Question No. 5 - IBO-06 - INTERNATIONAL BUSINESS FINANCE - Master of Commerce (M.Com)

Solutions to Assignments 

IBO-06 - INTERNATIONAL BUSINESS FINANCE

Master of Commerce (M.Com) - 1st Year

Question No. 5
a) Discuss the merits of foreign direct investment, portfolio investment and short term investment.

Foreign Direct Investment 

Foreign Direct Investment (FDI) is the investment of funds by an organisation from one country into another, with the intent of establishing ’lasting interest’. According to OECD (Organisation for Economic Co-operation and Development), lasting interest is determined when the organisation acquires a minimum of 10% of voting power in another organisation. For instance: the act of an Indian company such as Ola opening another headquarters in Sydney, Australia will be considered as bringing FDI into Australia. 

Reinvestment of profits from overseas operations, as well as intra - organisational loans and borrowings to overseas subsidiaries are also categorised as FDI.

The meaning of FDI is not restricted only to international movement of capital. Its definition also encompasses the international movement of elements that are complementary to capital - such as skills, processes, management, technology etc.

There is a difference between FDI and FPI (Foreign Portfolio Investments), wherein the investor purchases equity of foreign companies. FPI means only equity infusion, and does not imply the establishment of a lasting interest.

FDI can be Greenfield, wherein an organisation creates a subsidiary concern in another country and builds its business operations there from the ground up. Greenfield investments provide the highest degree of control to the organisation. It can construct the production plant as per its specifications, employ and train human resources as per company standards, as well as design and monitor its operational processes.  

Alternatively, FDI can be brownfield - wherein an organisation expands by way of cross-border mergers, acquisitions and joint ventures - by either leasing or purchasing existing facilities for its production. The clear advantage of brownfield investments is the savings in cost and time for starting up, as well as engaging in construction activities. Addition of equipment to an existing facility also qualifies as brownfield investment.

It is difficult to overstate the global and macroeconomic significance of FDI. As per UNCTAD (United Nations Conference on Trade and Development), global FDI amounted to around $ 1.8 tn in 2015. 

There are many ways in which FDI benefits the recipient nation:

1. Increased Employment and Economic Growth

Creation of jobs is the most obvious advantage of FDI. It is also one of the most important reasons why a nation, especially a developing one, looks to attract FDI. Increased FDI boosts the manufacturing as well as the services sector. This in turn creates jobs, and helps reduce unemployment among the educated youth - as well as skilled and unskilled labour - in the country. Increased employment translates to increased incomes, and equips the population with enhanced buying power. This boosts the economy of the country.

2. Human Resource Development

This is one of the less obvious advantages of FDI. Hence, it is often understated. Human Capital refers to the knowledge and competence of the workforce. Skills gained and enhanced through training and experience boost the education and human capital quotient of the country. Once developed, human capital is mobile. It can train human resources in other companies, thereby creating a ripple effect.  

3. Development of Backward Areas

This is one of the most crucial benefits of FDI for a developing country. FDI enables the transformation of backward areas in a country into industrial centres. This in turn provides a boost to the social economy of the area. The Hyundai unit at Sriperumbudur, Tamil Nadu in India exemplifies this process. 

4. Provision of Finance & Technology

Recipient businesses get access to latest financing tools, technologies and operational practices from across the world. Over time, the introduction of newer, enhanced technologies and processes results in their diffusion into the local economy, resulting in enhanced efficiency and effectiveness of the industry.

5. Increase in Exports

Not all goods produced through FDI are meant for domestic consumption. Many of these products have global markets. The creation of 100% Export Oriented Units and Economic Zones have further assisted FDI investors in boosting their exports from other countries.

6. Exchange Rate Stability

The constant flow of FDI into a country translates into a continuous flow of foreign exchange. This helps the country’s Central Bank maintain a comfortable reserve of foreign exchange. This in turn ensures stable exchange rates.

7. Stimulation of Economic Development

This is another very important advantage of FDI. FDI is a source of external capital and higher revenues for a country. When factories are constructed, at least some local labour, materials and equipment are utilised. Once the construction is complete, the factory will employ some local employees and further use local materials and services. The people who are employed by such factories thus have more money to spend. This creates more jobs. 

These factories will also create additional tax revenue for the Government, that can be infused into creating and improving physical and financial infrastructure. 

8. Improved Capital Flow

Inflow of capital is particularly beneficial for countries with limited domestic resources, as well as for nations with restricted opportunities to raise funds in global capital markets.

9. Creation of a Competitive Market

By facilitating the entry of foreign organisations into the domestic marketplace, FDI helps create a competitive environment, as well as break domestic monopolies. A healthy competitive environment pushes firms to continuously enhance their processes and product offerings, thereby fostering innovation. Consumers also gain access to a wider range of competitively priced products.

For a multinational corporation, FDI in India is a means to access new consumption and production markets, and thereby expand its influence and business operations. It can gain access not only to limited resources such as fossil fuels and precious metals, but also skilled and unskilled labour, management expertise and technologies. FDI also enables an organisation to lower its cost of production- by accessing cheaper resources, or going directly to the source of raw materials rather than buying them from third parties. Often, there are various tax advantages that accrue to a company undertaking FDI. This can occur when the home country allows tax deduction on foreign income, or when the recipient country allows tax deductions and benefits for organisations incurring FDI in that country. Additionally, this can happen when the recipient country has a more beneficial tax code than the home country.

Portfolio Investment

Unlike the investment approach of classic security analysis that focuses on individual security selection, portfolio investment is a modern investment method that involves asset allocation and diversification to construct a collection of investments. The biggest challenge in investing is the uncertainty of an investment's future performance and thus the risk of potential investment losses. Not counting on investment results of single investments, portfolio investment can hedge investment risks by canceling out different investment returns among component investments.

1. Risk Diversification and Reduction

Portfolio investment is about reducing risk rather than increasing return. It may well be that in certain years, individual investment returns based on security analysis exceed returns from portfolio investment. However, over the long run, portfolio investment is able to deliver a steady rate of return that is on average better than individual investment returns, because of the risk diversification among various investments inside a portfolio. Portfolio investment seeks out different asset classes that are less correlated or negatively correlated, such as combining stocks and bonds to even out volatility.

2. Minimal Security Analysis

Traditional security selection requires considerable efforts in terms of time and resources to perform the so-called three-step analysis of economy, industry and company. Although portfolio investment involves assembling a collection of individual securities, the focus is less about the merits of each security standing alone but more about how they may fit with the expected overall performance of the portfolio. Some portfolio investment, once constructed, can be left unadjusted regardless of the changing economic environment. When investment results are not solely dependent on an expected above-average performance of an individual security, a simple security analysis technique like security screening can keep the work of security analysis at a minimum.

3. Systematic Investment Approach

As portfolio investment moves away from mere individual security selections, it employs a systematic investment approach that is supposed to benefit the owner of the investment portfolio in the long run. To achieve such a positive, long-term goal, a portfolio investment starts with setting portfolio objectives followed by formulating an investment strategy. The level of expected rate of return and risk tolerance are assessed so that different weights can be assigned to different asset classes and categories. The future performance of portfolio investment hinges on the overall investment policy that strives to ensure that losses from one security are compensated by gains from the other.

4. Passive Investment Style

Active investment management of constant buying and selling increases transaction costs and has tax implications that can be especially worrisome when a short-term holding period results in capital gains taxed as ordinary income. While individual security selections rely on active stock picking to influence performance, portfolio investment is designed to be passively managed, minimizing portfolio turnovers to necessary portfolio rebalancing. The set percentage of weights assigned to different assets and securities does not have to respond to every move of the market and even the economy, as long as the total risk profile of the portfolio remains unchanged.

Short Term Investment 

Short-term investments are assets that can be converted into cash or can be sold within a short period of time, typically within 1-3 years. Common instruments for short-term investing include short-term bonds, Treasury bills, and other money market funds. Short-term trading or day trading entails a significant degree of speculation and, consequently, substantial risk.

Advantages of Short-Term Investing

• Short-term investing offers flexibility to the investor as they do not need to wait for the security to mature in order to get cash. On the other hand, long-term investments can be liquidated by selling in the secondary market, but the investor earns lower profits.
• Investors can make substantial profits in a very short amount of time.
• It is less risky as money invested per transaction is substantially lower.

b) Write short notes on for forfaiting.

Forfaiting is a means of financing that enables exporters to receive immediate cash by selling their medium and long-term receivables—the amount an importer owes the exporter—at a discount through an intermediary. The exporter eliminates risk by making the sale without recourse. It has no liability regarding the importer's possible default on the receivables.

The forfaiter is the individual or entity that purchases the receivables. The importer then pays the amount of the receivables to the forfaiter. A forfaiter is typically a bank or a financial firm that specializes in export financing.

How Forfaiting Works

A forfaiter's purchase of the receivables expedites payment and cash flow for the exporter. The importer's bank typically guarantees the amount.

The purchase also eliminates the credit risk involved in a credit sale to an importer. Forfaiting facilitates the transaction for an importer that cannot afford to pay in full for goods upon delivery. 

The importer's receivables convert into a debt instrument that it can freely trade on a secondary market. The receivables are typically in the form of unconditional bills of exchange or promissory notes that are legally enforceable, thus providing security for the forfaiter or a subsequent purchaser of the debt.

These debt instruments have a range of maturities from as short as one month to as long as 10 years. Most maturities fall between one and three years from the time of sale.

Advantages and Disadvantages of Forfaiting

Advantages

Forfaiting eliminates the risk that the exporter will receive payment. The practice also protects against credit risk, transfer risk, and the risks posed by foreign exchange rate or interest rate changes. Forfaiting simplifies the transaction by transforming a credit-based sale into a cash transaction. This credit-to-cash process gives immediate cash flow for the seller and eliminates collection costs. Additionally, the exporter can remove the accounts receivable, a liability, from its balance sheet.

Forfaiting is flexible. A forfaiter can tailor its offering to suit an exporter's needs and adapt it to a variety of international transactions. Exporters can use forfaiting in place of credit or insurance coverage for a sale. Forfaiting is helpful in situations where a country or a specific bank within the country does not have access to an export credit agency (ECA). The practice allows an exporter to transact business with buyers in countries with high levels of political risk.

Disadvantages

Forfaiting mitigates risks for exporters, but it is generally more expensive than commercial lender financing leading to higher export costs. These higher costs are generally pushed onto the importer as part of the standard pricing. Additionally, only transactions over $100,000 with longer terms are eligible for forfaiting, but forfaiting is not available for deferred payments.

Some discrimination exists where developing countries are concerned compared to developed countries. For example, only selected currencies are taken for forfaiting because they have international liquidity. Lastly, there is no international credit agency that can provide guarantees for forfaiting companies. This lack of guarantee affects long-term forfaiting.