Raising capital at the lowest possible cost, formulating capital structures and utilizing such capital to produce maximum value for your organization is a vital component to your success and the viability, profitability and future growth prospects of your firm. So when expansion plans consists of raising capital in a foreign currency there are various factors to consider to ensure your organization minimizes its risk.
A potential depreciation of the U.S. dollar will adversely increase the cost and value of a foreign liability as translated on your consolidated financial statements. In addition, if foreign revenue streams are not sufficient to cover liability payments during a potential U.S. dollar downturn; an increase in foreign note expense can potentially jeopardize working capital and erode profitability. Alternatively, servicing a U.S. dollar liability with foreign currency revenues can be a risk in an environment of an appreciating U.S dollar.
Another concern is the utilization of a foreign bank in which the working relationship is not as strong as the relationship with the home bank. In most circumstances, a longstanding relationship with the home bank can be leveraged to generate preferential cost structures and payment terms. Whereas negotiating advantageous terms with a newer banking relationship could potentially be a challenge. Furthermore the exposure to interest rate differentials and country specific financial regulatory regimes can add great complexity to achieving desired results.
One strategy to circumvent such concerns is the use of a currency swap. A currency swap is an effective tool that can be utilized to mitigate the risk and cost uncertainty associated with incurring a liability in a foreign currency. The swap will enable you to obtain access to foreign currency using locally raised capital (i.e., U.S. dollars) and will provide you fixed U.S. dollar exchange rates for future foreign currency revenues.
As an example, suppose an American company (XYZ Inc.) is planning on expanding to Mexico and is required to raise capital in Mexican Pesos to finance its project. XZY Inc. will also generate revenues in Mexican Pesos from the expansion. Let’s assume XZY Inc. has advantageous borrowing capacity in the United States with its local bank partner in U.S dollars. Mexican interest rate differentials have ranged between2.96 percent and 3.08 percent higher than US rates since October 2015. In February of this year it has increased to 3.66 percent*; the differential can be greater without a strong banking relationship in Mexico. In order to minimize its cost of capital, XZY Inc. can borrow in U.S. dollars and enter into a currency swap for Mexican pesos. Future Peso receivables can then be exchanged for U.S. dollars at the predetermined exchange rate of the swap without suffering any losses from market fluctuations.
Another consideration; Mexican revenue streams may initially be inadequate to service the note in the preliminary stages of the expansion. Consequently, the U.S. parent will be required to provide financial support in the period of non-self-sufficiency. A U.S. dollar liability will provide additional ease in budgeting the cash flow impact of servicing the debt for the U.S. parent. It will also reduce the risk of rising peso debt service costs due to adverse movements in the exchange rates.
Currency swaps are excellent asset/liability management tools that can help your organization reduce borrowing costs via the exchange of a liability or asset from one currency to another. In our example, a required peso note was made into a dollar liability with a currency swap in order to reduce financing costs by allowing XYZ Inc. to leverage its U.S. banking relationship to fund its international expansion and provide price stability on its peso denominated revenue. The currency swap will not be the appropriate tool in all expansion endeavors. However, it is an additional financial tool for consideration that can be utilized to generate cost savings and improve return on investment.
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