FN 605: International Business

Finance

1
 Lecture 1
Introduction – Financial Management
in the International Business

What is an International Business Finance

and what does it entail?

2
 Lecture 1
Objectives
• Evaluate the firm’s financial decisions
– Look at investment decisions to identify factors
that complicate capital budgeting decisions.
– Examining financing decisions, we look at the mix
of equity and debt financing and the advantages
and disadvantages of localizing the financial
structure.
– Look at the objectives of global money
management, the ways firms move money across
borders, and techniques for efficient management.
– Evaluate foreign exchange risk.

3
 International Business
• Movement of different tradable items from one country to
another
– Tangible
– Intangible
• Cross boarder transactions
 Importing and exporting
 Investment in physical and financial assets in foreign
countries
 Buying and selling in foreign countries
 Establishment of foreign warehousing, distribution systems

Finance theory
4
 Issues that are Peculiar to International
Business
• Transacting in foreign language, under foreign laws, customs and regulations
• Foreign currency transactions and exchange rate variations
• Cultural differences
• Complexity of monitoring and control communication systems
• Higher political risks - Variations in legal and political structures
• Difficulty in observing and monitoring trends and activities in foreign
countries.
• Diverse labor laws and requirements
• Differential rates of inflation
• Changes in exchange rates, possibility of foreign exchange controls,
restrictions on the outflow of funds and expropriation risks
• Differences in governmental policies: Fiscal and Monetary policies

5
Basic Principles of Global Finance
A. Market Imperfections
B. Risk-Return Trade-off
C. Portfolio Effect (Diversification)
D. Comparative Advantage
E. Internationalization Advantage
F Economies of Scale
G. Valuation

6
 Scope of Financial Management
• 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.

7
 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.
8
 Project and Parent Cash Flows

• Project cash flows may not reach the parent:

Host country may block Cash flows may be taxed at an

Cash flow repatriation. unfavorable rate.

Host government may require a

percentage of cash flows be
reinvested in the host country.

9
 Risk and Capital Budgeting

Handling Risk

Treat all risk as a

single problem
by increasing discount
rate to projects Better to revise
in risky countries. future cash flows
downward to reflect
possible future
Penalizes early cash adverse political
flows too much. Therefore: or economic risk.
Later cash flows,
too little.

10
 Financing Decisions
- Source of Financing -

• 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.

11
 Financing Decisions
- 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.

12
 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.

13
 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.

14
 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.
– 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.
15
 Dividend Remittances
• Most common method of transfer.
• Dividend varies with:
– Tax regulations.
– Foreign exchange risk.
– Age of subsidiary.
– Extent of local equity participation.

16
 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

17
 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.

18
 Benefits of Transfer Fees
• 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.

19
 Problems with Transfer Pricing
Governments don’t
like it. Impacts management
Believe (rightly) they incentives & performance
lose money. evaluations.

Inconsistent with
‘profit center’. Managers can hide
inefficiencies.

20
 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.

21
 An Example of the Tax Aspects of a Fronting
Loan
Deposit $1 Loan $1 Million
Million

Tax Haven London Foreign

Subsidiary Bank Operating
Subsidiary

Figure 20.1 Pays 8% Interest Pays 9% Interest

(Tax Free) (Tax
Deductible)

22
 Techniques for Global Money Management
- Centralized 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.

23
 Techniques for Global Money Management
-Multilateral Netting-

• Ability to reduce transaction costs.

– Bilateral netting.
– Multilateral netting - simply extending the bilateral
concept to multiple subsidiaries within an
international business.

24
 Cash Flows before Multilateral Netting
$4 Million

Tanzania Kenya
$3 Million
Subsidiary $6 Subsidiary
n
M illi i llio
on M
$2
$5 Million $4 Million $5 Million $3 Million

n $5
i llio M
3 M illi
$ on
Uganda Zambia
Subsidiary $2 Million Subsidiary

$1 Million

Figure 20.2a
25
 Calculation of Net Receipts
($ Million)
Paying Subsidiary Net
Receiving Total Receipts*
Subsidiary Tanzania Kenya Uganda Zambia Receipts (payments)

Tanzania - $3 $4 $5 $12 ($3)

Kenya $4 - 2 3 9 (2)
Uganda 5 3 - 1 9 1
Zambia 6 5 2 - 13 4

Total payments $15 $11 $8 $9

Net receipts = Total payments - total receipts

26
 Cash Flows After Bilateral Netting
$1 Million

Tanzania Kenya
Subsidiary $1
Subsidiary
Mi n
lli i llio
on M
$2
$1 Million $2 Million

n
li lio
1 M
$
Uganda Zambia
Subsidiary $1 Million Subsidiary

27
 Cash Flows after Multilateral Netting

Tanzania Kenya
Subsidiary Pay
Subsidiary
s $3
Mil
lion
Pays $1 Million
lio n
Mil
s $1
Pay
Uganda Zambia
Subsidiary Subsidiary

28
 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.

29
 Tactics and Strategies for Reducing Foreign
Exchange Risk
Reducing Transaction and Translation Exposure

• 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.

30
 Tactics and Strategies for Reducing Foreign
Exchange Risk

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

31
 Developing Policies for 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.

32