The letter of credit essentially substitutes the

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Unformatted text preview: y a company’s bank to the company’s foreign supplier, stating that the bank guarantees payment of an invoiced amount if all the underlying agreements are met. The letter of credit essentially substitutes the bank’s reputation and creditworthiness for that of its commercial customer. A U.S. exporter is more willing to sell goods to a foreign buyer if the transaction is covered by a letter of credit issued by a well-known bank in the buyer’s home country. Firms that do business in foreign countries on an ongoing basis often finance their operations, at least in part, in the local market. A company that has an assembly plant in Mexico, for example, might choose to finance its purchases of Mexican goods and services with peso funds borrowed from a Mexican bank. This not only minimizes exchange rate risk but also improves the company’s business ties to the host community. Multinational companies, however, sometimes finance their international transactions through dollar-denominated loans from international banks. The Eurocurrency loan markets allow creditworthy borrowers to obtain financing on very attractive terms. Transactions Between Subsidiaries Much international trade involves transactions between corporate subsidiaries. A U.S. company might, for example, manufacture one part in an Asian plant and another part in the United States, assemble the product in Brazil, and sell it in Europe. The shipment of goods back and forth between subsidiaries creates accounts receivable and accounts payable, but the parent company has considerable discretion about how and when payments are made. In particular, the parent can minimize foreign exchange fees and other transaction costs by “netting” what affiliates owe each other and paying only the net amount due, rather than having both subsidiaries pay each other the gross amounts due. Review Questions 15–4 15–5 15–6 15–7 How is the prime rate of interest relevant to the cost of short-term bank borrowing? What is a floating-rate loan? How does the effective annual rate diff...
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