© ram mudambi, temple university, 2007 1 lecture 10 financial management in the international...
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© Ram Mudambi, Temple University, 2007 1
Lecture 10Financial Management in the
International Business
© Ram Mudambi, Temple University, 2007 2
Introduction
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.
© Ram Mudambi, Temple University, 2007 3
Investment DecisionsInvestment 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
© Ram Mudambi, Temple University, 2007 4
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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The Internal Capital Market A recent literature has emerged, suggesting that
HQ’s most important function is to run the firm’s ‘internal capital market’
For a subsidiary, this market becomes more important as the external capital market is less developed The project resources exceed the subsidiary’s ability to
provide collateral The external capital market resource flow is
bounded below by zero. This is not the case with the internal capital market
© Ram Mudambi, Temple University, 2007 6
Internal Capital MarketInternal Capital Market
HOST
Subsidiary 1
HOME
Parent
Inflow offinancial resources
Outflow offinancial resources
Re-directedresources toSubsidiary 2
3rd CountrySubsidiary
2
LocalBank
LocalBank
ExternalCapitalmarket
ExternalCapitalmarket
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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.
© Ram Mudambi, Temple University, 2007 8
Euromoney Magazine’s Country Risk Ratings
Overall ScoreOverall Score Political risk Economic performance Debt indicators Debt in default or rescheduled Credit ratings Access to bank finance Access to short-term finance Access to capital markets Forfaiting*
100100 25 25 10 10 10 5 5 5 5
* The purchasing of an exporter's receivables (the amount importers owe the exporter) at a discount by paying cash.
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Euromoney Magazine’s Country Risk Ratings, Sept 2006
Total score = 100CountryCountry (rank)(rank) Risk RatingRisk Rating
Luxembourg (1) 99.651
The U.S. (5) 94.441
Japan (18) 89.056
Bermuda (23) 84.127
Chile (43) 66.257
Argentina (100) 39.237
Iraq (183) 5.172
Number of countries = 185
© Ram Mudambi, Temple University, 2007 10
Financing DecisionsFinancing Decisions (a) Source of financing:
Global capital markets for lower cost financing. 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.
© Ram Mudambi, Temple University, 2007 11
Financing DecisionsFinancing Decisions
HOME
Parent
Re-directedresources toSubsidiary 2
HOSTSubsidiary
2
Global Financial Center
Subsidiary 1
Outflow offinancial resources
GlobalBank
ExternalCapitalmarket
LocalBank
ExternalCapitalmarket
Govt loans
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Financing Decisions (b) 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 its cost of capital.
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0
10
20
30
40
50
60
70
De
bt
Ra
tio
Debt Ratio2003*
%
* All publicly traded companies
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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 Management(The 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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Argentina 35%
Canada 42.1%
Chile 15%
France 35.33
Germany 39.36%
Hong Kong 16%
Ireland 20%
Japan 42%
Mexico 35%
Singapore 25.5%
The U.K. 30%
The U.S. 40%
Corporate Income Tax RatesTop Rate 2001
35%
36.1%
17%
33.33%
38.34%
17.5%
12.5%
30%
29%
20%
30%
35%
Top Rate 2007Top Rate 2007
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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
Subsidiary
Parent•Dividend remittances
•Royalty payments and fees•Transfer Prices•Fronting loans
© Ram Mudambi, Temple University, 2007 18
Dividend Remittances Most common method of transfer.
Dividend varies with:
tax regulations.
Foreign exchange risk.
Age of subsidiary.
Extent of local equity participation.
Dividends
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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
© Ram Mudambi, Temple University, 2007 20
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 Transfer 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.
© Ram Mudambi, Temple University, 2007 22
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
A loan between a parent and subsidiary is channeled through a financial intermediary (bank). Can circumvent host-country restrictions on
remittance of funds from subsidiary to parent. Provides certain tax advantages.
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An Example of the Tax Aspects of a Fronting Loan
Tax Haven
Subsidiary
London Bank
Foreign Operating Subsidiary
Pays 8% Interest (Tax Free)
Pays 9% Interest (Tax Deductible)
Deposit $1 Million
Loan $1 Million
© Ram Mudambi, Temple University, 2007 25
Techniques for Global Money Management Centralized Depositories
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
Day-to-Day Cash Needs (A)
One Standard Deviation
(B)
Required Cash
Balance (A+3xB)
Spain $10 $1 $13
Italy $ 6 $2 $12
Germany $12 $3 $21
Total $28 $6 $46
© Ram Mudambi, Temple University, 2007 27
Techniques for Global Money Management Multilateral Netting
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
German Subsidiary
French Subsidiary
ItalianSubsidiary
SpanishSubsidiary
$4 Million
$1 Million
$3 Million
$2 Million
$5 Million $3 Million$4 Million$5 Million$2 M
illion
$5 Million
$6 Million
$3 Millio
n
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Calculation of Net Receipts($ Million)
Paying SubsidiaryReceiving
Subsidiary
Germany France Spain ItalyTotal Receipts
Net Receipts* (payments)
Germany - $3 $4 $5 $12 ($3)France $4 - 2 3 9 (2)Spain 5 3 - 1 9 1Italy 6 5 2 - 13 4Total payments $15 $11 $8 $9
Net receipts = Total payments - total receipts
© Ram Mudambi, Temple University, 2007 30
Cash Flows after Multilateral Netting
German Subsidiary
French Subsidiary
SpanishSubsidiary
ItalianSubsidiary
Pays $1
Million
Pays $3 MillionPays $1 Million
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Managing Foreign Exchange Risk
Risk that future changes in a country’s exchange rate will hurt the firm. Transaction exposure:extent income from
transactions is affected by currency fluctuations. Translation exposure:impact of currency
exchange rates on consolidated results and balance sheet.
Economic exposure:effect of changing exchange rates over future prices, sales and costs.
Effect
on
Effect
on
flows
flows
Effect on
Effect on
stocksstocks
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Strategies for Reducing Foreign Exchange Risk (a)
Primarily protect short-term cash flows. Reducing transaction and translation exposure:
Buying forward and currency swaps. Lead strategy:collecting receivables early when
currency devaluation is anticipated and paying early when currency may appreciate.
Lag strategy:delaying receivable collection when anticipating currency appreciation and delaying payables when currency depreciation is expected.
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Strategies for Reducing Foreign Exchange Risk (b)
Reducing economic exposure: Key is to distribute productive assets to various
locations so firm is not severely affected by exchange rate changes.
Manufacturing Facility Dispersal
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Managing Foreign Exchange Exposure
No agreement as to how, but commonality of approach does exist: Central control of exposure. Distinguish between transaction/translation
exposure and economic exposure. Forecast future exchange rate movements. Good reporting systems to monitor firm’s exposure
to exchange rate changes. Produce monthly foreign exchange exposure reports.
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An example During the Asian financial crisis, western
MNCs were differentially affected. Research now reveals that those MNCs that
were locally embedded in terms of their financial transactions were better off, compared to those which had central control Dealing with local suppliers in local currency Reduction in the extent of F/X transactions can
help the company.
© Ram Mudambi, Temple University, 2007 36
Takeaways
Global finance is parallel to global logistics Logistics - Managing the dispersion of real assets Finance – Managing the dispersion of financial assets
In MNCs, both functions uniquely impinge on all aspects of firm management Both have an intra-firm and an inter-firm aspect Both have a mechanistic and strategic aspect
• Logistics – minimize costs vs. build competencies
• Finance – minimize taxes vs. managing risk exposure