Assignment Code

IBO-06/TMA/2021-2022 Course Code

IBO-06

Assignment Name

International Business Finance

Year

2021-2022 Verification Status

Verified by Professor

Attempt all the questions:

Q 1. a) What is the concept of disequilibrium in balance of payment? Discuss the measures adopted to restore the equilibrium. (10)

Ans) Internal and/or external causes hinder market equilibrium from being attained or lead the market to become out of balance, resulting in disequilibrium. This can be a result of long-term structural imbalances or a short-term by-product of a shift in variable elements. A deficit or surplus in a country's balance of payments is also referred to as disequilibrium.

When external pressures interrupt a market's supply and demand balance, it is called disequilibrium. As a result, the market enters a situation where supply and demand are out of sync.:

1. Disequilibrium is caused due to several reasons, from government intervention to labour market inefficiencies and unilateral action by a supplier or distributor.

2. Disequilibrium is generally resolved by the market entering a new state of equilibrium.

3. For instance, people are incentivized to start producing more overpriced goods, increasing the supply to meet demand and lowering the price back to its equilibrium.

4. Examples can include short-term scenarios like flash crashes to long-term events like recessions and depressions.

The monetary methods for correcting disequilibrium in the balance of payment are as follows:

1)    Deflation

Deflation is defined as a drop in prices. Deflation has been used to resolve deficit imbalances in the past. When a country's imports surpass its exports, it has a deficit. Deflation is achieved using monetary policies such as bank rate policy, open market operations, and so on, as well as fiscal measures such as higher taxes, reduced government spending, and so on. Deflation would lower the cost of our goods on the international market, resulting in an increase in our exports. At the same time, as a result of higher taxes and lower income, import demand falls. This would create a favourable environment in terms of the balance of payments. Deflation, on the other hand, can be successful if the exchange rate remains constant.

2)    Exchange Depreciation

Depreciation of a native currency in terms of a foreign currency is referred to as exchange depreciation. This device indicates that a country's currency rate policy is flexible.

3)    Devaluation

Devaluation is a deliberate attempt by monetary authorities to lower the value of the domestic currency in relation to foreign currencies. Depreciation is a natural fall caused by market forces, whereas devaluation is an official act imposed by the monetary authorities. In general, the International Monetary Fund promotes devaluation as a disequilibrium correction mechanism for nations with a negative balance of payment position.

4)    Exchange Control

The monetary authority has gone to great lengths to gain complete control over exchange dealings. The central bank directs all exporters to submit their foreign exchange to the central authorities under such a policy. As a result, exchange reserves are concentrated in the hands of the central authorities. At the same time, foreign exchange supply is restricted to only essential products. It can only aid in preventing a worsening of the issue.

 In short, it is merely a stopgap measure, not a long-term solution.

Q1 b) Discuss the DCF techniques of project appraisal. What technique in your opinion is better and why? (10)

Ans) The NDCF and DCF project assessment tools are effective for examining capital cash flow streams. The fundamental distinction between these two sets of methodologies is that DCF procedures, which include time value of money, discount cash inflows. Because the current worth of money is always greater than what it will be at a later point, DCF techniques prove to be a stronger analytical tool. While NDCF procedures are simple to learn and execute, when the same project is analysed using DCF approaches, the project may appear to be financially unviable.

Discounted cash flow (DCF) is a valuation method that uses predicted future cash flows to determine the value of an investment. DCF analysis aims to determine the current value of an investment based on future forecasts of how much money it will generate.

This applies to decisions made by investors in companies or securities, such as acquiring a company, investing in a technology start-up, or purchasing a stock, as well as capital budgeting and operating expenditures decisions made by business owners and managers, such as opening a new factory or purchasing or leasing new equipment.

1. Discounted cash flow (DCF) helps determine the value of an investment based on its future cash flows.

2. The present value of expected future cash flows is arrived at by using a discount rate to calculate the DCF.

3. If the DCF is above the current cost of the investment, the opportunity could result in positive returns.

4. Companies typically use the weighted average cost of capital for the discount rate because it takes into consideration the rate of return expected by shareholders.

5. The DCF has limitations, primarily in that it relies on estimations of future cash flows, which could prove inaccurate.

The difference between the present value of cash inflows and outflows over time is known as net present value (NPV). The internal rate of return (IRR), on the other hand, is a formula for calculating the profitability of possible investments. Both of these metrics are commonly employed in capital budgeting, which is the process by which businesses decide whether or not a new investment or expansion opportunity is worthwhile.

The Bottom Line

Both IRR and NPV can be used to assess whether a project is worthwhile and will bring value to the organisation. One is expressed as a percentage, while the other is expressed as a cash amount. While some people use IRR as a capital budgeting metric, it has drawbacks because it ignores changing elements like discount rates. Using the net present value might be more useful in these situations.

Q 2. a) Explain the concept of transfer pricing. Why do companies resort to such a practice? (3+7)

Ans) The value ascribed to the commodities or services moved between related parties is known as transfer pricing. To put it another way, transfer pricing is the price paid for goods or services that are transferred from one unit of an organisation to other units in different nations (with exceptions)

The price that connected entities under common ownership decide on for the internal exchange of goods, intangibles, resources, or services is known as transfer pricing. Multinational enterprises (MNEs) having several subsidiaries or divisions that can transfer tangible or intangible assets internally are referred to as "transfer pricing." For example, Chevron Corporation has numerous subsidiaries, including Texaco, Saudi Arabian Chevron Inc, and Chevron Australia Pty Ltd, to mention a few, all of which are capable of transacting with one another. In a nutshell, transfer pricing is the amount of money exchanged when two or more connected business organisations interact with one another.

Transfer Pricing Benefits

Transfer pricing establishes prices for goods and services exchanged between subsidiaries, affiliates, or entities under shared management that are all part of the same bigger corporation. Corporations can save money on taxes by using transfer pricing, while tax authorities may challenge such claims. The following are some essential points:

1. Transfer pricing is an accounting practice that represents the price that one division in a company charges another division for goods or services provided.

2. A transfer price is based on market prices in charging another division, subsidiary, or holding company for services rendered.

3. However, companies have used inter-company transfer pricing to reduce the tax burden of the parent company.

4. Companies charge a higher price to divisions in high-tax countries (reducing profit) while charging a lower price (increasing profits) for divisions in low-tax countries.

5. The IRS states that transfer pricing should be the same between intercompany transactions that would have otherwise occurred had the company done the transaction outside the company.

Q 2. b) Explain the major techniques used by international firms for managing economic exposure. (10)

Ans) Economic risk is the most difficult to handle since it necessitates predicting future exchange values. Economists and investors, on the other hand, can use statistical regression equations to protect themselves from economic risk. Companies can employ a variety of ways to protect themselves from economic risk.

Economic exposure is difficult to quantify. Because transaction exposure has the capacity to modify future cash flows while foreign exchange rates fluctuate, the corporation must appropriately estimate cash flows and exchange rates. The net transaction exposure of a foreign subsidiary is low when it generates positive cash flows after correcting for currency exchange rates. When foreign exchange rates are trending and future cash flows are known, it is easier to evaluate economic vulnerability.

Techniques to Reduce Economic Exposure

International firms can use five techniques to reduce their economic exposure.

Five such techniques have been discussed:

1. Technique 1 − A company can reduce its manufacturing costs by taking its production facilities to low-cost countries. For example, the Honda Motor Company produces automobiles in factories located in many countries. If the Japanese Yen appreciates and raises Honda's production costs, Honda can shift its production to its other facilities, scattered across the world.

2. Technique 2 − A company can outsource its production or apply low-cost labour. Foxconn, a Taiwanese company, is the largest electronics company in the world, and it produces electronic devices for some of the world's largest corporations.

3. Technique 3 − A company can diversify its products and services and sell them to clients from around the world. For example, many U.S. corporations produce and market fast food, snack food, and sodas in many countries. The depreciating U.S. dollar reduces profits inside the United States, but their foreign operations offset this.

4. Technique 4 − A company can continually invest in research and development. Subsequently, it can offer innovative products at a higher price. For instance, Apple Inc. set the standard for high-quality smartphones. When dollar depreciates, it increases the price.

5. Technique 5 − A company can use derivatives and hedge against exchange rate changes. For example, Porsche completely manufactures its cars within the European Union and exports between 40% to 45% of its cars to the United States. Porsche financial managers hedged or shorted against the U.S. dollar when the U.S. dollar depreciated. Some analysts estimated that about 50% of Porsche's profits arose from hedging activities.

Q 3) Explain weighted average cost of capital, also discuss CAPM in this connection. (20)

Ans) The entire cost of capital for all funding sources in a corporation is defined by the weighted average cost of capital (WACC). In both public and private businesses, the weighted average cost of capital is extensively utilised. A business can raise funds from three different sources: equity, debt, and preferred stock. The weighted average of each of these costs is the total cost of capital.

The weighted average cost of capital is a measure of the company's overall required return on investment. It is beneficial for investors to determine whether projects, investments, or acquisitions are valuable. This can be used to determine whether or not the company can afford money, as well as to determine which sources of cash will be more or less valuable than others. It has also been defined as the lowest rate of return a corporation can achieve in order to repay capital providers.

The weighted average cost of capital (WACC) is a method of calculating a company's cost of capital in which each capital type is weighted proportionately.

1. All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation.

2. WACC is calculated by multiplying the cost of each capital source (debt and equity) by its relevant weight by market value, and then adding the products together to determine the total.

3. The cost of equity can be found using the capital asset pricing model (CAPM).

4. WACC is used by investors to determine whether an investment is worthwhile, while company management tends to use WACC when determining whether a project is worth pursuing.

In financial modelling, WACC is widely utilised. It can be used to calculate the net present value (NPV) of an investment's future cash flows, as well as its enterprise value and equity value.

 Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) is a mathematical model that describes the link between a security's expected return and risk. It demonstrates that a security's expected return is equal to the risk-free return plus a risk premium based on the security's beta.

CAPM was created to track this type of systematic risk. Sharpe discovered that the return on a single stock, or a portfolio of stocks, should be the same as the cost of capital. The CAPM, which describes the relationship between risk and expected return, remains the standard formula.

The risk-free rate–typically a 10-year government bond yield–is the starting point for CAPM. A premium is applied, which stock investors seek as remuneration for taking on more risk. This stock market premium is equal to the market's expected return minus the risk-free rate of return. Sharpe dubbed this coefficient "beta," and it is compounded by the stock risk premium. In the finance industry, the CAPM formula is commonly employed. Because CAPM calculates the cost of equity, it is critical in computing the weighted average cost of capital (WACC).

Q 4) What is exchange rate? Discuss the long term and short-term strategies in forecasting exchange rates. (20)

Ans) The value of one country's currency in relation to the currency of another country or economic zone is known as an exchange rate. Fixed or fluctuating exchange rates are available. Fixed currency rates are set by a country's central bank, whereas floating exchange rates are determined by market demand and supply.

1. An exchange rate is the value of a country's currency vs. that of another country or economic zone. 

2. Most exchange rates are free-floating and will rise or fall based on supply and demand in the market. 

3. Some currencies are not free-floating and have restrictions.

One of the objectives of studying exchange rate behaviour is to be able to forecast exchange rates. These theories are unable to accurately predict the behaviour of exchange rates. As a result, forecasting exchange rates appears to be a challenging assignment.

Forecasting Exchange Rates

International transactions are typically settled quickly. Forecasting exchange rates is required to assess the foreign currency cash flows involved in international transactions. As a result, anticipating exchange rates is critical for assessing the rewards and dangers associated with the worldwide business environment. A forecast is a prediction regarding the value or values of a variable in the future. The forecaster selects an information set from which to build the expectation. There are two pure techniques to forecasting foreign exchange rates based on the information set employed by the forecaster:

1. Fundamental Approach 

The fundamental method is based on a large number of data points that are considered fundamental economic variables that influence exchange rates. These basic economic variables have been derived from economic models. GNP, consumption, trade balance, inflation rates, interest rates, unemployment, productivity indices, and other indicators are frequently included. In general, structural (equilibrium) models are used to forecast fundamentals. These structural models are then tweaked to account for statistical aspects of the data as well as the forecasters' expertise. It's a mix of science and art. To generate equilibrium exchange rates, practitioners employ structural models. Equilibrium exchange rates can be utilised to provide forecasts or produce trade signals. When there is a considerable disparity between the model-based predicted or forecasted exchange rate and the exchange rate observed in the market, a trading signal can be generated. If the expected and actual foreign exchange rates differ significantly, the practitioner must determine whether the discrepancy is attributable to mispricing or a higher risk premium. A buy or sell signal is generated if the practitioner determines the discrepancy is due to mispricing.

2. Technical Approach

The fundamental method is based on a large number of data points that are considered fundamental economic variables that influence exchange rates. These basic economic variables have been derived from economic models. GNP, consumption, trade balance, inflation rates, interest rates, unemployment, productivity indices, and other indicators are frequently included. In general, structural (equilibrium) models are used to forecast fundamentals. These structural models are then tweaked to account for statistical aspects of the data as well as the forecasters' expertise. It's a mix of science and art.

To generate equilibrium exchange rates, practitioners employ structural models. Equilibrium exchange rates can be utilised to provide forecasts or produce trade signals. When there is a considerable disparity between the model-based predicted or forecasted exchange rate and the exchange rate observed in the market, a trading signal can be generated. If the expected and actual foreign exchange rates differ significantly, the practitioner must determine whether the discrepancy is attributable to mispricing or a higher risk premium. A buy or sell signal is generated if the practitioner determines the discrepancy is due to mispricing. The fundamental method is based on a large number of data points that are considered fundamental economic variables that influence exchange rates.

These basic economic variables have been derived from economic models. GNP, consumption, trade balance, inflation rates, interest rates, unemployment, productivity indices, and other indicators are frequently included. In general, structural (equilibrium) models are used to forecast fundamentals. These structural models are then tweaked to account for statistical aspects of the data as well as the forecasters' expertise. It's a mix of science and art. To generate equilibrium exchange rates, practitioners employ structural models. Equilibrium exchange rates can be utilised to provide forecasts or produce trade signals. When there is a considerable disparity between the model-based predicted or forecasted exchange rate and the exchange rate observed in the market, a trading signal can be generated. If the expected and actual foreign exchange rates differ significantly, the practitioner must determine whether the discrepancy is attributable to mispricing or a higher risk premium. A buy or sell signal is generated if the practitioner determines the discrepancy is due to mispricing.

Q 5. a) Explain political risk. How does it affect investment decisions? (10)

Ans) Political risk is defined as a risk that emerges as a result of a change in a country's governing body, and thus provides a danger to investors who have assets in financial instruments such as debt funds, mutual funds, and equities, among others. Specific phrases connected to a country's politics, such as corruption, terrorism, and so on, may originate as a result of a shift in the political landscape, which may lead to changes in the country's rules. Political risk is defined as the probability that political behaviour and events will have unintended repercussions.

Several research have been carried out to look into the relationship between political risk and foreign direct investment (FDI), with varying outcomes. Although other research claim that when political risk rises, foreign direct investment declines. Markets with stronger "law and order," a lower degree of "religious tension," and a more stable "administration" tend to attract more foreign direct investment in developing countries. Other research has found that political risk in the home country might have an impact on and limit investment in the host country. Political hazards may have varied effects on companies depending on their out-of-marketing characteristics, according to Holburn (2001), and companies with a high level of political risk management are more likely to invest in nations with high political risk.

Q 5. b) Discuss the role of Multinational Investment Guarantee Agency (MIGA) in providing protection against the political risk in developing countries. (10)

Ans) The Multilateral Investment Guarantee Agency, or MIGA, is an international organisation created to encourage large-scale foreign investment in developing nations. MIGA specialises in supporting high-risk investments in low-income nations and promoting socially, economically, and environmentally sustainable enterprises.

Role of Multinational Investment Guarantee Agency (MIGA)

It primarily offers political risk insurance, which secures an investment against threats of political instability, civil wars, terrorism, etc.

1. It provides guarantees against non-commercial risks to foreign direct investment projects in various sectors, including agribusiness, banking, financial markets, infrastructure, power and renewable energy, solid waste management, telecommunication, tourism, and transportation.

2. It boosts the confidence of both investors and lenders concerning the safety and return of their investment. MIGA charges investors an insurance premium like any other insurance agency.

3. The agency also advises governments on the best ways to attract and retain private investment, thus enabling rapid and sustained growth of their economies.

4. Its services include licensing, franchising, and technology support.

5. Additionally, it strives to add value to its clients by offering them extensive knowledge of emerging markets across the globe.