Conducting international business can be very lucrative, but it is also filled with problems. HW Technologies', a US based company, wants to establish a joint venture with a Malaysian partner to manufacture circuit boards. The key financial issue here is whether the project will be profitable in the long term after considering the exchange rate.
Covered Interest Rate Arbitrage
I disagree with Brian's claim that based on covered interest rate arbitrage, it made no difference whether HW Technologies raised the capital needed for the joint venture in Malaysia or the USA. What he was referring to is the interest rate parity theory where two investments carry equal risk and should promise equal returns. In reality, arbitrageurs in the foreign exchange and interest rate markets would borrow currency in one centre, convert it to the other, invest there and sell the proceeds forward. Such proceeds would, if equilibrium did not hold, exceed the amount repayable in terms of borrowing plus accrued interest and thereby yield a virtually riskless profit to the operator. The actions of dealers ensure that profitable opportunities of this kind do not last for more than fleeting instants. Exploitation of these brief opportunities creates movements in spot and forward exchange rates and in interest rates and such movements ensure that the tendency in the currency and interest rate markets is towards equilibrium.
Covered interest rate arbitrage involves borrowing in centre A for a specified period at a fixed interest rate and shipping the proceeds borrowed to centre B. The sum shipped is deposited there for the same period as the borrowing in centre A, again at a fixed interest rate. The total proceeds of investment in centre B that will accrue at the end of the investment period can be calculated, since the interest rate is fixed. Such proceeds are sold via the forward market for the period of the borrowing and lending and the sum received in centre A plus accrued interest. This profit is said to be a covered interest arbitrage profit.
In contrast, uncovered interest arbitrage involves a borrowing in centre A for a specified period at a fixed interest rate and shipping the proceeds borrowed to centre B via the spot market. The sum is again placed on deposit for the same period as that for which the borrowing was arranged in centre A and again it is at a fixed rate. This time the investor speculates that the proceeds from lending in centre B when shipped to centre A at the spot rate prevailing at the end of the investment period will exceed the borrowing plus accrued interest in centre A. under uncovered interest arbitrage, the operator speculates on the future spot rate. Any profit earned is a risky profit.
Expected Annual Exchange Rates
Year
Spot Exchange Rate
Annual Inflation Rates
Year End Exchange Rate
RM/US$
USA
Malaysia
RM/US$
1
3.650
0.03
0.05
3.721
2
3.721
0.03
0.06
3.829
3
3.829
0.04
0.08
3.977
4
3.977
0.04
0.08
4.129
5
4.129
0.04
0.08
4.288
6
4.288
0.04
0.08
4.453
7
4.453
0.04
0.08
4.625
Owing to the higher projected inflation rates in Malaysia, it is expected that the Ringgit will weaken against the US dollar.
Borrowing in the US versus Malaysia
HW Technology's share in the joint venture is half of the total costs, or US$1, 500, 000. It could either choose to raise the funds in the US at the rate of 10% per annum or in Malaysia at the rate of 15% per annum.
Borrowing in the US
Amount borrowed: US$1, 500, 000
Total interest payment: US$1, 500, 000 x 10% x 7 = US$1, 050, 000
Borrow in Malaysia
Amount borrowed: US$1, 500, 000 x 3.650 = RM5, 475, 000
Total interest payment:
Year
Amount (US$)
1
220714
2
214468
3
206524
4
198875
5
191510
6
184417
7
177586
Total
1394094
Therefore, using the home currency approach, James should recommend borrowing directly in the US because even though the dollar will strengthen against the ringgit, the amount of interest paid is still higher if borrowed in Malaysia.
Error in Calculations
When the book value is used instead of the market value, it has the impact of lowering the cost of investment. Once corrected, the amount that needs to be invested would be higher. However, this would not affect the decision to borrow in the US because different figures would not affect the analysis.
Malaysian Tax Incentive
By lowering the tax rate to foreign investors who use some indigenous raw materials and employed Malaysians, the Malaysian government is encouraging more foreign direct investment. The impact on HW Technologies is that it will increase the amount of after tax income that can be remitted to the US, assuming that it opts to do these things. However, the company needs to ensure that quality of the circuit boards is not compromised at the expense of favourable tax treatment.
Joint Venture as a Stepping Stone
There are many reasons for establishing a joint venture with a foreign partner. One, the local partner understands the customers, mores and institutions of the local environment. Two, the local partner can recruit management at all levels that is competent. Three, if the local partner is well-known, his or her reputation can be used to gain access to the host country's capital markets. Four, the public image of the firm that is partially locally owned may improve its sales possibilities if the purpose of the investment is to serve local markets. Finally, if the host country laws stipulate that there must be a share of ownership with a local owner, such as in Malaysia, then a wholly owned subsidiary is not a viable option to a joint venture.
However, there are many problems with a joint venture. Both partners may have different views about the need for cash dividends. Political risk can also increase if the wrong partner is chosen. Control of financing is also problematic. When goods or services are transferred at different prices within associate companies, this could potentially lead to a conflict of interest.
Therefore, it may be wise of HW Technologies decides to use the joint venture as a stepping stone to maintain a permanent position in Malaysia. If so, then James' calculations and recommendations have to be altered. These include making modifications to the weighted cost of capital, repatriation of funds to the US and reinvestment decisions in terms of dividends and retained earnings.
Other Risks
Apart from exchange rate fluctuations, James must also evaluate the political risks. These can be classified into three major categories. The first is firm specific risks which are the political risks that affect the MNE at the project or corporate level. Government risk due to goal conflict between an MNE and its host government is the main political firm specific risk.
The second category is country specific risk. These are political risks that originate at the country level but also affect the MNE at the project or corporate level. One of them is transfer risk which concerns the problem of block funds and sovereign credit risk. Cultural and institutional risks spring from ownership structure, human resource norms, nepotism and corruption, intellectual property rights and protection.
The final category is global specific risks which are those political risks that originate at the global level but also affect the MNE at the project or corporate level. Examples are terrorism, the anti-globalization movement, environmental concerns, poverty and cyber attacks.
Remitting Cash Flow from the Joint Venture
Multinational firms often unbundle their transfer of funds into separate flows for specific purposes. This allows a multinational form to recover funds form subsidiaries without annoying host countries about large dividend drains. One method HW Technologies can use is by making payments to the parent for goods or services. Two, it can make payments for technology, trademarks, copyrights, management or other shared services. Three, it can also remit funds in the form of payments of interest to the parent for intra-company debt. These three approaches are before tax in the host country. The normal after tax approach is through the distribution of dividends to the parent.
Conclusion
Setting up a joint venture is a smart move as it will bring long term benefits. However, a careful analysis must be done not just in terms of exchange rate risk, but political risk as well. Other factors such as changes in tax rates must also be considered. Ultimately, the decision must be made to benefit the strategic interest of HW Technologies.
