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Chapter 20 - Financial Management in the International Business

Financial Management in the International



Learning objectives

Discuss how operating in

different nations impacts
investment decisions
within the multinational

Discuss the different

financing options
available to the subsidiary
of a multinational

Understand how money

management in the
international business can
be used to minimize cash
balances, transaction
costs, and taxation.

Be familiar with the basic

techniques for global
money management.

This chapter deals with financial management in

international business. It illustrates and explains
how investment decisions, financing decisions,
and money management decisions are
complicated by different currencies, different tax
regimes, different levels of political and economic
risk, and so on. Financial managers must account
for all of these factors when deciding which
activities to finance, how best to finance those
activities, how best to manage the firms financial
resources, and how best to protect the firm from
political and economic risks, including foreign
exchange risk.
Good financial management can be a source of
competitive advantage because it can lower the
cost of activities and enhance the value of
activities of a firm. The Opening Case illustrates
how Proctor & Gamble has been able to benefit
from a strong global money management strategy.
The Closing Case describes how Brazils
successful, no frills airline, Gol, has been able to
expand its capital opportunities by listing on the
New York Stock Exchange.



Opening Case: Global Treasury Management at Proctor & Gamble
Investment Decisions
Capital Budgeting
Project and Parent Cash Flows
Adjusting for Political and Economic Risk
Management Focus: Black Sea Energy Ltd.
Financing Decisions
Source of Financing
Financial Structure
Global Money Management: The Efficiency Objective
Minimizing Cash Balances
Reducing Transaction Costs
Global Money Management: The Tax Objective
Moving Money across Borders: Attaining Efficiencies and Reducing
Dividend Remittances
Royalty Payments and Fees
Transfer Prices
Fronting Loans
Techniques for Global Money Management
Centralized Depositories
Multilateral Netting
Chapter Summary
Critical Thinking and Discussion Questions
Closing Case: Brazils Gol


Ask students to consider the role of international finance in building and sustaining a
competitive advantage in global markets. Set up an example of a multinational firm with
multiple cash flows in various currencies. Then, ask students how to manage all of the
accounts payable and receivable. Challenge students to consider the costs involved in
converting currencies and foreign exchange exposure incurred. Finally, try to get
students to develop a multilateral netting strategy as a solution to managing the cash
OPENING CASE: Global Treasury Management at Proctor & Gamble
The opening case explores Proctor & Gambles financial management decisions. Proctor
& Gambles global money management uses a centralized treasury function. This allows
the company to realize considerable cost economies. Discussion of the case can revolve
around the following questions:
1. How has Proctor & Gambles approach to global money management changed? Why
did the company make the changes it did?
2. What are the benefits of Proctor & Gambles new approach to global money
Another Perspective: To learn more about Proctor & Gambles foreign operations, go to
the companys web site at {}.
This lecture outline follows the Power Point Presentation (PPT) provided along with this
instructors manual. The PPT slides include additional notes that can be viewed by
clicking on view, then on notes. The following provides a brief overview of each
Power Point slide along with teaching tips, and additional perspectives.
Slides 20-3-20-4 Introduction
Financial management focuses on three types of decisions: investment, financing, and
money management. In international business, currencies, tax regimes, regulations on
capital flows, norms for the financing of business, levels of economic and political risk
all influence these decisions.
Slide 20-6 Investment Decisions
Financial managers must quantify the benefits, costs, and risks associated with an
investment in a foreign country.

Slides 20-7-20-8 Capital Budgeting

Capital budgeting quantifies the benefits, costs, and risks of an investment.
Slide 20-9 Project and Parent Cash Flows
For the parent company, the key figure is the cash flows it will receive, not the cash flows
the project generates because received cash flows are the basis for dividends, other
investments, repayment of debt, and so on.
Slides 20-10-20-12 Adjusting for Political and Economic Risk
The analysis of a foreign investment opportunity includes an assessment of political and
economic risk. Political risk is the likelihood that political forces will cause drastic
changes in a countrys business environment that hurt the profit and other goals of a
business. Economic risk is the likelihood that economic mismanagement will cause
drastic changes in a countrys business environment that hurt the profit and other goals of
a business.
Slide 20-13 Financing Decisions
Firms must consider two factors when considering financing options:
1. how the foreign investment will be financed
2. how the financial structure of the foreign affiliate should be configured
Slide 20-14 Source of Financing
The cost of capital is typically lower in the global capital market than in many domestic
Slide 20-15 Financial Structure
The mix of debt and equity used to finance a business varies across countries. Japanese
firms rely far more on debt financing than do most US firms.
Slide 20-16 Global Money Management
Money management decisions attempt to manage global cash resources efficiently.
Slide 20-17 Minimizing Cash Balances
Firms face a dilemma - when they invest in money market accounts they have unlimited
liquidity, but low interest rates, and when they invest in long-term instruments they have
higher interest rates, but low liquidity.
Slide 20-18 Reducing Transaction Costs
Transaction costs are the cost of exchange. Every time a firm changes cash from one
currency to another, they face transaction costs. Most banks also charge a transfer fee for
moving cash from one location to another.

Slides 20-20-20-23 Global Money Management: The Tax Objective

Double taxation occurs when the income of a foreign subsidiary is taxed by the hostcountry government and by the home-country government.
Another Perspective: The US offers extraterritorial tax credit for multinational companies
with offshore operations. The European Union has protested against this subsidy stating
that it creates unfair competition. The WTO ruled that the FSC/ETI provisions of the U.S.
Internal Revenue Code constitute a prohibited export subsidy and are in violation of
WTO rules. To learn more, go to {}.
A tax credit allows an entity to reduce the taxes paid to the home government by the
amount of taxes paid to the foreign government. A tax treaty between two countries is
an agreement specifying what items of income will be taxed by the authorities of the
country where the income is earned. A deferral principle specifies that parent companies
are not taxed on foreign source income until they actually receive a dividend.
A tax haven is a country with a very low, or no, income tax firms can avoid income
taxes by establishing a wholly-owned, non-operating subsidiary in the country.
Slide 20-25 Moving Money Across Borders: Attaining Efficiencies and Reducing Taxes
Firms transfer liquid funds across borders as dividend remittances, royalty payments and
fees, transfer prices, and fronting loans.
Slide 20-27 Dividend Remittances
The most common method of transferring funds from subsidiaries to the parent is through
Slide 20-28 Royalty Payments and Fees
Royalties represent the remuneration paid to the owners of technology, patents, or trade
names for the use of that technology or the right to manufacture and/or sell products
under those patents or trade names.
A fee is compensation for professional services or expertise supplied to a foreign
subsidiary by the parent company or another subsidiary.
Slides 20-29-20-30 Transfer Prices
Transfer prices can be used to position funds within an international business.
Slide 20-31 Fronting Loans
Fronting loans circumvent host government restrictions on the remittance of funds and
have certain tax advantages.

Slide 20-33 Techniques for Global Money Management

Two techniques used by firms to manage their global cash resources are:
centralized depositories
multilateral netting
Slide 20-34-20-35 Centralized Depositories
Most firms prefer the cash depositories for three reasons:
1. by pooling cash reserves centrally, firms can deposit larger amounts, and therefore earn
higher rates of interest
2. when centralized depositories are located in major financial centers, the firm has
access to a greater variety of investment opportunities than a subsidiary would have
3. by pooling cash reserves, firms can reduce the total size of the readily accessible cash
pool, and invest larger amounts in longer-term, less liquid accounts that have higher
interest rates
Slides 20-36-20-39 Multilateral Netting
Multilateral netting is an extension of bilateral netting.
QUESTION 1: How can the finance function of an international business improve the
competitive position of the firm in the global market place?
ANSWER 1: Good financial management can be an important source of competitive
advantage. While this is true in a purely domestic business, due to the added complexity
of the international marketplace, good financial management is even more important in
the case of an international business. Chapter 12 described the value chain and about
how creating a competitive advantage requires the firm to lower the costs of value
creation and/or add value by improving customer service. Good financial management
can help the firm both to lower the costs of value creation and to add value by improving
customer service. By lowering the firm's cost of capital, eliminating foreign exchange
losses, minimizing the firm's tax burden, minimizing the firm's exposure to unduly risky
activities, and managing the firm's cash flows and reserves efficiently, the finance
function in an international business can lower the costs of value creation.
QUESTION 2: What actions can a firm take to minimize its global tax liability? On
ethical grounds, can such actions be justified?

ANSWER 2: The complexity of the various national tax laws and tax treaties between
countries makes minimizing global tax liability a considerable challenge. The first step is
to become familiar with the appropriate regulations. Many multinationals use tax havens
to limit their tax liability. Charging royalties and fees to lower the taxable income in high
tax nations can lower taxes by shifting profits to countries with lower tax rates. The level
of transfer prices set can also shift profits between different national entities, although
there are laws that require that these prices be reasonable in some countries. Fronting
loans can also be used to minimize tax liability by treating invested funds as independent
loans that incur interest expense rather than using equity and earning profits. Most of the
actions outlined above might be justified on ethical grounds as long as they are done
reasonably, yet they may also be ethically questionable in that they often contradict the
spirit of local laws. For example, transfer prices that bear no relation to the true value of
a good would clearly be unethical.
QUESTION 3: You are the CFO of a US firm with a wholly owned subsidiary in Mexico
that manufactures component parts for your US assembly operations. The subsidiary has
been financed by bank borrowings in the United States. One of your analysts told you
that the Mexican peso is expected to depreciate by 30% against the US dollar on the
foreign exchange markets over the next year. What actions, if any, should you take?
ANSWER 3: This issue suggests that some interest and principal will have to be repaid
in US dollars in the near future, but the plan was likely to pay this off out of earnings
from the Mexican subsidiary. Paying off the entire loan in advance before the peso
depreciates would be a good option. At least the peso funds could be transferred out of
Mexico now and invested in the US in dollars to pay off the loan later. Alternately, it
may be possible to use a forward rate to lock in an exchange rate now for future
remittances, but unless the analyst has some information that is not generally available in
the market, the efficacy of this approach will be limited since the forward rate will likely
already reflect the expected depreciation. Another option available is to simply pay off
the loan with funds already in the US over time, and retain the pesos in Mexico for
reinvestment if needed. The actual action taken would likely depend upon the size of the
loan, any restrictions on the loan, and where funds are most efficiently available for
paying off the loan. In any case, it would probably be unlikely that the best solution
would be to wait until later to exchange pesos for dollars later to pay off the loan.

QUESTION 4: You are the CFO of a Canadian firm that is considering building a $10
million factory in Russia to produce milk. The investment is expected to produce net
cash flows of $3 million every year for the next 10 years, after which the investment will
have to close down due to technological obsolescence. Scrap values will be zero. The
cost of capital will be is 6% if financing is arranged through the Eurobond market.
However, you have an option to finance the project by borrowing funds from a Russian
bank at a 12 percent. Analysts tell you that due to high inflation in Russia, the Russian
ruble is expected to depreciate against the Canadian dollar. Analysts also rate the
probability of violent revolution occurring in Russia within the next ten years as high.
How would you incorporate these factors into your evaluation of the investment
opportunity? What would you recommend that the firm do?
ANSWER 4: In considering these investments there are three basic steps:
make a basic analysis
adjust for economic/political risk
decide on the source of capital, which involves a more careful analysis
of exchange rate risk.
There are several different ways of approaching this problem, and the method outlined
below is just one. Different assumptions would lead to different answers.
(1) Make a basic analysis of the investment:
a quick analysis of the basic problem, a $10m investment that pays $3m/year for
10 years shows a ROI of 27%, suggesting that this is a good opportunity.
(2) Adjust for risk
In the case of Russia, the likelihood of violent revolution, which could damage
the plant irreparably or cause the firm to lose ownership is probably as likely to
occur in the first year as it is in any future year. Hence treating later cash flows
different than earlier cash flows is inappropriate. By adjusting the $3m cash
flows down by some percentage for each year (the risk that there will be a violent
revolution that will cause the plant to close in any given year), probability that the
plant will still be available to the firm can be factored into the yearly cash flows.
(3) Determine whether it would be better to fund the project from Canada or Russia or
not at all.
(i) Russian funds: If we assume that if there is a violent revolution, we would
neither earn money nor have to pay back the bank. (Let them have the plant if
they are around to get it from the revolutionaries.) The financing in Russia looks
very good. Having a 27% ROI while having to pay only 12% shows this to be a
very profitable investment. And even if it does fail in the first year due to
revolution, the bank is at risk, not the firm. The main issue is being able to get
funds out of Russia and back to Canada. The yearly cash flows that could be
repatriated would be $3m less interest and principal. You might make an
adjustment for economic/political risk and anticipated exchange rate changes.
The net present value of these cash flows in Canadian dollars could then be

(ii) Eurobond Funds: Eurobond investors would still want to be paid even if the
plant goes out of production. They will also want to be paid most likely in US
dollars or some European currency; it is unlikely that the Eurobonds would be
denominated in either rubles or Canadian dollars. Hence the approach would be
to discount the cash flows for economic/political risk, discount them for the
currency depreciation, make payments on the Eurobonds, and then determine the
net present value of the remainder. The quick calculation shows that this is still a
positive net present value option.
After more careful analysis both choices would likely yield a positive net present value,
although which one is higher is not obvious. While one can make estimates for the risks
and include them as suggested, it is clear that the Eurobond option exposes the firm to
higher economic/political and exchange rate risks. It also requires that funds be
repatriated to pay off the bonds, while with the bank financing, the firm could just keep
the funds in Russia if foreign exchange controls were instituted. Thus, unless the
Eurobond option has a significantly higher net present value, the Russian bank financing
has some strong advantages that are difficult to fully quantify.
The closing case describes the financial approach Gol took to raising capital to fund its
expansion. Gol is Brazils version of JetBlue Airways. In 2004, the company made an
offering of nonvoting preferred stock on Brazils stock exchange, the Sao Paulo Bovespa,
and on the New York Stock Exchange. Discussion of the case can revolve around the
following questions:
QUESTION 1: What were the benefits to Gol of a listing on the New York stock
exchange in addition to the San Paulo Bovespa?
ANSWER 1: By listing on the NYSE, Gol was able to build recognition of its business
model internationally and establish itself in the same category as JetBlue, Ryanair, and
Southwest. The company also gained recognition by the market and got long-term
investors to join in the expansion efforts.
QUESTION 2: Why do you think the Gol stock offering was oversubscribed?
ANSWER 2: Most students will probably suggest that Gols position of being one of the
fastest growing and most profitable airlines in the world probably contributed to the
oversubscription to its stock. The companys strong business model was appealing to
investors in both the United States and in Brazil.
QUESTION 3: Do you think Gol would have raised as much money if it had just listed
on the New Sao Paulo exchange?

ANSWER 3: By listing its stock on both the New York Stock Exchange and the
Brazilian stock exchange, Gol was able to position itself to a much wider audience.
Many students may suggest that has Gol listed only in Sao Paulo, it may have had far
fewer investors.
QUESTION 4: How might the joint listing of the New York and San Paulo stock
exchanges affect Gols ability to raise additional capital in the future?
ANSWER 4: Gols successful stock offering help propel the company into a tier one
airline in company with other successful firms like Southwest, Ryanair, and JetBlue. Gol
now has an international presence and is in a position to tap global financial markets, and
should find it easier to raise funds in the future.
Another Perspective: To learn more about Gol, go to the companys web site at
There are several iGLOBE video clips that can be integrated with the material presented
in this chapter. In particular, you might consider the following:
Title: Federal Reserve Moves to Stabilize Market
Federal Reserve Spends Billions
Run Time: 10:21
Abstract: This video explores the efforts by the Federal Reserve and other central banks
to stabilize financial markets.
Key Concepts: international monetary system, investor psychology and the bandwagon
effect, globalization
Notes: Global markets, concerned about the availability of credit, received some
reassurance recently when the Federal Reserve, along with the European Central Bank,
and other central banks, announced that they would pump billions of dollars into the
global financial system. The hope is that the additional liquidity will ensure that prices in
the market reflect underlying risks. As a result of the Federal Reserves actions, the
federal funds rate, which had been 6 percent, dropped back to the targeted 5.25 percent.
Liquidity in the market had been disrupted by a very abrupt re-pricing of risk in the

Glenn Hubbard, dean of the Columbia Business School, believes that the move was
important for restoring market confidence and ensuring that there were no developments
in the market that could lead to a financial crisis. Laurence Meyer, former governor of
the Federal Reserve Board, noted that the problems that were addressed began in the
United States, and in particular with sub-prime loans. However, because financial
markets today are global in nature, the problems quickly spread to other countries in
Europe. Glenn Hubbard also stresses the need to fully understand the global nature of
financial markets, and the interconnectedness of the global economy.
Hubbard points out that while the current problem began in the United States and spread
to other countries, the contributions to global liquidity and investments in the United
States came from foreign markets. He notes that today, risks are spread and diversified
around the world. Hubbard expects further intervention in the market. Hubbard believes
the current situation is actually a correction in the market that will more accurately price
risk. He notes that the correction took place very quickly as people became worried
about credit spreads.
Discussion Questions:
1. Why did the Federal Reserve recently pump money into financial markets? What
problems was it trying to address? Did it succeed?
2. Consider the recent move by the Federal Reserve to inject additional liquidity into
financial markets. The Federal Reserves efforts were just part of a worldwide effort to
reassure investors of the availability of credit. Why was it important for the Federal
Reserve to work in tandem with other central banks? Could the Federal Reserve have
corrected the problem by working alone?
2. Reflect on the global nature of world financial markets. What are the implications of
this interconnectedness? As an investor, how does this affect you?
4. Discuss the implications of global financial markets, and the potential for a worldwide
economic crisis.
There are also several longer video clips that can be integrated with the material
presented in this chapter. In particular, you might consider the following:

Title 3: Yukos, Sale or Seizure

All eyes are on Russia as the drama involving the oil company Yukos Oil continues to
unfold. In 2003, Mikhail Khodorkovsky, the billionaire head of Yukos Oil, and political
opponent of Russian President Vladimir Putin, was charged with tax evasion and fraud,
and his company spun toward financial ruin. Now, the company's most valuable asset, a
subsidiary called Yuganskneftegas, which produces a million barrels of oil a day, was
auctioned off by the Russian government to the previously unknown Baikal Finans
group. Then, the mysterious Baikal was acquired by a prominent state-run oil concern
called Rosneft, a company that plans to merge with Gazprom, an even bigger,
government-controlled energy conglomerate. In sum, Yukos, once a leader of the move
towards privatization in Russia, has now been renationalized. Further complicating the
story is the lawsuit trying to stop the sale that was filed in Houston where a Yukos
executive lives.
Despite concern over the situation from various camps, including the White House, Putin
maintains that the process was legitimate. However, perhaps more telling is his
complaint that during the 1990s, when privatization was just taking hold in Russia, many
individuals made purchases at prices well below their market value. In fact, according to
Harvard Professor Marshall Goldman, this is just the first step in an effort to reverse the
privatization that took place in the 1990s, and recreate a variation of the Soviet Unions
Ministry of Energy.
This video clip can be used to extend the discussion of the differences in legal system and
also the section on privatization in Chapter 2. In addition, the video could be used in
conjunction with the discussion of evaluating political risk in Chapter 20.
Discussion Questions
1. Putin has called the scenario involving Yukos legitimate. The White House, in
contrast, has said it is watching the situation, and the U.S. Court has tried to halt the sale.
Who is correct? Does the U.S. have the right to question the series of events that
occurred in Russia?
2. Suppose your company was about to make a significant investment in Russia. Would
the case involving Yukos change your mind about the investment? Should an American
company that already has an established subsidiary in Russia be concerned?
3. Harvard professor Goldman has suggested that the Russian government is attempting
to recreate its control over energy sources and production. Do you agree with his
assertion? What are the implications of this policy?
4. If the company remains state-owned, what are the implications for the oil industry?

globalEDGE Exercise Questions

Use the globalEDGE site {} to complete the following
Exercise 1
Tax rates in different countries can impact the level of spending income available to
companies and people in different countries. The top management of your company
requested a report regarding the tax policies of the following countries: Argentina,
Belgium, Bulgaria, China, Czech Republic, Denmark, Egypt, Germany, Italy and the
United Kingdom. A tax colleague indicated over lunch that a resource called Worldwide
Tax may assist you in completing your report. Prepare a table including the corporate
and individual income tax rates and the value added tax rates (where applicable) for the
countries on your list.
Exercise 2
Country risk is an important issue for investors to consider prior to investing in foreign
countries. One of the Marketing Potential Indicators for Emerging Markets is identified
as country risk. Utilize the ranking provided by the globalEDGE website and identify
five emerging markets that exhibit the least risk for foreign investors.
Answers to the Exercises
Exercise 1
The tax rates are provided by a variety of sources. One of the most comprehensive
sources regarding the world countries fiscal policies are provided by The site can be accessed by browsing the category Money: Finance at
{}. Be sure to check the Resource Desk only
checkbox of the search function on the globalEDGE website.
Search Phrase: Worldwide Tax
Resource Name: Worldwide
Website: {}
globalEDGE Category: Money: Finance
Exercise 2
The report can be accessed by searching for the term Market Potential Indicators at
{}. Using this search, the link will lead the user
to this report. This resource is found under the globalEDGE category Research:
Rankings. Be sure to check the Resource Desk only checkbox of the search function
on the globalEDGE website.
Search Phrase: Market Potential Indicators
Resource Name: MSU-CIBER: Market Potential Indicators
Website: {}
globalEDGE Category: Research: Rankings