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The Multinational Finance Function
To describe the multinational finance function and how it 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
The role of corporate financial management is to create and maintain economic value by maximizing shareholder wealth, i.e., the market value of existing shareholders common stock. The corporate finance function focuses upon the acquisition and allocation of financial resources among a firm s activities and investments, i.e., short-term and long-term cash flows.
MNEs access both local and global capital markets to finance their current and future operations.
Financial Management Activities
Activities related to the management of international cash flows include:
capital structure management: determining the proper mix of debt and equity long-term financing: selecting, issuing, and managing long-term debt and equity capital, both at home and abroad capital budgeting: determining which projects in which countries will receive capital investment funds working capital management: properly managing the firm s current assets and liabilities [cash, receivables, marketable securities, inventory, trade receivables and payables, short-term bank debt]
19.Fig.1: Finance in International Business 19-5 .
The Role of the Chief Financial Officer Chief Financial Officer (CFO): the executive responsible for acquiring and allocating a firm s financial resources Financial resource acquisition (financing): internally or externally generating funds at the lowest possible cost Financial resource allocation (investing): increasing shareholder wealth through the allocation of funds to selected projects and investment opportunities The CFO s job becomes increasingly complex in a global environment because of foreign exchange risk. regulations regarding access to capital. differences in tax rates and laws. currency flows and restrictions. etc. 19-6 . political and economic risk.
19.Fig.2: Location of the Treasury Function in the Corporate Organizational Structure 19-7 .
Country-specific factors are a more important determinant of a firm s capital structure than any other factor.Capital Structure Leverage: the degree to which a firm funds the growth of its business through borrowing (debt) Weighted average cost of capital: weighted after-tax proportion cost proportion average cost = cost of × of debt + of × of equity of capital debt financing equity financing The interest that firms pay on debt is tax-deductible. whereas dividends paid to investors are not. 19-8 . Excessive reliance on long-term debt increases financial risk and thus requires a higher return.
5% Germany 39. 2005.Capital Structures Around the World: Ranked by Common Equity Ratios.7% France 38.7% 43.3% 24.8% 30.8% Japan 33.3% United States 48.7% 44. Brigham. 13th Ed.5% TOTAL 31.8% 22.2% 15.3% 76.2% 66.4% Canada 47.2% SHORTTERM DEBT N/A 24. 19-9 .6% 23.3% 61.0% 43.7% Italy 23.6% 52. 1995 LONGTERM DEBT N/A 26.7% 51.5% 60. Essentials of Managerial Finance.3% COUNTRY EQUITY United Kingdom 68.0% 52.5% 23.5% Source: Scott Besley and Eugene F.
19-10 . The lack of the development of the bond and equity markets in Southeast Asia led to excessive dollar bank debt and was a major cause of the Asian financial crisis of 1997. and internal funds from the corporate family. foreign debt and equity markets. dividend remission policies.Choice of Capital Structure A firm s choice of capital structure depends upon: tax rates the degree of development of local equity markets creditor rights MNEs have an advantage because they can tap local debt and equity markets. and foreign exchange controls may cause a firm to rely more on debt in some situations and more on equity in others. Different tax rates.
. The OECD is working to eliminate the harmful tax practices of tax-haven countries by improving their transparency and the effective exchange rate information they provide.Offshore Financial Centers Offshore financing: the provision of financial services by banks and other agents to nonresidents. and banking secrecy and anonymity.e. i. the borrowing of money from and the lending of money to nonresidents Offshore financial centers (OFCs): countries or citystates that (i) provide large amounts of funds in currencies other than their own and thus are centers for the Eurocurrency market and (ii) are used as locations in which to raise and/or accumulate cash OFCs offer low or zero taxation. 19-11 . moderate or light financial regulation.
net supplier of funds to the world s financial markets a market that serves as 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 [continued] 19-12 .OFC Characteristics An offshore financial center possesses one or more of the following characteristics: a large foreign currency (Eurocurrency) market for deposits and loans a market that serves as a large.
the Netherlands Antilles] Offshore financial centers offer a more flexible and less expensive source of funding for MNEs. the Bahamas. London. the Cayman Islands.OFCs are either: operational centers.. with extensive banking activities involving short-term financial transactions [e. Bahrain.g. in which little banking activity takes place but where transactions are recorded to take advantage of secrecy laws and/or low or no tax rates [e. Singapore. Switzerland] or booking centers. 19-13 .g..
Capital budgeting techniques include: payback period: the number of years required to recover the original investment the net present value of a project (NPV): the present value of future cash outflows minus the present value of future cash inflows the internal rate of return (IRR): the rate that equates the present value of future cash flows with the present value of the initial investment 19-14 .Capital Budgeting Capital budgeting: the process whereby firms determine which projects in which countries will receive capital investment funds MNEs determine their free cash flows based on cash flow estimates and tax rates in different countries as well as an appropriate required rate of return adjusted for risk.
Capital Budgeting: Foreign Project Assessment Unique capital budgeting aspects of foreign project assessment include: distinguishing parent cash flows from project cash flows accounting for the effects of legal and political constraints on the movement and remittance of funds anticipating differing rates of inflation and exchange rate fluctuations evaluating potential economic and political risk estimating the terminal value of a project [continued] 19-15 .
and pessimistic scenarios adjusting the hurdle rate. the return must be considered in terms of both (i) local currency and (ii) the parent s currency.e. i. Finally.Ways to deal with the variations in future cash flows in the capital budgeting process include: developing optimistic. for a project Once a budget is complete. capital budgeting decisions must ultimately be made in the strategic context of related investments. most likely. as well as their financial context.. 19-16 . the minimum required rate of return.
selling shares Uses of funds include: the purchase of fixed assets the purchase of materials and supplies paying employee wages and benefits investing in marketable securities and/or long-term investments 19-17 . issuing bonds.Internal Sources of Funds Funds: working capital..e. current assets minus current liabilities Internal sources of funds include: operations: intercompany receivables and payables. dividends financing activities: securing loans. i.
Fig.4: Internal Sources of Funds for MNEs 19-18 . 19.
Cash can also be remitted through royalties. how should it be used? Dividends are a good source of intercompany transfers. To ensure effective cash management. three questions must be answered: What are the local and corporate system needs for cash? How can cash be withdrawn from foreign operations and centralized? Once cash is centralized. 19-19 . management fees.Global Cash Management Global cash management is complicated by differing inflation rates. and government restrictions on the flow of funds. but governments often restrict their free movement. exchange rate fluctuations. and the repayment of principal and interest on loans.
19.5: Multilateral Cash Flows in the Absence of Netting 19-20 .Fig.
thus minimizing transaction costs Multilateral netting allows subsidiaries to transfer net intercompany flows to a cash center. transfers take place in the payer's currency. and the foreign exchange conversion takes place centrally. 19-21 .Multilateral Netting Multilateral netting: the process of coordinating cash inflows and outflows among subsidiaries so that only net cash is transferred. Generally. which then disburses cash to net receivers. Netting requires sophisticated software and good banking relationships in relevant countries. or clearing account.
000 $300.000 TOTAL PAYABLES $350.000 $250.Net Positions of Subsidiaries in Four European Countries (IN $US) SUBSIDIARY French German Italian British TOTAL RECEIVABLES $250.000 NET POSITION ($100.000 Net position = total receivables minus total payables. 19-22 .000 ($150.000) $150.000 $100.000 $300.000 $150.000) $100.000 $200.
Fig.6: Multilateral Netting 19-23 . 19.
19-24 . the basic methods of payments for exports are: cash in advance letter of credit (L/C): obligates the buyer s bank to pay the exporter either at sight or in time [may be revocable or irrevocable and/or confirmed by an additional bank] draft or commercial bill of exchange: either paid immediately via a sight draft or later via a time draft open account: generally reserved for members of the same corporate group Documentary drafts and letters of credit require that payment be made upon presentation of documents conveying the title.Cash Flow Aspects of Imports and Exports In terms of security to the exporter.
7: Letter of Credit Relationships 19-25 .Fig. 19.
Foreign Exchange Risk Management Types of exposure that can result from foreign exchange fluctuations include: translation exposure: the change in value of an exposed asset or liability due to exchange rate changes [the gain or loss does not represent an actual cash flow effect because it is only translated. the sourcing and cost of inputs. and the competitive position of the firm [cash flow impact may be both immediate and long-term] 19-26 . the location of investments. not converted] transaction exposure: the change in value of a payable or receivable due to exchange rate changes [foreign exchange risk] economic (operating) exposure: the potential change in expected cash flows arising from product prices.
Exposure Management Strategy To adequately protect assets. 19-27 . management must: define and measure all three types of exposure organize and implement a uniform reporting system to monitor exposure and exchange rate movements using both central control and foreign input adopt a centralized hedging policy that assigns responsibility for minimizing exposure formulate operational and/or financial strategies for hedging exposure The safest position is a balanced one in which exposed assets equal exposed liabilities.
e.. or paying foreign currency payables before they are due when that currency is expected to strengthen lag strategies. i. i. delaying the collection of foreign currency receivables when that currency is expected to strengthen.Hedging Strategies Operational strategies: adjusting the flow of money and other resources in normal operations so as to reduce foreign exchange risk the use of local debt to balance local assets lead strategies. collecting foreign currency receivables before they are due when that currency is expected to weaken.e.. or delaying the payment of foreign currency payables when that currency is expected to weaken shifting assets overseas to capture advantages embedded in currency fluctuations [continued] 19-28 .
Both operational and financial hedging strategies have cost/benefit as well as operational implications.Financial strategies: using the forward to specify future exchange rates market using forward contracts to establish fixed exchange rates for future transactions using currency options to ensure access to a foreign currency at a fixed exchanged rate for a specific period of time By consolidating its foreign currency exposure. 19-29 . a firm can net its exposures from different operations around the world and thus take advantage of natural offsets.
subsidiary) the location of facilities in tax haven countries to raise capital and manage cash the methods of financing (external sourcing. FDI) the legal form of a foreign enterprise (branch vs. or equity) capital budgeting transfer pricing methods 19-30 . licensing. debt.Taxation of Foreign Source Income Taxation can profoundly affect profitability and cash flow via the following decisions: the location of operations the choice of operating form (trade.
S. shareholders [a U. shareholder is any U. person or company that holds 10 percent or more of the CFC s voting stock] 19-31 .Legal Forms of Foreign Enterprises Foreign branch: a foreign extension of the parent company [profits or losses are directly included in the parent s taxable income] Foreign subsidiary: an independent legal entity established in a foreign country according to its laws of incorporation [income is either reinvested in the subsidiary or remitted as a dividend to the parent company] Controlled foreign corporation (CFC): a foreign corporation in which more than 50 percent of the voting stock is held by U.S.S.
S.S. person W U. person Y Foreign person Z Total A 100% B 45% 10% 20% 25% 100% 100% C 30% 10% 8% 8% 44% 100% 19-32 .S. person X U.Determination of Controlled Foreign Corporations PERCENTAGES OF VOTING STOCK FOREIGN FOREIGN FOREIGN CORPORATION CORPORATION CORPORATION SHAREHOLDER U.S. person V U.
government treats any country whose income tax is lower that that of the United States as a tax-haven country. corporation Passive income (Subpart F income): usually derived from the operations of a foreign subsidiary of a U.S.S.Active vs. 19-33 . corporation in a tax-haven country via: holding company income sales income service income The U.S. Passive Income Active income: derived from the direct conduct of trade or business of the foreign subsidiary of a U.
Fig.8: A Tax-haven Subsidiary as a Holding Company 19-34 . 19.
S.Fig.9: Tax Status of Active Subpart F Income from Foreign Operations of U. Companies 19-35 . 19.
tax liability that directly coincides with the recognition of income The OECD has established transfer pricing guidelines in order to eliminate the manipulation of prices and taxes paid by MNEs. finished goods and/or services to another entity.. i. components.e. an external market price Tax credit: a dollar-for-dollar reduction of a U.Transfer Prices and Tax Credits Transfer price: the price at which one member of a corporate family sells (transfers) inputs. 19-36 .S.e. i. an internal price Arm s-length price: the price between two parties that have no ownership interest in the other..
Tax Practices Variations in countries generally accepted accounting principles (GAAPs) can lead to differences in their determinations of taxable income.S. Corporate tax rates may be determined by: the separate entity (classical) approach: taxes each separate entity (firm or individual) when it earns income the integrated system approach: splits tax rates and/or gives tax credits in order to avoid the double taxation of corporate income Taxes on the earnings of foreign subsidiaries may be determined by: the territorial approach: taxes only domestically-sourced income the global approach: taxes both the profits of foreign branches and dividends received from foreign subsidiaries 19-37 .Non-U.
May 30.0 32. Gov.38 18.54 24.9 No United Kingdom 30.0 18.0 29.0 29.0 24.0 2.Selected Corporate Income Tax Rates Cent.5 44.0 17.6 Yes Finland 29.8 30. 19-38 .0 52. Gov.Corp.0 34.Tax Inc.0 27.Gov.0 24. Adj.0 28.0 30.9 Yes Korea 28. Combined Corp.5 6.7 6.2005.0 Yes United States 35.0 28.0 No Germany 42. Targeted Inc.0 Yes Japan 30.Cent.0 Yes Ireland 24.0 30.0 No Hungary 18.0 Yes Canada 29.7 39.Tax Inc. Sub-cent.8 Yes Norway 28.1 15.1 29.4 Yes Source: OECD Tax Rate Base.0 34. Corp.4 13.Tax Inc.Corp.0 18.Tax Corp.5 40.0 28.0 Yes Switzerland 8.Tax COUNTRY Rate Rate Rate Rate Rate Australia 34.2 35.
or to provide remedies when it occurs. interest payments The primary purpose of tax treaties is to prevent international double taxation. The OECD. occasionally. 19-39 . as well as the exemption of taxes on royalties and. and the EU are all working to help nations narrow their tax differences and crack down on the illegal transfer of money for illegal purposes.The VAT and Tax Treaties Value added tax: each independent firm is taxed a percentage of the value added at each stage of the business process Tax treaty: a treaty between two nations that usually results in a reciprocal reduction on dividend withholding taxes. the IMF.
Offshore financial centers represent jurisdictions with relatively large numbers of financial institutions primarily engaged in business with nonresidents.Implications/Conclusions MNEs may employ internal capital markets in order to overcome imperfections in external capital markets. [continued] 19-40 .
and the method of setting transfer prices. and a firm s production and marketing decisions. International tax planning has a strong impact on the choice of location for the initial investment. the amount of cash that can be earned from foreign currency transactions. 19-41 .Exchange rate fluctuations can influence the equivalency of foreign currency financial statements. the legal form of a new enterprise. the method of financing.
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