Strategies for Utilizing Available Global Funds - Assignment Example

1. Strategies for utilizing available global funds

Strategies that firms can adopt to tap into available foreign capital can be broadly classified into corporate borrowings and capital financing by issuing shares. Loans, bonds and debentures from international institutions such as International Monetary Finance (IMF) and the World Bank and other low cost loan granting institutions are available to corporations that demonstrate ability to expand. Business people and foreign firms are always looking for foreign partners to go into business with and are very willing to invest by buying ordinary shares and preference shares. Capital financing by issue of shares has its merits as well as its disadvantages. Since dividends are only issued if a corporation makes profit, it is a better strategy for a startup or a firm that intends to invest back most of its profit for expansion to issuing out shares to protect the company from possible liquidation which may be the case if it is unable to pay its debts.

Debt financing is considered a cheaper option to affirm for two major reasons. To begin with, loan interest is tax deductible in many jurisdictions. The tax liability of a borrowing company is decreased by gearing. The second advantage is the fact that once the loan is fully repaid together with all accruing interest, the firm enjoys all the profits henceforth. With share financing, though it may appear cheap and safe at the initial stages, the company’s obligation to pay dividends is endless as long as its operations are in existence. A firm should, therefore, where possible, finance its capital expansion plans with low cost loans rather than issuing shares.

2. (a) Balance of Payment

Balance of payment (BOP) is a way of tracing and recording activities involving transactions between a country and other countries. Balance of payment aids in estimating the difference between a country’s imports and export within a financial period which may be done quarterly, semi-annually or annually. When the net imports exceed the net export, the balance of payment is negative commonly referred to as deficit. A positive balance of payment, also referred to as surplus, is an indication of competitiveness of a country in the international market since the net income from abroad is higher than the net outflow. Most developed countries have a favorable BOP while the developing countries experiences are more likely to experience a negative BOP.

2(b) why current account have opposite sign to capital and financial account

The current account is financed by capital and balances in the financial account. Any amount deposited in the current account is withdrawn from a respective financial account in a specific financial institution. The accounting treatment requires that a debit entry in one account be credited in another account. In other words, an increase in the balance of one account leads to a decrease in the balance of another account. For instance, if the opening balance in capital account in a certain year is $10,000 and the deposit during the year in the financial account amounts to $ 25,000, whenever deductions are made in either of the account, they are debited in the current account. If for instance current account shows a balance of $15,000, the financial account will show remaining balance of $10,000. Any increase in the current account will result in a proportional decrease in the financial account, hence, the opposite signs in the two accounts.

2(c) United States and Australian Deficits in Current account

A deficit generally is an implication that the rate of a country’s acquisition of asset is less than the rate its assets are being acquired by other countries. Deficits in both Australia and the United states indicate that the two countries’ income from abroad is surpassed by outflows to other nations. The major reasons for this may be due to decreasing competitive exporting advantage as more countries consume locally produced goods in place of goods previously imported from US and Australia. A second reason may be as a result of heavy importation of goods produced by other countries. China and India have low labor cost as compared to US and Australia. They are able to produce and export goods at relatively lower cost phasing out of the market goods from Australia and United states.

2(d) Importance of Balance of payment knowledge to a financial manager

Financial managers need to be conversant with the BOP information as it affects all businesses directly or indirectly. The health of the national economy can be determined by the statistics obtained from the balance of payment. For instance, if there is a consistent surplus in the balance of payment, it is an indication that factors of production are not fully utilized and as such, there is a likelihood of fluctuation of currencies if they are heavily dependent on market forces. Depending on the nature of the business, the financial manager can advise the firm on the course of action to take to protect its income from fluctuation in foreign exchange. Knowledge in BOP will help the manager to understand if it is necessary to hedge or enter into forward contracts for foreign transaction if significant amounts are involved.

3 (a) Fixed exchange versus floating exchange regime

A fixed exchange regime is purely set by the governing authority, which sets the exchange rates. The opportunity resulting from this is that a country’s economy is not influenced by external factors as illustrated by the China’s control of RMB in the 1990’s (Huang, 2016). The risks faced by the country exercising fixed exchange rate is the dominance of other foreign currencies such as US dollar in processing foreign transactions. In the case of floating rates, the market forces of demand are allowed to play their role in determining the exchange rate. The opportunities presented by this are that traders stand to gain from foreign transactions when local currency depreciates. However, if the local currency appreciates in value, the risks faced include a decrease in revenue collected from exports.

3 (b) Comparison between China’s Renminbi and Indian Rupee

The major issue around the Chinese Renminbi (RMB) is globalization of the currency to make it more favorable among the traders and efficiently reduce the dominance of US dollar in the long run. Globalization of RMB faces many constraints due to the high exchange charges and high confidence that traders have in the US dollar. The fact that the currency is highly controlled by the China’s government rather than market forces of demand and supply also make the traders more skeptical about its competitiveness (Huang, 2016).

As regards to Indian Rupee, the major challenge is economic problems resulting from BOP, inflation rate increases and the local policies by the government. Nidugala, Shukla and Mostafa (2015) state that in 1991, India started experiencing a double digit rate of inflation where during the year, the national rate of inflation reached 13.6 percent. In the same year, the balance of payment deficit was 8.4 percent. The exchange rate was highly dependent on a small number of currencies. Since the exchange rate was rigid and the rate of inflation kept on increasing, India lost its export competitiveness. The gulf war accelerated the crises as petroleum products prices increased which constitutes a major import bill. At the same time, the country was facing political instability after a congress ministerial candidate was assassinated. All these factors led to the country’s economic crises that led to deterioration of its currency.

In the financial years 2007/2008 to financial year 2012/2013, the current account balance of India deteriorated towards negative with the last two financial years recording the lowest results which led to loss of foreign reserves. Due to the subprime global crises that had rocked the entire world only a few years earlier, the country was yet to recover from the shocks that the crises caused. In addition, the foreign reserves were also very minimal despite the fact that the current account was in deficit. Foreign direct investment (FDI) started to decline after a duration of stability leading to a sharp reversal of past trend where the non-FDI financing of the current account deficit became a new strategy. India realized that in the long run, dependence of foreign investment for financing of current account deficit is unwise move.

Both the Indian Rupee and the RMB have a huge potential in the global scale. They however, share common problems regarding the traders’ preference of currencies considered more stable such as US dollars and Euro. If global competitiveness is to be achieved, a lot of efforts need to be made both in the respective countries and their core trade partners in the international scale. Huang (2016), states that China is still “setting stones at the bottom of the river”, to imply that a stronger foundation is necessary to make the currency more acceptable globally.

4(a) Transactions risks versus Economic risks

Transactions risks are those threats faced by traders in the normal operation of their businesses such as failure of a customer to pay in time and changes in quoted prices due to exchange rate fluctuations. Economic risks are those risks inherent from the global market forces and cannot be controlled by an entity. In the case of Porsche, a company with production plant in Germany and Finland, transactions risks involved includes selling vehicles in foreign countries such as the United States, which solely constitutes 42% of its global sales. Change in exchange rates has a tremendous impact on total revenue collected. To minimize the risk involved, companies can create natural hedge by producing in the country where products are to be sold or by using other means such as forward contracts, options and other forms of hedges.

Alliance design faces transaction quotations are made at a particular date but implemented at a different time period. The company is based in Canada but gets its supplies from the United States. Since the supplies constitute between 60-80 percent of total costs, a change in the fluctuation cost implies that the price of an installation will change proportionally. Since the US supplier demands payment in US dollar, Alliance design may at some point pay more than what it had anticipated to pay when the order was made.

Economic risks facing businesses may be mitigated by a number of hedges available to firms. An ideal example is the put option strike exercised by Porsche to hedge its future revenues. The company enjoyed significant treasury profits years 1998 and 2004 from strike options purchased before. The management purchased dollars when the pound was still weak making their future sales more profitable in the United States.

4 (b) Financial Markets versus operating hedges

Financial market hedges involve using measures that employs financial institution to hedge against cash flow losses while operating hedges is putting measures in place, during the normal business operations, that protects against huge cash losses due to factors such as exchange rates fluctuations. For instance, alliance design had the option to open a foreign currency account with the local banks in Canada that would allow the company to avoid frequency conversion when paying for supplies. Additionally, as seen in Pixonic case, a company can buy and lock currency at a future exchange rate to pay for its future obligations.

Operating hedges may be classified into call option, put option, and forward contracts (Huang, 2016). A call option gives the buyer, who believes that the price will improve for the better, the right but not the obligation to purchase an asset at a future date. It puts a contractual obligation to the seller to sell should the buyer show interest. A put option, on the other hand, grants the buyer the right to sell a particular asset if he desires to exercise the right which the seller is legally required to exercise. Finally, the forward contract is instituted by signing contractual agreement between the buyer and the seller to either buy or sell an asset at a specific future date and time at an agreed price.

Both the financial market and operating hedges come at a price to the hedging party. They are only to be subscribed for when the risk involved is most likely to occur. One similarity that they possess is that they give peace of mind to firm’s management who do not have to speculate about the likely effects of fluctuation in exchange rates.