ABSOLUTE RATE To AUTOMATIC ADJUSTMENT MECHANISM (Finance and Banking)

ABSOLUTE RATE

An interest rate that is determined without reference to an index or funding base such as LIBOR or U.S. treasury rates. For example, rather than LIBOR + 0.75%, the bid is expressed as 10.375%.

ACCOUNTING FOR MULTINATIONAL OPERATIONS

At the beginning of the 21st century, the world economy has become truly internationalized and globalized. Advances in information technology, communications, and transportation have enabled businesses to service a world market. Many U.S. companies, both large and small, are now heavily engaged in international trade. The foreign operations of many large U.S. multinational corporations now account for a major percentage (10 to 50%) of their sales and/or net income.

The basic business functions (i.e., finance/accounting, production, management, marketing) take on a new perspective when conducted in a foreign environment. There are different laws, economic policies, political framework, and social/cultural factors that all have an effect on how business is to be conducted in that foreign country. From an accounting standpoint, global business activities are faced with three realities:

1. Accounting standards and practices differ from country to country. Accounting is a product of its own economic, legal, political, and sociocultural environment. Because this environment changes from country to country, the accounting system of each country is unique and different from all others.


2. Each country has a strong “accounting nationalism.” It requires business companies operating within its borders to follow its own accounting standards and practices. Consequently, a foreign company operating within its borders must maintain its topics and records and prepare its financial statements in the local language, use the local currency as a unit of measure, and be in accordance with local accounting standards and procedures. In addition, the foreign company must comply with the local tax laws and government regulations.

3. Cross-border business transactions often involve receivables and payables denominated in foreign currencies. During the year, these foreign currencies must be translated (converted) into the local currencies for recording in the topics and records. At year-end, the foreign currency financial statements must be translated (restated) into the parent’s reporting currency for purposes of consolidation. Both the recording of foreign currency transactions and the translation of financial statements require the knowledge of the exchange rates to be used and the accounting treatment of the resulting translation gains and losses.

The biggest mistake a company can make in international accounting is to not be aware of, or even worse, to ignore these realities. It should know that differences in accounting standards, tax laws, and government regulations do exist and that these differences need to be an integral part of formulating its international business plan.

A. Accounting for Foreign Currency Transactions

International business transactions are cross-border transactions; therefore, two national currencies are usually involved. For example, when a United States corporation sells to a corporation in Germany, the transaction can be settled in U.S. dollars (the seller’s currency) or in German marks (the buyer’s currency).

A.1. Transactions Denominated in U.S. Currency

When the foreign transaction is settled in U.S. dollars, no measurement problems occur for the U.S. corporation. As long as the U.S. corporation receives U.S. dollars, the transaction can be recorded in the same way as a domestic transaction.

EXAMPLE 1

A U.S. firm sells on account equipment worth $100,000 to a German company. If the German company will pay the U.S. firm in U.S. dollars, no foreign currency is involved and the transaction is recorded as usual:

Accounts Receivable 100,000
Sales 100,000
(To record sales to German company)

A.2. Transactions Denominated in Foreign Currency

If the transaction above is settled in German marks, however, the U.S. corporation will receive foreign currency (German marks) that must be translated into U.S. dollars for purposes of recording on the U.S. company’s books. Thus, a foreign currency transaction exists when the transaction is settled in a currency other than the company’s home currency.

A foreign currency transaction must be recorded in the topics of accounts when it is begun (date of transaction), then perhaps at interim reporting dates (reporting date), and finally when it is settled (settlement date). On each of these three dates, the foreign currency transaction must be recorded in U.S. dollars, using the spot rate on that date for translation.

A.3. Accounting at Transaction Date

Before any foreign currency transaction can be recorded, it must first be translated into the domestic currency, using the spot rate on that day. For the U.S. company, this means that any receivable and payable denominated in a foreign currency must be recorded in U.S. dollars.

EXAMPLE 2

Assume a U.S. firm purchases merchandise on account from a French company on December 1, 20X1. The cost is 50,000 French francs, to be paid in 60 days. The exchange rate for French francs on December 1 is $.20. Using the exchange rate on December 1, the U.S. firm translates the FFr 50,000 into $10,000 and records the following entry:

Dec. 1 Purchases 10,000
Accounts Payable 10,000

[To record purchase of merchandise on account (FFr 50,000 X $.20 = $10,000).]

A.4. Accounting at Interim Reporting Date

Foreign currency receivables and payables that are not settled at the balance sheet date are adjusted to reflect the exchange rate at that date. Such adjustments will give rise to foreign exchange gains and losses that are to be recognized in the period when exchange rates change.

EXAMPLE 3

Assume the same facts as in Example 2 and that the U.S. corporation prepares financial statements as of December 31, 20X1 when the exchange rate for the French franc is $0.22. The U.S. firm will make the following adjusting entry:

Dec. 31 Foreign Exchange Loss 1,000
Accounts Payable 1,000

[To adjust accounts payable to current exchange rate (FrF 50,000 X $0.22 = $11,000; $11,000 - $10,000 = $1,000).]

A.5. Accounting at Settlement Date

When the transaction is settled, if the exchange rate changes again, the domestic value of the foreign currency paid on the settlement date will be different from that recorded on the topics. This difference gives rise to translation gains and losses that must be recognized in the financial statements.

EXAMPLE 4

To continue our example, assume that the payable is paid on February 1, 20X2 when the exchange rate for the French franc is $0.21. The settlement will be recorded as follows:

Feb. 1 Accounts Payable 11,000
Cash 10,500
Foreign Exchange Gain 500

[To record payment of accounts payable (FrF 50,000 X $0.21 = $10,500) and foreign exchange gain. ]

To summarize: In recording foreign currency transactions, SFAS 52 adopted the two-transaction approach. Under this approach, the foreign currency transaction has two components: the purchase/sale of the asset and the financing of this purchase/sale. Each component will be treated separately and not netted with the other. The purchase/sale is recorded at the exchange rate on the day of the transaction and is not adjusted for subsequent changes in that rate. Subsequent fluctuations in exchange rates will give rise to foreign exchange gains and losses. They are considered as financing income or expense and are recognized separately in the income statement in the period the foreign exchange fluctuations happen. Thus, exchange gains and losses arising from foreign currency transactions have a direct effect on net income.

B. Translation of Foreign Currency Financial Statements

When the U.S. firm owns a controlling interest (more than 50%) in another firm in a foreign country, special consolidation problems arise. The subsidiary’s financial statements are usually prepared in the language and currency of the country in which it is located and in accordance with the local accounting principles. Before these foreign currency financial statements can be consolidated with the U.S. parent’s financial statements, they must first be adjusted to conform with U.S. GAAP (Generally Accepted Accounting Principles) and then translated into U.S. dollars.

Two different procedures may be used to translate foreign financial statements into U.S. dollars: (1) translation procedures and (2) remeasurement procedures. Which one of these two procedures is to be used depends on the determination of the functional currency for the subsidiary.

B.1. The Functional Currency

SFAS 52 defines the functional currency of the subsidiary as the currency of the primary economic environment in which the subsidiary operates. It is the currency in which the subsidiary realizes its cash flows and conducts its operations. To help management determine the functional currency of its subsidiary, SFAS 52 provides a list of six salient economic indicators regarding cash flows, sales price, sales market, expenses, financing, and intercompany transactions. Depending on the circumstances:

• The functional currency can be the local currency. For example, a Japanese subsidiary manufactures and sells its own products in the local market. Its cash flows, revenues, and expenses are primarily in Japanese yen. Thus, its functional currency is the local currency (Japanese yen).

• The functional currency can be the U.S. dollar. For foreign subsidiaries that are operated as an extension of the parent and integrated with it, the functional currency is that of the parent. For example, if the Japanese subsidiary is set up as a sales outlet for its U.S. parent, i.e. it takes orders, bills and collects the invoice price, and remits its cash flows primarily to the parent, then its functional currency would be the U.S. dollar.

The functional currency is also the U.S. dollar for foreign subsidiaries operating in highly inflationary economies (defined as having a cumulative inflation rate of more than 100% over a three-year period). The U.S. dollar is deemed the functional currency for translation purposes because it is more stable than the local currency.

Once the functional currency is determined, the specific conversion procedures are selected as follows:

• If foreign currency is the functional currency, use translation procedures.

• If U.S. dollar is the functional currency, use remeasurement procedures.

B.2. Translation Procedures

If the local currency is the functional currency, the subsidiary’s financial statements are translated using the current rate method. Under this method:

• All assets and liabilities accounts are translated at the current rate (the rate in effect at the financial statement date);

• Capital stock accounts are translated using the historical rate (the rate in effect at the time the stock was issued);

• The income statement is translated using the average rate for the year; and

• All translation gains and losses are reported on the balance sheet, in an account called “Cumulative Translation Adjustments” in the stockholders’ equity section.

The purpose of these translation procedures is to retain, in the translated financial statements, the financial results and relationships among assets and liabilities that were created by the subsidiary’s operations in its foreign environment.

EXAMPLE 5

Assume that the following trial balance, expressed in the local currency (LC) is received from a foreign subsidiary, XYZ Company. The year-end exchange rate is 1 LC = $.1.50, and the average exchange rate for the year is 1 LC = $1.25. Under the current rate method, XYZ Company’s trial balance would be translated as in Exhibit 1 which shows the translation procedures applied to XYZ Company’s trial balance. Note that the translation adjustment is reflected as an adjustment of stockholders’ equity in U.S. dollars.

EXHIBIT 1

Translation Procedures

XYZ COMPANY Trial Balance 12/31/01 Local Currency U.S. Dollars
Debit Credit Exchange Rate Debit Credit
Cash LC 5,000 (1 LC = $ 1.50) $7,500
Inventory 15,000 22,500
Fixed Assets 30,000 45,000
Payables LC 40,000 $60,000
Capital Stock 4,000 Historical rate 5,000
Retained Earnings 6,000 to balance 10,000
Sales 300,000 (1 LC = $1.25) 375,000
Cost of Goods Sold 210,000 262,500
Depreciation Expense 5,000 6,250
Other Expenses 85,000 106,250
LC 350,000 LC 350,000 $450,000 $450,000

B.3. Remeasurement Procedures

If the U.S. dollar is considered to be the functional currency, the subsidiary’s financial statements are then remeasured into the U.S. dollar by using the temporal method. Under this method:

• Monetary accounts, such as cash, receivables, and liabilities, are remeasured at the current rate on the date of the balance sheet;

• Nonmonetary accounts, such as inventory, fixed assets, and capital stock, are remeasured using the historical rates;

• Revenues and expenses are remeasured using the average rate, except for cost of sales and depreciation expenses that are remeasured using the historical exchange rates for the related assets; and

• All remeasurement gains and losses are recognized immediately in the income statement.

The objective of these remeasurement procedures is to produce the same U.S. dollar financial statements as if the foreign entity’s accounting records had been initially maintained in the U.S. dollar. Exhibit 2 shows these remeasurement procedures applied to XYZ Company’s trial balance. Note that the translation gain/loss is included in the income statement.

EXHIBIT 2

Remeasurement Procedures

XYZ COMPANY Trial Balance 12/31/01 Local Cu rrency U.S. Dollars
Debit Credit Exchange Rate Debit Credit
Cash LC 5,000 (1 LC = $1.50) $7,500
Inventory 15,000 (1 LC = $1.30) 19,500
Fixed Assets 30,000 (1 LC = $0.95) 28,500
Payables LC 40,000 (1 LC = $1.50) $60,000
Capital Stock 4,000 5,000
Retained Earnings 6,000 7,000
Sales 300,000 (1 LC = $1.25) 375,000
Cost of Goods Sold 210,000 (1 LC = $1.30) 273,000
Depreciation Expense 5,000 (1 LC = $0.95) 4,750
Other Expenses 85,000 (1 LC = $1.25) 106,250
439,500 447,000
Translation Gain/Loss 7,500
LC 350,000 LC 350,000 $447,000 $447,000

C. Interpretation of Foreign Financial Statements

To evaluate a foreign corporation, we usually analyze its financial statements. However, the analysis of foreign financial statements needs special considerations:

1. We often have the tendency of looking at the foreign financial data from a home country perspective. For example, a U.S. businessman has the tendency of using U.S. GAAP to evaluate the foreign financial statements. However, U.S. GAAP are not universally recognized and many differences exist between U.S. GAAP and the accounting principles of other countries (industrialized or nonindustrialized).

2. Because of the diversity of accounting principles worldwide, we have to overcome the tendency of using our home country GAAP to evaluate foreign financial statements. Instead, we should try to become familiar with the foreign GAAP used in the preparation of these financial statements and apply them in our financial analysis.

3. Business practices are culturally based. Often they are different from country to country and have a significant impact on accounting measurement and disclosure practices. Therefore, local economic conditions and business practices should be taken into consideration to correctly analyze foreign financial statements.

D. Harmonization of Accounting Standards

The diversity of accounting systems is an obstacle in the development of international trade and business and in the efficiency of the global capital markets. Many concerted efforts have been made to reduce this diversity through the harmonization of accounting standards. Also, as international business expands, there is a great need for international accounting standards that can help investors make decisions on an international scale. The agencies working toward the harmonization of accounting standards are:

D.1. The International Accounting Standards Committee (IASC) The IASC was founded in 1973. At that time, its members consisted of the accountancy bodies of Australia, Canada, France, Ireland, Japan, Mexico, the Netherlands, the United Kingdom, the United States, and West Germany. Since its founding, membership has grown to around 116 accountancy bodies from approximately 85 countries.

IASC’s fundamental goal is the development of international accounting standards. It is also working toward the improvement and harmonization of accounting standards and procedures relating to the presentation and comparability of financial statements (or at least through enhanced disclosure, if differences are present). To date, it has developed a conceptual framework and issued a total of 32 International Accounting Standards (IAS) covering a wide range of accounting issues. It is currently working on a project concerned with the core standards in consultation with other international groups, especially the International Organization of Securities Commissions (IOSCO), to develop worldwide standards for all corporations to facilitate multilisting of foreign corporations on various stock exchanges.

D.2. The International Federation of Accountants (IFAC)

IFAC was founded in 1977 by 63 accountancy bodies representing 49 countries. By 1990, IFAC membership had grown to 105 accountancy bodies from 78 different countries. Its purpose is to develop “a coordinated worldwide accountancy profession with harmonized standards.” It concentrated on establishing auditing guidelines to help promote uniform auditing practices throughout the world. It also promoted general standards for ethics, education, and accounting management.

In addition to the IASC and IFAC, there are a growing number of regional organizations involved in accounting harmonization at the regional level. These organizations include, among others, the Inter-American Accounting Association established in 1949, the ASEAN Federation of Accountants (AFA) established in 1977, and the Federation des Experts Compt-ables Europeens (FEE), created by the merger in 1986 of the former Union Europeenne des Experts Comptables Economiques et Financiers (UEC) and the Groupe d’ Etude (GE).

D.3. The European Economic Community (EEC)

The EEC, although not an accounting body, has made great strides in harmonizing the accounting standards of its member countries. During the 1970s, it began the slow process of issuing EEC directives to harmonize the national accounting legislation of its member countries. The directives must go through a three-step process before they are finalized. First, they are proposed by the EEC Commission and presented to the national representatives of the EEC members. Second, if the proposal is satisfactory to the nations, it is adopted by the commission. Finally, it must be issued by the Council of Ministers of the EEC, before it can be enforced on the members.

The most important directives in the harmonization of accounting standards among EEC members are:

• The Fourth Directive (1978), regarding the layout and content of annual accounts, valuation methods, annual report, publicity, and audit of public and private company accounts;

• The Seventh Directive (1983), regarding the consolidation of accounts for certain groups of enterprises; and

• The Eighth Directive (1984), regarding the training, qualification, and independence of statutory auditors.

ACCOUNTS RECEIVABLE MANAGEMENT

Accounts receivable management is the strategy used by some MNCs to adjust their accounts receivable (A/R) to reduce currency risk and to optimally time fund transfers. Various hedging alternatives are available, including forward and money-market hedges. Operating and financial strategies can also be used to minimize currency risk exposure. For example, in countries where currency values are likely to drop, financial managers of the subsidiaries should avoid giving excessive trade credit. If accounts receivable balances are outstanding for an extended time period, interest should be charged to absorb the loss in purchasing power. Note: a net asset position (i.e., assets minus liabilities) is not desirable in a weak or potentially depreciating currency. In this case, you should expedite the disposal of the asset. Likewise, you should lag or delay the collection against a net asset position in a strong currency.

ADJUSTED PRESENT VALUE

Adjusted present value (APV) is a type of net present value (NPV) analysis by multinational companies in capital budgeting. A foreign investment project that is financed differently from that of the parent firm could be evaluated using this approach. In APV, operating cash flows are discounted separately from (1) the various tax shields provided by the deductibility of interest and other financial charges and (2) the benefits of project-specific concessional financing. Each component cash flow is discounted at a rate appropriate for the risk involved. Typically, the operating cash flows from the project are discounted at the all-equity rate plus any financing side effects discounted at all-debt rate. Or

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where -I = the initial investment or cash outlay, CFt = estimated cash flows in t (t = 1,…T), k = the discount rate on those cash flows, FINt = any additional financial effect on cash flows, and kf = the discount rate applied to the financial effects. Possible financial effects include the tax shield arising from depreciation charges, subsidies, credit terms, interest savings, or penalties associated with project-specific financing. A project that is financed differently from that of the parent company should be evaluated with APV.

For example, consider a parent firm whose capital structure is 60% equity and 40% debt that is evaluating the financial feasibility of a potential foreign subsidiary whose capital structure would be only 40% equity and 60% debt. Discounting the potential subsidiary’s estimated net operating cash flows by the parent’s weighted average cost of capital (WACC) could be inappropriate.

APV divides the present value analysis into two components: (1) the operating cash flows which are customarily considered the only relevant cash flows and (2) the financial effects such as interest expense tax shields resulting from the use of debt in the financing of the project. Each component cash flow is discounted by its appropriate cost of all-equity and all-debt discount rates, respectively.

EXAMPLE 6

Suppose MYK Gold Miners has an opportunity to enter a small, developing country and apply its new gold recovery technique to some old mines that no longer yield profitable amounts of ore under conventional mining. MYK estimates that the cost of establishing the foreign operation will be $12 million. The project is expected to last for two years, during which period the operating cash flows from the new gold extracted will be $7.5 million per year. In addition, the new operating unit will allow the company to repatriate an additional $1 million per year in funds that have been tied up in the developing country by capital controls. If MYK applies a discount rate of 6% to operating cash flows and 10% to the funds that will be freed from controls, then the APV is:

tmp30-2_thumb

where T4 = present value of an annuity of $1.

Thus, the APV of the gold recovery project equals $3.49 million. The firm can compare this value to the APV of other projects it is considering in order to budget its capital expenditures in the optimum manner.

EXAMPLE 7

Am-tel Corporation is an MNC which owns a foreign subsidiary named Ko-tel. It has the following operating cash flows:

Year
0 1 2 3 4 5
Operating cash flows -11,000.0 1,274.4 1,881.4 2,578.3 3,378.8 11,343.4
(in thousands)

Assume Ko-tel was capitalized with 40% equity capital from Am-tel and the remaining 60% debt, the Am-tel’s capital structure was 40% debt and 60% equity, the cost of debt was 12.12%, the cost of equity was 18%, and U.S. taxes were 34%. The weighted average cost of capital would be:

tmp30-3_thumb

The regular NPV approach yields:

tmp30-4_thumb

where T3 = present value of $1.

In contrast, APV would decompose the valuation into the above operating cash flows and the tax shields arising from the use of debt in the foreign subsidiary. The operating cash flows from above would then be discounted by the cost of equity for a similar project undertaken with 100% equity. For illustration purposes here, we use the firm’s current cost of equity:

tmp30-5_thumb

The tax shields resulting from the use of debt in Ko-tel are found by estimating the annual interest expense on $727, 200 ($6,000,000 in debt at 12.12% per year), and the Ko-tel local tax savings resulting from interest expense deductions of $218,160 (30% local income tax on $727,200) over the life of the project.

tmp30-6_thumb

The resulting APV could be a proper approach to the valuation of the cash flows when the project is financed differently from that of the parent firm. Although the operating cash flows are valued lower (higher discount rate of straight equity applied to them), the tax shields resulting from the increased used of debt in the subsidiary (discounted at the cost of debt) offset the loss in equity-financed cash flows. Note: Although APV is a viable method of analysis it is not as widely used in practice as the traditional method using a weighted average cost of capital (WACC).

AD VALOREM TARIFF

An ad valorem tariff is a tariff assessed as a percentage of the value of the goods cleared through customs. Ad valorem means “according to value.” A 5% ad valorem tariff means the tariff is 5% of the value of the merchandise.

ADVISING BANK

An advising bank is a corresponding bank in the beneficiary’s country to which the issuing bank sends the letter of credit.

AGENCY FOR INTERNATIONAL DEVELOPMENT

The Agency for International Development (AID) is a U.S. government agency founded by President Kennedy in 1961 whose mission is to promote social and economic development in the Third World. It has been responsible for assisting transition to market-based economies in East Europe; establishment of a regulatory framework for securities markets in Indonesia, Jordan, and Sri Lanka; road construction and maintenance in Latin America and Southern Asia; and agricultural research and farm credits worldwide. AID fields workers worldwide and administrative officers in Washington, D.C. identify worthy projects and then ask U.S. industries to submit proposals. The winners receive government support.

ALL-EQUITY BETA

All-equity beta is the beta associated with the unleveraged cash flows of a capital project or company. It is determined as follows:

tmp30-7_thumb

where b = a firm’s beta, t = tax rate, and DE = debt-equity ratio.

EXAMPLE 8

If the beta of a firm’s stock is 1.2, and it has a debt-equity ratio of 60% and a tax rate of 34%, then its all-equity beta, b*, is 0.93;

tmp30-8_thumb

ALL-EQUITY (DISCOUNT) RATE

This is the discount rate that reflects only the business risks of a capital project and separates them from the effects of financing. This rate applies directly to a project that is financed entirely with owners’ equity.

ALL-IN-RATE

Rate used in charging clientele for accepting banker’s acceptances that consists of the interest rate for the discount and the commission.

AMERICAN DEPOSITORY RECEIPTS

An American depository receipt (ADR) is a certificate of ownership, issued by a U.S. bank, representing a claim on underlying foreign stocks. ADRs may be traded in lieu of trading in the actual underlying shares. The bank issues all ADRs, not the corporation’s stock certificate, to an American investor who buys shares of that corporation. The stock certificate is kept at the bank. The process of ADRs works as follows: a foreign company places shares in trust with a U.S. bank, which in turn issues depository receipts to U.S. investors. The ADRs are, therefore, claims to shares of stock and are essentially the same as shares. The depository bank performs all clerical functions—issuing annual reports, keeping a shareholder ledger, paying and maintaining dividend records, etc.—allowing the ADRs to trade in markets just as domestic securities trade. ADRs are traded on the NYSE, AMEX, and OTC markets as a share in stock, minus the voting rights. Examples of ADRs are Hanson, Cannon, and Smith-kline Beecham. ADRs have become an increasingly convenient and popular vehicle for investing internationally. Investors do not have to go through foreign brokers, and information on company operations is usually available in English. Therefore, ADRs are good substitutes for direct foreign investment. They are bought and sold with U.S. dollars, and they pay their dividends in dollars. Further, the trading and settlement costs that apply in some foreign markets are waived. The certificates are issued by depository banks (for example, the Bank of New York). ADRs, however, are not for everyone. Disadvantages are the following:

1. ADRs carry an element of currency risk. For example, an ADR based on the stock of a British company would tend to lose in value when the dollar strengthens against the British pound, if other factors were held constant. This is because as the pound weakens, fewer U.S. dollars are required to buy the same shares of a U.K. company.

2. Some thinly traded ADRs can be harder to buy and sell. This could make them more expensive to purchase than the quoted price.

3. You may face problems obtaining reliable information on the foreign companies. It may be difficult to do your own research in selecting foreign stocks. For one thing, there is a shortage of data: the annual report may be all that is available, and its reliability is questionable. Furthermore, in many instances, foreign financial reporting and accounting standards are substantially different from those accepted in the U.S.

4. ADRs can be either sponsored or unsponsored. Many ADRs are not sponsored by the underlying companies. Nonsponsored ADRs oblige you to pay certain fees to the depository bank. The return is reduced accordingly.

5. There are a limited number of issues available for only a small fraction of the foreign stocks traded internationally. Many interesting and rewarding investment opportunities exist in shares with no ADRs. For quotations on ADRs, log on to www.adr.com by J.P. Morgan.

Instead of buying foreign stocks overseas, investors can purchase foreign equities traded in the United States typically in two ways: (1) American Depository Receipts (ADRs) and American shares. American shares are securities certificates issued in the U.S. by a transfer agent acting on behalf of the foreign issuer. The foreign issuer absorbs part or all of the handling expenses involved.

AMERICAN TERMS

American terms are foreign exchange quotations for the U.S. dollar, expressed as the U.S. dollar price per unit of foreign currency. For example, U.S. $0.00909/yen is an American term. It is also called American basis or American quote. American terms are normally used in the interbank market of the U.K. pound sterling, Australian dollar, New Zealand dollar, and Irish punt. Sterling is quoted as the foreign currency price of one pound. The relationship between American terms and European terms and between direct and indirect can be summarized as follows:

American Terms European Terms
U.S. dollar price of one unit of foreign Foreign currency price of one U.S. dollar
currency (e.g., U.S. $0.00909/¥) (e.g., ¥110/$)
A direct quote in the U.S. A direct quote in Europe
An indirect quote in Europe An indirect quote in the U.S.

American terms are used in many retail markets (e.g., airports for tourists), on the foreign currency futures market in Chicago, and on the foreign exchange options market in Philadelphia.

ANALYSIS OF FOREIGN INVESTMENTS

Also called international capital budgeting, foreign investment decisions are basically capital budgeting decisions at the international level. Capital budgeting analysis for foreign as compared with domestic projects introduces the following complications:

1. Cash flows to a project and to the parent must be differentiated.

2. National differences in tax systems, financial institutions, financial norms, and constraints on financial flows must be recognized.

3. Different inflation rates can affect profitability and the competitive position of an affiliate.

4. Foreign exchange-rate changes can alter the competitive position of a foreign affiliate and the value of cash flows between the affiliate and the parent.

5. Segmented capital markets create opportunities for financial gains and they may cause additional costs.

6. Political risk can significantly change the value of a foreign investment.

The foreign investment decision requires two major components:

1. The estimation of the relevant future cash flows. Cash flows are the dividends and possible future sales price of the investment. The estimation depends on the sales forecast, the effects on exchange rate changes, the risk in cash flows, and the actions of foreign governments.

2. The choice of the proper discount rate (cost of capital). The cost of capital in foreign investment projects is higher due to the increased risks of:

(a) Currency risk (or foreign exchange risk)—changes in exchange rates. This risk may adversely affect sales by making competing imported goods cheaper.

(b) Political risk (or sovereignty risk)—possibility of nationalization or other restrictions with net losses to the parent company.

The methods of evaluating multinational capital budgeting decisions include net present value (NPV), adjusted present value (APV), and internal rate of return (IRR).

EXAMPLE 9

In what follows, we will illustrate a case of multinational capital budgeting. We will analyze a hypothetical foreign investment project by a U.S. manufacturing firm in Korea. The analysis is based on the following data gathered by a project team.

Product. The company (to be called Ko-tel hereafter) is expected to be a wholly owned Korean manufacturer of customized integrated circuits (ICs) for use in computers, automobiles, and robots. Ko-tel’s products would be sold primarily in Korea, and all sales would be denominated in Korean won.

Sales. Sales in the first year are forecasted to be Won 26,000 million. Sales are expected to grow at 10% per annum for the foreseeable future.

Working capital. Ko-tel needs gross working capital (that is, cash, receivables, and inventory) equal to 25% of sales. Half of gross working capital can be financed by local payables, but the other half must be financed by Ko-tel or by Am-tel, the parent company.

Parent-supplied components. Components sold to Ko-tel by Am-tel have a direct cost to Am-tel equal to 95% of their sales price. The margin is therefore 5%.

Depreciation. Plant and equipment will be depreciated on a straight-line basis for both accounting and tax purposes over an expected life of 10 years. No salvage value is anticipated.

License fees. Ko-tel will pay a license fee of 2.5% of sales revenue to Am-tel. This fee is tax-deductible in Korea but provides taxable income to Am-tel.

Taxes. The Korean corporate income tax rate is 35%; the U.S. rate is 38%. Korea has no withholding tax on dividends, interest, or fees paid to foreign residents.

Cost of capital. The cost of capital (or minimum required return) used in Korea by companies of comparable risk is 22%. Am-tel also uses 22% as a discount rate for its investments.

Inflation. Prices are expected to increase as follows.

Korean general price level: +9% per annum
Ko-tel average sales price: +9% per annum
Korean raw material costs: +3% per annum
Korean labor costs: +12% per annum
U.S. general price level: +5% per annum

Exchange rates. In the year in which the initial investment takes place, the exchange rate is Won 1050 to the dollar. Am-tel forecasts the won to depreciate relative to the dollar at 2% per annum.

Dividend policy. Ko-tel will pay 70% of accounting net income to Am-tel as an annual cash dividend. Ko-tel and Am-tel estimate that over a five-year period the other 30% of net income must be reinvested to finance working capital growth.

Financing. Ko-tel will be financed by Am-tel with a $11,000,000 purchase of Won 10,503,000,000 common stock, all to be owned by Am-tel.

In order to develop the normal cash flow projections, Am-tel has made the following assumptions.

1. Sales revenue in the first year of operations is expected to be Won 26,000 million. Won sales revenue will increase annually at 10% because of physical growth and at an additional 9% because of price increases. Consequently, sales revenue will grow at (1.1) (1.09) = 1.20, or 20% per annum.

2. Korean raw material costs in the first year are budgeted at Won 4,000 million. Korean raw material costs are expected to increase at 10% per annum because of physical growth and at an additional 3% because of price increases. Consequently, raw material cost will grow at (1.1) (1.03) = 1.13, or 13% per annum.

3. Parent-supplied component costs in the first year are budgeted at Won 9,000 million. Parent-supplied component costs are expected to increase annually at 10% because of physical growth, plus an additional 5% because of U.S. inflation, plus another 4% in won terms because of the expected deterioration of the won relative to the dollar. Consequently, the won cost of parent-supplied imports will increase at (1.1) (1.05) (1.04) = 1.20 or 20% per annum.

4. Direct labor costs and overhead in the first year are budgeted at Won 5,000 million. Korean direct labor costs and overhead are expected to increase at 10% per annum because of physical growth and at an additional 12% because of an increase in Korean wage rates. Consequently, Korean direct labor and overhead will increase at (1.1) (1.12) = 1.232 or 12.32% per annum.

5. Marketing and general and administrative expenses are budgeted at Won 4,000 million, fixed plus 4% of sales.

6. Liquidation value. At the end of five years, the project (including working capital) is expected to be sold on a going-concern basis to Korean investors for Won 9,000 million, equal to $7045.1 million at the expected exchange rate of Won 1,277.49/$. This sales price is free of all Korean and U.S. taxes and will be used as a terminal value.

Given the facts and stated assumptions, the beginning balance sheet is presented in Exhibit 3, while Exhibit 4 shows revenue and cost projections for Ko-tel over the expected five-year life of the project.

EXHIBIT 3

Beginning Balance Sheet

Millions Thousands
of of
Won Dollars
Assets
1 Cash balance 650 619
2 Accounts receivable 0 0
3 Inventory 1050 1000
4 Net plant and equipment 7000 6667
5 Total 8700 8286
Liabilities and Net Worth
6 Accounts payable 700 667
7 Common stock equity 8000 7619
8 Total 8700 8286

EXHIBIT 4

Sales and Cost Data

Item 1 2 Year 3 4 5
1 Total sales revenue 26000 31174 37378 44816 53734
2 Korean raw material 4000 4532 5135 5818 6591
3 Components purchased from Am-tel 9000 10811 12986 15599 18737
4 Korean labor and overhead 5000 6160 7589 9350 11519
5 Depreciation 700 700 700 700 700
6 Cost of sales [(2) + (3) + (4) + (5)] 18700 22203 26410 31466 37548
7 Gross margin [(1) - (6)] 7300 8971 10968 13350 16187
8 License fee [2.5% of (1)] 650 779 934 1120 1343
9 Marketing, general, and administrative 5040 5247 5495 5793 6149
10 EBIT* [(7) - (8) - (9)] 1610 2945 4538 6437 8694
11 Korean income taxes (35%) 564 1031 1588 2253 3043
12 Net income after Korean taxes [(10) - (11)] 1046 1914 2950 4184 5651
13 Cash dividend [70% of (12)] 733 1340 2065 2929 3956

* EBIT = earnings before interest and taxes

Exhibit 5 shows how the annual increase in working capital investment is calculated. According to the facts, half of gross working capital must be financed by Ko-tel or Am-tel. Therefore, half of any annual increase in working capital would represent an additional required capital investment.

Exhibit 6 forecasts project cash flows from the viewpoint of Ko-tel. Thanks to healthy liquidation value, the project has a positive NPV and an IRR greater than the 22% local (Korean) cost of capital for projects of similar risk. Therefore, Ko-tel passes the first of the two tests of required rate of return.

EXHIBIT 5

Working Capital Calculation

Item

1 Total revenue

2 Net working capital needs at year-end [25% of (1)]

3 Less year-beginning working capital

4 Required addition to working capital

5 Less working capital financed in Korean by payables

6 Net new investment in working capital

Year
1 2 3 4 5
26000 31174 37378 44816 53734
6500 7794 9344 11204 13434
1700 6500 7794 9344 11204
4800 1294 1551 1860 2230
2400 647 775 930 1115
2400 647 775 930 1115

EXHIBIT 6

Cash Flow Projection—NPV and IRR for Ko-tel

Item

1 EBIT [Exhibit 4, (10)]

2 Korean income taxes (35%)

3 Net income, all equity basis

4 Depreciation

5 Liquidation value

6 Half of addition to working capital

7 Cost of project

8 Net cash flow

9 IRR

10 NPV = PV (at 22%) – I

Year
0 1 2 3 4 5
1610 2945 4538 6437 8694
564 1031 1588 2253 3043
1046 1914 2950 4184 5651
700 700 700 700 700
9000
2400 647 775 930 1115
-8000
-8000 -654 1967 2874 3954 14236

tmp30-9_thumb

Does Ko-tel also pass the second test? That is, does it show at least a 22% required rate of return from the viewpoint of Am-tel? Exhibit 7 shows the calculation for expected after-tax dividends from Ko-tel to be received by Am-tel. For purposes of this example, note that Am-tel must pay regular U.S. corporate income taxes (38% rate) on dividends received from Ko-tel. However, the U.S. tax law allows Am-tel to claim a tax credit for income taxes paid to Korea on the Korean income that generated the dividend. The process of calculating the regional income in Korea is called “grossing up” and is illustrated in Exhibit 7, lines (1), (2), and (3).

This imputed Korean won income is converted from won to dollars in line (5). Then the U.S. income tax is calculated at 38% in line (6). A tax credit is given for the Korean income taxes paid, as calculated in line (7). Line (8) then shows the net additional U.S. tax due, and line (10) shows the net dividend received by Am-tel after the additional U.S. tax is paid. Finally, Exhibit 8 calculates the rate of return on cash flows from Ko-tel from the viewpoint of Am-tel. However, Ko-tel fails to pass the test because it has a negative NPV and an IRR, below the 22% rate of return required by Am-tel.

EXHIBIT 7

After-tax Dividend Received by Am-tel

Item

In Millions of Won

1 Cash dividend paid [Exhibit 4, (13)]

2 A 70% of Korean income tax [Exhibit 2, (11)]

3 Grossed-up dividend [(1) + (2)]

4 Exchange-rate (won/$)

In Thousands of Dollars

5 Grossed-up dividend [(3)/(4) x 1000]

6 U.S. tax (38%)

7 Credit for Korean taxes

[(2)/(4) x 1000]

8 Additional U.S. tax due [(6) - (7), if (6) is larger]

9 Excess U.S. tax credit [(7) - (6), if (7) is larger

10 Dividend received by Am-tel after all taxes [(1)/(4) x 1000 - (8)]

0 1 Ye

2

ar

3

4 5
733 1340 2065 2929 3956
394 721 1112 1577 2130
1127 2061 3177 4506 6086
1050.00 1075.20 1101.00 1127.43 1154.49 1182.19
1048.2 1872.3 2817.7 3902.7 5147.8
398.3 711.5 1070.7 1483.0 1956.2
366.9 655.3 986.2 1365.9 1801.7
31.4 56.2 84.5 117.1 154.4
0.0 0.0 0.0 0.0 0.0
649.9 1160.8 1747.0 2419.7 3191.6

EXHIBIT 8

NPV and IRR for Am-tel

Item

In Millions of Won

1 License fee from Ko-tel (2.5%) [Exhibit 4, (8)]

2 Margin on exports to Ko-tel [5% of (3) in Exhibit 4]

3 Total receipts

Year
01 2 3 4 5
650 779 934 1120 1343
450 541 649 780 937
1100 1320 1583 1900 2280

4 Exchange rate (won/$)

In Thousands of Dollars

5 Pre-tax receipts

[(3)/(4) x 1000]

6 U.S. taxes (38%)

7 License fees and export profits, after tax

8 After-tax dividend [Exhibit 7, (10)]

9 Project cost

10 Liquidation value

11 Net cash flow

12 IRR

13 NPV = PV (at 22%) – I

1050.00 1092.00 1135.68 1181.11 1228.35 1277.49
1007.3 1162.2 1340.9 1547.1 1784.7
382.8 441.6 509.5 587.9 678.3
624.5 720.6 831.4 959.2 1106.7
649.9 1160.8 1747.0 2419.7 3191.6
-11000.0 7045.1
-11000.0 0.1714 = 1274.4 17.14% 1881.4 2578.3 3378.8 11343.4
($1,549.20)

A. What-if Analysis

So far the project investigation team has used a set of “most likely” assumptions to forecast rates of return. It is now time to subject the most likely outcome to sensitivity analyses. As many probabilistic techniques are available to test the sensitivity of results to political and foreign exchange risks as are used to test sensitivity to business and financial risks. But it is more common to test sensitivity to political and foreign exchange risk by simulating what would happen to net present value and earnings under a variety of “what if” scenarios. Spreadsheet programs such as Excel can be used to test various scenarios

EXHIBIT 9

NPV Profiles for Ko-tel and Am-tel—Sensitivity Analysis

Discount rate
(%) 0 4 8 12 16
Project pt of view $14,378.57 10,827.01 7,958.71 5,621.75 3,702.09
(Ko-tel)
Parent pt of view $9,456.37 6,468.67 4,043.44 2,056.77 415.48
(Am-tel)
20 22 24 28 32 36 40
$2,113.17 1,421.37 788.65 (322.83) (1,261.35) (2,058.46) (2,739.20)
$ (951.26) (1,549.20) (2,097.87) (3,066.53) (3,890.23) (4,594.99) (5,201.51)

Exhibit 10 depicts an NPV graph of various scenarios.

EXHIBIT 10

NPV Profiles for Ko-tel and Am-tel Sensitivity Analysis

NPV Profiles for Ko-tel and Am-tel Sensitivity Analysis

ANNUAL PERCENTAGE RATE

Different types of investments use different compounding periods. For example, most bonds pay interest semiannually. Some banks pay interest quarterly. If an investor wishes to compare investments with different compounding periods, he or she needs to put them on a common basis.

The annual percentage rate (APR), or effective annual rate, is used for this purpose and is computed as follows:

tmp30-11_thumb

where r = the stated, nominal, or quoted rate, and m = the number of compounding periods per year.

EXAMPLE 10

Assume that a bank offers 6% interest, compounded quarterly, then the APR is:

tmp30-12_thumb

This means that if one bank offered 6% with quarterly compounding, while another offered 6.14% with annual compounding, they would both be paying the same effective rate of interest.

Annual percentage rate (APR) also is a measure of the cost of credit, expressed as a yearly rate. It includes interest as well as other financial charges such as loan and closing costs and fees. A lender is required to tell a borrower the APR. The APR provides a good basis for comparing the cost of loans, including mortgage plans.

A/P

1. In accounting, abbreviation for “accounts payable.”

2. In international trade and finance documentation, abbreviation for “authority to purchase” or “authority to pay.”

APPRECIATION OF THE DOLLAR

Also called strong dollar, strengthening dollar, or revaluation of a dollar, appreciation of the dollar refers to a rise in the foreign exchange value of the dollar relative to other currencies. The opposite of appreciation is weakening, deteriorating, or depreciation of the dollar. Strictly speaking, revaluation refers to a rise in the value of a currency that is pegged to gold or to another currency. A strong dollar makes Americans’ cash go further overseas and reduces import prices—generally good for U.S. consumers and for foreign manufacturers. If the dollar is overvalued, U.S. products are harder to sell abroad and at home, where they compete with low-cost imports. This helps give the U.S. its huge trade deficit. A weak dollar can restore competitiveness to American products by making foreign goods comparatively more expensive. But too weak a dollar can spawn inflation, first through higher import prices and then through spiraling prices for all goods. Even worse, a falling dollar can drive foreign investors away from U.S. securities, which lose value along with the dollar. A strong dollar can be induced by interest rates. Relatively higher interest rates abroad will attract dollar-denominated investments which will raise the value of the dollar. Exhibit 11 summarizes the impacts of changes in foreign exchange rates on the multinational company’s products and services.

EXHIBIT 11

The Impacts of Changes in Foreign Exchange Rates

Weak Currency Strong Currency
(Depreciation/devaluation) (Appreciation/revaluation)
Imports More expensive Less expensive
Exports Less expensive More expensive
Payables More expensive Less expensive
Receivables Less expensive More expensive
Inflation Fuel inflation by making Low inflation
imports more costly
Foreign investment Discourage foreign investment. High interest rates
Lower return on investments by could attract foreign
international investors. investors.
The effect Raising interests could slow Reduced exports could trigger
down the economy a trade deficit

The amount of appreciation or depreciation is computed as the fractional increase or decrease in the home currency value of the foreign currency or in the foreign currency value of the home currency:

With Direct Quotes (exchange rate expressed in home currency):

tmp30-13_thumb

With Indirect Quotes (exchange rate expressed in foreign currency):

tmp30-14_thumb

EXAMPLE 11

An increase in the exchange rate from $0.64 (or DM1.5625/$) to $0.68 (or DM1.4705) is equivalent to a DM appreciation of 6.25% [($0.68 - $0.64)/$0.64 = 0.0625] (direct quote) or [(DM1.5625 - DM1.4705)/DM 1.4705 = 0.0625] (indirect quote). This also means a dollar depreciation of 5.88% [($0.64 - $0.68)/$0.68 = -0.0588].

ARBITRAGE

Arbitrage is the simultaneous purchase or sale of a commodity in different markets to profit from unwarranted differences in prices. That is, it involves the purchase of a commodity, including foreign exchange, in one market at one price while simultaneously selling that same currency in another market at a more advantageous price, in order to obtain a risk-free profit on the price differential. Profit is the price differential minus the cost. If exchange rates are not equal worldwide, there would be profit opportunity for simultaneously buying a currency in one market while selling it in another. This activity would raise the exchange rate in the market where it is too low, because this is the market in which you would buy, and the increased demand for the currency would result in a higher price. The market where the exchange rate is too high is one in which you sell, and this increased selling activity would result in a lower price. Arbitrage would continue until the exchange rates in different markets are so close that it is not worth the costs incurred to do any further buying and selling. When this situation occurs, we say that the rates are “transaction costs close.” Any remaining deviation between exchange rates will not cover the costs of additional arbitrage transactions, so the arbitrage activity ceases.

EXAMPLE 12

Suppose ABC Bank in New York is quoting the German mark/U.S. dollar exchange rate as 1.4445—55 and XYZ Bank in Frankfurt is quoting 1.4425—35. This means that ABC will buy dollars for 1.4445 marks and will sell dollars for 1.4455 marks. XYZ will buy dollars for 1.4425 marks and will sell dollars for 1.4435 marks. This presents an arbitrage opportunity. An arbitrager could buy $1 million at XYZ’s ask price of 1.4435 and simultaneously sell $1 million to ABC at their bid price of 1.4445 marks. This would earn a profit of DM0.0010 marks per dollar traded, or DM10,000 would be the total arbitrage profit. If such a profit opportunity existed, the demand to buy dollars from XYZ would cause them to raise their ask price above 1.4435, while the increased interest in selling dollars to ABC at their bid price of 1.4445 marks would cause them to lower their bid. In this way, arbitrage activity pushes the prices of different traders to levels where no arbitrage profits are earned.

Exhibit 12 illustrates bounds imposed on spot rates by arbitrage transactions. As can be seen, there is strong arbitrage opportunity between banks A and B: you can buy cheap from A at its ask price, and resell at a high bid rate to B. In contrast, if the A’s quote is A’, you cannot profitably buy from either A’ or B and sell to the other.

EXHIBIT 12

Bounds Imposed on Spot Rates by Arbitrage Transactions

Bounds Imposed on Spot Rates by Arbitrage Transactions

ARBITRAGE PRICING MODEL (APM)

The Capital Asset Pricing Model (CAPM) assumes that required rates of return depend only on one risk factor, the stock’s beta. The Arbitrage Pricing Model (APM) disputes this and includes any number of risk factors:

tmp30-16_thumb

where

tmp30-17_thumb

Roll and Ross suggest the following five economic forces:

1. Changes in expected inflation

2. Unanticipated changes in inflation

3. Unanticipated changes in industrial production

4. Unanticipated changes in the yield differential between low- and high-grade bonds (the default-risk premium)

5. Unanticipated changes in the yield differential between long-term and short-term bonds (the term structure of interest rates)

EXAMPLE 13

Suppose returns required in the market by investors are a function of two economic factors according to the following equation, where the risk-free rate is 7 percent:

tmp30-18_thumb

ABC stock has the reaction coefficients to the factors such that bl = 1.3 and b2 = 0.90. Then the required rate of return for the ABC stock is

tmp30-19_thumb

ARBITRAGE PROFITS

Profits obtained by an arbitrageur through an arbitrage process are called arbitrage points.

EXAMPLE 14

You own $10,000. The dollar rate on the Japanese yen is ¥106/$. The Japanese yen rate is given in Exhibit 13 below.

EXHIBIT 13

Selling Quotes for the Japanese Yen in New York

Country Contract $/Foreign Currency
Japan (yen) Spot 0.009465
30-day 0.009508
90-day 0.009585

Note that the Japanese yen rate is ¥106/$, while the (indirect) New York rate is 1/0.009465 = ¥105.65/$. Assuming no transaction costs, the rates between Japan and New York are out of line. Thus, arbitrage profits are possible: (1) Because the yen is cheaper in Japan, buy $10,000 worth of yens in Japan. The number of yens would be $10,000 x ¥106/$ = ¥1,060,000. (2) Simultaneously sell the yens in New York at the prevailing rate. The amount received upon the sale of the yens would be: ¥1,060,000 x $0.009465 = $10,032.90. The net gain is $10,032.90 – $10,000 = $32.90.

EXAMPLE 15

You own $10,000. The dollar rate on the DM is 1.380 marks.

U.S. Dollar Equivalent Currency per U.S.$
Country Contract (Direct) (Indirect)
Germany Spot .7282 1.3733
(mark) 30-day future .7290 1.3716
90-day future .7311 1.3677

Based on the table above, are arbitrage profits possible? What is the gain (loss) in dollars? The dollar rate on the DM is 1.380 marks, while the table (indirect New York rate) shows 1.3733 (1/.7282) marks. Note that the rates between Germany and New York are out of line. Thus, arbitrage profits are possible. Since the DM is cheaper in Germany, buy $10,000 worth of marks in Germany. The number of marks purchased would be 13,800 ($10,000 x 1.380). Simultaneously sell the marks in New York at the prevailing rate. The amount received upon sale of the marks would be $10,049.16 (13,800 marks x $.7282/DM) = $10,049.16. The net gain is $49.16, barring transactions costs.

ARBITRAGEUR

An arbitrageur is an individual or business that exercises arbitrage seeking to earn risk-free profits by taking advantage of simultaneous price differences in different markets.

ARITHEMETIC AVERAGE RETURN VS. COMPOUND (GEOMETRIC) AVERAGE RETURN

It is one thing to calculate the return for a single holding period but another to explain a series of returns over time. If you keep an investment for more than one period, you need to understand how to derive the average of the successive rates of return. Two approaches to multiperiod average (mean) returns are the arithmetic average return and the compound (geometric) average return. The arithmetic average return is the simple mean of successive one-period rates of return, defined as:

tmp30-20_thumb

where n = the number of time periods and r = the single holding period return in time t. Caution: The arithmetic average return can be misleading in multiperiod return computations.

A better accurate measure of the actual return obtained from an investment over multiple periods is the compound (geometric) average return. The compound return over n periods is derived as follows:

tmp30-21_thumb

EXAMPLE 16

Assume the price of a stock doubles in one period and depreciates back to the original price. Dividend income (current income) is nonexistent.

Time periods

Time periods
t = 0 t = 1 t = 2
Price (end $40 $80 $40
of period)
HPR — 100% -50%

The arithmetic average return is the average of 100% and -50%, or 25%, as indicated below:

tmp30-22_thumb

However, the stock bought for $40 and sold for the same price two periods later did not earn 25%; it earned zero. This can be illustrated by determining the compound average return. Note that n = 2, rx = 100% = 1, and r2 = -50% = -0.5.

Then,

However, the stock bought for $40 and sold for the same price two periods later did not earn 25%; it earned zero. This can be illustrated by determining the compound average return. Note that n = 2, rx = 100% = 1, and r2 = -50% = -0.5.

tmp30-23_thumb

EXAMPLE 17

Applying the formula to the data below indicates a compound average of 11.63 percent, somewhat less than the arithmetic average of 26.1 percent.

(1) (2) (3) (4) (5)
Time Price Dividend Total return Holding period return (HPR)
0 $100 $-
1 60 10 -30(a) -0.300(b)
2 120 10 70 1.167
3 100 10 -10 -0.083

tmp30-24_thumb

The arithmetic average return is

tmp30-25_thumb

but the compound return is

tmp30-26_thumb

ARM’S-LENGTH PRICING

Arm’s-length pricing involves charging prices to which an unrelated buyer and seller would willingly agree. In effect, an arm’s-length price is a free market price. Although a transaction between two subsidiaries of an MNC would not be an arm’s-length transaction, the U.S. Internal Revenue Code requires arm’s-length pricing for internal goods transfers between subsidiaries of MNCs.

ARM’S-LENGTH TRANSACTION

An arm’s-length transaction is a transaction between two or more unrelated parties. A transaction between two subsidiaries of an MNC would not be an arm’s-length transaction.

ASIAN CURRENCY UNIT

Asian Currency Unit (ACU) is a division of a Singaporean bank that deals in foreign currency deposits and loans.

ASIAN DEVELOPMENT BANK

Created in the late 1960s, the Asian Development Bank is a financial institution for supporting economic development in Asia. It operates on similar lines as the World Bank. Member countries range from Iran to the United States of America.

ASIAN DOLLAR MARKET

Asian dollar market is the market in Asia in which banks collect deposits and make loans denominated in U.S. dollars.

ASIAN DOLLARS

Similar to Eurodollars, Asian dollars are U.S. dollar-denominated deposits kept in Asian-based banks.

ASKED RATE

Also called ask rate, selling rate, or offer rate. The price at which a dealer is willing to sell foreign exchange, securities, or commodities.

ASSET MANAGEMENT OF BANKS

A commercial bank earns profits for stockholders by having a positive spread in lending and through leverage. A positive spread results when the average yield on earning assets exceeds the average cost of deposit liabilities. A high-risk asset portfolio can increase profits, because the greater the risk position of the borrower, the larger the risk premium charged. On the other hand, a high-risk portfolio can reduce profits because of the increased chance that parts of it could become “nonperforming” assets. Favorable use of leverage (the bank’s capital-asset ratio is falling) can increase the return on owners’ equity. A mix of a high-risk portfolio and high leverage could result, however, in insolvency and bank failure. It is extremely important for banks to find an optimal mix.

A bank is also threatened with insolvency if it has to liquidate its asset portfolio at a loss to meet large withdrawals (a “run on the bank”). This can happen, because, historically, a large proportion of banks’ liabilities come from demand deposits and, therefore, are easily withdrawn. For this reason, commercial bank asset management theory focuses on the need for liquidity. There are three theories:

1. The commercial loan theory. This theory contends that commercial banks should make only short-term self-liquidating loans (e.g., short-term seasonal inventory loans). In this way, loans would be repaid and cash would be readily available to meet deposit outflows. This theory has lost much of its credibility as a certain source of liquidity, because there is no guarantee that even seasonal working capital loans can be repaid.

2. The shiftability theory. This is an extension of the commercial loan theory stating that, by holding money-market instruments, a bank can sell such assets without capital loss in the event of a deposit outflow.

3. The anticipated-income theory. This theory holds that intermediate-term installment loans are liquid because they generate continuous cash inflows. The focus is not on short-term asset financing but on cash flow lending.

It is important to note that contemporary asset management hinges primarily on the shiftability theory, the anticipated-income theory, and liability management.

ASSET MARKET MODEL

The asset market model is a model that attempts to explain how a foreign exchange rate is determined. It states that the exchange rate between two currencies stands for the price that exactly balances the relative supplies of, and demands for, assets denominated in those currencies. Within the family of asset market models, there are two basic approaches: (1) In the monetary approach, the exchange rate for any two currencies is determined by relative money demand and money supply between the two countries. Relative supplies of domestic and foreign bonds are unimportant. (2) The portfolio-balance approach allows relative bond supplies and demands, as well as relative money-market conditions, to determine the exchange rate.

AUTOMATIC ADJUSTMENT MECHANISM

Automatic adjustment mechanism is the automatic response of an economy that is triggered by a balance of payment imbalance. When a trade deficit exists under flexible exchange rates, a currency devaluation generally occurs to revitalize exports and reduce imports. Under fixed exchange rates, domestic inflation is expected to be below a foreign counterpart, which leads to relatively cheaper domestic products, thereby escalating exports and plummeting imports.

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