Financial Management in the International Business Chapter 20

1. Financial Management in the International BusinessChapter 20

2. Introduction • 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. 20-1

3. 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. 20-2

4. Project and Parent Cash Flows • Project cash flows may not reach the parent: • Host-country may block cash-flow repatriation. • Cash flows may be taxed at an unfavorable rate. • Host government may require a percentage of cash flows to be reinvested in the host country. 20-3

5. 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. 20-4

6. Euromoney Magazine’s Country Risk Ratings Total score = 100 Highest and lowest ranked countries. Adapted from Table 20.1 in text 20-5

7. Financing Decisions (a) • 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. 20-6

8. Financing Decisions (b) • 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 its cost of capital. 20-7

9. Debt Ratios for Selected Industrial Countries Country Mean Debt ratio = total debt / total assets at book value. Highest and lowest ranked countries. Adapted from Table 20.2 in text 20-8

10. 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. 20-9

11. 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. 20-10

12. OECD Corporate Income Tax Rates Top Tax Rate % Highest and lowest ranked countries and USA. Adapted from Table 20.3 in text 20-11

13. 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. 20-12

14. Dividend Remittances • Most common method of transfer. • Dividend varies with: • tax regulations. • Foreign exchange risk. • Age of subsidiary. • Extent of local equity participation. Dividends 20-13

15. 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 20-14

16. 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. 20-15

17. 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. 20-16

18. Problems with Transfer Pricing • Few governments like it. • Believe (rightly) that they are losing revenue. • Has an impact on management incentives and performance evaluations. • Inconsistent with a ‘profit center’. • Managers can hide inefficiencies. 20-17

19. 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. 20-18

20. An Example of the Tax Aspects of a Fronting Loan Deposit $1 Million Loan $1 Million Tax Haven Subsidiary London Bank Foreign Operating Subsidiary Figure 20.1 Pays 8% Interest (Tax Free) Pays 9% Interest (Tax Deductible) 20-19

21. Techniques for Global Money ManagementCentralized 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. 20-20

22. Centralized Depositories One Standard Deviation (B) Required Cash Balance (A+3xB) Day-to-Day Cash Needs (A) Spain $10 $1 $13 Italy $ 6 $2 $12 Germany $12 $3 $21 Total $28 $6 $46 20-21

23. Techniques for Global Money ManagementMultilateral Netting • Ability to reduce transaction costs. • Bilateral netting. • Multilateral netting - simply extending the bilateral concept to multiple subsidiaries within an international business. 20-22

24. Cash Flows before Multilateral Netting $4 Million German Subsidiary French Subsidiary $3 Million $6 Million $2 Million $5 Million $4 Million $5 Million $3 Million $3 Million $5 Million Spanish Subsidiary Italian Subsidiary $2 Million $1 Million Figure 20.2a 20-23

25. Calculation of Net Receipts($ Million) Paying Subsidiary Net Receipts* (payments) Receiving Subsidiary Total Receipts Germany France Spain Italy Germany - $3 $4 $5 $12 ($3) France $4 - 2 3 9 (2) Spain 5 3 - 1 9 1 Italy 6 5 2 - 13 4 Total payments $15 $11 $8 $9 Net receipts = Total payments - total receipts Figure 20.2b 20-24

26. Cash Flows after Multilateral Netting German Subsidiary French Subsidiary Pays $3 Million Pays $1 Million Pays $1 Million Spanish Subsidiary Italian Subsidiary Figure 20.2c 20-25

27. 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. 20-26

28. Strategies for Reducing Foreign Exchange Risk (a) • 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. 20-27

29. Strategies for Reducing Foreign Exchange Risk (b) • Reducing economic exposure: • Key is to distribute productive assets to various locations so firm is not severely affected by exchange rate changes. Manufacturing Facility Dispersal 20-28

30. 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. 20-29