Chapter 20- Final [Ppt-fm Report

(Textbook) Behavior in Organizations, 8ed (A. B. Shani)20 - *
Scope of Financial Management
Scope of financial management includes three sets of related decisions:
Investment decisions
Financing decisions
Money management decisions
Decisions about how to manage the firm’s financial resources most efficiently
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Introduction
currencies
norms regarding the
Introduction
3. how best to manage the firm’s 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
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:
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
received cash flows are the basis for dividends, other investments, repayment of debt, and so on
Cash flows to the parent may be lower because of host country limits on the repatriation of profits, host country local reinvestment requirements, etc.
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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
How Does Political Risk
Influence Investment Decisions?
Political risk - the likelihood that political forces will cause drastic changes in a country’s 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 firm’s assets, or complete economic collapse that renders a firm’s 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 country’s 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
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
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
Financing Decisions
Source of financing
How Do Firms Make
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
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
Individuals
Companies
Governments
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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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The argument is illustrated in Figure 20.1, using the China Mobile example. The vertical axis in the figure is the cost of capital (the price of borrowing money) and the horizontal axis is the amount of money available at varying interest rates. DD is the China Mobile demand curve for borrowings. Note that the China Mobile demand for funds varies with the cost of capital; the lower the cost of capital, the more money China Mobile will borrow. (Money is just like anything else; the lower its price, the more of it people can afford.) SHK is the supply curve of funds available in the Hong Kong capital market, and SG represents the funds available in the global capital market. Note that China Mobile can borrow more funds more cheaply on the global capital market. As Figure 20.1 illustrates, the greater pool of resources in the global capital market—the greater liquidity—both lowers the cost of capital and increases the amount China Mobile can borrow. Thus, the advantage of a global capital market to borrowers is that it lowers the cost of capital.
Figure 20.1, 674
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:
Tax regimes
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
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What Is Global
Money management decisions attempt to manage global cash resources efficiently
Firms need to
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
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
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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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
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The Tax Objective
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Compared to the other countries, corporate income tax rates in ________ are relatively low.
a) Canada
b) Ireland
c) Germany
d) Japan
How Can Firms Limit
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
Taxes can be minimized through
Tax credits - allow the firm to reduce the taxes paid to the home government by the amount of taxes paid to the foreign government
Tax treaties - agreement specifying what items of income will be taxed by the authorities of the country where the income is earned
Deferral principle - specifies that parent companies are not taxed on foreign source income until they actually receive a dividend
Tax havens - countries with a very low, or no, income tax – firms can avoid income taxes by establishing a wholly-owned, non-operating subsidiary in the country
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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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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
Moving Money Across Borders:
Firms can transfer liquid funds across border via:
dividend remittances
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
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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Firms can transfer liquid funds across border using all of the following techniques except:
a) dividend remittances
c) transfer prices
d) backing loans
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
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
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 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
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Benefits of Manipulating
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 host-government 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
But, using transfer pricing can be problematic because
Governments think they are being cheated out of legitimate income
Governments believe firms are breaking the spirit of the law when transfer prices are used to circumvent restrictions of capital flows
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
Tax Advantages of
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A fronting loan can also provide tax advantages. For example, a tax haven (Bermuda) subsidiary that is 100 percent owned by the parent company deposits $1 million in a London-based international bank at 8 percent interest. The bank lends the $1 million to a foreign operating subsidiary at 9 percent interest. The country where the foreign operating subsidiary is based taxes corporate income at 50 percent (see Figure 20.2). Under this arrangement, interest payments net of income tax will be as follows:
1. The foreign operating subsidiary pays $90,000 interest to the London bank. Deducting these interest payments from its taxable income results in a net after-tax cost of $45,000 to the foreign operating subsidiary.
2. The London bank receives the $90,000. It retains $10,000 for its services and pays $80,000 interest on the deposit to the Bermuda subsidiary.
3. The Bermuda subsidiary receives $80,000 interest on its deposit tax free.
The net result is that $80,000 in cash has been moved from the foreign operating subsidiary to the tax haven subsidiary. Because the foreign operating subsidiary’s after-tax cost of borrowing is only $45,000, the parent company has moved an additional $35,000 out of the country by using this arrangement. If the tax haven subsidiary had made a direct loan to the foreign operating subsidiary, the host government may have disallowed the interest charge as a tax-deductible expense by ruling that it was a dividend to the parent disguised as an interest payment.
Figure 20.2. p. 683
The most common method of transferring funds from subsidiaries to the parent is through
a) dividend remittances
c) transfer prices
d) backing loans
Techniques for Global
Money Management
Two techniques used by firms to manage their global cash resources are:
centralized depositories
multilateral netting
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 longer-term, less liquid accounts that have higher interest rates
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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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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
Bilateral netting
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Multilateral netting allows a multinational firm to reduce the transaction costs that arise when many transactions occur between its subsidiaries. These transaction costs are the commissions paid to foreign exchange dealers for foreign exchange transactions and the fees charged by banks for transferring cash between locations. The volume of such transactions is likely to be particularly high in a firm that has a globally dispersed web of interdependent value creation activities. Netting reduces transaction costs by reducing the number of transactions. 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 from
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Cash Flows Before
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Under multilateral netting, this simple concept is extended to the transactions between multiple subsidiaries within an international business. Consider a firm that wants to establish multilateral netting among four Asian subsidiaries based in South Korea, China, Japan, and Taiwan. These subsidiaries all trade with each other, so at the end of each month a large volume of cash transactions must be settled. Figure 20.3A shows how the payment schedule might look at the end of a given month. Figure 20.3B is a payment matrix that summarizes the obligations among the subsidiaries. Note that $43 million needs to flow among the subsidiaries. If the transaction costs (foreign exchange commissions plus transfer fees) amount to 1 percent of the total funds to be transferred, this will cost the parent firm $430,000. However, this amount can be reduced by multilateral netting. Using the payment matrix (Figure 20.3B), firm can determine the payments that need to be made among its subsidiaries to settle these obligations. Figure 20.3C shows the results. By multilateral netting, the transactions depicted in Figure 20.3A are reduced to just three; the Korean subsidiary pays $3 million to the Taiwanese subsidiary, and the Chinese subsidiary pays $1 million to the Japanese subsidiary and $1 million to the Taiwanese subsidiary. The funds that flow among the subsidiaries are reduced from $43 million to just $5 million, and the transaction costs are reduced from $430,000 to $50,000, a savings of $380,000 achieved through multilateral netting.
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Cash Flows After

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Chapter 20- Final [Ppt-fm Report