SREE SARASWATHI THYAGARAJA COLLEGE (AUTONOMOUS)

M.Com (International Business)

Global Financial Management
Course content
Dr.S.Nagarajan
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SREE SARASWATHI THYAGARAJA COLLEGE (AUTONOMOUS), POLLACHI

MASTER OF COMMERCE (INTERNATIONAL BUSINESS)

It is the management of finance in an international business environment; that is,

trading and making money through the exchange of foreign currency. The international
financial activities help the organizations to connect with international dealings with
overseas business partners- customers, suppliers, lenders etc. It is also used by
government organization and non-profit institutions.

Global financial management, also known as international finance is a well-

known term in today’s world. It simply means financial management in an
international business environment. It is different than financial management because
of the different factors involved like currency, political situations, imperfect markets,
and diversified opportunity sets.

Four Facets to Understand the Concept of International Financial Management

in India:
1. Foreign Exchange
Foreign exchange is an additional risk that a finance manager is required to cater to in
an international setting. Foreign exchange risk refers to the risk related to fluctuating
prices of currency that has the potential to convert a profitable deal into a loss-making
one.
2. Political Risks
Political risks may include any change in the business economic environment of the
country. These changes can include Taxation Rules, Contract Act, or any unforeseen
government action. It pertains to the government of a country that can change the
rules of the game anytime, in an unexpected manner.
3. Market Imperfection
Due to market and product integration, the world economy faces a lot of differences
across the countries in terms of transportation cost, different taxation systems, etc.
Imperfect markets force the finance manager to strive for the best opportunities across
international borders.
4. Enhanced Opportunity Set
By taking the business across national borders, a business expands its chances of
reaping fruits of a different taste. Not only does it enhances the opportunity for more
business but also diversifies the overall risk of business to various nations.

Objectives of International Financial Management

Basic Objectives:-
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Global Financial Management
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● Acquisition of Funds
This objective involves generating funds from internal as well as external sources.
The goal of international financial management is to acquire funds at the lowest
possible cost.
● Investment Decisions
International financial management is concerned with the investment of acquired
funds in an optimum manner in order to maximize shareholders’ as well as
stakeholders’ wealth.

Compared to national financial markets, international markets have different analytics

and dynamic. Proper management of international finances can help the organization
to achieve the same level of efficiency and effectiveness in all the markets. Hence,
without international financial management, sustaining in the market can be
extremely strenuous. Organizations are motivated to invest capital in international
markets for the following reasons:-
● Efficiently produce products in international markets
● Obtain the essential raw material needed for production
● Broaden and diversify markets
Importance of Global financial Management

Companies are motivated to invest capital in abroad for the following

reasons

➢ Efficiently produce products in foreignmarkets than that

domestically.
➢ Obtain the essential rawmaterials needed for production
➢ Broaden markets and diversify
➢ Earn higher returns

Meaning of Financial Management

Financial Management means planning, organizing, directing and
controlling the financial activities such as procurement and utilization of
funds of the enterprise. It means applying general management principles
to financial resources of the enterprise.
Nature/Scope
Investment decisions includes investment in fixed assets (called as
capital budgeting). Investment in current assets is also a part of

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M.Com (International Business)
Global Financial Management
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investment decisions called as working capital decisions.

Financial decisions - They relate to the raising of finance from
various resources which will depend upon decision on type of source,
period of financing, cost of financing and the returns thereby.
Dividend decision - The finance manager has to take decision with
regards to the net profit distribution. Net profits are generally divided into
two:
Dividend for shareholders- Dividend and the rate of it has to be
decided.
Retained profits- Amount of retained profits has to be finalized
which will depend upon expansion and diversification plans of the
enterprise.

The term financial management has been defined by Solomon, “It is

concerned with the efficient use of an important economic resource
namely, capital funds”

Topic 2: Basic finance functions

Finance functions can be grouped as outlined below:

i) Financial planning - A finance manager has to make estimation

with regards to capital requirements of the company. This will depend
upon expected costs and profits and future programmes and policies of a
concern. Estimations have to be made in an adequate manner which
increases earning capacity of enterprise. For additional funds to be
procured, a company has many choices like-

a. Issue of shares and debentures

b. Loans to be taken from banks and financial
institutions
c. Public deposits to be drawn like in form of
bonds.

Choice of factor will depend on relative merits and demerits of each

source and period of financing.

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M.Com (International Business)
Global Financial Management
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ii) Financial control- The finance manager has not only to plan,
procure and utilize the funds but he also has to exercise control over
finances. This can be done through many techniques like ratio analysis,
financial forecasting, cost and profit control, etc.

iii) Financing decisions-Once the estimation have been made, the

capital structure have to be decided. This involves short- term and long-
term debt equity analysis. This will depend upon the proportion of equity
capital a company is possessing and additional funds which have to be
raised from outside parties.

iv) Investment decision- The finance manager has to decide to

allocate funds into profitable ventures so that there is safety on
investment and regular returns is possible.

v) Management of income and dividend decision- Finance manager has

to make decisions with regards to cash management. Cash is required for
many purposes like payment of wages and salaries, payment of electricity
and water bills, payment to creditors, meeting current liabilities,
maintenance of enough stock, purchase of raw materials, etc. The net
profits decision have to be made by the finance manager. This can be done
in two ways:

 Dividend declaration - It includes identifying the rate of dividends and

other benefits like bonus.
 Retained profits - The volume has to be decided which will depend upon
expansion, innovational, diversification plans of the company.

vi) Incidental functions – Unexpected happenings.

Finance Function – Objectives

The objective of finance function is to arrange as much funds for the

business as are required from time to time.

This function has the following objectives.

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M.Com (International Business)
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1. Assessing the Financial Requirements

The main objective of finance function is to assess the financial

needs of an organization and then finding out suitable sources for raising
them. The sources should be commensurate with the needs of the
business. If funds are needed for longer periods then long-term sources
like share capital, debentures, term loans may be explored.

2. Proper Utilization of Funds

Though raising of funds is important but their effective utilization is

more important. The funds should be used in such a way that maximum
benefit is derived from them. The returns from their use should be more
than their cost. It should be ensured that funds do not remain idle at any
point of time. The funds committed to various operations should be
effectively utilized. Those projects should be preferred which are beneficial
to the business.

3. Increasing Profitability

The planning and control of finance function aims at increasing

profitability of the concern. It is true that money generates money. To
increase profitability, sufficient funds will have to be invested. Finance
function should be so planned that the concern neither suffers from
inadequacy of funds nor wastes more funds than required. A proper
control should also be exercised so that scarce resources are not frittered
away on uneconomical operations. The cost of acquiring funds also
influences profitability of the business

4. Maximizing Value of Firm

Finance function also aims at maximizing the value of the firm. It is

generally said that a concern’s value is linked with its profitability.

The Changing Concept of Finance

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According to Ezra Solomon, the changing concept of finance can be

analyzed by dividing the entire process into three broad groupings.

First Approach: This approach just emphasizes only on the

liquidity and financing of the enterprise.

Traditional Approach: This approach is concerned with raising of

funds used in an Organization. It compasses

a) Instruments, institutions and practice through which funds are

augmented.

b) the legal and accounting relationship between a company and its

source of funds.

Modern Approach

This approach is concerned not only with the raising of funds, but

their administration also.

This approach encompasses

a) Determination of the sum total amount of funds to employ in the

firm.

b) Allocation of resources efficiently to various assets.

c) Procuring the best mix of financing – i.e. the type and amount of

corporate securities.

An analysis of the aforesaid approaches unfold that modern Approach

involving an integrated approach to finance has considered not only
determination of total amount of funds but also allocation of resources
efficiently to various assets of the firm. Thus one can easily make out that
the concept of finance has undergone a perceptible change.

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M.Com (International Business)
Global Financial Management
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This is evident from the views expressed by one of the financial experts,
namely, James C Van Horne and the same are reproduced below:

Finance concept (function or scope) has changed from a primarily

descriptive study to one that encompasses regions analysis and normative
theory; from a field that was concerned primarily with the procurement of
funds to one that includes the management of assets, the allocation of
capital and the valuation of the firm as a whole; and from a field that
emphasized external analysis to the firm to one that stresses decision
making within the firm.

Finance, today, is best characterized as ever changing with new ideas and
techniques. The role of financial manager is considerably different from
what it was a few years ago and from what it will no doubt be in another
coming years. Academicians and financial managers must grow to accept
the changing environment and master its

challenge.

Name of the Author Content of Finance Functions

1) James C. Van Horne Investment Decision Financing Decision

Dividend Decisions

2) Earnest W. Walker Financial Planning Financial Co-ordination

Financial Control

3) J. Fred Weston and Eugene F. Brigham

Financial Planning and Control Management of Working Capital

Investment in Fixed Assets Capital Structure Decisions Individual
Financing Episodes

Domestic Vs International Financial Management (IFM)

Foreign currency, market imperfections enhanced opportunity sets

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M.Com (International Business)
Global Financial Management
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and political risks are four broader heads under which IFM can be
differentiated from Financial Management (FM) The goal of IFM is not only
limited to maximization of shareholders but also stakeholders.

Topic 4: Nature and scope of financial management

Nature of Financial Management Financial management is

applicable to every type of organization, irrespective of the size, kind or
nature. Every organization aims to utilize its resources in a best possible
and profitable way.

i) Financial Management is an integral part of overall management.

Financial considerations are involved in all business decisions.
Acquisition, maintenance, removal or replacement of assets, employee
compensation, sources and costs of different capital, production,
marketing, finance and personnel decision, almost all decisions for that
matter have financial implications. Therefore, financial management is
pervasive throughout the organisation.

ii) The central focus of financial management is valuation of the firm.

Financial decisions are directed at increasing/maximization/ optimizing
the value of the institution. Weston and Brigham depict the above
orientation in the exhibit given below:

iii) Financial management essentially involves risk-return trade-off.

Decisions on investment involve choosing of types of assets which
generate returns accompanied by risks. Generally higher the risk returns
might be higher and vice versa. So, the financial manager has to decide
the level of risk the firm can assume and satisfy with the accompanying
return. Similarly, cheaper sources of capital have other disadvantages. So
to avail the benefit of the low cost funds, the firm has to put up with
certain risks, so, risk-return trade-off is there throughout.

iv) Financial management affects the survival, growth and vitality of

the institution. Finance is said to be the life blood of institutions. The
amount, type, sources, conditions and cost of finance squarely influence
the functioning of the institution.

v) Finance functions, i.e., investment, raising of capital, distribution of

profit, are performed in all firms - business or non-business, big or small,
proprietary or corporate undertakings. Yes, financial management is a
concern of every concern including educational institutions.

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M.Com (International Business)
Global Financial Management
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vi) Financial management is a sub-system of the institutional system

which has other subsystems like academic activities, research wing, etc.,
In systems arrangement financial sub-system is to be well coordinated
with others and other sub-systems well matched with the financial sub-
system.

vii) Financial management of an institution is influenced by the

external legal and economic environment. The legal constraints on
using a particular type of funds or on investing in a particular type of
activity, etc., affect financial decisions of the institution. Financial
management is, therefore, highly influenced/constrained by external
environment.

viii) Financial management is related to other disciplines like

accounting, economics, taxation, operations research, mathematics,
statistics etc., It draws heavily from these disciplines.

ix) There are some procedural finance functions - like record keeping,
credit appraisal and collection, inventory replenishment and issue, etc.,
these are routinized and are normally delegated to bottom level
management executives.

x) The nature of finance function is influenced by the special

characteristic of the business. In a predominantly technology oriented
institutions like CSIR, CECRI, it is the R & D functions which get more
dominance, while in a university or college the different courses offered
and research which get more priority and so on.

Scope of International Finance

Three conceptually distinct but interrelated parts are identifiable in

international finance:

1. International Financial Economics: It is concerned with causes

and effects of financial flows among nations -application of
macroeconomic theory and policy to the globaleconomy.

2. InternationalFinancialManagement:Itisconcernedwithhowindivi
dualeconomic
units,especiallyMNCs,copewiththecomplexfinancialenvironmentofinterna
tional

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M.Com (International Business)
Global Financial Management
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Dr.S.Nagarajan
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business.Focusesonissuesmostrelevantformakingsoundbusinessdecisioni
na globaleconomy
International Financial Markets: It is concerned with international
financial/ investment instruments, foreign exchange markets,
international banking, international securities markets, financial
derivatives, etc.International financial management has a wider scope
than domestic corporate finance and design to cope with the greater
range of complexities than the latter.

The reason are as follows:

a) Longer distance is involved

b) Different currency involved

c) Different rates of interest in different countries

d) The existence of exchange controls in many countries

e) Different legal system in different countries

f) Political systems may be different in different countries

g) Different tax system in different countries

h) Customs, convention and ethics differ from country to country

Finance function of global financial manager is not different from

financial manager of

domestic oriented company. The only difference lies in the

recognition of additional risks

and opportunities present in the global economy. In general terms there

are two broad finance functions of global managers:

(a) Acquisition of funds

(b) Investment of funds. These two broad functions can be further

categorised into two

types of function

a)Treasury function

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M.Com (International Business)
Global Financial Management
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b) Accounting and control function

Treasury function may be described as: Acquisition of funds, Investment

of funds, Capital budgeting, Tax analysis and planning, Credit
management, Investors relation, Cash management, Risk management.

Other class of function are referred as accounting and control

function, which consist of:

-External reporting, Financial and management accounting, Tax

management, Management information system, Prepares budgets,
preparing forecasting etc. Objectives of the firm: Effective procurement
and efficient use of finance lead to proper utilization of the finance by the
business concern. It is the essential part of the financial manager. Hence,
the financial manager must determine the basic objectives of the financial
management.

Objectives of Financial Management may be broadly divided into two parts

such as:1. Profit maximization2.Wealth maximization.

Profit maximization :Profit Maximization Main aim of any kind of

economic activity is earning profit. A business concern is also functioning
mainly for the purpose of earning profit. Profit is the measuring
techniques to understand the business efficiency of the concern. Profit
maximization is also the traditional and narrow approach, which aims at,
maximizes the profit of the concern. Profit maximization consists of the
following important features.

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1. Profit maximization is also called as cashing per share

maximization. It leads to maximize the business operation for profit
maximization.
2. Ultimate aim of the business concern is earning profit, hence, it
considers all the possible ways to increase the profitability of the concern.
3. Profit is the parameter of measuring the efficiency of the business
concern. So it shows the entire position of the business concern.
4. Profit maximization objectives help to reduce the risk of the
business. Favorable Arguments for Profit Maximization

The following important points are in support of the profit

maximization objectives of the business concern:
(i) Main aim is earning profit.
(ii) Profit is the parameter of the business operation.
(iii) Profit reduces risk of the business concern.
(iv) Profit is the main source of finance.
(v) Profitability meets the social needs also.

Unfavorable Arguments for Profit Maximization

The following important points are against the objectives of profit
maximization:
(i) Profit maximization leads to exploiting workers and consumers.
(ii) Profit maximization creates immoral practices such as corrupt practice,
unfair trade practice, etc.
(iii) Profit maximization objectives leads to inequalities among the
sake holders such as customers, suppliers, public shareholders, etc.

Drawbacks of Profit Maximization Profit maximization objective

consists of certain drawback also:
(i) It is vague: In this objective, profit is not defined precisely or
correctly. It creates some unnecessary opinion regarding earning habits of
the business concern.
(ii) It ignores the time value of money: Profit maximization does not
consider the time value of money or the net present value of the cash
inflow. It leads certain differences between the actual cash inflow and net
present cash flow during a particular period.
(iii) It ignores risk: Profit maximization does not consider risk of the
business concern. Risks may be internal or external which will affect the
overall operation of the business concern.

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Global Financial Management
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Wealth Maximization: Wealth maximization is one of the modern

approaches, which involves latest innovations and improvements in the
field of the business concern. The term wealth means shareholder wealth
or the wealth of the persons those who are involved in the business
concern. Wealth maximization is also known as value maximization or net
present worth maximization. This objective is an universally accepted
concept in the field of business.

Favorable Arguments for Wealth Maximization

(i) Wealth maximization is superior to the profit maximization because the
main aim of the business concern under this concept is to improve the
value or wealth of the shareholders.
(ii) Wealth maximization considers the comparison of the value to cost
associated with the business concern. Total value detected from the total
cost incurred for the business operation. It provides extract value of the
business concern.
(iii) Wealth maximization considers both time and risk of the business
concern.
(iv) Wealth maximization provides efficient allocation of resources.
(v) It ensures the economic interest of the society.

Unfavorable Arguments for Wealth Maximization

(i) Wealth maximization leads to prescriptive idea of the business concern
but it may not be suitable to present day business activities.
(ii) Wealth maximization is nothing, it is also profit maximization, it is the
indirect
name of the profit maximization.
(iii) Wealth maximization creates ownership-management controversy.
(iv) Management alone enjoy certain benefits.
(v) The ultimate aim of the wealth maximization objectives is to maximize
the profit.
(vi) Wealth maximization can be activated only with the help of the
profitable position of the business concern.

Topic: 6
Duties and responsibilities of global financial managers,

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M.Com (International Business)
Global Financial Management
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According to Joseph Massie, “Financial management is the

operational activity of a business that is responsible for obtaining and
effectively utilizing the funds necessary for efficient operations.”

It is a general assumption that a finance manager works only in the

accounts department or he has to deal with the cash flow. In reality, he
has a large number of things to cater to. Also, every organization, public
or private, needs people from the finance background.

A finance manager shoulders major responsibilities. For example, all

the financial activities within an organization are undertaken by a finance
manager. It is his duty to plan stellar strategies and manage multifaceted
activities that ultimately affect the goodwill, financial status and growth
perspectives of the organization.

Some of the major responsibilities of finance manager are:

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Finance manager performs the following major functions:

1. Forecasting Financial Requirements It is the primary function of the
Finance Manager. He is responsible to estimate the financial requirement
of the business concern. He should estimate, how much finances required
to acquire fixed assets and forecast the amount needed to meet the
working capital requirements in future.
2. Acquiring Necessary Capital after deciding the financial requirement,
the finance manager should concentrate how the finance is mobilized and
where it will be available. It is also highly critical in nature.
3. Investment Decision The finance manager must carefully select best
investment alternatives and consider the reasonable and stable return
from the investment. He must be well versed in the field of capital
budgeting techniques to determine the effective utilization of investment.
The finance manager must concentrate to principles of safety, liquidity
and profitability while investing capital.
4. Cash Management Present days cash management plays a major role
in the area of finance because proper cash management is not only
essential for effective utilization of cash but it also helps to meet the short-
term liquidity position of the concern. 5. Interrelation with Other
Departments Finance manager deals with various functional departments
such as marketing, production, personel, system, research, development,
etc. Finance manager should have sound knowledge not only in finance
related area but also well versed in other areas. He must maintain a good
relationship with all the functional departments of the business
organization.

Topic 6A
➢ Functions of International Financial Manager :Decision making
the most important function
➢ Decisions Related with investment / deployment of funds in fixed
assets and current assets or capital expenditure and working capital
management In investment decision, he has to decide,
➢ what type or types assets are to be acquired, risks involved in the
acquisition of assets In MNC, the International Finance manager’s
responsibility is to identify and exploit profitable opportunities for long
term investment Survival and growth of MNC depends upon investment
decisions Has to employ capital budgeting techniques like NPV, IRR

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UNIT II

Topic I

Short-Term Financial Management in a Multinational Corporation:

Introduction, Short-term borrowing and Investment, Instruments and
Interest rates-International Cash Management-International Inventory
Management –International receivable management- Methods of financing
current assets.

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Prelude for II UNIT

Topic 1:

Short-Term Financial Management in a Multinational Corporation:

Introduction

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Although the fundamental principles governing the managing of

working capital such as optimization and suitability are almost the same
in both domestic and multinational enterprises, the two differ in respect
of the following: MNCs, in managing their working capital, encounter
with a number of risks peculiar to sourcing and investing of funds, such
as the exchange rate risk and the political risk

Unlike domestic firms, MNCs have wider options of procuring

funds for satisfying their requirements of their subsidiaries such as
financing of subsidiaries by the parent, borrowings from local sources
including banks and funds from Eurocurrency markets, etc.

MNCs enjoy greater latitude than the domestic firms in regard to

their capability to move their funds between different subsidiaries,
leading to fuller utilization of the resources.

MNCs face a number of problems in managing working capital of

their subsidiaries because they are widely separated geographically and
the management is not very well acquainted with the actual financial
state of affairs of the affiliates and working of the local financial
markets.

As such, the task of decision making in the case of MNCs' subsidiaries is

complex. Finance managers of MNCs face problems in taking financing
decision because of different taxation systems and tax rates.

In sum, through MNCs have some advantages in terms of latitude and

options in financing, the problems of working capital management in
MNCs are more complicated than those in domestic firms mainly
because of additional risks in the form of the currency exposure and
political risks as also due to differential tax codes and taxation rates

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Short-Term Financial Management in a Multinational Corporation:

Introduction

Global Corporation: It produces in home country or in a single country and

focuses on marketing these products globally or produces the products
globally and focuses on marketing these products domestically.

International Corporation: These corporations conduct the operations in

more than one foreign country, but with the domestic orientation. This
country believes that the practices adopted in the domestic business, the
people and products of the domestic business are superior to those of the
other countries. This company extends the domestic product, domestic price,
promotions and other business practices to the foreign market.

Multinational Corporation: There corporations responds to the specific

needs of the different country markets regarding products, promotions and
price. Thus MNC operates in more than one country but operates like a
domestic company of the country concerned.

Transnational Corporations: Transnational Corporations produces,

markets, invests, and operates across the world.

Short-term borrowing and Investment,

A multinational enterprise to survive and succeed in a fiercely

competitive environment must manage its working capital prudently.
Working capital management in an MNC requires managing its current
assets and current liabilities in such a way as to reduce funds tied in
working capital while simultaneously providing adequate funding and
liquidity for the conduct of its global businesses so as to enhance value to
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the equity shareholders and so also to the firm. While the basics of managing
working capital are, by and large, the same both in a domestic or
multinational organization, risks and options involved in working capital
management in MNCs are much greater than their domestic counterparts.
Further, working capital management in a multinational firm focuses on
inter subsidiary transfer of funds as well as transfers from the affiliates to
the parent firm. Besides, there are specific approaches to manage cash,
receivables and inventories in MNCs.

Instruments and Interest rates

Financing is a very important part of every business. Firms often
need financing to pay for their assets, equipment, and other important
items. Financing can be either long-term or short-term. As is obvious,
long-term financing is more expensive as compared to short-term
financing.

There are different vehicles through which long-term and short-term

financing is made available. This chapter deals with the major vehicles of
both types of financing.

The common sources of financing are capital that is generated by the

firm itself and sometimes, it is capital from external funders, which is
usually obtained after issuance of new debt and equity.

A firm’s management is responsible for matching the long-term or

short-term financing mix. This mix is applicable to the assets that are to be
financed as closely as possible, regarding timing and cash flows.

Short-Term Financing
Short-term financing with a time duration of up to one year is used
to help corporations increase inventory orders, payrolls, and daily supplies.
Short-term financing can be done using the following financial instruments
−
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Commercial Paper
Commercial Paper is an unsecured promissory note with a pre-noted
maturity time of 1 to 364 days in the global money market. Originally, it is
issued by large corporations to raise money to meet the short-term debt
obligations.

It is backed by the bank that issues it or by the corporation that

promises to pay the face value on maturity. Firms with excellent credit
ratings can sell their commercial papers at a good price.

Asset-backed commercial paper (ABCP) is collateralized by other

financial assets. ABCP is a very short-term instrument with 1 and 180
days’ maturity from issuance. ACBCP is typically issued by a bank or other
financial institution.

Promissory Note
It is a negotiable instrument where the maker or issuer makes an
issue-less promise in writing to pay back a pre-decided sum of money to
the payee at a fixed maturity date or on demand of the payee, under
specific terms.

Asset-based Loan
It is a type of loan, which is often short term, and is secured by a
company's assets. Real estate, accounts receivable (A/R), inventory and
equipment are the most common assets used to back the loan. The given
loan is either backed by a single category of assets or by a combination of
assets.

Repurchase Agreements
Repurchase agreements are extremely short-term loans. They usually
have a maturity of less than two weeks and most frequently they have a
maturity of just one day! Repurchase agreements are arranged by selling
securities with an agreement to purchase them back at a fixed cost on a
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given date.

Letter of Credit
A financial institution or a similar party issues this document to a
seller of goods or services. The seller provides that the issuer will definitely
pay the seller for goods or services delivered to a third-party buyer.

The issuer then seeks reimbursement to be met by the buyer or by

the buyer's bank. The document is in fact a guarantee offered to the seller
that it will be paid on time by the issuer of the letter of credit, even if the
buyer fails to pay Working capital management is associated with receiving
and paying out cash. As is obvious, the companies tend to maximize the
benefits of earning by paying as late as possible and getting paid as soon
as possible.
This chapter provides various ways to maximize the benefits of
working capital management and offers practical examples to understand
the concepts.
Why Firms Hold Cash
Economist John Maynard Keynes suggested three main reasons why
firms hold cash. The three reasons are for the purpose of speculation,
precaution, and transactions. All of these three reasons arise from the
necessity of companies to possess liquidity.
Speculation
According to Keynes, speculation for holding cash is seen as creating
the ability for a firm to take the benefits of special opportunities. These
opportunities, if acted upon quickly, tend to favor the firm. An example of
speculation is purchasing extra inventory at a discounted rate. This rate is
usually far greater than the carrying costs of holding the inventory.
Precaution
A precaution serves as a protectionist or emergency fund for a
company. When the cash inflows are not received according to expectation,
cash held on a precautionary basis can be utilized to satisfy the short-term
obligations for which cash inflow may have been sought for.
Transaction
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Firms either create products or they provide services. The offer of

services and creation of products results in the necessity for cash inflows
and outflows. Firms may hold enough cash to satisfy their cash inflow and
cash outflow needs that arise from time to time.
Float
Float is the existing difference between the given book balance and
the actual bank balance of an account. For example, you open a bank
account, say, with $500. You do not receive any interest on the $500 and
you also do not pay a fee to have the account.
Now, think what you do when you get a utility or water bill. You
receive your water bill and say, it is for $100. You can write a check for
$100 and then mail it to the particular water company. When you write the
$100 check, you also file the transaction or payment in the bank register.
The value your bank register reflects is the book value of the account. The
check may be "in the mail" for a few days. Then after the water company
receives, it may take several more days before it is cashed.
Now, between the moment you initiate or write the check and the
moment the bank cashes the check, there will obviously be a difference in
the book balance and the balance your bank lists for your checking
account. That difference is know
That difference is known as float.
International trade financing is required especially to get funds to
carry out international trade operations. Depending on the types and
attributes of financing, there are five major methods of transactions in
international trade. In this chapter, we will discuss the methods of
transactions and finance normally utilized in international trade and
investment operations.
International Trade Payment Methods
The five major processes of transaction in international trade are the
following −Prepayment
Prepayment occurs when the payment of a debt or installment
payment is done before the due date. A prepayment can include the entire
balance or any upcoming part of the entire payment paid in advance of the
due date. In prepayment, the borrower is obligated by a contract to pay for
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the due amount. Examples of prepayment include rent or loan repayments.

Letter of Credit
A Letter of Credit is a letter from a bank that guarantees that the
payment due by the buyer to a seller will be made timely and for the given
amount. In case the buyer cannot make payment, the bank will cover the
entire or remaining portion of the payment.
Drafts
Sight Draft − It is a kind of bill of exchange, where the exporter
owns the title to the transported goods until the importer acknowledges
and pays for them. Sight drafts are usually found in case of air shipments
and ocean shipments for financing the transactions of goods in case of
international trade.
Time Draft − It is a type of foreign check guaranteed by the bank.
However, it is not payable in full until the duration of time after it is
obtained and accepted. In fact, time drafts are a short-term credit vehicle
used for financing goods’ transactions in international trade.
Consignment
It is an arrangement to leave the goods in the possession of another
party to sell. Typically, the party that sells receives a good percentage of
the sale. Consignments are used to sell a variety of products including
artwork, clothing, books, etc. Recently, consignment dealers have become
quite trendy, such as those offering specialty items, infant clothing, and
luxurious fashion items.
Open Account
Open account is a method of making payments for various trade
transactions. In this arrangement, the supplier ships the goods to the
buyer. After receiving and checking the concerned shipping documents, the
buyer credits the supplier's account in their own books with the required
invoice amount.
The account is then usually settled periodically; say monthly, by
sending bank drafts by the buyer, or arranging through wire transfers and
air mails in favor of the exporter.
Trade Finance Methods
The most popular trade financing methods are the following −
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Accounts Receivable Financing

It is a special type of asset-financing arrangement. In such an
arrangement, a company utilizes the receivables – the money owed by the
customers – as a collateral in getting a finance.
In this type of financing, the company gets an amount that is a
reduced value of the total receivables owed by customers. The time-frame
of the receivables exert a large influence on the amount of financing. For
older receivables, the company will get less financing. It is also, sometimes,
referred to as "factoring".
Letters of Credit
As mentioned earlier, Letters of Credit are one of the oldest methods
of trade financing.
Banker’s Acceptance
A banker’s acceptance (BA) is a short-term debt instrument that is
issued by a firm that guarantees payment by a commercial bank. BAs are
used by firms as a part of the commercial transaction. These instruments
are like T-Bills and are often used in case of money market funds.
BAs are also traded at a discount from the actual face value on the
secondary market. This is an advantage because the BA is not required to
be held until maturity. BAs are regular instruments that are used in
international trade.
Working Capital Finance
Working capital finance is a process termed as the capital of a
business and is used in its daily trading operations. It is calculated as the
current assets minus the current liabilities. For many firms, this is fully
made up of trade debtors (bills outstanding) and the trade creditors (the
bills the firm needs to pay).
Forfaiting
Forfaiting is the purchase of the amount importers owe the exporter
at a discounted value by paying cash. The forfaiter that is the buyer of the
receivables then becomes the party the importer is obligated to pay the
debt.
Countertrade
It is a form of international trade where goods are exchanged for
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other goods, in place of hard currency. Countertrade is classified into three

major categories – barter, counter-purchase, and offset.
Barter is the oldest countertrade process. It involves the direct
receipt and offer of goods and services having an equivalent value.
In a counter-purchase, the foreign seller contractually accepts to buy
the goods or services obtained from the buyer's nation for a defined
amount.
In an offset arrangement, the seller assists in marketing the products
manufactured in the buying country. It may also allow a portion of the
assembly of the exported products for the manufacturers to carry out in
the buying country. This is often practiced in the aerospace and defense
industries.

Components associated with WCM:

Often the interrelationships among the working capital components

create real challenges for the financial managers. Inventory is purchased
from suppliers, sale of which generates accounts receivable and collected
in cash from customers to pay off those suppliers. Working capital has to
be managed because the firm cannot always control how quickly the
customers will buy, and once they have made purchases, exactly when
they will pay. That is why; controlling the “cash-to-cash” cycle is
paramount.
The different components of working capital management of any
organization are:
• Cash and Cash equivalents
• Inventory
• Debtors / accounts receivables
• Creditors / accounts payable
Topic 5: International Cash Management:
The basic principle to guide the management of cash balance
holdings in international working capital management is, broadly, similar
to the one applicable to domestic and International Investment situation.
That is, after carefully covering all the contingencies under contemplation,
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besides, regular requirements, the ideal cash balance holding should be

zero (0). However, such an ideal situation rarely exists even in case of
domestic enterprise; in spite of massive application of computers and
operations research techniques. This is as a result of problems in human
perception which continue to hunt modern managers in their role as
financial planners. That is, even the most perfect system of planning has
some lacuna to warrant the retention of residual cash reserve.
Cash Management in an MNC is primarily aimed at minimizing the
overall cash requirements of the firm as a whole without adversely affecting
the smooth functioning of the company and each affiliate, minimizing the
currency exposure risk, minimizing political risk, minimizing the
transaction costs and taking full advantage of the economies of scale and
also to avail of the benefit of superior knowledge of market forces. However,
these objectives are in conflict with each other leading to increased
complexity of the cash management.
International cash management is the set of activities determining
the levels of cash balances held throughout the MNE (cash management)
and the facilitation of its movement cross-border (settlements and
processing).
These activities are typically handled by the international treasury of
the MNE.
Cash balances, including marketable securities, are held partly to
enable normal day-to-day cash disbursements and partly to protect against
unanticipated variations from budgeted cash flows. These two motives are
called the transaction motive and the precautionary motive.
Efficient cash management aims to reduce cash tied up
unnecessarily in the system, without diminishing profit or increasing risk,
so as to increase the rate of return on invested assets.
For instance, minimization of the political risk involves conversion of
all receipts in foreign currencies in the currency of the home country. This
may, however, go against the interest of the affiliates who need minimum
working capital to be kept in the local currencies to meet their operational
requirements. Further, minimization of transaction costs involved in
currency conversions calls for holding cash balances in the currency in
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which they are received. In another respect too, primary objectives are
antagonistic to each other. A subsidiary, for example, may need to carry
minimum cash balances in anticipation of future payments due to the time
required to channelize funds to such a country. Holding of such balances
in excess of immediate requirements may ostensibly impringe on the
objective to benefit from economies of scale in earning the highest possible
rate of return from investing these resources.
Another major problem which an MNC faces in managing cash is
with respect to estimation of cash flows emanating out of operations
of its affiliates. This problem arises because of foreign exchange
fluctuations. Similar problem arises in estimating cash inflows stemming
out of future sales because actual volume of sales to overseas buyers
depends on foreign exchange fluctuations. The sales volume of exports is
also susceptible to business cycles of the importing countries.
Uncertainty arises with regard to cash collections from receivables
because it is the quality of credit standards that will decide the value of
goods sold to be received back in cash. Loose credit standards may cause a
slow. down in cash inflows from sales which could offset the benefits of
augmented sales.
In view of the above problems leading to increased uncertainty in
estimating cash flows, the management may be constrained to carry larger
amount of cash balances so as to protect the firm against any crisis.
Cash management in an MNC is further complicated by the absence
of effective tools to expedite transfers and by the great variations in the
practices of financial institutions.
Over time a number of techniques and services have evolved that
simplify and reduce the costs of making cross-border payments.
Four such techniques include:
 Wire transfers
 Cash pooling
 Payment netting
 Electronic fund transfers
As such, an international finance manager must exercise great
prudence in forecasting cash flows of the affiliates.
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Techniques to optimize Cash Flows

Cash flows can be optimized through:
o Accelerating cash inflows
o International Investment
o Minimizing currency conversion costs
o Managing inter-subsidiary cash transfers

Accelerating Cash Inflows Cash inflows can be prompted through quick

deposit of customer's cheques, establishing collection centers, lock-box
method and other devices.

Minimizing currency conversion costs Cash flow can also be optimized

through Netting. Netting involves offsetting receivables against payables of
the various entities so that only the net amounts are eventually transferred
among affiliates. An MNC can also utilize multilateral netting with outside
firms and agencies. This technique optimizes cash flow by reducing the
administrative and transaction costs arising out of currency conversion. It
also reduces unnecessary float, funds that are in the process of being
transferred among affiliates instead of being invested by the centre.
The process of netting forces tight control over information on
transaction between subsidiaries leading to greater coordination among all
subsidiaries to accurately report and settle their various accounts. Netting
also makes cash flows forecasting easier since only net cash transfers are
made at the end of each period, rather than individual cash transfers
throughout the period. There are two kinds of netting. A bilateral netting
system involves transactions between two units: between the parent and a
subsidiary or between two subsidiaries. A multilateral netting system
usually involves a more complex interchange among the parent and several
subsidiaries. Multilateral netting system is most useful to MNCs in
reducing administrative and currency conversion costs. Such a system is
highly centralized so that all necessary information is consolidated. With
the help of the consolidated cash flow information net cash positions for
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each pair of units (subsidiaries or parent) can be determined and the

actual reconciliation at the end of each period can be done.

Managing Inter-subsidiary Cash Transfers Through techniques of leading

and lagging, cash flows can be managed to the advantage of a subsidiary,
If A purchases supplies from B and pays for its supplies earlier than
necessary. This technique is called leading. Alternatively, if B sells supplies
to A, it could provide financing by allowing A to lag its payments. The
leading or lagging strategy can help in improving efficiency of cash
utilization and thereby reducing debt. Some host governments prohibit this
practice by requiring that a payment between subsidiaries occurs at the
time at which goods are transferred. MNC management must, therefore, be
aware of existence of such prohibitory laws.

International receivables management

Fundamental decision rules determining the optimal level of stock of raw

materials and components, work-in-process and finished goods are the
same for both MNCs and domestic firms. Even the techniques employed to
determine the level of required, safety stocks are also the same in both the
cases. However, MNCs have to face certain additional problems in
managing inventories which a domestic firm does not experience. These
problems are the diverse inventories maintained in several widely
separated locations, frequently changing import controls and tariffs, and
supply disruptions due to strikes and political turmoil. Above all, currency
fluctuation risk complicates the task of inventory management in an
international firm.

The magnitude of safety stock, which is the function of an optimum

solution equalizing stockout costs and the cost of carrying the safety stock,
has to be revised upward in case of an MNC due to the higher frequency of
estimated stockouts. Likewise, lead time in case of an MNC has to be
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longer to guard against a. higher probability of unexpected delays in

transit or delays in clearance from customs.

At times, MNCs are constrained to source their raw materials and

components on a worldwide basis. They may even decide to stockpile
certain materials when their supplies are likely to be disrupted due to
expected strikes, political crisis or other effectively managing accounts
receivables:

o Process and maintain records efficiently by regularly coordinating and

communicating with credit managers’ and treasury in-charges
o Prepare performance measurement reports
o Control accuracy and security of accounts receivable records.
o Captive finance subsidiary can be used to centralize accounts receivable
functions and provide financing for company’s sales
International receivable management-

Basic considerations influencing credit and collection policies of

MNCs are the same as those of domestic firms. However, certain additional
variables such as currency fluctuations, exchange restrictions, differential
inflation rates, etc have also to be reckoned with by an MNC while
managing receivables.

In an MNC, receivables arise for a short period when goods are sold on
cash against documents or sight draft and are in transit or for the time
which lapses between the drawing of the draft and its payment by the
importing firm or banker.

Receivables mainly arise when goods are shipped on open account,

consignment shipments and shipments of goods and services between
parent and affiliates, as well as among the latter. Besides, local sales on
credit by subsidiary units gives rise to receivables for the selling units, as
well as for the MNC as a whole.
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While deciding about sales on credit to a particular firm, an MNC has to

compare incremental benefits with incremental costs, as in the case of a
domestic firm. In addition, an additional factor, viz., foreign exchange loss
on sales on credit made by one of its subsidiaries has to be reckoned with.

Another issue related to receivables management in an international firm

relates to factoring of receivables. Decision on factoring should take into
account its benefits and costs. For example, factoring permits the exporter
to quote more competitive terms or to ship goods on open account rather
than insisting on cash terms or shipment against letter of credit. It relieves
the exporting firm from the costs of credit investigation, assessing the
political risk and collection. The factoring agency is better equipped to
assess these risks and can manage credit analysis and collection more
efficiently and at lower costs.

In view of the above, it is advisable to small firms who cannot afford the
cost of credit investigation and risk evaluation to factor their receivables.
Firms having occasional export sales to a few geographically dispersed
countries can also hire the services of factoring agency.

However, international factoring is still an expensive process. Factoring

fees differ depending on the size, quality, and the annual turnover of the
underlying receivables.

Trade credit is provided to customers on the expectation that it increases

overall profits by:

 Expanding sales volume

 Retaining customers
 Companies must keep a close eye on who they are extended, why
they are doing it and in which currency.
One way to better manage overseas receivables is to adjust staff sales
bonuses for the interest and currency costs of credit sales.

 MNCs tend to have difficulties in inventory management due to long

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transit times and lengthy customs procedures.

 Overseas production can lead to higher inventory carrying costs.
 Must weigh up benefits and costs of inventory stockpiling.
 Could adjust affiliates profit margins to reflect added stockpiling
costs.

PAYMENT NETTING EXAMPLE

Example: Cypress Semiconductor decided not to manufacture their circuits

overseas. By producing overseas they can reduce labour costs by $0.032
per chip.

BUT, offshore production incurs extra shipping and customs costs of

$0.025 per chip.
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AND, ties up capital in inventory for extra 5 weeks:

Capital cost = cost of funds x extra time x cost of part

= 0.20 x 5/52 x $8

= $0.154

Methods of financing current assets

Three principal short-term financing options:

Internal financing – borrowing from parent company or other affiliates.

Local currency loans – overdrafts, line of credit, discounting (commercial

paper) and term loans.

Euro market loans/issues – Euro notes and Euro-CP.

YouaretheCFOofalargeIndianpharmaceuticalcompany.Overthelastfivey
ears your company has grown primarily through overseas acquisitions. You
started acquiring companiesinEuropeandNorthAmericain2000.

YourbalancesheetonMarch2005hasassetsequivalentofUS$200million,i
ncluding those of yoursubsidiaries.

In the last board meeting, a presentation made by your major

European subsidiary
paintedaworrisomepicture.Thisbulkdrugmanufacturingfacilitysourcesitsraw
materials from a small South African country, which is facing political
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unrest. This means that the reliability of this source of raw materials, in the
days to come, is poor. Your subsidiary is keen to sources this material from
a small Taiwanese firm. This Taiwanese firm is willing
tosupplytherawmaterialbutwantspaymentsinUSdollarsfortheJanuarytoJune
2006 period: in euros for the July to December 2006 period through its
Cayman Island bank account.

If this supply contact clicks, it could mean at least two things; one
getting a reliable supplier, and two, opening a link in the Far East Market.

You are preparing to present a case for this supply contract to the top
management.
You search the web to get some data on USD/INR and EURJ1NR behaviour.

Download data for these two time series, calculate expected value and
variance/ standard deviation. Issues like planning horizon, overall
variability, and other assumptions should be discussed.

Question

1. What are the issues that you will take into account and what is the likely
responses from the board members?

UNIT III

Long-Term borrowing in the Global Capital Markets: Introduction, The

major Market Segments, Medium and long term instruments-International
Financing Decision.

Capital Structure: Cost of Capital and Capital Structure. Dividend policy:

forms of dividend- Model : International Capital Asset Pricing Model.

Self-study: International Financing Decision

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The major Market Segments, Medium and long term instruments

Medium Term Finance a) Syndicate Loans: These are loans given by

syndicates of banks to the borrowers. They carry a variable rate of interest
(LIBOR). They are tied to specific project in case of corporations. Government
can also borrow syndicate loans. But such loans are not tied to specific
projects. They can be even used to meet balance of payment difficulties.

b) Revolving underwriting facility (RUF): A RUF is a facility in which a

borrower issues on a revolving basis bearer notes, which are sold to investors
either by placing with an agent or through tenders. The investors in RUF
undertake to provide a certain amount of funds to the borrowers up to a
certain date. The borrowers is free to draw down repay and redraw the funds
after giving due notice. The London branch of the State Bank of India to an
Indian borrower provided the first RUF in 1984

c) Euro –Medium term notes (MTNs): The medium term notes have
maturity from 9months to 20 years. There is no secondary trading for MTNs.
Liquidity is provided by the commitments from dealers to buy back before
maturity at prices, which assure them of their spreads. These are issued just
like Euro-commercial paper. The issuer enjoys the possibility of issuing them
for different maturity periods. Companies use these notes. The sums
involved vary between $2 &$5 million.
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1. Based on the Period:

Sources of Finance may be classified under various categories based on the

period.

Long-term sources:

Finance may be mobilized by long-term or short-term. When the finance

mobilized with large amount and the repayable over the period will be more
than five years, it may be considered as long-term sources. Share capital,
issue of debenture, long-term loans from financial institutions and
commercial banks come under this kind of source of finance. Long-term
source of finance needs to meet the capital expenditure of the firms such as
purchase of fixed assets, land and buildings, etc.

Long-term sources of finance include:

● Equity Shares

● Preference Shares

● Debenture

● Long-term Loans

● Fixed Deposits
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Short-term sources:

Apart from the long-term source of finance, firms can generate finance with
the help of short-term sources like loans and advances from commercial
banks, moneylenders, etc. Short-term source of finance needs to meet the
operational expenditure of the business concern.

Short-term source of finance include:

● Bank Credit

● Customer Advances

● Trade Credit

● Factoring

● Public Deposits

● Money Market Instruments

2. Based on Ownership:
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Sources of Finance may be classified under various categories based on the

period:

An ownership source of finance include

● Shares capital, earnings

● Retained earnings

● Surplus and Profits

Borrowed capital include

● Debenture

● Bonds

● Public deposits

● Loans from Bank and Financial Institutions.

3. Based on Sources of Generation:

Sources of Finance may be classified into various categories based on the

period.

Internal source of finance includes

● Retained earnings

● Depreciation funds
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● Surplus

External sources of finance may be including

● Share capital

● Debenture

● Public deposits

● Loans from Banks and Financial institutions

4. Based in Mode of Finance

Security finance may be include

● Shares capital

● Debenture Retained earnings may include

● Retained earnings

● Depreciation funds

Loan finance may include

● Long-term loans from Financial Institutions

● Short-term loans from Commercial banks.

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The capital market is the sector of the financial market where long-term
financial instruments issued by corporations and governments trade. Here
“long-term” refers to a financial instrument with an original maturity greater
than one year and perpetual securities (those with no maturity).

There are two types of capital market securities: those that represent shares
of ownership interest, also called equity, issued by corporations, and those
that represent indebtedness, or debt issued by corporations and by the state
and local governments.

Financial markets can be classified in terms of cash market and derivative

markets.

The cash market, also referred to as the spot market, is the market for the
immediate purchase and sale of a financial instrument. I

n contrast, some financial instruments are contracts that specify that the
contract holder has either the obligation or the choice to buy or sell another
something at or by some future date.

The “something” that is the subject of the contract is called the underlying
(asset). The underlying asset is a stock, a bond, a financial index, an interest
rate, a currency, or a commodity.

Because the price of such contracts derives their value from the value of the
underlying assets, these contracts are called derivative instruments and the
market where they are traded is called the derivatives market. When a
financial instrument is first issued, it is sold in the primary market. A
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secondary market is such in which financial instruments are resold among

investors.

No new capital is raised by the issuer of the security. Trading takes place
among investors. Secondary markets are also classified in terms of organized
stock exchanges and over-the counter (OTC) markets.

Stock exchanges are central trading locations where financial instruments

are traded. In contrast, an OTC market is generally where unlisted financial
instruments are traded.

Equity market is one of the key sectors of financial markets where long-term
financial instruments are traded. The purpose of equity instruments issued
by corporations is to raise funds for the firms. The provider of the funds is
granted a residual claim on the company’s income, and becomes one of the
owners of the firm.

The purpose of equity is the following:

 A new issue of equity shares is an important source of external corporate

financing;

 Equity shares perform a financing role from internally generated funds

(retained earnings);

 Equity shares perform an institutional role as a means of ownership.

Equity Instruments
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1. Common (ordinary) shares represent partial ownership of the company and

provide their holders claims to future streams of income, paid out of
company profits and commonly referred to as dividends.
. If the company is liquidated, shareholders have a claim on any remaining
assets only after prior claimants have been paid.Common or ordinary share
(stock) – an equity share that does not have a fixed dividend yield.

2. Preferred shares:
Preferred stock is an attractive source of financing for highly leveraged
companies. Equity markets offer a variety of innovations in preferred shares
issues. These varieties include:
cumulative preference shares  non-cumulative preference shares 
irredeemable  redeemable preference shares  convertible preference shares
 participating preference shares  stepped preference shares

3. Private equity : When companies are organized as partnerships and private

limited companies, their shares are not traded publicly. The form of equity
investments, which is made through private placements, is called private
equity.

The most important sources of private equity investments come from venture
capital funds, private equity funds and in the form of leveraged buyouts.

3.1 Venture capital funds receive capital from wealthy individual or

institutional investors, willing to maintain the investment for a long-term
period (5-10 years). Venture capital market brings together private
businesses that need equity financing and venture capitalists (business
angels) that can provide funding.

3.2 Private equity funds pool resources of their partners to fund most often new
business start-ups. They can rely heavily on debt financing, also.
3.3 Leveraged buyouts are company equity purchases by individual or
institutional investors.
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Global shares and American Depository Receipts (ADR) Investors may invest
into foreign shares by purchasing shares directly, purchasing American
Depository Receipts (ADRs), Global Depository Receipts (GDRs).
Alternatively, investments can be made by investing into international funds
or purchasing exchange traded funds (ETFs).

A company can raise equity capital in international market in two ways: 1.

By issuing shares in Euro market which are listed on the foreign stock
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exchange. 2. Through the issue of America Depository Receipt (ADRs) or

European Depository Receipt EDRs or Global Depository Receipts (GDRs).

Exchange traded funds (ETFs) are passive funds, that track specific index.
Thus investor can invest into a specific index, representing a country’s (e.g.
foreign) stock market. Although ETFs are denominated in US dollars as a
rule, the net asset value of an international ETF is determined by translating
foreign currency value of the foreign securities into dollars.

American Depository Receipts (ADR) – a certificate of ownership issued by a

US bank to promote local trading on a foreign stock. US bank holds foreign
shares and issues ADRs against them.

These are the certificates denominated in dollars issued by a US. Bank on

the basis of a foreign equity it holds in custody in one of the branches
abroad, usually in the home country of the issuer. This system was
developed abroad, usually in the home country of the issuer.

This system was developed by Morgan Guaranty Trust Company of New

York on 1981 to facilitate the trading of foreign securities in the U.S.

The ADR represents a convenient way for a US investor to buy foreign equity
shares that were not listed in US Exchanges. The investor can receive
dividends in dollars without bearing foreign taxes or being subject to
exchange regulations.

The system also permits transfer of ownership of this receipt in the US

without the physical transfer of ownership of this receipt in the US without
the physical transfer of the underlying shares.
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Because the underlying shares are not subject to US Securities and

Exchange Commission (SEC) registration procedure, they have become more
attractive. Issues traded outside the US were called International Depositary
Receipt (IDR) issues.

GLOBAL DEPOSITORY RECEIPTS (GDRS) GDRs are traded and settled

outside the US. However, the SEC permits the foreign companies to offer
their GDRs to certain institutional buyers. The Government of India
contemplated in 1991 to permit Indian companies to issue equity and equity
related instruments in the form of GDRs and convertible bonds. A detailed
notification was form of GDRs and convertible bonds. A detailed notification
was issued in November 12, 1993 outlining the scheme for the issue of GDRs
and foreign currency convertible bonds. The scheme came into force effective
from April 1, 1992. In terms of guidelines issued by the Union Ministry of
Finance in November 1993, Indian companies have been permitted to raise
foreign currency resources through the issue of foreign currency convertible
bonds (FCCBs) and equity shares under the global depository receipt (GDR)
mechanism to foreign investors, both individual and institutional investors
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Cost of capital of an investor, in financial management, is equal to return, an

investor can fetch from the next best alternative investment. In simple
words, it is the opportunity cost of investing the same money in different
investment having similar risk and other characteristics. From a financing
angle, cost of capital is simply the cost which is paid for using the capital.
Alternatively, a percentage return on investment that convinces an investor
to invest in a particular project or company is the appropriate cost of capital
for that investor.

TYPES OF COST OF CAPITAL

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The term cost of capital is vague in general. Does it not clarify which capital
we are talking about? It could be equity or debt or any other source of
capital. We can classify cost of capital into following broad classifications.

COST OF EQUITY CAPITAL

Cost of equity capital is the cost of using the capital of equity shareholders in
the operations. This cost is paid in the form of dividends and capital
appreciation (increase in stock price). Most commonly, the cost of equity is
calculated using following formula:

The formula for Cost of Equity Capital = Risk-Free Rate + Beta * (Market Risk
Premium – Risk-Free Rate)
COST OF DEBT CAPITAL
Cost of debt capital is the cost of using bank’s or financial institution’s
money in the business. The banks are compensated in the form of interest
on their capital. The cost of debt capital is calculated using following
formula.

WEIGHTED AVERAGE COST OF CAPITAL (WACC)

Most of the times, WACC is referred as a cost of capital because of its

frequent and vast utilization especially when evaluating existing or new
projects. Weighted average cost of capital, as the term itself suggests, is the
weighted average of all types of capital present in the capital structure of a
company. Assuming these two types of capital in the capital structure i.e.
equity and debt, the WACC can be calculated by following formula:
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WACC = Weight of Equity * Cost of Equity + Weight of Debt * Cost of

Debt.

HOW AND WHY FINANCIAL MANAGERS USE IT?

Typically, financial managers use the cost of capital (refer as WACC) as a
benchmark or a qualifying criterion for selecting the new projects of a
company or evaluating the existing projects also. If a company is accepting
or implementing projecting with IRR less than WACC, it is construed as not
getting the best use of the investor’s capital and hence diminishing the
wealth of the investors. Indirectly, it is a signal to the investors to switch
their capital to better investments. If they remain invested in the company,
there are chances that they may not earn their required rate of return.

There are various factors that can affect the cost of capital. Some
fundamental factors are as follows:
Primarily, the market opportunity available to entrepreneurs is the most
contributing factor. If there are no new profitable businesses available in the
market, a businessman would not need money and therefore the demand for
money fall resulting in fall in the cost of capital as well.
Preferences of capital providers in terms of consumption or savings are
other important factors which vary from person to person and country to
country. If the capital providers are bent towards consumption, the supply of
capital would reduce and thereby increase in cost.
We already discussed the importance of risk. Higher the risk, higher would
be the required rate of return and vice versa.
In economics, it is said that inflation plays an important role in deciding the
cost of capital. Higher the inflation, higher would be expectations of the
capital providers else they may opt to consume or invest somewhere else.
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The capital structure itself should be the outcome of an optimal global

financial plan. This plan requires consideration not only of the component
costs of capital, but also of how the use of one source affects the cost and
availability of other sources. A firm that uses too much debt might find the
cost of equity (and new debt) financing prohibitive. The capital structure
problem for the multinational enterprise, therefore, is to determine the mix of
debt and equity for the parent entity and for all consolidated and
unconsolidated subsidiaries that maximizes shareholder wealth

When companies mobilize funds, they are mainly concerned with the
marginal cost of funds. The companies should always try to expand keeping
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in view their optimal capital structure. However, as their capital budget

expands in absolute terms, their marginal cost of capital (MCC) will
eventually increase. This means that companies can tap the capital market
for only some limited amount in the short run before their MCC rise, even
though the same optimum capital structure is maintained. In one analysis,
we hold the total amount of capital constant and change only the
combination of financing sources. We seek the optimum or target capital
structure that yields the lowest cost of capital. Now we attempt to determine
the size of the capital budget in relation to the levels of MCC so that the
optimum capital budget can be determined. The optimum capital budget is
defined as the amount of investment that maximizes the value of the
company. It is obtained at the intersection between the internal rate of
return (IRR) and the MCC. At this point, total profit is maximized. A variety
of factors affect a company’s cost of capital: its size, access to capital
markets, diversification, tax concessions, exchange rate risk, and political
risk. The first four factors favour the multinational company, where as the
last two factors favour the purely domestic company.

Figure 4 shows multinational companies usually enjoy a lower cost of capital

than purely domestic companies for a number of reasons. Firstly the
multinational companies usually enjoy a lower cost of capital than purely
domestic companies for a number of reasons. Firstly the multinational
companies may borrow money at lower rates of interest because they are
bigger, (ii) they may raise funds in a number of capital markets, (iii) the
MNCs are more diversified than purely domestic companies, and (iv) the
MNCs are able to lower their overall taxes because they can use tax heavens.
The MNCs are less riskier than purely domestic companies and because
these not only diversify in domestic investment projects but across countries
also. The lower overall risk of multinational companies tends to reduce their
overall taxes because they can use tax heavens. The MNCs are less riskier
than purely domestic companies and because these not only diversify in
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domestic investment projects but across countries also. The lower loverall
risk of multinational companies tends to reduce their overall cost of capital.

Determinants of Dividend Policy

The payment of dividend involves some legal as well as financial

considerations. It is difficult to determine a general dividend policy which
can be followed by different firms at different times because dividend
decision has to be taken considering the special circumstances of an
individual case. The following are important factors which determine
dividend policy of a firm:

1. Legal Restrictions: Legal Provisions relating to dividends as laid down in

section, 205, 205A, 206 and 207 of companies Act, 1956 are significant
because they lay down a framework within which dividend policy is
formulated. These provisions require that dividend can be paid only out of
current profit or past profits after providing for depreciation. The companies
(Transfer of Profits to Reserves) Rules, 1975 require a company providing
more than 10% dividend to transfer certain percentage of current year’s
profit to Reserves.

When Dividend Amount to be

Proposed transferred to Reserves
most not be less than

Exceeds 10% but not 2.5% of current year profit

12.5% of paid up capital

Exceeds 12.5% but not 5% of current year profit

15% of paid up capital

Exceeds 15% but not 7.5% of current year

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20% of paid up capital profits

Exceeds 20% of paid up 10% of current year

capital profits.

Companies Act, further provides that dividend cannot be paid out of capital,
because it will amount to reduction of capital adversely affecting the security
of creditors.

2. Desire and Type of Shareholders: Although, legally, the direction as to

whether to declare dividend or not has been left with BOD, the directors
should give importance to desires of shareholders in declaration of dividends
as they are representatives of shareholders. Investors such as retired
persons, widows, and other economically weaker persons view dividends as
source of funds to meet their day-to-day living expenses. To benefit such
investors, the companies should pay regular dividends. On other hand, a
wealthy investor in a high income tax bracket may not benefit by high
current dividend incomes. Such an investor may be interested in lower
current dividend and high capital gains.

3. Nature of Industry: Nature of Industry to which company is engaged also

considerably affects dividend policy. Certain industries have comparatively
steady and stable demand irrespective of prevailing economic conditions. For
example, people used to drink liquor both in boom as well as in recession.
Such firms expect regular earnings and hence follow consistent dividend
policy. On the other hand, if earnings are uncertain, as in the case of luxury
goods conservative policy should be followed. Such firms should retain a
substantial part of their current earnings during boom period in order to
provide funds to pay adequate dividends in the recession periods. Thus,
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industries with steady demand of their products can follow a higher dividend
payout ratio while cyclical industries should follow a lower payout ratio.

4. Age of Company: It also influences dividend decision of company. A

nearly established concern has to limit payment of dividend and retain
substantial part of earnings for financing its future growth while older
companies which have established sufficient reserves can afford to pay
liberal dividends.

5. Future Financial Requirements: If a company has highly profitable

investment opportunities it can convince the shareholders of need for
limitation of dividend to increase future earnings and stabilise its financial
position. But when profitable investment appointments do not exist then
company may not be justified in retaining substantial part of its current
earnings. Thus, a concern having few internal investment opportunities
should follow high payout ratio as compared to one having more profitable
investment opportunities.

6. Liquid Resources: The dividend policy of a firm is also influenced by

availability of liquid resources. Although, a firm may have sufficient available
profit to declare dividends, yet it may not be desirable to pay dividend if it
does not have sufficient liquid resources. Hence liquidity position of company
is an important consideration in paying dividends. If company does not have
liquid resources, it is better to declare stock dividend i.e. issue of bonus
shares to existing shareholders.

7. Requirements of Institutional Investors: Dividend policy of a company

can be affected by requirements of institutional investors such as financial
institutions, banks, insurance corporations etc. These investors usually
favour a policy of regular payment of cash dividends and stipulate there own
terms with regard to payment of dividend on equity shares.

8. Stability of Dividends: Stability of dividend refers to payment of dividend

regularly and shareholders generally, prefer payment of such regular
dividends. Some companies follow a policy of constant dividend per share
while others follow a policy of constant payout ratio and while there are some
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other who follow a policy of constant low dividend per share plus an extra
dividend in years of high profits. A policy of constant dividend per share is
most suitable to concerns whose earnings are expected to remain stable over
a number of years or those who have built up sufficient reserves to pay
dividends in years of low profits. The policy of constant payout ratio i.e.
paying a fixed percentage of net earnings every year may be supported by
firm because it is related to firms ability to pay dividends. The policy of
constant low dividend per share plus some extra dividend in years of high
profits is suitable to firms having fluctuating earnings from year to year.

9. Magnitude and Trend of Earnings: The amount and trend of earnings is

an important aspect of dividend policy. It is rather the starting point of the
dividend policy. As dividends can be paid only out of present or past’s years
profits, earnings of a company fix the upper limits on dividends. The
dividends should nearly be paid out of current years earnings only as
retained earnings of the previous years become more or less a part of
permanent investment in the business to earn current profits. The past trend
of the company’s earnings should also be kept in consideration while making
dividend decision.

10. Control objectives: When a company pays high dividends out of its
earnings, it may result in dilution of both control and earnings for existing
shareholders. As in case of high dividend pay out ratio the retained earnings
are insignificant and company will have to issue new shares to raise funds to
finance its future requirements. The control of the existing shareholders will
be diluted if they cannot buy additional shares issued by the company.
Similarly issue of new shares shall cause increase in number of equity
shares and ultimately cause a lower earnings per share and their price in the
market. Thus under these circumstances to maintain control of the existing
shareholders, it may be desirable to declare lower dividends and retain
earnings to finance the firm’s future requirements.

Types of Dividend Policy

The various types of dividend policies are discussed as follows:

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(a) Regular Dividend Policy: Payment of dividend at usual rate is termed as

regular Dividend. The investors such as retired persons, widows, and other
economically weaker persons prefer to get regular dividends. A regular
dividend offer following Advantages.

 It establishes profitable record of company.

 It creates confidence among shareholder.
 It stabilises market value of shares
 It aids in long term financing and renders financing easier.
 The ordinary shareholders view dividends as a source of founds to meet
their day-to-day living expenses.
Regular dividend can be maintained only by companies of long standing and
stable earnings.

(b) Stable Dividend Policy: The term ‘Stability of Dividend’ means

consistency or lack of variability in stream of dividend payments. A stable
dividend policy may be established in any of following three forms.

(i) Constant Dividend Per Share: Some companies follow a policy

of paying fixed dividend per share irrespective of level of earnings year after
year. Such firms usually create a ‘Reserve for Dividend Equalisation’ to
enable them pay fixed dividend even in year when earnings are not sufficient
or when there are losses. A policy of constant dividend per share is most
suitable to concerns whose earnings are expected to remain stable over
number of years.

(ii) Constant Pay out ratio: It means payment of fixed percentage

of net earnings as dividends every year. The amount of dividend in such a
policy fluctuates in direct proportion to earnings of company. The policy of
constant pay out is preferred by the firms because it is related to their ability
to pay dividends.

(iii) Stable rupee Dividend plus extra dividend: Some companies

follow a policy of paying constant low dividend per share plus an extra
dividend in the years of high profit. Such a policy is most suitable to the firm
having fluctuating earnings from year to year.
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Advantages of Stable Dividend Policy: A Stable dividend policy is

advantageous to both investors and company on account of the following:

(a) It is sign of continued normal operations of company.

(b) It stabilises market value of shares.

(c) It creates confidence among investors.

(d) It improves credit standing and making financing easier.

(e) It meets requirements of institutional investors who prefer companies

with stable dividends.

Dangers of Stable dividend policy

Inspite of many advantages, the stable dividend policy suffers from certain
limitations. Once a stable dividend policy is followed by a company, it is not
easier to change it. If stable dividends are not paid to shareholders on any
account including insufficient profits, the financial standing of company in
minds of investors is damaged and they may like to dispose of their holdings.
It adversely affects the market price of shares of the company. And if
companies pays stable dividends inspite of its incapacity it will be suicidal in
long run.

( c) Irregular Dividend Policy: Some companies follow irregular dividend

payments on account of following:

(a) Uncertainty of Business.

(b) Unsuccessful Business operations

(c) Lack of liquid resources.

(d) Fear of adverse effects of regular dividend on financial standing of

company.
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(d) No Dividend Policy: A company may follow a policy of paying no

dividends presently because of its unfavourable working capital position or
on account of requirements of funds for future expansion and growth.

Forms of Dividend

Dividends can be classified in various forms. Dividend paid in ordinary

course of business are known as Profit Dividends, while dividends paid out of
capital are known as Liquidation dividends. Dividend may also be classified
on the basis of medium in which they are paid:

(a) Cash Dividend: A cash dividend is a usual method of paying

dividends. Payment of dividend in cash results in outflow of funds and
reduces the company’s net worth, though the shareholder get an opportunity
to invest the cash in any manner they desire. This is why ordinary
shareholders prefer to receive dividends in cash. But the firm must have
adequate liquid resources at its disposal or provide for such resources so
that its liquidity position is not adversely affected on account of cash
dividends.

(b) Scrip or Bond Dividend: A scrip dividend promises to pay

shareholders at future specific date. In case a company does not have
sufficient funds to pay dividends in cash, it may issue notes or bonds for
amounts due to shareholders. The objective of scrip dividend is to postpone
the immediate payment of cash. A scrip dividend bears interest and is
accepted as a collateral security.

(c) Property Dividend: Property dividends are paid in the form of some
assets other than cash. They are distributed under exceptional
circumstances and are not popular in India.

(d) Stock Dividend: Stock Dividend means the issue of bonus shares to
the existing shareholders. If a company does not have liquid resources it is
better to declare stock dividend. Stock dividend amounts to capitalisation of
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earnings and distribution of profits among existing shareholders without

affecting the cash position of the firm.

Linter Model: Lintner Model supports the view on stability of dividend. Some
of proposition of Lintner model are:

(i) Firms follow a long – term target payout ratio.

(ii) Firms are more particular and careful for dividend changes than
absolute dividend amount.

(iii) Change in dividend follows change in earnings.

According to Linter Model, firms have a target payout ratio and change in
dividend would occur in such a way so as to move towards this ratio. The
dividend change depends upon adjustment factor. The more conservative the
firm is, the more slowly it would move towards its target and lower would be
adjustment rate. The model says that the dividends for a year depends partly
on earnings for that year and partly on dividend for previous year which in
turn depends on dividends for year before. In case of increase in earnings per
share the companies increase the dividends per share gradually which helps
in avoiding reduction in dividends if there is a decrease in earnings. The
Lintner model can be presented as follows:

Dt = EPSt x SA x DP Ratio + (1-SA) Dt-1

Dt – Dividend for current year

EPSt – EDS for current year.

SA – Speed of Adjustment

DP Ratio – Target pay out ratio

Dt-1 = Dividend for previous year.

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Bonus Shares

Bonus shares are the shares issued by a company free of costs by

capitalisation of its profits and reserves. The issue of bonus shares results in
increase in number of shares and hence increases the paid up capital of
company without involving any monetary transaction. Such shares are
issued to all existing equity shareholders in proportion of their holding of
share capital of company. Since, the number of shares increases as a result
of bonus shares, the book value and earnings per share of company will
decrease.

The mechanism of bonus share is simple. The firm first issues additional
shares by passing a resolution and then distribute these shares among
existing shareholder in proportion to their holding. The bonus shares do not
alter the proportional ownership of firm as far as existing shareholders are
concerned. As the bonus issue does not effect the cash flows or the
operational efficiencies of the firm, there should not be any change in total
value of firm. The market price per share would decrease but shareholder are
no worse off after the bonus, notwithstanding such decrease because they
receive compensatory increase in number of shares held.

Reasons for issue of Bonus Shares

Companies have a common tendency to issue bonus shares to their

shareholders. Many companies have issued bonus shares once a while,
whereas some other companies have issued bonus shares on regular basis.
Companies such as Bajaj Auto Ltd., Hindustan Level Ltd. have issued bonus
shares on regular basis. Companies prefer issue of bonus shares as against
payment of cash dividend for several reasons as follows:

1. When a company issues bonus shares, it utilises a part of profit of

company and also rewards the shareholders but without affecting liquidity of
company.

2. Since, bonus shares is capital receipt, it is not taxable in hands of

issuing company as well as shareholders.
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3. Issue of bonus shares increases the goodwill of company in capital

market and build confidence among investors and helps raising additional
funds in future.

4. Bonus issue helps a company to streamline its capital structure

and bring its paid-up capital in line with capital employed in business.

5. It makes available capital to carry on a larger and more profitable

business.

6. It enables a company to make use of its profits on a permanent

basis and increases creditworthiness of the company.

7. The balance sheet of the company will reveal a more realistic

picture of the capital structure and capacity of the company.

8. The investors can easily sell these shares and get immediate cash,
if they so desire.

9. The bonus shares are a permanent source of income to the

investors.

Disadvantages of Issue of Bonus Shares

1. The issue of bonus shares leads to drastic fall in the future rate of
dividend as it is only the capital that increases and not the actual resources
of the company. The earnings do not usually increase with the issue of
bonus shares.

2. The fall in the future rate of dividend results in the fall of the market
price of shares considerably, this may cause unhappiness among the
shareholders.

3. The reserves of the company after the bonus issue decline and leave
lesser security to investors.
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The Securities and Exchange Board of India has issued the guidelines for
issue of bonus shares in year 2000. The guidelines for issue of bonus shares
can be summarized as follows:

1. These guidelines are applicable to existing listed companies who shall

forward a certificate duly signed by the issuer and duly counter signed by its
statutory auditor or by company secretary in practice to the effect that the
terms and conditions for issue of bonus shares as laid down in these
guidelines have been complied with.
2. The bonus shares is made out of free reserves built out of genuine profits or
share premium collected in cash.
3. Reserves created by revaluation of fixed asset are not capitalized.
4. The declaration of bonus issue in lieu of dividend is not made.
5. The bonus issue is not made unless the partly paid shares if any existing
are made fully paid up.
6. A company which announces its bonus issue after the approval of the
board of directors must implement the proposals within the period of six
months from the date of such approval and shall not have the option of
changing the decision.
7. There should be provision in the Articles of Association of the company for
capitalisation of reserves etc., and if not the company shall pass resolution
at its general body meeting making provisions in the Articles of Association
for capitalization.
8. Consequent to issue of bonus shares if the subscribed and paid up capital
exceed the Authorised share capital a resolution shall be passed by the
company at its general body meeting for increasing authorized capital.
Shares Repurchase

The shares repurchase or buy back of shares is a situation when company

uses its accumulated profits to cancel or retire a part of its outstanding
shares by purchasing from the market or directly from the shareholders.
This is particularly relevant when the shares are available in the market at
price below the book value. When shares are repurchased for cancellation
the underlying motive is to distribute excess cash among the shareholders.
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The cancellation of shares means that the present shareholders will receive
cash for their shares. The rationale for repurchase is that as long as the
earnings remain constant, the repurchase of shares reduces the number of
shares outstanding and thus raising the earning per share and market price
of share. The company may have different methods of shares repurchase.
There are three widely used approaches to shares repurchase as follows:

1. Repurchase Tender Offer: In a repurchase tender offer, a firm specifies a

price at which it will buy back the shares the number of shares it intends to
repurchase and period of time for which it will keep the offer open and
invites the shareholders to submit their shares for the repurchase. The firm
may also retain the flexibility to withdraw the offer if insufficient number of
share re submitted for repurchase.

2. Open Market Repurchase: In case of open market repurchase the firm

buys the shares in the market at the prevailing market price. The open
market repurchase can be spread out over longer time periods than tender
offers. In terms of flexibility the open market repurchase provide the firm
more freedom in deciding when to repurchase and how many shares to be
repurchased.

3. Negotiated Repurchase: In this case, the firm may buy shares from large
shareholder at a negotiated price. This form of repurchase can be adopted
only when large shareholder generally one of the promoter groups is willing
to sell the shares.

Clientele Effect

The shareholders do have preference for cash dividends. However there are
companies like Microsoft which did not pay dividends for number of years
and still the shareholders seemed perfectly content with the policy. There are
some investors who prefer high pay out and there are some shareholders
which prefer low payout. Given the diversity of investors and that of dividend
policies match their preferences. This is known as clientele effect.
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The clientele effect refers to tendency of investors to buy shares in companies

that have dividend policies that meet their preferences for dividend payout.
The clientele effect states that different groups of investors desire different
levels of dividend.

The Capital Asset Pricing Model (CAPM) is a model that describes the
relationship between the expected return and risk of investing in a security.
It shows that the expected return on a security is equal to the risk-free
return plus a risk premium, which is based on the beta of that security.
Below is an illustration of the CAPM concept.

UNIT IV

The Nature and Measurement of Exposure and Risk: – Introduction-

different types of risk in cross boarder investments – Risk handling
techniques.
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Exposure Management :Introduction: classification of foreign exchange risk

exposures-transaction, translation and economic exposure- Techniques in
exposures management.

Self study: translation exposure

Introduction Currency risk is a form of risk that originates from changes in

the relative valuation of currencies. These changes can result in
unpredictable gains and losses when the profits or dividends from an
investment are converted from the foreign currency into U.S. dollars.
Investors can reduce currency risk by using hedges and other techniques
designed to offset any currency-related gains or losses. For example, suppose
that a U.S.-based investor purchases a German stock for 100 euros. While
holding this bond, the euro exchange rate falls from 1.5 to 1.3 euros per U.S.
dollar. When the investor sells the bonds, he or she will realize a 13% loss
upon conversion of the profits from Euros to U.S. dollars. However, if that
investor hedged his or her position by simultaneously short-selling the euro,
then the profit from the euro’s decline would offset the 13% loss upon
conversion.

Types of Currency Risks ➢➢ Transaction exposure ➢➢ Translation

exposure ➢➢ Economic exposure

Transaction Exposure Transaction Exposure is the risk of gains or losses

that occurs when a firm engages in commercial transactions in which the
currency of the transaction is foreign to the firm; i.e., it is denominated in a
foreign currency.

This is the type of exchange rate risk that we have looked at the various
ways of managing via futures, forward contracts, options and money market
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hedges. Financial Techniques of Managing Transaction Exposure We will

briefly go over the standard financial methods available for hedging this
exposure. The main distinction between transaction exposure and operating
exposure is the ease with which one can identify the size of a transaction
exposure. This, combined with the fact that it has a well-defined time
interval associated with it makes it extremely suitable for hedging with
financial instruments. Among the more standard methods for hedging
transaction exposure are:

i) Forward Contracts When a firm has an agreement to pay (receive) a fixed

amount of foreign currency at some date in the future, in most currencies it
can obtain a contract today that specifies a price at which it can buy (sell)
the foreign currency at the specified date in the future. This essentially
converts the uncertain future home currency value of this liability (asset)
into a certain home currency value to be received on the specified date,
independent of the change in the exchange rate over the remaining life of the
contract.

ii) Futures Contracts These are equivalent to forward contracts in function,

although they differ in several important features. Futures contracts are
exchange traded and therefore have standardized and limited contract sizes,
maturity dates, initial collateral, and several other features. Given that
futures contracts are available in only certain sizes, maturities and
currencies, it is generally not possible to get an exactly offsetting position to
totally eliminate the exposure. The futures contracts, unlike forward
contracts, are traded on an exchange and have a liquid secondary market
that make them easier to unwind or close out in case the contract timing
does not match the exposure timing. In addition, the exchange requires
position taker to post s bond (margins) based upon the value of their
positions. This virtually eliminates the credit risk involved in trading in
futures.

iii) Money Market Hedge Also known as a synthetic forward contract, this
method utilizes the fact from covered interest parity, that the forward price
must be exactly equal to the current spot exchange rate times the ratio of the
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two currencies’ riskless returns. It can also be thought of as a form of

financing for the foreign currency transaction. A firm that has an agreement
to pay foreign currency at a specified date in the future can determine the
present value of the foreign currency obligation at the foreign currency
lending rate and convert the appropriate amount of home currency given the
current spot exchange rate.

This converts the obligation into a home currency payable and eliminates all
exchange risk. Similarly a firmthat has an agreement to receive foreign
currency at a specified date in the future can determine the present value of
the foreign currency receipt at the foreign currency borrowing rate and
borrow this amount of foreign currency and convert it into home currency at
the current spot exchange rate. Since as a pure hedging need, this
transaction replicates a forward, except with an additional transaction, it will
usually be dominated by a forward (or futures) for such purposes; however, if
the firm needs to hedge and also needs some short term debt financing,
wants to pay off some previously higher rate borrowing early, or has the
home currency cash sitting around, this route may be more attractive that a
forward contract. iv) Options Foreign currency options are contracts that
have an up front fee, and give the owner the right, but not the obligation to
trade domestic currency for foreign currency (or vice versa) in a specified
quantity at a specified price over a specified time period. There are many
different variations on options: puts and calls, European style, American
style, and future-style etc. The key difference between an option and the
three hedging techniques above is that an option has a nonlinear payoff
profile. They allow the removal of downside risk without cutting off the
benefit form upside risk. There are different kinds of options depending on
the exercise time the determination of the payoff price or the possibility of a
payoff. While many different varieties exist, there are a few that corporations
have found useful for the purposes of hedging transaction exposures. One of
these is the average rate (or Asian or Look back) option. This option has as
its payoff price, not the spot price but the average spot price over the life of
the contract. Thus these options can be useful to a firm that has a steady
stream on inflows or outflows in a particular currency over time. One large
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average rate option will basically act as a hedge for the entire stream of
transaction. Moreover, the firms will lock in an average exchange rate over
the period no worse than that of the strike price of this option. Finally,
because the average rate is less volatile than the end of period rate
(remember the average smoothes volatility this option will be cheaper than
equivalent standard options. Thus the firms obtains in a single instrument
hedging for a stream of transaction so reduces transaction costs plus
benefits from the “hedging” over time of the averaging effect. Another popular
exotic option for corporations is the basket rate option. Rather than buy
options on a bunch of currencies individually, the firms can buy an option
based upon some weighted average of currencies that match its transaction
pattern. Here again since currencies are not perfectly correlated the average
exchange rate will be less volatile and this option will therefore be less
expensive. There firm can take advantage of its own natural diversification of
currency risk and hedge only the remaining risk.

Operational Techniques for Managing Transaction Exposure Transaction

exposures can also be managed by adopting operational strategies that have
the virtue of offsetting existing foreign currency exposure. These techniques
are especially important when well-functioning forward and derivative
market do not exist for the contracted foreign currencies. These strategies
include: i) Risk Shifting- The most obvious way to reduce the exposure is to
not have an exposure. By invoicing all transactions in the home currency a
firm can avoid transaction exposure all together. However, this technique
cannot work for every one since someone must bear transaction exposure for
a foreign currency transaction. Generally the firm that will bear the risk is
the one that can do so at the lowest cost. Of course, the decision on who
bears the currency risk may also impact the final price at which the contract
is set.
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ii) Currency risk sharing - An alternative to trying to avoid the currency risk
is to have the two parties to the transaction share the risk. Since short terms
transaction exposure is roughly a zero sum game, one party’s loss is the
other party’s gain. Thus, the contract may be written in such a way that any
change in the exchange rate from an agreed upon rate for the date for the
transaction will be split between the two parties. For example a U.S. firm A
contracts to pay a foreign firm B FC100 in 6 months based upon an agreed
on spot rate for six months from now of 141 $1 = FC10, thus costing the
U.S. firm $10. However, under risk sharing the U.S. firm and the foreign firm
agree to share the exchange rate gain or loss faced by the U.S. firm by
adjusting the FC price of the good accordingly. Thus, if the rate in 6 months
turns out to be $1 = FC12, then rather than only costing the U.S. firm
$100/12 = $8.50, the $1.50 gain over the agreed upon rate is split between
the firms resulting in the U.S. firm paying $9.25 and the foreign firm
receiving FC 111. Alternatively if the exchange rate had fallen to $1 = FC8,
then instead of paying $12.50 for the good, the exchange rate loss to the U.S.
firm is shared and it only pays $11.25 and the foreign firm accepts FC90.
Note that this does not eliminate the transaction exposure, it simply splits it.
iii) Leading and Lagging - Another operating strategy to reduce transaction
gains and losses involves playing with the timing of foreign currency cash
flows. When the foreign currency in which an existing nominal contract is
denominated is appreciating, you would like to pay off the liabilities early
and take the receivables later. The former is known as leading and the latter
is known as lagging. Of course when an the foreign currency in which a
nominal contract is denominated is depreciating, you would like to take the
receivables early and pay off the liabilities later.

iv) Re invoicing Centers - A re invoicing center is a separate corporate

subsidiary that manages in one location all transaction exposure from intra
company trade. The manufacturing affiliate sells the goods to the foreign
distribution affiliates only by selling to the re invoicing center. The re
invoicing center then sells the good to the foreign distribution affiliate. The
importance of the re invoicing center is that the transactions with each
affiliate are carried out in the affiliates local currency, and the re invoicing
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center absorbs all the transaction exposure. Three main advantages exist to
re invoicing centers: the gains associated with centralized management of
transaction exposures from within company sales, the ability to set foreign
currency prices in advance to assist foreign affiliates budgeting processes,
and an improved ability to manage intra affiliate cash flows as all affiliates
settle their intra company accounts in their local currency. Re invoicing
centers are usually an offshore (third country) affiliate in order to qualify for
local non resident status and gain from the potential tax and currency
market access benefits that arise with that distinction.

Translation exposure is also referred to as accounting exposure or balance

sheet exposure. The restatement of foreign currency financial statements in
terms of a reporting currency is termed translation. The exposure arises from
the periodic need to report consolidated worldwide operations of a group in
one reporting currency and to give some indication of the financial position
of that group at those times in that currency.

In any event, translation exposure is not a real gain or loss in terms of

making or losing money. The value of the asset is the value of the asset. The
gain or loss results simply from translating from one currency to another. In
that sense, one should not really worry about translation exposure (except to
the extent that there is a perceived gain or loss from unsophisticated users of
the financial statements). This is also referred to as conversion exposure or
cash flow exposure. It concerns the actual cash flows involved in setting
transactions denominated in a foreign currency. These could include, for
example: ➢➢ Sales receipts ➢➢ Payments for goods and services ➢➢
Receipt and/or payment of dividends ➢➢ Servicing loan arrangements as
regards interest and capital
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Measurement of Translation Exposure Translation exposure measures the

effect of an exchange rate change on published financial statements of a
firm. ➢➢ Assets & liabilities that are translated at the current exchange
rate are considered to be exposed (uncovered) as the balance sheet will be
affected by fluctuations in currency values over time. ➢➢ Assets &
liabilities that are translated at a historical exchange rate will be regarded as
not exposed as they will not be affected by exchange rate fluctuations. ➢➢
So, the difference between exposed assets & exposed liabilities is called
translation exposure.

Economic exposure or operational exposure moves outside of the accounting

context and has to do with the strategic evaluation of foreign transactions
and relationships. It concerns the implications of any changes in future cash
flows which may arise on particular transactions of an enterprise because of
changes in exchange rates, or on its operating position within its chosen
markets. Its determination requires an understanding of the structure of the
markets in which an enterprise and its competitors obtain capital, labour,
materials, services and customers. Identification of this exposure focuses
attention on that component of an enterprise’s value that is dependent on or
vulnerable to future exchange rate movements. This has bearing on a
corporation’s commitment, competitiveness and viability in its involvement in
both foreign and domestic markets.

Managing Operating Exposure Long-term; Techniques involve:

Marketing Management A. Market Selection To examine which markets to

sell products (strong currency market vs. weak currency market). Sell in
multiple markets to take advantage of economies of scale and diversification
of exchange rate risk. (Example: Mexican peso devalued in December 1994.
The sale of Goodyear tires of Mexican plant plunged more than 20% (i.e., a
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drop of 3,500 tires per day) in Mexico. The plant changed its sale strategy
quickly and exported tires to U.S., South America, and Europe.) B. Pricing
Strategy Emphasize on market share or profit margin. Exporters will benefit
from a weak home currency and can either increase price or increase market
share. C. Product Strategy New products, product line decisions, and
product innovation (through R&D), VW sold very inexpensive vehicles in the
early 1970s, but the appreciation of the DM caused VW to keep lowering
prices to maintain market share. VW lost over $300 million in 1974. VW
altered their strategy to sell more expensive cars with higher quality.
Successful R&D allows for cost cutting, enhanced productivity, and product
differentiation Production Management A. Product Sourcing: purchase
components overseas (outsource components) B. Plant Location: shift
production to lower cost sites. Increase production in a country with a
weaker currency, and decrease production in a country with a stronger
currency (e.g., Honda built North American factories in response to strong
yen, but later Honda imported the cars from Japan because of a weak yen).
C. Increase Productivity: close inefficient plants, high automation Financial
Hedging It involves the use of currency swaps, currency futures, currency
forwards, and currency options. 151 Proactive Management Six of the most
commonly employed proactive

Six of the most commonly employed proactive policies are

➢➢ Matching currency cash flows

➢➢ Risk-sharing agreements

➢➢ Back-to-back loans

➢➢ Currency swaps

➢➢ Leads and lags (pay early and pay late)

➢➢ Re invoicing centers Matching Currency Cash Flows

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➢➢ One way to offset an anticipated continuous exposure to a particular

currency is to acquire debt denominated in that currency

➢➢ This policy results in a continuous receipt of payment and a

continuous outflow in the same currenc

y ➢➢ This can sometimes occur through the conduct of regular operations

and is referred to as a natural hedge Risk-Sharing Agreements Risk-sharing
is a contractual arrangement in which the buyer and seller agree to share or
split currency movement impacts on payments Parallel Loan A back-to-back
loan, also referred to as a parallel loan or credit swap, occurs when two firms
in different countries arrange to borrow each other’s currency for a specific
period of time ➢➢ The operation is conducted outside the FOREX markets,
although spot rates may be used to decide the equivalent amount

➢➢ This swap creates a covered hedge against exchange loss, since each
company, on its own books, borrows the same currency it repays

Currency Swaps ➢ Currency swaps resemble back-to-back loans except that

it does not appear on a firm’s balance sheet.

➢➢ In a currency swap, a dealer and a firm agree to exchange an

equivalent amount of two different currencies for a specified period of time •
Currency swaps can be negotiated for a wide range of maturities

➢➢ A typical currency swap requires two firms to borrow funds in the

markets and currencies in which they are best known or get the best rates
Leads and Lags: Re-Timing the Transfer of Funds ➢➢ Firms can reduce
both operating and transaction exposure by accelerating or decelerating the
timing of payments that must be made or received in foreign currencies • To
lead is to pay early • To lag is to pay late
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➢➢ Leading and lagging can be done between related firms (intercompany)

or with independent firms (intercompany)

➢➢ Leading and lagging between related firms is more feasible because

they presumably share a common set of goals for the consolidated group

➢➢ In the case of financing cash flows with foreign subsidiaries, there is

an additional motivation for early or late payments to position funds for
liquidity reasons ➢➢ For example, a subsidiary which is allowed to lag
payments to the parent company is in reality “borrowing” from the parent
company

➢➢ Leading or lagging between independent firms requires the time

preference of one firm to be imposed to the detriment of the other firm

➢➢ For example, Trident Europe may wish to lead in collecting its

Brazilian accounts receivable (A/R) that are denominated in real because it
expects the real to drop in value compared with the euro

➢➢ However, the only way the Brazilians would be willing to pay their
accounts payable early would be for the German creditor to offer a discount
about equal to the forward discount on the real (or the difference between
Brazilian and German interest rates for the period of prepayment)

Transaction Exposure

TransactionExposureistheriskofgainsorlossesthatoccurswhenafirmeng
ages
incommercialtransactionsinwhichthecurrencyofthetransactionisforeigntoth
efirm;
i.e.,itisdenominatedinaforeigncurrency.Thisisthetypeofexchangerateriskthat
we have looked at the various ways of managing via futures, forward
contracts, options and money markethedges.
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Financial Techniques of Managing Transaction Exposure

We will briefly go over the standard financial methods available for

hedging this exposure. The main distinction between transaction exposure
and operating exposure is
theeasewithwhichonecanidentifythesizeofatransactionexposure.This,combin
edwith thefactthatithasawell-
definedtimeintervalassociatedwithitmakesitextremelysuitable for hedging
with financial instruments. Among the more standard methods for hedging
transaction exposureare:

i) ForwardContracts

When a firm has an agreement to pay (receive) a fixed amount of

foreign currency
atsomedateinthefuture,inmostcurrenciesitcanobtainacontracttodaythatspec
ifiesa
priceatwhichitcanbuy(sell)theforeigncurrencyatthespecifieddateinthefuture.
This
essentiallyconvertstheuncertainfuturehomecurrencyvalueofthisliability(asse
t)intoa
certainhomecurrencyvaluetobereceivedonthespecifieddate,independentofthe
change intheexchangerateovertheremaininglifeofthecontract.

ii) FuturesContracts

Theseareequivalenttoforwardcontractsinfunction,althoughtheydifferin
several
importantfeatures.Futurescontractsareexchangetradedandthereforehavesta
ndardized
andlimitedcontractsizes,maturitydates,initialcollateral,andseveralotherfeatu
res.Given that futures contracts are available in only certain sizes,
maturities and currencies, it is
generallynotpossibletogetanexactlyoffsettingpositiontototallyeliminatetheex
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posure.
Thefuturescontracts,unlikeforwardcontracts,aretradedonanexchangeandha
vealiquid
secondarymarketthatmakethemeasiertounwindorcloseoutincasethecontract
timing does not match the exposure timing. In addition, the exchange
requires position taker to
postsbond(margins)baseduponthevalueoftheirpositions.Thisvirtuallyelimina
testhe creditriskinvolvedintradinginfutures.
iii) Money MarketHedge

Also known as a synthetic forward contract, this method utilizes the

fact from covered interest parity, that the forward price must be exactly
equal to the current spot
exchangeratetimestheratioofthetwocurrencies’risklessreturns.Itcanalsobethou
ghtof
asaformoffinancingfortheforeigncurrencytransaction.Afirmthathasanagreem
entto
payforeigncurrencyataspecifieddateinthefuturecandeterminethepresentvalu
eofthe
foreigncurrencyobligationattheforeigncurrencylendingrateandconverttheapp
ropriate
amountofhomecurrencygiventhecurrentspotexchangerate.Thisconvertstheob
ligation
intoahomecurrencypayableandeliminatesallexchangerisk.Similarlyafirmthat
hasan
agreementtoreceiveforeigncurrencyataspecifieddateinthefuturecandetermine
the present value of the foreign currency receipt at the foreign currency
borrowing rate and borrow this amount of foreign currency and convert it
into home currency at the current spot exchange rate. Since as a pure
hedging need, this transaction replicates a forward,
exceptwithanadditionaltransaction,itwillusuallybedominatedbyaforward(orf
utures)
forsuchpurposes;however,ifthefirmneedstohedgeandalsoneedssomeshortter
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mdebt financing, wants to pay off some previously higher rate borrowing
early, or has the home
currencycashsittingaround,thisroutemaybemoreattractivethataforwardcontr
act.

iv) Options

Foreigncurrencyoptionsarecontractsthathaveanupfrontfee,andgivethe
owner the right, but not the obligation to trade domestic currency for
foreign currency (or vice versa) in a specified quantity at a specified price
over a specified time period. There are many different variations on options:
puts and calls, European style, American style, and future-
styleetc.Thekeydifferencebetweenanoptionandthethreehedgingtechniques
aboveisthatanoptionhasanonlinearpayoffprofile.Theyallowtheremovalofdown
side riskwithoutcuttingoffthebenefitformupsiderisk.

Therearedifferentkindsofoptionsdependingontheexercisetimethedeter
mination
ofthepayoffpriceorthepossibilityofapayoff.Whilemanydifferentvarietiesexist,t
here are a few that corporations have found useful for the purposes of
hedging transaction exposures.

Oneoftheseistheaveragerate(orAsianorLookback)option.Thisoptionhas
as
itspayoffprice,notthespotpricebuttheaveragespotpriceoverthelifeofthecontrac
t.
Thustheseoptionscanbeusefultoafirmthathasasteadystreamoninflowsoroutfl
owsin
aparticularcurrencyovertime.Onelargeaveragerateoptionwillbasicallyactasah
edge for the entire stream of transaction. Moreover, the firms will lock in an
averageexchange
rateovertheperiodnoworsethanthatofthestrikepriceofthisoption.Finally,becau
se
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theaveragerateislessvolatilethantheendofperiodrate(remembertheaveragesm
oothest volatility this option will be cheaper than equivalent standard
options. Thus the firms
obtainsinasingleinstrumenthedgingforastreamoftransactionsoreducestransa
ction costsplusbenefitsfromthe“hedging”overtimeoftheaveragingeffect.

Another popular exotic option for corporations is the basket rate

option. Rather than buy options on a bunch of currencies individually, the
firms can buy an option based
uponsomeweightedaverageofcurrenciesthatmatchitstransactionpattern.Here
again
sincecurrenciesarenotperfectlycorrelatedtheaverageexchangeratewillbelessv
olatile
andthisoptionwillthereforebelessexpensive.Therefirmcantakeadvantageofitso
wn naturaldiversificationofcurrencyriskandhedgeonlytheremainingrisk.

Transaction Hedging Under Uncertainty

Uncertaintyabouteitherthetimingortheexistenceofanexposuredoesnotp
rovide valid arguments againsthedging.

Uncertainty about Transaction Date:

Many corporate treasurers loath to commit themselves to the early

protection of foreign currency cash flow.

Oftenthereasonisthat,althoughtheyaresureaforeigncurrencytransactio
nwill
occur,theyareunsureasoftheexactdatethatthetransactionwilloccur.Thesefear
sarising from a possible mismatch of maturities of transaction and hedge
are unfounded. Through
themechanismofrollingorearlyunwinding,financialcontractsleaveopenthepos
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sibility of adjusting the maturity at a later date, when more precise

information is available. The
resultingriskbornefromthematuritymismatchisusuallyquitesmallrelativetoth
etotal
riskofleavingatransactionexposeduntilbetterinformationbecomesavailable.C
onsider the example of a French exporter who had been expecting to
receive, from a foreign purchaser, a payment of $1 million at a future date t.
Early on, he had hedged himself by selling forward the $1m at a forward
price of $1 = FF6.200. Come date t, he is informed that his foreign
customer will pay one month later at date t+1. Thus, at date tthe French
producermustrolloverhisforwardcontractonthebasisofthethenprevailingrates
:
Spot rate at t (FF/$): 5.9375 / 405

One-Month Franc Discount 74 / 100 (Outright Forward 5.9449 / 5.9505)

Uncertainty about Existence of Exposure:

Another form of uncertainty that arises regarding transaction

exposure is in
submittingbidswithpricesfixedinforeigncurrencyforfuturecontracts.Ifandwhe
nabid is accepted, the firm will either pay or receive foreign currency
denominated cash flows.
Thisisaspecialsourceofexchangerateriskasitisacontingenttransactionexposur
e.In
suchcases,anoptionisideallysuited.Asmentionedabove,thefirmisreallyinteres
tedin
insuranceagainstadverseexchangeratemovementsbetweenthetimethebidissu
bmitted and the time it may be accepted. Thus an option can be used to
protect the value of the
foreigncurrencycashflowsassociatedwiththebidagainstadversecurrencymove
ments.
Thecostoftheoption,whichcanbeincludedinthebid,protectsthevalueoftheexpe
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cted
cashflowsfromfallingbelowapredeterminedlevelandrepresentsthemostthefir
mcan
loseduetocurrencyrisk.Undersuchasituationtherearefourpossibleoutcomes:t
hebid iseitheracceptedorrejectedandtheoptioniseitherexercisedorlettoexpire.

Operational Techniques for Managing Transaction Exposure

Transaction exposures can also be managed by adopting operational

strategies that have the virtue of offsetting existing foreign currency
exposure. These techniques are especially important when well-functioning
forward and derivative market do not exist for the contracted foreign
currencies.

These strategies include:

i) Risk Shifting- The most obvious way to reduce the exposure is to not
have an exposure. By invoicing all transactions in the home currency a firm
can avoid
transactionexposurealltogether.However,thistechniquecannotworkforeveryo
ne since someone must bear transaction exposure for a foreign currency
transaction.
Generallythefirmthatwillbeartheriskistheonethatcandosoatthelowestcost.
Ofcourse,thedecisiononwhobearsthecurrencyriskmayalsoimpactthefinalpric
e atwhichthecontractisset.
ii) Currency risk sharing - An alternative to trying to avoid the
currency risk is to
havethetwopartiestothetransactionsharetherisk.Sinceshorttermstransaction
exposureisroughlyazerosumgame,oneparty’slossistheotherparty’sgain.Thus,
the contract may be written in such a way that any change in the exchange
rate from an agreed upon rate for the date for the transaction will be split
between the
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twoparties.ForexampleaU.S.firmAcontractstopayaforeignfirmBFC100in6
monthsbaseduponanagreedonspotrateforsixmonthsfromnowof
$1=FC10,thuscostingtheU.S.firm$10.However,underrisksharingtheU.S.firm
andtheforeignfirmagreetosharetheexchangerategainorlossfacedbytheU.S.fir
mby
adjustingtheFCpriceofthegoodaccordingly.Thus,iftheratein6monthsturnsoutt
obe
$1=FC12,thenratherthanonlycostingtheU.S.firm$100/12=$8.50,the$1.50ga
inover
theagreeduponrateissplitbetweenthefirmsresultingintheU.S.firmpaying$9.2
5and
theforeignfirmreceivingFC111.Alternativelyiftheexchangeratehadfallento$1=
FC8,
theninsteadofpaying$12.50forthegood,theexchangeratelosstotheU.S.firmiss
hared
anditonlypays$11.25andtheforeignfirmacceptsFC90.Notethatthisdoesnoteli
minate thetransactionexposure,itsimplysplitsit.

iii) LeadingandLagging-
Anotheroperatingstrategytoreducetransactiongainsand losses involves
playing with the timing of foreign currency cash flows. When the
foreigncurrencyinwhichanexistingnominalcontractisdenominatedisapprecia
t- ing,youwouldliketopayofftheliabilitiesearlyandtakethereceivableslater.The
former is known as leading and the latter is known as lagging. Of course
when an theforeign currency in which a nominal contract is denominated is
depreciating,
youwouldliketotakethereceivablesearlyandpayofftheliabilitieslater.

iv) ReinvoicingCenters-
Areinvoicingcenterisaseparatecorporatesubsidiarythat manages in one
location all transaction exposure from intra company trade. The
manufacturing affiliate sells the goods to the foreign distribution affiliates
only by
sellingtothereinvoicingcenter.Thereinvoicingcenterthensellsthegoodtothe
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foreign distribution affiliate. The importance of the re invoicing center is

that the transactions with each affiliate are carried out in the affiliates
localcurrency, and
thereinvoicingcenterabsorbsallthetransactionexposure.Threemainadvantage
s existtoreinvoicingcenters:thegainsassociatedwithcentralizedmanagementof
transactionexposuresfromwithincompanysales,theabilitytosetforeigncurrenc
y
pricesinadvancetoassistforeignaffiliatesbudgetingprocesses,andanimproved
abilitytomanageintraaffiliatecashflowsasallaffiliatessettletheirintracompany
accountsintheirlocalcurrency.Reinvoicingcentersareusuallyanoffshore(third
country)affiliateinordertoqualifyforlocalnonresidentstatusandgainfromthe
potentialtaxandcurrencymarketaccessbenefitsthatarisewiththatdistinction.

Information System for Exposure Management

Effective exposure management requires a well

designedmanagementinformation system (MIS). Exposure above a certain
minimum size must be immediately reported to the executive or
department responsible for exposure management. The three types of
exposure transactions, translation and operating must be clearly
separated. In the case of cash flow exposures, the report must state the
timing and amount of foreign currency
cashflows,whethereitherorbothareknownwithcertaintyor,ifuncertainthedegr
eeof uncertainty associated with the timing or amount. The exposure
management team must
evolveaprocedureofassessingtheriskassociatedwiththesesexposuresbyadopti
nga clearly articulated forecasting method scenario approach. The
benchmark for comparing
thealternativescenariosmustbeclearlystated.Asarguedabove,theappropriateb
enchmark forshorttermtransactionsexposuresistherelevantforwardrate.

If a discretionary hedging posture is to be adopted, stop less guidelines

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must be clearly articulated. These can take the form of specified levels of
forward rate or specified changes in the spot rate which when crossed would
automatically trigger appropriate hedging actions.

Allexposedpositionsincludingtheirhedgesifanyshouldbemonitoredatfre
quent intervalstoestimatemark-to-
marketvalueoftheentireportfolioconsistingoftheunderlying exposures and
their correspondinghedges.

When a particular exposure is extinguished, a performance

assessment must be carried out by comparing the actual all in rate
achieved with the benchmark. This should
bedoneatregularintervalswiththefrequencyofassessmentbeingdeterminedbyt
hesize
ofexposuresandtheirtimeprofiles.Periodicreviewsmustbecarriedouttoensuret
hatthe
riskscenariosbeingconsideredarenotfarremovedfaractualdevelopmentsinexc
hange ratesduetolargeforecastingerrors.

Effective management of operating exposures requires far more

information and judgmental inputs from operating managers. Pricing and
sourcing decisions must involve
theexchangeratedimensionanditslikelyimpactonfutureoperatingcashflows.As
trategic
reviewoftheentirebusinessmodelmustincorporaterealisticassessmentoftheim
pactof
exchangeratefluctuationsonthefirm’sentireoperationsinthemediumtolongter
m

Translation Exposure

Translation exposure is also referred to as accounting exposure or

balance sheet exposure. The restatement of foreign currency financial
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statements in terms of a reporting currency is termed translation. The

exposure arises from the periodic need to report consolidated worldwide
operations of a group in one reporting currency and to give some indication
of the financial position of that group at those times in that currency.

Translation exposure is measured at the time of translating foreign

financial statements for reporting purposes and indicates or exposes the
possibility that the foreign currency denominated financial statement
elements can change and give rise to further translation gains or losses,
depending on the movement that takes place in the currencies concerned
after the reporting date. Such translation gains and losses may well reverse
in future accounting periods but do not, in themselves, represent realized
cash flows unless, and until, the assets and liabilities are settled or
liquidated in whole or in part.

This type of exposure does not, therefore, require management action

unless there are particular covenants, e.g., regarding gearing profiles in a
loan agreement, that may be breached by the translated domestic currency
position, or if management believes that translation gains or losses will
materially affect the value of the business. International Accounting
Standards set out best practice.
Afirmwhichhassubsidiariesandassetsinanothercountryissubjecttotran
slation
exposure.Translationexposureresultsasaconsequenceofthefactthataparentco
mpany
mustconsolidatealloftheoperationsofitssubsidiariesintoitsownfinancialstate
ments.

Sinceaforeignsubsidiary’sassetsarecarried
onitsbooksinaforeigncurrency,it is necessary to convert the foreign values
into domestic currency for combining with the parent’sassets.

Fluctuatingexchangerates,resultsingainsandlossesoccurringduringthe
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translation
process.Sincethistypeofexposureisrelatedtobalancesheetassetsandliabilities,
itis oftenreferredtoasaccountingexposure.

Theprimaryissuerelatedtothetranslationofforeignassetvalueshastodow
ith
whethertheproperexchangeratetouseisthecurrentrateofexchangeorthehistori
crate
ofexchangethatexistedatthetimethatanassetwasacquired.Inordertoseethepos
sible gainsandlossesthatcanoccur,let’sconsiderthefollowing:

A U.S. company has a Mexican subsidiary that buys an asset for 12

million pesos in 20x1 when the exchange rate is 12 pesos per USD. Over
the following year, inflationin Mexico is 50% while in the U.S. it is 0%. Of
course, if purchasing power parity holds, then
theexchangerateinoneyearshouldbe18pesosperdollar.

Ifweusehistoricalcostaccounting,theassetwillhaveavalueof12millionpe
soson
theMexicansubsidiary’sbooks.Translatingthisatthecurrentexchangerateof18pe
sos/ USDyieldsaUSdollarvalueof

12,000,000 pesos
= = USD 666,667
18 pesos/USD

If we translate the historical cost of 12 million pesos at the historical

exchange rate at the time of acquisition of 12 pesos/USD we get a US dollar
value of

12,000,000 pesos
= = USD 1,000,000
12 pesos/USD
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Thus,thecorrectvaluewouldbetousethehistoricalexchangeratewhenthe
books arekeptonanhistoricalcostbasis.

Ontheotherhand,Mexicoisacountrythatutilizesaninflation-
adjusted(orcurrent) accounting system where assets are indexed for
inflation. Thus, the Mexicansubsidiary would carry the asset on the books
at 18 million pesos (12 million pesos * (1+50%) = 18 million pesos).
Translating this using the current exchange rate of 18 pesos/USD yields

18,000,000 pesos
= = USD 1,000,000
18 pesos/USD

If the historical exchange rate were used, we would obtain the following
value:

18,000,000 pesos
= = USD 1,500,000
12 pesos/USD

For the proper translation of value, we should either use the historic
exchange rate with historical cost accounting or the current exchange rate
with current accounting practices. For a foreign currency that has
depreciated, we get the following general results (an appreciating currency
would yield the opposite results)

In1981,FASB52settherulesforU.S.GAAPaccountinginwhichitstatedthat
all
assetandliabilityaccountsmustbetranslatedatthecurrentrateofexchange.Equi
tyaccounts
aretranslatedathistoricalratesofexchange.Aseparateaccount,”EquityAdjustm
entfrom Translation”, is used to reflect translation gains and losses. The
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only exception to this is

forassetsincountriesexperiencinghyperinflationwhichisdefinedascumulativei
nflation greaterthan100%overathree-
yearperiod.Inthatcase,historicalexchangeratesareallowed fornon-
monetaryitems(inventory/costofgoodssold,plant&equipment/depreciation).

In any event, translation exposure is not a real gain or loss in terms

of making or
losingmoney.Thevalueoftheassetisthevalueoftheasset.Thegainorlossresultss
imply from translating from one currency to another. In that sense, one
should not really worry
abouttranslationexposure(excepttotheextentthatthereisaperceivedgainorloss
from unsophisticatedusersofthefinancialstatements).

Thisisalsoreferredtoasconversionexposureorcashflowexposure.Itconce
rnsthe
actualcashflowsinvolvedinsettingtransactionsdenominatedinaforeigncurren
cy.These could include, forexample:

➢ Salesreceipts
➢ Payments for goods andservices
➢ Receipt and/or payment ofdividends
➢ Servicingloanarrangementsasregardsinterestandcapital

Theexistenceofanexposurealertsonetothefactthatanychangeincurrency
rates,
betweenthetimethetransactionisinitiatedandthetimeitissettled,willmostlikely
alter theoriginallyperceivedfinancialresultofthetransaction.

Itis,forexample,importanttocommencemonitoringtheexposurefromtheti
mea
foreigncurrencycommitmentbecomesapossibility,notmerelywhenanorderisini
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tiated or when delivery takesplace.

The financial or conversion gain or loss is the difference between the

actual cash
flowinthedomesticcurrencyandthecashflowascalculatedatthetimethetransac
tion
wasinitiated,i.e.,thedatewhenthetransactionclearlytransferredtherisksandre
wardsof
ownership.Wherefinancingofatransactiontakesplace,suchasaloanobligation,
thereare also gains/losses whichmay result.

Measurement of Translation Exposure

Translationexposuremeasurestheeffectofanexchangeratechangeonpub
lished financial statements of afirm.

➢ Assets&liabilitiesthataretranslatedatthecurrentexchangerateareconsi
dered
tobeexposed(uncovered)asthebalancesheetwillbeaffectedbyfluctuationsin
currency values overtime.

➢ Assets&liabilitiesthataretranslatedatahistoricalexchangeratewillbereg
ardedas notexposedastheywillnotbeaffectedbyexchangeratefluctuations.

➢ So,thedifferencebetweenexposedassets&exposedliabilitiesiscalledtran
slation exposure.

Translation Exposure = Exposed Assets- Exposed Liabilities (Change in

the Exchange Rate)

Under the generally accepted US accounting principles, the net

monetary asset position ofasubsidiaryisusedto
measureitsparent’sforeignexchangeexposure.The net monetary asset position
is monetary assets such as cash & accounts receivable minus monetary
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liabilities such as accounts payable & long-term debt.

Thetranslationofgains&lossesdoesnotinvolveactualcashflows–
thesegainsor lossesarepurelyonpaperi.e.theyareofanaccountingnature.
STEPS for Measuring Translation Exposure are:

1. Determine functionalcurrency.
2. Translate using temporal method recording gains/losses in the income
statement as realized
3. Translateusingcurrentmethodrecordinggains/lossesinthebalancesheet
&asrealized
4. Consolidateintoparentcompanyfinancialstatements.
5.

Economic Exposure

Economicexposureoroperationalexposuremovesoutsideoftheaccounting
context and has to do with the strategic evaluation of foreign transactions
and relationships. It
concernstheimplicationsofanychangesinfuturecashflowswhichmayariseonpa
rticular transactions of an enterprise because of changes in exchange rates,
or on its operating position within its chosen markets. Its determination
requires an understanding of the
structureofthemarketsinwhichanenterpriseanditscompetitorsobtaincapital,l
abour,
materials,servicesandcustomers.Identificationofthisexposurefocusesattenti
ononthat
componentofanenterprise’svaluethatisdependentonorvulnerabletofutureexcha
nge
ratemovements.Thishasbearingonacorporation’scommitment,competitiveness
and viabilityinitsinvolvementinbothforeignanddomesticmarkets.
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Thus, economic exposure refers to the possibility that the value of the
enterprise, defined as the net present value of future after tax cash flows, will
change when exchange rates change.

Economicexposurewillalmostcertainlybemanytimesmoresignificantth
aneither transaction or translation exposure for the long term well-being of
the enterprise. By its
verynature,itissubjectiveandvariable,dueinparttotheneedtoestimatefuturecas
hflows in foreign currencies. The enterprise needs to plan its strategy, and
to make operational decisions in the best way possible, to optimize its
position in anticipation of changes in economicconditions.

Identification of Exposure

The three types of exposure mentioned earlier require to be identified,

classified and collated in terms of the foreign currencies involved and their
related time frame. This is crucial for management reporting within an
enterprise. At no time should the enterprise lose sight of the overall position
in the process of managing any one particular type of exposure.

Operating Exposure

Operatingexposureisknownaseconomicexposure.Theextenttowhichth
evalue
ofthefirmchangeswhentheexchangeratechanges(valueismeasuredastheprese
ntvalue of expected future cashflows)

Suppose

PV = present value of the firm

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ΔPV = change in present value of the firm ΔS = change in exchange rate

If ΔPV/ΔS ≠ 0, then the firm is exposed to currency risk (i.e., operating

exposure)

Operatingexposurearisesbecausecurrencyfluctuationscanalterafirm’sfutu
re revenues and costs (i.e., its operating cash flows).

ManagingOperatingExposure

Long-term; Techniquesinvolve:
Marketing Management

A. MarketSelection

To examine which markets to sell products (strong currency market

vs. weak currency market).Sell in multiple markets to take advantage of
economies of scale and diversification of exchange rate risk.

(Example: Mexican peso devalued in December 1994. The sale of

Goodyear tires of Mexican plant plunged more than 20% (i.e., a drop of
3,500 tires per day) in Mexico.
TheplantchangeditssalestrategyquicklyandexportedtirestoU.S.,SouthAmeric
a,and Europe.)

B. PricingStrategy

Emphasize on market share or profit margin. Exporters will benefit

from a weak home currency and can either increase price or increase market
share.

C. ProductStrategy
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New products, product line decisions, and product innovation (through

R&D), VW sold very inexpensive vehicles in the early 1970s, but the
appreciation of the DM caused VW to keep lowering prices to maintain
market share. VW lost over $300 million in 1974. VW altered their strategy
to sell more expensive cars with higher quality. Successful R&D allows for
cost cutting, enhanced productivity, and product differentiation

Production Management

A. ProductSourcing:purchasecomponentsoverseas(outsourcecomponen
ts)

B. PlantLocation:shiftproductiontolowercostsites.Increaseproductionin
acountry with a weaker currency, and decrease production in a country
with a stronger
currency(e.g.,HondabuiltNorthAmericanfactoriesinresponsetostrongyen,but
laterHondaimportedthecarsfromJapanbecauseofaweakyen).
C. IncreaseProductivity:closeinefficientplants,highautomation

Financial Hedging

It involves the use of currency swaps, currency futures, currency

forwards, and currency options.

Proactive Management

Six of the most commonly employed proactive policies are

➢ Matching currency cashflows

➢ Risk-sharingagreements
➢ Back-to-backloans
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➢ Currencyswaps
➢ Leadsandlags(payearlyandpaylate)
➢ Re invoicingcenters

Matching Currency Cash Flows

➢ Onewaytooffsetananticipatedcontinuousexposuretoaparticularcurren
cyisto acquiredebtdenominatedinthatcurrency

➢ This policy results in a continuous receipt of payment and a

continuous outflow in the samecurrency

➢ Thiscansometimesoccurthroughtheconductofregularoperationsandisr
eferred to as a naturalhedge

Risk-Sharing Agreements

Risk-sharing is a contractual arrangement in which the buyer and

seller agree to share or split currency movement impacts on payments

Parallel Loan

A back-to-back loan, also referred to as a parallel loan or credit swap,

occurs when
twofirmsindifferentcountriesarrangetoborroweachother’scurrencyforaspecific
period oftime

➢ TheoperationisconductedoutsidetheFOREXmarkets,althoughspotrate
smaybe usedtodecidetheequivalentamount

➢ Thisswapcreatesacoveredhedgeagainstexchangeloss,sinceeachcompa
ny,onits ownbooks,borrowsthesamecurrencyitrepays
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Currency Swaps

➢ Currency swaps resemble back-to-back loans except that it does not

appear on a firm’sbalancesheet.

➢ Inacurrencyswap,adealerandafirmagreetoexchangeanequivalentamou
ntof twodifferentcurrenciesforaspecifiedperiodoftime

• Currency swaps can be negotiated for a wide range

ofmaturities

➢ A typical currency swap requires two firms to borrow funds in the

markets and currenciesinwhichtheyarebestknownorgetthebestrates

Leads and Lags: Re-Timing the Transfer of Funds

➢ Firms can reduce both operating and transaction exposure by

accelerating or decelerating the timing of payments that must be made or
received in foreign currencies
• To lead is to payearly
• To lag is to paylate

➢ Leading and lagging can be done between related firms

(intracompany) or with independent firms(intercompany)

➢ Leadingandlaggingbetweenrelatedfirmsismorefeasiblebecausetheypr
esumably shareacommonsetofgoalsfortheconsolidatedgroup

➢ In the case of financing cash flows with foreign subsidiaries, there is

an additional
motivationforearlyorlatepaymentstopositionfundsforliquidityreasons

➢ Forexample,asubsidiarywhichisallowedtolagpaymentstotheparentcom
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panyis inreality“borrowing”fromtheparentcompany

➢ Leadingorlaggingbetweenindependentfirmsrequiresthetimepreferen
ceofone firmtobeimposedtothedetrimentoftheotherfirm

➢ For example, Trident Europe may wish to lead in collecting its

Brazilian accounts
receivable(A/R)thataredenominatedinrealbecauseitexpectstherealtodropin
value compared with theeuro

➢ However,theonlywaytheBrazilianswouldbewillingtopaytheiraccountsp
ayable
earlywouldbefortheGermancreditortoofferadiscountaboutequaltotheforwar
d
discountonthereal(orthedifferencebetweenBrazilianandGermaninterestrates
for the period ofprepayment)

Re-Invoicing Centers

➢ A re-invoicing center is a separate corporate subsidiary that serves

as a type of “middle-man” between the parent or related unit in one location
and all foreign subsidiaries in a geographicregion
➢ Forexample,theU.S.manufacturingunitofTridentCorporationinvoicest
hefirm’s re-invoicingcenter–locatedwithinthecorporateHQinLosAngeles–
inU.S.dollars
➢ However,thephysicalgoodsareshippeddirectlytoTridentBrazil

➢ There-invoicingcenterinturnre-sellstoTridentBrazilinBrazilianreal

➢ Consequently,alloperatingunitsdealonlyintheirowncurrency,andalltra
nsaction exposurelieswiththere-invoicingcenter

There are three basic benefits arising from the creation of a re-invoicing
center:
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➢ Manageforeignexchangeexposures(specialization;economiesofscale)
➢ Guaranteetheexchangerateforfutureorders(marketingfocus)
➢ Manageintra-subsidiarycashflows(hedgeresidualcashflows)

The main disadvantage: an additional corporate unit must be created

(setup cost) and a separate set of books must be kept.

Management of Currency Risk

Managers of multinational firms employ a number of foreign exchange

hedging strategies in order to protect against exchange rate risk. Transaction
exposure is often managed either with the use of the money markets, foreign
exchange derivatives such as forward contracts, futures contracts, options,
and swaps, or with operational techniques such as currency invoicing,
leading and lagging of receipts and payments, and exposure netting.

Firms may exercise alternative strategies to financial hedging for

managing their economic or operating exposure, by carefullyselecting
production sites with a mind forlowering costs, using a policy of flexible
sourcing in its supply chain management, diversifying its export market
across a greater number of countries, or by implementing strong research
and development activities and differentiating its products in pursuit of
greaterinelasticityandlessforeignexchangeriskexposure.

Translation exposure is largely dependent on the accounting

standards of the home country and the translation methods required by
those standards. For example, the United States Federal Accounting
Standards Board specifies when and where to use
certainmethodssuchasthetemporalmethodandcurrentratemethod.Firmscan
manage
translationexposurebyperformingabalancesheethedge.Sincetranslationexpo
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surearises from discrepancies between net assets and net liabilities on a

balance sheet solely from
exchangeratedifferences.Followingthislogic,afirmcouldacquireanappropriate
amount
ofexposedassetsorliabilitiestobalanceanyoutstandingdiscrepancy.Foreignexc
hange derivativesmayalsobeusedtohedgeagainsttranslationexposure.

Value at Risk:

Practitionershaveadvancedandregulatorshaveacceptedafinancialriskm
anagement
techniquecalledvalueatrisk(VAR),whichexaminesthetailendofadistributionofr
eturns for changes in exchange rates to highlight the outcomes with the
worst returns. Banks in Europe have been authorized by the Bank for
International Settlements to employ VAR models of their own design in
establishing capital requirements for given levels of market
risk.UsingtheVARmodelhelpsriskmanagersdeterminetheamountthatcouldbel
oston
aninvestmentportfoliooveracertainperiodoftimewithagivenprobabilityofchang
esin exchangerates.

International Project Appraisal: Project Appraisal in the International Context-

Multinational Capital Budgeting.International Project Appraisal Methods: NPV and APV
framework- International joint ventures, Project financing and International venture capital,
International tax management.

International Project Appraisal: Project Appraisal in theInternational

Context- Multinational Capital Budgeting.International Project Appraisal
Methods: NPV and APVframework- International joint ventures, Project
financingand International venture capital, International taxmanagement.
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The fundamental goal of the financial manager is shareholder wealth

maximization. Shareholder wealth is created when the firm makes an
investment that will return more in a present value sense than the
investment costs. Perhaps the most important decisions that confront the
financial manager are which capital projects to select. By their very nature,
capital projects denote investment in capital assets that make up the
productive capacity of the firm. These investments, which are typically
expensive relative to the firm’s overall value, will determine how efficiently
the firm will produce the product it intends to sell, and thus will also
determine how profitable the firm will be. In total, these decisions determine
the competitive position of the firm in the product marketplace and the firm’s
long-run survival. Consequently, a valid framework for analysis is important.
The generally accepted methodology in modern finance is to use the net
present value (NPV) discounted cash flow model.

Multinational capital budgeting, like traditional capital budgeting, focuses on

cash inflows and outflows associated with long-term investments.
Multinational capital budgeting techniques are used in foreign direct
investment analysis.

Basic steps of multinational capital budgeting are:

1. Identify the capital put at risk.

2. Estimate the future cash flows generated by the project.

3. Identify the appropriate discount rate.

4. Apply traditional capital budgeting decision criteria such as NPV and IRR
to determine the acceptability or ranking of potential projects.
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Complexities of Budgeting for a Foreign Project • Parent cash flows must be

distinguished from project cash flows. • Parent cash flows often depend on
the form of financing which means that financing cash flows cannot be
clearly separated. • Additional cash flows from a new subsidiary may reduce
the cash flows from another subsidiary. • Nonfinancial payments such as
license fee and import payments can generate cash flows from subsidiaries.

Differing rates of national inflation have to be anticipated. • The possibility of

unanticipated changes in foreign exchange rates must be kept in mind. •
Political risk must be evaluated. • Terminal value may be hard to estimate
because potential buyers may have different views about the value of the
company’s cash flows.

Strong arguments exist in favour of analyzing any foreign project from the
viewpoint of the parent. Since most of the project’s cash flows to the parent
are financing cash flows, this violates the capital budgeting concept that
financing cash flows should not be mixed with operating cash flows.

Illustrative Case: Cemex Enters Indonesia In early 1998,

CementosMexicanos, Cemex, is considering the construction of a cement
manufacturing facility on the Indonesian island of Sumatra. The project,
Semen Indonesia, would be a wholly owned greenfield investment with a
total installed capacity of 20 million metric tonnes per year (mmt/y).

Three driving reasons for this project: 1. Initiate a productive presence in

Southeast Asia. 2. Favorable long-term prospects for Asian infrastructure
development and growth. 3. Positive prospects for producing and exporting
from Indonesia due to the depreciation of the Indonesian rupiah (Rp) in 1997
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Illustrative Case: Cemex Enters Indonesia Cemex considers the U.S. dollar to
be its functional currency. To evaluate the project, one needs to 1. construct
a set of pro forma financial statements for Semen Indonesia (in Indonesian
rupiah), 2. create two capital budgets, one from the project viewpoint and
one from the parent viewpoint.

Project appraisal basically involves answering the question : whether or not

to put the money in the project?

At a common sense level it means comparing return on investment with the

cost of the funds. Only if the return is higher than the cost of funds, it would
make sense to put the money in a project. This presumes, of course, that the
purpose and rationale for undertaking a project is to generate a surplus. A
literature survey on the motivation factors for undertaking FDI may highlight
diverse strategic. behavioral and economic factors viz. follow the leader,
bandwagon effect. market seekers, follow the customers, raw material
seekers, efficiency seekers. cutting cost, that is. taking advantage of lower
labour or input cost in other countries. pre-emption of competition,
international diversification. However, to the extent that maximization of
share holders wealth is a ' consensus objective of business, in financial
terms. project appraisal means assessing the possibilities of generating a
financial return higher than the cost of funds.

A Project is normally a long-term infrastructure, industrial or public services

scheme, development or undertaking having:

 large size.
 Intensive capital requirement – Capital Intensive.
 finite and long Life.
 few diversification opportunities i.e. assets specific.
 Stand alone entity.
 high operating margins.
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 Significant free cash flows.

Such projects are usually government regulated and monitored which are
allowed to an entity on B.O.O or B.O.T basis.

Project types

 Motorway and expressway.

 Metro, subway and other mass transit systems.
 Dams.
 Railway network and service – both passenger and cargo.
 Power plants and other charged utilities.
 Port and terminals.
 Airports and terminals.
 Mines and natural resource explorations.
 Large new industrial undertakings – [no expansion and extensions.
 Large residential and commercial buildings.

International Project Finance Association (IPFA) defined project financing as:

“The financing of long-term infrastructure, industrial projects and public

services based upon a non-recourse or limited recourse financial structure
where project debt and equity used to finance the project are paid back from
the cash flows generated by the project.”

Project finance is especially attractive to the private sector because they can
fund major projects off balance sheet.

The key characteristics of project financing are:

 Financing of long term infrastructure and/or industrial projects using debt

and equity.
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 Debt is typically repaid using cash flows generated from the operations of
the project.
 Limited recourse to project sponsors.
 Debt is typically secured by project’s assets, including revenue producing
contracts.
 First priority on project cash flows is given to the Lender.
 Consent of the Lender is required to disburse any surplus cash flows
to project sponsors
 Higher risk projects may require the surety/guarantees of the project
sponsors.
Pros

 Eliminate or reduce the lender’s recourse to the sponsors.

 Permit an off-balance sheet treatment of the debt financing.
 Maximize the leverage of a project.
 Avoid any restrictions or covenants binding the sponsors under their
respective financial obligations.
 Avoid any negative impact of a project on the credit standing of the
sponsors.
 Obtain better financial conditions when the credit risk of the project is
better than the credit standing of the sponsors.
 Allow the lenders to appraise the project on a segregated and stand-alone
basis.
 Obtain a better tax treatment for the benefit of the project, the sponsors or
both.
Cons

 Often takes longer to structure than equivalent size corporate finance.

 Higher transaction costs due to creation of an independent entity. Can be
up to 60bp
 Project debt is substantially more expensive (50-400 basis points) due to its
non-recourse nature.
 Extensive contracting restricts managerial decision making.
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 Project finance requires greater disclosure of proprietary information and

strategic deals.

Stages in Project Financing.

 Project identification
 Risk identification & minimizing Pre Financing Stage
 Technical and financial feasibility
 Equity arrangement
 Negotiation and syndication Financing Stage
 Commitments and documentation
 Disbursement.
 Monitoring and review
 Financial Closure / Project Closure Post Financing Stage
 Repayments & Subsequent monitoring.

Project finance chart for reference:

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What is Venture Capital?

It is a private or institutional investment made into early-stage / start-up

companies (new ventures). As defined, ventures involve risk (having
uncertain outcome) in the expectation of a sizeable gain. Venture Capital is
money invested in businesses that are small; or exist only as an initiative,
but have huge potential to grow. The people who invest this money are called
venture capitalists (VCs). The venture capital investment is made when a
venture capitalist buys shares of such a company and becomes a financial
partner in the business.
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Venture Capital investment is also referred to risk capital or patient risk

capital, as it includes the risk of losing the money if the venture doesn’t
succeed and takes medium to long term period for the investments to
fructify.

Venture Capital typically comes from institutional investors and high net
worth individuals and is pooled together by dedicated investment firms.

It is the money provided by an outside investor to finance a new, growing, or

troubled business. The venture capitalist provides the funding knowing that
there’s a significant risk associated with the company’s future profits and
cash flow. Capital is invested in exchange for an equity stake in the business
rather than given as a loan.

Venture Capital is the most suitable option for funding a costly capital
source for companies and most for businesses having large up-front capital
requirements which have no other cheap alternatives. Software and other
intellectual property are generally the most common cases whose value is
unproven. That is why; Venture capital funding is most widespread in the
fast-growing technology and biotechnology fields.

Features of Venture Capital investments

 High Risk
 Lack of Liquidity
 Long term horizon
 Equity participation and capital gains
 Venture capital investments are made in innovative projects
 Suppliers of venture capital participate in the management of the company
Methods of Venture capital financing

 Equity
 participating debentures
 conditional loan
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THE FUNDING PROCESS: Approaching a Venture Capital for funding as a

Company

The venture capital funding process typically involves four phases in the
company’s development:

 Idea generation
 Start-up
 Ramp up
 Exit
Step 1: Idea generation and submission of the Business Plan

The initial step in approaching a Venture Capital is to submit a business

plan. The plan should include the below points:

 There should be an executive summary of the business proposal

 Description of the opportunity and the market potential and size
 Review on the existing and expected competitive scenario
 Detailed financial projections
 Details of the management of the company
There is detailed analysis done of the submitted plan, by the Venture Capital
to decide whether to take up the project or no.

Step 2: Introductory Meeting

Once the preliminary study is done by the VC and they find the project as
per their preferences, there is a one-to-one meeting that is called for
discussing the project in detail. After the meeting the VC finally decides
whether or not to move forward to the due diligence stage of the process.

Step 3: Due Diligence

The due diligence phase varies depending upon the nature of the business
proposal. This process involves solving of queries related to customer
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references, product and business strategy evaluations, management

interviews, and other such exchanges of information during this time period.

Step 4: Term Sheets and Funding

If the due diligence phase is satisfactory, the VC offers a term sheet, which is
a non-binding document explaining the basic terms and conditions of the
investment agreement. The term sheet is generally negotiable and must be
agreed upon by all parties, after which on completion of legal documents and
legal due diligence, funds are made available.

Types of Venture Capital funding

The various types of venture capital are classified as per their applications at
various stages of a business. The three principal types of venture capital are
early stage financing, expansion financing and acquisition/buyout financing.

The venture capital funding procedure gets complete in six stages of

financing corresponding to the periods of a company’s development

 Seed money: Low level financing for proving and fructifying a new idea
 Start-up: New firms needing funds for expenses related with marketingand
product development
 First-Round: Manufacturing and early sales funding
 Second-Round: Operational capital given for early stage companies which are
selling products, but not returning a profit
 Third-Round: Also known as Mezzanine financing, this is the money for
expanding a newly beneficial company
 Fourth-Round: Also calledbridge financing, 4th round is proposed for
financing the "going public" process

The location of a business and structuring of a company’s activities to take

advantage of low tax opportunities, with the aim of optimizing taxes, is called
tax planning. It is both a tax reduction and tax avoidance mechanism. The
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objective of tax planning is to reduce (rather than minimize) a group’s tax

burden and its effective tax rate.

MNCs use a variety of tax planning strategies to bring down the group’s
tax burden, some of which are briefly described below:

Strategy # 1. Income Shifting:

It is a tax planning strategy in which income from high tax countries is

shifted to low tax countries through transfer pricing of goods and
intangibles. It can result in a steep loss of tax revenues for the high-tax
country. Conversely, current tax payable is reduced by moving the amount of
tax paid to future periods.

Strategy # 2. High Leverage:

Since interest is a tax-deductible expense, high leverage of an MNC affiliate

in a high tax jurisdiction is a tax planning strategy. Intra-group loans are a
tax planning strategy—an MNC affiliate in a tax haven gives a loan to an
affiliate in a high tax jurisdiction and the parent MNC may borrow money
and use this to ‘inject’ equity into the affiliate in the tax haven. It then makes
this affiliate lend the money to an affiliate in a high-tax country. Such inter-
company debt by tax haven affiliates is permitted by Japan.

Strategy # 3. Creation:

It is a tax planning strategy in which companies operating from a high-tax

country relocate to a low-tax jurisdiction, so as to reduce the effective tax
rate. Companies opt to change their primary establishment from one country
to another so as to take advantage of the lower and more favourable tax
regime.

Tax driven relocations can become disputes that require a court judgment. If
a company located in a country that levies capital gains tax, shifts its
primary establishment to another country that does not levy capital gains
tax, the company becomes a non-resident and avoids capital gains tax.
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Strategy # 4. Use of Tax Havens:

As a tax strategy, it is so widespread that MNC income earned from tax

havens is out of proportion to the tax havens’ levels of economic activity. So
rampant is this practice that given their small size (Mauritius, Netherlands
Antilles, and the Cayman Islands), tax havens account for a significant share
of the world’s FDI. Portfolio investment is routed into a country through a
tax haven with which the tax haven has signed a double taxation avoidance
agreement.

Mauritius is the preferred tax haven through which foreign portfolio

investment comes into Indian capital markets. Mauritius has no withholding
tax. The tax year is from July 1 to June 30. The domestic corporate tax rate
applies to offshore entities, which is of two types. Global Business Company
Category 1 is treated as a resident.

If it has a Tax Residency certificate, it enjoys the benefits of DTAAs signed by

Mauritius with other countries. Global Business Company Category 2 is
treated as a non-resident. It can have a minimum share capital of 1 share. It
does not enjoy the benefits of Mauritius’ DTAAs. It need not file annual tax
returns, and can maintain confidentiality through nominee Directors.

There are around 40 tax havens around the world. They are usually small,
rich countries (often islands) with small populations, not many natural
resources and good telecommunication links. The popular perception is that
they are used by persons to stash wealth acquired through tax evasion.
Because tax havens reduce tax revenues in high-tax countries, the OECD
published a list of tax havens, and encouraged them to improve their
information sharing with other countries.

Strategy # 5. Tax Deferral:

It is a tax planning strategy, under which an MNC affiliate does not

repatriate the parent company’s share of income (dividend, or interest). As a
result, the parent company avoids paying tax in its country, and the affiliate
avoids paying withholding taxes in its country.
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Illustration:

An MNC affiliate in India pays a dividend of Rs. 1,000,000 to the UK parent

company. The withholding tax is 20%. Tax rate in the UK is 30%. Calculate
the tax savings if dividend is not repatriated.

Solution:

Withholding tax paid by the affiliate = 20% of Rs. 1,000,000 = Rs. 200,000

Dividend payable less withholding tax = Rs. 1,000,000 – Rs. 200000 = Rs.
800,000

Tax on repatriated dividend paid by the parent company = 30% of Rs.

800,000 = Rs. 240,000

Total tax paid = Rs. 200,000 + Rs. 240,000 = Rs. 440,000. This is the tax
saved if dividends are not repatriated by the Indian affiliate.

Strategy # 6. Shell Corporation:

Establishing a shell corporation overseas is a tax planning strategy. A shell

corporation (also known as an international business corporation) has no
independent assets or operations of its own, and has existence only on
paper. Though it has its own bank account, and an address, it has very little
capital (a nominal amount as low as $1).

It does not reveal its Board of Directors, and it is very difficult to establish
the true owners, since the corporation’s shares are not listed or traded on
any stock exchange. It is usually set up in a country with strong secrecy
laws, and it is difficult to determine the origin of money received into its
bank account. One shell corporation may own another shell corporation,
which may own shares in a company operating in another country.

Such a string of shell corporations makes tracing of ownership extremely

difficult. Though it is not illegal to set up a shell corporation, it is viewed
with suspicion by tax authorities across the world, since it may be used as a
mechanism to evade taxes. Enron, an American energy trading company that
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collapsed, set up hundreds of shell corporations overseas, and used them to

hide the debt it had on its books.

Strategy # 7. Regulatory Arbitrage:

It is a tax planning strategy that exploits differences in regulations between

countries. If two countries have different treatments of an overseas branch
with a resultant difference in tax status, there is scope for tax reduction. The
MNC may set up a branch overseas, which is regarded as an offshore
unincorporated ‘branch’ according to its home country tax rules, but is
considered as an offshore incorporated entity, in the host country.

Similarly, if two countries have divergent views on the tax status of hybrid
securities, the MNC may issue hybrid financial instruments (with features of
equity and of debt) that are purchased by the affiliate. The hybrid
instruments are treated as equity by the tax authorities of the MNC’s parent
country, but are treated as debt instruments by tax authorities of the
affiliate’s country.

Strategy # 8. International Holding Company:

A holding company is an independent division, or a regional headquarters.

Setting up an international holding company is a tax planning strategy. It is
set up in a low tax jurisdiction and can save an MNC millions in taxes. A
‘pure’ holding company is one which has no operating activities or operating
income. Its main purpose is to hold a ‘long-term interest’ in one or more
independent companies. A Euro-holding company is a holding company set
up in the EU by a US parent company, and liaises with EU subsidiaries of
the US parent company.

Strategy # 9. Corporate Inversion:

It is a tax planning strategy in which there is an exchange of corporate

identities. The corporate structure is inverted so that the subsidiary becomes
the parent company, and the parent company becomes the subsidiary. This
mechanism, called ‘expatriation’, is used by American companies that want
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to avoid paying tax in the USA on their foreign incomes. How does it occur?
The worldwide approach of taxation is used in USA. The US parent company
chooses a subsidiary in a country which uses the territorial approach to
taxation.

This subsidiary is made a parent, and the parent US company becomes the
subsidiary. How can this be accomplished? The parent US company may set
up a foreign shell corporation in a tax haven such as the Cayman Islands.
The shell company issues its shares to the shareholders of the parent
company, in exchange for the shares of the parent company from these
shareholders. Alternatively, the shell company issues its shares to the parent
company in exchange for the parent company’s assets.

Strategy # 10. Conversion of Income:

It is a tax planning strategy, since not all sources of income are taxed at the
same rate—the tax rate on dividend may be different from that on capital
gains or interest income; withholding tax may be levied on dividend income
but not on interest income.