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Role and responsibility towards
stakeholders
Contents
The Role and Responsibility of a Senior Financial officer ...................................................... 3
THE ROLE OF FINANCIAL MANAGER................................................................................... 3
INVESTMENT SELECTION .................................................................................................... 3
MANAGING FINANCIAL COSTS AND CAPITAL STRUCTURE ................................................ 4
DISTRIBUTION AND RETENTION POLICY ............................................................................ 4
MANAGEMENT OF FINANCIAL RISKS .................................................................................. 4
COMMUNICATION WITH STAKEHOLDERS .......................................................................... 4
“3 E” PRINCIPLE .................................................................................................................. 4
Assessing Organisational Performance using Ratios and Trends .......................................... 5
PROFITABILITY: ................................................................................................................... 5
LIQUIDITY: ........................................................................................................................... 6
The Optimum Capital Structure of a Company .................................................................... 13
THE ROLE OF THE CORPORATE FINANCE MANAGER ....................................................... 13
OPTIMUM CAPITAL MIX ................................................................................................... 14
Financial Strategy Formulation ............................................................................................ 16
Distribution and Retention Policy ........................................................................................ 16
CLASSIC VIEW ON DIVIDENDS (MILLER AND MODIGLIANI) ............................................. 16
DIVIDEND CAPACITY ......................................................................................................... 17
DIVIDEND POLICY .............................................................................................................. 17
The Rationale for Risk Management in a Company ............................................................. 20
RATIONALE FOR RISK MANAGEMENT .............................................................................. 20
RISK APPETITE ................................................................................................................... 20
RISK MANAGEMENT FRAMEWORK .................................................................................. 21
RISK CLASSIFICATION ........................................................................................................ 21
INFORMATION SYSTEMS .................................................................................................. 21
RISK CONTROL STRATEGIES .............................................................................................. 22
RISK RESPONSES ............................................................................................................... 22
2
The impact of Behavioural Finance on Financial Strategies and Securities Prices .............. 23
BEHAVIOURAL FINANCE ................................................................................................... 23
Impact of behavioural finance on financial strategies and securities prices ....................... 25
Behavioural Finance ............................................................................................................. 25
ARE INVESTORS RATIONAL? ............................................................................................. 25
EXAMPLES OF DECISION MAKING .................................................................................... 25
Role and Responsibilities Towards Stakeholders ................................................................. 26
Managing Business and Financial Risk ................................................................................. 26
RISKS TO WHICH ORGANISATIONS ARE EXPOSED TO DUE TO THEIR INTERNATIONAL
ACTIVITIES: ........................................................................................................................ 26
Managing political risk: ..................................................................................................... 27
SUMMARY: ....................................................................................................................... 29
Revision ................................................................................................................................ 30
Yilandwe (Investment Appraisal and Licensing) ............................................................... 30
Riviere (Investment Appraisal) ......................................................................................... 34
3
The Role and Responsibility of a Senior Financial officer
THE ROLE OF FINANCIAL MANAGER
The financial manager serves a fundamental role in the organisation. By managing all the
financial affairs of the business, a financial manager attempts to increase the wealth of the
shareholders. The decisions made by the financial manager also affect regulatory
requirements and business environment. Essentially, the role of the financial manager is
interwoven in the company’s strategy.
A financial manager is typically responsible for:
Investment selection
Managing financial costs
Deciding optimal capital structure
Earnings retention
Dividend distribution policy
Financial risk management
Communicating with shareholders
INVESTMENT SELECTION
The investment selection is one of the most critical decisions made by the financial
manager. The primary objective should be to maximise the shareholder value. Apart from
the financial benefits, other factors that should be considered in selecting an appropriate
investment include:
Fit with company values
Ethical and environmental impact
Scarcity of resources
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MANAGING FINANCIAL COSTS AND CAPITAL STRUCTURE
All businesses need finance in order to facilitate day-to-day operations and to make new
investments. The financial manager arranges a suitable source of finance for the business
for the least possible cost.
Another key issue that occupies the financial manager is the optimal level of gearing. The
factors taken into account in deciding on the optimal capital structure of a company include
finance costs, perceptions of market analysts, tax issues, the risk profile of shareholders,
external regulations and debt covenants.
DISTRIBUTION AND RETENTION POLICY
The financial manager needs to decide whether to distribute the free cash flows to
shareholders or to reinvest them in different projects. The ultimate decision depends on the
profile of shareholders and the availability of different projects.
MANAGEMENT OF FINANCIAL RISKS
The financial manager of a company keeps the relevant risk factors, such as currency risk,
interest rate risk and credit risk, within the limits determined in accordance with the risk
appetite of the company. Effective risk management requires the monitoring and
measurement of risk, as well as dealing with risk, by means of mitigation, hedging or
diversification.
COMMUNICATION WITH STAKEHOLDERS
The financial manager is responsible for keeping both external stakeholders, such as
shareholders, creditors, government and customers, as well as internal ones, such as
employees and the management, informed about the financial condition of the company.
“3 E” PRINCIPLE
The financial manager ensures that the use of resources is economic, efficient and effective:
Economic => Minimum cost
Efficient => Value in relation to cost
Effective => Results in achievement of objectives
5
Assessing Organisational Performance using Ratios and
Trends
As you will surely appreciate, the evaluation of a company’s financial performance is crucial
not only from the perspective of formulating an appropriate financial strategy, but it is an
essential part of financial management in general. Ratios relating to an organisation’s
profitability, liquidity, gearing and market value, as well as their evolution over time, can
help explain changes in the way the company is perceived by investors. They may also signal
that the financial strategy adopted requires adjusting. In just a few moments, we will review
the ratios which are most commonly used in financial analysis, and illustrate their
computation and interpretation using a sample balance sheet and profit and loss account.
PROFITABILITY:
1. Return on capital employed:
The first area of financial performance which we will focus on is profitability. Among the
most commonly applied profitability ratios is the return on capital employed, usually
referred to as ROCE. It is typically computed as:
Where the capital employed is:
Capital employed = Equity + Debt (or long - term financing)
An after-tax version of ROCE is also used:
2. Operating profit margin:
Another profitability ratio which is commonly used to assess the performance of a
company is the operating profit margin, measuring the proportion of revenue left after
covering the costs directly associated with generating this revenue:
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LIQUIDITY:
1. Debtor days or receivables collection period:
The first ratio which we will be analysing is referred to as ‘debtor days’, or the receivables
collection period. It shows the average number of days which the company needs to wait to
receive cash from its trade receivables, and is calculated by taking trade receivables from
the balance sheet, dividing them by the revenue achieved from sales on credit terms and
multiplying the result by 365 days:
2. Creditor days or payables payment period:
Creditor days show the average period, after which the company pays its suppliers. So, the
higher or longer this ratio is, the more financing the company receives from its suppliers.
Creditor days are calculated by taking the balance of payables, dividing it by the purchases
made and multiplying the result by 365:
3. Inventory holding period:
This shows the average number of days, for which the company maintains items of
inventory (raw materials, work in progress, as well as finished products or goods held for
resale). This measure is obtained by taking the balance of inventories, dividing it by the cost
of sales and, once again, multiplying the result by 365:
4. Cash operating cycle:
All three of the liquidity measures, which we just discussed may be combined into one
indicator, known as the cash operating cycle. This metric shows the length of time, which on
average, elapses between the payment for inventories acquired and the receipt of cash for
goods and services sold. It is calculated by adding debtor days to the inventory holding
period, and deducting the number of creditor days:
Cash operating cycle = Debtor days + Inventory holding period Creditor days
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GEARING:
The third group of ratios typically used to analyse financial performance relates to gearing,
in other words, the level of the company’s indebtedness. If gearing is too high, then the
company may find it difficult to service its debts, as it may simply generate insufficient cash
to repay the interest on loans and bonds issued. Gearing may be assessed from the
perspective of:
1- Balance sheet:
The balance sheet gearing ratio is calculated as an entity’s debt divided by its equity, or
alternatively, as the proportion of debt in the total capital employed, that is the sum of debt
and equity:
2- Profit and loss (interest cover):
This will allow us to assess whether the company’s profits are sufficient to cover the burden
created by interest payments. In order to do this, we need to calculate the so-called interest
cover, being the ratio of profit before interest and tax to interest for the year:
STOCK MARKET RATIOS:
These ratios can only be calculated for entities, whose shares are listed on a stock exchange.
The stock market ratios which are most often used comprise:
1- Price to earnings ratio or P/E ratio:
This ratio shows the relation between a company’s share price and its earnings per share:
2- Dividend cover:
Dividend cover is the ratio of an entity’s earnings per share and its dividend per share and
shows the portion of earnings that are paid out in the form of dividends:
Total earnings / Total dividends OR Earnings per share / Dividend per share
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3- Dividend yield:
Dividend yield represents the relationship between dividend per share and the share price:
EXAMPLE:
Let us work through an example to compute the ROCE for a company with following
financial data:
Statement of Profit or Loss
EUR Year 1 Year 2
Sales (1) 5,400 5,500
Cost of Sales (2) 3,500 3,300
Gross profit (3) = (1) - (2) 1,900 2,200
Other expenses (4) 1,400 1,600
Profit before interest (5) = (3) – (4) 500 600
Interest (6) 110 80
Profit before tax (7) = (5) – (6) 390 520
Tax @30% (8) 117 156
Profit (9) = (7) – (8) 273 364
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Statement of Financial Position
EUR Year 1 Year 2
Intangible assets 310 180
Tangible assets 2,000 2,500
Non-current assets 2,310 2,680
Inventories 800 700
Receivables 350 250
Cash 150 223
Current assets 1,300 1,173
TOTAL ASSETS 3,610 3,853
Bonds issued 1,000 900
Non-current liabilities 1,000 900
Payables 280 350
Current liabilities 280 350
Share capital (1,000 shares at €1) 1,000 1,000
Retained earnings 1,330 1,603
Total equity 2,330 2,603
TOTAL EQUITY AND LIABILITIES 3,610 3,853
Assume that the share prices stood at €1.40 and €2.25 at the end of year 1 and year 2,
respectively.
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Solution
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Interpretation of operating profit margin:
The interpretation of the result of profitability ratios is that the company made 35% in profit
before fixed costs, interest and taxes, on every € of sales. This amount grew by 5% over the
course of the second year.
Interpretation of debtor days or receivables collection period:
In the second year, the company was able to shorten the average time needed to collect
cash from invoices issued.
Interpretation of creditor days or payables payment period:
The increase in payables payment period means that year-on-year, the company managed
to obtain significantly more favourable payment conditions in its relations with suppliers.
However, similar increases may also be a sign that the company is falling back on its
payment obligations due to a liquidity crunch.
Interpretation of cash operating cycle:
In the analysed case the cash operating cycle shortened from almost 78 days in year 1 to
55.3 days in year 2, which suggests a substantial improvement in the company’s liquidity
position.
Interpretation of gearing:
The gearing level of the company has decreased over the year.
Interpretation of interest cover:
The company’s potential to service its interest payments has increased over the period
analysed.
Interpretation of P/E ratio:
Once again, this represents an improvement, and is a reflection of increased shareholder
confidence in the company.
NOTE: As you can see, ratio analysis allows for a relatively easy and quick assessment of the
financial performance of a business. Additional insights are gained when trends in ratios are
analysed across periods. Ratio analysis can be used by both shareholders and market
analysts to assess the performance of entities listed on the stock market, but it is also
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applied by companies internally for the purpose of formulating and assessing financial
strategies.
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The Optimum Capital Structure of a Company
THE ROLE OF THE CORPORATE FINANCE MANAGER
Financing existing and planned investments:
- An optimum mix of the two main sources of finance (equity and debt).
Minimising the cost of company’s capital:
- Value creation for shareholders.
THE IMPACT OF GEARING ON COST OF CAPITAL
Enables the organisation to lower its cost of capital:
- Advantage of debt financing – cheaper source of finance
- Disadvantage of debt financing – risk associated with high gearing
From the perspective of expected return:
- Assume less risk;
- Expect fixed return (return);
- Relatively less risk as compared to shareholders; and
- Considered a cheaper source.
From the perspective of tax benefit:
- Interest is a tax-deductible expense;
- Debt provides tax shield; and
- Lowers the average cost of capital.
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From the perspective of business risk:
- Interest is an obligation;
- Fixed payment increases overall business risk;
- Reduces the flexibility of returns;
- High gearing increases the return expectations of shareholders; and
- Increase in average cost of capital.
From the perspective of cost of issuance:
- Cost of issuing debt is considered relatively less than issuing equity.
- From the perspective of other risks involved:
- Debt financing is associated with interest rate risk;
- Risk can be managed by hedging.
OPTIMUM CAPITAL MIX
At a certain level, debt helps lowering the cost of capital due to associated:
- Lower cost; and
- Tax shield.
Beyond that point, the associated risk due to high leverage rises and, therefore, the
average cost of capital as well.
Theories that help identify the optimal mix:
- Modigliani–Miller theory;
- Static tradeoff theory; and
- ‘Pecking order’ theory.
(continued on next page...)
Practical issues:
- Availability of debt:
Market of loans – banks less willing to lend.
Market of bonds – investors less interested to lend.
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Cost of debt:
- High leverage is associated with high risk, which in turn increases the cost of
debt.
Restrictions imposed by articles of association.
Restrictions imposed by existing lenders (credit covenants).
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Financial Strategy Formulation
Distribution and Retention Policy
CLASSIC VIEW ON DIVIDENDS (MILLER AND MODIGLIANI)
This view states that it should be irrelevant to shareholders if they receive dividends
or not, as long as the company invests its retained earnings in projects with a
positive net present value, or NPV.
Rationale:
- If a company invests retained earnings at the rate of return required by
shareholders, then a missed dividend should be matched by an equal
increase in the company’s share price.
- Rates of return on projects into which the company reinvests its profits
are higher than the rate of return expected by shareholders, therefore
reinvesting should increase shareholder wealth.
Assumptions:
- Irrelevance of external factors, such as:
Taxation; and
Cost of issuing equity.
Invalidity of theory / issues in assumptions:
- Investors have specific preferences regarding corporate dividend
policies.
- Certain investors may favour current income, which they can use to
finance current consumption needs.
- Dividend is considered a safer form of income than a capital gain.
- The realisation of a capital gain requires selling shares.
- Market participants often use dividend payments as sources of
information regarding the financial performance of a company
(dividend signalling).
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DIVIDEND CAPACITY
This is the ability to pay dividends to shareholders.
The more stable the earnings of a company, the greater portion of its profits may be
paid out to investors.
Dividend capacity also depends on the availability of other funding sources.
Affected by:
- Specific regulatory limitations:
Maintaining a certain level of profitability; and
Maintaining a minimum level of capital.
- Economic environment:
Level of inflation.
DIVIDEND POLICY
This is the trade-off between the ability to preserve cash for reinvestment and the
fulfilment of investors’ expectations regarding the realisation of current profit.
Types:
- Stable dividends:
Company pays out a fixed or growing dividend each period.
Attractive to investors with a strong preference for predictable
current revenue, and is typically adopted by mature companies with
stable profits.
- Ratchet pattern policy:
Dividends are paid out with a time lag relative to the earnings
achieved.
Level of dividend per share is maintained.
- Constant payout ratio:
Company pays out a constant portion of earnings achieved each
period.
Remainder earnings reinvested.
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19
- Residual dividend policy:
Company pays out only the residual portion of earnings which is not
reinvested in the company’s investment projects.
Lower predictability of future dividend levels.
- Zero dividend policy:
No dividends are paid out to investors as the entire profit is retained
and reinvested.
Favoured by companies during the growth phase.
- Scrip dividend:
An investor may choose between receiving a cash dividend and being
awarded new shares of the company.
Investors that prefer low liquidity will choose to receive shares.
Investors that prefer high liquidity will choose cash dividends.
- Share buyback:
An alternative to paying out dividends.
Option to either sell their shares back to the company and realise a
capital gain, or not sell and profit from future increases in the share
price.
Typically carried out when a company has a large cash surplus that
cannot be invested in an NPV-positive project.
Impact:
Increases the company’s share price.
Company becomes less prone to a takeover.
Increases the company’s gearing ratio.
Impact on cost of capital.
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The Rationale for Risk Management in a Company
RATIONALE FOR RISK MANAGEMENT
The role of corporate risk management is:
- To assure that the risk factors to which a given business activity is
exposed do not damage the business effort connected with this activity;
and
- To maintain uncertainty at a level which is acceptable by an organisation
and its shareholders.
Investors generally require higher returns on more risky projects.
After reaching a certain level of riskiness, the increased return does not
counterbalance the probability of a project’s failure.
A risk management system enables decision-makers to select those
investment opportunities which provide the level of return required by
shareholders without taking on excessive risk.
Risk management is a tool which helps ensure that management is taking
investment decisions that are in line with the expectations of shareholders.
Without an effective risk management system, management could be
tempted to take decisions which maximise their own value rather than
shareholder value.
RISK APPETITE
Risk appetite is the overall level of risk that an organisation accepts in pursuit
of its business goals.
It is essential that the maximum tolerated risk be defined and understood
before any management decisions are taken in the area to which the risk is
inherent.
Risk appetite differs across industries and organisations.
When defining its risk appetite, an organisation has to consider the volatility
of the industry in which it operates.
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RISK MANAGEMENT FRAMEWORK
– Process of risk identification, assessment and monitoring, as well as strategies for
dealing with risks identified.
– Risk assessment is largely dependent on the quality of estimates used to forecast
the outcome of an investment.
– Risk framework emphasises the awareness of factors which could affect
projections, as well as the quantification of their probability and impact.
RISK CLASSIFICATION
– Strategic risks:
- Risks that affect the overall direction of a project.
- For example: macroeconomic and political changes.
– Tactical risks:
- Risks that impact only a significant part of a project.
- For example: changes in the supply chain or in the timing of payments.
– Operational risks:
- Risks connected with the day-to-day management of the investment project.
- For example: breakdowns in equipment.
A potential approach to the management of these risks can be based on designing
appropriate measures to deal with risk factors, depending on the likelihood of
occurrence and significance of impact.
INFORMATION SYSTEMS
The primary function of information systems is the collection of data on identified
risk factors and on actions taken by managers at the appropriate level of the
company’s hierarchy.
Internal audit function also plays a significant role in risk identification.
Types of information systems:
- Management information system (MIS):
Provides operational data, allowing a company to make decisions
regarding identified risk factors and perform detailed risk analyses.
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- Executive information system (EIS):
Provides more high-level and summarised information regarding the
key aspects of risk management to the senior executives in the
organisation.
RISK CONTROL STRATEGIES
Mitigation: The impact of risk factors is reduced as a result of implementing control
procedures (preventive, detective and corrective controls).
Hedging: The risk factor is neutralised by means of a transaction which creates an
exposure to the same or similar risk as the hedged exposure (financial derivatives).
Diversification: Reducing the impact of a given risk factor by including and mixing a
number of different investments (portfolio).
RISK RESPONSES
23
The impact of Behavioural Finance on Financial Strategies
and Securities Prices
BEHAVIOURAL FINANCE
According to behavioural finance research, decisions made by investors are more often
taken based on emotional and psychological mechanisms, rather than the analysis of facts
and available information.
– Herd behaviour: A typical example of such mechanism is herd behaviour, causing
investors to mimic and blindly follow the decisions of others, and giving rise to such
market anomalies as excessive booms and crashes. It seems that herd behaviour is a
manifestation of another well-known psychological effect, namely over-reaction to
information, such as media reports on upward trends in a given market.
It has been psychologically proven that human behaviour is subject to significant
biases of various kinds. Examples of biases which typically influence the decisions of
investors are confirmation bias, where the investor has a pre-determined conviction
and only pays attention to arguments which support it, and hindsight bias, where the
investor believes that a certain, in reality, unpredictable event, was obvious and
could have been forecasted. Consequently, hindsight bias makes the investor
overconfident, which may lead to erroneous decisions in the future.
– Gambler’s fallacy: Another behavioural scheme, which may impact investors’
decisions is referred to as gambler’s fallacy. Here the investor is similar to a gambler,
who believes that a series of negative results increases the probability of scoring a
win, while in fact, the probability of statistically independent events is not impacted
by history. As a result, investors tend to, for example, maintain their investments in
assets, whose prices are plummeting, in the belief that the downward trend is bound
to reverse.
As you can see, there are several psychological mechanisms influencing the
behaviour of investors. As a result, prices of shares may change due to factors
independent of the actual financial position of a company.
A question arises, if behavioural finance should be reflected in the financial
strategies of companies. However, the question has no simple answer. Obviously,
financial managers should be aware of behavioural factors influencing share prices.
Certain elements of a financial strategy, such as for example decisions regarding
dividend signalling, may take into account the findings which come from the study of
behavioural finance. However, we have to remember that the main objective of
financial strategic management is the maximisation of shareholder value in the long
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term, and the effects of behavioural finance are typically observed in the short or
medium term only.
25
Impact of behavioural finance on financial strategies and
securities prices
Behavioural Finance
ARE INVESTORS RATIONAL?
Until relatively recently, finance theory assumed investors to be rational. They were
supposed to respond and make decisions in a predictable and consistent manner. However,
investors, being human beings, do not always behave rationally. There is extensive research
being carried out on the trading characteristics of human beings. In the exam, be prepared
to crticise any model or situation that assumes investors to be rational.
EXAMPLES OF DECISION MAKING
Anchoring: It refers to the fact that a decision maker may ‘anchor’ their view to something
that is familiar to help them decide on a course of action. This is a common technique used
by supermarkets as they show the original price to be, let’s say, $10 but it is now available at
$6.50 even though the original price appears to be unfair.
Herding: It refers to the phenomenon of following the crowd or an expert.
Overreacting to bad news: The investors often overreact to bad news. This action results in
a sudden and unreasonable plummet in the index.
Extrapolative expectations: The investors assume the shares to follow the historical trend in
the foreseeable future.
Narrow framing: It refers to a situation where decision makers place disproportionate
emphasis on a relatively small piece of information.
Prospect theory: It suggests that investors see very little difference between losing a large
amount and losing a little more than that. For example, compare a movement from $5 loss
to $20 loss due to a price move, with a movement of $1005 loss to $1020 loss. Although the
monetary loss is the same, it is considered insignificant in the second case.
26
Role and Responsibilities Towards Stakeholders
Managing Business and Financial Risk
RISKS TO WHICH ORGANISATIONS ARE EXPOSED TO DUE TO THEIR
INTERNATIONAL ACTIVITIES:
1. Political risk:
Political risk is associated with the instability of government in the country where a
company decides to locate a subsidiary. This risk is defined as the negative impact of
decisions taken by local policy makers on the value of a company.
Example:
Examples of extreme cases of political risk include:
– Outbreak of war;
– Expropriation of a company’s asset by a foreign government;
– Imposing tariffs or quotas on imported goods;
– Restrictions regarding the remittance of cash to the parent company;
– Special rules on the dividend policies of foreign entities;
– Limitations on access to local financing sources;
– Super-taxes imposed on foreign firms.
Types:
Political risk may be divided into:
– Micro risk – which relates solely to a given industry or sector.
– Macro risk – which affects all foreign companies present in a given country.
Measuring political risk:
Due to its complex nature, there is no simple way to measure political risk. However there
are tools, which companies interested in locating a subsidiary in a given country may use in
order to assess its level, such as:
1. The information provided by rating agencies.
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2. An alternative approach to the measurement of political risk involves the use of
quantitative methods, based on:
– Macroeconomic modelling or
– Real option valuation.
3. Another method used by organisations considering locating an investment in a given
country includes consulting experts such as:
– Academics,
– Diplomats or
– Businessmen already present in the local market.
4. A measure which is often applied before an investment decision is made is a “grand
tour”, which is an inspection of the locations considered, tied to meetings with local
government and aimed at gaining an understanding of the specifics of doing business
in a given country.
5. Finally, companies may use information provided by commercial political surveys,
which assess the level of political risk of countries on a numerical scale, based on
questionnaire data. Such survey-based information is for example offered by Business
Environment Risk Intelligence or the Political Risk Services Group.
Managing political risk:
Management of political risk has two aspects:
1. The first one includes actions that may be taken by a company prior to investing in a
country. Among the actions typically taken in the pre-investment phase is:
– The signing of a pre-trading agreement with the government of the host country.
The aim of such an agreement is to contractually regulate, and thus stabilise, the
factors which are deemed critical to the functioning of the subsidiary, such as
rules related to dividend policies and the remittance of cash flows. It should be
noted, however, that there is a risk that pre-trading agreements may stop being
recognised in the case of a change of government, which may be a frequent
occurrence in unstable host countries.
– Another way to reduce political risk in the pre-investment phase is by
transferring it to another entity via an insurance policy, such as export credit
guarantees.
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2. The second one consists of measures, which a company may put in place after a
subsidiary has already been set up:
– After a subsidiary has been set up in a country, the investing group typically
attempts to stabilise the level of political risk by managing its relations with
government and market participants in a way that will discourage local policy
makers from taking decisions which could negatively impact the foreign entity’s
business. The aim is to convince decision makers that the local economy, society
and government actually profit from the presence of foreign investors in the
country. This may include emphasising such factors as contracting local resources
and labour and obtaining funding via local financial markets.
– On the other hand, companies may also take actions aimed at lowering the value
of their overseas subsidiaries as perceived by local governments, in order to
deter them from attempts to expropriate those subsidiaries’ assets. Such actions
include locating critical, value-adding production stages in the home country,
holding control over distribution networks and protecting intellectual property
with international patents. Moreover, companies may finance their subsidiaries
via international financial markets, which should protect assets from
expropriation, because a potential default in the servicing of debt would expose
the local government to criticism from international financial institutions.
2. Economic risk:
Another type of risk which is connected with overseas investment, is economic risk, defined
as the volatility of a company’s value due to changes in the macroeconomic environment
of the host country, including factors such as economic growth, recession and
unemployment rates.
Having said this, the single most important factor which influences economic risk is the level
of the exchange rate of the local currency, which directly impacts the profitability of
imports and exports of a foreign company and in particular, the level of dividends and other
cash remittances made to the parent.
Managing of economic risk:
Although it is similar to transaction risk, economic risk is typically not hedged with
derivatives, but rather managed through the diversification of supply, distribution and
financing sources. As you can expect, when a company’s sources of supply as well as its
buyers are spread across different geographical locations, then the negative impact of the
weakening or strengthening of one currency should, at least to some extent, be offset by an
opposite change in the rate of another currency. Similar effects may also observed when the
sources of a company’s financing are diversified internationally as well.
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3. Regulatory risk:
Regulatory risk is similar to political risk, because it materialises through decisions of local
policy makers regarding specific requirements relating to a given industry or market. New
regulations may be of a general nature, that is related to all entities in a given jurisdiction,
such as anti-monopoly laws, or of a specific nature, which means that they are aimed at
certain industries only, for example new regulatory requirements related specifically to the
banking sector or to health services.
Managing of regulatory risk:
There is no simple recipe for managing regulatory risk. Typically, companies maintain
compliance teams which analyse planned and announced regulatory requirements and
assess their impact, project the necessary implementation actions and compute the cost of
conforming to the new laws. Alternatively, companies may hire external consultants to
perform these tasks.
4. Fiscal risk:
A similar approach is applied to fiscal risk, which represents the uncertainty related to
unfavourable changes in taxes levied in a country where an overseas subsidiary is located.
Managing fiscal risk:
Management of fiscal risk includes primarily keeping track of changes in a country’s tax
system and making sure that the policies followed are up-to date. As with the management
of regulatory risk, this may either be done in-house or be outsourced to external tax
consultants.
SUMMARY:
As you can see, the spectrum of risks associated with the presence of an organisation in a
foreign market is wide. These risks are interconnected and complex in their nature, which is
particularly true for political and economic risk. You should appreciate that the list of risks
discussed here is far from exhaustive. In fact, the range of risks to which firms are exposed
in their international activities, is widening. Terrorism and computer network security are
examples of risk categories, whose importance in investment decision making has recently
been on the rise. We must, therefore, keep in mind, that risk management is by its nature a
dynamic process, where risk exposures should constantly be tracked and analysed, and
policies updated.
As we have already mentioned, the risk types which we discussed here, cannot simply be
hedged, as is the case with market risks. The management of these exposures must be part
of a company’s strategic decision making process rather than relying on a day-to-day
management approach.
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Revision
Yilandwe (Investment Appraisal and Licensing)
QUESTION
Yilandwe, whose currency is the Yilandwe Rand (YR), has faced extremely difficult economic
challenges in the past 25 years because of some questionable economic policies and political
decisions made by its previous governments. Although Yilandwe’s population is generally poor,
its people are nevertheless well-educated and ambitious. Just over three years ago, a new
government took office and since then it has imposed a number of strict monetary and fiscal
controls, including an annual corporation tax rate of 40%, in an attempt to bring Yilandwe out
of its difficulties. As a result, the annual rate of inflation has fallen rapidly from a high of 65% to
its current level of 33%. These strict monetary and fiscal controls have made Yilandwe’s
government popular in the larger cities and towns, but less popular in the rural areas which
seem to have suffered disproportionately from the strict monetary and fiscal controls.
It is expected that Yilandwe’s annual inflation rate will continue to fall in the coming few years
as follows:
Year Inflation rate
1 22·0%
2 14·7%
3 onwards 9·8%
Yilandwe’s government has decided to continue the progress made so far, by encouraging
foreign direct investment into the country. Recently, government representatives held trade
shows internationally and offered businesses a number of concessions, including:
(i) zero corporation tax payable in the first two years of operation; and
(ii) an opportunity to carry forward tax losses and write them off against future profits
made after the first two years.
The government representatives also promised international companies investing in Yilandwe
prime locations in towns and cities with good transport links.
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Imoni Co
Imoni Co, a large listed company based in the USA with the US dollar ($) as its currency,
manufactures high tech diagnostic components for machinery, which it exports worldwide.
After attending one of the trade shows, Imoni Co is considering setting up an assembly plant in
Yilandwe where parts would be sent and assembled into a specific type of component, which is
currently being assembled in the USA. Once assembled, the component will be exported
directly to companies based in the European Union (EU). These exports will be invoiced in Euro
(€).
Assembly plant in Yilandwe: financial and other data projections
It is initially assumed that the project will last for four years. The four-year project will require
investments of YR 21,000 million for land and buildings, YR18,000 million for machinery and
YR9,600 million for working capital to be made immediately. The working capital will need to be
increased annually at the start of each of the next three years by Yilandwe’s inflation rate and it
is assumed that this will be released at the end of the project’s life.
It can be assumed that the assembly plant can be built very quickly and production started
almost immediately. This is because the basic facilities and infrastructure are already in place as
the plant will be built on the premises and grounds of a school. The school is ideally located,
near the main highway and railway lines. As a result, the school will close and the children
currently studying there will be relocated to other schools in the city. The government has
kindly agreed to provide free buses to take the children to these schools for a period of six
months to give parents time to arrange appropriate transport in the future for their children.
The current selling price of each component is €700 and this price is likely to increase by the
average EU rate of inflation from year 1 onwards.
The number of components expected to be sold every year are as follows:
Year 1 2 3 4
Sales component units (000s) 150 480 730 360
The parts needed to assemble into the components in Yilandwe will be sent from the USA by
Imoni Co at a cost of $200 per component unit, from which Imoni Co would currently earn a
pre-tax contribution of $40 for each component unit. However, Imoni Co feels that it can
negotiate with Yilandwe’s government and increase the transfer price to $280 per component
unit. The variable costs related to assembling the components in Yilandwe are currently
YR15,960 per component unit. The current annual fixed costs of the assembly plant are YR4,600
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million. All these costs, wherever incurred, are
expected to increase by that country’s annual
inflation every year from year 1 onwards.
Imoni Co pays corporation tax on profits at an annual rate of 20% in the USA. The tax in both
the USA and Yilandwe is payable in the year that the tax liability arises. A bilateral tax treaty
exists between Yilandwe and the USA. Tax allowable depreciation is available at 25% per year
on the machinery on a straight-line basis.
Imoni Co will expect annual royalties from the assembly plant to be made every year. The
normal annual royalty fee is currently $20 million, but Imoni Co feels that it can negotiate this
with Yilandwe’s government and increase the royalty fee by 80%. Once agreed, this fee will not
be subject to any inflationary increase in the project’s four-year period.
If Imoni Co does decide to invest in an assembly plant in Yilandwe, its exports from the USA to
the EU will fall and it will incur redundancy costs. As a result, Imoni Co’s after-tax cash flows will
reduce by the following
amounts:
Year 1 2 3 4
Redundancy and lost contribution 20,000 55,697 57,368 59,089
Imoni Co normally uses its cost of capital of 9% to assess new projects. However, the finance
director suggests that Imoni Co should use a project specific discount rate of 12% instead.
Other financial information
Current spot rates
Euro per Dollar €0·714/$1
YR per Euro YR142/€1
YR per Dollar YR101·4/$1
Forecast future rates based on expected inflation rate differentials
Year 1 2 3 4
YR/$1 120·1 133·7 142·5 151·9
Year 1 2 3 4
YR/€1 165·0 180·2 190·2 200·8
Expected inflation rates
EU expected inflation rate: Next two years 5%
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EU expected inflation rate: Year 3 onwards 4%
USA expected inflation rate: Year 1 onwards 3%
Required:
(a) Discuss the possible benefits and drawbacks to Imoni Co of setting up its own assembly
plant in Yilandwe, compared to licensing a company based in Yilandwe to undertake the
assembly on its behalf. (5 marks)
(b) Prepare a report which:
I. Evaluates the financial acceptability of the investment in the assembly plant in Yilandwe;
(21 marks)
II. Discusses the assumptions made in producing the estimates, and the other risks and
issues which Imoni Co should consider before making the final decision; (17 marks)
III. Provides a reasoned recommendation on whether or not Imoni Co should invest in the
assembly plant in Yilandwe. (3 marks)
Professional marks will be awarded in part (b) for the format, structure and presentation of the
report.
(4 marks) (50 marks)
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Riviere (Investment Appraisal)
QUESTION
Riviere Co is a small company based in the European Union (EU). It produces high quality frozen
food which it exports to a small number of supermarket chains located within the EU as well.
The EU is a free trade area for trade between its member countries.
Riviere Co finds it difficult to obtain bank finance and relies on a long-term strategy of using
internally generated funds for new investment projects. This constraint means that it cannot
accept every profitable project and often has to choose between them.
Riviere Co is currently considering investment in one of two mutually exclusive food production
projects: Privi and Drugi. Privi will produce and sell a new range of frozen desserts exclusively
within the EU. Drugi will produce and sell a new range of frozen desserts and savoury foods to
supermarket chains based in countries outside the EU. Each project will last for five years and
the following financial information refers to both projects.
Project Drugi, annual after-tax cash flows expected at the end of each year (€000s)
Year Current 1 2 3 4 5
Cash flows (€000s) (11,840) 1,230
1,680
4,350
10,240 2,200
Privi Drugi
Net present value € 2,054,000 € 2,293,000
Internal rate of return 17·6% Not provided
Modified internal rate of return 13·4% Not provided
Value at risk (over the project’s life)
95% confidence level € 1,103,500 Not provided
90% confidence level € 860,000 Not provided
Both projects’ net present value has been calculated based on Riviere Co’s nominal cost of
capital of 10%. It can be assumed that both projects’ cash flow returns are normally distributed
and the annual standard deviation of project. Drugi’s present value of after-tax cash flows is
estimated to be €400,000. It can also be assumed that all sales are made in € (Euro) and
therefore the company is not exposed to any foreign exchange exposure.
Notwithstanding how profitable project Drugi may appear to be, Riviere Co’s board of directors
is concerned about the possible legal risks if it invests in the project because they have never
dealt with companies outside the EU before.
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Required:
(a) Discuss the aims of a free trade area, such as the European Union (EU), and the
possible benefits to Riviere Co of operating within the EU. (5 marks)
(b) Calculate the figures which have not been provided for project Drugi and
recommend which project should be accepted. Provide a justification for the
recommendation and explain what the value at risk measures. (13 marks)
(c) (c) Discuss the possible legal risks of investing in project Drugi which Riviere Co may
be concerned about and how these may be mitigated.
(7 marks) (25 marks)
