2855-01-Introduction To International Finance-Ch 01 If

International Financial
Management
Introduction
The main objective of international
financial management is to
maximize shareholder wealth.
Adam Smith wrote in his famous title,
Wealth of Nations that if a
foreign country can supply us with a
commodity Cheaper than we
ourselves can make it, better buy it of
them with some part of the produce
of our own in which we have some
advantage.
Basic Functions
Acquisition of funds (financing decision)
This function involves generating funds from
internal as well as external sources.
The effort is to get funds at the lowest cost possible.
Investment decision
It is concerned with deployment of the acquired
funds in a manner so as to maximize shareholder
wealth.
Other decisions relate to dividend payment, working
capital and capital structure etc.
In addition, risk management involves both
financing and investment decision.
Nature & Scope
Finance function of a multinational firm
has two functions namely, treasury and
control.
The treasurer is responsible for
financial planning analysis
fund acquisition
investment financing
cash management
investment decision and
risk management
Controller deals with the functions related to
external reporting
tax planning and management
management information system
financial and management accounting
budget planning and control, and
accounts receivables etc.
Environment at
International Level
International financial management
practitioners are required the knowledge in
the
the following
knowledgefields.
of latest investment behaviour
changes in forex rates of investors
instability in capital
market export and import
interest rate trends
fluctuations Competition
macro level charges banking sector
micro level economic performance
indicators inflationary trends
savings rate
demand and supply
consumption pattern
conditions etc.
International financial
manager will involve the study
of
exchange rate and currency markets
theory and practice of estimating future
exchange rate
various risks such as political/country risk,
exchange rate risk and interest rate risk
various risk management techniques
cost of capital and capital budgeting in
international context
working capital management
balance of payment, and
international financial institutions etc.
Features of International
Finance
Foreign exchange
risk
Political risk
Expanded
opportunity sets
Market imperfections
Foreign exchange risk
In a domestic economy this risk is generally
ignored because a single national currency
serves as the main medium of exchange within a
country.
When different national currencies are
exchanged for each other, there is a definite risk
of volatility in foreign exchange rates.
The present International Monetary System set
up is characterised by a mix of floating and
managed exchange rate policies adopted by
each nation keeping in view its interests.
In fact, this variability of exchange rates is widely
regarded as the most serious international
financial problem facing corporate managers and
policy makers.
Political risk
Political risk ranges from the risk of loss (or gain)
from unforeseen government actions or other
events of a political character such as acts of
terrorism to outright expropriation of assets held by
foreigners.
For example, in 1992, Enron Development
Corporation, a subsidiary of a Houston based Energy
Company, signed a contract to build Indias longest
power plant. Unfortunately, the project got
cancelled in 1995 by the politicians in Maharashtra
who argued that India did not require the power
plant. The company had spent nearly $ 300 million
on the project.
Expanded Opportunity
Sets
When firms go global, they also tend
to benefit from expanded
opportunities which are available now.
They can raise funds in capital
markets where cost of capital is the
lowest.
The firms can also gain from greater
economies of scale when they operate
on a global basis.
Market Imperfections
domestic finance is that world
markets today are highly imperfect
differences among nations laws, tax
systems, business practices and
general cultural environments
International Trade
Theories
Theory of Mercantilism
Theory of Absolute Cost Advantage
Theory of Comparative Cost
Advantage
This theory is during the sixteenth to the three-
fourths of the eighteenth centuries.
It beliefs in nationalism and the welfare of the
nation alone, planning and regulation of
economic activities for achieving the national
goals, restriction imports and promoting exports.
It believed that the power of a nation lied in its
wealth, which grew by acquiring gold from
abroad.
Cont
Mercantilists failed to realize that simultaneous
export promotion and import regulation are not
possible in all countries, and the mere control of
gold does not enhance the welfare of a people.
Keeping the resources in the form of gold reduces
the production of goods and services and, thereby,
lowers welfare.
It was rejected by Adam Smith and Ricardo by
stressing the importance of individuals, and pointing
out that their welfare was the welfare of the nation.
Theory of Absolute Cost
Advantage
This theory was propounded by Adam Smith
(1776), arguing that the countries gain from
trading, if they specialise according to their
production advantages.
The pre-trade exchange ratio in Country I
would be 2A=1B and in Country II IA=2B.
Cont
Theory of Absolute Cost
Advantage
If it is nearer to Country I domestic
exchange ratio then trade would be more
beneficial to Country II and vice versa.
Assuming the international exchange ratio
is established IA=IB.
The terms of trade between the trading
partners would depend upon their
economic strength and the bargaining
power.
Advantage
Ricardo (1817), though adhering to the absolute
cost advantage principle of Adam Smith, pointed
out that cost advantage to both the trade partners
was not a necessary condition for trade to occur.
According to Ricardo, so long as the other country
is not equally less productive in all lines of
production, measurable in terms of opportunity
cost of each commodity in the two countries, it will
still be mutually gainful for them if they enter into
trade.
Cont

Advantage
In the example given, the opportunity cost of

one unit of A in country I is 0.89 (80/90) unit of
good B and in country II it is 1.2 (120/100) unit
of good B.
On the other hand, the opportunity cost of one
unit of good B in country I is 1.125 (90/80)units
of good A and 0.83 (100/120) unit of good A, in
country II.
Cont

Advantage
The opportunity cost of the two goods are different
in both the countries and as long as this is the case,
they will have comparative advantage in the
production of either, good A or good B, and will gain
from trade regardless of the fact that one of the
trade partners may be possessing absolute cost
advantage in both lines of production.
Thus, country I has comparative advantage in good
A as the opportunity cost of its production is lower
in this country as compared to its opportunity cost
in country II which has comparative advantage in
the production of good B on the same reasoning.
International Business
Methods
Licensing
Franchising
Subsidiaries and
Acquisitions
Strategic Alliances
Exporting

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In the example given, the opportunity cost of

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