sec b 2 Flashcards
1
Q
Determining the Optimal Level of Cash
A
The optimal cash balance is determined by cost-benefit analysis.
Cash doesn’t earn a return, so firms should only hold the amount required to meet current obligations.
The opportunity cost of holding cash is the missed return from other investments like marketable securities.
2
Q
Speeding Up Cash Collections: Key Strategies
What is Float?
A
The period between when a payor sends a check and when the funds are available in the payee’s bank is called float.
3
Q
Key Strategies to Reduce Float Time: Benefit Calculation
A
To determine the benefit of reducing float
Benefit = (Daily Cash Receipts × Days of Reduced Float) × Opportunity Cost of Funds
Daily cash receipts = $22,000, Reduced float time = 2 days , Opportunity cost of funds (market return) = 6%
Benefit = ($2,000 × 2 days)* 6% = $2,640 annually.
4
Q
Lockbox System:
A
Payments are directed to a mailbox, and bank personnel immediately deposit checks into the firm’s account.
Ideal for firms with a wide customer base across regions. A lockbox network can be set up with banks in multiple regions
5
Q
Concentration Banking:
A
Payments are first deposited into local accounts, then transferred to the firm’s main bank via a concentration account.
Wire transfers speed up the process by directly transferring funds.
Daily cash receipts = $150,000, Reduced float time = 2 days, Cost of plan = $1,250 per month, Expected return = 8% annual
Benefit = ($300,000 × 8%) - (1,250 × 12) = $24,000 - $15,000 = $9,000 annually.
The benefit of reducing float must outweigh the
associated costs for it to be worthwhile.
6
Q
Slowing Cash Payments: Key Concepts
A
1)Disbursement Float: The period between when a payor writes a check and when the funds are deducted from the account.
Check float provides an interest-free loan to the payor because of the delay.
To increase float, a firm may send checks without being sure it has enough funds to cover them.
2)Overdraft Protection: Banks offer overdraft protection, where they guarantee to cover shortages (for a fee) by transferring funds from the firm’s master account.
7
Q
Compensating Balance:
A
The minimum balance a bank requires a firm to keep in its account (usually non interest-bearing).
These balances are held to compensate the bank for services like check writing.
Opportunity Cost: The money in compensating balances is unavailable for investment, incurring an opportunity cost.
8
Q
Other Methods for Managing Cash Outflows:
A
1) Zero Balance Accounts (ZBAs): Accounts that maintain a $0 balance, with funds automatically transferred from a master account to cover checks.
2)Centralizing Accounts Payable: Streamlining and centralizing payments to better manage outflows.
3) Controlled Disbursement Accounts: Accounts where a bank controls the disbursements to ensure that only authorized payments are made.
9
Q
Managing Marketable Securities
Idle Cash and Opportunity Cost:
A
Firms invest idle cash in marketable securities to offset the opportunity cost (i.e., the return they miss out on if the cash isn’t invested).
It’s important to match the maturity of securities with cash needs, balancing risk and return
10
Q
Types of Marketable Securities: Money Market Instruments
A
The money market refers to the short-term investment market where firms place their temporary surpluses of cash.
This market is not formally organized but consists of a range of financial institutions, firms, and government agencies offering instruments with varying risk levels and short- to medium-range maturities.
11
Q
Liquidity and Safety
A
Liquidity: Ability to quickly convert an investment into cash without losing principal.
Safety: Low-risk, low-yield instruments in active markets (e.g., money market instruments).
The goal is to find a balance between risk, after-tax returns, liquidity, and safety in selecting marketable securities
12
Q
Common Marketable Securities
A
1)U.S. Treasury Obligations
2)Federal Agency Securities
3)Repurchase Agreements (Repos)
4)Bankers’ Acceptances
5)Commercial Paper
6)Certificates of Deposit (CDs)
7)Eurodollars
8)Money Market Mutual Funds
13
Q
U.S. Treasury Obligations
A
Treasury Bills (T-bills):
Short-term debt instruments with maturities of 1 year or less.
They are sold at a discount, meaning no interest is paid, and the return is the difference between the purchase price and the face value.
No default risk, making them highly liquid and often used as substitutes for cash
Treasury Notes (T-notes):
Medium-term instruments with maturities between 1 to 10 years.
They provide semiannual interest payments.
Treasury Bonds (T-bonds):
Long-term instruments with maturities of 10 years or more.
They also provide semiannual interest payments.
14
Q
Federal Agency Securities
A
These securities are backed by the U.S. government or a specific government agency.
State and local governments issue short-term securities that are exempt from taxation.
15
Q
Repurchase Agreements (Repos)
A
Repos are a short-term lending mechanism where a firm buys government securities from a dealer and the dealer agrees to repurchase them at a later date for a higher price.
These typically have overnight to a few days maturities.
Essentially, it’s a secured loan from the firm to the dealer
16
Q
Bankers’ Acceptances
A
These are drafts drawn by a non-financial firm on its deposits at a bank.
The bank guarantees payment at maturity, thus the payee can rely on the bank’s creditworthiness.
These are highly marketable and can be sold after acceptance by the bank.
17
Q
Commercial Paper
A
Unsecured short-term notes issued by large, creditworthy companies.
Used by firms to raise short-term capital.
Typically, they have high credit ratings and carry low risk
18
Q
Certificates of Deposit (CDs)
A
A form of savings deposit that cannot be withdrawn before maturity without a penalty.
Negotiable CDs can be sold in the secondary market.
These often offer a lower return compared to other instruments like commercial paper or bankers’ acceptances
19
Q
Eurodollars
A
These are U.S. dollar-denominated deposits held in foreign banks.
Typically used for international transactions.
20
Q
Money Market Mutual Funds
A
These funds invest in short-term, low-risk securities.
In addition to earning interest, they allow investors to write checks on their balances.
21
Q
Key Characteristics of Marketable Securities:
A
Liquidity: The ease of converting an asset into cash.
Safety: The low-risk nature of the investment, often determined by the issuing entity’s creditworthiness.
Yield: The return generated by the security, which is typically lower for safer investments.
By investing in marketable securities, firms can efficiently manage their cash balances, earning returns while maintaining sufficient liquidity to meet obligations
22
Q
Receivables Management (Trade Credit Policy)
A
Receivables management, or trade credit policy, refers to the management of accounts receivable to balance sales growth and risk. Firms offer credit to customers for competitive reasons and to stimulate sales.
23
Q
Key Elements of Receivables Management:
A
Credit Terms: Firms often must offer credit if their competitors do, and they may charge financing fees (interest income) for
customers who pay beyond the due date.
Collaboration across Functions: Sales, finance, and accounting functions must work together to manage accounts receivable effectively.
Administrative Factors:
Procedures for evaluating customer creditworthiness.
Formula for setting standard credit terms.
Systems for tracking accounts receivable and billing customers.
Procedures for following up on overdue accounts.
24
Q
Optimal Credit Policy:
A
The goal is not just maximizing sales. While offering discounts, longer payment periods, or accepting riskier customers can
increase sales, the company needs to balance this with the increase in bad debts (unpaid amounts) and its negative impact on cash flow.
25
Default Risk Management
Default risk is the probability that a customer may be unable or unwilling to pay the debt.
To manage default risk, firms often require customers to sign written agreements detailing the terms of credit and consequences for non-payment.
Credit scoring helps firms assess the risk by assigning numerical values to the elements of creditworthiness.
26
Aging Accounts Receivable
An aging schedule of accounts receivable stratifies accounts based on how long they've been outstanding. This tool helps in assessing the collectability of debts:
Longer outstanding accounts are less likely to be collected.
27
Basic Receivables Terms
The most common credit terms are 2/10, net 30, which means: A 2% discount is offered if the invoice is paid within 10 days. Otherwise, the full invoice amount is due within 30 days
28
Average Collection Period (Days Sales Outstanding):
The average collection period refers to the average number of days between a sale and the receipt of payment.
365 / Accounts Receivable Turnover Ratio
or (Average Accounts Receivable / Net Credit Sales) * 365. 0r Average Accounts Receivable / Credit Sale Per Day
29
Average Accounts Receivable
Average Accounts Receivable
= (beginning accounts receivable + ending accounts receivable) / divided by 2
Or
● net credit sales / 365 × Average collection period
● Net credit sales × (Average collection period ÷ 365)
● Net credit sales ÷ Accounts receivable turnover
30
Assessing the Impact of a Change in Credit Terms
A change in credit terms can increase or decrease the firm's receivables and, consequently, its opportunity cost.
31
Incremental Investment in Receivables:
Incremental variable costs ×( Incremental average collection period ÷ Days in year)
32
Cost of Change in Credit Terms:
Cost of change = Increased investment in receivables × Opportunity cost of funds
33
Benefit or Loss from Credit Policy Change:
Benefit = Incremental contribution margin – Cost of change.
34
Factoring
Factoring is when a company transfers its receivables to a third-party factor who takes responsibility for collections. The factor
charges a fee for financing and collections. Credit Card Sales as Factoring Credit card sales are a common form of factoring where the retailer receives immediate cash while avoiding credit losses. In exchange, the credit card company charges a fee
35
Inventory Management
Inventory is crucial for business operations, particularly for selling products to customers. However, inventory is also held for other
reasons, including:
Protecting against supply uncertainty (e.g., vendor issues or delayed shipments).
Protecting against demand fluctuations, ensuring stock availability during unexpected spikes in demand.
The optimal inventory level balances the costs of inventory while meeting the needs of the business. A firm must minimize total inventory cost while considering its inventory needs.
36
Costs Related to Inventory: Purchase Costs
Definition: Actual invoice price + shipping costs. Purpose: Represents the investment in inventory.
37
Costs Related to Inventory: Carrying Costs
Definition: Costs of holding inventory:
Storage, insurance, security, taxes.
Depreciation/rent of facilities, interest, obsolescence/spoilage.
Opportunity cost of funds tied in inventory.
Carrying costs(Avg Inventory ) = (Beginning inventory+Ending inventory) / 2
or
Order Quality / 2
38
Ordering Costs
Definition: Fixed costs per order (independent of units ordered).
Vendor order placement costs.
Production setup costs (for internally made goods).
Discounts lost (e.g., smaller orders may forfeit bulk discounts).
Ordering Cost = Number of Orders × Cost per Order.
39
Stockout Costs
Definition: Opportunity cost of unmet customer demand.
Includes:
Lost sales revenue.
Expedited shipping costs for emergency orders
40
Minimizing total inventory cost requires balancing:
Purchase costs (lower with bulk buys).
Carrying costs (lower with smaller orders).
Ordering costs (lower with fewer, larger orders).
Stockout costs (lower with adequate safety stock).
41
Safety Stock
Extra inventory held to mitigate stockout risks.
Increases carrying costs (storage, insurance, opportunity cost).
42
Factors Influencing Safety Stock
Demand variability: Higher fluctuations → More safety stock.
· Lead time variability: Unpredictable supplier delays → Higher safety stock.
· Risk tolerance: Lower acceptable stockout risk → Higher safety stock.
43
Cost Components
Total Safety Stock Cost = Expected Stockout Cost + Carrying Cost
Expected Stockout Cost: Lost sales, expedited shipping, customer dissatisfaction.
Carrying Cost: Storage, insurance, capital
tied up in inventory
44
Trade-offs in Inventory Management
· Stockout Costs ↓: Require high carrying costs (more safety stock).
· Carrying Costs ↓: Require frequent small orders (high ordering costs).
· Ordering Costs ↓: Require large orders (high carrying costs).
45
Economic Order Quantity (EOQ)
The Economic Order Quantity (EOQ) model calculates the optimal order quantity that minimizes total inventory costs (ordering +
carrying costs).
EOQ Formula
EOQ = Root of (2aD) / k
a = Fixed cost per purchase order (ordering costs)
D = Periodic demand in units (demand for inventory per period)
k = Carrying cost per unit (cost of holding one unit of inventory)
46
Assumptions of the EOQ Model
1. Demand is uniform and predictable.
2. Carrying costs (k) are constant (e.g., storage, insurance).
3. Same quantity ordered at each reorder point.
4. Purchasing costs are unaffected by order size (no bulk discounts).
5. Lead time and deliveries are consistent and known.
6. No stock outs occur (adequate safety stock).
47
Impact of Variable Changes on EOQ and reason: Demand (D)
Demand (D) ↑ / EOQ ↑ : Higher demand requires larger orders to reduce ordering frequency.
48
Impact of Variable Changes on EOQ and reason: Ordering Cost
Ordering Cost (S) ↑ /EOQ ↑ : Higher fixed costs
incentivize fewer, larger orders.
49
Impact of Variable Changes on EOQ and reason : Carrying Cost
Carrying Cost (H) ↑/ EOQ ↓ : Higher holding costs
make smaller orders economical.
50
Limitations of EOQ
1. Ignores demand variability (assumes uniform demand).
2. Excludes stockout costs (assumes no shortages).
3. No bulk discounts (assumes constant purchasing costs).
4. Static lead times (assumes no supply chain
disruptions).
51
Practical Applications of EOQ
· Use EOQ as a baseline for inventory decisions.
· Adjust for real-world factors (e.g., safety stock, discounts).
· Recalculate EOQ periodically if costs or demand
change
52
Key Takeaway of EOQ
EOQ balances ordering and carrying costs to minimize total inventory expenses. Adapt the model to align with dynamic business conditions.
53
Mergers and Acquisitions (M&A): Mergers
Definition: One firm (acquirer) absorbs another, forming a combined entity.
o Requires shareholder approval from both firms.
o Payment is typically in stock (e.g., shares of the acquirer).
o Acquirer: Often a cash-rich, mature firm seeking growth.
o Acquired: Usually a growing firm needing capital.
54
Types of Mergers
Horizontal
Vertical
Conglomerate
55
Horizontal
Merging two firms in the same
industry. Eliminate competition, gain market
share.
Eg: Two telecom companies combining.
56
Vertical
Merging with a supplier or
customer. Control supply chain
Eg: Car manufacturer acquires a tire co.
57
Conglomerate
Merging unrelated businesses. Diversify risk
Eg: Tech firm buys a food chain.
58
Consolidation :
Similar to a merger but creates a new entity; neither original firm survives.
59
Acquisitions
Definition: Purchase of all assets or a controlling stake (>50% voting shares) in another firm.
Control: Ability to direct management/policies of the acquired firm. Acquisitions focus on control (asset/stock purchase).
60
Methods of Acquisition
Asset Purchase
Stock Purchase
61
Methods of Acquisition: Asset Purchase
Requires shareholder vote of the target firm.
Transfers legal title (costly) but avoids minority shareholders.
62
Methods of Acquisition: Stock Purchase
Can bypass hostile management via tender offer (direct offer to shareholders).
No shareholder vote required.
63
Takeovers:
Tender Offer
Public offer to buy shares directly from shareholders at a premium. Tender offers bypass management in hostile bids.
Takeovers can be friendly (negotiated) or hostile (forced)
64
Friendly Takeover:
Target is successful/growth-oriented.
Payment in cash or stock; management often has high ownership.
65
Hostile Takeover:
Target is underperforming/
mature.
Multiple bidders; payment usually in cash.
Led by corporate raiders (investors targeting undervalued firms).
66
Friendly Takeover v/s Hostile Takeover: Target Industry:
Growth-oriented / Mature/declining
67
Friendly Takeover v/s Hostile Takeover: Management
High ownership, cooperative / Low ownership, resistant
68
Friendly Takeover v/s Hostile Takeover: Payment
Cash or stock / Cash
69
Friendly Takeover v/s Hostile Takeover: Bidders
Single bidder / Multiple bidders (raiders)
70
Motivations for Mergers and Acquisitions (M&A): A Structured Overview
Mergers and acquisitions (M&A) are driven by a complex interplay of managerial incentives and strategic economic objectives.
71
key motivations and their implications:
1. Managerial Motivations
2. Entity-Level Strategic Benefits
3. Conflicts and Considerations
72
Managerial Motivations
Personal Gain: Managers may pursue M&A to enhance their salary, power, or prestige, even if the deal does not align with shareholder interests.
Job Security: Fear of replacement may lead managers to resist beneficial M&As or pursue suboptimal ones to retain control.
73
Entity-Level Strategic Benefits:
A. Diversification
Objective: Stabilize earnings and reduce risk (e.g., entering new industries to mitigate sector-specific downturns).
Limitation: Shareholders can diversify individually, so corporate diversification adds value primarily through operational synergies.
74
Entity-Level Strategic Benefits:
B. Market Power
Goal: Increase pricing control by reducing competition. Challenges: Antitrust regulations, globalization, and emerging competitors limit this strategy
75
Entity-Level Strategic Benefits:
C. Asset Breakup
Arbitrage Opportunity: Acquire undervalued firms to sell assets piecemeal at a profit.
Example: Private equity firms buying conglomerates to divest non-core assets.
76
Entity-Level Strategic Benefits:
Definition: Combined entity value > sum of individual firms.
o Operational Synergy
o Financial Synergy:
77
Financial Synergy:
Lower Cost of Capital: Larger firms access cheaper debt/equity financing.
Tax Benefits: Increased debt capacity for interest tax shields.
78
Operational Synergy:
Cost Efficiency: Economies of scale (e.g., merged production facilities reduce overhead).
Revenue Growth: Cross-selling products or expanding distribution networks.
79
Valuation:
Use risk-adjusted discount rates to assess incremental cash flows from synergies.
80
Entity-Level Strategic Benefits:
Management Improvement
Targeting Inefficiency: Replace poorly performing management post-acquisition.
Example: Activist investors acquiring firms to overhaul leadership.
81
Entity-Level Strategic Benefits: Capital Structure Optimization
Tax Strategy: Leverage higher debt capacity post-merger for tax deductions. Risk: Over-leverage increases bankruptcy risk.
82
Conflicts and Considerations
Agency Problems: Misalignment between managerial and shareholder interests.
Regulatory Hurdles: Antitrust laws may block mergers that create monopolies.
Synergy Realization: Overestimation of synergies is common; rigorous due diligence is critical.
83
NOTE:
Economic Drivers: Synergies (operational/financial) and strategic positioning (diversification, market power) are primary
justifications.
Managerial Influence: Personal incentives can distort M&A decisions, necessitating governance mechanisms (e.g., board
oversight).
Risk Management: Assess regulatory, financial, and integration risks to avoid value destruction.
84
Defenses Against Takeovers
When a company faces a potential hostile takeover, it may employ various defensive strategies to protect itself from being acquired
85
Common defense tactics used by companies:
Pre-Offer Defenses
Post-Offer Defenses
Structural Defenses
Shareholder-Centric Defenses
86
Pre-Offer Defenses
Staggered Board (Classified Board)
Supermajority Provisions
Poison Pills
Fair Price Provisions
Corporate Charter Amendments:
87
Staggered Board (Classified Board):
Directors serve overlapping terms (e.g., 3 classes with 3-year terms).
Impact: Delays acquirer’s control, as only a portion of the board is replaced annually.
Example: A hostile bidder must wait multiple election cycles to gain majority control.
88
Supermajority Provisions:
Requires a high threshold (e.g., 80%) for merger approval.
Impact: Raises the bar for acquirer success, often combined with staggered boards.
89
Poison Pills:
A poison pill is a defense strategy where the target company makes itself less attractive to acquirers by issuing provisions that dilute the value of shares if certain conditions are met.
90
Types of Poison Pills:
Flip-Over Rights
Flip-In Rights:
91
Flip-Over Rights:
Shareholders of the target can acquire more stock in the acquirer at a favorable ratio if the
takeover happens
92
Flip-In Rights
If an acquirer purchases a significant stake (e.g., 25%) of the target, existing shareholders except the acquirer) can purchase additional shares at a discount.
93
Fair Price Provisions
Mandates a minimum price for all shares in a takeover, preventing lowball offers. Fair price provisions involve
issuing warrants to shareholders that allow them to purchase stock at a discounted price (often half the market price) in the event of a takeover attempt.
94
Corporate Charter Amendments:
Includes anti-greenmail clauses to prevent paying premiums to specific bidders.
95
Post-Offer Defenses
Greenmail
White Knight Defense
Crown Jewel Sale
Leveraged Recapitalization
Leveraged Buyouts (LBOs) and Going Private
Employee Stock Ownership Plan (ESOP)
Legal Action
96
Greenmail:
Target repurchases shares from the hostile bidder at a premium
Drawback: Costly and often criticized for benefiting the bidder over shareholders.
97
White Knight Defense
Target seeks a friendly acquirer (e.g., Paramount Pictures partnering with Viacom to avoid a hostile bid from QVC in 1994).
98
Crown Jewel Sale:
Sells key assets to reduce the target’s appeal (e.g. selling a profitable division).
99
Leveraged Recapitalization:
In leveraged recapitalization, a company takes on substantial debt to finance a large dividend to its shareholders. This increases the company’s debt relative to equity, making it less attractive for a potential acquirer.
Takes on debt to fund dividends, increasing leverage and deterring acquirers.
Risk: High debt may lead to credit downgrades or bankruptcy.
100
Leveraged Buyouts (LBOs) and Going Private
Leveraged Buyouts (LBOs): This financing technique uses a minimal amount of equity and large amounts of debt to acquire a company. The company’s assets serve as collateral for the loan.
Going Private: In a going private transaction, a small group of investors, including management, purchases the publicly traded stock, delisting it from the exchange. This transaction is often structured as an LBO.
101
Employee Stock Ownership Plan (ESOP):
Employees hold shares, voting against hostile bids (e.g., United Airlines’ ESOP in 1994).
102
Legal Action:
Lawsuits alleging antitrust violations or disclosure issues delay takeovers (e.g., delaying tactics by Yahoo against Microsoft in 2008).
103
Structural Defenses
Golden Parachutes
Pac-Man Defense
Reverse Tender Offer
104
Golden Parachutes:
Lucrative severance packages for executives post-takeover.
Impact: Increases acquisition costs but may entrench management.
105
Pac-Man Defense:
Target counter-bids to acquire the hostile bidder (rarely used, e.g., Martin Marietta vs. Bendix in 1982).
106
Reverse Tender Offer:
Target offers to buy acquirer’s shares to
destabilize their control
107
Shareholder-Centric Defenses
Voting-Rights Plans
Poison Put
108
Voting-Rights Plans:
Restrict voting power of large shareholders (e.g.,
limiting votes to 10% regardless of ownership).
109
Poison Put:
Bondholders can demand repayment if a
takeover occurs, straining the acquirer’s finances.
110
NOTES
Shareholder Impact: Defenses like poison pills or greenmail may protect management but harm shareholder value.
Market Reaction: Defensive measures can signal weak governance, potentially lowering stock prices.
111
Reasons for Expanding International Business:
Resource Acquisition: Secure raw materials unavailable domestically (e.g., oil companies investing in resource-rich regions).
Market Expansion: Enter new markets to drive growth (e.g., Starbucks entering China).
Cost Efficiency: Leverage lower labor or production costs (e.g., manufacturing in Vietnam).
Trade Barrier Avoidance: Bypass tariffs by local production (e.g., automakers building plants in
the EU to avoid import duties)
112
Types of Foreign Investment
Direct Foreign Investment (DFI)
Stock Purchases
113
Direct Foreign Investment (DFI):
Involves the acquisition of physical assets (equipment, buildings) in a foreign country to establish operations.:
Lower Taxes: Some countries offer tax incentives for foreign investors.
Depreciation Allowances: Companies can benefit from depreciation deductions in the foreign country.
Access to Foreign Capital: Investment may open access to local financing.
Avoiding Trade Restrictions: Companies may bypass trade barriers that affect foreign imports.
114
Stock Purchases:
Alternatively, companies may purchase the stock of foreign corporations as a form of investment.
Pros: Passive exposure, liquidity (e.g., investing in Japanese tech stocks).
Cons: Limited influence, currency risk.
115
Management Complexity:
Managing operations in foreign countries is often more difficult than handling domestic operations
due to cultural, legal, and operational differences.
116
Cost of Capital:
Foreign investments typically have a higher cost of capital due to:
Exchange Rate Risk: Fluctuations in currency value can affect returns.
Sovereignty Risk: Political instability, such as expropriation or restrictions on repatriating profits, can reduce the value of investments.
Legal and Regulatory Risks: Laws may require certain levels of local ownership or impose specific financing sources (e.g., 51% local ownership).
117
Challenges and Risks in Foreign Investment
Cost of Capital
Management Complexity
118
Ownership Rights and ADRs:
American Depository Receipts (ADRs)
ADRs are a way for U.S. investors to invest in foreign companies without directly
purchasing foreign stock. ADRs represent shares in foreign companies but are traded on U.S. stock exchanges.
Benefits: Provides Americans an opportunity to invest in international markets, Allows foreign companies to raise capital in the U.S.
119
Methods of Financing International Trade
Cross-Border Factoring
Letters of Credit
Banker’s Acceptances
Forfaiting
Open Account Sale
Prepayment
120
Cross-Border Factoring:
Involves purchasing receivables and assuming the risk of collection across borders. This method
helps in managing the receivables risk by
engaging factors in different countries.
121
Letters of Credit:
A bank (issuer) verifies that the exporter has fulfilled the contract conditions (e.g., shipment of goods).
The bank pays the exporter upon presentation of documents proving performance.
The bank is reimbursed by the importer (buyer).
122
Banker’s Acceptances:
A short-term credit investment where a bank guarantees payment on a draft issued by a non-financial company.
These are typically traded at a discount and
popular among money market funds.
123
Forfaiting:
Forfaiting is a form of factoring that involves the sale by exporters of large, medium- to long-term receivables to buyers (forfaiters) who are willing and able to bear the costs and risks of credit and collections
124
Countertrade:
Barter system where goods or services are exchanged instead of money, typically used in situations with limited access to foreign currency
or in countries with trade restrictions.
125
Open Account Sale:
Risky for the exporter, as it involves shipping goods to the importer who acknowledges receipt by signing an invoice.
Payment is not guaranteed, and this method is more common with established buyers.
126
Prepayment:
The exporter requires payment upfront before shipping goods, especially when dealing with first-time or high-risk
buyers.
Established buyers typically don’t accept prepayment terms.
127
The Market for Foreign Currency
International exchanges rely on currencies being easily convertible at a prevailing exchange rate. The exchange rate is the price of one country's currency in terms of another's. There are four systems for setting exchange rates, each with its own structure and impact on the global market.
128
Exchange Rate Systems
Fixed Exchange Rate System
Freely Floating Exchange Rate System
Managed Float Exchange Rate System
Pegged Exchange Rate System
129
Fixed Exchange Rate System:
The value of a country’s currency is either fixed or allowed to fluctuate only within a very narrow range against another
currency.
Advantages: Provides high predictability in international trade as currency values are stable, eliminating uncertainties
about exchange rate fluctuations.
Disadvantages: Governments can manipulate the currency’s value, which may lead to artificial
stability or imbalances
130
Freely Floating Exchange Rate System:
In this system, currency values are determined solely by market forces—supply and demand—without government
intervention.
Advantages: Allows the market to naturally adjust the value of currencies, promoting efficient resource allocation.
Disadvantages: The country can become vulnerable to global economic conditions, leading to unpredictable fluctuations in exchange rates.
131
Managed Float Exchange Rate System:
A hybrid system where market forces determine exchange rates, but the government intervenes when necessary to maintain a stable currency within a broad range.
Advantages: Allows for market-driven flexibility while providing a safeguard through government intervention if needed.
Disadvantages: Exports can be vulnerable to sudden changes in exchange rates, and the lack of a self-correcting mechanism might pose challenges.
132
Pegged Exchange Rate System:
A government fixes its currency’s exchange rate relative to another currency (or a basket of currencies).
Advantages:
Provides stability and predictability for international trade, as the currency's value is anchored to a stronger or more stable currency.
Disadvantages:
The pegged country’s economy can be adversely affected by fluctuations in the currency it is pegged to.
133
Exchange Rate Basics
Spot Rate
Forward Rate
134
Spot Rate:
The spot rate is the current exchange rate at which one currency can be exchanged for another immediately (for example, USD to EUR today)
135
Forward Rate:
The forward rate is the exchange rate agreed upon today for a currency exchange that will occur at a specified future date.
If the domestic currency exchanges for more units of a foreign currency in the forward market than in the spot market, the domestic currency is
said to be trading at a forward premium.
136
Forward Premium and Discount:
Forward Premium: Occurs when the forward rate is higher than the spot rate (indicating the domestic currency will appreciate).
Forward Discount: Occurs when the forward rate is lower than the spot rate (indicating the domestic currency will depreciate).
137
Formula for Forward Premium or Discount:
The forward premium or discount can be calculated using the formula:
Forward Premium or Discount = (Forward Rate − Spot RateSpot Rate) / Spot Rate * Days in a Year /
Days in Forward Period
Forward Premium: If a domestic currency is trading at a forward premium, it is expected to gain purchasing power in the future.
Forward Discount: If a domestic currency is trading at a forward discount, it is expected to lose purchasing power in the future.
138
Cross Rate:
A cross rate is used when two currencies are not directly quoted against each other. In this case, the exchange rate is determined by valuing the currencies through a third currency, often the U.S. dollar.
Cross Rate = Domestic Currency per USD / Foreign Currency per USD
139
Exchange Rates and Purchasing Power
Exchange rates reflect the value of one currency relative to another, and they play a crucial role in international trade.
{ from graph: Demand Curve: The demand for a foreign currency is downward sloping because as the foreign currency becomes cheaper,
the goods and services priced in that currency become more affordable to domestic consumers, which increases demand for that currency.
Supply Curve: The supply of a foreign currency is upward sloping because as the foreign currency becomes more expensive, goods and services in the domestic market become more attractive to foreign consumers, leading them to inject more of their currency into the domestic market.}
140
Appreciation of Currencies
Appreciation: When one currency gains purchasing power relative to another, it is said to have appreciated. For example, if the U.S. dollar gains value relative to the Euro, it means the dollar can now buy more Euros than before.
141
Depreciation of Currencies
Conversely, when one currency loses purchasing power relative to another, it is said to have depreciated. For example, if the Euro loses value relative to the U.S. dollar, it means the Euro can now buy fewer dollars
142
Note on Appreciation and Depreciation of Currencies
This relationship between the two currencies impacts international trade. A stronger domestic currency(appreciation) can make imports cheaper but may make exports more expensive for foreign buyers. Conversely, a weaker domestic currency (depreciation) can make exports more attractive to foreign buyers but may increase the cost of imports.
Appreciation and Depreciation: A currency's appreciation or depreciation impacts the cost of imports and exports, influencing international trade.
Effective Interest Rate: The fluctuating exchange rate can lead to a higher or lower effective interest rate for foreign loans,
depending on the changes in the value of the currency in which the loan is denominated.
143
Effective Interest Rate on a Foreign Currency Loan
The effective interest rate on a foreign currency loan is influenced by the appreciation or depreciation of the currency in which the
loan is denominated. The following example helps demonstrate how the exchange rate can affect the total repayment amount:
Example: Loan in Pesos (MXN):
Amount borrowed: 12,000,000 Pesos
Conversion rate (initial): 0.0921496 (USD to Pesos)
Equivalent in USD: $1,105,795
Stated interest rate: 6.5%
Interest charged: 780,000 Pesos
Total repayment (after interest): 12,780,000 Pesos
Conversion rate (final): 0.0940000 (USD to Pesos)
Total repayment in USD: $1,201,320
In this example, the loan repayment in USD increases because the Pesos depreciated (the exchange rate moved from 0.0921496 to
0.0940000). This demonstrates how fluctuations in the exchange rate can increase the cost of repaying a loan taken in a foreign
currency
144
Factors Affecting Exchange Rates
Exchange rates are influenced by a variety of factors, which can be categorized into trade
related factors and financial factors.
145
Trade-Related Factors
1. Relative Inflation Rates
2. Relative Income Levels
3. Government Intervention:
146
Relative Income Levels:
Effect: As incomes rise in one country, citizens look to spend more on foreign goods and services, driving up demand for foreign currencies. This causes the local currency to depreciate.
Mechanism: Higher incomes increase the demand for foreign currencies, shifting the demand curve for foreign
currencies to the right and causing the local currency to lose value.
Example: If incomes rise in Japan, Japanese citizens may demand more U.S. dollars to purchase American goods, driving up the value of the U.S. dollar relative to the Yen
147
Relative Inflation Rates:
Effect: When a country experiences higher inflation compared to others, its currency loses purchasing power, making it less desirable. This shift in demand results in a decrease in the value of that currency.
Mechanism: The demand curve for the currency shifts inward, and the supply curve shifts outward, leading to a decrease in the value of the currency relative to others.
Outcome: Investors may unload the inflated currency, which causes its value to fall in terms of other currencies, increasing the purchasing power of foreign currencies.
Example: If inflation in the U.S. rises faster than in Europe, the U.S. dollar might depreciate relative to the Euro, as investors seek more stable, lower-inflation currencies
148
Government Intervention:
Effect: Governments may intervene in exchange rate determination through trade barriers (such as tariffs) and currency restrictions (such as limiting the supply of foreign currency).
Mechanism: Government actions can complicate the forces of supply and demand in the foreign exchange market, often stabilizing or manipulating the value of the currency.
Example: A country may restrict the export of its currency or impose tariffs on foreign goods to protect its domestic industries, which can impact the exchange rate
149
Financial Factors
1. Relative Interest Rates
2. Ease of Capital Flow:
150
1. Relative Interest Rates:
Effect: When a country's interest rates rise relative to those of other countries, its currency becomes more attractive
to investors, increasing demand for the currency.
Mechanism: Higher interest rates attract foreign capital, leading to an outward shift in the demand curve and an inward shift in the supply curve, which raises the value of the currency.
Outcome: The domestic currency appreciates as foreign investors seek the higher returns offered by the higher interest rates.
Example: If the U.S. Federal Reserve raises interest rates while other countries keep theirs stable, the U.S. dollar may appreciate as
foreign investors flock to U.S. assets for better returns.
151
Ease of Capital Flow:
When a country allows easier movement of capital across borders, especially when it has high real interest rates, demand for its currency rises as investors seek higher returns.
Mechanism: The ease of capital flow allows capital to move quickly across countries, impacting currency values significantly.
Outcome: Countries with fewer restrictions on capital movement tend to see an increase in demand for their currency as global investors seek profitable opportunities.
Example: A country that loosens restrictions on foreign investments may experience an influx of capital, causing its currency to appreciate as investors buy local currency to make investments.
152
Summary of Effects on Currency:
Inflation: Higher inflation = Depreciation of currency.
Income Levels: Higher income = Currency depreciation due to increased demand for foreign goods.
Government Intervention: Actions like trade barriers and currency restrictions can affect exchange rates.
Interest Rates: Higher interest rates = Currency appreciation due to increased investment.
Capital Flow: Easier capital flow = Currency appreciation as foreign investors seek higher returns.
153
Exchange Rate Theories
Interest Rate Parity (IRP)
Purchasing Power Parity (PPP)
International Fisher Effect (IFE)
154
Interest Rate Parity (IRP):
Theory: This theory suggests that exchange rates will adjust such that the difference between the forward rate and spot rate (i.e., the forward premium or discount) is equal to the difference in interest rates between two countries.
Purpose: Ensures there is no arbitrage opportunity in the foreign exchange market, meaning investors cannot make a profit without
taking on risk
155
Purchasing Power Parity (PPP):
Theory: PPP theory states that exchange rates will adjust based on the differences in inflation rates between two countries. A country with a higher inflation rate will see its currency depreciate over time.
Purpose: Helps explain the long-term adjustments in exchange rates driven by inflation differences.
156
International Fisher Effect (IFE):
Theory: The IFE theory links exchange rates to real and nominal interest rates. It suggests that differences in expected inflation between two countries will lead to changes in exchange rates.
Purpose: Explains exchange rate changes through the expected inflation rate rather than absolute inflation rates.
157
Factors Influencing Exchange Rates Over Time
Long-Term Exchange Rates
Medium-Term Exchange Rates
Short-Term Exchange Rates
158
Long-Term Exchange Rates:
Dictated by the Purchasing Power Parity (PPP) theorem, which suggests that exchange rates will adjust until real prices are the same worldwide for a given good, after accounting for trade barriers and transportation costs.
159
Medium-Term Exchange Rates
Governed by a country’s economic activity. For example:
Recession: Decreased imports lead to a stronger domestic currency (less supply of currency in the market).
Exports: Increased demand for a country's goods leads to an appreciation of the domestic currency.
160
Short-Term Exchange Rates:
Primarily influenced by interest rates. If a country’s real interest rates rise relative to others, the currency will appreciate as investors seek higher returns.
Inflation's Role: Expected inflation can also drive changes in nominal interest rates, impacting currency values.
161
Risks of Exchange Rate Fluctuation
Transaction Exposure:
Receivables: If a company has foreign-denominated receivables and the foreign currency depreciates, the company receives less in its domestic currency than anticipated.
Payables: If a company has foreign-denominated payables and the foreign currency appreciates, the company must pay more in its domestic currency.
162
NOTE
Sale (Receivable): Risk of depreciation of the foreign currency.
Purchase (Payable): Risk of appreciation of the foreign currency
163
Hedging Exchange Rate Risk:
Hedging is a strategy used by exporters and importers to protect against potential losses due to exchange rate fluctuations.
164
Hedging a Foreign-Denominated Receivable:
Risk: The foreign currency may depreciate by the settlement date.
Solution: Sell the foreign currency forward to lock in a fixed exchange rate.
165
Hedging a Foreign-Denominated Payable:
Risk: The foreign currency may appreciate by the settlement date.
Solution: Purchase the foreign currency forward to lock in a fixed exchange rate.
166
Managing Net Receivables and Payables Positions
Firms can reduce exchange rate risk by ensuring that their foreign currency receivables and payables net to near zero.
Strategy: Multinational companies often use netting centers and enter into foreign currency futures contracts to balance their positions.
167
NOTES on Key concepts
Interest Rate Parity: Forward rate adjusts to offset interest rate differences between countries.
Purchasing Power Parity: Exchange rates adjust due to inflation differences.
International Fisher Effect: Exchange rates change based on expected inflation.
Hedging: Using forward contracts to lock in exchange rates and reduce exposure to currency fluctuations.
168
Tools for Mitigating Exchange Rate Risk
Short-Term Hedging Tools
Long-Term Hedging Tools
169
Money Market Hedges:
Purpose: Simple and effective method to hedge against exchange rate risk in the short term.
For Receivables: A firm with a foreign currency receivable can:
Borrow the equivalent amount in the foreign currency and convert it to its domestic currency immediately.
Pay off the foreign loan when the receivable is collected, thus avoiding exposure to exchange rate fluctuations.
For Payables: A firm with a foreign currency payable can: Buy a money market instrument denominated in the foreign currency, with the maturity matching the payable
due date.
This eliminates the risk of currency fluctuations between the transaction and settlement dates.
170
Futures Contracts:
Purpose: Provides a standardized agreement to buy or sell a specified amount of currency at a future date, traded on exchanges.
Characteristics:
Available in specific amounts (e.g., 62,500 British pounds or 12,500,000 Japanese yen).
Standard settlement dates (typically quarterly).
Impersonal: The two parties do not need to know each other’s identity.
Usage: Primarily used by larger entities or those familiar with the exchange for risk management in hedging short-term currency fluctuations.
171
Currency Options:
Types:
Call Option: Gives the holder the right to buy a specified amount of currency at a specified price in the future.
Ideal for hedging payables.
Put Option: Gives the holder the right to sell a specified amount of currency at a specified price in the future.
Ideal for hedging receivables.
Two Sources:
Exchange-Traded Options: Standardized contracts with predefined quantities.
Over-the-Counter (OTC) Options: Customizable contracts offered by commercial banks or brokerage houses.
Flexibility: The option is exercised only if the purchaser chooses, allowing flexibility in managing exchange rate risks.
172
Long-Term Hedging Tools
Forward Contracts
Currency Swaps
173
Forward Contracts:
Purpose: More customized and long-term tool used primarily by large corporations.
Characteristics:
The firm enters into a contract with a bank to purchase or sell a certain amount of foreign currency at a specific rate for a future date.
Not available to smaller firms or those without a strong relationship with a bank.
Premium: The bank charges a fee (premium) for providing this currency exchange guarantee.
Use Case: Large corporations can lock in future exchange rates to eliminate risk in long-term
contracts.
174
Currency Swaps:
Purpose: A financial arrangement where two parties agree to swap cash flows in different currencies to hedge
exchange rate risk.
Characteristics:
A broker facilitates the transaction, bringing together two parties who wish to exchange currency flows.
Used to manage both interest rate and currency risks in the long-term.
175
Functional Currency
The currency of the primary economic environment in which an entity operates.
This is typically the currency in which the entity generates and spends cash.
176
Foreign Currency:
Any currency other than the entity’s functional currency
177
Reporting Currency:
The currency in which an entity prepares its financial statements.
178
Foreign Currency Transactions:
Transactions denominated in a currency other than the functional currency, resulting from:
Buying or selling on credit.
Borrowing or lending.
Being a party to a derivative instrument.
Acquiring or disposing of assets, or incurring/settling liabilities, denominated in a
foreign currency.
179
Aspects of Cross-Border Transactions
Transactions are recorded at the spot rate (the exchange rate at the transaction date).
Transaction gains and losses are recorded at each balance sheet date and at the settlement date of the receivable or payable.
These gains and losses are typically included in the net income of the period.
180
Exchange Rate Exposure
When a U.S. firm buys from or sells to a foreign entity, the transaction is recorded in U.S. dollars, but settlement may not occur in dollars.
If the exchange rate is fixed, there’s no issue with measuring a foreign-denominated receivable or payable.
If the exchange rate is not fixed (which is common), there could be a gain or loss resulting from the change in exchange rates.
181
Types of Gains and Losses:
Transaction Gain or Loss
Translation Gain or Loss
182
Transaction Gain or Loss:
Occurs when the exchange rate changes between the functional currency and the foreign currency at the time of
settlement.
Affects cash flows and is recorded in net income.
183
Accounting for Transaction Gains and Losses
Transaction gains or losses result from changes in exchange rates between the functional currency and the currency in which
the transaction is denominated.
Recording Process:
Transactions are recorded at the spot rate on the transaction date.
Gains and losses are adjusted at each balance sheet date and at the settlement date of the receivable or payable.
184
Translation Gain or Loss:
Arises from the accrual-based accounting used by the firm.
Does not affect cash flows but arises due to exchange rate changes when preparing financial statements during the settlement period.
185
Re measurement
Occurs when the accounting records of a foreign entity are maintained in a currency different from the functional currency.
Foreign currency amounts are remeasured into the functional currency using the temporal method.
Non-monetary balance sheet items are remeasured at the historical rate.
Monetary items (e.g., receivables, payables) are remeasured at the current rate.
Net gains or losses from re measurement are recognized in current income
186
Translation:
Necessary when the functional currency differs from the reporting currency.
Assets and liabilities: Restated using the current exchange rate on the reporting date.
Shareholders’ equity: Restated at historical rates.
Revenues, expenses, gains, and losses: Restated using exchange rates in effect when they were recognized (or a weighted average rate for the period).
Translation gains and losses are included in other comprehensive income, not in earnings.
187
Conversion ratio
The formula for conversion ratio is the par value of the convertible bond divided by the conversion price. Therefore, the
conversion price can be calculated as follows:
Conversion ratio = Par value of the convertible bond ÷ Conversion price
188
end note 3
Par value per share does not change following a split-up effected in the form of a dividend.
189
end note 1
The price of the bond is equal to the sum of present value of the face value of the bond and the present value of the interest payments
190
end note 2
Unchanged by either the dividend declaration or the dividend distribution. ; A stock dividend (one less than 20% to 25% of the shares outstanding) requires a decrease to one equity account (retained earnings) and an increase to one or more other equity accounts (common stock dividend distributable and paid-in capital in excess of par) for the fair value of the stock. The
subsequent distribution of that stock dividend involves recording a common stock dividend distributable and an increase to common stock, both of which are equity accounts. Thus, liabilities are unaffected by either the declaration or distribution of a stock dividend
191
end note 4
How would a 5% stock dividend affect a company’s additional paid-in capital and retained earnings when declared? Increase additional paid in capital and decrease RE
192
end note 5
Stock dividend effect on equity, liabilities, reassess, Diff between stock and cash dividends.
