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INTERNATIONAL FINANCEIAME – International Academy of
Management & Entrepreneurship
Shashank BP
Module 05
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Assignment 4
•
Discuss “Long and Short Position with respectto Derivatives”.
• Team 01 - Akash, Ram Naveen, Vandana,
Saddam
• Team 02 - Kavya, Sharath, Shupriya, Sneha,
Snehitha
•
Team 03 - Vaishali, Manohar, Sasikumar,Rashmi
• Team 04 - Valentine, Pinky, Surendra,
Pushpamani2
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Assignment 4
•
Each group should come up with one exampleof “Long and Short Position w.r.t. Derivatives”.
• Example should be related clearly to
derivatives.
• PowerPoint presentation or White Board
presentation in class on 26 August 2015.
•
Each group presentation should be completedin less than 5 minutes.
• No two groups should present the same
example, else they both will be downgraded.3
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Long Position
• When a trader is “long”, he/she wins when theprice increases, and loses when the pricedecreases.
• When a trader buys an option contract thathe/she is not short, he/she is said to beopening a long position.
•
When a trader sells an option contract thathe/she is already long, he/she is said to beclosing a long position.
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Short Position
• When a trader is “short”, he/she wins whenthe price decreases, and loses when the priceincreases.
• When a trader sells an option contract thathe/she is not long, he/she is said to beopening a short position.
•
When a trader buys an option contract thathe/she is already short, he/she is said to beclosing a short position.
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Cost of Capital for Foreign
Investment• Concepts to know:
Deregulation of international financial
markets
Liberalization of cash flows Optimal capital structure and capital cost
How is optimal capital structure achieved
by MNCs? MNCs and their cost of capital advantage
due to size and economies of scale (large
scale operations)
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Cost of Capital for Foreign
Investment• Concepts to know:
Practical framework of capital structure in
MNCs
Pecking order finance: No specialattention to theories
Empirical evidence on capital structures
and MNC preferences of mix
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Cost of Capital for Foreign
Investment• With the developing countries liberalizing
their economies, MNCs have got more
opportunities to invest in those countries.
• Each country has different economiccharacteristics and business environment.
• Each country has different sectors which are
liberalized.• One country may at one particular time treat
a particular sector as priority and provide
incentives for investment in that sector.
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Cost of Capital for Foreign
Investment• India at this point of time gives top
preference to infrastructure sector.
• MNCs might get much higher rate of return in
such sector investments.• The first step for MNCs is to determine the
capital mix and cost of capital.
•
Capital mix could have debt, equity and othersources.
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Cost of Capital for Foreign
Investment• Depending on prevailing conditions, higher
debt than equity may bring down the cost of
capital in certain cases. In other cases, it may
be vice versa.• A single rate of return cannot be used by
MNCs for all their projects in various countries.
• The determination of cost of capital ininternational finance is a complex issue.
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Cost of Capital for Foreign
Investment• MNCs have advantages/disadvantages
because of their characteristics, that
differentiate them from large domestic firms,
like: Size of the firm
Foreign exchange risk
Access to international capital market International diversification
Political risk
Country risk
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Cost of Capital for Foreign
Investment• Size of the firm: MNCs are large, and have
economies of large scale negotiation. They also
have possibilities of reducing the various
transaction costs and brokerage expenses.They get preferential treatment from credit
agencies.
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Cost of Capital for Foreign
Investment• Foreign exchange risk: A firm more exposed
to the foreign exchange rate fluctuations
would have wider spread of possible cash
flows in future periods.• Exposure to exchange rate fluctuations could
lead to higher cost of capital.
•
At times, fluctuations also give advantage tothe MNCs, when currency depreciation takes
place.
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Cost of Capital for Foreign
Investment• Access to international capital market: Thiscould result in the subsidiary getting local
funds at lower rate than parent company.
• International diversification: This gives MNCslower cost of capital because they get cash
flows from various businesses & countries.
•
Note that diversification gives stability to thecash flow. Diversification also lowers
systematic (market related) risk, lowers beta
coefficient and thus lowers the cost of equity.
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Cost of Capital for Foreign
Investment• Political risk: Political risk is likely to begreater in the later years of a project because
of the length of time. This increases the cost of
capital because of an arbitrary risk premium.• Country risk: This is unique due to the
adverse impact of a country’s environment.
There are serious risks like bankruptcy of acountry, evacuation of foreigners and foreign
firms etc. For example, in Cuba in 1959, there
was mass scale expropriation of US firms.
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Cost of Capital for Foreign
Investment• Risk free rate, tax laws, demographics,
monetary policy and economic conditions vary
from country to country. Due to these factors,
risk premium on debt also varies.• Capital structure decisions (whether to use
more debt or more equity capital) for
subsidiaries ultimately are dependent on thecorporate culture and circumstances such as
stable cash flows, low credit risk etc.
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Cost of Capital for Foreign
Investment• Empirical studies of various MNCs reveal that
the parent company never wants a subsidiary
to be a defaulter, and so they adapt a practical
framework of capital structure, independent ofall theories. This policy is called “Pecking Order
of Financing”.
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Cost of Capital for Foreign
Investment• Empirical studies reveal that MNCs go in forlocal debt or equity issues as a last resort. They
prefer own generated funds (retentions).
• Empirical studies also show that MNC firms
are often thought to be reluctant to explicitly
guarantee the debt of their subsidiaries. They
rather leave subsidiaries to their merit.
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Cost of Capital for Foreign
Investment• The foreign creditors, investors andshareholders of MNCs prefer “global” target
capital structure rather than “local” capital
structure because they would have betterunderstanding and control over financial
operations at the macro level than at the micro
level.
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Case Study: Pharma Firms
Company Year 1 Year 2 Year 3 Year 4
Glaxo India 0.433 0.894 0.336 0.346
Glaxo Wellcome 2.860 2.670 2.140 1.680
Smithkline Beecham India 0 0 0 0
Smithkline Beecham UK 0.441 0.408 0.386 0.269
Novartis India 0.385 0.116 0.099 0.045
Novartis AG, Switzerland 0.460 0.460 0.410 0.280
Pfizer, India 0.143 0.265 0.019 0.112
Pfizer, US 0.075 0.091 0.077 0.089
Debt – Equity Trend of Parent Companies and
Indian Subsidiaries
Comment on the capital structure practices of
the four companies.
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Case Study (Contd.): Pharma Firms
•
Glaxo Wellcome uses debt significantlyinternationally, but rather conservatively in
Glaxo India.
• Smithkline Beecham takes no debt in India
and is an extreme case. It uses only retentions
from Smithkline Beecham UK.
• Novartis does not believe much in borrowing
either in the parent or in India. So is the casewith Pfizer.
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Case Study (Contd.): Pharma Firms
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It can thus be concluded that theseinternational pharmaceutical firms run on
retained earnings than on borrowings,
especially in subsidiaries.
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To compute the WACC for a multinational firm
with a foreign project, the following formula is
used:
Ko = (1-L)Ke + LKd(1-t)
Ko = Weighted Average Cost of Capital for themultinational parent and the project
L = Parent’s debt ratio (or debt to assets ratio) -
interpreted as the proportion of a company’sassets that are financed by debt.
Ke = Cost of equity capital
Kd(1-t) = After tax cost of debt
WACC formula for MNCs
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The WACC Ko is used as the discount rate in
evaluating the specific foreign investment. Note
that Ke is the required return on the firm’s stock
at the particular debt ratio selected.
Both project risk and project financial structure
can vary from the corporate norm because of the
project’s different debt capacity. In such a case,the project’s WACC will be:
Ko’ = (1-L’)Ke’ + L’Kd’(1-t)
WACC formula for MNCs
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Ko’ = WACC of the foreign project
L’ = Debt ratio of the foreign project
Ke’ = Cost of equity capital of the foreign project
Kd’ = Cost of debt of the foreign project
WACC formula for MNCs
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Cost of Capital Example• Lexon PLC, a successful UK-based MNC, is
considering how to obtain funding for a
project in Argentina during the next year. It
considers the following information:
– UK risk free rate = 6%
– Argentine risk free rate = 10%
– Risk premium on Pound debt by UK
creditors = 3%
– Risk premium on Peso debt by Argentine
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Cost of Capital Example
–
Beta of Project = 1.5 – Expected UK market return = 14%
– UK corporate tax rate = 30%
– Argentine corporate tax rate = 30% – Creditors will allow maximum of 50% debt
• Calculate Cost of Capital of each
component for Lexon PLC.
(Contd..)
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Cost of Capital Example
Answer:• Cost of Pound denominated debt in UK
= (Rf + Rp)(1 – T) where Rf = Risk free rate, Rp =
Risk premium, T is the Tax rate.= (6% + 3%)(1 – 0.3) = 6.3%
• Cost of Peso denominated debt in Argentina
= (10% + 5%)(1 – 0.3) = 10.5%
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Cost of Capital Example
Answer (Contd.):• Cost of Pound denominated Equity
= Rf + Beta(Rm – Rf) where Rf = Risk free rate,
Beta is market sensitivity, Rm = Market return= 6% + [1.5 * (14% - 6%)] = 18%
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Cost of Capital Example
• Now, you are expected to calculate the WACC
for Lexon PLC for 4 different scenarios as
follows:
– 30% UK debt, 70% UK equity
– 50% UK debt, 50% UK equity
– 20% UK debt, 30% Argentine debt, 50% UK
equity
– 50% Argentine debt, 50% UK equity
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Cost of Capital Example:
WACC Formula
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Where:
Re = cost of equity; Rd = cost of debtE = market value of the firm’s equity
D = market value of the firm’s debt
V = E + D = total market value of the firm’s financing
(equity and debt)
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate
Cost of Capital Example:
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Cost of Capital Example:
WACC Calculation
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• 30% UK debt, 70% UK equity
WACC = (30% * 6.3%) + (70% * 18%) = 14.49%
• 50% UK debt, 50% UK equity
WACC = (50% * 6.3%) + (50% * 18%) = 12.15%• 20% UK debt, 30% Argentine debt, 50% UK
equity
WACC = (20% * 6.3%) + (30%* 10.5%) + (50% *18%) = 1.26% + 3.15% + 9% = 13.41%
• 50% Argentine debt, 50% UK equity
WACC = (50% * 10.5%) + (50% * 18%) = 14.25%
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Cost of Capital Example: Risk Premium
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• Lexon estimated WACC at 12.15% if 50% UKdebt & 50% UK equity.
• But Argentine project is exposed to Exchange
Rate Risk.• Lexon decides to add Risk Premium of 6%
points to the estimated WACC.
• Thus, the required rate of return would be12.15% + 6% = 18.15%.
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Cost of Capital Example: NPV
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•
Lexon PLC worked out the NPV for 2 of the 4scenarios:
• 50% UK debt, 50% UK equity
WACC = 12.15%
NPV = -£1.42 millions
• 50% Argentine debt, 50% UK equity
WACC = 14.25%
NPV = £1.26 millions
• 50% Argentine debt, 50% UK equity has higherWACC but positive NPV!!
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Cost of Debt Example• How is the cost of debt computed in
international finance?
This can be explained using an example. Consider
Embraer, the Brazilian aerospace company. To
estimate Embraer’s cost of debt, we firstestimate a synthetic rating for the firm. Based
upon its operating income of $810 million and
interest expenses of $28 million in year 2000, wearrive at an interest coverage of 28.93, and thus
an AAA rating. The default spread for AAA rated
bonds is only 0.75%.
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Cost of Debt Example
Now, Embraer is a Brazilian firm. The Brazilian
government bond traded at a spread of 5.37%,
and so it could be argued that every Brazilian
company should pay this premium, in addition to
its own default spread. With this reasoning thepretax cost of debt for Embraer in US$ (assuming
a treasury bond rate of 5%) can be calculated as
follows:
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Cost of Debt Example
Cost of Debt = Risk Free rate + Default spread for
country + Default spread for firm
= 5% + 5.37% + 0.75% = 11.12%
Now, using a marginal tax rate of 33%, we can
estimate the after-tax cost of debt for Embraer:After-tax Cost of Debt
= Pre tax cost of debt * (1 – Tax rate)
= 11.12% * (1 – 0.33) = 7.45%Hence, the after-tax cost of debt for Embraer is
7.45%.
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Managing Political Risk
• Concepts to know:
Types of Political Risk
Techniques to assess political risk /
indicators of political risk
How MNCs can manage political risk Case Study: Discuss the steps taken to
attract FDI by the present Indian
Government.
M i P liti l Ri k
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Managing Political Risk• Since investing in a foreign country and
putting a subsidiary up involves time factorspanning generations, the first thing an MNC
assesses is the Political Risk.
•
Political risks are indicated through varioussocio-political and historical events.
• There are specialists who can read trends on:
the political parties and their philosophy
stability of local governments consensus of various political parties on
priorities – especially economic priorities.
M i P liti l Ri k
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Managing Political Risk• There are specialists who can read trends on:
attitude towards foreigners and foreigninvestments
war and other extreme calamities
military role in politics mechanism to express discontent and
anger
respect to democracy and democratic
institutions past history for a long period (like a
century) on tolerance and empathy.
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Managing Political Risk
• Political risk is divided into:
Macro risk – war, revolt, upheaval,
expropriation, insurrection
Micro risk – partisanship to certain
sectors, corruption, prejudicial actions Risk hotspots – certain regions within the
country
•
Certain times entering business with highpolitical risk countries can be very lucrative.
• In some countries, political risk insurance is
available.
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Managing Political Risk
•
Political risk consultants (Moody’s, Standard& Poor’s, McKinsey) and specialists are
available.
• MNCs do get “caught unawares” on rare
occasions.
• MNCs do not explicitly announce “exit policy”
but might keep an “exit plan” at the back of
the mind – unwritten, but fully conscious.
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Managing Political Risk
• MNCs contribution to local society, economy
and country’s overall growth is always keenly
observed by various activists, social
organizations and power groups.
• At times, this results in “forced withdrawals”as it happened in many countries.
• We have cases like the exit of Enron from
India, which was before its full-fledged entryinto the country.
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Managing Political Risk
• We also have cases like the one-time forced
exit of Coca Cola from India, after it was fully
established in the country.
• Fair trade policies, human rights
considerations, foreign policy of the country – these are some of the other factors that could
be classified under “Political Risk”.
• Generally, political risk comes to light by
studying historical data and evolutionary
events. So these risks do not spring a surprise.
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Managing Political Risk
•
Wherever there is Communist rule, oropposite geo-political environment, MNCs
from UK or USA may not be interested in
putting up capital investments, since political
risk multiplies.
• When geo-political developments take place,
MNCs keep a watch for stability in political
atmosphere, and then invest heavily like in thecase of China and Vietnam.
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Managing Political Risk
• Business and Politics are separate
philosophies in theory. However, in reality,
MNCs have to contribute to the host countries
and society’s stated and desired goals.
• Note that certain unforeseen events couldtrigger into political risk. A product quality
issue like Nestle’s Maggi in India (2015) could
turn into a socio-political issue. Before theissue escalates, MNCs use social interest and
technology to get over such situations.
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Political Risk: Expropriation
• What is expropriation?
The act of taking privately owned property by
a government to be used for the benefit of the
public is Expropriation. In the US, the Fifth
Amendment to the Constitution provides thatprivate property “will not be taken for public use
without just compensation”. While there is
compensation, the expropriation occurs withoutthe property owner’s consent.
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Political Risk: Expropriation
• What is expropriation?
Many, but not all, countries support the theory
that the expropriating country should pay
adequate, timely and effective compensation to
the involved party. Countries can expropriate foreign businesses
located within the country. Former socialist
Chilean President Salvador Allende expropriatedUS businesses located in Chile in the early 1970s.
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Managing Political Risk
• What is Host Government take over?
The most severe country risk is a take over of an
MNC’s local operations by the host government.
This type of take over may result in major losses,
especially when the MNC does not have anypower to negotiate with the host government.
The most common strategies used to reduce
exposure to a host government take over are:(a) concentrate on recovering cash flow quickly,
(Contd.)
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Managing Political Risk
(b) rely on unique supplies or technology that
cannot be duplicated locally so that the host
government cannot do without those supplies
or technology,
(c) hire local labor,(d) borrow local funds,
(e) purchase country risk insurance,
(f) use project finance to finance the projectheavily with credit. Project finance is based on
future cash flows from the project and
separates the MNC from the project.
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Case Study: Venezuela
• Assume you are CFO of a Cement Company
operating in Venezuela. You are planning a
major expansion in view of increasing
demand. The Venezuelan President hasthreatened that if prices are not brought
down by cement manufacturers, he would
nationalize all the companies, includingforeign companies operating there.
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Case Study: Venezuela
• How would you assess the political risk for
your project?
• What threats do you expect for your project in
future?
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Case Study: Venezuela - Answer
• This is a clear case of “Host Government Take
Over”.
• This will result in major losses in case of take
over.
• As CFO, I would focus on recovering cash flow
quickly.
• I would also hire more local labour and
borrow more local funds.
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Case Study: Venezuela - Answer
• If possible, I would purchase “country risk
insurance”.
• Also if possible I would separate the project in
Venezuela from the rest of the MNC.
• I would use internally generated cash flows
from the project to fund the project’s future
working capital and investment needs.
• This is also called using “project finance” to
run the project.54
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Case Study: Venezuela - Answer
• I will surely be cautious about increasing my
or my MNC’s exposure in Venezuela since the
threat of Host Government Take Over is very
real.• I will run the Venezuelan operation from the
parent office overseas.
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Case Study: India
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Case Study: India• Since 1991, by liberalizing its economy, India
has been struggling to gain a firm position inthe global economy. Though it has attracted
many foreign investors, it has not succeeded in
retaining them. Most of the companies have
left the country either because of the
infrastructure, which has to go a long way
before they meet the international standards
or because of the government policies, whichare not favorable for carrying out business in
India… (Contd..)
Case Study: India
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Case Study: IndiaThe basic requirements for carrying on any
business like power, telecommunications,roads, etc. are not up to the mark.
Question: Describe the various steps taken by
the present Indian government in the last one
year to attract more foreign players.
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Case Study: India - Answer
• Strong steps in foreign affairs: Political and
Economic relationship with SAARC, other Asian
countries.
• PM visits Japan, Germany, USA
• “Make in India” initiative, “Smart City”programme
• Ease of business – reduced red tape
• Transparency, Openness and Political stability• Control of rampant corruption
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Case Study: India - Answer
• Policy changes – Centre and states with stable
majority have new industrial policies
• Liberalized investment norms in Railway and
Defense ancillaries, Insurance
• Reduction of interest rates• Encouragement of savings from the poorest
of the poor
• Subsidies only to Below Poverty Line people
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Case Study: India - Answer
• Other positive factors:
Largest democracy in the world
Peaceful general elections always
No military coups or military juntas ever,
like in some Asian countries Political stability of the highest order
Mature political parties
Excellent banking and financial systems Mature stock and financial markets
Steady exports