© McGraw Hill Companies, Inc., 2000 Financial Management in the International Business Chapter 20

© McGraw Hill Companies, Inc., 2000 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

© McGraw Hill Companies, Inc., 2000 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

© McGraw Hill Companies, Inc., 2000 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

© McGraw Hill Companies, Inc., 2000 Adjusting for Political and Economic Risk  Political risk:  Expropriation - Iranian revolution,  Social unrest - after the breakup of Yugoslavia, company assets were rendered worthless.  Political change - may lead to tax and ownership changes. 20-4

© McGraw Hill Companies, Inc., 2000 Euromoney Magazine’s Country Risk Ratings Adapted from Table 20.1 in text Highest and lowest ranked countries. Total score =

© McGraw Hill Companies, Inc., 2000 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

© McGraw Hill Companies, Inc., 2000 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

© McGraw Hill Companies, Inc., 2000 Debt Ratios for Selected Industrial Countries Highest and lowest ranked countries. Debt ratio = total debt / total assets at book value. Country Mean Adapted from Table 20.2 in text 20-8

© McGraw Hill Companies, Inc., 2000 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

© McGraw Hill Companies, Inc., 2000 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

© McGraw Hill Companies, Inc., 2000 OECD Corporate Income Tax Rates Top Tax Rate % Highest and lowest ranked countries and USA. Adapted from Table 20.3 in text 20-11

© McGraw Hill Companies, Inc., 2000 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

© McGraw Hill Companies, Inc., 2000 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

© McGraw Hill Companies, Inc., 2000 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

© McGraw Hill Companies, Inc., 2000 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

© McGraw Hill Companies, Inc., 2000 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

© McGraw Hill Companies, Inc., 2000 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

© McGraw Hill Companies, Inc., 2000 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

© McGraw Hill Companies, Inc., 2000 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

© McGraw Hill Companies, Inc., 2000 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

© McGraw Hill Companies, Inc., 2000 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 $

© McGraw Hill Companies, Inc., 2000 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

© McGraw Hill Companies, Inc., 2000 Cash Flows before Multilateral Netting German Subsidiary French Subsidiary Italian Subsidiary Spanish Subsidiary $4 Million $1 Million $3 Million $2 Million $5 Million$3 Million$4 Million$5 Million $2 Million $5 Million $6 Million $3 Million Figure 20.2a 20-23

© McGraw Hill Companies, Inc., 2000 Calculation of Net Receipts ( $ Million) Paying Subsidiary Receiving Subsidiary Germany France Spain Italy Total Receipts Net Receipts* (payments) Germany - $3 $4 $5 $12 ($3) France $ (2) Spain Italy Total payments $15 $11 $8 $9 Net receipts = Total payments - total receipts Figure 20.2b 20-24

© McGraw Hill Companies, Inc., 2000 Cash Flows after Multilateral Netting German Subsidiary French Subsidiary Spanish Subsidiary Italian Subsidiary Pays $1 Million Pays $3 Million Pays $1 Million Figure 20.2c 20-25

© McGraw Hill Companies, Inc., 2000 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

© McGraw Hill Companies, Inc., 2000 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

© McGraw Hill Companies, Inc., 2000 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

© McGraw Hill Companies, Inc., 2000 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