International Financial Management

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International Financial Management
2
Introduction

• The main objective of international financial
  management is to maximize shareholder wealth.
• Adam Smith wrote in his famous title, Wealth of
  Nations that if a foreign country can supply us
  with a commodity Cheaper than we ourselves can
  make it, better buy it of them with some part of
  the produce of our own in which we have some
  advantage.

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Basic Functions

• Acquisition of funds (financing decision)
• This function involves generating funds from
  internal as well as external sources.
• The effort is to get funds at the lowest cost
  possible.
• Investment decision
• It is concerned with deployment of the acquired
  funds in a manner so as to maximize shareholder
  wealth.
• Other decisions relate to dividend payment,
  working capital and capital structure etc.
• In addition, risk management involves both
  financing and investment decision.

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Nature Scope

• Finance function of a multinational firm has two
  functions namely, treasury and control.
• The treasurer is responsible for
• financial planning analysis
• fund acquisition
• investment financing
• cash management
• investment decision and
• risk management
• Controller deals with the functions related to
• external reporting
• tax planning and management
• management information system
• financial and management accounting
• budget planning and control, and
• accounts receivables etc.

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Environment at International Level
International financial management practitioners
are required the knowledge in the following
fields.

• the knowledge of latest changes in forex rates
• instability in capital market
• interest rate fluctuations
• macro level charges
• micro level economic indicators
• savings rate
• consumption pattern

• investment behaviour of investors
• export and import trends
• Competition
• banking sector performance
• inflationary trends
• demand and supply conditions etc.

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International financial manager will involve the
study of

• exchange rate and currency markets
• theory and practice of estimating future exchange
  rate
• various risks such as political/country risk,
  exchange rate risk and interest rate risk
• various risk management techniques
• cost of capital and capital budgeting in
  international context
• working capital management
• balance of payment, and
• international financial institutions etc.

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Features of International Finance

• Foreign exchange risk
• Political risk
• Expanded opportunity sets
• Market imperfections

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Foreign exchange risk

• In a domestic economy this risk is generally
  ignored because a single national currency serves
  as the main medium of exchange within a country.
• When different national currencies are exchanged
  for each other, there is a definite risk of
  volatility in foreign exchange rates.
• The present International Monetary System set up
  is characterised by a mix of floating and managed
  exchange rate policies adopted by each nation
  keeping in view its interests.
• In fact, this variability of exchange rates is
  widely regarded as the most serious international
  financial problem facing corporate managers and
  policy makers.

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Political risk

• Political risk ranges from the risk of loss (or
  gain) from unforeseen government actions or other
  events of a political character such as acts of
  terrorism to outright expropriation of assets
  held by foreigners.
• For example, in 1992, Enron Development
  Corporation, a subsidiary of a Houston based
  Energy Company, signed a contract to build
  Indias longest power plant. Unfortunately, the
  project got cancelled in 1995 by the politicians
  in Maharashtra who argued that India did not
  require the power plant. The company had spent
  nearly 300 million on the project.

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Expanded Opportunity Sets

• When firms go global, they also tend to benefit
  from expanded opportunities which are available
  now.
• They can raise funds in capital markets where
  cost of capital is the lowest.
• The firms can also gain from greater economies of
  scale when they operate on a global basis.

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Market Imperfections

• domestic finance is that world markets today are
  highly imperfect
• differences among nations laws, tax systems,
  business practices and general cultural
  environments

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International Trade Theories

• Theory of Mercantilism
• Theory of Absolute Cost Advantage
• Theory of Comparative Cost Advantage

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Theory of Mercantilism

• This theory is during the sixteenth to the
  three-fourths of the eighteenth centuries.
• It beliefs in nationalism and the welfare of the
  nation alone, planning and regulation of economic
  activities for achieving the national goals,
  restriction imports and promoting exports.
• It believed that the power of a nation lied in
  its wealth, which grew by acquiring gold from
  abroad.

Cont
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Theory of Mercantilism

• Mercantilists failed to realize that simultaneous
  export promotion and import regulation are not
  possible in all countries, and the mere control
  of gold does not enhance the welfare of a people.
• Keeping the resources in the form of gold reduces
  the production of goods and services and,
  thereby, lowers welfare.
• It was rejected by Adam Smith and Ricardo by
  stressing the importance of individuals, and
  pointing out that their welfare was the welfare
  of the nation.

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Theory of Absolute Cost Advantage

• This theory was propounded by Adam Smith (1776),
  arguing that the countries gain from trading, if
  they specialise according to their production
  advantages.
• The pre-trade exchange ratio in Country I would
  be 2A1B and in Country II IA2B.

Cont
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Theory of Absolute Cost Advantage

• If it is nearer to Country I domestic exchange
  ratio then trade would be more beneficial to
  Country II and vice versa.
• Assuming the international exchange ratio is
  established IAIB.
• The terms of trade between the trading partners
  would depend upon their economic strength and the
  bargaining power.

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Theory of Comparative Cost Advantage

• Ricardo (1817), though adhering to the absolute
  cost advantage principle of Adam Smith, pointed
  out that cost advantage to both the trade
  partners was not a necessary condition for trade
  to occur.
• According to Ricardo, so long as the other
  country is not equally less productive in all
  lines of production, measurable in terms of
  opportunity cost of each commodity in the two
  countries, it will still be mutually gainful for
  them if they enter into trade.

Cont
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Theory of Comparative Cost Advantage

• In the example given, the opportunity cost of one
  unit of A in country I is 0.89 (80/90) unit of
  good B and in country II it is 1.2 (120/100) unit
  of good B.
• On the other hand, the opportunity cost of one
  unit of good B in country I is 1.125 (90/80)units
  of good A and 0.83 (100/120) unit of good A, in
  country II.

Cont
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Theory of Comparative Cost Advantage

• The opportunity cost of the two goods are
  different in both the countries and as long as
  this is the case, they will have comparative
  advantage in the production of either, good A or
  good B, and will gain from trade regardless of
  the fact that one of the trade partners may be
  possessing absolute cost advantage in both lines
  of production.
• Thus, country I has comparative advantage in good
  A as the opportunity cost of its production is
  lower in this country as compared to its
  opportunity cost in country II which has
  comparative advantage in the production of good B
  on the same reasoning.

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International Business Methods

• Licensing
• Franchising
• Subsidiaries and Acquisitions
• Strategic Alliances
• Exporting