Managing Global Financial Issues- Assessment 10

Managing Global Financial Issues- Assessment 10

Overview

Complete two problems related to strategically managing global financial issues. The problems focus on currency appreciation and exchange rates.

By successfully completing this assessment, you will demonstrate your proficiency in the following course competencies and assessment criteria:

• Competency 6: Strategically manage global financial environment.

o Calculate currency appreciation rates.

o Calculate cross rates in foreign currency.

Context

The Assessments 9 and 10 Context document provides helpful information related to risk management strategies and associated ethics issues as well as special considerations for multinational companies.

Risk Management

The topic of risk management is very broad, and it changes with the changes in the economic environment in which a firm operates. In business, the term risk management has broadened to include not only insurance protection coverage but also management of such risk factors as controlling costs of key inputs such as petroleum or metals by using derivatives or protecting against changes in interest rates and exchange rates using hedges in interest rate or foreign exchange markets.

One of the most important aspects of risk management involves the use of derivatives such as options, interest rate and exchange rate futures and swaps, and commodity futures. An option is a contract that gives its holder the right to buy or sell an asset at a predetermined price within a specified period. Conventional options are generally written for six months or less, but a new type of a longer time option called LEAPS has maturities of up to 2.5 years. Derivatives can become very complex and exotic; however, our goal is to focus on those features of derivatives that could help you as a manager to manage the risk of your firm. Therefore, other types of derivatives will be examined primarily from the standpoint of how they can be used in the process of managing and reducing the diverse risks facing a modern firm.

Managing Global Financial Issues- Assessment 10

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When you think of risk management, you typically think insurance. While insurance is a broad solution to risk management, the kinds of things we mean in the financial world go far beyond risks for which there is traditional insurance that allows you to actually transfer your risk to someone else. In many cases, you cannot pay someone to assume your risks, so you may consider taking other courses of action to abate it.

Sometimes those actions are simply management controls (for example, for a risk where an employee might embezzle funds). Alternatively, if the risk has to do with the availability of some resource needed, you might create secondary supplier relationships that can be called into action if your primary supply chain breaks down. In fact, there are several actions available to manage risks once those risks are identified, quantified, and categorized. Some of those actions include:

1. Transfer the risk (for example, insurance).

2. Reduce the probability (for example, controls).

3. Reduce the impact of the risk (for example, installing surveillance systems).

4. Limit or cease the activity that leads to the risk (for example, stop making a product or providing a function with high liability).

5. Use derivatives to manage financial exposures.

Mergers

The primary motivation for most mergers is to increase the value of the combined enterprise. Economic conditions under which the value of the resulting company is higher than the value of separate companies can arise from operating economies, financial economies, differential economies, and increased market power.

There are several methodologies used to value target firms. However, we will limit our examination to two of the most common methods:

1. The discounted cash flow approach.

2. The market multiple method.

Our merger analysis would have been incomplete if we ignored the accounting implications of mergers. Mergers are not the only existing types of corporate restructuring. Leveraged buyouts (LBO) occur when a small group of investors, usually including current management, acquires a firm in a transaction financed largely by debt.

Internal Controls

A properly-designed set of internal controls should look at both the risk and impact of specific exposures. For example, while the risk of employees taking home pads of paper may be high, the impact is low, so why bother having a lock on the file cabinet. But, writing checks to fictitious vendors is an example where the impact is as high as the sum total of the checks.

The classic internal control is to involve multiple parties in a transaction stream such that collusion would be required—this reduces the risk (though probably not the potential impact). Writing a check to a vendor requires a purchase authorization of some sort, followed by an invoice from the vendor, and eventually a voucher that authorizes payment. Obviously, if only one person had control over all of these steps and no supervisory approvals were needed, you would have a high risk.

Another good practice is to sample transactions. For example, take some payments and track the purchase to ensure it involves goods received at a fair price from a legitimate vendor.

Managing Global Financial Issues- Assessment 10

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Reports are also produced that show unusual patterns. These parameters can be set by the user so that, for example, you could query the accounts payables to see any vendor whose payments doubled in the last year or any new vendor with more than a certain amount of money in purchases.

Most companies have a board committee called the audit committee or something similar. Its function is to ensure that the right controls are in place so that a system of checks and balances exists to detect fraud or other questionable behavior. It is important to note that accounting firms that audit the financial statements will make it very clear that fraud detection is beyond the scope of a financial statement audit so that overt actions must be taken separately. Many companies use an internal audit staff, and some others may hire their external audit to do a specific controls review or audit if there is suspicion that something is wrong.

At least one form of internal control starts at the top; it is critical to have a board of directors that is truly looking out for the shareowner. However, that is as much an ethics issue as it is a controls issue.

Most recently, the fraud that has become known involves much more elaborate schemes; you have probably heard about Worldcom, Enron, Tyco, and many others. In some cases, the scheme is so complex, such as with Enron’s offshore subsidiaries, that even well-meaning external auditors will not really understand their implications, as was the case with Arthur Andersen.

As we see more directors required to be from outside the company (something many companies are doing voluntarily, though this too could be legislated), we hope this will become less frequent.

The Sarbanes-Oxley Act is a new piece of legislation that requires corporations to have a coherent and complete set of internal controls and to place clear accountability at the top. It is a very contemporary issue in today’s corporate world.

Multinational Financial Management

Multinational companies have more opportunities but also face different risks than do companies that operate in their local markets. Some of these important risks are related to differences in currency denominations, economic and legal structures, languages, cultural differences, and political risk. Since foreign exchange markets are of crucial importance to the multinational firms, it is important to examine the main financial instruments used in these markets and such concepts as interest rate parity and purchasing power parity.

Managing Global Financial Issues- Assessment 10

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The working capital management, debt management, credit policy, and capital budgeting concepts that you applied in previous assessments are also applicable in a multinational environment. However, additional risks that financial management faces often require that these multinational enterprises use more complex and elaborate procedures in determining their weighted average cost of capital, in forecasting their future cash flows, and so forth.

Questions to Consider

To deepen your understanding, you are encouraged to consider the questions below and discuss them with a fellow learner, a work associate, an interested friend, or a member of the business community.

• Should firms require higher rates of return on foreign projects than on identical projects located at home? Remember to take into account the effect of foreign exchange rates.

Resources

• Halmi, M. (2012). The correlation between the exchange rate and the direct foreign investments. Annals of the University of Oradea, Economic Science Series, 21(1), 809–815.

• Kroszner, R. S., & Strahan, P. E. (2011). Financial regulatory reform: Challenges ahead. American Economic Review, 101(3), 242–246. doi:10.1257/aer.101.3.242

• Lustig, H., Roussanov, N., & Verdelhan, A. (2011). Common risk factors in currency markets. Review of Financial Studies, 24(11), 3731–3777.

• Sun, W., & An, L. (2011). Dynamics of floating exchange rate: How important are capital flows relative to macroeconomic fundamentals? Journal of Economics & Finance, 35(4), 456–472. doi:10.1007/s12197-009-9103-5

• Parameswaran, S. (2011). Fundamentals of financial instruments: Stocks, bonds, foreign exchange, and derivatives. Hoboken, NJ: John Wiley & Sons.

Managing Global Financial Issues- Assessment 10

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o Chapter 8: Foreign Exchange.

Gerdes, W.D. (2014). The basics of foreign exchange markets: A monetary systems approach. New York, NY: Business Expert Press.

o Chapter 3: Foreign Exchange Markets.

Downes, J., & Goodman, J. E. (2014). Dictionary of finance and investment terms (9th ed.). Hauppague, NY: Barron’s.

• Brigham, E. F., & Houston, J. F. (2016). Fundamentals of financial management (14th ed.). Boston, MA: Cengage.

Assessment Instructions

Problem 1: Currency Appreciation

Suppose that 1 Euro could be purchased in the foreign exchange market today for $0.25. If the Euro appreciated 10 percent tomorrow against the dollar, how many Euros would a dollar buy tomorrow?

Problem 2: Cross Rates

Assume the exchange rate between US dollar and Indian Rupee is 60 Rupees = $1, and the exchange rate between dollar and British pound is 1 Pound = $1.5. What is the exchange rate between the Rupee and pound?

Managing Global Financial Issues- Assessment 10

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