Chapter 20 - Financial Management in the International Business

Chapter 20
Financial Management in the International Business
True / False Questions
1. (p. 676) Investment decisions, in international business, are decisions about how to finance a
firm's activities.
FALSE

Difficulty: Medium

2. (p. 676) In international business, money management decisions are decisions about how to
manage the firm's financial resources most efficiently.
TRUE

Difficulty: Easy

3. (p. 676) In an international business, investment, financing and money management decisions
are complicated by the fact that countries have different currencies.
TRUE

Difficulty: Easy

4. (p. 676) Good financial management can be an important source of competitive advantage.
TRUE

Difficulty: Easy

5. (p. 677) Capital budgeting quantifies the benefits, costs and risks of an investment.
TRUE

Difficulty: Medium

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6. (p. 677) Capital budgeting for a foreign project does not use the same theoretical framework
that domestic capital budgeting uses.
FALSE

Difficulty: Medium

7. (p. 677) If the net present value of the discounted cash flows is slightly less than zero, the firm
should go ahead with the project.
FALSE

Difficulty: Medium

8. (p. 678) The problem of blocked earnings is much more serious than it was previously.
FALSE

Difficulty: Easy

9. (p. 678) When using capital budgeting techniques to evaluate a potential foreign project, cash
flows to the project and cash flows to the parent must be considered as one.
FALSE

Difficulty: Medium

10. (p. 678) Stockholders do not perceive blocked earnings as contributing to the value of the
firm and creditors do not count them when calculating the parent's ability to service its debt.
TRUE

Difficulty: Medium

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11. (p. 678-679) In recent decades, the risk of outright expropriations has become almost zero.
TRUE

Difficulty: Easy

12. (p. 679) Political risk assessment is more art than science.
TRUE

Difficulty: Easy

13. (p. 680) In practice, the biggest problem arising from economic mismanagement has been
rising interest rates.
FALSE

Difficulty: Medium

14. (p. 680) Empirical studies show that there is a long-run relationship between a country's
relative inflation rates and changes in exchange rates.
TRUE

Difficulty: Easy

15. (p. 680) Surveys of actual practice within multinationals suggest that the practice of revising
future cash flows downward is more popular than that of revising the discount rate upward.
FALSE

Difficulty: Hard

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16. (p. 681) The cost of capital is typically lower in the global capital market, by virtue of its size
and liquidity, than in many domestic capital markets.
TRUE

Difficulty: Easy

17. (p. 681) The amount of local currency required to meet interest payments and retire principal
on local debt obligations is not affected when a country's currency depreciates.
TRUE

Difficulty: Medium

18. (p. 681) In capital budgeting decisions, the discount rate should be revised upward if a
foreign government offers foreign firms low-interest loans, lowering the cost of capital.
FALSE

Difficulty: Medium

19. (p. 681) Different tax regimes determine the relative attractiveness of debt and equity in a
country.
TRUE

Difficulty: Medium

20. (p. 682) Efficient money management involves minimizing cash balances and reducing
transaction costs.
TRUE

Difficulty: Easy

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21. (p. 682) Money market accounts offer a higher rate of interest than longer-term financial
instruments like certificates of deposit.
FALSE

Difficulty: Medium

22. (p. 682) Every time a firm changes cash from one currency into another currency it must bear
a transaction cost.
TRUE

Difficulty: Easy

23. (p. 682) According to the United Nations, less than 10 percent of international trade involves
transactions between the different national subsidiaries of transnational corporations.
FALSE

Difficulty: Medium

24. (p. 683) In the United States, the average effective corporate income rate is 35 percent.
FALSE

Difficulty: Medium

25. (p. 683) A tax treaty between two countries is an agreement specifying what items of income
will be taxed by the authorities of the country where the income is earned.
TRUE

Difficulty: Easy

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26. (p. 683) A deferral principle specifies that parent companies are not taxed on foreign source
income until they actually receive a dividend.
TRUE

Difficulty: Easy

27. (p. 684) U.S. regulations tax U.S. shareholders on the firm's overseas income when it is
earned, regardless of when the parent company in the United States receives it.
TRUE

Difficulty: Medium

28. (p. 684) The practice of unbundling refers solely to the use of royalty payments and fees to
transfer liquid funds across borders.
FALSE

Difficulty: Medium

29. (p. 684) Fronting loans is the most common method by which firms transfer funds from
foreign subsidiaries to the parent company.
FALSE

Difficulty: Medium

30. (p. 685) A fee is compensation for professional services or expertise the parent company or
another subsidiary supplies to a foreign subsidiary.
TRUE

Difficulty: Easy

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31. (p. 685) Dividends have certain tax advantages over royalties and fees, particularly when the
corporate tax rate is higher in the host country than in the parent's home country.
FALSE

Difficulty: Medium

32. (p. 685) The price at which goods and services are transferred between entities within the
firm is referred to as the transfer price.
TRUE

Difficulty: Easy

33. (p. 686) Transfer pricing is consistent with a policy of treating each subsidiary in the firm as
a profit center.
FALSE

Difficulty: Medium

34. (p. 686-687) In a fronting loan, the parent company lends cash directly to the foreign
subsidiary and the subsidiary repays it later.
FALSE

Difficulty: Easy

35. (p. 687) A fronting loan does not provide any tax advantage.
FALSE

Difficulty: Easy

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36. (p. 687) Fronting loans can circumvent host-country restrictions on the remittance of funds
from a foreign subsidiary to the parent company.
TRUE

Difficulty: Easy

37. (p. 688) In general, firms prefer each foreign subsidiary to hold its own cash balances.
FALSE

Difficulty: Medium

38. (p. 688) By holding cash at a centralized depository, the firm may be able to invest its cash
reserves more efficiently.
TRUE

Difficulty: Easy

39. (p. 689) Multilateral netting compounds the transaction costs that arise when many
transactions occur between a firm and its subsidiaries.
FALSE

Difficulty: Medium

40. (p. 689) Multilateral netting is an extension of bilateral netting.

TRUE

Difficulty: Easy

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Multiple Choice Questions

41. (p. 676) In international business, decisions about what activities to finance are best known
as
A. Investment decisions
B. Financing decisions
C. Money management decisions
D. Economic decisions

Difficulty: Medium

42. (p. 676) Theses are decisions about how to manage the firm's financial resources most
efficiently.
A. Investment decisions
B. Financing decisions
C. Money management decisions
D. Economic decisions

Difficulty: Easy

43. (p. 676) In international business, financing decisions are

A. Decisions about what activities to finance
B. Decisions about how to finance a firms activities
C. Decisions about how to manage the firm's financial resources most efficiently
D. Decisions about the operational activities of a firm

Difficulty: Easy

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44. (p. 676) Good financial management can help a firm in all of the following ways, except
A. Reduce the costs of creating value
B. Add value by improving customer service
C. Reduce the firm's cost of capital
D. Totally eliminate the firm's tax burden

Difficulty: Medium

45. (p. 677) _____ can best help financial manager in an international business to quantify the
various benefits, costs and risks that are likely to flow from an investment in a given location.
A. Operational techniques
B. Capital budgeting techniques
C. Socio-economic techniques
D. Production techniques

Difficulty: Hard

46. (p. 677) Capital budgeting

A. In practice is a very simple and perfect process
B. Techniques are not useful for quantifying the benefits, costs and risks of an investment
C. For a foreign project uses the same theoretical framework that domestic capital budgeting
uses
D. Techniques, for evaluating potential foreign projects, do not require the firm to recognize
the specific risks arising from its foreign location

Difficulty: Hard

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47. (p. 677) Identify the incorrect statement regarding cash flows that a firm must estimate, to
decide if it should go ahead with a project.
A. In most cases, the cash flows will be negative at first, because the firm will be investing
heavily in production facilities
B. After some initial period the cash flows becomes positive as investment costs decline and
revenues grow
C. Once the cash flows have been estimated, they must be discounted to determine their net
present value using an appropriate discount rate
D. If the net present value of the discounted cash flows is less than zero, the firm should go
ahead with the project

Difficulty: Hard

48. (p. 678) All of the following are factors complicating the capital budgeting process for an
international business except
A. A distinction must be made between cash flows to the project and cash flows to the parent
company
B. Cash flows to the project and to the parent company will be the same when a host-country
government blocks the repatriation of cash flows from a foreign investment
C. Political and economic risks, including foreign exchange risk, can significantly change the
value of a foreign investment
D. The connection between cash flows to the parent and the source of financing must be
recognized

Difficulty: Hard

49. (p. 678) Restrictions on a project, because of which a firm may not be able to remit all its
cash flows to the parent company,
A. Do not affect the net present value of the project to the parent company
B. Do not affect the net present value of the project itself
C. Do not limit the cash flows of the parent company in any manner
D. Establishes the fact that a foreign project need not be analyzed from the perspective of the
parent company

Difficulty: Hard

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50. (p. 678) Which of the following statements is not true about government restrictions that
block earnings from a foreign project?
A. The problem of blocked earnings is now much more serious than before
B. Greater acceptance of free market economics has reduced the number of countries in which
governments are likely to block earnings
C. Firms have a number of options for circumventing host-government attempts to block the
free flow of funds from an affiliate
D. Stockholders do not perceive blocked earnings as contributing to the value of the firm

Difficulty: Hard

51. (p. 678) Identify the incorrect statement regarding political risk.
A. It can be defined it as the likelihood that political forces will cause drastic changes in a
country's business environment that hurt the profit and other goals of a business
B. It tends to be greater in countries where the underlying nature of the society makes the
likelihood of social unrest high
C. When political risk is high, there is a high probability that a change will occur in the
country's political environment that will endanger foreign firms there
D. In most cases, political change may result in the expropriation of foreign firms' assets

Difficulty: Medium

52. (p. 679) Political risk assessment

A. Is without value
B. Is more science than art
C. Tries to predict a future that can only be guessed
D. Usually makes correct future predictions

Difficulty: Medium

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53. (p. 680) In practice, the biggest problem arising from economic mismanagement has been
A. Blocked earnings
B. Inflation
C. Economic collapse
D. The outright expropriations of foreign firms' assets

Difficulty: Easy

54. (p. 680) Historically, many governments have expanded their domestic money supply in
misguided attempts to stimulate economic activity. The result has often been
A. Price inflation
B. Low interest rates
C. A strong local currency
D. Private sector growth

Difficulty: Easy

55. (p. 680) The relationship between a country's relative inflation rates and changes in exchange
rates is,
A. Much closer than what theory would predict
B. Not reliable in the short run
C. Totally reliable in the long run
D. According to empirical studies, non existent in the long run

Difficulty: Medium

56. (p. 680) Adjusting discount rates to reflect a location's riskiness

A. Is not widely practiced by firms
B. Treats all risk as a single problem
C. Penalizes distant cash flows too heavily
D. Does not penalize early cash flows enough

Difficulty: Hard

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57. (p. 680) One method of analyzing a foreign investment opportunity is to treat all risk as a
single problem by adjusting the discount rate applicable. For countries with significant
political and economic risks, the
A. Discount rates are revised upward
B. Discount rates are revised downward
C. Early cash flows are not adjusted
D. Distant cash flows are heavily penalized

Difficulty: Medium

58. (p. 681) For firm's seeking external financing for a project, the cost of capital is typically
lower in
A. Global capital markets
B. Domestic capital markets
C. Small markets
D. Relatively illiquid markets

Difficulty: Easy

59. (p. 681) In capital budgeting decisions, the discount rate must be adjusted downward
A. In countries where liquidity is limited
B. When the cost of capital used to finance a project is high
C. In countries where governments offer foreign firms low-interest loans
D. In countries where the perceived political and economic risks are greater

Difficulty: Medium

60. (p. 681) Identify the incorrect statement pertaining to financial structures.
A. The financial structures of firms are remarkably similar across countries
B. It can be described as the mix of debt and equity used to finance a business
C. Different tax regimes determine the relative attractiveness of debt and equity in a country
D. An international business should adopt a financial structure for each foreign affiliate that
minimizes its cost of capital

Difficulty: Medium

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61. (p. 681) This is defined as the mix of debt and equity used to finance a business.
A. Portfolio analysis
B. Investment ratio
C. Balance sheet
D. Financial structure

Difficulty: Easy

62. (p. 682) _____ decisions attempt to manage a firm's working capital most efficiently.
A. Investment
B. Money management
C. Portfolio
D. Organization structure

Difficulty: Easy

63. (p. 682) The commission fee a firm pays to foreign exchange dealers for changing cash from
one currency into another currency is known as
A. Foreign exchange tax
B. Transfer fee
C. Transaction cost
D. Conversion tax

Difficulty: Easy

64. (p. 682) These are the charges that most banks take for moving cash from one location to
another.
A. Currency taxes
B. Location fee
C. Exchange charges
D. Transfer fee

Difficulty: Easy

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65. (p. 683) Which of the following observations is true?

A. Japan has the lowest corporate income tax rate
B. Ireland has a relatively high corporate income tax rate
C. Japan has the highest tax rate on dividends
D. France has a relatively high tax rate on dividends

Difficulty: Hard

66. (p. 683) This occurs when both the host-country government and the parent company's home
government tax the income of a foreign subsidiary.
A. Double taxation
B. Tax duplication
C. Tax discrepancy
D. Indirect taxation

Difficulty: Easy

67. (p. 683) A _____ allows an entity to reduce the taxes paid to the home government by the
amount of taxes paid to the foreign government.
A. Tax treaty
B. Tax credit
C. Deferral principle
D. Tax benefit

Difficulty: Easy

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68. (p. 683) A tax treaty

A. Allows an entity to reduce the taxes paid to the home government by the amount of taxes
paid to the foreign government
B. Directs both the host-country government and the parent company's home government to
tax the income of a foreign subsidiary
C. Between two countries is an agreement specifying what items of income will be taxed by
the authorities of the country where the income is earned
D. Specifies that parent companies are not taxed on foreign source income until they actually
receive a dividend

Difficulty: Medium

69. (p. 683) Which of the following specifies that parent companies are not taxed on foreign
source income until they actually receive a dividend?
A. Tax treaty
B. Tax credit
C. Deferral principle
D. Tax benefit

Difficulty: Easy

70. (p. 684) A tax haven

A. Allows an entity to reduce the taxes paid to the home government and those paid to foreign
governments
B. Directs both the host-country government and the parent company's home government not
to tax the income of a foreign subsidiary
C. Specifies that parent companies are not taxed on foreign source income until they actually
receive a dividend
D. Is a country with an exceptionally low or even no, income tax

Difficulty: Easy

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71. (p. 684) By using a mix of techniques to transfer liquid funds from a foreign subsidiary to the
parent company, _____ allow(s) an international business to recover funds from its foreign
subsidiaries without piquing host-country sensitivities with large "dividend drains."
A. Unbundling
B. Tax treaties
C. The deferral principle
D. Tax havens

Difficulty: Medium

72. (p. 684-685) Which of the following represents the remuneration paid to the owners of
technology, patents or trade names for the use of that technology or the right to manufacture
and/or sell products under those patents or trade names?
A. Trademarks
B. Royalties
C. Copyrights
D. Patents

Difficulty: Medium

73. (p. 685) Identify the incorrect statement about royalties and fees.
A. Royalties may be levied as a fixed monetary amount per unit of the product the subsidiary
sells or as a percentage of a subsidiary's gross revenues
B. A fee is compensation for professional services or expertise the parent company or another
subsidiary supplies to a foreign subsidiary
C. Royalties may be differentiated into "management royalties" for general expertise and
advice and "technical assistance royalties" for guidance in technical matters
D. Royalties and fees are often tax-deductible locally, so arranging for payment in royalties
and fees will reduce a foreign subsidiary's tax liability

Difficulty: Medium

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74. (p. 685) The price at which goods and services are transferred between entities within the
firm is referred to as
A. Transfer tax
B. Service tax
C. Service charges
D. Transfer price

Difficulty: Easy

75. (p. 685) All of the following are gains that can be derived by manipulating transfer prices,
except
A. A firm can reduce its tax liabilities by shifting earnings from a high-tax country to a lowtax one
B. A firm can move funds out of a country where a significant currency devaluation is
expected, thereby reducing its exposure to foreign exchange risk
C. Funds can be moved by a firm from a subsidiary to the parent company when financial
transfers in the form of dividends are blocked by host-country government policies
D. If there are high transfer prices on goods or services being imported into the country, a firm
can reduce the import duties it must pay when an ad valorem tariff is in force

Difficulty: Hard

76. (p. 686) This is a loan between a parent and its subsidiary channeled through a financial
intermediary, usually a large international bank.
A. International loan
B. Fronting loan
C. Transfer loan
D. Unbundling loan

Difficulty: Easy

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77. (p. 686-687) Which of the following is not an advantage of a fronting loan?
A. They help a multinational to make a direct intrafirm loan, where the parent company lends
cash directly to the foreign subsidiary and the subsidiary repays it later
B. They can circumvent host-country restrictions on the remittance of funds from a foreign
subsidiary to the parent company
C. They can be used by multinationals to lend funds to a subsidiary based in a country with a
fairly high probability of political turmoil that might lead to restrictions on capital flows
D. They can also provide tax advantages to international businesses

Difficulty: Hard

78. (p. 688) In general, firms prefer to hold cash balances at a centralized depository for all of
the following reasons except
A. By pooling cash reserves centrally, the firm can deposit larger amounts
B. It enables the firm to invest a larger amount of cash reserves in short-term, highly liquid
financial instruments that earn a lower interest rate
C. If the centralized depository is located in a major financial center, it has access to
information about good short-term investment opportunities that the typical foreign subsidiary
would lack
D. The firm can reduce the total size of the cash pool it must hold in highly liquid accounts

Difficulty: Hard

79. (p. 689) A French subsidiary owes a Mexican subsidiary $6 million and the Mexican
subsidiary simultaneously owes the French subsidiary $4 million. Through a mutual
settlement a single payment of $2 million is made from the French subsidiary to the Mexican
subsidiary, the remaining debt being canceled. This example best exemplifies
A. Bilateral netting
B. A transfer loan
C. Unbundling
D. A fronting loan

Difficulty: Hard

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80. (p. 689) This allows a multinational firm to reduce the transaction costs that arise when many
transactions occur between its subsidiaries.
A. Unbundling
B. Deferral principle
C. Fronting loan
D. Multilateral netting

Difficulty: Easy

Essay Questions
81. (p. 676) Identify the main sets of related decisions included within the scope of financial
management in the international business.
Three sets of related decisions, included within the scope of financial management are:
Investment decisions, decisions about what activities to finance.
Financing decisions, decisions about how to finance those activities.
Money management decisions, decisions about how to manage the firm's financial resources
most efficiently.

Difficulty: Easy

82. (p. 676) What is the role of investment, financing and money management decisions in an
international business?
In an international business, investment, financing and money management decisions are
complicated by the fact that countries have different currencies, different tax regimes,
different regulations concerning the flow of capital across their borders, different norms
regarding the financing of business activities, different levels of economic and political risk
and so on. Financial managers must consider all these factors when deciding which activities
to finance, how best to finance those activities, how best to manage the firm's financial
resources and how best to protect the firm from political and economic risks. Good financial
management can be an important source of competitive advantage.

Difficulty: Medium

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83. (p. 677) What is capital budgeting?

Capital budgeting quantifies the benefits, costs and risks of an investment. This enables top
managers to compare, in a reasonably objective fashion, different investment alternatives
within and across countries so they can make informed choices about where the firm should
invest its scarce financial resources. In capital budgeting a firm must first estimate the cash
flows associated with the project over time. In most cases, the cash flows will be negative at
first, because the firm will be investing heavily in production facilities. After some initial
period, however, the cash flows will become positive as investment costs decline and
revenues grow. Once the cash flows have been estimated, they must be discounted to
determine their net present value using an appropriate discount rate.

Difficulty: Medium

84. (p. 678) What are the factors complicating the process of capital budgeting for an
international business?
Capital budgeting is in practice a very complex and imperfect process. Following are the
factors complicating the process for an international business: 1. A distinction must be made
between cash flows to the project and cash flows to the parent company. 2. Political and
economic risks, including foreign exchange risk, can significantly change the value of a
foreign investment. 3. The connection between cash flows to the parent and the source of
financing must be recognized.

Difficulty: Medium

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85. (p. 678) Should foreign project be analyzed from the perspective of the parent company?
A theoretical argument exists for analyzing any foreign project from the perspective of the
parent company because cash flows to the project are not necessarily the same thing as cash
flows to the parent company. The project may not be able to remit all its cash flows to the
parent for a number of reasons. Cash flows may be blocked from repatriation by the hostcountry government, they may be taxed at an unfavorable rate or the host government may
require a percentage of cash flows generated from the project be reinvested within the host
nation. While these restrictions don't affect the net present value of the project itself, they do
affect the net present value of the project to the parent company because they limit the cash
flows that can be remitted to it from the project.

Difficulty: Hard

86. (p. 678-679) What are political risks? Why must a company evaluating foreign investment
opportunities consider the political risks that stem from the foreign location?
Political risk can be defined as the likelihood that political forces will cause drastic changes in
a country's business environment that hurt the profit and other goals of a business enterprise.
When political risk is high, there is a high probability that a change will occur in the country's
political environment that will endanger foreign firms there. In extreme cases, political
change may result in the expropriation of foreign firms' assets. It may also result in economic
collapse, which can render a firm's assets worthless. In less extreme cases, political changes
may result in increased tax rates, the imposition of exchange controls that limit or block a
subsidiary's ability to remit earnings to its parent company, the imposition of price controls
and government interference in existing contracts.

Difficulty: Medium

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87. (p. 680) What is economic risk? How does it affect international businesses?
Economic risk can be defined as the likelihood that economic mismanagement will cause
drastic changes in a country's business environment that hurt the profit and other goals of a
business enterprise.
The biggest problem arising from economic mismanagement has been inflation. Price
inflation is reflected in a drop in the value of a country's currency on the foreign exchange
market. This can be a serious problem for a foreign firm with assets in that country because
the value of the cash flows it receives from those assets will fall as the country's currency
depreciates on the foreign exchange market. The likelihood of this occurring decreases the
attractiveness of foreign investment in that country.

Difficulty: Medium

88. (p. 680) In analyzing a foreign investment opportunity, how can the additional risk that stems
from its location be handled?
The additional risk that stems from location can be handled in at least two ways. The first
method is to treat all risk as a single problem by increasing the discount rate applicable to
foreign projects in countries where political and economic risks are perceived as high. The
higher the discount rate, the higher the projected net cash flows must be for an investment to
have a positive net present value. The second method revises future cash flows downward.
This method, rather than using a higher discount rate to evaluate risky projects, which
penalizes early cash flows too heavily, revises future cash flows from the project downward to
reflect the possibility of adverse political or economic changes sometime in the future.

Difficulty: Hard

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89. (p. 681) What are the factors a firm considers while externally financing for a project?
If the firm is going to seek external financing for a project, it will want to borrow funds from
the lowest cost source of capital available. Firms increasingly are turning to the global capital
market to finance their investments. The cost of capital is typically lower in the global capital
market, by virtue of its size and liquidity, than in many domestic capital markets, particularly
those that are small and relatively illiquid.
However, despite the trends towards deregulation of financial services, in some cases hostcountry government restrictions may rule out this option. In addition to the impact of hostgovernment policies on the cost of capital and financing decisions, the firm may wish to
consider local debt financing for investments in countries where the local currency is expected
to depreciate on the foreign exchange market.

Difficulty: Hard

90. (p. 681) Define financial structure. Is it the same across various countries, if not why?
Financial structure can be defined as the mix of debt and equity used to finance a business.
There is a difference in the financial structures of firms based in different countries. It is not
clear why the financial structure of firms varies so much across countries. One possible
explanation is that different tax regimes determine the relative attractiveness of debt and
equity in a country. However, according to empirical research, country differences in financial
structure do not seem related in any systematic way to country differences in tax structure.
Another possibility is that these country differences may reflect cultural norms. This
explanation may be valid, although the mechanism by which culture influences capital
structure has not yet been explained.

Difficulty: Medium

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91. (p. 682) Should international businesses conform to local capital structure norms?
One advantage claimed for conforming to host-country debt norms is that management can
more easily evaluate its return on equity relative to local competitors in the same industry.
However, this seems a weak rationale for what is an important decision. Another point often
made is that conforming to higher host-country debt norms can improve the image of foreign
affiliates that have been operating with too little debt and thus appear insensitive to local
monetary policy. Just how important this point is, however, has not been established. The best
recommendation is that an international business should adopt a financial structure for each
foreign affiliate that minimizes its cost of capital, irrespective of whether that structure is
consistent with local practice.

Difficulty: Easy

92. (p. 682) What are cash balances? Why are they important for a firm?
For any given period, a firm must hold certain cash balances. This is necessary for serving
any accounts and notes payable during that period and as a contingency against unexpected
demands on cash. A firm typically invests its cash reserves in money market accounts so it can
earn interest on them. However, it must be able to withdraw its money from those accounts
freely. Such accounts typically offer a relatively low rate of interest. In contrast, the firm
could earn a higher rate of interest if it could invest its cash resources in longer-term financial
instruments. The problem with longer-term instruments, however is that the firm cannot
withdraw its money before the instruments mature without suffering a financial penalty.
Thus, the firm faces a dilemma. If it invests its cash balances in money market accounts, it
will have unlimited liquidity but earn a relatively low rate of interest. If it invests its cash in
longer-term financial instruments, it will earn a higher rate of interest, but liquidity will be
limited. In an ideal world, the firm would have minimal liquid cash balances.

Difficulty: Medium

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93. (p. 682) What are transaction costs? How can they be reduced?
Transaction costs are the cost of exchange. Every time a firm changes cash from one currency
into another currency it must bear a transaction costthe commission fee it pays to foreign
exchange dealers for performing the transaction. Most banks also charge a transfer fee for
moving cash from one location to another; this is another transaction cost. The commission
and transfer fees arising from intrafirm transactions can be substantial.
Multilateral netting can reduce the number of transactions between the firm's subsidiaries,
thereby reducing the total transactions costs arising from foreign exchange dealings and
transfer fees.

Difficulty: Medium

94. (p. 683) Differentiate between a tax credit, a tax treaty and a deferral principle. What is their
importance in international business?
A tax credit allows an entity to reduce the taxes paid to the home government by the amount
of taxes paid to the foreign government. A tax treaty between two countries is an agreement
specifying what items of income will be taxed by the authorities of the country where the
income is earned. A deferral principle specifies that parent companies are not taxed on foreign
source income until they actually receive a dividend.
For the international business with activities in many countries, the various tax regimes and
tax treaties have important implications for how the firm should structure its internal
payments system among the foreign subsidiaries and the parent company. The firm can use
transfer prices and fronting loans to minimize its global tax liability. In addition, the form in
which income is remitted from a foreign subsidiary to the parent company can be structured to
minimize the firm's global tax liability.

Difficulty: Medium

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95. (p. 684) What are tax havens? What is their importance in international business?
A tax haven is a country with an exceptionally low or even no, income tax. Some firms use
tax havens such as the Bahamas and Bermuda to minimize their tax liability. International
businesses avoid or defer income taxes by establishing a wholly owned, nonoperating
subsidiary in the tax haven. The tax haven subsidiary owns the common stock of the operating
foreign subsidiaries. This allows all transfers of funds from foreign operating subsidiaries to
the parent company to be funneled through the tax haven subsidiary. The tax levied on foreign
source income by a firm's home government, which might normally be paid when a foreign
subsidiary declares a dividend, can be deferred under the deferral principle until the tax haven
subsidiary pays the dividend to the parent. This dividend payment can be postponed
indefinitely if foreign operations continue to grow and require new internal financing from the
tax haven affiliate.

Difficulty: Medium

96. (p. 684) How are dividend remittances used by firms to transfer funds from foreign
subsidiaries to the parent company?
Payment of dividends is probably the most common method by which firms transfer funds
from foreign subsidiaries to the parent company. The dividend policy typically varies with
each subsidiary depending on such factors as tax regulations, foreign exchange risk, the age of
the subsidiary and the extent of local equity participation. With regard to foreign exchange
risk, firms sometimes require foreign subsidiaries based in "high-risk" countries to speed up
the transfer of funds to the parent through accelerated dividend payments. This moves
corporate funds out of a country whose currency is expected to depreciate significantly. The
age of a foreign subsidiary influences dividend policy in that older subsidiaries tend to remit a
higher proportion of their earnings in dividends to the parent, presumably because a
subsidiary has fewer capital investment needs as it matures.

Difficulty: Hard

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97. (p. 684-685) What are royalties and fees?

Royalties represent the remuneration paid to the owners of technology, patents or trade names
for the use of that technology or the right to manufacture and/or sell products under those
patents or trade names. It is common for a parent company to charge its foreign subsidiaries
royalties for the technology, patents or trade names it has transferred to them. Royalties may
be levied as a fixed monetary amount per unit of the product the subsidiary sells or as a
percentage of a subsidiary's gross revenues.
A fee is compensation for professional services or expertise the parent company or another
subsidiary supplies to a foreign subsidiary. Fees are sometimes differentiated into
"management fees" for general expertise and advice and "technical assistance fees" for
guidance in technical matters. Fees are usually levied as fixed charges for the particular
services provided.

Difficulty: Easy

98. (p. 685) Define transfer price. Enumerate the benefits of manipulating transfer prices.
The price at which goods and services are transferred between entities within the firm is
referred to as the transfer price.
At least four gains can be derived by manipulating transfer prices:
1. The firm can reduce its tax liabilities by using transfer prices to shift earnings from a hightax country to a low-tax one.
2. The firm can use transfer prices to move funds out of a country where a significant
currency devaluation is expected, thereby reducing its exposure to foreign exchange risk.
3. The firm can use transfer prices to move funds from a subsidiary to the parent company
when financial transfers in the form of dividends are restricted or blocked by host-country
government policies.
4. The firm can use transfer prices to reduce the import duties it must pay when an ad valorem
tariff is in force. In this case, low transfer prices on goods or services being imported into the
country are required. Since this lowers the value of the goods or services, it lowers the tariff.

Difficulty: Hard

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99. (p. 687) What are fronting loans? Why are they used by multinationals?
A fronting loan is a loan between a parent and its subsidiary channeled through a financial
intermediary, usually a large international bank.
Firms use fronting loans for two reasons. First, fronting loans can circumvent host-country
restrictions on the remittance of funds from a foreign subsidiary to the parent company.
A fronting loan can also provide tax advantages.

Difficulty: Easy

100. (p. 688) Why do firms prefer to hold cash balances at a centralized depository?
First, by pooling cash reserves centrally, the firm can deposit larger amounts. Cash balances
are typically deposited in liquid accounts, such as overnight money market accounts. Because
interest rates on such deposits normally increase with the size of the deposit, by pooling cash
centrally, the firm should be able to earn a higher interest rate than it would if each subsidiary
managed its own cash balances.
Second, if the centralized depository is located in a major financial center, it should have
access to information about good short-term investment opportunities that the typical foreign
subsidiary would lack.
Third, by pooling its cash reserves, the firm can reduce the total size of the cash pool it must
hold in highly liquid accounts, which enables the firm to invest a larger amount of cash
reserves in longer-term, less liquid financial instruments that earn a higher interest rate.

Difficulty: Hard

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