International Financial Management

Introduction• The main objective of international financial

management is to maximise shareholder wealth.

• Adam Smith wrote in his famous title, “Wealth of Nations” that if a foreign country can supply us with a commodity Cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own in which we have some advantage.

Basic Functions

• Acquisition of funds (financing decision)– This function involves generating funds from internal as

well as external sources. – The effort is to get funds at the lowest cost possible.

• Investment decision– It is concerned with deployment of the acquired funds in a

manner so as to maximize shareholder wealth. – Other decisions relate to dividend payment, working

capital and capital structure etc. – In addition, risk management involves both financing and

investment decision.

Nature & Scope• Finance function of a multinational firm has two

functions namely, treasury and control. – The treasurer is responsible for

• financial planning analysis• fund acquisition• investment financing• cash management• investment decision and • risk management

– Controller deals with the functions related to • external reporting• tax planning and management• management information system• financial and management accounting• budget planning and control, and • accounts receivables etc.

Environment at International Level

• the knowledge of latest changes in forex rates

• instability in capital market

• interest rate fluctuations• macro level charges• micro level economic

indicators• savings rate• consumption pattern

• investment behaviour of investors

• export and import trends• Competition• banking sector

performance• inflationary trends• demand and supply

conditions etc.

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

International financial manager will involve the study of

• exchange rate and currency markets• theory and practice of estimating future exchange rate• various risks such as political/country risk, exchange rate

risk and interest rate risk• various risk management techniques• cost of capital and capital budgeting in international

context• working capital management• balance of payment, and • international financial institutions etc.

Features of International Finance• Foreign exchange risk• Political risk• Expanded opportunity sets• Market imperfections

Foreign exchange risk• In a domestic economy this risk is generally ignored because a

single national currency serves as the main medium of exchange within a country.

• When different national currencies are exchanged for each other, there is a definite risk of volatility in foreign exchange rates.

• The present International Monetary System set up is characterised by a mix of floating and managed exchange rate policies adopted by each nation keeping in view its interests.

• In fact, this variability of exchange rates is widely regarded as the most serious international financial problem facing corporate managers and policy makers.

Political risk• Political risk ranges from the risk of loss (or gain) from

unforeseen government actions or other events of a political character such as acts of terrorism to outright expropriation of assets held by foreigners.

• For example, in 1992, Enron Development Corporation, a subsidiary of a Houston based Energy Company, signed a contract to build India’s longest power plant. Unfortunately, the project got cancelled in 1995 by the politicians in Maharashtra who argued that India did not require the power plant. The company had spent nearly $ 300 million on the project.

Expanded Opportunity Sets• When firms go global, they also tend to

benefit from expanded opportunities which are available now.

• They can raise funds in capital markets where cost of capital is the lowest.

• The firms can also gain from greater economies of scale when they operate on a global basis.

Market Imperfections• domestic finance is that world markets today

are highly imperfect• differences among nations’ laws, tax systems,

business practices and general cultural environments

International Trade Theories

• Theory of Mercantilism

• Theory of Absolute Cost Advantage

• Theory of Comparative Cost Advantage

Theory of Mercantilism• This theory is during the sixteenth to the three-fourths

of the eighteenth centuries.

• It beliefs in nationalism and the welfare of the nation alone, planning and regulation of economic activities for achieving the national goals, restriction imports and promoting exports.

• It believed that the power of a nation lied in its wealth, which grew by acquiring gold from abroad.

Cont …

Theory of Mercantilism

• Mercantilists failed to realize that simultaneous export promotion and import regulation are not possible in all countries, and the mere control of gold does not enhance the welfare of a people.

• Keeping the resources in the form of gold reduces the production of goods and services and, thereby, lowers welfare.

• It was rejected by Adam Smith and Ricardo by stressing the importance of individuals, and pointing out that their welfare was the welfare of the nation.

Theory of Absolute Cost Advantage

• This theory was propounded by Adam Smith (1776), arguing that the countries gain from trading, if they specialise according to their production advantages.

• The pre-trade exchange ratio in Country I would be 2A=1B and in Country II IA=2B.

Cont …

• If it is nearer to Country I domestic exchange ratio then trade would be more beneficial to Country II and vice versa.

• Assuming the international exchange ratio is established IA=IB.

• The terms of trade between the trading partners would depend upon their economic strength and the bargaining power.

Theory of Absolute Cost Advantage

Theory of Comparative Cost Advantage

• Ricardo (1817), though adhering to the absolute cost advantage principle of Adam Smith, pointed out that cost advantage to both the trade partners was not a necessary condition for trade to occur.

• According to Ricardo, so long as the other country is not equally less productive in all lines of production, measurable in terms of opportunity cost of each commodity in the two countries, it will still be mutually gainful for them if they enter into trade.

Cont …

– In the example given, the opportunity cost of one unit of A in country I is 0.89 (80/90) unit of good B and in country II it is 1.2 (120/100) unit of good B.

– On the other hand, the opportunity cost of one unit of good B in country I is 1.125 (90/80)units of good A and 0.83 (100/120) unit of good A, in country II.

Theory of Comparative Cost Advantage

Cont …

• The opportunity cost of the two goods are different in both the countries and as long as this is the case, they will have comparative advantage in the production of either, good A or good B, and will gain from trade regardless of the fact that one of the trade partners may be possessing absolute cost advantage in both lines of production.

• Thus, country I has comparative advantage in good A as the opportunity cost of its production is lower in this country as compared to its opportunity cost in country II which has comparative advantage in the production of good B on the same reasoning.

Theory of Comparative Cost Advantage

International Business Methods

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