IGNOU IBO 06 Free Solved Assignment 2022-Helpfirst

IBO 06


IBO 06 Free Solved Assignment

IBO 06 Free Solved Assignment jan 2022

Q. 1. (a) What were the distinctive features of Brettan Woods System?

Ans. In the year 1944, Bretton Wood’s system of monetary management established IMF and World Bank. This encouraged commercial and financial relations among the world’s major industrial states.

The Bretton Woods system was the first example of a completely negotiated monetary order formed to govern monetary relations among independent nation states.

Under the Bretton Woods system each country had an obligation to adopt a monetary policy that maintained the exchange rate of its currency at a fixed rate (plus or minus one percent) in terms of gold.

Also, under this agreement, US dollar became the standard measurement for new monetary system.

However, this system didn’t last for long. In the year 1973, to increase uncertainty and misalignment in foreign exchange rate system, the world switched to floating rates.

The Bretton Woods system of monetary system management created the rules for commercial and financial relations in the world’s major developing nations.

Until the early 1970s, the Bretton Woods system was effective in maintaining fixed exchange rates for the leading nations that had created it, especially the United States. Due to this fixed exchange rate, nations experienced balance of payments deficit.

This leads to increase in the respective currency in the foreign exchange market. Hence, affects the exchange value of that currency.

The Central Banks had to act at this time and failure to which might create financial crisis as it happened in the year 1956-58. French Franc crisis and problems of British pound were the examples. IBO 06 Free Solved Assignment

The currencies of the respective nations were then devalued to correct the payment imbalances.

Thus, the delayed adjustment of the parities to change in the economic environment of the countries was the weakest point of Bretton Woods Agreement. This led to a lack of trust and strike at the foundations of guesswork.

Another considerable problem was that one national currency had to be an international reserve currency at that time.

This made the national monetary and economic policy of the United States liberated from external fiscal pressures, while greatly influencing those external economies.

To guarantee international liquidity; USA was enforced to run shortage in their balance of payments, to avoid world inflation.

However, in the 1960s they ran a policy that restricted the convertibility of the U.S. dollar to compete the insufficient reserves to meet the currency supply and demand.

But other member nations were not ready to accept the high inflation rates and the value of dollar ended up being weak. Hence, the system of Bretton Woods collapsed.

(b) Briefly discuss the vaiours money market instruments with their purpose.

Ans. The money market possesses many prominent assets as:

1 Treasury Bill (T-bills),IBO 06 Free Solved Assignment

2 Commercial Papers (CPs),

3 Banker Acceptances (BAS),

4 Certificates of Deposits (CDs) and

5 Repurchase agreements (Repos)

6 Treasury bills are issued for raising short-term cash deficiencies for spending programme.

These T-bills have maturity period from the date of issue. However, the profits obtained from T-bills are lower than any other security in the mon, market due to their risk free nature.

Also, since their denominations range on a higher side, they are not suitable for small investors.

Treasury bills are very practical instruments to set-up short-term surpluses depending upon the accessibility and requirement. Even funds, which are kept in current accounts, can be deployed in treasury bills to maximize returns.

Banks do not pay any interest on fixed deposits of less than 15 days, or balances maintained in current accounts, whereas treasury bills can be purchased for any number of days depending on the requirements.

This helps in deployment of idle funds for very short periods as well. At times when the liquidity in the economy is unyielding, the returns on treasury bills are much higher as compared to bank deposits even for longer term.

Besides, better yields and accessibility for very short tenors, another important advantage of treasury bills over bank deposits is that the surplus cash can be invested depending upon the staggered requirements.

The T-bill yield is calculated as “Discount yield”. This is annualized yield and is calculated in the following way:IBO 06 Free Solved Assignment

= Face Value – Purchase Value/Face Value * 360

Days till maturity * 100%

2 Commercial papers are short-term unsecured promissory notes issued in the open market as a commitment to the issuing entity immediate financing needs. Commercial paper permits a corporation to issue for the short run until longer-term financing is foreseen.

Since stocks and bonds are subjected to limited SEC requirements and registration, this takes time and money, and hence commercial paper helps sidestep.

Each CP is issued as series of notes and each note promises to pay the bearer a stated sum of money at the maturity date.

Also, following things are always indicated on each note: The name of the issuing company, the amount of the note, the issue date, the maturity date, a certificate of authentication signed by authorized signatory of the company.

Also, each note is requ 2, to indicate that the note is negotiable, its bearer is entitled to payment and that the payment will be made by the issuer.

A Certificate of Deposit (CD) is a time deposit instrument or a financial product generally offered to consumers by banks, thrift institutions, and credit unions. CDs typically require a minimum deposit, and may offer higher rates for larger deposits.

A CD consists of a simple book entry and an item shown in the consumer’s periodic bank statements. Hence, there is no “certificate” as such.

There are number of variations in the terms and conditions for CDs. A CD has a specific, fixed term (often three months, six months, or one to five years), and are generally available at a fixed interest rate. IBO 06 Free Solved Assignment

However, CD can be liquidated at any given time at the prevailing rate in the secondary market.

IBO 06 Free Solved Assignment
IBO 06 Free Solved Assignment

Hence, they are an ideal funds short-term while retaining the flexibility to convert into cash at short notice if a need arises at any time.

Repurchase Agreements (RPs or Repos) are known as financial instruments used in money markets and capital markets.

Typical repurchase agreements has a borrower (seller/cash receiver) to sell securities for cash to a lender (buyer/cash provider) and who agrees to repurchase those securities at a later date for more cash. IBO 06 Free Solved Assignment

This repo rate is the difference between borrowed and paid back cash expressed as a percentage. A repo is economically similar to a secured loan, with the buyer receiving securities as collateral to protect against default.

There is little that prevents any security from being employed in a repo; so, Treasury or Government bills, corporate and Treasury / Government bonds, and stocks / shares, may all be used as securities involved in a repo.

Q. 2. (a) Explain the mechanism of money market hedge for managing transaction exposure.

Ans. For both in-house and retained international counsel, a thorough knowledge of international risk exposure techniques can serve as an effective way to supplement legal strategies for clients involved in international business transactions.

While creative and thorough legal drafting can go a long way to reduce some international transactions risks, many business risks can be obviated in whole or in part by the financial markets.

One such area of particular risk is known as transaction risk and is associated with foreign exchange rates.

Future payments or distributions payable in a foreign currency carry the risk that the foreign currency will depreciar value before the foreign currency payment is received and is exchanged into U.S. dollars.

While there is a chance of profit from the currency exchange in the event the price of the foreign currency increases, most investors and lenders would give up the possibility of currency exchange profit if they could avoid the risk of currency exchange loss.

For the company that wants to eliminate short-term transaction exposure (exposure of less than one year), a variety of hedging instruments are available at varying costs to the company.IBO 06 Free Solved Assignment

Forward Contracts: The most direct method of eliminating transaction exposure is to hedge the risk with a forward exchange contract. Forward rate contracts are often inaccessible for many small businesses.

Banks often tend to quote unfavourable rates for smaller business because the bank bears the risk the company will not fulfil the forward rate contracts.

Large spread in the forward rate quote suggests unfavourable offer terms. Banks will refuse to offer forward contracts at any rate to uncreditworthy companies.

Companies those are not eligible for forward rate contracts have the option, however, of hedging transaction exposure with futures contracts.

Futures Contracts: In principle, no differences exist between a futures market hedge and a forward market hedge. A short sale of a future contract puts the business in a position opposed to that of a business-owning the futures contract.

When the futures contract increases in value, the company loses that amount When the futures contract decreases in value, it gains that amount.

Despite their advantages, futures contracts also contain some disadvantages. Because futures contract are marked to market on a daily basis, any losses must be made up in cash on a daily basis, while the offsetting gain on the currency transaction will be deferred until the transaction actually occurs.

This imbalance can result in a severe liquidity crisis for small companies and for individuals.

Another disadvantage of using futures contracts for hedging is that they trade only in standardized amounts and maturi Companies may not have the choice of timing their receivables and payables to coincide with standardized futures contra Consequently, the hedges are not perfect

Hedges Using the Money Market: A company has the alternative of using a money market hedge if forward market hedges are not available or too expensive, and where a futures market hedge carries too much risk of insolvency.

A money market hedge is known that way because it necessitates borrowing or lending in the short-term money market enables a company with a future receivable or a future payable to make the required exchange of currencies at the current spot rate.

The difference between the borrowing and the lending interest rates is the cost of a money market hedge. IBO 06 Free Solved Assignment

In general, companies must pay more to borrow funds than they can receive when they lend funds.

In turn, banks lend funds at a higher interest rate than they pay for funds to earn a profit. The interest rate increases if default risk is present. A money market hedge may be the least costly hedging alternative.

Options: Currency options give one party the right, but not the obligation, to buy or sell a specific amount of currency at a specified exchange rate on or before an agreed-upon date.

If the exchange rate moves in favour of the option holder, the option can be exercised and the holder is protected from loss.

On the other hand, if the rate moves against the holders, it can let the option expire, but profit, by selling the foreign currency in the spot market.

Consequently, options are best characterised with potential for gain and no downside risk.

Hedging in the options market enables businesses and individuals to reduce loses caused by unfavourable exchange rate changes, while preserving gains from favourable exchange rate changes. However, this flexibility has a cost.

Cross Hedging: Thus far, a market for forward rates, futures contracts, credit or options in the foreign currency br hedged has been presumed to exist. But this may not be true in all cases, especially for small developing countries.

In such cao cross hedging may be the only hedging alternative available.

Cross hedging is a form of a hedge developed in a currency whose value is highly correlated with the value of the currency in which the receivable or payable is denominated.

In some cases, it is relatively easy to find highly correlated currencies, because many smaller countries try to peg the exchange rate between their currency and some major currency such as the dollar, the franc or euro.

However, these currencies may not be perfectly correlated because efforts to peg values frequently fail. IBO 06 Free Solved Assignment

Mitigating Long-term Currency Risk Exposure: Theoretically, the same hedging instruments discussed above to ease short-term currency risk can be used to hedge long-term transaction exposure.

However, at present, there is a limited market for currency futures options with maturities greater than one year.

A few multinational banks offer long-term forward exchange contracts with maturities as long as seven years. Unfortunately, for smaller companies, only large, creditworthy corporate customers qualify for such contracts.

Although individual companies can negotiate a currency option contract, there is no secondary market for the instrument.

Consequently, a number of alternative hedging techniques have developed for reducing long-term transaction exposure.

Currency Swaps/Credit Swaps: Swaps are like packages of forward contracts Currency swaps can be used to avoid the credit risk associated with parallell loan.

In broad items a currency (swap is an agreement by two companies to exchange specified amounts of currency now and to reverse the exchange at some point in the future. The lack of credit risk arises from the nature of a currency swap.

Default on a currency swap means that the currencies are not exchanged in the future, while default on a parallel loan means that the loan is not repaid.

Unlike a parallel loan, default on a currency swap entails no loss of investment or earnings. The only risk in a currency swap is that the companies must exchange the foreign currency in the foreign exchange market at the new exchange rate.

Frequently, multinational banks act as brokers to match partners in parallel loans and currency swaps. IBO 06 Free Solved Assignment

However, finding companies whose needs mutually offset one another is difficult, imperfect and only partially reduces currency exposure risk.

If a company cannot find a match, a credit swap may be used. Credit swaps involve a deposit in one currency and a loan in another. The deposit is returned after the loan is repaid.

IBO 06 Free Solved Assignment
IBO 06 Free Solved Assignment

(b) What is economic exposure and transaction exposure? How is economic exposure different from transaco exposure?

Ans. Extent to which a firm’s market value in dollars) is sensitive to unexpected changes in foreign currency is referred as economic exposure.

Economic exposure relates to ‘cash flow risks. The term cash flow has been defined in different ways. Cash flow means

(i) the total net dividends and liquidation proceeds available to the owners over future years,

(ii) the free cash flow,that is earnings before depreciation minus capital expenditure minus increases in working capital, IBO 06 Free Solved Assignment

(iii) the future earnings of the company defined in such a way as to reflect cash earnings rather than earnings computed on the accrual concept of accounting. The following distinguishing features apply to cash flow risk:

One, the threat is to the competitiveness of costs; it affects the ability of the business to compete, to obtain sales at a remunerative margin of profit over cost.

Two, the threat is from movements of the real, not the nominal exchange rate. A rise in the real rate of exchange erodes either margins or sales volume or a mixture of both.

Rise and fall in the real exchange rate of selling currencies tend to affect all competitors, and are part of the wider phenomenon of macro-economic uncertainty which every business must manage. It is thus not primarily a currency risk. This is a trading risk.

All businesses have to watch the forces which affect demand and supply of what they are offering.

This is a wider macroeconomic risk and not just a currency risk. Currencies are an important part, but not the whole of the relevant economic environment.

Consequently, if there are only two competing suppliers one with French and one with German costs, and if the bulk of sales are in the USA or in US dollars, a fall in the real exchange rate of the dollar would not cause economic or competitiveness risk.

Three, the risk are concerned with future sales for which prices have not yet been quoted. In these cases, management is concerned with nominal, ‘not real exchange rates.

Competitiveness risk, thus, excludes all potential sales for which the busiin has quoted prices, as well as actual sales, regardless of whether they have reached the balance sheet as receivables or payables. IBO 06 Free Solved Assignment

Four, the threat is to the competitive position of a business. Strictly, it is to a business in one or more of its commercial markets, where it incurs appreciable costs in a currency which may become less competitive.

Economic exposure depends on the unique characteristics of an industry and the individual characteristics of an individual firm.

Potential currency risk (unpredictable, random changes in ex-rates) is not the same as currency exposure, which is the firm’s actual exposure to currency risk.

If a company is hedged properly it might be insulated from currency risk and face no actual currency exposure.

Exposure to currency risk can be appropriately measured by the sensitivity of the firm’s future cash flows and the market value to random changes in exchange rates.

Statistically, this sensitivity can be estimated by the regression coefficient. Thus, exposure can be said to be the regression coefficient.

To explain this better lets consider an example. If a U.S. MNC were to run a regression on the dollar value (P) of its British assets on the dollar-pound exchange rate. S ($/£), the regression would be of the form:

P= a + 5+e

where a is the regression constant e is the random error term with mean zero, The regression coefficient b measures the sensitivity of the dollar value of the assets (P) to the exchange rate, S. IBO 06 Free Solved Assignment

The exposure coefficient, B, is defined as follows b-Cov(P.S)/ Var(S). where Cov (P, S) is the covariance between the dollar value of the asset and the exchange rate, and Var(S) is the variance of the exchange rate.

Hence, the exposure coefficient shows that there are two sources of economic exposure:
Cov (P.S)—– the variance of the exchange rate and
Var(S) ——– the covariance between the dollar value of the asset and exchange rate.

The risk faced by companies involved in international trade, that currency exchange rate will change after the companies have already entered into financial obligations.

Such exposure to fluctuating exchange rates can lead to major losses for finance.

Often, when a company identifies such exposure to changing exchange rates, it will choose to implement a hedging strategy, using forward rates to lock in an exchange rate and thus eliminate the exposure to the risk.

Transaction exposure arises when a firm faces contractual cash flows that are fixed in a foreign currency.

In other words, whenever a firm has foreign-currency-denominated receivables or payables, it is subject to transaction exposure, and the eventual settlements have the potential to affect the firm’s cash flow position. IBO 06 Free Solved Assignment

Since modern firms are often involved in commercial and financial contracts denominated in foreign currencies, management of transaction exposure has become an important function of international financial management.

Transaction exposure thus in simple words, defined as the amount of foreign currency that is receivable or payable.

As it’s a well known fact that foreign exchange rates are highly volatile. In a free market, changes occur practically every second.

The movement in foreign exchange rates occurs as a result of genuine trade transactions in the care of highly regulated markets like the Indian market where speculation is strictly prohibited.

Thus, export and import transactions or borrowings and lending in foreign currency move foreign exchange rates in India.

The intra-day trends may be more predictable than slightly longer-term trends, but the uncertainty does exist. And w’ there is a substantial time gap between the date of the contract and its maturity, the uncertainty can be quite fearsome.

The gap will depend on the credit period permissible for such transactions. At present, the Reserve Bank of India permits a credit period of up to six months or 180 days to be precise, for export and import transactions.

Now, surely, 180 days is a long enough periods for forecasts of movements in foreign exchange rates to be rendered imprecise. IBO 06 Free Solved Assignment

Hence, there arises a transaction exposure which needs to be measured and managed well in order to minimize its negative effect on corporate profitability or wealth.

The treasury departments managing foreign exchange fluctuations are sometimes looked upon as profit centres whereby, the main objective becomes that of making a profit out of foreign exchange movements.

Yet, the primary aim remains that of avoiding the uncertainty relating to the future exchange rate that will prevail on the date the contract matures.

A company’s transaction exposure is thus measured as currency by currency and equals the difference between contractually fixed future cash inflows and outflows in each currency.

Fluctuations in the exchange rates affect the overall performance of banks through foreign currency transactions and operations.

Nevertheless, even without such activities, exchange rate swings can influence banks circuitously, through their effect on the extent of foreign competition, loan demand and other banking conditions.

In international finance, a firm’s cash-flow exposure is described as transaction or economic exposure. IBO 06 Free Solved Assignment

Transaction exposure is the risk that exchange rates can change in the short-term between the times of foreign currency transaction is entered into and when it is settled.

Economic exposure is the risk that exchange-rate changes will alter the longterm future cash flows of a firm and, thereby, the value of the firm.

It is surprising that even though exchange rates are several times more volatile than inflation or interest rates, the association between firm value and exchange rates has not been the subject of much empirical research.

The difference between the two exposures can also be stated in following points :

Accounting exposure is the component of foreign currency risk that results from translating the statements of foreign subsidiaries into the reporting currency, which, in this course, is assumed to be Canadian dollars. IBO 06 Free Solved Assignment

The amount recognized in the financial statements as foreign exchange gains/losses or Other Comprehensive Income (OCI) varies depending on the translation method used and does not necessarily represent realized gains or losses.

Accounting exposure exists only on those financial statement elements translated at the current rate or future rates because these rates are constart! changing.

Economic exposure is the risk that changes to foreign exchange rates have on the earnings of foreign operations and long-term implications this may have to the parent.

It is measured in true economic terms, that is, whether the entity is economically better or worse off due to the change in exchange rates. Economic well-offness is difficult to measure precisely.

Financial statements attempt to reflect economic results. If so, foreign exchange gains/losses recognized in the financial statements ideally should reflect the true economic impact of foreign currency fluctuations.

Translation methods based on the parent’s relationship with its foreign subsidiary try to reflect the parent’s exposure to exchange rate changes.

Unfortunately, financial statements do not always accurately reflect economic reality when we use historical cost accounting as our basis of measurement.

Economic Esposure : IBO 06 Free Solved Assignment

1.A forward looking concept: It focuses on future cashflows.

2.Involves real cashflows, not just accounting figures.

  1. Relates to changes in the economic value (or,in an efficient market, the market value) of the firm.

4.Contractual exposure depends on the firm’s portfolio of FC engagements undertaken in the past.

Operating exposure depends on the environment (especially the market structure and the input-output mix) and on the firm’s strategic response (eg. relocation of production, changes in the marketing mix or financial stricturel etc.

  1. Also exists for firms without foreign subsidiaries, such as exporting firms, import competing firms, and notably potential import competing firms.

Transaction Exposure:

1.A backward-looking concept: it reflects past decisions as reflected in the subsidiary’s assets and liabilities, IBO 06 Free Solved Assignment

2.A change in an accounting value due to translation is not a “realized” gain or loss; no change in the cash situation is involved – except possibly through taxation effects.

3.Changes the firm’s accounting value, but not necessarily its market value.

4.Depends on the accounting rules chosen. This is because the subsidiary’s own internal rules affect its accounting values (e.g., type of depreciation, or inventory valuation methods) and also because the translation process itself can be done in different ways.

  1. Accounting exposure only exists in the case of foreign direct investment, since pure exporting or import-substituting firms have no foreign subsidiaries.

Q. 3. (a) What are the different ways of managing poltical risk? Discuss.

Ans. Management of Political Risk: Having analyzed the political environment of a country and having assessed the risk to its operations, a firm should decide

(a) Whether to invest is that country. IBO 06 Free Solved Assignment

(b) If so, how to device coping strategies to minimize the risk.

Pre-investment Planning: An MNC can follow each or all of the following policies:

(1) Avoidance
(2) Insurance

(3) Negotiating the Environment
(4) Structuring the Investment.

(1) Avoidance: Many firms tackle the political risk by avoiding investing in that country. The issue is what amount of risk, the company finds acceptable and is prepared to bear.

If the firms avoid investing in a high risk country, it also foregoes the high returns possibly available on its investment.

Thus most multinationals use avoidance strategy only rarely and try to recognize and assess the risk, e.g., investing in dictatorial China, or economically volatile South Asian countries is risky.

However, if the risk does not materialize, the returns are considerable.

(2) Insurance: Most developed countries sell political risk insurance to cover foreign assets of domestic companies. IBO 06 Free Solved Assignment

Many multinational corporations take advantage of it.
Mostly high-risk multinationals will seek insurance. Hence, adverse incentives are built in by adjusting premiums in accordance with the perceived risks.

Screening out certain high risk applicants and by providing reduced premium to the companies engaged in activities that are likely to reduce expropriation risk.

(3) Negotiating the Environment: There are two fundamental problems with relying on insurance as a protection from political risk. First, there is an asymmetry involved. If an investment proves unprofitable, it is unlikely to be expropriated.

Since business risk is not covered, any losses must be borne by the firm itself. On the other hand, if the investment proves succes and is expropriated, the firm is compensated only for the value its assets.

Thus, although insurance can provide partial protec from political risk, it is not a comprehensive solution. IBO 06 Free Solved Assignment

At times firms try to reach an understanding with the host government before undertaking an investment.

This is called a “concession agreement” in which rights and responsibilities of both parties are defined. These concession agreements are negotiated by multinational firms with developing countries.

However, as the experience in developing countries shows, such concession agreements are difficult to implement, particularly in countries like Iraq, Iran, etc.

(4) Structuring the Investment: Multinational firms try to increase the cost of interference by the host country to minimize its exposure to political risk.

This can be done by keeping the local affiliate dependent on sister companies for markets and supplies. IBO 06 Free Solved Assignment

Another strategy is to establish a single global trademark that cannot be legally duplicated by a government. Control of transportation is user by some companies to prevent any adverse action on their projects by the lost government.

(b) What are foreign bonds and euro bonds? What are the advantages of eurobonds ownert foreign bonds?

Ans. Foreign Bond: Bond that is issued in a domestic market by a foreign entity, in the domestic market’s currency.

Foreign bonds are regulated by the domestic market authorities and are usually given nicknames that refer to the domestic market in domestic market’s currency.

Foreign bonds are regulated by the domestic market authorities and are usually given nicknames that refer to the domestic market in which they are being offered.

Since investors in foreign bonds are usually the residents of the domestic country, investors find them attractive because they can add foreign content to their portfolios without the added exchange rate exposure.

A bond denominated in the currency of the country where it is issued when the issuer is a non-resident IBO 06 Free Solved Assignment

A debt security is issued by a borrower from outside the country in whose currency the bond is denominated and in which the bond is sold.

A bond denominated in U.S. dollars that is issued in the United States by the Government of Canada is a for a bond.

A foreign bond allows an investor a measure of international diversification without subjection to the risk of change relative currency values.

When bonds are purchased or sold, it’s usually between the dates when interest is payable. Thus, there is some amount paid or received for the bond that represents accrued interest that is earned but not yet payable.

These amounts should be treated as adjustments of the amount of the income received from the bonds.

Foreign bond is in the Banking, Commerce and Finance, Investing and Securities and Futures Trading subjects. IBO 06 Free Solved Assignment

Investing in foreign securities can actually trim down your overall group risk and at the same time humbly increase the prospective for returns.

The U.S. stock market still remains the chief in the world; however, foreign markets now account for approximately 50% of the global stock market capitalization.

Consequently, it is becoming more important to diversify portfolios globally, taking advantage of growth rates in different regions and countries.

Proper international diversification can help balance out your returns by reducing or avoiding losses when the U.S. markets are underperforming.

Also, the tax rules applicable to investments in corporate bonds are generally much more complicated than the rules that apply to corporate stocks.

When the bonds are foreign bonds and are not registered with the U.S. S.E.C. and do not report to the I.R.S., the complexities increase substantially.

With a U.S. company, the tax treatment is determined by the company and then reported on an information return to the IRS and to the investor.

With a foreign bond, the investor may need to hire a tax professional to try to determine the proper tax treatment of different kinds of debt payments. Types of foreign bonds include bulldog bonds, Matilda bonds, and Samurai bonds.

Euro Bond: A bond that is denominated in a different currency than the one of the country in which the bond is issued. Eurobonds are bonds issued in a currency other than the issuer’s home currency outside the issuer’s home country.

Euro-bonds are usually bearer bonds that pay interest annually without deduction of tax. They are often issued by an off-shore subsidiary ultimate borrower in order to ensure the latter.

A Euro-bond is usually categorized by the currency in which it is denominated, and is frequently issued by an international uro-dollar bond, which is denominated in U.S. dollars and issued in Japan by an Australian company.

Note that the Australian company can issue the Euro-dollar bond in any country other than the United States.

These bonds are the low risk building solutions. Euro-bonds may vary in the ways bonds usually do: They may pay fixed or floating rates, and they may be convertible.

Euro-bonds usually trade off exchange and are aimed at institutional rather than retail (private) investors. IBO 06 Free Solved Assignment

Euro bonds are attractive methods of financing as they give issuers the flexibility to choose the country in which to offer their bond according to the country’s regulatory constraints. In addition, they may denominate their Euro-bond in their preferred currency.

Euro-bonds are attractive to investors as they have small par values and high liquidity. A Euro bond is an international bond that is denominated in a currency not native to the country where it is issued.

It can be categorized according to the currency in which it is issued, London is one of the centres of the Euro-bond market, but Euro-bonds may be traded throughout the world – for example, in Singapore or Tokyo.

Euro-bonds are named after the currency they are denominated in.

For example, Euro yen and Euro dollar bonds are denominated in Japanese yen and American dollars respectively.

A Euro bond is normally a bearer-bond, payable to the bearer. It is also free of withholding tax. The bank will pay the holder of the coupon the interest payment due. Usually, no official records are kept. IBO 06 Free Solved Assignment

A bond issued and traded outside the country whose currency it is denominated in and outside the regulations of a single country; usually a bond issued by a non-European company for sale in Europe. Also called global bond.

Q. 4. (a) Discuss the factors that influence the design of world wide corporate capital structure.

Ans. Capital structure is essential for the survival, growth and performance of a firm. There has been a growing interest worldwide in identifying the factors associated with debt leverage.

However, nothing has been done so far in contrasting S ” and Medium sized Enterprises (SMEs) and Large Sized Enterprises (LSEs) on these aspects.

SMEs are very important 10/ Greek manufacturing sector for employment and growth. Empirical studies show that capital structure and the factors affectng vary with firm size.

The determinants of capital structure of Greek manufacturing firms and formulate some policy implications that may improve the financial performance of the sector.

Our study utilizes panel data of two random samples, one for SMEs and another for LSEs. The findings show that profitability is a major determinant of capital structure for both size groups. IBO 06 Free Solved Assignment

However, efficient assets management and assets growth are found essential for the debt structure of LSEs as opposed to efficiency of current assets, size, sales growth and high fixed assets, which were found to affect substantially the credibility of SMEs.

In an era of increasing globalization, the findings imply that Greek SMEs should focus their efforts on (a) increasing their cash flow capacity through better assets management and achievement of higher exports, and (b) ensuring good bank relations, but at the same time, turn to alternative forms of financing.

Greek LSEs should adopt strategies that will lead to the improvement of their competitiveness and securing new forms of financing. Government policy measures aiming at structural changes and economic efficiency should be designed clearly depending upon its targets.

SMEs need policies that will encourage information exchange and co-operation in local and foreign markets and use of ebusiness, as well as, financial assistance.

On the other hand, LSEs should be supported by policies aimed at new high-technology investments, entrance of new firms and foreign investments in the country, tax alleviation and increase of R&D and training expenditures.

The upgrading and transparency of the capital market in Greece is expected to improve the capital structure of Greek manufacturing firms.

Corporate and personal income tax regimes in different countries also influence choice of World-Wide Capital stru While in most of the countries, interest is tax deductible, effective rates of tax can significantly differ. IBO 06 Free Solved Assignment

Dividend income, comp. to interest income, is generally taxed leniently and many countries don’t have capital gain tax.

As capital gains are more likely to arise in the hands of equity investors than lenders, the expected return (that is cost of equity from the company point of view) can be mainly lower

Bankruptcy costs mainly depend on the probability of bankruptcy which not only depends on business risk but also inclination of lenders to file for bankruptcy.

The inclination to file for bankruptcy is generally seen higher among individual lenders than institutional lenders, particularly the one closely associated with borrowers like in Japan. Thus, bankruptcy costs also influence World-Wide capital structure.

The costs of bankruptcy includes legal and administrative expenses and the inability to continue business as usual. IBO 06 Free Solved Assignment

This leads to the trade off theory of capital structure As we saw earlier in the course, when a firm has debt, there are conflicts of interest between creditors and shareholders.

Shareholders may act in a way that helps them, but hurts the firm overall. A firm in financial distress may

• Take large risks that benefit shareholders if they succeed, but hurt creditors if they fail

• Not undertake needed investments, since the benefits will accrue to creditors if bankruptcy occurs

• Milk the company of assets in the face of impending bankruptcy.

The main argument for some debt in the capital structure is the tax deductibility of interest. Another argument in favour of some debt in the capital structure involves shirking, perquisites and bad investments (these are called agency costs of equity):

Shirking can be illustrated via the example of an owner of an all equity company needing outside financing faced with the choice of selling equity or debt to outsiders.

An owner will have less incentive to (continue to work very hard if she issues equity rather than debt, since some of the future benefits will then accrue to outsiders.

Financial mobility and flexibility are the other considerations which influence World-Wide capital structure. IBO 06 Free Solved Assignment

It is generally argued that a group management and capital structure is needed to permit movement of funds around the group as quic’ possible.

This requires the ability of being as mobile as possible, particularly within the 100 per cent owned part of the g. Firms generally have debt ratios well below 100%.

There is a degree of consistency within industries. Debt ratios are low in high growth industries with uncertain cash flows and less tangible assets.

Debt ratios are much higher in mature industries with large, stable cash flows.

There are a number of companies with essentially no debt at all. Companies with a significant ownership stake by 1 familythe founding family, often have lower debt levels than their more highly leveraged counterparts in the same industry.

This may be because the managers and major equity holders of these companies are less diversified than the managers and equity holders of similar, but levered firms, and are unwilling to accept the additional risk that significant leverage entails.

So, in conclusion, tax rates, the type of industry, the ownership pattern, personal tax rates on interest and dividends, the degree of uncertainty of operating income, etc., all help explain how managers determine the optimal level of debt in their capital structure.

(b) Describe adjusted present value method?

Ans. Adjusted Present Value (APV) is similar to NPV. The difference is that is uses the cost of equity as the discount rate (rather than WACC). Separate adjustments are made for the effects financing (e.g., the tax advantages of debt).

As usual with DCF models of this sort, the calculation of adjusted present value is straightforward but tedious. IBO 06 Free Solved Assignment

The first step in calculating an APV is to calculate a base NPV using the cost of equity as the discount rate.

This may be the same as the company’s cost of equity. In some cases it may be necessary to recalculate it by estimating a beta and using CAPM This is most likely when assessing a project or business that is very different from a company’s core business.

Once the base NPV has been calculated, the next step is to calculate the NPV of each set of cash flows that results. financing.

The most obvious of these are the tax effects of using debt rather than equity. These can be discounted either at the cost of debt or at a higher rate that reflects uncertainties about the tax effects (e.g., future tax rates, whether the company as a whole will be profitable and paying tax).

The NPV of the tax effects is then added to the base NPV.

If there are other effects of financing, then these are also added or subtracted, and the end result is the APV. IBO 06 Free Solved Assignment

Given capital structure irrelevance, the savings from financing should be balanced by changes in the required return on equity with changes in capital structure.

This usually makes a simple NPV with the WACC as the discount rate preferable.

Usually, the main benefit of APV is a tax shield resulted from tax deductibility of interest payments. Another one can be a subsidized borrowing.

The APV method of business valuation is especially effective when an LBO case is considered since the company is loaded with an extreme amount of debt, so tax shield is substantial

Technically, an APV valuation model would look pretty much the same as a standard DCF model.

However, instead of WACC, cash flows would be discounted at the cost of assets, and tax shields at the cost of debt. APV and the standard DCF approaches should give the identical result if the capital structure remains stable.

These more complicated situations are more easily handled by using Adjusted Present Value (APV).

APV is based on the following: APV = NPV of project assuming it is all equity
financed + NPV of financing effects.

Essentially, APV breaks the total value of the project into parts: One part is the value assuming no debt is used, and then you add on the extra value created from using debt in the capital structure. IBO 06 Free Solved Assignment

The benefit of APV is that it breaks the problem down into the value of the project itself (if equity financed) and the value of the financing (whereas the effect of financing is taken account of in the WACC when calculating regular NPV).

This makes flexible enough to cover many different types of real-world financing arrangements such as: Tax rates that change each amount of debt increases or decrease each year, government agency subsidizes your interest payments for a certain number of
years, new debt must be issued at some future time and that will involve flotation costs, etc.

In each of these cases the NPV of the project fewer than 100% equity financing would remain the same, and the value of the specific financing arrangement would simply be calculated separately, in the same way as in the simple example above.

Some people believe that APV is preferable from a managerial point of view as it shows directly the sources of value created by a project (i.e., how much is from running the actual project, how much is from the financing arrangements, how much value is created by a government subsidy etc.).

However, note that calculating NPV based on an estimated WACC is still, by far, the most common project valuation approach used by firms.

Q. 5. (a) Discuss the merits of foreign direct investment, portfolio investment and short term investment.

Ans. FDI or Foreign Direct Investment is considered as a form of investment that earns interest in enterprises which function outside of the domestic territory of the investor.

FDI requires a business association between a parent company and its foreign subsidiary. Foreign direct business relationships give rise to multinational corporations.

For an investment to be regarded as an FDI, the parent firm needs to have at least 10% of the ordinary shares of its foreign affiliates.

The investing firm may also qualify for an FDI if it owns voting power in a business enterprise operating in a foreign country.

Foreign Direct Investment (FDI) is also defined as a company from one country making a physical investment into building a factory in another country.

Its definition can be extended to include investments made to acquire lasting interest in enterprises operating outside of the economy of the investor.

The FDI relationship consists of a parent enterprise and a foreign affiliate which together form a Multinational Corporation (MNC).IBO 06 Free Solved Assignment

An outward-bound FDI is backed by the government against all types of associated risks. This form of FDI is subject to tax incentives as-well-as disincentives of various forms.

Risk coverage provided to the domestic industries and subsidies gran the local firms stand in the way of outward FDIs, which are also known as “direct investments abroad.”

Different economic factors encourage inward FDls. These include interest loans, tax breaks, grants, subsidies, anu un removal of restrictions and limitations.

Factors detrimental to the growth of FDIs include necessities of differential performance and limitations related with ownership patterns.

Portfolio investment represents passive holdings of securities such as foreign stocks, bonds, or other financial assets, none of which entails active management or control of the securities’ issuer by the investor where such control exists, it is known as foreign direct investment.

Portfolio investment consists of international equity and debt securities not classified to either direct investment or reserve assets.

Some examples of portfolio investment are

• Purchase of shares in a foreign company. IBO 06 Free Solved Assignment
• Purchase of bonds issued by a foreign government.
• Acquisition of assets in a foreign country.

Short-term investments involve securities with a maturity period of less than a year. Also, these short-term investments are vulnerable in nature as a part of capital account, so much so that several tiger economies of Asia are improvised during 1997-98. And this was consequent to massive withdrawal of foreign investments.

This limits the extent of damage to Indian economy. FDI is investment in productive assets, not financial assets. It does not include short-term flows of money, such as portfolio investments and foreign exchange dealings.

(b) Write short notes on forfaiting.

Ans. Forfaiting is a method of trade finance that allows exporters to obtain cash by selling their medium term foreign account receivables at a discount on a “without recourse” basis.

A forfaiter is a specialized finance firm or a department in banks that performs non-recourse export financing through the purchase of medium-term trade receivables.

Similar to factoring, virtually eliminates the risk of non-payment, once the goods have been delivered to the foreign buyer in accordance with the terms of sale.

However, unlike factors, forfaiters typically work with the exporter who sells capital goods, commodities, or large projects and needs to offer periods of credit from 180 days to up to seven years. IBO 06 Free Solved Assignment

In forfaiting, receivables are normally guaranteed by the importer’s bank, allowing the exporter to take the transaction off the balance sheet to enhance its key financial ratios. The current going minimum transaction size for forfaiting is $100,000.

In the United States, most users of forfaiting have been large established corporations, although small- and medium-size companies are slowly embracing forfaiting as they become more aggressive in seeking financing solutions for countries considered high risk.

Key Points:

• Eliminates virtually all risk to the exporter with 100 per cent financing of contract value.

• Allows offering open account in markets where the credit risk would otherwise be too high.

• Generally works with bills of exchange, promissory notes, or a letter of credit.

• Normally requires the exporter to obtain a bank guarantee for the foreign buyer.

• Financing can be arranged on a one-shot basis in any of the major currencies, usually on a fixed interest rate, but a floating rate option is also available.

The cost of forfaiting is determined by the rate of discount based on the aggregate of the LIBOR (London Inter Bank Offered Rate) rates for the tenor of the receivables and a margin reflecting the risk being sold.

The degree of risk varies based on the importing country, the length of the loan, the currency of transaction, and the repayment structure-the higher the risk, the! the margin and therefore, the discount rate.IBO 06 Free Solved Assignment

However, forfaiting can be more cost-effective than traditional trade finance tools because of many attractive benefits it offers to the exporter.

While the number of forfaiting transactions is growing worldwide, industry sources estimate that only 2 per cent of world trade is financed through forfaiting and that U.S. forfaiting transactions account for only 3 percent of that volume.

Forfaiting firms have opened around the world, but the Europeans maintain a hold on the market, including in North America.

While these firms remain few in number in the United States, the innovative financing they provide should not be overlooked as a viable means of export finance for U.S. exporters

The exporter approaches a forfaiter before finalizing a transaction’s structure. Once the forfaiter commits to the deal and sets the discount rate, the exporter can incorporate the discount into the selling price.

The exporter then accepts a commitment issued by the forfaiter, signs the contract with the importer, and obtains, if required, a guarantee from the importer’s bank that provides the documents required to complete the forfaiting.

The exporter delivers the goods to the importer and delivers the documents to the forfaiter who verifies them and pays for them as agreed in the commitment.

Since this payment is without recourse, the exporter has no further interest in the transaction and it is the forfaiter who must collect the future payments due from the importer. IBO 06 Free Solved Assignment






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