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International Business8e

By Charles W.L. Hill


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Chapter 20

Financial Management

in the InternationalBusiness

Copyright 2011 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/I rwin


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What Is

Financial Management? Financial managementinvolves

1. Investment decisionswhat to finance

2. Financing decisionshow to finance those decisions

3. Money management decisionshow to manage the firms

financial resources most efficiently Good financial management can create a competitive

advantage reduces the costs of creating value and adds value by improving

customer service

Decisions are more complex in international business different currencies, tax regimes, regulations on capital flows,

economic and political risk, etc.


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How Do Managers Make

Investment Decisions?Financial managers must quantify the benefits,

costs, and risks associated with an investment in aforeign country

To do this, managers use capital budgetinginvolves estimating the cash flows associated with the

project over time, and then discounting them todetermine their net present value

If the net present value of the discounted cashflows is greater than zero, the firm should goahead with the project


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Why Is Capital Budgeting More

Difficult For International Firms?

Capital budgeting is more complicated ininternational business

because a distinction must be made betweencash flows to the project and cash flows to theparent company

because of political and economic risk

because the connection between cash flows tothe parent and the source of financing must berecognized


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What Is The Difference Between

Project And Parent Cash Flows?

Cash flows to the project and cash flows to theparent company can be quite different

Parent companies are interested in the cash flows

they will receive, not the cash flows the projectgenerates

received cash flows are the basis for dividends, otherinvestments, repayment of debt, and so on

Cash flows to the parent may be lower because ofhost country limits on the repatriation of profits,host country local reinvestment requirements, etc.


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How Does Political Risk

Influence Investment Decisions?

Political risk- the likelihood that political forceswill cause drastic changes in a countrys business

environment that hurt the profit and other goals of

a businesshigher in countries with social unrest or disorder, or

where the nature of the society increases the chance forsocial unrest

Political change can result in the expropriation ofa firms assets, or complete economic collapse that

renders a firms assets worthless


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How Does Economic Risk

Influence Investment Decisions?

Economic risk- the likelihood thateconomic mismanagement will causedrastic changes in a countrys business

environment that hurt the profit and othergoals of a business

The biggest economic risk is inflation

reflected in falling currency values and lowerproject cash flows


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How Can Firms Adjust For

Political And Economic Risk?

Firms analyzing foreign investmentopportunities can adjust for risk

1. By raising the discount rate in countries

where political and economic risk is high

2. By lowering future cash flow estimates toaccount for adverse political or economic

changes that could occur in the future


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How Do Firms Make

Financing Decisions? Firms must consider two factors

1. How the foreign investment will be financed the cost of capital is usually lowest in the global capital market

but, some governments require local debt or equity financing

firms that anticipate a depreciation of the local currency, mayprefer local debt financing

2. How the financial structure (debt vs. equity) of theforeign affiliate should be configured need to decide whether to adopt local capital structure norms or

maintain the structure used in the home country

Most experts suggest that firms adopt the structure thatminimizes the cost of capital, whatever that may be


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What Is Global

Money Management? Money managementdecisions attempt to

manage global cash resources efficiently Firms need to1. Minimize cash balances - need cash balances

on hand for notes payable and unexpecteddemands cash reserves are usually invested in money market

accounts that offer low rates of interest

when firms invest in money market accounts theyhave unlimited liquidity, but low interest rates when they invest in long-term instruments they have

higher interest rates, but low liquidity


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What Is Global

Money Management?2. Reducetransaction costs - the cost of exchange

every time a firm changes cash from one currency toanother, they face transaction costs

Most banks also charge a transfer fee formoving cash from one location to another

Multilateral netting can reduce the number oftransactions between subsidiaries and thenumber of transaction costs


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How Can Firms Limit

Their Tax Liability?

Every country has its own tax policies

most countries feel they have the right to taxthe foreign-earned income of companies based

in the country

Double taxation occurs when the incomeof a foreign subsidiary is taxed by the host-

country government and by the home-country government


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How Can Firms Limit

Their Tax Liability? Taxes can be minimized through

1. Tax credits - allow the firm to reduce the taxes paid tothe home government by the amount of taxes paid tothe foreign government

2. Tax treaties - agreement specifying what items ofincome will be taxed by the authorities of the countrywhere the income is earned

3. Deferral principle - specifies that parent companiesare not taxed on foreign source income until theyactually receive a dividend

4. Tax havens - countries with a very low, or no, incometax firms can avoid income taxes by establishing awholly-owned, non-operating subsidiary in the country


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How Do Corporate

Tax Rates Compare?Corporate Income Tax Rates, 2006


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How Do Firms Move

Money Across Borders?

Firms can transfer liquid funds acrossborder via

1. Dividend remittances

2. Royalty payments and fees

3. Transfer prices

4. Fronting loans

Firms that use more than one of thesetechniques are unbundling


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What Are

Dividend Remittances?Paying dividends is the most common method of

transferring funds from subsidiaries to the parent

The relative attractiveness of paying dividends

varies according totax regulations high tax rates make this less attractiveforeign exchange risk dividends might speed up in

risky countries

the age of the subsidiary older subsidiaries remit ahigher proportion of their earning in dividends

the extent of local equity participation local ownersdemands for dividends come into play


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What Are

Royalty Payments And Fees? Royalties - the remuneration paid to the owners of

technology, patents, or trade names for the use of thattechnology or the right to manufacture and/or sellproducts under those patents or trade names

can be levied as a fixed amount per unit or as a percentage of grossrevenues

most parent companies charge subsidiaries royalties for thetechnology, patents or trade names transferred to them

A fee is compensation for professional services or

expertise supplied to a foreign subsidiary by the parentcompany or another subsidiary royalties and fees are often tax-deductible locally


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What Are Transfer Prices?

Transfer prices - the price at which goods andservices are transferred between entities withinthe firm

Transfer prices can be manipulated to

1. Reduce tax liabilities by shifting earnings from high-taxcountries to low-tax countries

2. Move funds out of a country where a significantcurrency devaluation is expected

3. Move funds from a subsidiary to the parent whendividends are restricted by the host government

4. Reduce import duties when ad valorem tariffs are ineffect


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What Makes

Transfer Prices Unattractive?

But, using transfer pricing can beproblematic because

1. Governments think they are being cheated out

of legitimate income

2. Governments believe firms are breaking thespirit of the law when transfer prices are used

to circumvent restrictions of capital flows3. It complicates management incentives and

performance evaluation


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What Are Fronting Loans?Fronting loans are loans between a parent

and its subsidiary channeled through afinancial intermediary, usually a large

international bank

Firms use fronting loans

to circumvent host-country restrictions on the

remittance of funds from a foreign subsidiary tothe parent company

to gain tax advantages


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What Are Fronting Loans?

An Example of the Tax Aspects of a Fronting Loan


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How Do Firms Manage

Global Cash Resources? Firms manage their global cash resources using

1. Centralized depositories

Holding cash balances at a centralized depository isattractive because

by pooling cash reserves centrally, firms can deposit largeramounts, and therefore earn higher rates of interest

when centralized depositories are located in major financialcenters, the firm has access to a greater variety of investmentopportunities than a subsidiary would have

by pooling cash reserves, firms can reduce the total size of thereadily accessible cash pool, and invest larger amounts in longer-term, less liquid accounts that have higher interest rates


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How Do Firms Manage

Global Cash Resources? But, centralized depositories can be unattractive

because of

government restrictions on cross-border capital flows

the transaction costs involved in moving money inand out

The use of centralized depositories is expectedto increase because of the globalization of capital

markets and the removal of barriers to the freeflow of capital across borders


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How Do Firms Manage

Global Cash Resources?2. Multilateral netting - can reduce the

transaction costs associated with manytransactions between subsidiaries

an extension ofbilateral netting if a French subsidiary owes a Mexican subsidiary $6 million,

and the Mexican subsidiary simultaneously owes the Frenchsubsidiary $4 million, a bilateral settlement will be made witha single payment of $2 million

Under multilateral netting, the concept isextended to multiple subsidiaries within aninternational business


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What Is Multilateral Netting?

Cash Flows Before Multilateral Netting


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Calculation of Net Receipts (millions)


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Cash Flows After Multilateral Netting


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Review Question

Which of the following is notone of the

decision areas in financial management?

a) cash operations decisions

b) investment decisions

c) financing decisionsd) money management decisions


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Review Question

The fee for moving cash from one location to

another is called

a) the money management fee

b) the transaction cost

c) the transfer feed) the cost of capital


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Review Question

Compared to the other countries, corporate

income tax rates in ________ are relatively low.

a) Canada

b) Ireland

c) Germanyd) Japan


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Review Question

A __________ specifies that parent companies

are not taxed on foreign source income until

they actually receive a dividend.

a) tax credit

b) deferral principle

c) tax haven

d) tax treaty


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Review Question

Firms can transfer liquid funds across borders

using all of the following techniques except

a) dividend remittances

b) royalty payments and fees

c) transfer pricesd) backing loans


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Review Question

The most common method of transferring

funds from subsidiaries to the parent is

through

a) dividend remittances

b) royalty payments and fees

c) transfer prices

d) backing loans

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