19.1 The Multinational Company and Its Environment

LG 1 19.1 The Multinational Company and Its Environment

In recent years, as world markets have become more interdependent, interna- tional finance has become an increasingly important element in the management

multinational companies of multinational companies (MNCs). Since World War II, an increasing number (MNCs)

of firms, including many based in emerging or developing countries, have become

Firms that have international

MNCs (also referred to as global firms or transnational corporations) by devel-

assets and operations in

oping targeted overseas markets, mainly through foreign direct investment

foreign markets and draw part of their total revenue and

(FDI)—that is, by establishing foreign subsidiaries or affiliates—and via mergers

profits from such markets.

and acquisitions. The principles of managerial finance in this text apply to the management of MNCs as well as to purely domestic firms. However, certain fac-

Matter of fact tors unique to the international setting tend to complicate the financial manage-

ment of multinational companies. A simple comparison between a domestic U.S.

Diversifying Operations

firm (firm A) and a U.S.-based MNC (firm B), as illustrated in Table 19.1, indi- cates the influence of some of the international factors on MNCs’ operations.

O firms have operations in foreign markets is the portfolio

ne of the reasons why

Multinationals face a variety of laws and restrictions when operating in dif-

ferent nation-states. The legal and economic complexities existing in this envi-

concept discussed in Chapter

ronment are significantly different from those a domestic firm would face. Here

8. Just as it is not wise for you

we take a brief look at that environment, starting with key trading blocs.

to put all of your investment into the stock of one firm, it is

KEY TRADING BLOCS

not wise for a firm to invest in

In late 1992, the presidents of the United States and Mexico and the prime min-

only one market. By having

ister of Canada signed the North American Free Trade Agreement (NAFTA). The

operations in many markets, firms can smooth out some of

U.S. Congress ratified NAFTA in November 1993. This trade pact simply mirrors

the cyclic changes that occur

underlying economic reality—Canada and Mexico are among the largest U.S.

in each market.

trading partners. In 2003–2004, the United States signed a bilateral trade deal

North American Free Trade Agreement (NAFTA)

The treaty establishing free TA B L E 1 9 . 1 International Factors and Their Influence on MNCs’ Operations trade and open markets

among Canada, Mexico, and Firm B (MNC) the United States.

Factor

Firm A (Domestic)

Foreign ownership

All assets owned by domestic

Portions of equity of foreign

entities

investments owned by foreign partners, thus affecting foreign decision making and profits

Multinational

All debt and equity structures

Opportunities and challenges

capital markets

based on the domestic capital

arise from the different capital

market

markets in which firms can issue debt and equity

Multinational

All consolidation of financial

Different currencies and specific

accounting

statements based on one

translation rules influence the

currency

consolidation of financial statements into one currency

Foreign exchange

All operations in one currency

Fluctuations in foreign exchange

risks

markets can affect foreign revenues and profits as well as the overall value of the firm

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Central American Free Trade with Chile and also a regional pact, known as the Central American Free Trade Agreement (CAFTA)

Agreement (CAFTA), with the Dominican Republic and five Central American

A trade agreement signed in

countries (Costa Rica, El Salvador, Guatemala, Honduras, and Nicaragua). Since

2003–2004 by the United

1985, the United States has signed bilateral and regional trade agreements with

States, the Dominican Republic, and five Central

more than 62 other nations.

American countries (Costa

The European Union, or EU, has been in existence since 1957. It has a cur-

Rica, El Salvador, Guatemala,

rent membership of 27 nations. With a total population estimated at more than

Honduras, and Nicaragua).

470 million (compared to the U.S. population of about 300 million) and an European Union (EU)

overall gross national income paralleling that of the United States, the EU is a sig-

A significant economic force

nificant global economic force. The countries of Western Europe opened a new

currently made up of 27

era of free trade within the union when intraregional tariff barriers fell at the end

nations that permit free trade

of 1992. This transformation is commonly called the European Open Market.

within the union.

Although the EU has managed to reach agreement on most economic, monetary, European Open Market

financial, and legal provisions, debates continue on certain other aspects (some

The transformation of the

key), including those related to automobile production and imports, monetary

European Union into a single

union, taxes, and workers’ rights.

market at year-end 1992.

As a result of the Maastricht Treaty of 1991, 12 EU nations adopted a single euro

currency, the euro, as a continent-wide medium of exchange. And beginning

A single currency adopted on

January 1, 2002, those 12 EU nations switched to a single set of euro bills and

January 1, 1999, by 12 EU

coins, causing the national currencies of all 12 countries participating in

nations, which switched to a

monetary union to slowly disappear in the following months. As of 2007, 13

single set of euro bills and

members were using the euro as their national currency.

coins on January 1, 2002.

At the same time that the European Union implemented monetary union, monetary union

(which also involved creating a new European Central Bank), the EU experienced

The official melding of the

a wave of new applicants, resulting in the May 1, 2004, admission of ten and the

national currencies of the EU

January 1, 2007, admission of two new members from Eastern Europe and the

nations into one currency, the euro, on January 1, 2002.

Mediterranean region. The rapidly emerging new community of Europe offers both challenges and opportunities to a variety of players, including multina- tional firms. MNCs today face heightened levels of competition when operating inside the EU. As more of the existing restrictions and regulations are elimi- nated, for instance, U.S. multinationals will have to face other MNCs, some from within the EU itself.

In addition to NAFTA and the EU, a number of other bilateral or regional trading blocs have emerged. The EU itself has entered into trade accords involving at least 35 countries. Latin America has several such blocs, including its

Mercosur largest, Mercosur, which is composed of Argentina, Brazil, Paraguay, Uruguay,

A major South American

and Venezuela. It has a population of more than 250 million and a combined eco-

trading bloc that includes

nomic size of about US$1.1 trillion. An even larger bloc exists in the form of countries that account for more ASEAN (Association of Southeast Asian Nations), with ten members. China has

than half of total Latin American GDP.

signed a trade deal with ASEAN, to be phased in by 2010. This will create a regional free market encompassing more than 1.8 billion people by 2015. Other

ASEAN trading agreements involving Japan, India, South Korea, Singapore, Australia,

A large trading bloc that

New Zealand, and various nations in Africa either have been completed or are

comprises ten member nations, all in Southeast Asia. China is

under negotiation.

expected to join this bloc in

These deals will result in an increasing share of world trade being covered by

2010. Also called the

regional accords. Meanwhile, an unintended consequence is the emergence of

Association of Southeast Asian

contradictions and incompatibilities vis-á-vis the multilateral-based system

Nations.

embedded in WTO (discussed in the next section). All of this will force the multi- nationals to navigate through a rising number of trade agreements worldwide.

CHAPTER 19

International Managerial Finance

regional and bilateral trade pacts, but only if they are prepared to exploit them. They must offer a desirable mix of products to a collection of varied consumers and be ready to take advantage of a variety of currencies and of financial markets and instruments (such as the Euroequities discussed later in this chapter). They must staff their operations with the appropriate combination of local and foreign personnel and, when necessary, enter into joint ventures and strategic alliances.

GATT AND THE WTO Although it may seem that the world is splitting into a handful of trading blocs,

this is less of a danger than it may appear to be, because many international treaties are in force that guarantee relatively open access to at least the largest

General Agreement on economies. The most important such treaty is the General Agreement on Tariffs Tariffs and Trade (GATT)

and Trade (GATT). In 1994, Congress ratified the most recent version of this

treaty, which has governed world trade throughout most of the postwar era. The world trade throughout most of current agreement extends free-trading rules to broad areas of economic activity—

A treaty that has governed

the postwar era; it extends free-trading rules to broad

such as agriculture, financial services, and intellectual property rights—that had

areas of economic activity and

not previously been covered by international treaty and were thus effectively off-

is policed by the World Trade

limits to foreign competition.

Organization (WTO).

The 1994 GATT treaty also established a new international body, the World World Trade Organization

Trade Organization (WTO), to police world trading practices and to mediate dis- (WTO)

putes between member countries. The WTO began operating in January 1995. In

International body that polices

2004, preliminary approvals were granted for an eventual membership of the

world trading practices and

Russian Federation in the WTO. In December 2001, the People’s Republic of

mediates disputes among

China was, after years of controversy, granted membership. As of 2007, the

member countries.

WTO had 151 members. Given the emergence of more bilateral and regional trade accords, however, its long-term prospects and effectiveness are becoming increasingly clouded. Key evidence was the organization’s lack of achieving final agreement by 2007 on the global round of trade negotiations, the Doha Round, which began in 2001.

LEGAL FORMS OF BUSINESS ORGANIZATION In many countries outside the United States, operating a foreign business as a

subsidiary or affiliate can take two forms, both similar to the U.S. corporation. In German-speaking nations the two forms are the Aktiengesellschaft (A.G.) or the Gesellschaft mit beschrankter Haftung (GmbH). In many other countries the sim- ilar forms are a Société Anonyme (S.A.) or a Société à Responsibilité Limitée (S.A.R.L.). The A.G. and the S.A. are the most common forms, but the GmbH and the S.A.R.L. require fewer formalities for formation and operation.

Establishing a business in a form such as the S.A. can involve most of the pro- visions that govern a U.S.-based corporation. In addition, to operate in many for- eign countries it is often essential to enter into joint-venture business agreements

joint venture with private investors or with government-based agencies of the host country. A

A partnership under which the

joint venture is a partnership under which the participants have contractually

participants have contractually

agreed to contribute specified amounts of money and expertise in exchange for

agreed to contribute specified amounts of money and

stated proportions of ownership and profit. Joint ventures are common in many

expertise in exchange for

emerging and developing nations.

stated proportions of

Emerging and developing countries have varying laws and regulations regarding

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Special Topics in Managerial Finance

(including Mexico, Brazil, South Korea, and Taiwan) have either completely removed or significantly liberalized their local-ownership requirements, other major economies (including China and India) are just beginning to relax these restrictions. China, for instance, has gradually opened up new economic sectors and industries to partial (and, in a few cases, full) foreign participation. India continues to insist on majority local ownership in wide-ranging segments of its economy. MNCs, especially those based in the United States, the EU, and Japan, will face new challenges and opportunities in the future in terms of ownership requirements, mergers, and acquisitions.

The existence of joint-venture laws and restrictions has implications for the operation of foreign-based subsidiaries. First, majority foreign ownership may result in a substantial degree of management and control by host country partici- pants. This, in turn, can influence day-to-day operations to the detriment of the managerial policies and procedures MNCs normally pursue. Next, foreign own- ership may result in disagreements among the partners as to the exact distribu- tion of profits and the portion to be allocated for reinvestment. Moreover, operating in foreign countries, especially on a joint-venture basis, can involve problems regarding the remittance of profits. In the past, the governments of Argentina, Brazil, Venezuela, and Thailand, among others, have imposed ceilings not only on the repatriation (return) of capital by MNCs but also on profit remit- tances by these firms to the parent companies. These governments usually cite the shortage of foreign exchange as the motivating factor. Finally, from a “positive” point of view, it can be argued that MNCs operating in many of the less devel- oped countries benefit from joint-venture agreements, given the potential risks stemming from political instability in the host countries. This issue will be addressed in detail in subsequent discussions.

TAXES Multinational companies, unlike domestic firms, have financial obligations in

foreign countries. One of their basic responsibilities is international taxation—a complex issue because national governments follow a variety of tax policies. In general, U.S.-based MNCs must take into account several factors.

Tax Rates and Taxable Income First, MNCs need to examine the level of foreign taxes. Among the major indus-

trial countries, corporate tax rates do vary. While the average rates in the United States, Germany, and Japan are close to 40 percent, those in the United Kingdom and Australia are near 30 percent. Ireland has a rate of about 12 percent. Many less industrialized nations maintain relatively moderate rates, partly as an incen- tive for attracting foreign capital. Certain countries—in particular, the Bahamas, Switzerland, Liechtenstein, the Cayman Islands, and Bermuda—are known for their low tax levels. As discussed in the Global Focus box in Chapter 11, China has had a low rate for foreign investors, to encourage investment. These nations typically have no withholding taxes on intra-MNC dividends.

Next, there is a question as to the definition of taxable income. Some coun- tries tax profits as received on a cash basis, whereas others tax profits earned on an accrual basis. Differences can also exist in treatments of noncash charges, such as depreciation, amortization, and depletion. Finally, the existence of tax agree-

CHAPTER 19 International Managerial Finance

the total tax bill of the parent MNC but also its international operations and financial activities.

Tax Rules Different home countries apply varying tax rates and rules to the global earnings of

their own multinationals. Moreover, tax rules are subject to frequent modifica- tions. In the United States, for instance, the Tax Reform Act of 1986 resulted in cer- tain changes affecting the taxation of U.S.-based MNCs. Special provisions apply to tax deferrals by MNCs on foreign income; operations set up in U.S. possessions, such as the U.S. Virgin Islands, Guam, and American Samoa; capital gains from the sale of stock in a foreign corporation; and withholding taxes. Furthermore, MNCs (both U.S. and foreign) can be subject to national as well as local taxes. Obviously, these laws can make a big difference in a multinational’s tax bill.

As a general practice, the U.S. government claims jurisdiction over all the income of an MNC, wherever earned. (Special rules apply to foreign corpora- tions conducting business in the United States.) However, it may be possible for a multinational company to take foreign income taxes as a direct credit against its U.S. tax liabilities. The following example illustrates one way of accomplishing this objective.