This Document Contains Chapters 15 to 16 CHAPTER 15 FOREIGN TRADE AND SHORT-TERM FINANCING This chapter is primarily factual, describing the various institutions and details involved in financing foreign trade. The most important documents encountered in bank related financing are the draft, which is a written order to pay; the letter of credit, which is a bank guarantee of payment provided that certain stipulated conditions are met; and the bill of lading, the document covering title and actual shipment of the merchandise by a common carrier. Other documents of lesser importance include the commercial and consular invoices and insurance certificate. The section on short-term financing discusses the alternative financing options available to companies. It emphasizes how exchange rate changes affect the home currency costs of borrowing in different currencies. The domestic analogy is calculating real borrowing costs, factoring in inflation and nominal interest rates. In this edition, Key Points 1. The functions of these instruments, and hence the rationale for their existence, are: • To reduce both buyer and seller risk. • To pinpoint who bears those risks that remain. • To facilitate the transfer of risk to a third party. • To facilitate financing. 2. Each instrument evolved over time as a rational response to the additional risks in international trade posed by greater distances, the lack of familiarity between exporters and importers, the possibility of government imposition of exchange controls, and greater costs involved in bringing suit against a party domiciled in another nation. 3. The existence of government programs that provide subsidized export financing, such as the U.S. Exim bank, creates a market imperfection that MNCs can exploit to lower their risk adjusted cost of funds. 4. Countertrade has evolved in response to government efforts to control the allocation of foreign exchange. Although an inefficient means of conducting trade, it exists and should be understood. 5. In formulating a borrowing strategy, the key factors and objectives associated with that strategy must be consistent with our understanding of the way in which financial markets work. 6. If forward contracts exist, then the only valid objective of a borrowing strategy is to minimize covered after tax interest costs. 7. In the absence of forward contracts, firms can either attempt to minimize expected costs or establish some trade off between reducing expected costs and reducing the degree of cash flow exposure. The latter goal involves offsetting operating cash inflows in a currency with financing cash outflows in that same currency. In general, the borrowing decision should be integrated with the hedging decision. SUGGESTED ANSWERS TO CHAPTER 15 QUESTIONS 1. What are the basic problems arising in international trade financing and how do the main financing instruments help solve those problems? Answer: The main problems arising in international trade financing are the risks that both buyer and seller bear in cross border trade, how to allocate those risks in a way that ensures that those best able to bear them or are in the best position to mitigate them do so, to facilitate the transfer of remaining risks to a third party, and to attain financing at as low a cost as possible. The principal financing instruments and mechanisms examined here are the letter of credit, banker’s acceptance, factoring, forfaiting, and government export financing and credit guarantees. LETTER OF CREDIT. The L/C eliminates credit risk to the exporter if the bank that opens it is of undoubted standing and it also reduces the danger that payment will be delayed or withheld owing to exchange controls or other political acts. Other risks that the L/C guards against are explained in the chapter. The L/C also facilitates financing because it ensures the exporter a ready buyer for its product. It also becomes especially easy to create a banker’s acceptance. From the importer’s standpoint, since payment is only in compliance with the L/C’s stipulated conditions, the importer is able to ascertain that the merchandise is actually shipped on, or before, a certain date by requiring an on-board bill of lading. BANKER’S ACCEPTANCE. With a banker’s acceptance, the bank effectively substitutes its own credit for that of a borrower, and, in the process, it creates a negotiable instrument that may be freely traded. This feature lowers the cost of acceptance financing. A banker’s acceptance helps an importer who does not have a close relationship with and cannot obtain financing from the exporter it is dealing with. FACTORING. By factoring on a nonrecourse basis, exporters can shift to the factor all the credit and political risks on their foreign sales except for those involving disputes between the transacting parties. Even if an exporter chooses not to discount its foreign receivables with a factor, it can still use the factor’s extensive credit information files to ascertain the creditworthiness of prospective customers. Despite its high costs, factoring can be quite worthwhile to many firms because the cost of bearing the credit risk associated with a given receivable can be substantially lower to a factor than to the selling firm. As the chapter notes, factoring is most useful for (1) the occasional exporter and (2) the exporter with a geographically diverse portfolio of accounts receivable. In both cases, it would be organizationally difficult and expensive to internalize the accounts receivable collection process. Such companies would generally be small or else would be involved on a limited scale in foreign markets. FORFAITING. This specialized factoring technique, which entails the discounting--at a fixed rate without recourse--of medium-term export receivables denominated in fully convertible currencies (U.S. dollar, Swiss franc, Deutsche mark). is useful in the case of extreme credit risk. GOVERNMENT SOURCES OF EXPORT FINANCING AND CREDIT INSURANCE. Most governments of developed countries provide their domestic exporters with low-cost export financing and concessionary rates on political and economic risk insurance. These credits and guarantees provide exporters with low-cost financing and shift risks to the government. Of course, there is a cost: Taxpayers get to bear these costs, although the risks may be lower since foreign governments may be more reluctant to interfere with payments to other governments than to private firms or banks. 2. The different forms of export financing distribute risks differently between the exporter and the importer. Analyze the distribution of risk in the following export financing instruments. 2.a. Confirmed, revocable letter of credit Answer: The revocable letter of credit can be revoked, without notice, at any time up to the time a draft is presented to the issuing bank. As such, it is favorable to the importer, but the exporter loses the guarantee that funds will be available if she meets the conditions specified on the L/C. 2.b. Confirmed, irrevocable letter of credit Answer: The confirmed, irrevocable L/C eliminates credit risk to the exporter if the banks that sign it are of undoubted standing. Other advantages of an irrevocable L/C are detailed in the chapter. 2.c. Open account credit Answer: Selling on open account is risky to the exporter because it has little evidence of the importer’s obligation to pay. The advantages come in the form of greater flexibility. But here the exporter bears virtually all the risk and the importer practically none. 2.d. Time draft, D/A Answer: A time draft D/A removes some of the risk faced by the exporter. Documents evidencing title to the merchandise are turned over to the importer only if the draft is accepted by the importer or his bank. The exporter still bears the risk of shipping goods that will be refused. In that case, the exporter must either sell the goods in the foreign market at a lower price or ship them home at added expense. 2.e. Cash with order Answer: Cash payment at the time of order provides the exporter with the greatest protection, because payment is received before he commits any of his funds. There is no risk of starting work on an order and then finding out that the order has been canceled. By contrast, the importer bears risk here because he has no guarantee that the exporter will perform the work as expected. 2.f. Cash in advance Answer: Cash in advance, prior to shipment or upon delivery of the goods, provides the exporter with a great deal of protection. The risk is that if cash is not received at the time the order is first processed, the exporter is out some of its cash if the order is canceled before payment is made. The importer bears risk because he has no guarantee that the goods requested will be delivered according to specifications. 2.g. Consignment Answer: Sending goods on consignment provides some protection to the exporter because he retains title to the goods until they are paid for. But this is a very risky method since there is little evidence of obligation to pay and it may be difficult to collect if the importer’s government imposes currency controls. 2.h. Sight draft Answer: With a sight draft, the importer receives no credit. This lessens the credit risk to the exporter. With a time draft, by contrast, the exporter only knows at maturity whether the importer will honor it. As with a draft in general, credit risk is reduced because the shipper, acting on orders of the exporter, will not turn over the goods until payment is made. 3. Describe the different steps and documents involved in exporting motors from Kansas to Hong Kong using a confirmed letter of credit, with payment terms of 90 days sight. What alternatives are available to the exporter to finance this shipment? Answer: The exporter will receive a letter of credit addressed to itself, written and signed by a bank acting on behalf of the buyer. In the letter, the bank promises it will honor drafts drawn on itself if the seller conforms to the specific conditions set forth in the L/C. The exporter can use the L/C to finance its sale by sending a draft, signed by itself and addressed to the bank that confirmed the L/C, ordering the importer to pay in 90 days the amount specified on its face. When accepted by the confirming bank, this draft becomes a banker’s acceptance that the exporter can then sell for cash to finance its shipment. To be honored when presented for payment, the draft must be accompanied by a commercial invoice containing an authoritative description of the engines being shipped, a clean bill of lading certifying that the engines were received in apparently good condition, an insurance certificate, and possibly a consular invoice, which is presented to the local consul in exchange for a visa. Of course, the exporter must manufacture the engines or take them out of inventory, deliver them to the cargo ship, take out the necessary insurance, and fill out the B/L, commercial invoice, and consular invoice (if required). Instead of using the L/C to arrange financing (by creating a B/A), the exporter can also arrange bank financing or use general corporate funds to finance its export. If it does the latter, it will hold onto the acceptance and then present it in 90 days and receive payment at that time. 4. Explain the advantages and disadvantages of each of the following forms of export financing. 4.a. Banker’s acceptances Answer: The low-risk nature of banker’s acceptances mean that they trade at rates very close to those on CDS. That is, the exporter can sell a banker’s acceptance at a relatively small discount (the lower the interest rate, the lower the discount). On the other hand, there are additional costs attached to a banker’s acceptance. Specifically, the accepting bank levies a fee, or commission, for accepting the draft. The bank also receives a fee if a letter of credit is involved. 4.b. Discounting Answer: An advantage of discounting is that the discount rate for trade paper is often lower than interest rates on overdrafts, bank loans, and other forms of local funding. This lower rate is usually a result of export promotion policies that lead to direct or indirect subsidies of rates on export paper. A disadvantage is that there are often fees involved. 4.c. Factoring Answer: Through factoring, firms can shift credit risks to the factor, who is often in a better position to assess and bear these risks, and also reduce their costs of the accounts receivable collection process. In addition, by using a factor, a firm can ensure that its terms are in accord with local practice and are competitive. However, factoring can be quite expensive once account is taken of the fees involved. 4.d. Forfaiting Answer: This specialized factoring technique helps shift extreme credit risk to the for faiter, usually a multinational bank. Forfaiting also provides help with administrative and collection problems. As with factoring, these services can be expensive. 5. What are the potential advantages and disadvantages of countertrade for the parties involved? Answer: Countertrade is less efficient than using cash or credit because the products taken in trade are not liquid. Sellers factor these costs into the price they charge countertrading buyers. Both parties, therefore, bear costs. A principal problem for counter traders is that it causes them to lose sight of the market that they are in. By failing to deal directly with customers, the counter trader never learns what the market really wants or how it might improve its competitiveness. Countertrading also creates other problems. First, the goods that can be taken in countertrade are usually relatively undesirable. Those that can be readily converted into cash already have been. So although a firm shipping computers to Brazil might prefer to take coffee beans in return, the only goods available might be Brazilian shoes. Second, the details are difficult to work out (how many tons of naphtha is a pile of shoddy Polish goods worth?). The inevitable result is a high ratio of talk to action; only a small percentage of deals that are talked about getting done. Lost deals cost money. There are few advantages to countertrading as an economic means of transacting. About the best that can be said for the recipient is that it is preferable to having no sales in a given market. Countertrading may also permit countries to cheat on the cartels they belong to by effectively underpricing their products. Countertrade may also reduce the risk faced by a nation that contracts for a new manufacturing facility. If the contractor’s payment is taken in the form of goods supplied by the facility, he has a strong incentive to do quality work and to ensure that the technology and equipment are appropriate for the workforce’s skill level, available materials, and so on. 6. What are the three basic types of bank loans? Describe their differences. Answer: The major forms of bank financing include overdrafts, discounting, and term loans. Term loans are straight loans, often unsecured, that are made for a fixed period of time, usually 90 days. Rather than a one time loan, like a term loan, an overdraft is a line of credit against which drafts (checks) can be drawn (written) up to a specified maximum amount. The discounting of trade bills is the preferred short term financing technique in many European and Latin American countries. A manufacturer takes a trade bill –reflecting goods sold on credit to a retailer – to his or her bank, and the bank accepts it for a fee if the buyer’s bank has not already accepted it. The bill is then sold at a discount to the manufacturer’s bank or to a money market dealer. ADDITIONAL CHAPTER 15 QUESTIONS AND ANSWERS 1. To “meet the competition” from its counterparts overseas, Exim bank will mechanically match the terms of a loan provided by a rival export financing agency – including the interest rate – when it finances U.S. exports. 1.a. What problems might arise from this rule of matching nominal interest rates? Answer: The effective subsidy associated with a particular interest rate equals the market interest rate minus the interest rate actually charged. Since nominal interest rates vary substantially from one country to another, this means that an 8% yen interest rate from Japan can imply a very different level of subsidy than an 8% interest rate on lira from Italy. For example, suppose that the market interest rates from Japan and Italy on a particular export credit are 9% and 15%, respectively. The implied Japanese subsidy will be 1% while the implied Italian subsidy will be 7%. If the intent is to match subsidies, therefore, matching nominal interest rates is a very inefficient way to achieve that objective. 1.b. As of January 15, 1988, the minimum interest rate on government supplied export credits to rich countries was set at a flat rate of 10.4% for all nations providing such credits. What problems might arise with this rule? Comment on which governments would push for such a rule. Which would be against it? Answer: High-inflation countries tend to have high nominal interest rates while low-inflation countries tend to have low nominal interest rates. Thus, the real interest rate implied by a given nominal interest rate will be very high for countries with low inflation rates and very low for countries with high interest rates. Thus, at any given nominal interest rate, high-inflation countries are able to subsidize their exports more than low-interest-rate countries. To take a not-too-extreme case, suppose that due to low inflation, the nominal market interest rate in Germany is only 7%, while high French inflation results in a nominal interest rate of 12%. If the minimum interest rate on government supplied export credits is 10.4%, the German government will be forced to charge an above market rate, while the French government will be able to provide a 1.6% (12% 10.4%) interest subsidy. High-inflation countries will push for setting maximum rates in nominal terms, while low inflation countries will be against such a policy. 1.c. How should minimum interest rates on export credits be set so as to ensure comparability across countries? Answer: The best approach would be to tailor the minimum rate to each country according to its level of nominal interest rates. A simple implementation of this approach could involve setting the minimum rate equal to the risk free rate in the country for a loan of that maturity plus or minus a constant S. For example, if S is set equal to 2%, then a country whose nominal risk free rate is 10% would have to charge a minimum rate of 8%, and a country with a nominal risk free rate of 6% would have to charge a minimum rate of 4%. 1.d. Suppose that instead of subsidizing interest rates, governments turn to export insurance subsidies. Is this move an improvement vis á vis export credit subsidies? Explain. Answer: The most important aspect of providing export credit insurance subsidies instead of subsidizing interest rates on export credits is that with the former the subsidy is limited to the difference between the market interest rate and the risk free interest rate. In contrast, with interest rate subsidies, the interest rate on export credit can fall below the risk free rate. In other words, the maximum possible subsidy with export credit insurance is less than the maximum possible subsidy with interest rate subsidies. 1.e. Why has the U.S. government fought against export credit subsidies? Answer: They are expensive and lead to misallocation of resources: Unprofitable deals get done. Thus, a nation that subsidizes exports simply gives away part of its wealth. Moreover, it is doubtful that export subsidies really improve the trade balance. Any increase in exports achieved by a subsidy must necessarily increase the demand for dollars by foreign purchasers of U.S. goods. The increase in demand will boost the dollar’s value, encouraging imports and discouraging unsubsidized exports. If investment and savings are unaffected, the trade deficit will not respond to export subsidies. 2. One of the purposes of Exim bank is to absorb credit risks on export sales that the private sector will not accept. Comment on this purpose. Answer: The private sector is always willing to absorb credit risks, but not necessarily at a low price. By providing low cost export credits, the government facilitates uneconomical deals. That is, the government is sending out the wrong signals about the profitability of doing certain deals. The exporter gets the benefits from any export sales while the taxpayer gets stuck with the cost of any credit that defaults. That is, poor foreign credit risks receive low cost financing, and taxpayers subsidize these bad risks. 3. Comment on the following statement: “Exim bank does not compete with private financial institutions. It offers assistance only in cases in which the export credit transaction would not take place without its help. Exim bank does not offer direct loan assistance to foreign buyers when private institutions will provide comparable financing on reasonable terms.” Answer: The market always provides financing on “reasonable” terms. Competition among financial institutions ensures that. But reasonable does not necessarily mean low cost. If foreign customers are risky, then the interest rate charged by the market will be high. No private lender will supply funds at 8% if the market rate is 14%. Thus, the Exim bank will find that if it sets a below market rate on its loans, no private institution will provide comparable financing on the same terms. Although the Exim bank might view this as a problem, most financial economists would not. 4. These questions relate to the Foreign Credit Insurance Association. 4.a. Describe the different risks covered by FCIA. Why does the FCIA require coinsurance? Answer: FCIA insurance offers protection from political and commercial risks to U.S. exporters: The private insurers cover commercial risks, and the Exim bank covers political risks. The exporter (or the financial institution providing the loan) must self-insure that portion not covered by the FCIA. Short-term insurance is available for export credits up to 180 days (360 days for bulk agricultural commodities and consumer durables) from the date of shipment. Coverage is of two types: comprehensive (90%-100% of political and 90%-95% of commercial risks) and political only (90%-100% coverage). Under the FCIA lease insurance program, lessors of U.S. equipment and related services can cover both the stream of lease payments and the fair market value of products leased outside the U.S. The FCIA charges a risk-based premium that is determined by country, lease term, and the type of lease. Coinsurance is required presumably because of the element of moral hazard: the possibility that exporters might take unreasonable risks knowing that they would still be paid in full. 4.b. What factors affect the insurance premium charged by the FCIA? Answer: The greater the loss experience associated with the particular exporter and the countries and customers it deals with, the higher the insurance premium charged. The rates depend on the terms of sale, with longer-term sales bearing higher rates. 4.c. Describe the basic features of a typical FCIA short-term policy. Answer: Rather than sell insurance on a case-by-case basis, the FCIA approves discretionary limits within which each exporter can approve its own credits. Insurance rates are based on the terms of sale, type of buyer, and the country of destination and can vary from a low of 0.1% to a high of 2%. The FCIA also offers pre shipment insurance up to 180 days from the time of sale. 4.d. Describe the basic features of a typical FCIA medium-term policy. Answer: Medium-term insurance is guaranteed by Exim bank and covers big-ticket items sold on credit usually from 181 days to five years. It is available on a case-by-case basis. As with short-term coverage, the exporter must reside in, and ship from, the U.S. However, the FCIA will provide medium-term coverage for that portion only of the value added that originated in the U.S. 5. Low-cost export financing is often a bad sign. Explain. Answer: A country that has a comparative advantage in the manufacture of certain products does not need to provide subsidies such as low cost financing to stimulate exports of those products. Its cost advantage will suffice. Thus, the fact that a nation feels it must subsidize export sales to be competitive could indicate that it is a high cost producer. Of course, the possibility always remains that the country is cost competitive but uses subsidies to counter the subsidies that foreign competitors receive. 6. What is countertrade? Why is it termed a sophisticated form of barter? Answer: Countertrade involves purchasing local products to offset the exports of their own products to that market. Countertrade is a form of barter because both involve swapping goods for goods. Countertrade transactions are often very complex, involving two way or three way transactions, especially where a company is forced to accept unrelated goods for resale by outsiders. In this way, countertrade is a sophisticated form of barter; that is, it may involve more than two parties and a number of transactions. SUGGESTED SOLUTIONS TO CHAPTER 15 PROBLEMS 1. Texas Computers (TC) recently has begun selling overseas. It currently has 30 foreign orders outstanding, with the typical order averaging $2,500. TC is considering the following three alternatives to protect itself against credit risk on these foreign sales: • Request a letter of credit from each customer. The cost to the customer would be $75 plus 0.25% of the invoice amount. To remain competitive, TC would have to absorb the cost of the letter of credit. • Factor the receivables. The factor would charge a nonrecourse fee of 1.6%. • Buy FCIA insurance. The FCIA would charge a 1% insurance premium. 1.a. Which of these alternatives would you recommend to Texas Computers? Why? Answer: The L/C will cost TC an average of $81.25 ($75 + 0.0025*$2,500) per order, or a total of $2,437.50 (30 * $81.25). The factoring alternative will cost an average of $40 (0.016 * $2,500) per order, or $1,200 in all. The FCIA insurance will cost an average of $25 (0.01 * $2,500) per order, or $750 in all. Thus, the least expensive alternative is the FCIA insurance. 1.b. Suppose that TC’s average order size rose to $250,000. How would that affect your decision? Answer: If TC’s average order size rises to $250,000, then the L/C will cost an average of $700 per order ($75 + 0.0025 * $250,000), or $21,000 in total. The FCIA insurance will cost an average of $2,500 per order, or $75,000 in total. Thus, the L/C is now the least expensive alternative (factoring is dominated by the FCIA insurance). 2. L.A. Cellular has received an order for phone switches from Singapore. The switches will be exported under the terms of a letter of credit issued by Sumitomo Bank on behalf of Singapore Telecommunications. Under the terms of the L/C, the face value of the export order, $12 million, will be paid six months after Sumitomo accepts a draft drawn by L.A. Cellular. The current discount rate on 6-month acceptances is 8.5% per annum and the acceptance fee is 1.25% per annum. In addition, there is a flat commission, equal to 0.5% of the face amount of the accepted draft, that must be paid if it is sold. 2.a. How much cash will L.A. Cellular receive if it holds the acceptance until maturity? Answer: If L.A. Cellular chooses to hold the acceptance, then in six months it will receive the face amount of $12 million less the acceptance fee of 0.625% (1.25%/2): Face amount of acceptance $12,000,000 Less: 1.25% per annum commission for six months -$75,000 Amount received by L.A. Cellular in six months $11,925,000 2.b. How much cash will it receive if it sells the acceptance at once? Answer: By selling the acceptance at once, paying the 0.5% selling commission, and taking the 4.25% discount (8.5%/2), L.A. Cellular will receive $11,355,000 immediately: Face amount of acceptance Less: 1.25% per annum commission for six months Less: 8.5% per annum discount for six months Less: 0.5% selling commission Amount received by L.A. Cellular immediately: $12,000,000 -$75,000 -$510,500 -$60,000 $11,355,000 2.c. Suppose L.A. Cellular’s opportunity cost of funds is 8.75% per annum. If it wishes to maximize the present value of its acceptance, should it discount the acceptance? Answer: Given that L.A. Cellular’s opportunity cost of money is 8.75%, then the present value of holding onto the acceptance is $11,925,000/(1 + (.0875/2)), or $11,425,150 (remember, it must pay the $75,000 commission in any case). Since this figure exceeds the amount of money it would receive from discounting the acceptance, L.A. Cellular should hold onto the acceptance. 3. Suppose Minnesota Machines (MM) is trying to price an export order from Russia. Payment is due nine months after shipping. Given the risks involved, MM would like to factor its receivable without recourse. The factor will charge a monthly discount of 2% plus a fee equal to 1.5% of the face value of the receivable for the nonrecourse financing. 3.a. If Minnesota Machines desires revenue of $2.5 million from the sale, after paying all factoring charges, what is the minimum acceptable price it should charge? Answer: At a monthly discount of 2%, and an extra 1.5% fee for nonrecourse financing, Minnesota Machines will pay a total fee equal to 19.5% (9 * 2% + 1.5%) of the face amount of its price for factoring its nine-month export receivable without recourse. In other words, after paying all factoring fees, MM will clear 80.5% of the price it sets. Thus, in order to net $2.5 million on its export sale, MM must set a price P such that 0.805P = $2,500,000. The solution to this equation is P = $3,105,590. This is the minimum acceptable price to MM. 3.b. Alternatively, County Bank has offered to discount the receivable, but with recourse, at an annual rate of 14% plus a 1% fee. What price will net MM the $2.5 million it desires to clear from the sale? Answer: If MM decides to discount the receivable with County Bank, it will pay a total fee equal to 11.5% (0.75 * 14% + 1%). Thus, in order to net $2.5 million on its export sale, MM must now set a price P* such that .885P* = $2,500,000, or P* = $2,824,859. 3.c. Based on your answers to parts a and b, should Minnesota Machines discount or factor its Russian receivables? MM is competing against Nippon Machines for the order, so the higher MM’s price, the lower the probability that its bid will be accepted. What other considerations should influence MM’s decision? Answer: Based purely on net revenue, MM should plan on discounting its receivable. However, this would expose it to credit risk. Credit risk reduces MM’s expected revenue from this sale (at the extreme it may receive nothing, if Russia defaults). This brings up two issues. First, is the price charged by the factor reasonably reflective of the risk of default or delay in receipt of payment? If so, then MM’s expected revenue from the sale at a given price will be the same from discounting or factoring even though the most likely revenue will differ. Second, how risk averse is MM? The more risk averse it is, the more reason for factoring its receivable. Most likely, the factor is charging a fair price for the risks involved. In that case, MM will be receiving the benefits of the factor's credit risk analysis and collection skills. In fact, as pointed out in the text, the cost of bearing the credit risk associated with MM’s Russian receivable may be substantially lower to the factor than to MM. If so, then MM will actually get a better deal with factoring then with discounting. A more important issue here is the price that MM should charge. Although MM desires revenue of $2.5 million from this sale, that may not be its minimum acceptable revenue. As a Japanese firm, Nippon is likely to focus on market share and so will probably compete very strongly on price. MM will therefore have to price its sale as low as possible. In setting a price, MM should consider the possibility of future sales stemming from this initial order. To the extent that there will be follow-up orders for additional units, parts, and service, MM might consider settling for a lower profit this time around in the expectation that it will make higher profits on future sales. 3.d. What other alternatives might be available to MM to finance its sale to Russia? Answer: MM may be able to take advantage of a government export financing agency to provide it with lower cost funds. Alternatively, MM may be able to receive low-cost government export insurance, thereby eliminating credit risk at a relatively low price. 4. Apex Supplies borrows FF 1 million at 12%, payable in one year. If Apex is required to maintain a compensating balance of 20%, what is the effective percentage cost of its loan (in FF)? Answer: The effective interest rate is defined as (annual interest paid)/(funds received). Since Apex Supplies receives only FF 800,000 net of the compensating balance requirement, this figure is FF 120,000/FF 800,000 = 15%. 5. The Olivera Corp., a manufacturer of olive oil products, needs to acquire Lit 100 million today to expand a pimento stuffing facility. Banca di Roma has offered them a choice of an 11% loan payable at maturity or a 10% loan on a discount basis. Which loan should Olivera choose? Answer: The effective interest rate on the first loan just equals its stated rate of 11%. By contrast, the effective interest rate on the loan priced on a discount basis is Lit 10 million/Lit 90 million = 11.11%. Hence, the 11% loan is less expensive. 6. If Consolidated Corp. issues a Eurobond denominated in yen, the 7% interest rate on the $1 million, one year borrowing will be 2% less than rates in the U.S. However, Con Corp would have to pay back the principal and interest in Japanese yen. Currently, the exchange rate is ¥183 = $1. By how much could the yen rise against the dollar before the Euroyen bond would lose its advantage to Con Corp? Answer: The breakeven exchange rate is found where the dollar cost of borrowing dollars just equals the dollar cost of borrowing yen. If Con Corp borrows dollars, it will owe 1.09 * $1,000,000 at the end of the year (the U.S. interest rate is 2% higher than the Japanese rate of 7%). The cost of borrowing yen equals 183 * 1,000,000 * 1.07/S, where S is the spot value of the dollar in one year. Setting these two figures equal and solving for S yields S = 183 * 1.07/1.09 = ¥179.64. Thus the yen must appreciate by (183 179.64)/179.64 = 1.87% before yen borrowing becomes more expensive than dollar borrowing. 7. Ford can borrow dollars at 12% or pesos at 80% for one year. The peso: dollar exchange rate is expected to move from $1 = Ps 3300 currently to $1 = Ps 4500 by year end. 7.a. What is the expected after tax dollar cost of borrowing dollars for one year if the Mexican corporate tax rate is 53%? Answer: According to Equation 19.4 in Section 19.4, the after tax dollar cost of borrowing dollars overseas equals rus(1 t) + ct, where rus is the dollar interest rate, t is the local tax rate and c is the change in the dollar value of the local currency (LC). Similarly, according to Equation 19.3, the after tax dollar cost of borrowing LC is rL(1 + c)(1 t) + c, where rL is the LC interest rate. In the situation facing Ford, the expected devaluation of the peso over the course of the year is (1/3300 1/4500)/(1/4500) = 22.67% The expected after tax dollar cost of borrowing dollars for a year at 12% is 0.12(1 0.53) 0.53 * 0.2667 = 8.50%. 7.b. What is Ford’s expected after tax dollar cost of borrowing pesos for one year? Answer: The expected after tax dollar cost of borrowing pesos at 80% for one year is .80(1 0.2667)(1 0.53) 0.2667 = 0.90%. 7.c. At what end of year exchange rate will the after tax peso cost of borrowing dollars equal the after tax peso cost of borrowing pesos? Answer: The point at which the peso costs of borrowing dollars and pesos are identical is the same as the point at which their dollar costs are identical (one is just a linear multiple of the other). Using the formulas presented above, the breakeven amount of currency changed is found at the point at which rus(1 t) + ct = rL(1 + c)(1 t) or c = (rus rL)/(1 + rL) Substituting in the numbers presented in the problem, c = (0.12 - 0.80)/1.80 = -37.78% The relationship between the beginning exchange rate, e0, and the end of period exchange rate, e1, is e1 = e0(1 + c). Here, e0 = 1/3300, so e1 = (1/3300) * (1 0.3778) = $0.00018855, or Ps 5300 = $1. CHAPTER 16 MANAGING THE MULTINATIONAL FINANCIAL SYSTEM Chapter 16 describes the nature of the multinational financial system and why the ability to shift profits and funds internally is potentially of far greater value to the MNC than to the purely domestic firm. It points out that the value of the multinational financial system arises out of the firm’s ability to use it to take advantage through arbitrage of market imperfections and tax differences. The three principal forms of arbitrage opportunities discussed include: 1. TAX ARBITRAGE. By shifting profits from units located in high tax nations to those in lower tax nations or from those in a taxpaying position to those with tax losses, MNCs can reduce their tax burden. 2. FINANCIAL MARKET ARBITRAge. By transferring funds among units, MNCs may be able to circumvent exchange controls, earn higher risk adjusted yields on excess funds, reduce their risk adjusted cost of borrowed funds, and tap previously unavailable capital sources. 3. REGULATORY SYSTEM ARBITRAGE. Where subsidiary profits are a function of government regulations (e.g., where a government agency sets allowable prices on the firm’s goods) or union pressure, rather than the marketplace, the ability to disguise true profitability by reallocating profits among units may provide the MNC with a negotiating advantage. The chapter then analyzes at length the most important conduits used by MNCs to transfer funds and profits internally: transfer pricing, fees and royalties, dividends, loans, leads and lags, and parent investment as debt or equity. It also illustrates the close relationship between a firm’s marketing, production, and logistics decisions (i.e., its real decisions) and its financial decisions. The greater the internal transfer of goods, technology, capital, and materials worldwide, the greater the scope for financial activities to enhance the value of the MNC globally. When teaching this material, I always emphasize the potential conflicts with home and host country governments inherent in taking advantage of the various arbitrage opportunities presented. An article that illustrates this point is M. Edgar Barrett, "Case of the Tangled Transfer Price," Harvard Business Review, May June 1977, pp. 20 36. SUGGESTED ANSWERS TO CHAPTER 16 QUESTIONS 1.a. What is the internal financial transfer system of the multinational firm? Answer: The internal financial transfer system of the multinational firm is the collection of internal transfer mechanisms that enables the MNC to move money and profits among its various affiliates. These mechanisms for fund flows within the MNC stem from the internal transfer of goods, services, technology, and capital. 1.b. What are its distinguishing characteristics? Answer: Although the financial transfer mechanisms available to the MNC exist among independent firms, the MNC has greater control over the mode and timing of these financial transfers. The MNC has considerable freedom in selecting the financial channels through which funds and allocated profits are moved. In addition, most MNCs have some flexibility regarding the timing of fund flows. They can speed up or slow down dividend payments, loan repayments, and payments for fees, royalties, and inter affiliate sales of goods and services. 1.c. What are the different modes of internal fund transfers available to the MNC? Answer: The mechanisms for transferring funds internally include transfer prices on goods and services traded internally, intra corporate loans and equity investments, dividend payments, leading (speeding up) and lagging (slowing down) intercompany payments, and fee and royalty charges. 2. How does the internal financial transfer system add value to the multinational firm? Answer: The MNC’s ability to transfer funds and profits internally may enable it to reduce its tax payments globally, circumvent currency controls and other regulations, and tap previously inaccessible investment and financing opportunities. 3. California, like several other states, applies the unitary method of taxation to firms doing business within the state. Under the unitary method a state determines the tax on a company’s worldwide profit through a formula based on the share of the company’s sales, assets, and payroll falling within the state. In California’s case, the share of worldwide profit taxed is calculated as the average of these three factors. 3.a. What are the predictable corporate responses to the unitary tax? Answer: Aside from lobbying against such a tax, firms can be expected to modify their business activities in such a way as to reduce the incidence of the unitary tax. In California, for example, this would mean moving assets and employees out of the state and using transfer prices to lower the value of reported in state sales. 3.b. What economic motives might help explain why Oregon, Florida, and several other states have eliminated their unitary tax schemes? Answer: These states were losing a lot of new investment, because any firm that increased its in state assets was assessed a higher unitary tax. By eliminating unitary taxes, these states were able to better compete for new investments with states that do not impose a unitary tax. 4. In comparisons of a multinational firm’s reported foreign profits with domestic profits, caution must be exercised. This same caution must also be applied when analyzing the reported profits of the firm’s various subsidiaries. Only coincidentally will these reported profits correspond to actual profits. 4.a. Describe five different means that MNCs use to manipulate reported profitability among their various units. Answer: MNCs can manipulate reported profit by adjusting transfer prices of goods, fees and royalties linked to patents, trademarks, and management assistance, allocated over¬head, and interest rates on inter affiliate debt. The parent can also adjust the amount of equity it invests and, hence, the amount of debt and interest payments the unit must bear. 4.b. What adjustments to its reported figures would be required to compute the true profitability of a firm’s foreign operations so as to account for these distortions? Answer: “True profitability” is an amorphous concept, but basically it involves determining the marginal revenue and marginal costs associated with the unit. In effect, it is necessary to determine worldwide cash flows with the unit less worldwide cash flows without the unit. This involves adding back allocated corporate overhead in excess of the amount attributable to managing the unit, adjusting transfer prices to reflect marginal costs, and adding back fees and royalties on patents and trademarks that would otherwise go unused. 4.c. Describe at least three reasons that might explain some of these manipulations. Answer: Firms manipulate transfer prices on goods and services in order to reduce total tax and tariff payments, to get around currency controls, and to access lower cost sources of funds. 5. It has been found that U.S.-controlled companies, on the average, earned higher returns on their assets as compared to their foreign-controlled counterparts. A number of American politicians have used these figures to argue that there is widespread tax cheating by foreign-owned multinationals. 5.a. What are some economically plausible reasons (other than tax evasion) that would explain the low rates of return earned by foreign-owned companies in the U.S.? Consider the consequences of the debt-financed U.S. investments made by foreign companies as well as the depreciation of the U.S. dollar. Answer: Buying binge in the U.S. meant big interest payments on acquisition debt and huge depreciation write-offs for newly acquired plant and equipment. Both depressed the bottom line, lowering tax liability. Many foreign companies have also spent millions building factories in the U.S., and that generates even more write-offs and lowers the reported return on assets. In addition, new investment usually involves high start-up costs, lowering initial returns as well. Moreover, historical-cost accounting means that the book value of older (mostly American) assets is often far below market value. So returns on these assets appear higher than those on newer, foreign investment. The devaluation of the dollar also raised the dollar cost of components imported into the U.S. 5.b. Could the differences in returns be attributed to the risks faced by U.S.-controlled companies outside of the U.S. and the foreign-controlled companies operating in the U.S.? Explain. Answer: They can raise transfer prices on goods and services supplied to their U.S. affiliates and lower them on goods and services exported to their non-U.S. units. They can also force their U.S. affiliates to have more debt in their capital structures to gain the interest tax shield. 5.c. A study reveals that a majority of foreign-controlled companies in the U.S. started their U.S. operations only during the late-1980s, while U.S.-controlled companies had been operating abroad for decades before that. Could the difference in returns be explained by experience? If not, why not? ADDITIONAL CHAPTER 16 QUESTIONS AND ANSWERS 1. In what aspect of an MNC’s multinational financial system does its value reside? Answer: The multinational financial system enables the MNC to engage in tax arbitrage, financial market arbitrage, and regulatory system arbitrage. 2. Under what circumstances is leading and lagging likely to be of most value? Answer: Leading and lagging has minimal impact on taxes and is of little value in currency risk management since companies can hedge their exchange risk in other ways. Expropriation risk can be managed, if need be, by shifting assets out of the country. The major value of leading and lagging is to enable firms to elude exchange and capital controls. 3. What are the principal advantages of investing in foreign affiliates in the form of debt instead of equity? Answer: By investing in the form of debt rather than equity, companies may be able to reduce their taxes (because principal repayments are treated as a return of capital and are not taxed) and to avoid currency controls (because governments are more reluctant to block loan repayments, even to a parent, than dividend payments). SUGGESTED SOLUTIONS TO CHAPTER 16 PROBLEMS 1. Suppose Navistar’s Canadian subsidiary sells 1,500 trucks monthly to the French affiliate at a transfer price of $27,000 per unit. The Canadian and French marginal tax rates on corporate income are assumed to equal 45% and 50%, respectively. 1.a. Suppose the transfer price can be set at any level between $25,000 and $30,000. At what transfer price will corporate taxes paid be minimized? Explain. Answer: Switching from a transfer price of $27,000 to a new transfer price P will lead to a monthly tax savings of 1,500(27,000 P)(0.45 0.50). Tax savings are maximized when P is set equal to $30,000. In effect, the firm will be shifting profits from France, where they are taxed at 50%, to Canada, where they are taxed at 45%. 1.b. Suppose the French government imposes an ad valorem tariff of 15% on imported tractors. How would this affect the optimal transfer pricing strategy? Answer: If the ad valorem tariff is paid by the French affiliate and is tax deductible, a change in the transfer price from $27,000 to P will lead to monthly tax savings of 1,500(27,000 P)[.45 + .15 .50(1.15)] = 1,500(27,000 P)(.025). In order to maximize the tax savings, P should now be set at its minimum level of $25,000. 1.c. If the transfer price of $27,000 is set in euros and the euro revalues by 5%, what will happen to the firm’s overall tax bill? Consider the tax consequences both with and without the 15% tariff. Answer: A 5% euro revaluation will increase the dollar value of the transfer price to $28,350. In the absence of a tariff, total taxes paid monthly will decline by 1,500(27,000 28,350)(0.45 0.50) = $101,250. With a 15% tariff, monthly taxes will increase by 1,500(28,350 27,000)[.45 + .15 .50(1.15)] = $50,625. 1.d. Suppose the transfer price is increased from $27,000 to $30,000 and credit terms are extended from 90 days to 180 days. What are the fund flow implications of these adjustments? Answer: Ignoring taxes, the month by month cash flows from the French affiliate to the Canadian affiliate before and after the changes in the transfer price and credit terms are: Cash Flow/Month ($ million) 1 2 3 4 5 6 7+ New Original 0 40.5 0 40.5 0 40.5 40.5 40.5 40.5 40.5 40.5 40.5 45.0 40.5 Net change Cumulative change -40.5 -40.5 -40.5 -81.0 -40.5 -121.5 0 -121.5 0 -121.5 0 -121.5 4.5 -117.0 These calculations assume that the new credit terms will be applied retroactively to previous credit sales. 2. Suppose a U.S. parent owes $5 million to its English affiliate. The timing of this payment can be changed by up to 90 days in either direction. Assume the following effective annualized after tax dollar borrowing and lending rates in England and the U.S. Lending (%) Borrowing (%) United States England 4.0 3.6 3.2 3.0 2.a. If the U.S. parent is borrowing funds while the English affiliate has excess funds, should the parent speed up or slow down its payment to England? Answer: Under the circumstances, the parent’s opportunity cost of funds is 3.2%, whereas the British unit’s opportunity cost of funds is 3.6%. Since the British unit has the higher opportunity cost of funds, the U.S. parent should speed up its $5 million payment by 90 days. 2.b. What is the net effect of the optimal payment activities in terms of changing the units’ borrowing costs and/or interest income? Answer: The U.S. parent will borrow an additional $5 million for 90 days, adding $5,000,000 * 0.032 * 0.25 = $40,000 to its interest expense. At the same time, the British unit will invest an additional $5 million for 90 days, raising its interest income by $5,000,000 * 0.036 * 0.25 = $45,000. The net effect is to raise consolidated income by $5,000. 3. Suppose that DMR SA, located in Switzerland, sells $1 million worth of goods monthly to its affiliate DMR Gmbh, located in Germany. These sales are based on a unit transfer price of $100. Suppose the transfer price is raised to $130 at the same time that credit terms are lengthened from the current 30 days to 60 days. 3.a. What is the net impact on cash flow for the first 90 days? Assume that the new credit terms apply only to new sales already booked but uncollected. Answer: This problem can best be worked by examining cash flows under the new setup and then subtracting cash flows under the old setup. Note that by changing credit terms to 60 days from 90 days, goods shipped in the first month are not paid for until the third month. The net effect during the first 90 days of simultaneously switching credit terms and changing the transfer price is to shift $700,000 from the Swiss affiliate to the German affiliate. This can be seen in the following exhibit, which traces out the cash flow effects of these changes. Cash Inflows for Swiss Unit and Cash Outflows for German Unit Month 1 2 3 New Terms Old Terms $1,000,000 1,000,000 0 1,000,000 $1,300,000 1,000,000 Change Cumulative 0 0 -$1,000,000 -$1,000,000 +$300,000 -$700,000 3.b. Assume the tax rate is 25% in Switzerland and 50% in Germany and that revenues are taxed and costs deducted upon sale or purchase of goods, not upon collection. What is the impact on after tax cash flows for the first 90 days? Answer: This problem is more complex because the tax effects occur prior to settling inter affiliate accounts with cash. The Swiss unit’s taxes are now $325,000/month (0.25 * $1,300,000) as compared with $250,000 previously, while the German unit’s monthly tax write-off has risen to $650,000 (0.5 * $1,300,000) as compared to $500,000 before. Cash Flows for Swiss Affiliate Month 1 2 3 New Terms Collection of receivables Tax payments $100,000 -325,000 0 -325,000 $1,300,000 -325,000 Net cash inflow $675,000 -$325,000 $975,000 Old terms Collection of receivables Tax payments 1,000,000 -250,000 1,000,000 -250,000 1,000,000 -250,000 Net cash inflow Change in net cash inflow Cumulative change $750,000 -$75,000 -$75,000 $750,000 -$1,075,000 -$1,150,000 $750,000 $225,000 -$925,000 Cash Flows for German Affiliate Month 1 2 3 New Terms Payment of payables Value of tax write-offs $1,000,000 -650,000 0 -650,000 $1,300,000 -650,000 Net cash outflow $350,000 -$650,000 $650,000 Old terms Payment of payables Value of tax write-offs $1,000,000 -500,000 $1,000,000 -500,000 $1,000,000 -500,000 Net cash outflow Change in net cash outflow Cumulative change $500,000 -$150,000 -$150,000 $500,000 -$1,150,000 -$1,300,000 $500,000 $150,000 -$1,150,000 The net result of the simultaneous change in credit terms and transfer price is that for the first 90 days the Swiss unit’s after-tax cash inflow drops by $925,000 and the German unit’s after-tax cash outflow falls by $1,150,000. The $225,000 gain in net cash flow is attributable to the change in transfer price which leads to a shift of $300,000 in reported monthly income from Germany to Switzerland, or a shift of $900,000 over the first 90 days. Because income in Switzerland is taxed at a rate of 25%, while German income is taxed at 50%, the net effect of this income shift for the first three months is to save an amount of taxes equal to $900,000 * (0.50 0.25) = $225,000. 4. Suppose a firm earns $1 million before tax in Spain. It pays Spanish tax of $0.52 million and remits the remaining $0.48 million as a dividend to its U.S. parent. Under current U.S. tax law, how much U.S. tax will the parent owe on this dividend? Answer: Under current U.S. tax law, the firm’s U.S. tax owed on the dividend is calculated as follows: As a result of paying Spanish tax at a rate that exceeds the U.S. tax rate of 35%, the company receives a $170,000 FTC that can be used to offset U.S. taxes owed on other foreign source income. 5. Suppose a French affiliate repatriates as dividends all the after tax profits it earns. If the French income tax rate is 50% and the dividend withholding tax is 10%, what is the effective tax rate on the French affiliate’s before tax profits, from the standpoint of its U.S. parent? Answer: Assume the French affiliate earns $1 million before tax. It then pays $500,000 in French income tax and remits the remaining $500,000 as a dividend to its U.S. parent. Only $450,000 gets through because of the 10% French dividend withholding tax. It appears as if the effective tax rate on this affiliate’s earnings from the parent’s standpoint is 55%. However, the parent will receive a foreign tax credit of $210,000, the difference between the $550,000 total tax payments to the French government and the $340,000 in U.S. tax owed on the $1 million in pre tax earnings. If the full FTC can be used, then the parent’s effective tax rate declines to 34%. If the FTC is unusable, the parent’s effective tax rate on the affiliate’s earnings is 55%. If part, but not all, of the tax credit is usable, the parent’s effective tax rate on its French unit’s earnings will lie between 34% and 55%. The higher the fraction of the FTC that is usable, the lower the parent’s effective tax rate. ADDITIONAL CHAPTER 16 PROBLEMS AND SOLUTIONS 1. Suppose that covered after tax lending and borrowing rates for three units of Eastman Kodak located in the U.S., France, and Germany are: Lending (%) Borrowing (%) United States France Germany 3.1 3.0 3.2 3.9 4.2 4.4 Currently, the French and German units owe $2 million and $3 million, respectively, to their U.S. parent. The German unit also has $1 million in payables outstanding to its French affiliate. The timing of these payments can be changed by up to 90 days in either direction. Assume that Kodak U.S. is borrowing funds while both the French and German subsidiaries have excess cash available. 1.a. What is Kodak’s optimal leading and lagging strategy? Answer: The following matrix of effective after tax dollar interest rate differentials, which is based on the covered rates presented in the problem, can be used to determine the value of leading and lagging for Kodak. The countries on the top of the matrix are those which receive payment from the countries listed on the left. Each subsidiary column is subdivided into “L” and “B.”" The L column is applicable if the unit has excess funds which it can invest in the local money market. The B column is applicable if the subsidiary is currently borrowing on the local money market or would have to borrow in order to pay an intercompany account. The entries refer to the dollar interest differentials that exist between each pair of affiliates given their current liquidity status. If this interest differential is positive, Kodak as a whole, by leading payments between the respective units, will either pay less on its borrowings or earn more interest on its investments. Lagging will be worthwhile if the interest differential is negative. According to the prevailing interest differentials, both subs should speed up their payments to the parent while the German unit should lag its payments to the French firm. 1.b. What is the net profit impact of these adjustments? Answer: The net effect of these adjustments is that Kodak U.S. reduces its borrowings by $5,000,000, the German unit has $2,000,000 less in cash, and the French affiliate winds up with a decrease in its cash balances of $3,000,000, all for 90 days. U.S. interest expense is pared by $48,750 ($5,000,000 * 0.039 * 90/360) while German and French interest income are reduced by $16,000 ($2,000,000 * 0.032 * 90/360) and $22,500 ($3,000,000 * 0.03 * 90/360), respectively, for a net savings of $10,250. This savings can be computed more directly by taking the interest differentials from the appropriate cells of the matrix. These differentials (in %) are: 0.9 (France “L” U.S. “B”); 0.7 (Germany “L” U.S. “B”); and 0.2 (Germany “L” France “L”). Net interest saved equals 0.25[0.009($2,000,000) + 0.007($3,000,000) + 0.002($1,000,000)] = $10,250. Moreover, for each additional 90 days that this new payment schedule exists, net interest savings worldwide will be $10,250. 1.c. How would Kodak’s optimal strategy and associated benefits change if the U.S. parent has excess cash available? Answer: If Kodak U.S. has excess cash, then the prevailing interest differentials indicate that the French affiliate should lag its payments to both the U.S. and French units. The higher interest earnings associated with this strategy can be calculated directly using the interest differentials taken from the matrix in part a). These differentials are: 0.1(U.S. L France L); .1(Germany L U.S. L); and 0.2(Germany L France L). Net additional interest earnings then are 0.25[.001($2,000,000) + 0.001($3,000,000) + 0.002($1,000,000)] = $1,750. 2. Suppose that in the section titled Dividends, International Products has $500,000 in excess foreign tax credits available. How will this situation affect its dividend remittance decision? Answer: Even if IP has $500,000 in excess foreign tax credits available, the company should still pay dividends out of its German affiliate. Since the French tax rate exceeds 46%, IP does not pay U.S. tax on dividends from France. Hence, paying dividends out of France does not save any U.S. taxes. If the dividend is paid by the Irish affiliate, IP saves $460,000 in tax, cutting worldwide taxes to $2,020,000. But this still exceeds worldwide taxes of $1,910,000 if the dividend is paid by the German affiliate. 3. Suppose affiliate A sells 10,000 chips monthly to affiliate B at a unit price of $15. Affiliate A’s tax rate is 45%, and affiliate B’s tax rate is 55%. In addition, affiliate B must pay an ad valorem tariff of 12% on its imports. If the transfer price on chips can be set anywhere between $11 and $18, how much can the total monthly cash flow of A and B be increased by switching to the optimal transfer price? Answer: For each $1 increase in income shifted from B to A, A’s taxes rise by $0.45. At the same time, B owes an extra $0.12 in tariffs. The before tax increase of $1.12 in B’s cost gives it a tax write off worth $1.12 * 0.55 = $0.616. By shifting $1 in income from B to A, the effect is to lower B’s tax payments by $0.616 and raise its tariffs by $0.12, a net decrease in tax plus tariff payments of $0.496. The net effect of switching $1 in income from B to A is to lower tax plus tariff payments to the world by $0.496 0.45 = $0.046. Thus, the transfer price should be set as high as possible in order to shift as much income to A from B as possible. The new transfer price should, therefore, be set at $18, a $3 increase over the old transfer price. The resulting increase in monthly cash flow is $.046 * 3 * 10,000 = $1,380. 4. Suppose GM France sells goods worth $2 million monthly to GM Denmark on 60 day credit terms. A switch in credit terms to 90 days will involve a one time shift of how much money between the two affiliates? Answer: Under the old 60 day terms, GM France is carrying two months’ worth of sales as receivables or $4 million. By switching credit terms to 90 days, GM France will now carry receivables equal to three months’ worth of sales or $6 million. The net result is a transfer of $2 million from GM France to GM Denmark. 5. Merck Mexicana SA, the wholly owned affiliate of the U.S. pharmaceutical firm, is considering alternative financing packages for its increased working capital needs resulting from growing market penetration. Ps 250 million are needed over the next six months and can be financed as follows: • From the Mexican banking system at the semiannual rate of 50%. • From the U.S. parent company at the semiannual rate of 6%. The parent company loan would be denominated in dollars and would have to be repaid through the floating exchange rate tier of the Mexican exchange market. The exchange loss would, thus, be fully incurred by the Mexican subsidiary. The exchange rate as of March 1, 1984, was Ps 250 = $1 and widely expected to depreciate further. 5.a. If interest payments can be made through the stabilized tier of the Mexican exchange market where the dollar is worth Ps 125, what is the break even exchange rate on the floating tier that would make Merck Mexicana indifferent between dollar and peso financing? Answer: If it borrows pesos from the Mexican bank at a 180 day interest rate of 50%, Merck Mexicana will owe before tax dollar principal plus interest payments in 180 days equal to 250,000,000(1 + 0.50) * e180 = 375,000,000e180 where e180 is the (unknown) spot rate in 180 days. Alternatively, if Merck Mexicana uses dollar financing, it would need to borrow $1 million (the dollar equivalent of Ps 250 million at the current exchange rate of Ps 250 = $1). At a semesterly rate of 6%, the total dollar interest plus principal payments owed in 180 days would be $1,000,000 + 125,000,000 * e180 = $1,000,000 + 7,500,000e180 The latter term reflects the fact that interest payments can be made at an exchange rate of Ps 125 to the dollar or a total of Ps 125,000,000 * 0.06 in peso interest payments on a loan of $1 million at 6% interest. The breakeven exchange rate – the rate at which the dollar cost of peso financing just equals the dollar cost of dollar financing – can be found by setting the two costs equal: 375,000,000e180 = 1,000,000 + 7,500,000e180 The solution is Ps 1 = $0.00272 or Ps 367.50 = $1. 5.b. Merck Mexicana imports from its U.S. parent $500,000 worth of chemical compounds monthly, payable on a 90 day basis. Suppose that the parent adjusts its transfer prices so that Merck Mexicana must now pay $700,000 monthly for its chemical supplies. All payments for imports of chemicals involved in the manufacture of pharmaceuticals are transacted through the stabilized tier of the exchange market. At the current exchange rate of Ps 250 = $1, what is the net before tax annual benefit to Merck of this transfer price increase? Answer: Because the importation of chemical compounds is carried out through the subsidized tier (i.e., at Ps 125 per dollar) Merck could lend in pesos rather than dollars but charge its subsidiary for the principal loss by setting a higher dollar transfer price. The parent would break even and the subsidiary would effectively pay for the principal loss through the subsidized exchange rate. In effect, Merck Mexicana would be paying back part of the principal at an exchange rate of Ps125 per dollar instead of the market rate, which will be at least Ps 250 = $1. If the dollar appreciates to Ps 300 = $1 from Ps 250 = $1, the dollar principal loss on a $1 million peso denominated parent loan is $1,000,000 250,000,000/300 = $166,667 The term 250,000,000/300 is the peso equivalent of $1 million at an exchange rate of Ps 250 = $1 converted at an end of period exchange rate of Ps 300 = $1. To make up the loss on principal repayment, the subsidiary would have to pay $166,667 extra to the parent. At an exchange rate of Ps 125 = $1, this translates into added payments to the parent of Ps 20,833,334 through higher transfer prices. If the loss is to be made up over a period of six months, this means that transfer prices would have to be raised such that monthly imports go up by one-sixth of this amount or Ps 20,830,000/6 = Ps 3,472,223. With current monthly imports of Ps 100 million, this requires a transfer price increase of about 3.47%. 6. A well-known U.S. firm has a reinvoicing center (RC) located in Geneva. The reinvoicing center handles an annual sales volume of $1.2 billion – $700 million in inter affiliate sales and the rest in third-party sales. The RC buys goods manufactured by the parent company or other subsidiaries and reinvoices the product to other affiliates or third parties. Many of these trades are with “low-volume, highly complex countries.” When buying the goods, the RC takes title to them, but it does not take actual possession of the goods. The RC pays the selling company in its own currency and receives payment from the purchasing company in its own currency. What benefits can such a center provide? Answer: The reinvoicing center can provide several benefits to its parent company. It can: a) Shift liquidity from surplus to deficit affiliates; b) Centralize management of transaction exposure; c) Reduce taxes by transfer price adjustments; d) Assure consistent pricing to customers placing orders with more than one unit; e) Net intercompany transfers; f) Take advantage of economies of scale in financing and investing; g) Concentrate trading expertise; h) Reduce FX trading costs by dealing in larger volumes; i) Centralize control over finance functions. NOTES ON INTERAFFILIATE TRANSACTIONS 1. Overview a) Mode of transfer b) Timing flexibility 2. Transfer pricing a) Tax effects A sells 100,000 circuit boards annually to B at a unit price of $10. Changing the transfer price to $10.50 will simultaneously increase A’s income by $50,000 and decrease B’s income by $50,000. If corporate tax rates for A and B are 35% and 50%, respectively, the net effect will be to increase A’s taxes by $17,500 and reduce B’s taxes by $50,000. Net tax savings are $7,500 annually. b) Section 482 i. What it is ii. Its consequences for setting transfer prices c) Shifting funds The above transfer price change will increase A’s after tax cash flow by $32,500 and reduce B’s after tax cash flow by $25,000. 3. Invoicing currency a) Importer’s currency i. No exposure or tax effects for importer ii. Exporter bears the currency exposure and tax effects b) Exporter’s currency i. No exposure or tax effects for exporter ii. Importer bears the currency exposure and tax effects 4. Leads and lags a) Shifting liquidity b) Costs and benefits i. Take advantage of interest differentials U.S. interest rate German interest rate for surplus (+) and deficit ( ) positions. ii. Avoid currency controls iii. Exposure management c) Information requirements i. intercompany payables and receivables ii. exchange control regulations iii. relevant tax laws iv. affiliate liquidity positions and fund requirements v. sources and availability of funds to each party vi. expected currency changes vii. forward exchange rates viii. currency exposures 5. Dividend planning a) Tax considerations b) Cash requirements c) Currency controls d) Corporate practice 6. Global tax planning a) U.S. taxation of foreign source income i. Branches versus subsidiaries ii. Foreign tax credits iii. Subpart F income iv. FSCs b) Information requirements i. Tax rates by affiliate ii. Cross border tax rates iii. Liquidity by affiliate iv. Tax credits c) Information requirements i. Intercompany payables and receivables ii. Exchange control regulations iii. Relevant tax laws iv. Affiliate liquidity positions and fund requirements v. Sources and availability of funds to each party vi. Expected currency changes vii. Forward exchange rates viii. Currency exposures Solution Manual for Foundations of Multinational Financial Management Atulya Sarin, Alan C. Shapiro 9780470128954
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