Mncs do increase their risk by borrowing foreign currencies, Corporate Finance

Assignment Help:

According to those who are in favor of borrowing, the MNCs can achieve lower financing costs and hence their competing ability is improved. But according to the international fisher effect, "the percentage change in the spot exchange rate of a currency in terms of another will, on average, equal to the differential of interest rates between the two countries". This is expressed in the below equation (Carey & Essayyad, 1990). 

Change in spot rate of foreign currency =

(1+ interest rate in the home country) – 1 /(1 + interest rate in the foreign country)

                Suppose a dollar debt can be obtained at 10% and a pound debt can be obtained at a cheaper 5%, according to the international fisher effect, the interest rate differences will be soon converted into appreciation on pound and depreciation on dollar, which implies that pounds are not cheap to borrow just because the interest rate on pound is lower comparatively. According to the international fisher effect, exchange rate in due course will balance the interest rate differentials.

Though international fisher effect has been proved to not work in reality by many, there are also evidences wherein it holds. For example, a study by Utami & Inanga (2009) has proved that international fisher effect holds for Indonesia. Hence this theory cannot be held aside. Hence the argument of those in favor of borrowing cannot hold when international fisher effect holds. The lower financing costs will be soon converted into exchange rate appreciation and depreciation, thus making both costs equal or at least approximately equal ultimately.

In addition, the international fisher effect has been known to hold at best in the long term compared to the short term. According to Bartram et al (2005), there is existence of foreign exchange rate risk because both PPP theory and international fisher effect holds in the long term much better. There are many other studies and research papers that prove the same as well. The foreign borrowing will be utilized especially by the MNCs for long term purposes. Hence it is again proved that the low cost of financing will be soon compensated through the changes in the respective exchange rates.

Thus the attractiveness of lower costs of financing will increase the foreign exposure of multinational companies, thus increasing their risk as well. With increased risk, the company would have to take precautionary measures such as hedging through various derivative instruments. This just increases the cost incurred by the firm and overall, with higher costs, the company's competitive ability is lowered in the global as well as domestic level thus leading to high failure chances for the business.       

 Thus I strongly believe that Multinational Corporations increase risk when borrowing foreign currencies. 


Related Discussions:- Mncs do increase their risk by borrowing foreign currencies

IRR, Hello, can you help me to calculate the Discount rate and Internal Rat...

Hello, can you help me to calculate the Discount rate and Internal Rate of Return?

Explain the negotiation of letter of credit in trade finance, Judges Maurit...

Judges Mauritius Co Ltd imports spare parts for cars from Dubai on a letter of credit basis, payable 60 days from ‘bill of lading' issue date. Each letter of credit is valid for 90

WACC, The cost of capital for a firm can differ from the cost of capital fo...

The cost of capital for a firm can differ from the cost of capital for each of its businesses. When a firm has multiple businesses, it is important to use the cost of capital appro

Determine monthly saving, Determine monthly saving: Based on the follo...

Determine monthly saving: Based on the following information, answer the questions. You consider a retirement plan. The retirement plan will give you $1,000 every month for 1

Replacement analysis, The Chang Co is considering the purchase of a new mac...

The Chang Co is considering the purchase of a new machine to replace an obsolete one. The machine being used for the operations has a book value and a market value of zero. However

Merger and aquisition, It is given that company A will acquire company B wi...

It is given that company A will acquire company B with shares of common stock. Present earnings of A is rs. 20 million and of company B is rs. 5 million. Earning price per share of

Definition of electronic banking and electronic money, Question: (a) G...

Question: (a) Give a definition of electronic banking and electronic money. (b) Outline the main differences between smart cards, credit cards and debit cards. (c) Giv

Describe reasons for corporate restructuring, 1. Describe three different...

1. Describe three different types of Mergers, and in what circumstances you expect to see each type occurring. 2. Just as Acquisitions and Mergers are a means by which compan

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd