Multinational Financial Management - Essay Example

Multinational Financial Management Every organization, irrespective of its size and mission, may be viewed as a financial entity. Management of an organization, particularly a business firm, is confronted with issues and decisions like the following, which have important financial implications: What kind of plant and machinery should the firm or a company buy? How should it raise finance? How much should company invest in inventories? What should be its credit policy depending on the nature of the organization? How should company gauge and monitor its financial performance? For example, let assume company XYZ, which is poised to be a multi-billion dollar multinational organization, is in desperate search of long-term funds. As a group treasurer of an organization, it is very important to understand the different financial instrument. It will involve analysis of financial condition and performance. Balance sheet and Profit & Loss account can go a long way in giving an overview on this regard. Secondly, as a treasurer it is important to use financial instrument like profit planning and financial forecasting, then only you can exercise financial control in proper utilization of long-term funds. On the other hand, if company XYZ has only $10,000 as an asset or in other word require short-term funds then as a treasurer of an organization your job will include analyzing financial instruments like management of current assets (cash, marketable securities, receivables and inventories). In addition, one can also use capital budgeting techniques like identification, selection and implementation of capital projects. Being a company with short-term funds, XYZ can also look out for mergers, reorganizations and divestments. Finally, if XYZ is in need of medium term funds, treasurer has to identify sources of finance and determination of financing mix because to make billion dollar XYZ company, multi-billion dollar treasurer has to cultivate sources of funds and have to raise funds. In addition, it’s his responsibility to dispose of profits between dividends and retained earnings. Financial management is broadly concerned with the acquisition and use of funds by a business firm. Its scope may be defined in terms of the following questions (1): How big should the firm be and how fast should it grow? What should be the composition of the firm’s assets? What should be the mix of the firm’s financing? How should the firm analyze, plan and most importantly control its financial affairs? Maximization of profit is not as inclusive a goal as maximization of shareholder wealth. Generally, it suffers from several limitations: Profit in absolute terms is not a proper guide to decision making. It should be expressed on a per share basis or related to investment. It leaves considerations of timing and duration undefined. There is no guide for comparing profit now with profit in future or for comparing profit streams of different durations. It glosses over the factor of risk. It cannot, for example, discriminate between an investment project, which generates a certain profit of $2000 and an investment project, which has a variable profit outcome with an expected value of $2000. Suppose a firm is considering an investment proposal. What aspects are relevant from the financial angle? From the financial point of view the relevant dimensions are return and risk. Take another decision situation in which the firm is considering a financing proposal. The aspects along which such a proposal is examined are cost and risk. As cost is the inverse of return, we find that in this case, too, the basic dimensions are return and risk. In general, we find that these are the two basic dimensions of financial analysis. What is the relationship between return, risk and market value of equity? Higher the return, higher the market value; higher the risk, lower the market value. It may be emphasized that typically risk and return go hand in hand. This means that in a decision situation, an alternative, which has a higher return, tends to have higher risk too. Likewise, an alternative which a lower return tends to have lower risk too. In financial analysis the trade off between risk and return needs to be properly analyzed. Firms raise funds from varied number of sources. Some funds for example share capital is kept permanently in the business. Some funds for instance debentures are kept for long periods while some funds are kept for short periods. The entire composition of these funds in an organization is generally termed as financial structure. Generally, the short-term funds are excluded since they are shifting quite often and the composition of long-term funds is known as capital structure. The design of the capital structure has an influence over the cost of capital, the financial risk and thereby the value of the firm. So, many decisions on capital structure are very crucial for a firm. The term capital structure refers to the relationship between various long-term forms of financing. Capital structure of a company refers to the composition or make up of its capitalization and it includes all long-term capital resources, viz., loans, reserves, shares and bonds (2). Thus capital structure indicates the composition of the long-term funds of an enterprise. It differs from financial structure in the sense that it excludes all sources of short-term financing. A business firm can raise funds from different sources. The important long-term sources of finance are issue of equity shares and preference shares, issue of debentures of different types, raising of term loans from financial institutions and generation of internal funds i.e., reserves. A firm may use different combinations of these sources by considering their relative cost and availability and their impact on the value of the firm, Leverage is employed for accelerating the profit. The two basic types of leverage are operating leverage and financial leverage. Operating leverage is employed for increasing the operating profit and financial leverage is employed for increasing the profit available to the equity shareholders. Since the purpose of leverage is to raise profits, a high degree of leverage gives a big push to profits. But sometimes it acts quite to the contrary. That is, it is a double-edged sword (3). The minimum required rate of return that a firm must earn on its investments in order to keep the present wealth of the shareholders unchanged or keep the market value of the firm’s equity shares is referred to as a ‘Cost of Capital’. This is in tune with the wealth maximization objective of a firm. In the context of evaluating the investment projects, cost of capital refers to the discount rate used for evaluating the desirability of the investment proposals. Cost of capital, plays a vital role in the realm of financial decision-making. It is the edifice on which the computations of capital budgeting decisions, capital structure decisions are built. Cost of capital provides a useful guideline in determining an optimal capital structure for a firm. An optimum capital structure is that which maximizes the value of share and maximizes the average and marginal cost of capital. While raising capital funds from various sources, the finance manager strikes a balance between the cost of capital and the risk and return expected by the shareholders. The finance manager tries to determine an ideal capital mix/ capital structure (mix of debt and equity) by way of establishing relationship between cost of capital and the value of equity stock of the firm. If the cost of capital of a firm is known, it is possible to make a fair estimation of the amount of risks that is involved in the company’s investment projects. For instance, if a firm is required to pay more than the market rate of interest in order to procure funds from the investors, this would present to the investors that the earnings rate of the firm is moderate or less and that the firm has limited opportunities to develop in future (4). Term loans, represent a source of debt finance, which is generally repayable in more than one year but less than 10 years. They are employed to finance acquisition of fixed assets and working capital margin. Term loans generally represent secured borrowing. In other word, assets, which are financed with the proceeds of the term loan, provide the prime security. That’s why, other assets of the firm may serve as collateral security. For purposes of valuing assets the following concept, is widely followed: “The value of a property (or asset) to its owner should be identical to the loss, direct and indirect, the owner might expect to suffer if he is deprived of the property or asset (5)”. With an unanticipated increase in inflation, the borrower benefits because the loan is repaid in ‘cheaper’ money than originally anticipated. To illustrate, consider a loan, which carries a 12 per cent nominal rate of interest based on an 8 per cent expected inflation rate and a required 4 per cent real rate of return. If the actual inflation rate turns out to be 10 per cent, rather than the expected 8 per cent, the real rate of return would be 2 per cent and not 4 per cent. As a consequence, the borrower gains whereas the lender loses. An unanticipated decrease in inflation would have the opposite consequences: the borrower will loose whereas the lender will gain. Suppose a firm has determined that it should have debt and equity in equal proportions in its capital structure. Does it mean that every time it raises finances, it will tap debt and equity in equal proportions? This does not happen for two reasons. Firstly, financing often is a lumpy process- so it is difficult for the firm to maintain strict proportions each time in raises finances. Secondly, the conditions in the capital market may not always be favorable for raising finances from both the sources, viz., debt and equity. Hence, timing of security issues is an important aspect of financing (6). The marginal cost of capital is the discount rate used for evaluating investments. A project is worthwhile if its net present value, discounted at the marginal cost of capital is positive. When the marginal cost of capital is constant, selecting the set of investments is a relatively straightforward task. All projects, which have a positive net present, value at the given marginal cost of capital would be acceptable. When the marginal cost of capital increases at discrete points as more and more financing is sought, determining the optimal capital budget is a somewhat difficult task. A precise solution to this problem is very difficult but one can follow a below mentioned procedure: Determine the set of projects that has the highest net present value for each level of financing before a break in the marginal cost of capital schedule. In addition, one can choose the level of financing and the corresponding set of investment projects, which has the highest net present value. In many cases the revenue expected from a project are conservatively estimated to ensure that the viability of the proposed projects is not easily threatened by unfavorable circumstances. A margin of safety is generally included in estimating cost figures. This varies between 10 per cent and 30 per cent of what is deemed as normal cost. The cut-off point on an investment varies according to the judgement of management about the riskiness of the project. It is worth mentioning that in company, replacement investments are Okayed if the expected post-tax return exceeds 15 per cent but new investments are undertaken only if the expected post-tax return is greater than 20 per cent (7). Bibliography: (1): Ezra Solomon, The Theory of Financial Management, New York, Columbia University Press, 1963 (2): Gitman, LJ. Principles of Managerial Finance, Harper & Row, New York, 1985, Chapters 12 and 13). (3): Hastem, John A. ‘Leverage Effects on Corporate Earnings’, Arizona Business Review, March 1970,7-11 (4): Financial Decision Making, John J. Hampton, Prentice Hall of India, New Delhi. (5): J.C. Bonbright, The Valuation of Property (6): The Capital Structure Decision, Harold Bierman, 1-7 (7): Investment Management, edited by Peter L Bernstein, Aswath Damodaran, 117-168 Read More