• • • • • • • • 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 216

also the review the map. where a weakening yen translated into millions of dollars of losses in exchange rate exposure. II. (ii) financial systems with external assets and liabilities out of proportion with domestic needs. Companies can raise funds in both local and international debt and equity markets (such as the Eurodollar. It is the responsibility of an organization’s chief financial officer (CFO) to acquire (generate) and allocate (invest) financial resources among activities and projects. currency flows and restrictions. The amount of leverage used varies from country to country. Critical functions associated with the management of international cash flows are global borrowing. Consequently. and figures in the text. OFFSHORE FINANCIAL CENTERS Offshore financing is the provision of financial services by banks and other agents to nonresidents of a country. (iii) long-term financing and (iv) working capital management. This job becomes increasingly complex in the global environment because of factors such as foreign-exchange risk. THE TREASURY AND FINANCE FUNCTIONS Cash flow management is divided into four major areas: (i) capital structure. A company’s choice of capital structure depends on tax rates.than in Japan. (iii) are a tax haven country (a country with low or 217 . they represent major centers for the Eurocurrency market. Teaching Tip: Review the PowerPoint slides for Chapter 19 and select those you find most useful for enhancing your lecture and class discussion. and foreign exchange risk minimization. Eurobond. The degree to which a firm funds the growth of business by debt is known as leverage. equity placement. and Euroequity markets) as well as raise internal funds from the corporate family. III. INTRODUCTION MNEs access both local and global capital markets in order to finance their operational and expansion activities. I. Nu Skin implemented the use of hedging strategies to reduce the risk of currency fluctuations. IV. For additional visual summaries of key chapter points. CAPITAL STRUCTURE Capital structure is the mix between long-term debt and equity. differing tax rates and laws and regulations regarding access to capital. (ii) capital budgeting. OFCs are (i) jurisdictions that have relatively large numbers of financial institutions engaged primarily in business with nonresidents. 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. table. 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. and creditor rights within its country and in other countries. degree of development of local equity markets.

Terrorists and drug dealers also use OFCs to launder money. COUNTERPOINT: Despite examples of corporate malfeasance.g. 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. establishing shell companies in the Caribbean to capture cash through fake invoices and taxation). 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. More and more countries are taxing offshore earnings. created hundreds of subsidiaries in tax havens and used them to pass off corporate debs. Parmalat used a similar strategy. Such centers are either operational centers.. 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. with extensive banking activities involving short-term financial transactions (e. The key is to improve transparency and reporting so that illegal activities can be curtailed.g. 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. and executive compensation. They allow subsidiaries to take advantage of lower borrowing costs and tax rates—activities that are not illegal. the Cayman Islands). lacking transparency and regulatory supervision. or booking centers. Enron. making it harder for companies to avoid paying taxes. separating non-resident financial activities from those of residents. and offer banking secrecy and anonymity. CAPITAL BUDGETING IN A GLOBAL CONTEXT Capital budgeting is the process whereby MNEs determine which projects and countries will receive capital investment funds. and lacking the effective exchange of information with other countries. Several approaches to capital 218 . Generally. losses. OFCs serve useful and ethical purposes. one of the largest bankruptcies in corporate history. V. London). have moderate to light financial regulation..

legal and political constraints on the movement of funds. local business norms. royalties. A. INTERNAL SOURCES OF FUNDS Funds refer to working capital. international cash management is complicated by differing inflation rates. Internal sources of funds include loans.. home. 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. services and funds all can move within an MNE. Another method is to determine the net present value (NPV) of a project.budgeting are possible.e. B. and differences in how financial markets and institutions function. subsidiary to parent and/or subsidiary to subsidiary. management fees and the repayment of principal and interest on loans. reducing transaction costs. One method uses a payback period—the number of years required to recover the initial investment made. Transfer pricing can be used to adjust the size of a payment. firms can generate cash from normal operations. Multilateral Netting Netting is the process of coordinating cash inflows and outflows among subsidiaries so that only net cash is transferred. 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. Interfirm financial links become extremely important as MNEs grow in size and complexity. payment of intracompany receivables and payables) is affected by differing tax systems. what should be done with it? Cash budgets and forecasts are essential in assessing a firm’s cash needs. or third countries may have widely divergent views on the project’s value VI. thus creating receivables and payables. which is a function of the annual free cash flow in a period. and the project’s expected life. Cash may be transferred within a firm via dividends. Goods. In addition. 219 . Global Cash Management Global cash management strategy focuses on the flow of money to serve specific operating objectives. fluctuating exchange rates and distinct national and regional bloc policies regarding the flow of funds. Whatever the means. the difference between current assets and current liabilities. Entities may choose to pay quickly (a leading strategy) or to defer payment (a lagging strategy). investment through equity capital. interfirm receivables and payables and dividends. i. 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. interest on loans. • 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. the initial outlay of cash. the required rate of return or cost of capital. Funds can flow from parent to subsidiary.

A letter of credit (L/C) obligates the buyer’s bank to pay the exporter. or clearing account. A. A confirmed letter of credit involves a guarantee of an additional bank. 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. thereby adding a level of payment protection to the exporter beyond the sight or time drafts. This is generally used only when the parties to the transaction are members of the same corporate group. the source and cost of inputs and the location of investment.e..e. i.FOREIGN-EXCHANGE RISK MANAGEMENT Major financial risks arise from foreign exchange rate fluctuations. the receivable or payable changes in value as the relevant exchange rate changes. Economic Exposure. CASH FLOW ASPECTS OF IMPORTS AND EXPORTS The basic methods of payment for exports. i. 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). Translation Exposure..e. the value of the exposed asset or liability changes as the exchange rate changes. VIII. Transaction Exposure. it arises from the effects of exchange-rate fluctuations on expected cash flows. Strategies to protect against such risks may include the internal movement of funds. 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. The three types of foreign-exchange risk include translation exposure. VII. An exporter may occasionally sell on open account in which the exporter bills the importer but does not require formal payment documents. With a sight draft the exporter requests immediate payment. transaction exposure and economic exposure. 30 days after delivery.. 220 . while an irrevocable letter of credit requires all parties to agree to any change in the documents. Documentary drafts and documentary letters of credit are used to protect both the buyer and the seller. Economic or operational exposure reflects the foreign-exchange risk MNEs face in the pricing of products. A revocable letter of credit may be changed by any of the parties to the agreement. A time draft allows payment to be made later—for example. B. which disburses cash to net receivers. listed in descending order in terms of security to the exporter. i. C. as well as the use of foreign-exchange instruments such as options and forward contracts.Multilateral netting allows subsidiaries to transfer net intercompany flows to a cash center.

transaction and economic components. 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. The system should combine central control with input from foreign operations. magnitude and timing of exchange-rate fluctuations. Defining and Measuring Exposure. 4. with the transaction exposure identified by cash inflows and outflows over time. A key aspect of measuring exposure is forecasting exchange rates. to buy or sell a certain amount of foreign currency at a set exchange rate within a specified amount of time. However. Firms may choose to balance local assets with local debt by borrowing funds locally. rather than extract huge profits or risk huge losses. derivatives. or paying foreign-currency payables before they are due when a currency is expected to strengthen. A Reporting System. or delaying payment of foreigncurrency payables when the currency is expected to weaken. A Centralized Policy. especially in international 221 . where the major concerns are the direction.. 1. which establish fixed exchange rates for future transactions and currency options.e. A firm must devise a uniform reporting system for all its entities that identifies the exposed accounts it wants to monitor. 3. A lag strategy means delaying collection of foreign-currency receivables if the currency is expected to strengthen. but each level of management must be aware of the size of the exposure and its potential impact on the firm. 2. Formulating Hedging Strategies. because that helps avoid the foreignexchange risk associated with borrowing in a foreign currency. top management should determine hedging policy. each with cost/benefit and operational implications. A foreign-currency option is more flexible than a forward contract because it gives the purchaser the right. which assure access to a foreign currency at a fixed exchange rate for a specific period of time. such strategies may not be useful for the movement of large blocks of funds. TAXATION OF FOREIGN SOURCE INCOME Taxes can profoundly affect profitability and cash flow. Most MNEs prefer to cover exposure.D. and they may also be subject to government restrictions. A firm can hedge its position by adopting operational and/or financial strategies. A firm can also hedge exposure through forward contracts. i. IX. Exposure-Management Strategy Management must do a number of things if it wishes to protect assets from exchange-rate risk. An MNE must forecast the degree of exposure in each major currency in which it operates and adopt appropriate hedging strategies for each. but does not impose the obligation. Specific hedging strategies can be taken at any level. To achieve maximum effectiveness in hedging. Exposure should be separated into translation. the amount of the exposure by currency of each account and the different periods under consideration.

A.5% to a high of 42. each separate unit (company or individual) is taxed when it earns income. companies pay to another country in order to avoid double taxation. ranging from a low of 8. however. Subsidiary income is either taxable to the parent or tax deferred (not taxed until it is submitted as a dividend to the parent). B. licensing. or subpart F income. the IRS allows a tax credit for corporate income tax for tax that U. 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. Foreign Subsidiary A foreign corporation is an independent legal entity set up in a country according to the laws of incorporation of that country.S. In the integrated system. comes from sources other than those connected with the direct conduct of a trade or business (generally in tax haven countries). Taxation of corporate income occurs through either the separate entity (or classical) approach or the integrated system approach. it is called a subsidiary.S. 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. Active income is derived from the direct conduct of a trade or business. The OECD. and service income. Non-U. Foreign Branch Since a foreign branch is an extension of the parent company. Tax Credit In the United Tax Practices MNEs face problems from differences in tax practices around the world such as a lack of familiarity with laws and loose enforcement.2%. sales income. Passive. When an MNE purchases or establishes such an entity. Companies establish arbitrary transfer prices primarily because of differences in taxation between countries.S. Transfer Prices Transfer pricing applies to transactions between related entities and is not usually an arm’s length price (price between two unrelated entities). In the separate entity approach. U. Subpart F income includes holding company income. shareholders hold more than 50% of the voting stock. any foreign branch income (or loss) is directly included in the parent’s taxable income. debt or equity) • Capital budgeting decisions • Method of setting transfer prices Two major types of taxes are income taxes and excise taxes. 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 222 . C. Corporate tax rates vary from country to country. Taxation has a strong impact on several choices including: • Location of operations • Choice of operating form (export/import. 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. In a CFC.

The explosion of information and technology and the growing number and sophistication of hedging instruments will significantly influence cash management. and sometimes interest payments. each company pays a percentage of the value added to a product at each stage of the business process.S. The OECD. When agreeing to a treaty. CLOSING CASE: Dell Mercosur [See Figure 19. Given how Dell translates its foreign currency financial statements into dollars. Greater emphasis will be placed on moving corporate cash worldwide to take advantage of differing rates of return. The company maintains a production facility in Brazil.10] Dell Mercosur is the South American subsidiary of Dell Computer. 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.S. The EU has worked hard to reduce and standardize VAT rates among its members. but about 97% of Dell’s manufacturing costs in Brazil are denominated in U. dollars due to the company’s use of imported parts and components from the U. but new accounting standards will force companies to recognize gains and losses from derivatives in income. QUESTION 1. Dell’s revenues and operating costs in Brazil are almost entirely denominated in reels. Under a VAT. 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. The company uses foreign currency option contracts and forward contracts to hedge its exposure on forecasted transactions. Tax Treaties: The Elimination of Double Taxation The purpose of tax treaties is to prevent double taxation or to provide remedies when it occurs. as well as a call center that services both Brazil and Argentina. countries generally grant reciprocal reduction on dividend withholding and exempt royalties. and EU will help countries narrow their tax differences and crack down on the illegal transfer of money for illegal purposes.European countries. how would a falling Brazilian real affect Dell Mercosur’s financial statements? What about a rising real? 223 . IMF.

. Accordingly. Dell imports about 97 percent of its manufacturing costs. Dell also uses purchased options contracts and forward contracts as cash flow hedges.e. foreign-currency denominated purchases of certain components and interfirm shipments to certain international subsidiaries. U. although it would also translate into its U. equity would remain unchanged. 3. Because Dell’s strategy is to hedge all foreign-exchange risk. A rising real would have the opposite effect. then the value of the foreign. If all of Dell’s subsidiaries have their assets and liabilities based on financial instruments in the same currency. paying for imports before they are due. Shareholder’s equity reflects assets minus liabilities. 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. Describe and evaluate Dell’s exposure management strategy. dollar/Brazilian real rate changes. the value of foreign revenues would also fall. i. 2.S.S. the translated value of the revenues on the consolidated. because the transfer price payable changes in value as the U.-dollardenominated income statement would decline as well. What type of exposure does this create for it? What are its options to reduce that exposure? Primarily. will minimize costs to Dell Mercosur. Rather than attempting to extract huge profits. the use of a lead strategy.-dollar equivalent at a lower value.currency denominated assets would fall. as the value of the real falls. The subsidiary can also hedge its exposure through forward contracts and foreign currency options. Subsequently.S.-dollar functional currency entities. What has happened to the value of the real? Based on the change in the exchange rate. 4. Foreign operating income would also decline when the home-country’s currency strengthens. Dell uses foreign-currency options contracts and forward contracts to hedge its exposure on forecasted transactions and company commitments. income statement (operating income) and balance sheet (shareholder’s equity) would all be affected by a falling real. With respect to revenues.S. In relative terms. it is considered to be a very aggressive strategy. Dell has chosen to avoid huge losses. When the value of the real declines with respect to the dollar. Hedged transactions include international sales by U. Build a graph on the value of the real against the dollar by quarter since the third quarter of 2002. but so would the value of the foreign-currency denominated liabilities.Dell Mercosur’s revenues. Dell also uses forward contracts to hedge monetary assets and liabilities that are denominated in a foreign currency. the fact that Dell Mercosur imports nearly all of its manufacturing costs impacts transaction exposure. how would you evaluate Dell’s hedging philosophy and strategy? 224 .

p. p. p. p. 684 commercial bill of exchange. 683 for additional information and links relating to the topics presented in Chapter Nineteen. 689 currency option. 686 economic or operational exposure. 680 netting. p. Dollar 3. p. p. 696 . 685 _________________________ 225 open account. p. p. 677 payback period. as well as the Internet exercises for Chapter Nineteen. p. 693 transfer pricing. p. p. 692 subpart F income. 677 tax haven country. 684 revocable letter of credit. 692 arm’s-length price. p. 684 time draft. p. 684 irrevocable letter of credit.S. 693 value-added tax (VAT). _________________________ CHAPTER TERMINOLOGY: offshore financing. hedging against currency fluctuations is beneficial regardless of the direction of the currency change.Brazilian Real/U. 686 lead strategy. p. p. p. 680 net present value (NPV). p. 689 controlled foreign corporation (CFC).prenhall. 684 letter of credit (L/C). 689 lag strategy. p. 685 translation exposure.5 0 20 03 20 1 03 20 -2 03 20 -3 03 20 4 04 20 -1 04 20 2 04 -3 20 04 20 -4 05 20 1 05 -2 20 05 20 -3 05 20 4 06 -1 Real/Dollar The value of the real has declined since the end of 2002. p. 676 offshore financial centers (OFC). p.5 2 1. 686 transaction exposure. 691 active income. Be sure to refer your students to the online study guide. p. p. Still. p. p.5 3 2.5 1 0. 684 confirmed letter of credit. WEB CONNECTION Teaching Tip: Visit www. Dell’s hedging philosophy and strategy needed to change to adapt to a falling real. p. 684 sight draft.

Exercise 19. firms will likely prefer to finance their investments by borrowing from the global capital market. a firm needs to recognize the specific political and economic risks (including foreign-exchange risk) arising from that foreign location. However. Other things being equal. When using capital budgeting techniques to evaluate a potential foreign project. 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. 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. stock exchanges has increased dramatically since the early 1980s. Ask students to discuss this phenomenon in light of the recent global economic downturn. Ask students to compare the advantages of (i) using a higher discount rate and (ii) forecasting lower cash flows to evaluate such projects. The number of foreign corporations listing American Depository Receipts (ADRs) on the U.1. Typically.S. the cost of capital is lower in the global capital market than in domestic capital markets.ADDITIONAL EXERCISES: Multinational Finance Exercise 19.2.3. 226 . 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. such borrowing may be restricted by host-country regulations or demands.

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