Financial Management in the

International Business
Chapter 20

© McGraw Hill Companies, Inc., 2000

 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.

© McGraw Hill Companies, Inc., 2000 20-1

 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.
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 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.
© McGraw Hill Companies, Inc., 2000 20-3
 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.

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 Euromoney Magazine’s
Country Risk Ratings
Total score = 100
100
90
80
70 Highest and
60 lowest ranked
50 countries.
40
30
20
10
0
USA

Neth

Benin
Lux

Azerbaijan
Bermuda
Ger

Madagascar
Adapted from
Table 20.1
in text
© McGraw Hill Companies, Inc., 2000 20-5
 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.

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 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.
© McGraw Hill Companies, Inc., 2000 20-7
 Debt Ratios for Selected
Industrial
Country
Countries
Mean
0.8
0.7
Debt ratio = 0.6 Highest and
total debt / 0.5 lowest ranked
total assets 0.4 countries.
at book 0.3
value. 0.2
0.1
0 Adapted from
Finland

Pakistan

Italy
Norway
Argentina

Australia
Malaysia
Singapore

Table 20.2
in text

© McGraw Hill Companies, Inc., 2000 20-8

 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.
© McGraw Hill Companies, Inc., 2000 20-9
 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.
© McGraw Hill Companies, Inc., 2000 20-10
 OECD Corporate Income Tax
Top Tax Rate %
Rates
60
50
Highest and
40 lowest ranked
countries and
30
USA.
Adapted from 20
Table 20.3
10
in text
0

USA
Japan

Swiss
Sweden
Finland
Italy

Canada

Norway
Germany

© McGraw Hill Companies, Inc., 2000 20-11

 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.

© McGraw Hill Companies, Inc., 2000 20-12

 Dividend Remittances
Most common method of transfer.
Dividend varies with:
tax regulations. Dividends
Foreign exchange risk.
Age of subsidiary.
Extent of local equity participation.

© McGraw Hill Companies, Inc., 2000 20-13

 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
© McGraw Hill Companies, Inc., 2000 20-14
 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.

© McGraw Hill Companies, Inc., 2000 20-15

 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.
© McGraw Hill Companies, Inc., 2000 20-16
 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.

© McGraw Hill Companies, Inc., 2000 20-17

 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.

© McGraw Hill Companies, Inc., 2000 20-18

 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)

© McGraw Hill Companies, Inc., 2000 20-19

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.

© McGraw Hill Companies, Inc., 2000 20-20

 Centralized Depositories
One Required
Day-to-Day Standard Cash
Cash Needs Deviation Balance
(A) (B) (A+3xB)

Spain $10 $1 $13

Italy $6 $2 $12

Germany $12 $3 $21

Total $28 $6 $46

© McGraw Hill Companies, Inc., 2000 20-21

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.

© McGraw Hill Companies, Inc., 2000 20-22

 Cash Flows before Multilateral
Netting
$4 Million

German French
$3 Million
Subsidiary Subsidiary

$5 Million $4 Million $5 Million $3 Million

Spanish Italian
Subsidiary $2 Million Subsidiary

$1 Million
Figure 20.2a

© McGraw Hill Companies, Inc., 2000 20-23

 Calculation of Net Receipts
($ Million)
Paying Subsidiary Net
Receiving Total Receipts*
Subsidiary Germany France Spain Italy Receipts (payments)

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

Figure 20.2b
© McGraw Hill Companies, Inc., 2000 20-24
 Cash Flows after Multilateral
Netting
German French
Subsidiary Subsidiary

Spanish Italian
Subsidiary Subsidiary

Figure 20.2c

© McGraw Hill Companies, Inc., 2000 20-25

 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.
© McGraw Hill Companies, Inc., 2000 20-26
 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.
© McGraw Hill Companies, Inc., 2000 20-27
 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

© McGraw Hill Companies, Inc., 2000 20-28

 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.

© McGraw Hill Companies, Inc., 2000 20-29