Multinational Financing

Another major facet of financial management is raising funds on as favorable terms as possible. In a multinational company, this involves raising funds from either internal or external sources to finance a foreign affiliate. Internal funds are comprised of equity investment and loans from the U.S. parent, retained earnings, and depreciation and depletion allowances. Recently, internal sources of funds have accounted for somewhat over 70 percent of the total financing of U.S. owned foreign affiliates. Of the internal sources, approximately three quarters is comprised of retained earnings and depreciation and depletion allowances.

Although the major sources of funds for a foreign affiliate are internal, external sources are often used, particularly for temporary requirements. A wide variety of sources of external financing are available to the foreign affiliate. These range from commercial bank loans within the host country to loans from international lending agencies. In this section we consider the chief sources of external financing.

Commercial Bank Loans and Trade Bills. One of the major sources of financing abroad, commercial banks perform essentially the same financing function as domestic banks a topic discussed in Chapter 16. One subtle difference is that banking practices in Europe allow longer term loans than are available in the United States. Another is that loans tend to be on an overdraft basis. That is, a company writes a check that overdraws its account and is charged interest on the overdraft. Many of these banks are known as merchant banks, which simply means that they offer a full menu of financial services to business firms. Corresponding to the growth in multinational companies, international banking operations of U.S. banks have increased. All the principal cities of the free world have branches or offices of a U.S. bank. Under the Edge Act, American banks may act as holding companies and own stock in foreign banks. These banks may be either wholly owned subsidiaries or owned in part by nationals. Thus, U.S banks are able to provide, directly or indirectly, banking arrangements for foreign affiliates in almost any country, Foreign affiliates sometimes bypass them, nevertheless, in favor of local banks, where they can make contacts and become familiar with local practices.

In addition to commercial bank loans, discounting trade bills is a common method of short term financing. Although this method of financing is not used extensively in the United States, it is widely used in Europe to finance both domestic and international trade. More will be said about the instruments involved later in the chapter.

Eurodollar Financing. A Eurodollar is defined as a dollar deposit held in a bank outside the United States. Since the late 1950s an active market has developed for these deposits. Foreign banks and foreign branches of U.S. banks, mostly in Europe, bid actively for Eurodollar deposits, paying interest rates that fluctuate in keeping with supply and demand. The deposits are in large denominations, frequently $100,000 or more, and the banks use them to make dollar loans to quality borrowers. The loans are made at a rate in excess of the deposit rate; the differential varies according to the relative risk of the borrower. All loans are unsecured. Essentially, borrowing and lending Eurodollars is a wholesale operation, with far fewer costs than are usually associated with banking. The market itself is unregulated, so supply and demand forces have free rein. The Eurodollar deposit rate usually is slightly above the rate paid by American banks on large, domestic certificates of deposit of the same maturity. The Eurodollar market is a major source of short term financing for the working capital requirements of the multinational company. Many American firms arrange for lines of credit and revolving credits from Eurodollar banks. For the revolving credit arrangement, the firm pays a commitment fee, the same as it does for a domestic revolving credit. In addition, there often is a front end fee that is expressed as a percentage of the total loan. This one time load charge might be 1 to 3 percent. The interest rate on loans is based upon the Eurodollar deposit rate and bears only an indirect relationship to the prime rate. Typically, rates on loans are quoted in terms of the London interbank offering rate, commonly called LIBOR. The greater the risk, the greater the spread above LIBOR. A prime borrower will pay about 1 percent over LIBOR for an intermediate term loan. One should realize that LIBOR usually is more volatile than the U.S. prime rate, owing to the sensitive nature of supply and demand for Eurodollar deposits. Consequently, it is more difficult to project the cost of a Eurodollar loan than that of a domestic loan. Nevertheless, no compensating balances are required, thus enhancing the attractiveness of this kind of financing.

We should point out that the Eurodollar market is part of a larger Eurocurrency market where deposit and lending rates are quoted on the stronger currencies of the world. The principles involved in these markets are the same as for the Eurodollar market, so we do not repeat them. The development of Eurocurrency markets has greatly facilitated international borrowing and financial intermediation.

International Bond Financing. The Eurobond market developed in the late 1960s into a highly regarded source of long term funds for the multinational company. A Eurobond is a long term security issued by an internationally known borrower in several countries, simultaneously. The currencies in which the bonds are denominated usually are actively traded and strong. Most bonds are straight fixed income bonds; some are convertible into common stock, others are floating rate bonds. The market for Eurobonds is truly international; investment banking syndicates are comprised of bankers from a number of countries, and the securities are placed all over the world. Like Eurocurrency markets, it is free of government regulation. Somewhat over half of its total volume of funds raised is in dollars. Still, its volume is only a fraction of that which occurs in the U.S. bond market.

A Eurobond issue is denominated in a single currency, though it usually is sold to investors in a number of countries. This type of issue should be distinguished from a bond issue floated entirely in a single foreign country. While both issues involve only one currency, the latter is restricted to investors in a single country. Also, Eurobonds are different from bond issues denominated in two or more currencies. For example, some issues allow the bondholder to choose the currency in which payment is to be received prior to each coupon or principal payment. This option typically is confined to two currencies, but it can be more. Finally, bond issues may be initially floated in multiple currencies. Known as a 41 currency cocktail," the market value of a bond is likely to be less volatile than that of a bond denominated in a single currency. We see then that a variety of bond financing is possible.

Development Banks

The Export Import Bank is an independent agency of the U.S. government. Known as the Exim Bank, it was established in 1934 to facilitate the financing of exports from the United States. It accomplishes this purpose in several ways. Its major program is making long term loans to foreigners, enabling them to purchase U.S. goods and services. The Exim Bank tries to supplement, rather than compete with, private capital. It will participate with private lenders in extending credit, and this arrangement has been used successfully. The bank also guarantees payment of medium term financing incurred in the export of U.S. goods and services.

The Inter American Development Bank was formed in 1959 by a number of Latin American countries together with the United States. It is an example of a regional development bank that makes both public and private loans for purposes of enhancing economic development in the member countries. The development banks of individual countries are too numerous to list. To mention only a few of the larger ones, there are the Industrial Reorganization Corporation in Britain, National Financiera, S.A., in Mexico, Credit National in France, Kreditanstalt fur Wiederaufbau in West Germany, and Instituto Mobiliare Italiano in Italy. Adela is an example of a privately owned development bank. It makes private investments in Latin American firms, usually in participation with other investors.