Students name : Kemenangan Tiba
Course number and Name : FIN 456 - International Financial Management
Instructors Name : Brittany Holloman
Date : 29/01/2024
ECONOMIC AND TRANSLATION EXPOSURES
A. Introduction:
Technological advances in the 4.0 era have brought drastic changes, one of which is in
the world of trade at the local, regional and international levels. Technological changes
encourage a faster globalization process, thus requiring companies to be more competitive in
increasing company value. Increased use of technology in the globalization process has an
impact on increasing the intensity of global trade activities and foreign investment activities.
This encourages companies to operate efficiently in order to compete in the global market.
Operating efficiently means that the company must be able to produce goods and services at
low cost at the economic level of scale. This competitiveness is influenced by various factors
such as product quality, environmental standards and after-sales services for products that
require maintenance. Multinational companies are defined as companies that have
subsidiaries, branches or affiliates located abroad that involve international activities, which
involve two or more companies different currencies. In addition to multinational companies,
domestic companies can also have international activities, if they import and export
products, components and services. Involvement with international activities causes the
company to face foreign currency risk. Foreign exchange exposure is a measure of the risk
faced by a company if there are changes in currency exchange rates.
Global trade transactions of both goods and services carried out in various types of
currencies will cause problems when the exchange rate of local and foreign currencies often
moves. The erratic movement of foreign exchange rates will cause uncertainty for
companies, especially multinational companies. This means that the company is
experiencing exposure to changes in currency values. no wonder many experts interpret that
exchange rate exposure is the sensitivity of changes in the real value of assets, liabilities or
operating income expressed in domestic currency to unanticipated changes in exchange
rates. To deepen this matter, this section will discuss about Economic Exposure, Factors that
become Basic Considerations to Minimize Economic Exposure, Translation Exposure,
Factors that Affect the Size of Translation Exposure, Managing Economic Exposure and
Managing Translation Exposure.
B. ECONOMIC EXPOSURE:
Economic exposure is the extent to which the present value of a company's future cash
flows can be affected by exchange rate fluctuations, (Madura, 2000). Meanwhile, according
to Saphiro (2013) Economic exposure shows the impact of the percentage change in
exchange rates and other factors on the percentage change in the company's cash flow which
is a reflection of the company's value. This economic exposure is much more important for
long-term health, namely seeing the company will continue to operate or ongoing concern
where costs and competitive prices can be affected by changes in currency exchange rates.
However, economic exposure is often considered subjective because it depends on the
estimated changes in future cash flows in the future an arbitrary period of time. Economic
exposure consists of (1) operating exposure, which is a situation where the present value of
the company is measured resulting from changes in cash flows due to future fluctuations.
Any company that has revenues and expenses in the form of foreign currency will have
operating exposure. This means that any movement in exchange rates will cause changes in
income and expenses and directly affect the profitability of current cash flows. Measuring
the operating exposure of the company requires forecasting and analyzing all transaction
exposure of the company in the future along with all exposures arising from competitors and
potential competitors and (2) transaction exposure is measuring changes in transaction value
due to different exchange rates before and after the transaction is made. So transaction
exposure is related to transactions that have been carried out but not yet due such as debts
and receivables. This type of economic exposure is most impacted when transactions are
made on credit both payables and receivables.
Transaction exposure occurs when there is a contractual transaction that binds cash
inflows and outflows denominated in foreign currencies. If there is a change in the exchange
rate between the time of receiving or spending money and the time of the transaction, the
value of money that will be expected to be received or spent at the time of the transaction
will not be the same as the reality, resulting in gains and losses. Techniques for managing
transaction exposure to cover foreign exchange risk. If multinational companies decide to
hedge some or all of their transaction exposure, they can use the following hedging tools (a)
The objective of operating and transaction exposure management is to anticipate and
influence the effects of unexpected changes in foreign exchange on the company's future
cash flows, rather than simply hoping for the best. To meet this objective, management may
diversify the company's operating and financing base. Management may also change the
company's operating and financing policies. The diversification strategy does not require the
company to predict imbalances, it simply recognizes them when they occurs. If a company's
operations are internationally diversified, management is positioned from the outset to be
able to recognize disequilibrium when it occurs and react competitively. By recognizing
temporary changes to competitive conditions around the world, management is able to make
adjustments in operating strategy.
Operating and transaction exposures can be partially managed by adopting operating or
funding policies that can offset anticipated foreign currency exposures. Six proactive
policies that are commonly adopted are (1) Currency cash flow equalization, (2) Risk
sharing agreements, (3) Back ti back or parallel loans, (4) Currency swaps, (5) Leads and
lags and (6) Reinvoicing centers. For example, a company from the United States wants to
continue export sales to Europe. In order to compete effectively in the European market, the
company will invoice all export sales in Euros. This policy results in continuous Euro
receipts month after month. This continuous series of transaction exposures can be hedged
on an ongoing basis with forwards or other contractual agreements, so in such cases the
proactive policy for operating exposures and transaction exposures is to (1) Equalize
currency cash flows One way to negate the company's anticipated continuous long exposure
is to obtain debt denominated in that currency (matching). Another alternative for US
companies is to find suppliers of raw materials and components in Europe as a substitute for
companies from the US or other countries. In addition, the company can also engage in
currency switching, i.e. the company pays foreign suppliers in Euros, (2) Currency
agreement clauses: risk sharing An alternative method of managing long-term cash flow
exposures between companies is to engage in risk sharing. This is a contractual agreement,
where the buyer and seller agree to spread or split the impact of currency movements on
payments between the two parties. This agreement is intended to reduce the impact of
volatility and unpredictable movements in exchange rates for both parties, (3) Back-to- back
loan, also known as a parallel loan or credit swap, occurs when two companies in two
different countries arrange to borrow in each other's currency over a period of time. On the
agreed repayment date, both companies return the borrowed currency. The swap creates a
covered hedge against foreign exchange losses, as each company, on its own books, borrows
in the same currency that it will repay later.
There are two fundamental obstacles that prevent the widespread use of back-to-back
loans, namely: It is difficult for the company to find a counterparty for the desired amount of
currency and time. There is a risk that one party will fail to repay the loaned funds at the
specified time even though each party has 100% collateral (denominated in a different
currency), (4) Currency Swaps: Currency swaps are similar to back-to-back loans, except
that they are not presented on the company's balance sheet. In a currency swap, the company
and a swap dealer or swap bank agree to exchange equivalent amounts of two different
currencies over a period of time, (5) Leads and Lags: Redefining the timing of funds
transfers Companies can reduce both operating and transaction exposures by accelerating or
delaying the timing of payments to be made or received in foreign currencies. Intra-company
leads and lags are more feasible as the related companies will most likely have the same
objectives as one consolidated company. Inter-company leads and lags, on the other hand,
require another company's time preference independent of the other company and (6) A
reinvoicing center is a subsidiary of a multinational company located in a particular country
whose function is to manage the operating exposure of affiliated companies.
C. Factors That Are Basic Considerations To Minimize Economic Exposure
1.
The company's sales targets are both domestic and overseas. Of course, minimizing
economic exposure can be done by reducing overseas sales or being more selective in
making sales both in terms of time and quantity.
2.
The company's biggest competitors are either domestic or foreign companies. It is
common that companies will always dominate the domestic market first. However,
some companies may have a stronger market abroad because their products are more
accepted. The company will inevitably have to analyze whether the benefits are worth
the economic risk of exposure.
3.
The location of the company's factory or the location of the company's production,
domestic or foreign. Companies that produce their goods abroad must be more careful
in choosing a country. The company must also consider whether it is better to produce
abroad or import the materials. Of course, there are many other variables that also
need to be considered such as salary, labor quality, and other regional aspects.
4.
Main and backup raw materials whether imported or not. Producing products with
special raw materials will certainly produce unique products that are different from
competitors. However, the risk of economic exposure must also be considered,
especially if the company only depends on one raw material supplier. If you don't
think about backup suppliers, then not only economic exposure, the sustainability of
the company can also be disrupted.
5.
The price used, whether domestic prices or world prices. Of course, this factor is very
influential and the company must be consistent in determining the price reference
used. That way, the profit and loss calculation can also be made more precise.
D. TRANSLATIONAL EXPOSURE:
Translation is not the same as conversion. Translation is simply a change of monetary
unit, just as a balance sheet expressed in British pounds is restated into its US dollar
equivalent. No physical exchange takes place, and no associated transactions occur as they
would with a conversion. Translation exposure, also referred to as accounting exposure,
arises because the financial statements of overseas subsidiaries expressed in foreign
currencies must be restated in the reporting currency of the parent company in order for the
company to prepare consolidated financial statements. The accounting process for
translation involves converting the financial statements of overseas subsidiaries into rupiah-
denominated financial statements.
Translation exposure is defined as the potential increase or decrease in the net worth of a
parent company and its reported net income caused by fluctuations in exchange rates since
the date of the prior period consolidated financial statements. The main purpose of
translation exposure is to prepare consolidated statements, but the translated financial
statements are also used by management to assess the performance of overseas subsidiaries.
Translation exposure is a measure of how much the consolidated financial statements of a
company are affected by fluctuations in foreign exchange rates. Consolidated financial
statements are generally used by company management to assess the performance of
overseas affiliates. If foreign exchange rates have changed since the previous reporting
period, the translation or reassessment of assets, liabilities, revenues, expenses, profits and
losses denominated in foreign currency will result in foreign exchange gains or losses. This
possible foreign exchange gain or loss is measured by the accounting exposure figure.
Some of the reasons for currency translation are (1) Companies with significant overseas
operations prepare consolidated financial statements that enable readers of the statements to
gain a holistic understanding of the company's operations, both domestic and overseas. To
achieve this, the financial statements of overseas subsidiaries that are denominated in
foreign currencies restated with the reporting currency of the parent company, (2)
Communicate with foreign stock enthusiasts. Companies that carry out translations are
companies in the form of open businesses so that financial reports can be read by the general
public easily, so that with converted financial reports it will stimulate investors to invest in
the company, (3) Record foreign currency transactions.
Foreign currency transactions occur when a company buys or sells goods with payments
made in a foreign currency or when a company borrows or lends in a foreign currency and
(4) Foreign currency translation is done to prepare financial statements that provide readers
with information about the company's operations on a global basis, taking into account.
Currently, many countries determine the translation method to be used by overseas
subsidiaries based on the nature of their business operations (based on the character of the
subsidiary). For example, an overseas subsidiary's business may be categorized as an
integrated overseas entity or a standalone overseas entity. Integrated overseas entities are
entities that operate as an extension of the parent company, i.e. cash flows and business lines
are closely related to each other.
A standalone overseas entity is one that operates in a local economic environment
independent of the parent company. The functional currency of the overseas subsidiary is the
currency of the primary economic environment in which the subsidiary operates and cash
flows are generated in that currency. In other words, the functional currency is the dominant
currency used by the overseas subsidiary in daily operations. The following table describes
the characteristics of the functional currency.
Factors Affecting the Size of Translational Exposure
1.
The extent of the role of the company's overseas branches. The greater the percentage
of the company's business conducted by overseas branches, the greater the percentage
of financial statement items that are easily affected by accounting exposures.
2.
The location of the company's overseas branches. This is because the financial
statement items in each branch are usually expressed in the local currency of that
country.
3.
Accounting standards used. Each country generally has standardized accounting
standards, which vary greatly between countries.
E. MANAGING ECONOMIC EXPOSURES:
Economic exposure represents any impact of exchange rate fluctuations on a company's
future cash flows. Corporate cash flows can be affected by exchange rate movements in
ways that are not directly related to foreign exchange transactions. So companies cannot just
focus on hedging their forex payables or receivables, but should also try to determine how
their overall cash flow will be affected by future exchange rate movements. There are
several methods that are usually used to measure economic exposure in a company,
(Kuncoro, 2016) as follows:
1.
Sensitivity of revenues and costs to exchange rate movements:
This is done by classifying cash flow into different income statement items and
subjectively predicting each of these items based on foreign exchange forecasts, i.e. by
separating operating expenses into fixed operating expenses and variable operating
expenses. The value of fixed operating expenses can be determined according to the
company's reporting history, while variable operating expenses are determined by the
company's sales level. Earnings before interest and tax is calculated by subtracting gross
profit from total operating expenses. Interest payable to banks in countries that are not
sensitive to exchange rate movements. However, the amount that would be required to pay
interest on loans taken out in countries that are sensitive to exchange rate movements
depends on the exchange rate scenario. Profit before tax is profit before interest and tax less
total interest expense.
Policies to increase sales in exchange rate sensitive countries or reduce the use of raw
materials from exchange rate sensitive countries will result in a more balanced impact.
2.
Regression analysis of historical cash flow and exchange rate data:
This means that foreign exchange exposure can be defined as the slope of the regression
equation that relates changes in real domestic currency values and assets, liabilities or
operating income to unanticipated changes in exchange rates, (Levi, 2001), as for the
regression analysis in measuring exposure is as follows:
a.
Historical cash flow and exchange rate data expressed in regression equations
PCF = a0 + a1 PER + e
PCF is the percentage change in inflation-adjusted cash flow measured in local
currency during period t. PER is the percentage change in exchange rate during a
given period t. The regression coefficient a1 indicates the degree of sensitivity of PCF
to PER.
b.
If a company is affected by multiple currencies and focuses more on the total
sensitivity to currency movements rather than the impact of a single currency, it
should consolidate its currencies into a composite index.
PCF = b0 + b1 PERI + e
PERI is the percentage change in the composite currency over period t and the weight
for each currency is based on the proportion of total cash flow to that currency.
c.
Some companies prefer to use the stock price as a proxy for the value of the company
and the shareholders' assessment of future cash flows. It then estimates how its share
price changes as a result of currency movements (in the model above replacing the
PCF with the percentage change in share price). Regression analysis is used to
determine how changes in a company's stock price are affected by fluctuations in the
exchange rate, i.e., how the company's stock price changes as a result of currency
movements:
r = a0 + a1 JCI + a2 E + e
r is the percentage change in the company's stock price, JCI is the percentage change
in the composite stock price index, E is the percentage change in the currency
exchange rate. The composite stock price index or market index is included in the
regression analysis because it is considered to have a large influence on the stocks of
individual companies in the market. So in this case the regression analysis is designed
to determine whether changes in the exchange rate (E) have an influence on changes in
stock prices (r) above and beyond the influence of the JCI.
Restructuring can reduce economic exposure by increasing sales to exchange rate
sensitive countries, reducing reliance on sourcing raw materials from exchange rate sensitive
countries, increasing borrowing from exchange rate sensitive countries, this strategy is
expected to reduce reliance on suppliers from exchange rate sensitive countries. It is worth
pointing out that some revenues or costs may be more exchange rate sensitive than other
cost-revenue items.
Therefore simply balancing the quantity of exchange rate sensitive income may not
insulate the company from exchange rate risk. A better way for a company to evaluate an
operations restructuring proposal is to make projections for all income statement items based
on several exchange rate scenarios.
F. Managing Translational Exposure:
Translational exposure arises when a multinational company translates the financial data
of each subsidiary into home country currencies for consolidation purposes. Some
multinational companies attempt to avoid translational exposure by matching foreign
liabilities with foreign assets. The use of forward contracts to hedge translational exposure
i.e. The amount of profit generated by the forward contract will inevitably depend on at the
spot rate of the exchange rate-sensitive country at the end of the year. If the exchange rate of
the exchange rate sensitive country appreciates during the fiscal year, the translation loss
will be covered by the profit earned from the forward contract. The management of
translation exposure can be done with basic hedging strategies to reduce translation exposure
including reducing soft currency assets (hard currency) and increasing soft currency
liabilities (hard currency assets). Forward contracts are the most popular hedging
instruments to reduce a company's translational exposure.
Currency selection, transfer pricing, and exposure netting are additional tools but are
rarely used due to the constraints imposed on these techniques by foreign governments. The
cost of hedging the balance sheet depends on the cost of borrowing, which is relative. This
hedging activity is a compromise that involves changing the currency denomination of
balance sheet accounts, which on the one hand incurs costs in the form of interest expense or
operational efficiency, but on the other hand can provide partial foreign currency protection.
If the subsidiary uses the local currency as the functional currency, the following
conditions may be the basis for determining when to hedge the balance sheet: (1) The
overseas subsidiary will be liquidated, so the value of the CTA will be realized, (2) The
company has a debt guarantee or bank agreement stating that the debt/equity ratio must be
maintained within certain limits, (3) Management is evaluated based on certain income
statement and balance sheet measures, which may be affected by translation losses or gains,
and (4) The overseas subsidiary operates in a hyperinflationary environment.
The translation methods used by multinational companies around the world on financial
statements are :
1.
Curren rate method is the most straightforward method as all balance sheet and
profit/loss items are converted at current exchange rates. This method is recommended
by the Institute of Accountants of England, Scotland and Wales and is widely used by
UK companies. Under this method, if the assets denominated in forex exceeds
liabilities denominated in forex, a devalusai will result in a loss. A variation of this
method is to convert all assets and liabilities, except net fixed assets which are
expressed at the current rate. The current rate method is the most widely used method
today, and the steps are as follows: (a) Assets and liabilities are translated at the
prevailing exchange rate, (b) Income statement items are translated at the rate
prevailing on the record date, or at least at the weighted average rate during the period,
(c) Dividends (profit distributions) are translated at the rate prevailing on the date of
payment and (d) Common stock and paid-in capital accounts are translated at
historical rates.
2.
Using the temporal method, currency translation is the process of converting
measurements or restating values. The method does not change the attributes of an
item being measured, but only changes the unit of measurement. The translation of
balances denominated in foreign currencies results in the remeasurement of the
denomination of the items, but not the actual valuation. This method is a modification
of the monetary/non-monetary method. The difference is that in the monetary/non-
monetary method, inventories are always converted at historical exchange rates. While
in the temporal method, inventories are generally converted at historical rates, but may
be converted at current rates if the inventory is recorded in the balance sheet at its
market value. Theoretically, the temporal method emphasizes more on cost evaluation
(historical or market). Items in the income statement are generally converted at the
average exchange rate for the reporting period. While cost of sales, debt repayments,
and depreciation relating to balance sheet items are converted at historical rates.
3.
The Current/ Noncurrent method is the oldest of the currency conversion methods.
Under this method, all current assets and liabilities of the company's branches are
converted into the currency of the home country at the current exchange rate, which is
the exchange rate at the time the balance sheet is prepared. While assets and liabilities
that are not Noncurrent items, such as depreciation expenses, are converted at the
historical exchange rate, which is the rate at which the asset was acquired or at which
the liability was incurred. Therefore, an overseas branch of a company that has
working capital that is positively valued in local currency will increase the risk of
translation loss due to devaluation using the current/noncurrent method. Conversely, if
the working capital is negatively valued in local currency, there will be a translation
gain due to revaluation using this method. However, this method does not consider the
economic element. Using the year-end exchange rate to translate current assets
indirectly suggests that cash, receivables, and inventories denominated in foreign
currencies are equally exposed to exchange rate risk. This is certainly not appropriate.
Instead, translating long-term debt based on historical exchange rates transfers the
effect of fluctuating currencies into the year of settlement.
4.
Monetary / Nonmonetary Method: Monetary assets (mainly cash, securities,
receivables, and long-term receivables) and monetary liabilities (mainly current debt
and long-term debt) are converted at current exchange rates. Non-monetary items,
such as stock items, fixed assets, and long-term investments, are converted at
historical exchange rates. Items in the income statement are converted at the average
rate for the period, except for revenue and expense items relating to non-monetary
assets and liabilities. Depreciation expense and cost of sales are converted at the same
rate as the balance sheet items. As a result, cost of sales may be converted at a rate
different from the rate used to convert sales. It should be noted that the monetary-non-
monetary method relies on the classification of the balance sheet scheme to determine
the appropriate translation rate. This may result in imprecise results. This method will
also distort the profit margin as it compares sales based on current prices and
translation rates with cost of sales measured at historical cost and translation rates.
Regardless of the method used, the translation method not only determines the
exchange rates used in the remeasurement of items in the balance sheet and statement
of financial position, it also determines the exchange rates used in the remeasurement
of items in the balance sheet and statement of financial position in profit or loss, but
also determines the balance of the recognized imbalance (i.e. affecting current profit or
equity reserve account). Gains or losses resulting from translation adjustments are not
included in consolidated net income, but are reported separately and recorded in a
separate capital reserve account (in the balance sheet) under the name Cumulative
Translation Adjustment (CTA). The biggest advantage of using the current rate method
is that translation gains or losses are not recognized in the income statement, but are
directly recognized in the reserve account, thereby reducing the volatility of reported
earnings.
Regardless of the method used, the translation method not only determines the exchange
rate used in remeasuring items in the balance sheet and income statement, but also
determines the balance of the recognized imbalance (i.e. affecting current profit or equity
reserve account).
Gains or losses resulting from translation adjustments are not included in consolidated
net income, but are reported separately and recorded in a separate capital reserve account (in
the balance sheet) under the name Cumulative Translation Adjustment (CTA). The biggest
advantage of using the current rate method is that translation gains or losses are not
recognized in the income statement, but are directly recognized in the reserve account,
thereby reducing the volatility of reported earnings.
G. Material Summary:
Economic exposure is the extent to which the present value of a company's future cash
flows can be affected by exchange rate fluctuations, (Madura, 2000). Meanwhile, according
to Saphiro (2013) Economic exposure shows the impact of the percentage change in
exchange rates and other factors on the percentage change in the company's cash flow which
is a reflection of the company's value. This economic exposure is much more important for
long-term health, namely seeing the company will continue to operate or ongoing concern
where costs and competitive prices can be affected by changes in currency exchange rates.
However, economic exposure is often considered subjective because it depends on the
estimated changes in future cash flows over an arbitrary period of time. Translation or
accounting exposure arises because the financial statements of a foreign branch, which are
denominated in a foreign currency, must be converted into the reporting currency of the
parent company to prepare consolidated financial statements. the difference between
transaction and operating exposure is that transaction exposure arises from future cash flows
for which contracts have been agreed since now, while operating exposure cash flows are
not related to contracts. Transaction and operating exposure both arise when there are
unexpected changes in future cash flows.
TASKS AND EVALUATION:
1.
Explain the definition of Economic Exposure.
2.
Explain the meaning of Translational Exposure.
3.
Explain how to manage economic exposure and translational exposure.
4.
Explain the translation methods of MNC companies.
5.
Describe the characteristics of functional currency.
INTERNATIONAL CAPITAL BUDGETING
A. Introduction:
In this era, the world economy is becoming increasingly globalized. The concept of
globalization refers to the increasing connectivity and integration of countries and their
corporations and societies in terms of economic, political and social activities. Multinational
corporations dominate the corporate landscape. A multinational company can sell goods or
services in more than one country (Eun and Resnick, 2015). Therefore, capital budgeting for
multinational companies is very important. Capital budgeting is a process of investigation
and analysis that leads to corporate financial decisions. Companies can strategize and
formulate decisions for long-term goals in the future. The capital budgeting process can
assist the company in forecasting and estimating future cash flows as well as controlling the
capital expenditure required in implementing projects. More broadly, capital budgeting is
defined as the process of analyzing capital investment opportunities and decide which
projects to implement. Capital budgeting decision making can be assumed that managers
seek to maximize firm value to shareholders. Managers determine whether or not an
international project is feasible by comparing the present value of the expected future cash
flows from the project to the initial investment required for that project. This type of
international project evaluation is similar to domestic project evaluation. (Madura, 2020).
Based on this objective, managers need some way to estimate the value that a project is
capable of delivering. Capital budgeting is also a business plan related to allocating
company capital for future and ongoing plans. An investment project is not only seen from a
financial perspective, but also focuses on its size, timing and risk factors (Chandra, 2011).
International capital budgeting is more complex than domestic capital budgeting because
the process involves more parameters and decision variables. In general, international capital
budgeting involves various considerations that carry more risk than domestic capital
budgeting. But like domestic capital budgeting, international capital budgeting also involves
the estimation of several measures or criteria as well as analysis that indicates whether or not
a project is feasible (Mossa, 2002).
Based on the explanation above, this chapter describes the parent company perspective
and subsidiary perspective, international capital budgeting analysis, the process of sending
subsidiary income to the parent company and international capital budgeting factors. After
studying this chapter, readers are expected to be able to examine and explain the parent
company perspective and subsidiary perspective, international capital budgeting analysis,
the process of sending subsidiary income to the parent company and international capital
budgeting factors.
B. Parent Company Perspective And Subsidiary Perspective:
Most investments made by multinationals are not the development of new projects, but
rather the acquisition of domestic companies' operations. Many multinationals' direct
investments are joint ventures, often involving partnerships with domestic companies,
although sometimes joint ventures are undertaken with other multinationals that share an
interest in a particular opportunity. However, whatever the form of direct investment, the
principle is the same, namely the evaluation of the cash flows of the project in terms of the
opportunity cost of the funds invested. Project evaluation, commonly referred to as capital
budgeting, but in international capital budgeting, often involves complex issues that are not
shared in the domestic context (Levi, 2009). The first issue faced in international capital
budgeting is whether the project under consideration is assessed from the perspective of the
subsidiary or the perspective of the parent company (multinational corporation).
Project feasibility analysis, such as NPV can be calculated from both perspectives,
depending on whether the calculation is based on cash flows received by the subsidiary or
remitted by the subsidiary to the parent company. There are several views on assessing
project feasibility, both from the parent's perspective and the subsidiary's perspective. One
view is that the project should be assessed from the subsidiary's perspective, as the
subsidiary will be responsible for managing the project. Another view assesses it from the
parent company's perspective, as the parent company is funding the project. Especially if the
subsidiary is wholly owned by the parent company. An exception occurs if the subsidiary is
not wholly owned by the parent company. In this case, the subsidiary also has the goal of
increasing its net worth as expected by shareholders who are not shareholders of the parent
company. Therefore, the acceptability of a project is determined by negotiations between the
parent company and the subsidiary.
Another insight in evaluating projects from the parent company's perspective is that
there is a tendency for subsidiaries not to fully appreciate the ways in which a project can
benefit the parent company. This tendency is reinforced by the practice of rewarding
subsidiary management on the basis of its net income, rather than its contribution to the
parent company's consolidated performance. The net cash flow after income earned by the
parent company can be very different from that earned by the subsidiary Bekaert and
Hodrick, 2017). The subsidiary's earnings are subject to corporate income tax and
withholding tax in the host country and part of the additional tax earnings are retained by the
subsidiary as retained earnings. Sometimes the entire earnings become retained earnings, in
which case the parent company gets nothing. Therefore, a project that is attractive from the
subsidiary's point of view may not be at all attractive to the parent company (Mossa, 2002).
The following are some of the reasons that explain the difference between the cash flows
earned by the parent company and the subsidiary.
The first reason for the difference between the cash flows received by the subsidiary and
those received by the parent company is the difference in tax rates, i.e. when there is a
difference between the tax rates in the host country (the country where the parent company
invests) and in the home country (the home country of the parent company). If the
government in the host country imposes a lower tax rate on income than the government in
the company's home country, then the project may be viable from the subsidiary's
perspective but not from the parent company's perspective. The second reason is restricted
remittances. This occurs when the government in the host country requires a certain
percentage of the subsidiary's income to remain in the host country. Sometimes the revenue
generated by the subsidiary is required to be reinvested in the host country for several years
before it can be remitted to the parent company.
If there are remittance restrictions, the parent company will not have access to these
funds, hence its after-tax cash flow will be lower than the subsidiary. Again, the project may
not be feasible from the parent company's perspective, but it is feasible from the subsidiary's
perspective. The third reason is excessive remittances. This occurs when the parent company
charges the subsidiary a high administrative fee, making the cash flow coming into the
subsidiary lower than that earned by the parent company. In this case, the project may be
viable from the parent company's perspective, but not viable from the subsidiary's
perspective. There is a clear difference between the revenues and costs of the parent
company and the subsidiary, what is considered as revenue by the parent company is
considered as cost by the subsidiary. The fourth reason is the difference in cash flow as seen
from the exchange rate movement. If the domestic currency strengthens against the foreign
currency, the cash flows received by the parent company will decrease in value measured in
domestic currency. The fifth reason is the difference in interest rates used by the parent and
subsidiary companies to calculate the present value of future cash flows arising from the
project. From the subsidiary's perspective, the appropriate interest rate should relate to the
cost of funds faced by the subsidiary's local competitors. For the parent company, the
interest rate should be related to the cost of capital associated with its worldwide operations,
these two rates can differ significantly.
C. International Capital Budgeting Analysis:
Once the company has compiled a list of prospective investments or projects, it must
analyze which projects maximize the value of the company. This selection requires various
decision rules and criteria that allow managers to determine whether to accept or reject
them. The net present value criterion is generally accepted as the most appropriate to use
because its consistent application will lead managers to maximize firm value (Alan and
Moles, 2014). Most readers are familiar with NPV analysis and its advantages over other
investment analysis methods as a tool to assist financial managers in maximizing
shareholder wealth.
1.
Net Present Value
Net Present Value (NPV) is defined as the present value of the net cash flows to the
parent company as a result of the project minus the initial expenditure for the project
(Madura, 2020). According to Alan and Moles (2014) net present value (NPV) is defined as
the present value of future cash flows discounted by the project's cost of capital minus the
initial net cash outlay for the project. According to Eiteman, et al. (2016) NPV is a capital
budgeting approach in which the present value of expected future cash inflows is subtracted
from the present value of cash outflows. If the NPV is positive, the project can be accepted
and continued, this indicates that the PV of proceeds is greater than the PV of initial cash
flow. Vice versa, if the NPV is negative then the project should be rejected. If two or more
projects have a positive NPV, the project with the higher NPV can be selected and accepted.
2.
International Capital Budgeting Analysis Example:
Buckeye Corporation, a US-based multinational company has a subsidiary in Mexico
that manufactures and sells agricultural equipment. Buckeye Corporation believes that its
subsidiary can also develop a farm equipment repair business. The following projections and
relevant data have been obtained for analysis purposes.
a.
The initial investment is expected to amount to 9.6 billion pesos, or $9.6 million based
on the current exchange rate of 0.0001 per peso.
b.
The new business is estimated to generate 5 million pesos per year for 4 years.
c.
The business will be sold after 4 years, then the guest will acquire it without
compensation to Buckeye, but the guest government does not tax the profits generated
by this new project, although it does impose a 20% withholding tax on any funds
repatriated to the parent company in the US.
d.
The US government will tax any dollar profit that the parent receives from the
subsidiary at a rate of 20%.
e.
The required rate of return of the new project is 18%. This desired rate of return is
based on current economic conditions, the company's capital structure, and the risk of
the project.
D. Process Shipping Income Subsidiary Company To Parent Company
The following figure illustrates the process from when revenue is generated by the
subsidiary until the parent company receives the remitted funds. The figure also shows how
the subsidiary's cash flow is reduced by the time the funds reach the parent company. The
subsidiary's earnings are initially reduced by corporate taxes paid to the government in the
host country.
The remaining funds will then be converted into the currency of the parent company's
home country (at the prevailing exchange rate) and remitted to the parent company. There
are various factors that can reduce a subsidiary's earnings, the cash flow actually remitted by
the subsidiary may only represent a fraction of the earnings it generates. Any project,
whether foreign or domestic, must ultimately generate sufficient cash flow to the parent
company to increase shareholder wealth. Any changes in the expenditure of funds from the
parent company should also be included in the analysis. The parent company may incur
additional costs to monitor the subsidiary's management or consolidate the subsidiary's
financial statements (Madura, 2020).
E. International Capital Budgeting Factors:
Capital budgeting for multinational companies is required for all long-term projects
worth considering, from the expansion of a subsidiary division to the establishment of a new
subsidiary. Regardless of the long-term project to be considered, multinational companies
will need to consider financial characteristics that affect the initial investment or cash flow
of the project. Capital budgeting for international projects is more complex than domestic
projects. Therefore, a number of factors must be taken into account. The following are
factors that need to be taken into account in international capital budgeting (Mossa, 2002).
1.
Initial Investment. Initial investment includes not only the funds needed to start the
project but also working capital over time. Working capital is needed to finance
supplies, wages and similar items until the project starts generating revenue. A major
problem in international capital budgeting arises when the parent company sets up part
of the initial investment as equipment or inventory.
2.
Consumer Demand. Forecasting consumer demand for the products produced by the
project is necessary to estimate future cash flows, as there are competing products, the
market share must be estimated. Forecasts of the total market size are usually is based
on historical data and may involve the use of univariate or multivariate models. Once a
model is estimated from historical data, it can be used to forecast or project future
consumer demand.
3.
Price. The revenue a project generates over its lifetime depends on the sales volume
and the selling price. So, the selling price must be predictable. The price each year
over the life of the project can be estimated in relation to inflation in the host country
where the project is located. A decision must be made as to whether prices will move
exactly in line with the inflation rate or whether they will move faster or slower. This
means that a forward forecast of the inflation rate is required. Again, inflation can be
estimated from univariate or multivariate models.
4.
Variable Costs. Variable costs depend on the units of production factors used (such as
labor) and the cost per unit (such as the hourly wage rate). The cost per unit is closely
linked to the inflation rate, while the number of units used depends on production.
5.
Fixed Costs. Fixed costs are easier to forecast than variable costs as they do not
depend on consumer demand. Again, fixed costs are determined by inflation and for
this purpose inflation forecasting is required.
6.
Project age. The age of the project may be easy or difficult to determine. In some
cases, the age of the project is predetermined, stating when the project will be
liquidated. In other cases, the project continues as long as it is profitable. Sometimes
the parent company has no control over the viability of the project due to political
risks, particularly the risk of government takeover in the host country.
7.
Residual value. Residual value is also known as terminal or liquidation value, and is
always measured after taxes. This item is difficult to forecast as it depends on the
success of the project as well as political risks. For example, the residual value will be
zero if the host government forecloses on the project, i.e. takes it over without
compensation. If the project is expected to continue generating cash flows beyond the
analysis endpoint, the residual value should represent these cash flows.
8.
Restrictions on Funds Transfer by Host Government. Restrictions on remittances are
related to political risk. This factor is important as it affects the cash flow received by
the parent company which is used to calculate the NPV. If the percentage of cash
flows allowed to be transferred to the parent company is known in advance, this
information can be used to forecast the cash flows received by the parent company.
However, the regulations regarding the transfer of funds may be changed by the
government in the host country at any time in the future for unforeseen reasons.
9.
Tax Law. Changes in Tax Laws may be enacted by both home and host country
governments. This item is difficult to foresee as these laws can change, either with or
without cause. For example, the home government may change the Tax Law in such a
way that it does not give the parent company credit for taxes paid by the subsidiary in
the host country. Such changes will reduce the cash flow received by the parent
company.
10.
Exchange Rates. Exchange rates are difficult to forecast, which is especially true for
exotic currencies, i.e. currencies that are not actively traded. Forecasting exchange
rates for a long time into the future is rather difficult, although they can be based on
purchasing power parity. Even fixed exchange rates do not solve this problem, as these
rates can be corrected (through devaluation or revaluation) over time.
11.
Discount Rate. To calculate the present value of future cash flows, a discount rate
must be used. This discount rate is usually the required rate of return on the project,
which may or may not be equal to the parent company's cost of capital. If the discount
rate is nominal (i.e. not adjusted for inflation) then consistency requires the cash flows
to be estimated nominally as well. If the real cash flows are discounted at the real
discount rate, then the same NPV will be obtained as discounting the nominal cash
flows at the nominal discount rate.
12.
Depreciation. Depreciation is usually determined by the accounting standards used in
the host country. This item applies to plant and equipment (including buildings). Cash
flow is affected by the length of time it takes to fully write off the asset. Depreciation
can be calculated using either the straight-line method or the accelerated method.
F. Summary Material:
International capital budgeting can provide different analysis results and different
conclusions depending on whether it is done from the subsidiary's perspective or from the
parent's perspective. International capital budgeting also analyzes factors that need to be
taken into account that will help estimate the initial outlay, periodic cash flows, residual
value and rate of return required for a project. Once these factors are estimated, the net
present value for an international project can be estimated, in principle the same as for a
domestic project. It is usually more difficult to estimate cash flows for international projects.
The exchange rate creates uncertainty as it affects the cash flows that the parent
company ultimately receives as a result of the project. In addition, funds restricted by the
government in the host country, incentives, taxation, discount rates from the government in
the host country, can also affect the cash flows ultimately received by the parent company.
TASKS AND EVALUATION:
1.
What is international capital budgeting?
2.
Why is capital budgeting analysis so important for multinational companies?
3.
What problems do multinational companies face in international capital budgeting?
4.
What factors should multinational companies take into account in capital budgeting?
Explain!
5.
Foreign projects will always be profitable from the parent company's perspective. True
or false? Explain!
