International Business
Chapter Nineteen
The Multinational Finance
Function
Chapter Objectives
• To describe the multinational finance function and how it fits
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in the MNE’s organizational structure
To show how companies can acquire outside funds for normal
operations and expansion
To explore how offshore financial centers are used to raise
funds and manage cash flows
To explain how companies include international factors in the
capital budgeting process
To discuss the major internal sources of funds available to
the MNE and to show how these funds are managed globally
To explain how companies pay for exports and imports
To describe how companies protect against the major financial risks of inflation and exchange rate movements
To highlight some of the tax issues facing MNEs
19-2
Introduction
• The role of corporate financial manage-
•
ment is to create and maintain economic
value by maximizing shareholder wealth,
i.e., the market value of existing shareholders’ common stock.
The corporate finance function focuses upon the
acquisition and allocation of financial resources
among a firm’s activities and investments, i.e.,
short-term and long-term cash flows.
MNEs access both local and global capital markets
to finance their current and future operations.
19-3
Financial Management Activities
Activities related to the management of international
cash flows include:
• capital structure management: determining the proper
•
•
•
mix of debt and equity
long-term financing: selecting, issuing, and managing
long-term debt and equity capital, both at home and
abroad
capital budgeting: determining which projects in which
countries will receive capital investment funds
working capital management: properly managing the
firm’s current assets and liabilities [cash, receivables, marketable securities, inventory, trade receivables and payables,
short-term bank debt]
19-4
Fig. 19.1: Finance in
International Business
19-5
The Role of the Chief Financial Officer
Chief Financial Officer (CFO): the executive responsible
for acquiring and allocating a firm’s financial resources
Financial resource acquisition (financing): internally or
externally generating funds at the lowest possible cost
Financial resource allocation (investing): increasing
shareholder wealth through the allocation of funds to
selected projects and investment opportunities
• The CFO’s job becomes increasingly complex in a global
environment because of foreign exchange risk, currency flows and restrictions, political and economic
risk, differences in tax rates and laws, regulations
regarding access to capital, etc.
19-6
Fig. 19.2: Location of the Treasury Function
in the Corporate Organizational Structure
19-7
Capital Structure
Leverage: the degree to which a firm funds the
growth of its business through borrowing (debt)
Weighted average cost of capital:
weighted
after-tax
proportion
cost
average cost = cost of × of debt + of
of capital
debt
financing
equity
proportion
× of equity
financing
• The interest that firms pay on debt is tax-deductible,
•
whereas dividends paid to investors are not.
Country-specific factors are a more important determinant of a firm’s capital structure than any other factor.
Excessive reliance on long-term debt increases financial risk
and thus requires a higher return.
19-8
Capital Structures Around the World:
Ranked by Common Equity Ratios, 1995
COUNTRY
EQUITY
United Kingdom 68.3%
United States
48.4%
Canada
47.5%
Germany
39.7%
France
38.8%
Japan
33.7%
Italy
23.5%
TOTAL
31.7%
51.6%
52.5%
60.3%
61.2%
66.3%
76.5%
LONGTERM
DEBT
N/A
26.8%
30.2%
15.6%
23.5%
23.3%
24.2%
SHORTTERM
DEBT
N/A
24.8%
22.7%
44.7%
43.0%
43.0%
52.3%
Source: Scott Besley and Eugene F. Brigham, 2005. Essentials of Managerial Finance, 13th Ed.
19-9
Choice of Capital Structure
• A firm’s choice of capital structure depends upon:
– tax rates
– the degree of development of local equity markets
– creditor rights
• MNEs have an advantage because they can tap local
•
debt and equity markets, foreign debt and equity
markets, and internal funds from the corporate family.
Different tax rates, dividend remission policies, and
foreign exchange controls may cause a firm to rely more
on debt in some situations and more on equity in others.
The lack of the development of the bond and equity markets
in Southeast Asia led to excessive dollar bank debt and was
a major cause of the Asian financial crisis of 1997.
19-10
Offshore Financial Centers
Offshore financing: the provision of financial services
by banks and other agents to nonresidents, i.e., the
borrowing of money from and the lending of money
to nonresidents
Offshore financial centers (OFCs): countries or citystates that (i) provide large amounts of funds in currencies other than their own and thus are centers for
the Eurocurrency market and (ii) are used as locations
in which to raise and/or accumulate cash
• OFCs offer low or zero taxation, moderate or light financial
regulation, and banking secrecy and anonymity.
The OECD is working to eliminate the harmful tax practices
of tax-haven countries by improving their transparency and
the effective exchange rate information they provide.
19-11
OFC Characteristics
An offshore financial center possesses one or more of
the following characteristics:
• a large foreign currency (Eurocurrency) market for
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•
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deposits and loans
a market that serves as a large, net supplier of funds to
the world’s financial markets
a market that serves as an intermediary or pass-through
for international loan funds
economic and political stability
an efficient and experienced financial community
good communications and supportive services
an official regulatory climate that is favorable to the
financial industry
[continued]
19-12
OFCs are either:
• operational centers, with extensive banking activities
involving short-term financial transactions
[e.g., London, Singapore, Switzerland]
or
• booking centers, in which little banking activity takes
place but where transactions are recorded to take
advantage of secrecy laws and/or low or no tax rates
[e.g., Bahrain, the Bahamas, the Cayman Islands,
the Netherlands Antilles]
Offshore financial centers offer a more flexible and less expensive
source of funding for MNEs.
19-13
Capital Budgeting
Capital budgeting: the process whereby firms deter-
mine which projects in which countries will receive
capital investment funds
• MNEs determine their free cash flows based on cash flow
estimates and tax rates in different countries as well as an
appropriate required rate of return adjusted for risk.
• Capital budgeting techniques include:
– payback period: the number of years required to recover the
original investment
– the net present value of a project (NPV): the present value
of future cash outflows minus the present value of future
cash inflows
– the internal rate of return (IRR): the rate that equates the
present value of future cash flows with the present value of
the initial investment
19-14
Capital Budgeting:
Foreign Project Assessment
Unique capital budgeting aspects of foreign project
assessment include:
• distinguishing parent cash flows from project cash flows
• accounting for the effects of legal and political con-
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•
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straints on the movement and remittance of funds
anticipating differing rates of inflation and exchange rate
fluctuations
evaluating potential economic and political risk
estimating the terminal value of a project
[continued]
19-15
Ways to deal with the variations in future cash flows in
the capital budgeting process include:
• developing optimistic, most likely, and pessimistic
scenarios
• adjusting the hurdle rate, i.e., the minimum required rate
of return, for a project
Once a budget is complete, the return must be considered in terms of both (i) local currency and
(ii)
the parent’s currency.
Finally, capital budgeting decisions must ultimately be
made in the strategic context of related investments, as well as their financial context.
19-16
Internal Sources of Funds
Funds: working capital, i.e., current assets minus
current liabilities
• Internal sources of funds include:
– operations: intercompany receivables and payables,
dividends
– financing activities: securing loans, issuing bonds, selling
shares
• Uses of funds include:
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–
–
–
the purchase of fixed assets
the purchase of materials and supplies
paying employee wages and benefits
investing in marketable securities and/or long-term
investments
19-17
Fig. 19.4: Internal Sources
of Funds for MNEs
19-18
Global Cash Management
Global cash management is complicated by differing
inflation rates, exchange rate fluctuations, and government restrictions on the flow of funds.
• To ensure effective cash management, three questions must be answered:
•
– What are the local and corporate system needs for cash?
– How can cash be withdrawn from foreign operations and
centralized?
– Once cash is centralized, how should it be used?
Dividends are a good source of intercompany transfers,
but governments often restrict their free movement.
Cash can also be remitted through royalties, management
fees, and the repayment of principal and interest on loans.
19-19
Fig. 19.5: Multilateral Cash Flows
in the Absence of Netting
19-20
Multilateral Netting
Multilateral netting: the process of coordinating cash
inflows and outflows among subsidiaries so that only
net cash is transferred, thus minimizing transaction
costs
• Multilateral netting allows subsidiaries to transfer net
intercompany flows to a cash center, or clearing account,
which then disburses cash to net receivers.
• Netting requires sophisticated software and good
banking relationships in relevant countries.
Generally, transfers take place in the payer's currency,
and the foreign exchange conversion takes place centrally.
19-21
Net Positions of Subsidiaries in
Four European Countries (IN $US)
SUBSIDIARY
TOTAL
RECEIVABLES
TOTAL
PAYABLES
NET
POSITION
French
German
Italian
British
$250,000
$250,000
$150,000
$300,000
$350,000
$100,000
$300,000
$200,000
($100,000)
$150,000
($150,000)
$100,000
Net position = total receivables minus total payables.
19-22
Fig. 19.6: Multilateral Netting
19-23
Cash Flow Aspects of Imports and
Exports
In terms of security to the exporter, the basic
methods of payments for exports are:
• cash in advance
• letter of credit (L/C): obligates the buyer’s bank to pay
the exporter either at sight or in time [may be revocable
or irrevocable and/or confirmed by an additional bank]
• draft or commercial bill of exchange: either paid immediately via a sight draft or later via a time draft
• open account: generally reserved for
members of the same corporate group
Documentary drafts and letters of credit require that payment be
made upon presentation of documents conveying the title.
19-24
Fig. 19.7: Letter of Credit Relationships
19-25
Foreign Exchange Risk Management
Types of exposure that can result from foreign
exchange fluctuations include:
• translation exposure: the change in value of an
exposed asset or liability due to exchange rate changes
[the gain or loss does not represent an actual cash flow
effect because it is only translated, not converted]
• transaction exposure: the change in value of a payable or receivable due to exchange rate changes
[foreign exchange risk]
• economic (operating) exposure: the potential change
in expected cash flows arising from product prices, the
sourcing and cost of inputs, the location of investments,
and the competitive position of the firm
[cash flow impact may be both immediate and long-term]
19-26
Exposure Management Strategy
To adequately protect assets, management must:
• define and measure all three types of exposure
• organize and implement a uniform reporting system to
monitor exposure and exchange rate movements using
both central control and foreign input
• adopt a centralized hedging policy that assigns responsibility for minimizing exposure
• formulate operational and/or financial strategies for
hedging exposure
The safest position is a balanced one in which
exposed assets equal exposed liabilities.
19-27
Hedging Strategies
Operational strategies: adjusting the flow of money and
other resources in normal operations so as to reduce
foreign exchange risk
• the use of local debt to balance local assets
• lead strategies, i.e., collecting foreign currency receivables
before they are due when that currency is expected to
weaken, or paying foreign currency payables before they
are due when that currency is expected to strengthen
• lag strategies, i.e., delaying the collection of foreign currency receivables when that currency is expected to
strengthen, or delaying the payment of foreign currency
payables when that currency is expected to weaken
• shifting assets overseas to capture advantages embedded
in currency fluctuations
[continued]
19-28
Financial strategies: using the forward
market
to specify future exchange rates
• using forward contracts to establish fixed exchange rates
for future transactions
• using currency options to ensure access to a foreign currency at a fixed exchanged rate for a specific period of
time
By consolidating its foreign currency exposure, a firm
can net its exposures from different operations around
the world and thus take advantage of natural offsets.
Both operational and financial hedging strategies
have cost/benefit as well as operational implications.
19-29
Taxation of Foreign Source Income
Taxation can profoundly affect profitability and cash
flow via the following decisions:
• the location of operations
• the choice of operating form (trade, licensing, FDI)
• the legal form of a foreign enterprise (branch vs.
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subsidiary)
the location of facilities in tax haven countries to raise
capital and manage cash
the methods of financing (external sourcing, debt, or
equity)
capital budgeting
transfer pricing methods
19-30
Legal Forms of Foreign Enterprises
Foreign branch: a foreign extension of the parent
company [profits or losses are directly included in
the parent’s taxable income]
Foreign subsidiary: an independent legal entity established in a foreign country according to its laws of
incorporation
[income is either reinvested in the subsidiary or
remitted as a dividend to the parent company]
Controlled foreign corporation (CFC): a foreign corporation in which more than 50 percent of the
voting stock is held by U.S. shareholders
[a U.S. shareholder is any U.S. person or company that
holds 10 percent or more of the CFC’s voting stock]
19-31
Determination of Controlled
Foreign Corporations
PERCENTAGES OF VOTING STOCK
FOREIGN
FOREIGN
FOREIGN
CORPORATION CORPORATION CORPORATION
SHAREHOLDER
A
B
C
U.S. person V
U.S. person W
U.S. person X
U.S. person Y
Foreign person Z
100%
45%
10%
20%
25%
30%
10%
8%
8%
44%
Total
100%
100%
100%
19-32
Active vs. Passive Income
Active income: derived from the direct conduct of
trade or business of the foreign subsidiary of a U.S.
corporation
Passive income (Subpart F income): usually derived
from the operations of a foreign subsidiary of a U.S.
corporation in a tax-haven country via:
• holding company income
• sales income
• service income
The U.S. government treats any country whose income tax is
lower that that of the United States as a tax-haven country.
19-33
Fig. 19.8: A Tax-haven Subsidiary
as a Holding Company
19-34
Fig. 19.9: Tax Status of Active Subpart F Income
from Foreign Operations of U.S. Companies
19-35
Transfer Prices and Tax Credits
Transfer price: the price at which one member of a
corporate family sells (transfers) inputs, components, finished goods and/or services to another
entity, i.e., an internal price
Arm’s-length price: the price between two parties
that have no ownership interest in the other, i.e., an
external market price
Tax credit: a dollar-for-dollar reduction of a U.S. tax
liability that directly coincides with the recognition
of income
The OECD has established transfer pricing guidelines in order to
eliminate the manipulation of prices and taxes paid by MNEs.
19-36
Non-U.S. Tax Practices
Variations in countries’ generally accepted accounting
principles (GAAPs) can lead to differences in their
determinations of taxable income.
• Corporate tax rates may be determined by:
– the separate entity (classical) approach: taxes each separate
entity (firm or individual) when it earns income
– the integrated system approach: splits tax rates and/or gives
tax credits in order to avoid the double taxation of corporate
income
• Taxes on the earnings of foreign subsidiaries may be
determined by:
– the territorial approach: taxes only domestically-sourced
income
– the global approach: taxes both the profits of foreign
branches and dividends received from foreign subsidiaries
19-37
Selected Corporate Income Tax Rates
Cent.Gov. Adj.Cent. Sub-cent. Combined
Corp.
Gov.Corp. Gov.Corp.
Corp.
Targeted
Inc.Tax
Inc.Tax
Inc.Tax
Inc.Tax Corp.Tax
COUNTRY
Rate
Rate
Rate
Rate
Rate
Australia
34.0
34.0
34.0
Yes
Canada
29.1
29.1
15.5
44.6
Yes
Finland
29.0
29.0
29.0
No
Germany
42.2
35.0
17.0
52.0
No
Hungary
18.0
18.0
18.0
Yes
Ireland
24.0
24.0
24.0
Yes
Japan
30.0
27.4
13.5
40.9
Yes
Korea
28.0
28.0
2.8
30.8
Yes
Norway
28.0
28.0
28.0
Yes
Switzerland
8.5
6.38
18.54
24.9
No
United Kingdom 30.0
30.0
30.0
Yes
United States
35.0
32.7
6.7
39.4
Yes
Source: OECD Tax Rate Base, May 30,2005.
19-38
The VAT and Tax Treaties
Value added tax: each independent firm is taxed a
percentage of the value added at each stage of the
business process
Tax treaty: a treaty between two nations that usually
results in a reciprocal reduction on dividend withholding taxes, as well as the exemption of taxes on
royalties and, occasionally, interest payments
• The primary purpose of tax treaties is to prevent inter-
national double taxation, or to provide remedies when it
occurs.
The OECD, the IMF, and the EU are all working to help
nations narrow their tax differences and crack down on
the illegal transfer of money for illegal purposes.
19-39
Implications/Conclusions
• MNEs may employ internal capital markets in
•
order to overcome imperfections in external
capital markets.
Offshore financial centers represent jurisdictions
with relatively large numbers of financial institutions primarily engaged in business with nonresidents.
[continued]
19-40
• Exchange rate fluctuations can influence the
•
equivalency of foreign currency financial statements, the amount of cash that can be earned
from foreign currency transactions, and a firm’s
production and marketing decisions.
International tax planning has a strong impact
on the choice of location for the initial investment, the legal form of a new enterprise, the
method of financing, and the method of setting
transfer prices.
19-41