International Financial Management International Financial Markets UNITS Madura & Fox International Financial Management* 1. International monetary system Ch 2 2. The market for foreign exchange Chs 3, 4, 6, 7 & 8 3. The derivative market and hedging strategies Ch 5 Financial Management and the Multinational Firm 4. Globalisation and the multinational firm Ch 1 5. Foreign investment Chs 13, 14 & 15 6. Multinational treasury management Chs 17,18 & 19 7. Review Ch 20 1

Foreign direct investment - definition An investment of at least 10% made by a company based in one country into a company based in another country Often need to buy into or set up a legal entity e.g. Renault (UK) ltd, Spar (UK) ltd These companies pay UK taxes Their exports count as UK exports Their purchases as UK purchases Their imports as UK imports Renault and Spar receive dividends (France and Holland respectively) Totals appear on the Balance of payments (see next slide) Not the same as portfolio investment 2

Foreign direct investment - definition 3

Foreign direct investment – motives, Dunning’s eclectic model advantages of internationalization Firm specific advantages: i) proprietary technology ii) managerial/ marketing skills iii) trademarks iv) economies of scale v) large capital requirements Internalization advantages: i) High enforcement costs ii) Buyer uncertainty over value iii) Need to control production iv) Tax Foreign direct investment – motives, Dunning’s eclectic model 3) Country Specific Advantages: i) Natural resources ii) Labour force iii) Trade barriers Plus: Greater profits, monopolistic advantages Reducing exchange rate exposure …. 4

Foreign direct investment – reducing exchange rate exposure Increase in value BPs Scenario 1 Decrease in value foreign sales cost $s BPs cost foreign profits Increase in value Scenario 2 foreign profits Decrease in value $s foreign profits cost

Foreign direct investment – reducing exchange rate exposure UK $1.5:£1 UK $1.9:£1 US $1.5:£1 US $1.9:£1 Sales £1,000 £789 $1,500 Costs £800 profit £200 (£11) $1,200 £158 $300 Scenario 1 Scenario 2 Foreign factories The variation of UK profits is less in scenario 2 as less is converted 6

Foreign direct investment – barriers Restrict ownership Red tape Local links with government Political instability Government requirements - local content 7

Foreign direct investment – country risk analysis Problems: Blocked funds Currency inconvertibility War Corruption New Zealand / Denmark / Singapore / Sweden /Switzerland…Japan / UK / US / …France / …Venezuela…Iran… Sudan… Somalia 8

Foreign direct investment – country risk analysis 9

✔ Foreign direct investment – country risk analysis debt crises Actually reschedules Does not reschedule Predict reschedule ✔ Type II error Predict not reschedule Type I error reduce Type II by decreasing reschedule predictions reduce Type I by increasing reschedule predictions Which is the more expensive error? 10

Foreign direct investment – country risk analysis significant factors (p.516 ) Most critical risk factor % respondents (2004) Govt regulations / legal decisions 64 Country financial risk 60 Currency interest rate volatility 51 Political and social disturbances 46 Corporate governance 30 Absence of the rule of law 29 Theft of intellectual property 28 11

Foreign direct investment – is FDI the new foreign aid…discuss AT Kearney FDI confidence index forecasts EMs to rise relative to developed countries www.myiris.com December 15, 2011 Thursday LENGTH: 1054 words A foreign direct investment (FDI) rebound will be slow at best and the focus of corporate investments is increasingly on developing markets, according to the 2011 A T Kearney Foreign Direct Investment Confidence Index, a regular measure of senior executive sentiment at the world`s largest companies. Conducted regularly over the last 13 years by global management consulting firm A T Kearney, the index provides a look at the present and future prospects for international direct investment flows. While 55% of corporate investors surveyed said their FDI budgets had returned to the levels they were prior to the economic crisis, more than one-fifth said they don`t expect their FDI to return to pre-crisis levels until 2014 or later. 12

International capital budgeting Foreign production and real investment planning 13

International capital budgeting Differences of international budgeting: Foreign currency Foreign inflation Foreign interest rates 14

International capital budgeting Illustrative problem: ABC plc has the following budget £ UK sales 5,000 Foreign sales 6,000 Variable costs (UK) (3,000) (Euro) (4,000) Fixed costs (UK) (1,000) (Euro) (2,000) Net 1,000 Budget prepared on the basis of 1.2€:£1 Revise the budget assuming an exchange rate of 1.3€:£1 and a 5% increase in euro prices. 15

International capital budgeting Budget prepared on the basis of 1.2€:£1 Revise the budget assuming an exchange rate of 1.3€:£1 and a 5% increase in euro prices and a 1% volume increase. Illustrative problem: ABC plc has the following budget £ £ € UK sales 5,000 5,000 Foreign sales 6,000 7,636 (6K x 1.2 x 1.05 x 1.01) Total Sales 11,000 Variable costs (UK) (3,000) (3,016) (3K x (1 + 6/11 x 0.01) (Euro) (4,000) (4,826) (4K x 1.2 x (1 + 6/11 x 0.01) Fixed costs (UK) (1,000) (1,000) (Euro) (2,000) (2,400) (2K x 1.2) Net 1,000 16

International capital budgeting Budget prepared on the basis of 1.2€:£1 Revise the budget assuming an exchange rate of 1.3€:£1 and a 5% increase in euro prices and a 1% volume increase. Illustrative problem: ABC plc has the following budget £ £ € £ UK sales 5,000 5,000 5,000 Foreign sales 6,000 7,636 5,873 Variable costs (UK) (3,000) (3,016) (3,016) (Euro) (4,000) (4,826) (3,712) Fixed costs (UK) (1,000) (1,000) (1,000) (Euro) (2,000) (2,400) (1,846) Net 1,000 1,299 Note that the euro value falls by 7.69% 17

International portfolio investment and diversification portfolio investment - buying shares for investment purposes only <10% ownership RETURN …. R£ = R$ + e$ RISK….. var (R£) = var (R$) + var (e$)+ 2 cov (R$, e$) Eg STDEV of (R$) & (e$) = 0.15 or 15% and 0 cov 0.045 = 0.0225 + 0.0225 + 0 >> STDEV (R£) = (SQRT(0.045)) = 21% NOT 30%) Eun and Resnick study: US investing in varR$ vare$ 2 cov (R$, e$) UK 51% 32% 17% France 62% 30% 8% R$= local stock market return in this case the US stock market E$ = % change in value of foreign currency 18

International portfolio investment and diversification portfolio investment - buying shares for investment purposes only <10% ownership RETURN …. R£ = R$ + e$ RISK….. var (R£) = var (R$) + var (e$)+ 2 cov (R$, e$) 19

International portfolio investment and diversification Do more diversified firms have lower betas? alternative approach: Jacquillat and Solnick study: 1) Looked at betas of multinational companies based on domestic index. beta i = cov(R i,R M) var(R M) 2) Recalculated betas based on foreign indexes. Think of it as Risk relative to the market 20

International portfolio investment and diversification Do more diversified firms have lower betas? alternative approach: Jacquillat and Solnik study: 2) Recalculated betas based on foreign indexes. multinationals betas US Germany France UK US .94 -.01 .02 -.07 Germany .24 1.18 .10 -.11 France -.10 .18 .95 .03 UK -.10 .09 -.09 .84 no relationship with foreign markets – the market does not value diversification!! "International Pricing of Risk, An Empirical Investigation of the World Capital Market Structure," Journal of Finance, May 1974. 21

International portfolio investment and diversification Do more diversified firms have lower betas? ►tests group shares into portfolios according to sales abroad. ►do shares with higher sales abroad have lower betas? Madura quotes: Portfolio %sales abroad beta 1 1- 7 1.04 4 13 - 17 0.82 8 28 - 35 0.99 no clear indication 22

International portfolio investment size 23