Financial management in international business

Case: Global treasury management at Proctor & Gamble  60% of P &G’s revenues from international sales Products sold in 130 countries  Has centralized global treasury management functi

Case: Global treasury management at

Proctor & Gamble

 60% of P &G’s revenues from international sales

Products sold in 130 countries

 Has centralized global treasury management function

 Management of all foreign exchange transactions

 P& G trades currency between subsidiaries, cutting

out banks and saving on transaction costs

 P & G is pooling foreign exchange risks and buying

an purchasing an umbrella option to cover risks associated with various currency options

 Subsidiaries can invest in and borrow money from

other P &G entities instead of dealing with banks

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

Investment decisions

 Capital budgeting:

 Quantifies the benefits, costs and risks of an

investment

 Managers can reasonably compare different

investment alternatives within and across countries

 Connection between cash flows to parent and the source

of financing must be recognized

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

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

 Examples Collapse of communism in Eastern Europe

 Attack on the world trade center

 Economic risk

 Inflation

Financing decisions

 When considering options for financing a

foreign investment, Int businesses have to

consider two factors

 Source of financing

 Financial structure

Source of financing

 Global capital markets for lower cost financing.

 Impact of host country-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

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

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

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

Corporate income tax rates

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

 Selecting a particular policy is limited when a

foreign subsidiary is part owned by a local

joint-venture partner or local stockholders

Dividend remittances

 Most common method of transfer.

 Dividend varies with:

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

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.

Benefits of manipulating transfer

prices

 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.

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

Fronting loans

 Loan between a parent and subsidiary is

channeled through a financial intermediary

(bank).

 Allows circumvention of host-country

restrictions on remittance of funds from subsidiary to parent.

 Provides certain tax advantages.

An example of the tax aspects of a

fronting loan

Fig 20.1

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.

Centralized depositories

Day-to-Day Cash Needs (A)

One Standard Deviation (B) Required Cash Balance

(A+3xB) Spain $10 $1 $13

Italy $6

$2 $12 Germany $ 12 $3 $21

Total $28 $6 $46

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

Cash flows before multilateral netting

Fig 20.2A

Cash flows after multilateral netting

Fig 20.2C

Net receipts

Fig 20.2B

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.

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.

Strategies for reducing foreign

 Reducing economic exposure:

 Key is to distribute productive assets to various

locations so firm is not severely affected by exchange rate changes

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.

Fig C1 Fig C2

Case: Motorola’s global cash management system

Pre netting and post netting info flows

Case: Motorola’s global cash management

system

Fig C1

Case: Motorola’s global cash management

system : Currency netting model

Fig C3

Case: Motorola’s global cash management

system