Fourth Edition

InternationalBusiness

CHAPTER 20

Financial Management in the International business

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20-3

Chapter Focus

Look at investment decisions to identify factors that complicate capital budgeting decisions.Examining financing decisions, we look at the mix of equity and debt financing and the advantages and disadvantages of localizing the financial structure.Look at the objectives of global money management, the ways firms move money across borders, and techniques for efficient management.Finally, we take a look at foreign exchange risk.

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20-4

Scope of Financial Management

Scope of financial management includes three sets of related decisions:

Investment decisions, decisions about what activities to finance.Financing decisions, decisions about how to finance those activities.Money management decisions, decisions about how to manage the firm’s financial resources most efficiently.

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Investment Decisions

Capital budgeting:Quantifies the benefits, costs and risks of an investment.Managers can reasonably compare different investment alternatives within and across countries.

Complicated process:Must distinguish between cash flows to project and those to parent.Political and economic risk can change the value of a foreign investment.Connection between cash flows to parent and the source of financing must be recognized.

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Project and Parent Cash Flows

Project cash flows may not reach the parent:

Host country may blockCash flow repatriation.

Cash flows may be taxed at anunfavorable rate.

Host government may require apercentage of cash flows be

reinvested in the host country.

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Adjusting for Political and Economic Risk

Political risk:Expropriation - Iranian revolution, 1979.Social unrest - after the breakup of Yugoslavia, company assets were rendered worthless.Political change - may lead to tax and ownership changes.

Economic risk:Inflation.

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Risk and Capital Budgeting

Treat all risk as a single problem

by increasing discount rate to projects

in risky countries.

Penalizes early cash flows too much. Later cash flows,

too little.

Better to revise future cash flows

downward to reflectpossible future adverse politicalor economic risk.Therefore:

Handling Risk

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Financing Decisions- Source of Financing -

Source of financing:Global capital markets for lower cost financing.Host-country may require projects to be locally financed through debt or equity.

Limited liquidity raises the cost of capital.Host-government may offer low interest or subsidized loans to attract investment.

Impact of local currency (appreciation/depreciation) influences capital and financing decisions.

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Financing Decisions - Financial Structure -

Financial structure:Debt/equity ratios vary with countries.

Tax regimes.

Follow local capital structure norms?More easily evaluate return on equity relative to local competition.Good for company’s image.

Best recommendation: adopt a financial structure that minimizes the cost of capital.

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Global Money Management- The Efficiency Objective -

Minimizing cash balances:Money market accounts - low interest - high liquidity.Certificates of deposit - higher interest - lower liquidity.

Reducing transaction costs (cost of exchange):

Transaction costs:changing from one currency to another.Transfer fee: fee for moving cash from one location to another.

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Global Money Management-The Tax Objective -

Countries tax income earned outside their boundaries by entities based in their country.

Can lead to double taxation.Tax credit allows entity to reduce home taxes by amount paid to foreign government.Tax treaty is an agreement between countries specifying what items will be taxed by authorities in country where income is earned.Deferral principle specifies that parent companies will not be taxed on foreign income until the dividend is received. Tax haven is used to minimize tax liability.

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Corporate Income Tax Rates2001

CountryTop Corporate Income Tax Rate

Canada 42.1%

Chile 15%France 35.33%

Germany 39.36%

Hong Kong 16%

Ireland 20%

Japan 42%

Mexico 35%

Singapore 25.5%

United Kingdom 30%

United States 40%

Table 20.1

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Moving Money Across Borders: Attaining Efficiencies and Reducing Taxes

Unbundling: a mix of techniques to transfer liquid funds from a foreign subsidiary to the parent company without piquing the host-country.

Dividend remittances.Royalty payments and fees.Transfer Prices.Fronting loans.

Selecting a particular policy is limited when a foreign subsidiary is part owned by a local joint-venture partner or local stockholders.

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Dividend Remittances

Most common method of transfer.

Dividend varies with:

Tax regulations.

Foreign exchange risk.

Age of subsidiary.

Extent of local equity participation.

Dividends

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20-16

Royalty Payments and Fees

Royalties represent the remuneration paid to owners of technology, patents or trade names for their use by the firm.

Common for parent to charge a subsidiary for technology, patents or trade names transferred to it.May be levied as a fixed amount per unit sold or percentage of revenue earned.

Fees are compensation for professional services or expertise supplied to subsidiary.

Management fees or ‘technical assistance’ fees.Fixed charges for services provided

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Transfer Prices

Price at which goods or services are transferred within a firm’s entities.

Position funds within a company.Move founds out of country by setting high transfer fees or into a country by setting low transfer fees.

Movement can be within subsidiaries or between the parent and its subsidiaries.

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20-18

Benefits of Transfer Fees

Reduce tax liabilities by using transfer fees to shift from a high-tax country to a low-tax country.Reduce foreign exchange risk exposure to expected currency devaluation by transferring funds.Can be used where dividends are restricted or blocked by host-government policy.Reduce import duties (ad valorem) by reducing transfer prices and the value of the goods.

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20-19

Problems with Transfer Pricing

Governments don’t like it.

Believe (rightly) they lose money.

Impacts management incentives & performance

evaluations.

Inconsistent with ‘profit center’. Managers can hide

inefficiencies.

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20-20

Fronting Loans

A loan between a parent and subsidiary is channeled through a financial intermediary (bank).

Can circumvent host-country restrictions on remittance of funds from subsidiary to parent.Provides certain tax advantages.

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20-21

An Example of the Tax Aspects of a Fronting Loan

Tax Haven

Subsidiary

London Bank

Foreign Operating Subsidiary

Pays 8% Interest (Tax Free)

Pays 9% Interest (Tax Deductible)

Deposit $1 Million

Loan $1 Million

Figure 20.1

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20-22Techniques for Global Money Management

- Centralized Depositories -

Need cash reserves to service accounts and insuring against negative cash flows.Should each subsidiary hold its own cash balance?

By pooling, firm can deposit larger cash amounts and earn higher interest rates.If located in a major financial center can get information on good investment opportunities.Can reduce the total size of cash pool and invest larger reserves in higher paying, long term, instruments.

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20-23

Centralized Depositories

Day-to-Day Cash Needs (A)

One Standard Deviation

(B)

Required Cash

Balance (A+3xB)

Spain $10 $1 $13

Italy $ 6 $2 $12

Germany $12 $3 $21

Total $28 $6 $46

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20-24

Techniques for Global Money Management -Multilateral Netting-

Ability to reduce transaction costs.

Bilateral netting.Multilateral netting - simply extending the bilateral concept to multiple subsidiaries within an international business.

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20-25

Cash Flows before Multilateral Netting

German Subsidiary

French Subsidiary

ItalianSubsidiary

SpanishSubsidiary

$4 Million

$1 Million

$3 Million

$2 Million

$5 Million $3 Million$4 Million$5 Million$2 M

illion

$5 Million

$6 Million

$3 Millio

n

Figure 20.2a

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20-26

Calculation of Net Receipts($ Million)

Receiving SubsidiaryS. Korea - $3 $4 $5 $12 ($3)

China $4 - 2 3 9 (2)

Japan 5 3 - 1 9 1

Taiwan 6 5 2 - 13 4

Total payments $15 $11 $8 $9

Paying Subsidiary

S.Korea China Japan Taiwan

Total Receipts

Net Receipts* (payments)

Net receipts = Total payments - total receipts

Figure 20.2b

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20-27

Cash Flows after Multilateral Netting

German Subsidiary

French Subsidiary

SpanishSubsidiary

ItalianSubsidiary

Pays $1

Million

Pays $3 Million

Pays $1 Million

Figure 20.2c

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20-28

Managing Foreign Exchange Risk

Risk that future changes in a country’s exchange rate will hurt the firm.

Transaction exposure:extent income from transactions is affected by currency fluctuations.Translation exposure:impact of currency exchange rates on consolidated results and balance sheet.Economic exposure:effect of changing exchange rates over future prices, sales and costs.

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Tactics and Strategies for Reducing Foreign Exchange Risk

Primarily protect short-term cash flows.Reducing transaction and translation exposure:

Buying forward and currency swaps.Lead strategy:collecting receivables early when currency devaluation is anticipated and paying early when currency may appreciate.Lag strategy:delaying receivable collection when anticipating currency appreciation and delaying payables when currency depreciation is expected.

Reducing Transaction and Translation Exposure

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Tactics and Strategies for Reducing Foreign Exchange Risk

Key is to distribute productive assets to various locations so firm is not severely affected by exchange rate changes.

Manufacturing Facility Dispersal

Reducing Economic Exposure

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Developing Policies for Managing Foreign Exchange Exposure

No agreement as to how, but commonality of approach does exist:

Central control of exposure.Distinguish between transaction/translation exposure and economic exposure.Forecast future exchange rate movements.Good reporting systems to monitor firm’s exposure to exchange rate changes.Produce monthly foreign exchange exposure reports.