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