(MF0015 International financial management)

Q1. How does International Financial Management helps in maximizing the wealth of the shareholders? Ans:- Effective financial management is not limited to the application of the latest business techniques or functioning more efficiently but includes maximization of wealth meaning that it aims to offer profit to the shareholder, the owners of the businesses and to ensure that they gain benefits from the business decisions that have been made. So, the goal of international financial management is to increase the wealth of shareholders just like in domestic financial management. The goals are not only limited to just the shareholders, but also to the suppliers, customers and employees. It is also understood that any goal cannot be achieved without achieving the welfare of the shareholders. Increasing the price of the share would mean maximizing shareholders wealth. Though in many countries such as Canada, the United Kingdom, Australia and the United States, it has been accepted that the primary goal of financial management is to maximize the wealth of the shareholders; in other countries it is not as widely embraced. In countries such as Germany and France, the shareholders are generally viewed as a part of the stakeholders along with the customers, ban ks, suppliers and so on. In European countries, the managers consider the most important goal to be the overall welfare of the stakeholders of the firm. On the other hand, in Japan, many companies come together to form a small number of business groups known as Keiretsu, including companies such as Mitsui, Sumitomo and Mitsubishi which were formed due to consolidation of family-owned business empires. The growth and the prosperity of their Keiretsu is the most critical goal for the Japanese managers. However, it doesnt mean that the maximization of shareholders wealth is just an alternative but it is a goal that a company seeks to fulfill along with other goals. The maximization of shareholders wealth is a long term goal. If a firm does not treat the employees properly or produces merchandises of poor quality, it cannot be expected that such firms will be able to maximize the shareholders wealth. Only those firms can stay in business for a long term and provide opportunities for employment that efficiently produces what is demanded from them. However, in recent times, as capital markets are becoming more integrated and liberalized, managers in countries such as France, Germany and Japan have started paying serious attention to the maximization of the sha reholders wealth. For instance, in Germany, companies can now repurchase stocks, if necessary for the shareholders benefit. Q2. Explain the major accounts and sub categories of the balance of payments statement. Ans:- The economic transactions of a countrys residents in relation to the rest of the world are summarized by the balance of payments statement. It also presents the transactions of movements in official reserves, the net income that has been generated abroad and the transactions that take place in the physical and financial assets. The BOP consists of current account, capital account and reserve account. The current account records flow of goods, services and unilateral transfers. The capital account shows the transactions that involve changes in the foreign financial assets and liabilities of a country. The reserve account records transactions pertaining to reserve assets like monetary gold, special drawings right (SDRs) and assets denominated in foreign currencies. BOP is neither an income statement nor a balance sheet. It is a statement of sources and uses of funds that reflects changes in assets, liabilities and net worth during a specified period of time. Decreases in assets and increases in liabilities or net worth represent credits or sources of funds. Increases in assets and decreases in liabilities or net worth represent debits or uses of funds. Sources of funds include exports of goods and services, investment and interest earnings, unilateral transfers received from abroad and loans from foreigners. Uses of funds include imports of goods and services, dividends paid to foreign investors, transfer payments abroad, loans to foreigners and increase in reserve assets.

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(MF0015 International financial management)

The Current Account The current account of the balance of payments refers to the monetary value of all exports and imports of merchandise and invisibles. All international flows associated with transactions in goods and services, investment income, and unilateral transfers are included in this account. It is divided into merchandise trade balance, the service balance and the balance on unilateral transfers. All the entries that are made in these accounts are of current value and they do not give rise to any future claim. A surplus in the current account represents an inflow of funds while a deficit represents an outflow of funds. The detail of these three sub-categories is presented as follows: Merchandise trade: It includes the balance between exports or imports of goods such as machinery, electronic goods, cars etc. A surplus balance of merchandise trade happens when exports are greater in value than imports. A deficit in balance of merchandise occurs when imports exceed exports. Invisibles: These include services like payments for legal assistance, tourists expend itures, and shipping fees, royalty payments and interest payments. International interest and dividend payments and the earnings of domestically owned firms operating abroad. Unilateral transfers: These include remittances, gifts and grants by both government and private sector. Government transfers include money, goods and services sent as an aid to other countries in the hour of need. Private gifts and grants include personal gifts of all kinds. Merchandise trade includes all of the goods a country exports or imports, such as agricultural products, machinery, automobiles, petroleum, electronics, textiles, and the like. The dollar value of merchandise exports is recorded as a plus (credit), and the dollar value of merchandise imports is recorded as a minus (debit). Combining the exports and imports of goods gives the merchandise trade balance. When this balance is negative, the result is a merchandise trade deficit; a positive balance implies a merchandise trade surplus. Exports and imports of services include a variety of items. When Indian ships carry foreign products or foreign tourists spend money at Indian restaurants and hotels, valuable services are being provided by Indian residents, who must be compensated. Such services are considered as exports and are recorded as credit items on the goods and services account. Conversely, when foreign ships carry Indian products or when Indian tourists spend money at hotels and restaurants abroad, foreign residents are providing services that require compensation. Because Indian residents are, in effect, importing these services, the services are recorded as debit items. Insurance and banking services are explained in the same way. Services also include items such as transfers of goods under military programmes, construction services, legal services, technical services, and the like. When the sum of all debits and credits is calculated, a country may have a deficit or surplus on the merchandise trade account. This measures whether the country is a net exporter or importer of goods. A trade surplus indicates that the countrys exports are greater than imports and a trade deficit indicates that a countrys imports are greater than exports. Just what does a surplus or deficit balance on the goods and services account mean? A surplus shows how much the country will have to lend or invest abroad. A deficit shows how much a country will have to borrow from aboard by issuing certain financial securities like bonds or stocks to finance its deficit. Capital Account It is an accounting measure of the total domestic currency value of financial transactions between domestic residents and the rest of the world over a period of time. This account consists of loans, investments and other transfers of financial assets and the creation of liabilities. It includes financial transactions associated with international trade as well as flows associated with portfolio shifts involving the purchase of foreign stocks, bonds and bank deposits. It includes three categories: direct investment, Portfolio investment and other capital flow. The detail of these three sub-categories is presented as follows: Direct investment: It occurs when the investor acquires shares of a company acquires the entire firm or the establishment of new subsidiaries. FDI takes place when the firms tend to take advantage of various market imperfections. Firms also undertake FDI when the expected returns from foreign investment exceed the cost of capital, allowing for foreign exchange and political risks. The expected returns from the foreign profits can be

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(MF0015 International financial management)

higher than those from domestic projects due to lower material and labour costs, subsidized financing, investment tax allowances, exclusive access to local markets etc. An example of direct investment is an Indian firm doing business in a foreign country. Portfolio investment: This represents the sales and purchases of foreign financial assets such as stocks and bonds that do not involve a transfer of management control. A desire for return, safety and liquidity in investments is the same for international and domestic portfolio investors. International portfolio investments have seen a boom in the recent years as the investors have become aware about the risk diversification that can be reduced if they invest in various financial assets globally. The increased returns from the foreign markets have also given a boost to such category of investors. An example is a foreign institutional investor buys the equity stock of an Indian company. Capital flows: It represents the claim with a maturity of less than one year. Such claims include bank deposits, short-term loans, short-term securities, money market investment etc. these investments are sensitive to both changes in relative interest rates between countries and the anticipated change in the exchange rate. Let us understand with the help of an example. If the interest rate increases in India then it will experience a capital inflow as investors would like to take advantage of the situation by buying bonds when prices are low, since interest rates on bonds and inversely proportional to the bond prices. The Official Reserve Account The Official reserve account of BOP measures a countrys official reserves which are in the form of liquid assets like the central banks holding of gold. They are government owned assets. This account represents only purchases and sales by the central bank (RBI). These reserves also include foreign exchange in the form of balances with the foreign banks and the IMF and the governments holding of Special drawing rights (SDRs).The changes in official reserves are necessary to account for the deficit or surplus in the BOPs. While an increase in the holdings of foreign currency reserves by the countrys central bank is debited to the official reser ve account, a decrease in the holdings of foreign currency reserves by the countrys central bank is credited to the reserve account. Q3. Define what you mean by Forward Markets. Discuss the differences between futures options and spot options. Ans:- Forward Market In the forward market, contracts are made to buy and sell currencies for future delivery, say, after a fortnight, one month two months, or three months. The rate of exchange for the transaction is agreed upon on the very day the deal is finalized. The forward rates with varying maturity are quoted in the newspapers and those rates form the basis of the contract. Both the parties have to abide by the exchange rate mentioned in the contract irrespective of whether the spot rate on the maturity date is more or less than that of the forward rate. In other words, no party can back out of the deal, even if changes in the future spot rate are not in his or her favour. The value date in case of a forward contract lies definitely beyond the value date applicable to a spot contract. If it is a one-month forward contract, the value date will be the date in the next month corresponding to the spot value date. Suppose a currency is purchased on 1 August, if it is a spot transaction, the currency will be delivered on 3 August. But if it is a one-month forward contract, the value date will fall on 3 September. If the value date falls on a holiday, the subsequent date will be the value date. If the value date does not exist in the calendar, such as 29 February (if it is not a leap year) the value date will fall on 28 February. Sometimes, the value date is structured to enable one of the parties to the transaction to have the freedom to select a value date within the prescribed period. This happens when the party does not know in advance the precise date on which it would be able to deliver the currency; for instance, an exporter who sells a foreign currency forward without knowing in advance the precise date of shipment.

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(MF0015 International financial management)

Again, the maturity period of forward contract is normally for one month, two months, three months, and so on but sometimes it may not be for the whole month and a fraction of a month may also be involved. A forward contract with a maturity period of thirty-five days is an opposite example. Naturally, in this case, the value date falls on a date between two complete months. Such a contract is known as broken-date contract. Forwards, Futures and Options: A Comparison While forwards, futures and options can all be used both to reduce foreign exchange risk (that is, to hedge) and to purposely take foreign exchange risk (that is, to speculate), the differences between forwards, futures, and options make them suitable for different purposes. An explanation of which type of contract would be most appropriate in different circumstances must wait until we have dealt with many other matters, including further ways of hedging and speculating. So at this point we can do little more than list the differences between forwards, futures, and options as shown in Table 4.1. The table notes the primary users of the markets, as well as the institutional differences between forwards, futures and options. The reasons different markets have different primary users can be explained with the pay-off profiles.

Q4. Define cost of capital. Discuss the approaches that are employed to calculate the cost of equity capital. Ans:- Cost of CapitalLet us begin with an example. There are two projects A and B which the firm is considering. It has to choose only one of them. It chooses project B. By taking up project B, the firm has to forego the opportunity to undertake project A. This means that the firm incurs an opportunity cost in terms of what it could have earned on an alternative investment. Suppose project A yields a return of 10 per cent. So, by undertaking project B, the firm forgoes the 10 per cent return on project A. Hence the firm should get a return of at least 10 per cent on project B. This is the required rate of return. The higher the risk of a project, the higher is the rate of return. However, if the project risk is zero, this does not imply that the rate of return is zero. This means that the project still requires compensation for the passage of time. This is called risk free rate of return. Thus, the required rate of return is a sum of risk free rate of return plus the risk premium. Cost of capital is another name for required rate of return. It is the minimum rate of return required by a firm on its investment in order to provide the rate of return

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required by its suppliers of capital. The suppliers of capital are equity shareholders and debt holders. A firm may have cost of equity, cost of retained earnings and cost of debt. The cost of capital is the combined cost of all sources of capital. As the components are combined according to the weight of each component of the firms capital structure, the overall cost of capital is also known as weighted average cost of capital (WACC). The cost of capital for foreign investment projects like domestic capital budgeting projects should be based on the weighted average cost of long-term sources of finance. While calculating the cost of capital, cash flows warrant adjustment not only for corporate taxes, but also for foreign exchange risk, withholding taxes on repatriations made, and so on. It must be added here that in case of international project evaluation, it is important to consider the country risk factor and therefore, the sovereign spread of the country gets added to the cost of debt and equity. The country risk arises due to macroeconomic variable, volatility and the inefficiencies of the capital market and the political situations. The determination of weighted average cost of capital (WACC) requires the calculation of specific costs of different sources of long-term funds. The procedure of computing various sources of finance is the measurement of:

Cost of Equity Capital Two possible approaches employed to calculate the cost of equity capital are:

(i) Dividend approach: As per this approach, the cost of equity capital is worked out on the basis of a required rate of return, in terms of the future dividends to be paid on the shares. Accordingly, ke is defined as the discount rate that equates the present value of all expected future dividends per share with the net proceeds of the sale (or the current market price) of a share. (ii) CAPM approach: Another technique that can be used to estimate the cost of equity is the CAPM approach. According to the CAPM approach, k is a function of the riskless rate of return (normally represented by the rate of return/ yield available on long term treasury bonds of the government of the country), market rate of return (average rate of return on market portfolio, represented in India by, say, the National Stock Exchange Index, NIFTY, and so on), and beta is the measure of systematic risk. It is significant to note that foreign companies/MNCs, in general, may have a lower ke than domestic companies due to the fact that they have access to several foreign capital markets to raise funds.

Q5. Explain the techniques adopted by MNCs to reduce country risk.

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(MF0015 International financial management)

Ans:- Risks that are faced by MNCs on an overseas direct investment are those related to the local economy. Among these, some may be due to the possibility of confiscation (government takeover without any compensation) and the rest may be because of the possibility of expropriation (government takeover with compensation). The other risks may be the political risks, risk of currency inconvertibility and restrictions on the repatriation of income beyond those reflected in the cash flows of an MNC. Before a company can consider how much of its country risk is systematic, it must be able to determine the risk in each country. One of the best-known country-risk evaluations is prepared by Euro money, a monthly magazine that periodically produces a ranking of country risks. It consults a cross-section of specialists. These specialists give their opinion on each country with regard to one or more factors used in their calculation. Three broad categories of factors are considered. These are analytical indicators, credit indicators and market indicators. The analytical indicators consist of economic and political-risk evaluations. The economic evaluation is based on the actual and projected growth in GNP. The political risk evaluation is provided by a panel of experts comprising risk analysts, insurance brokers and bank credit officers. The credit indicator includes measures of the ability of the country to service debts based on debt service versus exports, the size of the current account deficit or surplus versus GNP, and external debt versus GNP. Market indicators are based on assessments of a countrys access to bank loans, short-term credits, syndicated loans and the bond market as well as on the premiums occurring on recourse loans made to the exporters. Methods of reducing country risk Measures of country risk do not distinguish different risks facing different industries. They measure only the risk of countries. An MNC will have to reduce the country risk to gain. The various techniques that can be adopted by them are summarized as follows: Keeping control of crucial elements of corporate operations: Some companies making direct foreign investments try to prevent operations from running without their cooperation. This can be achieved if the investor maintains control of a crucial element of operations. For example, food and soft-drink manufacturers keep their special ingredients a secret. Auto companies can produce vital parts such as engines in some other countries and can refuse to supply these parts if their operations are seized. Programmed stages of planned divestment: An alternative technique for reducing the probability of expropriation is for the owner of an FDI to promise to turnover ownership and control to local people in the future. Joint ventures: Instead of promising shared ownership in the future, an alternative technique for reducing the risk of expropriation is to share ownership with foreign private or official partners from the very beginning. Such shared ownerships are known as joint ventures. Local debt: The risk of expropriation as well as the losses from expropriation can be reduced by borrowing within the countries where investment occurs. If the borrowing is denominated in the local currency, there will often also be a reduction of foreign exchange risk.

Q6. Define the benefits of FDI. State the cost of FDI to the home country. Ans:- Benefits of FDI Benefits to the host country Availability of scarce factors of production: FDI brings in capital and supplements the domestic capital, and in return can use the factors of productions that are cheap in comparison to the host country. Improvement in the balance of payments: The inflow of investment is credited to the capital account. The host country is able to produce those items that were being imported earlier. Building of economic and social infrastructure: Due to foreign investment the basic economic infrastructure, social infrastructure, financial markets and the marketing system of the host country develop fast. Fostering of economic linkages: Foreign firms have forward and backward linkages. They train the local labour with technical knowledge that increases the earning capacity; but it also increases the purchasing power.

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Strengthening of government budget: Foreign firms are a source of tax income for the government. They pay not only income tax, but also import tariff; thus they help the government in reducing its expenditure.

Benefits to the home country The home country gets supply of raw material that was not earlier available. The balance of payment improves as the parent company gets dividend, royalty, technical service fees and other payments. The parent company makes an entry into new financial markets through investment abroad. Government of the home country generates revenue through taxing the dividend and other earnings of the parent company. FDI is a complement to foreign aid and helps in developing closer politicalties between the home country and the host country which is beneficial for both the countries. Cost to the home country Making investment abroad takes away capital, skilled manpower and managerial professionals from the home country. Outflow of these factors of production may disturb the home countrys interest. Subsidiaries of MNCs operating in different countries may adopt various techniques that may not be in the interest of the home country.

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