International financial management is also known as international finance‘.
International finance is the set of relations for the creation and using of funds (assets), needed for foreign economic activity of international companies and countries. Assets in the financial aspect are considered not just as money, but money as the capital, i.e. the value that brings added value (profit). Capital is the movement, the constant change of forms in the cycle that passes through three stages: the monetary, the productive, and the commodity. So, finance is the monetary capital, money flow, serving the circulation of capital. If money is the universal equivalent, whereby primarily labor costs are measured, finance is the economic tool.
The definition of international finance is the combination of monetary relations that develop in process of economic agreements - trade, foreign exchange, investment - between residents of the country and residents of foreign countries.
Financial management is mainly concerned with how to optimally make various corporate financial decisions, such as those pertaining to investment, capital structure, dividend policy, and working capital management, with a view to achieving a set of given corporate objectives.
When a firm operates in the domestic market, both for procuring inputs as well as selling its output, it needs to deal only in the domestic currency. When companies try to increase their international trade and establish operations in foreign countries, they start dealing with people and firms in various nations. On this regards, as different nations have different currencies, dealing with the currencies becomes a problem-variability in exchange rates have a profound effect on the cost, sales and profits of the firm.
Globalization of the financial markets results in increased opportunities and risks on account of overseas borrowing and investments by the firm.
It is determination of exchange price when different business units within a firm exchange the products and services
Definition: As per section 92 (1) of the Income Tax Act, 1961 – Income from an international transaction shall be computed having regard to the Arm‘s length Price (correct market price). Commercial transactions between the different parts of the multinational groups may not be subject to the same market forces shaping relations between the two independent firms. One party transfers to another, goods or services, for a price. That price is known as ―transfer price‖.
Uses of Transfer Pricing
When product is transferred between profit centers or investment centers within a decentralized firm, transfer prices are necessary to calculate divisional profits, which then affect divisional performance evaluation. The objective is to achieve goal congruence, in which divisional managers will want to transfer product-when doing so maximizes consolidated corporate profits, and at least one manager will refuse the transfer when transferring product is not the profit-maximizing strategy for the company. When multinational firms transfer product across international borders, transfer prices are relevant in the calculation of income taxes, and are sometimes relevant in connection with other international trade and regulatory issues.
Transfer pricing is
- the process of setting transfer prices between associated enterprises or related parties where at least one of the related parties is a non-resident.
- the price at which an enterprise transfers goods and services, intangible and intangible assets, services or lending/ borrowing money to associated enterprises.
- generally decided prior to entering the transaction and they are audited/ reviewed by the auditor after the year finalization.
Transfer Pricing in Multinational Companies
Internal auditors play key roles in multinational corporations, including providing valuable input regarding effectiveness of business operations. They can help multinational corporations by assessing the effectiveness of corporate policies regarding international transfer pricing. International transfer pricing is a major issue for multinational corporations, as transfer pricing is a key element in corporate taxation strategies. Effective transfer pricing policies are very important to sustaining effective global business operations. Transfer pricing, if done correctly, can improve the overall success and value of an international company.
The creation of foreign subsidiaries and bases of operation for cross border flow of products, services, trademarks, funding and technology have a significant impact on the issue of transfer pricing in international business. The transfer pricing problem for multinationals is of great significance. There are different income tax rates in different countries. So, it becomes desirable from the view point of overall corporate strategy to show higher profits in low-tax countries and lower profits in high-tax countries. One way to do so is through transfer prices.
The resale price method begins with the price at which a product is resold to an independent enterprise (IE) by an associate enterprise.
Ex: X sold to AE at Rs. 1000 (profit: 300). AE sold to an IE at Rs. 2000 (profit of Rs. 500 for relevant IE). Arms length price = 2000 - 500 = 1500.
Methods of Transfer Pricing
Variable Cost Method Transfer price = variable cost of selling unit + markup Full Cost Method Transfer price = Variable Cost + allocated fixed cost
Market Price Method Transfer price = current price for the selling unit‘s in the market Negotiated Price Method
Strategic Factors of Transfer Pricing
- International Transfer Pricing Consideration
- Tax Rate- minimize taxes locally as well internationally
- Exchange Rate
- Custom Charges Risk of expropriation
- Currency Restriction
- Strategic relationship
- Assist bayside division to grow
- Gain entrance in the new country
- Supplier‘s quality or name
Reason for growth in international business
International business has growth dramatically in recent years because of strategic imperatives and environmental changes.
Strategic imperatives include the need to leverage core competencies, acquire resources, seek new markets, and match the actions of rivals. Although strategic imperatives indicate why firms wish to internationalize their operations, significant changes in the political and technical environment have facilitated the explosive growth in international business activity that has since World War 2. The growth of the internet and other information technologies is likely to redefine global competition and ways of doing international business.
There are many reasons why international business is growing at such a rapid pace. Below are some of those reasons:
Saturation of Domestic Markets
In most of the countries due to continuous production of similar products over the years has led to the saturation of domestic markets. For example in Japan, 95% of people have all types of electronic appliances and there is no growth of organization there, as a result they have to look out for new markets overseas.
Opportunities in Foreign Markets
As domestic markets in some countries have saturated, there are many developing countries where these markets are blooming. Organizations have great opportunities to boost their sales and profits by selling their products in these markets. Also countries that are attaining economic growth are demanding new goods and services at unprecedented levels.
Availability of Low Cost Labor
When we compare labor cost in developed countries with respect to developing countries they are very high. As a result, organizations find it cheaper to shift production in these countries. This leads to lower production cost for the organization and increased profits.
Either to stem the increased presence of foreign companies in their own domestic markets or to counter the expansion of their domestic markets, more and more organizations are expanding their operations abroad. International companies are using overseas market entry as a counter measure to increase competition.
Consumers in counties that did not have the purchasing power to acquire high-quality products are now purchasing them due to improved economic conditions
To counter cyclical patterns of business in different parts of the world, most of the companies expand and diversify their business, to attain profitability and uncover new markets. This is one of the reasons why international business is developing at a rapid pace.
Reduction of Trade Barriers
Most of the developing economics are now relaxing their trade barriers and opening doors to foreign multinationals and allowing their companies to set-up their organizations abroad. This has stimulated cross border trade between countries and opened markets that were previously unavailable for international companies.
Development of communications and Technology
Over last few years there has been a tremendous development in communication and technology, which has enabled everyone to know about demands, products and services offered in other part of the world. Adding to this is the reducing cost of transport and improved efficiency has also led to expansion of business.
Innovations in transport and communication has led to development of more aware consumer. This has led to consumers demanding new and better goods and services. The pressure has led to companies researching, merging or entering into new zones.
More companies operate internationally because
- New products quickly become known globally
- Companies can produce in different countries
- Domestic companies, competitors, suppliers have becomes international
As international companies venture into foreign markets, these companies will need managers and other personals who understand and are exposed to the concepts and practices that govern international companies. Therefore the study of international business may be essential to work in global environment.
Practical considerations in Transfer Pricing
Transfer pricing is used to ―window-dress‖ the profits of certain divisions of a multinational firm so as to reduce the borrowing costs.
For the long-term survival of a multinational firm, it is important that interdivisional profitability is measured accurately. This record of profitability of different divisions is valuable in allocating overall spending on capital projects and in sharing other corporate resources.
For correct profitability, the firm should be sure that interdivisional transfer prices are the prices that would have been paid had the transactions been with independent companies, so-called ‗arm‘s length process‘.
This is particularly difficult in the international allocation of items such as research and consulting services or head quarters overhead; there is rarely a market price for research or other services of corporate head quarters.
Profit allocations will usually be according to the distribution of corporate sales, with the sales valued at the ―correct‖ exchange rate.