• To describe the multinational finance function and how its fits 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.
Firms that invest and operate abroad access both debt and equity capital in large global markets as well as in local markets. Chapter Nineteen highlights the external sources of funds available to MNEs, as well as the internal sources that come from interfirm linkages. It first explores global debt markets, global equity markets, and offshore financial centers. Then the types of foreign-exchange risk and the hedging strategies associated with foreign-exchange risk management are discussed. The chapter concludes with a discussion of international capital budgeting decisions, import and export financing, and tax issues facing MNEs.
OPENING CASE: Nu Skin Enterprises in Asia
Nu Skin Enterprises, a U.S.-based manufacturer and multilevel marketer of personal care and nutritional products, operates in 40 countries throughout Asia, the Americas, and
Europe. Japan is Nu Skin’s leading country market, generating 51% of revenues, followed by China with 10% (20% including Hong Kong and Taiwan). Nu Skin generally opens a new country market by starting with a single office, a warehouse, and up to 60 employees led by one U.S. expatriate manager. The U.S. corporate staff allocates start-up funds from internal sources; retained earnings generally finances future growth.
Exchange rate volatility has always affected the firm’s bottom line, but never more so
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than in Japan, where a weakening yen translated into millions of dollars of losses in exchange rate exposure. Consequently, Nu Skin implemented the use of hedging strategies to reduce the risk of currency fluctuations. It entered into forward contracts to guarantee the value of its receivables and began to borrow in local currencies to help to stabilize its revenues.
Teaching Tip: Review the PowerPoint slides for Chapter 19 and select those you find most useful for enhancing your lecture and class discussion. For additional visual summaries of key chapter points, also the review the map, table, and figures in the text.
I. INTRODUCTION
MNEs access both local and global capital markets in order to finance their operational and expansion activities. Critical functions associated with the management of international cash flows are global borrowing, equity placement, and foreign exchange risk minimization.
II. THE TREASURY AND FINANCE FUNCTIONS
Cash flow management is divided into four major areas: (i) capital structure, (ii) capital budgeting, (iii) long-term financing and (iv) working capital management. It is the responsibility of an organization’s chief financial officer (CFO) to acquire
(generate) and allocate (invest) financial resources among activities and projects.
This job becomes increasingly complex in the global environment because of factors such as foreign-exchange risk, currency flows and restrictions, differing tax rates and laws and regulations regarding access to capital.
III. CAPITAL STRUCTURE
Capital structure is the mix between long-term debt and equity. The degree to which a firm funds the growth of business by debt is known as leverage . The amount of leverage used varies from country to country. A company’s choice of capital structure depends on tax rates, degree of development of local equity markets, and creditor rights within its country and in other countries. Companies can raise funds in both local and international debt and equity markets (such as the Eurodollar,
Eurobond, and Euroequity markets) as well as raise internal funds from the corporate family.
IV. OFFSHORE FINANCIAL CENTERS
Offshore financing is the provision of financial services by banks and other agents to nonresidents of a country. Offshore financial centers (OFC) are city-states or countries that provide large amounts of funds in currencies other than their own and are used as locations in which to raise and accumulate cash; they represent major centers for the Eurocurrency market. OFCs are (i) jurisdictions that have relatively large numbers of financial institutions engaged primarily in business with nonresidents, (ii) financial systems with external assets and liabilities out of proportion with domestic needs, (iii) are a tax haven country (a country with low or
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no taxation), have moderate to light financial regulation, and offer banking secrecy and anonymity.
Generally, OFCs provide a more flexible and less expensive source of funding for MNEs and exhibit one or more of the following characteristics:
• a large foreign-currency (Eurocurrency) market for deposits and loans
• a large net supplier of funds to the world financial markets
• 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.
Such centers are either operational centers, with extensive banking activities involving short-term financial transactions (e.g., London), or booking centers, in which little actual banking activities takes place but in which transactions are recorded to take advantage of secrecy laws and/or low or no tax rates (e.g., the
Cayman Islands). The Organization for Economic Cooperation and Development
(OECD) has been working closely with the major OFCs to ensure that they are engaged in legal activity and to eliminate harmful tax practices such as having low or no taxes on relevant income, separating non-resident financial activities from those of residents, lacking transparency and regulatory supervision, and lacking the effective exchange of information with other countries.
POINT-COUNTERPOINT:
Offshore Financial Centers Should Be Shut Down
POINT: OFCs operate in a shroud of secrecy that allows companies to engage in illegal and unethical behavior. Enron, one of the largest bankruptcies in corporate history, created hundreds of subsidiaries in tax havens and used them to pass off corporate debs, losses, and executive compensation. Parmalat used a similar strategy, establishing shell companies in the Caribbean to capture cash through fake invoices and credits. Terrorists and drug dealers also use OFCs to launder money.
COUNTERPOINT: Despite examples of corporate malfeasance, OFCs serve useful and ethical purposes. They allow subsidiaries to take advantage of lower borrowing costs and tax rates—activities that are not illegal. More and more countries are taxing offshore earnings, making it harder for companies to avoid paying taxes. The key is to improve transparency and reporting so that illegal activities can be curtailed.
V. CAPITAL BUDGETING IN A GLOBAL CONTEXT
Capital budgeting is the process whereby MNEs determine which projects and countries will receive capital investment funds. Several approaches to capital
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budgeting are possible. One method uses a payback period
—the number of years required to recover the initial investment made. Another method is to determine the net present value (NPV) of a project, which is a function of the annual free cash flow in a period, the required rate of return or cost of capital, the initial outlay of cash, and the project’s expected life. A third approach is to compute the internal rate of return—the rate that equates the present value of future cash flows with the present value of the initial investment. Several aspects of capital budgeting are unique to foreign project assessment:
•
Parent cash flows must be distinguished from project cash flows
•
Remittance of funds to the parent (such as dividends, interest on loans, payment of intracompany receivables and payables) is affected by differing tax systems, legal and political constraints on the movement of funds, local business norms, and differences in how financial markets and institutions function.
•
Differing rates of inflation
•
Unanticipated exchange-rate changes
• Political risk in the target market
•
The terminal value of the project is difficult to estimate because potential purchasers from host, home, or third countries may have widely divergent views on the project’s value
VI. INTERNAL SOURCES OF FUNDS
Funds refer to working capital, i.e., the difference between current assets and current liabilities. Internal sources of funds include loans, investment through equity capital, interfirm receivables and payables and dividends. Interfirm financial links become extremely important as MNEs grow in size and complexity. Funds can flow from parent to subsidiary, subsidiary to parent and/or subsidiary to subsidiary. Goods, services and funds all can move within an MNE, thus creating receivables and payables. Entities may choose to pay quickly (a leading strategy) or to defer payment
(a lagging strategy). Transfer pricing can be used to adjust the size of a payment. In addition, firms can generate cash from normal operations. Whatever the means, international cash management is complicated by differing inflation rates, fluctuating exchange rates and distinct national and regional bloc policies regarding the flow of funds.
A. Global Cash Management
Global cash management strategy focuses on the flow of money to serve specific operating objectives. Effective cash management hinges on the following questions:
•
What are the local and corporate system needs for cash?
•
How can the cash be withdrawn from subsidiaries and centralized?
• Once the cash has been centralized, what should be done with it?
Cash budgets and forecasts are essential in assessing a firm’s cash needs. Cash may be transferred within a firm via dividends, royalties, management fees and the repayment of principal and interest on loans.
B. Multilateral Netting
Netting is the process of coordinating cash inflows and outflows among subsidiaries so that only net cash is transferred, reducing transaction costs.
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Multilateral netting allows subsidiaries to transfer net intercompany flows to a cash center, or clearing account, which disburses cash to net receivers.
VII. CASH FLOW ASPECTS OF IMPORTS AND EXPORTS
The basic methods of payment for exports, listed in descending order in terms of security to the exporter, are:
•
Cash in advance
•
Letter of credit
•
Draft or bill of exchange
•
Open account
Company payments in a domestic setting are usually made as a draft or commercial bill of exchange (mainly bank checks and other related instruments). Documentary drafts and documentary letters of credit are used to protect both the buyer and the seller. With a sight draft the exporter requests immediate payment. A time draft allows payment to be made later—for example, 30 days after delivery. A letter of credit (L/C) obligates the buyer’s bank to pay the exporter, thereby adding a level of payment protection to the exporter beyond the sight or time drafts. A revocable letter of credit may be changed by any of the parties to the agreement, while an irrevocable letter of credit requires all parties to agree to any change in the documents. A confirmed letter of credit involves a guarantee of an additional bank. An exporter may occasionally sell on open account in which the exporter bills the importer but does not require formal payment documents. This is generally used only when the parties to the transaction are members of the same corporate group.
VIII.FOREIGN-EXCHANGE RISK MANAGEMENT
Major financial risks arise from foreign exchange rate fluctuations. Strategies to protect against such risks may include the internal movement of funds, as well as the use of foreign-exchange instruments such as options and forward contracts . The three types of foreign-exchange risk include translation exposure, transaction exposure and economic exposure .
A. Translation Exposure.
Translation exposure reflects the foreign-exchange risk that occurs because a parent company must translate foreign-currency financial statements into the reporting currency of the parent, i.e., the value of the exposed asset or liability changes as the exchange rate changes.
B. Transaction Exposure.
Transaction exposure reflects the foreign-exchange risk that arises because a firm has outstanding accounts receivable or payable that are denominated in a foreign currency, i.e., the receivable or payable changes in value as the relevant exchange rate changes.
C. Economic Exposure.
Economic or operational exposure reflects the foreign-exchange risk MNEs face in the pricing of products, the source and cost of inputs and the location of investment, i.e., it arises from the effects of exchange-rate fluctuations on expected cash flows.
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D. Exposure-Management Strategy
Management must do a number of things if it wishes to protect assets from exchange-rate risk.
1.
Defining and Measuring Exposure.
An MNE must forecast the degree of exposure in each major currency in which it operates and adopt appropriate hedging strategies for each. A key aspect of measuring exposure is forecasting exchange rates, where the major concerns are the direction, magnitude and timing of exchange-rate fluctuations.
2. A Reporting System. A firm must devise a uniform reporting system for all its entities that identifies the exposed accounts it wants to monitor, the amount of the exposure by currency of each account and the different periods under consideration. The system should combine central control with input from foreign operations. Exposure should be separated into translation, transaction and economic components, with the transaction exposure identified by cash inflows and outflows over time. Specific hedging strategies can be taken at any level, but each level of management must be aware of the size of the exposure and its potential impact on the firm.
3. A Centralized Policy.
To achieve maximum effectiveness in hedging, top management should determine hedging policy. Most MNEs prefer to cover exposure, rather than extract huge profits or risk huge losses.
4. Formulating Hedging Strategies.
A firm can hedge its position by adopting operational and/or financial strategies, each with cost/benefit and operational implications. Firms may choose to balance local assets with local debt by borrowing funds locally, because that helps avoid the foreignexchange risk associated with borrowing in a foreign currency. They may also choose to take advantage of leads and lags for interfirm payments. A lead strategy means collecting foreign-currency receivables before they are due when the currency is expected to weaken, or paying foreign-currency payables before they are due when a currency is expected to strengthen. A lag strategy means delaying collection of foreign-currency receivables if the currency is expected to strengthen, or delaying payment of foreigncurrency payables when the currency is expected to weaken. However, such strategies may not be useful for the movement of large blocks of funds, and they may also be subject to government restrictions. A firm can also hedge exposure through forward contracts, which establish fixed exchange rates for future transactions and currency options, i.e., derivatives , which assure access to a foreign currency at a fixed exchange rate for a specific period of time. A foreign-currency option is more flexible than a forward contract because it gives the purchaser the right, but does not impose the obligation, to buy or sell a certain amount of foreign currency at a set exchange rate within a specified amount of time.
IX. TAXATION OF FOREIGN SOURCE INCOME
Taxes can profoundly affect profitability and cash flow, especially in international
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business. Taxation has a strong impact on several choices including:
•
Location of operations
• Choice of operating form (export/import, licensing, overseas investment)
•
Legal form of the enterprise (branch or subsidiary)
•
Use of facilities in tax haven countries to raise capital and manage cash
• Method of financing (internal or external sourcing, debt or equity)
•
Capital budgeting decisions
•
Method of setting transfer prices
Two major types of taxes are income taxes and excise taxes.
A. Foreign Branch
Since a foreign branch is an extension of the parent company, any foreign branch income (or loss) is directly included in the parent’s taxable income.
B. Foreign Subsidiary
A foreign corporation is an independent legal entity set up in a country according to the laws of incorporation of that country. When an MNE purchases or establishes such an entity, it is called a subsidiary. Subsidiary income is either taxable to the parent or tax deferred (not taxed until it is submitted as a dividend to the parent). The tax status of a subsidiary depends on whether the subsidiary is a controlled foreign corporation (CFC) and whether the income is active or passive. In a CFC, U.S. shareholders hold more than 50% of the voting stock. Active income is derived from the direct conduct of a trade or business. Passive, or subpart F income , comes from sources other than those connected with the direct conduct of a trade or business (generally in tax haven countries). Subpart F income includes holding company income , sales income , and service income .
C. Transfer Prices
Transfer pricing applies to transactions between related entities and is not usually an arm’s length price
(price between two unrelated entities).
Companies establish arbitrary transfer prices primarily because of differences in taxation between countries. The OECD, however, is very concerned about the way companies manipulate transfer prices in order to minimize tax liability and has set transfer pricing guidelines to eliminate this manipulation.
D. Tax Credit
In the United States, the IRS allows a tax credit for corporate income tax for tax that U.S. companies pay to another country in order to avoid double taxation.
E. Non-U.S. Tax Practices
MNEs face problems from differences in tax practices around the world such as a lack of familiarity with laws and loose enforcement. Corporate tax rates vary from country to country, ranging from a low of 8.5% to a high of 42.2%.
Taxation of corporate income occurs through either the separate entity (or classical) approach or the integrated system approach. In the separate entity approach, each separate unit (company or individual) is taxed when it earns income. In the integrated system, double taxation is reduced or eliminated through the use of split tax rates or tax credits.
F. Value-Added Tax
Value-added tax (VAT) has been in existence since 1967 in most Western
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European countries. Under a VAT, each company pays a percentage of the value added to a product at each stage of the business process. The EU has worked hard to reduce and standardize VAT rates among its members.
G. Tax Treaties: The Elimination of Double Taxation
The purpose of tax treaties is to prevent double taxation or to provide remedies when it occurs. When agreeing to a treaty, countries generally grant reciprocal reduction on dividend withholding and exempt royalties, and sometimes interest payments, from any withholding tax.
LOOKING TO THE FUTURE:
Technology and Cash Flows
Companies will look for ways to drive down borrowing costs in order to improve performance. Greater emphasis will be placed on moving corporate cash worldwide to take advantage of differing rates of return. The explosion of information and technology and the growing number and sophistication of hedging instruments will significantly influence cash management. The cost of information will continue to decline and the speed with which it is available and transferred will continue to increase. Banks will continue to develop new derivative instruments to help companies hedge interest rate and exchange rate exposures, but new accounting standards will force companies to recognize gains and losses from derivatives in income. The OECD, IMF, and EU will help countries narrow their tax differences and crack down on the illegal transfer of money for illegal purposes.
CLOSING CASE: Dell Mercosur [See Figure 19.10]
Dell Mercosur is the South American subsidiary of Dell Computer. The company maintains a production facility in Brazil, as well as a call center that services both Brazil and Argentina. Dell’s revenues and operating costs in Brazil are almost entirely denominated in reels, but about 97% of Dell’s manufacturing costs in Brazil are denominated in U.S. dollars due to the company’s use of imported parts and components from the U.S. The company uses foreign currency option contracts and forward contracts to hedge its exposure on forecasted transactions.
QUESTION
1. Given how Dell translates its foreign currency financial statements into dollars, how would a falling Brazilian real affect Dell Mercosur’s financial statements? What about a rising real?
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Dell Mercosur’s revenues, income statement (operating income) and balance sheet
(shareholder’s equity) would all be affected by a falling real . With respect to revenues, as the value of the real falls, the value of foreign revenues would also fall.
Subsequently, the translated value of the revenues on the consolidated, U.S.-dollardenominated income statement would decline as well. Foreign operating income would also decline when the home-country’s currency strengthens. Shareholder’s equity reflects assets minus liabilities. If all of Dell’s subsidiaries have their assets and liabilities based on financial instruments in the same currency, then the value of the foreign- currency denominated assets would fall, but so would the value of the foreign-currency denominated liabilities. In relative terms, equity would remain unchanged, although it would also translate into its U.S.-dollar equivalent at a lower value. A rising real would have the opposite effect.
2.
Dell imports about 97 percent of its manufacturing costs. What type of exposure does this create for it? What are its options to reduce that exposure?
Primarily, the fact that Dell Mercosur imports nearly all of its manufacturing costs impacts transaction exposure , because the transfer price payable changes in value as the U.S. dollar/Brazilian real rate changes. When the value of the real declines with respect to the dollar, the use of a lead strategy , i.e., paying for imports before they are due, will minimize costs to Dell Mercosur. The subsidiary can also hedge its exposure through forward contracts and foreign currency options.
3.
Describe and evaluate Dell’s exposure management strategy.
Dell’s objective in managing its foreign currency exchange rate fluctuations is to reduce the impact of adverse fluctuations on earnings and cash flows associated with foreign currency exchange rate changes. Accordingly, Dell uses foreign-currency options contracts and forward contracts to hedge its exposure on forecasted transactions and company commitments. Dell also uses purchased options contracts and forward contracts as cash flow hedges. Hedged transactions include international sales by U.S.-dollar functional currency entities, foreign-currency denominated purchases of certain components and interfirm shipments to certain international subsidiaries. Dell also uses forward contracts to hedge monetary assets and liabilities that are denominated in a foreign currency. Because Dell’s strategy is to hedge all foreign-exchange risk, it is considered to be a very aggressive strategy. Rather than attempting to extract huge profits, Dell has chosen to avoid huge losses.
4.
Build a graph on the value of the real against the dollar by quarter since the third quarter of 2002. What has happened to the value of the real? Based on the change in the exchange rate, how would you evaluate Dell’s hedging philosophy and strategy?
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Brazilian Real/U.S. Dollar
3.5
3
2.5
2
1.5
1
0.5
Real/Dollar
0
20
03
-1
20
03
-2
20
03
-3
20
03
-4
20
04
-1
20
04
-2
20
04
-3
20
04
-4
20
05
-1
20
05
-2
20
05
-3
20
05
-4
20
06
-1
The value of the real has declined since the end of 2002. Dell’s hedging philosophy and strategy needed to change to adapt to a falling real. Still, hedging against currency fluctuations is beneficial regardless of the direction of the currency change.
WEB CONNECTION
Teaching Tip: Visit www.prenhall.com/daniels for additional information and links relating to the topics presented in Chapter Nineteen. Be sure to refer your students to the online study guide, as well as the Internet exercises for Chapter
Nineteen.
_________________________
C HAPTER T ERMINOLOGY : offshore financing, p. 676 offshore financial centers (OFC), p. 677 tax haven country, p. 677 open account, p. 685 translation exposure, p. 686 transaction exposure, p. 686 economic or operational exposure, payback period, p. 680 net present value (NPV), p. 680 netting, p. 683 draft, p. 684 p. 686 lead strategy, p. 689 lag strategy, p. 689 currency option, p. 689 commercial bill of exchange, p. 684 sight draft, p. 684 time draft, p. 684 letter of credit (L/C), p. 684 revocable letter of credit, p. 684 irrevocable letter of credit, p. 684 confirmed letter of credit, p. 685
_________________________ controlled foreign corporation
(CFC), p. 691 active income, p. 692 subpart F income, p. 692 arm’s-length price, p. 693 transfer pricing, 693 value-added tax (VAT), p. 696
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ADDITIONAL EXERCISES: Multinational Finance
Exercise 19.1.
When using capital budgeting techniques to evaluate a potential foreign project, a firm needs to recognize the specific political and economic risks
(including foreign-exchange risk ) arising from that foreign location. Ask students to compare the advantages of (i) using a higher discount rate and (ii) forecasting lower cash flows to evaluate such projects.
Exercise 19.2.
Typically, the cost of capital is lower in the global capital market than in domestic capital markets. Other things being equal, firms will likely prefer to finance their investments by borrowing from the global capital market. However, such borrowing may be restricted by host-country regulations or demands. Ask the students to discuss the point at which firms should consider using the global equity markets to finance foreign investments and operations in lieu of the global debt markets. Are firms likely to encounter restrictions in the equity markets as well?
What are the effects of such restrictions likely to be on a firm’s investment and operating decisions?
Exercise 19.3.
The number of foreign corporations listing American Depository
Receipts (ADRs) on the U.S. stock exchanges has increased dramatically since the early 1980s. Ask students to discuss this phenomenon in light of the recent global economic downturn. Do students foresee an increase in demand for either global depository receipts or European depository receipts in the near future? Why or why not? Be sure they consider the benefits of depository receipts to both firms and potential investors.
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