The Multinational Corporation and Globalization Chapter 13 The Multinational Corporation and Globalization

Outline Globalization Opportunities of international expansion Risks faced by a multinational corporation Exchange rates and exchange rate hedging Foreign direct investment Multinational capital budgeting Repositioning of funds Multinational transfer pricing

Learning Objectives Understand how supply and demand are affected in different countries around the world Define the exchange rate and identify several methods of hedging Understand multinational capital budgeting and explain how it differs from capital budgeting of a domestic corporation Show how changing transfer prices can benefit a corporation

Globalization One of the main reasons a company wants to operate globally is to take advantage of new growth opportunities Expand to serve new markets (e.g. food products) Take advantage of new suppliers (manufacturing and back office services) In looking at market opportunities, firms often look at international expansion.

Globalization Multinational corporations face the same opportunities and problems as a domestic corporation, but also face additional challenges: Fluctuations in currencies Different rules and regulations Different tax systems Tariffs and other restrictions Different costs of production Different cultures, languages, and business practices

Globalization The term ‘globalization’ Results in a closer integration of the countries of the world – especially the increased level of trade and movements of capital – brought on by lower costs of transportation and communication.

Risks Faced by MNCs Multinational corporation risk: risks that are present only because it transacts business across national borders Exchange rate risk: results from changes in exchange rates The multinational corporation faces all the categories of risk of domestic firms-but also additional risk due to international circumstances.

Risks Faced by MNCs Other risks faced by the MNC blockage of funds and capital controls differences in cultural and religious philosophies ownership restrictions human resource restrictions intellectual property discrimination red tape and corruption internal and external wars changes in government

Exchange Rates Exchange rate: price of one country’s currency in terms of another country’s May be quoted in terms of the domestic or foreign currency e.g. Є1/$1.40 or $1/ Є0.714 Hedging: various ways that companies can protect themselves from a potential loss from currency fluctuation

Exchange Rates Hedging techniques: Offsetting Transactions: export goods of the same amount to the same country from which it imported, in the same period of time Forward Market: permits a company to buy or sell currency at a specific rate at a specific time, customized to its needs Futures Market: similar to forwards, but on a standardized public exchange (set amounts, maturing on certain days)

Exchange Rates Hedging techniques: Currency Options: give the holder the right to buy or sell an amount of currency at a specified price during a certain period of time Currency Swaps: companies swap currencies when they expect a offsetting cash flow from other sources in their respective countries

Foreign Direct Investment Foreign direct investment (FDI): acquiring ownership rights in foreign fixed assets or existing firms, or establishing foreign subsidiaries with their own infrastructure This has been especially evident in the automotive industry-foreign firms have located manufacturing facilities in the US, and US firms have located plants outside the US.

Foreign Direct Investment Reasons for FDI Increase its earning and increase the value of the company Foreign country may impose import restrictions Take advantage of economies of scale, as well as lower production and transportation costs

MNC Capital Budgeting Similar process as for a domestic company, but must take into consideration several extra variables intercompany fund flows: cash flows between parent to subsidiary inflation rates: may differ in the country of the parent and of the subsidiary exchange rates: exchange rate between the parent and subsidiary country will change during the project period

MNC Capital Budgeting Tax differences: many types can differ between countries Income tax rates Tax on remittances to the parent’s country Double taxation on subsidiary profit and remittance to parent, offset by foreign tax credit

MNC Capital Budgeting Cash flows: cash flows received and recorded by the parent may differ substantially from those in the subsidiary’s country

MNC Capital Budgeting Cost of capital: difference in cost of capital for parent and subsidiary Final project valuation: differences are so significant that a project is acceptable in one country and not in the other

MNC Capital Budgeting Repositioning of Funds Examples: royalties and license fees can be used to channel funds to those areas of the company where they may be used most profitably dividend payments to the parent tax rates on distributed and undistributed earnings taxes levied on dividends transmitted to the parent re-invoicing centers

MNC Transfer Pricing Multinational transfer pricing: prices for products or services that are transferred from the parent company to the subsidiary or among subsidiaries Can affect a transfer of funds by charging high or low prices Can affect a company’s profitability

MNC Transfer Pricing Tax liability due to a change in transfer price DT = (Q · DP · te) – (Q · DP · tm) DT = change in total tax bill Q = quantity of products shipped by E (exporter) to M (importer) DP = change in the price of the product te = tax rate in the exporting country Tm = tax rate in the importing country

MNC Transfer Pricing Internal Revenue Code section 482 gives IRS authority to ‘shift around income and expense figures to arrive at what the government considers a more equitable result’. IRS requires transfer pricing to be done on an ‘arm’s length’ relationship. Developing countries are becoming more active in the area of regulating transfer pricing

Summary A multinational corporation must compete not just domestically but worldwide. The firm must consider the demand for their products, the cost of supplies, their productivity, and changes in technology. An MNC must consider economic factors, political factors, and social and cultural factors in their business decisions. Transfer pricing can be used to achieve higher profits, but governments are monitoring this activity more closely.