International business (1)

This text was adapted by The Saylor Foundation under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 License without attribution as requested by the work’s original creator or licensee Saylor URL: http://www.saylor.org/books Saylor.org Organization The overarching logic of the book is intuitive—organized around answers to the what, where, why, and how of international business WHAT? Section one introduces what is international business and who has an interest in it Students will sift through the globalization debate and understanding the impact of ethics on global businesses Additionally, students will explore the evolution of international trade from past to present, with a focus on how firms and professionals can better understand today’s complex global business arena by understanding the impact of political and legal factors The section concludes with a chapter on understanding how cultures are defined and the impact on business interactions and practices with tangible tips for negotiating across cultures WHERE? Section two develops student knowledge about key facets of the global business environment and the key elements of trade and cooperation between nations and global organizations Today, with increasing numbers of companies of all sizes operating internationally, no business or country can remain an island Rather, the interconnections between countries, businesses, and institutions are inextricable Even how we define the world is changing No longer classified into simple and neat categories, the rapid changes within countries are redefining how global businesses think about developed, developing, and emerging markets This section addresses the evolving nature of country classifications and helps develop a student’s ability to comprehend the rationale of how to analyze a specific country’s stage of development—rather than just memorize which countries are emerging Further, this section provides a unique approach and takes country-related “deep dives” that give greater detail about specific key countries This section ends with chapters devoted to providing accessible discussions of complex financial concepts within the global monetary system and the global capital markets, including currency and global venture capital WHY? Section three develops knowledge about how a student or organization can exploit opportunities in that global environment Students will learn about the fundamental choices they have in terms of international expansion and why such choices matter Using different models of internationalization and Saylor URL: http://www.saylor.org/books Saylor.org global market assessment, they will also learn why international business opportunities vary in their promise and complexity In this section, students also a deeper dive into the topics of exporting, importing, and global sourcing since these are likely to be the first forms of international business a student will encounter HOW? Section four is devoted to strategy and entrepreneurship in a flattening world and how key organizational activities can be managed for global effectiveness This part of the book shifts gears from the perspective of existing businesses to that of new business possibilities Our objective is to highlight strategy, entrepreneurship, and strategic and entrepreneurial opportunities in a flat and flattening world Beyond the basics of international strategy and entrepreneurship, students will be exposed to international human resource management so that they can better understand the global war for talent They will also develop good fundamental knowledge of international research and development, marketing, distribution, finance, and accounting Features Each chapter contains several staple and innovative features as follows: • opening cases—cases that are relatively timeless from an international business perspective and current and topical • sidebars titled “Did You Know”—factoids about international business • sidebars titled “Amusing Anecdote”—factoids about global marketing snafus and other mistakes coupled with related key international business facts • sidebars titled “An Eye on Ethics,” which provide examples of the ethical issues that arise in international business • chapter summaries • end of chapter exercises based on AACSB learning standards—these exercises include review questions, experiential exercises, ethical dilemmas, and exercises related to the opening chapter case • a closing section titled “Tools in Your Walkabout Kit” with specific and practical tools related to international business Saylor URL: http://www.saylor.org/books Saylor.org • supplemental support materials by chapter As you’d expect, our textbook also provides a set of end-of-chapter questions that are mapped to AACSB learning standards, such that the instructor will be able to measure how well students are grasping course content while ensuring alignment with the AACSB guidelines We recognize that you have choices on textbooks for your course, but hope that our innovative approach to both essential global business content and technology delivery options will encourage you to join our revolution Saylor URL: http://www.saylor.org/books Saylor.org Chapter Introduction WHAT’S IN IT FOR ME? What is international business? Who has an interest in international business? What forms international businesses take? What is the globalization debate? What is the relationship between international business and ethics? This chapter introduces you to the study of international business After reading a short case study on Google Inc., the Internet search-engine company, you’ll begin to learn what makes international business such an essential subject for students around the world Because international business is a vital ingredient in strategic management and entrepreneurship, this book uses these complementary perspectives to help you understand international business Managers, entrepreneurs, workers, for-profit and nonprofit organizations, and governments all have a vested interest in understanding and shaping global business practices and trends Section 1.1 "What Is International Business?" gives you a working definition of international business; Section 1.2 "Who Is Interested in International Business?" helps you see which actors are likely to have a direct and indirect interest in it You’ll then learn about some of the different forms international businesses take; you’ll also gain a general understanding of the globalization debate This debate centers on (1) whether the world is flat, in the sense that all markets are interconnected and competing unfettered with each other, or (2) whether differences across countries and markets are more significant than the commonalities In fact, some critics negatively describe the “world is flat” perspective as globaloney! What you’ll discover from the discussion of this debate is that the world may not be flat in the purest sense, but there are powerful forces, also called flatteners, at work in the world’s economies Section 1.5 "Ethics and International Business" concludes with an introductory discussion of the relationship between international business and ethics Opening Case: Google’s Steep Learning Curve in China Of all the changes going on in the world, the Internet is the one development that many people believe makes our world a smaller place—a flat orflattening world, according to Thomas Friedman, Pulitzer Saylor URL: http://www.saylor.org/books Saylor.org Prize–winning author of The World Is Flat: A Brief History of the Twenty-First Century andThe Lexus and the Olive Tree: Understanding Globalization Because of this flattening effect, Internet businesses should be able to cross borders easily and profitably with little constraint However, with few exceptions, cross-border business ventures always seem to challenge even the most able of competitors, Internetbased or not Some new international ventures succeed, while many others fail But in every venture the managers involved can and learn something new Google Inc.’s learning curve in China is a case in point In 2006, Google announced the opening of its Chinese-language website amid great fanfare While Google had access to the Chinese market through Google.com at the time, the new site, Google.cn, gave the company a more powerful, direct vehicle to further penetrate the approximately 94 million households with Internet access in China As company founders Larry Page and Sergey Brin said at the time, “Unfortunately, access for Chinese users to the Google service outside of China was slow and unreliable, and some content was restricted by complex filtering within each Chinese ISP Ironically, we were unable to get much public or governmental attention paid to the issue Although we dislike altering our search results in any way, we ultimately decided that staying out of China simply meant diminishing service and influence there Building a real operation in China should increase our influence on market practices and certainly will enhance our service to the Chinese people.” [1] A Big Market, Bigger Concerns Google’s move into China gave it access to a very large market, but it also raised some ethical issues Chinese authorities are notorious for their hardline censorship rules regarding the Internet They take a firm stance against risqué content and have objected to The Sims computer game, fearing it would corrupt their nation’s youth Any content that was judged as possibly threatening “state security, damaging the nation’s glory, disturbing social order, and infringing on other’s legitimate rights” was also [2] banned When asked how working in this kind of environment fit with Google’s informal motto of “Don’t be evil” and its code-of-conduct aspiration of striving toward the “highest possible standard of ethical business,” Google’s executives stressed that the license was just to set up a representative office in Beijing Saylor URL: http://www.saylor.org/books Saylor.org and no more than that—although they did concede that Google was keenly interested in the market As reported to the business press, “For the time being, [we] will be using the [China] office as a base from which to conduct market research and learn more about the market.” [3] Google likewise sidestepped the ethical questions by stating it couldn’t address the issues until it was fully operational in China and knew exactly what the situation was One Year Later Google appointed Dr Kai-Fu Lee to lead the company’s new China effort He had grown up in Taiwan, earned BS and PhD degrees from Columbia and Carnegie Mellon, respectively, and was fluent in both English and Mandarin Before joining Google in 2005, he worked for Apple in California and then for Microsoft in China; he set up Microsoft Research Asia, the company’s research-and-development lab in Beijing When asked by a New York Timesreporter about the cultural challenges of doing business in China, Lee responded, “The ideals that we uphold here are really just so important and noble How to build stuff that users like, and figure out how to make money later And ‘Don’t Do Evil’ [referring to the motto ‘Don’t be evil’] All of those things I think I’ve always been an idealist in my heart.” [4] Despite Lee’s support of Google’s utopian motto, the company’s conduct in China during its first year seemed less than idealistic In January, a few months after Lee opened the Beijing office, the company announced it would be introducing a new version of its search engine for the Chinese market Google’s representatives explained that in order to obey China’s censorship laws, the company had agreed to remove any websites disapproved of by the Chinese government from the search results it would display For example, any site that promoted the Falun Gong, a government-banned spiritual movement, would not be displayed Similarly (and ironically) sites promoting free speech in China would not be displayed, and there would be no mention of the 1989 Tiananmen Square massacre As one Western reporter noted, “If you search for ‘Tibet’ or ‘Falun Gong’ most anywhere in the world on google.com, you’ll find thousands of blog entries, news items, and chat rooms on Chinese repression Do the same search inside China on google.cn, and most, if not all, of these links will be gone Google will have erased them completely.” Saylor URL: http://www.saylor.org/books [5] Saylor.org Google’s decision didn’t go over well in the United States In February 2006, company executives were called into congressional hearings and compared to Nazi collaborators The company’s stock fell, and protesters waved placards outside the company’s headquarters in Mountain View, California Google wasn’t the only American technology company to run aground in China during those months, nor was it the worst offender However, Google’s executives were supposed to be different; given their lofty motto, they were supposed to be a cut above the rest When the company went public in 2004, its founders wrote in the company’s official filing for the US Securities and Exchange Commission that Google is “a company that is trustworthy and interested in the public good.” Now, politicians and the public were asking how Google could balance that with making nice with a repressive Chinese regime and the Communist Party behind it [6] One exchange between Rep Tom Lantos (D-CA) and Google Vice President Elliot Schrage went like this: Lantos: You have nothing to be ashamed of? I am not ashamed of it, and I am not proud of it…We have taken a path, we have begun on a path, we have done a path that…will ultimately benefit all the users in China If we determined, congressman, as a result of changing circumstances or as a result of the implementation of the Google.cn program that we are not achieving those results then we will assess our performance, our [7] Schrage: ability to achieve those goals, and whether to remain in the market See the video “Google on Operating inside China” athttp://news.cnet.com/1606-2-6040114.html In the video, Schrage, the vice president for corporate communications and public affairs, discusses Google’s competitive situation in China Rep James Leach (R-IA) subsequently accuses Google of becoming a servant of the Chinese government Google Ends Censorship in China In 2010, Google announced that it was no longer willing to censor search results on its Chinese service The world’s leading search engine said the decision followed a cyberattack that it believes was aimed at gathering information on Chinese human rights activists Saylor URL: http://www.saylor.org/books [8] Google also cited the Chinese government’s Saylor.org [9] restrictions on the Internet in China during 2009 Google’s announcement led to speculation whether Google would close its offices in China or would close Google.cn Human rights activists cheered Google’s move, while business pundits speculated on the possibly huge financial costs that would result from losing access to one of the world’s largest and fastest-growing consumer markets In an announcement provided to the US Securities and Exchange Commission, Google’s founders summarized their stance and the motivation for it Below are excerpts from Google Chief Legal Officer David Drummond’s announcement on January 12, 2010 [10] Like many other well-known organizations, we face cyberattacks of varying degrees on a regular basis In mid-December, we detected a highly sophisticated and targeted attack on our corporate infrastructure originating from China, resulting in the theft of intellectual property from Google However, it soon became clear that what at first appeared to be solely a security incident—albeit a significant one—was something quite different First, this attack was not just on Google As part of our investigation, we have discovered that at least twenty other large companies from a wide range of businesses—including the Internet, finance, technology, media, and chemical sectors—have been similarly targeted We are currently in the process of notifying those companies, and we are also working with the relevant US authorities Second, we have evidence to suggest that a primary goal of the attackers was accessing the Gmail accounts of Chinese human rights activists Based on our investigation to date, we believe their attack did not achieve that objective Only two Gmail accounts appear to have been accessed, and that activity was limited to account information (such as the date the account was created) and subject line, rather than the content of emails themselves Third, as part of this investigation but independent of the attack on Google, we have discovered that the accounts of dozens of US-, China- and Europe-based Gmail users who are advocates of human rights in China appear to have been routinely accessed by third parties These accounts have not been accessed Saylor URL: http://www.saylor.org/books Saylor.org through any security breach at Google, but most likely via phishing scams or malware placed on the users’ computers We have taken the unusual step of sharing information about these attacks with a broad audience, not just because of the security and human rights implications of what we have unearthed, but also because this information goes to the heart of a much bigger global debate about freedom of speech In the last two decades, China’s economic reform programs and its citizens’ entrepreneurial flair have lifted hundreds of millions of Chinese people out of poverty Indeed, this great nation is at the heart of much economic progress and development in the world today The decision to review our business operations in China has been incredibly hard, and we know that it will have potentially far-reaching consequences We want to make clear that this move was driven by our executives in the United States, without the knowledge or involvement of our employees in China who have worked incredibly hard to make Google.cn the success it is today We are committed to working responsibly to resolve the very difficult issues raised The Chinese government’s first response to Google’s announcement was simply that it was “seeking more information.” [11] In the interim, Google “shut down its censored Chinese version and gave mainlanders an uncensored search engine in simplified Chinese, delivered from its servers in Hong Kong.” [12] Like most firms that venture out of their home markets, Google’s experiences in China and other foreign markets have driven the company to reassess how it does business in countries with distinctly different laws Opening Case Exercises (AACSB: Ethical Reasoning, Multiculturalism, Reflective Thinking, Analytical Skills) Can Google afford not to business in China? Which stakeholders would be affected by Google’s managers’ possible decision to shut down its China operations? How would they be affected? What trade-offs would Google be making? Should Google’s managers be surprised by the China predicament? Saylor URL: http://www.saylor.org/books Saylor.org 10 explaining, and before long, people at headquarters will really understand what’s going on in this market.” [9] Hybrid Financial Organization Structures Finally, multinational companies follow a hybrid of centralized financial operations for some tasks and regional operations for others Before it was acquired by Hewlett-Packard (HP) in April 2010, network switching and routing solutions company 3Com had centralized specific operations in its North America shared service center (SSC) The North America SSC provided a number of accounting services globally Although the US-based SSC had a much higher cost of labor than Singapore (where 3Com offshored transaction-based processes), 3Com decided to keep higher-value services in the North America SSC due to 3Com’s assessment of the risk and complexity in comparison to the anticipated benefit of moving these from one global center to another Some of the tasks retained by the North American SSC were worldwide consolidation, worldwide intercompany accounting, and external reporting The following processes have been performed in each region (i.e., Europe, the Middle East, and Africa [EMEA]; North America; Latin America; and Asia-Pacific) due to language and local knowledge issues: • Regional general ledger • Regional revenue accounting • Local field finance accounting • Regional and local payroll • Regional and local value-added tax (VAT) and good-and-services tax (GST) compliance and reporting [10] 3Com also assigned local field finance managers to be key shared accounting services team members located in the company’s higher-risk countries to help ensure compliance with local legal, statutory, tax, and reporting requirements and to help with enforcement and communication of corporate policies locally Their responsibilities include the following: • Ensuring all statutory and tax (direct and indirect) filings are completed in accordance with local country requirements Saylor URL: http://www.saylor.org/books Saylor.org 716 • Liaising with local external auditors, tax authorities, and outsource agencies to ensure the proper execution of payroll and employee disbursements • Communicating and enforcing corporate accounting policies to local employees • Ensuring appropriate accounting for local accruals by liaising with local marketing and sales teams to determine if services related to outstanding purchase orders have been provided [11] Did You Know? What does the job description for a treasury operations manager look like? The tasks of a manager overseeing international-unit financial management include • managing foreign exchange exposures, hedging, accounting compliance, multilateral netting, and multilateral cash pool; • driving collection, disbursement, concentration and cash accounting, and domestic debt-portfolio management; • performing cost review and analysis of monthly cash management; • assisting the treasurer in bank coordination, agreement negotiations, and renewals; • modeling financial transaction scenarios for capital budgeting and planning analysis (i.e., debt, equity, and other capital market transactions); • preparing, reviewing, and maintaining Sarbanes-Oxley controls; and • delivering and coordinating cash forecasts with bank-funding needs and regulatory capital requirements The Impact of Religion: Islamic Finance Companies operating in countries where Islam is the official religion, such as Malaysia, Saudi Arabia, Kuwait, Bahrain, and Yemen, must adhere to Islamic finance laws Islamic law prohibits certain financial practices that are common in other countries For example, Islamic law (called Sharia) prohibits charging interest on money No interest can be charged, including fixed-rate, floating, simple, or compounded interest, at whatever rate The Sharia also prohibits financial practices like speculation, conventional insurance, and derivatives, because they’re considered gambling in the Islamic tradition Sharia also prohibits gharar, which means “uncertainty” and includes conventional practices like short selling Saylor URL: http://www.saylor.org/books Saylor.org 717 To overcome these prohibitions, financial products must be Sharia compliant There are approved alternatives to interest and speculative investments For example, instead of lending money and charging interest, banks can lend money and earn profits by charging rentals on the asset leased to the customer One alternative investment strategy, musharakah, allows profit and loss sharing It’s a partnership wherein profits are shared per an agreed-on ratio and losses are shared in proportion to the capital or investment of each partner A mudarabahis an investment partnership, whereby the investor provides capital to another party or entrepreneur in order to undertake a business or investment activity While profits are shared on an agreed-on ratio, loss of investment is born only by the investor The [12] entrepreneurs only lose their share of the expected income These investment arrangements demonstrate the Sharia’s risk-sharing philosophy—the lender must share in the borrower’s risk Since fixed, predetermined interest rates guarantee a return to the lender and fall disproportionately on the borrower, they are seen as exploitative, socially unproductive, and economically wasteful The preferred mode of financing is profit and loss sharing Islamic finance law extends to mutual funds, securities firms, insurance companies, and other nonbanks A growing number of conventional financial institutions, both inside and outside the Islamic world, have in recent years created Islamic subsidiaries or have been offering Islamic “windows” or products in addition to conventional ones [13] KEY TAKEAWAYS • Political and economic risks arise when a country lacks a long history or commitment to the rule of law Companies can prepare for volatility by thinking through “unthinkable” scenarios and planning how they would respond if such situations occurred • Multinational firms can organize their financial operations in a centralized, decentralized, or hybrid organization structure The advantages of a centralized structure are that the company can afford to hire and retain specialized staff who have deep expertise and can bring savings to the company through centralized cash management and more efficient capital investment Centralization also enables the firm to gain economies of scale for investment and borrowing activities that will reduce transaction costs and get the firm the most competitive pricing On the other hand, a decentralized financial organization structure allows the firm to recognize the variations in language, customs, cultures, business practices, Saylor URL: http://www.saylor.org/books Saylor.org 718 rules, laws, and regulations among different countries A decentralized structure lets multinational firms exploit local knowledge and business conditions to deal with uncertainty • It’s important for regional CFOs to stay in regular contact with corporate headquarters to alert headquarters to opportunities (or warn them of dangers) in their countries • Islamic countries practice Sharia—the prohibition of charging interest on money There are approved, Sharia-compliant alternatives to interest and speculative investments For example, instead of lending money and charging interest, banks can lend money and earn profits by charging rentals on the asset leased to the customer One alternative investment strategy,musharakah, allows profit and loss sharing It’s a partnership wherein profits are shared per an agreed-on ratio and losses are shared in proportion to the capital or investment of each partner EXERCISES (AACSB: Reflective Thinking, Analytical Skills) Name two ways that companies can prepare or deal with political risk or volatility in a country What advantages does a decentralized financial organization structure bring to a multinational firm? What advantages does a centralized financial organization structure bring? Why are frequent communications between a regional CFO and headquarters important? How might religion impact financing operations? [1] Renée Dye and Elizabeth Stephenson, “Five Forces Reshaping the Global Economy: McKinsey Global Survey Results,” McKinsey Quarterly, May 2010, accessed November 23, 2010,http://www.mckinseyquarterly.com/Five_forces_reshaping_the_global_economy_McKinsey_Global_Survey_ results_2581 [2] Rik Kirkland, “China’s State Capitalism and Multinationals: An Interview with the President of Eurasia Group,” McKinsey Quarterly, May 2010, accessed November 23, 2010,http://www.mckinseyquarterly.com/Chinas_state_capitalism_and_multinationals_An_interview_with_the_p resident _of_Eurasia_Group_2583 [3] Lowell Bryan, “Globalization’s Critical Imbalances,” McKinsey Quarterly, June 2010, accessed October 28, 2010,http://www.mckinseyquarterly.com/Globalizations_critical_imbalances_2624 Saylor URL: http://www.saylor.org/books Saylor.org 719 [4] Harjeet S Bhabra, Tong Liu, and Dogan Tirtiroglu, “Capital Structure Choice in a Nascent Market,” Financial Management, June 22, 2008, accessed November 25, 2010,http://www.allbusiness.com/company-activitiesmanagement/company-structures-ownership/11673477-1.html [5] Don Durfee, “Local Knowledge,” CFO, November 1, 2008, accessed August 12, 2010,http://www.cfo.com/printable/article.cfm/12465219 [6] Renée Dye and Elizabeth Stephenson, “Five Forces Reshaping the Global Economy: McKinsey Global Survey Results,” McKinsey Quarterly, May 2010, accessed November 23, 2010,http://www.mckinseyquarterly.com/Five_forces_reshaping_the_global_economy_McKinsey_Global_Survey_ results_2581 [7] Renée Dye and Elizabeth Stephenson, “Five Forces Reshaping the Global Economy: McKinsey Global Survey Results,” McKinsey Quarterly, May 2010, accessed November 23, 2010,http://www.mckinseyquarterly.com/Five_forces_reshaping_the_global_economy_McKinsey_Global_Survey_ results_2581 [8] Sheila Shayon, “Luxottica Envisions Future of Retail,” Brand Channel, July 22, 2010, accessed November 26, 2010,http://www.brandchannel.com/home/post/2010/07/22/Luxottica-Eye-Hub-Retail-Concept.aspx [9] Don Durfee, “Local Knowledge,” CFO, November 1, 2008, accessed August 12, 2010,http://www.cfo.com/printable/article.cfm/12465219 [10] Phil Searle and Fraser Kirk, “Expanding Geographic Scope and Setting Up a Truly Global Process Model,” Shared Services & Outsourcing Network 5, no (January 2004), accessed November 23, 2010, http://www.ssonetwork.co.uk/topic_detail.aspx?id=194&ekfrm=50 [11] Phil Searle and Fraser Kirk, “Expanding Geographic Scope and Setting Up a Truly Global Process Model,” Shared Services & Outsourcing Network 5, no (January 2004), accessed November 23, 2010, http://www.ssonetwork.co.uk/topic_detail.aspx?id=194&ekfrm=50 [12] “Introduction to Islamic Financing,” HSBC Amanah, accessed August 14, 2010,http://www.assetmanagement.hsbc.com/gam/attachments/mena/amanah/islamic_invest.pdf [13] Ibrahim Warde, Islamic Finance in the Global Economy (Edinburgh, UK: Edinburgh University Press, 2000) Saylor URL: http://www.saylor.org/books Saylor.org 720 15.5 Global Money Management: Moving Money across Borders LEARNING OBJECTIVES Understand the role of global money management in a multinational firm Know how multilateral netting and transfer pricing can be used to minimize transaction costs and taxes for the firm Appreciate the efficiencies and savings that result from centralized depositories Global Money Management and Centralized Depositories Global money management involves moving money across borders and managing the firm’s financial resources in a way that minimizes taxes and transaction fees while maximizing the firm’s returns A multinational company can make the most of its cash reserves by holding cash balances at a central location, called a centralized depository There are two main advantages of centralized depositories: The company earns a higher interest on higher amounts of cash, because cash from across the company is pooled Pooling cash reserves reduces the total amount of cash that the company needs to hold, because the amount of cash held on hand as a precautionary measure against the unexpected can be pooled and thus reduced—it’s unlikely that all the worst cases will happen simultaneously Centralized money management also lets a company trade currencies between its subsidiaries and thereby eliminate intermediaries like banks This practice saves the firm transaction costs Centralization also means that the company can buy currencies in larger lot sizes, which gives it a better price Two facts are important to keep in mind when using the centralized depository technique for global cash management First, a government can restrict how much capital can flow out of the country (governments this to preserve foreign exchange reserves) Second, there are transaction costs associated with moving money across borders, and these costs are incurred each time the money is moved Cash Management Saylor URL: http://www.saylor.org/books Saylor.org 721 Companies need to be aware of differences in local cash practices For example, business customers in Asia often pay their invoices via bank draft—a common method there, but almost unheard of in the United States This approach typically means a company gets its cash slowly, creating potential workingcapital problems “If you sell to a customer on 30-day terms and on day 29 they give you a bank draft, that’s three months more you’ll have to wait,” said Brian Kenny, CFO of specialty chemicals materials company W R Grace’s Asia-Pacific division [1] Multilateral Netting Multilateral netting is a technique which companies use to reduce the costs of cross-border payments between subsidiaries Three or more subsidiaries must participate (If only two participate, the technique is known as bilateral netting.) For example, let’s say a firm’s subsidiary in the Czech Republic owes the Australian subsidiary $4 million, while the Australian subsidiary owes the Czech subsidiary $10 million Rather than the Czech subsidiary transferring $4 million and the Australian transferring $10 million, the parties agree to one payment in which the Australian subsidiary pays the Czech $6 million Both payments are thus satisfied The total funds that flowed between the subsidiaries are reduced from $14 million to $6 million, reducing costs For example, if the transaction costs (i.e., the foreign exchange commission plus the transfer fees) are percent of the total funds transferred, the transaction costs in this example drop from $140,000 to $60,000 In cases where multiple subsidiaries trade amongst each other, the savings are even more significant For example, if four subsidiaries each trade with three other subsidiaries, the total number of transactions can be reduced from twelve to three, which reduces transaction costs substantially In a real-life example, Colgate-Palmolive operates in 218 countries Much of its manufacturing operations are centralized rather than being located in numerous countries around the world As a result, subsidiaries a lot of business with each other Colgate headquarters requires that all subsidiaries submit and settle their payments to each other on the same day By directing all settlements to one day, Colgate maximizes the benefits of multilateral netting and saves on the spread This reduces the transaction costs as well as the risk of currency fluctuations [2] Did You Know? Saylor URL: http://www.saylor.org/books Saylor.org 722 According to a survey of almost five hundred CFOs and controllers from US-based companies, the following are the top concerns regarding international taxes: • Cost of complying with international taxes (31 percent of respondents) • Transfer pricing (28 percent) • Repatriation of offshore earnings (21 percent) • Risk management in developing countries (14 percent) • Mergers and acquisitions transactions (5 percent) [3] Tax Advantages of 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 Transfer Pricing 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 Saylor URL: http://www.saylor.org/books Saylor.org 723 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 [4] 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 The test of fairness is, “What would an independent company, operating in a competitive market, charge for performing comparable services or selling similar products?” [5] 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 [6] Indirect Taxes One way that governments respond to budget shortfalls is by imposing or increasing indirect taxes like the value-added tax (VAT) and goods-and-services tax (GST) The reach of these indirect taxes is extending Saylor URL: http://www.saylor.org/books Saylor.org 724 into new areas of the global economy “The slow economy and falling direct-tax rates are causing many governments worldwide to tighten their existing indirect-tax regimes or introduce new ones,” said Frank Sangster, a principal in KPMG’s US Indirect Tax practice “Finance and tax directors must be proactive in considering how their organizations are responding to the global VAT changes, which are already affecting their markets, operations and internal systems.” [7] More countries are coming to rely on VAT as a significant and stable source of tax revenue, so these taxes are unlikely to diminish China and India are considering introducing national VAT systems for the first time, while European Union (EU) countries might be looking at ways to raise more revenue through VAT International companies can assess and manage the risks and opportunities of new VAT systems by using merging technologies to increase automation of the indirect tax process, deciding whether to insource or outsource new compliance obligations, and using modeling techniques to assess the impact of local VAT changes [8] Manufacturing shoes in China for the Chinese market is subject to a 17 percent VAT, for example, but shoes for export aren’t subject to this tax In some cases, it may be cheaper to make the shoes in China, export them to Hong Kong, reimport them into China, and pay import duties instead of VAT Local import/export regulations can also impact where companies decide to locate specific functions of the supply chain, such as distribution centers or warehouses In Fujian province, one can import materials one day and export the output the next day In Guangdong province, in contrast, the local authorities insist on thirty days’ notice for reexported materials The point is that each emerging-market country and even each region in an emerging-market country can have its own interplay of taxes, duties, and regulatory delays that affect how companies design their operations and the margins they’re able achieve Did You Know? Colombia and Indirect Taxes To attract business process outsourcing (BPO) vendors to Colombia, the country eliminated the VAT tax on BPO service exports This makes it more attractive to locate offshoring services in Colombia Local governments also created two free-trade zones in Bogotá and Medellín specifically for BPO, providing state-of-the-art infrastructure and services to companies that settle there Saylor URL: http://www.saylor.org/books [9] Saylor.org 725 KEY TAKEAWAYS • Global money management involves moving money across borders and managing the firm’s financial resources in a way that minimizes taxes and transaction fees while maximizing the firm’s returns • Companies can use multilateral netting as a way to reduce the costs of cross-border payments between subsidiaries They can also use fronting loans to gain tax advantages • The transfer price is the prices at which subsidiaries or affiliates of the same firm sell goods or services to each other When subsidiaries are located in countries with different tax rates, opportunities exist to move income to a lower-taxing jurisdiction Firms can manipulate transfer prices to reduce global tax liabilities • A multinational company can make the most of its cash reserves by holding cash balances at a central location, called a centralized depository, thus earning higher interest and being able to reduce the total amount of cash reserves held on hand However, the two downsides of centralized depositories are that governments can restrict how much capital flows out of their country and transaction costs are incurred each time money is moved across borders EXERCISES (AACSB: Reflective Thinking, Analytical Skills) How can local cash practices in a country affect a subsidiary’s cash flow? What are some advantages that multinational firms gain from centralized depositories? Explain multilateral netting and how it can reduce transaction costs Why would a company choose to a fronting loan? What are the challenges of transfer pricing? [1] Don Durfee, “Local Knowledge,” CFO, November 1, 2008, accessed August 12, 2010,http://www.cfo.com/printable/article.cfm/12465219 [2] Kabir Masson, “‘Managing International Financial Risk’: A Presentation by Hans L Pohlschroeder,” Columbia Business School Chazen Web Journal of International Business, February 24, 2009, accessed November 23, 2010,http://www1.gsb.columbia.edu/mygsb/faculty/research/pubfiles/3386/Managing%20International%20Finan cial%20Risk%2Epdf Saylor URL: http://www.saylor.org/books Saylor.org 726 [3] Marie Leone, “Tax Sticklers, Not Schemers,” CFO, May 26, 2010, accessed October 28, 2010, http://www.cfo.com/printable/article.cfm/14501223 Saylor URL: http://www.saylor.org/books Saylor.org 727 15.6 End-of-Chapter Questions and Exercises These exercises are designed to ensure that the knowledge you gain from this book about international business meets the learning standards set out by the international Association to Advance Collegiate Schools of Business (AACSB International) [1] AACSB is the premier accrediting agency of collegiate business schools and accounting programs worldwide It expects that you will gain knowledge in the areas of communication, ethical reasoning, analytical skills, use of information technology, multiculturalism and diversity, and reflective thinking EXPERIENTIAL EXERCISES (AACSB: Communication, Use of Information Technology, Analytical Skills) You’ve been tasked with obtaining financing for your subsidiary in Brazil Of all the sources of financing you’ve learned about in this chapter, which sources of financing would you explore? Would you consider equity financing in the Brazilian stock exchange? What factors would you research before making this financing decision? Go to http://www.oanda.com to check the current value of the US dollar relative to the euro Compare this exchange rate to the exchange rate one year ago Imagine that you are an executive in a multinational firm that will be manufacturing components at a Chinese subsidiary and selling those components to a US subsidiary that will assemble the components into finished goods and then sell them to a Portuguese subsidiary to sell to European markets What actions would you take to mitigate currency risk? You are the treasury operations manager for a multinational company You’ve been tasked with recommending a cash-investment strategy that will maximize a return on the cash and maintain the liquidity needed for emergencies Using what you’ve learned about centralized depositories, multilateral netting, fronting loans, tax havens, and transnational investment, what recommendations would you make? Ethical Dilemmas (AACSB: Ethical Reasoning, Multiculturalism, Reflective Thinking, Analytical Skills) Coca-Cola operates thirty-nine bottling plants in China [2] China is an important market for Coca- Cola The company’s sales in volume grew 19 percent in China in 2009 while declining percent in the Saylor URL: http://www.saylor.org/books Saylor.org 728 United States Coca-Cola also hopes to expand its business into the juice, dairy, and ready-to-drink markets It had offered $2.3 billion to buy Chinese company China Huiyuan Juice to get a strong (20 percent) share in China’s juice market Chinese regulators, however, rejected the deal In 2004, CocaCola was forced to shut down one of its bottling plants in south India after community organizers blamed it for causing water shortages there (A year earlier PepsiCo’s plant in the same state also lost its operating license for similar reasons.) Coca-Cola is now partnered with the World Wildlife Fund (WWF) to improve the water quality of the Yangtze River, which is the longest river in Asia and supplies 35 percent of China’s water but is now the most threatened river in the world due to pollution Coca-Cola is working with rural farmers, for example, to reduce runoff from animal waste into the river by turning it into biogas for cooking and heating instead The company has pledged $24 million over seven years to support fresh-water programs globally It’s also striving to be “water neutral” by making its “waste” water pure enough for agricultural irrigation and completely offsetting the amount of water it uses in its soft-drink products by funding clean-water projects and watershed preservation efforts around the world What you think of these moves by Coca-Cola? On the one hand, as the world’s largest beverage company, its water-neutral plan could make a big difference, and its clout brings attention to the world water issue On the other hand, bringing attention to the issue could put the spotlight on the company itself, which uses 2.5 liters of water to make a liter of Coke In fact, when looking across the whole supply chain, 200 liters of water go into making a single liter of Coke (due to water-intensive sugar cane crops) However, looked at from an entire-chain perspective, it takes 140 liters of water to make a cup of coffee and 800 to 1,000 gallons of water to get a single gallon of milk [3] If you were a Chinese consumer, would you be more likely to buy Coca-Cola products given the company’s efforts to clean up the Yangtze River? If you were an executive at CocaCola, what actions or programs would you recommend or support? As you learned in , transfer pricing is legal, and firms can manipulate transfer prices to avoid taxes The practice, however, violates the spirit of the law in some countries Should firms engage in this practice? On the other hand, by not taking advantage of these opportunities, would firms be shortchanging their investors? Saylor URL: http://www.saylor.org/books Saylor.org 729 [1] Association to Advance Collegiate Schools of Business website, accessed January 26, 2010, http://www.aacsb.edu [2] “Coca-Cola on the Yangtze: A Corporate Campaign for Clean Water in China,”Knowledge@Wharton, August 18, 2010, accessed August 25, 2010,http://knowledge.wharton.upenn.edu/article.cfm?articleid=2568 [3] Peter M Senge, The Necessary Revolution (New York: Doubleday, 2008), 77–92 Saylor URL: http://www.saylor.org/books Saylor.org 730 ... be international businesses The Forms of International Business It probably doesn’t surprise you that international businesses can take on a variety of forms Recognizing that international business, ... What is international business? Who has an interest in international business? What forms international businesses take? What is the globalization debate? What is the relationship between international. .. Saylor.org 11 1.1 What Is International Business? LEARNING OBJECTIVES Know the definition of international business Comprehend how strategic management is related to international business Understand