A STUDY OF THE INVESTMENT POLICY
AND PERFORMANCE OF SUBSIDIARIES
OF U. S. MANUFACTURING
CORPORATIONS IN BRAZIL

Thesis for the Degree of Ph. D.
MICHIGAN STATE UNIVERSITY
JOAO CARLOS HOPP
1969

*HEQAS

This is to certify that the
thesis entitled

A STUDY OF THE INVESTMENT POLICY AND PERFORMANCE
OF SUBSIDIARIES OF U.S. MANUFACTURING
CORPORATIONS IN BRAZIL

presented by

Jogo Carlos HOpp

has been accepted towards fulfillment
of the requirements for

Ph.D. Business Administration

degree in

 

 

M aior prot/essor

DK/Z/{Vfll’ CZ/QZ?

 

 

ABSTRACT
A STUDY OF THE INVESTMENT POLICY AND PERFORMANCE

OF SUBSIDIARIES OF U.S..MANUFACTURING
CORPORATIONS IN BRAZIL

BY
JoSo Carlos HOpp

The continuous flow of direct United States invest-
ment to Brazil, particularly in the manufacturing sector of
the economy, has brought with it unsettled questions in
reSpect to (l) motivational factors for the investment
decision, (2) performance of subsidiary companies, (3) risk
incurred in the venture, and (4) investment policy of the
subsidiary. The purpose of this study is to examine and
evaluate the investment performance and policies of subsid-
iary companies in comparison with their parent corporations.
In the search for answers for these questions this disserta—
tion uncovers some reasons for the investment decision in
Brazil as well as the beliefs of American managers in
respect to the risk variable. The basic hypotheses are:

(l) The subsidiary companies are net monetary debtors; (2)
Investement in Brazil carries more risk than in United
States; (3) A better performance, as measured by profitabil-
ity ratios, will be obtained by subsidiaries in comparison

with their parent companies.

JoSo Carlos HOpp

These hypotheses were tested by a comparison of
the annual report data of 47 Brazilian manufacturing subsid-
iaries of United States corporations, out of a total of 159
in Operation at December 31, 1967 with the data published by
the parent companies for a five-year period between 1963 and
1967. The sample used in this study consisted of all U.S.
subsidiaries in manufacturing and organized as corporations
in Brazil, where the owner's equity exceeded one million
dollars at the end of 1967. These 47 companies comprise
82.0 percent of the total owner's equity and 73.8 percent
of the total assets of all 159 manufacturing U.S. subsidiary
corporations in Brazil.

-A comparative study of subsidiary and parent com-
panies is hardly feasible unless the financial reports of
both groups are eXpressed in the same economic context. The
Brazilian economy during the period of study was character-
ized by a gallOping inflation which, if not accounted for
in the financial statements, can give rise to an erroneous
interpretation of profits and of investment policy. In
order to correct this situation, all the financial state-
ments of the subsidiaries were adjusted by using the tech-
nique of price-level adjustments. After the adjustments,
the annual reports were the instrumental device used in the
determination of the investment policy followed by the sub-
sidiaries. Investment policy, in this study, deals mainly

with asset distribution criteria adhered to by the subsidiary

JoSo Carlos HOpp

and parent companies. The financial reports are also uti-
lized for a study of the debt policy and capital structure
of the subsidiaries. A position of net monetary debtor/
creditor emerges as one of the most important policies that
influences the performance of subsidiary companies. Since
the subsidiary's annual reports do not provide sufficient
information for analysis of investment decision and U.S.
executives' perception of the risk element, a questionnaire
was developed and sent to 32 parent companies in order to
close this gap. A personal interview was conducted in an
additional 15 companies, using the same questionnaire. Out
of 32 questionnaires mailed, 10 companies participated in
the study, 12 eXpressed their inability to participate and
10 did not respond.

The findings of this study are, then, based on the
data collected in financial reports of the 47 companies
included in the sample and on the response and comments
gathered from the 25 companies that answered the question—
naire.

The empirical study yielded the following results:

1. The decision to invest in Brazil was determined, in
order of importance, by: (a) Demand for the product
in the Brazilian market, (b) Negative incentives of

Brazilian government, and (c) Positive incentives of

Brazilian government.

1.

JOSO Carlos HOpp

The risk element was analyzed by using quantitative
(business risk as evidenced by variability of returns)
and qualitative (perceptions of political risk)
approaches. By both methods, the risk was found to
be higher among the subsidiary companies than for
their parents.

Performance, as measured by net profit to total
assets, and net profit to owner's equity, was found
to be lower for the subsidiaries of all 47 companies
over the five-year period.

Subsidiary and parent companies follow different
investment policies, caused by many variables, such
as: trade credit policy, the availability of bank
credit, the business environment, and the stage of

develOpment of the market.

Regarding the hypotheses it was found that subsid—

iary companies are not net monetary debtors, Brazilian invest-
ment does carry more risk than investment in United States,

and subsidiary companies do not have better performance.

.An explanation why American companies are continuing

to Operate in Brazil when the return is smaller and the risk
larger than Operating in the United States, is given below

in summary form:

The goal of the subsidiaries is long-run profits,
rather than short-run profits.

Joao Carlos Hopp

The market is believed to have a good potential for
develOpment and Brazilian government regulations
force investment in local production facilities if
the parent wishes to participate in this market.

United States executives are Optimistic over the
develOpment of LAFTA (Latin America Free Trade
Association) and believe that a Brazilian manufac-
turing subsidiary will give them an advantageous
position to supply this regional market.

The period (1963-1967) used in this study was
considered to be atypical in relation to earlier
periods and eXpectations for the future.

In many cases, there was an increase in sales from
the parent company to the Brazilian market after
the Opening of the subsidiary, and these are not
shown in subsidiaries' annual reports but rather
in the reports of the parent.

A STUDY OF THE INVESTMENT POLICY AND PERFORMANCE
OF SUBSIDIARIES OF U.S. MANUFACTURING

CORPORATIONS IN BRAZIL

BY

JoSo Carlos HOpp

A THESIS

Submitted to
Michigan State University
in partial fulfillment of the requirements
for the degree of

DOCTOR OF PHILOSOPHY

Department of Accounting and Financial Administration

1969

 

‘I

,//./’

‘lll‘ll‘ll‘ll‘I

 

. .11.:II»nn.,1;.II.v.t nJ.

66. //42
34y,”

© COpyright by
JoKo CARLOS HOPP

1970

ACKNOWLEDGMENTS

The author wishes to eXpress his deep appreciation
to Dr. Adolph E. Grunewald, Chairman of my Advisory Committee
for his guidance in this study and in preparation for this
manuscript.

I shall always be grateful to Dr. Dole A. Anderson
for many hours of careful critical reading and analysis of
the manuscript, for his professional and personal encourage-
ment, and for his confidence in me.

Special gratitude is eXpressed to my thesis adviser,
Dr. George C. Mead, for the continual stimulation of his
insight and for the pleasure of the hours spent with him as
a student and friend.

There are many more who have made my work easier and
more rewarding: Dr. James Don Edwards, Chairman of the
Department of Accounting and Financial Administration, was
a constant source of encouragement during my three-and-a-
half-year stay at Michigan State University; Richard G.
Walter, my friend and doctoral candidate, for his many hours
‘of efforts and valuable suggestions during the course of
this study; the sometime much needed support and encourage-
ment were given generously by my Brazilian friends here at
Michigan State University and my colleagues at Escola de
AdministracSo de Emprésas de 850 Paulo.

My wife, Profess6ra Maria Isabel Ramos HOpp, through
her devoted support and willingness to be both mother and
father to the children on so many occasions has qualified
her for honors far greater than any recognition which might
accompany a graduate degree. She made all this worthwhile.

*****

iii

TABLE OF CONTENTS

Chapter Page
I O INI‘RODUflION O O O O O O O O O O O O O O O O O 1
Purpose of the Study . . . . . . . . . . . . 1
History of Brazilian Economy . . . . . . . . 3
Principal Economic Cycles . . . . . . . 4
Recent Tendencies . . . . . . . . . . . . . 10
Investment Policy and Measurement of
Performance of Subsidiary Companies . . . 19
The Hypotheses . . . . . . . . . . . . . 24
Organization of the Study . . . . . . . . . 24
II. METHODOLOGY IN THE DETERMINATION OF THE SAMPLE
AND LIMITATIONS OF THE PRIMARY DATA . . . . 26
IntrOduCtion o o o o o o o o O o o O o o o 26
Size and Characteristics of the Sample . . . 28
Limitations of Subsidiaries' Annual
Reports . g g g o o o o o o o o 33
Price-Level Adjustment MethOd . . . . . 39
Product Differences as a Limitation
Of the Study 0 O O O O O O I O C O O O O O 5 1
III. PROFIT ILLUSION IN AN INFLATIONARY ECONOMY . . 54
Introduction . . . . . . . . . . . . . . . 54
Effect of Inflation on Annual Reports . . . 59
Price-Level Accounting . . . . . . . . . . . 65
Example of the Use of Price-Level
Accounting . . . . . . . . . . . . . . . . 82

IV. FINANCIAL POLICIES IN AN INFLATIONARY
ECONOW O C O O C O C O O O C O O O O C O O 90

Introduction . . . . . . . . . . . . . . . . 90
Financial Policies of Subsidiary and
Parent Corporations: Application

of Funds . . . . . . . . . . . . . . . . . 96
Financial Policies and Subsidiary and

Parent Corporations: Source of Funds . . 112
Credit Policy of the Banking System in

Brazil . . . . . . . . . . . . . . . . . . 124

iv

Chapter

V. INVESTMENT PERFORMANCE OF BRAZILIAN
SUBSIDIARIES: A COMPARISON WITH
PAMNT CORPOMTIONS O O O C O . C O O 0

Introduction . . . . . . . . . . . . .
Questionnaire--Instrument and ReSpOnse .
Analysis of Risk . . . . . . . . . . . .
Empirical Findings Regarding Performance

Conclusion . . . . . . . . . . . .

Automobile Industry . . . . . . . .

-Auto Equipment Industry . . . .

.Soap and Toiletry Industry . .

Foodstuff and Soft Drink Industry .
Glass Industry . . . . . . . . . . .
Household Appliances Industry . . .
Machinery and Equipment Industry . .
Office Equipment Industry . . . . .
Packaging Industry . . . . . . . . .
Pharmaceutical Industry . .

Plastic and Chemical Industry
Tire and Rubber Industry . . .

Tractor and Earthmoving Industry . .

VI. SUMMARY AND CONCLUSION . . . . . . . . . .

Size and Characteristics of the Sample .

Investment Policy . . .
.Investment Performance .
Normative PrOpositions .
Conclusion . . . . . . .

BIBLIOGRAPHY

APPENDIX

A. QUESTIONNAIRE USED AT THE INTERVIEWS AND
SENT TO THE OFFICERS OF U.S. PARENT
COMPANIES O I O C O O O O C O O O O O O

B. INITIAL LETTER SENT TO OFFICERS OF U.S.
PAMNT CORPOMTIONS . O O O O O C C C C

C. FOLLOW-UP LETTER SENT TO OFFICERS OF ALL U.S.

PARENT COMPANIES WHO DID NOT ACKNOWLEDGE
INITIAL LETTER . . . . . . . . . . . . .

Page

130

130
135
139
144
145
149
151
156
159
162
165
168
171
174
177
180
183
188

190
190
191
194
196
200

203

207

212

213

Table

1.

10.

11.

LIST OF TABLES

Brazil, gross domestic product total and
per capita value, 1947/1966 . . . . . . . .

Brazil, index of real product (Base:
1949--100) I 1947/1966 0 o o o o o o o o o 0

Distribution of the 55 largest corporations
in Brazil into national and foreign (Year-—
1964) O I O C O O O 0 0 O O O O O O O O O 0

Distribution of foreign corporations by
countries (Ye ar-_1964) o o o o o o o o o 0

Distribution of the 55 largest corporations
in Brazil by basic sectors (Year--1964) . .

United States total direct investment and
direct manufacturing investment in Brazil .

Distribution of 405 United States subsid-
iaries in Brazil by type of business and
corporate form of organization in the
manufacturing sector . . . . . . . . . . .

Distribution of United States manufacturing
subsidiaries included in VisSo's survey and
in the sample . . . . . . . . . . . . . . .

Comparison of owner's equity and total assets

of the 47 manufacturing subsidiary corpora-
tions with the 75 listed in Visgo and with

the total of all United States manufacturing

subsidiary corporations in Brazil . . . . .

Cost of living index and exchange rate
variation 0 o C O o o o o o o o o O O O 0 O

Illusory profits in the replacement of
working capital . . . . . . . . . . . . . .

vi

Page

11

12

13

14

15

18

27

30

31

37

58

Table

12.

13.

14.

15.

16.

17.

18.

19.

20.

21.

22.

23.

24.

Consumer price index . . . . . .

Distribution by asset composition
subsidiaries and parent companies
the automobile industry . . . . .

Distribution by asset composition
subsidiaries and parent companies
auto equipment industry . . . . .

Distribution by asset composition
subsidiaries and parent companies
foodstuff and soft drink industry

Distribution by asset composition
subsidiaries and parent companies
glass industry . . . . . . . . .

Distribution by asset composition
subsidiaries and parent companies
household appliance industry . .

Distribution by asset composition
subsidiaries and parent companies
machinery and equipment industry

Distribution by asset composition
subsidiaries and parent companies
office equipment industry . . . .

Distribution by asset composition
subsidiaries and parent companies
packaging industry . . . . . . .

Distribution by asset composition
subsidiaries and parent companies
pharmaceutical industry . . . . .

Distribution by asset composition
subsidiaries and parent companies
plastic and chemicals industry .

Distribution by asset composition
subsidiaries and parent companies
tire and rubber industry . . . .

Distribution by asset composition

subsidiaries and parent companies
soap and toiletry industry . . .

vii

of
in

of
in

of
in

of
in

of
in

of
in

of
in

of
in

of
in

of
in

of
in

of
in

Page
70

102

102

103

103

104

104

105

105

106

106

107

107

Table

25.

26.

27.

T28.

.29.

230.

3]"

132.

313,

34.

35,

3€5_

Distribution by asset composition of
subsidiaries and parent companies in
tractor and earthmoving industry . . .

Ranking of the assets composition of
subsidiaries and parent companies in
different industries . . . . . . . . .

Classification by asset strategy of the
47 subsidiaries and parent corporations

Distribution by source of funds composi-
tion of subsidiary and parent companies
in automobile industry I. . . . . . . .

Distribution by source of funds composi-
tion of subsidiary and parent companies
in auto equipment industry . . . . . .

Distribution by source of funds composi-
tion of subsidiary and parent companies
in foodstuff and soft drink industry .

Distribution by source of funds composi-
tion of subsidiary and parent companies
in glass industry . . . . . . . . . . .

Distribution by source of funds composi-
tion of subsidiary and parent companies
in household equipment industry . . . .

Distribution by source of funds composi-
tion of subsidiary and parent companies
in machinery and equipment industry . .

Distribution by source of funds composi-
tion of subsidiary and parent companies
in office equipment industry . . . . .

Distribution by source of funds composi-
tion of subsidiary and parent companies
in packaging industry . . . . . . . . .

Distribution by source of funds composi-

tion of subsidiary and parent companies
in pharmaceutical industry . . . . . .

viii

Page

108

110

111

117

117

118

118

119

119

120

120

121

Table

37.

38.

39.

‘40.

‘41.

442.
‘43.

‘44.

‘45.

4'60

47,

Distribution by source of funds composi-
tion of subsidiary and parent companies
in plastic and chemicals industry . . . . . .

Distribution by source of funds composi-
tion of subsidiary and parent companies
in tire and rubber industry . . . . . . . . .

Distribution by source of funds composi-
tion of subsidiary and parent companies
in soap and toiletry industry . . . . . . . .

Distribution by source of funds composi-
tion of subsidiary and parent companies
in tractor and earthmoving industry . . . . .

Distribution by debt to total assets basis
for subsidiary and parent companies in
different industries in accordance with

data from Tables 28 through 40 . . . . . . .

Loans to the public versus money supply . . .
Real balance of loans to the public . . . . .

Distribution by industry of the companies
which responded to the questionnaire . . . .

Returns on total assets and owner's equity
of subsidiary (before and after adjustments)
and parent companies and variance of returns
on subsidiary (after adjustments) and parent
companies for the period of 1963-1967 in

the automobile industry . . . . . . . . . . .

Returns on total assets and owner's equity
of subsidiary (before and after adjustments)
and parent companies and variance of returns
on subsidiary (after adjustments) and parent
companies for the period of 1963-1967 in the
auto equipment industry . . . . . . . . . . .

Returns on total assets and owner‘s equity

of subsidiary (before and after adjustments)

and parent companies and variance of returns

on subsidiary (after adjustments) and parent

companies for the period of 1963-1967) in the
foodstuff and soft drink industry . . . . . .

ix

Page

121

122

122

123

125
126

127

138

146

150

153

Table
448.

£19.

£50.

£51.

£52.

5523.

54.

Page

Returns on total assets and owner's equity

of subsidiary (before and after adjustments)

and parent companies and variance of returns

on subsidiary (after adjustments) and parent
companies for the period of 1963-1967 in

the glass industry . . . . . . . . . . . . . . 157

Returns on total assets and owner's equity

of subsidiary (before and after adjustments)

and parent companies and variance of returns

on subsidiary (after adjustments) and parent
companies for the period of 1963-1967 in

the household appliances industry . . . . . . . 160

Returns on total assets and owner's equity

on subsidiary (before and after adjustments)

and parent companies and variance of returns

on subsidiary (after adjustments) and parent
companies for the period of 1963-1967 in

the machinery and equipment industry . . . . . 163

Returns on total assets and owner's equity

of subsidiary (before and after adjustments)

and parent companies and variance of returns

on subsidiary (after adjustments) and parent
companies for the period of 1963—1967 in

the office equipment industry . . . . . . . . . 166

Returns on total assets and owner's equity

of subsidiary (before and after adjustments)

and parent companies and variance of returns

on subsidiary (after adjustments) and parent
companies for the period of 1963-1967 in

the packaging industry . . . . . . . . . . . . 169

Returns on total assets and owner's equity

of subsidiary (before and after adjustments)

and parent companies and variance of returns

on subsidiary (after adjustments) and parent
companies for the period of 1963-1967 in

the pharmaceutical industry . . . . . . . . . . 172

Returns on total assets and owner's equity

of subsidiary (before and after adjustments)

and parent companies and variance of returns

on subsidiary (after adjustments) and parent
companies for the period of 1963-1967 in

the plastic and chemical industry . . . . . . . 175

Table

55.

56.

.57.

Page

Returns on total assets and owner's equity

of subsidiary (before and after adjustments)

and parent companies and variance of returns

on subsidiary (after adjustments) and parent
companies for the period of 1963-1967 in the

tire and rubber industry . . . . . . . . . . . 178

Returns on total assets and owner's equity

of subsidiary (before and after adjustments)

and parent companies and variance of returns

on subsidiary (after adjustments) and parent
companies for the period of 1963—1967 in the

soap and toiletry industry . . . . . . . . . . 181

Returns on total assets and owner's equity

of subsidiary (before and after adjustments)

and parent companies and variance of returns

on subsidiary (after adjustments) and parent
companies for the period of 1963-1967 in the

tractor and earthmoving industry . . . . . . . 184

xi

10.

11.

LIST OF FIGURES

Cost of living and wholesale prices . .

Indifference curves of eXpected return
and risk 0 C C O O C O O O C C O O I O 0

Risk and return on owner's equity of
automobile industry for subsidiary and
parent companies . . . . . . . . . . . .

Risk and return on owner's equity of
auto equipment industry for subsidiary
and parent companies . . . . . . . . . .

Risk and return on owner's equity of
foodstuff and soft drink industry for
subsidiary and parent companies . . . .

Risk and return on owner's equity of
glass industry for subsidiary and parent
companies . . . . . . . . . . . . . . .

Risk and return on owner's equity of
household appliances industry for
subsidiary and parent companies . . . .

Risk and return on owner's equity of
machinery and equipment industry for
subsidiary and parent companies . . . .

Risk and return on owner's equity of
office equipment industry for subsidiary
and parent companies . . . . . . . . . .

Risk and return on owner's equity of
packaging industry for subsidiary and
parent companies . . . . . . . . . . . .

Risk and return on owner's equity of

pharmaceutical industry for subsidiary
and parent companies . . . . . . . . . .

xii

Page

69

143

148

152

155

158

161

164

167

170

173

Figure Page

12. Risk and return on owner's equity of plastic
and chemical industry for subsidiary and
parent companies . . . . . . . . . . . . . . . 176

13. Risk and return on owner's equity of tire
and rubber industry for subsidiary and
parent companies . . . . . . . . . . . . . . . 179

14. Risk and return on owner's equity of soap
and toiletry industry for subsidiary and
parent companies . . . . . . . . . . . . . . . 182

15. Risk and return on owner's equity of tractor

and earthmoving industry for subsidiary and
parent companies . . . . . . . . . . . . . . . 185

xiii

CHAPTER I

INTRODUCTION

Purpose of the Study

The eXpansion of United States direct investment in

Brazil has proceeded continuously with the exception of 1964
ever since World War II. This tremendous eXpansion has led
to Speculation concerning exorbitant profit expectations on
the part of American parent firms whose subsidiaries are
located in Brazil. In traditional investment theory it is
assumed that a firm‘would make foreign investments only if
the rate of return on those investments exceeded the rate of
return on domestic investments of the same risk class. That
additional risks are incurred in undertaking foreign invest-
ment cannot be denied. However, there are certain market
considerations which may more than make up for the differ-
ence in terms of higher returns. The main purpose of this
paper is to examine the relative returns of Brazilian sub—
sidiaries and evaluate them in relation to:

1. parent company's return,

2. risk incurred, and

3. professed goals of parent company's investment

decision in Brazil.

The high inflation rate experienced in Brazil for
the last twenty-five years calls for a specific investment
policy of the subsidiary company. .Accordingly, my secondary
purpose is to determine whether investment policies followed
were rational in the light of the inflation (and other busi-
ness factors) again using the parent company's policies as
benchmarks.

Hopefully, this study will help the interested
reader to get some insights in the following problems:

1. the basic factors that motivate American corpora—
tions in investing in Brazil.

2. the adjustment of financial reports of Brazilian
subsidiaries (made necessary by the high rate of
inflation).

3. the impact of rapid inflation in the policies and
performance of the company.

4. to evaluate the contentions of extremist "national-
ists" that United States companies earn exorbitant

profits in Brazil.

In the next section of this chapter a short back—
ground on the history of the Brazilian economy is develOped,
to familiarize the reader with the pattern of dependency on
certain key primary commodities, which dominated in succes-
sive cycles its eXport structure. This part can be omitted
by the reader who is familiar with these economic cycles,

but the section "Recent Tendencies" in which are discussed

the origins of the develOpment of the manufacturing sector
in Brazil as well as the importance of United States invest—
ment should be read by all.

The importance of obtaining an historical perspec-
tive lies in gaining an appreciation of the need for indus-
trialization of Brazil and therefore the key role in the
Brazilian economy of the largely industrial United States

subsidiaries included in this study.
History of Brazilian Economy

Investment for utilization and develOpment of
resources has been part of the history of Brazil from the
very start with its contact with EurOpeans.

The beginning of the economic occupation of Brazil
was largely the result of political pressure exerted on
Portugal and Spain by other EurOpean nations. -Among the
latter, the prevailing principle was that the Spanish and
Portuguese should be entitled only to those tracts of land
which they had effectively occupied. The gold mirage hang-
ing over inland Brazil greatly influenced Portugal's deci-
sion to make a strong effort to keep their territories in
America, inasmuch as Portugal's own resources available for
productive investment in Brazil were small.

Further, economic (agriculture or trade) utilization
of the Western HemiSphere would have seemed a completely
unfeasible undertaking in the sixteenth century. .At the

time, no agricultural product was the Object of large scale

trade within EurOpe. Thus, eXploitation of natural
resources was the motive in the colonial develOpment of

early Brazilian economy.

Principal Economic Cycles

Brazil-wood.--Lack of knowledge of Brazil's possi-
bilities and preoccupation with the riches of the Indies
meant that Portugal neglected the economic eXploitation of
the country in the first thirty years of its history, i.e.,
from 1500 to 1530. Brazil-wood, found in abundance on the
Brazilian coast, was what afforded the greatest advantages.
In the EurOpean market, this wood produced highly rewarding
prices and gave exceptional profits to those who dealt with
it. Brazil-wood, therefore, was the initial economic basis,
defining in this way, the first cycle of Brazilian economy
that prevailed during the beginning of the sixteenth century.

Sugar-cane.--Around 1550 great estates arose where

 

the cultivation of sugar—cane and stockbreeding began. From
the middle of the sixteenth century until the second half of
the seventeenth century sugar was its principal eXport crop.
Sugar was also one of the principal items of international
trade at that time, and Brazil was the dominant source of
supply. For twenty-five years in the first half of the
seventeenth century, the Dutch occupied the part of north-
eastern Brazil which was the main sugar producing region.

After their eXpulsion, the Dutch used their technical skills

and the capital to develOp the production of sugar in the
British and French West Indies.

The Dutch contribution to the great eXpansion of the
sugar market in the latter half of the sixteenth century may
be viewed as a basic cause of the success of agricultural
settlement in Brazil.

.In the period from 1530 to 1822, of a total export
value at 530 million pounds sterling, sugar earned 300 mil-
lion (32:170). The importance of the sugar-cane industry
~in the Colonial economy is eXpressed by these figures and
by the closeness of man to the land, which facilitated the
prosperity of the large land estates, the origin of the
agrarian nobility, who were the principal support of
Brazilian society.

IStockbreeding.--Introduced together with sugar-cane,

 

stockbreeding furnished indiSpensable elements of life and
work in the country. Moving towards the interior, a favor-
able habitat for cattle was found.

Cattle breeding was an activity with economic char-
acteristics completely different from those of the sugar
producing sector. Occupation of land was extensive and to
some degree nomadic. Water availability entailed periodic
moving of herds, the prOportion of permanently occupied land
being insignificant.

gglg,--The gold mining period lasted throughout most
of the eighteenth century and had a number of important

effects. Because of it, the economic center of the country

shifted from the north to the central-south; the shift of
labor from the sugar mills to mining accelerated the con-
traction of sugar production; for the first time there was

a large inflow of Portuguese immigrants mainly because min-
ing required much smaller initial capital resources than the
establishment of sugar-cane plantations; and, finally, an
urbanization process started with the appearance of numerous
cities in the mining area.

The very nature of the mining enterprise did not
stimulate as much attachment to the land as prevailed in the
sugar regions. Fixed assets involved were small and the
organization was such as to permit a change of location at
short notice. On the other hand, the high profitability of
the business was conducive to a concentrating of all avail—
able resources in the mining activity.

In some regions the curve of production rose and
fell sharply, causing sudden flows of pOpulation back and
forth: in others the curve was less marked, permitting more
regular pOpulation growth as well as the permanent settling
of important centers of pOpulation.

Since no permanent forms of economic activity were
created in the mining regions, with the exception of some
subsistence agriculture, it was only natural that with the
drOp in gold production, rapid and general decline should
set in. As production was reduced, the major mining con-
cerns underwent a process of capital loss and liquidation.

There was no possibility of replacing slave manpower, and

with the passing of time many mining entrepreneurs became
reduced to mere prospectors. .Decline thus occurred through
a slow shrinkage of the capital invested in the mining sector.

Between the years of 1500 and 1800 the total of gold
eXported by the Spanish and Portuguese colonies was worth
350 million pounds sterling, Brazilian gold participating in
this total in the same period with 194 million pounds ster-
ling, corresponding approximately 1,000 tons (32:25).

When the production of gold had decreased, at the
beginning of the nineteenth century, well defined deficien-
cies appeared in the general economy of Brazil. The lack of
roads and other means of tranSport created closed circles
of economic activities, separated by economically stagnant
zones. External trade was monOpolized by Portugal, which
re-exported the Brazilian products transported to Lisbon.
.Any industrial initiative was forbidden to the colony. This
period of great economic difficulties coincided with the
Napoleonic Wars, which threatened Portugal, causing its king
to take refuge in Brazil, in 1808.

This historical event gave the country a new per-
Spective. The Opening of its ports to international trade,
freedom to establish industry in the country, the creation
of the Bank of Brazil, the exemption from duties on Brazil—
ian textiles entering the United Kingdom, the creation of
a Royal School Of Arts, Professions and Sciences, the
organization of immigration and colonization among many

other things, were measures which brought Brazil noteworthy

progress. This progress could have been even greater had it
not been the drawbacks resulting from the trade treaty
signed in 1810 between Portugal and the United Kingdom,
which caused deficits in Brazilian exchange position until
the year of 1840, when the cultivation of coffee began a new
phase in the progress of the country.

Coffee.--The nineteenth century was characterized by
the rise of coffee as Brazil's principal staple crOp. In
the beginning, coffee production was based on labor force
which had been underutilized since the decline of the gold
boom. However, with the decline of importing of slaves, the
complete suSpension of such imports in 1853, and finally the
abolition of slavery in 1888, the eXpansion of coffee pro-
duction came to be based on the work of immigrant wage
laborers. Coffee remained and remains as Brazil's principal
staple, although its strength fluctuated substantially with
changes in world demand.

The Brazilian coffee production rose from 3.7 mil-
lion 60-kilo bags in 1880-1881, to 5.5 million in 1890-1891
and attained 16.3 million in 1901-1902 (16:193).

When the first overproduction crisis occurred in
the early twentieth century, Brazilian entrepreneurs soon
realized they were in a privileged position for erecting
defenses against a fall in prices. -All they needed were
financial resources for keeping a part of the output off the
market, that is, for artificially restricting supply. To

reestablish the balance between supply and demand the

government was to intervene in the market and purchase the
surpluses. In order to reach a long term solution to the
problem, the governments of the coffee growing states were
to discourage the eXpansion of plantations.

Obviously, this situation had enormous potential
ability for disrupting the economy. Financing for those
inventories had largely been Obtained from foreign banks.
When the world crisis burst upon the scene, coffee produc-
tion, then at high levels, had to go on increasing because
growers had continued to eXpand plantations until that time.
In fact, the maximum production was to be attained in 1933--
that is, at the lowest point of the depression--as a reflec-
tion of the extensive planting of 1927-1928. Coffee prices,
being fundamentally dependent on the pattern of supply, con-
tinued low in the thirties without showing any results of
the recuperation which started in 1934 in the industrialized
countries.

In the early years of the Republic, that is in the
early 1890's, prOponents of industrialization were able to
secure not merely greater tariff protection but also govern-
mental financial assistance. This was in keeping with an
unbroken tradition of state support for favored business
enterprises running all the way back to the first Brazilian
settlement. On each occasion of market decline for the
staple eXport crOps, there occurred a small wave of indus-
trialization, plantation owners and merchants putting some

of their liquid funds into industry.

10
Recent Tendencies

The Great Depression, followed by World War II and
by a sustained period of deliberate promotion of manufactur-
ing after the war appears to mark an important and lasting
shift of direction in Brazil's economic develOpment. The
economic crisis contributed to industrialization in several
ways. Coffee growers shifted their available investment
funds into industry. Far reaching foreign exchange depre—
ciation provided, for a time, unusually effective protection
against foreign competition, and existing surplus industrial
capacity was brought into production. The political orien—
tation of the dictatorial regime under Getulio Vargas (1930-
1945) tended to favor industrialists and their interests as
contrasted to the old land—holding aristocracy and these
trends were further enhanced by the war, which drastically
curtailed imports and led to every type of substitute
domestic production for which capital goods could somehow
be made or secured.

During the years after the'World‘War II Brazil has
eXperienced almost continuous general economic growth with
develOpment of the industrial sector far outpacing that in
agriculture or services as shown on Tables 1 and 2,
respectively.

Ever since World War I, Brazil's rate of industrial-
ization increased, particularly in the early 1950's which

witnessed a large influx of foreign capital in more

11

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13

SOphisticated fields, such as chemicals, pharmaceuticals and
electronics. Within a relatively short time, Brazil ceased
to depend on eXports and imports and began to produce most
of her consume goods. Brazil has attracted between three
and a half to four billion dollars in foreign investment of
which about 40 percent originated in United States, 20 per-
cent in West Germany, and the remainder in Switzerland,
France, Canada, Great Britain, Holland, Italy and other
countries.

The relative importance of foreign capital compared
to national capital can be found in a study made by the
Institute of Social Sciences of the Federal University of
Rio de Janeiro (28:83), which studied the 55 largest private
corporations in Brazil, where 31 (56.4 percent) are foreign
capital and 24 (43.6 percent) are nationals, as shown in

Table 3 below.

Table 3. Distribution of the 55 largest corporations in
Brazil into national and foreign (Year--l964)

 

 

 

 

 

Nationals Foreign

Millions of US$ (96) (‘36)
1.5 to 2.5 19 - 79 18 - 58
2.5 to 5.0 3 - 13 10 - 32
More than 5.0 2 - 8 3 - 10
Total 24 -100 31 -100

 

Source: Revista do Instituto de Ciéncias Sociais, Universi-
dade Federal do Rio de Janeiro, Vol..II, No. l, 1965.

14

This means that foreign capital predominates among
the most important corporations of the Brazilian economy.
Such predominance becomes even more impressive when we com—
pare the aggregate capital controlled by these corporations.
This indicates a tendency towards a greater predominance of
foreign corporations.

The comparison between the American corporations and
those of other countries is given on Table 4 below. American
firms predominate, comprising 45 percent of the foreign
companies and 25 percent of the national and foreign com—

panies taken together.

Table 4. Distribution of foreign corporations by countries
(Year--l964)

American . . . . . . . . . . . . . . . . . . . . . . . 14
German . . . . . . . . . . . . . . . . . . . . . . . . 4
British . . . . . . . . . . . . . . . . . . . . . . . 3
French . . . . . . . . . . . . . . . . . . . . . . . . 2
Italian . . . . . . . . . . . . . . . . . . . . . . . 2
Swiss . . . . . . . . . . . . . . . . . . . . . . . . 1
.Dutch . . . . . . . . . . . . . . . . . . . . . . . . l
. Argent ine . . . . . . . . . . . . . . . . . . . . . . 1
Canadian . . . . . . . . . . . . . . . . . . . . . . . l
Anglo-Dutch . . . . . . . . . . . . . . . . . . . . . l
»Anglo-Belgian-American . . . . . . . . . . . . . . . . .__l

Total . . . . . . . . . . . . . . . . . . . . . . _;ZL

Source: Revista do Instituto de Ciéncias Sociais, Universi-
dade Federal do Rio de Janeiro, Vol. II, No. l
(1965).

15

-As it is to be eXpected, foreign investment has been
largely in the industrial sector, where large amounts of
easily importable capital and technical ability are so

necessary, as shown on Table 5.

Table 5. Distribution of the 55 largest corporations in
Brazil by basic sectors (Year--1964)

 

 

 

 

 

 

 

National Foreign

Economic Sector No. ‘% No. %
Industrial 17 70.8 26 83.8
Commercial 3 12.5 4 12.9
Banking __4_ _l§;§ .__l 3.2
Total é _1_Q0._0 g 100. O

 

 

 

Source: Revista do Instituto de Ciéncias Sociais, Universi-
dade Federal do Rio de Janeiro, Vol. II, No. l
(1965).

The study shown before considered only private owned
companies. If we include government owned companies the
relative importance of foreign corporations is decreased.

In accordance with data cited by Dole A. Anderson, we have;

16

Distribution of Thirty Largest Firms by Type of Ownership*

 

 

Private— Private-

Government National Foreign
Ten Largest Firms 6 3 1
Next Ten Largest Firms 3 l 6
Next Ten Largest Firms _43 .44 ‘_3
Total _1:__2_ 1__Q_

_§

Of the three companies among the t0p ten,
one is the industrial complex begun by an Italian
and now controlled by his sons that are Brazilians,
the second and third have Japanese and American
origins with majority ownership now held by
Brazilians.

By type of activity, the twelve government
companies include the Federal Railroad System,
Petrobas (the national oil monOpoly), six hydro-
electric companies and three iron and steel com—
panies. Of the ten foreign companies, three are
in automobile industry, three in food and agri-
cultural products, two petroleum distribution and
one each in textiles and steel.

These data confirming the importance of private
foreign investment correspond approximately to
those shown by Frank Brandenburg, in The Develop-
ment of Latin America Private Enterprises (30:116).

While United States investments have played an
important role in the develOpment of public utilities in
Brazil, and a more modest but significant part in finance,
air tranSportation, retail distribution and mining, the most
dynamic area of United States investment in Brazil during
the period since World War II has been in manufacturing for

the local market. This is clearly shown by the data in

 

*Source: Banas, Brazil, pp. 69-75 (Year--l965).

17

Table 6 which also indicates the scale of United States
direct investments in Brazil in relation to the totals in
Latin America and in all foreign countries.

The role of Brazilian Government policies in the
investment decision of foreign companies is very important.
These policies can be broadly classified as negative and
positive incentives.

The most important negative incentive is the so—
called "Law of Similars". In accordance with this law,
local producers desiring tariff protection from importation
of items locally produced could apply for registration. In
practice, the registration of a product as a "similar" would
become the basis for a broad tariff protection as well as
for classification of the product in the high foreign
exchange rate category under the multiple rate system. As
is reported by Gordon and Grommers:

In many cases, the mere report that some

Brazilian or competing foreign firnlwas contem-
plating manufacture with the implication that
imports of similar goods would henceforth be
ruled out, was the critical factor impelling
U.S. companies to move to preserve their market
position by building local plant (18:24).

The most important positive incentive was a measure
introduced in 1955 that enabled foreign investors, under
certain conditions, to import equipment without exchange
cover, known as Sumoc-Instruction 113.

In accordance with Gordon and Grommers:

A very large part of U.S. manufacturing invest-
ment in Brazil has been made through the channels

18

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Opened by Instruction 113. Since 1957 they
have usually received sizable tariff reduction
or exemption at the same time (18:28).

The main benefit offered by Instruction 113 has been
the possibility of importing equipment without buying for—
eign exchange at a high price through the auction market.

Instruction 113 has also made it possible for com-
panies which had been considering investment or expansion
in Brazil, but which lacked sufficient investment funds, to
employ used equipment rather than cash.

Investment Policy and Measurement of
Performance of Subsidiary Companies

A thorough search of the literature in the measure-
ment of performance of foreign companies indicates the
predominance of the following factors:

1. Profitability,

2. Market penetration,

3. Productivity,

4. Industrial and Labor Relations, and

5. Public and Government Relations.

Market penetration can best be measured by comparing
company sales to the market as a whole.

Companies which use productivity as a measure of
performance consider output factors, such as units sold or
units produced and input factors such as man-hours worked or

payroll expense.

.20

Industrial and Labor Relations are evaluated sub-
jectively, considering the following factors:
a. Employee morale and attitudes,
b. Work time lost due to absenteeism, turnover, etc.
c. Union Relations: walkouts and strikes,

d. Effectiveness of training programs.

Public and Government Relations are especially
important in areas where strong nationalistic pressures are
present. The factors considered are:

a. Degree of identification with local and national
goals,

b. Community relations,

c. Relations with local and national business leaders,

d. Relationship with government authorities.

While short-term profitability is not the total
measure of a subsidiary's performance, it often provides the
best means for capsulizing the results of diverse efforts
'within an Operation. There are, however, factors that tend
to complicate even this simplified attempt at measurement.

First of all, there is no single profitability
measure that is acceptable by itself. The practice of most
companies is to utilize a series of financial ratios that
give a more comprehensive picture of strengths and weaknesses.

There are differing Opinions as to what constitutes
the investment figure. One group (11:3) contends that total

funds invested (long term debt plus equity) is the most

21

meaningful figure, since it represents the actual dollar
commitment and reduces the distorting effect of leverage.
Another group (11:4) feels that investment is the figure for
net assets, or shareholder's equity. They point out that
this measure rewards the manager with decentralized invest-
ment authority who utilizes the most effective means of
raising local debt capital.

Other complications in regard to comparable rates
of return involve the question as to what are "profits“.
Some companies consider the return as only those dollars
remitted to the parent company through dividends and various
fees against dollars actually invested. In most cases, book
profits (whether remitted or not) are used, and in some
cases, other fees remitted to the parent are added.

In this study the performance of subsidiaries is
compared to the parent corporation and in both groups,
performance is determined by using the following profitabil-
ity evaluation factors:

a. Net profit to net assets (shareholder's equity), and

b. Net profit to total assets (net of depreciation).

The ratio of gross profit to net sales is not
employed because there is no possibility of collecting the
data on the sales figures of Brazilian subsidiaries. The
other factors by which performance of subsidiaries can be
evaluated will not be considered in this study, due to their

subjectivity and/or the impossibility of obtaining data.

22

Performance, as measured by profitability, is only
part of the picture. In assessing the performance of a
company we must also consider the risk taken, eSpecially
when the company is in a foreign country. Rational manage-
ment will not increase the eXposure to risk unless the
eXpected return increases more than enough to offset the
increased risk. A two parameter model, as discussed by
Markowitz, of this trade-off between eXpected return and
risk can be used to eXplain the management decision.
Rational management will invest only when the increase in
eXpected returns is greater than the eXpected increase in
risk.

Risk, in this study, is measured by applying two
different bases:

1. Quantitativelye-through the variability of return,
that will be determined on the basis of standard
deviation or variance.

2. Qualitatively--through interviews with and ques-
tionnaires from apprOpriate officials of the

United States parent companies.

The performance of United States subsidiaries
corporations in foreign countries is subject to widely-held
Opposing assumptions.

One group assumes that due to the superior manage-
ment techniques in United States the factors of production

are utilized in a more efficient manner in this country than

23

in Brazil, and this will normally result in a better per-
formance for the parent corporation. .An alleged evidence of
the above reasoning is that in order to attract foreign
investment the host country must offer some sort of tax
exemption or impose fiscal and/or legal barriers for import
of products, without which a United States company would not
invest in foreign countries, as is the case of Brazil.

The other point of view, exaggerated by nationalists,
is that particularly in develOping countries such as Brazil,
due to lower labor and raw material costs or due to higher
sale prices of the final product, the American company will
enter a foreign market because it can and does earn exorbi-
tant profits, profits many times greater than it could earn
in United States.

In.Chapters IV and V the reader will find an evalua-
tion of the statements described above in light of the
information gathered by the author through questionnaire and
interviews with officers of parent companies as well as from
analysis of annual reports of subsidiary and parent companies.

In addition to examining and measuring investment
performance a further purpose of this study is to determine
the investment policy of the subsidiary and parent companies.
The Brazilian economy during the period of 1963 to 1967, was
characterized by a high level of inflation, which reached a
total of 299 percent for the five year period. In an infla-

tionary economy the company's investment decision in regard

24

to the source and application of funds are greatly influ-
enced by the economic circumstances. In accordance with
Kassel's hypothesis "net monetary debtors will gain and net
monetary creditors lose vis-a-vis their pre-inflation wealth

position" (21:129).

The Hypotheses
Considering the previous discussion, the hypotheses
to be tested are:
l. The subsidiary companies are net monetary debtors.
2. Investment in Brazil carries more risk than in
United States.
3. A better performance, in terms of profitability
ratios, will be Obtained by the subsidiaries in

comparison to their parent companies.
Organization of the Study

Chapter II is essentially concerned with the size,
characteristics and procedures in determining the forty-
seven manufacturing subsidiary corporations included in the
sample. Concentration statistics relating the percentage of
total assets and net assets of these forty-seven companies
to the total invested by manufacturing corporations, as well
as a breakdown by type of industry are presented and analyzed.

Chapter III is devoted primarily to a discussion of
the Brazilian inflation experience and the appearance of

illusory profits in the annual reports of firms. The

25

limitations of annual reports, as presented by Brazilian
subsidiaries and the accounting differences between the two
countries are analyzed. In this chapter a more realistic
profit measurement for the subsidiary is determined, through
price-level adjustments.

Chapter IV deals with the financial policies adOpted
by the subsidiary company, particularly on capital structure,
debt policy and the application of the funds available to
the management through an empirical analysis of the annual
reports. A vertical analysis of the balance sheets, after
price level adjustment, is presented. .Also, in this chapter
a study of the credit policies followed by the banks is
develOped and their implications for the foreign subsid-
iaries is discussed.

In Chapter V the empirical findings of the study are
presented. The performance of the companies, by using the
profitability ratios mentioned before, is determined. There
is an analysis of the performance by considering the net
income before and after adjustments as well as a study of
the companies by specific type of industry. An eXplanation
of the non—conformity of the results to the basic hypotheses
is develOped in this chapter.

The last chapter contains, in addition to a summary
of the major observations of this study, some normative
prOpositions regarding investment policy and performance

for the subsidiaries of American corporations in Brazil.

CHAPTER II

METHODOLOGY IN THE DETERMINATION OF THE SAMPLE

AND LIMITATIONS OF THE PRIMARY DATA

Introduction

At the end of 1967, subsidiaries of American corpo-
rations in Brazil numbered 405 according to information
gathered from the Brazilian Government Trade Bureau (18:12).
From this total, slightly over half (229) were manufacturing
Operations and the other 176 were Spread among miscellaneous
activities. A breakdown of both categories is shown in
Table 7.

These numbers substantiate the findings that American
companies prefer the industrial sector as shown by the study
of the Institute of Social Sciences of the Federal University
of Rio de Janeiro, mentioned before in Table 5 and the data
from the United States Department of Commerce, in Table 6.

The financial statements to evaluate the performance
and investment policy of United States manufacturing subsid-
iaries are drawn from annual reports published in official
Brazilian newspapers. In accordance with Brazilian legis-

lation only corporations ("sociedades anOnimas") are required

26

27

Table 7. Distribution of 405 United States subsidiaries in
Brazil by type of business and corporate form of
organization in the manufacturing sector

 

 

Non-Manufacturing Companies

 

 

 

 

 

 

Type of Business Number
Sales Office 26
Service 22
Engineering 19
EXport 19
Insurance 17
Holding 14
Mining 11
Petroleum 9
Motion Picture Distributor 8
Investment and Banks 5
Advertising 5
Auditing 4
Shipping and Airlines 4
Public Utilities 3
Miscellaneous '_;9

Total 176

Manufacturing Companies
Corporate Form
Closely Corporations

Type of Industry Held (S.A.) Total
Machinery and Equipment 14 42 56
Plastic and Chemicals 7 28 35
Auto Equipment 9 17 26
Pharmaceutical l3 9 22
Foodstuff and Soft Drink 6 12 18
Soap and Toiletry 5 8 13
Household Appliance 3 10 13
Tractor and Earthmoving 2 6 8
Metal 1 7 8
Automobile .. 4 4
Tire .. 4 4
Dental Supplies 4 1 5
Packaging 1 4 5
Miscellaneous __§_ __1_ _;L2

Total 70 59 2 9

 

Source: Brazilian Government Trade Bureau, New York, April
1968.

28

to publish their financial statements, closely held com-
panies ("sociedades limitadas") do not.

Table 7 shows the classification of the 229 manufac-
turing companies, which indicates that 159, or 69.5 percent
are organized as corporations and the other 70, or 30.5
percent are organized as closely held companies from which
no data can be obtained.

The sample was drawn from these 159 companies, in
view of the impossibility of Obtaining the data from closely
held companies.

.Many companies that are included in the universe and
among the 159 companies mentioned above are of small size.
In order to limit the survey to companies with an influence
on the economy of the country, the list was further re-
stricted to those included in VisSo‘s second annual survey,
published in August of 1968, "Who's‘Who in Brazilian Economy"
(40:164). The companies listed by VisEo are the ones report-
ing an owner's equity figure of at least NCr$ 4 million,
which is roughly equivalent to US$ 750,000, which auto-
matically selected the largest companies.

Size and Characteristics
of the Sample

The number of United States manufacturing subsid-
iary corporations listed in the survey mentioned above was
75. In an effort to have represented the largest companies

in each type of industry (and to further reduce the sample

29

to a more workable size), the sample used in this study was
finally defined to include all companies ("public-held" man—
ufacturing corporate subsidiaries) with owner's equity (both
United States and any other ownership) larger than US$ 1
million, in December of 1967.

Table 8 shows the distribution, by type of industry,
of the companies listed by VisSo's survey and the companies
included in the study, as well as the relative percentage to
its respective total. It is important to note that, percent-
agewise, there is no great discrepancy in the distribution
of companies by type of industry.

A breakdown of the 47 companies that met the afore—
mentioned criteria and their relative importance in owner's
equity and total asset size are shown on columns 1 and 3 of
the Table 9. The columns 9, 10, 11 and 12 compare, in per—
centage terms, the companies included in the sample to the
companies listed in VisSo's survey and the total of 159
manufacturing companies organized as corporations.

This table supports the statement made earlier that
the largest companies are represented in the sample. These
47 companies have an aggregate owner's equity of US$ 490
million and the total assets of approximately US$ 640 mil-
lion or 82.0 percent of the combined owner's equity and
73.8 percent of the total assets of all 159 manufacturing

subsidiaries companies organized as corporations.

30

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32

In each particular type of industry, the companies
included in the sample represent more than half of capital
invested (owner's equity) in it ranging from a low of 50.6
percent in the tractor and earthmoving equipment to a high
of 100.0 percent in the automobile industry. The most
recent data regarding the total investment in Brazilian
industries shown on Table 9 is only available to the year
1962. This precludes comparing the total assets and total
owner's equity of the 159 manufacturing subsidiary corpora-
tions, broken down by industry, with the figures of the
total Brazilian investment in total assets and owner's
equity in each of this respective industry.

The time period covered by the study is five years,
from 1963 to 1967. This selection was based mainly on
practical grounds, because if the study should go before
1963 the possibility of getting the financial statements
becomes much smaller. The publication by the Brazilian
subsidiaries of their annual reports in official newspapers
is done during the year after the closing date of the bal-
ance sheet. For instance, the annual reports of the year
of 1967 are published during the year of 1968, and thus the
most recent data available for the study were the annual
reports of the fiscal year ended in 1967.

Since the financial data of the subsidiaries are
not disclosed in the annual reports of the parent organiza-

tion, the primary source of information of the study was the

33

financial statements actually published by the subsidiaries
and was gathered through research in official Brazilian
newspapers and direct contact with apprOpriate officials in
Brazil of the 47 companies.
Limitations of Subsidiaries'
Annual Reports

Many of the conclusions of this study will be drawn
from comparisons of financial data as reported by the sub-
sidiary company and by its United States' parent. However,
the subsidiaries annual reports, according to conventional
Brazilian reporting practices, will not give a reliable
basis for comparison with the annual reports of the parent
corporation without certain adjustments. The very high rate
of inflationary spiral eXperienced by the Brazilian economy
distorts the figures presented in the annual reports in a
short period of time.

In order to adjust for this distortion, two ways can
be followed:

1. to "translate" the subsidiaries' reports from
cruzeiros into dollar figures at the various rates
of exchange prevailing when transactions occurred
(the method conventionally used in the United States
to account for foreign Operations); and

2. to keep the annual reports in cruzeiros and adjust
for the influence of inflation by using price—level

adjustments.

34

The first method has received wide acceptance and
it is the most used by the United States parent companies.
Some Of the arguments in defense Of this method are set
forth by Hepworth, as follows:

The immediate objective Of the process Of trans-
lating foreign accounting balances into dollars
is Of achieving an eXpression Of the financial
position and Operating results Of the foreign
subsidiary in the same monetary units in which
the accounts Of the parent enterprise are
eXpressed. Underlying this is the more funda-
mental objective Of achieving a manner Of
eXpression Of the financial data Of foreign
subsidiaries which will create a maximum degree
Of understanding Of such data on the part Of the
management, creditors, and stockholders Of the
domestic parent enterprise. There is little
question but what these groups accustomed as
they are tO thinking in terms Of dollars and
cents, can derive maximum utility from finan-
cial data eXpressed in terms Of familiar mone-
tary-units. It must be recognized that inter-
natiOnal monetary conditions may exist which will
render the results Of the translation process
more misleading than informative (19:1).

The importance Of using the first method is also
pointed out by the National Association Of Accountants in
the NAA Research Report NO. 36. It reads:

Local currency financial reports must be trans-
lated into U.S. dollars for these important
reasons:

1. Since the U.S. parent company's investment
is in dollars, the Operations Of the foreign
subsidiary must be expressed in dollars in
order tO evaluate the return produced by the
dollar investment.

2. Management in U.S. is accustomed to thinking
in terms Of dollars rather than in foreign
currency units.

3. The objective Of business Operations abroad
is profit which benefits shareholders Of U.S.
parent company through dollar values Of the
U.S. shareholders' equity. Translation Of
local currency tO dollars is a prerequisite

35

tO determining the periodic loss or gain
sustained by the U.S. parent company from
movements in exchange rates. This figure
measures the degree Of success which man-
agement has had in protecting the U.S. com-
pany's dollar investment against erosion
from currency depreciation.

In order to consolidate foreign financial
statements with domestic statements, all Of
the statements tO be consolidated must first
be eXpressed in homogeneous monetary units
(27:10).

Though it is the more widely used, the first method

does not seem tO be the better alternative for the purposes

Of this study, for the following_reasons:

3.

By using the exchange rate method we are adOpting a
point Of view Of immediate conversion tO dollars
which Obviously has not been the purpose Of most
United States parent corporations, as shown by the
continuous and increasing capital investment in such
subsidiaries. Almost all Of the companies in the
sample have subsidiaries which have Operated in
Brazil for more than 15 years--some for more than
40 years.
The exchange rate used for the conventional transla-
tiOn Of the subsidiaries' annual reports figures
into dollars is highly influenced by government
policies and thus does not reflect only economic
conditions prevailing in the country.
1) The determination Of the Official exchange rate
is under direct control Of the Brazilian author-
ities, who can, and have, established very

distorted rates.

36

2) The exchange rate can be influenced by the
variables Of international trade, which may have
nO bearing on the Operations Of a subsidiary in
a different sector Of the Brazilian economy. In
Brazil, this situation is especially prevalent,
due tO the importance Of one product (coffee) in
the eXport trade Of the country.

3) When there is a large influx Of private foreign
investment due tO many different reasons such as
government incentives and/or penalties, the
influx may Offset other negative factors and a
certain stability in the exchange rate might be
reached.

Over the long run, exchange rates Of course must

reflect the relative value Of the two currencies but

administered rates can distort economic comparisons
in the short run (such as the annual financial
reporting period). During the five year period Of
study, the Brazilian inflation rate and the change
in the cruzeirO dollar exchange ratio were almost

identical (the inflation rate was 299 percent (2:21)

and the exchange-rate increased 306 percent (15:36),

as shown on Table 10. However, there are large

variations, percentagewise, when we consider year

by year. The most extreme case occurred in 1966,

when the exchange rate remained constant during the

whole period (from December 1965 to January 1967)

37

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38

due to government regulation, but the inflation rate

was 41 percent.

1) This difference will distort the conclusions.of
comparability for the years Of 1965, 1966 and
1967; in these years the devaluation Of the
Brazilian cruzeiro in relation tO the dollar was
83 percent and the inflation rate for the same

period was 137 percent.

In order tO illustrate the points made in "c" above, the

following simplified example shows the results Of using

"translation" method versus price-level adjustment method.

The following assumptions are made:
The company starts Operations on December 31, 1965.

There is no devaluation Of the cruzeiro during 1966
and the exchange rate for one US$ is Cr$ 2,000.

During the year Of 1966 there is inflation Of 49.5
percent with a higher rate Of inflation in the first
months Of the year as compared tO the last months.

The company's monetary assets equal monetary liabil—
ities, i.e., the position Of net monetary debtor or
creditor is zero.

Fixed Assets (Land) is acquired On the last day of
December, 1965.

After working for one year, the company shows no
profit or loss in the unadjusted profit and loss
statement.

At December 31, 1966 the accounts in the balance
sheet remained the same as on December 31, 1965.

(Sales, purchases and miscellaneous expenses are

assumed tO be incurred evenly through the year.

Beginning Inventory was acquired in December 31,
1965.

39

10. Ending Inventory consisted Of products acquired in

.the last three months Of 1966.

This method does not recognize an increase in the
value Of the fixed asset in dollar terms. In accordance
with assumption 3, with inflation Of 49.5 percent the value
Of the fixed assets in cruzeiros will increase approximately
by the same prOportion. Using a multiplier, as in the price—
level adjustment method, the value Of fixed assets, at the
end Of the year is 747,5 million cruzeiros; since the dollar
exchange rate is still the same, or Cr$ 2,000 for 1 dollar,
the real value Of this asset to the subsidiary, but in terms
Of dollars, has increased from US$ 250,000 to US$ 373,700.
Under the conventional "translation" method, this is not
disclosed either on the cruzeiro or dollar balance sheet as

Of December 31, 1966 (page 40).

Prive:Level Adjustment Method

In contrast, Observe the accounting measurement Of
the same example set of circumstances, using price-level
adjustment method. All amounts are stated in terms Of a
common unit Of purchasing power, in this case the December 31,
1966 cruzeiro. The conversion multiplier represents the
December 31, 1966 price level index divided by the price
level index prevailing when the historical cost amount arose
(for example 149,5 at 12-31-1966 divided by 100 at 12-31-1965

equals 1.495): this is discussed in more detail in Chapter III.

CONVENTIONAL OR

40

"TRANSLATION" METHOD

BALANCE SHEET AS OF DECEMBER 31 1965

 

(in millions Of Cr$)

 

ASSETS
Cash 100
Accounts Receivable 200
Inventories 200
Fixed Assets (Land) 500

 

 

LIABILITIES AND OWNER'S EQUITY

Accounts Payable 300
Owner's Equity 700
1.000

 

 

$ - Cr$
Exchange
Rate

2,000
2,000
2,000
2,000

2,000
2,000

(in thousands of US$)

 

 

ASSETS
Cash 50
Accounts Receivable 100
Inventories 100
Fixed Assets 250

LIABILITIES AND OWNER'S EQUITY

Accounts Payable 150
Owner's Equity 350
500

 

PROFIT AND LOSS STATEMENT FOR THE YEAR OF 1966

 

 

 

 

 

 

 

 

 

 

(in millions Of Cr$) Exchange (in thousands of US$)
Rate
Sales 4,000 2,000 Sales 2,000
- Cost Of Goods Sold: - Cost Of Goods Sold:
Beginning Inventory 200 2,000 Beginning Inventory 100
+ Purchases 3,600 2,000 + Purchases 1,800
3,800 1,900
- Ending Inventory 200 3,600 2,000 - Ending Inventory 100 1,800
Gross Profit 400 Gross Profit 200
- Operating Expenses 400 2,000 - Operating Expenses 200
, 0
BALANCE SHEET AS OF DECEMBER 31, 1966
$ - Cr$
(in millions Of Cr$) Exchange (in thousands of US$)
Rate
ASSETS ASSETS
Cash 100 2,000 Cash 50
Accounts Receivable 200 2,000 Accounts Receivable 100
Inventories 200 2,000 Inventories 100
Fixed Assets (Land) _§QQ 2,000 Fixed Assets _352
1.000 =ggg
LLAQILITIES AND OWNER'S EQUITY LIABILITIESfiAND OWNER'S EQUITY
Accounts Payable 300 2,000 Accounts Payable 150
Owner's Equity _ZQQ 2,000 Owner's Equity '_;§g
1,000 500

 

 

 

 

 

 

 

CONVENTIONAL OR

41

"TRANSLATION" METHOD

 

BALANCE SHEET AS OF DECEMBER 31,
1965
CONVENTIONAL (HISTORICAL COST)
(in millions of Cr$)

BALANCE SHEET AS OF DECEMBER 31,

MULTIPLIER 1965 IN DECEMBER 31, 1966 Cr$

(RESTATED in millions Of Cr$)

 

 

 

ASSETS ASSETS
Cash 100 1,495 Cash 149.50
Accounts Receivable 200 1,495 Accounts Receivable 299.00
Inventories 200 1,495 Inventories 299.00
Fixed Assets 500 1,495 Fixed Assets 747,50
1,000 1,495.00
LIABILITIES AND OWNER'S EQUITY LIABILITIES AND OWNER'S EQUITY
Accounts Payable 300 1,495 Accounts Payable 448.50
Owner's Equity 700 1,495 Owner's Equity 1,046.50
1,000 1,495.00
PROFIT AND LOSS STATEMENT FOR THE YEAR OF 1966
(in millions Of Cr$)
HISTORICAL COST MULTIPLIER RESTATED IN 12-31-66 Cr$
Sales 4,000 1,125 Sales 4,500
- Cost of Goods Sold: - Cost Of Goods Sold:
Beginning Inventory 200 1,495 Beginning Inventory 299
+ Purchases 3,600 1,125 + Purchases 4,050
3,800 4,349
- Ending Inventory 200 3,600 1,018 - Ending Inventory 203.6 4,145.4
Gross Profit 400 Gross Profit 354.6
- Operating Expenses 400 1,125 - Operating Expenses 450.0
0 Operating Loss (95.4)

 

BALANCE SHEET AS OF DECEMBER 31, 1966
RESTATED IN DECEMBER 31, 1966 Cr$
(in millions Of Cr$)

 

 

 

ASSETS LIABILITIES AND OWNER'S EQUITY
Cash 100 Accounts Payable 300
Accounts Receivable 200 Owner's E uity (*) 951.1
Inventories 203.6
Fixed Assets 747.5
1,251,1 1,251.1
*Owner's Equity as of December 31, 1965 in December 31, 1966 Cr$ 1,046.5

Loss in the year Of 1966, as above

95.4

Adjusted Owner's Equity as of December 31, 1966 as above 951.1

42

PRICE-LEVEL ADJUSTMENT METHOD

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

BALANCE SHEET AS OF DECEMBER 31, 1966
$ -Cr$
(in millions Of Cr$) Exchange (in thousands Of US$)
Rate
ASSETS ASSETS
Cash 100 2,000 Cash 50
Accounts Receivable 200 2,000 Accounts Receivable 100
Inventories 200 2,000 Inventories 100
Fixed Assets 500 2,000 Fixed Assets 250
1,000 500
LIABILITIES AND OWNER'S EQUITY LIABILITIES AND OWNER'S EQUITY
Accounts Payable 300 2,000 Accounts Payable 150
Owner's Equity 700 2,000 Owner's Equity 350
1,000 500
PROFIT AND LOSS FOR THE YEAR OF 1967
$ -Cr$
(in millions of Cr$) Exchange (in thousands Of US$)
Rate
Sales 4,000 2,400 Sales 1,667
- Cost of Goods Sold: — Cost of Goods Sold:
Beginning Inventory 200 2,000 Beginning Inventory 100
+ Purchases 3,600 2,400 + Purchases 1,500
3,800 1,600
- Ending Inventory 200 3,600 2,800 - Ending Inventory 71 1,529
Gross Profit 400 Gross Profit 138
- Operating EXpenses 400 2,400 - Operating EXpenses 167
0 Operating Loss (29)

 

 

BALANCE SHEET AS OF DECEMBER 31,

 

 

1967

 

 

 

 

 

 

ASSETS $ - Cr$ ASSETS
Exchange

(in millions Of Cr$) Rate (in thousands Of dollars)
Cash 100 2,800 Cash 36
Accounts Receivable 200 2,800 Accounts Receivable 71
Inventories 200 2,800 Inventories 71
Fixed Assets 500 2,000 Fixed Assets 250
1,000 428

LIABILITIES AND OWNER'S EQUITY LIABILITIES AND OWNER‘S EQUITY
Accounts Payable 300 2,800 Accounts Payable 107
Owner's Equity 700 Owner's Equity (*) 321
1,000 428

 

 

 

 

*The decrease in Owner's Equity from US$ 350 to US$ 321 is eXplained by the
Operating loss for the year Of US$ 29.

43

As we can see in the example (page 40), by using the
conventional method no loss is shown in the subsidiary com-
pany despite the fact that the earning power Of the assets
of the subsidiary has decreased, due to the inflation of
41 percent which occurred during the year.

A real economic loss has been suffered by the sub-
sidiary that is shown only if price-level accounting is used.
This was what actually happened during the year Of 1966 in
Brazil, when the government "pegged" the exchange rate and
the rate Of inflation was 41 percent.

For the sake Of clarity let us present the inverse
(that is, exchange rate changes and no inflation) Of this
situation for the year Of 1967. All the assumptions, from
1 to 10 made above, are held constant with the exception Of
assumptions 2 and 3 that will read:

Assumption 2. There is a devaluation Of 40 percent
Of the cruzeiro during 1967, i.e., the exchange‘
rate for one US$ is Cr$ 2,800.00.

.Assumption 3. There is nO inflation in Brazil

during 1967.

This method will not recognize a loss suffered by
the company in the fixed assets, dollarwise (page 41). As
we can see in the balance sheet (page 45), the traditional
method will use as an exchange rate figure for the fixed
asset, that rate in effect at the date Of acquisition of the
asset, which was Cr$ 2,000 to one dollar. In accordance
with the assumption made above Of nO inflation in 1967, the

cruzeiro value Of the asset at the end Of 1967 is the same,

44

but there was an increase Of the exchange rate for the
dollar, i.e., in order tO buy one dollar it is necessary tO
give up more cruzeiros. The value Of the asset, in dollars
at year-end 1967 is US$ 179,00 but the value Of this asset
in adjusted balance sheet at end Of 1966 is Cr$ 747,5 which
equals US$ 250 and under conventional method you happen to
get the right answer (however, during the year, its value in
dollar terms has drOpped because Of the exchange rate varia-
tion and conventional method ignores this).

The translation method, in 1967, shows a loss Of
US$ 29,000 in the subsidiary, but as far as the subsidiary
is concerned there was nO gain or loss, since there was no
earning power loss on any asset.

These two examples bring up a very interesting
aspect. From which point Of view (parent or subsidiary)
should we look at the financial statements?

1. If from the parent's, there was a gain in 1966 Of

US$ 124 (374-250) and offsetting US$ 124 loss in

1967. This situation is not considered in the

dissertation mainly for two reasons:

a. Conventional methods assume liquidation point

of view, which is not the case in Brazil, and

b. The principal activity Of subsidiaries is not

to gain or loose on exchange variation.
2. If from the subsidiary's, there was an Operating
loss Of 95.4 million cruzeiros in 1966 and no loss

in 1967.

45

PRICE-LEVEL ADJUSTMENT METHOD

[t is important to Observe that no adjustment is necessary because it is assumed
mo price-level change in 1967)

BALANCE SHEET AS OF DECEMBER 31, 1966

RESTATED IN DECEMBER 31, 1966-1967 Cr$
(in millions of Cr$)

 

 

    

ASSETS LIABILITIES AND OWNER'S EQUITY
ash 100 Accounts Payable 300
:counts Receivable 200 Owner's E uity 951.1
1ventories 203.6
Lxed Assets 747.5
1,251.1 1,251.1

PROFIT AND LOSS STATEMENT FOR THE YEAR OF 1967
UNADJUSTED AND ADJUSTED STATEMENT

ales 4,000
Cost Of Goods Sold:
Beginning Inventory 203.6
+ Purchases 3,600.0
3,803.6
- Ending Inventory 203.6 3,600
Gross Profit 400
- Miscellaneous EXpenses 400
0

 

 

BALANCE SHEET AS OF DECEMBER 31, 1967
(in millions of Cr$)

 

ASSETS LIABILITIES AND OWNER'S EQUITY
sh 100 Accounts Payable 300
counts Receivable 200 Owner's E uity 951.1
Mentories 203.6

 

.xed Assets 747.5
1,251.1 1,251.1

 

46

In this study the author is trying to analyze the
performance Of subsidiary companies in comparison with the
parent corporation. The activities Of the management group
of the subsidiary is done in Brazil, and its performance
must be analyzed in light Of the economic variables affect-
ing the Brazilian economy. In 1966 there was a real eco-
nomic loss that is not recognized if we adOpt the transla-
tion method. Thus the price-level adjustment method was
adOpted for this study because it appears to be consistent
with the above vieWpOint, better than using either unadjusted
cruzeiros statement or statements conventionally translated
into dollars.

There is another very important variable,purchasing
power lost (gained) by being in a net creditor (debtor)
position during inflation that must be considered in the
total picture Of the subsidiary's activities. In the
example develOped above for the year 1966 the subsidiary
made a prOper investment decision in allocating its funds
in Fixed Assets (Land) that will not decrease its value
(purchasing power) during inflation. If they had invested
in monetary assets (cash) a purchasing power loss would have
resulted and the owner's equity figure would be smaller than
the initial amount in 1965 as restated in terms Of year-end
1966 cruzeiros.

For the sake Of the discussion let us revert tO the

initial set Of assumptions (see pages 38-39), changing only

47

the composition Of the balance sheet as Of December 31, 1965
as follows (page 48) (the 500 million cruzeiros held as cash
instead Of invested in land).

The management Of the subsidiary, then, has at its
disposal alternatives that can minimize the eXposure Of loss
from inflation, as can be seen by comparing this example
with the one presented before. (A better or poorer financial
policy will not be detected if we use the translation method
by assuming no change in the exchange rate, as happened in
1966.

Of course, these extreme positions do not often
happen in the real world. As was shown in Table 10 in the
five-year period the inflation rate and the exchange rate
almost Offset each other and the findings Of this study will
not change if we use one or the other method, when the
entire period is analyzed but it will make a difference for
yearly analysis.

In this study it is assumed that there has been no
inflation in United States, and no adjustment is made in the
financial reports of the parent company. The true picture,
however, is that during the period Of the study the infla-

tion rate was 10.5 percent, as follows:

48

 

 

 

BALANCE SHEET AS OF DECEMBER 31, BALANCE SHEET AS OF DECEMBER 31,
6 MULTIPLIER 1965 IN DECEMBER 31, 1966 Cr$
ASSETS ASSETS
CONVENTIONAL
(HISTORICAL COST) RESTATED
(in millions of Cr$) (in millions of Cr$)
Cash 600 1,495 Cash 897.0
Accounts Receivable 200 1,495 Accounts Receivable 299.0
Inventories 200 1,495 Inventories 299.0
1,000 1,495.0
LIABILITIES AND OWNER'S EQUITY LIABILITIES AND OWNER'S EQUITY
Accounts Payable 300 1.495 Accounts Payable 448.5
Owner's Equity 700 1.495 Owner's Equity 1,046.5
1,000 1,495.0

 

For convenience let us assume that the Operating loss for the year was the

 

 

 

 

same as the one determined before, i.e., Cr$ 95,4. The balance sheet for December
1966 will be:
ADJUSTED BALANCE SHEET AS OF DECEMBER 31, 1966
(in millions Of Cr$)
ASSETS LIABILITIES AND OWNER'S EQUITY
Cash 600 Accounts Payable 300
Accounts Receivable 200 Owner's E uity (*) 703.6
Inventories 203.6 '—I____—_£L‘--___.._._.___________
1,003.6 1,003.6
1) Operating loss, as shown in profit and loss statement 95.4
2) Loss for holding net monetary creditor position (a) 247.5
342.9
Adjusted as Of
(a) Monetary Assets: Multiplier December 31, 1966
Cash 600
Accounts Receivable 200
800
Monetary Liabilities:
Accounts Payable 300
Net monetary assets at
1-1-66 restated in terms
of 12-31-66 Cr$ 500 1.495 747.5
Less: Net monetary balance as Of 12-31-1966 (by definition,
in terms of 12-31-66 Cr$) 500,0
Loss from holding net monetary creditor position 247.5

 

... *The difference in owner's equity of Cr$ 342.9 (1,046.5-703.6) is eXplained
by two losses as shown above.

31,

49
Gross National Product Implicit
Price Deflator*
1958 = 100
Egg; - Percent
1963 . . . . . . . . . 1.3

1964 . . . . . . . . . 1.7

1965 . . . . . . . . . 1.8
1966 . . . . . . . . . 2.7
1967 . . . . .V. . . . _;;g;
Total . . . . . . . . . 10.5

The magnitude Of the changes in United States are
very small when compared with the changes in Brazil for the
same period. In not adjusting the annual reports Of the
parent companies the final findings Of the thesis will not
be invalidated. Obviously, more correct data would have
been Obtained if the adjustment were made, but expediency
more than compensates for any lack Of accuracy Of the data.

Besides all the disadvantages of the translation
method mentioned above, the comparison Of the rate Of profit
earned in each country can be made without "translation" Of
cruzeiros into dollars, as eXplained by Chambers:

Suppose a merchant has branches in Canada, Hong-
Kong and the U.S.A., and that in each country

he both buys and sells a certain good. There
are thus statements Of the cost price and selling

 

*From.U.S. Department Of Commerce,.Survey Of Current
Business, issued monthly.

50

price in the currency Of each country. He may
find it Of interest tO discover the rate Of the
cost price and selling price in the currency

Of each country. He may find it Of interest tO
discover the rate Of profit earned in each coun-
try and tO compare the rates. This may be done
without converting the different currencies into
one currency, for each ratio Of profit (the dif-
ference between cost and selling prices) tO cost
prices is a ratio of measurements in the same
scale. If he were to convert all the cost
prices, selling prices, and amounts Of profit

to the currency Of one country, by using pre-
vailing rates of exchange, he would get exactly
the same ratios as if he used the three differ-
ent currencies (13:96) (underlining added).

It is at least useless, and possibly deceiving, tO
add monetary units representing different purchasing powers
cruzeiros Of 1963, 1964 . . . 1967 when the purchasing power
Of the cruzeiro has continually changed. By using price
.level adjustment each item in the financial statements will
be shown in terms Of a common cruzeiro, i.e., in terms Of
cruzeiros of the same purchasing power. This technique is
discussed in detailed form in Chapter III.

In this study the Consumer Price Index is used in
adjusting for the changing price level; the economic factors
that influence the inflationary process are reflected in
this index, and will not be biased by Special conditions as
in the case Of the exchange rate. Besides that, most Of the
firms in the sample deal in consumer products.

By adjusting the financial reports presented by the
subsidiaries, a profit figure more reliable than either

‘"conventiona1 translation into dollars" or unadjusted Brazil-

ian reports as published is determined. The so—called

51

"paper profits" which are included in the unadjusted Brazil-
ian profit and loss statements are brought to light, as well

as the gain or loss from holding monetary items.

Product Differences as a
Limitation Of the Study

The majority Of subsidiaries constituting the sample
Of this study Operate in the same type Of industry as their
parents. However, in some cases, the Operations Of the
parent company comprise more complex and different activ-
ities not found in the subsidiary. This should not be con-
‘sidered as a barrier tO comparing the results Of the com—
panies because, as explained by Chambers, the productivity
of the assets are not determined only by physical prOperties,

as follows:

In a given trade, one firm may manufacture the
whole Of the components Of its finished goods,
another may merely assemble bought parts manu-
factured by others. The productivity Of any
asset or combination Of assets is not uniquely
determined by physical prOperties; the skill
with which assets are employed bears directly
.On it. (For such reasons as these, all firms
will differ. But any chosen combination Of
assets may be supposed to have been chosen
because, in the state Of available techniques
and resources and in the state Of market eXpec-
tations at the time, it was believed tO Offer
the prOSpect Of a better rate Of return than
alternatives (13:197) (underlining added).

The marketing mix Of the subsidiary and the parent
corporation also have different magnitudes. Again, by using

an argument develOped by Chambers, this discrepancy can not

52

be considered as invalidating the results Of this compara-
tive study. According to Chambers:
Though the numerator and denominator Of any
ratio or rates are logically required to be
measurements in the same scale, ratios or rates
are pure numbers Of nO-dimensional magnitudes.
.It is logically possible to compare these num-
bers as they are discovered from time to time,
regardless Of changes in the scale Of Operations
Of a firm (13:194) (underlining added).

By considering the above arguments develOped by
Chambers, the profitability ratios as explained in Chapter I
are utilized as a comparative measurement Of performance.

Summarizing then, in the first two sections the
methodology and characteristics Of the sample are discussed.
The following section establishes the superiority Of price-
level adjustment techniques tO the financial reports Of
Brazilian subsidiaries for the purpose Of comparison with
the parent companies, as compared to the following methods:

a. Unadjusted subsidiary reports,

b. Translation into dollars or the "traditional"
method, and

c. Translation into dollars after price-level
adjustment.

The main reasons for not using the three methods
mentioned above are:

l. Unadjusted subsidiary reports grossly overstate
profits,

2. Translation method, in using the exchange rate,
is influenced by variables unrelated tO the internal
economic environment in which the subsidiary Oper-
ates (international trade, government policy Of
"pegged" rate), and

53

3. The exchange rate is not an accurate reflector Of
the economic environment (see particularly explana-
tions for the year Of 1966). By using the exchange
rate after price—level adjustment Of the financial
reports Of the Brazilian subsidiary, will result in
misrepresentation Of the financial condition Of the
subsidiary. Over the entire period (1963-1967) the
difference between price-level adjustment and
exchange rate methods is immaterial but is highly
significant over short periods during which the
exchange rate has not adjusted to account for
inflation.

The price-level adjustment is preferable mainly
because it takes into consideration the variables affecting
the Brazilian economy. 1A further advantage is that the
indices for the adjustment are readily available in Special-
ized periodicals.

In the next chapter, price-level adjustment tech-

niques are used tO assess the impact of inflation on finan-

cial reports.

CHAPTER III

PROFIT ILLUSION IN AN INFLATIONARY ECONOMY

Introduction

 

Inflation can cause the appearance Of illusory
profits in the firm's accounts and financial reports as
shown in a later part Of this section. ‘When the inflation
rate attains high prOportions, such profits can lead firms
into distorted production and investment decisions which
could, under certain circumstances, harm their long term
position, depending on complementary price and dividend
policies.

Brazil's experience fits the classic pattern Of the
inflationary process. .On the demand side, the continued
rise in prices has been fostered by two factors:

1. .Federal government deficits financed through
eXpanded loans from the monetary authorities

to the national treasury, and

2. .EXpansion Of bank credit to companies.

These have been the main causes of the increase in

money supply, which in Brazil's case has been correlated

54

55

closely with the increment in the total demand for gOOds
and services.

On the cost side, prices have been pushed upward by
the frequent wage adjustments granted by the government and
carried beyond the levels that would normally be paid by the
market. .In other words, institutional variables along with
market forces have pushed wages.

.In an inflationary economy, part Of a firm's profit
can be considered as illusory, i.e., the portion which rep-
resents the amount needed tO preserve the real value Of the
capital Of the firm. The two most prominent items giving
rise to illusory profits in the firm are long-term asset
depreciation charges and expense of products sold (inventory
replacement) when each is measured in terms Of original cost.

.In many countries the law requires that depreciation
be calculated on the basis Of historical cost Of fixed
assets or it may be that this procedure is the result Of
usual accounting practices Of the firms. In an inflationary
economy, such depreciation procedures will result in the
firm's inability to replace the depreciating assets (produc-
tive capacity) without the use Of retained "profits"--part
Of such profits are illusory.

Current Brazilian law, however, permits upward
restatement of prOperty, plant and equipment and related
depreciation expense charges tO reflect price—level in-
creases, tO the extent Of the coefficients established by

the government. .Although the practice Of allowing such

56

upward restatements Of prOperty had been permitted for
limited periods in the past, it was not established on a
regular basis until November 1958. The law NO. 3470 Of
November Of 1958 permits restatement Of prOperty in deter-
mining income for purposes Of taxation to be made on the
basis Of coefficients to be determined and revised every
two years by the Brazilian National Economic Council. .Such
restatement is also now the standard practice for purposes
Of Official financial reporting, as well. The restatement
of assets is a partial recognition Of the decreasing value
Of the cruzeiro.

.Also, given an inflationary situation, some Of the
profits will be illusory tO the extent that they are needed
tO replace inventories whose money value has risen. Even
the cash balance necessary for regular transactions must be
increased to accommodate the same real volume of business.

Statistical evidence is available concerning illu-
sory profits stemming from the replacement Of inventories
and the maintenance Of the real value of cash balances.

Once a year, the consolidated balance sheets Of the most
important Brazilian corporations (about 7,000 which actually
amount tO about 80 percent Of all Brazilian corporations)
are published. On the basis Of these data, illusory profits
stemming from the replacement Of inventories and the mainte—
nance Of real cash value were determined by taking the
figures at the beginning Of the year and at the end of the

year, and the rate Of inflation during the year. The

57

resulting data were then compared with the nominal profits
shown in the balance sheets. ,All this is summarized in
Table 11.

Some simplifications have been made for the calcula-
tions in Table 11, as follows:

a. Inventories were assumed tO be correctly valued in
the balance sheets, and that the first-in first-out
method is used.

b. -Accounts receivable and accounts payable were all
treated as cruzeiro credits and debits (rather than
amounts due in other currencies).

The errors arising from such simplifications are
probably small since the effect is generally Offset from One
year to the other in the case Of inventories, and from
assets to liabilities in the case Of accounts receivable and
accounts payable.

As can be seen in Table 11, more than one-third Of
the profits were illusory, i.e., were absorbed by the
replacement Of working capital (inventories + net cash).
Inventory replacement alone shows a higher percentage Of
illusory profits, ranging from almost half Of reported
profits in 1966 to a peak Of more than two-thirds in 1963.
Real cash effect was negative in the five year period. The
reason for this phenomenon is that in total the corporations

owed more to banks and tO other firms than they had as cash

deposits and accounts receivable.

5E3

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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.HH OHAMB

59

Effect of Inflation on Annual Reports

Financial statements that are not corrected for the

effects of inflation can so distort the presentation Of

facts that the less informed readers Obtain the impression

Of excessive profiteering on the part Of private enterprise,

and this can encourage social unrest, as well as imprOper

decisions by management. The following are the principal

items in the financial statements that would require restate-

ments for the effects Of price level changes.

3.

Monetary assets such as cash On hand and in the bank
do not require restatements as they are stated in
current cruzeiros. Losses may be realized by hold-
ing cash, but such loss will only be recognized when
accounts are again restated at a subsequent date in
terms Of a cruzeiro Of lesser value. Other monetary
assets and liabilities, such as trade accounts
receivable and accounts payable to suppliers would
not normally require price level restatements since
they are usually stated On the books in current
cruzeiros. Just as with cash, losses will be
realized if the firm hold more monetary assets than
monetary liabilities.

PrOperty, plant and equipment and the related
depreciation reserves, would be restated in terms

Of current cruzeiros by the use Of index numbers

applied to historical cost. Where these accounts

60

have been restated to the full extent Of the Govern-
ment coefficients (these are Of a general consumer
price index nature), this will serve as a recogni-
tion Of the price level change.

Where inventories have been acquired in the last
month Of the fiscal year, they will probably not
require price-level adjustments, but because of the
high rate Of inflation, inventories that have been
held for longer period, may require some adjustments
tO increase the historical cost to a cost stated in
current depreciated cruzeiros.

Sales and current eXpenses would normally be ex-
pressed in terms Of the actual average price level
cruzeiro amounts throughout the year, and are
adjusted to year-end depreciated cruzeiros. The
non-monetary charges for depreciation Of prOperty
and for cost Of sales would require adjustments for
the price level changes.

The loss Of purchasing power Of the net monetary
assets would be charged to income and credited tO

a reserve for maintenance Of capital. The results
which are presented without reflecting losses aris-
ing through depreciation Of the currency dO not
represent true profits in the economic sense, and
therefore, such losses must be taken into account

in order tO fairly present the results Of Operations.

61

Just as the holding Of monetary assets results in a
loss when currency depreciates, so the existence Of
liabilities Of fixed amounts Of cruzeiros results in
economic gains when currency depreciates since the
liabilities can be liquidated in cruzeiros Of lower

purchasing power.

The full effect on the results Of Operations Of the

price level changes affecting prOperty, inventories and net

monetary assets could be achieved by further adjustments for:

1.

funds,

“Additional depreciation where that recorded does not

give full recognition to the use in price level.
Additional cost Of inventories sold, being the
difference between the historical cost and the
corresponding amounts after price level adjustments.
Maintenance Of purchasing power Of capital invested

in net monetary assets.

In cases where liabilities are a major source Of

the economic gains on cruzeiro liabilities should

also be given recognition for two reasons:

a.

b.

TO show the eXperience with price level adjustments,
TO eXplain a major factor Of adjustment in the

example given at the end Of the chapter.

Except for the effect on income Of the price level

adjustment Of prOperty, tO the extent Of the established

coefficients (as discussed before in this chapter), only a

62

little has been done in Brazilian accounting to recognize
the full effect Of inflation on the profits reported.

Until 1964, tax legislation permitted the write-up
Of the prOperty accounts (in determining a firm's investment
for purposes Of the excess profits tax) to the extent Of the
coefficients and thereby had to some extent provided the
means for adjusting balance sheet amounts Of prOperty and
depreciation reserves. But tax deduction was not allowed
for depreciation on this write-up, and so the income tax
laws had not recognized the effect Of inflation on the
depreciation chargeable to income.

The law 3470 did not require that companies restate
their assets, but in 1964, Decree NO. 54.298 superseded that
law, and the fixed assets of all companies were subject to
compulsory restatement. The depreciation chargeable to
income was calculated as a percentage of the depreciable
assets corrected monetarily. SO, from 1964 on, the fixed
assets and the depreciation expenses shown on the annual
reports are already adjusted figures.

A few companies use~the last-in, first-out (LIFO)
basis for pricing inventories, thereby to some extent
eliminating from income the inflationary profits that would
otherwise arise from merely turning over inventories,
although the LIFO basis tends tO understate the inventories

from the balance sheet point Of view.

63

However, neither the tax laws nor current Brazilian
accounting practices have recognized until November Of 1967
the effect Of inflation upon net monetary assets and the
overstatement Of profits that results from the failure tO
provide for the erosion Of the purchasing power Of such net
monetary assets, so this was tOO late to affect any Of the
figures Of the companies considered in the sample.

The usual corporate practice, therefore, is for the
income statement tO show relatively large cruzeiros profits,
and in recognition Of the fact that tO a considerable extent
these are not real profits in an economic sense, a major
part thereof is retained as undistributed surplus or credit
to general reserve accounts.

The annual reports published by the Brazilian sub-
sidiaries, which constitute the primary source Of informa-
tion for this study cannot be used as presented in Official
neWSpapers, due tO not only price-level problems but also to
accounting practices followed by accountants in Brazil.

Some Of the points in which accounting procedures might
distort a comparison between parent and subsidiary companies,
are the following:

1. Accounts receivable are usually stated at gross
amounts deSpite the fact that a reserve for bad
debts is determined every year. This reserve
instead Of being shown as "contra" account of the

asset is classified in the owner's equity group.

64

Inventories are carried by the rule Of "cost or
market," whichever is lower. Since LIFO is not an
acceptable method for pricing inventories due to
income tax laws, the method adOpted is either FIFO
(first-in, first-out) or weighted average. In such
a highly inflationary economy, this has immediate
and important implications in the cost Of sales, and
the profits, by understating the first and overstat-
ing the second.

Fixed assets are carried at historical cost, and
their monetary correction is shown as a separate
account in the assets. In many cases, this account
is presented at its full amount, i.e., the reserve
for depreciation is not deducted, and the net amount
invested in fixed assets at the date Of the balance
sheet is not readily determinable. The reserve for
depreciation is shown in the owner's equity group Of

accounts.

‘The profit and loss statement, sales and cost Of

goods sold are not required tO be presented in the
published reports, and very few companies present
these figures. The first item in this statement
typically is Gross Profits.

The method used for Depreciation is "straight line"
up to a maximum Of 10 percent per yearover the life
Of the asset. Under special circumstances the

depreciation eXpense can be increased tO 15 and 20

65

percent, if the company works in two and three
shifts respectively. Depreciation on buildings was
not allowed for income tax purposes until 1965 and
practically not considered in the accounting records

before 1965.

The financial reports Of Brazilian subsidiaries were
reclassified tO United States style in order to facilitate
the comparison with their parent companies, and adjusted by

using price level accounting techniques (as described next).
Price Level Accounting

The problem Of accounting for inflation is a diffi-
cult One, particularly in Brazil where the rate Of inflation
is so great. There is nO doubt that any attempt tO intro-
duce accounting recognition Of the effects Of inflation will
encounter many difficulties and much resistance, but if
financial statements are tO be meaningful and are to give
a fair presentation Of financial position and results Of
Operations, satisfactory accounting treatment must be devel-
Oped, as has happened in the past.

The essential element Of price-level accounting is
the recognition that cruzeiros in use as Of one date repre-
sent different purchasing power than those in use at another
date. The problem is tO translate statements in cruzeiros

costs originating at various dates into cruzeiros Of common

66

purchasing power, for instance, as Of the current year-end
data.

It is important to keep in mind that the application
Of price-level accounting is not a departure from the
accounting principle Of historical cost; rather, accounting
done under the traditional concept Of cost basis accounting,
which assumes stability Of purchasing power of the unity Of
currency, is being corrected to recognize the fact that such
stability does not exist. This requires that the statements
be adjusted to reflect the effect Of the price level changes,
i.e., the change Of purchasing power Of the currency.

In discussion and literature pertaining tO price-
level accounting, the term “revaluation Of assets" is fre-
quently found. This is not a correct use Of the term. NO
attempt is being made to establish current "value" but
merely to restate costs for the change in purchasing power
of the currency. It is advisable tO avoid the term "reval-
uation". All such adjustments should be referred to as
"restatements Of assets".

Confusion and misunderstanding Of the Objectives Of
price level accounting is also created by the lOOse use Of
the term "replacement" in connection with the various adjust—
Iments made. Replacement accounting implies the specific
replacement Of each asset sold or used. This is not the
Objective Of price level accounting. AAlthough businessmen

may think in terms Of setting selling prices on the basis of

 

 

 

 

re;

7.!
HI-
5.

67

replacement cost, which is a sound business procedure, the
approach Of price level accounting is that there should be
an Objective measure Of the change in purchasing power of
the cruzeiro which would be independent Of the company's
Operations.

.Since the purpose Of price level adjustment is to
reflect the effect Of the change in purchasing power Of the
cruzeiro, it is necessary tO determine which is the best
index number that will reflect this change.

The best index for the purpose Of calculating price
level adjustment is the one which is most representative Of
the general level Of prices throughout the country rather
than one which is tied tO any particular type Of asset or
any particular locality.

A price index can be defined as,

a series of measurements, expressed as percent-
ages, Of the relationship between the average
price Of a group Of goods and services at a
succession Of dates and the average price Of a
similar group Of gOOds and services at a common
date (27:63).

The most used indices for price level adjustments
are the Consumer Price Index and Wholesale Price Index.. The
first measures "change in prices of goods and services pur-
chased by city wage-earner and clericalaworker families tO

maintain their level Of living" (27:102) and the Wholesale

Price Index is "the prices either paid to or received by

sales made in large lots at a primary market level, i.e.,

68

the first important commercial transaction for each
commodity" (27:105).

In Brazil, the Consumer Price Index and Wholesale
Price Index have usually "moved together" as is shown in
Figure l which covers the years from 1963 to 1967.

There have been many criticisms of the use Of the
Wholesale Price Index, and the more important are:

a. The index is not designed to measure change in
absolute levels Of prices, and the quotations used
in the index for individual commodities do not
necessarily measure the cruzeiro level Of prices.

b. The index does not measure prices paid by industrial
consumers since it normally excludes transportation
costs and similar factors affecting final prices.

c. .Many components Of the Wholesale Price Index never
enter retail markets, machinery for example.

d. Many components Of the Consumer Price Index, such as
services and rents are not covered by the Wholesale

Price Index.

In view Of the above reasoning, the index used in
this work is the Consumer Price Index. This index, despite
having a high correlation with the Wholesale Price Index as
shown in Figure 1, does not present all the limitations
mentioned above, and is readily available by monthly changes

in specialized periodicals, as shown on Table 12.

69

 

COST OFlJVWG 8
WHOLESALE PRmES
QUARTEREY CHANGES

 

 

J 3 o .I a II
was 1 1m 1967 1

o

a-

u
.4

 

 

Figure 1. Cost of living and wholesale prices (percentage

change). Source: Conjuntura Econ6mica,
International Edition, February, 1968.

7O

 

 

 

 

 

Table 12. Consumer price index (Base: 1953 a 100)

Cost of Cost of

Living Living

Year Month Index Year Month Index
1962 January 753 1963 January 1320
February 777 February 1333

March 803 March 1357

April 826 April 1378

May 858 May 1447

June 895 June 1507

July 922 July 1573

August 972 August 1662

September 1072 September 1769

October 1121 October 1879

November 1151 November 1976

December 1303 December 2093

Average for the year 926 Average for the year 1607
Average for the last three months 1192 Average for the last three months 1982
1964 January 2229 1965 January 4110
February 2368 February 4278

March 2546 March 4481

April 2611 April 4608

May 2673 May 4755

June 2902 June 4808

July 3115 July 4971

August 3214 August 5028

September 3321 September 5187

October 3489 October 5265

November 3584 November 5346

December 4008 December 5483

Average for the year 3005 Average for the year 4860
Average for the last three months 3694 Average for the last three months 5364
1966 January 5981 1967 January 8260
February 6229 February 8386

March 6452 March 8649

April 6756 April 8976

May 6946 May 9069

June 7180 June 9161

July 7310 July 9372

August 7426 August 9467

September 7597 September 9623

October 7734 October 9799

November 7879 November 9975

December 8021 December 10053

Average for the year 7126 Average for the year 9233
Average for the last three months 7878 Average for the last three months 9942
Source: Conjuntura Econamica, International Edition, June 1963, 1964, 1965, 1966, 1967

 

and October 1968.

71

.An example of the techniques Of price level adjust—

ment used in this study is given at the end Of this chapter.

It is based on the recommendations Of the Statement Of the

Accounting Principles Board NO. 3 "Financial Statements

Restated for General Price-Level Changes" issued by the

.Accounting Principles Board Of the American Institute Of

Certified Public Accountants (3).

made:

1.

In this example, the following assumptions were

The inventory is priced on first-in, first-out
(FIFO) basis.

All revenue and expenses, except for depreciation
and for that portion Of the cost Of goods sold
represented by the beginning inventory, are earned
or incurred evenly throughout each year, i.e., the
transactions occur at the average price level Of
the year.

‘Acquisitions Of plant and equipment take place at

the Opening Of the year.

The ending inventory is considered Of products
manufactured or acquired on the last three months
Of the year.

Unless disclosed in the financial reports, the fixed
assets are considered not to have been adjusted by
the government coefficients in the year Of 1963.
From 1964 on, due to compulsory requirement Of
monetary correction for fixed assets, all such data
in the financial reports are considered restated.

Depreciation is assumed to be determined on a
"straight line" basis.

In this dissertation the comparison between parent

and subsidiary companies is done on a year-by-year basis,

and the subsidiaries' financial statements are restated in

72

terms of the cruzeiro at the end Of each year, that is, in
terms Of the current cruzeiro as Of each balance sheet date.
Since the process is the same for all companies and

all periods, this example will show the application Of the
techniques Of price-level adjustments for a three-year
period and is divided in three sections:

A. Adjustments Of Income Statements

B. Adjustments Of Monetary Items

C. :Adjustments Of Balance Sheets.

A. ~Adjustments Of Income Statement

I. Sales* are assumed to have been made evenly in all
months during the year, that is, when the price
index was at the average for the year. In order to
show the sales figures at the year-end cruzeiro, it
is sufficient tO divide the year-end index number by
the average index number for the year and multiply
this result by the sales figure.

1963 2093 + 1607 1.302 x Sales

1964 4008-+ 3005 1.333 x Sales

1965 5483 + 4860 1.129 x Sales

1966 8021 + 7126 1.125 x Sales

1967 10053 + 9233

1.088 x Sales

 

*In this case the multiplier for five years is pre-
sented, in order tO show the multipliers actually utilized
in the adjustment Of subsidiary's financial report for the
period covered in the dissertation. In all other cases, it
is restricted tO three years, the necessary period for this
example.

73

II. Cost Of Goods SOld--In this section Of the income
statement it is necessary tO use three different
index numbers, because Cost Of Goods Sold is deter—

mined by the equation:

C.G.S. = B.I. + P. - E.I., where

w
H
II

Beginning Inventory

*Purchases

’6
ll

B.I. = Ending Inventory

11.1. The beginning inventory is assumed tO have
been valued at a cruzeiro equal tO the average
Of the three last months Of the previous year,
which is consistent with the assumption of FIFO
method Of inventory pricing. By using the his-
torical figure in the income statement, the cost
Of gOOds sold is grossly understated, and the
beginning inventory at the year-end cruzeiro is
determined by dividing the year-end index number
by the average index number for the last three
months Of the previous year and multiply this

result by the beginning inventory figure.

1963 2093 + 1192

1.755 x Beginning Inventory

1964 4008 + 1982

2.022 x Beginning Inventory

1965 5483 + 3694 1.484 x Beginning Inventory

III C

74

II.2. The purchases are assumed to have been evenly
made in all months Of the year, that is at the
average price level Of the year. In order tO
restate this account at the year-end cruzeiro
we divide the year-end index number tO the aver-
age index number for the year and multiply this

result by the purchases figure.

1963 2093 + 1607 1.302 x Purchases

1964 4008 + 3005

1.333 x Purchases

1965 5483 + 4860 1.129 x Purchases

11.3. The Ending Inventory is assumed to be com-
prised Of products manufactured or acquired in
the last three months Of the current year; to
restate this account at the year-end cruzeiro,
the year-end index number of the current year
is divided by the average index number Of the
last three months Of the current year and multi-
ply this result by the ending inventory figure.

1963 2093 + 1982 = 1.056 x Ending Inventory

1964 4008 + 3694 1.085 annding Inventory

1965 5483 + 5364 1.022 x Ending Inventory
Depreciation. ,For this account two different prO-
cedures were adOpted. It is assumed that deprecia-
tion is made on a straight line basis, and the fixed
asset is considered as acquired in the beginning Of

the year. For the initial year Of 1963, it was

assumed that fixed assets were eXpressed in cruzeiros

IV.

75

as of price-level index Of the previous year-end:

in order to restate this account tO a cruzeiro Of

current year-end we divide the index number at the
end Of the current year by the index number at the
end Of previous year, and multiply this result by

the depreciation figure.

1963 2093 +- 1303 == 1.604 x depreciation.
If, however, it is disclosed on the financial
reports that the fixed assets and depreciation
expenses have been readjusted by the Government
coefficients, no further adjustment Of depreciation
is made.

For the years Of 1964 to 1967, all the companies
have made monetary corrections Of their reported
fixed assets, which was a restatement Of the costs
Of those assets tO a year-end cruzeiro. .Since the
depreciation eXpense is based on fixed assets, and
this account has been adjusted, no further adjust-
ment was needed in this account.

Other Expenses and Other Income. The other eXpenses,
which include general, administrative and sales
expenses, and other income were assumed to be

incurred evenly through all the months Of the year.

.The price level adjustment, in order tO restate these

accounts at the year-end cruzeiro is made by dividing

the year-end index number by the average index

76

number for the year and multiplying this result by

the figures Of each Specific account.

1963 2093 + 1607 1.302 x Expense or income account

1964 4008 + 3005 1.333 x EXpense or income account

1965 5483 + 4860

1.129 x EXpense or income account

The approach described in "A" is in accordance with

the statement Of Accounting Principles Board N0. 3

issued by the American Institute Of Certified Public

.Accountants (3).
Adjustments Of Monetary Items

Monetary items are divided into two categories:
monetary assets and monetary liabilities. When a firm
has a position Of net creditor, also called net monetary
assets,.i.e., when the monetary assets are greater than
monetary liabilities, given the inflationary condition
in Brazil an economic loss occurs as price levels in-
crease. If the firm has a position Of net debtor, also
called net monetary liabilities, i.e., when the monetary
liabilities are greater than monetary assets, and eco-
nomic gain occurs as price levels increase.

”For the purpose Of this study, the following items
are considered as monetary assets:

a. Cash

b. Accounts receivable (short and long term)

77

c. Government Bonds (short and long term)

Any accounts receivable which originated from eXport Of

merchandise, which was encountered in rare cases, were

excluded from the monetary items subject tO adjustment,
since would be in a foreign currency. The reasons for
this procedure was that as inflation continues the num-
ber Of cruzeiros that could be exchanged for One dollar,
for example, also increases, as shown on Table 10 in

Chapter II.

Monetary liabilities were considered to include all
the current and long term liabilities. In this group an
exception was also considered, in the cases when the
subsidiary borrowed money from the parent corporation.
Since the repayment must be made in dollars, for the
same reason eXplained in the previous paragraph this
amount was excluded from the monetary liabilities. This
long-term borrowing from the parent company was more
common, due to the difficulties in Obtaining loans on a
long term basis from the financial institutions in
Brazil.

A gain or loss on monetary items was determined by
following the procedures described below:

a. Determination Of the monetary position Of the com-
pany at the end Of the previous year, i.e., if it
was a net debtor or net creditor. In order tO show
the purchasing power represented by this position in

terms Of the year-end cruzeiros, the year-end index

78

number Of the current year was divided by the
year-end index number Of the previous year and this
result is multiplied by the net monetary position

Of the previous year.

1963 2093 + 1303

1.604 x Net monetary position
at the end Of the year
Of 1962

1964 4008 + 2093

1.914 x Net monetary position
at the end Of the year
Of 1963

1965 5483 + 4008

1.368 x Net monetary position
at the end Of the year
Of 1964
Determination Of the net monetary position Of the
company at the end Of the current year; the differ-
ence between this year-end and previous year-end
positions (unadjusted) is assumed as being evenly
incurred during the twelve months Of the year, that
is, when the price index was at the average for the
year. In order to show this amount at the year-end
cruzeiro, we divide the year-end index number Of the
current year by the average index number for the
year and multiply this result by the-difference Of
net monetary position Of the previous and current
year.
1963 2093 + 1303 = 1.604 x Difference in net mone-

tary position Of pre-
vious and current year

79

1964 4008 + 2093 1.914 x Difference in net mone-
tary position in pre-

vious and current year

1965 5483 + 4008 1.368 x Difference in net mone-
tary position in pre-

vious and current year

c. Add the adjusted figures (beginning balance plus/
minus change) as determined in "a" and "b" above.
This computed year-end figure is compared with the
actual net monetary position at the end Of the cur-
rent year. If the company is holding a position Of
net monetary debtor, and the computed balance is
greater than the actual net monetary assets figure,
the company suffered a lOss Of purchasing power, and
if the figure is smaller the company had a gain- If
the company holds a position of net monetary credi-
tor the reverse situation Occurs;.if the adjusted
figure Of net monetary liability is greater than the
unadjusted figure Of net monetary liability at the
end Of the current year the company had a gain, and
if the figure is smaller the company had a loss. In
any event the gain or loss is considered as quite
"real" and is included in determining the price-
level adjusted income amount.

-C. ,Adjustments Of the Balance Sheet
The amounts of the monetary assets at the end Of the

IYear require no adjustment since they are, as legal

'tender, or by agreement with the debtors and creditors,

80

receivable or payable in current cruzeiros. The gain or
loss for holding monetary items was eXplained in section
"Bu.

The adjustments Of inventories were eXplained in
section A.II, when Cost of Goods Sold was discussed.

Other current assets usually amount tO a small fig-
ure and were assumed as being evenly acquired during the
year, that is, when the price index was at the average
for the year. The procedure followed tO restate this
account at year-end cruzeiro, was to divide the year-end
index number by the average index number for the year

and multiply this result by other current asset account.

1963 2093 + 1607 1.302 x Other current assets

1.333 x Other current assets

1964 4008 + 3005

1965 5483 + 4860 1.129 x Other current assets

The procedure followed for the restatement of fixed
assets was discussed in section A.III when the restate-
ment of the depreciation account was explained.

The monetary liabilities do not require any adjust-
ment for the same reasons explained in the first para-
graph Of this section.

Reserve accounts are a kind Of recognition by the
management that not all the profit shown in the profit
and loss statement is real profit and part of it must
Ibe set aside as a reserve tO avoid decapitalization Of

“the company. In order to restate this account in

81

year-end cruzeiros, we divide the year-end index number
by the average index number for the year and multiply

this result by reserve account.

1963 2093 + 1607 1.302 x Reserves

1.333 x Reserves

1964 4008 + 3005

1965 5483 + 4860

1.129 x Reserves

For the capital account two procedures, again, were
utilized. On all 47 companies there was no increase in
the capital account due to new investment from the
parent corporation or tO sale Of stocks tO the public.
,All the increases in capital were originated from mone-
tary correction Of fixed assets.

In view Of the above reasoning, for the year Of 1963
this account was considered as stated in cruzeiros Of
the end Of 1962, and in order to adjust for the cruzeiro
of 1963 year-end, the index number at 1963 year-end was
divided by the index number at 1962 year-end and the
result multiplied by the figures shown in the capital

account.

1963 3093 + 1303 - 1.604 x Capital

The capital account was already adjusted for the
years Of 1964 tO 1967, due tO the compulsory law that
required a monetary correction Of the fixed assets Of
the corporations. The credit resulting from such write-

up is made tO capital, and ordinarily is accompanied by

82

issuance Of additional capital stocks pro-rata basis tO
the stockholders. Hence, nO change was made in capital
for these years on the figures shown on the financial
statements.

The adjusted retained earnings is a residual account
and it represents the accumulated excess Of adjusted net
income expressed in current year-end cruzeiros and all
gains and losses from.hOlding a.5pecific monetary
position.

Example Of the Use Of Price-
Level Accounting

The example presented below is based on the actual
figures of the financial reports Of one Of the companies and
can be described as a representative company Of the sample,
because it shows a large decrease in profits in the adjusted
profit and loss statement, and as most Of the companies have
a purchasing power loss for holding a position Of net mone-
tary assets.

This is what was done with the financial statements

Of the 47 subsidiaries.

£33

XYZ COMPANY INCOME STATEMENT FOR THE YEAR OF 1963

 

 

 

 

RESTATED IN DECEMBER 31,

 

 

 

 

 

HISTORICAL MULTIPLIER 1963 CRUZEIROS
Sales 22,363 2093/1607=1,302 29,116
- Cost of Goods Sold:
Beginning Inventory 2,664 2093/1192=1,755 4,676
+ Purchases 16,075 2093/1607=1,302 20,930
- Ending Inventories 4,335 14,404 2093/l982=1,056 4,578 21,028
Gross Profits 7,959 8,088
- Sales and Administra-
tive Expenses 1,665 2093/1607=l,302 2,168
- Miscellaneous Expenses 738 2093/l607=1,302 961
- Depreciation 298 2,701 2093/1303=1,604(I) 478 3,607
Operating Income 5,258 4,481
+ Interest 21 2093/1607=1,302 28
+ Other Income 90 111 2093/l607=1,302 117 145
Total Income 5,369 4,626
Purchasing power loss from
holding net monetary assets
(see statement below) ... 650
Net Income before taxes 5,369 3,976
- Taxes 2,001 2093/1607=1,302 2,605
Net Income after taxes 3,368 1,371
XYZ COMPANY STATEMENT OF GAIN AND LOSSES ON MONETARY ITEMS
(See explanation in B)
HISTORICAL MULTIPLIER ADJUSTED
Net Monetary Assets, 12-31-1962 750 2093/1303=1,604 1,204
Increase in Monetary Assets during 1963 653 2093/1607=1,302 849
Adjusted Balance in Net Monetary Assets
at end of 1963 2,053
Net Monetary Assets, 12-31-1963 1,403
Net Loss from holding Net Monetary Assets 650
XYZ COMPANY BALANCE SHEET AS OF DECEMBER 31, 1963
ASSETS HISTORICAL MULTIPLIER ADJUSTED
Cash 563 ... 563
Accounts Receivable 5,997 ... 5,997
Long Term Receivable 482 ... 482
Inventories (see explanation C) 4,335 2093/1982=1,056 4,578
Other Current Assets (see
explanation C) 138 2093/1607=1,302 180
Fixed Assets (Net of Depreciation) 4,576 2093/1303=1,604(II) 7,340
16,091 19,140
LIABILITIES AND OWNER'S EQUITY
Current Liabilities 6,637 ... 6,637
Long Term Debt ... ... ...
Reserves (see explanation C) 391 2093/1607=1,302 509
Capital 6,100 2093/1303=1,604(III) 9,784
Retained Earnings (see explanation C) 2,963 ... 2,210
16,091 19,140

 

(I) Since depreciation is based on Fixed Asset this expense might be grossly under-
stated (see explanation II in Balance Sheet Statement Of December 31, 1963).

(II)

Fixed assets are assumed as being acquired in its total amount in December 31,

1962 due to the impossibility of getting detailed information from the annual
reports in respect to the date Of acquisition and amount paid for each asset.

(III)

Capital is assumed as being totally subscribed in December 31, 1962.

There is

no way to determine from the financial statements the exact date and amount Of
initial subscription and subsequent increases of capital.

XYZ COMPANY INCOME STATEMENT FOR THE YEAR OF 1964

RESTATED IN DECEMBER 31.

 

 

 

 

 

 

 

HISTORICAL MULTIPLIER 1964 CRUZEIROS

Sales 51,753 4008/3005=1,333 68,988
- Cost of Goods Sold:

Beginning Inventory 4,335 4008/1982=2,022 8,766

+ Purchases 36,141 4008/3005=1,333 48,175

— Ending Inventory 7,756 32,720 4008/3694=1,085 8,414 48,527
Gross Profits 19,033 20,461
— Sales and Administra-

tive Expenses 2,899 4008/3005=1,333 3,865
- Miscellaneous Expenses 1,272 4008/3005=1,333 1,695
- Depreciation (see ex-

planation in A.III) 694 4,865' ... 694 6,254
Operating Income 14,168 14,207
+ Interest 23 4008/3005=1,333 31
+ Other Income 178 201 4008/3005=1,333 237 268
Total Income 14,369 14,475
Purchasing power loss
from holding net monetary
assets (see statement
below) ... 1,689
Net Income before taxes 14,369 12,786
- Taxes 7,860 4008/3005=1,333 10,477
Net Income after taxes 6,509 2,309

XYZ COMPANY STATEMENT ON GAIN AND LOSSES 9N MONETARY ITEMS
(See eXplanation in B)

HISTORICAL MULTIPLIER ADJUSTED
Net Monetary Assets, 12-31-1963 1,403 4008/2093=1,914 2,686
Increase in Monetary Assets during 1964 1,219 4008/3005=1,333 1,625
Adjusted Balance in Net Monetary Assets
at end Of 1964 4,311
Net Monetary Assets, 12-31-1964 2,622
Net Loss from holding Net Monetary Assets 1,689

 

XYZ COMPANY BALANCE SHEET AS OF DECEMBER 31Li1964

ASSETS HISTORICAL MULTIPLIER ADJUSTED
Cash 782 ... 782
Accounts Receivable 15,576 ... 15,576
Long Term Receivable 885 ... 885
Inventories (see explanation C) 7,756 4008/3694=1,085 8,414
Other Current Assets (see explanation C) 273 4008/3005=1,333 366
Fixed Assets (Net of Depreciation) ...
(see explanation A.III) 12,937 12,937
38,209 38,960
LIABILITIES
Current Liabilities 12,686 ... 12,686
Long Term Debt 5,078 ... 5,078
Reserves (see explanation C) 2,336 4008/3005=l,333 3,114
Capital (see explanation C) 14,404 ... 14,404
Retained Earnings (see explanation C) 3,705 ... 3,678
38 209 38 960

85

m COMPANY moor; STATEMENT FOR THE YEAR OF 1965

RESTATED IN DECEMBER

 

 

 

 

 

 

 

 

HISTORICAL MULTIPLIER 1965 CRUZEIROS

Sales 74,378 5483/4860=1,129 83,972
- Cost Of Goods Sold:

Beginning Inventory 7,755 5483/3694=1,484 11,509

+ Purchases 51,421 5483/4860=1,129 58,054

- Ending Inventory 9,999 49,177 5483/5364=1,022 10,219 59,344
Gross Profits 25,201 24,628
- Sales and Adminis—

trative EXpenses 4,764 5483/4860=1,129 5,378
- Miscellaneous Expenses 2,996 5483/4860=1,129 3,383
- Depreciation (see ex-

planation in A.III) 2,004 9,764 ... 2,004 19,765
Operating Income 15,437 13,863
+ Interest 46 5483/4860=1,129 53
+ Other Income 207 253 5483/4860=1,129 233 286
Total Income 15,690 14,149
— Purchasing power loss from

holding net monetary assets

(see statement below) ... 1,440
Net Income before taxes 15,690 12,709
- Taxes 8,665 5483/4860=1,129 9,781
Net Income after taxes 7,025 2,928

XYZ COMPANY STATEMENT ON,GAIN AND LOSSES ON MONETARY ITEMS
(See eXplanation in B)
HISTORICAL MULTIPLIER ADJUSTED

Net Monetary Assets, 12-31-1964 2,622 5483/4008=1,368 3,588
Increase in Monetary Assets during 1965 3,679 5483/4860=1,129 4,153
Adjusted Balance in Net Monetary Assets

at end of 1965 7,741
Net Monetary Assets, 12-31-1965 6,301
Net Loss from holding Net Monetary Assets 1 440

XYZ COMPANY BALANCE SHEET AS OF DECEMBER 31,

1965

RESTATED IN DECEMBER 31,

__l—__

 

ASSETS HISTORICAL MULTIPLIER 1965 CRUZEIROS
Cash 3,156 ... 3,156
Accounts Receivable 21,245 ... 21,245
Long Term Receivable 942 ... 942
Inventories (see eXpla-

nation C) 9,999 5483/5364=1,022 10,219
Other Current Assets (see ,

explanation C) 626 5483/4860=1,129 707
Fixed Assets (Net of Depre-

ciation) (see explanation

A.III) 22,319 ... 22,319

58,287 58,588

LIABILITIES
Current Liabilities 17,302 ... 17,302
Long Term Debt 5,078 ... 5,078
Reserves (see explanation C) 3,228 5483/4860=1,129 3,645
Capital (see explanation C) 24,017 ... 24.017
Retained Earnings (see expla-

nation C) 8,662 ... 8,546

58,287 58,588

86

In the example Of XYZ, the company disclosed the
figures relative to Sales and Cost Of Goods Sold. As was
said before the majority of Brazilian subsidiaries dO not
show the data on these accounts.

In order to adjust the price-level income statements
for the illusory profits corresponding to inventory replace-
ments the amounts Of beginning and ending inventory were
adjusted at the year-end cruzeiros. The basic assumptions
in respect to inventory are the same ones as develOped
before, namely:

a. Sales and purchases are earned or incurred evenly

throughout the year, i.e., the transactions occur
at average price level of the year.

Recall, however these gross profit relationships:

G.P. = Sales - Cost Of Goods Sold.

G.P. = Sales - (Beginning inventory + purchases —
ending inventory)

G.P. = Sales - Purchases - (Beginning inventory +

ending inventory)
b. Inventory is priced on first-in, first-out (FIFO)
basis, and
c. The ending inventory is comprised Of products
manufactured or acquired on the last three months
Of the year.
The two major factors, sales and purchases are
restated by the regular multiplier (year-end index/average
index for the year). Only beginning inventory and ending

inventory call for a different multiplier. Thus adjusted

87

Gross profits can be computed by applying the regular multi-
plier tO historical gross profit plus added correction for
beginning and ending inventory.

TO restate these accounts in year-end cruzeiros, the
same technique as the one used in the previous example is
applied. The adjustment tO beginning inventory has the
effect Of reducing gross profits. The adjustment to closing
inventory also results in a reduction so the sum Of these
two reductions is subtracted from gross profits.

In this example, also, a case is shown where the
company holds a net monetary liability position, which
resulted in a "Gain" for the company.

.Since the same procedures are used in all the years,

the example in this case is restricted tO the year Of 1963.

88

 

 

 

ABC COMPANI INCOME STATEMENT FOR THE YEAR OF 1963
RESTATED AT DECEMBER 31,
HISTORICAL MULTIPLIER 1963 CRUIEIROS
Beginning Inventory 309 2093/1192-1,755 542
Less 309 2093/1607-1,302 402
Amount overstated in Gross
Profits 140
Ending Inventory 363 2093/1982-1,056 384
Less 363 2093/1607c1,302 473
Amount overstated in Gross
Profits (89)
Balance of amount overstated
in Gross Profits due to
Inventory replacements 229
Gross Profits 1,140 2093/1607=l,302 1,484
- Amount overstated in Gross ‘
Profits, as above 229 1,255
- Sales and Administrative
EXpenses 745 2093/1607-1,302 970
- Depreciation _45 ,129 2093/1303=1,604 72 1,042
Operating Income 350 213
+ Other Income 19 2093/1607=1,302 25

 

Total Income

+ Purchase power gain from
holding Net Monetary
Liability (see statement

to
0"
RD
N
LO
(D

 

 

 

 

 

 

 

 

below) ... 61
Net income before taxes 369 299
- Taxes 166 2093/1607-1,302 217
Net income after taxes 203 82
= E—
ABC wMPANY STATEMENT OLGAIN AND IOSSES ON FDNETARY ASSETS
UNADJUSTED MULTIPLIER ADJUSTED
Net Monetary Liabilities, 12-31-1962 33 2093/1303-1,604 54
Increase in monetary liabilities during 1963 135 2093/1607=l,302 175
Adjusted net monetary liabilities at end of
1963 . 229
Net monetary liability, 12-31-1963 168
Net gain from holding net monetary liabilities 61
ABC CDMPANY BALANCE SHEET AS OF DECEMBER 31,_1963
ASSETS UNADJUSTED MULTIPLIER ADJUSTED
Cash 115 ... 115
Accounts Receivable 23 ... 23
Long Term Receivable 33 ... 33
Inventories 363 2093/1982=1,056 384
Other current assets 8 2093/1607=1,302 10
Fixed Assets (Net of Depreciation) 1,379 2093/l303=1,604 2,012
1, 921 2, 577
LIABILITIES AND OWNER'S EQUITY
Current Liability 648 ... 648
Reserves 241 2093/l607=1,302 313
Capital 700 2093/1303-1,604 1,122
Retained Earnings 332 ... 494
l 921 2 577

 

89

In this chapter, the techniques of price-level
sadjustment have been discussed in detailed form, which
brings to light the illusory profits reported in unadjusted
financial statements. The published financial statements of
the subsidiaries, adjusted in this way, along with the
parents' unadjusted financial statements are the basic data
used in Chapters IV and V in determining the findings of the
empirical research. The adjustment process results in
financial data that are both:
1. better measures of economic factors, and

2. more comparable to the parent company data.

CHAPTER IV

FINANCIAL POLICIES IN AN

INFLATIONARY ECONOMY

Introduction

The existence of an inflationary situation which can
give rise to illusory profits is not necessarily harmful to
the firm if its price and dividend policies are such as to
prevent an inordinate real amount of resources from leaving
the firm. Although a firm might have an illusory profit
arising from its depreciation policies, the firm*will not
necessarily "eat into its capital" if the illusory profits
are retained within the firm and can be applied for future
eXpansion purposes.

If the profit illusion is eXplicitly recognized, the
firm can include the existence of illusory profits in its
price setting, if prices are set on a cost plus basis.

There are, however, some difficulties for such rational
behavior in Brazil, due mainly to political factors. It is
difficult for a firm to justify to an unSOphisticated public
‘what at first seems to be excessive price mark-ups. The

same holds for dividend policies. It is difficult to

90

91

convince the economically unSOphisticated shareholder that
much of the nominal profit is illusory and that dividend
policy has to be based on profits which are substantially
less than apparent profits.

Even if the firm is capable of acting rationally
according to the above mentioned precepts and resists the
political difficulties of following a rational price and
dividend policy, the tax authorities' lack of recognition
of the profit illusion problem can prejudice the firm's
position. In Brazil until 1964 the tax authorities did not
take into account the existence of illusory profits. Both
an income tax and occasionally an excess profits tax fell
heavily on the "profits" of firms. If the firms should
adOpt realistic price policies to achieve a desired rate of
real profits, it was in danger, under tax systems in force
until 1967, of being taxed on the basis of excess profits.

This has been changed. Law No. 4357 of July 1964,
allows the deduction of depreciation for income tax purposes
on the basis of reappraised assets. The Decree Law No. 62,
passed on November 1967 went one step further, creating the
full monetary correction of the balance sheets for purposes
of excess profit tax companies. According to this law,
illusory gains emerging from the working capital group of
accounts of the balance sheet will be treated as eXpendi-

tures and not as profits.

92

Until November of 1967 even if the firm followed a
prOper price and dividend policy, the tax system in Brazil
was established in such a way that it led firms to invest in
fixed assets, pressing the banking system for the financing
of their working capital, so as to minimize the tax inci-
dence of illusory profits.

Before analyzing the financial policy of the subsid—
iaries it is important to discuss the consequences of infla-
tion in Brazil at the macroeconomic level. Some of the
effects Observed in Brazil are:

a. .Even if the firms act rationally, the share of
investment of the private sector may be reduced if
the banking system does not eXpand with sufficient
elasticity. This mainly results from the fact that
real profits will have to be retained so as to
maintain the real volume of Operations of the firm.

b. The appearance of illusory profits can lead to
investment distortions in the economy. Obviously,
higher nominal profits usually occur in activities
which have higher percentage of illusory profits.
The naive entrepreneur could thus be guided in his
investment decisions by nominal instead of real
profits. The SOphisticated entrepreneur will be
inclined to escape from the bad consequences of
illusory profits, i.e., heavier taxation, sharehold-
ers' pressure for higher dividends, wage pressures,

etc. These might change the direction of his

93

investment and might make him willing to depend more
heavily on the banking system, and even pay higher
interest rates, thus pressuring the general interest
rate up.

The lack of recognition by the government in its tax
policy of the existence of illusory profits will
result in too much profits being taxed (until
November of 1967) and thus resources being trans-
ferred to the government.

One of the traditional effects of inflation consists
in destroying the possibilities of financial fore-
casts. The costs estimates of any project are
repeatedly shattered by cost increases. Even if
allowances are made on financial calculations for
the inflationary effect, the inflation rate still
moves beyond eXpectations. The cost of any under-
taking extending over three or four years become
almost completely unpredictable. Without any doubt
this has been one of the most upsetting consequences
of the Brazilian inflation for entrepreneurs.
Financing plans must be stepped periodically until
new resources are found. Inflation dramatically
prolongs investment schedules. As a result private
capital shied away from those basic sectors of the
economy requiring long maturations terms of invest-

ment.

94

e. On tOp of all this, one must take into account still
a further and even more basic distortion. It is
impossible to state a realistic ratio of profits to
capital, since total capital is grossly understated
by calculating it on the value of past cruzeiros,

without any adjustment for inflation.

All of this results in a very distorted picture, not
only for entrepreneurs but likewise for the government and
public. Unable to rely on accounting as a reasonable reflec-
tion of their situation, entrepreneurs often make poor
decisions; not a few companies have decapitalized themselves
through distribution of dividends. The government has taxed
illusory profits as though they were real, frequently as
excess profits. The public, that does not see what really
happens, views seemingly high profits of business as an
abuse of economic power. This has strengthened the pOpular
belief that the increased cost of living has been caused by
the greed of businessmen, and this in turn has worsened the
climate for private enterprise.

When we turn our analysis to the impact of inflation
at the microeconomic level, we can safely state that the
inflationary condition in Brazil will necessarily generate a
different approach to investment from the one followed by
the parent company.

As was indicated in Chapter I, one of the purposes

of this dissertation is to investigate the investment

95

policies followed by the Brazilian subsidiaries in compar-
ison with the policies of the parent corporations, which is
the tOpic of the next section. In other words, the evalua-
tion of the investment policies and performance of United
States subsidiaries in Brazil will be based on an empirical
search based on published financial statements for the sim-
ilarities and differences between parent-subsidiary pairs.
Because every subsidiary may in general be assumed to be
similar to its parent in industry class and because the tOp
management of each is identical, one might prOpose there
will be "no material difference." If differences are found
(alternative hypothesis) eXplanations or evaluations of such
differences will be attempted. Any differences in business
and environmental risk would, of course, be important in
such eXplanation. Other potential explanatory factors
considered will include age of the subsidiaries, degree

of Brazilian ownership and management industry, size of
subsidiaries and other factors as brought out by the ques-

tionnaire information and personal interviews.

96

Financial Policies of Subsidiary
and Parent Corporations:
Application of Funds

 

 

In the nee—classical management approach, the
financing function was viewed as only the acquisition of
funds.

In the modern concept of Finance, financial
management

is prOperly viewed as an integral part of the
over-all management rather than a staff Specialty
concerned with fund raising Operations (36:2).

If the sc0pe of financial management is redefined
to cover decisions about both the use and acqui-
sitions of funds it is clear that the principal
content of the subject should be concerned with
how financial management should make judgements
about whether an enterprise should hold, reduce

or increase its investments in all forms of assets
that require company funds. This in turn requires
a defensible basis for answering two questions:

a. What specific assets should an enterprise
acquire?

b. How should the funds required be financed?
(36:8)

First let us deal with the question "a" as prOposed
by Solomon, namely: "What Specific assets should an enter—
prise acquire?" In an inflationary condition, which was the
Brazilian case from 1963 to 1967, all companies should try
to retain the smallest possible amount of funds invested in
monetary assets. As was eXplained by Kessel, monetary
assets will increase the eXposure of the company to loss of

real purchasing power.

97

This reasoning was the basis for the first hypoth-
esis, namely:

1. The subsidiary companies are net monetary
debtors

that will be discussed later in this chapter.

An investment in fixed assets, on the other hand,
will not show a loss because its price will usually increase
in the same prOportion as the inflation rate, and in some
cases as for instance in land and buildings, the price of
the asset will increase more than the inflation. The invest—
ment in inventories will give the firm some hedge against
inflation, if the sales price of its product is not subject
to government controls.

The companies studied in this thesis are all in
manufacturing Operations, which normally have the largest
percentage of their funds invested in fixed assets.

By considering the effects of inflation noted above
one can eXpect that the composition of the asset of those
forty seven manufacturing subsidiaries will show a relatively
large percentage of their funds invested in fixed assets and
inventories and as small percentage on monetary assets.

An analysis of the asset investment policy of the
subsidiary companies is examined first, and then a compar-
ison of the policies of parent and subsidiary is develOped.

In Tables 13 through 25 we have a distribution by
asset composition of thirteen different industries, at sub-

sfldiary and parent companies level. All the subsidiaries'

98

percentages are based on price-level adjusted balance sheet
figures.

At the subsidiaries, in four of the thirteen indus-
tries analyzed, monetary assets ranked as the largest type
of assets, specifically: household appliances, office
equipment, pharmaceutical and tire industries. The reasons
for this uneXpected investment policy in these four indus-
tries are mainly marketing strategies.

In personal interviews and questionnaire response,
the companies which are included in these industries revealed
that they face keen competition in their respective industry
either from.Brazilian companies or from companies of other
foreign countries that have subsidiaries in Brazil. A very
strong form of competition is done through terms of credit
which extends the time for the payment of an account and
increases the amount of investment in accounts receivable
which constitutes the largest portion of monetary assets in
all the industries included here.

Another reason disclosed for this policy is, also
of marketing strategy, the channel of distribution of their
products. The companies in these industries sell to a large
number of small distributors and retailers all over the
country who in the great majority do not have a solid finan-
cial position and consequently delay their payment of

accounts receivable.

99

The collection process in Brazil is also slow. In
most cases the collection is made through banks. Sales by
the manufacturing companies may be made all over the country
often in some small and distant places where the bank.with
which the company Operates does not have branch offices.
The collection, then, has to be made by a correspondent or
representative of the bank which also delays the collection
process and increases the amount tied up in accounts
receivable.

In addition, monetary assets account for the second
largest type of assets in five more of the industries con-
sidered, Specifically: auto equipment, soap and toiletry
products, machinery and equipment, plastic and chemicals,
and packaging. .For various reasons the companies in these
industries have relatively greater investments in other
asset types.

In the case of auto equipment industry it is neces-
sary to maintain a large and diversified inventory of parts
and/or raw material in order to supply the needs of auto
companies. This accounts for inventories being the most
important item in their assets.

The soap and toiletry goods industry consists of one
company only in the sample; it also shows inventory as the
largest fraction of its assets. This industry has been
established in Brazil for a long time, that is, for more
than thirty years. Due to their position of leadership in

the market, this company can avoid too much investment in

100

monetary items by imposing a cash policy sales, which are
then rapidly invested in invetories. Another reason is that
there has not been a large eXpansion of this company lately
which accounts for a lower percentage of its funds being
invested in fixed assets.

The companies included in machinery and equipment,
packaging, and plastic and chemicals industries are come
panies relatively new in Brazil. These firms are still
undergoing in a process of heavy investment or expansion of
their facilities which accounts for the predominance of
investment in fixed assets.

The Brazilian industries in this study with the
smallest percentage of their assets invested in monetary
assets are the automobile, foodstuff and soft drinks, glass,
tractor and earthmoving industries. .Again, various factors
explain this.

In the case of the food and soft drink industry and
the glass industry, United States subsidiaries have a posi-
tion of quasi monOpoly in the market. There are no large
companies in their specific industries which represent a
threat to them, and a policy of cash sales is enforced. The
cash is immediately reinvested in inventories and/or fixed
assets.

In the case of the auto industry and tractor and
earthmoving equipment industry, the manufacturing companies

sell their products to large dealers and/or distributors

101

which will honor the payment of the account on the due date
because they typically are of sound financial position.
Those distributors are mostly located in big cities which
also avoid the problem of correspondent banks and Speeds

up the liquidation of the account.

The parent companies in eleven of the thirteen
industries showed that fixed assets account for the largest
or the second largest category of assets. During the inter—
views with executives of the companies, it was pointed out
that in order to have a mass production volume, that is the
situation prevailing in the American companies, it is neces-
sary to maintain very specialized and expensive machinery as
well as large building and facilities.

In the pharmaceutical industry, where fixed assets
is the smallest class, it was eXplained that this position
is due mainly to the eXpenses of research and develOpment.
Though invested for future benefits, these expenses are not
capitalized as fixed assets, which accounts for this rela—

tively lower percentage in this type of asset.

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104

 

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106

 

 

 

 

 

 

 

 

 

 

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107

 

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109

Table 26 ranks, by importance, the asset composition
of the subsidiaries and parent companies using as basis the
results disclosed in Tables 13 through 25.

Table 27 summarizes the strategy of asset investment
policy followed by subsidiary and parent companies.

In only one industry we have the same asset invest-

ment strategy at the parent and subsidiary level, namely:
»Strategy 3-2-1 Foodstuff and Soft Drink

but the relative percentage is well defined at the subsid-
iary companies while at the parent the distribution of the
assets is almost the same: by analyzing Table l5 we see that
the difference between the highest and lowest percentage in
assets is less than 1 percent at the parent companies and
12.3 percent at the subsidiaries.

In all other twelve industries, parent and subsid-
iaries pursue different asset investment policies. The
difference in asset investment strategy was eXplained by the
economic conditions prevailing in Brazil that do not occur
in United States and to the stage of develOpment of the
industry in United States.

Let us turn now to the traditional subject of finan-
cial policy, i.e., source of funds. .A discussion of the

question "b" prOposed by Solomon, namely:

"How should funds required be financed?"

111)

.ooneuHOQEN
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111

.muomme mo
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112

will reveal the usual issues involved in the problem.

As can be eXpected, this tOpic will be influenced by the
financial institutions and practices of the country, as
noted in the following section, and are also influenced (or
distorted) by a highly inflationary economy.

Financial Policies and Subsidiary and
Parent Corporations: Source of Funds

 

Since the inflationary rate has been much higher in
Brazil than the one in United States, we might expect that
subsidiaries in Brazil will have a higher percentage (rela-
tive to the parent) of their funds coming from liabilities
rather than from owners equity and also that the subsid-
iaries debt-total equities ratios, will be higher than these
found in the parent companies, which is analyzed in Table 41.

In Tables 28 through 40 we have a distribution by
source of funds composition of the thirteen different indus-
tries, at subsidiary and parent company level. All the per-
centages determined at the subsidiary companies are based on
adjusted figures of the balance sheet.

An analysis of the financial policy in each subsid-
iary company disclosed that in only ten companies, out of
forty-seven, the monetary liabilities were greater than
monetary assets. In this way, the findings of the empirical
research do not agree with the first hypothesis, since the
great majority of subsidiary companies held a position of

net monetary creditor rather than net monetary debtor.

113

An explanation for this pattern came out during the
interviews with executives and on the questionnaires, which
are summarized below:

a. The credit market in Brazil was tight during those
years, and the total amount of credit for the
private sector of the economy during that period
actually decreased as is shown elsewhere in this
chapter.

b. The interest rates charged by the commercial banks
were very high, and it was preferable for the come
panies to use funds generated inside the company to
maintain the working capital and/or expansion of
their facilities, that is, through the reinvestment

of retained earnings.

The owner's equity accounts for the subsidiary
companies also presents very specific characteristics of
their own. A further analysis of owner's equity accounts
shows that retained earnings and the great number of differ-
ent reserve accounts are the largest items included in this
group. The policy of creating reserve accounts is a sound
one in the case of Brazilian subsidiaries: otherwise a large
amount of profit would be Shown as available for dividends.
AS was discussed in Chapter II those are illusory profits
and if distributed, it would involve a decapitalization of

the company, or the company would "eat its capital."

114

This policy of the subsidiaries has a direct bearing
on the dividend policy. During the five-year period, one
company declared and paid dividends in all the five years,
and two others declared dividends once and remitted to the
parent corporation. The company which distributed dividends
in all five years was the only company with a large number
of Brazilian stockholders and with shares actively traded in
Brazilian Stock Exchanges. The other two were wholly owned
by the parent corporation.

The capital account in the owner's equity group also
reveals different approaches at parent and subsidiary come
panies. While in United States the shares of the parent
companies are owned by a large number of stockholders, in
Brazil the subsidiary is usually under the control of the
parent company. The empirical results disclosed that in
approximately 90 percent of the companies included in the
sample, the subsidiary is either wholly owned or the parent
company retains more than 50 percent of the Shares. This
condition of majority ownership by the parent company allows
the policy of no dividend distribution, as shown before, by
the subsidiary without any major Opposition from the stock-
holders.

The alternative of selling stock in the Brazilian
market has not been used as a source of funds by the sub-
sidiary company, except in one case. This condition, added

to the majority ownership by almost all the companies was

115

discussed during the interviews and on the questionnaire.

In most

parent companies the controlling interest is an

important factor for the decision to invest in foreign

Operations. The reasons advanced by United States execu-

tives for majority ownership vary from one company to the

other but can be grouped in some general basic points, as

follows:

3.

Since the parent company transfers its "know-how",
and in some cases secret formulas and designs to
the subsidiary, it is important to have control
over them.

The products made in Brazil bear the trade name of
the company, which requires control to have assur-
ance that the quality meets the required standards.
Since the company does not seek short run profits
and eXpects no early payment of cash dividends it is
difficult to interest local investors in buying
stocks. In many cases the company is prepared to
take losses for several years before having any
profits and assumes that Brazilian investors would
expect to start receiving dividends soon.

The investment market in Brazil is very small and
is just starting; private sector savings presumably

will not support a stock issue.

116

Since the stock market is still in its formative
stage and there is a credit pinch by the banking industry,
sources of funds for the subsidiaries were extremely limited.
Hence, the alternatives left for the subsidiaries are to
reinvest the earnings or to borrow in a foreign country.

This last alternative brings with it all the negative impli-
cations of the devaluation of the money and the continuous
increase in the exchange rate and are normally avoided by
the subsidiaries, unless the company can buy "futures" as

is explained in Chapter VI.

117

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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121.

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122

 

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124

As can be noted in Table 41, only in four subsidiary
industries the debt/total equity ratio is higher than the
ratio found at the parent companies. This table also
reveals that ten industries, at the subsidiary level, have
ownership equity rather than debt as their main source of
funds. In the case of office equipment industry it is
barely greater than owner's equity. .Even where liabil—
ities account for the largest percentage of source of funds,
the tractor and earthmoving equipment industry, the percent-
age is only 52.6 percent.

In order to verify the interpretation of United
States executives in respect to the credit policy followed
by the banking system in Brazil, an analysis covering the
period from 1951 to 1967 is discussed in the next section.

Credit Policy of the Banking
System in Brazil

During the 1950's the structure of the banking
system's Operations was substantially altered, a large
portion of credit being assigned to the government at the
expense of the private sector. This is clearly shown in
Tables 42 and 43. The first table demonstrates how loans
to the public as prOportion to total money supply have
decreased. The second stresses that between 1951 and 1967,
the balance of banking loans to the private sector was
practically unchanged in real terms, although the real

product rose by 110 percent during the period.

125

 

 

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126

Table 42. Loans to the public versus money supply (balance
as of December 31, in millions of Cr$)

‘
F

 

Loans to Balance of
Year the Public Money Supply Ratio
A B A/B
1951 85,647 90,479 0.944
1952 102,279 104,152 0.982
1953 120,360 124,069 0.970
1954 152,194 153,474 0.983
1955 171,405 177,922 0.963
1956 205,449 217,283 0.946
1957 254,509 290,938 0.875
1958 311,577 353,138 0.882
1959 400,859 500,572 0.801
1960 565,044 692,032 0.816
1961 781,422 1,041,842 0.750
1962 1,254,472 1,702,305 0.737
1963 1,945,848 2,792,183 0.697
1964 3,506,300 5,190,700 0.675
1965 5,547,500 9,074,600 0.611
1966 6,657,300 10,400,000 0.640
1967 10,496,600 14,931,100 0.703

 

Sources: Bulletins from Superintendéncia da Moeda e do
Crédito (SUMOC) and Conjuntura Econamica.

127

Table 43. Real balance of loans to the public (balances as
of December 31, in millions of Cr$)

 

 

 

Loans to General Consumer

the Public Price Index Real Value of Loans

in Current Basis: to the Public in 1953
Year Cr$ Average 1953 .Cruzeiros
1951 85,647 82.5 103,815
1952 102,279 90.4 104,898
1953 120,360 113.2 106,325
1954 152,194 140.3 108,478
1955 171,405 153.5 111,663
1956 205,449 192.9 106,505
1957 254,509 199.4 127,637
1958 311,577 255.0 122,187
1959 400,859 347.1 115,488
1960 565,044 460.8 122,622
1961 781,422 691.6 112,898
1962 1,254,472 1,037.0 120,971
1963 1,945,848 1,855.0 104,897
1964 3,506,300 3,645.0 96,104
1965 5,547,500 4,638.0 119,610
1966 6,657,300 6,413.0 103,810
1967 10,496,600 9,534.0 110,212

 

Sources: Bulletins from Superitendéncia da Moeda e do
Crédito (SUMOC) and Conjuntura Econ6mica.

128

The shift in investment in favor of the government
and away from the private sector was achieved mainly through
increased compulsory deposits of commercial banks at the
order of the Central Bank. »A certain conservatism in
rediscount limits, which eXpanded less rapidly than the
general price level, also contributed to the same result.

The tables above confirm the statements made by the
executives and eXplain, in part, the difficulties the
Brazilian subsidiaries have had in obtaining credit from
financial institutions.

A summary of the most important tOpics of this

chapter is given below.

In the first section, the impact of inflation on
prices, dividends and taxes is discussed. The macroeconomic
implications of inflation are also treated in this section.
In the second section, the asset investment policy of the
subsidiary and parent companies are analyzed, by industry.
An explanation for the diversified policies among industries
and for the unique policies at the subsidiary and parent
companies is also presented. The debt and capital structure
is treated in the third section, also by industry. The
reasons for the low percentage of debt at the subsidiaries
are given as well as an analysis of the capital structure
and dividend policies for the subsidiary companies. The

last section is an investigation of the credit policy of

129

the banking system in Brazil and its implications for the
private companies.

The financial policies followed by the subsidiary
and parent companies have a direct influence on the per-
formance of the companies. The results of the empirical
research concerning the performance of subsidiary and parent
companies is the tOpic which will be handled in the next

chapter.

CHAPTER V

INVESTMENT PERFORMANCE OF BRAZILIAN SUBSIDIARIES:

A COMPARISON WITH PARENT CORPORATIONS

Introduction

Measuring the comparable performance of a firm's
foreign subsidiary is a complex task. The many variables
from country to country (economic, legal, social and polit-
ical) preclude the use of most of the familiar quantitative
devices and force the evaluator to depend upon less precise
approximations and qualitative guidelines. For instance, an
8 percent rate of return on owner's equity might be a good
target in a mature EurOpean market, but the greater invest-
ment risk in a less stable country might require a higher
return.

As was pointed out in Chapter I the main purpose of
this thesis is to examine the relative performance of sub-
sidiary companies in Brazil compared with the American
parent corporation. The choice of using profitability
evaluation factors as a measurement was determined by the

type of information required in this study.

130

131

As was discussed in Chapter III the measurement of

the performance of the subsidiary is made in price-level

adjusted cruzeiros and the computation of the ratios will

show the profitability of the subsidiary-as if it were an

isolated unit.

In using profitability ratios, the following

questions arise in arriving at a meaningful measurement:

a. What capital basis should be chosen for the

calculation?

b. What basis of valuation should be used in

determining the assets?

c. What income figure should be used?

Shown below are the bases studied for the calculation

of performance and reSpective objectives.

A.

Capital Bases

1. Capital invested (net)
or total assets minus
'total liabilities.

2. Capital invested (net)
long term liabilities
or total assets minus
current liabilities.

3. Capital employed or
total assets.

Bases for Valuation of
Assets

1. Historical Cost

2. Replacement Cost

Objectives

1.

3.

To test management over-
all performance in meet-
ing its responsibilities
to owners.

To test management ability
to use financial leverage
to increase common stock-
holder's return.

To test management ability
to produce income through
the use of all sources of
capital.

Objectives

1.

2.

To adhere to figures con-
tained in the company's
accounting records.

To Show assets at appraised
or estimated values.

132

3. Historical Cost 3. To Show assets at values
Adjusted to the which reflect general
Current Cost. price-level changes.

4. Current Cost. 4. To Show assets at values

which reflect Specific
price changes.

 

 

C. .Adjusted Income Figures Objectives
1. Net Operating income 1. To measure the productiv-
of subsidiaries before ity of the firm as an
local taxes and economic unit.
deductions.

2. Net Operating income of 2. To measure management's

subsidiaries after effectiveness in earning
local taxes and a satisfactory return from
deductions. the subsidiary's viewpoint.
3. Profits and other 3. To measure parent's
remittances received investment payback,
in the U.S. before gross.
U.S. tax.
4. Profits and other 4. To measure parent's
remittances received investment payback,
in the U.S. after net.
U.S. tax.

In selecting the valuation base, several things
should be considered. Historical costs should not be used
in the calculations for the measurement of performance in an
inflationary economy since they tend to cause an overstate-
ment of the return. The use of replacement cost introduces
several problems. The cost itself is often difficult to
estimate. ‘Where fixed assets are involved, it is also dif-
ficult to determine the depreciation applicable to it. In
addition, the estimation of replacement costs does not

provide a measure of the value of assets in use.

133

Current costs would be an apprOpriate basis of
valuation because they contain the effect of increases in
prices of specific assets and would thus be adequate for
measurement of performance. Unfortunately, market values
for many assets are either not available or are difficult
to obtain.

While restatements of assets based on price-level
changes are not as "precise“ as restatements based on cur-
rent costs--the prices of certain assets do not necessarily
fluctuate in the same fashion as prices in genera1-—this
method provides meaningful results because it shows how
great a command over goods and services a company's assets
have in terms of the prevailing purchasing power of the
monetary unit. Furthermore, since only one index is
required, and it is available in Specialized publications,
it is less time consuming.

For these reasons restatement of assets based on
price-level changes were utilized in Chapter III for the
purpose of determining the performance of the subsidiaries.

In this study the income figure used is net profit
after tax. The income figures discussed in C.3 and C.4 are
practically non-existent during the five years covered
(1963-1967) because in the first two years the remittance
of profits was prohibited and in the last three, the great
majority of the companies had to reinvest their price-level
adjusted profits merely to maintain the past level of Opera-

tions. The preference in using C.2 over C.l is that we are

 

134

trying to measure management's performance or its effective-
ness, which is the objective of C.2.

For capital bases the criterion established in A.2
was not used because, as explained in Chapter IV, the credit
market in Brazil has declined in the five-year period and
long term liabilities are almost non-existent.

By considering the arguments develOped above, the
two ratios utilized for measurement of performance of sub-
sidiary and parent companies are:

1. Net profit after taxes to net assets (capital
invested), and

2. Net profit after taxes to total assets (capital

employed) .

The above ratios were calaculated for the 47 parent
and subsidiary companies for the years 1963 to 1967. The
findings of this analysis are shown in a later part of this
chapter.

Having defined the measures that are used in the
determination of the performance of the companies, let us
examine the procedures to be used for gathering the neces-

sary information, which are discussed in the next sections.

135

QuestiOnnaire--Instrument
.and Response

Since information concerning important elements in

investment performance, such as risk, investment criteria

and financial criteria for evaluating the performance Of

the subsidiary are not available in the annual reports, an

officer of each Of the 47 parent companies was asked to

participate in the study and provide the requested infor-

mation.

In order to get the information needed for this

study two procedures were followed:

a.

In cities where there was a concentration Of parent
companies, an effort was made to have a personal
interview with the tOp financial executive, control-
ling the Brazilian Operations. Contacts were made
through professors from the Graduate School Of Busi-
ness Administration at Michigan State University and
the Council for Latin America in New York. As a
result, 15 high Officers were interviewed using the
questionnaire found in Appendix A.

The other 32 companies were asked, via letter, found
in Appendix B, tO participate by answering the same
questionnaire used in the interviews. A second
letter, presented in Appendix C, was required in
several cases where the initial letter was not

acknowledged within 45 days.

136

As expected, due to the very confidential kind Of
information requested, a relatively small number Of com-
panies--a total Of 10--provided the information requested,
12 companies declined to participate and from 10 companies
there was no reSponse.

The 12 companies which declined to participate gave
different reasons for their decision. A representative
sample Of these reasons are quoted below:

While we understand the reasons that motivate
your request, the fact remains that due to the
excessive number Of this type Of inquiry
received, and because we do not have adequate
personnel to handle these, we are unable tO
devote enough time tO each to prOperly answer
the questions.

In answer to your August 1 inquiry, I regret
that we will be unable to participate. It is
not our policy tO divulge information necessary
for your dissertation.

With reference tO your letter Of August 1, 1969,
I must decline to participate in your survey as
a matter Of policy.

We regret very much that we are not able to fill
your questionnaire since this is the kind Of
information we do not normally reveal to anyone
outside Of our company management.

Since the great majority Of Officers Of participating
companies requested that their company's data and personal
comments not be ascribed to their respective corporations
the names Of all Officers and companies are withheld through-
out the study.

The findings Of this study are, then, based on the

data collected in financial reports Of the 47 companies

included in the sample and on the reSponse and comments

137

gathered from the 25 companies (15 by interview and 10 by
response to the mailed questionnaire).

A comparison Of the 10 companies that responded tO
the questionnaire and the 15 companies interviewed relative
to the whole sample is made in Table 44.

.As we can see in Table 44 all the industries were
represented by the questionnaire response, with exception
Of the soap and toiletry industry. In this industry there
was only one company in the sample, and it did not reSpond.

In a more detailed analysis Of these twenty-five
companies the author did not find any significant factor
that might distinguish them from the other twenty-two
companies. The same characteristics in relation tO policy
and performance are found among both groups, hence there is
no reason tO single Out the group which responded to the
questionnaire from the others.

A good example Of the utilization Of the two sources
of information, mentioned before, namely financial reports
and questionnaire, is found when the discussion Of the
"risk" element is brought into consideration, which is the

subject of the next section.

1353

 

 

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139
Analysis Of Risk

In this thesis the problem Of risk is studied by
using two procedures, as follows:
1. Quantitative approach, using variance Of return as
a measure Of risk.
2. Qualitative approach, by analyzing the answers
given by United States executives on the Section III

Of the questionnaire.

Before proceding to the analysis Of the problem, let

us define risk by using'Weston and Brigham's definition:
Risk is defined as these situations in which
a probability distribution Of the returns to
a given project can be estimated (41:215).

By using the data published in the financial reports
the variance Of the returns for the subsidiary and parent
companies were calculated, as shown in Tables 45 to 58.

The assessment of risk is in direct relation with the vari-
ance Of the returns, i.e., the higher the variance Of
returns the higher the risk.

The quantitative analysis Of risk reveals that the
highest variability Of return is found among the subsid-

iaries in all cases. Hence, the second hypothesis.

investment in Brazil carries more risk
than in United States.

is supported when the quantitative analysis Of risk is

applied.

140

In order to calculate the variance the following

formula was used:

-'2

 

, where
S _ n - 1
2 .
S = Variance Of return,
Xi = Rate Of return, and
i' = Average rate of return Of the period.

The second way for the measurement Of risk is through

the qualitative approach. Section III Of the questionnaire,

shown in Appendix A, provides for the evaluation Of the risk

criteria.

The response Of the executives Of United States

parent companies lead to the following generalizations:

1e

In all cases, except for one, the executives Of the
parent companies expected a higher return on invest-
ments in Brazilian Operations than the return gen-
erated by the parent company. The company that
expected a lower return eXplained that this expecta-
tion is only temporary, since they are completely
changing the production, marketing, and finance
policies in Brazil. The results of this change will
come in the future, and in the period Of the study
the parent company was expecting a loss, which
actually did occur. However, in the long run the
returns of Brazilian Operations are expected to be

higher than the Ones reported by the parent company.

-‘w‘-

 

 

141

Not all 25 companies that participated in the survey
have a specific percentage which they considered the
minimal differential expected in Brazil. Those with
such a goal hOpe to realize a return rate that is
between 5 and 10 percentage points higher than the
parents'. The large majority Of the companies (80
percent) expected 5 percentage points more in returns.
All companies attach great importance to political
risk, but only in relation tO the inability to con—
vert cruzeiros into dollars. The executives
eXpressed no worries over eXprOpriation or damage to
the physical assets, a position which is consistent
with the answers given to the question 6,.where it
was found that 90 percent Of the companies are not
covered by the Risk Guaranty Program Offered by the
United States Government through the Agency for
International DevelOpment (AID).
Executives of 25 companies believe that business
risk is much greater in Brazil than in the United
States. The reasons for this condition were
eXplained as follows:
a. The market Of each company in Brazil is still in
the formative stage. There is a high volatility
in the market and it is very difficult to pre-

dict what competitors will dO next.

142

b. Political instability (coup d'etat) in 1964 with
harmful reflections in the business Operations
of the companies.

c. Government measures to stOp inflation through
tight credit policies by the bank system create
acute internal liquidity pressures.

d. Political and social instability, added to the
measures to stOp inflation, create swings in the
business cycle, as happened in 1965 and the first
half Of 1966 when a strong recession movement
develOped in the economy.

5. The purchasing power risk was also considered as
being greater in Brazil than in United States. This
situation is enforced by three variables:

a. The high rate of inflation in Brazil.

b. The tight credit policies adOpted by the
government Officials.

c. A strong element Of competition involves credit
terms, which increases the amount tied up in
accounts receivable (monetary assets subject to

purchasing power loss).

By considering the above arguments the second hypoth-
esis is also corrOborated by the qualitative approach Of the

analysis Of risk.

143

Financial theory indicates that rational management
will not increase the exposure to risk unless expected
returns increase more than enough to Offset the increased
risk. This is supported by the answer provided in the first
question of Part III Of the questionnaire, where all 25
United States executives expected a higher return on
Brazilian Operations.

A two parameter model of this trade—off between

expected return and risk is presented in Figure 2 below.

 

 

Expected Return

 

Figure 2. Indifference curves of expected return and risk.

144

Before the investment, the parent company can be
visualized at point A on indifference curve I with an
expected return Of El and risk of V1. Suppose, for example,
that risk increases to V2 if the decision to invest in
Brazil is made. Even if management were indifferent,
eXpected return had to increase at least to E2 to Offset
increased risk (V2 at point B on indifference curve I).
However since management actively chose to invest in Brazil,
the eXpected return had to increase even more--in the

example, to E at point C On indifference curve II.

3
In the last question Of the Section III in the
questionnaire the United States executives were asked if
they had any method tO evaluate risk. ,About half Of the
companies gave a positive answer but none had an Objective
or quantitative approach. The method used is qualitative
by using subjective executive judgment, eXperiences Of the
company in Brazil or through predictions of the economic,

social and political conditions made by eXperts in different

fields.
Empirical Findings Regarding Performance

As was indicated before the United States executives
>eXpect a higher return On the Brazilian subsidiary than the
return of the parent company. This eXpectation is the basis
for the third hypothesis, namely:

A better performance, in terms Of profitability

ratios, will be Obtained by the subsidiary in
comparison to the parent company.

145

The determination Of the profitability ratios,
discussed in the first section Of this chapter, from the
data collected on the financial reports will serve as the
instrumental device for the evaluation Of the third hypoth-
esis mentioned above. This is the tOpic analyzed in
Empirical Findings, which is the subject of this section.

This section analyzes the relative performance in
terms of return on owner's equity and total assets Of parent
and subsidiary corporations. The study is divided by indus-
try and the results Of the subsidiaries are considered

before and after price-level adjustments.

Automobilejgndustry

As is shown by the figures in Table 45 the dismaying
results Of the subsidiary companies as a group is caused
mostly by companies A and B. In the interviews with execu-
tives Of these two companies, it was learned that company A
was expecting losses for the period due to a complete change
in management Of the subsidiary including a major expansion
Of the production facilities.

Company B also Shows a very small return as an
average for the 5 years. The reason for this low profitabil—
ity is eXplained by the expansion Of production facilities
and the introduction Of a new and larger car in the market.

Company C Shows better results than companies A and
B but still far behind the results reached by the parent

company. The return before adjustments is smaller than

146

 

 

 

 

 

 

 

 

 

 

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147

after adjustment, the primary reason being their position Of
net monetary debtor for the entire five—year period.

Company D is the Only subsidiary that shows a higher
return than its parent but only when we compare the returns
before adjustments. The actual return Of the subsidiary,
calculated after price—level adjustments, is much smaller
than the parent company's return.

The poor results Of the automobile industry in
Brazil is eXplained by the below capacity volume of Opera-
tion Of the industry and relatively recent develOpment and
eXpansiOn Of the industry. .A characteristic that the indus-
try was still in the formative stage was that in 1963 there
were 7 different companies producing cars for the small
Brazilian market, and economies of scale were never reached
by any of the 7 companies. In 1967 the number Of companies
was reduced to 4, suggesting an excessive number Of car
producing companies in earlier years.

Analyzing FigureIB a clear picture Of the relation-
ship between risk and return Of subsidiary and parent come
panies is disclosed. The returns of the parent companies
are clearly greater than the ones presented by the subsid-
iaries, and also a lower risk is found among the parent
companies.

The returns of the subsidiaries are clustered in the

area below 7 percent point but risk is between 15 and 17.

148

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149

The analysis Of this figure shows, in short, a lower
return and a greater risk for the subsidiary when compared

't0 the parent companies.

Auto Equipment Industry

An interesting trend is encountered when we compare
'the six subsidiary and parent companies in the auto equip-
ment industry.

If we compare column I (subsidiary's results before
adjustments) with column II (results Of the parent companies),
in Table 46, the subsidiaries show a better result in five
companies and in company C the results Of the subsidiary is
almost the same as the result Of the parent company.

However, when the real profit Of the-subsidiaries
shown in column II (subsidiary's results after adjustments)
is compared with the results Of the parent, the return Of
the former is much lower.

By doing a detailed analysis Of the yearly results
Of these companies an eXplanation for this discrepancy is
found in a monetary creditor position followed by all come
panies in the five years. Besides that, the cost Of goods
sold, as presented in the unadjusted profit and loss state-
ment, is highly undervalued which accounts for such a large

decrease in returns after the adjustments.

 

(150

 

 

 

 

 

 

 

 

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151

Figure 4 shows that the returns of the parent
companies are concentrated in the range of 9 to 17 percent,
with a very low risk. The returns of the subsidiaries, on
the other hand, are mostly in the area below 8 percent with
higher risk.than the parent companies. The risk at the
subsidiaries is Spread from a low of almost 10 to a high
of 40.

The conclusion is the same as reached in the auto—
mobile industry, that is, a lower return and a greater risk

for the subsidiary in comparison with the parent.

Foodstuff andjgcft Drink Industry

In this industry a comparison of column I and
column III shows that in companies A, C and E the returns
are higher on the subsidiaries than on the parent companies.
Companies B and D show almost the same returns in the sub-
sidiary and parent companies.

A comparison of the returns over price-level adjust-
ments (column II) shows a higher return by the parent come
panies with the exception of company C, where a loss is
reported by the parent company on two of the five years
included in the period.

An analysis of Table 47 shows that the difference
before and after price-level adjustments is not very large.
In doing a more detailed analysis on the annual reports of
these companies we learn that only company D had a loss

because of a net monetary creditor position and that all

152

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154

the other four companies had a gain on monetary assets by
holding a net monetary debtor position. This conclusion is
supported also by Table 26 where it is shown that monetary
assets represent the smallest percentage in the composition
of the total assets of the subsidiaries.

The explanation for a lower return after adjustments,
even with a gain in monetary assets in four out of five com—
panies in the industry, is that the unadjusted profit and
loss statement considered the cost of goods sold at histor-
ical figure, and by assuming FIFO method of valuation at the
subsidiary, this cost is grossly understated. This adjust-
ment is the most important factor for this large decrease in
the returns.

By focussing our attention on Figure 5 it is
revealed that the returns on the subsidiary and parent com-
panies are similarly distributed, but a higher risk is shown
for the subsidiary companies which are wide-spread in the
figure, from a low of 3 up to 21.

The conclusion is, then, a similar return at
subsidiary and parent companies with a higher risk at the

subsidiaries.

155

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156

Glas§_Industry

 

In this industry only one company met the necessary
requirements to be included in the sample. The return of
the parent company is larger than the subsidiary even when
we compare columns I (before adjustments) and II (parent's
returns), as shown in Table 48.

A large decrease is observed on the subsidiary's
return when the data is adjusted. This condition is due
mainly to the losses suffered by the company in keeping a
position of net monetary creditor during all the five years.

Figure 6 shows a definite divergence in risk and
return at subsidiary and parent level. At the parent a very
high return concentrated around 18 percent with a low risk
is shown and a much higher risk with returns of almost 8
percent is the picture at the subsidiary.

The conclusion is a lower return and a higher risk

at the subsidiary in comparison with parent company.

157

 

 

 

 

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159

Household.Appliances Industry

A comparison of columns I and III, in Table 49,
shows that in companies A and C the returns of the subsid-
iaries are higher than the returns of the parent companies
and lower for companies B and D.

In these four companies, the returns of the subsid-
iaries are always smaller than the parent after price-level
adjustments. The difference between columns I and II is
large, which is a reflection of a net monetary debtor posi-
tion followed by these companies.

A personal interview was held in companies B and C
and the poor performance of these companies was eXplained by
a large drOp in sales due mainly to the aggressive marketing
policy develOped by other Brazilian companies in the same
industry.

A study of Figure 7 shows that the returns of parent
companies are well Spread but generally above 6 percent with
a low risk in almost all cases.

At the subsidiaries, though, the returns are clus—
tered in the area below 6 percent with a much wider disper-
sion in the risk variable.

The conclusion is, again, a lower return and higher

risk at the subsidiaries in comparison with parent companies.

160

 

 

 

 

 

 

 

 

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160

 

 

 

 

 

 

 

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161

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162

Machinery and Equipmentggndustry

The returns of the parent companies are higher in
all companies studied in this industry group, even before
price-level adjustments on the subsidiaries' financial
reports, as shown in Table 50.

The difference between before and after price-level
adjustments is explained by the net monetary creditor posi-
tion followed by all companies in the period and the over-
statement of profits due to understatement of cost of goods
sold, as eXplained in the foodstuff and soft drink industry.

A clear pattern at the parent companies of very
small risk with returns widely Spread is observed in Figure 8.
The returns of the subsidiary companies are smaller than the
ones observed at the parent with a higher and more widely
Spread risk ranging from a low of 4 to a high of 25.

The same pattern observed in other industries is
also found here, that is, a lower return and higher risk at

the subsidiaries in comparison with parent companies.

163

 

 

 

 

 

 

 

 

 

 

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164

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165

Office Equipment Industry

A comparison between columns I and III, in Table 51,

 

discloses a higher return by the subsidiaries, but the comp
parison of column II (after price-level adjustments) with
column III shows that the return of the parent companies are
higher than the return of the subsidiaries.

An analysis of the annual reports of the two sub-
sidiaries disclosed a position of net monetary debtor in the
two companies, but the gains for holding this position was
not large enough to cover for the undervaluation of the cost
of goods sold considered in the unadjusted profit and loss
statement.

Figure 9 discloses a lower return and higher risk
in subsidiary companies in comparison to the parent com-
panies, following the general pattern as in the other

industries.

166

 

 

 

 

 

 

 

 

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168

Packaging gndustry

In this industry the returns before price-level
adjustments are smaller than after adjustments in companies
B and C. The reason for this is a net monetary debtor posi-
tion policy followed by these two companies for the five-year
period which actually resulted in a gain from inflation.

Company A followed a different policy, that is, held
a position of net monetary creditor, which accounts for the
decrease of returns, after price—level adjustment, as shown
in Table 52.

Despite this condition in companies B and C the
returns of the parent companies are greater than the returns
of the subsidiaries after price—level adjustments. The
reason for this is, again, the understatement of cost of
goods sold in the unadjusted profit and loss statement as
has been discussed in foodstuff and soft drink industry.

In Figure 10 we can clearly observe that at the
parent companies a small risk.with returns concentrated in
the area between 7 and 11 percent is the characteristic of
that group. The subsidiary companies demonstrate a smaller
return ranging from a low of 4 to 9 percent mark and with a
very large dispersion on the risk variable ranging from a
low of'2 to a high of 32.

The conclusion is the same as that reached for most
of the industries, namely, a lower return and a greater risk

at the subsidiary when compared to the parent companies.

169

 

 

 

 

 

 

 

 

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Pharmaceutical gndustry

Once more the results shown by the parent companies
are higher than the subsidiaries before we apply price-level
adjustments on the financial reports of the subsidiaries.

The difference in the returns before and after
price-level adjustment is high for companies B and C, due
to a policy of net monetary creditor followed in all five
years by these two companies. For company A, however, this
difference is small, due mainly to a policy of net monetary
debtor followed by this company. The undervaluation of cost
of goods sold accounts for the large decrease in the returns
of companies B and C and offsets the gain on monetary assets
experienced by company A.

Figure ll shows a higher return at the parent com-
pany level with a low risk element. Subsidiaries disclosed
a return clustered in the area between 10 and 12 percent, as
well as a large dispersion in the risk variable, ranging
from a low of 7 to a high of 35.

The above statement once more indicates the same
conclusion observed in the other industries of a lower
return and greater risk at the subsidiary when compared to

the parent companies.

172

 

 

 

 

 

 

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174

Plastic and Chemical Industry

The same pattern is presented by all the companies
in this industry with the exception of company G. If we
compare the returns of the subsidiaries before adjustments
(column I) in Table 54, with the returns of the parent com-1
panies (column III) the parent companies will have a smaller
return. After the adjustments a smaller return is shown by
the subsidiaries.

In the case of company G a greater return both
before and after price-level adjustment is presented by the
parent company; again, the large difference between the
return before and after the adjustment is eXplained by the
net monetary creditor policy followed by the subsidiaries
and the overstatement of profits in the unadjusted profit
and loss statement.

.An analysis of Figure 12 discloses that the returns
of the parent companies are Spread between 9 and 20 percent
and the risk element is also spread from a low of almost
zero to 15.

The subsidiaries present the pattern of widely-
sPread and high risks reaching up to 36 from a low of 2.
The returns of the subsidiaries are also widely spread
ranging from a low of 1.5 to a high of 13 percent.

The conclusion, following the same pattern as before,
is a lower return and greater risk at the subsidiary when

compared to the parent company.

175

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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177

Tire and Rubber Industry

The same characteristics found in the other indus-
tries are also encountered in the tire industry. A compar-
ison of columns I and III, in Table 55, gives as a result a
better return for the subsidiaries in all three companies.
After price-level adjustments the results of the subsid-
iaries are smaller than the results of parent companies.

A position of large net monetary creditor was found
in all three companies for the five-year period, which
partly accounts for the large difference on returns before
and after the adjustments. Again, the cost of goods sold is
grossly understated in the unadjusted profit and loss state-
ment and is responsible also for this decrease in the
returns after the adjustments.

A very typical pattern of large return and small
risk on the parent companies is encountered in this industry.
The returns of the parent companies, as shown in Figure 13,
are clustered at the 11 and 12 percent mark, with the
exception of one company which shows only 7.5 percent in
returns.

The returns of the subsidiaries are Spread on the
figure from about 4 percent up to 7 percent. The risk of
the subsidiaries is scattered on Figure 13, ranging from a
low of 2 up to 39.

In this industry the conclusion is similar to most
of the other industries where the subsidiaries shousa lower

return and greater risk.when compared to the parent company.

178

 

 

 

 

 

 

 

 

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180

Soap and Toiletry Industry

In this industry only one company met the necessary
requirements to be included in the sample. A comparison of
columns I and II, in Table 56, shows a better result at the
subsidiary but the comparison between columns II and III
discloses a better result by the parent company.

The main reason for such a large difference in the
returns before and after price-level adjustment is eXplained
by the undervaluation of cost of goods sold in the unadjusted
profit and loss statement. This company invested the largest
percentage of its assets in inventory and assuming FIFO
method, the beginning inventory is calculated at its his-
torical cost, which understated cost of goods sold and over-
stated gross profits.

Figure 14 discloses, at the parent level, a small
risk with return concentrated in the 10.5 percent mark. At
the subsidiary company there is a very high risk of almost
16 as compared to 0.60 at the parent company.

The general pattern of lower return and greater risk
for the subsidiary when compared to the parent company is

the main characteristic of this industry.

181

 

 

 

 

 

 

 

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183

Tractor and Earthmoving Industry

In this industry the returns of the parent companies
are better than the results of the subsidiaries considered
before and after price-level adjustments, as shown in Table
57.

An interesting point in this industry is that in
company A the results after adjustments are better than
before adjustments. The reason for this situation is that
this company during all the five-year period had a position
of net monetary debtor and actually had a gain with infla-
tion- Despite this condition the returns of the subsidiary
is still below the return of the parent company.

Company B follows the general pattern of most of the
companies where a better performance before adjustment is
shown by the subsidiary while after the adjustment the higher
performance is presented by the parent company.

The returns of subsidiary and parent companies, as
reflected on Figure 15, shows a similar pattern. The risk,
however, is lower at parent companies as the risk of the
subsidiaries are in the area of 18 and 30 and in the parent
it ranges from 2 to 20.

The conclusion of this industry is similar to the
findings on foodstuff and soft drink industry when a similar
return at subsidiary and parent companies and a greater risk
for the subsidiaries are the main characteristics of these

industries.

184

 

 

 

 

 

 

 

 

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186

The empirical findings do not support the third

hypothesis, since in all the companies the adjusted returns

of the subsidiary companies are smaller than the results of

the parent companies.

.In personal interviews and in the questionnaire the

reasons for this poor performance of the subsidiaries were

discussed and can be summarized, as follows:

1.

In the majority of cases, the subsidiaries are
Operating at below capacity. The reason for this
condition is that the markets are not fully develOped
to utilize the capacity of plants which were built to
Optimum size.

Price control exercised by Brazilian authorities has
reduced earnings for many industries. The price
increase for the products lags behind the increases
in material costs and labor which obviously influ-
ences the returns of the subsidiaries.

The tight credit policy followed by the banking
system has restricted the possibility of Obtaining
local financing which might have reduced the risk of
purchasing power loss on monetary assets.

The government efforts to reduce inflation from a
high of 92 percent in 1964 to a low of 30 percent

in 1967 also diminished the total demand and a
recession in 1965 and the first half of 1966 was
reflected in a low profitability for all companies

in Brazil.

187

In the case of a complimentary industry, as for
instance automotive equipment, a company must wait
for the full develOpment of the automobile industry
before to start receiving the full benefits of its
investments.

In some industries, as for instance, chemicals and
plastics, and automobiles, were still in a develOp—
ment stage and large profits were eXpected only

after the 1963-1967 period.

When asked why they are still Operating in Brazil

when the return there is smaller than the returns of invest-

ing in United States the executives interviewed had the

following reasons:

1.

Their goal is profits in the long-run and not in
the short-run.

The Brazilian market has a good potential for
develOpment and the Brazilian government policies
do not leave other alternatives, if they do not
invest, they will be cut out of the market.
Usually, an increase in the sales of the parent
company to the Brazilian market, in the form of
Specialized parts and implements not locally pro-

duced, results when a subsidiary starts Operations

-in Brazil. These sales and their profits are not

shown in subsidiary's annual reports but rather in

reports of the parent companies.

188

4. The five-year period considered in the study is not
typical. There were political changes in 1964, a
large inflation in 1962, 1963 and 1964 and the very
strong efforts by the government to stOp inflation
which resulted in a very tight bank credit policy.
The experience of many companies is that in previous
years the results of Brazilian subsidiaries Opera-
tion were adequate and in accordance with their
expectations.

5. Some companies considered that the Latin America
Free Trade Association (LAFTA) has a good chance of
full develOpment and a manufacturing subsidiary in
Brazil will give an advantageous position to supply

this market.
Conclusion

, At this point it is valid to discuss whether the
financial theory of "a greater risk will be taken only if a
higher return is eXpected" has been disregarded.

The result disclosed in the survey is an ex-post
situation, but it is important to remember that all the
executives in United States answered that a greater return
in Brazilian Operations is expected. The actual results
which are not in accordance with their predictions are for
the most part the effects of exogeneous variables beyond the

control of the management of Brazilian Operations.

189

DeSpite the lower performance encountered in Brazil-
ian subsidiaries, the financial theory is not contradicted

because an expected higher return is still a constant goal

 

of the Brazilian subsidiaries.

As a summary of this chapter we see that in the
first part, the rationality for the choice of the two
profitability ratios is established. By using quantitative
and qualitative measurement it is clearly indicated that
investment in Brazil carries more risk than investment in
the United States. The third hypothesis is then contradicted
by the results of the empirical survey of annual reports of
the subsidiary companies.

A summary of the major observations of this thesis
as well as some normative prOpositions in respect to invest-
ment policy and investment performance for subsidiary com-

panies will be offered in the next and last chapter of this

study.

CHAPTER VI

SUMMARY AND CONCLUSION

This chapter serves to summarize the major findings
which have emerged from the several preceding analyses of
investment policy and performance of subsidiaries of United

States manufacturing corporations in Brazil.
Size and Characteristics of the Sample

The empirical examination covered 47 Brazilian man-
ufacturing subsidiaries of United States corporations out of
a total Of 159 in Operation at December 31, 1967.

The number of companies was limited to 47 in order
to reduce the sample to a more workable size and to have
represented only large companies in each type of industry
and which have a significant influence on the economy of the
country. All of the subsidiary companies which had an
owner's equity greater than one million dollars were included
in the study.

These 47 companies have an aggregate owner's equity
of US$ 490 million and the total assets of approximately

US$ 640 million. These figures represent 82 percent of the

190

191

combined owner‘s equity and 73.8 percent of total assets of
all 159 manufacturing subsidiaries of United States corpora-

tions in Brazil.
Investment Policy

Investment policy was examined primarily in terms of
source and applications of funds at the subsidiary company
level as compared with the policy followed by the parent
companies.

Additional information concerning investment objec-
tives and Specific problems related to an inflationary
economy was Obtained through interviews and correspondence
with officers of several participating companies at the
parent level.

.According to most company Officers the initial
investment in Brazil was determined, in order of importance,
by the following factors:

1. Demand for the product in the Brazilian market,

2. Negative incentives of the Brazilian government,
i.e., protection against outside competition through
prohibition of importation of products manufactured
in Brazil,

3. Positive incentives of the Brazilian government
through tax exemption and tariff advantages in
specific industries such as: automobiles, tractors,

chemicals and pharmaceuticals.

192

Only two companies considered the lower cost of labor and/or
raw material as the most important factor in making their
initial investment in Brazil. Of the twenty-five respon-
dents to the questionnaire, all considered growth of the
market as the most important reason for making major eXpan-
sion in their Brazilian investments.

In an inflationary economy we would eXpect all com-
panies to try to retain the smallest possible investment in
monetary assets in order to avoid eXposure to devaluation
risk. An analysis of asset composition of the 47 subsidiary
companies has shown that in 12 companies monetary assets
were ranked as the largest investment and in 23 other com-
panies monetary assets accounted for the second largest.
The explanation given for this uneXpected policy can be
summarized as follows:

a. A strong form of competition in Brazil involves
trade credit terms,

b. Collections, which are made through the banking
system, are very slow,

c. When the company deals with a small distributor or
retailer a substantial delay in the payment of the

invoices is inevitable.

On the other hand, the asset composition at the
parent company level disclosed fixed assets as the largest

or second largest type of investment in 43 companies.

193

The Brazilian subsidiary Should use liabilities,
within certain limits, as its principal source of funds.
The liability debt will be paid in the future, and the
"future" cruzeiro has a lower purchasing power than the
current cruzeiro so that a firm can gain by extending the
payment of a debt into the future. Given the conditions
described in the preceding sentence the percentage of
liabilities of subsidiary companies should be higher than
the owner's equity. The examination of the data revealed
that in only Six companies were the liabilities greater than
the owner's equity figure.

At the parent level, all companies have owner's
equity as their major source of funds, except in the cases
of two companies in the office equipment industry.

The eXplanation for this policy at the subsidiary
level can be summarized as follows:

a. ‘A decrease in the credit available to private
companies from the banking system in Brazil,

b. A very high interest rate (28 to 40 percent per
annum) forces the companies to reinvest all their
profits,

c. Medium and long-term debt in Brazil can be secured
only from governmental agencies, and the great
majority of subsidiaries have not used this alterna-

tive.

194
Investment Performance

Considering the entire five-year period for all
companies the performance of the subsidiaries was poorer
than that of the parent corporations, after price-level
adjustment of the subsidiaries.

The financial criteria used by all companies for the
evaluation of the performance of the Brazilian subsidiary
was based on profitability but a few companies also eval—
uated by market penetration criteria.

The methods vary from one company to another, but
in order of importance are:

1. Net profit to total assets,
2. Net profit to owner's equity,

3. Gross profit to sales.

The discount cash flow method was used by two
companies.

In this thesis, investment performance was measured
by using methods 1 and 2 as described above. Since most of
the subsidiaries do not Show sales figure on their financial
reports there was no data available for the evaluation of
performance by using Gross profit to Sales.

The degree of risk was considered by all the partic—
ipants to be higher in Brazil than in United States. The
political risk is a cause for concern by United States
executives, mainly in reSpect to inability to convert

cruzeiros into dollars representing earnings on or returns

195

of, the investment. .In terms of business risk the loss of
the market due to competition appeared as the most important
aspect, since the prediction of the competitor's strategy is
almost always impossible.

The United States manager in charge of Brazilian
Operations is aware in all cases of greater risk at the
subsidiary level and eXpects a greater return in Brazil than
in the United States of at least 5 percentage points to a
maximum of 10 percentage points.

The empirical results, considering the entire five
year period, failed to support the eXpectations of the
United States investor. In no case did the findings provide
evidence that the performance of the subsidiary was better
than that attained by the parent company.

This low performance of the subsidiaries confirms
the findings of Polk,.Meister and Veit:

In fact, for some companies, return on invested
capital in countries classified as "risky" has
been, and is eXpected to remain in the near
future smaller than the return on investment in
United States or EurOpe. These companies feel
that the current return is not the important
point. Rather, only by being present in these
promising markets now can they hOpe to deve10p
a position which would allow them to be compet-
itive in the future (28:76).

The response to the question of why they continue to
Operate in Brazil is in complete accordance with the citation
above. Most companies are investing in Brazil because mar-

keting considerations outweigh the financial aspects of

higher risks and Short-run lower returns.

196

In summary, the examination revealed that marketing
considerations, that is, an effort to "save" a present or
future market in Brazil, seem to be the most important moti-
vation at the moment. This conclusion agrees with the
findings of Gordon and Grommers:

The basic objective of U.S. investments in
Brazil is the desire to secure or maintain a
foothold in a generally attractive market where
government policies leave no means of accomplish-

ing this objective other than by direct invest-
ment (18:148).

Normative~Propositions

The general trends of prices, wages and foreign
exchange rates can be anticipated and roughly extrapolated
because of the unlikelihood that they would go anywhere but
up. Absence of deflation permits complete concentration on
how to minimize the effects of inflation. This condition
calls for minimization of so-called monetary assets-awith
cash retention to be avoided as much as possible and
receivables to be collected as quickly as possible.

The sales price of inventories has to be marked up
as quickly as price controls and customer resistance will
permit. The safest pricing for a company practicing in
Brazil is "cost-plus". But this brings another variable
into the problem, namely: "What cost?" Original or average
cost iS a concept acceptable only to tax-minded government
officials and conservative bankers and will underestimate

the cost of the product and will overestimate the profit of

197

the company. FIFO (first—in, first-out) inventory
accounting is obviously no way to stay in business in an
inflationary economy. LIFO (last-in, first-out) would be
an improvement Since the cost of the latest purchases would
be closer to the most recent level of rising prices.

However, even using LIFO would not be sufficient in
the face of cost-wage-price relationships ascending as fast
as those in Brazil. A more relevant inventory pricing would
be replacement costing or, NIFO (next-in, first-out) method,
that is, pricing the product on the basis of future inven—
tory costs.

Fixed assets present no problem. Land, buildings
and machinery have increased in value in prOportion to, and
in some cases by more than, the inflation rate.

DeSpite many limitations in the accounting concepts
and practices, Brazil in the last five years, however,
prOperly did what United States and many other countries
have not. It reCOgnized that in an inflationary economy
the determination of profit based on depreciation of the
original cost of fixed assets would:

1. overstate business income in terms of the prevailing
price levels,

2. exact greater tax as a result of that overstatement,
and thereby

3. reduce or retard the ability of business to replace

its productive assets at the higher costs.

198

Thus it has provided that depreciable assets could
be revalued annually on the basis of government furnished
indexes related to earlier periods of acquisition and has
permitted depreciation to be calculated on the revised basis.

On the other side of the balance sheet the objective
(within the limits of prudence) is to maximize cruzeiro lia-
bilities of all kinds--to suppliers, tax-gatherers, bankers
and other kinds of creditors. Since "future" cruzeiros will
be worth less than current cruzeiros hence it is a good
policy to pay in the future.

Harder currency liabilities for imported goods or
borrowed foreign funds are to be avoided--unless they can be
adequately hedged. Until recently there were no "futures"
in cruzeiros. Through a financial device called "swaps"
some companies have found a form for borrowing funds which
offered a hedge against currency devaluation. Swap con-
tracts are no longer available, however another source of
borrowing foreign funds with some hedge effect is found in
what is called Sumoc-Instruction 289. Under its provisions,
the Brazilian subsidiary may:

1. obtain from the Bank of Brazil approval of a one-
year dollar loan from the United States parent.

2. upon receipt of the loaned dollars, convert them to
cruzeiros at the then prevailing rate.

3. 60 days later exercise an Option available under the

instruction to purchase from a private bank, at the

199

exchange rate then prevailing, the amount of dollars
to be delivered on the due date of the loan.

4. pay the private bank interest at rates varying
between 1.66 percent and 2 percent a month for the
10 months of protection thus offering in effect, a

form of futures hedging.

This still leaves at least two months of eXposure to
exchange fluctuation. But at a time when the rate was moving
up by about 400 points during the term of the arrangement,
the subsidiary often found the protection worth the cost.

Another alternative that is Open to subsidiaries for
protection in making intercompany dollar loans is by invest—
ing the proceeds in "readjustable" or variable one-year
Brazilian Treasury bonds. Escalation of the principal
amount iS based on an index reflecting the internal "monetary
correction" or the external exchange rate. While they are
outstanding the bonds can be used as collateral for local
borrowing of dollars which are converted to cruzeiros for
local use. In this way:

1. funds required in Brazil were obtained from the
proceeds of the United States parent's loan.

2. the cost of the funds so obtained was less than it
would have been for normal local borrowing, and

3. the escalation feature in the cruzeiro bond provided
a hedge against the deterioration of the dollar

exchange rate.

200

Some alternative financial policies that can be
pursued by the subsidiary in order to survive in an infla-
tionary economy have been discussed in this section, and we
believe that in taking advantage of these possibilities the

subsidiary may improve its return.
Conclusion

It was suggested in Chapter I that an examination of '
investment policy and performance should tend to confirm the
rationality of investment strategy and Show that a position
of net monetary debtor would characterize the investment
policy of the subsidiary in Brazil.

The findings of this study, however, have shown a
different Situation. (All the companies included in the
sample, in an ex-post analysis of the returns, were found to
have failed to achieve a higher return in Brazil than in the
United States, deSpite a greater risk being attached to
Brazilian Operations.

The monetary debtor position was found in only 10
companies out of 47, and when the devaluation risk which
includes inventory replacements is taken into consideration,
all the subsidiary companies disclosed the existence of
unprotected assets.

The problem of translation of financial data from
Brazil can be more correctly treated by using price-level

adjustments techniques rather than using the exchange rate

201

which is subject to inconsistencies and government regu-
lation.

It is important to recognize the limitations of this
study. Some benefits to the parent company from the Opera-
tions of its Brazilian subsidiary, have not been taken into
account. It was learned during the interviews that the
sales of parts and implements from the parent company to the
Brazilian market had increased for some companies, after the
Opening of the subsidiary in Brazil. These increased sales
are not included in the results of the Brazilian subsidiary
and there was no way that the author could measure these
benefits from the data available.

The years of the study may not be typical of the
Brazilian economy and/or five years may be too short a
period to fairly appraise the investment policy and perfor—
mance of the subsidiaries.

Therefore, while this study has laid some groundwork
for an appraisal of investment policy and performance of
subsidiaries of United States manufacturing corporations in
Brazil, the subject can be eXplored to reach more conclu-
sively findings if more parent corporations give their
support by Opening their confidential files to a more exten-
sive and intensive research effort.

This study also provides a basis of reference for
Brazilian corporations which are not subsidiaries of foreign

companies to compare their results with the findings disclosed

202

here. This, however, is a subject for another research
study, which must necessarily be left to others who have
access to data and related information from Brazilian

executives.

BIBLIOGRAPHY

lO.

BIBLIOGRAPHY

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Archer, Stephen A. and D'Ambrosio, Charles A. Business
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Baer, Werner. Industrialization and Economic DevelOp-
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Carl, Beverly M. "Incentives for Private Investment
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Hepworth, Samuel R. Reporting Foreign Operations.
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Mann, Everett J. "Inflation and Accounting in Brazil,"
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McMillan, Claude, Jr., Gonzalez, Richard F. and
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Polk, Judd, Meister, Irene W. and Veit, Lawrence A.
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APPENDICES

APPENDIX A

QUESTIONNAIRE USED AT THE INTERVIEWS AND SENT

TO THE OFFICERS OF U.S. PARENT-COMPANIES

I. BACKGROUND QUESTIONS

 

 

 

 

1. When did you start manufacturing Operations in T
Brazil?

2. Did manufacturing in Brazil deve10p in substitution M
for a former direct export business? Yes
NO If yes, why?

3. fWhen the Brazilian Operation was originally capital-

ized how was the financing divided among the follow-
ing sources (please indicate whether equity or debt)

 

 

 

 

 

a) U.S. private-~your company g%
b) U.S. private-~others ‘%
c) 0.8 . Government %
d) Brazilian partners %
e) Brazilian Government %
f) Any other (please specify) ‘%

 

II . INVESTMENT CRLI‘ERIA

1.

Which factors were responsible for the decision to
invest in Brazil?
Please Check
a) Lower cost of labor and/or raw
material
b) Incentives of Brazilian government,
either postively (as tariff or tax
exemption) or negatively (as pro-
tection against outside competition)
c) Demand for your products in Brazilian
market
d) Possibility of eXport to other
countries in Latin America Free
Trade Association (LAFTA)
e) Any other reason? (Please specify)

 

 

 

 

 

207

'n

208

Before becoming committed to a direct manufacturing
investment, did you ever consider the alternative of
a licensing arrangement with a purely Brazilian
company? YeS No ; if yes, what considera-
tions led you to reject this alternative?

.What is the percentage of parent ownership in the

Brazilian subsidiary?
Please Check

a) Wholly

b) Majority

c) Minority (less than 50%)

 

 

 

If a or b, was control a prerequisite for your
decision in making the investment? Yes No
Why?

Have you employed used equipment in your Brazilian
Operation? Yes NO If yes, was it done
through Brazilian Government incentive, of SUMOC
Instruction 113 (possibility of investment in kind
by foreign entrepreneurs without exchange cover)
Yes No

If yes, was this incentive essential in your invest-
ment decision?

If you had undergone major eXpansion of Brazilian
Operation since your first investment decision,
which of the following were the principal causes?

Please Check
a) Government pressures or Special
incentives
b) Growth in the market
c) Other (Please Specify)

 

 

 

Have your investment decisions been significantly
affected by the regional economic develOpment plans
of the Brazilian Government (for example, Northeast
Economic DevelOpment Agency (SUDENE), Western Amazon
DevelOpment Agency (SUDAM)? Yes NO

If you could make your investment decision again
would you have done anything significantly different?

 

III.

1.

209

RISK CRITERIA

Does your company eXpect a higher return on invest-
ment in Brazil than the return in the U.S.? Yes
No

If yes, what is the minimum differential eXpected?
_%

Does the political risk, as defined below, play an
important role in your investment decision? Yes
NO

a) Inability to convert cruzeiros into dollars rep-
resenting earnings on or return of, the invest-
ment or compensation for sale of the investment.

b) Loss due to eXprOpriation or confiscation of the
investment.

c) ,Damage to the physical assets of the investment
attributable to war, revolution or insurrection.

If yes, which is the most important factor, and why?

Does the business risk, as defined below, play an
important role in your investment decision? Yes
NO

a) Loss of the market due to competition.

b) Recession, or depression, of the Brazilian
economy.

c) Other reasons for the Brazilian subsidiary been
unable to repay its loans or return on invest-
ments?

If yes, which is the most important factor, and why?

.Do you think that the business risk, as defined

above, is greater in Brazil than in the U.S.A.?
Yes No EXplain.

IV.

210

Is your company covered by the "Specific Risk
Guaranty Program" and/or "Extended Risk Guaranty
Program" Offered by the U.S. Government through
A.I.D.? Yes No

a) If yes, did this program influence your decision
to invest in Brazil? Yes No

Do you have any measure for risk evaluation? Yes
No If yes, please eXplain.

FINANCIAL CRITERIA

1.

Does your company use any of the criteria described
below, as a basis for evaluation of the performance
of the Brazilian subsidiary?

a) Profitability
b) Market penetration
c) Productivity

If you use profitability criteria, which method or
methods are considered as more important and why?

Please Check

a) Pay—out period, or cash received
from the subsidiary to original
investment

b) Net profit to Net Assets (Share-
holders' Equity)

c) Net Profit to Total Assets

d) Net Profit to Sales

e) Discounted Cash Flow

f) Any other method (please Specify)

 

 

 

 

 

 

In general, from 1963 to 1967, did your Brazilian
subsidiary Show a lower profitability than the
parent company? Yes No . If yes, do you
have any Specific policy to change this situation?

What effective rates of interest have you had to pay
in Brazil?

a) For working capital? 76
b) For medium and long term funds? 96

211

Does the subsidiary Operate at full capacity of
production? Yes NO If no, why?

Have you had any eXperience with price control
exercised by the Brazilian authorities? Yes
No If yes, with what effect?

FINANCIAL POLICIES

lo

2.

To what extent have you been able to meet your work-
ing capital needs from.Brazilian sources?

What prOportion of your needs have you been able to
fill from commercial banks in Brazil?

To what extent has the Brazilian subsidiary been
able to provide funds for eXpanSion of Operations?

__%

Have you been able to secure any medium or long term
funds from governmental agencies, such as National
Bank for Economic DevelOpment (BNDE)? Yes

NO

Have you received funds for Operating the Brazilian
subsidiary through sale of stocks (of the subsidiary)
to the Brazilian public? Yes No If no, why?

Has the chronic inflationary situation in Brazil
generally been helpful or harmful to the expansion
or profitability of your business?
Please eXplain.

 

Has the Brazilian subsidiary followed a specific
policy in order to adjust for the inflationary
situation? (For example net monetary debtor posi—
tion, investment in fixed assets or inventories)
Please explain.

APPENDIX B

INITIAL LETTER SENT TO OFFICERS OF U.S. PARENT

CORPORATIONS, LETTER DATED JUNE 18, 1969

Dear Sir:

I am currently doing research in the area of investment of
(private U.S. companies in Brazil for a doctoral dissertation
study at Michigan State University. Specifically, I am
attempting to measure the investment policy and performance
of the subsidiaries of U.S. manufacturing companies in
Brazil. The methodology adhered to in this study was to get
the annual reports from 1963 to 1967 published by your sub-
sidiary in official Brazilian newspapers and, after the
necessary accounting adjustments, compare its results with
the data of the parent company published in.Moody's.

A complete analysis of the problem can not be done only from
the data published on annual reports, and a questionnaire
was develOped in order to help obtain a better conception of
the problem. Of course, any information obtained will be
treated as confidential. In no case, will the name of a
participating company be associated with a particular find-
ing or conclusion of the study.

Would it be possible for you to answer the questionnaire
that is attached to this letter and send it back through

the addressed enveIOpe enclosed?

The study Should be completed sometime during the early fall.
At that time a summary of the findings will be made avail-
able to all interested participating companies.

Your assistance in this study is greatly appreciated.
Comments and questions concerning the project are certainly
welcome.

Very truly yours,

JOEO Carlos HOpp

212

APPENDIX C

FOLLOW-UP LETTER SENT TO OFFICERS OF ALL U.S. PARENT
COMPANIES WHO DID NOT ACKNOWLEDGE INITIAL
LETTER OF JUNE 18, 1969,

LETTER DATED AUGUST 1, 1969

Dear Sir:

On June 18, 1969, I wrote to you asking if you would partic-
ipate in a doctoral dissertation study in the area of invest-
ment policy and performance of the subsidiaries of U.S.
manufacturing companies in Brazil. Since I have not heard
from you, I presume that you would like further information
concerning the study. My purpose in writing to you at this
time is to provide such information.

The purpose of the study is to analyze the performance of
the subsidiary in comparison with the parent corporation, by
using two profitability ratios, as follows:

a) Net Profit to Owner's Equity, and
b) Net Profit to Total Assets.

In order to have a meaningful basis of comparison, the
thesis will Show the limitations of the annual reports
presented by Brazilian subsidiaries, due to the inflationary
condition of the country, and a more reliable figure for
comparison is determined by using price-level adjustment
techniques. Equally important purposes are:

a) to demonstrate that the subsidiaries do not have
exorbitant profits, as might be considered by
analyzing the unadjusted financial reports published
in official Brazilian neWSpapers

b) financial structure of Brazilian subsidiaries

c) risk factor and investment criteria.

To fully eXplore the areas suggested above your subsidiary's

annual reports, which I have collected in Brazil, does not
render sufficient information; therefore I sent you the

213

214

questionnaire to obtain additional information. To date,
about 22 companies out of 47 have answered the questionnaire.
I expect this number will climb to about 35 within the next
few weeks.

In no case, will the name of a participating company be
associated with a particular finding or conclusion of the
study.

If you would like to participate in this study, please
complete the questionnaire and send it back to me. If not,
please let me know.

I believe that the study has considerable merit; and your
participation will make any findings even more conclusive.

Irrespective of your decision, thank you for the attention
you have given my request.

Very truly yours,

J050 Carlos HOpp

...

 

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