TOPIC 1 Multinational Financial Goals

Learning Goals
1. 2. 3. 4.

Recognize the Globalization Process and the risks involved Distinguish multinational financial management from domestic financial management Compare the goals of multinational financial management Identify major trends of globalization of the World Economy
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Multinational Corporation (MNC)



 

A multinational corporation (MNC) is a firm that has incorporated in one country, and has production and sales operations (subsidiaries, branches or affiliates) in other countries. Firms merely exporting products and importing raw materials are not MNC. Many MNCs obtain raw materials from one nation, financial capital from another, produce goods with labor and capital equipment in a third country and sell their output in various other national markets. There are about 60,000 MNCs in the world. MNCs are managed from a global perspective rather than from the perspective of any single country. 3

PurelyPurely-Domestic & Domestic Firm



While multinational business finance emphasizes MNCs, purely-domestic and domestic firms purelyalso often have significant international activities: Exposure to foreign competition in the domestic market (for purely domestic firms) Import & Export of products, components and services Licensing / Franchising of foreign firms to conduct their foreign business Indirect exposure to international risks through relationships with foreign customers and suppliers 4

Top 10 MNCs
1 2 3 4 5 6 7 8 9 10 General Electric Vodafone Group PLC Ford Motor Company General Motors Royal Dutch/Shell Group Toyota Motor Corporation Total Fina Elf France Telecom ExxonMobile Corporation United States United Kingdom United States United States United Kingdom / Netherlands Japan France France United States
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British Petroleum Co. PLC United Kingdom

Why are firms motivated to expand their business internationally?

Theory of Comparative Advantage
Specialization by countries can increase production

efficiency.

Market Imperfections Theory

production are imperfect availability and lower costs. Legal restrictions on movement of goods, people and capital Difference in tax laws
Markets for the various resources/factors used in

Product Cycle Theory

As a firms product life cycle reaches maturity/decline

stage, it may recognize additional opportunities outside its home country (stabilize total sales revenue). 6 Expanded opportunity set outside home country.

The International Product Life Cycle

Firm creates product to accommodate local demand Firm exports product to accommodate foreign demand Firm establishes foreign subsidiary to establish presence in foreign country and possibly to reduce costs

Firm differentiates product from competitors and/or expands product line in foreign country

or Firms foreign business declines as its competitive advantages are eliminated

The Globalization Process



The globalization process is the structural and managerial changes and challenges experienced by a firm as it moves from domestic to global in operations. operations.
We will examine the case of Trident, a young firm that manufactures and distributes an array of telecommunication devices (refer to main textbook by Moffett) Tridents initial strategy is to develop a sustainable competitive advantage in the U.S. market Trident is currently constrained by its small size, stiff competition, and lack of access to cheap capital.
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The Globalization Process

Phase One: Domestic Operations
U.S. Suppliers (domestic)
All payments in US dollars; All credit risk under U.S. law

U.S. Buyers (domestic)

Trident Corporation
(Los Angeles, USA)

The Globalization Process

  

In Phase One, Trident is not itself international or global in its operations However, some of its competitors, suppliers or customers may be This is one of the key drivers pushing Trident into Phase Two, the first transition of the globalization process This is the Global Transition I: The Domestic Phase to The International Trade Phase
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The Globalization Process

Phase Two: Expansion into International Trade
Trident Corporation
(Los Angeles, USA)

Mexican Suppliers

Canadian Buyers

Are Mexican suppliers dependable? Will Trident pay US$ or Mexican pesos?

Are Canadian buyers creditworthy? Will payment be made in US$ or C$?

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Trident Corp: Phases Combined

Phase One: Domestic Operations
U.S. Suppliers (domestic)
All payments in US dollars; All credit risk under U.S. law

U.S. Buyers (domestic)

Trident Corporation
(Los Angeles, USA)

Mexican Suppliers
Are Mexican suppliers dependable? Will Trident pay US$ or Mexican pesos?

Canadian Buyers
Are Canadian buyers creditworthy? Will payment be made in US$ or C$?
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Phase Two: Expansion into International Trade

The Globalization Process



In the International Trade Phase, Trident responds to globalization factors by importing inputs from Mexican suppliers and exporting products to Canadian customers Exporting and importing products and services increases the demands of financial management over and above the traditional requirements of the domestic-only business

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The Globalization Process

First, foreign exchange risk are now borne by the firm Receipts and payments may be in different currencies The value of these foreign currency receipts and payments in home currency terms can change, creating a new source of risk  Second, the evaluation of the credit quality of foreign customers and sellers is now more important than ever; this is known as credit risk management Potential for non-payment of exports and non-delivery nonnonof imports Differences in business and legal systems and practices

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The Globalization Process



If Trident is successful in its international trade activities, it will soon need to establish foreign sales and service affiliates. This step is often followed by establishing manufacturing operations abroad or by licensing foreign firms to produce and service Tridents products. This is the Global Transition II: The International Trade Phase to The Multinational Phase
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The Globalization Process

 

Tridents continued globalization will require it to identify the sources of it competitive advantages. This variety of strategic alternatives available to Trident is called the foreign direct investment sequence which include the creation of foreign sales offices, licensing agreements, manufacturing plants, etc. (cover in Topic 12) Once Trident owns assets and enterprises in foreign countries it has entered the Multinational Phase of globalization. Domestic International Trade MNC 16

Foreign Direct Investment Sequence

Trident and its Competitive Advantage

Greater Foreign Presence

Change Competitive Advantage

Exploit Existing Competitive Advantage Abroad

Production at Home: Exporting

Production Abroad

Licensing Management Contract

Control Assets Abroad

Greater Foreign Investment

Joint Venture

Wholly-Owned Subsidiary

Greenfield Investment

Acquisition of a Foreign Enterprise 17

Role of MNC Finance Managers



As firm increases its foreign presence and level of foreign investment its management team must: Develop knowledge of the global financial environment Understand foreign exchange theories and markets Manage foreign exchange exposures including transaction, transaction, operating and translation exposures Gain access to global equity and debt markets by globalizing the cost and availability of capital Continue to make strategic foreign investment decisions Minimizes group effective tax rate Manage multinational operations 18

Role of MNC Finance Managers



Group Effective Tax Rate (in %) * 100% = Total tax in home currency Total profit before tax in home currency Group EPS (in home currency terms) = Total net income in home currency _ Number of Parents equity shares outstanding

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Multinational vs. Domestic Financial Management



There are significant differences between multinational and domestic financial management: Cultural issues Corporate governance issues Foreign exchange risk Political risk Modification of domestic finance theories Modification of domestic financial instruments

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What is the Goal of Multinational Financial Management?



As firm becomes more deeply committed to multinational operations, a new constraint develops one that springs from divergent worldwide opinions and practices as to just what the firms overall goal should be: Shareholder Wealth Maximization As characterized by Anglo-American markets Corporate Wealth Maximization As characterized by Continental European and Japanese markets

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Shareholder Wealth Maximization



In a Shareholder Wealth Maximization model (SWM), a firm should strive to maximize the return to shareholders, as measured by the sum of capital gains and dividends, for a given level of risk. Alternatively, the firm should minimize the level of risk to shareholders for a given rate of return.

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Shareholder Wealth Maximization

 

The SWM model assumes as a universal truth that the stock market is efficient. An equity share price is always correct because it captures all the expectations of return and risk as perceived by investors, quickly incorporating new information into the share price. Share prices are, in turn, the best allocators of capital in the macro economy.
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Shareholder Wealth Maximization

 

The SWM model also treats its definition of risk as a universal truth. Risk is defined as the added risk that a firms shares bring to a diversified portfolio (systematic risk). Therefore the unsystematic, or firm-specific risk, should not be of concern to investors (unless bankruptcy becomes a concern) because it can be eliminated through diversification. Systematic, or market, risk cannot however be eliminated (can be reduce through international diversification).

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Shareholder Wealth Maximization



When a corporations shareholders differ from its managers, a conflict of goals can existthe agency problem. Agency costs are normally larger for MNCs than for purely domestic firms, due to: the difficulty in monitoring distant managers the different cultures of foreign managers the sheer size of the larger MNCs the tendency of foreign managers to yield short-term results
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Shareholder Wealth Maximization

 

The magnitude of agency costs can also vary with the management style of the MNC. A centralized management style reduces agency costs, but slows down decision making at foreign subsidiaries (which may miss business opportunities). A decentralized management style gives more control to those foreign managers who are closer to their subsidiarys operations and environment. Faster decision making, but may increases 27 agency costs.

Shareholder Wealth Maximization

As shown by a series of recent corporate scandals at companies like Enron, WorldCom, and Global Crossing, managers may pursue their own private interests at the expense of shareholders when they are not closely monitored.  These calamities have painfully reinforced the importance of corporate governance, i.e. the financial and legal framework for regulating the relationship between a firms management and its shareholders.  Legal protection of shareholders is weak or virtually nonexisting in emerging and transitional economies such as Indonesia, Russia and North Korea.

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Shareholder Wealth Maximization

Agency theory is the study of how shareholders can motivate management to accept the prescriptions of the SWM model.  Liberal use of stock options should encourage management to think more like shareholders.  If management deviates too extensively from SWM objectives, the board of directors should replace them (audit committee and non-executive directors)  If the board of directors is too weak (or not at armslength) the discipline of the capital markets could effect the same outcome through a takeover. This outcome is made more possible in Anglo-American 29 markets due to the one-share one-vote rule.


Shareholder Wealth Maximization

 

 

Long-term value maximization can conflict with short-term value maximization as a result of compensation systems focused on quarterly or near-term results. Short-term actions taken by management that are destructive over the long-term have been labeled impatient capitalism. This point of debate is often referred to a firms investment horizon (how long it takes for a firms actions, investments and operations to result in earnings). Patient capitalism focuses on long-term SWM. Many investors, such as Warren Buffet, have focused on mainstream firms that grow slowly and steadily and have good fundamentals, rather than latching on to high-growth but risky sectors.
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Corporate Wealth Maximization



Continental European and Japanese markets are characterized by a philosophy that a corporations objective should be to maximize corporate wealth (the CWM model). In CWM, a firm should treat shareholders on a par with other corporate interest groups, such groups, as management, employees, the local community, suppliers, customers, creditors and even the government. This model, also called the stakeholder capitalism model, focuses on earning as much model, as possible in the long-run while retaining longenough to increase the corporate wealth for 31 the benefits of all interest groups. groups.

Corporate Wealth Maximization



 

The definition of corporate wealth is much broader than just financial wealth (cash, marketable securities and lines of credit). Corporate wealth includes technical, market and human resources. This measure goes beyond financial reports to include the firms market position, employee knowledge base and skill sets, manufacturing processes, technological proficiencies, marketing and administration capabilities (non-financial (nonaspects of performance). performance).
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Corporate Wealth Maximization



The CWM model does not assume that equity markets are either efficient or inefficient. In fact, market efficiency does not matter as the firms financial goals are not exclusively shareholderoriented. This model assumes that long-term loyal shareholders should influence corporate strategy, not transient portfolio investors.

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Corporate Wealth Maximization



The CWM model assumes that total risk, which consist of operating risk and financial risk, does count. In the CWM model, it is a corporate objective to generate growth in earnings and dividends over the long run with as much certainty as possible given the firms mission statement and goals. Operating risk is measured more by product market variability than by short-term variation in earnings and share prices.
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Corporate Wealth Maximization



Although the CWM model avoids the impatient capitalism as seen in the SWM, it has its own flaw in that management is tasked with meeting the demands of multiple stakeholders. This leaves management without a clear signal about the tradeoffs. In contrast to the CWM model, the SWM model requires a single goal of value maximization. Not easy to measure corporate wealth which include non-financial aspects.
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Recent Trends of SWM vs. CWM



While both forms of wealth maximization have their strengths and weaknesses, two trends in recent years have led to a focus on the SWM model. As non Anglo-American markets privatize their industries the SWM model becomes more important in the overall effort to attract foreign capital Many analysts believe that shareholder-based MNCs are increasingly dominating their global industry segments
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Globalization of the World Economy: Major Trends



Emergence of Globalized Financial Markets  Emergence of the Euro as a Global Currency  Trade Liberalization and Economic Integration  Privatization

Emergence of Globalized Financial Markets



Deregulation of Financial Markets coupled with Advances in Technology have greatly reduced information and transactions costs, which has led to financial innovations such as: Currency futures and options Multi-currency bonds Cross-border stock listings International mutual funds
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Emergence of the Euro as a Global Currency

 

 

A momentous event in the history of world financial systems (4th Jan 1999). Currently, more than 300 million Europeans in 22 countries are using the common currency on a daily basis. In May 2004, 10 more countries joined the European Union and adopt the euro. The transaction domain of the euro may become larger than the U.S. dollars in the near future. 39

Euro Area
          

Austria Belgium Cyprus Czech Republic Estonia Finland France Germany Greece Hungary Ireland

          

Italy Latvia Lithuania Luxembourg Malta Netherlands Poland Portugal Slovak Republic Slovenia Spain
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Value of the Euro in Dollar Terms (US$/Euro)

January 1999 to Dec 2004

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Economic Integration
 

Over the past 50 years, international trade increased about twice as fast as world GDP. There has been a sea change in the attitudes of many of the worlds governments who have abandoned mercantilist views and embraced free trade as the surest route to prosperity for their citizens.

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Liberalization of Protectionist Legislation



  

The General Agreement on Tariffs and Trade (GATT) a multilateral agreement among member countries has reduced many barriers to trade. The World Trade Organization has the power to enforce the rules of international trade. North American region NAFTA ASEAN region AFTA

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NAFTA


The North American Free Trade Agreement (NAFTA) calls for phasing out impediments to trade between Canada, Mexico and the United States over a 15-year period. For Mexico, the ratio of export to GDP has increased dramatically from 2.2% in 1973 to 28.7% in 2001. The increased trade will result in increased numbers of jobs and a higher standard of living for all member nations.
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Privatization


  

The selling off state-owned enterprises (or government-linked companies) to private sector firms or investors. Also known Denationalization Often seen in socialist economies in transition to market economies. By most estimates this increases the efficiency of the enterprise. Often spurs a tremendous increase in crossborder investment into the country.