Cash Flows of Multinational Corporations - Assignment Example

? Finance and Accounting By Due Q1 I have learnt about the cash flows of multinational corporations. Apart from profit maximization, maintaining a healthy cash flow is also very important for a company and it needs very good management. The manager has a variety of internal and external tools available to delay the cash disbursements and accelerate cash receipts to maintain a good cash flow. However, these tools are required to be applied intelligently. The importance of exchange rates and their role in the working of international financial markets is also very important. The fluctuations in the forex may result in great losses. In order to get protection from such losses, there are helpful tools like futures contracts which reduce the credit risk greatly. Forward contracts are also very helpful if a party is looking for hedging. A party can also make currency option contracts to protect itself from fluctuating rates. A country has the option to adopt an exchange rate system of its choice. It looks to adopt the system that works best in achieving current account equilibrium. Exchange rates also influence inflation and interest rates of a country which is why the central banks seek some involvement to control the exchange rates. Q2 In the context of international trade, absolute advantage is the ability of a country to use the similar amount of resources as other countries and produce more of a product. On the other hand, comparative advantage is a country’s ability to produce more of a product than other countries at a lower opportunity cost. (Findlay, 1987) Suppose that there are two countries A and B. Country A produces the amount of wheat in 10 hours which is produced by country B in 15 hours. Also, country A produces that much rice in 10 hours which is produced in 15 hours in country B. Assuming that the wheat and rice produced in both countries are homogeneous, country A can produce more of both products by using all of its resources. Therefore, country A has an absolute advantage. Assuming that trade is possible between these countries without any cost, buying wheat and rice from country A is more beneficial for country B than by producing these on their own. However, since country B has nothing to offer to country A, there might be no trade at all. Now it is supposed that country B can produce one bushel of wheat in 5 hours and 1kg of rice in 10 hours. On the other hand, country A produces 1 bushel of wheat in 3 hours and 1kg of rice in 1 hour. Once again, country A is more productive than country B. However, for country B, the cost of producing one bushel of wheat is half kg of rice. For country A, the cost of producing one bushel of wheat is 3kg of rice. It means that the opportunity cost of the production of wheat is lower for country B than country A in terms of the kilograms of rice that are to be given up. Therefore, country B has a comparative advantage in producing wheat. Similarly, for country B, the cost of producing 1kg of rice is two bushels of wheat. For country A, the cost of producing 1kg of rice is one-third of a bushel of wheat. Hence, country A has a comparative advantage in the production of rice. Now, if the two countries decide to trade one bushel of wheat with 1kg of rice, country B can specialize in the production of wheat, while trading some with country A, and country A can specialize in the production of rice trading some of it to country B. Now, country B can shift the hours of producing rice to wheat which would result in the production of 2 bushels of wheat which can be exchanged for 2kg of rice. Similarly, country A can reallocate the hours used in the production of wheat to the production of rice hence resulting in the production of 3kg of rice which can be exchanged for 3 bushels of wheat. Therefore, both countries gain from trade where there is a comparative advantage. (Ricardo, 1821) Q3 A forward contract is a contract to buy or sell an asset at a time in future which is pre-agreed by the parties involved. (Madura, 2008) A futures contract is a contract to buy or sell a specified asset, at a certain date in the future, which has a standardized quantity and quality at the price agreed upon by the parties at the time of making the contract. (Powers, 2001) The two types of contracts differ from each other in the following ways: i. A futures contract takes place in a futures market which means that it is standardized and faces an exchange while a forward contract takes place over-the-counter which means that trading is done directly between the parties and there is no provision of exchange; ii. The credit-risk in a futures contract is significantly lesser than a forward contract because it is margined. This means that the parties agree to deposit a surety bond with a clearing house to guarantee the performance of the contract. There is no guarantee of settlement in a forward contract and the price depends on the spot price of the asset at the maturity date; iii. Forward contracts mature when the asset is delivered while a futures contract does not mature on delivery of the asset; iv. The parties themselves act as buyers and sellers and there is no involvement of a clearing house in forward contracts. The clearance house acts as the buyer to the seller and as a seller to the buyer in a futures contract; v. The futures contracts take place in a market that is regulated by the Government. The market is not regulated in forward contracts; vi. Futures contracts are pre-terminated by opposite contracts on exchange. The opposite contract is with same or different counterparty to pre-terminate a forward contract. Q4a A stronger dollar could very well enlarge the trade deficit of the US primarily due to the price mechanism. An increase in the exchange rate of dollar means that the US exports become more expensive for the foreign buyers. As the price increases, demand falls. Therefore, the US exports would experience a downfall as a result. On the other hand, the imports become cheaper when the exchange rate appreciates. As the price falls, demand increases. Hence, the overall imports would increase in volume. As the exports decrease and the imports increase, the balance of trade would become negative and the trade deficit would increase for the US. Therefore, the US would depreciate the dollar in order to achieve betterment in the balance of trade. (Madura, 2008) Q4b When there is a current account deficit, for instance, for the US, the demand for dollars to buy the US exports would fall. (Carlberg, 1997) The US consumers would demand more of the foreign currency to buy more imported goods. With the fall of demand for dollar, the price of the dollar falls too. This makes exports cheaper and imports more expensive. Therefore, the domestic users would shift their purchases from imports to domestic goods. On the contrary, the foreign users would switch their purchases from domestic goods to imports as they are cheaper for them now. Hence, the current account deficit is automatically restored or lessened. Therefore, the statement that “a floating exchange rate will adjust to reduce or eliminate any current account deficit” is correct. Q4c When a country’s currency depreciates or devalues, the balance of trade worsens initially. It is because the exchange rate becomes higher and imports become costly while the exports become very cheap and inferior. With the passage of time, the cheaper exports start to increase due to competition. The delay is due to the Marshall–Lerner condition according to which the sum of price elasticity of exports and imports (in absolute value) must be greater than 1 to have a positive impact on trade balance. (Davidson, 2009) The increase in exports would depend greatly on their price elasticity. They would increase if they are elastic to price. Similarly, if the imports are elastic to price, the local consumers also shift their purchases to domestic goods and purchase very little of the costly imports. Therefore, the balance of trade starts to improve. If we plot this activity on a graph, we see that the trade balance first falls, steadies and then starts to increase. The graph looks like the shape of “J”. This is why the whole process following the devaluation of currency is called the J-curve effect. (Carbaugh, 2010) References Carbaugh, RJ 2010, International Economics, South-Western/Cengage Learning, USA. Carlberg, M 1997, International Economic Growth: with 136 figures and 23 tables, Physica-Verlag Heidenberg. Davidson, P 2009, The Keynes Solution: The Path to Global Economic Prosperity, New York: Palgrave Macmillan Findlay, R 1987, The New Palgrave: A Dictionary of Economics, Palgrave Macmillan, US, pp. 514–17. Madura, J 2008, International Financial Management, South-Western/Cengage Learning, USA. Powers, MJ 2001, Starting Out in Futures Trading, McGraw Hill, USA. Ricardo, D 1821, On the Principles of Political Economy and Taxation, London: John Murray. Read More