International Managerial Finance Prepared by Keldon Bauer The MNC and its Environment In recent years international finance has become an increasingly important element in the management of MNCs Although the principles of managerial finance are applicable to MNCs certain factors unique to the international setting tend to complicate the financial management of MNCs A simple comparison between a domestic U S firm and a U S based MNC is given in Table 16 1 The MNC and its Environment The MNC and its Environment cont During the 1990s three important trading blocks emerged In 1992 the United States Mexico and Canada signed the North American Free Trade Agreement NAFTA In 1992 Western Europe also strengthened previously existing European Union by forming the European Open Market which included the adoption of a common currency called the EURO in January 1999 The MNC and its Environment cont In 1991 the Mercosur Group of South America including the countries of Brazil Argentina Paraguay and Uruguay formed a trading block The General Agreement on Tariffs and Trade GATT is currently the most important international treaty governing trade It extends free trading rules to broad areas of economic activity and is policed by the World Trade Organization WTO The MNC and its Environment Legal Forms of Business In many countries outside the U S operating foreign subsidiaries can take two forms similar to a U S corporation In German speaking nations the two forms are the Aktiengesellschafts A G or the Gesellschaft mit beschrankter Haftun GmbH In many other countries the similar forms are Societe Anonymes S A or Societe a Responsibilite Limitee S A R L The MNC and its Environment Legal Forms of Business cont One major difference however is that it is often essential to enter into joint ventures with private investors or with governmentbased agencies in the host country Such joint venture laws can result in a substantial degree of management control by host countries and may result in disagreements among the partners as to the distribution of profits the portions to be allocated for reinvestment and the remittance of profits The MNC and its Environment Taxes From the perspective of a U S based MNC several factors related to taxation in foreign countries must be considered First the level of foreign taxes needs to be examined Second the definition of what constitutes taxable income must be ascertained Foreign tax rates and tax rules must be understood In general U S based MNCs may often take foreign taxes as a direct credit against U S tax liabilities The MNC and its Environment Financial Markets During the past two decades the Euromarket which provides for borrowing and lending currencies outside their country of origin has grown rapidly and provides MNCs with an external opportunity to borrow or lend funds with little government regulation One aspect of the Euromarket is offshore centers which is composed of cities or states including London Singapore Nassau and Hong Kong that have achieved prominence as major centers for Euromarket business The MNC and its Environment Financial Markets In addition a variety of new financial instruments including currency and interest rate swaps forward contracts options contracts and international commercial paper have been created to facilitate international trade and finance The Euromarket is still dominated by the U S dollar However other currencies such as the Euro Swiss Franc Japanese Yen and British Pound have increased in importance Financial Statements Consolidation Presently U S tax rules require the consolidation of financial statements of subsidiaries according to the percentage of ownership by the parent as described in Table 18 2 below Financial Statements Translation of Individual Accounts Unlike domestic items in financial statements international items require translation back into U S dollars Since 1982 all financial statements of U S MNCs have to conform to FASB No 52 Under FASB 52 the current rate method of translation is used Financial Statements Translation of Individual Accounts cont The current rate method is implemented in two steps First each subsidiary s balance sheet and income statements are measured in terms of their functional currency Second as described in Figure 18 1 on the following slide balance sheet items are translated at the closing date exchange rate and all income statement items are translated at average rates Financial Statements Translation of Individual Accounts cont Risk Exchange Rate Risk Exchange rate risk is the risk caused by varying exchange rates between two currencies The foreign exchange rate between the U S dollar US and Swiss Franc SF is expressed as follows US 1 SF 1 4175 SF 1 US 0 7055 The usual exchange rate quotation in international markets is given as SF1 4175 US Risk Exchange Rate Risk cont Under the current system of floating exchange rates the value of any two major currencies with respect to one another is allowed to fluctuate on a daily basis For smaller country currencies however exchange rates are fixed or semi fixed with respect to one of the major currencies The spot exchange rate is the rate of exchange between any two currencies on a given day Risk Exchange Rate Risk cont The forward exchange rate is the rate of exchange between two currencies at some specific future date These rates and their relationships can be described as shown in Figure 18 2 on the following slide Although a number of factors can influence exchange rate movements by far the most important influence is differing inflation rates between two currencies where the currency with the higher rate of inflation will decline relative to the country with the lower rate Insert Figure 18 2 here Risk Exchange Rate Risk cont Although several economic and political factors influence foreign exchange rate movements by far the most important explanation for long term changes is differing inflation between two countries Countries that experience high inflation rates will see their currencies decline in value depreciate relative to the currencies of countries with lower inflation rates Risk Exchange Rate Risk cont It is also useful to describe the difference between accounting exposure and economic exposure Accounting exposure is the risk resulting from the effects of changes in foreign exchange rates on the translated value of a firm s financial statements Perhaps more importantly economic exposure is the risk resulting from the effects
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