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Definitions Money is the blood of business MNC face numerous difficulties when they need to move and position funds among their subsidiaries MNC are exposed to currency exchange risks, such as transaction, translation and economic risk MNC perform financial hedging, in order to minimize these risk There numerous techniques that estimate the financial result and worthiness of a project 2

Parent-subsidiary relationship Polycentric structure – decision-making is decentralized and subsidiaries are more independent, control becomes diluted Ethno(mono)centric structure – decision-making is centralized, control is concentrated in P Regiocentric structure – Subsidiaries coordinate regionally, but decision-making remains centralized Geocentric structure – differentiated relationship, based on a global strategy (dependent on location of S and need for particular need for synchronization) 3

Diagrams of P-S relationship 4

Funds flows in the MNE Three main internal sources of funding: Working capital – the difference between currents assets and currents liabilities Borrowing – one S can borrow from another (or the P) and repay interest Acquiring equity – when P holds equity in a S, it acquires dividends (royalties, fees) Parent Subsidiary A Subsidiary B 5 Loan Interest Loan Interest Equity investment Dividends Royalties Fees Working capital

Multilateral netting Whenever subsidiaries trade with each other, numerous receivables and payables accounts are outstanding Instead of transferring payments from one S to another, MNE set up clearing centers Clearing managers calculates the net position of each S and transfers funds at the end of a fixed period 6

MLN – a diagram 7

Managing cash Managing the volume of cash in the company can prove a very difficult task Central cash management of the MNE (as a single unit) provides several benefits: Pooling cash reduces total cash holdings Multilateral netting reduces the total amount of cash in intra- company circulation Company cash management goals over affiliates’ ones One department to deal with that, instead of many (cost reduction) Control becomes centralized Might be hindered on purpose by some countries 8

Funds positioning in the MNE Transfer pricing (TP) The price, which MNC set for intra-firm trade By manipulating the TP, companies: Maximize profits where taxes are the lowest Concentrate funds where the conditions are favorable Reduce payment for (ad valorem) tariffs Arm’s length P (S1)Arm’s length P (S2)TP (S1)TP (S2) Sales$ export to$ Cost of Sales$ 8 000$ $ 8 000$ Gross Profit$ $ Tax (S1 40%; S2 50%)$ 800$ 1 000$ Net Profit $ 1 200$ 1 000$

10 NO personal income taxes personal income taxes capital gains taxes capital gains taxes corporate taxes corporate taxes payroll taxes payroll taxes withholding taxes on domestic of foreign entities withholding taxes on domestic of foreign entities

Funds positioning in the MNE (2) Tax havens Death is certain, but taxes do not have to be Tax haven is a country with very low or no tax rates, stable and encouraging business climate, and no disclosure of financial information to foreign governments The subsidiary in the tax haven is where company profits maximize It is applied together with transfer pricing 11

Top tax havens PlaceReliefs Delaware$ 100 corporation tax ! Hong KongNo payroll, sales tax, capital gains taxes, personal tax deductions DubaiNo taxes of any kind, no tax audits, no information shared Channel Islands No capital gains, council tax, no value added taxes LuxemburgNo tax on bank interest, dividends, or capital gains LichtensteinVery easy for foreigners to set up trusts, provides no financial info MonacoNo income, capital gains, property taxes, high VAT 12

Funds positioning in the MNE (3) Fronting loans Financial operation, where MNC deposits funds with local financial institution, that provides a loan to the subsidiary Applied to deal with political risk, turbulent environment and currency transfer restrictions 13 Subsidiary in Tax Haven Subsidiary in China HSBC branch in China Deposits $ 1 m Loans $ 1 m Pays 9% interest (tax deductible) Pays 8% interest (tax free)

Exchange (rate) risks Transaction risk – the risk that an unexpected change in the value of home currency against a foreign one leads to changes in expected cash flows (payables and receivables, bank deposits and loans) Translation (accounting) risk – unexpected change in the exchange rate leads to losses or gains on the balance sheet: Economic risk – unexpected change in the exchange rate leads to losses or gains from company operations abroad: If the value of the ¥ (versus the $) increases, selling assets of the Japanese subsidiary will generate higher profit in $ 14 Value of $ in ¥Value of assets (denominated in ¥) Value of liabilities (denominated in ¥) US companyIncreasesDecreases

Hedging MNCs often incur losses, arising currency fluctuation (exchange rate) risks Hedging is a type of ‘insurance’ against from transaction, translation and economic (and other) exposure It implies strategic investment in financial instruments, that will offset the above losses When the company needs to make a payment at a set date in the future, it can by a financial instrument, with a fixed (strike) price to avoid exchange risk Hedging is not an investment that generates profit, instead it minimizes loss 15

Example US company X has an account payable of £ 5 M in 180 days: Buying a currency future: Spot (current) rate: $ /£ Strike price in 180 days: $ /£ £ 5M x = $ 9.543M < £ 5M x = $ 9.645M Depositing £ in a six months bank account Annual interest rate for a £ deposit: % To get £ 5M in six months, X needs to deposit: £ 5M / ( ) = £ M £ M x = $ M = better alternative 16

Evaluating financial risk Financial structure – Debt-equity ratio shows how leveraged the firm is, the higher debt level implies more risk Return on investment (ROI) – calculates the gain/loss from a project as a percentage of initial investment Weighted average cost of capital (WACC) – calculates the average cost of acquiring capital from different sources (retained earnings, loans, etc.) Whenever ROI > WACC the project is worth doing ! Net present value (NPV) – shows the current value of future cash flows, discounted by the WACC. Positive NPV implies that inflows will outweigh investment = profit 17 Calculate WACC:

Evaluating other pros and cons Country risk – some host countries will restrict outflow of subsidiary profits, hence dividend payments are not possible. Solution ? Incremental impact – potential gains from other international project need to be taken into account. Which one creates overall company value ? Institutional impact – host government intervention may impact international project (foreign investment review agencies; employment quotas; local ownership requirements etc.) 18

Bibliography Lecture is based on: International Financial Management (Chapter 14) in Rugman, A. Collinson, S and Hodgetts, R. (2006) International Business (4 th eds) UK: McGraw-Hill 19