Fourth Edition International Business

CHAPTER 20 Financial Management in the International business

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Chapter Focus Look at investment decisions to identify factors that complicate capital budgeting decisions. Examining financing decisions, we look at the mix of equity and debt financing and the advantages and disadvantages of localizing the financial structure. Look at the objectives of global money management, the ways firms move money across borders, and techniques for efficient management. Finally, we take a look at foreign exchange risk.

McGraw-Hill/Irwin © 2003 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 © 2003 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 © 2003 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 be reinvested in the host country.

McGraw-Hill/Irwin © 2003 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. Economic risk: Inflation.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Risk and Capital Budgeting Treat all risk as a single problem by increasing discount rate to projects in risky countries. Penalizes early cash flows too much. Later cash flows, too little. Better to revise future cash flows downward to reflect possible future adverse political or economic risk. Therefore: Handling Risk

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Financing Decisions - Source of Financing - 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.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Financing Decisions - 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 © 2003 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 © 2003 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 © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Corporate Income Tax Rates 2001 Country Top Corporate Income Tax Rate Canada 42.1% Chile 15% France35.33% Germany39.36% Hong Kong16% Ireland 20% Japan 42% Mexico 35% Singapore 25.5% United Kingdom 30% United States 40% Table 20.1

McGraw-Hill/Irwin © 2003 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 © 2003 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. Dividends

McGraw-Hill/Irwin © 2003 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 © 2003 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 © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Problems with Transfer Pricing Governments don’t like it. Believe (rightly) they lose money. Impacts management incentives & performance evaluations. Inconsistent with ‘profit center’. Managers can hide inefficiencies.

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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 20.1

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Calculation of Net Receipts ($ Million) Receiving Subsidiary S. Korea - $3 $4 $5 $12 ($3) China $ (2) Japan Taiwan Total payments $15 $11 $8 $9 Paying Subsidiary S.Korea China Japan Taiwan Total Receipts Net Receipts* (payments) Net receipts = Total payments - total receipts Figure 20.2b

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved 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/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Tactics and Strategies for Reducing Foreign Exchange Risk 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. Reducing Transaction and Translation Exposure

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Tactics and Strategies for Reducing Foreign Exchange Risk Key is to distribute productive assets to various locations so firm is not severely affected by exchange rate changes. Manufacturing Facility Dispersal Reducing Economic Exposure

McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved Developing Policies for 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.