Financial Aspects

Foreign Investment by International Companies

The proliferation of MNCs began 200 years back, but then, foreign investments were quite limited. Investments were made through portfolio and long-term Greenfield or joint venture investments were low. Globalization, however, has led MNCs to become more dominant players in the global economy.

The end of the cold war that brought the idea of liberalization of the developing markets and opening of their economies has played a major role in international investments. With the vanishing of foreign investment barriers, privatization of the state economic organizations and development of FDI policies, MNCs have started investing aggressively.

FDI has become by far the single largest component of the net capital inflows. It also has effects on the human capital of the economies. Countries benefit substantially from the investment. Investments in developing countries have integrated the developing economies with other countries of the world. This is often referred to as economic openness.

Note − Seventy percent of world trade is controlled by just 500 of the largest industrial corporations. In 2002, the combined sales volume of the top 200 companies was equivalent to 28% of the overall GDP of the world.

International Investment Outcomes

International corporations have shaped the global economy in the 20th century. Now, any of the world’s Top 100 or global companies exceed the GDP of many nations. The MNCs are also creating most of the output and employment opportunities in the world.

The MNCs have started building local relationships and establishing a strong local presence through FDI’s to benefit from different advantages, where the countries focusing on getting more FDI investment have become busy with giving MNCs more freedom and assistance in seeking economic cooperation with them.

As the importance MNCs in the global economy increases, companies have been both criticized and appreciated. The growing shares of MNCs in developing economies and the impact of their decisions in overall economic conditions of the host countries have been under review.

• Cons − MNCs are mainly criticized for disappearance of domestic players due to their global brand, use of latest technology, marketing and management skills, and economies of scale which domestic firms cannot compete with. MNCs have also been criticized for controlling the domestic economic policies and taking actions against the developing country’s national interests.

• Pros − The investments have brought technological and managerial assets to developing countries. Employment with a better-trained labor force, a higher national income, more innovations, and enhanced competitiveness are some of the positive contributions of MNCs to developing countries.

Factors for Investment Decisions

MNCs want to minimize the cost and maximize their economies of scale. They invest in different locations to operate better in their home base. It motivates firms to expand and invest abroad and become multinational. Looking for new markets, want of cheaper raw materials, and managerial knowledge or technology and cheaper production are the major motivations for global expansion.

International companies want the perfect mix of the factors for finding "where to invest". Labor costs and skill and educational levels of workforce, the purchasing power of the market and proximity to other markets are considered while making an investment decision.

Funding the International Business

Funding is the act of acquiring resources, either money (financing) or other values such as effort or time (sweat equity), for a project, a person, a business, or any other private or public institution. The soliciting and gathering process of funds is called fundraising.

Economically, funds are invested as capital by lenders in the markets and are taken up as loans by borrowers. There are two ways how capital can end up at the borrower

• Lending via a middlemen is an example of indirect finance.

• Direct lending to a borrower is called direct finance.

An international business depends on its capital structure to find the best debt-to-equity ratio of the funding to maximize value. There must be a balance between the ideal debt-to-equity ranges to minimize the firm's cost of capital. Theoretically, debt financing generally is least costly due to its tax deductibility. However, it is not the optimal structure as a company's risk generally increases as debt increases.

Sources of Funds

• Export-Import Banks − These banks provide two types of loans − Direct loans to foreign buyers of exports, and Intermediary loans to responsible parties, such as foreign government-lending agencies which then re-lend to foreign buyers of capital goods and related services.

• With-in company loans − New companies raise funds through external sources, such as shares, debentures, loans, public deposits, etc., while an existing firm can generate funds through retained earnings.

• Eurobonds − International bonds are denominated in a currency of non-native country where it is issued. This is good in providing capital to MNCs and foreign governments. London is the center of the Eurobond market, but Eurobonds may be traded throughout the world.

• International equity markets − International businesses can issue new shares in a foreign market. Shares are the most common tool for raising long-term funds from the market. All companies, except those that are limited by a guarantee, have a statutory right to issue shares.

• International Finance Corporation − Loans from specialized financial institutions and development banks or from commercial banks are also tools for generating funds.

Foreign Exchange Risks

There are three types of risks associated with foreign exchange −

• Transaction risk − This is the risk of an exchange rate change on transaction date and the subsequent settlement date, i.e., it is the gain or loss arising on conversion.

• Economic risk − Transactions depend on relatively short-term cash flow effects. However, economic exposure encompasses the longer-term effects on the market value of a company. Simply put, it is a change in the present value of the future after-tax cash-flows for exchange rate changes.

• Translation risk − The financial statements are usually translated into the home currency to consolidate into the group's financial statements. It can pose a challenge when exchange rates change.

Hedging Forex Risks – Internal Techniques

Internal techniques to manage/reduce forex exposure include the following −

• Invoice in Home Currency − An easy way is to insist that all foreign customers pay in your home currency and that your company pays for all imports in your home currency.

• Leading and Lagging − If an importer (payment) expects that the currency it is due to pay will depreciate, it may attempt to delay payment. This may be achieved by agreement or by exceeding credit terms. If an exporter (receipt) expects that the currency it is due to receive will depreciate over the next three months, it may try to obtain payment immediately. This may be achieved by offering a discount for immediate payment. The problem lies in guessing which way the exchange rate will move.

• Matching − If receipts and payments are in the same currency and are due at the same time, matching them against each other is a good policy. However, the only requirement is to deal with the forex markets for the unmatched portion of the total transactions. Also, setting up a foreign currency bank account is an extension of matching.

• Doing Nothing − The theory suggests that long-term gains and losses gets hedged automatically. Short-term losses may be significant in such processes. Advantage is the savings in transaction costs.

Hedging Forex Risks – External Techniques

Transaction risks can also be hedged using a range of financial products −

• Forward Contracts − The forward market is used to buy and sell a currency, on a fixed date for a rate, i.e., the forward rate of exchange. This effectively fixes the future rate.

• Money Market Hedges − The idea is to minimize uncertainty by making the exchange at the current rate. This is done by depositing/borrowing the foreign currency till the real commercial cash flows occur.

• Futures Contracts − Futures contracts are standard sized, traded hedging instruments. The aim of a currency futures contract is to fix an exchange rate at some future date, subject to basis risk.

• Options − A currency option is a right, but not an obligation, to buy or sell a currency at an exercise price on a future date. The right will only be exercised in the worst-case scenario.

• Forex Swaps − In a Forex swap, the parties agree to swap equivalent amounts of currency for a period and then re-swap them at the end of the period at an agreed swap rate. The rate and amount of currency is fixed in advance. Thus, it is called a fixed rate swap.

• Currency Swaps − A currency swap lets the parties to swap interest rate commitments on borrowings in different currencies. The swap of interest rates could be fixed.