Introduction • 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.
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
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.
The Internal Capital Market • A recent literature has emerged, suggesting that HQ’s most important function is to run the firm’s ‘internal capital market’ • For a subsidiary, this market becomes more important as • the external capital market is less developed • The project resources exceed the subsidiary’s ability to provide collateral • The external capital market resource flow is bounded below by zero. This is not the case with the internal capital market
External Capital market Local Bank Local Bank External Capital market 3rd Country Re-directed resources to Subsidiary 2 Subsidiary 2 Internal Capital Market Inflow of financial resources HOST HOME Subsidiary 1 Parent Outflow of financial resources
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.
Overall Score Political risk Economic performance Debt indicators Debt in default or rescheduled Credit ratings Access to bank finance Access to short-term finance Access to capital markets Forfaiting* 100 25 25 10 10 10 5 5 5 5 Euromoney Magazine’s Country Risk Ratings * The purchasing of an exporter's receivables (the amount importers owe the exporter) at a discount by paying cash.
Euromoney Magazine’s Country Risk Ratings, Sept 2006 Number of countries = 185 Total score = 100
Financing Decisions (a) • Source of financing: • Global capital markets for lower cost financing. • 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.
External Capital market Global Financial Center Subsidiary 1 Global Bank Local Bank Outflow of financial resources External Capital market Re-directed resources to Subsidiary 2 Govt loans Financing Decisions HOME Parent HOST Subsidiary 2
Financing Decisions (b) • 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 its cost of capital.
2003* % * All publicly traded companies
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.
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.
Corporate Income Tax Rates Top Rate 2001 Top Rate 2007 35% 36.1% 17% 33.33% 38.34% 17.5% 12.5% 30% 29% 20% 30% 35%
Dividend remittances • Royalty payments and fees • Transfer Prices • Fronting loans 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 Parent Subsidiary
Dividend Remittances • Most common method of transfer. • Dividend varies with: • tax regulations. • Foreign exchange risk. • Age of subsidiary. • Extent of local equity participation. Dividends
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
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.
Benefits of 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.
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.
Fronting Loans • A loan between a parent and subsidiary is channeled through a financial intermediary (bank). • Can circumvent host-country restrictions on remittance of funds from subsidiary to parent. • Provides certain tax advantages.
An Example of the Tax Aspects of a Fronting Loan Deposit $1 Million Loan $1 Million Tax Haven Subsidiary London Bank Foreign Operating Subsidiary Pays 8% Interest (Tax Free) Pays 9% Interest (Tax Deductible)
Techniques for Global Money ManagementCentralized Depositories • 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.
Centralized Depositories One Standard Deviation (B) Required Cash Balance (A+3xB) Day-to-Day Cash Needs (A) Spain $10 $1 $13 Italy $ 6 $2 $12 Germany $12 $3 $21 Total $28 $6 $46
Techniques for Global Money ManagementMultilateral Netting • Ability to reduce transaction costs. • Bilateral netting. • Multilateral netting - simply extending the bilateral concept to multiple subsidiaries within an international business.
Cash Flows before Multilateral Netting $4 Million German Subsidiary French Subsidiary $3 Million $6 Million $2 Million $5 Million $4 Million $5 Million $3 Million $3 Million $5 Million Spanish Subsidiary Italian Subsidiary $2 Million $1 Million
Calculation of Net Receipts($ Million) Paying Subsidiary Net Receipts* (payments) Receiving Subsidiary Total Receipts Germany France Spain Italy Germany - $3 $4 $5 $12 ($3) France $4 - 2 3 9 (2) Spain 5 3 - 1 9 1 Italy 6 5 2 - 13 4 Total payments $15 $11 $8 $9 Net receipts = Total payments - total receipts
Cash Flows after Multilateral Netting German Subsidiary French Subsidiary Pays $3 Million Pays $1 Million Pays $1 Million Spanish Subsidiary Italian Subsidiary
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. Effect on flows Effect on stocks
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.
Strategies for Reducing Foreign Exchange Risk (b) • Reducing economic exposure: • Key is to distribute productive assets to various locations so firm is not severely affected by exchange rate changes. Manufacturing Facility Dispersal
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.
An example • During the Asian financial crisis, western MNCs were differentially affected. • Research now reveals that those MNCs that were locally embedded in terms of their financial transactions were better off, compared to those which had central control • Dealing with local suppliers in local currency • Reduction in the extent of F/X transactions can help the company.
Takeaways • Global finance is parallel to global logistics • Logistics - Managing the dispersion of real assets • Finance – Managing the dispersion of financial assets • In MNCs, both functions uniquely impinge on all aspects of firm management • Both have an intra-firm and an inter-firm aspect • Both have a mechanistic and strategic aspect • Logistics – minimize costs vs. build competencies • Finance – minimize taxes vs. managing risk exposure