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Multinational Budgeting and Cont


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									Multinational Budgeting
   Control Systems
        Fall, 2006
     Multinational Budgeting and
           Control Systems
   Planning and control are not new...
    domestic corporations have been doing
    them for years.
   However, the development of
    comprehensive MNC international
    planning and control systems with long-
    range strategic focus is new.
     Examples of Variables Calling for
         Specialized Knowledge
   Foreign currency exchange risks,
   Restrictions on fund remittances across
    national borders,
   Diverse national tax laws,
   Interest rate differentials between various
    national financial markets,
   The global shortage of money capital,
   The effects of worldwide inflation on
    enterprise assets, earnings, and capital
   A direct response to such
    environmental complexities is the
    emergence of the international
    financial management function.
       Managerial Accounting
Managerial accounting issues may be divided
  into two broad areas:
(1) financial planning and
(2) financial control
These may be broken into specific
 subtopics, including
   strategic planning
   foreign investment analysis (capital budgeting)
   foreign exchange risk management
   management information systems and control
   profitability analysis
   performance evaluation of foreign operations
           Strategic Planning
As a process, strategic planning involves four
  critical dimensions:
1) Identifying key factors relevant to the future
  progress of the company
2) Formulating appropriate techniques to
  forecast future development states and
  assessing the company's ability to adapt to or
  exploit such future developments
3) Developing data sources to support
  strategic choices, and
4) Translating selected options into specific
  courses of action.
      Complexities in Developing
      Global Business Strategies
   Planning in the international arena can be
    more complex than in the domestic arena.
   The international environment may be more
    susceptible to change than the domestic
    environment, and this could severely
    complicate business planning, particularly
    long-range planning.
   This makes planning even more critical in the
    international environment.
     Variables Important in Global

   Economic and legal environments differ from
    country to country.
       Each country has its own business regulatory
        framework, tax system, financial reporting
        requirements, inflation rates, and currency with
        fluctuation exchange rates.
   Political environments are different
       Often the political system has a direct impact
        on the business operations.
       Lack of political stability increases the political
        risk for foreign-based enterprises, as does the
        abrupt change in governmental policies in
        countries that do not have a long-standing
        tradition of free market economy.
        Variables Important in Global
   Labor considerations are different for each
       Labor laws may have an impact on the ability of a
        multinational company to hire and terminate
       Labor productivity and the availability of skilled
        workforce vary in different parts of the world.
   Language and cultural differences may
    create problems in communication
    strategies and plans.
       Some cultures make the acceptance of
        planning difficult because of a cultural sense
        of fatalism regarding the future.
       The degree of reliance on trust and on long-
        standing traditions also varies among
          Formulating International
            Business Strategies
MNCs must answer questions such as:
 In which countries should the company
  expand or curtail its operations?
 What should be the scope of operations in a
  new country?
       Should it be a sales operation?
       A manufacturing operation? Or both?
   Should the entry in a new country be in the
    form of a joint venture or should it be as a
    wholly-owned subsidiary?
                  Added Risk
   The strategic planning process of a
    multinational corporation takes into account
    the external as well as the internal
    environmental factors of a company.
   Prediction of external environmental factors is
    difficult even within the boundaries of one
   The task is inherently more complex when
    many countries are involved.
      Geographical Distance and
          Planning Horizon

   Most foreign affiliates of MNCs are farther
    removed geographically from central
    headquarters than the domestic companies
    and affiliates are;
   This can also present problems for the
    budgeting process.
   The time required for approval of the budget
    may need to be lengthened, and great
    uncertainty or instability in some nations may
    necessitate that a high priority be given to
    reducing the time horizon for planning.
   A great distance between the operating
    units of a MNC may lead to severe
    problems and complication in
    communication and logistics, as there may
    be increased transportation costs, longer
    delivery times, and a greater frequency of
    delays in the intracompany movement of
    materials and other goods.
          Frequency of Revision
   Uncertainty in the international environment
    usually means that the budgets of foreign
    divisions need to be evaluated and revised
    more frequently than do those of domestic
   Planning requires, traditionally, a stable basis
    on which to build assumptions and forecasts.
   Where such a stable basis does not exist, the
    planner must look for other means of locating
    the company's position and of setting the
    course for the future.
          Management Quality and
          Subsidiary Sophistication
   A potential problem facing the multinational
    corporation is the quality of management at the
    foreign affiliate.
   Some companies use foreign nationals to staff the
    top management positions in foreign subsidiaries.
   Many countries discourage the use of
    foreign expatriates, and some have
    passed laws restricting them.
   Even if the foreign nationals are fully
    versed in the customs and language of the
    local country, there may still be problems
    in communication and differences in
    management practices, and directives may
    be misunderstood.
         Management Quality and
         Subsidiary Sophistication
   There may be important differences among
    nationalities in:
       the attitudes toward risk;
       relation to government;
       delegation of authority;
       disclosure of information and ideas;
       acceptance of criticism and authority;
       openness in discussing business problems;
       and methods of dealing with lending institutions,
        suppliers, and various service organizations.
       Management Quality and
       Subsidiary Sophistication
   These differences must be considered when
    developing the management control system.
   No control system is going to be of any
    benefit to a company if it cannot be
    comprehended and accepted by the people to
    whom the budget pertains.
   It is unreasonable to expect that all
    subsidiaries will maintain homogeneous
    technology and functional skills, or will
    operate in local markets and operating
    environments of the same relative
     Other Environmental Factors

   Environmental factors can affect the
    MNCs control system.
   Government regulations and restrictions
    on the movement of goods and
    personnel across national boundaries
    can complicate the planning and control
      Foreign Investment Analysis
   The decision to invest abroad is a principal
    means of implementing the global strategy of
    a multinational company.
   Direct investment beyond national
    boundaries, however, typically involves an
    enterprise in a commitment of enormous
    sums of capital to an uncertain future.
   Risk is compounded by an unfamiliar
    international environment that is distant and
    complex and in a constant state of change.
       Foreign Investment Analysis
   The capital budgeting framework compares the
    benefits and costs of any contemplated activity.
   While capital expenditures of sufficient size
    normally constitute part of a firm's strategic
    plans, capital budgeting analysis helps to ensure
    that the implementation of strategic plans is
    financially feasible and desirable.
        Foreign Investment Analysis
   The following all introduce a degree of
    complexity not usually found under
    more homogeneous and stable
    domestic conditions.
       Different tax laws and accounting
        measurement rules,
       differential rates of inflation,
       risks of expropriation ,
       exchange controls,
       fluctuating exchange rates,
       restrictions on the transferability of foreign
       language and intercultural differences
   Because of these complications,
    modification of traditional investment
    planning models is necessary.
    Foreign Investment Analysis

 Specifically, adaptations have occurred
  in 3 major areas:
1) determination of the relevant return
  from a multinational investment
2) measurement of expected cash flows,
3) calculation of the multinational cost of
               Relevant Return

   Should the international financial manager
    evaluate expected investment returns from
    the perspective of the foreign project or that
    of the parent company?
   Returns could differ dramatically because
       governmental restrictions on repatriation of
        earnings and capital
       license fees, royalties, and other payments
        that provide income to the parent but are
        expenses from the project viewpoint
       differential rates of national inflation
       changing foreign currency values
       and differential taxes, to name a few...
             Relevant Return

   One might argue that, ultimately, return
    and risk considerations of a foreign
    investment should be on behalf of the
    parent company's stockholders.
   This is consistent with domestic capital
    budgeting doctrine, as cash flows to the
    parent ultimately provide the basis for
    dividend payments and other uses that
    support parent company objectives.
               Relevant Return
   On the other hand, arguments can be made that
    such an ethnocentric posture is no longer
   Investors in the parent company are increasingly
    drawn from a worldwide community, so
    investment objectives should reflect a more
    cosmopolitan outlook than before.
   Funds generated abroad tend to be
    reinvested there rather than repatriated to
    the parent, so returns from a host country
    perspective may be more appropriate.
   Emphasis on local project returns is
    consistent with the objective of
    maximizing consolidated earnings of the
              Relevant Return

   A dual rate of return calculation would
    provide a basis for evaluating this component
    of the capital budgeting process.
   However, the numbers cannot be looked at
    without considering the environment.
   For example:
      Would the project rate of return calculations
       really reflect the host country's opportunity
      Are the expected returns limited to projected
       cash flows or are there additional social
       externalities to be considered?
      Can externalities be measured?

      Does a foreign investment require any special
       overhead expenditures by the host country?
     Measurement of Cash Flows
   An issue with predicting cash flows is
    the impact of changing prices and
    fluctuating currency values on expected
    foreign currency returns.
   A parent company is concerned with
    the parent-currency utility of foreign
    cash flows.
   Estimates of future inflation and the
    relationship between inflation and
    exchange rates used to convert foreign
    cash flows to parent currency are needed.
    Provisions relating to the taxation of
    foreign source income must also be
      Multinational Cost of Capital

    Some factors that can influence the
    multinational cost of capital that need
    to be considered:
   The availability of capital. The
    availability of capital is assumed in
    some economies, but it may be an
    important variable in an international
   Segmented national capital markets. In
    some markets, required returns of
    securities of comparable risk and return
    can differ, which may distort capital costs.
   Investor demands. Some investors may
    be willing to pay a premium for shares of
    an MNC because it can satisfy their
    international portfolio diversification
      Multinational Cost of Capital

   The cost of capital may be adjusted to
    reflect foreign exchange and political
   International tax considerations may
    significantly affect the after-tax rate of
   Financial disclosure may affect a company's
    access to international capital markets and
    consequently, the cost of capital
   Multinational operations may change a firm's
    optimal financial structure. Specifically, the
    added international availability of capital and
    the ability to diversify cash flows
    internationally may affect a firm's optimal debt
    Foreign Exchange Management
   Foreign exchange risk refers to the risk of
    loss due to changes in the international
    exchange value of national currencies.
   Fluctuating exchange rates can affect the
    values of a firm's foreign assets and liabilities,
    its current profits and future cash flows.
   Now that foreign currencies of most major
    industrial nations are relatively free to find
    their own value levels in the international
    marketplace, the frequency of exchange
    rate changes has almost become a daily
    occurrence, and the magnitude of rate
    changes is significant.
    Foreign Exchange Management
   In view of currency instability, a major
    objective of financial management is to
    minimize financial losses.
   This requires:
      forecasting exchange rate movements

      measuring a firm's exposure to the risks of
       loss caused by currency movements
      designing strategies to hedge exchange
      assessing performance
    Foreign Exchange Management
   Those supporting exchange rate
    forecasting as a valid risk management
    tool operate on the premise that
    decisions makers in the firm have the
    capability of outperforming the market
    as a whole when it comes to predicting
    exchange rate behavior.
   This is based on the existence of timely
    and comprehensive information on
    which to base such predictions.
    Foreign Exchange Management
   This information includes changes in the
       Inflation differentials
       Monetary policy
       Balance of trade
       Balance of payments
       International monetary reserves
       National budget
       Forward exchange quotations
       Unofficial rates
       Behavior of related currencies
       Interest rate differentials.
           Translation Exposure
   Translation exposure stems from the
    preparation of consolidated accounts.
   Foreign currency assets and liabilities that are
    translated at the current rate are subject to
    exchange rate risk.
   Translation exposure is the difference
    between the relevant assets and liabilities.
           Translation Exposure
   A net asset position is called a positive
   Devaluation of the foreign currency relative to
    the domestic currency produces a loss.
   A net liability position is called a negative
    exposure, and a devaluation of the foreign
    currency relative to the domestic currency
    produces a gain.
   Hedging activities can minimize the risk.
   One possibility is to take steps to come up
    with equal foreign currency assets and
          Transaction Exposure
   Transaction exposure refers to exchange
    gains and losses that rise from the settlement
    of transactions denominated in foreign
   Unlike translation gains and losses,
    transaction gains and losses have a direct
    effect on cash flows.
   Again, once the exposure is identified,
    hedging activities can minimize the risk.
   One possibility is to hedge purchase
    commitments with forward contracts.
Management Information Systems
        and Control
   Once questions of strategy have been
    decided, attention generally focuses on the
    areas of financial control and performance
   as effectively and efficiently as possible.
   This enables financial mangers to:
       Implement the global financial strategy of the
        multinational enterprise
       Evaluate the degree to which the chosen
        strategies contribute to the attainment of
        enterprise objectives
       Motivate management and employees to
        achieve the financial goals of the enterprise
Management Information Systems
        and Control
   Goals and objectives often differ among
    international subsidiaries and thus uniform
    performance criteria for all subsidiaries would
    not be appropriate.
       A foreign subsidiary may be established to
        manufacture a component for other subsidiaries.
       Another subsidiary may be formed to take
        advantage of certain advanced technology in the
        host country.
       Yet a third subsidiary may be established to take
        advantage of tax incentives granted by the local
   Different corporate objectives require
    different performance evaluation criteria.
    Foreign Corrupt Practices Act
   The FCPA is designed to eliminate 2
   --poor internal controls
   --bribery
   SEC was astounded at the extent to which
    corporate executives and employees
    falsified books and records and
    circumvented internal control systems to
    make foreign bribes
   The SEC response was the FCPA
           Problems for MNCs
   Operate in a variety of countries with
    different business practices and laws
   Compete with companies from other
    countries that have different sets of laws
    and customs
   Bribes may be paid because the receiver
    has a strong market position or control
    over an aspect of the environment that
    impacts a firm’s operations
   Sometimes payments are made in
    countries where this is an accepted
    business practice, some in countries
    where such payments are illegal.
   Sometimes payments are made without
    the knowledge of headquarters. If a fee
    is paid to a local agent, it may not known
    how that fee is then used.
   A local subsidiary may choose to “play the
          Nature of Payments
   The FCPA made it illegal to pay or to offer
    to pay money or anything of value to a
    foreign government official to get them to
    abuse their power to benefit the firm for
    business purposes.
   The FCPA excluded “grease payments.”
            Grease payments
   Payments to foreign officials with little
    decision-making authority and if they have
    little impact on the relations between the
    US and the local government, assuming
    the payments are made to expedite trade.
   Parent may be exonerated if a NON-wholly
    owned subsidiary engages in payments
    above the protest of the parent
   If a payment is construed as extortion,
    approval may be granted by the Justice
    Department in the US
        US Corporate Reaction
   78% felt that the FCPA made it difficult to
    sell in countries where bribery is a way of
   55% felt that unless the law was tough,
    small payments would escalate into major
   Fines of up to $1,000,000 for a company
   Fines of up to $10,000 and five years in
    prison for an individual.
   Only civil, rather than criminal, penalties
    for negligent or unintentional violators of
    the law.
   A good accounting control system is
    designed to safeguard corporate assets
    and to enhance fair presentation of
    financial accounting information.
   Firms were falsifying records to disguise
    improper transactions. Some transactions
    were not recorded.
                Two Issues
   Payment of bribes
   Recording payment of bribes.

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