1. International Business: The New Realities by Cavusgil, Knight and Riesenberger Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall

2. Learning Objectives 1.Key tasks in international financial management 2.International capital structure 3.Raising funds for the firm’s international activities 4.Management of working capital and cash flow 5.Capital budgeting for international operations 6.Management of currency risk 7.Management of international accounting and taxes Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-2

3. International Financial Management It is the acquisition and use of funds for cross-border trade, investment, and other commercial activities. MNEs must carry out transactions in a multitude of foreign currencies and diverse environments characterized by restrictions on capital flows, country risk, and varying accounting and tax systems. Firms access funds from a variety of sources—foreign bond markets, local stock exchanges, foreign banks, venture capital firms, and intra-corporate financing— based on wherever in the world capital is cheapest. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-3

4. Typical International Financial Activities Motorola has facilities in nearly 50 countries and raises funds in financial markets worldwide. Its managers must be familiar with the laws and regulations that govern worldwide financial exchanges. The financial dimensions of Motorola’s activities are managed globally through a network of subsidiaries and strategic business units. The units are a complex web of financial coordination and control processes supplemented by investment analysis, capital structure optimization, risk reduction, and mobilization of global financial resources. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-4

5. International Financial Management Tasks 1.Decide on the capital structure: Determine the ideal long-term mix of debt versus equity financing 2.Raise funds for the firm: Acquire equity, debt, or intra-corporate financing for funding activities and investments 3.Working capital and cash flow management: Manage funds passing in and out of the firm’s value-adding activities Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-5

6. 4.Capital budgeting: Assess financial attractiveness of major investment projects (e.g., foreign market expansion and entry) 5.Currency risk management: Manage the multiple- currency transactions of the firm and its exposure to exchange-rate fluctuations 6.Manage the diversity of international accounting and tax practices: Learn to operate in a global environment with diverse accounting practices and international tax regimes International Financial Management Tasks (cont.) Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-6

7. Task One: Decide on the Capital Structure Capital structure: The mix of long-term equity and debt financing firms use to support their activities. The firm obtains equity financing by selling stock to investors or by retaining earnings, which is profit reinvested in the firm rather than paid to investors. Shares of stock provide investors with an ownership interest—equity—in the firm. In new firms, founders may provide equity from their personal savings. Debt financing comes from either loans from banks and other financial intermediaries or from money raised by selling corporate bonds to individuals or institutions. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-7

8. Task Two: Raising Funds Global money market: Financial market where firms and governments raise short-term financing. It is the meeting point of those who want to invest money and those who want to raise funds. Global capital market: Financial market where firms and governments raise intermediate-term and long-term financing. Participating in the global capital market allows firms to access funds from a larger pool of capital at competitive interest rates. International investors access a much wider range of investment opportunities than are available in the domestic capital market. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-8

9. Financial Centers New York, London, and Tokyo are the major centers. Frankfurt, Hong Kong, Paris, San Francisco, Sydney, Singapore, and Zurich are secondary centers. Firms access major capital suppliers—banks, stock exchanges, and venture capitalists—at such centers. In 2009, international issues of equity in world securities markets were about $400 billion, up from $83 billion in 1996 and $14 billion in 1986. In 2009, the stock of cross-national bank loans and deposits exceeded $22,000 billion, up from $11,000 billion 10 years earlier. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-9

10. Share of Financial Markets in Major World Regions Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-10

11. Causes of Rapid Rise in Global Capital Markets 1.Governments’ deregulation of financial markets made capital easier to move across national borders. 2.Innovation in information and communication technologies accelerated the ease and pace of global financial transactions. 3.Globalization pressured firms to seek new and lower- cost ways to finance global operations and to manage global financial management activities. 4.Widespread securitization led to conversion of illiquid financial instruments, such as bank loans, into tradable securities, such as bonds. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-11

12. Advantages of the Global Capital Markets for the Firm 1. Compared to being restricted to financial markets in the home country, the global market provides a broader base from which the firm can draw funds. 2.Greater breadth of financing sources means firms can often access funds at substantially lower cost. 3. The market provides a variety of investment opportunities for MNEs, professional investment firms, and individuals. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-12

13. Sources of Funding: 1. Equity Financing The firm obtains capital by selling shares of stock. Main advantage is the firm obtains capital without incurring debt and having to repay funds to providers. Main disadvantage is the firm’s ownership is diluted. The global equity market is the worldwide market of funds for equity financing—the stock exchanges worldwide where investors and firms meet to buy and sell shares of stock. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-13

14. World’s Largest Stock Exchanges, 2009–2010 Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-14

15. Sources of Funding: 2. Debt Financing The firm borrows money from a creditor in exchange for repayment of principal and interest. The main advantage over equity financing is that the firm does not sacrifice any ownership interests. Debt financing is obtained from two sources: Loans (usually from banks) and the sale of bonds. The firm may borrow money from banks in its home market or in foreign markets. Borrowing internationally is complicated by differences in banking laws and infrastructure, lack of loanable funds, and fluctuating exchange rates. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-15

16. The Eurocurrency Market The Eurocurrency market, representing money deposited in banks outside its country of origin, is a key source of loanable funds. U.S. dollars account for the largest share of such funds. Eurodollars are U.S. dollars held in banks outside the United States, including foreign branches of U.S. banks. Other Eurocurrencies include euros, yen, and British pounds, as long as they are banked outside their home country. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-16

17. Bonds: A Major Source of Debt Financing A bond is a debt instrument that enables the issuer (borrower) to raise capital by promising to repay the principal along with the interest on a specified date (maturity). Governments, states, and other institutions also sell bonds. Investors purchase bonds and redeem them at face value in the future. The global bond market is the international marketplace in which bonds are bought and sold, primarily through banks and stockbrokers. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-17

18. Foreign Bonds and Eurobonds Foreign bonds are sold outside the bond issuer’s country and denominated in the currency of the country in which they are issued. E.g., when Mexico’s Cemex sells dollar-denominated bonds in the United States, it is issuing foreign bonds. Eurobonds are sold outside the bond issuer’s home country and denominated in its own currency. For example, when Toyota sells yen-denominated bonds in the United States, it is issuing Eurobonds. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-18

19. Sources of Funding: 3. Intracorporate Financing Intracorporate financing: Obtaining funds from within firm’s network of subsidiaries and affiliates. In firms with extensive international operations, at times some units are cash rich while others are cash poor. Usually has little effect on the parent’s balance sheet because the funds are simply transferred from one area of the firm to another. Minimizes transaction costs of borrowing from banks and avoids the ownership-diluting effects of equity financing. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-19

20. Task Three: Working Capital and Cash Flow Management Cash flow needs arise from everyday business activities, such as paying for labor and materials or resources, servicing interest payments on debt, paying taxes, or paying dividends to shareholders. Cash flow management ensures cash is available where and when it is needed. Cash is generated from various sources, and needs to be transferred from one part of the MNE to another. International financial managers devise strategies for transferring funds within the firm’s worldwide operations to optimize global operations. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-20

21. Typical Methods for Transferring Funds in the MNE Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-21

22. Methods for Transferring Funds Within the MNE Through trade credit, a subsidiary defers payment for goods received from the parent firm. Dividend remittances are commonly used to transfer funds from foreign subsidiaries to the parent, but vary depending on tax levels, currency risks, and other factors. Royalty payments are compensation paid to owners of intellectual property. Assuming the subsidiary has licensed technology, trademarks, or other assets from the parent or other subsidiaries, royalties can be an efficient way to transfer funds. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-22

23. Methods for Transferring Funds Within the MNE (cont.) In a fronting loan, the parent deposits a large sum in a foreign bank, which then transfers the funds to the subsidiary in the form of a loan. Fronting allows the parent to circumvent restrictions that foreign governments impose on direct intracorporate loans. If the loan is made through a bank in a tax haven country, the parent can minimize taxes that might otherwise be due if the loan were made directly. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-23

24. Methods for Transferring Funds Within the MNE (cont.) Transfer pricing (also known as intracorporate pricing) refers to prices that subsidiaries and affiliates charge one another as they transfer goods and services within the same MNE. Firms can use transfer pricing to: Shift profits out of high-tax countries into low-tax countries Minimize foreign exchange risks, e.g., by moving funds out of countries where a currency devaluation is forecast Optimize the management of internal cash flows Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-24

25. Centralized Depository and Multilateral Netting MNEs pool surplus funds into a central depository that functions either globally or for a region. The funds are then directed to needful subsidiaries or invested to generate income. Multilateral netting: Strategic reduction of cash transfers within the MNE family through the elimination of offsetting cash flows. Multilateral netting involves three or more subsidiaries that hold accounts payable or accounts receivable with one other. MNEs with numerous subsidiaries usually establish a netting center that headquarters supervises. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-25

26. Task Four: Capital Budgeting Managers use capital budgeting to decide which international projects are economically desirable. The net present value (NPV) of a project depends on the initial investment, the cost of capital, and the amount of incremental cash flow or other advantages the proposed project is expected to provide over time. Internationally, such decisions are complex because managers must consider many variables, each of which can strongly affect the potential profitability of a venture. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-26

27. Capital Budgeting Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-27

28. Task Five: Currency Risk Management Currency risk concerns exchange rate fluctuations that harm business profits. Transaction exposure is currency risk that firms face when outstanding accounts receivable or payable are denominated in foreign currencies. Translation exposure is currency risk that results when a firm translates financial statements denominated in a foreign currency into the functional currency of the parent firm. Economic exposure is currency risk that results from exchange rate fluctuations affecting the pricing of products, the cost of inputs, and the value of foreign investments. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-28

29. Foreign Exchange Trading A relatively limited number of currencies facilitate cross- border trade and investment, mainly dollars, euros, yen, and British pounds. In 2010, the daily volume of global trading in foreign exchange amounted to some $3.2 trillion, which is more than 100 times the daily value of global trade in products and services. Large banks are the primary dealers in currency. Currency traders are especially active in major financial centers such as London, New York, and Tokyo. Trading is increasingly done online. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-29

30. Specialized Terminology in Currency Trading Spot rate: Exchange rate based on the current rate of exchange Forward rate: Exchange rate applicable at some future date, but specified at time of the transaction Direct quote: The number of units of the domestic currency needed to acquire one unit of the foreign currency; e.g., “It costs $1.42 to acquire one euro.” Indirect quote: The number of units of the foreign currency obtained for one unit of the domestic currency; e.g., “For $1, I can receive 0.74 euros.” Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-30

31. Types of Currency Traders Hedgers seek to minimize the risk of exchange rate fluctuations, often by buying forward or similar financial instruments. They include MNEs who conduct international trade. Speculators are currency traders who seek profits by investing in currencies with the expectation that they will rise in value. Arbitragers are currency traders who buy and sell the same currency in two or more foreign-exchange markets to profit from differences in the currency’s exchange rate. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-31

32. Exchange Rate Forecasting Exchange rates typically respond rapidly to economic information, such as election of a new government, labor disputes, and major supply shocks (as when oil-exporting countries announce a drop in supply). Managers seek to forecast exchange rates to protect against currency risk. Firms with extensive international operations develop in-house forecasting capabilities. Other firms rely on reports provided by major banks and professional forecasters. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-32

33. Management of Currency Risk Through Hedging Hedging refers to efforts to compensate for a possible loss from a bet or investment by making offsetting bets or investments. In international business, it refers to using financial instruments and other measures to reduce or eliminate exposure to currency risk. If the hedge is perfect, the firm is protected against the risk of adverse changes in the price of a currency. Banks offer various financial instruments—forward contracts, options, and swap agreements—to facilitate hedging. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-33

34. Hedging Instruments Forward contract: A financial instrument to buy or sell a currency at an agreed-upon exchange rate at the initiation of the contract for future delivery Futures contract: An agreement to buy or sell a currency in exchange for another at a pre-specified price and on a pre-specified date Currency option: Gives the purchaser the right, but not the obligation, to buy a certain amount of foreign currency at a set exchange rate within a specified amount of time Currency swap: The exchange of one currency for another currency according to a specified schedule Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-34

35. Task Six: Manage International Accounting and Tax Practices Developing accounting systems to identify, measure, and communicate financial information is especially challenging in firms with multi-country operations. Dozens of approaches are used to determine cost of goods sold, return on assets, R&D expenditures, net profits, and other outcomes in different countries. Balance sheets and income statements vary mainly in language, currency, format, and underlying accounting principles. Financial statements prepared in one country may be difficult to compare with those prepared in another. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-35

36. Managerial Guidelines for Minimizing Currency Risk Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-36

37. Transparency in Financial Reporting Transparency: Degree to which firms regularly and comprehensively reveal substantial information about their financial condition and accounting practices. The more transparent a nation’s accounting systems, the more regularly and comprehensively its public firms report their financial results in a reliable manner. Transparency improves the ability of investors to accurately evaluate company performance. In many developing and emerging market economies, accounting systems have low transparency. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-37

38. Trends Towards Harmonization of Accounting Standards Growth of international business pressures MNEs and international organizations, such as the International Accounting Standards Board (IASB), to harmonize world accounting systems, particularly regarding measurement, disclosure, and auditing standards. For example, the IASB has been working to develop a single set of high-quality, understandable, and enforceable global accounting standards that emphasize transparent and comparable information. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-38

39. Consolidating Financial Statements of Subsidiaries A special challenge in international accounting is foreign currency translation, translating data denominated in foreign currencies into the firm’s functional currency. Translation is critical because subsidiaries’ financial records are normally maintained in the currencies of the countries where they are located. When headquarters consolidates financial records, foreign currencies are translated into the functional currency by using one of two methods: The current rate method or the temporal method. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-39

40. Current Rate Method Current rate method: All foreign currency balance- sheet and income statement items are translated at the current exchange rate—the spot exchange rate in effect on the day (in the case of balance sheets), or for the period (in the case of income statements) when the statements are prepared. This method is typically used when translating records of foreign subsidiaries that are considered separate entities, rather than part of the parent firm’s operations. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-40

41. Temporal Method Temporal method: The choice of exchange rate depends on the underlying method of valuation. Assets and liabilities normally valued at historical cost are translated at historical rates, that is, the rates in effect when the assets were acquired. Assets and liabilities normally valued at market cost are translated at the current exchange rate. Thus, monetary items, such as cash, receivables, and payables, are translated at the current exchange rate. Non-monetary items, such as inventory and property, plant, and equipment, are translated at historical rates. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-41

42. International Taxation A direct tax is imposed on income derived from business profits, intracorporate transactions, capital gains, and sometimes royalties, interest, and dividends. An indirect tax applies to firms that license or franchise products and services, or that charge interest. The government withholds some percentage of royalty payments or interest charges as tax. A sales tax is a flat percentage tax on the value of goods or services sold, and is paid by the ultimate user. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-42

43. International Taxation (cont.) A value-added tax (VAT) is payable at each stage of processing in the value chain of a product or service. VAT is calculated as a percentage of the difference between the sale and purchase price of a good. VAT is common in Canada, Europe, and Latin America. Each business in a product’s value chain is required to bill the VAT to its customers and to pay the tax on its purchases, crediting the amounts it paid against the amounts due on its own activities. The net result is a tax on the added value of the good. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-43

44. Tax Havens Tax havens are countries hospitable to business and inward investment because of their low corporate income taxes. The Bahamas, Luxembourg, Monaco, Singapore, and Switzerland are examples. Tax havens exist in part because tax systems vary greatly worldwide. Thus, MNEs have an incentive to structure their global activities to minimize taxes. MNEs take advantage of tax havens either by establishing operations in them or by funneling business transactions through them. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-44

45. Corporate Income Tax Rates Around the World Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-45

46. Copyright © 2012 Pearson Education, Inc. publishing as Prentice Hall 20-46 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. Printed in the United States of America.