Global corporate finance - Kim

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REFERENCES

Case Problem 13: Arms Dealers Get Creative with Offsets

In December 2002, Lockheed Martin, with its F-16 Fighting Falcon, beat French and AngloSwedish rivals to land a $3.6 billion deal from Poland, which is Eastern Europe’s largest defense order. Do you know how Lockheed won the contract? The answer is simple. Lockheed’s offset offer was larger than that of their two rivals. Lockheed put together over 100 projects it valued at $9.8 billion, compared with $7.8 billion from its Anglo-Swedish rival and $3.9 billion from its French rival.

In recent years, The General Accounting Office (GAO) of the USA examined offset agreements between the US arms producers and 10 buyer countries in the Middle East, Asia, and Europe (which included the world’s most active buyers of US arms, such as Taiwan, South Korea, Saudi Arabia, Kuwait, and the UK). The USA controls about one-half of the world’s arms exports and dominates sales in most regions. The GAO study also found that the United Arab Emirates (UAE) have broken new ground in recent years by demanding that Boeing invest in and help with big projects that are not related to the company’s main lines of business. For example, the UAE requires that Boeing and other sellers return 60 percent of the value of its arms purchases through investment in commercially viable ventures. And the seller company is deemed to have satisfied its obligation only on the basis of the profits generated by these ventures. The UAE and other countries increasingly insist that the contracts and technologies be delivered into new businesses, rather than existing ones.

“Offsets” are trade demanded by a foreign buyer, which for decades mostly wanted to help the US seller build the planes, missiles, or other weapons being sold. Since the mid1980s, buyers have increasingly wanted commercial and military technology to broaden the purchaser’s economy. In fact, such contracts and technology transfers now occur in aero-

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invested for offset credit. Lockheed Martin Corp.’s $6.4 billion sale of F-16 jets to the UAE in March 2000 corroborates this inference. Lockheed satisfied its offset by investing $160 million in the petroleum-related “investment portfolio” of the Offsets Group, which administers the program in the UAE. Some US government officials have expressed a concern about the possibility that such offset payments could be used to channel favors to foreign officials. That is barred under US law.

Case Questions

1The terms of the offset on individual contracts may vary substantially. The most common categories of offsets are coproduction, licensed production, subcontractor production, overseas investment, and technology transfer. Briefly describe each of these offsets.

2What are the policy goals of those foreign countries that demand offset concessions to US arms producers?

3What is the adverse economic impact of offset agreements in the USA?

4Name and discuss the US law that makes it illegal for US companies to make payments to foreign officials with hopes of winning their favors in business transactions? (Hint: look at chapter 20: Multinational Accounting.)

5Explain why Lockheed’s $160 million investment in the UAE Offset Group might violate the US law.

6Use the website of the American Countertrade Association (ACA), www.countertrade.org, to list the types of services provided by the ACA.

Sources: J. K. Cole, “Evaluating Offset Agreements: Achieving a Balance of Advantages,” Law and Policy in International Business, Vol. 19, 1987, pp. 766–809; J. Cole and H. Cooper, “Buyers of US Arms Toughen Demands,” The Wall Street Journal, Apr. 16, 1997, pp. A1, A16; H. Cooper, “US Defense Firms Hurt by Offset Deals Abroad,” The Wall Street Journal, May 21, 1997, pp. A2, A4; G. T. Hammond, Countertrade, Offsets, and Barter in International Political Economy, New York: St Martin’s Press, 1990; “Lockheed Wins $3.5 B F-16 Deal With Poland,” http://www.foxnews.com, Dec. 27, 2002; and D. Pearl, “Arms Dealers Get Creative with Offsets,” The Wall Street Journal, Apr. 20, 2000, p. A18.

CHAPTER 14

Financing Foreign

Investment

Opening Case 14: Failed US–Vietnamese Joint Ventures

Since 1994, US companies have established joint ventures with Vietnamese businesses on everything from auto factories and cola bottlers to power plants and steak houses. American partners include Chrysler, Ford, Proctor & Gamble, Citibank, Caterpillar, and Nike. Many factors – more capital, less political risk, and local marketing expertise among others – favored US–Vietnamese joint ventures. However, many American investors are forsaking their enterprises because of heavy losses. Consequently, US investment in Vietnam dropped from $635 million in 1996 to $117 million in 1999. Investors from several other countries, such as Taiwan, Korea, and Japan, have also lost heavily in Vietnam.

A key example of a failed joint venture is American Rice. Its multimillion-dollar effort to build a rice business in the Mekong delta – one of the first and most prominent US ventures in Vietnam – had collapsed in 1998. American Rice’s local partners had become enemies, the police threatened to put its employees in prison, and the Communist Party attacked the situation as the latest example of American imperialism. Many US companies in Vietnam today realize that they share all of American Rice’s problems – poor legal protection, hostile joint-venture partners, heavy bureaucracy, and differences in culture. Because of its importance, let us review the case.

In early 1994, American Rice set up a joint venture with an influential local partner to sell Vietnamese rice overseas. With American Rice hungry for supply and Vietnam desperate for customers, the venture seemed ideal for both sides and for millions of struggling Vietnamese farmers. But what started as a partnership quickly became a contest. The local partner refused to grant American Rice permits for exports and charged the company new fees that doubled the costs of the joint venture.

A few months into the new venture, American Rice received permits to export only 30,000 tons, well below the 120,000 tons agreed upon. In 1995, American Rice won a contract to sell the government of Iran $100 million of rice at the highest-ever price

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debts of their subsidiaries, indications are these guarantees will increase. There are a variety of parent guarantees:

1The parent may sign a purchase agreement under which it commits itself to buy its subsidiary’s note from the lender in the event of the subsidiary’s default.

2The lender may be protected on only a part of the specific loan agreement.

3Another type of guarantee is limited to a single loan agreement between a lender and the subsidiary.

4The strongest type requires that the lender be protected on all loans to the subsidiary without limits on amount or time.

The types of loans with parent guarantees and the availability of such loans depend largely upon the parent’s prestige and credit standing.

14.1.2Funds provided by operations

Once a newly formed subsidiary gets on its feet, internal fund flows – retained earnings and depreciation – are the major sources of funds. These internal fund flows, coupled with local credits, leave relatively little need for fresh funds from the parent.

Foreign subsidiaries are not always free to remit their earnings in hard currency elsewhere. Many developing countries have problems with their balance of payments and do not have sufficient international reserves. Thus, they restrict repatriation of funds for a specified number of years or to a certain percentage of the net income. These factors frequently force foreign subsidiaries to reinvest their internally generated funds in the host country. If a company wishes to use these internal fund flows for the expansion of an initial project in later years, an initial project may have to be smaller than actual demand requirements. If the anticipated expansion is necessary to meet current demand and the normal growth in demand, MNCs would have no difficulty in profitably using the internal fund flows in the host country.

14.1.3Loans from sister subsidiaries

The availability of intersubsidiary credit, in addition to funds from the parent, vastly expands the number of possibilities for internal financing. For example, if a subsidiary in Austria has funds which it does not need immediately, it may lend these funds to a sister subsidiary in Norway, and vice versa. However, many countries impose exchange restrictions on capital movements to limit the range of possibilities for intersubsidiary loans. Moreover, the extensive use of intersubsidiary financial links makes it extremely difficult for a parent company to control its subsidiaries effectively.

Nevertheless, many subsidiaries borrow cash from their sister subsidiaries. When there are only a few subsidiaries within a company’s family, it is straightforward to arrange intersubsidiary loans. One subsidiary treasurer may negotiate directly with another sister subsidiary treasurer to obtain or give credit. However, an MNC with many subsidiaries in many countries may prefer to have its central staff handle all excess funds, or to establish a central pool of these funds on a worldwide basis under two conditions: (1) if the number of financial relationships does not exceed the

capability of the main office to manage them effectively; and (2) if a parent company does not want to lose control over its subsidiaries.

14.2External Sources of Funds

If an MNC needs more funds than the amount that can be reasonably generated within a corporate family, the parent or its foreign subsidiaries may seek outside sources of funds. Such external sources of funds include joint business ventures with local owners and/or borrowings from financial institutions in the parent country, the host country, or any third country (see Global Finance in Action 14.1).

Although subsidiaries can borrow directly from outside the host country, most of them borrow locally for a number of reasons:

1Local debts represent automatic protection against losses from a devaluation of local currency.

2Subsidiary debts frequently do not appear on the consolidated financial statement issued by a parent as part of its annual report.

3Some host countries limit the amount of funds that foreign companies can import from outside the host country.

4Foreign subsidiaries often borrow locally to maintain good relations with local banks.

Global Finance in Action 14.1

Guidelines for Adequate Capitalization

MNCs are not only able to raise funds in international and national capital markets but also to take advantage of capital market imperfections throughout the world. This comparative advantage should theoretically allow MNCs to enjoy a lower cost of capital than competing domestic companies. Companies have a number of outside financial options from which to choose to finance their foreign investment projects. These external financial options include banks, government institutions, other types of financial intermediaries, and even the public sector in the host country. To avoid drawbacks inherent in the thin capitalization of foreign investment projects, companies usually seek an optimum capital structure. An optimum capital structure is defined as the combination of debt and equity that yields the lowest cost of capital.

Several ratios can be used to determine an optimum financing mix of debt and equity for overseas projects. Cassidy (1984) recommends a number of guidelines for companies to develop capitalization strategies for their overseas projects:

1The investor’s own resources should be sufficient to approximately cover the project investment in fixed assets. Outside financing should support investment in net working capital of the unit.

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2The ratio of outside financing to total capitalization of the project (the debt ratio) should generally be about 0.50. Thus, approximately equal amounts of outside debts and equity investments will be employed in the local project.

3The projected earnings from the overseas project should provide adequate “interest coverage” for its intended outside debt service. To ensure continuing liquidity, these earnings should be a substantial multiple of the project’s annual financial costs.

Source: G. T. Cassidy, “Financing Foreign Investments: The International Capital Markets,” in Allen Sweeny and Robert Rachlin, eds., Handbook for International Financial Management, New York: McGraw-Hill, 1984, pp. 1–11.

14.2.1Commercial banks

As noted in chapter 13, commercial banks are a major financial intermediary in trade credit. They are also the most important external source for financing nontrade international operations. The types of loans and services provided by banks vary from country to country, but all countries have some funds available at local banks.

Most of the local loans obtained by subsidiaries are short-term credits from commercial banks. These short-term credits are used largely to finance inventory and accounts receivable. They are self-liquidating loans to the extent that sufficient cash flows are produced to repay the credits as inventories are sold on credit and receivables are collected over the business cycle. The principal instruments used by banks to service an MNC’s request for a loan are as follows:

•Overdrafts are lines of credit that permit the customer to write checks beyond deposits. The bank establishes the maximum amount of such credit on the basis of its analysis of the customer’s request, needs, and potential cash flows. The borrower agrees to pay the amount overdrawn and interest on the credit. Although some banks waive service charges for their creditworthy customers, others frequently require service charges and other fees.

•Unsecured short-term loans – most short-term bank loans for MNCs to cover seasonal increases in current assets are made on an unsecured basis. The percentages of such loans vary from country to country, and reflect variations in individual bank policy and central government regulations. Most MNCs prefer to borrow on an unsecured basis because bookkeeping costs of secured loans are high, and because these loans have a number of highly restrictive provisions. However, some foreign subsidiaries cannot obtain loans on an unsecured basis, because they are either financially weak or have not established a satisfactory performance record.

•Bridge loans are short-term bank loans used while a borrower obtains long-term fixed-rate loans from capital markets. These bridge loans are repaid when the permanent financing arrangement is completed. During the peak of its currency crisis in early December 1997, Korea obtained a bridge loan of $1.3 billion from the Bank of Japan. This bridge loan was aimed at tiding Korea over until a $58 billion rescue package arranged by the International Monetary Fund began to kick in.

•Currency swaps are agreements to exchange one currency with another for a specified period, after which the two currencies are re-exchanged. Arbi loans are the best-known example of

such swaps. An arbi loan is arranged in a country where money is readily available at reasonable rates. It is converted to the desired local currency, but the borrower arranges a forward exchange contract to insure converting the local currency into the foreign currency of original denomination at a specified future date. Thus, arbi loans allow MNCs to borrow in one market for use in another market and to avoid foreign-exchange risks. The cost of arbi loans includes the interest on the loans and the charges associated with the forward exchange contract.

•Link financing is an arrangement whereby banks in strong-currency countries help subsidiaries in weak-currency countries obtain loans by guaranteeing repayment on the loans. These subsidiaries borrow money from local banks or firms with an excess of weak money. Certainly, banks in strong-currency countries require some sort of deposits from a borrower’s parent company and the borrower must pay local interest rates. To protect itself against foreign-exchange risk, the lender usually hedges its position in the forward exchange market.

14.2.2Interest rates on bank loans

Interest rates on most business loans are determined through direct negotiations between the borrower and the bank. The prevailing prime lending rate and the creditworthiness of the borrower are the two major factors of the interest rate charged. The prime rate is the rate of interest charged on short-term business loans to the most creditworthy customers.

Interest rates may be paid on either a collect basis or on a discount basis. On a collect basis, interest is paid at the maturity of the loan, which makes the effective rate of interest equal to the satiated rate of interest. On a discount basis, interest is paid in advance, which increases the effective rate of interest. Most short-term securities, such as Treasury bills, euro commercial papers, and bankers’ acceptances, are sold on a discount basis.

Example 14.1

Assume that a company borrows $10,000 at 10 percent. Compute the effective rate of interest for the loan on a collect basis as well as on a discount basis.

The effective rate of interest on a collect basis is:

$1,000 = 10% $10,000

The effective rate of interest on a discount basis is:

$1,000

= 11.11%

$10,000 - $1,000