International Business
by
Daniels and Radebaugh
Chapter 20
The Multinational
Finance Function
© 2001 Prentice Hall
20-1
Objectives
To describe the multinational finance function and how it fits in the
MNE’s organization structure
To show how companies can acquire outside funds for normal
operations and expansion
To discuss the major internal sources of funds available to the MNE
and show how these funds are managed globally
To explain how companies protect against the major financial risks of
inflation and exchange-rate movement
To highlight some of the financial aspects of the investment decision
© 2001 Prentice Hall
20-2
Finance in International Business
OPERATIONS
EXTERNAL INFLUENCES
OBJECTIVES
PHYSICAL AND
SOCIETAL FACTORS
STRATEGY
MEANS
COMPETITIVE
ENVIRONMENT
Modes
© 2001 Prentice Hall
Overlaying
Alternatives
Functions
• Marketing
• Exporting and
importing
• Global manufacturing
• Supply chain
management
• Accounting
• FINANCE
• Human resources
20-3
Introduction
MNEs need access to capital
• Finance is integral to firm’s operating strategies
• Concern with access to capital in local and global markets
Finance and Treasury Functions in the Internalization
Process
Chief Financial Officer (CFO)—vice president of finance
• Responsible for controllership and treasury functions
• Acquires financial resources—generates funds from
internal and external sources
• Allocates financial resources—increases stockholders’
wealth by allocating funds to different projects and
investment opportunities
• Manages cash flows
© 2001 Prentice Hall
20-4
Location of Treasury Function in the Corporate
Organizational Structure
Board of Directors
Chairman and CEO
President and COO
VP, Sales/Marketing
Cash Manager
VP, Finance
VP, Operations
Controller
Treasurer
Credit Manager
Global Finance
Exposure
Management
Budget
Planning
Capital
Expenditure
Bid Support
© 2001 Prentice Hall
VP, R&D
Financial
Planning
Process Foreign
Currency
20-5
Global Debt Markets
Companies follow financing trends in their own country and industry
• Leverage—degree to which a firm funds the growth of the
business by debt
– interest on debt is tax deductible
• Equity capital—stocks or shares
– dividends paid to investors are not deductible
• Choice of debt versus equity affected by a variety of factors
Companies can use local and international debt markets to raise funds
• Subsidiaries or foreign companies may find it easier to obtain
credit than local companies
– back-to-back loan—made between a firm in country A with a
subsidiary in country B and a bank in country B with a branch
in country A
© 2001 Prentice Hall
20-6
Global Debt Markets (cont.)
Eurocurrencies—any currency that is banked outside of its country of
origin
• Major sources of Eurocurrencies include:
– foreign governments or individuals who want to hold dollars
outside of the U.S.
– MNEs with excess cash
– European banks with excess foreign currency
– countries with large balance-of-trade surpluses held as
reserves
• Characteristics of Eurocurrency market
– completely unregulated offshore market
– both short and medium term
– Eurocurrency deposits yield higher interest
– Eurocurrency loans tend to be cheaper
» London Inter-Bank Offered Rate (LIBOR)—interest rate
that banks charge each other on Eurocurrency loans
© 2001 Prentice Hall
20-7
Global Debt Markets (cont.)
International bond market—an attractive place to borrow money that fills
an important niche in financing
• Tends to be less expensive than local markets
• Foreign bonds—sold outside of the borrower’s country but in the
currency of the country of issue
• Eurobonds—underwritten by banking syndicate and sold in
countries other than the one in whose currency the bond is
denominated
– sold in several financial centers
– some have currency options allowing the creditor to demand
repayment in one of several currencies
• Global bond—combination of domestic bond and Eurobond
– registered in each national market
© 2001 Prentice Hall
20-8
Equity Securities and the Euromarket
Equity securities—investor takes an ownership position in return for
shares of stock, the promises of capital gain, and dividends
• Many companies are using private placements to raise equity
capital
– venture capitalist—invests money in a new venture in
exchange for stock
• Equity-capital markets (stock markets)—listing may be on home
country or foreign exchange
– market capitalization—total number of shares of stock listed
times the market price per share
» in part the increase has resulted from privatization in
emerging markets and global economic growth
© 2001 Prentice Hall
20-9
Equity Securities and the Euromarket (cont.)
Euroequity market—market for shares sold outside the issuing
company’s home country
• Firms often list on only one big foreign exchange
– e.g., 379 foreign companies listed on the New York Stock
Exchange
• Companies with investments in several countries may list on
different exchanges
• American Depositary Receipt (ADR)—a negotiable certificate
issued by a U.S. bank and representing shares of stock of a
foreign company
• Global Depositary Receipts and European Depositary Receipts—
other markets for Euroequities
• Global share offering—simultaneous offering of actual shares on
different exchanges
• Electronic trading of stocks is a major source of competition for
stock exchanges
© 2001 Prentice Hall
20-10
Growth of Emerging Stock Markets
1986
3.60%
Emerging markets
Developed markets
1994
96.40%
12.70%
87.30%
1998
6.90%
93.10%
© 2001 Prentice Hall
20-11
Offshore Financial Centers
Cities or countries that engage in a variety of financial transactions
• Provide significant tax advantages
• Centers for the Eurocurrency market
• Markets are less regulated than domestic markets
• Provide an alternative, cheaper source of funding
• May be:
– operational centers—extensive banking activities involving
short-term financial transactions
– booking centers—little banking activity
» financial transactions recorded to take advantage of
secrecy and low tax rates
• Good locations for establishing financial subsidiaries
© 2001 Prentice Hall
20-12
Characteristics of Offshore Financial Centers
Large foreigncurrency market
for loans/deposits
Pass-through for
international
loan funds
Favorable
regulatory
climate
Efficient and
experienced
financial
community
Offshore
Financial
Center
Economic and
political stability
Good
communications
Large net supplier
of funds to world
financial markets
© 2001 Prentice Hall
Good supportive
services
20-13
Internal Sources of Funds
Funds—working capital, i.e., the difference between current assets and
current liabilities
• Used to expand operations or satisfy demands for capital
Sources of funds—MNEs have more complex arrangements due to the
number of subsidiaries and the diverse environments in which they
operate
• Loans
• Dividends
• Intercompany receivables and payables
• Investments through equity capital
Funds may flow from subsidiaries to parent or vice versa
© 2001 Prentice Hall
20-14
Internal Sources of Working Capital for MNEs
Parent
Company
Loans
Dividends,
royalties,
and fees
French
Subsidiary
Guarantee
loans
Loans
Extensions of
accounts payable
© 2001 Prentice Hall
Invests more
equity capital
Brazilian
Subsidiary
20-15
Internal Sources of Funds (cont.)
Global cash management—requires the collection and payment of cash
resulting from the normal operational cycle
• Generates and invests cash through dealings with financial
institutions
• Assesses a company’s cash needs using budgets and forecasts
• Involves decisions about the degree of centralization of cash
– transfers of cash may be in the form of dividends, royalties,
management fees, and repayment of loans
– governments concerned about the outflow of foreign
exchange may curtail cash transfers abroad
© 2001 Prentice Hall
20-16
Internal Sources of Funds (cont.)
Multilateral netting—company establishes one center to handle all
internal cash, funds, and financial transactions
• Enables companies to reduce the amount of cash flow and move
cash more quickly and efficiently
• Advantages include:
– optimizing the use of excess cash
– reducing interest expenses and maximizing interest yields
– reducing costly foreign exchange, swap transactions, and
intercompany transfers
– minimizing administrative paperwork
– centralizing and speeding information
• Multilateral cash flows in the absence of netting require each
subsidiary to settle intercompany obligations
– not as advantageous as netting
© 2001 Prentice Hall
20-17
Multilateral Cash Flows
French
Subsidiary
$150,000
Italian
Subsidiary
$50,000
$200,000
$200,000
$200,000
$50,000
German
Subsidiary
$100,000
© 2001 Prentice Hall
United Kingdom
Subsidiary
20-18
Multilateral Netting
French
Subsidiary
Italian
Subsidiary
$100,000
$150,000
Clearing
Account
$150,000
$100,000
German
Subsidiary
United Kingdom
Subsidiary
© 2001 Prentice Hall
20-19
Foreign-Exchange Risk Management
Translation exposure—arises because, as the exchange rate
changes, the dollar value of the exposed asset or liability
changes
• Combined effect of the exchange-rate change is either a
net gain or loss
– does not represent an actual cash flow effect because
the cash is only translated into dollars, not converted
into dollars
Transaction exposure—arises because the receivable or payable
changes in value as the exchange rate changes
Economic exposure (operating exposure)—potential for change
in expected cash flows that arise from the:
• Pricing of products
• Sourcing and cost of inputs
• Location of investments
• Competitive position of the company in markets
© 2001 Prentice Hall
20-20
Exposure-Management Strategy
Defining and measuring exposure
• MNE must forecast the degree of exposure in each major
currency in which it operates
– exchange-rate movements are forecasted using inhouse or external experts
Reporting system—substantial participation from foreign
operations combined with central control
• Foreign input important to ensure forecasting effectiveness
• Central control of exposure protects resources more
efficiently
– defines and controls overall company exposure
• MNEs should devise uniform reporting system for its
subsidiaries
• Time periods of reports vary
• Final reporting should be at corporate level
© 2001 Prentice Hall
20-21
Exposure-Management Strategy (cont.)
Centralized policy—top management should determine hedging policy
• Corporate treasurer should be able to design and implement a
cost-effective program
• Some decisions must be decentralized in order to react quickly to
changes in the international monetary environment
• Some companies run hedging operations as profit centers and
nurture in-house trading desks
Formulating hedging strategies—safest position has exposed assets
equal to exposed liabilities
• Operational strategies—involve adjusting the flow of money and
resources to reduce foreign-exchange risk
– using local debt to balance local assets
– taking advantage of leads and lags for intercompany
payments
© 2001 Prentice Hall
20-22
Exposure-Management Strategy (cont.)
Formulating hedging strategies (cont.)
• Contractual arrangements
– forward contract—establishes a fixed exchange rate for
future transactions
– foreign-currency option—purchaser has the right, but not the
obligation, to buy or sell a certain amount of foreign currency
at a set exchange rate within a specified period of time
– more flexible than forward contract
© 2001 Prentice Hall
20-23
Capital Budgeting Decision in an International Context
Parent company needs to compare the net present value or internal rate
of return of a foreign project with that of its other projects and with that
of others available
Unique aspects of capital budgeting for foreign projects
• Parent cash flows must be distinguished from project cash flows
• Remittance of funds to the parent affected by differing tax
systems, and legal and political constraints on movement of funds
• Differing rates of inflation must be anticipated
• Parent must consider possible changes in exchange rates
• Must evaluate political risk in foreign market
• Terminal value is difficult to estimate
© 2001 Prentice Hall
20-24