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This document contains course content for several subjects related to business and management including Business Policy & Strategic Analysis, Decision Support Systems and MIS, Research Methodology, and International Business Environment. For each subject, it includes the syllabus, content for each unit (I-IV), and past year question papers and worksheets. The content covers topics such as strategic management process, responsibilities of top management, environmental analysis, strategic models, international financial management, foreign exchange markets, and exchange rate determination and risk management.
This document contains course content for several subjects related to business and management including Business Policy & Strategic Analysis, Decision Support Systems and MIS, Research Methodology, and International Business Environment. For each subject, it includes the syllabus, content for each unit (I-IV), and past year question papers and worksheets. The content covers topics such as strategic management process, responsibilities of top management, environmental analysis, strategic models, international financial management, foreign exchange markets, and exchange rate determination and risk management.
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This document contains course content for several subjects related to business and management including Business Policy & Strategic Analysis, Decision Support Systems and MIS, Research Methodology, and International Business Environment. For each subject, it includes the syllabus, content for each unit (I-IV), and past year question papers and worksheets. The content covers topics such as strategic management process, responsibilities of top management, environmental analysis, strategic models, international financial management, foreign exchange markets, and exchange rate determination and risk management.
Drepturi de autor:
Attribution Non-Commercial (BY-NC)
Formate disponibile
Descărcați ca PDF, TXT sau citiți online pe Scribd
C O M P U T E R S CONTENTS BUSINESS POLICY & STRATEGIC ANALYSIS UNIT II.............................................................................................31 - 37 UNIT III............................................................................................38 - 49 UNIT IV............................................................................................50 - 59 Past Year Question Papers................................................................60 - 62 Worksheet..........................................................................................63 - 66 DECISION SUPPORT SYSTEMS AND MIS Syllabus.............................................................................................67 - 67 UNIT I..............................................................................................68 - 77 UNIT II.............................................................................................78 - 86 UNIT III............................................................................................87 - 97 UNIT IV..........................................................................................98 - 104 Past Year Question Papers............................................................105 - 107 Worksheet......................................................................................108 - 110 RESEARCH METHODOLOGY Syllabus..........................................................................................111 - 111 UNIT I..........................................................................................112 - 127 UNIT II.........................................................................................128 - 142 UNIT III........................................................................................143 - 152 UNIT IV........................................................................................153 - 165 Past Year Question Papers............................................................166 - 168 Worksheet......................................................................................169 - 170 INTERNATIONAL BUSINESS ENVIRONMENT Syllabus.........................................................................................171 - 171 UNIT I..........................................................................................172 - 195 UNIT II.........................................................................................196 - 211 UNIT III........................................................................................212 - 242 UNIT IV........................................................................................243 - 251 Past Year Question Papers............................................................252 - 253 Worksheet......................................................................................254 - 256 Syllabus.................................................................................................5 - 5 UNIT I................................................................................................6 - 30 Z A D
C O M P U T E R S Unit - I Business policy as a field of study : Nature and objectives of business policy; strategic management process-vision, mission, establishment of organisational direction, corporate strategy, strategic activation. Unit - II Top management : Constituents-board of directors, sub-commite, chief executive officer; task, responsibilities and skills of top management. UNIT - III Formation of strategy : Nature of companys environment and its analysis; SWOT analysis; evaluating multinational environment; identifying corporate competence and resources; principles and rules of corporate strategy : strategic excellence positions. UNIT - IV Strategic analysis and choice : BCG matrix; stop light strategic model; directional policy matrix model; grand strategy selection matrix; model of grand strategy clusters; behavioural considerations affecting strategic choice; contingency approach to strategic choice. MBA3rd SEMESTER, M.D.U., ROHTAK SYLLABUS External Marks : 70 Time : 3 hrs. Internal Marks : 30 INTERNATIONAL FINANCIAL MANAGEMENT 5 Z A D
C O M P U T E R S Q. Define International Financial Management. What is the nature and scope of International Financial Management? Ans. International Financial Management (IFM) : International financial management deals with the financial decisions taken in the area of international business. IFM helps in taking correct financial decisions so that the maximum gain may be derived from international business. The decisions vary from one mode of international business to another. International financial management covers the study of: Foreign exchange market Exchange rate determination Exchange rate risk and its management MNCs investment decisions International working capital decisions Financing decision of the MNCs International Accounting. Nature and Scope of IFM : It has already been mentioned that IFM is concerned with the financial aspects of international business. It helps in taking the correct financial decision so that the maximum gain may be derived from international business. The nature and scope of IFM are: (1) Modes of International Business : Modes of international business are: (i) Foreign Trade : The oldest mode of international business is foreign trade. A firm imports its necessary inputs from the cheapest source, while it exports its output to different countries in order to earn maximum amount of foreign exchange. In this case, no overseas manufacturing is involved. (ii) Licencing : The other mode of international business is licensing. When a firm lacks capital and detailed knowledge about a foreign market, it allows its technology, patent, trade mark and other proprietary advantages to be used for a fee by a licensee or technology-importing firm. UNIT I FINANCE : SPECIALIZATION PAPERS INTERNATIONAL FINANCIAL MANAGEMENT 6 Z A D
C O M P U T E R S 7 INTERNATIONAL FINANCIAL MANAGEMENT (iii) Management Contracting : The third mode is known as management contracting. In this mode, the company sells abroad a particular resource, like management skills. The contract is meant for a given number of years during which the seller of management skills manages affairs of the company located in the host country for a specific fee. (iv) Joint Ventures : Joint ventures are the fourth mode. They represent a partnership agreement in which the venture is owned jointly by the international company and a company of the host country. Naturally, the joint venture allows the two firms to apply their respective comparative advantages in a given project. (2) Foreign Exchange Market : The study of the foreign exchange market forms an important area of IFM. The importers of goods have normally to pay for the import in convertible currencies which they buy with their own currency. The exporters convert their export proceeds into their own currency. Currency arbitrage is also quite common in the foreign exchange market and since the market is not perfect, the value of a particular currency differs in different market, the arbitrageurs take advantage of this fact. Forward trading is a common feature in the foreign exchange market. It is because hedgers reduce the foreign exchange exposure forward contracts. Speculators make profit out of them. The hedgers take advantage of the market for currency futures and currency options that are important segments of the foreign exchange market. IFM cover the study of the distinguishing features of operation in these different segments of the foreign exchange market. (3) Exchange Rate Determination : The behaviour and determination of exchange rate is another segment of the study of IFM. The question of day-to-day exchange rate determination does not arise in a fixed-rate regime but in a system of floating exchange rate, this question is very important. The rate depends upon the forces of supply and demand that in turn depend upon the macroeconomic variables, such as interest rate, inflation rate, etc. Determination of Exchange Rate : D S S D Z A D
C O M P U T E R S 8 (4) Exchange Rate Risk and Its Management : Changes in exchange rate consequent upon the changes in macroeconomic fundamentals impact international business in the form of gains and losses. The gain or loss arising on account of unanticipated exchange rate changes is known as foreign exchange exposure. Foreign exchange exposure is classified as: (i) Transaction Exposure : Transaction exposure involves changes in the present cash flows, on account of: (a) Export and import of commodities on open account : There are two situations: If a firm has to make payments for imports in a foreign currency and the foreign currency appreciates, the firm will have to incure loss in term of its own currency. Similarly, if an exporter has to receive foreign currency for its export and the foreign currency depreciates, the exporter will have to face loss in terms of its own currency. (b) Borrowing and lending in a foreign currency : The borrower of a foreign currency is put to loss if that particular foreign currency appreciates. (ii) Translation Exposure : Translation exposure, which is also known as accounting exposure, does not involve cash flow. Translation exposure refers to exchange rate risk arising out of the translation of the functional currency into the reporting currency. When a parent company consolidates the financial statements of its subsidaries in order to assess the overall profitability, the change in exchange rate alters the entire scenario. Because of the deeper impact of the exchange rate changes, various tools are applied to hedge such risks. These tools come under the domain of IFM (5) MNCs Investment Decisions : When a company innovates a specific technology and its product is mature in the markets abroad or when the company wants to reap the location advantage in a foreign country, it sets up an affiliate there. Whatever the motivation behind foreign investment or foreign manufacturing, the company evaluates the cash inflow and outflow during the life of the project and makes investment only when the net present value of cash inflows is positive. Besides, it takes into account the foreign exchange risk and the political risk involved. IFM thus studies the Different theories of overseas production The various strategies of Investment Capital Budgeting Decision Evaluation of foreign exchange Political risks pertaining to overseas investment. Z A D
C O M P U T E R S (6) International Working Capital Decisions : When foreign operation begins, the parent company evaluates different sources of working capital so that the cost of financing is the cheapest. In this context, an international company maintains an edge over a domestic company insofar as it can easily reach the international financial market or can siphon resources from one subsidiary to another. When targeting sources of funds, it has also to decide the size of current assets because these facts have a close link with the cost of production and the overall profitability of the firm. IFM helps in taking a correct decision regarding the size of working capital and suggests a mechanism for its management. It also deals with how foreign trade is financed. (7) Financing Decisions of the MNCs : Any investment needs raising of funds. The MNCs take advantage of the many innovations which have taken place in the international financial market, and IFM guides them on how to take advantage of these. It deals with how different instruments are issued to raise funds and how swaps are used for minimizing the cost of funds. The nature and management of interest-rate exposure too form a part of the study of IFM. (8) International Accounting : International accounting forms an integral part of IFM. It analyses the following : (i) Techniques for consolidation of financial statements of the various affiliates (ii) International audit (iii) International financing reporting (iv) International taxation. (v) Transfer pricing Q. Explain the Evolution of International Monetary System. Ans. International Monetary System : International monetary system is defined as a set of procedures, mechanism, processes, and institutions to establish that rate at which exchange rate is determined in respect to other currency. To understand the complex procedure of international trading practice, it is pertinent to have a look at the historical perspective of the financial and monetary system. The whole story of monetary and financial system revolves around exchange rate i.e. the rate at which currency is exchanged among different countries for settlement of payments arising from trading of goods and services. To have an understanding of historical perspectives of international monetary system, firstly one must have a knowledge of exchange rate regimes. Various exchange rate regimes from 1880 to till date at the international level are described as follows: (A) Monetary System before First World War (1880-1914 Era of Gold Standard) : The oldest system of exchange rate was known as Gold Species Standard in which actual currency contained a fixed content of gold. The other version called Gold Bullion Standard, where the basis of money remained fixed gold but the authorities 9 INTERNATIONAL FINANCIAL MANAGEMENT Z A D
C O M P U T E R S were ready to convert, at a fixed rate, the paper currency issued by them into paper currency of another country which is operating in Gold. The exchange rate between pair of two currencies was determined by respective exchange rates against Gold which was called Mint Parity. The main rules were followed with respect to this conversion: The authorities must fix some once-for-all conversion rate of paper money issued by them into gold. There must be free flow of Gold between countries on Gold Standard. The money supply should be tied with the amount of Gold reserves kept by authorities. The gold standard was very rigid and during great depression it vanished completely. (B) The Gold Exchange Standard (1925-1931) : With the failure of gold standard during first world war, a much refined form of exchange regime was initiated in 1925 in which US and England could hold gold reserve and other nations could hold both gold and dollars as reserves. In 1931, England took its foot back which resulted in abolition of this regime. (C) The Gold Exchange Standard ( 1925-1931) : With the failure of gold standard during first world war, a much refined form of exchange regime was initiated in 1925 in which US and England could hold gold reserve and other nations could hold both gold and dollars as reserves. In 1931, England took its foot back which resulted in abolition of this regime. (D) The Bretton Woods Era (1946 to 1971) : To streamline and revamp the war ravaged world economy & monetary system allied powers held a conference in Bretton Woods, which gave birth to two super institutions: (i) International Monetary Fund (IMF) (ii) World Bank (WB) In Bretton Woods modified form of Gold Exchange Standard was set up with the following characteristics: (i) One US dollar conversion rate was fixed by the USA as one dollar = 35 ounce of Gold. (ii) Other member agreed to fix the parities of their currencies vis--vis dollar with respect to permissible central parity with one per cent fluctuation on either side. In case of crossing the limits, the authorities were free hand to intervene to bring back the exchange rate within limits. Mechanism of Bretton Woods : The mechanism of Bretton Woods can be understood with the help of the following illustration and diagram: 10 Z A D
C O M P U T E R S Quantity of Dollars Suppose there is a supply curve SS and demand curve DD for dollars. On OY-axis price of dollar with respect of rupees are shown. Suppose Indian residents start demanding American goods & services. Naturally demand of US Dollar will rise. And suppose US residents develop an interest in buying goods and services from India, it will increase supply of dollars from America. Assume a parity rate of exchange is Rs. 10.00 per dollar. The +1% limits are therefore Rs. 10.10 (Upper Support) and Rs. 9.90 (Lower Support). As long as the demand and supply curve intersect within the permissible rant; Indian authorities will not intervene. Suppose demand curve shifts towards right due to a shift in preference of Indian towards buying American goods and the market determined exchange rate would fall outside the band, in this situation, Indian authorities will intervene and buy rupees and supply dollars to bring back the demand curve within permissible band. The vice-versa can also happen. During Bretton Woods regime American dollar became international money while other countries needed to hold dollar reserves. US could buy goods and services from her own money. The confidence of countries in US dollars started shaking in 1960s with chronological events which were political and economic and on August 15, 1971 American abandoned their commitment to convert dollars into gold at fixed price of $35 per ounce, the currencies went on float rather than fixed. Though Smithsonian Agreement. (E) Current Scenario of Exchange Rate Regime : At present IMF categories different exchange rate mechanism as follows: (i) Currency Board Agreement : In this regime, there is a legislative commitment to exchange domestic currency against a specified at a fixed rate. As of 1999, eight members had adopted this regime. 11 INTERNATIONAL FINANCIAL MANAGEMENT D1 D S Rs./$ 10.10 Upper Support Parity 10.00 9.90 Lower Support D1 S D Z A D
C O M P U T E R S (ii) Conventional Fixed peg arrangement : This regime is equivalent to Bretton Woods in the sense that a country pegs its currency to another or to a basket of currencies with a band variation not exceeding + 1% around the central parity. Upto 1999, thirty countries had pegged their currencies to a single currency while fourteen countries to a basket of currencies. (iii) Pegged Exchange Rates within Horizontal Bands : In this regime, the variation around a central parity is permitted within a wider band, it is a middle way between a fixed peg and floating peg. Upto 1999, eight countries had this regime. (iv) Crawling Peg : Here also a currency is pegged to another currency or a basket of currencies but the peg is adjusted periodically which may be pre-announced or discretion based or well specified criterion. Sixty countries had this type of regime in 1999. (v) Crawling Bands : the currency is maintained within a certain margin around a central parity which crawls in response to certain indicators. Upto 1999, nine countries enjoyed this regime. (vi) Managed Float : In this regime, central bank interferes in the foreign exchange market by buying and selling foreign currencies against home currencies without any commitment. Twenty five countries have this regime as in 1999. (vii) Independent Floating : Here exchange rate is determined by market forces and central bank only act as a catalyst to prevent excessive supply of foreign exchange and not to drive it to a particular level. Including India, in 1999, forty eight countries had this regime. Q. Explain the evolution of International Financial System. Ans. Evolution of International Financial System : International financial system consists of international financial market, international financial intermediaries and international financial instruments. It is divided into three sections: (A) International Financial Markets : International financial market can be compartmentalized into two segments: (1) International Money Market : One is the international money market represented by the flow of short term funds. International banks or short term securities come under this segment. (2) International Capital Market : On the other hand, the international capital market forms the other segment where medium and long term fund flow. 12 Z A D
C O M P U T E R S (B) International Financial Institutions : International Financial Institutions Official Sources Non-Governmental Agencies (a) Multilateral Agencies (a) International Banks (b) Bilateral Agencies (b)Securities Market (1) Official Sources : Official sources include: (a) Multilateral Agencies : Up to the mid-1940s, there was no multilateral agency to provide funds. (i) Establishment of IBRD : It was only in 1945 that the International Bank for reconstruction and Development (IBRD) was established as an outcome of the Bretton Woods conference. It provided loans for reconstruction of the war ravaged economies of Western Europe and then also started developmental loans in 1948. The IBRDs function was limited to lending and so the provision of equity finance lay beyond its scope. Moreover, it lent only after the guarantee by the borrowing government. (ii) Establishment of IFC : Thus, in order to overcome these problems, the International Finance Corporation (IFC) was established in 1956 to provide loans even without government guarantee and also provided equity finance. However, one problem remained to be solved. It was regarding the poorer countries of the developing world, which were not in a position to utilize the costly resources of the IBRD, because those funds were carrying the market rate of interest. (iii) Establishment of IDA : Another sister institution was created in 1960 for these countries and it was named the International Development Association (IDA). The two institutions-IBRD and IDA together came to be known as the World Bank. (iv) Establishment of MIGA : Multilateral Investment Guarantee Agency (MIGA) was established in 1980s in order to cover the non-commercial risks of foreign investors. (b) Bilateral Agencies : The history of bilateral lending is not older than that of multilateral lending. During the first half of the twentieth century, funds flowed from the empire to its colonies for meeting a part of the budgetary deficit of the colonial government. But it was not a normal practice. Nor was it ever considered as external assistance, as it is in the present day context. Bilateral 13 INTERNATIONAL FINANCIAL MANAGEMENT Z A D
C O M P U T E R S economic assistance was announced for the first time by the US President Truman in January 1951. In fact, the motivation behind the announcement was primarily political and economic. The cold war between the United States of America and the then Union of Soviet Socialist Republic was at its peak during this period. The US government tried to befriend developing countries and bring them into it own camp in order to make itself politically more powerful. It could help the US economy to come closer to developing economies and also to get the desired raw material and food stuffs from them. The economic assistance could help build the infrastructural facilities in the developing countries, which could in turn help increase US private investment in those countries. In the second half of 1950s, the then USSR bloc too announced its external assistance programme in order to counter the US move. (2) Non-Government Agencies : Non-government agencies include: (1) International Banks : Among the non-official funding agencies, international banks occupy the top position. If one looks at their development since 1950s, distinct structural changes are evident. In the first half of the twentieth century and till the late 1950s, international banks were primarily domestic banks performing the functions of international banks. This means that they operated in foreign countries, accepting deposits from and making loans to, the residents in the host countries. They dealt in the currency of the host countries, but at the same time, they dealt in foreign currency, making finance available for foreign trade transactions. (2) International Securities Market : International Securities Market id divided into two parts: (i) Debt Securities (ii) Equities. (C) International Financial Instruments : Funds are raised from the international financial market also through the sale of securities, such as international equities or euro-equities, euro bonds, medium term and short term euro notes and euro commercial papers etc. Types of International Financial Instruments : There are basically three types of International Financial Instruments: (A) Long Term Instruments (B) Medium-Term Instruments (C) Short-Term Instruments Q. Define International Financial Instruments. Explain its types. Ans. International Financial Instruments : Funds are raised from the international financial market also through the sale of securities, such as international equities or euro- equities, euro bonds, medium term and short term euro notes and euro commercial papers etc. 14 Z A D
C O M P U T E R S Types of International Financial Instruments : There are basically three types of International Financial Instruments: (A) Long Term Instruments (B) Medium-Term Instruments (C) Short-Term Instruments Types of International Financial Instruments can be presented with the help of following diagram: Types of International Financial Instruments Long-Term Medium-Term Short- Term Instruments Instruments Instruments Medium-Term Euro Notes International International Euro Euro Commercial Equities Bonds Notes Papers Foreign Bonds Global Straight Floating Convertible And Euro Bonds Bonds Bonds Rate Bonds Bonds (A) Long-Term Instruments : Long-term international financial instruments are: (1) International Equities OR Euro Equities : International equities or euro-equities are not debts as holder are paid dividend. They do not represent FDI as the holders do not enjoy voting rights. They represent a mixture of the two and, hence, are in great demand. (i) They are issued when the domestic market is already flooded with shares and the issuing company would not like to add further stress to the domestic stock of shares since such additions may cause a fall in share prices. (ii) Companies issue such shares for gaining international recognitions. (iii) Such issues bring in scarce foreign exchange. (iv) Capital is available at lower cost (v) Funds raised this way do not add to foreign exchange exposure. 15 INTERNATIONAL FINANCIAL MANAGEMENT Z A D
C O M P U T E R S Features of International Equities : (i) Investor gets the dividend and not the interest as in case of debt instruments. (ii) On the other hand, it does not have the same pattern of voting right that it does have in the case of foreign direct investment. (iii) International equities are a compromise between the debt and the foreign direct investment. (iv) International equities are presently on the preference list of the investors as well as the issuers. (2) International Bonds Or Euro Bonds : International bonds are a debt instrument. International bonds may take many forms. They are issued by international agencies, governments and companies for borrowing foreign currency for a specified period of time. The issuer pays interest to the creditor and makes repayment of capital. Types of International Bonds : There are different types of such bonds: (a) Foreign Bonds and Euro Bonds: International Bonds are classified as foreign bonds and Euro bonds. (i) Foreign Bonds : In case of foreign bond, the issuer selects a foreign financial market where the bonds are issued in the currency of that country. Foreign bonds are underwritten normally by the underwriters of the country where they are issued. (ii) Euro Bonds : In case of euro bonds, bonds are denominated in a currency other than the currency of the country where the bonds are issued. Euro bonds are underwritten by the underwriter of multi-nationally. (b) Global Bonds : It is the World Bank which issued the global bonds for the first time in 1989 and 1990. Since 1992, such bonds are being issued also by companies. Presently, there are seven currencies in which such bonds are denominated namely: Australian Dollar Canadian Dollar Japanese Yen DM Finnish Markka Swedish Krona and Euro Features of Global Bonds: (i) They carry high ratings (ii) They are normally large in size (iii) They are offered for simultaneous placement in different countries 16 Z A D
C O M P U T E R S (c) Straight Bonds : The straight bonds are the traditional type of bonds. In this case, interest rate if fixed. The interest rate is known as coupon rate. The credit standing of the borrower is also taken into consideration for fixing the coupon rate. Straight bonds are of many varieties: (i) Bullet-Redemption Bond : In Bullet-Redemption bond the repayment of principal is made at the end of the maturity and not in installment every year. (ii) Rising-Coupon Bond : In rising coupon bond, the coupon rate rises over time. The benefit is that the borrower has to pay small amount of interest payment during early years of debt. (iii) Zero-Coupon Bond : It carries no interest payment. But since there is no interest payment, it is issued at discount and redeemed at par. It is the discount that compensates for the loss of interest faced by the creditors. Such bonds was issued for the first time in 1981. (iv) Bonds with Currency Options: In case of bonds with currency options, the investor has the right to received payments in a currency other than the currency of the issue. (v) Bull and Bear Bonds: The bull bonds are those where the amount of redemption rises with a rise in the index. The bear bonds are those where the amount of redemption falls with a fall in the index. (d) Floating-Rate Notes: Bonds, which do not carry fixed rate of interest, are known as floating rate notes (FRNs).Such bonds were issued for the first time in Italy during 1970 and they have become common in recent times. (e) Convertible Bonds: International bonds are also convertible bonds meaning that these bonds are convertible into equity shares. Some of the convertible bonds have detachable warrants involving acquisition rights. In other cases, there is automatic convertibility into a specified number of shares. Convertible bonds command a comparatively high market value because of the convertibility privilege. (B) Medium-Term Instruments : (1) Medium-Term Euro Notes : Medium-term Euro notes are just an extension of short- term euro notes. They are a compromise between short-term euro notes and long- term euro bonds as their maturity between one year and five to seven years. Every three or six months, the short-term euro notes are redeemed and a fresh issue is made. Alternatively, a medium-term Euro note is issued to get medium-term funds in foreign currency without any need for redemption and fresh issue. Medium-term euro notes are not underwritten, yet there is provision for underwriting. This is for ensuring the borrowers that they get the funds even if they lack sufficient creditworthiness. They are issued broadly on the pattern of US medium-term notes that are found there since early 1970s. Medium-term euro notes carry fixed rate of interest, although floating rates are also there. 17 INTERNATIONAL FINANCIAL MANAGEMENT Z A D
C O M P U T E R S (C) Short-Term Instruments: Short-term Instruments are: (1) Euro Notes: Euro notes are like promissory notes issued by companies for obtaining short-term funds. They emerged in early 1980s with growing securitization in the international financial market. Features of Euro Notes: (i) They are denominated in any currency other than the currency of the country where they are issued. (ii) They represent low cost funding route. (iii) Documentation facilities are the minimum. (iv) They can be easily tailored to suit the requirements of different kinds of borrowers. (v) Investors too prefer them in view of short maturity. (vi) When the issuer plans to issue euro notes, it hires the services of facility agents or the lead arranger. On the advice of the lead arranger, it issues the notes, gets them underwritten and sells them through the placement agents. After the selling period is over, the underwriter buys the unsold issues. Cost Components : The cost components of euro notes are: (i) Underwriting Fee (ii) One-time Management Fee for structuring, pricing and documentation. (iii) Margin in the notes themselves. Documentation : Documents accompanying these notes are the (i) Underwriting agreement (ii) Paying Agency Agreement (iii) Information Memorandum (iv) Financial Position of the Issuer. (2) Euro Commercial Papers (ECP): Another attractive form of short-term debt instrument that emerged during mid 1980s cam to be known as Euro Commercial Paper (ECP). It is a promissory note like the short-term euro notes but it is different from euro notes in that it is not underwritten and also it is issued by highly creditworthy borrowers. Features : The main features of Euro Commercial Papers are: (i) It is not underwritten because it is issued only by those companies that possess a high degree of rating. (ii) ECPs came up on the pattern of domestic market commercial papers that had a beginning in the USA and then in Canada as back as in 1950s. (iii) ECPs face minimal documentation. 18 Z A D
C O M P U T E R S 19 Q. What do you mean by Cash? What are the motives of holding cash? Ans. Cash : For the purpose of cash management, the term cash not only includes coins, currency, notes, cheques, bank drafts, demand deposits with banks but also the near-cash assets like marketable securities and time deposits with banks because they can be readily converted into cash. For the purpose of cash management, near-cash assets are also included under cash because surplus cash is required to be invested in near-cash assets for the time being. Motives of Holding Cash : In every business assets are kept because they generate profit. But cash is an asset which does not generate any profit itself, yet in every business sufficient cash balance is maintained. There are four primary motives or causes for maintaining cash balances: (1) Transaction Motive : A number of transactions take place in every business. Some transactions result in cash outflow such as payment for purchases, wages, operating expenses, financial charges like interest, taxes, dividends etc. Similarly, some transactions result in cash inflow such as receipt from sales, receipt from investment, other incomes etc. But the cash outflows and inflows do not perfectly match with each other. At times, inflows exceed outflows while, at other times outflows exceed inflows. To meet the shortage of cash in situation when cash outflows exceed cash inflows, the business must have an adequate cash balance. (2) Precautionary Motive : In every business, some cash balance is kept as a precautionary measure to meet any unexpected contingency. These contingencies may contingencies may include the following: (i) Floods, strikes and failure of important customers. (ii) Unexpected slow down in collection from debtors. (iii) Cancellation of orders by customers. (iv) Sharp increase in cost of Raw-materials. (v) Increase in operating costs etc. UNIT II FINANCE : SPECIALIZATION PAPERS INTERNATIONAL FINANCIAL MANAGEMENT Z A D
C O M P U T E R S 20 (3) Speculative Motive : In business, some cash is kept in reserve to take advantage of profitable opportunities which may arise from time to time. These opportunities are: (i) Opportunity to purchase raw material at low prices on payment of immediate cash. (ii) Opportunity to purchase other assets for the business when their prices are low. (iii) Opportunity to purchase other Assets for the business when their prices are low. (4) Compensative Motive : Banks provide a number of services to the business such as clearance of cheques, supply of credit information about other customers, transfer of fund and so on. Bank charge commission or fee for some of these services. For other services, banks do not charge any commission or fee they require indirect compensation. For this purpose, bank requires the client to maintain a minimum balance in their accounts in the bank. The clients cannot use this bank balance & banks compensate the cost of providing free services by using this amount to earn a return. Therefore, cash is also kept at the bank to compensate for free services by banks to the business. Q. Describe the different steps involved in International Cash Management. Ans. International Cash Management : After raising funds, the firm begins operation. During operations, an optimum cash balance is maintained so as to ensure adequate liquidity without impinging upon profitability. In an international firm, management of cash is a complex task in view of intra-firm transfers of cash and the restrictions imposed on them by the home and the host governments. Steps Involved in International Cash Management : The management of cash basically involves four steps. They are: (A) Assessment of the Cash Requirements (B) Optimization of cash need, by restructuring inflows and outflows. (C) Selection of sources from where cash could be brought in (D) Investment of surplus cash, if any, into near-cash assets. (A) Assessment of the Cash Requirements : The first step in international cash management is to establish the need for cash during a specific period, which may be a week, a fortnight, or a month. It is computed on the basis of the expected amount of cash disbursement vis--vis expected inflow of cash during a particular period. The outflow and inflow of cash occurs mainly on account of various transactions. The firm holds cash also to meet precautionary and speculative needs, but such needs are fixed and the amount of cash for these purposes is determined on the basis of experience and the general trend of the business environment. Steps involved in Assessment of Cash Needs: (1) A cash budget is prepared for each subsidiary. Z A D
C O M P U T E R S 21 INTERNATIONAL FINANCIAL MANAGEMENT (2) After assessing the cash need of each of the subsidiaries, the figures are consolidated in order to assess the cash need of the firm as a whole. It is because in a multinational enterprise, it is the cash flow of the firm as a whole that is taken into account and which needs to be managed. (B) Optimization of Cash Needs : After the preparation of Cash Budget and the estimation of the cash requirements, the firm needs optimization of cash level at different units. It can be done in three ways. (1) Intra-firm Transfer of cash : When a particular unit faces a shortage of cash, it gets it from a cash surplus unit, may it be the parent unit or any other sister subsidiary. It may raise funds from outside the firm if outside funds are cheaper and easier than the intra- firm flow of cash in view of governmental restrictions on such flows. However, the unit often prefers intra-firm transfer of cash in view of the fact that the surpluses of the other units are utilized. This is perhaps why funds are transferred from one unit to the other. The modes are: (i) Transfer Pricing (ii) Leads and Lags (iii) Parallel Loans (iv) Changes in the rates of royalty. (v) Dividend and so on. (2) Accelerating Inflows and Delaying Outflows : (i) Accelerating Inflows : There are two types of delays in the collection of cash. One is the mailing delay and the other is the processing delay. In collection from across the border, long procedural formalities and governmental restrictions too come in the way. For accelerating inflows following methods are used: (a) Cable Remittances : As regards curbing of mailing delay, the use of cable remittances is often suggested. In this respect, the Society for Worldwide Inter- bank Financial Telecommunications (SWIFT) is doing a commendable job. It has brought into its fold around one thousand banks among which funds are transferred electronically with ease. (b) Establishment of Collection Centres : The firm opens up regional mobilization centres and instructs customers to make their payments to the centres falling in their respective vicinity. (c) Lock- Box System : Sometimes, a postal box are set up in post-offices within customers vicinity. The postal box is operated by the local offices of the bank authorized by the firm. (d) Reduction of Processing Delay : As far as processing delay is concerned, there are some multinational banks that provide same-day-value facilities. Under this facility, the amount deposited in any branch of the bank in any country is credited to the firms account on the same day. This is done through electronic devices. Thus, it is suggested that the firm should take help from such banks to cut short processing delays. Z A D
C O M P U T E R S 22 (e) Pre-Authorised Payment System : Some firms adopt a pre-authorised payment system in which they are authorized to charge a customers bank account up to a specific limit. (ii) Delaying Outflows : Payment should be made as late as possible without damaging the goodwill and credit rating of the firm. There are certain techniques to slow the disbursement: (a) Avoidance of early payments : One way to slow disbursements is to avoid early tpayments. The firm should not be made before or after due date. (b) Centralized Disbursement : Another way to slow down disbursements is to make all he payments by the head office from the centralized account. This system increase the time gap between remittances are made locally by the branches, it will take lesser time to reach the creditors by post. Since accelerating cash inflow and decelerating disbursements involve additional cost, it is advisable for the company to follow them as long as their marginal returns exceed their marginal cost. (3) Netting of Intra-firm Payments : Another step towards lessening the requirements for cash at a particular point of time is to encourage netting of intra-firm payments. There is usually a large volume of intra-firm payments. Such payments required not only a huge amount of cash, but also transaction cost, inter currency conversion cost, and opportunity cost of float. The different units of a firm require cash not only for making payments but also for meeting such costs. Netting is a solution to this problem. Netting is in fact the elimination of counter payments. This means that only net amount is paid. Example : If the parent company is to receive US$ 3.0 million from its subsidiary and if the same subsidiary is to get US$ 1.0 million from the parent company, these two transactions can be netted to one transaction, where the subsidiary will transfer US$ 2.0 million to the parent company. The cost of transfer too will be lower. Netting can be bilateral, involving two units. It may be multilateral, involving more than two units. Example : Suppose A, B, and C are the three units of a firm. A has to receive US$ 15.0 million from B and US$ 12.0 million from C. B has to receive US$ 20.0 million from C and US$ 20.0 million from A. C has to receive US$ 30.0 million from A and US$ 6.0 million from B. In the absence of netting, there will be 6 transactions involving US$ 103 million. If it is bilateral netting, there will be three transactions involving US$37.0 million. If it is multilateral netting, there will be only two transactions involving only US$ 23.0 million. Netting of payments can be shown with the help of following presentation: Z A D
C O M P U T E R S A B C 15 20 6 30 20 12 23 INTERNATIONAL FINANCIAL MANAGEMENT (i) No Netting: (ii) Bilateral Netting: (iii) Multilateral Netting: Problems with the Cash Optimization Process : The problems coming in the way of accelerating and decelerating of cash flows or the netting process may be grouped as: (1) Firm-Related Problems: When a multinational enterprise has a large number of subsidiaries and there is large fluctuation in host country currencies, the acceleration or deceleration of cash flows or netting of payments will turn out to be complicated. (2) Government Restrictions: There are many host government that practice exchange control mechanism in view of their weak balance of payments. The parent companys decision to accelerate or decelerate cash flows of a subsidiary or to net the payments cannot be carried out unless the government of the host country permits such actions. A B C 5 14 18 A B C 19 4 Z A D
C O M P U T E R S 24 (3) Deficiency in the Banking System: There are still a number of international banks that have not developed sophisticated system of collections and payments. In these cases, acceleration of collection and netting of payments cannot be effective. (4) Opposition by Subsidiaries: The acceleration or deceleration of cash flows may be beneficial for one unit or one firm, but it may not be beneficial for the other unit or another firm. In such cases, the subsidiaries or firms that are at loss resent such a move. (C) Selection of Sources from where cash could be brought in (D) Investment of Surplus Cash : The cash balance for precautionary and speculative purposes is fixed and so it is held in the form of near-cash assets. Surplus cash in excess of transaction purpose too is held in the form of near-cash assets or short-term marketable securities. The reason is that near-cash assets earn for the firm and are definitely preferable to an idle cash balance. In this context, a few questions need to be probed. They are: (1) Should the surplus cash balance of the entire firm centralized and only then invested? (2) How much of the surplus cash balance should be invested in near-cash assets? (3) Which currency should be preferred for investment? (1) Centralization of Surplus Cash : The process of centralization of surplus cash can take two forms. One is the centralized control of the parent company over the surplus cash of different units. In this case, cash does not actually move to a centralized pool, but its movement to a cash-deficit unit or for investment in near-cash assets is strictly guided by the parent company. The other form manifests in the actual movement of cash to a centralized pool. Any investment in near-cash assets take place only out of the centralized pool. (2) How much of the Surplus to be invested : Surplus cash should not lie idle. It should be invested. The larger the investment, the greater the interests earned, but at the same time the great risk is illiquidity. Lower the investment, liquidity will improve but earning on the investment will be lower. Thus, an optimal division of funds between cash and near-cash assets requires a tradeoff between liquidity and profitability. While making an investment in near-cash assets, the international finance manager has to take care of a number of facts, of which the following are important: (a) Portfolio should be diversified so as to maximize yield for a given level of risk. (b) The portfolio should be reviewed daily so as to decide which particular investment has to be liquidated or which particular securities should remain undistributed. (c) Investment should only be made in assets where liquidity prevails. Z A D
C O M P U T E R S 25 INTERNATIONAL FINANCIAL MANAGEMENT (d) The maturity structure of investment should coincide with the need for cash so that securities can be easily converted back into cash whenever the need for fresh cash arises. (3) Currency of Investment : Normally, the surplus cash is invested in a country where the interest rate is higher. However, the answer is not so simple. In fact, the firm has to take into account the effective yield/return that depends not simply on the rate of interest but also on the changes in the exchange rate. If the currency of the country where the funds are invested depreciates vis--vis the home-country currency, the return in terms of home country currency will be lower. More often, a firm makes multiple-currency investments and reaps the benefit of diversification. Q. Explain International Receivable Management. Ans. Introduction : Credit sales lead to the emergence of account receivables. The management of receivables focuses on two important facts. One is that the cost of the credit sale should not exceed the benefit from the credit sales. The other is whether the sale is confined within different units of the firm or it is an inter-firma sale. Meaning of Receivable Management : The term receivables refers to debt owed to the firm by the customers resulting from sale of goods or services in the ordinary course of business. These are the funds blocked due to credit sales. Receivables are also called as trade receivables, accounts receivables, book debts, sundry debtors and bills receivables etc. Management of receivables is also known as management of trade credit. Motives of Maintaining Receivables : (i) Sales Growth Motives:- The main objectives of credit sales is to increase the total sales of the business. On being given the facility of credit, customers have shortage of cash may also purchase the goods. Therefore, the prime motive for investment in receivables is sales growth. (ii) Increased profit Motive:- Due to credit sales, the total sales of business increases. Thus, in turn, results in increase in profits of the business. (iii) Meeting Competition Motive:- In business, goods are sold on credit to protect the current sales against emerging competition. If goods are not sold on credit, the customers may shift to the competitors who allow credit facility to them. Costs of Investment in Receivables : When a firm sells goods or services on credit, it has to bear several types of costs. These costs are as follows:- (i) Administrative Cost : To record the credit sale and collections from customers, a separate credit department with additional staff, accounting records, stationery etc is needed. Expenses have also to be incurred on acquiring information about the credit worthiness of the customers. Z A D
C O M P U T E R S 26 (ii) Capital Cost : There is a time lage between sale of goods and its collection from customers. In that time period, the firm has to pay for purchases, wages, salary and other expenses. Therefore, the firm needs additional funds which may arrange either from external sources or from retained earnings. Both of these sources involve cost. If funds are arranged from external sources, interest has to be paid. On the other hand, if retained earnings are used for this purpose, the firm has to bear opportunity cost. Opportunity cost means the income which could have been earned by investing this amount elsewhere. (iii) Collection Cost : These are the expenses incurred by the firm on collection from the customers after expiry of the credit period. (iv) Default Cost : Despite all efforts by the management, the firm may not be able to recover full amount due from the customers. Such dues are known as bad debts or default cost. Management of Receivables : Thus the appropriate policy of managing account receivables should be that a firm extends credit only upto a point where the marginal profits on its increased sale are equal to the marginal cost of receivables. Since the benefit and cost are dependent on the terms of credit, a firm has to determine optimal terms of credit. In order to determine how much liberal the credit terms should be, it prepares a proforma income statement based on different terms and adopts a particular term where the net profit is the highest. Management of receivables is divided into two parts: (1) Intra-Firm Sales : In case of intra-firm sales, the focus of receivable management is not on the quantum of credit sale or on the timing of payment but on the global allocation of firms resources. There are the following steps taken: (i) There is often vertical integration among different units located in different countries. Different parts of the same product are manufactured in different units and exported to the assembly unit. In such cases, the size of receivables is very large. (ii) Early payment or the late payment does not matter because the seller and the purchases represent the same firm. (iii) A particular unit may delay the payment if it is suffering from cash shortage. (iv) The payment may be quickly if the unit has surplus of cash. However, if a unit of the firm is located in a weak-currency country, it is asked to make a quick payment so that the cost of receivables borne by the firm as a whole may not be large. (2) Inter-Firm Sales : In the case of inter-firm sales or the sales to an outside firm, a couple of decisions are involved. One is about the currency in which the transaction should be denominated, while the other is about what the terms of payment should be. Z A D
C O M P U T E R S 27 INTERNATIONAL FINANCIAL MANAGEMENT (i) Currency Denomination : As regards currency denomination, the exporter likes to denominate the transaction in a strong currency, while the importer likes to get it denominated in weak currency. In such a situation, it is the question of bargaining. However, the exporter may be ready to invoice the transaction in the weak currency even for a long period of credit if it has debt in that currency. It is because the sale proceeds can be used to retire the debt without any loss on account of exchange rate changes. (ii) Terms of Payment : As regards the terms of payment, the exporter does not provide a longer period of credit and tries to get the export proceeds as early as possible if the transaction is invoiced in a weak currency. But sometimes, there is found deviation from this simple norm. The credit term may be liberal if the exporter is able to borrow from the bank on the basis of bill receivables and not on the basis of actual inventory. Again, the term of credit may be liberal also in cases where competition in the market is tough. Q. Define Securitization of Receivables. Explain its process. Ans. Meaning of Securitization : Securitization is the process of pooling and repackaging of homogeneous illiquid financial assets into marketable securities that can be sold to investors. In other words, securitization is the process of transforming assets into securities. The process leads to the creation of financial instruments that represent ownership interest in, or are secured by a segregated income producing asset or pool, of assets. The pool of assets collateralizes securities. These assets are generally secured by personal or real property such as automobiles, real estate, or equipment loans but in some case are unsecured for example, credit card debt and consumer loans. Securitization Process : The securitization process is listed below: (1) Asset are originated through receivables, leases, housing loans or any other form of debt by a company and funded on its balance sheet. The company is normally referred to as the originator. (2) Once a suitably large portfolio of assets has been originated, the assets are analysed as a portfolio and then sold or assigned to a third party, which is normally a special purpose vehicle company (SPV) formed for the specific purpose of funding the assets. It issues debt and purchases receivables from the originator. (3) The administration of the asset is then subcontracted back to the originator by the SPV. It is responsible for collecting interest and principal payments on the loans in the underlying poolt of assets and transfer to the SPV. (4) The SPV issues tradable securities to fund the purchase of assets. The performance of these securities is directly linked to the performance of the assets and there is no resource back to the originator. Z A D
C O M P U T E R S Obligor Ancillary Service Provider Interest and Principal Issue of Securities Originator Special Purpose Vehicle Investors Subscription of Securities Credit rating of Securities Rating Agency Structure 28 (5) The investors purchase the securities because they are satisfied that the securities would be paid in full and on time from the cash flows available in the asset pool. The proceeds from the sale of securities are used to pay the originator. (6) The SPV agrees to pay any surpluses which, may arise during its funding of the assets, back to the originator. Thus, the originator, for all practical purposes, retains its existing relationship with the borrowers and all of the economies of funding the assets. (7) As cash flow arise on the assets, these are used by the SPV to repay funds to the investors in the securities. Graphic Presentation of Securitization Process : Parties to a Securitization Transaction : (1) Originator: This is the entity on whose books the assets to be securitized exist. It sells the assets on its books and receives the funds generated from such sale. Z A D
C O M P U T E R S 29 INTERNATIONAL FINANCIAL MANAGEMENT (2) SPV: An issuer, also known as the SPV, is the entity, which would typically buy the assets to be securitized from the originator. (3) Investors: The investors may be in the form of individuals or institutional investors, and so on. They buy a participating interest in the total pool of receivables and receive their payment in the form of interest and principal as per agreed pattern. (4) Obligors: the obligors are the original debtors. The amount outstanding from an obligor is the asset that is transferred to an SPV. (5) Rating Agency: Since the investors take on the risk of the asset pool rather than the originator, an external credit rating plays an important role. The rating process would assess the strength of the cash flow and the mechanism designed to ensure full and timely payment by the process of selection of loans of appropriate credit quality, the extent of credit and liquidity support provided and the strength of the legal framework. (6) Administrator or Servicer: It collects the payment due from the obligors and passes it to the SPV, follows up with delinquent borrowers and pursues legal remedies available against the defaulting borrowers. Since it receives the installment and pays it to the SPV, it is also called the Receiving and Paying Agent. (7) Structure: Normally, an investment banker is responsible as structure for bringing together the originator, the credit enhancers, the investors and other partners to a securitization deal. It also works with the originator and helps in structuring deals. Z A D
C O M P U T E R S 30 Q. What is Foreign Direct Investment. What are the benefits and costs of Foreign Direct Investment? Ans. Foreign Direct Investment (FDI) : Foreign investment takes two forms. One is foreign portfolio investment, the other is Foreign Direct Investment. Foreign direct investment is very much concerned with the operation and ownership of the host country firm. The very beginning of the overseas operation of the MNCs is represented by foreign direct investment comprising investment for establishment of a new enterprise in foreign country either as a branch or as a subsidiary, expansion of an overseas branch or subsidiary, and acquisition of overseas business enterprises. Whenever an MNC decides to make foreign direct investment, it confronts a host of questions: (i) What are the motivating factors behind such a move? (ii) What should be the mode of investment? (iii) Which country should it move to? (iv) Is the project viable in terms of cash flow? (v) How much is the risk involved in the operation? Types of Foreign Direct Investment : There are four classification of FDI: (1) Green-field Investment : Green-field investment takes place either through opening of branches in a foreign country or through foreign financial collaborations-meaning investment in equity capital of a foreign company, in the majority of cases a newly established one. Green-field investment are may be of three: (i) Wholly-Owned Subsidiary of the Buying firm : If the firm buys the entire equity shares in a foreign company, it is known as the Wholly-owned subsidiary of the buying firm. (ii) Subsidiary of the Buying firm : If the firm buys more than 50 per cent shares, it is known as Subsidiary of the buying firm. (iii) Equity Alliance : If the firm buys less than 50 per cent, it is known simply as an equity alliance. UNIT III FINANCE : SPECIALIZATION PAPERS INTERNATIONAL FINANCIAL MANAGEMENT Z A D
C O M P U T E R S 31 INTERNATIONAL FINANCIAL MANAGEMENT (2) Mergers & Acquisition ( M & As) : Mergers and acquisitions are either outright purchase of running company abroad or an amalgamation with a running foreign company. Forms of Mergers & Acquisition: (i) Based on corporate structure: Acquisition Amalgamation (ii) Based on financial relationship: Horizontal Vertical Conglomerate (iii) Based on technique: Hostile Friendly (3) Brown-Field Investment : The term brown field investment is used to denote a combination of green-field and M & As. It is found in cases when a firm acquires another firm; and after the acquisition, it completely replaces the plant and equipment, labour and product line. (4) Horizontal FDI : Horizontal FDI is said to exist when a firm invests abroad in the same operation/industry. Suzukis investment in India to manufacture cars is an example of Horizontal FDI. (5) Vertical FDI : Vertical FDI is said to exist when a firm invests abroad in other operations wither with a view to have control over the supply of inputs or to have control over marketing of its product. British Petroleum and Royal Dutch Shell have invested abroad in the production of oil. (6) Classification on the basis of motives of the MNCs : Based on the motives of the MNCs, FDI mat be classified as: (a) Market-seeking FDI: Market-seeking FDI moves to a country where per capital income and the size of the market are large. (b) Resource-seeking FDI: The resource-seeking FDI flows to a host country where raw material and manpower are available in abundance. (c) Efficiency-seeking FDI: The efficiency-seeking FDI moves to a country where the abundance of resources and presence of large market help MNCs to improve their efficiency. Z A D
C O M P U T E R S 32 Benefits and Costs of FDI : When direct investment flows from one country to another, it creates benefits both for the home country and the host country. At the same time, it involves some costs too. Thus, when a firm decides to make FDI, it takes into consideration the benefits and costs to be accrued, not only to its home country but also to the host country. Benefits to the Host Country : (1) Availability of Scarce Factors of Production : FDI helps attain a proper balance between different factors of production through supply of scarce factors and fosters the pace of economic development. FDI brings in capital (scarce foreign exchange), skilled personnel, strategic raw material and improved technology. FDI brings in scarce foreign exchange, which activates the domestic savings that would not have been put into investment in the absence of foreign exchange availability. Sometimes FDI is accompanied by labour forces that performs jobs that the local labour force is either not willing to do or is incapable of doing on account of lack of desired skill. Besides, foreign investors make available raw material and improved technology. (2) Improvement in the Balance of Payments : FDI helps improve the balance of payments of the host country. The inflow of investment is credited to the capital account. At the same time, the current account improves because FDI helps either import substitution or export promotion. The host country is able to produce items that were being imported earlier. FDI is able to augment export because foreign investors bring in the knowledge of exporting mechanics and of foreign markets. They bring in improved technology to produce goods of international standards and at lower cost. They possess a world-reputed brand bane, which is helpful in promoting export. They are more capable of availing export credits from the cheapest source in the international financial market. (3) Building of Economic and Social Infrastructure : When foreign investors invest in sectors such as basic economic infrastructure, social infrastructure, financial markets, and marketing system, the host country is able to develop a support system that is required for rapid industrialisation. Even if there is nor investment in these sectors, the very presence of foreign investors in the host country creates a multiplier effect. A support system develops automatically (4) Fostering of Economic Linkages : Foreign firms have forward and backward linkages. They make demand for various inputs, which in turn helps develop input supplying industries. They employ labour force, which helps raise the income of employed people, which in turn raises the demand and industrial production in the country. In all, the total investment in the host country increases by more than the amount of FDI. (5) Strengthening of Government Budget : Foreign firms are a source of tax income for the government. They pay not only income tax but also the tariff on their import. At the same time they help reduce governmental expenditure requirements through supplementing the governments investment activities. Z A D
C O M P U T E R S 33 INTERNATIONAL FINANCIAL MANAGEMENT Benefits for Home Country : FDI benefits the home country too. (1) Increases the Supply of Raw material : The country gets the supply of necessary raw material if the investor makes investments in the exploration of a particular raw material. (2) Improvement in the Balance of Payments : The balance of payments improves insofar as the parent company gets dividend, royalty, technical services fees, and other payments. It is also because of the rising export of the parent company to the subsidiary. (3) Benefit to the government of the home country : Moreover, the government of the home country generates revenue by taxing the dividend and other earnings of the parent company. There is also revenue from tariff on imports of the parent company from its subsidiary abroad. Cost to Host Country : (1) Deteriorates the Balance of Payments : It is a fact that the inflow of foreign investment helps improve the balance of payments, but the outflow on account of imports and the payments of dividend, technical services, royalty and so on deteriorates the balance of payments. There is evidence to prove that such outflows have exceeded the investment inflows in some of the years in India (Sharan, 1978). (2) Dependent for Technology on Home Country : The parent company supplies the technology to the subsidiary, but normally does not disseminate it to the host market. The result is that host country remains dependent on the home country for the technology, which is often received at an exorbitant price. Sometimes the technology is inappropriate for the local environment and in that case, the loss to the host country is large. (3) Loss to Domestic Industrialists : Foreign investors are generally more powerful. Domestic industrialists not compete with them, with the result that the domestic industry fails to grow. Cost to Home Country : (1) Outflow of Factors of Production : The cost to the home country is only little. However it cannot be denied that investments abroad take away capital, skilled manpower and managerial professionals from the country. Sometimes the outflow of these factors of production is so large that it hampers the home countrys interest. (2) Only Profit Motive : The MNCs operate in different countries in order to maximize their overall profit. To this end, they adopt various techniques that may not be in the interest of the host country. Conclusion : Thus, FDI is not an unmixed blessing. It does possess bright features, but at the same time, it has dark spots too. Thus, global benefit can be achieved only if it is carefully handled. Z A D
C O M P U T E R S 34 Q. What is Foreign Portfolio Investment? Ans. Foreign Portfolio Investment : Foreign investment takes two forms. One is foreign portfolio investment, another is foreign direct investment. Foreign portfolio investment does not involve the production and distribution of goods and services. It is not concerned with the control of the host country enterprise. It simply gives the investor, a non-controlling interest in the company. Investment in securities on the stock exchanges of a foreign country is an example of foreign portfolio investment. Foreign portfolio investment is an investment in the shares and debt securities of companies abroad in the secondary market nearly for sake of returns and not in the interests of the management of the company. Benefits of International Portfolio Investment : An investor opts for international portfolio investment because international diversification of portfolio of assets helps achieve a higher risk-adjusted return. This means that an investor is able to reduce risk and raise return through international investment. Risk : Risk can be defined as the probability that the expected return from the security will not materialize. Every investment involves uncertainties that make future investment returns risk-prone. Uncertainties could be due to the political, economic and industry factors. Risk of Portfolio (two assets) : 2 2 2 2 sP = W + W +2 WA WB rAB A B s = Standard deviation of portfolio consisting securities A and B WA WB = Proportion of funds invested in Security A and B sA sB = Standard deviation of returns of Security A and Security B rAB = Correlation coefficient between returns of Security A and Security B The correlation coefficient can be calculated as follows: Cov AB rAB = sA sB Risk of Portfolio (three assets): 2 2 2 2 2 2 sP = W s + W s + W s +2 WxWy ryz sy sz+ WxWz rxsz x sz W 1, W2, W3 = Proportion of amount invested in securities X, Y and Z sxsy sz = Standard deviation of Securities X, Y and Z rxy = Correlation coefficient between Securities X and Security Y r = Correlation coefficient between Securities Y and Security Z yz r = Correlation coefficient between Securities X and Security Z xz ss ss P Z A D
C O M P U T E R S 35 INTERNATIONAL FINANCIAL MANAGEMENT Return : Return is the amount or rate of produce, proceeds, profits which accrues to an economic agent from an undertaking or investment. It is a reward for and a motivating force behind investment, the objective of which is usually to maximize return. Return of Portfolio (Two Assets) : The expected return from a portfolio of two or more securities s equal to the weighted average of the expected returns from the individual securities. S(Rp) = WA (RA) + WB (RB) S(R )= Expected return from a portfolio of two securities WA = Proportion of funds invested in Security A WB = Proportion of funds invested in Security B RA = Expected return of Security A RB = Expected return of Security B WA+WB = 1 Example : A Ltd.s share gives a return of 20% and B Ltd.s share gives 32% return. Mr. Gotha invested 25% in A Ltd.s share and 75% of B Ltd.s shares. What would be the expected return of the portfolio? Solution : Portfolio Return = .25 (20) + .75 (32) = 29% Q. What is International Capital Budgeting? Explain the methods OR Techniques of International Capital Budgeting. Ans. International Capital Budgeting : The decision to invest abroad takes a concrete shape when a future project is evaluated in order to ascertain whether the implementation of the project is going to add to the value of the investing company. The evaluation of the long- term investment project is known as capital budgeting. The technique of capital budgeting is almost similar between a domestic company and an international company. The only difference is that some additional complexities appear in the case of international capital budgeting. These complexities influence the computation of the cash flow and the required rate of return. Capital Budgeting is the technique of making decisions for investment in long-term assets. It is a process of deciding whether or not to invest the funds in a particular asset, the benefit of which will be available over a period of time longer than one year. Methods of Capital Budgeting : There are two criterias for capital expenditure decisions: (A) Accounting Profit Criteria (B) Cash Flow Criteria p Z A D
C O M P U T E R S 36 Techniques of Capital Budgeting Accounting Cash Flow Profit Criteria Criteria 1. Average Rate of 1. Non-Discounting 2. Discounting Return Method Methods Methods (i) Pay Back (i) Net Present Value Method Method (ii) Profitability Index Method (iii) Internal Rate of Return Method (A) Accounting Profit Criteria : Under accounting profit criteria, there is only one method for making capital expenditure decisions. This method is known as Average Rate of Return Method. (1) Average Rate of return Method (ARR) : This method is also known as Accounting Rate of Return Method. It is based on accounting information rather than cash flows. It is calculated as follows: Average Annual Profits after Taxes ARR = X 100 Average Investment Total of after tax profits of all years Average Annual Profits after Taxes = Number of years Original investment + Salvage value Average Investment = 2 Accept-Reject Criteria : If actual ARR is higher than the predetermined rate of returnProject would be accepted. If actual ARR is lower than the predetermined rate of returnProject would be rejected. Z A D
C O M P U T E R S 37 INTERNATIONAL FINANCIAL MANAGEMENT (B) Cash Flow Criteria : Cash flow criteria is based on cash flows rather than accounting profit. Cash flow methods are divided into two sections: (1) Non-Discounting Methods : Under non-discounting methods only method is included: (i) Pay Back Method (PB) : The payback method is the simplest method. This method calculates the number of years required to payback the original investment in a project. There are two methods of calculating the Payback Period: First Method : This method is adopted when the project generates equal cash inflow each year. In such a case payback period is calculated as follows: Investment Payback Period (PB)= Constant Annual Cash Flow Second Method : This method is adopted when the project generates unequal cash inflow each year. Under this method, payback period is calculated by adding up the cash inflows till the time they become equal to the original investment. Formula: Amount required to equalise the investment Completed Year + Amount received during the period Accept-Reject Criteria: If the actual payback period is less than the predetermined payback period Project would be accepted. If the actual payback period is more than the predetermined payback period Project would be rejected. (2) Discounting Methods : Under discounting methods we include: (I) Net Present Value (NPV) Method : This method measures the Present value of returns per rupee invested. Under this method, present value of cash outflows and cash inflows is calculated and the present value of cash outflow is subtracted from the present value of cash inflows. The difference is called NPV. NPV= PV of Inflow PV of Outflow OR st 1 nd 2 NPV = [(Cash inflow in 1 year x PVF) + (Cash inflow in 2 year x PVF) +(Cash inflow in 3 3rdyear x PVF) +(Cash inflow in nth year X PVFn)] - [Initial 0 cash outflow X PVF] Z A D
C O M P U T E R S 38 1 st PVF = Present Value Factor in 1 year 2 nd PVF= Present value factor in 2 year and so on. If PVF is not given, we may calculate NPV as follows: OR st 1 nd 2 NPV = [Cash inflow in 1 year X 1/(1+r) ] + [Cash inflow in 2 year X 1/(1+r) ] + [Cash 3 n inflow in 3rd year X 1/(1+r) ] +[Cash inflow in nth year X 1/(1+r) ] - 0 [Initial Cash outflow X 1/(1+r) ] Accept-Reject Criteria: If NPV is positive, the project may be accepted If NPV is negative, the project may not be accepted. If NPV is zero, the project may be accepted only if non-financial benefits are there. (II) Profitability Index OR (PI) : Second method of evaluating a project through discounted cash flows is profitability index method. This method is also called Benefit- Cost Ratio. This method is similar to NPV approach. A major drawback of the NPV method was that it does not give satisfactory results while evaluating the projects requiring different initial investments. PI method provides a solution to this problem. Present Value of Cash Inflows PI = Present Value of Cash Outflows Accept-Reject Criteria : If PI is more than one, the project will accepted If PI is less than one, the project will be rejected. If PI is one, project may be accepted only on the basis of non-financial considerations. (III) Internal Rate of return Method (IRR) : IRR method is also known as time adjusted rate of return, marginal efficiency of capital, marginal productivity of capital and yield on investment. Like the NPV method the IRR method also takes into consideration the time value of money by discounting the cash flows. IRR is the discount rate at which [resent value of cash inflows is equal to the present value of cash outflows. Z A D
C O M P U T E R S 39 INTERNATIONAL FINANCIAL MANAGEMENT Procedure to Find Out IRR: Step I : Calculate the fake payback period Initial Cash Outflows Fake Payback Period = Average Cash Inflows Total Cash Inflows during the life of the project Average Cash Inflows = Number of year of life Step II : Locate the closest figure to fake payback period in the annuity table A-2 against the row of number of years of the project. Tae rate of that column will be the first discount rate. Step III : Find the NPV of the project at the first discount rate located above. If NPV is positive, determine one more discount rate which should be higher than the first discount rate so that the second NPV may be negative. Similarly, If NPV from first discount rate located above is negative, determine second rate lower than the first rate so that second NPV may be positive. No there are two NPVs at two different rates, one is positive and other is negative. Step IV : Now, apply the following formula to find IRR: NPV at lower discount rate IRR = Lower discount rate + X Difference in discount rate NPV at lower discount rate NPV at higher discount rate Q. What are the distinctive features of the cash flow calculation in international capital budgeting? Explain. Ans. International Capital Budgeting : The decision to invest abroad takes a concrete shape when a future project is evaluated in order to ascertain whether the implementation of the project is going to add to the value of the investing company. The evaluation of the long- term investment project is known as capital budgeting. The technique of capital budgeting is almost similar between a domestic company and an international company. The only difference is that some additional complexities appear in the case of international capital budgeting. These complexities influence the computation of the cash flow and the required rate of return. Computation of the Cash Flow : Any investment for a new project demands a part of the firms current wealth, but, in turn, it brings in funds and adds to the firms stock of wealth in the future. The former results in cash outflow from the firm, while the latter is represented by cash inflows into the firm. Cash outflow occurs on account of capital expenditure; other expenses, excluding depreciation; and the payment of tax. Z A D
C O M P U T E R S 40 Cash Inflow : Cash inflow includes revenue on account of additional sale or cash from eventually selling off an asset, which is known as salvage value. Thus, cash flows are grouped under three heads: (1) Initial Investment (2) Operating Cash Flow (3) Terminal Cash Flow or Salvage Value. Complexities in Cash Flow Computation : The computation of cash flow is complex in international firms. At there very onset of multinational capital budgeting, a decision needs to be taken regarding whether the cash flow should be computed from the viewpoint of the parent company or from the viewpoint of the subsidiary. This is because the cash flow accruing to the subsidiary may not be represented entirely by the cash flow accruing to the parent company. In some cases the cash outflow of the subsidiary is treated as the cash inflow of the parent company. (A) Parents Perspective : The computation of cash flow in the context of international capital budgeting incorporates factors that influence the very size of the cash flow at different stages. These factors operating stages of cash flow need to be analysed here. (1) Initial Investment : If the entire project cost is met by the parent company, the entire amount of initial investment is treated as the cash outflow. Cash outflow may be arranged from the following sources: (i) Local Borrowings: In some cases, the project is partly financed by the subsidiary itself through local borrowing. But such borrowings of the subsidiary do not form a part of the initial cash outflow. (ii) Use of Retained Earnings : Again, in some cases, the subsidiary makes additional investment for expansion out of the retained earning. It should be treated as an opportunity cost insofar as in the absence of retention of earnings, these funds could have been remitted to the parent company rather than invested in the project in question. Thus, investment out of retained earnings should be treated as cash outflow from the parents perspective. (iii) Use of Blocked Funds : Yet again, the issue of blocked funds is very pertinent in this respect. Some times the host government imposes exchange control and does not allow any cash to flow to the parent company. These funds are known as blocked funds. Use of blocked funds should be treated as an investment by the parent company and is recorded as a cash outflow. Initial Investment Fresh Investment made by parent Use of retained earning, if any Use of blocked funds, if any = + + Z A D
C O M P U T E R S 41 INTERNATIONAL FINANCIAL MANAGEMENT (2) Operating Cash Flow : The operating cash flow is computed on an after tax basis as well as on an incremental basis. It does not consider depreciation as it is a non-cash expenses. Depreciation, however, helps arrive at the pre-tax profit. The operating cash flow is influenced by the following factors : (i) Payment of Royalty, dividend etc. : If the subsidiary pays royalty to the parent company, the operating cash inflow will rise. But if the parent company faces loss an account of lack of economies of scale, due to shifting of production to the host country, the operating revenue will come down. (ii) Transfer Pricing : The operating cash flow is influenced by transfer pricing when the parent company or any other unit of the firm charges arbitrary prices for intra-firm movement of intermediate goods. It may be noted here that transfer pricing is adopted either for better working capital management or for reducing the overall burden of taxes of the company through shifting of the before tax profit to a country with lower tax rates. If transfer pricing lower the overall tax burden of the company and thereby increases the revenue of the parent company, the additional revenue should be treated as cash inflow. (iii) Subsidies or Tax Incentives : If the host government offers incentives, they should be included in the capital budgeting decision. For example, if the host government offers tax incentives or provides loan at subsidies rates, the amount of gain on this account should be added to the operating cash inflow. (iv) Interest on Local Borrowings : When the subsidiary avails of local borrowing for meeting a part of the initial investment and pays interest on such borrowings, the amount of interest payment is deducted from the operating cash inflow. (v) Inflation rate Differential : The inflation rate differential needs to be taken into account. Inflation influences, both, the cost and revenue streams of the project. If the inflation rate is higher in the host country and if the import from the parent company constitutes a significant portion of the input of the subsidiary, the cost will not become very high. But if the inputs are obtained locally, the cost will become very high. Also, as far as revenue is concerned, it will move up if there is no competition from foreign suppliers and if the demand for the product is price inelastic. So the computation of cash flow relies on the inflation forecast in the host country and its possible effects. (vi) Exchange Rate Fluctuation : Exchange rate fluctuation influences the size of the cash flow. It is a fact that changes in the exchange rate are tagged to changes in the rate of inflation. But there are other factors that shape exchange rate fluctuations. It is difficult to predict of all those factors. Nevertheless, the cash flow computation process incorporates different scenarios of exchange rate movements. From the parent companys point of view, appreciation in the currency of the host country will be favourable and will increase the size of the cash inflow in terms of the home country currency. Z A D
C O M P U T E R S 42 Factors that Influence Operating Cash Flow: All above factors are also shown in the following way: (3) Terminal Cash Flow : Besides adjustments in the initial investment and in the operating cash flow, some adjustments have to be made for the salvage value that influences the terminal cash flow: (i) If there is a provision in the foreign collaboration agreement for the reversion of the project to the host government after a certain period of time on the payment of a specific amount, the specific amount is treated as the terminal cash inflow. (ii) If the first condition is not present, the net cash flow generated in the terminal year is multiplied by the specific number of years and the product is treated as the terminal cash inflow. (iii) If the project is dismantled in the terminal year, the scrap value is treated as the terminal cash inflow. (iv) When the salvage value is uncertain, the parent company makes various estimates of the salvage value or terminal cash flow and computes the NPV based on each possible outcome of the terminal cash flow. Alternatively, it computes the break-even-salvage value, which is the terminal cash flow necessary to achieve a zero NPV for the project. The break-even salvage value is compared with the estimated terminal cash flow. If the estimated terminal cash flow is less than the break-even salvage value, the investment proposal will be rejected. This is because in this case, the NPV will be negative. Operating Cash Flow Sale of goods in host country markets Export of goods Lost Export Flow of dividend, royalty etc. Supply of inputs by parent Lost income due to diseconomies of scale Any decrease in tax bruden due to transfer pricing Subsidy given by host government Interest payment on local borrowing Any gain on account of inflation rate differential Any gain arising out of changes in exchange rate = + - + + + - - + + + Z A D
C O M P U T E R S 43 INTERNATIONAL FINANCIAL MANAGEMENT On the contrary, if the parent company assesses that the subsidiary would sell for more than break-even salvage value, it will incorporate this assessment into it accept-reject decision. For computing the break-even salvage value, the cash flow beginning from the first year to the nth year is segregated into the operating cash flow, OCF, and the terminal t cash flow, TCF. The break-even salvage value is derived as follows: n n n t NPV = S[OCF t / (1+k) ] + [TCFn /(1+k) ] I0 t=1 n n t 0 = S[OCF t / (1+k) ] + [TCFn /(1+k) ] I0 t=1 n n t I0 - S[OCF t / (1+k) ] = [TCFn /(1+k) ] t=1 n TCF n = I0 - S[OCF t / (1+k)t] X (1+k)n t=1 NPV= Net Present Value TCF = Terminal Cash Flow OCF= Operating Cash Flow K = Discount Rate n= Number of years Example : Suppose the net cash inflow in a three-year period, which is the life span of the project, is respectively $10000, $12000 and $13000. The initial investment is $20000 and the discount rate is 10 per cent. The break-even salvage value will be: 2 3 3 = $ [20000-{10000/1.10 + 12000/1.10 + 13000/1.10}] X (1.10) = $ -11680 (B) Parent-Subsidiary Perspective : The analysis of project appraisal so far takes into account the parent units perspective, of course, based on valid reasons. Even in this case, the parent unit takes into account the subsidiarys perspective, at least to some extent, and makes adjustment in the cash flow and the discount rate under the NPV framework. The very rationale of this argument is that if a projects NPV is positive, it is bound to add to the corporate wealth of the firm as a whole. Under this approach two NPVs are computed. Z A D
C O M P U T E R S 44 (i) One is the NPV from the parents perspective i.e. NPV p (ii) And the other is the NPV from the viewpoint of the project itself, which is known as the subsidiarys perspective i.e. NPVs Finally, the acceptance/rejection decision of the project is based on the NPV of both of them. Calculation of NPVp : In order to find the NPVp, the following steps are taken: (i) Estimate the cash flow in the host country currency (ii) Estimate the future spot exchange rate on the basis of available forward rates. (iii) Convert the host currency cash flow into the home country currency. (iv) Find NPV in home country currency using the home country discount rate. Calculation of NPVs : Similarly, to find out the NPVs, the following steps are taken: (i) Estimate the cash flow in host country currency ii) Identify the host country discount rate. (iii) Discount the host currency cash flow at the host country discount rate (iv) Convert the resultant NPV into the home country currency at the spot exchange rate. The results of two approaches will differ. The possible results will be : (i) NPVp and NPVs are both negative. In such a case, the project cannot be accepted. (ii) NPVp and NPVs are both positive. In such a case, the project is accepted (iii) NPV p >0>NPVs. The project is attractive from the viewpoint of the parent unit but not attractive from the subsidiarys viewpoint. In such a case, the project may be accepted but there will be chances of loss in value in terms of the host country currency. (iv) NPVp<0<NPVs. The project is attractive from the subsidiarys perspective but unattractive from the parnets perspective and though it may be accepted, it is doubltful far the project will be useful to the parent unit. Q. What is political risk? How is it assessed? What are the different modes of its management? Ans. Political Risk : There is no precious definition. However, in Thunells view, political risk is said to exist when sudden and unanticipated changes in political set-up in the host country lead to unexpected discontinuities that bring about changes in the very business environment and corporate performance. For Example, if a rightist party wins election in the host country and the policy towards foreign investment turns liberal, it would create a positive impact on the operation of MNCs. On the other hand, if a left party comes to power in the host country, it will have a negative impact on the operation of MNCs. It is the negative impact that is normally the focus of attention of transnational investors. Z A D
C O M P U T E R S 45 INTERNATIONAL FINANCIAL MANAGEMENT Forms of Political Risks : Some of the forms of political risks are: (1) Expropriation : Expropriation means seizure of private property by the government. Confiscation is similar to expropriation, but the difference between two is that while expropriation involves payment of compensation, confiscation does not involve such payments. International law provides protection to foreigners property. It provides for compensation in case of unavoidable seizure. But the process of compensation is often lengthy and cumbersome. The firm usually requires going-concern value tied to the present value of lost future cash flows. On the other hand, government prefers depreciated historical book value, which is lower in the eyes of the firm. (2) Currency Inconvertibility : Sometimes the host government enacts law prohibiting foreign companies from taking their money out of the country or from exchanging the host country currency for any other currency. This is a financial form of political risk. (3) Credit Risk : Refusal to honour a financial contract with a foreign company or to honour foreign debt comes under this form of political risk. (4) Risk from Ethnic, Religious, or Civil Strife : Political risk arises on account of war and violence and racial, ethnic, religious or civil strife within a country. (5) Conflict of Interest : The interest of MNCs is normally different from the interest of the host government. The former manifests in the maximization of corporate wealth, while the latter is evident in the welfare of the economy, in general and of the citizens of a constituency, in particular. It is the conflicting interest that gives rise to political risk. (6) Corruption : Corruption is endemic in many host countries, as a result of which MNCs have to face serious problems. Transparency International has surveyed 85 countries and has brought out the Corruption Perception Index. Many countries rank high on this index. Evaluation or Assessment of Political Risk : Assessment of political risk is an important step before a firm moves abroad. It is because if such risks are very high, the firm would not like to operate in that country. If the risk is moderate or low, the firm will operate in that country, but with a suitable political-risk management strategy. But any such strategy cannot be formulated until one assesses the magnitude of political risk. The ways of assessment may be either qualitative or quantitative. (1) Qualitative Approach : Qualitative approaches involve inter-personal contact. Persons are often available who are well acquainted with the political structure of a particular country or region. They may come from within the enterprise, particularly those who are posted in that area. They may come from outside the firm-from academic institutions or from foreign offices of the government or from the field of journalism, especially correspondents in that area. Z A D
C O M P U T E R S 46 Sometimes a company sends a team of experts for on the spot study of the political situation in a particular country. This step is taken only after a preparatory study yields a favourable feature. This method gives a more reliable picture but it is always subject to availability of correct information from the local people in the host country. The qualitative approach also involves the examination and interpretation of diverse secondary facts and figures (2) Quantitative Models : Quantitative tools are also used to estimate political risk. The following techniques are used: (i) Primary Risk Investment Screening Matrix : American Can uses a computer programme known as primary risk investment screening matrix involving about 200 variables and reducing them to two numbers. The variables include, in general, : Frequency of changes in government Level of violence in the country Conflicts with other nations Economic factors such as inflation rate, external balance deficit, growth rate of the economy and so on. (ii) Decision-Tree Approach : Robert Stobaugh (1969) uses a decision-tree approach to find out the probability of nationalization. He begins his analysis from the very contention whether there will be change in the government. If there is change, the new government may or may not opt for nationalization. If it does opt for nationalization, the question of whether it will pay adequate compensation arises. Thus, in each possible event, there are many possible sub-events. Probabilities of the events occurring are indicated along the tree branches. Probabilities are multiplied along the branches and then they are summed up. Example : There is 50 per cent probability of change in government and 50 per cent probability for no change in government. If the government changes, there is 40 per cent probability for nationalization and 60 per cent probability for no nationalization. Again, if there is nationalization, there is 60 per cent probability for adequate compensation and 40 per cent probability for inadequate compensation. With these figures, the probability of nationalization without adequate compensation would be: 0.5 X 0.4 X 0.4 = 0.08 (iii) Scale Technique : Haner uses a scale beginning from zero to seven in order to rate political risk. He groups the factors leading to political risk into two parts- Z A D
C O M P U T E R S 47 INTERNATIONAL FINANCIAL MANAGEMENT (a) Internal Factors: Fractionalisation of the political spectrum Fractionalisation of the social spectrum Restrictive measures required to retain power Socio-economic conditions Strength of radical left government (b) External Factors: Dependence on a hostile major power Negative influence of regional political forces Conclusion of this technique: After adding up the rating points, if the total is 19 or below, Haner is of the view that the political risk is only minimal. If the total lies between 20 and 34, the risk may be acceptable. If the total lies between 35 and 44, the risk is suppose to be very high. If the total exceeds 44 rating points, it is not advisable to investment in that country. Management of Political Risk : The political risk management strategy depends upon the type of risk and the degree of risk the investment carries. It also depends upon the timing of the steps taken. For example, the strategy will be different if it is adopted prior to investment from that adopted during the life of the project. Again, it will be different if it is adopted after expropriation of assets. The management of political risk is divided into three sections: (A) Management Prior to Investment : Investment will prove a viable venture if political risk is managed from the very beginning-even before the investment is made in a foreign land. At this stage, there are five ways to manage it. (1) Increased in Discount Rate : In the first method, the factor of political risk is included in the very process of capital budgeting and the discount rate is increased. But the problem is that it penalizes the flows in the earlier years of operation, whereas the risk is more pronounced in the later years. (2) Reducing the Investment Flow : The risk can be reduced through reducing the investment flow from the parent to the subsidiary and filling the gap through local borrowing in the host country. In this strategy, it is possible that the firm may not get the cheapest fund, but the risk will be reduced. The firm will have to make a trade-off between higher financing cost and lower political risk. (3) Agreement with the Host government : If the investing company undergoes an agreement with the host government over different issues prior to making any investment, the latter shall be bound by that agreement. Z A D
C O M P U T E R S 48 (4) Planned Divestment : Planned divestment is yet another method of reducing work. If the company plans an orderly shifting of ownership and control of business to the local shareholders and it implements the plan, the risk of expropriation will be minimal. (5) Insurance of Risk : Political risk can also be reduced by the insurance of risk. The investing firm can be insured against political risk. Insurance can be purchased from governmental agencies, private financial service, organizations or from private property-centred insurers. (B) Risk Management during the Life Time of the Project : Management of risk during the pre-investment phase lessens the intensity of risk, but does not eliminate it. So the risk management process continues even when the project is in operation. There are four ways to handle the risk in this phase. (1) Joint Venture and Concession Agreement : In a joint venture agreement, the participants are local shareholders who have political power to pressurize the government to take a decision in their favour or in favour of the enterprise. In case of concession agreements that are found mainly in mineral exploration, the government of the host country retains ownership of the property and grants lease to the producer. The government is interested in earning from the venture and so it does not cancel the agreement. (2) Political Support: Risk can also be managed with political support. International companies sometimes act as a medium through which the host government fulfils its political needs. As long as political support is provided by the home country government, the assets of the investing company are safe. (3) Structured Operating Environment: The third method is through a structured operating environment. Political risk can be reduced by creating a linkage of dependency between the operation of the firm in high risk country and the operation of other units of the same firm in other countries. If the unit in a high risk country is dependent on its sister units in other countries for the supply of technology or raw material , the former is normally not nationalized so long as dependency is maintained. (4) Anticipatory Planning: Anticipatory planning is also useful toll in risk management. It is a fact that the investing company takes necessary precautions against the political risk prior to the investment or after the investment. But it is of utmost significance that it should plan the measures to be taken quite in advance. (C) Risk Management following Nationalisation: Despite care taken by the international firms for minimizing the impact of political risk, there are occasions when nationalization takes place. In such cases, the investing company tries to minimize the effects of such a drastic measure. There are many ways to do it. Z A D
C O M P U T E R S 49 INTERNATIONAL FINANCIAL MANAGEMENT (1) The investing company negotiates with the host government on various issues and shows its willingness to support the policy and programmes of the latter. Sometimes the investing company foregoes majority control in order to please the host government. (2) Political and Economic Pressure: On failure of negotiation with the host government, the investing company tries to put political and economic pressure. (3) Arbitration: If nationalization is not reversed through negotiation and political- economic pressure, the firm goes for arbitration. It involves the help of a neutral third party who mediates and asks for the payment of compensation. (4) Approach the court of law: When the arbitration fails, the only way out is to approach the court of law. The international law suggests that the company has, first of all, to seek justice in the host country itself. If it is not satisfied with the judgement of the court, the company can go to the international court of justice for fixation of adequate compensation. Q. Define Cost of Capital. How will you determine the cost of capital? Ans. Meaning of Cost of Capital : Cost of capital of a firm is the minimum rate of return expected by its investors. The cost of capital is simply the weighted average of the cost of equity and the cost of debt. The debt-equity ratio has a definite bearing on the average cost of capital. Significance of the Cost of Capital : (1) Helpful in Designing the Capital Structure: The concept of cost of capital plays a vital role in designing the capital structure of a company. Capital structure of a company is the ratio of debt and equity. These sources differ from each other in terms of their respective costs. As such a company will have to design such a capital structure which minimizes cost of capital. (2) Helpful in taking capital Budgeting Decisions: Capital budgeting is the process of decision making regarding the investment of funds in long term projects of the company. The concept of cost of capital is very useful in making capital budgeting decisions because cost of capital is the minimum required rate of return on an investment project. (3) Helpful in evaluation of financial efficiency of top management: Concept of cost of capital can be used to evaluate the financial efficiency of top management. Such an evaluation will involve a comparison of projected overall cost of capital with the actual cost of capital incurred by the management. Lower the actual cost of capital is the better financial performance of the management of the firm. (4) Helpful in comparative analysis of various sources of finance: Cost of capital to be raised from various sources goes on changing from time to time. Calculation of cost of capital is helpful in analysis of usefulness of various sources of finance. Z A D
C O M P U T E R S 50 (5) Helpful in taking other financial decisions: The cost of capital concept is also useful in making other financial decisions such as: Dividend Policy Right Issue Working Capital Decisions Capitalisation of profits. Computation of Average Cost of Capital : Average cost of capital represents the weighted average of the cost of the equity and the cost of debt. As an equation, the average cost of capital, K = KdWd + KeWe Kd = Cost of debt Wd = Proportion of debt Ke = Cost of equity We = proportion of equity (1) Cost of Debt : A company may raise the debt in a number of ways. It may borrow funds from the financial institutions or public wither in the form of public deposits or debentures for a specified period of time at a specified rate of interest. A debenture or bond may be issued at par, at a discount or at a premium. Debt may either be irredeemable or redeemable after a certain period. (i) Cost of Irredeemable Debt : Cost of Irredeemable Debt, before tax : Formula for calculating cost of debt before tax is: I Kdb = X 100 NP Kdb = Cost of debt before tax I = Annual Interest Charges NP= Net Proceeds from the issue of Debt Cost of Irredeemable Debt, after Tax : When a company uses debt as a source of finance then it saves a considerable amount in payment of tax because the amount of interest paid on the debts is a deductible expense in computation of tax. Formula for calculating cost of debt after tax is: I Kda = X 100 (1-t) NP Kda = Cost of debt after tax I = Annual Interest Charges NP= Net Proceeds from the issue of Debt t = Rate of Tax Z A D
C O M P U T E R S 51 INTERNATIONAL FINANCIAL MANAGEMENT (ii) Cost of Redeemable Debt : Normally a company issues a debt which is redeemable after a certain period during its life-time. Such a debt is termed as Redeemable Debt. Cost of redeemable debt may also be calculated before tax and after tax: Cost of Redeemable Debt, before tax : 1 I + (RV NP) n Kdb = X 100 1 (RV +NP) 2 Kdb = Cost of debt before tax I = Annual Interest Charges NP= Net Proceeds from the issue of Debt n = Number of years in which debt is to be RV = Redeemable Value of Debt redeemed. Cost of Redeemable Debt, after tax: 1 I + (RV NP) n Kdb = - X 100 (1-t) 1 (RV +NP) 2 Kdb = Cost of debt before tax I = Annual Interest Charges NP= Net Proceeds from the issue of Debt n = Number of years in which debt is to be redeemed RV = Redeemable Value of Debt t = Rate of Tax (2) Cost of Equity Share Capital : The cost of equity is the maximum rate of return that the company must earn on equity financed position of its investments in order to leave unchanged the market price of its stock. The cost of equity capital is a function of the expected return by its investors. The cost of equity share capital can be computed in the following ways: (i) Dividend Yield Method : This method is based on the assumption that when an investor invests in the equity shares of a company he expects to get a payment at least equal to the rate of return prevailing in the market. The equation is: Z A D
C O M P U T E R S 52 DPS Ke = X 100 MP Ke = Cost of Equity Capital DPS = Dividend Per Share MP = Market Price Per Share (ii) Dividend Yield Plus Growth in Dividend Method : This method is used to compute the cost of equity capital when the dividends of a firm are expected to grow at a constant rate. DPS Ke = X 100 + G MP Ke = Cost of Equity Capital DPS = Dividend Per Share MP = Market Price Per Share G = Rate of growth in Dividend (iii) Earning Yield Method : As per this method, cost of equity capital is calculated by establishing a relationship between earning per share and the current market price of the share. The equation is : EPS Ke = X 100 MP Ke = Cost of Equity Capital DPS = Earning Per Share MP = Market Price Per Share (iv) Earning Yield plus Growth in Earning Method : If the EPS of a company is expected to grow at a constant rate of growth, the cost of equity capital can be computed as follows: EPS Ke = X 100 + G MP Ke = Cost of Equity Capital EPS = Earning Per Share MP = Market Price Per Share G = Rate of growth in EPS Z A D
C O M P U T E R S 53 INTERNATIONAL FINANCIAL MANAGEMENT (3) Cost of Retained Earnings : In case of international investment, the cost of retained earning is calculated separately because the earnings repatriated by the subsidiary to the parent company are subject to tax. The after tax cost of retained earnings is Ks = Ke (1-t) Where Ks = Cost of Retained Earnings Ke = Cost of Equity Capital t = tax rate Q. Explain the Capital Structure of Multinational Firms. Ans. Meaning of Capital Structure : The term capital structure refers to the proportion between the various long-term sources of finance in the total capital of the firm. The major sources of long term finance include Proprietor Funds and Borrowed Funds. (i) Proprietors Funds : Proprietors funds include equity share capital, preference capital, reserves and surpluses etc. (ii) Borrowed Funds : Borrowed funds include long-term debts such as loans from financial institutions, debentures etc. In the capital structure decisions, it is determined as to what should be the proportion of each of the above sources of finance in the total capital of the firm. In other words, how much finance is to be raised from each of these sources. While choosing the source of finance a financial manager makes an attempt to ensure that risk as well as cost of capital is minimum. For this purpose he has to answer the following questions: (i) How much amount should be raised through issue of equity? (ii) How much amount should be raised through issue of preference share capital? (iii) How much amount should be raised through debentures and other long-term debts? Capital Structure of MNCs : The capital structure problem for the multinational enterprise, therefore, is to determine the mix if debt and equity for the parent entity and for all consolidated and unconsolidated subsidiaries that maximizes shareholders wealth. The focus is on the consolidated, world wide capital structure because suppliers of capital to a multinational firm are assumed to associate the risk of default with the MNCs world-wide debt ratio. This association stems from the view that bankruptcy or other forms of financial distress in an overseas subsidiary can seriously impair the parent companys ability to operate domestically. Any deviations from the MNCs target capital structure will cause adjustments in the mix of dent and equity used to finance future investments. Z A D
C O M P U T E R S 54 Foreign Subsidiary Capital Structure : After a decision has been made regarding the appropriate mix of debt and equity for the entire corporation, questions about individual operations can be raised. How should MNCs arrange the capital structure of their foreign affiliates? And what factors are relevant in making this decision? Specially, the problem is whether foreign subsidiary capital structures should Conform to the capital structure of the parent company Reflect the capitalization norms in each foreign country Vary to take advantage of opportunities to minimize the MNCs cost of capital. The parent company could finance its foreign affiliates by raising funds in its own country and investing these funds as equity. The following situations may be: (i) Case I : 100% Parent Financed: 100% Parent Financed Rs. 100 D = 50 E = 50 D/E = 1:1 (ii) Case II : 100% Parent Financed 100% Parent Financed Rs. 100 D = 0 E = 100 D/E = 0 (iii) Case III : 100% Parent Financed: 100% Parent Financed Rs. 100 D = 100 E = 0 D/E = Infinity Z A D
C O M P U T E R S 55 INTERNATIONAL FINANCIAL MANAGEMENT (iv) Case IV : 100% Bank Financed: 100% Bank Financed Rs. 100 D = 100 E = 0 D/E = Infinity In case I, II and III, the parent borrows Rs. 100 to invest in a foreign subsidiary, in varying portions of debt and equity. In case IV, the subsidiary borrows the Rs. 100 directly from the bank. Depending on what the parent calls its investment, the subsidiarys debt-to-equity ration can vary from zero to infinity. Subsidiary Capital Structure can also be explained with the help of following diagram : Optimal Capital Structure : When companies mobilize funds, they are mainly concerned with the marginal cost of funds. The companies should always try to expand keeping in view their optimal capital structure. However, as their capital budget expands in absolute terms, their marginal cost of capital (MCC) will eventually increase. This means that companies can tap the capital market for only some limited amount in short run before their MCC rise, even though the same optimum capital structure is maintained. Equity Debt Subsidiary Parent Interest and Principal Dividends Loan Interest And Principal Interest And Principal Loan Bank Z A D
C O M P U T E R S 56 In one analysis, we hold the total amount of capital constant and change only the combination of financing sources. We seek the optimum or target capital structure that yields the lowest cost of capital. Now we attempt to determine the size of the capital budget in relations to the levels of MCC so that the optimum capital budget can be determined. The optimum capital budget is defined as the amount of investment that maximizes the value of the company. It is obtained at the intersection between the internal rate of return (IRR) and the MCC. At this point, total profit is maximized. This position can be shown with the help of following figure: Explanation : This figure shows that the optimum capital budget of a typical multinational company is higher than the capital budget of a purely domestic company. The multinational corporations can tap foreign capital markets, when the domestic markets are saturated and their risk is lower than that of purely domestic companies. International capital availability and lower risk permit multinational companies to lower their cost of capital and maintain a constant MCC for a broad range of their capital budget. They have more investment opportunities than purely domestic companies. These two factors give multinational company higher optimum capital structure than the optimum structure of domestic companies. MCC of purely domestic company MCC of MNC M C C
/
I R R
( % ) IRR (MNC) IRR of purely domestic company A B Budget Size (Amount of Capital) Budget size of MNC Budget size of purely domestic company Z A D
C O M P U T E R S 57 Q. What are the strategic considerations in issuing Euro Equities issues? Ans. Euro Equities : International equities or euro-equities do not represent debt, nor do they represent foreign direct investment. They do not represent FDI as the holders do not enjoy voting rights. They represent a mixture of the two and, hence, are in great demand. (i) They are issued when the domestic market is already flooded with shares and the issuing company would not like to add further stress to the domestic stock of shares since such additions may cause a fall in share prices. (ii) Companies issue such shares for gaining international recognitions. (iii) Such issues bring in scarce foreign exchange. (iv) Capital is available at lower cost (v) Funds raised this way do not add to foreign exchange exposure. Features of International Equities : (i) Investor gets the dividend and not the interest as in case of debt instruments. (ii) On the other hand, it does not have the same pattern of voting right that it does have in the case of foreign direct investment. (iii) International equities are a compromise between the debt and the foreign direct investment. (iv) International equities are presently on the preference list of the investors as well as the issuers. Benefits of International Equities : (i) The presence of restriction on the issue of shares in domestic market facilitates the issue of euro-equities. (ii) The company issues international equities also for the sake of gaining international recognition among the public. (iii) International equities bring in foreign exchange which is vital for a firm in a developing country. (iv) International capital is available at lower cost through the euro equities. UNIT IV FINANCE : SPECIALIZATION PAPERS INTERNATIONAL FINANCIAL MANAGEMENT Z A D
C O M P U T E R S 58 (v) Funds raised through such an instrument do not add to the foreign exchange exposure. (vi) From the viewpoint of the investors, international equities bring in diversification benefits and raise return with a given risk or lower the risk with a given return. Procedure of issuing euro equities : (1) For the issue, the issuing company approaches a lead manager who advises the issuer on different aspects of the issue. (2) On getting the advice, the issuer prepares a prospectus and other documents and takes permission from the regulatory authorities. (3) It deposits the shares to be issued with a custodian bank located in the domestic country. The custodian bank is appointed by the depository in consultation with the issuing company. (4) After the custodian holds the shares, the depository issues global depository receipts. The ratio between the number of shares and the number of GDRs is decided before the issue is launched. (5) The GDRs are sold to international investors and funds move from the investors to the depository, from the depository to the custodian bank, and from the custodian bank to the issuing company. The investor has right to surrender the GDR and to take back the investment. In this case, GDR is submitted to the depository who informs the custodian who, in turn, will issue share certificates in exchange for the GDR. The proceeds from the sale of shares are converted into foreign exchange and remitted to the investor through the depository. In the process of the issue, the role of underwriting and listing is very important. The lead manager normally acts as the underwriter as well as the listing agent. After the listing formalities are over, the GDRs are traded on stock exchanges. International clearing houses facilitate the settlement of transactions. Q. Write a short note on International Bond Financing. Ans. International Bond : International bonds are debt securities. These are issued by international agencies, governments and companies for borrowing foreign currency for a specified period of time. The issuer pays interest to the creditor and makes repayment of capital. These are different types of bonds, some of which are mentioned below: Types of International Bonds : There are different types of such bonds: (1) Foreign Bonds and Euro Bonds : International Bonds are classified as foreign bonds and Euro bonds. (i) Foreign Bonds : In case of foreign bond, the issuer selects a foreign financial market where the bonds are issued in the currency of that country. Foreign bonds are underwritten normally by the underwriters of the country where they are issued. Z A D
C O M P U T E R S 59 INTERNATIONAL FINANCIAL MANAGEMENT (ii) Euro Bonds : In case of euro bonds, bonds are denominated in a currency other than the currency of the country where the bonds are issued. Euro bonds are underwritten by the underwriter of multi-nationally. (2) Global Bonds : It is the World Bank which issued the global bonds for the first time in 1989 and 1990. Since 1992, such bonds are being issued also by companies. Presently, there are seven currencies in which such bonds are denominated namely: Australian Dollar Canadian Dollar Japanese Yen DM Finnish Markka Swedish Krona and Euro Features of Global Bonds : (i) They carry high ratings (ii) They are normally large in size (iii) They are offered for simultaneous placement in different countries (3) Straight Bonds : The straight bonds are the traditional type of bonds. In this case, interest rate if fixed. The interest rate is known as coupon rate. The credit standing of the borrower is also taken into consideration for fixing the coupon rate. Straight bonds are of many varieties: (i) Bullet-Redemption Bond : In Bullet-Redemption bond the repayment of principal is made at the end of the maturity and not in installment every year. (ii) Rising-Coupon Bond : In rising coupon bond, the coupon rate rises over time. The benefit is that the borrower has to pay small amount of interest payment during early years of debt. (iii) Zero-Coupon Bond : It carries no interest payment. But since there is no interest payment, it is issued at discount and redeemed at par. It is the discount that compensates for the loss of interest faced by the creditors. Such bonds was issued for the first time in 1981. (iv) Bonds with Currency Options : In case of bonds with currency options, the investor has the right to received payments in a currency other than the currency of the issue. (v) Bull and Bear Bonds : The bull bonds are those where the amount of redemption rises with a rise in the index. The bear bonds are those where the amount of redemption falls with a fall in the index. (4) Floating-Rate Notes : Bonds, which do not carry fixed rate of interest, are known as floating rate notes (FRNs). Such bonds were issued for the first time in 'Italy' during 1970 and they have become common in recent times. Z A D
C O M P U T E R S 60 (5) Convertible Bonds : International bonds are also convertible bonds meaning that these bonds are convertible into equity shares. Some of the convertible bonds have detachable warrants involving acquisition rights. In other cases, there is automatic convertibility into a specified number of shares. Convertible bonds command a comparatively high market value because of the convertibility privilege. Procedure of Issuing International Bond : The procedure of issue is simple. (1) The firm approaches a lead manager (a commercial bank or an investment bank) who advises the issuer on different aspects of the issue- such as- Timing Price Maturity Size Buyers' Potential-for a fee. The lead manager may take the help of co-managers. (2) After getting advice from the lead manager, the issuer prepares the prospectus and other legal documents and secures the approval of the regulatory authorities. (3) After approval, it launches the issue. (4) The documents accompanying the issue of bonds are normally: Prospectus Subscription Agreement Trust Deed Listing Agreement Paying Agency Agreement Underwriting Agreement Selling Group Agreement. (5) The lead manager underwrites the issue and charges an underwriting fee. After the underwriting is done, the bonds are sold. The lead manager functions as a selling group for a fee. (6) There are also trustees appointed by the issuer, who protect the interest of the bondholders in case of default. In many cases, the lead manager functions as a trustee. (7) Finally, there are listing institutions for listing the bonds for secondary marketing. The secondary marketing for international bonds is mainly an over-the-counter market, although the bonds are listed with stock exchange. Z A D
C O M P U T E R S 61 INTERNATIONAL FINANCIAL MANAGEMENT Q. Explain Dividend Policy of Multinational firms. Ans. Dividend : Dividend refers to that part of net profits of a company which is distributed among shareholders as a return on their investment in the company. Dividend is paid on preference as well as equity shares of the company. On preference shares, dividend is paid at a predetermined fixed rate. But decision of dividend on equity shares, dividend is taken for each year separately. A settled approach for the payment of dividend is known as dividend policy. Thus, the dividend policy divide the net profits or earnings after taxes into two parts: (1) Earnings to be distributed as dividend (2) Earnings retained in the business. Determinants of Dividend by MNC : International dividend policy is influenced by tax considerations, political risk, and foreign exchange risk, as well as a return for business guidance and technology. (1) Tax Implications : Host country tax laws influence the dividend decision. Countries such as Germany tax retained earnings at one rate while taxing distributed earnings at a lower rate. Most countries levy withholding taxes on dividends paid to foreign parent firms and investors. Again, most parent countries levy a tax on foreign dividends received but allow a tax credit for foreign taxes already paid on that income stream. (2) Political Risk : Political risk may motivate parent firms to require foreign affiliates to remit all locally generated funds in excess of stipulated working capital requirements and planned capital expansions. Such policies, however, are not universal. (3) Foreign Exchange Risk : If a foreign exchange loss is anticipated, this lead usually part of a larger strategy of moving from weak currencies to strong currencies and can include speeding up intra-firm payments on accounts receivable and payable. (4) Age and Size of Affiliates : Among other factors that influence dividend policy are the age and size of the foreign affiliate. Older affiliates often provide a greater share of their earnings to their parent, presumable because as the affiliate matures it has fewer reinvestment opportunities. (5) Availability ofFfunds : Dividends are a cash payment to owners equal to all or a portion of earnings of a prior period. To pay dividends, an affiliate needs both past earnings and available cash. Affiliates sometimes have earnings without cash, because earnings are measured at the time of a sale but cash is received later when the receivable is collected. Profits of rapidly growing affiliates are often tied up in ever- increasing receivables and inventory. Hence, rapidly growing foreign affiliates may lack the cash to remit a dividend equal to even a portion of earnings. The reverse may also be true; firms may be receiving cash from the collection of old receivables even when profits are down because current sales have fallen off or current expenses have risen relative to current sales prices. Z A D
C O M P U T E R S 62 (6) Payout ration of the Parent Company : The payout ratio of the parent company plays a crucial role in deciding the dividend policy of the MNC. The policy is based on two perspective: (i) Some firms require same payout ratio as that of the parent company. (ii) Others target payout ratio as a percentage of total overall foreign earnings without receiving the same amount from each subsidiary. (7) Tax Effects : Effective tax rates on payments from different subsidiaries are required to decide dividend policy of the firm. By varying payment ratio among its foreign subsidiaries it can reduce the total tax burden. Once the firm decides to remit dividends to its parent company, it can reduce the tax bill by withdrawing funds from high tax location to low tax location through transfer pricing or in other forms of withdraws. (8) Exchange Control : Sometimes national impose restrictions on repatriation to control balance of payment problems. Hence exchange control play major role in deciding dividend policy of the MNC firm. Q. Explain the different bases of the International Tax System. Ans. Introduction : Taxation plays a vital role in international operation of firms. It is the core of various financial decisions, such as international investment decision, international working capital decision, funds raising decisions and decisions concerning dividend and other payments. It is true that the tax issue is relevant to such decisions also in respect of domestic firms. But the management of taxation is a highly complex issue for international corporations. The reasons are very much evident: (i) Multiplicity of tax jurisdictions : Firstly, these firms have to operate in many tax jurisdictions where tax rates are different and also the administration of tax system is not uniform. (ii) Varying definitions of tax base in different countries : Secondly, the ultimate burden of tax in the context of international firms is determined by a more complicated interplay of varying definitions of the tax base. (iii) Varying tax treatment in different countries : Thirdly, the varying tax treatment in different countries can lead to distortions in international trade and investment. Bases of International Tax System : It is expected that the international tax system should be neutral. At the same time, it should be equitable. And also, a firm should not be taxed twice for the same income. These three concepts are: (1) Tax Neutrality : Neutrality of international taxation is based on the concept of economic efficiency. This means that tax should not come in the way of optimal allocation of capital among different countries. If tax is neutral, capital will move from a country with lower returns to a country with higher returns. Consequently, the gross world output will be maximized. On the contrary, if international taxation does not Z A D
C O M P U T E R S 63 INTERNATIONAL FINANCIAL MANAGEMENT possess this objective, the after-tax return from investment will stand distorted. As a result, resources may not be allocated efficiently. Gross world output, in turn, will be lower. (2) Tax Equity : The principle of tax equity rests on the belief that all similarly situated taxpayers should participate in the cost of operating the government according to the same rules. The concept of equity can be interpreted in two ways: (i) One is that the contribution of each taxpayer should be in conformity with the amount of public services he or she received. (ii) The other is that each taxpayer should pay taxes according to his or her ability to pay. The ability to pay means a person with greater ability has to pay a greater amount of tax. (3) Avoidance of Double Taxation : Corporate income tax is levied when a firm earns income. But if the post tax income is remitted to foreign countries, the recipient of such income is taxed again. This means the same income is subject to double taxation. Double taxation dampens the incentive to invest. And so, it needs to be avoided. For this purpose, the entire income from foreign sources may be exempted from tax. Types of Taxes : The international operation of a firm is subjected broadly to three kinds of taxed. They are: (1) Income Tax (2) Withholding Tax (3) Value Added Tax (1) Income Tax : A significant part of the tax revenue in a country is represented by tax on personal income as well as on corporate income. The tax is levied on income arising out of a firm's operation-whether the operation is a manufacturing one or it is concerning the provision of services, However, the rate of the tax varies widely among different countries or different tax jurisdictions with the results that the concept of neutrality or equity is hard to be adhered to. (2) Withholding Tax : Withholding tax is a tax levied on the passive income earned by an individual or a corporate body. The word' "passive" is used because the income arises, or is generated, in another country. Suppose a corporate body in India earns dividend from its subsidiary operating in another country and pays tax on the dividend income to the Indian government. The dividend income is a passive income as it generated abroad. The tax on such income is known as withholding tax. The passive income takes many forms such as: Dividend Income Income from Royalty Technical Service Fees Income from interest and so on. Z A D
C O M P U T E R S 64 It has been observed that the rate of taxes varies from one form of passive income to the other and from one country to the other. (3) Value Added Tax : A value added tax is a tax levied on the value added at different stages of production of a commodity or services. VAT is an indirect tax and it is often preferred to direct income tax insofar as VAT discourages unnecessary consumption, fosters national savings, and is easier to be collected. However, this tax too faces the same problem of having different rates in different tax jurisdictions. Tax Havens : A tax haven country is one that has zero rate, or a very low rate, of income tax and withholding tax. Additionally, there are some non-tax factors that make a country a tax haven. Alworth groups the tax havens into four groups: (i) Those having no income or capital gains tax (ii) Those having a very low rate of tax (iii) Those exempting all income from foreign sources from taxation (iv) Those allowing special tax privileges in specific cases. International Tax Management Strategy : The minimization of the overall tax burden so as to maximize the overall profit is the strategy of an international firm. A number of activities are directed to this end: (1) Trade-off between dividend repatriation and retention of earnings : First of all, a firm has to take a decision whether the profits of the subsidiaries should lie with them and their repatriation to the parent unit should be delayed in order to evade taxes at home. In this case, the profits should be reinvested in profitable channels and the corporate wealth of the subsidiary will increase. But if the repatriation is delayed, the parent unit will not witness a net cash inflow and the basic purpose of investment in a subsidiary is marred. Thus, there should be a tradeoff between the repatriation of dividend and retention of earning with the subsidiary. (2) Higher cost allocation in higher tax country : Secondly, the objective of minimization of tax burden depends on the cost allocation between the different units of the firm. If a firm allocates higher cost in a higher tax country and shows greater profits in a low tax country, the total tax burden would be greatly reduced. However, there are limits to cost allocation. And so, to overcome these limits, a firm adopts transfer pricing devices. (3) Selection mode of operation branch or subsidiary : Thirdly, the tax management strategy incorporates the decision whether the foreign operation should take the form of either a branch or a subsidiary. If foreign operation is expected to incur huge losses in some of the years, it is better to operate through branches. Branches do not represent an independent entity and so the loss incurred by one branch will be absorbed by the profits earned by other units and the total tax burden will be lower. Z A D
C O M P U T E R S 65 INTERNATIONAL FINANCIAL MANAGEMENT (4) Constant eye on tax rate differential between home and host country : Whatever the strategy, a firm needs to consider the tax provisions in the home country as well as in the host country. It is only then that any strategy should be implemented. Q. Write a short note on Country Risk Analysis. Ans. Country Risk : Country risk is a broader concept than political risk or sovereign risk. Country risk involves the possibility of losses due to country specific economic, political or social events or because of company specific characteristics, therefore all political risks are country risk but all country risks are not political risks. Sovereign risks involve the possibility of losses on private claim as well as on direct investment. Sovereign risk is important to banks where as country risk important o MNCs. Sovereign risk is a sub component of country risk. Types of Country Risk : Country risk refers to uncertainty associated with political activities and events. The major country risks are of two types: (A) Macro Risks (B) Micro Risks (A) Macro Risks : By macro risk we mean, risks affecting all the multinational firms. The major macro risks are: (1) Forced Disinvestment : Governments may, as a matter of political philosophy, force firms to disinvest. Forced disinvestment may take place for variety of reasons such as: a) That the government believes that it may make better utilization resources b) It feels that such a take over may improve the image of the government c) Government wants to control these resources for strategic or developmental reasons. The forced disinvestments are legal under international law as long as it is accompanied by adequate compensations. Such a takeover does not involve the risk of total loss of assets, however, some times the compensation provided by the government may not match the expectation of company taken over by the governments. Forms of Forced Disinvestment : (i) Takeovers/Nationalization : Usually takeovers and nationalization are done as a matter of political philosophy. While doing so, a general policy of takeover or nationalization is announced with a package of compensation. The company owners are asked to withdraw from the management for announced compensation which usually does not match with the expectation of the owners of company. Z A D
C O M P U T E R S 66 (ii) Confiscation/Expropriation with or without Compensation : This is another form of forced disinvestment. In this the government expropriates legal title to property or the stream of income the company generates. Confiscation may be with a minimal compensation or even without compensation. (2) Unwelcomed Regulations : The purpose of these regulations is to reduce profitability of MNC's. These regulations may relate to the tax laws, ownership, management, re-investment, limitations on employment and location. (3) Interface with Operations : Interface with operations refer to any government activity that makes it difficult for business to operate effectively. This risk includes such things as government's encouragement of unionization, government's expression of negative comments-about foreigners and discriminatory government support to locally owned and operated business. The governments generally engage in these kinds of activities when they believe that a foreign company's operation could be detrimental to local development or would harm the political interest of the government. (4) Social Strife : In any country there may be social strife arising due to ethnic, religious, tribal or civil tensions or natural calamities such as drought, etc. may cause economic dislocation. (B) Micro Risks : Micro risks are firm specific and affect every firm differently. The micro risks are: (1) Goal Conflicts with economic policies : Conflicts between objectives of multinational firms and host government have risen over such issues as the firm's impact on economic development, foreign control of key industries, sharing of ownership and control with local interest, impact on host country's balance of payment, influence on the exchange rate and control over export market, and of domestic versus foreign executives. The economic policies of the government are geared to achieve sustainable rate of growth in per capital, gross national product, full employment, price stability external balance and fair distribution of income. The policies through which these objectives are to be achieved are as follows: Monetary Policies Fiscal Policies Trade Policies and economic controls Balance of Payment and Exchange Rate Policy. Economic Development Policies. Each of these policies may conflict with the goals of MNCs. Z A D
C O M P U T E R S 67 INTERNATIONAL FINANCIAL MANAGEMENT (2) Corruption and Bureaucratic Delays : Political corruption and blackmail contribute to the risk. Corruption is endemic to developing countries. If these bribes are not paid, either the projects are nor cleared or delayed through bureaucratic system to make the project instructions. Q. Define Long-Term Financing. What are the Costs and Risks of Long-Term Financing? Ans. Long Term Financing : Since MNCs commonly invest in long-term projects, they rely heavily on long-term financing. Long-term Financing includes Debt Versus Equity. Debt means long term loans and equity means proprietor's funds or shareholder's funds. Once that decision is made, the MNC must consider the possible source of equity or debt and cost and risk associated with each source. (1) Equity Sources : Equity can be issued in the following ways: (i) MNCs may consider a domestic equity offering in their home country, in which the funds are denominated in their local currency. (ii) Second, they may consider a global equity offering, in which they issue stock in their home country and in one or more foreign countries. They may consider this approach to obtain partial funding in a currency that they need to finance a foreign subsidiary's operation (iii) Third, MNCs may offer a private placement of equity to financial institutions in their home country. (iv) Fourth, they may offer a private placement of equity to financial institutions in the foreign country where they are expanding. Private placements are beneficial because they may reduce transaction costs. (2) Debt Source : When MNCs consider debt financing, they have a similar set of options. These options are: (i) They can engage in a public placement of debt in their own country (ii) They can engage in a public placement of debt in a global debt. (iii) They can engage in a private placement of debt in their own country (iv) They can engage in a private placement in the foreign country where they are expanding. Cost and Risks of Long-Term Financing : Most MNCs obtain equity funding in their home country. In contrast, debt financing is frequently done in foreign countries. Thus the focus in on how debt financing decisions can affect the MNCs cost of capital and risk. Debt Financing Cost : An MNC's long-term financing decision is commonly influenced by the different interest rates that exist among currencies. The actual cost of such financing depends on the quoted interest rate, as well as the changes in the value of the borrowed currency over the life of the loan. Z A D
C O M P U T E R S 68 To make the long-term financing decision, the MNC must (a) Determine the amount of funds needed, (b) Forecast the price (interest rate) at which the bond may be issued, and (c) Forecast the exchange rates of the borrowed currency for the times when it has to make payments (coupons and principal) to the bondholders. There are two types of Debt Financing Cost: (A) Exchange Rate Risk of Debt Financing : It includes 1. When issuing bonds in a foreign currency, the exchange rate is very important. However, a point estimate does not account for forecast uncertainty. 2. Hence, a probability distribution of the exchange rate should be developed and used to compute the expected financing cost and its probability distribution. 3. The exchange rate probability distribution can also be fed into a computer simulation program to generate the probability distribution of the financing cost. Reducing Exchange Rate Risk : The exchange rate risk from financing with bonds in foreign currencies can be reduced in various ways. 1. Offsetting Cash Inflows: Foreign currency receipts can help offset bond payments in the same currency. In particular, an MNC can aggregate its cash inflows from all euro-zone countries to cover the payments for its euro-denominated bonds. 2. Forward Contracts A firm may hedge its exchange rate risk through the forward market. However, the firm may not be able to save costs due to interest rate parity. 3. Currency Swaps A currency swap enables firms to exchange currencies at periodic intervals. It can be a useful alternative to forward or futures contracts. 4. Parallel Loans In a parallel (or back-to-back) loan, two parties simultaneously provide loans to each other (or to a subsidiary of the other party) with an agreement to repay at a specified point in the future. Z A D
C O M P U T E R S 69 INTERNATIONAL FINANCIAL MANAGEMENT Illustration of A Parallel Loan : 5. Diversifying Aamong Currencies A firm may issue bonds in several foreign currencies for diversity. To avoid the higher transaction costs associated with multiple bond issues, the firm may develop a currency cocktail bond. One popular currency cocktail is the Special Drawing Right (SDR). (B) Interest Rate Risk from Debt Financing 1. An MNC must also decide on the maturity that it should use for its debt. 2. If the bond term is too short, the MNC may have to refinance at a higher interest rate. 3. However, if the bond term matches the expected business life, the MNC is obligated to continue paying interest at the same rate even when market interest rates fall. Interest Rate Swap : Interest rate swap involves the exchange of interest payments. It usually occurs when a person or a firm needs fixed rate funds but is only able to get floating rate funds. It finds another party who needs any floating rate loan but is able to get fixed rate funds. The two, known as counter parties, exchange the interest payments and the loans according to their own choice. It is the swap dealer, usually a bank, that brings together the two counter-parties for the swap. Essential Conditions for Interest-Rate Swap are : (i) The amount of loan is identical in the two cases. (ii) The periodic payment of interest takes place in the same currency. (iii) At the same time, there must be coincidence between the two parties-one getting cheaper fixed rate funds and the other getting cheaper floating rate funds. U.S. Parent Provision of loans British Parent Subsidiary of U.S. - based MNC that is located in the U.K. Repayment of loans in the currency that was borrowed Subsidiary of U.K.- based MNC that is located in the U.S. Z A D
C O M P U T E R S 70 For Example : Suppose Firm A needs fixed rate funds, which is available to him at the rate of 10.50 per cent to be computed half yearly, but it has access to cheaper floating rate funds available to it at LIBOR+0.3 per cent. Firm B needs floating rate funds, available to it at 6-month LIBOR flat, but has access to cheaper fixed rate funds available to it a the rate of 9.50 per cent to be computed half yearly. Both the principals are identical in size and maturity and are in the same currency. The interest rate swap will take place in the following stages: Stage 1 : If firm A has access to the floating rate loan market, it will borrow from the floating rate loan market. Similarly, Firm B having access to the fixed rate loan market, will borrow a fixed rate loan. Stage 1 of Interest Rate Swap :
Stage 2 : Both the counterparties approach a swap dealer. Since Firm A needs a fixed rate loan, swap delaer asks firm A to pay fixed rate interest to it as if it has borrowed fixed rate loan. The fixed rate of interest payable through the swap dealer is higher than what firm B has to pay to the lender in the fixed rate loan market but lower than what firm A has to pay to thelender if it had borrowed from the fixed rate loan market. It is, say, 9.75 per cent. In exchange , the swap dealer pays firm A the interest at 6-month LIBOR. Firm A pays LIBOR+o.3 percent to the lender on its floating rate borrowing. On the other hand, the swap delaer asks firm B to pay 6 month LIBOR as if it has borrowed a floating rate loan. In exchange, the swap dealer pays firm B fixed rate interest, which is higher than what Firm B has to pay to the ultimate lender. This is the interest rate that the swap dealer has received from firm A minus its swap commission. It is ,say, 9.65 per cent. Here firm B gets interest from the swap dealer at 9.65 per cent and pays interest to the fixed rate lender at 9.50 per cent. PRINCIPAL FIXED RATE LOAN MARKET FLOATING RATE LOAN MARKET PRINCIPAL FIRM A FIRM B Z A D
C O M P U T E R S PRINCIPAL FIXED RATE LOAN MARKET FLOATING RATE LOAN MARKET PRINCIPAL FIRM A FIRM B 75 INTERNATIONAL FINANCIAL MANAGEMENT Stage 2 of Interest Rate Swap :
Firm A is attracted to the swap deal as it uses the loan according to its own choice and also because the fie\xed rate of interest payable by it is lower thsn what it had to pay in case it borrowed firm the fixed rate loan market. Firm B is attracted to the swap deal not only becasuse it is using the loan according to iuts own choice but also becuase the swap delaer gives an interest rate that is higher than what it has to pay to the ultimate lender. The swap delaer is attracted to the swap deal becuase it earns from such a deal. Stage 3 : At maturity, the two firms repay the loan. Firm A repays the floating rate loan and Firm B repays fixed rate loan. Stage 3 of Interest Rate Swap :
Gain to Swap Dealer : Interest Rate Received 9.75% Interest Rate Paid 9.65% Net Gain 0.10% LIBOR + 0.3% FIXED RATE LOAN MARKET FLOATING RATE LOAN MARKET 9.50% FIRM A FIRM B SWAP DEALER Z A D
C O M P U T E R S 72 Hedging with Interest Rate Swaps When MNCs issue floating-rate bonds that expose them to interest rate risk, they may use interest rate swaps to hedge the risk. Interest rate swaps enable a firm to exchange fixed rate payments for variable rate payments, and vice versa. Bond issuers use swaps to reconfigure their future cash flows in a way that offsets their payments to bondholders. Financial intermediaries are usually involved in swap agreements. They match up participants and also assume the default risk involved for a fee. Z A D