Transcript Business Environment - International University College, Sofia

Lecture 23 (L10/S2)
International Financial Management
Milena Malinowska
1
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
2
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)
3
Diagrams of P-S relationship
4
Funds flows in the MNE
Working
capital
Parent
Equity
investment
Dividends
Royalties
Fees
Interest
Loan
Loan
Working
capital
Subsidiary B
Working
capital
Subsidiary A
Interest
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)
5
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
6
MLN – a diagram
7
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
8
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
Arm’s length P (S1)
Arm’s length P (S2)
TP (S1)
TP (S2)
$ 10 000 export to
$ 12 000
$ 12 000
$ 12 000
Cost of Sales
$ 8 000
$ 10 000
$ 8 000
$ 12 000
Gross Profit
$ 2 000
$ 2 000
$ 4 000
0
Tax (S1 40%; S2 50%)
$ 800
$ 1 000
$ 1 600
0
Net Profit
$ 1 200
$ 1 000
$ 2 400
0
Sales
9
NO





personal income taxes
capital gains taxes
corporate taxes
payroll taxes
withholding taxes on domestic of
foreign entities
10
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
11
Top tax havens
Place
Reliefs
Delaware
$ 100 corporation tax !
Hong Kong
No payroll, sales tax, capital gains
taxes, personal tax deductions
Dubai
No taxes of any kind, no tax audits,
no information shared
Channel
Islands
No capital gains, council tax, no
value added taxes
Luxemburg
No tax on bank interest, dividends,
or capital gains
Lichtenstein Very easy for foreigners to set up
trusts, provides no financial info
Monaco
No income, capital gains, property
taxes, high VAT
12
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
Pays 8% interest
(tax free)
Subsidiary
in China
Pays 9% interest
(tax deductible)
13
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:
Value of $ in ¥
US company
Increases
Value of assets
Value of liabilities
(denominated in ¥)
(denominated in ¥)
Decreases
Decreases
 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 $
14
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
15
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
16
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
17
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.)
18
Bibliography
 Lecture is based on:
International Financial Management (Chapter 14)
in Rugman, A. Collinson, S and Hodgetts, R. (2006)
International Business (4th eds) UK: McGraw-Hill
19