INTERNATIONAL BUSINESS Professor H. Michael Boyd, Ph.D.

2. Chapter 20International Financial Management

3. Scope of Financial Management Three Sets of Related Decisions Investment Decisions what activities to finance Financing Decisions how to finance those activities Money Management Decisions how to manage financial resources most efficiently

4. International Financial Management Complexity of International Business Investment, financing and money management decisions in international business are complicated by: different currencies tax regimes capital control regulations financial structure norms economic and political risk

5. International Financial Management Source of Competitive Advantage Effective and efficient international financial management can be a source of competitive advantage for a firm by reducing their cost of creating value by: minimizing the tax burden minimizing unnecessary risk (political, economic, foreign exchange) efficiently managing the cash flows and reserves

6. Scope of Financial Management Three Sets of Related Decisions Investment Decisions Financing Decisions Money Management Decisions

7. Investment Decisions Capital Budgeting Quantifies the benefits, costs and risks of an investment Enables managers to reasonably compare different investment alternatives within and across countries Estimates the project’s cash flows over time Discounts the cash flows to determine the net present value of the project

8. International Capital Budgeting Complicated Process Must distinguish between cash flows to project and cash flows to the parent company Political, economic and foreign exchange risk can change the value of a foreign investment Connection between cash flows to parent and the source of financing must be recognized

9. Project and Parent Cash Flows Project cash flows may not reach the parent due to: 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 When evaluating investments, the parent firm should focus the cash flows it will receive and not what the project generates

10. Adjusting for Political Risk The likelihood that political forces will cause drastic changes in a country’s business climate that might harm the profits or goals of the firm Expropriation (of the firm’s assets) Political and Social Unrest leads to economic collapse which can render the firm’s assets as worthless Political Change which can lead to harmful changes in tax policies or exchange controls

11. Adjusting for Economic Risk The likelihood that economic mismanagement will cause drastic changes in the country’ business climate that might harm the profits or goals of the firm Inflation Level of Business and Government Debt

12. Risk and Capital Budgeting Typical Process Treat all risk as a single problem by increasing discount rate to projects in risky countries Problems Penalizes early cash flows too much Penalizes later cash flows too little Better to revise future cash flows downward to reflect possible future adverse political or economic risk

13. Scope of Financial Management Three Sets of Related Decisions Investment Decisions Financing Decisions Money Management Decisions

14. Financing Decisions Three Factors to Consider Will the foreign investment will be internally financed or externally financed ? (we will assume that it will be external) What is the source of financing (domestic or global)? How should the financial structure of the foreign affiliate be configured?

15. Financing Decisions Source of Financing Global capital markets provide a lower cost of financing due to its increased liquidity interest rates on the debt loan expected dividend yield for equity shares capital gain for equity shares

16. Financing Decisions Problems and Risks of Global Capital Market Host-country may require projects to be locally financed through debt or equity limited liquidity may raise the cost of capital host-government may offer low interest subsidized loans Impact of local currency (appreciation/depreciation) influences capital and financing decisions May increase or decrease the actual cost of capital Borrow debt locally if local currency is expected to weaken

17. Financing Decisions Financial Structure The mix of debt and equity used to finance the business Debt/equity ratios vary between countries due to differences in tax regimes or cultural norms

18. Financing Decisions Financial Structure Should firms follow local capital structure norms? Easier to evaluate ROE relative to local competitors Might improve the company’s image Best recommendation is to adopt a financial structure that minimizes the cost of capital

19. Scope of Financial Management Three Sets of Related Decisions Investment Decisions Financing Decisions Money Management Decisions

20. Global Money Management The process and system that attempts to manage the firm’s global cash resources (working capital) most efficiently by: minimizing cash balances reducing transaction costs minimizing tax obligations

21. Global Money Management The Efficiency Objective: Minimizing Cash Balances Money Market Accounts low interest high liquidity Certificates of Deposit higher interest lower liquidity Using a centralized depository will reduce required cash balances in liquid accounts

22. Global Money Management The Efficiency Objective: Reducing Transaction Costs Transaction Costs changing from one currency to another Transfer Fees fee for moving cash between locations 40% of international trade involves transactions between national subsidiaries of transnational firms Multilateral netting can reduce such transactions

23. Global Money Management The Tax Objective Countries tax income earned outside their boundaries by firms based in their country This may lead to double taxation whereby the firm is taxed by both the host-country government and the parent firm’s home government Tax rates vary across countries Tax rates are continually changing and harmonizing

24. Corporate Income Tax Rates 2006

25. Mitigation of Double Taxation Tax Credit allows entity to reduce home taxes by the amount of taxes paid to foreign government Tax Treaty an agreement between countries specifying what items will be taxed by authorities of the country where income is earned Deferral Principle allows parent companies to not be taxed on foreign income until the dividend is received Tax Haven used to minimize tax liability

26. Moving Money Across Borders: Attaining Efficiencies and Reducing Taxes

27. Unbundling Mix of techniques used to transfer liquid funds from a foreign subsidiary to the parent company without concerning the host-country Dividend Remittances Royalty Payments and Fees Transfer Prices Fronting Loans Selecting a particular policy is limited when a foreign subsidiary is part-owned by a local joint venture partner or local stockholders

28. Dividend Remittances Most common method of transfer Dividends remittances vary due to: tax regulations foreign exchange risk age of subsidiary extent of local equity participation

29. Royalty Payments 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 Often tax-deductible locally not like dividends

30. Fees Fees are compensation for professional services or expertise supplied to subsidiary by parent firm Management fees or ‘technical assistance’ fees Fixed charges for services provided Often tax-deductible locally not like dividends

31. Transfer Prices Price at which goods and/or services are transferred within a firm’s entities Used to position funds within a company Move funds out of country by setting high transfer fees or into a country by setting low transfer fees Movement can be between subsidiaries or between the parent and its subsidiaries UN estimates that 40% of international trade is between the subsidiaries of companies

32. Benefits of Manipulating Transfer Prices Reduce tax liabilities by using transfer fees to shift earnings from a high-tax country to a low-tax country Move funds out of a country where a significant currency devaluation is expected to help reduce foreign exchange risk Move funds from a subsidiary to the parent firm (or tax haven) when dividends are restricted by host country Reduce import duties (ad valorem) by reducing transfer prices and the value of the goods

33. Problems with Transfer Pricing Governments don’t like losing their tax revenue Inconsistent with treating subsidiaries as profit centers Impacts management incentives and performance evaluations when it changes a subsidiary’s profits Managers can manipulate transfer prices to distort subsidiary’s performance to mask inefficiencies The ethics of transfer pricing are dubious at best

34. “Arm’s-Length” Price The price that would prevail between two unrelated firms in a market setting

35. Fronting Loans Loan between a parent and subsidiary is channeled through a financial intermediary (bank) Allows circumvention of host-country restrictions on remittance of funds from subsidiary to parent company Provides certain tax advantages by shifting tax liability to a country with a lower tax rate

36. Tax Aspects of a Fronting Loan Interest Payments Net of Income Taxes Foreign subsidiary pays $90,000 interest to London bank and deducts the interest payments from its taxable income resulting in $45,000 after-tax cost London bank receives $90,000 and retains $10,000 for services rendered and pays $80,000 interest on deposit to Bermuda subsidiary Bermuda subsidiary receives $80,000 interest on deposit tax free Because the foreign subsidiary’s after-tax cost of borrowing is $45,000, the parent company moved an additional $35,000 out of the country

37. Techniques for Global Money Management Two major techniques to most efficiently manage their global cash resources: Centralized Depositories Multilateral Netting

38. Centralized Depositories Firms need cash reserves to service accounts and insure against unanticipated negative cash flows Should each foreign subsidiary hold its own cash balance? Or should each subsidiary’s cash balances be held at a central depository?

39. Centralized Depositories Firms Prefer to Hold Cash at Central Depository By pooling reserves, firms can deposit larger cash amounts and earn higher interest rates If central depository is located in a major financial center, the firm can get information on good short-term investment opportunities Can reduce the total size of the cash pool in highly liquid accounts, which enables the firm to invest larger amount of cash reserves in longer-term, less liquid instruments that earn a higher interest rate

40. Centralized Depositories Limitations Government restrictions on cross-border cash flows Transaction costs of moving funds in and out of different currencies Facilitators Globalization of capital markets Removal of restrictions on cross-border cash flows

41. Multilateral Netting Allows a firm to reduce the transaction costs: foreign exchange commissions bank transfer fees Bilateral Netting settlement where the amount the Subsidiary A owes to Subsidiary B can be canceled by the debt of that Subsidiary B owes Subsidiary A Multilateral Netting extending the bilateral concept to multiple subsidiaries within an international business

42. Cash Flows before Multilateral Netting $43 M needs to flow between subsidiaries $430,000 foreign exchange costs (1% fee)

43. Cash Flows after Multilateral Netting $5 M needs to flow between subsidiaries $50,000 foreign exchange costs (1% fee) Savings of $380,000