Chapter Twenty Financial Management in the International Business 20 - Scope of Financial Management • Scope of financial management includes three sets of related decisions: • Investment decisions - Decisions about what activities to finance • Financing decisions - Decisions about how to finance those activities • Money management decisions - Decisions about how to manage the firm’s financial resources most efficiently McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 20 - Investment Decisions • Capital budgeting: - Quantifies the benefits, costs and risks of an investment - Managers can reasonably compare different investment alternatives within and across countries • Complicated process: - Must distinguish between cash flows to project and those to parent - Political and economic risk can change the value of a foreign investment - Connection between cash flows to parent and the source of financing must be recognized McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 20 - 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 McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 20 - Adjusting for Political and Economic Risk • Political risk: - Expropriation - Iranian revolution, 1979 - Social unrest - after the breakup of Yugoslavia, company assets were rendered worthless - Political change - may lead to tax and ownership changes • Collapse of communism in Eastern Europe • Attack on the World Trade Center • Economic risk - Inflation McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 20 - Financing Decisions • When considering options for financing a foreign investment, international businesses have to consider two factors - Source of financing - Financial structure McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 20 - Financing Decisions and The Global Capital Market • A capital market brings together those who want to invest money and those who want to borrow money • Those who want to invest money include - Corporations - Individuals - Non-bank financial institutions • Those who want to borrow money include - Individuals - Companies - Governments McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 20 - Financing Decisions and The Global Capital Market • Capital market loans to corporations re either - Equity loans occur when corporations sell stock to investors - Debt loans occur when a corporation borrows money and agrees to repay a predetermined portion of the loan amount at regular intervals regardless of how much profit it is making • Cost of capital is the price of borrowing money, which is the rate of return that borrowers must pay investors - In a purely domestic capital market the pool of investors is limited to residents of the country • Places an upper limit on the supply of funds available • Increases the cost of capital - A global capital market provides a larger supply of funds for borrowers to draw on • Lowers the cost of capital McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 20 - 10 Financing Decisions and The Global Capital Market McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 20 - 14 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 McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 20 - 15 2004 Corporate Tax Rates McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 20 - 16 Moving Money Across Borders: Attaining Efficiencies and Reducing Taxes • Unbundling: A mix of techniques to transfer liquid funds from a foreign subsidiary to the parent company without piquing the host country - Dividend remittances Royalty payments and fees Transfer Prices Fronting loans • Selecting a particular policy is limited when a foreign subsidiary is part owned by a local jointventure partner or local stockholders McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 20 - 17 Dividend Remittances • Most common method of transfer • Dividend varies with: - Tax regulations - Foreign exchange risk - Age of subsidiary - Extent of local equity participation McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 20 - 18 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 McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 20 - 19 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 McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 20 - 20 Benefits of Manipulating 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 McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 20 - 21 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 McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 20 - 22 Fronting Loans • Loan between a parent and subsidiary is channeled through a financial intermediary (bank) - Allows circumvention of host country restrictions on remittance of funds from subsidiary to parent - Provides certain tax advantages McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 20 - 23 Tax Advantages of Fronting Loans McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 20 - 24 Techniques for Global Money Management • 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 McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 20 - 25 Centralized Depositories McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 20 - 26 Techniques for Global Money Management • Ability to reduce transaction costs - Bilateral netting - Multilateral netting – simply extending the bilateral concept to multiple subsidiaries within an international business McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 20 - 27 Cash Flows Before Multilateral Netting McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved 20 - 28 Cash Flows After Multilateral Netting McGraw-Hill/Irwin International Business, 6/e © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved ... McGraw -Hill/ Irwin International Business, 6/e © 200 7 The McGraw -Hill Companies, Inc., All Rights Reserved 20 - 15 200 4 Corporate Tax Rates McGraw -Hill/ Irwin International Business, 6/e © 200 7... McGraw -Hill/ Irwin International Business, 6/e © 200 7 The McGraw -Hill Companies, Inc., All Rights Reserved 20 - 23 Tax Advantages of Fronting Loans McGraw -Hill/ Irwin International Business, 6/e © 200 7... McGraw -Hill/ Irwin International Business, 6/e © 200 7 The McGraw -Hill Companies, Inc., All Rights Reserved 20 - 25 Centralized Depositories McGraw -Hill/ Irwin International Business, 6/e © 200 7