INTERNATIONAL FINANCIAL MANAGEMENT

Establishment of the overseas operation in Canada

This report, based on a given scenario, is written on behalf of NEXT PLC and consists of a recommendation as to whether the project should be undertaken, and a consideration and evaluation of specific foreign exchange exposure arising from the investment together with a hedging and management of this potential risk, and a strategy for the management of foreign exchange risk which may arise as a result of investment and on-going activities, and finally an evaluation and selection of the appropriate organisational structure and financing arrangements taking into account any risks and opportunities presented by trading in Canada.

N0405073 3/29/2012

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Contents
1. INTRODUCTION ..............................................................................................................................................2 1.1. Retail Industry ..........................................................................................................................................2

1.1.1. 1.1.2.
1.2.

Porters 5 Forces .............................................................................................................. 2 Segmentation .................................................................................................................. 2 Macro Framework ........................................................................................................... 2 Currency .......................................................................................................................... 2 Tax Regulations .............................................................................................................. 2 Treaties............................................................................................................................ 2 Demographics .................................................................................................................. 2

Canadian Market ......................................................................................................................................2

1.2.1. 1.2.2. 1.2.3. 1.2.4. 1.2.5.

2. 2.1. 2.2. 3.

FINANCIAL APPRAISAL ................................................................................................................................3 Methodology...............................................................................................................................................3 Interpreting the Data and Financing ......................................................................................................3

FOREIGN CURRENCY EXPOSURE ..............................................................................................................4 3.1. 3.2. 3.3. Transaction Exposure ...............................................................................................................................4 Translation Exposure ................................................................................................................................5 Macroeconomic Exposure..........................................................................................................................5

3.3.1. 3.3.2. 3.3.3.

4. 4.1. 4.2. 4.3. 5.

Competitive Edge ............................................................................................................ 5 Strategy ........................................................................................................................... 5 Hedging in a Total Framework ....................................................................................... 6

ORGANISATIONAL STRUCTURE .................................................................................................................6 Subsidiary vs. Branch ...............................................................................................................................6 Management from a Distance ..................................................................................................................6 Risks and Advantages of Trading in Canada ..........................................................................................6

CONCLUSION ..................................................................................................................................................7

References ..................................................................................................................................................................8

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1. INTRODUCTION
1.1. Retail Industry
1.1.1. Porters 5 Forces
The barriers to start up a chain store can be defined medium. Whereas opposing to an individual, customers as a whole have a power on quality and prices, suppliers tend to have very little power. What one store offers will likely be available at another store, therefore threat of substitutes are high. In sum, retailers face harsh competition.

1.1.2. Segmentation
The Next retail chain operates in soft line segment which consists of clothing, appeal and other fabrics since 1982. In contrast to department stores, Next stores can be defined as individual stores which are focused on clothing. Primary merchandise category is womenswear, menswear, and childrenswear. Predominant customer group can be defined as assured individual (snap-shop 2012); shoppers see themselves as young but not immature and mostly their attitude to purchase is individual.

1.2. Canadian Market

1.2.1. Macro Framework
The data state (IMF 2012) in 2010, Canada was the ninth largest consumer market and during the last decade, Canadas economy grew faster than any other G7 countries after Germany.

1.2.2. Currency
In last five years GBP / CAD steadily decreased from around 2.2 to around 1.5 during the years between 2008 and 2010, and fluctuated between around 1.5 and 1.6 after 2010 to 2012. (Bloomberg 2012)

1.2.3. Tax Regulations

Corporations in Canada pay provincial tax in addition to federal tax. According to the calculated weighted average provincial tax rate (see appendix-tax estimated) as 11% and federal tax rate is 15% by the 1st of January 2012. (Canada Revenue Agency 2012) Also, withholding tax is stated in explanatory memorandum as 5%. (HM Revenue & Customs 2012)

1.2.4. Treaties
Canada/UK Double Taxation Convention in 1978, Canada/UK 1st Protocol to the Double Taxation Convention in 1980 and Canada/UK 2nd Protocol to the Double Taxation Convention in 1985 provides a taxefficient business and trade between Canada and UK. (HM Revenue & Customs 2012)

1.2.5. Demographics
The population of Canada is 34.482.800. The most populated provinces are Ontario, Quebec, British Colombia, and Alberta, 13.3m, 7.9m, 4.5m, and 3.7m respectively. (Statics Canada 2011) According to 2006 census (Statics Canada 2010), population with English and French are 8.3 m and 0.5m respectively.

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2. FINANCIAL APPRAISAL
2.1. Methodology
Process of investment appraisal relies on net present value of an investment which is inseparable from weighted average cost of capital calculation of the corporation carrying out the investment. Based on the figure of net present value of an investment, internal rate of return in comparison to the corporations WACC may be a respond as well to the question; whether the project should be undertaken. It should be highlighted that both methods are also should be the subject of a global benchmarking among other investment possibilities. However, in this appraisal, only the Canada operation will be analyzed due to the requirements of the assessment. In the following section after calculation of NPV, methods of financing the investment and how this method may affect the NPV of the investment will be defined.

2.2. Interpreting the Data and Financing

WACC is a significant value varying from one to another due to the tax that corporation is paying, beta value and debt & equity structure of the corporation. In the case of Next, predominantly leaded by low gearing, 0.56, 0.55, and 0.50 by the end of the years of 2009, 2010, 2011 respectively (NEXT plc. 2010, 2011), WACC can be considered 7.05%. (see appendix-WACC) According to NPV calculation (see appendix-NPV), a main tool of discounted cash flow and carried out time value of consideration states the NPV as 79,536. During the calculation withholding tax considered as 5% (Canada Revenue Agency 2012) exchange rate considered as 1.55 (see appendix-NPV) due to the fluctuations of GBP/CAD in last 2 years. In my point of view, based on previous years peaks and bottoms, I dont consider possible fluctuations as significant as that can affect the decision of whether the project should be undertaken. Since, in case of GBP/CAD 1.52, the bottom of last 5 years, NPV of project results 81,106, in case of GBP/CAD2.25, the peak of our 5year graph, NPV results 54,791. However, the exposure should be hedged anyway which is a subject of following section. Positive NPV and IRR greater In both scenarios, internal rate of return doesnt than cost of capital constitute change and thats what internal refers, not incorporating an acceptable investment. external or in other saying macro-environmental factors. Still, a significant measure of acceptability of an investment, IRR states internal return of the project is greater than the cost of capital, 13% and 7.05% respectively. (see appendix-IRR) Positive NPV and IRR greater than cost of capital, constitute an acceptable investment. Three paths lie on project, one is financing the project with equity and the rest are borrowing in Canada and UK. In consideration of official interest rates are 1.25% in Canada and 0.50% in UK (Financial Times 2012) it is seen why NEXT should go with the path of borrowing in UK. As we already know that equity financing costs more than borrowing due to the tax rates are being higher than interest rates in natural, financing with borrowing became cheaper relatively in last decades in consideration of very low interest rates. (FED 2012) Also, Ben Bernankes announcement (The Guardian 2012) that interest rates will have to stay low to help the recovery, in particular, high unemployment, provides a guarantee for NEXTs second party borrowing in 2013. (see appendix-borrowing in UK) Lastly, the gearing ratio of NEXT we previously mentioned provides an appropriate ground for borrowings as well.

3/29/2012 Borrowing in UK is also adding extra value to the project due to the tax and interest rate relation already mentioned, by increase in NPV from 79,536 to 193,778. (see appendix-borrowing in UK)

3. FOREIGN CURRENCY EXPOSURE

3.1. Transaction Exposure
Transaction exposure is a cash flow exposure and arises because the cost or proceeds in home currency of settlement of a future payment or receipt denominated in a currency other than the home currency may vary because of changes in exchange rates. This may arise at the time of settlement the exchange rate may have changed from the date of the transaction or due to future borrowings commitments in foreign currency or future dividend repatriations to home. By failing to cover transaction exposure may result in an overall loss. There is a significant balance between short and long term performances during decision of hedging risks. Because a company dead in short term will likely wont be all right in the future. It can be seen from the GBP-CAD chart (Bloomberg 2012) below that survival of any UK company carrying out no hedging techniques during the years between 2007 and 2012 is unlikely. As I dont suggest waiting for a long time for Fisher effect to assert itself in terms of four-way equivalence relationship, some hedging ways to manage the exposure will be presented. Based on the given scenario, the subsidiary is sourcing half of its goods in Canada, and sourcing the rest in UK. Proceeds are denominated in Canadian Dollar whereas half of the costs of goods sold are denominated in British Pound. Also in previous section, it is suggested to increase net present value of the project via borrowing in UK which is a matter of exposure as well due to varying denomination from the proceeds. In recent five years GBP-CAD rate peaked at 2.28 closing rate and hit bottom at 1.49 closing rate and by the date of 26/03/2012 realised as 1.58. It is hard to forecast how the exchange rate will move in short term but in consideration of expectations theory is based on the forward rate being an unbiased predictor of the future spot rate in the long term, one month, three month and one year forward rates (Financial Times 2012) predict a slight increase at 0.0006, 0.0021 and 0.0093 respectively. By the end of the first year of the investment, as we expect 350m CAD revenue (see appendixNPV) according to the prediction based upon the one month forward rate at 1.5893 the consolidated revenue will decrease 220.2m GBP from 221.5 GBP which refers a 1.2 m loss. As it is not an exact science the amount could be more or less, also it is possible CAD could strengthen against pound which refers a gain for the subsidiary.

3/29/2012 Borrowing in UK leads arise the exposure, on the other hand the way of borrowing in Canada due to absorb the change in revenue is offset by the high interest rate. In case of borrowing in Canada, only in 2013 the relative loss to borrowing in UK will be 4.3 m, therefore if the management forecasts CAD will weaken against GBP, hedging the risk by forwards or options contracts as external hedging techniques would be wiser.

3.2. Translation Exposure

This exposure arises on the process of foreign-currency-denominated assets and liabilities consolidation. There are 2 methods of profit and loss accounts translation permissible in accounting procedures of UK (Buckley 2004); one is translating at average exchange rate, another one is translating at the exchange rate at the end of the accounting year. There are four methods as well for balance sheet translation; the all-current, current/non-current method, the temporal, and the monetary/non-monetary method. I advise utilising the all-current (closing rate) method which merely translates all foreign-currencydenominated items at the closing rate, due to its consistency and popularity over the world for translating foreign subsidiaries balance sheets. On the other hand, although the gains and losses are real, this kind of exposure has little effect on value in an economic understanding but only gearing should be concerned (Edelshain 1995) in translation exposure. On the other hand, we previously mentioned that group has a low gearing moreover we also highlighted the vitality of borrowing in UK, the probable losses will be offset by gains of borrowing in UK. In sum, first principle, it is uncommercial to hedge a non-cash item with a cash one. (Clark and Taiyeb 1987)

3.3. Macroeconomic Exposure

Measuring and hedging the macroeconomic exposure should be carried out in competitive edge, because it is concerned with how cash flows, profit and hence value change due to the economic environment as a total framework within inflation rates, exchange rates, interest rates, commodity price levels and wage levels etc. In other saying, every corporations vulnerability or sensitivity varies. As previously mentioned in investment appraisal section, a change in foreign exchange rate or interest rate movements will have a direct impact on the value of the project or the company, as it is a cash flow exposure.

3.3.1. Competitive Edge

Operating in Canada requires a high competitiveness not only against Canadian corporations but also other foreign corporations. In assumption, in case of Pounds strengthening against Canadian Dollar whereas Euro is stable against Canadian Dollar, ceteris paribus, a French subsidiary sourced by French Head Office will increase its competitiveness against subsidiary of Next. The same assumption can be expanded with switching the variable of exchange rates with commodity prices which will directly increase cost of goods sold. Also a collective agreement that increase wages will have an effect on profitability and in the end the value of the subsidiary. Opposing to transaction exposure, measuring the exposure within a total framework is not easy.

3.3.2. Strategy
As a consequence of sourcing goods from UK and ongoing inflow from sales in Canadian dollars, subsidiary wishes to avoid the Canadian dollar exposure by usage forward market. On the other hand, it might decide to source a significant volume of purchases from the Canada, or, denominated in Canadian

3/29/2012 dollars. At that time, the aggressive strategy will increase exposed cash, debtors and loans receivable in strong currencies and increase borrowings and trade creditors in weak currencies if there any, maybe during the sourcing commodities for production in both UK and Canada and from another standpoint, reducing exposed borrowings and trade creditors in strong currencies and reducing cash, debtors and loans receivable in weak currencies at the same time. Price variation should be based on that there is always a possibility of a need to increase prices to counter the negative effects raised by changes of exchange rates. This aims to maximize the profits and it can be termed as aggressive strategy but also, in asset/liability management, as previously suggested a defensive approach, matching inflows and outflows in same denomination, in contrast to aggressive approach of increasing exposed cash inflows denominated in currencies expected to be stronger and increases exposed cash outflows denominated in weak currencies. This can be stated as the backbone of balanced and hybrid character of advised hedging strategy.

3.3.3. Hedging in a Total Framework

If the subsidiary wishes to hedge this exposure, it would use foreign exchange forwards, interest rate futures and commodity futures as external techniques In terms of carrying out internal techniques, corporations which have subsidiaries under effect of different dynamics in different countries like NEXT has a chance to carry out multilateral netting. Invoicing customers in home currency seems not possible or at least limited due to the character of retail industry. Also increasing currency portfolio and balancing liabilities are not appropriate for a consistent strategy within a total framework. In long term company should aim to source all of the goods from Canada by local production facilities and fund local expenses denominated in local currency.

4. ORGANISATIONAL STRUCTURE
4.1. Subsidiary vs. Branch
I suggest structuring a subsidiary rather than a branch. In first look branch may be attractive for tax purposes, or establishing a swift harmony with the head office. On the other hand, Canadian Act imposes a "branch tax" on any non-resident corporation carrying on business in Canada. (PKF LLP 2011) This tax is meant to be a proxy for Canadian non-resident withholding tax. In addition the benefits absorbed by branch tax also the ability of making the process of executing documents much simpler can be counted.

4.2. Management from a Distance

Employee retention can be provided by financial motivations, group sessions with all acquired employees, team of seasoned managers who is available for dispatching to Canada, senior management involvement and provide future career development paths. Alongside with these structuring measurement of the performance should be compared with budget using local currency (Carsberg 1983) As mentioned in demographics Canada is a multi-lingual country consisting of English, French and aboriginal languages. In consideration of establishing 24 branches in Quebec which populates mostly French speaking people, it should be highlighted the necessity of recruitment of local multi-lingual people from the bottom to the top of the hierarchy.

4.3. Risks and Advantages of Trading in Canada

3/29/2012 In light of the facts given in introduction part, Canada is one of the most politically, socially and economically stable and promising country all over the world. Any other than given in Porters 5 forces analysis affecting the trade is the double taxation treaties and not being subject to exchange controls or convertibility restrictions. The core competency of Canada is its vast consumer market and its promising fiscal condition.

5. CONCLUSION
Both during the investment and after the investment, it is suggested to carry out borrowing in UK due to its vital contribution to the value of the subsidiary and the Group. Gearing ratio of the Group and expectations on interest rates will be stable at low levels in short term provides an appropriate ground for future borrowings as well. In consideration of expectations theory, forward contracts are predicting a slight strengthening in British Pound against Canadian Dollar which refers a loss for the subsidiary whose proceeds denominated in Canadian dollar. In a total framework, as exchange rates are not moving apart from macro factors, all inflows and outflows and their relation causing exposure should be hedged in a strategy considering a balance between short/long run, and aggressive/defensive standing as well. As increasing currency portfolio is limited with CAD, GBP and currencies the company sources its commodities, matching sales and costs currencies denominations being impossible at least in short term, and impossibility of invoicing customers in GBP due to the character of retail industry, and lastly, matching assets and liabilities not being consistent with the strategy of borrowing in UK while company is earning in CAD whereas equipping derivatives such as forwards and options in addition to swift and efficient pricing strategy against losses due to foreign currency exposure refers a vital importance in short term. As for long term, strategy of becoming a self-sufficient organization in terms of sourcing goods from Canada and funding costs via its proceeds denominated in same currency should be carried out for a higher value for all stakeholders. Structuring a subsidiary within a consideration of branch tax would be better for the Group. Strength of employee retention mechanisms and efficient management of multi-lingual markets have key importance and Canada is a right place to invest in consideration of its politically, economically and socially stable environment.

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REFERENCES
Bloomberg 2012, British pound-Canadian dollar Exchange Rate, Viewed 27 March 2012, <http://www.bloomberg.com/quote/GBPCAD:CUR/chart/>. Buckley, A., 2004. Multinational Finance. 5th ed. London: Pearson Education Canada Revenue Agency 2012, Corporation Tax Rates, Viewed 05 March 2012, <http://www.craarc.gc.ca/tx/bsnss/tpcs/crprtns/rts-eng.html>. Canada Revenue Agency 2012, Non-resident Tax Calculator, Viewed 05 March 2012, < http://www.cra-arc.gc.ca/esrvcsrvce/tx/prtxiii/menu-eng.html>. Carsberg. B. and A. Hope (1976), Business Investment Decisions Under Inflation: Theory and Practice (IGAEW). Edelshain, D.J. (1995), British Corporate Currency Exposure and Foreign Exchange Risk Management, unpublished PhD Thesis, London Business School, London Financial Times 2012, Bonds&Rates, Viewed 14 March 2012, <http://markets.ft.com/RESEARCH/Markets/InterestRates>. FED 2012, Selected Interest Rates, Viewed 07 March 2012, <http://www.federalreserve.gov/releases/h15/data.htm>. The Guardian 2012, Ben Bernanke's promise to support economic recovery boosts US markets, Viewed 27 March 2012, < http://www.guardian.co.uk/business/2012/mar/27/ben-bernanke-economy-us-markets>. HM Revenue&Customs 2012, Explanatory Memorandum. [pdf] : HM Revenue&Customs. Available at: <http://www.hmrc.gov.uk/international/canadaem.pdf> [Accessed 05 March 2011]. HM Revenue&Customs 2012, Tax Treaties in Force- Canada, Viewed 05 March 2012, <http://www.hmrc.gov.uk/international/canada-index.htm>. IMF 2012, World Economic Outlook, Viewed 05 March 2012, <http://www.imf.org/external/pubs/ft/weo/2012/update/01/index.htm>. NEXT plc, 2010. Annual report and Accounts 2009-2010, London: NEXT plc.http://ir2.flife.de/data/next/igb_html/download.php?bericht_id=1000005&lang=ENG

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NEXT plc, 2011. Annual report and Accounts 2009-2010, London: NEXT plc.http://ir2.flife.de/data/next/igb_html/download.php?bericht_id=1000005&lang=ENG PKF LLP 2011, Canada Tax Guide. [pdf] London: PKF LLP. Available at: <http://www.wipfli.com/Resources/Images/13726.pdf> [Accessed 27 March 2011]. Snap-shop 2012, Viewed 05 March 2012, <http://www.snap-shop.co.uk/retailerdirectory/retailer.aspx?ret_id=561&retailer_name=Next>. Statics Canada 2010, Portrait of Official-Language Minorities in Canada: Francophones in Ontario. [pdf] Ottawa: Statics Canada. Available at: <http://www.statcan.gc.ca/pub/89-642-x/89-642-x2010001-eng.pdf> [Accessed 05 March 2011]. Statics Canada 2011, Population by year, by province and territory, Viewed 05 March 2012, <http://www40.statcan.gc.ca/l01/cst01/demo02a-eng.htm>.