The basic principles of corporate finance will also be applicable to investments in the foreign countries as they apply to domestic companies. The only complication and the most important one in international finance management is posed by the foreign exchange. Though the foreign exchange markets provide basic information and opportunities for an international corporation when it decides to make a large capital investment in another country, still the risk being taken by the firm is large in terms of the foreign exchange involved both in the short-term and long-term perspectives.
The company should take guard against various kinds of exchange risks like the transaction exposures and translation exposures. In addition there is the economic exposure which is dependent on the policies of the government of the foreign country in which the investment is proposed to be made. Apart from these risks the political stability of the country of investment also has a major role to play in the success of the firm in its foreign venture.
This paper presents a study of the various financial issues connected with the investment in a foreign nation. 1. 0 Introduction: Companies that wish to invest in foreign countries must consider many financial factors that do not directly affect the working of the domestic firms. The companies while making large investments in the foreign countries are exposed to larger economical, political and financial risks against which the firms should take guard against.
The financial risks include changes in the foreign exchange rates, different interest rates from country to country, complex legislative provisions and accounting procedures for foreign operations, foreign tax rates and above all the intervention of the foreign governments in the administration of the companies by their changing policies. The most important of the financial risks is “the exchange rate risk which is the natural consequence of international operations in a world where foreign currency values move up and down.
” (Ross, Westerfield, Jaffe). With this background this report aims to bring out the basic issues that need to be considered by the firms which intend to make large investments in foreign countries. 2. 0 Foreign Exchange Risks: Foreign exchange transactions are susceptible to foreign exchange fluctuations in that there will be always be the possibility of the firm that deals with the foreign countries is subjected to such risks due to the nature of their transactions which may take the form of exports or imports.
Especially for the company which wants to invest large capital in a manufacturing facility in Ruritania being a foreign country, the exposure to foreign exchange risks is much more even at the time of investments as it has to transfer a large amount of capital to the foreign country for investing there. This risk continues when it continues to do the business transaction as the company would be transferring materials from and to the foreign location.
Similarly there will be movement of funds from and to the foreign location Ruritania to the company that has invested. These funds may represent the sale value or profits transferred to the holding company. “Some countries' currencies are more volatile than others because of their inflationary or unstable economies. This makes their exchange rates more liable to extreme movements. ” (Business Link) or even the value of goods and service being provided by the company in the UK to the entity in the foreign nation of Ruritania.
The exchange risks to which the company is exposed takes different forms depending up on the nature of transactions. They are: 2. 1 Transaction Exposure: The transaction exposure is the result of the foreign exchange risks a firm is facing because of its contractual transactions with the entity in the foreign country Ruritania. The transaction exposure represents the fixed obligations of the firm against amounts receivable or payable under trading transactions.
The transaction risk may be the result f an export or import activity or it may relate to the borrowing or lending activities under which funds need to be transferred to foreign nations. “Unlike many forms of economic exposure, transaction exposure is always easily identifiable and quantifiable, because it is the exact amount of the payable or receivable, which is known and certain. ” (Chapter 13) Transaction exposure risks are short term in nature. Such risks take place from the time the transaction is entered till the time it is concluded.
Thus the transaction exposure is the result of foreign exchange obligations already contracted by the firms towards the payment or receipt in the foreign currency. Such exposures to fluctuating exchange rates often may result in huge losses to the business firms if they have not adequately covered themselves against such risks. The high risk on account of transaction exposure can be mitigated by undertaking a hedging strategy which protects the company from exposure to the transaction risks.