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International Financial
UNIT 1 INTERNATIONAL FINANCIAL Management :
An Introduction
MANAGEMENT: AN INTRODUCTION
Objectives

After going through this unit, you should be able to understand about

• Development of' multinational corporations

• Steps involved in internationalization process

• International financial management

Structure

1.1 Introduction

1.2 Multinational Corporation (AMINC)

1.3 Steps in Internationalisation

1.4 International Financial Management

1.5 Summary

1.6 Key Words

1.7 Self-Assessment Questions

1.8 Further Readings

1.1 INTRODUCTION
We know that international business activity has been in existence for hundreds of
years. More than two hundred years back. 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, The period after the World
War II has seen a phenomenal growth in exchange of goods between nations. During
this period. There has been a systematic effort to facilitate the free flow of goods and
services across national boundaries. Rapid economic growth in the Western countries
owed much to the relatively free flow of goods and services. Now, other countries
have joined in this process and growth of international trade continues unabated. Pros
and cons of this development are debated in different fora all the time. Even disputes
arise between nations. To resolve disputes and make further progress on free flow,
the bodies like World Trade Organisation (WTO) have come into existence. Despite
the difficulties and road blocks. Integration of the world economy is moving forward.
Fast means of communication have made the world a small village. No single nation
can remain aloof today, without having to transact with others. Exchange of goods,
services, financial resources. Technology and manpower (albeit to a limited extent) is
the reality of today's economic system. The world trade has in fact grown at a pace
much faster than the world output. For several countries, the growth has been
described as export oriented growth since the share of exports in their GDP is
significantly high.

Even in case of India, the period after 1951 has been one of liberalization and
integration with the world economy. The country followed, for very long time. The
policy of import substitution and self-reliance. In Net, in the past, there used to be
some sort of merit associated with the dictum, "import and perish". Now there is
implied virtue in the dictum. "export and prosper". Now many countries like India, 5
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Environment feel the need for increasing their share in international exchange of goods, services
capital and technology. Some of the important steps taken over the period of last 15
years can be summarized as follows:

(a) establishment of unified market determined exchange rate;

(b) introduction of current account convertibility and phased introduction of capital

account convertibility, which will lead to full convertibility in due course;

(c) reduction in import duties;

(d) liberalization of portfolio and foreign direct investment;

Over a period very large size business organisations have developed. Big
multinational corporations (MNCs) have production and sales activities spread in
many countries. About one thousand big multinationals are stated to be owning about
half of the assets of the world economic system. Fast development of international
movement of goods and investment was not possible without corresponding
development or Financial system. They had to go hand-in-hand. A sophisticated and
well networked banking system and various financial products in the form of risk
management tools and insurance are necessary to allow the momentum of growth to
continue. The arrangements are needed to tide over short-term imbalances as and
when they occur in any country or any part of the world.

The process of integration of the world economy has witnessed the creation of a very
dynamic international financial market. A new field of finance namely financial
engineering, has come into existence. The financial market of today offers a large
variety of financial products for investment, speculation and risk management. The
financial market with innovative products presents vast opportunities as well as
unprecedented risks. Therefore, understanding operations in this market is a must for
any finance manager, particularly the one dealing with international operations. Now,
more and more companies are venturing into international operations in one form or
another. Some may be doing only exports, others may be doing both exports and
imports and still others may be doing exports, imports and investments. In order to be
effective in managing the expanding cross-border activities, finance managers are
required to have a good command on working of the financial markets, underlying
which are sophisticated financial products. Theoretical basis for these products has to
be clearly understood. The market dynamics of many of these products is such that a
risk management product can turn into a big risk itself, if not understood properly or
not dealt with due care.

1.2 MULTINATIONAL CORPORATION (MNC)

An MNC is a company engaged in making and selling its products in more than one
country. It operates in other countries through subsidiary companies or branches.
Unlike earlier days, the factors of production (capital, raw material, technology and
labor) tend to move from one place to another within a country as also from country
to country in search of higher returns. Natural resources have their value but even
more important are new technologies that give rise to genetic engineering and
miniaturization. Capital as a resource is no longer monopoly of a nation state bound
by geographical borders; it moves around the world. A typical MNC raises capital in
several countries simultaneously or sequentially. Technologies may be developed in
one country but used in different countries. Labor also, despite many restrictions, is
becoming increasingly global. People move easily from one country to another to
acquire new skills to use them in a third country. The ability of MNCs to use these
globally available factors of production makes them competitive rather than the
resource endowments of the parent country. The existence of an MNC is based on the
6 international mobility of factors of production. An Indian parent company may raise
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finances in the US capital market to use it to acquire a company in Malaysia and sell International Financial
the products of this acquired company in Latin American countries. Part of the labor Management :
An Introduction
force employed in the Malaysian subsidiary may come from other South East Asian
countries such as Indonesia, Philippines and Thailand etc. In today's context,
development of design and other software can be done in far-off locations and used
in other corner of the world as these travel with the speed of light on information
networks. Value addition in products takes place at different locations in different
countries before they are finally consumed.

Beginning in 1980s and accelerating from 1990s onwards, the world has witnessed
some fundamental evolution on technological, regulatory and economic policy fronts.
Some of the elements of this evolution are: (i) a large scale deregulation, cutting
down the system of licenses and permits; (ii) substantial reduction in public sector
enterprises and increase in privatisation; (iii) increased development and use of
information technology: (iv) a large numbers of mergers, takeovers and buyouts of
corporate entities to have better structure and control; and (v) an increasing and more
visible adoption of free-market policies in the developing countries etc. This process
has brought about competition in all sorts of activities-be they manufacturing selling
or providing services. The business organizations have been investing heavily in new
technologic~ and developing new strategies in order to gain in productivity as well as
expand their rnarlcets. MNCs are the main entities to induce competition across the
world. They do so by allocating resources globally in an optimal manner. They make
decision on the aspects such as ownership, production, financing and marketing with
a single aim as to what is best for the corporation as a whole. The emphasis is on
group performance rather than the achievements of individual subsidiaries.

As of now there are many MNCs with their headquarters in the USA or in Europe or
in Japan. But gradually, MNCs of other countries are taking shape. Some of the well
known American MNCs are: Coca-cola, Colgate-Palmolive, Compaq. Dow Chemical
and IBM etc. Coca-cola earns more than three-fourths of its revenues from outside
the USA. As a matter of fact, earning more than half of their revenues outside the
parent country is a norm for a large majority of MNCs. Yet, one can come across vast
dil'l'erences in the extent to which foreign operations are of importance to MNCs. For
example. General Motors generates its revenues abroad in much greater proportions
than its counterparts, Ford and Chrysler Internationalisation of certain industry
groups or some companies is mind boggling. For example, a film was made by a
Hungarian-born producer, directed by a Dutch, starred an Austrian hero and a
Canadian villain, shot in Mexico and distributed by a studio of Hollywood, which
was owned by a Japanese.

If we look at the evolution of the goals of MNCs, they can be seen evolving on the
path of raw-material seekers, then market seekers and cost minimizers. The raw
material seekers were the earliest ones. They grew under the protection of various
empires such as British. French and Dutch. The modern counterparts of those
multinationals of colonial period are some of the big oil and mining companies.
Some examples of these 20th century MNCs are British Petroleum, Standard Oil.
International Nickel etc. But more typical of today's MNCs are those that go abroad
to seek larger markets. Several names can be cited of market seekers. Some are
Unilever, IBM, MacDonald's and Coca-Cola etc. Most of the market seekers
maintain vast manufacturing, marketing and distribution networks, spread over
several countries. The third category, viz, cost minimizers, is fairly recent
development. The MNCs of this category invest in lower cost production sites such
as China, Taiwan, Hongkong and India etc. But with time, such categorization is
becoming blurred as also the direction of investment flows. Earlier, flows were from
US to other countries, then came European and Japanese MNCs and now onwards,
MNCs of other countries are also developing.

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Environment 1.3 STEPS IN INTERNATIONALIZATION

It has been seen that firms become multinationals through a gradual process. A firm
tries to exploit factor advantages internationally and to attempt to reduce the
competitive threats by others. Companies gradually increase their commitment to
international business. The sequence normally involves exporting, setting up an
international operations department, establishing a marketing subsidiary, entering
into licensing agreements and eventually creating facilities for manufacturing abroad.
It is not necessary that all companies follow this evolutionary process, This process
represents a sequence of moving from a relatively low-risk, low-return, export-based
strategy to a higher-risk, higher-return, production-based strategy.

Starting the internationalization process from exports has certain advantages. Capital
needed is low, risk is low and profits are immediate. This phase provides an
opportunity to the exporting firm to learn about demand conditions, competitors,
financial system abroad and payment and hedging techniques etc. As the learning
process matures. Companies expand their marketing and start dealing with foreign
distributors leading to setting up of new service facilities and warehouses.

The advantage of creating manufacturing base abroad is that the MNC will be able to
realize full sales potential of its product. This enables the firm to keep abreast with
newer developments in the market demand, to meet the customer needs faster, to
provide better after-sales service and to keep track of the competition which can be
outwitted with innovation and R&D efforts. Most firms selling in foreign markets
eventually start manufacturing abroad. Foreign production may cover a wide variety
of activities such as packaging, finishing, assembling or full manufacture.

When an MNC sets up production facility abroad, one of the important decisions it is
confronted with is whether to create its own affiliate or to acquire a going concern.
The advantage of acquisition is that the local firm provides readily available
marketing network. Larger and more experienced firms use acquisition route less
often than smaller and relatively less experienced ones. At times, of course, a parent
may not have a choice to acquire abroad simply because there is no local firm
available having special technology or equipment needed to manufacture its product.

MNCs also use licensing agreements as an alternative to setting up manufacturing

facilities. In return they receive royalties and other forms of payments. Licensing has
the advantage of smaller investment requirement, faster market entry and lower
financial risk. But there are disadvantages associated with licensing. The licensee
may turn into a competitor in due course. Besides, the licensor gets lower revenue
stream and may find it difficult to maintain quality standards.

1.4 INTERNATIONAL FINANCIAL MANAGEMENT

The main objective of international financial management is to maximise shareholder

wealth. This would require making sound investment and financing decisions that
would result in adding value to the firm. One of the main reasons for focusing on
shareholder wealth is that the companies who do not do so may be taken over by
others. If the shareholder wealth is maximized or, in other words, if share price is
made to go up hostile takeover becomes difficult and costly. Also, it becomes easier
for a company to attract additional capital from the investors if it cares for increasing
shareholder wealth. Companies which create more value will have more money to
distribute to all stakeholders not only shareholders-be they employees, managers or
other beneficiaries in the society. It has been argued, and very rightly so, that
maximizing shareholder wealth is not the best way but the only way to benefit all
8 stakeholders.
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Traditionally financial management is separated into two basic functions. The first is International Financial
concerned with acquisition of funds, also known as financing decision. This function Management :
An Introduction
involves generating funds from internal as well as external sources. The effort is to
get funds at the lowest cost possible. The second, that is, investment decision 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.

A finance manager in an MNC faces many challenges that his counterpart in a

domestic firm does not encounter. These challenges include political risks leading to
expropriation or confiscation of assets, exchange rate risk, control on repatriation of
profits, different tax laws, multiple money markets and different interest rates etc.
MNCs and their financial managers have to be abreast with the changes taking place
all the time and develop ways to take advantages of the changes while reducing risks
that these changes create. They have operations in different countries. This gives
them opportunity to access segmented capital markets to lower their overall cost of
capital. They can shift profits to lower the tax outflows. They have ability to move
people, money and material on a global basis to derive the maximum advantage out
of these resources- They are able to practise the economic adage, "do not put all your
eggs in one basket". International diversification of markets and production facilities
reduces their risk. Operating globally gives MNCs continuous access to information
on the latest process technologies and latest R&D activities of their competitors.
They are able to access world's capital markets and thus diversify their funding
sources.

International finance manager has to analyze and balance international risks and
advantages. Some of the key challenges he must be prepared to face are listed
hereunder:

(i) To understand the interrelationship between environmental changes and

corporate response. For example, how will the credit conditions be impacted by
stock market crash? How will defaults by some debtor countries affect funding
ability in the international capital market?

(ii) To understand the development and use of new instruments such as options,
forwards futures and swaps for effective management.

(iii) To develop ways to minimize risks through internal and external techniques.

(iv) To take a balanced view of successes and failures, treating them as experiences
to learn from. Decisions such as taking loan in a currency that has started
appreciating fast, taking a fixed rate financing when rates have started going
down will have an adverse impact and impel finance manager to contain the
damage to the extent possible.

International financial management will involve the study of (a) exchange rate and
currency markets, (b) theory and practice of estimating future exchange rate, (c)
various risks such as political/country risk, exchange rate risk and interest rate risk,
(d) various risk management techniques, (e) cost of capital and capital budgeting in
international context, (t) working capital management, (g) balance of payment, and
(h) international financial institutions etc.

1.5 SUMMARY

• Over the years, there has been a systematic effort to facilitate the free flow of
goods and services across national boundaries. Rapid economic growth in the
Western countries owed much to this process. Now this process is getting more
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Environment generalized across the world. In spite of some difficulties, integration of the
Environment economies across nations is progressing and moving forward.

• In case of India, the period after 1991 has been' one of liberalisation and
integration with the world economy. Some of the steps that have been taken over
a period of last 15 years are:
-establishment of a unified market-determined exchange rate;
-introduction of current account convertibility;
-phased introduction of capital account convertibility;
-reduction in import duties;
-liberalization of portfolio and foreign direct investment.
• The process of integration of the world economy has seen emergence of very
large size business organization, called MNCs, and a very dynamic international
financial market.
• Financial markets with innovative products present opportunities as well as
varied risks. This required a very deep understanding of the products and market
dynamics.
• Capital as a resource is no longer a monopoly of a nation state bound by
geographical borders. It moves around the world. A typical MNC raises capital
in several countries.
• An MNC moves its resources (money, technology, raw material and labor)
globally to draw maximum advantage.
• Earlier, MNCs were largely US-based. Later on, European and Japanese MNCs
also because important players. Now, some MNCs based in developing
countries are also emerging.
• Internationalization of a business involves steps like exporting, setting up an
international operations department, establishing a marketing subsidiary,
entering into licensing agreements and eventually creating facilities, for
manufacturing abroad. This sequence represents a sequence of moving from a
relatively low-risk low-return, export-oriented strategy to a higher-risk, higher-
return production based strategy.
• An MNC, while establishing production facility abroad, takes one of the two
options: either to create its own affiliate or to acquire a going concern.
• MNCs also use licensing agreements as an alternative to establishing their own
manufacturing facilities.
• A finance manager of an MNC aims at maximizing shareholder wealth. To be
able to do so, he has to make sound financing and investment decisions.
• While taking financing and investment decisions in an MNC, the finance
manager faces many challenges/risks apart from those that he may face in a
purely domestic firm. These include political risk, exchange rate risk, interest
rate risk, different inflation rates, different tax laws and multiple money markets
etc.
• International finance manager has to balance the risks and advantages so as to
optimize the gains from internationalization of business.

1.6 KEYWORDS
• Liberalization: Reduction or elimination of controls on business activities.

• MNC: A company with headquarters in one country and operating in several

10 • Subsidiary: A company abroad which is owned by a parent located in home

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country International Financial
Management :
An Introduction
• Shareholder wealth: The value of shares owned by an investor, which is
measured by the product of total number of shares and share price.

1.7 SELF-ASSESSMENT QUESTIONS

Q.1 Discuss the tends in the world economy over last some decades.

Q.2 How do MNCs come into existence? What steps may an MNC follow in
becoming global?

Q.3 Compare licensing agreement with establishment of a subsidiary.

Q.4 What risks does an international finance manager face?

Q.5 What goal should a finance manager pursue and why?

1.8 FURTHER READINGS

1. Apte. P. G. (1995). "International Financial Management ", Tata McGraw-
Hili Publishing Company Ltd, New Delhi.

2. Bhalla, V.K. "International Financial Management", Sultan Chand & Co.,

New Delhi.

3. Jain. P. K.. Josette Peyrard and Surendra S. Yadav (1998), internationat

Financial Management, Macmillan India Ltd., New Delhi,

4. Maurice D. Levi (1996), "international Finance ", McGraw-Hili Inc.

5. Shapiro, Alan C. (1999), "Multinational Financial Management", John Wiley

& Sons, Inc, New York.

6. Yadav. Surendra S.. P. K. Jain and Max Peyrard (2001), Foreign Exchange
Markets: Understanding Derivatives and Other Instruments, Macmillan India
Ltd., New Delhi.

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