The Foreign Investment by the Company - Essay Example

International Finance Case Study and Section # of Contents Contents 2 INTRODUCTION 3 LACK OF HARD CURRENCY 3 HIGHER INFLATION 4 FIXING EXCHANGE RATE 5 HIGHER WAGE RATES 6 CAPITAL EXPENDITURE APPRAISAL 6 BETTER POLICIES FOR THE LOCALS 7 DIFFERENCE IN NATIONAL GROWTH RATES 7 TYPE OF FDI 8 EXCHANGE CONTROL 9 COMPLICATIONS IN CURRENCIES MANAGEMENT 10 CONCLUSION 11 Bibliography 12 INTRODUCTION The foreign investment by the company represents entry of the company into a new venture. Since the beginning, all the manufacturing was done by the company on the homeland of United Kingdom. Board of Directors has always considered the entry of company into a foreign venture to be riskier than investment at home. The company is now considering investing in Ruritania located in Eastern Europe. The company has taken the decision of investing £ 55 million to set up a new manufacturing facility in Ruritania. The company will mainly benefit from the low labour cost in the country and to establish a presence in the region. The will help the company gain competitive advantage over the global competitors. Though these benefits will exist but the company will face some financial issues that will be discussed in this report. LACK OF HARD CURRENCY Ruritania is a politically stable and economically developing country, but the currency of the country is not very stable. Four years ago, when the Crown, Ruritania’s currency, was allowed to float freely by the government, there was a large drop in its value. In the past, the Crown had a centrally managed exchange rate. This caused the currency to have a fixed rate against the foreign currencies. The value of the currency dropped sharply when it was allowed to float freely in the foreign market. This is the evidence that a very low demand for the Crown existed in the foreign market. A floating exchange rate is self-correcting, as it fixes the exchange rate according to its demand. Although the currency has shown stability now, but there is a risk of a drop in currency value in the future. This would cause the imports for the company to get expensive. If the company decides to purchase anything from foreign market, it will have to pay higher costs. If the company is importing raw material from another country, the price of the raw material will go up and the company will lose out. The final product of the company will also be priced higher because of the higher cost of raw material. This will cause the local competitors to gain a higher market share because they will be offering lower prices. The Crown faces risk in the international market right now because only one and a half year has passed since it has been stable against the major international currencies. Eighteen months is not a very long period to determine the stability of currency of a country. Therefore this lack of a hard currency will restrict the ability of the company to import raw material from the headquarters in UK. HIGHER INFLATION The country Ruritania is planning to join the European Union (EU) and it has taken many steps which would ease its membership in the EU. The single currency in the European Union provides ‘one size fits all’ solution to the EU members. The countries which join the EU require economic stimulation and controls in order to ensure the stability of the Euro. Once Ruritania joins the EU, the country will have to replace the Crown with the Euro as a means of exchange. The EU policies will not only result in loss of national sovereignty but also inflation in the country. In 2002, when the Euro was introduced in the ERM 2 member countries, the general price inflation temporarily increased. This increase in inflation rate in the Euro-changeover countries was sudden which gradually decreased (Ercolani and Dutta, 2006). Therefore a similar event can be expected when Ruritania changes its currency from the Crown to the Euro. As a result of revaluing the currency, the country might need to change its monetary policies which would increase inflation. Policies which increase public expenditure by the government help the currency to get devalued but on the other hand these policies increase the inflation in the country. FIXING EXCHANGE RATE Ruritania is joining the ERM 2 in order to make the exchange rate of the Crown more stable and attract foreign investment as a result. The central rate of exchange will be agreed upon through negotiations between the country officials and the EU. The central rate will be a sustainable one and will reflect the underlying exchange rate equilibrium which tells us that the Crown should neither be undervalued nor overvalued. The currency then will be allowed to fluctuate around the central rate of 15% or a narrower band of 2.25% which can be negotiated with the EU. The exchange rate in the market is allowed to roam freely within one of this central rate. The exchange rate can be corrected through the revaluation or devaluation of the currency. The central bank and the ECB are allowed to intervene as much as they want to realign the currency. Therefore monetary policies and other policies which can harm the company can be introduced by the ECB or the central bank of Ruritania in order to maintain the exchange rate. The country may decide to have strict monetary policies in order to revalue the currency if the currency is falling short of the 15% band or 2.25% band whichever is applicable. Revaluation of the currency requires the central bank to restrict the flow of the Crown in the international market. This can only be achieved through controlling the supply of the currency in the local and international market. Taxation could be increased on the corporation or even the taxation structure could increase which is harmful for the multinational corporations such as ours. All the steps taken to restrict the supply of money in the international market will effect negatively to our company. HIGHER WAGE RATES The wage rates for the labour would rise in Ruritania once the country is a member of EU because of the higher requirements of GDP and lower inflation rate. Taxation on the wages could rise as a result of joining the ERM 2. This is because the central bank and the ECB will be controlling the factors associated with devaluation and revaluation of the money. Expenditure on the public could be decreased so that the supply of money can be restricted in the international market in order to revalue the currency. Therefore the company can make losses instead of benefitting from the savings on lower labour cost. The main reason for the company to setup another production facility in the country of Ruritania is to benefit from the lower wage rates in the country. If the wages rise in the coming years when the country becomes a member of EU and ERM 2, then the company will lose out. CAPITAL EXPENDITURE APPRAISAL The assets that will be used in the business in Ruritania need to be identified before setting up the facility. The cost of the resources and the benefits from the proposed expenditure should be calculated and some form of appraisal should be performed in order to maximize the returns from the expenditure in Ruritania. The traditional methods of expenditure appraisal are Accounting Rate of Return (ARR) and Payback Period. ARR is unable to recognize the time value of money and is a profit based measure. The top management prefers percentages which is why ARR is used in most of the multinationals to appraise the expenditure and calculate the rate of return on the investment. Whereas the Payback Period is cash based measure which does not recognize cash flows after the payback point of the investment. The Net Present Value (NPV) for expenditure appraisal is also based on cash flows with single investment rate and single set of data. There is no allowance for sensitivity in the NPV method of appraisal. The Internal Rate of Return (IRR) provides the sensitivity measures to the NPV method. BETTER POLICIES FOR THE LOCALS Ruritania may develop policies in the future which are good for the local competitors and the international competitors may find it difficult to operate in that environment. These policies can be a result of controlling budget deficits or trade deficits. It the country is going into a deficit, it will introduce policies in order to control the deficit and keep it under the allowed deficit percentage by the EU. These efforts include higher import tariffs on raw material, creating artificial barriers to entry of market and other localization policies so that the demand for locally manufactured products increases and the demand for products produced by imported raw material are decreased. These policies will be beneficial for the local companies but not beneficial for the multinational corporations operating in Ruritania. DIFFERENCE IN NATIONAL GROWTH RATES UK is a country with average GDP growth rate of -5.20% (TradingEconomics, 2009) in 2009 whereas Ruritania had an average growth rate of 3.2%. This shows that the economic conditions in the two environments will be quite different. To analyze and establish strategic objectives, the company will need more finances and will have to hire more staff at headquarter as well as the new facility. The company will need to analyze the GDP growth rate in the two countries. Previous year’s growth rates also need to be considered. It should be made clear whether the GDP growth rate of Ruritania is stable or it has only increased this year similar to the situation in UK where the growth rate plunged below -5% this year whereas it was positive since many years. The study and analysis of the UK growth rate will show that the country’s growth rate will be improved in the coming years because only this year it fell in the negative figure. TYPE OF FDI The company will need to decide whether the company will be investing in a joint venture with a firm already present in Ruritania or will it be investing in a minority stake in a local company. Joint venture will require the company to engage in the investment highly as a new project will be established in collaboration with another firm. This type of investment is more risky than minority investment in another company. In a joint venture, risks and rewards are shared by the collaborating parties. An exit strategy will have to be developed by the company in order to come up with clear terms of dissolution of the joint venture (Kotelnikov, 2009). Most of the joint ventures result in a failure because of poor leadership and poor integration process (Kotelnikov, 2009). Minority investment in another local company in Ruritania will be less risky but the return on investments will be lower than in joint venture. Minority investment requires the investor to purchase shares of a particular company in order to control some of the resources. However, less than 50% of the shares can be only purchases by the interested party to have a minority stake in the company. This type of investment will not allow the company to enforce its decisions in the company. Establishment of a new branch or a subsidiary is a higher risk than joint venture and minority investment. This involves the expansion of overseas branch or subsidiary or an acquisition of overseas business enterprise or controlling its assets. EXCHANGE CONTROL Ruritania may present a risk to free international movement of cash in the future. This would be very harmful for the company once it invests in Ruritania. These policies can be a result of the change in government that is expected after the local election in some days in Ruritania. If the government is changed, some of the policies can be changed which our company would prefer the government not to take. On the other hand, the government may not take any actions that are favourable for our company and we prefer if they take those actions. This is a risk that is presented by the Ruritania political government at all levels, national, sub-national and multi-national levels. Ruritania is a less developed country and hence there are a lot of country risks which may affect the company financially. The company will have to divert a lot of its resources to measure and asses these risks in the future and then develop strategies to mitigate them. For the protection of the Crown, until the government is able to join the ERM 2, the government can introduce policies which are not favourable to our company. Before the Euro is introduced in the country, Ruritania will have to join ERM 2. For joining ERM 2, the current currency, the Crown, needs to be stabilized. The country is not fully developed, which means it is more probable that the protection of currency will take place. The government may impose restrictions on the free movement of cash. Under this restriction, the company will need to take permission from the central bank of Ruritania if it wants to send money to headquarter. The government controls the movement of cash in this exchange control. The control can change quickly and the decisions can be taken without any notifications to the multinational corps. In 1990s, Vietnam imposed a three month delay on international payment. The corporation that was affected was PepsiCo as it could not send the revenues to headquarters. Another exchange control can be placed under which the company may be forced to have non-approved movements to secondary markets. Under this exchange control, the corporations are forced to have non-approved movements from commercial banks to financial markets. Heavy surcharges are charged on non-approved movement of cash; therefore, the corporations are forced to restrict their movement of cash. The company may also face disincentives if it engages in the free movement of cash in Ruritania. This can be in the form of heavy taxation especially the withholding tax. COMPLICATIONS IN CURRENCIES MANAGEMENT Our company is UK based company, therefore if the company decides to purchase assets on lease, the company will have to lease in Ruritanian Crown. Therefore if the currency of the country Ruritania is changed to Euro in the future, the company will face higher cost of leasing. This is because Great Britain Pound (GBP) is lower in value against the Euro. The cost of leasing will be higher in Ruritania because the repayment of lease will be done from headquarter in UK in GBP. But the lease was done in Euro. Therefore the company will have to pay a higher principal amount. The revenues that will be recorded by the subsidiary in Ruritania will be in GBP. Therefore the cash that the company has in Ruritanian banks in GBP is Eurocurrency and is subject to separate demand and supply pressures. This is because Eurocurrency market is a separate market and has a separate interest rate structure. The GBP that is placed in the Ruritanian banks is much riskier than that is placed in the UK banks. CONCLUSION The company should keep in mind the complications that will be caused in managing the two currencies and at the time of the changeover to Euro, a lot of other problems will also be faced in Ruritania. The other issues to consider are the government policies and the uncertainty in the political environment. Once the elections have taken place and it is decided that which party will rule, then the company should consider investing in Ruritania. To minimize risks, the company should wait until 2014, until then the country is expected to join EU and ERM 2. Bibliography Butler, K. "Kirt C. Butler." Michigan State University. 2009. https://www.msu.edu/~butler/ (accessed 1 2, 2010). Ercolani, M, and J Dutta. "The Euro-changeoverand Euro-inflation: Evidence from Eurostats HICP." IDEAS. Feburary 2006. http://ideas.repec.org/p/bir/birmec/06-03.html (accessed 1 1, 2010). Kotelnikov, Vadim. Joint Ventures. 2009. http://www.1000ventures.com/business_guide/jv_main.html (accessed 1 2, 2010). MapsofWorld.com. International Finance Risks. 2008. http://finance.mapsofworld.com/finance/international/finance-risk.html (accessed 1 2, 2010). TradingEconomics. UK GDP Growth Rate. 12 22, 2009. http://www.tradingeconomics.com/Economics/GDP-Growth.aspx?Symbol=GBP (accessed 1 2, 2010). Read More