Fin management materials / P4AFM-Session16_j08

SESSION 16 – INTERNATIONAL OPERATIONS

OVERVIEW

Objective

¾To consider further aspects of financial management relating to the international operations of companies.

INTERNATIONAL

OPERATIONS

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SESSION 16 – INTERNATIONAL OPERATIONS

1INTERNATIONAL TRADE RISKS

Apart from foreign exchange issues, many of the risks of engaging in foreign trade are shared with those domestic operations. However the management of such risks in an international context may require particular approaches.

1.1Foreign exchange risks

¾Short-term transaction risk and longer term economic risk.

¾Translation risk on the consolidation of overseas subsidiaries’ financial statements into the group accounts.

¾Management of these risks is dealt with in session 13.

1.2Commercial risk

¾The risk that the overseas customer will not pay or pay late.

¾The level of credit risk can be evaluated by using agencies such as Dun and Bradstreet.

¾The risk can be managed by:

Buying credit insurance from a commercial bank (UK exporters can also obtain insurance from NCM Holding)

Using export factoring (without recourse)

Requesting a letter of credit from the customer’s bank

1.3Physical risk

¾Loss or damage to goods in transit.

¾Managed using insurance.

1.4Political Risk

¾Examples include quotas and tariffs, exchange controls, bureaucratic delays and excessive documentation. Appropriation of assets may be a risk in some countries.

¾The level of political risk can be evaluated using the Department of Trade, Embassy or commercial reports e.g. from the Economist Intelligence Unit.

1.5Cultural risk

¾Different business customs overseas can hinder foreign trade.

¾The problem may be reduced by using local agents.

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2METHODS OF PAYMENT

Risk of default on exports may be higher than on domestic sales. Ideally cash in advance should be requested, or at least a percentage deposit – however such terms may not be acceptable to the customer.

In fact credit periods on exports are often longer than for those on domestic sales. Therefore the firm needs to carefully consider the method of payment both with a view to minimizing default risk and of financing the export.

2.1 Open account trading

¾ This means simply trusting the customer to pay within the stated credit period with no additional collateral or security.

2.2 Cash Against Documents

¾ Documents of title to the goods are not released to the customer until payment is made.

2.3 Bills of Exchange

¾A Bill of Exchange is a document drawn by the exporter and sent to the customer who signs to accept responsibility to pay the amount specified on the stated date.

¾Often the documents of title to the goods will not be released to the customer until he has accepted a bill of exchange.

¾The exporter may choose to hold the bill until maturity and then receive payment from the customer or to discount the bill with a bank in order to receive the cash earlier. However if the customer does not eventually pay up on the bill the bank will have recourse to the exporter for payment.

¾ A letter of credit is issued by the customer’s bank in favour of the exporter. If this letter of credit is then expressed as irrevocable and then confirmed the exporter has absolute assurance of payment.

2.6 Export credit houses

¾ These give credit to the overseas customer and guarantee payment to the exporter.

2.7 Export merchants

¾Operate as intermediaries between the exporter and the overseas customer.

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¾The merchant buys the goods (at a discount) from the exporter, sells them to the final customer and pays the exporter (usually within 7 days).

2.8 Export factors

¾ Factors buy the trade receivables from the exporter and charge commission on the transaction. Other services such as operating the receivables ledger and credit insurance may also be offered.

2.9 The Export Credits Guarantee Department (ECGD)

¾ UK exporters can obtain guarantees from the ECGD on bank loans taken to finance exports.

2.10 Counter-trade

Counter-trade is an agreement where goods exported are matched by a commitment to import. There are several types:

¾Barter, where goods are exchanged.

¾Counter-purchase, goods are purchased and an agreement signed that the seller will itself purchase different goods at some time in the future.

¾Switch trading, involves using trade agreements between countries. Country A wishes to export to country B but can’t because of restrictions. Country C has capacity within its agreement with B so A’s goods go via C. In return A will have to import goods from C.

3OVERSEAS EXPANSION

3.1Methods

¾Exporting – relatively low risk but no local presence and high travel cost of sales force.

¾Licensing agreement − relatively low risk but limited period of time.

¾Joint Venture − pools expertise, gives access to local knowledge but can lead to arguments over profit sharing. In some developing markets such as China this may be the only permitted route to local presence.

¾Set up an overseas branch − establishes local presence and can be tax efficient as branch losses in early years can be offset against head office profits in the home country.

¾Overseas subsidiary − gives evidence of long term commitment and may attract government grants. However it may not be tax efficient if payment of dividends to the parent company incurs withholding tax.

¾Economic Interest Groups − facilitate cooperation between firms based in different countries.

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3.2Political risk

¾Possible government actions that give rise to political risk are:

appropriation of assets e.g. nationalization (with or without compensation);

limits on local currency convertibility;

laws regarding local ownership;

laws regarding employment of local staff;

blocks or high withholding tax on the payment of dividends to a foreign parent.

¾There are ways of limiting exposure to political risk:

structuring the investment so that it is unattractive as a target for government action e.g. retention of technical knowledge in the parent company;

borrowing locally so that if there is uncompensated appropriation of assets the company could default on local loans;

prior negotiation with host governments;

being “good corporate citizens” of the host country, e.g., high levels of local employment, use of local suppliers etc.

using a variety of methods to repatriate funds, not only dividends e.g.

−transfer pricing

−management fees

−royalty payments

−interest payments.

4INTERNATIONAL TREASURY FUNCTION

4.1Role of international treasury

¾Cash flow forecasting

¾Cash management

¾Foreign exchange risk management

¾Interest rate risk management

¾Financing decisions

¾Investment decisions

¾Global tax planning

4.2Cost centre vs. profit centre

¾Cost centre – the cost of the treasury department is recharged throughout the group on some equitable basis.

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¾Profit centre – creates an incentive for the treasury department to be an income generator. However this may lead to speculation and hence there is a need for strong internal controls to avoid disasters such as:

In 1990 Allied Lyons’ treasury took a speculative high-risk position on the level of volatility of the £/$ exchange rate. Unfortunately this lead to £150 million of losses.

In 1993 the German oils and metals company Metallgesellschaft lost $1 billion after becoming over-exposed to oil derivative contracts.

In 1994 the US consumer products group Procter & Gamble lost $102 million on two swap contracts from fixed rate loans into floating rate – gambling that US and German interest rates would stay low. Unfortunately both interest rates rose sharply.

4.3 Centralized vs. decentralized

Advantages of centralized treasury management

9Economies of scale – lower staff costs, increased power with financial institutions, lower transaction costs.

9Multilateral netting – finding the net position for group companies regarding intercompany payments. This can reduce the number of transactions and hence cash transmission costs.

9Control over subsidiaries – for example regarding gearing levels.

9“Pooling” of short-term cash surpluses and deficits - to reduce interest expense.

9Netting of currency exposures to reduce the amount of external hedging required.

9Identification of the best investments available within the group.

9Transfer of cash from subsidiaries producing surpluses to those requiring project finance.

9Effective global tax planning – via transfer pricing and offshore “dividend mixer” companies.

9Minimizing finance costs - perhaps through the use of Special Purpose Vehicles; diverting low risk cash flows into a separate entity which gains a high credit rating and can issue bonds at low interest rates.

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Disadvantages of centralized treasury management

8Reduced autonomy of subsidiaries – may lead to demotivation.

8Lack of understanding of local conditions.

8Slow to react to opportunities at local level.

8Potentially dangerous to concentrate power in the hands of a few personnel.

4.4International cash transfer mechanisms

¾Cheque – slow and risk of loss in the postal system.

¾Banker’s draft – a cheque drawn by a bank against funds held in another bank e.g. an overseas customer’s bank may draw a banker’s draft against a bank in the exporter’s country. The draft is posted to the exporter who presents it and arranges payment into their own account. Slow and risk of loss in the postal system.

¾SWIFT (Society for Worldwide Inter-bank Financial Telecommunications) – electronic funds transfer; fast and reliable but high fees.

4.5Short-term investments

Short-term cash surpluses should be invested in lowrisk, high liquidity investments e.g.

¾Short-term bank deposits

¾Eurocurrency deposits

¾Certificates of Deposit (issued by banks) − pay specified rate of interest and have a fixed maturity date. They are negotiable instruments i.e. they can be resold.

¾Treasury Bills

¾Bills of Exchange

¾Commercial paper − unsecured short term promissory notes issued by banks and creditworthy corporate borrowers

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5INTERNATIONAL CAPITAL BUDGETING

5.1Net Present Value

¾The key issue here is to find the value of an overseas project in the hands of the parent company’s shareholders i.e. if the parent is UK based then it is necessary to find the sterling NPV of the project. However there may be various complications:

differences between the cash flows generated by the project and the amount that can actually be remitted to the parent - the remittable cash flow may be significantly less than the project cash flow due to exchange controls for example. We need to value the project in the hands of the ultimate shareholders hence it is the remittable cash flow which is relevant.

Taxation policies – the project’s returns will often be taxable both in the overseas country and, on a remittance basis, in the home country. However bilateral tax treaties may offer some relief from double taxation.

Exchange rates – as we need to value the remittable cash flows in terms of the home currency it is necessary to forecast future exchange rates.

¾The recommended approach to deal with these complications is as follows:

1.forecast the relevant cash flows in the foreign country, taking into account any foreign tax effects.

2.estimate remittable cash flows to the parent company.

3.forecast future spot exchange rates e.g. using Purchasing Power Parity.

4.translate the remittable cash flows into the parent company’s currency.

5.incorporate any other cash flows for the parent that arise due to the project e.g. lost contribution from exporting, additional tax in the home country.

6.estimate the parent’s WACC that reflects the risk of the project and find the NPV.

5.2Adjusted Present Value

¾APV may be a suitable method for appraising an overseas investment where the project finance significantly disturbs the existing capital structure

¾The first step would be to calculate the “base case” NPV - the present value of the posttax remittable operating cash flow discounted at the cost of equity ungeared.

¾The base case NPV would then be adjusted for any financing side effects which in an international context might be:

subsidies from foreign governments;

tax shields on local and/or home country loan finance.

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6INTERNATIONAL CAPITAL STRUCTURE

There are a variety of ways in which a holding company can finance its overseas subsidiary:

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7TRANSFER PRICING

7.1When is transfer pricing required?

A transfer pricing policy is needed when:

¾a business has been decentralised into divisions or subsidiaries and;

¾inter-divisional/company trading of goods or services occurs.

Transfers between divisions must be recorded in monetary terms as revenue for supplying divisions and costs for receiving divisions.

Transfer pricing is more than just a bookkeeping exercise. It can have a large effect on the behaviour of divisional managers.

7.2Objectives of transfer pricing

7.2.1Goal congruence

Transfer prices should encourage divisional managers to make decisions which are in the best interests of the parent company’s shareholders.

In any divisionalised organisation there is a risk of dysfunctional decision making. Where inter-divisional trading occurs, this risk is particularly high.

Achievement of goal congruence must be the primary objective of a transfer pricing system.

7.2.2Divisional autonomy

Divisional managers should be free to make their own decisions. A transfer pricing system should eliminate the need for head office to tell divisions what to do – instead it gives information to divisional managers which allows them to make the correct decisions.

Autonomy should improve motivation of divisional managers.

7.2.3Divisional performance evaluation

Transfer prices should be “fair” and allow an objective assessment of divisional performance.

If there is conflict between these objectives then goal congruence must taken priority.

7.3Optimal transfer price for goal congruence

The classic example of opportunity cost is where an internal sale will be at the expense of an external sale i.e. the opportunity cost is the lost contribution from the missed external sale.

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