International Business Finance Issues in IBF Supplies Plc and Joe Company - Research Paper Example

International Business Finance Contents Contents 1 1. IBF Supplies Plc: Financial and non-financial factors influencing the proposal of establishing subsidiaries in Eastern Europe, Africa as well as Asia 2 Foreign investments of IBF Supplies Plc: Potential risks and possible external strategies to manage such risks 4 IBF Supplies Plc: Foreign entry strategies other than establishing a foreign subsidiary 5 2. Joe Company: Effect on transaction exposure due to fluctuation of Euro 6 Change in the global chemicals market due to fluctuation of Euro 7 3. Capital budgeting for projects in an overseas subsidiary: Assessment from the perspective of parent’s cash flow rather than just the subsidiary’s cash flow 8 Multinational vs. domestic capital budgeting project: consideration of additional factors 8 Characteristics of multinational companies (MNCs) affecting the cost of capital 9 Ram plc and Pram plc: Benefits from economies of scale 10 Theory of Comparative Advantage as a motive for international trade: Usefulness 11 Reference 13 1. IBF Supplies Plc: Financial and non-financial factors influencing the proposal of establishing subsidiaries in Eastern Europe, Africa as well as Asia IBF Supplies Plc is one of the leading companies in the UK market in supplying office items to its clients. The company holds a competitive edge over the its competitors as its supplies the office items at competitive price and also the time of delivery of IBF Supplies Plc is comparatively low. The management of the company has assessed that there would be a decrease in demand in the domestic markets in future for which the Director has envisaged expansion of the company into foreign markets. IBF Supplies Plc found there is increasing demand of supply of its products in the markets of Eastern Europe, Africa as well as Asia. Thus expanding operations into the foreign markets of Eastern Europe, Africa as well as Asia in order to offset the decreasing future business in the domestic markets require assessment of feasibility of the proposal of foreign investment through establishing foreign subsidiaries of IBF Supplies Plc in the markets of Eastern Europe, Africa as well as Asia. The factors influencing the proposal of establishment of foreign subsidiaries of IBF Supplies Plc include both financial and non-financial factors. The financial factors to be considered in the proposal of establishing foreign subsidiaries of IBF Supplies Plc in Eastern Europe, Africa as well as Asia includes assessment of the economy of the respective local markets, the costs involved in the foreign investments which ranges from the cost of raising of capital, cost for working capital, financing costs, etc. The financial factors also include assessment of financial risks, benefits and disadvantages associated with the foreign investments of IBF Supplies Plc. The non-financial factors to be considered which influences the foreign investment proposal of IBF Supplies Plc are the social factors, political factors, technological factors and the legal factors of the foreign land that has impact on the business of IBF Supplies Plc. The assessment of cost of raising capital is one of the most important financial factors to be assessed by IBF Supplies Plc. The capital may be raised from the local markets by IBF Supplies Plc through equity financing or debt financing. The equity financing option would involve share part of the ownership and control of the company but at the same time the cost and risk of the foreign investment would be shared. The debt financing option would incur re-payment of loans and interest payments to the lender over a period of time which could increase the cost of operation of the foreign subsidiaries. At the same time, IBF Supplies Plc would benefit from the tax deductibility feature of debt financing option by which it can reduce the payment of interest resulting out of the tax shield. The right mix of the debt-equity is to be ascertained for the foreign investments by IBF Supplies Plc. The social factors would influence the business as the culture and habits of the society as well as the social events would create an impact on the business operations (Seabrooke, 2006, p.173). The political factors would also influence the business operation as they control the labour parties, work environment and is responsible for amendment of laws and regulations. Thus legal factors are also important to assess the proposal of foreign investments by IBF Supplies Plc. The technological advancements of the local markets would also influence the logistics and supplies of IBF Supplies Plc. Foreign investments of IBF Supplies Plc: Potential risks and possible external strategies to manage such risks In case the new proposals of foreign investments considered by IBF Supplies Plc is implemented, there would be potentials risks associated based on the local factors of the land and thus IBF Supplies Plc would need to apply plausible external strategies to hedge those risks. The potential foreign country risk factors include business risk, market risk, financial risk, liquidity risk, interest rate risk, economic risk, political risk, social risk and legal risk. Business risk would occur if the business model of IBF Supplies Plc is unable to grow and achieve targets in the foreign markets of Eastern Europe, Africa as well as Asia (Carey and Stulz, 2007, p.44). In order to manage business risk, IBF Supplies Plc would need to carefully inspect the business model and adjust the supply chain, logistics, etc according to the local factors of foreign market so as to meet the targets and growth rates. Market risk would occur as result of fluctuation of demand in the foreign market of Eastern Europe, Africa as well as Asia. In order to manage the market risk, IBF Supplies Plc would need to carefully assess the parameters of quality, cost, delivery time and adjust their supplies accordingly to the markets (Wagner, 2012, p.246). The economic risk would occur as a result of fluctuation in macro economic factors including the GDP growth rates, inflation, allowable limits of foreign investment, etc. IBF Supplies Plc could mange economic risk by adjusting its supply levels according to the demands in the economy and reduce the inventory of the supply items. Financial risk would occur due to varying interest rates, foreign currency fluctuations, corporate tax rates, etc. The tax rates in Asia, African countries like Ivory Coast, etc is 25% whereas the tax rates in some countries of Eastern Europe, Lithuania, etc is as low as 15%. In order to manage the risk, the IBF Supplies Plc would need to take advantage of the tax rate shields through appropriate mix of debt-equity financing. Also IBF Supplies Plc would need to take advantage of its international operations by offsetting partial reduction in some countries by higher gains in other countries (Dickie, 2006, p.261). Potential risks would occur from the status of political stability in the continents which affects the operations of business. Many countries in Asia have multi-party governments while in some countries in other continents, there is single-party dominance. IBF Supplies Plc would need to engage in discussion with the ruling and opposition political parties to maintain as stable environment for their business. Potential risks would also occur from the social factors. The societies in which IBF Supplies Plc would exist must have different religious beliefs, language and culture in different parts of Asia, Africa and Central Europe. In order to gain access to the people of the society, IBF Supplies Plc would need to fulfil corporate social responsibilities in the foreign land. The company would also need to employ local people for aligning their operations with society. The regulatory and legal framework also varies from country to country in the continents of Asia, Central Europe and Africa which would impose restriction in business operations. In order to manage those risks, IBF Supplies Plc would need to be compliant with the local regulatory and legal framework in order to avoid penalties and maintain its goodwill in the foreign markets. IBF Supplies Plc: Foreign entry strategies other than establishing a foreign subsidiary Apart from considering the proposal of establishing foreign subsidiaries, IBF Supplies Plc. could also consider other strategies for entry to the foreign markets of Asia, Central Europe and Africa. In order to tap the demands of the foreign market, IBF Supplies Plc. could enter into strategic alliance with the industrial leaders of the foreign market. This is a foreign entry strategy where IBF Supplies Plc. would not establish a wholly owned subsidiary. For this IBF Supplies Plc. could enter into joint venture with the Asian, European and African suppliers of the land. By this strategy, IBF Supplies Plc. would able to penetrate the foreign markets by sharing the risk as well as adhering to the regulatory framework of the foreign land. However, the profits earned would also be shared with the foreign business partner according to the stake-holdings. Other foreign entry strategies of IBF Supplies Plc. would include contract with an agent or distributor in the foreign land and export the supply items to the foreign market. IBF Supplies Plc. could adopt licensing strategy where it licenses foreign partners to market their products. Franchising is another foreign entrant strategy available to IBF Supplies Plc. where it teaches the franchisee how to market its products. IBF Supplies Plc. could also use piggybacking strategy where it would it would supply the office items to a large company in UK who would in turn supply its products in the international markets. 2. Joe Company: Effect on transaction exposure due to fluctuation of Euro Joe Company is a manufacturer of chemicals in the UK industry and earns major part of its revenue through export of chemical to Germany. The main competitors of Joe Company are chemical producers from its own country UK. It is thus evident that the business transactions of Joe Company involve the effect of international currency conversion rate. Although the invoices of the exported chemicals are done in the denominations of Pound Sterling, the value of the transactions is highly dependent on the currency conversion rates of Pound Sterling and the foreign currency of Euro. Germany is the head-quarter of the European Central Bank which monitors the liquidity of Euro in the European nations. Due to the European debt crisis and other factors in the European economy, the currency rates of Euro are subject to fluctuation which in turn increases the exposure of the business transaction carried out by Joe Company. If Euro currency is appreciated, the revenues earned by Joe Company would decrease for exporting the same amount of chemicals. The market in which Joe Company operates in Germany is highly competitive due to presence of chemical companies from the same country, i.e. UK. Thus the option of increasing the price of its chemical is limited in order to maintain its market share. Thus Joe Company would have leverage on its operating efficiency to increase its production volume in order hedge the risk of its transaction exposure case of strengthening of Euro. On the other hand if euro depreciates, Joe Company would be able to earn more revenues and profits with the same quantity of exports as the currency conversion rates between the Pound Sterling and Euro would increase in favour of the Joe Company. Thus the transaction exposure for Joe Company would decrease in case of weakening of Euro. Change in the global chemicals market due to fluctuation of Euro The changes in currency conversion rates due to fluctuation in Euro would create an impact in the chemical markets all over the world. In case Euro is weakened for several years, the production levels and revenues of the global chemical markets would also change thereby affecting the profitability of the chemical producers across the world. This would have impact on the global economy as well. As European countries offer a strong chemical market, the exporters from other parts of the world like UK, USA, Africa, Asia would be able to able earn more revenue for export of the same quantity of chemicals in case of weakening of Euro. But the imports of European countries would also decrease as a result of weakening of Euro. Hence, the earnings of global chemical markets would reduce which would pull down the global economy. Thus the global chemical markets would face contraction in the face of weakening of Euro. 3. Capital budgeting for projects in an overseas subsidiary: Assessment from the perspective of parent’s cash flow rather than just the subsidiary’s cash flow For investing in projects for establishment of overseas subsidiary, the capital budgeting analysis for assessing feasibility of the investment proposals should be carried out considering the expected future cash flows of the parent organization. Consideration of parent’s cash flow is essential because the risks borne by the investment options have to be covered from the parent’s future cash flows till the time the overseas subsidiary attain the break-even point in its business. Consideration of subsidiary’s cash flows at the point of investment has limitations for setting the cost of capital as the discounting factor for finding the present value of investment. Also consideration of future cash flows of the parent business would help in finding the exact internal rate of return, payback period and the profitability of the investment. Although responsibility of decision making is delegated to overseas subsidiary but the operations of the subsidiary are guided by the policies of the parent business (Solberg, 2002, p.3). Multinational vs. domestic capital budgeting project: consideration of additional factors Feasibility assessment of multinational capital budgeting projects include assessment of additional factors that are not relevant for domestic capital budgeting. Multinational capital budgeting includes consideration of different foreign government policies on allowable foreign investment limits in the particular industry. The interest rates of different rates for availing debt from foreign financial markets need to be considered for the purpose of raising capital which is a part of portfolio investment analysis (Tarantino, 2010, p.25). This is not present in domestic capital budgeting as includes consideration of a single economy. The interest rate fluctuations, foreign currency exchange rates are to be considered additionally in multinational capital budgeting which is not required for domestic investment proposals. The regulatory and legal framework in the foreign land needs to be considered in addition to the domestic business framework in order to assess whether the business could cope up with the target growth rates in the overseas market. Also a portfolio analysis of multinational environment with respect to social conditions and political conditions, technology advancements need to be considered in multinational projects which is not required for domestic capital budgeting analysis by the companies (Giovanis, 2010, p.3). Characteristics of multinational companies (MNCs) affecting the cost of capital The cost of capital for multinational companies would vary based on their characteristic and approach towards raising capital for investment in foreign and domestic lands. The multinational companies may like to invest in wholly owned subsidiaries in the foreign market or may like to enter into strategic alliance with a local company. The multinational companies would need to decide on the appropriate mix or proportions of equity and debt financing. In theoretical cases, financing fully through equity would create an unlevered firm with a lower value than adopting a levered model consisting of both equity and debt financing (Nekrassov, 2008, p.7). Multinational companies which raise capital partly by debt financing would have to bear interest payments but would get the advantage of reducing interest payment due to tax shield. Another part of equity financing would share the risk of business at the cost of sharing ownership. Thus for equity financing, the cost bore by the multinational companies are payment of dividends which is, however, not guaranteed (Sofat and Hiro, 2008, p.326). The cost of debt financing is the interest payment for acquiring debt over a period of time but the control structure is not compromised. The company value for a levered firm would be more at the cost of incurring higher cost of capital and higher risk (Pratt, 2003, p.3). Ram plc and Pram plc: Benefits from economies of scale Ram Plc. and Pram Plc. are automobile manufacturers who desire to take advantage of economies of scale. Economies of scale explain that with the increase in production, economies are achieved with reduction in per unit cost of the product. Ram Plc. has decided to set up distributorship subsidiaries in various countries whereas Pram Plc. has decided to set up manufacturing facilities in other countries. Although Ram Plc. would reduce the logistic costs by setting up distributorships, the cost per unit of the product would not vary much due to unchanged cost of production. On the other hand, setting up manufacturing units by Pram Plc. would distribute the cost of fixed assets in its production activities over a period of time thus resulting in lower cost of input and hence would reduce the cost per unit of automobile with increase in production. Thus Pram Plc. would achieve higher economies of scale with respect to Ram Plc (Carbaugh, 2010, p.495). Theory of Comparative Advantage as a motive for international trade: Usefulness The international trade has an underlying theory of comparative advantage applicable to the participants of international trade. Assuming both the countries has same production capacities of a product, goods or services, international trade between the two countries would still exist as a result of relative difference in the efficiency levels of production and existence of opportunity cost. Comparative advantage works as a motive for international trade as the cost of production of certain goods or services due to unavailability of resources in the national boundary could be reduced by availing the option of import of the same product from another country that has abundant supply of resources in its geographical boundary for production of that product (Price, 1995, p.3). Thus there is an opportunity cost to the country for availing the option of import instead of spending more on its production. This comparative advantage leads to export and import across geographical boundaries and acts as a motive for international trade. The importing country would export another product that is manufactured in its country and holds a comparative advantage over another country which is undertaking imports of the product. The comparative advantage theory of international trade attains usefulness in the modern business scenario as there lays proven reserves of huge volume in the geographical boundaries of several countries. For example, countries in the middle-east have rich reserves of oil and gas and are called Gulf Gulliver. Australia is rich in dairy production all over the world. This creates comparative advantage in the modern business scenario of globalization. Thus in order to meet the demand through available supplies, international trade take place through imports and exports which at the same time is useful in sustaining the scenario of modern business. Reference Seabrooke, L. 2006. The Social Sources of Financial Power: Domestic Legitimacy And International Financial Orders. Cornell University Press; New York. Carey, M. and Stulz, R. M. 2007. The Risks of Financial Institutions. University of Chicago Press; USA. Nekrassov, A. 2008. Cost of Equity and Risk in Earnings Components. 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