Chapter 20- Final [Ppt-fm Report

Chapter Twenty

Financial Management in the International Business

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McGraw-Hill/IrwinInternational Business, 6/e

© 2007 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

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Introduction

• In an international business, 　 investment, financing, and money management decisions are complicated by different：

• currencies• regulations concerning

the flow of capital across borders• norms regarding the

financing of business activities• tax regimes

• levels of economic

and political risk

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Introduction

• Financial managers must consider ： 1. when deciding which activities to finance 2. how best to finance those activities 3. how best to manage the firm’s financial resources

4. how best to protect the firm from political and economic risks (including foreign exchange risk)

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•Good financial management can be a source of competitive advantage•Firms with good financial management can reduce the costs of creating value and add value by improving customer service

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Classroom Performance System

Which of the following is not one of the decision areas in financial management?

a) cash operations decisions

b) investment decisions

c) financing decisions

d) money management decisions

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Investment Decisions

•Financial managers must quantify the benefits, costs, and risks associated with an investment in a foreign country•To do this, managers use capital budgeting

- involves estimating the cash flows associated with the project over time, and then discounting them to determine their net present value

•If the net present value of the discounted cash flows is greater than zero, the firm should go ahead with the project

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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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What Is The Difference Between Project And Parent Cash Flows?

• Cash flows to the project and cash flows to the parent company can be quite different

• Parent companies are interested in the cash flows they will receive, not the cash flows the project generates

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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

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How Does Political Risk Influence Investment Decisions?

• Political risk - the likelihood that political forces will cause drastic changes in a country’s business environment that hurt the profit and other goals of a business

- higher in countries with social unrest or disorder, or where the nature of the society increases the chance for social unrest

• Political change can result in the expropriation of a firm’s assets, or complete economic collapse that renders a firm’s assets worthless

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How Does Economic Risk Influence Investment Decisions?

• Economic risk - the likelihood that economic mismanagement will cause drastic changes in a country’s business environment that hurt the profit and other goals of a business

• The biggest economic risk is inflation- reflected in falling currency values and lower project cash flows

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How Can Firms Adjust For Political And Economic Risk?

• Firms analyzing foreign investment opportunities can adjust for risk

1. By raising the discount rate in countries where political and economic risk is high

2. By lowering future cash flow estimates to account for adverse political or economic changes that could occur in the future

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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 DecisionsHow Do Firms Make 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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How Do Firms Make Financing Decisions?

Source of financing 1. How the foreign investment will be financed - the cost of capital is usually lowest in the global capital market- but, some governments require local debt or equity financing- firms that anticipate a depreciation of the local currency, may

prefer local debt financing

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How Do Firms Make Financing Decisions?

Financial structure

2. How the financial structure (debt vs. equity) of the foreign affiliate should be configured

- need to decide whether to adopt local capital structure norms or maintain the structure used in the home country

• Most experts suggest that firms adopt the structure that minimizes the cost of capital, whatever that may be

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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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• 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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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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What Is Global Money Management?

• Money management decisions attempt to manage global cash resources efficiently

• Firms need to 1. Minimize cash balances - need cash balances on

hand for notes payable and unexpected demands- cash reserves are usually invested in money market

accounts that offer low rates of interest - when firms invest in money market accounts they have

unlimited liquidity, but low interest rates- when they invest in long-term instruments they have

higher interest rates, but low liquidity

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What Is Global Money Management?

Firms need to:

2. Reduce transaction costs - the cost of exchange - every time a firm changes cash from one currency to

another, they face transaction costs

• Most banks also charge a transfer fee for moving cash from one location to another

• Multilateral netting can reduce the number of transactions between subsidiaries and the number of transaction costs

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Global Money Management-The Efficiency Objective

Summary• 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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The fee for moving cash from one location to another is called

a) the money management fee

b) the transaction cost

c) the transfer fee

d) the cost of capital

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Global Money ManagementThe Tax Objective

• Table 20.1: Corporate Income Tax Rates, 2006

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Compared to the other countries, corporate income tax rates in ________ are relatively low.

a) Canada

b) Ireland

c) Germany

d) Japan

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How Can Firms Limit Their Tax Liability?

• Every country has its own tax policies - most countries feel they have the right to tax the foreign-earned

income of companies based in the country

• Double taxation occurs when the income of a foreign subsidiary is taxed by the host-country government and by the home-country government

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How Can Firms Limit Their Tax Liability?

• Taxes can be minimized through1. Tax credits - allow the firm to reduce the taxes paid to the

home government by the amount of taxes paid to the foreign government

2. Tax treaties - agreement specifying what items of income will be taxed by the authorities of the country where the income is earned

3. Deferral principle - specifies that parent companies are not taxed on foreign source income until they actually receive a dividend

4. Tax havens - countries with a very low, or no, income tax – firms can avoid income taxes by establishing a wholly-owned, non-operating subsidiary in the country

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Global Money ManagementThe Tax Objective

Summary• 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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A __________ specifies that parent companies are not taxed on foreign source income until they actually receive a dividend.

a) tax credit

b) deferral principle

c) tax haven

d) tax treaty

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Moving Money Across Borders: Attaining Efficiencies and Reducing Taxes

Firms can transfer liquid funds across border via:•dividend remittances•royalty payments and fees•transfer prices•fronting loans

•Firms that use more than one of these techniques is using a practice called unbundling

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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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Firms can transfer liquid funds across border using all of the following techniques except:

a) dividend remittances

b) royalty payments and fees

c) transfer prices

d) backing loans

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What Are Dividend Remittances?

Paying dividends is the most common method of transferring funds from subsidiaries to the parent

The relative attractiveness of paying dividends varies according to

•tax regulations – high tax rates make this less attractive•foreign exchange risk – dividends might speed up in risky countries•the age of the subsidiary – older subsidiaries remit a higher proportion of their earning in dividends•the extent of local equity participation – local owners’ demands for dividends come into play

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Royalty Payments and FeesWhat Are

Royalty Payments And Fees?

• Royalties - the remuneration paid to the owners of technology, patents, or trade names for the use of that technology or the right to manufacture and/or sell products under those patents or trade names

- can be levied as a fixed amount per unit or as a percentage of gross revenues

- most parent companies charge subsidiaries royalties for the technology, patents or trade names transferred to them

• Most parent companies charge subsidiaries royalties for the technology, patents or trade names transferred to them

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Royalty Payments and FeesWhat Are

Royalty Payments And Fees?

• A fee is compensation for professional services or expertise supplied to a foreign subsidiary by the parent company or another subsidiary

- royalties and fees are often tax-deductible locally

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Transfer PricesWhat Are 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

Transfer prices can be manipulated to:• 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(Move funds from a subsidiary to the parent when dividends are restricted by the host government)

• Reduce import duties (ad valorem) by reducing transfer prices and the value of the goods

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Problems With Transfer PricingWhat Makes Transfer Prices Unattractive?

• But, using transfer pricing can be problematic because1. Governments think they are being cheated out of legitimate

income

2. Governments believe firms are breaking the spirit of the law when transfer prices are used to circumvent restrictions of capital flows

3. It complicates management incentives and performance evaluation

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Fronting LoansWhat Are Fronting Loans?

• FRONTING LOANS -Loan between a parent and subsidiary is channeled through a financial intermediary (bank)

• Firms use fronting loans- to circumvent host-country restrictions on the remittance of funds

from a foreign subsidiary to the parent company- to gain tax advantages

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Tax Advantages of Fronting Loans

An Example of the Tax Aspects of a Fronting Loan

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The most common method of transferring funds from subsidiaries to the parent is through

a) dividend remittances

b) royalty payments and fees

c) transfer prices

d) backing loans

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Techniques for Global Money Management

Two techniques used by firms to manage their global cash resources are:•centralized depositories•multilateral netting

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Centralized Depositories

•All firms must maintain easily accessible cash balances•Firms must decide whether to hold cash balances at each subsidiary or at a centralized depository•Most firms prefer the latter for three reasons:1. by pooling cash reserves centrally, firms can deposit larger amounts, and therefore earn higher rates of interest2. when centralized depositories are located in major financial centers, the firm has access to a greater variety of investment opportunities than a subsidiary would have3. by pooling cash reserves, firms can reduce the total size of the readily accessible cash pool, and invest larger amounts in longer-term, less liquid accounts that have higher interest rates

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•Sometimes, government restrictions on cross-border capital flows limit the use of centralized depositories•Firms must also be aware of the transaction costs involved in moving money in and out of a centralized depository•The use of centralized depositories is expected to increase thanks to the globalization of capital markets and the removal of barriers to the free flow of capital across borders

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• 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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Multilateral Netting

•Firms using multilateral netting can reduce the transaction costs associated with many transactions between subsidiaries•Multilateral netting is an extension of bilateral netting

-Under bilateral netting, if a French subsidiary owes a Mexican subsidiary $6 million, and the Mexican subsidiary simultaneously owes the French subsidiary $4 million, a bilateral settlement will be made with a single payment of $2 million

-Under multilateral netting, the concept is extended to multiple subsidiaries within an international business

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• 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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Chapter 20- Final [Ppt-fm Report