Business Finance

This article focuses on business finance and how it relates to the corporate and non-profit sectors. In order for organizations to be successful, they must create a strategic plan that will position the firm for growth and competitiveness. The senior management team will need to analyze all data, including the financial records, to ensure that the organization can make a profit, remain competitive and be in position for continued growth. There is an introduction to the concept of capital budgeting and how it applies to businesses as well as to multinational corporations. Capital budgeting could be the result of purchasing assets that are new for the organization or getting rid of some of the current assets in order to be more efficient. Capital budgeting for the multinational corporation presents many problems that are rarely fund in domestic capital budgeting.

Keywords Capital Budgeting; Chief Financial Officer; Expropriation; International Capital Budgeting; Multinational Corporation (MNC); Net Present Value Technique; Risk Adjusted Discount Rate; Strategic Planning; Transfer Pricing

Finance > Business Finance

Overview

In order for organizations to be successful, they must create a strategic plan that will position the firm for growth and competitiveness. The senior management team will need to analyze all data, including the financial records, to ensure that the organization can make a profit, remain competitive and be in position for continued growth. "In discussing corporate financial strategy, the question can well be asked as to how strategy differs from more modest decision making" (Bierman, 1980, p. 1).

Elements & Approaches to Financial Strategy

Bierman (1980) provided five elements and four approaches that he believed should be considered by corporate financial managers as they planned their strategies for the organizations in which they worked. The five elements were to:

• Identify the problems and opportunities that exist;
• Set goals and objectives;
• Develop a procedure for providing potential solutions or "paths" that the organization could follow in order to find a solution;
• Choose the best solution given the possible solutions and the organization's objectives; Implement a review process where the best solution can be evaluated on its performance.

These elements are very broad so that the corporate finance manager has an opportunity to consider a wide range of financial decisions. For example, the organization's main goal may be to pursue substantial growth with minimum risk. Therefore, the financial management team has to take these factors into consideration when developing the strategic financial plan for the organization. One type of strategy that financial professionals may use is the capital budgeting process.

Capital Budgeting

Many organizations charge the finance department with overseeing the financial stability of the organization. The chief financial officer (CFO) may lead a team of financial analysts in determining which projects deserve investment. This process is referred to as capital budgeting and is an example of how an organization may conduct a cost-benefit analysis. The process entails a comparison between the cash inflows (benefits) and outflows (costs) in order to determine which is greater. Capital budgeting could be the result of purchasing assets that are new for the organization or getting rid of some of the current assets in order to be more efficient. The finance team is charged with evaluating: Which projects would be good investments; which assets would add value to the current portfolio, and; how much is the organization willing to invest into each asset.

In order to answer the questions about the potential assets, there are a set of components to be considered in the capital budgeting process. The four components are initial investment outlay, net cash benefits (or savings) from the operations, terminal cash flow, and net present value (NPV) technique. Most of the literature discusses how the capital budgeting process operates in the traditional, domestic environment. However, as the world moves to a more global economic environment, consideration needs to be made as to how multinational corporations will conduct the capital budgeting process when operating in countries outside of their home base.

International Capital Budgeting

International capital budgeting refers to when projects are located in host countries other than the home country of the multinational corporation. Some of the techniques (i.e. calculation of net present value) are the same as traditional finance. However, "capital budgeting for a multinational is complicated because of the complexity of cash flows and financing options available to the multinational corporation" (Booth, 1982, p. 113). Capital budgeting for the multinational corporation presents many problems that are rarely found in domestic capital budgeting (Shapiro, 1978; Ang & Lai, 1989). Financial analysts may find that foreign projects are more complex to analyze than domestic projects due to the need to:

• Distinguish between parent cash flow and projects cash flow.

Multinationals will have the opportunity to evaluate the cash flow associated with projects from two approaches. They may look at the net impact of the project on their consolidated cash flow or they may treat the cash flow on a stand alone or unconsolidated basis. The theoretical perspective asserts that the project should be evaluated from the parent company's viewpoint since dividends and repayment of debt is handled by the parent company. This action supports the notion that the evaluation is actually based on the contributions that the project can make to the multinationals bottom line.

• Some organizations may want to evaluate the project from the subsidiary's (local point of view) point of view. However, the parent company's viewpoint should supersede the subsidiary's point of view. Multinational corporations tend to compare their projects with the subsidiary's projects in order to determine where their investments should go. The rule of thumb is to only invest in those projects that can earn a risk-adjusted return greater than the local competitors performing the same type of project. If the earnings are not greater than the local competitors, the multinational corporation can invest in the host country's bonds since they will pay the risk free rate adjusted for inflation.
• Although the theoretical approach is a sound process, many multinationals tend to evaluate their projects from both the parent and project point of view because of the combined advantages. When looking from the parent company's viewpoint, one could obtain results that are closer to the traditional net present value technique. However, the project's point of view allows one to obtain a closer approximation of the effect on consolidated earnings per share. The way the project is analyzed is dependent on the type of technique utilized to report the consolidated net earnings per share.
• Recognize money reimbursed to parent company when there are differences in the tax system.

The way in which the cash flows are returned to the parent company has an effect on the project. Cash flow can be returned in the following ways:

• Dividends — It can only be returned in this form if the project has a positive income. Some countries may impose limits on the amounts of funds that subsidiaries can pay to their foreign parent company in this form.
• Intrafirm Debt —

Interest on debt is tax deductible and it helps to reduce foreign tax liability.

• Intrafirm Sales —

This form is the operating cost of the project and it helps lower the foreign tax liability.

• Royalties and License Fees —

This form covers the expenses of the project and lowers the tax liability.

• Transfer Pricing —

This form refers to the internally established prices where different units of a single enterprise buy goods and services from each other.

• Anticipate the differences in the inflation rate between countries given that it will affect the cash flow over time.

• Analyze the use of subsidized loans from the host country since the practice may complicate the capital structure and discounted rate.

The host country may target specific subsidiaries in order to attract specific types of investment (i.e. technology). Subsidized loans can be given in the form of tax relief and preferential financing, and the practice will increase the net present value of the project. Some of the advantages of this practice include: Adding the subsidiary to project cash inflows and discount; discounting the subsidiary at some other rate, risk free, and; lowering the risk adjusted discount rate for the project in order to show the lower cost of debt.

• Determine if the political risk will reduce the value of the investment.

Expropriation is the ultimate level of political risk, and the effects of it depends on: When the expropriation takes place; the amount of money the host government will pay for the expropriation; how much debt is still outstanding; the tax consequences of expropriation and the future cash flow.

• Assess the different perspectives when assessing the terminal value of the project.

Estimating the salvage value or terminal value depends on the value of the project if retained, the value of the project if purchased by outside investors and the value of the project if it were liquidated. The corporation would use the assessment that yields the highest value.

• Review whether or not the parent company had problems transferring cash flows due to the funds being blocked.

An example would be when a host country limits the amounts of dividends that can be paid. If this were to occur, the multinational corporation would have to reexamine its reinvestment return and other methods in which the funds could be transferred out of the country. The blocked funds can be used to repay bank debt in the host country and allow the organization to have open lines of credit to other countries.

• Make sure that there is no confusion as to how the discount rate is going to be applied to the project.
• Adjust the project cash flow to account for potential risks.

One must assume that every project has some level of risk. The risk is usually seen as part of the cost of capital. International projects tend to have more risk than domestic projects. Therefore, it is advantageous to review the risk based on the parent's and project's perspective. Each perspective has a different way of adjusting risk. For example, the parent company may propose to: Treat all foreign risk as a single problem by increasing the discount rate applicable to the foreign projects, or; incorporate all foreign risk in adjustments to forecasted cash flows of the project. The first option is usually not recommended because it may penalize the cash flows that are not really affected by any sort of risk and it may ignore events that are favorable to the organization. The four components are initial investment outlay, net cash benefits (or savings) from the operations, terminal cash flow, and net present value (NPV) technique.

• "Capital budgeting is a financial analysis tool that applies quantitative analysis to support strong management decisions" (Bearing Point, n.d.). Capital budgeting seeks to provide a simple way for the finance department to see the "big picture" of the benefits, costs and risks for a corporation planning to make short term and/or long term investments. Unfortunately, many of the leading methods have experienced problems, especially when an organization is using a standardized template. Examples of potential problems include:
• The benefits, costs, and risks associated with an investment tend to be different based on the type of industry (i.e. technology versus agricultural).
• A corporation may highlight the end results of the return on investment model and the assumptions that support the results versus a balanced analysis of benefits, costs, and risks.

Data Error Prevention

If an organization does not account for the above-mentioned scenarios, there is a possibility for skewed results, which would make the data unusable. This type of error could hinder a project from receiving approval. Therefore, it is critical for financial analysts to have a more effective and efficient technique to use. Bearing Point (n.d.) identified several leading practices that organizations are using in order to avoid reporting faulty information. The theme in all of the techniques is that capital budgeting is not the only factor considered. Other quantifiable factors are utilized in order to see the big picture.

• Consider the nature of the request:

The type of benefit obtained by the investment will determine the nature of the request. Therefore, it may be beneficial to classify the benefit types into categories such as strategic, quantifiable and intangible.

• All benefits are not created equal:

Benefits should be classified correctly in order to properly analyze. There are two types of benefits — hard and soft. Hard benefits affect the profit and loss statement directly, but soft benefits do not have the same affect.

• Quantify risk:

Make sure that the risks are properly evaluated. In most cases, risks are neglected. Also, it would be a good idea to build a risk factor into whatever model is utilized.

• Be realistic about benefit periods:

Make sure that the expectations are realistic. In the past, corporations have created unrealistic goals for the benefits period by anticipating benefits to come too early and reusing models that reflect the depreciation period for the capital asset.

Application

Business Finance in Non-Profits

Strategic financial planning is important in all sectors. Having a sound financial planning process is essential to a healthy organization. This section will discuss how a non-profit organization can evaluate its financial position and implement processes to keep them on track.

A social service organization (Strategic financial planning, n.d.) identified four important stages in the financial planning process. These stages are reviewing the past, forecasting the future, setting strategies and plans, and setting annual budgets. Each of these phases is of equal importance and some of the tasks at each phase include:

Reviewing the Past

• Monitor recent trends in demand and expenditure.
• Monitor trends in funding streams.
• Monitor and report on actual performance and outcomes, including end-of-year position and performance against specific performance indicators for social services.
• Collect comparative information about actual costs and cost drivers.
• Review the results and evaluate the recommendations from any external inspection reports and management letters from external auditors (Strategic financial planning, n.d., “Stages of financial planning”).

Forecasting the Future

• Evaluate the impact of national policies and strategies.
• Identify and estimate levels of the various funding streams.
• Review the impact of local policy initiatives and priorities.
• Determine the future impact of known trends in demand and expenditure.
• Identify the financial implications of demographic trends and other "drivers" of demand which are outside of the control of the council (Strategic financial planning, n.d., “Stages of financial planning”).

Setting Strategies & Plans

• Take into account the corporate context for strategic planning.
• Link financial planning with service, human resource and asset management planning.
• Collect information on the knowledge and skill base required for effective budget management at all organizational levels.
• Engage all key stakeholders in the strategic financial planning.

Set Annual Budgets

• Come to consensus on what the budget process should be.
• Ensure budgets are informed by financial plans.
• Involve budget managers in budget setting.
• Match commitments and expected changes in demand with resources available.
• Respond to unexpected changes.
• Review budget structures.
• Engage with key stakeholders.
• Ensure short term decisions in budget setting do not undermine longer-term priorities and strategies (Strategic financial planning, n.d., “Stages of financial planning”).

As the organization goes through the process, key decision makers should determine the types of policies that need to be in effect in order to be successful at each of the individual phases. Although these steps apply to a non-profit organization, the steps are valuable for any type of organization. Therefore, the corporate sector may benefit by comparing and contrasting how each of the sectors operate and discussing what works for both.

Viewpoint

State Corporate Tax Disclosure

One aspect of a business attempting to plan its finances involves the tax structures that are imposed upon it. Some tax professionals and policymakers have been reviewing the state corporate income tax and believe there is a problem with it. "The share of corporate profits in the U.S. collected by state governments via the corporate income tax has fallen sharply in the past quarter century" (Wilson, 2006, p.1). Mazerov (2007) reported that there is data that suggests: “The share of tax revenue supplied by this tax in the 45 states that levy it fell from more than 10 percent in the late 1970s, to less than 9 percent in the late 1980s, to less than 7 percent at the present time; the effective rate at which states tax corporate profits fell from 6.9 percent in the 1981-85 period, to 5.4 percent in 1991-95, to 4.8 percent in 2001-05, and; many state-specific studies have found that most corporations filing income tax returns paid the minimum corporate tax even in years in which the economy was growing strongly” (Mazerov, 2007, p. 1).

Although there is continuous debate surrounding this information, many in the business community believe that there are organizations that are explouting the provisions of company income tax mandates that have been enacted (i.e. tax incentives for corporations that make significant financial contributions to the state). However, the policymakers and advocates disagree. This group of individuals believes that corporate tax incentives are not financially efficient and cannot effectively stimulate a positive economic growth. Mazerov (2007) believes that this debate will not be able to reach closure until the states monitor public advertisement of the amount of company income tax that specified businesses pay to certain states. He believes that this type of change would:

• Help show policymakers and the public whether the corporate income tax is structured in a way that ensures all corporations doing business in the state are paying their fair share of tax.

Because of the large number of variables that affect a corporation's tax liability, it is difficult for non-experts to understand the impact of states' tax policy choices. Examples of how these policies actually affect the tax liability of identifiable corporations could be an asset in assisting policymakers and advocates to comprehend the effectiveness and fairness of a state's corporate tax policies.

• Shed light on the effectiveness of tax policies designed to promote economic development.

A number of states have enacted corporate tax incentives and/or tax cuts with the aim of creating jobs or encouraging investment in the state. Without the information provided by company-specific tax disclosure, it is difficult to analyze the effectiveness of such policies.

• Stimulate any needed reform of the state's corporate income tax system.

Despite the significant drop in state corporate income taxes in recent decades, very few states have enacted meaningful reforms to address this problem Efforts against this tax shelter have been successful in a number of states, primarily because the public has learned the names of specific well-known corporations that have exploited this shelter. Similarly, corporate tax disclosure could inspire tax reform efforts by encouraging public and policymaker interest in these issues (Mazerov, 2007, p. 1-2).

Essentially, corporate tax disclosure would aid in clarifying the actual results of a state's corporate tax laws and procedures and helps to reform when necessary.

Conclusion

In order for organization's to be successful, they must create a strategic plan that will position the firm for growth and competitiveness. The senior management team will need to analyze all data, including the financial records, to ensure that the organization can make a profit, remain competitive and be in a position for continued growth.

Capital budgeting could be the result of purchasing assets that are new for the organization or getting rid of some of the current assets in order to be more efficient. The finance team will be charged with evaluating: Which projects would be good investments; which assets would add value to the current portfolio, and; how much the organization willing to invest into each asset. International capital budgeting refers to when projects are located in host countries other than the home country of the multinational corporation.

Strategic financial planning is important in other sectors. Having a sound financial planning process is essential to a healthy organization. The viewpoint section discussed how a non-profit organization can evaluate its financial position and implement processes in order to keep them on track. A social service organization (Strategic financial planning, n.d.) identified four important stages in the financial planning process. These stages are reviewing the past, forecasting the future, setting strategies and plans, and setting annual budgets.

Some tax professionals and policymakers have been reviewing the state corporate income tax and believe there is a problem with it. "The share of corporate profits in the U.S. collected by state governments via the corporate income tax has fallen sharply in the past quarter century" (Wilson, 2006, p.1). Although there is continuous debate surrounding this information, many in the business community believe that there are organizations that are exploiting the provisions of company income tax laws that have been implemented (i.e. tax incentives for corporations that make large contributions to the state). However, the policymakers and advocates disagree. This group of individuals believes that company tax incentives are not as cost-efficient and do not adequately stimulate economic growth.

Terms & Concepts

Capital Budgeting: Capital budgeting involves deciding which long-term projects are worthy of investing in and undertaking. Choosing such potential projects usually involves making comparisons of anticipated discounted cash flows and the internal rates of return.

Chief Financial Officer: The role of the chief financial officer involves financial planning and recordkeeping for a corporation.

Expropriation: The action of the state in taking or modifying the property rights of an individual in the exercise of its sovereignty.

International Capital Budgeting: When projects are located in host countries other than the home country of the multinational corporation.

Multinational Corporation (MNC): A company that invests its one facilities and other assets in a country other than its own.

Net Present Value (NPV) Technique: The method of calculating the value of an investment by adding the initial cost and the current value of anticipated cash flows.

Risk Adjusted Discount Rate: The risk-free rate (essentially the return on shorter term U.S. Treasury securities) added to the risk premium that is gathered from an assessment of the risks involved in a certain investment project.

Strategic Planning: A company’s method of defining its personal strategy, plan, or decision making process regarding the allocation of its resources intended to help in pursuing a strategy, such as its capital and people.

Transfer Pricing: The estimated cost of products and services that a business provides to another part or department within the same corporation. The transfer pricing helps to measure each division’s gain and loss as it stands separately from the company at large.

Bibliography

Ang, J., & Lai, T. (1989). A simple rule for multinational capital budgeting. Global Finance Journal, 1(1), 71-76. Retrieved July 5, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=6338721&site=bsi-live

Bearing Point (n.d.). Improve your capital budget techniques. Retrieved July 9, 2007, from http://office.microsoft.com/en-us/help/HA011553851033.aspx

Bierman, Jr., H. (1980). Strategic financial planning. New York, NY: The Free Press.

Booth, L. (1982). Capital budgeting frameworks for the multinational corporation. Journal of International Business Studies, 13(2), 113-123.

Brunnermeier, M.K., & Oehmke, M. (2013). The maturity rat race. Journal of Finance, 68(2), 483-521. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=85938185&site=ehost-live

Hong, S. (2013). Wheeling and dealing. Entrepreneur, 41(5), 76. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=87079968&site=ehost-live

Mazerov, M. (2007) State corporate tax disclosure: The next step in corporate tax reform. Retrieved August 10, 2007, from http://www.cbpp.org/2-13-07sfp.pdf

Mina, A., Lahr, H., & Hughes, A. (2013). The demand and supply of external finance for innovative firms. Industrial & Corporate Change, 22(4), 869-901. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=89520165&site=ehost-live

Shapiro, A. (1978). Capital budgeting for the multinational corporation. Financial Management (1972), 7(1), 7-16. Retrieved July 5, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=5029365&site=bsi-live

Strategic financial planning. (n.d.). Making Ends Meet. Retrieved September 3, 2007, from http://www.joint-reviews.gov.uk/money/Financialmgt/1-22.html

Wilson, D. (2006). The mystery of falling state corporate income taxes. FRBSF Economic Letter, 2006(35), 1-3. Retrieved August 19, 2007, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=23637606&site=bsi-live

Suggested Reading

Bernhart, M. (2006). Finance and HR: How business gets done. Employee Benefit News, 20(15), 18. Retrieved January 4, 2008, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=23201644&site=bsi-live

Financial services used by small businesses: Evidence from the 2003 survey of small business finances. (2006, October 24). Federal Reserve Bulletin, A167-A195. Retrieved January 4, 2008, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=24429387&site=bsi-live

Put finance at heart of business to succeed. (2006). Accountancy Ireland, 38(3), 94. Retrieved January 4, 2008, from EBSCO Online Database Business Source Premier. http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=21160485&site=bsi-live