HO CHI MINH CITY OPEN UNIVERSITY ADVANCED EDUCATION DEPARTMENT SUBJECT: FINANCIAL MANAGEMENT IN THE INTERNATIONAL BUSINESS HO CHI MINH CITY - 2017 TABLE OF CONTENTS FINANCIAL MANAGEMENT: THE INVESTMENT DECISION Capital Budgeting Project And Parent Cash Flow Adjusting For Political And Economic Risk Political Risk Economic Risk Risk And Capital Budgeting FINANCIAL MANAGEMENT: THE FINANCING DECISION FINANCIAL MANAGEMENT: GLOBAL MONEY MANAGEMENT Minimizing Cash Balances Reducing Transaction Costs Managing The Tax Burden Moving Money Across Borders Dividend Remittances Royalty Payments and Fees Transfer Prices Fronting Loans FINANCIAL MANAGEMENT: THE INVESTMENT DECISION Capital Budgeting Definition: Capital budgeting is the planning process used to determine whether an organization's long term investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash through the firm's capitalization structure (debt, equity or retained earnings) It is the process of allocating resources for major capital, or investment, expenditures steps of the capital budgeting process: Various methods of capital budgeting can include: Payback period (PB), Net Present Value (NPV), Internal Rate of Return (IRR) Why capital budgeting is important? Develop and formulate long-term strategic goals – the ability to set long-term goals is essential to the growth and prosperity of any business The ability to appraise/value investment projects via capital budgeting creates a framework for businesses to plan out future long-term direction Seek out new investment projects – knowing how to evaluate investment projects gives a business the model to seek and evaluate new projects, an important function for all businesses as they seek to compete and profit in their industry Estimate and forecast future cash flows – future cash flows are what create value for businesses overtime Capital budgeting enables executives to take a potential project and estimate its future cash flows, which then helps determine if such a project should be accepted In most cases, the cash flows will be negative at first, because the firm will be investing heavily in production facilities After some initial period, the cash flows will become positive as investment cost decline and revenues grow Facilitate the transfer of information – from the time that a project starts off as an idea to the time it is accepted or rejected, numerous decisions have to be made at various levels of authority The capital budgeting process facilitates the transfer of information to the appropriate decision makers within a company Project And Parent Cash Flow There are ways to measure cash flow: Parent Cash Flow and Project Cash Flow The theoretical perspective asserts that the project should be evaluated from the parent company's viewpoint since dividends and repayment of debt is handled by the parent company The project may not be able to remit all its cash flows to the parents for a number of reasons For example, cash flows may be blocked from repariation by the host-country government, they may be taxed at an unfavorable rate, or the host goverment may require that a certain percentage of the cash flows generated from the project be reinvested within the host nation While these restrictions don't affect the net present value of the project itself, they affect the net presnt value of the project to the parent company because they limit the cash flows that can be remitted to it from the project Today, the problem of blocked earnings is not as serious as it once was the worldwide move toward greater acceptance of free market economics has reduced the number of countries in which government are likely to prohibit the affiliates of foreign multinationals from remitting cash flows to their parent companies Adjusting For Political And Economic Risk Before looking at how capital budgeting can be adjusted to take risks into account, we have to consider the political and economic risks from the foreign location Political Risk It can be defined as 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 The higher political risks get, the more foreign firms will be endangered by the change in coutry’s political environment Political change may result in the unrest or disorder like expropriation In 2014, to object to violation of the oil rig Haiyang 981 which was located on East Vietnam Sea, a thousand de facto employees who worked for Chinese factories in Binh Duong started a protest It soon went wrong, they started to invade factories, demolish euipments and plunder products Moreover, political and social unrest may also result in economic collapse, which can render worthless a firm’s assets In less extreme cases, not only causing the increasing of tax rates, but political changes also cause the imposition of exchange or price controls and the government interference in existing contracts This makes the attractiveness of a foreign investnent opporunity decrease, foreign companies will be not interested in investing in these countries anymore or withdraw their all capital Many firms devote considerable attention to political risk analysis and to quantifying political risk Lots of economic magazine publish an annual “country risk rating” to assess political and other risks However, the prolem is that they just try to forecast the future which is like finding a needle in a haystack There are many events from the past that prove it Nobody could predict the breakup of Soviet Union, the revolution of Iranian in 1979, or the terrorist attacks on 11/9 So forecasting the political risk is just for consulting Economic Risk Like political risk, economic risk should also be discussed before investing in any foreign coutries It can be defined as the likelihood that economic mismanagement will cause drastic changes in a coutry’s business environment that hurt the profit and other goals of a business The biggest risk is the inflation which occur the government try to stimulate economic activity, they expand their domestic money supply immoderately This makes the value of a country’s currency drop, which harm to the assets of foreign firms in that country Therefore, the attractiveness of foregin investment in that country will decrease Many economists also attempts to quatify countries’ economic risk, many “country risk rating” are published annually to forecast the long-term movement in exchange rates Inspite there is the relationship between inflation rates and changed in exchange rate, it’s sill not as close as theory would predict This is not to say that political and economic risk assessment is without value, but it is moere art than science Risk And Capital Budgeting The capital budgeting involces estimating the cash flows associated with the project over time, and then discounting them to determine their net present value So the main question here is how can firms adjust for political and economic risk? There are two ways can handle it effectively: Raise discount rate in countries where risk is high: foreign firms apply 6% discount rate to US but 12% Russia, which means they think US political and economic situation is more stable than Russia The higher the discount rate, the higher the projected net cash flows must be for an investment to have a positive net present value But this method is criticised for penalizing early cash flows too heavily and not penalizing distant cash flows enough Lower future cash flow estimates: it reflects the possibility of adverse political or economic changes sometime in ther future FINANCIAL MANAGEMENT: THE FINANCING DECISION When the comapany want to invest in foreign market, they will consider how the project will be financed It is important to make wise decisions about when, where and how should a business acquire funds If external financing is required, the firms have two choices: the global capital market or sources in the host country And of course, it will want to borrow funds from the lowest-cost source of capital available There is a trend toward borrowing from the global captital market, because it has many advantages The global funds has a lower cost than many domestic capital, it also has convient size and high liquidity, so the international company could easily use it Howerver, in some cases host-country government require or prefer the firm to borrow from the local sources to finace project Not like the global capital, the liquidity of domestic funds in some countries is limmited, this raises the cost of capital used to finance a project But sometimes, the host-government want attract foreign investment, so they offer foreign firms low-interest loans, lowering the cost of capital In addition to the impact of host-government policies on the cost of capital and financing decisions, the firm may wish to consider local debt financing for investments in countries where the local currency is expected to depreciate on the foreign exchange market The amount of local currency required to meet interest payments and retire principal on local debt obligations is not affected when a country's currency depreciates FINANCIAL MANAGEMENT: GLOBAL MONEY MANAGEMENT Money management decisions attempt to manage the firm's global cash resources-its working capitalmost efficiently This involves minimizing cash balances, reducing transaction costs, and minimizing the corporate tax burden Minimizing Cash Balances Every business needs to hold some cash balances for servicing accounts that must be paid and for solving some unpredictable situation when the project was conducted There are two choices for international business about cash balance: whether each foreign subsidiary should hold its own cash balances or whether cash balances should be held at a centralized depository In fact, firms prefer to hold cash balances at a centralized depository for three reasons: First is about the higher interest rate If the company hold cash centrally, it can deposit larger amount so the interest rate will be higher Second, holding cash balances at a centralized depository help the firm easily manage the money The headquater will know how to use the money the most efficiently Third, by pooling its cash reserves, the firm can reduce the total size of the cash pool it must hold in highly liquid accounts, which enables the firm to invest a larger amount of cash reserves in longerterm, less liquid financial instruments that earn a higher interest rate However, a firm's ability to establish a centralized depository that can serve short-term cash needs might be limited by government-imposed restrictions on capital flows across borders (e.g., controls put in place to protect a country's foreign exchange reserves) Also, the transaction costs of moving money into and out of different currencies can limit the advantages of such a system Despite this, many firms hold at least their subsidiaries' precautionary cash reserves at a centralized depository, having each subsidiary hold its own dayto-day-needs cash balance The globalization of the world capital market and the general removal of barriers to the free flow of cash across borders (particularly among advanced industrialized countries) are two trends likely to increase the use of centralized depositories Example: the company has three subsidiaries in Korea, China and Japan: Day-to-Day Cash Needs (A) One Standard Deviation (B) Required Cash Balance (A+3xB) Korea $10 $1 $13 China 12 Japan 12 21 total $28 $6 $46 The totl of the required cash balances for all three subsidiaries when each foreign subsidiary holds its own cash balances is $46 million Now consider what might occur if the firm decided to maintain all three cash balances at a centralized depository in Tokyo Because variances are additive when probability distributions are independent of each other, the standard deviation of the combined precautionary account would be: = √($1,000,0002 + $2,000,0002 + $3,000,0002 ) = √$14,000,000 = $3,741,657 Therefore, if the firm used a centralized depository, it would need to hold $28 million for day-to-day needs plus (3 X $3,741,657) as a precautionary amount, or a total cash balance of $39,224,971 In other words, the firm's total required cash balance would be reduced from $46 million to $39,224,971, a saving of $6,775,029 Reducing Transaction Costs What is “transaction costs”? The cost associated with exchange of goods or services and incurred in overcoming market imperfections Transaction costs cover a wide range: communication charges, legal fees, informational cost of finding the price, quality, and durability, etc., and may also include transportation costs Transaction costs are a critical factor in deciding whether to make a product or buy it Also called frictional cost Every time a firm changes cash from one currency into another currency it must bear a trasa the transaction cost – the commission fee it pays to foreign exchange dealers for performing the trasaction Most banks also charge a transfer fee for moving cash from one location to another; this is another transaction cost How to reduce transaction costs? Multilateral netting allows a multinational firm to reduce the transaction costs that arise when many transactions occur between its subsidiaries by reducing the number of transactions 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 simutaneously owes the French subsidiary $4 million, a bilateral settlement will be made with a single payment of $2 million from the French subsidiary to the Mexican subsidiary, the reamaining debt being canceled Paying Subsidiary Receiving Sibsidiary Korea China Japan Taiwan Total receipt Net receipts (payments) Korean - $3 $4 $5 $12 ($3) Chinese $4 - (2) Japanese - Taiwanese - 13 Total payments $15 $11 $8 $9 $43 $5 Calculation of Net Receipts (all amounts in millions) This is a payment matrix that summarizes the obligations among the subsidiaries Note that $43 million needs to flow among the subsidiaries If the transaction costs ( foreign exchange commissions plus transfer fees) amount to 1% of the total funds to be transferred, this will cost the parent firm $43000 However, this amount can be reduced by multilateral netting Using the payment matrix, the firm can determine the payments that need to be made among its subsidiaries to settle these obligations Managing The Tax Burden Different countire have different tax regimes For example, among developed nations the top rates for corpoorate income tax varies from a high of 40.69% in Japan to a low of 12.5% in Ireland In Germany and Japan, the tax rate is lower on income distributed to stockholders as dividends (36% and 35%, respectively), whereas in Frnace the tax on profits distributed ti stockholders is higher (42%) Many nations follow the worldwide principle that they have the right to tax income earned outside their boundaries by entities based in their country Double taxation occurs when the income of a subsidiary is taxed both by the host-country gorvernment and by the parent company’s home gorvernment However, double taxation is mitigated by tax credits, tax treaties and the deferral principal Tax credits: allows an entity to reuduce the taxes paid to the home government by the amount of taxes paid to the foreign government Tax treaty: an agreement between to countries specifying which items of income will be taxed by the authorities of the country where the in income is earned Deferral principle: specifies that parent companies are not taxed on foreign source income until they actually receive a dividend Some firms use tax havens such as Bahamas and Bermuda to minimize their tax liability It is a country with an exceptionally low, or even no, income tax International businessed avoid or defer income taxes by establishing a wholly owned, nonoperating subsidiary in the tax haven The tax haven subsidiary owns the common stock of the operating foreign subsidairy This allows all transfer of fund from foreign operating subsidiary to the parent company to be funneled through the tax haven subsidiary Moving Money Across Borders Unbundling: A mix of techniques to transfer liquid funds from foreign subsidiary to the parent company without piquing the host-country Firms can transfer liquid funds across border via: 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 The most common method of transferring funds from subsidiaries to the parent is through dividends The relative attractiveness of 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 Royalty Payments and Fees Royalties represent 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 Most parent companies charge subsidiaries royalties for the technology, patents or trade names transferred to them Royalties can be levied as a fixed amount per unit or as a percentage of gross revenues A fee is compensation for professional services or expertise supplied to a foreign subsidiary by the parent company or another subsidiary: Management fees – for general expertise and advice Technical assistance fees – for guidance in technical matters Fees are usually levied as fixed charges for the particular services provided Royalties and fees are often taxdeductible locally - so arranging for payment in royalties and fees will reduce the foreign subsidiary’s tax liability Transfer Prices Multinational firms that conduct business among their cross-border subsidiaries can use taxadvantageous transfer pricing Transfers occur when a company transfers goods or services between its subsidiaries in different countries For example, a firm might design a product in one country, manufacture it in a second country, assemble it in a third country, and then sell it around the world Each time the good or service is transferred between subsidiaries, one subsidiary sells it to the other The question is, what price should be paid? The transfer price is the price that one subsidiary (or subunit of the company) charges another subsidiary (or subunit) for a product or service supplied to that subsidiary Since the pricing taking place is between entities owned by the same parent firm, there’s an opportunity for pricing an item or service at significantly above or below cost in order to gain advantages for the firm overall For example, transfer pricing can be a way to bring profits back to the home country from countries that restrict the amount of earnings that multinational firms can take out of the country In this case, the firm may charge its foreign subsidiary a high price, thus extracting more money out of the country The firm would use a cost-plus markup method for arriving at the transfer price, rather than using market prices Although this practice optimizes results for the company as a whole, it may bring morale problems for the subsidiaries whose profits are impacted negatively from such manipulation In addition, the pricing makes it harder to determine the actual profit which the favored subsidiary would bring to the company without such favored treatment Finally, all the price manipulations need to remain compliant with local regulations In fact, to combat such potential losses of income tax revenue, more than forty countries have adopted transfer-pricing rules and requirements Generally, compliance with local tax regulations means setting prices such that they satisfy the “arm’s length principle.” That is, the prices must be consistent with third-party market results Nonetheless, even within these guidelines, multinational firms can adjust prices to shift income from a higher-tax country to a lower-tax one Governments, of course, are instituting or revising legislation to ensure maximum taxes are collected in their own countries As a result, multinational firms must monitor compliance with local transfer-pricing regulations Fronting Loans A fronting loan is a loan made between a parent company and its subsidiary through a financial intermediary such as a bank The advantage of using fronting loans as a way to lend money, rather than the parent lending the money directly to the subsidiary, is that the parent can gain some tax benefits and bypass local laws that restrict the amount of funds that can be transferred abroad With a fronting loan, the parent deposits the total amount of the loan in the bank The bank then lends the money to the subsidiary For the bank, the loan is risk free, because the parent has provided the money to the bank The bank charges the subsidiary a slightly higher interest rate on the loan than it pays to the parent, thus making a profit The tax advantages of fronting loans come into play if the loan is made by a subsidiary located in a tax haven A tax haven is a country that has very advantageous (i.e., low) corporate income taxes Bermuda is a well-known tax haven The bank pays interest to the tax-haven subsidiary The subsidiary doesn’t pay taxes on that interest because of the tax-haven laws At the same time, the interest paid by the subsidiary receiving the loan is tax deductible For example: 10 ... Capital Budgeting FINANCIAL MANAGEMENT: THE FINANCING DECISION FINANCIAL MANAGEMENT: GLOBAL MONEY MANAGEMENT Minimizing Cash Balances Reducing Transaction... Capital Budgeting The capital budgeting involces estimating the cash flows associated with the project over time, and then discounting them to determine their net present value So the main question... FINANCIAL MANAGEMENT: THE INVESTMENT DECISION Capital Budgeting Definition: Capital budgeting is the planning process used to determine whether an organization's long term investments