International financial management

Question 1

International financial management Risks of international trading

Answer 1

International trade exposes companies to greater risk than just trading domestically.
These risks and how to mitigate them is assumed knowledge from BTF and FM:
 Physical risk: Goods being lost/damaged in transit – can be mitigated with
insurance
 Trade risk e.g. 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 (covered in more detail later)

Question 2

International financial management Risks of international trading 1.1 Mitigating credit and liquidity risks

Answer 2

Key ways of mitigating credit and liquidity risks:

Bill of exchange: A document drawn up by the exporter (seller) and sent to the
overseas buyer’s 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 (the forfaiter) 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 forfaiter.
Export factoring: Similar to domestic factoring.

Documentary Credit/Letter of credit: Letters 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.

Although international expansion was covered at the professional level in both FM
and BST, it is examinable in more detail at the advanced stage.

Question 3

International financial management Risks of international trading 2.1 Deciding what markets to enter

Answer 3

The three main headings from Kotler’s market entry matrix can be used to help
evaluate possible markets for expansion:
1. Market attractiveness – considerations include income per head and forecast
demand.
2. Competitive advantage – the expected level of competitive advantage can be
judged by previous experience in similar markets
3. Risk – especially, the risk of currency fluctuations and remittance restrictions.
The best markets to enter will be low risk but also have high market attractiveness
and potential for competitive advantage.

3.2.2 Market entry modes
There are two main methods of entering overseas markets:
1. Exporting
2. Overseas production, which can be subdivided into:
– Outsourced/contracted manufacture
– Overseas production (setting up overseas operations)

Question 4

International financial management Risks of international trading 2.1 Deciding what markets to enter Exporting

Answer 4

Pros:
 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/minimise operating costs (no real
need of overseas staff etc.)
 Can gain access to local knowledge by using a local distributor (indirect
exporting).

Cons:
 Exposure to FX risk
 Export taxes/tariffs and red tape
 Production costs may be lower with overseas manufacture.

Question 5

International financial management Risks of international trading 2.1 Deciding what markets to enter Outsourced/contracted manufacture

Answer 5

Pros:
 No investment in operations required
 Access to 3rd party expertise in production/local compliance issues
 Enables the company to focus on its core competencies
 The outsourcing company may benefit from economies of scale, which may
result in a lower price
Cons:
 Finding a suitable overseas producer
 The need to train the contractee’s personnel
 Contractee may copy designs and set themselves up as a competitor
 Loss of control/quality issues
 Bad press associated with the perception of jobs leaving the home country
 Difficult to bring back in-house if required later on
 Data security if information is shared.

Question 6

International financial management Risks of international trading 2.1 Deciding what markets to enter Overseas production (setting up overseas operations)

Answer 6

This section focuses on the advantages and disadvantages of overseas production
compared to exporting. Setting up an overseas operation is discussed in more detail
in the next section.
Pros:
 May enable a better understanding of the 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
 Reduced FX risk if also serving that market.
Cons:
 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
 Problems recruiting local staff/managers.

Question 7

International financial management Setting up an overseas operation

Answer 7

There are several ways of setting up an overseas operation:
 Acquisition
 Setting up an overseas subsidiary
 Overseas branch
 Joint ventures
 Strategic alliance
 Franchising

An exam question may ask you to evaluate several options for setting
up an overseas operation. Thus, an awareness of the generic pros and
cons of each alternative will help you generate specific ideas in the
exam.

Question 8

International financial management Setting up an overseas operation Overseas branch

Answer 8

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
 It may be easier to utilise the tax relief generated by the initial losses in a
branch than if those losses were in a foreign subsidiary
Cons:
 The parent company will be fully liable for any obligations of the branch
 Customers and banks may prefer to deal with a local company rather than a
branch of an O/S company

Question 8

International financial management Setting up an overseas operation Acquisition

Answer 8

Pros:
 Acquiring an established business grants access to:
– Knowledge of the local market
– Established customer base/market share
– Established distribution channels/customer relationships
– Existing brand/reputation
– Management expertise in local marketing/distribution/production
– Any intangible assets such as patents and trademarks
 Access to finance may be improved by access to additional cash or debt
capacity in the acquired company
 Circumnavigating trade barriers
 Removal of a competitor
 Start-up costs avoided
 Other synergies, for example:
– Increased utilisation of shared central services e.g. finance
– Economies of scope in marketing
– Rationalisation and sale of surplus assets
Cons:
 Culture clashes
 Integration costs/problems e.g. unforeseen costs in integrating IT systems
 Acquisition cost may be expensive (and may reduce shareholder wealth if a
premium is paid to obtain control plus fees exceeds synergies)
 Higher than expected reorganisation costs e.g. redundancies etc.
 Duplication of resources/operations across the new group
 Potential reputational damage from prior actions of target
 Public opinion and reaction

Question 8

International financial management Setting up an overseas operation Setting up an overseas subsidiary

Answer 8

Pros:
 A local company may be better received by local consumers
 As a separate local legal entity, a subsidiary may be able to qualify for
government grants and tax reliefs that a branch cannot
 The parent will have greater control of systems and processes (compared to the
acquisition of an existing company)
 Limited liability can protect the parent company if the subsidiary suffers losses
(with a branch the parent would be liable)
Cons:
 Legal costs to set-up overseas
 Significant regulatory burden
 In some regimes, the activities of the subsidiary may be limited to the objects
set out in its constitution
 Legal complexities of dissolving a subsidiary on exit
 Unlike an acquisition, there is no access to established local brands, distribution
networks etc.

Question 9

International financial management Setting up an overseas operation Strategic alliance

Answer 9

Pros:
 Sharing of development costs
 May be easier than a takeover if there are regulations in place restricting
ownership
 Can be complementary markets or technology
 It is possible that the companies are able to learn from each other
 Ability to spread risk. E.g. new technology is expensive and uncertain and may
be better to acquire with a partnering company, rather than buy and update
individually.
Cons:
 It may restrict the ability to generate new core competencies
 Difficult to achieve economies of scale as the two entities remain separate
 Less control
 Risk to the reputation
 Potential for conflict.

Question 9

International financial management Setting up an overseas operation Joint ventures

Answer 9

Pros:
 Gives relatively low-cost access to O/S markets
 Working with a local partner may make it easier to raise finance in a foreign
country (in particular the JV may have access to government grants and tax
reliefs that an O/S company wouldn’t qualify for)
 Access to existing local knowledge, contacts and skills of the JV partner
 Sharing of set up and operating costs
 Sharing of risk
 If there are legal restrictions on foreign ownership of local branches/companies,
a JV may be the only way to access the O/S market
Cons:
 Culture clashes
 Lack of freedom to determine systems, processes and strategic direction (has
to be agreed with partner)
 Potential disagreements over operating decisions and ownership structure
 Sharing of profits
 Risk of the JV partner gaining information/technology that could later be used in
competing businesses

Question 10

International financial management Setting up an overseas operation Franchising

Answer 10

Pros:
 Reduces capital requirements
 Reduces managerial resources required
 Can be a quicker method of expansion
 Benefits of specialisation, the franchisee can focus on their skills without
needing to deal with other elements of the business, e.g. marketing
 Lower head office costs as there is a considerable delegation of operational
responsibility to the franchisees.
Cons:
 Profits are shared
 Candidates need to be selected on competency, which can be time consuming
 Less control
 Risk to the reputation
 Potential for conflict

Question 11

International financial management Remittance restrictions 4.1 Impact of remittance restrictions on NPV

Answer 11

The most likely scenario is that no repatriation of funds is allowed until the end of the
project.
However, 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 to this type of question is very similar to a normal foreign NPV
question.

Question 12

International financial management Transfer pricing for multinationals

Answer 12

BST recap: Market price is generally considered to be an appropriate transfer price,
which should lead to division managers making goal congruent decisions.

However, multinational companies may wish to charge higher or lower prices to
artificially reduce or increase profits in a foreign subsidiary.

Question 12

International financial management Remittance restrictions

Answer 12

Remittance restrictions are a type of exchange control where certain types of
payments abroad are restricted or banned.
For example, the payment of dividends to foreign shareholders by local companies
may be suspended

Question 13

International financial management Remittance restrictions 4.3 Overcoming remittance restrictions

Answer 13

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

Question 14

International financial management Remittance restrictions 4.2 Approach

Answer 14

1. Convert the initial investment in to home currency using the T0 spot rate
2. Calculate the net foreign currency CFs for each year
3. Calculate the terminal value of the foreign currency CFs (assuming the CFs can
   be reinvested at the rate given)
4. Deduct any withholding tax from the terminal value
5. Convert the FC terminal value net of withholding tax into home currency using
   the FX rate at the end of the project
6. Discount at the domestic cost of capital
7. Less the initial investment in home currency
   = The home currency NPV

Question 15

International financial management Dividend management

Answer 15

Factors to consider when deciding the amount of dividends foreign subsidiaries
should pay the parent company:
 Whether 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 country:
– If undistributed earnings are taxed this will encourage distributions
– 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: The parent will wish to take higher dividends now if they expect
the foreign currency to depreciate in the future (and vice versa)

Question 16

International financial management Transfer pricing for multinationals 6.1 Reasons for transfer price manipulation

Answer 16

 To shift profits from high tax countries to low tax countries
 Low transfer prices may be used to avoid ‘ad valorem’ export taxes
 To avoid remittance restrictions (using high prices to reduce profits in the
foreign sub)

Question 17

International financial management Transfer pricing for multinationals 6.2 Response of government/tax authorities

Answer 17

Generally, the response of tax authorities has been to write tax rules which say all
international transfer prices should be set with reference to the ‘arms length
standard’.
Arms-length standard: Intra-firm trade of multinationals should be priced as if they
took place between unrelated parties acting at arm’s length in competitive industries.
There are several different methods of calculating the arms-length transfer price

1.The comparable uncontrolled price method (CUP): Take a 3rd party market price
for identical (or very close to identical) goods or services.
Most tax authorities prefer this method as it is based on actual transactions.

2,The resale price method: The resale price less the expected margin.
For example, the manufacturing division sells a product to distributing division for the
TP. To calculate the arms-length TP; the tax authorities find the selling price of
comparable distributors, selling comparable products, and deduct the distributors’
expected margin.

3,Cost plus: The costs of the selling division/subsidiary plus the expected mark-up of
similar companies.

4.The comparable profit method (CPM): Uses accounting ratios of similar companies
(e.g. ROAs) to calculate the expected profit. The TP is then derived from this
expected profit.

5.The profit split method (PSM): This splits the consolidated profit from a transaction
or group of transactions between the related parties (normally, on the basis of
operating assets).