Lecture 1: Introduction

 Scope of International financial management includes

three sets of related decisions:
 International Investment decisions: decisions about what activities
to finance.
 International Financing decisions: decisions about how to finance
those activities.
 International Money management decisions: decisions about how
to manage the firm’s financial resources most efficiently.
International Investment Decisions
 Capital budgeting:
• quantifies the benefits, costs and risks of an
investment.
• Managers can reasonably compare different
investment alternatives within and across countries.
 Complicated process:
• Must distinguish between cash flows to project and those to
parent.
• Political and economic risk can change the value of a foreign
investment.
Project and Parent Cash Flows
 Project cash flows may not reach the parent:
• Host-country may block cash-flow repatriation.
• Cash flows may be taxed at an unfavorable rate.
• Host government may require a percentage of cash flows to be
reinvested in the host country.
Financing Decisions:
 Financing Decisions:
 Global capital markets for lower cost financing.
 Host-country may require projects to be locally financed through debt
or equity.
• Limited liquidity raises the cost of capital.
• Host-government may offer low interest or subsidized loans to attract
investment.
• Impact of local currency (appreciation/depreciation) influences capital and
financing decisions.
 Financial structure:
 Debt/equity ratios vary with countries.
• Tax regimes.
 Follow local capital structure norms?
• More easily evaluate return on equity relative to local competition.
• Good for company’s image.
 Best recommendation: adopt a financial structure that
minimizes its cost of capital.
Global Money Management
 Minimizing cash balances:
• Money market accounts - low interest - high liquidity.
• Certificates of deposit - higher interest - lower liquidity.

 Reducing transaction costs (cost of exchange):

• Transaction costs: changing from one currency to another.
• Transfer fee: fee for moving cash from one location to another.
 Tax issues:
• Double taxation.
• Tax credit.
• Deferral Principle.
• Tax haven.
Moving Money Across Borders
 Unbundling: a mix of techniques to transfer liquid funds from a
foreign subsidiary to the parent company without piquing the host-
country.
• Dividend remittances.
• Royalty payments and fees.
• Transfer Prices.
• Fronting loans.

 Dividend Remittances: Most common method of transfer. It

varies with tax regulations, foreign exchange risk, age of subsidiary,
extent of local equity participation.
Royalty Payments and Fees
 Royalties represent the remuneration paid to owners of technology,
patents or trade names for their use by the firm.
• Common for parent to charge a subsidiary for technology, patents
or trade names transferred to it.
• May be levied as a fixed amount per unit sold or percentage of
revenue earned.
• Fees are compensation for professional services or expertise
supplied to subsidiary.
• Management fees or ‘technical assistance’ fees.
• Fixed charges for services provided.
Transfer Prices
 Price at which goods or services are transferred within a firm’s
entities.
 Position funds within a company.
 Move founds out of country by setting high transfer fees or into a
country by setting low transfer fees.
 Movement can be within subsidiaries or between the parent and its
subsidiaries.
 Benefits of Transfer Fees:
 Reduce tax liabilities by using transfer fees to shift from a high-tax
country to a low-tax country.
 Reduce foreign exchange risk exposure to expected currency
devaluation by transferring funds.
 Can be used where dividends are restricted or blocked by host-
government policy.
 Reduce import duties (ad valorem) by reducing transfer prices and
the value of the goods.
 Transfer Pricing
Problems with Transfer Pricing:
 Few governments like it.
• Believe (rightly) that they are losing revenue.
 Has an impact on management incentives and performance evaluations.
• Inconsistent with a ‘profit center’.
• Managers can hide inefficiencies.

• Fronting Loans: A loan between a parent and subsidiary is channeled

through a financial intermediary (bank).
• Can circumvent host-country restrictions on remittance of funds from
subsidiary to parent.
• Provides certain tax advantages.
Techniques for Global Money Management
Centralized Depositors:
 Need cash reserves to service accounts and insuring against
negative cash flows.
 Should each subsidiary hold its own cash balance?
• By pooling, firm can deposit larger cash amounts and earn higher
interest rates.
• If located in a major financial center can get information on good
investment opportunities.
• Can reduce the total size of cash pool and invest larger reserves in
higher paying, long term, instruments.
Techniques for Global Money Management
 Multilateral Netting: Ability to reduce transaction costs.
• Bilateral netting.
• Multilateral netting – simply extending the bilateral concept
to multiple subsidiaries within an international business.
 Managing Foreign Exchange Risk: Risk that future changes in
a country’s exchange rate will hurt the firm.
 Transaction exposure: extent income from transactions is affected
by currency fluctuations.
 Translation exposure: impact of currency exchange rates on
consolidated results and balance sheet.
 Economic exposure: effect of changing exchange rates over future
prices, sales and costs
The International Financial Environment
Multinational Corporation (MNC)

Foreign Exchange Markets

Dividend
Remittance
Exporting & Financing Investing
& Importing & Financing

Product Markets Subsidiaries International

Financial
Markets
Root Causes of International Business

Comparative Advantage Theory.

 Imperfects market Theory.
 Product Life Cycle Theory.
 Globalization and Free Trade.
Free Trade Issues
What is meant by free trade?
 Commerce activities that are not subject to any market
frictions (tariffs etc.) when such activities cross borders.

Scope of Free Trade:

Inputs Outputs
a. Land a. Goods
b. labor b. Services
c. capital
 Does free trade just apply to goods and services?
International Opportunities
• Opportunities in Europe
• The Single European Act of 1987.
• The removal of the Berlin Wall in 1989.
• The inception of the euro in 1999.
• Opportunities in Latin America
• The North American Free Trade Agreement (NAFTA) of 1993.
• The General Agreement on Tariffs and Trade (GATT) accord.
International Opportunities
• Opportunities in Asia
• The reduction of investment restrictions by many Asian countries
during the 1990s.
• China’s and India’s Growth.
• The ASEAN.
Valuation Model for an MNC
Valuation model on the basis of cash flows:
m 
n 
E CFj , t  E ER j , t 
 j 1 
Value =   
t =1  1  k  t

 
E (CFj,t ) = expected cash flows denominated in currency j to be
received by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can be
converted to dollars at the end of period t
k = the weighted average cost of capital of the U.S.
parent company