed peg arrangement the country locks, or domestic currency
“pegs,” its currency to another currency or basket of currencies at a fixed restrictions, unless it
exchange rate. It allows the currency to vary only slightly from its desired has the foreign cur-
rate, and if the currency moves outside the specified limits (often set at Ϯ1 rency reserves to cover
percent of the target rate), it intervenes to force the currency back within the requested exchanges.
limits. An example is China, where the yuan is no longer just pegged to the
U.S. dollar but rather to a basket of currencies. The Chinese government is Fixed Peg
keeping the currencies making up the basket secret, but the U.S. dollar will Arrangement
likely remain the most important. For right now (July 2005), China will limit Occurs when a country
the yuan’s move each day to Ϯ0.3 percent against the dollar. It’s unclear locks its currency to a
whether it will move every day or how much it will move over time. Addi- specific currency or
tional examples include Bhutan’s ngultrum, which is pegged to the Indian basket of currencies at
rupee; the Falkland Islands’ pound, which is pegged to the British pound; a fixed exchange rate.
and Barbados’s dollar, which is pegged to the U.S. dollar. The exchange rate is
allowed to vary only
Other variations have been used, and new ones are developed from time to within Ϯ1 percent of
time. A majority of the world’s countries employ some sort of fixed-exchange- the target rate.
rate arrangement. So, while the most important currencies (as measured by vol-
ume of transactions) are allowed to float, and the international monetary system
is often called a floating regime, most currencies are actually fixed in some
manner.

What is an international monetary system?

What is the difference between spot and forward exchange rates?

What is the difference between floating- and fixed-exchange rates?

Differentiate between devaluation/revaluation of a currency and
depreciation/appreciation of a currency.

What is meant by a soft or weak currency? A hard or strong currency?

What are the two broad categories of the various currency regimes?
What are the subgroups of these two broad categories?

19.4 FOREIGN EXCHANGE RATE For up-to-date currency
QUOTATIONS quotations on the Web,
visit two popular sites:
Foreign exchange rate quotations can be found in The Wall Street Journal and other www.bloomberg.com/
leading print publications and Web sites. Exchange rates are given in two different markets/currencies/fxc
ways. As shown in Table 19-1, which is an excerpt from The Wall Street Journal, in .html or finance.yahoo
Column 1, they are quoted as “USD equivalent” and in Column 2 as “Currency .com/currency.
per USD.” For example, one Canadian dollar is worth (or can be exchanged for)
0.8206 U.S. dollar, or one U.S. dollar could buy 1.2186 Canadian dollars.

624 Part 7 Special Topics in Financial Management

TA B L E 1 9 - 1 Sample Exchange Rates: Monday, July 25, 2005

Brazilian real Direct Quotation: Indirect Quotation:
British pound U.S. Dollars Required to Buy Number of Units of Foreign
Canadian dollar One Unit of Foreign Currency
Denmark krone Currency per U.S. Dollar
Euro (1) (2)
Hungarian forint
Israeli shekel $0.4025 2.4845
Japanese yen 1.7471 0.5724
Mexican peso 0.8206 1.2186
South African rand 0.1618 6.1805
Swedish krona 1.2069 0.8286
Swiss franc 0.004918 203.33
Venezuelan bolivar 0.2207 4.5310
0.008974 111.43
0.0931 10.7400
0.1507 6.6357
0.1281 7.8064
0.7725 1.2945
0.000466 2145.92

Note: Column 2 equals 1.0 divided by Column 1. However, rounding differences do occur.
Source: Adapted from The Wall Street Journal, July 26, 2005, p. C12.

Note that if the foreign exchange markets are in equilibrium, which is usu-
ally the case for the major traded currencies, then the two quotations must be
reciprocals of one another as shown below for the Canadian dollar.

Canadian dollar: 1/1.2186 ϭ 0.8206

1/0.8206 ϭ 1.2186

Cross Rates

Cross Rate All of the exchange rates given in Table 19-1 are relative to the U.S. dollar.
Suppose, though, that a German executive is flying to Tokyo on business. The
The exchange rate exchange rate of interest is not euros or yen per dollar—rather, he or she wants
between any two to know how many yen can be purchased with euros. This is called a cross rate,
currencies. and it can be calculated from the following data in Column 2 of Table 19-1:

Spot Rate

Euro €0.8286/$1
Yen ¥111.43/$1

Because the quotations have the same denominator—one U.S. dollar—we can cal-
culate the cross rate between these (and other) currencies by using the Column 2
quotations. For our German national, the cross rates are found as

Euro>$
Euro>yen exchange rate ϭ Yen>$

and when we cancel the dollar signs, we are left with the number of euros 1 yen
would cost.

€0.8286/¥111.43 ϭ €0.007436/¥

Chapter 19 Multinational Financial Management 625

TA B L E 1 9 - 2 Key Currency Cross Rates

Canada Dollar Euro Pound SFranc Peso Yen CdnDlr
Japan
Mexico 1.2186 1.4708 2.1291 0.9414 0.11347 0.01094 —
Switzerland 111.43 134.49 194.68 86.082 10.376 — 91.442
United Kingdom
Euro 10.7400 12.9621 18.764 8.2966 — 0.09638 8.8132
United States 1.2945 1.5623 2.2616 — 0.12053 0.01162 1.0623
0.57240 0.6908 — 0.05329 0.00514 0.46969
0.82860 — 1.4476 0.4422 0.07715 0.00744 0.67992
— 1.2069 1.7471 0.64007 0.09311 0.00897 0.82060
0.77250

Source: Adapted from “Key Currency Cross Rates,” The Wall Street Journal, July 26, 2005, p. C12.

Alternatively, we could find the number of yen 1 euro would buy: American Terms
The foreign exchange
Yen>$ rate quotation that rep-
Yen>euro exchange rate ϭ Euro>$ resents the number of
American dollars that
¥111.43/€0.8286 ϭ ¥134.48/€ can be bought with one
unit of local currency.
Note that these two cross rates are reciprocals of one another.
Financial publications such as The Wall Street Journal and Web sites such as the European Terms
The foreign exchange
Bloomberg and Yahoo sites provide tables of key currency cross rates. Table 19-2 rate quotation that
gives the one published in The Wall Street Journal on July 26, 2005. Notice that there represents the units of
may be slight rounding differences when you calculate cross rates due to the local currency that can
rounding of individual quotations. Currency traders carry quotations out to 12 be bought with one
decimal places. U.S. dollar. “European”
is intended as a
To facilitate worldwide currency trading through electronic media, the inter- generic term that
bank foreign exchange market has adopted a system under which all quotations applies globally.
are given in European (Column 2) terms with a few exceptions. The excep-
tions—the euro, British pound, Australian dollar, and New Zealand dollar—are Direct Quotation
quoted in American terms (Column 1). Because of this convention, traders The home currency
throughout the world see similar quotations on their computer screens, making price of one unit of the
it easy for them (and their computers) to compare rates quoted in different mar- foreign currency.
kets and to earn arbitrage profits if differences exist.
Indirect Quotation
Interbank Foreign Currency Quotations The foreign currency
price of one unit of the
The quotations from The Wall Street Journal given in Tables 19-1 and 19-2 are suf- home currency.
ficient for many purposes. For other purposes, however, additional terminology
and conventions are useful. There are two ways to state the exchange rate
between two currencies, either in American or European terms. Accordingly, we
need to designate one of the currencies as the “home” currency and the other as
the “foreign” currency. This designation is arbitrary. The home currency price of
one unit of the foreign currency is called a direct quotation. Thus, to a person
who considers the United States to be “home,” American terms represent a
direct quotation. On the other hand, the foreign currency price of one unit of the
home currency is called an indirect quotation. European terms represent indirect
quotations to people in the United States. Note that if the perspective changes
and the “home” currency is no longer the U.S. dollar, then the designations of
direct and indirect change. For the remainder of this chapter, we will assume
that the United States is the “home” country, unless specifically stated otherwise.

626 Part 7 Special Topics in Financial Management

Explain the difference between direct and indirect quotations.

What is a cross rate?

Assume that today 1 Canadian dollar is worth 0.75 U.S. dollar. How
many Canadian dollars would you receive for 1 U.S. dollar? (1.333)

Assume that 1 U.S. dollar can either be exchanged for 105 Japan-
ese yen or for 0.80 euro. What is the Euro/yen exchange rate?
(€0.007619/¥)

Updated currency 19.5 TRADING IN FOREIGN EXCHANGE
spot and forward rates
(from 1 to 12 months) are Importers, exporters, tourists, and governments buy and sell currencies in the
provided by the Bank of foreign exchange market. For example, when a U.S. trader imports automobiles
Montreal Financial Group’s from Japan, payment will probably be made in Japanese yen. The importer buys
Economic Research and yen (through its bank) in the foreign exchange market, much as one buys com-
Analysis at http://www mon stocks on the New York Stock Exchange or pork bellies on the Chicago
.bmo.com/economic/ Mercantile Exchange. However, whereas stock and commodity exchanges have
regular/fxrates.html. organized trading floors, the foreign exchange market consists of a network of
brokers and banks based in New York, London, Tokyo, and other financial cen-
Spot Rate ters. Most buy and sell orders are conducted by computer and telephone.4
The effective exchange
rate of a foreign Spot Rates and Forward Rates
currency for delivery on
(approximately) the The exchange rates shown earlier in Tables 19-1 and 19-2 are known as spot
current day. rates, which means the rate paid for delivery of the currency “on the spot” or, in
reality, no more than two days after the day of the trade. For most of the world’s
Forward Exchange major currencies, it is also possible to buy (or sell) currencies for delivery at
Rate some agreed-upon future date, usually 30, 90, or 180 days from the day the
An agreed-upon price transaction is negotiated. This rate is known as the forward exchange rate.
at which two currencies
will be exchanged at For example, suppose a U.S. firm must pay 500 million yen to a Japanese
some future date. firm in 30 days, and the current spot rate is 111.43 yen per dollar. Unless
spot rates change, the U.S. firm will pay the Japanese firm the equivalent of
$4.487 million (500 million yen divided by 111.43 yen per dollar) in 30 days. But
if the spot rate falls to 100 yen per dollar, for example, the U.S. firm will have to
pay the equivalent of $5 million. The treasurer of the U.S. firm can avoid this
risk by entering into a 30-day forward exchange contract. This contract promises
delivery of yen to the U.S. firm in 30 days at a guaranteed price of 111.09 yen
per dollar. No cash changes hands at the time the treasurer signs the forward
contract, although the U.S. firm might have to put some collateral down as a
guarantee against default. Because the firm can use an interest-bearing instru-
ment for the collateral, though, this requirement is not costly. The counterparty
to the forward contract must deliver the yen to the U.S. firm in 30 days, and
the U.S. firm is obligated to purchase the 500 million yen at the previously
agreed-upon rate of 111.09 yen per dollar. Therefore, the treasurer of the U.S.
firm is able to lock in a payment equivalent to $4.501 million, no matter what
happens to spot rates. This technique, which is called “hedging,” was discussed
in Chapter 18.

4 For a more detailed explanation of exchange rate determination and operations of the foreign
exchange market, see Roy L. Crum, Eugene F. Brigham, and Joel F. Houston, Fundamentals of
International Finance (Mason, OH: Thomson/South-Western, 2005).

Chapter 19 Multinational Financial Management 627

TA B L E 1 9 - 3 Selected Spot and Forward Exchange Rates (Number
of Units of Foreign Currency per U.S. Dollar)

FORWARD RATES

British pound Spot 30 Days 90 Days 180 Days Forward Rate at a
Canadian dollar Rate Premium or Discount
Japanese yen 0.5730 0.5737 0.5740
Swiss franc 0.5724 1.2177 1.2158 1.2120 Discount
1.2186 111.09 110.41 109.28 Premium
111.43 1.2913 1.2850 1.2740 Premium
1.2945 Premium

Notes:
a. These are representative quotes as provided by a sample of New York banks. Forward rates for
other currencies and for other lengths of time can often be negotiated.
b. When it takes more units of a foreign currency to buy one dollar in the future, the value of the
foreign currency is less in the forward market than in the spot market, hence the forward rate is at a
discount to the spot rate. Likewise, when it takes less units of a foreign currency to buy one dollar in
the future, the value of the foreign currency is more in the forward market than in the spot market,
hence the forward rate is at a premium to the spot rate.

Source: Adapted from The Wall Street Journal, July 26, 2005, p. C12.

Forward rates for 30-, 90-, and 180-day delivery, along with the current spot Discount on Forward
rates for some commonly traded currencies, are given in Table 19-3. If we can Rate
obtain more of the foreign currency for a dollar in the forward than in the spot The situation when the
market, the forward currency is less valuable than the spot currency, and the for- spot rate is less than
ward currency is said to be selling at a discount. Conversely, if we can obtain the forward rate.
less of the foreign currency for a dollar in the forward than in the spot market,
the forward currency is more valuable than the spot currency, and the forward Premium on Forward
currency is said to be selling at a premium. Thus, because a dollar would buy Rate
fewer Canadian dollars, yen, and Swiss francs in the forward than in the spot The situation when the
market, the forward Canadian dollars, yen, and Swiss francs are selling at a pre- spot rate is greater
mium. On the other hand, a dollar would buy more pounds in the forward than than the forward rate.
in the spot market, so the forward pounds are selling at a discount.

Explain what it means for a forward currency to sell at a discount
and at a premium.

Suppose a U.S. firm must pay 200 million Swiss francs to a Swiss
firm in 90 days. Briefly explain how the firm would use forward
exchange rates to “lock in” the price of the payable due in 90 days.

19.6 INTEREST RATE PARITY Interest Rate Parity

Market forces determine whether a currency sells at a forward premium or dis- Specifies that investors
count, and the general relationship between spot and forward exchange rates is should expect to earn
specified by a concept called “interest rate parity.” the same return in all
countries after adjust-
Interest rate parity holds that investors should earn the same return on ing for risk.
security investments in all countries after adjusting for risk. It recognizes that
when you invest in a country other than your home country, you are affected by
two forces—returns on the investment itself and changes in the exchange rate. It

628 Part 7 Special Topics in Financial Management

follows that your overall return will be higher than the investment’s stated
return if the currency in which your investment is denominated appreciates rela-
tive to your home currency. Likewise, your overall return will be lower if the
foreign currency you receive declines in value.

The relationship between spot and forward exchange rates and interest
rates, which is known as interest rate parity, is expressed in the following
equation:

Forward exchange rate ϭ 11 ϩ rh 2
Spot exchange rate 11 ϩ rf 2

Here both the forward and spot rates are expressed in terms of the amount of
home currency received per unit of foreign currency, and rh and rf are the peri-
odic interest rates in the home country and the foreign country, respectively. If
this relationship does not hold, then currency traders will buy and sell curren-
cies—that is, engage in arbitrage—until it does hold.

To illustrate interest rate parity, consider the case of a U.S. investor who can
buy default-free 90-day Japanese bonds that promise a 4 percent nominal return.
The 90-day interest rate, rf, is 4%/4 ϭ 1% because 90 days is one-fourth of a 360-
day year. Assume also that the spot exchange rate is $0.008974, which means
that you can exchange 0.008974 dollar for 1 yen, or 111.43 yen per dollar. Finally,
assume that the 90-day forward exchange rate is $0.009057, which means that
you can exchange 1 yen for 0.009057 dollar, or receive 110.41 yen per dollar
exchanged, 90 days from now.

The U.S. investor can receive a 4 percent annualized return denominated
in yen, but if he or she ultimately wants to consume goods in the United
States, those yen must be converted to dollars. The dollar return on the invest-
ment depends, therefore, on what happens to exchange rates over the next
three months. However, the investor can lock in the dollar return by selling
the foreign currency in the forward market. For example, the investor could
simultaneously

• Convert $1,000 to 111,430 yen in the spot market.
• Invest the 111,430 yen in 90-day Japanese bonds that have a 4 percent annu-

alized return or a 1 percent quarterly return, hence will pay (111,430)(1.01) ϭ
112,544.30 yen in 90 days.
• Agree today to exchange these 112,544.30 yen 90 days from now at the 90-day
forward exchange rate of 110.41 yen per dollar, or for a total of $1,019.33.

This investment, therefore, has an expected 90-day return of $19.33/$1,000 ϭ
1.933%, which translates into a nominal return of 4(1.933%) ϭ 7.73%. In this
case, 4 percent of the expected 7.73 percent return is coming from the bond itself,
and 3.73 percent arises because the market believes the yen will strengthen
relative to the dollar. Note that by locking in the forward rate today, the investor
has eliminated any exchange rate risk. And, because the Japanese bond is
assumed to be default-free, the investor is assured of earning a 7.73 percent
dollar return.

Interest rate parity implies that an investment in the United States with the
same risk as a Japanese bond should have an annual return of 7.73 percent. Solv-
ing for rh in the parity equation, we indeed find that the predicted annual inter-
est rate in the United States is 7.73 percent.

Interest rate parity shows why a particular currency might be at a forward
premium or discount. Note that a currency is at a forward premium whenever
domestic interest rates are higher than foreign interest rates. Discounts prevail if
domestic interest rates are lower than foreign interest rates. If these conditions
do not hold, then arbitrage will soon force interest rates back to parity.

Chapter 19 Multinational Financial Management 629

What is interest rate parity?

Assume interest rate parity holds. When a currency trades at a for-
ward premium, what does that imply about domestic rates relative to
foreign interest rates? When a currency trades at a forward discount?

Assume that 90-day U.S. securities have a 3.5 percent annualized
interest rate, whereas 90-day Canadian securities have a 4 percent
annualized interest rate. In the spot market, 1 U.S. dollar can be
exchanged for 1.4 Canadian dollars. If interest rate parity holds,
what is the 90-day forward exchange rate between U.S. and Cana-
dian dollars? ($0.7134/C$ or C$1.40173/$)

On the basis of your answer to the previous question, is the Cana-
dian dollar selling at a premium or discount on the forward rate?
(Discount)

19.7 PURCHASING POWER PARITY

We have discussed exchange rates in some detail, and we have considered the Purchasing Power
relationship between spot and forward exchange rates. However, we have not yet
addressed the fundamental question, What determines the spot level of exchange Parity (PPP)
rates in each country? While exchange rates are influenced by a multitude of
factors that are difficult to predict, particularly on a day-to-day basis, over the The relationship in
long run market forces work to ensure that similar goods sell for similar prices in which the same
different countries after taking exchange rates into account. This relationship is products cost roughly
known as “purchasing power parity.” the same amount in
different countries after
Purchasing power parity (PPP), sometimes referred to as the law of one price, taking into account the
implies that the level of exchange rates adjusts so as to cause identical goods to exchange rate.
cost the same amount in different countries. For example, if a pair of tennis
shoes costs $150 in the United States and 100 pounds in Britain, PPP implies that
the exchange rate be $1.50 per pound. Consumers could purchase the shoes in
Britain for 100 pounds, or they could exchange their 100 pounds for $150 and
then purchase the same shoes in the United States at the same effective cost,
assuming no transactions or transportation costs. The equation for purchasing
power parity is shown here:

Ph ϭ (Pf)(Spot rate)

or Spot rate ϭ Ph
Here Pf

Ph ϭ the price of the good in the home country ($150, assuming the United
States is the home country).

Pf ϭ the price of the good in the foreign country (100 pounds).

Note that the spot market exchange rate is expressed as the number of units of
home currency that can be exchanged for one unit of foreign currency ($1.50 per
pound).

PPP assumes that market forces will eliminate situations in which the same
product sells at a different price overseas. For example, if the shoes cost $140 in
the United States, importers/exporters could purchase them in the United States
for $140, sell them for 100 pounds in Britain, exchange the 100 pounds for $150
in the foreign exchange market, and earn a profit of $10 on every pair of shoes.

630 Part 7 Special Topics in Financial Management

Ultimately, this trading activity would increase the demand for shoes in the
United States and thus raise Ph, increase the supply of shoes in Britain and thus
reduce Pf, and increase the demand for dollars in the foreign exchange market
and thus reduce the spot rate. Each of these actions works to restore PPP.

Note that PPP assumes that there are no transportation or transactions costs,
or import restrictions, all of which limit the ability to ship goods between coun-
tries. In many cases, these assumptions are incorrect, which explains why PPP is
often violated. An additional complication, when empirically testing to see
whether PPP holds, is that products in different countries are rarely identical.
Frequently, there are real or perceived differences in quality, which can lead to
price differences in different countries.

Still, the concepts of interest rate and purchasing power parity are critically
important to those engaged in international activities. Companies and investors
must anticipate changes in interest rates, inflation, and exchange rates, and they
often try to hedge the risks of adverse movements in these factors. The parity
relationships are extremely useful when anticipating future conditions.

What is purchasing power parity?

A television set sells for $1,000 U.S. dollars. In the spot market,
$1 ϭ 110 Japanese yen. If purchasing power parity holds, what should
be the price (in yen) of the same television set in Japan? (¥110,000)

Price differences in “similar” products in different countries often
exist. What can explain these differences?

19.8 INFLATION, INTEREST RATES,
AND EXCHANGE RATES

Relative inflation rates, or the rates of inflation in foreign countries compared with
that in the home country, have many implications for multinational financial deci-
sions. Obviously, relative inflation rates will greatly influence future production
costs at home and abroad. Equally important, inflation has a dominant influence on
relative interest rates and exchange rates. Both of these factors influence the meth-
ods chosen by multinational corporations for financing their foreign investments,
and both have an important effect on the profitability of foreign investments.

The currencies of countries with higher inflation rates than that of the United
States by definition depreciate over time against the dollar. Countries where this
has occurred include Mexico and all the South American nations. On the other
hand, the currencies of Canada, Switzerland, and Japan, which have had less
inflation than the United States, have appreciated against the dollar. In fact, a for-
eign currency will, on average, depreciate or appreciate at a percentage rate approximately
equal to the amount by which its inflation rate exceeds or is less than our own.

Relative inflation rates also affect interest rates. The interest rate in any
country is largely determined by its inflation rate. Therefore, countries currently
experiencing higher inflation rates than the United States also tend to have
higher interest rates. The reverse is true for countries with lower inflation rates.

It is tempting for a multinational corporation to borrow in countries with the
lowest interest rates. However, this is not always a good strategy. Suppose, for
example, that interest rates in Switzerland are lower than those in the United
States because of Switzerland’s lower inflation rate. A U.S. multinational firm
could therefore save interest by borrowing in Switzerland. However, because of
relative inflation rates, the Swiss franc will probably appreciate in the future,
causing the dollar cost of annual interest and principal payments on Swiss debt

Chapter 19 Multinational Financial Management 631

to rise over time. Thus, the lower interest rate could be more than offset by losses from
currency appreciation. Similarly, multinational corporations should not necessarily
avoid borrowing in a country such as Brazil, where interest rates have been very
high, because future depreciation of the Brazilian real could make such borrow-
ing relatively inexpensive.

What effects do relative inflation rates have on relative interest
rates?

What happens over time to the currencies of countries with higher
inflation rates than that of the United States? To those with lower
inflation rates?

Why might a multinational corporation decide to borrow in a coun-
try such as Brazil, where interest rates are high, rather than in a
country like Switzerland, where interest rates are low?

19.9 INTERNATIONAL MONEY Eurocredits
Floating-rate bank
AND CAPITAL MARKETS loans, available in most
major trading curren-
One way for U.S. citizens to invest in world markets is to buy the stocks of U.S. cies, that are tied to
multinational corporations that invest directly in foreign countries. Another way is LIBOR.
to purchase foreign securities—stocks, bonds, or money market instruments issued
by foreign companies. Security investments are known as portfolio investments, and Eurodollar
they are distinguished from direct investments in physical assets by U.S. corporations. A U.S. dollar deposited
in a bank outside the
From World War II through the 1960s, the U.S. capital markets dominated United States.
world markets. Today, however, the value of U.S. securities represents less than
one-fourth the value of all securities. Given this situation, it is important for both Eurobond
corporate managers and investors to have an understanding of international An international bond
markets. Moreover, these markets often offer better opportunities for raising or underwritten by an
investing capital than are available domestically. international syndicate
of banks and sold to
International Credit Markets investors in countries
other than the one in
There are three major types of credit markets in the international marketplace whose money unit the
that mirror equivalent U.S. markets in many ways. Floating-rate bank loans, bond is denominated.
called eurocredits, are tied to a standard rate known by the acronym LIBOR,
which stands for London Inter Bank Offer Rate. LIBOR is the interest rate offered
by the largest and strongest London-based banks on large deposits. In July
2005, the three-month LIBOR rate was 3.6 percent. Eurocredits tend to be
issued for a fixed term with no early repayment. The oldest example of a euro-
credit is a eurodollar deposit, which is U.S. dollars deposited in a bank outside
the United States. Today, eurocredits exist for most major trading currencies.

The eurobond market is the medium- to long-term international market for
both fixed- and floating-rate debt. It is almost as old as the eurodollar market
and is a natural extension of it. A eurobond is an international bond underwrit-
ten by an international bank syndicate and sold to investors in countries other
than the one in whose money unit the bond is denominated. Thus, U.S.
dollar–denominated eurobonds cannot be sold in the United States, sterling
eurobonds cannot be sold in the United Kingdom, and yen eurobonds cannot be
sold in Japan. This is a true international debt instrument and is usually issued
in bearer form, which means that the owner’s identity is not registered and
known; to receive the interest payments the owner must clip a coupon and
present it for payment at one of the designated payor banks. Most eurobonds are

632 Part 7 Special Topics in Financial Management

Hungry for a Big Mac?
Go to China!

Purchasing power parity (PPP) implies that the same the actual exchange rate at the time was 28.33
product will sell for the same price in every country rubles per dollar, this implies that the ruble was 52
after adjusting for current exchange rates. One prob- percent undervalued, which is shown in the last col-
lem when testing to see if PPP holds is that it umn of Panel B.
assumes that goods consumed in different countries
are of the same quality. For example, if you find that The evidence suggests that strict PPP does not
a product is more expensive in Switzerland than it is hold, but recent research suggests that the Big Mac test
in Canada, one explanation is that PPP fails to hold, may shed some insights about where exchange rates
but another explanation is that the product sold in are headed. The average price of a Big Mac within the
Switzerland is of a higher quality and therefore European Monetary Union (EMU) is 2.91 euros. This
deserves a higher price. implies that the euro’s PPP is $1.05, so at its current rate
of $1.23 the euro is overvalued by 17 percent.
One way to test for PPP is to find goods that
have the same quality worldwide. With this in mind, England, Sweden, Switzerland, and Denmark—
The Economist magazine occasionally compares the four European countries that are not part of the
prices of a well-known good whose quality is the EMU—have currencies that are significantly overval-
same in 118 different countries: the McDonald’s Big ued against the dollar. The British pound is overval-
Mac hamburger. ued by 12 percent, the Swedish krona is overvalued
by 36 percent, the Swiss franc is overvalued by 65
The tables shown in Panels A and B on the next percent, and the Danish krone is overvalued by 50
page provide information collected during 2005. The percent. In contrast, the Japanese yen is the most
Panel A table gives the price of a Big Mac in each undervalued rich-world currency—by 23 percent.
country’s local currency and the actual dollar exchange
rate when these data were collected. In Panel B, the According to the Big Mac Index, the U.S. dollar
first numeric column calculates the price of the Big is no longer overvalued against the euro. However,
Mac in terms of the U.S. dollar—this is obtained by the dollar may decline in value because of the
dividing the local price by the actual exchange rate increasing difficulty in financing the U.S. govern-
at that time. For example, a Big Mac costs 6.30 Swiss ment’s huge current account deficit. In addition, the
francs in Zurich, which is shown in Panel A. Given an index indicates that the Japanese yen is likely to see
exchange rate of 1.25 Swiss francs per dollar (as a large gain and the British pound will continue to
shown in Panel A), this implies that the dollar price of fall against the euro. Moreover, this index suggests
a Big Mac is 6.30 Swiss francs/1.25 Swiss francs per that the Chinese yuan was significantly undervalued
dollar Ϸ $5.05, shown in Panel B. relative to the U.S. dollar. Indeed, a month after this
index was published, the Chinese government did
The second numeric column in Panel B backs announce a 2.1 percent revaluation of the yuan.
out the implied exchange rate that would hold under
PPP. This is obtained by dividing the price of the Big One last benefit of the Big Mac test is that it
Mac in each local currency by its U.S. price. For tells us the cheapest places to find a Big Mac.
example, as shown in Panel A, a Big Mac costs 41.92 According to the data, if you are looking for a Big
rubles in Russia and $3.06 in the United States. If Mac, head to China, and avoid Switzerland. In other
PPP holds, the exchange rate should be 13.7 rubles words, the Chinese yuan is the most undervalued
per dollar (41.92 rubles/$3.06), which is shown in currency and the Swiss franc is the most overvalued.
Panel B.
Sources: Adapted from “Fast Food and Strong Currencies,”
Comparing the implied exchange rate (shown in The Economist, Vol. 375 (June 11, 2005), pp. 70–72; and Li
Panel B) to the actual exchange rate (shown in Panel Lian Ong, “Burgernomics: The Economics of the Big Mac
A), we see the extent to which the local currency is Standard,” Journal of International Money and Finance, Vol.
under- or overvalued relative to the dollar. Given that 16, no. 6 (1997), pp. 867–878.

Chapter 19 Multinational Financial Management 633

PANEL A Big Mac Actual PANEL B Big Mac Implied Under (؊)
Prices Dollar Prices PPP Over (؉)
United Statesa in Local Exchange United Statesa in of Valuation
Argentina Rate, 4/05b Argentina Dollarsc the against
Australia Currencyb Australia
Brazil — Brazil $3.06 Dollard the
Britain $3.06 2.89 Britain 1.64 Dollar, %
Canada Peso4.74 1.30 Canada 2.50 —
Chile 2.47 Chile 2.39 1.55 —
China A$3.24 1.83e China 3.44 1.06 Ϫ46
Czech Republic Real5.91 1.24 Czech Republic 2.63 1.93 Ϫ18
Denmark Denmark 2.53 1.63e Ϫ22
Egypt £1.88 592.65 Egypt 1.27 1.07
Euro area C$3.27 8.26 Euro area 2.30 490 12
Hong Kong Peso1,499.40 Hong Kong 4.58 3.43 Ϫ14
Hungary Yuan10.50 24.48 Hungary 1.55 18.4 Ϫ17
Indonesia Koruna56.30 6.06 Indonesia 3.58f 9.07 Ϫ59
Japan DKr27.75 5.80 Japan 1.54 2.94 Ϫ25
Malaysia Pound9.00 1.23g Malaysia 2.60 1.05g
Mexico 7.79 Mexico 1.53 3.92 50
New Zealand €2.91 New Zealand 2.34 173 Ϫ49
Peru HK$12.00 203.61 Peru 1.38 4,771
Philippines Forint529.38 9,542.00 Philippines 2.58 81.7 17
Poland Rupiah14,599.26 Poland 3.17 1.72 Ϫ50
Russia 106.84 Russia 2.76 9.15 Ϫ15
Singapore ¥250.00 3.81 Singapore 1.47 1.45 Ϫ50
South Africa M$5.26 South Africa 1.96 2.94 Ϫ23
South Korea Peso28.00 10.85 South Korea 1.48 26.1 Ϫ55
Sweden NZ4.44 1.40 Sweden 2.17 2.12 Ϫ16
Switzerland NewSol9.00 3.26 Switzerland 2.10 13.7
Taiwan Peso79.87 Taiwan 2.49 1.18 4
Thailand Zloty6.49 54.33 Thailand 4.17 4.56 Ϫ10
Turkey Rouble41.92 3.31 Turkey 5.05 817 Ϫ52
Venezuela S$3.61 Venezuela 2.41 10.1 Ϫ36
Rand13.95 28.33 1.48 2.06 Ϫ52
Won2,500.02 1.66 2.92 24.5 Ϫ29
SKr30.91 6.64 2.13 19.6 Ϫ31
SFr6.30 1.31 Ϫ19
NT$74.97 1,004.02 1,830
Baht59.98 7.41 36
Lira4.01 1.25 65
Bolivar5,599.80 Ϫ21
31.11 Ϫ52
40.52 Ϫ5
Ϫ30
1.37
2,629.01

Notes:
a Average of New York, Chicago, San Francisco, and Atlanta.
b Calculated from data provided in article.
c At current exchange rate.
d Purchasing power parity: Local price divided by price in the United States.
e Dollars per pound.
f Weighted average of member countries.
g Dollars per euro.

Sources: McDonald’s; and “Fast Food and Strong Currencies,” The Economist, Vol. 375 (June 11, 2005), pp. 70–72.

634 Part 7 Special Topics in Financial Management

Stock Market Indices
Around the World

In Chapter 5, we described the major U.S. stock mar- which is calculated every minute throughout daily
ket indices. As discussed herein, similar market trading, consists of a collection of highly liquid equity
indices also exist for each major world financial cen- issues thought to be representative of the Japanese
ter. The accompanying figure compares four of these economy.
indices against the U.S. indices.
Chile
Hong Kong The Santiago Stock Exchange has three main share
In Hong Kong, the primary stock index is the Hang indices: the General Stock Price Index (IGPA), the
Seng. Created by HSI Services Limited, the Hang Seng Selective Stock Price Index (IPSA), and the INTER-10
index reflects the performance of the Hong Kong stock Index. The IPSA, which reflects the price variations of
market. It is composed of 33 domestic stocks (account- the most active stocks, is composed of 40 of the
ing for about 70 percent of the market’s capitalization), most actively traded stocks on the exchange.
which are divided into four subindices: Commerce and
Industry, Finance, Utilities, and Properties. India
Of the 22 stock exchanges in India, the Bombay
Germany Stock Exchange (BSE) is the largest, with more than
The major indicator of the German stock market, the 6,000 listed stocks and approximately two-thirds of
XETRA DAX, is comprised of 30 German blue chip the country’s total trading volume. Established in
stocks. These stocks are all listed on the Frankfurt 1875, the exchange is also the oldest in Asia. Its
exchange, and they are representative of the indus- yardstick is the BSE Sensex, an index of 30 publicly
trial structure of the German economy. traded Indian stocks that account for one-fifth of the
BSE’s market capitalization.
Great Britain
The FT-SE 100 Index (pronounced “footsie”) is the most Spain
widely followed indicator of equity investments in Great In Spain, the IBEX 35 is the official index for measur-
Britain. It is a value-weighted index composed of the ing equity market performance for continuously
100 largest companies on the London Stock Exchange traded stocks. This index is composed of the 35
whose value is calculated every minute of trading. most actively traded securities on the Joint Stock
Exchange System (comprising the four Spanish stock
Japan exchanges).
In Japan, the principal barometer of stock perfor-
mance is the Nikkei 225 Index. The index’s value,

Foreign Bond not rated by one of the rating agencies such as S&P or Moody’s, although an
increasing number of them are starting to be rated. Eurobonds can be issued
A type of international with either a fixed coupon rate or a floating rate depending on the preferences of
bond issued in the the issuer, and they have medium- or long-term maturities.
domestic capital mar-
ket of the country in Another type of international bond is a foreign bond. A foreign bond is
whose currency the issued in the domestic capital market of the country in whose currency the bond
bond is denominated, is denominated and is underwritten by investment banks from the same country.
and underwritten by The only thing foreign about a foreign bond is the nationality of the borrower.
investment banks from For instance, Canadian companies often issue U.S. dollar–denominated foreign
the same country. bonds in New York to fund their U.S. operations. Foreign bonds issued in the
United States are sometimes called “Yankee bonds.” Similarly, “bulldogs” are
foreign bonds issued in London, and “samurai bonds” are foreign bonds issued
in Tokyo. Foreign bonds can be either fixed or floating and have the same matu-
rities as the purely domestic bonds with which they must compete for funding.

Chapter 19 Multinational Financial Management 635

Selected International Stock Indices—Compound Returns Since January 1995

Relative
Value (%)
300

250

200 United States

150
Germany

100
England

50

0 India

–50
Japan

–100
1/95 1/96 1/97 1/98 1/99 1/00 1/01 1/02 1/03 1/04 1/05

Source: Adapted from Yahoo Finance historical quotes obtained from the Web site at http://finance.yahoo.com.

International Stock Markets

New issues of stock are sold in international markets for a variety of reasons.
For example, a non-U.S. firm might sell an equity issue in the United States
because it can tap a much larger source of capital than in its home country. Also,
a U.S. firm might tap a foreign market because it wants to create an equity mar-
ket presence to accompany its operations in that country. Large multinational
companies also occasionally issue new stock simultaneously in multiple coun-
tries. For example, Alcan Aluminum, a Canadian company, recently issued new
stock in Canada, Europe, and the United States simultaneously, using different
underwriting syndicates in each market.

In addition to new issues, outstanding stocks of large multinational com-
panies are increasingly being listed on multiple international exchanges. For
example, Coca-Cola’s stock is traded on six stock exchanges in the United

636 Part 7 Special Topics in Financial Management

American Depository States, four stock exchanges in Switzerland, and the Frankfurt stock exchange
Receipts (ADRs) in Germany. Some 500 foreign stocks are listed in the United States—one
Certificates represent- example is Royal Dutch Petroleum, which is listed on the NYSE. U.S. investors
ing ownership of can also invest in foreign companies through American Depository Receipts
foreign stock held in (ADRs), which are certificates representing ownership of foreign stock held in
trust. trust. About 1,700 ADRs are now available in the United States, with most of
them traded on the over-the-counter (OTC) market. However, more and more
Repatriation of ADRs are being listed on the New York Stock Exchange, including England’s
Earnings British Airways, Japan’s Honda Motors, and Italy’s Fiat Group.
The process of sending
cash flows from a for- What are the three major types of international credit markets?
eign subsidiary back to
the parent company. What is LIBOR?

What are ADRs?

19.10 INTERNATIONAL CAPITAL
BUDGETING

Up to now, we have discussed the general environment in which multinational
firms operate. In the remainder of the chapter, we will see how international fac-
tors affect key corporate decisions. We begin with capital budgeting. Although
the same basic principles of capital budgeting analysis apply to both foreign and
domestic operations, there are some key differences. First, cash flow estimation
is more complex for overseas investments. Most multinational firms set up sepa-
rate subsidiaries in each foreign country in which they operate, and the relevant
cash flows for the parent company are the dividends and royalties paid by the
subsidiaries to the parent. Second, these cash flows must be converted into the
parent company’s currency, hence they are subject to exchange rate risk. For
example, General Motors’ German subsidiary may make a profit of 100 million
euros in 2005, but the value of this profit to GM will depend on the dollar/euro
exchange rate: How many dollars will 100 million euros buy?

Dividends and royalties are normally taxed by both foreign and home-country
governments. Furthermore, a foreign government may restrict the amount of the
cash that may be repatriated to the parent company. For example, some govern-
ments place a ceiling, stated as a percentage of the company’s net worth, on the
amount of cash dividends that a subsidiary can pay to its parent. Such restric-
tions are normally intended to force multinational firms to reinvest earnings in
the foreign country, although restrictions are sometimes imposed to prevent
large currency outflows, which might disrupt the exchange rate.

Whatever the host country’s motivation for blocking repatriation of profits,
the result is that the parent corporation cannot use cash flows blocked in the for-
eign country to pay dividends to its shareholders or to invest elsewhere in the
business. Hence, from the perspective of the parent organization, the cash flows
relevant for foreign investment analysis are the cash flows that the subsidiary is actually
expected to send back to the parent. The present value of those cash flows is found
by applying an appropriate discount rate, and this present value is then com-
pared with the parent’s required investment to determine the project’s NPV.

In addition to the complexities of the cash flow analysis, the cost of capital
may be different for a foreign project than for an equivalent domestic project, because for-
eign projects may be more or less risky. A higher risk could arise from two primary
sources—(1) exchange rate risk and (2) political risk. A lower risk might result
from international diversification.

Chapter 19 Multinational Financial Management 637

Exchange rate risk relates to the value of the basic cash flows in the par- Exchange Rate Risk
ent company’s home currency. The foreign currency cash flows to be turned The risk that relates to
over to the parent must be converted into U.S. dollars by translating them at what the basic cash
expected future exchange rates. An analysis should be conducted to ascertain flows will be worth in
the effects of exchange rate variations, and, on the basis of this analysis, an the parent company’s
exchange rate risk premium should be added to the domestic cost of capital to home currency.
reflect this risk. It is sometimes possible to hedge against exchange rate fluctua-
tions, but it may not be possible to hedge completely, especially on long-term Political Risk
projects. If hedging is used, the costs of doing so must be subtracted from the Potential actions by a
project’s cash flows. host government that
would reduce the
Political risk refers to potential actions by a host government that would value of a company’s
reduce the value of a company’s investment. It includes at one extreme the investment.
expropriation without compensation of the subsidiary’s assets, but it also
includes less drastic actions that reduce the value of the parent firm’s investment Business Climate
in the foreign subsidiary, including higher taxes, tighter repatriation or currency Refers to a country’s
controls, and restrictions on prices charged. The risk of expropriation is small in social, political, and
traditionally friendly and stable countries such as Great Britain or Switzerland. economic environment.
However, in Latin America, Africa, the Far East, and eastern Europe, the risk
may be substantial. Past expropriations include those of ITT and Anaconda Cop-
per in Chile, Gulf Oil in Bolivia, Occidental Petroleum in Libya, and the assets of
many companies in Iraq, Iran, and Cuba.

Note that companies can take several steps to reduce the potential loss from
expropriation: (1) finance the subsidiary with local capital, (2) structure opera-
tions so that the subsidiary has value only as a part of the integrated corporate
system, and (3) obtain insurance against economic losses due to expropriation
from a source such as the Overseas Private Investment Corporation (OPIC). In
the latter case, insurance premiums would have to be added to the project’s
cost.

Several organizations rate the country risk, or the risk associated with
investing in a particular country. These ratings are based on the country’s social,
political, and economic environment, or its business climate.

Perhaps surprisingly, many of these types of studies suggest that the United
States does not have the lowest level of country risk. This is particularly signifi-
cant because even though people in the United States often assume that our
bonds have no country risk, others do not agree. Foreign investors are concerned
about how changes in U.S. policies (say, tax and Federal Reserve policies) might
affect their investments. To the extent that these perceptions about U.S. country
risk influence investors’ willingness to hold U.S. securities, they will have an
effect on U.S. interest rates.

List some key differences in capital budgeting as applied to foreign
versus domestic operations.

What are the relevant cash flows for an international investment—
the cash flows produced by the subsidiary in the country where it
operates or the cash flows in dollars that it sends to its parent
company?

Why might the cost of capital for a foreign project differ from that of
an equivalent domestic project? Could it be lower?

What adjustments might be made to the domestic cost of capital for
a foreign investment due to exchange rate risk, political risk, and
country risk?

638 Part 7 Special Topics in Financial Management

19.11 INTERNATIONAL CAPITAL

STRUCTURES

Companies’ capital structures vary among countries. For example, the Organiza-
tion for Economic Cooperation and Development (OECD) recently reported that,
on average, Japanese firms use 85 percent debt to total assets (in book value
terms), German firms use 64 percent, and U.S. firms use 55 percent. One prob-
lem, however, when interpreting these numbers is that different countries often
use very different accounting conventions with regard to (1) reporting assets on
a historical- versus a replacement-cost basis, (2) the treatment of leased assets,
(3) pension plan funding, and (4) capitalizing versus expensing R&D costs.
These differences make it difficult to compare capital structures.

A study by Raghuram Rajan and Luigi Zingales of the University of Chicago
attempts to control for differences in accounting practices. In their study, Rajan
and Zingales used a database that covers fewer firms than the OECD but that
provides a more complete breakdown of balance sheet data. They concluded
that differences in accounting practices can explain much of the cross-country
variation in capital structures.

Rajan and Zingales’s results are summarized in Table 19-4. There are a num-
ber of different ways to measure capital structure. One measure is the average
ratio of total liabilities to total assets—this is similar to the measure used by the
OECD, and it is reported in Column 1. Based on this measure, German and
Japanese firms appear to be more highly levered than U.S. firms. However, if you
look at Column 2, where capital structure is measured by interest-bearing debt to
total assets, it appears that German firms use less leverage than U.S. and Japa-
nese firms. What explains this difference? Rajan and Zingales argue that much of
this difference is explained by the way German firms account for pension liabili-
ties. German firms generally include all pension liabilities (and their offsetting
assets) on the balance sheet, whereas firms in other countries (including the
United States) generally “net out” pension assets and liabilities on their balance
sheets. To see the importance of this difference, consider a firm with $10 million
in liabilities (not including pension liabilities) and $20 million in assets (not
including pension assets). Assume that the firm has $10 million in pension liabili-
ties that are fully funded by $10 million in pension assets. Therefore, net pension
liabilities are zero. If this firm were in the United States, it would report a ratio of
total liabilities to total assets equal to 50 percent ($10 million/$20 million). By
contrast, if this firm operated in Germany, both its pension assets and liabilities
would be reported on the balance sheet. The firm would have $20 million in lia-
bilities and $30 million in assets—or a 67 percent ($20 million/$30 million) ratio
of total liabilities to total assets. Total debt is the sum of short-term debt and long-
term debt and excludes other liabilities including pension liabilities. Therefore,
the measure of total debt to total assets provides a more comparable measure of
leverage across different countries.

Rajan and Zingales also make a variety of adjustments that attempt to con-
trol for other differences in accounting practices. The effects of these adjust-
ments are reported in Columns 3 and 4. Overall, the evidence suggests that
companies in Germany and the United Kingdom tend to have less leverage,
whereas firms in Canada appear to have more leverage, relative to firms in the
United States, France, Italy, and Japan. This conclusion is supported by data in
the final column, which shows the average times-interest-earned ratio for firms
in a number of different countries. Recall from Chapter 4 that the TIE ratio is the
ratio of operating income (EBIT) to interest expense. This measure indicates
how much cash the firm has available to service its interest expense. In general,

Chapter 19 Multinational Financial Management 639

TABLE 19-4 Median Capital Structures among Large Industrialized Countries
(Measured in Terms of Book Value)
Country
Canada Total Debt to Total Debt to Times
France Liabilities to Total Assets Liabilities to Total Assets Interest
Germany Total Assets (Unadjusted Total Assets Earned (TIE)
Italy (Unadjusted (Adjusted
Japan for (Adjusted for Ratio
United Kingdom for Accounting for (5)
United States Accounting Differences) Accounting
Mean Differences) Accounting Differences) 1.55ϫ
Standard deviation (2) Differences) 2.64
(1) (4) 3.20
32% (3) 1.81
56% 25 32% 2.46
71 16 48% 18 4.79
73 27 69 11 2.41
70 35 50 21 2.69ϫ
69 18 68 21 1.07ϫ
54 27 62 10
58 26% 47 25
64% 52 20%
7% 57%
8% 10% 8%

Source: Raghuram Rajan and Luigi Zingales, “What Do We Know about Capital Structure? Some Evidence from International
Data,” Journal of Finance, Vol. 50, no. 5 (December 1995), pp.1421–1460. Used with permission.

firms with more leverage have a lower times-interest-earned ratio. The data
indicate that this ratio is highest in the United Kingdom and Germany and low-
est in Canada.

Do international differences in financial leverage exist? Explain.

19.12 MULTINATIONAL WORKING
CAPITAL MANAGEMENT

Cash Management

The goals of cash management in a multinational corporation are similar to
those in a purely domestic corporation: (1) to speed up collections, slow down
disbursements, and thus maximize net float; (2) to shift cash as rapidly as possi-
ble from those parts of the business where it is not needed to those parts where
it is needed; and (3) to maximize the risk-adjusted, after-tax rate of return on
temporary cash balances. Multinational companies use the same general proce-
dures for achieving these goals as domestic firms, but because of longer

640 Part 7 Special Topics in Financial Management

distances and more serious mail delays, such devices as lockbox systems and
electronic funds transfers are especially important.

Although multinational and domestic corporations have the same objectives
and use similar procedures, multinational corporations face a far more complex
task. As noted earlier in our discussion of political risk, foreign governments
often place restrictions on transfers of funds out of the country, so although IBM
can transfer money from its Salt Lake City office to its New York concentration
bank just by pressing a few buttons, a similar transfer from its Buenos Aires
office is far more complex. Buenos Aires funds are denominated in pesos
(Argentina’s equivalent of the dollar), so the pesos must be converted to dollars
before the transfer. If there is a shortage of dollars in Argentina, or if the Argen-
tinean government wants to conserve dollars to purchase strategic materials,
then conversion, hence the transfer, may be blocked. Even if no dollar shortage
exists in Argentina, the government may still restrict funds outflows if those
funds represent profits or depreciation rather than payments for purchased
materials or equipment, because many countries, especially those that are less
developed, want profits reinvested in the country in order to stimulate economic
growth.

Once it has been determined what funds can be transferred, the next task is
to get those funds to locations where they will earn the highest returns. Whereas
domestic corporations tend to think in terms of domestic securities, multina-
tionals are more likely to be aware of investment opportunities all around the
world. Most multinational corporations use one or more global concentration
banks, located in money centers such as London, New York, Tokyo, Zurich, or
Singapore, and their staffs in those cities, working with international bankers,
know of and are able to take advantage of the best rates available anywhere in
the world.

Credit Management

Like most other aspects of finance, credit management in the multinational cor-
poration is similar to but more complex than that in a purely domestic business.
First, granting credit is more risky in an international context because, in addi-
tion to the normal risks of default, the multinational corporation must also
worry about exchange rate fluctuations between the time a sale is made and the
time a receivable is collected. For example, if IBM sold a computer to a Japanese
customer for 90 million yen when the exchange rate was 90 yen to the dollar,
IBM would receive 90,000,000/90 ϭ $1,000,000 for the computer. However, if it
sold the computer on terms of net/6 months, and if the yen fell against the
dollar so that one dollar would now buy 112.5 yen, IBM would end up realizing
only 90,000,000/112.5 ϭ $800,000 when it collected the receivable. Hedging can
reduce this type of risk, but at a cost.

Offering credit is generally more important for multinational corporations
than for purely domestic firms for two reasons. First, much U.S. trade is with
poorer, less-developed nations, where granting credit is generally a necessary
condition for doing business. Second, and in large part as a result of the first
point, developed nations whose economic health depends on exports often help
their manufacturing firms compete internationally by granting credit to foreign
countries. In Japan, for example, the major manufacturing firms have direct
ownership ties with large “trading companies” engaged in international trade,
as well as with giant commercial banks. In addition, a government agency, the
Ministry of International Trade and Industry (MITI), helps Japanese firms iden-
tify potential export markets and also helps potential customers arrange credit
for purchases from Japanese firms. In effect, the huge Japanese trade surpluses
are used to finance Japanese exports, thus helping to perpetuate their favorable

Chapter 19 Multinational Financial Management 641

trade balance. The United States has attempted to counter with the Export-
Import Bank, which is funded by Congress, but the fact that the United States
has a large balance of payments deficit is clear evidence that we have been less
successful than others in world markets in recent years.

The huge debt that countries such as Korea and Thailand owe U.S. and
other international banks is well known, and this situation illustrates how credit
policy (by banks in this case) can go astray. The banks face a particularly sticky
problem with these loans, because if a sovereign nation defaults, the banks can-
not lay claim to the assets of the country as they could if a corporate customer
defaulted. Note too that although the banks’ loans to foreign governments often
get most of the headlines, many U.S. multinational corporations are also in trou-
ble as a result of granting credit to business customers in the same countries
where bank loans to governments are on shaky ground.

By pointing out the risks in granting credit internationally, we are not sug-
gesting that such credit is bad. Quite the contrary, for the potential gains from
international operations far outweigh the risks, at least for companies (and
banks) that have the necessary expertise.

Inventory Management

As with most other aspects of finance, inventory management in a multinational
setting is similar to but more complex than for a purely domestic firm. First,
there is the matter of the physical location of inventories. For example, where
should ExxonMobil keep its stockpiles of crude oil and refined products? It has
refineries and marketing centers located worldwide, and one alternative is to
keep items concentrated in a few strategic spots from which they can then be
shipped as needs arise. Such a strategy might minimize the total amount of
inventories needed and thus might minimize the investment in inventories.
Note, though, that consideration will have to be given to potential delays in get-
ting goods from central storage locations to user locations all around the world.
Both working stocks and safety stocks would have to be maintained at each user
location, as well as at the strategic storage centers. Problems like the Iraqi occu-
pation of Kuwait and the subsequent trade embargo, which brought with it the
potential for a shutdown of production of about 25 percent of the world’s oil
supply, complicate matters further.

Exchange rates also influence inventory policy. If a local currency, say, the
Danish krone, were expected to rise in value against the dollar, a U.S. company
operating in Denmark would want to increase stocks of local products before the
rise in the krone, and vice versa if the krone were expected to fall.

Another factor that must be considered is the possibility of import or export
quotas or tariffs. For example, Apple Computer Company was buying certain
memory chips from Japanese suppliers at a bargain price. Then U.S. chipmakers
accused the Japanese of dumping chips in the U.S. market at prices below cost,
so they sought to force the Japanese to raise prices.5 That led Apple to increase

5 The term “dumping” warrants explanation, because the practice is so potentially important in
international markets. Suppose Japanese chipmakers have excess capacity. A particular chip has a
variable cost of $25, and its “fully allocated cost,” which is the $25 plus total fixed cost per unit of
output, is $40. Now suppose the Japanese firm can sell chips in the United States at $35 per unit,
but if it charges $40, it will not make any sales because U.S. chipmakers sell them for $35.50. If the
Japanese firm sells at $35, it will cover variable cost plus make a contribution to fixed overhead, so
selling at $35 makes sense. Continuing, if the Japanese firm can sell in Japan at $40, but U.S. firms
are excluded from Japanese markets by import duties or other barriers, the Japanese will have a
huge advantage over U.S. manufacturers. This practice of selling goods at lower prices in foreign
markets than at home is called “dumping.” U.S. firms are required by antitrust laws to offer the
same price to all customers and, therefore, cannot engage in dumping.

642 Part 7 Special Topics in Financial Management

its chip inventory. Then computer sales slacked off, and Apple ended up with an
oversupply of obsolete computer chips. As a result, Apple’s profits were hurt
and its stock price fell, demonstrating once more the importance of careful
inventory management. As mentioned earlier, another danger in certain coun-
tries is the threat of expropriation. If that threat is large, inventory holdings
will be minimized, and goods will be brought in only as needed. Similarly, if
the operation involves extraction of raw materials such as oil or bauxite, pro-
cessing plants may be moved offshore rather than located close to the produc-
tion site.

Taxes have two effects on multinational inventory management. First, coun-
tries often impose property taxes on assets, including inventories, and when this
is done, the tax is based on holdings as of a specific date, say, January 1 or
March 1. Such rules make it advantageous for a multinational firm (1) to sched-
ule production so that inventories are low on the assessment date, and (2) if
assessment dates vary among countries in a region, to hold safety stocks in dif-
ferent countries at different times during the year.

Finally, multinational firms may consider the possibility of at-sea storage.
Oil, chemical, grain, and other companies that deal in a bulk commodity that
must be stored in some type of tank can often buy tankers at a cost not much
greater—or perhaps even less, considering land cost—than land-based facilities.
Loaded tankers can then be kept at sea or at anchor in some strategic location.
This eliminates the danger of expropriation, minimizes the property tax prob-
lem, and maximizes flexibility with regard to shipping to areas where needs are
greatest or prices highest.

This discussion has only scratched the surface of inventory management in
the multinational corporation—the task is much more complex than for a purely
domestic firm. However, the greater the degree of complexity, the greater the
rewards from superior performance, so if you want challenge along with poten-
tially high rewards, look to the international arena.

What are some factors that make cash management especially com-
plicated in a multinational corporation?

Why is granting credit especially risky in an international context?

Why is inventory management especially important for a multina-
tional firm?

Tying It All Together

Over the past two decades, the global economy has become increasingly
integrated, and more and more companies generate more and more of their
profits from overseas operations. In many respects, the concepts developed
in the first 18 chapters still apply to multinational firms. However, multina-
tional companies have more opportunities but also face different risks than

Chapter 19 Multinational Financial Management 643

do companies that operate only in their home market. The chapter discussed
many of the key trends affecting the global markets today, and it described
the most important differences between multinational and domestic financial
management.

SELF-TEST QUESTIONS AND PROBLEMS
(Solutions Appear in Appendix A)

ST-1 Key terms Define each of the following terms:
ST-2
a. Multinational corporation
b. Vertically integrated investment
c. International monetary system
d. Exchange rate
e. Freely-floating regime; managed-float regime
f. Currency board arrangement
g. Fixed peg arrangement
h. Cross rate
i. American terms; European terms
j. Direct quotation; indirect quotation
k. Spot rate; forward exchange rate
l. Discount on forward rate; premium on forward rate
m. Interest rate parity; purchasing power parity
n. Eurocredits; eurodollar
o. Eurobond; foreign bond
p. American Depository Receipts (ADRs)
q. Repatriation of earnings; exchange rate risk; political risk; business climate

Cross rates Suppose the exchange rate between U.S. dollars and EMU euros is €1.1215 ϭ
$1.00, and the exchange rate between the U.S. dollar and the Canadian dollar is $1.00 ϭ
C$1.5291. What is the cross rate of euros to Canadian dollars?

QUESTIONS

19-1 Why do U.S. corporations build manufacturing plants abroad when they could build
19-2 them at home?
19-3
If the euro depreciates against the U.S. dollar, can a dollar buy more or fewer euros as a
19-4 result?
19-5
19-6 If the United States imports more goods from abroad than it exports, foreigners will tend
19-7 to have a surplus of U.S. dollars. What will this do to the value of the dollar with respect
to foreign currencies? What is the corresponding effect on foreign investments in the
United States?

Should firms require higher rates of return on foreign projects than on identical projects
located at home? Explain.

Does interest rate parity imply that interest rates are the same in all countries?

Why might purchasing power parity fail to hold?

What is a eurodollar? If a French citizen deposits $10,000 in Chase Manhattan Bank in New
York, have eurodollars been created? What if the deposit is made in Barclay’s Bank in Lon-
don? Chase Manhattan’s Paris branch? Does the existence of the eurodollar market make
the Federal Reserve’s job of controlling U.S. interest rates easier or more difficult? Explain.

644 Part 7 Special Topics in Financial Management

PROBLEMS

Easy 19-1 Exchange rate If British pounds sell for $1.50 (U.S.) per pound, what should dollars sell
Problems 1–4 19-2 for in pounds per dollar?
19-3
Intermediate 19-4 Cross rates A currency trader observes that in the spot exchange market, 1 U.S. dollar
Problems 5–11 19-5 can be exchanged for 4.0828 Israeli shekels or for 111.23 Japanese yen. What is the cross-
19-6 exchange rate between the yen and the shekel; that is, how many yen would you receive
Challenging for every shekel exchanged?
Problems 12–17 19-7
19-8 Interest rate parity Six-month T-bills have a nominal rate of 7 percent, while default-free
19-9 Japanese bonds that mature in 6 months have a nominal rate of 5.5 percent. In the spot
19-10 exchange market, 1 yen equals $0.009. If interest rate parity holds, what is the 6-month
19-11 forward exchange rate?
19-12
Purchasing power parity A television set costs $500 in the United States. The same set
19-13 costs 725 euros. If purchasing power parity holds, what is the spot exchange rate
between the euro and the dollar?

Exchange rates Table 19-1 lists foreign exchange rates for July 25, 2005. On that day,
how many dollars would be required to purchase 1,000 units of each of the following:
British pounds, Canadian dollars, EMU euros, Japanese yen, Mexican pesos, and
Swedish kronas?

Exchange rates Look up the 6 currencies in Problem 19-5 in the foreign exchange section
of a current issue of The Wall Street Journal.

a. What is the current exchange rate for changing dollars into 1,000 units of pounds,
Canadian dollars, euros, yen, Mexican pesos, and Swedish kronas?

b. What is the percentage gain or loss between the July 25, 2005, exchange rate and the
current exchange rate for each of the currencies in part a?

Currency appreciation Suppose that 1 Danish krone could be purchased in the foreign
exchange market for 14 U.S. cents today. If the krone appreciated 10 percent tomorrow
against the dollar, how many krones would a dollar buy tomorrow?

Cross rates Suppose the exchange rate between the U.S. dollar and the Swedish krona
was 10 krona ϭ $1.00, and the exchange rate between the dollar and the British pound was
£1 ϭ $1.50. What was the exchange rate between Swedish kronas and pounds?

Cross rates Look up the 3 currencies in Problem 19-8 in the foreign exchange section of
a current issue of The Wall Street Journal. What is the current exchange rate between
Swedish kronas and pounds?

Interest rate parity Assume that interest rate parity holds. In both the spot market and
the 90-day forward market 1 Japanese yen ϭ 0.0086 dollar. And 90-day risk-free securi-
ties yield 4.6 percent in Japan. What is the yield on 90-day risk-free securities in the
United States?

Purchasing power parity In the spot market 7.8 Mexican pesos can be exchanged for
1 U.S. dollar. A compact disc costs $15 in the United States. If purchasing power parity
(PPP) holds, what should be the price of the same disc in Mexico?

Interest rate parity Assume that interest rate parity holds and that 90-day risk-free secu-
rities yield 5 percent in the United States and 5.3 percent in Britain. In the spot market 1
pound ϭ 1.65 dollars.

a. Is the 90-day forward rate trading at a premium or discount relative to the spot rate?
b. What is the 90-day forward rate?

Spot and forward rates Chamberlain Canadian Imports has agreed to purchase 15,000
cases of Canadian beer for 4 million Canadian dollars at today’s spot rate. The firm’s finan-
cial manager, James Churchill, has noted the following current spot and forward rates:

U.S. Dollar/Canadian Dollar Canadian Dollar/U.S. Dollar

Spot 0.6930 1.4430
30-day forward 0.6935 1.4420
90-day forward 0.6944 1.4401
180-day forward 0.6957 1.4374

Chapter 19 Multinational Financial Management 645

19-14 On the same day, Churchill agrees to purchase 15,000 more cases of beer in 3 months at
19-15 the same price of 4 million Canadian dollars.
19-16
19-17 a. What is the price of the beer, in U.S. dollars, if it is purchased at today’s spot rate?
b. What is the cost, in U.S. dollars, of the second 15,000 cases if payment is made in

90 days and the spot rate at that time equals today’s 90-day forward rate?
c. If the exchange rate for the Canadian dollar is 1.20 to $1 in 90 days, how much will

Churchill have to pay for the beer (in U.S. dollars)?

Exchange gains and losses You are the vice president of International InfoXchange,
headquartered in Chicago, Illinois. All shareholders of the firm live in the United States.
Earlier this month, you obtained a loan of 5 million Canadian dollars from a bank in
Toronto to finance the construction of a new plant in Montreal. At the time the loan was
received, the exchange rate was 75 U.S. cents to the Canadian dollar. By the end of the
month, it has unexpectedly dropped to 70 cents. Has your company made a gain or loss
as a result, and by how much?

Results of exchange rate changes Early in September 1983, it took 245 Japanese yen to
equal $1. Nearly 22 years later, in July 2005 that exchange rate had fallen to 111 yen to
$1. Assume the price of a Japanese-manufactured automobile was $9,000 in September
1983 and that its price changes were in direct relation to exchange rates.

a. Has the price, in dollars, of the automobile increased or decreased during the
22-year period because of changes in the exchange rate?

b. What would the dollar price of the automobile be in July 2005, again assuming that
the car’s price changes only with exchange rates?

Foreign investment analysis After all foreign and U.S. taxes, a U.S. corporation expects
to receive 3 pounds of dividends per share from a British subsidiary this year. The
exchange rate at the end of the year is expected to be $1.60 per pound, and the pound
is expected to depreciate 5 percent against the dollar each year for an indefinite period.
The dividend (in pounds) is expected to grow at 10 percent a year indefinitely. The par-
ent U.S. corporation owns 10 million shares of the subsidiary. What is the present value
in dollars of its equity ownership of the subsidiary? Assume a cost of equity capital of
15 percent for the subsidiary.

Foreign capital budgeting Solitaire Machinery is a Swiss multinational manufacturing
company. Currently, Solitaire’s financial planners are considering undertaking a 1-year
project in the United States. The project’s expected dollar-denominated cash flows
consist of an initial investment of $1,000 and a cash inflow the following year of
$1,200. Solitaire estimates that its risk-adjusted cost of capital is 14 percent. Currently,
1 U.S. dollar will buy 1.62 Swiss francs. In addition, 1-year risk-free securities in the
United States are yielding 7.25 percent, while similar securities in Switzerland are
yielding 4.5 percent.

a. If this project were instead undertaken by a similar U.S.-based company with the
same risk-adjusted cost of capital, what would be the net present value and rate of
return generated by this project?

b. What is the expected forward exchange rate 1 year from now?
c. If Solitaire undertakes the project, what is the net present value and rate of return of

the project for Solitaire?

COMPREHENSIVE/SPREADSHEET
PROBLEM

19-18 Multinational financial management Yohe Telecommunications is a multinational cor-
poration that produces and distributes telecommunications technology. Although its cor-
porate headquarters are located in Maitland, Florida, Yohe usually must buy its raw
materials in several different foreign countries using several different foreign currencies.
The matter is further complicated because Yohe usually sells its products in other foreign
countries. One product in particular, the SY-20 radio transmitter, draws its principal
components, Component X, Component Y, and Component Z, from Switzerland, France,
and England, respectively. Specifically, Component X costs 165 Swiss francs, Component Y

646 Part 7 Special Topics in Financial Management

costs 20 euros, and Component Z costs 105 British pounds. The largest market for the
SY-20 is in Japan, where it sells for 38,000 Japanese yen. Naturally, Yohe is intimately
concerned with economic conditions that could adversely affect dollar exchange rates.
You will find Tables 19-1, 19-2, and 19-3 useful for this problem.

a. How much, in dollars, does it cost for Yohe to produce the SY-20? What is the dollar
sale price of the SY-20?

b. What is the dollar profit that Yohe makes on the sale of the SY-20? What is the
percentage profit?

c. If the U.S. dollar were to weaken by 10 percent against all foreign currencies, what
would be the dollar profit for the SY-20?

d. If the U.S. dollar were to weaken by 10 percent only against the Japanese yen and
remained constant relative to all other foreign currencies, what would be the dollar
and percentage profits for the SY-20?

e. Using the 180-day forward exchange information from Table 19-3, calculate the
return on 1-year securities in Switzerland, if the rate of return on 1-year securities in
the U.S. is 4.9 percent.

f. Assuming that purchasing power parity (PPP) holds, what would be the sale price
of the SY-20 if it were sold in England rather than Japan?

Integrated Case

Citrus Products Inc.

19-19 Multinational financial management Citrus Products Inc. is a medium-sized producer of citrus juice
drinks with groves in Indian River County, Florida. Until now, the company has confined its operations and
sales to the United States, but its CEO, George Gaynor, wants to expand into the Pacific Rim. The first step
would be to set up sales subsidiaries in Japan and Australia, then to set up a production plant in Japan, and,
finally, to distribute the product throughout the Pacific Rim. 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 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, Schmidt has supplied you with the fol-
lowing list of questions.

a. What is a multinational corporation? Why do firms expand into other countries?
b. What are the 5 major factors that distinguish multinational financial management from financial manage-

ment as practiced by a purely domestic firm?
c. Consider the following illustrative exchange rates:

Japanese yen U.S. Dollars Required to Buy
Australian dollar One Unit of Foreign Currency

0.009
0.650

(1) Are these currency prices direct quotations or indirect quotations?
(2) Calculate the indirect quotations for yen and Australian dollars.
(3) What is a cross rate? Calculate the two cross rates between yen and Australian dollars.
(4) Assume Citrus Products can produce a liter of orange juice and ship it to Japan for $1.75. If the firm

wants a 50 percent markup on the product, what should the orange juice sell for in Japan?
(5) Now, assume Citrus Products begins producing the same liter of orange juice in Japan. The product

costs 250 yen to produce and ship to Australia, where it can be sold for 6 Australian dollars. What is
the U.S. dollar profit on the sale?
(6) What is exchange rate risk?

Chapter 19 Multinational Financial Management 647

d. Briefly describe the current international monetary system. What are the different types of exchange rate
systems?

e. 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?

f. What is interest rate parity? Currently, you can exchange 1 yen for 0.0095 U.S. dollar in the 30-day for-
ward market, and the risk-free rate on 30-day securities is 4 percent in both Japan and the United States.
Does interest rate parity hold? If not, which securities offer the highest expected return?

g. What is purchasing power parity (PPP)? If grapefruit juice costs $2.00 a liter in the United States and pur-
chasing power parity holds, what should be the price of grapefruit juice in Australia?

h. What effect does relative inflation have on interest rates and exchange rates?
i. (1) Briefly explain the three major types of international credit markets.

(2) Briefly explain how ADRs work.
j. To what extent do average capital structures vary across different countries?
k. What is the effect of multinational operations on each of the following financial management topics?

(1) Cash management.
(2) Capital budgeting decisions.
(3) Credit management.
(4) Inventory management.

Please go to the ThomsonNOW Web site to access the
Cyberproblems.

HAPTE

20

HYBRID FINANCING: PREFERRED
STOCK, LEASING, WARRANTS,
AND CONVERTIBLES
RC

Amazon.com Taking a Wild Ride with Amazon’s © JOHN RIZZO/BLOOMBERG NEWS/LANDOV
Convertible Debt

The use of convertible securities—generally bonds or preferred stocks that can
be exchanged for common stock of the issuing corporation—has soared during
the last decade. In recent years there have been instances where the capital
raised through convertible securities has exceeded the amount of capital raised
through common stock.

Why do companies use convertibles so heavily? To answer this question, rec-
ognize that convertibles virtually always have coupon rates that are lower than
would be required on straight, nonconvertible bonds or preferred stocks. There-
fore, if a company raises $100 million by issuing convertible bonds, its interest
expense is lower than if it financed with nonconvertible debt. But why would
investors be willing to buy convertibles, given their lower cash payments? The
answer lies in the conversion feature—if the price of the issuer’s stock rises, the
holder of the convertible can exchange it for stock and realize a capital gain. So,
convertibles hold down the cash costs of financing by giving investors an oppor-
tunity for capital gains. A convertible bond’s value is tied to the price of the
stock into which it is convertible, whereas a nonconvertible bond’s price is based
on its fixed-income payments. Therefore, convertibles’ prices rise and fall much
more than regular bonds’ prices; hence, convertibles are relatively risky. A 1999
article in Forbes estimated that if a company’s common stock increases in value,
the returns on its convertibles also rise, but by only 70 percent of the stock’s per-
centage increase. However, if the stock declines, the convertible will decline by
only 50 percent of the stock’s decline. Thus, while convertibles are more risky
than straight bonds, they are less risky than stock.

To illustrate all this, consider Amazon.com. In early 1999 Amazon issued
$1.25 billion of 10-year convertible bonds. Amazon’s bonds were issued at a par

Chapter 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 649

value of $1,000 and a 4.75 percent coupon rate. The bonds also had a conver-
sion price of $78.0275, which meant that investors who purchased the bonds
could at any time convert their bond to roughly 12.8 shares of Amazon common
stock. Consequently, because they can be converted to Amazon common stock,
changes in the stock price will have a profound effect on the convertibles’ value.

During 1999 Amazon’s convertibles took their holders on a wild ride. During
the first four months Amazon’s stock rose about 70 percent, to more than $100
per share, causing its convertibles to rise by 50 percent, to $1,500. During the
next four months, the stock lost more than 60 percent of its value. This caused
the convertibles’ price to drop to $750. Three months later Amazon’s stock had
rebounded, and its convertibles were once again trading above $1,500, only to
decline sharply one month later. By year-end 1999, the convertibles were about
back to their $1,000 issue price.

In the two subsequent years, Amazon, like most other “tech” companies,
witnessed a sharp decline in its stock price—Amazon dropped from its 1999
high of more than $100 to a low of $5.51 in 2001, or by about 95 percent. The
convertibles also declined, but only to $376, or by about 75 percent, bad but
not as bad as the stock. The convertibles held up better for two reasons. First,
they paid $47.50 per year interest, whereas the common paid nothing, and sec-
ond, if Amazon was forced into bankruptcy, which was a real possibility in 2001,
the convertibles would have a claim on their $1,000 par value ahead of stock-
holders’ claims. After the 2001 trough, Amazon’s fortunes improved. Rumors of
impending bankruptcy were dispelled, and by mid-2005, the stock stood
around $46 a share, and the convertibles were once again trading around par.

Amazon’s experience with convertibles is not unusual. The convertible
bonds rose in price with the common, but not as rapidly, and the bonds also
declined with the stock, but again the losses were less pronounced. Thus, con-
vertibles offer investors a bit of protection against losses, but also opportunities
for capital gains. Not surprisingly, convertibles are used by companies, whose
futures are highly uncertain, to attract investors who are not willing to bear the
risks inherent in their common stocks.

When you finish this chapter, you should have a good understanding of
what convertibles are, how they are valued, and why a firm might choose to
issue a convertible bond rather than either straight debt or common stock.

Source: John Gorham, “Chicken Little Stocks,” Forbes, December 27, 1999, p. 200.

Putting Things In Perspective

In previous chapters we examined common stocks and the various types of
long-term debt. In this chapter, we examine four other types of long-term
capital: (1) preferred stock, which is a hybrid security that represents a cross
between debt and common equity; (2) leasing, which is used by financial
managers as an alternative to borrowing to finance fixed assets; (3) war-
rants, which are derivative securities issued by firms to facilitate the
issuance of some other type of security; and (4) convertibles, which com-
bine the features of debt (or preferred stock) and warrants.

650 Part 7 Special Topics in Financial Management

Cumulative 20.1 PREFERRED STOCK
A protective feature on
preferred stock that Preferred stock is a hybrid—it is similar to bonds in some respects and to com-
requires preferred divi- mon stock in other ways. Accountants classify perpetual preferred stock as
dends previously not equity, hence show it on the balance sheet as an equity account. However, from a
paid to be paid before finance perspective preferred stock lies somewhere between debt and common
any common dividends equity—it imposes a fixed charge and thus increases the firm’s financial leverage,
can be paid. yet omitting the preferred dividend does not force a company into bankruptcy. We
first describe the basic features of preferred, after which we discuss other types of
Arrearages preferred stock and the advantages and disadvantages of preferred stock.
Unpaid preferred
dividends. Basic Features

Preferred stock has a par (or liquidating) value, often either $25 or $100. The div-
idend is stated as either a percentage of par, as so many dollars per share, or both
ways. For example, several years ago Klondike Paper Company sold 150,000
shares of $100 par value perpetual preferred stock for a total of $15 million. This
preferred had a stated annual dividend of $12 per share, so the preferred divi-
dend yield was $12/$100 ϭ 0.12, or 12 percent, at the time of issue. The dividend
was set when the stock was issued; it will not be changed in the future. There-
fore, if the required rate of return on preferred, rp, changes from 12 percent after
the issue date—as it did—then the market price of the preferred stock will
increase or decrease. Currently, rp for Klondike Paper’s preferred is 9 percent, and
the price of the preferred has risen from $100 to $12/0.09 ϭ $133.33.

If the preferred dividend is not earned, the company does not have to pay it.
However, most preferred issues are cumulative, meaning that the cumulative
total of all unpaid preferred dividends must be paid before dividends can be paid
on the common stock. Unpaid preferred dividends are called arrearages. Divi-
dends in arrears do not earn interest; thus, arrearages do not grow in a compound
interest sense—they only grow from additional nonpayments of the preferred div-
idend. Also, many preferred stocks accrue arrearages for only a limited number of
years, say, three years, meaning that the cumulative feature ceases after three
years. However, the dividends in arrears continue in force until they are paid.

Preferred stock normally has no voting rights. However, most preferred
issues stipulate that the preferred stockholders can elect a minority of the direc-
tors—say, 3 out of 10—if the preferred dividend is passed (omitted). Jersey Cen-
tral Power & Light, one of the companies that owned a share of the Three Mile
Island (TMI) nuclear plant, had preferred stock outstanding that could elect a
majority of the directors if the preferred dividend was passed for four successive
quarters. Jersey Central kept paying its preferred dividends even during the
dark days following the TMI accident. Had the preferred not been entitled to
elect a majority of the directors, the dividend would probably have been passed.

Although nonpayment of preferred dividends will not bankrupt a company,
corporations issue preferred with every intention of paying the dividend. Even if
passing the dividend does not give the preferred stockholders control of the
company, failure to pay a preferred dividend precludes payment of common
dividends. In addition, passing the dividend makes it difficult to raise capital by
selling bonds, and virtually impossible to sell more preferred or common stock.
However, having preferred stock outstanding does give a firm the chance to
overcome its difficulties—if bonds had been used instead of preferred stock,
Jersey Central would have been in danger of being forced into bankruptcy
before it could straighten out its problems. Thus, from the viewpoint of the issuing
corporation, preferred stock is less risky than bonds.

However, for investors preferred stock is riskier than bonds: (1) Preferred
stockholders’ claims are subordinated to those of bondholders in the event of
liquidation, and (2) bondholders are more likely to continue receiving income

Chapter 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 651

during hard times than are preferred stockholders. Accordingly, investors
require a higher after-tax rate of return on a given firm’s preferred stock than on
its bonds. However, because 70 percent of preferred dividends is exempt from
corporate taxes, preferred stock is attractive to corporate investors. In recent
years, high-grade preferred stock, on average, has sold on a lower pre-tax yield
basis than have high-grade bonds. As an example, Bear Sterns preferred G stock
recently had a market yield of about 5.4 percent, whereas its bonds provided a
yield of 5.9 percent, or 0.5 percentage point more than its preferred. The tax treat-
ment accounted for this differential; the after-tax yield to corporate investors was
greater on the preferred stock than on the bonds.1

About half of all preferred stock issued in recent years has been convertible
into common stock. For example, on July 31, 2002, Corning Incorporated issued
$500 million of mandatory convertible preferred stock with a 7 percent annual
dividend rate. The issue is mandatorily convertible into between approximately
254 million and 313 million shares. Convertibles are discussed at length in Sec-
tion 20.4.

Some preferred stocks are similar to perpetual bonds in that they have no
maturity date, but most new issues now have specified maturities. For example,
many preferred shares have a sinking fund provision that calls for the retirement
of 2 percent of the issue each year, meaning that the issue will “mature” in a
maximum of 50 years. Also, many preferred issues are callable by the issuing
corporation, which can also limit the life of the preferred.2

Nonconvertible preferred stock is virtually all owned by corporations, which
can take advantage of the 70 percent dividend exclusion to obtain a higher after-
tax yield on preferred stock than on bonds. Individuals should not own preferred
stocks (except convertible preferreds)—they can obtain higher yields on safer
bonds, so it is not logical for them to hold preferreds. As a result of this ownership
pattern, the volume of preferred stock financing is geared to the supply of money
in the hands of corporate investors. When the supply of such money is plentiful,
the prices of preferred stocks are bid up, their yields fall, and investment bankers
suggest that companies that need financing consider issuing preferred stock.

For issuers, preferred stock has a tax disadvantage relative to debt—interest
expense is deductible, but preferred dividends are not. Still, firms with low tax
rates may have an incentive to issue preferred stock that can be bought by cor-
porate investors with high tax rates, who can take advantage of the 70 percent
dividend exclusion. If a firm has a lower tax rate than potential corporate buy-
ers, the firm might be better off issuing preferred stock than debt. The key here
is that the tax advantage to a high-tax-rate corporation is greater than the tax
disadvantage to a low-tax-rate issuer. To illustrate, assume that risk differentials
between debt and preferred would require an issuer to set the interest rate on
new debt at 10 percent and the dividend yield on new preferred at 12 percent in a
no-tax world. However, when taxes are considered, a corporate buyer with a high
tax rate, say, 40 percent, might be willing to buy the preferred stock if it has an 8

1 The after-tax yield on a 5.9 percent bond to a corporate investor in the 35 percent marginal tax rate
bracket is 5.9%(1 Ϫ T) ϭ 5.9%(0.65) ϭ 3.84%. The after-tax yield on a 5.4 percent preferred stock is
5.4%(1 Ϫ Effective T) ϭ 5.4%[1 Ϫ (0.30)(0.35)] ϭ 5.4%(0.895) ϭ 4.83%. Also, note that tax law pro-
hibits firms from issuing debt and then using the proceeds to purchase another firm’s preferred or
common stock. If debt is used for stock purchases, then the 70 percent dividend exclusion is voided.
This provision is designed to prevent a firm from engaging in “tax arbitrage,” using tax-deductible
debt to purchase largely tax-exempt preferred stock.
2 Prior to the late 1970s, virtually all preferred stock was perpetual, and almost no issues had sink-
ing funds or call provisions. Then, insurance company regulators, worried about the unrealized
losses the companies had been incurring on preferred holdings as a result of rising interest rates,
put into effect some regulatory changes that essentially mandated that insurance companies buy
only limited-life preferreds. From that time on, virtually no new preferred has been perpetual. This
example illustrates the way securities change as a result of changes in the economic environment.

652 Part 7 Special Topics in Financial Management

Adjustable Rate Pre- percent before-tax yield. This would produce an 8%(1 Ϫ Effective T) ϭ 8%[1 Ϫ
ferred Stocks (ARPs) 0.30(0.40)] ϭ 7.04% after-tax return on the preferred versus 10%(1 Ϫ 0.40) ϭ 6.0%
Preferred stocks whose on the debt. If the issuer has a low tax rate, say, 10 percent, its after-tax costs
dividends are tied to would be 10%(1 Ϫ T) ϭ 10%(0.90) ϭ 9% on the bonds and 8 percent on the pre-
the rate on Treasury ferred. Thus, the security with lower risk to the issuer, preferred stock, also has a
securities. lower cost. Such situations can make preferred stock a logical financing choice.3

Market Auction Other Types of Preferred Stock
(Money Market)
Preferred In addition to the “plain vanilla” variety of preferred stocks, several variations
A low-risk, largely are also used. Two of these, floating rate and market auction preferred, are dis-
tax-exempt, seven- cussed in the following sections.
week-maturity security
that can be sold Adjustable Rate Preferred Stock
between auction dates
at close to par. Instead of paying fixed dividends, adjustable rate preferred stocks (ARPs) have
their dividends tied to the rate on Treasury securities. The ARPs, which are
issued mainly by utilities and large commercial banks, were touted as nearly
perfect short-term corporate investments because (1) only 30 percent of the divi-
dends are taxable to corporations, and (2) the floating-rate feature was supposed
to keep the issue trading at near par. The new security proved to be so popular
as a short-term investment for firms with idle cash that mutual funds designed
just to invest in them sprouted like weeds (shares of the funds, in turn, were
purchased by corporations). However, the ARPs still had some price volatility
due to (1) changes in the riskiness of the issues (some big banks that had issued
ARPs, such as Continental Illinois, ran into serious loan default problems) and
(2) fluctuations in Treasury yields between dividend rate adjustments dates.
Thus, the ARPs had too much price instability to be held in the liquid asset port-
folios of many corporate investors.

Market Auction Preferred Stock

In 1984, investment bankers introduced money market, or market auction, pre-
ferred. Here the underwriter conducts an auction on the issue every seven
weeks (to get the 70 percent exclusion from taxable income, buyers must hold
the stock at least 46 days). Holders who want to sell their shares can put them
up for auction at par value. Buyers then submit bids in the form of the yields they
are willing to accept over the next seven-week period. The yield set on the issue for
the coming period is the lowest yield sufficient to sell all the shares being offered at
that auction. The buyers pay the sellers the par value; hence, holders are virtually
assured that their shares can be sold at par. The issuer then must pay a dividend
rate over the next seven-week period as determined by the auction. From the
holder’s standpoint, market auction preferred is a low-risk, largely tax-exempt,
seven-week-maturity security that can be sold between auction dates at close to
par. However, if there are not enough buyers to match the sellers (in spite of the
high yield), then the auction can fail, which has occurred on occasion.

Advantages and Disadvantages of Preferred Stock

There are both advantages and disadvantages to financing with preferred stock.
Here are the major advantages from the issuers’ standpoint:

3 For a more rigorous treatment of the tax hypothesis of preferred stock, see Iraj Fooladi and
Gordon S. Roberts, “On Preferred Stock,” Journal of Financial Research, Winter 1986, pp. 319–324.
For an example of an empirical test of the hypothesis, see Arthur L. Houston, Jr., and Carol Olson
Houston, “Financing with Preferred Stock,” Financial Management, Autumn 1990, pp. 42–54.

Chapter 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 653

1. In contrast to bonds, the obligation to pay preferred dividends is not contrac-
tual, and passing a preferred dividend cannot force a firm into bankruptcy.

2. By issuing preferred stock, the firm avoids the dilution of common equity
that occurs when common stock is sold.

3. Because preferred stock sometimes has no maturity, and because preferred
sinking fund payments, if present, are typically spread over a long period,
preferred issues reduce the cash flow drain from repayment of principal that
occurs with debt issues.

There are two major disadvantages:

1. Preferred stock dividends are not deductible to the issuer, hence the after-tax
cost of preferred is typically higher than the after-tax cost of debt. However,
the tax advantage of preferreds to corporate purchasers lowers its pre-tax
cost and thus its effective cost.

2. Although preferred dividends can be passed, investors expect them to be
paid, and firms intend to pay the dividends if conditions permit. Thus, pre-
ferred dividends are considered to be a fixed cost. Therefore, their use, like
that of debt, increases financial risk and thus the cost of common equity.

Should preferred stock be considered as equity or debt? Explain. Sale and Leaseback

Who are the major purchasers of nonconvertible preferred stock? Why? An arrangement
whereby a firm sells
Briefly explain the mechanics of adjustable rate and market auction land, buildings, or
preferred stock. equipment and simul-
taneously leases the
What are the advantages and disadvantages of preferred stock to the property back for a
issuer? specified period under
specific terms.
20.2 LEASING

Firms generally own fixed assets and report them on their balance sheets, but it
is the use of buildings and equipment that is important, not their ownership per
se. One way of obtaining the use of assets is to buy them, but an alternative is to
lease them. Prior to the 1950s, leasing was generally associated with real estate—
land and buildings. Today, however, it is possible to lease virtually any kind of
fixed asset.4

Types of Leases

Leasing takes three different forms: (1) sale-and-leaseback arrangements, (2) operat-
ing leases, and (3) straight financial, or capital, leases.

Sale and Leaseback

Under a sale and leaseback, a firm that owns land, buildings, or equipment sells
the property and simultaneously executes an agreement to lease the property
back for a specified period under specific terms. The purchaser could be an
insurance company, a commercial bank, a specialized leasing company, or even
an individual investor. The sale-and-leaseback plan is an alternative to taking
out a mortgage loan.

4 For a detailed treatment of leasing, see James S. Schallheim, Lease or Buy? Principles for Sound Deci-
sion Making (Boston: Harvard Business School Press, 1994).

654 Part 7 Special Topics in Financial Management

Funny-Named Preferred-Like
Securities

Wall Street’s “financial engineers” are constantly trying dividend payments. Because the parent company has
to develop new securities with appeal to issuers and issued debt, its interest payments are tax deductible.
investors. One such new security is a special type of
preferred stock created by Goldman Sachs in the mid- If the dividends could be excluded from taxable
1990s. These securities trade under a variety of color- income by corporate investors, this preferred would
ful names, including MIPS (modified income preferred really be a great deal—the issuer could deduct the
securities), QUIPS (quarterly income preferred securi- interest, corporate investors could exclude most of
ties), and QUIDS (quarterly income debt securities). the dividends, and the IRS would be the loser. The
The corporation that wants to raise capital (the “par- corporate parent does get to deduct the interest
ent”) establishes a trust, which issues fixed-dividend paid to the trust, but IRS regulations do not allow the
preferred stock. The parent then issues bonds (or debt dividends on these securities to be excluded.
of some type) to the trust, and the trust pays for the
bonds with the cash raised from the sale of preferred. Because there is only one deduction, why are
At that point, the parent has the cash it needs, the these new securities attractive? The answer is as follows:
trust holds debt issued by the parent, and the invest- (1) The parent company gets to take the deduction,
ing public holds preferred stock issued by the trust. thus its cost of funds from the preferred is rp(1 Ϫ T),
The parent then makes interest payments to the trust, just as it would be if it used debt. (2) The parent gen-
and the trust uses that income to make the preferred erates a tax savings, and it can thus afford to pay a
relatively high rate on trust-related preferred; that is,
it can pass on some of its tax savings to investors to

Lessee The firm that is selling the property, or the lessee, immediately receives the
The party that uses, purchase price put up by the buyer, or the lessor.5 At the same time, the seller-
rather than the one lessee firm retains the use of the property just as if it had borrowed and
who owns, the leased mortgaged the property to secure the loan. Note that under a mortgage loan
property. arrangement, the financial institution would normally receive a series of equal
Lessor payments just sufficient to amortize the loan while providing a specified rate of
The owner of the return to the lender on the outstanding balance. Under a sale-and-leaseback
leased property. arrangement, the lease payments are set up in exactly the same way; the
payments are set so as to return the purchase price to the investor-lessor while
Operating Lease providing a specified rate of return on the lessor’s outstanding investment.
A lease under which
the lessor maintains Operating Leases
and finances the
property; also called a Operating leases, sometimes called service leases, provide for both financing and
service lease. maintenance. IBM is one of the pioneers of the operating lease contract, and com-
puters and office copying machines, together with automobiles and trucks, are
the primary types of equipment involved. Ordinarily, these leases call for the les-
sor to maintain and service the leased equipment, and the cost of providing
maintenance is built into the lease payments.

Another important characteristic of operating leases is the fact that they are
frequently not fully amortized; in other words, the payments required under the
lease contract are not sufficient to recover the full cost of the equipment. How-
ever, the lease contract is written for a period considerably shorter than the
expected economic life of the leased equipment, and the lessor expects to
recover all investment costs through subsequent renewal payments, through
subsequent leases to other lessees, or by selling the leased equipment.

5 The term lessee is pronounced “less-ee,” not “lease-ee,” and lessor is pronounced “less-or.”

Chapter 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 655

induce them to buy the new securities. (3) The pri- As we discussed in our chapter on dividends, in 2003
mary purchasers of the preferred are low-tax-bracket Congress passed legislation that reduced the individual
individuals and tax-exempt institutions such as pen- tax rates on dividends. It turns out that these lower
sion funds. For such purchasers, not being able to tax rates do not apply to these types of preferred secu-
exclude the dividend from taxable income is not rities where the issuing company is allowed to deduct
important. (4) Due to the differential tax rates, the the interest paid to the trusts. As a result, some ana-
arrangement results in a net tax savings. Competition lysts speculate that some companies may once again
in capital markets results in a sharing of the savings start issuing more traditional preferred securities.
between investors and corporations.
Sources: Kerry Capell, “High Yields, Low Cost, Funny
A 1999 SmartMoney Online article argued that Names,” BusinessWeek, September 9, 1996, p. 122; Leslie
these hybrid securities are a good deal for individual Haggin, “SmartMoney Online: MIPS, QUIDS, and QUIPS,”
investors for the reason set forth above and also SmartMoney Interactive, April 6, 1999; Kathleen Pender, “Tax-
because they are sold in small increments—often as ing Dividends on Preferred Stock Quite a Mind-Bender,” The
small as $25. However, these securities are relatively San Francisco Chronicle, June 1, 2003, p. I1; and Jane J. Kim,
complex, which increases their risk and makes them “Getting Personal: Tax Law May Create New Preferred
hard to value. Stocks,” Dow Jones Newswires, August 6, 2003.

If this isn’t confusing enough, recent tax law
changes have made things even more complicated.

A final feature of operating leases is that they frequently contain a cancellation Financial Lease
clause, which gives the lessee the right to cancel the lease before the expiration of
the basic agreement. This is an important consideration for the lessee, for it means A lease that does not
that the equipment can be returned if it is rendered obsolete by technological devel- provide for mainte-
opments or if it is no longer needed because of a decline in the lessee’s business. nance services, is not
cancelable, and is fully
Financial, or Capital, Leases amortized over its life;
also called a capital
Financial leases, sometimes called capital leases, are differentiated from operating lease.
leases in three respects: (1) they do not provide for maintenance services, (2) they
are not cancelable, and (3) they are fully amortized (that is, the lessor receives rental
payments that are equal to the full price of the leased equipment plus a return on
the investment). In a typical financial lease arrangement, the firm that will use the
equipment (the lessee) selects the specific items it requires and negotiates the price
and delivery terms with the manufacturer. The user firm then negotiates terms
with a leasing company and, once the lease terms are set, arranges to have the les-
sor buy the equipment from the manufacturer or the distributor. When the equip-
ment is purchased, the user firm simultaneously executes the lease agreement.

Financial leases are similar to sale-and-leaseback arrangements, the major
difference being that the leased equipment is new and the lessor buys it from a
manufacturer or a distributor instead of from the user-lessee. A sale and lease-
back may thus be thought of as a special type of financial lease, and both sale
and leasebacks and financial leases are analyzed in the same manner.6

6 For a lease transaction to qualify as a lease for tax purposes, and thus for the lessee to be able to
deduct the lease payments, the life of the lease must not exceed 80 percent of the expected life of the
asset, and the lessee cannot be permitted to buy the asset at a nominal value. These conditions are
IRS requirements, and they should not be confused with the FASB requirements discussed later in
the chapter concerning the capitalization of leases. It is important to consult lawyers and accoun-
tants to ascertain whether or not a prospective lease meets current IRS regulations.

656 Part 7 Special Topics in Financial Management

Off Balance Sheet Financial Statement Effects
Financing
Financing in which the Lease payments are shown as operating expenses on a firm’s income statement,
assets and liabilities but under certain conditions, neither the leased assets nor the liabilities under
involved do not appear the lease contract appear on the firm’s balance sheet. For this reason, leasing is
on the firm’s balance often called off balance sheet financing. This point is illustrated in Table 20-1 by
sheet. the balance sheets of two hypothetical firms, B (for Buy) and L (for Lease). Ini-
tially, the balance sheets of both firms are identical, and both have debt ratios of
FASB #13 50 percent. Each firm then decides to acquire fixed assets that cost $100. Firm B
The statement of the borrows $100 to make the purchase, so both an asset and a liability are recorded
Financial Accounting on its balance sheet, and its debt ratio is increased to 75 percent. Firm L leases
Standards Board that the equipment, so its balance sheet is unchanged. The lease may call for fixed
details the conditions charges as high as or even higher than those on the loan, and the obligations
and procedures for assumed under the lease may be equally or more dangerous from the standpoint
capitalizing leases. of financial safety, but the firm’s debt ratio remains at 50 percent.

To correct this problem, the Financial Accounting Standards Board issued
FASB #13, which requires that for an unqualified audit report, firms that enter into
financial (or capital) leases must restate their balance sheets to report (1) leased
assets as fixed assets and (2) the present value of future lease payments as a lia-
bility. This process is called capitalizing the lease, and its net effect is to cause
Firms B and L to have similar balance sheets, both of which will resemble the
one shown for Firm B after the asset increase.7

The logic behind FASB #13 is as follows. If a firm signs a lease contract, its
obligation to make lease payments is just as binding as if it had signed a loan
agreement. The failure to make lease payments can bankrupt a firm just as
surely as can the failure to make principal and interest payments on a loan.
Therefore, for all intents and purposes, a financial lease is identical to a loan.8

TA B L E 2 0 - 1 Balance Sheet Effects of Leasing

BEFORE ASSET INCREASE AFTER ASSET INCREASE
Firms B and L
Firm B, Which Borrows and Buys Firm L, Which Leases

Current assets $ 50 Debt $ 50 Current assets $ 50 Debt $150 Current assets $ 50 Debt $ 50
Fixed assets Fixed assets 50
50 Equity 50 150 Equity 50 Fixed assets 50 Equity
$100
Total $100 $100 Total $200 $200 Total $100

Debt ratio: 50% Debt ratio: 75% Debt ratio: 50%

7 FASB #13, “Accounting for Leases,” November 1976, spells out in detail the conditions under
which leases must be capitalized, and the procedures for doing so. Also, see Schallheim, Lease or
Buy?, Chapter 4, for more on the accounting treatment of leases. The FASB has recently added leas-
ing to the scope of its Fair Value Measurement project, and a final statement had not yet been
issued at the time we were writing this chapter (August 2005).
8 There are, however, certain legal differences between loans and leases. In a bankruptcy liquidation,
the lessor is entitled to take possession of the leased asset, and, if the value of the asset is less than
the required payments under the lease, the lessor can enter a claim (as a general creditor) for one
year’s lease payments. In a bankruptcy reorganization, the lessor receives the asset plus three year’s
lease payments, if needed, to bring the value of the asset up to the remaining investment in the
lease. Under a secured loan arrangement, on the other hand, the lender has a security interest in the
asset, meaning that if it is sold, the lender will receive the proceeds, and the full unsatisfied portion
of the lender’s claim will be treated as a general creditor obligation (see Web Appendix 7B). It is not
possible to state as a general rule whether a supplier of capital is in a stronger position as a secured
creditor or as a lessor. Since one position is usually regarded as being about as good as the other at
the time the financial arrangements are being made, a lease is about as risky as a secured term loan
from both the lessor-lender’s and the lessee-borrower’s viewpoints.

Chapter 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 657

This being the case, when a firm signs a lease agreement, it has, in effect, raised
its “true” debt ratio and thereby has changed its “true” capital structure. Accord-
ingly, if the firm had previously established a target capital structure, and if
there is no reason to think that the optimal capital structure has changed, then
using lease financing requires additional equity just as does debt financing.

If a disclosure of the lease in the Table 20-1 example were not made, then
investors could be deceived into thinking that Firm L’s financial position is
stronger than it actually is. Even if the lease were disclosed in a footnote,
investors might not fully recognize its impact and might not see that Firms B
and L are in essentially the same financial position. If this were the case, Firm L
would have increased its true amount of debt through a lease arrangement, but
its required return on debt, rd, its required return on equity, rs, and consequently
its weighted average cost of capital, would not have increased as much as those
of Firm B, which borrowed directly. Thus, investors would be willing to accept a
lower return from Firm L because they would mistakenly view it as being in a
stronger financial position than Firm B. These benefits of leasing would accrue
to stockholders at the expense of new investors, who were, in effect, being
deceived by the fact that the firm’s balance sheet did not fully reflect its true lia-
bility situation. This is why FASB #13 was issued.

A lease must be classified as a capital lease, and hence be capitalized and
shown directly on the balance sheet, if any one of the following conditions
exists:

1. Under the terms of the lease, ownership of the property is effectively trans-
ferred from the lessor to the lessee.

2. The lessee can purchase the property or renew the lease at less than a fair
market price when the lease expires.

3. The lease runs for a period equal to or greater than 75 percent of the asset’s life.
4. The present value of the lease payments is equal to or greater than 90 percent

of the initial value of the asset.9

These rules, together with strong footnote disclosures for operating leases, are
sufficient to ensure that no one will be fooled by lease financing. Thus, leases are
recognized to be essentially the same as debt, and they have the same effects as
debt on the firm’s required rate of return. Therefore, leasing will not generally
permit a firm to use more financial leverage than could be obtained with con-
ventional debt.

Evaluation by the Lessee

Any prospective lease must be evaluated by both the lessee and the lessor. The
lessee must determine whether leasing an asset will be less costly than buying it,
and the lessor must decide whether or not the lease will provide a reasonable rate
of return. Since our focus in this book is primarily on financial management as
opposed to investments, we restrict our analysis to that conducted by the lessee.10

9 The discount rate used to calculate the present value of the lease payments must be the lower of
(1) the rate used by the lessor to establish the lease payments or (2) the interest rate that the lessee
would have paid for new debt with a maturity equal to that of the lease.
10 The lessee is typically offered a set of lease terms by the lessor, which is generally a bank, a
finance company such as General Electric Capital (the largest U.S. lessor), or some other institu-
tional lender. The lessee can accept or reject the lease, or shop around for a better deal. In this chap-
ter, we take the lease terms as given for purposes of our analysis. See Chapter 18 of Eugene F.
Brigham and Phillip R. Daves, Intermediate Financial Management, 8th ed. (Mason, OH: Thomson/
South-Western, 2004), for a discussion of lease analysis from the lessor’s standpoint, including a dis-
cussion of how a potential lessee can use such an analysis in bargaining for better terms.

658 Part 7 Special Topics in Financial Management

In the typical case, the events leading to a lease arrangement follow the
sequence described in the following list. We should note that a great deal of the-
oretical literature exists about the correct way to evaluate lease-versus-purchase
decisions, and some very complex decision models have been developed to aid
in the analysis. The analysis given here, however, leads to the correct decision in
every case we have ever encountered.

1. The firm decides to acquire a particular building or piece of equipment. This
decision is based on regular capital budgeting procedures, and the decision
to acquire the asset is a “done deal” before the lease analysis begins. There-
fore, in a lease analysis we are concerned simply with whether to finance the
machine by a lease or by a loan.

2. Once the firm has decided to acquire the asset, the next question is how to
finance it. Well-run businesses do not have excess cash lying around, so new
assets must be financed in some manner.

3. Funds to purchase the asset could be obtained by borrowing, by retaining
earnings, or by issuing new stock. Alternatively, the asset could be leased.
Because of the FASB #13 capitalization/disclosure provision for leases, a
lease would have the same capital structure effect as a loan.

As indicated earlier, a lease is comparable to a loan in the sense that the firm
is required to make a specified series of payments, and a failure to make these
payments can result in bankruptcy. Thus, it is most appropriate to compare the
cost of leasing with that of debt financing.11 The lease-versus-borrow-and-
purchase analysis is illustrated with data on the Mitchell Electronics Company.
The following conditions are assumed:

1. Mitchell plans to acquire equipment with a five-year life that has a cost of
$10,000,000, delivered and installed.

2. Mitchell can borrow the required $10 million, using a 10 percent loan to be
amortized over five years. Therefore, the loan will call for payments of
$2,637,974.81 per year, found with a financial calculator as follows: input
N ϭ 5, I/YR ϭ 10, PV ϭ Ϫ10000000, and FV ϭ 0, and then press PMT to find
the payment, $2,637,974.81.

3. Alternatively, Mitchell can lease the equipment for five years at a rental
charge of $2,800,000 per year, payable at the end of the year. The lessor will
own the asset at the expiration of the lease.12 The lease payment schedule is
established by the potential lessor, and Mitchell can accept it, reject it, or
negotiate.

4. The equipment will definitely be used for five years, at which time its esti-
mated net salvage value will be $715,000. Mitchell plans to continue using
the equipment beyond Year 5, so (a) if it purchases the equipment, the com-
pany will keep it, and (b) if it leases the equipment, the company will exer-
cise an option to buy it at its estimated salvage value, $715,000.

5. The lease contract stipulates that the lessor will maintain the equipment.
However, if Mitchell borrows and buys, it will have to bear the cost of main-
tenance. This service will be performed by the equipment manufacturer at a
fixed contract rate of $500,000 per year, payable at year-end.

11 The analysis should compare the cost of leasing to the cost of debt financing regardless of how the
asset is actually financed. The asset may actually be purchased with available cash if it is not leased,
but because leasing is a substitute for debt financing, a comparison between the two is still
appropriate.
12 Lease payments can occur at the beginning of the year or at the end of the year. In this example,
we assume end-of-year payments, but we demonstrate beginning-of-year payments in Self-Test
Problem ST-2.

Chapter 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 659

6. The equipment falls in the MACRS 5-year class life, and Mitchell’s effective
federal-plus-state tax rate is 40 percent. Also, the depreciable basis is the
original cost of $10,000,000. The MACRS depreciation rates are 20, 32, 19, 12,
11, and 6 percent.

NPV Analysis

Table 20-2 shows the cash flows that would be incurred each year under the two
financing plans. The table is set up to produce two time lines of cash flows, one
for owning as shown on Line 5 and one for leasing as shown on Line 10. All
cash flows occur at the end of the year.

TABLE 20-2 Mitchell Electronics Company: NPV Lease Analysis
(Thousands of Dollars)

I. COST OF OWNING 0 1 2 YEAR 4 5
1. Net purchase price ($10,000) 3
2. Maintenance cost ($ 500) ($ 500) ($ 500) ($ 500)
3. Tax savings from maintenance ($10,000) 200 200 ($ 500) 200 200
4. Tax savings from depreciation ($ 8,023) 800 200 480 440
5. Net cash flow 1,280 760
6. PV cost of owning at 6% $ 500 $ 980 $ 180 $ 140
$ 460
II. COST OF LEASING $0 ($2,800) ($2,800) ($2,800) ($2,800)
7. Lease payment ($ 7,611) 1,120 1,120 ($2,800) 1,120 1,120
8. Tax savings from lease payment 1,120 (715)
9. Cost to exercise option ($1,680) ($1,680) ($1,680)
($1,680) ($2,395)
10. Net cash flow
11. PV cost of owning at 6%

III. COST COMPARISON
12. Net advantage to leasing ϭ NAL
ϭ PV cost of owning Ϫ PV cost of leasing
ϭ $8,023 Ϫ $7,611 ϭ $412 ϭ $412,000

Note: A line-by-line explanation of the table follows:
1. If Mitchell buys the equipment, it will have to spend $10,000,000 at t ϭ 0.
2. If the equipment is owned, Mitchell must pay $500,000 at the end of each year for maintenance.
3. The $500,000 maintenance expense is tax deductible, so it will produce an annual tax savings of (Tax rate)(Maintenance
expense) ϭ 0.4($500,000) ϭ $200,000.
4. If Mitchell buys the equipment, it can depreciate it for tax purposes and thus lower taxable income and taxes. The tax savings in
each year is equal to (Tax rate)(Depreciation expense) ϭ 0.4(Depreciation expense). As shown in Appendix 12A, the MACRS rates
for 5-year property are 20, 32, 19, 12, and 11 percent in Years 1–5, respectively. To illustrate the calculation of the depreciation
tax savings, consider Year 2. The depreciation expense is 0.32($10,000,000) ϭ $3,200,000, and the tax savings is 0.4($3,200,000) ϭ
$1,280,000.
5. The net cash flows associated with owning are found by summing Lines 1 through 4.
6. The PV (in thousands) of the Line 5 cash flows, when discounted at 6 percent, is Ϫ$8,023.
7. The annual end-of-year lease payment is $2,800,000.
8. Because the lease payment is tax deductible, a tax savings of (Tax rate)(Lease payment) ϭ 0.4($2,800,000) ϭ $1,120,000 results.
9. Because Mitchell plans to continue to use the equipment after the lease expires, it must exercise the purchase option for $715,000
at the end of Year 5 if it leases.

10. The net cash flows associated with leasing are found by summing Lines 7 through 9.
11. The PV (in thousands) of the Line 10 cash flows, when discounted at 6 percent, is Ϫ$7,611.
12. The net advantage to leasing is merely the difference between the PV cost of owning (in thousands) and the PV cost of leasing (in

thousands) ϭ $8,023 Ϫ $7,611 ϭ $412. Since the NAL is positive, leasing is favored over borrowing and buying.

660 Part 7 Special Topics in Financial Management

The top section of the table (Lines 1 through 6) is devoted to the cost of own-
ing (borrowing and buying). Lines 1 through 4 show the individual cash flow
items. Line 5 is a time line that summarizes the annual net cash flows that
Mitchell will incur if it finances the equipment with a loan. The present values of
these cash flows are summed to find the present value of the cost of owning, which
is shown on Line 6 in the Year 0 column. (Note that with a financial calculator,
we would input the cash flows as shown on Line 5 into the cash flow register,
input the interest rate, I/YR ϭ 6, and then press the NPV key to obtain the PV of
owning the equipment.)

Section II of the table calculates the present value cost of leasing. The lease
payments are $2,800,000 per year; this rate, which in this example (but not in all
cases) includes maintenance, was established by the prospective lessor and then
offered to Mitchell Electronics. If Mitchell accepts the lease, the full $2,800,000
will be a deductible expense, so the tax savings is (Tax rate)(Lease payment) ϭ
(0.4)($2,800,000) ϭ $1,120,000. These amounts are shown on Lines 7 and 8.

Line 9 in the lease section shows the $715,000 that Mitchell expects to pay in
Year 5 to purchase the equipment. We include this amount as a cost of leasing
because Mitchell will almost certainly want to continue the operation and thus
will be forced to purchase the equipment from the lessor. If we had assumed
that the operation would not be continued, then no entry would have appeared
on this line. However, in that case, we would have included the $715,000, minus
applicable taxes, as a Year 5 inflow in the cost of owning analysis, because if the
asset were purchased originally, it would be sold after five years. Line 10 shows
the net cash flows associated with leasing for each year, and Line 11 shows the
PV cost of leasing. (As indicated earlier in the cost of owning analysis, using a
financial calculator, we would input the cash flows as shown on Line 10 into the
cash flow register, input the interest rate, I/YR ϭ 6, and then press the NPV key
to obtain the PV cost of leasing the equipment.)

The rate used to discount the cash flows is a critical issue. In Chapter 8, we
saw that the riskier a cash flow, the higher the discount rate used to find its pres-
ent value. This same principle was observed in capital budgeting, and it also
applies in lease analysis. Just how risky are the cash flows under consideration
here? Most of them are relatively certain, at least when compared with the types
of cash flow estimates that were developed in capital budgeting. For example,
the maintenance payments are set by contract, as is the lease payment schedule.
The depreciation expenses are also established by law and are not subject to
change. The tax savings are somewhat uncertain because tax rates may change,
although tax rates do not change very often. The residual value is the least cer-
tain of the cash flows, but even here the $715,000 cost is set, and Mitchell’s man-
agement is fairly confident that it will want to acquire the property.

Since the cash flows under both the lease and the borrow-and-purchase
alternatives are all reasonably certain, they should be discounted at a relatively
low rate. Most analysts recommend that the company’s cost of debt be used, and
this rate seems reasonable in our example. Further, since all the cash flows are
on an after-tax basis, the after-tax cost of debt, which is 6 percent, should be used.
Accordingly, in Table 20-2, we used a 6 percent discount rate to obtain the pres-
ent values of the costs of owning and leasing. The financing method that results
in the smaller present value of costs is the one that should be selected. The
example shown in Table 20-2 indicates that leasing has a net advantage over
buying: the present value of the cost of leasing is $412,000 less than that of buy-
ing. Therefore, it is to Mitchell’s advantage to lease.

Factors That Affect Leasing Decisions

The basic method of analysis set forth in Table 20-2 is sufficient to handle most
situations. However, two factors warrant additional comments.

Chapter 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 661

Estimated Residual Value Residual Value
The value of leased
It is important to note that the lessor will own the property upon the expiration property at the end of
of the lease. The estimated end-of-lease value of the property is called the resid- the lease term.
ual value. Superficially, it would appear that if residual values are expected to be
large, owning would have an advantage over leasing. However, if expected resid- Warrant
ual values are large—as they may be under inflation for certain types of equip- A long-term option to
ment as well as if real property is involved—then competition among leasing buy a stated number of
companies will force leasing rates down to the point where potential residual val- shares of common
ues will be fully recognized in the lease contract rates. Thus, the existence of large stock at a specified
residual values on equipment is not likely to bias the decision against leasing. price.

Increase Credit Availability

As noted earlier, leasing is sometimes said to have an advantage for firms that are
seeking the maximum degree of financial leverage. First, it is sometimes argued that
a firm can obtain more money, and for a longer period, under a lease arrangement
than under a loan secured by the asset. Second, because some leases do not appear
on the balance sheet, lease financing has been said to give the firm a stronger
appearance in a superficial credit analysis, thus permitting it to use more leverage
than it could if it did not lease. There may be some truth to these claims for smaller
firms. However, now that larger firms are required to capitalize major leases and to
report them on their balance sheets, this point is of questionable validity.

Define each of these terms: (1) sale-and-leaseback arrangements,
(2) operating leases, and (3) financial, or capital, leases.

What is off balance sheet financing, what is FASB #13, and how are
the two related?

List the sequence of events, for the lessee, leading to a lease
arrangement.

Why is it appropriate to compare the cost of lease financing with
that of debt financing? Why does the comparison not depend on
how the asset will actually be financed if it is not leased?

20.3 WARRANTS

A warrant is a certificate issued by a company that gives the holder the right to
buy a stated number of shares of the company’s stock at a specified price for
some specified length of time. Generally, warrants are distributed with debt, and
they are used to induce investors to buy long-term debt with a lower coupon rate
than would otherwise be required. For example, when Infomatics Corporation, a
rapidly growing high-tech company, wanted to sell $50 million of 20-year bonds
in 2005, the company’s investment bankers informed the financial vice president
that the bonds would be difficult to sell, and that a coupon rate of 10 percent
would be required. However, as an alternative the bankers suggested that
investors might be willing to buy the bonds with a coupon rate of only 8 percent
if the company would offer 20 warrants with each $1,000 bond, each warrant
entitling the holder to buy one share of common stock at an exercise price of $22
per share. The stock was selling for $20 per share at the time, and the warrants
would expire in the year 2015 if they had not been exercised previously.

Why would investors be willing to buy Infomatics’ bonds at a yield of only
8 percent in a 10 percent market just because warrants were also offered as part of
the package? It is because the warrants are long-term call options that have value
because holders can buy the firm’s common stock at the exercise price regardless

662 Part 7 Special Topics in Financial Management

of how high the market price climbs. This option offsets the low interest rate on
the bonds and makes the package of low-yield bonds plus warrants attractive to
investors. (See Chapter 18 for a more complete discussion of options.)

Initial Market Price of a Bond with Warrants

The Infomatics bonds, if they had been issued as straight debt, would have car-
ried a 10 percent interest rate. However, with warrants attached, the bonds were
sold to yield 8 percent. Someone buying the bonds at their $1,000 initial offering
price would thus be receiving a package consisting of an 8 percent, 20-year bond
plus 20 warrants. Since the going interest rate on bonds as risky as those of Info-
matics was 10 percent, we can find the straight-debt value of the bonds, assum-
ing an annual coupon for ease of illustration, as follows:

0 10% 1 2 3 20
PV 80 80 80
80
1‚000

Using a financial calculator, input N ϭ 20, I/YR ϭ 10, PMT ϭ 80, and
FV ϭ 1000. Then, press the PV key to obtain the bond’s value, $829.73, or
approximately $830. Thus, a person buying the bonds in the initial underwriting
would pay $1,000 and receive in exchange a straight bond worth about $830 plus
20 warrants presumably worth about $1,000 Ϫ $830 ϭ $170:

Price paid for ϭ Straight-debt ϩ Value of
bond with warrants value of bond warrants
(20-1)

$1,000 ϭ $830 ϩ $170

Investors receive 20 warrants with each bond, so each warrant has an implied
value of $170/20 ϭ $8.50.

The key issue in setting the terms of a bond with warrants is valuing the
warrants. The straight-debt value can be estimated quite accurately, as was done
above. However, it is more difficult to estimate the value of the warrants. The
Black-Scholes Option Pricing Model (OPM), which we discussed in Chapter 18,
can be used to find the value of a call option. There is a temptation to use this
model to find the value of a warrant, since call options are similar to warrants in
many respects: Both give the investor the right to buy a share of stock at a fixed
exercise price on or before the expiration date. However, there is a major differ-
ence between call options and warrants: When call options are exercised, the
stock provided to the optionholder comes from the secondary market, but when
warrants are exercised, the stock provided to the warrant holders are newly
issued shares. This means that the exercise of warrants dilutes the value of the
original equity, which could cause the value of the original warrant to differ
from the value of a similar call option. Therefore, investment bankers cannot use
the Black-Scholes model to determine the value of warrants.

It is extremely important to assign the correct value to the warrants. If, when
the issue is originally priced, the value assigned to the warrants is greater than
their true market value, then the coupon rate on the bonds will be set too low,
and it will be impossible to sell the bond-with-warrants package at its par value.
In this case, Infomatics will not be able to raise the full $50 million that it needs
to fund its growth.

Conversely, if the value of the warrants is underestimated, then the coupon
rate will be set too high. This means that the true value of the bonds with war-
rants will be greater than the issue price. Suppose this happens, and the true
value of the bonds with warrants is $60 million. Investors will eagerly buy all of

Chapter 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 663

the bonds with warrants at the issue price, and Infomatics will receive the full
$50 million that it needs. But this is not good news for the existing shareholders.

To see this, think of the total value of Infomatics as being analogous to a pie.
The size of the pie is equal to the present value of all the future cash flows
expected to be generated by Infomatics’ operations and investments. Pieces of
the pie belong to different groups of investors, such as debtholders and holders
of bonds with warrants. Shareholders come last and get the remaining piece of
the pie, after the other investors have received their fair share.

At the time of the bond offering, Infomatics had 10 million shares of common
stock outstanding and no other debt or preferred stock. The stock price was $20
per share, so the total market value of Infomatics was 10 million ϫ $20 ϭ $200
million. The offering itself will raise $50 million in cash, which will subsequently
be invested in projects. Therefore, immediately after the offering the total value of
Infomatics is $250 million ($200 million in stock plus $50 million in cash).13 If
investors in the bonds with warrants pay only $50 million for a piece of pie that
is worth $60 million, then the piece of pie remaining for the original shareholders
is only worth $190 million ($250 million Ϫ $60 million). The result is a $10 million
transfer of wealth from the original shareholders to the investors in the bonds
with warrants. Therefore, it is extremely important for Infomatics to correctly
estimate the value of the warrants at the time the bonds with warrants are issued.

Use of Warrants in Financing

Warrants generally are used by small, rapidly growing firms as “sweeteners”
when they sell debt or preferred stock. Such firms frequently are regarded by
investors as being highly risky, so their bonds can be sold only at extremely high
coupon rates and with very restrictive indenture provisions. To avoid this, firms
such as Infomatics often offer warrants along with the bonds. However, some
years ago, AT&T raised $1.57 billion by selling bonds with warrants. This was
the largest financing of any type ever undertaken by a business firm, and it
marked the first use ever of warrants by a large, strong corporation.14

Getting warrants along with bonds enables investors to share in the com-
pany’s growth, assuming it does in fact grow and prosper. Therefore, investors
are willing to accept a lower interest rate and less restrictive indenture provi-
sions. A bond with warrants has some characteristics of debt and some charac-
teristics of equity. It is a hybrid security that provides the financial manager with
an opportunity to expand the firm’s mix of securities and thus to appeal to a
broader group of investors.

13 We assume that the average expected net present value of these projects is zero. If NPV Ͼ 0, then
the total value of Infomatics will be greater than $250 million. In this case, there will be little change
in the price of the bonds, since bondholders receive the fixed coupon payment no matter how well
the company does. However, the stock price and the value of the warrants will increase, since the
total value of the company has increased without a commensurate increase in the value committed
to the bondholders. The reverse would occur if NPV Ͻ 0.
14 It is interesting to note that before the AT&T issue, the New York Stock Exchange’s stated policy
was that warrants could not be listed because they were “speculative” instruments rather than
“investment” securities. When AT&T issued warrants, however, the Exchange changed its policy,
agreeing to list warrants that met certain requirements. Many other warrants have since been listed.

It is also interesting to note that, prior to the sale, AT&T’s treasury staff, working with Morgan
Stanley analysts, estimated the value of the warrants as a part of the underwriting decision. The
package was supposed to sell for a total price in the neighborhood of $1,000. The bond value could
be determined accurately, so the trick was to estimate the equilibrium value of the warrant under
different possible exercise prices and years to expiration, and then to use an exercise price and life
that would cause Bond value ϩ Warrant value ϭ $1,000. Using a warrant pricing model, the
AT&T/Morgan Stanley analysts set terms that caused the warrant to sell on the open market at a
price that was only 35¢ off from the estimated price.

664 Part 7 Special Topics in Financial Management

Detachable Warrant Virtually all warrants today are detachable. Thus, after a bond with attached
A warrant that can be warrants is sold, the warrants can be detached and traded separately from the
detached from a bond bond. Further, even after the warrants have been exercised, the bond (with its
and traded indepen- low coupon rate) remains outstanding.
dently of it.
The exercise price on warrants is generally set some 20 to 30 percent above
Stepped-Up Exercise the market price of the stock on the date the bond is issued. If the firm grows
Price and prospers, and if its stock price rises above the exercise price at which shares
An exercise price that may be purchased, warrant holders could exercise their warrants and buy stock
is specified to rise if a at the stated price. However, without some incentive, warrants would never be
warrant is exercised exercised prior to maturity—their value in the open market would be greater
after a designated than their value if exercised, so holders would sell warrants rather than exercise
date. them. There are three conditions that encourage holders to exercise their war-
rants: (1) Warrant holders will surely exercise and buy stock if the warrants are
about to expire and the market price of the stock is above the exercise price.
(2) Warrant holders will exercise voluntarily if the company raises the dividend
on the common stock by a sufficient amount. No dividend is earned on the war-
rant, so it provides no current income. However, if the common stock pays a
high dividend, it provides an attractive dividend yield but limits price growth.
This induces warrant holders to exercise their option to buy the stock. (3) War-
rants sometimes have stepped-up exercise prices, which prod owners into exer-
cising them. For example, Williamson Scientific Company has warrants out-
standing with an exercise price of $25 until December 31, 2009, at which time the
exercise price rises to $30. If the price of the common stock is over $25 just before
December 31, 2009, many warrant holders will exercise their options before the
stepped-up price takes effect and the value of the warrants falls.

Another desirable feature of warrants is that they generally bring in funds
only if funds are needed. If the company grows, it will probably need new
equity capital. At the same time, growth will cause the price of the stock to rise
and the warrants to be exercised, hence the firm will obtain additional cash. If
the company is not successful, and it cannot profitably employ additional
money, the price of its stock will probably not rise sufficiently to induce exercise
of the warrants.

Wealth Effects and Dilution Due to Warrants

Assume that the value of Infomatics’ operations and investments, which is $250
million immediately after issuing the bonds with warrants, is expected to grow,
and does grow, at 9 percent per year. When the warrants are due to expire in
10 years, the total value of Infomatics will be $250(1.09)10 ϭ $591.841 million.
How is this value allocated among the original stockholders, the bondholders,
and the warrant holders? The bonds will have 10 years remaining until maturity,
with a fixed coupon payment of $80. If the expected market interest rate is still
10 percent, then:

0 10% 1 2 3 10
PV 80 80 80
80
1‚000

Using a financial calculator, input N ϭ 10, I/YR ϭ 10, PMT ϭ 80, and FV ϭ
1000. Press the PV key to obtain the bond’s value, $877.11. The total value of all
of the bonds is 50,000($877.11) ϭ $43.856 million.

The value remaining for the original stockholders and the warrant holders is
equal to the remaining value of the firm, after deducting the value due to the
bondholders. This remaining value is $591.841 Ϫ $43.856 ϭ $547.985 million. If
there had been no warrants, then the original stockholders would have been

Chapter 20 Hybrid Financing: Preferred Stock, Leasing, Warrants, and Convertibles 665

entitled to all of this remaining value. Recall that there are 10 million shares of
stock, so the price per share would be $547.985/10 ϭ $54.80. Suppose the company
has a basic earning power of 13.5 percent (recall that BEP ϭ EBIT/Total Assets)
and total assets of $591.841 million.15 This means that EBIT is 0.135($591.841) ϭ
$79.899 million; interest payments are $4 million ($80 coupon payment per bond ϫ
50,000 bonds); and earnings before taxes are $79.899 Ϫ $4 ϭ $75.899 million.
With a tax rate of 40 percent, after-tax earnings are equal to $75.899(1 Ϫ 0.4) ϭ
$45.539 million, and earnings per share are $45.539/10 ϭ $4.55. Therefore, if
Infomatics had no warrants, the stock price would be $54.80 per share, and the
earnings per share would be $4.55.

But Infomatics does have warrants, and with the stock price over $50 the
warrant holders surely will choose to exercise their warrants. Infomatics will
receive $22 million when the 1 million warrants are exercised at a price of
$22 per warrant. This makes the total value $613.841 million (the $591.841 mil-
lion total value of the firm plus the $22 million raised by the exercise of the war-
rants). The total value remaining for stockholders is now $569.985 million
($613.841 million less the $43.856 million allocated to bondholders). There are
now 11 million shares of stock (the original 10 million plus the new 1 million
due to the exercise of the warrants), so the stock price is $569.985/11 ϭ $51.82
per share. Note that this is lower than the $54.80 price per share that Infomatics
would have had if there had been no warrants. In other words, the warrants
have diluted the value of the stock.

A similar dilution occurs with earnings per share. After exercise, the asset base
would increase from $591.841 million to $613.841 million, with the additional $22
million coming from the purchase of 1 million shares of stock at $22 per share. If
the new funds have the same basic earning power as the existing funds, then the
new EBIT would be 0.135($613.841) ϭ $82.869 million. Interest payments would
still be $4 million, so earnings before taxes would be $82.869 Ϫ $4 ϭ $78.869 mil-
lion, and after-tax earnings will be $78.869(1 Ϫ 0.4) ϭ $47.321 million. With 10 ϩ 1
ϭ 11 million shares now outstanding, EPS would be $47.321/11 ϭ $4.30, down
from $4.55. Therefore, exercising the warrants would dilute EPS.

Has this wealth transfer harmed the original shareholders? The answer is yes
and no. Yes, because the original shareholders clearly are worse off than they
would have been if there had been no warrants. However, if there had been no
warrants attached to the bonds, then the bonds would have had a 10 percent
coupon rate instead of the 8 percent coupon rate. Also, if the value of the company
had not increased as expected, then it might not have been profitable for the war-
rant holders to exercise their warrants. In other words, the original shareholders
were willing to trade off the potential dilution for the lower coupon rate. In this
example, the original stockholders and the investors in the bonds with warrants
got what they expected. Therefore, the answer is no, the wealth transfer at the
time of exercise did not harm the original shareholders, because they expected an
eventual transfer and were fairly compensated by the lower coupon payments.

Note too that investors would recognize the situation, so the actual wealth
transfer would occur gradually over time, not in a fell swoop when the warrants
were exercised. First, EPS would have been reported on a diluted basis over the
years, and on that basis, there would be no decline whatever in EPS. (We discuss
this in a later section of this chapter.) Also, investors would know what was hap-
pening, so the stock price, over time, would reflect the likely future dilution, so
it too would be stable when the warrants were exercised. So, whereas our calcu-
lations show the effects of the warrants, those effects would actually be reflected
in EPS and the stock price on a gradual basis over time.

15 In this case, the total market value equals the book value of assets, but the same calculations
would follow even if market and book values were not equal.

666 Part 7 Special Topics in Financial Management

The Component Cost of Bonds with Warrants

When Infomatics issued its debt with warrants, the firm received $50 million, or
$1,000 for each bond. Simultaneously, the company assumed an obligation to pay
$80 interest for 20 years plus $1,000 at the end of 20 years. The pre-tax cost of the
money would have been 10 percent if no warrants had been attached, but each
Infomatics bond had 20 warrants, each of which entitles its holder to buy one
share of Infomatics stock for $22. What is the percentage cost of the $50 million?
As we shall see, the cost is well above the 8 percent coupon rate on the bonds.

As we demonstrated earlier, when the warrants expire 10 years from now,
the expected stock price is $51.82. The company would then have to issue one
share of stock worth $51.82 for each warrant exercised and, in return, Infomatics
would receive the exercise price, $22. Thus, a purchaser of the bonds, if he or she
holds the complete package, would realize a profit in Year 10 of $51.82 Ϫ $22 ϭ
$29.82 for each common share issued. Since each bond has 20 warrants attached,
and each warrant entitles the holder to buy one share of common stock, investors
would have a gain of 20($29.82) ϭ $596.40 per bond at the end of Year 10. Here is
a time line of the cash flow stream to an investor:

01 9 10 11 20

Ϫ1‚000 80 80 80.00 80 80
596.40 1‚000
676.40 1‚080

The IRR of this stream is 10.7 percent, which is the investor’s overall pre-tax
rate of return on the issue. This return is 70 basis points higher than the return
on straight debt. This reflects the fact that the issue is riskier to investors than a
straight-debt issue because some of the return is expected to come in the form of
stock price appreciation, and that part of the return is relatively risky.

The expected rate of return to investors is the before-tax cost to the com-
pany—this was true of common stocks, straight bonds, and preferred stocks,
and it is also true of bonds sold with warrants.

Problems with Warrant Issues

Although warrants are bought by investors with the expectation of receiving a
total return commensurate with the overall riskiness of the package of securities
being purchased, things do not always work out as expected. For example, in
1989 Sony paid $3.4 billion for Columbia Pictures, a U.S. movie studio. To help
finance the deal, in 1990 Sony sold $470 million of four-year bonds with war-
rants at an incredibly low 0.3 percent coupon interest rate. The rate was so low
because the warrants, which also had a maturity of four years, allowed investors
to purchase Sony stock at 7,670 yen per share, only 2.5 percent above the share
price at the time the bonds with warrants were issued.

Investors snapped up the issue, and many of the warrants were “peeled off”
and sold separately on the open market. The warrant buyers obviously believed
that Sony’s stock would climb well above the exercise price. From Sony’s point
of view, the bond-with-warrants package provided a very low-cost “bridge
loan” (the bonds) that would be replaced with equity financing when the war-
rants were exercised, presumably in four years when the bonds became due.
This very low cost capital encouraged Japanese firms to acquire foreign compa-
nies and to invest huge amounts in new plant and equipment.

However, the willingness of investors to buy Japanese warrants suffered a
severe blow when the Japanese stock market fell by 40 percent. By 1994, when
the warrants expired, Sony’s stock sold for only 5,950 yen versus the 7,670 yen
exercise price, so the warrants were not exercised. Thus, Sony’s planned infusion