Instruments

In your own words, distinguish the characteristics of debt instruments.

Your response should be at least 200 words in length. All sources used, including the textbook, must be referenced; paraphrased and quoted material must have accompanying citations.

Moffett, M. H., Stonehill, A. I., & Eiteman, D. K. (2012). Fundamentals of multinational finance. (IV ed., pp. 370-374). New York: Pearson.

FAI-lT .1 Financing the Global Firm

Cost of Capital (‘/d

20
1

B
6
4
2

The Cost of Capital and Financial Structure

ke = cost of equity

k’vncc = weighted
average after-tax
cost of capita

ka r x) = after-iax
cost of deb

Total Debt (D)
Debt Ratio (o/”\ =

–

Total Assets (V)

Partly offsetting the favorable effect of more debt is an increase in the cost of equity (k”),
because investors perceive greater financial risk. Nevertheless, the overall lveighted average
after-tax cost of capital (kwacc) continues to decline as the debt ratio increases, until finan-
cial risk becomes so serious that investors and management alike pierceive a real danger of
insoivency. This result causes a sharp increase in the cost of new debt and equity, thus increas-
ing the weighted average cost of capital. The lou,point on the resulting U-shaped cost of cap-
ital curve. which is at 14″/” in Exhibit 13.2. defines the debt ratio range in which the cost of
capital is minimized.

Most theorists believe that the low point is actually a rather broad flat area encompass-
ing a wide range of debt ratios, 30% to 60% In Exhibit 13.2, rvhere little difference exists in
the cost of capital. They also believe that, at least in the United States, the range of the flat
area and the location of a particular firm’s debt ratio rvithin that range are determined by
such variables as 1) the industry in which it competes;2) volatility of its sales and operating
income; and 3) the collateral value of its assets.

*ptirt:;:l Finasreial Strer*t*r* and the MfdH
The domestic theory of optimal financial structures needs to be modified by four more vari-
ables in order to accommodate the case of the MNE. These variables, in order of appearance,
are 1) availability of capital; 2) diversification of cash flows; 3) foreign exchange risk; and
4) expectations of international portfoiio investors.

Availability of Capital. Chapter 12 demonstrated that access to capital in global markets allows
an MNE to lower its cost of equity and debt compared rvith most domestic firms. It also per-
mits an MNE to maintain its desired debt ratio, even when significant amounts of new funds
must be raised. In other wordq a multinational firm’s marginal cost of capital is constant for
considerable ranges of its capital budget. This statement is not true for most small domestic

k”).
1ge

an-
‘of
ras-

ap-
.of

firms because they do not have access to the national
equity or debt markets’ They must either

rely on internally generated funds or borrow for
the short and medium terms from commel-

cial banks. : r ^^-:+-r *^.lzatc are
Multinational firms domiciled in countries that have illiquid

capital markets ale rn

almost the same ,it,ruiion u, small domesri” tlt*t uniess they have
gained a global cost and

availability of capital. They must rely on l”t”t”u!V generated
funds and bank borrowing’ If

they need to raise significant u*o,rrrt. of new iunO–t
to finance growth opportunities’ they

may need to borrow more than would be optimal from
the viewpoint of minimizing their cost

of capital.This is equivalentio saying tttut tfteir murginal
cost of capital is increasing at higher

budget levels’

Diversification of cash Flows. As explained in chapter
12, the-theoretical possibility exists

that multinational firms ur” in u bettlr position than domestic
firms to support higher debt

ratios because their “u*t
no*” are diveriified internationally’ The probability

of a firm’s cov-

ering fixed charges uoo”, uuryirrg conditions ir product, fila.ncjal,
and foreign exchange mar-

kets should increase it tfre vaiiaillity of its cash flows
is minimized’

By diversifyirrg “u*t
flo*’ ini”‘oationaffy’ the MNE might be able to achieve

the

same kind of reductitn lo ,urt ftow uariaJlity asportfolio
investors receive from diver-

sifying their security holdings internationaily. R”tu’n’ are not
perfectly correlated

between countries.
Incontrast’adomesticGermanfirmwouldnotenjoythebenefitofcashflowinterna-

tional diversification but would have to rely entirely
on-iti own net cash inflow from domes-

tic operations. Perceived financial risk for the German
firm would be greater than for a

multinational firm because ifre variaUility of its German
domestic cash flows could not be off-

set by positive cash flows elsewbere in the world’ L-^- ^haltcnoe^ hv e-n
As i.ntroduc”d i.A;;;; lz,thediversification argument has been challenged

by empr-

ical research findings ttrai traNgs in tire united StateJ
actually have lower debt ratios th

their domestic counterparts. The agency costs of debt
were higher for the MNEs’ as were

p”riiur risks, foreigr”l”rtuog” riski and asymmetric information’

Foreign Exchange Risk and the Cost of Debt

When a firm issues foreign currency denominated debt,
its effective cost equals the after-tax

cost of repaying the principal and interest, in terms
of the firm’s own culfency’ This amount

includes the nominal;;;i principal and interest in foreign currency terms’
adjusted for any

foreign exchange gains or losses’
For example, if a U.S.-based firm borrows Sfr1,

00,000

for one year at 5.00″/” interest’ and

during the year the Swiss franc appreciut”t r.o* un initial rate of
-Sfr1’50001$

to Sfrl’4400/

what is the dollar cost of this debt (kd$)? Th; Joitu’ p’o”””ds
of the initial borrowing are cal-

culated at the current spot rate of Sfrl’5000/$:

sfrl’5oo’ooo
= $1,ooo,ooo

Sfr].5000/$

At the end of one year the u.S.-based firm is responsible for
repaying the sfr1,500,000 prin-

cipal plus 5.00% i,,t*,”,t, o. a total-of Sfr1,5r5,000. This repayment,
however, must be made

aian ending spot rate of Sfrl’4400/$:

CHAPTER 1 3 Sourcing Equiiyand Debt Globally
355

Sfr1,500,000 x 1.05

ISS-

;in
llat
by
ing

Lnd

rws

rds

for
iiic Sfr1.4400/$

= 91,093,750

356 PA FT 4 Financing the Global Firm

The actual dollar cost of the loan’s repayment is not the nominal 5.00o/o paid in Swiss franc
interest, but 9.37 5″/” :

l- sr.oq:.zso

Lffirp*l – 1 = o’oe37s

: e’3’15″/”
The dollar cost is higher than expected due to appreciation of the Swiss franc against the U.S.
dollar.

This total home-currency cost is actually the result of the combined percentage cost of
debt and percentage change in the foreign currency’s value. We can find the total cost of bor-
rowing Swiss franJs by a U.S.-dollar based firm,k4$,by multiplying one plus the Swiss franc
interest expense, katt’,by one plus the percentage change in the Sfri$ exchange rate,,t:

kl : I(1 + kaso) x (1 + s)l – 1

where kott’ : 5.00% and s : 4.1667c./”.The percentage change in the value of the Swiss franc
versus the U.S. dollar, when the home currency is the U.S. dollar, is

Sr – Sz Sfr1..5000/$ –!!11440qq x 100: +4.1667%s2 xloo: srrt.++ool$
The total expense, combining the nominal interest rate and the percentage change in the
exchange rate, is

ft,1$: [(1 + .0500) x (1 + .A41.667)] – 1 – .A%75 – 9.375o/o

The total percentage cost of capital is 9.3750/”,not simply the foreign currency interest pay-

ment of 5%. The after-tax cost of this Swiss franc denominated debt, when the U.S. income
taxrate is 34%, is

tra$(I – t) : 9.375″/” x 0.66 : 6.1,875%

The firm would report the added 4.1667% cost of this debt in terms of U.S. dollars as a foreign

exchange transaction loss, and it would be deductible for tax purposes.

Fx g-te*tati *ns *f E nternati€3ffi al Foc”tf * I i a { nvest*rs
Chapter 12 highlighted the fact that the key to gaining a global cost and availability of capital

is atiracting and retaining international portfolio investors.Their expectations for a firm’s debt

ratio and overall financial structures are based on global norms that have developed over the
past 30 years. Because a large proportion of international portfolio investors are based in the

most liquid and unsegmented capital markets, such as the United States and the United King-

dom, thiir expectations tend to predominate and override individual national norms. There-
fore, regardless of other factors, if a firm wants to raise capital in global markets, it must adopt
global norms that are close to the U.S. and U.K. nonns. Debt ratios up to 60% appear to be
acceptable. Any higher debt ratio is more difficult to sell to international portfolio investors.

Fieraa-?eial Strasc{atne *fl Foreigru Sutrsieliaries
If we accept the theory that minimizing the cost of capital for a given level of business risk and
capital budget is an objective that should be implemented from the perspective of the consol-
idated MNE, then the financial structure of each subsidiary is relevant only to the extent that

364 PA RT 4 Financing the Global Firm

attractive regulatory and tax environments, and low levels of corruption. Location and the
use of English, increasingly acknowledged as the language of global finance, are also
important factors.

Global Derivatives
With respect to the global derivatives, Chicago continues to be the dominant location for
derivative creation and trading. This lead was reinforced recently with the merger of the
Chicago Mercantile Exchange (CME) with the Chicago Board of Tiade (CBOT). Eurex
(Frankfurt) and Euronext LIFFE (London) are also important liquid derivative markets. Other
derivative exchanges are actively considering mergers to gain competitiveness and liquidity.

Flectronic Trading
Most exchanges have moved heavily into electronic trading in recent years. For example, the

role of the specialist on the floor of the NYSE has been greatly reduced with a corresponding
reduction in employment by specialist firms. They are no longer responsible for ensuring an
orderly movement for their stocks, but are still important in making more liquid markets for
the less-traded shares. The same fate has reduced the importance of market makers on the

London Stock Exchange. Now the U.S. stock market is actually a network of 50 different
venues connected by an electronic system of published quotes and sales prices.

Hedge funds and other high frequency traders dominate the market. High frequency
traders now account for 60% of daily volumes. Equity volume controlled by the NYSE fell
from 807o in 2005 to 25″k in 2010. Tiades are executed immediately by computer. Spreads
between buy and sell orders are in decimal points as low as a penny a share instead of an
eighth of a point. Liquidity has greatly increased but so has the risk of unexpected swings in
prices. For example, on May 6,2010,the Dow Jones Average fell 9.2Yo at one point but even-

tually recovered by the end of the day. Nineteen billion shares were bought and sold.

Effect of Cross-l-isting ancl Equity lssuance
on Share Price
Although cross-listing and equity issuance can occur together, their impacts are separable
and significant in and of.themselves.

eross-Listing
Does merely cross-listing on a foreign stock exchange have a favorable impact on share
prices? It depends on the degree to which markets are segmented.

If a firm’s home capital market is segmented, the firm could theoretically benefit by
cross-listing in a foreign market if that market values the firm or its industry more than does

the home market. This was certainly the situation experienced by Novo when it listed on the

NYSE in 1981 (see Chapter 12). However, most capital markets are becoming more inte-
grated with global markets. Even emerging markets are less segmented than they were just a

few years ago.
A more comprehensive study consisted of 181 firms from 35 countries that instituted

their first ADR program in the United States over the period from 1985 to 1995.1The author
measured the stbck price impact of the announcement of a cross-listing in the

United States

lDarius p. Miller, “The Market Reaction to International Cross-Listings: Evidence from Depositary Receipts,”

Journal of Financial Economics, Vol. 51, 1999, pp. 102-723.

CHAPTER 1 3 Sourcing Equityand DebtGlobally 365

I the
also

r for
. the
urex
)ther

.v.

, the
ding
o 2n

s far
: the

– :_
tc,-

:ad.
; –t dt:
:s ii
;e:”

and found significant positive abnormal retulns around the announcement date’
These were

retained in the immediate following period. As expected, the study showed that the abnormal

returns were greater for firms resident in emerging markets with a low level of legal barriers

to capital flois, than for firms resident in developed markets. Rrms resident in emerging

marklts with heavy restrictions on capital flows received some abnormal returns, but not as

high as firms resident in the other maikets. This was due to the perceived limited liquiditv of

firms resident in markets with too many restrictions on capital flows’

Fquity issuance
It is well known that the combined impact of a new equity issue undertaken simultane-
ously with a cross-listing has a more favorable impact on stock price than cross-listing

alone. This occurs beca1ie the new issue creates an instantly enlarged shareholder base’

Marketing efforts by the underwriters prior to the issue engender higher levels of.visibil-

ity. post-is’sue efforti by the underwriters to support at least the initial offering price also

reduce investor risk.
The study of 181 firms cross-listing in the United States contained 30 firms that initiated

new equity iisues (Level III ADRs). The author found a statistically significant abnormal
return for these firms, even higher tlan for the firms that just cross-listed (Levels I and II)’
Furthermore, the highest abnormal return was for Chilean firms (8’23%)’Th” Chilean

market has one of the highest levels of restrictions affecting foreign investors. Since it is well

known that stock prices.ieact negatively to new domestic issues in the United States’ some-

thing truly significant must be happening when foreign ADRs are sold in the United States’

Even U.S. firms can benefit uy issuing equity abroad. A study of u.S. firms that issued
equity abroad concluded that increased name recognition and accessibility from global

equity issues leads to increased investor recognition and- participation in both the primary

and slcondary markets.2 Moreover, the abilityio issue global shares can validate firm quality

by reducing tle information asymmetry between insiders and investors’ Another conclusion
was that U.S. firms may seize a window of opportunity to switch to global offerings when

domestic demand for their shares is weak. finatiy, the study found that U.S’ firms announcing

global equity offerings have significantly fewer negative market reactions by about one per-

Jentage point than *hut *o,r1O have been expected had they limited their issues to the
domestic market.

lncreasing Visibility and Political Acceptance. MNEs list in markets where they have sub-

stantial physical operations. Commercial objectives are to enhance corporate image, adver-

tise trademarks and products, get better local press coverage, and become more familiar
wi

the local financial community in order to raise working capital locally.

Political objectives mighi include the need io meet local ownership requirements for a

multinational firm’s foreigi joint venture’ Local ownership of the parent firm’s shares might

provide a forum for puUticiiing the firm’s activities and how they support the host country’

this objective is the most important one for Japanese firms. The Japanese domestic market
has both low-cost capital unO ftlgtr availability. Therefore, Japanese firms are not trying to

increase the stock priie, the liquidity of their shares, or the availability of capital’

lncreasing Potential for Share Swaps with Acquisitions. Firms that follow a strategy of

growth by acquisition are always looking for creative ways to fund these acquisitions rather

ii,un puying cash. Offering their shares as partial payment is considerably more attractive
if

zCongsheng Wu and Chuck C.y. Krvok, “Why Do U.S. Firms Choose Global Equity Offerings?”‘ Financial

M anagement,Summer 2002, pp. 47 -65.

366 PA F T .i Financing the Global Firm

those shares have a liquid secondary market. In that case, the target’s shareholders have an
easy wav to convert their acquired shares to cash if they do not prefer a share swap. However,

a share swap is often attractive as a tax-free exchange.

Compensating Management and Employees, If an MNE wishes to use stock options and
share purchase compensation plans for local management and employees, local listing would

enhance the perceived value of such plans. It should reduce transaction and foreign exchange
costs for the local beneficiaries.

Barriers to Crass-Listing arxl Sclling fiquity Abroad
Although a firm may decide to cross-list and/or sell equity abroad, certain barriers exist.
The most serious barriers are the future commitment to providing fuli and transparent
disclosure of operating results and balance sheets as well as a continuous program of
investor relations.

The Snr*mitment to Sisclosure and lnvestcr fielations
A decision to cross-list must be balanced against the implied increased commitment to full
disclosure and a continuing investor relations program. For firms resident in the Anglo-
American markets, listing abroad might not appear to be much of a barrier. For example, the

SEC’s disciosure rules for listing in the United States are so stringent and costly that any

other market’s rules are mere child’s play. Reversing the logic, however, non-lJ.S. firms must

really think twice before cross-listing in the United States. Not only are the disclosure
requirements breathtaking, but also continuous timely quarterly information is required by

U.S. regulators and investors. As a result, the foreign firm must provide a costly continuous
investor relations program for its U.S. shareholders, including frequent “road shows” and the

time-consuming personal involvement of top management’

Disclosure ls a Fouble-Sdged Sward
The U.S. school of thought is that the worldwide trend torn’ard requiring fuller, more transpar-

ent, and more standardized financial disclosure of operating results and financial positions

may have the desirable effect of lowering the cost of equity capital. As we observed tn 2002

und 2008, lack of full and accurate disclosure, and poor transparency worsened the U.S’ stock

market decline as investors fled to safer securities such as U.S. government bonds’This action

increased the equity cost of capital for all firms. The other school of thought is that the ll.S-

level of required^ diiclosure is an onerous, costly burden. It chases away many potential listers,

thereby narrowing the choice of securities available to U.S. investors at reasonable trans-

action costs.
A study of 203 internationally traded shares concluded that there is a statistically signifi-

cant relationship between the level of financial disclosure required and the markets on which

the firms chose io list.3 The higher the level of disclosure required, the less likely a firm would

be to list in that market. Howiver, for those firms that do list despite the disclosure and cost

barriers, the payoff could be needed access to additional equity funding of a large factory or

an acquisition in t6″ United States. Daimler Benz took the painful step of crossJisting on the

NYSE prior to raising equity in the United States to fund a new auto plant and, as it turned

out later, to merge with Chrysler Corporation.

3Saudagaran, Shahrokh M. and Gary Biddle, “Foreign Listing Location: A Study of MNEs and Stock Exchanges in

Eight Countrie s,” Journcl of International Business sndies,Yohtme26’No’ 2′ Second Quarter 1995’pp’319141′

370 PART 4 Financing the Global Firm

Hs’a{ex”seafi*na! Debt k!arkets
The international debt markets offer the borrower a variety of different

maturities, repay-

ment structures, and currencies of denomination. The markets and their many
different

instruments vary by source of funciing, pricing structure, maturity, and
subordination or link-

age to other debt and equity instrumelnti.
pxtriUlt 13.7 provides an overview of the three basic

lit”gori”, described in itre fotlowing sections, along with their primary components as issued

or tradetj in the international debt markets today. The three major sources
of debt funding on

the international markets are international bank loans and syndicated credits,the
Ettonote

market,and the international bond market

Eank Lsans and Syndicated Gredits
lnternational Bank Loans. Internationai bank loans have traditionally

been sourced in the

Eurocurrency markets. Furodollar bank loans are also called “Eurodollar
credits” or simply

,,Eurocredits.” The latter title is broader because it encompasses nondollar loans in the
Eurocurrency market. The key factor attracting both depositors and

borrowers to the

Eurocurrency loan market is the narrow interest iate spread within
that market’ The differ-

ence between deposit and loan rates is often less lhan L”/o ‘

Eurocredits. Eurocredits are bank loans to MNEs, sovereign governments,
international

institutions, and banks denominated in Furocurrencies and extended
by banks in countries

other than the countrf in *hos” currency the loan is denominated’
The basic borrowing inter-

est rate for Eurodolia. loans has long been tied to the London Interbank
offered

Rate

(LIBoR), which is ttre deposit rate app’iicable to interbank loans within London’
Eurodollars

are lent for both short- and medium-term maturities, with transactions
for six months or less

regarded as routine. Most Eurodollar loans are for a fixed term
with no provision for early

repayment.

o’

Bank Loans and
Syndications
(floating-rate’

short- to mediumterm)

lnternational Bank Loans

Eurocredits

Syndicated Credits

Euronotes and Euronoie Facilities

Eurocommercial Paper (ECP)

Euro Medium-Term Notes (EMTNs)

Eurobond
. straight fixed-rate issue
. {loating-rate note {FRN)
. equitY-related issue

Foreign Bond

A
Lt

al
Euronote

Market
(lloating-rate’

short- to mediumierm)

lnternational
Bond Market

(f ixed and f loaiing-rate
medium- to long{erm)

CHAPTf R 1 3 Sourcing Equityand DebtGlobally 371

Syndicated Credits. The syndication of loans has enabled banks to spread the risk of very

large loans among a number of banks. Syndication is particularly important because many

large MNEs need credit in excess of a single bank’s loan limit. A syndicated bank credit is
arranged by a lead bank on behalf of its client. Before finalizing the loan agreement, the lead

bank seeks the participation of a group of banks, with each participant providing a portion of
the total funds needed.The lead manager bank will work with the borrower to determine the
amount of the total credit, the floating-rate base and spread over the base rate, maturity, and

fee structure for managing the participating banks. The periodic expenses of the syndicated
credit are composed of two elements:

1. The actual interest expense of the loan, normally stated as a spread in basis points over a
variable-rate base such as LIBOR.

2. T\e commitment fees paid on any unused portions of the credit. The spread paid over
LIBOR by the borrowir is considered the risk premium, reflecting the general business
and financial risk applicable to the borrower’s repayment capability.

Gtobal Finance in Practice 13.1 illustrates the pricing common to the syndicated loan mar-
kets, including interest expenses and the commitment and investment banking fees’

$Eearonote fu4arket

The Euronote market is the collective term used to describe short- to medium-term debt
instruments sourced in the Eurocurrency markets. Although a multitude of differentiated
financial products exists, they can be divided into two major groups-underwritten facilities
and nonirfderwritten facititiis.TJnderwritten facilities are used for the sale of Euronotes in a

–
– 13J Ty^::l^til”j sroups:

1) the lead arranser bank(s), which

organizes the loan and participants; 2) the lead managing
pricing and Structure and underwriting banks, which aid in the svndication of the
of a syndicated Eurocredit loan; and 3)the participating banks, which actmllv provide

the capital.
Borrower:

Amount:

lrish Aerospace, GPA Airbus, GPA
Fokker, GPA Jetprop, GPA Rolls
US$l ,25 billion; Revolving loanV
guaraniees lletters of credit

Terms: Eight years at 93.75 basis points over
LIBOR, with a margin of 7/8% for GPA

Arranger:
Airbus drawings
Citicorp lnvestment Bank

Lead Managers
and Underwriters: Citibank, Chase lnvestment Bank,

Toronio-Dominion Bank, Citibank
(Channel lslands) for a syndicate of
Japanese leasing companies,
Credit Suisse,- Soci6t6 G6n6rale
(London), Amsterdam-Fotterdam
Bank, Bank o{ Nova Scotia, Bank of
Tokyo lnternational, Daiwa Bank, lBJ,
lrish lntercontinental

lf the 1.5% total fee was subdivided equally among the

three groups, the proceeds of the loan after expenses of
issuance and arrangement

$1,2s0,000,000 – [(0.005 + 0.005 + 0.005) x
$1 ,25o,ooo,oool : $1,231,250,000

The debt service payments over the B-year period prior to
principal repayment are LIBOFI + 93.75 basis points; assum-
ing an initial LIBOR rate of 9.00% (reset every six monihs for

semiannual debi service payments):

0.0900 + 0.0093751
I x $1,250,000,000 : $62’109’375

The effective annual cost is thus

x2x100=10.490/o

A typical syndicated loan of this type would have up-front The syndicated credit will cost lrish Aerospace 10.09% ai the
fees totaling 1 .5% of the principal. The fees would be divided culent LIBOR rate of 9.000o/o.

[ $oz,rog,szs I
Ls, B., e..p*J

372 PA R-i 4 Financing the Global Firm

number of different forms. Nonunderwritten facilities are used for the sale and distribuiion
of Euro-commercial paper (ECP) and Euro medium-term nores (EMTNs),

Euronote Facilities. A major development in international money markets was the establish-
ment of facilities for sales of short-term, negotiable, promissory notes-euronotes. Among
the facilities for their issuance were revolving underwriting facilities (rufs), note issuance
facilities (nifs), and standby note issuance facilities (snifs). These facilities were provided by
international investment and commercial banks. The euronote was a substantially cheaper
source of short-term funds than were syndicated loans because the notes were placed directly
with the investor public, and the securitized and underwritten form allowed the ready estab-
lishment of liquid secondary markets. The banks received substantial fees initially for their
underwriting and placement services.

Euro-Commercial Paper (ECP). Euro-commercial paper (ECP),like commercial paper issued
in domestic markets around the world, is a short-term debt obligation of a corporation or
bank. Maturities are typically one, three, and six months. The paper is sold normally at a dis-
count or occasionally with a stated coupon. Although the market is capable of supporting
issues in any major currency, over 907″ of issues outstanding are denominated in U.S. dollars.

Euro Medium-Term Notes (EMTNs). The Euro medium-term note (EMTN) market effec-
tively bridges the maturity gap between ECP and the longer-term and less flexible interna-
tional bond. Although many of the notes were initially underwritten, most EMTNs are now
nonunderwritten.

The rapid initial growth of the EMTN market followed directly on the heels of the same
basic instrument that began in the U.S. domestic market when the U.S. Securities and
Exchange Commission (SEC) instituted Rule #415, allowing compapies to obtain shelf regis-
trations for debt issues. What this meant was that once the registration was obtained, the cor-
poration could issue notes on a continuous basis without having to obtain new registrations
for each additional issue. This, in turn, allowed a firm to sell short- and medium-term notes
through a much cheaper and more flexible issuance facility than ordinary bonds.

The EMTN’s basic characteristics are similar to those of a bond, with principal, maturity,
and coupon structures and rates being comparable. The EMTN’s typical maturities range
from as little as nine months to a maximum of 10 years. Coupons are typically paid semiannu-
ally, and coupon rates are comparable to similar bond issues.The EMTN does, however, have
three unique characteristics. 1) the EMTN is a facility, allowing continuous issuance over a
period of time, unlike a bond issue which is essentially sold all at once1’z) because EMTNs are
sold continuously, in order to make debt service (coupon redemption) manageable, coupons
are paid on set calendar dates regardless of the date of issuance; 3) EMTNs are issued in rel-
atively small denominations, from $2 million to $5 million, making medium-term debt acqui-
sition much more flexible than the large minimums customarily needed in the international
bond markets.

i nt*rg’latia*al *ar:d fdiarket
The international bond market sports a rich array of innovative instruments created by imag-
inative investment bankers, who are unfettered by the usual controls and regulations govern-

ing domestic capital markets.Indeed, the international bond market rivals the international
banking market in terms of the quantity and cost of funds providedto international borrow-
ers. All international bonds fall within two generic classifications, Eurobonds and lbreign
bonds. The distinction between categories is based on whether the borrower is a domestic or
a foreign resident, and whether the issue is denominated in the local currency or a foreign
currency.

C l-1 r\ F j’I i] ‘l li Sourcing Equity and Debt Globally 373

Eurobonds. A Eurobond is underwritten by an international syndicate of banks and other
securities firms, and is sold exclusively in countries other than the country in whose currency

the issue is denominated. For example, a bond issued by a firm resident in the United States,

denominated in U.S. dollars, but sold to investors in Europe and Japan (not to investors in the

United States), is a Eurobond.
Eurobonds are issued by MNEs, large domestic corporations, sovereign governments,

governmental enterprises, and international institutions.They arc offered simultaneously in a

number of different national capital markets, but not in the capital market or to residents of

the country in whose currency the bond is denominated. Almost all Eurobonds are in bearer

form with call provisions and sinking funds’
The syndicate that offers a n”*lsu” of Eurobonds might be composed of underwriters

from a number of countries, including European banks, foreign branches of U’S’ banks’ banks

from offshore financial centers, investment and merchant banks, and nonbank securities firms’

t The Straight Fixed-Rate Issue. The sftaight fixed-rate issue is structured like most domestic
bonds, wiitr a fixed coupon, set maturity date, and full principal repayment upon final matu-

rity. Coupon, ur” nor*ully paid annually, rather than semiannually, primarily because-the

bonds are bearer bonds and-annual coupon redemption is more convenient for the holders.

t The Floating-Rate Note (FRN). The FRN normally pays a semiannual coupon which is
determined

-using
a variable-rate base. A typical coupon would be set at some fixed spread

over LIBOR. This structure, like most variable-rate interest-bearing instruments, was

designed to allow investors to shift more of the interest-rate risk of a financial investment

to the borrower. Although many FRNs have fixed maturities, a number of major issues

since 1985 are perpetuitiEs. The principal will never be repaid. Thus, they provide many of

the same financial functions as equity.

g The Equity-Related Issue. The equity-related international bond resembles the straight
fixed-rate issue in practically all price and payment characteristicq with the added feature

that it is convertible to stoci prior to maturity at a specified price per share (or alterna-

tively, number of shares per bond). The borrower is able to issue debt with lower coupon

payments due to the added value of the equity conversion feature’

Foreign Bonds. A foreign bond isunderwritten by a syndicate composed of members
frgm a

single-country, sold prirrcipally within that country, and denominated in the currency of that

.o,intry. The lssuer,-however, is from another country. A bond issued by a firm resident in
Sweden, denominated in dollars, and sold in the United States to U.S. investors by U.S. invest-

ment bankers, is a foreign bond. Foreign bonds have nicknames: foreign bonds sold in the

United States are “Yankie bonds”; foreign bonds sold in Japan are “samurai bonds”; and for-

eign bonds sold in the United Kingdom are “Bulldogs'”

l.J n iq u* f; hara*teri sti** *f Eurobond fvlarket*
Although the Eurobond market evolved at about the same time as the Eurodollar market’

the twomarkets exist for different reasons, and each could exist independently of the other.

The Eurobond market owes its existence to several unique factors. They are the absence of

regulatory interference, less stringent disclosure practices, and favorable tax treatment.

Absence of Regulatory lnterference. National governments often impose tight controls on

foreign issuers of ,””uiiti”, denominated in the local currency and sold within their national
boundaries. However, governments in general have less stringent limitations for securities

denominated in foreigri currencies and sold within their markets to holders of those foreign

currencies. In effect, Eurobond sales fall outside the regulatory domain of any single nation’

374 PA R T 4 Financing the Global Firm

Less Stringent Disclosure, Disclosure requirements in the Eurobond market are much less
stringent than those of the Securities and Exchange Commission (SEC) for sales within the
United States. U.S. firms often find that the registration costs of a Eurobond offering are less
than those of a domestic issue and that less time is needed to bring a new issue to market. Non-
U’S’ firms often prefer Eurodollar bonds over bonds sold within the United States because ther
!9lot wish to undergo the costs, and disclosure, needed to register with the SEC. However, the
SEC has relaxed disclosure requirements for certain private placements (Rule #1444), which
has improved the attractiveness of the U.s. domestic bond and equity markets.

Favorable Tax Status. Eurobonds offer tax anonymity and flexibility. Interest paid on
Eurobonds is generally not subject to an income withholding tax. As one might expect.
Eurobond interest is not always reported to tax authorities. Eurobonds are usually issued in
bearer form, meaning that the name and country of residence of the owner is not on the cer-
tificate. To receive interest, the bearer cuts an interest coupon from the bond and turns it in at
a banking institution listed on the issue as a paying agent. European investors are accus-
tomed to the privacy provided by bearer bonds and are very reluctant to purchase registered
bonds, which require holders to reveal their names before they receive interest. Bear-er bond
status, of course, is also tied to tax avoidance.

ffiating *f Hur*b*nds and *ther tnternati*na! issLres
Purchasers of Eurobonds do not rely only on bond-rating services or on detailed analyses of
financial statements. The general reputation of the issuing corporation and its underwriters
has been a major factor in obtaining favorable terms. For this reason, larger and better-
known MNEs, state enterpriseg and sovereign governments are able to obtain the lowest
interest rates. Firms whose names are better known to the general public, possibly because
they manufacture consumer goods, are often believed to have an advantage over equally
qualified firms whose products are less widely known.

Rating agencies, such as Moody’s and Standard and Poor’s (S&Ps), provide ratings for
selected international bonds for a fee. Moody’s ratings for international bonds imply the
same creditworthiness as for domestic bonds of U.S. issuers. Moody’s limits its evaluation to
the issuer’s ability to obtain the necessary currency to repay the issue according to the origi-
nal terms of the bond. The agency excludes any assessment of risk to the investor caused by
changing exchange rates.

Moody’s rates international bonds upon request of the issuer. Based on supporting finan-
cial statements and other material obtained from the issuer, it makes a preliminary rating and
then informs the issuer who has an opportunity to comment. After Moody’s determines its
final rating, the issuer may decide not to have the rating published. Consequently, a dispro-
portionately large number of published international ratings fall into the highest categories,
since issuers about to receive a lower rating do not allow publication.

Moody’s review of political risk includes study of the government system, the social envi-
ronment, and the nation’s external relations. Its review of economic risk looks at debt bur-
den. international liquidity, balance of payments flexibility, economic structure, growth
performance, economic management, and economic outlook. Moody’s also evaluates the
bonds of sovereign-supported entities by tooking first at their creditworthiness on a stand-
alone basis and then at the extent to which sovereign support either enhances or diminishes
the borrower’s financial strength. Credit ratings are critical to borrowers and investors alike.
An MNE’s credit rating determines its cost of funds.

Access to debt capital is, however, in the end, still a function of basic societal norms. Reli-
gion itself, may play a part in the use and availability of debt capital. Global Finance in prac-
tice 13.2 illustrates one area rarely seen by westerners, Islamic Finance.

u
*si

t-.s

lcr,

,;,ai-

c4€

f€

ini

bir

tn{

an
th

a.l

1],

tit

A
sc

t
I

t
t

CHAir T EH 1.1 Multinational Tax Management 387

completely neutral in its effect on private decisions and completely equitable amongtax’
puy”rr. However, other theorists cLim that national policy objectives such as balance of

puy*”ntt or investment in developing countries should be encouraged through an aclive tax

inientive policy rather than requiring taxes to be neutral and equitable. Most tax systems
compromise between these two viewpoints.

br” *uy to view neutrality is to require that the burden of taxation on each dollar’ euro,
-^,,-.{ ^f nrnfir ^^—,{ in hnme n^rrn!r’ nnerrlinns ht’ an MNE be eqUal tO the bUf-pouiici, uj ycii ui PiuiiL uciiiitru iii itviiiu uvurtrrJ “J *’^ ‘
den of taxation on each currency-equivalent of profit earned by the same firm in its foreign

operations. This is called domeitic ieutrality. A second way to view neutrality is to require

that the tax burden on each foreign subsidiary of the firm be equal to the tax burden on its

competitors in the same country. This is called /o reign neutratity .T\e latter interpretation is

often supported by MNEs because it focuses more on the competitiveness of the individual
firm in individual country-markets.

The issue of tax equiiy is also difficult to define and measure. In theory, an equitable tax

is one that imposes the same total tax burden on all taxpayers who are similarly situated and

located in the same tax jurisdiction. In the case of foreign investment income, the U’ S’
Tieasury argues that sinie the United States uses the nationality principle to claim tax
jurisdiciion,t s.-owned foreign subsidiaries are in the same tax jurisdiction as U.S’ domestic
iubsidiaries. Therefore, a dollar earned in foreign operations should be taxed at the same rate

and paid at the same time as a doiiar earned in domestic operations.

f{atlonal Tsx f; nvircnsnent$
Despite the fundamental objectives of national tax authorities, it is widely agreed that taxes

do affect economic decisioni made by MNEs. Tax treaties between nations’ and differential

tax structures, rates, and practices all result in a less than level playing field for the MNEs

competing on world markets.
bxniUit 14.1 provides an overview of corporate tax rates as applicable to the United

States, Germany, and Japan. Th e eategorrzationi of income (e.g., distributed versus undistrib-

uted profits), the differences in iax raies, and the discrimination in tax raies applicable to

income earned in specific countries serve to introduce the critical dimensions of tax planning

for the MNE.
Nations typically structure their ta,x systenns along one of two basic approaches: the

worldwide approach at the territorial approach. Both approaches are attempts to determine
which firms, fbreign or domestic by inCorporation, or which incomes, foreign or domestic in

origin, are subject to the taxation of host country tax authorities’

Worldwide Approach. Tlte worldwide approach, also referred to as the residential or
national approach,levies taxes on the income earned by firms that are incorporated in the

host couniry-, regardless of where the income rvas earned (domestically or abroad). An MNtr

earning incbme bottr at home and abroad would therefore find its worldwide income taxed

by its host-country tax authorities. For example, a country like the United States taxes the

income earned by firms based in the United States regardless of whether the income
earned by the firm is domestically sourced or foreign sourced. In the case of the United
States, oidinury foreign-sourced income is taxed only as remitted to the parent firm’ As

with all questions of tax. however, numerous conditions and exceptions exist. The primary

problemis that this does not address the income earned by foreign firms operating within

th” Urrit”d States. Countries like the United States then apply the principle of territorial
taxation to foreign firms within their legal jurisdiction, taxing all income earned by foreign

firms in the United States.

388 IrA RT 4 Financing the Global Firm

Taxable lncome Category

Cor[oiate income tax rates

Withholding taxes on dividends (portfolio):

with

Japan

with

Germany

with United States

Withholding taxes on dividends (substantial holdings):

with Japan
with Germany
with United States

Withholding taxes on interest:

with Japan
with Germany
with United States

Withholding taxes on royalties:

with Japan
with Germany
with United States

Comparison of corporate rax nates io; J;;;;, C”rr”ny,
and the United States

Japan

4i,;l;

15%

Oo/o

tv70

0/5o/o

0o/o

1Oo/o

Oolo

Germany United States
29.5o/o 40%

15% 5%
5o/o

O/5/

15o/o

15olo 1a/o
5o/o

O/5/15o/o

10o/o lOo/o
Oo/o

ato/eJ /o

10% O%
Oo/o

0o/o

Source: Coporate income tax rates drawn from “KPMG’S Corpoiate and lndirect Tax Rate Survey, 2008,’ KPMG.com. Tax rates as ol
April 1, 2008. Withholding tax rates extracled from Price Waterhouse Coopers, Corporate Taxes: A Worldwide Summary 2009.

Territorial Approach. The territorial approach. also termed the source approach,focuses on
the income earned by firms within the legal jurisdiction of the host country, not on the
country of firm incorporation. Countries like Germany, that follow the territorial
approach, apply taxes equally to foreign or ‘jor-nesiic firrns on income earned wiihin ihe
country, but in principle not on income earned outside the country. The territorial
approach,like the worldwide approach, results in a major gap in coverage if resident firms
earn income outside the country’, but are nct taxed by the country in which the profits are
earned. In this case, tax authorities extend tax coverage to income earned abroad ifit is not
currently covered by foreign tax jurisdictions. Once again, a mix of the two tax approaches
is necessary for full coverage of income.

Tax Deferral, If the worldwide approach to international taxation is followed to the letter, it
would end the tax-deferral privilege for many MNEs. Foreign subsidiaries of MNEs pay host-
ccuntry corporate income taxes, but many parent couniries defer claiming a,idiiionai inc,cine
taxes on that foreign-source income until it is remitted to the parent firm. For example, U.S.
corporate income taxes on some types of foreign-source income of U.S.-owned subsidiaries
incorporated abroad are deferred until the earnings are remitted to the U.S. parent. How-
ever, the ability to defer corporate income taxes is highly restricted and has been the subject
of many of the tax law changes in the past three decades.

The deferral privilege was challenged once again in the2004 U.S. presidential campaign by
Senator Kerry the Democratic candidate for President. Senator Kerry claimed that tax deferrals
create an incentive for outsourcing abroad-so called offshoring-of certain manufacturing

CH/\PT ER 1 4 MultinationalTax Management

and service activities by U.S. firms. The added concern to the potential loss of American jobs
was the potential reduction in tax collections in the United States, enlarging the already siz-
able U.S. government’s fiscal deficit.

Tax Treaties
A network of bilateral tax treaties, many of which are modeled after one proposed by the
Organization for Economic Cooperation and Development (OECD), provides a means of
reducing double taxation. Tax treaties normally define whether taxes are to be imposed on
income earned in one country by the nationals of another, and if so, how. Tax treaties are
bilateral, with the two signatories specifying what rates are applicable to which types of
income between themselves alone. Exhibit 14.1’s specification of withholding taxes on divi-
dends, interest, and royalty payments between resident corporations of the United States,
Germany, and Japan, is a classic example of the structure of tax treaties. Note that Germany,
for example, imposes a10″/o withholding tax on royalty payments to Japanese investors, while
royalty payments to U.S. investors are withheld at a 0o/o rate.

The individual bilateral tax jurisdictions as specified through tax treaties are particularly
important for firms that are primarily exporting to another country rather than doing busi-
ness there through a “permanent establishment.” The latter would be the case for manufac-
turing operations. A firm that only exports would not want any of its other worldwide income
taxed by the importing country. Tax treaties define what is a “permanent establishment” and
what constitutes a limited presence for tax purposes. Tax treaties also typically result in
reduced’withholding tax rates between the two signatory countries, the negotiation of the
treaty itself serving as a forum for opening and expanding business relationships between the
two countries.

Tax “f-ypes

Taxes are classified on the basis of whether they are applied directly to income, called direct
taxes, or on the basis of some other measurable performance characteristic of the firm,
called indirect taxes. Exhibit 14.2 illustrates the wide range of corporate income taxes in the
world today.

lncome Tax. Many governments rely on income taxes, both personal and corporate, for their
primary revenue source. Corporate income taxes are widely used today. Some countries
impose different corporate tax rates on distributed income versus undistributed income. Cor-
porate income tax rates vary over a relatively wide range, rising as high as 45% in Guyana
and falling as low as 160/” in Hong Kong, 157″ in the British Virgin Islands, 10% in Cyprus,
and effectively 0% in a number of offshore tax havens.

Withholding Tax. Passive income (dividends, interest, royalties) earned by a resident of one
country within the tax jurisdiction of a second country are normally subject to a withholding
tax in the second country. The reason for the institution of withholding taxes is actually quite
simple: governments recognize that most international investors will not file a tax return in
each country in which they invest, and the government therefore wishes to assure that a min-
imum tax payment is received. As the term “withholding” implies, the taxes are withheld by
the corporation from the payment made to the investor, and the taxes withheld are then
turned over to government authorities. Withholding taxes are a major subject of bilateral tax
treaties, and generally range between 0 and 25o/o .

Value’Added Tax. One type of tax that has achieved great prominence is the value-added
tax.The value-added tax is a type of national sales tax collected at each stage of production
or sale of consumption goods in proportion to the value added during that stage. In general,

389

390 PA R-f 4 Financing the Global Firm

Corporate lncome Tax Rates for Selected Countries

Rate Country Rate
Gibraltar

Greece

Guatemala

Honduras

9o,nl_ry,
Albania

Angola

Argentina

Armenia

Aruba

. Australia
Austria

Bahamas

Bahrain

Bangladesh

Barbados

Belarus

Belgium

Bermuda

Bolivia

1Oo/o

35o/o

35%

20o/o

28o/o

30%

25o/o

0o/o
Oo/o

27.5o/o

25o/o

24a/o

33.9

9o/o

25o/o
1Oo/o

25Yo

34%

10%

20o/o

31 .0o/o

17%

25Vo

33%

30%

2Oo/o

1Oo/o

19o/o

aao/

25o/o

25o/s

2Oo/o

21o/o

29o/o

26%

33.33%

29.41o/o

22o/o

244/o

31o/o

25o/o

16.s%

19%

1Bo/o

QQ OOo/^

25o/o

25%

12.5%

Oo/o

tRo/^

31 .4%

33.33o/o

40.69%

QEO/

20%

o A Do/^

15%

I C”/o

4Ooio

15o/o

28.59Yo

12%

10o/o

25o/a

35%

1So/a

3oo/o

9o/o

32%
t E Fo/^

34.54/o

3oa/a

3Oo/o

29o/o

_ _co!.!lry
Oman

Pakistan

Panama

12o/o

35%

27.5%

30%
10%
3oo/o

3Ao/o

19o/o
25o/o
10%

16%

20%

27%

2Ao/o

1Oo/o

17o/o

1o0/^

2Ao/o
Rate

Bosnia and Heaegovina

Botswana

Brazil

Bulgaria

Cambodia

Canada

Cayman islands

Chile

China

Colombia

Costa Rica

Croatia

Cyprus

Czech Republic

Denmark

Dominican Republic

Ecuador

Forrnf

Estonia

Ftti

Finland

France

Germany

Hong Kong

Hungary

lceland

lndia

lndonesia

lran

lreland

lsle of Man

lsrael

Italy

Jamaica

Japan

Jersey

Jordan

Kazakhstan

Korea, Republic of

Papua New Guinea

Paraguay

Peru

Philippines

Poland

Poftugal

Qatar

Romania

Russia

Samoa

Saudi Arabia

Serbia

Singapore

Slovak Bepublic

Siovenia

South Africa

Spain

Sri Lanka

Sweden

Switzerland

Syria

Taiwan

Tanzania

Thailand

Tunisia

Turkey

Ukraine

United Arab Emirates

United Kingdom

United States

Uruguay

Venezuela

Vietnam

Yernen

Zambia

Zimbabwe

Kuwait

Latvia

Libya

Lithuania

Luxembourg

Macau

Macedonia

Malaysia

Malta

Mauritius

Mexico

Montenegro

Mozambique

Nethedands

Netherlands Antilles

New Zealand

Nigeria

Norway

34.55%

3Oo/o

354/o

26.3%

21 .1770

29o/a

17%

30o/”

3oo/o
30%
20o/o
25o/o

55o/o

28a/o

4Ao/o

25o/o

34a/o

25o/o
35o/o
35o/o

25.750/o
Sorirce: “KPlrlG s Corporate and lndkecl Tax Rate Suruey 2010,,’ KpMG.co m, ep. 12-14.

production goods such as plant and equipment have not been subject to the value-added
tax’

Certain basic necessities, such as mediiines and other health-related expenses’ education
and

religious activities, a.rd ihe postal service are usually exempt or taxed at lower rates’
The

value-added tax has been adopted as the main source of revenue from indirect taxation
by all

members of the European tinion, most other countries in Western Europe, a number
of

Latin American countiies, canada, and scattered other countries. A numerical example of
a

value-added tax computation is shown in Exhibit 14’3′

Other National Taxes. There are a variety of other national taxes, which vary in importance

from country to country. The turnover tax (taxon the purchase or sale of securities in some

country stock markets) and the tsx on undistributed profits were mentioned before’

Propeity and inheritanc’e taxes,also termed transfer taxes,ate imposed in a variety of ways

to aihieve intended social redistribution of income and wealth as much as to raise revenue’

There are a number of red-tape charges for public services that are in reality user taxes’

Sometimes foreign exchange purchas& or sales are in effect hidden taxes inasmuch
as the

government earns revenuJrutn”t than just regulates imports and exports for balance
of

payments reasons.

Foreign Tax Credits. To prevent double taxation of the same income, most countries
grant a

forei{n tux creditfor income taxes paid to the host country.
Countries differ on how-they chl-

“utate
the foreign tax credit and what kinds of limitations they place on the total dmount

claimed. Normally foreign tax credits are also available for withholding taxespaid to other

countries on dividends,”royaities, intetest, and other income remitted to the parent’
The

value-added tax and other sales taxes are not eligible for a foreign tax creditbut are typically

deductible from pretax income as an expense.

CHAPTER 1 4 MultinationalTax Management

Value-Added Tax Applied to the Sale of a Wooden Fence Post

This is an example of how a wooden fence post would be assessed for value-added
taxes in the course of its

production and subsequent sale. A value-added tax of loyo is assumed’

Step 1

Step 2

Sales Price Value Added
Value-Added Cumulalive
Tax at 10% Value-Added Tax

391

So.oZ

$0.04

$o’os

$o oB

Stage of Production

Tree owner

Lumber mill

Lumber wholesaler

Lumber retailer

The original tree owner sells to the lumber mill, for $0 20, that part of a tree that ultimately

becomls the fence post. The grower has added $0.20 in value up to this
point by planting

and raising ihe tree. while collJcting $0,20 from the lumber mill, the grower must sel
aside

$0.02 to pay the value-added tax to the government

The lumber mill processes the tree into fence posts and sells each post for $O’+O to the
lum-

ber wholesaler. ihe lumber mill has added $O.ZO in value ($0,40 less $0 20) through its
pro-

cessing activities. Therefore, the lumber mill owner must set aside $0.o2 io pay the
mill’s

value-idded tax to the government. in practice, the owner would probrably calculate
the mill3

t* flnifity
“r

i0% of Sd.40, or $0.04, with a tax credit of $0.02 for the value-added tax

already paid by the tree owner’

steps 3 and 4 The lumber wholesaler and retailer also add value to the fence post through their selling and
distribution activities. They are assessed $0.01 and $0.03 respectively, making the

cumulative

value-added iax collected by the government $0.08, or 10% of the final sales
price.

$0.20

$0.40

$0.20
$0.20

$0.10

$0.30

$0.02

$o.ot

$0.03

$0.50

$0.80

392 PA RT 4 Financing the Global Firm

Foreign Tax Credits

Without loreign
tax credits

With foreign
tax credits

Before{ax foreign income

Less foreign tax @ 30%

Available to parent and paid as dividend

Less additional parent-country tax at 35%

Less incremental tax (after credits)

Profit after all taxes

Total taxes, both jurisdictions

Effective overall tax rate (total taxes paid + foreign income)

$10,000

-3,000

$10,000
-3,000

$ 7,000

*2,450

$ 7,000

-500
$ 4,550
$ 5,450

$ 6,500
$ 3,500

54.Se/o 35.Oo/o

A tax credit rs a direct reduction of taxes that would otherwise be due
and payable’ It differs

from a deductible expense,which is an expense used to reduce
taxable income before the tax

rate is applied. A $100 tax credit reduces taxes payable by the.fuU $100′ whereas
a $100

deductible expense reduces taxable income by $100 and taxes
payable by $100 X t’ wiere / is the

tax rate. Thx credits are more valuable on a dollar-for-dollar basis
than are deductible expenses’

If there were no credits for foreign taxes paid, sequential taxation by the host
govern-

ment and then by the home government would result in a very high
cumulative tax rate’ To

illustrate, assume the wholly 6wned foreign subsidiary of an MNE
earns $10’000 before local

income taxes and puy, u Olnia”nd equal tJ at of its after-tax income’The
host country income

tax rate is 30%, and the home countiy of the parent tax rate ifll:’assuming no
withholding

taxes.Total taxation with and without tax credits is shown in
Exhibit 14’4′

If tax credi.ts ur” ,roi utto*ed, sequential levying olboth a 307o host
country tax and then a

35% home country tax on the income that remains results in an
effective 54’5% tax’ a cumula-

tive rate that would render many MNEs uncompetitive with single-country
local firms’ The

effect of allowing tax credits is to tlmit total taxation on the original
before-tax income to no

more than ttre trlgrrest single rate among jurisdictions. In the
case depicted in Exhibit 1’4’4’the

effective overall tax rate of 35o/o with foreign tax credits is equivalent
to the higher tax rate of

the home country (and is the tax rate payable if the income had
been earned at home)’

The $500 of additional home country tax under the tax
credit system in Exhibit 14’4 is the

amount needed to urlog;ul taxation i$:,ooo already paid plus.the additional $500)
up to

but not beyond 35% of lhe original $10,000 of before-tax foreign
income’

Traxrsfer Fricing
The pricing of goods, services, and technology tralsferred to

a foreign subsidiary from an

affiliated company, t*rtl”r pridng, is the first-and foremost method of transferring
funds out

of a foreign subsidiary.Tirese costJenter directly into the cost
of goods sold component of the

subsidiary’s income statement.This is a particularly sensitive
problem for MNEs’ Even purely

domestic firms find it difficutt to reach agreement on the best
method for setting prices on

transactions betrveen related units. In the multinational case,
managers must balance conflict-

ingconsiderations.Theseincludefundpositioningandincometaxes.

* Fund Positioning Effect. A parent wishing to transfer funds out of a particular country
can

charge higher prices on goods sola to its subsidiary in that country-to
the degree that govern-

ment regulations attori. A foreign subsidiary can be financed by the reverse
technique’

what is the dollar cost of this debt (kd$)? Th; Joitu’ p’o”””ds
of the initial borrowing are cal-
culated at the current spot rate of Sfrl’5000/$:
sfrl’5oo’ooo
= $1,ooo,ooo
Sfr].5000/$
At the end of one year the u.S.-based firm is responsible for
repaying the sfr1,500,000 prin-
cipal plus 5.00% i,,t*,”,t, o. a total-of Sfr1,5r5,000. This repayment,
however, must be made
aian ending spot rate of Sfrl’4400/$:
CHAPTER 1 3 Sourcing Equiiyand Debt Globally
355
Sfr1,500,000 x 1.05
ISS-
;in
llat
by
ing
Lnd
rws
rds
for
iiic Sfr1.4400/$
= 91,093,750

356 PA FT 4 Financing the Global Firm
The actual dollar cost of the loan’s repayment is not the nominal 5.00o/o paid in Swiss franc
interest, but 9.37 5″/” :
l- sr.oq:.zso I
Lffirp*l – 1 = o’oe37s
: e’3’15″/”
The dollar cost is higher than expected due to appreciation of the Swiss franc against the U.S.
dollar.
This total home-currency cost is actually the result of the combined percentage cost of
debt and percentage change in the foreign currency’s value. We can find the total cost of bor-
rowing Swiss franJs by a U.S.-dollar based firm,k4$,by multiplying one plus the Swiss franc
interest expense, katt’,by one plus the percentage change in the Sfri$ exchange rate,,t:
kl : I(1 + kaso) x (1 + s)l – 1
where kott’ : 5.00% and s : 4.1667c./”.The percentage change in the value of the Swiss franc
versus the U.S. dollar, when the home currency is the U.S. dollar, is
Sr – Sz Sfr1..5000/$ –!!11440qq x 100: +4.1667%s2 xloo: srrt.++ool$
The total expense, combining the nominal interest rate and the percentage change in the
exchange rate, is
ft,1$: [(1 + .0500) x (1 + .A41.667)] – 1 – .A%75 – 9.375o/o
The total percentage cost of capital is 9.3750/”,not simply the foreign currency interest pay-
ment of 5%. The after-tax cost of this Swiss franc denominated debt, when the U.S. income
taxrate is 34%, is
tra$(I – t) : 9.375″/” x 0.66 : 6.1,875%
The firm would report the added 4.1667% cost of this debt in terms of U.S. dollars as a foreign
exchange transaction loss, and it would be deductible for tax purposes.
Fx g-te*tati *ns *f E nternati€3ffi al Foc”tf * I i a { nvest*rs
Chapter 12 highlighted the fact that the key to gaining a global cost and availability of capital
is atiracting and retaining international portfolio investors.Their expectations for a firm’s debt
ratio and overall financial structures are based on global norms that have developed over the
past 30 years. Because a large proportion of international portfolio investors are based in the
most liquid and unsegmented capital markets, such as the United States and the United King-
dom, thiir expectations tend to predominate and override individual national norms. There-
fore, regardless of other factors, if a firm wants to raise capital in global markets, it must adopt
global norms that are close to the U.S. and U.K. nonns. Debt ratios up to 60% appear to be
acceptable. Any higher debt ratio is more difficult to sell to international portfolio investors.
Fieraa-?eial Strasc{atne *fl Foreigru Sutrsieliaries
If we accept the theory that minimizing the cost of capital for a given level of business risk and
capital budget is an objective that should be implemented from the perspective of the consol-
idated MNE, then the financial structure of each subsidiary is relevant only to the extent that

364 PA RT 4 Financing the Global Firm
attractive regulatory and tax environments, and low levels of corruption. Location and the
use of English, increasingly acknowledged as the language of global finance, are also
important factors.
Global Derivatives
With respect to the global derivatives, Chicago continues to be the dominant location for
derivative creation and trading. This lead was reinforced recently with the merger of the
Chicago Mercantile Exchange (CME) with the Chicago Board of Tiade (CBOT). Eurex
(Frankfurt) and Euronext LIFFE (London) are also important liquid derivative markets. Other
derivative exchanges are actively considering mergers to gain competitiveness and liquidity.
Flectronic Trading
Most exchanges have moved heavily into electronic trading in recent years. For example, the
role of the specialist on the floor of the NYSE has been greatly reduced with a corresponding
reduction in employment by specialist firms. They are no longer responsible for ensuring an
orderly movement for their stocks, but are still important in making more liquid markets for
the less-traded shares. The same fate has reduced the importance of market makers on the
London Stock Exchange. Now the U.S. stock market is actually a network of 50 different
venues connected by an electronic system of published quotes and sales prices.
Hedge funds and other high frequency traders dominate the market. High frequency
traders now account for 60% of daily volumes. Equity volume controlled by the NYSE fell
from 807o in 2005 to 25″k in 2010. Tiades are executed immediately by computer. Spreads
between buy and sell orders are in decimal points as low as a penny a share instead of an
eighth of a point. Liquidity has greatly increased but so has the risk of unexpected swings in
prices. For example, on May 6,2010,the Dow Jones Average fell 9.2Yo at one point but even-
tually recovered by the end of the day. Nineteen billion shares were bought and sold.
Effect of Cross-l-isting ancl Equity lssuance
on Share Price
Although cross-listing and equity issuance can occur together, their impacts are separable
and significant in and of.themselves.
eross-Listing
Does merely cross-listing on a foreign stock exchange have a favorable impact on share
prices? It depends on the degree to which markets are segmented.
If a firm’s home capital market is segmented, the firm could theoretically benefit by
cross-listing in a foreign market if that market values the firm or its industry more than does
the home market. This was certainly the situation experienced by Novo when it listed on the
NYSE in 1981 (see Chapter 12). However, most capital markets are becoming more inte-
grated with global markets. Even emerging markets are less segmented than they were just a
few years ago.
A more comprehensive study consisted of 181 firms from 35 countries that instituted
their first ADR program in the United States over the period from 1985 to 1995.1The author
measured the stbck price impact of the announcement of a cross-listing in the United States
lDarius p. Miller, “The Market Reaction to International Cross-Listings: Evidence from Depositary Receipts,”
Journal of Financial Economics, Vol. 51, 1999, pp. 102-723.

CHAPTER 1 3 Sourcing Equityand DebtGlobally 365
I the
also
r for
. the
urex
)ther
.v.
, the
ding
o 2n
s far
: the
– :_
tc,-
:ad.
; –t dt:
:s ii
;e:”
and found significant positive abnormal retulns around the announcement date’
These were
retained in the immediate following period. As expected, the study showed that the abnormal
returns were greater for firms resident in emerging markets with a low level of legal barriers
to capital flois, than for firms resident in developed markets. Rrms resident in emerging
marklts with heavy restrictions on capital flows received some abnormal returns, but not as
high as firms resident in the other maikets. This was due to the perceived limited liquiditv of
firms resident in markets with too many restrictions on capital flows’
Fquity issuance
It is well known that the combined impact of a new equity issue undertaken simultane-
ously with a cross-listing has a more favorable impact on stock price than cross-listing
alone. This occurs beca1ie the new issue creates an instantly enlarged shareholder base’
Marketing efforts by the underwriters prior to the issue engender higher levels of.visibil-
ity. post-is’sue efforti by the underwriters to support at least the initial offering price also
reduce investor risk.
The study of 181 firms cross-listing in the United States contained 30 firms that initiated
new equity iisues (Level III ADRs). The author found a statistically significant abnormal
return for these firms, even higher tlan for the firms that just cross-listed (Levels I and II)’
Furthermore, the highest abnormal return was for Chilean firms (8’23%)’Th” Chilean
market has one of the highest levels of restrictions affecting foreign investors. Since it is well
known that stock prices.ieact negatively to new domestic issues in the United States’ some-
thing truly significant must be happening when foreign ADRs are sold in the United States’
Even U.S. firms can benefit uy issuing equity abroad. A study of u.S. firms that issued
equity abroad concluded that increased name recognition and accessibility from global
equity issues leads to increased investor recognition and- participation in both the primary
and slcondary markets.2 Moreover, the abilityio issue global shares can validate firm quality
by reducing tle information asymmetry between insiders and investors’ Another conclusion
was that U.S. firms may seize a window of opportunity to switch to global offerings when
domestic demand for their shares is weak. finatiy, the study found that U.S’ firms announcing
global equity offerings have significantly fewer negative market reactions by about one per-
Jentage point than *hut *o,r1O have been expected had they limited their issues to the
domestic market.
lncreasing Visibility and Political Acceptance. MNEs list in markets where they have sub-
stantial physical operations. Commercial objectives are to enhance corporate image, adver-
tise trademarks and products, get better local press coverage, and become more familiar
with
the local financial community in order to raise working capital locally.
Political objectives mighi include the need io meet local ownership requirements for a
multinational firm’s foreigi joint venture’ Local ownership of the parent firm’s shares might
provide a forum for puUticiiing the firm’s activities and how they support the host country’
this objective is the most important one for Japanese firms. The Japanese domestic market
has both low-cost capital unO ftlgtr availability. Therefore, Japanese firms are not trying to
increase the stock priie, the liquidity of their shares, or the availability of capital’
lncreasing Potential for Share Swaps with Acquisitions. Firms that follow a strategy of
growth by acquisition are always looking for creative ways to fund these acquisitions rather
ii,un puying cash. Offering their shares as partial payment is considerably more attractive
if
zCongsheng Wu and Chuck C.y. Krvok, “Why Do U.S. Firms Choose Global Equity Offerings?”‘ Financial
M anagement,Summer 2002, pp. 47 -65.

366 PA F T .i Financing the Global Firm
those shares have a liquid secondary market. In that case, the target’s shareholders have an
easy wav to convert their acquired shares to cash if they do not prefer a share swap. However,
a share swap is often attractive as a tax-free exchange.
Compensating Management and Employees, If an MNE wishes to use stock options and
share purchase compensation plans for local management and employees, local listing would
enhance the perceived value of such plans. It should reduce transaction and foreign exchange
costs for the local beneficiaries.
Barriers to Crass-Listing arxl Sclling fiquity Abroad
Although a firm may decide to cross-list and/or sell equity abroad, certain barriers exist.
The most serious barriers are the future commitment to providing fuli and transparent
disclosure of operating results and balance sheets as well as a continuous program of
investor relations.
The Snr*mitment to Sisclosure and lnvestcr fielations
A decision to cross-list must be balanced against the implied increased commitment to full
disclosure and a continuing investor relations program. For firms resident in the Anglo-
American markets, listing abroad might not appear to be much of a barrier. For example, the
SEC’s disciosure rules for listing in the United States are so stringent and costly that any
other market’s rules are mere child’s play. Reversing the logic, however, non-lJ.S. firms must
really think twice before cross-listing in the United States. Not only are the disclosure
requirements breathtaking, but also continuous timely quarterly information is required by
U.S. regulators and investors. As a result, the foreign firm must provide a costly continuous
investor relations program for its U.S. shareholders, including frequent “road shows” and the
time-consuming personal involvement of top management’
Disclosure ls a Fouble-Sdged Sward
The U.S. school of thought is that the worldwide trend torn’ard requiring fuller, more transpar-
ent, and more standardized financial disclosure of operating results and financial positions
may have the desirable effect of lowering the cost of equity capital. As we observed tn 2002
und 2008, lack of full and accurate disclosure, and poor transparency worsened the U.S’ stock
market decline as investors fled to safer securities such as U.S. government bonds’This action
increased the equity cost of capital for all firms. The other school of thought is that the ll.S-
level of required^ diiclosure is an onerous, costly burden. It chases away many potential listers,
thereby narrowing the choice of securities available to U.S. investors at reasonable trans-
action costs.
A study of 203 internationally traded shares concluded that there is a statistically signifi-
cant relationship between the level of financial disclosure required and the markets on which
the firms chose io list.3 The higher the level of disclosure required, the less likely a firm would
be to list in that market. Howiver, for those firms that do list despite the disclosure and cost
barriers, the payoff could be needed access to additional equity funding of a large factory or
an acquisition in t6″ United States. Daimler Benz took the painful step of crossJisting on the
NYSE prior to raising equity in the United States to fund a new auto plant and, as it turned
out later, to merge with Chrysler Corporation.
3Saudagaran, Shahrokh M. and Gary Biddle, “Foreign Listing Location: A Study of MNEs and Stock Exchanges in
Eight Countrie s,” Journcl of International Business sndies,Yohtme26’No’ 2′ Second Quarter 1995’pp’319141′

370 PART 4 Financing the Global Firm
Hs’a{ex”seafi*na! Debt k!arkets
The international debt markets offer the borrower a variety of different
maturities, repay-
ment structures, and currencies of denomination. The markets and their many
different
instruments vary by source of funciing, pricing structure, maturity, and
subordination or link-
age to other debt and equity instrumelnti.
pxtriUlt 13.7 provides an overview of the three basic
lit”gori”, described in itre fotlowing sections, along with their primary components as issued
or tradetj in the international debt markets today. The three major sources
of debt funding on
the international markets are international bank loans and syndicated credits,the
Ettonote
market,and the international bond market
Eank Lsans and Syndicated Gredits
lnternational Bank Loans. Internationai bank loans have traditionally
been sourced in the
Eurocurrency markets. Furodollar bank loans are also called “Eurodollar
credits” or simply
,,Eurocredits.” The latter title is broader because it encompasses nondollar loans in the
Eurocurrency market. The key factor attracting both depositors and
borrowers to the
Eurocurrency loan market is the narrow interest iate spread within
that market’ The differ-
ence between deposit and loan rates is often less lhan L”/o ‘
Eurocredits. Eurocredits are bank loans to MNEs, sovereign governments,
international
institutions, and banks denominated in Furocurrencies and extended
by banks in countries
other than the countrf in *hos” currency the loan is denominated’
The basic borrowing inter-
est rate for Eurodolia. loans has long been tied to the London Interbank
offered Rate
(LIBoR), which is ttre deposit rate app’iicable to interbank loans within London’
Eurodollars
are lent for both short- and medium-term maturities, with transactions
for six months or less
regarded as routine. Most Eurodollar loans are for a fixed term
with no provision for early
repayment.
Y
o’
Br
At
Te
Bank Loans and
Syndications
(floating-rate’
short- to mediumterm)
lnternational Bank Loans
Eurocredits
Syndicated Credits
Euronotes and Euronoie Facilities
Eurocommercial Paper (ECP)
Euro Medium-Term Notes (EMTNs)
l
Eurobond
. straight fixed-rate issue
. {loating-rate note {FRN)
. equitY-related issue
Foreign Bond
A
Lt
al
Euronote
Market
(lloating-rate’
short- to mediumierm)
lnternational
Bond Market
(f ixed and f loaiing-rate
medium- to long{erm)

CHAPTf R 1 3 Sourcing Equityand DebtGlobally 371
Syndicated Credits. The syndication of loans has enabled banks to spread the risk of very
large loans among a number of banks. Syndication is particularly important because many
large MNEs need credit in excess of a single bank’s loan limit. A syndicated bank credit is
arranged by a lead bank on behalf of its client. Before finalizing the loan agreement, the lead
bank seeks the participation of a group of banks, with each participant providing a portion of
the total funds needed.The lead manager bank will work with the borrower to determine the
amount of the total credit, the floating-rate base and spread over the base rate, maturity, and
fee structure for managing the participating banks. The periodic expenses of the syndicated
credit are composed of two elements:
1. The actual interest expense of the loan, normally stated as a spread in basis points over a
variable-rate base such as LIBOR.
2. T\e commitment fees paid on any unused portions of the credit. The spread paid over
LIBOR by the borrowir is considered the risk premium, reflecting the general business
and financial risk applicable to the borrower’s repayment capability.
Gtobal Finance in Practice 13.1 illustrates the pricing common to the syndicated loan mar-
kets, including interest expenses and the commitment and investment banking fees’
$Eearonote fu4arket
The Euronote market is the collective term used to describe short- to medium-term debt
instruments sourced in the Eurocurrency markets. Although a multitude of differentiated
financial products exists, they can be divided into two major groups-underwritten facilities
and nonirfderwritten facititiis.TJnderwritten facilities are used for the sale of Euronotes in a
–
– 13J Ty^::l^til”j sroups:
1) the lead arranser bank(s), which
organizes the loan and participants; 2) the lead managing
pricing and Structure and underwriting banks, which aid in the svndication of the
of a syndicated Eurocredit loan; and 3)the participating banks, which actmllv provide
the capital.
Borrower:
Amount:
lrish Aerospace, GPA Airbus, GPA
Fokker, GPA Jetprop, GPA Rolls
US$l ,25 billion; Revolving loanV
guaraniees lletters of credit
Terms: Eight years at 93.75 basis points over
LIBOR, with a margin of 7/8% for GPA
Arranger:
Airbus drawings
Citicorp lnvestment Bank
Lead Managers
and Underwriters: Citibank, Chase lnvestment Bank,
Toronio-Dominion Bank, Citibank
(Channel lslands) for a syndicate of
Japanese leasing companies,
Credit Suisse,- Soci6t6 G6n6rale
(London), Amsterdam-Fotterdam
Bank, Bank o{ Nova Scotia, Bank of
Tokyo lnternational, Daiwa Bank, lBJ,
lrish lntercontinental
lf the 1.5% total fee was subdivided equally among the
three groups, the proceeds of the loan after expenses of
issuance and arrangement
$1,2s0,000,000 – [(0.005 + 0.005 + 0.005) x
$1 ,25o,ooo,oool : $1,231,250,000
The debt service payments over the B-year period prior to
principal repayment are LIBOFI + 93.75 basis points; assum-
ing an initial LIBOR rate of 9.00% (reset every six monihs for
semiannual debi service payments):
0.0900 + 0.0093751
I x $1,250,000,000 : $62’109’375
The effective annual cost is thus
x2x100=10.490/o
A typical syndicated loan of this type would have up-front The syndicated credit will cost lrish Aerospace 10.09% ai the
fees totaling 1 .5% of the principal. The fees would be divided culent LIBOR rate of 9.000o/o.
[ $oz,rog,szs I
Ls, B., e..p*J

372 PA R-i 4 Financing the Global Firm
number of different forms. Nonunderwritten facilities are used for the sale and distribuiion
of Euro-commercial paper (ECP) and Euro medium-term nores (EMTNs),
Euronote Facilities. A major development in international money markets was the establish-
ment of facilities for sales of short-term, negotiable, promissory notes-euronotes. Among
the facilities for their issuance were revolving underwriting facilities (rufs), note issuance
facilities (nifs), and standby note issuance facilities (snifs). These facilities were provided by
international investment and commercial banks. The euronote was a substantially cheaper
source of short-term funds than were syndicated loans because the notes were placed directly
with the investor public, and the securitized and underwritten form allowed the ready estab-
lishment of liquid secondary markets. The banks received substantial fees initially for their
underwriting and placement services.
Euro-Commercial Paper (ECP). Euro-commercial paper (ECP),like commercial paper issued
in domestic markets around the world, is a short-term debt obligation of a corporation or
bank. Maturities are typically one, three, and six months. The paper is sold normally at a dis-
count or occasionally with a stated coupon. Although the market is capable of supporting
issues in any major currency, over 907″ of issues outstanding are denominated in U.S. dollars.
Euro Medium-Term Notes (EMTNs). The Euro medium-term note (EMTN) market effec-
tively bridges the maturity gap between ECP and the longer-term and less flexible interna-
tional bond. Although many of the notes were initially underwritten, most EMTNs are now
nonunderwritten.
The rapid initial growth of the EMTN market followed directly on the heels of the same
basic instrument that began in the U.S. domestic market when the U.S. Securities and
Exchange Commission (SEC) instituted Rule #415, allowing compapies to obtain shelf regis-
trations for debt issues. What this meant was that once the registration was obtained, the cor-
poration could issue notes on a continuous basis without having to obtain new registrations
for each additional issue. This, in turn, allowed a firm to sell short- and medium-term notes
through a much cheaper and more flexible issuance facility than ordinary bonds.
The EMTN’s basic characteristics are similar to those of a bond, with principal, maturity,
and coupon structures and rates being comparable. The EMTN’s typical maturities range
from as little as nine months to a maximum of 10 years. Coupons are typically paid semiannu-
ally, and coupon rates are comparable to similar bond issues.The EMTN does, however, have
three unique characteristics. 1) the EMTN is a facility, allowing continuous issuance over a
period of time, unlike a bond issue which is essentially sold all at once1’z) because EMTNs are
sold continuously, in order to make debt service (coupon redemption) manageable, coupons
are paid on set calendar dates regardless of the date of issuance; 3) EMTNs are issued in rel-
atively small denominations, from $2 million to $5 million, making medium-term debt acqui-
sition much more flexible than the large minimums customarily needed in the international
bond markets.
i nt*rg’latia*al *ar:d fdiarket
The international bond market sports a rich array of innovative instruments created by imag-
inative investment bankers, who are unfettered by the usual controls and regulations govern-
ing domestic capital markets.Indeed, the international bond market rivals the international
banking market in terms of the quantity and cost of funds providedto international borrow-
ers. All international bonds fall within two generic classifications, Eurobonds and lbreign
bonds. The distinction between categories is based on whether the borrower is a domestic or
a foreign resident, and whether the issue is denominated in the local currency or a foreign
currency.

C l-1 r\ F j’I i] ‘l li Sourcing Equity and Debt Globally 373
Eurobonds. A Eurobond is underwritten by an international syndicate of banks and other
securities firms, and is sold exclusively in countries other than the country in whose currency
the issue is denominated. For example, a bond issued by a firm resident in the United States,
denominated in U.S. dollars, but sold to investors in Europe and Japan (not to investors in the
United States), is a Eurobond.
Eurobonds are issued by MNEs, large domestic corporations, sovereign governments,
governmental enterprises, and international institutions.They arc offered simultaneously in a
number of different national capital markets, but not in the capital market or to residents of
the country in whose currency the bond is denominated. Almost all Eurobonds are in bearer
form with call provisions and sinking funds’
The syndicate that offers a n”*lsu” of Eurobonds might be composed of underwriters
from a number of countries, including European banks, foreign branches of U’S’ banks’ banks
from offshore financial centers, investment and merchant banks, and nonbank securities firms’
t The Straight Fixed-Rate Issue. The sftaight fixed-rate issue is structured like most domestic
bonds, wiitr a fixed coupon, set maturity date, and full principal repayment upon final matu-
rity. Coupon, ur” nor*ully paid annually, rather than semiannually, primarily because-the
bonds are bearer bonds and-annual coupon redemption is more convenient for the holders.
t The Floating-Rate Note (FRN). The FRN normally pays a semiannual coupon which is
determined
-using
a variable-rate base. A typical coupon would be set at some fixed spread
over LIBOR. This structure, like most variable-rate interest-bearing instruments, was
designed to allow investors to shift more of the interest-rate risk of a financial investment
to the borrower. Although many FRNs have fixed maturities, a number of major issues
since 1985 are perpetuitiEs. The principal will never be repaid. Thus, they provide many of
the same financial functions as equity.
g The Equity-Related Issue. The equity-related international bond resembles the straight
fixed-rate issue in practically all price and payment characteristicq with the added feature
that it is convertible to stoci prior to maturity at a specified price per share (or alterna-
tively, number of shares per bond). The borrower is able to issue debt with lower coupon
payments due to the added value of the equity conversion feature’
Foreign Bonds. A foreign bond isunderwritten by a syndicate composed of members
frgm a
single-country, sold prirrcipally within that country, and denominated in the currency of that
.o,intry. The lssuer,-however, is from another country. A bond issued by a firm resident in
Sweden, denominated in dollars, and sold in the United States to U.S. investors by U.S. invest-
ment bankers, is a foreign bond. Foreign bonds have nicknames: foreign bonds sold in the
United States are “Yankie bonds”; foreign bonds sold in Japan are “samurai bonds”; and for-
eign bonds sold in the United Kingdom are “Bulldogs'”
l.J n iq u* f; hara*teri sti** *f Eurobond fvlarket*
Although the Eurobond market evolved at about the same time as the Eurodollar market’
the twomarkets exist for different reasons, and each could exist independently of the other.
The Eurobond market owes its existence to several unique factors. They are the absence of
regulatory interference, less stringent disclosure practices, and favorable tax treatment.
Absence of Regulatory lnterference. National governments often impose tight controls on
foreign issuers of ,””uiiti”, denominated in the local currency and sold within their national
boundaries. However, governments in general have less stringent limitations for securities
denominated in foreigri currencies and sold within their markets to holders of those foreign
currencies. In effect, Eurobond sales fall outside the regulatory domain of any single nation’

374 PA R T 4 Financing the Global Firm
Less Stringent Disclosure, Disclosure requirements in the Eurobond market are much less
stringent than those of the Securities and Exchange Commission (SEC) for sales within the
United States. U.S. firms often find that the registration costs of a Eurobond offering are less
than those of a domestic issue and that less time is needed to bring a new issue to market. Non-
U’S’ firms often prefer Eurodollar bonds over bonds sold within the United States because ther
!9lot wish to undergo the costs, and disclosure, needed to register with the SEC. However, the
SEC has relaxed disclosure requirements for certain private placements (Rule #1444), which
has improved the attractiveness of the U.s. domestic bond and equity markets.
Favorable Tax Status. Eurobonds offer tax anonymity and flexibility. Interest paid on
Eurobonds is generally not subject to an income withholding tax. As one might expect.
Eurobond interest is not always reported to tax authorities. Eurobonds are usually issued in
bearer form, meaning that the name and country of residence of the owner is not on the cer-
tificate. To receive interest, the bearer cuts an interest coupon from the bond and turns it in at
a banking institution listed on the issue as a paying agent. European investors are accus-
tomed to the privacy provided by bearer bonds and are very reluctant to purchase registered
bonds, which require holders to reveal their names before they receive interest. Bear-er bond
status, of course, is also tied to tax avoidance.
ffiating *f Hur*b*nds and *ther tnternati*na! issLres
Purchasers of Eurobonds do not rely only on bond-rating services or on detailed analyses of
financial statements. The general reputation of the issuing corporation and its underwriters
has been a major factor in obtaining favorable terms. For this reason, larger and better-
known MNEs, state enterpriseg and sovereign governments are able to obtain the lowest
interest rates. Firms whose names are better known to the general public, possibly because
they manufacture consumer goods, are often believed to have an advantage over equally
qualified firms whose products are less widely known.
Rating agencies, such as Moody’s and Standard and Poor’s (S&Ps), provide ratings for
selected international bonds for a fee. Moody’s ratings for international bonds imply the
same creditworthiness as for domestic bonds of U.S. issuers. Moody’s limits its evaluation to
the issuer’s ability to obtain the necessary currency to repay the issue according to the origi-
nal terms of the bond. The agency excludes any assessment of risk to the investor caused by
changing exchange rates.
Moody’s rates international bonds upon request of the issuer. Based on supporting finan-
cial statements and other material obtained from the issuer, it makes a preliminary rating and
then informs the issuer who has an opportunity to comment. After Moody’s determines its
final rating, the issuer may decide not to have the rating published. Consequently, a dispro-
portionately large number of published international ratings fall into the highest categories,
since issuers about to receive a lower rating do not allow publication.
Moody’s review of political risk includes study of the government system, the social envi-
ronment, and the nation’s external relations. Its review of economic risk looks at debt bur-
den. international liquidity, balance of payments flexibility, economic structure, growth
performance, economic management, and economic outlook. Moody’s also evaluates the
bonds of sovereign-supported entities by tooking first at their creditworthiness on a stand-
alone basis and then at the extent to which sovereign support either enhances or diminishes
the borrower’s financial strength. Credit ratings are critical to borrowers and investors alike.
An MNE’s credit rating determines its cost of funds.
Access to debt capital is, however, in the end, still a function of basic societal norms. Reli-
gion itself, may play a part in the use and availability of debt capital. Global Finance in prac-
tice 13.2 illustrates one area rarely seen by westerners, Islamic Finance.
u
*si
t-.s
lcr,
,;,ai-
c4€
f€
ini
bir
tn{
an
th
a.l
q
1],
+
+
tit
A
sc
t
I
t
t

:!
CHAir T EH 1.1 Multinational Tax Management 387
completely neutral in its effect on private decisions and completely equitable amongtax’
puy”rr. However, other theorists cLim that national policy objectives such as balance of
puy*”ntt or investment in developing countries should be encouraged through an aclive tax
inientive policy rather than requiring taxes to be neutral and equitable. Most tax systems
compromise between these two viewpoints.
br” *uy to view neutrality is to require that the burden of taxation on each dollar’ euro,
-^,,-.{ ^f nrnfir ^^—,{ in hnme n^rrn!r’ nnerrlinns ht’ an MNE be eqUal tO the bUf-pouiici, uj ycii ui PiuiiL uciiiitru iii itviiiu uvurtrrJ “J *’^ ‘
den of taxation on each currency-equivalent of profit earned by the same firm in its foreign
operations. This is called domeitic ieutrality. A second way to view neutrality is to require
that the tax burden on each foreign subsidiary of the firm be equal to the tax burden on its
competitors in the same country. This is called /o reign neutratity .T\e latter interpretation is
often supported by MNEs because it focuses more on the competitiveness of the individual
firm in individual country-markets.
The issue of tax equiiy is also difficult to define and measure. In theory, an equitable tax
is one that imposes the same total tax burden on all taxpayers who are similarly situated and
located in the same tax jurisdiction. In the case of foreign investment income, the U’ S’
Tieasury argues that sinie the United States uses the nationality principle to claim tax
jurisdiciion,t s.-owned foreign subsidiaries are in the same tax jurisdiction as U.S’ domestic
iubsidiaries. Therefore, a dollar earned in foreign operations should be taxed at the same rate
and paid at the same time as a doiiar earned in domestic operations.
f{atlonal Tsx f; nvircnsnent$
Despite the fundamental objectives of national tax authorities, it is widely agreed that taxes
do affect economic decisioni made by MNEs. Tax treaties between nations’ and differential
tax structures, rates, and practices all result in a less than level playing field for the MNEs
competing on world markets.
bxniUit 14.1 provides an overview of corporate tax rates as applicable to the United
States, Germany, and Japan. Th e eategorrzationi of income (e.g., distributed versus undistrib-
uted profits), the differences in iax raies, and the discrimination in tax raies applicable to
income earned in specific countries serve to introduce the critical dimensions of tax planning
for the MNE.
Nations typically structure their ta,x systenns along one of two basic approaches: the
worldwide approach at the territorial approach. Both approaches are attempts to determine
which firms, fbreign or domestic by inCorporation, or which incomes, foreign or domestic in
origin, are subject to the taxation of host country tax authorities’
Worldwide Approach. Tlte worldwide approach, also referred to as the residential or
national approach,levies taxes on the income earned by firms that are incorporated in the
host couniry-, regardless of where the income rvas earned (domestically or abroad). An MNtr
earning incbme bottr at home and abroad would therefore find its worldwide income taxed
by its host-country tax authorities. For example, a country like the United States taxes the
income earned by firms based in the United States regardless of whether the income
earned by the firm is domestically sourced or foreign sourced. In the case of the United
States, oidinury foreign-sourced income is taxed only as remitted to the parent firm’ As
with all questions of tax. however, numerous conditions and exceptions exist. The primary
problemis that this does not address the income earned by foreign firms operating within
th” Urrit”d States. Countries like the United States then apply the principle of territorial
taxation to foreign firms within their legal jurisdiction, taxing all income earned by foreign
firms in the United States.

388 IrA RT 4 Financing the Global Firm
Taxable lncome Category
Cor[oiate income tax rates
Withholding taxes on dividends (portfolio):
with Japan
with Germany
with United States
Withholding taxes on dividends (substantial holdings):
with Japan
with Germany
with United States
Withholding taxes on interest:
with Japan
with Germany
with United States
Withholding taxes on royalties:
with Japan
with Germany
with United States
Comparison of corporate rax nates io; J;;;;, C”rr”ny,
and the United States
Japan
4i,;l;
15%
1Oo/o
tv70
0/5o/o
10%
10o/o
1Oo/o
Oolo
Germany United States
29.5o/o 40%
15% 5%
5o/o
O/5/ 15o/o
15olo 1a/o
5o/o
O/5/15o/o
10o/o lOo/o
Oo/o
ato/eJ /o
10% O%
Oo/o
0o/o
Source: Coporate income tax rates drawn from “KPMG’S Corpoiate and lndirect Tax Rate Survey, 2008,’ KPMG.com. Tax rates as ol
April 1, 2008. Withholding tax rates extracled from Price Waterhouse Coopers, Corporate Taxes: A Worldwide Summary 2009.
Territorial Approach. The territorial approach. also termed the source approach,focuses on
the income earned by firms within the legal jurisdiction of the host country, not on the
country of firm incorporation. Countries like Germany, that follow the territorial
approach, apply taxes equally to foreign or ‘jor-nesiic firrns on income earned wiihin ihe
country, but in principle not on income earned outside the country. The territorial
approach,like the worldwide approach, results in a major gap in coverage if resident firms
earn income outside the country’, but are nct taxed by the country in which the profits are
earned. In this case, tax authorities extend tax coverage to income earned abroad ifit is not
currently covered by foreign tax jurisdictions. Once again, a mix of the two tax approaches
is necessary for full coverage of income.
Tax Deferral, If the worldwide approach to international taxation is followed to the letter, it
would end the tax-deferral privilege for many MNEs. Foreign subsidiaries of MNEs pay host-
ccuntry corporate income taxes, but many parent couniries defer claiming a,idiiionai inc,cine
taxes on that foreign-source income until it is remitted to the parent firm. For example, U.S.
corporate income taxes on some types of foreign-source income of U.S.-owned subsidiaries
incorporated abroad are deferred until the earnings are remitted to the U.S. parent. How-
ever, the ability to defer corporate income taxes is highly restricted and has been the subject
of many of the tax law changes in the past three decades.
The deferral privilege was challenged once again in the2004 U.S. presidential campaign by
Senator Kerry the Democratic candidate for President. Senator Kerry claimed that tax deferrals
create an incentive for outsourcing abroad-so called offshoring-of certain manufacturing

CH/\PT ER 1 4 MultinationalTax Management
and service activities by U.S. firms. The added concern to the potential loss of American jobs
was the potential reduction in tax collections in the United States, enlarging the already siz-
able U.S. government’s fiscal deficit.
Tax Treaties
A network of bilateral tax treaties, many of which are modeled after one proposed by the
Organization for Economic Cooperation and Development (OECD), provides a means of
reducing double taxation. Tax treaties normally define whether taxes are to be imposed on
income earned in one country by the nationals of another, and if so, how. Tax treaties are
bilateral, with the two signatories specifying what rates are applicable to which types of
income between themselves alone. Exhibit 14.1’s specification of withholding taxes on divi-
dends, interest, and royalty payments between resident corporations of the United States,
Germany, and Japan, is a classic example of the structure of tax treaties. Note that Germany,
for example, imposes a10″/o withholding tax on royalty payments to Japanese investors, while
royalty payments to U.S. investors are withheld at a 0o/o rate.
The individual bilateral tax jurisdictions as specified through tax treaties are particularly
important for firms that are primarily exporting to another country rather than doing busi-
ness there through a “permanent establishment.” The latter would be the case for manufac-
turing operations. A firm that only exports would not want any of its other worldwide income
taxed by the importing country. Tax treaties define what is a “permanent establishment” and
what constitutes a limited presence for tax purposes. Tax treaties also typically result in
reduced’withholding tax rates between the two signatory countries, the negotiation of the
treaty itself serving as a forum for opening and expanding business relationships between the
two countries.
Tax “f-ypes
Taxes are classified on the basis of whether they are applied directly to income, called direct
taxes, or on the basis of some other measurable performance characteristic of the firm,
called indirect taxes. Exhibit 14.2 illustrates the wide range of corporate income taxes in the
world today.
lncome Tax. Many governments rely on income taxes, both personal and corporate, for their
primary revenue source. Corporate income taxes are widely used today. Some countries
impose different corporate tax rates on distributed income versus undistributed income. Cor-
porate income tax rates vary over a relatively wide range, rising as high as 45% in Guyana
and falling as low as 160/” in Hong Kong, 157″ in the British Virgin Islands, 10% in Cyprus,
and effectively 0% in a number of offshore tax havens.
Withholding Tax. Passive income (dividends, interest, royalties) earned by a resident of one
country within the tax jurisdiction of a second country are normally subject to a withholding
tax in the second country. The reason for the institution of withholding taxes is actually quite
simple: governments recognize that most international investors will not file a tax return in
each country in which they invest, and the government therefore wishes to assure that a min-
imum tax payment is received. As the term “withholding” implies, the taxes are withheld by
the corporation from the payment made to the investor, and the taxes withheld are then
turned over to government authorities. Withholding taxes are a major subject of bilateral tax
treaties, and generally range between 0 and 25o/o .
Value’Added Tax. One type of tax that has achieved great prominence is the value-added
tax.The value-added tax is a type of national sales tax collected at each stage of production
or sale of consumption goods in proportion to the value added during that stage. In general,
389
5

390 PA R-f 4 Financing the Global Firm
Corporate lncome Tax Rates for Selected Countries
Rate Country Rate
Gibraltar
Greece
Guatemala
Honduras
9o,nl_ry,
Albania
Angola
Argentina
Armenia
Aruba
. Australia
Austria
Bahamas
Bahrain
Bangladesh
Barbados
Belarus
Belgium
Bermuda
Bolivia
1Oo/o
35o/o
35%
20o/o
28o/o
30%
25o/o
0o/o
Oo/o
27.5o/o
25o/o
24a/o
33.99o/o
o%
25o/o
1Oo/o
25Yo
34%
10%
20o/o
31 .0o/o
0%
17%
25Vo
33%
30%
2Oo/o
1Oo/o
19o/o
aao/
25o/o
25o/s
2Oo/o
21o/o
29o/o
26%
33.33%
29.41o/o
22o/o
244/o
31o/o
25o/o
16.s%
19%
1Bo/o
QQ OOo/^
25o/o
25%
12.5%
Oo/o
tRo/^
31 .4%
33.33o/o
40.69%
0%
QEO/
20%
o A Do/^
15%
I C”/o
4Ooio
15o/o
28.59Yo
12%
10o/o
25o/a
35%
1So/a
3oo/o
9o/o
32%
t E Fo/^
34.54/o
3oa/a
3Oo/o
29o/o
_ _co!.!lry
Oman
Pakistan
Panama
12o/o
35%
27.5%
30%
10%
3oo/o
3Ao/o
19o/o
25o/o
10%
16%
20%
27%
2Ao/o
1Oo/o
17o/o
1o0/^
2Ao/o
Rate
Bosnia and Heaegovina
Botswana
Brazil
Bulgaria
Cambodia
Canada
Cayman islands
Chile
China
Colombia
Costa Rica
Croatia
Cyprus
Czech Republic
Denmark
Dominican Republic
Ecuador
Forrnf
Estonia
Ftti
Finland
France
Germany
Hong Kong
Hungary
lceland
lndia
lndonesia
lran
lreland
lsle of Man
lsrael
Italy
Jamaica
Japan
Jersey
Jordan
Kazakhstan
Korea, Republic of
Papua New Guinea
Paraguay
Peru
Philippines
Poland
Poftugal
Qatar
Romania
Russia
Samoa
Saudi Arabia
Serbia
Singapore
Slovak Bepublic
Siovenia
South Africa
Spain
Sri Lanka
Sweden
Switzerland
Syria
Taiwan
Tanzania
Thailand
Tunisia
Turkey
Ukraine
United Arab Emirates
United Kingdom
United States
Uruguay
Venezuela
Vietnam
Yernen
Zambia
Zimbabwe
Kuwait
Latvia
Libya
Lithuania
Luxembourg
Macau
Macedonia
Malaysia
Malta
Mauritius
Mexico
Montenegro
Mozambique
Nethedands
Netherlands Antilles
New Zealand
Nigeria
Norway
34.55%
3Oo/o
354/o
26.3%
21 .1770
29o/a
17%
30o/”
3oo/o
30%
20o/o
25o/o
55o/o
28a/o
4Ao/o
25o/o
34a/o
25o/o
35o/o
35o/o
25.750/o
Sorirce: “KPlrlG s Corporate and lndkecl Tax Rate Suruey 2010,,’ KpMG.co m, ep. 12-14.

production goods such as plant and equipment have not been subject to the value-added
tax’
Certain basic necessities, such as mediiines and other health-related expenses’ education
and
religious activities, a.rd ihe postal service are usually exempt or taxed at lower rates’
The
value-added tax has been adopted as the main source of revenue from indirect taxation
by all
members of the European tinion, most other countries in Western Europe, a number
of
Latin American countiies, canada, and scattered other countries. A numerical example of
a
value-added tax computation is shown in Exhibit 14’3′
Other National Taxes. There are a variety of other national taxes, which vary in importance
from country to country. The turnover tax (taxon the purchase or sale of securities in some
country stock markets) and the tsx on undistributed profits were mentioned before’
Propeity and inheritanc’e taxes,also termed transfer taxes,ate imposed in a variety of ways
to aihieve intended social redistribution of income and wealth as much as to raise revenue’
There are a number of red-tape charges for public services that are in reality user taxes’
Sometimes foreign exchange purchas& or sales are in effect hidden taxes inasmuch
as the
government earns revenuJrutn”t than just regulates imports and exports for balance
of
payments reasons.
Foreign Tax Credits. To prevent double taxation of the same income, most countries
grant a
forei{n tux creditfor income taxes paid to the host country.
Countries differ on how-they chl-
“utate
the foreign tax credit and what kinds of limitations they place on the total dmount
claimed. Normally foreign tax credits are also available for withholding taxespaid to other
countries on dividends,”royaities, intetest, and other income remitted to the parent’
The
value-added tax and other sales taxes are not eligible for a foreign tax creditbut are typically
deductible from pretax income as an expense.
CHAPTER 1 4 MultinationalTax Management
Value-Added Tax Applied to the Sale of a Wooden Fence Post
This is an example of how a wooden fence post would be assessed for value-added
taxes in the course of its
production and subsequent sale. A value-added tax of loyo is assumed’
Step 1
Step 2
Sales Price Value Added
Value-Added Cumulalive
Tax at 10% Value-Added Tax
391
So.oZ
$0.04
$o’os
$o oB
Stage of Production
Tree owner
Lumber mill
Lumber wholesaler
Lumber retailer
The original tree owner sells to the lumber mill, for $0 20, that part of a tree that ultimately
becomls the fence post. The grower has added $0.20 in value up to this
point by planting
and raising ihe tree. while collJcting $0,20 from the lumber mill, the grower must sel
aside
$0.02 to pay the value-added tax to the government
The lumber mill processes the tree into fence posts and sells each post for $O’+O to the
lum-
ber wholesaler. ihe lumber mill has added $O.ZO in value ($0,40 less $0 20) through its
pro-
cessing activities. Therefore, the lumber mill owner must set aside $0.o2 io pay the
mill’s
value-idded tax to the government. in practice, the owner would probrably calculate
the mill3
t* flnifity
“r
i0% of Sd.40, or $0.04, with a tax credit of $0.02 for the value-added tax
already paid by the tree owner’
steps 3 and 4 The lumber wholesaler and retailer also add value to the fence post through their selling and
distribution activities. They are assessed $0.01 and $0.03 respectively, making the
cumulative
value-added iax collected by the government $0.08, or 10% of the final sales
price.
$0.20
$0.40
$0.20
$0.20
$0.10
$0.30
$0.02
$0.02
$o.ot
$0.03
$0.50
$0.80

392 PA RT 4 Financing the Global Firm
Foreign Tax Credits
Without loreign
tax credits
With foreign
tax credits
Before{ax foreign income
Less foreign tax @ 30%
Available to parent and paid as dividend
Less additional parent-country tax at 35%
Less incremental tax (after credits)
Profit after all taxes
Total taxes, both jurisdictions
Effective overall tax rate (total taxes paid + foreign income)
$10,000
-3,000
$10,000
-3,000
$ 7,000
*2,450
$ 7,000
-500
$ 4,550
$ 5,450
$ 6,500
$ 3,500
54.Se/o 35.Oo/o
A tax credit rs a direct reduction of taxes that would otherwise be due
and payable’ It differs
from a deductible expense,which is an expense used to reduce
taxable income before the tax
rate is applied. A $100 tax credit reduces taxes payable by the.fuU $100′ whereas
a $100
deductible expense reduces taxable income by $100 and taxes
payable by $100 X t’ wiere / is the
tax rate. Thx credits are more valuable on a dollar-for-dollar basis
than are deductible expenses’
If there were no credits for foreign taxes paid, sequential taxation by the host
govern-
ment and then by the home government would result in a very high
cumulative tax rate’ To
illustrate, assume the wholly 6wned foreign subsidiary of an MNE
earns $10’000 before local
income taxes and puy, u Olnia”nd equal tJ at of its after-tax income’The
host country income
tax rate is 30%, and the home countiy of the parent tax rate ifll:’assuming no
withholding
taxes.Total taxation with and without tax credits is shown in
Exhibit 14’4′
If tax credi.ts ur” ,roi utto*ed, sequential levying olboth a 307o host
country tax and then a
35% home country tax on the income that remains results in an
effective 54’5% tax’ a cumula-
tive rate that would render many MNEs uncompetitive with single-country
local firms’ The
effect of allowing tax credits is to tlmit total taxation on the original
before-tax income to no
more than ttre trlgrrest single rate among jurisdictions. In the
case depicted in Exhibit 1’4’4’the
effective overall tax rate of 35o/o with foreign tax credits is equivalent
to the higher tax rate of
the home country (and is the tax rate payable if the income had
been earned at home)’
The $500 of additional home country tax under the tax
credit system in Exhibit 14’4 is the
amount needed to urlog;ul taxation i$:,ooo already paid plus.the additional $500)
up to
but not beyond 35% of lhe original $10,000 of before-tax foreign
income’
Traxrsfer Fricing
The pricing of goods, services, and technology tralsferred to
a foreign subsidiary from an
affiliated company, t*rtl”r pridng, is the first-and foremost method of transferring
funds out
of a foreign subsidiary.Tirese costJenter directly into the cost
of goods sold component of the
subsidiary’s income statement.This is a particularly sensitive
problem for MNEs’ Even purely
domestic firms find it difficutt to reach agreement on the best
method for setting prices on
transactions betrveen related units. In the multinational case,
managers must balance conflict-
ingconsiderations.Theseincludefundpositioningandincometaxes.
* Fund Positioning Effect. A parent wishing to transfer funds out of a particular country
can
charge higher prices on goods sola to its subsidiary in that country-to
the degree that govern-
ment regulations attori. A foreign subsidiary can be financed by the reverse
technique’

Turn in your highest-quality paper
Get a qualified writer to help you with

“ Instruments ”

Get high-quality paper

Guarantee! All work is written by expert writers!

Still stressed from student homework?

Get quality assistance from academic writers!

Order now