International Financial

Management
 Introduction
• The main objective of international
financial management is to maximise
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 following fields.
• the knowledge of latest • investment behaviour of
changes in forex rates investors
• instability in capital
market • export and import trends
• interest rate 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 India’s 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
 Theory of Mercantilism
• 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 …
 Theory of Mercantilism
• 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.
 Theory of Comparative Cost 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 …
 Theory of Comparative Cost 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 …
 Theory of Comparative Cost 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