Multinational businessLecture, week 3

FINANCING THE OPERATIONS OF THE MULTINATIONAL ENTERPRISE

International financial management

• Acquisition and use of funds for cross border trade, investment and other commercial activities

• Carry out transaction in a multitude of foreign currencies, diverse environment characterized by restrictions on capital flows, country risk and varying accounting and tax system

• Funds from variety of sources: foreign bond markets, local stock exchange, foreign banks, venture capital firms and intra corporate financing: whatever is the cheapest

• Access to funding crucial for small business to finance the large orders until they get payment

Primary task in international financial management• MNC such as Motorola have facilities in nearly 50 countries• Raises fund in financial markets worldwide• Firms manager must therefore be familiar with the laws and

regulations that govern the financial exchanges worldwide• Managed through network of subsidiaries and strategic business units• Financial manager involved in acquisition and allocation of financial

resources for the firms current and future activities and projects with primary objective of maximizing the firm value

Financial management tasks

• There are 6 major financial management tasks that are crucial to the survival of firms engaged in international business:

• Decide on the capital structure(ideal mix of Deb vs Equity financing)• Raise funds for the firms(acquire equity, debt or intra-corporate financing for funding

value adding activities and investment projects)• Working capital and cash flow management(manage funds passing in and out of the

firms value adding activity)• Capital budgeting(assess the financial attractiveness of major investment projects)• Currency risk management(manage the multiple currency transactions of the firm

and the exposure to risk created by exchange rate fluctuation)• Manage the diversity of international accounting and tax practices(learn to operate in

global environment with diverse accounting practices and international tax regime)

DECIDE ON THE CAPITAL STRUCTURE • Capital structure is the mix of long-term EQUITY FINANCING and DEBT FINANCING

firms use to support their international activities. • Equity financing is obtained from selling shares and stock to investors or by retaining

earnings which is profit reinvested in the firm rather than paid out to investors• Debt financing comes from either of two sources:

• loans from banks and other financial intermediaries or • money raised from the sale of corporate bonds (via the bond market) to individuals or

institutions.

• Using debt finance can add value to the firm• But too much debt could lead firm to financial distress and possible bankruptcy• Therefore the firm to maintain a good credit rating and minimize the possibility of

going bankrupt, most MNE’s keep the debt proportion below a maximum thresholds

DECIDE ON THE CAPITAL STRUCTURE• Asian financial crisis of 1997• The debt ratio – debt divided by total assets – gives an indication of whether a

company is over-borrowed (and therefore has a high risk exposure) or not. • In the UK and the USA the debt ratio is about 0.55 – i.e. the capital structure is

composed of roughly equal amounts of debt and equity financing. • How much debt a firm should hold partly depends on the nature of its industry and

target markets.

• Debt ratio varies among countries: Germany-0.62, Italy- 0.76 and even higher in Japan and other developing countries

• Lack of well developed stock market, therefore no choice but to borrow money from banks• Nations firm may have much closer relationship with bank. For e.g. sony co. has its own bank.

RAISE FUNDS FOR THE FIRM

• Firms can obtain financing in • GLOBAL MONEY MARKET, which are the collective financial markets where

firms and governments raise short-term financing, and the • GLOBAL CAPITAL MARKET, which are the collective financial markets where

firms and governments raise intermediate- and long-term financing.

• The global capital market provides three key advantages for the international business.

• Ability to access funds from large pool of sources at a competitive cost• For international investor, ability to access a much wider range of

investment opportunities than is available in domestic market

Financial centre

• The global capital market is concentrated in major financial centres such as New York, London, and Tokyo.

• Major secondary centres include Frankfurt, Hong Kong, Paris, San Francisco, Singapore, Sydney and Zurich.

• At these locations firms can access the major supplies of capital( banks, stock exchanges and venture capitalists)

• Global capital market is huge and growing rapidly• Deregulation of financial markets- easy movement of capital across border• Innovation of ICT- quick financial transaction• Firm seek new and more cost efficient ways to finance global operations• Securitization of financial instruments

Sources of funds for international operations• Equity • Debt• Intra-corporate financing

Equity financing

• Issue share in return for ownership of the firm and often stream of dividend• Advantage: obtains needed fund without incurring debt• Disadvantage: ownership diluted; risk of loosing control• Internationally obtain equity financing by selling shares in global equity

market(worldwide market of funds for equity financing)• Important trend today is that investors who buy stocks in foreign exchanges• The marriage of technology and trading has allowed stock exchanges to grow

rapidly• Diversification and opportunity• Trading has been easier: online trading, collaboration between exchanges

Debt financing

• Borrow money in exchange for repayment of principal and interest• No loss of ownership• Sources: loans and sale of bonds• International Loan: loan from government agencies, MNE gets loan from parent firm or sister

subsidiary• Eurocurrency market: any currency deposited in bank outside its country of origin; for e.g.

Eurodollars; market more attractive; different government regulations compared to home; high interest rate on Eurocurrency deposits and low interest rate on loan

• Bonds: debt instrument that enables the issuer to raise capital by promising to repay the principal along with interest in specified date; global bond market(international market place in which bonds are bought and sold primarily through bank and brokers); foreign bond(bond sold outside issuer country and dominated in the currency of country in which it is issued); Eurobond(bond sold outside issuer home country but dominated in its own country)

Intra-corporate financing

• Funds provided from the source inside the firm in the form of equity, loans and trade credits

• Several advantages:• Interest payments are often tax deductibles: borrowing subsidiaries income

tax burden is reduced• Has little effect on the parents balance sheet when financial results are

consolidated• Saves transaction cost of borrowing funds from banks• Avoids dilution of ownership compared to equity financing

WORKING CAPITAL AND CASH FLOW MANAGEMENT• WORKING CAPITAL refers to the current assets of a company. • NET WORKING CAPITAL is the difference between current assets and current

liabilities• An important component of working capital management in the MNE is cash

flow management, which ensures that cash is available where and when it is needed.

• International finance managers devise various strategies for transferring funds within the firm’s worldwide operations in order to optimise global operations.

• The network of potential intra-corporate fund transfers is both vast and complex

• For e.g. bankruptcy of energy giant Enron.

Methods of transferring funds within the MNE• Trade credit(defer payments for goods and services received from the parent

company)• Dividend remittances(depends on factors such as tax levels and currency risks)• Royalty payments(assuming that subs has licensed from parent, royalties are

tax deductible in many countries)• Fronting loan(loan between parent and subsidiary channelled through large

banks, parents deposit the large sum of money in foreign bank, which loan out to subsidiary)

• Transfer pricing(intra-corporate pricing; price that subsidiary and affiliates charge one another as they transfer goods and services within the same MNE)

• Multilateral netting

Multilateral netting

• Strategic reduction of cash transfer within the MNE family through the elimination of offsetting cash flows

• Concentrating the firms financial operation at some central location, known as centralized depository

• Pooling: bringing together surplus fund and directing this to needful subsidiary• Various advantages:

• Reduces the size of highly liquid accounts and use the funds in longer term investment that can provide higher return

• Interest rate on larger deposits are higher• If the depository is based in financial centre, management can easily access a variety of

financial instruments for short term investment that pay higher rate of return• Depository centralizes expertise and financial services

CAPITAL BUDGETING

• Major decision on International Business: which market to enter and what to accomplish

• Firms must decide whether to invest in diverse ventures• Limited resources, can’t invest in every project• The purpose of CAPITAL BUDGETING is to help managers decide

which international projects are economically viable. • The ultimate decision to accept or reject an investment project

depends on the project’s initial investment requirement, its cost of capital, and the amount of incremental cash flow or other advantages that the proposed project is expected to provide.

Techniques used in the evaluation

• The following are some techniques used in the evaluation of investment projects:

• Accounting Rate of Return (ARR) – assesses the percentage return on capital invested in a project, usually the average annual percentage profit before taxation relative to the average amount of capital invested in a project.

Payback period

• Assesses how quickly the initial outlay is paid back from after-tax cash flows that are generated from investments.

• Only projects which are paid back within a period of time that is considered acceptable to the investing company would be undertaken.

Net present value

• Net Present Value (NPV) – This is the commonest technique used by financial managers to evaluate capital investment projects.

• The technique is based on cash flows and takes account of the time value of money by discounting all future cash flows in today’s value.

• The discount rate used is the minimum rate of return required by the company’s investors, and is normally found by estimating a weighted average cost of capital (WACC), taking into account the risk of the investment.

• A very simple formula for calculating NPV is: NPV = CF/(1+ r) Where CF = cash flow in period t r = annual discount rate • Note that a zero or positive NPV means that , on financial grounds, the company should invest in the

project. A negative NPV project should be rejected on financial grounds as it would not produce sufficient cash flows to repay the financial cost of undertaking it . Note however investment decisions are often based upon other than purely financial factors.

Internal rate of return(IRR)

• This is sometimes referred to as the YIELD. • The IRR is the discount rate which, when applied to the cash flows of

a project, results in net present value (NPV) of zero. A very simple formula for calculating IRR is:

IRR = CF/(1+ r) = 0 Where CF = cash flow in period t r = internal rate of return

Internal rate of return

• The IRR is a percentage measure, unlike NPV which measures the absolute financial benefit of a project.

• A project is considered to be acceptable if the IRR exceeds some predetermined hurdle rate, usually the cost of capital that would be used to estimate the NPV of the project.

• Although NPV and IRR both allow for the time value of money, NPV is the recommended appraisal method as IRR and NPV may result in different investment decisions where mutually exclusive alternative projects are being considered.

• NPV is the only one of the four techniques that will result in decisions which consistently lead to shareholder wealth maximisation, given the existence of efficient capital markets that accurately reflect the decisions of management.

Currency risk management

• Fluctuating currency values- challenge to manage this risk• Firms face exposure to currency risk when their cash flows and the

value of their assets and liabilities change as a result of unexpected changes in foreign exchange rates.

• Currency fluctuations result in three types of exposure for the firm:• Transaction exposure• Translation exposure• Economic exposure

Transaction exposure

• Refers to the currency risk that firms face when outstanding accounts receivable or payable are denominated in foreign currencies.

• For e.g. CO.X imports 3 million Taiwan dollars worth of computer parts and pays in foreign currency

• Exchange rate: US$1= T$30• Credit term 3 month• Rate after 3 month: US$1=T$27• CO X will have to pay extra US$11,111 (3,000,000/27- 3,000,000/30)

Translation exposure

• The currency risk that results when an MNE translates financial statements denominated in a foreign currency into the functional currency of the parent firm, as part of consolidating international financial results.

• As exchange rate fluctuates, so do the functional-currency values of exposed assets, liabilities, expenses and revenues

• Translating foreign financial statements into parents functional currency results in gains or losses on the date when foreign financial statements are consolidated

Economic exposure

• This is sometimes called OPERATING EXPOSURE. • This is the currency risk that results from exchange rate fluctuations

affecting the pricing of products and the cost of inputs• Economic exposure is the risk that exchange rate fluctuations will

distort or diminish long-term financial results.• When a firm prices its products, exchange rate fluctuations help or

hurt sales by making those products relatively more or less expensive from the standpoint of foreign buyers.

Strategies to deal with currency risk exposure• The most common method for managing exposure is HEDGING, which

refers to the use of financial instruments and other measures to reduce or eliminate exposure to currency risk.

• Hedging allows the firm to limit potential losses by locking in guaranteed foreign exchange positions.

• Banks offer the following financial instruments as hedging techniques:• Forward contracts• Future contracts• Currency options• Currency swaps

Forward contracts

• A financial instrument to buy or sell a currency at an agreed-upon exchange rate at the initiation of the contract for future delivery and settlement.

• In the forward market, trade are made for future delivery at an agreed upon date and an agreed upon price on the day of hedging transaction

• Until the delivery date, no money changes hands• For e.g. Dow chemicals sells merchandise to German importer for

Euro100,000 payable in 90 days. Dow has transaction exposure to currency risk. If Euro depreciates in 90 days time then Dow will receive few dollar. Therefore it enters into forward contract with bank to sell Euro 100,000, 90 days from now at an exchange rate agreed upon today.

Future contracts

• An agreement to buy or sell a currency in exchange for another at a pre-specified price and on a pre-specified date.

• It differs from forward contract in a way that it is standardized to enable trading in organized exchanges such as Chicago Mercantile Exchanges(CME)

• Standardized maturity periods and contract sizes• For example CME British pound futures contract has a size of £62,500

and matures in the months that are in March quarterly cycle (March, June, September and December)

• Especially useful for hedging transaction exposure

Currency options

• A contract that gives the purchaser the right, but not the obligation, to buy a certain amount of foreign currency at a set exchange rate within a specified amount of time.

• Currency options are traded on organized exchanges such as Philadelphia stock exchanges (PHLX)

• As such they are only available for the major currencies• Two types of option: • Call option: is the right but not the obligation to buy a currency at a specified

price within a specific period(American Option) or at a specified date(European option)

• Put option: right to sell the currency at a specified price

Currency swaps

• An agreement to exchange one currency for another, according to a specified schedule to give back the original swapped amounts

• Thus a swap is a simultaneous spot and forward transaction• When the agreement is activated, the parties exchanges principals at the current spot

rate• Usually each parties pays interest on the principal as well• For example: an agreement by MNE to pay 4% compounded annually on a euro principal

of Euro1,000,000 and receive 5% compounded annually on a US dollar principal of $1,300,000 every year for 2 years constitute a currency swaps.

• As a result of this agreement, the MNE will receive Euro 1,000,000 and pay $1,300,000 today. It will then pay euro40,000 annual interest and receive $65,000 annual interest for 2 years. At the end of the second year, the MNE will receive $1,300,000 and pay Euro1,000,000.

In addition to hedging strategies

• In addition to these hedging strategies financial managers are well advised to use the following common sense guidelines:

• Seek expert advice • Centralise currency management within the MNE • Decide on the level of risk the firm can tolerate • Devise a system to measure exchange rate movements and currency risks • Monitor changes in key currencies • Be wary of unstable currencies or those subject to exchange controls • Monitor long-term economic and regulatory trends• Distinguish economic exposure from transaction and translation exposure • Emphasise flexibility in international operations.

MANAGE THE DIVERSITY OF INTERNATIONAL ACCOUNTING AND TAX PRACTICES • In international business, firms have to record the transactions and list

the assets and liabilities related to each operation. • Developing accounting systems to identify, measure, and communicate

this financial information is especially challenging in multi-country operations where substantial variations in accounting systems exist.

• Balance sheets and income statements vary internationally, primarily with regard to language, currency, format, and the underlying accounting principles that are applied or emphasised.

• Financial statements prepared according to the rules of one country may be difficult to compare with those prepared in another country

MANAGE THE DIVERSITY OF INTERNATIONAL ACCOUNTING AND TAX PRACTICES • The following measures can help to reduce the complexity surrounding the

reporting of financial statements in international business:• Transparency in financial reporting(the degree to which companies regularly reveal

substantial information about their financial condition and accounting practices)• Harmonisation of accounting standards and practices(IASB has been working to

develop a single set of high quality, understandable, and enforceable global accounting standards that emphasize transparent and comparable information)

• Consolidating the financial statements of subsidiaries(current rate method- financial statement translated at spot rate of the date when the statements are prepared and temporal method-translation of financial statements varies with the underlying method of valuation)

• International taxation(try to minimize international taxes such as direct tax, indirect tax, sales tax or value added tax)