International Financial Management

SCF-181, HUDA Complex,
Near New Telephone Exchange, Rohtak (Haryana)

Publications
By :
Expert Faculties
Z
A
D

C
O
M
P
U
T
E
R
S
Z
A
D

C
O
M
P
U
T
E
R
S
Z
A
D

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
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
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
6
Z
A
D

C
O
M
P
U
T
E
R
S
7
(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
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 $35 per ounce, the
currencies went on float rather than fixed. Though Smithsonian Agreement.
(E) Current Scenario of Exchange Rate Regime : At present IMF categories different
exchange rate mechanism as follows:
(i) Currency Board Agreement : In this regime, there is a legislative commitment
to exchange domestic currency against a specified at a fixed rate. As of 1999,
eight members had adopted this regime.
11
D1
D
S
Rs./$
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
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
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
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
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
(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
(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
(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
(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
(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
Z
A
D

C
O
M
P
U
T
E
R
S
31
(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
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
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
(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
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
(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
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
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
(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
(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
(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
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
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
DPS = Dividend 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
DPS = Earning 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
EPS = Earning Per Share
G = Rate of growth in EPS
Z
A
D

C
O
M
P
U
T
E
R
S
53
(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
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
Rs. 100 D = 0
E = 100
D/E = 0
(iii) Case III : 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
(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
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
(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
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
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
(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
(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
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
PRINCIPAL
FIRM A FIRM B
75

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.

Gain to Swap Dealer :
Interest Rate Received 9.75%
Interest Rate Paid 9.65%
Net Gain 0.10%
LIBOR + 0.3%
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

C
O
M
P
U
T
E
R
S

International Financial Management

Caricato da

Informazioni sul documento

Copyright

Formati disponibili

Condividi questo documento

Condividi o incorpora il documento

Opzioni di condivisione

Hai trovato utile questo documento?

Questo contenuto è inappropriato?

Copyright:

Formati disponibili

International Financial Management

Caricato da

Copyright:

Formati disponibili

SCF-181, HUDA Complex,

Near New Telephone Exchange, Rohtak (Haryana)

Potrebbero piacerti anche