Page 324 - Encyclopedia of Business and Finance

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Finance

investment decisions, the returns used should be those rates and U.S. dollars at the current exchange rates
that are incremental of the specific investment. can be used. The required return or cost of capital
Return/interest rates are based on three components: then need only be adjusted, as with any investment,
pure return for the investor or creditor providing funds; for the greater or lesser risk of the project in which
coverage of inflation rates, so that the purchasing power of the investment is made, which includes the greater
the proceeds is maintained apart from the true return; and or lesser risk of the country in which the investment
additional return for additional risk, such as an equity is being made.
investment in a risky business as opposed to a bond from
2. Foreign capital markets are a source for both debt
the U.S. government. These components are then com-
and equity funds, for both foreign subsidiary opera-
pounded with each other, rather than merely added
together, to obtain the overall interest rate or required tions and the general needs of the overall business.
return on equity investment. When calculating return or Foreign subsidiary capital structures often utilize
interest rates, any additional up-front money, such as clos- more local debt when legally and practically avail-
ing costs, must also be added to the investment; this able in order to reduce the risk of blockages of
amount increases or reduces the return, depending on earned funds from repatriation to the parent com-
who pays for it. pany in another country. In addition, local-currency
Residual values are a portion of the returns to be debt reduces the risk for the parent company if the
earned in an investment that is returned to the business exchange rates for the local currency change
when the investment is sold or the project is terminated. adversely.
This can be most important in the liquidation of inven- 3. Foreign-exchange rates can change dramatically and
tory and receivables when operations of a portion of a therefore pose a significant risk for the value of
business are terminated or when real estate ceases to be
assets held in or future payments from foreign coun-
required and thus can be sold, for example, when a factory
is closed or when a lease term is complete. tries. These exposures may be in dealings with third
parties or within a company’s own foreign sub-
Maturities of debt instruments, such as bonds, loans,
sidiaries. Forward currency contracts or currency
or notes payable, are the amounts of time outstanding
options, instruments used to purchase one currency
before the debt becomes due. The financial management
rule with respect to maturities is to match the duration of for another currency in the future at guaranteed
the funds being borrowed by the debtor, or invested by exchange rates, can be used to protect against such
the creditor, with the timing of his or her own business risk. While these contracts are often also used to
needs for funds in the future. Thus, the financing of a new make profits by managers who believe the exchange
business—with the likely future expansions of property, rates will change in a manner different from the
plant, equipment, inventory, and receivables—can be expectations implicit in the overall currency market,
done with longer-term debt funds. Yet the financing of a such use should be viewed as risky speculation.
specific shorter-term need, such as the outlays on a con-
4. Personal finance is concerned with the same
struction project before completion payments are made,
methodology of allocating resources, but with a
should be comparably shorter in maturity. Similarly, the
investment of temporary excess cash should be in shorter- greater emphasis on allocating some of them to
term instruments, such as short-term CDs or Treasury obtain the maximum consumption satisfaction at
bills. If maturities are not matched, then the additional the lowest cost, as opposed to earning income and
time before the debt becomes due from or to the investor cash flow returns on the investments.
becomes a period of speculation on the rise or fall of 5. Budgeting and financial planning are the processes
future interest rates. used by financial managers to forecast future finan-
International finance is concerned with the same cial results for a business, a person, or a particular
methodology of allocating financial resources, but with investment. Usually, the major components of earn-
modifications or areas of emphasis required by the restric- ings, cash flow, and capital are projected in the form
tions of currency and capital movements among countries
of forecasted income statements, cash-flow state-
and the differences in the currencies used in different
ments, and balance sheets. The latter show where
countries. The following paragraphs represent some of the the capital funds are invested in the components of
major changes to the basic financial decisions:
fixed and working capital, as well as the sources of
1. Foreign capital budgeting requires the use of foreign these capital funds in terms of the debt, stock, and
cash flows and local tax rates, but U.S. inflation retained earnings.

ENCYCLOPEDIA OF BUSINESS AND FINANCE, SECOND EDITION 301