multinational finance 2

FIn 763: Lecture 2 1

Multinational Finance Multinational enterprise and multinational

financial management

Alon RavivFIN-763, Spring 2008

Boston University, The Metropolitan College


Today’s plan Part 1: The rise of the multinational corporation

• THE MNC definition, reason for evaluation and management.

Part 2: Internationalization of business and finance Part 3. Multinational financial management: theory

and practice

• The MNC’s policies

• Function of financial management

• Theoretical foundation

• The global financial market place


PART 1: THE RISE OF THE MULTINATIONAL CORPORATION

I. The MNC: A Definition

• A company with production and

distribution facilities in more than one country.

• with a parent company located in the home country

• at least five or six foreign subsidiaries


THE RISE OF THE MULTINATIONAL CORPORATION

A. Forces Changing Global Markets• Massive deregulation

• Collapse of communism

• Privatizations of state-owned industries

• Revolution in information technology

• Wave of M&A

• Emergence of free market policies in Third World Nations

• The unprecedented number of nations submitting themselves to the exacting rigors standards of the global marketplace.



The Rise of China as a Global Competitor

The most dramatic change in the international economy over the last decade.

The number one destination for foreign direct investment (FDI)

Note: FDI is the acquisition abroad of companies, property, or physical assets



C. The MNC’s Evolution Reasons to Go Global:

1. More raw materials

2. New markets

3. Minimize costs of production

4. Access to new technologies



RAW MATERIAL SEEKERS• exploit markets in other countries

• historically first to appear: the British, Dutch and French East India Companies that grow up under the protective mantle of the colonial empires.

• modern-day counterparts: the multinational oil and mining companies.

British PetroleumExxon



MARKET SEEKERS• Produce and sell in foreign markets

• Have heavy foreign direct investors

• Represented today by firms such as:

• IBM

•MacDonald’s

•Nestle

•Levi Strauss



COST MINIMIZERS• seek lower-cost production abroad

• Their motive: to remain cost competitive

• The investment can be done internally by establishment of wholly owned foreign affiliates or externally by outsourcing a service.

• Represented today by firms such as:

•Texas Instruments

• Intel

•Seagate Technology



D. What is the MNC?

From a Behavioral View:it’s a state of mind committed to globally• producing,• undertaking investment,• marketing, and financing.



E. THE GLOBAL MANAGER:

1. Understands political and economic differences;

2. Searches for most cost-effective suppliers;

3. Evaluates changes on value of the firm.


Part II INTERNATIONALIZATION OF BUSINESS AND FINANCE

I. Globalization

II. Political and Labor Union Concerns

• Corporation that invest abroad are defined as “job exporters”.III. Consequences of Global Competition:

• The acceleration of the global economy

• International economic integration reduces the freedom of government to determine their own economic policy.

• The globalization of trade and finance has created an unforgiving environment that penalizes economic mismanagement and allots capital and jobs to the nation delivering the highest risk adjusted return


What is NAFTA?

• The North American Free Trade Agreement (NAFTA) is one of the most powerful and wide-reaching treaties in the world.

• NAFTA is a treaty between Canada, Mexico, and the United States that was designed to foster greater trade between the three countries. NAFTA has been in effect since 1 January 1994

• NAFTA eliminate a large number of tariffs on goods shipped between the three countries. Prime examples of these goods were cars, car parts, computers, and food.

• As a result of NAFTA, Mexico especially has purchased goods from the US in much greater numbers than before. This saves Mexican companies money on imports, and it saves American companies money on export shipping costs.


The debate over NFTA: Clinton versus Perot

• The New York Times, NOV -9, 1993:

• Mr. Perot dismisses the foreign policy implications while manhandling the economic data. In a nine-month anti-Nafta crusade that has taken him to 43 states and 91 cities, he has warned that Nafta would cause American industry and agriculture to flee south with "a giant sucking sound" toward cheaper Mexican labor, costing

Americans 5.9 million jobs.


The debate over NFTA: Clinton versus Perot


The Results…


The Consequences of NAFTA


The Consequences of NAFTA Schiff and Yanling (2002) have found that trade with

Mexico's NAFTA partners has a large and significant impact on Mexico's trade-related foreign R&D and total productivity

See: http://ssrn.com/abstract=323040 Coughlin and Wall (2000) have found that NAFTA

has increased U.S. merchandise exports to Mexico and Canada by over 15 percent, and has increased total U.S. merchandise exports by nearly 8 percent

See: http://ssrn.com/abstract=249008


1997 Asian financial crisis

• For years the nations of South East Asia were held as economic icon due to:• High saving rates

• High investment rates.

• Autocratic political system

• Export oriented business

• Government direct capital allocation

• Controlled financial system

All together were hailed as the ideal recipe for strong economic growth


1997 Asian financial crisis

• The crisis started in Thailand with the financial collapse of the Thai Bath caused by the decision of the Thai government to float the baht,

cutting its peg to the USD, after exhaustive efforts to support it.• At the time Thailand had acquired a burden of Foreign debt that

made the country effectively bankrupt even before the collapse of its currency.

• The drastically reduced import earnings that resulted from the forced devaluation then made a quick or even medium-term recovery impossible without strenuous international intervention.

• As the crisis spread, most of Southeast and Japan saw slumping currencies, devalued stock markets and asset prices, and a precipitous rise in private debt.


The neighboring countries

• Investors then turned to other Asian economies and saw similar flaws there

• The dominoes effect:


Table 1: East Asian GDPAverage annual percentage growth

1987-1996 1997-1999 2000-2006

Hong Kong 5.2 -0.8 4.7

Indonesia 7.1 -6.4 4.9

Korea 8.1 1.0 4.6

Malaysia 9.5 -0.8 4.7

Philippines 3.6 1.4 4.6

Singapore 9.2 2.8 4.6

Taiwan 7.2 5.1 3.3

Thailand 9.5 -3.3 5.1

East Asia* 7.6 0.0 4.5

* Excluding China and Japan

Source: IMF, CEIC, RBA


The recovery (2000)

• A number of factors contributed to the rebound: • strong growth of exports reflecting both the impact of substantial

currency depreciations on external competitiveness and the surge in global demand for electronic equipment produced in the region;

• restoration of more orderly financial market conditions, partly in response to current account improvements and external financing support;

• fiscal stimulus to support domestic demand;

• significant recoveries in regional stock markets, mainly in the information technology and communications (ITC) sectors


PART III. MULTINATIONAL FINANCIAL MANAGEMENT: THEORY AND PRACTICE

• I. The MNC’s PoliciesA. Main Objective of MNC: Maximize shareholder wealth

• This means: making financing and investment decision that add as much value as possible to the firm.

• Why do we focus on shareholder value?• Shareholders are the legal owners of the firm and management has a

fiduciary obligation to act in their best interests

• Provides the best defense against hostile takeover: high share price

• Easy to attract equity capital

B. Other Objectives Reflect Its Ability via affiliate transfer mechanisms

•

•


MFM: THEORY AND PRACTICE

C. Mode of Transfer:• Reflects freedom to select a variety of financial channels.

D. Timing Flexibility:• Most MNC have some flexibility in timing of fund

flows.

E. Value• The ability to avoid national taxes has led to controversy.



II. FUNCTIONS OF FINANCIAL MANAGEMEN• A. Two Basic Functions

1. Financing decision: Generating funds from external and internal funds at the lowest long run cost possible

2. Investing decision: The allocation of funds over time in such a way that shareholder wealth is maximized.

The interaction between financing and investment decision is the key for maximizing the value of the firm



B. Additional Factors Facing the MNC Executive• 1. Political risk

• Example: Sudden expropriation

• 2. Economic risk• Exchange and inflation risk

• International differences in tax rates

• Multiply money markets

• Currency control



III. THEORETICAL FOUNDATIONS A. Useful Concepts from Financial Economics: A discipline that emphasizes the use of economic analysis to understand the

basic workings of financial markets, particularly the measurement and pricing of risk and the intertemporal allocation of funds

Three concepts arising in financial economics have particular importance in international corporate finance:

1. Arbitrage• Definition: Traditionally has been defined as the purchase of assets or commodities in

one market for immediate resale on another in order to profit from price discrepancy • Tax arbitrage• Risk arbitrage• The process of arbitrage insures market efficiency

2. Market Efficiency 3. Capital Asset Pricing

• CAPM and APT models• Systematic (non diversifiable risk) versus unsystematic (diversifiable risk)



B. Importance of Total Risk Although the message of the CAPM model is that only

systematic risk should be rewarded with risk premium, this does not mean that the total risk is not important to the value of the firm.

1. Adverse Impact: lower sales and higher costs• The probability of financial distress is determined by the

total risk and financial distress might be costly 2. Justifies hedging activities of MNC 3. Diversification reduces risk



IV. THE GLOBAL FINANCIAL MARKET PLACE

A. Inter-linkage by Computers

B. Market Acts as A Global Referendum Process Where : Currencies may rise or fall


Assignment Two: Q-1

1. Historically, the primary motive for U.S. multinationals to produce abroad has been to

a. lower costs b. respond more quickly to the marketplace c. avoid trade barriers d. gain tax benefits


Assignment Two: Q-2

2. The value of good financial management is ___________ in the global markets because of the much greater probability of market imperfections and multiple tax rates.

a. minimized b. neutralized c. enhanced d. arbitraged away


Assignment Two: Q-3

3. ___________ are a recent category of multinationals that seek out and invest in lower cost production sites overseas.

a. Cost minimizers b. Market seekers c. Raw-material seekers d. High tech firms


Assignment Two: Q-4

4. Critics of the multinational corporation would not fault its tendency to

a. shift production from one location to another in search of lower costs

b. avoid taxes

c. cause balance of payments difficulties

d. engage in environmental protection measures


Assignment Two: Q-5

According to the efficient market hypothesis, which one of the following is NOT correct?

a.markets place a premium on the future

b.today’s stock price is the best predictor of tomorrow’s stock price

c.stock prices reflect all available information

d.today’s stock price incorporates the past history of prices


Assignment Two: Q-6

According to the capital asset pricing model

a.only the systematic component of risk affects the required return

b. foreign investments whose returns are uncorrelated with the market's return should have a higher required return than comparable domestic investments

c. total risk of the investment is most relevant for small to medium-sized firms

d.diversification is secondary to risk levels of the investment

multinational finance 2

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