Assessing of a Multinational Company Essay Example Pdf

A multinational company as stated by Madura (2010) is ‘a firm that engages in some sort of international businesses’, with globalization and diversification of multinational firms comes along with it certain exposures such as country risk and political risk along with certain financial risk. Multinational firm do face greater risk in such environment compared to domestic firms as they raise capital in one country because of low cost of capital and invest in another country and also produce goods in one country to be sold in different countries. The business of multinational companies carries with it certain types of risk while trading with different countries; The risk associated with multinational firms in contrast to domestic firms are global economic exposure, political risk, actions of host country, economic risk, exchange rate risk, cultural risk, operational risk, transaction risk, translation risk. Economic risk is a concern for multinational firms as fundamental changes of economic policy can be constraints to them and hamper their anticipated profit from the investment, which is also suggested by Glantz and Jonathan (2008) as the significant change in growth rate or in the economic structure that brings about a major change in return on investment than expected.

Madura and Fox (2007) states that high level of inflations can be unfavourable to business as it affect the buying power of consumers and which could lead to decline in economic growth of that country’. According to the World Bank, exchange rate risk is the unpredictability in the movements in exchange rate that results in the variability in the value of the investments’ (www.worldbank.org). This risk arises because of the value of investment varies with the exchange rate, if the foreign currency appreciates as at the time of remittance of profits by the subsidiary firm then the profit remitted will decrease for the parent company because of the exchange rate fluctuations. This risk is only of concern with those domestic companies who are dealing with foreign currency or doing a business of import or export. According to Apte (2006) transaction risk can be defined as ‘a measure of variability in the value of assets and liability when they are liquidated’. The important factor of concern is that transaction exposures usually have short time horizons and also the cash flows may be affected because of the effect of exchange rate movements. Other short term exposure in relation to it can be translation exposure which occurs. As noted by Buckley (2004) that, when the accounts of subsidiary firms are consolidated and the income or loss in foreign currency are translated home currency, then the consolidated profit will vary with the fluctuations in exchange rates. This risk is more of concern with accounting aspects and does not create much impact on overall economic value of the firm. With most multinational firms raising capital in one country and investing in another country carries a risk because if the firm is raising capital in The United Kingdom and makes investment in India because of better borrowing rate of interest at the time of investment and the interest rate increases more than anticipated then it can decrease the profitability of that investment because of the increase in interest payments. Similarly, a multinational firm also has to face operational issues and many a times has to abide or follow the dictates of the foreign country in setting up plant and also with employment of local people, which is not of any hindrance or issue for domestic companies. Rugman and Brewer (2001) notes political risk ‘as one of a component of the international or country level risk faced by multinational firms’. And Madura (2010) states that ‘subsidiary firms may be taken over by the Government of the host country in case of extreme form of political risk’, and local political factors of the host country can hinder the performance of the company. Political risk may be characterized as industry specific or being firm. Another major concern for multinational firms is the risk attached with certain country; country risk as defined by Calverley (1985) is, ‘the potential losses that can arise because of the problems which may occur due to the political or macro-economic factors in a country’. Much of the risk facing a company is related to the cyclical nature of the domestic economy of the home country. As multinational firms operates in different countries, the economic cycles are of those are not perfectly in the same phase, thus reduces the overall variability of the firms earnings.

Thus, even though the riskiness of operating in any single country may exceed the operating risk in the other host country, much of that risk is eliminated through diversification. According to Business International Corporation as cited by Rugman and Brewer (2001) refers country risk as “the exposure to either an outright loss or to an unanticipated lower earnings stream in cross border business, caused by economic, financial or socio-political events or conditions in a particular country that is not under the control of a private enterprise or individual”. This type of risk exposure generally refers to the uncertainty about the current conditions or about the future conditions within a country which causes inherent stability or uncertainty about the future. Cultural difference in the operations of firms can also be attributed to the business environment of certain countries and as suggest (b) Cosset and Suret (1995) states that ‘diversifying investment among politically risky countries not only improves risk return characters but also reduces overall risk in the business prospect of multinational firms’ as cited by Rugman and Brewer (2001). Although multinational firms are confronted with many additional risks when trading in different countries, but at the same time as a long term strategy , they can also take advantage of international diversification to reduce their overall riskiness through various foreign operations to cover up against foreign competitive intrusions in the domestic market and more closely monitor their international and domestic competitors, reducing the risk of being unaware by the new developments in different counties.

The diversification strategy helps multinational firms to reduce the total risk they face. But according to Mcrae (1996) ‘diversification of the investment portfolio is not the only approach to hedging the risk in foreign investments’ , political and economic risk is difficult to hedge but it can be dealt by using internal hedging techniques such as having the manufacturing unit in the host country, netting the payments and receipts. Madura (2010) is of the view that if the country risk is within the tolerable range to the enterprises, then the business prospect in that country needs to be given further observation as the risk of that country can be included in the capital budgeting and the firm can also increase the hurdle rate or discount rate to adjust with the level of risk perceived in that proposal. With the risk in international business for multinational firms, now they can avail insurance to cover the risk of expropriation of assets, ‘the U.S. Government provides such insurance through the Overseas Private Investment Corporation, the cost of business proposal may increase with the addition of insurance premium for multinational firms but with this strategy the a part of the firms total foreign exposure will be covered’ Madura (2010). McRae (1996) suggests that to mitigate the political risk of a country it is imperative to be a part of it, multinational firms can hire and train local people and utilize local resources to improve its image and reputation. The firm can give a boost to local talent by the virtue of providing training and recruiting them.

The firm can use the services of local industries for their business operations. Also, the firm can be part of the Government’s social initiatives and may support a part of it, which will portray the firm as being in good interest of the country and this will be a strong hedge against any Governmental interference in the firm’s business. Multinational firm’s investment projects are highly exposed to the risk of fluctuations in the exchange rates, ‘the term exchange rate refers to the situations in which movements in exchange rates changes the financial performance of firms, which are measures by the conventional financial statements or corporate cash flow’ (Dhanani 2003). When a multinational firm is exposed to the risk of unexpected changes, which is most likely to occur with countries with high inflations or instability of the foreign currency that may depreciate the value of the foreign currency in future, the multinational firm is exposed to risk of its future profits. The strategy for this type of risk to hedge the foreign currency and it can insure against exchange rate risk by selling the foreign currency futures as the firm will be antipating future profits to be remitted back to the parent company. Multinational firms can also borrow in foreign currency to cover this type of risk and also cover itself from local political and country risk as the prospect of the firm will also be a concern for the host country. Other strategy for multinational firm is to borrow foreign currency against its future earnings, sell the currency spot and at the same time make an investment of the money in the country of parent company. Other foreign exchange hedging technique would be to raise a loan in host country and the payment can be made from the payout of the business, the loan from the host country can also be used as additional liquidity in certain international market or make an investment in international money market. Also, the loan taken in the host country will cover the currency fluctuations as the funds generated from the local money market can be utilized in the investment in the same country, the advantage of it will be from the debt payment which can be made without the risk of currency fluctuation.

And as portrayed by Madura (2010) that ‘ in case of extreme form of political risk the host country Government can takeover the subsidiary firm, so if for any reason situation like that occur where the government would want to take over the firm, the local lending bank or institution will attempt to prevent that. Multinational firms also have option of availing project finance for international exposure, so that the firm’s exposure is limited as it will only invest a part of the equity in the project. The advantage of this strategy is that the firm is secured by the projects future revenues from the business on and as this type of arrangement are non recourse loan, the creditor banks or lending institution would not be able to pursue the multinational firms for payment but only the assets and cash flows of the multinational firms project can be taken over by the lenders. This arrangement also protects the firm from hostile takeovers by governments because of the credit arrangement; under credit arrangement like this, all the existing liabilities will have to be borne by the host government. A multinational firm can mitigate some risk involved due to fluctuations in exchange and interest rate risks by means of hedging strategies. A multinational firm can net out its exposure in foreign currencies by netting out its receivables with payables, to be able to use this strategy efficiently, multinational firms need to be regularly updated with the cash flow of the subsidiary firms. Multinational firms can use forward contracts to hedge its foreign currency exposures; it can sell forward its net inflow of foreign currency and buy forward the net outflow of foreign currency and removes all the uncertainty regarding the domestic currency value of the payable or receivable. As most multinational firms must have access to international money markets for short term borrowing and can also invest in the same market if it has additional funds. It can use the money market for hedging transaction exposure. It can also hedge with currency options, which provides more flexible method of covering the transaction exposure. A contracted foreign currency of a multinational firm can be hedge through purchase of a call option on the currency and the cash inflow can be hedge through the purchase of put option, as options are in particular significant where the cash flows are uncertain. Another strategy for multinational firms is hedging with currency futures, though it is similar to hedging with forward contracts in some respects but it differs because of the fundamental feature of future contracts.

The advantage of this strategy is the liquidity it brings with it and as the agreements are generally with banks and large corporate with good credit rating so the futures hedge are convenient for the parties to the agreement. Multinational firms can also mitigate interest rate exposures by entering into Forward rate agreements, as stated by Hull (2006) ‘it is a bilateral contract fixing the rate of interest that will apply to a notional principle sum of money for an agreed future time period’. In case of this agreement, the notional principal amount is never transferred among the parties but only the compensation or settlement amount is exchanged among the parties. Multinational firms can enter into Interest rate swap agreement to benefit from differences in interest rates, Winstone (1995) suggest it as “an agreement between two or more parties to swap obligations on two or more debt instruments or benefits on assets so that all can gain; an arrangement of swaping floating for fixed rate of interest among parties. It refers to the exchange between two parties of interest obligations (payments of interest) or receipts in the same currency on an agreed amount of notional principle for an agreed period of time, in the same currency”. A multinational firm can mitigate some risk involved due to fluctuations in exchange and interest rate risks by means of hedging strategies. Levi (2009) also states that a multinational firm is likely to be in a better position to avoid foreign exchange exposure than that of a domestic firm with local operations.

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