1. © Ram Mudambi, Temple University, 2007 1 Lecture 10 Financial Management in the International Business

2. © Ram Mudambi, Temple University, 2007 2 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.

3. © Ram Mudambi, Temple University, 2007 3 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

4. © Ram Mudambi, Temple University, 2007 4 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.

5. © Ram Mudambi, Temple University, 2007 5 The Internal Capital Market  A recent literature has emerged, suggesting that HQ’s most important function is to run the firm’s ‘internal capital market’  For a subsidiary, this market becomes more important as  the external capital market is less developed  The project resources exceed the subsidiary’s ability to provide collateral  The external capital market resource flow is bounded below by zero. This is not the case with the internal capital market

6. © Ram Mudambi, Temple University, 2007 6 Internal Capital Market HOST Subsidiary 1 HOME Parent Inflow of financial resources Outflow of financial resources Re-directed resources to Subsidiary 2 3 rd Country Subsidiary 2 Local Bank Local Bank External Capital market External Capital market

7. © Ram Mudambi, Temple University, 2007 7 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.

8. © Ram Mudambi, Temple University, 2007 8 Euromoney Magazine’s Country Risk Ratings  Overall Score  Political risk  Economic performance  Debt indicators  Debt in default or rescheduled  Credit ratings  Access to bank finance  Access to short-term finance  Access to capital markets  Forfaiting*  100  25  10  5 * The purchasing of an exporter's receivables (the amount importersr owe the exporter) at a discount by paying cash.

9. © Ram Mudambi, Temple University, 2007 9 Euromoney Magazine’s Country Risk Ratings, Sept 2006 Total score = 100 Country (rank) Risk Rating Luxembourg (1)99.651 The U.S. (5)94.441 Japan (18)89.056 Bermuda (23)84.127 Chile (43)66.257 Argentina (100)39.237 Iraq (183)5.172 Number of countries = 185

10. © Ram Mudambi, Temple University, 2007 10 Financing Decisions 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.

11. © Ram Mudambi, Temple University, 2007 11 Financing Decisions HOME Parent Re-directed resources to Subsidiary 2 HOST Subsidiary 2 Global Financial Center Subsidiary 1 Outflow of financial resources Global Bank External Capital market Local Bank External Capital market Govt loans

12. © Ram Mudambi, Temple University, 2007 12 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.

13. © Ram Mudambi, Temple University, 2007 13 2003* % * All publicly traded companies

14. © Ram Mudambi, Temple University, 2007 14 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.

15. © Ram Mudambi, Temple University, 2007 15 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.

16. © Ram Mudambi, Temple University, 2007 16 Argentina35% Canada42.1% Chile15% France35.33 Germany39.36% Hong Kong16% Ireland20% Japan42% Mexico35% Singapore25.5% The U.K.30% The U.S.40% Corporate Income Tax Rates Top Rate 2001 35% 36.1% 17% 33.33% 38.34% 17.5% 12.5% 30% 29% 20% 30% 35% Top Rate 2007

17. © Ram Mudambi, Temple University, 2007 17 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 Subsidiary Parent Dividend remittances Royalty payments and fees Transfer Prices Fronting loans

18. © Ram Mudambi, Temple University, 2007 18 Dividend Remittances  Most common method of transfer.  Dividend varies with:  tax regulations.  Foreign exchange risk.  Age of subsidiary.  Extent of local equity participation. Dividends

19. © Ram Mudambi, Temple University, 2007 19 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. © Ram Mudambi, Temple University, 2007 20 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.

21. © Ram Mudambi, Temple University, 2007 21 Benefits of 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.

22. © Ram Mudambi, Temple University, 2007 22 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.

23. © Ram Mudambi, Temple University, 2007 23 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.

24. © Ram Mudambi, Temple University, 2007 24 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

25. © Ram Mudambi, Temple University, 2007 25 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.

26. © Ram Mudambi, Temple University, 2007 26 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

27. © Ram Mudambi, Temple University, 2007 27 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.

28. © Ram Mudambi, Temple University, 2007 28 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

29. © Ram Mudambi, Temple University, 2007 29 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 $4 - 2 3 9 (2) Spain 5 3 - 1 9 1 Italy 6 5 2 - 13 4 Total payments $15 $11 $8 $9 Net receipts = Total payments - total receipts

30. © Ram Mudambi, Temple University, 2007 30 Cash Flows after Multilateral Netting German Subsidiary French Subsidiary Spanish Subsidiary Italian Subsidiary Pays $1 Million Pays $3 Million Pays $1 Million

31. © Ram Mudambi, Temple University, 2007 31 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. Effect on flows stocks stocks

32. © Ram Mudambi, Temple University, 2007 32 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.

33. © Ram Mudambi, Temple University, 2007 33 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

34. © Ram Mudambi, Temple University, 2007 34 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.

35. © Ram Mudambi, Temple University, 2007 35 An example  During the Asian financial crisis, western MNCs were differentially affected.  Research now reveals that those MNCs that were locally embedded in terms of their financial transactions were better off, compared to those which had central control  Dealing with local suppliers in local currency  Reduction in the extent of F/X transactions can help the company.

36. © Ram Mudambi, Temple University, 2007 36 Takeaways  Global finance is parallel to global logistics  Logistics - Managing the dispersion of real assets  Finance – Managing the dispersion of financial assets  In MNCs, both functions uniquely impinge on all aspects of firm management  Both have an intra-firm and an inter-firm aspect  Both have a mechanistic and strategic aspect Logistics – minimize costs vs. build competencies Finance – minimize taxes vs. managing risk exposure