978-0134200057 Chapter 11 Lecture Notes

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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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