Financial Management in the International Business

1. Financial Management in the International Business

2. Introduction: Financial management related to investment decision, financing decision and money management decisions. In an international business, investment, financing and money management decisions are complicated by the fact that countries have different currencies, different tax regimes, different regulations concerning the flow of capital across their borders, different norms regarding the financing of business activities, different levels of economic and political risk and so on. Chapter 10: Financial Management in the International Business

3. Financial managers must consider all these factors when deciding which activities to finance, how best to finance those activities, how best to manage the firm’s financial resources and how best to protect the firm from political and economic risks. Good financial management of a business can be an important source of competitive advantage in international business. Introduction

4. A decision to invest in activities in a given country must consider many economic, political, cultural and strategic variables because these influence the benefits, costs and risks of doing business there and thus its attractiveness as an investment. The role of financial manager in an international business is to try to quantify the various benefits, costs and risks that are likely to flow from an investment in a given location. Investment Decisions

5. Capital budgeting quantifies the benefits, costs, and risks of an investment. This enables top managers to compare, in a reasonably objective fashion, different alternatives within and across countries so they can make informed choices about where the firm should invest its scarce financial resources. Capital budgeting for a foreign project uses the same theoretical framework that domestic capital budgeting uses; that is the firm must estimate the cash flows associated with the project over time. Capital Budgeting

6. 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, however, the cash flows will become positive as investment costs decline and revenue grow. Once the cash flows have been estimated, they must be discounted to determine their net present value using an appropriate discount rate. Capital Budgeting

7. Cash flows to project are not necessarily the same thing as cash flows to the parent company. The project may not be able to remit all its cash flows to the parent for many reasons. When evaluating a foreign investment opportunity, the parent should be interested in the cash flows it will receive – as opposed to those the project generates, because those are the basis for dividends to stockholders, investment elsewhere in the world, repayment of worldwide corporate debt and so on. Stockholders will not perceive blocked earnings as contributing to the value of the firm and creditors will not count them when calculating the parent’s ability to service its debt. Project and Parent Cash Flows

8. When analysing a foreign investment opportunity, the company must consider the political and economic risks that stem from the foreign location. Political risk is defined as the likelihood that political forces will cause drastic changes in a company’s business environment that hurt the profit and other goals of a business enterprise. Political risk tend to be greater in countries experiencing social unrest or disorder and countries where the underlying nature of the society makes the likelihood of social unrest high. When political risk is high, there is a high probability that a change will occur in the country’s political environment that will endanger foreign firms there. Adjusting for Political and Economic Risks

9. Economic risk is defined as the likelihood that economic mismanagement will cause drastic changes in a country’s business environment that hurt the profit and other goals of a business enterprise. The most important mismanagement is the inflation. There is a long-run relationship between a country’s relative inflation rates and changes in exchange rates that will certainly affect the viability of the foreign project adversely. Adjusting for Political and Economic Risks

10. In analyzing a foreign investment opportunity, the additional risk that stems from its location can be handled in two ways such as: to treat all risk as a single problem by increasing the discount rate applicable to foreign projects in countries where political and economic risks are perceived as high and to adjust expected cash flows by adjusting risk stem from changed political and economic condition. Risk and Capital Budgeting

11. In analyzing a foreign investment opportunity, the additional risk that stems from its location can be handled in two ways such as: to treat all risk as a single problem by increasing the discount rate applicable to foreign projects in countries where political and economic risks are perceived as high and to adjust expected cash flows by adjusting risk stem from changed political and economic condition. Risk and Capital Budgeting

12. When considering options for financing, an international business must consider two factors such as how the foreign investment will be financed i.e. for required external financing, the firm must decide whether to tap the global capital market for funds, or borrow from sources in the host country and how the financial structure of the foreign affiliate should be configured. Financing Decisions

13. If the firm is going to seek external financing for a project, it will want to borrow funds from the lowest cost source of capital available. The cost of capital is typically lower in the global capital market, by virtue of its size and liquidity, than in many domestic capital markets, particularly those that are small and relatively illiquid. 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. Sources of Financing

14. 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. However, if foreign debt obligations must be served, the amount of local currency required to do this will increase as the currency depreciates, and this effectively raises in cost of capital. Sources of Financing

15. By financial structure we mean the mix of debt and equity used to finance a business. Financial structure of firms should vary so much across countries. For MNCs, different tax regimes and diffrences in cultural norms determine the relative attractiveness of debt and equity in a country. The best recommendation is that in an international business should adopt a financial structure for each foreign affiliate that minimizes its cost of capital, irrespective of whether that structure is consistent with its local practice. Financial Structure

16. Global money management involves the following factors: 1. Minimizing cash balances – by managing global cash reserves through a centralized depository, an international business can reduce the amount of funds it must hold in liquid accounts and thereby increase its rate of return on its cash reserves. Global Money Management: The Efficiency Objective

17. Global money management involves the following factors: 2. Reducing transaction costs – transaction costs are cost of exchange of one currency into anther currency and transfer fee. Multilateral netting can reduce the number of transactions between the firm’s subsidiaries, thereby reducing the total transactions costs arising from foreign exchange dealings and transfer fees. Global Money Management: The Efficiency Objective

18. Pursuing the objectives of utilizing the firm’s cash resources most efficiently and minimizing the firm’s global tax liability requires the firm to be able to transfer funds from one location to another around the globe. International business uses the following techniques for transferring liquid funds across boarders: Moving Money Across Boarders: Efficiencies and Reducing Taxes

19. 1. Dividend remittances – payment of dividends is the common method by which firms transfer funds form foreign subsidiaries to the parent company. The dividend policy typically varies with each subsidiary depending on such factors as tax regulations, foreign exchange risk, the age of the subsidiary and the extent of local equity participation. Moving Money Across Boarders: Efficiencies and Reducing Taxes

20. 2. 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 sell products under those patents or trade names. It is common for a parent company to charge its foreign subsidiaries royalties for the technology, patents or trade names it has transferred to them. A fee is compensation for professional services or expertise the parent company or another subsidiary supplies to a foreign subsidiary. Moving Money Across Boarders: Efficiencies and Reducing Taxes

21. 3. Transfer prices – an international business normally involves a large number of transfer of goods and services between the parent company and the foreign subsidiaries and between foreign subsidiaries. The price charged on transferred goods and services by the parent to the foreign subsidiaries is known as transfer price. This can be used to position funds within an international business. Moving Money Across Boarders: Efficiencies and Reducing Taxes

22. 4. Fronting loans – a fronting loan is a loan between a parent and its subsidiary channeled through a financial intermediary, usually a large international bank. In a direct intrafirm loan, the parent company lends cash directly to the foreign subsidiary, and the subsidiary repays it later. In a fronting loan, the parent company deposits funds in an international bank, and the bank lends the same to the foreign subsidiary. Moving Money Across Boarders: Efficiencies and Reducing Taxes

23. 1. Centralized depositories – every business needs to hold some cash balances for servicing accounts that must be paid and for insuring against unanticipated negative variation from its projected cash flows. Generally firms prefer to hold cash balances at a centralized depository for three reasons such as by pooling cash reserves centrally, the firm can deposit larger amounts, it has access to information about good short-term investment opportunities and the firm can reduce total size of the cash pool it must hold in highly liquid accounts and invest larger amount for earning higher interest. Techniques for Global Money Management

24. 2. Multilateral netting – it allows a multinational firm to reduce the transaction costs that arise when many transactions occur between its subsidiaries. These transactions costs are the commissions paid to foreign exchange dealers for foreign exchange transactions and the fees banks charge for transferring cash between locations. Under this, it is extended to the transactions between multiple subsidiaries within an international business. Techniques for Global Money Management

25. Period t 1. Demand (1) 2. Price per unit (2) 3. Total revenue (1)(2)=(3) 4. Variable cost per unit (4) 5. Total variable cost (1)(4)=(5) 6. Annual lease expense (6) 7. Other fixed periodic expenses (7) 8. Noncash expense (depreciation) (8) 9. Total expenses (5)+(6)+(7)+(8)=(9) 10. Before-tax earnings of subsidiary (3)–(9)=(10) 11. Host government tax tax rate(10)=(11) 12. After-tax earnings of subsidiary (10)–(11)=(12) Capital Budgeting Analysis

26. Period t 13. Net cash flow to subsidiary (12)+(8)=(13) 14. Remittance to parent (14) 15. Tax on remitted funds tax rate(14)=(15) 16. Remittance after withheld tax (14)–(15)=(16) 17. Salvage value (17) 18. Exchange rate (18) 19. Cash flow to parent (16)(18)+(17)(18)=(19) 20. Investment by parent (20) 21. Net cash flow to parent (19)–(20)=(21) 22. PV of net cash flow to parent (1+k)-t(21)=(22) 23. Cumulative NPV PVs=(23) Capital Budgeting Analysis

27. Exchange rate fluctuations. Different scenarios should be considered together with their probability of occurrence. Inflation. Although price/cost forecasting implicitly considers inflation, inflation can be quite volatile from year to year for some countries. Factors to Consider in Multinational Capital Budgeting

28. Financing arrangement. Financing costs are usually captured by the discount rate. However, many foreign projects are partially financed by foreign subsidiaries. Blocked funds. Some countries may require that the earnings be reinvested locally for a certain period of time before they can be remitted to the parent. Factors to Consider in Multinational Capital Budgeting

29. Uncertain salvage value. The salvage value typically has a significant impact on the project’s NPV, and the MNC may want to compute the break-even salvage value. Impact of project on prevailing cash flows. The new investment may compete with the existing business for the same customers. Host government incentives. These should also be considered in the analysis. Factors to Consider in Multinational Capital Budgeting

30. If an MNC is unsure of the cash flows of a proposed project, it needs to adjust its assessment for this risk. One method is to use a risk-adjusted discount rate. The greater the uncertainty, the larger the discount rate that is applied. Many computer software packages are also available to perform sensitivity analysis and simulation. Adjusting Project Assessmentfor Risk

31. Multinational Capital Budgeting Decisions Impact of Multinational Capital Budgetingon an MNC’s Value

32. 1. Assume that the project’s required rate of return is 15% and the initial required outlay is $250000. The pretax earnings are expected to be £400000 at the end of one year form investment in UK when the exchange rate will be £1=$1.75. The British economy may weaken (probability = 40%), which would cause the expected pretax earnings to be £240000. The British corporate tax rate may increase from 35% to 45% (probability= 30%). These two forms of country risk are independent. Calculate the expected value of the project’s net present value. Problems

33. 2. Before tax expected earnings of a subsidiary of an MNC for next five years are: Tk.100000, Tk.120000, Tk.90000, Tk.130000 and Tk.80000 with expected exchange rates of $0.017, $0.018, $0.016, $0.019 and $0.020 respectively. Current exchange rate is Tk.1=$0.016. The host government would have charged corporate tax @ 30% and withholding tax @ 10%. The initial investment was Tk.350000. The company applied sum of years’ digit method of depreciation with salvage value of Tk.45000. Exchange rates are given in terms of dollar against taka. If the cost of capital of the parent company is 11%, then would it be wise for the company to make investment? Problems

34. 3. An US MNC is planning to invest $10 million in Singapore (S$1= $0.50). Expected sales are 60000 units, 60000 units, 100000 units & 100000 units: expected selling price of S$350, S$350, S$360 & S$380: budgeted variable cost per unit is S$200, S$200, S$250 & S$260 respectively in next four years. Fixed costs per year are S$1 million for lease and S$1 million for operating. Singapore Government will allow the MNC to charge maximum S$2 million as depreciation on plant per year. There is 20% tax on income and 10% tax on fund remittance. Problems

35. It is expected that exchange rate will be prevailing same during the investment period. Required rate of return of the MNC is 15%. Evaluate the capital investment decision under the followings: i. Subsidiary perspective and Parent perspective. ii. S$ is expected to be stronger against $ with $0.54, $0.57, $0.61 & $0.65. iii. S$ is expected to be weaker against $ with $0.47, $0.45, $0.40 & $0.37. iv. Fund blockage for four years and reinvestment rate is 6%. Problems