Chapter 20

The Multinational Finance Function





!          Describe the multinational finance function and how its fits in the MNE’s organizational structure.

!          Show how companies can acquire outside funds for normal operations and expansion.

!          Discuss the major internal sources of funds available to the MNE and show how these funds are managed globally.

!          Explain how companies protect against the major financial risks of inflation and exchange-rate movements.

!          Highlight some of the financial aspects of the investment decision.



Chapter Overview


Firms that invest and operate abroad access both debt and equity capital in large global markets as well as in local markets. Building on Chapter 19, Chapter 20 highlights the external sources of funds available to MNEs, as well as the internal sources that come from interfirm linkages. It first explores global debt markets, global equity markets and offshore financial centers. Then the types of foreign-exchange risk and the hedging strategies associated with foreign-exchange risk management are discussed. The chapter concludes with a brief discussion of international capital budgeting decisions.



Chapter Outline


OPENING CASE: Nu Skin Enterprises

Nu Skin Enterprises, a U.S.-based manufacturer and multi-level marketer of personal care and nutritional products, operates in 34 countries throughout Asia, the Americas and Europe. Japan is Nu Skin’s leading country market, followed by Taiwan and South Korea. Nu Skin generally opens a new country market by starting with a single office, a warehouse and up to 60 employees led by one U.S. expatriate manager. The U.S. corporate staff allocates start-up funds from internal sources; retained earnings generally finances future growth. Exchange rate volatility has always affected the firm’s bottom line, but never more so than in Japan, where a weakening yen translated into millions of dollars of losses in exchange rate exposure. Consequently, Nu Skin implemented the use of hedging strategies to reduce the risk of currency fluctuations. It entered into forward contracts to guarantee the value of its receivables and began to borrow in local currencies to help to stabilize its revenues.


Teaching Tip: Review the PowerPoint slides for Chapter 20 and select those you find most useful for enhancing your lecture and class discussion. For additional visual summaries of key chapter points, also the review the map, table and figures in the text.


I.                   INTRODUCTION

MNEs access both local and global capital markets in order to finance their operational and expansion activities. Critical functions associated with the management of international cash flows are global borrowing, equity placement and foreign exchange risk minimization.



Cash flow management is divided into four major areas: (i) capital structure, (ii) capital budgeting, (iii) long-term financing and (iv) working capital management. It is the responsibility of an organization’s chief financial officer (CFO) to acquire (generate) and allocate (invest) financial resources among activities and projects. This job becomes increasingly complex in the global environment because of factors such as foreign-exchange risk, currency flows and restrictions, differing tax rates and laws and regulations regarding access to capital.



Leverage represents the degree to which a firm funds the growth of its business through borrowing (debt). Leverage is often perceived as the most cost-effective route to capitalization because the interest companies pay on debt is a tax-deductible expense, whereas the dividends paid on equity (stocks or shares) are not. However, excessive reliance on long-term debt increases financial risk and thus requires a higher rate of return for investors. In addition, foreign subsidiaries may have limited access to local capital markets, making it difficult for an MNE to rely on debt to fund asset acquisition. Different tax rates, dividend remission policies and exchange controls also affect a firm’s debt/equity decision. Firms can tap local and international banks for local and/or Eurocurrency borrowings, as well as the longer-term bond markets.

A.                Eurocurrencies

A Eurocurrency represents any currency banked outside its country of origin. Eurocurrencies are also known as offshore currencies, while currencies banked within their country of origin are known as onshore currencies. In essence, the Eurocurrency market is an offshore wholesale or trade market that started with the deposit of U.S. dollars in London banks. Eurodollars, which constitute 65 to 80 percent of the Eurocurrency market, are dollars banked outside of the U.S. The major sources of Eurocurrencies are foreign governments or individuals, multinational enterprises, foreign banks and countries with large balance-of-payments surpluses. Demand, which reflects the greater convenience, increased security, lower rates and higher yields of Eurocurrencies, comes from governments, organizations, firms and individuals. Transactions are large and subject to less regulation than their domestic counterparts. A Eurocredit is a type of loan or line of credit that matures in one to five years. Syndication occurs when several banks pool specific resources in order to spread the risks associated with a large loan. The London Inter-Bank Offered Rate (LIBOR) reflects the interest rate London banks charge one another for short-term Eurocurrency loans. Traditionally, Eurocurrency loans are made at a certain percentage point above the LIBOR.

B.                 International Bonds: Foreign, Euro and Global

The international bond market can be divided into foreign bonds, Eurobonds and global bonds. Foreign bonds are sold outside of the borrower’s home country but are denominated in the currency of the country of issue (e.g., a French firm floating a bond issue in Swiss francs in Switzerland). Eurobonds are usually underwritten (placed in the market for the borrower) by a syndicate of banks from different countries and sold in countries other than the one in whose currency the bond is denominated (e.g., a U.S. firm floating a bond issue in dollars in London and Luxembourg.) A global bond, which was first introduced by the World Bank (IBRD) in 1989, is a large, liquid bond issue designed to be traded simultaneously in numerous capital markets that is registered according to the requirements of each national market. Although the Eurobond market is centered in Europe, it has no national boundaries. Eurobonds are typically issued in denominations of $5,000 or $10,000, pay interest annually, are held in bearer form, and are traded over the counter (OTC). (An OTC bond is traded with or through an investment bank, rather than on a securities exchange.) Occasionally, Eurobonds may provide currency options, which allow the creditor to demand repayment in one of several currencies, thus reducing the exchange-risk inherent in single-currency foreign bonds. It is also possible to issue a Eurobond in one currency and then swap the obligation to another currency.



A second major source of funds is the global equity market, in which an investor takes an ownership position in return for shares of stock in the firm and the expectation of capital gains and, perhaps, dividends. A private placement with a venture capitalist is a relatively easy and inexpensive way to gain access to capital. More commonly, however, firms access the stock market. In terms of market capitalization (the total number of shares listed times the market price per share), the world’s three largest stock markets are New York, Tokyo and London. A major development during the past decade has been the growth of the Euroequity market, in which shares are sold outside the boundaries of the issuing firm’s home country. Because it is expensive to list on a foreign exchange, firms often list on just one big one. The most popular way for a Euroequity to get a listing in the U.S. is to issue an American Depositary Receipt (ADR), i.e., a negotiable certificate issued by a U.S. bank that represents underlying shares of stock of a foreign corporation held in trust at a custodial bank in the foreign country. ADRs are traded like stocks, with each ADR representing some number of shares of the underlying stock. There are also global depository receipts and European depository receipts, but the U.S. dominates the ADR market. A global share offering represents the simultaneous offering of actual shares on different exchanges. As MNEs generate an increasing proportion of their revenues outside of their home countries, it will be easier to attract investors from those countries in which they operate and raise capital outside of their home markets. In the future, a major source of competition to the stock exchanges will be Internet trading, which is already beginning to put pressure on the major exchanges; it is expected to grow in developing countries as well.



Offshore financial centers are city-states or countries that provide large amounts of funds in currencies other than their own and are used as locations in which to raise and accumulate cash; they represent major centers for the Eurocurrency market. Generally, they provide a more flexible and less expensive source of funding for MNEs and exhibit one or more of the following characteristics:

·         a large foreign-currency (Eurocurrency) market for deposits and loans

·         a large net supplier of funds to the world financial markets

·         an intermediary or pass-through for international loan funds

·         economic and political stability

·         an efficient and experienced financial community

·         good communications and supportive services

·         an official regulatory climate that is favorable to the financial industry.

Such centers are either operational centers, with extensive banking activities involving short-term financial transactions (e.g., London), or booking centers, in which little actual banking activities takes place but in which transactions are recorded to take advantage of secrecy laws and/or low or no tax rates (e.g., the Cayman Islands).



Funds refer to working capital, i.e., the difference between current assets and current liabilities. Internal sources of funds include loans, investment through equity capital, interfirm receivables and payables and dividends. Interfirm financial links become extremely important as MNEs grow in size and complexity. Funds can flow from parent to subsidiary, subsidiary to parent and/or subsidiary to subsidiary. Goods, services and funds all can move within an MNE, thus creating receivables and payables. Entities may choose to pay quickly (a leading strategy) or to defer payment (a lagging strategy). Transfer pricing can be used to adjust the size of a payment. In addition, firms can generate cash from normal operations. Whatever the means, international cash management is complicated by differing inflation rates, fluctuating exchange rates and distinct national and regional bloc policies regarding the flow of funds.

A.                Global Cash Management

Global cash management strategy focuses on the flow of money to serve specific operating objectives. Effective cash management hinges on the following questions:

·         What are the local and corporate system needs for cash?

·         How can the cash be withdrawn from subsidiaries and centralized?

·         Once the cash has been centralized, what should be done with it?


Cash budgets and forecasts are essential in assessing a firm’s cash needs. Cash may be transferred within a firm via dividends, royalties, management fees and the repayment of principal and interest on loans.



Major financial risks arise from foreign exchange rate fluctuations. Strategies to protect against such risks may include the internal movement of funds, as well as the use of foreign-exchange instruments such as options and forward contracts. The three types of foreign-exchange risk include translation exposure, transaction exposure and economic exposure.

A.                Types of Foreign Exchange Exposure

1.                  Translation Exposure. Translation exposure reflects the foreign-exchange risk that occurs because a parent company must translate foreign-currency financial statements into the reporting currency of the parent, i.e., the value of the exposed asset or liability changes as the exchange rate changes.

2.                  Transaction Exposure. Transaction exposure reflects the foreign-exchange risk that arises because a firm has outstanding accounts receivable or payable that are denominated in a foreign currency, i.e., the receivable or payable changes in value as the relevant exchange rate changes.

3.                  Economic Exposure. Also known as operating exposure, economic exposure reflects the foreign-exchange risk MNEs face in the pricing of products, the source and cost of inputs and the location of investment, i.e., it arises from the effects of exchange-rate fluctuations on expected cash flows.

B.                 Exposure Management Strategy

Management must do a number of things if it wishes to protect assets from exchange-rate risk.

1.         Defining and Measuring Exposure. An MNE must forecast the degree of exposure in each major currency in which it operates and adopt appropriate hedging strategies for each. A key aspect of measuring exposure is forecasting exchange rates, where the major concerns are the direction, magnitude and timing of exchange-rate fluctuations.

2.                  A Reporting System. A firm must devise a uniform reporting system for all its entities that identifies the exposed accounts it wants to monitor, the amount of the exposure by currency of each account and the different periods under consideration. The system should combine central control with input from foreign operations. Exposure should be separated into translation, transaction and economic components, with the transaction exposure identified by cash inflows and outflows over time. Specific hedging strategies can be taken at any level, but each level of management must be aware of the size of the exposure and its potential impact on the firm.

3.                  A Centralized Policy. To achieve maximum effectiveness in hedging, top management should determine hedging policy. Most MNEs prefer to cover exposure, rather than extract huge profits or risk huge losses.

4.                  Formulating Hedging Strategies. A firm can hedge its position by adopting operational and/or financial strategies, each with cost/benefit and operational implications. Firms may choose to balance local assets with local debt by borrowing funds locally, because that helps avoid the foreign-exchange risk associated with borrowing in a foreign currency. They may also choose to take advantage of leads and lags for interfirm payments. A lead strategy means collecting foreign-currency receivables before they are due when the currency is expected to weaken, or paying foreign-currency payables before they are due when a currency is expected to strengthen. A lag strategy means delaying collection of foreign-currency receivables if the currency is expected to strengthen, or delaying payment of foreign-currency payables when the currency is expected to weaken. However, such strategies may not be useful for the movement of large blocks of funds, and they may also be subject to government restrictions. A firm can also hedge exposure through forward contracts, which establish fixed exchange rates for future transactions and currency options, i.e., derivatives, which assure access to a foreign currency at a fixed exchange rate for a specific period of time. A foreign-currency option is more flexible than a forward contract because it gives the purchaser the right, but does not impose the obligation, to buy or sell a certain amount of foreign currency at a set exchange rate within a specified amount of time.



To determine which projects and countries will receive capital investment funds, a parent company must compare the net present value or internal rate of return of a potential foreign project with that of its other projects to determine the best place to invest its resources. As part of this process, parent cash flows must be distinguished from project cash flows; legal, economic and political constraints must be taken into account; differing rates of inflation and exchange rate fluctuations must be anticipated; and the terminal value of a project must be determined. To deal with the variations in future cash flows, firms may (i) determine the net present value or internal rate of return of a given project or (ii) establish a hurdle (minimal) rate of return that a project must meet in order to be eligible to receive funds.



What’s Wrong with Banking in a Tax-haven Country?

Cash flow management gives rise to numerous ethical dilemmas. Many critics question the practice of firms establishing subsidiaries in tax-haven countries in order to take advantage of the lower tax rates they offer and the secrecy they provide. Tax havens are natural locations in which to hide cash—MNEs have been known to use money deposited in tax haven accounts to secretly pay bribes, which is both unethical and illegal. While not all tax-haven transactions are illegal, there are many gray areas. In 2002, the WTO ruled against the FSC law enacted by the U.S. on the grounds that there was a lack of true business purpose of the operations of U.S. firms in tax-haven countries, i.e., tax-haven offices were deemed to be mere fronts that allowed U.S. firms to lower their prices in foreign markets.



Capital Markets and the Information Explosion

It is difficult to forecast trends in global capital markets because of the scope and pace of economic changes worldwide. Although the major financial markets will continue to be dominated by the world’s largest players, action will surely increase within the developing markets of Eastern Europe, Latin America and Southeast Asia. In addition, the cash management and hedging strategies of MNEs will be subject to further developments in information technology, as well as the increasing number and sophistication of hedging instruments (e.g., options and forwards), thus enabling firms to manage cash and use interfirm resources more effectively and efficiently.




Teaching Tip: Visit for additional information and links relating to the topics presented in Chapter 20. Be sure to refer your students to the on-line study guide, as well as the Internet exercises for Chapter 20.



CLOSING CASE: Dell Mercosur [See Figure 20.5]


1.         Given how Dell translates its foreign currency financial statements into dollars, how would a falling Brazilian real affect Dell Mercosur’s financial statements?

Dell Mercosur’s revenues, income statement (operating income) and balance sheet (shareholder’s equity) would all be affected by a falling real. With respect to revenues, as the value of the real falls, the value of foreign revenues would also fall. Subsequently, the translated value of the revenues on the consolidated, U.S.-dollar-denominated income statement would decline as well. Foreign operating income would also decline when the home-country’s currency strengthens. Shareholder’s equity reflects assets minus liabilities. If all of Dell’s subsidiaries have their assets and liabilities based on financial instruments in the same currency, then the value of the foreign- currency denominated assets would fall, but so would the value of the foreign-currency denominated liabilities. In relative terms, equity would remain unchanged, although it would also translate into its U.S.-dollar equivalent at a lower value.


2.                  Dell imports about 97 percent of its manufacturing costs. What type of exposure does this create for it? What are its options to reduce that exposure?

Primarily, the fact that Dell Mercosur imports nearly all of its manufacturing costs impacts transaction exposure, because the transfer price payable changes in value as the U.S. dollar/Brazilian real rate changes. When the value of the real declines with respect to the dollar, the use of a lead strategy, i.e., paying for imports before they are due, will minimize costs to Dell Mercosur. The subsidiary can also hedge its exposure through forward contracts and foreign currency options.


3.                  Describe and evaluate Dell’s exposure management strategy.

Dell’s objective in managing its foreign currency exchange rate fluctuations is to reduce the impact of adverse fluctuations on earnings and cash flows associated with foreign currency exchange rate changes. Accordingly, Dell uses foreign-currency options contracts and forward contracts to hedge its exposure on forecasted transactions and company commitments. Dell also uses purchased options contracts and forward contracts as cash flow hedges. Hedged transactions include international sales by U.S.-dollar functional currency entities, foreign-currency denominated purchases of certain components and interfirm shipments to certain international subsidiaries. Dell also uses forward contracts to hedge monetary assets and liabilities that are denominated in a foreign currency. Because Dell’s strategy is to hedge all foreign-exchange risk, it is considered to be a very aggressive strategy. Rather than attempting to extract huge profits, Dell has chosen to avoid huge losses.


4.                  What are the costs and benefits of hedging all foreign exchange risk?

The primary costs of hedging all foreign exchange risk relate to the fact that a firm will miss out on any positive swings in exchange rate fluctuations, but the benefits are that it will avoid the costs of any negative swings in exchange rate fluctuations. Firms that choose to follow such a strategy are likely to accept the idea of offsetting effects, i.e., in the long run, losses or less than maximum gains will be offset by gains or less than maximum losses.

Additional Exercises: Multinational Finance


Exercise 20.1. When using capital budgeting techniques to evaluate a potential foreign project, a firm needs to recognize the specific political and economic risks (including foreign-exchange risk) arising from that foreign location. Ask students to compare the advantages of (i) using a higher discount rate and (ii) forecasting lower cash flows to evaluate such projects.


Exercise 20.2. Typically, the cost of capital is lower in the global capital market than in domestic capital markets. Other things being equal, firms will likely prefer to finance their investments by borrowing from the global capital market. However, such borrowing may be restricted by host-country regulations or demands. Ask the students to discuss the point at which firms should consider using the global equity markets to finance foreign investments and operations in lieu of the global debt markets. Are firms likely to encounter restrictions in the equity markets as well? What are the effects of such restrictions likely to be on a firm’s investment and operating decisions?


Exercise 20.3. The number of foreign corporations listing American Depository Receipts (ADRs) on the U.S. stock exchanges has increased dramatically since the early 1980s. Ask students to discuss this phenomenon in light of the recent global economic downturn. Do students foresee an increase in demand for either global depository receipts or European depository receipts in the near future? Why or why not? Be sure they consider the benefits of depository receipts to both firms and potential investors.