The Ruritanian Project - Coursework Example

?Analysis of the case study -The Ruritanian Project Ruritania is a perfect example of a transitional economy. Ruritania is currently an economically developing Eastern European country. The annual growth rate has averaged around 6% per annum over the last five years with annual inflation rate of 5.2% (Case Study). The country is currently politically stable. Governments have been democratically elected for the last twenty years. There are two major political parties in Ruritania. The country is about to go for polling in next couple of months. Recent opinion polls suggest that the present Government currently enjoys a 7% lead over the other major party and this view has remained reasonably stable. So if the incumbent government stays in power, it will continue the reform works. The other major party is also committed to democratic principles and a market based economy. They intend to increase both corporate and personal taxation to provide additional funding for their proposed social expenditure (Case Study). The currency of the country was deregulated nearly twelve years ago. Though there was initially a sharp depreciation of the currency, the currency has gained stability against major international currencies during the past three or four years. There has been a speculation that the government will peg the currency with a major currency as a first step for joining the euro. Ruritania is currently negotiating for membership of the European Union and hopes to join in about 2014 (Case Study). In this case, our company wishes to set up a manufacturing in the country in order to utilize the low cost labor and access the local market. We are going to discuss various long term and short term financial issues and underlying theories that are likely to influence the investment decision (Case Study). Foreign Direct Investment as a Strategic Decision of the Firm FDI refers to the reassignment of the capital, managerial and technical assets of a firm from the dwelling country to the host country. It is a type of international finance which consists of lending and portfolio investments. It is unlike lending because it demands ownership. Also it is different from portfolio investment since it entails control of financed actions over administration. There is no united theory associated to FDI. Basically, three levels of analysis have been differentiated by theories based on conventional trade and location theories, theories based largely on industrial organization economics, and theories are based on the theory of the firm and center on the competitive advantage of the firm. Customary international trade theories have been enlarged to FDI with regard to the international movement of factors of production. Examples incorporate such extensions of the international trade theory, as factor endowment theory that includes factor mobility (Helpman, 1984, pp. 451-471) and specific factor models (Markusen & Venables, 1998, pp. 183-204), which both are delegates of the new trade theory. They are valid in the context of FDI, as they let imperfect competition and product differentiation. Also traditional location theory stresses on the least-cost location of production as the best location of the firm. Macro-economic investment theories include Dunning's developmental model of international investment. The theory relates the determinants of outward and inward investments to the developmental stage of the state. According to the model, outward investment beats the inward investment as the country grows. The ongoing shift from negative to positive on net investment depends on a country's factor endowments, politico-economic system and its interdependencies with the world economy (Dunning 1993). Vernon pioneered the product life cycle theory in the mid-1960s, but expanded it later to a clearly oligopolistic understanding. The theory elucidates the geographical course of locating the manufacturing units in the four broad stages of development. In the first phase, new products are launched by a firm griping technological headship in a location. Overseas demand is provided by export. In the second stage, the firm begins to set up production facilities in a foreign country as soon as it uncovers a chance to cut costs to maintain its market share intact. In the third stage, the freshly established plant provides the local market in the host country and dislodges exports from the home country. Thus, home country based firms export directly to third countries. Lastly, in the fourth phase, the originally started plant in the host country spreads out its exports also to third-country markets. As the pioneering lead is vanished and the product becomes mature, the production facilities will be moved to low-cost locations (Vernon, 1979, pp. 255-267). Finally, the eclectic theory is Dunning's attempt to combine various theories on FDI. Eclectic theory says compared to local competitors foreign firm does not have as good information of the local business environment. Thus, transitional companies will engage in international production only if a set of particular advantages are present, namely ownership advantage, internalization advantage and location advantage (Dunning 1993). Political System of the Host Country The political system of a country can be defined as a persistent pattern of human relationship, which involves control, influence, power, or authority (Dahl, 1976, p. 4). The political system includes the cases of totalitarianism and democracy, and all the various conditions between them. However, the political system as such does not have an impact on the firm's investment decision as long as the system is stable and predictable. Instead, political instability blocks the possibilities of transitional companies and thus, they tend to avoid countries with an unstable political climate. The political system of the host country basically creates the prevalent attitudes toward business enterprises whether domestic or foreign. Transitional companies need to take into account the overall legal system of the country. Economic System of the Host Country Economic policies can be defined as government activities to promote economic development. In creating the welfare of the country, the government aims to achieve a number of other economic objectives, such as a high and sustained level of economic growth, full employment, low inflation, and a sound balance of payments and a strong currency value in foreign exchange markets (Nellis & Parker 1996, p. 12). The free market approach demonstrates that the market mechanism guarantees economic efficiency and thus, the less the state intervenes, the better the market works. The governed market approach claims that the economy is inherently unstable and requires active government intervention to achieve stability. In a governed market, transitional companies need special skills in order to convince the host government of the benefits of the FDI for the host country. Trade policies are closely linked with the investment policies. From the host government's perspective, there are at least two ways how countries can combine trade and investment. From the transitional companies’ perspective, high tariffs and non-tariff barriers create an incentive to invest in the country. Consequently, when the trade barriers are not significant, transitional companies would rather export goods than invest in the host country. Issues Related to Transitional Economies in Central and Eastern European Countries United Nations Conference on Trade and Development (UNCTAD) defines a transition economy as one which is in transition from centrally planned to market economies (UNCTAD, 2012). Wages in the transitional economies are amongst the lowest in Europe. The subject concerning impact of labor costs on the choice to invest in the transition economies is an significant one and the topic of some dispute. Konings and Janssens (1996) found labor costs to be a relatively important factor in the location decision in Hungary, although less important than achieving a market share. Savary (1997) found that French firms view the central and eastern European countries as more attractive in terms of production costs, especially labor costs, than Southern Europe. In the context of the central and eastern European countries, we may find that membership of the Central European Free Trade Area has an impact on the investment decision. Agreements with the EU have been reached by most of the Central European countries, establishing timetables for free trade and eventual negotiations about membership. This may encourage investment targeted at sales to the EU. Lankes and Venables (1997) found that tax incentives for foreign investment are not considered important to the location decision in central and eastern European countries, although individual agreements between the investor and the government are significant for a small group of investors. Current trend in the FDI into the transitional economies is a mixed picture. The source of the data is United Nations Conference on Trade and Development website. The table shows foreign direct investment as a percentage of total GDP of the country. Here the countries are from all over the world. The countries from the central and Eastern Europe along with neighboring Asian countries still have a higher FDI to GDP ratio. The following chart depicts the FDI to GDP situation in Croatia and Ukraine. These are two representative countries of central and Eastern Europe. Figure: FDI to GDP Ratio for Croatia and Ukraine on a Comparative Basis (Source: UNCTAD, 2012) Financial Issues related to Foreign Operation Investing in a foreign country has its direct impact on the accounting policies and financial management of the company. There are many accounting related issues with the internationalization. Three main issues are currency translation, multiple reports and segmental reports. Other major issues (e.g. how to account for global inflation) are more complicated to handle (Samuels and Piper, 1985, pp. 119-127). Currency translation is not a new problem as it existed ever since one country ever traded with another. Earlier the term ‘conversion’ was used in place of ‘translation’. But translation means actual exchange of one currency for another and conversion means re-express the financial data denominated in one currency in terms of another currency. Though the first process is a real transaction, the second one is a necessity for preparation of consolidated financial statements. During the 1950s and 1960s when the most of the exchange rates were fixed, there was not much problem. Following the devaluation of sterling against US dollar in 1967, there was a need for guidance. As a result, accounting treatment of major changes in the sterling parity required the identification of exceptional gain or losses together with its segregation from the normal gains or losses as a separate exceptional item. This adjustment could be done below the ‘profit after taxes’ or it can directly be dealt with the reserves in the balance sheet. It could be done as the profit or loss due to currency translation is not of revenue nature. Generally, two methods are used for valuing these items. One is historical rate and the other is closing rate. Currently, the market rate has gained the center stage. Historical rates can be used if the foreign activities are mere the extension of the home activities. On the contrary, if the overseas operation is independent, then this investment should be valued at market rates (Samuels and Piper, 1985, pp. 119-127). In our Ruritanian investment case, the manufacturing facility should come as a separate entity as per the prevailing laws and trade policy of the country. So, a market based valuation is quite appropriate. Another related issue is hedging. To remove the fluctuations in the earnings, a lot of firms adhere to the policy of taking position in the forward contracts. For the time being, the currency of Ruritania has not being pegged to any influential currency. So, taking forward position is necessary. As the currency is replaced by euro, situation will be much conventional. Through such hedging reduces the competitiveness of the firm on an international level, such measures are necessary as they reduce risk to a significant level (Samuels and Piper, 1985, pp. 119-127). Similarly the issue of multiple reports and segmental reports are very important. Next important issue is multinational capital budgeting. In our case the total investment is going to be GBP 55 million (Case Study). Normally, multinational capital budgeting is based on the parent company’s perspective. Some projects may be feasible for a subsidiary but not feasible for the parent, since net after tax cash flows to the subsidiary can significantly differ from those of the parent. Such difference is attributable to several factors that we are going to discuss. If the earnings due to the project someday get remitted to the parent, then the parent needs to how the parent’s government taxes all those earnings. If the parent’s government imposes a high tax rate, then the project may be feasible from subsidiary’s point of view, but the parent company gains nothing. Now there are some political issues as well. The host government may impose restrictions on remitted earnings by subsidiaries. Generally the host country government wants a part of the earnings to stay inside the country. In such a case the project may be unattractive for the parent. The capital budgeting is also influenced by the foreign exchange movements (Madura, 2011, pp. 421-24). While investing the company should be well aware of cost of capital which is the combination of cost of debt and equity. The cost of debt and equity varies across the nations. For example, Japan has been a country of very low cost of capital. In Japan the risk free rates are very low and the price earning multiple for the companies is very high. Also the relation between the currency of borrowing and currency of investing needs to be understood (Madura, J. 2009, pp. 509-10). With foreign subsidiaries, the cash management of the parent company becomes complicated. Cash management should cover the scheduled outflows of the fund during a cash budgeting period and fund kept aside as precautionary cash balances. Precautionary cash balances are necessary as it is easy to underestimate the cash needs. Firms with multinational operations, has to deal with more than one currency. Hence the cost of foreign exchange transaction becomes an important part of efficient cash management. Also, there is a great debate about the fact whether the entire cash management should be centralized or not, though centralized management gives more control (Eun and Resnick, 2008, pp. 467-68). Firms which are setting up the manufacturing units outside the home country for the first time can still afford to manage cash centrally. Conclusion The purpose of accounting is to create true and fair view of the business entity. But foreign subsidiaries make the financial statements more opaque. The financial details of the foreign subsidiaries highly are dependent on the currency of the host country. The currency of the host country is again highly dependent on the political and economic structure of the country as discussed earlier. Also, the relative attractiveness of the host country as an appropriate investment destination depends on the factors which were mentioned in the theories related to FDI. Though in the short term, it does not have any influence on the financial status of the parent company, but in the long run, this attractiveness will determine the longevity of the foreign subsidiary and success or failure of the investment on behalf of the parent. References 1. Dunning, J. H. (1993) Multinational enterprises and the global economy, Addison-Wesley Publishing Company, Suffolk. 2. Dahl, R. A. (1976) Modern political analysis, Prentice-Hall 3. Eun, C.S. and Resnick, B.G. (2008), International Financial Management, India: Tata McGraw Hill 4. Helpman, E. (1984), A simple theory of international trade with multinational corporations, Journal of Political Economy, June, Vol: 92 No.3, pp. 451-471. 5. Konings, J, and S Janssens, (1996), How Do Western Companies Respond to the Opening of Central and East European Countries- Survey Evidence from a small open economy – Belgium, Leuven Institute for Central and East European Studies, Working Paper No. 60. 6. Lankes, H P and Venables A. J., (1997), ‘Foreign direct investment in Eastern Europe and the former Soviet Union: results from a survey of investors’, in Zecchini S. (ed.) Lessons From the Economic Transition: Central and Eastern Europe in the 1990s, OECD and Kluwer Academic Publishers. 7. Markusen, J. R. & Venables A. J. (1998) Multinational firms and the new trade theory, Journal of International Economics, December, Vol: 26 No.2, pp. 183-204 8. Madura, J. (2011), International Financial Management, US: Cengage Learning 9. Madura, J. (2009), International Financial Management, US: Cengage Learning 10. Nellis, J. G. & Parker, D. (1996), The Essence of the Economy, Second Edition, Prentice Hall, Great Britain, p. 12 11. Savary, J. (1997), ‘The French firms motivations for investing in Eastern Europe countries. A study of investors and potential investors’, in Witkowska, Janina-Wysokinska and Zofia (eds), Motivations of Foreign Direct Investors and Their Propensity to Exports in the Context of European Integration Process, University of Lodz, pp. 43-76. 12. Samuels, J.M. and Piper, A.G., 1985, International Accounting: A Survey, Great Britain: Guildford and King’s Lynn, pp. 119-127. 13. UNCTAD, Data on foreign direct investment, 2012, available at http://unctadstat.unctad.org/ReportFolders/reportFolders.aspx (accessed on April 13, 2012) 14. UNCTAD, 2012, retrieved on: April 12, 2012, URL: http://unctadstat.unctad.org/UnctadStatMetadata/Classifications/Methodology&Classifications.html#DISTRIBUTION OF COUNTRIES AND TERRITORIES 15. Vernon, R. (1979) The product cycle hypothesis in a new international environment, Oxford bulletin of economics and statistics, Vol 41, No 4, pp. 255-267 Appendix YEAR 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 ECONOMY Albania 6.78 8.04 8.11 9.83 11.23 12.48 15.35 23.21 21.57 29.15 36.67 Armenia 26.84 27.37 28.80 28.26 29.02 26.49 27.79 27.00 30.19 42.48 44.74 Azerbaijan 70.84 69.41 85.86 118.73 140.49 104.75 63.35 25.85 17.52 20.99 17.63 Belarus 12.53 11.31 11.28 10.65 8.89 7.89 7.40 9.90 11.00 17.41 18.27 Bosnia and Herzegovina 19.66 20.90 22.05 22.08 27.98 27.54 33.16 44.46 38.87 44.84 42.50 Croatia 13.10 17.03 22.97 25.40 30.51 32.74 55.80 76.93 44.54 57.04 56.68 Georgia 25.64 27.29 30.90 34.96 37.23 37.02 45.95 52.65 52.85 68.52 67.14 Kazakhstan 55.09 58.31 62.77 57.04 51.86 44.83 40.59 42.53 44.24 66.46 61.15 Kyrgyzstan 31.52 27.13 29.28 27.24 32.20 21.04 21.87 21.52 20.67 21.93 21.62 Montenegro _ _ _ _ _ _ _ _ 74.19 123.71 138.18 Republic of Moldova 34.84 37.08 38.31 36.05 32.48 34.14 36.92 41.89 42.39 49.02 49.17 Russian Federation 12.40 17.26 20.52 22.42 20.67 23.57 26.87 37.77 12.94 31.04 28.71 Serbia _ _ _ _ _ _ _ _ 34.81 43.81 46.51 Serbia and Montenegro 8.87 7.86 9.17 12.97 14.43 20.03 31.65 33.48 _ _ _ Tajikistan 15.82 13.48 14.88 13.72 12.11 13.22 25.34 35.95 27.76 17.48 16.21 TFYR of Macedonia 15.05 26.65 31.91 35.25 40.85 35.88 42.14 45.92 42.01 47.52 47.98 Turkmenistan 21.48 22.33 25.70 26.63 28.26 27.58 29.44 30.33 30.56 35.16 40.68 Ukraine 12.40 12.63 13.97 15.09 14.81 19.98 21.46 26.67 26.11 44.31 42.48 Uzbekistan 5.08 8.37 8.57 9.15 9.20 9.43 8.61 9.73 11.23 11.03 11.67 Table: Foreign direct investment as % of GDP in transitional economies (UNCTAD, 2012) http://unctadstat.unctad.org/ReportFolders/reportFolders.aspx The countries are in these table has been termed as transitional as they are moving from totalitarian regime to a more democratic system. 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