ifm

By :Expert Faculties

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

CONTENTSBUSINESS POLICY & STRATEGIC ANALYSISSyllabus................................................................................................ .5 - 5 UNIT I................................................................................................6 - 30 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 MISSyllabus.............................................................................................6 7 - 67 UNIT I..............................................................................................68 - 77 UNIT II.............................................................................................78 - 86 UNIT III............................................................................................87 - 97 UNIT IV..........................................................................................98 - 104Year Question Papers............................................................105 Past 107 Worksheet......................................................................................108 110

RESEARCH METHODOLOGYSyllabus..........................................................................................111 111 I..........................................................................................112 UNIT - 127 II.........................................................................................128 UNIT - 142 III........................................................................................143 UNIT - 152 IV........................................................................................153 UNIT - 165Year Question Papers............................................................166 Past 168 Worksheet......................................................................................169 170

INTERNATIONAL BUSINESS ENVIRONMENTSyllabus.........................................................................................171 171 I..........................................................................................172 UNIT - 195 II.........................................................................................196 UNIT - 211 III........................................................................................212 UNIT - 242 IV........................................................................................243 UNIT - 251Year Question Papers............................................................252 Past 253 Worksheet......................................................................................254 256

SYLLABUS

INTERNATIONAL FINANCIAL MANAGEMENTMBA3rd SEMESTER, M.D.U., ROHTAKExternal Marks : 70 Time : 3 hrs. Internal Marks : 30

Unit - IBusiness 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 - IITop management : Constituents-board of directors, sub-commite, chief executive officer; task, responsibilities and skills of top management.

UNIT - IIIFormation 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 - IVStrategic 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.

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INTERNATIONAL FINANCIAL MANAGEMENTFINANCE : SPECIALIZATION PAPERS

UNIT IQ. Define International Financial Management. What is the nature and scope of International Financial Management? Ans. International Financial Management International financial management (IFM) : the financial decisions taken in the area of international business. IFM helps in deals with 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 It has already been mentioned that IFM is concerned with the IFM : aspects of international business. It helps in taking the correct financial decision so financial that the maximum gain may be derived from international business. The nature and scope of IFM are: (1) Modes of International Modes of international business are: Business : (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.6

INTERNATIONAL MANAGEMENT

FINANCIAL

(iii) Management The third mode is known as management Contracting : 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 Joint ventures are the fourth mode. They represent a Ventures : 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 The behaviour and determination of exchange rate Determination : segment of the study of IFM. The question of day-to-day exchange rate is another 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 : DS

SD

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(4) Exchange Rate Risk and Its Changes in exchange rate consequent Management : changes in macroeconomic fundamentals impact international business in upon the 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 : cash flows, on account of: Transaction exposure involves changes in the present There are two

(a) Export and import of commodities on open account : 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 The borrower of currency : currency is put to loss if that particular foreign currency a foreign 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 When a company innovates a specific technology Decisions its product is mature in the markets abroad or when the company wants to reap and : 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 8

Different theories of overseas production The various strategies of Investment Capital Budgeting Decision Evaluation of foreign exchange Political risks pertaining to overseas investment.


FINANCIAL

(6) International Working Capital When foreign operation begins, the Decisions : company evaluates different sources of working capital so that the cost of parent 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 Any investment needs raising of funds. The MNCsMNCs 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 : the following : analyses (ii) International audit (iii) International financing reporting (iv) International taxation. (v) Transfer pricing Q. Explain the Evolution of International Monetary System. Ans. International Monetary International monetary system is defined as a set System : 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) : system of exchange rate was known as Gold Species Standard in which oldest 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 The International accounting forms an integral part of IFM. It

(i) Techniques for consolidation of financial statements of the various affiliates

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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 ( 1925With the failure of gold standard during 1931) :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 The mechanism of Bretton Woods can be understood with Woods :of the following illustration and diagram: the help10

INTERNATIONAL MANAGEMENT Rs./$ 10.10 10.00 D

FINANCIAL D1 S

Upper Support Parity

9.90 D 1 SD

Lower Support

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 Regime : exchange rate mechanism as follows: Rate At present IMF categories different

(i) Currency Board In this regime, there is a legislative commitment Agreement : to exchange domestic currency against a specified at a fixed rate. As of 1999, eight members had adopted this regime.11

(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 In this regime, the Bands 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 the currency is maintained within a certain margin around a Bands 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 Here exchange rate is determined by market forces Floating : central bank only act as a catalyst to prevent excessive supply of foreign and 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 International financial system System : international financial market, international financial intermediaries and consists of international financial instruments. It is divided into three sections: (A) International Financial Markets : compartmentalized into two segments: International financial market can be

(1) International Money One is the international money market Market : represented by the flow of short term funds. International banks or short term securities come under this segment. (2) International Capital On the other hand, the international capital Market : market forms the other segment where medium and long term fund flow.12

INTERNATIONAL MANAGEMENT (B) International Institutions :

FINANCIAL Financial 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: Up to the mid-1940s, there was no multilateral agency

(a) Multilateral Agencies : to provide funds.

(i) Establishment of It was only in 1945 that the International Bank IBRD : reconstruction and Development (IBRD) was established as an for 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 Thus, in order to overcome these problems, the IFC : 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 Another sister institution was created in 1960 for IDA : 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 Multilateral Investment Guarantee Agency MIGA(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. Bilateral13

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 Non-government agencies include: Agencies : (1) International Among the non-official funding agencies, international banks 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 Market : parts: Securities International Securities Market id divided into two

(i) Debt Securities (ii) Equities. (C) International Financial Funds are raised from the international Instruments : market also through the sale of securities, such as international equities or financial euro-equities, euro bonds, medium term and short term euro notes and euro commercial papers etc. Types of International Instruments Financial Instruments: : International (A) Long Term Instruments (B) Medium-Term Instruments (C) Short-Term Instruments Q. Define International Financial Instruments. Explain its types. Ans. International Financial Funds are raised from the international Instruments : also through the sale of securities, such as international equities or eurofinancial market equities, euro bonds, medium term and short term euro notes and euro commercial papers etc.14

Financial

There are basically three types of

INTERNATIONAL MANAGEMENT Types of International Instruments Financial Instruments: International : (A) Long Term Instruments (B) Medium-Term Instruments (C) Short-Term Instruments

FINANCIAL Financial There are basically three types of

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 Long-term international financial instruments are: Instruments : (1) International Equities OR Euro International equities or euro-equities are Equities : debts as holder are paid dividend. They do not represent FDI as the holders do not 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

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 International bonds are a debt instrument. Bonds 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 : (a) Foreign Bonds and Euro Bonds and Euro bonds. There are different types of such bonds: : International Bonds are classified as foreign 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 It is the World Bank which issued the global bonds for the first time in Bonds 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 countries16


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(c) Straight The straight bonds are the traditional type of bonds. In this case, Bonds 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 In Bullet-Redemption bond the repayment of Bond principal is made at the end of the maturity and not in installment every year. : (ii) Rising-Coupon In rising coupon bond, the coupon rate rises over time. Bond :The benefit is that the borrower has to pay small amount of interest payment during early years of debt. (iii) Zero-Coupon It carries no interest payment. But since there is no Bond 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 : In case of bonds with currency options, the Options investor has the right to received payments in a currency other than the currency of the issue. (v) Bull and Bear The bull bonds are those where the amount of Bonds: 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 : Bonds, which do not carry fixed rate of interest, are known as Notes 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 : International bonds are also convertible bonds meaning that Bonds 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 Medium-term Euro notes are just an extension of shortNotes :term euro notes. They are a compromise between short-term euro notes and longterm 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

(C) Short-Term : Short-term Instruments are: Instruments (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: are denominated in any currency other than the currency of the country (i) They 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 Fee (i) Underwriting : The cost components of euro notes are:

(ii) One-time Management Fee for structuring, pricing and documentation. (iii) Margin in the notes themselves. Documentation Documents accompanying these notes are the : Underwriting agreement (i) (ii) Paying Agency Agreement (iii) Information Memorandum (iv) Financial Position of the Issuer. (2) Euro Commercial Papers Another attractive form of short-term debt (ECP): 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.

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UNIT IIQ. What do you mean by Cash? What are the motives of holding cash? Ans. For the purpose of cash management, the term cash not only includes coins, Cash : notes, cheques, bank drafts, demand deposits with banks but also the near-cash currency, 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 In every business assets are kept because they generate profit. Cash : is an asset which does not generate any profit itself, yet in every business sufficient But cash 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.19

(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 After raising funds, the firm begins operation. Management : 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 Managementsteps. They are: involves four : (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 : The first step in international cash Requirements 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.20

Cash

The management of cash basically


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(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 : After the preparation of Cash Budget and the Needs 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 When a particular unit faces a shortage of cash, it gets it cash : 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 intrafirm 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 There are two types of delays in the collection of cash. One is Inflows : mailing delay and the other is the processing delay. In collection from across the the border, long procedural formalities and governmental restrictions too come in the way. For accelerating inflows following methods are used: (a) Cable As regards curbing of mailing delay, the use of cable Remittances : remittances is often suggested. In this respect, the Society for Worldwide Interbank 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 The firm opens up regional Centres : mobilization centres and instructs customers to make their payments to the centres falling in their respective vicinity. (c) LockBox Sometimes, a postal box are set up in post-offices within System : customers vicinity. The postal box is operated by the local offices of the bank authorized by the firm. (d) Reduction of Processing As far as processing delay is concerned, Delay : 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.21

(e) Pre-Authorised Payment Some firms adopt a pre-authorised System : payment system in which they are authorized to charge a customers bank account up to a specific limit. (ii) Delaying Payment should be made as late as possible without damaging Outflows : 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 : Another way to slow down disbursements is to Disbursement he payments by the head office from the centralized account. This make all 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 Another step towards lessening the requirements Payments : 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:22

INTERNATIONAL MANAGEMENT (i) Netting: No

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15 B 20 6 30 20 12 C A

(ii) Bilateral Netting

: 5 B A

14 18 C

(iii) Multilateral Netting:

B

19

A

4 C

Problems with the Cash Optimization The problems coming in the way of Process : and decelerating of cash flows or the netting process may be grouped as: accelerating (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 There are many host government that practice exchange Restrictions: mechanism in view of their weak balance of payments. The parent companys control 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.23

(3) Deficiency in the Banking : There are still a number of international banks System have not developed sophisticated system of collections and payments. In these that cases, acceleration of collection and netting of payments cannot be effective. (4) Opposition by : The acceleration or deceleration of cash flows may be Subsidiaries 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 The process of centralization of surplus cash can Cash :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.24


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(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 Normally, the surplus cash is invested in a country where Investment : 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. Credit sales lead to the emergence of account receivables. The Introductionof receivables focuses on two important facts. One is that the cost of the credit management : 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 :- The main objectives of credit sales is to increase the total Motives 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 When a firm sells goods or services on credit, it has Receivables : types of costs. These costs are as follows:to bear several (i) Administrative To record the credit sale and collections from customers, a Cost : 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.25

(ii) Capital There is a time lage between sale of goods and its collection from Cost :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 Despite all efforts by the management, the firm may not be able to Cost :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 In case of intra-firm sales, the focus of receivable management is Sales :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 In the case of inter-firm sales or the sales to an outside firm, Sales : 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.26

INTERNATIONAL MANAGEMENT (i)

FINANCIAL

Currency As regards currency denomination, the exporter Denomination : the transaction in a strong currency, while the importer likes likes to denominate 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 is the process of pooling and repackaging Securitization : illiquid financial assets into marketable securities that can be sold to of homogeneous 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.27

(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 :

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

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.28


FINANCIAL

(2) An issuer, also known as the SPV, is the entity, which would typically buy the SPV: 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) Normally, an investment banker is responsible as structure for bringing Structure: 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.

29


UNIT IIIQ. What is Foreign Direct Investment. What are the benefits and costs of Foreign irect Investment? D 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 There are four classification of FDI: Investment : (1) Green-field Green-field investment takes place either through opening Investment : 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 If the firm buys the entire firm : equity shares in a foreign company, it is known as the Wholly-owned subsidiary of the buying firm. (ii) Subsidiary of the Buying If the firm buys more than 50 per cent shares, it firm : is known as Subsidiary of the buying firm. (iii) Equity Alliance : equity alliance.30

If the firm buys less than 50 per cent, it is known simply as an


FINANCIAL

(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 The term brown field investment is used to denote a Investment : combination of green-field and M & As. It is found in cases when a firm acquiresfirm; and after the acquisition, it completely replaces the plant and equipment, another 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 Vertical FDI is said to exist when a firm invests abroad in FDI : operations wither other a view to have control over the supply of inputs or to have with 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 MNCsMNCs, FDI mat be classified as: : Based on the motives of the

(a) Market-seeking Market-seeking FDI moves to a country where per capital FDI: income and the size of the market are large. (b) Resource-seeking The resource-seeking FDI flows to a host country FDI: where raw material and manpower are available in abundance. (c) FDI Efficiency-seeking : The efficiency-seeking FDI moves to a country where the abundance of resources and presence of large market help MNCs to improve their efficiency.31

Benefits and Costs of When direct investment flows from one country to another, it FDI : benefits both for the home country and the host country. At the same time, it involves creates 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 FDI helps improve the balance of Payments : 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 When foreign investors invest in Infrastructure : as basic economic infrastructure, social infrastructure, financial markets, sectors such 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 Foreign firms are a source of tax income for Budget : government. They pay not only income tax but also the tariff on their import. At the the same time they help reduce governmental expenditure requirements through supplementing the governments investment activities.32


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Benefits for Home FDI benefits the home country too. Country : (1) Increases the Supply of Raw The country gets the supply of necessary material : material if the investor makes investments in the exploration of a particular raw raw material. (2) Improvement in the Balance of The balance of payments improves Payments : as the parent company gets dividend, royalty, technical services fees, and insofar 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 Moreover, the government of the country : 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 It is a fact that the inflow of foreign Payments : 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 The parent company supplies the Country : 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 Foreign investors are generally more powerful. Industrialists : industrialists not compete with them, with the result that the domestic Domestic industry fails to grow. Cost to Country : (1) Outflow Home of Factors of The cost to the home country is only little. Production : it cannot be denied that investments abroad take away capital, skilled However 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 The MNCs operate in different countries in order to maximize Motive : overall profit. To this end, they adopt various techniques that may not be in the their 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.33

Q. What is Foreign Portfolio Investment? Ans. Foreign Portfolio Foreign investment takes two forms. One is foreign Investment : 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 An investor opts for international portfolio Investmentbecause international diversification of portfolio of assets helps achieve a higher investment : 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) : s P = W2 2 2 2 + W ss ss

+2 W

A

WB r AB

A B

s = Standard deviation of portfolio consisting securities A and B P WA W B sA sB r AB = Proportion of funds invested in Security A and B = Standard deviation of returns of Security A and Security B = Correlation coefficient between returns of Security A and Security B The correlation coefficient can be calculated as follows: r AB Cov AB = sA s B (three s+W s +2 Wx

Risk of Portfolio assets): s P = W2 2 2 2 +2 W s2 W 1, W2 , W 3 sx s y s z

Wy r yz sy sz + Wx Wz r x sz x sz

= Proportion of amount invested in securities X, Y and Z = Standard deviation of Securities X, Y and Z

r x y = Correlation coefficient between Securities X and Security Y r = Correlation coefficient between Securities Y and Security Zyz

r = Correlation coefficient between Securities X and Security Zxz

34


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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(R p ) = (RA ) + (RB ) A B W W S(R p)= 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 The decision to invest abroad takes a concrete Budgeting :a future project is evaluated in order to ascertain whether the implementation of shape when the project is going to add to the value of the investing company. The evaluation of the longterm 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 There are two criterias for capital expenditure decisions: Budgeting : (A) Accounting Profit Criteria (B) Cash Flow Criteria35

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 Under accounting profit criteria, there is only one method Criteria : making capital expenditure decisions. This method is known as Average Rate of for 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 = Average Investment 100 X

Average Annual Profits

Total of after tax profits of all years 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.36


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(B) Cash Flow Cash flow criteria is based on cash flows rather than accounting Criteria : Cash flow methods are divided into two sections: profit. (1) Non-Discounting Methods : included: Under non-discounting methods only method is

(i) Pay Back Method The payback method is the simplest method. This method (PB) : calculates the number of years required to payback the original investment in a project. There are two methods of calculating the Payback Period: First This method is adopted when the project generates equal cash Method : year. In such a case payback period is calculated as follows: inflow each Investment Payback Period (PB)= Constant Annual Cash Flow Second This method is adopted when the project generates unequal Method : each year. Under this method, payback period is calculated by cash inflow 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 Under discounting methods we include: Methods : (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 NPV = [(Cash inflow in 1 year x PVF ) + (Cash inflow in 2 year x PVF ) +(Cash inflow in 3rdyear x PVF ) +(Cash inflow in nth year X PVFn)] [Initial outflow cash X PVF ]st 1 n d 2 3 0

37

PVF = Present Value Factor in 1 year = Present value factor in 2 year and so on. PVF1 st 2 nd

If PVF is not given, we may calculate NPV as follows: OR NPV = [Cash inflow in 1 year X 1/(1+r) ] + [Cash inflow in 2 year X 1/(1+r) ] + [Cash in 3rd year X 1/(1+r) ] +[Cash inflow in nth year X 1/(1+r) ] inflow [Initial Cash outflow X 1/(1+r) ]st 1 nd 2 3 0

n

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 Second method of evaluating a project through (PI) : discounted cash flows is profitability index method. This method is also called BenefitCost 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 PI Inflows 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 method is also known as time adjusted (IRR) 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.38


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Procedure to Find Out IRR: Step Calculate the fake payback period I: 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 Locate the closest figure to fake payback period in the annuity table A-2 II : the row of number of years of the project. Tae rate of that column will be the first against discount rate. Step Find the NPV of the project at the first discount rate located above. If NPV is III : 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. NPV at lower discount rate IRR = Lower discount rate + X Difference in discount NPV at lower discount rate NPV rate at higher discount rate Q. What are the distinctive features international budgeting? Explain. capital of the cash flow calculation in Step IV : Now, apply the following formula to find IRR:

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 longterm 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 Any investment for a new project demands a part of the Flow :current wealth, but, in turn, it brings in funds and adds to the firms stock of wealth in the firms 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.39

Cash Cash inflow includes revenue on account of additional sale or cash from Inflow : selling off an asset, which is known as salvage value. Thus, cash flows are eventually grouped under three heads: (1) Initial Investment (2) Operating Cash Flow (3) Terminal Cash Flow or Salvage Value. Complexities in Cash Flow The computation of cash flow is complex in Computation : 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 The computation of cash flow in the context of international Perspective : budgeting incorporates factors that influence the very size of the cash flow at capital different stages. These factors operating stages of cash flow need to be analysed here. (1) Initial If the entire project cost is met by the parent company, the entire Investment : of initial investment is treated as the cash outflow. Cash outflow may be amount 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 Again, in some cases, the subsidiary makes Earnings : 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 Yet again, the issue of blocked funds is very pertinent Funds 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. Fresh Investment made by parent Use of retained earning, if any Use of blocked funds, if any

Initial Investment

= +

+

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(2) Operating Cash The operating cash flow is computed on an after tax basis as Flow : 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 If the subsidiary pays royalty to the parent etc. : 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 If the host government offers incentives, they Incentives : be included in the capital budgeting decision. For example, if the host should 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 The inflation rate differential needs to be taken into Differential : Inflation influences, both, the cost and revenue streams of the project. account. 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.41

Factors that Influence Operating Cash Flow: All above factors are also shown in the following way: Sale of goods in = + -host country + markets Flow of dividend, royalty etc.

Operating Cash Flow

Export of goods

Lost Export

+

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

(3) Terminal Cash Besides adjustments in the initial investment and in the Flow :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.

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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 cash flow, TCF . The break-even salvage value is derived as follows:t n

n t NPV S[OCF t / (1+k) t=1 = [TCF 0 = I0 n t S[OCF t / (1+k) t=1 [TCF n t S[OCF t / (1+k) t=1 [TCF n TCF n = I 0 t=1 ]

]

+ n /(1+k)n ] I 0

+ n /(1+k)n ] I 0

]

=

n

/(1+k)n ]

S[OCF t / (1+k) t ] Xn (1+k)

NPV= Net Present Value Terminal Cash Flow TCF = 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: = $ [20000-{10000/1.10 + 12000/1.10 + 13000/1.10 }] X (1.10)2 33

= $ -11680 (B) Parent-Subsidiary The analysis of project appraisal so far takes into Perspective : the parent units perspective, of course, based on valid reasons. Even in this account 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.43

(i) One is the NPV from the parents perspective i.e. NPV p And the other is the NPV from the viewpoint of the project itself, which is known (ii) 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 In order to find the NPVp, the following steps are taken: NPVp (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 Similarly, to find out the NPVs, the following steps are taken: NPVs : Estimate the cash flow in host country currency (i) 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 t