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CHAPTER ELEVEN
GLOBAL CAPITAL MARKETS
OBJECTIVES
11-1 Describe the finance function of an MNE in a global context
11-2 Define leverage and how it affects the choice of capital structure
11-3 Explain the different ways to access debt internationally
11-4 Summarize how foreign source income is taxed
11-5 Analyze how offshore financial centers provide financing opportunities for MNEs
CHAPTER OVERVIEW
Firms that invest and operate abroad access both debt and equity capital in large global
markets as well as in local markets. Chapter eleven highlights the external sources of
funds available to MNEs, as well as the internal sources that come from interfirm
linkages. It first explores global debt markets, global equity markets, and offshore
financial centers. Then the types of foreign-exchange risk and the hedging strategies
associated with foreign-exchange risk management are discussed. The chapter concludes
with a discussion of international capital budgeting decisions and tax issues facing
MNEs.
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CHAPTER OUTLINE
OPENING CASE: Tax Wars: Pfizer Versus the U.S. Government
In 2014, Pfizer, the U.S.-based pharmaceutical company, and Allergan, the pharma
headquartered in Ireland, planned to merge and move Pfizer corporate
headquarters to Dublin, Ireland. From a competitive perspective, Pfizer needed
to expand its portfolio of new drugs. From another perspective, if the merger
went through and Pfizer was able to move its corporate headquarters to Ireland,
it stood to significantly reduce its corporate tax liability and therefore free up
more cash for its equity shareholders and for reinvestment into the development
of new drugs. Not only was Pfizer interested in the tax benefits from the
inversion, but it also had over $74 billion in profits kept overseas that
would be subject to U.S. tax if brought back to the United States. A merger between
Pfizer and Allergan would probably not have been an issue for U.S. regulators
from a competitive standpoint. However, the issue for the Treasury Department
is not a loss of competition; it’s a loss of tax revenues. The fight against
inversions was taken up by the U.S. Treasury, not Congress. The problem with
Congress is that the Democrats and Republicans couldn’t agree on
comprehensive tax reform, so there wasn’t much incentive to take on one
isolated issue. In 2016, the Treasury Department slammed the door shut on
certain tax inversions, or at least made it more difficult for them, in a series of regulations
aimed directly at Pfizer. Soon afterward, Pfizer and Allergan followed up with
their own announcement that the merger would no longer make sense.
Teaching Tips: Review the PowerPoint slides for Chapter Eleven and select
those you find most useful for enhancing your lecture and class discussion. For
additional visual summaries of key chapter points, also review the map, tables,
and figures in the text.
INTRODUCTION
MNEs access both local and global capital markets in order to finance their
operational and expansion activities. This chapter examines external sources of debt
and equity capital available to companies operating abroad as well as internal
sources of funds that arise from intercompany links. Additional topics explored
include international dimensions of the capital investment decision, global cash
management, foreign-exchange risk-management strategies, and international tax
issues.
I. THE FINANCE FUNCTION
The finance function in the firm focuses on cash flows, both short term and long
term. Cash flow management is divided into four major areas: (i) capital structure,
(ii) capital budgeting, (iii) long-term financing, and (iv) working capital
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management.
A. The Role of the CFO [see Figure 10.1]
It is the responsibility of an organization’s chief financial officer (CFO) to
acquire (generate) and allocate (invest) financial resources among activities and
projects.
1. The CFO’s Global Perspective. The CFO’s job becomes increasingly
complex in the global environment because of factors such as
foreign-exchange risk, currency flows and restrictions, political risk,
differing tax rates, and laws and regulations regarding access to capital.
II. CAPITAL STRUCTURE
Capital structure is the mix between long-term debt and equity.
A. Leveraging Debt Financing
The degree to which a firm funds the growth of business by debt is known as
leverage. The amount of leverage used varies from country to country, and
country-specific factors are a more important determinant of a company’s capital
structure than any other factor because companies tend to follow the financing
trends in their own country and their particular industry within their country.
Leveraging is often perceived as the most cost-effective route to capitalization.
1. When Is Leveraging Not the Best Option? Leveraging may not be
the best approach in all countries for two reasons. First, excessive reliance
on long-term debt increases financial risks and thus requires a higher rate of
return for investors. Second, foreign subsidiaries of an MNE may have
limited access to local capital markets.
B. Factors Affecting the Choice of Capital Structure
A company’s choice of capital structure depends on tax rates, degree of
development of local equity markets, and creditor rights within its country and
in other countries.
1. Debt and Exchange Rates. The global financial crisis of 2007–2009
highlighted foreign exchange risk. Leading up to the crisis, many Asian
companies borrowed in dollars at relatively low-interest rates. But when the
dollar rose in value, the companies couldn’t generate enough cash to
convert into dollars to pay off their debts.
2. Regulatory Risk. A second factor that affects local borrowing is regulatory
risk. Regulatory reform has complicated access to debt financing. The Basel
Committee on Global Banking Supervision has set standards for stronger
capital positions and increased liquidity. The most recent agreement is
called Basel III; it is designed to strengthen regulation, supervision, and risk
management of the banking sector.
III. GLOBAL DEBT MARKETS
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A. Eurocurrencies and the Eurocurrency Market
A Eurocurrency is any currency banked outside its country of origin.
1. Major Sources of Eurocurrencies. There are four major sources of
Eurocurrencies: foreign governments or individuals who want to hold
dollars outside the U.S., MNEs that have excessive cash, European banks
with excessive currency, and countries with large balance-of-trade
surpluses.
2. Characteristics of the Eurocurrency Market. The market is a
wholesale market, with very large transactions, typically consisting of short
to medium term loans.
3. Interest Rates in the Eurocurrency Market. A major attraction of the
Eurocurrency market is the difference in interest rates compared with those
in the domestic market. The global financial crisis forced central banks all
over the world to drop interest rates to stimulate economic growth.
a. London Inter-Bank Offered Rate (LIBOR). This is the deposit rate
that applies to an inter-bank loan within London.
B. International Bonds
Many companies have active bond markets available to domestic and foreign
investors.
1. Types of International Bonds.
a. Foreign Bonds. A bond sold outside the country of the borrower but
denominated in the currency of the country of issue.
b. Eurobonds. A bond issue sold in a currency other than that of the
country of origin.
c. Global Bond. A Eurobond which is issued in several locations at the
same time.
2. What’s So Attractive about the International Bond Market?
The international bond market is a desirable place to borrow money. For
one thing, it allows a company to diversify its funding sources from the
local banks and the domestic bond market and borrow in maturities that
might not be available in the domestic markets. It also tends to be less
expensive than local bond markets and attracts investors from around the
world.
C. Global Equity Market
Whereby an investor takes an ownership position in return for shares of stock
and possible capital appreciation and/or dividends. One way a company can
easily and inexpensively get access to capital is through private placement. In
addition, the company can issue stock on one or more foreign exchanges.
Sovereign Wealth Funds (SWF) are also an important source of capital. An SWF
is a state-owned investment fund that generates resources from a variety of
places, including revenues from the exports of natural resources, such as oil.
D. The Size of Global Stock Markets.
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Map 11.1 identifies the 10 largest stock markets in the high-income countries
and top-10 largest stock markets in emerging countries in terms of domestic
market capitalization in January 2016.
1. Political and Economic Forces and Trends in Global Stock
Market. To understand trends in stock markets, it is important to
understand trends in political and economic forces worldwide and that
forces in countries or regions often vary. During the past few years, global
markets have been in turmoil, and that will continue to be the case. Major
sources of influence on global stock markets are oil prices, weakness in the
global economy, weakness in the Chinese economy, and interest rates.
2. The Rise of the Euroequity Market. Euroequities are shares listed on
stock exchanges in countries other than the home country of the issuing
company.
a.The Trend toward Delisting. The trend of listing on more than one
exchange began to reverse somewhat as more and more companies reduced
the number of exchanges on which their stocks were listed. Investors are
finding that the best price for stocks is usually in the home market of the
company in which they are investing.
b. American Depositary Receipt. Most foreign companies that list on
U.S. stock exchanges do so through an ADR, which is a financial document
that represents a share or part of a share of stock in a foreign company.
IV. TAXATION OF FOREIGN-SOURCE INCOME
Taxes can profoundly affect profitability and cash flow, especially in international
business. Taxation has a strong impact on several choices, including:
• Location of operations
• Choice of operating form (export/import, licensing, overseas investment)
• Legal form of the enterprise (branch or subsidiary)
• Possible facilities in tax haven countries to raise capital and manage cash
• Method of financing (internal or external sourcing, debt or equity)
• Capital budgeting decisions
• Method of setting transfer prices
A. International Tax Practices
1. Differences in Tax Practices. Countries differ in terms of the types of
taxes they have (income versus excise), the tax rates applied to income, the
determination of taxable income, and the treatment of foreign-source
income.
2. Differences in Types of Taxes. Two major types of taxes are income
taxes and excise taxes.
3. Differences in GAAP. Variations among countries in GAAP can lead to
differences in the determination of taxable income.
4. Differences in Tax Rates. Corporate tax rates differ from country to
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country.
5. Two Approaches to Corporate Taxation.
a. Separate Entity Approach. Each separate entity, company, or
individual is taxed when it receives income.
b. Integrated System Approach. Avoids double taxation. When
shareholders report the dividends in their taxable income, they also get
a credit for taxes paid on that income by the company that issued the
dividend.
B. Taxing Branches and Subsidiaries
To illustrate the complexities of taxing foreign-source income, it is useful to
examine how U.S.-based companies tax earnings from a foreign branch and a
foreign subsidiary.
1. The Foreign Branch. Since a foreign branch is an extension of the parent
company, any foreign branch income (or loss) is directly included in the
parent’s taxable income.
2. The Foreign Subsidiary. A foreign corporation is an independent legal
entity set up in a country according to the laws of incorporation of that
country. When an MNE purchases or establishes such an entity, it is called
a subsidiary. Subsidiary income is either taxable to the parent or tax
deferred (not taxed until it is submitted as a dividend to the parent). The tax
status of a subsidiary depends on whether the subsidiary is a controlled
foreign corporation (CFC) and whether the income is active or passive.
3. The Controlled Foreign Corporation. In a CFC, U.S. shareholders
hold more than 50% of the voting stock. A U.S. shareholder is any U.S.
person or company that holds 10 percent or more of the CFC’s voting stock.
Any foreign subsidiary is considered a CFC for tax purposes. A joint
venture company abroad may not be considered a CFC if the U.S. MNE
does not own more than 50% of the stock in the joint venture.
a. Active versus Passive Income. Active income is derived
from the direct conduct of a trade or business. Passive, or subpart
F income, comes from sources other than those connected with the
direct conduct of a trade or business (generally in tax haven
countries). Subpart F income includes holding company income,
sales income, and service income.
b. Determining a Subsidiary’s Income. Figure 11.2 illustrates
how the tax status of a subsidiary’s income is determined.
C. Transfer Prices
Transfer pricing applies to transactions between related entities and is not
usually an arm’s length price (price between two unrelated entities). The
assumption is that an arm’s-length price is more likely than a transfer price to
reflect the market accurately.
1. Transfer Prices and Taxation. Companies establish arbitrary transfer
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prices primarily because of differences in taxation between countries. The
OECD, however, is very concerned about the way companies manipulate
transfer prices in order to minimize tax liability and has set transfer pricing
guidelines to eliminate this manipulation.
D. Double Taxation and Tax Credit
In the United States, the IRS allows a tax credit for corporate income tax for tax
that U.S. companies pay to another country in order to avoid double taxation. A
tax credit is a dollar-for-dollar reduction of tax liability and must coincide with
the recognition of income.
1. Tax Treaties: Eliminating Double Taxation. The purpose of tax
treaties is to prevent double taxation or to provide remedies when it occurs.
When agreeing to a treaty, countries generally grant reciprocal reduction on
dividend withholding and exempt royalties, and sometimes interest
payments, from any withholding tax.
E. Dodging Taxes
Some countries provide tax incentives to attract investment, and these incentives
can help MNEs lower their overall tax liability. One advantage that MNEs have
is that it may be hard for a country to figure out its own tax policy, but it is
almost impossible for countries to come up with one global tax policy that
everyone can agree on. As a result, companies do the best they can to exploit the
differences.
V. OFFSHORE FINANCING AND OFFSHORE FINANCIAL CENTERS
Companies can raise debt or equity funds in their domestic market or offshore.
Offshore financing is the provision of financial services by banks and other agents
to nonresidents of a country.
A. What’s an OFC?
Offshore financial centers (OFC) are cities or countries that provide large
amounts of funds in currencies other than their own and are used as locations in
which to raise and accumulate cash.
1. Characteristics of OFCs. Generally, OFCs provide a more flexible and
less expensive source of funding for MNEs and exhibit one or more of the
following characteristics:
• A large foreign-currency (Eurocurrency) market for deposits and loans
• A large net supplier of funds to the world financial markets
• An intermediary or pass-through for international loan funds
• Economic and political stability
• An efficient and experienced financial community
• Good communications and supportive services
• An official regulatory climate that is favorable to the financial industry
2. Operational versus Booking Centers. Centers are either operational
centers, with extensive banking activities involving short-term financial
transactions (e.g., London), or booking centers, in which little actual
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banking activity takes place but in which transactions are recorded to take
advantage of secrecy laws and/or low or no tax rates (e.g., the Cayman
Islands).
3. OFCs as “Tax Havens.” The Organization for Economic Cooperation
and Development (OECD) has been working closely with the major OFCs
to ensure that they are engaged in legal activity. The OECD is trying to
reduce harmful tax practices through improved translation and disclosure.
Putting the spotlight on countries seems to be the best approach.
POINT-COUNTERPOINT:
Should Offshore Financial Centers and
Aggressive Tax Practices Be Eliminated?
POINT: OFCs operate in a shroud of secrecy that allows companies to engage in illegal
and unethical behavior. Enron, one of the largest bankruptcies in corporate history,
created hundreds of subsidiaries in tax havens and used them to pass off corporate debts,
losses, and executive compensation. Parmalat used a similar strategy, establishing shell
companies in the Caribbean to capture cash through fake invoices and credits. Terrorists
and drug dealers also use OFCs to launder money.
COUNTERPOINT: Despite examples of corporate malfeasance, OFCs serve useful and
ethical purposes. They allow subsidiaries to take advantage of lower borrowing costs and
tax rates—activities that are not illegal. More and more countries are taxing offshore
earnings, making it harder for companies to avoid paying taxes. The key is to improve
transparency and reporting so that illegal activities can be curtailed.
LOOKING TO THE FUTURE
The Growth of Capital Markets and the Drive by Governments to Capture More
Tax Revenue by MNEs
Global capital markets are in disarray largely because of unstable macroeconomic forces
and political instability. Despite these conditions, companies are scouring the world in
search of cheap capital. The stock and bond markets will be increasingly important
as banks deal with their own financial problems and increased regulations to protect
against default. Investments in emerging markets will continue to be a flight
to risk. China is in deep trouble and will continue to be so for several years because of
mountains of debt and weak economic growth. The competition for global capital will be
fierce as companies are forced to shift funding from banks that are under great financial
stress to issuing stocks and bonds as a way to grow and expand. Another source of cash to
MNEs will continue to be tax minimization schemes. However, the OECD countries are
working hard to close tax loopholes used by MNEs as they expand abroad. The OECD,
IMF, and EU will help countries narrow their tax differences and crack down on the
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illegal transfer of money for illegal purposes.
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