Chapter 19

1. Chapter 19 International Managerial Finance

2. Learning Goals LG1 Understand the major factors that influence the financial operations of multinational companies (MNCs). LG2 Describe the key differences between purely domestic and international financial statements—consolidation, translation of individual accounts, and international profits. LG3 Discuss exchange rate risk and political risk, and explain how MNCs manage them.

3. Learning Goals (cont.) LG4 Describe foreign direct investment, investment cash flows and decisions, the MNCs’ capital structure, and the international debt and equity instruments available to MNCs. LG5 Discuss the role of the Eurocurrency market in short-term borrowing and investing (lending) and the basics of international cash, credit, and inventory management. LG6 Review recent trends in international mergers and joint ventures.

4. The Multinational Company and Its Environment Multinational companies (MNCs) are firms that have international assets and operations in foreign markets and draw part of their total revenue and profits from such markets. • Multinationals face a variety of laws and restrictions when operating in different nation-states. • The legal and economic complexities existing in this environment are significantly different from those a domestic firm would face.

5. Table 19.1 International Factors and Their Influence on MNC’s Operations

6. Matter of Fact Diversifying Operations • One of the reasons why firms have operations in foreign markets is the portfolio concept discussed in Chapter 8. • Just as it is not wise for you to put all of your investment into the stock of one firm, it is not wise for a firm to invest in only one market. • By having operations in many markets, firms can smooth out some of the cyclic changes that occur in each market.

7. The Multinational Company and Its Environment: Key Trading Blocs The North American Free Trade Agreement (NAFTA) is the treaty establishing free trade and open markets between Canada, Mexico, and the United States. The Central American Free Trade Agreement (CAFTA) is a trade agreement signed in 2003–2004 by the United States, the Dominican Republic, and five Central American countries (Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua).

8. The Multinational Company and Its Environment: Key Trading Blocs (cont.) The European Union (EU) is a significant economic force currently made up of 27 nations that permit free trade within the union. The European Open Market is the transformation of the European Union into a single market at year-end 1992.

9. The Multinational Company and Its Environment: Key Trading Blocs (cont.) The euro is a single currency adopted on January 1, 1999, by 12 EU nations, which switched to a single set of euro bills and coins on January 1, 2002. A monetary union is the official melding of the national currencies of the EU nations into one currency, the euro, on January 1, 2002.

10. The Multinational Company and Its Environment: Key Trading Blocs (cont.) Mercosur is a major South American trading bloc that includes countries that account for more than half of total Latin American GDP. ASEAN is a large trading bloc that comprises 10 member nations, all in Southeast Asia. China is expected to join this bloc in 2010. Also called the Association of Southeast Asian Nations.

11. The Multinational Company and Its Environment: GATT and the WTO The General Agreement on Tariffs and Trade (GATT) is a treaty that has governed world trade throughout most of the postwar era; it extends free-trading rules to broad areas of economic activity and is policed by the World Trade Organization (WTO). The World Trade Organization (WTO) is the international body that polices world trading practices and mediates disputes between member countries.

12. The Multinational Company and Its Environment: Legal Forms of Business Organization In many countries outside the United States, operating a foreign business as a subsidiary or affiliate can take two forms, both similar to the U.S. corporation. • In German-speaking nations the two forms are the Aktiengesellschaft (A.G.) or the Gesellschaft mit beschrankter Haftung (GmbH). • In many other countries the similar forms are a Société Anonyme (S.A.) or a Sociétéà Responsibilité Limitée (S.A.R.L.). A joint venture is a partnership under which the participants have contractually agreed to contribute specified amounts of money and expertise in exchange for stated proportions of ownership and profit.

13. The Multinational Company and Its Environment: Legal Forms of Business Organization (cont.) The existence of joint-venture laws and restrictions has implications for the operation of foreign-based subsidiaries. • Majority foreign ownership may result in a substantial degree of management and control by host country participants. • Foreign ownership may result in disagreements among the partners as to the exact distribution of profits and the portion to be allocated for reinvestment. • Operating in foreign countries can involve problems regarding the remittance of profits. • From a “positive” point of view, it can be argued that MNCs operating in many of the less developed countries benefit from joint-venture agreements, given the potential risks stemming from political instability in the host countries.

14. The Multinational Company and Its Environment: Taxes Multinational companies, unlike domestic firms, have financial obligations in foreign countries. • One of their basic responsibilities is international taxation—a complex issue because national governments follow a variety of tax policies. • In general, U.S.-based MNCs must take into account several factors. • MNCs need to examine the level of foreign taxes. • There is a question as to the definition of taxable income. • The existence of tax agreements between the United States and other governments can influence not only the total tax bill of the parent MNC but also its international operations and financial activities.

15. The Multinational Company and Its Environment: Taxes (cont.) As a general practice, the U.S. government claims jurisdiction over all the income of an MNC, wherever earned. However, it may be possible for a multinational company to take foreign income taxes as a direct credit against its U.S. tax liabilities. The following example illustrates one way of accomplishing this objective.

16. The Multinational Company 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%.

17. The Multinational Company and Its Environment: Taxes (cont.) Subsidiary income before local taxes $100,000 Foreign income tax at 35% –35,000 Dividend available to be declared $ 65,000 Foreign dividend withholding tax at 10% –6,500 MNC’s receipt of dividends $ 58,500

18. The Multinational Company and Its Environment: Taxes (cont.) Using the so-called grossing up procedure, the MNC will add the full before-tax subsidiary in-come to its total taxable income. Next, the company calculates the U.S. tax liability on the grossed-up income. Finally, the related taxes paid in the foreign country are applied as a credit against the additional U.S. tax liability: Additional MNC income $100,000 U.S. tax liability at 34% $  34,000 Total foreign taxes paid, to be used as a credit –41,500 U.S. taxes due 0 Net funds available to the parent MNC $ 58,500

19. The Multinational Company 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, as shown in what follows, would have resulted in a substantial drop in the overall net funds available to the parent MNC:

20. The Multinational Company and Its Environment: Taxes (cont.) Subsidiary income before local taxes $100,000 Foreign income tax at 35% –35,000 Dividend available to be declared $ 65,000 Foreign dividend withholding tax at 10% –6,500 MNC’s receipt of dividends $ 58,500 U.S. tax liability at 34% –19,890 Net funds available to the parent MNC $ 38,610

21. The Multinational Company and Its Environment: Financial Markets The Euromarket is the international financial market that provides for borrowing and lending currencies outside their country of origin. The Euromarket has grown large for several reasons. • First, beginning in the early 1960s, the Russians wanted to maintain their dollar earnings outside the legal jurisdiction of the U.S., mainly because of the Cold War. • Second, the consistently large U.S. balance-of-payments deficits helped to “scatter” dollars around the world. • Third, the existence of specific regulations and controls on dollar deposits in the U.S., including interest rate ceilings imposed by the government, helped to send such deposits to places outside the U.S.

22. The Multinational Company and Its Environment: Financial Markets (cont.) Offshore centers are certain cities or states (including London, Singapore, Bahrain, Nassau, Hong Kong, and Luxembourg) that have achieved prominence as major centers for Euromarket business. The availability of communication and transportation facilities, along with language, costs, time zones, taxes, and local banking regulations, are among the main reasons for the prominence of these centers.

23. The Multinational Company and Its Environment: Financial Markets (cont.) The U.S. dollar continues to dominate various segments of the global financial markets. Yet, in other activities—including currency in circulation and the international bond market—the euro has surpassed the dollar, with more challenges coming from other, potential contenders such as the Chinese yuan. Similarly, although U.S. banks and other financial institutions continue to play a significant role in the global markets, financial giants from Japan and Europe have become major participants in the Euromarket.

24. Table 19.2 Subsidiary/Currency Operations and Translation Method

25. Financial Statements: Translation of Individual Accounts (cont.) FASB No. 52 is a statement issued by the FASB requiring U.S. multinationals first to convert the financial statement accounts of foreign subsidiaries into the functional currency and then to translate the accounts into the parent firm’s currency using the all-current-rate method. The functional currency is the currency in which a subsidiary primarily generates and expends cash and in which its accounts are maintained.

26. Financial Statements: Translation of Individual Accounts (cont.) The all-current-rate method is the method by which the functional-currency-denominated financial statements of an MNC’s subsidiary are translated into the parent company’s currency. The temporal method is a method that requires specific assets and liabilities to be translated at so-called historical exchange rates, and that foreign-exchange translation gains or losses be reflected in the current year’s income.

27. Figure 19.1 Procedure Flow Chart for U.S. Translation Practices

28. Risk: Exchange Rate Risks Exchange rate risk is the risk caused by varying exchange rates between two currencies. The foreign exchange rate is the value of two currencies with respect to each other. It is expressed as follows: US$1.00 = ¥ 98.03 ¥1.00 = US$0.01020

29. Risk: Exchange Rate Risks (cont.) A floating relationship is the fluctuating relationship of the values of two currencies with respect to each other. A fixed (or semifixed) relationship is the constant (or relatively constant) relationship of a currency to one of the major currencies, a combination (basket) of major currencies, or some type of international foreign exchange standard.

30. Risk: Exchange Rate Risks (cont.) The spot exchange rate is the rate of exchange between two currencies on any given day. The forward exchange rate is the rate of exchange between two currencies at some specified future date.

31. Figure 19.2 Exchange Rates (Friday, July 30, 2013)

32. Figure 19.2 Exchange Rates (Friday, July 30, 2013) (cont.)

33. Personal Finance Example Floyd Gonzalez is considering a bicycling tour. • The cost of the tour, which includes ground transportation, hotels, and route support in France, is 3,675 euros (€). • He estimates that his round-trip airfare (including shipment of his bike) from his home in Iowa will be $1,160; in addition he will incur another $100 in incidental U.S. travel expenses. • Floyd estimates the cost of meals in France to be about €400, and he plans to take an additional $1,000 to buy gifts and other merchandise. • From Figure 19.2, the current exchange rate is US$1.3033/€1.00 (or €0.7673/US$1.00). • Given this information, Floyd wishes to determine (1) the total dollar cost of the trip and (2) the amount in euros he will need to cover the cost of meals, gifts, and other merchandise while in France.

34. Personal Finance Example (cont.) (1) Total cost of trip in U.S. dollars Cost of tour (€3,675  US$1.3033/€) $4,790 Round-trip airfare 1,100 Incidental travel expenses 100 Cost of meals in (€400  US$1.3033/€) 521 Gifts and other merchandise    1,000   Total cost of trip in $ $7,511 (2) Amount of euros needed in Cost of meals in €   400 Gifts and other merchandise ($US1,000  €0.7673)     767 Amount of €s needed in France €1,167 The total cost of Floyd’s trip would be $7,511, and he would need 1,167 euros to cover his cost of meals, gifts, and other merchandise while in France.

35. Risk: Exchange Rate Risks (cont.) Although several economic and political factors influence foreign exchange rate movements, by far the most important explanation for long-term changes in exchange rates is a differing inflation rate 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.

36. Risk: Exchange Rate Risks (cont.) Assume that the current exchange rate between the United States and the new nation of Farland is 2 Farland guineas (FG) per U.S. dollar, FG 2.00/US$, which is also equal to $0.50/FG. This exchange rate means that a basket of goods worth $100 in the United States sells for $100  FG 2/US$ = FG 200 in Farland, and vice versa (goods worth FG 200 in Farland sell for $100 in the United States).

37. Risk: Exchange Rate Risks (cont.) Now assume that inflation is running at a 25% annual rate in Farland but at only a 2% annual rate in the United States. In one year, the same basket of goods will sell for 1.25  FG 200 = FG 250 in Farland, and for 1.02  $100 = $102 in the United States. These relative prices imply that in 1 year, FG 250 will be worth $102, so the exchange rate in 1 year should change to FG 250/$102 = FG 2.45/US$, or $0.41/FG. In other words, the Farland guinea will depreciate from FG 2/US$ to FG 2.45/US$, while the dollar will appreciate from $0.50/FG to $0.41/FG.

38. Table 19.3 Financial Statements for MNC, Inc.’s British Subsidiary

39. Risk: Exchange Rate Risks (cont.) Accounting exposure is the risk resulting from the effects of changes in foreign exchange rates on the translated value of a firm’s financial statement accounts denominated in a given foreign currency. Economic exposure is the risk resulting from the effects of changes in foreign exchange rates on the firm’s value.

40. Risk: Political Risks Political risk is the potential discontinuity or seizure of an MNC’s operations in a host country via the host’s implementation of specific rules and regulations. • Political risk is usually manifested in the form of nationalization, expropriation, or confiscation. • In general, the host government takes over the assets and operations of a foreign firm, usually without proper (or any) compensation. • Macro political risk is the subjection of all foreign firms to political risk (takeover) by a host country because of political change, revolution, or the adoption of new policies. • Micro political risk is the subjection of an individual firm, a specific industry, or companies from a particular foreign country to political risk (takeover) by a host country.

41. Table 19.4 Approaches for Coping with Political Risks

42. Risk: Political Risks (cont.) National entry control systems are comprehensive rules, regulations, and incentives introduced by host governments to regulate inflows of foreign direct investments from MNCs and at the same time extract more benefits from their presence. • National entry control systems regulate flows of a variety of factors—local ownership, level of exportation, use of local inputs, number of local managers, internal geographic location, level of local borrowing, and the percentages of profits to be remitted and of capital to be repatriated to parent firms. • Host countries expect that as MNCs comply with these regulations, the potential for acts of political risk will decline, thus benefiting the MNCs as well.

43. Focus on Ethics Chiquita’s Slippery Situation • Chiquita sources its bananas from Latin America, operating banana farms stretching from Mexico to Ecuador. • In 1997, Chiquita received threats to its facilities and employees, and, through its Colombian subsidiary, began making payments to a militant organization in exchange for protection. • As a result, Chiquita became the first U.S. corporation ever convicted of financial dealings with terrorists. Chiquita saw their options in Colombia as (a) pay extortion to a terrorist organization or (b) put their employee’s safety at risk. Is it ethical to break the law in an effort to save lives? What, if anything, do you think Chiquita should have done differently?

44. Long-Term Investment and Financing Decisions: Foreign Direct Investment Foreign direct investment (FDI) is the transfer by a multinational firm of capital, managerial, and technical assets from its home country to a host country. FDI can be explained on the basis of two main approaches: the OLI paradigm and strategic motives by MNCs. • The first encompasses “O” (owner-specific) advantages in an MNC’s home market, “L” (location-specific) characteristics abroad, and “I” (internalization) through which the multinational controls the value chain in its industry. • The second refers to companies that invest abroad as they seek markets, raw materials, production efficiency, knowledge, and/or political safety.

45. Long-Term Investment and Financing Decisions: Investment Cash Flows and Decisions Several factors that are unique to the international setting need to be examined when one is making long-term investment decisions. • Firms need to consider elements related to a parent company’s investment in a subsidiary and the concept of taxes. • The existence of different taxes—as pointed out earlier—can complicate measurement of the cash flows to be received by the parent because different definitions of taxable income can arise. • There are still other complications when it comes to measuring the actual cash flows. From a parent firm’s viewpoint, the cash flows are those that are repatriated from the subsidiary. In some countries, however, such cash flows may be totally or partially blocked. • Finally, there is the issue of risk attached to international cash flows.

46. Matter of Fact Adjusting Discount Rates • The discount rates used by the parent and subsidiary to calculate the NPV will be different. • The parent company has to add in a risk premium based on the possibility of exchange rates changing and the risk of not being able to get the cash out of the foreign country.

47. Long-Term Investment and Financing Decisions: Capital Structure Both theory and empirical evidence indicate that the capital structures of multinational companies differ from those of purely domestic firms. Several factors tend to influence the capital structures of MNCs. • International capital markets • International diversification • Country factors

48. Personal Finance Example An important aspect of personal financial planning involves channeling savings into investments that can grow and fund long-term financial goals. • Investors can invest in both domestic and foreign-based companies. • Investing internationally offers greater diversification than investing only domestically. • A number of academic studies overwhelmingly support the argument that well-structured international diversification does indeed reduce the risk of a portfolio and increase the return of portfolios of comparable risk. • One study found that over the 10 years ended in 1994, a diversified portfolio consisting of 70% domestic and 30% foreign stocks reduced risk by about 5% and increased return by about 7%.

49. Global Focus Take an Overseas Assignment to Take a Step Up the Corporate Ladder • There is nothing like an extended stay in a foreign country to get a different perspective on world events, and there are sound career-enhancing reasons to work abroad. International experience can give you a competitive edge and may be vital to career advancement. • As globalization has pushed companies across more borders, CFOs with international experience have found themselves in greater demand. • Some chief executives value international experience in their CFOs more highly than either mergers and acquisitions or capital-raising experience. If going abroad for a full-immersion assignment is not possible, what are some substitutes for a global assignment that may provide some—albeit limited—global experience?

50. Long-Term Investment and Financing Decisions: Long-Term Debt An international bond is a bond that is initially sold outside the country of the borrower and is often distributed in several countries. A foreign bond is an international bond that is sold primarily in the country of the currency in which the issue is denominated. 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.