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Financial Management in the International Business

Chapter 20

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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.

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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 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.

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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.

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Euromoney Magazine’s Country Risk Ratings

0102030405060708090100

Lux

USA Ger

Neth

Bermuda

Benin

Azerbaijan

Madagascar

Adapted from Table 20.1 in text

Highest and lowest ranked countries.

Total score = 100

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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.

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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.

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Debt Ratios for Selected Industrial Countries

00.1

0.20.30.40.5

0.60.70.8

Singapore

Malaysia

Argentina

Australia

Finland

Pakistan

Norway

Italy

Highest and lowest ranked countries.

Debt ratio = total debt / total assets at book value.

Country Mean

Adapted from Table 20.2 in text

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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.20-9

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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.20-10

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OECD Corporate Income Tax Rates

0

10

20

30

40

50

60Germany

Italy

Japan

Canada

Finland

Norway

Sweden

Swiss

USA

Top Tax Rate %

Highest and lowest ranked countries and USA.Adapted

from Table 20.3 in text

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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.

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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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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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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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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.

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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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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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Techniques 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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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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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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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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Calculation of Net Receipts($ Million)

Paying SubsidiaryReceiving

Subsidiary

Germany France Spain ItalyTotal Receipts

Net Receipts* (payments)

Germany - $3 $4 $5 $12 ($3)France $4 - 2 3 9 (2)Spain 5 3 - 1 9 1Italy 6 5 2 - 13 4Total payments $15 $11 $8 $9

Net receipts = Total payments - total receipts

Figure 20.2b

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Cash Flows after Multilateral Netting

German Subsidiary

French Subsidiary

SpanishSubsidiary

ItalianSubsidiary

Pays $1

Million

Pays $3 MillionPays $1 Million

Figure 20.2c

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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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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.

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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

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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.

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