OHANA

International Financial Management

Presented to Sir Tasawar Javed

Group members

Iqra Butt 25Rashid Badar 38

Nadia Perveen 49Sariya Manzoor 59

Sheraz Irshad 63

Introduction

International financial management encompasses a number of key areas. These include

• Management of Global cash flow• Foreign exchange risk management• Capital expenditure analysis• Capital budgeting

• Decision in each of these areas can significantly impact the others. For example, if the exchange rate of Mexican peso sharply decline against the dollar the multinational may decide to transfer more dollars to its Mexican subsidiary so that the unit can continue paying for imports from the US.

Objectives

• Provide assistance to all geographic operations

• To limit financial losses through the use of carefully formulated cash flow guidelines

• Timely execution of foreign exchange risk strategies

• Prudent capital expenditures • Careful capital budgeting

The responsibility for these activities is spread thought the organization and some of these decisions are made on day-to day basis whereas others are determine periodically

• Some decisions are made by the parent company whereas others fall within the preview of the subsidiary.

Determining parent-subsidiary relationship

• Parent companies firmly establish the relationship that will exist regarding financial planning and control authority

• Each branch or subsidiary should be responsible for its own planning and control system

• There must be some central control in order to coordinate overall operations and to ensure both efficiency and profitability

• Addressing these challenges, MNEs tend to operate for one of three solutions

• Polycentric solution• Ethnocentric solution• Geocentric solution

Polycentric solution

• An approach to determining parent- subsidiary relation

• It involves treating the MNE as a holding company and decentralizing decision making to the subsidiary level

• Advantages of polycentric approach are those commonly obtained with decentralization

• Decision are made on the spot by those most informed about market conditions and international subsidiary tend to be more flexible, motivated, efficient and competitive

• It reduce the authority of the home office and senior corporate management often dislike this dilution of authority

Ethnocentric solution

• It involves treating all foreign operations as if they were extensions of domestic operations

• Advantage of this approach is that management is able to coordinate overall operations carefully

• Drawback of this approach is that it can cause problem for the individual subsidiary which may feel that it need more cash than is left on hand or that it is hindered in its efforts to expand because the parent company is siphoning off necessary resources

Geocentric solution

• Handling financial planning and controlling decisions on a global basis

• These decisions influcend by two factors• Nature and location of subsidiary For example British investment in north

America has predominantly been via holding companies, the polycentric approach, since the quality of local management largely rewards decentralization.

• A second influencing factor is the gains that can be achieved by coordinating all units in a carefully synchronized way.

• Example????

Managing Global Cash Flows

1. Internal Funds Flows2. Funds positioning techniques3. multilateral netting.

Internal Funds Flows

1.Working Capital.• Difference between current assets and

current liabilities. For example• If GM German subsidiary wants to heir more

employees it may be able to pay for this payroll increase out of the funds it generates from on going operations.

• 2.Borrowing from a local bank.• For Example an MNE’s Chilean subsidiary will

get a loan from the parent company or the German subsidiary and then repay the money with interest out of operations.

• 3.By having the parent company increase its equity capital investment in the subsidiary.

Funds positioning techniques

• Strategies that are used to to move monies from one multinational operations to another.

• Three most common approaches are 1.Transfer pricing 2.Tax havens3.Fronting loans

Transfer pricing

• An internal price set by a company in intrafirm trade such as the price at which one subsidiary will sell a product to another subsidiary.

• Exapmle?????

Tax Havens

• Low tax countries that are hospitable to business.

Tax Havens

• It involves a subsidiary selling its output at a very low cost to a subsidiary in a tax haven which in turn sells the merchandise at a very high price to a third subsidiary.

Transfer Pricing through Tax Havens

Country ASubsidiary

Country BSubsidiary (Tax Haven)

Country CSubsidiary

Sales $ 8,000 exports $12,000 exports $12,000

Cost of sales 8,000 8,000 8,000

Profit ____ ____ ____

Tax RateA .40%, B.0%, C .50%

____ ____ ____

Net Profit 0 4,000 0

Tax Haven: International Business Strategy in Action

• Switzerland, Bahamas, Monaco and Andora.• What led to creation of Tax Haven???

-No single international tax standard

• Each tax haven jurisdiction has its own sets of laws on taxation and transparency.

Tax Haven: International Business Strategy in Action

OECD factors for identifying a tax haven are,

I. Impose no or nominal taxes and is used by foreigners to escape tax in their own countries.

II. Has laws or administrative practices which prevent the exchange of information with other governments on taxpayers benefiting from low taxation.

Tax Haven: International Business Strategy in Action

iii. Lack transparency

iv. Does not require substantial productive operations in the country, suggesting policies geared to attracting income only on a preferential basis

Fronting Loans

• “A funds positioning strategy that involves having a third party manage the loan”.

• For example, if a US multinational decided to set up operations in china , the MNE might be concerned with the political risk that accompanies such a decision.

Fronting Loans

• For protecting their investment, the parent company could deposit funds with a major international bank that has strong ties to china and is on good terms with the government.

• In turn the subsidiary would apply for a loan with this bank and the multinational company’s deposit would be given to the subsidiary in the form of a loan.

Multilateral Netting

• “The process of determining the net amount of money owed to subsidiaries through multilateral transactions”.

Multilateral dollar flows between subsidiaries.

Germany subsidiary

Mexican subsidiary

Chilean subsidiary

Japanese subsidiary

Centralized Netting Process in Action

Germany subsidiary

Japanese subsidiary

Mexican subsidiary

Central Clearing Account

Chilean subsidiary

Multilateral Netting

• The clearing account manager is responsible for seeing that this process occurs quickly and correctly.

• These transfers usually take place in the currency of the payer.

Multilateral Netting

• Advantages:1. Helps the parent company to ensure that financial

interactions between the units are quickly brought to completion.

2. Units that are owed money have faster access to their funds3. Parent company knows which subsidiaries are amassing large

amounts of cash and can tap these sources if necessary to support activities in other locales.

4. The cost of converting foreign exchange is minimized.

Multilateral Netting

• Disadvantages:1.Many governments place controls on these

operations by allowing them only for trade transactions.

2.Government have required that payment fir imports be delayed until these goods clear customs, thus slowing down the netting process by as much as 60 to 90 days.

Multilateral Netting

3.Reluctance to cooperate on the part of managers whose cash outflows are substantially larger than their inflows.

Inherent Problem in this process is of foreign exchange risk.

Foreign Exchange Risk Management

• Areas of attention when examining foreign exchange risk management are,

1.Inflation and its impact on foreign exchange2.Type of exposure that exchange rate create.3.Hedging strategies used to minimized risk4.Types of forecasting and reporting systems

that must be developed in order to plan and control company responses

Inflation

• Inflation encourages buyers to purchase now while prices are lower.

• It affects interest rates by driving up the cost of loans.

• Affects value of local currency in international marketplace.

Inflation

• Financial strategies used when MNE’s do business in a country facing rapid inflation are,

i. Rapid depreciation of equipmentii. Slower payments of outstanding accounts to

sellers who are taking payment in local currency

Inflation

iii. Greater emphasis on collecting current receivables since this currency is losing its value each month.

iv. Holding minimum amounts of local currency while transferring the rest of these funds into more stable or appreciating currencies

Inflation

v. Looking for other sources of capital since local borrowers are going to be increasing interest rate in order to protect the real return on investment. Multinationals will also consider raising their prices so as to protect their profitability in the face of inflation.

Addressing exchange rate fluctuations

• For reducing exchange rate fluctuations techniques used are,

1.Translation Exposure2.Transaction Exposure3.Economic Exposure

• Translation ExposureTranslation Exposure – Relates to the change in accounting income and balance sheet statements caused by changes in exchange rates.

• Transactions ExposureTransactions Exposure – Relates to settling a particular transaction at one exchange rate when the obligation was originally recorded at another.

• Economic ExposureEconomic Exposure – – Involves changes in expected future cash flows, and hence economic value, caused by a change in exchange rates.

Hedging Strategies

• A form of protection used against an adverse movement of an exchange rate most common forms of hedging are

• Operating financial strategies• Forward exchange contracts• Currency options

Operating financial strategies

• Design to minimize the effect of changing exchange rate on a local unit’s profitability

• In this we use two strategies: 1.Lead strategies 2.Lag strategies

Lead strategy

• A hedging strategy that calls for collecting foreign currency receivables before they are due if the currency is expected to weaken and paying foreign currency payables before they are due if the currency is expected to strengthen

Lag strategy

• A hedging strategy that calls for delaying the receipts of foreign currency payments if this foreign currency is expected to strengthen and delaying foreign currency payables when the local currency is expected to weaken

Forward exchange contracts

• A legally binding agreement between a firm and a bank that calls for the delivery of foreign currency at the specific exchange rate on a predetermined future date

Currency options

• An instrument that gives the purchaser the right to buy or sell a specific amount of foreign currency at a predetermined rate within a specified time period

Capital expenditure analysis and capital budgeting

• Capital expenditures are major projects in which the cost are to be allocated over a number of years. Example includes major acquisitions the building of new plants and refurbishing of existing equipment.

• Mathematical techniques of analysis are often used including discounting cash flow technique such as net present value (NPV) and internal rate of return

Who should conduct the analysis, parent or the foreign subsidiary?

• Initial analysis is done at the subsidiary or branch level and then passed to the head office

Use of NPV

• The parent company will review the expenditure proposals because it has the necessary overall information to make these decisions

• NPV equation is:• NPV=

• We must realize the disagreement between parent and subsidiary can arise because of the discount rate, investment cost and annual cash flows

• Political risk can also affect all values• Political risk may cause the parent to increase

the discount rate or required return to reflect that risk

Institutional features

There are two institutional factors that warrant attention

• Government subsidies and controls• Political risk insurance

Government subsidies and control

• Foreign investment review agencies which review foreign investment to ensure that they benefit the local economy

Political risk insurance

• It is available in most countries for exports and foreign direct investment

• In the US the overseas private investment corporation (OPIC) was established in January 1971 to provide insurance for US forgien investment against blocked funds expropriation and war and revolution and insurrection

• In the US it is estimated that about 70 percent of foreign investment in less developed countries is insured through OPIC

Strategic international finance

• In it we use three approaches to chose site for overseas operations

• Establishing overseas operations• Reducing financinal risk• Cost cutting

Establishing overseas operations

• Because US is the major market for many international firms forigen MNEs have been particullarly concered about the value of the US doller

Reducing financinal risk

• There are some techniques which are used to reduce the financinal risk

• Mergers• Acquisitions• Joint ventures• Partnering

Alliances

• In recent years an incerasing number of MNEs have been joining together to share the costs of high-tech projects

• It not involve only research and devlopment expenses but also the costs of manufacutring and selling the finished products

Cost cutting

• Another key financinal stratgey is cutting cost and investing in new plant and equipment resulting in higher productivity and lower expences