International Financial Management

Unit-1

I-International financial management:

International financial management may be defined as the management of the whole

financial operations relating to international activities of business organizations. These
activities include
 Expansion of existing business in foreign countries.
 Decisions of existing business in foreign countries.
 Decisions of setting up a plant abroad or participating in the investment in another
country.
 Setting up joint ventures.
 Exporting and importing of goods and services.
 Financing of subsidiaries abroad and distribution if dividends on the profits
earned by multinational.

Structure of international financial system

Country ‘A’ Country ‘B’

Domestic bank
Domestic bank

Financial institution
Financial institution International
financial system
Forex mkt MNC
Forex mkt MNC

Functions of international financial system

 Foreign exchange market

 Exchange determination
 Exchange exposure
 MNC’s Working capital
 Study the balance of payment position
 Assessment and management of interest rate
 Investment decisions like FDI , FPI/FII
Evaluation of international financial system

 By metallic period (before 175)

 Gold standard (1875-1914)
 Inter war period (191-1944)
 Breton woods / fixed exchange rate regime(1945-1972)
 Floating/flexible exchange rate regime(since 1973)

II. The Bretton woods system(1944-77):

A conference was held at bretton woods in the USA, in July 1994, in order to put
in place a new international system.

Objectives of the bretton wood conference:

 To review the existing rules

 To devise a system to encourage international monetary cooperation
 To establish an international institution to ensure good functioning of system

Characteristics of Bretton woods:

 System of gold standard

 A procedure for mutual international credits
 Creation of international monetary fund to supervise and ensure smooth
functioning of the system.
 Devaluation and revaluation of more than 5% had to be done with the
permission of the IMF.

III. International monetary fund:

The international monetary fund had 44 countries as its members in

1946.currently almost all the countries (178) are members of this institution. The only
exception is Cuba

The main functions of IMF

 To help member countries in stabilizing their currency.

 To supervise the evaluation of exchange rates and provide
 Provide guidance to countries on their exchange rate policies
 To accord temporary financing to tide over balance of payments difficulties
Resources of the IMF:

The capital of IMF is constituted by the totality of the subscription of member states,
known as quotas. In 1994, the capital of IMF was SDR 144.6 billion.
Since 1970, a new instrument of reserve has been created, namely SDR (special
drawing right). The value of SDR represents a weighted average of 5 currencies, such
as
 US dollar (40%)
 German deutschmark (21%)
 UK pound sterling (11%)
 Japanese Yen (17%)

Activities of the IMF

 Appropriate adjustment mechanism

 The compensatory financing facility(established in 1963 and liberalized in 1975)
 The buffers stock financing facility (established in 1969 )
 Extended facility(established in 1974 and expanded in 1983)

IV. Exchange rate Regimes

The IMF classifies exchange rate regimes in four categories

 Regime of fixed exchange rates

 Regime of free floating exchange rate
 Regime of managed floating rate
 Regime of limited Flexibility

V. European monetary system:

In 1978 the European council decided to establish a European monetary system

(EMS).in 1989 at the Strasbourg summit, it was decide to convene an inter
governmental conference, this conference gas led to the signing of the Maastricht
Treaty on 7 February 1992 after the Maastricht treaty EEC has been renamed as
European union from 1 January 1993 the internal European market has been
operational.

Objectives of the European monetary system

 To promote and enhance monetary stability in the European community

 Improvement of the general and economic situation of the countries of the
European union in terms of growth
 Full employment
 Increase standard of living
 Reduction of regional disparities
 Stabilizing effect on international economic and monetary relations.
Characteristics of European monetary system

The following are the major characteristics of the EMS

 Single uniform monetary unit of the European union, namely the European
currency unit(ECU)
 A stable and adjustable exchange rate.

The mechanism of the EMS

The EMS operates in three mechanisms such as

 Exchange and invention mechanism

 Settlement mechanism
 Credit mechanism
 Very short credit mechanism(45 days to 3 months)
 Short term credits( maximum 9 months)
 Medium credit(2 to 5 years)

South East Asia crisis:

The collapse of Thai bath (currency of Thailand) in July 1997 marked the
beginning Asian crisis. Thai bath in 1997 was followed by financial panic that spreads
Malaysia, Indonesia, and other countries in the world.

Causes for crisis:

First oil shock:

Oil shock means rising strains on the balance of payments of the oil-importing
Countries. The most significant change in the international economic environment
was the first oil shock of 1973-74.

Abrupt cutback of lending:

Over-lending was followed by an abrupt cutback of leading. The debt problem

would not have been serious had there been regular flow of loans and borrowing
countries could have got new loans to repay the older ones. It happens in 1982.

Transition from inflation to disinflation

It was the transition from inflation to disinflation that aggravated the problem of
indebtedness. The second oil stock of 1979-80 failed to stop the upsurge in real
interest rates, and repayment of loans became a costly affair.
Emerging recession:

The 1980 decade dawned with emerging recession among many of the industrialized
countries

Deteriorating terms of trade:

The deteriorating terms of the net oil importing developing countries during 1980-82
caused the debt crisis.
Defective policy of the borrowing countries

Kharas amd Levonshon (1988) find that in case of 12 out of 26 countries, the level of
consumption rose with an increase in borrowings in which case, external debt
problem was bound to emerge.

Additional problems during the 1990s and thereafter.

 The gulf war led to be rise in oil import bills of many developing borrowers
 The turmoil in global fixed-income markets in the summer of 1998
 Problems in high-yield markets following slowdown of 2001.
 Fall in debt flows in East Asia, Russian federation and Latin America
 Unit-II

Foreign Exchange risk:

Foreign Exchange risk is inherent in the businesses of all multinational enterprises as

they are to make or receive payments in foreign currencies .this risk means eventual
losses incurred by these enterprise due to adverse movement of exchange rates between
the dates of contract and payment.

Types of Exchange risk /Exposure:

A multinational enterprise faces the following four types of risks/exposures

Foreign exchange risk/exposure

Transaction exposure Operating exposure Accounting/transla Economic exposure

tion exposure

Contingent yuu Competition

I. Transaction exposure:

Transaction risk can be defined as measure of variability in the value of assets and
liabilities when they are liquidated. Transaction exposures usually have short time
horizons and operating cash flows are affected

Management of transaction exposure

There are two techniques are used to manage transaction risk, such as
1. Financial techniques
 Forward mkt hedging
 Money mkt hedging
 Option mkt hedging
 Swap mkt hedging
2. Opertional techniques

 Choice of the currency invoicing

 Leads and lags
 Exposure netting

II. Operating exposure

Operating exposure capture the impact of unanticipated exchange rate changes on

the firm’s revenue, operating cost and operating net cash flows over a medium horizon
(up to three years)

Management of operating exposure:

 Selection of low cost production sites

 Flexible sourcing policy
 Diversification of mkt
 Product differentiation& R&D offsets
 Financial hedging

III. Translation exposure/Accounting exposure:

Transaction exposure is one of the short term exposures. It is also known as accounting
exposure. At the time of consolidation, the exchange rate is different from what it was at
the time of investment, there would be difference of consolidation. The accounting
practices in this regard vary from country to country, and even with in a country from
company to company

Methods translation / accounting exposure.

 Current / non current method

 Monetary /Non monetary method
 Temporary method
 Current rate method
Management of transaction / accounting exposure:

 B/s hedge
 Financing derivative hedge
IV. Economic exposure:-

The economic exposure refers to the change in expected cash flow as a result of an
unexpected change in exchange rates. This not a direct foreign exchange risk exposure,
the underlying economic factors may become a risk factor

Channels of economic exposure

Home currency
value of liabilities

Value of firm
Exchange

Future cash flow

Internal techniques of hedging:

The following techniques can be used to reduce the exchange rate risk
Choice of currency invoicing:
In order to avoid the exchange rate risk, many companies try to invoice their exports
in the national currency and try to pay the their suppliers in the national currency as well.
2. Leads and lags:
This technique consists of accelerating or delaying receipt or payment in foreign
exchange as warranted by position / expected position of the exchange rate

3. Indexation clauses in contracts:

For protecting against the rate risk, sometimes, several clauses of indexation are
included by exports and imports.

4. Netting (Internal compensation):

An enterprise may reduce its exchange risk by making and receiving payments in the
same currency. Netting can be classified in to two types
 (a) Bilateral :
A parent company sells semi finished products to its subsidiary and repurchase
the finished product from the latter. Movements of funds to be done will look like as
shown given below

$80,000
Subsidiary Co
Parent Co
$1, 00,000
Funds movement without netting

$20,000
Parent Co Parent Co

Funds movement with netting

(b)Multilateral

In multilateral netting funds moves between the parent company and it’s all
subsidiaries. In multilateral netting movements of funds can be done as shown given
below

Parent Co Subsidiary ‘A’

Subsidiary ‘C’ Subsidiary ‘B’

Subsidiary ‘D’
Funds movement without netting
Parent Co Subsidiary ‘A’

Subsidiary ‘B’ Subsidiary ‘C’

Subsidiary ‘D’

Funds movement with netting

5.Switching the base of the manufacturer:

In the case of manufacturing companies, switching the base of manufacturer may be

useful so that costs and revenues are in same currency.

6.Reinvoicing currency:

A reinvoicing centre of a multinational group does billing in respective national

currencies of subsidiary companies and receives the invoices made in foreign currency
from each one of them.

Client Pay in Reinvoicing pay in Supplier

(Debtor) centre (Creditor)
Foreign Foreign
Currency Currency
`
Pay in local currency pay in local currency

Subsidiary ‘A’ & ‘B”

7.Swaps in foreign currencies

 Swaps in agreements reached between two parties which exchange a
predetermined sum of foreign currencies with a condition to surrender that sum on a
predecided. Swaps can be classified in to following types

 Cross credit swaps

 Back to back swaps
 Credit swaps
 Exp[ort swaps

Management of risk in foreign exchange market.

Foreign Exchange risk is inherent in the businesses of all multinational enterprises

as they are to make or receive payments in foreign currencies .this risk means eventual
losses incurred by these enterprise due to adverse movement of exchange rates between
the dates of contract and payment. Foreign exchange risk can be classified into following
types.

 Exchange rate risk

 Interest rate risk
 Financial risk
 Political risk

1. hange rate risk:

It can be classified into three types such as

Economic risk:-

The economic exposure refers to the change in expected cash flow as a result of an
unexpected change in exchange rates.
Transaction risk:

Transaction risk can be defined as measure of variability in the value of assets and
liabilities when they are liquidated.

Consolidation risk:

Consolidation risk is the one of the short term risk. At the time of consolidation, the
exchange rate is different from what it was at the time of investment; there would be
difference of consolidation. The accounting practices in this regard vary from country to
country, and even with in a country from company to company
Tehniques for covering and managing exchange rate risk:

 Covering risk in the forward market

 Covering risk in the money market
 Advances in foreign currency
 Covering in financial futures market
 Covering in the options market
 Covering through currency swaps
 Recourse to specialized organizations

Interest rate risk

Interest rate risk results into an increase of financial chare on borrowing or into a
capital loss on bonds. Interest rate risk concerns the following
 Present credits and debts
 Future credits and debts
 Conditional credits and debts

Management of interest rate risk:

 Modify the characteristics of the instrument used on financial market

 Short term contracts which permit the enterprise to cover themselves against
short-term interest rate risk
 Long term contracts permitting the enterprise to cover themselves against long
term risks.
Political risk:

Political risk is the risk that from political changes or instability in a country.

Types of political risk

 Country risk
 Sector risk
 Project risk

Methods of political risk evolution:

 Index approach
 Scenario approach
 Sociological approach

Political risk management:

It can be done in three ways
1. political risk management by multinational
  Management of political risk before the investment
 Dichotomic decisions
 Assigning a risk premium
 Sensitivity analysis
 Management of political risk during life of the investment
 Public insurances
 Insurance offered by international organizaions
 Private insurances
 Management of political risk after Nationalization
 Determination of the compensatory indemnity
 Modalities of payment of compentiation
 Settlement of disputes

2. Political risk management by exporting Organizations

 Internal
 External

3 political Risk management by banks

 UNIT-III

Euro loans;

Euro loans are medium-term credits with variable rate linked to Euro-currency
deposits and accorded by an international bank syndicate.

Participants in euro credit/loan market:

The major lending banks in Euro –credit market are

 Euro bank
 American, Japanese, British, French, German, and Asia banks
 Chemical bank
 JP Morgan
 CITI group
 Bankers trust
 National bank of Chicago
 Barclay’s bank
 BNP etc………..

Dealing in Euro credits/Loans

When a borrower approaches a bank for Euro-loan a formal document is prepare

on behalf of potential borrowers. Several causes are introduced in the contract of Euro-
credit such as

Pari-pasu clause:

it prevents the borrower from contracting new debts that subordinate the interest
rate lenders.

Exchange option clause:

It allows the withdrawal of part or totality of loan in another currency

Negative guarantee clause:

Negative guarantee clause commits the borrower not to contract other debts that
subordinate the interest rates of lenders
Characteristics of Euro credit/loan

 A major part (more than 80%) of the Euro debt is made in US dollars.
 Pound sterling followed by ECU, Deutschmark, Japanese Yen, Swiss franc and so
on
 Maturity period is 5 years and some cases it is 20 years
 The interest rate on Euro loan is calculated with respect to rate of reference,
increased by a margin or spread.
 The rates are variable and renewable every six months, fixed with reference to
LIBOR
 The margin depends on the supply and of the capital as also on the degree pf the
risk pf these credits and rating of borrowers.

CPs(Commercial papers):

Commercial paper is a corporate short-term, unsecured promissory note issued on

a discount to yield basis. It can be regarded as a corporate equivalent of CD (certificate of
deposits) which is an inter bank instrument. Euro commercial paper emerged in 1980’s

Characteristics of CPs

 Issues usually roll over the CP dealer, in a few cases; large corporations have
their own sales force.’
 Commercial papers represent a cheap and flexible source of funds especially for
highly rated borrowers, cheaper than bankers.
 Commercial paper maturities generally do not exceed 270 days.
 CPs are negotiable, secondary markets tend to be not active since most investors
hold the paper to maturity.
 United States has the largest and long established Dollar CP market.
 Investors in CP consist of money market funds, insurance companies, pension
funds, other financial institutions and corporations with short-term cash
surpluses.

Face value
Cost of CP = --------------------
1+ r (n / 360)

Loan syndication:

While the loan syndication procedures and documentation have become fairly
standardized, there may be considerable room for negotiations in a particular case
Categories of banks in loan Syndication

 Lead bankers
 Managing bankers
 Participate bankers.
Loan Syndicate Mechanism

Invite bids Analyse bids apply to MOF MOF approval

Apply to RBI & approval Award mandate Formal launch

Formal closure Documents approval Sign loan agreement

Tombstone Legal option Loan effective

Documents are recommended Drawdown

MOF/RBI

Provisions in loan syndication

 The business terms

 Changes of circumstances
 declaration of the borrower
 conditions of closing
 guarantees and collateral
 positive and negative covenants
 fiscal treatment
 events of default
 agency
 Applicable law, jurisdiction and immunity.
Bond:

Bond is a certificate of debt issued by a company or the government. Bonds

generally pay a specific rate of interest, and pay back the original investment after a
specified period of time.

Bonds are classified in to the following categories

Bond

Foreign bonds Euro bonds Parallel bonds

Euro bond:

Euro bonds are the bonds issued in euro-currencies and placed simultaneously and
in similar conditions in several countries through an international banks syndication bank
These bonds represent a loan of medium or long term from 5 to 15 years. And
generally carry interest.

Types of euro bonds

Straight bonds

It is a debt instrument with a fixed maturity period, a fixed coupon which is a

fixed periodic payment usually expressed as percentage of the face or par value and
repayment of the face value at a maturity period. nominal value of bond is minimum
$5000.

Floating rate bonds;

The interest rate of this of bonds revised every six months. It is based on LIBOR
to which a margin is added.

Convertible bonds:

These bonds may be converted into shares of the issuing company

Reverse floating rate bonds:

 These bonds pay a higher interest when the rate of reference decreases. The
coupon is a fixed at rate minus –LIBOR so when LIBOR decreases the interest rate
decrease.

Callable bond:

A callable bond can be redeemed by the issuer’s choice, prior to its maturity

Puttable bond:

Puttable bond is opposite of the callable bond. It allows the investor to sell it back
to the issuer the prior to maturity.

Sinking fund bonds:

These bonds related to small amount. In this bonds risk is very less.

Deep discount bonds

Deep discount bonds do pay a coupon but at a rates below the market rate for a
corresponding straight bond

Zero coupon bonds:

These bonds do not pay interest. They are issued at a price lower than their
reimbursement value to take care of yield investors.

Bonds with warrant:

These bonds resemble convertible bonds with the difference that warrants are
detached from bonds and negotiated separately.

Different stages of a Euro –issue

 Issuer

Selection of lead manager

Selection of co-lead manager by the lead manager

 Lead manager  Banks

 Co-lead managers  Placement establishments
 Major guarantor
 Minor guarantor
 Sub-major and sub-
Foreign
minorbonds:
guarantors

International bonds

 Samurai bonds and shibosai bonds(Japan)

 Shogun bonds
 Geisha bonds
 Bulldog bonds
 Rembrandt bond
 Yankee bond

Global depositary receipts (GDR):

 GDR is a negotiable certificate that represents a company’s publicly traded equity
or debt. Depositary receipts create when a broker purchases the company shares on the
domestic stock market and delivers these shares to the depositaries local custodian banks
who are instruct the depositary plan to issue GDR.

GDR mechanism / issue of GDR

The shares are issued by a company to an intermediatary called the depositary

(whose name is registered to the shares)
 The depositary which subsequently issue the GDR
 The physical possession of equity of share is entrusted to an other intermediatary
called ‘custodian’(who is an agent of the depositary)

Subscribers and Company

Lead Managers

Depositary
managers Custodian

Nominee for Hold the American GDR holders

Euroclear and GDR and registrar it
CEDEL in the name of DTC

Uses of GDR:

Benefits to the issuing company;

 GDR issue enlarge the mkt (share market)

 GDR issue enhances the image of the company’s product.
 GDR issue is mechanism for raising capital vehicle for an acquisitions
 GDR also enable to invest easily in the parent company.

Benefits to the investors:

 GDR is usually quoted in dollar interest and dividend payments are also in dollar
 GDR Overcome obstacles that mutual funds ,pension funds and other institutions
 GDR as liquid as the underlying securities.
 GDR selected and cleared according to US standards
 GDR s overcomes foreign investment restrictions.
Other uses of GDR
  Useful To raise debt or equity capital in international corporate finance
 To diversify shareholders base
 To increase demand for the securities
 Tax advantage
 To enhance global image

American depositary receipts (ADR):

ADRs are most suitable than GDRs to a depositary. A particular bunch of shares
where the receipt holder has the right to receive dividend , other payments and benefits
which from time to time for the share holder .it is non equity holding shares. Indian
GDRs based upon ADRs. They are identical from a legal operational, technical and
administration view points.

Types of ADRs:

 Un sponsored ADRs
 Sponsored ADRs

Issue mechanism of ADRs

ADR Investor

Broker in USA Depositary

NASDAQ NYSE OTC Local bank Custodian bank

Levels of ADRs:
 1. ADR program level –I

 Disclosure requirements are minimal

 Traded on US over the counter
 Company are assessing ADR need not comply with GAAP

2. ADR program level- II

 More disclosure
 ADR meet the listing requirements of the particular exchanges
 Reconcile information to GAAP

3. ADR program level – III

 ADR represents public offerings to raise new money

 Comply with GAAP

Benefits of the ADRs:

 Benefits to the issuing company

 Benefits to the investor
 Benefits of ADRs Vs Foreign shares.

UNIT-IV

International Investment Decision:

 International investment decision is a difficult task. The actual implementation of
the selected funding programme involves several other considerations such as satisfying
all the regulatory requirements, choosing the right timing and pricing issue, effective
marketing of the issue and so forth.
International investment decision can be explained by using the following
graphical representation.

International financing decision

Capital structure: how much debt?

Domestic External

Maturity Interest rate basis currency

Medium short Fixed Floating

To long rolled over

Access and availability domestic regulation

Choice of market and instrument

I. Theories of Foreign Direct Investment (FDI):

Foreign direct investment theories can be classified into following types.

1. Mc Dougall theory:

This theory is developed by MC Dougall in 1958 and elaborated by Kemp in 1964

according to this theory FDI moves from capital –abundant economy to a capital-scarce
one till the marginal productivity of capital is equal in both the countries.

Product life cycle theory

This theory was developed by American economist R.vernon in 1966 according to
this theory

 FDI takes place only when the product in question achievers a specific stage in its
life cycle.
 Innovation stage is characterized with quite newness of product having price –
inelastic demand.
 Maturating product stage appears when the product turns price-elastic along with
similar products in the market.
 Standardized product stage with greater price competitiveness motivates firm to
start production in a low-cost location.
 Dematuring stage breaks down product standardization with sophisticated models
of the product being manufactured in high-income countries

2. Industrial Organization theory

It is developed by Hymer in 1976.accrding to this theory An MNC with superior

technology moves to different countries to supply innovated product making in turn
ample gains.

3.Location specific theory

It is developed by Hood and Young in 1979. According to this theory FDI moves
to a country with abundant raw material and cheap material.

4. Internationalization approach

Internationalize is a process when an MNC passes on improved technology to its

foreign subsidiary at zero/low cost in order to grab the market.

5. Electic theory of international production

The electic approach introduced in 1993 by Dunning. It is the combination of

three advantages ownership, location and internalization –that motivates a firm to make
FDI
6. Currency based approach
It is developed by Aliber in 1971 according to this approach affirm moves a
strong currency country to a weak-currency country.
7.Politico economic theory:
It is developed by Faechi and safizedah in 1989. According to this theory a firm
moves from a politically unstable country to a politically stable country.

II. Benefits and Costs of FDI

Benefits to the host country

 Availability of scarce factors of production

 Improvement in the balance of payments
 Building of economic and social infrastructure
 Forecasting of economic linkages
 Strengthening of the govt budget

Costs the host country

 Strained balance of payments following reverse flow

 Dependence of the import of technology
 Employment of expatriates
 Inappropriate technology
 Unhealthy competition
 Cultural and political interference

Benefits the home country

 Availability of raw material

 Improvement in BOP
 Employment generation
 Revenue to the govt
 Improved political relations

Cost to the Home country

 Undesired outflow of factors of production

 Possibility of conflict with the host country govt

III. Strategies for FDI

Firm –specific strategy

 Firm’s specific strategy means offering new kind of product or differentiated
product.

Cost-economizing strategy;

Cost can be lowered through moving firm to a raw material abundant/labor –

abundant location

Strategy of Entering in new Areas.

The firm tries to enter a new area where competition is yet to begin.

Cross investment strategy

A firm begins its foreign operation not primarily for capturing the foreign market
or for reducing the cost of production, but to avoid price cuts by competing firms

Joint venture with a Rival firm

When a rival firm in the host country is so powerful that it is not easy for the
MNC to compete the latter prefers to join hands with the host country firm for a joint-
venture.

Investment mode strategy:

A comparison between Greenfield investment and M&As is presented here to

show when a particular mode should be preferred

IV. International Capital Budgeting:

Capital budgeting is long term planning for making and financing proposed
capital outlay. Capital budgeting involves the planning expenditure for asset, the returns
from which will be realized in future time.
Need and importance of capital budgeting.
 Long term implications
 Irreversible Decisions
 Effect on company future structure
 Bearing on competitive position of the firm
 Cash forecast
 Worth-Maximization of shareholders

Steps in capital budgeting

 Creative search for profitability
opportunities

Long range capital plan

Short –range capital budget

Measurement of project worth

Screening and selection

Establish priorities

Final approval

Forms and procedures

Retirement and disposal

Evolution

Methods of capital budgeting

 Capital budgeting methods

Non discounting methods Discounting methods

ARR Payback period NPV Profitability index IRR

Average/accounting rate of return:

Average annual profits

ARR= -----------------------------

Outlay of the project

Payback period method

Original investment
Payback period = --------------------------
Annual cash flow

Net present value:

Net present value is the residue after deducting the initial investment from the
present value of future of future cash flow relating to a project .Positive NPV means
additions to the corporate wealth.

n CFt
NPV= ∑ [---------------]-Io
t=1 (1+k) n
t t
CFt = expected after tax cash flow from 1 to n, including both the operating cash flow
. and the terminal cash flow
Io = initial investment.
K= risk – adjustment
n = life span of the project

Profitability index (PI):

Profitability index is the ratio between the present value of future cash flows and
the initial investment.

n CFt / (1+k)n

PI = ∑ [--------------]
t=1 Io

Internal rate of return (IRR):

IRR is the discount rate equating the present value of future cash flows and the initial
investment. For accepting a project, IRR > hurdle rate.

n CFt

IRR = ∑ [--------------- ]-Io = 0

t=1 (1+IRR) n

International merger & acquisition :

Merger and acquisition are forms of business combinations .achieving a corporate

growth and diversification by mergers and acquisition is a well-established business
practice. M&A has played an important role in the growth of international business.

Reasons / motives for merger and acquisition :

  Economic objectives
 Operating economies
 Increased managerial skills
 Diversification
 Stability of income
 Growth
 Fund-raising
 Tax benefits

Valuation of merged firm and gains from M&As:

M&A is a gainful strategy only when the value of the combined firms is greater than the
sum of the values of the two firms computed individually in the absence of the merger. In
the form of equation

Gain = VAB-(VA+VB)

[VAB-(VA+VB)] > (Price-VB)

Approaches for valuation merged firms

The following three approaches are followed for determining the exchange ratios
of the merging companies
.
 Earning value
 Present earning value
 Future earning value
 Market value
 Book value

UNIT-V

International accounting:
 International accounting refers to Accounting principle and practices followed by
the different countries. In another way international accounting refers to harmonization
among varying accounting practices and accounting practices prevalent in different
countries.

Foreign currency transaction:

A transaction that requires settlement in a foreign currency is called as foreign

currency transaction.

Analyzing foreign financial statements:

The analysis of financial statements of foreign companies is the subject-matter of

international accounting. The issues that arise in accounting for foreign currency
transactions are

 Fixing the rate to be used for initially accounting for the transaction when it
takes place
 Dealing with the exchange gain or loss arising on partial or full settlement
during the same financial year
 Dealing with the exchange gain or loss on translation of the foreign currency
monetary item on the date of B/S.

Issues in foreign currency accounting:

These issues are addressed hereunder.

 Initial accounting
 Conversion on settlement
 Translation at each B/S date

Initial accounting
A foreign currency transaction is required to be accounted by an Indian enterprise
as at date on which the transaction occurs by translating the foreign currency into Indian
rupees by ness days.

Conversion on settlement:

A transaction in foreign currency may be settled either partly or fully on date later
than the date of the transaction.

Translation at each balance sheet date

All foreign currency monetary items are retranslated into rupees at each balance
sheet date by using the closing rate and the resultant exchange difference is recognized in
the profit and loss account

Different approaches to accounting transactions:

 There are various alternative approaches available for accounting foreign
currency transactions. A few of these are

 Two transaction - recognize

 Two transaction - defer
 One transaction - recognize

Techniques of analyzing financial statements:

There are three approaches for the analysis of financial statements:

 Horizontal
 Vertical
 Combination of the above two

Horizontal:

Horizontal approach represents comparison of data on a time series basis

Vertical:

Vertical approach represents comparing the financial variables of two or more

firms for the same period.

Problems in the analysis:

 Language and terminology.

 Forms and contents of annual reports.
 Varying practices of accounting.
 Extent of disclosure.
 Environmental differences.

Transfer pricing:

Transfer pricing is basically the pricing of intra-corporate transactions. Transfer

pricing is intra-corporate transaction pricing where the prices are above / below the
arm’s-length price. Arm’s-length prices are uncontrollable market price found in case of
unrelated firms.
Setting of transfer prices:

Since transfer prices are set on the basis of arm’s-length prices, the process
embraces two elements. These elements are:

1. The arm’s-length price determined by

(a) market price
(B) Cost of production
2. The element of arbitrariness which is influenced by the desires to achieve a particular
corporate objective.

Motivations behind transfer pricing:

 Reducing tax burden

 Reduction of tariff burden
 Controlling currency risk
 Joint-venture constraints
 Liquidity adjustments
 Fostering benefits

Regulation of transfer pricing:

 Direct regulation
 Indirect regulation

Direct regulation:

Direct regulation involves alternative prices set by the government

Indirect regulation:

Indirect regulation means

 Harmonization of tax and tariff differential
 Taxation of intra firm payments
 Apportioning of the consolidated profits among the units of the firm on
the basis of assets, etc……………..

Performance evolution and measurement:

Performance evolution can be measured by using the followed criteria /techniques

 Operating results
 Cash flow
  Net margin
 Sales
 Market share
 Performance forecasts
 Rate of return on equity
 Rate of return on investment
 Comparison with results of the other foreign subsidiaries
 Net profit before taxes, financial charges and contribution to the group
charges.
 The purchase from the factories of the group.

Consolidation:

The process of combination of financial statements is known as consolidation.

Techniques of consolidation

There are two ways for consolidating financial statements.

 Gross consolidation
 Net consolidation

Gross consolidation:

Gross consolidation refers to adding up of liabilities and then making adjustment

for the minority interest. Under the process of gross consolidation, all the assets and
liabilities of the subsidiary are added to the respective values of the B/S of the parent
company irrespective of the share of the parent company in the equity of the subsidiary.

Net consolidation:

Net consolidation involves adding up of only the net figures excluding the
minority interest from the very beginning. Under the net consolidation method, the
procedure of adding up of the whole of the subsidiary’s value and then making
adjustments for the minority interest is avoided. This means that the minority interest is
excluded from the very beginning.

Procedure of consolidation of financial statements:

 The cost to the parent of its investment in each subsidiary and the patent’s
position of equity of each subsidiary should be eliminated.
 Any excess of such cost over the parent’s portion of equity in subsidiary is
known as good will and is recognized as an asset in the consolidated statement.

 If such costs are less than the parent’s portion of equity in the subsidiary, the
difference is regarded as capital reserve in the consolidated statement.

 Monetary interest in the net assets of the consolidated solitaries is presented in

the consolidated B/S separately from the liabilities and equity of the parent’s
share holders.

 Un realized profit/ loss resulting from intra- group transactions is eliminated.

 If subsidiaries statements have different reporting dates, necessary adjustments

are made to bring them in line with the parent’s one.

 If a subsidiary has outstanding cumulative preference shares held outside the

group, the parent computes its share of profit or loss after making adjustments for
the subsidiary’s preference dividends, whether or not dividend has been declared.