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Consultancy Report to Senior Management
Executive Summary
This report addresses in detail all the factors that a company needs to analyze before deciding to start operations in another country. The report continues to elaborate upon the different types of structures that can be utilized and the logic behind each structure, for instance direct investment model or a parent-subsidiary model. Furthermore, the report also elaborates upon what is the multinational financial system, and how companies that operate in various international locations can benefit from it. Moreover, the important managerial issues that arise due to the global nature of the company are also discussed, for instance global cash management or repatriation regulations. Another important factor that is discussed in this report is the additional risk that the company takes when it goes global and how this risk can be minimized, for instance exchange rate risk and political risk. This report discusses the different available strategic options, and analyzes the viability of the alternatives through the use of financial and non-financial tools. The financial aspect of the analysis will entail the use of Net Present Value (NPV), while the non-financial analysis will look at the PESTEL analysis.
Introduction
The issue of investment appraisal is of major concern among all the financial managers. The essence of investment appraisal is to determine which of the competing needs is of benefit to the entity that is planning to invest (Pauline & Sidney, 2007, p. 108). A project or an investment is termed as financially viable if the amount of cash flows it generates offsets the costs incurred and provides a residual amount to the company as profit (Jayaratne & Philip, 1996, p. 233).
Although financial tools are used to appraise investments, there are other non-financial factors that are considered when planning on the investment (Demirgüç-Kunt & Vojislav, 1998, p. 203). A rise in globalization has given rise to international business and as such, individuals have engaged in cross-border business activities. Most of the modern day business entities have an aspect of international business either through selling or buying internationally (Daniels, 1997, p. 118).
Multinational Capital Budgeting
When a company intends to expand and invest in markets where it has not operated before, it has several critical decisions to make, and Capital Budgeting is one of the most important ones. The company has two basic options: it can operate through a subsidiary unit or run the operations by itself, and this decision has huge implications on the future operations of the company (Buckley 2000). The basic differences are in the tax calculations, allowance of remittances and exchange rates of the currencies of the two countries. Exchange rate fluctuations and the rate of inflation in the host country is also of critical importance in the decision making process. Following factors need to be analyzed while developing a multinational capital budget (Baker 1998):
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Initial investment
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Price and Consumer demand
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Costs
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Tax laws
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Remitted Funds
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Exchange Rates
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Salvage value
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Required rate of return
Multinational Financial System
For a firm that operates in a global market, with operations spanning over several financial regimes, the multinational financing system creates several opportunities, which can be classified as arbitrage. Following are the three main ways by which the company can benefit through the multinational financial system (Madura 1999):
Tax arbitrage
MNCs can shift their accounting profits from units in high tax brackets to units in low tax brackets, or from units in tax paying position to units which are in tax losses, thus substantial amounts of tax payments can be avoided.
Financial Market Arbitrage
MNCs can shift funds from one unit to another and in the process get round exchange controls, receive better risk-adjusted returns on surplus funds, and utilize formerly unavailable sources of capital.
Regulatory System Arbitrage
Under some government regulations the profitability of a company is to keep under a certain limit, MNCs can disguise their true profits by reallocating them to other units.
Use of International Financial Markets
When the operations of the company are in the international market, it also helps to use the international financial markets. It broadens the scope of the company, and provides additional opportunities by increasing the possible sources of funds (Wendy & Mayer 2003). It also makes the portfolio more diversified, thus decreasing the risk. International debt market, for instance, is huge in size and provides a great opportunity for funding new projects.
Repatriation of Profits
The second most important thing after making the profit is the repatriation of the profit (Solnik 2000). The purpose of going into other global markets is to make profit in those markets and bring an optimal amount back to the home country. The repatriation laws may vary largely between different countries. Therefore, before making any investment decision, the company should analyze in detail the regulations which rule the repatriation of profits.
International Tax Planning
When a company shifts from domestic operations to global level of operations, it presents a lot of opportunities and challenges, as well. One such case is the taxes that the company incurs. The company needs to plan its taxes in a very sophisticated manner. Shifting the profits and losses amongst different units of business, which are under different tax regulations, the company can save significant amounts of taxes (Pauline & Sidney 2007).
Management of Risk Hedging
Expanding the business to other countries offers several opportunities, but it also exposes the company to previously irrelevant risk, for instance exchange rate risk or political risk etc (Walter & Smith 1999). The company thus needs to take precautionary measures to hedge itself against the risk. There are several alternatives available to the company, for instance to hedge against the exchange rate risk, the company can invest into options and futures, according to the forecasted fluctuations of the currencies. Furthermore, the purpose of risk management is to manage the risk and be ready in case crisis occurs, it can never be used to eliminate all risk. Therefore, while making the projections of future cash flows, the company should use risk-adjusted discounting rate. The company should also do sensitivity analysis and simulations to better understand their exposure to the risk.
Forecasting Future Exchange Rates
Forecasting the future exchange rates is of critical importance for the company, because eventually the company needs to convert the profits into their home country currency. Hedging is one way to minimize this risk, but the company still needs to make the projections. For this purpose the overall economic and political situations of the country need to be studied. The inflation rates, the rates of growth, the GDP all need to be studied in order to forecast the exchange rates. Much of the required date can be taken from IMF and World Bank resources.
After Tax Home Cash Flows
One of the prime concerns of the parent company is to calculate the after-tax cash flows the company would be able to bring back to the home country. This process involves certain steps. First of all, the operational unit generates a certain income in the host country, on which it has to pay the host country corporate tax rate. After that the unit itself has to retain a certain level of earnings to fund the operations of the company. After which the remaining profits are remitted by that unit, on which the host government puts a holding tax, and takes the required actions under the repatriation laws. The remaining amount is then converted into home country currency, which is the actual after-tax cash flow that the parent company gets.
Multinational Working Capital Management
In order to manage the Working Capital in a multinational setting, the companies need to manage the current assets and current liabilities, while also tackling with several other factors such as the political factors, the exchange rate issues, taxation and liquidity limitations. Overall, the company has two goals:
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to minimize the funds tied up in the working capital,
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arrange sufficient funds and liquidity for the running of global business.
Working capital has to be managed in an attempt to maximize the ROA and ROE, and it also has an effect on the performance and efficiency ratios (Baker 1998).
International Cash Management
International cash management refers to the efforts of the MNC to determine the amount of cash balances held throughout the units and its aim it to aid the cross-border movement of cash. MNC typically establish an international treasury to carry out these activities (Daniels 1997). It aims to release the cash that is unnecessarily tied up in the system. Cash netting is a very effective alternative in this matter, and also techniques such as wire transfer, cash pooling and electronic transfer are widely used to facilitate the cash management.
Assessment of the Political Risk
Assessing the political risk of a particular region is also very important for the parent company. Even if the market has good demand for the product, the prices are also very good, and the taxation laws are also favourable, a market with a high level of political risk can still prove to be a bad investment. An unstable political environment, for instance, can pose several threats to the company. A change in the government may result in formation of new regulations or tax laws, thus rendering a very lucrative market completely useless, and the huge initial investments can all be lost.
Analysis using Net Present value
Net present value is a capital investment appraisal method that takes in to consideration the time value of money. It gives the present value of the future cash flows of a project. The essence of the present values is that a dollar today is worth more than a similar dollar at a future date (Madura, 1999, p. 196). This method uses the cost of capital, the discounting factor, the duration of the project, and the financial values of the projects (Shaprio, 2000, p. 122). It is usually given as a percentage using the cost of capital, it is possible to determine the present value of the future cash flows of the project and hence establish whether the project is in real sense profitable or not (Buckley, 2000, p. 98).
When appraising investments using the net present value the limiting factor is the net present value of the project (Vance, 2003, p. 139). This is because the higher net present value results in value maximization of the enterprise and using the rules of rationality, investors would opt to invest in projects that will result in maximization of the value of the firms.
If there is only one project to be appraised, it is acceptable only if the NPV is more than zero. If an investments return does not provide an NPV that is more than 0, the investment in that particular project is usually rejected since the project is not financially viable.
Evaluating the investment using NPV
The figure calculated for the net present value of the investment is -696,315.78 (appendix). This means that the project is unable to fund its cost of investment and also the operational costs and yet make profit. The investment proposal by EMF Plc is therefore not financially viable and as such, the management of IMF Plc should reject the investment if the results of this appraisal technique are to go by.
The Assumptions made
While coming up with the figures for use in the Net Present Value, there are various assumptions that have been made. The first assumption is that the cash flow of ¬ 450,000.00 in the first year is the half the total cash flow of ¬ 900,000.00 from the total cash flow of the whole project. This is because of the fact that the Joint venture project is a 50:50 sharing ratio between EMF Plc and IMF Plc. The same case applies to the sharing of the operational costs.
The second assumption is that the cash inflows predicted will actually be the exact figures if the joint venture is implemented. This is normally not the case since it is usually impossible to predict with certainty what amount of cash can be earned at such periods. However, for calculation purposes the predicted cash flows are assumed to be true.
The non-financial appraisal methods (PESTEL)
The analysis of the PESTEL factors presents the internal and the external environments that the business operates in. This acronym stands for Political, Ecological, Social, Economic, and Legal factors. These are remote factors that the company does not have control over and as such the organization has to adjust so as to fit in the remote environment.
Political factors have to do with assessing the political conditions that affect the business environment. The formation of the joint venture however is not affected by the political situation in the country. This is primarily because the business was already running even before the joint venture proposal by EMF Plc. The Social factors have to do with the general perspective of the public about the business and its products. Again, for the simple reason that the business was already running before the joint venture and also the fact that the business specializes in offering financial services cushions it against dealing with the social factors in the country.
The legal factors deal with adhering to the rules and regulations that have been set by the government. The government provides the environment under which companies do business. The government therefore expects all these persons no matter what they are doing to adhere to the set rules and regulations.
The law enactments, therefore, provide a vital non-financial factor which ought to be considered carefully before accepting the joint venture proposal from EMF Plc.
Operational and strategic Challenges in re-domiciling to Monaco
Re-domiciling to Monaco is one of the intentions of the management. While Monaco is a fast growing haven for international business headquarters, there are several challenges that come along with shifting from France to Monaco.
First, re-domiciling to Monaco would mean investing a lot in non-current assets so as to fund the new company headquarters. This is because the government requires any company doing business in Monaco to have a physical premise within the country. (Walter & Smith, 1999, p. 146). The company will need to invest heavily in the noncurrent assets and this has the potentiality of affecting the liquidity position of the company.
The other operational challenge that the company has to deal with is working out tax. This country is never considered as a tax haven. A Monaco company that makes more than 25% of its annual sales in Monaco will be liable to pay over 33% in taxes, despite the fact that the company is fully incorporated in Monaco.
Overall, re-domiciling to Monaco has more disadvantages than advantages. It would expose the company to stricter regulations and higher taxes. It would decrease the level of profits, and increase the taxes imposed on those profits. Demand conditions in Monaco are suitable since the growth rate is high, but from an operations point of view, it is not a very ideal place.
Sources of Finance for the proposed expansion to Asia
During expansion programs, businesses incur along of expenses more so when moving into new markets where they have not been before (Shleifer & Vishny, 1992, p. 120). This necessitates a company to look for external sources of finance so that it could cater for these costs.
The essence of external financing goes beyond just the funding. External financing is also used as a risk management tool. The management of a multinational corporation can use external financing as a tool to spread risk. This happens where the capital structure of the company involves debt thus ensuring that the risk of failure is shared among different parties in the organization. In case of a loss, the pain incurred is not wholly borne by the share holders of the company but is also felt by the various other stakeholders.
The first source is the use of inter-company financing. This is where the company uses funds from the existing companies that have operations in other countries to fund the expansion (van Lelyveld & Knot, 2008, p. 189). The advantage of this is that it is a cheap source of financing.
The other source of financing for the company is through the use of Local currency financing where the company can borrow from the local banks so as to finance the operations (Eitemann & Stonehill, 1998, p. 253). This can be a very useful financing source more so for working capital (Solnik, 2000, p. 156).
Another possible source of financing is sourcing for loans from the various lending institutions. The importance of a loan is that a company can negotiate for a large sum of money and pledge some of the assets as collateral. The loan is usually a common source of finance for many companies. It should however be noted that loans are expensive to service since in most cases they attract high interests rates and as such, the company may incur huge interest expenses when repaying the loan which may in turn reduce the profit from the operations.
Conclusion
The running of a multinational business presents many challenges both in the operational and strategic activities of the corporation. However, with the right tools and effective management practices that includes risk management and effective employment of corporate governance principles, the company is able to man the operations well.
As such IMF Plc should objectively evaluate the available options in order to make the right decisions with regard to accepting the joint venture or not. It should also look at the various non financial factor that influence the choice of investment option so as to ensure that the decisions made are sound and to the best interests of the various stakeholders. Once the company puts all these factors into consideration, the decision on whether to divest or accept the joint venture will be an easy one. The strategic goal of expanding to Asia should also be objective appraised by the various investment appraisal methods; both financial and non financial as presented by this paper.
Based purely on the NPV the joint venture does not seem to be a profitable option.
Appendix 1
Calculation of the Net present value of the proposed investment in a joint venture with EMF Plc
References
Baker, J 1998, International Finance, 5th edn, Prentice Hall, New York.
Buckley, A 2000, Multinational Finance, 4th edn, Prentice Hall, New York.
Daniels, J 1997, International Business, 3rd edn, Addison-Wesley, London.
Demirgüç-Kunt, A & Vojislav, M 1998, Law, Finance and Firm Growth, Journal of Finance , vol 22, no. 3, pp. 2017-2037.
Eitemann, DK & Stonehill, AI 1998, Multinational Business Finance, 7th edn, Addison-Wesley., London.
Jayaratne, J & Philip, E 1996, The Finance-Growth Nexus: Evidence from Bank Branch Deregulation, Quarterly Journal of Economics, vol 13, no. 1, pp. 639-671.
Madura, J 1999, International Financial Management, 2nd edn, International Thomson, New Jersey.
Pauline, W & Sidney, J 2007, International Financial Analysis and Comparative Corporative Performance, Journal of International Financial Management and Accounting, vol 19, no. 5, pp. 111-130.
Shaprio, A 2000, Multinational Financial Management, 4th edn, Wiley & Sons, New York.
Shleifer, A & Vishny, R 1992, Liquidation values and debt capacity: A market equilibrium approach, The Journal of Finance, vol 12, no. 3, pp. 1343-1366.
Solnik, B 2000, International investments, London, 4th edn, Addison-Wesley, New York.
Taylor, F 1996, Mastering Derivatives Markets, 5th edn, FT-Pitman, Oxford.
van Lelyveld, I & Knot, K 2008, Do financial conglomerates create or destroy value? Evidence for the EU, Journal of Banking and Finance, vol 22, no. 2, pp. 2312-2321.
Vance, D 2003, Financial Analysis & Decision Making: Tools and Techniques to Solve Management Problems and Make Effective Business Decisions, 4th edn, McGraw Hill., New York.
Walter, I & Smith, R 1999, Global Capital Markets and Banking, 5th edn, McGraw-Hill, New York.
Wendy, C & Mayer, T 2003, Finance, Investment and Growth, Journal of Financial Economics, vol 17, no. 3, pp. 10-36.
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