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Student ID: Level of Study: Module Title: Course Title: Module Tutor Full text word count: Student Name: Date of Submission:

77110156 MA Management of International Business Finance MA INTERNATIONAL TRADE AND FINANCE Roger Lakhani 4030 words PHAM THUY DUONG 21 October 2011

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I.

Introduction

The Air Team is an alliance of ten international airlines: Russian International Airways, Air Mexico, LKM (Netherlands), French Airlines, North East Airways (USA), Air Italy, Intercontinental Airline (USA), Air Korea, Hong Kong Airline and Air South Africa. The purpose of the alliance is to improve customer services and reduce costs. This is achieved by code sharing, facilities sharing and the provision of an integrated network of routes and timetables. The alliance is discussing the possibility of merging the all the airlines into one company. The plan is create a holding company called Internal Travel Corporation (ITC) to buy the shares of all the above airlines. Payment would be in shares in ITC. Estimated restructuring costs will exceed $700

million and the group's capital expenditure is estimated at 14%. The report will analyze the issues related to location of the parent company, the most appropriate capital source to fund the ITC, the advantages of the international financial system and centralization of treasury functions and refers to a net financial benefit of the merger, and to assess the potential growth of cash flow from investment demand.

II.

ITC and Financial review

1. Task A: The financial considerations to be taken into account when deciding the location of the headquarters of ITC. ITC is a joint-stock company which consists of ten international airlines in the Air alliance, so its operation is like one multinational company. Therefore, the consideration when deciding the location of headquater of ITC is on of the most important issues for this company which is an important element for the companys personality and image, one of important part of the companys identity and position for the companys investors and customers and relate to managing business performance and developing of the company.

In this part of paper, the financial consideration will be ananlyzed to be taken into account when deciding the headquarters of ITC. And the location which is chossen in this consideration is Netherlands. There are .. reasons for this choice. Firstly, in term of geography, Netherlands locates in the center of three largest economies in Europe: the UK, France and Germany. The expansion of EU membership in 2004 and 2007 makes Netherlands more attractive for the foreign investors as a location for headquarter of mutinational companies for implementing and developing pan-European strategies. Secondly, the airport in Netherlands is one of issues which is worth considering. Comparing to the airport in all of the world, the Ducht airport has a high modern level of technology. Netherlands has one of Europes major airports like other major airports in Europe such as airports in Germany, France, the UK. Every year, the airport of Netherlands serves more than 44 thousand passengers and 35% of the visitors who fly across the continent and is ranked third in Europe for cargo transport (1450 tonnes). The Ducht airport is one of the best airport of the world with international and intercontinental flights with straight flight to 260 points and 91 countries in the world. Moreover, the center of KLMs operations is airport so the headquater in Netherlands has so many advantages. Thirdly, an effective, internationally oriented banking system is also an inportant indicator that needs to be considering when deciding the headquater for the company. Banks play an important role in economic life of each country. The health of the economiy is closely related to the soundness of its banking system. One country which has an effective, internationally oriented banking system will attract more investors because of supporting in funding and ensuring a stable business environment. This is very important for multinational enterprises like ITC. In one survey of the Worlds Economic Forum in 2008, the ranking for the world soundest banking system is as followed: 1. 2. 3. 4. 5. 6. 7. 8. 9. Canada Sweden Luxembourg Australia Denmark Netherland Belgium New Zealand Ireland

10.Malta 11.Hongkong 12.Finland 13.Singapore 14.Norway 15.South Africa 16.Switzerland 17.Namibia 18.Chile 19.France 20.Spain (The World Economic Forums Global Cometitiveness Report based on its findings on poinions of executives and handed banks a score between 1.0 (insolvent and possibly requiring a government bailout) and 7.0 (healthy, with sound balance sheets)) This report showed that in 20 countries which have soundest banking system there are four members of ITC: Netherlands, Hongkong, South Africa, France. Netherlands ranks at No.6, Hongkong at No.11, South Africa at No.15 and France at No.19. This rank indicated that in ten members of ITC cosidering for the location of headquater, Netherlands has a highest rank. The financial services industry in Netherlands has a long history. Moreover, Netherlands has the oldest stock exchange in the world (the Amsterdam Stock Exchange). Since it found in the early of 17th century, it is now one of the largest stock exchange in operation. The Netherlands Bank supervised the issurance of new securities on the exchange. Strong international orientation of Ducht stock exchange is reflected in the fact that its share of Europes total market capitalization far outweighs the relative importance of the Dutch economy. This is of advantage to funding operations of ITC. The fourth factor considering here is political stability and lack of government interference. This factor influence so much to the decision of the investors. It disturb the flow of foreign direct investment plans both into the private sector as well as the government owned public sector units and that surely affects economic growth. In this aspect, Netherlands is the most political stability and absence of violence in this members of ITC. It has the high ranking for the worlds top countries which have the political stability. In Netherlands there is no abnormal changes of the political institutions or the impact of instability in society which many limit the consequences for businesses. This reason leads to the fact that every year, this country attracts a lot of tourists and investors that promote the demand for using

airline. Headquater in Netherlands is also a choice for ITC to approach this potential market. The Fifth reason is Netherlands has a high quality of infrastructure. The World Bank ranked the Netherlands second in Logistic Performance Index (2010). Netherlands has a dense yet highly efficient infrastructure of ultramodern and well-maintained roads, railways, inland waterways, airports and seaports which are well-equipped facilities, good security, affordable utilities, frequent schedules, and high-efficiency processing of cargos. This country has many expressways and roadway that stretch 136,827 kilometres, over 2,896kilometres of railways, 27 airports with many big international airports (Maastricht, Eindhoven, Rotterdam, Eelde, and Schipol in Amsterdam), more than 70 air freight companies serving Europe and the world, more than 28 carriers (majors include KLM). Moreover, Netherlands has a number of important waterways and port (the largest port in Netherlands is the Port of Rotterdam). Its waterways total 6,215 kilometres and are navigable for shops up to 50 tons. Sixth, Netherlands has an open and good economic system with existence of grants and tax concessions. Due to the rational economic intervention policy of state, this country had a national budget balance and the fight against stagnation in the labor market. The feature of the Dutch economy is a developing and stable industry, unemployment and inflation (5.5% and 1.3% - est 2010) at low level and is an important gateway in Europe. The World Banks Doing Business report ranks the Netherlands 30th in the world in terms of ease of doing business. And Netherlands is ranked 13th in the world for the ease of trading across borders. On the tax front, the Netherlands has a 25.5% base corporate income tax and a lower 20% for smaller companies, which are below the equivalent rates in many of its EU partners. Moreover, dividends from subsidiaries will be generally excluded from the basis for taxation. This Dutch participation exemption system for avoidance of double taxation has over the past few years found followers in many of the governments around the globe, with the United States being one exception. Its the reason for the many companies that choose the Netherlands as their headquarters location. Seventh is the advantage about the good quality of life and labour force of Netherlands. This is the countrys highly skilled, multilingual and well educated labor force in a population of 16.5m that holds particular appeal. It is estimated that 87% of the Dutch workforce use English. They also speak many of the European languages of score markets in region (including French and German). It is an easy for most executives or employes from the other country make any transition or move to the Netherlands. The minimum wage

in the Netherlands set by the government is 1,398 per month or 322 per week (est. 2009) for full-time working adults over 23 years of age. It is also an attrativeness for employees from other country. Among the 9 countries of the alliance, Netherlands is not the lowest labor costs and rents but quality and availability of labor in this country is always attractive the investors considering location as their headquater. In short, due to political stability, an effective, internationally oriented banking system, tax concession, efficient infrastructure, good quality of life, legal system, freedom of information, level of technological development, economic development and the educational level of people, Netherlands is considered as one of the most ideal location for the headquarters of ITC. The advantages of the Dutch headquarters of the ITC will make the reorganization of ITC rapid and convenient, the new system is set up and operates more efficiently by reducing the setup costs initially because of the available facilities in the Netherlands.

2. Task B: Recommends how to decide on the best source of the US$700 million required for the merger. You are also required to express an opinion on the most suitable sources of the funds for ITC. Basically, capital decisions include the short-term and long-term capital decisions. Long-term capital decisions are that the company decides how to mobilize how much equity and debt, decides what kind of equity and debt that companies use and decides when to mobilize capital. During operation, the company generates demand of short-term financing. To meet the needs of short-term capital, companies may use other payable sources in advance, if inadequate, they can mobilize short-term debt. To use the short-term debt, the company can borrow from banks or other syndications. The choice of short-term capital depends on the cost of raising capital compared to other sources of capital and bargaining power to obtain capital. In addition to short-term financing needs, the company also needs long-term funding to invest in mobile assets and fixed assets. To mobilize long-term financing, companies can choose one of three funds: common stock, preferred shares and long-term debt, including long-term debt can select loans from banks or issue bonds . Bank loans may also be

divided into several types of loans and bonds also may be issued by various categories such as debentures, convertible bonds, bonds with the acquisition terms, bonds having floating interest rates ... The multitude of channels and methods to mobilize funding make such companies and investors have more opportunities to choose. The choice of long-term capital, primarily depends on the cost of raising capital, then the advantages and disadvantages of raising capital measures, ultimately the cash flow that the company expects to pay the cost of raising capital. In case of ITC, there are some main ways of funding. One of these ways, ITC can consider finding the source of debt funding on the international market. It offers the borrower a variety of different maturities, repayment structures and currencies of denomination (David K. Eiteman, 2010). There are three major sources of debt funding on international markets: international bank loans and syndicated credits, the Euronote market and the international bond market. Three majors are summerized in this table followed:

International Debt Markets and Instruments

Bank Loans and Syndications (floating-rate, short- to medium- term)

International Bank Loans Eurocredits Syndicated Credits

Euronote Market (floating-rate, short- to medium- term)

Euronotes and Euronote Facilities Euro-Commercial Paper (ECP) Euro Medium-Term Notes (EMTNs) Eurobond: Straight fixed-rate issue Floating-rate note (FRN) Equity-related issue Foreign Bond

International Bond Market (fixed- and floating-rate medium- to long- term)

Source: Multinational Business Finance, David K. Eiteman, 2010

The total profit from the members of alliance is -$US8.2 million, so the funding from Euronote market is not suitable for ITC. Moreover, Euronote market are all short- to medium- term debt instruments sourced in the Eurocurrency markets. It encompasses nondollar loans in the Eurocurrency market, this is not an advantage for ITC because ITC is a multinational enterprises, the currency used for the company may not be Euro. On the other hand, companies always want long-term loans because the company could raise and use funds in longer. However, for the ITC, it is difficult because of high costs of long-term borrowing. Furthermore, the airlines are almost all highly geared and the companys main assets are mostly leased, therefore, it is difficult for ITC to get long-term loans from bank. But ITC may consider short-term loans and issuing shares. The shortterm loans to bring the control of the operation of management systems and low-cost loans. ITC needs to pay debts on time, then ITC will create confidence of the bankers to continue borrowing. International bond market is also a fund considering for ITC. According to David K. Eiteman (2010), the international bond market rival the international banking market in terms of the quantity and cost of funds provided to international borrowers. Eurobond and foreign bond are two main kind of it. Eurobonds are issued by multinational corporations, large domestic corporations, spvereogn governments, governmental enterprises and

international institutions. There are three kinds of it: the straight fixed-rate, the floating-rate note and the equity-related issue. In three kinds of Eurobond, the straight fixed-rate and equity-related issue are suitable for funding of ITC. In the straight fixed-rate, coupons are normally paid annually, rather than semiannually, primarily because the bonds are bear bonds and annual coupon redemption is more convenient for the holders (David K. Eiteman, 2010). And with the equity-related issue, the borrower is able to issue debt with lower coupon payments due to the added value of the equity conversion feature. With the straight fixed-rated, the fixed rate could help the ITC reduce risk from financial and currency instability. It makes the company easier to develop business plan. And the equity-related is beneficial for ITC to source funding from issuing this kind of Eurobonds especially when the ITC is newly-established, companys capital is not much. An other kind of international bond market is foreign bonds. It is underwritten by a syndicate composed of members from a single country, sold principally within that country and denominated in the currency of that country. This is one way of funding but it is not suitable for ITC. Because when using foreign bonds, ITC could be risky at foreign exchange rate change, currency instability Other way of ITCs funding is share issuance. It has been help ITC have longterm funds so that the company can pay for their business activities. ITC should use this type of sourcing equity globally to raise fund in many market, especially for a multinational enterprise as ITC. ITCs listing in market help the company to enhance corporate image, advertise trademarks and products, get better local press coverage, and become more familiar with the local financial community in order to raise working capital locally. Moreover, the ideal location of the holding company proves to be Netherlands. It is also an advantage for ITC because of Netherlands has one of the oldest and largest stock exchange. However, the ITC has to consider the problems of control and shared interest between shareholders. In conclusion, ITC should combine both sources of equity and debt. Sources of equity or internal funds includes funds from multinational enterprises and

funds generated internally by the foreign subsidiaries. Loans or external sources of capital includes short term loans and issuing shares.

3. Task C: An outline of the potential benefits and cost saving that might accrue as a result of: the multinational financial system (using appropriate figures from the case study), the centralisation of ITCs treasury function. a. Multinational financial system

The system uses multi-national financial help boost the financial activities between member companies. The company will take advantage of each country strengths: the source of cheap labor, access to cheaper imported inputs to create conditions to reduce costs, increase competitiveness against other alliances. The fluctuation of fuel prices and global economic slowdown has led to difficulties of multinational companies operating in the fields of transport business. Therefore, the current airline alliance not only share the reservation code but there are steps of closer links to form a new block of business more efficiently. Beginning with simple marketing agreement and sharing the code of book, contacting more often, they will establish the close economic relations. A financial system multinational many advantages such as accessibility to international capital markets and the possibility of international diversification by sources of funds which are formed from its subsidiaries in the alliance. The multi-national companies like ITC may receive funds from international capital markets with the various cost of capital and opportunity to access to

cheap capital. In addition, the ITC may receive funds from other countries in alliance with a lower cost at the headquarters if the interest rate in that country is relatively attractive. If the ITC has more stable revenue streams by diversifying business around the world, the probability of bankruptcy will reduce and it can minimize the cost of capital. The financial system can also receive tax incentives which can be received by the preferential tax policies of host countries to encourage investment and reduce costs through the use of funds. Alternatively, it can use transfer pricing method to transfer profits to overseas on purpose of minimizing its high income tax,
duties, tariffs and maximizing its benefits. MNEs like ITC can set transfer prices to minimize taxable income in country with a high income tax rate and maximize income in a country with a low income tax rate. In the case of ITC among the 9 countries in the alliance, Hong Kong is the country having the lowest tax income (17%). So ITC can use transfer-pricing method to shift the profit of the rest 8 nations to Hong Kong. By doing this, the company can save a big amount of its tax expense and maximize its profit. Moreover the company is able to manage the exchange rate risk by using internal hedging techniques. Hedging is the tasking of a position either acquiring a cash flow, an asset or a contract that will rise (or fall) in value and offset a fall (or rise) in the value of an existing position (Eiteman, 2010). These hedging methods allow ITC to mitigate the risk of exchange rate changes, therefore managing a comparative advantage over the individual shareholders. Management is in a better position than shareholders to recognize disequilibrium conditions and to take advantage of one-time opportunities to enhance firm value through selective hedging.

b. The centralisation of ITCs treasury function

Centralized treasury function enables the fund manager of ITC only need to manage transactions in one location, the time frame specified in the national headquarters. Thus the control of information in real time on a geographic area between the many organizations will be done promptly, quickly and achieve greater efficiency and transparency. Centralization of treasury function also helps ITC have greater control, adjust and move free cash flow of the subsidiaries to other activities which are in need of capital. This makes ITC reduce cost of capital and maximize effectiveness of using capital as well as increase liquity of ITCs activities. Centralized treasury function will help ITC manage foreign exchange, interest rate risk more quickly and promptly. The centralized treasury function concentrates amounts of cash, cash capital contribution of the coalition and replaces bank accounts in banks of the country by local accounts in international banks . Currency risk of the ITC may be related to the stability of cash flows, exchange rate risk, credit risk and ability to retain the profits of ITC. Centralized control of diversification of revenue stream to the business by diversifying income and cash flows in from around the world have reduced the risk of currency risk with multi-national companies.
The treasury department of ITC will act as an intermediary financial institution to transfer the funds among international airlines as well as selling/buying foreign exchange with many other financial companies in the world, as a result each alliance member can have enough foreign currency

for international payment or even gain more profit from foreign exchange trading. Another benefit of centralization of ITCs treasury function is productivity resulting in saving subsidiaries salary costs. The productivity of ITC is improved as standardized policies, practices, and performance measures which create an efficient treasury operation. Thus, subsidiaries dont need make a great effort to manage the complex procedures anymore, only need to focus on doing their business in local countries. Therefore, there is a high possibility that the productivity of subsidiaries will go up.

In sum up, centralization of treasury function helps ITC have more cash visibility and greater control so that it can mobilize soures of capital actively, use them effectively and then reduce exchange rate risk. From that, it can be operated better and bring more benefits to shareholders.
4. Task 4: An evaluation of the potential increases in cash flows compared to the capital investment required. You can assume that the potential increases in cash flows will take the form of a perpetuity. You should also recommend by how much cash flows should increase if in fact three times is not enough to justify the investment of US$700 million. Expected annual cash flow = 38.2-8.2 = U.S. $ 30 million The present value of estimated annual cash flow = 90/0.14 = U.S. $ 642.86 Net present value proposal = 642.86 - 700 = U.S. $ 57.14 million negative Suppose that X is the annual cash flow ($ million) NPV = X / r = X/0.14. Therefore, the annual cash flow will be at least X/0.14> 700 X> 98 million while the annual cash flow is expected to be 30 million USD

Therefore, X> 98/30 X> 3.2 Therefore, the annual cash flow would have to be at least 3.2 times larger than the current cash flow. Assessing the feasibility of this index as well as finding the method to make the operation, revenues and gains in the future to obtain such this index are very important. Cash management in a multi-national company has special challenges and has to deal with a variety of exchange rate risk, country risk, interest rate risk ... The above calculation and estimation can be considerably affected by macroeconomic factors such as interest rate, exchange rate or tax rate... With the above suggestion that Netherlands shall be the best choice for the headquater of the alliance, some supporting ideas shall be given as follows: The exchange rate of Euros has been quite stable (1 euro= around 1.2 to 1.5 $ from 2008 to 9/2011). The inflation of Netherlands was about 1.1% from 2004 to 2008, 1.2% in 2009 and 1.3% in 2010. This makes the estimation of future exchange rate easier. For companies and investors, this rate makes the Netherlands one of the more competitive European markets. Euros are used as Dutch main currency. It is the second largest reserve currency in the world after the US dollar. But in compared with US dollar and other currencies, Euros is a quite stable currency with the fluctuation of around 2.5% in recent years. Moreover, the interest rate in this country is low (3% in 2007), this will maximize net present value. In addition, the Euros transference policy of the Dutch government is quite flexible and the government seems not to interfere much in this policy. The interest rate policy is the contribution of enhancing competition among banks.

In conclusion, with all the supporting ideas mentioned above, we shall minimize difficulties in estimating the future exchange rate of Euros with other foreign currency and have proper policies in hedging activities for the Alliance benefits.

III. References
1. David K.Eiteman, Authur I.Stonehill, Michael H Moffett; Multinational Bussiness Finance, 12th Edition. 2. Howard Fletcher, Cash Flow Part 13 Multinational Companies December 15,2007 3. Dr Elizabeth Maitland, Dr Stephen Morgan, and Professor Stephen Nicholas. Investing in China: The Investment Decision, Operations and Performance of Australian Multinational Enterprises. Australian Centre for International Business, University of Melbourne. 4. Yves Doz, Nicolai J. Foss, Stefanie Lenway, Marjorie Lyles, Silvia Massini, Thomas P. Murtha and Torben Pedersen (2003). Future Frontiers in International Management Research: Innovation, Knowledge Creation, and Change in Multinational Companies. 5. Nicolai J. Foss and Torben Pedersen (2003) The MNC as a Knowledge Structure: The Roles of Knowledge Sources and Organizational Instruments in MNC Knowledge Management CKG Working Paper. 6. Koen H. Heimeriks (2003) Alliance capability as a mediator between experience and alliance performance: An empirical investigation into the alliance capability development process 7. Christian Geisler Asmussen, Torben Pedersen & Charles Dhanaraj (2006) Evolution of Subsidiary Competences: Extending the Diamond Network Model

8. Teppo Felin & Nicolai J. Foss (2006) Individuals and Organizations: Thoughts on a Micro-Foundations Project for Strategic Management and Organizational Analysis 9. Birgitte Grgaard, Carmine Gioia & Gabriel R.G. Benito (2005) An Empirical Investigation of the Role of Industry Factors in the Internationalization Patterns of Firms 10.Bo Bernhard Nielsen and Snejina Michailova (2004) Toward a phasemodel of global knowledge corporations 11.Jens Gammelgaard and Torben Pedersen (2003) Internal versus External Knowledge Sourcing of Subsidiaries - An Organizational Trade-Off. management systems in multinational