Chapter Twenty

Financial Management in the International Business

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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

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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

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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

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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

• Collapse of communism in Eastern Europe• Attack on the World Trade Center

• Economic risk- Inflation

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Financing Decisions

• When considering options for financing a foreign investment, international businesses have to consider two factors

- Source of financing - Financial structure

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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

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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

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Financing Decisions and The Global Capital Market

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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

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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

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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

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Global Money ManagementThe 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

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2004 Corporate Tax Rates

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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

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Dividend Remittances

• Most common method of transfer

• Dividend varies with:

- Tax regulations

- Foreign exchange risk

- Age of subsidiary

- Extent of local equity participation

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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

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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

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Benefits of ManipulatingTransfer 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

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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

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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

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Tax Advantages of Fronting Loans

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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

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Centralized Depositories

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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

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Cash Flows Before Multilateral Netting

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Cash Flows After Multilateral Netting