Financial and Non-financial Issues and Risks of Setting Up Foreign Subsidiaries and Impact of Export Trade

Table of Contents

1 Introduction

2 Important Factors
2.1 Financial Factors
2.2 Non-financial Factors

3 Potential Risks and External Strategies
3.1 Currency Risk
3.1.1 Transaction Exposure
3.1.2 Translation Exposure
3.1.3 Economic Exposure
3.2 External Hedging Techniques
3.2.1 Forward Market Hedge
3.2.2 Money Market Hedge
3.2.3 Futures Hedge
3.2.4 Currency Options Hedge
3.2.5 Currency Swaps

4 Impact of Export Trade

5 Remedies to Reduce Foreign Debtors
5.1 Export Factoring
5.2 Bills of Exchange
5.3 Letter of Credit

6 Conclusion

7 Appendices
7.1 Calculations
7.2 Forward Market Hedge
7.3 Futures Hedge
7.4 Currency Options Hedge
7.5 Export Factoring

8 Bibliography

Tables and Figures

Table 1: Impact of Export Trade

Table 2: Working Capital

Table 3: Cash Operating Cycle

Table 4: Balance Sheet

Table 5: Current Ratio and Acid Test Ratio

Table 6: Profit and Loss Account

Table 7: Ratios on Working Capital Management

Table 8: Forward Rates

Table 9: Example Currency Futures

Table 10: Example Currency Options

Figure 1: Stages in a Factoring Deal

Figure 2: The Bill of Exchange Sequence

Figure 3: Annual Interest Rate (Bill of Exchange)

List of Abbreviations

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1 Introduction

According to our market forecast study in 2003, demand for office supplies in the UK is declining which forces IFM Supplies plc (IFM) to penetrate new markets in order to achieve its growth and profit objectives. Another reason for exploring overseas markets is the aim to diversify risk across national boundaries making IFM less dependant upon single markets. According to the decision 63/2006, the board of directors is planning to establish foreign subsidiaries during the next few years in Europe, Asia and Africa.

This report written by the finance department and directed to the CFO Mr Kamara, gives an overview of financial and non-financial factors (Chapter 2) that have to be considered before finalising the proposal. Potential risks and a brief description of possible external strategies to manage such risks are described in Chapter 3. The impact of export trade will be explored in Chapter 4. Chapter 5 highlights three remedies for IFM’s high foreign debtors.

2 Important Factors

Before finalising the proposal of establishing subsidiaries in Eastern Europe, Asia and Africa, the following financial and non-financial factors have to be considered.

2.1 Financial Factors

Regarding IFM’s foreign investments, these can be funded by raising debt or equity or a mixture of both. If IFM has to pay high taxes in the host country, than it might be useful to finance its activities with debt because interest payments are usually tax deductible. Equity finance might be preferable, if IFM wants local investors to participate. This might protect IFM from adverse actions of the host government.^[1] However, the gearing ratio of the IFM Group has to be considered because it influences the WACC.^{[2] [3]}

Another issue is whether funds are raised locally or from the parent company. Financing operations with local money provides a hedge against exchange rate depreciation and local inflation. Yet, restrictions on local borrowing might be imposed by the host government. The borrowing of local funds is also a measure of protection from political risk such as expropriation and nationalisation, because adverse actions against IFM would also affect local banks which might suffer from political intervention.^[4] On the other hand, borrowing on a global basis might be advantageous if it is cheaper. Borrowing from a parent company might facilitate the repatriation of money because it is easier to transfer interests or dividends rather than profits. Other measures to overcome exchange controls are charging management fees, royalty fees for property rights, trademarks and transfer pricing.^[5]

Moreover, by forecasting future exchange rates, the balance of payments of the country concerned should be analysed as a deficit on the current account increases the depreciation of the currency.^[6] Furthermore, a deficit might lead to domestic deflation and import restrictions may be imposed by the host government.^[7] For evaluating long-term prospects, also the determinants of international competitiveness, a possible government budget deficit and its funding should be analysed.^[8]

The following factors should also be considered when evaluating the best location to invest:

- Exchange rate fluctuations
- Inflation and interest rates in the UK and in the country concerned
- Volatility of a currency because high volatility increases option premiums^[9]
- Tax issues (corporate income tax, withholding tax)
- Tax laws and regulations
- Existence of tax incentives
- Double taxation agreements with the UK and tax credits
- Restrictions on transfer pricing
- Investment incentives

A detailed assessment of the political and country risk^[10] has to be carried out in order to estimate a suitable required rate of return which is necessary for discounting future cash flows because the risk of the foreign project might be quite different from the risk of equivalent projects in the domestic economy.^[11]

2.2 Non-financial Factors

Before finalising the proposal of the establishment of foreign subsidiaries, the mode of entry has to be chosen. Where the acquisition of existing foreign operations (brownfield investment) allows IFM to enter a market very quickly, the establishment of new foreign subsidiaries (greenfield) requires huge investments and takes much longer because a new plant has to be built before producing and selling products.^[12] Moreover, decisions should be taken with regard to ownership. If IFM lacks knowledge or skills which are required to serve local needs and requirements or high risk is better shared, a partly owned subsidiary should be taken into account (e.g. joint venture).

IFM should verify whether tariffs, quotas, import duties or other trade barriers are imposed by the host government. These measures might constitute a constraint for foreign operations if it is integrated in global trade. Therefore, it should be determined whether the foreign subsidiaries create links to local suppliers by sourcing its inputs in the host country or whether the inputs are imported from other countries. Moreover, the market served by the foreign subsidiary should be identified. Does the subsidiary operate as an export base for a whole region or does it solely serve the domestic market? In this context, free-trade agreements with other countries should be analysed as well in order to prevent IFM from paying custom duties for exporting goods.

With regard to treasury and cash management, IFM should decide whether this function should be centralised at the UK headquarters or decentralised in each subsidiary. It should be defined whether currency speculation should be permitted or a risk minimising strategy should be pursued. Where the former approach requires a treasury management acting as a profit centre and a currency strategy, the latter requires a treasury operating as a cost centre. A profit centre speculates and runs strictly limited risk in order to generate profits whereas a cost centre would be only responsible for hedging currency risk and financing.

The following factors also have to be analysed:

- Exchange and currency conversion rules
- Repatriation restrictions
- Market interventions by the host government
- Political stability
- Investment climate
- Political, economical, socio-cultural and technological factors (PEST factors)
- Legal issues such as the national business law, employment law, environmental law
- Availability and cost of labour
- Skills and knowledge of local workforce
- Infrastructure

3 Potential Risks and External Strategies

In the following, currency risk and external hedging techniques are described.

3.1 Currency Risk

3.1.1 Transaction Exposure

Transaction exposure derives from transactions in foreign currencies. It occurs when cash denominated in foreign currency has to be paid or received at a future date. Due to exchange rate movements the cash will have a variable value in the home currency and changing exchange rates can have a substantial effect on the company’s cash flow and profit margins unless action is taken to control the risk.^[13]

3.1.2 Translation Exposure

The Sterling value of company assets and liabilities denominated in foreign currencies fluctuates when exchange rates change. Moreover, currency changes might have an adverse effect on the profit and loss account of the IFM Group when profits of foreign subsidiaries are translated into GBP. The risk is called translation exposure.^[14] If IFM funds its overseas assets with local borrowings, the translation exposure is naturally hedged. In the event of a decline of GBP, the adverse effect on the GBP value of debts denominated in foreign currencies will be offset by beneficial effects on the GBP value of IFM’s overseas assets. Thus, no further action will be required.^[15]

3.1.3 Economic Exposure

Economic exposure is the risk of a declining GBP value of IFM’s whole operation (present value of future cash flows) due to a shift in exchange rates that influences foreign cash flows in the long run.^[16] Economic exposure can have a direct and indirect effect on IFM. An increasing GBP makes IFM’s products more expensive and could lead to a loss of sales (direct effect). An indirect effect might occur if products of our German competitor become cheaper due to a decreasing euro or increasing US$, for instance. Economic exposure should be managed by monitoring and hedging long-term exchange rate movements. This can be done by replacing transactions in currencies that have an adverse effect on the long-term profitability with transactions in currencies with favourable movements.^[17]

3.2 External Hedging Techniques

3.2.1 Forward Market Hedge

The most common external hedging technique is the pre-selling or buying of a specific amount of foreign currency at a rate specified at the current time for delivery in the future.^[18] This can be done with a fixed forward contract which eliminates the risk of adverse currency fluctuations by locking in the current forward rate. However, compared to standardised futures, forward contracts create credit risk^[19] and counterparty risk^[20] but are more flexible.^[21]

If IFM is unsure about the payment date by its customer, an option forward contract can be entered. The bank leaves the exact settlement date open and chooses the most beneficial forward rate for themselves within the period concerned.^[22]

3.2.2 Money Market Hedge

IFM could also hedge currency exposure by using the money market. For instance, goods are sold for $10m, cash is expected in three months’ time and the US$ interest rate over three months is 1%. In this case IFM would borrow ($10 / 1.01) = $9.9m and convert this amount into GBP at a current spot rate of $1.50:£1 to £6.6m. The amount of sterling can be invested at the local money market for three months to defray the cost. In three months the US$ loan (principal plus interest) will be redeemed by the $10m received from IFM’s customer.^[23]

[...]

^[1] Pike, R., (2003), Page 268

^[2] According to the traditional view, a gearing ratio which is not at its optimum level increases the weighted average of cost of capital (WACC).

^[3] Arnold, G. (2005), Page 875 - 883

^[4] Pike, R., (2003), Page 268

^[5] op.cit. Page 252

^[6] Pike, R., (2003), Page 553 - 554

^[7] Kamara, M., (2006), Page 19

^[8] Pike, R., (2003), Page 553 - 554

^[9] see Chapter 3.2.

^[10] For further information look at web pages of rating agencies such as Standard & Poors and Moody’s Investor Services

^[11] Pike, R., (2003), Page 251

^[12] Eiteman, D. K., (2004), Page 435

^[13] Shapiro, A. C., (2003), Page 329 - 330

^[14] Arnold, G., (2005), Page 1172

^[15] Pike, R., (2003), Page 544 - 545

^[16] Arnold, G., (2005), Page 1173

^[17] Pike, R., (2003), Page 545 - 546

^[18] Examples are given in Appendix 7.2.

^[19] Default of the trading partner

^[20] Default of the bank that arranges the deal

^[21] Pike, R., (2003), Page 563 - 564

^[22] ibid

^[23] Pike, R., (2003), Page 565