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ACCA P4

Advanced Financial Management (AFM)

高级财务管理

ACCA Lecturer: Lily Wang

Copyright © ACCAspace.comACCAspace 中国ACCA特许公认会计师教育平台 2

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Multinational companies&international trading

Forecasting foreign exchange rates

P4 Chapter 7 Content

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Investment appraisal for international projects

The impact of taxation, inter company cf

and remittance restrictions

NPV analysis for foreign projects

6 Analysis of comprehensive example


1.Multinational companies and international trading

A multinational company is defined as one that generates at least

25%of its sales from activities in countries other than its own.

The economic environment

for multionationals

Strategic business planning

for multinationals

Management of international

trade and finance



International trading

Practical reasons for international trading

• Choice- The diversity of goods available in a domestic economy is

increased through the import of goods that could be uneconomic or

impossible to produce at home

• Competition-International trade will increase compeition in domestic

markets, which is likely to lead to both a reduction in price, together

with increasing pressure for new products and innovation.

• Economies of scale- By producing both for the home and international

markets companies can produce at a larger scale and therefore take

advantage of economies of scale.

• Specialisation- If a country specialises in producing the goods and

services at which it is most efficient, it can maximise its economic

output



Trade barriers

There are a number of ways that a country can seek to restrict imports.

Trade barriers include:

Quotas- imposition of a maximum number of units that can be

imported e.g. quotas on the number of cars manufactured outside of

Europe that can be imported into the EU.

Tariffs- imposition of an import tax on goods being imported into the

country to make them uncompetitive on price.

Exchange controls- domestic companies wishing to buy foreign goods

will have to pay in the currency of the exporter's country. To do this

they will need to buy the currency invloved by selling sterling. If the

government controls the sale of sterling it can control the level of

imports purchased.



Trade barriers

Administrative- a domestic government can subject imports to

excessive levels of administration, paperwork and red tape to slow

down and increase the cost of importing goods into the home

economy.

Embagoes- the prohibition of commerce and trade with a certain

country

Multinational companies have to find ways of overcoming these barriers,

for example by investing directly and manufacturing within a country

rather than importing into it.



Trade agreements and common markets

In many parts of the world, governments have created trade

agreements and common markets to encourage free trade. However,

the World Trade Organisation is opposed to these trading blocs and

customs unions (e.g. The European Union) because they encourage

trade between members but often have high trade barriers for non-

members

The World Trade Organisation (WTO)

• WTO was set up to continue to implement the General

Agreement on Tariffs and Trade, and its main aims are to reduce

the barriers to international trade.

• It does this by seeking to prevent protectionist measures such as

tariffs, quotas and other import restrictions.





• It also acts as a forum for negotiation and offering sittlement

processes to resove disputes between countries.

• The WTO encourages free trade by applying the most favoured

nation principle between its members, where reduction in tariffs

offered to one country by another should be offered to all members.





• Advantages of reducing protectionist measures:

• A country (say X) can benefit from reducing protectionist

measures because its actions would make other nations reduce

their protectionist measures against it .

• A reduction in these may allow X to benefit from increased trade

and economic growth.

• Such a policy may also all X to specialise and gain competitive

advantage in certain products and services, and compete more

effectively globally.

• Its actions may also gain political capital and more influencee

worldwide.





• Disadvantages of reducing protectionist measures:

• It mayrevolve around the need to protect certain industries.

• It may be that these industries are developing and in time would be

competitive on a global scale. However, inactions to protect them

now would damage their development irreparably.

• Protection could also be given to lod, declining industries, which, if

not protected, would fail too quickly due to international competition,

and ould create large scale unemployment making such inaction

politically unacceptable.

• Certain protectionist policies are designed to prevent "dumping "of

goods at a very cheap price, which hurt local producers.




Strategic issues for MNCs- national governance requirement

Different coutries have different governance requirement. These national

governance requirements will impact on the behaviour of multinational

organisations.

Individual countries have imposed their own restrictions from time to time

by, for example, reserving certain shareholdings for their won national or by

limiting the transference of profits or royalties. But even governments have

to tread carefully lest the subject of their attentions abandons the market

altogether.




Strategic issues for MNCs- Mobility of capital

• The mobility of capital

One of the drivers of globalisation has been the increased level of mobility

of capital across borders.

• Implications of an increased mobility of capital

• Lower costs of capital

• Ability of MNCs to switch activities between countries.

• Ability of MNCs to circumnavigate national restrictions

• Potentially increased exposure to foreign currency risk.




Strategic issues for MNCs- Local risk

• Local risk for multinationals includes the following:

• Economic risk is the possiblity of loss arising to a firm from changes

in the economy of a country

• Politicial risk is the possibility of loss arising to a firm form actions

taken by the government or people of a country.

• Political risk

Examples of political risk:

• Confiscation political risk

This is the risk fo loss of control over the foreign entity through

intervention of the local government or other force.

• Commercial political risk





• Examples of political risk:

• Financial political risk

This risk takes many forms:

• Restricted access to local borrowings

• Restrictions on repatriating capital, dividend or other

remittances

• Financial penalties on imports from the rest of the group such

as heavy interest-free import deposits.





• Examples of political risk:

• Exchange control risk

One form of exchange control risk is that the group may accumulate

surplus cash in the country where the subsidiary operaties, either as

profits or as amounts owed for imports to the subsidiary, which cannot

be remitted out of the country. This can be mitigated by using FOREX

hedging




Strategic issues for MNCs- Control

• Within the hierarchy of firms goal incougurence may arise when

divisional managerss in overseas operations promote theri own self-

interest over those of other divisions and of the organisation generally.

• In order to motivate local management and to obtain the benefit of

their local knowledge, decision making powers should be delegated

to them. However, given the wide geographical spread of divisions, it

is difficult for group management to control the behaviour of the local

managers.




Strategic issues for MNCs- Control

• This gives rise to agency cost, and a difficult balance between local

autonomy and effective central control.

• In order to minimise the agency problems which might arise in

multinational company, it is important that the company implement

suitable corporate governance procedures, and attempts to a lign the

goals of all the managers by using appropriate managerial

compensation packages


2.Investment appraisal for international projects.

InternationalInvestment

FinancingOverseas projects

Forecasting exchange rates

Issues to consider

NPV Techniques

Forex riskInvestmentAppraisal

The APV method

TAX

Inter-companyFlows

RemittanceRestrictions

Working Capital

InternationalCAPM



NPV analysis

The appraisal of projects involving international investments uses the

same NPV model we have used in earlier sessions. It includes basics

such:

Identifying relevant cash flows

calculating a project's corporation tax liability, including the calculation

of tax relief on capital expenditure

dealing with inflation and distinguishing money and real flows.

However, international investment appraisal includes additional

challenges:

Forecasting future exchange rates

Double taxation

Inter-company flows

Remittance restrictions



NPV analysis

Impact of a project on the firm's risk exposure

• Transaction risk

Individual receipts and payments which arise during the new

project's life will be subject to transaction risk, in that the value of

the transactions will initially be calculatied using the forecast rate of

exchange which may differ from the actual rate on the transaction

date.

• Economic risk

The project NPV is initially calculated using forecast exchange rates.

A change in these forecasts over the life of the project will increase

of decrease the project NPV, and hence the gain to shareholders.

• Translation risk


3.Forecasting foreign exchange rates

The relationship between interest, inflation ,spot and forward rates

The overall relationship between spot rates, interest rates, inflation

rates and the forward and expected future spot rates was overed in

Paper F9

A feature of exam questions covering international investment

decision is often the need to calculate the relevant exchange rates

over a number of years, and a summary of the key relationships is

therefore given in the four way equivalence table follows.



• F0=forward rate

• S0=spot rate

• S1=expected future spot rate

• ib=interest rate for base currency

• ic=interest rate for counter currency

• hb=inflation rate for base currency

• hc=inflation rate for counter currency

Difference in Interest rates

Expected differencein inflation rates

Difference betweenforward and spotrate

Expected change inspot rates

Equalinternational Fisher Effect

EqualExpectation theory

EqualInterest rate parity theory

EqualPurchasing power parity theory



Changing inflation rates

When finding exchange rates it might first be necessary to calculate

the inflation rates expected in a foreign country.

E.G.



Changing inflation rates

Step1- Find the infaltion rate in Costovia over the next three years:

step2- find the exchange rate

expand the mid point of the quoted spread as the exchange rate today:

142+(146-142)/2=144

The calculations for the next three years are:


4.The impact of taxation, inter company cash flows and remittance restrictions

Taxation

The level of taxation on a project's profits will depend on the

relationship between the tax rates in the home and foreign country.

There are three possible tax scenarios for an exam question

The home country may have a tax rate that is :

• lower than

• the same as

• higher than the foreign country.

The question will always assume a double-tax treaty -- PRJECTS

always tax at the highest rate.



Taxation



Inter-company cash flows

Inter-company cash flows, shuch as transfer prices, royalties and

management charges, can also affect the tax computations.

Although complex in trality, in the exam

• Assume inter-company cash flows are allowable for tax unless

the question says otherwise

• If an inter-company cash flow is allowable for tax relief overseas,

there will be a corresponding tax liability onthe income in the

home country

• Assume that the tax authorities will only allow 'arm's length'/

open-makret prices for tax relief and will not allowa an artificially

high or lowo transfer price




Transfer pricing

• The transfer price is the price charged by one part of a company

when supplying goods or services to another part of the company

• By manipulating the transfer prices charged it may be possible to

minimise the global taxation cost for the group.

• Company A will report low income therefore limiting the tax charge

• Company B will be reporting high income as it pays less tax.

Company A Corporation tax@50%

Company B Corporation tax@20%

Low transfer priceHigh transfer price




Transfer pricing

• The issues of double taxation and the tax treatment of inter-company

flows can be shown with an example:




Remittance restrictions occur where a foreign government places a

limit on the fund that can be repatriated back to the holding company.

This restriction may change the cash flows that are received by the

holding company.

The actual amount received by the parent company ( and therefore

the shareholders ) is the relevant flow for NPV purposes.

E.G.




E.G.



Working capital

It is a normally assumed that the working capital requirement for the

foreign project will increase by the annual rate of inflation in that

country



Working capital


5.NPV analysis for foreign projects

NPV analysis for foreign project

There are two methods for calculating the NPV of foreign projects

NPV analysis

on foreign projects

Step1-Estimate the

project's cash flows post-tax

inthe overseas currency

Step2-Convert the flows

to the home currency

Step3-Add any home

country cash flows,e.g.tax

Step4-Discount the net

home country cash flows

at the company cost of capital

NPV- same either way

Step2-Convert the company

cost of capital to an overseas

equivalent assuming IRP

Step3-Use adjusted CoC to

find NPV in overseas currency

Step4-Convert the NPV into

the sterling equivalent

Step5-Add in the PV of

any additional home

country flows, e.g. tax



Standard proforma for the conventional approach



Performing the calculation

It will be necessary to do a number of subsidiary workings in order to

reach the final NPV figure, so remember the basic rules:

• Lay out your table clearly and remember you will need one

column more than the length of the project if tax is lagged by a

year

• Make sure all workings are clearly referenced

• State any assumptions and be prepared to comment on them

further in any written report that follows



Performing the calculation

The following is a guideline order of approach for the conventional

approach

• calculate all the relevant flows in the foreign currency

• If tax is payable on the foreign flows, deduct it

• convert the net flows into the domestic currency

• consider whether any restrictions are placed on the remeittances

and if so ,calculate the cash flows actually received by the parent

• add any other domestic cash flows to the remitted amounts from

overseas

• discount the total net cash flows inthe domestic currency at an

appropriate cost of capital


Analysis of Example


Solution of Example

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