International Financial Management - Essay Example

?Contents Executive Summary 2 International Financial Management – An overview 3 International Financial Markets 4 Foreign Currency Risks and Types 5Exposure to Foreign Exchange Rate Risk 6 Exposure to Interest Rate Risk 8 Foreign Direct Investment and its Management 9 Multinational Capital Budgeting 11 References 12 Executive Summary Multinationals are now focusing more and more towards practicing prudent international financial management. Communication and advancement in technology has bridged the distances and companies are indulging in international trade through various means. Financial management primarily requires effective monitoring of foreign exchange exposure risk and interest rate risk. Hedging plays a very important role in international financial risk management. Cautious foreign direct investment (FDI) decisions and vigilant international capital budgeting is also of prime significance. International Financial Management – An overview The world is now a global village – a phenomenon which can be interpreted as a fact that the advancement in communication and technology has integrated the various economies on the globe. A brief analysis of the current economic scenario of any country would reveal that it is, in one way or the other, dependent on the social and economical activities of the other countries. A downward plunge in the New York stock exchange is likely to send shockwaves all across the globe which can be felt in financial market as further as Far East countries. Recently, when the cherished credit rating of United State of America was downgraded to AA+ from AAA, it caused turmoil at a global stage especially in the European countries. All the giant economies such as China and India were badly affected. The economies are have become interlinked in this era due to the fact that now the firms are indulging in international trade and have started exploring markets outside their place of origin. Companies such as HSBC holdings, General Electric, ExxonMobil, British Petroleum and Toyota Motor have two things in common. First, they are the leading and biggest multinationals in the world and second, they all practice prudent international financial management. From a theoretical point of view, the firms engage in international trade in order to obtain comparative advantage which allows the firms to penetrate the foreign markets. Other popular explanations for the firms indulging in the international trade are the product cycle theory and imperfect market theory. There are several ways through which a firm can participate in international business. The most common methods are International Trade Licensing Franchising Joint Ventures Acquisition of companies Foreign subsidiary International Financial Markets In today’s economy, international business is carried out at international financial market. These markets can be categorized as foreign exchange market, international money market, international credit market, international bond market and international stock market. Foreign Exchange market allows for the trading of different currencies at a rate which is determined based on several facts such as inflation and relative interest rates. Foreign exchange market is not a specific building or place; rather the companies indulge in foreign currency transaction through commercial banks and telecommunication networks. Foreign exchange dealers serve intermediaries between the companies who intend to enter into a foreign exchange transaction. In International Money Market, the trading of currency futures and options takes place. Globalization have abridged the distances and abridged the financial bridges between the countries. Multinationals can now obtain medium and long term loan from banks and financial institution located in other countries. Especially in Europe these loans are termed as euro credit loans and are transacted in the Euro Credit market. The international credit markets are now developing rapidly in Asia and South America. Recent global economic events have revealed that banks and financial institution tend to resist participation in the countries which shows higher credit risk such as certain African countries which had been facing financial turmoil in the last decade. In order to raise funds to finance their operations, multinationals can also issue bonds in the international market which are termed as the International Bond Market. Multinational usually issue bonds in foreign country in order to finance a foreign project. For example, for any company situated in any Asian country it would be wise to issue bonds in the United States of America of it wishes to start a project there or to finance its foreign subsidiary. In addition, multinationals can also raise funds by issuing securities overseas and getting them listed in International Stock Markets. Foreign Currency Risks and Types When a multinational operates in such a number of markets, internationally, it is exposed to a great deal of risks, and in order to operate as per its predetermined objectives, the management of these risks is of prime importance. These risks pose a direct threat to the assets, liabilities and operative income of the firm which commonly results from the variations in interest rates, exchange rates and inflation rates. Macroeconomic environment of different countries plays n important role in setting up these risks which affect different countries according to their structure. For example a multinational which is heavily involved in the import and export business is likely to get affected significantly due to the fluctuation in both the exchange rate and inflation rate of the country it is transacting with, whereas, a multinational having a foreign subsidiary is not likely to be affected by the change in the exchange rate. Effective financial management requires identification of risks and taking effective measures in order to curb them. This requires evaluating the exposure of the multinational firm and the corresponding risk. Exposure of a firm can be defined as the value of its assets and liabilities, presented in its functional (primary) currency, exposed to the change in the foreign interest rates, exchange rates and inflation rates. The foreign risk exposure can be classified into two broad categories. Transaction Exposure; and Translation Exposure Transaction exposure can be defined as the risk arising due to the unanticipated change in the exchange rate which affects the cash inflow or outflow at the time of the settlement of an asset or liability. An important factor to consider in these types of risks is that the foreign currency value in such circumstances is fixed and thus these types of risks are also termed as contractual exposure. On the other hand, translation exposure arises due to the operation of the accounting and legislative standards which requires the foreign currency balances of assets and liabilities appearing in the balance sheet, to be revalued at the closing spot rate. These assets are of the time which is not going to be liquated in the near future. Translation risk, which is also termed as the accounting risk, is basically the related measure of variability. Exposure to Foreign Exchange Rate Risk Exchange rate can be defined as the relative price of one currency in terms of other. The exchange rate plays a very significant role in determining the capital flows and investments between international boundaries. In order to exercise prudent financial management, it is of prime importance for the multinationals to forecast the future exchange rates so that they do not suffered exchange losses and incur additional liability. There are two famous theories used for the determination for the prevailing exchange rates. One is interest rate parity theory and the other is purchasing power parity theory. According to the interest rate parity theory, the difference between the interest rate of two countries is equal to the differential between the forward exchange rate and the spot exchange rate of two countries. In the current global economy, interest rate parity theory plays a great part in connecting the interest rates and exchange rates of two countries. The origin of this theory can be associated to an article written by Walther Lotz in 1884 which was concerned with the Vienna forward market. In 1927, another renowned economist Keynes pointed out the fact that forward premiums are affected by the relative interest differential. There are certain assumptions which need to be considered. The securities, both domestic and foreign, are considered to be identical in terms of maturity time and risk. It is the prevailing interest rate on these securities that is utilized in the interest rate parity calculation. In addition, it is also assumed that there are no capital controls or transaction cost and market imperfections. Purchasing power parity theory, another theory widely used in determining the forward rates of a particular currency. As per this theory when a country’s inflation rate rises, the demand for its currency declines as its exports also declines due to the higher prices. As a corresponding impact, the importers and firms in that country start putting more emphasis on the imported goods and other items. These two factors in combination cast a downward impact on the high inflation country’s currency. Inflation rates do not remain constant between countries which cause international trade patterns and exchange rates to adjust accordingly. There are two forms of purchasing power parity theory. One is absolute form and the other is relative form. The rationale behind the purchasing power parity theory is that whether buying products locally or from another country, exchange rate adjustment is necessary for the relative purchasing power. If there is no such equilibrium, the consumer will shift purchases to wherever products are cheaper till the time the economy achieves equilibrium. Multinational nationals, in order to curb the foreign exchange risk exposure enter into hedging transaction which means reducing or controlling risk. In hedging transaction, the firm take place a position in the future market which is opposite to the one being taken in the spot market. The underlying objective of the hedging is to reduce or limit the risk associated with the change in the exchange rate. For example, if an American company has an obligation to pay ?100 in month time and currently the exchange rate parity between USA and UK is ?1 is equal to $1.5, currently in its principal currency, $, the American company has the obligation of paying $150. Now if the financial managers of the American company forecast that the exchange rate parity between USA and UK will be ?1 to $2, then the company will be liable to pay $200 and thus will have to pay $50 more due to the fluctuation in exchange rate. In order to cater this situation, the company can enter into a hedging transaction whereby it enters into a transaction where it has to receive ?100 in one month, so that the loss on payable is offset by the gain on receivables. There are several types of foreign currency risk hedging. The most common types of foreign currency hedges that can be observed are the foreign currency forward contracts and foreign currency options. In forward contracts, the settlement of the transaction is contracted at a rate which is decided beforehand at a rate which is termed as the forward rate. On the other hand, in foreign currency options, the owner has the right to buy or sell a particular amount of the currency at a rate which is predetermined on the purchase date. There is no obligation in the case of foreign currency options, whereas the forward foreign currency contracts are binding. Other forms of hedges are money market hedge and foreign currency swaps. Exposure to Interest Rate Risk Multinationals tend to borrow and lend and in international capital markets based on which the uncertainty in the fluctuation in the interest rate also poses a threat to the profitability. Uncertain exposure in the interest rate affects both the income and expense on the financial asset and liability of the company. Effective management of financial affairs requires that the multinationals identify its exposure to the fluctuation in the interest rate and then set comprehensive guidelines for monitoring key parameters. These objectives might include monitoring the net interest income of the company (total interest income minus total interest expense). This close monitoring also assists the company in identifying the sensitivity of the firms profit to the change in the interest rates. Prudent risk managers also keep into consideration the effect of the fluctuation of the interest rates to the net worth of the company. Interest rate hedging can be done through several ways which includes forward rate agreements, future contracts, swaps and interest rate options. Foreign Direct Investment and its Management The global economy is becoming more and more integrated and countries are now exploring ventures in other parts of the globe for sustainable and lucrative investments. Direct foreign investment (DFI) is one of the strategies which have lately been adopted by various MNCs in order to make the most of the foreign economic environments. DFI encompasses a broad spectrum of investment ranging from investment in existing companies, real estate, equity and capital market and even investment in the development of infrastructure. Acquisition of foreign entities and establishment of joint ventures abroad can also be categorized as DFI. Any capital venture, along with forecasts of return and profit, also comes with an array of risk and uncertainties. In the case of DFI the element of risk is comparatively higher as the investing entity might not be able to correctly forecast the political, economical, social, technological and legal environment of the country in which it plans to invest. The following table illustrates the FDI inflows in few major counties of the world over the past few years. Cost of factor of production varies from country to country. MNCs are now opting to invest in countries where the labor market is skilled and demands lesser wage as compared to the labor in their home country. Companies are now adhering towards countries such as China, Mexico and Japan where the labor is considerably cheap. FDI in Mexico is reported to have recorded a 21% increase in the year 2007 which amount to US$23.3 billion. Taxation structure also holds a very significant position in assessing the suitability of the country for investment related decisions. There are several tax havens in the world where the local statute exempts the levitation of taxation laws and regulation on certain forms of businesses. Cheaper and high quality raw material is another reason for the organizations to explore other areas on the globe. Exchange rate can also be a very crucial factor in deciding which country to invest in and when to invest. If the exchange rate of a country is low, an organization might adhere to invest in such country as the initial cash out flow in such country would be lower. Techniques such as hedging and setting up an effective treasury set up are imperative in such situations. Multinational Capital Budgeting International Capital Budgeting forms the backbone of cautious and effective financial management. It is of logic and in accordance with the prime objectives of the multinational to enter into such investment decisions which add value to the company. International capital budgeting often involves investment appraisal on long term basis. International capital budgeting, in principal is similar in procedures and techniques to that of a domestic investment appraisal, but it involves certain additional complexities. These complexities include plotting of cash flows in foreign currencies, foreign country inflation rates, foreign regulations etc. International capital budgeting can broadly be categorized as Non-discounting method and discounting method. Average rate of return and payback period are the most commonly used non discounting appraisal methods. In average rate of return, only the mean profit prior to interest and tax payments is given attention and decisions are made on that basis only. The biggest shortcoming of this method is that it ignores the impact of corporation tax and time value of money. Another non-discounting method is payback period through which the company can determine the number of years it would to take to recover the initial investment. The drawback of this method is that it only keeps into account the payback period and disregards the cash flows after the profitability period. Multinationals generally use discounting cash flow techniques in the foreign investment appraisal. Net present value (NPV) and internal rate of return (IRR) are the two most common discounting method of appraisal. According to the NPV method, the future expected cash flow, over the time span of the project, are discounted based on the expected discount rate in the economy. The expected cash flow from each year is multiplied by the discount factor to arrive at the present value at year 0 i.e. at the time of making of the capital expenditure. An investment whose NPV is positive is considered to be a rewarding one, whereas an entity does not venture on an investment where the NPV of the cumulative cash flows is negative. Where the management has to rank the investments, with the objective of giving priority to the most rewarding ones, the investment with the highest NPV must be ranked first. Calculating Internal Rate of Return (IRR) is another method extensively used in the investment appraisals. IRR is a rate where the cost of investment, cash outflow, is equal to the cash inflows. The proposal with the highest IRR is considered to be the most rewarding one. Investment appraisal through NPV method and IRR method are both very useful in order to financially attractive prospective of any investment decision. References [1] Heather Stewart “Financial crisis: full force of US downgrade is felt around the world ” guardian.com. Guardian news and media limited, n.d. Web. 19 March. 2012. [2] “The global 2000” forbes.com. 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