Chapter 19

International Managerial Finance

Instructors Resources
Overview
In todays 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 students 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 companys 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 activitysuch as agriculture, financial services, and intellectual propertyto 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 origin, 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 originally dominated by the U.S. dollar, the euro and Chinese yuan have become popular
Euromarket currencies.

Certain cities around the worldincluding London, Singapore, Hong Kong, Bahrain, Luxembourg,
and Nassauhave 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 firms
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 years income. By comparison, under the all-current-rate method, gains or losses are charged
to a separate component of stockholders equity.

6. The spot exchange rate is 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 statements; this risk is called accounting exposure.
Economic exposure is the risk arising from the potential impact of exchange rate fluctuations on the
firms 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 inflation rate 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-rate-
adjusted 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 subsidiarys point of view. From the parents 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 parents 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 subsidiarys 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 MNCs parent
currency is involved. Effective interest rates are nominal rates adjusted for any forecast changes
in the foreign currency relative to the parent MNCs 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 subsidiarys 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 subsidiarys resources in the local currency when it is expected
to appreciate relative to the parent MNCs currency.

15. When it is expected that the subsidiarys local currency will depreciate 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 somealbeit limitedglobal 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: Chiquitas 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 Chiquitas 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 $55,000
Foreign income tax at 40% 22,000
Dividend available to be declared $33,000
Foreign dividend withholding tax at 5% 1,650
Santanas receipt of dividends $31,350
a. Santanas receipt of dividends $31,350
U.S. tax liability at 34% $10,659
Foreign taxes available to
be used as a credit 23,650 23,650
U.S. taxes due (i.e., credit exceeds U.S.tax) 0
Net funds available to Santana $31,350
b. Foreign taxes cannot be applied against the U.S. tax liability
Santanas 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 + F + (N F) = 0.02 + 0.10 + (0.02 0.10) = 0.1220 = 12.20%

E19-4. Effective interest rate of a foreign loan

Answer: F = Forecast percentage change of the yen = 9.09%

E = N + F + (N F) = 0.03 + 0.0909 + (0.03 0.0909) = 0.1236 = 12.36%

E19-5. Comparing effective interest rates of two loans
Answer: EMP = N + F + (N F) = 0.08 0.10 + (0.08 0.10) = 0.0280 = 2.80%
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
MNCs receipt of dividends can be calculated as follows:
Subsidiary income before local taxes $250,000
Foreign income tax at 33% 82,500
Dividend available to be declared $167,500
Foreign dividend withholding tax at 9% 15,075
MNCs receipt of dividends $152,425
a. If tax credits are allowed, then the so-called grossing up procedure will be applied:
Additional MNC income $250,000
U.S. tax liability at 34% $ 85,000
Total foreign taxes paid (credit)
($82,500 + $15,075) (97,575) (97,575)
U.S. taxes due 0
Net funds available to the MNC $152,425
b. If no tax credits are permitted, then:
MNCs receipt of dividends $152,425
U.S. tax liability ($152,425 0.34) 51,825
Net funds available to the MNC $100,600

P19-2. Translation of financial statements

LG 3; Intermediate
Balance Sheet
12/31/12 12/31/13
U.S.$ U.S.$*
Cash 48.00 50.88
Inventory 360.00 381.60
Plant and equipment (net) 192.00 203.52
Total 600.00 636.00
Debt 288.00 305.28
Paid-in capital 240.00 254.40
Retained earnings 72.00 76.32
**
Total 600.00 636.00**
Partial income statement
12/31/12 12/31/13
U.S.$ U.S.$
Sales 36,000.00 38,160.00
Cost of goods sold 35,700.00 37,842.00
Operating profits 300.00 318.00
*
At 6% appreciation, the new exchange rate becomes U.S.$ 1.272 //
**
Differences in totals result from rounding.

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P19-3. Personal finance problem: Exchange rates

LG 3; Easy
a. Cost of tour (EUR) 2,750
Current exchange rate 1.3411
Cost of tour in dollars $ 3,688
Round trip airfare $ 1,490
Incidental travel expenses $ 300
Cost of meals in Italy (EUR) 500
Cost of meals in Italy ($) $ 671
Miscellaneous expenditures $ 1,000
Total cost of trip in dollars $ 7,149

b. Amount of euros needed in Italy

Cost of means in Italy (EUR) 500
Miscellaneous expenditures $ 1,000
Current exchange rate 0.7456
Miscellaneous expenditures (EUR) 746
Amount of euros needed in Italy 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 dont be fooled by their
cosmopolitan-sounding name. Theyre able to be invested in any region of the world,
including the United States, so they dont actually offer as much diversification as a
good international fund. A prime example: Vanguards 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 thats 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. Vanguards 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
Prices 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
riskspolitical upheaval, corruption, and currency collapse, to name just a few.
Dont 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 of
concentration makes them particularly volatile. If you pick the right countrylike the
Turkey Investment Fund, with a 160% rise in 2009the 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:

US$ MP
Effective rates
Euromarket 4.00% 3.01% 3.53%
Domestic 3.75% 2.72% 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 philosophyalthough 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 investmentconstruction 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 capitalUS$:

Type of Capital Amount Weight Cost Weighted Cost

Long-term debt 6,000,000 60.00% 6.0% 3.60%
Equity 4,000,000 40.00 % 12.0% 4.80%
Total $10,000,000 100.00% 8.40%

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

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b. Present value (PV), 5 years:

Operating cash flow = sales 0.20

= $20,000,000 0.20
= $4,000,000
Present value N = 5, I = 8%, PMT = $4,000,000
Calculation
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. 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 USCCs 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.
d. 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 USCCs 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 Chiles economic ties with the United States. This
should make the project more attractive.

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

Incremental Present Value
Year Cash Flow Discount Rate of GTI
1 $18,750,000 16% $139,243,245
2 18,750,000
3 20,500,000
4 21,750,000
5 24,000,000
630 25,000,000 [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, GTIs owners would receive $130,843,245.

b. 1. Straight bondsFinancing 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 bondsInitially 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 attachedThe 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 GTIs stock to acquire the firm in a
stock swap.
2. The exchange of stock should increase OSs EPS to $3.93, an increase from $3.50.

Calculations:
New OS shares required: 4,620,000 0.60 = 2,772,000
Total OS shares: 10,000,000 + 2,772,000 = 12,772,000
$35,000,000 + $15,246,000
EPS for OS: = $3.93
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:

OS GTI
Price per share $50 $30
(market) (price paid)
EPSpremerger $3.50 $3.30
P/E ratio 14.29 9.09
EPSpostmerger $3.93 $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 companys EPS and a decrease in the targets EPS.
3. Over the long run, the EPS of the merged firm would probably not increase. Usually the earnings
attributable to the acquired companys assets grow at a faster rate than those resulting from the
acquiring companys premerger assets.

d. OS could make a tender offer to GTIs 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 a variety of factors, including local taxes in host countries, host-country regulations that
may block the return of MNCs cash flow, the usual business and financial risks, currency and
political actions of host governments, and local capital market conditions. Foreign exchange risks
can also complicate international cash management.

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