Financial management in international business

Chapter 20 Financial Management in International Business 20-2 Case: Global treasury management at Proctor & Gamble   60% of P &G’s revenues from international sales Products sold in 130 countries Has centralized global treasury management function     Management of all foreign exchange transactions P& G trades currency between subsidiaries, cutting out banks and saving on transaction costs P & G is pooling foreign exchange risks and buying an purchasing an umbrella option to cover risks associated with various currency options Subsidiaries can invest in and borrow money from other P &G entities instead of dealing with banks McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved 20-3 Scope of financial management   Scope of financial management includes three sets of related decisions: Investment decisions   Financing decisions   Decisions about what activities to finance 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, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved 20-4 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, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved 20-5 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, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved 20-6 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 Examples Collapse of communism in Eastern Europe  Attack on the world trade center   Economic risk  Inflation McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved 20-7 Financing decisions    When considering options for financing a foreign investment, Int businesses have to consider two factors Source of financing Financial structure McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved 20-8 Source of financing   Global capital markets for lower cost financing Impact of host country-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 McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved 20-9 Financial structure  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 the cost of capital McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved 20-10 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 McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved 20-20 An example of the tax aspects of a fronting loan Fig 20.1 McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved 20-21 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, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved 20-22 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 McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved 20-23 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, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved 20-24 Cash flows before multilateral netting Fig 20.2A McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved 20-25 Cash flows after multilateral netting Fig 20.2C McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved 20-26 Net receipts Fig 20.2B McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved 20-27 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 McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved 20-28 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 McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved 20-29 Strategies for reducing foreign exchange risk (b)  Reducing Transaction and translation exposure    Lead strategy Lag strategy Reducing economic exposure:  Key is to distribute productive assets to various locations so firm is not severely affected by exchange rate changes McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved 20-30 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 McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved 20-31 Case: Motorola’s global cash management system Pre netting and post netting info flows Fig C1 McGraw-Hill/Irwin International Business, 5/e Fig C2 © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved 20-32 Case: Motorola’s global cash management system Fig C1 McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved 20-33 Case: Motorola’s global cash management system: Currency netting model Fig C3 McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved 20-34 Case: Motorola’s global cash management system McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved ... Financing decisions    When considering options for financing a foreign investment, Int businesses have to consider two factors Source of financing Financial structure McGraw-Hill/Irwin International. .. (appreciation/depreciation) influences capital and financing decisions McGraw-Hill/Irwin International Business, 5/e © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved 20-9 Financial structure  Financial. ..  Bilateral netting  Multilateral netting - simply extending the bilateral concept to multiple subsidiaries within an international business McGraw-Hill/Irwin International Business, 5/e © 2005