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DefinitionsMoney is the blood of businessMNC 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

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Parent-subsidiary relationshipPolycentric 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)

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Diagrams of P-S relationship

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Funds flows in the MNEThree main internal sources of funding: Working capital – the difference between currents assets and currents liabilitiesBorrowing – one S can borrow from another (or the P) and repay interestAcquiring equity – when P holds equity in a S, it acquires dividends (royalties, fees)

ParentParent

Subsidiary Subsidiary AA

Subsidiary Subsidiary BB

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Loan

Interest

Loan

Interest

Equity investmentDividend

sRoyaltiesFees

Working capital

Working capital

Working capital

Multilateral nettingWhenever 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

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MLN – a diagram

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Managing cashManaging the volume of cash in the company

can prove a very difficult taskCentral 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

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Funds positioning in the MNETransfer pricing (TP)The price, which MNC set for intra-firm tradeBy manipulating the TP, companies: Maximize profits where taxes are the lowestConcentrate funds where the conditions are favorableReduce payment for (ad valorem) tariffs

Arm’s length P (S1)

Arm’s length P (S2)

TP (S1) TP (S2)

Sales $ 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

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NO NO personal income taxes personal income taxes capital gains taxes capital gains taxes corporate taxescorporate taxespayroll taxes payroll taxes withholding taxes on domestic of withholding taxes on domestic of foreign entitiesforeign entities

Funds positioning in the MNE (2)Tax havensDeath 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 governmentsThe subsidiary in the tax haven is where company profits maximizeIt is applied together with transfer pricing

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Top tax havensPlace 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

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Funds positioning in the MNE (3)Fronting loansFinancial operation, where MNC deposits funds with local financial institution, that provides a loan to the subsidiaryApplied to deal with political risk, turbulent environment and currency transfer restrictions

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SubsidiaSubsidiary in Tax ry in Tax HavenHaven

SubsidiaSubsidiary in ry in

ChinaChina

HSBC HSBC branch branch

in Chinain China

Deposits $ 1 m

Loans $ 1 m

Pays 9% interest (tax deductible)

Pays 8% interest(tax free)

Exchange (rate) risksTransaction 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:

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 $

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Value of $ in ¥

Value of assets

(denominated in ¥)

Value of liabilities(denominated in ¥)

US company Increases Decreases Decreases

HedgingMNCs often incur losses, arising currency

fluctuation (exchange rate) risksHedging 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

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ExampleUS 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 accountAnnual 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

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Evaluating financial riskFinancial 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

17Calculate WACC: http://www.moneychimp.com/glossary/wacc.htm

Evaluating other pros and consCountry 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.)

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BibliographyLecture is based on:International Financial Management

(Chapter 14) in Rugman, A. Collinson, S and Hodgetts, R. (2006) International Business (4th eds) UK: McGraw-Hill

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