1. CHAPTER NINETEEN
THE MULTINATIONAL FINANCE FUNCTION
Objectives
• 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.
Chapter Overview
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.
Chapter Outline
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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2. 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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3. 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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4. 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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5. 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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6. 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 foreign-exchange
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 foreign-currency
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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7. 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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8. 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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9. 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.-dollar-denominated
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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10. Brazilian Real/U.S. Dollar
3.5
3
2.5
2
1.5
1
0.5
0
2003-1
2003-2
2003-3
2003-4
2004-1
2004-2
2004-3
2004-4
2005-1
2005-2
2005-3
2005-4
2006-1
Real/Dollar
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.
_________________________
CHAPTER TERMINOLOGY:
offshore financing, p. 676
offshore financial centers (OFC),
p. 677
tax haven country, p. 677
payback period, p. 680
net present value (NPV), p. 680
netting, p. 683
draft, p. 684
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
open account, p. 685
translation exposure, p. 686
transaction exposure, p. 686
economic or operational exposure,
p. 686
lead strategy, p. 689
lag strategy, p. 689
currency option, p. 689
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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11. 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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