International Financial Managemnet

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International Financial Management

By Prof.Augustin Amaladas

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Objective

• Explain international FM multinational capital budgeting

• Working capital

• Sources of international finance

• Special aspects related to the financial decisions of MNCs and International firms

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Chapter-1

• Multinational Capital budgeting

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Nature, difficulties and importance

• MNCs face exchange rate risks,

• Expropriation risk

• Blocked funds

• Foreign tax regulations

• Political risk

• Basic business risks of foreign and domestic projects

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Motivating factors

• Comparative cost advantage

• Taxation

• Financial diversification to reduce risk

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Uniform basis of evaluation

• Incremental cash outflows

• Incremental cash inflows

• Discounting at an appropriate cost of capital

• NPV

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Incremental cash outflows

• Cost of the proposed plant and equipment• +Shipping charges, custom duties, local transport etc• +Installation cost of plant and equipment• +Additional working capital• +Cost of technology transfer• +Training cost of personnel• - SALE PROCEEDS AFTER TAXES FROM

EXISTING PLANT AND EQUIPMENT AND TECHNOLOGY

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Incremental cash Inflows-Cannibalisation

• Identify cash inflows exclusively/wholly identifiable with the proposed project.

• 1.Cannibalisation:lost sales on existing product which was exported earlier

-loss of profit on lost sales to be considered as outflow. Or reduction from inflow.

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2.Sales creation

• Additional sales of existing products of parent company

• If newly set up all sales and profits are relevant cash inflow

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3. Opportunity cost

• Rent forgone on account of the proposed project-cash inflow

• Current market value of land and building that are used for undertaking of a new project-cost of the project.

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Treatment of fixed overheads

• Additional fixed overheads are to be considered

• Existing overheads to be excluded

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Fees and royalties

• Fees and royalties, management costs, training of personnel by head office are to be incurred unless they are additional.

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Intangible benefits

• It is qualitative in nature

• Better quality

• Faster time to market

• Higher customer satisfaction

• Valuable learning experience

• Helpful to new and existing products

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Incremental Analysis

• It is also known as additional benefit and additional cost analysis.

Example-1:Costs that will be incurred in future( less) savings on cost due to the new project

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Relevant cost and relevant benefit

• Allocated common costs are irrelevant• Opportunity costs are relevant (shadow

price)• Incremental costs and incremental benefits

are relevant.• Avoidable costs are relevant and

unavoidable costs are irrelevant for decision making.

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Relevant and irrelevant

• Five engineers already employed on monthly salary but will not be sent out if not employed in an another project. The salary paid to those engineers are relevant or irrelevant to estimate the price for a new project which will be completed with in a month?

• Two more engineers are selected exclusive to the new project.-Are the costs relevant to take decision for new project?

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Example for relevant cost

• Survey conducted by incurring Rs.10,00,000. Product P can be produced and marketed. If P is produced it estimated that 1,00,000 units per annum can be produced at a selling price of Rs.100per unit.It requires a machine costs Rs.1.5 crores .The material, manufacturing variable cost=Rs.65.

• What are relevant cost to take decision to go for the project or not?

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Example-1

• 1. Machine just purchased a few days back by spending Rs. 20,00,000. Cost of running this machine per hour is 100. It is about to be installed but we come across

an another efficient machine available in the market for Rs. 35,00,000. Cost of running this machine=70 per hour. If new machine is purchased the machine just bought can be disposed of for Rs 12,00,000

Question 1. What are relevant costs in this problem? 2. If so, how many hours should we run minimum so that it is beneficial

to the company.3. If company wants to run maximum 60000 hours which machine is

beneficial?4. What is the Break even hours between these two machines?

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Example-2

• We have manufactured 20,000 units of shirts which are meant for export by spending Rs. 150 per shirt. We can sell this product in the market for Rs. 120 per shirt because of defects. We can further process them to rectify the mistake by spending Rs.30.and we can export and sell for Rs.160. Other good units are sold for Rs.200 per shirt.

• Question: 1) What are relevent cost and relevant benefits?

• Should we rectify them or not?

• How much gain or loss if not rectified?.

• How much gain or loss if rectified?.

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Example-3

• X Ltd has a machine 001 produces product H. The selling price of H is Rs.100 and marginal cost is 60.It takes 20 hours to produce one H.

• The company has alternative to produce product ‘S’ which takes 3 hours per unit of S.The marginal cost of S=5. S can be purchased from market at a price of Rs.10

• Question: Should product S to be produced on the same machine 001

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Exercise-4

• An US multinational is planning to set up a subsidiary in India in view of cost cutting measures.The initial project cost is $400 million. Working capital required for the project is $.50 million. The company follows WDV method of depreciation.

• At present it is exporting 2 million units every year at a unit price of US $80, its variable cost is $50.

• As per the future plan it is estimated that variable cost is reduced by $30. Additional fixed cost per annum is $30 million and the share of allocated fixed costs are to be $3 million. The capacity to produce in India is 4.0 million units. Useful life is 5 years and no salvage value.

• The firm’s existing working capital investment in production and sales of 2 million units was $10 million.

• The export will decrease to 1.6 million units incase the firm does not set up the unit in India. The tax rate is 34% in India.The required rate of return is 15%.The annual appreciation in rupee is 2%.The spot rate is 42/$.The profits can be repartiated without withholding taxes, advise the US multinational regarding the financial viability of having subsidiary in India.

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Answer

1.Incremental cash outflows:

• Cost of plant and Machinery $400

• Additional working capital

• ($50 million-release of existing working capital $10 million) $40

• Total Incremental cash outflow is $440

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• 2.Incremental cash Inflows:• Sales revenue(4 million x $80) $320• Less: Variable cost(4 million x$30) $ 120• Additional fixed cost $ 30• Depreciation per year($400 mill./5) $ 80• Earning before tax $90• Less: tax (34% x $90) $ 30.6• Profit after tax $59.4• Add:Depreciation $ 80• Cash Inflow per year $139.4• Cash inflow for release of working capital at the

end of the project (5th Year) $40

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• 3. Profit on lost sales:• Sales revenue( 1.6 mill.units x $80) $128mill.• Less: variable cost(1.6mill.x $40) $ 64 mill.• Contribution(Sales-VC) $ 64 mill.• Less: taxes(34%) $ 21.76Mill.• Contribution after taxes $42.24 Mill.

(Lost contribution per year)

4.Net cash inflow per year

$139.4-$42.24=$97.16 mill.

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• Determination of NPV:

Particulars Cash flows

PV factor

(15%)

Present valie

Year

1

2

3

4

5

5 working capital release

97.16

97.16

97.16

97.16

97.16

40.00

0.869

0.756

0.657

0.571

0.497

0.497

84.432

73.452

63.834

55.478

48.288

19.887

345.372

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NPV

• Present value of incremental cash outflows $440

• Present value of incremental cash inflow$345.37

Net present value(NPV) (94.62Mill)Conclusion : Reject the project as NPV is negative as it

is not financially viable.

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Cash flow at Independent subsidiary as per Shapiro

• Sales revenue• Less: Variable costs• Less: Additional fixed costs• Less: Management fees charged by parent• Less: Royalty for patents, licenses, brands charged by parent• Less: Depreciation/amortisation/non-cash expenses• Earnings before tax• Less: Earnings after taxes• Add:depreciation/amortisation/non-cash expenses• CFAT(operating)• Add: salvage value of plant in the last year/one year after the lat year• Add: recovery of working capital(nth year or in earlier years)

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Cash Inflows to the parent company

• Dividend received +Interest received

+ Management fees + Royalties received for parents, licenses, brands, technology transfer etc.+Terminal cash flows(Net of taxes) such AS REPATRIATION OF SALE PROCEEDSOF PLANT, REEASE OF WORKING CAPITAL, BLOCKED FUNDS NOT PAID DUE TO EXCHANGE CONTROL RESTRICTIONS

Repayment of loanIncrease in cash profits due to increased export sales of other products at

parent MNCLess: decrease in cash profits(after taxes) due to decrease in export sales

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Impact of taxes

• The earnings are subject to tax at more than one stage as per the tax laws of many countries.

• 1. Taxes levied on subsidiary by local government where business is located

• 2.Tax on Dividends remitted to parent company by subsidiary in the country where subsidiary is set up.

• 3.Dividend received by parent company is also taxed as their income in the parent country.

• Note:- Inorder to avoid multiple tax double taxation agreement might help parent company to reduce tax liability.

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Example

• If HP has set up its subsidiary in India where tax rate is 20%.Assume further that corporate firms in US are subject to tax of 35%.Tax credit is allowed in USA due to double tax agreement.

• A)Determine the amount of tax credit available to a subsidiary having remitted US$ 4 million after-tax earnings as dividend.

Answer:- Next page

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• The subsidiary’s before-tax earning is equivalent to $5 (ie.$4 million (1-tax rate 0.2)

• Tax paid on $5 milion is 20% on $5 million is $1 million

• In USA tax on income is( $5 million x 0.35) $1.75 million

• Excess tax payable in USA is 1.75-1.0=$0.75 million.

• If tax rate in subsidiary country is 40%, what will be the position?

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• If tax rate in subsidiary country is 40% then in USA the benefit is limited to 35% only. Therefore no additional tax will be imposed.

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Exchange rate risk and capital budgeting

• If currencies are devalued or appreciated it affects capital budgeting decision as flow of funds in future is affected due to which profitability of the project also affected.

• Take the exercise 4(slide number 24) where subsidiary company country’s currency depreciates every year by say 2% what are the impacts?

• The current exchange rate is Rs.43/$

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Devalued value

• Year Rs/$

• 1 43

• 2 43.86

• 3 44.74

• 4 45.63

• 5 46.54

1.02(43)===

Calculator

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Devaluation and cash inflows• The annual cash Inflow is (Net cash inflow per year )-

Calculated as per slide number 24 exercise number 4 net annual cash inflow $97.16 million.=Rs.4177.88

Year

(1)

CAFT

Rs(2)

Exchange rate: Rs(3)

$ equivalent

4=2/3

1

2

3

4

5

5

4177.88

4177.88

4177.88

4177.88

4177.88

1720.00

(40x43)

43

43.86

44.74

45.63

46.544

46.544

97.16

95.25

93.38

91.56

89.77

36.95

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Calculation of Net present value$ equivalent

4=2/3

Present value

factor

Present value

97.16

95.25

93.38

91.56

89.77

36.95

0.869

0.756

0.657

0.572

0.497

0.497

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Tax planning –employees’ remuneration

• 1.Employer and employee relationship -Taxable to employee and deduction to employer2. Remuneration to partner:-Payment of salary to a

partner is disallowed to the firm.3. Director/managing director’s remuneration:-Managing director is normally considered as

employee. Director is not normally considered as employee. Managing director-salary.

Director-not a salary

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Fringe benefit tax

• Section 115WA• It is payable by employer-If no employer no need to

pay fringe benefit tax• Only when the employer has one or more employees

based in India.• Benefits provided to employees or deemed to have been

provided are taxable @30%+surcharge(10%)+Educational cess(3%)-domestic company, firm and artificial juridical person

• Foreign company-@30%+2.5%(surcharge)+3% educational cess

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If no income tax is payable should FBT to be payable?

• Yes

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Are 100% export zone, SEZ covered under FBT?

• Yes

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Who are not covered under FBT?

• Section 10(23C), 12AA, Political party(29A), companies registered u/s 25