CHAPTER 15 Current Liabilities Management 649letter of credit
A letter written by 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.
well known in the United States, some financial institutions are reluctant to lend
to U.S. exporters or importers, particularly smaller firms.Financing International Trade
Several specialized techniques have evolved for financing international trade. Per-
haps the most important financing vehicle is the letter of credit,a letter written by
a company’s bank to the company’s foreign supplier, stating that the bank guar-
antees payment of an invoiced amount if all the underlying agreements are met.
The letter of credit essentially substitutes the bank’s reputation and creditworthi-
ness 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, some-
times finance their international transactions through dollar-denominated loans
from international banks. The Eurocurrency loan marketsallow 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 consider-
able 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 How is the prime rate of interestrelevant to the cost of short-term bank
borrowing? What is a floating-rate loan?
15–5 How does the effective annual ratediffer between a loan requiring inter-
est payments at maturityand another, similar loan requiring interest in
advance?
15–6 What are the basic terms and characteristics of a single-payment note?
How is the effective annual rateon such a note found?
15–7 What is a line of credit?Describe each of the following features that are
often included in these agreements: (a)operating-change restrictions; (b)
compensating balance; and (c)annual cleanup.