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Subject code: FM-406/IB-416Author: Dr. Sanjay TiwariLesson: 1Vetter: Dr. B.S. BodlaMULTINATIONAL FINANCIAL MANAGEMENT:AN ture and scope of international financial management1.3Evolution of MNCs1.4Theory and practice of international financial management1.5Summary1.6Keywords1.7Self assessment questions1.8References/Suggested readings1.0 OBJECTIVESAfter reading this lesson, you should be able to Understand the factors responsible for emergence of globalizedfinancial markets. Understand meaning, nature and scope of international financialmanagement. Describe goals for international financial management.1.1 INTRODUCTIONFinancial management is mainly concerned with how to optimally makevarious corporate financial decisions, such as those pertaining toinvestment, capital structure, dividend policy, and working capitalmanagement, with a view to achieving a set of given corporate objectives.

2In anglo-American countries as well as in many advanced countries withwell-developed capital markets, maximizing shareholder wealth isgenerally considered the most important corporate objective.Why do we need to study “international” financial management? Theanswer to this question is straightforward: We are now living in a highlyglobalized and integrated world economy. American consumers, forexample, routinely purchase oil imported from Saudi Arabia and Nigeria,TV sets and camcorders from Japan, Italy, and wine from France.Foreigners, in turn, purchase American-made aircraft, software, alizationofinternational trade is certain to further internationalize consumptionpatterns around the world.Recently, financial markets have also become highly integrated. Thisdevelopment allows investors to diversify their investment portfoliosinternationally. In the words of a recent Wall Street Journal article, “Overthe past decade, US investors have poured buckets of money intooverseas markets, in the form of international mutual funds. At the sametime, Japanese investors are investing heavily in US and other foreignfinancial markets in efforts to recycle their economous trade surpluses.In addition, many major corporations of the world, such as IBM, DaimlerBenz (now, Daimler Chrysler), and Sony, have their shares cross-listed onforeign stock exchanges, thereby rendering their shares internationallytradable and gaining access to foreign capital as well. Consequently,Daimler-Benz’s venture, say, in China can be financed partly byAmerican investors who purchase Daimler-Benz shares traded on theNew York Stock Exchange.During last few decades a rapid internationalization of business hasoccurred. With the increase in demand of goods and services due toopening of borders of countries around world, the requirement of capital,

3machinery and technological know-how has reached to the topmost level.Now no single country can boast of self-sufficiency because in a globalvillage a vast population of multidimensional tastes, preferences anddemand exists.Undoubtedly, we are now living in a world where all the major ment–arehighlyglobalized. It is thus essential for financial managers to fully understandvital international dimensions of financial management.In order to cater to needs/demand of huge world population, a countrycan engage itself in multi trading activities among various nations. In thepost WTO regime (after 1999 onwards), it has became pertinent to notethat MNCs (Multinational corporations) with their world-wide productionand distribution activities have gained momentum. An understanding ofinternational financial management is quite important in the light ofchanges in international environment, innovative instruments andinstitutions to facilitate the international trading activities.Classical theory of trade assumes that countries differ enough from oneanother in terms of resources endowments and economic skills for oratecompetitiveness. Now there is free mobility of funds, resources,knowledge and technology which has made international trade moredynamic and complex. Capital moves around the world in huge amount;corporations are free to access different markets for raising finance.There exists an international competitiveness in different areas of tradeand commerce. The enormous opportunities of investments, savings,consumption and market accessibility have given rise to big institutions,financial instruments and financial markets. Now a days an investor inUSA would like to take investment opportunity in offshore markets. Thetrade off between risk of investing in global markets and return from

4these investments is focussed to achieve wealth maximisation of thestakeholders. It is important to note that in international financialmanagement, stakeholders are spread all over the world.1.2 NATURE AND SCOPE OF INTERNATIONAL FINANCIALMANAGEMENTLike any finance function, international finance, the finance function of amultinational firm has two functions namely, treasury and control. Thetreasurer is responsible for financial planning analysis, fund acquisition,investment financing, cash management, investment decision and riskmanagement. On the other hand, controller deals with the management,management information system, financial and management accounting,budget planning and control, and accounts receivables etc.For maximising the returns from investment and to minimise the cost offinance, the firms has to take portfolio decision based on analytical skillsrequired for this purpose. Since the firm has to raise funds from differentfinancial markets of the world, which needs to actively exploit marketimperfections and the firm’s superior forecasting ability to generatepurely financial gains. The complex nature of managing internationalfinance is due to the fact that a wide variety of financial instruments,products, funding options and investment vehicles are available for bothreactive and proactive management of corporate ature,whileanunderstanding of economic theories and principles is necessary toestimate and model financial decisions, financial accounting andmanagementaccountinghelpmanagement at multinational level.indecisionmakinginfinancial

5Because of changing nature of environment at international level, theknowledge of latest changes in forex rates, volatility in capital market,interest rate fluctuations, macro level charges, micro level economicindicators, savings, consumption pattern, interest preference, investmentbehaviour of investors, export and import trends, competition, bankingsector performance, inflationary trends, demand and supply ationalfinancialmanagement.1.2.1Distinguishing features of international financeInternational Finance is a distinct field of study and certain features setit apart from other fields. The important distinguishing features ofinternational finance from domestic financial management are discussedbelow:1.Foreign exchange riskAn understanding of foreign exchange risk is essential for managers andinvestors in the modern day environment of unforeseen changes inforeign exchange rates. In a domestic economy this risk is generallyignored because a single national currency serves as the main medium ofexchange within a country. When different national currencies areexchanged for each 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 managed exchange rate policiesadopted by each nation keeping in view its interests. In fact, thisvariability of exchange rates is widely regarded as the most seriousinternational financial problem facing corporate managers and policymakers.At present, the exchange rates among some major currencies such as theUS dollar, British pound, Japanese yen and the euro fluctuate in a totally

6unpredictable manner. Exchange rates have fluctuated since the 1970safter the fixed exchange rates were abandoned. Exchange rate variationaffect the profitability of firms and all firms must understand foreignexchange risks in order to anticipate increased competition from importsor to value increased opportunities for exports.2.Political riskAnother risk that firms may encounter in international finance is politicalrisk. Political risk ranges from the risk of loss (or gain) from unforeseengovernment actions or other events of a political character such as acts ofterrorism to outright expropriation of assets held by foreigners. MNCsmust assess the political risk not only in countries where it is currentlydoing business but also where it expects to establish subsidiaries. Theextreme form of political risk is when the sovereign country changes the‘rules of the game’ and the affected parties have no alternatives open tothem. For example, in 1992, Enron Development Corporation, asubsidiary of a Houston based energy company, signed a contract tobuild India’s longest power plant. Unfortunately, the project got cancelledin 1995 by the politicians in Maharashtra who argued that India did notrequire the power plant. The company had spent nearly 300 million onthe project. The Enron episode highlights the problems involved inenforcing contracts in foreign countries. Thus, episode highlights theproblems involved in enforcing contracts in foreign countries. Thus,political risk associated with international operations is generally greaterthan that associated with domestic operations and is generally morecomplicated.3.Expanded opportunity setsWhen firms go global, they also tend to benefit from expandedopportunities which are available now. They can raise funds in capital

7markets where cost of capital is the lowest. In addition, firms can alsogain from greater economies of scale when they operate on a global basis.4.Market imperfectionsThe final feature of international finance that distinguishes it fromdomestic finance is that world markets today are highly imperfect. Thereare profound differences among nations’ laws, tax systems, businesspractices and general cultural environments. Imperfections in the worldfinancial markets tend to restrict the extent to which investors candiversify their portfolio. Though there are risks and costs in coping withthese market imperfections, they also offer managers of internationalfirms abundant opportunities.1.3 GOALS FOR INTERNATIONAL FINANCIALMANAGEMENTThe foregoing discussion implies that understanding and ithmarketimperfections have become important parts of the financial manager’sjob. International Financial Management is designed to provide today’sfinancial managers with an understanding of the fundamental conceptsand the tools necessary to be effective global managers. Throughout, timperfections, using the various instruments and tools that are available,while at the same time maximizing the benefits from an expanded globalopportunity set.Effective financial management, however, is more than the application ofthe newest business techniques or operating more efficiently. There mustbe an underlying goal. International Financial Management is written ancialmanagement is shareholder wealth maximization. Shareholder wealth

8maximization means that the firm makes all business decisions andinvestments with an eye toward making the owners of the firm– theshareholders– better off financially, or more wealthy, than they werebefore.Whereas shareholder wealth maximization is generally accepted as theultimate goal of financial management in ‘Anglo-Saxon’ countries, suchas Australia, Canada, the United Kingdom, and especially the UnitedStates, it is not as widely embraced a goal in other parts of the world. Incountries like France and Germany, for example, shareholders aregenerally viewed as one of the ‘stakeholders’ of the firm, others beingemployees, customers, suppliers, banks, and so forth. Europeanmanagers tend to consider the promotion of the firm’s stakeholders’overall welfare as the most important corporate goal. In Japan, on theother hand, many companies form a small number of interlockingbusiness groups called keiretsu, such as Mitsubishi, Mitsui, andSumitomo, which arose from consolidation of family- owned businessempires. Japanese managers tend to regard the prosperity and growth oftheir keiretsu as the critical goal; for instance, they tend to strive tomaximize market share, rather than shareholder wealth.Obviously, the firm could pursue other goals. This does not mean,however, that the goal of shareholder wealth maximization is merely analternative, or that the firm should enter into a debate as to itsappropriate fundamental goal. Quite the contrary. If the firm seeks tomaximize shareholder wealth, it will most likely simultaneously beaccomplishing other legitimate goals that are perceived as worthwhile.Share-holder wealth maximization is a long-run goal. A firm cannot stayin business to maximize shareholder wealth if it treats employees poorly,produces shoddy merchandise, wastes raw materials and naturalresources, operates inefficiently, or fails to satisfy customers. Only a wellmanaged business firm that profitably produces what is demanded in an

9efficient manner can expect to stay in business in the long run andthereby provide employment opportunities.Shareholders are the owners of the business; it is their capital that is atrisk. It is only equitable that they receive a fair return on theirinvestment. Private capital may not have been forthcoming for thebusiness firm if it had intended to accomplish any other objective.1.4 EMERGENCE OF GLOBALIZED FINANCIAL MARKETSAND MNCSThe 1980s and 90s saw a rapid integration of international capital andfinancial markets. The impetus for globalized financial markets initiallycame from the governments of major countries that had begun toderegulate their foreign exchange and capital markets. For example, in1980 Japan deregulated its foreign exchange market, and in 1985 theTokyo Stock Exchange admitted as members a limited number of foreignbrokerage firms. Additionally, the London Stock Exchange (LSE) beganadmitting foreign firms as full members in February, 1986.Perhaps the most celebrated deregulation, however, occurred in Londonon October 27, 1986, and is known as the “Big Bang.” On that date, ason “May Day” in 1975 in the United States, the London Stock Exchangeeliminated fixed brokerage commissions. Additionally, the regulationseparating the order-taking function from the market-making functionwas eliminated. In Europe, financial institutions are allowed to performboth investment-banking and commercial-banking; functions. Hence, gibleformember-ship on the LSE. These changes were designed to give Londonthe most open and competitive capital markets in the world. It hasworked, and today the competition in London is especially fierce amongthe world's major financial centers. The United States recently cialbanksfrom

10investment banking activities (such as underwriting corporate securities),fur-ther promoting competition among financial institutions. Evendeveloping countries such as Chile, Mexico, and Korea began to liberalizeby allowing foreigners to di-rectly invest in their financial markets.Deregulated financial markets and heightened competition in financialservices provided a natural environment for financial innovations thatresulted in the intro-duction of various instruments. Examples of ndoptions,multicurrency bonds, international mutual funds, country funds, andforeign stock index futures and options. Corporations also played anactive role in integrating the world financial markets by listing theirshares across national treasury hard-currency foreign reserves. The saleproceeds are often used to pay down sovereign debt that has weighedheavily on the economy. Additionally, privatization is often seen as a curefor bureaucratic inefficiency and waste; some economists estimate thatprivatization improves efficiency and reduces operating costs by as muchas 20 per cent. The International Finance in Practice box on pages 12-13further describes the privatization process.There is no one single way to privatize state-owned operations. Theobjectives of the country seem to be the prevailing guide. For the CzechRepublic, speed was the overriding factor. To accomplish privatization enmasse, the Czech government essentially gave away its businesses to theCzech people. For a nominal fee, vouchers were sold that allowed Czechcitizens to bid on businesses as they went on the auction block. From1991 to 1995, more than 1,700 companies were turned over to zensbecamestockholders in these newly privatized firms.In Russia, there has been an ‘irreversible’ shift to private ownership,according to the World Bank. More than 80 per cent of the country’s non-

11farm workers are now employed in the private sector. Eleven millionapartment units have been privatized, as have half of the country’s240,000 other business firms. Additionally, via a Czech-style vouchersystem, 40 million Russians now own stock in over 15,000 medium- tolarge-size corporations that recently became privatized through massauctions of state-owned enterprises.International financial management is related to managing finance ofMNCs. There are five methods by which firms conduct internationalbusiness activities– licensing, franchising, joint ventures, managementcontracts and establishing new foreign subsidiaries. Licensing: A firm in one country licenses the use of some or all ofits intellectual property (patents, trademarks, copyrights, brandnames) to a firm of some other country in exchange for fees orsome royalty payment. Licensing enables a firm to use itstechnology in foreign markets without a substantial investment inforeign countries. Franchising: A firm in one country authorising a firm in anothercountry to utilise its brand names, logos etc. in return for royaltypayment. Joint ventures: A corporate entity or partnership that is jointlyowned and operated by two or more firms is known as a jointventure. Joint ventures allow two firms to apply their respectivecomparative advantage in a given project. Establishing new foreign subsidiaries: A firm can also penetrateforeign markets by establishing new operations in foreign countriesto produce and sell their products. The advantage here is that theworking and operation of the firm can be tailored exactly to thefirms needs. However, a large amount of investment is required inthis method.

12 Management contracts: A firms in one country agrees to operatefacilities or provide other management services to a firm in anothercountry for an agreed upon fee.1.5 FOREIGN INVESTMENT FLOWS TO INDIA AND OTHERDEVELOPING COUNTRIESIn the last two decades there has been a rapid growth in internationalfinancial flows to both India and other emerging economies. There aretwo types of foreign investment flows. One is foreign direct investment(FDI) and other is called indirect investment (portfolio investment). If welook at FDI trends in India then during last decade the following patternhas emerged (Table 1.1).TABLE 1.1: FOREIGN INVESTMENT (FDI) FLOWS TO INDIAYearDirect investmentPortfolio investmentTotalRs.US Rs.US Rs.US 141200738241613351381995-9671722144919227481636448

financial markets. Understand meaning, nature and scope of international financial management. Describe goals for international financial management. 1.1 INTRODUCTION Financial management is mainly concerned with how to optimally make various corporate financial decisions, such as those pertaining to

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