Chapter 17 Financial Management
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.
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.
Global Financial Goals The three primary financial objectives are: 1. Maximization of consolidated, after-tax income. 2. Minimization of the firm’s effective global tax burden. 3. Correct positioning of the firm’s income, cash flows, and available funds.
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
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 firm’s financial performance on the basis of earnings per share (EPS). • Each affiliate is located within a country’s borders and is therefore subject to all laws and regulations within that country.
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.
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.
Financial Trust Using a Letter of Credit (L/C) 3 Yokohama Bank (Japan) Pacific First Bank (United States) 6 Financing of trade with L/C 1 2 & 4 7 Vanport Lumber Company (United States) Endaka Construction (Japan) Old-growth pine lumber exported 5
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 exporter’s 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.
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.
Capital Budget Components Initial Expenses and Capital Outlays Operating Cash Flows Terminal Cash Flows
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.
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.
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.
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.
Cash Management (cont.) • Reinvoicingoccurs when one office in a multinational firm takes ownership of all invoices and payments between units. • An internal bankcan 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.
Types of Foreign Currency Exposure Transaction Exposure Economic Exposure Translation Exposure
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.
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.
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 firm’s 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.
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.
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.
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.