Department of Commerce

University of Calcutta

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University of Calcutta

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 For

Semester-IV

[Additional Materials]

Series-II
 University of Calcutta
M.Com. Semester IV: 2020
Strategic Management
Module 1
(Dr. Bikram Singh)

Chapter 4: Business Level Strategy and Functional Strategy

i. Generic Business Level Strategy - Meaning

A generic business level strategy gives a company a specific form of competitive position and
advantage vis-a-vis its rivals that results in above average profitability. ‘Generic’ means that
all companies can potentially pursue these strategies regardless of whether they are
manufacturing, service, or non-profit enterprises; they are also generic because they can be
pursued across different kinds of industries. [Ref: Hill and Jones (2015)]

ii. Three Approaches to Market Segmentation

Standardization Strategy: When a company decides to ignore different segments,
and produce a standardized product for the average consumer.

Segmentation Strategy: When a company decides to serve many segments, or

even the entire market, producing different offerings for different segments.

Focus Strategy: When a company decides to serve a limited number of segments,

or just one segment. [Ref: Hill and Jones (2015)]

iii. Business Level Strategy: Types

a. Broad Low-Cost Strategy (Cost Leadership)
When a company lowers costs so that it can lower prices and still make a profit it is said to
follow broad low-cost strategy.

b. Broad Differentiation Strategy (Differentiation)

When a company differentiates its product in some way, such as by recognizing different
segments or offering different products to each segment it is said to follow broad
differentiation strategy.
c. Focus Low-Cost Strategy (Focused Cost Leadership)
When a company targets a certain segment or niche, and tries to be the low-cost player in that
niche it is said to follow focus low cost strategy.
d. Focus Differentiation Strategy (Focused Differentiation)
When a company targets a certain segment or niche, and customizes its offering to the needs
of that particular segment through the addition of features and functions it is said to follow
focus differentiation strategy. [Ref: Hill and Jones (2015)]

iv. Business -Level Strategy, Industry and Competitive Advantage

Properly executed, a well-chosen and well-crafted business-level strategy can give a company
a competitive advantage over actual and potential rivals. More precisely, it can put the
company in an advantageous position relative to each of the competitive forces.
The low-cost enterprise can make profits at price points that its rivals cannot profitably
match. This makes it very hard for rivals to enter its market. In other words, the low-cost
company can build an entry barrier into its market. It can, in effect, erect an economic moat

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around its business that keeps higher-cost rivals out. A low-cost position and the ability to
charge low prices and still make profits also give a company protection against substitute
goods or services. Low costs can help a company to absorb cost increases that may be passed
on downstream by powerful suppliers. Low costs can also enable the company to respond to
demands for deep price discounts from powerful buyers and still make money. The low-cost
company is often best positioned to survive price rivalry in its industry. Indeed, a low-cost
company may deliberately initiate a price war in order to grow volume and drive its weaker
rivals out of the industry.
The successful differentiator is also protected against each of the competitive forces. The
brand loyalty associated with differentiation can constitute an important entry barrier,
protecting the company’s market from potential competitors. Because the successful
differentiator sells on non-price factors, such as design or customer service, it is also less
exposed to pricing pressure from powerful buyers. Indeed, the converse may be the case—the
successful differentiator may be able to implement price increases without encountering
much, if any, resistance from buyers. The differentiated company can also fairly easy absorb
price increases from powerful suppliers and pass those on downstream in the form of higher
prices for its offerings, without suffering much, if any, loss in market share. The brand
loyalty enjoyed by the differentiated company also gives it protection from substitute goods
and service. The differentiated company is protected from intense price rivalry within its
industry by its brand loyalty, and by the fact that non-price factors are important to its
customer set. At the same time, the differentiated company often does have to invest
significant effort and resources in non-price rivalry, such as brand building through
marketing campaigns or expensive product development efforts, but to the extent that it is
successful, it can reap the benefits of these investments in the form of stable or higher prices.
Focused companies often have an advantage over their broad market rivals in the segment or
niche that they compete. The same can be true for a differentiated company. By focusing on a
niche, and customizing the offering to that segment, a differentiated company can often
outsell differentiated rivals that target a broader market. [Ref: Hill and Jones (2015)]

v. Market Segmentation, Costs and Revenues

Different approaches to market segmentation have different implications for costs and
revenues. A standardization strategy is typically associated with lower costs than a
segmentation strategy. A standardization strategy involves the company producing one basic
offering, and trying to attain economies of scale by achieving a high volume of sales. In
contrast, a segmentation strategy requires that the company customize its product offering to
different segments, producing multiple offerings, one for each segment.
Customization can drive up costs for two reasons; first, the company may sell less of each
offering, making it harder to achieve economies of scale, and second, products targeted at
segments at the higher-income end of the market may require more functions and features,
which can raise the costs of production and delivery. On the other hand, it is important not to
lose sight of the fact that advances in production technology, and particularly lean production
techniques, have allowed for mass customization—that is, the production of more product
variety without a large cost penalty. In addition, by designing products that share common
components, some manufacturing companies are able to achieve substantial economies of
scale in component production, while still producing a variety of end products aimed at
different segments. This is an approach adopted by large automobile companies, which try to
utilize common components and platforms across a wide range of models. To the extent that

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mass customization and component sharing is possible, the cost penalty borne by a company
pursuing a segmentation strategy may be limited. Although a standardization strategy may
have lower costs than a segmentation strategy, a segmentation strategy does have one big
advantage: it allows the company to capture incremental revenues by customizing its
offerings to the needs of different groups of consumers, and thus selling more in total. A
company pursuing a standardization strategy where the product is aimed at the average
consumer may lose sales from customers who desire more functions and features, and are
prepared to pay more for that. Similarly, it may lose sales from customers who cannot afford
to purchase the average product, but might enter the market if a more basic offering was
available.
As for a focus strategy, here the impact on costs and revenues is subtler. Companies that
focus on the higher-income or higher-value end of the market will tend to have a higher cost
structure for two reasons. First, they will have to add features and functions to their product
to appeal to higher-income consumers, and this will raise costs. Second, the relatively limited
nature of demand associated with serving just a segment of the market may make it harder to
attain economies of scale. Offsetting this, however, is that the customization and exclusivity
associated with a strategy of focusing on the high-income end of the market may enable such
a firm to charge significantly higher prices than those enterprises pursuing standardization
and segmentation strategies. For companies focusing on the lower-income end of the market,
or a segment that desires value for money than they are about price or are less concerned
about brands, a different strategy comes into play. Such companies tend to produce a more
basic offering that is relatively inexpensive to produce and deliver. This may help them to
drive down their cost structures. [Ref: Hill and Jones (2015)]

vi. Generic Business Level Strategy and Strategic Choices

a. Cost Leadership
A company’s business model based on cost leadership is based on doing everything it can to
lower its cost structure so that it can make/sell goods or services at a lower cost than its
competitors. It positions itself on the value creation frontier as close as possible to the lower
costs/ lower prices.
A cost leader chooses low to moderate level of product differentiation relative to its
competitor. It ignores different market segments and produces products that appeal ‘average’
customers. Its strategy is based on producing least/smallest number of products desired by the
highest number of customers. They have increased efficiency and a reduced cost structure.
[Ref: Hill and Jones (2015)]

b. Focused Cost Leadership

Cost Leader is not always a large, national company that targets ‘average’ customer.
Sometimes a company targets one/few market segments and successfully pursues cost
leadership by developing right strategies to serve those segments. These companies pursue a
business model based on focused cost leadership. Such companies compete against the cost
leader in the market segmentation at no cost disadvantage. In doing this focused cost leaders
concentrates on small volume custom products and, leaves the large volume standardised

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market to the cost leader. Because of no cost disadvantage it operates on the value creation
frontier and earns above average profits.

c. Differentiation
A company’s business model is based on achieving competitive advantage by creating
products that customers perceive as different or distinct in some important way. A
differentiator has the ability to satisfy customers’ needs in a way that its competitors cannot
and is in the position to charge higher prices. Differentiation strategy safeguards a company
against competition to the degree that customers develop brand loyalty. However, a
differentiator must watch out imitations and be careful that they do not charge higher than the
market can bear.

d. Focused Differentiation
A focused differentiator chooses to specialise in serving the needs of one/two market
segmentation/niches. Once it has chosen its market segment, a focused company positions
itself using differentiation. Focusing on one type of customers/only one segment of product
line a focused differentiator is able to reach the value frontier because they are frequently
able to develop a differentiated product that better satisfies the needs of customers in
particular segment than a differentiator. The focused differentiator does not attempt to serve
all market segments because that would bring it into direct competition with the broad
differentiator. If the focused differentiator tries to compete with the broad differentiator, it
may run into trouble because the broad differentiator has the resources to imitate the focused
differentiator’s business model. Many companies who started off as focused differentiators
have become leading differentiators in their industry either through internal growth or issuing
stocks and building debt to raise the capital they needed to expand their business by taking
over focused companies and combing their resources. However, focused differentiators must
stay close to customers and respond to their needs. If the focuser’s niche disappears over time
because of technological change/changes in customer’s tastes, it cannot move easily to new
niches and this can be a major danger. [Ref: Hill and Jones (2015)]
vii. Functional-level Strategy
Functional-level strategies are actions that managers take to improve the efficiency and
effectiveness of one or more of value creation activities. A firm can use functional-level
strategies to build valuable resources that enable it to attain superior efficiency, quality,
innovation, and customer responsiveness. For example, McDonald’s has been a standout
performer in the fast-food industry. McDonald’s was a fast-food innovator, developing many
of the practices that have become standard in the industry. It was responsive to customer
needs for inexpensive fast food, good, quick service, and a clean environment. By
standardizing the process of making fast food and working closely with its suppliers,
McDonald’s improved its efficiency, thereby lowering costs and prices, while offering a
product of reliable quality that was the same no matter where it was purchased. In this
section we will learn how functional-level strategies can be used to build a sustainable
competitive advantage in terms of attaining superior efficiency, quality, innovation, and
customer responsiveness.

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 (I) Achieving Superior efficiency:
One common measure of efficiency is employee productivity. It helps a company attain a
competitive advantage through a lower cost structure. Another important measure of
efficiency is capital productivity. It refers to the output produced by a dollar of capital
invested in the business. In short, measure of efficiency is the quantity of inputs that it takes
to produce a given output; that is, efficiency = outputs/inputs. A company can takes the
following steps at the functional level to increase efficiency and lower cost structure at
various value creation activities:
 Economies of scale are unit cost reductions associated with large-scale output.
Another source of scale economy is greater division of labour and specialization.
Specialization enables employees to become very skilled at performing a particular
task and have a favourable impact on productivity. Managers must know the extent of
economies of scale, and where diseconomies of scale begin to occur.

 Learning effects are cost savings that result from “learning by doing.” Labour
productivity increases over time, and unit costs decrease as individuals learn the most
efficient way to perform a particular task. It has been suggested that they are most
important during the start-up period of a new process.

 Experience curve refers to the systematic lowering of the cost structure, and
consequent unit cost reductions that have been observed to occur over the life of a
product. The strategic significance of the experience curve is clear: Increasing a
company’s product volume and market share will lower its cost structure relative to
its rivals.

 Flexible production technologies may increase efficiency and lower unit costs by
enabling the company to customize its product offering to a much greater extent. The
term mass customization has been described as a company’s ability to use flexible
manufacturing technology to reconcile low cost and differentiation through product
customization.

 The marketing strategy that a company adopts can have a major impact on efficiency
and cost structure. Marketing strategy refers to the position that a company takes with
regard to market segmentation, pricing, promotion, advertising, product design, and
distribution. Some of the steps leading to greater efficiency are fairly obvious. For
example, moving down the experience curve to achieve a lower cost structure can be
facilitated by aggressive pricing, promotions and advertising—all of which are the
task of the marketing function. Other aspects of marketing strategy have a less
obvious—but no less important impact—on efficiency. One important aspect is the
relationship of customer defection rates, cost structure, and unit costs. Customer
defection is the percentage of a company’s customers who defect every year to
competitors. Lowering customer defection rates allows a company to achieve a lower
cost structure.

 Materials management encompasses the activities necessary to get low cost inputs
and components to a production facility and out through a distribution system to the
end-user. Improving materials-management function through just-in-time (JIT)
approach and managing the flow of inputs, components from suppliers or supply
chain management are advisable.

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  R&D function can boost efficiency by designing products that are easy to
manufacture and by pioneering process innovations that can help a company achieve a
lower cost structure.

 Human Resource Strategy deals with employee productivity and emphasis on two
aspects. First, self-managing teams, whose members coordinate their own activities
and make their own hiring, training, work, and reward decisions. Second, pay for
performance which linked to the ability of the team to meet productivity and quality
goals.

 Cost efficiency can also be realized by using web-based information systems to

automate many internal company activities, from managing expense reimbursements
to benefits planning and hiring processes, thereby reducing the need for internal
support personnel.

 Company’s infrastructure- including its organizational structure, culture, style of

strategic leadership, and control system—determines the context within which all
other value creation activities take place. Appropriate infrastructure can help foster a
companywide commitment to efficiency and promote cooperation among different
functions in pursuit of efficiency goals.

Strategic leadership is especially important in building a companywide commitment to

efficiency. The leadership task is to articulate a vision that recognizes the need for all
functions of a company to focus on improving efficiency.

(II) Achieving Superior quality:

A product is said to have superior quality when customers perceive that its attributes provide
them with higher utility than the attributes of products sold by rivals. The quality of a product
is commonly measured in terms of reliability and excellence. Excellence signifies some
important product attributes, such as a product’s design and styling, its aesthetic appeal, its
features and functions, the level of service associated with delivery of the product, and so on.
Reliability develops when it consistently performs the function it was designed for, performs
it well, and rarely, if ever, breaks down. A company can takes the following steps at the
functional level to increase quality at various value creation functions:

(A) Reliability improving mechanism: The principal tool that most managers use to
increase the reliability of their product offering is the Six Sigma quality improvement
methodology. Improvement in product reliability is a cross-functional process. Its
implementation requires close cooperation among all functions in the pursuit of
improving quality. These functions in implementing reliability improvement
methodologies are summarized:

 At first senior managers agree to a quality improvement program and communicate its
importance to the organization.
 If a quality improvement program is to be successful, individuals must be identified to
lead the program.

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  Quality improvement methodologies advocate the need to identify defects that arise
from processes, trace them to their source, find out what caused the defects, and make
corrections.
 Quality improvement program emphasise to create a metric that can be used to
measure quality.
 Once a metric has been devised, the next step is to set a challenging quality goal and
create incentives for reaching it.
 Shop floor employees can be a major source of ideas for improving product quality,
so these employees must participate and be incorporated into a quality improvement
program.
 A major source of poor-quality finished goods is poor-quality component parts. A
company must work with its suppliers to improve the quality of the parts they supply.
 Designing products with fewer parts is often a major component of any quality
improvement program.
 Implementing quality improvement methodologies requires organization wide
commitment and substantial cooperation among functions.

(B) Excellence improving mechanism: A product is comprised of different attributes like

include the form, features, performance, service, durability, reliability and styling of a
product. Achieving a perception of being high in the excellence dimension on any of these
attributes requires specific actions by managers, which are as follows:

 It is important for managers to collect marketing intelligence indicating which

attributes are most important to customers.
 Once the company has identified the attributes that are important to customers, it
needs to design its products (and services) in such a way that those attributes are
embodied in the product.
 The company must decide which significant attributes to promote and how it creates a
consistent image in the minds of customers.
 It must be recognized that competition is not stationary, but instead continually
produces improvement in product attributes, and often the development of new-
product attributes.

(III) Achieving Superior Innovation:

There are two main types of innovation: product innovation and process innovation. Product
innovation generates value by creating new products, or enhanced versions of existing
products, that customers perceive as having more value, thus increasing the company’s
pricing options. Process innovation is the development of a new process for producing and
delivering products to customers. Basically, it allows a company to create more value by
lowering production costs. But in reality, the failure rate of innovative products is very high.
So, at first, we will try to identify reasons behind failures in the process of innovation, then
explore how to minimise failure.

(A) Reasons behind high failure rate in innovation:

 It is impossible to know prior to market introduction whether the new product has
tapped an unmet customer need, and if there is sufficient market demand to justify
manufacturing the product.

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  When there is definite customer demand for a new product, but the product is not well
adapted to customer needs because of factors such as poor design and poor quality.
 New products may fail because of poor positioning strategy a company adopts for a
product-based upon price, distribution, promotion and advertising, and product
features.
 Many new-product introductions fail because companies make the mistake of
marketing a technology for which there is not enough demand.
 The more time that elapses between product development and final marketing—the
more likely it is that a competitor will beat the company to market and gain a first-
mover advantage.
 If a new product is not designed with manufacturing capabilities in mind, it may
prove too difficult to build with existing manufacturing technology. In this case both
overall development costs and time to market may increase significantly

(B) Reducing failure rate in innovation: Managers can reduce the high failure rate
associated with innovation by ensuring tight cross-functional integration among R&D,
production, and marketing. The best ways to achieve integration is to establish cross
functional product development teams which attributes to the following
 The team leader should be skilled at integrating the perspectives of different functions
and facilitate cross-functional cooperation for a common goal.
 The team should be composed of at least one member from each key function or
position. They work in proximity to one another to create a sense of camaraderie and
facilitate communication.
 The team should have a clear plan and clear goals, particularly with regard to critical
development milestones and development budgets.
 Each team needs to develop its own processes for communication, as well as conflict
resolution.
 Managers need to undertake an objective assessment after a product development
project has been completed, identifying key success factors and the root causes of
failures, and allocating resources to repairing failures.

(IV) Achieving Superior Customer Responsiveness:

Achieving superior customer responsiveness means giving customers value for their money,
and steps taken to develop a competency in listening to its customers, focusing on its
customers, and investigating and identifying their needs. Primary roles of different functions
in achieving superior customer responsiveness are as follows:
 Building superior customer responsiveness needs demonstrating leadership, shaping
employee attitudes, and using mechanisms for making sure that customer needs are
well known within the company.
 Companies can provide a higher level of satisfaction if they differentiate their
products by (1) customizing them, where possible, to the unique demands of
individuals or groups and (2) reducing the time it takes to respond to or time that it
takes for a good to be delivered or a service to be performed.
 Other sources of enhanced responsiveness to customers are superior design, superior
service, and superior after-sales service and support. In turn, differentiation enables a
company to build brand loyalty and charge a premium price for its products.

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Achieving superior efficiency, quality, and innovation are integral part of achieving superior
responsiveness to customers. It must constantly seek better ways to satisfy those needs. [Ref:
Hill and Jones (2015)]

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SCM: Prof. D.R, Dandapat

www.nitropdf.com
 Paper CC 402: Strategic Cost and Management
Accounting (SCM)

Module –I

Transfer Pricing

(Prof. Ashish Kumar Sana)

Transfer Price-Shared Contribution/Market Price Method

(Problems on Transfer price based on Shared Contribution /Market Price Method already
solved in Previous Classes)

Transfer pricing based on Opportunity Cost

Example 1

Division X is a profit centre which produces four products A,B,C and D. Each product is sold
in the external market also. Following information is available for the period:

Particulars A B C D
Market price p.u. (Rs.) 300 292 280 260
Variable Cost p.u. (Rs.) 260 200 180 170
Labour hours required p.u. 3 4 2 3
Product D can be transferred to Division Y but the maximum quantity that might required for
transfer is 2500 units of D.
The maximum sales in the external market are:
A 2800 Units
B 2500 Units
C 2300 Units
D 1600 Units

Division Y can purchase the same product at a slightly cheaper price of Rs.250 p.u. instead of
receiving transfers of product D from Division X.
What should be the transfer price for each unit for 2500 units of D, if the total labour hours
available in Division X are 20,000 hours?

1
Solution:
Calculation of Ranking of Products when availability of time is the key
No Particulars A B C D
1 Market price p.u. (Rs.) 300 292 280 260
2 Less: Variable Cost p.u. (Rs.) 260 200 180 170
3 Contribution p.u. (1-2) 40 92 100 90
4 Labour hours required p.u. 3 4 2 3
5 Contribution per hour (3÷4) 13.33 23 50 30
6 Ranking IV III I II
7 Maximum Demand (units) 2800 2500 2300 1600
8 Total No. of Hours (4x7) 8400 10000 4600 4800
9 Allocation of hours on the basis of ranking 600 10,000 4600 4800

Note: Time required to meet the demand of 2,500 units of Product D for Division Y is 7500
(2500×3) hours. This requirement of time viz. 7,500 hours for providing 2,500 units of
Product D for Division Y can be met by sacrificing 600 hours of Product A (600÷3= 200
Units) and 6,900 hours of Product B (6900÷4=1725 Units).
Transfer Price= Variable Cost + Opportunity Cost
= Rs.170+ ([Rs. 8,000+ Rs. 158700]÷2500 Units]
= Rs.170+[ Rs.166700÷2500 Units]

= Rs.170+Rs.66.68 = Rs.236.68

Opportunity Costs
No Particulars A B
1 Opportunity Cost (Rs.) 600 6900
2 Contribution p.u . (Rs.) 13.33 23
3 Total Opportunity Costs (Rs.) 8,000 158700

Example 2: (Corrected)

Division X is a profit centre, which produces four products P, Q, R, S. Each product is sold in
the external market also. Following information is available for the period:
Particulars P Q R S
Market price p.u. (Rs.) 700 690 560 460
Variable Cost p.u. (Rs.) 660 620 360 370
Labour hours required p.u. 3 4 2 3
Product S can be transferred to Division Y but the maximum quantity that might required for
transfer is 2000 units of S.
The maximum sales in the external market are:

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 P 3000 Units
Q 3500 Units
R 2800 Units
S 1800 Units

Division Y can purchase the same product at a slightly cheaper price of Rs.450 p.u. instead of
receiving transfers of product S from Division X.
What should be the transfer price for each unit for 2000 units of S, if the total labour hours
available in Division X are: (i) 24,000 hours and (ii) 32,000 hours?

Solution:
Step 1: Calculation of Ranking based on Time Factor
Calculation of Ranking of Products when availability of time is the key factor
No Particulars P Q R S
1 Market price p.u. (Rs.) 700 690 560 460
2 Less: Variable Cost p.u. (Rs.) 660 620 360 370
3 Contribution p.u. (1-2) 40 70 200 90
4 Labour hours required p.u. 3 4 2 3
5 Maximum Demand (Units) 3,000 3,500 2,800 1,800
6 Total No. of Hours 12,000 14,000 5,600 5,400
7 Contribution per hour (3÷4) 13.33 17.50 100 30
8 Ranking IV III I II

Step 2: Identify the sacrificing products and allocation would be based on ranking
Situation 1 : When labour hours available in Division X is 24, 000 hours
Statement showing product mix
Product Maximum Demand Hours Units Hours Balance Hours
(Ranking) (Units) p.u. Produced Used
R 2,800 2 2,800 5,600 (24,000-5,600)=18,400
S 1,800 3 1,800 5,400 (18,400-5,400)=13,000
Q 3,500 4 3,250 13,000 (13,000-13,000)=0
(Balance)
P 3,000 3 0 0 0

Here, sacrificing product is Q.

Time required meeting the demand of 2,000 units of Product S for Division Y is 6000 hours
(2,000×3). This requirement of time viz. 6,000 hours for providing 2,000 units of Product S
for Division Y can be met by sacrificing the production of 1,500 units of Product Q
(1500 units ×4 hours).

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Statement showing Transfer Price for each unit for 2,000 units of Product S
Transfer Price 2,000 units of product S Per unit of Product S
(Rs.) (Rs.)
Variable Cost (Rs.) 7,40,000 370
Opportunity Cost of the Contribution 1,05,000 52.50
foregone by not producing 1,500
units of Q (1500 units ×Rs.70)
Transfer price 8,45,000 422.50

Situation 2 : When labour hours available in Division X is 32, 000 hours

Statement showing product mix
Product Maximum Demand Hours Units Hours Balance Hours
(Ranking) (Units) p.u. Produced Used
R 2800 2 2800 5600 (32000-5600)=26400
S 1800 3 1800 5400 (26400-5400)=21000
Q 3500 4 3500 13000 (21000-14000)=7000
P 3000 3 2333 0 (7000-7000)=0
(Balance)

Here, sacrificing product is P.

Time required to meet the demand of 2,000 units of Product S for Division Y is 6000 hours.
This requirement of time viz. 6,000 hours for providing 2,000 units of Product S for Division
Y can be met by sacrificing the production of 2,000 units of Product P (2000 units ×3 hours).
Statement showing Transfer Price for each unit for 2000 units of Product S
Transfer Price 2000 units of product S Per unit of Product S
(Rs.) (Rs.)
Variable Cost (Rs.) 7,40,000 370
Opportunity Cost of the Contribution 80,000 40.00
foregone by not producing 2,000
units of P (2000 units ×Rs.40)
Transfer price 8,20,000 410.00

4
 Paper CC.403: Auditing and Assurance Services
Module II
MCQ for Internal Assessment

1. _________empowers the Central Government to specify audit of items of cost in respect

of certain companies.

(a) Section 143 of Companies Act, 2013

(b) Section 139 of Companies Act, 2013
(c) Section 148 of Companies Act, 2013
(d) Section 147 of Companies Act, 2013
2. Cost Audit represents true and fair view of the _________of any product.
(a) Cost of sale
(b) Cost of raw material consumption
(c) Cost of production
(d) None of these
3. A company shall within _________ days from the date of receipt of the Cost audit report
shall furnish the same to the Central Government.
(a) 60
(b) 15
(c) 30
(d) 90
4. The cost records are to be maintained as specified in
(a) CRA 1
(b) CRA 2
(c) CRA 3
(d) CRA 4
5. The Cost Auditor appointed has to render the cost audit report to the board of directors
of the Company, as per the specified time limit, in Form ____________.
(a) CRA 3
(b) CRA 1
(c) XBRL
(d) CRA 2

1
6. The applicability of cost audit under Companies (Cost Records and Audit) Rules, 2014
for regulated industries having overall annual turnover during immediate preceding
financial year
(a) Rs. 25 crores or more
(b) Rs.35 crores or more
(c) Rs.50 crores or more
(d) Rs.100 crores
7. Which of the following type of Electricity Company is under the purview of regulated
sector?
(a) Engaged in Generation
(b) Engaged in Transmission
(c) Engaged in Distribution & Supply
(d) All the above
8. The applicability of cost audit under Companies (Cost Records and Audit) Rules, 2014
for non-regulated industries having ________turnover of individual products or services
during immediate preceding financial year
(a) Rs. 25 crores or more
(b) Rs. 35 crores or more
(c) Rs.50 crores or more
(d) Rs. 100 crores or more
9. Which one of the below is not a regulated industry
(a) Telecommunication
(b) Electricity
(c) Drugs & Pharma
(d) Automobile
10. Any casual vacancy in the office of a cost auditor, whether due to resignation, death or
removal, to be filled by the Board of Directors within ________days of occurrence of such
vacancy.
(a) 30 days
(b) 60 days
(c) 90 days
(d) 180 days
11. Every cost auditor shall forward his duly signed report to the Board of Directors of the
company within a period of ________ days from the closure of the financial year to which
the report relates.
2
(a) 60 days
(b) 90 days
(c) 180 days
(d) 270 days
12. The requirement for the cost audit shall not apply to a company whose revenue from
exports, in foreign exchange exceeds of its total revenue
(a) 25%
(b) 50%
(c) 75%
(d) 10%

Model Questions

1. (a) What is Cost Audit? Discuss its importance.

(b) What are the objectives of Cost Audit?

(c) Find out the major differences between Cost Audit and Financial Audit.

(d) What is the procedure for appointment of cost auditor under the Companies Act, 2013?

(e) Discuss the applicability of Rule 3 and Rule 4 of the Companies (Cost Records and Audit)
Rules, 2014 in respect of Cost Audit.

(f) A company has units in SEZ and in non-SEZ areas. The Companies (Cost Records and
Audit) Rules 2014 has exempted companies operating in special economic zones from
cost audit. What would be applicability of the Companies (Cost Records and Audit)
Rules 2014 on such a company in respect of maintenance of cost accounting records and
cost audit?

2. (a) Define Management Audit. Discuss about the uses of Management Audit.

(b) What are the objectives of management audit?

(c) What are the steps followed in Management audit?

(d) What is the relevance of management audit in today’s business scenario?

(e) What are the behavioral aspects encountered in Management Audit? How the Management
Auditor can overcome these behavioral problems?

3
3. (a) What is Environmental Audit? What are its objectives?

(b) Discuss the major benefits of Environmental Audit.

4. (a) What is Secretarial Audit?

(b) What are the benefits of Secretarial Audit?

(c) Which companies are required to undergo Secretarial Audit?

(d) “The scope of Secretarial Audit is not restricted to Companies Act” – Discuss.

5. (a) What is Secretarial Standard? Whether it is a substitute of any Act or Rules?

(b) Discuss the procedure of issuing a secretarial standard.

6. (a) What do you mean by Professional Ethics? What are the objectives of Professional Ethics?

(b) Mention the fundamental principles of Professional Ethics.

(c) Write a short note on ‘Other Misconduct’ as per the Chartered Accountants Act, 1949.

(d) Explain the mechanism to enquire into charges of misconduct of the Chartered
Accountants as per the Chartered Accountants Act, 1949.
7. (a) How computerized Auditing System differs from Conventional Auditing System?

(b) Write short notes on ‘White Box Approach’ and ‘Black Box Approach’ of auditing in a
CIS environment.

(c) What are the factors that an auditor has to consider while using Computer Assisted
Auditing Techniques (CAAT)?

8. (a) What is Government Audit?

(b) Discuss the Duties and Powers of Comptroller and Auditor General as per the Comptroller
& Auditor General’s (Duties, Powers and Conditions of Service) Act, 1971.

(c) What are the basic standards for the audit of the government expenditure?

9. (a) Write a short note on - Audit of local bodies.

(b) What are the objectives of the audit of local bodies?

10. Briefly discuss about the audit programme of non-profit making organization.

(Prepared by: Atanu Pramanick)

4
 PAPER: CC.403: AUDIGING AND ASSURANCE SERVICES
MODULE-I
UNIT/CHAPTER 3: AUDITOR’S REPORT AND AUDITOR’S INDEPENDENCE

PREPARED BY: CMA DR. SAMYABRATA DAS

Important Matters to be Included in CARO 2016

Fixed Asset [clause 3 (i)]

(a) Whether the company is maintaining proper records showing full particulars, including
quantitative details and situation of fixed asset;
(b) Whether these fixed asset have been physically verified by management at reasonable
intervals;
(c) Whether any material discrepancies were noticed on such verification and if so, whether the
same have been properly dealt with in the books of account;
(d) Whether the title deeds of immovable properties are held in the name of the company. If not,
provide the details thereof.

Inventory [Clause 3 (ii)]

(a) Whether physical verification of inventory has been conducted at reasonable intervals by the
management; and
(b) Whether any material discrepancies were noticed on such verification and if so, whether the
same has been properly dealt with in the books of account.

Deposits [Clause 3 (v)]

In case, the company has accepted deposits, whether the following has been complied with:

(a) Directives issued by the Reserve Bank of India,

(b) The provision of sec 73 to 76 or any other relevant provision of Companies Act, 2013 and the
rules framed there under,
(c) An order passed by Company Law Board (CLB) or National Company Law Tribunal
(NCLT) or RBI or any court or any other tribunal.
However, if any of the above has not been complied with, the nature of contraventions should
be stated.
 Approval of Managerial Remuneration [Clause 3 (xi)]

Whether managerial remuneration has been paid or provided in accordance with the requisite
approvals mandated by the provisions of Section 197 read with schedule V to the Companies
Act, 2013. If not, the amount involved and step taken by the company for securing refund of
the same have to be stated.

Nidhi Company [Clause 3 (xii)]

(a) Whether the Nidhi company has complied with the Net Owned Funds to Deposit in the ratio
of 1:20 to meet out the liability, and
(b) Whether the Nidhi Company is maintaining 10% unencumbered term deposit as specified in
the Nidhi Rules, 2014 to meet out the liability.

Related Party Transaction [Clause 3 (xiii)]

Whether all transactions with the related party are in compliance with Sections 177 and 188
of the Companies Act, 2013 where applicable and the details have been disclosed in the
financial statement etc., as required by the applicable accounting standard.
 GE 404: Business Research Methods
Module – I

CHAPTER-2: RESEARCH PROBLEM FORMULATION

In this Chapter, we shall study the research problem formulation. First of all we shall identify
the broad problem area and try to define the problem we are to move ahead with in order to
pursue our research. We shall also study some available research work related to the research
problem we have identified. On the basis of existing literature we shall also identify the
research gap. Once we shall successfully identify the gap, now we can give the final shape to
the research problem i.e. problem formulation and also formulate hypothesis. With the help of
undergoing through the process we shall finally draft the research proposal. The whole chapter
is organized as follows:
 Broad Problem Area
 Problem Definition
 Literature Survey
 Identification of Research Gap
 Problem Formulation
 Hypothesis Formulation, and
 Drafting Research Proposal

BROAD PROBLEM AREA

In research process the first and foremost task is to select and define a research problem. In
general terms a research problem indicated some difficulties which a researchers experiences
in context of theoretical or practical situation and wants to find (search) a solution for the
same. It is a situation where one sees a possible need for research and problem solving.
The specific issues that need to be researched within the situation may not be identified at this
stage.

The process begins with a researcher selecting a topic or a general area of study. A topic
appears to be too broad for conducting research. A research problem is the topic you would like
to address, investigate, or study, whether descriptively or experimentally. It is the focus or
reason for engaging in your research. It is typically a topic, phenomenon, or challenge that you
are interested in and with which you are at least somewhat familiar. So, it is known as broad
problem area.

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PROBLEM DEFINITION

It is said that a problem clearly stated is a problem half solved. Defining research problem is
more essential than its solution. It is believed that selection of a good research problem is a
discovery in itself. A research problem is a question that a researcher wants to answer or a
problem that researcher wants to solve. Identification and formulation of the research problem
is the first step in research process. Therefore, there is a need for defining the research
problem. The problem to be investigated must be defined unambiguously. It will also help
researcher to discriminate relevant data from the irrelevant ones. A correctly defined research
problem will enable the researcher to be on the right track whereas a poorly defined research
problem may create obstacles for the researchers. Research related many questions viz. What
data is to be collected? Which types of data are relevant for the study? What relations are to be
explored? What techniques are to be used for the purpose? etc. are cropping up in the mind of
researcher which may be taken care of by him well in advance if the problem is well defined.

Problem definition is a prerequisite for any study and is a step of highest importance. Defining a
research problem involves the task of laying down boundaries within which a researcher shall
study the problem with a pre-determined objective in view. Defining research problem
properly and clearly is a crucial part of a research study and it should be completed with due
care by the researcher. He should define the problem in a systematic manner giving due
weightage to all relating points.

The technique for defining a research problem involves the following steps:

1. Statement of the problem in a general way

2. Understanding the nature of the problem
3. Surveying the available literature
4. Developing the ideas through discussion
5. Rephrasing the research problem

The characteristics of a good research question/ problem are:

a) Specific
b) Clear
c) Refer to the problem or phenomenon
d) Reflect the intervention in experimental research, and
e) Note the target group of participants

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LITERATURE SURVEY

Once the problem is formulated, a brief summary of it should be written down. Literature
survey is the written and systematic summary of the research which is conducted on a
particular topic. It is a summary and synopsis of a particular area of research. It expands upon
the reasons behind selection a particular research questions. Literature survey reduces the risk
of reinventing the wheel confirms that the problem is perceived as relevant and significant. It
helps in the development of the theoretical framework and hypothesis for testing. The
documentation of relevant studies relating to the author and the year of the study is called
literature review/literature survey. The various published and un-published materials those are
available to the topics of interest and gaining access to these for literature survey. Academic
journals, conference proceedings, government reports, books, etc. must be tapped depending
on the nature of the research problem. Another step for survey of literature is gathering the
relevant information either by going through necessary materials in a library or getting access
to online source. In the present era of information communication technology (ICT) it has
become quite easy to search the articles through ‘google’ or ‘google scholar’ etc.

It is compulsory for a research worker writing a thesis for a Ph.D. degree to write a synopsis of
the topic and submit it to the Research Board for approval. At this juncture, the researcher
should undertake extensive literature survey related with the problem. The earlier studies, if
any, which are similar to the study in hand, should be carefully studied. A good library will be a
great help to the researcher at this stage.

IDENTIFICATION OF RESEARCH GAP

A research gap is the missing element in the existing research literature, and we are to fill with
our research approach to make our research proposal. A research gap is defined as a topic or
area for which missing or insufficient information limits the ability to reach a conclusion for a
question. A research need is defined as a gap that limits the ability of decision-makers (policy-
makers, patients, practitioners) from making decisions. There is no specific process for
identifying research gaps during systematic reviews. In business research organizations most
commonly used variations of the PICO (population, intervention, comparison, outcomes)
framework, which is proposed as a framework for identifying research gaps from systematic
reviews.
As we search for journal articles, we need to read critically across the breadth of the literature
to identify these gaps. Our goal should be to find a ‘space’ or opening for contributing new
research. The first step is gathering a broad range of research articles on our topic. Once we
start to gather the literature, we will try to critically read for what has, and has not, been

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learned from the research. Also consider what has not been explored in the study and what
may be a possible ‘gap’ or opening for our potential research and contribution to the topic.

PROBLEM FORMULATION

According to Albert Einstein “The mere formulation of a problem is far more essential than its
solution, which may be merely a matter of mathematical or experimental skill. To raise new
questions, new possibilities, to regard old problems from a new angle require creative
imagination and marks real advances in science.”
The problem formulation consists of just one sentence and should make it clear to
everyone what research problem, we aim to address and to whom and where it is relevant. The
aim of a problem formulation is also to set a framework for your research and a good problem
formulation is essential for completing a good study. If the problem is not stated properly the
objectives will not be clear. If the objective is not clearly defined, the data collection becomes
meaningless.
Formulating our research problem enables us to make a purpose of our study clear to us and
target readers. Focus our paper on providing relevant data to address it. A problem statement
is an effective and essential tool to keep us on track with research and evaluate it. How can we
formulate a powerful research problem? Consider the following 5 ways to formulate the
research problem:
1. Specify research objectives;
2. Review its context or environment;
3. Explore its nature;
4. Determine variable relationships;
5. Anticipate the possible consequences of alternative approaches.
Proper problem formulation is the key to success in the research. It is vital and any error in
defining the problem may result in wastage of time and other resources.

HYPOTHESIS FORMULATION

After extensive literature survey, researcher should state in clear terms the working hypothesis
or hypotheses.
Hypothesis may be defined as a proposition or a set of proposition set forth as an explanation
for the occurrence of some specified group of phenomena either asserted merely as a
provisional conjecture to guide some investigation or accepted as highly probable in the light of
established facts. Quite often a research hypothesis is a predictive statement, capable of being
tested by scientific methods, that relates an independent variable to some dependent variable.
For example, consider statements like the following ones: “Students who receive counselling

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will show a greater increase in creativity than students not receiving counselling” Or “the
automobile A is performing as well as automobile B.” These are hypotheses capable of being
objectively verified and tested. Thus, we may conclude that a hypothesis states what we are
looking for and it is a proposition which can be put to a test to determine its validity.
In most types of research, the development of working hypothesis plays an important role.
Hypothesis should be very specific and limited to the piece of research in hand because it has to
be tested. The role of the hypothesis is to guide the researcher by delimiting the area of
research and to keep him on the right track. It sharpens his thinking and focuses attention on
the more important facets of the problem. It also indicates the type of data required and the
type of methods of data analysis to be used. How does one go about developing working
hypotheses? The answer is by using the following approach:
(a) Discussions with colleagues and experts about the problem, its origin and the objectives in
seeking a solution;
(b) Examination of data and records, if available, concerning the problem for possible trends,
peculiarities and other clues;
(c) Review of similar studies in the area or of the studies on similar problems; and
(d) Exploratory personal investigation which involves original field interviews on a limited scale
with interested parties and individuals with a view to secure greater insight into the practical
aspects of the problem.
Working hypotheses are more useful when stated in precise and clearly defined terms. It may
be remembered that occasionally we may encounter a problem where we do not need working
hypotheses, specially in the case of exploratory or formulative researches which do not aim at
testing the hypothesis. But as a general rule, specification of working hypotheses is another
basic step of the research process in most research problems.

DRAFTING RESEARCH PROPOSAL

A written proposal is often required when a study is being suggested. This is specially true when
an outside research supplier is contracted to conduct the research. The written proposal
ensures that the parties concur on the project’s purpose, the proposed methods of
investigation, the extent of analysis, and the timing of each phase as well as of delivery of
results. Budgets and other responsibilities and obligations are spelled out clearly. Normally, a
research proposal should contain all the key elements involved in the research process and
include sufficient information for the readers to evaluate the proposed study. A research
proposal must include the research area, methodology and also address the questions like,
what we plan to accomplish, why we want to do it and how we are going to do it.

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Before writing up a research proposal, it is essential to identify the sponsors for the research. At
the time of writing research proposal we must read and understand application guidelines from
sponsors or clients, e.g., Universities, Ministry of Health, DRDO, DST etc.
A research proposal must have the following components:
 Title: The title of a research proposal should be concise and descriptive. We should try
to think of an informative and catchy title. An effective title draws the attention and
interest of readers and also influences them favourably towards the research proposal.
 Introduction/ Background: The main purpose of the introduction is to provide the
necessary background or context for the research problem. How to frame the research
problem is perhaps the biggest problem in proposal writing. The introduction typically
begins with a general statement of the problem area, with a focus on a specific research
problem, to be followed by the rational or justification for the proposed study. It
includes the research problem, rationale of the proposed study clearly indicating why it
is worth doing. It also includes the brief description on the major issues and sub-
problems to be addressed by the research.
 Literature review/ Survey of Literature: The aim of the literature review is to provide
adequate background information on the research being proposed, especially on the
prevalence or incidence of area of study or research problem. It should be brief, and
indicate relevant related research that had or is being conducted and references should
also be included. The review committee is normally aware of the various projects going
on in the specified area of research. The literature review gives credits to those who
have laid the groundwork for the proposed research. It shows researchers ability to
critically evaluate relevant literature information and indicates their ability to integrate
and synthesize the existing literature. It provides new theoretical insights or develops a
new model as the conceptual framework for the proposed research and convinces your
reader that your proposed research will make a significant and substantial contribution
to the literature (i.e., resolving an important theoretical issue or filling a major gap in
the literature).
 Objectives of the Study: Objectives of the proposed study should be stated clearly. The
objectives identified should be general as well as specific. It should be clear and concise.
It must be measurable and feasible such that it can be achieved within specified
timeframe.
 Methodology: The Methodology section is very important because it tells the Research
Committee how we plan to tackle our research problem. It will provide our work plan
and describe the activities necessary for the completion of the project. For quantitative
studies, the methodology section typically consists of the research study design
(questionnaire study or laboratory experiment), selection of research location, subjects
or participants (respondents), sampling method, sample size, study instruments, data

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 collection, data analysis and interpretation (e.g. Statistical Package for Social Sciences/
SPSS, Microsoft Excel, Statistical Analysis Software/SAS, R, Minitab, etc.), ethical
considerations. Researchers should make sure that the research design or approach is
appropriate for the stated objectives. We should not assume that the reviewers are
familiar with techniques to be used in the study. In this section researchers should
provide a brief description of the study location, study design and flow of activities.
 Plan - time frame and schedule of activities (Gantt chart): Planning for the research
proposal should include the time frame and activity schedule for the proposed research.
The time frame should include time for purchasing and obtaining relevant consumables
and facilities needed to conduct the study, conduct of study, analysis of data, and
writing up the project report. The activity schedule is essential for effective monitoring
of project. It should list the time frame for major activities, and include milestones. A
most effective way of plotting the activity schedule is by using the Gantt Chart. See
Example Below:
Year 2020
Project (Activities) J F M A M J J A S O N D
1. Planning of research
2. Literature search
3. Development of
questionnaire
4. Pre-testing
5. Training of researchers and
research assistants
6. Data collection
7. Data entry and analysis
8. Report writing and
presentation

 Budget: An adequate budget is essential for the study researchers plan to conduct. In
preparation of the budget we should provide a total and yearly break-up of the fund
needed for the research project. We should follow the guidelines provided by the
sponsors wherefrom we plan to obtain the grant. Researcher should give appropriate
estimates of costs depending on the different areas, e.g. travel and transportation,
consumables, salaries, services, rentals, equipment, utilities, repairs, etc. and also they
should provide adequate justification, especially for costly items.
 Details of research team: Researcher should identify all expertise required for the
proposed research and the curriculum vitaes (CVs) of all key researchers be attached.
Researchers should obtain agreement of participation by team members in writing.

Page 7 of 9
 They should ensure adequate expertise and spell out responsibilities of each of the
researchers in the team.
The above recommended elements in the research proposal are only suggestive. They do not
guarantee a successful research application. They may however, help researcher prepare a
carefully conceptualized and comprehensive proposal. Sometime the elements of the proposal
vary as per the requirement criteria of the Research Board, Sponsoring Agencies, etc. One
should also keep in mind the following common errors in proposal writing:
 Objectives too broad or too ambitious
 Objectives do not reflect title of the study or statement of problem
 No literature review or relevant references
 Inadequate information on methodology
 Inappropriate time-frame and schedule of activities – too ambitious
 No justification for Budget – asking for too much or too little

Multiple Choice Questions:

1. The problem to be investigated must be defined

a. unclearly
b. uncertainly
c. unambiguously
d. indifferently
2. The characteristics of a good research problem does not include
a. specific
b. clear
c. refer to the problem
d. leisurely
3. A good _______________will be a great help to the researcher at the stage of literature
survey.
a. cafeteria
b. library
c. cinema halls
d. museum
4. Which of the following is not a statistical software
a. SPSS
b. SAS
c. AAR
d. Minitab

Page 8 of 9
 5. A most effective way of plotting the activity schedule is by using the
a. Gantt Chart
b. Pie Chart
c. Line Chart
d. Bar Chart

References:

 Kothari, C R and Garg, Gaurav, Research Methodology- Methods and Techniques, New
Age International Publishers, 2014
 Mishra, Prahlad, Business Research Methods, Oxford University Press, New Delhi, 2015
 Cooper, Donald R. and Schindler, Pamela S, Business Research Methods, McGraw-
Hill/Irwin, New York, 2014
 Bhome, S. S, Prajapati, N, Banga, C. K, and Desai, Swati S, Business Research Methods,
Himalaya Publishing House Pvt. Ltd., Mumbai, 2016

***

Lecture Note Prepared By:

Prof. Ram Prahlad Choudhary
Dept. of Commerce, University of Calcutta

Page 9 of 9
 Paper: Business Research Methods; Unit 8; Dr. S Sarkar
Interpretation of the result of a Multiple Regression Analysis (Basic Idea)
The output of any Multiple Regression Analysis (i.e. where there is one dependent and more
than one independent variables) obtained through any standard statistical package (like
Statistical Package for Social Sciences or SPSS) has the following three parts:
1. Model Summary: This shows the dependent variable, independent variables included in
the model, whether the model includes any intercept or constant term (for example, in Y = a
+ b.X equation á’ is called the constant term), value of R (i.e. coefficient of multiple
correlation = correlation between the dependent variable with all the independent variables),
value of R2 (i.e. coefficient of multiple determination = percentage of variation in dependent
variable as explained by the independent variable taken together; it indicates the overall
explanatory power of the model) and adjusted R2 (which has the same function as R2 but is
more reliable).
2. ANOVA Table: The results included in this table shows the overall significance of the
model under consideration. The test is done by an F test being the ratio between regression
mean square and error mean square. If F statistic is found higher than the critical value of F
statistic then the null hypothesis of the model being non-significant is rejected and the model
is considered to be significant (a researcher always wants a significant model as it facilitates
estimation of dependent variable based on independent variables value).
3. Coefficients: This table includes the value of all regression coefficients including the
constant term, their t value and p value. If t value (absolute value) is found to be higher than
the critical value of t (absolute value) the null hypothesis of insignificant coefficient of the
independent variable is rejected and the variable is considered to be a good predictor of the
dependent variable.
Note: p values are an alternative in deciding the acceptability of null hypothesis. If p value is
found to be lower than 0.01 (or 0.05) then the hypothesis is considered to be rejected at 1%
level (or 5% level respectively).
Now consider the following example:
A consumer electronic company has adopted an aggressive policy to increase sales of a newly
launched product. The company has invested in advertisement as well as employed salesmen
for increasing sales rapidly. A multiple regression analysis has been done based on the results
of 24 months of sales with sales being the dependent variable and advertisement expenditure
and no. of salesmen being the independent variables.
The results of the regression are given below:
Model Summary
Model R R2 Adjusted R2
1 0.860a 0.739 0.714
a. predictors: (constant, advertisement, salesmen)
b. Dependent variable: sales
 ANOVA Table
Model Sum of df Mean F Sig. (p
squares Square value)
1 Regression 1.449E8 2 7.243E7 29.740 0.000
Error 5.114E7 21 2435305.428
Total 1.960E8 23
a. predictors: (constant, advertisement, salesmen)
b. Dependent variable: sales
Coefficients
Model Value of the Standard t value Sig. (p
coefficients Error value)
1 Constant 3856.693 1340.772 2.876 0.009
Salesmen -104.321 39.489 -2.642 0.015
Advertisement 24.609 3.923 6.273 0.000
a. dependent variable: sales
You are required to interpret the above results.
Solution:
The results of the regression can be interpreted as follows:
Model Summary: The model summary shows that the regression under study is a linear
regression with sales being the dependent and salesmen and advertisement expenditure being
the independent variables. The model has a constant term and hence it will look like –
X1 = C + b1X2 + b2X3 where X2 = salesmen and X3 = advertisement expenditure
The value of multiple correlation coefficient is 0.860.
The value of coefficient of multiple determination is 0.739 which means 73.9% of the
variation in sales can be explained by the variation in salesmen and advertisement
expenditure. The percentage is quite high. The value of Adjusted R2 is 0.714 which is almost
similar to R2. Thus, the overall explanatory power of the model is satisfactory.
ANOVA Table: The ANOVA table shows that the F statistic is having a p value of 0.000
which is lower than 0.01. Thus, the null hypothesis is rejected and alternative hypothesis of
the model being significant is accepted.
Coefficients: The table shows that the constant term and the variable ‘advertisement’ have
coefficients with p value less than 0.01 and hence they are significant at 1% level. Similarly,
the coefficient of ‘salesmen’ is significant at 5% level (more than 0.01 but less than 0.05).
Thus, the variables have significant effect on then dependent variable and the constant term is
also important.
 Existence of constant term signifies that irrespective of salesmen and advertisement
expenditure a minimum amount of sales is expected.
 Salesmen have a negative impact on sales i.e. increasing salesmen will reduce sales by
104 unit.
 Advertisement expenditure has a positive impact on sales i.e. increasing advertisement by
1 unit will increase sales by 24 units.
 Financial Analysis_ Module 2_ Unit 2
(Prof. S. Sen and Dr. S. Sarkar)
Please consider the corrected problem as follows:
Application of Altman’s Z Score Model; Numerical Example:
Q. The Statement of Assets and Liabilities of XYZ Ltd as on 31.03.2016 is given below:
Liabilities Amount(Rs.) Assets Amount(Rs.)
Equity Share Capital (Rs.10) 800000 Fixed Assets 2000000
Reserve and Surplus 500000 Investments 400000
10% Debentures 800000 Inventories 500000
12% Term Loan 800000 Sundry Debtors 700000
Sundry Creditors 600000 Cash and Bank 200000
Provision for Tax 300000
3800000 3800000
Additional Information:
i. Net Sales for the year 2015-16 was Rs.1,04,00,000.
ii. Dividend per share was Rs.2.50
iii. Dividend Payout ratio was 60%.
iv. Price-Earnings ratio is 11.
v. Corporate tax rate is 30%

Using Altman’s model, calculate Z score of XYZ Ltd. and interpret the results.
Solution:
The Altman’s Z score equation for prediction of bankruptcy is -
Z = 0.012x1+0.014x2+0.033x3+0.006x4+0.999x5 ; Where
x1= (a liquidity measure)
x2= (a measure of re-invested earnings)
x3= (a profitability measure)
x4= (a measure for the firm’s financial structure or leverage)

x5= (a measure for sales generating ability of the firm’s assets)

1. Here, working capital = C.A – C.L

= (500000+700000+200000) – (600000+300000) = 500000
Total Assets = 3800000
So, x1 = (500000/3800000) × 100 = 131.58%
2. Here, Retained earnings = Reserve and surplus = 500000
So, x2 = (500000/3800000) × 100 = 131.58%

1
3. Here, DPS = EPS × Dividend payout ratio
Or, EPS = DPS/Dividend payout ratio = 2.50/60% = 4.17
So, Earnings available for equity shareholders = EPS × No. of shares = 4.17×80000 = 333333
Calculation of EBIT
Particulars Amount (Rs.)
Earnings available for equity shareholders i.e. PAT 333333
Add. Tax ( ×333333) 142857
476190
EBT
Add. Interest on debenture (800000*10%) 80000
Interest on debenture (800000*12%) 96000
176000
EBIT
652190
X3 = (652190/3800000)×100 = 171.63%
4. Market price per share = EPS × P/E Ratio = 4.17*11 = 45.87
Market value of equity = 45.87 × 80000 = 3669600
Book value of total debt = Total Assets – (E.S.C + Reserve and Surplus) = 3800000 –
(800000+500000) = 2500000
(Alternatively, Book value of total debt = Long term debt + current liabilities)
x4 = (3669600/2500000) ×100 = 146.78%
5. Net sales = 1,04,00,000
x5= 1,04,00,000/3800000 = 2.74 (not to be converted into percentage)
So, Z = 0.012 × 131.58+0.014 × 131.58 +0.033 × 171.63 + 0.006 × 146.78+0.999 × 2.74
= 1.58 + 1.84 + 5.66 + 0.88 + 2.73 = 12.69
Since the value of Z is higher than 2.99, the firm is not a bankrupt firm.

2
 Paper DSE.406A

International Finance

Dr. Bappaditya Biswas

Assistant Professor, Department of Commerce
University of Calcutta

Module – II

Status of Study Material

Chapters Status
Unit- 6 International Financing Study Materials are attached with
this file.
Unit -7 International Capital Study Materials are attached with
Budgeting this file.
Unit -8 International Transfer Hard copy of Study materials have
Pricing already been provided to Day and
Evening Students of M.Com,
Semester IV in classroom.
Unit -9 International Taxation Soft copy of Study materials have
been uploaded to university
website in first lot.

Note:
There is a typing error in the study material of ‘International Taxation’. In point no 12 it
will be Base Erosion and Profit Shifting (BEPS) instead of Base Erosion and Profit Sharing
(BEPS).

1|Page
 International Financing

Content: Corporate Sources and Uses of Funds - Equity Financing (ADR and GDR) -
International Financial Markets - Development Banks –Project Finance - The Euro Markets

1. Introduction

The world economy is becoming increasingly globalized. The concept of globalization refers
to the increasing connectivity and integration of countries and corporations and the people
within them in terms of their economic, political, and social activities. Globalization affects
all aspects of society, but economically, two main trends define it. First, countries continue to
expand their trade in goods and services. Second, countries continue to reduce their barriers
to capital flows through the international financial system. The international financial system
consists of international financial markets, international financial intermediaries and
international financial instruments. Because of deregulation, liberalisation and technological
innovation that have taken place since the early 1970's, international capital markets have
shown considerable growth.
Because of globalization, multinational corporations dominate the corporate landscape. A
multinational corporation (MNC) produces and sells goods or services in more than one
nation. An MNC consists of a parent company in the firm’s originating country and the
operating subsidiaries, branches, and affiliates it controls both at home and abroad. The
United Nations refers to such firms as transnational corporations to emphasize that the
operation and ownership of these enterprises is spread throughout the world.

2. Globalization of Financial Markets

The globalization of financial markets and the profound changes they have undergone have
also dramatically changed how MNCs manage their business risks, improved their access to
foreign capital, and enhanced their ability to reduce financing costs. The advancement in
communications and technology together with financial deregulation abroad has blurred the
distinction between domestic and foreign financial markets. As the necessary electronic
technology has been developed and transaction costs have plummeted, the world has become
one vast, interconnected market. The major issues and factors behind the globalization of
financial markets are discussed below:

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 (a) Financial Regulation and Deregulation
Growing competition also has led to increasing deregulation of financial markets worldwide.
Deregulation is hastened by the process of regulatory arbitrage, whereby the users of
capital markets issue and trade securities in financial centers with the lowest regulatory
standards and, hence, the lowest costs. Regulatory arbitrage is the practice of taking
advantage of regulatory difference between two or more markets which finally results in
similar type of regulation in all financial centers. In order to win back business, financial
centers around the world are throwing off obsolete and costly regulations.

(b) Financial Innovation

Whereas competition drives the international financial system, innovation is its fuel.
Financial innovation segments, transfers, and diversifies risk. It also enables companies to tap
previously inaccessible markets and permits investors and issuers alike to take advantage of
tax loopholes. More generally, financial innovation presents opportunities for value creation.
To the extent that a firm can design a security that appeals to a special niche in the capital
market, it can attract funds at a cost that is less than the market’s required return on securities
of comparable risk.

(c) Trends in Financial Openness

A country is financially open if it allows foreigners to invest in its capital markets and allows
its citizens to invest abroad. After World War II, most countries had controls or restrictions in
place that prevented the free flow of capital across borders. However, in the 1980s, many
developed countries began liberalizing their capital markets. For example, Japan started to
liberalize in 1984; in Europe, the movement toward the Single Market forced many countries
to abolish their capital controls, with France abolishing capital controls in 1986, Italy in 1988,
India in 1991 and Belgium in 1990. In the late 1980s and during the 1990s, many developing
countries began a financial liberalization process, relaxing restrictions on foreign ownership
of their assets and taking other measures to develop their capital markets, often in tandem
with macroeconomic and trade reforms.

(d) The New Financial Landscape

The deregulatory zeal of governments worldwide happened against the background of and
perhaps as a reaction to a vastly different financial landscape that emerged in the 1980s. Most
importantly, the markets for financial derivatives exploded, backed by advances in financial

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economics and computer technology. A derivative security is an investment whose payoff
over time is derived from the performance of underlying assets (such as commodities,
equities, or bonds), interest rates, exchange rates, or indices (such as a stock market index, a
consumer price index, or an index of weather conditions).
Another important development was the increased use of securitization —the repackaging of
“pools” of loans or other receivables to create a new financial instrument that can be sold to
investors. For example, financial institutions package mortgages or car loans into complex
securities that are sold to investors, thereby spreading the risks involved. Moreover, banks
earn fees on these securities and need not hold a capital buffer on their balance sheets to
protect against possible losses as required for a regular loan. The spectacular growth in
derivatives and securitization considerably increased the complexity in the financial
intermediation business. These developments dramatically improved the ability of banks and
corporations to manage risk.
(e) Global Financial Crisis
From 2007 through 2010, the world witnessed a full-blown financial crisis that started in the
United States and led to a global recession, the longest and deepest in the post-war era. The
crisis also raised a host of regulatory issues. Central banks and governments across the world
reacted vehemently to contain the crisis, pumping money into banks and companies and
running very expansionary monetary and fiscal policies. Insurance may make people behave
riskier, just as an anti-lock braking system may not necessarily increase road safety because
drivers with such systems drive faster. When large institutions feel they are “too big to fail,”
they may behave recklessly. Such issues will undoubtedly be debated and studied at length in
years to come.

3. Corporate Sources and Uses of Funds

3.1. Corporate Sources of Finance

The sources of funds for an MNC (and its subsidiaries) can be split into two major categories:
cash that is internally generated by the MNC and cash that is externally provided from the
debt markets or the equity markets. The potential sources of external capital are extremely
wide ranging. Both bonds and stocks (debt and equity financing) can be issued by a firm and
sold to investors, typically through the financial intermediation of an investment bank. These
externally issued securities are often tradable in secondary markets.

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In contrast, loans are obtained from specialized financial intermediaries, typically commercial
banks, and the lender monitors the financial behaviour of the firm to make sure she will get
repaid. For all three types of external sources of funds (bank loans, debt securities, and
equity), MNCs and their affiliates can tap either domestic or international markets. A foreign
affiliate of an MNC can obtain funds from within the MNC or from the same external sources
as mentioned in the Exhibit below. The affiliate’s external borrowing ability may be
enhanced when the parent company guarantees the loan.
Exhibit -1: Corporate Sources of Finance

(Source: Bekaert, G and Hodrick, R. J., International Financial Management, Pearson)

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 3.2. External Financing

External finance can come from investors or lenders. Investors give a company money by
buying the securities it issues in the financial markets. These securities, which are generally
negotiable (tradable), usually take the form of publicly issued debt or equity. Debt is the
preferred alternative: Regardless of the country studied, debt accounts for the overwhelming
share of external funds. By contrast, new stock issues play a relatively small and declining
role in financing investment.
The main alternative to issuing public debt securities directly in the open market is to obtain a
loan from a specialized financial intermediary that issues securities (or deposits) of its own in
the market. These alternative debt instruments usually are commercial bank loans for short-
term and medium-term credit or privately placed bonds for longer-term credit. Unlike
publicly issued bonds, privately placed bonds are sold directly to only a limited number of
sophisticated investors, usually life insurance companies and pension funds.

Covenants

Privately placed bonds are generally non-negotiable and have complex, customized loan
agreements called covenants. The restrictions in the covenants range from limits on dividend
payments to prohibitions on asset sales and new debt issues. They provide a series of
checkpoints that permit the lender to review actions by the borrower that have the potential to
impair the lender’s position. These agreements have to be regularly renegotiated before
maturity. As a result, privately placed bonds are much more like loans than like publicly
issued and traded securities.

4. Financial Systems and Corporate Governance

Despite the apparent convergence of financial systems, there are still some notable
differences among countries in terms of corporate governance, which refers to the means
whereby companies are controlled. So the financial systems can be broadly categorised into
two i.e. Anglo-Saxon or AS model and the Continental European and Japanese or CEJ type
of financial system. These are discussed below:
(a) The Anglo-Saxon (AS) model
The United States and the United Kingdom are often viewed as prototypes of a market-
oriented financial system frequently referred to as the Anglo- Saxon or AS model. In AS

6|Page
countries, institutional investors (pension funds, mutual funds, university and other non-profit
endowments, and insurance companies) make up an important part of the financial system.
Equity finance is important in AS countries and institutional shareholders exert a great deal of
corporate control. The accepted objective is to maximize shareholder value, and boosting the
return on capital employed is stressed.

(b) The Continental European and Japanese (CEJ) model

Germany, France, and Japan are generally regarded as typical representatives of bank-centerd
finance (the Continental European and Japanese or CEJ type of financial system). In CEJ
countries, bank finance is prominent, share ownership and control are concentrated in banks
and other firms, and corporate decision making is heavily influenced by close personal
relationships between corporate leaders who sit on one another’s boards of directors.
Individual shareholders have little voice, resulting in much less concern for shareholder value
and relatively low returns on capital. However, in all countries, competitive pressures and the
threat of hostile takeovers of underperforming companies are forcing greater managerial
accountability and an increased focus on shareholder value. For example, a number of
Continental European companies are trying to make themselves more attractive to the
growing ranks of international investors by improving their disclosure and corporate
governance practices.

Keiretsu
Japanese and Korean firms use a high degree of leverage, having a large amount of debt.
Large Japanese and Korean companies use vast mutual-aid networks called keiretsu &
chaebol – usually with a major bank at the center. Keiretsu and chaebol ties constitute a web
of tradition, cross shareholdings, trading relationships, management, cooperative projects and
information swapping. They offer financial backing, management advice and favourable
contracts, etc., to their members and also provide a safety net to their members when in
trouble. The bank holds an important position.

Universal Banking

In Germany, there is the universal banking. The German banks give loans and also hold
major equity positions in the companies. This reduces conflicts between the two categories
of investors and lowers costs and speeds up resolution of problems. However, the financing

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pattern has started changing in Germany and Japan and they are now increasingly turning to
the market for equity capital.

5. Financial Centers

Financial centers are locations with high concentration of participants in banking, asset
management, insurance or financial markets with venues and supporting services for these
activities to take place. Participants can include financial intermediaries (such as banks and
brokers), institutional investors (such as investment managers, pension funds, insurers, hedge
funds), and issuers (such as companies and governments). Financial centers usually host
companies that offer a wide range of financial advisory services, for example relating
to mergers and acquisitions, or which participate in other areas of finance, such as private
equity and reinsurance.

5.1. International Financial Centers (IFCs)

International financial centers are the markets in which foreigners can both borrow and lend
money. These markets can develop anywhere, provided that local regulations permit the
market and that the potential users are attracted to it. International Financial Centers (IFCs)
are large international full-service centers with advanced settlement and payments systems,
supporting large domestic economies, with deep and liquid markets where both the sources
and uses of funds are diverse, and where legal and regulatory frameworks are adequate to
safeguard the integrity of principal-agent relationships and supervisory functions. IFCs
generally borrow short-term from non-residents and lend long-term to non-residents. In terms
of assets, London is the largest and most established such center, followed by New York, the
difference being that the proportion of international to domestic business is much greater in
the former.

The most important international financial centers are London (UK), New York (USA),
Tokyo (Japan), Paris (France), Frankfurt (Germany), Singapore, Hong Kong, Sydney
(Australia) and Zurich (Switzerland), Belgium, Netherlands, Cayman Islands and Bahamas.
Other centers include Amsterdam (Holland), Edinburgh and Glasgow (Scotland) and Milan
(Italy). These centers play a key role in the financing of internationally involved firms and
also in their foreign exchange risk management.

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 5.2. Offshore Financial Centers (OFCs)

Offshore finance is, at its simplest, the provision of financial services by banks and other
agents to non-residents. These services include the borrowing of money from non-residents
and lending to non-residents. This can take the form of lending to corporates and other
financial institutions, funded by liabilities to offices of the lending bank elsewhere, or to
market participants. It can also take the form of the taking of deposits from individuals, and
investing the proceeds in financial markets elsewhere. Offshore Financial Center can be
defined as any financial center where offshore activity takes place. (IMF, 2000)

A more practical definition of an OFC is a center where the bulk of financial sector activity is
offshore on both sides of the balance sheet, (that is the counterparties of the majority of
financial institutions liabilities and assets are non-residents), where the transactions are
initiated elsewhere, and where the majority of the institutions involved are controlled by non-
residents. Thus OFCs are usually referred to as:

• Jurisdictions that have relatively large numbers of financial institutions engaged primarily
in business with non-residents;
• Financial systems with external assets and liabilities out of proportion to domestic financial
intermediation designed to finance domestic economies; and
• More popularly, centers which provide some or all of the following services: low or zero
taxation; moderate or light financial regulation; banking secrecy and anonymity.

Incentives offered by a typical OFC to non-residents

According to the Report of the Working Group on Offshore Financial Centers of the
Financial Stability Forum (2000), the following are some of the incentives offered by a
typical OFC to non-residents:

• Either very low taxes or no taxes on business or investment income.

• No withholding taxes.
• Incorporation and licensing facilities light and flexible.
• Supervision very light and flexible.
• Flexibility in the use of trusts and other special corporate vehicles.
• Not necessary for financial institutions and/or corporates to have a physical presence, i.e.,
brass-plate institutions are allowed.

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• Very high level of client confidentiality based on impenetrable secrecy laws.

The aforementioned incentives are not allowed to residents. An OFC is not directly under the
control and supervision of the authorities of a particular country. A number of important
OFCs are small island states, having only few domestically owned financial institutions and
little non-financial economic activity but with a large number of ‘brass-plate’ institutions.
Many of the banks licensed in OFCs are, ‘brass-plate’ – that is, they have no physical
presence in the OFC and conduct their operations from New York, London or elsewhere.

The following table shows the lists of international offshore financial centers.
Andorra Cayman Islands Luxembourg New Caledonia
Anguilla Costa Rica Macau Panama
Antigua Cyprus Malta St. Kitts And Nevis
Aruba Gibraltar Mauritius Seychelles
Bahamas Guernsey Monaco Singapore
Bahrain Hong Kong Montserrat Switzerland
Barbados Ireland Nauru Tonga
Belize Isle Of Man Netherlands Turks And Caicos
Bermuda Jersey Netherlands Vanuatu
British Virgin Liechtenstein Antilles
Islands

6. Foreign Access to Domestic Markets

Despite the increasing liberalization of financial markets, governments are usually unwilling
to rely completely on the market to perform the functions of gathering and allocating funds.
Foreigners in particular are often hampered in their ability to gain access to domestic capital
markets because of government-imposed or government-suggested restrictions relating to the
maturities and amounts of money that they can raise. Nonetheless, the financial markets of
many countries are open wide enough to permit foreigners to borrow or invest. MNCs are in
a better position to access domestic capital markets in the following three ways.

6.1. The Foreign Bond Market

The foreign bond market is an important part of the international financial markets. It is
simply that portion of the domestic bond market that represents issues floated by foreign
companies or governments. As such, foreign bonds are subject to local laws and must be
denominated in the local currency. At times, these issues face additional restrictions as well.

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The United States and Switzerland contain the most important foreign bond markets. (Dollar-
denominated foreign bonds sold in the United States are called Yankee bonds.) Major foreign
bond markets are also located in Japan and Luxembourg. (Yen bonds sold in Japan by a non-
Japanese borrower are called Samurai bonds, in contrast to Shogun bonds, which are foreign
currency bonds issued within Japan by Japanese corporations.) Since the 1990s, more of
these foreign bond offerings have consisted of global bond issues. A global bond issue is an
offering, usually denominated in dollars that is registered in several national jurisdictions and
marketed to investors around the world.

6.2. The Foreign Bank Market

The foreign bank market represents that portion of domestic bank loans supplied to foreigners
for use abroad. As in the case of foreign bond issues, governments often restrict the amounts
of bank funds destined for foreign purposes. Foreign banks, particularly Japanese banks, have
become an important funding source for U.S. corporations.

6.3. The Foreign Equity Market

The idea of placing stock in foreign markets has long attracted corporate finance managers.
One attraction of the foreign equity market is the diversification of equity funding risk. A
pool of funds from a diversified shareholder base insulates a company from the vagaries of a
single national market. Some issues are too large to be taken up only by investors in the
national stock market.

7. Equity Financing through ADR and GDR

7.1. American Depositary Receipts (ADR)

Depository receipt represents a claim on foreign shares held by a trustee. Depository receipts
are denominated in the domestic currency, regulated by domestic authorities, and sold
through domestic brokers. Depository receipts issued in the US market are known as
American Depository Receipts (ADRs). ADRs are denominated in dollars and trade just like
any other US share. To issue an ADR, a foreign firm enlists an investment bank to purchase a
block of shares to act as trustee. The investment bank issues dollar-denominated stock
certificate ADRs – in the US market with foreign share as collateral. The underlying asset is
a portfolio of foreign shares held by investment bank as trustee. Dividends are converted into
11 | P a g e
dollars and distrusted by the trustee. Such receipts must be issued in accordance with the
provisions stipulated by the Securities and Exchange Commission of USA (SEC) which are
very stringent.

The ADR holder is entitled to the same rights and advantages as owners of the underlying
securities in the home country. Several variations on ADRs have developed over time to
meet more specialized demands in different markets. The Bank of New York Mellon (BNY
Mellon) dominates the ADR custodial market, but JPMorgan Chase, Citigroup, and Deutsche
Bank are also important players.

7.2. Global Depositary Receipts (GDR)

GDRs are like ADRs, but they can trade across many markets and settle in the currency of
each market. A GDR program allows foreign companies to raise capital in two or more
markets simultaneously and broaden their shareholder base. Global depositary receipts are
not always associated with existing companies seeking to increase their shareholder base and
raise additional capital. They can also be associated with companies wanting to tap the equity
market for the first time. Some companies issue stock locally but also target foreign investors,
especially foreign institutional investors.

Characteristics of GDR

(i) Holders of GDRs participate in the economic benefits of being ordinary

shareholders, though they do not have voting rights.
(ii) GDRs are listed on the Luxemburg stock exchange.
(iii)Trading takes place between professional market makers on an OTC (over the counter)
basis.
(iv) The instruments are freely traded.
(v) They are marketed globally without being confined to borders of any market or
country as it can be traded in more than one currency.
(vi) Investors earn fixed income by way of dividends which are paid in issuer currency
converted into dollars by depository and paid to investors and hence exchange risk is
with investor.
(vii) As far as the case of liquidation of GDRs is concerned, an investor may get
the GDR cancelled any time after a cooling off period of 45 days.

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 7.3. Global Shares

One outcome of the increasing globalization of stock markets is the global share. Global
shares are ordinary shares of company listed and traded in the same form on any market in
the world. They are tracked in a single global registry and trade in the home currency of each
market. Cross-border clearing and settlement occur electronically, as the leading international
clearing and settlement organizations are setting up one global system of securities
processing and settlement. The first global share arose in late 1998 when the newly created
Daimler Chrysler began trading as a global share in the United States, Germany, Japan, and
five other countries.

8. Development Banks

To help provide the huge financial resources required to promote the development of
economically backward areas, the United States and other countries have established a
variety of development banks, whose lending is directed to investments that might not
otherwise be funded by private capital. These investments include dams, roads,
communication systems, and other infrastructure projects whose economic benefits cannot be
completely captured by private investors, as well as projects such as steel mills or chemical
plants whose value lies in perceived political and social advantages to the nation (or at least
to its leaders). The loans generally are medium to long term and carry concessionary rates.

This type of financing has three implications for the private sector-

First, the projects require goods and services, which corporations can provide.

Second, establishing an infrastructure makes available new investment opportunities for

multinational corporations.

Third, even though most development bank lending is done directly to a government,
multinationals find that these banks are potential sources of low-cost, long-term, fixed-rate
funds for certain types of ventures.

There are three types of development banks: the World Bank Group, regional development
banks, and national development banks.

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 8.1. The World Bank Group

The World Bank Group is a multinational financial institution that was established at the end
of World War II to help provide long-term capital for the reconstruction and development of
member countries. It is composed of three related financial institutions: the International
Bank for Reconstruction and Development (IBRD), also known as the World Bank; the
International Finance Corporation (IFC); and the International Development Association
(IDA).
a. International Bank for Reconstruction and Development (IBRD)

The IBRD, or World Bank, makes loans at nearly conventional terms for projects of high
economic priority. To qualify for financing, a project must have costs and revenues that can
be estimated with reasonable accuracy. A government guarantee is a necessity for World
Bank funding. The bank’s main emphasis historically has been on large infrastructure
projects such as roads, dams, power plants, education, and agriculture.

b. International Finance Corporation (IFC)

The purpose of the IFC is to finance various projects in the private sector through loans and
equity participations and to serve as a catalyst for flows of additional private capital
investment to developing countries. In contrast to the World Bank, the IFC does not require
government guarantees. It emphasizes providing risk capital for manufacturing firms that
have a reasonable chance of earning the investors’ required rate of return and that will
provide economic benefits to the nation.
c. International Development Association (IDA)
The World Bank concentrates on projects that have a high probability of being profitable;
consequently, many of the poorest of the less-developed countries (LDCs) are unable to
access its funds. IDA was founded in 1960 to remedy this shortcoming. As distinguished
from the World Bank, IDA is authorized to make soft (highly concessionary) loans (e.g., 50-
year maturity with no interest). It does require a government guarantee, however.

8.2. Regional Development Banks

Regional development banks provide funds for the financing of manufacturing, mining,
agricultural, and infrastructure projects considered important to development. They tend to
support projects that promote regional cooperation and economic integration. Repayment
terms for the loans, in most cases, are over a 5- to 15-year period at favourable interest rates.
14 | P a g e
The leading regional development banks include the following: European Investment Bank
(EIB), Inter-American Development Bank (IADB), Atlantic Development Group for Latin
America (ADELA), Asian Development Bank (ADB), African Development Bank (AFDB),
Arab Fund for Economic and Social Development (AFESD), European Bank for
Reconstruction and Development (EBRD), etc.

8.3. National Development Banks

Some national development banks concentrate on a particular industry or region; others are
multipurpose. Although most are public institutions, there are several privately controlled
development banks as well. The characteristics for success, however, are the same: They
must attract capable, investment-oriented management; and they must have a large enough
supply of economically viable projects to enable management to select a reasonable portfolio
of investments.

9. Project Finance

The term “project finance” is used loosely by academics, bankers and journalists to describe a
range of financing arrangements. The financing of a project is said to be nonrecourse when
lenders are repaid only from the cash flow generated by the project or, in the event of
complete failure, from the value of the project’s assets. Lenders may also have limited
recourse to the assets of a parent company sponsoring a project.
Project financing can be defined as the raising of funds to finance an economically separable
capital investment project in which the providers of the funds look primarily to the cash flow
from the project as the source of funds to service their loans and provide the return of and a
return on their equity investment in the project.

This definition highlights several key attributes of project financing

First, it focuses on the economically separable nature of investment projects suitable for
project financing, such as power plants or pipelines.
Second, because projects are set up as legally independent entities, nonrecourse lenders have
resort only to project assets and cash flows; they have no recourse to the sponsors.
Third, unlike the case for financial instruments such as mortgage-backed securities, the
underlying assets in project finance are large, illiquid industrial assets.

Finally, although not specified in the definition, projects have a finite life, at the end of which
all debt and equity investors are repaid.
15 | P a g e
 Exhibit-2: Project Finance Structure

(Source: https://ppp.worldbank.org/public-private-partnership/financing/project-finance-concepts)

Typical Project Finance Structure

The typical project financing structure (simplified for these purposes) for a build, operate and
transfer (BOT) project is shown below. The key elements of the structure are:
• Special purpose vehicle (SPV) project company with no previous business or record;
• Sole activity of project company is to carry out the project – it then subcontracts most
aspects through construction contract and operations contract;
• For new build projects, there is no revenue stream during the construction phase and
so debt service will only be possible once the project is on line during the operations
phase (parties therefore take significant risks during the construction phase);
• Sole revenue stream likely to be under an off-take or power purchase agreement;
• There is limited or no recourse to the sponsors of the project (shareholders of project
company are generally only liable up to the extent of their shareholdings);
• Project remains off-balance-sheet for the sponsors and for the host government.
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 10.The Euromarkets
The most obvious example of the globalization of financial markets is the rise of the
Euromarkets. This term encompasses the Eurocurrency and Eurobond markets as well as the
Euronote and Euro-commercial paper markets. Eurocurrency, Eurobonds, Euronote and
Euro-commercial papers are financial instruments denominated in a currency other than that
of the nations in which instruments are issued. Eurobonds are long term debt instruments
denominated in a currency other than that of the country in which the instruments is issued.
Euro-commercial papers are the unsecured short term debt instruments issued in a currency
other than that of the country in which the instrument is issued. The major participants in
these markets are large commercial and investment banks, multinational companies, central
banks, and international financial organizations such as the International Monetary Fund
(IMF) and World Bank. London is home to the most important Euromarket, but smaller ones
exist in Paris, Brussels, and Frankfurt. The different components of the Euromarkets are
discussed below:

10.1. The Eurocurrency Market

A Eurocurrency is a dollar or other freely convertible currency deposited in a bank outside its
country of origin. Thus, U.S. dollars on deposit in London become Eurodollars. Note that the
prefix Euro as used here has nothing to do with the currency known as the euro or with
Europe. U.S. dollars on deposit in Montreal or Hong Kong are also Eurodollar deposits.
These deposits can be placed in a foreign bank or in the foreign branch of a domestic U.S.
bank. The Eurocurrency market then consists of those banks—called Eurobanks—that accept
deposits and make loans in foreign currencies.

The Eurocurrency market is characterized by the absence of regulations (self-regulated) and

exists because of regulations in different countries. The origin of the post-World War II
Eurodollar market is often traced to the fear of Soviet Bloc countries that their dollar deposits
in U.S. banks might be attached by U.S. citizens with claims against communist
governments. Therefore, they left their dollar balances with banks in France and England.

10.2. Eurocurrency Loans

The most important characteristic of the Eurocurrency market is that loans are made on a
floating-rate basis. Interest rates on loans to governments and their agencies, corporations,
and nonprime banks are set at a fixed margin above LIBOR for the given period and currency
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chosen. At the end of each period, the interest for the next period is calculated at the same
fixed margin over the new LIBOR. For example, if the margin is 75 basis points (100 basis
points equal 1%) and the current LIBOR is 6%, then the borrower is charged 6.75% for the
upcoming period. The reset period normally chosen is six months, but shorter periods such as
one month or three months are possible. The LIBOR used corresponds to the maturity of the
reset period (e.g., six-month LIBOR, or LIBOR6, for a six-month reset period). Borrowing
can be done in many different currencies, although the dollar is still the dominant currency.

10.3. Eurobonds
Eurobonds are similar in many respects to the public debt sold in domestic capital markets,
consisting largely of fixed-rate, floating-rate, and equity-related debt. Unlike domestic bond
markets, however, the Eurobond market is almost entirely free of official regulation and is
instead self-regulated by the Association of International Bond Dealers. The prefix Euro
indicates that the bonds are sold outside the countries in whose currencies they are
denominated. Borrowers in the Eurobond market are typically well known and have
impeccable credit ratings (e.g., developed countries, international institutions, and large
multinational corporations like General Motors).

10.4. Note Issuance Facilities and Euronotes

Eurobanks have responded to the competition from the Eurobond market by creating a new
instrument: the note issuance facility (NIF), called Euronotes. In a basic Euronote facility, a
syndicate of banks commits to distribute the borrower’s notes (the “Euronotes”) for a
specified period, typically 5 to 7 years, with maturities ranging between 1, 3, 6, and 12
months. Like commercial paper, notes under NIFs are unsecured short-term debt generally
issued by large corporations with excellent credit ratings. Borrowers issue NIFs to raise short-
term funds instead of borrowing from banks. These are underwritten by banks.

10.5. Euro Commercial Papers

Another innovation in nonbank short-term credits that bears a strong resemblance to

commercial paper is the non-underwritten short-term Euronote, often called Euro-commercial
paper (Euro-CP, for short). Although historically Euro-CP was mostly denominated in
dollars, nondollar issues now account for more than two-thirds of all issues. Aside from the
obvious benefit of allowing overseas subsidiaries to borrow in their local currencies, a
multicurrency Euro-CP program also allows considerable scope for swap arbitrage. The euro

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commercial papers are usually for longer term than US commercial papers. These are actively
traded in a secondary market unlike US CPs which are held till maturity.
10.6. The Asiacurrency Market

This is the Asian counterpart of the Eurocurrency market. Although dominated by its
European counterpart, the Asiacurrency (or Asiadollar) market has been growing rapidly in
terms of both size and range of services provided. Located in Singapore, because of the lack
of restrictive financial controls and taxes there, the Asiadollar market was founded in 1968 as
a satellite market to channel to and from the Eurodollar market the large pool of offshore
funds, mainly U.S. dollars, circulating in Asia. Its primary economic functions these days are
to channel investment dollars to a number of rapidly growing Southeast Asian countries and
to provide deposit facilities for those investors with excess funds. The market’s fundamental
problem is that Asian borrowers with a good international credit rating can raise money for
longer, and less, in Europe or the United States.
Dragon Bond
The Asiabond counterpart in the Asiadollar market is the Dragon bond. It is the debt
denominated in a foreign currency usually dollar, but launched, priced and traded in Asia.
The first dragon bond was issued by the Asian Development Bank in 1991. It is no longer
very popular.

Masala Bonds
These are Indian rupee-denominated bonds issued in offshore financial markets. The first
masala bonds were issued by the International Finance Corporation (IFC) in 2014 when it
raised ₹1000 crore bonds to fund Indian infrastructure projects. These were listed in the
London Stock Exchange.

Courtesy:
Prof. Jita Bhattacharyya, Retired Professor, Department of Commerce, University of Calcutta

References:
• Shapiro, A.C., Multinational Financial Management, Wiley.

• Bekaert, G and Hodrick, R. J., International Financial Management, Pearson

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 Paper DSE.406A

International Finance

Dr. Bappaditya Biswas

Assistant Professor, Department of Commerce
University of Calcutta

Module – II

International Capital Budgeting

1. Introduction

Multinational Capital Budgeting has to take into consideration the different factors
and variables which affect a foreign project and are complex in nature than
domestic projects. Such problems include differences between project and parent
company cash flows, foreign tax regulations, expropriation, blocked funds, exchange
rate changes and inflation, project-specific financing, and differences between the
basic business risks of foreign and domestic projects. The factors crucial in
international capital budgeting decisions are:

a. Cash flows from foreign projects have to be converted into the currency of
the parent organization.

b. Parent cash flows are quite different from project cash flows.

c. Profits remitted to the parent firm are subject to tax in the home country as
well as the host country.

d. Effect of foreign exchange risk on the parent firm’s cash flow.

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 e. Changes in rates of inflation causing a shift in the competitive
environment and thereby affecting cash flows over a specific time period.

f. Restrictions imposed on cash flow distribution generated from foreign

projects by the host country.

g. Political risk in the form of changed political events reduces the possibility
of expected cash flows.

h. Concessions/benefits provided by the host country ensures the upsurge in

the profitability position of the foreign project

2. Evaluating Foreign Projects in Capital Budgeting Process

Once a firm has compiled a list of prospective investments, it must then select from
among them that combination of projects that maximizes the firm’s value to its
shareholders. This selection requires a set of rules and decision criteria that enable
managers to determine, given an investment opportunity, whether to accept or reject
it. The criterion of net present value is generally accepted as being the most
appropriate one to use because its consistent application will lead the company to
select the same investments the shareholders would make themselves, if they had the
opportunity. But with the time some other methods have also been introduced to
evaluate the foreign projects. These are discussed below:

a. Net Present Value

The net present value (NPV) is defined as the present value of future cash flows
discounted at the project’s cost of capital minus the initial net cash outlay for the
project. Projects with a positive NPV should be accepted; projects with a negative
NPV should be rejected. If two projects are mutually exclusive, the one with the
higher NPV should be accepted.

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The most desirable property of the NPV criterion is that it evaluates investments in
the same way that the company’s shareholders do; the NPV method properly focuses
on cash rather than on accounting profits and emphasizes the opportunity cost of the
money invested. Thus, it is consistent with shareholder wealth maximization.

b. Adjusted Present Value (APV)

Adjusted Present Value (APV) is used in evaluating foreign projects. The APV model
is a value additive approach to capital budgeting process i.e. each cash flow is
considered individually and discounted at a rate consistent with risk involved in the
cash flow. Different components of the project’s cash flow have to be discounted
separately. The APV method uses different discount rates for different segments of
the total cash flows depending on the degree of certainty attached with each cash
flow. The financial analyst tests the basic viability of the foreign project before
accounting for all complexities. If the project is feasible no further evaluation based
on accounting for other cash flows is done. If not feasible, an additional evaluation
is done taking into consideration the other complexities.

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Tt →Tax Saving in year t due to financial mix adopted

St →Before tax value of interests subsidies (on home currency) in year t due to project
specific financing.

id →Before tax cost of dollar dept (home currency)

3. Incremental Cash Flows in International Capital Budgeting

Decisions
(Source: Shapiro, A.C., Multinational Financial Management, Wiley)

The most important as well as the most difficult part of an investment analysis is to calculate
the cash flows associated with the project: the cost of funding the project; the cash inflows
during the life of the project; and the terminal, or ending, value of the project. Shareholders
are interested in how many additional dollars they will receive in the future for the dollars
they lay out today. Hence, what matters is not the project’s total cash flow per period, but the
incremental cash flows generated by the project. The distinction between total and
incremental cash flows is a crucial one. Incremental cash flow can differ from total cash flow
for a variety of reasons. We now examine some of them.

a. Cannibalization
Cannibalization refers to the reduction of a product’s sales due to the release of a newly
created product. In other words, a newly introduced product line might take away market
share from an existing product line instead of gaining overall market share for the company.
When Honda introduced its Acura line of cars, some customers switched their purchases from
the Honda Accord to the new models. This example illustrates the phenomenon known as
cannibalization, a new product taking sales away from the firm’s existing products.
Cannibalization also occurs when a firm builds a plant overseas and winds up substituting
foreign production for parent company exports. To the extent that sales of a new product or
plant just replace other corporate sales, the new project’s estimated profits must be reduced
by the earnings on the lost sales.

b. Sales Creation
GM’s auto plants in Britain use parts made by its U.S. plants, parts that would not otherwise
be sold if GM’s British plants disappeared. In this case, an investment either created or was
expected to create additional sales for existing products. Thus, sales creation is the opposite

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of cannibalization. In calculations of the project’s cash flows, the additional sales and
associated incremental cash flows should be attributed to the project.

c. Opportunity Cost
Project costs must include the true economic cost of any resource required for the project,
regardless of whether the firm already owns the resource or has to go out and acquire it. This
true cost is the opportunity cost, the maximum amount of cash the asset could generate for
the firm should it be sold or put to some other productive use. It would be foolish for a firm
that acquired oil at $60 a barrel and converted it into petrochemicals to sell those
petrochemicals based on $60 a barrel oil if the price of oil has risen to $150 per barrel. So,
too, it would be foolish to value an asset used in a project at other than its opportunity cost,
regardless of how much cash changes hands.

d. Transfer Pricing
The transfer prices at which goods and services are traded internally can significantly distort
the profitability of a proposed investment. Whenever possible, the prices used to evaluate
project inputs or outputs should be market prices. If no market exists for the product, then the
firm must evaluate the project based on the cost savings or additional profits to the
corporation of going ahead with the project.

e. Fees and Royalties

Often companies will charge projects for various items such as legal counsel, power, lighting,
heat, rent, research and development, headquarters staff, management costs, and the like.
These charges appear in the form of fees and royalties. They are costs to the project, but they
are a benefit from the standpoint of the parent firm. From an economic standpoint, the project
should be charged only for the additional expenditures that are attributable to the project;
those overhead expenses that are unaffected by the project should not be included in
estimates of project cash flows.

f. Getting the Base Case Right

The base case is the model’s expected case, determined by using the assumptions that the
project team consider are most likely to occur. In general, a project’s incremental cash flows
can be found only by subtracting worldwide corporate cash flows without the investment—
the base case—from post investment corporate cash flows. To come up with a realistic base
case, and thus a reasonable estimate of incremental cash flows, managers must ask the key
question, ‘‘What will happen if we don’t make this investment?’’ Failure to heed this

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question led General Motors during the 1970s to slight investment in small cars despite the
Japanese challenge; small cars looked less profitable than GM’s then-current mix of cars. As
a result, Toyota, Nissan, and other Japanese automakers were able to expand and eventually
threaten GM’s base business.

g. Accounting for Intangible Benefits

Intangibles such as better quality, faster time to market, quicker and less error-prone order
processing, and higher customer satisfaction can have tangible impacts on corporate cash
flows, even if they cannot be measured precisely. Similarly, many investments provide
intangible benefits in the form of valuable learning experiences and a broader knowledge
base.

4. Issues in Foreign Investment Analysis

Along with incremental cash flows the analysis of a foreign project raises two additional
issues. These are:
a. Should cash flows be measured from the viewpoint of the project or that of the
parent?
b. Should the additional economic and political risks that are uniquely foreign be
reflected in cash-flow or discount rate adjustments?

a. Parent versus Project Cash Flows

There exists a big difference between the project and parent cash flows due to tax rules,
exchange controls. Management and royalty payments are returns to the parent firm. The
basis on which a project shall be evaluated depend on one’s own cash flows, cash flows
accruing to the parent firm or both.

Evaluation of a project on the basis of own cash flows entails that the project should compete
favourably with domestic firms and earn a return higher than the local competitors. If not, the
shareholders and management of the parent company shall invest in the equity/government
bonds of domestic firms. Project evaluation based on local cash flows avoid currency
conversion and eliminates problems associated with fluctuating exchange rate changes.

A strong theoretical argument exists in favour of analysing any foreign project from the view
point of the parent. Cash flows to the parent are ultimately the basis for dividend to the

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shareholders, reinvestment elsewhere in the world, repayment to the corporate-wide debt and
other purposes that affect firm’s many interest groups. However, since most of a project’s
cash flow to its parent or to sister subsidiaries are financial cash flows rather than operating
cash flows, the parent viewpoint usually violates a fundamental concept of capital budgeting,
namely the financial cash flow should not be mixed with operating cash flows.

In reality, most firms appear to evaluate foreign projects from both parent and project
viewpoints. The parent’s viewpoint gives results closer to the traditional meaning of net
present value in capital budgeting. Project valuation provides closer approximation of the
effect on consolidated earnings per share, which all surveys indicate is of major concern to
practicing managers.

b. Political and Economic Risk Analysis

All else being equal, firms prefer to invest in countries with stable currencies, healthy
economies, and minimal political risks, such as expropriation. All else is usually not equal,
however, and so firms must assess the consequences of various political and economic risks
for the viability of potential investments. The three main methods for incorporating the
additional political and economic risks, such as the risks of currency fluctuation and
expropriation, into foreign investment analysis are (a) shortening the minimum payback
period, (b) raising the required rate of return of the investment, and (c) adjusting cash flows
to reflect the specific impact of a given risk.

5. Political Risk Analysis

Political risk is the risk that a government action will negatively affect a company’s cash
flows. In its most extreme form, governments seize property without compensating the
owners in a total expropriation (or nationalization). The general approach recommended for
incorporating political risk in an investment analysis usually involves adjusting the cash
flows of the project (rather than its required rate of return) to reflect the impact of a particular
political event on the present value of the project to the parent. Generally, political risk
services examine indicators of political risk, such as the following:

(i) Political stability (for example, the number of different governments in power
over time).

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 (ii) Ethnic and religious unrest; the strength and organization of radical groups.

(iii)The level of violence and armed insurrections; the number of demonstrations.

(iv) Enforcement of property rights.

(v) The extent of xenophobia (fear of foreigners); the presence of extreme

nationalism.
The MNCs used to face two types of problems comes out of extreme political risks, i.e.
expropriation and blocked fund. These are discussed below:

a. Expropriation

The most extreme form of political risk is the possibility that the host country takes over an
MNC’s subsidiary, with or without compensation. This is the worst-case scenario for firms.
Expropriation is an obvious case where project and parent company cash flows diverge.
Outright expropriations used to be common: Regimes in Eastern Europe (after World War II)
and in Cuba (in 1960) expropriated private businesses, both domestic and foreign. More
recently, Venezuela has systematically expropriated foreign businesses as part of President
Chavez’s socialist revolution. In 2010, the Venezuelan government expropriated the
equipment of the U.S. oil services company Helmerich & Payne, the Venezuelan operations
of Owen-Illinois, a U.S. glassware manufacturer, and the Spanish agricultural firm
Agroisleña.
The approach suggested here examines directly the impact of expropriation on the present
value of the project to the parent. The example of United Fruit Company shows how the
technique of adjusting expected cash flows can be used to evaluate how expropriation affects
the value of specific projects.

Illustration-1
Suppose that United Fruit Company (UFC) is worried that its banana plantation in Honduras
will be expropriated during the next 12 months. The Honduran government has promised,
however, that compensation of $100 million will be paid at the year’s end if the plantation is
expropriated. UFC believes that this promise would be kept. If expropriation does not occur
this year, it will not occur any time in the foreseeable future. The plantation is expected to be
worth $300 million at the end of the year. A wealthy Honduran has just offered UFC $128
million for the plantation. If UFC’s risk-adjusted discount rate is 22%, what is the probability

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of expropriation at which UFC is just indifferent between selling now or holding onto its
plantation?
(Source: Shapiro, A.C., Multinational Financial Management, Wiley)
Solution:

Exhibit below displays UFC’s two choices and their consequences. If UFC sells out now, it
will receive $128 million today.

Alternatively, if it chooses to hold on to the plantation, its property will be worth $300
million if expropriation does not occur and worth only $100 million in the event the
Honduran government expropriates its plantation and compensates UFC.

If the probability of expropriation is p, then the expected end-of-year value of the plantation
to UFC (in millions of dollars) is 100p + 300(1 − p) = 300 − 200p.

The present value of the amount, using UFC’s discount rate of 22%, is (300 − 200p)/1.22.

Setting this equal to the $128 million offer by the wealthy Honduran yields a value of p =
72%.

In other words, if the probability of expropriation is at least 72%, UFC should sell out now
for $128 million. If the probability of expropriation is less than 72%, it would be more
worthwhile for UFC to hold on to its plantation.
Exhibit
United Fruit Company’s Choices (U.S. $ Millions)
Expropriation No Expropriation Expected Present Value
Sell out now 128 128 128
Wait 100 300 [100p + 300(1 − p)]/1.22

b. Blocked Funds

‘Blocked Funds’ are balances held in foreign countries that cannot be remitted to the parent
due to Exchange Control regulations. Apart from this, it is quite possible that significant costs
in the form of local taxes or withholding taxes arise at the time of remittance of the funds to
the parent country. Such ‘blocked funds’ are indirect. If a parent company can release such
‘Blocked Funds’ in one country for the investment in a overseas project, then such amounts
will go to reduce the ‘Cost of Investment Outlay’. The initial investment will be net of any
‘Blocked Funds’ that can be made use of by the parent company for investment in the project.

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In any discussion of blocked funds, it must be pointed out that if all funds are expected to be
blocked in perpetuity, then the value of the project is zero.

Illustration-2:

On January 01, 2019, the Italian telecom authority expropriated a network service provider
owned by ABC Ltd., an American operator of foreign telecom facility. In compensation, a
perpetuity of $ 100 million will be paid annually at the end of each year. ABC Ltd believes,
however, that the Italian Central Bank may block currency repatriations during the calendar
year 2021, allowing only 70% of each year’s payment to be repatriated (and no repatriation of
investment from other 30%). Assuming a cost of capital of 25% and a probability of currency
blockage of 40%, what is the current value (on January 01, 2019) of Italy’s compensation?

Solution

If currency controls are not imposed, ABC Ltd will receive $ 100 million annually at the end
of each year starting from 01.01.2019.

The present value of this stream of cash flow equals to $ 400 million (100/0.25).

Alternatively, if controls are imposed, ABC Ltd will receive $ 100 million at the end of first
two year and $ 70 million (100×0.70) on each December 31st thereafter.

The present value of this cash flow is-

[100/1.25 + 100/(1.25)2 + (70/0.25)/(1.25)2]

=80+64+179.2

=323.2 i.e. $ 323.2 million.

Weighting these present values by the probability that each will come to pass yields an
expected present value of [0.6×400+0.4×232.2]=369.28.

So, the current value (on January 01, 2019) of Italy’s compensation will be $ 369.28 million.

References:

• Shapiro, A.C., Multinational Financial Management, Wiley

• Paper -2 : Strategic Financial Management, Final Course, ICAI

(https://resource.cdn.icai.org/57048bos46238cp10.pdf)

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