Chapter 16 International Managerial Finance. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-2 Learning Goals 1.Understand the major.

Chapter 16

International Managerial Finance

Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-2

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.


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.


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.


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.


• 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: 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.).


• 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.)


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.


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.)




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.





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: 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.


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.


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.


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.


• 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.

Financial Statements: Translation of Individual Accounts (cont.)


Financial Statements: Translation of Individual Accounts (cont.)


US$1.00 = SF1.4175

SF1.00 = US$0.7055

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$.


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.


• 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.



Insert Figure 18.2 here



• 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.


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.



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.



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.


• Multinational companies face exchange rate risk under either fixed or floating-rate systems.

• Consider the following floating-rate example.





• 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.


• 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.



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.


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.


Risk: Political Risks (cont.)


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.


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.


• 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 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.



• 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.



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 subsidiary’s borrowing and lending opportunities are often greater since it can rely on the potential backing of the parent company.


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.


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 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.



On the basis of all available information, the parent firm has

provided each subsidiary with figures given as shown below:



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.



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.



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.


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).


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.

Chapter 16 International Managerial Finance. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 16-2 Learning Goals 1.Understand the major.

Documents

pearson addisonwesley

foreign countries

following slide

foreign income tax rate

foreign tax rates

level of foreign taxes

based mncs

international finance