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ỊỊỊmỹÌŨìCelaì?!

Fundamentals of

MULTINATIONAL FINANCE

Edition III

MICHAEL H MOFFETT

Thunderbird School o f G lobal M anagement

ARTHUR I STONEHILL

Oregon State University and

University o f H aw aii at M anoa

DAVID EL EITEMAN

University o f California, L o s A ngeles

PEARSON

B oston San Francisco N ew York

L o ndon Toronto Sydney Tokyo Singapore M adrid

M exico C ity M unich Paris Cape Tow n H o n g K ong M ontreal

Executive Editor: D onna B attista

Assistant Editor: Kerri M cQ ueen

Managing Editor: Nancy Fenton

Senior Production Supervisor: M eredith Gertz

Cover Designers: Gillian Hall and B eth Paquin

Design Manager: Joyce Wells

Text Designer: Gillian Hall

Supplements E ditor: H eather McNally

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Senior M anufacturing Buyer: Carol Melville

Production Coordination, Composition, and Illustrations:

Gillian Hall, The A ardvark G roup Publishing Services

Copyeditor: Kathleen Cantwell, C4 Technologies

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Cover image: © Im age Source Pink

Library o f Congress Cataloging-in-Publication Data

1 International business enterprises—Finance 2 International finance

3 Foreign exchange I Stonehill, A rthur I II Eitem an, David K III Title HG4027.5.M64 2008

2 3 4 5 6 7 8 9 lO -DO W -12 11 10 09 08

Fundamentals o f Multinational Finance, third edition, views the m ultinational

enterprise (M NE) as an organization th at poses unique demands on the business leaders of tomorrow Those leaders—possibly some readers of this tex t—will be

confronted with a m ultitude of challenges that will test not only their ability to com ­ prehend global markets, b u t also m ore importantly, their ability to lead organizations

through the constantly shifting currents and tides of global change Com petent leader­ship may indeed be the scarcest global commodity

This book is about m ultinational m anagement, and more specifically, the financial

m anagem ent (dimensions of leading a m ultinational enterprise The M NE itself acts as

a catalyst and facilitator of international trade, and as an im portant producer and dis­tributor in the host countries where it operates The M N E ’s potential success, however, rests in the hands of the truly com petent global leader The success of any M NE depends on its leadership’s ability to lead and manage the global organization., In writing this book, our vision is to aid the developm ent of tom orrow ’s M NE leaders I t is their ability to recognize and benefit from business opportunities such as imperfections in national markets, unequal costs and efficiencies of production factors, wellsprings of intellectual property, and sources of global funding to facilitate growth that adds value

The financial m anagers of M NEs face num erous foreign exchange and political risks These risks can be daunting, but if properly understood they also present oppor­tunities for creating value These risks and opportunities are most effectively under­stood in the context of the global business itself, and the ability of m anagem ent to integrate the strategic and financial challenges th at the business faces

Audience

Fundamentals o f Multinational Finance, third edition, is appropriate for university

level courses in international financial management, international business finance, international finance, and similar subjects It can be used at the undergraduate or grad­uate level as well as in executive education courses

A prerequisite course or experience in corporate finance or financial managem ent would be ideal However, we review the basic finance concepts before we extend them

to the multinational case We also review the basic concepts of international econom­ics and international business

We recognize the fact th at many potential adopters of this book live outside the

U nited States and Canada Therefore, we use a significant num ber of non-U.S exam­

ples, mini-cases, and Global Finance in Practice boxes, as seen in the business and news

press (anecdotes and illustrations)

Organization

Fundamentals o f Multinational Finance, third edition, is organized into seven parts

They are unified by the common thread of the globalization process by which a firm moves from a domestic to a multinational business orientation

• Part i describes the road to globalization

• Part 2 introduces the global financial environment

® Pari 3 explains foreign exchange theory

• Part 4 analyzes foreign exchange rate exposure

® Part 5 analyzes financing the global firm

• Part 6 analyzes international investment decisions

• Part 7 examines managing m ultinational operations

New in the Third Edition

• Chapter 1, Globalization and the Multinational Enterprise, is new but mainly incor­

porates topics that were previously discussed in the chapter on Foreign D irect Investment

• C hapter 2, Financial Goals and Corporate Governance, is largely new and expands

on the discussion of corporate governance presented previously in Chapter l.T h e chapter now includes private ownership of business and differing perspectives on the value of good global corporate governance

• Chapter 5, The Foreign Exchange Market, includes the (2007) results of the

“Triennial Central Bank Survey of Foreign Exchange and Derivatives M arket Activity.”

• C hapter 13, Sourcing Equity Globally, includes the various capital m arket stock

exchange mergers, additional m aterial on equity funds, and family-owned compa­nies

Preface v¡¡

• Chapter 17, Foreign Direct Investment Theory and Strategy, has a new section on

emerging m arket MNEs

® There are now 22 mini-cases, many of which are new; and in response to user feed ­back, fifteen of the most popular mini-cases are retained

• There are m ore Global Finance in Practice, boxes.

• Internet exercises, end-of-chapter questions, and end-of-chapter problems are updated There are more than 200 problems throughout

' In this book, we use foreign exchange quotations th at sometimes may differ from the latest com puter code quotation symbols (three-digit symbols) This is a result of constant change in the marketplace, coupled with our text being revised every three years, and our preference to use traditional symbols—$, ¥, £, € —rather than three-digit codes, which in our opinion are more sterile We also recognize that we may appear out

of date when we reference specific rates of exchange B ut that is what this book is p ar­tially about—the difficulties and challenges of managing businesses in a rapidly chang­ing financial environment We also are cognizant that many professors have prepared additional teaching materials based on our existing foreign exchange quotations Therefore, we try to continue a mix of selected existing quotations (from previous edi­tions) with the introduction of the latest rates and movements in the marketplace In any case, we use the quotations to illustrate a particular problem, not as a basis for up- to-the-m inute solutions

Pedagogical Tools

To make Fundamentak o f Multinational Finance, third edition, as comprehensible as

possible, we use a large num ber of proven pedagogical tools Again, our efforts have been informed by the detailed reviews and suggestions of a panel of professors who are recognized individually for excellence in the field of international finance, particu­larly at the undergraduate level Among these pedagogical tools are the following:

• A student friendly writing style combined with a structured presentation of m ate­

rial begins with chapter learning objectives and ends with a summarization of how

those learning objectives were realized

• Numerous illustrations and exhibits provide a visual parallel to the concepts and

content presented The book uses a multicolor presentation, which provides a visual attractiveness that contributes significantly to reader attention and reten­tion

• A running case about a hypothetical U.S.-based firm, Trident Corporation, pro­

vides a cohesive framework for the multifaceted globalization process, and is rein­forced in several end-of-chapter problems

• Spreadsheet analyses prepared by Francis Clauss illustrate the quantitative dimen­

sions of the analysis These spreadsheet analyses n ot only provide the computa­tional support to improve reader understanding, but also provide the detailed formula behind their construction

• A mini-case at the end of each chapter illustrates the chapter content and extends

it to the multinational financial business environment

viii Preface

• Global Finance in Practice boxes illuminate the theory with accounts of actual

business practices These applications extend the concepts without adding to the length of the text itself

• The power and resources of the Internet are leveraged throughout the text in a

variety of applications Every chapter has end-of-chapter exercises that require the use of the Internet, while a variety of Internet references are dispersed throughout the chapters in text and exhibits

• Additional end-of-chapter questions and problems assess students’ understanding

of the course material A ll end-of-chapter problems are solved using spreadsheet solutions Selected end-of-chapter problem answers, indicated with an asterisk (*), are now included at the back of the book

A Rich Array of Support Materials

A robust package of m aterials for instructors and students accompanies the text to facilitate learning and to support teaching and testing All instructor resources are available for dow nload from the online catalog page for this book (www.prenhall.com/finance or www.prenhall.com/irc)

• Instructor’s Manual The Instructor’s Manual, prepared by the authors, contains answers to all end-of-chapter questions, problems, and mini-cases All quantitative end-of-chapter problems are solved using spreadsheets, which are available for download and on the Instructor’s Resource CD-ROM

• Test Bank The Test Bank, prepared by Curtis Bacon of Southern Oregon University, contains m ore than 1,200 multiple choice and short essay questions The multiple choice questions are labeled by topic and by category—recognition, conceptual, and analytical The test bank is available for download on the online catalog page and on the Instructor’s Resource CD-ROM

• Computerized Test Bank The Test Bank is also available in Pearson E ducation’s TestGen software for Windows® and Macintosh® TestG en’s graphical interface enables instructors to view, edit, and add questions; transfer questions to tests; and print different forms of tests Search-and-sort features enable the instructor to locate questions quickly and arrange them in a preferred order The Quizmaster application allows the instructor to administer TestGen tests over the school’s com puter netw ork M ore inform ation on TestG en software is available at www.prenhall.com/testgen

• Mini-Case PowerPoint® Presentations A significant addition to the instructor’s resources in this edition, each of th e 22 m ini-cases has a stand-alone PowerPoint presentation, which is available on the Instructor’s Resource CD- ROM and on the online catalog page for this book (www.prenhall.com/finance or www.prenhall.com/irc)

• PowerPoint Presentation Slides The extensive set of PowerPoint slides available on the Instructor’s R esource CD-RO M and on the online catalog page for this book provides lecture outlines and selected graphics from each chapter

• Instructor’s Resource CD-ROM This CD-ROM contains the Test Bank, Computerized Test Bank files, the Instructor’s M anual files, and PowerPoint files

Preface ix

• Study Guide W ritten by Timo Korkeam aki of Gonzaga University, the Study Guide enhances understanding and retention of concepts by providing detailed study outlines It helps students prepare for tests with a series of self-test questions, including true/false, multiple choice, and short essay—all with answers

• Web Site A dedicated Web site (www.prenhall.com/moffett) contains the Web exercises from the book with wired links, self-study quizzes, electronic flashcards

of glossary terms, and selected solutions and spreadsheets for end-of-chapter problems

international Editions

Fundamentals o f Multinational Finance and Multinational Business Finance have been

used throughout the world to teach students of international finance O ur books are published in several foreign languages including Chinese, French, Spanish, Indonesian, Portuguese, and Ukrainian

Acknowledgments

The authors are very thankful for the many detailed reviews and suggestions from num erous colleagues The third edition reviews included 15 detailed chapter-by- chapter reviews The final version of this edition reflects most of the suggestions p ro ­vided We appreciate the following reviewers: Torben A ndersen, N orthw estern

U niversity; K ristine Beck, U niversity of Wisconsin; G eorge Change, B radley University; O rkunt Dalgic, SUNY New Paltz; R obert Duvic, U T Austin; Ling He, University of Central Arkansas; Pankaj Jain, University of Memphis; David Ng, Cornell University; R olando Pelaez, University of H ouston; N iranjan Tripathy, University of N orth Texas; Consheng Wu, University of Bridgeport; Jimmy Yang, Oregon State

Previous editions of Fundamentals o f Multinational Finance greatly benefited

from other reviewers including the following: M orten Balling, W Brian B arrett, Cetin Ciner, Joseph F Greco, K en H unsader, Charm en Loh, Beverly B Marshall, Daniel L McCounaughy, Simona Mola, Ali M Parhizgari, Olgun Fuat Shahin, Jimmy Senteza, James G Tompkins, Phil Uhlm ann, and M iland M Shrikhande

We would also like to thank two people at Prentice Hall who have worked dili­gently on this edition: D onna Battista, Executive E ditor for Finance, and K erri

M cQueen, Assistant Editor

Finally, we dedicate this book to our parents, Bennie R u th and the late Hoy Moffett, the late H arold and Norm a Stonehill, and the late Wilford and Sylvia Eitem an, who m otivated us to becom e academicians and authors We thank our wives,

Megan, Kari, and Keng-Fong, for their patience while we prepared Fundamentals o f Multinational Finance, third edition.

Pacific Palisades, California D.K.E

About the Authors

Michael H Moffett Michael H M offett is Associate Professor of Finance at Thunderbird,The A m erican G raduate School of International Management Formerly,

he was Associate Professor of Finance at O regon State University (1985-1993) H e has also held teaching or research appointm ents at the University of Michigan, A nn A rbor (1991-1993); the Brookings Institution, Washington, D.C.; the University of Hawaii at Manoa; the Aarhus School of Business (D enm ark); the Helsinki School of Economics and Business A dm inistration (Finland); th e International C entre fo r Public Enterprises (Yugoslavia); and the University of Colorado, Boulder

Professor M offett received a B.A (Economics) from the University of Texas at Austin (1977); an M.S (Resource Economics) from Colorado State University (1979);

an M.A (Economics) from the University of Colorado, Boulder (1983); and a Ph.D (Economics) from the University of Colorado, Boulder (1985)

H e has authored, co-authored, or contributed to six books and fifteen other pub­

lications His articles have appeared in Journal o f Financial and Quantitative Analysis, Journal o f A pplied Corporate Finance, Journal o f International Money and Finance, Journal o f International Financial Management and Accounting, Contemporary Policy Issues, Brookings Discussion Papers in International Economics, and others H e has contributed to a num ber of collected works, including the H andbook o f Modern Finance, the International Accounting and Finance Handbook, and the Encyclopedia o f International Business H e has co-authored two books on m ultinational business with Michael Czinkota and Ilkka Ronkainen: International Business (sixth edition) and Global Business (fourth edition).

Arthur I S to n eh ili A rthur I Stonehill is a Professor of Finance and International Business, Emeritus, at O regon State University, where he taught for 24 years (1966-1990) From 1991 to 1997 he held a split appointm ent at the University of Hawaii at M anoa and Copenhagen Business School From 1997 to 2001 he continued

as a visiting professor at the University of Hawaii at Manoa H e has also held teaching

or research appointm ents at the University of California, Berkeley; Cranfield School

of M anagement (U.K.); and the N orth European M anagement Institute (Norway) Formerly, he was president of the Academ y of International Business, and was a west­ern director of the Financial M anagem ent Association \

Professor Stonehill received a B.A (History) from Yale University (1953), an M.B.A from H arvard Business School (1957), and a Ph.D in Business Adm inistration from the University of California, Berkeley (1965) H e was awarded honorary doctor­ates from the A arhus School of Business (Denm ark, 1989), the Copenhaigen Business School (D enm ark, 1992), and Lund University (Sweden, 1998)

H e has authored or co-authored nine books and twenty-five other publications

His articles have appeared in Financial Management, Journal o f International Business Studies, California M anagement Review, Journal o f Financial and Quantitative Analysis, Journal o f International Financial Management and Accounting, International Business Review, European Management Journal, The Investment A nalyst (U.K.), National0konom isk Tidskrift (D enm ark), Sosial0konom en (Norway), Journal o f Financial Education, and others.

David K E ite m a n David K Eitem an is Professor Emeritus of Finance at the John E

A nderson G raduate School of M anagement at UCLA H e has also held teaching or research appointments at the Hong Kong University of Science & Technology, Showa Academy of Music (Japan), the National University of Singapore, Dalian University (China), the Helsinki School of Economics and Business Administration (Finland), University of Hawaii at M anoa, University of Bradford (U.K.), Cranfield School of

M anagement (U.K.), and ID E A (Argentina) Formerly, he was president of the International Trade and Finance Association, the Society for Economics and

M anagem ent in China, and the Western Finance Association

Professor E item an received a B.B.A (Business A dm inistration) from the University of Michigan, Ann A rbor (1952), M.A (Economics) from the University of California, Berkeley (1956), and a Ph.D (Finance) from Northwestern University (1959)

H e has authored or co-authored four books and twenty-nine other publications

His articles have appeared in The Journal o f Finance, The International Trade Journal, Financial Analysts Journal, Journal o f World Business, Management International, Business Horizons, M SU Business Topics, Public Utilities Fortnightly, and others.

Brief Contents

PART 1 GLOBAL FINANCIAL ENVIRONMENT - 1

Chapter 1 Globalization and the Multinational E nterprise 2

Chapter 2 Financial Goals and Corporate Governance 27

Chapter 3 The International Monetary System 59

Chapter 4 The Balance of Paym ents 90

Chapter 5 The Foreign Exchange M a rk et 123

PART 2 FOREIGN EXCHANGE THEORY 153 Chapter 6 International Parity Conditions 154

Chapter 7 Foreign Exchange Rate Determination and Forecasting 189

Chapter 8 Foreign Currency Derivatives 218

PART 3 FOREIGN E X C H A iC i EXPOSURE 251 Chapter 9 Transaction Exposure 252

Chapter 10 Operating Exposure 285

Chapter 11 Translation Exposure 312

PART 4 FINANCING THE GLOBAL FIRM 331 Chapter 12 The Global Cost and Availability of Capital 338

Chapter 13 Sourcing Equity Globally .374

Chapter 14 Financial Structure and International D ebt 400

Chapter 15 Interest Rate and Currency Swaps 426

PART 5 INTERNATIONAL INVESTMENT DECISIONS 4SI Chapter 16 International Portfolio Theory and Diversification 454

Chapter 17 Foreign Direct Investment Theory and Strategy 477

Chapter 18 Political Bisk Assessment and Management 501

Chapter 19 Multinational Capital Budgeting 531

p a r t 6 m a n a g in g m u l t in a t io n a l o p e r a t io n s s ss Chapter 20 International Trade Finance 560

Chapter 21 Multinational Tax Management 588

Chapter 22 Working Capital Management 612

Answers to Selected End-of-Chapter Problems A-l Glossary G-l Index 1-1

PART 1

GLOBAL FINANCIAL ENVIRONMENT 1

CHAPTER 1

Globalization and the Multinational Enterprise 2

Globalization and Creating Value in the Multina­

tional Enterprise 4

Global Finance in Practice i.i

National Multinational or ‘A-National’? .6

The Theory of Comparative Advantage 7

What Is Different about Global Financial Manage­

ment? 12

Global Finance in Practice 1.2

The Mystery of Capital D eepens 13

Market Imperfections: A Rationale for the Exis­

tence of the Multinational F irm 14

The Globalization Process , , 15

m i n i - c a s e

Porsche Changes T a c k 18

Summary of Learning Objectives .24

Questions 24 • Problems 25 • Internet Exercises 26

CHAPTER 2

Who Owns the Business? .28

Global Finance in Practice 2.1

Family Controlled Firms in France

Outperform the Public S e c to r 30

What Is the Goal of Management? .30

Global Finance in Practice 2.2

What Drives Value? .35

Corporate G overnance 36

Global Finance in Practice 2.3

When Scandals Go Global 42

Global Finance in Practice 2.4

Corporate Governance Reform in China 48

M IN I-CA SE

Governance Failure at Enron , 49

Summary of Learning Objectives 53Questions 54 • Problems 55 • Internet Exercises 58

CHAPTER 3

History of the International Monetary System 60 Global Finance in Practice 3.1

Hammering Out an Agreement

at Bretton Woods 63Contemporary Currency Regimes .70Emerging Markets and Regime Choices 73The Birth of a European Currency: The Euro 76 Global Finance in Practice 3.2

New EU Members and Adoption of the Euro 80 Exchange Rate Regimes: What Lies Ahead? 81 Global Finance in Practice 3.3

Calculating the Euro's Success 81

M IN I-C A S SThe Revaluation of the Chinese Yuan .82

M IN I-CA SE APPENDIXPublic Announcement of the People’s Bank of China or Reforming the RMSExchange Rate Regime 85Summary of Learning Objectives 86Questions 86 • Problems 87 • Internet Exercises 89

CHAPTER 4

Typical Balance o f Payments Transactions 92 Fundamentals of Balance of

Payments Accounting 92The Accounts of the Balance of Payments 94The Capital and Financial Accounts .97Global Finance in Practice 4.1

Official Foreign Exchange Reserves:

The Rise of China 101The Balance o f Payments in T o ta l 103The Balance of Payments Interaction with KeyMacroeconomic V ariables 105Trade Balances and Exchange Rates .108

xiv Contents

Global Finance in Practice 4.2

The United States as the World’s

Largest Debtor Nation 108

Capital Mobility .I l l

Global Finance in Practice 4.3

Thailand Fails to Stem Capital Inflows 112

MS11-CAS1

Turkey’s Kriz (A): Deteriorating Balance

of Payments .115

Summary of Learning Objectives 117

Questions 117 • Problems 119 • Internet Exercises 122

CH A PTER 5

Geographical Extent of the Foreign

Exchange M arket 124

Functions of the Foreign Exchange Market 125

Market Participants 126

Global Finance in Practice 5.1

The Foreign Exchange Dealer’s D ay 127

Global Finance in Practice 5.2

My First Day of Foreign Exchange Trading 128

Transactions in the Interbank M arket 129

Global Finance in Practice 5.3

A Hedge Against Foreign

Exchange Exposure? 131

Foreign Exchange Rates and Q uotations 134

M ill-C A S E

The Venezuelan Bolivar Black M a rk et 144

Summary of Learning Objectives 147

Questions 148 • Problems 148 • Internet Exercises 151

P A R T 2

CH APTER 6

Prices and Exchange R ates 155

Purchasing Power Parity and the

Law of One P rice 156

Global Finance in Practice 6.1

Purchasing Power Parity:

Burgers or Beans? 159

Global Finance in Practice 6.2Deviations from Purchasing PowerParity in the Twentieth Century .163Global Finance in Practice 6.3

Currency Pass-Through at Porsche 165

Interest Rates and Exchange Rates 166

Global Finance in Practice 6.4The Carry Trade and the Japanese Yen 173Forward Rate as an Unbiased Predictor

of the Future Spot R a t e 175Prices, Interest Rates, and Exchange

Rates in Equilibrium 177MINI-CASE

Iceland 2006—A Small Country

in a Global Capital Market .178Summary of Learning Objectives .182Questions 182 • Problems 183 • Internet Exercises 188

CHAPTER 7Foreign Exchange Rate Determination

A Roadmap to Exchange RateDetermination .190Exchange Rate Determination:

The Theoretical T h re a d 191The Asset Market Approach to Forecasting 194 Global Finance in Practice 7.1

Uruguay infected 195Disequilibrium: Exchange Rates

in Emerging M arkets 197Illustrative Case: The Asian C risis 197Illustrative Case: The Argentine Crisis

of 2002 , .2 0 0Forecasting in Practice 205Global Finance in Practice 7.2

Technical versus FundamentalTrading Strategies? 207MINI-CASE

JPMorgan Chase's Forecasting Accuracy 211Summary of Learning Objectives 213Questions 213 • Problems 214 • Internet Exercises 217

CHAPTER 8

Foreign Currency Futures 220Currency O ptions 222

Foreign Currency Speculation .226

Global Finance in Practice 8.1 Rogue Currency Trader at Allied Irish Bank 227

Global Finance in Practice 8.2 Putting the Kiwi to Flight 229

Option Pricing and Valuation 234

Valuation .236

Prudence in Practice 239

Global Finance in Practice 8.3 A Select List of Derivative and Managerial Disasters 239

M INi-CASE Rogue Trader, Nicholas Leeson 240

Summary of Learning Objectives 244

Questions 245 • Problems 245 • Internet Exercises 248 PART 3 F O R llG i ÍI C H Ã iS i EXPOSURE 151 CHAPTER 9 Transaction Exposure 252 Types o f Foreign Exchange E xposure 253

Why Hedge? 255

Global Finance in Practice 9.1 Amazon.com's Quest for Profits: The Roie of Currency Gains/Losses 255

Measurement of Transaction Exposure 257

Trident’s Transaction Exposure .260

Management of an Account Payable 268

Risk Management in Practice 270

Global Finance in Practice 9.2 Manipulation of Currency Gains and Losses 271 Global Finance in Practice 9.3 Five Hedging Mistakes to Avoid 272

M INI-CASE Xian-Janssen Pharmaceutical (China) and the Euro 272

Summary of Learning Objectives 275

Questions 276 • Problems 276 • Internet Exercises 284 CHAPTER 10 Operating Exposure 285 Attributes of Operating Exposure .286

Illustrating Operating Exposure: T rid en t 288

Global Finance in Practice 10.1 Volvo C a r 289

Strategic Management of \ Operating E xposure 293

Global Finance in Practice 10.2 Goodyear’s Response to the Mexican Peso’s Devaluation 294

Global Finance in Practice 10.3 Detroit Dreams of a Rising Yen in the Fail of 2 0 0 7 295

Proactive Management of Operating Exposure 296

Contractual Approaches: Hedging the Unhedgeable .304

MINI-CASE Toyota’s European Operating Exposure 305

Summary of Learning Objectives 308

Questions 308 • Problems 309 • Internet Exercises 311 CHAPTER 11 Translation Exposure 312 Overview of Translation 313

Translation M ethods 316

Translation Example: Trident Europe 321

Comparing Translation Exposure with Operating Exposure 325

Managing Translation Exposure 325

Global Finance in Practice 11.1 Gyrus (UK): Translation Exposure or Transaction Exposure? . 3 2 6 Global Finance in Practice 11.2 Hedging the Euro Away . 329

M INI-CASE laJolla Engineering Services 330

Summary of Learning Objectives 332

Questions 333 • Problems 333 • Internet Exercises 335 PART 4 FINANCING THE GLOBAL FIRM I I I CHAPTER 12 The Global Cost and Availability of Capital 338 Global Cost and Availability of C apital 339

Weighted Average Cost of C ap ital 341

xvi Contents

The Demand for Foreign Securities: The Role

of International Portfolio Investors 347

Global Finance in Practice 12.1

Market Liquidity 348

Illustrative Case: Novo Industri A/S (N ovo) .352

The Cost of Capital for MNEs

Compared to Domestic F ir m s 358

Global Finance in Practice 12.2

Bang & Olufsen and Philips N.V 359

Solving a Riddle: Is the Weighted Average

Cost of Capital for MNEs Really Higher

Than for Their Domestic Counterparts? 361

MINI-CASE

Petrobräs of Brazil and the Cost of Capital 363

MINi-CASE APPENDIX 366

Summary of Learning Objectives 367

Questions 368 • Problems 369 * Internet Exercises 373

CHAPTER 13

Designing a Strategy to Source

Equity G lobally 376

Global Finance in Practice 13.1

How Big Is Your Share Price? 379

Foreign Equity Listing and Issu an c e 380

Global Finance in Practice 13.2

Demutualisation, Diversification,

and Globalisation 382

Global Finance in Practice 13.3

The Chicago Exchanges Merge .384

Effect of Cross-Listing and Equity Issuance

Global Finance in Practice 13.4

Equity Firms and Their Assets (billions) 392

Global finance in Practice 13.5

Private Equity in Argentina and

the Argentine C risis 393

MINI-CASE

Rosneft’s initial Ptibik Offering 393

Summary of Learning Objectives 396

Questions 397 • Problems 397 • Internet Exercises 399

CHAPTER 14

Financial Structure and International Debt 400Optimal Financial Structure 401Optimal Financial Structure and the MNE 402 Financial Structure of Foreign Subsidiaries 406Global Finance in Practice 14.1

Equity Carve-Outs .407International Debt M arkets 410Global Finance in Practice 14.2

Pricing and Structure of a Syndicated Eurocredit 412Project Financing 416Global Finance in Practice 14.3

Islamic Finance 417Global Finance in Practice 14.4

Project Finance B o o m 419MIMI-CASE

Tirstrup BioMechanics (Denmark):

Raising Dollar D e b t 419Summary of Learning Objectives 421Questions 422 • Problems 423 • Internet Exercises 425

CHAPTER 15

Defining Interest Rate Risk 427Management of Interest Rate R is k 430Global Finance in Practice 15.1

interest Rate Derivatives—

Booming in 2 0 0 7 432Global Finance in Practice 15.2

A Floating-Rate World of Debt .433Trident Corporation: Swapping

to Fixed Rates .440Currency Swaps .441Trident Corporation: Swapping

Floating Dollars into Fixed RateSwiss Francs .442Counterparty R isk 444Illustrative Case: A Three-Way

Back-to-Back Cross-Currency Swap 445MiNI-CASE

McDonald’s Corporation’s BritishPound Exposure .446Summary of Learning Objectives 447Questions 448 • Problems 448 • Internet Exercises 450

Contents xvii

PART 5

INTERNATIONAL

INVESTMENT DECISIONS #51

CHAPTER 16

International Portfolio Theory

International Diversification and R is k 455

Global Finance in Practice 16.1 Should Fund Managers Hedge Currency Risk? 459 Internationalizing the Domestic Portfolio _ 459 National Markets and Asset P erform ance _ 464 Global Finance in Practice 16.2 Equity Market Crises in the Twentieth Century \ 466

m i i i - c i i s g : Strategic Currency Hedging 470

Summary of Learning O bjectives 472

Questions 473 • Problems 474 • Internet Exercises 475 CHAPTER 17 Foreign Direct Investment Theory and Strategy 477 Sustaining and Transferring Competitive A dvantage 478

The OLI Paradigm and Internalization .481

Deciding Where to Invest 483

How to Invest Abroad: Modes of Foreign Involvem ent 485

Global Finance in Practice 17.1 Keeping it in the Family: American Exports to and imports from American-Owned Affiliates Abroad (Billions of US$) 486

Foreign Direct Investment Originating in Developing Countries 489

Global Finance in Practice 17.2 Haier Builds Brands 491

Global Finance in Practice 17.3 Embraer of Brazil 491

M IN I-CASE The GM-AvtoVAZ Joint Venture 492

Summary of Learning Objectives 498

Questions 498 * Internet Exercises 499 CHAPTER 18 Political Risk Assessment and M anagem ent 501 Defining Political Risk .502

Assessing Political R is k 503

Firm-Specific Risks .506

Country-Specific Risks: Transfer R isk 509

Country-Specific Risks: Cultural and Institutional R is k s 513

Global Finance in Practice 18.1 Zimbabwe’s Disposable Currency 515

Global-Specific R isk s 518

Global Finance in Practice 18.2 Enron International in India .519

Global Finance in Practice 18.3 International Supply chain Security: Time Is Money 522

Global Finance in Practice 18.4 Starbucks Coffee and Corporate Social Responsibility 524

MINI-CASE Mattel's Chinese Sourcing Crisis of 2 0 0 7 -525

Summary of Learning Objectives 528

Questions 528 • Internet Exercises 530 CHAPTER 19 M ultinational Capital Budgeting 531 Complexities of Budgeting for a Foreign Project 533

Project versus Parent Valuation .534

Illustrative Case: Cemex Enters Indonesia 535

Global Finance in Practice 19.1 Prospecting for Riches in the Tax Code 546

Real Option A n a ly sis 549

MINI-CASE Trident’s Chinese Market Entry— An Application of Real Option Analysis 550

Summary of Learning Objectives 552

Questions 553 • Problems 554 • Internet Exercises 557 PART 6 MANAGING MULTINATIONAL OPERATIONS 559 CHAPTER 20 International Trade Finance 560 The Trade Relationship .561

The Trade D ilem m a 563

Benefits o f the S y ste m 564

Letter o f Credit (L/C) 566

xvîîi Contents

Draft 568

Bill of Lading (B/L) 570

Example: Documentation in a Typical Trade Transaction 571

Global Finance in Practice 20.1 The Resurgence of Transaction Banking and Letters of C re d it 573

Government Programs to Help Finance E x ports 573

Trade Financing A lternatives 574

Global Finance in Practice 20.2 Tunisian Private Equity and Factoring 577

Forfaiting: Medium- and Long-Term Financing 578

M iN i-C A SE Crossweil international's Precious Ultra-Thin Diapers 580

Summary of Learning Objectives .583

Questions 584 • Problems 585 • Internet Exercises 587 CH A PTER 21 Multinational Tax Managem ent 588 Tax Principles 590

Global Finance in Practice 21.1 Should the United States Cut Corporate Taxes? 595

Transfer Pricing .598

Tax Haven Subsidiaries and International Offshore Financial Centers .602

Global Finance in Practice 21.2 The Activities of Offshore Financial Centers 603

M INI-CASE • Stanley Works and Corporate Inversion 604

Summary of Learning Objectives 608

Questions 608 • Problems 609 • Internet Exercises 611 CH APTER 22 Working Capital M anagem ent 612 Trident Brazil’s Operating C y c le 614

Trident’s Repositioning D ecisions 615

Constraints on Repositioning Funds .617

Global Finance in Practice 22.1 P&G’s Acquisition and Financial Management in In d ia 617

Conduits for Moving Funds by Unbundling Them 618

International Dividend Remittances 619

Net Working C apital 621

International Cash M anagement 627

Financing Working Capital 633

M IN I-CA SE Honeywell and Pakistan international Airways 636

Summary of Learning Objectives .638 Questions 639 • Problems 641 • Internet Exercises 644

Answers to Selected

Globalization and the Ente

rinar.ciai Goals and Corporate Ccvernanc

The internatioflal /Vionetaa* System

The Balance of Payments

The Foreign Exchange Market

rprise

c.

Globalization

and the Multinational

Enterprise

L E A R N I N G O B J E C T I V E S

Examine the requirements for the creation of value

Consider the basic theory, com parative advantage, and its requirements for the

explanation and justification for international trade and commerce

- Discover what is different about international financial m anagement

Detail which market imperfections give rise to the m ultinational enterprise

- -Consider how the globalization process moves a business from a p jre ly domestic focus in its financial relationships and composition to one truly global In scope

■- Examine possible causes to the lim itations to globalization in

finance-I N T R O D U C T finance-I O N

Porsche Changes Tack

A fter reading this chapter, you will be able to debate the question posed by this chap­

te r’s main mini-case entitled Porsche Changes Tack—whether Porsche’s new strategy

will increase or decrease its returns to its shareholders

M I N I - C A S E

Porsche’s financial results—including returns to shareholders— had been the envy of the automobile industry for a decade It was indeed the world’s most profitable automobile com­ pany Porsche's CEO, Dr Wendelin Wiedeking, had been credited with clarity of purpose and

Chapter Globalization and the Multinational Enterprise

sureness of execution As one colleague described him: “He grew up PSD: poor, smart, and : driven.” He was now rich, smart, and riding.

Porsche’s strategy had been unique among high-end European automakers Ii had cho- i sen to remain largely Germany-based (or more accurately European-based) Unlike Mercedes

or BMW, it had chosen not to build manufacturing facilities in its largest single market, the United States Instead, it maintained all manufacturing and assembly in Europe, but did so : with corporate partners in different ways The Boxster, what some called the "poor man's Porsche," was manufactured by Va I met of Finland under an outsourced manufacturing agree­ ment The Porsche Cayenne, the $80,000 sport utility vehicle, was largely assembled on the Volkswagen Touareg assembly line in Bratislava in the Slovak Republic Porsche had achieved some of the highest returns on invested capital in the auto industry by using other people’s

But Porsche had just announced two strategic initiatives, wh'ch seemingly were a com­ pletely new competitive direction It would begin the design and development of a fourth auto model, the Panamera, but would do so completely in-house, using its own money and own facilities Simultaneously, it shocked the markets by spending more than €3 billion to acquire a controlling interest in whal was considered one of Europe’s worst automobile com­ panies—Volkswagen Shareholders and analysts alike were aghast What was this company

To check your understanding, read the chapter and the mini-case in its entirety (the complete mini-case is located toward the end of this chapter), and then answer the case questions at the end

This book is about international financial managem ent with special emphasis on the multinational enterprise The multinational enterprise (M NE) is defined as

one th at has operating subsidiaries, branches, or affiliates located in foreign coun­tries It also includes firms in service activities such as consulting, accounting, con­struction, legal, advertising, entertainm ent, banking, telecommunications, and lodging.MNEs are globally headquartered Many of them are owned by a m ixture of domestic and foreign shareholders The ownership of some firms is so dispersed inter­nationally that they are known as transnational corporations The transnationals are usually managed from a global perspective rath er than from the perspective of any sin­gle country

Although Fundamentals o f Multinational Finance emphasizes MNEs, purely

domestic firms also often have significant international activities These include the

im port and export of products, components, and services Dom estic firms can also license foreign firms to conduct their foreign business They have exposure to foreign competition in their domestic m arket They also have indirect exposure to interna­tional risks through their relationships with customers and suppliers Therefore, domestic firm managers need to understand international financial risk, especially those related to foreign exchange rates and the credit risks related to trade payments

Fundamentals o f Multinational Finance is w ritten in English and usually uses the

U.S dollar in its exposition However, the authors have tried to m ake it relevant for all

PART 1 Î Global Financial Environment

m ultinational enterprises by using num erous non-U.S.-based MNEs We will use the

term multinational enterprise (M NE) throughout this text for two very im portant rea­ sons First, the term multinational is used rather than international because we will

focus on the third phase of the globalization process in which firms operate businesses

in many different countries Second, we use the term enterprise instead o f corporation

because as businesses move into many emerging markets, they will enter into joint ven­tures, strategic alliances, or simply operating agreements with enterprises that may not

be publicly traded or even privately owned (and therefore not corporations), but actu­ally extensions of government

“I define globalization as producing where it is most cost-effective, selling where it is

m ost profitable, and sourcing capital where it is cheapest, without worrying about national boundaries.”

Global business, like any business, is the social science of managing people to organize,

maintain, and grow the collective productivity toward accomplishing productive goals, typically to generate profit and value for its owners and stakeholders Reaching that goal—building firm value—requires combining three critical elements: 1) an open mar­ ketplace; 2) high quality strategic management; and 3) access to capital As shown in Exhibit 1.1, any M N E attempting to create value would need to combine these three

critical elements composing the sides of the firm value pyramid

Globalization and Creating Value

in the Multinational Enterprise

—N arayana Murthy, President and CEO, Infosys

The challenge to building firm value—value for all stakeholders including stockholders,

corporate stakeholders, and social community— is in the expansion and development

of all three sides of the global pyramid: an open marketplace; access to affordable capital-, and high-quality strategic management.

Chapter i: Globalization and the Multinational Enterprise

An Open Marketplace

M arket economics is the fundamental condition for value creation The MNE has little opportunity to thrive and grow if it is not operating within a marketplace that allows free movement and competition of labor, capital, technology, and the spirits of innova­tion and entrepreneurship The rapid economic development of China, and the many businesses arising within China today, are ready examples of the power of the increas­ingly open marketplace There are, however, many complexities to fostering healthy

m arket economics in any country, and many countries have yet to find the magical mix.Strategic Management

A lthough the ability to compete in a m arketplace is a requirement, the ability to see business opportunities, and then to design, develop, and execute a corporate strategy through all levels of leadership and m anagem ent is needed to create value Although the basic elements of innovation and entrepreneurship are probably embedded in the hum an DNA, good strategy and m anagem ent are not Yet insightful strategy and adept leadership is critical to creating value It is not something that has yet been quantified or captured; as any business student knows, if computers could do it, they wouldn’t hire you

Access to Capital

O pen m arkets and insightful leadership is all for nought, however, if the M N E cannot gain ready access to affordable capital It is the capital that allows the investment needed to obtain the technology, execute the strategy, and expand across global m ar­

kets It is the “capital” in capitalism; it is the ability of the enterprise to reach out and

obtain resources from outside of the firm to pursue the firm’s vision and create the value for all of the key stakeholders in the enterprise itself, and subsequently for the community and society of which it is an integral element

The level of development of these three combined elements, Levels I—III shown in Exhibit 1.1, is representative of the degrees of depth, breadth, and sophistication acces­sible by the MNE For example:

® G eneral Electric (USA) may be considered a resident of Level III It is a global

M NE with widely recognized strategic leadership and management quality, ready access to cheap and plentiful capital, and a key competitor in the most competitive and open m arketplaces in the world

• Cemex (Mexico) may be an example of a resident of Level II A rapidly growing competitor in its global industry, it is based in Mexico, which is rapidly emerging as

a m arket economy of nearly limitless potential Yet Cemex is still sometimes ham ­pered in its access to ready and affordable capital to support its business goals

• The H aier G roup (China) may be representative of an MNE resident in Level I of the value pyramid Although highly successful and an M NE to be reckoned with

in a growing number o f marketplaces, H aier is still struggling to overcome barri­ers and limitations of all three critical elements from its Chinese base

A s described in Global Finance in Practice 1.1, the evolution of the domestic company

to multinational and “a-national” is generating significant benefits for all stakeholders.These three firms are residents of the pyramid Their positions in the pyramid are the result of the complex interaction of the three key elem ents—the three sides of the

PART Global Financial Environment

¡lobal Finance In Practice 1.1

Jational Multinational or'A-National'?

/hen Isaac Merritt Singer set up a branch of his

sewing machine maker in Paris in 1855, he probably

jr did not think he was blazing a trail US companies

? would still be following more than 150 years later.

Singer's expansion in France turned the New York-

: based company into the first US multinational, pio-

i: neering a business model that would be adopted by

1 ;i other icons of American capitalism, from Ford to

tandard Oil to General Electric But perhaps the

lost important legacy of Singer’s daring move was

nat it worked: within six years of the French

open-i - open-ing, foreopen-ign sales had exceeded US revenues It open-is a

lesson not lost on today's corporate leaders.

Over the past three months, blue-chips such as

t 3 _ General Electric, the conglomerate, IBM,the technol-

>gy giant, and UPS, the logistics group, have hitched

ride on a global economy growing faster than the

S By contrast, companies that depend on domestic

; consumers such as Wal-Mart, the retail bell-wether,

ind Home Depot, the do-it-yourself chain, have

released disappointing results and gloomy predic­

tions.

But if foreign earnings have helped US multina-

s - tionals stave off a fall in profitability, the question is

.vhether the current reliance on the rest of the world

; just a cyclical phase or the harbinger of a

transfor-* mation in corporate America Could the importance

f overseas markets destroy—as Sam Palmisano,

IBM’s chief executive, has argued—the old multina-

3 tional model whereby companies decentralised

nanufacturing and sales operations but kept key

unctions such as the executive office, research and

iproduct design in the "home country”? And if so, are

Jsome US companies ready to become truly "transna-

£ tional” by scattering their top executives around the

-world?

At first sight, there are significant cyclical forces

Ifcehind the recent rise of US multinationals—forces,

||h other words, that could change in the near future

First, the dollar has lost nearly a third of its value

against America’s largest trading partners over the past seven years, making it easierfor US exporters to sell to the world and boosting the dollar value of overseas earnings Second, US multinationals have been boosted by global economic growth, which has largely been driven by emerging markets hungry for infrastructure and consumer goods—two of America Inc’s strongest suits.

But even if economic changes and internal revolu­ tions at companies mean, in the words of Steve Mills, head of IBM’s global software business, that “things cannot go back to the way they were”, will more com­ panies abandon national allegiance and become truly "a-national”? “Big Blue”—as IBM is known— claims to be just that, with operations in more than

150 countries and key functions spread around the world Its head of procurement, for example, is based

in Shenzhen, China, half a world away from Mr Palmisano’s headquarters in Armonk, New York

“Ours is a boundary-less way of thinking,” says Mr Mills.

However, many US chief executives regard such moves as impractical, if not outright dangerous.They argue that being rooted in the US is not only an insurance policy in case the globalisation tide turns, but also a way of maintaining order and focus in increasingly complex and dispersed enterprises—of letting everybody know where the buck stops and who is in charge Jeffrey Immelt, who heads GE, one

of the most "global” companies in the US, recently distilled this view: "We're an American company but

in order to be successful we've got to win in every corner of the world "In other words, global aspira­ tions tinged with national pride—which Singer would have understood—is just as recognisable today among US business leaders.

Source- Excerpted from “US Companies Choose: National Multinational or 'A-National'?," Francesco Guerrera, Financial Times,

August 16,2007, p 7.

of their business activities The Porsche mini-case at the end of the chapter will chal­lenge the reader to determ ine where it might fall within the architecture of the value

Chapter 1: Globalization and the Multinational Enterprise 7

As we shall see throughout this book, the global economy is seeing an unprece­dented growth in the resident M NEs in the value pyramid, and the size and shape of the pyramid tomorrow is probably limitless We now m ove to the underlying principle

driving the growth of the global business—comparative advantage.

The Theory of Comparative Advantage

The theory o f comparative advantage provides a basis for explaining and justifying

international trade in a m odel world assumed to enjoy free trade, perfect competition,

no uncertainty, costless information, and no government interference.1 The theory con­tains the following features:

• E xporters in Country A sell goods or services to unrelated im porters in Country B

® Firms in Country A specialize in making products that can be produced relatively efficiently, given Country A ’s endowment of factors of production; that is, land, labor, capital, and technology Firms in Country B do likewise, given the factors of production found in Country B In this way the total combined output of A and B

An Example of Comparative Advantage

For an example of the benefits of free trade based on comparative advantage, assume that Thailand is more efficient than Brazil at producing both sports shoes and stereo equipment With one unit of production (a mix of land, labor, capital, and technology), efficient Thailand can produce either 12 shipping containers (ctrs) of shoes or 6 ship­ping containers of stereo equipment Brazil, being less efficient in both, can produce only 10 containers of shoes or 2 containers of stereo equipm ent with one unit of input These production capabilities are as follows:

Production Capability

Containers of stereo equipment

6 containers/unit

2 containers/unit

A production unit in Thailand has an absolute advantage over a production unit in Brazil in both shoes and stereo equipment Nevertheless, Thailand has a larger relative advantage over Brazil in producing stereo equipm ent (6 to 2) than shoes (12 to 10) As long as these ratios are unequal, comparative advantage exists

theory o f com parative advantage was first proposed by David Ricardo in Principles o f Political

Containers of sports shoesThailand has -i.ooo production units: 12 containers/unit

Brazil has 1,000 production units: 10 containers/unit

PART I Global Financial Environment

The Theory of Comparative Advantage: A Numerical Example of Brazil and Thailand

Production if No Trade

Shoe Produt tion (dis) Stereo Production (ctrs)

Complete Specialization

Shoe Production (ctrs) tSrfandiproduces only stereo equipment

Stereo Production (ctrs) 1,000 x 6 = 6,000 ;

6,000 •

Assume that no trade takes place, and each country divides its own production units betw een shoes and stereo equipment Each country elects to allocate 300 p ro ­duction units to shoes and 700 production units to stereo equipm ent, resulting in the production and consumption outcomes in the top half of Exhibit 1.2

Now assume complete specialization Thailand produces only stereo equipm ent and Brazil produces only shoes World production would be higher for both shoes and stereo equipment, as shown in the bottom half of Exhibit 1.2

Clearly, the world in total is now better off because there are now 10,000 contain­ers of shoes instead of just 6,600 A nd there are 6,000 containers of stereo equipm ent— instead of just 5,600 But distribution is quite distorted The Thais now tap bare feet to their music, and the Brazilians dance during Carnival with good shoes but no recorded music!

Trade can resolve this distribution problem Assume initially that trade between Thailand and Brazil takes place at the ratio of 2 containers of shoes for 1 container of stereo equipment This “exchange rate” of 2 containers of shoes for 1 container of stereo equipment is Thailand’s “domestic” price; that is, the ratio of trade within Thailand should it produce both items and not engage in international trade Assume further that Thailand exports 1,800 containers of stereo equipment to Brazil and imports 3,600 con­tainers of shoes from Brazil The situation would be as shown in Exhibit 1.3

EX H IB IT 1.3

Trade at Thailand’s Domestic “Price”

For each container of stereo equipment exported, Thailand imports two containers of shoes from Brazil

Shoe Production Stereo Production plus/minus trade (ctrs) plus/minus trade (ctrs) iiteilandsproduces 6,000 containers of stereo

¿sqSpnaantiarod exports 1,800 containers o -t 3,600 -= 3,600 6,000 -1,800 = 4,200 Brazil produces 10,000 containers of shoes and

exports 3,600 containers 10 ,0 0 0 -3 ,6 0 0 -6 ,4 0 0 0 + 1,800 = 1,800

Chapter Globalization and the Multinational Enterprise 9

EX H IB IT 1.4

Trade at Brazil’s Domestic “Price”

For each container of stereo equipment exported, Thailand imports five containers o f shoes from Brazil.

A t this price all gains go to Brazil, which consumes 6,400 containers of shoes (instead of 3,000 with no trade) and consumes 1,800 containers of stereo equipment (instead of 1,400 with no trade).T hailand’s consumption, 3,600 containers of shoes and4.200 containers of stereos, is just as it was with no trade Thailand has gained nothing from trade at this price although it has lost nothing either!

Assume now that trade takes place at Brazil’s “domestic price” of 5 containers of shoes for each container of stereo equipment This is shown in Exhibit 1.4 A t B razil’s internal price, all gains go to Thailand, which now consumes 7,000 containers of shoes (instead of 3,600 with no trade) and 4,600 containers of stereo equipment (instead of4.200 with no trade) Brazil’s consumption, 3,000 containers of shoes and 1,400 con­tainers of stereo equipment, is the same as with no trade Brazil has gained nothing from trade at this price—although neither has it lost anything

Now let trade take place at a price in between Thailand’s domestic price of 2-to-l and Brazil’s domestic price of 5-to-l Assume that free bargaining leads to a price of 4- to-1, as seen in Exhibit 1.5 A t any price betw een the boundaries of 2-to-l and 5-to-l, both countries benefit from specializing and trading A t a 4-to-l price, Thailand con­sumes 2,800 m ore containers of shoes as well as 200 m ore containers of stereo equip­

m ent than it has consumed with no trade Brazil consumes 600 more containers of shoes as well as 200 more containers of stereo equipment than it has consumed with

no trade Total combined production of both shoes and stereo equipment has increased through the specialization process, and it only remains for the exchange ratio to d eter­mine how this larger output is distributed betw een the two countries

E li If ¡S IT 1.S

Trade at a Price Reached by Free Bargaining

For each container of stereo equipment exported, Thailand imports four containers of shoes from Brazil.

Shoe Production Stereo Productionplus/minus trade (ctrs) plus/minus trade (cirs'iThailand produces 6,ooo containers of stereo

equipment and exports 1,400 containers

Brazil produces 10,000 containers of shoes and

exports 7,000 containers

World production and consumption

Shoe Production Stereo Productionplus/minus trade (ctrs) plus/minus trade (ctrs)Thailand produces 6,coo containers of stereo

equipment and exports 1,600 containers

Brazil produces 10,000 containers of shoes and

PART 1 I Global Financial Environment

Limitations of Comparative Advantage

Although international trade might have approached the comparative advantage model during the nineteenth century, it certainly does not today, for the following reasons:

• Countries do n ot appear to specialize only in those products that could be most efficiently produced by that country’s particular factors of production Instead, governments interfere with comparative advantage for a variety of economic and political reasons, such as to achieve full employment, economic development, national self-sufficiency in defense-related industries, and protection of an agricul­tural sector’s way of life Governm ent interference takes the form of tariffs, quo­tas, and other non-tariff restrictions

• At least two of the factors of production, capital and technology, now flow directly and easily betw een countries, rath er than only indirectly through traded goods and services This direct flow occurs between related subsidiaries and affiliates of multinational firms, as well as betw een unrelated firms via loans, and license and management contracts Even labor flows betw een countries such as immigrants into the U ntied States (legal and illegal), immigrants within the European Union, and possibly other economic unions

• M odem factors of production are more numerous than in this simple model Factors considered in the location of production facilities worldwide include local and managerial skills, a dependable legal structure for settling contract disputes, research and developm ent competence, educational levels of available workers, energy resources, consumer demand for brand name goods, mineral and raw m ate­rial availability, access to capital, tax differentials, supporting infrastructure (roads, ports, communication facilities), and possibly others

® Although the terms of trade are ultimately determ ined by supply and demand, the process by which the term s are set is different from that visualized in traditional trade theory They are determ ined partly by administered pricing in oligopolistic markets

• Comparative advantage shifts over time as less developed countries become more developed and realize their latent opportunities For example, over the past 150 years comparative advantage in producing cotton textiles has shifted from the

U nited Kingdom to the U nited States, to Japan, to Hong Kong, to Taiwan, and to China

• The classical m odel of comparative advantage did n ot really address certain other issues such as the effect of uncertainty and information costs, the role of differen­tiated products in imperfectly competitive markets, and economies of scale.Nevertheless, although the world is a long way from the classical trade model, the general principle of comparative advantage is still valid The closer the world gets to true international specialization, the more world production and consumption can be increased, provided the problem of equitable distribution of the benefits can be solved

to the satisfaction of consumers, producers, and political leaders Complete specializa­tion, however, rem ains an unrealistic limiting case, just as perfect competition is a lim­iting case in microeconomic theory

Chapter 1: Globalization and the Multinational Enterprise

Supply Chain Outsourcing:

Comparative Advantage Today

C om parative advantage is still a relevant theory to explain why particular countries are m ost suitable for exports of goods and services that support the global supply chain

of both M NEs and domestic firms The comparative advantage of the twenty-first cen­tury, however, is one that is based m ore on services, and th e k cross border facilitation

by telecommunications and the Internet The source of a nation’s comparative advan­tage, however, still is created from the mixture of its own labor skills, access to capital, and technology

M any locations for supply chain outsourcing exist today Exhibit 1.6 presents a geographical overview of this m odern reincarnation of trade-based comparative advantage To prove that these countries should specialize in the activities shown you would need to know how costly the same activities would be in the countries that are importing these services com pared to their own other industries R em em ber th at it

takes a relative advantage in costs, n ot just an absolute advantage, to create comparative advantage.

For example, India has developed a highly efficient and low-cost software indus­try This industry supplies not only the creation of custom software, but also call cen­ters for customer support, and other information technology services The Indian software industry is composed of subsidiaries of M NEs and independent companies If you own a Hew lett-Packard com puter and call the customer support center num ber for help, you are likely to reach a call center in India Answering your call will be a knowledgeable Indian software engineer or program m er who will “walk” you through

EX H IB IT 1.6

MNEs based in many industrial countries are outsourcing intellectual

functions to providers based in traditional emerging market countries.

PART t j Global Financial Environment

your problem India has a large num ber of weE-educated, English-speaking technical experts who are paid only a fraction of the salary and overhead earned by their U.S counterparts The overcapacity and low cost of international telecommunication net­works today further enhances the comparative advantage of an Indian location.The extent of global outsourcing is already reaching out to every com er of the globe From financial back-offices in Manila, to information technology engineers in Hungary, m odem telecommunications now take business activities to labor rather than moving labor to the places of business

What Is Different about Global Financial Management?

Exhibit 1.7 details some of the main differences between international and domestic financial m anagement These component differences include institutions, foreign exchange and political risks, and the modifications required of financial theory and

financial instruments Global Finance in Practice 1.2 offers one famed econom ist’s

views on how different social, institutional, and political factors combine to alter the prospects of business in many countries

International financial m anagem ent requires an understanding of cultural, histor­ical, and institutional differences such as those affecting corporate governance

A lthough both domestic firms and MNEs are exposed to foreign exchange risks,

M NEs alone face certain unique risks, such as political risks, th at are n ot normally a threat to domestic operations

M NEs also face other risks that can be classified as extensions of domestic finance theory For example, the norm al domestic approach to the cost of capital, sourcing debt and equity, capital budgeting, working capital managem ent, taxation, and credit analy­sis needs to be modified to accommodate foreign complexities Moreover, a num ber

of financial instruments that are used in domestic financial managem ent have been

EXHIBIT l.' i

What Is Different about International Financial Management?

Concept International

Culture, history Each foreign country is unique and not

and institutions always understood by MNE management

Corporate Foreign countries' regulations and institutional

governance practices are all uniquely different

Foreign exchange MNEs face foreign exchange risks due to

risk their subsidiaries, as well as import/export

and foreign competitors

Political risk MNEs face political risks because of their

foreign subsidiaries and high profile

Modification of MNEs must modify finance theories like

domestic finance capital budgeting and cost of capital

theories because of foreign complexities

Modification of MNEs utilize modified financial instruments

domestic financial such as options, futures, swaps, and letters of

instruments credit

D om t'slic Each country has a known base case

Regulations and institutions are well known

Foreign exchange risks from import/ export and foreign competition (no subsidiaries) as-

Negligible political risks

Traditional financial theory applies w

Limited use of financial instruments and derivatives because of fewer foreign exchange and political risks

Chapter v. Globalization and the Multinational Enterprise 13

Global Finance in Practice 1.2

The Mystery of Capital Deepens

n 1981 about 1,800 families occupied a stretch of

vasteland in the municipality of Ouilmes on the out-

kirts of Buenos Aires The squatters lacked legal title

0 their new place in the sun, but they did not lack for

enacity They outlasted Argentina’s military junta,

vhich tried several times to evict them, and in 1984,

ifter the return of democracy, the provincial govern­

ment passed a law expropriating the land from its

rightful owners so that the squatters could enjoy for-

nal ownership of it.

This is a tale that would warm the heart of

Hernando de Soto, a Peruvian economist, celebrated

jy this newspaper and many others for his book "The

Mystery of Capital" (2000), and for his vigorous

rfforts to extend secure property rights to the poor

In his book, Mr de Soto argues that the poor have

more assets—shacks, stalls, plots—than you might

think But because they lack title to these assets, they

cannot pass them on, divide them up, or offer them

is collateral for a loan to expand their makeshift

jusinesses and fully express their entrepreneurial

mergies Their assets remain embalmed as "dead

capital"

But the victory of the Buenos Aires squatters was

>nly partial Eight of the former landowners

iccepted the government’s compensation in 1986,

me did not relent until 1998, and the remaining four

ire still contesting it in Argentina’s Dickensian

courts As a result, several hundred families now own

their land, but their neighbours still squat uneasily

on theirs This is unfortunate for the squatters, but a rare opportunity for economists to test the power of property rights Sebastian Galiani of San Andres University and Ernesto Schargrodsky of Torcuato di Telia University believe the case provides a natural experiment The families lucky enough to win title can be compared with a ready-made control group: the otherwise Identical families that did not This makes it possible for the study to distinguish cause and effect; to isolate the impact of title from all the other confounding factors.

The results of the experiment are mixed Secure land rights do encourage the poor to build their nests But even in a relatively advanced country such

as Argentina, title is not enough in itself to animate the dead capital interred in land and property The landowning families invested more in their homes, which had noticeably better walls and roofs But the titled households enjoyed no better access to bank loans, credit cards or bank accounts, and only 4 % of them acquired a mortgage.

Disappointing, but not surprising Argentine banks tend to lend only to workers with high wages and a stable job Titled or not, the former squatters still fell well below the official poverty line The cost

of making and enforcing a loan contract might exceed the modest sums they were able to borrow.

Source: Abstracted from "The Mystery of Capital Deepens," The Economist London: Aug 26,2006, p 66.

modified for use in international financial management Examples are foreign cur­rency options and futures, interest rate and currency swaps, and letters of credit.The main, them e of this book is to analyze how a m ultinational enterprise’s finan­cial management evolves as it pursues global strategic opportunities and new con­straints emerge In this opening chapter, we will take a brief look at the challenges and risks associated with Trident Corporation (Trident), a company evolving from dom es­tic in scope to being truly multinational The discussion will include the constraints that

a company will face in terms of managerial goals and governance as it becomes increasingly involved in m ultinational operations B ut first we need to clarify the unique value proposition and advantages which the M N E was created to exploit

14 PART j Global Financial Environment

Market Imperfections: A Rationale for

the Existence of the Multinational Firm

MNEs strive to take advantage of imperfections in national m arkets for products, fac­tors of production, and financial assets Imperfections in the m arket for products trans­late into m arket opportunities for MNEs Large international firms are better able to exploit such competitive factors as economies of scale, m anagerial and technological expertise, product differentiation, and financial strength than are their local competi­tors In fact, MNEs thrive best in m arkets characterized by international oligopolistic competition, where these factors are particularly critical In addition, once M NEs have established a physical presence abroad, they are in a better position than purely domestic firms to identify and implement m arket opportunities through their own internal information network

Why Do Firms Become Multinational?

Strategic motives drive the decision to invest abroad and become an M NE These motives can be summarized under the following five categories

1 Market seekers produce in foreign m arkets either to satisfy local dem and or to

export to m arkets other than their home m arket U.S automobile firms m anufac­turing in E urope for local consumption are an example of market-seeking m oti­vation Porsche, a E uropean autom aker discussed in this chapter’s mini-case, has

chosen not to follow this path.

2 Raw material seekers extract raw materials wherever they can be found, either for

export or for further processing and sale in the country in which they are found—

the host country Firms in the oil, mining, plantation, and forest industries fall into

this category

3 Production efficiency seekers produce in countries where one or more of the fac­

tors of production are underpriced relative to their productivity Labor-intensive production of electronic components in Taiwan, Malaysia, and Mexico is an exam­ple of this motivation

4 Knowledge seekers operate in foreign countries to gain access to technology or

managerial expertise For example, G erm an, Dutch, and Japanese firms have p u r­chased U.S.-located electronics firms for their technology

5 Political safety seekers acquire or establish new operations in countries that are

considered unlikely to expropriate or interfere with private enterprise For exam­ple, H ong Kong firms invested heavily in the U nited States, U nited Kingdom, Canada, and Australia in anticipation of the consequences of China’s 1997 takeover of the British colony

These five types of strategic considerations are not mutually exclusive Forest products firms seeking wood fiber in Brazil, for example, may also find a large Brazilian m arket for a portion of their output

In industries characterized by worldwide oligopolistic competition, each of the

above strategic motives should be subdivided into proactive and defensive investments

Proactive investments are designed to enhance the growth and profitability of the firm itself Defensive investments are designed to deny growth and profitability to the firm’s competitors Examples of the latter are investments th at try to preem pt a m arket

Chapter i: Globalization and the Multinational Enterprise 15

before competitors can get established in it, or capture raw m aterial sources and deny them to competitors

Trident is a hypothetical U.S.-based firm th at will be used as an illustrative example

throughout the book to dem onstrate the globalization process—the structural and

managerial changes and challenges experienced by a firm as it moves its operations from domestic to global

Trident is a young firm that m anufactures and distributes an array of telecommunica­tion devices Its initial strategy is to develop a sustainable competitive advantage in the U.S m arket Like many other young firms it is constrained by its small size, competi­tors, and lack of access to cheap and plentiful sources of capital The top half of Exhibit

1.8 shows Trident in its early domestic phase Trident sells its products in U.S dollars to

U.S customers and buys its manufacturing and service inputs from U.S suppliers, pay­ing U.S dollars The ereditw orth of all suppliers and buyers is established under domes­tic U.S practices and procedures A potential issue for Trident at this time is that although Trident is not international or global in its operations, some of its competi­tors, suppliers, or buyers may be This is often the impetus to push a firm like Trident into the first transition of the globalization process, into international trade

The Globalization Process

Global Transition I: Trident Moves from the

Domestic Phase to the Internationa! Trade Phase

All payments in U.S dollars

All credit risk under U.S law.

Trident Corporation

(Los Angeles, USA)

t

Are Mexican suppliers dependable?

Will Trident pay US$ or Mexican pesos?

Are Canadian buyers creditworthy?

Will payment be made

in US$ or C$?

Phase Two: Expansion into international Trade

16 j Global Financial

Trident was founded by James and E dgar Winston in Los Angeles in 1948 to make telecommunications equipment The family-owned business expanded slowly but steadily over the following 40 years The demands of continual technological invest­

m ent in the 1980s, however, required that the firm raise additional equity capital in order to compete This need led to its initial public offering (IPO ) in 1988 As a U.S.-

based publicly traded company on NASDAQ, Trident’s m anagem ent sought to create value fo r its shareholders.

As Trident became a visible and viable competitor in the U.S m arket, strategic opportunities arose to expand the firm ’s m arket reach by exporting product and ser­vices to one or m ore foreign markets The N orth Am erican Free Trade A rea (NAFTA) made trade with Mexico and Canada attractive This second phase of the globalization process is shown in the lower-half of Exhibit 1.8 Trident responded to these globaliza­tion forces by importing inputs from Mexican suppliers and making export sales to

Canadian buyers We define this stage of the globalization process as the International Trade Phase.

Exporting and importing products and services increases the demands of financial

m anagem ent over and above the traditional requirements of the domestic-only busi­

ness First, direct foreign exchange risks are now borne by the firm Trident may now

need to quote prices in foreign currencies, accept payment in foreign currencies, or pay suppliers in foreign currencies As the value of currencies change from m inute to

m inute in the global m arketplace, Trident will now experience significant risks from the changing values associated with these foreign currency payments and receipts As discussed in this chapter’s mini-case on Porsche, foreign exchange risks may result in gains as well as losses!

Second, the evaluation of the credit quality of foreign buyers and sellers is now

m ore im portant than ever Reducing the possibility of non-payment for exports and non-delivery of imports becomes one of two main financial managem ent tasks during

the international trade phase This credit risk management task is much more difficult

in international business, as buyers and suppliers are new, subject to differing business practices and legal systems, and generally m ore challenging to assess

Global Transition II:The International

Trade Phase to the Multinational Phase

If Trident is successful in its international trade activities, the time will come when the globalization process will progress to the next phase Trident will soon need to estab­lish foreign sales and service affiliates This step is often followed by establishing m an­ufacturing operations abroad or by licensing foreign firms to produce and service Trident’s products The multitudes of issues and activities associated with this second

Trident’s continued globalization will require it to identify the sources of its com1- petitive advantage, and with that knowledge, expand its intellectual capital and physi­cal presence globally A variety of strategic alternatives are available to Trident—the

foreign direct investment sequence—as shown in Exhibit 1.9.These alternatives include

the creation of foreign sales offices, the licensing of the company name and everything associated with it, and the manufacturing and distribution of its products to other firms

in foreign markets As Trident moves farther down and to the right in Exhibit 1.9, the degree of its physical presence in foreign m arkets increases It may now own its own

Chapter i: Globalization and the Enterprise 17

EXHIBIT 1.9

Trident’s Foreign Direct Investment Sequence

TiidanL i.id its CorriLiCLÜwc Ad»?,ibagc " " "¿7e"tc7” "> '

Change Exploit Existing Competitive

Com petitive Advantage Advantage Abroad

panies Once Trident owns assets and enterprises in foreign countries it has entered the

multinational phase of its globalization.

The Limits to Financial Globalization

The theories of international business and international finance introduced in this chapter have long argued that with an increasingly open and transparent global m ar­ketplace, in which capital may flow freely, capital will increasingly flow and support

countries and companies based on the theory o f comparative advantage Since the m id­

twentieth century this has indeed been the case as more and m ore countries have p u r­sued more open and competitive markets But the past decade has seen the growth of

a new kind of limit or impediment to financial globalization: the growth in the influ­

ence and self-enrichment of organizational insiders 2

O ne possible representation of this process can be seen in Exhibit 1.10 If influ­ential insiders in corporations and sovereign states continue to pursue the increase in firm value, there will be a definite and continuing growth in financial globalization But, if these same influential insiders pursue their own personal agendas, which may increase their personal power and influence or personal wealth, or both, then capital will not flow into these sovereign states and corporations The result is the growth of financial inefficiency and the segmentation of globalization outcomes—creating win­ners and losers As we will see throughout this book, this barrier to international finance may indeed be increasingly troublesome

2This section draws upon the stimulating thoughts presented in “The Limits of Financial Globalization,”

Licensing

M anagem ent Contract

Control Assets Abroad

_l :

Joint Venture W holly Owned

Subsidiary

C reenfie'd Investm ent

- 1

Acquisition of a Foreign Enterprise

8 1 I Globa! Environment

1ÎCHÏBJT 1.10

The Potential Limits There is a growing debate over whether many of the insiders and rulers of organizations

of Financial with enterprises globally are taking actions consistent with creating firm value or consistent

Globalization with increasing their own personal stakes and power.

Higher Firm Value

(possibly lower insidervalue)

I

Actions of Corporate Insiders

If these influential insiders are building personal wealth overthat of the firm, it will indeed

result in preventing the flow of capital across borders, currencies, and institutions to create

a more open and integrated global financial community.

Source: Constructed by authors based on "The Limits of Financial Globalization,” Rene M Stub,

Journal of Applied Corporate Finance,Volume 19 Number i, Winter 2007, pp 8-15.

This growing dilemma is also something of a composite of what this book is about

The three fundamental elem ents—financial theory, global business, management beliefs and actions—combine to present either the problem or the solution to the grow­

ing debate over the benefits of globalization to countries and cultures worldwide The mini-case on Porsche which follows sets the stage for our debate and discussion—are the controlling family mem bers of this company creating value for themselves or their shareholders?

M I N I - C A S

Porsche Changes Tack3

"Yes, of course we have heard of shareholder value, j

But that does not change the fact that we put eus- I

tomers first, then workers, then business partners, j

suppliers, and dealers, and then shareholders.” j

—-Dr Wendelin Wiedeking, CEO, Porsche, Die Zeit, j

April 17,2005 ( Porsche had always been different Statements by j

Porsche leadership, like the one above, always made !

Veselina (Vesi) Dinova nervous about the company’s j

attitude about creating shareholder value.The company j

was a paradox Porsche's attitudes and activities were like that of a family-owned firm, but it had succeeded in creating substantial shareholder value for more than a decade Porsche’s CEO, Dr Wendelin Wiedeking, had been credited with clarity of purpose and sureness of execution As one colleague described him: "He grew up PSD: poor, smart, and driven."

Porsche's management had created confusion in the marketplace as to which value proposition Porsche pre­ sented Was Porsche continuing to develop an organiza­

tional focus on shareholder value, or was it returning to

3Copyright ©2007 Thunderbird School of Global M anagement All rights reserved This case was prepared

by Professor Michael H M offett for the purpose o f classroom discussion only.

Chapter v Globalization and the Multinational Enterprise 19

its more traditional German roots of German cronyism?

Simply put, was Porsche's leadership pursuing family

objectives at the expense of its shareholders?

Porsche AG

Porsche AG was a publicly traded, closely held German-

based auto manufacturer Porsche’s President and Chief

Executive Officer, Dr Wendelin Wiedeking, had returned

the company to both status and profitability since tak­

ing over the company in 1993 Immediately after taking

over, he had killed the 928 and 968 model platforms to

reduce complexity and cost, although at the time this

left the company with only one platform, the 911

Wiedeking had then brought in a group of Japanese

manufacturing consultants, in the Toyota tradition, who

led the complete overhaul of the company’s manufac­

turing processes.

Although Porsche was traded on the Frankfurt Stock

Exchange (and associated German exchanges), control

of the company remained firmly in the hands of the

founding families, the Porsche and Piech families

Porsche had two classes of shares, ordinary and

preference The two families held all 8.75 million

ordinary shares—the shares which held all voting

rights The second class of share, preference shares, par­

ticipated only in profits All 8.75 million preference

shares were publicly traded Approximately 50% of all

preference shares were held by large institutional

investors in the United States, Germany, and the United

Kingdom, 14% were held by the Porsche and Piech fami­

lies, and 36% were held by small private investors As

noted by the Chief Financial Officer, Hoiger Härter, “As

long as the two families hold on to their stock portfo­

lios, there won't be any external influence on company-

related decisions I have no doubt that the families will

hang on to their shares”.

Porsche was somewhat infamous for its indepen­

dent thinking and occasional stubbornness when it

came to disclosure and compliance with reporting

requirements—the prerequisites of being publicly

traded In 2002 the company had chosen not to list on

the New York Stock Exchange after the passage of the

Sarbanes-Oxley Act The company pointed to the spe­

cific requirement of Sarbanes-Oxley that senior man­

agement sign off on the financial results of the

company personally as being inconsistent with German

law (which it largely was) and illogical for management

to accept Management had also long been critical of

the practice of quarterly reporting, and had in fact been

j removed from the Frankfurt Exchange's stock index in { September 2002 because of its refusal to report quar-

j But, after all was said and done, the company had

i just reported record profits for the tenth consecutive } year (see Exhibit 1) Returns were so good and had grown

j so steadily that the company had paid out a special ( idend of €14 per share in 2002, in addition to increasing

div-j the size of the regular dividend.There was a continuing

j concern that management came first In the words of

I one analyst “ we think there is the potential risk that

i management may not rate shareholders’ interests very

j highly” The compensation packages of Porsche's senior

\ management team were nearly exclusively focused on

I current year profitability (83% of executive board

com-j pensation was performance-related pay), with no

man-! agement incentives or stock option awards related to

j Porsche had three major vehicle platforms: the premier

i luxury sports car, the giv, the competitively priced

S Boxster roadster; and the recently introduced off-road

j sport utility vehicle, the Cayenne Porsche had also

j recently announced that it would be adding a fourth

I platform, the Panamera, which would be a high-end

j sedan to compete with Jaguar, Mercedes, and Bentley

i 911 The 911 series was still the focal point of the ( Porsche brand, but many believed that it was growing

j old and due for replacement Sales had seemingly

j peaked in 2001/02, and fallen back more than 15% in

i 2002/03 The 911 had always enjoyed nearly exclusive

j ownership of its market segment Prices continued to be

| high, and margins were some of the very highest in the

I global auto industry for production models.The 911 was

| the only Porsche model that was manufactured and

j Boxster The Boxster roadster had been introduced in [ 1996 as Porsche's entry into the lower price end of the

j sports car market The Boxster was also considered an

I anticyclical move because the traditional 911 was so

I high-priced.The Boxster’s lower price made it affordable and less sensitive to the business cycle It did, however, compete in an increasingly competitive market seg­ ment Boxster sales volumes had peaked in 2000/01.

Cayenne The third major platform innovation was Porsche's entry into the sports utility vehicle (SUV) seg-

i ment, the Cayenne Clearly at the top end of the market

20 PARTI I Global Financia! Environment

Note: EBIT=earnings before interest and tax.

(2002/03 Cayenne sales averaged more than $70,000 !

each), the Cayenne had been a very quick success, espe- )

dally in the SUV-crazed American market It was consid- j

ered the most successful new product launch in auto j

history The Cayenne’s success had been even more dra- j

matic given much pre-launch criticism that the market j

would not support such a high-priced SUV, particularly (

one that shared a strong bloodline with the Volkswagen j

(VW) Touareg The Porsche Cayenne and VW Touareg ¡

shared a common chassis, and in fact were both manu- j

factured at the same factory in Bratislava, Slovakia j

Porsche shipped the Cayenne chassis to its facility in j

Leipzig where the engine, drive train, and interior were j

!

Panamera On July 27,2005, Porsche announced that I

it would proceed with the development and production ¡

of a fourth major model—the Panamera.The name was j

derived from the legendary Carrera Panamericana long- i

distance road race held for many years in Mexico The j

Panamera would be a premium class four-door four- I

seat sports coupe, and would compete with the pre- j

mium sedan models Pricing was expected to begin at j

$125,000, rising to $175,000 Production was scheduled i

to begin in 2009 at a scale of 20,000 units per yean \

The Most Profitable Automobile

Com pany in the World

Porsche’s financial performance and health, by auto manufacturer standards, European or elsewhere, was excellent It was clearly the smallest of the major European-based manufacturers with total sales of €6.4

billion in 2004 But, as shown in Exhibit 2, Porsche was

outstanding by all metrics of profitability and return on invested capital Porsche’s EBITDA, EBIT, and net income margins were the highest among all European automakers in 2004.

Foreign Exchange Porsche’s financial results, how-i ever; had been the subject of substantial debate in i recent years as upwards of 4 0% of operating earnings * were thought to be derived from currency hedging/ Porsche’s cost-base was purely European euro; it pro­ duced in only two countries, Germany and Finland, and both were euro area members Porsche believed that the quality of its engineering and manufacturing were

at the core of its brand, and it was not willing to move production beyond Europe (BMW, Mercedes, and VW had all been manufacturing in both the United States and Mexico for years) Porsche's sales by currency in

2004 were roughly 45% European euro,4 0 % U.S dollar,

Chapter i: Globalization and the Multinational Enterprise 21

EX H IB IT 2

Return on Invested Capital (ROIC) for European Automakers, 2004

Automaker (miüions) EBIT Taxes After-tax Bearing Debt Equity Capital Turnover ROIC

taxes / Invested capital.

10% British pound sterling, and 5% other (primarily the

Japanese yen and Swiss franc).

Porsche’s leadership had undertaken a very aggres­

sive currency hedging strategy beginning in 2001 when

the euro was at a record low against the US dollar In the

following years these financial hedges (currency deriva­

tives) proved extremely profitable For example, nearly

43% of operating earnings in 2003 were thought to

have been derived from hedging activities Although

profitable, many analysts argued the company was

increasingly an Investment banking firm rather than an

automaker, and was heavily exposed to the unpre­

dictable fluctuations between the world's two most

powerful currencies, the dollar and the euro.

ROIC It was Porsche’s return on invested capital

(ROIC), however, which had been truly exceptional over

time.The company’s ROIC in 2004—following Deutsche

Bank's analysis presented in Exhibit 3, was 15.15% This

was clearly superior to all other European automakers.

This ROIC reflected Porsche’s two-pronged financial

strategy: i) superior margins on the narrow but selective

product portfolio; and 2) leveraging the capital and

capabilities of manufacturing partners in the develop­

ment and production of two of its three products The

company had successfully exploited the two primary

drivers of the ROIC formula:

nnir EBIT after-tax Sales

Sales Invested Capital

The first component, operating profits (EBIT, earnings before interest and taxes) after-tax as a percent of

sales—operating margin—was exceptional at Porsche

due to the premium value pricing derived from its global brand of quality and excellence This allowed Porsche to charge premium prices and achieve some of the largest margins in the auto industry As shown in Exhibit 3, Porsche's operating profits after-tax of €671 million produced an operating margin after tax of 10.55% (€671 divided by €6,359 in sales), the highest in the industry in 2004.

The second component of ROIC, the capital turnover

ratio (sales divided by invested capital)—velocity—

although quite high compared to other automakers in the past, was one of the lowest in 2004 as seen in Exhibit

3 In recent years, however, invested capital had risen

faster than sales But Porsche was not adding fixed assets to its invested capital basis, but cash The rising cash balances were the result of retained profits (undis­ tributed to shareholders) and new debt Issuances (rais­ ing more than €600 million in 2004 alone) As a result, fiscal 2003/04 had proven to be one of Porsche's poorest years in ROIC Porsche’s minimal levels of invested capi­ tal resulted from some rather unique characteristics.

Invested capital is defined a number of ways, but Vesi

used her employer’s standardized definition of cash plus net working capital plus net fixed assets Porsche’s invested capital was growing primarily because of its accumulation of cash Vesi was concerned that using

22 PART Global Financial Environment

this measure of “invested capital” led to a distorted view

of the company's actual performance Porsche’s mini­

mal fixed asset capital base resulted from the explicit

strategy of the company as executed over the past

decade.

Porsche Changes Tack

The summer and fall of 2005 saw a series of surprising

moves by Porsche First, Porsche announced that the A

billion investment to design and manufacture the new

Panamera would be largely funded by the company

itself Although the introduction of the Panamera had

been anticipated for quite some time, the market was

surprised that Porsche intended to design and build the

car—and its manufacturing facility—nearly totally in-

house As opposed to the previous new product intro­

ductions, the Boxster and the Cayenne, there would be

no major production partner involved Porsche CEO

Wendelin Wiedeking specifically noted this in his press

release: “There are no plans for a joint venture with

another car maker But to ensure the profitability of this

new model series we will cooperate more closely than

so far with selected system suppliers.” The German

share of the value of the Panamera would be roughly

Ị 70% Like the 911, Boxster; and Cayenne, the Panamera

‘ would bear the Made in Germany stamp The second

surprise occurred on September 25, 2005, with the announcement to invest €3 billion in VW.

i Porsche AG, Stuttgart, seeks to acquire a share of approximately 20 per cent in the stock capital of Volkswagen AG, Wolfsburg, entitled to vote Porsche

is taking this decision because Volkswagen is now not only an important development partner for Porsche, but also a significant supplier of approxi-

i mately 30 per cent of Porsche's sales volume In the

I words of Porsche's President and CEO: "Making this

\ investment, we seek to secure our business relations

\ with Volkswagen and make a significant

contribu-Í tion to our own future plans on a lasting, long-term

ị basis.” Porsche is in a position to finance the

acquisi-I tion of the planned share in Volkswagen through its

j own, existing liquidity After careful examination of

5 this business case, Porsche is confident that the

I investment will prove profitable for both parties.

J The planned acquisition is to ensure that there

I will not be a hostile takeover of Volkswagen by

Ị investors not committed to Volkswagen’s long-term

ị interests In the words of Porsche’s President and

Chapter 1: Globalization and the Multinational Enterprise 23

CEO: "Our planned investment is the strategic j

answer to this risk We wish in this way to ensure the j

independence of the Volkswagen Group in our own {

interest This'German solution'we are seeking is an i

essential prerequisite for stable development of the j

Volkswagen Group and, accordingly, fo r continuing 1

our cooperation in the interest of both Companies." j

—'Acquisition of Stock to Secure Porsche's Business," J

Porsche AG (press release), September 25,2005 j

Porsche would spend approximately €3 billion to j

take a 20% ownership position in VW This would make \

Porsche VW’s single largest investor; slightly larger than f

the government of Lower Saxony 4 It clearly eliminated j

any possible hostile acquisitions that may have been on j

the horizon (DaimlerChrysler was rumored to have been \

interested in raiding VW.) The announcement was met j

The family linkages between the two companies J

were well known Ferdinand K Piech, one of the most

prominent members of the Piech family, which along

with the Porsche family controlled Porsche, was the for­

mer CEO (he retired in 2002) and still Chairman of s

Volkswagen Fie was the grandson of Ferdinand Porsche, !

the founder of Porsche Accusations of conflict of inter- |

est were immediate, as were calls for his resignation, !

and the denial of Porsche’s request for a seat on VW's

board Although VW officially welcomed the investment

by Porsche, Christian WuIff, VW’s board member repre­

senting the state of Lower Saxony where VW was head- j

quartered, publicly opposed the investment by Porsche {

In the eyes of many the rriove by Porsche was a return to j

For years, “Deutschland AG" was emblematic of the j

cosy network of cross-shareholdings and shared !

non-executive directorships that insulated Germany \

from international capitalism Wendelin Wiedeking, j

Porsche’s chief executive, him self invoked the \

national angle, saying this "German solution" was j

essential to secure VW, Europe’s largest carmaker, j

against a possible hostile takeover by short-term {

investors j

—"Shield for corporate Germany or a family affair? f

VW and Porsche close ranks,” Financial Times, [

Tuesday, September 27,2005, p 17 j

Germany, although long known for complex net­ works of cross-shareholdings, had effectively unwound most of these in the iggos.This move by Porsche and VW was seen as more of a personal issue— Ferdinand Piech—rather than a national issue of German alliances Many Porsche investors had agreed, arguing that if they had wanted to invest in VW they would have done it themselves Although the arguments for solidifying and securing the Porsche/VW partnership were rational, the cost was not At €3 billion, this was an enormous invest­ ment in a non-performing asset Analysts concluded that the potential returns to shareholders, even in the form of

a special dividend, were now postponed indefinitely The announcement of Porsche's intention to take a 20% equity interest in VW was greeted with outright opposition on the part of many shareholders in both

VW and Porsche Major investment banks immediately

downgraded Porsche from a buy to a sell, arguing that

the returns on the massive investment, some €3 billion, would likely never accrue to shareholders Although Porsche had explained its investment decision to be one that would assure the stability of its future cooperation with VW, many critics saw it as a choice of preserving the stakes of the Porsche and Piech families at the expense of non-family shareholders.

“Why should a small and highly-profitable maker of sports cars suddenly hitch its fortunes to a lumber­ ing and struggling mass-produced That was the question that some alarmed shareholders asked this week when Porsche, the world’s most profitable car­ maker, announced plans to buy 2 0 % stake in Volkswagen (VW), Europe’s biggest carmaker To some critics of the deal, Porsche’s move looked like a return to cosy, German corporatism at its worst Since January 2002, when a change in the law encouraged German companies to sell their cross­ shareholdings in each other, free of capital gains tax, new foreign shareholders have often shaken up fos­ silized German management A deal with friendly compatriots from Porsche might rescue V)N from this distasteful fate, particularly since foreign hedge funds and corporate raiders have been rumored to be circling VW.”

—"Business: Keeping It in the Family,"

The Economist, October 1,2005.

4The resulting ownership structure of Volkswagen in O ctober 2005 was: 18.53% Porsche; 18.2% State of Lower Saxony; 13.0% Volkswagen; 8.58% Brandes Investm ent Partners; 3.5% Capital G roup; and 38.19% widely distributed.