Individual assignments

Section A – short answer questions:

1) Summarize the five main motives that drive the decision to initiate FDI.

In general the are 2 main objectives for MNCs to initiate FDI , 1)Revenue related

objectives and 2)Cost related objectives .

Revenue related motives can be summarized as follows

i) Attract new sources of demand. A MNC will reach a market saturation in

their home country and when this happens , MNCs will look out for

markets where can they find a new demand for their product or expansion

of their products.

ii) Enter new markets where superior profit is possible.

iii) Exploit monopolistic advantages , enter the market where there is demand

and yet the local competitor do not have the means or technology to

produce and sell the product.

iv) React to trade restriction , establish a subsidiary in a market where

tougher trade restriction will adversely affect the existing export volume.

v) Diversify internationally ,establish subsidiary in markets whose business

cycle differ from those where existing subsidiaries are based.

Cost related motives

i) Fully benefit from economies of scale , establish subsidiary in a new

market that can sell products produced elsewhere , this allows for

increase production and possibly better production efficiency.

ii) Use foreign factors of production ,establish subsidiary where the foreign

labor , land is cheaper and sell the products to countries where it is more

expensive.

iii) Use of foreign raw material , establish subsidiary where raw materials is

easily available and cheaper and manufacture the product in these

countries and sell the products to countries where it is more expensive to

produced.

iv) Use of foreign technology , participate in joint venture in order to learn

about new technology or processes. Implement these technologies to

countries where it is not available for product efficiency and technically

more competent.

v) React to exchange rate movements, establish subsidiary in countries

where the currency is weak but will strengthen over time.

With these motives , MNCs will make decision on where to establish the

subsidiary in order to maximize shareholder’s wealth. Besides these motives , it

is important for decision makers to compare benefits of FDI in different

countries .

Another form of FDI is international diversification where MNC can reduce it’s

risk exposure in their home countries due to economic conditions. International

projects allow MNCs to achieve lower risk than 100% domestic projects without

reducing their expected returns. International projects tends to be able to reduce

risk when the FDI is targeted to countries whose economies are somewhat

unrelated to the home country economy.

In the choice of FDI location , few factors need to be consider:

1) Protectionism barriers

2) Red tape barrier

3) Industry barrier

4) Environmental barrier

5) Regulatory barrier

6) Ethical barrier

7) Political stability

Other factors that affect choice of FDI locations are cost of capital , local

resources , supply chain effectiveness and technology competencies.

 2) Define political risks. Explain the classification of political risks

a) Political risk are factors that impede the performance of the subsidiary in a

foreign country. The extreme example is the possibility of the host country that

will take over the subsidiary either by confiscating the assets and no

compensation is provided.

b) Classification of political risks:

1) Protectionism – actions where the local government heavily subsidize the

local manufacturer or ban foreign enterprises from trading in the local context.

2) Ownership - In some countries where there is a requirement from the

government that any foreign invested company must have local

representatives in the shareholder. An example will be Malaysia where any

foreign invested companies must have a “Bumiputra” shareholder. The

Bumiputras enjoy only the benefits but the business risk.

Some advantage of this setup are local knowledge and government network

which is key importance to new MNCs that setup in these countries.

Elimination of “red tapes” can be a motivation factor for MNCs to have these

Bumiputras.

Disadvantage of this system is the intervention of these Bumiputras that may

impede the aggressive growth of the MNCs. These sleeping partner may act

as “spies” and any trade secrets maybe leak out via these channels.

3) Blockage of funds transfer – foreign entities initiate FDI to increase the wealth

of shareholders, if the risk of blocking funds transfer arises in the foreign

 country where the subsidiary is , it loses its initial objective of setting up the

subsidiary. At the same time , any funds that cannot be transfer may result in

business obstacles as funds are needed for operational matters to purchase

materials etc.

4) Corruption and Neopotism – corruption may result in inefficient bureaucracy

and breach company’s policy .Corruption may also affects a company image

and reputation. Countries which are rated high on the “most corruption” list

will be avoided as much as possible by reputable MNCs as unfair treatment

whether for legal matters or award of business contracts are treated unfairly.

5) Religion/heritage – Religion may also be a source of political risk in the event

of a religious uprising and consumers may ban buying the products from the

company. This may also result in mass resignation of the workers and result

in operations inefficiency and loss of revenue.

 3) what is hedging? Briefly discuss the reasons for and against hedging.

a) Hedging is a financial instrument used by MNC for payments to be made or

receive in the future. The MNCs will locked in the exchange rate and the amount

to be paid or receive in the future . This will reduce the uncertainty of the risk of

fluctuations and volatility of the cash flows.

b) Hedging will reduce the uncertainties for the exchange rates and the risk

exposure of currencies .By averting these risk , the MNCs cash flow and wealth

to share holders are certain. This can be explain by the formulae:

N m

VMNC= ∑ {∑[E(CF ) X E(S )]}

jt jt
t=1 j=1 .
t
(1 + K)

Where CFj,t represent the cash flow denominated in a particular currency and S j,t

represents the exchange rate at which the MNC can convert the foreign currency

at the end of period t.

and K =weighted cost of capital and WACC = cost of debt +cost of equity.

The foreign denominated cash flow can be affected by political situation of that foreign

country. The foreign government may increase taxes or impose barriers on the MNCs

subsidiary or the consumers in that country may boycott the MNC . Political risk like

these will affect the cash flow of the MNCs.

If the foreign currencies to be received by the MNCs weaken against the home currency

, the MNCs will receive lesser amount of dollars as dictate by S j,t in the formulae .

Assuming K remains constant if CFj,t and Sj,t are not properly hedge the value of the

MNCs are subject to high volatility of the cash flows and currency exchange rates.
Therefore by hedging the exchange rates , the uncertainties of the MNC risk are

averted to a certain extent.

An MNC’s cost of capital is influenced by the return required by the investors , if there

are uncertainties surrounding the future cash flows , investor may invest in the MNC if

there is higher rate of return. The higher level of uncertainties will increase the MNC’s

cost of obtaining capital and the valuation of the MNC decreases. Since WACC is equal

to cost of debt and cost of equity , hedging of exchange rates will reduce the

uncertainties of risk for MNC.

c) There are often expensive premiums to be paid for any hedging instrument ,

therefore increasing the cost of finance . It is also time consuming to prepare a

good hedging plan which again reflects in costs. Instead of hedging , MNCs can

do diversification of business investment in order to reduce their risk exposure.

Back to back investment is also another way to reduce the risk exposure ,

example funds/earnings from a foreign subsidiary need not be transfer back to

parent company and it is use to pay operational expenses, example , salary

,materials and others.

 4) Define balance of payments. Why balance of payment is important?

Balance of payment is a summary of transactions between domestic and foreign

businesses ,individual and government for a specific country and the rest of the

countries over a specified period of time. The BOP is a measure of international

money flow and indicate the volume of transaction between specific countries and

may signal the potential shift in specific exchange rates.

BOP is important measurement as it can be used as an indicator of a country ‘s

economic and political stability. If that country has a positive BOP , it means that

there is a substantial investment in that country and it does not export much of it’s

currency.

The main components of BOP can be broken down into:

1) current account – which represent the account for payment of

a) merchandise and services – tangible goods such as computers and clothing

and services such as tourism ,legal , insurance etc.

b) Factor income payments which represent income from interest and dividend

receive by investors on foreign investment.

c) Transfer payments which represent aid , grants and gifts from one country to

another.

2) Capital account includes financial assets transfer across borders , it also includes

value of non produced non financial assets such as patents and trademarks.

3) Financial accounts includes DFI and portfolio investment.

4) Errors and Omissions and Reserve. In theory the current account ,capital and

financial account should have a sum of zero , which means it should be perfectly

balance. However in real life this is not the case as it is difficult to have a perfect

offset because measurement errors can occur while measuring funds transfer

into and out of the country. Therefore the BOP has a category of errors and

omissions.
 5) The Japanese Yen –US dollar spot rate is 140¥/$ and the 6 months forward

rate is 120¥/$. Calculate the annual forward premium/discount for Jap. Yen

using direct and indirect quotations.

a) Formulae : direct quotation P (forward premium/discount) = F(forward

rate)/S(spot rate) – 1

Therefore in this case for a 6 month premium or discount ,

P = [(120/140) – 1] X360/180 express as % equals to -28.5714%

b) Indirect quotation :

P = [(140/120)-1]X360/180 = 0.3333 or expressed in percentage : 33.3333%

 6) What is J curve effect? How to explain the J-curve effect?

a) J curve effect refers to a country trade balance after a devaluation or depreciation

of its currency.

b) A devaluation of its currency means that the import became more expensive or

its export becomes cheaper but due to the devalued currency ,the balance of trade

dips further. However due to cheaper currency , its export competitiveness will

improve and grow in volume overtime and thus results in improved trade balances

as seen in the upward trend of the curve –hence the J curve effect.
7) Outline the 2 basic approaches of the tax system.

a) Direct tax – Taxes paid directly by individual or corporation to the government.

Direct tax can be calculated and provision can made in advance to be paid when

the due date. These provision are known and it is taken into the bottom line of the

business , therefore no risk are involve.

b) Indirect tax - Taxes such as GST , VAT or excise duties which can be pass on by

the suppliers to the end consumer.

8) Briefly discuss the main reasons for the demises of the Bretton Woods system.

a) The Bretton Woods system is a fixed exchange rate system between currencies

where the US dollars is use as a reference instead of gold. The US dollars is

pegged at 35US dollars per ounce of gold. In the 1971 the US economy is

almost devastated resulting in a depreciation of US dollars. Under the Bretton

Woods system , countries that has international trade and need foreign

currencies will have a unfair value to their own currencies since they are pegged

to the US dollars which is over-value at that time. Therefore over time , due to

over-value of the US dollars and the economic situation in the US , the Bretton

Woods system was abolished.

9) On its issue of 20 December 2010, the straits times newspaper reported that the

US dollar has dropped steadily against major currencies since the start of May.

That fall makes the US dollar the worst performer for the period among frequently

traded currencies in the world. This could be related to the current economic

conditions in USA. In addition , European countries sovereign debt crisis has

worsen in the meantime. Please explain why the US dollar depreciated sharply

by using the knowledge learnt from international finance class and other reading

materials.

a) The situation in the US can be explained as follows:

i)PPP – Since ef = ih - if where if =foreign inflation and ih =home inflation

ef will be higher when ih is larger than if. Therefore if the home inflation is higher

than foreign country the home currency will be weaker as explain by the

formulae.

ii) IFE – ef = Ih – If where Ih is home country interest rates and If is foreign

country interest rates. If the home country interest rates is higher than the foreign

interest rates , the home country currency will be weaker as explain by the

formulae.

Therefore in the Straits Times as reported , the US currency has gone weaker

even though the government is putting a lot of aids in the economy is due to 2

main reasons. Home country inflation and interest rates are high and that foreign

investor are pulling out of the country to invest their money somewhere .
10) Briefly discuss how to determine the optimal international portfolio?

Conceptually , how do the two performance measures define risk differently?

a) Optimal international portfolio are defined by less risk and higher return to

investor or MNCs which are taking the right decision.

b) Conceptually 2 methods are used:

i) Sharpe measurement = (Ri – Rf) / δi where δi is the total risk comprising of

systematic and unsystematic risk. R is return of asset.

ii) Tragner measurement = (Ri – Rf) / βi where βi is unsystematic risk or

unique risk.

iii) Since βi is a subset of δi , the Tragner method will be a preferred method.