INTERNATIONAL BUSINESS

Professor H. Michael Boyd, Ph.D.

Chapter 20 International Financial Management

Scope of Financial Management

Three Sets of Related Decisions

Investment Decisions what activities to finance

Financing Decisions how to finance those activities Money Management Decisions how to manage financial resources most efficiently

International Financial Management

Complexity of International Business

Investment, financing and money management decisions in international business are complicated by: different currencies tax regimes capital control regulations financial structure norms economic and political risk

International Financial Management

Source of Competitive Advantage

Effective and efficient international financial management can be a source of competitive advantage for a firm by reducing their cost of creating value by:

minimizing the tax burden

minimizing unnecessary risk

(political, economic, foreign exchange)

efficiently managing the cash flows and reserves

Scope of Financial Management

Three Sets of Related Decisions

Investment Decisions
Financing Decisions
Money Management Decisions

Investment Decisions
Capital Budgeting

Quantifies the benefits, costs and risks of an investment

Enables managers to reasonably compare different investment alternatives within and across countries Estimates the projects cash flows over time Discounts the cash flows to determine the net present value of the project

International Capital Budgeting

Complicated Process

Must distinguish between cash flows to project and cash flows to the parent company Political, economic and foreign exchange risk can change the value of a foreign investment Connection between cash flows to parent and the source of financing must be recognized

Project and Parent Cash Flows

Project cash flows may not reach the parent due to:

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

When evaluating investments, the parent firm should focus the cash flows it will receive and not what the project generates

Adjusting for Political Risk

The likelihood that political forces will cause drastic changes in a countrys business climate that might harm the profits or goals of the firm

Expropriation (of the firms assets) Political and Social Unrest leads to economic collapse which can render the firms assets as worthless Political Change which can lead to harmful changes in tax policies or exchange controls

Adjusting for Economic Risk

The likelihood that economic mismanagement will cause drastic changes in the country business climate that might harm the profits or goals of the firm

Inflation Level of Business and Government Debt

Risk and Capital Budgeting

Typical Process Treat all risk as a single problem by increasing discount rate to projects in risky countries Problems Penalizes early cash flows too much Penalizes later cash flows too little

Better to revise future cash flows downward to reflect possible future adverse political or economic risk

Scope of Financial Management

Three Sets of Related Decisions

Investment Decisions

Financing Decisions
Money Management Decisions

Financing Decisions
Three Factors to Consider

Will the foreign investment will be internally financed or externally financed ? (we will assume that it will be external) What is the source of financing (domestic or global)? How should the financial structure of the foreign affiliate be configured?

Financing Decisions
Source of Financing

Global capital markets provide a lower cost of financing due to its increased liquidity
interest rates on the debt loan expected dividend yield for equity shares capital gain for equity shares

Financing Decisions
Problems and Risks of Global Capital Market

Host-country may require projects to be locally financed through debt or equity

limited liquidity may raise the cost of capital host-government may offer low interest subsidized loans

Impact of local currency (appreciation/depreciation) influences capital and financing decisions

May increase or decrease the actual cost of capital Borrow debt locally if local currency is expected to weaken

Financing Decisions
Financial Structure

The mix of debt and equity used to finance the business

Debt/equity ratios vary between countries due to differences in tax regimes or cultural norms

Financing Decisions
Financial Structure

Should firms follow local capital structure norms? Easier to evaluate ROE relative to local competitors Might improve the companys image
Best recommendation is to adopt a financial structure that minimizes the cost of capital

Scope of Financial Management

Three Sets of Related Decisions

Investment Decisions
Financing Decisions

Money Management Decisions

Global Money Management

The process and system that attempts to manage the firms global cash resources (working capital) most efficiently by:
minimizing

cash balances

reducing

transaction costs tax obligations

minimizing

Global Money Management

The Efficiency Objective: Minimizing Cash Balances

Money Market Accounts low interest high liquidity

Certificates of Deposit higher interest lower liquidity Using a centralized depository will reduce required cash balances in liquid accounts

Global Money Management

The Efficiency Objective: Reducing Transaction Costs

Transaction Costs changing from one currency to another

Transfer Fees fee for moving cash between locations 40% of international trade involves transactions between national subsidiaries of transnational firms Multilateral netting can reduce such transactions

Global Money Management

The Tax Objective

Countries tax income earned outside their boundaries by firms based in their country This may lead to double taxation whereby the firm is taxed by both the host-country government and the parent firms home government Tax rates vary across countries Tax rates are continually changing and harmonizing

Corporate Income Tax Rates 2006

Mitigation of Double Taxation

Tax Credit

allows entity to reduce home taxes by the amount of taxes paid to foreign government

Tax Treaty

an agreement between countries specifying what items will be taxed by authorities of the country where income is earned

Deferral Principle

allows parent companies to not be taxed on foreign income until the dividend is received

Tax Haven

used to minimize tax liability

Moving Money Across Borders:

Attaining Efficiencies and Reducing Taxes

Unbundling

Mix of techniques used to transfer liquid funds from a foreign subsidiary to the parent company without concerning 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

Dividend Remittances

Most common method of transfer

Dividends remittances vary due to:

tax regulations
foreign exchange risk age of subsidiary extent of local equity participation

Royalty Payments
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

Often tax-deductible locally not like dividends

Fees
Fees are compensation for professional services or expertise supplied to subsidiary by parent firm

Management fees or technical assistance fees Fixed charges for services provided Often tax-deductible locally not like dividends

Transfer Prices
Price at which goods and/or services are transferred within a firms entities

Used to position funds within a company

Move funds out of country by setting high transfer fees or into a country by setting low transfer fees

Movement can be between subsidiaries or between the parent and its subsidiaries

UN estimates that 40% of international trade is between the subsidiaries of companies

Benefits of Manipulating Transfer Prices

Reduce tax liabilities by using transfer fees to shift earnings from a high-tax country to a low-tax country Move funds out of a country where a significant currency devaluation is expected to help reduce foreign exchange risk Move funds from a subsidiary to the parent firm (or tax haven) when dividends are restricted by host country Reduce import duties (ad valorem) by reducing transfer prices and the value of the goods

Problems with Transfer Pricing

Governments dont like losing their tax revenue

Inconsistent with treating subsidiaries as profit centers

Impacts management incentives and performance evaluations when it changes a subsidiarys profits Managers can manipulate transfer prices to distort subsidiarys performance to mask inefficiencies

The ethics of transfer pricing are dubious at best

Arms-Length Price
The price that would prevail between two unrelated firms in a market setting

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 company Provides certain tax advantages by shifting tax liability to a country with a lower tax rate

Tax Aspects of a Fronting Loan

Fig 20.1

Interest Payments Net of Income Taxes

Foreign subsidiary pays $90,000 interest to London bank and deducts the interest payments from its taxable income resulting in $45,000 after-tax cost London bank receives $90,000 and retains $10,000 for services rendered and pays $80,000 interest on deposit to Bermuda subsidiary Bermuda subsidiary receives $80,000 interest on deposit tax free Because the foreign subsidiarys after-tax cost of borrowing is $45,000, the parent company moved an additional $35,000 out of the country

Techniques for Global Money Management

Two major techniques to most efficiently manage their global cash resources:

Centralized Depositories Multilateral Netting

Centralized Depositories

Firms need cash reserves to service accounts and insure against unanticipated negative cash flows Should each foreign subsidiary hold its own cash balance? Or should each subsidiarys cash balances be held at a central depository?

Centralized Depositories
Firms Prefer to Hold Cash at Central Depository

By pooling reserves, firms can deposit larger cash amounts and earn higher interest rates
If central depository is located in a major financial center, the firm can get information on good short-term investment opportunities

Can reduce the total size of the cash pool in highly liquid accounts, which enables the firm to invest larger amount of cash reserves in longer-term, less liquid instruments that earn a higher interest rate

Centralized Depositories

Limitations Government restrictions on cross-border cash flows Transaction costs of moving funds in and out of different currencies Facilitators Globalization of capital markets Removal of restrictions on cross-border cash flows

Multilateral Netting

Allows a firm to reduce the transaction costs:

foreign exchange commissions bank transfer fees

Bilateral Netting settlement where the amount the Subsidiary A owes to Subsidiary B can be canceled by the debt of that Subsidiary B owes Subsidiary A

Multilateral Netting extending the bilateral concept to multiple subsidiaries within an international business

Cash Flows before Multilateral Netting

$43 M needs to flow between subsidiaries $430,000 foreign exchange costs (1% fee)

Cash Flows after Multilateral Netting

$5 M needs to flow between subsidiaries $50,000 foreign exchange costs (1% fee) Savings of $380,000