ASSIGNMENT

Course Code : MS-45

Course Title : International Financial Management

Assignment No. : MS-45/TMA/Sem-II/2020

Coverage : All Blocks

Note: Attempt all the questions and submit this assignment to the Coordinator of your Study
Centre on or before 31st October, 2020.

1. What are the main features of the exchange rate regime that was designed at Bretton
Woods? Discuss the different options available under the fixed exchange rate system
and floating exchange rate system.

2. Why is cost of capital important for a firm? Explain the reasons for variations in the
cost of capital across different countries.

3. What do you understand by Exchange Rate Exposures? Describe different types of

exchange rate exposures and the techniques used to manage them.

4. What is meant by Foreign Direct Investment (FDI)? What are the major stimulating
factors that spur foreign investment in a country?

5. What role does Export Credit Guarantee Corporation (ECGC) play in financing of
exports from India? Discuss the various types of guarantees offered by ECGC. What
are the risks covered under Standard Policies issued by it?
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ASSIGNMENT REFERENCE MATERIAL (July20 to Dec20)

MS-45
INTERNATIONAL FINANCIAL MANAGEMENT

Q1. What are the main features of the exchange rate regime that was designed at
Bretton Woods? Discuss the different options available under the fixed exchange rate

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system and floating exchange rate system.

Ans:- The exchange rate regime was known as the fixed parity system with adjustable pegs.
In fact, it was designed at Bretton Woods and so it was also known as the Bretton Woods
exchange rate system.

.c
In the fixed parity system, each member country was to set a fixed value-called the par value-
of its currency in terms of gold or US dollar. It was the par value that determined the rate of
exchange between two currencies. Minor fluctuations in the exchange rate within a narrow
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band of one per cent above and below the established parities could not be ruled out. They
were to be corrected through active intervention of the monetary authorities of that country.

It may, however, be mentioned that the fixed parity under the Bretton Woods system was not

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like that of gold standard of 1880-1914. It was a fixed parity with adjustable pegs meaning
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that any member country could alter the value of its currency or, in other words, could
devalue its currency in case of "fundamental disequilibrium" in the balance of payments.
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Changes up to five per cent did not require prior approval of the IMF, but beyond it, IMF's
approval was necessary. Fundamental disequilibrium was never formally defined; but in
practice, it meant continued and chronic balance of payments problem and colossal loss of
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reserves. The purpose of the adjustable peg system was, therefore, to establish a balance
between the objectives of stable exchange rates and the macro-economic goals of the
countries going for such adjustments as also to help avoid any use of exchange control and
50

trade-restrictive measures. In other words, it brought flexibility in the fixed exchange rate
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system for the purpose of attaining equilibrium in the balance of payments. The provisions
also contained cautions so that there might not be competitive devaluation. It was maintained
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through supervision and scrutiny over desired exchange rate changes.

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Again, an important aspect of the Bretton Woods exchange rate system was that the US dollar
was convertible into gold at a fixed rate of $ 35 a troy ounce of gold. The other currencies
were convertible into gold via US dollar. This currency was given the position or intervention
currency in the system in view of the fact that in the immediate post-War period, it was the
strongest currency. This system was, therefore, likened with the gold exchange standard
where countries redeemed their currency into gold-convertible currency and not necessarily
into gold directly. In the post-War system, the US dollar came to be the intervention currency
what was the British pound during the early decades of the twentieth century.

Q2. Why is cost of capital important for a firm? Explain the reasons for variations in
the cost of capital across different countries.

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Ans. The determination of the firm’s cost of capital is important because it : (a) provides the
very basis for financial appraisal of new capital expenditure proposals and thus serves as
acceptance criterion for capital expenditure projects, (b) helps the managers in determining
the optimal capital structure of the firm, (c) serves as the basis for evaluating the financial
performance of top management,

(d) helps in formulating dividend policy and working capital policy, and Can serve as
capitalization rate which can be used to determine capitalization of a new firm.

An understanding of why cost of capital varies across different countries provides an insight
into the reasons for competitive superiority of some MNCs in some countries. Knowledge of
differences in cost of capital in different countries may enable an MNC to formulate suitable
strategy regarding procurement of funds from those countries where they are available at

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lower cost. An appreciation of cost of capital across the globe can throw light on the
differences existing in the pattern of capitalization of different MNCs.

Although concept of cost of capital and methodology applied to compute it are invariably the
same both in case of domestic firms and MNCs, yet they differ in practice because of several
peculiar features of an MNC, as outlined below :–

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Scale of Operations : MNCs generally being larger in size as compared to the domestic firms
may be in a privileged position to garner funds both through stocks and bonds at lower cost
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because they are accorded preferential treatment due to their size.

Access to International Capital Markets : In view of easier access to international capital

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markets, MNCs are in a position to obtain funds at lower cost than that paid by the domestic
firms. Further, international availability permits MNCs to maintain the desired ratio, even if
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substantially large funds are required. This is not true in the case of domestic firms. They
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have either to rely on internally generated funds or borrow for short and medium-term from
commercial banks. Furthermore, subsidiaries may be in a position to procure money locally
at a lower cost than that available to the parent company if the prevailing interest rates in the
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host country are relatively low. For example, the Coca-Cola company, because of its global
presence and strong capital position and therefore, having an easy access to key financial
markets, could raise funds with a lower effective cost.
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Exposure to Exchange Rate Risk : Operations of MNCs and their cash flows are exposed to
higher exchange rate fluctuations than domestic firms leading to greater possibility of
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bankruptcy. As a result, creditors and stockholders demand a higher return, which enhances
the MNC’s cost of capital.
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Exposure to Country Risk : The total country risk of foreign investment, as noted earlier, is
greater in the case of foreign investment than in similar domestic investment because of the
additional cultural, political and financial risks of foreign investments. Thus, risks increase
the volatility of returns on foreign investment, often to the detriment of the MNC. To what
extent international diversification minimizes the impact of country-specific and currency-
specific risks would depend on the magnitude of capital market segmentation and how widely
the firm’s investments are locally or globally diversified. Where a firm’s investment is
concentrated in a local economy and markets are partially segmented from other capital
markets, country-specific and currency-specific risks cannot be diversified and hence the
firm’s exposure to these risks cannot be eliminated. In contrast, a firm with globally

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diversified investors especially in integrated financial markets can eliminate these risks and
the cost of capital of such firm will obviously be low. According to a large body of literature,
MNCs have lower systematic risks in relatively integrated financial markets, such as the UK
and the USA than comparable domestic companies, presumably, due to benefits of
international diversification.

The above factors that distinguish between cost of capital of an MNC and that of a domestic
firm are exhibited in Figure 1 on next page. In general, the first three factors listed below, viz;
(scale, access to international capital markets, and international diversification) are favorable
factors for an MNC resulting in reduced cost of capital, while the last two factors (exchange
rate risk and country risk) are unfavorable, and are likely to result in increase in cost of
capital.

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Preferential
Larger scale Treatment from
Creditors
Greater access to
international Possible Access to Cost of
Capital Market Low-Cost Foreign Capital

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Financing
International
Diversification
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Exposure to Probability
Exchange Rate of
Risk Bankruptcy

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Exposure to
Country Risk
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Fig. 1 : Summary of factors contribution to differences between cost of
capital of MNC and that of a domestic firm
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Q3. What do you understand by Exchange Rate Exposures? Describe different types of
exchange rate exposures and the techniques used to manage them.
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Ans:- Exchange rate risk or exchange rate exposure results from fluctuations in the exchange
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rate. In this unit, we have used exchange rate risk and exposure interchangeably. Currency
rate fluctuations affect the value of revenues, costs, cash flows, assets and liabilities of a
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business organisation. Transactions of business firms with foreign entities could be in the
form of exports, imports, borrowing, lending, portfolio investment and direct investment etc.
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So a firm with any one or more types of transactions is subject to exchange rate exposure.

Firms have to become more and more careful about currency rate exposure as the process of
globalisation gains further momentum. Suppose US dollar depreciation against euro. This
change in the exchange rate can have significant consequence both for American as well as
European firms. For example, it can adversely affect the competitive position of European
firms in the highly competitive US market. They will be forced to raise dollar prices of their
products by more than their US competitors. The same change in exchange rate, however,
will strengthen the competitive position of import-competing US firms. On the other hand,
should the dollar appreciate against the euro, it would enhance the competitive position of
European firms at the exposure of US firms.

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Exchange rate fluctuations can affect not only firms that are directly engaged in international
trade but also purely domestic firms. Consider, for example, an Indian leather goods
manufacturer who sources only domestic materials and sells exclusively in the Indian market,
with no foreign currency receivables or payables. This seemingly purely domestic Indian firm
can be subject to foreign exchange exposure if it competes against imports, say, from Chinese
leather goods manufacturer. When Chinese yuan depreciates against Indian rupee, this is
likely to lean to a lower rupee price of Chinese goods, increasing their sales in India, thus
harming Indian manufacturer.

(a) Transaction Exposure: This exposure arises when a company has assets and liabilities
the value of which is contractually fixed in foreign currency and these items are to be
liquidated in the near future. For example, the value of assets in the form of foreign currency
receivables or liabilities in the form of foreign currency payables will be sensitive to the

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exchange rate. Likewise, currency rate fluctuations would impact loans, interest, dividend
and royalty etc. to be paid to the foreign entities or to be received from them.

To illustrate, let us consider that a company buys raw material from abroad the contractual
price of which is $100. The payment will be settled after a credit period of six months within
the current financial year. Till the date of settlement, this company has a transaction exposure

.c
of $100. If dollar appreciates during six months period, the company will have to pay more in
rupees than what it would have paid on the date of contract. Conversely, depreciation of
dollar will result in a smaller rupee outflow. Either way, the company remains under an
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uncertainty as to what rupee outflow will take place on the settlement date. This uncertainty
of cash flows is what constitutes the exposure/risk. Like receivables or payables, repayment
of principal and interest to foreign entities due during the current financial year also gives rise

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to transaction exposure.
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(b) Translation Exposure: Translation exposure arises from the variability of the value of
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assets and liabilities as they appear in the balance sheet and are not to be liquidated in near
future. Translation of the balance sheet items from their value in foreign currency to that in
domestic currency is done to consolidate the accounts of various subsidiaries. Therefore,
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translation exposure is also known as Consolidation Exposure or balance sheet exposure.

For the purpose of illustration, let us take an Indian parent company having a subsidiary in
50

the USA. In the beginning of the year, the US subsidiary has capital equipment, inventory
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and cash valued at $200 000, $100 000 and $20 000 respectively. The exchange rate is Rs 45
per dollar. Therefore the translated value of these assets is Rs 1,44,00,000. At the end of the
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year, the assets are $210 000 (capital equipment), $105000 (inventory) and $10000 (cash)
respectively. At the exchange rate of Rs 46 per dollar, the translated value becomes Rs 1,
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49,50,000. Thus, there is a translation “gain” of Rs 5,50,000 on asset side of the balance
sheet. Likewise there must have been a translation “loss” on liabilities of the subsidiaries
such as, debts denominated in dollars.

Here; it must be noted that there is no movement of cash since these assets and liabilities are
not being liquidated. Simply, their value is being worked out in the currency of the parent
company. Thus, translation “gains” or “losses” are notional, assuming that there are no tax
implications related thereto. As a matter of fact, the main difference between transaction
exposure and translation exposure is that while the former has effect on cash flows, the latter
does not.

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A view about translation exposure is that it is only notional in character since the translation
losses or gains will differ according to the accounting practices. However, this view is not
accepted unanimously. That is why an attempt is made to measure and manage it.

(c) Economic Exposure: Economic exposure results from those items which have an affect
on cash flows but the value of which is not contractually defined, as is the case of transaction
exposure. Some examples of operating exposure are given below;

a) Tender submitted for a contract remains an item of operating exposure until the award of
contract. Once the contract is awarded, it becomes transaction exposure.

b) A deal for buying or selling of goods is under negotiation. The price of goods being
negotiated may be affected by fluctuations in the exchange rate.

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c) If a part of raw material is imported, the cost of production will increase following a
depreciation of the home currency.

Exchange rate will affect future revenues as well as costs and hence operating profits. Since
these effects are of long-term nature and impact the competitiveness of firms, operating

.c
exposure is also called Strategic Exposure. It influences the long-term business decisions
such as products, markets, sources of supply and location of production facilities etc.
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For example, continued appreciation of dollar in early eighties rendered many American
firms uncompetitive vis-a-vis their competitors because the value of revenue streams
denominated in foreign currencies diminished when converted into dollars. On the contrary,

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in later part of eighties, many Japanese and German companies were not able to keep their
operating income at satisfactory level due to fall of dollar. Some of these companies shifted
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their manufacturing activities in USA :–

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Q4. What is meant by Foreign Direct Investment (FDI)? What are the major
stimulating factors that spur foreign investment in a country?
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Ans:- FDI there are multiple benefits like more employment, more taxes, greater availability
of goods and services and so on assuming the funds are poured into Greenfield projects and
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not in a takeover of an existing business.

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Foreign direct investment is that investment, which is made to serve the business interests of
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the investor in a company, which is in a different nation distinct from the investor’s country
of origin. A parent business enterprise and its foreign affiliate are the two sides of the FDI
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relationship. Together they comprise an MNC.

Key factors that spur foreign investment are discussed below :–

Product and Market imperfections : MNCs possessing specific intangible capital in the form
of trade marks, patents, general marketing skills, and other organizational abilities may be
inspired to make overseas investment through new product development and adaptation,
quality control, advertising, distribution, after sales service and the general ability to read
changing market requirements and translate them into saleable products and take advantage
of market imperfections.

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At times, MNCs prefer FDI to other modes of entry into overseas markets for protecting
misuse of their intangible assets by local firms. Coca-Cola chose FDI as a mode of entry into
foreign markets, and set up bottling plants instead of licensing local firms mainly to protect
the formula for its famed soft drink. If the company licenses a local firm to produce coke, it
has no guarantee that the secrets of the formula will be maintained.

It must, however, be remembered that mere existence of market failure is not sufficient to
justify FDI, for the fact that local firms have an inherent cost advantage over foreign
investors and MNCs can succeed abroad only if the production or marketing edge that they
possess cannot be purchased or initiated by local firms. They have to create and preserve on
enduring basis effective barriers to direct competition in product and factor markets.

Market Opportunities: Existence of tremendous market opportunities abroad and fiercely

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competitive domestic market limiting the growth in demand and the consequent decline in
market share may stimulate MNCs to enter into high-potential overseas markets. For
instance, many of the developing countries, viz; Argentina, China, Mexico, Chile and
Hungary have, of late, been able to attract FDI flows because of existence of attractive
markets.

.c
Trade Barriers: Because of government created restrictions in the form of tariffs, quotas, etc.
on imports and exports hindering the free flow of the products across national boundaries, a
firm may decide to set up production plants in such countries as means of circumventing the
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trade barriers. Honda, for example, set up plant in Ohio to produce cars to escape from the
US Government tariff control. The recent spurt in FDI in Mexico and Spain can be partly
attributed to the desire of MNCs to circumvent external wade barriers imposed by NAFTA

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and the European Union.
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Existence of Superior Profits in Overseas Markets: Possibility of making superior earnings

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in certain overseas market may also allure the MNCs to divert their funds in these markets,
However, MNCs are likely to face competitive challenge from the local firms who may
prevent a new competitor from taking their business by lowering their prices.
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Imperfect Labour Market: The labour market is the most imperfect among all the factors of
production, and labour costs vary widely in different countries. Wage costs in Mexico,
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Malaysia and India are relatively much lower. Substantially lower labour costs in these
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countries have attracted MNCs like Black & Decker Corporator, Eastman Kodak Co., Ford
Motor Co., General Electric Co, Smith Corona, Zenith Corp. and Honeywell to invest.
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Access to Inputs: Due to transport costs, MNCs generally avoid importing raw materials
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from a country where it is not available at a stable price, especially when they plan to sell the
finished product to consumers of that very country. Under the circumstances, it would be
pertinent to set up production plants in the country where the raw materials are easily
available in abundance. Many MNCs involved in extractive/natural resources tend to directly
own oil fields, mine deposits and forests for these reasons.

Access to Foreign Technology: MNCs are growingly setting up manufacturing plants or

acquiring existing plants in those countries just to learn about the advanced technology and
use them to improve their own production process at their subsidiary plants around be globe.

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Q5. What role does Export Credit Guarantee Corporation (ECGC) play in financing of
exports from India? Discuss the various types of guarantees offered by ECGC. What
are the risks covered under Standard Policies issued by it?

Ans. ECGC issues financial guarantees to the banks, assuring them that in the event of an
exporter failing to discharge his liability to the bank, the ECGC would make good a major
portion of the loss thus caused to the bank.

ECGC issues the following types of financial guarantees to the banks :–Packing Credit
Guarantee: Packing Credit guarantee is issued for a period of 12 months and covers all
advances made by the bank to an exporter within an approved limit during the period. The
bank has to submit monthly declaration of the advances and repayments. Premium is charged
at the rate of 10 paise per Rs. 100 per month on the highest amount of advance outstanding

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on any day during the months. ECGC reimburses the bank to the extent of 66.6% of its loss,
if the entire amount due from the exporter is not recovered within a period of 4 months from
the due date of repayment. If any amount is recovered by the bank subsequently, it is to be
shared between ECGC and the bank in the same ratio; in which the loss was borne by them.

Export Production Finance Guarantee: This guarantee is also issued in respect of packing

.c
credit granted by banks. It enables the banks to sanction advances to the full extent of cost of
production if it exceeds the F.O.B value of the export order. The difference represents the
incentive receivable by the exporter. The extent of cover and premium rates are the same as
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in case of Packing Credit Guarantee.

Post-shipment Export Credit Guarantee: Post-shipment finance given to exporters by way

07
of purchase, negotiation or discount of export bills or advances against such bills is eligible
for this guarantee. The exporter is required to hold a suitable policy of ECGC to cover the
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overseas credit risks.

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ECGC charges premium @ 7 paise per Rs.100 per month and reimburses the loss to the
extent of 75%. This guarantee is also issued on whole turnover basis. In such cases the loss is
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covered to the extent of 85%, in case the advance is granted to exporters holding ECGC
policy. Advances granted to non-policy-holders are also covered but the percentage of cover
is 60%. The premium rate is 5 paise per Rs.100 per month, if advances granted under Letters
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of Credit bills are also covered under this guarantee. Otherwise the premium rate is 6 paise,
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Individual Post - Shipment Export Credit Guarantee can also be obtained in case of non-
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policy holder, provided the exporter makes shipments solely against letters of credit.
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Export Finance Guarantee: This guarantee is issued to cover post-shipment advances

granted by banks to exporters against export incentives receivable in the form of cash
assistance, duty drawbacks, etc. Thus this guarantee is issued when bank provides finance
equal to the difference between the export value and the domestic price; such difference is
receivable by the exporter from the Government.

ECGC charges premium of such policies @ 10 paise per Rs.100 per month and covers loss to
the extent of 75%. Banks having whole turnover packing credit guarantees are eligible for
concession in premium rate and higher cover.

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