Overview 1

Multinational Corporation (MNC)

Foreign Exchange Markets

Product Markets Subsidiaries InternationalFinancialMarkets

DividendRemittance& FinancingExporting

& ImportingInvesting

& Financing

Module IThe International Financial Environment

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‘The globe is not a level playing field’

- ANONYMOUS

-Firms devise strategies to improve their cash flows, Indian and foreign firms / MNCs alike.

-Many barriers to entry into foreign markets – both product & funds market – have been eased.

-Both global as well as purely domestic firms are affected in today’s globalizing world similarly than few decades ago: bcz. Competition will be affected by movements in exchange rates, foreign interest rates, labor costs and inflation.

Such changes can affect the market player’s relative cost of production& pricing policy.

Notes:A level playing field is a concept about fairness, not that each player has an equal chance to succeed, but that they all play by the same set of rules

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Discussion Objectives

• To identify the main goal of the multinational corporation (MNC) and conflicts with that goal;

• To describe the rationale / key theories that justify international business strategy;

• To explain the common methods used to conduct or expand global business;

• To examine global business opportunities and potential exposure to exchange rate risk& uncertainty; and

• To assess exchange rate exposure and its impact on value of an MNC and concluding remarks.

• Exercises:

• Case study: Ranger Supply Company.

• Article Review& Discussion: Finance Function in a Global Corporation, Harvard Business Review .

• Self-assessment: Blades Inc. Case & Small Business Dilemma

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The Context of a Global Corporation

Global companies present new opportunities and challenges

Apart from the usual capital structure and dividend decisions, they also have to manage capital structure and profit repatriation policies of their subsidiaries.

Capital budgeting decisions and valuation must reflect not only the divisional differences but also the complications introduced by currency, tax and country risk factors.

Incentive systems need to measure and reward country managers / CFOs operating in diverse socio-economic, cultural and financial settings.

The existence of Internal Capital Markets – gives MNCs a powerful mechanism for arbitrage across national financial markets.

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Goal of the MNC

• The commonly accepted goal of an MNC is to maximize shareholder wealth / achieve a positive EVA (i.e. return on total capital – cost of capital . Total capital ).

• We will focus on MNCs and that wholly own their foreign subsidiaries.

• This is the most common form of ownership of MNCs and it enables financial managers / CFOs throughout the MNC to have a single goal of maximizing value of the entire MNC instead of maximizing the value of any particular foreign subsidiary.

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Note:

• Any MNC operating in India through a local joint venture can set up a wholly owned subsidiary or a joint venture with a controlling stake for itself only if a no-objection certificate is obtained from its Indian joint venture partner.

• The current thinking is that mostly those joint ventures will continue which are necessitated by the government’s norms, such as in the areas of insurance, retail and telecommunications.

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Conflicts Against the MNC Goal

• For corporations with shareholders who differ from their managers, a conflict of goals can exist - the agency problem.

• Agency costs* are normally larger for MNCs than for purely domestic companies.

¤ The sheer size of the MNC and the scattering of distant subsidiaries. If Wal-Mart were a country, its revenues would make it on par with the GDP of the 25th largest economy in the world.

¤ The culture of foreign managers.

¤ . * cost of ensuring that managers maximize shareholders wealth.

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Conflicts Against the MNC Goal

¤ Subsidiary value versus overall MNC value – subsidiary decisions yet times may not be in accordance with parent company’s – E.g. If estimated after-tax benefits received by the parent were more than off-set by the cost of financing the project by the subsidiary company.

¤ E.g. GM, Energy giant AES, Ashi Glass.

¤ Think of tax laws, exchange rates, production costs, socio-economic dynamics.

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Agency costs, Mgt style, Impact of Management Control & Effective Mgt.

• The magnitude of agency costs can vary with the management style of the MNC.

• A centralized management style reduces agency costs. However, a decentralized style gives more control to those managers who are closer to the subsidiary’s operations and environment.

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Centralized Multinational Financial ManagementConsider an MNC with two subsidiaries, A and B

CFOof Parent

Capital Expendituresat A

Inventory andAccounts

ReceivableManagement at A

CashManagement

at A

Financing at A

Capital Expendituresat B


ReceivableManagement at B

CashManagement

at B

Financing at B

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Decentralized Multinational Financial ManagementConsider an MNC with two subsidiaries, A and B

CFOsOf A

Capital Expendituresat A


ReceivableManagement at A

CashManagement

at A

Financing at A

Capital Expendituresat B


ReceivableManagement at B

CashManagement

at B

Financing at B

CFOsOf B

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Impact of Management Control• Barings Bank collapse in 1995, Nick Leeson

• Some MNCs attempt to strike a balance - they allow subsidiary managers to make the key decisions for their respective operations, but the decisions are monitored by the parent’s management.

• Consider the case of GM in our class discussion – Finance Function in a Global Corp. - when the company balancing geographic boundary of its subsidiary vs. its financial performance moving away from clearly seen financial gains of a centralized one ; and also between financial incentives and operational effectiveness – essentially a mid-path between centralized and that of decentralized operational structures!

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Impact of Management Control

• Electronic networks make it easier for the parent to monitor the actions and performance of foreign subsidiaries.

• For example, corporate intranet or internet email facilitates communication. Financial reports and other documents can be sent electronically too.

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Impact of Corporate Control

• Various forms of corporate control can reduce agency costs.¤ Stock compensation for board members and

executives.¤ The threat of a hostile takeover.¤ Monitoring and intervention by large

shareholders.

Quick Quiz: What happened during the Financial Market Crisis 2007-10?

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An Assessment of Factors that contributed to the Financial Market Crisis 2007-10

15

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The 2007-2009 Financial Crisis and Executive Compensation: An Analysis and a Proposal for a Novel Structure(2010) by Alon Raviv International Business School, MA

& Yoram Landskroner, Stern School of Business

• During the 2007-2009 crises financial institutions have come under increasing pressure from regulators, politicians and shareholders to change their compensation practices in order to remove the incentive for ‘short-term excessive risk taking’.

In this work they analyzed how commonly used executive compensation plans can lead to two socially undesirable outcomes?

• : excessive risk taking at one extreme and complete freeze of new lending on the other. We propose adding a new component to the executive compensation which is paid only if the value of the firm will be located in some predetermined range. This components will push the executive towards the first best solution in which an intermediate (internal solution) level of assets risk, an optimal one.

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Constraints Interfering with the MNC’s Goal-

It’s Value• As MNC managers attempt to maximize their

firm’s value, they may be confronted with various constraints.¤ Environmental constraints.¤ Regulatory constraints - taxes, currency

convertibility rules, earnings remittance restrictions and others, employee rights and protection; capital flows restrictions and potential changes in them in future.

¤ Ethical constraints – standardized business conduct!.

¤ Wider economic& financial developments and potential changes in them.

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Why are firms motivated to expand their business internationally? Why firms are able to penetrate foreign markets? Why firms evolve into MNCs? A. Broad Rationale

Rationale for Foreign Business(financial) Operations:

Theories of International Business

Theory of Comparative Advantage¤ Specialization by countries can increase

production efficiency.

Imperfect Markets Theory¤ The markets for the various resources

used in production are “imperfect.”

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Notes

• Pure competition vs. Perfect competition

Complete knowledge of all market information - markets are ‘symmetric’

Free mobility of resources or factors of production

Why these assumptions imply several important things about competitive markets ?!.

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Why are firms motivated to expand their business internationally?

Theories of International Business

International Product Cycle Theory¤ As a firm matures, it may recognize

additional opportunities outside its home country. Ex: Minnesota Mining& Manufacturing (3M)Company uses one new product to penetrate foreign markets. After entering the market it expands its product line

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Firm exports product to accommodate foreign demand.

Firm creates product to accommodate local demand.

The International Product Life Cycle

Firm establishes foreign subsidiary to establish presence in foreign country and possibly to reduce costs. 1,2&3

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

b. Firm’s foreign business declines as its competitive advantages are eliminated.

or

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II. Rationale for Foreign Business Operations - continued

B. Specific Rationale - 1. Rate of return

2. Diversification

3. Sources of resources

4. New technology

5. Related concerns

a. growth

b. lower production cost

c. prestige

d. weaken labor’s power

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InternationalBusiness Methods

- How firms penetrate foreign markets? Define

an MNC?

• International trade is a relatively conservative approach involving exporting and/or importing.¤ The internet facilitates international trade

by enabling firms to advertise and manage orders through their websites.

There are several methods by which firms can conduct international business. Each of the method in turn can be seen in terms of its risk and return features!

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• Licensing allows a firm to provide its technology in exchange for fees or some other benefits. Ex. AT& T and Nynex Corp. have licensing agreements to build and operate parts of India’s telephone system.

• Franchising obligates a firm to provide a specialized sales or service strategy, support assistance, and possibly an initial investment in the franchise in exchange for periodic fees.

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• Firms may also penetrate foreign markets by engaging in a joint venture(joint ownership and operation) with firms that reside in those markets.

• Acquisitions of existing operations in foreign countries allow firms to quickly gain control over foreign operations as well as a share of the foreign market.

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Tata Completes Jaguar Land Rover Acquisition

• Tata Motors has eventually paid USD 2.3 billion in cash while Ford has contributed USD 600 million to the Jaguar Land Rover pension plans, leaving Ford with USD 1.7 billion. Ford and Tata have agreed on long term cooperation plans in regards to the supply of engines, stampings and other components to Jaguar Land Rover.

• Read more: http://www.worldcarfans.com/10806041083/tata-completes-jaguar-land-rover-acquisition#ixzz1QmaPsc6N

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• Firms can also penetrate foreign markets by establishing new foreign subsidiaries.

• In general, any method of conducting business that requires a direct investment in foreign operations is referred to as a direct foreign investment (DFI). Then which form of intrnational business is DFI?

• The optimal international business method may depend on the characteristics of the MNC.

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Degree of International Business by MNCs

26%

62%58%

33%

47%50%

66%

12%

46%40%

0%

10%

20%

30%

40%

50%

60%

70%

Campbell'sSoup

DowChemical

IBM Motorola Nike

Foreign Sales as a % of Total Sales

Foreign Assets as a % of Total Assets

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Online Application

• Check out the following international trade promotion sites.

• Trade conditions for Industries:

• An outlook of international trade conditions for each of several industries is provided at: http://www.ita.doc.gov/td/industry/otea

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Global Opportunities

• Investment opportunities - The marginal return on projects for an MNC is above that of a purely domestic firm because of the expanded opportunity set of possible projects from which to select.

• Financing opportunities - An MNC is also able to obtain capital funding at a lower cost due to its larger opportunity set of funding sources around the world.

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Marginal Return on

Projects

Purely Domestic Firm

MNC

Asset Levelof Firm

InvestmentOpportunities

Global OpportunitiesCost-benefit Evaluation for

Purely Domestic Firms vis-a-vis MNCs

Appropriate Size for Purely Domestic Firm

Appropriate Size for MNC

X Y

Marginal Cost of Capital

Purely Domestic Firm MNC

FinancingOpportunities

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Global Opportunities

• Opportunities in Europe¤ The Single European Act of 1987.¤ The removal of the Berlin Wall in 1989.¤ The inception of the euro in 1999.

• Opportunities in Latin America¤ The North American Free Trade Agreement

(NAFTA) of 1993 / Regionalisation of trade& currency consequences .

¤ The General Agreement on Tariffs and Trade (GATT) accord / WTO/ presence of BRIC nations.

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International Opportunities

• Opportunities in Asia¤ The reduction of investment restrictions by

many Asian countries during the 1990s.¤ Emerging markets such as China’s and

India’s potential for growth.¤ The Asian economic crisis in 1997-1998.¤ GE, P&G, and Coca-cola Co, were among

the companies that acquired business units in Asia during this period.

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Online Application

• For more information on the Asian crisis, check out the following sites:¤ http://www.stern.nyu.edu/~nroubini/asia/Asi

aHomepage.html¤ http://www.asienhaus.org/navigat/english/a

sienhau.htm

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What’s Special about “International” Finance?

Exposure to International Risk

exchange rate movements¤ Exchange rate fluctuations affect cash flows and

foreign demand.

foreign economies¤ Economy(ic) fundamentals / conditions affect

demand.

Country risk / political risk¤ Political actions affect cash flows.

International business usually increases an MNC’s exposure to:

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What’s Special about “International” Finance?

• 3. Market Imperfections

• 4. Expanded Opportunity Set

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Exposure to International Risk

$130,000

$135,000

$140,000

$145,000

$150,000

$155,000

$160,000

$165,000

Jan Mar May Jul Sep Nov Jan Mar May

2000 2001

U.S. Firm’s Cost of Obtaining £100,000

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• Visit FRED®, Fed's economic time-series database, at http://www.stls.frb.org/fred for numerous economic and financial time series, e.g., balance of payment statistics, interest rates, foreign exchange rates.

• Visit http://www.ita.doc.gov/td/industry/otea (Office of Trade and Economic Analysis) for an outlook of international trade conditions for each of several industries.

Online Application

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Overview of an MNC’s Cash Flows

type of cashflow streamsProfile A: MNCs focused on International Trade

U.S. Businesses

Foreign Importers

U.S. Customers

Foreign Exporters

U.S.-based MNC

Payments for products

Payments for supplies

Payments for exports

Payments for imports

Overview 1

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Transcript of Overview 1