2. INTERNATIONAL FINANCE
International Finance
The purpose of this paper is to provide analysis of XYZ’s operational performance,
financial markets and funding choices. The process to complete the analysis involves comparing
financial statements highlights for two years, and conducting research regarding information on
currency denomination choices for debt, centralized and decentralized denominations of debt,
fixed and floating debt. In addition equity financing options are also included in the analysis. As
a company which is expanding and growing, considerably, with a significant aspect of this
growth generated from the markets in Brazil, analyzing the option of opening a manufacturing
plant in Brazil to take care of the expanding market in Brazil and Latin America is important.
Analysis of XYZ’s Operational Performance
The year to year financial statements show a decrease in the net amount of sales, by $200
million. The cost as a percentage of total sales has stayed the same. Variable operating cost is 78
% of sale, gross profit is 22 % of total sales, and fixed operating cost excluding depreciation is
1.3%. Earnings before interest, taxes, depreciation, and amortization are 20.7%, depreciation is
33%, and earnings before interest and taxes are 19.9% year 1 and 20% in year 2. Interest is .5% ,
taxes are 35%, and net income is 12.6%. The net income in year one decreased from $567.5
million to $543.4 million , but the percentage to net sales is the same 12%. The stable percentage
of cost indicates stability in the operations of the organization. When making the decision to
expand operations to another market factors to consider are the effect of the stability which
currently exits in the operations.
The variable cost like cost of labor could decrease as a percentage when a plant is opened
in Brazil due to the lower labor cost in Brazil compared to the labor cost in the United States.
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The fixed cost could also benefit because the cost of building the manufacturing plant in Brazil is
potentially less than the total cost of building a new plant in the United States. Diversifying
production in this way, allows the company to take advantage of the purchasing power parity,
due to the lower standard of living cost in Brazil (Kpekpena, Nettey, & Rosecky,
2017). Considering the same amount of dollar exchanged to the Brazilian real purchases the
same quantity of goods of services in Brazil, then no issues will arise from differences in
exchange rates. There is a challenge expanding to Brazil, when the exchange rate fluctuates,
interest rates are different, and when the political environment is different.
Analyzing the Choices of Funding For the New Plant Debt Financing
Currency Denomination Choices for Debt
XYZ has to analyze the currency denomination of the funding choice for the new plant.
The debt choice is not independent of the exchange rates risk. The decision regarding the
denomination is influenced in one way by the taxes and interest. The higher the taxes on interest
of the subsidiary then XYZ will benefit if they have excess foreign tax credits (O'Brien,
2009). Another challenge with choosing the denomination of the debt is the exchange rate
fluctuation. In the event the value of the currency denomination of the debt used to finance the
project in Brazil plummets then the cost to the company will be higher (Tschoegl, 1997). When
sales are mostly in the currency which is experiencing decrease in value, and the debt is in the
currency which is experiencing increase in value, the net profit is affected after taking into
consideration the effect of the change in exchange rate value. Capital structure is determined by
the way the company is funded. Traditionally debt capital is cheaper (Berzkalne, 2015).
Financial structure influences how to divide responsibilities for the final results of company's
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activity (Savina, 2010). The debt structure when effective is beneficial to the financial options
the company has to distribute to the different departments. The company should optimize the
debt structure to ensure the different operations in Brazil and the United States have the
financing necessary to operate effectively. The debt should be denominated in the United States
dollar when the dollar is stronger, and the sales are mostly from the United States. The company
will have enough resources to pay the debt.
Some companies use arbitrage by borrowing funds in one country at a low interest rate
and depositing the funds in a country with a higher interest rate to get the benefit of the
difference in interest rate. The opportunity does not last long because the money would be
borrowed in one currency and then converted to another to be deposited. The demand will
increase as one currency is exchanged for another and the exchange rate difference would offset
the difference in the interest rate. Financial derivatives are options to hedge against currency
exchange risk (Allayannis, Ihrig, & James, 2001). The company can obtain commodities
contracts, in the futures market for currency denominated in the best value for the company.
Centralized And Decentralized Denomination
In a decentralized denomination the currency is issued in both United States Dollars and
Brazilian reals. In a centralized denomination the currency is issued only in the home currency
the United States dollars. The decentralized denomination allows for diversification of the risk of
currency exchange from cash flow activities from United States and Brazil operations. of debt
and its effect on the debt issuance. Other ways to hedge the exchange rate risk is diversifying
production activities and diversifying financing activities (Norton, & Malindretos, 1991). The
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company should use the decentralized currency denomination to issue currencies, because of the
reduction in risk due to diversification.
Analyze the Choices of Funding For The New Plant Equity Financing
The option of funding using equity requires the raising of funds using shareholders. This
is usually more expensive as the owners often require payment of dividends and return on equity
for the duration of the life of the company. In debt funding the cost to the firm ends when the
debt is paid off. Funding through equity is part of diversification of funding which is necessary
for the stabilization of the company’s operations (Norton, & Malindretos, 1991). The currency of
the equity purchased fluctuates but does not have the danger of affecting how the cash flows in
the business on a current basis, because the company can hold off on distributing dividends when
the cash flow circumstance is not suitable.
The risk of using equity to fund the expansion to Brazil is also challenging because the
new market is a new venture. The change in return on equity is not known, so the reaction of the
shareholders is not known. The market capitalization changes as the perspectives of investors
changes. The company has to balance the equity funding such that the company still has enough
funding in the event investors do not react positively to the return of equity change due to the
expansion to Brazil.
The equity should be domestically listed because of the relative strength of the dollar.
When the fund raised is exchanged from the United States dollars to the Brazilian real the
company will have the benefit of the increased exchange rate. When the exchange rates between
the United States dollars and the Brazilian real falls, then the equity is preferably raised in the
Brazilian real to support a higher purchasing power.
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In conclusion when a company wants to expand into another country there are many
things to consider. The exchange rates of the currencies are very significant in making the
decision. The denomination of the currency is important. The type of funding is also important.
Choosing equity funding or debt funding will affect the company differently as the currency
exchange rate changes.
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References
Kpekpena, I., Nettey, T., & Rosecky, R. B. (2017). A test of purchasing power parity and
currency exchange rates: Supermarket prices in Ghana and the USA. Northeast Region
Decision Science Institute (NEDSI), 762 799.
O'Brien, T. J. (2009). Currency denomination of inter-company debt and multinational taxes.
Journal of Applied Corporate Finance, 21,(3), 86 - 94. DOI 10.1111/j.1745-
6622.2009.00242.x.
Berzkalne,, I (2015). Company;s capital structure and value: a panel threshold regression
analysis, Applied Economics: Systematic Research, 9, (1), 77 - 94
Savina, S. (2010). The application of process-based approach for financial structure construction.
Journal of business Management, 3, ( 156 - 161.
Norton, E., & Malindretos, J. (June 1991). FAS #52 and exchange rates exposure: Hedging
strategies. American Business Review, 9, (2), 31.
Tschoegl, A., E., (November 1997). The optimal denomination of currency. Journal of Money,
Credit & Banking (Ohio State University Press), 29, (4 ), 546 – 554.
Allayannis, G., Ihrig, J., & James, P. (May 2001). Exchange rate hedging: Financial versus
operational strategies. American Economic Review, 91, (2), 391 – 395.