Risk That Might Arise Due to Opening of a Subsidy in Foreign Countries - Assignment Example

? Table of Contents Executive Summary 2 Introduction 2 Financial and non-financial factors 3 The potential risks and possible external strategies to manage such risks. 5 Other strategies available other than establishing a foreign subsidiary 7 Conclusion 8 Question 2 9 Question 3 11 References 15 Executive Summary Purpose of the report is to enlighten the top management about risk that might arise due to opening of a subsidy in foreign countries. It will also provide information regarding the outlook of the top management for the subsidy, this information mostly will pertain to financial aspect of the companies new subsidy. Although this may be a feasible option, another proposition to be considered is whether this is worth compromising quality and customers of its base country. REPORT TO IBF Respected Directors, IBF London (U.K) Introduction IBF Supplies Plc is a London based large manufacturer and distributor of office supplies. A recent forecast shows decline has been shown in the demand for office supplies in the UK. At the same time it is anticipates a strong demand for office supplies in Eastern Europe, Asia and Africa over the next several years. Hence, executives of IBF have started exploring the overseas markets and are planning to establish foreign subsidiaries in new markets. Before entering the market certain aspects are to be considered. These aspects include: Financial and non-financial factors The potential risks and possible external strategies to manage such risks. Other strategies available other than establishing a foreign subsidiary Financial and non-financial factors First of all it is to be made sure that whether the selected countries are going to produce the desired results or not. It is a good thing that IBF has anticipated a strong demand in Eastern Europe, Asia and Africa for the type of goods it manufactures but again a detailed research needs to be done before taking any final decision. Developing a foreign subsidiary means establishing company’s branch outside the country to run as a separate entity than IBF the parent company itself. There are a lot of things that need to be considered like the political stability of these selected countries, their legal systems, the fiscal policies, the monetary policies, availability of labor that is skilled, logistics infrastructure etc (Terpstra and Sarathy 2001). It is a good thing that IBF has a proactive approach but still there are a lot of things that are of utmost importance before any final decision can be taken. The financial situation of the company happens to be one very important factor to be considered before IBF can take any decision. The tax bracket is to be kept in mind before actually deciding to expand the business to a new area. The net worth and the objectives of the company happen to be of critical importance. The level of risk that the company can afford to take is also a point of significant importance. While considering the financial factors, IBF needs to take a decision regarding choosing one of the two financing techniques or may be both the techniques. These two financing techniques are debt and equity financing. If IBF chooses debt financing to raise funds it means that the company will borrow money from another source like bank. IBF will have to return the loan with interest and it can be short term or long term. The other way is that of equity financing. In this way IBF can raise finance by selling off its business part to some other party like the investors or the venture capitalists. The company need to decide whether it is going to be generating funds locally or by the parent company. A detailed PESTEL Analysis is required that includes things like political factors etc. The forecasting regarding the exchange rates and the taxation agreement needs to be done before taking any final decision. It is to be kept in mind that these foreign subsidiaries are going to be exposed to volatility of exchange rates. IBF will need to evaluate its risk associated with exchange of foreign currency through monitoring the external factors and market data that are likely to impact these fluctuations. IBF may also have to bear completely all the risk of the foreign subsidiaries like a law aimed at subsidiary can possibly result to big financial loss for IBF itself. It is strongly recommended that there are other options like strategic alliance and mergers and acquisitions that IBF can bring into consideration before taking any final decision. As it is known that the products of IBF are pretty similar to its competing companies so here the major differentiation is on delivery and price. Thus it is to be kept in mind by IBF that the investment efficiency is going to come from devising strong investment management structure. This means that a framework needs to be established related to how the investment assets will be divided among different approaches and managers of investment (Richard, 1971). The expected return and risk need to be encompassed. The number of managers that will be required and how will look after which aspect needs to be identified to ensure similar efficiency and product quality in the foreign subsidiary. Other than the above mentioned financial aspects there are a lot non financial aspects to be considered too. May be the already existing competition is foreign markets is going to be big issue to be addressed by IBF. Moreover there a number of non financial factors those need special attention too. The currency and the exchange rules, the repatriation restrictions, the entry of mode, the trade barriers, availability of labor and natural resources, ownership, cash management etc are a few of the important factors that need consideration.There are chances that the products that are so successful in the host country may not be as successful and appreciated in the new market. The interference of IBF in the foreign subsidiary is not going to be so high to assure the similar quality level and management effectiveness so all this is important. The labor costs may be higher in these picked up countries. Therefore, other options need to be evaluated as well which can serve as an alternative to foreign subsidiary. The potential risks and possible external strategies to manage such risks. There are a lot of risks involved for IBF in its plan to grow its business. The growth in business brings along a lot of risks such as the instability risk, financial risk, ineffective management risk, competitive risk, unfamiliar terrains, aggressive competitors and unknown markets, political risks, revenue and tax law, law related to pollution, labour laws, economic risks, currency risks and the culture risk. The whole business becomes pressurized when it comes to expansion. It may create a new timing for payables and receivables creating a financial strain. There are chances that they customers start feeling underserved. The big risk of employees being at unease is also an issue that IBF is likely to face. There may be a lack of skills in the company to bring about such a change in the organization. There are chances that by pushing your already existing product into a new market may bring about unexpected results that you may not have thought of. So IBF needs to be very critically about those factors. These factors include the risks that are associated with the expansion of a business into an unknown market with aggressive competitors and unfamiliar terrain (Ignacio and Tham, 2008). It is important for IBF to train its staff for such a change in the company. IBF will have to take risk of entering into a great competition because the existing companies in the Eastern Europe, Africa and Asia will not let IBF take their market share so easily so IBF has to face this big competitive risk. It is going to be hard for IBF to sustain in such an environment. IBF needs to come up with some creative and innovative idea to make a place in the new markets and to gain market share. IBF may have to take the risk of low profitability as efforts may be a lot more than the returns. Structural growth strategies may have to be brought into action to avoid such risks. It is very strongly recommended to test the market before actually expanding the business to those areas because the new market may not respond like any other market in the past. IBF may fall short of expertise and the markets operate differently everywhere so this also happens to be a big risk for IBF. A big outlay of capital may be required for IBF to hire new expertise according to the different markets. Financing will have to be done through new equity instead of the existing cash flows. As IBF is a large business so there are chances that the interest rate gets swap. So for such a situation protect against the fluctuation of the interest rate needs to be implemented. To plug the unexpected shortfalls of short termed cash flows can be dealt with an operating credit line. IBF should make sure that the strategy they plan to implement is completely risk adjusted and is fully aligned with the risk appetite. As soon as the policies get approved by the senior management and board only then they should be implemented. The policies of financial management of risk must be properly adjusted and monitored after its implementation. This involves production of periodic and regular review reports by finance and treasury department and the audit committee of the board to monitor the progress properly for better results. There are several tools that can hedge the risks for IBF. Most appropriate tools which can be used by IBF are CALMS (Credit Adjudication and Lending Management System Software, software for financial analysis, software for customer relationship management and planning programs for enterprise resource. So IBF needs to hedge these risks before they can take any final decision. Other strategies available other than establishing a foreign subsidiary According to Knowdell (2010) there are a lot of strategies related to foreign market entry that have a differing degree of risk associated with them. So there are a few other options also available to IBF to implement its expansion strategy other than a foreign subsidiary establishment. Contract manufacturing and assembling are a few other options available to IBF. What happens in contract manufacturing is that the IBF’s products will be produced by the local producers in the foreign market under a contract. Under the contract only the manufacturing side is going to be handled by IBF whereas the sales subsidiary is handled by the firm which has the market control. This type of strategy helps in getting an advantage for advertisement of the products like locally manufactured. This also helps in enabling IBF to avoid the labor issues for having lack of being familiar with the local culture and economy of foreign countries that it wants to expand its business to. At the same time it is important for IBF to develop a good relationship with the contract manufacturer as the reputation and image of the company can be highly at risk. The other alternative to expansion strategy can be that of assembling. In this strategy IBF will produce the products locally and then will be shipping it to the foreign markets to be assembled that is putting together like finished product. In this strategy IBF will benefit as it will start penetrating in the foreign market by using local employment. IBF is also likely to enjoy low custom tariffs as generally custom tariffs are low for unassembled goods and equipments. Other expansion strategies are licensing and franchising, joint ventures, exporting and strategic alliance. In strategic alliance the two on more parties have partnership and agreed upon objectives and goals while they remain independent organizations. Partners are likely to provide the strategic alliance with resources like project funding, products, capital equipment, knowledge, distribution channels, manufacturing capability, expertise, or intellectual property. Moreover the other expansion strategy that the company can use is joint venture. It means the parties agree to develop for a limited time a new asset and new entity by contributing equity. Conclusion Despite of all these positive aspects IBF will be greatly risking its service level for its customer which has been its major strength in its own country. Quality control will be greatly at risk too. So IBF needs to be very careful before taking any decision. Question 2 The time when a currency of a country is traded for the other country then the market of foreign exchange is developed. Same is the case here with Joe Company. Generally the foreign currency is exposed to three types things namely transaction, translation and economic. Joe Company needs to critically observe all these three types of exposures (James, 2000). As Joe Company is exporting so it needs to be a number of things in mind like transactions in foreign currency are more sensitive to the exchange rate fluctuations. It may rise or fall at any time resulting in loads of profits and loss for the company so therefore it involves a lot of risk. Foreign currency is generally demanded by the people because of the purchasing power it posses on its own nation. A particular purchasing power is also tolerated by the domestic currency as it is capable of purchasing services and goods in domestic economy. The domestic purchasing is regarded as to be exchanged for the purchasing power when the currency of home is exchanged for any foreign currency as it has the potential to buy a few goods and services in the domestic economy. Taking the scenario of Joe Company it has been found out that the company produces the invoices of the products in sterling pounds. Here it is to be noted that whether the transaction is strengthening or weakening the Euro. In a situation where Euro is likely to weaken for a number of years then the sterling pound that is the reverse currency is likely to strengthen. This can produce positive results for Joe company as the invoices of the company are in Sterling pounds. In a case where the company goes a step ahead and supplies UK and the Euro weakens as compared to Pound so every pound will help in getting more Euros. The most favorable thing that Joe company can do to avoid big losses from this currency fluctuations is the hedging of exposure of currency. This hedging can take place by utilizing various hedging instruments that will mitigate risks of losses. At the current time the company is enjoying higher returns due to weak Euro currency as compared to the Sterling Pound. Joe Company should spend time on understanding how the currency values, also on the fact that the exchange rates have an important role to play in the return rate of the investment. Question 3 i) When a parent company has decided to allocate funds for any sought of project, it should view the feasibility of the respected project from its own perspective. It may be possible that a project may seem feasible from the perspective of a subsidiary but at the same time not be feasible in the parent's perspective. A reason may possibly be effects of withholding taxes in another country and/or due to the fluctuations in exchange rate. The analysis of capital budgeting is very important. It is a process in which the investment in the capital assets is evaluated and the firm is able to take the decision regarding whether long term investment is to be made or not. These capital budgeting projects are expected to produce cash flows for numerous years and decision regarding the potential investments that are long term generally. It is very important for the firms to decide the payback period, the internal return rate and the NPV that is net present value. All these factors have greater impact on the parent company than the subsidiary so they should be assessed from the parent company’s perspective. ii) There are a lot of other things to be considered in multinational capital budgeting that are discussed ahead. An exchange rate fluctuation is one very important thing to be considered with the occurrence of profitability. Even though inflation is considered in the pricing and costing forecast but still there may be a lot of variance in inflation from a year to another. Financing arrangements need to be given special attention too. It means that normally the financing costs are taken into account by discount rates (Leroy, 1989). Issue like blocked funds needs to be addressed too. An uncertain value of salvage can have an important impact on the project’s NPV (Net Present Value). In the Net Present Value approach the project is accepted at a point where its net cash inflow’s present value during the project’s life span is more than the initial investment (Howard, 1969). Moreover current cash flows of IBF from the same customers may be greatly impacted by the investment in new project. Incentives for the host government need to be analyzed too before taking any decision. It is to be kept in mind that the cash flows are considered on after tax basis. There are a few other factors to be considered like the exchange rates, the case whether the currency restrictions exist or not, probability of a host government takeover, and the foreign demand for the product also need special consideration and happen to be very critical factors. So, therefore adjustments in accordance with inflation and the other above mentioned factors are very important so that an accurate forecast can be made. If IBF will fail to consider these factors ten the project will having an inaccurate evaluations leading to a big impact on the bottom line of the company. iii) The term cost of capital is the cost of funds of the company in terms of cost of debt and cost of equity both. It is also referred as the required shareholders return on existing securities of company’s portfolio. It is very important that the cost of capital should be lesser than the expected return on capital if the investment is intended to be a success. Cost of capital is required to be estimated in the correct manner through making adjustments that are most suitable. For MNC, the size of the firm is very important in determining the cost of capital. The cost of capital can be reduced by borrowing substantial amounts from the creditors. MNCs are generally having quicker access to the capital markets that are international. International diversification is another thing that can affect the cost of capital of MNCs. The scale of operation that is the size of the MNCs have greater opportunities to grow, there are more sources of funds accessible than the domestic firms, international diversification is enjoyed, exchange rate fluctuations can give rise to financial issues and can incur a greater cost of capital and the unstable political situation can give rise to higher cost of capital that is the country risk. The cash flows of an MNC can be more volatile in a same industry as that of domestic firm if exposed to high risks of exchange rates. The exposure to the country risk like the government of the host country can also have affects on the MNCs cost of capital. If the percentage of assets of MNC that are invested in foreign countries is higher than the overall risk for MNC is greater in its operation which can lead in bankruptcy also. So generally size, international diversification and access to capital markets internationally produce favorable results whereas country risk and rate risk are unfavorable for MNCs. ii) Ram plc and Pram plc During the procedure of taking decision regarding the foreign direct investment by any company a few things need to be kept in mind. There are two broad things that affect the decision process one is the revenue related motives while the other is the cost related motives. According to the revenue related motives things like establishing a subsidiary or acquiring a competitor in different new market is done this gives rise to new demand sources. Moreover things like entering profitable markets, exploiting monopolistic advantages and diversifying internationally is enjoyed by the company. On the other hand in case of cost related motives the company is likely to fully benefit from economies of scale. The company can use foreign factors of production, foreign raw material that costs cheap can be used and new technology can be taken advantage of. So according to the situation provided in this case it can be said that Ram plc is likely to enjoy more from the economies of scale. iii) theory of comparative advantage as a its usefulness According to the theory of comparative advantage a basis which explains and justifies the international trade in modern world is provided that is assumed to enjoy the a free trade, no uncertainty, no government interference and perfect competition along with costless information. According to the theory of comparative advantage it has been argued that different countries have different endowments factors of land, labor and capital inputs (Costinot, 2009). Countries will export the goods and will specialize in those products that are using the most endowed production factors. If this starts to happen then the country starts to enjoy an advantage and the total economic welfare and output can be increased. According to the comparative advantage principle the international trade bases upon the specialization that mutually benefits the trading partners. According to this theory the benefits and cause of international trade to discrimination amongst countries in relative opportunity costs that is the costs in terms of other goods given up, of producing the same commodities is attributed. The theory has a lot of benefits like the exporters from Country X sell services or goods to unconnected importers in Country Y, the companies in Country X specialize in producing products that are capable of being made relatively more efficiently, as the production factors cannot be stimulated freely so the specialization benefits are comprehended via international trade and the way in which the benefits of extra production are shared is dependent on the trade terms, the proportion at which quantities of the physical goods are traded. References Agarwal, S., and Ramaswami, S.N. (1990) Choice of foreign market entry mode, impact of ownership, location and internalization factors, Journal of International Business Studies, 23, 1-27. Costinot, A. (2009) An Elementary Theory of Comparative Advantage, Econometrica, 77, 1165-1192. Costinot, A., Dave, D., and Komunjer, I. (2011) What Goods Do Countries Trade? A Quantitative Exploration of Ricardo’s Ideas, Review of Economic Studies forthcoming. Howard, V. (1969) The Tortuous Evolution of the Multinational Corporation, Columbia Journal of World Business, 9-18. Ignacio, V., Tham, J. (2008) Guidelines for forecasting the financial statements, Journal of Business Studies, 32, 761-832. James, K. (2000) The price of retail investing in the U.K. Financial Standards Authority occasional paper OP06. Knowdell, J. (2010) The Benefits and Disadvantages of Contract Manufacturing. IQS Newsroom. Industrial Quick Search. Leroy, S.F. (1989) Efficient markets and martingales. Journal of Economic Literature, 27,1583-1621. Richard C. (1971) International corporations, the industrial economies of foreign investment, Economica. Terpstra, V., and Sarathy, R. (2001) International Marketing, Chicago IL, Dryden Press. Read More