CHAPTER 11

11

INTERNATIONAL FINANCIAL
MANAGEMENT
LEARNING OUTCOMES
After going through the chapter student shall be able to understand
 International Capital Budgeting
 Raising funds from International Sources
 Sovereign Funds
 International Financial Centre (GIFT City)
 International Working Capital Management
(a) International Working Capital Management
(b) Multinational Cash Management
(c) Multinational Inventory Management
(b) Multinational Receivable Management

1. INTERNATIONAL CAPITAL BUDGETING

1.1 Complexities Involved
Multinational Capital Budgeting has to take into consideration the different factors and variables
which affect a foreign project and are complex in nature than domestic projects. The factors crucial
in such a situation are:
(a) Cash flows from foreign projects have to be converted into the currency of the parent
organization.

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(b) Parent cash flows are quite different from project cash flows.
(c) Profits remitted to the parent firm are subject to tax in the home country as well as the host
country.
(d) Effect of foreign exchange risk on the parent firm’s cash flow.
(e) Changes in rates of inflation causing a shift in the competitive environment and thereby
affecting cash flows over a specific time period.
(f) Restrictions imposed on cash flow distribution generated from foreign projects by the host
country.
(g) Initial investment in the host country to benefit from the release of blocked funds.
(h) Political risk in the form of changed political events reduce the possibility of expected cash
flows.
(i) Concessions/benefits provided by the host country ensures the upsurge in the profitability
position of the foreign project.
(j) Estimation of the terminal value in multinational capital budgeting is difficult since the buyers
in the parent company have divergent views on acquisition of the project.
1.2 Problems Affecting Foreign Investment Analysis
The various types of problems faced in International Capital Budgeting analysis are as follows:
(1) Multinational companies investing elsewhere are subjected to foreign exchange risk in the
sense that currency appreciates/ depreciates over a span of time. To include foreign exchange risk
in the cash flow estimates of any project, it is necessary to forecast the inflation rate in the host
country during the lifetime of the project. Adjustments for inflation are made in the cash flows
depicted in local currency. The cash flows are converted in parent country’s currency at the spot
exchange rate multiplied by the expected depreciation rate obtained from purchasing power parity.
(2) Due to restrictions imposed on transfer of profits, depreciation charges and technical
specifications differences exist between project cash flows and cash flows obtained by the parent
organization. Such restriction can be diluted by the application of techniques viz internal transfer
prices, overhead payments. Adjustment for blocked funds depends on its opportunity cost, a vital
issue in capital budgeting process.
(3) In Multinational Capital Budgeting, after tax cash flows need to be considered for project
evaluation. The presence of two tax regimes along with other factors such as remittances to the
parent firm in the form of royalties, dividends, management fees etc., withholding tax provisions with
held in the host country, presence of tax treaties, tax discrimination pursued by the host country
between transfer of realized profits vis-à-vis local re-investment of such profits cause serious
impediments to multinational capital budgeting process. MNCs are in a position to reduce overall tax
burden through the system of transfer pricing.

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For computation of actual after tax cash flows accruing to the parent firm, higher of home/ host
country tax rate is used. If the project becomes feasible then it is acceptable under a more favourable
tax regime. If not feasible, then, other tax saving aspects need to be incorporated in order to find
out whether the project crosses the hurdle rate.
1.3 Project vis-a-vis Parent Cash Flows
There exists a big difference between the project and parent cash flows due to tax rules, exchange
controls etc. Management and royalty payments are returns to the parent firm. The basis on which
a project shall be evaluated depends on one’s own cash flows, cash flows accruing to the parent
firm or both.
Evaluation of a project on the basis of own cash flows entails that the project should compete
favourably with domestic firms and earn a return higher than the local competitors. If not, the
shareholders and management of the parent company shall invest in the equity/government bonds
of domestic firms. A comparison cannot be made since foreign projects replace imports and are not
competitors with existing local firms. Project evaluation based on local cash flows avoid currency
conversion and eliminates problems associated with fluctuating exchange rate changes.
For evaluation of foreign project from the parent firm’s angle, both operating and financial cash flows
actually remitted to it form the yardstick for the firm’s performance and the basis for distribution of
dividends to the shareholders and repayment of debt/interest to lenders. An investment has to be
evaluated on basis of net after tax operating cash flows generated by the project. As both types of
cash flows (operating and financial) are clubbed together, it is essential to see that financial cash
flows are not mixed up with operating cash flows.
1.4 Discount Rate and Adjusting Cash Flows
An important aspect in multinational capital budgeting is to adjust cash flows or the discount rate for
the additional risk arising from foreign location of the project. Earlier MNCs adjusted the discount
rate upwards for riskier projects as they considered uncertainties in political environment and foreign
exchange fluctuations. The MNCs considered adjusting the discount rate to be popular as the rate
of return of a project should be in conformity with the degree of risk. It is not proper to combine all
risks into a single discount rate. Political risk/uncertainties attached to a project relate to possible
adverse effects which might occur in future but cannot be foreseen at present. So adjusting discount
rates for political risk penalises early cash flows more than distant cash flows. Also adjusting
discount rate to offset exchange risk only when adverse exchange rate movements are expected is
not proper since a MNC can gain from favourable currency movements during the life of the project
on many occasions. Instead of adjusting discount rate while considering risk it is worthwhile to adjust
cash flows. The annual cash flows are discounted at a rate applicable to the project either at that of
the host country or parent country. Probability with certainty equivalent method along with decision
tree analysis are used for economic and financial forecasting. Cash flows generated by the project
and remitted to the parent during each period are adjusted for political risk, exchange rate and other
uncertainties by converting them into certainty equivalents.

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1.5 Adjusted Present Value (APV)

APV is used in evaluating foreign projects. The APV model is a value additive approach to capital
budgeting process i.e. each cash flow is considered individually and discounted at a rate consistent
with risk involved in the cash flow.
Different components of the project’s cash flow have to be discounted separately.
The APV method uses different discount rates for different segments of the total cash flows
depending on the degree of certainty attached with each cash flow. The financial analyst tests the
basic viability of the foreign project before accounting for all complexities. If the project is feasible
no further evaluation based on accounting for other cash flows is done. If not feasible, an additional
evaluation is done taking into consideration the other complexities.
The APV model is represented as follows.
n n n
Xt Tt St
- I0 + ∑ (1 + k ) ∑ (1 + i ) ∑ (1 + i )
t =1
* t
+
t =1
t
+
t =1
t
d d

Where I0 → Present Value of Investment Outlay

Xt
→ Present Value of Operating Cash Flow
(1 + k ) * t

T
t
Present Value of Interest Tax Shields
(1+ i ) → d
t

St
→ Present Value of Interest Subsidies
(1 + id )t
k* → Unlevered Cost of Capital
Tt → Tax Saving in year t due to financial mix adopted

St → Before tax value of interests subsidies in year t due to project specific

financing
id → Before tax cost of debt
The initial investment will be net of any ‘Blocked Funds’ that can be made use of by the parent
company for investment in the project. ‘Blocked Funds’ are balances held in foreign countries that
cannot be remitted to the parent due to Exchange Control regulations. These are ‘Direct Blocked
Funds’. Apart from this, it is quite possible that significant costs in the form of local taxes or
withholding taxes arise at the time of remittance of the funds to the parent country. Such ‘Blocked
Funds’ are indirect. If a parent company can release such ‘Blocked Funds’ in one country for the

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investment in a overseas project, then such amounts will go to reduce the ‘Cost of Investment
Outlay’.
The last two terms are discounted at the before tax cost of debt to reflect the relative cash flows due
to tax and interest savings.
1.6 Scenarios
Following three illustrations are based on three different scenarios:
1.6.1 A foreign company is investing in India
Illustration 1
Perfect Inc., a U.S. based Pharmaceutical Company has received an offer from Aidscure Ltd., a
company engaged in manufacturing of drugs to cure Dengue, to set up a manufacturing unit in Baddi
(H.P.), India in a joint venture.
As per the Joint Venture agreement, Perfect Inc. will receive 55% share of revenues plus a royalty
@ US $0.01 per bottle. The initial investment will be ` 200 crores for machinery and factory. The
scrap value of machinery and factory is estimated at the end of five (5) year to be ` 5 crores. The
machinery is depreciable @ 20% on the value net of salvage value using Straight Line Method. An
initial working capital to the tune of ` 50 crores shall be required and thereafter ` 5 crores each
year.
As per GOI directions, it is estimated that the price per bottle will be ` 7.50 and production will be
24 crores bottles per year. The price in addition to inflation of respective years shall be increased
by ` 1 each year. The production cost shall be 40% of the revenues.
The applicable tax rate in India is 30% and 35% in US and there is Double Taxation Avoidance
Agreement between India and US. According to the agreement tax credit shall be given in US for
the tax paid in India. In both the countries, taxes shall be paid in the following year in which profit
have arisen/ remittance received.
The Spot rate of $ is ` 57. The inflation in India is 6% (expected to decrease by 0.50% every year)
and 5% in US.
As per the policy of GOI, only 50% of the share can be remitted in the year in which they are realised
and remaining in the following year.
Though WACC of Perfect Inc. is 13% but due to risky nature of the project it expects a return of 15%.
Determine whether Perfect Inc. should invest in the project or not (from subsidiary point of view).
Solution
Working Notes:
1. Estimated Exchange Rates (Using PPP Theory)

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Year 0 1 2 3 4 5 6
Exchange rate * 57 57.54 57.82 57.82 57.54 56.99 56.18
2. Share in sales

Year 1 2 3 4 5
Annual Units in crores 24 24 24 24 24
Price per bottle (`) 7.50 8.50 9.50 10.50 11.50
Price fluctuating Inflation Rate 6.00% 5.50% 5.00% 4.50% 4.00%
Inflated Price (`) 7.95 8.97 9.98 10.97 11.96
Inflated Sales Revenue (` Crore) 190.80 215.28 239.52 263.28 287.04
Sales share @55% 104.94 118.40 131.74 144.80 157.87

3. Royalty Payment

Year 1 2 3 4 5
Annual Units in crores 24 24 24 24 24
Royalty in $ 0.01 0.01 0.01 0.01 0.01
Total Royalty ($ Crore) 0.24 0.24 0.24 0.24 0.24
Exchange Rate 57.54 57.82 57.82 57.54 56.99
Total Royalty (` Crore) 13.81 13.88 13.88 13.81 13.68

4. Tax Liability
(` Crore)
Year 1 2 3 4 5
Sales Share 104.94 118.40 131.74 144.80 157.87
Total Royalty 13.81 13.88 13.88 13.81 13.68
Total Income 118.75 132.28 145.61 158.61 171.55
Less: Expenses
Production Cost (Sales share x 40%) 41.98 47.36 52.69 57.92 63.15
Depreciation (195 x 20%) 39.00 39.00 39.00 39.00 39.00
PBT 37.77 45.92 53.92 61.69 69.40
Tax on Profit @30% 11.33 13.78 16.18 18.51 20.82
Net Profit 26.44 32.14 37.74 43.18 48.58

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5. Free Cash Flow

(` Crore)
Year 0 1 2 3 4 5 6
Sales Share 0.00 104.94 118.40 131.74 144.80 157.87 0.00
Total Royalty 0.00 13.81 13.88 13.88 13.81 13.68 0.00
Production Cost 0.00 -41.98 -47.36 -52.69 -57.92 -63.15 0.00
Initial Outlay -200.00 0.00 0.00 0.00 0.00 0.00 0.00
Working Capital -50.00 -5.00 -5.00 -5.00 -5.00 70.00 0.00
Scrap Value 0.00 0.00 0.00 0.00 0.00 5.00 0.00
Tax on Profit 0.00 0.00 -11.33 -13.78 -16.18 -18.51 -20.82
Free Cash Flow -250.00 71.77 68.59 74.15 79.51 164.89 -20.82

6. Remittance of Cash Flows

(` Crore)
Year 0 1 2 3 4 5 6
Free Cash Flow -250.00 71.77 68.59 74.15 79.51 164.89 -20.82
50% of Current Year 0.00 35.89 34.29 37.07 39.76 82.45 0.00
Cash Flow
Previous year 0.00 0.00 35.88 34.30 37.08 39.75 82.44
remaining cash flow
Total Remittance -250.00 35.88 70.17 71.37 76.84 122.20 61.62

NPV of Project under Appraisal

Year 0 1 2 3 4 5 6 7
Total Remittance -250.00 35.88 70.17 71.37 76.84 122.20 61.62
(` Crore) -
Exchange Rate 57.00 57.54 57.82 57.82 57.54 56.99 56.18 -
Remittance ($ mn) -43.86 6.24 12.14 12.34 13.35 21.44 10.97 -
US Tax @35% ($ mn) 0.00 0.00 2.18 4.25 4.32 4.67 7.50 3.84
Indian Tax ($ mn) 0.00 0.00 1.96 2.38 2.82 3.25 3.71 -
Net Tax ($ mn) 0.00 0.00 0.22 1.87 1.51 1.42 3.79 3.84
Net Cash Flow ($ mn) -43.86 6.24 11.92 10.47 11.84 20.02 7.18 -3.84
PVF @ 15% 1.000 0.870 0.756 0.658 0.572 0.497 0.432 0.376
Present Value ($ mn) -43.86 5.43 9.01 6.89 6.77 9.95 3.10 -1.44
Net Present Value ($ mn) = -4.15

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Decision: Since NPV of the project is negative, Perfect inc. should not invest in the project.
* Estimated exchange rates have been calculated by using the following formula:
Expected spot rate = Current Spot Rate x expected difference in inflation rates
(1 + Id )
E(S1) = S0 x
(1 + 1f )

Where
E(S1) is the expected Spot rate in time period 1
S0 is the current spot rate (Direct Quote)
Id is the inflation in the domestic country (home country)
If is the inflation in the foreign country
1.6.2 An Indian Company is investing in foreign country by raising fund in the same
country
Illustration 2
Its Entertainment Ltd., an Indian Amusement Company is happy with the success of its Water Park
in India. The company wants to repeat its success in Nepal also where it is planning to establish a
Grand Water Park with world class amenities. The company is also encouraged by a marketing
research report on which it has just spent ` 20,00,000.
The estimated cost of construction would be Nepali Rupee (NPR) 450 crores and it would be
completed in one years time. Half of the construction cost will be paid in the beginning and rest at
the end of year. In addition, working capital requirement would be NPR 65 crores from the year end
one. The after tax realizable value of fixed assets after four years of operation is expected to be
NPR 250 crores. Under the Foreign Capital Encouragement Policy of Nepal, company is allowed to
claim 20% depreciation allowance per year on reducing balance basis subject to maximum capital
limit of NPR 200 crore. The company can raise loan for theme park in Nepal @ 9%.
The water park will have a maximum capacity of 20,000 visitors per day. On an average, it is
expected to achieve 70% capacity for first operational four years. The entry ticket is expected to be
NPR 220 per person. In addition to entry tickets revenue, the company could earn revenue from sale
of food and beverages and fancy gift items. The average sales expected to be NPR 150 per visitor
for food and beverages and NPR 50 per visitor for fancy gift items. The sales margin on food and
beverages and fancy gift items is 20% and 50% respectively. The park would open for 360 days a
year.
The annual staffing cost would be NPR 65 crores per annum. The annual insurance cost would be
NPR 5 crores. The other running and maintenance costs are expected to be NPR 25 crores in the
first year of operation which is expected to increase NPR 4 crores every year. The company would
apportion existing overheads to the tune of NPR 5 crores to the park.

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All costs and receipts (excluding construction costs, assets realizable value and other running and
maintenance costs) mentioned above are at current prices (i.e. 0 point of time) which are expected
to increase by 5% per year.
The current spot rate is NPR 1.60 per rupee. The tax rate in India is 30% and in Nepal it is 20%.
The average market return is 11% and interest rate on treasury bond is 8%. The company’s current
equity beta is 0.45. The company’s funding ratio for the Water Park would be 55% equity and 45%
debt.
Being a tourist Place, the amusement industry in Nepal is competitive and very different from its
Indian counterpart. The company has gathered the relevant information about its nearest competitor
in Nepal. The competitor’s market value of the equity is NPR 1850 crores and the debt is NPR 510
crores and the equity beta is 1.35.
State whether Its Entertainment Ltd. should undertake Water Park project in Nepal or not.
Solution
Working Notes:
1. Calculation of Cost of Funds/ Discount Rate
Competing Company's Information
Equity Market Value 1850.00
Debt Market Value 510.00
Equity Beta 1.35

Assuming debt to be risk free i.e. beta is zero, the beta of competitor is un-geared as follows:
E 1850
Asset Beta = Equity Beta x = 1.35 x = 1.106
E + D(1 - t) 1850 + 510(1 - 0.20)
Equity beta for Its Entertainment Ltd. in Nepal
Assets beta in Nepal 1.106
Ratio of funding in Nepal
Equity 55.00%
Debt 45.00%
55
1. 1.106 = Equity Beta x
55+ 45(1 - 0.20)

Equity Beta = 1.83

Cost of Equity as per CAPM
Market Return 11.00%

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Risk free return 8.00%

Cost of Equity = Risk free return + β (Market Return - Risk free return)
= 8.00% + 1.83(11.00% - 8.00%) = 13.49%
WACC = 13.49% x 0.55 + 9%(1- 0.20) x 0.45 = 10.66%
2. Present Value Factors at the discount rate of 10.66%
Year 0 1 2 3 4 5
PVAF 1.000 0.904 0.817 0.738 0.667 0.603
3. Calculation of Capital Allowances
Year 1 2 3 4
Opening Balance (NPR Crore) 200.00 160.00 128.00 102.40
Less: Depreciation (NPR Crore) 40.00 32.00 25.60 20.48
Closing Balance (NPR Crore) 160.00 128.00 102.40 81.92
Calculation of Present of Free Cash Flow
Year 0 1 2 3 4 5
Expected Annual
visitors 5040000 5040000 5040000 5040000
Entry ticket price per
visitor (NPR) 242.55 254.68 267.41 280.78
Profit from sale of
Food and
Beverages per visitor
(NPR) 33.08 34.73 36.47 38.29
Profit from sale of
Fancy Gift Items per
visitor (NPR) 27.56 28.94 30.39 31.91
Revenue per visitor
(NPR) 303.19 318.35 334.27 350.98

Total Revenue (NPR

crores) 152.81 160.45 168.47 176.89
Less:
Annual Staffing Cost
(NPR crores) 71.66 75.25 79.01 82.96
Annual Insurance
Costs (NPR crores) 5.51 5.79 6.08 6.38
Other running and
maintenance

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costs (NPR crores) 25.00 29.00 33.00 37.00

Depreciation
Allowances (NPR
crores) 40.00 32.00 25.60 20.48
Total Expenses (NPR
crores) 142.17 142.04 143.69 146.82

PBT (NPR crores) 10.64 18.41 24.78 30.07

Tax on Profit (NPR
crores) 2.13 3.68 4.96 6.01
Net Profit (NPR
crores) 8.51 14.73 19.82 24.06
Add: Depreciation
Allowances (NPR
crores) 40 32 25.6 20.48
Park Construction
Cost (NPR crores) -225 -225
After tax assets
realisation value
(NPR crores) 250
Working capital (NPR
crores) -65.00 -3.25 -3.41 -3.58 75.25
Net cash Flow (NPR
crores) -225.00 -290.00 45.26 43.32 41.84 369.79
PVF at discount rate 1.00 0.904 0.817 0.738 0.667 0.603
Present Values (NPR
crores) -225.00 -262.16 36.98 31.97 27.91 222.98
Net Present Value (NPR crores) -167.32
Decision: Since NPV of the project is negative the Entertainment Ltd. should not undertake Water
Park project in Nepal.
1.6.3 An Indian Company is investing in foreign country by raising fund in different
country through the mode of Global Depository Receipts (GDRs)
Illustration 3
Opus Technologies Ltd., an Indian IT company is planning to make an investment through a wholly
owned subsidiary in a software project in China with a shelf life of two years. The inflation in China
is estimated as 8 percent. Operating cash flows are received at the year end.
For the project an initial investment of Chinese Yuan (CN¥) 30,00,000 will be in land. The land will
be sold after the completion of project at estimated value of CN¥ 35,00,000. The project also requires

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an office complex at cost of CN¥ 15,00,000 payable at the beginning of project. The complex will be
depreciated on straight-line basis over two years to a zero salvage value. This complex is expected
to fetch CN¥ 5,00,000 at the end of project.
The company is planning to raise the required funds through GDR issue in Mauritius. Each GDR will
have 5 common equity shares of the company as underlying security which are currently trading at
` 200 per share (Face Value = `10) in the domestic market. The company has currently paid the
dividend of 25% which is expected to grow at 10% p.a. The total issue cost is estimated to be 1
percent of issue size.
The annual sales is expected to be 10,000 units at the rate of CN¥ 500 per unit. The price of unit is
expected to rise at the rate of inflation. Variable operating costs are 40 percent of sales. Fixed
operating costs will be CN¥ 22,00,000 per year and expected to rise at the rate of inflation.
The tax rate applicable in China for income and capital gain is 25 percent and as per GOI Policy no
further tax shall be payable in India. The current spot rate of CN¥ 1 is ` 9.50. The nominal interest
rate in India and China is 12% and 10% respectively and the international parity conditions hold
You are required to
(a) Identify expected future cash flows in China and determine NPV of the project in CN¥.
(b) Determine whether Opus Technologies should go for the project or not assuming that there
neither there is restriction on the transfer of funds from China to India nor any charges/taxes
payable on the transfer of funds.
Solution
Working Notes:
1. Calculation of Cost of Capital (GDR)
Current Dividend (D0) 2.50
Expected Dividend (D1) 2.75
Net Proceeds (` 200 per share – 1%) 198.00
Growth Rate 10.00%

2.75
ke = + 0.10 = 0.1139 i.e. 11.39%
198

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2. Calculation of Expected Exchange Rate as per Interest Rate Parity

YEAR EXPECTED RATE
1 (1 + 0.12)
= 9.50 × = 9.67
(1 + 0.10)
2 (1 + 0.12) 2
= 9.50 × = 9.85
(1 + 0.10) 2

3. Realization on the disposal of Land net of Tax

CN¥
Sale value at the end of project 3500000.00
Cost of Land 3000000.00
Capital Gain 500000.00
Tax paid 125000.00
Amount realized net of tax 3375000.00
4. Realization on the disposal of Office Complex
(CN¥)
Sale value at the end of project 500000.00
WDV 0.00
Capital Gain 500000.00
Tax paid 125000.00
Amount realized net of tax (A) 375000.00
5. Computation of Annual Cash Inflows
Year 1 2
Annual Units 10000 10000
Price per bottle (CN¥) 540.00 583.20
Annual Revenue (CN¥) 5400000.00 5832000.00
Less: Expenses
Variable operating cost (CN¥) 2160000.00 2332800.00
Depreciation (CN¥) 750000.00 750000.00
Fixed Cost per annum (CN¥) 2376000.00 2566080.00
PBT (CN¥) 114000.00 183120.00
Tax on Profit (CN¥) 28500.00 45780.00
Net Profit (CN¥) 85500.00 137340.00
Add: Depreciation (CN¥) 750000.00 750000.00
Cash Flow 835500.00 887340.00

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(a) Computation of NPV of the project in CN¥

(CN¥)
Year 0 1 2
Initial Investment -4500000.00
Annual Cash Inflows 835500.00 887340.00
Realization on the disposal of 3375000.00
Land net of Tax
Realization on the disposal of 375000.00
Office Complex
Total -4500000.00 835500.00 4637340.00
PVF @11.39% 1.000 0.898 0.806
PV of Cash Flows -4500000.00 750279.00 3737696.00
NPV -12,025
(b) Evaluation of Project from Opus Point of View
(i) Assuming that inflow funds are transferred in the year in which same are
generated i.e. first year and second year.
Year 0 1 2
Cash Flows (CN¥) -4500000.00 835500.00 4637340.00
Exchange Rate (`/ CN¥) 9.50 9.67 9.85
Cash Flows (`) -42750000.00 8079285.00 45677799.00
PVF @ 12% 1.00 0.893 0.797
-42750000.00 7214802.00 36405206.00
NPV 870008.00
(ii) Assuming that inflow funds are transferred at the end of the project i.e. second
year.
Year 0 2
Cash Flows (CN¥) -4500000.00 5472840.00
Exchange Rate (`/ CN¥) 9.50 9.85
Cash Flows (`) -42750000.00 53907474.00
PVF 1.00 0.797
-42750000.00 42964257.00
NPV 214257.00
Though in terms of CN¥ the NPV of the project is negative but in ` it has positive NPV due to
weakening of ` in comparison of CN¥. Thus, Opus can accept the project.

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2. INTERNATIONAL SOURCES OF FINANCE

Indian companies have been able to tap global markets to raise foreign currency funds by issuing
various types of financial instruments which are discussed as follows:
2.1 Foreign Currency Convertible Bonds (FCCBs)
A type of convertible bond issued in a currency different than the issuer's domestic currency. In other
words, the money being raised by the issuing company is in the form of a foreign currency. A
convertible bond is a mix between a debt and equity instrument. It acts like a bond by making regular
coupon and principal payments, but these bonds also give the bondholder the option to convert the
bond into stock.
These types of bonds are attractive to both investors and issuers. The investors receive the safety
of guaranteed payments on the bond and are also able to take advantage of any large price
appreciation in the company's stock. (Bondholders take advantage of this appreciation by means of
warrants attached to the bonds, which are activated when the price of the stock reaches a certain
point.) Due to the equity side of the bond, which adds value, the coupon payments on the bond are
lower for the company, thereby reducing its debt-financing costs.
Advantages of FCCBs
(i) The convertible bond gives the investor the flexibility to convert the bond into equity at a price
or redeem the bond at the end of a specified period, normally three years if the price of the
share has not met his expectations.
(ii) Companies prefer bonds as it leads to delayed dilution of equity and allows company to avoid
any current dilution in earnings per share that a further issuance of equity would cause.
(iii) FCCBs are easily marketable as investors enjoy the option of conversion into equity resulting
into capital appreciation. Further investor is assured of a minimum fixed interest earnings.
Disadvantages of FCCBs
(i) Exchange risk is more in FCCBs as interest on bonds would be payable in foreign currency.
Thus, companies with low debt equity ratios, large forex earnings potential only opt for
FCCBs.
(ii) FCCBs mean creation of more debt and a forex outgo in terms of interest which is in foreign
exchange.
(iii) In the case of convertible bonds, the interest rate is low, say around 3–4% but there is
exchange risk on the interest payment as well as re-payment if the bonds are not converted
into equity shares. The only major advantage would be that where the company has a high
rate of growth in earnings and the conversion takes place subsequently, the price at which
shares can be issued can be higher than the current market price.

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2.2 American Depository Receipts (ADRs)

Depository receipts issued by a company in the United States of America (USA) is known as
American Depository Receipts (ADRs). Such receipts must be issued in accordance with the
provisions stipulated by the Securities and Exchange Commission of USA (SEC) which are very
stringent.
An ADR is generally created by the deposit of the securities of a non-United States company with a
custodian bank in the country of incorporation of the issuing company. The custodian bank informs
the depository in the United States that the ADRs can be issued. ADRs are United States dollar
denominated and are traded in the same way as are the securities of United States companies. The
ADR holder is entitled to the same rights and advantages as owners of the underlying securities in
the home country. Several variations on ADRs have developed over time to meet more specialized
demands in different markets. One such variation is the GDR which are identical in structure to an
ADR, the only difference being that they can be traded in more than one currency and within as well
as outside the United States.
2.3 Global Depository Receipts (GDRs)
A depository receipt is basically a negotiable certificate, denominated in a currency not native to the
issuer, that represents the company's publicly - traded local currency equity shares. Most GDRs are
denominated in USD, while a few are denominated in Euro and Pound Sterling. The Depository
Receipts issued in the US are called American Depository Receipts (ADRs), which anyway are
denominated in USD and outside of USA, these are called GDRs In theory, though a depository
receipt can also represent a debt instrument, in practice it rarely does. DRs (depository receipts) are
created when the local currency shares of an Indian company are delivered to the depository's local
custodian bank, against which the Depository bank (such as the Bank of New York) issues
depository receipts in US dollar. These depository receipts may trade freely in the overseas markets
like any other dollar-denominated security, either on a foreign stock exchange, or in the over-the-
counter market, or among a restricted group such as Qualified Institutional Buyers (QIBs). Indian
issues have taken the form of GDRs to reflect the fact that they are marketed globally, rather than
in a specific country or market.
Through the issue of depository receipts, companies in India have been able to tap global equity
market to raise foreign currency funds by way of equity. Quite apart from the specific needs that
Indian companies may have for equity capital in preference to debt and the perceived advantages
of raising equity over debt in general (no repayment of "principal" and generally lower servicing
costs, etc.) the fact of the matter is quite simple, that no other form of term foreign exchange funding
has been available. In addition, it has been perceived that a GDR issue has been able to fetch higher
prices from international investors (even when Indian issues were being sold at a discount to the
prevailing domestic share prices) than those that a domestic public issue would have been able to
extract from Indian investors.

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• Impact of GDRs on Indian Capital Market

Since the inception of GDRs a remarkable change in Indian capital market has been observed
as follows:
(i) Indian stock market to some extent is shifting from Bombay to Luxemburg.
(ii) There is arbitrage possibility in GDR issues.
(iii) Indian stock market is no longer independent from the rest of the world. This puts
additional strain on the investors as they now need to keep updated with world wide
economic events.
(iv) Indian retail investors are completely sidelined. GDRs/Foreign Institutional Investors'
placements + free pricing implies that retail investors can no longer expect to make
easy money on heavily discounted rights/public issues.
As a result of introduction of GDRs a considerable foreign investment has flown into India.
• Markets of GDRs
(i) GDR's are sold primarily to institutional investors.
(ii) Demand is likely to be dominated by emerging market funds.
(iii) Switching by foreign institutional investors from ordinary shares into GDRs is likely.
(iv) Major demand is also in UK, USA (Qualified Institutional Buyers), South East Asia
(Hong Kong, Singapore), and to some extent continental Europe (principally France
and Switzerland).
• Mechanism of GDR: The mechanics of a GDR issue may be described with the help of
following diagram.
Company issues

Ordinary shares

Kept with Custodian/depository banks

against which GDRs are issued

to Foreign investors
Characteristics
(i) Holders of GDRs participate in the economic benefits of being ordinary shareholders, though

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they do not have voting rights.

(ii) GDRs are settled through CEDEL & Euro-clear international book entry systems.
(iii) GDRs are listed on the Luxemburg stock exchange.
(iv) Trading takes place between professional market makers on an OTC (over the counter) basis.
(v) The instruments are freely traded.
(vi) They are marketed globally without being confined to borders of any market or country as it
can be traded in more than one currency.
(vii) Investors earn fixed income by way of dividends which are paid in issuer currency converted
into dollars by depository and paid to investors and hence exchange risk is with investor.
(viii) As far as the case of liquidation of GDRs is concerned, an investor may get the GDR cancelled
any time after a cooling period of 45 days. A non-resident holder of GDRs may ask the
overseas bank (depository) to redeem (cancel) the GDRs. In that case overseas depository
bank shall request the domestic custodians bank to cancel the GDR and to get the
corresponding underlying shares released in favour of non-resident investor. The price of the
ordinary shares of the issuing company prevailing in the Bombay Stock Exchange or the
National Stock Exchange on the date of advice of redemption shall be taken as the cost of
acquisition of the underlying ordinary share.
Illustration 4
X Ltd. is interested in expanding its operation and planning to install manufacturing plant at US. For
the proposed project it requires a fund of $ 10 million (net of issue expenses/ floatation cost). The
estimated floatation cost is 2%. To finance this project it proposes to issue GDRs.
You as financial consultant is required to compute the number of GDRs to be issued and cost of the
GDR with the help of following additional information.
(i) Expected market price of share at the time of issue of GDR is ` 250 (Face Value ` 100)
(ii) 2 Shares shall underly each GDR and shall be priced at 10% discount to market price.
(iii) Expected exchange rate ` 60/$.
(iv) Dividend expected to be paid is 20% with growth rate 12%.
Solution
Net Issue Size = $10 million
$10 million
Gross Issue = = $ 10.204 million
0.98

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Issue Price per GDR in ` (250 x 2 x 90%) ` 450

Issue Price per GDR in $ (` 450/ ` 60) $ 7.50
Dividend Per GDR (D1) (` 20 x 2) ` 40
Net Proceeds Per GDR (` 450 x 0.98) ` 441.00
$10.204 million
(a) Number of GDR to be issued = 1.3605 million
$7.50
40.00
(b) Cost of GDR to X Ltd. ke = + 0.12 = 21.07%
441.00

2.4 Euro-Convertible Bonds (ECBs)

A convertible bond is a debt instrument which gives the holders of the bond an option to convert the
bond into a predetermined number of equity shares of the company. Usually, the price of the equity
shares at the time of conversion will have a premium element. The bonds carry a fixed rate of
interest. If the issuer company desires, the issue of such bonds may carry two options viz.
(i) Call Options: (Issuer's option) - where the terms of issue of the bonds contain a provision for
call option, the issuer company has the option of calling (buying) the bonds for redemption before
the date of maturity of the bonds. Where the issuer's share price has appreciated substantially, i.e.
far in excess of the redemption value of the bonds, the issuer company can exercise the option. This
call option forces the investors to convert the bonds into equity. Usually, such a case arises when
the share prices reach a stage near 130% to 150% of the conversion price.
(ii) Put options - A provision of put option gives the holder of the bonds a right to put (sell)his
bonds back to the issuer company at a pre-determined price and date. In case of Euro-convertible
bonds, the payment of interest on and the redemption of the bonds will be made by the issuer
company in US dollars.
2.5 Other Sources
• Euro-Convertible Zero Coupon Bonds: These bonds are structured as a convertible bond.
No interest is payable on the bonds. But conversion of bonds takes place on maturity at a
pre-determined price. Usually there is a 5 years maturity period and they are treated as a
deferred equity issue.
• Euro-bonds with Equity Warrants: These bonds carry a coupon rate determined by the
market rates. The warrants are detachable. Pure bonds are traded at a discount. Fixed
income funds may like to invest in these bonds for the purposes of regular income.
• Syndicated bank loans: It is one of the earlier ways of raising funds in the form of large
loans from banks with good credit rating, can be arranged in reasonably short time and with
few formalities. The maturity of the loan can be for a duration of 5 to 10 years. The interest
rate is generally set with reference to an index, say, LIBOR plus a spread which depends

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upon the credit rating of the borrower. Some covenants are laid down by the lending institution
like maintenance of key financial ratios.
• Euro-bonds: These are basically debt instruments denominated in a currency issued outside
the country of that currency for examples Yen bond floated in France. Primary attraction of
these bonds is the refuge from tax and regulations and provide scope for arbitraging yields.
These are usually bearer bonds and can take the form of
(i) Traditional Fixed Rate Bonds.
(ii) Floating Rate Notes (FRNs)
(iii) Convertible Bonds.
• Foreign Bonds: Foreign bonds are denominated in a currency which is foreign to the
borrower and sold at the country of that currency. Such bonds are always subject to the
restrictions and are placed by that country on the foreigners funds.
• Euro Commercial Papers: These are short term money market securities usually issued at
a discount, for maturities less than one year.
• Credit Instruments: The foregoing discussion relating to foreign exchange risk management
and international capital market shows that foreign exchange operations of banks consist
primarily of purchase and sale of credit instruments. There are many types of credit
instruments used in effecting foreign remittances. They differ in the speed, with which money
can be received by the creditor at the other end after it has been paid in by the debtor at his
end. The price or the rate of each instrument, therefore, varies with extent of the loss of
interest and risk of loss involved. There are, therefore, different rates of exchange applicable
to different types of credit instruments.

3. INTERNATIONAL FINANCIAL CENTRE (GIFT CITY)

International Financial Centre (IFC) is the financial center that caters to the needs of the customers
outside their own jurisdiction. Broadly, speaking IFC is a hub that deals with flow of funds, financial
products and financial services even though in own land but with different set of regulations and
laws.
Thus, these centers provide flexibility in currency trading, insurance, banking and other financial
services. This flexible regime attracts foreign investors which is of potential benefit not only to the
stakeholders but as well as for the country hosting IFC itself.
3.1 Benefits of IFC
There are numberless direct and indirect benefits of setting up IFC but some major benefits
emanating from establishing IFC are as follows:
(i) Opportunity for qualified professionals working outside India come here and practice their
profession.
(ii) A platform for qualified and talented professionals to pursue global opportunities without
leaving their homeland.

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(iii) Stops Brain Drain from India.

(iv) Bringing back those financial services transactions presently carried out abroad by overseas
financial institutions/entities or branches or subsidiaries of Indian Financial Market.
(v) Trading of complicated financial derivative can be started from India.
3.2 Constituents of IFC
Although there are many constituents for IFC but some of the important constituents are as follows:
(i) Highly developed Infrastructure: - A leading edge infrastructure is a prerequisite for
creating a platform to offer internationally competitive financial services.
(ii) Stable Political Environment: - Destabilized political environment brings country risk for
investment by foreign nationals. Hence, to accelerate foreign participation in growth of
financial center, stable political environment is a prerequisite.
(iii) Strategic Location: - The geographical location of the finance center should be strategic
such as near to airport, seaport and should have friendly weather.
(iv) Quality Life: - The quality of life at the center should be good as center retains highly paid
professionals from own country as well from outside.
(v) Rationale Regulatory Framework: - Rationale legal regulatory framework is another
prerequisite of international finance center as it should be fair and transparent.
(vi) Sustainable Economy: - The economy should be sustainable and should possess capacity
to absorb all the shocks as it will boost investors’ confidence.
3.3 GIFT City - India’s International Financial Services Centre
To compete with its rival financial services centres situated in Dubai, Hong Kong etc. the idea of
setting up an International Financial Center in India was coined in 2007. The main motive of setting
up IFC in India was to retain the financial services businesses in India which moves out of India.
Since foreign investors normally remain hesitant to get registered in India GIFT city provides them
a separate jurisdiction where it is easy to do business because of relaxed tax and other laws.
Accordingly, Government of India operationalized International Financial Services Centre (IFSC) at
GIFT Multi Services SEZ in April 2015. The Union Budget 2016 provided competitive tax regime for
the IFSC at GIFT SEZ.
With the objective of achieving sustainable growth and achieving above cited objective India’s
honorable Prime Minister in inaugurated India’s first International Exchange – India INX, a wholly
owned subsidiary of Bombay Stock Exchange on 9/1/2017. The India INX has stated trading in Index,
currency, commodity and equity derivatives.

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On 5th June, 2017, National Stock Exchange (NSE) the competitor of Bombay Stock Exchange
(BSE) also launched its trading at GIFT. Initially, it started trading in derivative products in equity,
currency, interest rate futures and commodities.
GIFT IFSC provides very competitive cost of operations with very competitive tax regime, single
window clearance; relax company law provisions, international arbitration centre with overall
facilitation of doing business. GIFT IFSC is now moving toward unified regulatory mechanism.
GIFT City is a new Financial & Technology Gateway of India for the World. To be internationalized,
exchange controls cannot apply. So, FEMA is not applicable at GIFT city.
Hence, with all these development more and more financial institutions are setting business units in
GIFT as they will pay reduced taxes as valid for special economic zones and can easily offer foreign
currency loans to Indian Companies abroad and foreign firm.

4. SOVEREIGN FUNDS
A Sovereign Wealth Fund (SWF) is a state-owned investment fund comprised of money generated
by the government. This money generally derived by Government from country's own surplus
reserves. SWFs provide a benefit for a country's economy and its citizens. Since it is created by the
Government the legal basis on which these are created varies from Government to Government.
The legal basis for a sovereign wealth fund can be Constitutive Law, Fiscal Law, Constitution,
Company Law or any Other Laws and Regulations.
The popular sources for funding SWF are:
 Surplus reserves from state-owned natural resource revenues and trade surpluses,
 Bank reserves that may accumulate from budgeting excesses,
 Foreign currency operations,
 Money from privatizations, and
 Governmental transfer payments.
Generally, SWFs are created for a targeted purpose though some countries have created SWFs like
venture capital for the private sector. Some of the common objectives of a sovereign wealth fund
are as follows: -
• Protection & Stabilization of the budget and economy from excess volatility in
revenues/exports
• Diversify from non-renewable commodity exports
• Earn better returns than returns on foreign exchange reserves
• Assist monetary authorities dissipate unwanted liquidity
• Increase savings for future generations

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• Fund social and economic development

• Ensuring Sustainable long term capital growth for target countries
• Political strategy
Like any other type of investment funds, SWFs can have their own objectives, risk tolerances, terms,
and liquidity concerns etc. While some funds prefer returns over liquidity and some may prefer vice-
versa. Depending on the assets and objectives, sovereign wealth funds’ risk management can range
from very conservative to a high tolerance for risk. Traditional classifications of SWFs include:
 Stabilization funds
 Savings or future generation funds
 Public benefit pension reserve funds
 Reserve investment funds
 Strategic Development Sovereign Wealth Funds (SDSWF)
Various types of Sovereign Investment Vehicles are:
• Sovereign Wealth Funds (SWFs)
• Public Pension Funds
• State-Owned Enterprises
• Sovereign Wealth Enterprises (SWEs)

5. INTERNATIONAL WORKING CAPITAL MANAGEMENT

The management of working capital in an international firm is much more complex as compared to
a domestic one. The reasons for such complexity are:
(1) A multinational firm has a wider option for financing its current assets. A MNC has funds
flowing in from different parts of international financial markets. Therefore, it may choose to
avail financing either locally or from global financial markets. Such an opportunity does not
exist for pure domestic firms.
(2) Interest and tax rates may vary from one country to another. A Treasurer associated with a
multinational firm has to consider the interest/ tax rate differentials while financing current
assets. This is not the case for domestic firms.
(3) A multinational firm is confronted with foreign exchange risk as the value of inflow/outflow of
funds as well as the value of import/export are influenced by exchange rate variations.
(4) Restrictions imposed by the home or host country government towards movement of cash
and inventory on account of political considerations affect the growth of MNCs. Domestic
firms limit their operations within the country and do not face such problems.

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(5) With limited knowledge of the politico-economic conditions prevailing in different host
countries, a Manager of a multinational firm often finds it difficult to manage working capital
of different units of the firm operating in these countries. The pace of development taking
place in the communication system has to some extent eased this problem.
(6) In countries which operate on full capital convertibility, a MNC can move its funds from one
location to another and thus mobilize and ‘position’ the funds in the most efficient way
possible. Such freedom may not be available for MNCs operating in countries that have not
subscribed to full capital convertibility (like India).
A study of International Working Capital Management requires knowledge of Multinational Cash
Management, International Inventory Management and International Receivables Management.
5.1 Multinational Cash Management
MNCs are very much concerned for effective cash management. International money managers
follow the traditional objectives of cash management viz.
(1) Effectively managing and controlling cash resources of the company as well as
(2) Achieving optimum utilization and conservation of funds.
The former objective can be attained by improving cash collections and disbursements and by
making an accurate and timely forecast of cash flow pattern. The latter objective can be reached by
making money available as and when needed, minimising the cash balance level and increasing the
risk adjusted return on funds that is to be invested.
International Cash Management requires Multinational firms to adhere to the extant rules and
regulations in various countries that they operate in. Apart from these rules and regulations, they
would be required to follow the relevant forex market practices and conventions which may not be
practiced in their parent countries. A host of factors curtail the area of operations of an international
money manager e.g. restrictions on FDI, repatriation of foreign sales proceeds to the home country
within a specified time limit and the, problem of blocked funds. Such restrictions hinder the
movement of funds across national borders and the manager has to plan beforehand the possibility
of such situation arising on a country to country basis. Other complications in the form of multiple
tax jurisdictions and currencies and absence of internationally integrated exchange facilities result
in shifting of cash from one location to another to overcome these difficulties.
The main objectives of an effective system of international cash management are:
(1) To minimise currency exposure risk.
(2) To minimise overall cash requirements of the company as a whole without disturbing smooth
operations of the subsidiary or its affiliate.
(3) To minimise transaction costs.
(4) To minimise country’s political risk.

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(5) To take advantage of economies of scale as well as reap benefits of superior knowledge.
A centralized cash management group is required to monitor and manage parent subsidiary and
inter-subsidiary cash flows. Centralization needs centralization of information, reports and decision
making processes relating to cash mobilisation, movement and investment. This system benefits
individual subsidiaries which require funds or are exposed to exchange rate risk.
A centralised cash management system helps MNCs as follows:
(a) To maintain minimum cash balance during the year.
(b) To manage judiciously liquidity requirements of the centre.
(c) To optimally use various hedging strategies so that MNC’s foreign exchange exposure is
minimised.
(d) To aid the centre to generate maximum returns by investing all cash resources optimally.
(e) To aid the centre to take advantage of multinational netting so that transaction costs and
currency exposure are minimised.
(f) To make maximum utilization of transfer pricing mechanism so that the firm enhances its
profitability and growth.
(g) To exploit currency movement correlations:
(i) Payables & receivables in different currencies having positive correlations.
(ii) Payables of different currencies having negative correlations.
(iii) Pooling of funds allows for reduced holding – the variance of the total cash flows for
the entire group will be smaller than the sum of the individual variances.
Consider an MNC with two subsidiaries in different countries. The two subsidiaries periodically send
fees and dividends to the parent as well as send excess cash – all of them represent incoming cash
to the parent while the cash outflows to the subsidiaries include loans and return on cash invested
by them. As subsidiaries purchase supplies from each other they have cash flows between
themselves.

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Interest and/or principal on

excess cash invested by
Purchase of Securities
Short Term

Loans Funds received

from
Sale of securities
Subsidiary A

Excess Cash to
be invested
Long
Term Long Term

Funds Funds Loans

for Sources of
Suppliers for
Parent Debt
Suppliers
Repayment on Loans

Excess Cash
Funds paid for
new stock issues
Subsidiary Sources of
Fees and part of
earnings Debt

Cash Dividends
Interest and/or principal on
excess cash invested by subsidiary

Loans
Cash Flow of the Overall MNC

International Cash Management has two basic objectives:

1. Optimising Cash Flow movements.
2. Investing excess cash.
As no single strategy of international cash management can help in achieving both these objectives
together, its task on such aspects becomes very challenging.
There are numerous ways of optimising cash inflows:
1. Accelerating Cash Inflows.
2. Managing Blocked Funds.
3. Leading and Lagging strategy.
4. Minimising tax on cash flow through International Transfer Pricing.

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5. Using netting to reduce overall transaction costs by eliminating number of unnecessary

conversions and transfer of currencies (Netting).
6. Investing Excess Cash
5.1.1 Accelerating Cash Inflows
Faster recovery of cash inflows helps the firm to use them whenever required or to invest them for
better returns. Customers if using cheques for making payments, all over the world are instructed to
send their payments to lockboxes set up at various locations, thereby reducing the time and
transaction costs involved in collecting payments. Also, through pre-authorized payment, an
organization may be allowed to charge the customer’s bank account up to some limit.
5.1.2 Managing Blocked Funds
The host country may block funds of the subsidiary to be sent to the parent or make sure that
earnings generated by the subsidiary be reinvested locally before being remitted to the parent so
that jobs are created and unemployment reduced. The subsidiary may be instructed to obtain bank
finance locally for the parent firm so that blocked funds may be utilised to pay off bank loans.
The parent company has to assess the potential of future funds blockage in a foreign country. MNCs
have to be aware of political risks cropping up due to unexpected blockage of funds and devise ways
to benefit their shareholders by using different methods for moving blocked funds through transfer
pricing strategies, direct negotiations, leading and lagging and so on.
5.1.3 Leading and Lagging
This technique is used by subsidiaries for optimizing cash flow movements by adjusting the timing
of payments to determine expectations about future currency movements. MNCs accelerate (lead)
or delay (lag) the timing of foreign currency payments through adjustment of the credit terms
extended by one unit to another. This technique helps to reduce foreign exchange exposure or to
increase available working capital. Firms accelerate payments of hard currency payables and delay
payments of soft currency payables in order to reduce foreign exchange exposure. Suppose an MNC
in the USA has subsidiaries all over the world. The subsidiary in India purchases its supplies from
another subsidiary in Japan. If the Indian subsidiary expects the rupee to fall against the yen, then
it shall be the objective of that firm to accelerate the timing of its payment before the rupee
depreciates. Such a strategy is called Leading. On the other hand, if the Indian subsidiary expects
the rupee further to be stronger against the yen then it shall be the objective of that firm to delay the
timing of its payment before the rupee appreciates. Such a strategy is called Lagging. MNCs should
be aware of the government restrictions in such countries before availing such strategies.
5.1.4 Minimising Tax on Cash Flows through Transfer Pricing Mechanism
Large entities having many divisions require goods and services to be transferred frequently from
one division to another. The profits of different divisions are determined by the price to be charged
by the transferor division to the transferee division. The higher the transfer price, the larger will be

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the gross profit of the transferor division with respect to the transferee division. The position gets
complicated for MNCs due to exchange restrictions, inflation differentials, import duties, tax rate
differentials between two nations, quotas imposed by host country, etc.
5.1.5 Netting
It is a technique of optimising cash flow movements with the combined efforts of the subsidiaries
thereby reducing administrative and transaction costs resulting from currency conversion. There is
a co-ordinated international interchange of materials, finished products and parts among the different
units of MNC with many subsidiaries buying /selling from/to each other. Netting helps in minimising
the total volume of inter-company fund flow.
Advantages derived from netting system includes:
1) Reduces the number of cross-border transactions between subsidiaries thereby decreasing
the overall administrative costs of such cash transfers
2) Reduces the need for foreign exchange conversion and hence decreases transaction costs
associated with foreign exchange conversion.
3) Improves cash flow forecasting since net cash transfers are made at the end of each period
4) Gives an accurate report and settles accounts through co-ordinated efforts among all
subsidiaries.
There are two types of Netting:
1. Bilateral Netting System – It involves transactions between the parent and a subsidiary or
between two subsidiaries. If subsidiary X purchases $ 20 million worth of goods from
subsidiary Y and subsidiary Y in turn buy $ 30 million worth of goods from subsidiary X, then
the combined flows add up to $ 50 million. But in bilateral netting system subsidiary Y would
pay subsidiary X only $10 million. Thus, bilateral netting reduces the number of foreign
exchange transactions and also the costs associated with foreign exchange conversion. A
more complex situation arises among the parent firm and several subsidiaries paving the way
to multinational netting system.
2. Multilateral Netting System – Each affiliate nets all its inter affiliate receipts against all its
disbursements. It transfers or receives the balance on the position of it being a net receiver
or a payer thereby resulting in savings in transfer / exchange costs. For an effective
multilateral netting system, these should be a centralised communication system along with
disciplined subsidiaries. This type of system calls for the consolidation of information and net
cash flow positions for each pair of subsidiaries.
Subsidiary P sells $ 50 million worth of goods to Subsidiary Q, Subsidiary Q sells $ 50 million worth
of goods to Subsidiary R and Subsidiary R sells $ 50 million worth of goods to Subsidiary P. Through
multilateral netting inter affiliate fund transfers are completely eliminated.

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$ 50 $ 50
million million

Q $ 50 R
million

The netting system uses a matrix of receivables and payables to determine the net receipt / net
payment position of each affiliate at the date of clearing. A US parent company has subsidiaries in
France, Germany, UK and Italy. The amounts due to and from the affiliates is converted into a
common currency viz. US dollar and entered in the following matrix.
Inter Subsidiary Payments Matrix (US $ Thousands)
Paying affiliate
France Germany UK Italy Total
Receiving affiliate France --- 40 60 100 200
Germany 60 --- 40 80 180
UK 80 60 --- 70 210
Italy 100 30 60 --- 190
Total 240 130 160 250 780

Without netting, the total payments are $ 780 Thousands. Through multinational netting these
transfers will be reduced to $ 100 Thousands, a net reduction of 87%. Also currency conversion
costs are significantly reduced. The transformed matrix after consolidation and net payments in both
directions convert all figures to US dollar equivalents to the below form:
Netting Schedule (US $ Thousands)
Receipt Payment Net Receipt Net Payments
France 200 240 --- 40
Germany 180 130 50 ---
UK 210 160 50 ---
Italy 190 250 --- 60
100 100

5.1.6 Investing Excess Cash

Euro Currency market accommodates excess cash in international money market. Euro Dollar

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deposits offer MNCs higher yield than bank deposits in US. The MNCs use the Euro Currency market
for temporary use of funds, purchase of foreign treasury bills / commercial paper. Through better
telecommunication system and integration of various money markets in different countries, access
to the securities in foreign markets has become easier.
Through a centralized cash management strategy, MNCs pool together excess funds from
subsidiaries enabling them to earn higher returns due to the larger deposits lying with them.
Sometimes a separate investment account is maintained for all subsidiaries so that short term
financing needs of one can be met by the other subsidiary without incurring transaction costs
charged by banks for exchanging currencies. Such an approach leads to excessive transaction
costs. The centralized system helps to convert the excess funds pooled together into a single
currency for investments thereby involving considerable transaction cost and a cost benefit analysis
should be made to find out whether the benefits reaped are not offset by the transaction costs
incurred. A question may arise as to how MNCs will utilise their excess funds once they have used
them to meet short term financing needs. This is vital since some currencies may provide a higher
interest rate or may appreciate considerably. So deposits made in such currencies will be attractive.
Again MNCs may go in for foreign currency deposit which may give an effective yield higher than
domestic deposit so as to overcome exchange rate risk. Forecasting of exchange rate fluctuations
needs to be calculated in this respect so that a comparative study can be effectively made. Lastly
an MNC can go for a diversification of its portfolio in different countries having different currencies
because of the exchange rate fluctuations taking place and at the same time avoid the possibility of
incurring substantial losses that may arise due to sudden currency depreciation.
5.2 International Inventory Management
An international firm possesses normally a bigger stock than EOQ and this process is known as
stock piling. The different units of a firm get a large part of their inventory from sister units in different
countries. This is possible in a vertical set up. Due to political disturbance there may be bottlenecks
in import. If the currency of the importing country depreciates, imports will be costlier thereby giving
rise to stock piling. To take a decision against stock piling the firm has to weigh the cumulative
carrying cost vis-à-vis expected increase in the price of input due to changes in exchange rate. If
the probability of interruption in supply is very high, the firm may opt for stock piling even if it is not
justified on account of higher cost.
Also in case of global firms, lead time is larger on various units as they are located far off in different
parts of the globe. Even if they reach the port in time, a lot of customs formalities have to be carried
out. Due to these factors, re-order point for international firm lies much earlier. The final decision
depends on the quantity of goods to be imported and how much of them are locally available. Relying
on imports varies from unit to unit but it is very much large for a vertical set up.
5.3 International Receivables Management
Credit Sales lead to the emergence of account receivables. There are two types of such sales viz.
Inter firm Sales and Intra firm Sales in the global aspect.

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In case of Inter firm Sales, the currency in which the transaction should be denominated and the
terms of payment need proper attention. With regard to currency denomination, the exporter is
interested to denominate the transaction in a strong currency while the importer wants to get it
denominated in weak currency. The exporter may be willing to invoice the transaction in the weak
currency even for a long period if he/she has debt in that currency. This is due to sale proceeds
being used to retire debts without loss on account of exchange rate changes. With regard to terms
of payment, the exporter does not provide a longer period of credit and ventures to get the export
proceeds quickly in order to invoice the transaction in a weak currency. If the credit term is liberal
the exporter is able to borrow currency from the bank on the basis of bills receivables. Also, credit
terms may be liberal in cases where competition in the market is keen on compelling the exporter to
finance a part of the importer’s inventory. Such an action from the exporter helps to expand sales in
a big way.
In case of Intra firm sales, the focus is on global allocation of firm’s resources. Different parts of the
same product are produced in different units established in different countries and exported to the
assembly units leading to a large size of receivables. The question of quick or delayed payment
does not affect the firm as both the seller and the buyer are from the same firm though the one
having cash surplus will make early payments while the other having cash crunch will make late
payments. This is a case of intra firm allocation of resources where leads and lags explained earlier
will be taken recourse to.

TEST YOUR KNOWLEDGE

Theoretical Questions
1. Write a short note on Instruments of International Finance.
2. What is the impact of GDRs on Indian Capital Market?
Practical Questions
1. ABC Ltd. is considering a project in US, which will involve an initial investment of
US $ 1,10,00,000. The project will have 5 years of life. Current spot exchange rate is ` 48
per US $. The risk free rate in US is 8% and the same in India is 12%. Cash inflow from the
project is as follows:
Year Cash inflow
1 US $ 20,00,000
2 US $ 25,00,000
3 US $ 30,00,000
4 US $ 40,00,000
5 US $ 50,00,000

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Calculate the NPV of the project using foreign currency approach. Required rate of return on
this project is 14%.
2. A USA based company is planning to set up a software development unit in India. Software
developed at the Indian unit will be bought back by the US parent at a transfer price of US
$10 millions. The unit will remain in existence in India for one year; the software is expected
to get developed within this time frame.
The US based company will be subject to corporate tax of 30 per cent and a withholding tax
of 10 per cent in India and will not be eligible for tax credit in the US. The software developed
will be sold in the US market for US $ 12.0 millions. Other estimates are as follows:
Rent for fully furnished unit with necessary hardware in India ` 15,00,000
Man power cost (80 software professional will be working for 10 ` 400 per man hour
hours each day)
Administrative and other costs ` 12,00,000
Advise the US Company on the financial viability of the project. The rupee-dollar rate is `48/$.
Note: Assume 365 days a year.
3. XY Limited is engaged in large retail business in India. It is contemplating for expansion
into a country of Africa by acquiring a group of stores having the same line of operation as
that of India.
The exchange rate for the currency of the proposed African country is extremely volatile.
Rate of inflation is presently 40% a year. Inflation in India is currently 10% a year.
Management of XY Limited expects these rates likely to continue for the foreseeable future.
Estimated projected cash flows, in real terms, in India as well as African country for the
first three years of the project are as follows:
Year – 0 Year – 1 Year – 2 Year - 3
Cash flowsin Indian -50,000 -1,500 -2,000 -2,500
` (000)
Cash flows in African -2,00,000 +50,000 +70,000 +90,000
Rands (000)
XY Ltd. assumes the year 3 nominal cash flows will continue to be earned each year
indefinitely. It evaluates all investments using nominal cash flows and a nominal discounting
rate. The present exchange rate is African Rand 6 to ` 1.
You are required to calculate the net present value of the proposed investment considering
the following:
(i) African Rand cash flows are converted into rupees and discounted at a risk adjusted
rate.

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(ii) All cash flows for these projects will be discounted at a rate of 20% to reflect it’s
high risk.
(iii) Ignore taxation.
Year - 1 Year - 2 Year - 3
PVIF @ 20% .833 .694 .579
4. A multinational company is planning to set up a subsidiary company in India (where hitherto
it was exporting) in view of growing demand for its product and competition from other MNCs.
The initial project cost (consisting of Plant and Machinery including installation) is estimated
to be US$ 500 million. The net working capital requirements are estimated at US$ 50 million.
The company follows straight line method of depreciation. Presently, the company is
exporting two million units every year at a unit price of US$ 80, its variable cost per unit being
US$ 40.
The Chief Financial Officer has estimated the following operating cost and other data in
respect of proposed project:
(i) Variable operating cost will be US $ 20 per unit of production;
(ii) Additional cash fixed cost will be US $ 30 million p.a. and project's share of allocated
fixed cost will be US $ 3 million p.a. based on principle of ability to share;
(iii) Production capacity of the proposed project in India will be 5 million units;
(iv) Expected useful life of the proposed plant is five years with no salvage value;
(v) Existing working capital investment for production & sale of two million units through
exports was US $ 15 million;
(vi) Export of the product in the coming year will decrease to 1.5 million units in case the
company does not open subsidiary company in India, in view of the presence of
competing MNCs that are in the process of setting up their subsidiaries in India;
(vii) Applicable Corporate Income Tax rate is 35%, and
(viii) Required rate of return for such project is 12%.
Assuming that there will be no variation in the exchange rate of two currencies and all profits
will be repatriated, as there will be no withholding tax, estimate Net Present Value (NPV) of
the proposed project in India.
Present Value Interest Factors (PVIF) @ 12% for five years are as below:

Year 1 2 3 4 5
PVIF 0.8929 0.7972 0.7118 0.6355 0.5674

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5. XYZ Ltd., a company based in India, manufactures very high quality modem furniture and
sells to a small number of retail outlets in India and Nepal. It is facing tough competition.
Recent studies on marketability of products have clearly indicated that the customers are now
more interested in variety and choice rather than exclusivity and exceptional quality. Since
the cost of quality wood in India is very high, the company is reviewing the proposal for import
of woods in bulk from Nepalese supplier.
The estimate of net Indian (`) and Nepalese Currency (NC) cash flows in Nominal terms for
this proposal is shown below:
Net Cash Flow (in millions)
Year 0 1 2 3
NC -25.000 2.600 3.800 4.100
Indian (`) 0 2.869 4.200 4.600

The following information is relevant:

(i) XYZ Ltd. evaluates all investments by using a discount rate of 9% p.a. All Nepalese
customers are invoiced in NC. NC cash flows are converted to Indian (`) at the forward
rate and discounted at the Indian rate.
(ii) Inflation rates in Nepal and India are expected to be 9% and 8% p.a. respectively. The
current exchange rate is ` 1= NC 1.6
Assuming that you are the finance manager of XYZ Ltd., calculate the net present value (NPV)
and modified internal rate of return (MIRR) of the proposal.
You may use following values with respect to discount factor for ` 1 @9%.
Present Value Future Value
Year 1 0.917 1.188
Year 2 0.842 1.090
Year 3 0.772 1

ANSWERS/ SOLUTIONS
Answers to Theoretical Questions
1. Please refer paragraph 2.
2. Please refer paragraph 2.3.
Answers to the Practical Questions
1. (1 + 0.12) (1 + Risk Premium) = (1 + 0.14)
Or, 1 + Risk Premium = 1.14/1.12 = 1.0179

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Therefore, Risk adjusted dollar rate is = 1.0179 x 1.08 = 1.099 – 1 = 0.099

Calculation of NPV
Year Cash flow (Million) PV Factor at 9.9% P.V.
US$
1 2.00 0.910 1.820
2 2.50 0.828 2.070
3 3.00 0.753 2.259
4 4.00 0.686 2.744
5 5.00 0.624 3.120
12.013
Less: Investment 11.000
NPV 1.013

Therefore, Rupee NPV of the project is = ` (48 x 1.013) Million= `48.624 Million
2. Proforma profit and loss account of the Indian software development unit

` `
Revenue 48,00,00,000
Less: Costs:
Rent 15,00,000
Manpower (`400 x 80 x 10 x 365) 11,68,00,000
Administrative and other costs 12,00,000 11,95,00,000
Earnings before tax 36,05,00,000
Less: Tax 10,81,50,000
Earnings after tax 25,23,50,000
Less: Withholding tax(TDS) 2,52,35,000
Repatriation amount (in rupees) 22,71,15,000
Repatriation amount (in dollars) $ 4.7 million

Advise: The cost of development software in India for the US based company is $5.268
million. As the USA based Company is expected to sell the software in the US at $12.0 million,
it is advised to develop the software in India.

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Alternatively, if is assumed that since foreign subsidiary has paid taxes it will not pay
withholding taxes then solution will be as under:
` `
Revenue 48,00,00,000
Less: Costs:
Rent 15,00,000
Manpower (`400 x 80 x 10 x 365) 11,68,00,000
Administrative and other costs 12,00,000 11,95,00,000
Earnings before tax 36,05,00,000
Less: Tax 10,81,50,000
Earnings after tax 25,23,50,000
Repatriation amount (in rupees) 25,23,50,000
Repatriation amount (in dollars) $ 5,257,292

Advise: The cost of development software in India for the US based company is $4.743
million. As the USA based Company is expected to sell the software in the US at $12.0 million,
it is advised to develop the software in India.
Alternatively, if it assumed that first the withholding tax @ 10% is being paid and then
its credit is taken in the payment of corporate tax then solution will be as follows:
` `
Revenue 48,00,00,000
Less: Costs:
Rent 15,00,000
Manpower (`400 x 80 x 10 x 365) 11,68,00,000
Administrative and other costs 12,00,000 11,95,00,000
Earnings before tax 36,05,00,000
Less: Withholding Tax 3,60,50,000
Earnings after Withholding tax @ 10% 32,44,50,000
Less: Corporation Tax net of Withholding Tax 7,21,00,000
Repatriation amount (in rupees) 25,23,50,000
Repatriation amount (in dollars) $ 5,257,292

Advise: The cost of development software in India for the US based company is $4.743
million. As the USA based Company is expected to sell the software in the US at $12.0
million, it is advised to develop the software in India.

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3. Calculation of NPV
Year 0 1 2 3
Inflation factor in India 1.00 1.10 1.21 1.331
Inflation factor in Africa 1.00 1.40 1.96 2.744
Exchange Rate (as per IRP) 6.00 7.6364 9.7190 12.3696
Cash Flows in ` ’000
Real -50000 -1500 -2000 -2500
Nominal (1) -50000 -1650 -2420 -3327.50
Cash Flows in African Rand ’000
Real -200000 50000 70000 90000
Nominal -200000 70000 137200 246960
In Indian ` ’000 (2) -33333 9167 14117 19965
Net Cash Flow in ` ‘000 (1)+(2) -83333 7517 11697 16637
PVF@20% 1 0.833 0.694 0.579
PV -83333 6262 8118 9633
NPV of 3 years = -59320 (` ‘000)
16637
NPV of Terminal Value = × 0.579 = 48164 ( ` ’000)
0.20
Total NPV of the Project = -59320 (` ‘000) + 48164 ( ` ’000) = -11156 ( ` ’000)
4. Financial Analysis whether to set up the manufacturing units in India or not may be carried
using NPV technique as follows:
I. Incremental Cash Outflows
$ Million
Cost of Plant and Machinery 500.00
Working Capital 50.00
Release of existing Working Capital (15.00)
535.00

II. Incremental Cash Inflow after Tax (CFAT)

(a) Generated by investment in India for 5 years
$ Million
Sales Revenue (5 Million x $80) 400.00
Less: Costs
Variable Cost (5 Million x $20) 100.00

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Fixed Cost 30.00

Depreciation ($500Million/5) 100.00
EBIT 170.00
Taxes@35% 59.50
EAT 110.50
Add: Depreciation 100.00
CFAT (1-5 years) 210.50

(b) Cash flow at the end of the 5 years (Release of Working Capital) 35.00
(c) Cash generation by exports (Opportunity Cost)

$ Million
Sales Revenue (1.5 Million x $80) 120.00
Less: Variable Cost (1.5 Million x $40) 60.00
Contribution before tax 60.00
Tax@35% 21.00
CFAT (1-5 years) 39.00

(d) Additional CFAT attributable to Foreign Investment

$ Million
Through setting up subsidiary in India 210.50
Through Exports in India 39.00
CFAT (1-5 years) 171.50

III. Determination of NPV

Year CFAT ($ Million) PVF@12% PV ($ Million)

1-5 171.50 3.6048 618.2232
5 35 0.5674 19.8590
638.0822
Less: Initial Outflow 535.0000
103.0822

Since NPV is positive the proposal should be accepted.

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5. Working Notes:
(i) Computation of Forward Rates

End of Year NC NC/`

1  (1 + 0.09 )  1.615
NC1.60 x 
 (1 + 0.08 ) 
 
2  (1 + 0.09 )  1.630
NC1.615 x 
 (1 + 0.08 ) 
 
3  (1 + 0.09 )  1.645
NC1.630 x 
 (1 + 0.08 ) 
 

(ii) NC Cash Flows converted in Indian Rupees

Year NC (Million) Conversion Rate ` (Million)

0 -25.00 1.600 -15.625
1 2.60 1.615 1.61
2 3.80 1.630 2.33
3 4.10 1.645 2.49

Net Present Value

(` Million)
Year Cash Flow in Cash Flow Total PVF PV
India in Nepal @ 9%
0 --- -15.625 -15.625 1.000 -15.625
1 2.869 1.61 4.479 0.917 4.107
2 4.200 2.33 6.53 0.842 5.498
3 4.600 2.49 7.09 0.772 5.473
-0.547

Modified Internal Rate of Return

Year
0 1 2 3
Cash Flow (` Million) -15.625 4.479 6.53 7.09

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Year 1 Cash Inflow reinvested for 2 5.32

years (1.188 x 4.479)
Year 2 Cash Inflow reinvested for 1 7.12
years (1.090 x 6.53)
19.53

TerminalCashFlow 19.53
MIRR = n −1= 3 − 1 = 0.0772 say 7.72%
InitialOutlay 15.625

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© The Institute of Chartered Accountants of India
© The Institute of Chartered Accountants of India