Business Risks International Financial Management Final exam=case study

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Section 1 International Payments

4 principal payment mechanism for settling international trade transactions: - Open account - Documentary collections - Documentary credits - Payment/cash in advance Level of security differs from one to the other, depending if you are the seller or the buyer. For every specific operations, find out what's the best way for you to pay/sell your good/service. It depends on the variables of international trade operations: Quantity Quality Price Kind of payment Cost of the kind of payment chosen

You need to negotiate for who is going to pay the cost. Risks for exporter/seller of different payment terms What kind of risks do we have to face? 1 = higher risks for the exporter/seller 9 = most secured for the importer/buyer 1- Extended payment terms: Promise of payment? - importer pays for goods over a period of time after receipt (up to 10 years for capital goods). They would normally issue a set of promissory notes upon shipment. 2- Open account, clean draft: Exporter expects payment from importer on shipment or arrival. The exporter selling on credit terms to the buyer. The importer is allowed to make payments at some specific dates in the future without the buyer issuing any negotiable instrument avidencing his legal commitment to pay at the appointed time. It does not involve banks. It's very used between subsidiaries

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companies from the same mother company. - Eg: You are paying me only once a semester or once a year (depending on the strategy of the company). The cost will be liability buyer and seller must trust each other. Most secured payment method for the importer. Working Capital= current assets current liabilities. Working Capital Capacity = Own E + Long term liabilities Financial assets Cash = Working Capital Capacity Working Capital When can it be used? A/ This payment mechanism is used when the exporter has a well-established commercial relationship with a credit-worthy importer and when the importing country enjoys reasonable political and economic stability. B/ When the exporter is shipping goods to a parent or subsidiary company, it is expected that payment timing and modalities, including provisions for unsold portions, would be outlined. C/ When the exporter is faced with excessive inventory, it seeks markets desperately and would take the risk of delivering to a seller without excellent credit records. This is more relevant for items with short expiration dates that could spoil. D/ Sellers faced with strong competition may also decide to ship goods on open account as a way to squarely face the challenges posed by competition. It is a way of making their products visible in the international market. E/ Extended terms can be used for an otherwise creditworthy importer in a country with scarce foreign exchange, but where the importer produces goods that are sold in hard currency the importer can then pay out of these earnings. Summary Open Accounts - Focus on risks and disadvantages Informal arrangement whereby goods are shipped and the importer is billed later (Invoice sent with or after shipment). Provides great flexibility and fits well with small shipments which have good profit margins. Useful with well known customers who are good credit risks, and common with longstanding good customer-supplier relationships. Government loan guarantees (by Export Credit Agencies) may be available. Typical disadvantages: If ECA guarantees are not available, credit insurance and factoring can be expensive. If payments are made under extended terms, the notes can be sold on the secondary market, but only with the aval of the importers bank, and even then, deep discounts may be necessary. Typical risks include: Customer refuses to take possession Customer unable or unwilling to pay Customer is slow in paying Customer restricted from paying by its central bank

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3- Time or date draft or documents against acceptance: Exporter makes shipment and presents draft and shipping documents to bank, with instructions that the documents be only released to the importer once they acknowledge the draft. Banks have instructions from importer and exporter. Their 2 banks have agreements to deliver goods only under certain conditions. 4- Consignment (with retention of title): Exporter makes shipment, and is paid when importer sells goods. Sales contract gives exporter the right to repossess goods when left unsold. Only works when importers country has good legal system allowing retention of title and easy repossession of goods. Not allowed in France: if you sell something you dont have the right to take it back. When i retain the property of a good i sold you, you are not the seller but the agent (ex: travel agencies, they sell rooms, collect customers money (but this money does not belong to them its a commission). You are not the holder of the price, you are the holder of a commission. This is allowed in Italy, Greece, Germany. 5- Documentary Collection: Documentary against payment / Sight Draft Documentary against acceptance / Term draft After shipment, exporter sends documents to bank with instructions that they only released once importer pays the draft. In this case, the management happens between bankers. (General Culture: Incoterms international Commerce Terms, Documentary Collection is one of them). The payment method by which the transaction is settled through an exchange of documents enabling simultaneous payment and transfer of title. It's a middle of the road approach to satisfy both the exporter and importer. The importer is not obliged to pay for goods prior to shipment and the exporter retains title to the goods until the importer either pays for the value of the draft upon presentation (sight draft) or accept to pay at later date and time (term draft). Banks are more or less present in this process. Generally, banks in the transaction control the flow and transfer of documents and regulate the timing of the transaction. They must ensure the safety of the documents in their possession, but are not responsible for their validity and accuracy. They play the role of agents. 2 major banks come into the scene: Remitting Bank: This is the exporters bank and acts as the exporters agent in collecting payment from the importer. It basically transmits the exporters instructions along with the terms of the draft to the importers bank. The bank does not assume any risks and does not undertake to pay the exporter, but maintains influence to settle a bill. Collecting Bank: The importer's bank. This is the importers bank and takes up the role of ensuring that the buyer pays (or accepts to pay) for the goods before shipping documents are released to them.

Documentary Collections Flow Chart 1. Agreement from both importer and exporter on the sale contract. Exporter/drawer and Importer/drawee agree on a sales contract, including payment to be made under a Documentary Collection. 2. The Exporter ships the merchandise to the foreign buyer and receives in exchange the shipping documents. 3. Immediately thereafter, the Exporter presents the shipping documents with detailed instructions for obtaining payment to their bank (Remitting bank).

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4. The Remitting bank sends the documents along with the Exporters instructions to a designated bank in the importing country (Collecting Bank). 5. Depending on the terms of the sales contract, the Collecting Bank would release the documents to the importer only upon receipt of payment or acceptance of draft from the buyer. (The importer will then present the shipping documents to the carrier in exchange for the goods). 6. Having received payment, the Collecting bank forwards proceeds to the Remitting bank. 7. Once payment is received, the Remitting bank credits the Exporters account less its charges. The Banks act as a witness. Cash against documents/sights drafts: the exporter releases the shipping documents to the importer only on payment for the goods. It can only be used with importers with good credit ratings and low-risk countries. The exporter runs the risk of the shipment being refused. Cash against goods, shipment into bonded warehouse: Goods are released to an exporter's agent in the importing country. The importer can take just-in-time delivery by paying cash. Pulling system / Just in time production system. Document against Acceptance/Term Drafts: An exporter may decide to release shipping documents to a buyer on acceptance of the exporter's draft the importer is obliged to pay at future date. Good for the importer: receive good before payment. Good for exporter: he has the assurance that payment will come at a future date. Only works for importers with good credit risk and low country risk. Insurance is available and term drafts can also be sold on the secondary market. More expensive than the open account. Risks in Documentary Collections: *To the exporter: If it is a sight draft, the exporter will reduce the risk of non-payment but will not eliminate it totally since the importer may not be in a position to pay for the goods or may not be able to procure sufficient foreign exchange to make the payment. In this case the exporter may be forced to either call back the goods or negotiate sale to some other interested party, may be at a reduced rate. In the case of term draft, the risk to the exporter is higher since the foreign buyer will take possession of the goods and may not pay at due date, forcing the exporter to try and collect payment from the foreign buyer in the foreign buyer's home country.

To the importer: The importer faces the risk of paying for goods of sub-standard quality or even with shortages. In such a circumstance, it would take some time to get refunds from the exporter. It could also happen that the exporter refuses to make refunds, leading the importer to lengthy legal proceedings. When can it be used? When a country needs cash Since Documentary Credit transactions entail some measure of differed payment it's advisable to use

Business Risks International Financial Management only when the following conditions apply: when the exporter and importer have a well established relationship

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when there is little or no threat of a total loss resulting from the buyers inability or refusal to pay when the foreign political and economic situation is stable and when a letter of credit is too expensive or not allowed. Some governments do not allow their exporters to sell under documentary collection terms. 6- Cash against goods, shipment into bonded warehouse: shipment to exporters or independent warehouse in importers country. When can it be used? Works well when there are many potential buyers. Used in Greece and Turkey few years ago. The exporter pays a rent for the place occupied by the shipment (warehouse). The importer goes to the warehouse pays in cash the full amount of the final product. The warehouse will send the money to the exporter through the banking system. Inconvenients: It's more expensive but extremely secure. The warehouse can be used as bank guarantees- second hand banker (for locals). If you lack of cash, the importer can use raw material as a deposit if the bank doesn't want to lend him more money. It's the last chance to get cash process. Advantage for the exporter: If the importer is enable to pay the exporter, the only thing the exporter is going to loose is the rent of the warehouse not the merchandise. 7- Documentary Credits - Irrevocable L/C (letter of credit): A documentary credit is a written undertaking from a bank to pay a certain sum (or to accept payment to negotiate it or to authorize another bank to do so) on instructions from the importer (the Applicant) to the exporter (the Beneficiary) within a prescribed time limit, provided that the exporter submits the required documents, and the terms and conditions of the letter of credit are strictly complied with. Trade transactions on the basis of L/Cs are governed by Uniform Customs Practice (UCP) for documentary credits established by the International Chamber of Commerce (ICC). Letters of credit are typically issued and advised via tested telex, with shipment taking place within 90 days of the issue date. Certain circumstances may also demand that an L/Cs life be extended. This is also effected via tested telex without altering other terms of the transaction. Documentary credit is for an exporter the next best thing after Payment in Advance. Compared to other payment forms, a banks role is substantial. DCs are one of the most widely used methods of settlement for international trade transactions because the security they offer is well balanced between the two commercial parties.

Business Risks International Financial Management Payment will be made to exporter on presentation of proper documents. Inconvenients:

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Can be costy, and the exporter has to prepare the documents carefully. He remains exposed to the importers country risk. Advantages: If you want to export a good. Prepare a letter of credit for the importer. The exporter send the shipment only when the importer have pay a deposit to his bank half or the entire amount of the price of the good. This is a bank guarantee. The exporter will receive the money either from the importer or his banker. If the transaction happens between 2 countries you can take into account the country risk. It's a written undertaking from a bank to pay a certain sum on instructions from the importer to the exporter within a prescribed time limit, provided that the exporter submits the required documents. The agreement is no longer between the exporter and importer both parties will agreed with an intermediate: the bank. Letter of Credit fraud: Letter of credits depend on bank country credit lines Banks are selective in confirming L/Cs as there is significant counter party risk between the buyer's bank and the seller's bank. Comments schema: Freight forwarder = transfering company. Documentary credits are based on documents, not on goods CDI (credit default investment) or CDS (credit defaults swaps kind of insurance contract) Collateral is the object of the transaction (eg: if u go to the bakery to buy bread, the collateral is the bread). Subprime crisis: collateral and insurance contract were separated. The person who owes the insurance contract (CDS) will earn if something goes wrong with the collateral (eg: if the collateral is a car, the person owing the CDS will earn money if the car has an accident). Problem of over concentration of capital: the value of the fictive economy worth 3 times the value of the products/goods available. Cf: Vernimen all the financial definitions. How does it work? A commercial agreement proceeds the initiation of the L/C process. The seller agrees to deliver certain goods on certain conditions to a buyer. The buyer agrees to pay for these goods under a L/C, and negotiates with the seller what documents the seller should deliver in order to obtain payment under the L/C (although much international commodity trade is under standard contract which spell out many of the documents required under the contract, many buyers prefer to make certain amendments). The list of documents they agree on become the documentary conditions in the L/C. The first step in the L/C process is taken by the buyer who applies to his bank (the Issuing Bank) to open

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a letter of credit in favor of a beneficiary (the seller), that is, to issue a letter of credit to the seller undertaking either payment of the contract price or payment, or acceptance or negotiation of a bill of exchange drawn for the contract price. The buyer at this stage is required to complete the banks standard form of application to open a credit. The Issuing Bank then contacts a bank in the exporters country, to open the L/C. This bank (the Advising Bank) then informs the exporter that the L/C has actually been opened. The exporter exports and sends the documents (together with a draft demanding payment) which, presumably conform to the list as spelled out in the L/C, to a bank which was appointed the Negotiating Bank (it can be the advising bank). The Negotiating Bank checks the documents, and if they conform (and assuming it has not confirmed the L/C), sends them to the issuing bank for payment. Payment is then made by the Issuing Bank.

Role of banks in Documentary Credit: The banks provide additional security for both parties in a trade transaction by playing the role of intermediaries. The issuing bank working for the importer and the advising bank working for the exporter. The banks assure the seller that he would be paid if he provides the necessary documents to the issuing bank through the advising bank. On the other hand, the banks also assure the buyer that his money would not be released unless the shipping documents evidencing proper and accurate shipment of goods are presented. On the basis of these roles, it can be said that banks are the beacon which guide parties in an international trade transaction, without which, pitfalls would abound.

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But: banks pay on the basis of documents. If the L/C is irrevocable, then this is an irrevocable obligation. If proper documents are presented, the bank must pay. Suspicion of fraud does not absolve the bank from its payment obligation. Such refusal is only accepted if it is proved to the satisfaction of the bank that the documents tendered are fraudulent and the seller is a party to the fraud or knew of it. For a bank to confirm the L/C of another bank, it must have an open line of credit with the other bank. This in turn has two elements: its willingness to take exposure towards the country in which the other bank is based (it needs to position itself against such exposure so it comes at a cost), and its willingness to take (more) exposure towards the bank itself. If it has no credit line or its credit line is full, it needs to pass through a third bank or more (as a result, actual payments often appear as outlined below). This results in higher costs for the buyer and seller, and makes the L/C based payment system vulnerable to shocks. Country credit lines can be cut from one day to the other making it difficult for importers to open new letters of credit, even if they wish to import raw materials for later export. Voir slide 33 40 Letters of credit Summary: Provides exporter the greatest degree of safety when extending credit Useful when importer is not well known Useful when exchange restrictions exist or are possible But, care is required in their use. 8- Confirmed irrevocable: similar to simple irrevocable L/C, but greatly reduces country risk. SWIFT = international organisation making transfers only between banks. It transforms a letter of credit in a CONFIRMED letter of credit. If the country importer decide to stop a transaction/transfer, SWIFT is going to pay the exporter country. Inconvenient: Extremely expensive. 9- Cash in advance: importer pays before goods are shipped. The most expensive way of payment. The exporter receives your cash first and then send the good/product. The exporter is the cash holder. In contrast to open account, this is the most secure payment method. When is this method used? When paying with a credit card on a website, making purchase on the Internet. It may be used for custom made purchase, when the producer need the cash to launch the process of production. Necessary when in doubt with the financial stability of the client or the client's country. Quite oftenly used with certain Asian or African countries (eg: Sudan that splited into 2 countries, North Korea, Iran from next week, Somalia, Nigeria (on the list, not yet applying))

What are the disadvantages to the Exporter? Both importer and exporter tend to take internal market rates as a benchmark. If we were to apply this technique to China, they would turn themselves toward their internal market. They will copy your

Business Risks International Financial Management product and sell them at better price.

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Payment in advance may be outlawed in some countries Difficult for importers to effect remittance of funds (= good payments). Problems for the exporter if goods have already been produced. Cash is the most vital and useless asset a company may possesses. If you don't have enough cash to pay your liabilities on time bankruptcy. Summary: Typical risks 6-7 should be used if you are exporting to risky countries. Payment Mechanisms: Open account Documentary collections Documentary credits Revocable Irrevocable Payment/cash in advance

Factoring = when you sell your credit letters to your banker. Forfaiting = when you sell your current assets to your banker. Oseo (ex banque franaise du commerce extrieur) = Public administration. industrial bank without being called so. Manage international debts? The higher the risk of not collecting the money of our sale is, the higher the amount of cashed need to be.

Section 2: Financial Management and risk management - The process of internal hedging
Hedging = protecting oneself against a human risk. A hedgeis an investment position intended to offset potential losses that may be incurred by a companion investment. Forex = Foreign Exchange What is Risk in International Finance? Exchange Rate Risk: On purchases: condition of purchase Credit Risk Price Risk: Currency Risk: The changes in the price of the currency, Interest Rate Risk: Changes in the relative relationship between the interest rate of the importer and the exporter.

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Market Risk Liquidity Risk: not having the money to pay your liabilities at a specific moment. Cash Flow Risk: On the long term, not being able to collect enough cash to avoid liquidity risk. You can have profits but you don't generate enough cash to cover your working capital and the liquidity risk. The cash flow risk lead to liquidity risk.

How Forex Affects balance Sheet and Income Statement: Impact on Balance Sheet Assets: FA (Fixed assets) (part of it are foreign investments) + CA (current assets) + Cash Liabilities: OE (owners equity) + LTL (long term liabilities)+ SHT (Short term liabilities) Any increase of the value of my foreign investment will increase my net worth (Owners equity = natural wealthness). Impact on Income Statement Revenues Expenses

If most of my production is sold abroad in dollar. The price of the dollar decrease, i will notice a decrease in Euros in my Revenues. Good reasons to Hedge: We hedge to reduce future prices To increase Cash Flows by: Reducing Tax payments Reduce cost of financial distress To better plan future capital needs and then reduce amount of extra-capital more expensive To improve decision making by reducing the degree of risk.

Image of cash flow The more you are hedging, the more the return on your cash flow will be. When hedging you collect less cash flow because of the cost of hedging. How hedging affects the firm's stakeholders? Debt and equity holders Employees and customers Managerial behavior Managerial incentives to hedge: Some companies force their managers to hedge, some other created incentives to make them hedge. Managerial incentives to speculate

Alternatives for managing Forex Risks: Choices between alternative liability streams (Only one way to protect companies from Forex). Main elements of choice: Managing the Forex risk of assets and liabilities

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Decomposing Forex into real and inflation component (inflation is not taken into account in what we earn in a Forex) Hedging Exposure to Comparative Credit Rate changes

Types of Currency Risk Transaction Risk Translation Risk Economic Risk

Why do Exchange Rates change? Inflation reasons (case of no real effects) Inflation differences Tend to Generate Real Effects.

Every company calculates his sales, liabilities, etc in its own currency. Because, let's say that you are a French company, the euro decrease and you are supposed to make a purchase in dollar it will be more expensive for you. Even if the value of the dollar remains the same. Larger Firms are more likely to use Hedging: Firms with more growth opportunities Highly Levered Firms

Section 3 Internal Hedging

International Finance Questions about Short Term Financing and Cash Management - Working Capital Requirements - Sources Of Working Capital - Available Cash as a result. - Currency Risk Issues in the case of International Business (Lets analyze in volumes the balance sheet of a MNC) Delays Between Cash Payments and Cash Receipts can be a major source of cash problems. Changes in currency values may cause major problems of cash management in terms of the origin currency. Cash management issues: Size of cash balances: do i have enough cash?

The optimal size of the firm's cash balance depend upon: The cost of keeping too much or not much cash in hand. i.e. The opportunity costs of holding cash If you dont have enough cash extremely expensive as you have to negotiate with your banker for an

Business Risks International Financial Management extra amount of cash (it will cost you a lot). If you have too much cost...expensive...why?? The variability of cash flows. The less variable your cash flow is, the lower the quantity of cash you need to hold is. The higher the variability is, the higher your cash flow stocks need to be.

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Currency denomination: what is my basic currency/the currency of the mother company? By maintaining cash balances in a particular currency, the MNC is essentially speculating (or hedging?) in that currency. Every company has to do his accountancy in the currency of the country where it has its administrative board. But it doesn't means that the cash hold by the company will be in this currency. Where these cash balances are located? Should the firm have centralized cash management in the home country? Or should the firm let each affiliate handle it locally? Where are borrowing costs lowest and investment returns highest? (this question is the answer to the 2 previous ones). Book recommended: Anthony Management Control (read the introduction) Cash Management Systems in Practice: Matching: In order to avoid Forex risks. If you have to collect dollars from your clients and pay dollars to your suppliers every 1st of each month. Ask my client to pay earlier and negotiate with the supplier to pay him later so I'm not collecting the money from my client the same day I have to pay my supplier. The fact to negotiate with both of them is called matching process. The price of the currency won't be the same because of the delay between the day when your client is paying you (15th Jan) and the day you have to pay your supplier (15th Feb) you might loose money that's a Forex Risk. The higher the standard deviation of the asset is, the higher the risk is. (for example: if you are comparing 2 products A (min = -2 and max = 2) and B (min = 30 and max = 60). The higher risk will be on product B. Simple Netting: To simplify the number of transactions. You create a bilateral netting if you owe me 20 and I owe you 10: instead of doing 2 transactions, you just give me 10.

Multilateral Netting: same as simple netting or bilateral netting but you try to reduce the number of transactions by considering the amounts dues by all the actors on the market. Is an efficient and cost-effective mechanism for settling inter-affiliate foreign exchange transactions. Not all countries allow MNCs to net payments By limiting netting, more unnecessary foreign exchange transactions flow through the local banking system. Netting with Central Depository (cash pooling system): Cash pool to facilitate funds mobilization and reduce the chance of misallocated funds. That's a central authority that manage and redistribute funds.

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Section 4: Taxation, Forex, Management, Control and Financial Management Issues. The common point: Transfer Pricing.
Case studies: Read it and try to find the questions. 2 hours 2-3-4 questions? Possibility to answer in a scholar way: answer each question one by one Second way (managerial way): make a report! Attention paraphrase! Demonstration below with no external purchases: Country A (Constructor) ---100--> Country B (Sell to C)----200---> Country C (Purchase to B)--300-> ---150--> ---170---> 100 100 100 Taxation in A 20% - Taxes 20 - Taxes 30 Taxation in B 30% - Taxes 30 - Taxes 6 Taxation in C 20% - Taxes 20 - Taxes 26 = 70 =62 Taxation Issues of Multinational Companies Taxation issues Tax morality = a state tax cant be established for an immoral reason (eg: cannot create a tax in order to encourage prostitution). Every state define what is the internal morality of the state. Tax neutrality = A tax is supposed to be neutral it is supposed to advantage or disadvantage everyone in the same way. Territorial approach = more traditional way of taxing individuals (eg: you live in France, you are taxed in France for your incomes, if you have income abroad, you have to pay taxes to make them come to your country) VS World Wide Approach = You are supposed to pay income in your state for the whole income you make in the world. The 2 previous approach can lead to double taxation. To avoid that, they have set up the following tax system: Tax Deferral and tax Treaties (Eg: If you are a French company making profits in Italy, you don't pay taxes until you bring back your profits from Italy Dividend taxation in Europe is 2.5% Taxation can be direct (taxes paid on your income) or indirect: Income Tax Value Added Tax tax on the consumption. The only payer is the final consumer. (before also the producer had to pay tax) Withholding Tax (on interests, dividends, royalties) Whatever the volume of dividend your company is earning, you are paying the same % of taxes unlike indirect taxes. That creates a point of definition for income and expenses. Mother company for a firm has to optimize the taxation process.

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When you buy a product abroad, 2 options: 1/ FOB: Free On Board (you have to pay taxes to your post office to receive the product) 2/ CIF: Cost Insurance Fret Transfer pricing Issues A major Issue during the 60s and 70s basically because of US MNEs. A major Issue in International Economy at the beginning it became to be a major issue in management control and internal finance for MNEs. Finally it is just a pricing issue.

Basic external effects are: Fund positioning effect Income tax effect Morality and Ethical problems (Local Ethics, Minority, Interests...). Eg: Ethical behavior of the majority of share holders towards the minority.

Definition of Transfer Pricing: Transfer Price is the price one subunit charges for a product or service supplied to another subunit of the same organisation. 4 criteria: 1/ Goal congruence (of subunit) we won't maximize the profit of the 4 subsidiaries but the profit of the group. The optimization of profit of each of them individually won't always have a positive effect on the group. 2/ Management effort 3/ Subunit performance evaluation: You are evaluate on things you are controlling. If my mother company oblige me to sell smthg at 100 without agreement. I cant be blame for my low profitability because i dont decide on the prices you don't have any autonomy (see next point). 4/ Subunit autonomy Multinational companies use transfer pricing to minimize their worldwide taxes, duties, and tariffs. Transfer Costing Methods: 1/ Market Based Transfer Prices. This method is best if: Perfectly competitive market Interdependence of subunit is minimal No additional cost-benefits to company Problem: Market prices are not always available for items transferred internally (eg: items produced just to be sold to the mother company or the other subsidiaries).

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2/ Cost Based About half of the major companies in the world transfer items at cost. Full cost We use it when we have capacity to produce. Variable Cost We use variable cost when we have low capacity to produce. Because it allows us to take into account the bottom (bottle?) neck (limited possibilities to produce). Calculate your margin price with the percentage of contribution (this % will be higher than the markup of the full cost) Dual Pricing (Discriminatory pricing) Eg: if you sell a component to someone in your company at 10 and to someone outside your company at 12. Its linked to the reduction of the markup when its based on full cost or.... Eg: In France, the higher your consumption of water is, the higher the price of m3 will be. 3/ Negociated: Companies heavily committed to segment autonomy often allow managers to negotiate transfer prices.

Figures of 2005 shows that during the last 10 years : 53% of MNEs apply a cost based method (Increase) 31% apply the market price (same) Negotiated Price (decrease)

Virtually any type of transfer pricing policy can lead to dysfunctional behavior actions taken in conflict with organizational goals. Factors affecting transfer prices: An item is produced by Division A in a country with a 25% income tax rate. It is transferred to Division B in a country with a 50% income tax rate. An import duty equal to 20% of the price of the item is assessed. Full unit cost is Rs100, and variable cost is Rs60 (either transfer price could be chosen).

Eg Multinational Transfer Pricing: Income of A is Rs40 higher: 25% 40 = (Rs10) higher taxes Income of B is Rs40 lower: 50% 40 = Rs20 lower taxes Import duty paid by B: 20% 40 = (Rs8) Net savings = Rs2 Criteria's for Transfer Pricing: 1/ Tax regimes 2/ Local market conditions 3/ Market imperfections i.e. any kind of distorsion on competition. (eg: you cant export electronic components to North Korea) 4/ Joint-venture partner. For eg, you cant apply the transfer taxing tax optimization process in China with

Business Risks International Financial Management a local Chinese partner.

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Difference between: 1/ Subsidiary when you have the full position of management and the property right) 2/ Joint venture When you need management in a certain place. Even if you pocess 51 % your partner may have the control of the management. Joint venture are created when you cant control the market but someone can control it locally). Eg: In China, you are not allowed to have subsidiaries if you are not Chinese You will have to create a joint venture managed by a chinese local entity. Key drivers behind transfer pricing in foreign countries (4 ways to succeed or to fail): Market conditions Competition Profit for the affiliate Tax rates

Key drivers apply as well for foreign exchanges: Economic conditions: PESTEL method: E- economic situation (degree of employment, of human qualification, etc.) Import restrictions: if a country decide to reduce the amount it is importing from you, you will have a surplus of production even if you taxation process is optimized. Custom duties Price controls: in Russia, when local or national authorities do not agree with a price on a market, they use taxation to adjust the price (eg: Vodka). Exchange controls

- Inside Sourcing or Out-Sourcing Issue - Simplicity, Acceptability and Management of the system - Motivational Factors and Ethical Issues due to the actual International Environment: *Transparency (IFRS) *Internal Transparency (Communication between BU) *Information *Sustainable development protection of the environment, social responsability of the company, Human rights If you don't respect one of these 3 criteria, you are doing green washing. Pricing corporate services: 1/ Control over the amount of Service 2/ Optional Use of Services 3/ Simplicity of the mechanism

Business Risks International Financial Management 4/ Control of the Negotiation 5/ Arbitration of Conflicts Between BUs Inside the MNE. Control System Design Issues: 1/ Who is responsible ? 2/ What currency use in order to evaluate 3/ What kind of exposure is included in the performance evaluation 4/ Is the Exposure evaluated differently from the local manager? Management considerations:

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If you want to have a good transfer pricing, find a way to neutralize the fact that you are using euros and your subsidiary is using dollars. 1/ Translations effects have to be excluded 2/ Transaction Results have to be managed by the parent company 3/ Subsidiary has to be evaluated for the economic exposure 4/ Evaluation of the subsidiary as a hole. 5/ Creation of a balance scorecard fitting with those considerations and the mothers company strategy.