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    Prof.CA.Rudramurthy.BV

    CA, M.COM, MFM, M-PHIL, PGDBA, PGDMM.

    For Further details CONTACT 9845620530 / 9886842254

    II SEM FM CRASH COURSE STARTING FROM 16TH

    MAY 2009.

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    International Financial Management:y International financial management is

    concerned with Capital structure,Investment and Dividend Decisions of aMultinational firm.

    y It is the process of integrating the financefunctions of parent company in the home

    country and its subsidiary in the host countryso as to maximize the wealth of theshareholders given the risks associated with

    international business. 2

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    International Financial Management:y International financial management refers to

    global decisions taken in the context of crossborder transactions so as to maximize the

    wealth of shareholders keeping in mind theinternational risk associated with suchinternational transactions.

    3

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    Importance of IFM:Study if international finance is important forthe following reasons:

    1. Currency risks involved in Internationalbusiness.

    2. Study of host countries policies towardsMultinational companies.

    3. Opportunity to tap resources like raw-materials, labour etc cheaply and effectively.

    4. Expansion and Diversification of business.

    5. International sources of funds. 4

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    Differences between Domestic and

    International Financial Management:4. Domestic FM has limited scope for mitigatingits risk whereas International FM has vide

    variety of risk mitigating techniques using

    various derivative instruments and othertechniques.

    5. Domestic FM has a limited cultural and

    language shocks compared to InternationalFM.

    6. The legal systems of Domestic FM andInternational FM differs due to home country

    and host country disparities. 6

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    Differences between Domestic and

    International Financial Management:7. Domestic FM is concerned with Domestic Accounting standards (Ex: For India, IndianAccounting Standards) whereas International FM

    is concerned with Global Accounting Standardslike GAAPs, IFRS etc.

    8. The area of operation of a Domestic FM is muchLimited compared to that of International FM.

    9. Domestic FM has limited scope of resources for various factors of production whereasInternational FM has a multiple resource beltfrom where Cos can raise resources costeffectively. 7

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    Differences between Domestic and

    International Financial Management:10. Domestic FM has no Translation exposures whereas International FM results inTranslation exposures.

    11. Domestic FM is regulated by the law of thecountry whereas International FM is regulatedby International Unions and organizations like

    World Banks, IMF etc.12. Study of Economic Conditions like Growth,

    Inflation, Interest rates etc prevalent inInternational FM is more complex than

    Domestic FM. 8

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    IFM ENVIRONMENT:yThe Scope of International Finance widens

    due to its peculiarities in operations such as:

    1. International MonetarySystem.2. International Sources of funds.

    3. International Financial Institutions.

    4. International Taxation systems.5. International Political setup.

    6. Differing treatment to Host and Domestic

    corporates. 9

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    Scope of IFM:The scope of International finance can bestudied under three broad categories namely:

    I. FINANCING DECIS

    IONS

    .II. INVESTMENT DECISIONS.

    III. WORKING CAPITAL MANAGEMENTDECISIONS OR MONEY MANAGEMENTDECISIONS.

    10

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    INVES

    TMENTD

    ECIS

    IONS

    :y Investment Decisions in a global scenario is

    taken considering the International CapitalBudgeting techniques.

    y Various Investment risk involved inmultinational scenario like Political,Economic, Commercial etc should be

    considered before making InternationalInvestment Decisions.

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    INVES

    TMENTD

    ECIS

    IONS

    :yThe various factors considered for

    International Capital budgeting include:

    a) Life of the Project.b) Cash Flows associated with the projects.

    c) Exchange rates.

    d) Discount factor.e) Terminal or Salvage value.

    f) Income tax and Withholding tax.

    g) Financing availability in host country etc. 13

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    WORKING CAPITAL MANAGEMENT

    DECIS

    IONS

    :y It is concerned with the decision of a multinational

    company on the combination of current assets andcurrent liabilities that will maximize the value of

    the firm.y It includes areas such as:

    1. International Cash Management.

    2. International Receivable or Debtors Management.3. International Inventory Management.

    4. International Creditors or Suppliers Management.

    14

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    Significance of IFM:y In this globalised economy where the entire

    globe is considered as one single country,study of international finance is highlysignificant and a must for the survival ofCorporate entities due to the followingreasons:

    1) To undertake International Businessopportunities.

    2) To understand the effect of exchange rates

    on the companies. 15

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    Significance of IFM:6) To learn international ways of hedging in

    International derivative markets.

    7) To understand the Political situations anddecisions in Global world.

    8) To tap resources globally at effective prices.

    9) For expansion and diversification ofbusiness.

    10) To learn International Working capitaldecisions.

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    Finance Function:Finance function in a multinational firm canbe broadly classified into 2types namely:

    yTreasurer Function.

    yAccounting and Control Function.

    y

    Both these functions are to be studied intotality and not in isolation as decisions takenby treasurer affects the controller and vice-

    versa.18

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    Treasurer Function:y Treasury function is concerned withacquisition and allocation of financial

    resources so as to minimize the cost andmaximize the return consistent with thelevel of financial risk acceptable by the

    firm.

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    Treasurer Function:yTreasurer functions include:

    1. Financial Planning analysis.

    2. Fund acquisition.3. Investment Decision.

    4. Working Capital management decisions.

    5. Risk Management.

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    Accounting and Control Function:y Accounting and Control Functioninclude:

    1. External Reporting.2. Financial & Management Accounting.

    3. Tax Planning and Management.

    4. Budget Planning and Control.

    5. Management Information System.

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    Institutional structure of IF Markets:y Euro Dollar Deposit Vs Offshore currencies:

    yEuro Dollar deposits refers to US Dollardenominated bank deposit outside the US.

    yOffshore currencies are generalized form ofEuro Dollar deposit which includes not onlyEuro Dollar Deposit but also other externally

    held foreign offshore currencies such as EuroSterling deposit, Euro Yen deposit etc.

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    Institutional structure of IF Markets:yThus Offshore currency markets ensuresingle point solution to all types of currencyneeds and there is no need to go different

    currency centers to arrange deals.

    yDifferent types of Offshore currencyInstruments include:

    1. Offshore term Deposits with fixed term suchas 30 days or 90 days and are not negotiable.

    2. Offshore currency deposits denominated in

    Special drawing rights. 23

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    Institutional structure of IF Markets:3. Offshore currency deposits in the form ofCertificate of Deposits which are negotiableinstruments that can be traded in the secondary

    markets.y Offshore banks are well hedged by havingsufficient assets in the currencies in which they

    accept deposits. Thus they balance both sides oftheir accounts with equal volumes and maturitiesof assets and liabilities in every foreign currencyso as to safeguard itself from exchange rate

    changes. 24

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    International Instruments:Letter of Credit:

    y The importers banker can ask for collateral ifit is not satisfied with the importercreditworthiness.

    y The above service comes for a fee, which Isborne generally by the importer in full.

    y A copy of letter of credit will be sent tobranch of importers banker in sellersdestination.

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    International Instruments:Letter of Credit:

    y That bank in turn informs the exportersbank which will in turn inform the exportingcompany.

    y On receipt of letter of credit, the exporterstarts producing and preparing for the goods

    to be exported as he is assured of the paymentby the issuing bank of letter of credit.

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    International Instruments:Letter of Credit:

    y The actual payment will be made in the formof draft or bill of exchange drawn by theexporter and sent to importers bank foracceptance. It is sent directly or through theexporters bank.

    y On satisfaction of various necessarydocuments in conformity will the terms ofletter of credit, the importers bank accepts the

    bill by stamping and signing across the same. 28

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    International Instruments:Letter of Credit:yBefore acceptance, the acceptor banker demands forbill of lading or airway bill as the most important

    document entailing the ownership of goods.yThe Exporter can discount or endorse the accepteddraft based on the quality and credit rating of theissuing banker at a cost for the short term financing

    requirement.

    y Instead the Exporter may even chose to hold the billtill maturity and then collect the entire receivable on

    maturity. 29

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    International Instruments:Letter of Credit:y The Importers bankers branch in exporterdestination will forward the documents to the

    exporters banks branch and the importer shouldmake payment to his bank which issued the letterof credit based on the forward hedge taken by the

    importer or settlement on the due date.y After receiving the sum due from the importer,the bank hands over the various documentscollected from the exporter to importer who in

    turn can take delivery of the imported goods. 30

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    International Instruments:Letter of Credit:

    y Importer would have made payment to theissuing bank branch in his country, which inturn would have made payment to its branchin Exporters country, which in turn will makepayment to Exporters banker and who in turn

    will credit the exporters account.y Letter of credit is a documentary credit as itrequires many documents to be presented for

    its honour. 31

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    International Instruments:Clean credit Vs Documentary credit:

    yLetter of credit is a documentary credit as itrequires many documents to be presented forits honour.

    y Whereas Clean credit does not requirepresentation of any document and it is issued

    only when there exists complete trust and where goods are transferred from onesubsidiary to another of the same company.

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    Other International Instruments:Open Account:

    yThe importer can avoid the expenses of letterof credit (Bankers fee) through an open accountif the Exporter and Importer have long termrelationships.

    yAn Open account is a simple credit mechanism

    (Debtors) where the importers account isdebited in the books of exporter and exportersaccount is credited in the books of importer and

    payment is made on the due date. 33

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    Other International Instruments:Cash in Advance:

    yIn case importer being a stranger and wherethe exporter doubts the creditworthiness ofimporter, then he might prefer cash in advance.

    yUnder this case, importer has to makepayment in advance even before the goods are

    shipped to him.

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    Other International Instruments:Export Insurance:

    yIn case of exporter demanding only Letter ofcredit, due to competition from other exportingunits he may lose the sale.

    yThus he can hedge his Political andCommercial Risk by buying a Export Credit

    insurance covering either both risks or any one.yHowever the coverage of Export insuranceunlike letter of credit is not in full and it is only

    after a deductible. 36

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    Financing of International trade:

    y Exporter can avail short term credit on hiscredit sale in the following ways:

    1. Discounting the trade draft accepted by theImporter. (Higher discount rate)

    2.Discounting the Letter of credit - Draftaccepted by the banker. (Lower discount rate)

    Generally a letter of credit is issued for 30, 60,90 or 180 days.

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    Financing of International trade:3. Forfaiting:

    y Forfaiting is a medium term non recourse exporterarranged financing of importers credits.

    y It is a form of medium term financing which involvesdiscounting by the forfaiting bank a series ofpromissory notes due for a period of 6months intervalsranging for 3 to 5years signed by an importer in favour

    of the exporter. These instruments gain value and areliquid as it is guaranteed by the importers bank.

    y These notes may be held by the forfaiting bank tillmaturity or even sold to another investor.

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    Financing of International trade:y Unlike trade drafts discounted, forfaiting is annon recourse instrument where the exporter isnot liable for non payment by importer.

    y Thus the cost of forfaiting is generally highercompared to discounting of drafts since thereexists no recourse from exporter.

    y

    The cost of forfaiting depends upon thedenominated currencies strength, terms of thenotes, credit rating of the issuer, commercial andpolitical risk of the importer and his country.

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    Financing of International trade:4. Financing by Government Agencies of Homecountry:

    yAs exports bring foreign currency inflows to the

    host country, the Government of host countryfinances various short term, medium term andlong term needs of the exporter through its EXIM

    Banks and other agencies.yGovernment also does indirect financing byproviding funds to local financial institutions

    which in turn provide loans to exporters.40

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    Financing of International trade:5. Private Export Funding Corporation (PEFC):

    y It is a private lending organisation started by agroup of commercial banks and large export

    manufacturers.yThese PEFC finances international trade throughits sources of funds raised by sale of foreign

    repayment obligations and secured notes on thesecurity markets.

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    Institutions regulating International trade:

    y The two most important arrangementsinvolving the regulation of internationaltrade and its conduct are:

    1. World Trade Organisation.

    2. Free Trade areas.

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    World Trade Organizations:y The World Trade Organization (WTO) is the

    only global international organization dealingwith the rules of trade between nations.

    y At its heart are the WTO agreements,negotiated and signed by the bulk of the worldstrading nations and ratified in theirparliaments.

    y The goal is to help producers of goods andservices, exporters, and importers conduct theirbusiness as smoothly, predictably and freely as

    possible. 43

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    Functions ofWTO:

    y Administering trade agreements.

    yActing as a forum for trade negotiations.

    y

    Settling trade disputes.yReviewing national trade policies.

    y Assisting developing countries in trade

    policy issues, through technical assistanceand training programs.

    yCooperating with other internationalorganizations.

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    Structure ofWTO:

    y The WTO has 153 members, accounting forover 97% of world trade. Around 30 othersare negotiating membership.

    yDecisions are made by the entiremembership typically by consensus.

    yThe hierarchy of WTO consists of ministerial

    conference which is the top most decisionmaking body and below it we have GeneralCouncil, Goods Council, Service Council and

    Intellectual Property Council. 45

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    Differences b/w GATT and WTO:WTO is not an extension of GATT but it is asuccession to GATT. The main differences are:

    yGATT has no legal status whereas WTO has a

    legal status.yGATT had a set of rules and regulations whichwere of selective nature and were not binding on

    all members whereas WTO has rules andregulations which are mandatory and bindingon all members.

    yGATT discussion were not time bound unlike

    WTO which is time bound. 47

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    Differences b/s GATT and WTO:y The WTO is a chartered trade organisation

    unlike GAAT which was a secretariat.

    yWTO has extended its coverage even to aspects

    of Intellectual Property rights (TRIPS) whichwas not under the ambit of GATT.

    yWTO has a better dispute settlement function

    compared to GATT since agreements cannot beblocked for reason of failure to achieveconsensus.

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    Free Trade areas and Custom Unions:

    y In case of free trade areas, Tariffs are removedon trade among members whereas they havetheir own systems of tariffs for non member

    countries trade which are differential innature.

    yEx: NAFTA North American Free Trade

    Agreement.

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    Free Trade areas and Custom Unions:yCustom Unions are similar to free trade areas

    except for common tariff to all non membercountries.

    yEuropean Union is a Custom Union set up inJan 1993 which has 27 members till date.

    y It is the largest custom union till date.

    yCompanies operating outside the EuropeanUnion as to face competition with firms insidethe European Union that have favourable

    terms when traded within the members. 50

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    Euro Equity issue:y An Euro Equity issue refers to shares issued

    outside the home country.

    Ex: If a Non US based Co issues shares in US or

    if a US based Co raises equity funds outsideUS, then it is known as Euro Equity Issue.

    yConsiderations in Euro Equity issue include:

    1. Selecting the country in which stock should beissued based on the best price for the stock

    where a Company can get on its shares net ofissuance cost.

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    Euro Equity issue:2. The vehicle of share issue i.e. whether the

    issue should be done by the Parent or by theSubsidiary.

    Tax considerations may motivate use ofspecially established financing subsidiary toavoid withholding tax on payments made to

    foreigners.

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    SOURCES OF FUNDS:I. Equity Instruments in International Market:

    1.Depositary receipt is a type of negotiablefinancial security that is traded on a local

    stock exchange but represents a security,usually in the form of equity, that is issued bya foreign publicly listed company.

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    SOURCES OF FUNDS:1.a).Global depository receipts(GDR)

    represents the shares traded in various localstock exchanges around the world (such as NSE

    and BSE in India, Nikkie in Japan, Hongkongstock exchange in China, New York stockexchange in America, London Stock exchange inEurope)issued by foreign public listed company.

    The global depository receipts will be traded allover the world expect the issuing country.

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    SOURCES OF FUNDS:1.b). An American Depositary Receipt (ADR)

    represents the ownership in the shares of aforeign company trading on US financial

    markets. The stock of many non-US companiestrades on US exchanges through the use ofADRs. ADRs enable US investors to buy sharesin foreign companies without undertaking

    cross-border transactions. ADRs carry prices inUS dollars, pay dividends in US dollars, and canbe traded like the shares of US-basedcompanies.

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    SOURCES OF FUNDS:II. DEBT/BOND Instruments:

    1. Euro Bonds:

    Euro bond is issued outside the country of

    the currency in which it is denominated. It islike any other Euro instrument and throughinternational syndication and underwriting,

    the paper can be sold without any limit ofgeographical area.

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    SOURCES OF FUNDS:2. Foreign Bonds:

    a) Yankee Bonds: These are US dollardenominated issues by foreign borrowers

    (Non US borrowers) in US Bonds markets.Usually foreign government or entities,supernationals and highly rated corporate

    borrowers issue yankee bonds.

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    SOURCES OF FUNDS:DEBT Instruments:

    2. Foreign Bonds:

    b) Samurai Bonds: These are bonds issued by

    Non-japanese borrowers in domestic Japanese markets with a maturity varyingover 3 to 20 years. The borrowers are

    supernationals and have at least a minimuminvestment grade rating (A Rated)

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    SOURCES OF FUNDS:DEBT Instruments:

    2. Foreign Bonds:

    c) Bull dog Bonds: These are sterling

    denominated foreign bonds which are raised inthe UK domestic securities market. Thematurity of these bonds vary from 5 to 25 years.

    These bonds are subscribed by the long terminstitutional investors like pension funds andlife insurance companies. These bonds areredeemed on bullet basis (one time lump sum

    payment on maturity.) 59

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    SOURCES OF FUNDS:DEBT Instruments:

    2. Foreign Bonds:

    d) Shibosai Bonds: These are privately placed

    bonds issued in the Japanese markets. Thequalifying criteria is less stringent ascompared to Samurai or Euro Yen bonds.

    Shibosai bonds are offered to a different setof investors such as institutional investorsand banks.

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    SOURCES OF FUNDS:

    3. Euro Notes:

    yEuro notes are the short term instrumentsand the return on these instruments arebased on the varying bench mark LIBOR.The funding instruments in the form ofEuro notes possess flexibility and can be

    tailored to suit the specific requirements ofdifferent types of borrowers.

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    SOURCES OF FUNDS:

    4. Euro Credit Syndication:

    y It is a private arrangement between the

    lending banks and borrowers. Lendingbanks join together and advance the loans tothe borrower.

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    SOURCES OF FUNDS:

    6. Credit Swaps:

    y It involves exchange of currencies between a

    bank and a firm wherein the parent makes adeposit of local currency in a bank and thebank instructs its branch in the country

    where the subsidiary is situated to make

    payment in foreign currency to thesubsidiary.

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    SOURCES OF FUNDS:

    7. Government and Development banklending:

    yThe Government of host country providesnecessary finance to the foreign affiliate ifthe project generates necessary jobs, earnforeign exchange and provide training fortheir citizens. International developmentagency (IDA) and International FinanceCorporation (IFC) are affiliate of worldbanks which provide financial assistance.

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    IMPORTANCE OF INTERNATIONAL CAPITAL

    BUDGETING:

    yHeavy expenditure

    yLong duration

    y Irreversible of decision making

    yComplexity of decision making

    y

    Direct impact on organizationyCurrency fluctuation

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    Differences between Domestic and

    International Capital budgeting:

    yExchange rate fluctuations causes change inestimated cash flow in case of internationalcapital budgeting.

    yThe government of host country (foreigncountry) may impose withholding tax forfunds remitted by the subsidiary company to

    the parent company.yA portion of international project financing

    can be done by borrowing funds from a

    bank in host country. 68

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    Differences between Domestic and

    International Capital budgeting:

    yAscertainment of expected salvage value dueto early divestment may result in change incash flow.

    yCorporate tax rate differs from homecountry to host country.

    yEstimated exchange rates for future is

    uncertain.yPolitical conditions, social set up and

    economic conditions in the home country

    and host country may differ. 69

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    TECHNIQUES OF CAPITAL BUDGETING:

    There are two techniques or methods ofInternational Capital Budgeting:

    yMethods which do not consider time value

    of money.

    yMethods which do consider time value ofmoney.

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    Methods which do not consider time value

    of money:

    1. PAY BACK PERIOD:

    y It is a period within which we get our initialinvestment.

    yPBP = initial investment

    uniform annual cash inflow

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    Methods which do not consider time value

    of money:

    2. PAY BACK RECIPROCAL:

    y It is a reciprocal of pay back period

    yPBR = uniform cash inflow * 100

    initial investment

    y

    Interpretation:higher the pay back

    reciprocal, better the proposal

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    Methods which do not consider time value

    of money:

    3. POST PAY BACK PERIOD:

    yLife of project pay back period

    y Interpretation: higher the PPBP, betterthe proposal.

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    Methods which do not consider time value

    of money:

    4. POST PAY BACK PERIOD:

    yARR = Average Profit * 100

    Initial Investment

    yAverage profit= Total PATAD

    life of project

    y Interpretation: higher the ARR, better theproposal.

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    Methods which do consider time value of

    money:

    1. NET PRESENT VALUE METHOD:

    yNPV = Total of PV of Cash Inflows - Total ofPV of Cash Outflows.

    yHigher the NPV better the proposal.

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    Methods which do consider time value of

    money:

    2. INTERNAL RATE OF RETURN:

    y It is at that rate of return at which the PV oftotal cash inflows = the PV of total cashoutflows.

    y It is at that rate of return at which NPV =

    Zero.y If IRR is > Cost of Capital accept the project

    or else reject it.

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    Methods which do consider time value of

    money:

    3. PROFITABILITY INDEX OR BENEFITCOST RATIO:

    yPI = Total of Discounted Cash Inflows

    Total of Discounted Cash Outflows

    yPI of 1 or above 1 shall be preferred.

    yHigher the PI, better the proposal.

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    Methods which do consider time value of

    money:

    4. DISCOUNTED PAY BACK PERIOD:

    yDPBP = Discounted Annual Cash Inflows

    Initial Investment

    yLower the DPBP better the proposal.

    yDPBP is same as PBP except it considerstime value of money which is not consideredby PBP.

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    FOREIGN DIRECT INVESTMENT:y FDI refers to investment of foreign assets into

    domestic structures, equipment andorganisations.

    yFDI occurs when an organisation in a foreigncountry gains sufficient interest of at least 10%or more control on the domestic assets.

    yA cross border investment in which the residentin one country acquires a lasting interest in anenterprise in another economy.

    y FDI can be either in the form of Green Field

    Investment or Acquisition/Merger. 79

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    FACTORS RESPONSIBLE FOR GROWTH OF FDI:

    yPressure of competition in Domestic country.

    yTo benefit from economies of scale.

    yProduct Imperfection.

    yMarket Imperfection.

    yMarket Opportunities.

    y

    Imperfect Raw-materials.y Imperfect labour markets.

    yBetter technology in foreign markets.

    y

    Foreign exchange rates. 80

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    FACTORS RESPONSIBLE FOR GROWTH OF FDI:

    y Imperfect financial markets resulting inbetter raising of funds globally.

    y Imperfect financial instruments.

    y Imperfect financial system.

    y Imperfection in financial intermediaries.

    yBetter demand for product.

    yProduct differentiation.

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    FDI ADVANTAGES TO HOST COUNTRY:

    y Increases import capacity.

    y Increase Productivity and efficiency.

    yStimulate better economic activity.

    yBetter utilisation of capacity.

    yForeign flows to country helping it in betterreserves.

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    FDI DISADVANTAGES TO HOST COUNTRY:

    y Increases competition in domestic markets.

    yLoss of control to foreign corporates.

    yHigher Imports.

    yNegative Impact on small and medium sizeddomestic corporates.

    yUnfair competition and exploitation of localresources.

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    FDI ADVANTAGES TO HOME COUNTRY:

    y Increases income and profit levels.

    yExpansion and Diversification.

    yLower cost of access to resources.

    yPortfolio diversification.

    yBetter use of technology.

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    FDI DISADVANTAGES TO HOME COUNTRY:

    yLanguage and cultural barriers.

    yCost of international movement of resources.

    yPoor knowledge of local conditions.

    yDisparity in Political system and legalcontrol.

    yDifferential tax systems and jurisdiction.

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    International Cost of Capital:yA firms weighted average cost of capital is

    the total cost of financing by taking the weight age of the percentage of financing

    from each source of capital. Thus, when afirm has both debt and equity in its capitalstructure, its financing cost can be

    represented by the weighted average cost ofcapital. This is computed by considering costof equity and after tax cost of debt.

    yKA = Wd [Kd(1-t)] + We(Ke).86

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    Cost of capital of MNCs Vs Domestic Firms:

    The reasons for the differences in cost of capital foran MNC from that of fully established domesticfirm are:

    1. Size of the firm:Firms which operate at international level borrowhuge capital at lower cost when compared to that oflocal domestic firms. MNCs also have the

    opportunity to borrow form that place where cost ofcapital is low. Therefore, MNCs will be able to getlower cost of capital when compared to that ofdomestic firms.

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    Cost of capital of MNCs Vs Domestic Firms:

    2. Foreign Exchange Risk:

    MNCs are subject to foreign exchange risk. Theshare holders demand higher dividend when there

    exists more foreign exchange. This results in theincrease in the cost of capital of MNCs.

    3. International Diversification Effect:

    MNCs operate in diversified operations which helps

    them to reduce their cost of capital. It also enjoysthe stability of cash flows because of diversifiedoperations.

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    Cost of capital of MNCs Vs Domestic Firms:

    4. Access to international capital markets:

    The MNCs have access to international capitalmarkets. This is an advantage as the firms can

    attract funds from international markets. And thesubsidiary which is established in the home countrycan also attract funds from the local market if thefunds are cheap.

    5. Country Risk analysis:Country risk refers to the exposure to loss in cross-border lending caused by Political and Economicevents.

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    Cost of capital of MNCs Vs Domestic Firms:

    6. Tax concessions:

    MNCs choose those countries where the tax lawsare favourable for them. This is very important

    because their net income substantially depends onthe tax policies.

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    International Capital structure:Capital structure refers to the financing the firm with the combination of debt and equity. Theoverall capital structure of MNC refers to thecombination of all its subsidiaries capital structure.The debt is the cheaper source of capital whencompared to equity. The increase of debt in thecapital structure decreases the cost of capital to

    some extent. It the debt is increased over and abovethe maximum level of debt, the share holdersdemand higher return on equity to set off againstthe risk of bankruptcy because of higher debt. This

    again results in higher cost of capital. 91

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    International Capital structure:y The trade off between the debts advantage (low cost

    of capital because of tax deductibility of interest)and its advantage (increases the probability ofbankruptcy) is illustrated in the following diagram.Initially the cost of capital decreases as the debtincreases to some extent. After some point, the costof capital rises as the ratio of debt to total capital

    increases.

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    COUNTRY RISK ANALYSIS:

    yAssess the firm in subsidiary investment ordivestment decision based on analysis of

    various political economic risk factors

    y it is a continuous process of monitoringvarious factors that affects the risk analysis ofa particular country

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    COUNTRY RISK ANALYSIS:

    I. Political risk assessing factors:

    yStability of local political environment

    yConsensus regarding priority

    y attitude of host government

    yWar & terrorism

    y

    Major changes in political system

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    COUNTRY RISK ANALYSIS:

    II. Economic risk assessing factors:

    y Inflation rate

    yGrowth rate

    yNational human and financial capital

    yAdjustment external shock

    y

    Degree of dependency and independencywith other nation

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    Techniques to assess country risk analysis:

    yDebt servicing capacity.

    yBop assessment.

    yEconomic indicator analysis.

    yChecklist method.

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    Managing Political Risk:yFinance the subsidiary with local capital.

    yStructure operations so that the subsidiaryhas value only as a part of the integrated

    corporate system.yObtain insurance against risk.

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    International Working Capital Management:

    y It is the process of planning and controllingthe level and mix of current assets of thefirm as well as financing of these assets

    through various current liabilities.y International working capital management

    includes managing of international cash

    transactions, inventory management andreceivable management.

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    Objectives of International W/C mgt:

    y To determine the optimal amount of investmentsin various current assets.

    y To minimize the investments in current assets.

    yTo match the short term fund requirement withvarious combination of short term funds.

    y To allocate short term investment and cashbalance holdings between currencies and

    countries to maximize overall corporate returns.y To borrow in various money markets and to

    achieve minimum cost of borrowing.

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    Factors affecting international W/C requirements:

    yNature of business.

    yProduction policy.

    yLead time.

    yCurrency fluctuation.

    y International tax regulation.

    yGovt. Rules and regulations.

    yAccessibility to credit.

    yDividend Policy.

    y

    Cost of Capital. 101

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    International Cash Management:

    y International Cash Management refers to crossborder movement of funds from and to othercompanies as well as within the company.

    y

    Basic principles of International Cashmanagement include:

    a) Having a Cash mgt center that receives anddistributes timely information relating to cash

    movement in international scenario.b) Use of modern communication system.

    c) To have minimum banks and maximum control.

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    Objectives of International Cash Management:

    yTo allocate necessary cash to the requiredareas at proper quantity and time.

    yTo maximize return on investment.

    yTo ensure lower transaction cost.

    yTo fasten transfer of funds from one place toanother.

    yTo minimize borrowing cost.

    yTo minimize currency exposure risk.

    yTo minimize country and political risk.103

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    Centralized Vs Decentralized Cash Management:

    yCentralized Cash Management refers tomanaging of international short termresources from one place, preferably the

    head office.yDecentralized Cash Management involve

    management of short term funds at branch

    or departmental level.

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    Centralized Cash Management:

    y A centralized cash management group isneeded to monitor and manage the parent/subsidiary and inter subsidiary cash flows.

    yCentralization refers to centralization ofinformation, reports and the decisionmaking process as to cash mobilization,

    movement and investment outlets.

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    Advantages of Centralized Cash Management:

    yMaintaining minimum cash balance during theyear.

    yHelping the centre to generate maximum

    possible returns by investing all cash resourcesoptimally.

    yJudiciously manage the liquidity requirementsof the centre.

    yHelping the centre to take complete advantageof multinational netting so as to minimizetransaction costs and currency exposure.

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    Advantages of Centralized Cash Management:

    yOptimally utilize the various hedgingstrategies so as to minimize the MNCsforeign exchange exposure.

    yAchieve maximum utilization of the transferpricing mechanism so as to enhance theprofitability and growth by the firm.

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    Dis-Advantages of Centralized Cash Management:

    yDelay in decision making.

    yLoss of sales.

    yAutocratic management.

    yLacks worker involvement etc.

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    De-Centralized Cash Management:

    y It is a system where the branch head is givenan authority to deal with cash inflow andcash payments.

    yThe advantages of Centralized systembecomes disadvantages of De-Centralizedsystem and vice-versa.

    yA thorough Cost Benefit analysis shouldbe done before deciding the system of cashmanagement.

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    Techniques to optimize cash flow:

    yAccelerating cash inflows: It refers to thequick recovery of the cash flows. Variousinnovative measures and new technologies

    and banking system helps in maintainingthe system to accelerate the cash flows.

    yManaging blocked funds: Some times the

    host Government insists the subsidiary toinvest the income in the host country itself.This increases the pay back period of theMNC.

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    Techniques to optimize cash flow:Leading and lagging strategy:

    yHard currency receivable is lagged andpayment is leaded and soft currency receivable

    is leaded and payment is lagged.yHard currency is the currency which is

    expected to appreciate in future and Softcurrency is expected to depreciate in future.

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    Techniques to optimize cash flow:

    yNetting: It refers to offsetting exposure inone currency with exposure in the same oranother currency whose exchange rates are

    expected to move in a way such that loss orgain on first exposed position will be offsetby gain or loss in the second exposedposition.

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    The advantages of Netting:yReduces the number of cross border

    transaction between parent and subsidiarycompany

    yThere is a collective effort among allsubsidiaries to accelerate report and settle

    various accounts

    yIt Reduces lead for foreign exchangeconversations

    y It reduces the limit of hedging

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    Types of Netting:Bilateral Netting:

    y It is netting done between parent andsubsidiary or between 2 subsidiaries

    Multilateral Netting:

    y It involves adjustment of funds of even 3rd

    party receipt or payment.

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    Techniques to optimize cash flow:

    yMinimization of tax using internationaltransfer pricing: If the intra companytransfer is made, and if the transfer price is

    higher, then it leads to high profits and hencemore tax has to be paid.

    yThis decision is more complicated in an MNC

    because of exchange restrictions, differencein tax rates between the two countries,inflation differentials and import duties andblockage of funds in host country.

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    Investment of surplus cash:y Money market instruments.

    y Capital market instruments.

    y Real estate.

    y Gold.y Insurance.

    y Government securities.

    y

    Provident fund.y Bank deposit.

    y Mutual fund.

    y Derivative and commodity instruments.117

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    International Receivable Management:The level of International receivables depends upon:

    y The volume of credit sales.

    y The average collection period.

    y Credit standards.y Credit terms.

    y Collection Policy.

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    Strict credit policy Vs Liberal Credit Policy.

    yStrict Credit policy results in lower Sales, but with fewer bad debts and fewer collectionexpenses resulting in fewer profits.

    yLiberal credit policy will results in highersales and better profits but it comes withhigher bad debt cost and collection expenses.

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    Risk:yRisk can be defined as the quantifiable

    likelihood of loss or less than expectedreturn.

    yRisk can be defined as the probability ofunfavorable condition.

    yRisks are future issues which can be avoided

    or mitigated through the process of hedging.yRisk is the product of severity of a hazard

    resulting in an adverse event times the

    severity of the event. 120

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    Risk Management:yRisk Management is a process of

    identification, analysis and mitigation of riskin Investment decision making.

    y It is a simple two step process of Determination of Risk that exits in anInvestment and handling the same in the

    best suited manner so as to achieve theplanned investment objective.

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    Financial Risk:yFinancial Risk refers to risk associated with

    any form of financing whether equity,preference or debt.

    y It is the risk associated with the mix ofcapital structure.

    ySpecifically it refers to risk associated with

    Debt financing where it includes the risk ofnon payment of interest or the repayment ofprincipal amount in time.

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    Risk Vs Uncertainity:yRisk is a situation where the investor can

    assign probabilities to the possible outcomewhereas Uncertainity is immeasurable.

    yRisk is present when future event occurs withmeasurable probability whereas Uncertainityis present where the likelihood of future

    event is indefinite or immeasurable.yRisk is the possibility of loss whereas

    Uncertainity is a future event which isindefinite or indeterminate.

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    Types of Risk:y Political Risk:

    Political risk refers to risk host countriesPolitical decision either at Macro or Micro level

    which will affect the profits of the multinationalfirm adversely.

    Ex: Acts of war, terrorism, Laws pertaining tomovement of capital, higher taxes to MNCs etc.

    Political risk can be reduced by local financing,purchasing the rawmaterial and componentslocally, and by less dependence on parentcompany.

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    Types of Risk:yCommercial Risk:

    Commercial risk refers to risk of expectedcash flows differing from actual cash

    flows.It includes all those risks other thanPolitical risks. Commercial risk arises

    irrespective of the political conditions inthat particular host country.

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    Types of Risk:yCommercial Risk:

    Ex: It can arise due to change in Demand,Supply, Selling price, Costs, Banker not

    committing to his responsibilities, Buyersfinancial limitations, Sellers limitation inmeeting the right quantity and quality of

    goods etc.

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    Types of Risk:yEconomic Risk:y It is the risk of Cash inflows realised from

    sale of a product or a service not covering

    its cost i.e. cash outflows.yEconomic risk refers to the risk of Cash

    Inflows being less than the estimate and

    Cash Outflows being more than what wasestimated, resulting in actual net cashprofits being less than the estimate.

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    Remittance Risk:

    y Exchange control restrictions refers torestrictions imposed by the Government of theHost country on all Foreign currency receipts

    and payments.y Exchange control restrictions affects the free

    flow of receipts and payments of foreigncurrency from one country to another.

    y Exchange control restrictions on remittancesmade by subsidiary to parent company in theform of dividends shall be looked through by

    MNCs.128

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    Exchange Control restrictions on remittances:

    yExchange control restrictions can be in theform of charging with holding tax, fixingceiling limits on maximum dividends that can

    be paid by the subsidiary company, Lock intime period on Investments made bysubsidiary etc.

    yThese restrictions ensure no free flow of fundsfrom host country to home country and it alsoencourages reinvestment of profits in the hostcountry itself rather than transfering the same

    to home country.129

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    Differing Tax Systems:

    yThe multiple tax jurisdictions and varyingtax rates among different countries makesInternational taxation as one of the most

    important risks to be considered by MNCs.y International Tax systems should be neutral,

    equitable and must avoid double taxation

    effect.y It should be neutral enough to allow flow of

    funds to move from low return country tohigh return countries.

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    Differing Tax Systems:

    y It should be equitable in terms of progressivesystem of taxation.

    y It should avoid double taxation by providing

    necessary tax credits, bilateral andmultilateral agreements.

    yThus the International taxation system of an

    MNCs should consider differing tax systemsprevailing in home and host countries so asto take the overall benefit of reducedtaxation.

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    Modes ofDouble taxation relief:

    yCredit system without deferral.

    yCredit system with deferral.

    yTax Exemptions.

    yAdmissibility of tax paid as expenditure.

    y Investment Credit.

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    FOREIGN EXCHANGE EXPOSURE AND

    EXCHANGE RATE FLUCTUATIONS:yForeign exchange exposure is defined as the

    sensitivity of value of assets, liabilities or

    operating incomes of a MNC due tounexpected changes in exchange rates.

    y It is the level of commitment and the degree

    to which a MNC is affected because ofunexpected exchange rate movements.

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    FOREIGN EXCHANGE RISK:

    yForeign exchange risk emanates due to thepresence of Foreign Exchange Exposure andit is the variability of domestic currency value

    of an asset, liability or an operating incomedue to unexpected changes in exchange rates.

    yHigher the exposure, higher is the foreign

    exchange risk and vice versa. No exposure toa particular currency, will have no foreignexchange risk to that particular currency.

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    TYPES OF FOREIGN EXCHANGE EXPOSURE:

    yTRANSLATION EXPOSURE.

    yTRANSACTION EXPOSURE.

    yECONOMIC EXPOSURE.

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    TRANSLATION EXPOSURE:y It is the exposure arising out of need to convertvalues of various foreign currency denominatedassets, liabilities, and Operating incomes intolocal or domestic currency denominated assets,liabilities and Operating incomes forconsolidation of financial statements andreporting purpose.

    yTranslation Exposure is also called as AccountingExposure since it is notional in nature as there isno real exchange rate gain or loss since the asset orliability is not sold to realise the gain or loss.

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    TRANSLATION EXPOSURE:

    y Translation exposure arises only when the rate atwhich initial transaction is recorded is differentfrom the rate at which it is translated on the

    date of consolidating the financial statement.y Ex: If at the time of occurring of transaction if

    Historical rate (Rate at the time of occurring oftransaction) is considered and on the date of

    consolidation, if Current rate (Rate at the timeof Consolidating of transaction) is considered,then it results in Translation exposure.

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    TRANSLATION EXPOSURE:

    y Translation exposure does not arise in case ofthose assets and liabilities which are initiallyrecorded and translated at the same rate.

    yThe assets and liabilities which are to betranslated at current rate are considered to beexposed and those assets and liabilities

    which are translated at historical rate are notconsidered to be exposed. Hence, translationexposure refers to the difference betweenexposed assets and exposed liabilities.

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    TRANSLATION EXPOSURE:

    yMeasurement of translation exposure isretrospective in nature and it arises onaccount of past transactions translated at a

    rate different from there historical rate.yEx: IfStock is recorded at Historical rate and

    on the date of consolidation, it is recorded at

    Current rate, then it results in translationexposure.

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    TRANSACTION EXPOSURE:

    yTransaction Exposure arises due to changesin the value of outstanding foreign currencydenominated contracts.

    y It arises on account of foreign currencydenominated transactions committed by thefirm to complete in future.

    y

    The measurement of transaction exposure isboth retrospective and prospective in naturebecause it is based on activities that occur inthe past but will be settled in the future.

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    TRANSACTION EXPOSURE:

    yEx: If a firm as made a Credit purchase ofGoods from a Foreign exporter for $1,00,000payable after 3months, and due to exchange

    rate movements its payability after 3monthsdiffers, then the firm is said to be exposed totransaction exposure.

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    ECONOMIC EXPOSURE:

    yEconomic Exposure describes the risk offuture cash flows changing due to exchangerate movements. It mentions that expected

    change in the value of the firm based onexchange rate movements.

    yThese are exposure arising out of

    transactions which do not have fixedcontractual commitments.

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    ECONOMIC EXPOSURE:

    y It measures the extent to which currencyexposure can alter a companys futureoperating cash flows. The measurement of

    operating exposure is prospective in natureand it is based on future activities of thefirm. It effects revenues and costs associated

    with future sales.

    yEx: Exposure faced by a Firm in terms offuture sales to a country due to exchange ratefluctuations.

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    METHODS OF TRANSLATION EXPOSURE:

    1. Current and Non current method:y Under this method, all current assets and current

    liabilities of foreign affiliate are translated intohome currency at the current exchange rate whilethe non current assets and non current liabilitiesare translated at historical rates that is, the rate ineffect when the asset was acquired or liability wasincurred.

    y The income statement is translated at the averageexchange rate of the period, except for thoserevenues and expense items associated with non

    current assets or liabilities.145

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    METHODS OF TRANSLATION EXPOSURE:

    2. Monetary and Non monetary method:y According to this method all monetary assets and

    monetary liabilities are translated at current rateswhere as non monetary assets and liabilities are

    translated at historical rates.

    y Monetary items are those items which represent aclaim to receive or an obligation to pay a fixedamount of foreign currency units. Eg: Cash, accountreceivables (Debtors + Bills receivable), Accountspayables ( creditors + Bills payable), other currentliabilities, long term debt etc.

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    METHODS OF TRANSLATION EXPOSURE:

    yNon Monetary items are those items thatdo not represent a claim to receive or anobligation to pay a fixed amount of foreign

    currency units. Eg: Stock, fixed assets, equityshares, preference shares etc.

    yThe income statement is translated at theaverage exchange rate of the period, exceptfor those revenues and expense itemsassociated with non monetary assets orliabilities.

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    METHODS OF TRANSLATION EXPOSURE:

    3. Temporal Method:y It is a modified version of monetary and non

    monetary method. The only difference between

    monetary and non monetary method andtemporal method is valuation of stock.

    yUnder monetary/non monetary method, stockis considered as non monetary assets and it is

    valued at historical rate; where as undertemporal method, stock is valued at historicalrate, if it is shown at cost price or it is valued atcurrent rate if it is shown at market price. 148

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    METHODS OF TRANSLATION EXPOSURE:

    4. Current Rate Method:yUnder this method, all balance sheet items

    are translated at current exchange rate,

    except for share holders equity (share capital+ reserves and surplus) which is translated athistorical rate.

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    HR: Historical Rate and CR: Current Rate

    Items Current/ Non-current Method

    Monetary/Non-monetary Method

    Temporal Method Current RateMethod

    Cash CR CR CR CR

    Receivables CR CR CR CR

    Inventory CR HR HR /CR CR

    Fixed Assets HR HR HR CR

    Payables CR CR CR CR

    Long term Debt HR CR CR CR

    Net worth HR HR HR HR

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    THE

    BALANCE

    OF PAYME

    NT:MEANING:

    y Balance of payment of a Country is a systematicaccounting record of all economic transactions during

    a given period of time between the residents of thecountry and residents of foreign countries. Itrepresents an accounting of countrys internationaltransactions for a particular period of time, generally a

    year. It accounts for transactions by individual,businesses and Government.

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    ECONOM

    ICT

    RANSACTI

    ONS:y It refers to transfer of economic value from one economic agentto another. Transfer can be Bilateral or Unilateral. The followingare the different types of economic transactions:

    y One Real and another Financial Transfer.

    Ex: Purchase or Sale of goods and services.y Two Real Transfers.

    Ex: Barter transactions.

    y Two Financial Transfers.

    Ex: Purchase of foreign securities for payment in cash.

    y One Real Transfer.Ex: A Unilateral gift in kind.

    y One Financial Transfer.

    Ex: A Unilateral Financial gift.152

    BALANCE OF PAYMENT ACCOUNTING:

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    BALANCE OF PAYMENT ACCOUNTING:

    yBOP conforms to the principles of doubleentry system i.e. every internationaltransaction should have a debit and

    corresponding credit. BOP is neither anincome statement nor a Balance sheet. Itis a statement ofSources and Application

    of funds that reflects changes in assets,liabilities and Networth during aspecified period of time.

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    BALANCE OF PAYMENT ACCOUNTING:

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    BALANCE OF PAYMENT ACCOUNTING:y Decrease in assets, increase in liabilities and increase in

    Networth represent credit or Sources of fund andsimilarly Increase in assets, decrease in liabilities anddecrease in Networth represent debit or Application offunds. Sources of funds (Credits) include export of goods

    and services, investment and interest earnings, unilateraltransfers received from abroad and loans fromforeigners. Application of funds (Debits) include importof goods and services, dividends paid to foreign

    investors, transfer payments abroad, loans to foreignersand increase in reserve assets. In short transactions which earn foreign exchange inflows are credits andthose which expend or use up foreign exchange aredebits.

    154

    BALANCE OF PAYMENT ACCOUNTING:

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    BALANCE OF PAYMENT ACCOUNTING:

    y If expenditure abroad by residents of one nationexceeds what the residents of that nation can earnfrom abroad, that nation is supposed to have a

    Deficit in BOP. However if a nation receives fromabroad more than what it spends, then it is supposedto have Surplus.

    155

    COMPONENTS OF BALANCE OF

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    PAYME

    NT

    :1. The Current Account:y It is typically divided into 3 categories namely, merchandise

    trade balances, services balance and the balance onunilateral transfers. Entries are recorded at their current

    value and surplus in current account represents an inflowof funds while a deficit represents an outflow of funds.The balance of merchandise trade refers to balancebetween exports and imports of goods such as machinery,automobiles etc. Services also called Invisibles includeinterest payments, shipping and insurance fees, tourism,

    dividends, military expenses etc. Unilateral transfersinclude gifts and grants from both private andGovernment.

    156

    COMPONENTS OF BALANCE OF

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    PAYME

    NT

    :2. The Capital Account:y Capital account consists of Foreign investment

    including direct Investment and portfolio Investments,

    Loans, Banking Capital, Rupee debt service and otherCapital. It includes acquisition of firms, Purchase andsale of stocks, Establishment of subsidiaries, etc.

    157

    COMPONENTS OF BALANCE OF

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    PAYME

    NT

    :3. The Official Reserve Account:y These are Government owned assets which represents

    purchases and sales by the central bank of the country.

    The changes in the Official reserve account arenecessary to account for the deficit or surplus in theBOP.

    158

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    FORMATI. Current Account:y a) Merchandisey b) Services (Invisibles)y c) Other Income (Transfers and others)II. Capital Account:

    y a) Foreign Investment.y b) Loans.y c) Banking Capital.y d) Rupee Debt service.y e) Other Capital.III. Official Reserve Account:

    y a) Errors and Omissions.y b) Overall balance. (Total of Current Account, Capital Account and Errors and

    Omissions)y c) Monetary Movements.

    159

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