SYMBIOSIS INSTITUTE OF OPERATIONS MANAGEMENT

MBA(2010-2012) ASSIGNMENT-1

INTERNATIONAL FINANCE

SUBMITTED BY: PANKAJ MURUDKAR [063] VINAY NADAR [064] SACHIN BAJAJ [066] SUMIT PAHUJA [067]

1.Introduction:

In todays era of globalization and economic liberalization, the goal of each organization is to increase its material wealth, goods, service and overall profit by extending its presence across the globe. The current wave of globalization has been driven by policies that have opened economies domestically and internationally. In the years since the Second World War, and especially during the past two decades, many governments have adopted free-market economic systems, vastly increasing their own productive potential and creating myriad new opportunities for international trade and investment. Governments also have negotiated dramatic reductions in barriers to commerce and have established international agreements to promote trade in goods, services, and investment. Taking advantage of new opportunities in foreign markets, corporations have built foreign factories and established production and marketing arrangements with foreign partners. A defining feature of globalization, therefore, is an international industrial and financial business structure. International Business is all business transactions that involve two or more countries. It comprises a large and growing portion of the worlds total business. International Business usually takes place within a more diverse external environment. International trade is a vital part of the economy for any country. The reason for an international business is to increase sales, acquiring resources, diversifying source of sales and supplies. A multinational corporation (MNC) or enterprise (MNE), is a corporation or an enterprise that manages production or delivers services in more than one country. It can also be referred to as an international corporation. MNCs organize this operation in different countries through any of the following five alternatives:

Branches Subsidiaries Joint venture company Franchise holders Turn-key projects

While doing a business in any host country it faces various kinds of risks, such as foreign exchange risks, political risk, economic risks, interest risk, accounting risk etc. This report takes the case of Mc Donald chain of restaurants as a case and analysis the above mentioned risks for them. The report also throws light and suggestions how they can mitigate the risk using futures, forwards and swap options.

2.About the Company:

McDonald's Corporation is the world's largest chain of hamburger fast food restaurants, serving around 64 million customers daily. Headquartered in Oak Brook, Illinois, United States, the corporation was founded by businessman Ray Kroc in 1955 after he purchased the rights to a small hamburger chain operated by the eponymous Richard and Maurice McDonald. Its traded in NYSE as MCD. A McDonald's restaurant is operated by a franchisee, an affiliate, or the corporation itself. The corporation's revenues come from the rent, royalties and fees paid by the franchisees, as well as sales in company-operated restaurants. McDonald's revenues grew 27% over the three years ending in 2010 to $24.8 billion, and 9% growth in operating income to $7.47 billion. McDonald's primarily sells hamburgers, cheeseburgers, chicken, French fries, breakfast items, soft drinks, shakes and desserts. In response to changing consumer tastes, the company has expanded its menu to include salads, wraps and fruits. McDonald's restaurants are found in 119 countries and territories around the world and serve 64 million customers each day. McDonald's operates over 31,000 restaurants worldwide, employing more than 1.5 million people. The company also operates other restaurant brands, such as Piles Caf. Focusing on its core brand, McDonald's began divesting itself of other chains it had acquired during the 1990s. The company owned a majority stake in Chipotle Mexican Grill until October 2006, when McDonald's fully divested from Chipotle through a stock exchange. Until December 2003, it also owned Donatos Pizza. On August 27, 2007, McDonald's sold Boston Market to Sun Capital Partners. As McDonald's has increasingly expanded internationally over the years, the company now offers a regionalized version of its menu, from satisfying the local population to conforming to religious beliefs of a particular country. This results in products that are specific to particular regions and which are not seen in other countries. McDonald's franchises grew swiftly: by the end of the 1960s, there were more than 1,000 across the U.S. The first international franchise opened in 1967 in British Columbia, and was followed by another in Costa Rica later that year. From there, the chain spread steadily: over a six-month period in 1971, Golden Arches popped up on three new continents, as stores launched in Japan, Holland and a suburb of Sydney. A Brazilian McDonald's opened in 1979, bringing Ronald McDonald to South America for the first time. McDonald's reached its sixth (and, barring a sub-Arctic drive-thru, final) continent in 1992, with the opening of a restaurant in Casablanca, Morocco. Four years later, the company heralded the expansion into its 100th nation, Belarus, and claimed to be opening a new restaurant somewhere in the world every three hours. McDonalds has two sources of profit: Sales made by company-owned restaurants Rental and royalty income from franchised restaurants.

Restaurant Sales McDonalds retains all of the profit earned by company-owned restaurants. An example Profit & Loss Statement for a restaurant is shown left and highlights how food and labour constitute a restaurants largest costs. In addition to variable costs, which increase or decrease depending on the level of sales, McDonalds also incurs costs that are largely fixed, for example utilities and advertising, which need to be paid for even before the restaurant makes any sales. Increasing sales and controlling costs are fundamental to ensuring the profit of each restaurant is either maintained or increased. Franchise Rental & Royalty Income The owner of each franchised restaurant, known as the franchisee, keeps all of the profit they make through sales after paying McDonalds a royalty for trading under the brand name and rent for operating in a McDonalds owned property. The benefit to McDonalds of operating franchised restaurants is that these restaurants guarantee a stream of income for McDonalds at a reduced level of risk while enabling the company to maintain a single brand presence. The risk to McDonalds is reduced because much of it is borne by the Franchisee. The Franchising Accounts team works closely with franchisees to provide the support they require to grow their profitability.

Financial reporting looks at historical performance with the primary responsibility of the Corporate Accounts department being the preparation of annual financial statements and reporting McDonalds monthly results to their parent company in the U.S. Several specific functions are in place in order to achieve these requirements. A centralized accounting centre is responsible for processing all accounts receivable and payable transactions, banking income, managing working capital and also for the maintenance of the fixed asset registers. The accounting centre provides day-to-day support to every McDonalds restaurant. Treasury and tax experts ensure compliance with tax laws and make sure the company has sufficient cash flow and appropriate finance in place in order to meet business needs. Payroll staff is responsible for the accounting

3.Risks Involved in International Business: a.Foreign Exchange Rate Risk:

Exchange rate risk is simply the risk to which investors are exposed because changes in exchange rates may have an effect on investments that they have made. The most obvious exchange rate risks are those that result from buying foreign currency denominated investments. The commonest of these are shares listed in another country or foreign currency bonds. Investors in companies that have operations in another country, or that export, are also exposed to exchange rate risk. A company with operations abroad will find the value in domestic currency of its overseas profits changes with exchange rates. Similarly an exporter is likely to find that an appreciation in its domestic currency will mean that either sales fall (because its prices rise in terms of its customers currency) or that its gross margin shrinks, or both. A depreciation of its domestic currency would have the opposite effect. For Mc Donald Corporation this is a very high risk as its functioning in approximately 120 countries. Today, more than 65% of total revenue is derived internationally, as more and more restaurants are

opened in countries outside the United States, increasing McDonalds foreign exchange and interest rate risks. McDonalds Treasury is challenged with managing these risks. This is no small task, as hedging the interest rate and foreign exchange risks for operations based in foreign countries is complex. McDonalds Treasury is divided into four areas Cash Management, Financial Markets, Domestic Finance, and International Finance. The Cash Management team takes care of the administration and back office duties of the treasury, while the Domestic Finance and International Finance areas manage the banking relationships for McDonalds Corporation, franchisees, and suppliers. The Financial Markets group is responsible for hedging the balance sheet and income statement against foreign exchange and interest rate risks, while funding the growth of global operations They often fund assets locally, but in many markets this is challenging. The assets are funded by more than $8 billion in debt, with over 50% of the debt denominated in a foreign currency. McDonalds uses swaps and options in managing their financial risks So any change in the exchange rate between the two countries will affect the operations of McDonalds. For example : McDonalds today have 169 restaurants across India with about 5000 employees and currently the exchange rate between India and US is 46.56 ( 1 USD is equal to 46.56 INR ), so if any change in the currency happen due to disturbance between the supply and demand of the currency it will affect the cash flow of McDonalds. Change in the value of exchange rates can affect the organization can help the organization to boost up its sales and also to make the conditions worse for that organization. Like McDonalds business in India is comparatively less as compared with the nations, so if the Indian rupee value appreciates it means the US dollar value depreciate which ultimately decreases the revenue generated from Indian subsidiaries and vice versa.

b.Political Risk:
The risk that an investment's returns could suffer as a result of political changes or instability in a country. Instability affecting investment returns could stem from a change in government, legislative bodies, other foreign policy maker or military control. Political risk is also known as "geopolitical risk", and becomes more of a factor as the time horizon of an investment gets longer. Below mentioned explains the two non tariff barriers in France and how it affects the McDonalds:

Local Purchase and Adaptation: A Local Content Purchases requirement is a requirement that some specific portion of a good, or the good itself, be domestically produced. So McDonalds is importing all the raw products that it requires from there other local source but according to those political barriers McDonalds have to produced or purchase the required material in France itself. McDonalds restaurants as part of its responsible purchasing initiative attempts to purchase the products it needs for its restaurants from either local or regional suppliers in the country in which its restaurants are doing business. This is especially true in France where McDonalds purchases over 80 percent of its needed supplies from French companies. In fact, McDonalds even advertises in local newspapers about the number of cows, chickens, and other vegetables it has purchased from French farmers each year.

Employment Law: In France, the 35-hour workweek has been mandatory since 2002 and is one of many regulations that prevent companies from having flexibility in their workforce. So according to this law in France McDonalds is facing a problem because they want to run their fast food restaurants 8 hours a day which mean 48 hours a week but they are not allow to do so. For this above reason McDonalds is facing problem in running their fast food chains in France. c.Accounting Risk: For a country like Mc Donald with presence in 120 countries around the globe it has to adhere to financial accounting and reporting standards of each and every country according to the parent countries financial system. It has to continuously monitor all its assets otherwise following errors can take place. The accounting reports could contain incorrect or misleading information for a number of reasons: errors, omissions, misstatements, and misrepresentations. This could occur either by accident, oversight, or by intentional human intervention. The risks of reports being incorrect is typically categorized as follows: Reporting error an error was made in the preparation of the accounting information and there was a failure to spot this during management review before publication. There was no intention by management to make the error. Omission something wasnt included because the accountants were unaware of the information or event. Misstatement when something is stated incorrectly, wrongly, or falsely. Misrepresentation or fraud where there is deliberate, intentional , human effort to present incorrect, misleading, information. This is often associated with creative accounting references such as: innovative accounting, aggressive accounting, earnings management, or cooking the books. This may be described as accounting irregularities to avoid suggestion of wrong doing. This usually occurs where management bias exists, there is a lack of objectivity, or a conflict of interest between managements objectives and those of other stakeholders. d.Interest Rate Risk: For a company like Mc Donalds which is in food chain retail business interest rate risks can be fatal. As it affects its consumers and product prices drastically as it has direct impact on countries currency rates and inflation According to countries changing rate the consumers capacity to buy its product will change. Thus Mc Donalds product pricing and franchising price will have a direct effect. It risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve or in any other interest rate relationship.

Such changes usually affect securities inversely and can be reduced by diversifying (investing in fixedincome securities with different durations) or hedging (e.g. through an interest rate swap). Interest rate risk affects the value of bonds more directly than stocks, and it is a major risk to all bondholders. As interest rates rise, bond prices fall and vice versa. The rationale is that as interest rates increase, the opportunity cost of holding a bond decreases since investors are able to realize greater yields by switching to other investments that reflect the higher interest rate. e.Economic Risk: It is a danger that the economy could turn against your investment. Economic risk is the likelihood that economic activities, including economic mismanagement would cause drastic changes in a country's business environment that would have a negative impact on revenue and other short term and long term goals of companies. Economic risk could mean both internal and external. Internal factors include monetary stability, the currency exchange system (fixed vs. floating), government expenditure policies and the country's resource base. External economic risks include uncontrollable risks like supply shocks, currency fluctuations, trade deficits, natural disasters and the health of the overall global economy. For McDonalds this is a very fatal risk as it has operations in over 120 countries. It has to critically analyze and evaluate the GDP, inflation and growth rate before making an investment decision.

4.Risk Reduction Technique: The risk reduction techniques include spot, forward contracts, options, futures and currency swaps. a.Forward Contract: Theoretically, forward contracts are intended for clients who want to fix a favorable current exchange rate on a specified future date. This fixed exchange rate guarantees a customized future payment and the maturity date, and thus eliminates the risk of future volatility. However, forward transactions give up translation profit if the foreign currency appreciates against the domestic currency and creates transaction costs of forward contracts. Whether the bank or the non-bank corporations are competent at forecasting exchange rates is an essence.

The advantages of using forward contracts are: 1) It is a tailored instrument including its all parameters, such as the amount, the maturity date and the type of particular currency; 2) The cost of forward contracts is low comparing with other instruments; and 3) The settlement date is up to one year.

b.Futures: Unlike forwards, futures contracts are standardized in terms of a standard volume that is about to be exchanged on a settlement date in the future. The standard volume means no tailored transaction amounts can be traded on markets like the Chicago Mercantile Exchange. Futures contracts are similar to forwards contracts. However, trading futures contracts is intended to speculating profits, since futures positions can be closed out before their delivery dates. In contrast, most forwards contracts are used for currency hedging and obliged on the delivery date. For its franchising business it should use the future options where they can predetermine the rates of currency at a future date and get in contract with party.

c.Spot: A spot contract allows you to buy or sell foreign currency at today's exchange rate and its final settlement date usually will be two business days later. Spot foreign exchange transactions are available for those clients who benefit from approval spot limits. For smaller transactions on day to day basis it can use spot method. It can act as a good hedging technique for its daily operations and managing working capital in foreign countries. d.Currency Options: Another often used currency hedging instrument is currency options, because it guarantees a worst-case exchange rate for the future purchase of one currency for another. Options are also contracts but the costs of options are much more than the costs of forward contracts. Since the company has the right but not the obligation to purchase (a call option) or sell (a put option) a currency at an agreed exchange rate (the strike price) (Desai, 2007). Because of this right, the buyer pays a premium that is more expensive than the costs of forward contracts. Unlike a forward contract, the option does not obligate the buyer to deliver a currency on the settlement date unless they exercise the option. The big advantage of using options is to protect against downside risk and allow upside appreciation, which leads to a more stable company with more stable infrastructure. Whether the upside appreciation can speculate profits is Dependent on how much the foreign currency goes up or goes down against domestic currency. If the foreign currency only goes up a little bit, suppose we buy put option denominated in the foreign currency, and then the put option would be worthless. For its foreign suppliers it should use the options method of hedging. Where it can pay a premium but have an advantage of rolling back if they are not satisfied with rates. e.Currency Swaps: In addition to the most popular hedging approaches, currency swaps is sometimes used. Currency swaps are generally used for long term period with a high volume under an ensured high liquidity. When entering into a currency swap, the client simultaneously purchases and sells a given currency at a fixed exchange rate and then re-exchanges those currencies at a future date allowing you to convert a stream of cash flows in one currency into another currency at a fixed exchange rate. This can be used between Mc Donald USA and its subsidiaries across globe. For any long term purpose they can swap the currencies between USA and another country. Thus Mc Donald will have a liquidity of

another currency apart from dollar so that it can tackle any unseen foreign exchange fluctuation. This can be used for its long term expansion and investments in the another country. Its main advantages are: 1) Minimizing the costs of foreign conversions and thus client is protected against exchange rate risk 2) Allowing firms to make use of advantages of maturities 3) Clients are flexible to shorten or prolong the period of the existing swap; 4) It costs nothing to enter into a swap which is an at-the-money initiative. Except for advantages, its disadvantages are: 1) Since the volatility of exchange rate increases as time goes on, the actual market rates could deviate from the contractual rates more; this potential risk may lead to greater gains or losses. 2) The client can be suffered from the default risk of its counterparty. Other derivative instruments are worthless be described in this paper since they are seldom used in practice.

5.Conclusion: Foreign exchange is a risk factor that is often overlooked by small and medium-sized enterprises (SMEs) that wish to enter, grow, and succeed in the global marketplace. Although most SME exporters prefer to sell in local currency, creditworthy foreign buyers today are increasingly demanding to pay in their local currencies. Obviously, this exposure can be avoided by insisting on selling only in local currency. However, such an approach may result in losing export opportunities to competitors who are willing to accommodate their foreign buyers by selling in their local currencies. This approach could also result in the non-payment by a foreign buyer who may find it impossible to meet export country currency denominated payment obligations due to the devaluation of the local currency against the local currency of exporter. For Mc Donald it sources its local product from local suppliers by which it mitigates it financial risks. But it has to imbibe a proper accounting system to keep track of its profit and loss across 120 countries. It could have problems in pricing of products due to fluctuating currency rates which it should mitigate a proper pricing strategy and for any other foreign transactions involved like franchising etc. it should use a proper hedging technique as mentioned above like futures, forwards, options and contracts.