International Financial Management - Coursework Example

International financial management Contents Contents 2 Introduction 3 Discussion 3 Internal Sources of Funding for Subsidiaries 4 External Sources ofFunding for Subsidiaries 6 Conclusion 9 References 11 Introduction For the international expansion process, it is majorly important to evaluate the different internal and external sources of fund for establishing the subsidiary as well as choose the most suitable financial structure for the subsidiary to be opened in China. The choice of funds and the design of the capital structure should be integrated and made in such a way as to accomplish the minimization of the cost of getting the external financing. Also, the decision of choosing the external resources should be done by considering the foreign exchange risks and the internal resources by considering the ways to minimize the different political risks and the tax payment for the successful running of the subsidiary in China. The economy of China is continuously evolving from being a collective enterprise reliant economy to a mixed economy in which the role of the private businesses have become more pivotal. Therefore, the opportunities and risks should be critically evaluated while considering the source of financing for the subsidiary and the effect of the different financing activities on the costs of capital for the business. Discussion The company can mainly fund the subsidiary in China through an effective combination of debt financing and equity financing. Both the external sources of funds as well as the internal sources of funds should be ideally considered for funding the setting up and the operations of the subsidiary in China (Allen and Qian, 2005, p.57). The selection of the sources of finance should be done after a careful evaluation of the different costs and benefits associated with each mode of financing and how these would affect the capital structure of the business. The company can balance the capital structure by following the strategy of internationalizing the cost of capital as the profit reaping capital expenses are likely to lower the cost of capital for the company (Garci-Fontes, 2005, p.14). Internal Sources of Funding for Subsidiaries The company can raise finances from the following internal sources: Equity: Equity financing is a major source of internal financing by the sale of common equity instruments and quasi equity instruments like convertible preferred stocks and preferred stocks. Equity financing is characterized by risk and reward balances. Equity financing can ensure the maintenance of the control of the business on the foreign subsidiary. The company can use preferred equity and debt equity to fund the new expansion process (Tam, 2004, p.118-131). But equity financing would majorly affect the cost of capital of the business if a proper balance is not maintained between the different sources of equity financing. The company should try to keep the cost of equity lower to maintain an effective capital structure in the business. Depreciation and non-cash charges: Depreciation is a type of non-cash charge that can be used as an effective internal financing source for the business expansion processes. Depreciation is recorded in the profit and Loss account as the amount of money by which a fixed asset has been used up. The depreciation charges are much useful in reducing the distribution of the profits as dividends because some amount is retained within the company as the depreciation amount shown in the profit and Loss account (Myers and Majluf, 1984, p.117-121). This non-cash charge can later be used to fund the business expansion process by the use of the money that is saved in the business (Li, Meng, Wang and Zhou, 2007, p.12-18). Depreciation can be a major source of internal financing as depreciation is a major tax deductive option as it is a non-cash charge. Retained earnings: Retained earnings are the profit kept within the company after paying off the taxes to the authorities and the dividends to the shareholders (Madura and Fox, 2007, p.56). The retained earnings can be considered as a major source of internal financing. The main advantage of using the retained earnings as the capital for business expansion processes is that it helps to save the taxes paid by the company. Also, there is no cost of borrowing to be paid by the company when it uses the retained earnings to fund the expansion projects (Luo, 2011, p.89). Therefore, not only the retained earning reinvested as capital but also a lot of money is saved due to the cost saving caused by not having to pay the interest on the money. There is no interest costs associated with the retained earnings as there are with the debt financing modes. External Sources of Funding for Subsidiaries The company might raise finances from the following external sources: Bank Lending: The external sources of financing that can be accessed for establishing the subsidiary are loan from the Chinese banks, stock market and informal financing sources like venture capitalists and private investors (National Bureau of Statistics of China, 2010, p.2). Banks can be considered as the most significant source of financing for establishing the subsidiary (Gregory and Tenev, 2001, pp.1-4). This is because the banking institutions in China, especially the state owned banks operate as the most critical source of financing for the private businesses operating in the Chinese market. But there are much problems associated with the access of banking loans by the companies conducting their business in China which is indicated by the fact that the private enterprises in China form only 0.23% of the total bank lending in the country as calculated in 2010 (Huihui, 2012, p.14-18). The Stock Markets: The stock markets are also important sources of external funding for the business. Therefore, the company may also consider entering the stock markets so that it can raise the funds through the listing of the shares of the company (Salehi and Biglar, 2009, p.97-103). There are two major stock exchanges in China which are the Shenzhen Stock Exchange and the Shanghai stock Exchanges. Since, the borrowing from the bank is a difficult process in China, the company can consider financing from the stock exchanges for establishing the subsidiary in China (McKinsey & Co, 2013, p.4). Local Currency debt: The debt taken from the host country can be used as a mode of external financing. China issues the emerging market debts (EMD) which can be an effective source of financing for the subsidiary. The Yuan dominated debt issued in China has much significance in the local market (United Nations Conference on Trade and Development, 2010, p.5). Therefore, the company can choose the local currency debt in China for establishing the subsidiary. Eurocurrency Debt: The Eurocurrency debt is one important way of debt financing approach in international financing. The innovation of the Eurocurrency markets as an effective source of external finance have been a recent development and more and more companies are opting for this mode because of two major benefits (Schramm and Guijun, 2006 pp.6-7). The Eurocurrency market can act as a major source of short term borrowings from the bank which can be used to fund the working capital requirements of a business unit. Also, the Eurocurrency market acts as a convenient and effective money market used for to hold any excess liquidity in the corporate businesses (Poncet, Steingress and Vandenbussche, 2008, p.608-614). Individual local shareholders: The Company may try to find the local shareholders who would be in interested to invest in the subsidiary. The shareholders would invest capital in the business and gain a part of the ownership in the subsidiary (Qiao and Siu, 2006, p.90-92). The shareholders would also be interested because they would be getting returns when the business becomes profitable and the liability on their side would be limited. According to the traditional theory of capital structure, there is an optimal structure existing for the business and the value of the business can be increased by opting for a careful combination of financial leveraging options. Therefore, for the subsidiary, an effective combination of finance sourcing from bank lending, stock markets and Eurocurrency debt would be suitable to ensure a balanced cost of capital for the company (Bai, Lu and Tao, 2006, pp.611-628). Since the debt versus equity i.e. the cost of capital is driven by the capital structure of the business, therefore, a low cost debt should be accessed to ensure better value for the business. Also, equity borrowing becomes costlier than debts and a higher level of borrowing increases the risk of the shareholders and consequently increases the cost of capital (Baker, 1998, p.98). Therefore, the business should try to access the internal source of financing at the beginning and when the internal sources are exhausted then it should consider the external sources for financing the subsidiary. According to Modigliani and Miller (1958), under specific conditions like the absence of taxes, agency costs and bankruptcy costs, the value of the business is not dependant on the financial leverage factors in the business (Modigliani and Miller, 1958, pp.261-275). But this theory has been followed by the trade-off theory of capital structure according to which a company should balance the debt and equity borrowings by considering the trade-off between the costs and benefits of these two different sources of financing. In China, the interest rates for the bank lending are capped (Hale and Long, 2010, p.8). Therefore, the company may opt for the borrowing from the bank so that the cost of capital is not highly impacted. The debts borrowing would help in saving the tax rates whereas the equity borrowings would help in saving the cost of borrowing. But considering the fact that the cost of borrowing is much lesser in China, it is advisable that the company gives more weightage to the debt financing part for the funding of the subsidiary in China (Bell and Chao, 2010, p.351-366). According to the pecking order theory, the cost of financing a business would increase in case there is much information asymmetry in the market. The theory focuses on the consideration of internal financing modes as the primary funding sources for a business followed by debt financing. The raising of equity to fund the business operations is often considered as the last resort for external financing sources (Ge and Qiu, 2007, pp.513-520). Therefore, the company must consider the retained earnings and other internal financing modes and combine these with the borrowings from the bank at a low interest rate so that the cost of capital is not majorly affected by the financing activities. The herding theory in behavioural finance is characterized by the investment behaviour of different companies following a mob mentality. This is generally caused due to the presence of asymmetrical information in the markets (Seabrook, 2006, p.119). A lot of difference is caused in the investment and financing aspects of different individuals and corporates due to the different levels of information that is present with them. Therefore, while deciding the choice of the modes of financing, the herding theory must be considered so that much focus is given to reduce the information asymmetry within the business and the market (Hamed, Afrasiabishani and Elham, 2012, p.79-90). Conclusion It can be concluded that different factors should be considered while choosing the sources of financing for establishing the subsidiary in China. The choice of the financing modes would be affected by major factors like the effect that the funding modes will have on the financial structure of the company including the capital structure. The external environment existing in the market of China should also be considered while deciding on the financing modes. The trends of the economy, the government policies including the lending rates and the tax payment system should be evaluated before deciding on the balance between debt and equity financing for the establishment of the subsidiary. Also, the structure of the business should be ideally considered to understand how funds can be raised from the capital markets. Much emphasis should be given on the impact of the financing processes on the capital structure of the company. According to macroeconomic analyses, the private companies in China are extensively financed by internal financing sources. 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