Question Paper

International Finance and Trade – II (222) : October 2004

Section D : Case Study (50 Marks)
• This section consists of questions with serial number 1 - 4.
• Answer all questions.
• Marks are indicated against each question.
• Do not spend more than 80 - 90 minutes on Section D.

Case Study
Read the case carefully and answer the following questions:
1. Discuss the various ways through which restrictions on profit repatriation can be avoided.
(12 marks)< Answer >
2. Appraise the project using adjusted present value technique after defining all the relevant parameters.
(20 marks)< Answer >
3. Assume you arrive at the APV of –$ 15 million for the same concessional loan at 8%, what should be
the interest rate on concessional loan to make the project viable?
(8 marks) < Answer >
4. Discuss in brief the various instruments available to raise funds in international financial markets.
(10 marks)< Answer >

Office Automation Inc., a US based multinational firm, is trying to decide whether to establish a manufacturing
unit in Romania. Office Automation, US expects to significantly boost its European sales of hi-tech machineries
it is currently exporting there. The exports in the current year reached a level of $80 million, which is expected
to rise as per inflation rate in US. At the moment Office Automation, US is unable to increase exports because
its domestic plants are producing to its full capacity. However, exports to Europe are residual output that it is not
able to sell domestically.
Office Automation has made a decision to significantly increase its presence and sales overseas. A logical first
target of this international expansion is the European Union (EU) countries. The sales executives of the
company in Europe believe that manufacturing in Romania will give the firm a key advantage with local
customers in Europe. However, it will stop exports from its domestic plant.
Romania is chosen as the production base because Office Automation can acquire an existing assembling plant
from BMT, which used to assemble its products before its recent closing. As an inducement to locate in this
closed plant and, thereby, ease unemployment among plant workers and also creating new employment, the
Romanian government has agreed to provide a five-year loan Euro 100 million at 8% interest, with interest paid
annually at the end of each year and the principal to be repaid in two equal installments starting at the end of
fourth year.
Office Automation has estimated project cost of Euro 300 million for acquiring BMT and renovating and
expanding existing facilities. Full scale production in this plant will start only after 1 year when all these
renovation and expansion will be completed. Till such time, this plant can be used to assemble its exported
machineries from its US plant.
Office Automation has accumulated profit of Euro 50 million, which is invested in different countries in Euro-
zone. The company has to pay tax at the rate of 30% if it wants to take it back to US. But due to the agreement
among European Union countries, transferring this profit within these European Union countries will not call
any tax implications. So Office Automation has decided to use this fund for funding the project. If the
investment in the project is not done, the accumulated funds would have been at some point in time has to be
transferred to US as nothing better could have been done with them. The rest of the funds the company will
provide from its internal accrual created in US.
The following are the other information relating to the project:
i. Project life is estimated as 5 years for appraisal purposes.
ii. Profit margin from the current exports is 10%.
iii. The tax rate in Romania is 30% and in US is 35%.
iv. The book value of depreciable assets will be Euro 280 million at the time of starting production. The US
tax laws allow a depreciation of 15% on the original cost, the Romanian tax laws allow the writing-off of
the entire historical costs over 5 years. There is a strong probability of positive cash flows being
generated and hence depreciation tax shield can be availed with certainty.
v. The salvage value of fixed assets at the end of fifth year is estimated at 20% of the value of fixed assets
at inception.
vi. The investment would increase the borrowing capacity of Office Automation in US to the extent of $100
million.
vii. The sales projection for the first five years of operation:
Year 1 2 3 4 5
Sales ($ million) 130 145 160 175 175
All the sales have been measured in current $.
viii. The variable manufacturing expense to sales ratio is expected to be 50% in euro terms.
ix. The fixed cost of manufacturing and sales excluding depreciation at current prices are estimated as
follows:
Year 1 2 3 4 5

Fixed cost (Euro million) 12 15 18 20 20

x. All the revenues and costs are expected to move in line with the inflation in Euro-zone.
xi. The company has estimated that each year a profit of $ 8 million can be remitted illegally to the parent.
xii. A working capital margin of Euro 20 million is included in the project cost.
xiii. The nominal interest rate for borrowing in Romania is 10% and in US is 8% for the company.
xiv. The risk-free rate in Romania and US are 3% and 2% respectively.
xv. The current euro-dollar exchange rate is $1.24 / Euro.
xvi. The expected inflation rates for dollar and euro are 3% and 2% respectively. The purchasing power parity
is assumed to be applicable for the currencies.
xvii. The equity shareholders of Office Automation expect a return of 12% on such investments.

END OF SECTION D

Section E : Caselets (50 Marks)

• This section consists of questions with serial number 5 - 12.
• Answer all questions.
 • Marks are indicated against each question.
• Do not spend more than 80 - 90 minutes on Section E.

Caselet 1
Read the caselet carefully and answer the following questions:
5. Discuss the benefits and negative implications of capital account convertibility (CAC).
(7 marks)< Answer >
6. What are the preconditions for implementing capital account convertibility (CAC) in India?
(7 marks)< Answer >
7. In the light of international experience, discuss whether India is fit for adopting fully capital account
convertibility.
(6 marks)< Answer >
Convertibility of currency means that the currency can be exchanged for any other convertible currency, without
any restriction, at the market determined exchange rate. Thus, it means that the rupee can be freely converted
into dollar, pound sterling, yen, euro, etc., and vice versa at the rates of exchange determined by the demand and
supply forces.
In a broader sense, the currency convertibility means instituting exchange arrangements whereby residents, non-
residents and foreigners can exchange (transform) freely (without limit) domestic currency for (into) any foreign
currency or gold and vice versa at a predetermined (fixed) or a variable market rate of exchange for the purpose
of transactions on trade, invisible, current or capital accounts.
According to one working definition, “Currency is convertible if domestic nationals wishing to buy foreign
goods and services…can freely sell domestic currency for foreign currency…at a single but possibly variable
foreign exchange rate covering all current transactions inclusive of normal trade credit, whereas foreigners
(non-residents) with balances in domestic currency arising from current transactions can sell them at the same
foreign exchange rate or purchase domestic goods freely at prevailing domestic currency prices.”
Normally, this convertibility of currency takes place on current account and capital account transactions in any
country for the sustainable growth of the economy. In the recent past, globalization has led countries both
developed and developing, including underdeveloped countries, to run after full convertibility on current
account and capital account.
Capital Account Convertibility (CAC) is one of the essential parameters for any country to integrate their
economy with global economy, to deepen and integrate financial markets, to raise the access to global savings,
to discipline domestic policy makers and to allow greater freedom to individual decision-making and
proliferation of Information Technology. It is the view of the majority that CAC is the only solution for all the
economic ills affecting a poor country like India. At this instance, every one speaks with one voice that under
present circumstances one should mull over CAC.
The experience of other countries with currency convertibility presents a mixed picture. Britain that introduced
full convertibility in July 1947 had to beat a hasty retreat the very next month because of large-scale flight of
capital. In 1958, Britain introduced restricted convertibility. South Korea, which faced problems with partial
convertibility in the beginning, rescinded it in 1985 but ultimately restored it in 1989 and succeeded. Fiji, which
introduced current account convertibility in 1985, made a retreat in 1987. Although Pakistan’s balance of
payments crisis was more severe than that of India, after the recent convertibility their rupee has more or less
stabilized. The experience of countries like Mexico, Argentina, Peru and Chile has also been encouraging.
The convertibility of the Indian rupee has been a subject of great interest and excited discussions in recent years.
After the collapse of the Bretton Woods System in 1971, the rupee was pegged to pound sterling for four years
after which it was linked to a basket of 14 and later five major currencies. In 1981, a rise in dollar due to high
interest rates in the US led to rupee appreciation, which adversely affected India’s exports due to fall in export
profitability. It prompted Reserve Bank of India to experiment with a managed float, pegging the rupee to dollar
and pound sterling alternatively depending on which was going down, to guard against the appreciation of the
rupee that would adversely affect the exports.
As a part of the economic policy reforms, the Finance Minister in his Budget speech announced partial
convertibility of the rupee on the current account for 1992-93 and the rupee has become partially convertible
since March 1992. The move towards convertibility of the rupee has been in line with the worldwide trend
towards currency convertibility. According to the IMF, 70 countries accepted current account convertibility by
1990 while another 10 joined them in 1991. Many other countries including the East European countries and
Russia have been contemplating the convertibility move.
Caselet 2
Read the caselet carefully and answer the following questions:

8. Why exporters are worried of an appreciating rupee? Discuss.

(7 marks)< Answer >
9. Explain the role played by RBI in this appreciating rupee scenario.
(6 marks)< Answer >
10. Do you think the appreciation of rupee is sustainable? Explain.
(4 marks)< Answer >

Indians would have never imagined the rupee appreciating against the dollar. We have been seeing the rupee
only depreciating against the dollar for the last twenty years. It had depreciated by almost 8% every year. It had
reached a low of Rs.49.12 in May 2002, and since then, the state of affairs reversed and now the rupee is poised
to move only northwards. The rupee has gained over 10% since May 2002. It has gained almost 7.3% in the
financial year 2003-04, of which 3.4% appreciation has come about in the calendar year 2004 alone. Though
economists cite various reasons for this unprecedented phenomenon, most of them are agreeing with the view
that this appreciation is more because of the slowdown in the US economy rather than the strength of the Indian
economy. Whatever may be the reason, the implications are interesting.
Lately, the rupee-dollar exchange rate has become a matter of discussion among the economists, bankers,
foreign investors, and the exporters. No wonder that these people have something to say about this phenomenon
but how does the rupee dollar exchange rate matter to a common man, who may not depend on dollars for his
daily transactions? Changes in the exchange rates do affect the common man even if he is not directly exposed
to dollar denominated transactions. Before seeing how, let us look at some basics.
When the rupee appreciates against the dollar, we get dollars at a cheaper rate. In May 2002, we needed to
spend Rs.49.12 to get a dollar. But today, we need to spend only Rs.44 to get that same dollar. Apparently, it
seems that the competitiveness of rupee has increased. But actually because of dollar becoming cheaper for
Indians and rupee becoming costlier for Americans, there is a positive impact on imports to India and a negative
impact on exports from India As the exports and imports play a vital role in determining the prices of domestic
goods, the common man is affected. For instance, the petrol, electronic goods, mobile phones, etc., which
heavily depend on imported components have become cheaper in India. Similarly foreigners, who import our
tea, coffee, food grains, etc., have to pay more in dollar terms. So the Americans are tending to depend less on
Indian exports. So, the strengthening rupee is posing certain opportunities as well as threats.
Earlier when the rupee was depreciating, exporters were happier because the appreciating dollar used to fetch
more number of rupees per dollar for their receivables. Therefore, they did not have any motivation for hedging
their receivables. But now, as the dollar is depreciating and the rupee is appreciating, the exporters are worried
about getting fewer rupees for a dollar. Therefore in order to avert this uncertainty, exporters are very much in
favor of utilizing the forward market route. On the other hand, importers are refusing to take cover as they feel
that rupee would continue to appreciate against the dollar, helping them to settle their payables at a lower price.
An exporter entering into a forward contract agrees to sell dollars on a future date at an agreed price. This
allows him to lock-in a rate for the future transaction so that, even a fall in the value of the dollar in the spot
market does not affect him. Similarly, an importer entering into a forward contract agrees to buy dollars on a
future date at an agreed price. This allows him to lock-in a rate for the future transaction so that even a rise in
the value of the dollar in the spot market does not affect him. Therefore, importers pay a premium for buying
low and exporters receive a premium for selling low. Forward premiums construe a lot to the participants in the
foreign exchange markets. They reflect the rupee’s outlook and factor in domestic money market conditions and
interest rate differentials between the US and India.
As the rupee is ascending continuously, only the exporters are entering into forward contracts to hedge their
receivables whereas, the importers do not find any reason to hedge their payables. Therefore, virtually there’s
nobody to pay premiums to the exporters. Since the transactions have become one-sided, the premiums are
almost diminishing and are becoming negative.
Added to this, RBI mopped up $5 bn from the market to arrest the appreciation of the rupee and keep the Indian
rupee at a steady level of 45.25 between January and March of this year. This action on part of the RBI, and
excessive demand for the dollars from the importers has led to shortage of dollars in the market. Banks in order
to meet the dollar demand resorted to buy-sell swaps, i.e., buying spot dollars and selling them forward. This
factor has also contributed largely to the falling of forward premiums.
The strengthening rupee coupled with the falling forward premia is keeping exporters on their toes. It would
reduce India’s export competitiveness. Those who are exporting software products and those in the outsourcing
industry are the worst hit. As most of their receivables are invoiced in dollars, they are looking forward to the
rupee reversing its direction at the earliest. Therefore, they are literally waiting for the RBI to check the rupee
appreciation.

Caselet 3
Read the caselet carefully and answer the following questions:
11. Discuss the problems, US economy will face due to weak dollar. Does increasing interest rate helps?
(7 marks) < Answer >
12. How higher interest rate may help dollar in regaining its losing sheen? Explain.
(6 marks)< Answer >

When the Federal Reserve put up America's short-term interest rates on June 30th, by a quarter of a percentage
point to 1.25%, financial markets shrugged rather than trembled. Rarely has a central bank's decision been so
long and so accurately anticipated. The Fed's move lifts America's short-term rates off their floor-scraping low
of 1%, the cheapest that money had been since the late 1950s.
Just over four years ago, as the great technology boom was ending, short-term rates stood at 6.5%. But as signs
of the global downturn emerged, the Fed began cutting rates aggressively. Now the era of ultra-cheap money is
drawing to a close, and not only in America. Other central banks have raised rates already. The Bank of England
has put up rates by a percentage point, to 4.5%, since November. Australia's central bank has raised its base rate
by the same amount, to 5.25%, in the past two years. Both sets of increases seem to have been driven as much
by worries over booming asset prices, especially housing, as by incipient consumer-price inflation.
Nevertheless, it may be a while before official short-term rates increase in Japan and the euro area. Despite
signs that deflation in Japan may be abating, few expect the Bank of Japan to end its zero-interest-rate policy in
the near future. On July 1st, the European Central Bank (ECB) kept its main short-term rate at 2%.
A couple of months ago, it seemed that the ECB might cut rates, in response to continuing sluggishness in the
euro area, especially in Germany. But that never happened. Indeed, with inflation at 2.4% in June, almost half a
point more than the ECB says it will tolerate, an increase now looks much more likely. However, the central
bank's recent attempts to explain its policy publicly have left analysts confused.
Despite the reputation for oblique language enjoyed by Alan Greenspan, the Fed's chairman, he has managed to
make his intentions clear. Just as well: last year, he confused the bond market by sending mixed signals about
the Fed's plans for interest rates. Worse, in the previous tightening cycle, in 1994, the Fed wrong-footed the
bond market completely, sending prices crashing. No wonder the central bank has prepared the ground more
carefully this time, and will no doubt continue to do so if and when it raises rates further. And given the amount
of debt Americans now carry, there is a risk that a rapid, unexpected rise in rates could damage asset prices and
consumer spending, and hence the economy.
So this week's rate increase is intended to be the first stage of a “measured” monetary tightening. The case for
raising rates is plain from recent data. Job growth has quickened, and spare capacity is beginning to shrink.
Consumer prices in America rose by 3.1% up from 2.1% a year ago. “Core” consumer-price inflation, which
excludes the volatile prices of energy and food, climbed from 1% in December to 1.8% in May. By historical
standards, this is tame—implying there is no need to tighten policy in a hurry.
Even so, has the Fed been too slow to act? America has enjoyed an enormous monetary stimulus in the past few
years (and a giant fiscal boost too). In real terms, American interest rates are negative. They would remain so
even if the Fed were to push up rates as far as 3%. With the economy motoring and inflation already showing
signs of picking up, perhaps rates will have to be increased faster and by more than markets expect.

END OF SECTION E

END OF QUESTION PAPER

 Suggested Answers
International Finance and Trade – II (222) : October 2004
Section D : Case Study

1. There are a number of legal ways to circumvent restrictions on profit repatriations.

• • Transfer pricing
• • Royalties
• • Leading and lagging
• • Financing structure
• • Inter-company loans
• • Currency of invoicing
• • Reinvoicing centers
• • Countertrade
Transfer Pricing
Transfer pricing refers to the policy of invoicing purchase and sale transactions between a parent company
and its foreign subsidiary on terms which are favorable to the parent company, thus shifting a part of the
subsidiary’s rightful profits to the parent. As this method of circumventing repatriation restrictions is very
common, authorities are generally very alert as to the price at which transfers are made.
Royalties
The foreign subsidiary may use the parent company’s trademarks and copyrights and pay royalties as
compensation. As this is not a transfer of profit, the normal restrictions on profit repatriation do not cover
these payments.
Leading and Lagging
Leading and lagging payments between the parent company and the subsidiary, based on expected
movements in exchange rates can help in transferring profits from the latter to the former. Suppose the
subsidiary has to pay its parent company a sum which is denominated in a currency that is expected to
harden. The subsidiary lags (delays) the payment so that a part of the subsidiary’s profits get transferred to
the parent company. In the event of such a payment being denominated in a currency that is expected to
depreciate, the subsidiary leads (advances) the payment, again with the same effect.
Financing Structure
An overseas project can be funded solely through equity investments, or through a mixture of equity and
debt. In cases where there are restrictions on repatriation of profits and repayment of capital, part of the
project can be funded through loans from the parent company to the foreign subsidiary. Generally, there are
fewer restrictions on payment of interest and repayment of loans than on profit repatriation. Also, interest
payments are tax deductible for the subsidiary whereas dividend payments are not (for the parent company
both are taxable). There is another tax incentive involved as repayment of loans is non-taxable in the hands
of the parent company, whereas funds transferred as dividends are. This way, repatriation restrictions can be
maneuvered around, along with getting additional tax advantages, by extension of loans to the subsidiary
by the parent company, instead of making direct equity investments.
Inter-company Loans
The methods mentioned above are fairly common ways of getting around regulations in a legal manner.
Over a period of time, authorities have become aware of them and frown upon payments to a foreign parent
company, under whatever disguise. Hence the danger of the subsidiaries being disallowed from making
such payments always looms large. To get around these problems, companies can resort to inter-company
loans. The simplest way is that two companies make parallel loans to each others’ subsidiaries, with the
amounts and timing of the loans and the interest payment as also the loan repayment matching. This can be
 refined if each of the subsidiary companies is based in the same country as the other’s parent company. In
that case, the loans come totally out of the ambit of exchange control regulations as both the loans are made
within the countries involved.
Currency of Invoicing
Choice of currency in which intra-group trade is invoiced is an important tool for transferring profits within
different companies of the same group. Exchange controls are generally imposed to prevent the local
currency from depreciating. If the currency is expected to depreciate despite the controls, the exports from
the subsidiary based in that country to other group companies can be invoiced in that country’s currency.
Also, the imports of that subsidiary from other group companies can be invoiced in some hard currency
(one that is expected to appreciate). As the country’s currency depreciates, the subsidiary’s profits will fall
from what they would have been otherwise, and the profits of other group companies will increase.
Reinvoicing Centers
Trades between companies in the same group can be routed through a reinvoicing center. Reinvoicing
centers act as an intermediary by buying from one company and selling them on to the other. The margin
between the buying and the selling rates is the amount of profit transferred from the subsidiary to the
reinvoicing center. Such centers are mainly used for the management of exposures, but can also be used for
converting non-repatriable cash flows into repatriable cash flows, when set up in countries with lesser
capital controls. In addition to such conversion, setting up of such reinvoicing centers in tax havens can
reduce the overall taxes, and hence increase the after-tax cash flows.
Countertrade
Countertrade involves the parent company and the subsidiary buying from and selling to each other. The
most common form taken is barter trade. While the goods transferred from the subsidiary (the value of
which may be very high compared to the value of goods received by it) may not be useful for the parent
company directly, it can sell them to some third party, with the proceeds serving as an indirect transfer of
the subsidiary’s profits.
< TOP >
2. The adjusted present value is given by,
n
rB0 T
∑ (1 + k
n n
(S t C t + E t ) (1 − T ) D T
∑ ∑ (1 + kt t
b)
t t
t =1 (1 + k e ) t =1 d) t =1
APV = –S0 (C0 –A0) + + +
 n
Rt  n
It
S 0 CL 0 − ∑ t
t =1 (1 + k c ) 
 ∑ (1 + k ) t
  t =1 i
+ +
The above parameters are defined below:
Where,
S0 = Current exchange rate = $/Euro 1.24
C0 = Initial cash outflow in foreign currency terms = Euro 300 million.
A0 = Blocked funds – if those funds Euro 50 million are repatriated the company has to pay 30%
tax. Thus the opportunity cost of using these funds for the project is Euro 15 million.
St = Expected exchange rate at time ‘t’
n = Life of the project i.e. 5 years
Ct = Expected cash flow at time ‘t’, in foreign currency terms
Et = Effect of loss of export sales, in domestic currency terms
T = Domestic or foreign tax rate, whichever is higher = 35%
Dt = Depreciation in home currency terms at time ‘t’
B0 = Increased borrowing capacity due to the project = $100 million
r = Domestic interest rate = 8%
CL0 = Amount of concessional loan received = Euro 100 million
Rt = Repayment of concessional loan
 It = Illegally repatriated cash flows at time t = $ 8 million
ke = All equity discount rate = 12%
kd = Discount rate for depreciation allowance = 2%
Kb = Discount rate for tax savings from incremental borrowing capacity = 2%
Kc = Discount rate for savings due to concessionary loan = 10%.
Ki = Discount rate for illegally repatriated cash flows = 12%.
The expected exchange rates for next five years using PPP can be determined as follows:
Current $/Euro = 1.2400
1.03
1.02
After 1 year $/Euro = 1.2400 × = 1.2522
After 2 year $/Euro = 1.2522 × = 1.2644
After 3 year $/Euro = 1.2644 × = 1.2768
After 4 year $/Euro = 1.2768 × = 1.2893
After 5 year $/Euro = 1.2893 × = 1.3020
Loss of profit from export sales
Year 1 2 3 4 5
Sales ($) 82.40 84.87 87.42 90.04 92.74
Profit ($) 8.24 8.49 8.74 9.00 9.28
Depreciation tax shield
Year 1 2 3 4 5
Depreciation (Euro) 56 56 56 56 56
Depreciation in $ 70.12 70.81 71.50 72.20 72.91
Tax shield 24.54 24.78 25.03 25.27 25.52
Term loan repayment Schedule
Year Principal o/s at Interest Principal Total
end of the year Repayment Repayment
1 100 8 – 8
2 100 8 – 8
3 100 8 – 8
4 100 8 50 58
5 50 4 50 54
Cash flows from operation (Net of lost sales)
 Year 1 2 3 4 5
Sales (in $) 130 145 160 175 175
Sales (in Euro) [at current 104.84 116.94 129.03 141.13 141.13
prices]
Sales (inflation adjusted) 106.94 121.66 136.93 152.76 155.82
Mfd. Variable expense 53.47 60.83 68.47 76.38 77.91
Contribution 53.47 60.83 68.47 76.38 77.91
Fixed cost 12.24 15.61 19.10 21.65 22.08
PBT 41.23 45.22 49.37 54.73 55.83
Tax @ 35% 14.43 15.83 17.28 19.16 19.54
PAT 26.80 29.39 32.09 35.57 36.29
Terminal cash flow (S.V. of 76
F.A. + Recovery of W Cap.
Margin)
Operating Cash flow 26.80 29.39 32.09 35.57 112.29
(PAT + TC)
Cash flows in dollar 33.56 37.16 40.97 45.86 146.20
Less: Profit from present 8.24 8.49 8.74 9 9.28
sales
Net cash flows 25.32 28.67 32.23 36.86 136.92
APV = – 1.24 (300 – 15)
+ [25.32 × PVIF(12%, 1) + 28.67 × PVIF (12%,2) + 32.23 × PVIF(12%,3)
+ 36.86 × PVIF(12%,4) + 136.92 × PVIF(12%,5)]
+ [24.54 × PVIF(2%,1) + 24.78 × PVIF(2%,2) + 25.03 × PVIF(2%,3) + 25.27 × PVIF(2%,4)
+ 25.52 × PVIF(2%,5)]
+ [0.08 × 100 × 0.35 × PVIFA(2%,5)]
+ 1.24 [100 – {8 × PVIF(10%,1) + 8 × PVIF(10%,2) + 8 × PVIF(10%,3) + 58× PVIF(10%,4)
+ 54 × PVIF(10%,5)}]
+ [8 × PVIFA(12%,5)]
= –353.40 + 169.50 + 117.91+ 13.20 + 8.64 + 28.84
= –$ 15.31 million.
< TOP >
3. Let the interest rate on concessional loan be ‘k’
Loan repayment Schedule
Year Principal o/s Int. Principal Repay. Total repay.
1 100 100k – 100k
2 100 100k – 100k
3 100 100k – 100k
4 100 100k 50 50 + 100k
5 50 50k 50 50 + 100k
Present value of interest tax shield
= 1.24 [100 – {100k × PVIF(10%,1) + 100k × PVIF(10%,2) + 100k × PVIF(10%,3)
+ (50+100k) × PVIF(10%,4) + (50 + 100k) × PVIF(10%,5)]
= 1.24 [100 – {90.9k + 82.6k + 75.1k + 34.15 + 68.3k + 31.05 + 62.1k}]
= 1.24 [34.8 – 379k]
= 43.15 – 469.96k
 To make the project viable for the APV of –$ 15 million
43.15 – 469.96k > 15 + 8.64
469.96k > 43.15 – 23.64
or, 469.96k < 19.51
19.51
469.96
or, k < = 4.15%
So, interest rate on concessional loan should be less than 4.15% to make the project viable.

< TOP >

4. The various instruments used to raise funds in international financial markets include: equity, straight debt
or hybrid instruments.
Debt Instruments
The issue of bonds to finance cross-border capital flows has a history of more than 150 years. In the 19th
century, foreign issuers of bonds, mainly governments and railway companies, used the London market to
raise funds.
International bonds are classified broadly under two categories:
Foreign Bonds: These are the bonds floated in the domestic market denominated in domestic currency by
non-resident entities. Dollar denominated bonds issued in the US domestic markets by non-US companies
are known as Yankee Bonds, Yen denominated bonds issued in Japanese domestic market by non-Japanese
companies are known as Samurai Bonds and Pound denominated bonds issued in the UK by non-UK
companies are known as Bulldog Bonds. Similarly, currency sectors of other foreign bond markets have
special names like Rambrandt Dutch Guilder, and Matador Spanish Peseta etc.
Eurobonds: The term `Euro' originated in the fifties when the USA under the Marshall Plan was assisting
the European nations in the rebuilding process after the devastation caused by the second world war. The
dollars that were in use outside the US came to be called as "Eurodollars". In this context the term `Euro'
signifies a currency outside its home country. The term `Eurobonds' thus refers to bonds issued and sold
outside the home country of the currency. For example, a dollar denominated bond issued in the UK is a
Euro (dollar) bond, similarly a Yen denominated bond issued in the US is a Euro (Yen) bond.
The companies wishing to come out with shorter maturities have an option to issue Euronotes in the
European Markets. The important ones being Commercial Paper (CP), Note Issuance Facilities (NIF) and
Medium-Term Notes (MTNs).
Euro-Commercial Paper issued with maturity of up to one year, are not underwritten and are unsecured.
Equity Instruments
Issuers from developing countries, where issue of dollar/foreign currency denominated equity shares are
not permitted, are now able to access international equity markets through the issue of an intermediate
instrument called `Depository Receipt'.
A Depository Receipt (DR) is a negotiable certificate issued by a depository bank which represents the
beneficial interest in shares issued by a company. These shares are deposited with a local `custodian'
appointed by the depository, which issues receipts against the deposit of shares.
According to the placements planned, DRs are referred to as (i) Global Depository Receipts (GDRs) (ii)
American Depository Receipts (ADRs) and (iii) International Depository Receipts (IDRs). Each of the
Depository Receipt represents a specified number of shares in the domestic markets. Usually, in countries
with capital account convertibility, the GDRs and domestic shares are convertible (may be redeemed)
mutually. This implies that, an equity shareholder may deposit the specified number of shares and obtain
the GDR and vice versa.
Quasi-instruments
These instruments are considered as debt instruments for a time-frame and are converted into equity at the
option of the investor (or at company's option) after the expiry of that particular time-frame. The examples
of these are Warrants, Foreign Currency Convertible Bonds (FCCBs), etc. Warrants are normally issued
 along with other debt instruments so as to act as a `sweetener'.
FCCBs have a fixed coupon rate with a legal payment obligation. It has greater flexibility with the
conversion option – at the choice of the investor – to equity. The price of the conversion of FCCB closely
resembles the trading price of the shares at the stock exchange.
A Euro Convertible Bond is issued for investment in Europe. It is a quasi equity issue made outside the
domestic market and provides the holder with an option to convert the instrument from debt to equity.
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Section E: Caselets
Caselet 1
5. There are various benefits of CAC, such as development of financial markets and a disciplining influence
on macroeconomic policies. It also enables the country to integrate its economy with global economy, and
thereby facilitates greater access to international financial markets to obtain larger stock of foreign capital
at relatively low costs, to supplement domestic capital resources. A two-way movement of capital and
increased flow of foreign capital especially in portfolio form is likely to lead to a fall in interest rates. This
would boost the investment and GDP growth. It also allows domestic residents to invest in foreign market.
By diversifying their investment portfolio they can reduce the risk factor. Further, it facilitates
specialization in financial services and thereby, increases allocative efficiency and productivity of capital.
When a currency becomes convertible on capital account, financial prices, both domestic and international,
tend to level off as capital can move both ways without any hindrance. This leads to a fall in domestic tax
regime in line with tax regimes elsewhere. Moreover, it has to be noted that over a period of time capital
controls turn ineffective, costly and even distorting.
The above benefits, however, leads to a dangerous illusion about CAC. It is generally assumed that CAC
would not only encourage large inflows of capital but also bring back capital taken out of the country
illegally in the past. At the same time, it ignores the possibility that if market conditions deteriorate at some
time in future then CAC would facilitate a reverse flight of capital of not only foreign but also domestic
capital. CAC also has another serious implication. Presently, resident Indians can buy only shares and
debentures of Indian companies. With CAC they can also buy foreign shares and debentures. Thus, Indian
households can chose between investments in Indian and foreign companies. This implies that Indian-based
companies will find even greater difficulties in mobilizing capital from primary market. In an emerging
capital-starved economy this may stifle the growth of Indian companies. Therefore, it becomes imperative
to go for CAC cautiously.
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6. Preconditions for implementing CAC
1. Slash or subsidies provided by the government in different sectors of the economy.
2. Control/cut-down of non-plan expenditure to the barest minimum level.
3. Reduction in the deficit in the Annual Fiscal Budgets.
4. Fast/quick implementation of dis-investment of Forex
5. Deploying foreign funds for productive use, i.e., in growth-oriented sectors.
6. Increasing the base levels of Forex reserves of the country.
7. Strengthening of the Balance of Payments, in particular, current account transactions.
8. Control of reduction in the inflation rate in the economy within manageable levels.
9. Gearing up the economic/financial reforms in the country
10. Strengthening the capital base levels of Indian banks on par with international banks.
11. Improvement in the quality of assets of the Banking Sector and the reduction in NPAs to
internationally accepted levels.
12. Increase in the efficiency of commercial banks, reduction in their operating costs, developing risk
 management skills, modernizing management, pressing into service modern technology to raise
productivity, etc.
13. Implementing reforms both in Primary and Secondary capital markets in order to attract foreign
capital from NRIs, OCBs and FILs for development of infrastructure projects and industries such as
cement, steel, road and bridge construction, capital goods, telecom etc., in the country, introduction of
wide range of derivatives such as futures, options, etc.
14. Implementation of International reporting norms such as International Accounting Standards, GAAP,
etc., in Indian companies to attract inflow of foreign capital through ADRs/GDRs. etc.
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7. International experience with CAC reveals that countries that initiated the move to CAC on the basis of
strong fundamentals were able to modulate the pace of instituting CAC without undertaking large and
dramatic shifts in the stance of macroeconomic policies. Furthermore, these countries were less vulnerable
to backtracking and the re-imposition of controls. Countries with weak initial conditions were constrained
to adopt drastic macroeconomic policies to facilitate the move to CAC. Some of these countries had to face
interruptions and reintroduce capital controls in the evolution of CAC. However, it is noted that most
countries considered a strong balance of payments position, universally built up reserves and strengthening
of the financial system as the most important preconditions for CAC. On the other hand, Fiscal
consolidation and appropriate exchange rate policies are important preconditions in the process of CAC.
Indian economy is not strong enough to allow capital convertibility. Neither the Asian Tigers nor China has
gone in for full convertibility of their currencies. The fall and failure of Mexican economy and its currency
Peso is attributed mainly to full capital account convertibility. It was massive US loans to Mexico in 1994,
which bailed out the country. But who will bail out India if Indian economy collapses due to full capital
account convertibility?
Neither India’s economy nor stock markets are in a position to absorb the heavy shock waves likely to be
created as a result of capital account convertibility. It may lead to price rise, high import costs,
uncontrollable outflow of capital, serious balance of payments problems etc.
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Caselet 2
8. An appreciating rupee, it is feared, will make our exports less competitive in the global markets. By virtue
of an appreciating rupee the exporters would suffer losses since realization in terms of rupees would be les.
It is reported that Infosys is anticipating a reduction in its revenues of around 0.5% for every 1%
appreciation in the rupee. It would still be worse in case of textile exports as they are already working on
wafer-thin margins. Encouragingly, this time around, the Indian exporters have of course not made much
noise over the rising rupee. One reason for this courageous display of exporters could be that despite a
rising rupee, exports have risen by 15% during the first 11 months of 2003-04 and a staggering 35% during
February 2004 over the corresponding month of the previous year. But this cannot be taken as a final proof
of appreciating rupee having no impact on exports for there is a valid argument to the effect that exchange
rates affect trade flows with a lag of around 6-12 months.
An appreciating rupee equally impacts the future cash flows and profits of a firm that is operating even
within the domestic market. It simply makes imports cheaper, thereby encouraging traders to import goods
from abroad to meet local demand. To that extent the demand for locally manufactured goods will be
adversely affected. In a globalized economy, where tariffs on cross-border goods are falling at a faster rate,
this phenomenon poses a great threat to the local-market players too. More the competition from the global
players, more would be the impact on the sales of domestic companies. But ironically, today, nobody is
paying the required attention to this prospective ‘silent killer’.
It is true, exchange rates can move both ways and thus can lead to profit as often as to losses. It is also true
that the extent of profit or loss owing to exchange rate movement should average out over a period of time.
But the danger with forex risk is it could result in large enough loss to wipe out the business in one stroke,
denying the company a second opportunity to wait for the probability of making an equally large profit. In
 conclusion, one must say that an appreciating rupee challenges the business acumen of not only exporters,
but also companies operating exclusively in the domestic market.
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9. In order to keep the level of rupee at an optimal level, the Central Bank indulges in the “sterilization
process.” This sterilized intervention is a threefold act. The Central Bank initially buys dollar from the
market (to prevent a sudden appreciation in rupee value). This is then followed by releasing an equival
amount of domestic currency (rupees) in the market (to avoid an asset-liability mismatch). Finally, it mops
up the excess liquidity from the market by issuing government bonds (in this case, the Market Stabilization
Bonds (MSBs).
Coming back to the present state of affairs, it is to be noted that the government was facing trouble to check
the rising value of rupee. The first problem is that the government has to bear a direct as well as indirect
cost of the specially issued MSBs. And the other problem is that the RBIs present stock of bonds that can
be used to mop up the excess liquidity from the market was also fast depleting. It has come down to the
level of Rs.24,000 cr that was just enough to sterilize a few more billion dollars. As a result of which the
Central Bank came out with the specially designed market stabilization bonds worth Rs.60,000 cr.
The first batch of such securities worth Rs.5,000 cr is already pumped into the market on April 6, 2004. It is
to be remembered that through these bonds entail a cost to the Central Bank, it has to be set off against the
possible decline in export earnings resulting from persistent appreciation. Though at this juncture it is
difficult to estimate the same, given the strong export employment linkages, the impact on jobs in a variety
of export-intensive sectors could be quite significant. Thus, the cost of sterilization may, therefore, turn out
to be small as compared to its benefits.
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10. A trend towards appreciation of the rupee in the context of the performance of the Indian economy and the
decline of the US dollar against other currencies is a sign that there is a shift in the performance of the
rupee in a general way. The rupee could continue to appreciate in the medium-term due to comfortable
forex reserves, increased inflows from NRI deposits and service deposits. According to some economists,
“The rupee will continue to rise for some more time to come. There might be minor blips or corrections, but
it seems that the overall direction of the rupee is going to be northward for any foreseeable time in the
future.” Economists are of the view that the dollar needs to fall by another 10-12% globally. If the rupee
mirrors that trend, it could end up around 39 to a dollar in a year or so. What we have seen now is only the
beginning. The real fireworks are still to come.
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Caselet 3
11. If money is too cheap, then rates of return will fall, companies will tend to use capital rather than labour,
and people will spend money on riskier assets; on things that have little to do with underlying economic
growth; and on things that are in short supply. As it happens, this is a decent description of America in the
past few years. Companies have been slow to hire workers even as the economy has bounced back; and
workers' share of national income is very low. The low cost of capital has, moreover, encouraged
speculation in risky assets, such as emerging markets, or—closer to home, as it were—property. And, yes,
with all that money sloshing about, it has also pushed up inflation a bit.
There is thus a distinct danger that by pushing real interest rates back to where they should have been. In
the first place, monetary tightening will reveal the economic recovery to have been more fragile than most
think—and threaten a hard landing and the malign sort of deflation that the Fed was so keen to avoid. This
could even mean that rates need to fall next year, not rise. And with rates so low and budget deficits already
high, America's economic armory is much depleted.
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12. Higher rates can strengthen a currency as it may attract “hot money”. However, over the long term, high
rates have been a mixed blessing as they are often associated with high inflation and depreciating
currencies. Hard currencies have usually had low rates, but it is weak currencies that need higher rates to
compensate for the probability of depreciation. Thus, higher rates show a positive commitment to fighting
inflation, and this is positive for the currency.
Another reason why increases in interest rates may support a currency is: Interest parity dictates, if rates
increase, the spot exchange rate will increase to satisfy the interest parity condition, if the expected
depreciation (spot exchange – forward exchange rate) is equal to the interest rate differential.
The prospect of higher US interest rates also forces investors to unwind carry trades, where investors
borrow dollars at low US rates in order to invest in assets with higher expected returns. If the carry trade is
being unwound, hot money will have to move fast to avoid losses – and that will support the dollar.
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