Chapter 16 International Managerial Finance

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved The MNC and its Environment (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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). The MNC and its Environment (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.).

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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. The MNC and its Environment: Legal Forms of Business (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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%. The MNC and its Environment: Taxes (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved The MNC and its Environment: Taxes (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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. The MNC and its Environment: Taxes (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved The MNC and its Environment: Taxes (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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. The MNC and its Environment: Taxes (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved The MNC and its Environment: Taxes (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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 originhas 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.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved The current rate method is implemented in two steps: – First, each subsidiarys 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. Financial Statements: Translation of Individual Accounts (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Financial Statements: Translation of Individual Accounts (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved US$1.00 = SF SF1.00 = US$ 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$) and Swiss Franc (SF) is expressed as follows: The usual exchange rate quotation in international markets is given as SF1.4175/US$.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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. Risk: Exchange Rate Risk (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Insert Figure 18.2 here

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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 $ in the U.S. sells for $ X FG 2.00 = FG 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 = FG in Farland but for only 1.02 X $ = $ in the U.S. Risk: Exchange Rate Risk (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved These relative prices imply that that in 1 year, FG will be worth $ so the exchange rate in 1 year should change to FG250.00/$ = 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. Risk: Exchange Rate Risk (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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 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. Risk: Exchange Rate Risk (cont.) Multinational companies face exchange rate risk under either fixed or floating-rate systems. Consider the following floating-rate example.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Risk: Exchange Rate Risk (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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 firms financial statements. Perhaps more importantly, economic exposure is the risk resulting from the effects of changes in foreign exchange rates on the firms value.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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 managements attitude toward risk. Risk: Exchange Rate Risk (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Risk: Political Risks Political risk results from the discontinuity or seizure of an MNCs operations in a host country due to the hosts 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.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Risk: Political Risks (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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 companys 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.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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. Long-Term Investment and Financing Decisions (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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. Long-Term Investment and Financing Decisions (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Equity Capital – One way for MNCs to raise equity is the have the parents 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. Long-Term Investment and Financing Decisions (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Short-Term Financial Decisions Like purely domestic firms, MNCs have access to accounts payable, accruals, bank and non- bank sources of short-term funds. In addition, MNCs have access to the local economic market for both short and long- term funding. Finally, the subsidiarys borrowing and lending opportunities are often greater since it can rely on the potential backing of the parent company.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved Short-Term Financial Decisions (cont.) The Eurocurrency market is the portion of the Euromarket that provides short-term, foreign- currency 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.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved A multinational plastics company, International Molding, has subsidiaries in Switzerland (Swiss Franc, SF) and Japan (Japanese Yen, ¥). Based on each subsidiarys forecast operations, the short- term financial needs (in US$) are as follows: Switzerland: $80 million excess cash to be invested (lent) Japan: $60 million funds to be raised (borrowed) 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. Short-Term Financial Decisions (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved On the basis of all available information, the parent firm has provided each subsidiary with figures given as shown below: Short-Term Financial Decisions (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved From the MNCs point of view, the effective rates of interest, which take into account each currencys 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. Short-Term Financial Decisions (cont.)

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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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Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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 Chinas Hong Kong). Still others are operating from emerging nations (such as Brazil, China, Mexico, India, and Thailand).

Copyright © 2006 Pearson Addison-Wesley. All rights reserved 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.