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Business Environment

Business Environment. Lecture 23 ( L10/S2) International Financial Management Milena Malinowska. Definitions. Money is the blood of business MNC face numerous difficulties when they need to move and position funds among their subsidiaries

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Business Environment

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  1. Business Environment Lecture 23 (L10/S2) International Financial Management MilenaMalinowska

  2. Definitions • Money is the blood of business • MNC face numerous difficulties when they need to move and position funds among their subsidiaries • MNC are exposed to currency exchange risks, such as transaction, translation and economic risk • MNC perform financial hedging, in order to minimize these risk • There numerous techniques that estimate the financial result and worthiness of a project

  3. Parent-subsidiary relationship • Polycentric structure – decision-making is decentralized and subsidiaries are more independent, control becomes diluted • Ethno(mono)centric structure – decision-making is centralized, control is concentrated in P • Regiocentric structure – Subsidiaries coordinate regionally, but decision-making remains centralized • Geocentric structure – differentiated relationship, based on a global strategy (dependent on location of S and need for particular need for synchronization)

  4. Diagrams of P-S relationship Polycentric Ethnocentric Geocentric Regiocentric

  5. Funds flows in the MNE Three main internal sources of funding: • Working capital – the difference between currents assets and currents liabilities • Borrowing – one S can borrow from another (or the P) and repay interest • Acquiring equity – when P holds equity in a S, it acquires dividends (royalties, fees) Parent Working capital Equity investment Dividends Royalties Fees Interest Working capital Loan Subsidiary B Loan Working capital Interest Subsidiary A

  6. Multilateral netting • Whenever subsidiaries trade with each other, numerous receivables and payables accounts are outstanding • Instead of transferring payments from one S to another, MNE set up clearing centers • Clearing managers calculates the net position of each S and transfers funds at the end of a fixed period

  7. MLN – a diagram

  8. Managing cash • Managing the volume of cash in the company can prove a very difficult task • Central cash management of the MNE (as a single unit) provides several benefits: • Pooling cash reduces total cash holdings • Multilateral netting reduces the total amount of cash in intra-company circulation • Company cash management goals over affiliates’ ones • One department to deal with that, instead of many (cost reduction) • Control becomes centralized • Might be hindered on purpose by some countries

  9. Funds positioning in the MNE Transfer pricing (TP) • The price, which MNC set for intra-firm trade • By manipulating the TP, companies: • Maximize profits where taxes are the lowest • Concentrate funds where the conditions are favorable • Reduce payment for (ad valorem) tariffs

  10. Cayman Islands • NO • personal income taxes • capital gains taxes • corporate taxes • payroll taxes • withholding taxes on domestic of foreign entities

  11. Funds positioning in the MNE (2) Tax havens • Death is certain, but taxes do not have to be • Tax haven is a country with very low or no tax rates, stable and encouraging business climate, and no disclosure of financial information to foreign governments • The subsidiary in the tax haven is where company profits maximize • It is applied together with transfer pricing

  12. Top tax havens

  13. Funds positioning in the MNE (3) Fronting loans • Financial operation, where MNC deposits funds with local financial institution, that provides a loan to the subsidiary • Applied to deal with political risk, turbulent environment and currency transfer restrictions Loans $ 1 m Deposits $ 1 m Subsidiary in Tax Haven HSBC branch in China Subsidiary in China Pays 8% interest (tax free) Pays 9% interest (tax deductible)

  14. Exchange (rate) risks • Transaction risk – the risk that an unexpected change in the value of home currency against a foreign one leads to changes in expected cash flows (payables and receivables, bank deposits and loans) • Translation (accounting) risk – unexpected change in the exchange rate leads to losses or gains on the balance sheet: • Economic risk – unexpected change in the exchange rate leads to losses or gains from company operations abroad: • If the value of the ¥ (versus the $) increases, selling assets of the Japanese subsidiary will generate higher profit in $

  15. Hedging • MNCs often incur losses, arising currency fluctuation (exchange rate) risks • Hedging is a type of ‘insurance’ against from transaction, translation and economic (and other) exposure • It implies strategic investment in financial instruments, that will offset the above losses • When the company needs to make a payment at a set date in the future, it can by a financial instrument, with a fixed (strike) price to avoid exchange risk • Hedging is not an investment that generates profit, instead it minimizes loss

  16. Example US company X has an account payable of £ 5 M in 180 days: • Buying a currency future: • Spot (current) rate: $ 1.9290/£ • Strike price in 180 days: $ 1.9086/£ • £ 5M x 1.9086 = $ 9.543M <£ 5M x 1.9290 = $ 9.645M • Depositing £ in a six months bank account • Annual interest rate for a £ deposit: 4.9187% • To get £ 5M in six months, X needs to deposit: • £ 5M / (1 + 0.024593) = £ 4.879 M • £ 4.879 M x 1.9290 = $ 9.413 M = better alternative

  17. Evaluating financial risk • Financial structure – Debt-equity ratio shows how leveraged the firm is, the higher debt level implies more risk • Return on investment (ROI) – calculates the gain/loss from a project as a percentage of initial investment • Weighted average cost of capital (WACC) – calculates the average cost of acquiring capital from different sources (retained earnings, loans, etc.) • Whenever ROI > WACC the project is worth doing ! • Net present value (NPV) – shows the current value of future cash flows, discounted by the WACC. Positive NPV implies that inflows will outweigh investment = profit Calculate WACC: http://www.moneychimp.com/glossary/wacc.htm

  18. Evaluating other pros and cons • Country risk – some host countries will restrict outflow of subsidiary profits, hence dividend payments are not possible. Solution ? • Incremental impact – potential gains from other international project need to be taken into account. Which one creates overall company value ? • Institutional impact – host government intervention may impact international project (foreign investment review agencies; employment quotas; local ownership requirements etc.)

  19. Bibliography • Lecture is based on: International Financial Management (Chapter 14) in Rugman, A. Collinson, S and Hodgetts, R. (2006) International Business (4theds) UK: McGraw-Hill

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