Investing in Ruritania

An Evaluation of Financial Issues Involved
Ruritania is one of the democratic nations situated in Eastern Europe.  Through this report, an attempt has been made to evaluate the significance of the proposal of  making investments in opening up a new manufacturing unit in Ruritania.  This being the first opportunity for the company to make a foreign investment, holds great importance for the company. Performance in this venture could decide the path for the organisation in becoming a multinational organisation from being a domestic company  as of today.  Expansion and globalisation  of this sort has its own advantages as well as challenges.

Advantages include comparative cost advantage in terms of labour cost, material cost, transportation cost, etc. Tax benefits received in destination countries is another advantage. Financial diversification in terms of spreading the firms risk over larger number of nations rather than limiting it to just one nation  is yet another motivation for acquiring a multinational character by a company. Moreover the  company hopes to establish a profound presence in the region through this project. The company would also be in a position to deny the markets to the companys global competitors.

However such investments  also has some problems in the areas of capital budgeting decisions, which are seldom encountered in domestic enterprises. International firms have to deal with various issues among others, such as exchange rate risk, expropriation risk, blocked funds, foreign tax regulations, political risk, differences between basic business risks of foreign and domestic projects, FDI allowance regulations, tariff  non tariff trade barriers posed by the target nation, monetary policy of the country, remittance limits set by the country, country risk or sovereign risk, corruption level in the country, costs of sustainability goal obligations if any, set by the government of the country, interest risk on loans taken both domestically as well as internationally, market risk, risks arising due to violence, agitations, unrests, environmental calamities and others.

The choice of eastern Europe as a destination for expansion, needs to be studied. Other developed export driven economies like Germany  France already rely heavily on the eastern European countries to satisfy their globalisation aspirations. This however has added pressure on these not yet developed economies. Vistesen and Hugh (2009) point out that an extraordinarily high inward flow of funds into these countries in the form of FDI, combined with a high outflow of labour through migration leads to the incapability of these countries in catering to the rising credit driven consumer demand and high growth rate needs particularly due to the lack of enough labour supply. Therefore before investing in these countries, it is important to predict whether these nations would be able to deal with this peculiar situation.

The concerned data available for these economies (International Monetary Fund 2009) have been tabulated as below.
Data for 2008Size of GDP
(Billions US )GDP annual percent growth rateGDP per capita ()Rate of InflationMajor trade partnersCountriesArmenia11.916.78 3684.555.2 Germany, Netherland, Belgium, RussiaAzerbaijan46.37811.63 5349.39115.4 Italy, Czech Republic, UK, RussiaBelarus60.30210.02 6234.68613.3 Russia, Latvia, Ukraine, UK.Bulgaria49.9046.01 6560.7237.18 Germany, Turkey, Italy, Greece.Georgia12.8642.06 2923.5455.55 CIS countries, TurkeyMaldova6.0477.2 1692.5477.3 Russia, Romania, Ukraine, GermanyRomania200.0747.1 9310.3866.3 EU, Russia, ChinaUkraine179.6042.1 3909.87322.34 EU, CIS, China, USRuritania-3.2 -5.2 -

From the above table we can observe that the GDP growth rate of Ruritania at 3.2  is lower than all of its neighbours excepting that  of Ukraine and Georgia. Its inflation rate at 5.2  is also lower than the average of the countries of the region.  However, the recent recession has turned the picture, and fast growing economies have shown deeper signs of recession in 2009.  We may conclude that Ruritania has not yet fully exploited its potential if it has any,  and these figures must be taken into account while reaching to any decision about making investments in Ruritania. Moreover UK is a major trade partner for most of the nations in the region.

It is pertinent to note that Ruritanias government is systematically doing enough groundwork by pegging the Crown with a major currency at this point of time. Its intention to join Exchange Rate Mechanism (ERM 2) would link Crown to the Euro, thus helping the European Union to evaluate the proposed inclusion of Ruritania into the Eurozone. Inclusion of Ruritania in the Eurozone, would mean having a free access to the markets of Ruritania which would prove to be a great boon to the company in the event of the company having a manufacturing facility in the country.

In spite of the evident bright future prospects,  it would be prudent if several other factors were taken into  consideration before going ahead with the investment

Incremental Cash Flows  Any project has its cash outflows and inflows. In order that a foreign capital budgeting project be evaluated correctly, it is important to calculate the incremental Cash Flows After Taxes (CFAT) that the project eventually has. This incremental CFAT is distinct from total CFAT and essentially involves the use of cash outflows and inflows, that can be exclusively and wholly identified with the proposed project. Thus the firms profits should be reduced with decrease in the cash profits due to decrease in export sales of the parent company, costs of technology transfer, shipping charges, custom duties, training costs, repatriation costs, and opportunity costs involved. On the other hand, dividends received from the subsidiary, management fees, royalties received, increase in cash profits of the parent company due to the increase in export sales to the subsidiary and others should be added to this amount to arrive at the correct decision.

Transfer Pricing policies  This area needs great emphasis and diligence because of the complex set of interests involved in this type of a decision. Factors influencing transfer pricing include, minimising income taxes, achieving goal congruence, tariffs and customs duties levied on imports of products into a country,  restrictions that some countries place on dividend or income related payments to parties outside their national borders (Horngren, Datar and Foster 2006, p.776). In countries having high income taxes, and high restrictions on profit repatriation to outside countries, subsidiaries may keep the prices of their products low while selling to the parent company.  This would also help minimise import duties and tariff payments of the parent company if such duties levied  in home country of the parent company are too high. Prices can be kept high for products of subsidiaries located in countries having low income taxes, and minimum restrictions on repatriation amounts. This would help minimise income taxes paid by the parent company. However, performance measurement and evaluation goals for motivating management effort in the subsidiary as well as parent company must also be factored in while making a transfer pricing decision. There is a high possibility of all these motives conflicting with each other.

FDI allowance regulations  Each country has its own policy regarding the way it wants the businesses in its economy to function. Those leaning towards a communist ideology tend to have more and more industries in government control. These countries do not allow much foreign capital invested in the country to retain ownership of its assets. Similarly conservative economies and economies who are at nascent stages of opening up prefer to keep the Foreign Direct Investment (FDI) at the minimum possible level. It should be gauged whether Ruritania will continue to allow same or even increasing levels of FDI in their county in the coming future.    

Tariff  non tariff trade barriers  Nations employ various barriers or hurdles on imports as well as exports in their countries to curtail trade in certain industries, products or services. This is done either to protect domestic companies in fierce competition from the global players, to give boost to domestic companies in order to reach them to a comparatively advantageous positions in the global competition, or to harm the interests of the foreign companies.  Such trade barriers can be tariff or non tariff. Tariff barriers include levying of import and custom duties, excise duties, cesses etc. Non tariff barriers include lengthy registration and documentation procedures, quantitative restrictions, standard requirements, subsidies, legislations and others which cut on the profits of the foreign players. The members of the EU when faced with such trade barriers are expected to register a complaint on the Complaints register section of the Market Access Database website of the European Union Commission at  HYPERLINK httpwww.mkaccdb.eu www.mkaccdb.eu .  

Monetary policy of the country  Depending upon the condition of the economy of a country and the ideology of the ruler of the government of a nation, the countrys central bank may have a tighter or lenient monetary policy.  Monetary policy directly influences the bank  interest rates, inflation rate,  money supply in the market of the country and such other major determinants of volume of business in the economy.  Knowledge of the generally pursued monetary policy in Ruritania would make the company more equipped to take a right decision.  

Repatriation of Profits  remittance limits set by the country  Small economies and  conservative economies tend to place restrictions on the volume of profits that can be repatriated to the home country.  Limited foreign currency reserves, need for making funds available for the development of the country, increasing the supply of money in the domestic markets to curtail inflation, could be the reasons behind such restrictions. These restrictions reduce the amount of funds repatriated to the parent company  and in effect it adversely impacts the profitablity of the parent company.  Effective Transfer pricing policy, loan repayments, fees and royalty payment adjustments, are the tools to deal with such situations. However such restrictions should not be worrying for this company if it plans to continue to expand its business  in Ruritania over a long term period.    

Capital Structure  financing methods available  At the outset, the company will have to decide the capital structure of the manufacturing facility in Ruritania. It has to decide the percentage of total capital that it is going to invest itself, that it is going to raise from the public through sale of shares, that it is going to raise from the banks, and other financial institutions. Money can also be raised through ECBs in the form of buyers credit, suppliers credit, floating rates notes, fixed interest bonds and others.  Other long term primary instruments are Foreign Currency Bonds (FCCBs), American Global Depository receipts Cerificates (ADRsGDRs) (Khan  and Jain 2007, p.36.26).  

Having done preliminary study of the micro and macro economic conditions for the business in Ruritania, it would now become important to get aquainted with the various risks involved in the investment. Risks faced in international businesses have more dimensions alongwith those faced in the domestic business.  

Interest rate risk This risk occurs in the situation when company has borrowed from various domestic  international lenders, and interest rates fluctuate in a very volatile environment. This risk can be mitigated by trading surplus funds in debt market.

Country risk or sovereign risk  This form of risk arises out of the very existence of the subsidiary in a foreign country.  The government of the host country may take actions such as prohibiting remittance  to a particular country or in a particular currency due to foreign currency shortages and adverse political events.  In order to predict such a risk, issues such as trade policy, fiscal stance ( deficit or surplus ) of the government, government intervention  in the economy, its monetary policy, capital flows and foreign investment, inflation, structure of the financial system and political stability history and others must be studied (Saunders and Cornett 2007, p.564). An extention of this form of risk would be Expropriation risk and political risk. Political risk may be mild interference or even reach upto complete confiscation of all assets termed as expropriation risk.  Mild interference would include law making it mandatory to employ nationals at important positions or upto a percentage of total labour force, to invest in environmental and social projects, and restricting currency convertibility etc.

Corruption Level in the country  High corruption level in many countries make it unviable to do business in those countries, even if all other conditions and regulations are favourable.  So a company must always be aware of the levels of corruption in a country before entering into the foray.

Exchange rate risk  Any business indulging in international trade and business inherently face foreign exchange risk. The business charges its clients and customers in one currency. If that currency fluctuates unfavourably drastically after an agreement or commitment has been made in relation to supplying of goods, the company has to bear the losses to the tune of number of goods times the difference that occurred in the exchange rate of the currencies. In case of such drastic changes, a profitable project might turn unviable overnight.  Hence stability in the value of currency is of utmost importance. Ruritania does not have a long history of exchange rate stability. Stability over a period of eighteen months does not warranty anything about the future. Hence it is worth mentioning that the decision of investing in Ruritania is challengeable on the grounds of high level of  foreign exchange risk. Foreign exchange risk can however be mitigated by hedging.  On- balance sheet hedging involves making changes in the balance sheet assets and liabilities whereas off - balance sheet hedging involves taking a position in forward or other derivative securities  (Saunders and Cornett 2007, p.238).

Apart from these risks, there are also risks arising due to possibilities of violence, agitations, unrests among the people of the host nation or possible environmental calamities in risk prone countries.  Market risk arising out of fluctuating prices of the companys products due to fluctuations in overall demand and supply of the particular product in the economy  should also be considered while devising the business plan.

Other Considerations
Performance measurement in Multinational Corporations  becomes complicated because of the various inherent differences between economic, social and business environments across these countries.  The commonly used ROI method of evaluating and comparing performances of the units and managers suffers from inefficiency because of the foreign exchange fluctuations. To get a true picture therefore, historical cost based ROIs of units in different countries should be compared instead of current cost values, because they negate the effects of any differences in inflation rates between the two countries. This should also be applied to the Residual Income method of performance measurement (Horngren,  Datar and Foster 2006, p.804). This method can however be used only for relatively newer organisations, as using historical values of the assets of older organisations would be misleading, they being irrelevant and insignificant as of today .

Other costs that can be incurred by the company in the course of its business such as legal costs for registration  and lisencing purposes, and in the event of any litigation should be taken into account.  Some governments may have mandatory laws regarding sustainablility goals to be achieved by businesses. Businesses would have to incur costs in order to install proper environment management systems in their units. Such and other such costs and risks if any must be considered at the time of preparing the budget for the new manufacturing facility in Ruritania.

Recommendations
From the above discussion we can conclude that the growth rate figures  of other nations in Eastern Europe are more attractive for doing business than Ruritania. Prospects of Ruritania entering the EU look good, but the business could face high foreign exchange risk which is indicated from the absence of long history of currency stability of the country.  Hence through this report, it is advised to the company to refrain from taking any hasty steps towards investment in Ruritania, and that a deeper study of the economy of the country needs to be done to verify the future prospects.

Besides  considering all the above issues, if a manufacturing facility is to be set up, a systematic procedure must be adopted to arrive at the decision on whether to venture into  such a particular International Capital Investment. The Net Present Value (NPV) of the Future Cash Flows after taxes (CFAT) that can be repatriated to the parent company must be calculated and the decision should be taken accordingly (Khan and Jain 2007, p.36.9).  The steps involve the following
Estimating cash outflows for undertaking said foreign investment in Sterling Pound.

Determining the expected incremental cash inflows after taxes (CFAT) mentioned earlier. This should be calculated  in terms of Crown.

Determining the expected repatriation of CFAT as per the regulations of the Government of Ruritania.

Deducting the withholding tax from expected repatriation. This amount so determined will be the amount available for repatriation to this company.

Converting the expected CFAT into Pounds at the future projected exchange rates.

Determining the Net Present Value (NPV) of the CFAT of the project by discounting it with the appropriate rate of return  cost of capital, also adjusted for the aforesaid risks that the proposed international project carries.

The project is accepted if the NPV calculated as above is positive. It should be rejected in case the NPV is negative.

All said and done, management decisions must always have an element of individual judgement in making any strategic level decisions. This report therefore calls upon the management to factor in all these issues as well as their judgement to devise a prudent strategy.

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