INTERNATIONAL BUSINESS Professor H. Michael Boyd, Ph.D.

1. INTERNATIONAL BUSINESS Professor H. Michael Boyd, Ph.D.

2. Accounting and Finance in the International Business

3. What Is Financial Management? • Financial management involves • Investment decisions –what to finance • Financing decisions –how to finance those decisions • Money management decisions –how to manage the firm’s financial resources most efficiently

4. What Is Accounting? • Accounting is the language of business • it is the way firms communicate their financial positions • Accounting is more complex for international firms because of differences in accounting standards from country to country • differences make it difficult for investors, creditors, and governments to evaluate firms • It is difficult to compare financial reports from country to country because of national differences in accounting and auditing standards

5. What Determines National Accounting Standards? • Several variables influence the development of a country’s accounting system including • the relationship between business and the providers of capital • political and economic ties with other countries • the level of inflation • the level of a country’s economic development • the prevailing culture in a country

6. How Do Providers Of Capital Influence Accounting? • A country’s accounting system reflects the relative importance of each constituency as a provider of capital • accounting systems in the U.S. and Great Britain are oriented toward individual investors • Switzerland and Germany focus on providing information to banks

7. How Do Political And Economic Ties Influence Accounting? • Similarities in accounting systems across countries can reflect political or economic ties • the U.S. accounting system influences the systems in the Philippines • in the European Union, countries are moving toward common standards • the British system of accounting is used by many former colonies

8. How Do Levels of Development Influence Accounting? • Developed nations tend to have more sophisticated accounting systems than developing countries • larger, more complex firms create accounting challenges • providers of capital require detailed reports • Many developing nations have accounting systems that were inherited from former colonial powers • lack of trained accountants

9. What Are Accounting And Auditing Standards? • Accounting standards are rules for preparing financial statements • they define useful accounting information • Auditing standards specify the rules for performing an audit • the technical process by which an independent person gathers evidence for determining if financial accounts conform to required accounting standards and if they are also reliable

10. Why Are International Accounting Standards Important? • The growth of transnational financing and transnational investment has created a need for transnational financial reporting • many companies obtain capital from foreign providers who are demanding greater consistency • Standardization of accounting practices across national borders is probably in the best interests of the world economy • will facilitate the development of global capital markets

11. Why Are International Accounting Standards Important? • The International Accounting Standards Board (IASB) is a major proponent of standardization of accounting standards • most IASB standards are consistent with standards already in place in the U.S. • by 2011, 100 nations have adopted IASB standards or permitted their use in reporting financial results • the EU has mandated harmonization of accounting principles for members • there soon could be only two major accounting bodies with substantial influence on global reporting • FASB in the U.S. and IASB elsewhere

12. How Does Accounting Influence Control Systems? • The control process in most firms is usually conducted annually and involves three steps • Subunit goals are jointly determined by the head office and subunit management • The head office monitors subunit performance throughout the year • The head office intervenes if the subsidiary fails to achieve its goal, and takes corrective actions if necessary

13. How Do Exchange Rates Influence Control? • Budgets and performance data are usually expressed in the corporate currency • normally the home currency • facilitates comparisons between subsidiaries • but, can create distortions in financial statements

14. How Do Exchange Rates Influence Control? • The Lessard-Lorange Model • firms can deal with the problems of exchange rates and control in three ways • The initial rate • the spot exchange rate when the budget is adopted • The projected rate • the spot exchange rate forecast for the end of the budget picture • The ending rate • the spot exchange rate when the budget and performance are being compared

15. What Is The Lessard-Lorange Model? Possible Combinations of Exchange Rates in the Control Process

16. Why Separate Subsidiary and Managerial Performance? • Subsidiaries operate in different environments which influence profitability • the evaluation of a subsidiary should be kept separate from the evaluation of its manager • A manager’s evaluation should • consider the country’s environment for business • take place after making allowances for those items over which managers have no control

17. What Is Financial Management? • Good financial management can create a competitive advantage • reduces the costs of creating value and adds value by improving customer service • Decisions are more complex in international business • different currencies, tax regimes, regulations on capital flows, economic and political risk, etc.

18. How Do Managers Make Investment Decisions? • Financial managers must quantify the benefits, costs, and risks associated with an investment in a foreign country • To do this, managers use capital budgeting • involves estimating the cash flows associated with the project over time, and then discounting them to determine their net present value • If the net present value of the discounted cash flows is greater than zero, the firm should go ahead with the project

19. Why Is Capital Budgeting More Difficult For International Firms? • Capital budgeting is more complicated in international business • because a distinction must be made between cash flows to the project and cash flows to the parent company • because of political and economic risk • because the connection between cash flows to the parent and the source of financing must be recognized

20. What Is The Difference Between Project And Parent Cash Flows? • Cash flows to the project and cash flows to the parent company can be quite different • Parent companies are interested in the cash flows they will receive, not the cash flows the project generates • received cash flows are the basis for dividends, other investments, repayment of debt, and so on • Cash flows to the parent may be lower because of host country limits on the repatriation of profits, host country local reinvestment requirements, etc.

21. How Does Political Risk Influence Investment Decisions? • Political risk - the likelihood that political forces will cause drastic changes in a country’s business environment that hurt the profit and other goals of a business • higher in countries with social unrest or disorder, or where the nature of the society increases the chance for social unrest • Political change can result in the expropriation of a firm’s assets, or complete economic collapse that renders a firm’s assets worthless

22. How Does Economic Risk Influence Investment Decisions? • Economic risk - the likelihood that economic mismanagement will cause drastic changes in a country’s business environment that hurt the profit and other goals of a business • The biggest economic risk is inflation • reflected in falling currency values and lower project cash flows

23. How Can Firms Adjust For Political And Economic Risk? • Firms analyzing foreign investment opportunities can adjust for risk • By raising the discount rate in countries where political and economic risk is high • By lowering future cash flow estimates to account for adverse political or economic changes that could occur in the future

24. How Do Firms Make Financing Decisions? • Firms must consider two factors • How the foreign investment will be financed • the cost of capital is usually lowest in the global capital market • but, some governments require local debt or equity financing • firms that anticipate a depreciation of the local currency, may prefer local debt financing

25. How Do Firms Make Financing Decisions? • How the financial structure (debt vs. equity) of the foreign affiliate should be configured • need to decide whether to adopt local capital structure norms or maintain the structure used in the home country • Most experts suggest that firms adopt the structure that minimizes the cost of capital, whatever that may be

26. What Is Global Money Management? • Money management decisions attempt to manage global cash resources efficiently • Firms need to • Minimize cash balances - need cash balances on hand for notes payable and unexpected demands • cash reserves are usually invested in money market accounts that offer low rates of interest • when firms invest in money market accounts they have unlimited liquidity, but low interest rates • when they invest in long-term instruments they have higher interest rates, but low liquidity

27. What Is Global Money Management? • Reduce transaction costs - 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 • Multilateral netting can reduce the number of transactions between subsidiaries and the number of transaction costs

28. How Can Firms Limit Their Tax Liability? • Every country has its own tax policies • most countries feel they have the right to tax the foreign-earned income of companies based in the country • Double taxation occurs when the income of a foreign subsidiary is taxed by the host-country government and by the home-country government

29. How Can Firms Limit Their Tax Liability? • Taxes can be minimized through • Tax credits - allow the firm to reduce the taxes paid to the home government by the amount of taxes paid to the foreign government • Tax treaties - agreement specifying what items of income will be taxed by the authorities of the country where the income is earned • Deferral principle - specifies that parent companies are not taxed on foreign source income until they actually receive a dividend • Tax havens - countries with a very low, or no, income tax – firms can avoid income taxes by establishing a wholly-owned, non-operating subsidiary in the country

30. How Do Firms Move Money Across Borders? • Firms can transfer liquid funds across border via • Dividend remittances • Royalty payments and fees • Transfer prices • Fronting loans

31. What Are Dividend Remittances? • Paying dividends is the most common method of transferring funds from subsidiaries to the parent • The relative attractiveness of paying dividends varies according to • tax regulations – high tax rates make this less attractive • foreign exchange risk – dividends might speed up in risky countries • the age of the subsidiary – older subsidiaries remit a higher proportion of their earning in dividends • the extent of local equity participation – local owners’ demands for dividends come into play

32. What Are Royalty Payments And Fees? • Royalties - 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 • can be levied as a fixed amount per unit or as a percentage of gross revenues • most parent companies charge subsidiaries royalties for the technology, patents or trade names transferred to them

33. What Are Royalty Payments And Fees? • A fee is compensation for professional services or expertise supplied to a foreign subsidiary by the parent company or another subsidiary • royalties and fees are often tax-deductible locally

34. What Are Transfer Prices? • Transferprices - the price at which goods and services are transferred between entities within the firm • Transfer prices can be manipulated to • Reduce tax liabilities by shifting earnings from high-tax countries to low-tax countries • Move funds out of a country where a significant currency devaluation is expected • Move funds from a subsidiary to the parent when dividends are restricted by the host government • Reduce import duties when ad valorem tariffs are in effect

35. What Makes Transfer Prices Unattractive? • But, using transfer pricing can be problematic because • Governments think they are being cheated out of legitimate income • Governments believe firms are breaking the spirit of the law when transfer prices are used to circumvent restrictions of capital flows • It complicates management incentives and performance evaluation

36. What Are Fronting Loans? • Fronting loans are loans between a parent and its subsidiary channeled through a financial intermediary, usually a large international bank • Firms use fronting loans • to circumvent host-country restrictions on the remittance of funds from a foreign subsidiary to the parent company • to gain tax advantages

37. What Are Fronting Loans? An Example of the Tax Aspects of a Fronting Loan