Chapter Twenty

Financial Management in the

International Business

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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 firms financial
resources most efficiently
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Introduction

In an international business, investment, financing, and money

management decisions are complicated by different

currencies
regulations concerning
the flow of capital across borders
norms regarding the
financing of business activities
tax regimes
levels of economic
and political risk
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Introduction
Financial managers must consider
1. when deciding which activities to finance
2. how best to finance those activities
3. how best to manage the firms financial resources
4. how best to protect the firm from political and economic risks
(including foreign exchange risk)

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Good financial management can be a source of competitive

advantage
Firms with good financial management can reduce the costs of
creating value and add value by improving customer service

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Classroom Performance System

Which of the following is not one of the decision areas in

financial management?
a) cash operations decisions
b) investment decisions
c) financing decisions
d) money management decisions

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Investment Decisions

Financial managers must quantify the benefits, costs, and risks

associated with an investment in a foreign country
To do this, managers use capital budgeting
- involves estimating the cash flows associated with the
project over time, and then discounting them to determine
their net present value

If the net present value of the discounted cash flows is

greater than zero, the firm should go ahead with the
project
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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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What Is The Difference

Between Project And Parent
Cash Flows?
Cash flows to the project and cash flows to the parent
company can be quite different
Parent companies are interested in the cash flows they
will receive, not the cash flows the project generates

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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

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Adjusting for Political and

Economic Risk

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How Does Political Risk

Influence Investment
Decisions?
Political risk - the likelihood that political forces will
cause drastic changes in a countrys business
environment that hurt the profit and other goals of a
business
- higher in countries with social unrest or disorder, or where
the nature of the society increases the chance for social
unrest

Political change can result in the expropriation of a

firms assets, or complete economic collapse that
renders a firms assets worthless
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How Does Economic Risk

Influence Investment
Decisions?
Economic risk - the likelihood that economic mismanagement
will cause drastic changes in a countrys business environment
that hurt the profit and other goals of a business
The biggest economic risk is inflation
- reflected in falling currency values and lower project cash flows

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How Can Firms Adjust For

Political And Economic Risk?

Firms analyzing foreign investment opportunities can adjust

for risk
1.
2.

By raising the discount rate in countries where political and

economic risk is high
By lowering future cash flow estimates to account for adverse
political or economic changes that could occur in the future

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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
Collapse of communism in Eastern Europe
Attack on the World Trade Center

Economic risk
- Inflation

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Financing Decisions
How Do Firms Make
Financing Decisions?
When considering options for financing a foreign
investment, international businesses have to consider
two factors
- Source of financing
- Financial structure

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How Do Firms Make

Financing Decisions?

Source of financing

1.

How the foreign investment will be financed

the cost of capital is usually lowest in the global capital market

but, some governments require local debt or equity financing
firms that anticipate a depreciation of the local currency, may
prefer local debt financing

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How Do Firms Make

Financing Decisions?
Financial structure

2.

How the financial structure (debt vs. equity) of the foreign

affiliate should be configured

need to decide whether to adopt local capital structure norms or

maintain the structure used in the home country

Most experts suggest that firms adopt the structure that

minimizes the cost of capital, whatever that may be

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Financing Decisions and

The Global Capital Market
A capital market brings together those who want to invest
money and those who want to borrow money
Those who want to invest money include
- Corporations
- Individuals
- Non-bank financial institutions

Those who want to borrow money include

- Individuals
- Companies
- Governments

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Financing Decisions and

The Global Capital Market
Capital market loans to corporations re either
- Equity loans occur when corporations sell stock to investors
- Debt loans occur when a corporation borrows money and agrees
to repay a predetermined portion of the loan amount at regular
intervals regardless of how much profit it is making

Cost of capital is the price of borrowing money, which is the

rate of return that borrowers must pay investors
- In a purely domestic capital market the pool of investors is limited
to residents of the country
Places an upper limit on the supply of funds available
Increases the cost of capital

- A global capital market provides a larger supply of funds for

borrowers to draw on
Lowers the cost of capital
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Financing Decisions and

The Global Capital Market

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Source of Financing
Global capital markets for lower cost financing.
Impact of 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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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 companys image

Best recommendation: adopt a financial structure that

minimizes the cost of capital

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What Is Global
Money Management?

Money management decisions attempt to manage

global cash resources efficiently
Firms need to
1. Minimize cash balances - need cash balances on
hand for notes payable and unexpected demands
-

cash reserves are usually invested in money market

accounts that offer low rates of interest
when firms invest in money market accounts they have
unlimited liquidity, but low interest rates
when they invest in long-term instruments they have
higher interest rates, but low liquidity

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What Is Global
Money Management?
Firms need to:
2. Reduce transaction costs - the cost of exchange
-

every time a firm changes cash from one currency to

another, they face transaction costs

Most banks also charge a transfer fee for moving

cash from one location to another
Multilateral netting can reduce the number of
transactions between subsidiaries and the number of
transaction costs

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Global Money Management

-The Efficiency Objective
Summary
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
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Classroom Performance System

The fee for moving cash from one location to another is called
a) the money management fee
b) the transaction cost
c) the transfer fee
d) the cost of capital

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Global Money Management

The Tax Objective
Table 20.1: Corporate Income Tax Rates, 2006

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Classroom Performance System

Compared to the other countries, corporate income tax rates in

________ are relatively low.
a) Canada
b) Ireland
c) Germany
d) Japan

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How Can Firms Limit

Their Tax Liability?
Every country has its own tax policies
- most countries feel they have the right to tax the foreign-earned
income of companies based in the country

Double taxation occurs when the income of a foreign

subsidiary is taxed by the host-country government and by the
home-country government

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How Can Firms Limit

Their Tax Liability?
Taxes can be minimized through
1. Tax credits - allow the firm to reduce the taxes paid to the
home government by the amount of taxes paid to the
foreign government
2. Tax treaties - agreement specifying what items of income
will be taxed by the authorities of the country where the
income is earned
3. Deferral principle - specifies that parent companies are not
taxed on foreign source income until they actually receive
a dividend
4. Tax havens - countries with a very low, or no, income tax
firms can avoid income taxes by establishing a whollyowned, non-operating subsidiary in the country
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Global Money Management

The Tax Objective
Summary
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

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Classroom Performance System

A __________ specifies that parent companies are not taxed on

foreign source income until they actually receive a dividend.
a) tax credit
b) deferral principle
c) tax haven
d) tax treaty

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Moving Money Across Borders:

Attaining Efficiencies and Reducing Taxes
Firms can transfer liquid funds across border via:
dividend remittances
royalty payments and fees
transfer prices
fronting loans
Firms that use more than one of these techniques is using a
practice called unbundling

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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
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Classroom Performance System

Firms can transfer liquid funds across border using all of the
following techniques except:
a) dividend remittances
b) royalty payments and fees
c) transfer prices
d) backing loans

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What Are
Dividend Remittances?
Paying dividends is the most common method of
transferring funds from subsidiaries to the parent
The relative attractiveness of paying dividends
varies according to

tax regulations high tax rates make this less attractive

foreign exchange risk dividends might speed up in risky
countries
the age of the subsidiary older subsidiaries remit a higher
proportion of their earning in dividends
the extent of local equity participation local owners
demands for dividends come into play

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Royalty Payments and Fees

What Are
Royalty Payments And Fees?
Royalties - the remuneration paid to the owners of
technology, patents, or trade names for the use of that
technology or the right to manufacture and/or sell
products under those patents or trade names
- can be levied as a fixed amount per unit or as a percentage
of gross revenues
- most parent companies charge subsidiaries royalties for the
technology, patents or trade names transferred to them
Most parent companies charge subsidiaries royalties for the
technology, patents or trade names transferred to them
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Royalty Payments and Fees

What Are
Royalty Payments And Fees?
A fee is compensation for professional services or expertise
supplied to a foreign subsidiary by the parent company or
another subsidiary
- royalties and fees are often tax-deductible locally

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Transfer Prices
What Are Transfer Prices?
Price at which goods or services are transferred within
a firms 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

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Benefits of Manipulating
Transfer Prices
Transfer prices can be manipulated to:
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 hostgovernment policy(Move funds from a subsidiary to the parent when
dividends are restricted by the host government)
Reduce import duties (ad valorem) by reducing transfer prices and
the value of the goods

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Problems With Transfer Pricing

What Makes Transfer Prices
Unattractive?

But, using transfer pricing can be problematic because

1. Governments think they are being cheated out of legitimate
income
2. Governments believe firms are breaking the spirit of the law
when transfer prices are used to circumvent restrictions of
capital flows
3. It complicates management incentives and performance
evaluation

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Fronting Loans
What Are Fronting Loans?
FRONTING LOANS -Loan between a parent and
subsidiary is channeled through a financial
intermediary (bank)
Firms use fronting loans
- to circumvent host-country restrictions on the remittance of funds
from a foreign subsidiary to the parent company
- to gain tax advantages

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Tax Advantages of
Fronting Loans
An Example of the Tax Aspects of a Fronting Loan

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Classroom Performance System

The most common method of transferring funds from subsidiaries

to the parent is through
a) dividend remittances
b) royalty payments and fees
c) transfer prices
d) backing loans

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Techniques for Global

Money Management
Two techniques used by firms to manage their global cash
resources are:
centralized depositories
multilateral netting

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Centralized Depositories

All firms must maintain easily accessible cash balances

Firms must decide whether to hold cash balances at each
subsidiary or at a centralized depository
Most firms prefer the latter for three reasons:
1. by pooling cash reserves centrally, firms can deposit larger
amounts, and therefore earn higher rates of interest
2. when centralized depositories are located in major financial
centers, the firm has access to a greater variety of investment
opportunities than a subsidiary would have
3. by pooling cash reserves, firms can reduce the total size of the
readily accessible cash pool, and invest larger amounts in longerterm, less liquid accounts that have higher interest rates
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Centralized Depositories

Sometimes, government restrictions on cross-border capital

flows limit the use of centralized depositories
Firms must also be aware of the transaction costs involved in
moving money in and out of a centralized depository
The use of centralized depositories is expected to increase
thanks to the globalization of capital markets and the removal of
barriers to the free flow of capital across borders

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Techniques for Global

Money Management
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

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Centralized Depositories

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Multilateral Netting

Firms using multilateral netting can reduce the transaction costs

associated with many transactions between subsidiaries
Multilateral netting is an extension of bilateral netting
-Under bilateral netting, if a French subsidiary owes a Mexican
subsidiary $6 million, and the Mexican subsidiary simultaneously
owes the French subsidiary $4 million, a bilateral settlement will be
made with a single payment of $2 million
-Under multilateral netting, the concept is extended to multiple
subsidiaries within an international business
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Techniques for
Global Money Management
Ability to reduce
transaction costs
- Bilateral netting
- Multilateral netting
simply extending the
bilateral concept to
multiple subsidiaries
within an international
business

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Cash Flows Before

Multilateral Netting

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