International Trade

Question 1

What is a Direct foreign investment?

Answer 1

A company planning a foreign investment can either purchase the stock of a foreign corporation or make a direct foreign investment

A direct foreign investment involves buying equipment and buildings for a new company

Question 2

What are the advantages of making a direct foreign investment (as opposed to buying stock in a foreign company)?

Answer 2

The advantages of a direct foreign investment include:

1. Lower taxes in the foreign nation
2. Annual depreciation allowances for the amount invested
3. Access to foreign capital sources

Question 3

What are the relevant cash flows in foreign investments?

Answer 3

Relevant cash flows are the dividends and possible future sales price of the investment paid to the investor

To this extend, traditional capital budgeting techniques can be used

Question 4

Why is the cost of capital for foreign projects higher than domestic projects?

Answer 4

Cost of capital for foreign projects is higher because of increased:

1. Exchange-rate risk
2. Sovereignty (or political) risk arising from possible expropriation (or other restrictions), with net losses to the parent company
3. The likelihood of laws requiring financing from certain sources (i.e. a requirement that foreign subsidiaries must be at least 51% owned by locals)
4. Foreign operations are more difficult to manage than domestic operations

Question 5

What are American depository receipts (ADRs)?

Answer 5

Ownership rights in foreign corporations are sometimes evidenced by American depository receipts (ADRs)

The foreign stocks are deposited with a large U.S. bank, which in turn issues ADRs representing ownership in the foreign shares

The ADR shares then trade on a U.S. stock exchange, whereas the company’s original shares trade in foreign stock markets. ADRs allow foreign companies to develop a U.S. shareholder base without being subject to many SEC restrictions

Question 6

What are foreign investments funded by?

Answer 6

Foreign investments are funded by:

1. Parent company resources
2. Common stock sales in the foreign country
3. Bond sales in the foreign country
4. Borrowing in world financial markets

Question 7

With regard to multinational corporations, what are the benefits to the home country?

Answer 7

Benefits to the home country include:

1. Improved earnings and exports of products to foreign subsidiaries
2. Improved ability to obtain scarce resources
3. The typical benefits of free trade (i.e. greater product availability, a better international monetary system and improved international understanding)

Question 8

With regard to multinational corporations, what are the adverse effects on the home country?

Answer 8

Adverse effects on the home country include:

1. Loss of jobs and tax revenues
2. Instability caused by reduced flexibility of operation in a foreign political system and the risk of expropriation
3. Competitive advantage of multinationals over domestic rivals

Question 9

With regard to multinational corporations, what are the benefits to the host country?

Answer 9

Benefits to the host country include:

1. New investment of capital, technology and management abilities
2. Improvements in output and efficiency along with the resulting stronger balance of payments
3. Stimulation of competition, increased tax revenues and higher standards of living

Question 10

With regard to multinational corporations, what are the adverse effects to the host country?

Answer 10

Adverse effects on the host country include:

1. Remittance of royalties, dividends and profits that can result in a net capital outflow
2. Setting of transfer prices among subsidiaries so that profits will be earned where taxes are lowest or restrictions on the export of profits are least stringent
3. Multinationals engaging in anticompetitive activities (i.e. the formation of cartels)

Question 11

How is Cross-border factoring used as a method of financing international trade?

Answer 11

A factor purchases receivables and assumes the risk of collection

Cross-border factoring is a method of consummating a transaction by a network of factors across borders. The exporter’s factor contacts correspondent factors in other countries to assist in the collection of account receivable

Question 12

How are letters of credit used as a method of financing international trade?

Answer 12

Under a letter of credit, an issuer (usually a bank) undertakes with the account party (an importer-buyer that obtains the letter of credit) to verify that the beneficiary (seller-exporter) has performed under the contract (i.e. by shipping goods)

Thus, the issuer pays the beneficiary when it presents documents (i.e. bills of lading) that provide evidence of performance. The issuer then is reimbursed by the account party

Question 13

What is the process of how a letter of credit used as a method of financing international trade?

Answer 13

The process is as follows:

The importer applies to its home country bank (issuer) for a letter of credit. The issuer sends the letter to a correspondent bank in the exporter’s country

The correspondent bank transfers the letter to the exporter, who is thereby assured of payment

The exporter ships the goods and delivers the shipping documents to the correspondent bank, which pays the exporter if they are in order

The correspondent bank sends the shipping documents to the issuer, which reimburses the correspondent bank and charges the importer’s account

The importer (of its broker) receives the shipping documents and presents them to the carrier to obtain the goods

Question 14

What are Banker’s acceptances?

Methods of financing international trade

Answer 14

Banker’s acceptances are time drafts drawn on deposits in a bank. They are short-term credit investments created by a nonfinancial firm and guaranteed (accepted) by a bank as to payment

Acceptances are traded at discounts in secondary markets. These instruments have been a popular investment for money market funds

Question 15

What is Forfaiting?

Methods of financing international trade

Answer 15

Forfaiting is a form of factoring that involves the sale by exporters of large medium to long-term receivables to buyers (forfaiters) who are willing and able to bear the costs and risks of credit and collections

Question 16

What is Countertrade?

Methods of financing international trade

Answer 16

Countertrade at its simplest is barter - the exchange of goods or services for other goods or services rather than merely for cash

Question 17

What are Treaties?

Answer 17

To avoid double taxation, two or more countries may adopt treaties to coordinate or synchronize the effects of their taxing statutes

Treaties are also used to integrate other governmental goals (i.e. providing incentive for desired investment)

If a U.S. statute and a treaty to which the U.S. is a party conflict, the one enacted or adopted last controls

A treaty might modify the rules in a country’s statutes that designate to which country income is sourced or of which country a firm is a resident

Question 18

How are multinational corporations taxed?

Answer 18

Multinational corporations frequently derive income from several countries. The government of each country in which a corporation does business may enact statutes imposing one or more types of tax on the corporation

1. Most countries tax only the income sourced to that country
2. The U.S. taxes worldwide income (from whatever source derived) of a domestic corporation. Double taxation is avoided by allowing a credit for income tax paid to foreign countries or by treaty provisions
3. In the case of foreign corporations, the U.S. taxes only income sourced to the U.S. Ordinarily, such income is effectively connected with engaging in a trade or business in the U.S. Certain U.S. source income (i.e. gain on the sale of most stock) is not taxed by the U.S.

Question 19

What is Transfer pricing?

Answer 19

Transfer pricing is an important aspect of the tax calculation for multinational corporations that transfer inventories between branches in different countries

The U.S. tax laws have limits on the amount of profit that can be transferred from a U.S. parent to a foreign subsidiary or branch

Although there are exceptions, the basic transfer pricing rules under the IRC limit the amount of taxable income that can be claimed by the foreign subsidiary to no more than 50% of the total taxable income

Thus, transfer prices charged to foreign subsidiaries may differ substantially form those charged to domestic subsidiaries

Question 20

Are there non-tax aspects to transfer pricing?

Answer 20

Yes, for example, limitations on taking profits out of a foreign country, or currency restrictions can be avoided by charging the foreign subsidiary a higher transfer price than that charged to domestic subsidiaries

This is because firms in developing countries are allowed to pay their accounts payable to foreign vendors but are NOT allowed to distribute profits to foreign owners

Note: The existence of tariffs in the foreign country may necessitate a lower transfer price to reduce a tariff based on the inventory value