Finance chapter

1. © 2006 Thomson Learning/South-Western

2.  The payment for a transaction between an
exporter (seller) and an importer (buyer) is
complicated because of concerns that one
party might not fulfill its obligation to the
other party.
 First, the exporter may be concerned that it
will not receive the payment from the
importer.
 Second, even if the importer is willing to
make payment, its government might
 impose exchange controls that prevent it
from paying the exporter.
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3.  Third, the importer may not trust the
exporter to ship the products ordered.
Financial managers must be aware of
methods that they can use to ensure delivery
of the products or the payment in
international trade.
 In general, five basic methods of payment are
used to settle international transactions, each
of which carries a different degree of risk for
the exporter and the importer.
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4.  ■■ 1. a. Prepayment
 ■■ 1. b. Letters of credit
 ■■ 1. c. Drafts
 ■■ 1. d. Consignment
 ■■ 1. e. Open account
 ■■ 1. f. Impact of the Credit Crisis on
Payment Methods
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5.  Under the prepayment method, the exporter
will not ship the products until it has received
payment from the importer.
 Payment is usually made in the form of an
international wire transfer to the exporter’s
bank account or a foreign bank draft.
 International electronic payment systems also
allow firms engaged in international trade to
make electronic credits and debits through an
intermediary bank.
 This method provides the exporter with the
most protection.
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6.  In most cases, exporters require prepayment
when dealing for the first time with importers
whose creditworthiness is unknown or whose
countries are in financial difficulty.
 Most importers, however, may not be willing
to prepay because of concerns that the
exporter might not ship the products
ordered.
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7.  The letter of credit (L/C) is a written
obligation to ensure that the importer makes
payment to the exporter once it receives
proof that the products have been shipped.
Specifically, the importer’s bank (also referred
to as the “issuing bank”) issues an L/C by
making a written commitment on behalf of
the importer to pay the exporter when the
importer’s bank receives shipping documents
confirming that the exporter has shipped the
products to the importer.
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8.  The exporter benefits from the L/C because it
may trust the importer’s bank more than the
importer itself to make payment.
 In the usual procedure, the exporter’s bank
(also referred to as the “advising bank”) sends
the shipping documents to the importer’s
bank to verify that the products have been
 shipped.
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9.  Key Documents in Shipments Facilitated by a
Letter of Credit The key document in an
international shipment under an L/C is the
bill of lading (B/L).
 The B/L serves as a receipt for shipment and
a summary of freight charges; most
importantly, it conveys title to the
merchandise.
 If the merchandise is to be shipped by boat,
the carrier will create an ocean bill of lading.
When the merchandise is shipped by air, the
carrier will create an airway bill.
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10.  The B/L usually includes the following
documents:-
 ■■ A description of the merchandise
 ■■ Identification marks on the merchandise
 ■■ Evidence of loading (receiving) ports
 ■■ Name of the exporter (shipper)
 ■■ Name of the importer
 ■■ Status of freight charges (prepaid or
collect)
 ■■ Date of shipment
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11.  A draft (or bill of exchange) represents a
written order from the exporter instructing
the importer to pay the face amount of the
draft either when it is presented or at a
specified future date.
 The documents for an L/C generally include a
draft, but a draft may also be used without an
L/C.
 However, a draft without an L/C affords the
exporter less protection than an L/C because
no bank is obligated to make the payment on
the importer’s behalf.
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12.  Most trade transactions handled on a draft
basis are processed through banking
channels.
 In these transactions, which are known as
documentary collections, banks on both ends
act as intermediaries in processing the
shipping documents and collecting payment.
 When the products are shipped under a sight
draft, the exporter is paid once the shipment
has been made and the draft is presented to
the importer for payment
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13.  Under a consignment arrangement, the
exporter ships the products to the importer
while still retaining actual title to the
merchandise.
 The importer has access to the products but
does not have to pay for them until they have
been sold to a third party.
 The exporter trusts the importer to remit
payment for the products sold at that time.
 If the importer fails to pay, the exporter has
limited recourse because no draft is involved
and the products have already been sold.
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14.  In an open account transaction, the exporter
ships the merchandise and expects the
importer to send payment according to the
agreed-upon terms. With this approach, the
exporter relies fully upon the importer’s
financial creditworthiness and integrity.
 This method is used only when the exporter
and the importer have mutual trust and a
great deal of experience with each other.
 Despite the risks, open account transactions
are widely utilized, particularly among the
industrialized countries in North America and
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15.  When the credit crisis intensified in the fall of
2008, international trade transactions stalled.
 Commercial banks facilitate trade
transactions because they are usually trusted
to guarantee payment on behalf of an
importer.
 However, during the credit crisis, many
financial institutions experienced financial
problems.
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16.  Consequently, exporters lost trust in
commercial banks, and did not want to
export products even if an importer’s bank
would guarantee payment.
 The 2008–2009 credit crisis illustrated how
international trade is highly reliant on the
soundness and integrity of commercial
banks.
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17.  In any international trade transaction, credit
is provided by the exporter, the importer, one
or more financial institutions, or any
combination of these.
 The exporter may have sufficient cash flows
to finance the entire trade cycle, beginning
with the production of the product until
payment is eventually made by the importer.
This form of credit is known as supplier
credit because the exporter that supplies the
products also provides the credit.
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18.  If the exporter does not have sufficient cash
to fund the entire cycle, it may require bank
financing, or the importer will have to finance
the transaction.
 Thus, commercial banks commonly play an
integral role in trade financing on both sides
of a transaction.
 The following are some of the more popular
methods of financing international trade:-
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19.  ■■ 2. a. Accounts receivable financing
 ■■ 2. b. Factoring
 ■■ 2. c. Letters of credit
 ■■ 2. d. Banker’s acceptances
 ■■ 2. e. Medium-term capital goods
financing (forfaiting)
 ■■ 2. f. Countertrade
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20.  An exporter may be willing to ship products
to an importer without an assurance of
payment from a bank, by using an open
account shipment or a time draft.
 Prior to shipment, the exporter should
conduct a credit check of the importer to
determine its creditworthiness.
 If the exporter is willing to wait for payment,
it will extend credit to the importer.
 If the exporter needs funds immediately, it
may obtain financing from a bank.
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21.  In an arrangement referred to as accounts
receivable financing, the bank will provide a
loan to the exporter secured by the account
receivable.
 The bank’s loan is made to the exporter
based on its creditworthiness.
 If the importer fails to pay the exporter for
any reason, the exporter is still responsible
for repaying the bank.
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22.  When an exporter ships products before
receiving payment, its accounts receivable
balance increases.
 Unless the exporter has received a loan from
a bank, it is initially financing the transaction
and must monitor the collections of
receivables.
 Because it faces the danger that the importer
will never pay at all, the exporter may decide
to sell the accounts receivable to a third
party, known as a factor.
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23.  The factor then assumes all responsibility for
collecting from the importer and the
associated credit risk. The factor usually
purchases the receivable at a discount and
also receives a flat processing fee.
 Before purchasing the receivable, the factor
conducts a credit check on the importer.
 In international transactions, MNCs may use
cross-border factoring, which involves a
network of factors in various countries that
assess credit risk.
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24.  Factoring provides several benefits to the
exporter.
 First, by selling the accounts receivable, the
exporter does not have to worry about the
costs of maintaining and monitoring an
accounts receivable accounting ledger.
 Second, the factor assumes the credit risk, so
the exporter does not have to assess the
creditworthiness of the importer.
 Finally, by selling the receivable to the factor,
the exporter obtains immediate payment and
improves its cash flow.
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25.  Letters of credit are not only an important
payment method in international trade (as
described earlier), but also a source of
financing.
 Many L/Cs are payable at a specified future
date, meaning that the exporter provides
financing to the importer until the importer
(or the importer’s bank) makes its payment to
the exporter.
 The importer’s bank may also provide
financing. When an importer obtains an L/C,
it must pay its bank the amount of the L/C
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26.  A banker’s acceptance (B/A) is a bill of
exchange, or time draft, that is issued by a
firm and guaranteed by a bank.
 As the first step in creating a banker’s
acceptance in international trade, the
importer orders products from the exporter.
 The importer then requests its local bank to
create an L/C on its behalf that will ensure
payment to the exporter.
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27.  The exporter presents a time draft along with
the shipping documents to its local bank, and
the exporter’s bank sends the time draft
along with the shipping documents to the
importer’s bank.
 The importer’s bank accepts (agrees to) the
conditions of the draft, thereby creating a
banker’s acceptance.
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28.  Because capital goods are often quite
expensive, an importer may not be able to
make payment on the products within a short
time period.
 In such a case, longer-term financing may be
required.
 The exporter might be able to provide
financing for the importer but may not desire
to do so because the financing may extend
over several years
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29.  In this case, a type of trade finance known as
forfeiting could be used.
 Forfeiting refers to the purchase of financial
obligations, such as bills of exchange or
promissory notes, from the original holder
(usually, the exporter).
 In a for fait transaction, the importer issues a
promissory note to pay the exporter for the
imported products over a period that
generally ranges from three to seven years.
The exporter then sells the notes to the
forfaiting bank.
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30.  The term countertrade denotes all types of foreign
trade transactions in which the sale of products to
one country is linked to the purchase or exchange
of products from that same country.
 Some types of countertrade, such as barter, have
existed for thousands of years.
 Only recently, however, has countertrade gained
popularity and importance.
 The growth in various types of countertrade has
been fueled by large balance-of-payment
disequilibria, foreign currency shortages, the debt
problems of less developed countries, and stagnant
worldwide demand.
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31.  Barter is the exchange of products between
two parties without the use of any currency as
a medium of exchange.
 Most barter arrangements are one-time
transactions governed by a single contract
 An example would be the exchange of 100
tons of wheat from Canada for 20 tons of
shrimp from Ecuador.
 In a compensation or clearing-account
arrangement, the delivery of products to one
 party is compensated for by the exporter
buying back a certain amount of the product 31

32.  Given the inherent risks of international
trade, government institutions and the private
sector offer various forms of export credit,
export finance, and guarantee programs to
reduce risk and stimulate foreign trade.
 Three prominent agencies provide these
services in the United States:-
 ■■ The Export-Import Bank of the United
States.
 ■■ The Private Export Funding Corporation
 ■■ The Overseas Private Investment
Corporation. 32

33.  The Export-Import Bank (Ex-Im Bank) was
established in 1934 with the original goal of
facilitating Soviet–American trade.
 Today, its missions are to finance and
facilitate the export of American products
and services and to maintain the
competitiveness of American companies in
overseas markets.
 It operates as an independent agency of the
U.S. government and, as such, carries the full
faith and credit of the United States.
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34.  The Private Export Funding Corporation
(PEFCO) is a private corporation owned by a
consortium of commercial banks and
industrial companies. In cooperation with the
Ex-Im Bank, PEFCO provides medium- and
long-term fixed rate financing to importers.
 The Ex-Im Bank guarantees all export loans
made by PEFCO.
 Most PEFCO loans are made to finance large
projects, such as aircraft and power
generation equipment, so they tend to have
relatively long terms (sometimes as long as
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35.  The Overseas Private Investment Corporation
(OPIC) was formed in 1971 as a self-
sustaining federal agency responsible for
insuring direct U.S. investments in foreign
countries against the risks of currency
inconvertibility, expropriation, and other
political risks.
 Through the direct loan or guaranty program,
OPIC will provide medium- to long-term
financing to U.S. investors undertaking an
overseas venture.
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36.  In addition to general insurance and finance
programs, OPIC offers specific types of
coverage for exporters bidding on or
performing foreign contracts.
 American contractors can insure themselves
against contractual disputes and even against
the wrongful calling of standby letters of
credit.
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37.  ■ The common methods of payment for
international trade are (1) prepayment (before
products are sent), (2) letters of credit, (3)
drafts, (4) consignment, and (5) open
accounts.
 ■The most popular methods of financing
international trade are (1) accounts receivable
financing, (2) factoring, (3) letters of credit,
(4) banker’s. acceptances, (5) medium-term
capital goods financing (forfeiting), and (6)
countertrade.
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38.  The major agencies that facilitate
international trade with export insurance
and/or loan programs are:-
 (1) the Export-Import Bank of the United
States,
 (2) the Private Export Funding Corporation,
and
 (3) the Overseas Private Investment
Corporation.
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39.  1. Explain why so many international
transactions require international trade credit
facilitated by commercial banks.?
 2. Explain the difference in the risk to the
exporter between accounts receivable
financing and factoring.?
 3. Explain how the Export-Import Bank of the
United States can encourage U.S. firms to
export their products to less developed
countries where there is political risk.
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