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Corporate Finance

<<< Previous FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk
Corporate Finance ­FIN 622
Lesson 45
We shall take care of following topics in this hand out:
Motives for foreign investment
Economic and other motives
International operations
Different forms
Joint venture
Licensing agreements
Political risk
Risk of confiscation
Commercial risk
Financial risk
Motives for Foreign Investment
We can divide the motives of MNCs into two broad categories. These are:
-  Strategic motives
-  Economic motives
Strategic Motives:
Market Development: A MNC may invest in foreign country in order to expand to new markets. Such
companies have very strong product line and have expertise in the field of sales and marketing. Car
assembly plants in Pakistan are a good example of market development.
Backward Integration: companies may be stretching to other countries in search and import to the home
country cheap raw materials.
Cheap inputs: labor and raw materials in developing countries provide MNCs an opportunity to reduce
the cost of sales, as labor is expensive in developed countries. This results in larger profit margin.
Political safety: Political stability and non-interference is what a MNC is looking for. Above all every
company will ensure the safety of its investment.
Economic motives:
MNCs have competitive edge over the local companies due to their strengths.
Financial Strength: MNCs have much liquidity and funds available to invest internationally. Further, they
have the ability to raise the money internationally at cheap rates compared to local companies. This is
because of their ability to generate future cash flow. They have strong products, huge marketing network
and efficient human resources to influence the money market. They can also raise capital by issuing shares
and debt instruments because they have expertise with them.
Technological strength: MNCs are using latest and state of the art technology in the business. The ability
to use technology to achieve the business efficiencies manifest cost control and profit enhancement.
Economies of scale: As the MNCs are operating all over the world having strong distribution network,
the economies of scale is achieved by efficient utilization of fixed cost. This is the greatest advantage over
the local companies.
Human resources: MNCs can hire and do have the best managerial and marketing capabilities. The
human resources they employee are the world's best having diverse and inter-culture experience, which a
local company cannot afford to have.
International Operations:
A company can kick start international operation in many ways. The option that a company would select is
primarily dependent upon the surrounding circumstances. Most important factor would be the tax position
of the entity because a company may be exposed to double taxation ­ in its home country and in the
country of operation.
Corporate Finance ­FIN 622
Different Ways to Commence International Operations:
A company can feel its presence in the other country by exporting its products. This is probably a cheapest
and in-expensive way to begin international operation because the company does not even set up any office
in that country. It can tap the customers by approaching them online or through an agent. Although is cost
effective way but this may not prolong because customers normally do not attach value to such a company
who is "not" present physically in their country. They may feel the company will be able to meet its after
sales commitments and warranty issues. Further, the company is not in a position to seek market related
knowledge required to develop and improve markets and products. A company making export to other
countries is always at risk of being exposed to protective tariffs that may result in loosing the
competitiveness of the products in terms of price.
A company can commence it overseas operations swiftly by setting up a branch in other country. This will
result in corporate presence in the country and will remove the issues we discussed in the above paragraph.
A branch may have some staff members but a distribution network must exist. Even with the establishment
of branch, the customers show less loyalty to the company's product because it is not very time taking issue
to wind up the branch. Companies can close their branch with out any long proceedings. So starting
operations through branch is a short-term option. As stated earlier, there are some tax consequences in
running an overseas branch ­ it is likely that the profit of the branch would be treated as profit s of the
parent company.
A subsidiary is a legal entity in other country like the parent company. This represents long-term
commitment to foreign country and increases the business reputation. There is a tax advantage, as the home
country tax will only be levied until profits are repatriated to home. However, this is very expensive option
in terms of upfront cost and working capital.
Joint venture
A jointly controlled entity by two or more venturer having a joint motive. Normally one venturer comes of
local market or country of JV operations. Local venturer is considered expert and knowledgeable person as
far as local market is concerned. This will help managing the business like obtaining loans, statutory
regulation compliance, local laws, taxes etc.
Less risky as compared to subsidiary options.
A joint venture is a legal organization that takes the form of a short-term partnership in which the persons
jointly undertake a transaction for mutual profit. Generally each person contributes assets and share risks.
Like a partnership, joint ventures can involve any type of business transaction and the "persons" involved
can be individuals, groups of individuals, companies, or corporations.
Joint ventures are also widely used by companies to gain entrance into foreign markets. Foreign companies
form joint ventures with domestic companies already present in markets the foreign companies would like
to enter. The foreign companies generally bring new technologies and business practices into the joint
venture, while the domestic companies already have the relationships and requisite governmental
documents within the country along with being entrenched in the domestic industry.
Licensing agreements
Such agreements are cheap, as these do not require any capital expenditure to expand to foreign lands. In
other words, these are less risky. The license issuer receive fixed amount as a percentage of sales for
granting license to the licensee. However, the licensor has little control over the licensee as far as the quality
of goods is concerned. The licensor cannot exercise control over the licensee.
The licensee may transfer industrial secrets to another independent firm, thereby creating a rival.
Political risk:
Political risk can be divided into following categories:
1) Confiscation risk
The risk of loss of control, business may be taken over by the local govt. or intervention and interference by
the local authorities. This risk can be reduced by insurance policies.
A JV would be preferable in less or developing country. A subsidiary would be preferable in stabled and
developed countries. Even then, this risk is present and can be reduced by:
- High gearing
- High local loans/finances
- Share in equity from local resources
Corporate Finance ­FIN 622
2) Commercial risk
- There may be discriminative laws for foreign companies ­ wages level or lower prices for products,
repatriation of profits and more emphasis to use local resources.
3) Financial risk
-  Restricted access to local resources ­ loans etc
-  Terms of maximum foreign equity
-  Restrictions on repatriation of capital and dividend
-  Exchange and currency risk
-  Measurement & management of political risk
-  Comparative techniques like rating mapping
-  Analytical techniques ­ special reports, expert opinion
****************THE END**************
Table of Contents:
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  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
  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