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INSTITUTE OF ACCOUNTANCY ARUSHA

MODULE NAME: FINANCIAL RISK MANAGEMENT

MODULE CODE: 09105

PROGRAMME: MSC FINANCE AND INVESTMENT

TOPIC: INTERNATIONAL BUSINESS ENVIRONMENT

International business environment

Now days all sectors are being internationalised with motives of global concentration, global
synergies and other strategic global motivations therefore manager to increase the value of the
firm should take appropriate financing decision by acquiring an appropriate amount and mix of
funds procured at competitive cost of capital and then allocating these funds in various assets
which basing on sound analysis, are expected to generate returns greater than the cost of
acquired funds. Those financing decision and or investment decision can be done through cross
borders.

As the business firm which may be government owned or private firm can operate in the global
environments which are dynamic and turbulent, therefore the change in global business
environment can be opportunities or threats to the firm depending on the impact to the
performance of the firm.

Those environment factors which influence the performance of the firm but can not modified
by the given firm they called external factors and can easily identified using PEST Model.

P-Political

E-Economic

S-Social

T-Technological

Political: A country's political system and government policies affect the economic, social and
political environment e.g the government economic policies such as fiscal policies and
monetary policies have an impact on the market conditions, the funding environment etc
which in turn have bearing on the organisation. Therefore, while assessing the performance of
an organisation managers should consider political system such as political processes, political
parties and their ideologies, political stability , maintenance of external relationships with other
countries, attitude of government on globalisation and privatization etc.
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Economic: Economic factors refer to the macroeconomic factors that will shape the broader
economic environment within which the firm operates. They represent the financial condition
of the external environment within which the organization must operate. These factors include
GDP,taxes, exchange rates, interest rates, inflation, unemployment, trade factors and tariffs as
well as monopolistic practices.

Social: Social factors refer to factors such as changing demographic patterns, changing
consumer tastes and preferences, attitudes of society towards business and its management,
expectations of society from business, views towards customs and traditions, disposable
income levels, age and health of population and educational levels.

Technological: Technological factors take into account the that technology has on the way an
organization makes and delivers its goods and services. In addition to looking at present
technology, organisations also need to look at upcoming technology and how will affect the
current way of business. Technological factors affecting an organisation include rate of change
and new development in technology, patents granted and diffusion of technology.

With internalization of companies, various opportunities and threats are brought by above
factors leading to different financial and business strategies by the firm

Relevant financial market issues impacting business and financial strategy.

Financial markets: These are the markets where by the financial instruments are bought and
sold. Depending maturity of financial instruments which are traded there are two types of
financial markets:

1. Money market
2. Capital market
Relevant financial market issues impacting business and financial strategy.

• Deregulation of financial markets-reduction or elimination of strict rules prior raising

funds in the capital market has simplified possibilities of raising funds from different
economies. It has vastly increased the ability of financial market to allocate international
capital efficiently. Deregulation has increased growth in financial transactions and
resulted in a restructured, more competitive and less costly financial services industry.
• Cross listing: This refers to the process of listing of a company's common shares on
different exchange market than its primary and original exchange market. With
numerous time zones and multiple currencies, cross listing results to increased liquidity,
access to more investors and it enhances corporate governance practices. Cross listed
companies will abide by corporate governance rules adopted by well-developed stock
market.
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• Access of capital: refers to the need that small businesses have for loans or investment
money, so they can grow. With internalization ir is now easy for companies to access
capital from different parties of the world. Not only in form of debt, but also in form of
equity.
• Minimization of transaction cost- With the growth in technology, investors can access
information easily so that can easily know what is happening in other economies and
make timely decisions.
• Economic integration-when countries located in a particular geographic area agree to
reduce and or remove trade barriers, there will be free flow of goods or services and
factors of production among each other. This will stimulate financial market as well as
economic growth among member countries.
Major effects in developing countries that have resulted the globalization of financial markets

1. Increased competition
2. Expansion of product base
3. Expansion of customer base
4. Increase usage of information technology
5. Increased unemployment
6. Increase of market efficiency
Multinational corporations (MNCs)

Multinational corporations are defined as business entities in some form of international

business. Their managers conduct international financial management, which involves
international investing and international financing decisions that are consistent to the
maximization of the value of the MNC.

Central goal of MNCs

A firm can have one or more goals such as sales maximazation, survival, profit maximization
keeping employee turnover at minimum etc. Despite all these goals, there is a need for a
single financial objective as leads to clear decisions and harmonizes several roles to unified
objective.

The most widely accepted financial objective of the firm whether operating in local or
foreign environment is to maximize the value of firm for its owner that is to maximize
shareholder wealth through increase the current market price of their shares.

Reasons of why the wealth maximization is taken as central goal of the firm in finance

1. Wealth maximization is based on cash flows and not profits- in contrast to profits, cash
flows are exact and explicit and therefore avoid ambiguity associated with accounting
profits which is subjected to judgment and estimates
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2. Wealth maximization consider future prospects- to value the company the expected
future cash flows are discounted to obtain the present value whereas profit is historical
in nature which fails to display the growth potential by using current profit figure to
project future growth
3. Wealth maximization considers time value of money- to determine the value of the
firm the future cash flows are discounted at appropriate discount rate for the given
period of time to represent their present value.
4. Risk-variability of return is not displayed in profit figures but wealth maximization
consider the element of risk. Wealth maximization principle considers the risk and
uncertainty factor while considering the discounting rate. The higher the uncertainty,
the higher the discounting rate and vice-versa. Two firms with identical profits may
exposed different risk scenarios and hence different value before the eyes of
shareholders.
5. Wealth maximization presents a longer-term view relative to other goals such as
profit. Accounting profit tends to be shorter oriented and can be achieved by the
manager at the cost of long-term sustainability of the business.
MNCs and Agency problem

As it is the case with domestic corporations, agency problem for MNCs is also caused by
separation of ownership and control. Managers of MNCs may make decisions that are contrary
to the maximazation of long-term shareholders wealth which is is the central goal of the
firm. With MNCs managers are having more room to pursue their own interest rather than
interests of the shareholders.

These situations result to conflict of interests between managers of MNCs and central goal of
MNCs hence amounting to agency problem

MNCs should incur costs to make sure the agents (managers) make decisions which are
consistent to the owners (principals) which is shareholders wealth maximization

Usually agency costs for MNC are larger than agency costs for a purely domestic corporations
due to the following reasons:

• Monitoring managers of distant subsidiaries in foreign countries is more difficult

• Foreign subsidiary managers raised in different cultures may not follow uniform
goal
• Going concern assurance provided by operations in other countries may induce
some managers to pursue own interests rather than maximising shareholders
wealth
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• Managers of MNCs located abroad tend to downplay the short-term effects of

decisions, which may result in decisions for foreign subsidiaries to be inconsistent
with maximising shareholders wealth.
Factors for growth of global business and MNCs

1. Comparative advantage:
The increase in multinational business can generally linked to the classical theory of
comparative advantage. This theory argues that countries should specialise in producing
products which result to comparative advantage. When a country specialises in the
production of some products, it will not produce other products, making trade between
countries is unavoidable. This is achieved become competitive through modernisation and
technical improvements to the product or to the production process.

2.Market imperfection theory

Market imperfection bring about immobility of factors of production such as labour,

rationalize international trade and investments. Imperfect markets provide an incentive for
firms to seek out foreign opportunities. The unrestricted mobility would have made
international trade irrelevant since each country would have incurred the same cost and
return in producing a product.

3. Product cycle theory

Is the argument that as a firm matures, it may recognize additional opportunities outside its
home country. According to this theory, corporations become established in the domestic
market because of some perceived advantage over existing competitor. As competitors
become informed at home, a firm is likely to establish itself in its home country. At this
stage, firms foreign demand will be accommodated through exportation. With time foreign
competitors will be informed, and foreign competition will increase. The firm may feel the only
way to retain its advantage over competition in foreign countries is to produce the product
in foreign markets. This is done to reduce transportation costs and other operational costs. As
foreign competition increases the firm will become more established by differentiating its
product.

4.Deregulation

Strict regulations within an economy make it difficult for growth of global business and
MNCs. Relaxations of these regulations attract foreign investors.
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Risks and Opportunities associated with global business

Opportunities associated with global business

Global companies have some significant advantages over local businesses. Below are
opportunities associated with global business:

• Opportunities for market growth- going international results to a widened customer

base. This results growth of business due to increased sales which eventually results
to maximization of long-term shareholders wealth
• Opportunity for risk minimisation through diversification: A multinational corporation
can offset a negative growth in one country by success in the other country
• Access of new talent- International labour can offer a company unique advantage in
terms of productivity, advanced language skills as well as diverse educational
background
• Enhanced competitive advantage- Companies which starts operating in other
countries attain a first move advantage and hence in a position to build awareness
before competitors.
• Reducing production and redistribution costs- Allocating factory closer to the market
and sources of inputs results to a reduced operational costs. This makes a company
gaining more competitive advantage relative its competitors.
• Quickening diffusion of technology- once the company from country of low technology
starts operation in a country of advanced technology, the company will advance in
term of technology due to experience obtained
Despite all these opportunities, global business is exposed to several risks. As the value of a
corporation depends on its future cash flows. Uncertainties surrounding MNC's future cash
flows amounts to risks facing multinational companies. These risks can be categorised into
three groups:

1. Foreign exchange risks- is the foreign currencies to be received by MNC is suddenly

weaken against its operating currency, the MNC will receive a lower amount of cash
flows than expected. This may reduce the value of the MNC. To protect itself against
this risk a MNC may adopt different techniques which include internal hedging
techniques and external hedging techniques. Internal hedging techniques include
measures such as invoicing in hard currency, leading and lagging as well as netting.
External hedging techniques include measures such as as money market hedge,
forward contract, future contracts, options as well as swaps.
2. Political Risks-These include the risk of interference ( law, restrictions on convertibility of
current currency etc ).
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Types of political Risks

• Confiscation political risk

The risk of control over the foreign entity through intervention of local government or other
forces

The financing tactics which minimise this risk include: high gearing, minimize intra-group
sources of finances, maximize finance from local sources, avoid parent group guarantees,
have the subsidiary partly owned by local shareholders

• Commercial political risk

This involves commercial discrimination against foreign controlled firms for instance giving
commercial advantage to locally owned competitors, restrict raw material licenses and
refuse work permits to expatriate staff.

Several measures can be employed by multinational corporations to av6 political risks

Measures before locating Production facilities overseas /Prior to Investment

• Assess the political environment of the host government

• Enter into binding agreements with the host government
Measures after locating production facilities overseas/During Investment

• Invite influential political leaders to form part of the Board of Directors of a

Multinational firm
• Provide employment to indigenous people
• Support infrastructure activities
• Buy raw materials from local suppliers
• Support social activities
• Borrow from local sources to finance your firm operation

3. Economic Risks- If economic conditions weaken, the income of consumers become

relatively low, consumer purchases of products decline, and MNC's sales in that
country . This is because the amount of consumption in any country is influenced by
income earned by consumers in that country. All in all, economic risk involves changes
in expected future cash flows and hence economic value caused by a change in
exchange.
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Alternative global business entry strategies ( methods)

There are various ways/methods on how the company can go global, but all in all safety of
capital to be involved should be a priority

1. Exportation
This involves selling goods and/ or services abroad

Advantages:

• Less risk and less cost method

• Political risks are minimal
• Agency costs is avoided such as monitoring and valuation costs
Disadvantages

• Host country's citizens denied employment chances

• Inputs not obtained from host country
• Host country not participating in the entire value chain activities
2. Management contracts
This is a contract that involves provision of management services to a foreign firm. It is an
agreement by which company will provide its organizational and management expertise in
the form of services to a foreign company.

Advantages

• Minimum investment
• Minimum political risks
• Host country's company may become more innovative and productive
Disadvantages

• Involves payment of high cost to foreign experts

• May result to significant outflow of funds from host country
3.Licensing a foreign firm

This involves granting rights and provision of technology to a foreign entity to produce
particular product in exchange for fees or some other benefits. It obligates a firm to provide
its technology (copyrights, patents , trademarks or trade names in exchange of fees or some
specified benefit. The right is always is granted for a specified period.

Advantages

• Requirement of minimum capital investment

• Faster way of foreign market entry
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• Fewer risks especially political risks

• Gives room for host country to participate in value chain activities
• Employments to citizen of host country
• Helps to escape high tariffs
Disadvantages

• Cannot be applied in some goods or services

• Cash flow is relatively low- license fees is likely to be lower than FDI profit
• Possible loss of quality control- product quality standard may be compromised
• Competition from the licensee after the expiry of contracted period
• Difficult to control the transfer of technology to competitors
• High agency costs
4.joint venture

Joint venture is defined as shared ownership in a foreign business. A foreign business unit
that is owned partially by the parent company is termed a foreign affiliate such as sharing
ownership and risk with a local partner. A foreign unit that is 50% or more owned and
therefore controlled by the parent is typically designated as foreign sub8. A joint ventu6 is
therefore a foreign affiliate but not a subs9

Advantages

• Shared risks and shared profit

• The public image of the firm that is partially local owned may improve its sales
• The local partner can provide competent management in both middle and top
• Local partner's contact and reputation enhance access to the host country’ s capital
Disadvantages

• Political risk is increased rather than reduced if the wrong partner is chosen
• Local and foreign partner may have divergent view about cash dividends
5.Acquision of existing business

Firms frequently acquire other forms on foreign countries as means of penetrating foreign
market

Advantages

• firms to have full control over their business

• Enables the firm quickly to obtain large portion of foreign market share
Disadvantages

• Expose the company at risk

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• It requires a substantial capital for investment

• High agency costs
• If it is performing poorly it may be difficult to sell operations at reasonable price
6.Franchising

Franchising is the practice of using another firm's successful business model. In this case
multinational company allow an individual to sell its product in specific country and the
company receives fees plus a periodical royalties and return.

Advantages

• Independence of small start-up business supported by big business network

• Training provided by franchisor compensate for the need of experience
• Already established reputation and image
• Easiness of securing finance due to brand awareness
Disadvantages

• Binding agreement
• Little room for creativity
• Failure of franchise may cost other franchises
• Sharing profit with the franchisor

REVIEW QUESTIONS

QUESTION ONE:

In deciding whether to invest abroad management must first determine whether the firm
has sustainable compete advantage that enables it to compete effectively.

Required

Discuss the financial market issues relevant to multinational companies willing to invest in
less developed countries

QUESTION TWO

It is claimed that agency costs for MNCs are larger agency costs for purely domestic firms.
Justify this claim by explaining possible agency costs which are incurred by MNCs

QUESTION THREE

METL Group, Tanzanian home grown with presence in eleven countries in Africa appoints
highly qu6 and technically trained managers. The group decided to expand its operations
after realising that Tanzanian market has matured. It is group's policy to invest in its people
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and infrastructure. It also takes advantage of availability of cheap materials other factors
of production although there is strong domestic competition from other giants such as
Azam group, METL has focused on producing the products which it do better than that of its
rivals. The market segment chosen by METL does not necessitate sophistication of products
given the nature of customers it services.

Required

Using MELT as a case study discuss factors for the growth of global business and MNCs

QUESTION FOUR

Various researchers on “ investment in Tanzania “ indicated that tax holidays and

exemptions offered by government of Tanzania to attract FDI are not only reason behind
many investors decision to come to invest in Tanzania

Required

Using examples, discuss any four other determinants that may be an attraction to FDI to
country like Tanzania