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Global corporate finance - Kim

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22 INTRODUCTION

funds on favorable terms (financing) are conceptually the same for both types of companies. However, these two types of companies differ because they do business in different environments. International financial managers must understand these differences if they are to succeed in the international environment.

For successful international operations, a manager must have information about environmental factors that affect business operations in foreign countries. Domestic methods should be adjusted to accommodate customs, attitudes, economic factors, and political factors that prevail in the country of operation.

How do management practices in one country differ from those in other countries? In principle, concepts in accounting, economics, finance, management, and marketing are as relevant to business management in one country as they are in another country. However, when a business crosses national boundaries, the environment differs for these functions. In other words, multinational financial managers are confronted with various environmental constraints when they attempt to maximize their firm’s value on a global basis. The three types of environmental constraints described in this section are (1) various risks, (2) conflicts of interest, and (3) multiple environments. These constraints are not mutually exclusive, nor do they exhaust the differences that we might find in international business.

1.6.1Types of risk

Three major risks in international business are political, financial, and regulatory. Political risks range from moderate actions, such as exchange controls, to extreme actions, such as confiscation of assets. Financial risks involve varying exchange rates, divergent tax laws, different interest and inflation rates, and balance-of-payments considerations. Regulatory risks are differences in legal systems, overlapping jurisdictions, and restrictive business practices against foreign companies.

If a company plans to invest heavily in foreign countries, it must consider all of these risks. Business operations that cross national boundaries add dimensions of risk that are rarely confronted in domestic business operations. Ideally, a company should analyze these risks to understand their underlying causal forces, so that the company may develop specific measures to handle them.

1.6.2Conflicts of interest

Conflicts of interest may occur for a variety of reasons. Owners, employees, suppliers, and customers may have different national identities. The interests of sovereign national states may be divergent. The goals of MNCs and host countries may conflict. Some conflicts of interest may exist within an MNC. Furthermore, the MNC and the external environment may clash.

Companies tend to have home-country nationals in key positions for foreign operations, but they tend to hire local persons for nonmanagerial positions. Thus, disparities in salaries and wages are inevitable. Most developing countries require MNCs to hire and train local people for management positions in exchange for local business operations. External conflicts relate to profitmotivated decisions that involve the transfer of funds, production, exports, imports, and employment from one country to another. For instance, an MNC’s wish for foreign-exchange remittances frequently conflicts with a local government’s restrictions on these remittances.

THE STRUCTURE OF THIS BOOK

23

 

 

1.6.3Multiple environments

In addition to risk and conflict, MNCs can have operational problems because they operate in several international environments. These environmental diversities require different concepts, analytic methods, and information. Therefore, MNCs should identify, evaluate, and predict all environmental variables. Some important environmental variables are the form of business organization, different institutional settings, and cultural differences.

1.7 The Structure of this Book

This book has five major parts. Part I (chapters 1–4) provides an overview of the global financial environment, such as motives for foreign trade and investment, the balance of payments, and the international monetary system. In other words, this part develops the primary goal of an MNC and the basics of international finance.

Part II (chapters 5–10) deals with the forces that affect the relative prices of currencies in international markets. This part is devoted to financial derivatives – currency forwards, futures, options, and swaps – with an emphasis on their relationships to foreign-exchange risk management.

Part III (chapters 11–14) describes sources of global corporate finance. One major facet of corporate finance is to raise funds on favorable terms. In the case of global corporate finance, financing involves the sources of funds for international trade and foreign investment.

Part IV (chapters 15–20) discusses the management of assets. The second major facet of corporate finance is the efficient allocation of funds among assets. A decision to invest abroad must take into account various environmental differences, such as disparities in exchange rates, differences in taxes, and differences in risk factors.

SUMMARY

The international financial manager has the same objective as every other manager in the multinational firm: to maximize the wealth of the stockholders. If the firm’s stock price goes up as a result of the manager’s decisions, the decisions were good ones. The stockholders would recognize that the value of the company has been enhanced by the manager’s efforts. In order to achieve the firm’s primary goal of maximizing stockholder wealth, the financial manager performs three major functions: financial planning and control, the efficient allocation of funds, and the acquisition of funds on favorable terms.

MNCs have superior performance over domestic companies because they enjoy a better risk–return trade-off, market imperfections, the portfolio effect, comparative advantage, internationalization advantage, economies of scale, and a higher valuation. However, when MNCs attempt to maximize their overall company value, they face various constraints, such as large agency costs, a variety of risks, conflicts of interest, and multiple environments.

24 INTRODUCTION

Questions

1What is the primary goal of multinational companies? Why is stockholder wealth maximization more important than profit maximization?

2Discuss the agency problem of multinational companies.

3In order to achieve a firm’s primary goal of maximizing stockholder wealth, the financial manager performs a number of important functions. What are the three major functions of financial management?

4Why do multinational companies perform better than domestic companies?

5Explain environmental constraints that conflict with the primary goal of multinational companies.

6The concept of a perfect market depends on a number of conditions. What are these conditions? Would inflation rates, interest rates, and wages among countries be more similar or less similar under conditions of a perfect market than under conditions of an imperfect market?

7Global companies can become so well known throughout the world that they lose their association with any single country. Can you match the following companies with the location of their headquarters?

1

Xerox

A

Atlanta, Georgia, USA

2

Royal Philips Electronics

B

Ludwigshafen, Germany

3

ABB

C

Montreal, Canada

4

BASF

D

Ludvika, Sweden

5

Alcan Aluminum

E

Stamford, Connecticut, USA

6

Nestlé

F

Eindhoven, the Netherlands

7

Coca Cola

G

Vevey, Switzerland

8What are the two major sets of external forces that are causing fundamental change in financial management?

9Explain why management should focus on stockholder wealth maximization.

10What is corporate governance? What are the changes that have made US managers more responsive to the interests of shareholders since 1980?

11What is meant by Japanese-style corporate governance structures?

REFERENCES

Baker, J. C., International Finance, Upper Saddle River, NJ: Prentice Hall, 1998.

Ball, D. A., W. H. McCulloch, J. M. Geringer, P. L. Frantz, and M. S. Minor, International Business, New York: McGraw-Hill/Irwin, 2004, ch. 1.

Economic Report of the President to Congress, The, Washington, DC: US Government Printing Office, 2004.

Eun, C. S. and G. S. Resnick, International Financial Management, Boston: McGraw-Hill/Irwin, 2004.

Glain, S., “Asian Firms, Amid Currency Turmoil, Turn to Hedging Experts to Cut Risk,” The Wall Street Journal, Nov. 19, 1997, p. A18.

Gillan, S. L. and L. T. Starks, “A Survey of Shareholder Activism: Motivation and Empirical

CASE PROBLEM 1

25

 

 

Evidence,” Contemporary Finance Digest, Autumn 1998, pp. 10–34.

Grinblatt, M. and S. Titman, Financial Markets and Corporate Strategy, New York: Irwin/McGrawHill, 1998, ch. 17.

Groshen, E. L., “Special Issue: Corporate Governance: What Do We Know and What Is Different About Banks,” Economic Policy Review, Federal Reserve Bank of New York, Apr. 2003.

Harry, T. R., “Globalization . . . Let’s Get It Straight,” O’Fallon, MO, 2001.

Lessard, D. R., “Global Competition and Corporate Finance in the 1990s,” Journal of Applied Corporate Finance, Winter 1991, pp. 59–72.

Madura, J., International Financial Management, St Paul, MN: West, 2003.

Mankiw, N. G., Principles of Economics, New York: The Dryden Press, 2003.

Marsh, P., “Measuring Globalization: The Role of Multinationals in OECD Countries,” The Financial Times, Mar. 20, 2002, p. 6.

Moffett, M. H., A. I. Stonehill, and D. K. Eiteman,

Foundations of Multinational Finance, New York: Addison-Wesley, 2003.

Nofsinger, J. and K. Kim, Infectious Greed: Restoring Confidence in America’s Companies, Upper Saddle River, NJ: Prentice Hall, 2003.

OECD (The Organization for Economic Cooperation and Development), ed., The Future of the Global Economy, Paris: OECD, 1999, p. 119.

Rugman, A. M., “Multinational Enterprises Are Regional, Not Global,” Multinational Business Review, Spring 2003, pp. 3–12.

Santomero, A. M., “Corporate Governance and Responsibility,” Business Review, Federal Reserve Bank of Philadelphia, Second Quarter 2003, pp. 1–5.

Scism, L., “Benefiting From Operating Experience, More Finance Chiefs Become Strategists,” The Wall Street Journal, June 8, 1993, p. B1.

Shapiro, A. C., Multinational Financial Management, New York: John Wiley, 2003.

Simison, R. L., “Firms Worldwide Should Adopt Ideas of US Management, Panel Tells OECD,” The Wall Street Journal, Apr. 2, 1998, p. A4.

Case Problem 1: What is a National Company?

Evidence indicates that it has become increasingly difficult to define a national company in recent years. “There is no longer any such thing as a purely national economy. The rest of the world is just too big to ignore, either as a market or as a competitor. If business schools do nothing other than to train their students to think internationally, they would have accomplished an important task” (John Young, CEO of Hewlett-Packard). “There is no German, French, or American capital market any more. It is a global capital market, and we all have to play by the same rules” (Ulrich Hartmann, CEO of Veba AG). On the one hand, many nonUS companies such as Toyota Motor and BP Amoco are also listed on the New York Stock Exchange. On the other hand, US companies, such as IBM and GM, are listed on most European stock exchanges. A management team from Ford took over Mazda Motor of Japan in 1996. In 1999, capital raised in several countries by Deutsche Bank financed its acquisition of Bankers Trust New York, which had taken over management of overseas clients from Nippon Credit Bank of Japan in 1996.

Companies have pursued international business for many years – in order to expand sales, acquire resources, diversify sources of sales and supplies, and minimize competitive risk. However, they have recently entered an era of unprecedented worldwide production, distrib-

26 INTRODUCTION

ution, and financing due to several factors: expansion of technology, liberalization of crossborder movements, increased global competition, and the development of supporting institutional arrangements.

In today’s global economy, it is not easy to define “a national company,” especially a US company. In his recent interview with The Wall Street Journal, Edmund Fitzgerald, Chairman of Northern Telecom, said: “My company has its headquarters in Canada, but most of its sales are in the United States. It employs about as many Americans as Canadians. A big chunk of its shares are owned by Americans. Whose company is it anyway?”

In 1993, US government economic officials attempted to prepare papers on the issue and debated it at the National Economic Council. The outcome of these discussions would deeply influence trade and technology policies, ranging from who builds next-generation television sets to US negotiations with Japan. The US government needs a set of guidelines to follow, so that government economic officials can handle such questions as “What is an American company?” and “Whose interests do they advocate?”

When Labor Secretary Robert Reich was an academic, he posed a simple-sounding but fundamental question to US capitalism: “Who is us?” In an age of global business, he asked, do US-owned companies still represent the USA?

Mr Reich argued that American workers should come first, because America’s standard of living depends primarily on improving worker skills. “American” companies are those that provide high-skill jobs for American workers in America – regardless of whether those companies are owned by American, German, or Japanese shareholders. The flag that flies over a factory or corporate headquarters is less and less relevant, he said.

Not at all, responded chief White House economist Laura Tyson, who said that the nationality of a company still largely determines where it will locate the bulk of its sales, production, and research and development. In her paper entitled, “They Are Not Us,” written before either she or Mr Reich joined the government, Tyson argued that “the economic fate of nations is still tied closely to the success of their domestically-based corporations.”

With the globalization of trade, dumping cases can be difficult. Under American law, only US companies are eligible to bring charges. In case law, though not by statute, the firm is considered to be a US company when half or more of a product is made in the USA. A US subsidiary of a Japanese firm, Brother Industries USA, makes portable electric typewriters in the USA. In 1993, it won a dumping case against Smith-Corona, a US company that makes its typewriters in Singapore.

Case Questions

1What are the reasons for the recent growth in international business?

2What are the possible definitions of a US company described in the case?

3Why is it so important to be a US company?

4Explain how Japanese negotiators have cited Mr Reich’s theories in talks with the USA over opening the Japanese government procurement market to foreign computer makers (see Reich 1990).

 

CASE PROBLEM 1

27

 

 

 

 

 

 

 

 

 

 

 

 

 

5Can you guess how Mr Reich reacted to the fact that the Bush Administration helped Toys “R” Us Inc. set up stores in Japan? Do you think that President Clinton’s Japan team had the same reaction as Mr Reich’s?

6How would Mr Reich rank companies owned by Americans and/or with US operations?

7The website of the White House, www.whitehouse.gov/, gives direct access to US Federal services, a virtual library of the White House press releases, executive orders, and many other pieces of information. Access the above website to answer the following questions: How and when was the National Economic Council (NEC) created? Who is the current chairman of the NEC? What are the principal functions of the NEC?

Sources: D. B., “Clinton Aids Grapple With Definition of a US Company in Global Economy,” The Wall Street Journal, July 2, 1993; R. B. Reich, “Who Is Us?” Harvard Business Review, Jan./Feb., 1990, pp. 53–64; and M. Starr, “Who Is the Boss? The Globalization of US Employment Law,” Business Lawyer, May 1996, pp. 635–52.

CHAPTER 2

Motives for World Trade and Foreign Investment

Opening Case 2: The Effect of Foreign Investment on Exports

In 1989, Mexico significantly liberalized its foreign investment regulations to allow 100 percent foreign ownership. The North American Free Trade Agreement of 1994 extends the areas of permissible foreign direct investment (FDI) and protects foreign investors with a dispute settlement mechanism. In addition, Mexico has recently taken a series of additional actions to increase FDI in Mexico. As a consequence, the US FDI in Mexico has increased more rapidly in recent years than ever before. Mexico is now the third-largest host country for US FDI after the United Kingdom and Canada.

Because FDI is generally used to set up foreign production, US exports to Mexico should have dropped as a result of increased US FDI in Mexico. Right? Apparently not, according to a 1999 study by Wilamoski and Tinkler. The study found that US FDI in Mexico raises total US exports to Mexico and has a positive effect on the US trade balance with Mexico. The removal of barriers to investment has allowed US firms to establish a presence in Mexico. This has required the Mexican subsidiary to import inputs from the US parent firms and capital goods from unaffiliated US firms.

International investment flows can boost efficiency and the flow of information across borders. In addition, FDI is closely linked to export expansion. For example, FDI by US companies can open the way for US exports, both as inputs to foreign production and as consumer goods to supply foreign demand. It also offers US companies a toehold in foreign markets, from which they can further expand sales. In many cases, investment in distribution and other essential services increases a supplier’s ability to export into a market. Trade between firms and their foreign affiliates (intrafirm trade) can be an efficient means of international trade, particularly when problems of imperfect information exist. Over a third of US exports and two-fifths of

MOTIVES FOR FOREIGN TRADE

29

 

 

US imports are estimated to be intrafirm. Worldwide, about a third of trade is intrafirm trade. In fact, many recent studies have confirmed that FDI is closely linked to export expansion.

Source: Peter Wilamoski and Sarah Tinkler, “The Trade Balance Effect of US Foreign Direct Investment in Mexico,” Atlantic Economic Journal, Mar. 1999, pp. 24–37.

This book deals with both foreign trade and foreign investment. Because these two types of international transactions are extremely interdependent, this chapter examines motives for foreign trade and foreign investment. The knowledge and understanding of these motives are essential if we are to appreciate the economic dynamics and policy issues of trade and investment flows among nations. Thus, in this important overview, we will discuss key trade and investment theories before we consider them separately in the coming chapters. This chapter also describes global and regional market agreements designed to eliminate trade barriers.

2.1 Motives for Foreign Trade

Human desires for goods and services are unlimited, yet our resources are limited. Thus, one of our most important tasks is to seek new knowledge necessary to bridge the gap between desires and resources. The traditional concept of economic man assumed that man allocates his scarce resources between competing uses in the most economical manner. In Robinson Crusoe’s world, for example, he would allocate his time for labor between different alternatives. He would use one level site on the uncharted island as either the location for a hut (shelter) or as a vegetable garden (food). Of course, the real world consists of many persons and nations that are interdependent for sociological and economic reasons. Most societies face problems similar to those faced by Robinson Crusoe, but in more complex forms.

The advantages of economic interdependence between persons and nations center mainly on the efficiency of specialization. Specialization of function or division of labor allows each person or nation to utilize any peculiar differences in skills and resources in the most economical manner. There are a number of reasons why specialization produces a greater amount of goods and services:

1Natural talents among people are different. If intelligent people specialized only in mental tasks while physically strong people specialized only in physical tasks, the total amount of their output would be greater than if each person tried to do both for himor herself.

2Even if the natural abilities of two persons are identical, specialization is advantageous because it creates the opportunity for improved skills and techniques through repetition of tasks.

3The simplification of function through specialization leads to mechanization and the use of large-scale machinery.

4Personal specialization saves time, because one person does not have to shift from one task to another.

The theories of comparative advantage, factor endowments, and product life cycle have been suggested as three major motives for foreign trade.

30 MOTIVES FOR WORLD TRADE AND FOREIGN INVESTMENT

2.1.1The theory of comparative advantage

The classical economic theory of comparative advantage explains why countries exchange their goods and services with each other. Here, the underlying assumption is that some countries can produce some types of goods more efficiently than other countries. Hence, the theory of comparative advantage assumes that all countries are better off if each specializes in the production of those goods that it can produce more efficiently and buys those goods that other countries produce more efficiently.

WHY COMPARATIVE ADVANTAGE OCCURS The theory of comparative advantage depends on two elements:

1Factors of production, such as land, labor, capital, and technology, are unequally distributed among nations.

2Efficient production of various goods and services requires combinations of different economic resources and different technologies.

For instance, Canada has vast amounts of fertile land resources and relatively few people. In contrast, Japan has little land and abundant skilled labor. Thus, Canada may produce such landintensive goods as wheat more economically than Japan, while Japan may produce such labor-intensive goods as cameras more economically than Canada.

However, it is important to recognize that the distribution of economic resources and technology can change over time. This change may alter the relative efficiency of production. In the past 10–20 years, some developing countries have considerably upgraded the quality of their labor forces and have substantially expanded their stock of capital. Therefore, they now produce capital-intensive products such as steel, machinery, and automobiles. Moreover, some newly developed countries, such as Korea, Taiwan, and Brazil, now produce high-technology products, such as computers and computer software.

Example 2.1

Suppose, for the time being, that the world has two nations (Canada and Japan) and two commodities (wheat and cameras). For a fixed amount of $1,000 in land, labor, capital, and technology, Canada and Japan can produce either of the two commodities listed in table 2.1. In other words, if each country were to make one or the other, Canada could produce 180 bushels of wheat or six cameras, while Japan could produce 80 bushels of wheat or eight cameras. If there is no trade, then Canada can produce 90 bushels of wheat and three cameras, while Japan can produce 50 bushels of wheat and three cameras.

It is clear from table 2.1 that under full employment conditions, Canada’s exchange ratio for the two products is one camera (C) for 30 bushels of wheat (W), or 1C = 30W. Japan’s

MOTIVES FOR FOREIGN TRADE

31

 

 

 

Table 2.1 Production alternatives of wheat and cameras

 

 

 

 

 

 

 

 

 

Country

Wheat

 

Cameras

 

 

 

 

 

 

 

 

 

Canada

180

 

6

 

 

 

Japan

80

 

8

 

 

 

 

 

 

 

Table 2.2 Gains to both nations from specialization and trade

 

 

 

 

 

 

 

 

 

 

 

 

 

Exports (-)

 

 

Gains

 

Before

After

and

After

from

Country

specialization

specialization

imports (+)

trade

trade

 

 

 

 

 

 

Canada

90 W

180 W

-80 W

100 W

10 W

 

3 C

0 C

+4 C

4 C

1 C

Japan

50 W

0 W

+80 W

80 W

30 W

 

3 C

8 C

-4 C

4 C

1 C

 

 

 

 

 

 

 

exchange ratio for the two products is one camera for 10 bushels of wheat, or 1C = 10W. Thus, Canada has a greater advantage in the production of wheat, whereas Japan has a better advantage in the production of cameras. In other words, these two countries produce both products but at different levels of economic efficiency. If they specialize according to their comparative advantage, Canada must produce only wheat while Japan must produce only cameras. If they trade with each other, larger outputs of both wheat and cameras would be available to both nations, because specialization allocates world resources more efficiently.

The exchange ratios for the two products differ in the two countries. This difference becomes the basis for mutually beneficial specialization and trade. Trade requires a new exchange ratio between the two products, so that Canada may obtain one camera for less than 30 bushels of wheat and Japan may obtain more than 10 bushels of wheat for one camera. Thus, the terms of trade lie somewhere between 1C = 30W and 1C = 10W, or 30W > 1C > 10W. The actual exchange ratio will depend on world conditions of supply and demand. However, assume that the international exchange ratio for the two products is 1C = 20W. The quantities of the two products available to both countries after specialization and trade would be greater than the optimum product mixes before specialization and trade.

Table 2.2 shows the gains of the two nations from specialization and trade. If Canada were to export 80 bushels of wheat (out of 180 bushels) for four cameras, it would enjoy 100 bushels of wheat and four cameras. Hence, Canada would have 10 more bushels of wheat and one more camera than the optimum product mix that existed before specialization and trade. If Japan were to trade four cameras (out of eight cameras) for 80 bushels of wheat, Japan would enjoy four cameras and 80 bushels of wheat. Thus, Japan would enjoy one more camera and 30 more bushels of wheat than its optimum product mix without specialization and trade.

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