Lecture 1 Corp Gov and Financial Goals

8/2/2019 Lecture 1 Corp Gov and Financial Goals

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Chapter 1

Financial Goalsand Corporate Governance


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The Multinational Enterprise

A multinational enterprise (MNE) is defined asone that has operating subsidiaries, branches oraffiliates located in foreign countries.

The ownership of some MNEs is so dispersedinternationally that they are known astransnationalcorporations.

The transnationals are usually managed from aglobal perspective rather than from theperspective of any single country.


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Multinational Business Finance

While multinational business finance emphasizesMNEs, purely domestic firms also often havesignificant international activities:

Import & export of products, components and services

Licensing of foreign firms to conduct their foreignbusiness

Exposure to foreign competition in the domestic market

Indirect exposure to international risks through

relationships with customers and suppliers


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Global of Financial Management

There are significant differences between

international and domestic financialmanagement:

Cultural issues

Corporate governance issues

Foreign exchange risks

Political Risk

Modification of domestic finance theories

Modification of domestic financial instruments


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The Goal of Management

Maximization of shareholders wealth is the dominant goal ofmanagement in the West.

In the rest of the world, this perspective still holds true (although toa lesser extent in some countries).

In Western markets, this goal is realistic; in many other countries it isnot.

There are basic differences in corporate and investor philosophies

globally.

In this context, the universal truthsof finance become culturallydetermined norms.


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Shareholder Wealth Maximization

In a Shareholder Wealth Maximization model (SWM), a firm should strive

to maximize the return to shareholders, as measured by the sum ofcapital gains and dividends, for a given level of risk.

Alternatively, the firm should minimize the level of risk to shareholdersfor a given rate of return.

The SWM model assumes as a universal truth that the stock market isefficient.

An equity share price is always correct because it captures all the

expectations of return and risk as perceived by investors, quicklyincorporating new information into the share price.

Share prices are, in turn, the best allocators of capital in the macroeconomy.


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Shareholder Wealth Maximization The SWM model also treats its definition of risk as a universal truth.

Risk is defined as the added risk that a firms shares bring to a diversifiedportfolio.

Therefore the unsystematic, or operational risk, should not be of concern toinvestors (unless bankruptcy becomes a concern) because it can be diversified.

Systematic, or market, risk cannot however be eliminated.

In this context understanding theAgency Theoryis becoming a necessity.

Agency theoryis the study of how shareholders can motivate management toaccept the prescriptions of the SWM model.

Liberal use of stock options should encourage management to think more likeshareholders.

If management deviates too extensively from SWM objectives, the board ofdirectors should replace them.

If the board of directors is too weak (or not at arms-length) the discipline ofthe capital markets could effect the same outcome through a takeover.

This outcome is made more possible in the Western markets due to the one-

share one-vote rule.


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Shareholder Wealth Maximization

Long-term value maximization can conflict with short-term value

maximization as a result of compensation systems focused on quarterlyor near-term results.

Short-term actions taken by management that are destructive over thelong-term have been labeled impatient capitalism.

This point of debate is often referred to a firms investment horizon(how long it takes for a firms actions, investments and operations toresult in earnings).

In contrast to impatient capitalismis patient capitalism.

This focuses on long-term SWM.

Many investors, such as Warren Buffet, have focused on mainstreamfirms that grow slowly and steadily, rather than focusing on high-

growth but risky sectors.


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Stakeholder Capitalism Model

In the Non-Western markets, controlling shareholders also strive to maximize long-termreturns to equity.

However, they are more constrained by other powerful stakeholders.

In particular, labor unions are more powerful than in the Western markets.

In addition, Governments interfere more in the marketplace to protect importantstakeholder groups, such as local communities, the environment and employment.

The SCM model does not assume that equity markets are either efficient or inefficient.

The inefficiency does not really matter, because the firms financial goals are notexclusively shareholder-oriented, because they are constrained by the other stake-holders.

The SCM model assumes that long-term loyal shareholders those typically withcontrolling interests should influence corporate strategy, rather than the transientportfolio investor.

The SCM model assumes that total risk i.e. operating and financial risk does count.

It is a specific corporate objective to generate growing earnings and dividends over thelong run with as much certainty as possible.

In this case, risk is measured more by product market variability than by short-term

variation in earnings and share price.


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Operational Goals for MNEs

The MNE must determine for itself proper balancebetween three common operational financial objectives:

maximization of consolidated after-tax income;

minimization of the firms effective global tax burden;

correct positioning of the firms income, cash flows, andavailable funds as to country and currency.

These goals are frequently incompatible, in that thepursuit of one may result in a less-desirable outcome inregard to another.


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Corporate Governance

Although the governance structure of any company domestic,international, or multinational is fundamental to its very existence,this subject has become a lightning rod for political and businessdebate in the past few years.

Spectacular failures in corporate governance have raised issues aboutthe very ethics and culture of the conduct of business.

The single overriding objective of corporate governance is the

optimization over time of the returns to shareholders.

In order to achieve this goal, good governance practices should focusthe attention of the board of directors of the corporation by developingand implementing a strategy that ensures corporate growth andimprovement in the value of the corporations equity.


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Corporate Governance

The most widely accepted statement of good corporategovernance practices are established by the OECD:

The corporate governance framework should protect shareholdersrights.

The corporate governance framework should ensure the equitabletreatment of all shareholders.

Stakeholders should be involved in corporate governance.

Disclosure and transparency is critical.

The board of directors should be monitored and heldaccountable for what guidance it gives.


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Failures in Corporate Governance

Failures in corporate governance have become increasingly

visible in recent years.

In each case, prestigious auditing firms missed theviolations or minimized them, presumably because of

lucrative consulting relationships or other conflicts ofinterest.

In addition, security analysts urged investors to buy theshares of firms they knew to be highly risky (or even close

to bankruptcy).

Top executives themselves were responsible formismanagement and still received overly generous

compensation while destroying their firms.


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Corporate Governance Reform

Within the United States and the United Kingdom, the maincorporate governance problem is the one treated by agencytheory: with widespread share ownership, how can a firmalign managements interest with that of the shareholders?

Because individual shareholders do not have the resourcesor the power to monitor management, the U.S. and U.K.markets rely on regulators to assist in the agency theorymonitoring task.

Outside the U.S. and U.K., large, controlling shareholdersare in the majority these entities are able to monitormanagement in some ways better than the regulators can.


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The Sarbanes-Oxley Act This act was passed by the US Congress, and signed by President

Bush during 2002 and has three major requirements:

CEOs of publicly traded companies must vouch for the veracity ofpublished financial statements;

corporate boards must have audit committees drawn fromindependent directors;

companies can no longer make loans to corporate directors, and

Companies must test their internal financial controls against fraud

Penalties have been spelled out for various levels of failure.

Most of its terms are appropriate for the US situation, but someterms do conflict with practices in other countries.


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Additional Corporate Governance Issues

Board structure and compensation

issues

Transparency, accounting and auditing

Minority shareholder rights


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Currency Terminology Foreign Currency Exchange Ratethe price of one countrys

currency in units of another currency of commodity.

Can be fixed or floating

Spot Exchange Rate the quoted price for foreign exchange to bedelivered at once, or in two days for interbank transactions.

Forward Rate the quoted price for foreign exchange to bedelivered at a specified date in the future.

Can be guaranteed with a forward exchange contract

Forward Premium or Discountthe percentage difference between

the spot and forward exchange rate.

Calculated as Spot Forward x 360 x100Forward n


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Currency Terminology Devaluation of Currency refers to a drop in foreign exchange value of

a currency that is pegged to gold or another currency.

The opposite is revaluation

Weakening, deterioration, or depreciationof Currency refers to a dropin the foreign exchange value of a floating currency.

The opposite is strengtheningor appreciation

Softor Weak describes a currency that is expected to devalue ordepreciate relative to major currencies.

Also refers to currencies being artificially sustained by their

governments

Hardor Strong describes a currency that is expected to revalue orappreciate relative to major trading currencies.

Eurocurrencies are domestic currencies of one country on deposit in a

bank in a second country.


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Case Study: EnronQuestions

Which parts of the corporate governance system, bothinternal and external, do you believe failed Enron the most?

Describe how you think each of the individual stakeholdersand components of the corporate governance system shouldhave either prevented the problems at Enron or acted toresolve the problems before they reached crisis proportions?

If all publicly traded firms in the United States are operatingwithin the same basic corporate governance system asEnron, why would some people believe this was an isolatedincident, and not an example of many failures to come?


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Exhibit1.1


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Exhibit 1.2


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Exhibit 1.3


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Exhibit 1.4


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Exhibit 1.5


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Exhibit 1.6


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Exhibit A


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Source

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

, 11

th

Edition,Pearson Prentice Hall, International Edition, 2007

Lecture 1 Corp Gov and Financial Goals

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