International Business by Daniels and Radebaugh Chapter 20 The Multinational Finance Function © 2001 Prentice Hall

Objectives To describe the multinational finance function and how it fits in the MNE’s organization structure To show how companies can acquire outside funds for normal operations and expansion To discuss the major internal sources of funds available to the MNE and show how these funds are managed globally To explain how companies protect against the major financial risks of inflation and exchange-rate movement To highlight some of the financial aspects of the investment decision © 2001 Prentice Hall

Finance in International Business EXTERNAL INFLUENCES COMPETITIVE ENVIRONMENT PHYSICAL AND SOCIETAL FACTORS OPERATIONS OBJECTIVES STRATEGY MEANS Overlaying Alternatives Modes Functions Marketing Exporting and importing Global manufacturing Supply chain management Accounting FINANCE Human resources © 2001 Prentice Hall

Finance and Treasury Functions in the Internalization Process Introduction MNEs need access to capital Finance is integral to firm’s operating strategies Concern with access to capital in local and global markets Finance and Treasury Functions in the Internalization Process Chief Financial Officer (CFO)—vice president of finance Responsible for controllership and treasury functions Acquires financial resources—generates funds from internal and external sources Allocates financial resources—increases stockholders’ wealth by allocating funds to different projects and investment opportunities Manages cash flows © 2001 Prentice Hall

Location of Treasury Function in the Corporate Organizational Structure © 2001 Prentice Hall

Global Debt Markets Companies follow financing trends in their own country and industry Leverage—degree to which a firm funds the growth of the business by debt interest on debt is tax deductible Equity capital—stocks or shares dividends paid to investors are not deductible Choice of debt versus equity affected by a variety of factors Companies can use local and international debt markets to raise funds Subsidiaries or foreign companies may find it easier to obtain credit than local companies back-to-back loan—made between a firm in country A with a subsidiary in country B and a bank in country B with a branch in country A © 2001 Prentice Hall

Global Debt Markets (cont.) Eurocurrencies—any currency that is banked outside of its country of origin Major sources of Eurocurrencies include: foreign governments or individuals who want to hold dollars outside of the U.S. MNEs with excess cash European banks with excess foreign currency countries with large balance-of-trade surpluses held as reserves Characteristics of Eurocurrency market completely unregulated offshore market both short and medium term Eurocurrency deposits yield higher interest Eurocurrency loans tend to be cheaper London Inter-Bank Offered Rate (LIBOR)—interest rate that banks charge each other on Eurocurrency loans © 2001 Prentice Hall

Global Debt Markets (cont.) International bond market—an attractive place to borrow money that fills an important niche in financing Tends to be less expensive than local markets Foreign bonds—sold outside of the borrower’s country but in the currency of the country of issue Eurobonds—underwritten by banking syndicate and sold in countries other than the one in whose currency the bond is denominated sold in several financial centers some have currency options allowing the creditor to demand repayment in one of several currencies Global bond—combination of domestic bond and Eurobond registered in each national market © 2001 Prentice Hall

Equity Securities and the Euromarket Equity securities—investor takes an ownership position in return for shares of stock, the promises of capital gain, and dividends Many companies are using private placements to raise equity capital venture capitalist—invests money in a new venture in exchange for stock Equity-capital markets (stock markets)—listing may be on home country or foreign exchange market capitalization—total number of shares of stock listed times the market price per share in part the increase has resulted from privatization in emerging markets and global economic growth © 2001 Prentice Hall

Equity Securities and the Euromarket (cont.) Euroequity market—market for shares sold outside the issuing company’s home country Firms often list on only one big foreign exchange e.g., 379 foreign companies listed on the New York Stock Exchange Companies with investments in several countries may list on different exchanges American Depositary Receipt (ADR)—a negotiable certificate issued by a U.S. bank and representing shares of stock of a foreign company Global Depositary Receipts and European Depositary Receipts—other markets for Euroequities Global share offering—simultaneous offering of actual shares on different exchanges Electronic trading of stocks is a major source of competition for stock exchanges © 2001 Prentice Hall

Growth of Emerging Stock Markets Emerging markets Developed markets © 2001 Prentice Hall

Offshore Financial Centers Cities or countries that engage in a variety of financial transactions Provide significant tax advantages Centers for the Eurocurrency market Markets are less regulated than domestic markets Provide an alternative, cheaper source of funding May be: operational centers—extensive banking activities involving short-term financial transactions booking centers—little banking activity financial transactions recorded to take advantage of secrecy and low tax rates Good locations for establishing financial subsidiaries © 2001 Prentice Hall

Characteristics of Offshore Financial Centers Large foreign- currency market for loans/deposits Favorable regulatory climate Pass-through for international loan funds Efficient and experienced financial community Offshore Financial Center Economic and political stability Good communications Large net supplier of funds to world financial markets Good supportive services © 2001 Prentice Hall

Internal Sources of Funds Funds—working capital, i.e., the difference between current assets and current liabilities Used to expand operations or satisfy demands for capital Sources of funds—MNEs have more complex arrangements due to the number of subsidiaries and the diverse environments in which they operate Loans Dividends Intercompany receivables and payables Investments through equity capital Funds may flow from subsidiaries to parent or vice versa © 2001 Prentice Hall

Internal Sources of Working Capital for MNEs Parent Company Invests more equity capital Loans Dividends, royalties, and fees Guarantee loans French Subsidiary Loans Extensions of accounts payable Brazilian Subsidiary © 2001 Prentice Hall

Internal Sources of Funds (cont.) Global cash management—requires the collection and payment of cash resulting from the normal operational cycle Generates and invests cash through dealings with financial institutions Assesses a company’s cash needs using budgets and forecasts Involves decisions about the degree of centralization of cash transfers of cash may be in the form of dividends, royalties, management fees, and repayment of loans governments concerned about the outflow of foreign exchange may curtail cash transfers abroad © 2001 Prentice Hall

Internal Sources of Funds (cont.) Multilateral netting—company establishes one center to handle all internal cash, funds, and financial transactions Enables companies to reduce the amount of cash flow and move cash more quickly and efficiently Advantages include: optimizing the use of excess cash reducing interest expenses and maximizing interest yields reducing costly foreign exchange, swap transactions, and intercompany transfers minimizing administrative paperwork centralizing and speeding information Multilateral cash flows in the absence of netting require each subsidiary to settle intercompany obligations not as advantageous as netting © 2001 Prentice Hall

Multilateral Cash Flows $150,000 French Subsidiary Italian Subsidiary $50,000 $200,000 $200,000 $200,000 German Subsidiary United Kingdom Subsidiary $100,000 © 2001 Prentice Hall

Multilateral Netting French Subsidiary Italian Subsidiary Clearing $100,000 $150,000 Clearing Account $150,000 $100,000 German Subsidiary United Kingdom Subsidiary © 2001 Prentice Hall

Foreign-Exchange Risk Management Translation exposure—arises because, as the exchange rate changes, the dollar value of the exposed asset or liability changes Combined effect of the exchange-rate change is either a net gain or loss does not represent an actual cash flow effect because the cash is only translated into dollars, not converted into dollars Transaction exposure—arises because the receivable or payable changes in value as the exchange rate changes Economic exposure (operating exposure)—potential for change in expected cash flows that arise from the: Pricing of products Sourcing and cost of inputs Location of investments Competitive position of the company in markets © 2001 Prentice Hall

Exposure-Management Strategy Defining and measuring exposure MNE must forecast the degree of exposure in each major currency in which it operates exchange-rate movements are forecasted using in-house or external experts Reporting system—substantial participation from foreign operations combined with central control Foreign input important to ensure forecasting effectiveness Central control of exposure protects resources more efficiently defines and controls overall company exposure MNEs should devise uniform reporting system for its subsidiaries Time periods of reports vary Final reporting should be at corporate level © 2001 Prentice Hall

Exposure-Management Strategy (cont.) Centralized policy—top management should determine hedging policy Corporate treasurer should be able to design and implement a cost-effective program Some decisions must be decentralized in order to react quickly to changes in the international monetary environment Some companies run hedging operations as profit centers and nurture in-house trading desks Formulating hedging strategies—safest position has exposed assets equal to exposed liabilities Operational strategies—involve adjusting the flow of money and resources to reduce foreign-exchange risk using local debt to balance local assets taking advantage of leads and lags for intercompany payments © 2001 Prentice Hall

Exposure-Management Strategy (cont.) Formulating hedging strategies (cont.) Contractual arrangements forward contract—establishes a fixed exchange rate for future transactions foreign-currency option—purchaser has the right, but not the obligation, to buy or sell a certain amount of foreign currency at a set exchange rate within a specified period of time more flexible than forward contract © 2001 Prentice Hall

Capital Budgeting Decision in an International Context Parent company needs to compare the net present value or internal rate of return of a foreign project with that of its other projects and with that of others available Unique aspects of capital budgeting for foreign projects Parent cash flows must be distinguished from project cash flows Remittance of funds to the parent affected by differing tax systems, and legal and political constraints on movement of funds Differing rates of inflation must be anticipated Parent must consider possible changes in exchange rates Must evaluate political risk in foreign market Terminal value is difficult to estimate © 2001 Prentice Hall