Making investment and financing Decisions in a global market. Cash flows associated with these decisions Risks associated with these cash flows The international financial markets
WHAT’S SPECIAL ABOUT “INTERNATIONAL” FINANCE?
CHAPTER ONE OVERVIEW • • • • •
What’s Special about “International” Finance? Goals of MNC The rise of the MNCs The Internationalization of Business & Finance Multinational Financial Management: Theory & practice
• • • •
Foreign Exchange Risk Political Risk Market Imperfections Expanded Opportunity Set
WHAT’S SPECIAL ABOUT “INTERNATIONAL” FINANCE?
WHAT’S SPECIAL ABOUT “INTERNATIONAL” FINANCE? • Foreign Exchange Risk
• Market Imperfections
– This is risk that foreign currency profits may evaporate in dollar terms due to unanticipated unfavorable exchange rate movements. – Suppose $1 = ¥100 and you buy 10 shares of Toyota at ¥10,000 per share. One year later the investment is worth ten percent more in yen: ¥110,000. – But, if the yen has depreciated to $1 = ¥120, your investment has actually lost money in dollar terms.
– Legal restrictions on the movement of goods, people, and money – Transactions costs – Shipping costs – Tax arbitrage
WHAT’S SPECIAL ABOUT “INTERNATIONAL” FINANCE?
THE EXAMPLE OF NESTLÉ’S MARKET IMPERFECTION • Nestlé used to issue two different classes of common stock bearer shares and registered shares.
• Political Risk – Sovereign governments have the right to regulate the movement of goods, capital, and people across their borders. These laws sometimes change in unexpected ways.
– Foreigners were only allowed to buy bearer shares. – Swiss citizens could buy registered shares. – The bearer stock was more expensive.
• On November 18, 1988, Nestlé lifted restrictions imposed on foreigners, allowing them to hold registered shares as well as bearer shares.
WHAT’S SPECIAL ABOUT “INTERNATIONAL” FINANCE?
NESTLÉ’S FOREIGN OWNERSHIP RESTRICTIONS
• Expanded Opportunity Set 12,000 10,000
– It doesn’t make sense to play in only one corner of the sandbox. – True for corporations as well as individual investors.
8,000 6,000 4,000
2,000 0 11
Source: Financial Times, November 26, 1988 p.1. Adapted with permission. 1-9
THE EXAMPLE OF NESTLÉ’S MARKET IMPERFECTION • Following this, the price spread between the two types of shares narrowed dramatically.
GOALS FOR INTERNATIONAL FINANCIAL MANAGEMENT • Maximization of shareholder wealth? or • Other goals?
– This implies that there was a major transfer of wealth from foreign shareholders to Swiss shareholders.
• Foreigners holding Nestlé bearer shares were exposed to political risk in a country that is widely viewed as a haven from such risk. • The Nestlé episode illustrates both the importance of considering market imperfections and the peril of political risk. 1-10
• In other countries shareholders are viewed as merely one among many “stakeholders” of the firm including:
• Goal of MNCs is maximizing shareholder’s wealth – The SWM model – Shareholder Wealth Maximization (US company)
– Employees – Suppliers – Customers
• In Japan, managers have typically sought to maximize the value of the keiretsu—a family of firms to which the individual firms belongs.
– The CWM model – Corporate Wealth Maximization (European & Japanese company): requires a single goal of value maximization with a well-defined score card
MAXIMIZE SHAREHOLDER WEALTH
• 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 firm’s management and its shareholders.
• Long accepted as a goal in the Anglo-Saxon countries, but complications arise. – Who are and where are the shareholders? – In what currency should we maximize their wealth?
THEORIES OF INTERNATIONAL BUSINESS
• These types of issues can be much more serious in many other parts of the world, especially emerging and transitional economies, such as Indonesia, Korea, and Russia, where legal protection of shareholders is weak or virtually non-existing. • No matter what the other goals, they cannot be achieved in the long term if the maximization of shareholder wealth is not given due consideration.
– Financial instruments – International finance models
International Financial Management
– Current international finance issues.
• The focus is to understand how The markets, instruments, risks and rewards affect investment and financing decisions Managing FOREX Exposure
Foreign Investment Decisions
DEGREE OF INTERNATIONALIZATION RELATED TO THE INVOLVEMENT OF CAPITAL AND MANAGEMENT IN THE HOME COUNTRY AND THE HOST COUNTRY
MULTINATIONAL CORPORATION • 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 reshaping the structure of the world economy. – The true MNCs emphasizes group performance rather than the performance of its individual parts. – MNC may gain from their global presence in a variety of way. First of all, MNC can benefit from the economy of scale by (1) spreading R&D expenditures and advertising costs over their global sales, (2) pooling global purchasing power over suppliers, (3) utilizing their technological and managerial know-how globally with minimum additional costs … – MNCs can use their global presence to take advantage of underpriced labor service available in LDCs – Companies are increasingly using offshore outsourcing as a way of saving costs and boosting productivity.
In the host country
Affiliate Production plant Foreign branch Joint venture Franchising License Agreement
In the home country
Export 100% In the home country
In the host country 23
Involvement of management
TYPICAL FOREIGN EXPANSION SEQUENCE
BASIC TYPES OF MNCS There are three basic types of MNCs.
In all cases, MNCs involved recognize that the world is larger than the home
country and provides opportunities to gain additions supplies, sell more products or find lower cost sources of production.
THE PROCESS OF OVERSEA EXPANSION
OPERATING & FINANCING CASH FLOWS
The process of international expansion ordinarily evolves from a low risk low-return to a higher -risk-higher return strategy • Exporting. Exporting is a low cost, low risk strategy for learning about and developing foreign markets. At the same time, internet limits a company’s ability to fully exploit foreign markets. • Oversea production. A company can more easily keep abreast of market developments, Adapt its products to local tastes and conditions and provide more comprehensive after sales-service Foreign production often requires a substantial capital investment, internet may allow company access lower cost local labor and materials. – Internet also demonstrates a tangible commitment to local market and an increased assurance of supply stability – – – –
Financial Cash Flows Dividend paid to parent Parent invested equity capital Interest on intrafirm lending Intrafirm principal payments
Payment for goods & services Rent and lease payments Royalties and license fees Management fees & distributed overhead
Operational Cash Flows
Dividends Fees, Royalties, corporate overhead for services
THE PROCESS OF OVERSEA EXPANSION
Interest and repayment of credit/loan Equity investment Loans Credit on goods and services
• Licensing. Foreign licensing tends to be a low risk - low return strategy
Capital goods Technology Management Intermediate goods Finished goods Technology/market intelligence
– Instead of spending money to set up production facilities abroad, company can license a local firm to manufacture its products – Licensing allows the company access its licensee’s marketing smarts and distribution network. – The principal advantages of licensing are the minimal investment required, faster market entry, and fewer financial and legal risks involved – However, licensing may create a competitive in other markets because internet is often difficult to control exports by foreign licensees. – It may also be dificult to displace the licensee in the local market once the license expires – Cash flow is relatively low, and there may be problems in maintaining product quality standards
Alan C Sharpiro, Multinational Financial Management, 9th edition, Willey & son
MULTINATIONAL FINANCIAL MANAGEMENT
MULTINATIONAL FINANCIAL MANAGEMENT • MNC has considerable freedom in selecting the financial channels through which funds and allocated profits are moved. • In addition, MNCs have some flexibility regarding the timing of fund flows. They can speed up or slow down dividend payments, loan repayments, and payments for fees, royalties, and interaffiliate sales of goods and services. • The different modes of internal fund transfers available to the MNC: – – – – –
• Timing flexibility
Transfer prices on goods and services traded internally Intercompany loans and equity investment Dividend payments Leading (speeding up) and lagging (slow down) intercompany payments Fees and royalty charges
– Leading and lagging is most often applied to interaffiliate trade credit. – MNCs have the greatest amount of flexibility in the timing of equity claims. The earning of a affiliate can be retained or used to pay dividends that in turn can be deferred or paid in advance – MNCs have some flexibility in the timing of fund flows even the frequent presence of government regulations or limited contractual arrangement – MNCs have been able to control the timing of many of the underlying real transaction Value. The ability of MNCs to avoid taxes and regulatory barriers by shifting money and profit among their various units has led to conflicts with nationstates
MULTINATIONAL FINANCIAL MANAGEMENT
FOUNDATIONS OF INTERNATIONAL FINANCIAL • Three basic concepts provide the foundation for study of international finance: arbitrage, market efficiency, and capital asset pricing model • Arbitrage: Taxes arbitrage, risk arbitrage, currency arbitrage… • Market efficiency:
• The multinational firm can control the mode and timing of internal financial transfers and thereby maximize global profit. • Mode of transfer. MNCs have freedom in selecting the financial channels through which funds, allocated profit, or both are moved. Ex. – MNC can move profits and cash from one unit to another by adjusted transfer prices on intercompany sales and purchases of goods and services – Capital can be sent overseas as debt – Regarding to the limits of various national laws, MNC can take more advantage than independent company
– An efficient market is one which new information is readily incorporated in the price of traded securities . In an efficient market can not expect to prosper by finding overvalued or undervalued assets. – All funds require the same risk-adjusted returns – Absent tax consideration or government intervention, market efficiency suggests that there are no financing bargains available
ROLE OF THE FINANCIAL EXECUTIVE IN AN EFFICIENT MARKET
VALUATION MODEL FOR MNC • DOMESTIC MODEL
• Financial executives of MNCs face added political and economic risks,
m E CF$, t n Value = j 1 t 1 k t =1
as well as more complex tax laws and multiple money markets. • Financial managers can create value by taking advantage of capital market imperfections and tax asymmetries
E (CF$,t ) = expected cash flows to be received at the end of period t n = The number of periods into the future in which cash flows received k = the required rate of return by investors
VALUATION MODEL FOR MNC
Cost-benefit Evaluation for Purely Domestic Firms versus MNCs Purely Domestic Firm
Investment Opportunities Marginal Return on Projects
• VALUING INTERNATIONAL CASH FLOWS
m E CFj , t E ER j , t n Value = j 1 t 1 k t =1
MNC MNC Purely Domestic Firm
Marginal Cost of Capital Financing Opportunities
Appropriate Size for Purely Domestic Firm
Appropriate Size for MNC
E (CFj,t ) = expected cash flows denominated in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = the weighted average cost of capital of the U.S. parent company
Asset Level of Firm 34
GLOBALIZATION OF THE WORLD ECONOMY: MAJOR TRENDS AND DEVELOPMENTS
• • • • • •
EMERGENCE OF THE EURO AS A GLOBAL CURRENCY
Emergence of Globalized Financial Markets Emergence of the Euro as a Global Currency Europe’s Sovereign Debt Crisis of 2010 Trade Liberalization and Economic Integration Privatization Global Financial Crisis of 2008-2009
• A momentous event in the history of world financial systems. • Currently more than 300 million Europeans in 16 countries are using the common currency on a daily basis. • In May 2004, 10 more countries joined the European Union. • The “transaction domain” of the euro may become larger than the U.S. dollar’s in the near future.
EMERGENCE OF GLOBALIZED FINANCIAL MARKETS
EUROPE’S SOVEREIGN-DEBT CRISIS OF 2010 • In December of 2009 the new Greek government revealed that its budget deficit for the year would be 12.7% of GDP, not the 3.7% forecast. • Investors sold off Greek government bonds and the ratings agencies downgraded them to “junk.” • While Greece represents only 2.5% of euro-zone GDP, the crisis became a Europe-wide debt crisis. • The challenge remains that fiscal indiscipline of one euro-zone country can escalate to a Europe-wide crisis.
• Deregulation of Financial Markets coupled with • Advances in Technology – have greatly reduced information and transaction costs, which has led to: • Financial Innovations, such as – – – –
Currency futures and options Multi-currency bonds Cross-border stock listings International mutual funds
LIBERALIZATION OF PROTECTIONIST LEGISLATION
THE GREEK DRAMA
• The General Agreement on Tariffs and Trade (GATT) is a multilateral agreement among member countries that has reduced many barriers to trade. • The World Trade Organization has the power to enforce the rules of international trade. • On January 1, 2005, the era of quotas on imported textiles ended. • This is an event of historic proportions. • Greece paid no premium above the German rate until late fall 2009. • The Greek interest rate rose until the bailout package on May 9. 1-41
• Over the past 50 years, international trade increased about twice as fast as world GDP. • There has been a change in the attitudes of many of the world’s governments, who have abandoned mercantilist views and embraced free trade as the surest route to prosperity for their citizenry.
• The North American Free Trade Agreement (NAFTA) calls for phasing out impediments to trade between Canada, Mexico, and the United States over a 15year period beginning in 1994. • For Mexico, the ratio of export to GDP has increased dramatically from 2.2% in 1973 to 29% in 2006. • The increased trade has resulted in increased numbers of jobs and a higher standard of living for all member nations.
GLOBAL FINANCIAL CRISIS OF 2008—2009
• The selling of state-run enterprises to investors is also known as “denationalization.” • Privatization is often seen in socialist economies in transition to market economies. • By most estimates, this increases the efficiency of the enterprise. • It also often spurs a tremendous increase in crossborder investment.
• The “Great Recession” was the most serious, synchronized economic downturn since the Great Depression of the 1930s. • Factors included: – Households and financial institutions borrowed too much and took too much risk. – This risk was repackaged with securitization, and so defaults on subprime mortgages in the U.S. came to threaten the solvency of a teacher’s retirement plans in Norway.
GLOBAL FINANCIAL CRISIS 2008—2009
• State-owned enterprises have been listed on organized stock exchanges. • More than 1,500 companies are currently listed on China’s stock exchanges. • The Chinese government still retains the majority stakes in most public firms. • Chinese citizens can buy “A” shares, while foreigners are limited to “B” shares. • During the course of the crisis, the G-20 emerged as the premier forum for discussing international economic issues and coordinating financial regulations and macroeconomic policies. 1-46
THE GEOMETRY OF COMPARATIVE ADVANTAGE
THE FOLLOWING SLIDES COVER THE APPENDIX TO CHAPTER 1.
• Consider the example where there are two countries, A and B, who can each produce only food and textiles. • Initially they do not trade with one another. • The graph on the next slide shows the increase in consumption available to the citizens of countries A and B with trade arising from the differences in their opportunity costs of production.
THE THEORY OF COMPARATIVE ADVANTAGE
THE GEOMETRY OF COMPARATIVE ADVANTAGE A production possibilities curve shows quantities of food or textiles each country can make.
• A comparative advantage exists when one party can produce a good or service at a lower opportunity cost than another party. • The opportunity cost of making one additional unit of a good (or service) can be defined as the value of some other good that you have to give up in order to produce this additional unit.
The production possibilities of Country A are such that if they concentrated 100% of their resources into the production of textiles, they could produce 180 million yards of textiles. If Country A chose to concentrate 100% of their resources into the production of food, they could produce as much as 300 million pounds of food. Country A can produce any combination of food and textiles between these two points.
– For example, if you can work as many hours as you like at your current employer and get paid $10 per hour, then the opportunity cost of your leisure is $10 per hour.
As a practical matter, the citizens of Country A must choose a point along their production possibilities curve.
60 200 300 1-50
Suppose they initially choose 200m pounds of food and 60m yards of textiles.
THE GEOMETRY OF COMPARATIVE ADVANTAGE
THE GEOMETRY OF COMPARATIVE ADVANTAGE Without trade, if both countries make only food, the combined production would be 1,200 million pounds of food = 900 + 300.
If Country B chose to concentrate 100% of their resources into the production of textiles, they could produce 240 million yards of textiles. If Country B chose to concentrate 100% of their resources into the production of food, they could produce 900 million pounds of food.
The citizens of Country B must also choose a point along their production possibilities curve;
80 60 Food 200 300 600 900 1,200 Initially they choose 600 million pounds of food, and 80 million yards of textiles. 1-53
THE GEOMETRY OF COMPARATIVE ADVANTAGE Textiles
Put another way, country B enjoys a comparative advantage in food because they have to give up textiles at a lower rate than A when making more food. Geometrically, a comparative advantage exists because the slopes of the production possibilities differ.
If the countries specialize according to their comparative advantage, then Country A should make textiles and trade for food, while Country B should grow food and trade for textiles.
80 60 Food 200 300
Country A enjoys a comparative advantage in textiles because they have to give up food at a lower rate than B when making textiles. 1-54
The combined production possibilities curve of country A and B without trade are shown in the green line.
Before trade, combined consumption is 800 million lbs of food (= 200 + 600) and 140 million yards of textiles (= 60 + 80).
240 180 140 80 60 Food 200 300
Without trade, if both countries make only textiles, the combined production would be 420 million yards of textiles = 240 + 180.
A production possibilities curve shows the in various amounts of they food have GEOMETRY OFadvantage COMPARATIVE ADVANTAGE Country ATHE enjoys a comparative textiles because Without trade, if both countries make only textiles, the combined or textiles that each country can make. to give up food at awould lower be rate than B when making textiles. production 420 million yards of textiles = 240 + 180. Country A canifproduce textiles at amake lower opportunity cost, so let them Without trade, both countries only food, thethat combined IfThe country B chose tocountry concentrate 100% of their resources production possibilities of country A are such if into the Put another way, B enjoys a comparative produce the first 180 million yards of textiles. Textiles would be 1,200 pounds food 900 + 300. production ofintextiles, theymillion 240 million yards of Textilesproduction they concentrated 100% ofcould their resources into the advantage food because theyproduce have toof give up= textiles The combined production possibilities curve with trade is yards textiles. production of textiles, could produce 180 million atThe a lower rate than Athey when making more food. combined production possibilities curve of country original curves joined 100% as shown. Ifcomposed countryofBthe chose to concentrate of their resources of textiles. and B without are shownadvantage in theofgreen line. IfAcountry A chosetrade tocomparative concentrate 100% their Geometrically, a exists into the production of food, they could produce 900because million 420 420 The gains from trade arethe shown by the increase in consumption resources into the production of food, they could the slopes of production possibilities Before trade, combined consumption pounds is 800 million ofdiffer. food.lbs available. produce as much as 300 million pounds oftheir food. IfThe thecitizens countries specialize country B+ according must also choose comparative a point along of of food (= 200 600) andto 140 million yards of Country A can any combination of food and andcurve; advantage, thenproduce country their A should production maketextiles possibilities textiles trade (= 60 + 80). 240 240 textiles between these two points. grow food and trade for 180 for food, while country B should 180 initially they choose 600 of million pounds of As a practical matter, the citizens country A must 140 140 textiles. food, and 80 millionpossibilities yards of textiles. 80 choose a point along their production curve 80 60 60 Food Food 200 800 1,200 200 300 300Suppose 600 600 800 900 900 1,200 that initially they choose 200 million County B can produce food at a lower opportunity cost, so let B produce the first 900 pounds of food, and 60 million yards of textiles. 1-56 million pounds of food.
ARGUMENTS IN FAVOR OF FREE TRADE
QUESTION? 1. Why is it important to study international financial management? 2. How is international financial management different from domestic financial management? 3. What are multinational corporations (MNCs) and what economic roles do they play? 4. Suppose you are interested in investing in shares of Nokia Corporation of Finland, which is a world leader in wireless communication. But before you make investment decision, you would like to learn about the company. Visit the website of Yahoo (finance.yahoo.com) and collect information about Nokia, including the recent stock price history and analysts’ views of the company. Discuss what you learn about the company. Also discuss how the instantaneous access to information via internet would affect the nature and workings of financial markets.
• Both partners gain from trade; we have more material goods. • “Freedom” is a good thing in and of itself. – In this case, consumers have the freedom to choose imported goods and producers have the freedom to choose to sell to foreigners.
MINI CASE: NIKE AND SWEATSHOP LABOR Discussion points 1. Do you think the criticism of Nike is fair, considering that the host countries are in dire needs of creating jobs? 2. What do you think Nike’s executives might have done differently to prevent the sensitive charges of sweatshop labor in overseas factories? 3. Do firms need to consider the so-called corporate social responsibilities in making investment decisions?
OPPORTUNITY COST # The opportunity cost of good X in term of good Y
Number of units of good Y/ = Number of units good X
$1 buys 2 candies
$1 buys 4 stamps
1 candy = 4/2 = 2 stamps
Opportunity Cost 1 stamp =2/4=0.5 candies
$1,000,000 buys 4 cars
$1,000,000 buys 10 boats
1 car = 10/4 = 2.5 boats
1 boat =4/10=0.4 cars
Output /hour = 25 calculators
Output /hour = 5 computers
1 calculator = 5/25=0.2 computers
1 computers = 25/5= 5 calculators
1 worker can produce 8000lbs of wheat
1 worker can produce 2000lbs of cotton
1 lbs of wheat = 2000/8000 = 0.25lbs of cotton
1 lbs of cotton = 8000/2000 = 4 lbs of wheat
SOLUTION IN-CLASS EXERCISE # 2 TOTAL OUTPUT PER WORKER BRAZIL CHINA
OPPORTUNITY COST Cost of TEA (in term of Cof)
Cost of Cof. (in term of tea)
BRAZIL CHINA 1 pound of tea = 32 lb Cof. 1 pound of cof = 0.035 lb tea 1 pound of cof = 0.065 lb tea 1 pound of tea = 20 lb Cof. 61
IN-CLASS EXERCISE # 3 TOTAL OUTPUT PER WORKER FOOD (F)