Chapter Twenty Financial Management in the International Business

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 Collapse of communism in Eastern Europe Attack on the World Trade Center Economic risk -Inflation

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Financing Decisions When considering options for financing a foreign investment, international businesses have to consider two factors -Source of financing -Financial structure

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Financing Decisions and The Global Capital Market A capital market brings together those who want to invest money and those who want to borrow money Those who want to invest money include -Corporations -Individuals -Non-bank financial institutions Those who want to borrow money include -Individuals -Companies -Governments

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Financing Decisions and The Global Capital Market Capital market loans to corporations re either -Equity loans occur when corporations sell stock to investors -Debt loans occur when a corporation borrows money and agrees to repay a predetermined portion of the loan amount at regular intervals regardless of how much profit it is making Cost of capital is the price of borrowing money, which is the rate of return that borrowers must pay investors -In a purely domestic capital market the pool of investors is limited to residents of the country Places an upper limit on the supply of funds available Increases the cost of capital -A global capital market provides a larger supply of funds for borrowers to draw on Lowers the cost of capital

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Financing Decisions and The Global Capital Market

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Source of Financing Global capital markets for lower cost financing. Impact of 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

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. 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/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved Corporate Tax Rates

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Dividend Remittances Most common method of transfer Dividend varies with: -Tax regulations -Foreign exchange risk -Age of subsidiary -Extent of local equity participation

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. 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/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Benefits of Manipulating Transfer Prices 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/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. 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/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Fronting Loans Loan between a parent and subsidiary is channeled through a financial intermediary (bank) -Allows circumvention of host country restrictions on remittance of funds from subsidiary to parent -Provides certain tax advantages

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Tax Advantages of Fronting Loans

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Techniques for Global Money Management 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/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Centralized Depositories

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Techniques for Global Money Management Ability to reduce transaction costs -Bilateral netting -Multilateral netting – simply extending the bilateral concept to multiple subsidiaries within an international business

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Cash Flows Before Multilateral Netting

McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Cash Flows After Multilateral Netting