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Chapter 19 International Managerial Finance Instructor’s Resources Overview In today’s global business environment, the financial manager must also be aware of the international aspects of finance. A variety of international finance topics are presented in this chapter, including taxes, accounting practices, risk, the international capital markets, and the effect on capital structure of operating in different countries. This chapter discusses limited techniques but provides a broad overview of the financial considerations of the multinational corporation (MNC). Chapter 19 highlights the fact that international differences in culture, currencies, and taxes impact the student’s personal life as well as his or her future professional activities.

Suggested Answer to Opener in Review Question What makes entering an international marketplace attractive for companies like GE, and what are some common risks associated with operating internationally? At many companies, including GE, a majority of revenue comes from sales occurring outside the United States. By having locations in many areas, the firm may be more responsive to changes in the marketplace. To be selected and developed, international markets must meet the same criteria as domestic markets, plus compensate for the additional hurdles faced by the firm. The area must provide solid and predictable demand for the company’s products. Areas of the world that are unstable are generally not attractive markets for most companies. If the product is to be produced locally and the manufacturing process is sophisticated, the international market also must provide a local workforce that is educated. Finally, the international market must be receptive to foreign capital and foreign business. Countries that protect their local markets and industries make poor choices for companies looking to enter a foreign market.

Answers to Review Questions 1. One of the most important trading blocs was created by the North American Free Trade Agreement (NAFTA) which is the treaty that establishes free trade and open markets between Canada, Mexico, and the United States. Like NAFTA, the European Union (EU ) is a trading bloc designed to eliminate tariff barriers and create a single marketplace. Twenty-seven countries, representing almost half of a billion people, are members of the EU. The EU has established a single currency for thirteen member countries called the euro. Mercocur is a trading bloc in Latin America. However, the largest one is ASEAN, which with China has a regional free market including over 1.8 billion people. Countries also participate in bilateral and regional trade agreements.

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An important component of free trade among countries, including those not part of one of the three trading blocs, is the General Agreement on Tariffs and Trade (GATT ). GATT extends free trade to broad areas of activity—such as agriculture, financial services, and intellectual property—to any member country. GATT also established the World Trade Organization (WTO) to police and mediate disputes between member countries. 2. A joint venture is 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. It is essential to use this type of arrangement in countries requiring that majority ownership of MNC joint venture projects be held by domestically-based investors. Laws and restrictions regarding joint ventures have effects on MNC operations in four major areas: (1) majority foreign ownership reduces management control by the MNC, (2) disputes over distribution of income and reinvestment frequently occur, (3) ceilings cap profit remittances to parent company, and (4) there is political risk exposure. 3. From the point of view of a U.S.-based MNC, key tax factors that need to be considered are (1) the level of foreign taxes, (2) the definition of taxable income, and (3) the existence of tax agreements between the U.S. and the host country. Although the U.S. government taxes MNC income regardless of source, MNCs can typically reduce federal taxes by the taxes paid abroad. 4. The emergence and the subsequent growth of the Euromarket, which provides for borrowing and lending currencies outside the country of srcin, have been attributed to the following factors: the desire by the Russians to maintain their dollars outside the U.S.; consistent U.S. balance of payments deficits, and the existence of certain regulations and controls on dollar deposits in the United States. Though srcinally dominated by the U.S. dollar, the euro and Chinese yuan have become popular Euromarket currencies. Certain cities around the worldincluding London, Singapore, Hong Kong, Bahrain, Luxembourg, and Nassauhave become known as major offshore centers of Euromarket business, where extensive Eurocurrency and Eurobond activities take place. Major participants in the Euromarket include the United States, Germany, Switzerland, Japan, France, Britain, and the OPEC nations. In recent years, developing nations have also become part of the Euromarket. 5. FASB No. 52 requires MNCs first to convert the financial statement accounts of foreign subsidiaries into functional currency (the currency of the economy where the entity primarily generates and spends cash and where its accounts are maintained) and then to translate the accounts into the parent firm’s currency, using the all-current-rate method. Under the temporal method, specific assets are translated at historical exchange rates, and the foreign-exchange translation gains or losses are reflected in the current year’s income. By comparison, under the all-current-rate method, gains or losses are charged to a separate component of stockholder’s equity. 6. The spot exchange rateis the rate of exchange between two currencies on any given day. The forward exchange rate is the rate of exchange between two currencies at some future date. Foreign exchange fluctuation affects individual accounts in the financial statem ents; this risk is calledaccounting exposure. Economic exposure is the risk arising from the potential impact of exchange rate fluctuations on the firm’s value. Accounting exposure demonstrates paper translation losses, while economic exposure is the potential for real loss.

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7. If one country experiences a higher inflationrate than a country it trades with, the high inflation country will experience a decline (depreciation) in the value of its currency. This depreciation results from the fact that relatively high inflation causes the price of goods to increase. Foreign purchasers will decrease their demand for products from the country with high inflation due to the higher cost. This decrease in demand forces the value of the inflated currency to decline to bring the exchange-rateadjusted price back into line with pre-inflation prices. 8. Macro political risk means that uncertainty due to political change, all foreign firms in the country will be affected. Micro political risk is specific to the individual firm or industry that is targeted for nationalization. Techniques for dealing with political risk are outlined in Table 19.4 and include joint venture agreements, prior sale agreements, international guarantees, license restrictions, and local financing. 9. If cash flows are blocked by local authorities, the net present value (NPV) of a project and its level of return is “normal,” from the subsidiary’s point of view. From the parent’s perspective, however, NPV in terms of repatriated cash flows may actually be “zero.” The life of a project, of course, can prove to be quite important. For longer projects, even if the cash flows are blocked during the first few years, there can still be meaningful NPV from the parent’s point of view if later years’ cash flows are permitted to be freely repatriated back to the parent. 10. Several factors cause MNCs’ capital structure to differ from that of purely domestic firms. Because MNCs have access to international bond and equity markets, and therefore to a greater variety of financial instruments, certain capital components may have lower costs. The particular currency markets to which the MNC has access will also affect capital structure. The ability to diversify internationally also affects capital structure and may result in either higher leverage and/or higher agency costs. The differing political, legal, financial, and social aspects of each country can also impact capital structure considerations. 11. A foreign bond is an international bond sold primarily in the country of the currency in which it is issued. A Eurobond is sold primarily in countries other than the country of the currency in which the issue is denominated. Foreign bonds are generally sold by those resident underwriting institutions that normally handle bond issues. Eurobonds are usually handled by an international syndicate of financial institutions based in the United States or Western Europe. In the case of foreign bonds, interest rates are generally directly correlated with the domestic rates prevailing in the respective countries. For Eurobonds, several domestic and international (Euromarket) interest rates can influence the actual rates applicable to these bonds. 12. In terms of potential political risks and adverse actions by a host government, having more local debt (and thus more local investors or investments) in a foreign project can prove to be a valuable protective measure over the long run. This strategy will likely cause the local government to be less threatening in the event of governmental or regulatory changes, since the larger amount of local sources of financing are included in the subsidiary’s capital structure. 13. The Eurocurrency market provides short-term foreign currency financing to MNC subsidiaries. Supply and demand are major factors influencing exchange rates in this market. In international markets, the nominal interest rate is the stated interest rate charged when only the MNC’s parent currency is involved. Effective interest rates are nominal rates adjusted for any forecast changes in the foreign currency relative to the parent MNC’s currency. Consideration of effective rates of interest is critical to any MNC investment and borrowing decisions.

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14. In dealing with “third parties,” when the subsidiary’s local currency is expected to appreciate in value, attempts must be made to increase accounts receivable and to decrease accounts payable. The net result would be to increase the subsidiary’s resources in the local currency when it is expected to appreciate relative to the parent MNC’s currency. 15. When it is expected that the subsidiary’s localcurrency willdepreciate relative to the “home” currency of the parent, intra-MNC accounts payable must be paid as soon as possible while intra-MNC accounts receivable should not be collected for as long as possible. The net result would be to decrease the resources denominated in that local currency. 16. The motives of international business combinations are much the same as for domestic combinations: growth, diversification, synergy, fund-raising, increased managerial skills, tax considerations, and increased ownership liquidity. Additional considerations are entry into foreign markets, and a conducive legal, corporate, and tax environment.

Suggested Answer to Global Focus Box: Take an Overseas Assignment to Take a Step Up the Corporate Ladder If going abroad for a full-immersion assignment is not possible, what are some substitutes for a global assignment that may provide some—albeit limited—global experience? International experience can begin as early as your college years if you seek out a study abroad program or international internship. Once in the workforce, even though you may not be initially assigned to an overseas job, there are several things you can do to gain some global experience. You may want to get involved in internationally focused business groups in your area. The Chicago Council on Foreign Relations and the World Council in Maine are just two examples of such groups. Another way to develop global experience is to develop expertise in a particular area such as U.S. GAAP, valuation, or turnaround management. Those skills are often needed at a foreign business location where local skills are not developed in those subjects. Finally, at most large companies, global audit, treasury, and international M&A staffs offer the best international exposure with shorter but more frequent trips overseas to a variety of locations.

Suggested Answer to Focus on Ethics Box: Chiquita’s Slippery Situation Chiquita saw their options in Columbia as (a) pay extortion to a terrorist organization or (b) put their employees’ safety at risk. Is it ethical to break the law in an effort to save lifes? Most will probably agree that Chiquita’s initial decision to pay for protection was justified. However, Chiquita continued to operate in this environment for nearly eight years before selling their Colombian banana operations. Chiquita might have been better off exiting Colombia at an earlier date.

What, if anything, do you think Chiquita should do differently? Chiquita should have sold their Colombian banana operations as soon as possible after receiving threats from the AUC.

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Answers to Warm-Up Exercises E19-1.

Taxation of income of a foreign subsidiary

Answer: Subsidiary income before local taxes Foreign income tax at 40% Dividend available to be declared Foreign dividend withholding tax at 5% Santana’s receipt of dividends a.

$55,000 −22,000 $33,000 −1,650 $31,350

Santana’s receipt of dividends

$31,350

U.S. tax liability at 34% Foreign taxes available to be used as a credit U.S. taxes due (i.e., credit exceeds U.S.tax) Net funds available to Santana

$10,659 −

23,650

23,650 0 $31,350

−

b. Foreign taxes cannot be applied against the U.S. tax liability Santana’s receipt of dividends $31,350 U.S. tax liability at 34% −10,659 Net funds available to Santana $20,691 E19-2.

Currency valuation

Answer: a. Dollar price for the Mexican peso = US$0.083333 b. Calculate the exchange rates 1 year from now Assume a basket of goods costs $100 in the United States and 1,200 pesos in Mexico. One year from now the expected cost of the same basket of goods will be: United States

$100 × 1.03 = $103

Mexico 1,200 pesos × 1.05 = 1,260 pesos Dollar price of the Mexican peso 1 year from now

=

$103 ÷ 1,260 pesos = US$0.081746

Peso price of the U.S dollar 1 year from now = $1,260 peso ÷ $103 = 12.233010 pesos Based on expected inflation rates, the dollar is expected to appreciate in value against the peso and the peso is expected to depreciate in value against the U.S. dollar over the next year. E19-3.

Effective interest rate of a foreign currency loan

Answer: E = N E19-4.

+

F

+

(N × F) = 0.02

+

0.10

+

(0.02 × 0.10) = 0.1220 = 12.20%

Effective interest rate of a foreign loan

Answer: F = Forecast percentage change of the yen E=N

E19-5. Answer:

+

F

+

(N × F ) = 0.03

+

0.0909

+

=

9.09%

(0.03 × 0.0909) = 0.1236 = 12.36%

Comparing effective interest rates of two loans + F + (N × F ) = 0.08 − 0.10 + (0.08 × −0.10) = −0.0280 = −2.80%

EMP = N ECD = N

+

F

+

(N × F ) = 0.03

+

0.03

+

(0.03 × 0.03) = 0.0609 = 6.09%

The loan in Mexican pesos has the lower effective annual interest rate.

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Solutions to Problems P19-1. Tax credits LG 1; Intermediate MNC’s receipt of dividends can be calculated as follows: Subsidiary income before local taxes Foreign income tax at 33% Dividend available to be declared Foreign dividend withholding tax at 9%

$250,000 82,500 $167,500 15,075

MNC’s receipt of dividends $152,425 a. If tax credits are allowed, then the so-called “grossing up” procedure will be applied: Additional income MNC $250,000 U.S. tax liability at 34% $ 85,000 Total foreign taxes paid (credit) ($82,500 $15,075)+ (97,575 ) U.S. taxes due Net funds available to the MNC b. If no tax credits are permitted, then: MNC’s receipt of dividends U.S. tax liability 0.34) ($152,425 × Net funds available to the MNC

(97,575) 0 $152,425 $152,425

51,825 $100,600

P19-2. Translation of financial statements LG 3; Intermediate

Balance Sheet 12/31/12 U.S.$ Cash 48.00 Inventory 360.00 Plant and equipment (net) 192.00 Total 600.00 Debt 288.00 Paid-in capital 240.00 Retained earnings 72.00 ** Total 600.00

12/31/13 * U.S.$ 50.88 381.60 203.52 636.00 305.28 254.40 76.32 ** 636.00

Partial income statement 12/31/12 U.S.$

12/31/13 U.S.$

Sales

36,000.00

38,160.00

Cost of goods sold Operating profits

35,700.00 300.00

37,842.00 318.00

*

At 6% appreciation, the new exchange rate becomes U.S.$ 1.272 /€/

**

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P19-3. Personal finance problem: Exchange rates LG 3; Easy a.

Cost of tour (EUR) Current exchange rate Cost of tour in dollars Round trip airfare Incidental travel expenses Cost of meals in Italy (EUR) Cost of meals in Italy ($) Miscellaneous expenditures Total cost of trip in dollars

b.

Amount of euros needed in Italy Cost of means in Italy (EUR) Miscellaneous expenditures Current exchange rate Miscellaneous expenditures (EUR) Amount of euros needed in Italy

2,750 1.3411 $ 3,688 $ 1,490 $ 300 500 $ 671 $ 1,000 $

7,149 500 $ 1,000 0.7456 746 1,246

P19-4. Personal finance: International investment diversification LG 4; Intermediate b.

(1)

Global funds are the most diverse of the four categories. But don’t be fooled by their cosmopolitan-sounding name. They’re able to be invested in any region of the world, including the United States, so they don’t actually offer as much diversification as a good international fund. A prime example: Vanguard’s Global Equity Fund (VHGEX), which is 42% invested in the United States, 24% in Europe, 16% in the Pacific Rim, and the remaining 18% in emerging markets. Global funds tend to be the safest foreign-stock investments, but that’s because they typically lean on better-known U.S. stocks.

(2)

International funds invest most of their assets outside the United States. Depending on the countries selected for investment, international funds can range from relatively safe to more risky. Vanguard’s International Growth Fund (VWIGX), for instance, has 53% invested in Europe, 24% in emerging markets, and 21% in the Pacific Rim, which leaves only 2 percent for North American companies. Fidelity Diversified International, by comparison, has at least one percent of its assets in 23 different countries, many of which are in Europe. One can even invest in mutual funds that provide extensive exposure to companies in communist countries, such as T. Rowe Price’s Emerging Markets Stock Fund which has a plurality of its portfolio in Chinese companies. Oakmark International Small Cap, on the other hand, has significant exposure to some of the most volatile regions in the world: Thailand, South Korea, Hong Kong, and Turkey. The best thing to do is to choose a fund with the best balance, or make sure the manager has done a good job of moving in and out of regions profitably.

(3)

Emerging-market funds are the most volatile. They invest in undeveloped regions of the world, which have enormous growth potential, but also pose significant risks—political upheaval, corruption, and currency collapse, to name just a few. Don’t go near these funds with anything but money you are willing to lose.

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(4)

Country-specific funds are invested in one country or region of the world. That kind o concentration makes them particularly volatile. If you pick the right country—like th Turkey Investment Fund, with a 160% rise in 2009—the returns can be substantial. But pick the wrong one, and watch out. For instance, the Japan Equity Fund rose only 9% in 2009. Only the most sophisticated investors should venture into this territory

P19-5. Euromarket investment and fund raising

LG 5; Challenge The effective rates of interest can be obtained by adjusting the nominal rates by the forecast percent revaluation in each case:

Effective rates Euromarket Domestic

US$

MP

¥

4.00% 3.75%

3.01% 2.72%

3.53% 3.68%

Following the assumption outlined in the problem, the best sources of investment and borrowing are the following: $80 million excess is to be invested in the US$ Euromarket. $60 million to be raised in the MP Euromarket. P19-6. Ethics problem

LG 1; Intermediate Yes, because the company may lose out in numerous contract bid opportunities. The management team must explain that it is “ethics first” when doing business, and that the objective is to maximize shareholder wealth subject to ethical constraints. Hopefully, over time, stockholders will get on board with this philosophy—although most will likely be supportive from the outset.

Case Case studies are available on www.myfinancelab.com.

Assessing a Direct Investment in Chile by U.S. Computer Corporation In this case, students evaluate the feasibility of a proposed foreign investment construction of a factory in Chile. They must consider many factors that make international transactions complex, including political and foreign exchange rate risks and raising funds in international markets. a.

Cost of capital—US$:

Type of Capital

Amount

Long-term debt Equity

6,000,000 4,000,000

60.00% 40.00 %

$10,000,000

100.00%

Total

Weight

Cost

Weighted Cost

6.0% 12.0%

3.60% 4.80%

WACC = 8.40%, or 8% to the nearest whole percent

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8.40%

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Present value (PV), 5 years: Operating cash flow

sales × 0.20 $20,000,000 × 0.20 $4,000,000

= = =

Present value Calculation

N = 5, I = 8%, PMT = $4,000,000 Solve for PV = $15,970,840

If the dollar appreciates (gets stronger) against the Chilean peso, it takes more pesos to buy each dollar. For example, if the exchange rate changes to 800 pesos per dollar, sales of Ps 14 billion equals $17,500,000, compared to $20,000,000 at the current exchange rate. Peso cash flows are therefore worth less, and the present value would decrease. c.

d.

USCC faces foreign exchange risks because the value of the Chilean peso can fluctuate against the dollar, and it is not a currency that can be hedged. Any changes in exchange rates will result in a corresponding change in USCC’s dollar-denominated revenues, costs, and profits. To minimize foreign exchange risk, USCC can purchase more components with pesos, sell more products priced in dollars, or both. It could purchase or produce more computer components in Chile rather than importing them from the United States. USCC could also export finished computers to market outside of Chile with sales denominated in dollars. Local (peso) financing carries a much higher cost, 14% for long-term funds versus 6% in the Eurobond market. Also, if the peso depreciates against the dollar, the value of USCC’s investment will decrease, as will any repatriated amounts. The use of peso financing minimizes exchange rate risk. An unstable political environment increases both political and exchange rate risks. The factory could be seized by the Chilean government if it decides to nationalize foreign assets. The value of the peso relative to the dollar would be likely to depreciate. Joining into a bilateral trade pact would strengthen Chile’s economic ties with the United States. This should make the project more attractive.

Spreadsheet Exercise The answer to Chapter 19’s MNC economic exposure spreadsheet problem is located on the Instructor’s Resource Center at www.pearsonhighered.com/irc under the Instructor’s Manual.

Group Exercise Group exercises are available on www.myfinancelab.com.

This final chapter broadens the view of the firm internationally. This is also the direction of this final assignment. Opportunities for expansion are now investigated beyond the fictitious firm’s domestic borders. This expansion will take the form of either an attempt to increase market share or locate a new supplier. This, in fact, is the first task of this assignment. The next decision is the nation chosen for the potential expansion.

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Exchange rate risk is the next part of the assignment. This begins by first retrieving recent exchange rate information for the national currency of choice. This recent information is then compared to the past 5 years to give students a sense of volatility in the exchange rate. Risk analysis is then enhanced by comparing the U.S. inflation rate to that of the chosen nation. The progenitor of the inflation comparison is the theory of purchasing power parity. Although not discussed in detail, students are asked to use recent inflation rates to form expectations of future exchange rate moves. Specifically, the nation with the higher inflation rate is expected to see its currency fall in value if this inflation differential persists. Inflation differences are then compared to the recent evolution of the exchange rate. The final task is to explain what advantages are to be gained by “going international.” Although the project asks groups to consider either a situation where the fictitious firm is looking abroad for a foreign supplier or foreign sales, both could be done. As in other group exercises, providing examples of firms going abroad brings realism to the classroom and makes unrealistic assumptions less likely.

Integrative Case 8: Organic Solutions Integrative Case 8, Organic Solutions, asks students to evaluate a proposed acquisition by means of either a cash transaction or a stock swap. The effects on the short- and long-term earnings per share (EPS) should be calculated and other proposals to achieve the merger discussed. The students must also consider the qualitative implications of acquiring a non-U.S.-based company. a.

Price for cash acquisition of GTI:

Year

Incremental Cash Flow

1 2 3 4 5 6–30

$18,750,000 18,750,000 20,500,000 21,750,000 24,000,000 25,000,000

Discount Rate

Present Value of GTI

16%

$139,243,245

[Note: F6 = 25]

The maximum price Organic Solutions (OS) should offer GTI for a cash acquisition is $139,243,245. Net of the $8,400,000 liabilities, GTI’s owners would receive $130,843,245. b.

1. Straight bonds—Financing such a large portion of the acquisition with straight bonds will dramatically increase the financial risk of the firm. The management of OS must be very comfortable that the combined firm is able to generate adequate cash to service this debt. The coupon rate on these bonds could also be quite high. The potential benefit to the OS owners is the magnified return on equity that could result from the leverage. 2. Convertible bonds—Initially convertibles will provide much of the same concern as straight bonds since financial leverage will increase. There are two benefits to convertible bonds not available with straight bonds. First is that the coupon rate will be lower. Investors will value the conversion feature and will be willing to pay more, thus reducing the cost, for the convertible bond. The second advantage is that the leverage will decrease as conversion occurs, assuming the benefits of the acquisition ultimately proves favorable, and the value of the firm increases by the merger. The drawback is the potential dissolution of ownership that will occur if and when the bonds are converted.

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3. Bonds with stock purchase warrants attached—The benefits and disadvantages of this security mix are similar to those of a convertible bond. However, there is one major difference. The attached warrants may eventually be used to supply the firm with additional equity capital. This inflow of capital will lower the financial risk of the firm and generate additional funds. There will still be the dissolution of ownership potential. c.

1. Ratio of exchange: $30 ÷ $50 = 0.60 OS must exchange 0.60 shares of its stock for each share of GTI’s stock to acquire the firm in a stock swap. 2. The exchange of stock should increase OS’s EPS to $3.93, an increase from $3.50. Calculations: New OS shares required: Total OS shares:

4,620,000 × 0.60 10,000,000 + 2,772,000

=

2,772,000 12,772,000

=

$3.93

=

EPS for OS:

$35,000,000 + $15,246,000 12,772,000

EPS for GTI:

$3.93 × 0.60 = $2.36, a decrease from $3.30

The decrease in EPS for GTI can be explained by looking at the price/earnings (P/E) ratio for OS and the P/E ratio based on the price paid for GTI:

Price per share EPS—premerger P/E

ratio

EPS—postmerger

14.29

OS

GTI

$50 (market) $3.50

$30 (price paid) $3.30

$3.93

9.09

$2.36

When the P/E ratio paid is less than the P/E ratio of the acquiring company, there is an increase in the acquiring company’s EPS and a decrease in the target’s EPS. 3. Over the long run, the EPS of the merged firm would probably not increase. Usually the earnings attributable to the acquired company’s assets grow at a faster rate than those resulting from the acquiring company’s premerger assets. d.

OS could make a tender offer to GTI’s stockholders or the firm could propose a combination cash payment-stock swap acquisition.

e.

The fact that GTI is actually a foreign-based company would impact many areas of the foregoing analysis. Regulations that apply to international operations tend to complicate the preparation of financial statements for foreign-based subsidiaries. Certain factors influence the risk and return characteristics of a MNC, particularly economic and political risks. There are two forms of political risk: macro, which involves all foreign firms in a country, and micro, which involves only a specific industry, individual firm, or corporations from a particular country. International cash flows can be subject to athe variety including local host countries, host-country regulations may block returnofoffactors, MNCs’ cash flow, thetaxes usualinbusiness and financial risks, currency and that political actions of host governments, and local capital market conditions. Foreign exchange risks can also complicate international cash management.

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