Chapter 18 International Managerial Finance

Transcription

1 -GITM.ch CTP 12/8/04 6:15 PM Page 790 Chapter 18 International Managerial Finance L E A R N I N G LG1 LG2 LG3 G O A L S Understand the major factors that influence the financial operations of multinational companies (MNCs). Describe the key differences between purely domestic and international financial statements consolidation, translation of individual accounts, and international profits. Discuss exchange rate risk and political risk, and explain how MNCs manage them. ACROSS TH E DISCI P LI N ES LG5 LG6 Describe foreign direct investment, investment cash flows and decisions, the MNCs capital structure, and the international debt and equity instruments available to MNCs. Discuss the role of the Eurocurrency market in short-term borrowing and investing (lending) and the basics of international cash, credit, and inventory management. Review recent trends in international mergers and joint ventures. WHY THIS CHAPTER MATTERS TO YOU Accounting: You need to understand the tax rules for multinational companies, how to prepare consolidated financial statements for subsidiary companies, and how to account for international items in financial statements. Information systems: You need to understand that if the firm undertakes foreign operations, it will need systems that track investments and operations in another currency and their fluctuations against the domestic currency. Management: You need to understand both the opportunities and the risks involved in international operations; the possible role of international financial markets in raising capital; and the basic hedging strategies that multinational 790 LG4 companies can use to protect themselves against exchange rate risk. Marketing: You need to understand the potential for expanding into international markets and the ways of doing so (exports, foreign direct investment, mergers, and joint ventures); also, you should know how investment cash flows in foreign projects will be measured. Operations: You need to understand the costs and benefits of moving operations offshore and/or buying equipment, parts, and inventory in foreign markets. Such an understanding will allow you to participate in the firm s decisions with regard to international operations.

2 -GITM.ch CTP 12/7/04 7:12 PM Page 791 GENERAL ELECTRIC COMPANY GROWING IN AN UNCERTAIN WORLD T he world s largest firm, General Electric Company ( with a market capitalization of more than $343 billion, considers globalization one of its core competencies. GE has manufactured and sold products outside the United States for 100 years, and a third of its leadership team is global. With global revenues of $61 billion (45 percent of its total revenues in 2003), the company expects its international sales to grow 15 percent in GE believes that global growth requires more than simply shipping products. A company must be equally committed to developing capabilities and relationships in the markets where it wants to succeed. One of GE s markets is China, where its revenues totaled $2.6 billion in China will invest $300 billion for infrastructure energy, aviation, water, and health care in this decade. The 2008 Olympics in Beijing will be one of its massive infrastructure projects. With its superior infrastructure technology, GE expects to be a major participant in helping China prepare for the 2008 summer games. To support its Chinese customers, GE has more than 1,700 sales and service people on the ground. It has built a Global Research Center in Shanghai to develop the capabilities of its Chinese suppliers, and the company is training its own Chinese business leaders and customers in GE management techniques. In other words, it is treating China exactly as it does developed markets such as the United States, Japan, and Europe. This approach is working in other developing markets. The firm s revenues in Eastern Europe, Russia, and Iraq are expected to grow from $1.2 billion in 2003 to $5 billion in GE recently signed a $700 million agreement to modernize the rail system in Russia and has an additional $2 billion of power project opportunities. GE s Consumer and Commercial Finance profits in Eastern Europe are growing 30 percent annually. With more than half of Iraq s power grid based on GE technology, the company has the capabilities that Iraq will need as it rebuilds. GE received $450 million of orders in Iraq in 2003 and believes that it could receive $3 billion more over the next few years. Like GE, many companies are looking beyond their home countries borders for new market opportunities. While globalization can bring controversy, companies such as GE believe that future growth requires that U.S. companies view the world as their market. This chapter will explain the additional considerations they must take into account as they apply the principles of managerial finance in the international setting. Source: 2003 Annual Report, (accessed August 16, 2004). When countries or regions experience currency and/or economic stress, how might it affect a company that does business in that area of the world? 791

3 792 PART SIX Special Topics in Managerial Finance LG The Multinational Company and Its Environment multinational companies (MNCs) Firms that have international assets and operations in foreign markets and draw part of their total revenue and profits from such markets. Hint One of the reasons why firms have operations in foreign markets is the portfolio concept that was discussed in Chapter 5. Just as it is not wise for the individual investor to put all of his or her investment into the stock of one firm, it is not wise for a firm to invest in only one market. By having operations in many markets, firms can smooth out some of the cyclic changes that occur in each market. In recent years, as world markets have become significantly more interdependent, international finance has become an increasingly important element in the management of multinational companies (MNCs). These firms, based anywhere in the world, have international assets and operations in foreign markets and draw part of their total revenue and profits from such markets. The principles of managerial finance presented in this text are applicable to the management of MNCs. However, certain factors unique to the international setting tend to complicate the financial management of multinational companies. A simple comparison between a domestic U.S. firm (firm A) and a U.S.-based MNC (firm B), as illustrated in Table 18.1, indicates the influence of some of the international factors on MNCs operations. In the present international environment, multinationals face a variety of laws and restrictions when operating in different nation-states. The legal and economic complexities existing in this environment are significantly different from those a domestic firm would face. Here we take a brief look at the newly emerging trading blocs in North America, western Europe, and South America; GATT and the WTO; legal forms of business organization; taxation of MNCs; and financial markets. Emerging Trading Blocs During the early 1990s, three important trading blocs emerged, centered in the Americas and western Europe. Chile, Mexico, and several other Latin American countries began to adopt market-oriented economic policies in the late 1980s, TABLE 18.1 International Factors and Their Influence on MNCs Operations Factor Firm A (Domestic) Firm B (MNC) Foreign ownership All assets owned by domestic Portions of equity of foreign entities investments owned by foreign partners, thus affecting foreign decision making and profits Multinational All debt and equity structures Opportunities and challenges capital markets based on the domestic capital arise from the existence of market different capital markets where debt and equity can be issued Multinational All consolidation of financial The existence of different accounting statements based on one currencies and of specific currency translation rules influences the consolidation of financial statements into one currency Foreign exchange All operations in one currency Fluctuations in foreign exchange risks markets can affect foreign revenues and profits as well as the overall value of the firm

4 CHAPTER 18 International Managerial Finance 793 North American Free Trade Agreement (NAFTA) The treaty establishing free trade and open markets between Canada, Mexico, and the United States. Central American Free Trade Agreement (CAFTA) A trade agreement signed in by the United States and five Central American countries (Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua). European Union (EU) A significant economic force currently made up of 25 nations that permit free trade within the union. European Open Market The transformation of the European Union into a single market at year-end euro A single currency adopted on January 1, 1999, by 12 EU nations, which switched to a single set of euro bills and coins on January 1, monetary union The official melding of the national currencies of the EU nations into one currency, the euro, on January 1, Mercosur Group A major South American trading bloc that includes countries that account for more than half of total Latin American GDP. forging very close financial and economic ties with the United States and with each other. In 1988, Canada and the United States negotiated essentially unrestricted trade between their countries, and this free-trade zone was extended to include Mexico in late 1992 when the North American Free Trade Agreement (NAFTA) was signed by the presidents of the United States and Mexico and the prime minister of Canada. NAFTA was ratified by the U.S. Congress in November This trade pact simply mirrors underlying economic reality Canada and Mexico are among the United States largest trading partners. In , the United States signed a bilateral trade deal with Chile and also a regional pact, known as the Central American Free Trade Agreement (CAFTA), with the Dominican Republic and five Central American countries (Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua). The European Union, or EU, has been in existence since It has a current membership of 25 nations. With a total population estimated at more than 430 million (compared to the U.S. population of about 295 million) and an overall gross national income paralleling that of the United States, the EU is a significant global economic force. Via a series of major economic, monetary, financial, and legal provisions set forth by the member countries during the 1980s, the countries of Western Europe opened a new era of free trade within the union when intraregional tariff barriers fell at the end of This transformation is commonly called the European Open Market. Although the EU has managed to reach agreement on most of these provisions, debates continue on certain other aspects (some key), including those related to automobile production and imports, monetary union, taxes, and workers rights. As a result of the Maastricht Treaty of 1991, 12 EU nations adopted a single currency, the euro, as a continentwide medium of exchange beginning January 1, Beginning January 1, 2002, 12 EU nations switched to a single set of euro bills and coins, causing the national currencies of all 12 countries participating in monetary union to slowly disappear in the following months. At the same time that the European Union implemented monetary union (which also involved creating a new European Central Bank), the EU had to deal with a wave of new applicants, resulting in the May 1, 2004, admission of 10 new members from eastern Europe and the Mediterranean region. The rapidly emerging new community of Europe offers both challenges and opportunities to a variety of players, including multinational firms. MNCs, especially those based in the United States, today face heightened levels of competition when operating inside the EU. As more of the existing restrictions and regulations are eliminated, for instance, U.S. multinationals will have to face other MNCs, some from within the EU itself. The third major trading bloc that arose during the 1990s is the Mercosur Group of countries in South America. Beginning in 1991, the nations of Brazil, Argentina, Paraguay, and Uruguay began removing tariffs and other barriers to intraregional trade. The second stage of Mercosur s development, which began at the end of 1994, involved the development of a customs union to impose a common tariff on external trade while enforcing uniform and lower tariffs on intragroup trade. The long-term importance of Mercosur, CAFTA, and other regional and bilateral trade agreements will be influenced by the decisions of the U.S. Congress in expanding the reach of NAFTA, as well as by other hemispheric and global economic developments and agreements. In any case, the Mercosur countries represent well over half of total Latin American GDP, and

5 794 PART SIX Special Topics in Managerial Finance thus they will loom large in the plans of any MNC that wishes to access the growth markets of this region. U.S. companies can benefit from the formation of regional and bilateral trade pacts, but only if they are prepared to exploit them. They must offer a desirable mix of products to a collection of varied consumers and be ready to take advantage of a variety of currencies and of financial markets and instruments (such as the Euroequities discussed later in this chapter). They must staff their operations with the appropriate combination of local and foreign personnel and, when necessary, enter into joint ventures and strategic alliances. General Agreement on Tariffs and Trade (GATT) A treaty that has governed world trade throughout most of the postwar era; it extends free-trading rules to broad areas of economic activity and is policed by the World Trade Organization (WTO). World Trade Organization (WTO) International body that polices world trading practices and mediates disputes between member countries. GATT and the WTO Although it may seem that the world is splitting into a handful of trading blocs, this is less of a danger than it may appear to be, because many international treaties are in force that guarantee relatively open access to at least the largest economies. The most important such treaty is the General Agreement on Tariffs and Trade (GATT). In 1994, Congress ratified the most recent version of this treaty, which has governed world trade throughout most of the postwar era. The current agreement extends free-trading rules to broad areas of economic activity such as agriculture, financial services, and intellectual property rights that had not previously been covered by international treaty and were thus effectively off-limits to foreign competition. The 1994 GATT treaty also established a new international body, the World Trade Organization (WTO), to police world trading practices and to mediate disputes between member countries. The WTO began operating in January In 2004, preliminary approvals were granted for an eventual membership of the Russian Federation in the WTO. As more countries join the WTO, the long-term prospects are expected to improve for trade and economic performance around the world. In December 2001, the People s Republic of China was, after years of controversy, granted membership. Now that China s status is resolved, there is an improved chance for stability in world trading patterns, in spite of the stunning collapse of several East Asian economies that began in July joint venture A partnership under which the participants have contractually agreed to contribute specified amounts of money and expertise in exchange for stated proportions of ownership and profit. Legal Forms of Business Organization In many countries outside the United States, operating a foreign business as a subsidiary or affiliate can take two forms, both similar to the U.S. corporation. In German-speaking nations the two forms are the Aktiengesellschaft (A.G.) or the Gesellschaft mit beschrankter Haftung (GmbH). In many other countries the similar forms are a Société Anonyme (S.A.) or a Société à Responsibilité Limitée (S.A.R.L.). The A.G. and the S.A. are the most common forms, but the GmbH and the S.A.R.L. require fewer formalities for formation and operation. Although establishing a business in a form such as the S.A. can involve most of the provisions that govern a U.S.-based corporation, to operate in many foreign countries, it is often essential to enter into joint-venture business agreements with private investors or with government-based agencies of the host country. A joint venture is a partnership under which the participants have contractually

6 CHAPTER 18 International Managerial Finance 795 agreed to contribute specified amounts of money and expertise in exchange for stated proportions of ownership and profit. Joint ventures are common in most of the less developed nations. Emerging and developing countries have varying laws and regulations regarding MNCs subsidiary and joint-venture operations. Whereas many host countries (including Mexico, Brazil, South Korea, Thailand, and Taiwan) have either completely removed or significantly liberalized their local-ownership requirements, other major economies (including China and India) are just beginning to relax these restrictions. China, for instance, has gradually opened up new economic sectors and industries to partial (and, in a few cases, full) foreign participation, while India continues to insist on majority local ownership in wideranging segments of its economy. MNCs, especially those based in the United States, the EU, and Japan, will face new challenges and opportunities in the future in terms of ownership requirements, mergers, and acquisitions. The existence of joint-venture laws and restrictions has implications for the operation of foreign-based subsidiaries. First, majority foreign ownership may result in a substantial degree of management and control by host country participants; this, in turn, can influence day-to-day operations to the detriment of the managerial policies and procedures that are normally pursued by MNCs. Next, foreign ownership may result in disagreements among the partners as to the exact distribution of profits and the portion to be allocated for reinvestment. Moreover, operating in foreign countries, especially on a joint-venture basis, can involve problems regarding the remittance of profits. In the past, the governments of Argentina, Brazil, Venezuela, and Thailand, among others, have imposed ceilings not only on the repatriation (return) of capital by MNCs but also on profit remittances by these firms to the parent companies. These governments usually cite the shortage of foreign exchange as the motivating factor. Finally, from a positive point of view, it can be argued that MNCs operating in many of the less developed countries benefit from joint-venture agreements, given the potential risks stemming from political instability in the host countries. This issue will be addressed in detail in subsequent discussions. Taxes Multinational companies, unlike domestic firms, have financial obligations in foreign countries. One of their basic responsibilities is international taxation a complex issue because national governments follow a variety of tax policies. In general, from the point of view of a U.S.-based MNC, several factors must be taken into account. Tax Rates and Taxable Income First, the level of foreign taxes needs to be examined. Among the major industrial countries, corporate tax rates do not vary too widely. Many less industrialized nations maintain relatively moderate rates, partly as an incentive for attracting foreign capital. Certain countries in particular, the Bahamas, Switzerland, Liechtenstein, the Cayman Islands, and Bermuda are known for their low tax levels. These nations typically have no withholding taxes on intra-mnc dividends.

7 796 PART SIX Special Topics in Managerial Finance Next, there is a question as to the definition of taxable income. Some countries tax profits as received on a cash basis, whereas others tax profits earned on an accrual basis. Differences can also exist in treatments of noncash charges, such as depreciation, amortization, and depletion. Finally, the existence of tax agreements between the United States and other governments can influence not only the total tax bill of the parent MNC but also its international operations and financial activities. unitary tax laws Laws in some U.S. states that tax multinationals (both U.S. and foreign) on a percentage of their total worldwide income rather than solely on the MNCs earnings arising within their jurisdiction. EXAMPLE Tax Rules Different home countries apply varying tax rates and rules to the global earnings of their own multinationals. Moreover, tax rules are subject to frequent modifications. In the United States, for instance, the Tax Reform Act of 1986 resulted in certain changes affecting the taxation of U.S.-based MNCs. Special provisions apply to tax deferrals by MNCs on foreign income; operations set up in U.S. possessions, such as the U.S. Virgin Islands, Guam, and American Samoa; capital gains from the sale of stock in a foreign corporation; and withholding taxes. Furthermore, MNCs (both U.S. and foreign) can be subject to national as well as local taxes. As an example, a number of individual U.S. states have special unitary tax laws that tax the multinationals on a percentage of their total worldwide income rather than solely on their earnings arising within the jurisdiction of the state government. Obviously, these laws can make a big difference in a multinational s tax bill. (In response to unitary tax laws, some MNCs have pressured state governments into abolishing the laws. In addition, some MNCs have relocated their investments away from those states that continue to apply such laws.) 1 As a general practice, the U.S. government claims jurisdiction over all the income of an MNC, wherever earned. (Special rules apply to foreign corporations conducting business in the United States.) However, it may be possible for a multinational company to take foreign income taxes as a direct credit against its U.S. tax liabilities. The following example illustrates one way of accomplishing this objective. 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 aftertax 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%. Subsidiary income before local taxes $100,000 Foreign income tax at 35% 235,000 Dividend available to be declared $ 65,000 Foreign dividend withholding tax at 10% 26,500 MNC s receipt of dividends $ 58,500 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 1. For updated details on various countries tax laws, consult relevant publications of international accounting firms.

8 CHAPTER 18 International Managerial Finance 797 grossed-up income is calculated. Finally, the related taxes paid in the foreign country are applied as a credit against the additional U.S. tax liability: Additional MNC income $100,000 U.S. tax liability at 34% $ 34,000 Total foreign taxes paid to be used as a credit ($35,000 $6,500) 241,500 41,500 U.S. taxes due Net funds available to the parent MNC 0 $ 58,500 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, as shown in what follows, would have resulted in a substantial drop in the overall net funds available to the parent MNC: Subsidiary income before local taxes $100,000 Foreign income tax at 35% 235,000 Dividend available to be declared $ 65,000 Foreign dividend withholding tax at 10% 26,500 MNC s receipt of dividends $ 58,500 U.S. tax liability at 34% 219,890 Net funds available to the parent MNC $ 38,610 The preceding example clearly demonstrates that the existence of bilateral tax treaties and the subsequent application of tax credits can significantly enhance the overall net funds available to MNCs from their worldwide earnings. Consequently, in an increasingly complex and competitive international financial environment, international taxation is one of the variables that multinational corporations should fully utilize to their advantage. The In Practice box on page 798 discusses the ethical issues of gift-giving and bribery when doing business in foreign countries, which some consider a form of additional taxation. Financial Markets Euromarket The international financial market that provides for borrowing and lending currencies outside their country of origin. During the last two decades the Euromarket which provides for borrowing and lending currencies outside their country of origin has grown rapidly. The Euromarket provides multinational companies with an external opportunity to borrow or lend funds, with the additional feature of less government regulation. Growth of the Euromarket The Euromarket has grown large for several reasons. First, beginning in the early 1960s, the Russians wanted to maintain their dollar earnings outside the legal jurisdiction of the United States, mainly because of the Cold War. Second, the

9 798 PART SIX Special Topics in Managerial Finance In Practice FOCUS ON ETHICS IS GREASING THE PALMS AN ETHICAL GREASY POLE? When in Rome, do as the Romans do. Everybody does it. Got to do it if you re going to do business in that country. These are common rationalizations for excessive gift-giving and bribery, or greasing the palms of a government official or corporate purchasing agent to get a contract. The Conference Board Working Group on Global Business Ethics asks members not to engage in bribery regardless of how much justification there seems to be to do so. Sometimes business professionals fall into the end justifies the means rationalizations, thinking that they might just as well bribe someone to win a contract if they think their quality will be better than that of other companies which might be bribing someone as well while offering a lower-cost, lowerquality, and unsafe product. The result of such practices abroad is staggering: In Hong Kong, it is estimated that 3 to 5 percent of companies operating costs comprise gifts and bribes ($3 to $5 billion per year); in Russia, food prices plummeted 20 percent after sellers gained protection from having to bribe government officials. Northrop Grumman ran into ethical problems with illegal overseas payoffs and domestic political-contributions scandals. It now studies past ethical misdeeds as a means of enabling current employees to understand the new transparency and accountability at the company. For example, employees must watch a video called What Went Wrong, showing how engineering tests were falsified by the company, leading to a court case in which Northrop Grumman entered a guilty plea. The human resources department polls finance employees every 6 months to ensure that they know the procedures for reporting any wrongs they see. In the words of the firm s CFO, You don t get fired for identifying; you get fired for covering up. The Foreign Corrupt Practices Act prohibits payments and offers of payments or items of value to foreign officials, political parties, and political candidates with the intent of obtaining, keeping, or directing business. ServiceMaster, in its policy statement Our Responsibilities When Operating in Other Countries, highlights adherence to this act. It does allow for payment of modest gratuities to induce a person to do only what he or she is required to do and to which the Company is legally entitled... if it clearly conforms to local custom but only in certain areas of the world in which timely action by lowranking government employees can be obtained only by generally accepted payment of modest gratuities. The employee must document this payment and the ServiceMaster Law Department must be consulted prior to any such payments. Sources: Marianne M. Jennings, The Ethics of Business in China and Business Ethics in China, Corporate Finance Review (2001), pp ; Lisa Yoon, Work in Progress: As Mentoring and Ethics Training Evolve, Finance Learns How to Boost Team Spirit, CFO (November 2003), pp ; Our Responsibilities When Operating in Other Countries, media.corporate-ir.net/ media_files/nys/svm/corpgov/ code_of_conduct_v2.pdf, p. 21. ServiceMaster has carefully prepared its code of conduct, and it even has a financial ethics document available at its Web site. Ignoring the legal department approval for the moment, do you see any way an employee could interpret its foreign gratuity policy so as to justify paying a bribe? consistently large U.S. balance-of-payments deficits helped to scatter dollars around the world. Third, the existence of specific regulations and controls on dollar deposits in the United States, including interest rate ceilings imposed by the government, helped to send such deposits to places outside the United States. These and other factors have combined and contributed to the creation of an external capital market. Its size cannot be accurately determined, mainly because of its lack of regulation and control. Several sources that periodically estimate its size are the Bank for International Settlements (BIS), Morgan Guar-

10 CHAPTER 18 International Managerial Finance 799 offshore centers Certain cities or states (including London, Singapore, Bahrain, Nassau, Hong Kong, and Luxembourg) that have achieved prominence as major centers for Euromarket business. anty Trust, the World Bank, and the Organization for Economic Cooperation and Development (OECD). Today the overall size of the Euromarket is well above $4.0 trillion net international lending. One aspect of the Euromarket is the so-called offshore centers. Certain cities or states around the world including London, Singapore, Bahrain, Nassau, Hong Kong, and Luxembourg are considered major offshore centers for Euromarket business. The availability of communication and transportation facilities, along with the importance of language, costs, time zones, taxes, and local banking regulations, are among the main reasons for the prominence of these centers. In recent years, a variety of new financial instruments have appeared in the international financial markets. One is interest rate and currency swaps. Another is various combinations of forward and options contracts on different currencies. A third is new types of bonds and notes along with an international version of U.S. commercial paper with flexible characteristics in terms of currency, maturity, and interest rate. More details will be provided in subsequent discussions. Major Participants The Euromarket is still dominated by the U.S. dollar. However, activities in other major currencies, including the Swiss franc, Japanese yen, and British pound sterling, and (increasingly) the euro, have in recent years grown much more rapidly than those denominated in the U.S. currency. Similarly, although U.S. banks and other financial institutions continue to play a significant role in the global markets, financial giants from Japan and Europe have become major participants in the Euromarket. Following the oil price increases by the Organization of Petroleum Exporting Countries (OPEC) in and , massive amounts of dollars were placed in various Euromarket financial centers. International banks, in turn, began lending to different groups of borrowers. At the end of 2001, estimates showed that a group of Latin American countries had international debt in excess of $750 billion, with Russia owing more than $153 billion. Meanwhile, 2004 estimates put Iraq s foreign debts and war reparations at more than $350 billion. Clearly, as the 1997 financial/currency crises of Asia, the 1998 currency collapse of Russia, and the default of Argentina have shown, too much international debt, along with unstable economies and currencies, can cause massive financial losses and problems for the world s MNCs. Although developing countries have become a major borrowing group in recent years, the industrialized nations also continue to borrow actively in international markets. Included in the latter group s borrowings are the funds obtained by multinational companies. The multinationals use the Euromarket to raise additional funds as well as to invest excess cash. Both Eurocurrency and Eurobond markets are extensively used by MNCs. R EVIEW QUESTIONS 18 1 What are the three important international trading blocs? What is the European Union and what is its single new unit of currency? What is GATT? What is the WTO?

11 800 PART SIX Special Topics in Managerial Finance 18 2 What is a joint venture? Why is it often essential to use this arrangement? What effect do joint-venture laws and restrictions have on the operation of foreign-based subsidiaries? 18 3 From the point of view of a U.S.-based MNC, what key tax factors need to be considered? What are unitary tax laws? 18 4 Discuss the major reasons for the growth of the Euromarket. What is an offshore center? Name the major participants in the Euromarket. LG Financial Statements Several features differentiate internationally based reports from domestically oriented financial statements. Among these are the issues of consolidation, translation of individual accounts, and overall reporting of international profits. Consolidation At the present time, U.S. tax rules require the consolidation of financial statements of subsidiaries according to the percentage of ownership by the parent company. Table 18.2 illustrates this point. As indicated, the regulations range from a one-line income-item reporting of dividends to a pro rata inclusion of profits and losses to a full disclosure in the balance sheet and income statement. Translation of Individual Accounts Unlike domestic items in financial statements, international items require translation back into U.S. dollars. Since December 1982, all financial statements of U.S. multinationals have had to conform to Statement No. 52 issued by the Financial Accounting Standards Board (FASB). The basic rules of FASB No. 52 are given in Figure TABLE 18.2 U.S. Rules for Consolidation of Financial Statements Beneficial ownership Consolidation for financial by parent in subsidiary reporting purposes 0 19% Dividends as received 20 49% Pro rata inclusions of profits and losses % Full consolidation a a Consolidation may be avoided in the case of some majority-owned foreign operations if the parent can convince its auditors that it does not have control of the subsidiaries or if there are substantial restrictions on the repatriation of cash. Source: Rita M. Rodriguez and E. Eugene Carter, International Financial Management, 3rd ed. (Englewood Cliffs, NJ: Prentice-Hall, 1984), p. 492.

12 CHAPTER 18 International Managerial Finance 801 FIGURE 18.1 FASB No. 52 Details of FASB No. 52 Assets/Liabilities Revenue/Expenses Translated to functional currency per GAAP* Subsidiary s Functional Currency Translated to parent currency using the all-current-rate method Parent s Currency ($) *Generally accepted accounting principles. Transactional gains/losses on foreign-currency accounts are charged to current income. Translation adjustments are charged to a separate component of stockholders equity. Source: John B. Giannotti, FAS 52 Gives Treasurers the Scope FAS 8 Denied Them, Euromoney (April 1982), pp FASB No. 52 Statement issued by the FASB requiring U.S. multinationals first to convert the financial statement accounts of foreign subsidiaries into the functional currency and then to translate the accounts into the parent firm s currency using the all-current-rate method. functional currency The currency of the host country in which a subsidiary primarily generates and expends cash and in which its accounts are maintained. all-current-rate method The method by which the functional-currency-denominated financial statements of an MNC s subsidiary are translated into the parent company s currency. Under FASB No. 52, the current-rate method is implemented in a two-step process. First, each subsidiary s balance sheet and income statement are measured in terms of the functional currency by using generally accepted accounting principles (GAAP). That is, foreign-currency elements are translated by each subsidiary into the functional currency the currency of the host country in which a subsidiary primarily generates and expends cash and in which its accounts are maintained before financial statements are submitted to the parent for consolidation. In the second step, the functional-currency-denominated financial statements of the foreign subsidiary are translated into the parent s currency. This is done using the all-current-rate method, which requires the translation of all balance sheet items at the closing rate and all income statement items at average rates. Each of these steps can result in certain gains or losses. The first step can lead to transaction (cash) gains or losses. Whether realized or not, these gains or losses are charged directly to current income. The completion of the second step can result in translation (accounting) adjustments, which are excluded from current income. Instead, they are disclosed and charged to a separate component of stockholders equity. International Profits Before January 1976, the practice for most U.S. multinationals was to utilize a special account called the reserve account to show smooth international profits. Excess international profits due to favorable exchange fluctuations were deposited in this account. Withdrawals were made during periods of high losses stemming from unfavorable exchange movements. The overall result was to display a smooth pattern in an MNC s international profits. Between 1976 and 1982, however, FASB No. 8 required that both transaction gains or losses and translation adjustments be included in net income, with separate disclosure of only the aggregate foreign exchange gain or loss. This requirement caused highly visible swings in the reported net earnings of U.S. multinationals. Since the issuance of FASB No. 52, only certain transactional gains or losses are reflected in the income statement.

13 802 PART SIX Special Topics in Managerial Finance R EVIEW QUESTION 18 5 State the rules for consolidation of foreign subsidiaries. Under FASB No. 52, what are the translation rules for financial statement accounts? LG Risk The concept of risk clearly applies to international investments as well as to purely domestic ones. However, MNCs must take into account additional factors, including both exchange rate and political risks. Exchange Rate Risks exchange rate risk The risk caused by varying exchange rates between two currencies. foreign exchange rate The value of two currencies with respect to each other. floating relationship The fluctuating relationship of the values of two currencies with respect to each other. fixed (or semifixed) relationship The constant (or relatively constant) relationship of a currency to one of the major currencies, a combination (basket) of major currencies, or some type of international foreign exchange standard. Because multinational companies operate in many different foreign markets, portions of these firms revenues and costs are based on foreign currencies. To understand the exchange rate risk caused by varying exchange rates between two currencies, we examine the relationships that exist among various currencies, the causes of exchange rate changes, and the impact of currency fluctuations. Relationships Among Currencies Since the mid-1970s, the major currencies of the world have had a floating as opposed to a fixed relationship with respect to the U.S. dollar and to one another. Among the currencies regarded as being major (or hard ) currencies are the British pound sterling ( ), the European Union euro, the Japanese yen ( ), the Canadian dollar (C$), and, of course, the U.S. dollar (US$). The recently adopted euro circulates as a currency among consumers in 12 European countries and is increasingly being used for financial transactions particularly debt security issues. The value of two currencies with respect to each other, or their foreign exchange rate, is expressed as follows: US$ US$ Because the U.S. dollar has served as the principal currency of international finance for more than 60 years, the usual exchange rate quotation in international markets is given as /US$, where the unit of account is the Japanese yen and the unit of currency being priced is one U.S. dollar. In this case, the dollar is the currency that is actually being priced. Expressing the exchange rate as US$ / would indicate a dollar price for the Japanese yen. For the major currencies, the existence of a floating relationship means that the value of any two currencies with respect to each other is allowed to fluctuate on a daily basis. Conversely, many of the nonmajor currencies of the world try to maintain a fixed (or semifixed) relationship with respect to one of the major currencies, a combination (basket) of major currencies, or some type of international foreign exchange standard.

14 CHAPTER 18 International Managerial Finance 803 spot exchange rate The rate of exchange between two currencies on any given day. forward exchange rate The rate of exchange between two currencies at some specified future date. On any given day, the relationship between any two of the major currencies will contain two sets of figures. One reflects the spot exchange rate the rate on that day. The other indicates the forward exchange rate the rate at some specified future date. The foreign exchange rates given in Figure 18.2 illustrate these concepts. For instance, the figure shows that on Tuesday, June 29, 2004, the spot rate for the Japanese yen was US$ (or /US$, as usually stated), and the forward (future) rate was US$ / (or /US$) for 1-month delivery. In other words, on June 29, 2004, one could execute a contract to take delivery of Japanese yen in 1 month at a dollar price of US$ /. Forward rates are also available for 3-month and 6-month contracts. For all such contracts, the agreements and signatures are completed on, say, June 29, 2004, but the actual exchange of dollars and Japanese yen between buyers and sellers will take place on the future date (say, 1 month later). Figure 18.2 also illustrates the differences between floating and fixed currencies. All the major currencies previously mentioned have spot and forward rates FIGURE 18.2 Exchange Rates (Tuesday, June 29, 2004) Spot and forward exchange rate quotations Source: Wall Street Journal, June 30, 2004, p. B8.

15 804 PART SIX Special Topics in Managerial Finance with respect to the U.S. dollar. Moreover, a comparison of the exchange rates prevailing on Tuesday, June 29, 2004, versus those on Monday, June 28, 2004, indicates that the floating major currencies (currencies such as the Japanese yen and Swiss franc that float in relation to the U.S. dollar) experienced changes in rates. Other currencies, such as the Chinese renminbi (yuan) and Uruguay s peso, do not fluctuate as much on a daily basis with respect to either the U.S. dollar or the currency to which they are pegged. That is, those currencies have very limited movements with respect to either the U.S. dollar or other currencies. A final point to note is the concept of changes in the value of a currency with respect to the U.S. dollar or another currency. For the floating currencies, changes in the value of foreign exchange rates are called appreciation or depreciation. For example, Figure 18.2 shows that the value of the Japanese yen depreciated from /US$ on Monday to /US$ on Tuesday. In other words, it took more yen to buy one U.S. dollar on Tuesday than it did on Monday. It is also correct to say that the dollar appreciated from US$ / on Monday to US$ / on Tuesday. For the fixed currencies, changes in values are called official revaluation or devaluation, but these terms have the same meanings as appreciation and depreciation, respectively. What Causes Exchange Rates to Change? Although several economic and political factors influence foreign exchange rate movements, by far the most important explanation for long-term changes in exchange rates is a differing inflation rate 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. EXAMPLE Hint A firm that borrows money in a developing nation faces the possibility of a double penalty due to inflation. Because many of the loans have floating interest rates, inflation will increase the interest rate on the loan as well as affect the exchange rate of the currencies. Assume that the current exchange rate between the United States and the new nation of Farland is 2 Farland guineas (FG) per U.S. dollar, FG 2.00/US$, which is also equal to $0.50/FG. This exchange rate means that a basket of goods worth $ in the United States sells for $ FG 2.00/US$ FG in Farland, and vice versa (goods worth FG in Farland sell for $ in the United States). Now assume that inflation is running at a 25% annual rate in Farland but at only a 2% annual rate in the United States. In one year, the same basket of goods will sell for 1.25 FG FG in Farland, and for 1.02 $ $ in the United States. These relative prices imply that in 1 year, FG will be worth $102.00, so the exchange rate in 1 year should change to FG /$ 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. This simple example can also predict what the level of interest rates will be in the two countries. To be enticed to save money, an investor must be offered a return that exceeds the country s inflation rate otherwise, there would be no reason to forego the pleasure of spending money (consuming) today because inflation would make that money less valuable 1 year from now. Let s assume that this real rate of interest is 3 percent per year in both Farland and the United States. Using Equation 6.1 (page 279), we can now reason that the nominal rate

16 CHAPTER 18 International Managerial Finance 805 of interest quoted market rate, not adjusted for risk will be approximately equal to the real rate plus the inflation rate in each country, or percent in Farland and percent in the United States. 2 Impact of Currency Fluctuations Multinational companies face exchange rate risks under both floating and fixed arrangements. The case of floating currencies can be used to illustrate these risks. Consider the U.S. dollar U.K. British pound relationship; note that the forces of international supply and demand, as well as economic and political elements, help to shape both the spot and the forward rates between these two currencies. Because the MNC cannot control much (or most) of these outside elements, the company faces potential changes in exchange rates. These changes can, in turn, affect the MNC s revenues, costs, and profits as measured in U.S. dollars. For fixed-rate currencies, official revaluation or devaluation, like the changes brought about by the market in the case of floating currencies, can affect the MNC s operations and its dollar-based financial position. EXAMPLE accounting exposure The risk resulting from the effects of changes in foreign exchange rates on the translated value of a firm s financial statement accounts denominated in a given foreign currency. economic exposure The risk resulting from the effects of changes in foreign exchange rates on the firm s value. MNC, Inc., a multinational manufacturer of dental drills, has a subsidiary in Great Britain (the United Kingdom) that at the end of 2006 had the financial statements shown in Table 18.3 on the next page. The figures for the balance sheet and income statement are given in the local currency, British pounds ( ). Using an assumed foreign exchange rate of 0.70/US$ for December 31, 2006, MNC has translated the statements into U.S. dollars. For simplicity, it is assumed that all the local figures are expected to remain the same during As a result, as of January 1, 2007, the subsidiary expects to show the same British pound figures on 12/31/07 as on 12/31/06. However, because of the appreciation in the assumed value of the British pound relative to the dollar, from 0.70/US$ to 0.60/US$, the translated dollar values of the items on the balance sheet, along with the dollar profit value on 12/31/07, are higher than those of the previous year. The changes are due only to fluctuations in the foreign exchange rate. In this case, the British pound appreciated relative to the U.S. dollar, which means that the U.S. dollar depreciated relative to the British pound. There are additional complexities attached to each individual account in the financial statements. For instance, it is important whether a subsidiary s debt is all in the local currency, all in U.S. dollars, or in several currencies. Moreover, it is important which currency (or currencies) the revenues and costs are denominated in. The risks shown so far relate to what is called the accounting exposure. In other words, foreign exchange rate fluctuations affect individual accounts in the financial statements. A different, and perhaps more important, risk element concerns economic exposure, which is the potential impact of foreign exchange rate fluctuations on the firm s value. Given that all future revenues and thus net profits can be subject 2. This is an approximation of the true relationship, which is actually multiplicative. The correct formula says that 1 plus the nominal rate of interest, k, is equal to the product of 1 plus the real rate of interest, k*, and 1 plus the inflation rate, IP; that is, (1 k) (1 k*) (1 IP). This means that the nominal interest rates for Farland and the United States should be 28.75% and 5.06%, respectively.