ch-20

274

CHAPTER 20

MANAGING THE MULTINATIONAL FINANCIAL SYSTEM

Chapter 20 describes the nature of the multinational financial system and why the ability to shift profits and fundsinternally is potentially of far greater value to the MNC than to the purely domestic firm. It points out that the valueof the multinational financial system arises out of the firm's ability to use it to take advantage through arbitrage ofmarket 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 thosein 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 exchangecontrols, earn higher risk-adjusted yields on excess funds, reduce their risk-adjusted cost of borrowed funds, andtap previously unavailable capital sources.

3. Regulatory system arbitrage--Where subsidiary profits are a function of government regulations (e.g., where agovernment agency sets allowable prices on the firm's goods) or union pressure, rather than the marketplace, theability to disguise true profitability by reallocating profits among units may provide the multinational firm witha 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 alsoillustrates 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, thegreater the scope for financial activities to enhance the value of the MNC globally. When teaching this material, Ialways emphasize the potential conflicts with home and host country governments inherent in taking advantage of thevarious arbitrage opportunities presented. An article that illustrates this point is M. Edgar Barrett, "Case of the TangledTransfer Price," Harvard Business Review, May-June 1977, pp. 20-36.

SUGGESTED ANSWERS TO CHAPTER 20 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 transfermechanisms that enables the MNC to move money and profits among its various affiliates. These mechanisms for fundflows within the MNC stem from the internal transfer of goods, services, technology, and capital.

b. What are its distinguishing characteristics?

ANSWER . Although the financial transfer mechanisms available to the MNC exist among independent firms, the MNChas greater control over the mode and timing of these financial transfers. The MNC has considerable freedom inselecting the financial channels through which funds and allocated profits are moved. In addition, most MNCs havesome flexibility regarding the timing of fund flows. They can speed up or slow down dividend payments, loanrepayments, and payments for fees, royalties, and interaffiliate sales of goods and services.

c. What are the different modes of internal fund transfers available to the MNC?

CHAPTER 20: MANAGING THE MULTINATIONAL FINANCIAL SYSTEM 275

ANSWER. The mechanisms for transferring funds internally include transfer prices on goods and services tradedinternally, intracorporate loans and equity investments, dividend payments, leading (speeding up) and lagging (slowingdown) 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 financingopportunities.

3.a. Why do companies generally follow a sequential strategy in moving overseas?

ANSWER . The usual sequence of overseas expansion involves exporting, setting up a foreign sales subsidiary, possiblelicensing agreements and, eventually, foreign production. This sequential approach can be viewed as a risk-minimizingresponse to operating in a highly uncertain foreign environment. By internationalizing in phases, a firm can graduallymove from a relatively low risk-low return, export-oriented strategy to a higher risk-higher return strategy emphasizinginternational production. In effect, the firm is investing in information, learning enough at each stage to significantlyimprove its chances for success at the next stage.

b. What are the pluses and minuses of exporting? Licensing? Foreign production?

ANSWER. Exporting is a low-cost, low-risk strategy for learning about and developing foreign markets. At the sametime, it limits a company's ability to fully exploit foreign markets. By producing abroad, a company can more easilykeep abreast of market developments, adapt its products to local tastes and conditions, and provide more comprehensiveafter-sales service. And while foreign production often requires a substantial capital investment, it may allow acompany to access lower cost local labor and materials. It also demonstrates a tangible commitment to the local marketand an increased assurance of supply stability. Instead of spending the money to set up production facilities abroad,the company can license a local firm to manufacture its products. Licensing also allows the company to access itslicensee's marketing smarts and distribution network. But licensing may create a competitor in other markets becauseit is often difficult to control exports by foreign licensees. It may also be difficult to displace the licensee in the localmarket once the license expires.

4. 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.

5. 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 onthe share of the company's sales, assets, and payroll falling within the state. In California's case, the share ofworldwide profit taxed is calculated as the average of these three factors.

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 sucha way as to reduce the incidence of the unitary tax. In California, for example, this would mean moving assets andemployees out of the state and using transfer prices to lower the value of reported in-state sales.

b. What economic motives might help explain why Oregon, Florida, and several other states have eliminated theirunitary tax schemes?

276 INSTRUCTORS MANUAL: FOUNDATIONS OF MULTINATIONAL FINANCIAL MANAGEMENT, 4TH ED.

ANSWER. These states were losing a lot of new investment, because any firm that increased its in-state assets wasassessed a higher unitary tax. By eliminating unitary taxes, these states were able to better compete for new investmentswith states that do not impose a unitary tax.

6. 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 sincecompanies can hedge their exchange risk in other ways. Expropriation risk can be managed, if need be, by shiftingassets out of the country. The major value of leading and lagging is to enable firms to elude exchange and capitalcontrols.

7. 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 (becauseprincipal repayments are treated as a return of capital and are not taxed) and to avoid currency controls (becausegovernments are more reluctant to block loan repayments, even to a parent, than dividend payments).

8. 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. Onlycoincidentally will these reported profits correspond to actual profits.

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 topatents, trademarks, and management assistance, allocated overhead, and interest rates on interaffiliate debt. The parentcan also adjust the amount of equity it invests and, hence, the amount of debt and interest payments the unit must bear.

b. What adjustments to its reported figures would be required to compute the true profitability of a firm's foreignoperations so as to account for these distortions?

ANSWER. "True profitability" is an amorphous concept, but basically it involves determining the marginal revenueand marginal costs associated with the unit. In effect, it is necessary to determine worldwide cash flows with the unitless worldwide cash flows without the unit. This involves adding back allocated corporate overhead in excess of theamount attributable to managing the unit, adjusting transfer prices to reflect marginal costs, and adding back fees androyalties on patents and trademarks that would otherwise go unused. Chapter 17 discussed other adjustments.

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, toget around currency controls, and to access lower cost sources of funds.

9. In 1987, U.S.-controlled companies earned an average 2.09% return on assets, nearly four times theirforeign-controlled counterparts. A number of American politicians have used these figures to argue that there iswidespread tax cheating by foreign-owned multinationals.

a. What are some economically plausible reasons (other than tax evasion) that would explain the low rates of returnearned by foreign-owned companies in the United States? Consider the consequences of the debt-financedU.S.-investment binge that foreign companies went on during the 1980s and the dramatic depreciation of the U.S.dollar beginning in 1985.


ANSWER. The 1980s buying binge in the U.S. meant big interest payments on acquisition debt and huge depreciationwrite-offs for newly acquired plant and equipment. Both depressed the bottom line, lowering tax liability. Many foreigncompanies have also spent millions building factories in the U.S., and that generates even more write-offs and lowersthe reported return on assets. In addition, new investment usually involves high start-up costs, lowering initial returnsas well. Moreover, historical-cost accounting means that the book value of older (mostly American) assets is often farbelow market value. So returns on these assets appear higher than those on newer, foreign investment. The devaluationof the dollar also raised the dollar cost of components imported into the United States.

b. What are some of the mechanisms that foreign-owned companies can use to reduce their tax burden in the U.S.?

ANSWER. They can raise transfer prices on goods and services supplied to their U.S. affiliates and lower them ongoods and services exported to their non-U.S. units. They can also force their U.S. affiliates to have more debt in theircapital structures to gain the interest tax shield.

c. The corporate tax rate in Japan is 60%, whereas it is 34% in the United States. Are these figures consistent withthe argument that big Japanese companies are overcharging their U.S. subsidiaries in order to avoid taxes? Explain.

ANSWER. Since the Japanese corporate tax rate at 60% is almost double the 34% U.S. corporate tax rate, the tax-minimizing strategy for Japanese firms would be to shift profit from Japan to the United States. Thus, these figures areinconsistent with the tax avoidance story. However, some observers claim that Japanese companies that shift profitsto Japan, and thereby boost Japanese tax revenue at the expense of the United States, are "taken care of" by theirgovernment in other ways. Another explanation for shifting profit to Japan is that Japanese culture is such thateverything goes to make the head office look more profitable.

SUGGESTED SOLUTIONS TO CHAPTER 20 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% and50%, respectively.

a. Suppose the transfer price can be set at any level between $25,000 and $30,000. At what transfer price willcorporate 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 of1,500(27,000 - P)(.45 - .50). Tax savings are maximized when P is set equal to $30,000. In effect, the firm will beshifting profits from France, where they are taxed at 50%, to Canada, where they are taxed at 45%.

b. Suppose the French government imposes an ad valorem tariff of 15% on imported tractors. How would this affectthe 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 pricefrom $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.

c. If the transfer price of $27,000 is set in French francs and the French franc revalues by 5%, what will happen tothe firm's overall tax bill? Consider the tax consequences both with and without the 15% tariff.


ANSWER. A 5% French franc revaluation will increase the dollar value of the transfer price to $28,350. In the absenceof a tariff, total taxes paid monthly will decline by 1,500(27,000 - 28,350)(.45 - .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.

d. Suppose the transfer price is increased from $27,000 to $30,000 and credit terms are extended from 90 days to 180days. 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 beforeand after the changes in the transfer price and credit terms are :

Cash Flow/Month ($ million) 1 2 3 4 5 6 7+

NewOriginal

040.5

040.5

040.5

40.540.5

40.540.5

40.540.5

45.040.5

Net changeCumulative 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 upto 90 days in either direction. Assume the following effective annualized after-tax dollar borrowing and lendingrates in England and the United States.

Lending(%)

Borrowing(%)

United StatesEngland

4.03.6

3.23.0

a. If the U.S. parent is borrowing funds while the English affiliate has excess funds, should the parent speed up orslow down its payment to England?

ANSWER. Under the circumstances, the parent's opportunity cost of funds is 3.2%, whereas the British unit'sopportunity cost of funds is 3.6%. Since the British unit has the higher opportunity cost of funds, the U.S. parent shouldspeed up its $5 million payment by 90 days.

b. What is the net effect of the optimal payment activities in terms of changing the units' borrowing costs and/orinterest income?

ANSWER . The U.S. parent will borrow an additional $5 million for 90 days, adding $5,000,000 x .032 x .25 = $40,000to its interest expense. At the same time, the British unit will invest an additional $5 million for 90 days, raising itsinterest income by $5,000,000 x .036 x .25 = $45,000. The net effect is to raise consolidated income by $5,000.

3. Suppose that covered after-tax lending and borrowing rates for three units of Eastman Kodak--located in the UnitedStates, France, and Germany--are:


Lending(%)

Borrowing(%)

United StatesFranceGermany

3.13.03.2

3.94.24.4

Currently, the French and German units owe $2 million and $3 million, respectively, to their U.S. parent. The Germanunit also has $1 million in payables outstanding to its French affiliate. The timing of these payments can be changedby up to 90 days in either direction. Assume that Kodak U.S. is borrowing funds while both the French and Germansubsidiaries have excess cash available.

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 coveredrates presented in the problem, can be used to determine the value of leading and lagging for Kodak. The countries onthe top of the matrix are those which receive payment from the countries listed on the left. Each subsidiary column issubdivided into "L" and "B." The "L" column is applicable if the unit has excess funds which it can invest in the localmoney market. The "B" column is applicable if the subsidiary is currently borrowing on the local money market orwould have to borrow in order to pay an intercompany account.

Receiving Units

U.S. France Germany

Paying Units L B L B L B

U.S.

France

Germany

LBLBLB

0.1-1.1-0.1-1.2

0.9-0.30.7

-0.5

-0.1-0.9

-0.2-1.4

1.10.3

1.0-0.2

0.1-0.70.2

-1.0

1.30.51.40.2

The entries refer to the dollar interest differentials that exist between each pair of affiliates given their current liquiditystatus. If this interest differential is positive, Kodak as a whole, by leading payments between the respective units, willeither pay less on its borrowings or earn more interest on its investments. Lagging will be worthwhile if the interestdifferential is negative. According to the prevailing interest differentials, both subs should speed up their payments tothe parent while the German unit should lag its payments to the French firm.

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 Germanunit 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 x .039 x 90/360) while German and Frenchinterest income are reduced by $16,000 ($2,000,000 x .032 x 90/360) and $22,500 ($3,000,000 x .03 x 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: -.9 (France "L" - U.S. "B"); -.7 (Germany "L" - U.S. "B"); and -.2 (Germany "L" - France"L"). Net interest saved equals .25[.009($2,000,000) + .007($3,000,000) + .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.


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 affiliateshould lag its payments to both the U.S. and French units. The higher interest earnings associated with this strategy canbe calculated directly using the interest differentials taken from the matrix in part a). These differentials are: .1(U.S."L" - France "L"); .1(Germany "L" - U.S. "L"); and .2(Germany "L" - France "L"). Net additional interest earnings thenare 1/4[.001($2,000,000) + .001($3,000,000) + .002($1,000,000)] = $1,750.

4. Suppose that in the section titled Dividends, International Products has $500,000 in excess foreign tax creditsavailable. 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 outof 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, IPsaves $460,000 in tax, cutting worldwide taxes to $2,020,000. But this still exceeds worldwide taxes of $1,910,000 ifthe dividend is paid by the German affiliate.

5. 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 thetransfer price on chips can be set anywhere between $11 and $18, how much can the total monthly cash flow ofA 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 $.45. At the same time, B owes anextra $.12 in tariffs. The before-tax increase of $1.12 in B's cost gives it a tax write-off worth $1.12 x .55 = $.616. Byshifting $1 in income from B to A, the effect is to lower B's tax payments by $.616 and raise its tariffs by $.12, a netdecrease in tax plus tariff payments of $.496. The net effect of switching $1 in income from B to A is to lower tax plustariff payments to the world by $.496 - .45 = $.046. Thus, the transfer price should be set as high as possible in orderto shift as much income to A from B as possible. The new transfer price should, therefore, be set at $18, a $3 increaseover the old transfer price. The resulting increase in monthly cash flow is $.046 x 3 x 10,000 = $1,380.

6. Suppose GM France sells goods worth $2 million monthly to GM Denmark on 60-day credit terms. A switch incredit 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 month's worth of sales as receivables or $4 million.By switching credit terms to 90 days, GM France will now carry receivables equal to three month's worth of sales or$6 million. The net result is a transfer of $2 million from GM France to GM Denmark.

7. 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.

a. What is the net impact on cash flow for the first 90 days? Assume that the new credit terms apply only to new salesalready booked but uncollected.


ANSWER. This problem can best be worked by examining cash flows under the new setup and then subtracting cashflows under the old setup. Note that by changing credit terms to 60 days from 90 days, goods shipped in the first monthare not paid for until the third month.

Cash Inflows for Swiss Unit and Cash Outflows for German Unit

Month 1 2 3

New TermsOld Terms

$1,000,0001,000,000

01,000,000

$1,300,0001,000,000

ChangeCumulative

00

-$1,000,000-$1,000,000

+$300,000-$700,000

The net effect during the first 90 days of simultaneously switching credit terms and changing the transfer price is toshift $700,000 from the Swiss affiliate to the German affiliate.

b. Assume the tax rate is 25% in Switzerland and 50% in Germany and that revenues are taxed and costs deductedupon sale or purchase of goods, not upon collection. What is the impact on after-tax cash flows for the first 90days?

ANSWER. This problem is more complex because the tax effects occur prior to settling interaffiliate accounts withcash. The Swiss unit's taxes are now $325,000/month (.25 x $1,300,000) as compared with $250,000 previously, whilethe German unit's monthly tax write-off has risen to $650,000 (.5 x $1,300,000) as compared to $500,000 before.

Cash Flows for Swiss Affiliate

Month 1 2 3

New TermsCollection of receivablesTax payments

$100,000-325,000

0-325,000

$1,300,000-325,000

Net cash inflow $675,000 -$325,000 $975,000

Old termsCollection of receivablesTax payments

1,000,000-250,000

1,000,000-250,000

1,000,000-250,000

Net cash inflow

Change in net cash inflowCumulative 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 TermsPayment of payablesValue 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 termsPayment of payablesValue 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 outflowCumulative 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'safter-tax cash inflow drops by $925,000 and the German unit's after-tax cash outflow falls by $1,150,000. The $225,000gain in net cash flow is attributable to the change in transfer price which leads to a shift of $300,000 in reportedmonthly income from Germany to Switzerland, or a shift of $900,000 over the first 90 days. Because income inSwitzerland is taxed at a rate of 25%, while German income is taxed at 50%, the net effect of this income shift for thefirst three months is to save an amount of taxes equal to $900,000 x (.50 - .25) = $225,000.

8. 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 oweon this dividend?

ANSWER. Under current U.S. tax law, the firm's U.S. tax owed on the dividend is calculated as follows:

Dividend $480,000Spanish tax paid 520,000Included in U.S. taxable income $1,000,000U.S. tax @ 35% 350,000Less: U.S. indirect tax credit 520,000Net U.S. tax owed ($170,000)

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 FTCthat can be used to offset U.S. taxes owed on other foreign source income.

9. Suppose a French affiliate repatriates as dividends all the after-tax profits it earns. If the French income tax rateis 50% and the dividend withholding tax is 10%, what is the effective tax rate on the French affiliate's before-taxprofits, 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 andremits the remaining $500,000 as a dividend to its U.S. parent. Only $450,000 gets through because of the 10% Frenchdividend withholding tax. It appears as if the effective tax rate on this affiliate's earnings from the parent's standpointis 55%. However, the parent will receive a foreign tax credit of $210,000, the difference between the $550,000 totaltax payments to the French government and the $340,000 in U.S. tax owed on the $1 million in pre-tax earnings. If thefull FTC can be used, then the parent's effective tax rate declines to 34%. If the FTC is unusable, the parent's effectivetax 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 lowerthe parent's effective tax rate.

10. Merck Mexicana SA, the wholly owned affiliate of the U.S. pharmaceutical firm, is considering alternativefinancing packages for its increased working capital needs resulting from growing market penetration. Ps 250million 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 thefloating-exchange-rate tier of the Mexican exchange market. The exchange loss would, thus, be fully incurred bythe Mexican subsidiary. The exchange rate as of March 1, 1984, was Ps 250 = $1 and widely expected todepreciate further.

a. If interest payments can be made through the stabilized tier of the Mexican exchange market where the dollar isworth Ps 125, what is the break-even exchange rate on the floating tier that would make Merck Mexicanaindifferent 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 owebefore-tax dollar principal plus interest payments in 180 days equal to

250,000,000(1 + .50) x e180 = 375,000,000e 180

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 ofPs 250 million at the current exchange rate of Ps 250 = $1). At a semesterly rate of 6%, the total dollar interest plusprincipal payments owed in 180 days would be

$1,000,000 + 125,000,000 x .e180 = $1,000,000 + 7,500,000e 180

The latter term reflects the fact that interest payments can be made at an exchange rate of Ps 125 to the dollar or a totalof Ps 125,000,000 x .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 dollarfinancing--can be found by setting the two costs equal:

375,000,000e180 = 1,000,000 + 7,500,000e180

The solution is Ps 1 = $.00272 or Ps 367.50 = $1.

b. Merck Mexicana imports from its U.S. parent $500,000 worth of chemical compounds monthly, payable on a90-day basis. Suppose that the parent adjusts its transfer prices so that Merck Mexicana must now pay $700,000monthly for its chemical supplies. All payments for imports of chemicals involved in the manufacture ofpharmaceuticals are transacted through the stabilized tier of the exchange market. At the current exchange rate ofPs 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 125per dollar) Merck could lend in pesos rather than dollars but charge its subsidiary for the principal loss by setting ahigher dollar transfer price. The parent would break even and the subsidiary would effectively pay for the principal lossthrough the subsidized exchange rate. In effect, Merck Mexicana would be paying back part of the principal at anexchange 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-denominatedparent 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 anend-of-period exchange rate of Ps 300 = $1. To make up the loss on principal repayment, the subsidiary would haveto pay $166,667 extra to the parent. At an exchange rate of Ps 125 = $1, this translates into added payments to theparent of Ps 20,833,334 through higher transfer prices. If the loss is to be made up over a period of six months, thismeans that transfer prices would have to be raised such that monthly imports go up by one-sixth of this amount or Ps20,830,000/6 = Ps 3,472,223. With current monthly imports of Ps 100 million, this requires a transfer price increaseof about 3.47%.

11. A well-known U.S. firm has a reinvoicing center (RC) located in Geneva. The reinvoicing center handles an annualsales volume of $1.2 billion--$700 million in interaffiliate sales and the rest in third-party sales. The RC buysgoods manufactured by the parent company or other subsidiaries and reinvoices the product to other affiliates orthird parties. Many of these trades are with "low-volume, highly complex countries." When buying the goods, theRC takes title to them, but it does not take actual possession of the goods. The RC pays the selling company in itsown currency and receives payment from the purchasing company in its own currency. What benefits can sucha 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. Overviewa) Mode of transferb) Timing flexibility

2. Transfer pricinga) Tax effects

A sells 100,000 circuit boards annually to B at a unit price of $10. Changing the transfer price to $10.50 willsimultaneously increase A's income by $50,000 and decrease B's income by $50,000. If corporate tax ratesfor A and B are 35% and 50%, respectively, the net effect will be to increase A's taxes by $17,500 and reduceB's taxes by $50,000. Net tax savings are $7,500 annually.

b) Section 482i. what it isii. its consequences for setting transfer prices

c) Shifting fundsThe above transfer price change will increase A's after-tax cash flow by $32,500 and reduce B's after-tax cashflow by $25,000.

3. Invoicing currencya) Importer's currency

i. no exposure or tax effects for importerii. exporter bears the currency exposure and tax effects

b) Exporter's currencyi. no exposure or tax effects for exporterii. importer bears the currency exposure and tax effects

4. Leads and lagsa) Shifting liquidity

b) Costs and benefits i. take advantage of interest differentials

Borrowing rate

United States 8.7% 7.6%Germany 8.1% 7.2%

U.S. interest rate - German interest rate for surplus (+) and deficit (-) positions.

Germany + -

+ .4% - .5%United States

- 1.5% .6%

ii. avoid currency controlsiii. exposure management


c) Information requirementsi. intercompany payables and receivablesii. exchange control regulationsiii. relevant tax lawsiv. affiliate liquidity positions and fund requirementsv. sources and availability of funds to each partyvi. expected currency changesvii. forward exchange ratesviii. currency exposures

5. Dividend planninga) Tax considerationsb) Cash requirementsc) Currency controlsd) Corporate practice

6. Global tax planninga) U.S. taxation of foreign source income

i. branches versus subsidiariesii. foreign tax creditsiii. Subpart F incomeiv. FSCs

b) Information requirementsi. tax rates by affiliateii. cross-border tax ratesiii. liquidity by affiliateiv. tax credits

TESTBANK 287

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