International Financial Management - Essay Example

? International Financial Management Table of Contents 2. Literature review 4 2 Transportations Costs 4 2.2 Market imperfections 5 2.3 Strategic behaviour 6 2.4 Product life cycle 6 2.5 Location specific advantage 7 3. FDI trend 7 4. Potential problems 10 5. Minimizing problems 13 6. Conclusion 14 Reference List 16 1. Introduction International companies spread around the world carry out transactions with foreign counterparts which run into millions of dollars. A significant portion of the cross border transaction constitutes foreign direct investment (Achrol, 2011). Companies engage in foreign direct investment due to various reasons, but mainly to generate profit and secondly to hedge risk. Sometimes the companies would have huge cash surplus and fear that due to unfavourable movement in the exchange rate the dollar value of the cash surplus would decrease (Bajaj, 2001). The companies would park their extra cash in various foreign countries in the form of foreign direct investment. Generally the FDI are long term in nature but a company looking for quick gain can resort to short term borrowing. The research endeavours to create an international financial management report on FDI for Infosys. Infosys, a software giant in India is contemplating to conduct a FDI in another international country. The target firm chosen is Apple and the target market chosen is USA. The choice of the target market and the choice of the target company bear special significance (Bonaccorsi and Daraio, 2009). Apple has a myriad of products and service starting from electronic gadgets to the creation of operating systems. Apple has experienced one of the highest rises in the price of shares and apart from that the company is in an excellent growth trajectory. Infosys wants to cash in from the excellent growth opportunity of Apply by investing directly in it its path breaking technologies. Apart from this USA has a strong track record of FDI. These are two motivating factors behind the choice of Apple and America for FDI. Infosys wishes to follow a joint venture Greenfield with Apple. The joint venture Greenfield will help to create new products in USA. 2. Literature review The factors affecting the global flow of foreign direct investment in USA or as a matter of fact any country is many and varied. Although in the present context, only 4 important factors are considered which are transportations costs, market imperfections, strategic behaviour, product life cycle and location specific advantage. 2.1 Transportations Costs The diagram given below is an indication of the transportation cost at present in USA. The cost of transportation is shown as cumulative of the average costs incurred by travelling both by air and road. The cost of transportation is major issues but only for those products which have a low value to weight ratio. In the present case the value to weight ratio is assumed to be very high (Clark and Mathur, 2013). This is because of the reason that the target products (electronic gadgets) are negligible in terms of weights. So the cost of transportation will not pose as a serious threat. Fig 1: Transportation cost over the last 10 years Source: (Mintzberg and Waters, 2011) 2.2 Market imperfections Over the last 50 years almost 56% of the foreign companies that took part in the FDI considered market imperfections to be the single most important factor. Whenever there are impediments in both exporting and sale of know-how through licensing then FDI takes place. Barriers to export include quotas, complete bans, tariffs and other restrictions that hinder the free flow of product between two nations. Most of the foreign countries in the world do not share a mutual bilateral trade between themselves that facilitates the flow of goods and services (Das, Quelch and Swartz, 2000). During 2000 to 2012 phases some of the emerging nations resorted to FDI with USA since international groups like NATO ordered restrictions on establishing trade relations with different countries. Thus these countries like China, Japan, Korea, Iran and Iraq established trade agreements with USA (Flint, Woodruff and Gardial, 2002). Another important factor that counts in taking part in FDI is reluctance of the companies to grant license to the exporters due to fact that the contractors may not be able to protect the products from possible misuse. The electronic products have considerable knowledge value but it is seen that that in almost 29% of the case charges of misuse are put forth by the manufacturers on the exporters. For this reason the firm resort to FDI instead of export (Garrick, 2013). 2.3 Strategic behaviour Firms are always on a look out to do and outsmart each other in terms of competitive advantage. Due to this reason if any firm from an industry decides to undertake FDI then the firms from that industry will do the same and engage in FDI activities. This is because of the reason that the firms want to match the each other’s moves in different markets to ensure that a rival does not gain a dominant position in one market and then use the profits generated there to subsidize competitive attacks in other markets (Ger, 2000). 2.4 Product life cycle Firms which have already introduced a product in their home market use FDI to market the product in the foreign countries. Studies indicate that over the last 40 years nearly 29% of the firms that invested in FDI in USA have already introduced the product in the home market. Then depending upon the feedback received from the customers in the home market, the products can be modified with the additional features and sold in the foreign markets (Gina, 2013). Thus the product will be sold at a slightly high price in the foreign markets. As the demand of the products increase in the market of USA, the foreign companies resort to direct export instead of manufacturing them in the foreign market. Thus the transition takes place from FDI to direct export. First firms take route to FDI and then finally shifts to direct export of the goods, if deemed fit. Finally the firm shifts the production overseas. 2.5 Location specific advantage USA is the centre of software and hardware development. Some of the software giants are located in USA like IBM, Google and many more. The presence of the software giants in one place has prompted the software companies from the around the world to tent in USA. The software companies resorted to various kinds of strategies like joint ventures, strategic alliance and mergers and acquisitions (Gummesson, 2010). Other than these the companies also resort to strategies like FDI. A study indicates that FDI occurs highest in the manufacturing sector (almost 51% of the companies) and then comes the information technology sector (39% of the companies). 3. FDI trend The above diagram gives an indication of the FDI in the last 9 years starting from the year 2003 to the year. The trend line drawn is derived using the moving average method. The trend line depicts a general S shaped nature in the flow of direct foreign capital. The general S shaped nature of the trend, line is indication of the fact that the FDI increased in 2007 and then it fell sharply during the period of acute crisis in 2009. With gradual improvement in the outlook of the economy the FDI increased steadily from 2010 onwards. Fig 2: FDI in the last 9 years Source: (Gina, 2013) FDI before and after the financial crisis Fig 3: FDI before the start of the financial crisis Source: (Gina, 2013) Fig 4: FDI after the financial crisis Source: (Gina, 2013) The above two diagrams is separate indication of the FDI before the financial crisis hit the USA market and FDI after the USA market started recuperating slowly from the financial fiasco. The sudden fall and jump in the FDI trend in USA in simple words is a result of investor anxiety followed by sudden realization of the benefits that can be achieved. The bankruptcy of the major financial institution, followed by acknowledge of the fact by the USA government that is running into high sovereign debt, startled the investors (Hamel and Prahalad, 2005). With Nas Daq registering the lowest ever growth in index and the investors pulling out their money, the foreign direct investor’s resorted to premature withdrawal particularly from the manufacturing and IT sector. After the financial fiasco the dollar exchange rate deteriorated significantly. This deterioration led to the huge inflow of foreign capital. This is the same reason for which the FDI started improving significantly (Hastings, 2005). The high dollar exchange rate proved to be a barrier for the foreign investors. After the fall of the exchange rate the investors realized that one dollar will cost a lot less than before. Due to this reason there is an influx of foreign capital. 4. Potential problems The potential problems with FDI are mainly two types which are different types of barriers and the country risk factors. The different types of risk are restricting ownership, red tape, and local links with the government, political instability and requirement of the government in the local context (Johnson, 2012). The red tape refers to the problems related to processing the paper works regarding legal hurdles and bureaucratic obligations, the excess of which slows down pace of work. The different states of USA have its own set of rules and moreover there are different set of rules in the different sectors in terms of ownership and control. Almost 50% of the litigation in FDI is related to ownership and control. There are various kinds of legal obligations and paperwork in IT sector. In other words investing in IT must be done after factoring in the costs and troubles associated with red tapes (Levitt, 2003). Fig 5: Country Risk analysis Source: (Gina, 2013) Political risk involves mainly three different types of risk which are transfer risk, operational risk and control risk (Louis and Ronald, 2005). USA has sanctioned ban on cross border capital controls with various countries. These countries are Burma, Cuba, Iran, Libya, North Korea, Sudan and Syria. Other types of risk are operational risk and control risk. If India engages with FDI with these countries then the imposition of cross border controls with these countries will lead to problems in ownership and control. Although both Infosys and Apple has presence in countries like Africa, so the problem of cross border capital controls can be avoided effectively. The operational risk is very low in USA. This is due to the reason that over the last 20 years the USA has not made any drastic changes in the countries policy regarding local operations of the foreign firms. Apart from that USA has very specific policies that pertaining to the fixation of the minimum wages, access to local credit and environmental protection act. Very few foreign companies that have created green field projects in alliance with a USA company is found to be in complete violation of the policies. Thus it is assumed that the both Infosys and Apple can mitigate the operational risks effectively. Since this will be a green field project done through FDI so Infosys and Apple will share will have a 49:51 ratio in the control of the ownership shares. The studies indicate that green field project generally take place for 10 years during which in the first 5 years the control of local enterprises are done by the foreigners and then the control shifts to the company of the host company. Thus in this regard it can be said both the companies will be able to minimize the operational risk effectively. There are although occasional cases where the contracts need to be renegotiated due to the change in the political powers. Thus changes in political powers pose as a serious threat in the minimization of the operational risks to some extent. Fig 6: Country Risk Ranking Source: (Gina, 2013) The exchange rate risk is one of the significant problems in foreign direct investment. The exchange rate determines the convertibility between dollar and other currencies. Due to unfavourable exchange rate the companies have to face haircuts. The hair cuts are situations when the companies faced with unfavourable exchange rate conditions loses the value of the convertible currency in terms of dollar (Mallon and Webb, 2006). For example if Infosys invest a total of $ 100 million, then its equivalent value in the Indian currency is Re 5891 million. Due to unfavourable economic conditions if the dollar value weakens and the exchange rate comes to be as $50/Re 1 then Infosys will be left with Re 5000 million in value. Thus there is an outright loss of Re 891 million. The example of exchange rate risk is explained only in terms of profitability between USA and India (Mascarenhas, Baveja and Jamil, 2012). The risk of exchange rate can also pose as a serious threat over the operations like the import and export also. Apple deals in electronic gadgets, so it has to resort to import of various kind of electronic parts and accessories. These parts and accessories are shipped from countries like various developing countries (Meyer, 2011). Due to inconvenient exchange rate the export and import operations can be hard hit. Fig 7: Analysis of significant factors Sourcing: (Gina, 2013) 5. Minimizing problems The strategies that can be adopted in order to avoid the problems of political risk and exchange rate risk as described above are explained below. The transfer risk which is ban on cross border capital controls can be avoided or can be minimized if the two companies mediate the process of capital inflow and outflow through some subsidiaries which are located in different countries. It is unlikely that the countries between which trade restrictions are sanctioned will also have trade restrictions with other countries (Moessinger, 2013). For this reason other countries over which trade restrictions are not imposed can act as intermediary for the two countries. Some of the countries over which trade restrictions are not imposed and can act as an intermediary of USA and India are Africa, Mongolia, Europe and Middle East. The operational risk can be minimized if proper care is taken to adhere to the laws as to the use of local resources, the minimum wage and access to local credit. The investment banks will be approached for the purpose of syndication. Syndication helps to gather the resources. One of the most immediate threats in operational risk is the presence of corruption, kidnapping and extortion demands, which can be minimized with the use of proper securities. Control risks can be eliminated or reduced if an Infosys and Apple sorts out the problems or issues beforehand by making it clear on control of the ownership share and control of local enterprises. The two companies can decide on the nationalization of the local operations of the companies (Johnson, 2012). The exchange rate risk can be controlled if the company covers the exposure using different kind of risk hedging tools. The tools that can be used for hedging the risk are derivatives and options and futures (Hamel and Prahalad, 2005). The advantages that Infosys can enjoy by using future hedging contracts are access to liquid and central market, gain of leverage. 6. Conclusion USA will continue to witness strong growth in revenue for the next 5 years. The political risk and exchange risks are two types of risk that the government of USA has still not been able to address properly. It is recommended that the USA government form separate policies that is specific to the demands of the foreign companies that invests in USA. In order to reduce the exchange rate risk, the USA government need to make special amendments in the Foreign Exchange Management Act that clearly defines the guidelines that need to be followed for better exchange risk control. In order to reduce the political risk the USA government needs to lift the trade embargoes with several countries to facilitate the cross border capital controls. In case of minimization of the operational risk the legislations and rules and regulations need to be updated so that the foreign companies do not have chance to misuse them and perform illegal actions in the use of local resources, in paying wages, in accessing the local credit and in taking care of the environment. The control risks can be minimized if the USA government makes separate pacts or policies as to the control of ownership shares and control of local enterprises by the foreign companies. Reference List Achrol, R. S., 2011. Evolution of the marketing organization: New forms for turbulent environments. Journal of Marketing, 5(5), pp. 77 – 93. Bajaj, C., 2001. Foreign Collaborations: An innovative option. IIMB Management Review, 6(3), pp.142-145. Bonaccorsi, A. and Daraio, C., 2009. 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