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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
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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.
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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:
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.
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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
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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.
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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 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.
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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.
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.
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.
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.
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.
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.
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.-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.
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
Real/Dollar
1.5
1
0.5
0
20 1
20 -2
20 -3
20 4
20 -1
20 2
20 3
20 -4
20 1
20 2
20 -3
20 4
-1
-
-
-
-
03
03
04
04
05
03
03
04
04
05
05
05
06
20
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
_________________________
CHAPTER TERMINOLOGY:
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ADDITIONAL EXERCISES: Multinational Finance
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?
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