A Company’s Forex Management ~ Finance Function

Anish Bengeri (5)

Anirudh Jindal (22)

Sachin Mittal (35)

Agenda

• The Finance Function

• Capital Structure

• Global Capital Markets

• Offshore Financing and Offshore Financial Centers

• Capital Budgeting in Global Context

• Internal Sources of Funds

• Foreign Exchange Risk Management

• Taxation of Foreign Source Income

Financial Functions In Multinational Firms

Finance is the Life Blood of the Business and so the case of MNCs also. The only difference in finance of domestic companies and MNCs is that the finance in domestic companies is in domestic currency where as in case of the MNCs the finance is in multi currencies.

Finance is required for many purposes like purchase of raw material, purchase of machinery, purchases of the related items, payment of salaries, meeting the operational expenses, etc., so the finance is required for all these purposes.

There are three types of financing namely :- Short – Term Financing Financing Foreign Trade Long- Term Financing

Types of Financing

• Financing the working capital requirements of multinational companies’ foreign affiliate’s poses a complex decision problem.

• This complexity stems from the large number of financing options available to the subsidiary of an MNC.

• Subsidiaries have access to funds from sister affiliates and the parent, as well as external sources.

Short Term Financing

• Foreign Trade is the main business of the traders of ever country. Almost all the MNCs are heavily involved of foreign trade in addition to their other international activities.

• Hence, the people who are responsible for the management of the MNCs must have the practical knowledge of the institutions to facilitate the international movement of goods.

Financing Foreign Trade

• The following are the long term financing particularly for the capital equipment's and other big items given to the MNCs who are actively engaged in the Foreign Trade :-

• Export Financing• Export Credit Subsidies and• Export Credit Insurance

Long Term Financing

Finance and Treasury Functions in the Internalization Process

Chief Financial Officer (CFO)—vice president of finance Responsible for controllership and treasury functions

Acquires financial resources—generates funds from internal and external sources

Allocates financial resources—increases stockholders’ wealth by allocating funds to different projects and investment opportunities

Manages cash flows

Role of CFO

OPERATIONS

OBJECTIVES

STRATEGY

EXTERNAL INFLUENCES

COMPETITIVE ENVIRONMENT

PHYSICAL AND SOCIETAL FACTORS

Functions• Marketing• Exporting and

importing• Global manufacturing• Supply chain management• Accounting• FINANCE• Human resources

Modes

MEANSOverlayingAlternatives

Finance in International Business

V P , S a les /M ark etin g

C on tro lle r

C ash M an ag er C red it M an ag er

E xp osu reM an ag em en t

B u d g e tP lan n in g

B id S u p p ort P rocess F ore ig nC u rren cy

G lob a l F in an ce C ap ita lE xp en d itu re

F in an c ia lP lan n in g

Treasu re r

V P , F in an c e V P , O p era tion s V P , R & D

P res id en t an d C O O

C h a irm an an d C E O

B oard o f D irec tors

Location of Treasury Function in the Corporate Organizational Structure

Capital Structure

Companies follow financing trends in their own country and industry

Companies can use local and international debt markets to raise funds

Leveragin

g Debt Financin

g

• The degree to which a firm funds the growth of the business by debt• Interest on debt is tax deductible• Amount of leverage used varies from country to country

Equity

Capital

• Capital—stocks or shares• Dividends paid to investors are not deductible• Choice of debt versus equity affected by a variety of factors

Debt Mark

ets

• Subsidiaries or foreign companies may find it easier to obtain credit than local companies

• Back to back loan - made between a firm in country A with a subsidiary in country B and a bank in country B with a branch in country A

EUROCURRENCIES - any currency that is banked outside of its country of origin• Major sources of Eurocurrencies include:

– foreign governments or individuals who want to hold dollars outside of the U.S.

– MNEs with excess cash– European banks with excess foreign currency– countries with large balance-of-trade surpluses held as reserves

• Characteristics of Eurocurrency market– completely unregulated offshore market– both short and medium term– Eurocurrency deposits yield higher interest– Eurocurrency loans tend to be cheaper

LONDON INTER-BANK OFFERED RATE (LIBOR) - interest rate that banks charge each other on Eurocurrency loans

Global Capital Markets

INTERNATIONAL BOND MARKET

An attractive place to borrow money that fills an important niche in financing

Tends to be less expensive than local markets Foreign bonds - sold outside of the borrower’s country but in the currency

of the country of issue Eurobonds - underwritten by banking syndicate and sold in countries other

than the one in whose currency the bond is denominated• sold in several financial centers• some have currency options allowing the creditor to demand repayment

in one of several currencies Global bond - combination of domestic bond and Eurobond

• registered in each national market

Equity Securities and the Euromarkets

EQUITY SECURITIESInvestor takes an ownership position in return

for shares of stock, the promises of capital gain, and dividends.

Many companies are using private placements to raise equity capital

VENTURE CAPITALISTInvests money in a new

venture in exchange for stock

EQUITY CAPITAL MARKETS (stock markets)

Listing may be on home country or foreign exchange

MARKET CAPITALIZATION Total number of shares of stock listed times

the market price per share in part the increase has resulted from privatization in emerging

markets and global economic growth

EUROEQUITY MARKETMarket for shares sold outside the issuing company’s home

country

Firms often list on only one big foreign exchange

e.g., 379 foreign companies listed on the New York Stock Exchange

Companies with investments in several countries may list on different exchanges

AMERICAN DEPOSITARY RECEIPT (ADR)

A negotiable certificate issued by a U.S. bank and

representing shares of stock of a foreign company

GLOBAL DEPOSITARY RECEIPTS and EUROPEAN DEPOSITARY RECEIPTS

Other markets for Euro equities

GLOBAL SHARE OFFERING

Simultaneous offering of actual shares on different exchanges

Electronic trading of stocks is a major source of competition for

stock exchanges

19863.60%

96.40%1994

12.70%

87.30%1998

93.10%

6.90%

Emerging markets

Developed markets

Growth of Emerging Stock Markets

Cities or countries that engage in a variety of financial transactions Provide significant tax advantages Centers for the Eurocurrency market Markets are less regulated than domestic markets Provide an alternative, cheaper source of funding May be:

• Operational centers - extensive banking activities involving short-term financial transactions

• Booking centers - little banking activity• financial transactions recorded to take advantage of secrecy and

low tax rates Good locations for establishing financial subsidiaries

Offshore Financial Centers

Large foreign-currency marketfor loans/deposits

OffshoreFinancial

CenterGood

communications

Pass-through forinternational

loan funds

Efficient andexperienced

financialcommunity

Favorableregulatory

climate

Economic andpolitical stability

Large net supplierof funds to worldfinancial markets

Good supportiveservices

Characteristics of Offshore Financial Centers

Internal Sources of Funds

FUNDS

Working capital, i.e., the difference between

current assets and current liabilities

Used to expand operations or satisfy demands for capital

SOURCES OF FUNDSMNEs have more complex

arrangements due to the number of subsidiaries and the diverse environments in which they

operate

Loans

Dividends

Intercompany receivables and payables

Investments through equity capital

Funds may flow from

subsidiaries to parent or vice versa

Dividends,royalties,and fees

FrenchSubsidiary

BrazilianSubsidiary

ParentCompany

Loans

Extensions ofaccounts payable

Invests moreequity capital

Loans Guaranteeloans

Internal Sources of Working Capital for MNEs

GLOBAL CASH MANAGEMENT

Requires the collection and payment of cash resulting from the normal operational cycle Generates and invests cash through dealings with financial institutions

Assesses a company’s cash needs using budgets and forecasts

Involves decisions about the degree of centralization of cash• transfers of cash may be in the form of dividends, royalties, management

fees, and repayment of loans• governments concerned about the outflow of foreign exchange may

curtail cash transfers abroad

MULTILATERAL NETTING

Company establishes one center to handle all internal cash, funds, and financial transactions Enables companies to reduce the amount of cash flow and move cash more

quickly and efficiently Advantages include:

• optimizing the use of excess cash• reducing interest expenses and maximizing interest yields• reducing costly foreign exchange, swap transactions, and intercompany

transfers• minimizing administrative paperwork• centralizing and speeding information

Multilateral cash flows in the absence of netting require each subsidiary to settle intercompany obligations• Not as advantageous as netting

GermanSubsidiary

$150,000

$200,000 $200,000

$100,000 United KingdomSubsidiary

FrenchSubsidiary

$50,000

$50,000

$200,000

ItalianSubsidiary

Multilateral Cash Flows

FrenchSubsidiary

ItalianSubsidiary

GermanSubsidiary

United KingdomSubsidiary

ClearingAccount

$100,000

$100,000$150,000

$150,000

Multilateral Netting

Foreign Exchange Risk Management

Translation (accounting)

exposure

Transaction (commitment)

exposure

Foreign exchange

risk

Economic (operational)

exposure

Arises from converting financial statements expressed in foreign currencies into home currency

All foreign currency denominated assets and liabilities as well as revenues and costs have to be translated in one basic currency

Assets and liabilities translated at current exchange rate are exposed, and those translated at historical rate are not exposed because we use the same rate in this case. The exposure depends on the translation method to be used

Combined effect of the exchange-rate change is either a net gain or loss• Does not represent an actual cash flow effect because the cash is only

translated into dollars, not converted into dollars

TRANSLATION EXPOSURE

Transaction exposure occurs when a company trades, borrows or lends in a foreign currency, or sells fixed assets of its subsidiaries in a foreign country. All these operations involve time delay between the commitment of the transaction (sale of an asset, for example) and the receipt or delivery of the payment

Arises because the receivable or payable changes in value as the exchange rate changes

In order to measure Transaction exposure, three techniques can be used: the firm can measure the variability of each currency in which it has some

transactions the measurement based on the correlation between two currencies is also used an increasingly implemented technique used for measurement is the VaR

(Value-at-Risk) model

TRANSACTION EXPOSURE

Economic exposure measures the change in the present value of the firm resulting from any change in the future cash flows of the firm caused by an unexpected change in the exchange rates.

Economic risk arises, when a multinational firm incurs costs in one currency and generates sales in another. Changes in foreign exchange rates affect the competitive position of the firm.

Economic exposure (operating exposure) is potential for change in expected cash flows that arise from the:

• Pricing of products • Sourcing and cost of inputs• Location of investments• Competitive position of the company in markets

ECONOMIC EXPOSURE

DEFINING AND MEASURING EXPOSURE• MNE must forecast the degree of exposure in each major currency in which it

operates• Exchange-rate movements are forecasted using in-house or external experts

CREATING A REPORTING SYSTEM• Substantial participation from foreign operations combined with central

control• Foreign input important to ensure forecasting effectiveness• Central control of exposure protects resources more efficiently

defines and controls overall company exposure• MNEs should devise uniform reporting system for its subsidiaries• Time periods of reports vary• Final reporting should be at corporate level

Exposure-Management Strategy

Exposure-Management Strategy (Contd.)

CENTRALIZED POLICY Top management should determine hedging policy Corporate treasurer should be able to design and implement a cost-effective

program Some decisions must be decentralized in order to react quickly to changes in the

international monetary environment Some companies run hedging operations as profit centers and nurture in-house

trading desks

FORMULATING HEDGING STRATEGIES Safest position has exposed assets equal to exposed liabilities Operational strategies

• involve adjusting the flow of money and resources to reduce foreign-exchange risk

• using local debt to balance local assets

• taking advantage of leads and lags for intercompany payments

A lead strategy means collecting foreign-currency receivables before they are due when the currency is expected to weaken, or paying foreign-currency payables before they are due when a currency is expected to strengthen.

A lag strategy means delaying collection of foreign-currency receivables if the currency is expected to strengthen, or delaying payment of foreign-currency payables when the currency is expected to weaken.

Contractual arrangements

• Forward contract - Establishes a fixed exchange rate for future transactions

• Foreign-currency option - Purchaser has the right, but not the obligation, to buy or sell a certain amount of foreign currency at a set exchange rate within a specified period of time

• More flexible than forward contract

Capital Budgeting Decision in an International Context

Capital budgeting is the process whereby MNEs determine which projects and countries will receive capital investment funds.

Parent company needs to compare the net present value or internal rate of return of a foreign project with that of its other projects and with that of others available

Unique aspects of capital budgeting for foreign projects• Parent cash flows must be distinguished from project cash flows

• Remittance of funds to the parent affected by differing tax systems, and legal and political constraints on movement of funds

• Differing rates of inflation must be anticipated

• Parent must consider possible changes in exchange rates

• Must evaluate political risk in foreign market

• Terminal value is difficult to estimate

Taxation of Foreign Source Income

International Tax Practices

Taxing Branches and Subsidies

Transfer Prices

Double Taxation and Tax Credit

International Tax Practices

INTERNATIONAL TAX PRACTISES

Difference in Tax Practices

Differences in Types of Taxes

Differences in GAAP

Differences in Tax Rates

Approaches to Corporate Taxation

Separate Entity

Approach

Integrated System

Approach

Taxing Branches and Subsidies

FOREIGN BRANCH• Foreign Branch Income

(or loss) is directly included in the parent’s taxable income

• If the branch suffers a loss, the parent is allowed to deduct that loss from its taxable income, reducing it overall tax liability

FOREIGN SUBSIDIARY• A foreign corporation is an

independent legal entity set up in a country according to the laws of incorporation of that country.

• When an MNE purchases or establishes such an entity, it is called a subsidiary. Subsidiary income is either taxable to the parent or tax deferred (not taxed until it is submitted as a dividend to the parent).

CONTROLLED FOREIGN CORPORATION• The tax status of a subsidiary

depends on whether the subsidiary is a controlled foreign corporation (CFC) and whether the income is active or passive.

• Active income is derived from the direct conduct of a trade or business. Passive, or subpart F income, comes from sources other than those connected with the direct conduct of a trade or business (generally in tax haven countries).

Determining Subsidiary Income

A price on goods and services one member of a corporate family sells to another.

Transfer pricing applies to transactions between related entities and is not usually an arm’s length price (price between two unrelated entities).

Transfer Prices and Taxation• Companies establish arbitrary transfer prices because of differences in

taxation between countries.• The OECD is concerned about how companies manipulate transfer prices

to minimize their tax liability worldwide.

Transfer Prices

Double Taxation and Tax Credit

Value-added tax (VAT) has been in existence since 1967 in most Western European countries. Under a VAT, each company pays a percentage of the value added to a product at each stage of the business process. The EU has worked hard to reduce and standardize VAT rates among its members.

The purpose of tax treaties is to prevent double taxation or to provide remedies when it occurs. When agreeing to a treaty, countries generally grant reciprocal reduction on dividend withholding and exempt royalties, and sometimes interest payments, from any withholding tax.

Tax Treaties Eliminating Double Taxation• The purpose of tax treaties is to prevent double taxation or to provide

remedies when it occurs.

Future: Technology and Cash Flows

• Greater emphasis on moving corporate cash worldwide to take advantage of differing rates of return and minimize tax bills.

• OECD countries are trying to break barriers to bank secrecy.

• Technological innovation will allow companies to transfer funds more quickly worldwide.