Introduction• The main objective of internationalfinancial management is to maximiseshareholder wealth.• Adam Smith wrote in his famous title,“Wealth of Nations” that if a foreigncountry can supply us with a commodityCheaper than we ourselves can make it,better buy it of them with some part ofthe produce of our own in which we havesome advantage.
Basic Functions• Acquisition of funds (financing decision)– This function involves generating funds from internal aswell 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 amanner so as to maximize shareholder wealth.– Other decisions relate to dividend payment, workingcapital and capital structure etc.– In addition, risk management involves both financing andinvestment decision.
Nature & Scope• Finance function of a multinational firm has twofunctions 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 latestchanges in forex rates• instability in capitalmarket• interest rate fluctuations• macro level charges• micro level economicindicators• savings rate• consumption pattern• investment behaviour ofinvestors• export and import trends• Competition• banking sectorperformance• inflationary trends• demand and supplyconditions etc.International financial management practitioners arerequired the knowledge in the following fields.
International financial manager willinvolve the study of• exchange rate and currency markets• theory and practice of estimating future exchange rate• various risks such as political/country risk, exchangerate risk and interest rate risk• various risk management techniques• cost of capital and capital budgeting in internationalcontext• 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 ignoredbecause a single national currency serves as the mainmedium of exchange within a country.• When different national currencies are exchanged foreach other, there is a definite risk of volatility in foreignexchange rates.• The present International Monetary System set up ischaracterised by a mix of floating and managedexchange rate policies adopted by each nation keepingin view its interests.• In fact, this variability of exchange rates is widelyregarded as the most serious international financialproblem facing corporate managers and policy makers.
Political risk• Political risk ranges from the risk of loss (or gain) fromunforeseen government actions or other events of apolitical character such as acts of terrorism to outrightexpropriation 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 thepoliticians in Maharashtra who argued that India didnot require the power plant. The company had spentnearly $ 300 million on the project.
Expanded Opportunity Sets• When firms go global, they also tend tobenefit from expanded opportunities whichare available now.• They can raise funds in capital markets wherecost of capital is the lowest.• The firms can also gain from greatereconomies of scale when they operate on aglobal basis.
Market Imperfections• domestic finance is that world markets todayare highly imperfect• differences among nations’ laws, taxsystems, business practices and generalcultural 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 nationalone, planning and regulation of economic activitiesfor achieving the national goals, restriction importsand promoting exports.• It believed that the power of a nation lied in itswealth, which grew by acquiring gold from abroad.Cont …
Theory of Mercantilism• Mercantilists failed to realize that simultaneous exportpromotion and import regulation are not possible in allcountries, and the mere control of gold does not enhance thewelfare of a people.• Keeping the resources in the form of gold reduces theproduction of goods and services and, thereby, lowers welfare.• It was rejected by Adam Smith and Ricardo by stressing theimportance of individuals, and pointing out that their welfarewas 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 theyspecialise according to their production advantages.• The pre-trade exchange ratio in Country I would be2A=1B and in Country II IA=2B.Cont …
• If it is nearer to Country I domestic exchange ratiothen trade would be more beneficial to Country IIand vice versa.• Assuming the international exchange ratio isestablished IA=IB.• The terms of trade between the trading partnerswould depend upon their economic strength and thebargaining power.Theory of Absolute Cost Advantage
Theory of Comparative Cost Advantage• Ricardo (1817), though adhering to the absolute costadvantage principle of Adam Smith, pointed out thatcost advantage to both the trade partners was not anecessary condition for trade to occur.• According to Ricardo, so long as the other country isnot equally less productive in all lines of production,measurable in terms of opportunity cost of eachcommodity in the two countries, it will still bemutually gainful for them if they enter into trade.Cont …
– In the example given, the opportunity cost of oneunit of A in country I is 0.89 (80/90) unit of good Band in country II it is 1.2 (120/100) unit of good B.– On the other hand, the opportunity cost of oneunit of good B in country I is 1.125 (90/80)units ofgood A and 0.83 (100/120) unit of good A, incountry II.Theory of Comparative Cost AdvantageCont …
• The opportunity cost of the two goods are different in boththe countries and as long as this is the case, they will havecomparative advantage in the production of either, good A orgood B, and will gain from trade regardless of the fact thatone of the trade partners may be possessing absolute costadvantage in both lines of production.• Thus, country I has comparative advantage in good A as theopportunity cost of its production is lower in this country ascompared to its opportunity cost in country II which hascomparative advantage in the production of good B on thesame reasoning.Theory of Comparative Cost Advantage
International Business Methods• Licensing• Franchising• Subsidiaries and Acquisitions• Strategic Alliances• Exporting