DAY 1Global Financial Environment

The Globalization ProcessLearning ObjectivesConsider how globalization process moves a business from domestic focus to financial relationships and composition global in scopeThe implications of phase one of globalization the international trade phase on the risks and rewards of a businessExamine process as it moves from international trade to multinational operations

The Globalization ProcessLearning ObjectivesDiscover three major currency exposures that arise from doing business on a multinational levelHow globalization affects corporate governance and the creation of value for stakeholders

The Globalization ProcessThe globalization process is the structural and managerial changes and challenges experienced by a firm as it moves from domestic to global in operationsGlobal Transition I Trident moves from the domestic phase to the international trade phase

The Globalization ProcessPhase One: Domestic OperationsAll payments in US dollars;All credit risk under U.S. law

The Globalization ProcessTrident may not be global or international itself, yet its competitors, suppliers and buyers may be working across bordersThis is often a key driver to push a firm like Trident into first phase international tradeThe second half of this phase is the international trade phase

The Globalization ProcessPhase Two: Expansion into International Trade

Trident Corp: Initiation of Globalization

The Globalization ProcessTrident will now experience significant risks from the daily volatility in exchange ratesTrident also faces risks associated with credit quality and evaluation of international counterpartsThis credit risk management task is much more difficult in international business as buyers and suppliers are new and subject to differing business practices and legal systems

The Globalization ProcessGlobal Transition IIThe move from the international trade phase to the multinational phaseIf Trident is successful in international trade then the time will come for the next step in the globalization processTrident will eventually need to establish foreign sales and services affiliatesThis step is followed by the establishment of manufacturing operations or licensing agreements abroad

The Globalization ProcessGlobal Transition IITridents continued globalization will require it to identify the sources of it competitive advantagesThis variety of strategic alternatives available to Trident is called the foreign direct investment sequenceThese alternatives include the creation of foreign sales offices, licensing agreements, manufacturing, etc.Once Trident owns assets and enterprises in foreign countries it has entered the multinational phase of globalization

Foreign Direct Investment SequenceTrident and itsCompetitive AdvantageExploit Existing CompetitiveAdvantage AbroadChangeCompetitive AdvantageLicensingManagement ContractControl AssetsAbroadAcquisition of aForeign EnterpriseGreenfieldInvestmentProduction at Home:ExportingProduction AbroadJoint VentureWholly-OwnedSubsidiary

Foreign Exchange Exposure Due to the fact that more cash flows are denominated in foreign currencies, Trident and other corporations must manage these new exposuresThere are three main foreign exchange exposures that must be managed by multinationalsTransaction Exposure comes from cash flows associated from payments and receivables in foreign currenciesOperating Exposure comes from the changes in cash flows caused by an unexpected exchange change in exchange ratesTranslation Exposure is an accounting exposure associated with the restatement of foreign currency denominated financial statements

Foreign Exchange Exposure

Financing the Global Firm

The Globalization ProcessTrident responds to globalization factors by importing inputs from Mexican suppliers and making exports sales to Canadian buyersThis stage is called the international trade phaseExporting and importing products increases the demands and requirements of a domestic only businessThe first is direct foreign exchange risks borne by TridentTrident may have to quote prices and receive payments in foreign currenciesAs Trident prospers at home and abroad, it confronts a constraint on further growth access to cheap and plentiful capitalThis can be overcome by accessing global debt and equity markets while maintaining an optimal financial structureThe strategy of globalizing the cost & availability of capital is a critical one for firms wishing to reach true global competitiveness

Foreign Investment DecisionsForeign investment decisions combine both strategy and financeThis strategy of expanding operations abroad leads to a corporations transition into a multinational enterpriseAn MNE is defined as a firm that has operating subsidiaries in countries outside of its home production and marketThese firms also face evaluation of foreign located projects using a capital budgeting framework

Foreign Investment DecisionsAs Trident moves from a domestic operation towards a MNE, it faces new and considerable risks and returns dependent upon the strategies employed for its expansion

Foreign Investment Decisions

Foreign Investment IssuesOther issues that firms face when expanding abroad areCorporate Governance the different corporate cultures encountered when dealing with firms abroadGlobal Portfolio Diversification the management of the risks and rewards needed to understand the various foreign operations and their affects on the domestic firms results

Managing Multinational OperationsThus far the focus on Tridents expansion into international markets has been on operations and financing, but the issue of management has not been addressedTrident must also address the issue of maximizing shareholder value Trident must minimize its worldwide burden of taxationThrough transfer pricing (the prices charged on sales of goods between units of Trident itself globally), Trident can reduce its global tax liabilitiesTrident can also assess charges from the parent (US) to the subsidiaries (foreign) in the form of license fees and royaltiesTrident must also consider the cash flow effects of blocked funds (governmental regulations that hinder the movement of capital out of a country)

The Goal of ManagementTwo different points of view on the goal of managementThe Anglo-American markets believe that a firms objective should be to maximize shareholder wealthThese countries include the US, Canada, Australia, United KingdomShareholder believes that markets are efficient and that prices are correctFollow financial theory about markets efficiency, systematic and unsystematic risk

The Goal of ManagementThe Continental European and Japanese markets believe that a firms objective should be to maximize corporate wealthThese countries include the EU, Japan and Latin American countriesDefinition of corporate wealth is broader than Anglo-American viewpoint that wealth is strictly financialA corporations role in wealth maximization includes the firms technical, market and human resourcesConsiderations as to the implications of strategic moves affecting all parties, human resources, towns, state, etc.

The Goal of ManagementPatient CapitalImpatient CapitalThe Anglo-American Model has beenfrequently criticized as focusing onshort-term profitability rather thanlong-term growth.The Non-Anglo-American Modelhas come under increasing criticismfor its lack of accountability to equityinvestors its shareholders whilefocusing on the demands of toodiffuse a group of stakeholders.

Corporate GovernanceThese two approaches focus around the issue of corporate governanceCorporate Governance is the method by which an organization establishes order among various stakeholders to ensure that decisions are made and interests are represented in line with the firms stated objectivesThese include failures (Enron), poor performance (AT&T), and emerging markets (China)As a result, companies are moving towards model of one share, one vote in their corporate structures

The MNC and its EnvironmentIn recent years, international finance has become an increasingly important element in the management of MNCs.Although the principles of managerial finance are applicable to MNCs, certain factors unique to the international setting tend to complicate the financial management of MNCs.A simple comparison between a domestic U.S. firm and a U.S.based MNC is given in Table 18.1.

Long-Term Investment and Financing Decisions (cont.)Capital StructureBecause of their greater access to capital, MNCs have lower costs of long-term financing.Some studies have suggested that MNCs have higher debt ratios, while other studies have found the opposite to be true.Part of this might be explained that MNCs based in different countries and regions may have access to currencies and markets, resulting in variances in capital structures for these MNCs.

The MNC and its Environment (cont.)

The MNC and its Environment (cont.)During the 1990s, three important trading blocks emerged.In 1992, the United States, Mexico and Canada signed the North American Free Trade Agreement (NAFTA).In 1992, Western Europe also strengthened previously existing European Union by forming the European Open Market which included the adoption of a common currency called the EURO in January, 1999.

The MNC and its Environment (cont.)In 1991, the Mercosur Group of South America, including the countries of Brazil, Argentina, Paraguay and Uruguay formed a trading block.The General Agreement on Tariffs and Trade (GATT) is currently the most important international treaty governing trade.It extends free trading rules to broad areas of economic activity and is policed by the World Trade Organization (WTO).

The MNC and its Environment: Legal Forms of BusinessIn many countries outside the U.S., operating foreign subsidiaries can take two forms similar to a U.S. corporation.In German-speaking nations, the two forms are the Aktiengesellschafts (A.G.) or the Gesellschaft mit beschrankter Haftun (GmbH). In many other countries, the similar forms are Societe Anonymes (S.A.) or Societe a Responsibilite Limitee (S.A.R.L.).

The MNC and its Environment: Legal Forms of Business (cont.)One major difference however, is that it is often essential to enter into joint-ventures with private investors or with government-based agencies in the host country.Such joint-venture laws can result in a substantial degree of management control by host countries and may result in disagreements among the partners as to the distribution of profits, the portions to be allocated for reinvestment, and the remittance of profits.

The MNC and its Environment: Financial MarketsDuring the past two decades the Euromarketwhich provides for borrowing and lending currencies outside their country of originhas grown rapidly and provides MNCs with an external opportunity to borrow or lend funds with little government regulation.One aspect of the Euromarket is offshore centers, which is composed of cities or states (including London, Singapore, Nassau, and Hong Kong) that have achieved prominence as major centers for Euromarket business.

The MNC and its Environment: Financial MarketsIn addition, a variety of new financial instruments including currency and interest rate swaps, forward contracts, options contracts, and international commercial paper have been created to facilitate international trade and finance.The Euromarket is still dominated by the U.S. dollar.However, other currencies such as the Euro, Swiss Franc, Japanese Yen, and British Pound have increased in importance.

Risk: Exchange Rate RiskExchange rate risk is the risk caused by varying exchange rates between two currencies.The foreign exchange rate between the U.S. dollar (US$) and Swiss Franc (SF) is expressed as follows:The usual exchange rate quotation in international markets is given as SF1.4175/US$.US$1.00 = SF1.4175SF1.00 = US$0.7055

Risk: Exchange Rate Risk (cont.)Under the current system of floating exchange rates, the value of any two major currencies with respect to one another is allowed to fluctuate on a daily basis.For smaller country currencies, however, exchange rates are fixed or semi-fixed with respect to one of the major currencies.The spot exchange rate is the rate of exchange between any two currencies on a given day.

Risk: Exchange Rate Risk (cont.)The forward exchange rate is the rate of exchange between two currencies at some specific future date.These rates and their relationships can be described as shown in Figure 18.2 on the following slide.Although a number of factors can influence exchange rate movements, by far the most important influence is differing inflation rates between two currencies, where the currency with the higher rate of inflation will decline relative to the country with the lower rate.

Insert Figure 18.2 here

Risk: Exchange Rate Risk (cont.)Although several economic and political factors influence foreign exchange rate movements, by far the most important explanation for long-term changes is differing inflation between two countries.Countries that experience high inflation rates will see their currencies decline in value (depreciate) relative to the currencies of countries with lower inflation rates.

Risk: Exchange Rate Risk (cont.)Assume that the current exchange rate between the U.S. and the new nation of Farland is 2 Farland Guineas per U.S. dollar, FG2.00/US$, which is also equal to $0.50/FG. This exchange rate means that a basket of goods worth $100.000 in the U.S. sells for $100.00 X FG 2.00 = FG 200.00 in Farland.Now assume that inflation is running at a 25% annual rate in Farland but at only 2% in the U.S. In one year, the same basket of goods will sell for 1.25 X FG 200.00 = FG 250.00 in Farland but for only 1.02 X $100.00 = $102.00 in the U.S.

Risk: Exchange Rate Risk (cont.)These relative prices imply that that in 1 year, FG 250.00 will be worth $102.00 so the exchange rate in 1 year should change to FG250.00/$102.00 = FG 2.45/US$ or $0.41/FG.In other words, the Farland Guinea will depreciate from FG 2.00/US$ to FG 2.45/US$, while the dollar will appreciate from $0.50/FG to $0.41/FG.

Risk: Exchange Rate Risk (cont.)Multinational companies face exchange rate risk under either fixed or floating-rate systems.Consider the following floating-rate example.MNC, Inc. a multinational manufacturer of dental drills, has a subsidiary in Great Britain (U.K.) that at the end of 2006 had the financial statements shown in Table 18.3. The figures for the balance sheet and income statement are given in the local currency, British Pounds (). Using an exchange rate of 0.70/US$ for December 31, 2006, MNC has translated the statements into U.S. dollars.

Risk: Exchange Rate Risk (cont.)

Risk: Exchange Rate Risk (cont.)It is also useful to describe the difference between accounting exposure and economic exposure.Accounting exposure is the risk resulting from the effects of changes in foreign exchange rates on the translated value of a firms financial statements.Perhaps more importantly, economic exposure is the risk resulting from the effects of changes in foreign exchange rates on the firms value.

Risk: Exchange Rate Risk (cont.)In general, it is possible for management to insure against these risks and exposures through hedging.The decision as to whether management will hedge and the extent to which they do depends largely upon managements attitude toward risk.

Risk: Political RisksPolitical risk results from the discontinuity or seizure of an MNCs operations in a host country due to the hosts implementation of specific rules and regulations.Macro political risk is the subjection of all foreign firms to political risk by a host country because of political change, revolution, or adoption of new policies.Micro political risk is the subjection of an individual firm, a specific industry, or companies from a particular country to political risk.

Risk: Political Risks (cont.)Although many least developed and developing nations present great opportunities for MNCs, these nations are also more unstable and more politically risky than their developed nation counterparts.Table 18.4 on the following slide shows some of the approaches that MNCs use to cope with political risk.The negative approaches are generally used by firms in attractive industries such as oil, gas, and mining.The best approaches are positive approaches, which have, which have both economic and political aspects.

Risk: Political Risks (cont.)

Long-Term Investment and Financing DecisionsForeign Direct InvestmentForeign Direct Investment (FDI) is the transfer of capital, managerial, and technical assets from an MNCs home country to a host country.An MNC can be a 100% equity participant (resulting a wholly-owned subsidiary) or less (leading to a joint venture project with foreign participants).FDI projects are subject not only to business, financial, inflation, and exchange rate risk, but also to the additional element of political risk.

Long-Term Investment and Financing Decisions (cont.)Investment Cash Flows and DecisionsA number of factors must be considered when estimating cash flows in foreign projects.First, elements relating the parent companys investment in a subsidiary and the concept of taxes must be considered.Also, the parent must consider the risk that the repatriation of cash flows will be blocked.Finally, the risk of international cash flows must also be considered.

Long-Term Investment and Financing Decisions (cont.)Long-Term DebtAn international bond is a bond that is initially sold outside the country of the borrower and often distributed in several countries.A foreign bond is an international bond that is sold primarily in the country of the currency of issue.A Eurobond is an international bond that is sold primarily in countries other than the country of the currency in which the issue is denominated.

Long-Term Investment and Financing Decisions (cont.)Equity CapitalOne way for MNCs to raise equity is the have the parents stock distributed internationally and owned by shareholders in different countries.In recent years, the Euroequity market has continued to evolve and develop.The Euroequity market is the capital market around the world that deals in international equity issues.London has become the center of Euroequity activity.

Short-Term Financial DecisionsLike purely domestic firms, MNCs have access to accounts payable, accruals, bank and non-bank sources of short-term funds.In addition, MNCs have access to the local economic market for both short and long- term funding.Finally, the subsidiarys borrowing and lending opportunities are often greater since it can rely on the potential backing of the parent company.

Short-Term Financial Decisions (cont.)The Eurocurrency market is the portion of the Euromarket that provides short-term, foreign-currency financing to subsidiaries of MNCs.Unlike borrowing in domestic markets, where only one currency and a nominal interest rate is involved, financing in the Euromarket may involve several currencies and both nominal and effective interest rates.

Short-Term Financial Decisions (cont.)Effective interest rates in the international context, is the rate equal to the nominal rate plus (or minus) any forecast appreciation (or depreciation) of a foreign currency relative to the currency of the MNC parent.A multinational plastics company, International Molding, has subsidiaries in Switzerland (Swiss Franc, SF) and Japan (Japanese Yen, ). Based on each subsidiarys forecast operations, the short-term financial needs (in US$) are as follows:Switzerland: $80 million excess cash to be invested (lent)Japan: $60 million funds to be raised (borrowed)

Short-Term Financial Decisions (cont.)On the basis of all available information, the parent firm has provided each subsidiary with figures given as shown below:

Short-Term Financial Decisions (cont.)From the MNCs point of view, the effective rates of interest, which take into account each currencys forecast percentage change (appreciation or depreciation) relative to the US$, are the main considerations for borrowing and investing decisionsFor investment purposes, the highest available effective rate of interest is 3.30% in the US$ Euromarket. To raise funds, the cheapest source open to the Japanese subsidiary is the 2.01% effective rate for the Swiss Franc in the Euromarket.

Short-Term Financial Decisions: Cash ManagementIn its international cash management, the MNC can respond to exchange rate risk by hedging its undesirable cash and marketable securities exposures or by certain adjustments in its operations.Hedging strategies are techniques used to offset or protect against risk.These strategies are summarized in Table 18.5 on the following slide.

Short-Term Financial Decisions: Credit and Inventory ManagementBecause MNCs compete for the same global markets, it is essential that they offer attractive credit terms to potential customers.With respect to inventory management, MNCs must consider a number of factors related to both economics and politics, including exchange rate fluctuations, tariff and non-tariff barriers, and varying laws and regulations.

Mergers and Joint VenturesInternational mergers and joint ventures, especially those involving European firms acquiring assets in the U.S., increased significantly beginning in the 1980s.Moreover, a fast-growing group of MNCs recently emerged based in the so-called newly industrialized countries (including Singapore, South Korea, and Chinas Hong Kong).Still others are operating from emerging nations (such as Brazil, China, Mexico, India, and Thailand).

Mergers and Joint Ventures (cont.)Foreign direct investments (FDI) in the U.S. have also gained popularity in recent years.Most FDI comes from Britain, Canada, France, the Netherlands, Japan, Switzerland, and Germany and is concentrated in manufacturing, petroleum, and trade/service sectors.Developing countries, too, have been attracting FDI and a number of these nations have adopted specific policies and regulations aimed at controlling the inflows of foreign investments.

Summary of Learning ObjectivesFinancial management is an integral part of a firms strategy. This course analyzes how a firms financial management tasks evolve as it pursues global strategic opportunities and new constraints unfoldThe evolution of firms from domestic to multinational is called the globalization process. A firm may enter into international trade transactions, then international contractual arrangements and ultimately the acquisition of foreign subsidiaries. This final stage is when a firm truly becomes a multinationalThe decision whether or not to invest abroad may require the MNE to enter into global licensing agreements, joint ventures, acquisitions or Greenfield investments

Summary of Learning ObjectivesThree major currency exposures arising from the conduct of multinational business that impact all firms are transaction, operating and translation exposureThe definitions of return and risk are not universally accepted. Indeed they may be culturally-denominated norms that vary by countryIn Anglo-American markets, shareholder wealth maximization model is the norm. In non-Anglo-American markets, the corporate wealth model is the norm. Distinct differences exist as to how these models treat return and risk

Summary of Learning ObjectivesAs MNEs become more dependant on global capital markets for financing they may need to modify their policies of corporate governance. A trend exists for firms resident in non-Anglo-American markets to move toward being more stockholder friendly while Anglo-American markets are moving toward being more stakeholder friendly.