Financial Management

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Chapter 17

• Financial Management

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Learning Objectives

• To understand how value is measured
  and managed across the multiple units
  of the multinational firm.
• To understand how international business and
  investment activity alters and adds to the
  traditional financial management activities of
  the firm.
• To understand the three primary currency
  exposures that confront the multinational firm.
• To examine how exchange rate changes alter the
  value of the firm, and how management can manage
  or hedge these exposures.

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The Goal of Management

• The goal for most Anglo-American markets is
  stockholder maximization - the management of the
  company seeks to maximize the returns to
  stockholders by working to push share prices up
  and to continually grow dividends.
• The goal for most Continental European and
  Japanese firms is corporate wealth maximization -
  considering the financial and social health of
  all stakeholders.

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Global Financial Goals

• The three primary financial objectives are
• 1. Maximization of consolidated, after-tax
  income.
• 2. Minimization of the firms
  effective global tax burden.
• 3. Correct positioning of the firms income,
  cash flows, and available funds.

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Genus Corporation and Foreign Subsidiaries
Genus Corporation (USA)
Brazil
Germany
China
Moderate Tax Unstable Currency Limited Funds
Movement
High Tax Stable Currency Free Funds Movement
Low Tax Stable Currency Blocked Funds
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Multinational Management at Genus

• The primary goal of the firm is the maximization
  of consolidated profits, after tax.
• Consolidated profits are the profits of all the
  individual units of the firm originating in many
  different currencies.
• Each of the incorporated units of the firm has
  its own set of traditional financial statements,
  which are expressed in the local currency.
• The shareholders of Genus track the firms
  financial performance on the basis of earnings
  per share (EPS).
• Each affiliate is located within a countrys
  borders and is therefore subject to all laws and
  regulations within that country.

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Evaluating Potential Foreign Investment

• Evaluating the potential for foreign investment
  includes
• Capital budgeting - the process of evaluating the
  financial feasibility of an individual
  investment.
• Capital structure - the determination of the
  relative quantities of debt capital and equity
  capital that will constitute the funding of the
  investment.
• Working capital and cash flow management - the
  management of operating the financial cash flows
  passing in and out of a specific investment
  project.

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Financial Trust

• Unlike most domestic business, international
  business often occurs between two parties that do
  not know each other very well.
• In order to conduct business, a large degree of
  financial trust must exist.
• Financial trust is the trust that the buyer
• of a product will actually pay for it
• on or after delivery.

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Financial Trust Using a Letter of Credit (L/C)
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Yokohama Bank (Japan)
Pacific First Bank (United States)
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Financing of trade with L/C
1
2
4

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Vanport Lumber Company (United States)
Endaka Construction (Japan)
Old-growth pine lumber exported
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Financial Trust Using a Letter of Credit (L/C)

• 1. Endaka Construction requests a letter of
  credit to be issued by its bank.
• 2. Yokohama Bank will determine if Endaka is
  financially sound and capable of making the
  payments required.
• 3. Yokohama Bank issues the letter of credit to
  the exporters bank, Pacific First Bank.
• 4. Pacific First assures Vanport that payment
  will be made after evaluating the letter of
  credit.
• 5. The lumber order is loaded onboard the
  shipper.
• 6. Vanport draws a draft against Yokohama Bank
  for payment.
• 7. Pacific Bank confirms the letter of credit and
  collects from Yokohama Bank.

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Multinational Investing

• An investment is financially justified if it has
  a positive net present value (NPV).
• The construction of a capital budget is the
  process of projecting the net operating cash
  flows of the potential investment to determine if
  it is indeed a good investment.
• A capital budget is composed primarily of cash
  flow components.

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Capital Budget Components
Initial Expenses and Capital Outlays
Operating Cash Flows
Terminal Cash Flows
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Risks in International Investments

• Risks are higher for international investments
  than domestic investments.
• The risk arises from the different countries,
  their laws, regulations, potential for
  interference with the normal operations of the
  investment project, and currencies.
• Foreign governments have the ability to pass new
  laws, increasing risk for a parent company.
• Another risk issue is that the viewpoint or
  perspective of the parent and the project may no
  longer be the same.

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International Cash Flow Management

• Cash management is the financing of short-term or
  current assets.
• Operating cash flows arise from the everyday
  business activities of the firm such as paying
  for materials or resources or receiving payments
  for items sold.
• Financing cash flows arise from the funding
  activities of the firm. The servicing of
  existing funding resources, interest on existing
  debt, and dividend payments to shareholders
  constitute frequent cash flows.

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Transfer Prices

• The prices at which multinational firms sell
  their products to their subsidiaries and
  affiliates are called transfer prices.
• Theoretically, they are equivalent to what the
  product would cost if purchased on the open
  market. Sometimes, transfer prices are set
  internally, which may result in the subsidiary
  being more or less profitable.

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Cash Management

• Netting, which combines cash flows between
  subsidiaries and parent companies, is
  particularly helpful if the two way flow is in
  two currencies.
• Combining capital, or cash pooling, allows a firm
  to spend less in terms of foregone interest on
  cash balances.
• A foreign subsidiary that is expecting its local
  currency to fall in value relative to that of the
  parent company may try to speed up, or lead its
  payments to the parent.
• If the local currency is expected to rise versus
  that of the parent company, the subsidiary may
  want to wait, or lag payments.

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Cash Management (cont.)

• Reinvoicing occurs when one office in a
  multinational firm takes ownership of all
  invoices and payments between units.
• An internal bank can be established within a firm
  if its financial resources and needs are either
  too large or too sophisticated for the financial
  services that are available in local subsidiary
  markets.

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Types of Foreign Currency Exposure
Transaction Exposure
Economic Exposure
Translation Exposure
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Transaction Exposure

• Transaction exposure is the risk associated with
  a contractual payment of foreign currency.
• It is the most common type of exchange risk.
• The two conditions necessary for a transaction
  exposure to exist are
• 1. A cash flow that is denominated in a foreign
  country.
• 2. The cash flow will occur at a future date.

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Transaction Exposure (cont.)

• Managing transaction exposures usually is
  accomplished by either natural hedging or
  contractual hedging.
• Natural hedging describes how a firm might
  arrange to have foreign currency cash flows
  coming in and going out at roughly the same times
  and same amounts.
• Contractual hedging is when a firm uses financial
  contracts to hedge the transaction exposure. The
  most common foreign currency contractual hedge is
  the forward contract.
• Firms that import or export on a continuing basis
  have constant transaction exposures.

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Economic Exposure

• Economic exposure is the risk to the firm that
  its long-term cash flows will be affected,
  positively or negatively, by unexpected future
  exchange rate changes.
• It emphasizes that there is a limit to a firms
  ability to predict either cash flows or exchange
  rate changes in the medium to long term.
• Management of economic exposure is being prepared
  for the unexpected.

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Translation Exposure

• Translation exposure is the risk that arises from
  the legal requirement that all firms consolidate
  their financial statements of all worldwide
  operations annually.
• Unlike transaction and economic exposures, which
  are true exposures, translation exposure is an
  economic problem.

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Countertrade

• Countertrade is a sale that encompasses more than
  an exchange of goods, services, or ideas for
  money.
• Historically, countertrade was mainly conducted
  in the form of barter, which is a direct exchange
  of goods of approximately equal value, with no
  money involved.
• Conditions that encourage countertrade are
• lack of money,
• lack of value of or faith in money,
• lack of acceptability of money as an exchange
  medium,
• greater ease of transaction by using goods.

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Reasons for Countertrade

• Increasingly, countries and companies are
  deciding that sometimes countertrade transactions
  are more beneficial than transactions based on
  financial exchange.
• The use of countertrade permits the covert
  reduction of prices and therefore allows the
  circumvention of price and exchange controls.
• Many countries are responding favorably to the
  notion of bilateralism.
• Countertrade is viewed as an excellent mechanism
  to gain entry into new markets.