Chapter 16
International
Managerial
Finance
Learning Goals
1. Understand the major factors that influence
the financial operations of multinational
companies (MNCs).
2. Describe the key differences between purely
domestic and international financial statements
–consolidation, translation of individual
accounts, and international profits.
3. Discuss exchange rate risk and political risk,
and explain how MNCs manage them.
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Learning Goals
4. Describe foreign direct investment, investment
cash flows and decisions, the MNCs’ capital
structure, and the international debt and equity
market instruments available to MNCs.
5. Discuss the role of the Eurocurrency market in
short-term borrowing and investing (lending)
and the basics of international cash, credit, and
inventory management.
6. Review recent trends in international mergers
and joint ventures.
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The MNC and its Environment
• In recent years, international finance has
become an increasingly important element in
the management of MNCs.
• Although the principles of managerial finance
are applicable to MNCs, certain factors unique
to the international setting tend to complicate
the financial management of MNCs.
• A simple comparison between a domestic U.S.
firm and a U.S.–based MNC is given in
Table 18.1.
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The MNC and its Environment (cont.)
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The MNC and its Environment (cont.)
• During the 1990s, three important trading
blocks emerged.
• In 1992, the United States, Mexico and Canada
signed the North American Free Trade
Agreement (NAFTA).
• In 1992, Western Europe also strengthened
previously existing European Union by forming
the European Open Market which included the
adoption of a common currency called the
EURO in January, 1999.
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The MNC and its Environment (cont.)
• In 1991, the Mercosur Group of South America,
including the countries of Brazil, Argentina,
Paraguay and Uruguay formed a trading block.
• The General Agreement on Tariffs and Trade
(GATT) is currently the most important
international treaty governing trade.
• It extends free trading rules to broad areas of
economic activity and is policed by the World
Trade Organization (WTO).
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The MNC and its Environment:
Legal Forms of Business
• In many countries outside the U.S., operating
foreign subsidiaries can take two forms similar
to a U.S. corporation.
• In German-speaking nations, the two forms are
the Aktiengesellschafts (A.G.) or the
Gesellschaft mit beschrankter Haftun (GmbH).
• In many other countries, the similar forms are
Societe Anonymes (S.A.) or Societe a
Responsibilite Limitee (S.A.R.L.).
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The MNC and its Environment:
Legal Forms of Business (cont.)
• One major difference however, is that it is often
essential to enter into joint-ventures with private
investors or with government-based agencies in
the host country.
• Such joint-venture laws can result in a
substantial degree of management control by
host countries and may result in disagreements
among the partners as to the distribution of
profits, the portions to be allocated for
reinvestment, and the remittance of profits.
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The MNC and its Environment: Taxes
• From the perspective of a U.S.-based MNC, several
factors related to taxation in foreign countries must be
considered.
• First, the level of foreign taxes needs to be examined.
• Second, the definition of what constitutes taxable
income must be ascertained.
• Foreign tax rates and tax rules must be understood.
• In general, U.S.–based MNCs may often take foreign
taxes as a direct credit against U.S. tax liabilities.
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The MNC and its Environment:
Taxes (cont.)
American Enterprises, a U.S.-based MNC that
manufactures heavy machinery, has a foreign subsidiary
that earns $100,000 before local taxes. All of the after-tax
funds are available to the parent in the form of dividends.
The applicable taxes consist of a 35% foreign income tax
rate, a foreign dividend withholding tax rate of 10%, and a
U.S. tax rate of 34%.
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The MNC and its Environment:
Taxes (cont.)
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The MNC and its Environment:
Taxes (cont.)
Using the so-called grossing up procedure, the MNC will
add the full before-tax subsidiary income to its total taxable
income. Next, the U.S. tax liability on the grossed-up
income is calculated. Finally, the related taxes paid in the
foreign country are applied against the U.S. tax liability as
shown on the following slide.
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The MNC and its Environment:
Taxes (cont.)
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The MNC and its Environment:
Taxes (cont.)
Because the U.S. tax liability is less than the total taxes paid
to the foreign government, no additional U.S. taxes are due
on the income from the foreign subsidiary. In our example, if
tax credits had not been allowed, then “double taxation” by
the two authorities would have resulted in a substantial drop
in the overall net funds available to the parent MNC.
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The MNC and its Environment:
Taxes (cont.)
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The MNC and its Environment:
Financial Markets
• During the past two decades the Euromarket—
which provides for borrowing and lending
currencies outside their country of origin—has
grown rapidly and provides MNCs with an
external opportunity to borrow or lend funds with
little government regulation.
• One aspect of the Euromarket is offshore
centers, which is composed of cities or states
(including London, Singapore, Nassau, and
Hong Kong) that have achieved prominence as
major centers for Euromarket business.
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The MNC and its Environment:
Financial Markets
• In addition, a variety of new financial instruments –
including currency and interest rate swaps, forward
contracts, options contracts, and international
commercial paper – have been created to facilitate
international trade and finance.
• The Euromarket is still dominated by the U.S. dollar.
• However, other currencies such as the Euro, Swiss
Franc, Japanese Yen, and British Pound have increased
in importance.
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Financial Statements: Consolidation
• Presently, U.S. tax rules require the consolidation of financial
statements of subsidiaries according to the percentage of
ownership by the parent as described in Table 18.2 below.
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Financial Statements: Translation
of Individual Accounts
• Unlike domestic items in financial
statements, international items require
translation back into U.S. dollars.
• Since 1982, all financial statements of
U.S. MNCs have to conform to FASB No.
52.
• Under FASB 52, the current rate method
of translation is used.
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Financial Statements: Translation
of Individual Accounts (cont.)
• The current rate method is implemented in
two steps:
– First, each subsidiary’s balance sheet and
income statements are measured in terms of
their functional currency.
– Second, as described in Figure 18.1 on the
following slide, balance sheet items are
translated at the closing date exchange rate
and all income statement items are translated
at average rates.
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Financial Statements: Translation
of Individual Accounts (cont.)
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Risk: Exchange Rate Risk
• Exchange rate risk is the risk caused by
varying exchange rates between two currencies.
• The foreign exchange rate between the U.S.
dollar (US$) and Swiss Franc (SF) is expressed
as follows:
US$1.00 = SF1.4175
SF1.00 = US$0.7055
• The usual exchange rate quotation in
international markets is given as SF1.4175/US$.
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Risk: Exchange Rate Risk (cont.)
• Under the current system of floating exchange
rates, the value of any two major currencies
with respect to one another is allowed to
fluctuate on a daily basis.
• For smaller country currencies, however,
exchange rates are fixed or semi-fixed with
respect to one of the major currencies.
• The spot exchange rate is the rate of exchange
between any two currencies on a given day.
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Risk: Exchange Rate Risk (cont.)
• The forward exchange rate is the rate of exchange
between two currencies at some specific future date.
• These rates and their relationships can be described as
shown in Figure 18.2 on the following slide.
• Although a number of factors can influence exchange
rate movements, by far the most important influence is
differing inflation rates between two currencies, where
the currency with the higher rate of inflation will decline
relative to the country with the lower rate.
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Insert Figure 18.2 here
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Risk: Exchange Rate Risk (cont.)
• Although several economic and political factors
influence foreign exchange rate movements, by
far the most important explanation for long-term
changes is differing inflation between
two countries.
• Countries that experience high inflation rates will
see their currencies decline in value
(depreciate) relative to the currencies of
countries with lower inflation rates.
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Risk: Exchange Rate Risk (cont.)
Assume that the current exchange rate between the U.S. and
the new nation of Farland is 2 Farland Guineas per U.S. dollar,
FG2.00/US$, which is also equal to $0.50/FG. This exchange
rate means that a basket of goods worth $100.000 in the U.S.
sells for $100.00 X FG 2.00 = FG 200.00 in Farland.
Now assume that inflation is running at a 25% annual rate in
Farland but at only 2% in the U.S. In one year, the same
basket of goods will sell for 1.25 X FG 200.00 = FG 250.00 in
Farland but for only 1.02 X $100.00 = $102.00 in the U.S.
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Risk: Exchange Rate Risk (cont.)
These relative prices imply that that in 1 year, FG 250.00 will
be worth $102.00 so the exchange rate in 1 year should
change to FG250.00/$102.00 = FG 2.45/US$ or $0.41/FG.
In other words, the Farland Guinea will depreciate from FG
2.00/US$ to FG 2.45/US$, while the dollar will appreciate from
$0.50/FG to $0.41/FG.
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Risk: Exchange Rate Risk (cont.)
• Multinational companies face exchange rate risk under
either fixed or floating-rate systems.
• Consider the following floating-rate example.
MNC, Inc. a multinational manufacturer of dental drills, has
a subsidiary in Great Britain (U.K.) that at the end of 2006
had the financial statements shown in Table 18.3. The
figures for the balance sheet and income statement are
given in the local currency, British Pounds (£). Using an
exchange rate of £0.70/US$ for December 31, 2006, MNC
has translated the statements into U.S. dollars.
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Risk: Exchange
Rate Risk (cont.)
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Risk: Exchange Rate Risk (cont.)
• It is also useful to describe the difference
between accounting exposure and
economic exposure.
• Accounting exposure is the risk resulting from
the effects of changes in foreign exchange rates
on the translated value of a firm’s financial
statements.
• Perhaps more importantly, economic exposure
is the risk resulting from the effects of changes
in foreign exchange rates on the firm’s value.
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Risk: Exchange Rate Risk (cont.)
• In general, it is possible for management
to insure against these risks and
exposures through hedging.
• The decision as to whether management
will hedge and the extent to which they do
depends largely upon management’s
attitude toward risk.
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Risk: Political Risks
• Political risk results from the discontinuity or
seizure of an MNCs operations in a host country
due to the host’s implementation of specific
rules and regulations.
• Macro political risk is the subjection of all
foreign firms to political risk by a host country
because of political change, revolution, or
adoption of new policies.
• Micro political risk is the subjection of an
individual firm, a specific industry, or companies
from a particular country to political risk.
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Risk: Political Risks (cont.)
• Although many least developed and developing nations
present great opportunities for MNCs, these nations are
also more unstable and more politically risky than their
developed nation counterparts.
• Table 18.4 on the following slide shows some of the
approaches that MNCs use to cope with political risk.
• The negative approaches are generally used by firms
in attractive industries such as oil, gas, and mining.
• The best approaches are positive approaches, which
have, which have both economic and political aspects.
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Risk: Political Risks (cont.)
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Long-Term Investment
and Financing Decisions
• Foreign Direct Investment
– Foreign Direct Investment (FDI) is the transfer of
capital, managerial, and technical assets from an
MNCs home country to a host country.
– An MNC can be a 100% equity participant (resulting
a wholly-owned subsidiary) or less (leading to a joint
venture project with
foreign participants).
– FDI projects are subject not only to business,
financial, inflation, and exchange rate risk, but also to
the additional element of political risk.
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Long-Term Investment
and Financing Decisions (cont.)
• Investment Cash Flows and Decisions
– A number of factors must be considered when
estimating cash flows in foreign projects.
– First, elements relating the parent company’s
investment in a subsidiary and the concept of taxes
must be considered.
– Also, the parent must consider the risk that the
repatriation of cash flows will be blocked.
– Finally, the risk of international cash flows must also
be considered.
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Long-Term Investment
and Financing Decisions (cont.)
• Capital Structure
– Because of their greater access to capital, MNCs
have lower costs of long-term financing.
– Some studies have suggested that MNCs have
higher debt ratios, while other studies have found the
opposite to be true.
– Part of this might be explained that MNCs based in
different countries and regions may have access to
currencies and markets, resulting in variances in
capital structures for these MNCs.
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Long-Term Investment
and Financing Decisions (cont.)
• Long-Term Debt
– An international bond is a bond that is initially sold
outside the country of the borrower and often
distributed in several countries.
– A foreign bond is an international bond that is sold
primarily in the country of the currency of issue.
– A Eurobond is an international bond that is sold
primarily in countries other than the country of the
currency in which the issue is denominated.
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Long-Term Investment
and Financing Decisions (cont.)
• Equity Capital
– One way for MNCs to raise equity is the have the
parent’s stock distributed internationally and owned
by shareholders in different countries.
– In recent years, the Euroequity market has
continued to evolve and develop.
– The Euroequity market is the capital market around
the world that deals in international equity issues.
– London has become the center of Euroequity activity.
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Short-Term Financial Decisions
• Like purely domestic firms, MNCs have access
to accounts payable, accruals, bank and nonbank sources of short-term funds.
• In addition, MNCs have access to the local
economic market for both short and longterm funding.
• Finally, the subsidiary’s borrowing and lending
opportunities are often greater since it can rely
on the potential backing of the parent company.
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Short-Term Financial Decisions (cont.)
• The Eurocurrency market is the portion of the
Euromarket that provides short-term, foreigncurrency financing to subsidiaries of MNCs.
• Unlike borrowing in domestic markets, where
only one currency and a nominal interest rate is
involved, financing in the Euromarket may
involve several currencies and both nominal and
effective interest rates.
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Short-Term Financial Decisions (cont.)
• Effective interest rates in the international context, is the
rate equal to the nominal rate plus (or minus) any
forecast appreciation (or depreciation) of a foreign
currency relative to the currency of the MNC parent.
A multinational plastics company, International Molding, has
subsidiaries in Switzerland (Swiss Franc, SF) and Japan (Japanese
Yen, ¥). Based on each subsidiary’s forecast operations, the shortterm financial needs (in US$) are as follows:
Switzerland: $80 million excess cash to be invested (lent)
Japan: $60 million funds to be raised (borrowed)
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Short-Term Financial Decisions (cont.)
On the basis of all available information, the parent firm has
provided each subsidiary with figures given as shown below:
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Short-Term Financial Decisions (cont.)
From the MNC’s point of view, the effective rates of interest,
which take into account each currency’s forecast percentage
change (appreciation or depreciation) relative to the US$, are
the main considerations for borrowing and investing decisions
For investment purposes, the highest available effective rate of
interest is 3.30% in the US$ Euromarket. To raise funds, the
cheapest source open to the Japanese subsidiary is the 2.01%
effective rate for the Swiss Franc in the Euromarket.
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Short-Term Financial Decisions:
Cash Management
• In its international cash management, the
MNC can respond to exchange rate risk
by hedging its undesirable cash and
marketable securities exposures or by
certain adjustments in its operations.
• Hedging strategies are techniques used to
offset or protect against risk.
• These strategies are summarized in
Table 18.5 on the following slide.
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Short-Term Financial Decisions:
Credit and Inventory Management
• Because MNCs compete for the same global
markets, it is essential that they offer attractive
credit terms to potential customers.
• With respect to inventory management, MNCs
must consider a number of factors related to
both economics and politics, including exchange
rate fluctuations, tariff and non-tariff barriers,
and varying laws and regulations.
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Mergers and Joint Ventures
• International mergers and joint ventures,
especially those involving European firms
acquiring assets in the U.S., increased
significantly beginning in the 1980s.
• Moreover, a fast-growing group of MNCs
recently emerged based in the so-called newly
industrialized countries (including Singapore,
South Korea, and China’s Hong Kong).
• Still others are operating from emerging nations
(such as Brazil, China, Mexico, India,
and Thailand).
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Mergers and Joint Ventures (cont.)
• Foreign direct investments (FDI) in the U.S.
have also gained popularity in recent years.
• Most FDI comes from Britain, Canada, France,
the Netherlands, Japan, Switzerland, and
Germany and is concentrated in manufacturing,
petroleum, and trade/service sectors.
• Developing countries, too, have been attracting
FDI and a number of these nations have
adopted specific policies and regulations aimed
at controlling the inflows of foreign investments.
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