CHAPTER 17
FINANCIAL
MANAGEMENT
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Copyright © 2011 John Wiley & Sons
1. Understand how value is measured and managed
across the multiple units of the multinational firm
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2. Examine how international business and investment
Learning
Objectives
3. Understand the primary decision methods used to
activity alters and adds to the traditional financial
management activities of the firm
evaluate the potential risks and returns of a proposed
investment in a foreign country
4. Explore how both operating and financing cash flows
are managed within the multinational firm
5. Understand the three primary currency exposures
that confront the multinational firm
6. Analyze the process of using goods and services as a
medium of exchange in addition to money in
international business
7. Examine the primary differences in the taxation of
business internationally, and how governments tax
firms operating in their markets
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What is the Goal of Management?
 Stockholder wealth maximization – Seeking to
maximize the returns to stockholders
 Corporate wealth maximization – Directs
management to consider the financial and social
health of all stakeholders
 Global Financial Goals



Maximization of consolidated, after-tax income
Minimization of the firm’s effective global tax burden
Correct positioning of the firm’s income, cash flows, and
available funds
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Focus on Ethics: Stockholder Wealth
Maximization and Corporate Culture:
The Enron Debacle
Enron may be the classic tale of how the singular
pursuit of profit, in the absence of consideration of
other interests, can lead to ruin. Without the
healthy balance of wisdom and experience from a
time-tested corporate culture, Enron in many ways
became a naïve and blind pursuer of stockholder
wealth maximization. Many believe that it was it’s
corporate culture that led to questionable ethical
decisions and ultimately to its demise.
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Genus Corporation
A sample corporation illustrates how the components fit together and
how financial management must make trade-off decisions
Genus Corporation is a U.S.-based manufacturer and distributor of
extremity-stimulus medical supplies
 Would have Genus rearrange its profits into the
Tax
countries having the lowest tax rates
Management
 Would have Genus rearrange its profits into Germany
Currency
because of the stability of the euro
Management
Funds Flow  Would have Genus rearrange its profits and cash flow
to minimize having funds blocked up in China
Management
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Genus Corporation and Foreign
Subsidiaries
Genus
Corporation
Brazil
Moderate Tax
Unstable Currency
Limited Funds Movement
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Germany
High Tax
Stable Currency
Free Funds Movement
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China
Low Tax
Stable Currency
Blocked Funds
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Multinational Management at Genus
 Primary goal is maximization of consolidated profits after tax
 Consolidated profits are profits of all the individual units of




the firm originating in many different currencies
Subsidiary financial statements are in local currency
Firm’s performance is on basis of earnings per share (EPS) –
Consolidated profits after taxes divided by shares outstanding
Each affiliate is subject to laws of the country where it is
located
Financial decisions at Genus



Capital budgeting
Capital structure
Working capital and cash flow management
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Trade Financing with a
Letter of Credit (L/C)
Germany
Issues L/C
Financing of
Trade with L/C
Old Growth
Pine Lumber
Exported
Pacific First
Bank (U.S.)
Draft
drawn and
payment made
Assures that
payment will
be made
Determination
of financial
soundness
Request L/C
Yokohama
Bank (Japan)
Vanport
Lumber
Company (U.S.)
Bill of lading signed
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Multinational Investing
 Capital Budgeting



Net present value – The sum of the present values of all cash
inflows and outflows from an investment project discounted at
the cost of capital
Capital budget – The process of projecting the net operating
cash flows of the potential investment to determine if it is
indeed a good investment
Cash Flow Components
Initial expenses and capital outlays
 Operating cash flows
 Terminal cash flows


Decision Criteria – Positive Net Present Value
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Weis Markets Announces
2010 Capital Budget
Weis Markets, Inc., which owns and operates supermarkets and
discount retail centers, announced a capital budget of $102.8 million
in 2010, a 27% increase over the year before.
The company said that the increased spending would be used to
increase and update the store base of the company. This would include
up to 3 new stores, 2 expansions and remodeling of 23 existing stores.
The company would also use some of the extra capital to increase its
investment in technology infrastructure to support the increased sales
growth.
Source: http://www.ibtimes.com/articles/21691/20100430/weis-markets-inc-wmk-announces-2010-capital-budget.htm
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Risks in International Investments
 Types of Financial Risks:


Exchange Risk
Interest Rate Risk
 Combining Interest-Rate and Exchange-Rate
Risks


A common mistake is not understanding what borrowing and
investing in foreign currency really means
Borrowing or investing in foreign currencies includes foreign
exchange risk
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Focus on Politics:
Brazil Fighting the Rise of the Real
Brazil’s government is applying a tax on Brazilian
stocks traded as American depository receipts
(ADRs) to stem the rapid flow of capital into
Brazilian securities. The move is an effort to close
a loophole that allowed investors to buy Brazilian
shares overseas and avoid a two percent tax on
foreign investments.
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Operating Cash Flows and
Financial Cash Flows
 Cash management – Management of cash balances
owned by the firm held by banking and other
financial institutions


Operating Cash Flows are from daily business activities and
operations
Financing Cash Flows come from the funding activities of the
firm (debt or equity)
 Intrafirm Cash Flows and Transfer Prices


Transfer prices occur when a company sells products to its
own subsidiaries and affiliates
Repayments of loans from subsidiary who funded a project
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Cash Management
 Netting – Cash flow coordination between global units of

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

a corporation so that one smaller cash transfer is made
Cash Pooling – Centralizing individual units’ cash flows
Lead – Paying a debt early to take advantage of exchange
rates
Lag – Paying a debt late to take advantage of exchange
rates
Reinvoicing – Buying goods from one unit and selling
them to a second unit to take advantage of favorable
exchange rates
Internal Banks – A “bank” owned by the company to buy
and sell receivables from units
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Netting and Cash Pooling of Cash Flows
in the Multinational Firm
U.S. Parent
U.S. $
German
Subsidiary
€
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Cash Flows
Move Both Ways
Between the Units
of the Firm
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French
Subsidiary
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Transaction Exposure
 Transaction Exposure is the potential for losses or gains
when a firm completes a foreign currency transaction


Most common type of exchange risk
Two conditions are necessary:
Cash flow is denominated in a foreign currency
 The cash flow will occur at a future date

 Transaction Exposure Management


Natural hedging – Cash inflows and cash outflows by currency are
matched
Contractual hedging – Use of contracts to minimize transaction
exposure
Forward contract – Agreement that permits the firm to either sell
or buy a specific currency at a future date at a known price
 Hedge – An asset or a position whose value moves in the equal but
opposite direction of the exposure

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Speculation
 Speculation occurs when currency
positions or financial instruments are
purchased (or sold) with the expectation
that a specific currency movement will
result in a profit
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Hedging Against Foreign Exchange Risk
For small import and export companies, foreign exchange volatility is
one of the most difficult and frustrating aspects of doing business
internationally. Hedging is often used to offset foreign exchange risk.
An article from GoCurrency.com provides detailed information about
hedging, including:
• Calculating foreign exchange exposures
• How does it work?
• Knowing when to hedge
• Who should hedge?
Source: GoCurrency.com: http://www.gocurrency.com/international-foreign.htm
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Transaction Exposure Case: Lufthansa
 In January 1985, the German airline Lufthansa
purchased 20 Boeing 737 jet aircraft
 The exposure – Lufthansa agreed to pay Boeing
$500 million a year later and if the deutschemark
continued to fall that would end up being more
money to pay in one year
 The management strategy – Decided to use forward
contracts to cover half the exposure
 The outcome – Since the dollar fell dramatically the
company had to pay for the forward contract
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Economic Exposure
 The change in the value of a firm arising from
unexpected changes in exchange rates
 All firms, either directly or indirectly, have economic
exposure
 Impact of Economic Exposure – As diverse as firms’
international structures
 Economic Exposure Management – Be prepared for
the unexpected
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Countertrade
 Countertrade is a sale that encompasses more than an
exchange of goods, services, or ideas for money
 Barter – Direct exchange of goods with no money involved
Benefits of
Countertrade
Disadvantages
of
Countertrade
• Allows the circumvention of
price controls
• Excellent mechanism to gain
entry into new markets
• Can provide major growth
opportunities for firms
• Can provide stability for longterm sales
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• May not be efficient
• Accounts must be
settled on a countryby-country or
transaction-bytransaction basis
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MIT Study Shows Barter’s
Use in Monetary Crisis
Dr. David Woodruff of MIT reports that barter’s use was very
important after the collapse of the Soviet Union in the late 1990’s. At
the time Russia was in a political and economic crisis that lasted a
decade. Inflation had destroyed the currency, and there was neither a
banking sector to speak of nor a functioning monetary system.
Barter was the answer. It was used by individuals, businesses, and the
central government. Woodruff says that in 1998 a huge 50% to 75% of
exchange in Russian industry took the form of barter. At least onequarter of the revenue collected in 1997 for the federal budget took a
non-monetary form.
Source: BarterNews.com: http://www.barternews.com/mit_study_shows_barters_use_in_monetary_crisis.htm
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International Tax Jurisdictions
and Tax Types
 Tax Jurisdictions
 Residential Approach – Taxes the international income of its
residents without regard to where the income is earned
 Territorial/Source Approach – Taxes all parties, regardless of
country of residency, within its territorial jurisdiction
 Most countries combine the two approaches to tax foreign and
domestic firms equally
 Tax Types



Direct taxes – Taxes applied directly to income
Indirect taxes – Taxes applied to non-income items
Value-added tax – Taxes applied on the value contributed at
each stage of the production and distribution process
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Focus on Politics: How High Taxes
Make the U.S. Uncompetitive
One of the biggest challenges facing the U.S.
economy is that it is now a high corporate income
tax country. Although the U.S. possessed one of
the lowest corporate tax rates for many years, it
has stayed relatively constant while most major
industrialized countries continually cut tax rates.
The higher tax rate has made the U.S. an
unattractive country in which to invest.
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Income Categories and Taxation
 Three methods used for the transfer of funds across
tax jurisdictions:



Royalties – For use of intangible assets
Interest – Payment for the capital lent for the financing of
normal business activity
Dividends – Income paid to shareholders from residual
earnings of operations
 Royalty and interest payments are normally subject
to withholding taxes
 Corporate profits are typically double taxed through
corporate and personal taxes
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