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Corporate Finance ­ FIN 622
VU
Lesson 02
COMPARISON OF FINANCIAL STATEMENTS
Often it becomes very difficult to compare financial statements of two or more business entities due to
i)
Size
ii)
Functional currency.
However, we can overcome these problems by utilizing two effective tools of comparison. These tools can
be used for comparing performance of single entity over period of time and to compare two or more
entities.
1) COMMON SIZE STATEMENTS
2) RATIO ANALYSIS
1) COMMON SIZE STATEMENTS
BALANCE SHEET
AS AT 30 JUNE 2003
2003
2002
2003
2002
%
age
RUPEES
RUPEES
%age
OPERATING ASSETS
62.87
60.73
Fixed assets (at cost less accumulated depreciation)
125,138,737
109,101,363
6.36
10.31
DEFERRED COST
12,653,681
18,514,377
LONG TERM DEPOSITS (against Lease)
2,930,337
827,737
1.47
0.46
140,722,755
128,443,477
CURRENT ASSETS
Stores & spares
7,347,476
11,215,891
3.69
6.24
11.37
10.70
Stocks
-do-
22,628,137
19,231,731
1.08
1.79
Trade debtors
2,149,858
3,211,998
Advances, deposits, prepayments and
13.11
9.71
other receivables
26,089,950
17,450,008
Cash and bank balances
107,524
110,421
0.05
0.06
100.00
100.00
58,322,945
51,220,049
CURRENT LIABILITIES
Current maturity portion of lease liability
(6,794,240)
(2,821,322)
3.41
1.57
(8,004,000)
4.02
-
Current maturity portion of Long Term Loans
-
(6,760,139)
(19,270,244)
3.40
10.73
Short term borrowings
(30,831,550)
(44,786,359)
15.49
24.93
Creditors, accruals and other liabilities
(52,389,929)
(66,877,925)
NET CURRENT ASSETS
5,933,016
(15,657,876)
TOTAL ASSETS LESS CURRENT
LIABILITIES
146,655,771
112,785,601
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Corporate Finance ­ FIN 622
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LONG TERM LIABILITIES
(1,692,510)
0.85
-
Deferred Income
-
(37,056,700)
(21,693,585)
18.62
12.07
Due to directors and relatives
(926,457)
(926,457)
0.47
0.52
Provident fund trust and gratuity payable
(27,828,000)
(47,500,000)
13.98
26.44
Long term loans
Dealers & Distributors securities
(23,871,350)
(19,398,600)
11.99
10.80
Long term portion of leasehold assets
(12,710,887)
(1,936,847)
6.39
1.08
(104,085,904) (91,455,489)
TOTAL NET ASSETS
42,569,867
21,330,112
REPRESENTED BY :
39,800,000
(30.04) (22.15)
Share capital
59,800,000
(27,457,311)
(29,697,066)
13.79
16.53
Profit & (loss) account
8,227,178
(4.13)
(4.58)
Surplus on revaluation of fixed assets
8,227,178
Share deposit money
2,000,000
3,000,000
(1.00)
(1.67)
42,569,867
21,330,112
The annexed notes form an integral part of these
accounts.
(199,045,700) (112,785,601) 100.00
100.00
LAHORE
DATED
Take the balance sheet first. Instead of putting rupee values in balance sheet, we place %age against each
line item with regard to total asset. The total assets are taken as 100 and every line item relationship with
total assets expressed in %age is placed against it. Take a look at the attached Common Size balance sheet.
During 2002 total assets were 60.73% of total assets and that has been increased to 62.87% of total assets in
2003. Every line-item on asset side is expressed as % of total assets. You are now in a position to compare
financial statements over a period of time to know what developments have been made over time.
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Corporate Finance ­ FIN 622
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PROFIT AND LOSS ACCOUNT
FOR THE PERIOD ENDED 30TH JUNE, 2003.
2003
2002
2003
2002
RUPEES
RUPEES
SALES
116,811,832
109,030,501
100.00
100.00
COST OF SALES
(60,117,579)
(58,812,941)
(51.47)
(53.94)
48.53
46.06
GROSS PROFIT
56,694,253
50,217,560
(56,105,424)
(53,414,839)
OPERATING EXPENSES
(8,691,429)
(9,173,201)
(7.44)
(8.41)
Administrative
(37,385,642)
(31,684,350)
(32.01)
(29.06)
Selling, distribution and amortization
Financial charges
(10,028,353)
(12,557,288)
(8.59)
(11.52)
OPERATING PROFIT/(LOSS)
588,828
(3,197,279)
2,387,106
360,873
2.04
0.33
OTHER INCOME/(LOSS)
2,975,934
(2,836,406)
PROFIT/(LOSS) BEFORE TAXATION
(148,797)
-
(0.13)
-
WORKERS PROFIT PARTICIPATION
2,827,137
(2,836,406)
2.42
(2.43)
PROFIT/(L0SS) BEFORE TAXATION
PROVISION FOR TAXATION
(587,382)
(545,152)
(0.50)
(0.50)
PROFIT/(L0SS) AFTER TAXATION
2,239,755
(3,381,558)
(29,697,066)
(26,315,508)
PROFIT/(LOSS) BROUGHT FORWARD
PROFIT/(LOSS) CARRIED OVER TO
(27,457,311)
(29,697,066)
BALANCE SHEET
In common size income statement every line item is expressed as %age of sales. In other words, cost of
sales, operating expenses and net income add up to 100%. Let look at the Common Size Income Statement.
Cost of Sales in 2002 was 53.94% of sales, which dropped to 51.47% in 2003. This is a favorable symptom
because any reduction in cost will lead to increase in profit. This is confirmed when we look at the gross
profit. In 2002 GP was 46.06% of sales and that increased to 48.53% in 2003. The comparison here reveals
that company has improved it performance over the year 2002.
Base Year Analysis: Common Size analysis is also known as Vertical Analysis. Base year analysis is another
tool of comparing performance and is also known as Horizontal Analysis.
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Corporate Finance ­ FIN 622
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BASE YEAR /HORIZONTAL ANALYSIS
BALANCE SHEET
EXAMPLE HORIZONTAL ANALYSIS
BASE
YEAR
ASSETS
2006
2005
2004
2003
2002
2001
FIXED ASSETS
145,000.00
125,000.00 100,000.00
160,000.00
155,000.00
145,000.00
160.00
155.00
145.00
145.00
125.00
100.00
55,000.00
56,000.00
CURRENT ASSETS
50,000.00
58,000.00
70,000.00
65,000.00
140.00
130.00
112.00
116.00
110.00
100.00
TOTAL ASSETS
230,000.00
220,000.00
201,000.00
203,000.00
180,000.00 150,000.00
153.33
146.67
134.00
135.33
120.00
100.00
CAPITAL &
LIABILITIES
CURRENT
LAIBILITIES
22,000.00
21,500.00
19,000.00
17,000.00
16,000.00
15,000.00
146.67
143.33
126.67
113.33
106.67
100.00
LONG TERM
LIABILITIES
15,000.00
13,000.00
12,000.00
11,500.00
10,500.00
10,000.00
150.00
130.00
120.00
115.00
105.00
100.00
EQUITY
193,000.00
185,500.00
170,000.00
174,500.00
153,500.00 125,000.00
154.40
148.40
136.00
139.60
122.80
100.00
TOTAL CAPITAL
& LIABILITIES
230,000.00
220,000.00
201,000.00
203,000.00
180,000.00 150,000.00
153.33
146.67
134.00
135.33
120.00
100.00
In this case, performance is compared over, say, five years period. The earliest year or the first year is taken
as base year and every line item in the balance sheet of base year is taken as 100%. In the subsequent years
amounts of every line item are expressed as %age of base year amount.
You can see the Base Year analysis example from the attached balance sheet. Comparison is being made
from the year 2001 to 2006; therefore, the earliest year i.e., 2001 is labeled as base year. Total fixed assets in
2001 were Rs. 100,000/- expressed as 100% (cell H9: in blue font). In year 2005 the total investment in
fixed assets has risen to Rs. 155,000/-, which is 155% of base year amount (Rs. 100,000). This means that
from 2002 to 2005, 55% investment of base year amount has been injected in fixed assets and that further
increased to 60% at the end of year 2006.
2) Ratios Analysis:
This is another widely acknowledged and used comparison tool for financial managers. A ratio is a
relationship between two or more line items expressed in %age or number of times. Financial ratios are
useful indicators of a firm's performance and financial situation. Most ratios can be calculated from
information provided by the financial statements. Financial ratios can be used to analyze trends and to
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Corporate Finance ­ FIN 622
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compare the firm's financials to those of other firms. In some cases, ratio analysis can predict future
bankruptcy.
Financial ratios can be classified according to the information they provide.
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Corporate Finance ­ FIN 622
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BALANCE SHEET
AS AT 30 JUNE 2003
NOTES
2003
2002
2003
2002
RUPEES
RUPEES
CURRENT RATIO
1.11
0.77
OPERATING ASSETS
Fixed assets (at cost less accumulated depreciation)
3
125,138,737
109,101,363
QUICK RATIO
(0.54)
(0.31)
DEFERRED COST
4
12,653,681
18,514,377
LONG TERM DEPOSITS (against Lease)
2,930,337
827,737
TOTAL DEBT RATIO
140,722,755
128,443,477
CURRENT ASSETS
=Total Debt/Total Assets
0.31
0.40
OR
Stores & spares
7,347,476
11,215,891
Total Assets - Equity
0.79
0.88
Stocks
5
22,628,137
19,231,731
Total Assets
Trade debtors
6
2,149,858
3,211,998
Advances, deposits, prepayments and
DEBT - EQUITY RATIO
other receiveables
7
26,089,950
17,450,008
Cash and bank balances
8
107,524
110,421
=Total Debt / Equity
(1.46)
(3.35)
58,322,945
51,220,049
CURRENT LIABILITIES
Current maturity portion of lease liability
9
(6,794,240)
(2,821,322)
TIMES INTEREST EARNED
Current maturity portion of Long Term Loans
(8,004,000)
-
Short term borrowings
10
(6,760,139)
(19,270,244)
Earning before Tax
0.30
0.23
(30,831,550)
Creditors, accruals and other liabilities
11
(44,786,359)
Interest Expense
(52,389,929)
(66,877,925)
NET CURRENT ASSETS
5,933,016
(15,657,876)
INVENTORY TURNOVER
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Corporate Finance ­FIN 622
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CURRENT LIABILITIES
2003
2002
2003
2002
Current maturity portion of lease liability
9
(6,794,240)
(2,821,322)
TIMES INTEREST EARNED
Current maturity portion of Long Term Loans
(8,004,000)
-
Short term borrowings
10
(6,760,139)
(19,270,244)
Earning before Tax
0.30
0.23
(30,831,550)
(44,786,359)
Interest Expense
Creditors, accruals and other liabilities
11
(52,389,929)
(66,877,925)
NET CURRENT ASSETS
5,933,016
(15,657,876)
INVENTORY TURNOVER
TOTAL ASSETS LESS CURRENT LIABILITIES
146,655,771
112,785,601
Cost of Good Sold
(2.87)
(3.06)
Avg. Inventory
LONG TERM LIABILITIES
Deferred Income
(1,692,510)
-
Due to directors and relatives
(37,056,700)
(21,693,585)
A/R TURNOVER
Provident fund trust and gratuity payable
12
(926,457)
(926,457)
Long term loans
13
(27,828,000)
(47,500,000)
Sales
54.33
33.94
Dealers&Distributors securities
14
(23,871,350)
(19,398,600)
Account Receivable
Long term portion of leasehold assets
(12,710,887)
(1,936,847)
(104,085,904)
(91,455,489)
Avg Collection Period
365
6.72
10.75
TOTAL NET ASSETS
42,569,867 0
21,330,112
A R Turnover
REPRESENTED BY :
Share capital (5,980,000)
15
59,800,000
39,800,000
PAYABLE TURNOVER
Profit & (loss) account
(27,457,311)
(29,697,066)
Surplus on revaluation of fixed assets
8,227,178
8,227,178
Cost of Good Sold
(2.42)
(1.61)
Share deposit money
2,000,000
3,000,000
Trade Creditors
42,569,867
21,330,112
The annexed notes form an integral part of these accounts.
NET PROFIT RATIO
LAHORE
-
DATED
Net Income
2.420
(2.601)
Sales
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Corporate Finance ­FIN 622
VU
2003
2002
2003
2002
NET PROFIT RATIO
-
Net Income
2.420
(2.601)
Sales
RETURN ON ASSETS
11 CREDITORS, ACCRUED AND OTHER LIABILITIES
Net Income
2.259
(2.5998)
Creditors
24,820,277.00
36,565,866.00
Total Assets
Advances from customers
57,178.00
17,650.00
Accrued liabilities
2,710,813.00
2,847,749.00
Accrued interest on secured loans
1,200,010.00
2,844,012.00
RETURN ON EQUITY
Sales tax payable
1,571,414.00
1,800,396.00
Income tax payable - employees
12,131.00
15,920.00
Net Income
6.64
(13.30)
Other liabilities
310,930.00
694,766.00
Equity
WPPF Payable
148,796.71
-
30,831,549.71
44,786,359.00
MARKET RATIOS
Earning Per Share
Net Income
0.47
(0.71)
Total Shares (O/S)
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Corporate Finance ­FIN 622
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The following types of ratios frequently are used:
1. Short Term Solvency or Working Capital ratios
2. Long term solvency ratios
3. Asset management turnover ratios
4. Profitability ratios
5. Market value ratios
Short Term Solvency or Working Capital ratios:
These ratios provide information about a firm's ability to meet its short-term financial obligations. They are of
particular interest to those extending short-term credit to the firm. Two frequently-used liquidity ratios are the
current ratio (or working capital ratio) and the quick ratio.
The current ratio is the ratio of current assets to current liabilities:
Current Ratio = Current Assets/Current Liabilities
Keeping the comparison purpose in our mind, you can see that in the attached balance sheet this ratio improved in
2003 over 2002. Normally, this ratio is expressed as 0.77:1meaning that current assets are 77% of current liabilities in
2002. This was improved at the end of year 2003 when our current assets were more than liabilities. The ratio in
2003 is 1.11:1.
Short-term creditors prefer a high current ratio since it reduces their risk. Shareholders may prefer a lower current
ratio so that more of the firm's assets are working to grow the business. Typical values for the current ratio vary by
firm and industry. For example, firms in cyclical industries may maintain a higher current ratio in order to remain
solvent during downturns. One drawback of the current ratio is that inventory may include many items that are
difficult to liquidate quickly and that have uncertain liquidation values. The quick ratio is an alternative measure of
liquidity that does not include inventory in the current assets. The quick ratio is defined as follows:
Quick Ratio = (Current Assets ­ Inventory)/ Current Liabilities
This ratio also shows the investment level in inventories. Excessive investment in inventories is often considered as
inefficient use of resources.
The current assets used in the quick ratio are cash, accounts receivable, and notes receivable. These assets essentially
are current assets less inventory. The quick ratio often is referred to as the acid test.
Asset Turnover Ratios:
Asset turnover ratios indicate of how efficiently the firm utilizes its assets. They sometimes are referred to as
efficiency ratios, asset utilization ratios, or asset management ratios. Two commonly used asset turnover ratios are
receivables turnover and inventory turnover.
Receivables turnover is an indication of how quickly the firm collects its accounts receivables and is defined as
follows:
Receivables Turnover = Annual Credit Sales / Accounts Receivable
The receivables turnover often is reported in terms of the number of days that credit sales remain in
accounts receivable before they are collected. This number is known as the collection period.
The collection period also can be written as:
Average Collection Period = 365 / Receivables Turnover
Another major asset turnover ratio is inventory turnover. It is the cost of goods sold in a time period
divided by the average inventory level during that period:
Inventory Turnover = Cost of Goods Sold/Inventory
The variations in formula of inventory turnover relates to the denominator as some financial managers take
closing inventory value and other prefer to have average inventory, which we can work out by adding
opening and closing inventories and dividing by 2.
The inventory turnover often is reported as the inventory period, which is the number of days worth of
inventory on hand, calculated by dividing the inventory by the average daily cost of goods sold:
Inventory Period = Annual Cost of Goods Sold / Average Inventory
The inventory period also can be written as:
Inventory Period = 365/Inventory Turnover
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Corporate Finance ­FIN 622
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Other asset turnover ratios include fixed asset turnover and total asset turnover.
Leverage or Long term solvency Ratios
Financial leverage ratios provide an indication of the long-term solvency of the firm. Unlike liquidity ratios
that are concerned with short-term assets and liabilities, financial leverage ratios measure the extent to
which the firm is using long term debt.
The debt ratio is defined as total debt divided by total assets:
Debt Ratio = Total Debt/Total Assets
The debt-to-equity ratio is total debt divided by total equity:
Debt-to-Equity Ratio = Total Debt/Total Equity
Debt ratios depend on the classification of long-term leases and on the classification of some items as long-
term debt or equity. The times interest earned ratio indicates how well the firm's earnings can cover the
interest payments on its debt. This ratio also is known as the interest coverage and is calculated as follows:
Interest Coverage = EBIT/Interest Charges
Where EBIT = Earnings before Interest and Taxes Profitability Ratios Profitability ratios offer several
different measures of the success of the firm at generating profits.
The gross profit margin is a measure of the gross profit earned on sales. The gross profit margin considers
the firm's cost of goods sold, but does not include other costs. It is defined as follows:
Gross Profit Margin = Sales - Cost of Goods Sold/Sales
Return on assets is a measure of how effectively the firm's assets are being used to generate profits. It is
defined as:
Return on Assets = Net Income/Total Assets
Return on equity is the bottom line measure for the shareholders, measuring the profits earned for each
dollar invested in the firm's stock. Return on equity is defined as follows:
Return on Equity = Net Income/Equity
Market Ratios:
Earning Per Share:
This explains the portion of net income attributable to one common share. It is calculated as:
EPS = net income / No. of O/S shares
P/E ratio = price per share/EPS
Market to Book Value:
= MV per share/BV per share
Use and Limitations of Financial Ratios
Attention should be given to the following issues when using financial ratios:
A reference point is needed. To be meaningful, most ratios must be compared to historical values of the
same firm, the firm's forecasts, or ratios of similar firms.
Most ratios by themselves are not highly meaningful. They should be viewed as indicators, with several of
them combined to paint a picture of the firm's situation.
Year-end values may not be representative. Certain account balances that are used to calculate ratios may
increase or decrease at the end of the accounting period because of seasonal factors. Such changes may
distort the value of the ratio. Average values should be used when they are available. Ratios are subject to
the limitations of accounting methods. Different accounting choices may result in significantly different
ratio values.
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Table of Contents:
  1. INTRODUCTION TO SUBJECT
  2. COMPARISON OF FINANCIAL STATEMENTS
  3. TIME VALUE OF MONEY
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  6. TERM STRUCTURE OF INTEREST RATES
  7. COMMON STOCK VALUATION
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  10. METHODS OF PROJECT EVALUATIONS 2
  11. METHODS OF PROJECT EVALUATIONS 3
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  42. FOREIGN EXCHANGE MARKET’S OPTIONS
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk