Why Is Financial Planning Important in Business

Financial planning is the backbone of a successful company. Without a solid financial road map, even a thriving company may find itself in over its head when it comes to making payroll or in the realm of accounts payable. By starting with a thorough financial plan, business owners are better able to weather the bad times and excel during the good times. Proper planning means fewer surprises down the line.

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SOURCES OF INTERNATIONAL INVESTMENT CAPITAL

Having identified such profitable opportunities firm must secure sufficient capital to them from external or internal sources to minimize the worldwide cost of its capital while also minimizing its foreign-exchange risk, political risk and global tax burden.

i)             External Sources Of Investment Capital

When raising external financing for their investment projects internal businesses may choose from a rich source of debt and equity alternatives. International firms also have many opportunities to borrow funds internationally on either a short or long-term basis. Securities firms and investment banks are continually developing innovative financing techniques to reduce the costs of borrowing for their MNC clients or to exploit gaps in national financial regulations.

A particularly important facet of the international capital market is the swap market in which two firms can exchange their financial obligations. Swaps are undertaken to change the cost and nature of a firm’s interest obligations or to change the currency in which its debt is denominated. A swap may be arranged between two firms that have differing currency preferences. International banks play a key role in the currency swap market. Most international banks engage in currency swap with corporate clients on an ongoing basis.

ii)            Internal Sources Of Investment Capital

Another source of investment capital for international businesses is the cash flows generated internally. Subject  to legal constraints the parent firm may use the cash flow generated by any subsidiary to fund the investment projects of any member of the corporate family. The corporate parent may access the cash flow directly via the subsidiary’s dividend payments to parent. The parent then can channel those funds those to another subsidiary through either a loan or additional equity investment in that subsidiary. Figure 1 summarizes the various internal sources of capital available to the parent and its subsidiaries.

Figure 1

Two legal constrains may affect the parent’s ability to shift funds among its subsidiaries. First if the subsidiary is not wholly owned by the parent the parent must respect the rights of the subsidiary ‘s other shareholders. Any intracorporate transfers of fund must be done on a fair-market basis. This ensures that the parent does not siphon off the subsidiary’s profits through self-dealing thereby harming the other shareholders interest. If the subsidiary is wholly owned transfers of funds do not raise this issue. Second some countries impose restriction on the repatriation of profit  thus blocking their intracorporate transfer.

Strategic Use Of Transfer Pricing

A transfer price is the paid for goods and services involved in intracorporate transaction between a subsidiary and other branches of the corporate family. In practice transfer prices are calculated in one of two way :

i)             Market-based method

The market-based method utilizes prices determined in the open market to market to transfer goods between units of the same corporate parent  and has two main benefits. First reduces conflict between the two units over the appropriate price. The higher the price charged in the intracorporate transfer the better the selling subsidiary’s performance appears and the poorer the buying subsidiary’s performance appears. Second the market-based approach promotes the MNC’s overall profitability by encouraging the efficiency of the selling unit. Motivated by the prospects of bonuses and lucrative promotions unit managers have every incentive to improve the efficiency and profitability of their operations.

ii)            Nonmarket-based method

Prices may be set by negotiations between the buying and selling units or on the basis of cost-based rules of thumb such as production cost plus a fixed markup. Some service of corporate parent may be assessed as a percentage of the subsidiary’s sales such as charges for general corporate overhead and administrative services or for the right to use technology o intellectual property owned by the parent. One disadvantages is that managers of the buying and selling units may waste and energy arguing over the appropriate transfer price because it will affect their reported profits even though it will have no overall impact on their parent’s consolidated before-tax income. Also reduce the selling unit’s efficiency. However strategic use of nonmarket-based transfer prices may benefit an international business as table 2. Creative rearranging of intracorporate prices may allow the parent to lower its overall tax bill.

Table 2

The firm can raise the transfer prices charged to the subsidiary in the high-tax country and lower those charged to the subsidiary in the low-tax country, thereby reducing the firm’s overall tax burden.

TAX HAVENS

The ability of multinational corporations to lower their tax burden by the strategic use of transfer prices is facilitated by the existence of tax havens countries that impose little or no corporate income taxes. By manipulating payments such as transfer prices, dividends, interest, royalties and capital gains between its various subsidiaries an MNC’s may divert income from subsidiaries in high-tax countries to the subsidiary operating in the tax haven. By booking its profits in the tax haven subsidiary the MNC escape the clutches of revenue agents in other countries. Being a ta haven can create a thriving economy. A common approach is to use an arm’s length test whereby government officials attempt to determine the price that two unrelated firms operating at arm’s length would have agreed on. In many cases however an appropriate arm’s length price is difficult to establish leading to conflict between international businesses and tax authorities.

International Capital Budgeting

INTERNATIONAL CAPITAL BUDGETING

Numerous approaches for evaluating investment projects are available, but the most commonly used methods include net present value, internal rate of return and payback period. To calculate the net present value of a project, a firm’s financial officers estimate the cash flows the project will generate in each time period and then discount them back to the present.

i)             Net present value

Financial officers must decide which interest rate, called the rate of discount, to use in the calculation, based on the firm’s cost of capital. The firm will undertake only projects that generate a positive net present value.  The net present value approach can be used for both domestic and international projects. However several additional factors must be considered when determining whether to undertake an international project. These factors are risk adjustment, currency selection and choice of perspective for the calculation.

 The amount of risk adjustment should reflect the degree of riskiness of operating in the country in question such religious conflict and civil war warrant the use of much larger adjustment for potential investments. The determination of currency in which the project should be evaluated depends on the nature of the investment. If the project is an integral part of the business of an oversea subsidiary, use of the foreign currency is appropriate.

MNCs often impose arbitrary accounting charges on the revenues of the operating units for the unit’s use of corporate trademark or cover general corporate overhead. These arbitrary  charges may reduce the perceived cash flows generated by the project but not the real cash flows returned to the parent. Similarly fees assessed against the subsidiary for the use of corporate trademarks, brand names, or patents should not be considered in the net present value calculation because the parent firm incurs no additional cost regardless of whether the subsidiary undertakes the project. The importance of currency controls in determining the attractiveness of a project also may be a function of the parent’s overall strategy.

ii)            internal rate of return

Financial officers first estimate the cash flows generated by each project under consideration in each time period. They then calculate the interest rate – called the internal rate return- that makes the net value of the project just equal to zero. Then they compare the project’s internal rate of return with the hurdle rate – the minimum rate of return the firm finds acceptable for its capital investment.  The hurdle rate may vary by country to account for differences in risk.

iii)           Payback Period

Payback period is the number of years it will take the firm to recover or payback the original cash investment from the project’s earnings.  The Payback Period technique has the virtue of simplicity. A project that earns large early profits but whose later profits diminish steadily over time may be selected over a project that suffers initial  start-up losses but makes large continuous profit after that. Adjustments must be made to eliminate intracorporate charges that have no real effect on corporate cash flows.

Working Capital

Managing

Working Capital

 In doing business, financial officers also need to manage working capital, or cash, balances, and this task is more complicated for multinational corporations compare to domestic firms. Besides, financial officers must consider about firm’s working capital in each of its foreign subsidiaries and each currency which subsidiaries do business. There are three corporate financial goals that must be balance. Its include;-

Minimizing working capital balances

Domestic and international firms must hold working capital for two reasons, which is: first is to facilitate day-to-day transactions and second is to cover against unexpected demands for cash. Any firms should not run out of cash on hand. It will cause failure to have sufficient cash to pay workers or suppliers. It can lead at a minimum, to expensive emergency borrowing or in the worst case, to an embarrassing loss of reputation that may cause suppliers and lenders to cut off future lines of credit.

 Financial officers usually need to balance the firm’s need for cash against the opportunity cost of holding the firm’s financial asset in such low yielding forms. One technique that been use by multinational corporations to minimize their company-wide cash holdings is centralized cash management. Each of the subsidiaries send to the centralized cash managers a daily cash report and an analysis of subsidiary’s expected cash balances and needs over the short run These report then are assembled by the centralized cash manager’s staff, who uses them to reduce the precautionary balances held by the corporations as a whole and to plan short-term investment and borrowing strategies. Instead of each subsidiary holding precautionary, “just in case” cash balances, the staff may direct each subsidiaries to send cash in excess of its operational needs to a central corporate bank then they will pool these funds, funneling it to subsidiaries when and if emergency arise. Thus the centralized cash manager ia able to reduce the precautionary held as whole and thereby reduce the amount of the firm’s assets tied up in such a low-yielding form. It is more efficient and cost effective to concentrate such financial information gathering and decision making in one unit of the corporation, rather than compelling each subsidiary to develop such expertise-in-house by reducing number of high-salaried financial specialists.

Minimizing currency conversion costs

Multinational corporations face another complication in doing international businesses, which involved their foreign subsidiaries, for example they buy and sell parts and finished goods among themselves. The constant transfer of parts and finished goods among subsidiaries generates blizzard of invoices and a constant need to transfer funds among the subsidiaries’ bank account. Cumulative bank charges for transferring these funds and converting the currencies involve can be high. In large transactions it involved two major currencies,   conversion fees and expenses may average 0.3 percent of the value of the transaction.

For smaller-sized transactions or for involving minor currencies with narrow markets, such fees and expenses can easily be 3 or 4 times higher. The conversion cost can be cut considerably, however if the subsidiaries engage in bilateral netting, in which two subsidiaries net out their mutual invoices. Currency conversion costs can be reduced further if the company engages in multilateral netting, which is done among three or more business units. However, some countries impose restrictions on netting operations to support their local banking industries, which benefit from fees charged for currency exchange.

Minimizing foreign-exchange risk

In minimizing foreign- exchange risk , financial officers typically adjust the mix of currencies that make up the firm’s working capital. Often firms use a leads and lags strategy to try to increase their net holdings of currencies that are expected to rise in value and to decrease their net holdings of currencies that are expected to fall in value. Financial officers in multinational face a complex task to ensure each subsidiary maintains sufficient cash balances to meet expected ordinary day-to-day cash outflows, as well as an appropriate level of precautionary balances to respond quickly to sudden, unexpected increase in cash outflow. They also balance each subsidiary’s expected and unexpected demands for cash against the opportunity cost of holding the firm’s financial assets in such low-yielding forms, while simultaneously controlling working capital-related currency conversion costs and foreign-exchange risk.

Exchange Risk

Managing

Foreign Exchange Risk

International business are exposed to the exchange risk that may affect the firm. There are 3  types of foreign-exchange exposure confronting international firms and it is transaction, translation and economic

Transaction Exposure

A firm faces transaction financial when the financial benefits and costs of an international transaction can be affected by exchange rate movements that occur after the firm is legally obligated to complete the transaction. Many  international business involved transaction exposure including; purchase of goods, services, or assets, sales of goods, services, or assets, extension of credit, borrowing of credit. In most international transactions, one of the parties has to bear transaction exposure. There are several options for responding to this transaction exposure which is Go naked, Buy forward currency, Buy currency future, Buy currency option and Acquire offsetting asset that explain as follow;

Table

Translation Exposure

Translation exposure is the impact on the firm’s consolidated financial statements of fluctuations in exchange rates that change the value of foreign subsidiaries as measured in the parent’s currency. If the exchange rates were fixed, translation exposure would not exist. Translation exposure develops from the need to consolidate financial statements into a common currency, it is often called accounting exposure.

Financial officers can reduce their firm’s translation exposure through the use of balance sheet hedge. A balance sheet hedge is created when an international firm matches its assets denominated a given currency with its liabilities denominated in that same currency. Tis balance occurs on a currency-by-currency basis, not on a subsidiary-by-subsidiary basis. Some experts believe managers should ignore translation exposure and instead focus on reducing transaction exposure, arguing that transaction exposure can produce true cash losses to the firm, whereas translation exposure produces only paper, or accounting, losses. Other experts disagree, stating that translation exposure should not be ignored. For instance, firms forced to take write-downs of the value of their foreign subsidiaries may trigger default ckauses in their loan contracts if their debt-to-equity ratios rise too high.

Economic Exposure

 Economic exposure is the impact on the value of a firm’s operations of unanticipated exchange rate changes. From a strategic perspective, the threat of the economic exposure deserves close attention from the firm’s highest policy makers because it affects virtually every area of operations, including global production, marketing and financial planning. Unanticipated exchange rate fluctuations may affect a firm’s overall sales and profitability in numerous markets.

One approach firms can use to address the problem of economic exposure is to utilize an operational hedge or natural hedge by trying to match their revenues in a given currency with an equivalent flow of costs. An important element of managing economic exposure is analyzing likely changes in exchanges rates.

The theory of purchasing power parity, for example, provides guidance regarding long-term trends in exchange rates between countries. In the short term forward exchange rates have been found to be unbiased predictors of future spot exchange rates, because of the importance of interest arbitrage in establishing equilibrium exchange rates, experts also may forecasts countries’ monetary policies ti predict future currency values.

Balance of payments performance also is useful because it provides insights into whether a country’s industries are remaining competitive in world markets and whether foreigners’ short-term claims on a country are increasing. Prospects for inflation also carefully assessed because inflation can affect a country’s export prospects, demand for imports and future interests rates.

Method Of Payment

Payment Methods for International Trade

Parties to the international transaction normally negotiate a method of payment based on the exporter’s of the importer’s credtiworthtiness and the norms of their industry. Many forms of payment have evolved over the centuries, including payment in advance, open account, documentary collection, letters of credit, credit cards, and countertrade. As with most aspects of finance, each form involves different degrees of risk and cost.

METHOD	TIMING OF PAYMENT	TIMING OF DELIVERY OF GOODS	RISK FOR EXPORTER	RISK FOR IMPORTER	AVAILABILITY OF FINANCING FOR EXPORTER	CONDITION FAVORING USE
Payment in advance	Prior to delivery of goods	After payment, when goods arrive in importer’s country	None	Exporter may fail to deliver goods	N/A	Exporter has strong bargaining power importer unknown to exporter
Open Account	According to credit terms offered by exporter	When goods arrive in importer’s country	Importer may fail to pay account balance	None	Yes, by factoring of accounts receive able	Exporter has complete trust in importer; exporter and importer are part of the same corporate family
Documentary collection	At delivery if sight drat is used; at specified later time if time draft is used	Upon payment if sight draft is used; upon acceptance if time draft is used	Importer may default or fail to accept draft	None	Yes, by discounting draft from its face value	Exporter trusts importer to pay as specified; when risk of default is low
Letter of credit	After terms of letter are fulfilled	According to terms of sales contract and letter of credit	Issuing bank may default; document may not be prepared correctly	Exporter may honor terms of letter of credit but not terms of sales contract	Yes, by discounting letter from its face value	Exporter lacks knowledge of importer; importer has good credit with local bank
Credit card	According to normal credit card company procedures	When goods arrive in importer’s country	None	Exporter fails to deliver goods	N/A	Transaction size is small
Countertrade	When exporter sells countertraded goods	When goods arrive in importer’s country	Exporter may not be able to sell countertraded goods	None	No	Importer lacks convertible currency; importer or exporter wants access to foreign distribution network

Financial Issues In International Trade

FINANCIAL ISSUES IN INTERNATIONAL TRADE

When begin by considering the problems associated with financing international trade. In any business transaction, the buyer and the seller must negotiate and reach agreement on such basic issues as price, quantity, and delivery date. However, when the transaction involves a buyer and a seller form two countries, several other issues arise:

1)      Which currency to use for the transaction

2)      When and how to check credit

3)      Which form of payment to use

4)      How to arrange financing

Choice of currency

One problem unique to international business is choosing the currency to use to settle a transaction. Exporters and importers usually have clear and confliction preferences as to which currency to use. The exporters typically prefer payment in its home currency so it can know the exact amount it will receive form the importer. The importer generally prefers to pay in its home currency so it can know the exact amount it must pay the exporter. Sometimes an exporter and an importer may elect to use a third currency. For example, if both parties are based in countries with relatively weak or volatile local currencies, they may prefer to deal in a more stable currency such as the Japanese yen or U.S. dollar. By some estimates, more than 70 percent of the exports of less developed countries and 85 percent of the exports of Latin American countries are invoiced using the U.S. dollar, while the exports of many of the new entrants into the European Union favor the euro.

Credit Checking

Another critical financial issue in international trade concerns the reliability and trustworthiness of the buyer. If an importer is a financially healthy and reliable company and one with whom an exporter has had previous satisfactory business relations, the exporter may choose to simplify the payment process by extending credit to the importer. However, if the importer is financially troubled or known to be a poor credit risk, the exporter may demand a form of payment that reduces its risk.  In commercial transactions it is wise to check customer’s credit ratings. For most domestic business transactions firms have simple and inexpensive mechanisms for doing this. In North America, for instance, firms may ask for credit reference or contact established sources of credit information such as Dun & Bradstreet or Moody’s.  Similar sources are available in other countries; however, many first-time exporters are unaware of the. Fortunately, an exporter’s domestic banker often can obtain credit information on foreign customer through the bank’s foreign banking operations or through its correspondent bank in a customer’s country. Most national government agencies in charge of export promotion also offer credit-checking services.

Method of Payment

1)      Payment in Advance

-          Payment in advance is the safest method of payment from the exporter’s perspective. The exporter receives the importer’s money prior to shipping the goods. But, from the importer’s perspective, payment in advance is very undesirable. The importer must give up the use of its cash prior to its receipt of the goods and bears the risk that the exporter will fail to deliver the goods in accordance with the sales contract.

2)      Open Account

-          From the importer’s perspective the safest form of payment is the open account, whereby goods are shipped by the exporter and received by the importer prior to payment. But, from the exporter’s perspective, an open account may be undesirable for several reasons.

3)      Documentary Collection

-          To get around the cash flow and risk problems caused by the use of payment in advance and open accounts, international businesses and banks have developed several other methods to finance transactions. One is documentary collection, whereby commercial banks serve as agents to facilitate the payment process. There are two major forms of drafts: a sight draft & a time draft

4)      Letter of Credit

-          To avoid such difficulties, exporters often request payment using a letter of credit, a document that is issued by a bank and contains its promise to pay the exporter on receiving proof that the exporter has fulfilled all requirements specified in the document. Depending on the product involved, the importer’s bank may demand additional documentation before funding the letter, such as the following:

a)      Export licenses

b)      Certificates of product origin

c)       Inspection certificates

5)      Credit card

-          For small international transactions, particularly those between international merchants and foreign retail customers, credit cards such as American Express, VISA, and MasterCard may be used. A firm may tap into the well-established credit card network to facilitate international transactions, subject to the normal limitations of these cards. The credit card companies collect transaction fees form the merchant and in return assume the costs of collecting the funds form the customer and any risks of nonpayment. The companies typically charge an additional 1 to 3 percent for converting currencies. However, the offer exporters and importers none of the help banks do in dealing with the paperwork and documentation requirements of international trade.

6)      Countertrade

-          This method occurs when a firm accepts something other than money as payment for its goods or services. Forms of countertrade include barter, counter purchase, buy-back, and offset purchase.

Financing trade

Financing terms are often important in closing an international sale. In most industries standard financing arrangements exist, and an international firm must be ready to offer those terms to tis foreign customers. Depending on the product, industry practice may be to offer the buyer 30 to 180 days to pay after receipt of an invoice. For the sale of complex products such as commercial aircraft, which will be delivered several years in the future, the payment terms may be much more complicated. They may include down payments, penalty payments for cancellation or late delivery, inflation clauses, and concessionary interest rates for long-term financing.