Chapter 12 - Strategic Accounting Issues in Multinational Corporations

CHAPTER 12
STRATEGIC ACCOUNTING ISSUES IN MULTINATIONAL
CORPORATIONS
Chapter Outline

I. The strategic issues faced by a MNC are related to strategy formulation and strategy
implementation.
A. Strategy formulation is the process of deciding on the goals of the organization and
plans for attaining those goals, whereas strategy implementation refers to the
process by which managers influence others within the organization to behave in
accordance with those goals.
B. Capital budgeting is an important activity associated with strategy formulation, and
strategies are implemented mainly through operational budgeting and performance
evaluation. Accounting plays a major role in these activities as a source of
information.

II. Accounting provides quantitative information about (a) opportunities and threats as well
as strengths and weaknesses, and (b) costs and benefits needed for long-term
investment (or capital budgeting) decisions.
A. Techniques such as payback period, return on investment (ROI), net present value
(NPV), and internal rate of return (IRR) are employed in making long-term
investment decisions.
B. All capital budgeting techniques compare estimates of future cash flows with the
cost of the investment.
C. NPV and IRR take the time value of money into consideration by calculating the
present value of future cash flows in evaluating potential capital investments.
D. Preferences for using particular capital budgeting techniques vary across countries
due to cultural and other reasons.
E. In calculating future cash flows from foreign investments, MNCs should consider
various risks associated with them, namely, political risk, economic risk, and
financial risk.
F. MNCs tend to evaluate foreign investments from both project and parent
viewpoints.

III. Accounting provides tools for implementing strategies and monitoring their
effectiveness through the development of operating budgets.
A. Operating budgets help express a firm’s long-term strategy within shorter time
frames and specify criteria for monitoring progress.
B. It is important for MNCs to translate operating budgets of foreign subsidiaries using
an appropriate exchange rate.

IV. Accounting provides tools for evaluating organizational effectiveness in fulfilling its
objectives, and at the same time for motivating organizational members to behave in a
manner consistent with the organization’s goals.
A. The level of performance depends on many factors, and no single measure can
incorporate all of them. Therefore, it is common for MNCs to use a mixture of
measures, financial and non-financial, formal and informal, and formula-based and
subjective in evaluating performance.
B. MNCs do not seem to use any particular measure consistently for evaluating
performance.

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V. Performance evaluation in MNCs is complicated by exchange rate fluctuations, varying

rates of inflation in foreign countries, international transfer pricing, and cultural and
environmental differences that exist across countries.
A. A potential problem for MNCs is the tendency for headquarters to rely on simple
financial control systems, often designed for home country operations and extend
them to foreign subsidiaries.
B. The financial measures used to evaluate performance, such as sales growth, cost
reduction, profit and return on investment, are provided through the accounting
system.
C. MNCs also use non-financial measures, such as market share, relationship with
host country government, to evaluate performance, and such measures are not
based on information obtained directly from financial statements.

VI. The method of evaluation used depends largely on the type of subsidiary involved, for
example, its strategic role within the MNC and its organizational culture.

VII. The importance of non-financial measures in evaluating performance is reflected in the

growing popularity of the balanced scorecard approach, focusing on integrating the key
elements of a business, vision strategy, and four perspectives, namely, financial,
customer, internal business process, and learning and growth.

VIII. In evaluating the performance of a foreign subsidiary, important questions include:

whether to separate managerial performance from the unit performance; and how to
separate controllable items and non-controllable items.

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Answers to Questions

1. A strategy indicates the general direction in which a firm plans to move to attain its goals.
The strategies of any business organization, whether purely domestic or multinational,
are determined by matching two key ingredients: core competencies and available
opportunities. Internal factors relate to the identification of core competencies of a firm
focusing on strengths and weaknesses with regard to the expertise available within the
firm in the areas of technology, manufacturing, distribution, and logistics.

2. A strategy indicates the general direction in which a firm plans to move to attain its goals.
The strategies of any business organization, whether purely domestic or multinational,
are determined by matching two key ingredients: core competencies and available
opportunities. The external factors relate to the identification of the opportunities
available to the firm, the second key ingredient in formulating strategy. Identification of
opportunities also includes the threats facing the firm in the areas of competitors,
customers, suppliers, regulatory bodies, as well as socio-political circumstances.

3. Accounting provides the skills necessary to quantify in financial terms the factors that
influence strategy formulation -- strengths, weaknesses, opportunities and threats --, and
to develop projections of costs and benefits as financial expressions of strategy. Capital
budgets are a prime example of the contribution accounting makes in strategy
formulation. Further, organizational goals are often expressed in financial terms, for
example, to achieve a particular level of return on investment.

4. Both NPV and IRR are discounted cash flow techniques (recognizing the time value of
money) used for evaluating capital investment proposals. The NPV method uses a
discount rate (usually, the firm’s cost of capital) to restate all future net cash inflows in
terms of their present values to be compared with the initial investment, while the IRR
method identifies the discount rate that equates the cash outflows and inflows of a
proposed investment project. In other words, the NPV method indicates whether or not a
particular proposed investment is capable of generating a desired rate of return, and the
IRR method indicates the exact return that can be expected from a proposed investment.
The NPV method allows the use of a realistic discount rate for reinvestment, whereas the
IRR method might not. The IRR method facilitates comparison of projects requiring
different amounts of investments, whereas the NPV method is not helpful in comparing
projects requiring different amounts of investments. Another weakness of the NPV
method is that it tends to favor large investments. A weakness of the IRR method is that
its assumption on reinvestment rate of return could be unrealistic.

5. The organizational structure of a MNC is determined to a considerable extent on the

roles assigned to its subsidiaries. Some subsidiaries play the role of a producer of
products for the parent company, where as others have catering for the needs of the
host country market as their main role. There are also subsidiaries that operate as part of
a global network. Attainment of corporate goals is the main objective of implementing
strategy. The subsidiary managers’ contributions towards this end will depend on the
roles assigned to each subsidiary within the organizational structure. For example, the
contribution expected from the manager of a subsidiary that plays the role of an
integrated player would be different from that expected from the manager of a subsidiary
that focuses mainly on catering for the host country market.

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6. Due to cultural differences across countries, corporate managers may have to tailor the
manner in which strategy is implemented in a specific country in order to achieve the
desired results. For example, a management control tool such as standard costing that
assumes that the responsibility for specific tasks lies with the individual who is traceable
may not be effective in a cultural context such as Japan where a group, rather than an
individual, is assigned responsibilities. Further, the managers of a subsidiary located in
a strong uncertainty avoidance society can be expected to create more slack in
preparing budgets as a method of dealing with future uncertainty, compared to managers
of a subsidiary located in a weak uncertainty avoidance society. In implementing
multinational strategy it is important to ensure that the managers and other members of
foreign subsidiaries are motivated to behave in accordance with corporate goals.
However, people from different cultural backgrounds may respond differently, for
example, to financial incentives.

7. The role of accounting in implementing multinational business strategy is to assist the

process by which managers influence other members of the organization. Accounting
fulfills this role primarily through the budgeting process, in particular, operational
budgeting. An operating budget is a financial expression of a firm’s long-tern strategy
within a shorter time frame, usually one year. It helps plan what the organization should
do to effectively implement strategy, coordinate the activities of several parts of the
organization, communicate information to organizational members, and evaluate
information. Budgeting also offers tools for monitoring progress. In addition, accounting
provides the skills necessary to deal with the effects of exchange rate changes and
foreign inflation in implementing corporate strategy. Performance evaluation is a part of
the process by which managers influence other members of the organization. Accounting
plays an important role in this regard in providing targets which are used in evaluating
performance.

8. One of the main issues in designing an appropriate performance evaluation system for a
foreign affiliate relates to the selection of the criteria to be used in evaluating
performance. This is critical because correctly selected criteria can act as a motivating
factor within the unit. However, if not done carefully, evaluation criteria can have
dysfunctional effects. Firms often use a mixture of financial measures, such as profit and
ROI, and nonfinancial measures, such as market share and customer satisfaction, in
evaluating the performance of foreign operations.
When profit is used as part of the measure of performance, a decision has to be made
as to how it should be calculated. For example, should it be calculated using host
country or parent company accounting principles.
Another issue that must be resolved is how to treat a foreign unit for performance
evaluation purposes. For example, the measures used to evaluate the performance of a
unit treated as a cost center would be different from those used for a unit that is treated
as an investment center, because the level of responsibility given to the manager of an
investment center is much higher compared to that given to a cost center manager. A
related issue is whether to evaluate the unit and the manager using the same criteria or
to use different sets of criteria to evaluate the manager and the unit. The main concern
here is that the manager of a unit should not be held responsible for decisions, which are
beyond his or her control. This is often known as the controllability principle. It is possible
that the manager has performed well despite the poor performance of the unit.
All these issues are also common to a group that only has local affiliates. However, each
one of the issues mentioned above is complicated by changes in exchange rates and
interest rates as well as other issues related to foreign inflation.

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9. Survey results clearly show that there are variations in the evaluation methods adopted
by Japanese and U.S. MNCs. These variations are most likely due to cultural
differences. For example, Bailes and Asada’s 1991 survey found that the most frequently
used performance measure by U.S. MNCs was ROI, whereas ROI was relatively
unimportant for Japanese MNCs. On the other hand, the most frequently used measure
by Japanese MNCs was sales volume, whereas it was relatively much less important for
U.S. MNCs. Another interesting finding of that survey is the high importance given to
production costs by Japanese MNCs as a performance evaluation measure, in contrast
to how it was viewed by U.S. MNCs.

10. MNCs often use financial measures in evaluating foreign subsidiary performance, mainly
due to the fact that the information is readily available from the financial statements.
However, now there is increasing recognition that focusing on financial information alone
is not sufficient in evaluating a firm’s performance. Nonfinancial measures that can be
used to evaluate the performance of a foreign subsidiary include (but are not limited to):
growth in market share, relationship with host country government, cooperation with
corporate management and peer units, ability to maintain an appropriate level of
employee morale and to retain skilled employees, improvement in productivity, product
innovation, customer service, research and development, and social/environmental
sensitivity.

11. The factors that influence the manner in which a particular subsidiary should be treated
include the strategic role assigned to the subsidiary, and the level of responsibility given
to its management. For example, if the role assigned to a particular subsidiary only
requires it to produce as much as possible at a specified level of quality with a fixed
amount of resources, then it would be treated as a cost center as its main focus would
be cost control. If the subsidiary’s managers were expected to determine product prices,
market the products, and achieve sales growth, then their responsibilities would be
greater. In this case, the subsidiary would have the responsibility for both costs and
revenues, and as such it should be evaluated as a profit center. If, in addition to
managing costs and revenues, the subsidiary manager were also given the responsibility
for making investment decisions, then such a subsidiary would be treated as an
investment center. Investment center managers have the highest level of responsibility.

12. It is important to separate the performance of a subsidiary from that of its management
for evaluation purposes, mainly because the performance of a subsidiary can be
influenced by decisions made by corporate management and other parties, events that
are beyond the control of subsidiary management. Examples of items that are not
controllable by local management are transfer-pricing decisions made by corporate
headquarters and a general labor strike, which can affect both the costs and revenues of
the subsidiary. It would not be fair to include the effects of these factors in measuring
the performance of the subsidiary manager, as the manager has no control over these
factors. This is consistent with the concept of responsibility accounting, which suggests
that a manager should not be held responsible for costs over which he/she has no
control. Because of noncontrollable items, it is possible to have good management
performance despite poor performance of the subsidiary, and vise versa. Separating the
two would be important in rewarding and retaining good managers. The main purpose of
performance evaluation is to motivate managers and other employees to achieve
organizational goals. Managers are likely to be more highly motivated if they know that
their performance is fairly measured, appreciated, and rewarded.

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13. Several issues must be addressed in measuring the profit of a foreign subsidiary for
performance evaluation purposes. These include:
 Whether the effect of corporate transfer pricing policy on costs and revenues should
be included or excluded from the measure of proflt.
 Whether corporate overhead allocations should be included or excluded from the
measure of profit.
 Whether foreign subsidiary profit should be measured in local currency or parent
company currency. If parent company currency, whether translation adjustments
should be included in profit or not.
 Whether profit should be based on historical cost accounting or some current value
accounting method.

14. During a period of inflation, asset values based on historical costs often understate their
current values. Lower asset values result in higher profits through lower depreciation
and cost-of-goods-sold expenses. Lower asset values also results in a lower base for
calculating rates of return. The combined effect of these two factors is a higher rate of
return on assets based on historical costs than if assets were adjusted to their current
values. This could distort the evaluation of the performance of foreign subsidiaries,
especially when comparisons are made across subsidiaries located in different countries
experiencing different levels of inflation.

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Solutions to Exercises and Problems

1. For capital budgeting purposes, the U.S. company needs to determine the after-tax cash
inflow in U.S. dollars arising from the royalty payment. Three factors will affect the net
amount received by the U.S. company: (1) German withholding taxes on royalty
payments made to a foreign parent company, (2) the exchange rate between the euro
and the U.S. dollar, and (3) taxes paid in the U.S. on the royalty received. Assuming the
royalty is to be paid annually for a number of years, assumptions must be made
regarding the stability of the tax rules in Germany and the U.S. and forecasts must be
made regarding the euro/U.S. dollar exchange rate over the investment horizon.

2. In this exercise, students are expected to select a developing country and find the
relevant information. Try to use an Internet search engine, such as Google and Yahoo,
or any other source. The source(s) used should be clearly acknowledged. Information
should be structured under social influence, political influence, economic influence, and
technological influence.

The purpose of this exercise is to emphasize the importance of being able to think and
work independently. Exhibit 5 can be used as guidance for collecting the necessary
information with regard to the selected country. Students may not be able to find the
relevant information under all the items in Exhibit 5. However, this would be a good
learning experience for them. Assessment of an appropriate response to this question
should be based on the seriousness of the attempt made.

3. If the exchange rate is expected to remain constant, then the real dollar value of the
German mark is expected to decline at the same rate as the real mark value, namely the
5% German inflation rate. Hence, the real dollar value of the depreciation tax write-off
will decline at the rate of 5% per annum. If the German tax rate is 50%, then a
depreciation charge of $5 million is worth $2.5 million in 2005 dollars. If the real dollar
value of this write-off is declining at the rate of 5% annually, then its real value in 2009
(given that the write-off is taken at the end of the year) is: $2,500,000 (.783526) =
$1,958,815. (.783526 is the factor used to calculate the present value of an amount
received at the end of five years at 5% discount rate)

4. The exchange rate between the Chinese RMB and the U.S. dollar is expected to remain
constant therefore all calculations may be done in dollars. The annual cash flow as a
consequence of the original investment proposal is:

Project cash flow in China:

Sales (25,000 units @ $50) 1,250,000

less: cost of Chinese material (25,000 units@$15) -375,000
less: cost of U.S. components (25,000 units@$8) -200,000
Gross Profit 675,000

less: depreciation ($750,000/ 5 ) 150,000

Pre-tax profit 525,000
less: 40% Chinese tax 210,000
Net Income 315,000

add back depreciation 150,000

Annual project cash flow 465,000

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Project cash flow to Sedona:

Cash flow to Sedona is the same as annual project cash flow in China because cash
equal to depreciation may be returned freely to the U.S: $465,000

Profit on Sedona’s sales of components,

(25,000 units x $4 unit x .60 after tax) $60,000

Cash reduction on Sedona’s loss of current exports (25,000 units x $15 profit
contribution x .60 after tax): $225,000

At the end of 5 years no additional cash will be received in respect of building and
equipment as these will have been fully depreciated.

(a)

Flow in Year 15% PV PV of

Thousands factor flow
Cost of project $1,500 0 1.000 (1,500)
Project flows 465 1- 5 3.352 1,559
Profit on components 60 1- 5 3.352 201
Lost export profit -225 1- 5 3.352 (754)
WC recapture 750 5 0.497 373
-121

NPV is Negative $121,000. Therefore reject.

(b)

Since current exports will now be lost in any case, the lost profits on current exports are
not an incremental flow.

Flow in Year 15% PV PV of

Thousands factor flow
Cost of project $1,500 0 1.000 (1,500)
Project flows 465 1- 5 3.352 1,559
Profit on components 60 1- 5 3.352 201
WC recapture 750 5 0.497 373
633

NPV is now positive $633,000. Therefore accept.

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(c)

Cash flow to the U.S. parent would not change, because the drop in Chinese taxes will
be offset by an equal increase in U.S. taxes on profit remitted to the U.S.

Pre-tax profit (original projection) $525,000

Less: 20% Chinese taxes -105,000
Net income – dividend to U.S. 420,000

Dividend received from China 420,000

Add back Chinese taxes 105,000
Grossed up taxable U.S. income 525,000
Tentative 40% U.S. tax charge 210,000
Less; credit for Chinese tax paid -105,000
Additional U.S. tax paid 105,000
Dividend to U.S. after additional taxes 315,000
Add back depreciation 150,000
Annual project cash flow to U.S. 465,000

5. The risk management activities of Nokia Company cover strategic, operational, financial,
and hazard risks. Financial risk management (identifying, evaluating and hedging) is one
of the two main objectives of the Treasury function. Since a substantial proportion of
Nokia’s production and sales activities are outside Euro zone, managing foreign
exchange risk is crucial to the company’s success. Foreign exchange exposures are
mainly hedged with derivative financial instruments such as forward exchange contracts
and foreign exchange options. The majority of financial instruments hedging foreign
exchange risk have durations of less than a year. Treasury is responsible for monitoring
and managing the interest rate exposure of the Group. Interest rate risk mainly arises
through interest bearing liabilities and assets.
Credit risks related to customer financing are analyzed, monitored and managed by
Customer Finance section. Credit risks are approved and monitored by the Credit
Committee in accordance with the principles set out in the Company’s credit policy.
Financial credit risk, which is the risk of the counterparties to a financial instrument being
unable to meet their obligation, is measured and monitored by the Treasury function.
Nokia’s policy is to guarantee a sufficient liquidity at all times by efficient cash
management and by investing in liquid interest bearing securities. Insurance is
purchased for risks, which cannot be internally managed.

6. It is clear that U.S. companies place much more emphasis on profit oriented goals
compared to Japanese companies, which place more emphasis on sales volume and
production costs.
One reason for this is the pressure from the capital market for companies in the U.S. to
achieve profit targets. Unlike U.S. companies, Japanese companies are not under so
much pressure to focus on profits, because in Japan the capital market is not the main
provider of finance for business; a greater proportion of shares is held by related banks,
suppliers, and corporate customers. These stakeholders are more interested in strong
long-term business ties than in maximizing short-term profit. Management jobs are
relatively more secure in Japan, and there is less pressure for managers to show short-
term results. On the other hand, price competition in export markets is very intense
among Japanese companies, and this is reflected in their concern for production costs
as a top goal.

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Another reason for the emphasis on profit in the U.S. is cultural. The U.S. is a highly
individualistic society, and as a result, demonstration of achievement becomes
important. In the case of companies, profit is a clear demonstration of achievement. On
the other hand, Japan is a collectivistic society, where long-term survival is highly valued
highly, and this is reflected in the focus on sales growth and reducing production costs.

7. There is increasing recognition internationally that focusing on financial measures alone

is not sufficient in managing the business, and other factors such as customer
satisfaction and internal business processes also should be considered. The balanced
scorecard provides a mechanism for incorporating a variety of measures into the
performance evaluation process for this purpose. The balanced scorecard is a
performance management system that can be used in any organization to align its vision
and mission with customer requirements and day-to-day work, monitor implementation of
business strategy, build organization capacity, and communicate progress to all
employees.

8. The statement is correct in that it is not always possible to clearly separate the
performance of a subsidiary from that of its managers, because costs often cannot be
classified as either completely controllable or completely uncontrollable and are
influenced by both managerial actions and other external factors. External factors that
influence a subsidiary’s performance include decisions made by corporate management,
policy decisions by the parent country and host governments, and other factors such as
terrorism, labor strikes, and natural disasters.
However, the second part of the statement is not correct. It is necessary to separately
identify the performance of the managers from the performance of the subsidiary,
because it is neither correct nor fair to include the impact of factors beyond a manager’s
control in evaluating his or her performance. Managers expect to be evaluated on the
basis of their own performance focusing on the impact of the decisions they have made.
A main objective of performance evaluation is to motivate managers to perform better
over time and to reward good performance. This cannot be achieved if managers’
performance is not separately identified. However, as described above, this is not
always an easy task.

9. It would be appropriate to evaluate the performance of a foreign subsidiary in terms of

local currency (rather than in terms of parent currency) when the foreign subsidiary is not
expected to generate parent currency to be received by the parent. Such a case might
exist, for example, when the foreign subsidiary plays the role of a raw material supplier.
In evaluating other types of foreign operations, use of the local currency could be
justified by the argument that over the long run the ability to achieve good performance
in local currency would result in good performance in parent company currency.

10. The complexities in developing global business strategies arise mainly from the diversity
in business environments internationally. Economic and legal environments vary across
countries and are reflected in differences in the level of economic development,
regulatory structures, taxation systems, financial reporting requirements and
enforcement mechanisms, and inflation rates. Another element of the business
environment that varies internationally is the political situation. Host governments’
attitudes towards foreign business and the level of political stability in a host country are
factors that will have a direct impact on foreign operations. For example, a non-Chinese
company seeking to establish a business in China is required to enter into a joint venture
partnership with a local entity. This is not true in many other countries. Labor laws also
can vary across countries. In some countries, such as Germany and France, where
trade unions are strong, it is more difficult for firms to lay-off employees than, for
example, it is in the U.S. One of the most important factors that cause complexities in
developing global business strategies relates to cultural difference across countries.

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Both the formulation of strategy and the communication of strategy to subsidiary

managers are affected by the cultural value orientation of the host country. Language
can be another impediment to developing a global strategy. Certain ideas in the
corporate strategy may not be capable of translation into the host country language.

11. This question should be answered by the student stating whether or not they agree with
the view expressed, and then developing a discussion in a logical fashion to support the
position taken. The main points that could be considered in such a discussion include the
following:
 Globalization is a process that leads to convergence of markets internationally,
making national boundaries irrelevant. Globalization is also associated with a
particular set of market-based values, such as the use of capital market oriented
measures in evaluating performance of businesses. Proponents of globalization
argue that the forces of globalization are so strong that every society has to fully
embrace it if not to be left behind. For example, as financial markets are becoming
increasingly integrated, multinational businesses are evaluated in the same fashion
regardless of where they are located. On this view, it is argued that globalization has
made cultural differences among countries irrelevant in conducting business. This
seems to be the rationale for the efforts to develop a set of global standards for
financial reporting.
 On the other hand, research has shown over and over again that different societies
have different cultural value orientations and that these cultural values influence
every aspect of life, for example, the behavior patterns as managers, employees and
investors. One of the most important objectives of managing a multinational business
operation is to motivate its employees to perform better. However, a single strategy
cannot be effective in motivating people from different cultural backgrounds, because
they tend to respond differently depending on their value orientations. For example,
offering financial incentives to employees may be effective in a U.S. company, but
not so effective in a Japanese company. There may be nonfinancial but more
culturally sensitive incentives, which are more effective in motivating Japanese
employees, such as recognition as a valued member of the company. To be
successful in business, it is essential to be sensitive to local conditions and
circumstances.

 What we have is a situation where two forces going in opposite directions, the force
of globalization in the direction of convergence, and the force of culture emphasizing
the importance of local conditions and values. It is not possible to ignore one in favor
of the other, because both are important. Therefore, what is needed is a
compromise, or to be sensitive to the positive aspects of both forces in developing
strategies and standards.

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Case 12-1 CANYON POWER COMPANY

Solution

Project Perspective (in Indian Rupees)

Year 1 Year 2 Year 3 Year 4
Price Price Price Price
Units (Rs.) Total (Rs.) Units (Rs.) Total (Rs.) Units (Rs.) Total (Rs.) Units (Rs.) Total (Rs.)
Sales

Local 5,000 4,500.00 22,500,000 6,000 4,950.00 29,700,000 7,000 5,445.00 38,115,000 8,000 5,989.50 47,916,000

Export 10,000 4,500.00 45,000,000 12,000 4,950.00 59,400,000 14,000 5,445.00 76,230,000 16,000 5,989.50 95,832,000
Total sales 67,500,000 89,100,000 114,345,000 143,748,000
Operating expenses (40,000,000) (40,000,000) (40,000,000) (40,000,000)
Depreciation (17,975,000) (17,975,000) (17,975,000) (17,975,000)
Interest expense (27,000,000 x 10%) (2,700,000) (2,700,000) (2,700,000) (2,700,000)
Royalty payment (20,000,000) (20,000,000) (20,000,000) (20,000,000)
Earnings (13,175,000) 8,425,000 33,670,000 63,073,000
add: depreciation 17,975,000 17,975,000 17,975,000 17,975,000
Cash flow from operations 4,800,000 26,400,000 51,645,000 81,048,000
Salvage value of plant 0 0 0 10,000,000
Repayment of local loan 0 0 0 (27,000,000)
Total annual cash flows 4,800,000 26,400,000 51,645,000 64,048,000

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Net Present Value: Year 1 Year 2 Year 3 Year 4 Total

Total annual cash flows 4,800,000 26,400,000 51,645,000 64,048,000

Present value factor (16%) 0.862 0.743 0.641 0.552
Present value 4,137,600 19,615,200 33,104,445 35,354,496 92,211,741
Initial investment (67,500,000)
Net Present Value (NPV) 24,711,741

Initial Investment: $ Ex. Rate Rs.

Equity 1,500,000 45 67,500,000

Calculation of depreciation: $ Rs.

Cost of plant 1,800,000 45 81,000,000
Installation costs 15,000 45 675,000
Testing costs 5,000 45 225,000
1,820,000 81,900,000
Less: Salvage value (10,000,000)
Depreciable cost 71,900,000
Annual depreciation expense (71,900,000/4 years) 17,975,000

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Parent Company Perspective (in U.S. dollars)

Year 1 Year 2 Year 3 Year 4 Total
Exchange Rate Rs. 45 Rs. 43 Rs. 40 Rs. 38
Royalties (Rs. 20,000,000) $ 444,444 $ 465,116 $ 500,000 $ 526,316
Dividends (Earnings) 0 195,930 841,750 1,659,816
U.S. income tax on dividend 0 (68,576) (294,613) (580,936)
Terminal value (Rs. 10,000,000) 0 0 0 263,158
Total cash flow to parent $ 444,444 $ 592,471 $ 1,047,138 $ 1,868,354
Present value factors (16%) 0.862 0.743 0.641 0.552
Present value $ 383,111 $ 440,206 $ 671,215 $ 1,031,331 $ 2,525,864
Initial investment 1,500,000
Net present value $ 1,025,864

The positive NPV from both the project and parent company perspectives would suggest that the proposal should be
accepted. Students should explore other issues to be considered before making a final decision including, for example,
conducting a sensitivity analysis.

Note:
Project perspective – the foreign bank loan is not part of the initial investment by the parent
Parent company perspective – in addition to royalties, dividends and terminal value are cash flows to the parent.

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Case 12-2 LION NATHAN FACES REALITY!

Solution

Lion Nathan is a typical case of a company, which has grown from its humble beginnings to
become a large MNC, “one of Australasia’s largest brewery companies.” With a Chairman/CEO
who has a passion for the brewing industry, Lion entered into a new phase in its growth with the
decision to expand across borders, first to Australia and then to China (Exhibit II). The purpose
of this case is to highlight some of the accounting and related issues faced by companies like
Lion that enter into foreign markets that are different in many ways from those of their own
countries. Students are expected to prepare a report identifying the main strategic issues
related to Lion’s Chinese operation.

On the surface at least, the conditions of the Chinese beer market appeared to be excellent as a
business proposition. For example, Wuxi, situated in the Yangtse River Delta area, was one of
the wealthiest cities in China; the region had very high growth rates over several years; the level
of beer consumption, while currently low, was on the increase; Wuxi offered a great opportunity
for further expansion within China, the world’s second largest market. Lion invested over $200
million. However, with all the resources and expertise in the industry, the Chinese initiative was
fraught with problems from the beginning.

Issues
 As part of the joint venture arrangement, Lion was expected to retain local management
personnel, except for specialists in production and marketing. However, this was not easy.
 The complex nature of the issues related to international mergers and acquisitions:
o In 1998, Kirin Brewery, Japan’s largest Brewer, purchased 45% of Lion.
o In 1999, Lion entered into an agreement with a German Brewer, Brauerei Beck, showing
Lion’s commitment to China.
o However, there were some concerns about Kirin’s motives and commitment to China
(Exhibit III). Kirin’s attitude was problematic to Lion’s strategic direction.
 Currency translation issues, e.g., the loss of RMB 83.8 million was a 32% improvement
compared to the previous year, but in Australian dollar terms, this was only a 21%
improvement. How could this be?
 The importance of market research as part of investment decisions, particularly in foreign
markets. Lion does not appear to have conducted a thorough market research before
venturing into the Chinese market, which was characterized by,
o A high level of competition involving the major brewery companies from around the
world,
o Transport problems,
o Problems of recruiting, training, and retaining local personnel,
o The differential treatment of foreign companies compared to local companies, for
example, in applying regulations.
 Cultural issues -- The importance of understanding the impact of cultural values on peoples’
behavior, for example, in conducting business.
o The way business is conducted in China, e.g., the role of “guanxi” in business dealings.
o Long-term vs. short-term orientation (Confucian dynamism).
Lion’s executives may not have fully understood the cultural differences and the impact
of those differences on the behavior of business people.

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Chapter 12 - Strategic Accounting Issues in Multinational Corporations

 The effect of corruption on business activities.

To emphasize that certain business practices may be considered as corruption in
society, and accepted behavior in another society.

The concept of globalization itself would be an interesting issue for discussion. For example, are
the critiques of globalization right when they refer to it as a lot of “globolony”? Other possible
topics for discussion include internationalization of capital markets, for example, the reasons for
MNCs to list their shares on foreign stock exchanges, and the problems associated with brand
valuation, and the impact of brand values on the reported financial position and results. IAS -38
could be incorporated into this discussion.

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