International Business Finance - Coursework Example

International Business Finance Course work Author Course Tutor Date Question 1 Efficiency in investment depends of risk, return, and the costs incurred in managing the investment. Establishing subsidiaries in Eastern Europe, Asia and Africa is a good strategy for IBF Supplies Plc. However, before the company implements this decision it has to consider both the financial and non-financial aspects in order for it to be successful. A company that wants to expand its business must have a strong financial base. Financial pressure affects investments of firms (Carrascal and Ferrando, 2008). The company should consider the following financial factors before establish its subsidiaries in the three coninents. They include taxation policy, the level of cash flow, indebtedness and capital. The company should consider the taxation policy in the host countries to establish the subsidiaries. In the current business world, governments compete to attract MNCs and this has made the fiscal incentives a global concern. Low tax rate in the host counties should be the major factor to be considered by IBF Supplies Plc, since it intends to start subsidiaries in multiple markets. Starting the subsidiaries in countries with low tax shall give the company the chance to establish strategies to avoid tax. It is normally hard for a country to take the responsibility of taxing the holding company which has established subsidiaries in different markets. Some of the tax instruments used by governments to encourage multinationals relates to corporate income tax like tax allowance and tax holidays (Morisset and Pirnia, 2000). Therefore, the company should understand different governments’ policies related to tax before it decides on the location of its subsidiaries in the three continents. Cash flow defines how a company receives and spends its revenues. In order for a company to be successful, it has to experience increase in the cash flow. IBF Supplies Plc should consider managing its cash flows well, and avoid spending more revenues on operating expenses. There is a relationship between the profits a company gets and its capital demand. A company that has high level of cash flow compared to its assets shall be able to expand its investment faster (Carrascal and Ferrando, 2008). Establishing subsidiaries in the three countries requires huge revenue, which could be a challenge to the company in case it runs short of a stable cash flow after resuming operations in foreign countries. According to Carrascal and Ferrando (2008) most businesses rely on debt to carry out their various operations. Companies use debt to finance projects in situations where the internal resources are not available. Although debt is sometimes necessary to a company, the commitment involved in repaying the debt could affect the company’s spending decisions. IBF Supplies Plc should evaluate its level of debts before it implements it expansion strategy. A company that has many debts experiences financial pressure and this adversely affects its level of investments. Highly indebted business enterprises encounter difficulties getting more funds from the external environment to finance their business. However, firms with high levels of investments attract external funding (Harif, Hoe and Noor, 2011). Therefore, the company should analyze its financial position to determine whether it can acquire more funds to facilitate its projects in the three countries. This is because the company may need extra funds in form of debt to finance its projects. Capital is one of the major financial considerations when starting or expanding a business. As mentioned earlier establishing subsidiaries requires heavy financial investments, a factor IBF Supplies Plc has to consider in its expansion strategy. The company must ensure that it has adequate operating capital, especially in the initial stages of business development. When a company becomes big and more successful like IBF Supplies Plc, it requires huge capital to maintain its capacity. The company should be able to sustain its capital base as long as it exists in the business, and as it intends to open subsidiaries in Eastern Europe, Asia and Africa. The company will be required to fund its debtors, stock, purchase new facilities, and encounter unexpected financial requirements, which requires huge capital (Harif, Hoe and Noor, 2011). IBF Supplies Plc should also consider the non-financial factors before it establishes subsidiaries in the three continents. These factors include the location, legal requirements, and management. Location is very important factor to consider when establishing a business. The location where an entrepreneur decides to establish his or her business, determines whether or not it will be successful (Harif, Hoe and Noor, 2011). Eastern Europe, Asia and Africa are big continents, and the company has to identify which country or state to develop its subsidiaries. The location will determine the acceptance of its products. The company should choose a location where it can compete favorably, now that it will be new in those locations. Legal requirements are another factor of consideration by the company. Every state or country has its rules and regulations which guides the citizens and the activities they perform. The company should have a clear understanding of legal requirements in the nations where it will establish the subsidiaries (Harif, Hoe and Noor, 2011). Understanding the legal aspect would help the company to develop and maintain its business code and conduct in respective locations. Several issues could emerge leading to conflict of interest among the players in the industry, and without proper knowledge of the legal requirements it would be hard for the company to resolve such disputes. IBF Supplies Plc will be required to recruit a dedicated management team when the subsidiaries begin operating. This could be challenging to the company since it will be required to meet the international standards during the selection process. Having the right skills and knowledge to handle business operations is very important to prevent failure. The company will have to recruit reliable staff, which has the potential to manage finances, achieve goals, and manage other business requirements (Carrascal and Ferrando, 2008). According to Hayakawa, Kimura and Lee (2011), business investments face various risks that sometimes may not be avoided. IBF Supplies Plc is likely to encounter political risk and financial risk when it establishes its subsidiaries in the three continents. Political risks involve the institutional environment in which businesses operate. Quality institutional environment and political stability promotes investment in a country. The company should invest in nations which have experience political stability, and have organized institutional framework. It should also consider the likelihood of experiencing sunk costs in the foreign nations. The cost of acquiring information about the foreign country is an example of sunk cost. High political risk and institutions that are not efficient could affect the operation costs of a company. Production costs of firms in foreign countries are likely to be high due to long red-tape. Therefore, the company should establish business in nations with well defined institutional frameworks and with a history of political stability. The company may use two strategies to manage the political risk in the foreign country: risk avoidance and risk negotiation strategies. The company will would use the risk avoidance strategy by utilizing the financial, non-financial and legal framework to avoid the risk. This approach is intended to integrate the political risk in the company’s capital budget and operating strategies. On the other hand, risk negotiation strategy will require the company to make a favorable deal with the governments in the foreign nations. These risk management strategies are mutually inclusive, and the company may be required to use both of them when managing the political risk (Leopold and Wafo, 1998). Financial risk occurs when the host country is not in a position to clear off its foreign liabilities. Nations with high level of financial risk may not attract foreign investors due to their delicate situation. Such countries are likely to experience immediate financial crisis, and this does not work out well for foreign investments (Harif, Hoe and Noor, 2011). Therefore, IBF Supplies Plc should be very sensitive to the host countries' financial risk before it implements its business plans. Hayakawa, Kimura and Lee (2011) argue that when the host country's foreign debt rises relative to its GDP, it becomes hard for such a country to repay the debt, and this increases its financial risk. IBF Supplies Plc should avoid investing in such countries since it business operations may be affected when the country eventually experiences financial problems. The company should also be sensitive to the exchange rate instability in the countries it intends to invest. High inflation rates hinder foreign investments. It also lowers the country's currency value. This may affect the profitability of the foreign investments, which may lead to its collapse. In managing the financial risk, the company will be required to appoint risk management champion to help to integrate the financial risk into the culture of the company. This should be an independent person meant to assess the financial position of the company and its liquidity and advice the company accordingly. Many firms interested in operating in foreign countries encounter problems in choosing the mode of entry to those countries. Research on the mode of entry to foreign countries is vast in the study of International business (Ferreira, Li and Jang, 2007). There are three entry strategies IBF Supplies Plc could use to start its business activities in the foreign countries. The first strategy is the stages or process strategy. This entry mode requires the company to establish links first with those countries whose geographical distance is shorter. The strategy allows the company to use low involvement modes of entry at the initial stage. However, the company then continues to expand its operations to countries whose geographical distance is long by use of high involvement modes of entry (Ferreira and Serra, 2008). In this model of entry, the company follows a systematic pattern, where it begins by exporting goods to the foreign country and latter FDI operations. The second strategy explains that entry into foreign countries results from market imperfections. In this respect, the multinationals internalize the imperfect markets which make them to expand to foreign markets. The more knowledge about the market the company has, the higher the chances of internalizing that market. IBF Supplies Plc should seek to have higher market imperfection in various continents in order to find out strengths in those markets. Acquiring such market imperfections will enable the company to use high involvement entry modes like acquisitions, Greenfield, and joint ventures (Ferreira, Li and Jang, 2007). The third strategy of entry according to Ferreira and Serra (2008) is based on a perspective of quasi-social networks. IBF Supplies Plc's ties to other companies in the foreign market should determine its location, and the mode of entry to those foreign markets. The company should therefore , establish business ties with other firms so as it acquires information that could help the company get the opportunity to move some of its operations in the location of its choice (Ferreira, Li and Jang, 2007). IBF Supplies Plc should consider entering into foreign markets through cooperation with other firms since it facilitates entry to the markets, reduces associated risks and costs, and minimizes cultural and political problems. Question 2 The payment that Joe Company receives for its exports in Germany does not require conversion into the pound sterling since the exports are invoiced in pound sterling. Therefore, Joe’s transaction with Germany is not exposed to transaction risk, that is, the risk of exchange rates changing before the settlement date of a transaction. The chemicals are more saleable by Joe Company because the company does not face exchange rate risk since his export bill is in the company’s country currency. Ward and Grundy (1996) observes that if the Euro is at premium, Joe Company can make profits over the current spot rate if the company had taken a forward contract. Strengthening or weakening of the Euro will only benefit or hurt a Germany exporter if he has not hedged against the exchange risk. However, if the Euro weakened for several years the market for chemicals may shift to Germany since the main currency in Germany is the Euro. This is because if the euro weakens in relation to sterling pound, imports of chemicals from Germany will be relatively cheaper to a UK consumer than the UK made chemicals. Conversely, German importing chemicals from UK will be forced to pay heavily hence he will prefer to consume chemicals from his home country since it is relatively cheap. The net effect is that German chemicals are more attractive than UK chemicals due to price differences (Welsch, Hilton and Gordon, 1988). The UK consumers will be importing chemicals from Germany, but German consumers will not be importing chemicals from the UK. Therefore, the other UK exporters will have a competitive edge over Joe Company since they do not export their chemicals to Germany and their market remains unaffected. Question 3 Part (a) According to Wissema (1985), capital budgeting for projects usually involve large amount of capital outlay. These projects are evaluated in terms of real cash flows that will emanate from the project investment. Company finances are usually managed from the headquarter where the parent company is situated (Eiteman, Stonehill and Moffett, 2001). The international financial reporting standards require that a company report its financial performance by preparing a consolidated financial statements and a separate disclosure of the financial results of the parent company. Therefore, it may be hard to determine cash flow that comes from a particular subsidiary since the subsidiary financial results is not reported separately. Moreover, the functions of every subsidiary are regulated by the parent company including the funding and investment decisions. In addition, assessing capital budgeting for projects in the perspective of subsidiaries cash flow will expose the firm to translation risk. This is the risk of exchange rate movements between one year and the next causing fluctuations in values of foreign currency assets and liabilities in consolidated accounts. Beware that unrealised translation losses can affect borrowing capacity and the firm being a heavy dependant on debt financing cannot risk losing borrowing power. Part (b) Capital budgeting is associated with capital expenditure decisions. These are firm’s decisions to invest its finances most effectively in the long term activities in anticipation of flow of future benefits over a series of years (Weston and Brigham, 1971). Multinational companies operate in various countries hence when making capital budgeting they have to consider the exchange rate among various currencies. If the company uses a particular currency in its capital budgeting and it happens that the currency depreciate in relation to other currencies then the finances budgeted for in a particular project may not be enough. Exchange rates allow the decision maker to compare relative prices of capital investment in different countries. Multinational companies must also consider the domicile of the parent company. This is because majority of multinational companies consist of a parent company, which is mostly the headquarter and other local and international subsidiaries. The subsidiaries are supervised and assisted by the headquarter hence before they make huge capital investment they have to consult with the headquarter. This is the case so that the firm can realize corporate scale and scope effects since capital budgeting entails the joint efforts of many specialist and general firm’s officers. Part (c) The major determinants of cost of capital of a company are capital structure, the discounting rate and the level of risk of the business undertaking. If any of these factors change, it affects cost of capital of a company. Most multinational companies are characterized by huge size and they involve large amount of capital that is mainly debt financed. This means that the ratio of debt financing will be high in multinational companies and as a consequence the cost of capital will be close to the cost of debt. In addition, multinational companies operate in different countries and consequently they obtain revenue in different currencies hence these firms are usually exposed to foreign currency exchange risk (Horne, 1971). This means the discount rate associated with these firms will change to take into account the additional risk. As a result the cost of capital of a company will change. Part (d) Economies of scale arise when a firm increases its sales volume in a trade. Several factors are considered when determining the benefits of economies of scale. The major among them is relative prices of product in various countries and factor endowment in various producing countries. Economies of large scale production is a challenge to multinational companies. In some countries there are large internal markets which encourage industries to develop large scale output. The greater efficiency is reflected in the lower average and marginal cost of production as output increases (Walter, 1991). Economies of scale may be internal or external. Internal economies are those realized by the corporation as a result of large scale production. External economies may result from outside factors affecting the industry as a whole, for instance, a corporation can benefit from a large and better trained specialised labour force that an expanding industry can cause to develop. Pram will benefit from economies of scale if the firm establishes manufacturing in countries where factors of production are less costly so that the relative prices of its products will be correspondingly lower. The economies of scale are associated with large scale production. However, large output is economically feasible only when the market for the product is large. Countries with small national markets either because of small populations or small per capita income are not able to produce those goods subject to economies of large scale production. Establishing distributorship subsidiaries in various countries will benefit more from economies of scale than establishing manufacturing in various countries if there is existence of relative price differences. However, the gains from this establishment may be negated by high transport costs. Schall (1972) explains that when transport costs are added to production costs it becomes unprofitable to shift some products for long distance hence Ram will not benefit more from economies of scale. Part (e) The theory of comparative advantage is an expansion of Adam Smith’s theory of absolute advantage in trade by David Ricardo. He explores what would happen if one of the trading countries had an absolute advantage in the production of both commodities being traded. The theory of absolute advantage postulates that the country that has an absolute disadvantage in the production of all the products should stop producing the products and imports the products from other countries. This would create a very dangerous dependence on foreign products (Brigham and Ehrhardt, 2009). According to the theory of comparative advantage, even if a country had an absolute disadvantage in the production of all the goods and services it produces, mutually advantageous trade can still take place if the country specializes in the production of those goods in which its relative disadvantage is less. These are the products in which the country has a comparative advantage. This means the country is comparatively more efficient in the production of those goods in which it has comparative advantage. This theory is not useful in modern business environment because of its various limitations in its unrealistic assumptions. The assumption that there are only two countries and two products being traded does not hold in modern business environment since there are many countries trading and a range of products are delivered in global market. The theory also assumes that there are no transport costs which are not realistic because the cost of transporting the products is a very significant cost of imported products. It is erroneous to assume that there are price differences of resources in different trading countries and the failure to consider exchange rates. Different countries are differently endowed with resources hence due to abundance in one country and scarcity in another country, these resources will be priced differently in modern business environment. Exchange rate is a common phenomenon in modern business environment where inflation is prevalent in some countries causing depreciation of that currency relative to other foreign currencies (Brigham and Daves, 2009). Therefore, ignoring exchange rate will not be realistic. In addition, the theory assumes that there is free movement of resources from the production of one product to another within the country which is not true in the present competitive business environment. Hence the theory of comparative advantage is not useful in modern business environment. References Brigham, E. and Ehrhardt, M. 2009. Financial Management: Theory and Practice, 13th Edition. Ohio: Thompson South-Western. Brigham, F.E., and Daves, P. R., 2009. Intermediate Financial Management. New York: Cengage Learning. Eiteman, D. K., Stonehill, A.I. and Moffett, M. H., 2001. 9th ed. Multinational Busi­ness Finance. Reading Mass: Addison-Wesley. Horne, J. C., 1971. Financial management and policy, (2nd ed.). New Jersey Schall, L. D., 1972. Asset valuation, firm investment and firm diversification. Journal of Business, 45, pp. 11-28. Walter, N. 1991. Microeconomic Theory: Basic Principles and Extensions. New Delhi: Dryden Press. Ward, K. and Grundy, T., 1996. 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M., Hoe, C. H., & Noor, N. H. M 2011 “Franchisee failures in Malaysia: Contribution of financial and non-financial factors”. World, 1(2), pp:52-65. Hayakawa, K., Kimura, F., & Lee, H. H 2011 “How does country risk matter for foreign direct investment?”, Institute of Developing Economies, 51(1), pp:1-30. Leopold, G., & Wafo, K 1998 “Political Risk and Foreign Direct Investment”, Faculty of Economics and Statistics, University of Konstanz. Read More