CHAPTER 1- An Overview of Financial Management

INTRODUCTION

Any business needs finance to meet their requirements in the economic world. Any kind of
business activity depends on the finance. Hence, it is called as lifeblood of business organization.
Whether the business concerns are big or small, they need finance to fulfil their business
activities.

In the modern world, all the activities are concerned with the economic activities and very
particular to earning profit through any venture or activities. The entire business activities are
directly related with making profit. (According to the economics concept of factors of
production, rent given to landlord, wage given to labor, interest given to capital and profit given
to shareholders or proprietors), a business concern needs finance to meet all the requirements.
Hence finance may be called as capital, investment, fund etc., but each term is having different
meanings and unique characters. Increasing the profit is the main aim of any kind of economic
activity.

MEANING OF FINANCE

Finance may be defined as the art and science of managing money. It includes financial service
and financial instruments. Finance also is referred as the provision of money at the time when it
is needed. Finance function is the procurement of funds and their effective utilization in business
concerns.

The concept of finance includes capital, funds, money, and amount. But each word is having
unique meaning. Studying and understanding the concept of finance become an important part of
the business concern.

DEFINITION OF FINANCE

According to Khan and Jain, “Finance is the art and science of managing money”. In addition to
principles and techniques, finance requires individual judgment of the person making the
financial decision. Hence, finance can also be defined as the art and science of managing money.
 Finance emerged as a separate field of study in the early 1900s; previously it was part of
economics. Its role since then followed the general trend of economic development in the world.
Upon its emergence in the 1900s, its emphasis was on the legal aspects of mergers, formation of
new firms and the analysis of various types of securities firms could issue to raise capital.

Money and Capital Markets

Finance consists of three interrelated

About securities markets and financial institutions

Investments
Focuses on the decisions made by both individual and institutional investors as they
choose securities for their investment portfolios

Financial Management or “Business Finance”

Which involves decisions within firms. The career opportunities within each field are
many and varied, but financial managers must have knowledge of all three areas if they
areas

are to do their jobs well.

 AIMS OF FINANCE FUNCTION

 Acquiring Sufficient and Suitable Funds: The primary aim of finance function is to
assess the needs of the enterprise, properly, and procure funds, in time.
 Proper Utilization of Funds: Raising funds is important, more than that is its
proper utilization. If proper utilization of funds were not made, there would be no
revenue generation. Benefits should always exceed cost of funds so that the
organization can be profitable.
 Increasing Profitability: Profitability is necessary for every organization. The
planning and control functions of finance aim at increasing profitability of the
firm. To achieve profitability, the cost of funds should be low. Idle funds do not
yield any return, but incur cost. So, the organization should avoid idle funds.
Finance function also requires matching of cost and returns of funds. If funds are
used efficiently, profitability gets a boost.
 Maximizing Firm’s Value: The ultimate aim of finance function is maximizing the
value of the firm, which is reflected in wealth maximization of shareholders. The
market value of the equity shares is an indicator of the wealth maximization.
 FUNCTIONS OF FINANCE
 Finance is, closely, connected with production, marketing and other activities. In
the absence of finance, all these activities come to a halt. In fact, only with finance,
a business activity can be commenced, continued and expanded.
 Finance exists everywhere, be it production, marketing, human resource
development or undertaking research activity.
 Understanding the universality and importance of finance, finance manager is
associated, in modern business, in all activities as no activity can exist without
funds.
 Financial Decisions or Finance Functions are closely inter-connected. All
decisions mostly involve finance. When a decision involves finance, it is a
financial decision in a business firm. In all the following financial areas of
decision-making, the role of finance manager is vital. We can classify the finance
functions or financial decisions into three major groups:
 Investment Decision or Asset mix decision
 Finance Decision or Capital mix decision
 Dividend Decision or Profit allocation decision

 DEFINITION OF FINANCIAL MANAGEMENT

According to Weston and Brigham, financial management is an area of financial decision

making, harmonizing individual motives and enterprise goals. In another words financial
management is concerned with the managerial decisions that result in the acquisition and
financing of long-term and short-term recognitions for the firm. As such it deals with the
situations that require selection of specific assets / combination of assets, the selection of specific
liability / combination of liabilities as well as the problem of size and growth of an enterprise.
The analysis of these decisions is based on the expected inflows and outflows of funds and their
effects upon managerial objectives.
Financial management “is the operational activity of a business that is responsible for obtaining
and effectively utilizing the funds necessary for efficient operations. Thus, Financial
Management is mainly concerned with the effective funds management in the business.

 Nature of Financial Management

Financial management is applicable to every type of organization, irrespective of the size, kind
or nature. Every organization aims to utilize its resources in a best possible and profitable way.
a) Financial Management is an integral part of overall management. Financial considerations
are involved in all business decisions. Acquisition, maintenance, removal or replacement of
assets, employee compensation, sources and costs of different capital, production, marketing,
finance and personnel decision, almost all decisions for that matter have financial
implications. Therefore, financial management is pervasive throughout the organization.
b) The central focus of financial management is valuation of the firm. Financial decisions are
directed at increasing/maximization/ optimizing the value of the institution. Weston and
Brigham depict the above orientation in the exhibit given below:
Orientation of Financial Management

Policy Decisions
1. Line of activities
2. Mode of entry
3. Size of operation Risk
4. Assets mix Value of
5. Capital mix Organization
6. Liquidity
Return
7. Solvency

c) Financial management essentially involves risk-return trade-off. Decisions on investment

involve choosing of types of assets which generate returns accompanied by risks. Generally,
higher the risk, returns might be higher and vice versa. So, the financial manager has to
decide the level of risk the firm can assume and satisfy with the accompanying return.
Similarly, cheaper sources of capital have other disadvantages. So to avail the benefit of the
 low cost funds, the firm has to put up with certain risks, so, risk-return trade-off is there
throughout.
d) Financial management affects the survival, growth and vitality of the institution. Finance is
said to be the life blood of institutions. The amount, type, sources, conditions and cost of
finance squarely influence the functioning of the institution.
e) Finance functions, i.e., investment, raising of capital, distribution of profit, are performed in
all firms - business or non-business, big or small, proprietary or corporate undertakings. Yes,
financial management is a concern of every concern including educational institutions.
f) Financial management is a sub-system of the institutional system which has other subsystems
like academic activities, research wing, etc., In systems arrangement financial sub-system is
to be well coordinated with others and other sub-systems well matched with the financial
sub-system.
g) Financial management of an institution is influenced by the external legal and economic
environment. The legal constraints on using a particular type of funds or on investing in a
particular type of activity, etc., affect financial decisions of the institution. Financial
management is, therefore, highly influenced/constrained by external environment.
h) Financial management is related to other disciplines like accounting, economics, taxation,
operations research, mathematics, statistics etc., It draws heavily from these disciplines.
i) There are some procedural finance functions - like record keeping, credit appraisal and
collection, inventory replenishment and issue, etc., these are routinized and are normally
delegated to bottom level management executives.
j) The nature of finance function is influenced by the special characteristic of the business. In a
predominantly technology and R & D functions which get more dominance.

 SCOPE OF FINANCIAL MANAGEMENT

Financial management is not a revolutionary concept but an evolutionary. The definition and
scope of financial management has been changed from one period to another period and applied
various innovations. Theoretical points of view, financial management approach may be broadly
divided into two major parts i.e. traditional and modern approach.
A. Traditional Approach

Traditional approach is the initial stage of financial management, which was followed, in the
early part of during the year 1920 to 1950. This approach is based on the past experience and the
traditionally accepted methods. Main part of the traditional approach is rising of funds for the
business concern. Traditional approach consists of the following important area.

 Arrangement of funds from lending body.

 Arrangement of funds through various financial instruments.
 Finding out the various sources of funds.

B. Modern Approach

In the modern times, the financial management includes besides procurement of funds, the three
different kinds of decisions as well namely, investment, financing and dividend.Modern
approach consists of the following important activity.

• Determination of size of the enterprise and determination of rate of growth.

• Determining the composition of assets of the enterprise.

• Determining the mix of enterprises financing i.e. consideration of level of debt to equity,
etc.

• Analyze, planning and control of financial affairs of the enterprise.

 Functions of Finance Manager

Finance function is one of the major parts of business organization, which involves the
permanent and continuous process of the business concern. Finance is one of the interrelated
functions which deal with personal function, marketing function, production function and
research and development activities of the business concern. At present, every business concern
concentrates more on the field of finance because, it is a very emerging part which
reflects the entire operational and profit ability position of the concern. Deciding the proper
financial function is the essential and ultimate goal of the business organization.
Finance manager is one of the important role players in the field of finance function.
He must have entire knowledge in the area of accounting, finance, economics and
management. His position is highly critical and analytical to solve various problems related
to finance. A person who deals finance related activities may be called finance manager.
Finance manager performs the following major functions:

1. Forecasting Financial Requirements

It is the primary function of the Finance Manager. He is responsible to estimate the financial
requirement of the business concern. He should estimate, how much finances required to acquire
fixed assets and forecast the amount needed to meet the working capital requirements in future

.2. Acquiring Necessary Capital

After deciding the financial requirement, the finance manager should concentrate how the
finance is mobilized and where it will be available. It is also highly critical in nature.

3. Investment Decision
The finance manager must carefully select best investment alternatives and consider the
reasonable and stable return from the investment. He must be well versed in the field of capital
budgeting techniques to determine the effective utilization of investment. The finance manager
must concentrate to principles of safety, liquidity and profitability while investing capital

4. Cash Management
Present day’s cash management plays a major role in the area of finance because proper cash
management is not only essential for effective utilization of cash but it also helps to meet the
short-term liquidity position of the concern.

5. Interrelation with Other Departments

Finance manager deals with various functional departments such as marketing, production,
personnel, system, research, development, etc. Finance manager should have sound knowledge
not only in finance related area but also well versed in other areas. He must maintain a good
relationship with all the functional departments of the business organization.
 Financial Markets and Institutions
Financial Institutions
Financial institutions are financial intermediaries, which are specialized financial firms that
facilitate the transfer of funds from savers to demanders of capital. They accept savings from
customers and lend this money to other customers or they invest it. In many instances, they pay
savers interest on deposited funds. In some cases, they impose service charges on customers for
the services they render. For example, many financial institutions impose service charges on
current accounts.

The key participants in financial transactions of financial institutions are individuals, businesses,
and government. By accepting the savings from these parties, financial institutions transfer again
to individuals, business firms, and governments. Since financial institutions are generally large,
they gain economies of scale in the transfer of money between savers and demanders. By pooling
risks, they help individual savers to diversify their risk.

The major classes of financial institutions include commercial banks, savings and loan
associations, mutual savings banks, credit unions, pension funds and life insurance companies.
Among these, commercial banks are by far the most common financial institutions in many
countries worldwide. In Ethiopia too, commercial banks are the major institutions that handle the
savings and borrowing transactions of individuals, businesses, and governments.

Cash Flows to and from the Firm

The interplay between the corporation and the financial markets is illustrated in Figure 1.2. The
arrows in Figure 1.2 trace the passage of cash from the financial markets to the firm and from the
firm back to the financial markets.
1.2.3 Financial Markets
Financial markets are markets in which financial instruments are bought and sold by suppliers
and demanders of funds. They, unlike financial institutions, are places in which suppliers and
demanders of funds meet directly to transact business.

Functions of Financial Markets

Generally, financial markets play three important roles in functioning of corporate finance.
1. They assist the capital formation process. Financial markets serve as a way through
which firms can obtain the capital they need for their operations and investment.
2. Financial markets serve as resale markets for financial instruments. They create
continuous liquid markets where firms can obtain the capital they need from individuals
and other businesses easily.
3. They play a role in setting the prices of securities. The price of a financial instrument is
determined through the interaction of demand and supply of the security in the financial
markets.
 Classification of Financial Markets
There are many types of financial markets and hence several ways to classify them. For our
purpose, here we shall consider the following two classifications.

1. Classification on the basis of maturity

This is based on the maturity dates of securities
i) Money Markets
ii) Capital Markets

2. Classification on the basis of the nature of securities

This is based on whether the securities are new issues or have been outstanding in the market
place.
i) Primary Markets
ii) Secondary Markets

1.2.4 Money markets versus Capital markets

Money markets versus capital markets. Money markets are the markets for short-term, highly
liquid debt securities. The New York, London, and Tokyo money markets are among the world’s
largest. Capital markets are the markets for intermediate- or long-term debt and corporate stocks.
The New York Stock Exchange, where the stocks of the largest U.S. corporations are traded, is a
prime example of a capital market. There is no hard-and-fast rule, but in a description of debt
markets, short-term generally means less than 1 year, intermediate-term means 1 to 10 years, and
long-term means more than 10 years.

1.2.5 Primary versus Secondary Markets

Financial markets function as both primary and secondary markets for debt and equity securities.
The term primary market refers to the original sale of securities by governments and
corporations. The secondary markets are those in which these securities are bought and sold after
the original sale. Equities are, of course, issued solely by corporations. Debt securities are issued
by both governments and corporations.
1.3 Financial management decisions
The financial manager must be concerned with three basic types of decisions. Those decisions
are concerned with the special activities or purposes of financial management. The functions of
financial management are planning for acquiring and utilizing funds by a firm as well as
distributing funds to the owners in ways that achieve goal of the firm.
In general, the functions of financial management include three major decisions a firm must
make. These are:
 Investment decisions
 Financing decisions
 Dividend decisions
1.3.1 Investment Decisions
They deal with allocation of the firm’s scarce financial resources among competing uses. These
decisions are concerned with the management of assets by allocating and utilizing funds within
the firm. Specifically, the investment decisions include:
i) Determining the asset mix or composition: - determining the total amount of the
firm’s finance to be invested in current and fixed assets.
ii) Determining the asset type: - determining which specific assets to maintain within
the categories of current and fixed assets.
iii) Managing the asset structure, i.e., maintaining the composition of current and fixed
assets and the type of specific assets under each category.
The investment decisions of a firm also involve working capital management and capital
budgeting decisions. The former refers to those decisions of a firm affecting its current assets and
short – term liabilities. The later, on the other hand, involves long – term investment decisions
like acquisition, modification, and replacement of fixed assets.
Generally, the investment decisions of a firm deal with the left side of the basic accounting
equation: A = L + OE (Assets = Liabilities + Owners’ Equity).

1.3.2 Financing Decisions

The financing decisions deal with the financing of the firm’s investments, i.e., decisions whether
the firm should use equity or debt funds in order to finance its assets. They are also concerned
with determining the most appropriate composition of short – term and long – term financing.
In simple terms, the financing decisions deal with determining the best financing mix or capital
structure of the firm. The financing decisions of a firm are generally concerned with the right
side of the basic accounting equation.
1.3.3 Dividend Decisions
The dividend decisions address the question how much of the cash a firm generates from
operations should be distributed to owners in the form of dividends and how much should be
retained by the business for further expansion. There are tradeoffs on the dividend policy of a
firm. On the one hand, paying out more dividends will make the firm to be perceived strong and
healthy by investors; on the other hand, it will affect the future growth of the firm. So the
dividend decision of a firm should be analyzed in relation to its financing decisions.

1.4 Goal of the firm

Assuming that we restrict ourselves to for-profit businesses, the goal of financial management is
to make money or add value for the owners. This goal is a little vague, of course, so we examine
some different ways of formulating it in order to come up with a more precise definition. Such a
definition is important because it leads to an objective basis for making and evaluating financial
decisions.

1.4.1 Possible Goals

If we were to consider possible financial goals, we might come up with some ideas like the
following:

o Survive.

o Avoid financial distress and bankruptcy.

o Beat the competition.

o Maximize sales or market share.

o Minimize costs.

o Maximize profits.

o Maintain steady earnings growth.

These are only a few of the goals we could list. Furthermore, each of these possibilities presents
problems as a goal for the financial manager. For example, it’s easy to increase market share or
unit sales; all we have to do is lower our prices or relax our credit terms. Similarly, we can
always cut costs simply by doing away with things such as research and development. We can
avoid bankruptcy by never borrowing any money or never taking any risks, and so on. It’s not
clear that any of these actions are in the stockholders’ best interests.
Profit maximization would probably be the most commonly cited goal, but even this is not a very
precise objective. Do we mean profits this year? If so, then we should note that actions such as
deferring maintenance, letting inventories run down, and taking other short-run cost-cutting
measures will tend to increase profits now, but these activities aren’t necessarily desirable.

The goal of maximizing profits may refer to some sort of “long-run” or “average” profits, but it’s
still unclear exactly what this means. First, do we mean something like accounting net income or
earnings per share? Second, what do we mean by the long run? As a famous economist once
remarked, in the long run, we’re all dead! More to the point, this goal doesn’t tell us what the
appropriate trade-off is between current and future profits. The goals we’ve listed here are all
different, but they do tend to fall into two classes.

The first of these relates to profitability. The goals involving sales, market share, and cost
control all relate, at least potentially, to different ways of earning or increasing profits. The goals
in the second group, involving bankruptcy avoidance, stability, and safety, relate in some way to
controlling risk. Unfortunately, these two types of goals are somewhat contradictory. The
pursuit of profit normally involves some element of risk, so it isn’t really possible to maximize
both safety and profit. What we need, therefore, is a goal that encompasses both factors.

GOAL OF FINANCIAL MANAGEMENT

Effective procurement and efficient use of finance lead to proper utilization of the finance by the
business concern. It is the essential part of the financial manager. Hence, the financial manager
must determine the basic objectives of the financial management. Objectives of Financial
Management may be broadly divided into two parts such as: Profit maximization and Wealth
maximization.

a) Profit maximization

Profit Maximization Main aim of any kind of economic activity is earning profit. A business
concern is also functioning mainly for the purpose of earning profit. Profit is the measuring
techniques to understand the business efficiency of the concern. Profit maximization is also the
traditional and narrow approach, which aims at, maximizes the profit of the concern. Profit
maximization consists of the following important features.

 Profit maximization is also called as cashing per share maximization. It leads to

maximize the business operation for profit maximization.
 Ultimate aim of the business concern is earning profit; hence, it considers all the
possible ways to increase the profitability of the concern.
 Profit is the parameter of measuring the efficiency of the business concern. So it
shows the entire position of the business concern.
 Profit is the main source of finance.

However, profit maximization cannot be the sole objective of a company. It is at best a limited
objective. If profit is given undue importance, a number of problems can arise. Some of these
have been discussed below:

The term profit is vague. It does not clarify what exactly it means. It conveys a different
meaning to different people. For example, profit may be in short term or long term
period; it may be total profit or rate of profit etc.
Profit maximization has to be attempted with a realization of risks involved. There is a
direct relationship between risk and profit. Many risky propositions yield high profit.
Higher the risk, higher is the possibility of profits. If profit maximization is the only goal,
then risk factor is altogether ignored. This implies that finance manager will accept highly
risky proposals also, if they give high profits. In practice, however, risk is very important
consideration and has to be balanced with the profit objective.
Profit maximization as an objective does not take into account the time pattern of returns.
Proposal A may give a higher amount of profits as compared to proposal B, yet if the
returns begin to flow say 10 years later, proposal B may be preferred which may have
lower overall profit but the returns flow is more early and quick.
Profit maximization as an objective is too narrow. It fails to take into account the social
considerations as also the obligations to various interests of workers, consumers, society,
as well as ethical trade practices. If these factors are ignored, a company cannot survive
 for long. Profit maximization at the cost of social and moral obligations is a short sighted
policy.

b) Wealth Maximization

Wealth Maximization Wealth maximization is one of the modern approaches, which involves
latest innovations and improvements in the field of the business concern. The term wealth means
shareholder wealth or the wealth of the persons those who are involved in the business concern.
Wealth maximization is also known as value maximization or net present worth maximization.
This objective is an universally accepted concept in the field of business. How do we measure
the value/wealth of a firm? According to Van Horne, Value of a firm is represented by the
market price of the company's common stock.

The market price of a firm's stock represents the focal judgment of all market participants as to
what the value of the particular firm is. It takes into account present and prospective future
earnings per share, the timing and risk of these earnings, the dividend policy of the firm and
many other factors that bear upon the market price of the stock. The market price serves as a
performance index or report card of the firm's progress.

Favorable Arguments for Wealth Maximization

Wealth maximization is superior to the profit maximization because the main aim of the
business concern under this concept is to improve the value or wealth of the shareholders.

Wealth maximization considers the comparison of the value to cost associated with the
business concern. Total value detected from the total cost incurred for the business
operation. It provides extract value of the business concern.

Wealth maximization considers both time and risk of the business concern.

Wealth maximization provides efficient allocation of resources.

It ensures the economic interest of the society.

Unfavorable Arguments for Wealth Maximization

 Wealth maximization leads to prescriptive idea of the business concern but it may not be
suitable to present day business activities.

 Wealth maximization creates ownership-management controversy.

 Wealth maximization can be activated only with the help of the profitable position of the
business concern.

Basic forms of business organizations

The basics of financial management are the same for all businesses, large or small, regardless of
how they are organized. Still, a firm’s legal structure affects its operations and thus should be
recognized. There are three different legal forms of business organization are sole proprietorship,
partnership, and corporation.

1.5.1. Sole Proprietorship

A sole proprietorship is a business owned by one person. This is the simplest type of business to
start and is the least regulated form of organization. Depending on where you live, you might be
able to start up a proprietorship by doing little more than getting a business license and opening
your doors. For this reason, there are more proprietorships than any other type of business and
many businesses that later become large corporations start out as small proprietorships.

The owner of a sole proprietorship keeps all the profits. That’s the good news. The bad news is
that the owner has unlimited liability for business debts. This means that creditors can look
beyond business assets to the proprietor’s personal assets for payment. Similarly, there is no
distinction between personal and business income, so all business income is taxed as personal
income.

1.5.2. Partnership

A partnership is similar to a proprietorship, except that there are two or more owners (partners).
In a commonly known general partnership, all the partners share in gains or losses, and all have
unlimited liability for all partnership debts, not just some particular share. The way partnership
gains (and losses) are divided is described in the partnership agreement.

The advantages and disadvantages of a partnership are basically the same as those of a
proprietorship. Partnerships based on a relatively informal agreement are easy and inexpensive to
form. General partners have unlimited liability for partnership debts, and the partnership
terminates when a general partner wishes to sell out or dies. All income is taxed as personal
income to the partners, and the amount of equity that can be raised is limited to the partners’
combined wealth. Ownership of a general partnership is not easily transferred, because a transfer
requires that a new partnership be formed.

Based on our discussion, the primary disadvantages of sole proprietorships and partnerships as
forms of business organization are (1) unlimited liability for business debts on the part of the
owners, (2) limited life of the business, and (3) difficulty of transferring ownership. These three
disadvantages add up to a single, central problem: the ability of such businesses to grow can be
seriously limited by an inability to raise cash for investment.

1.5.3. Corporation

The Corporation is the most important form of business organization. A corporation is a legal
“person” separate and distinct from its owners, and it has many of the rights, duties, and
privileges of an actual person. Corporations can borrow money and own property, can sue and be
sued, and can enter into contracts. A corporation can even be a general partner or a limited
partner in a partnership, and a corporation can own stock in another corporation.

Not surprisingly, starting a corporation is somewhat more complicated than starting the other
forms of business organization. Forming a corporation involves preparing articles of
incorporation (or a charter) and a set of bylaws. The articles of incorporation must contain a
number of things, including the corporation’s name, its intended life (which can be forever), its
business purpose, and the number of shares that can be issued. This information must normally
be supplied to the state in which the firm will be incorporated. For most legal purposes, the
corporation is a “resident” of that state.
The bylaws are rules describing how the corporation regulates its own existence. For example,
the bylaws describe how directors are elected. These bylaws may be a very simple statement of a
few rules and procedures, or they may be quite extensive for a large corporation. The bylaws
may be amended or extended from time to time by the stockholders.

In a large corporation, the stockholders and the managers are usually separate groups. The
stockholders elect the board of directors, who then select the managers. Management is charged
with running the corporation’s affairs in the stockholders’ interests. In principle, stockholders
control the corporation because they elect the directors. As a result of the separation of
ownership and management, the corporate form has several advantages. Ownership (represented
by shares of stock) can be readily transferred, and the life of the corporation is therefore not
limited. The corporation borrows money in its own name. As a result, the stockholders in a
corporation have limited liability for corporate debts. The most they can lose is what they have
invested. The relative ease of transferring ownership, the limited liability for business debts, and
the unlimited life of the business are the reasons why the corporate form is superior when it
comes to raising cash.

Multinational Financial Management

International Finance

International finance is the branch of financial economics broadly concerned with monetary and
macroeconomic interrelations between two or more countries. International finance is defined as
the set of relations for the creation and using of funds (assets), needed for foreign economic
activity of international companies and countries. International finance examines the dynamics of
the global financial system, international monetary systems, balance of payments, exchange
rates, foreign direct investment, and how these topics relate to international trade. Sometimes
referred to as multinational finance, international finance is additionally concerned with matters
of international financial management. Investors and multinational corporations must assess and
manage international risks such as political risk and foreign exchange risk, including transaction
exposure, economic exposure, and translation exposure.
International Financial Management

International financial management (IFM) is a term that grew out of the need for individuals and
organizations to consider the implications of financial decisions due to cross-border transactions
prevalent in the world economy. Thus, international financial management is the study and
application of financial strategy that takes into account the differences and complexities involved
in cross border transactions. The term accounts for such topics as raising capital, making
acquisitions, investment strategy, managing risk, organizational restructuring, and overall
financial policy in global context. Finance managers of such international activities are
concerned with aspects like exchange rates, rules regarding taxation, legal complexities and
regulations, and risk factors associated with doing business in another nation. Familiarity with
international trade agreements is an important part of the topic as well.

Currency exchange rates and differing methods to determine price of assets can have a major
impact on the bottom line in international financial management. As such, the topic accounts for
the structure of the currency exchange system and how to determine asset prices in a global
setting. In addition, IFM is also concerned with how different currencies impact the prices on
stock markets.

Decision making in international financial management must account for potential impacts
related to various capital structures, approaches to risk management, and how to best leverage
taxation systems. IFM will examine how a firm may take advantage of local partnerships in other
countries or how to capitalize on international subsidies that are available. Taking into account
taxation and exposure to exchange rates, IFM managers will research and decide how to best
hedge those exposures and responsibilities.

Valuation and policies for obtaining financing internationally are usually modified when a
dealing cross-border investment. International finance management will consider the cost of
placing operations in other nations and discern how to best value investments in developing
nations. Other areas of concern include penetrating markets and sustaining a presence in those
markets effectively.
Additionally, international financial management accounts for differing institutional
arrangements, whether formal or informal, that reflect decision making. Differences in legalities,
such as protection of creditors and shareholders, impacts both investment and restructuring
decisions. This means IMF requires excellent communication skills and building relationships in
order to get the job done correctly.

Overall, the main goal of international financial management is to create the most wealth
possible for shareholders. Stakeholders also are important for IFM managers. They include
suppliers, vendors, employees and end customers who all must be observed from a financial
perspective when considering cross-border transactions.

International Financial Management Different from Financial Management at Domestic

Level

The important distinguishing features of international finance from domestic financial

management are discussed below:

Foreign exchange risk

An understanding of foreign exchange risk is essential for managers and investors in the modern
day environment of unforeseen changes in foreign exchange rates. In a domestic economy this
risk is generally ignored because a single national currency serves as the main medium of
exchange within a country. When different national currencies are exchanged for each other,
there is a definite risk of volatility in foreign exchange rates. The present International Monetary
System set up is characterized by a mix of floating and managed exchange rate policies adopted
by each nation keeping in view its interests.

In fact, this variability of exchange rates is widely regarded as the most serious international
financial problem facing corporate managers and policy makers.

At present, the exchange rates among some major currencies such as the US dollar, British
pound, Japanese yen and the euro fluctuate in a totally unpredictable manner. Exchange rates
have fluctuated since the 1970s after the fixed exchange rates were abandoned. Exchange rate
variation affect the profitability of firms and all firms must understand foreign exchange risks in
order to anticipate increased competition from imports or to value increased opportunities for
exports. Thus, changes in the exchange rates of foreign currencies results in foreign exchange
risks.

Political risk

Another risk that firms may encounter in international finance is political risk. Political risk
ranges from the risk of loss (or gain) from unforeseen government actions or other events of a
political character such as acts of terrorism to outright expropriation of assets held by foreigners.
The other country may seize assets of the company without any reimbursements by utilizing their
sovereign right, and some countries may restrict currency remittances to the parent company.
MNCs must assess the political risk not only in countries where it is currently doing business but
also where it expects to establish subsidiaries. The extreme form of political risk is when the
sovereign country changes the ‘rules of the game’ and the affected parties have no alternatives
open to them.

Example: In 1992, Enron Development Corporation, a subsidiary of a Houston based Energy

Company, signed a contract to build India’s longest power plant. Unfortunately, the project got
cancelled in 1995 by the politicians in Maharashtra who argued that India did not require the
power plant. The company had spent nearly $ 300 million on the project. The Enron episode
highlights the problems involved in enforcing contracts in foreign countries.

Thus, political risk associated with international operations is generally greater than that
associated with domestic operations and is generally more complicated.

Expanded opportunity sets

When firms go global, they also tend to benefit from expanded opportunities which are available
now. They can raise funds in capital markets where cost of capital is the lowest. In addition,
firms can also gain from greater economies of scale when they operate on a global basis.

Market imperfections

The final feature of international finance that distinguishes it from domestic finance is that world
markets today are highly imperfect. There are profound differences among nations laws, tax
systems, business practices and general cultural environments. Imperfections in the world
financial markets tend to restrict the extent to which investors can diversify their portfolio.
Though there are risks and costs in dealing with these market imperfections, they also offer
managers of international firm’s abundant opportunities.

Tax and Legal system

Tax and legal system varies from one country to another country and this leads to complexity in
their financial implications and hence give rise to tax and legal risks.

Inflation

Inflation rate differs from country to country. Higher inflation rates in few countries denote
inflation risks.

Multinational Companies and Theories of International Business (assignment)

To understand the pattern in international trade, different trade theories are postulated. Some
famous trade theories are:

1. Mercantilism

2. Absolute Advantage Theory

3. Comparative Advantage Theory

4. Hecksher-Ohlin Factor endowment theory

5. Product Life Cycle Theory

6. New Trade Theory

7. Porter’s Diamond Theory for competitive advantage.

International Business Method and Exposure to International Risk

INTERNATIONAL BUSINESS METHODS

The four types of international businesses are:
1. Exporting
2. Licensing
3. Franchising
4. Foreign Direct Investment (FDI)

Exporting

Exporting is often the first choice when manufacturers decide to expand abroad. Exporting
means selling abroad, either directly to target customers or indirectly by retaining foreign sales
agents or/and distributors. Either case, going abroad through exporting has minimal impact on
the firm’s human resource management because only a few, if at all, of its employees are
expected to be posted abroad.

Exporting is the practice of shipping goods from the domestic country to a foreign country. This
term export is derived from the conceptual meaning as to ship the goods and services out of the
port of a country. In national accounts ―exports‖ consist of transactions in goods and services
(sales, barter, gifts or grants) from residents to non-residents.

The seller of such goods and services is referred to as an exporter who is based in the country of
export, whereas the overseas based buyer is referred to as an importer. An export’s counterpart is
an import. In international trade, exporting refers to selling goods and services produced in the
home country to other markets. Export of commercial quantities of goods normally requires the
involvement of customs authorities in both the country of export and the country of import. Data
on international trade in goods is mostly obtained through declarations to customs services. If a
country applies the general trade system, all goods entering or leaving the country are recorded.

Licensing

Licensing is another way to expand one’s operations internationally. In case of international

licensing, there is an agreement whereby a firm, called licensor, grants a foreign firm the right to
use intangible (intellectual) property for a specific period of time, usually in return for a royalty.
Licensing of intellectual property such as patents, copyrights, manufacturing processes, or trade
names abound across the nations. The Indian basmati (rice) is one such example. When
considering strategic entry into an international market, licensing is a low-risk and relatively fast
foreign market entry tactic.

Compared to the other potential entry models for foreign market entry, licensing is relatively low
risk in terms of time, resources, and capital requirements. Advantages of licensing include
localization through a foreign partner, adherence to strict international business regulations,
lower costs, and the ability to move quickly. Disadvantages to this entry mode include loss of
control, potential quality assurance issues in the foreign market, and lower returns due to lower
risk.

When deciding to license abroad, careful due diligence should be done to ensure that the licensee
is a strong investment for the licensor and vice versa. A licensor in a licensing relationship is the
owner of the produce, service, brand or technology being licensed and a licensee is the buyer of
the produce, service, brand or technology being licensed. A licensor (i.e. the firm with the
technology or brand) can provide their products, services, brand and/or technology to a licensee
via an agreement. This agreement will describe the terms of the strategic alliance, allowing the
licensor affordable and low risk entry to a foreign market while the licensee can gain access to
the competitive advantages and unique assets of another firm. This is potentially a strong win-
win arrangement for both parties, and is a relatively common practice in international business.

Example: Due to food import regulations in Japan, the licensor in a company involved in energy
health drinks cannot sell the product at local wholesalers or retailers. In order to circumvent this
strategic barrier, the licensor finds a local sports drink manufacturer to license their recipe to. In
exchange, the licensee sells the product locally under a local brand name and kicks back 15% of
the overall revenues to the licensor.

Licenses are signed for a variety of time periods. Depending on the investment needed to enter
the market, the foreign licenses may insist on a longer licensing period to pay on the initial
investment. The license will make all necessary capital investment such as machinery inventory
and so on and market the products in the assigned sales territories, which may consist of one or
more countries. Licensing arrangements are subjected to negotiations and tend to vary
considerably from company to company and from industry to industry.

The Pros and Cons

Before deciding to use licensing as an entry strategy, it‘s important to understand in which
situations licensing is best suited.

Advantages
Licensing affords new international entrants with a number of advantages:

 Licensing is a rapid entry strategy, allowing almost instant access to the market with the
right partners lined up.
 Licensing is low risk in terms of assets and capital investment. The licensee will provide
the majority of the infrastructure in most situations.
 Localization is a complex issue legally, and licensing is a clean solution to most legal
barriers to entry.
 Cultural and linguistic barriers are also significant challenges for international entries.
Licensing provides critical resources in this regard, as the licensee has local contacts,
mastery of local language, and a deep understanding of the local market.

Disadvantages

While the low-cost entry and natural localization are definite advantages, licensing also comes
with some opportunity costs:

 Loss of control is a serious disadvantage in a licensing situation in regards to quality

control. Particularly relevant is the licensing of a brand name, as any quality control issue
on behalf of the licensee will impact the licensor’s parent brand.
 Depending on an international partner also creates inherent risks regarding the success of
that firm. Just like investing in an organization in the stock market, licensing requires due
diligence regarding which organization to partner with.
 Lower revenues due to relying on an external party are also a key disadvantage to this
model. (Lower risk, lower returns.)

Franchising

Franchising is closely related to licensing and is a special form of it. Franchising is an option in
which a parent company grants another company/firm the right to do business in a prescribed
manner. A franchisee is a holder of a franchise; a person who is granted a franchise. And a
franchiser is a person who grants franchises. Franchising differs from licensing in the sense that
it usually requires the franchisee to follow much stricter guidelines in running the business than
does licensing. Further, licensing tends to be confined to manufacturers, whereas franchising is
more popular with service firms such as restaurants, hotels and rental services.

Franchisee will take the majority of the risk in opening a new location (e.g. capital investments
while gaining the advantage of an already established brand name and operational process. In
exchange, the franchisee will pay a certain percentage of the profits of the venture back to the
franchiser. The franchiser will also often provide training, advertising, and assistance with
products.

Franchising enables organizations a low cost and localized strategy to expanding to international
markets, while offering local entrepreneurs the opportunity to run an established business. A
franchise agreement is defined as the franchiser granting an entrepreneur or local company (the
franchisee) access to its brand, trademarks, and products. Franchising is designed to enable large
organizations rapid access to new markets with relatively low barriers to entry.

Advantages of franchising (for the franchiser) include low costs of entry, a localized workforce
(culturally and linguistically), and a high speed method of market entry.

Disadvantages of franchising (for the franchiser) include loss of some organizational and brand
control, as well as relatively lower returns than other strategic entry models (with lower risk).
Way to rapidly expand both domestically and globally.

Foreign Direct Investment (FDI)

Exporting, licensing and franchising make companies get them only so far in international
business. Companies aspiring to take full advantage of opportunities offered by foreign markets
decide to make a substantial direct investment of their own funds in another country. This is
popularly known as Foreign Direct Investment (FDI).

FDI is practiced by companies in order to benefit from cheaper labor costs, tax exemptions, and
other privileges in that foreign country. FDI is the flow of investments from one company to
production in a foreign nation, with the purpose of lowering labor costs and gaining tax
incentives. FDI can help the economic situations of developing countries, as well as facilitate
progressive internal policy reforms.
A major contributing factor to increasing FDI flow was internal policy reform relating to trade
openness and participation in international trade agreements and institutions. Foreign direct
investment (FDI) is investment into production in a country by a company located in another
country, either by buying a company in the target country or by expanding operations of an
existing business in that country.

FDI is done for many reasons including to take advantage of cheaper wages in the country,
special investment privileges, such as tax exemptions, offered by the country as an incentive to
gain tariff-free access to the markets of the country or the region. FDI is in contrast to portfolio
investment which is a passive investment in the securities of another country, such as stocks and
bonds.

Increase in the inward flow of FDI is a best choice for developing countries. However,
identifying the conditions that best attract such investment flow is difficult, since foreign
investment varies greatly across countries and over time. Knowing what has influenced these
decisions and the resulting trends in outcomes can be helpful for governments, non-
governmental organizations, businesses, and private donors looking to invest in developing
countries.

Foreign direct investment refers to operations in one country that are controlled by entities in a
foreign country. In a sense, this FDI means building new facilities in other country.

There are two forms of direct foreign investment: joint ventures and wholly-owned subsidiaries.
A joint venture is defined as ―the participation of two or more companies jointly in an
enterprise in which each party contributes assets, owns the entity to some degree, and shares
risk‖. In contrast, a wholly-owned subsidiary is owned 100% by the foreign firm.

Exposure to International Risk

International business usually increases an MNC’s exposure to:

 Exchange rate movements

 Foreign economic risk
 Political risk