Financial Management means planning, organizing, directing and controlling the financial

activities such as procurement and utilization of funds of the enterprise. It means applying
general management principles to financial resources of the enterprise.

Scope/Elements

1. Investment decisions includes investment in fixed assets (called as capital budgeting).

Investment in current assets are also a part of investment decisions called as working
capital decisions.

2. Financial decisions - They relate to the raising of finance from various resources which
will depend upon decision on type of source, period of financing, cost of financing and
the returns thereby.

3. Dividend decision - The finance manager has to take decision with regards to the net
profit distribution. Net profits are generally divided into two:

A. Dividend for shareholders- Dividend and the rate of it has to be decided.

B. Retained profits- Amount of retained profits has to be finalized which will depend
upon expansion and diversification plans of the enterprise.

Objectives of Financial Management

The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern. The objectives can be-

1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders which will depend upon the earning
capacity, market price of the share, expectations of the shareholders.

3. To ensure optimum funds utilization. Once the funds are procured, they should be
utilized in maximum possible way at least cost.

4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that
adequate rate of return can be achieved.

5. To plan a sound capital structure-There should be sound and fair composition of capital
so that a balance is maintained between debt and equity capital.

Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make estimation with

regards to capital requirements of the company. This will depend upon expected costs
 and profits and future programmes and policies of a concern. Estimations have to be
made in an adequate manner which increases earning capacity of enterprise.

2. Determination of capital composition: Once the estimation have been made, the
capital structure have to be decided. This involves short- term and long- term debt
equity analysis. This will depend upon the proportion of equity capital a company is
possessing and additional funds which have to be raised from outside parties.

3. Choice of sources of funds: For additional funds to be procured, a company has

many choices like-

a. Issue of shares and debentures

b. Loans to be taken from banks and financial institutions

c. Public deposits to be drawn like in form of bonds.

4. Choice of factor will depend on relative merits and demerits of each source and period
of financing.

5. Investment of funds: The finance manager has to decide to allocate funds into
profitable ventures so that there is safety on investment and regular returns is possible.

6. Disposal of surplus: The net profits decision have to be made by the finance
manager. This can be done in two ways:

a. Dividend declaration - It includes identifying the rate of dividends and other

benefits like bonus.

b. Retained profits - The volume has to be decided which will depend upon
expansional, innovational, diversification plans of the company.

7. Management of cash: Finance manager has to make decisions with regards to cash
management. Cash is required for many purposes like payment of wages and salaries,
payment of electricity and water bills, payment to creditors, meeting current liabilities,
maintenance of enough stock, purchase of raw materials, etc.

8. Financial controls: The finance manager has not only to plan, procure and utilize the
funds but he also has to exercise control over finances. This can be done through
many techniques like ratio analysis, financial forecasting, cost and profit control, etc.

International Financial Management

International Financial Management is a well-known term in today’s world and it is also known
as international finance. It means financial management in an international business
environment. It is different because of the different currency of different countries, dissimilar
political situations, imperfect markets, diversified opportunity sets.
International Financial Management came into being when the countries of the world started
opening their doors for each other. This phenomenon is well known by the name of
“liberalization”. Due to the open environment and freedom to conduct business in any corner
of the world, entrepreneurs started looking for opportunities even outside their country
boundaries. The spark of liberalization was further aired by swift progression in
telecommunications and transportation technologies that too with increased accessibility and
daily dropping prices. Apart from everything else, we cannot forget the contribution of financial
innovations such as currency derivatives; cross-border stock listings, multi-currency bonds
and international mutual funds.
The resultant of liberalization and technology advancement is today’s dynamic international
business environment. Financial management for a domestic business and an international
business is as dramatically different as the opportunities in the two. The meaning and
objective of financial management do not change in international financial management but
the dimensions and dynamics change drastically.

Difference between International and Domestic Financial Management:

Four major facets which differentiate international financial management from domestic
financial management are an introduction of foreign currency, political risk and market
imperfections and enhanced opportunity set.
Foreign Exchange: It’s an additional risk which a finance manager is required to cater to
under an International Financial Management setting. Foreign exchange risk refers to the risk
of fluctuating prices of currency which has the potential to convert a profitable deal into a loss
making one.
Political Risks: Political risk may include any change in the economic environment of the
country viz. Taxation Rules, Contract Act etc. It is pertaining to the government of a country
which can anytime change the rules of the game in an unexpected manner.
Market Imperfection: Having done a lot of integration in the world economy, it has got a lot of
differences across the countries in terms of transportation cost, different tax rates, etc.
Imperfect markets force a finance manager to strive for best opportunities across the
countries.
Enhanced Opportunity Set: By doing business in other than native countries, a business
expands its chances of reaping fruits of different taste. Not only does it enhances the
opportunity for the business but also diversifies the overall risk of a business.
Just like domestic financial management, the goal of International Finance is also to maximize
the shareholder’s wealth. The goal is not only is limited to the ‘Shareholders’ but extends to all
‘Stakeholders’ viz. employees, suppliers, customers etc. No goal can be achieved without
achieving welfare of shareholders. In other words, maximizing shareholder’s wealth would
mean maximizing the price of the share. Here again comes a question, whether in which
currency should the value of the share be maximized? This is an important decision to be
taken by the management of the organization.

What are the new challenges for the International Financial Management?
Challenges of international financial management Financial management of a company is a
complex process, involving its own methods and procedures. It is made even more complex
because of the globalization taking place, which is making the worlds financial and commodity
markets more and more integrated. The integration is both across countries as well as
markets. Not only the markets, but even the companies are becoming international in their
operations and approach. Managers of international firms have to understand the
environment in which they function if they are to achieve their objective in maximizing the
value of their firms, or the rate of return from foreign operations.
The environment consists of:
 1. The international financial system, which consists of two segments: the official part
represented by the accepted code of behavior by governments comprising the
international monetary system, and the private part, which consists of international
banks and other multinational financial institutions that participate in the international
money and capital markets.
2. The foreign exchange market, which consists of multinational banks, foreign exchange
dealers, and organized exchanges where currency futures are regularly traded.
3. The foreign country’s environment, consisting of such aspects as the political and
socioeconomic systems, and people’s cultural values and aspirations. Understanding
of the host country’s environment is crucial for successful operation and essential for
the assessment of the political risk.
The multinational financial manager has to realize that the presence of his firm in a number
of countries and the diversity of its operations present challenges IFM 7 as well as
opportunities. The challenges are the unique risks and variables the manager has to contend
with which his or her domestic counterpart does not have to worry about. One of these
challenges, for example, is the multiplicity and complexity of the taxation systems, which
impact the MNC’s operations and profitability. But this same challenge presents the manager
with opportunities to reduce the firm’s overall tax burden, through transfer of funds from high-
to low-tax affiliates and by using tax havens. The financing function is another such challenge,
due to the multiplicity of sources of funds or avenues of investment available to the financial
manager. The manager has to worry about the foreign exchange and political risks in
positioning funds and in mobilizing cash resources. This diversity of financial sources enables
the MNC at the same time to reduce its cost of capital and maximize the return on its excess
cash resources, compared to firms that raise and invest funds in one capital market. In a real
sense MNCs are particularly situated to make the geographic, currency, and institutional
diversity work for them. This diversity, if properly managed, helps to reduce fluctuations in
their earnings and cash flows, which would translate into higher stock market values for their
shares. This observation is especially valid for the well-diversified MNCs. This is not to
suggest that the job of the manager of an MNC is easier, or less demanding, than if he or she
were to operate within the confines of one country. The challenges and the risks are greater,
but so are the rewards accruing to intelligent, flexible, and forward-looking management. The
key to such a management is to make the diversity and complexity of the environment work
for the benefit of the firm and to lessen the adverse impact of conflicts on its progress.

Main Challenges of Global Financial Management

Global financial management is the financial system of operations that determines the health
and performance of the world economy. Even a small business owner needs to be conversant
with global finance, especially if you do business internationally. Your marketing and
investment strategies hinge on an understanding of the economics of the different regions
where you have an interest.

1. Diverse Economic Environment

Operating in a globalized environment means being answerable to different countries
with different political environments and cultural norms, as well as trade procedures
and tax conditions to comply with. In addition, the credit conditions may be totally
different from what they are domestically. Anticipate day-to-day financial
management challenges when operating internationally and devise ways to maintain
 healthy equilibrium within this economic framework to ensure your business's
continued growth and survival.
2. Risk Management Challenges

Risk management is a major challenge of global financial management. For example,

if you're buying supplies or selling products overseas, your business may face the
risk of high prices caused by inflation in emerging economies. Although vulnerability
to financial crises in many emerging markets has been reduced significantly due to
stronger balance sheets, better fiscal policies and more flexible exchange rate
regimes, other factors still pose risks. Potential threats to energy supplies,
imbalances in the world economy and other fiscal sustainability issues call for
prudent financial planning and management of those risks that most affect your
particular business.

3. Dynamic Foreign Exchange Rates

In a globalized economy, the cash that goes in and out of the various countries is
subject to fluctuations in exchange rates. This creates uncertainty for financial
managers when it comes to the value of the home currency in relation to foreign
currencies. Continuous fluctuations in the foreign exchange market could mean slow
business for global organizations. If you need part of your financing for projects in
emerging economies where you conduct your business, fluctuating exchange rates
can subject you to higher interest rates. You have to monitor the foreign exchange
market closely for suitable rates that benefit your organization.
Banking Regulations
Unlike financial management in a single country, global financial management must
deal with many other banking institutions that have problems of their own. Some
multilateral development banks, such as the International Monetary Fund and World
Bank, have been set up to regulate international economic affairs in emerging
economies and typically give conditions to various countries and their banks. This
can be a challenge when doing business in a country where these institutions have
influence, since they advise banks in such countries to avoid testing waters in the
riskier markets in its structural adjustment programs.

International Monetary System and Financial Market

Explain the IMF and its objective and functions.

IMF The International Monetary Fund was originally created as part of the Bretton Woods
system exchange agreement in [Link] the Great Depression, countries sharply raised
barriers to foreign trade in an attempt to improve their failing economies. The IMF was
formally organized on December 27, 1945, when the first 29 countries signed its Articles of
Agreement. The International Monetary Fund was one of the key organizations of the
international economic system; its design allowed the system to balance the rebuilding of
international capitalism with the maximization of national economic sovereignty and human
welfare, also known as embedded liberalism. The members of the IMF are 188 members of
the UN and the Republic of Kosovo All members of the IMF are also International Bank for
Reconstruction and Development (IBRD) members and vice versa. Member countries of the
IMF have access to information on the economic policies of all member countries, the
opportunity to influence other members’ economic policies, technical assistance in banking,
fiscal affairs, and exchange matters, financial support in times of payment difficulties, and
increased opportunities for trade and investment. Organization Board of Governors: The
Board of Governors consists of one governor and one alternate governor for each member
country. Each member country appoints its two governors. While the Board of Governors is
officially responsible for approving quota increases, special drawing right allocations, the
admittance of new members, compulsory withdrawal of members, and amendments to the
Articles of Agreement and By-Laws. Executive Board: 24 Executive Directors make up
Executive Board. The Executive Directors represent all 188 member-countries. Countries with
large economies have their own Executive Director, but most countries are grouped in
constituencies representing four or more countries.
Managing Director: The IMF is led by a Managing Director, who is head of the staff and
serves as Chairman of the Executive Board. The Managing Director is assisted by a First
Deputy Managing Director and three other Deputy Managing Directors.

Voting power: Voting power in the IMF is based on a quota system. Each member has a
number of “basic votes" plus one additional vote for each Special Drawing Right (SDR) of
100,000 of a member country’s quota. The Special Drawing Right is the unit of account of the
IMF and represents a claim to currency
Functions The IMF works to foster global growth and economic stability. It provides policy
advice and financing to members in economic difficulties and also works with developing
nations to help them achieve macroeconomic stability and reduce poverty. It provides balance
of payments financing and the justification for official financing. fixed exchange rate
arrangements between countries. The IMF also researched what types of government policy
would ensure economic recovery

International Financial Markets: A Diverse System Is the Key to Commerce

The International Financial Market is the place where financial wealth is traded between
individuals (and between countries). It can be seen as a wide set of rules and institutions
where assets are traded between agents in surplus and agents in deficit and where
institutions lay down the rules.
The financial market comprises the markets strictu sensu (stock market, bond market,
currency market, derivatives market, commodity market and money market), the institutions
which work in them with different aims and functions (Central Bank, Ministry of Economy and
Finance, Monte Titoli, Borsa Italiana and CONSOB), as well as direct/indirect policies
orientated to making the market the place (not necessarily a physical place and not
necessarily ruled but regulated) where the exchange between surplus and deficit units is
carried out as efficiently as possible.
Bond market
The bond market (also debt market or credit market) is a financial market where
participants can issue new debt, known as the primary market, or buy and sell debt securities,
known as the secondary market. This is usually in the form of bonds, but it may include notes,
bills, and so on.
Its primary goal is to provide long-term funding for public and private expenditures.[1] The
bond market has largely been dominated by the United States, which accounts for about 44%
of the market.[2] As of 2009, the size of the worldwide bond market (total debt outstanding) is
estimated at $82.2 trillion,[3] of which the size of the outstanding U.S. bond market debt was
$31.2 trillion according to Bank for International Settlements (BIS), or alternatively $35.2
trillion as of Q2 2011 according to Securities Industry and Financial Markets
Association (SIFMA).[3]

What is an Equity Market?

An equity market is a market in which shares are issued and traded, either through
exchanges or over-the-counter markets. Also known as the stock market, it is one of the most
vital areas of a market economy because it gives companies access to capital and investors a
slice of ownership in a company with the potential to realize gains based on its future
performance.

What is the Forex Market

The forex market is the market in which participants can buy, sell, exchange, and speculate
on currencies. The forex market is made up of banks, commercial companies, central
banks, investment management firms, hedge funds, and retail forex brokers and investors.
The currency market is considered to be the largest financial market with over $5 trillion in
daily transactions, which is more than the futures and equity markets combined.

International Flow of Funds (Balance of Payments)

Balance of Payments (BOP) : The balance of payments is a statement of accounts that

summarizes all transactions between residents of one country and the rest of the world, for a
specific period of time, normally a year. Inflows of funds generate credits (+) for the
country’s BOP, while outflows of funds generate debits (-).

The Current Account Balance : The current account summarizes the flow of funds between
a country and rest of the world due to purchases of goods, services, and income from
financial assets and transfer payments. The current account balance measures a country’s
savings surplus or deficit and indicates the financing needs of a country. Countries that
incur a current account deficit will witness a downward pressure on their currency to
depreciate.

Financial Account Balance : The financial account summarizes the flow of funds resulting
from the sale/purchase of assets between one country and rest of the world. • The key
components of the financial account are foreign direct investment, portfolio investment, trade
finance and other short-term capital investment, so called “hot” money.

What do you mean by balance of Payment?

Ans. Balance of payments (BoP) accounts are an accounting record of all monetary
transactions between a country and the rest of the world. These transactions include
payments for the country's exports and imports of goods, services, financial capital, and
financial transfers.

The IMF definition The International Monetary Fund (IMF) use a particular set of definitions for
the BOP accounts, which is also used by the Organization for Economic Cooperation and
Development (OECD), and the United Nations System of National Accounts (SNA). The main
difference in the IMF's terminology is that it uses the term "financial account" to capture
transactions that would under alternative definitions be recorded in the capital account. The
IMF uses the term capital account to designate a subset of transactions that, according to
other usage, form a small part of the overall capital account.[6] The IMF separates these
transactions out to form an additional top level division of the BOP accounts. Expressed with
the IMF definition, the BOP identity can be written: The IMF uses the term current account
with the same meaning as that used by other organizations, although it has its own names for
its three leading subdivisions, which are: The goods and services account (the overall trade
balance) The primary income account (factor income such as from loans and investments)
The secondary income account (transfer payments)

International Portfolio Management

Global Portfolio Management, also known as International Portfolio

Management or Foreign Portfolio Management, refers to grouping of investment assets
from international or foreign markets rather than from the domestic ones. The asset grouping
in GPM mainly focuses on securities. The most common examples of Global Portfolio
Management are −

• Share purchase of a foreign company

• Buying bonds that are issued by a foreign government
• Acquiring assets in a foreign firm
Factors Affecting Global Portfolio Investment

Global Portfolio Management (GPM) requires an acute understanding of the market in which
investment is to be made. The major financial factors of the foreign country are the factors
affecting GPM. The following are the most important factors that influence GPM decisions.

Tax Rates

Tax rates on dividends and interest earned is a major influencer of GPM. Investors usually
choose to invest in a country where the applied taxes on the interest earned or dividend
acquired is low. Investors normally calculate the potential after-tax earnings they will secure
from an investment made in foreign securities.

Interest Rates

High interest rates are always a big attraction for investors. Money usually flows to countries
that have high interest rates. However, the local currencies must not weaken for long-term as
well.

Exchange Rates

When investors invest in securities in an international country, their return is mostly affected by
−

• The apparent change in the value of the security.

• The fluctuations in the value of currency in which security is managed.
Investors usually shift their investment when the value of currency in a nation they invest
weakens more than anticipated.

Modes of Global Portfolio Management

Foreign securities or depository receipts can be bought directly from a particular country’s stock
exchange. Two concepts are important here which can be categorized as Portfolio
Equity and Portfolio Bonds. These are supposed to be the best modes of GPM. A brief
explanation is provided hereunder.

Portfolio Equity

Portfolio equity includes net inflows from equity securities other than those recorded as direct
investment and including shares, stocks, depository receipts (American or global), and direct
purchases of shares in local stock markets by foreign investors.

Portfolio Bonds

Bonds are normally medium to long-term investments. Investment in Portfolio Bond might be
appropriate for you if −
 • You have additional funds to invest.
• You seek income, growth potential, or a combination of the two.
• You don’t mind locking your investment for five years, ideally longer.
• You are ready to take some risk with your money.
• You are a taxpayer of basic, higher, or additional-rate category.

Global Mutual Funds

Global mutual funds can be a preferred mode if the Investor wants to buy the shares of an
internationally diversified mutual fund. In fact, it is helpful if there are open-ended mutual funds
available for investment.

Closed-end Country Funds

Closed-end funds invest in internationals securities against the portfolio. This is helpful because
the interest rates may be higher, making it more profitable to earn money in that particular
country. It is an indirect way of investing in a global economy. However, in such investments,
the investor does not have ample scope for reaping the benefits of diversification, because the
systematic risks are not reducible to that extent.

Foreign Exchange Exposure: The risk associated with the foreign exchange rates that change
frequently and can have an adverse effect on the financial transactions denominated in some
foreign currency rather than the domestic currency of the company.
In other words, the firm’s risk that its future cash flows get affected by the change in the value
of the foreign currency, in which it has maintained its books of accounts (balance sheet), due
to the volatility of the foreign exchange rates is termed as foreign exchange exposure.

Types of Foreign Exchange Exposure

1. Transaction Exposure
2. Operating Exposure
3. Translation Exposure
Out of these three risks, the first two risks, i.e. transaction risk and the operating risk are
called “cash flow exposure” or “economic exposure”, while the translation risk is called
the “accounting exposure”.
TRANSACTION EXPOSURE:

The simplest kind of foreign currency exposure which anybody can easily think of is the
transaction exposure. As the name itself suggests, this exposure pertains to the exposure due
to an actual transaction taking place in business involving foreign currency. In a business, all
monetary transactions are meant for profits as its end result. There are all the chances of that
final objective getting hampered if it is a foreign currency transaction and the currency market
moves towards the unfavorable direction.
If you have bought goods from a foreign country and payables are in foreign currency to be
paid after 3 months, you may end up paying much higher on the due date as currency value
may increase. This will increase your purchase price and therefore the overall costing of the
product compelling the profit percentage to go down or even convert to lose.

Transaction exposure normally occurs due to foreign currency debtors of sale, payment for
imported goods or services, receipt / payment of dividend, or payment towards the EMIs of
debts etc.

TRANSLATION EXPOSURE:
This exposure is also well known as accounting exposure. It is because the exposure is due
to the translation of books of accounts into the home currency. Translation activity is carried
out on account of reporting the books to the shareholders or legal bodies. It makes sense also
as the translated financial statements show the position of the company as on a date in its
home currency.
Gains or losses arising out of translation exposure do not have more meaning over and above
the reporting requirements.

Such exposure can even get reversed in the next year translation if currency market moves in
the favorable direction. This kind of exposure does not require too much of management
attention.

ECONOMIC EXPOSURE:
The impact and importance of this type of exposure are much higher compared to the other
two. Economic exposure directly impacts the value of a firm. That means, the value of the firm
is influenced by the foreign exchange.
The value of a firm is the function of operating cash flows and the assets it possesses. The
economic exposure can have bearings on assets as well as operating cash flows.
Identification and measuring of this exposure is a difficult task. Although, the asset exposure
is still measurable and visible in books but the operating exposure has links to various factors
such as competitiveness, entry barriers, etc which are quite subjective and interpretation of
different experts may be different.
Techniques to Manage Foreign Exchange Risk
Foreign Exchange Risk: Technique # 1.

Forward contracts:

A forward contract is a commitment to buy or sell a specific amount of foreign currency at a

later date or within a specific time period and at an exchange rate stipulated when the

transaction is struck. The delivery or receipt of the currency takes place on the agreed

forward value date.

A forward transaction cannot be cancelled but can be closed out at any time by the
repurchase or sale of the foreign currency amount on the value date originally agreed upon.
Any resultant gains or losses are realized on this date.

Generally, there is variation in the forward price and spot price of a currency. In case the

forward price is higher than the spot price, a forward premium is used whereas if the forward

price is lower, a forward discount is used.

To compute annual percentage premium or discount, the following formula may be

used:

Forward premium or discount = (Forward rate – Spot rate)/Spot rate x 360/Number of days

under the forward contract

In this formula, the exchange rate is expressed in terms of domestic currency units per unit of
foreign currency. To illustrate, if the spot price of 1 US dollar is Indian rupees 39.3750 on a
given date and its 180-day forward price quoted is Rs 39.8350, the annualized forward
premium works out to 0.92, as under:

Forward premium or discount = (39.8350 – 39.3750) * 360/180 = 0.92

The forward differential is known as swap rate. By adding the premium (in points) to or

subtracting the discounts (in points) from the spot rate, the swap rate can be converted into

an outright rate. These forward premiums and discounts reflect the interest rate differentials

between the respective currencies in the inter-bank market.

If a currency with higher interest rates is sold forward, sellers enjoy the advantage of holding

on to the higher earning currency during the period between agreeing upon the transaction
and its maturity.
Buyers are at a disadvantage since they must wait until they can obtain the higher earning
currency. The interest rate disadvantage is offset by the forward discount. In the forward
market, currencies are bought and sold for future delivery, usually a month, three months, six
months, or even more from the date of transaction.

Foreign Exchange Risk: Technique # 2.

Future contracts:

Commonly used by MNEs as hedging instruments, future contracts are standardized

contracts that trade on organized futures markets for a specific delivery date only.

The major difference in forward and future markets is summarized as follows:

iii. The forward contract does not have lot size and is tailored to the need of the exporter,
whereas the futures have standardized round lots.

iv. The date of delivery in forward contracts is negotiable, whereas future contracts are for

particular delivery dates only.

v. The contract cost in future contracts is based on the bid/offer spread, whereas

brokerage fee is charged for futures trading.

vi. The settlement of forward contracts is carried out only on expiration date, whereas

profits or losses are paid daily in case of futures at the close of trading.

vii. Forward contracts are issued by commercial banks, whereas international monetary
markets (for example, the Chicago Mercantile Exchange) or foreign exchanges issue
futures contracts.

Foreign Exchange Risk: Technique # 3.

Options:

Foreign currency options provide the holder the right to buy or sell a fixed amount of foreign

currency at a pre-arranged price, within a given time. An option is an agreement between a

holder (buyer) and a writer (seller) that gives the holder the right, but not the obligation, to buy

or sell financial instruments at a time through a specified date.

Thus, under an option, although the buyer is under no obligation to buy or sell the currency,
the seller is obliged to fulfil the obligation.
This provides the flexibility to the holder of a foreign currency option not to buy or sell the

foreign currency at the pre-determined price, unlike in a forward contract, if it is not profitable.

Price at which the option is exercised, i.e., at which a foreign currency is bought or sold, is

known as strike price. Both currency call and put options can be purchased on an exchange.

There are two types of foreign currency options:

Call option gives the holder the right to buy foreign currency at a pre-determined price. It is

used to hedge future payables.

Put option gives the holder the right to sell foreign currency at a pre-determined price. It is
used to hedge future receivables.

Foreign currency options are used as effective hedging instruments against exchange- rate

risks as they offer more flexibility than forward or future contracts because no obligation is

required on the part of the buyer under the currency options.

Foreign Exchange Risk: Technique # 4.

Swap:

In order to hedge long-term transactions to currency rate fluctuations, currency swaps are

used. Agreement to exchange one currency for another at a specified exchange rate and date

is termed as currency swap. Currency swaps between two parties are often intermediated by
banks or large investment firms. .

Foreign exchange swap accounts for about 55.6 per cent of the average daily foreign

exchange turnover of the world, whereas spot deals account for 32.6 per cent and outright

forward for 11.7 per cent.

Buying a currency at a lower rate in one market for immediate resale at higher rate in another

with an objective to make profit from divergence in exchange rates in different money markets

is known as ‘currency arbitrage’. To capitalize on discrepancy in quoted prices, arbitrage is

often used to make riskless profits.
Exchange Rate Forecasts

Economists and investors always tend to forecast the future exchange rates so that they can
depend on the predictions to derive monetary value. There are different models that are used
to find out the future exchange rate of a currency.

However, as is the case with predictions, almost all of these models are full of complexities and
none of these can claim to be 100% effective in deriving the exact future exchange rate.

Exchange Rate Forecasts are derived by the computation of value of vis-à-vis other foreign
currencies for a definite time period. There are numerous theories to predict exchange rates,
but all of them have their own limitations.

Exchange Rate Forecast: Approaches

The two most commonly used methods for forecasting exchange rates are −

1. Fundamental Approach − This is a forecasting technique that utilizes elementary

data related to a country, such as GDP, inflation rates, productivity, balance of trade,
and unemployment rate. The principle is that the ‘true worth’ of a currency will
eventually be realized at some point of time. This approach is suitable for long-term
investments.
2. Technical Approach − In this approach, the investor sentiment determines the
changes in the exchange rate. It makes predictions by making a chart of the patterns.
In addition, positioning surveys, moving-average trend-seeking trade rules, and
Forex dealers’ customer-flow data are used in this approach.

Exchange Rate Forecast: Models

Some important exchange rate forecast models are discussed below.

Purchasing Power Parity Model

The purchasing power parity (PPP) forecasting approach is based on the Law of One Price. It
states that same goods in different countries should have identical prices. For example, this law
argues that a chalk in Australia will have the same price as a chalk of equal dimensions in the
U.S. (considering the exchange rate and excluding transaction and shipping costs). That is,
there will be no arbitrage opportunity to buy cheap in one country and sell at a profit in another.

Depending on the principle, the PPP approach predicts that the exchange rate will adjust by
offsetting the price changes occurring due to inflation. For example, say the prices in the U.S.
are predicted to go up by 4% over the next year and the prices in Australia are going to rise by
only 2%. Then, the inflation differential between America and Australia is:

4% – 2% = 2%
According to this assumption, the prices in the U.S. will rise faster in relation to prices in
Australia. Therefore, the PPP approach would predict that the U.S. dollar will depreciate by
about 2% to balance the prices in these two countries. So, in case the exchange rate was 90
cents U.S. per one Australian dollar, the PPP would forecast an exchange rate of −

(1 + 0.02) × (US $0.90 per AUS $1) = US $0.918 per AUS $1

So, it would now take 91.8 cents U.S. to buy one Australian dollar.

Relative Economic Strength Model

The relative economic strength model determines the direction of exchange rates by taking into
consideration the strength of economic growth in different countries. The idea behind this
approach is that a strong economic growth will attract more investments from foreign investors.
To purchase these investments in a particular country, the investor will buy the country's
currency – increasing the demand and price (appreciation) of the currency of that particular
country.

Another factor bringing investors to a country is its interest rates. High interest rates will attract
more investors, and the demand for that currency will increase, which would let the currency to
appreciate.

Conversely, low interest rates will do the opposite and investors will shy away from investment
in a particular country. The investors may even borrow that country's low-priced currency to
fund other investments. This was the case when the Japanese yen interest rates were
extremely low. This is commonly called carry-trade strategy.

The relative economic strength approach does not exactly forecast the future exchange rate
like the PPP approach. It just tells whether a currency is going to appreciate or depreciate.

Econometric Models

It is a method that is used to forecast exchange rates by gathering all relevant factors that may
affect a certain currency. It connects all these factors to forecast the exchange rate. The factors
are normally from economic theory, but any variable can be added to it if required.

For example, say, a forecaster for a Canadian company has researched factors he thinks would
affect the USD/CAD exchange rate. From his research and analysis, he found that the most
influential factors are: the interest rate differential (INT), the GDP growth rate differences (GDP),
and the income growth rate (IGR) differences.

The econometric model he comes up with is −

USD/CAD (1 year) = z + a(INT) + b(GDP) + c(IGR)
Now, using this model, the variables mentioned, i.e., INT, GDP, and IGR can be used to
generate a forecast. The coefficients used (a, b, and c) will affect the exchange rate and will
determine its direction (positive or negative).

Time Series Model

The time series model is completely technical and does not include any economic theory. The
popular time series approach is known as the autoregressive moving average (ARMA)
process.

The rationale is that the past behavior and price patterns can affect the future price behavior
and patterns. The data used in this approach is just the time series of data to use the selected
parameters to create a workable model.

To conclude, forecasting the exchange rate is an ardent task and that is why many companies
and investors just tend to hedge the currency risk. Still, some people believe in forecasting
exchange rates and try to find the factors that affect currency-rate movements. For them, the
approaches mentioned above are a good point to start with.

What is Volatility?

Volatility is a statistical measure of the dispersion of returns for a given security or market
index. In most cases, the higher the volatility, the riskier the security.
Volatility can either be measured by using the standard deviation or variance between returns
from that same security or market index.
In the securities markets, volatility is often associated with big swings in either direction. For
example, when the stock market rises and falls more than one percent over a sustained
period of time, it is called a "volatile" market.

Market volatility can be seen through the VIX or Volatility Index. The VIX was created by the
Chicago Board Options Exchange as a measure to gauge the 30-day expected volatility of the
U.S. stock market derived from real-time quote prices of S&P 500 call and put options. It is
effectively a gauge of future bets investors and traders are making on the direction of the
markets or individual securities. A high reading on the VIX implies a risky market.
A variable in option pricing formulas showing the extent to which the return of the underlying
asset will fluctuate between now and the option's expiration. Volatility, as expressed as a
percentage coefficient within option-pricing formulas, arises from daily trading activities. How
volatility is measured will affect the value of the coefficient used.

What is Currency Derivatives?

The term 'Derivatives' indicates it derives its value from some underlying i.e. it has no
independent value. Underlying can be securities, stock market index, commodities, bullion,
currency or anything else. From Currency Derivatives market point of view, underlying would
be the Currency Exchange rate. To put it simply an example of Derivatives is curd which is
derived from Milk. Derivatives are unique product, which helps in hedging the portfolio against
the future risk. At the same time, derivatives are used constructively for arbitrage and
speculation too.

What are currency derivatives?

Currency derivatives are defined as the Future and Options contracts that one can buy or sell
in specific quantity of a particular currency pair at a future date (Wikipedia). The underlying
would be a currency exchange rate. It is generally unlisted and thereby traded OTC (over the
counter).

In the Indian markets, Currency Derivatives are available on four currency pairs namely US
Dollars (USD), Euro (EUR), Great Britain Pound (GBP) and Japanese Yen (JPY). Currency
options are currently available on US Dollars.

Foreign exchange (FOREX) is the simultaneous buying of one currency and selling in
another.

Forex derivatives are defined as type of a financial derivative in which the payoff depends on
the foreign exchange rate of two or more currencies. It basically helps in locking the future
foreign exchange rate. It is used to transfer liquidity from one currency to another keeping the
currency risk aside.

Types of Forex Derivatives

iii. Forex swaps

iv. Forex future contracts

v. Forex currency swaps

vi. Forward purchase or sales

Different products of the currency derivatives segment
The trading can be in futures and options or carry forwards or could be intraday depending
when the position is to be squared off.

Forward markets facilitate the trading of forward contract on currencies. When one can
anticipate future need or receipt of foreign currency, forward contracts can be set up to lock-in
the exchange rate.

Currency future contracts can be used to hedge currency positions or capitalize on

expected exchange rate movements. Currency derivative contracts are traded in pairs like
Rupee-Dollar, Rupee-British pound or Rupee-Euro. Price fluctuations in the currency
contracts are linked to the economic indicators of the particular country of which the currency
is being traded. Thereby, trade balance, interest rates, inflation and political risks affects the
movement of the currency futures contracts.

Types of currency derivatives

Currency options: It gives the right but not obligation to buy /sell currency in exchange for
another currency at a predetermined price and date.

Currency forwards: It is a contract between two parties to buy / sell underlying asset at a
predetermined price at a later date.

Currency swaps: It is an agreement to exchange payment flows in two different currencies

with each other on different dates.

Benefits of currency derivatives

1. They are efficient risk management instruments

2. They can be used for hedging as well as to speculate on short term movements in
the market

3. They are widely used arbitrage instruments

4. They can be used to leverage by paying the margin money and not the full traded
value

5. They can be used to protect holding

Disadvantages of currency derivatives
1. There is high risk of loss when options are issued

2. Extensive monitoring of the price performance needs to be done

What are Commodity Derivatives?

A commodity is defined as a basic good that is used as an input in the manufacturing of other
goods or services.

A multinational corporation (MNC) or worldwide enterprise is a corporate

organization which owns or controls production of goods or services in at least one country
other than its home country. Black's Law Dictionary suggests that a company or group should
be considered a multinational corporation if it derives 25% or more of its revenue from out-of-
home-country operations. A multinational corporation can also be referred to as
a multinational enterprise (MNE), a transnational enterprise (TNE), a transnational
corporation (TNC), an international corporation, or a stateless corporation.[13] There
are subtle but real differences between these three labels, as well as multinational corporation
and worldwide enterprise.

Financial Management in MNCs :

Many companies are multinational corporations (MNCs) that have significant foreign
operations and derive a high percentage of their sales from overseas. The CFOs of MNCs
need to understand the complexities of international finance to make sound financial and
investment decisions. International finance involves consideration of managing working
capital, financing the business, control of foreign exchange and political risks, and foreign
direct investments. Most important, the CFO has to consider the value of the U.S. dollar
relative to the value of the currency of the foreign country in which business activities are
being conducted. Currency exchange rates may materially affect receivables and payables as
well as imports and exports of the U.S. company in its multinational operations. The effect is
more pronounced with increasing activities abroad.

The unique characteristics of financial management of MNCs are:

1. Multiple‐currency problem;
2. Various legal, institutional, and constraints; and
3. Internal control problem.

The chief financial officer (CFO) of an MNC must be cognizant of local customs and risks in
the international markets.
Capital Budgeting: MNCs employ the same capital budgeting approaches employed by domestic
firms. The main focus of MNCs is on the cash inflows and outflows associated with the
prospective long-term investment projects (Madura and Fox, 2007).

MNC capital budgeting begins with an identification of the initial capital required for the
project. The next step is to estimate the future cash inflows and outflows over the investment
horizon as well as the estimation of the terminal or scrap value of the investment. The next
step is to determine the discount rate to use in valuing the cash flows and the last step is to
apply a traditional capital budgeting decision criteria such as the NPV, the IRR, the payback
period, or the adjusted present value (APV) (Shapiro, 2006).

While the capital budgeting approach is basically the same as that of domestic firms, there
are specific issues that the MNC needs to consider. The MNC must distinguish between the
cash flows of the parent company from those of specific projects. The parent cash flows are
determined by the form of financing. Additional cash flows generated by a new investment in
one subsidiary may be partly or wholly transferred to another subsidiary (Watson and Head,
2006).

Hillier et al (2010) also argue that the MNC must also take into account specific issues that
affect the remittance of funds from the foreign country to the home country such as differing
tax systems, legal and political constraints on the investment of funds, local business norms,
and differences in the manner in which financial markets and institutions operate across
different countries.

The MNC must also consider an array of non-financial payments, the impact of unexpected
changes in currency exchange rates, the use of segmented national capital markets, the use
of host-government subsidized loans, political risk and the identification of terminal value
(Fabozzi et al, 2009).

From the perspective of the parent, only the cash flows to the payment should be considered.
These cash flows form the basis for stock dividends, reinvestment elsewhere in other
countries, repayment of corporate-wide debt, and other purposes that can different
stakeholders of the firm. MNC capital budgeting often violates a cardinal rule of capital
budgeting, which states that financial cash flows should be kept separate from operating cash
flows (Buckley, 2004).

MNCs should not invest in foreign projects unless there is ample evidence that the risk-
adjusted return of the foreign project is greater than the return that locally-based competitors
can earn. If MNCs are unable to earn superior profits on foreign investments, shareholders
would find it more profitable to buy shares in local firms. Projects should be evaluated from
the perspective of the project and parent view. By so doing, the MNC will be better placed to
evaluate the viability of the project and whether it is better than locally-based projects.

Capital budgeting & Multinational Capital Budgeting

The process of identifying, analyzing and selecting investment projects whose returns (cash
flows) are
expected to extend beyond one year. Capital Budgeting may be defined as the decision
making
process by which firms evaluate the purchase of majorfixed assets including premises,
machinery and equipment. Capital budgeting is the process of identifying, evaluating,
and implementing a firm’s investment opportunities. Multinational capital budgeting, like
traditional domestic capital budgeting, focuses on the cash inflows and outflows associated
with prospective long-term (foreign) investment projects. Multinational capital budgeting has
the same theoretical framework as domestic capital budgeting

Five Steps Involved In The Capital Budgeting Process

1. Proposal generation: Proposal generation is the origination of proposed capital

projects for the firm by individuals at various levels of the organization.
2. Review and analysis: Review and analysis is the formal process of assessing the
appropriateness and economic viability of the project in light of the firm's overall
objectives. This is done by developing cash flows relevant to the project and
evaluating them through capital budgeting techniques. Risk factors are also
incorporated into the analysis phase.
3. Decision making: Decision making is the step where the proposal is compared
against predetermined criteria and either accepted or rejected.
4. Implementation: Implementation of the project begins after the project has been
accepted and funding is made available.
5. Follow-up: Follow-up is the post-implementation audit of expected and actual costs
and revenues generated from the project to determine if the return on the proposal
meets preimplementation projections.

Key Motives for Making Capital Expenditures

Expansion: The most common motive for a capital expenditure is to expand the level of
operations—usually through acquisition of fixed assets. A growing firm often needs to acquire
new fixed assets rapidly, as in the purchase of property and plant facilities.

Replacement: As a firm’s growth slows and it reaches maturity, most capital expenditures will
be made to replace or renew obsolete or worn-out assets. Each time a machine requires a
major repair, the outlay for the repair should be compared to the outlay to replace the
machine and the benefits of replacement.

Renewal: Renewal, an alternative to replacement, may involve rebuilding, overhauling, or a

physical facility could be renewed by rewiring and adding air conditioning. To improve
efficiency, both replacement and renewal of existing machinery may be suitable solutions.
These expenditures include outlays for advertising, research and development, management
consulting, and new products.

Other capital expenditure proposals—such as the installation of pollution-control and

safety devices mandated by the government—are difficult to evaluate because they provide
intangible returns rather than clearly measurable cash flows.

Subsidiary versus Parent Perspective

Should the capital budgeting for a multi-national project be conducted from the viewpoint of
the subsidiary that will administer the project, or the parent that will provide most of the
financing? The results may vary with the perspective taken because the net after-tax cash
inflows to the parent can differ from those to the subsidiary.
A parent’s perspective is appropriate when evaluating a project, since any project that can
create a positive net present value for the parent should enhance the firm’s value. However,
one exception to this rule may occur when the foreign subsidiary is not wholly owned by the
parent.

The difference in cash inflows is due to :

1. Tax differentials

2. Regulations that restrict remittances

3. Excessive remittances

4. The parent may charge its subsidiary very high administrative fees.

5. Exchange rate movements

Calculation of Multinational Capital Budgeting

Capital budgeting is necessary for all long-term projects that deserve consideration. One
common method of performing the analysis is to estimate the cash flows and salvage value to
be received by the parent, and compute the net present value (NPV) of the project.
Multinational corporations (MNCs) evaluate international projects by using multinational
capital budgeting, which compares the benefits and costs of these projects. Multinational
capital budgeting involves determining the project’s net present value by estimating the
present value of the project’s future cash flows and subtracting the initial outlay required for
the projects. Some special circumstances of international projects that affect the future cash
flow or the discount rate used to discount cash flow make multinational capital budgeting
more complex

Why Multinational capital budgeting?

1. Many international projects are irreversible and cannot be easily sold to other
corporations at a
2. reasonable price
3. Proper use of multinational capital budgeting can identify the international projects
worthy of
4. implementation.
5. It affects the profitability of a firm.
6. It effect over a long time spans and inevitably affectsthe company’s future cost
structure.
7. Capital investment decision once made, are noteasily reversible without much financial
loss of firm
8. It involves cost and the majority of the firms havescarce capital sources.

Factors to Consider in Multinational Capital Budgeting

Exchange rate fluctuations. Different scenarios should be considered together with their
probability
of occurrence.
Inflation. Although price/cost forecasting implicitly considers inflation, inflation can be quite
volatile
from year to year for some countries.
Financing arrangement. Financing costs are usually captured by the discount rate.
However, many foreign projects are partially financed by foreign subsidiaries.
Blocked funds. Some countries may require that the earnings be reinvested locally for a
certain period of time before they can be remitted to the parent.
Uncertain salvage value. The salvage value typically has a significant impact on the
project’s NPV, and the MNC may want to compute the break-even salvage value.
Impact of project on prevailing cash flows. The new investment may compete with the
existing business for the same customers.

Host government incentives. These should also be considered in the analysis.

Multinational Capital Budgeting Formula

NPV = Net Present Value

i = the required rate of return on the project

n = project lifetime in terms of periods

SV = Salvage Value

CF0 = Initial investment (cash outlay)

CF1 = Cash Flow of year one

CF2 = Cash Flow of year Two

If NPV > 0, the project can be accepted.

Capital Structure and MNCs

Capital structure refers to the amount of debt vs. equity that a firm is willing and able to
maintain as capital on its balance sheet without being overly leveraged • Certain countries,
like those in East Asia, allow companies to be more leveraged than those in the EU or the
United States • MNCs take advantage of those differences to leverage their overseas
operations to enhance returns to equity holders. 17. 2 Cost of Capital and MNCs • Cost of
capital is the weighted cost of equity and debt where the weights reflect the firm’s capital
structure • Cost of equity reflects the opportunity cost for investors in a country and will
depend on investment alternatives and risk profile • Cost of debt is the net interest expense,
i.e., net of taxes which vary with country • MNCs take advantage of differences in interest and
tax rates among countries to minimize their cost of debt and capital
Cost of Capital •
A firm’s capital consists of equity (retained earnings and funds obtained by issuing stock) and
debt (bank loans or floating bonds). • The cost of equity reflects an opportunity cost, while the
cost of debt is reflected in the interest expenses. • Firms target a capital structure that will
minimize their cost of capital, and hence the required rate of return on projects.

Capital Structure Decision in MNC: Concept and Factors

Concept of Capital Structural Decision:

In case of an MNC, capital structure decision is concerned with determining the mix of debt

and equity for the parent entity and for all consolidated and unconsolidated subsidiaries. As a

matter of fact, capital structure decision in an MNC is about striking trade off between using

debt and using equity for financing its operations.

The opportunities as well as the complexities of multinational capital strategy are much more

complex than those of their domestic counterparts. MNCs have comparatively greater

flexibility in choosing the markets and currencies in which it garnishes funds. By assessing

unsaturated demand in international capital markets, the MNC can lower its cost of debt and

equity capital and thereby increase its value.

In recent years, many major firms across the globe have tended to internationalize their

capital structure by raising funds from foreign as well as domestic sources. This tendency has

gained further prominence because of a conscious effort on the part of the firms to lower cost
of capital by international sourcing of funds but also the on-going liberalization and

deregulation of international financial markets that make them accessible for many firms.

Thrust of MNCs is on worldwide capital structure because suppliers of capital to a

multinational firm are assumed to associate the risk of default with the MNC’s worldwide debt

ratio. This association stems from the view that bankruptcy or other forms of financial distress

in an overseas subsidiary can seriously impair the parent company’s ability to operate

domestically.
Choice of debt Vs. equity financing by MNCs depends on corporate characteristics specific to

these corporations as well as to the countries where the MNCs have established their

subsidiaries.
Factors Influencing MNCs Capital Structure Decision:

Some of the major characteristics unique to each MNC that impact its capital structure

decision are outlined below:

(i) Character of MNC’s Cash Flows:

ADVERTISEMENTS:

An MNC having volatile cash flows can ill afford debt financing because it is not assured of
generating adequate cash to service debt periodically. In refreshing contrast to this, MNCs

having stable cash flows can manage more debt due to regular flow of earnings.

MNCs having diversified operations across the globe usually have relatively more stable cash

flows because the conditions in a country do not exert major influence on their cash flows.

Hence such companies can comfortably have greater financial leverage in their capitalization.
(ii) Credit Standing of MNC:

MNCs enjoying high reputation and low credit risk find it easy to access to cheaper debt.

Further, those with marketable assets that serve as acceptable collateral can raise borrowings

at reasonable terms. In contrast, MNCs with high credit risk and assets which are not highly

marketable are left with no option but to take recourse to equity financing.
(iii) Profitability of MNC:

MNCs operating profitably are in a position to build retained earnings which can be employed

to finance their expansion programmes economically. Such corporations have lower degree of

leverage as compared to those having small levels of retained earnings. Growth oriented

MNCs usually rely on debt financing because of their limited access to retained earnings.
(iv) MNCs Guarantees on Debt:

ADVERTISEMENTS:

Where an MNC guarantees borrowings of its subsidiary, the latter is likely to rely less on
equity financing. However, the borrowing capacity of such MNCs will tend to decline as
suppliers are less willing to supply large funds to the parent if those funds are needed to

rescue a parent’s subsidiary.

(v) Monitoring of Subsidiary by MNC:

Where investors of the parent company are finding it difficult to monitor operations of the

subsidiary effectively, the latter will be induced to issue equity shares in the local market. This

will enable the parent company to monitor the managers to ensure maximization of the firm’s

stock price.

This strategy can affect the MNC’s capital structure also. Success of this strategy hinges

essentially upon the initiatives taken by the MNC’s parent to beef up the image of the
subsidiary in the host country.

What is Cash Management

Cash management is the corporate process of collecting and managing cash, as well as
using it for short-term investing. It is a key component of a company's financial stability
and solvency. Corporate treasurers or business managers are frequently responsible for
overall cash management and related responsibilities to remain solvent.

Importance of cash management

Just like a ‘no cash situation’ in our day to day lives can be a nightmare, for a business it can
be devastating. Especially for small businesses, it can lead to a point of no return. It affects
the credibility of the business and can lead to them shutting down. Hence, the most important
task for business managers is to manage cash.
Management needs to ensure that there is adequate cash to meet the current obligations
while making sure that there are no idle funds. This is very important as businesses depend
on the recovery of receivables. If a debt turns bad (irrecoverable debt) it can jeopardize the
cash flow. Therefore, cash management is also about being cautious and making enough
provision for contingencies like bad debts, economic slowdown, etc.

Functions of cash management

In an ideal scenario, an organization should be able to match its cash inflows to its
cash outflows. Cash inflows majorly include account receivables and cash outflows
majorly include account payables.
Practically, while cash outflows like payment to suppliers, operational expenses, payment to
regulators are more or less certain, cash inflows can be tricky. So the functions of cash
management can be explained as follows :
Inventory management
Higher stock in hand means trapped sales and trapped sales means less liquidity. Hence, an
organization must aim at faster stock out to ensure movement of cash.

Receivables Management
An organization raises invoices for its sales. In these cases, the credit period for receiving the
cash can range between 30 – 90 days. Here, the organization has recorded the sales but has
not yet received cash for the transactions.
So the cash management function will ensure faster recovery of receivables to avoid a cash
crunch. If the average time for recovery is shorter, the organization will have enough cash in
hand to make its payments. Timely payments ensure lesser costs (interests, penalties) to the
organization.
Receivables management also includes a robust mechanism for follow-ups. This will ensure
faster recovery and it will also assist the business to predict bad debts and unforeseen
situations.

Payables Management
While receivables management is one of the primary areas in the cash management
function, payables management is also important. Payables arise when the organization has
made purchases on credit and needs to make payments for the same within a fixed time.
An organization can take short-term credit from banks and financial institutions. However,
these credit facilities come at a cost and therefore, an organization must ensure that they
maintain a good liquidity position; this will help in timely repayments of debts.

Forecasting
While planning investments, the managers need to be very careful as they need to plan for
future contingencies and also ensure profitability. For this, they must use efficient forecasting
and management tools. When the cash inflows and outflows are efficiently managed it gives
the firm good liquidity.

Short-term investments
Avoiding cash crunch, insolvency and ensuring financial stability are the main criterias of cash
management. But it is equally important to invest the surplus cash in hand wisely. Despite
being a liquid asset, idle cash does not generate any returns. While investing in short-term
investments an organization must ensure liquidity and optimum returns. Therefore, this
decision needs to be taken with prudence. Here, the quantum/amount of investment needs to
be calculated and decided carefully. This caution is necessary because an organization
cannot invest all the available funds. Businesses need to reserve cash for contingencies
(cash in hand) too.

Other functions
Cash management also includes monitoring the bank accounts, managing electronic banking,
pooling and netting of assets, etc. So the cash management for treasury can also be a core
function. Although for large corporates this function is managed by softwares, small
businesses have to monitor it manually and ensure liquidity at all times. To add, large
businesses have access to credit facilities at competitive rates. For small businesses that
access is not available. Therefore cash management is vital for them. However, even large
corporations need to monitor their systems time and again to avoid a situation of bankruptcy.

International Project Appraisal

International project appraisal also known by a variety of names such as internal company
analysis, profiling the organization, capability or resource audit position and strategic
advantage analysis, is the process of evaluating a company’s posture relative to its business
competition within and outside the country, overall performance and its capability in terms of
strengths and weaknesses.

Significance of International Project Appraisal

1. The organization’s deficiency should also be compared with those of its successful
competitors. Such perceptive self appraisal when matched with environmental analysis
facilities management to grasp the opportunities and combat the threats inherent in the
environment.
2. International project appraisal has such a vital significance in international corporate
planning. Without such am-exercise it will not be possible to formulate economic strategy for
an organization on the objective basis.
3. It helps the management in choosing the most suitable niche for the organization.
4. Economic opportunities may bound in different parts of the globe.
5. Position audit of the organization highlights its distinctive capabilities on which empire
of foreign business can be gainfully built. It also enables management to formulate
suitable competitive strategy.
6. It focuses sharply on the areas where it is strong and can operate most [Link]
this kind analysis the management can decide on the type of business, company should
engage in a country and what business abandon.
7. It provides an insight into the weakness of the organization, through this way the
management can take steps to remove the weaknesses of the organization in the long run.

Steps in International Project Appraisal

With the intention of developing the strategic advantage profile of an organization the
management should first collect information from external or internal sources both from formal
as well as informal channels and then interpret as well as informal channels and then interpret
them incisively to determine its strengths and weaknesses. The following steps involved in
international project appraisal.

1. Identifying strategic factors: The first step in the process of corporate analysis is the
identification of all those factors which are crucial to the success of an international
organization. These factors may relate to different aspects of the organization. These factors
could conveniently be found in different functional areas such as marketing and finance
personal, research and development.
2. Determining the importance of factors: After identifying crucial factors for corporate
appraisal the management will have to determine the importance of each of these factors. Since
all the factors may not be of equal value to the organization for accomplishing its purpose it will
be very necessary to attach due importance to them.
3. Determining strengths and weaknesses: Once the relative significance of different
factors has been assessed the management should then attempt to determine the position of
the organization in each of these factors. Normally the strengths and weakness of a firm can
be assessed by with the firms own past results, comparing with accomplishment of competitors
and also by comparing with what they ought to be.
4. Constructing strategic advantage profile of a firm: After weighing the significance of each
factor for the company in its environment, the management compiles a strategic advantage
profile for the firm and compares it with profiles successful competitors of the potential of host
countries to develop a pattern of the firms strengths and weaknesses relative to its present and
proposed product market strategy.

Net Present Value

A project's net present value is determined by summing the net annual cash flow, discounted
at the project's cost of capital and deducting the initial outlay. Decision criteria is to accept a
project with a positive net present value. Advantages of this method are that it reflects the
time value of money and maximizes shareholder's wealth. Its weakness is that its rankings
depend on the cost of capital; present value will decline as the discount rate increases.

Payback Method
A company chooses the expected number of years required to recover an original investment.
Projects will only be selected if initial outlay can be recovered within a predetermined period.
This method is relatively easy since the cash flow doesn't need to be discounted. Its major
weakness is that it ignores the cash inflows after the payback period, and does not consider
the timing of cash flows.

Internal Rate of Return

This method equates the net present value of the project to zero. The project is evaluated by
comparing the calculated Internal rate of return to the predetermined required rate of return.
Projects with Internal rate of return that exceed the predetermined rate are accepted. The
major weakness is that when evaluating mutually exclusive projects, use of Internal rate of
return may lead to selecting a project that does not maximize the shareholders' wealth.
Profitability Index
This is the ratio of the present value of project cash inflow to the present value of initial cost.
Projects with a Profitability Index of greater than 1.0 are acceptable. The major disadvantage
in this method is that it requires cost of capital to calculate and it cannot be used when there
are unequal cash flows. The advantage of this method is that it considers all cash flows of the
project.
What is country risk assessment?

Country risk assessment, also known as country risk analysis, is the process of determining a
nation's ability to transfer payments. It takes into account political, economic and social
factors, and is used to help organisations make strategic decisions when conducting business
in a country with excessive risk.

Different types of country risk

Country risk assessments are generally segregated into different categories, which take a
closer look at some of the factors we mentioned prior. Let's discuss some of the most
common and what they mean, so you can determine how they might impact your clients'
transactions and, thus, premiums on TCI products.

1. Political risk

Political risk determines a country's political stability, either internally or externally. For
instance, a recent military coup would increase a nation's internal political risk for businesses
as rules and regulations suddenly shift. Other risks in this category could include war,
terrorism, corruption and excessive bureaucracy (i.e. host government red tape is preventing
certain fund transfers or other transactions).

Political risk can affect a country's attitude to meeting its debt obligations and may cause
sudden changes in the foreign exchange market.

2. Sovereign risk

There is some crossover between political and sovereign risk, although the latter – also
known as sovereign default risk – primarily examines debt. Specifically, this risk category
measures the build up of debt that is the obligation of a government or its agencies (or that is
guaranteed by the government), and how much said government is anticipated to fulfil these
obligations.

For example, if a government agency refuses to carry out debt refunding, this could impact
local lenders and lead to losses. This would of course have roll-on effects to local businesses
and anyone undertaking trade with them.
3. Neighbourhood risk

Neighbourhood risk, also known as location risk, may not be the direct fault of the country
with which your clients are dealing, but instead is caused by trouble elsewhere. This can have
spillover effects on other sovereign nations, creating turmoil in the foreign market or putting
pressure on local lenders and businesses.

Neighbourhood risk can be caused by:

• Geographic neighbours.

• Trading partners.

• Co-members of certain institutions or organisations.

• Strategic allies.

• Nations with similar perceived characteristics.

4. Subjective risk

Subjective risk is not a term that is used everywhere, but it measures factors that are common
to most risk assessments – and could greatly impact foreign business owners trading with a
host nation. Subjective risk is about attitudes, and can include social pressures and consumer
opinions – whether to certain types of goods or certain types of enterprise.

5. Economic risk

Economic risk encompasses a wide range of potential issues that could lead a country to
renege on its external debts or that may cause other types of currency crisis (i.e. recession). A
major factor here is economic growth – the health of a nation's GDP and the outlook for its
future. For instance, if a country relies on a few key exports and the prices for these are
dropping, this creates a negative outlook and may increase the economic risk for foreign
trading partners.
Acts of government may also impact economic risk, such as intervention in the money market
or policy changes that cause tax instability. One other factor is issues with foreign currency
exchange, for instance a shortage in certain currencies or a devaluation of the exchange rate.

6. Exchange risk

Any predicted loss created by sudden changes in exchange rate are generally covered under
the exchange risk factor. This is another all-encompassing term as fluctuations in the foreign
exchange can be caused by a wide variety of factors. Economic and political factors such as
those mentioned above can be significant drivers of exchange risk, although currency
reserves, interest rates and inflation are also potential factors.

One example of political change that can harm economic risk is a change in currency regime,
for example from fixed regime to floating.

7. Transfer risk

The final country risk assessment factor we'll discuss today is transfer risk. This is where the
host government becomes unwilling or unable to permit foreign currency transfers out of the
nation. Sweeping controls such as these may be a side effect of a nation in crisis attempting
to prevent creditor panic turning into significant capital outflow. A major example of this
occurring is the Malaysia credit controls after the 1997-98 Asian currency crisis.

Regardless of cause, capital control can prevent foreign traders from retrieving profits or
dividends from the host country.

Rating a Risk
Once you have identified the hazards in your business you need to rate the risk. The rating
will determine whether or not it is safe enough to continue with the work or whether you need
to adopt additional Control Measures to reduce or eliminate the risk still further.

The rating depends upon the likelihood of an event occuring (from most unlikely to most
likely) and the severity of the injuries that might arise if the event does occur (from trivial
injuries to major injuries).
You can do what is called a Qualitative Risk Rating which means you can simply decide
whether the risk is minimal, low, medium or high. Generally this short hand form of risk rating
is used to determine which hazard should take priority over another in terms of deciding what
to do and when.
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To calculate a Quantative Risk Rating, begin by allocating a number to the Likelihood of the
risk arising and Severity of Injury and then multiply the Likelihood by the Severity to arrive at
the Rating. The number to be allocated is set out in the table below.
Example:
A Most Unlikely Event [1] x Trivial Injuries if event occurs [1] = Risk Rating of [1] Minimal Risk
(1x1=1)
A Likely Event [3] x Major Injuries if event occurs [4] = Risk Rating of [12] High Risk (3x4=12)

When you allocate the Rating you do so after taking into consideration any safety measures –
called Control Measures – that you already have in place to reduce the hazard and any
safety measure which you say you will put into place.

Risk assessment

From Wikipedia, the free encyclopedia

Broadly speaking, a risk assessment is the combined effort of 1. identifying and analyzing
potential (future) events that may negatively impact individuals, assets, and/or the
environment (i.e., risk analysis); and 2. making judgments "on the tolerability of the risk on the
basis of a risk analysis" while considering influencing factors (i.e., risk evaluation).[1][2]Put in
simpler terms, a risk assessment analyzes what can go wrong, how likely it is to happen, what
the potential consequences are, and how tolerable the identified risk is.[1] As part of this
process, the resulting determination of risk may be expressed in
a quantitative or qualitative fashion. The risk assessment is an inherent part of an overall risk
management strategy, which attempts to, after a risk assessment, "introduce control
measures to eliminate or reduce" any potential risk-related consequences.[1][2]

Economic Indicators for Global Investors

Economic indicators help investors and analysts assess investment opportunities or
entire economies as a whole. From gross domestic products (GDPs) to consumer price
indices (CPIs), there are a number of data points that can help global investors predict
changes in a country's economy and strategically adjust their portfolios.
For example, suppose an international investor has generated healthy returns over the past
several years from Brazilian equities. An investor that tracks the consumer price index may
notice that inflation is rising, which means the central bank may decide to hike interest rates.
Knowing that interest rate hikes tend to hurt equities, the investor may reduce his holdings.

1. Gross Domestic Product

GDP represents the market value of all final goods and services produced within a country
during a given period. The figure is usually given in nominal and real formats, with real GDP
adjusting for changes in monetary value. Given its vast breadth, this indicator is among the
most watched by the financial markets.

The expansion of a country's GDP is indicative of a growing economy, while a contraction in

GDP indicates a slowdown in a country's economy. Meanwhile, a country's projected GDP
growth rate can be used to determine an appropriate level of sovereign debt or determine if
companies operating within the country are likely to experience growth.

2. Employment Indicators
The productivity and wealth of a country's citizens is arguably the ultimate determiner of
economic success. Employment indicators, such as labor force, payroll, and unemployment
data estimate how many citizens are employed and whether they are making more or less
money than before.

The financial markets carefully watch these employment indicators, especially in developed
countries that generate most of their income from domestic consumer spending. A fall in
employment is often followed by a fall in consumer spending, which can hurt GDP statistics
and overall economic growth prospects.

3. Consumer Price Index

CPI measures changes in the prices of consumer goods and services that are purchased by
households. The index is a statistical estimate created by using prices from a sample of
representative items collected periodically. Often times, this measure is used as a gauge
of inflation, which can positively or negatively affect a country's currency.

The financial markets carefully watch CPI figures for signs of inflation. Rising inflation can
lead to higher interest rates and reduced lending, while deflation can lead to lower interest
rates and greater lending.

4. Central Bank Minutes

Central banks create monetary policy and exert significant control over a country's economy.
Consequently, the financial markets tend to listen closely to every word that central bankers
utter publicly for clues about the future. Central bank minutes are formal releases that contain
valuable economic commentary that can signal future policy action.

In the U.S., the Federal Reserve issues what's called the Beige Book, which contains
anecdotal information about current economic conditions from each Federal Reserve Bank.
Similar notes are released by many other central banks, including the Bank of
Japan, European Central Bank (ECB), and others on a regular or semi-regular schedule.
5. PMI Manufacturing & Services
The Purchasing Manager's Index (PMI) is an economic indicator developed by Markit Group
and the Institute for Supply Management. By polling businesses on a monthly basis, the index
reflects the acquisition of goods and services by purchasing managers. The two most
important surveys are the PMI Manufacturing and PMI Services indices.

The financial markets watch the PMI Manufacturing and PMI Services indices as key leading
economic indicators because companies stop purchasing raw materials when demand dries
up. This can indicate problems in an economy much before other reports like retail sales or
consumer spending.

What Is Valuation?
Valuation is the analytical process of determining the current (or projected) worth of an asset
or a company. There are many techniques used for doing a valuation. An analyst placing a
value on a company looks at the business's management, the composition of its capital
structure, the prospect of future earnings, and the market value of its assets, among other
metrics.
Fundamental analysis is often employed in valuation, although several other methods may be
employed such as the capital asset pricing model (CAPM) or the dividend discount model
(DDM).
The Two Main Categories of Valuation Methods

Absolute valuation models attempt to find the intrinsic or "true" value of an investment
based only on fundamentals. Looking at fundamentals simply means you would only focus on
such things as dividends, cash flow, and the growth rate for a single company, and not worry
about any other companies. Valuation models that fall into this category include the dividend
discount model, discounted cash flow model, residual income model, and asset-based model.

Relative valuation models, in contrast, operate by comparing the company in question to

other similar companies. These methods involve calculating multiples and ratios, such as the
price-to-earnings multiple, and comparing them to the multiples of similar companies.

For example, if the P/E of a company is lower than the P/E multiple of a comparable
company, the original company might be considered undervalued. Typically, the relative
valuation model is a lot easier and quicker to calculate than the absolute valuation model,
which is why many investors and analysts begin their analysis with this model.

Valuation Methods
There are various ways to do a valuation. The discounted cash flow analysis mentioned
above is one method, which calculates the value of a business or asset based on its earnings
potential. Other methods include looking at past and similar transactions of company or asset
purchases, or comparing a company with similar businesses and their valuations.

The comparable company analysis is a method that looks at similar companies, in size and
industry, and how they trade to determine a fair value for a company or asset. The past
transaction method looks at past transactions of similar companies to determine an
appropriate value. There's also the asset-based valuation method, which adds up all the
company's asset values, assuming they were sold at fair market value, and to get the intrinsic
value.

Sometimes doing all of these and then weighing each is appropriate to calculate intrinsic
value. Meanwhile, some methods are more appropriate for certain industries and not others.
For example, you wouldn't use an asset-based valuation approach to valuing a consulting
company that has few assets; instead, an earnings-based approach like the DCF would be
more appropriate.
Discounted Cash Flow Valuation

Analysts also place a value on an asset or investment using the cash inflows and outflows
generated by the asset, called a discounted cash flow (DCF) analysis. These cash flows are
discounted into a current value using a discount rate, which is an assumption about interest
rates or a minimum rate of return assumed by the investor.

If a company is buying a piece of machinery, the firm analyzes the cash outflow for the
purchase and the additional cash inflows generated by the new asset. All the cash flows are
discounted to a present value, and the business determines the net present value (NPV). If
the NPV is a positive number, the company should make the investment and buy the asset.

Key Principles of Business Valuation

The following are the key principles of business valuation that business owners who want to
create value in their business must know.

1. The value of a business is defined only at a specific point in time.

The value of a privately-held business usually experiences changes every single day. The
earnings, cash position, working capital, and market conditions of a business are always
changing. The valuation prepared by business owners a few months or years ago may not
reflect the true current value of the business.
The value of a business requires consistent and regular monitoring. This valuation principle
helps business owners to understand the significance of the date of valuation in the process
of business valuation.

2. Value primarily varies in accordance with the capacity of a business to generate

future cash flow
A company’s valuation is essentially a function of its future cash flow except in rare situations
where net asset liquidation leads to a higher value. The first key takeaway in the second
principle is “future.” It implies that historical results of the company’s earnings before the date
of valuation are useful in predicting the future results of the business under certain conditions.
The second key in this principle is “cash flow.” It is because cash flow, which takes into
account capital expenditures, working capital changes, and taxes, is the true determinant of
business value. Business owners should aim at building a comprehensive estimate of future
cash flows for their companies.
Even though making estimates is a subjective undertaking, it is vital that the value of the
business is validated. Reliable historical information will help in supporting the assumptions
that the forecasts will use.

3. The market commands what the proper rate of return for acquirers is
Market forces are usually in a state of flux, and they guide the rate of return that is needed by
potential buyers in a particular marketplace. Some of the market forces include the type of
industry, financial costs, and the general economic conditions.
Market rates of return offer significant benchmark indicators at a specific point in time. They
influence the rates of return wanted by individual company buyers over the long term.
Business owners need to be wary of the market forces in order to know the right time to exit
that will maximize value.

4. The value of a business may be impacted by underlying net tangible assets

This principle of business valuation measures of the relationship between the operational
value of a company and its net tangible value. Theoretically, a company with a higher
underlying net tangible asset value has higher going concern value. It is due to the availability
of more security to finance the acquisition and lower risk of investment since there are more
assets to be liquidated in case of bankruptcy.
Business owners need to build an asset base. For industries that are not capital intensive, the
owners need to find means to support the valuation of their goodwill.

5. Value is influenced by transferability of future cash flows

How transferable the cash flows of the business are to a potential acquirer will impact the
value of the company. Valuable businesses usually operate without the control of the owner. If
the business owner exerts a huge control over the delivery of service, revenue growth,
maintenance of customer relationships, etc., then the owner will secure the goodwill and not
the business. Such a kind of personal goodwill provides very little or no commercial value and
is not transferable.
In such a case, the total value of the business to an acquirer may be limited to the value of
the company’s tangible assets in case the business owner does not want to stay. Business
owners need to build a strong management team so that the business is capable of running
efficiently even if they left the company for a long period of time. They can build a stronger
and better management team through enhanced corporate alignment, training, and even
through hiring.

6. Value is impacted by liquidity

This principle functions based on the theory of demand and supply. If the marketplace has
many potential buyers, but there are a few quality acquisition targets, there will be a rise in
valuation multiples and vice versa. In both open market and notional valuation contexts, more
business interest liquidity translates into more business interest value.
Business owners need to get the best potential purchasers to the negotiating table to
maximize price. It can be achieved through a controlled auction process.

VALUATION TECHNIQUES OVERVIEW

of Investment Banking Technical Training
Investment banks perform two basic, critical functions for the global marketplace. First,
investment banks act as intermediaries between those entities that demand capital (e.g.
corporations) and those that supply it (e.g. investors). This is mainly facilitated through debt
and equity offerings by companies. Second, investment banks advise corporations on mergers
& acquisitions (M&A), restructurings, and other major corporate actions. The majority of
investment banks perform these two functions, although there are boutique investment banks
that specialize in only one of the two areas (usually advisory services for corporate actions like
M&A).
In providing these services, an investment bank must determine the value of a company. How
does an investment bank determine what a company is worth? In this guide you will find a
detailed overview of the valuation techniques used by investment bankers to facilitate these
services that they provide.
In this chapter we will cover two primary topic areas:
• How do bankers determine how much a company is worth—in other words, what
valuation techniques are typically used?
• What are the advantages and disadvantages of each valuation technique,
and when should which technique be used?
Valuation Techniques: Overview
While there are many different possible techniques to arrive at the value of a company—a lot
of which are company, industry, or situation-specific—there is a relatively small subset of
generally accepted valuation techniques that come into play quite frequently, in many different
scenarios. We will describe these methods in greater detail later in this training course:
• Comparable Company Analysis (Public Comps): Evaluating other, similar
companies’ current valuation metrics, determined by market prices, and applying them to the
company being valued.
• Discounted Cash Flow Analysis (DCF): Valuing a company by projecting its future cash
flows and then using the Net Present Value (NPV) method to value the firm.
• Precedent Transaction Analysis (M&A Comps): Looking at historical prices for completed
M&A transactions involving similar companies to get a range of valuation multiples. This
analysis attempts to arrive at a “control premium” paid by an acquirer to have control of the
business.
• Leverage Buyout/“Ability to Pay” Analysis (LBO): Valuing a company by assuming the
acquisition of the company via a leveraged buyout, which uses a significant amount of
borrowed funds to fund the purchase, and assuming a required rate of return for the
purchasing entity.
These valuation techniques are easily the most commonly used, other than in valuations for
specific, niche industries such as oil & gas or metal mining (and even in those industries, the
aforementioned valuation techniques frequently come into play). Different parts of the
investment bank will use these core techniques for different needs in different circumstances.
Frequently, however, more than one technique will be used in a given situation to provide
different valuation estimates, with the concept being to triangulate a company’s value by looking
at it from multiple angels.
For example, M&A bankers are typically most interested in Transaction and Comparables
valuation for acquisition and divestiture. Equity Capital Markets (ECM) bankers underwrite
company shares in the public equity markets in advance of an initial public offering (IPO) or
secondary offering, and thus rely heavily on Comparables valuation. Financial sponsors and
leveraged finance groups will almost always value a company based upon leveraged buyout
(LBO) transaction assumptions, but will also look at others. Also, in many cases, all of these
groups will employ some degree of DCF valuation analysis. These different divisions of an
investment bank may come up with similar valuation ranges using some subset of the
techniques given, but will approach this process often with entirely different goals in mind.
Thus all of these techniques are used routinely by investment banks, and for a banking analyst,
at least some degree of familiarity with all of these techniques must be achieved in order for
that analyst to be considered proficient at his or her job.
When To Use Each Valuation Technique
All of the valuation techniques listed earlier should be practiced by a junior banker, but some
may be more applicable than others, given the group, the client, and the exact situation.
COMPARABLE COMPANY ANALYSIS
The Comparable Company valuation technique is generally the easiest to perform. It requires
that the comparable companies have publicly traded securities, so that the value of the
comparable companies can be estimated properly. We will detail the calculation process for
Comparable Company analysis later in this guide.
The analysis is best used when a minority (small, or non-controlling) stake in a company is
being acquired or a new issuance of equity is being considered (this also does not cause a
change in control). In these cases there is no control premium, i.e., there is no value accrued
by a change in control, wherein a new entity ends up owning all (or at least the majority) of the
voting interests in the business, which allows the owner to control the company cleanly. With
no change of control occurring, Comparable Company analysis is usually the most relied-upon
technique.
DISCOUNTED CASH FLOW ANALYSIS (DCF)
A DCF valuation attempts to get at the value of a company in the most direct manner possible:
a company’s worth is equal to the current value of the cash it will generate in the future, and
DCF is a framework for attempting to calculate exactly that. In this respect, DCF is the most
theoretically correct of all of the valuation methods because it is the most precise.
However, this level of preciseness can be tricky. What DCFs gain in precision (giving an exact
estimate based on theory and computation), they often lose in accuracy (giving a true indicator
of the exact value of the company). DCFs are exceedingly difficult to get right in practice,
because they involve predicting future cash flows (and the value of them, as determined by the
discount rate), and all such predictions require assumptions. The farther into the future we
predict, the more difficult these projections become. Any number of assumptions made in a
DCF valuation can swing the value of the company—sometimes quite significantly. Therefore,
DCF valuations are typically most useful and reliable in a company with highly stable and
predictable cash flows, such as an established Utility company.
Because DCFs are so difficult to “get perfect,” they are typically used to supplement
Comparable Companies Analysis and Precedent Transaction Analysis (discussed next).
PRECEDENT TRANSACTION ANALYSIS
The Precedent Transaction valuation technique is also generally fairly easy to perform. It does
require that the specifics of a prior acquisition/divestiture deal are known (price per share,
number of shares acquired or spun off, amount of debt assumed, etc.), but this is usually the
case if the target (acquired company) had publicly traded instruments prior to the transaction.
In some industries, however, relatively few truly comparable M&A transactions have occurred
(or the acquisitions were too small to have publicized deal details), so the Precedent
Transaction analysis maybe be difficult to conduct.
If the buyer acquires a majority stake in a company (or similarly, when a controlling stake in a
business is divested), a Precedent Transaction analysis is almost always the theoretically
correct Comparable Company analysis to perform. Why do we use Precedent Transactions
analysis in this scenario? Because when a majority stake is purchased, the buyer assumes
control of the acquired entity. By having control over the business, the buyer has more flexibility
and more options about how to create value for the business, with less interference from other
stakeholders. Therefore, when control is transferred, a control premium is typically paid.
Precedent Transactions are designed to attempt to ascertain the difference between the value
of the comparable companies acquired in the past before the transaction vs. afterthe
transaction. (In other words, the analyst determines the difference between the market value of
the company before the transaction is announced vs. the amount paid for the company in a
control-transferring purchase.) This difference represents the premium paid to acquire the
controlling interest in the business. Thus when a change of control is occurring, Precedent
Transaction analysis should typically be one of the valuation methods used.
We will detail the calculation process for Precedent Transaction analysis later in this guide.
LEVERAGE BUYOUT ANALYSIS (LBO)
Another possible way to value a company is via LBO analysis. LBOs are typically used by
“financial sponsors” (private equity firms) who are looking to acquire companies inexpensively
in the hopes that they can be sold at a profit in several years. In order to maximize returns from
these investments, LBO firms generally try to use as much borrowed capital (debt financing) as
possible to fund the acquisition of the company, thereby minimizing the amount of equity capital
that the sponsor itself must invest (equity financing). Assuming that the investment makes a
profit, this debt leverage maximizes the return achieved for the sponsors’ investors.
There are three possible approaches to take in running an LBO analysis for a target company:
1. Assume a minimum required return for the financial sponsor plus an appropriate
debt/equity ratio, and from this impute a company value.
2. Assume a minimum required return for the financial sponsor plus an appropriate company
value, and from this impute the required debt/equity ratio.
3. Assume an appropriate debt/equity ratio and company value, and from this compute the
investment’s expected return.
Usually the first analysis is performed by investment bankers. If the value of the company is
unknown (as is usually the case), then the goal of the LBO exercise is to determine that value
by assuming an expected return for a private equity investor (typically 20-30%) and a feasible
capital structure, and from that, determining how much the company could be sold for (and
thereby still allow the financial sponsor to achieve that required return). If the expected sale
price/value of the company is known (for example, if a bid on the company has been proposed),
then the primary goal of performing an LBO analysis is to determine the best possible returns
scenario given that value. (Bankers will often use LBO analysis to determine whether a higher
valuation from private equity investors is possible, again using the first analysis.)
LBO analysis can be quite complex to perform, especially as the model gets more and more
detailed. For example, different assumptions about the capital structure can be made, with
increasing layers of refinement, to the point where each individual component of the capital
structure is being modeled over time with a host of tranche-specific assumptions and features.
That said, a simple, standard LBO model with generic, high-level assumptions can be put
together fairly easily.
Unfortunately, LBO valuations can be highly subject to market conditions. In a poor market
environment (periods of low capital markets activity, high interest rates, and/or high credit
spreads for High Yield bond issuances), this type of transaction is difficult to use. Hence LBO
investing is highly cyclical depending upon market forces.
Check out our Private Equity Training Course for much more detail on conducting LBO analysis.
Valuation Technique Advantages and Disadvantages
Each valuation method naturally has its own set of advantages and disadvantages. Some are
more reliable and accurate, while others are easier to perform, for example. Additionally, some
valuation methods are specifically indicated in certain circumstances. Here are the main Pros
and Cons of each method:
COMPARABLE COMPANY ANALYSIS
• Pro: Market efficiency ensures that trading values for comparable companies serve as a
reasonably good indicator of value for the company being evaluated, provided that the
comparables are chosen wisely. These comparables should reflect industry trends, business
risk, market growth, etc.
• Pro: Values obtained tend to be most reliable as an indicator of value of the company
whenever a non-controlling (minority) investment scenario is being considered.
• Con: No two companies are perfectly alike, and as such, their valuations generally should
not be identical either. Thus comparable valuation ratios are often an inexact match. Also,
 for some companies, finding a decent sample of comparables (or any at all!) can be very
challenging. As a result in Comparable Companies analysis are always running the risk of
“comparing apples to oranges,” never being able to find a true comparable, or simply having
an insufficient set of comparable valuations from which to draw.
• Con: Illiquid comparable stocks that are thinly traded or have a relatively small percentage
of floated stock might have a price that does not reflect the fundamental value of that
company.
DISCOUNTED CASH FLOW (DCF) ANALYSIS
• Pro: Theoretically the most sound method if one is very confident in the projections and
assumptions, because DCF values the individual cash streams (the actual source of the
company’s value) directly.
• Pro: DCF method is not heavily influenced by temporary market conditions or non-economic
factors.
• Con: Valuation obtained is very sensitive to modeling assumptions—particularly growth rate,
profit margin, and discount rate assumptions—and as a result, different DCF analyses can
lead to wildly different valuations.
• Con: DCF requires the forecasting of future performance, which is very subjective, and most
of the value of the company is usually derived from the “terminal value,” which is the set of
cash flows that occurs after the detailed projection period (and is therefore usually projected
in a very simple way).
PRECEDENT TRANSACTION/PREMIUM PAID ANALYSIS
• Pro: Generally regarded as the best valuation tool for control-transferring transactions
because the previous transaction has validated the valuation (in other words, a precedent has
been established, whereby a previous buyer has actually paid the amount specified in the
precedent transaction).
• Pro: Assuming that the required transaction data is available/public information, precedent
transactions are typically an easy analysis to perform.
• Con: The valuation multiples found in prior transactions typically include control premium
and synergy assumptions, which are not public knowledge and are often transaction-specific.
These assumptions are not always achievable by other market participants conducting a
new transaction.
• Con: Precedent Transaction valuations are easily influenced by temporary market
conditions, which fluctuate over time. For example, a prior transaction might have been
conducted in a more favorable environment for debt or equity issuance.
LEVERAGE BUYOUT (LBO) ANALYSIS
• Pro: An excellent means to establish a “floor” valuation—i.e., an LBO analysis will
determine the amount that a financial buyer (sponsor) would be willing to pay for the company,
thereby determining the value that a strategic bidder will have to exceed.
• Pro: LBO valuation is realistic, as it does not require synergies to achieve (financial buyers
usually do not have synergy opportunities).
• Con: Ignoring synergies could result in an underestimated valuation, particularly for a well-
fitting strategic buyer.
• Con: The valuation obtained is very sensitive to operating assumptions (growth rate,
operating working capital assumptions, profit margins, etc.) and financing cost assumptions
(and thus LBO valuation is dependent upon the quality of the prevailing financing market
conditions).
Capital Asset Pricing Model – CAPM

What is the Capital Asset Pricing Model - CAPM

The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk
and expected return for assets, particularly stocks. CAPM is widely used throughout finance
for pricing risky securities and generating expected returns for assets given the risk of those
assets and cost of capital.
DCF Analysis: Calculating the Discount Rate All financial theory is consistent here: every time
managers spend money they use capital, so they should be thinking about what that capital
costs the company. There can be many sources of capital, and the weighted average of those
sources is called WACC (Weighted Average Cost of Capital). For most companies it’s just a
weighted average of debt and equity, but some could have weird preferred structures etc so it
could be more than just two components.
To calculate WACC, one multiples the cost of equity by the % of equity in the company’s
capital structure, and adds to it the cost of debt multiplied by the % of debt on the company’s
structure. Because interest in debt is a pre-tax expense, the cost of debt is reduced by the tax
rate (it’s effectively tax deductible).
The formula is

Ke = the cost of equity. This comes from the Capital Asset Pricing Model (CAPM), described
below.
Kd = cost of debt. This is the average interest rate on the company’s debt. To be completely
correct, it’s the coupon divided by the market value of debt, since the value of company bonds
fluctuates, but generally this is too complicated for the exercise at hand and, unless the
company is in distress, just looking at the book value is close enough.
T = corporate tax rate. The right number to use is the marginal tax rate since you’re trying to
make a marginal decision, and that’s typically 35% in the US.
Ve = value of equity. Company market cap less cash plus debt. For a private company, best
estimate – probably based on last round price.
Vd = value of debt. As described before, the proxy is book value.
Simplifying this for Startups
For most startups, equity is the primary method of financing, so it may be helpful to simplify
things and state that WACC equals Ke (the cost of equity), which effectively also means that
the Discount Rate should be equal to Ke.

Computing the Cost of Equity – The Capital Asset Pricing Model (CAPM)
The cost of equity, Ke, comes from the CAPM. What investors expect to earn on their
investment in the stock. If they conclude they won’t get this return they’ll sell the stock and the
price will go down, if they conclude they’ll get more than this return additional investors will
buy the stock and the price will go up, eventually driving the return to Ke in equilibrium.
The basic CAPM formula for Ke is
• Rf = Risk free rate of return. A good proxy is a US government bond of a duration
that’s commensurate with the time frame an investor would think of when owning the
stock. The 5 year T-bill is a good proxy. Today the 5 year T-bill yields 1.7%, the 10 year 2.2%,
so a 2% risk free rate is a good proxy.
• B (Beta) = Sensitivity of the expected stock return to the market return. Have to use
history to estimate. Mathematically it’s the covariance of the historical return of this particular
stock and the market divided by the variance of the market. So B = Cov (Rs, Rm)/Var(Rm).
The best way of getting at this is to look at the beta of similar public stocks. For public SaaS
companies, the beta today seems to be about 1.3.
• Rm = Market rate of return – what the investors expect the market to return. The public
markets have returned around 8% per year over the last decade, and one would think that
that’s a reasonable rate expected by investors. There could be different opinions (for
example the 5 year rate of return is a lot higher). If a company is private, one would expect a
much higher rate of return.
Plugging all this in for a SaaS company, one would get
Ke = 2% + 1.3 (8% – 2%) = 9.8% ~ 10% for a public SaaS company.
For a private, or higher risk company, Ke will depend on the assumption on Rm (the market
rate of return). Reality is this is highly volatile and situation specific – sometimes one can
raise cheap money and sometimes one can not. While a lot of situational judgment should be
applied, Cambridge Associates, which tracks the stronger venture firms, claims a 30 year
venture return of 17.7%, and that’s probably the best proxy.
So for a private SaaS company one could assume
Ke = 2% + 1.3 (17.7% – 2%) = 22.4% ~ 20% would be a good estimate to use
For reference our Beta calculation came from averaging Google Finance Betas for a selection
of public SaaS companies:
• [Link] – 1.33
• Workday – 1.53
• ServiceNow – 1.11
• Netsuite – 1.5
• LogMeIn – .96
• Liveperson – 1.35
• Demand ware – 1.31.
The newer SaaS public cos (ZEN, HUBS, MKTO) haven’t been public long enough to
calculate a good Beta.

Introduction to the DCF Model

A discounted cash flow model ("DCF model") is a type of financial model that values a
company by forecasting its' cash flows and discounting the cash flows to arrive at a current,
present value. The DCF has the distinction of being both widely used in academia and in
practice. Valuing companies using the DCF is considered a core skill for investment
bankers, private equity, equity research and "buy side" investors.
The DCF model estimates a company’s intrinsic value (value based on a company's ability to
generate cash flows) and is often presented in comparison to the company's market value.
For example, Apple has a market capitalization of approximately $909 billion. Is that market
price justified based on the company's fundamentals and expected future performance (i.e. its
intrinsic value)? Thatis exactly what the DCF seeks to answer.
In contrast with market-based valuation like a comparable company analysis, the idea behind
the DCF model is that the value of a company is not a function of arbitrary supply and
demand for that company's stock. Instead, the value of a company is a function of a
company's ability to generate cash flow in the future for its shareholders.

6 steps to building a DCF

The premise of the DCF model is that the value of a business is purely a function of its future
cash flows. Thus, the first challenge in building a DCF model is to define and calculate the
cash flows that a business generates. There are two common approaches to calculating the
cash flows that a business generates.
1. Unlevered DCF approach
Forecast and discount the operating cash flows. Then, when you have a present value, just
add any non-operating assets such as cash and subtract any financing related liabilities such
as debt.
2. Levered DCF approach
Forecast and discount the cash flows that remain available to equity shareholders after cash
flows to all non-equity claims (i.e. debt) have been removed.
Both should theoretically lead to the same value at the end (though in practice it's actually
pretty hard to get them to exactly equal). The unlevered DCF approach is the most common
and is thus the focus of this guide. This approach involves 6 steps:
1. Forecasting unlevered free cash flows
Step 1 is to forecast the cash flows a company generates from its core operations after
accounting for all operating expenses and investments. These cash flows are called
"unlevered free cash flows."
2. Calculating terminal value
You can't keep forecasting cash flows forever. At some point, you must make some high level
assumptions about cash flows beyond the final explicit forecast year by estimating a lump-
sum value of the business past its explicit forecast period. That lump sum is called the
"terminal value."
3. Discounting the cash flows to the present at the weighted average cost of capital
The discount rate that reflects the riskiness of the unlevered free cash flows is called
the weighted average cost of capital. Because unlevered free cash flows represent all
operating cash flows, these cash flows “belong” to both the company’s lenders and owners.
As such, the risks of both providers of capital need to be accounted for using appropriate
capital structure weights (hence the term “weighted average” cost of capital). Once
discounted, the present value of all unlevered free cash flows is called the enterprise value.
4. Add the value of non-operating assets to the present value of unlevered free cash
flows
If a company has any non-operating assets such as cash or has some investments just sitting
on the balance sheet, we must add them to the present value of unlevered free cash flows.
For example, if we calculate that the present value of Apple’s unlevered free cash flows is
$700 billion, but then we discover that Apple also has $250 billion in cash just sitting around,
we should add this cash.
5. Subtract debt and other non-equity claims
The ultimate goal of the DCF is to get at what belongs to the equity owners (equity
value). Therefore if a company has any lenders (or any other non-equity claims against the
business), we need to subtract this from the present value. What’s left over belongs to the
equity owners.
In our example, if Apple had $50 million in debt obligations at the valuation date, the equity
value would be calculated as:
$700 billion (enterprise value) + $200 billion (non-operating assets) - $50 (debt) = $850 billion
Often, the non-operating assets and debt claims are added together as one term called net
debt (debt and other non-equity claims – non-operating assets). You’ll often see the
equation: enterprise value – net debt = equity value. The equity value that the DCF spits out
can now be compared to the market capitalization (that’s the market’s perception of the equity
value).
6. Divide the equity value by the shares outstanding
The equity value tells us what the total value to owners is. But what is the value of each
share? In order to calculate this, we divide the equity value by the company’s diluted shares
outstanding.