INTERNATIONAL FINANCIAL

MANAGEMENT

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SUNIL KUMAR YADAV MFC 4TH SEMESTER
 UNIT- 1
( MULTINATIONAL FINANCIAL MANAGEMENT)

#INTERNATIONAL FINANCIAL MANAGEMENT OVERVIEW:

International Financial Management is a well-known term in today’s world and it is also known as international
finance. It means financial management in an international business environment. It is different because of the
different currency of different countries, dissimilar political situations, imperfect markets, diversified
opportunity sets. International Financial Management came into being when the countries of the world started
opening their doors for each other. This phenomenon is well known by the name of “liberalization”. Due to the
open environment and freedom to conduct business in any corner of the world, entrepreneurs started looking for
opportunities even outside their country boundaries. The spark of liberalization was further aired by swift
progression in telecommunications and transportation technologies that too with increased accessibility and
daily dropping prices. Apart from everything else, we cannot forget the contribution of financial innovations
such as currency derivatives; cross-border stock listings, multi-currency bonds and international mutual funds.

Difference between Domestic and International Financial Management

Four major facets which differentiate international financial management from domestic financial management
are an introduction of foreign currency, political risk and market imperfections and enhanced opportunity set.

Foreign Exchange
It’s an additional risk which a finance manager is required to cater to under an International Financial
Management setting. Foreign exchange risk refers to the risk of fluctuating prices of currency which has the
potential to convert a profitable deal into a loss-making one.
Political Risks
The political risk may include any change in the economic environment of the country viz. Taxation Rules,
Contract Act etc. It is pertaining to the government of a country which can anytime change the rules of the
game in an unexpected manner.

Market Imperfection
Having done a lot of integration in the world economy, it has got a lot of differences across the countries in
terms of transportation cost, different tax rates, etc. Imperfect markets force a finance manager to strive for best
opportunities across the countries.

#EVOLUTION OF INTERNATIONAL MONETARY AND FINANCIAL SYSTEM:

The international monetary system refers to the system and rules that govern the use and exchange of money
around the world and between countries.

HISTORY OF INTERNATIONAL MONETARY SYSTEM

There have been four phases/ stages in the evolution of the international monetary system:

 Gold Standard (1875-1914)

 Inter-war period (1915-1944)

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  Bretton Woods system (1945-1972)
 Present International Monetary system (1972-present)

1) GOLD STANDARD
The gold standard is a monetary system in which each country fixed the value of its currency in terms of
gold. The exchange rate is determined accordingly.
Let’s say- 1 ounce of gold = 20 pounds (fixed by the UK) and 1 ounce of gold = 10 dollars (fixed by the US).
Hence, the dollar-pound exchange rate will be 20 pounds = 10 dollars or 1 pound = 0.5 dollars
The Gold standard created a fixed exchange rate system.
There was a free convertibility between gold and national currencies.
Also, all national currencies had to be backed by gold. Therefore, the countries had to keep enough gold
reserves to issue currency.
One advantage of the gold standard was that the Balance of payments (BOP) imbalances were corrected
automatically.
Let’s say- There are only two countries in the world – The UK and France. The UK runs a BOP deficit as it has
imported more goods from France. France runs a BOP surplus.
This will obviously result in the transfer of money (gold) from the UK to France as payment for more imports.
The UK will have to reduce its money supply due to decline in gold reserves. The reduction in the money
supply will bring down prices in the UK.
The opposite will happen in France. Its prices will increase.
Now, the UK will be able to export the cheaper goods to France. On the other hand, the imports from
France will slow down. This will correct the BOP imbalances of both the countries.
Another advantage was that the gold standard created a stable exchange rate system that was
conducive to international trade.

2) INTER-WAR PERIOD
After the world war started in 1914, the gold standard was abandoned.
Countries began to depreciate their currencies to be able to export more. It was a period of fluctuating
exchange rates and competitive devaluation.

3) BRETTON WOODS SYSTEM

In the early 1940s, the United States and the United Kingdom began discussions to rebuild the world economy
after the destruction of two world wars. Their goal was to create a fixed exchange rate system without the gold
standard.
The new international monetary system was established in 1944 in a conference organised by the United
Nations in a town named Bretton Woods in New Hampshire (USA).
The conference is officially known as United Nations Monetary and Financial Conference. It was attended
by 44 countries.

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India was represented in the Bretton-woods conference by Sir C.D. Deshmukh, the first Indian Governor of
RBI.
[The conference also led to the creation of International Monetary Fund (IMF), World Bank and GATT. GATT
is the predecessor of WTO. Read: WTO: Meaning, Origin etc.}
The Bretton-woods created a dollar-based fixed exchange rate system.
In the Bretton-woods system, only the US fixed the value of its currency to gold. (The initial peg was 35
dollars = 1 ounce of gold). All the other currencies were pegged to the US dollar instead. They were
allowed to have a 1 % band around which their currencies could fluctuate.
The countries were also given the flexibility to devalue their currencies in case of emergency.
It was similar to the gold standard and was described as a gold-exchange standard.
There were some differences. Only the US dollar was backed by gold. Other currencies did not have to
maintain gold convertibility.
Also, this convertibility was limited. Only governments (not anyone who demanded it) could convert their US
dollars into gold.

4) PRESENT INTERNATIONAL MONETARY SYSTEM

The Bretton Woods system collapsed in 1971. The United States had to stop the convertibility to gold due to
high inflation and trade deficit in the economy.
Inflation led to an increase in the price of gold. Hence, the US could not maintain the fixed value of 35
dollars to 1 ounce of gold.
In 1973, the world moved to flexible exchange rate system.
In 1976, the countries met in Jamaica to formalize the new system.
Floating exchange rate system means that the exchange rate of a currency is determined by the market forces of
demand and supply.

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 UNIT- 2
#TERM INVESTMENT DECISION:

Investment Decision
Definition: The Investment Decision relates to the decision made by the investors or the top level management
with respect to the amount of funds to be deployed in the investment opportunities.

Simply, selecting the type of assets in which the funds will be invested by the firm is termed as the investment
decision. These assets fall into two categories:

1. Long Term Assets

2. Short-Term Assets
3. The decision of investing funds in the long term assets is known as Capital Budgeting. Thus, Capital
Budgeting is the process of selecting the asset or an investment proposal that will yield returns over a long
period.

4. The first step involved in Capital Budgeting is to select the asset, whether existing or new on the basis of
benefits that will be derived from it in the future.

5. The next step is to analyze the proposal’s uncertainty and risk involved in it. Since the benefits are to be
accrued in the future, the uncertainty is high with respect to its returns.

6. Finally, the minimum rate of return is to be set against which the performance of the long-term project can
be evaluated.

7. The investment made in the current assets or short term assets is termed as Working Capital Management.
The working capital management deals with the management of current assets that are highly liquid in
nature.

8. The investment decision in short-term assets is crucial for an organization as a short term survival is
necessary for the long-term success. Through working capital management, a firm tries to maintain a trade-
off between the profitability and the liquidity.

9. In case a firm has an inadequate working capital i.e. less funds invested in the short term assets, then the
firm may not be able to pay off its current liabilities and may result in bankruptcy. Or in case the firm has
more current assets than required, it can have an adverse effect on the profitability of the firm

10. Thus, a firm must have an optimum working capital that is necessary for the smooth functioning of its day
to day operations.

11. The decision of investing funds in the long term assets is known as Capital Budgeting. Thus, Capital
Budgeting is the process of selecting the asset or an investment proposal that will yield returns over a long
period.

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12. The first step involved in Capital Budgeting is to select the asset, whether existing or new on the basis of
benefits that will be derived from it in the future.

13. The next step is to analyze the proposal’s uncertainty and risk involved in it. Since the benefits are to be
accrued in the future, the uncertainty is high with respect to its returns.

14. Finally, the minimum rate of return is to be set against which the performance of the long-term project can
be evaluated.

15. The investment made in the current assets or short term assets is termed as Working Capital Management.
The working capital management deals with the management of current assets that are highly liquid in
nature.

16. The investment decision in short-term assets is crucial for an organization as a short term survival is
necessary for the long-term success. Through working capital management, a firm tries to maintain a trade-
off between the profitability and the liquidity.

17. In case a firm has an inadequate working capital i.e. less funds invested in the short term assets, then the
firm may not be able to pay off its current liabilities and may result in bankruptcy. Or in case the firm has
more current assets than required, it can have an adverse effect on the profitability of the firm

18. Thus, a firm must have an optimum working capital that is necessary for the smooth functioning of its day
to day operations.

The decision of investing funds in the long term assets is known as Capital Budgeting. Thus, Capital
Budgeting is the process of selecting the asset or an investment proposal that will yield returns over a long
period.

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The first step involved in Capital Budgeting is to select the asset, whether existing or new on the basis of
benefits that will be derived from it in the future.

The next step is to analyze the proposal’s uncertainty and risk involved in it. Since the benefits are to be accrued
in the future, the uncertainty is high with respect to its returns.

Finally, the minimum rate of return is to be set against which the performance of the long-term project can be
evaluated.

The investment made in the current assets or short term assets is termed as Working Capital Management.
The working capital management deals with the management of current assets that are highly liquid in nature.

The investment decision in short-term assets is crucial for an organization as a short term survival is necessary
for the long-term success. Through working capital management, a firm tries to maintain a trade-off between
the profitability and the liquidity.

In case a firm has an inadequate working capital i.e. less funds invested in the short term assets, then the firm
may not be able to pay off its current liabilities and may result in bankruptcy. Or in case the firm has more
current assets than required, it can have an adverse effect on the profitability of the firm

Thus, a firm must have an optimum working capital that is necessary for the smooth functioning of its day to
day operations.

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 UNIT-3
#POLITICAL RISK:
Political risk is a type of risk faced by investors, corporations, and governments that political decisions, events,
or conditions will significantly affect the profitability of a business actor or the expected value of a given
economic action.[1] Political risk can be understood and managed with reasoned foresight and investment.
The term political risk has had many different meanings over time.[2] Broadly speaking, however, political risk
refers to the complications businesses and governments may face as a result of what are commonly referred to
as political decisions—or "any political change that alters the expected outcome and value of a given economic
action by changing the probability of achieving business objectives".[3] Political risk faced by firms can be
defined as "the risk of a strategic, financial, or personnel loss for a firm because of such nonmarket factors as
macroeconomic and social policies (fiscal, monetary, trade, investment, industrial, income, labour, and
developmental), or events related to political instability (terrorism, riots, coups, civil war, and
insurrection)."[4] Portfolio investors may face similar financial losses. Moreover, governments may face
complications in their ability to execute diplomatic, military or other initiatives as a result of political risk. The
field has historically focused on analyzing political risks predominantly in emerging economies, but such risks
also exist in developed economies and liberal democracies as well, albeit in different manifestations.[5]

Types of Political Risks

categorization, negative political risk has been generally divided into following types:

1. Risk of expropriation:
Nathan holds that expropriation risk is either direct or indirect.[20] Direct expropriation risk is the “risk that the
host government will [wholly or partially] nationalize the assets or equity of the project company in an arbitrary
or discriminatory manner or without payment of just compensation.”[21] It also includes other forms of forceful
alienations of project assets at the instance of host government; viz. forceful sale of assets or production to an
instrumentality of host government at below market prices.[22] Direct expropriation deprives a project
sponsor/investor the right to use or benefit from the project assets in any manner and, is therefore, an extreme
and most dramatic form of political risk.[23] Although developing countries, including India, are increasingly
adopting model of economic development which is based on public private partnerships (PPP) and
privatization, even a minor risk of direct expropriation significantly affects investment decision of project
sponsors.[24] Indirect expropriation risk, on other hand, is the risk of “major contract disputes that affect the
assets and ownership structure” of a project company or a firm.[25] This includes host government’s
(politically-driven) debt default, failure to deliver on a contract, etc.[26]
Example: Direct expropriation of captive coal block mines by Government of India from private companies
after first-cum-first-serve allocation of such mines was held as constitutionally ultra vires by Supreme Court of
India in Manohar Lal Sharma v. The Principal Secretary & Ors. [Coalgate Judgement] W.P. (Crl.) 120/2012
2. Risk of changes in regulatory regime:
It means the risk of politically motivated changes in regulatory policies or legal framework of the host
government which render the project unprofitable. Examples may include: import and export restrictions, price
controls, excessive taxation (like taxes on windfall gains, duplicate tax claims by both central and state
government), stringent environmental laws or labour standards, preferential policy towards protection of
domestic companies or financial institutions, etc.[27] Even ‘cash flow expropriation’ or ‘resource nationalism’,
by host government, aimed at expropriating cash, i.e. money raised through project, instead of its physical
assets, through government regulatory policies is also included.[28]Such policies include: “increased taxation
over transfer pricing within companies, [requiring] companies to partner with local firms for specific activities
such as processing (providing a hidden subsidy), or retroactive [application of taxes] or environmental or health
and safety fines.”[29] Hood explains that regulatory changes may occur, inter alia, when there is a change in
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ruling government, or even the preexisting host government changes its priorities, or when the political system
itself changes.[30] For instance, if the power to effect such regulatory changes is delegated to administrative
authorities in a parliamentary democracy (like India), the risk will be much higher for lack of need of extensive
parliamentary deliberations. If, sufficiently prior to enacting such adverse regulatory changes, the host
government notifies the concerned investor/owner, this risk may be minimized.
Example: Enactment of Section 7 of Electricity Act 2003 (w.e.f. 10 June 2003), which de-licensed power
generation by any generating company subject to compliance with technical standards, reduced the risk of
regulatory regime in relation to captive power generation in India. Another example may be the imposition of
corporate tax on foreign investments by clarification in nature of retrospective amendment of Income Tax Act
1961 undertaken by Finance Act 2012 to effectively overturn ratio of Vodafone International Holdings v. Union
of India C.A. 733/2012 (Sup.Ct.).
2. Risk of war and terrorism:
Since wars and terrorist organizations [like Al-Qaeda, ISIS etc.] are no longer associated with a specific nation-
state or a geographical area [viz. cyber terrorism], politically motivated wars and terrorism are not country risks
rather political risks.[31] Nevertheless, there may arise circumstances wherein such war or terrorism is focused
against specific industry, sector, economy, government or its policy framework, viz. Eco-Terrorism. Even
ancillary impacts owing to such acts of terrorism or war, viz. halt of transport owing to border/road closure due
to inter-state fighting are included within this risk.
Example: Risk of terrorist activities (especially, in transport sector like, aviation and metro-rail) around
Obama’s visit to Delhi, India for Republic Day celebration in 2015; risk of disruption of projects by naxalites in
MoU Belt, especially in Dantewada, Chhattisgarh, etc.
4. Risk of imposition of capital controls:
There is a risk of host government adopting stringent currency or trade controls. Administrative delays
in approving capital transfers, excessive/severe limits on repatriation of profits [like, by imposition of onerous
tax on conversion of currency, etc.] are examples of currency controls.[32] Imposition of trade barriers,
licensing requirements, etc.; restrictions on cross-border transfer of resources are examples of trade
controls.[33] Hood explains by empirical evidence that uncertainty of severity and duration of these controls are
aggravating factors for political risk.[34]
Example: India allows free repatriation of profits once all the local and central tax liabilities are met. Imposition
of Goods and Services Tax (GST) would decrease existing onerous tax liabilities and thus, is expected to further
liberalize the repatriation of profits.
5. Currency risk:
Weiss explains that there is a risk of inconvertibility of local currency revenues into foreign currency required to
pay off the debts owing to foreign exchange shortage in host country.[35] Currency risk also includes risk of
devaluation which is the shortfall in ex ante returns from foreign investment owing to depreciation of local
currency in which revenue was earned in host country.[36] This currency risk becomes political risk when the
currency market is fixed or regulated by the host government or its instrumentality.
Example: There is a greater risk of China allowing its currency to depreciate in 2015, because of domestic
economic slowdown and other international factors.[37]
6. Risk of political upheaval (other than war or terrorism):
It includes political revolution, social movements, protests, strikes, civil commotions, internal armed
conflicts [like, insurrections, riots, mutiny, rebellion, military coup d’état, civil war etc.] which may arise due to
social mobilization or change of public opinions aimed at thwarting corruption, creating political imbalance or
instability, removing existing power structures, etc.[38] Therefore, higher the improprieties present in political
or administrative system [viz. nepotism, corruption, bribery, red-tapism, administrative laxity, etc.], higher is
the risk of such upheaval and lesser is the viability of investments.
Example: Risk of separation of Telengana and Andhra Pradesh which materialized from 2010 onwards upon
formation of Srikrishna Committee on Telangana or the Committee for Consultations on the Situation in
Andhra Pradesh (CCSAP).

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7. Risk of ‘crossfire’ sanctions:
This is the risk of incurring sanctions or consumer boycotts by host government or consumer base in
host country because of infliction by of “human rights abuses (e.g. imprisonment, torture or murder of political
opponents; use of prison labor; persecution of minority groups; not abiding by election results); conflicts with
neighboring countries; lack of concern for the environment, endangered species, etc.; disregard for international
agreements [e.g. Nuclear Non-Proliferation Treaty); misuse of social issues as means of protectionism, etc.” by
your project company or your home country.[39] It includes the risk of “loss of social license to operate”, i.e.
opposition by indigenous, social, environmental or political groups to economic projects or, boycott of products
of specific brand whereby, extensive delays, increase in social costs, market imbalances, safety costs, etc. result
in impracticability or unprofitability of the venture.[40]
Example: risk of opposition by environmentalists to Adani Group’s Great Barrier Reef Project in Australia
owing to its past disregard for environmental concerns.
8. Risk of non-neutrality of legal framework:
Risk of judicial biasness against foreign investors assumes greater significance if the judiciary
(including quasi-judicial bodies) is not insulated from political pressure.[41] This risk somewhat reduces if the
host country is signatory to international/regional conventions which safeguard international investments,
promote natural justice, principle of rule of law and doctrine of separation of powers.[42]
It must, however, be in no way construed as an exhaustive list of types of political risk. In fact, each type or
category in itself is also not exhaustive, and may at times overlap with other similar categories. This is because,
the concept of political risk is dynamic and its contours ever expanding. Insofar as this list is an amalgam from
different sources, it is also worthwhile to note that different stakeholders have recognized and defined types of
political risks differently. As mentioned before, there is no universal recognition of different types or limits of
such types of political risks.

# Political Risk Management

From now on, we will proceed with the presumption that political risk is negative, i.e. unprofitable for the
impugned business venture/investment. The process of political risk management by any
investor/sponsor/owner before taking an investment decision involves three stages: (i) identification of political
risk; (ii) assessment of political risk; and, (iii) action plans for management or mitigation of political risk.[43] If,
however, such investment has already been made in a business, which is now affected with negative political
risk, the sponsors/investors/owners must directly initiate ‘post-entry’ action plans for mitigation of such risk.

Identification of Political Risk:

Identification of of the type of political risk relevant to a specific investment is crucial for its later assessment
and mitigation. Risk Managers are usually appointed by MNCs to identify the main political risks of investment
qua particular industry, sector, economy, and geography. The foremost task of risk manager is to separate real
political risk from ‘headline hype’ or perceived risk, i.e. those highly publicized socio-political upheavals which
are often perceived as political risk but may instead offer an equally or more significant investment
opportunity.[44] Political risks should neither be farfetched nor inconceivable even with reasonable/due
diligence. Therefore, the factors contributing to perception of such risk have to be carefully analyzed on basis of
highly verifiable, well-defined and specifically relevant data; and then, the factors which may partially or fully
offset this risk have to be considered. After such careful analysis, if the risk still remains substantial enough not
to be ignored, the risk has to be identified as a potential political risk. All such potential political risks have to
be then prioritized qua their material significance to the company. The criteria for such prioritization usually
includes: combination of probability and impact (both, material and good-will) of such risk, board level
concerns, vulnerability to extremities, finance plan, corporate structure etc.[45]

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Now the question emerges as to what data should be conceivable as highly relevant to identification of any
political risk, and from where such data should be accessed or obtained. It is important to keep in mind that the
perception of what data is relevant and the perception of political risk on same or similar data may subjectively
vary.[46] Therefore, identification of relevant data with sufficient objectivity is to be done at both, holistic
political level and, at specific level of inquiry, by taking into account past experiences and sufficient empirical
evidence (historical probabilities). For instance, Nathan has proved by empirical study of historical analysis of
political regimes that democracy leads to lower levels of political risks owing to constraints [viz. reputational,
judicial, political, social, etc.] imposed on executives in such regimes.[47] Beside the factum of nature of
political system, other important aspects at identification of political risk may include:[48]
government budget deficits, transparency, openness of the economy, political stability or degree of acceptable
instability, savings, development and social stability, economic planning failures, political leadership, external
conflict, corruption in government, military in politics, organized religion in politics, law and order tradition,
racial and national tensions, political terrorism, civil war risks, quality of bureaucracy, repudiation of
contracts by government, expropriation of private investments, losses from exchange controls, enforcement of
laws in past (including practices for accessing legal recourse and enforcing awards), strength of institutions
(including the efficiency of the agency involved, strength and quality of institutions in arbitration proceedings,
assistance provided by the judiciary, and existence of and support for alternative dispute resolution
mechanisms), effectiveness of policies and procedures (including their timeliness, such as the length of
arbitration procedures) relative to global best practice.
Relevant data may be obtained from any of following sources: (i) comprehensive databases of political risks
maintained by agencies and consultants like Business Environment Risk Intelligence (BERI) Political Risk
Index, the Economist Intelligence Unit (EIU) Political Instability Index, EURASIA’s Global Political Risk
Index, Euromoney, Transparency International, World Audit Organization, Delcredere Ducroire, Verisk
Maplecroft, International Country Risk Guide (ICRG), World Bank Group’s Investing Across Borders database,
etc.; (ii) specialized political risk consultants like Corr Analytics, Business International, F&S Political Risk,
Political Risk Services (PRS), etc.; (iii) “local subsidiaries and partners, public domain, other companies,
industry associations, local organizations”, and other reliable sources in host country.[49] However, reliance on
judgement of host-country level experts may be fallacious on two accounts: first, there may be concealment of
data because of conflict of interest [in revealing the requisite information regarding potentiality of political risk
and the consequent impact of withdrawal of parent company’s investments from local operations in host
country];[50] and second, much of the data relating to political turmoil including possibility of war is classified
and not accessible to general public. Therefore, corporations usually rely on empirical data studies on
identification of political risks provided by consultants mentioned before.

# Measurement or Assessment of Political Risks:

Coping with uncertainty in forecasting political risk incurs time and research costs which get sunk if the process
turns out to be futile for insufficiency of predictability. Paucity of reliable statistical data, especially in relation
to small market for impugned project in developing countries, may present formidable unit costs to any such
attempt at political risk assessment.[51] Therefore, first, a superficial assessment must be undertaken through
careful analysis of database of different political risk indices [per country or specific geographical locations]
provided through open or trial access by agencies aforementioned viz. ICRG, Delcredere Ducroire, Verisk
Maplecroft. In-depth political risk assessment must be undertaken only if the probability of losing investment
from political risks is superficially high and; sunk costs by loss of such investment are relatively much higher
than the costs of such assessment.

#Action Plans for Management or Mitigation of Political Risks:

The perceived political risk must be gauged against ex-ante profits and returns from investment, while bearing
in mind that investments are intrinsically risky in nature.[52] Upon this thorough cost-benefit analysis, decision
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to ignore, completely avoid, manage or mitigate the political risk must be undertaken. Political Risk Mitigation
includes ‘pre-entry’ prevention and ‘post-entry’ protection against perceivable risks. Other action plans include,
external or internal financing of such political risk through political risk insurance (PRI).[53] All these action
plans are aimed at mitigation or management of political risk, either generally or risk specific level.

# General Mitigation of Political Risks;

The investment decision must be pragmatically made taking into consideration the effect which several
dimensions of political risk play out in practice. For instance, usually stable democracies are preferred over
monarchies (supra) because of popular constraints over whimsical action by political regime.[54] Despite taking
into account these broad considerations, strategic flexibility to ensure adaptability to political risks (in practice)
must be adopted by investors through:
1. Diversification: undertaking a wide variety of investments (i.e. investment portfolio diversification using
political risk as key factor),[55] non-committal of resources into fixed and specific assets overseas, undertaking
sub-contracting, leasing and sub-leasing, diversification of production catering to different markets, reducing
structural dependence on a single country [viz. in relation to market for raw material or sale of product,
increased flexibility to switch supplies through global operations or international product markets including the
ability to recruit globally], etc.[56]
2. Decentralization of decision making: Decentralization leads to freedom of sub-units in quickly making
decisions to allow for smooth liquidation of assets, withdrawal of investments, exit from business, etc. if the
political risk seems to be materializing.[57]
3. Avoiding long-term commitments: of resources including labour, capital, physical assets etc. through
insertion of relevant contractual clauses.[58]
4. Implementation of intelligence system: to monitor recent social, political and environmental trends that may
reasonably impact business. Such monitoring allows enough opportunity to respond to brewing political
risks.[59]
5. Lobbying: Influencing host government through informal negotiations, industry associations, business
goodwill, personal contacts, advice from ambassadors of domestic country, etc. is strategically
important.[60] Presence of influential management is significant in this regard. Further, investor/owner must not
antagonize host government with threat of recourse to commercial dispute mechanism unless no other option
left for this leads to loss of reputation of host government and consequent friendly business atmosphere for the
investment concern.[61]
6. Local Stakeholders: It is empirically proven that if there are local stakeholders [like, sponsors/investors,
market shareholders, creditors, debtors, etc. of host country] including Government in PPP model, political risk
(especially, of nationalization) reduces.[62] A joint business venture is preferable with a domestic company
which understands the political risk environment in host country, or which is in favor or position to lobby the
host government.[63]
7. Negotiations with host government: to secure preferential arrangements from host government for instance,
concession in taxation, licensing, etc.[64] Abrogation of guarantee obtained from host government will vest a
right in project sponsors/investors to claim compensation, thereby allocating the risk to the host government
itself.[65]
8. Indispensability to host government: Such indispensability allows bargaining leverage to the corporation for,
any adverse impact on its operations would result in increased economic, social or political loss.[66] This
indispensability may be created by offering net social benefits, through CSR, creation of public trusts, adoption
of public relations campaigns and development model consistent with national aspirations like, sustainable
development, self-sustenance etc.; making scarce and significant resources available to the economy through
technical expertise, managerial skills, product or capital access to export market, etc.; partnerships with NGOs;
and, social investments in community initiatives, education, health, public infrastructure development, etc.[67]
9. Financial Hedging: Hedging through financial instruments like, forward supply contracts, currency trading,
commodity hedging instruments, etc. may offset or limit the financial exposure to political risks, especially
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currency risks.[68] Furthermore, an escrow account could be maintained with sufficient liquid assets to pay off
the debt obligations if political risks actually materialize.[69]
10. Managing Reputational and integrity risks: Bribing officials in relation to project, money laundering,
terrorist financing, indifference to mitigating social and environmental costs of projects, ignoring standards set
by applicable environmental and labour laws, non-performance of contractual obligations qua host government
(viz. in PPP), exploitation of consumers, adopting anti-competitive policies, etc. increase the risk of
compromise of reputation and integrity of business.[70] Such face high political risks of expropriation,
regulatory changes, losing social license to operate, etc. Therefore, businesses must aim at working with clean
reputation in public relations.

#MULTINATIONAL CAPITAL BUDGETING:

Meaning:
Capital Budgeting or investment decisions play a vital role in the future profitability of a concern. The process
of decisions to invest a sum of money when the expected results will flow after the lapse of a period of more
than one year is called Capital Budgeting.

It also includes the process of decision regarding disinvestment, i.e., a decision to sell off an undertaking or a
part of it. Normally, however, specially in these days, it is the former type of decision which predominates. It is
a most important decision to make since afterwards, after money has been irrevocably committed, it may not be
possible to do much in improving results.

Meaning:
Capital Budgeting or investment decisions play a vital role in the future profitability of a concern. The process
of decisions to invest a sum of money when the expected results will flow after the lapse of a period of more
than one year is called Capital Budgeting.

It also includes the process of decision regarding disinvestment, i.e., a decision to sell off an undertaking or a
part of it. Normally, however, specially in these days, it is the former type of decision which predominates. It is
a most important decision to make since afterwards, after money has been irrevocably committed, it may not be
possible to do much in improving results.

Meaning:
Capital Budgeting or investment decisions play a vital role in the future profitability of a concern. The process
of decisions to invest a sum of money when the expected results will flow after the lapse of a period of more
than one year is called Capital Budgeting.

It also includes the process of decision regarding disinvestment, i.e., a decision to sell off an undertaking or a
part of it. Normally, however, specially in these days, it is the former type of decision which predominates. It is
a most important decision to make since afterwards, after money has been irrevocably committed, it may not be
possible to do much in improving results.

Meaning:
Capital Budgeting or investment decisions play a vital role in the future profitability of a concern. The process
of decisions to invest a sum of money when the expected results will flow after the lapse of a period of more
than one year is called Capital Budgeting.

It also includes the process of decision regarding disinvestment, i.e., a decision to sell off an undertaking or a
part of it. Normally, however, specially in these days, it is the former type of decision which predominates. It is
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a most important decision to make since afterwards, after money has been irrevocably committed, it may not be
possible to do much in improving results.

1. Payback period:
The payback (or payout) period is one of the most popular and widely recognized traditional methods of
evaluating investment proposals, it is defined as the number of years required to recover the original cash outlay
invested in a project, if the project generates constant annual cash inflows, the payback period can be computed
dividing cash outlay by the annual cash inflow.

Payback period = Cash outlay (investment) / Annual cash inflow = C / A

2. Accounting Rate of Return method:
The Accounting rate of return (ARR) method uses accounting information, as revealed by financial statements,
to measure the profit abilities of the investment proposals. The accounting rate of return is found out by
dividing the average income after taxes by the average investment.

ARR= Average income/Average Investment

3. Net present value method:

The net present value (NPV) method is a process of calculating the present value of cash flows (inflows and
outflows) of an investment proposal, using the cost of capital as the appropriate discounting rate, and finding
out the net profit value, by subtracting the present value of cash outflows from the present value of cash
inflows.

The equation for the net present value, assuming that all cash outflows are made in the initial year (tg), will be:

Where A1, A2…. represent cash inflows, K is the firm’s cost of capital, C is the cost of the investment proposal
and n is the expected life of the proposal. It should be noted that the cost of capital, K, is assumed to be known,
otherwise the net present, value cannot be known.

4. Internal Rate of Return Method:

The internal rate of return (IRR) equates the present value cash inflows with the present value of cash outflows
of an investment. It is called internal rate because it depends solely on the outlay and proceeds associated with
the project and not any rate determined outside the investment, it can be determined by solving the following
equation:

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5. Profitability index:
It is the ratio of the present value of future cash benefits, at the required rate of return to the initial cash outflow
of the investment. It may be gross or net, net being simply gross minus one. The formula to calculate
profitability index (PI) or benefit cost (BC) ratio is as follows.

PI = PV cash inflows/Initial cash outlay A,

1. It gives due consideration to the time value of money.

2. It requires more computation than the traditional method but less than the IRR method.

3. It can also be used to choose between mutually exclusive projects by calculating the incremental benefit cost
ratio.

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 Unit -4
( Cost and capital structure of the multinational firm)

Multinational Cost of Capital and Capital Structure:

#Cost of Capital :

The primary meaning ofCost of capital is merely the cost an entity must pay to raise funds. The term can refer,
for instance, to the financing cost (interest rate) a company pays when securing a loan.

The cost of raising funds, however, is measured in several other ways, as well, most of which carry a name
including "Cost of."

Defining "Cost of" Terms

Seven similar-sounding terms have the following definitions:

1. Cost of Capital

This term refers to the price an organization pays to raise funds, for example, through bank loans or issuing
bonds. Cost of capital usually appears as an annual percentage.

2. Weighted Average Cost of Capital WACC

WACC is the arithmetic average (mean) capital cost that weights the contribution of each capital source by the
proportion of total funding it provides. "Weighted average cost of capital" usually appears as an annual
percentage.

3. Cost of Borrowing

Cost of borrowing refers to the total amount a debtor pays to secure a loan and use funds, including financing
costs, account maintenance, loan origination, and other loan-related expenses. "Cost of borrowing" sums appear
as amounts, in currency units such as dollars, pounds, or euro.

4. Cost of Debt

Cost of debt is the overall average rate an organization pays on all its obligations. These typically consist of
bonds and bank loans. "Cost of debt" usually appears as an annual percentage.

5. Cost of Equity COE

Cost of equity COE is part of a company's "capital structure." COE measures the returns demanded by stock
market investors who will bear the risks of ownership. COE usually appears as an annual percentage.

6. Cost of Funds

This term refers to the interest cost that financial institutions pay for the use of money. "Cost of funds" usually
appears as an annual percentage.
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 7. Cost of Funds Index (COFI)

A Cost of Funds Index (COFI) refers to an established Cost of Funds rate for a region. In the United States, for
instance, a regional COFI might be set by a Federal Home Loan Bank.

CALCULATION FORMULA OF COST OF CAPITAL:

Cost of debt:
When companies borrow funds from outside lenders, the interest paid on these funds is called the cost of debt.
The cost of debt is computed by taking the rate on a risk-free bondwhose duration matches the term structure of
the corporate debt, then adding a default premium. This default premium will rise as the amount of debt
increases (since, all other things being equal, the risk rises as the cost of debt rises). Since in most cases debt
expense is a deductible expense, the cost of debt is computed on an after-tax basis to make it comparable with
the cost of equity (earnings are taxed as well). Thus, for profitable firms, debt is discounted by the tax rate. The
formula can be written as

where is the corporate tax rate and is the risk free rate.

Cost of equity
The cost of equity is inferred by comparing the investment to other investments (comparable) with similar
risk profiles. It is commonly computed using the capital asset pricing model formula:
Cost of equity = Risk free rate of return + Premium expected for risk
Cost of equity = Risk free rate of return + Beta × (market rate of return – risk free rate of return)
where Beta = sensitivity to movements in the relevant market. Thus in symbols we have

where:
Es is the expected return for a security;
Rf is the expected risk-free return in that market (government bond yield);
βs is the sensitivity to market risk for the security;
Rm is the historical return of the stock market; and
(Rm – Rf) is the risk premium of market assets over risk free assets.
The risk free rate is the yield on long term bonds in the particular market, such as government bonds.
An alternative to the estimation of the required return by the capital asset pricing model as above, is the use of
the Fama–French three-factor model.

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#Capital Structure:

Capital Structure refers to the amount of debt and/or equity employed by a firm to fund its operations and
finance its assets. The structure is typically expressed as a debt-to-equity or debt-to-capital ratio.

Debt and equity capital are used to fund a business’ operations, capital expenditures, acquisitions, and other
investments. There are tradeoffs firms have to make when they decide whether to raise debt or equity and
managers will balance the two try and find the optimal capital structure.

Optimal capital structure

The optimal capital structure of a firm is often defined as the proportion of debt and equity that result in the
lowest weighted average cost of capital (WACC) for the firm. This technical definition is not always used in
practice, and firms often have a strategic or philosophical view of what the structure should be.

In order to optimize the structure, a firm will decide if it needs more debt or equity and can issue whichever it
requires. The new capital that’s issued may be used to invest in new assets or may be used to repurchase
debt/equity that’s currently outstanding as a form or recapitalization.

Dynamics of debt and equity

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Below is an illustration of the dynamics between debt and equity from the view of investors and the firm.

Debt investors take less risk because they have the first claim on the assets of the business in the event
of bankruptcy. For this reason, they accept a lower rate of return, and thus the firm has a lower cost of capital
when it issues debt compared to equity.

Equity investors take more risk as they only receive the residual value after debt investors have been repaid. In
exchange for this risk equity investors expect a higher rate of return and therefore the implied cost of equity is
greater than that of debt.

#Dividend policy;

Meaning of Dividend Policy:

The term dividend refers to that part of profits of a company which is distributed by the company among its
shareholders. It is the reward of the shareholders for investments made by them in the shares of the company.
The investors are interested in earning the maximum return on their investments and to maximise their wealth.
A company, on the other hand, needs to provide funds to finance its long-term growth.

If a company pays out as dividend most of what it earns, then for business requirements and further expansion it
will have to depend upon outside resources such as issue of debt or new shares. Dividend policy of a firm, thus
affects both the long-term financing and the wealth of shareholders.

Types of Dividend Policy:

The various types of dividend policies are discussed as follows:
(a) Regular Dividend Policy:
Payment of dividend at the usual rate is termed as regular dividend. The investors such as retired persons,
widows and other economically weaker persons prefer to get regular dividends.

(b) Stable Dividend Policy:

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The term ‘stability of dividends’ means consistency or lack of variability in the stream of dividend payments. In
more precise terms, it means payment of certain minimum amount of dividend regularly.

A stable dividend policy may be established in any of the following three forms:
(i) Constant dividend per share:
Some companies follow a policy of paying fixed dividend per share irrespective of the level of earnings year
after year. Such firms, usually, create a ‘Reserve for Dividend Equalisation’ to enable them pay the fixed
dividend even in the year when the earnings are not sufficient or when there are losses.

A policy of constant dividend per share is most suitable to concerns whose earnings are expected to remain
stable over a number of years.

(ii) Constant payout ratio:

Constant pay-out ratio means payment of a fixed percentage of net earnings as dividends every year. The
amount of dividend in such a policy fluctuates in direct proportion to the earnings of the company. The policy
of constant pay-out is preferred by the firms because it is related to their ability to pay dividends. Figure given
below shows the behaviour of dividends when such a policy is followed.

(iii) Stable rupee dividend plus extra dividend:

Some companies follow a policy of paying constant low dividend per share plus an extra dividend in the years
of high profits. Such a policy is most suitable to the firm having fluctuating earnings from year to year.

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 Unit -5

#Taxation of multinational firm:

Taxation of Multinational Corporations

1. Where are MNCs?

Their offices are located in major international cities, metropolitan areas,

and port cities to meet local consumer demands and to acquire resources
such as materials and laborers.

Metropolitan areas

Green Gate, Long Street (Gdansk)

Dutch (multinational company) buildings in Long Street, Gdansk, Poland.

These were destroyed by Germans during WWII, but were meticoulously
rebuilt in accordance with the blue print after the war.

A night scene of multinational firms at Victoria harbor in Hong Kong.

Multinational firms tend to be capital-intensive and require high-skilled

workers. Universities are an important source of high-skilled workers.

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 2. US Tax Policy towards MNCs

Operating in many countries, MNCs are subject to multiple tax jurisdictions, i.e., they
may be forced to pay taxes to several countries. National tax systems are exceedingly
complex and differ between countries.

Differences among national income tax systems affect the decisions of managers of
MNCs, regarding the location of subsidiaries, financing, and the transfer prices (the prices
of products and assets transferred between various units of MNCs)

President Trump argues that American firms are moving their factories to Mexico,
because of high US wages, high corporate tax rates, and currency manipulations of other
countries.

Overlapping Multiple Tax Jurisdictions create two problems, overlapping and underlapping
⇒ double jurisdictions. When overlapping occurs, two or more governments claim tax jurisdictions
taxation over the same income of an MNC. The overlapping may result in double taxation.

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 Underlapping
Conversely, when underlapping occurs, an MNC falls between tax jurisdictions and
⇒ tax
escape taxation. Underlapping encourages tax avoidance.
avoidance

National governments may claim territorial jurisdiction or national tax jurisdiction or

both.
Territorial TT: The government taxes business income that is earned on the national territory.
Tax system
 Any business income earned on the US territory is subject to income tax,
regardless of whether the business is owned by foreigners.
 any foreign source income earned by the nationals are exempt from taxation. This

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 approach is used by most European countries (e.g., France, Italy, Netherlands. 34
countries)

 Tax comptition: Since countries have different tax rates, multinational companies
choose to invest in low-tax countries. Governments may compete to attract
multinational enterprises by offering them lower tax rates and other incentives.
This is called tax competition. Since high-tax countries lose lucrative businesses,
they want to harmonize tax rates, especially within a free trade area or customs
union (e.g., European Community). For more information on this subject, see
Daniel Mitchell (Heritage Foundation article on tax competition).
 Lowering corporate tax rate ⇒(i) worsens income inequality, i.e., the rich gets
richer, but (ii) creates more jobs and improves income inequality, i.e., the poor
gets richer.

NT: Both domestic and foreign source income of national companies is subject to
National
income tax. US government taxes both domestic and foreign source incomes of US
Tax system
MNCs.

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 Remark: Most governments that adopt NT system also claim Territorial Tax
jurisdiction. This creates the problem of double taxation.

3. US Taxation of Foreign Source Income

1. In general the US government does not distinguish between income

earned abroad and income earned at home (NTJ).
NT
However, to avoid double taxation, the US government gives credit to
MNEs headquartered in the US for the amount of tax paid to foreign
governments.

2. Foreign Trade and Investment Act of 1972 (Burke-Hartke Bill) was

defeated.
Burke-Hartke Bill
US federal income tax rate is 35%, but the average state and local tax
rate is about 4%. The combined US corporate tax rate is thus 39%.
According to this plan, foreign taxes would be treated as business

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 expenses. For example,

Assume: t = 40%, t* = 30% (Spain)

Pretax profit = $1,000

MNC's profit after foreign tax = 1,000 - 300 = 700

If foreign tax is treated as business expense, then

MNC's tax to IRS = 700 × 40% = 280.

Total taxes = 300 + 280 = 580. (45% more)

(To raise more revenue, this idea is being discussed recently.)

Taxes to foreign government = 1000 × 30% = 300

US taxes = 1000 × 40% = 400

Current Method but foreign tax credit = 300

Net tax to IRS = 400 - 300 = 100.

Total taxes = 300 + 100 = 400.

It is essential to have a low tax rate to attract FDI. Foreign investers may
invest in Canada or Mexico, rather than in the US.

Japan = 40.69% (2011) →30.86% (2016)

China = 33%
Germany =38.31%
France = 33.33% (individual tax: 41% after €1 million ⇒ 75%)
Finland = 26%
Hong Kong = 17.5%
Macau = 12%
US = 39% (max individual tax: 56%)
corporate tax rates Canada = 26%, Mexico = 30%
Russia = 13%

0-25%: 75 countries

25-30%: 43 countries

30-35%: 28 countries

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 >35%: 3 countries

US Marginal corporate tax rate: 39% > 34% (France) > 22.5% (world
average)

4. Transfer Pricing

Intrafirm Transfer prices are the prices paid for imports/exports between the headquarters (HQ) and
trade subsidiaries.

MNCs manipulate prices between the HQ and the subsidiaries so as to realize more profits. Profits
may be the highest in the countries with lowest tax rates.
Why
manipulat Purpose: to minimize the total tax a multinational firm pays.
e TP?
MNCs try to reduce their overall tax burden. An MNC reports most of its profits in a low-tax
country, even though the actual profits are earned in a high-tax country.

tp = tax rate in the parent country

Example th = tax rate in the host country

If tp > th, then lower export prices to the subsidiary in the host country, and raise import prices
from the subsidiary. ⇒ lower tax.

Transfer
prices
affect China's investment in EU rose from $6 billion in 2010 to $55 billion in 2014.
MNC's
profit

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 In High-Tax countries: To reduce MNC profits,
MNC's
Goal: (i) lower selling prices, and
report
maximum (ii) raise buying prices
profit in
the In Low Tax countries, do the opposite
country
with the Total tax = $135 ($7000 × 15%)
lowest tax
Thus, a multinational company's overall tax could be paid at the lowest tax rate of all countries in

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rate. which it operates.

Abuses in pricing across national borders are illegal (if they can be proved). MNCs are required to
set prices at "arms length" (set prices as if they are unrelated).

IRS argued that Toyota Inc. of Japan had systematically overcharged its US subsidiary for years
on most of trucks, automobiles and parts sold to the US (Martz and Thomas, 1991).

Because of abuses in transfer pricing, taxable profits were shifted to Japan. The settlement Toyota
offered to IRS reportedly approached $1 billion.

5. Policies toward FDI

National Defense Authorization Act 2019 limits technology transfers to other

countries.

6. Taxation and Gains from Factor Mobility

why invest US firms invest overseas because the returns are higher there.
overseas
(private gains)

National gains natonal gains can be higher when investment stays home.

Assume both countries have the same corporate tax rates = 40%

US Canada
Pretax profits 10% 12%
Tax 4% 4.8%
Tax Wars to attract Net to investors 6% 7.2%
FDI US Gains 10% (4+6) 7.2%

US Gains from domestic investment = 10% (= 4% + 6%) because tax

revenues can be used to build US infrastructure.

US corporate tax rate was the second highest after Japan (40.69% in 2011,
but declined to 30.86% in 2016), and is a loser in international tax wars /tax

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 competition. ⇒ Outbound FDI > Inward FDI.

Multinationals may retain profits for investment purposes, and need not
repatriate profits to the US.

Total Gains from foreign investment = 7.2% < 10% (= Gains from domestic
investment, because US government gets nothing). The tax revenue which
could have been used to build US highways would be used by Canadian
government to build their highways.

Effects of lowering corporat tax rate: (i) increase inward FDI and decrease
outbound FDI, (ii) increase repatriation of foreign profits. (Foreign profits of
US multinationals are not subject to US income tax if they are parked or
reinvested overseas.)

#Long-Term Financing:
Long-term financing is usually needed for acquiring new equipment, R&D, cash flow enhancement, and
company expansion. Some of the major methods for long-term financing are discussed below.

Equity Financing
Equity financing includes preferred stocks and common stocks. This method is less risky in respect to cash
flow commitments. However, equity financing often results in dissolution of share ownership and it also
decreases earnings.

The cost associated with equity is generally higher than the cost associated with debt, which is again a
deductible expense. Therefore, equity financing can also result in an enhanced hurdle rate that may cancel any
reduction in the cash flow risk.

Corporate Bond
A corporate bond is a special kind of bond issued by any corporation to collect money effectively in an aim to
expand its business. This tern is usually used for long-term debt instruments that generally have a maturity date
after one year after their issue date at the minimum.

Some corporate bonds may have an associated call option that permits the issuer to redeem it before it reaches
the maturity. All other types of bonds that are known as convertible bonds that offer investors the option to
convert the bond to equity.

Capital Notes

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Capital notes are a type of convertible security that are exercisable into shares. They are one type of equity
vehicle. Capital notes resemble warrants, except the fact that they usually don’t have the expiry date or an
exercise price. That is why the entire consideration the company aims to receive, for the future issuance of the
shares, is generally paid at the time of issuance of capital notes.

Many times, capital notes are issued with a debt-for-equity swap restructuring. Instead of offering the shares
(that replace debt) in the present, the company provides its creditors with convertible securities – the capital
notes – and hence the dilution occurs later.

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