Chapter 5 International financial management Flashcards
1.1 Risks of international trading
International trade exposes companies to greater risk than just trading domestically. These risks are:
- Physical risk: goods being lost/damaged in transit – can be mitigated with insurance.
- Trade risk: faulty products causing injury – can be mitigated with insurance.
- Liquidity risk: inability to finance a longer operating cycle.
- Credit risk: increased risk of bad debts
- FX risk
1.2 Mitigating credit and liquidity risks
The key ways of mitigating credit and liquidity risks:
- Bills of exchange: a document drawn up by the exporter and sent to the overseas buyers bank. The bank accepts the obligation to pay the bill by signing it and therefore payment is guaranteed. The seller can sell or discount the bill to a third party for cash now. Helps to reduce the risk of bad debts and improve liquidity.
- Forfaiting: a form of medium term, non-recourse, export financing, whereby a 3rd party effectively purchases the receivable from the exporter. Generally receivable is first converted into a financial instrument such as a bill of exchange which is then purchased for cash at a discount by the forfeiter.
- Export factoring: similar to domestic factoring
- Documentary credit/letter of credit: provide a method of payment in international trade which is risk free. The arrangement between the exporter, the buyer and participating banks must take place before the export sale takes place. The exporter receives immediate payment of the amount due, less the discount from the bank. The buyer is often able to get a period of credit before having to pay for the imports.
- Export credit insurance: insurance against the risk of non-payment by foreign customers for export debts
2.1 International expansion – deciding what markets to enter
The three main headings from Kotler’s market entry matrix can be used to evaluate markets for expansion:
- Market attractiveness: considerations include income per head and forecast demand.
- Competitive advantage: expected level of competitive advantage can be judged by previous experience in similar markets.
- Risk: especially risk of currency fluctuations and remittance restrictions
2.2 Market entry modes
There are two main methods of entering overseas markets:
- Exporting
- Overseas production, which can be subdivided into outsourced/contracted manufacture and overseas production.
Pros of exporting include economies of scale from concentrated production in one location, opportunity to test the success of a product overseas before committing to an overseas operation, can be done on a small scale/accessible for smaller companies, avoid set up costs of overseas operation and can gain access to local knowledge by using a local distributor. The cons are exposure to FX risk, export taxes/tariffs and production costs may be lower with overseas manufacture.
Pros of outsourced/contracted manufacture include no investments in operations required, access to 3rd party expertise in production/local compliance issues, enables the company to focus on its core competencies and the outsourcing company may benefit from economies of scale, which may result in a lower price. The cons are finding a suitable producer, need to train the contractor’s personnel, contratee may copy designs and set themselves up as a competitor, loss of control/quality issues, and press associated with perception of jobs leaving home country, difficult to bring back in-house if required later and data security if information is shared.
Pros of overseas production include may enable a better understanding of overseas market, potential access to cheaper labour and factory costs, lower storage and transportation costs if also serving that market, local production may help win public sector orders and reduced FX risk. Cons include significant investment in overseas plant, higher transport costs/longer lead times if serving home market, compliance with local health and safety regulations, potential loss of control/quality issues and problems recruiting local staff.
3.1 Setting up an overseas operations
There are several ways to set up an overseas operation. Acquisition, subsidiary, overseas branch, joint ventures, strategic alliance and franchising.
Acquisition:
Pros: knowledge local market, established customer base and distribution channels, existing brand, management expertise in local marketing/distribution/production and any intangible assets such as patents and trademarks. Access to finance improved, circumnavigating trade barriers, removal of a competitor, start-up costs avoided and other synergies created.
Cons: culture clashes, integration costs, acquisition costs, higher than expected reorganisation costs, duplication of resources/operations, potential damage from prior actions of target and public opinion and reaction.
Setting up overseas subsidiary:
Pros: a local company may be better received, qualify for government grants, parent greater control of systems and processes and limited liability can protect the parent company if subsidiary suffers losses.
Cons: legal costs to set-up overseas, significant regulatory burden, legal complexities of dissolving a subsidiary on exit and unlike an acquisition there is no access to established local brands.
Overseas branch:
Pros: establishment of a branch likely to be simpler than a subsidiary, remitted profits from a subsidiary may be taxed at a higher rate than those of a branch and it may be easier to utilise the tax relief generated by the initial losses in a branch if those losses were in a foreign subsidiary.
Cons: the parent company will be fully liable for any obligations of the branch and customers and banks may prefer to deal with a local company rather than a branch of an O/S company.
Joint ventures:
Pros: gives low-cost access to O/S markets, easier to raise finance in foreign country, access to local knowledge, sharing of set up and operating costs, sharing of risk and can get around potential legal restrictions on foreign ownership.
Cons: culture clashes, lack of freedom to determine systems, processes and strategic direction, disagreements over operating decisions and ownership structure, sharing of profits and risk of JV partners gaining information to use in a competing business at a later date.
Strategic alliance:
Pros: sharing of development costs, can be complementary markets or technology, possibles companies learn from another and ability to spread risk.
Cons: restrict ability to generate new core competencies, difficult to achieve economies of scale, less control, risk to reputation and potential for conflict.
Franchising:
Pros: reduces capital requirements, reduces managerial resources required, quicker method of expansion, benefits of specialism and lower head office costs.
Cons: profits are shared, candidates selected on competency (so time consuming), less control, risk to reputation and potential for conflict.
4.1 Remittance restrictions
Remittance restrictions are a type of exchange control where types of payments abroad are restricted or banned. The impact on NPV is that no repatriation of funds is allowed until the end of the project. A common assumption is that cash flows generated by the foreign subsidiary can earn interest in a foreign bank account until the suspension of repatriation is lifted at the end of the project.
The approach is:
- Convert initial investment into home currency using T0 spot rate.
- Calculate the bet foreign currency CFs for each year.
- Calculate the terminal value of the foreign currency CF.
- Deduct any withholding tax from the terminal value.
- Convert the FC terminal value net of withholding tax into home currency using the FX rate at the end of the project.
- Discount at the domestic cost of capital
- Less the initial investment in home currency, to get the home currency NPV.
4.2 Overcoming remittance restrictions.
Remittance restrictions or other exchange controls can be overcome by extracting funds from a foreign subsidiary via:
- High transfer prices
- Large royalty payments
- High interest charges on inter-company loans
- High management fees
5.1 Dividend management
Factors to consider when deciding the amount of dividends foreign subsidiaries should pay the parent company:
- Whether the cash is needed to finance domestic investment
- Whether cash is needed to pay domestic dividends/maintain the domestic dividend payout ratio
- The tax treatment in the foreign currency:
o If undistributed earnings are taxed this will encourage distributions
o If withholding taxes are high, it may discourage distributions
- Agency problems: high dividends can be used to restrict the funds available to local managers, who may not be expected to act in a goal congruent manner.
- Exchange rates: parent will wish to take higher dividends now if they expect the foreign currency to depreciate in the future.
6.1 Transfer pricing for multinationals
Multinationals may wish to manipulate transfer price:
- To shift profits from high tax countries to low tax countries
- Low transfer prices may be used to avoid ‘ad valorem’ export taxes.
- Avoid remittance restrictions.
6.2 Response of government/ tax authorities
Arms-length standard: intra-firm trade of multinationals should be priced as if they took place between unrelated parties acting at arm’s length transfer price.
There are several methods of calculating the arms-length transfer price:
- Comparable uncontrolled price method: take a rd. party market price for identical goods or services
- The resale price method: the resale price less the expected margin
- Cost plus: the costs of the selling division/subsidiary plus the expected mark-up of similar companies
- The comparable profit method: uses accounting ratios of similar companies to calculate the expected profit. The TP is then derived from this expected profit
- The profit split method: the splits the consolidated profit from a transaction or group of transactions between the related parties
