Chapter 16 International Financial Management

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Rugman and Collinson, International Business,6thEdition, Pearson Education Limited 2013

International financial management

Chapter 16


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International financial management

Objectives Introduction

Determining parentsubsidiary relationships

Managing global cash flows

Exchange risk management Capital budgeting in the MNE

International financing in the MNE

Control: Identifying objectives, evaluating affiliate

performance and making performance consistent withgoals.


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Objectives

Compareand contrasthow polycentric, ethnocentric andgeocentric solutions are used in determining the financial

planning and controlling authority that is given to subsidiaries.

Studysome of the most common techniques that are used in

managing global cash flows, including funds positioning and

multilateral netting. Examineforeign exchange risk strategies that are used to

protect the multinational against transaction, translation and

economic exchange risks.

Explainhow capital budgeting is carried out in a multinational

firm. Describehow international financing opportunities for an MNE

differ from those available to a domestic firm.

Provide examples of international financial strategies currently

being used by multinationals.


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Introduction

International financial management encompasses anumber of key areas. These include:

the management of global cash flows;

foreign exchange risk management;

capital expenditure analysis and capital budgeting. The objective of international financial management

strategies is to provide assistance to all geographic

operations and to limit financial losses through:

the use of carefully formulated cash flow guidelines; the timely execution of foreign exchange risk

management strategies;

prudent capital expenditures;

careful capital budgeting.


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Financial management

Basic financial management can be divided intotwo broad headings:

choice and management of sourcesof funds;

choice and management of usesof funds.

At the international level, exchange risk

management must be added.


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Figure 16.1 Financial management in the MNE


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Determining parent

subsidiaryrelationships


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Three managerial solutions

Polycentric solution:it involves treating theMNE as a holding company and decentralizing

decision making to the subsidiary levels.

Ethnocentric solution:it involves treating all

foreign operations as if they were extensions ofdomestic operations.

Geocentric solution:it involves handling

financial planning and controlling decisions on aglobal basis.


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Managing global cash flows


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Internal flow of funds Working capital:the difference between current

assets and current liabilities.

Borrowing from a local bank or from the parent

company.

Having the parent company increase its equity

capital investment in the subsidiary.

Internal funds flows

S


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Figure 16.2 Common examples of internal sources and flows of funds

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Funds positioning techniques

Funds positioning techniques:strategies usedto move monies from one multinational operationto another.

Transfer price:an internal price set by a company

in intrafirm trade such as the price at which onesubsidiary will sell a product to another subsidiary.

Cf. Arms length price: the price a buyer will pay formerchandise in a market under conditions of perfectcompetition.

Tax havens:low-tax countries that are hospitableto business.

Fronting loans:a funds positioning strategy thatinvolves having a third party manage the loan.

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Table 16.1 Shifting profits by transfer pricing

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Table 16.2 Transfer pricing through tax havens

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Multilateral netting

Multilateral netting:the process of determiningthe net amount of money owed to subsidiaries

through multilateral transactions.

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Table 16.3 Net cash positions of subsidiaries

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Figure 16.3 Multilateral dollar flows between subsidiaries

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Figure 16.4 Centralized netting process in action

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Managing cash

Viewing the company as a single unit forpurposes of cash management can yield far

better results than would be obtained if each

affiliate managed its cash independently.

For example, much less foreign exchangeprotection is generally needed if all of the affiliates

are evaluated together than if each affiliate hedges

its own position.

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Potential gains to the MNE

from centralized cash management

1. By pooling the cash holdings of affiliates, the MNE canhold a larger total amount of cash, thus reducing itsfinancing needs.

2. It can have one group of people specialize in theperformance of centralizing cash management task, thus

achieving better decisions and economies of scale.3. By reducing the amount of cash in any one affiliate, it can

reduce country risks as well as financial costs.4. It can net out intracompany accounts when there are

multiple payables and receivables among affiliates, thusreducing the amount of money actually transferred amongaffiliates.

5. Its central cash management group can ensure that cashmanagement decisions aim at corporate goals rather thanthe goals of individual affiliates when these might conflict.

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Exchange risk management

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Three types of exchange risk

Three kinds of exchange risk should bedifferentiated: Transaction risk: the risk of an unexpected

change in the home-currency value during the timeof maturity.

For example, accounts payable and receivable, loansand bank deposits denominated in foreigncurrencies.

Translation risk:the risk of value changes inforeign currency assets and liabilities on thebalance sheet, whether or not the transactionsoccur during the accounting period. For example, the plant and equipment of foreign

subsidiaries. Economic risk:the risk of unexpected changes in

future cash flows from foreign operations.

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Table 16.4 Exchange risk hedging techniques** These techniques assume no expectation about the direction of exchange rate change. If devaluation is expected, then creation of a net liability

position is attractive and vice versa for expected revaluation.

In each instance, the hedge must produce an equal-value asset (liability) in the same currency with equal maturity to offset the exposed liability (asset)

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Developing forecasting and reporting systems

Decide the types and degrees of economic exposure thatthe company is willing to accept.

Develop the necessary expertise for monitoring exchangerates and for forecasting those rates that are applicable tothe identified exposures.

Construct a reporting system that allows the firm toidentify exposed accounts, to measure this exposure andto feed back information on what the firm is doing and thestatus of these decisions.

Include all MNE units in this reporting system so that eachbetter understands the risks it is assuming and is aware ofthe actions that must be taken to deal with these risks.

Keep senior-level management fully apprised of what isgoing on in each area of responsibility so that every

manager is able to periodically revise the exposure risk.

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Capital budgeting in the MNE

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Expenditures

Capital expenditures: Major projects for whichthe costs are to be allocated over a number ofyears

For example, major acquisitions, the building of

new plants and the refurbishing of existingequipment.

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Risks in international

capital investments

Types of risk the MNE faces when undertakinginternational capital investments.

Exchange risk

Affects the US dollar value of the profits earned,

potentially raising or lowering them substantially.

Country risk

For example, currency inconvertibility, corporate

taxes and investment laws. Borrowing risk

Country-dependent.

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Net Present Value (NPV)

Because the firm has to live with the results ofthese decisions for a long period of time,

mathematical techniques of analysis are often

used, including discounted cash flow techniques.

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where,

It= investment cash outlays in year t

Ct= cash inflows in year t

T = terminal date or end of project

KA= weighted average cost of capital

ke= cost of equity capital

kd= cost of debt financing

tx= tax rate

D/V, S/ V= debt and equity ratios,

respectively

NPV = incremental net present

value for the project.

Net Present Value (NPV) (Continued)

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Institutional features

Government subsidies and controls Foreign investment review agencies in Australia

and Canada.

Political risk insurance

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International financing in the MNE

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Table 16.5 International sources of credit (including markets and intrafirm transfers)Note:Direct means borrowing from owners of wealth (e.g. investors); intermediated means borrowing from a financial intermediary (e.g. a bank).

International back-to-back loan means a loan in which two companies in different countries borrow offsetting amounts from one another in each others

currency

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Financial structure

Debt-equity ratio:the value of a firms total debtdivided by the value of its total equity. A higherratio implies greater leverage and potentiallygreater risk.

The normal debt/equity ratiodiffers from industryto industry and from country to country.

Since the MNE is evaluated by investors in thehome country, its overall debt/equity structure

must satisfy the financial community in thatcountry.

If the firm sells shares of an affiliate in the hostcountrys financial market, the debt/equity positionof the affiliate is an important issue.

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Reasons for local borrowing

If funding is available at low cost (adjusted forexpected exchange rate changes).

If a substantial amount of assets is exposed

locally, local borrowing provides a hedge to both

exchange and country risks. If the local currency is expected to devalue

substantially, then, even if local interest rates are

high, it may make sense to borrow locally,

assuming the expected postdevaluation interest

costs would be lower than the home country

costs.

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Other issues regarding

financial structure

Local equity financing may be forced on the firm ifthe host government demands partial local

ownership of foreign enterprises.

Reinvestment of funds that face repatriation

restrictions.

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Control

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Control

Control is the fundamental function ofmanagement that involves developing profit plans

for the firm and its divisions and then deciding

what to do when actual operating results differ

from those planned.

Evaluating the performance of managers of

foreign affiliates must take into consideration

exchange risk and the constraints placed upon

the subsidiary.

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Chapter 16 International Financial Management