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# MNC SOURCE OF FINANCING: Euronotes: are unsecured debt securities with typical maturities of 1, 3 or 6 months.

They are underwritten by commercial banks. MNCs may also issue Euro-commercial papers to obtain short-term financing. MNCs utilize direct Eurobank loans to maintain a relationship with the banks too.

Short Term Financing Multinationals engage in foreign financing for two major reasons, to offset foreign receivables and to get cheaper financing. Whether or not foreign currency financing has an effective financing cost that is cheaper than in the MNC's home market depends both upon the interest rate charged and the relative movements of the currencies of the lender country and of the home country. A handy formula to use in calculating the effective financing rate (rf) is as follows: rf = (1 + foreign interest rate)(1 plus/minus the % change in foreign spot rate) - 1

For example, if the interest rate in Great Britain is 9% and the pound strengthens by 6%, the effective financing rate is: (1 + .09) X (1 + .06) - 1 = .155 or 15.5%

If the mark weakens by 6%, the formula would look as follows: (Remember to subtract the % decline of the mark)

## (1 + .09) X (1 + (- .06) - 1 = (1.09) X (.94) - 1 = 2.5%

If the foreign currency depreciates substantially over the life of the loan, the MNC may wind up with a negative effective financing rate, implying that the MNC actually paid fewer dollars to repay the loan than it borrowed. For example, if the mark had depreciated by 10% in the example above, the MNC would have paid an effective financing rate of: (1.09)(.90) -1 = -.019 or -1.9%

To calculate the percentage appreciation or decline of the foreign currency, use the formula : % change in foreign currency = (Ending spot rate - Beginning spot rate) / Beginning spot rate OR, to put it more briefly, % change in foreign currency (S St-1 )/ St-1 To determine whether or not it is advantageous to borrow in a foreign currency, the MNC must forecast movements in the foreign currency. To do this, the MNC may rely upon theories of interest rate parity, may use the forward rate as a forecast or may make use of exchange rate forecasts. As we have seen previously, if interest rate parity holds, the effective financing rate will be the same as the domestic interest rate, because the two currencies would adjust until there was interest rate parity. We could use the interest rate parity formula to estimate how much the foreign currency will appreciate or depreciate over the course of the loan because solving for P in the formula below tells us what the forward discount premium or discount should be. First, to refresh your memories, the interest rate parity formula is P = {(1 + IH ) / (1+ IF)} -1 Or to put it in words,

Parity = {(1 + home country interest rate) (1 + foreign country interest rate)} -1
For example, if the interest rate in Great Britain is 9% and is 6% in the United States, heres what we would expect to happen to the pound. Parity = {(1 + .06) / (1 + .09)} - 1 = -0275 or -2.75%

According to interest rate parity, the pound must weaken by about 2.75% over the loan period to make the loans cost as much in the U.S. as in Great Britain. The parity formula tells us the amount that the foreign currency should appreciate or depreciate. If interest rate parity holds true, the only way an MNC could pay a lower rate overseas than domestically would be if the forward rate overestimated the future spot rate. A break-even exchange rate percentage change will indicate to a firm the amount by which a low interest rate currency must appreciate to make its financing cost the same as a domestic currency. Assume that the one-year loan rate for a U.S. firm is 15% and the one-year loan rate on euros is 7%. The firm wishes to determine by how much must the euro appreciate to cause the loan in euros to be more costly than a U.S.-dollar loan.

The breakeven is calculated as: (1.15/1.07) 1 = 7.477%. The euro must appreciate by about 7.477% over the year in order to make the loan in euros as costly as a U.S. dollar loan. Of course, it is possible for a firm to incur a negative effective financing rate. If the currency borrowed substantially depreciates against the firms home currency (by at least the interest rate percentage as a rough approximation), the effective financing rate will be negative.

To determine whether financing in a foreign currency is advantageous or not, a firm would develop its own forecast of the foreign currency's movements, and compare the forecast effective financing rate with the home country rate, using the formula above.

Examples: Assume the U.S. one-year interest rate is 8%, and the British one-year interest rate is 6%. The one-year forward rate of the pound is \$1.97. The spot rate of the pound at the beginning of the year is \$1.95. By the end of the year, the pound's spot rate is \$2.05. Based on the information, what is the effective financing rate for a U.S. firm that takes out a one-year, uncovered British loan? a. b. c. d. e. about 12.4%. about 7.1%. about 13.5%. about 10.3%. about 11.3%.

Missoula, Inc., decides to borrow Japanese yen for one year. The interest rate on the borrowed yen is 8 percent. Missoula has developed the following probability distribution for the yens degree of fluctuation against the dollar: Possible Degree of Fluctuation of Yen Percentage Probability Against the Dollar -4% 20% -1% 30% 0% 10% 3% 40% Given this information, what is the expected value of the effective financing rate of the Japanese yen from the U.S. Corporations perspective? (Chapter 20, Question 15). Lecture 10, Question 9 ANSWER: Japanese Interest Rate 8% 8% 8% 8% Possible % Change in Yen Value 4% 1% 0% 3% Effective Financing Rate Based on That Change 3.68% 6.92% 8.00% 11.24%