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As the field of international finance has evolved, so has the content of Multinational Business Finance As in previous editions, we perceive the multinational enterprise (MNE) to be a unique institution that acts as a catalyst and facilitator of international trade and as an impor- tant producer and distributor in host countries where its subsidiaries are located The success

of a multinational enterprise continues to depend on its ability to recognize and benefit from imperfections in national markets for products, factors of production, and financial assets

Also carried over from earlier editions is the theme that volatile exchange rates may not only increase risk, but also they may create opportunities for both investors and firms to” profit, given a proper understanding of exchange risk management

The 12th edition continues to recognize the increasing importance of global integration

of money and capital markets, a trend that is creating expanded opportunities for both investors and organizations that must raise capital Although global integration of financial markets removes some market imperfections that impede the flow of capital internationally, excellent opportunities continue to exist for investors to increase their returns while lower- ing their risk through international portfolio diversification and for firms to lower their cost

of capital by sourcing it internationally

The 12th edition views the MNE as an organization that poses unique demands on the business leaders of tomorrow Those leaders— possibly some of the readers of this text —will

be confronted with a multitude of challenges that will test not only their ability to compre- hend global markets, but also, more importantly, to /ead their organizations through the con- stantly shifting currents and tides of global change Competent leadership may indeed be the scarcest global commodity

This book is about multinational management, and more specifically, the financial man-

agement dimensions of leading a multinational enterprise The MNE’s potential success, however, rests in the hands of the truly competent global leader The success of any MNE depends on its leadership’s ability to guide and manage the global organization

Our vision for this book is to aid in the development of tomorrow’s MNE leaders Their ability to recognize and benefit from business opportunities such as imperfections in national markets, unequal costs and efficiencies of the factors of production, wellsprings of intellec- tual property, and sources of global funding to facilitate growth adds value

The financial managers of MNEs face numerous foreign exchange and political risks

These risks can be daunting, but if properly understood they present opportunities for creat- ing value These risks and opportunities are most effectively understood in the context of the global business itself, and the ability of management to integrate the strategic and financial challenges that business faces

Audience

Multinational Business Finance, 12th edition, is appropriate for university-level courses in

international financial management, international business finance, international finance,

and similar titles It can be used at the undergraduate and graduate level as well as in execu- tive education courses

A prerequisite course or experience in corporate finance or financial management would

be ideal However, we review the basic finance concepts before we extend them to the multi-

v

Organization

Multinational Business Finance, 12th edition, is organized into six parts, unified by the com- mon thread of the globalization process by which a firm moves from a domestic to a multi- national business orientation

£™%

Part 1 introduces the global financial environment

Part 2 explains foreign exchange theory and markets

Part 3 analyzes foreign exchange exposure

Part 4 analyzes financing the global firm

Part 5 analyzes international investment decisions

Part 6 examines managing multinational operations

© New in the 12th Edition

= Chapter 1, Globalization and the Multinational Enterprise, traces the logical devel- opment of globalization forces, comparative advantage, foreign direct investment by multinational enterprises, and financial globalization principles of multinational financial management

8 Chapter 2, Financial Goals and Corporate Governance, expands on the discussion of corporate governance, and now includes private ownership of business—the still dominant form of ownership globally—and differing perspectives on the value of good global governance

® Chapter 5, Current Multinational Financial Challenges: The Credit Crisis of 2007-2009, is completely new It details the origins and dissemination of the securi-

ties and derivatives and market developments behind the current global financial

crisis and proposed solutions

@ Chapter 18, Foreign Direct Investment Theory and Political Risk, includes a new sec-

tion on emerging market MNEs, m= There are 22 Mini-Cases Four are new and 18 are retained in response to reader feedback

® There are additional Global Finance in Practice boxes throughout the text, high- lighting current events as tied to the chapter material

® Complete answers to starred (*) end-of-chapter Problems are provided at the rear

of the book in a section called Answers to Selected Problems

In this book, we use foreign exchange quotations that sometimes may differ from the lat-

est computer code quotation symbols (three-digit symbols) This results from the constant

change in the marketplace and because sometimes we prefer to use traditional symbols—$,

¥, £—rather than three-digit codes, which we consider to be more sterile We acknowledge

that this decision may make the material seem out of date But then again, this book is some- what about the difficulties and challenges of managing businesses in a rapidly changing finan- cial environment We also understand that many professors have prepared additional teaching materials based on our existing foreign exchange quotations Therefore, we continue

to use a mix of selected existing quotations (from previous editions) and the latest rates and

movements in the marketplace In any case, the quotations are meant to illustrate a particu-

lar problem, not to support up-to-the-minute solutions

A Rich Array of Support Materials

A robust package of materials for the instructor and student accompanies the text to facilitate learning and to support teaching and testing Alll instructor resources are available for down-

load from the online catalog page for this book (www.pearsonglobaleditions.conveiteman)

® Instructor’s Manual The Online Instructor’s Manual, prepared by the authors, con-

tains answers to end-of-chapter questions and mini-cases Excel® solutions for all

end-of-chapter problems are available as well as PowerPoint teaching solutions for all mini-cases The Instructor’s Manual is available for download as Microsoft®

‘Word files or as Adobe® PDF files and the solutions to the problems are available for download as Microsoft Excel® files from the Instructor Resource Center or from your local sales representative

#_ Test Bank The Test Bank, prepared by Curtis J Bacon of Southern Oregon University, contains more than 700 multiple choice and true/false questions The multiple choice questions are labeled by topic and category—recognition, concep-

tual, and analytical The test bank is available for download from the Instructor’s

Resource Center

# Computerized Test Bank The Test Bank is also available in Pearson Education’s TestGen software for Windows® and Macintosh® TestGen's graphical interface enables the instructor 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 as preferred The Quizmaster application allows the instructor to administer TestGen tests over the school’s computer network More information on TestGen software is available at www.pearsoned.com/testgen PowerPoint Presentation The PowerPoint presentation slides, prepared by Mark J Bradt, provide lecture outlines and selected graphics from the text for each chapter The PowerPoint presentation is also available for download from the Instructor’s Resource Center

® Companion Web Site A dedicated Web site (www.pearsonglobaleditions.com/ eiteman) contains access to chapter exhibits, Excel solutions for select end-of chap- ter problems (denoted with an asterisk), Internet exercises, and glossary flashcards instructors have access to spreadsheet solutions for all problems from the Instructor Resource Center

Vill Preface

Acknowledgments The authors are very thankful for the many detailed reviews and suggestions from numerous

colleagues These reviews, by more than 100 adopters and non-adopters, include detailed chapter-by-chapter reviews and answers to a comprehensive questionnaire The current edi- tion of Multinational Business Finance reflects most of the suggestions provided by these

teviewers The survey participants are anonymous The detailed reviewers are as follows:

Gordon M Bodnar, John Hopkins University

Imad A Elhah, University of Louisville Larry Fauver, University of Tennessee

John P Lajaunie, Nicholls State University

Sheryl Winston Smith, University of Minnesota Masahiro Watanabe, Rice University

Gwinyai Utete, Auburn University

Special thanks are extended to the reviewers and survey participants of the previous editions:

Kam C Chan

University of Dayton Chun Chang

University of Minnesota Sam Chee

Boston University Metropolitan

College Kevin Cheng

New York University

It-Keong Chew

University of Kentucky Frederick D S, Choi

New York University

Jay Choi

Temple University

Nikolai Chuvakhin

Pepperdine University Mark Ciechon

University of California, Los Angeles

J Markham Collins University of Tulsa Alan N, Cook Baylor University

Kerry Cooper

Texas A&M University

Robert Cornu Cranfield School of Management,

UK

Roy Crum University of Florida Steven Dawson

University of Hawaii at Manoa

David Distad

University of California, Berkeley

Gunter Dufey University of Michigan, Ann Arbor Mark Eaker

University of Hlinois at Urbana- Champaign

Germany

Manolete Gonzales

Oregon State University

Deborah Gregory University of Georgia

Rita Maldonado-Baer

New York University

Anthony Matias Palm Beach Atlantic College Charles Maxwell

Murray State University

Sam McCord

Auburn University”

Jeanette Medewitz University of Nebraska at Omaha

Robert Mefford

University of San Francisco Paritash Mehta

Temple University Antonio Mello University of Wisconsin at Madison

Michigan State University Lars Oxelheim

Lund University, Sweden Jacob Park

Green Mountain College

‘Yoon Shik Park

George Washington University

Harvey Poniachek New York University Yash Pari

University of Massachusetts at Lowell

R Ravichandran University of Colorado at Boulder Scheherazade Rehman

George Washington University

Jeff Rosenlog Emory University

Dayid Rubinstein

University of Houston Alan Rugman

Oxford University, U.K

R J Rummel

University of Hawaii at Manoa

Mehdi Salehizadeh San Diego State University

Michael Salt

San Jose State University

Roland Schmidt Erasmus University, the Netherlands

Lemma Senbet University of Maryland

Alan Shapiro University of Southern California Hany Shawky

State University of New York,

Jahangir Sultan Bentley College

University of St Thomas

Harald Vestergaard Copenhagen Business School

K G Viswanathan Hofstra University

Joseph D Vu

University of Illinois, Chicago

x Preface

Mahmoud Wahab Payson Cha Arthur J Obesler

University of Hartford HKR International, Hong Kong Eximbank

University of Texas at Austin Private Export Funding Continental Bank

Brigham Young University Kare Dullum Overseas Private Investment

Bob Wood Gudme Raaschou Investment Corporation

aL reese Technological University Bank, Denmark Willem Winter

Bentley College Hewlett Packard

ome ae se Universi David Heenan International Reviewers

Orida Mlantic University Campbell Estate, Hawaii Catherine S F Ho, PhD

Tom Zwirlein r S F Ho, Ph.D

Universit niversity of Colorado, Colorado Sharyn HL Hess , Universiti Teknologi MARA,

Association Tee Peck Ling

Industry (present or former affiliation) Aage Jacobsen Universiti Tunku Abdul Rahman

Philadelphia Stock Exchange Bank, Denmark Boaz Nandwa

Barbara Block Tra G Kawaller American University in Dubai

Tektronix, Inc Chicago Mercantile Exchange Raymond W So

Holly Bowman Kenneth Knox The Chinese University

Bankers Trust Tektronix, Inc of Hong Kong

Inevitably woven into the fabric of this book are ideas received from faculty and students from institutions where we have taught from all over the world They include our home uni- versities of University of California, Los Angeles; Oregon State University; University of Hawaii; and Thunderbird Our visiting stints have been at the Hong Kong University of

Science and Technology; University of California, Berkeley; University of Michigan, Ann Arbor; Cranfield School of Management, United Kingdom; University of Hawaii at Manoa;

Northern European Management Institute, Norway; Copenhagen Business School,

Denmark; Aarhus School of Business, Denmark; Helsinki School of Economics and Business

Administration, Finland; Indian School of Business, Hyderabad; Institute for the Development of Executives, Argentina; National University of Singapore; International Centre for Public Enterprises, Yugoslavia; Beijing Institute of Chemical Engineering and Management; and Dalian University of Science & Technology, China Further ideas came from consulting assignments in Argentina, Belgium, Canada, Denmark, Finland, Guatemala,

Hong Kong, Indonesia, Japan, Malaysia, Mexico, the Netherlands, Norway, People’s Republic

of China, Peru, Sweden, Taiwan, the United Kingdom, and Venezuela

We would also like to thank two key individuals at Pearson who worked diligently on this 12th edition: Donna Battista and Kerri McQueen

Finally, we would like to rededicate this book to our parents, the late Wilford and Sylvia Hiteman, the late Harold and Norma Stonehill, and Bennie Ruth and the late Hoy Moffett, who motivated us to become academicians and authors We thank our wives, Keng-Fong, Kari, and Megan for their patience throughout the years spent preparing this edition

Pacific Palisades, California D.K.E

Arthur | Stonehill is a Professor of Finance and International Business, Emeritus, at Oregon State University, where he taught for 24 years (1966-1990) During 1991-1997 he held a split

appointment at the University of Hawaii at Manoa and Copenhagen Business School From

1997 to 2001 he continued as a Visiting Professor at the University of Hawaii at Manoa He has also held teaching or research appointments at University of California, Berkeley;

Cranfield School of Management (U.K.); and the North European Management Institute

(Norway) He was a former president of the Academy of International Business and a west- ern director of the Financial Management Association

Professor Stonehill received a B.A (History) from Yale University (1953), an M.B.A

from Harvard Business School (1957), and a Ph.D, in Business Administration from University of California, Berkeley (1965) He was awarded honorary doctorates from the Aarhus School of Business (Denmark, 1989), the Copenhagen Business Schoo! (Denmark, 1992), and Lund University (Sweden, 1998)

He has authored or coauthored nine books and twenty-five other publications His arti- cles have appeared in Financial Management, Journal of International Business Studies, California Management Review, Journal of Financial and Quantitative Analysis, Journal of

International Financial Management and Accounting, International Business Review,

European Management Journal, The Investment Analyst (UK.}, Nationalpkonomisk Tidskrift (Denmark), Sosialgkonomen (Norway), Journal of Financial Education, and others

David K Eiteman is Professor Emeritus of Finance at the John E Anderson Graduate School of Management at UCLA He 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 Manoa, University of Bradford (U.K.), Cranfield School of Management (U.K.), and IDEA (Argentina) He is a former president of the International Trade and Finance Association, Society for Economics and Management in China, and Western Finance Association

Professor Eiteman received a B.B.A (Business Administration) from the University of Michigan, Ann Arbor (1952); M.A (Economics) from University of California, Berkeley (1956); and a Ph.D (Finance) from Northwestern University (1959)

He has authored or coauthored four books and twenty-nine other publications His arti- cles have appeared in The Journal of Finance, The International Trade Journal, Financial

Analysts Journal, Journal of World Business, Management International, Business Horizons, MSU Business Topics, Public Utilities Fortnightly, and others

Michael H Moffett is Continental Grain Professor of Finance at Thunderbird School of Global Management He was formerly Associate Professor of Finance at Oregon State University (1985-1993) He has also held teaching or research appointments at the

University of Michigan, Ann Arbor (1991-1993); the Brookings Institution, Washington,

D.C, the University of Hawaii at Manoa; the Aarhus School of Business (Denmark); the

Helsinki School of Economics and Business Administration (Finland); the International

Centre for Public Enterprises (Yugoslavia); and the University of Colorado, Boulder

About the Authors

Professor Moffett 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)

He has authored, coauthored, or contributed to six books and 15 other publications His

articles have appeared in the Journal of Financial and Quantitative Analysis, Journal of Applied Corporate Finance, Journal of International Money and Finance, Journal of

International Financial Management and Accounting, Contemporary Policy Issues, Brookings Discussion Papers in International Economics, and others He has contributed to a number of

collected works including the Handbook of Modern Finance, the International Accounting and Finance Handbook, and the Encyclopedia of International Business He is also coauthor

of two books on multinational business with Michael Czinkota and Ilkka Ronkainen, International Business (7th edition) and Global Business

Global Financial Environment 1

Chapter 1 Globalization and the Multinational Enterprise 2

Chapter 2 Financial Goals and Corporate Governance 22

Chapter 3 The International Monetary System S50 Chapter 4 International Business Transactions: The Balance of Payments 78 Chapter 5 Current Multinational Financial Challenges:

‘The Credit Crisis of 2007-2009 106

Foreign Exchange Theory and Markets 137

Chapter 6 The Foreign Exchange Market 138 Chapter 7 International Parity Conditions 164

Chapter 8 Foreign Currency Derivatives 197 Chapter 9 Interest Rate and Currency Swaps 234

Chapter 10 Foreign Exchange Rate Determination and Forecasting 256

Foreign Exchange Exposure 281

Chapter 11 Transaction Exposure 282

Chapter 12 Operating Exposure 320 Chapter 13 Translation Exposure 344

Financing the Global Firm 365

Chapter 14 The Global Cost and Availability of Capital 366 Chapter 15 Sourcing Equity Globally 391

Chapter 16 Sourcing Debt Globally 410

Foreign Investment Decisions 431

Chapter 17 International Portfolio Theory and Diversification 432

Chapter 18 Foreign Direct Investment Theory and Political Risk 452

Chapter 19 Multinational Capital Budgeting 487

Managing Multinational Operations 513

Chapter 20 Multinational Tax Management 514 Chapter 21 Working Capital Management 535 Chapter 22 Global Petroleum Development: Fiscal Regimes and Funding 565

Answers to Selected Problems 595

Glossary 598

Index 610

Credits 627

xiii

PART |

Contents

Global Financial Environment 1

Chapter 1 Globalization and the Multinational Enterprise 2

Globalization and Creating Value in the Multinational Enterprise 3

The Theory of Comparative Advantage 4 What Is Different about Global Financial Management? 7 Market Imperfections: A Rationale for the Existence of the Multinational Firm 8 The Globalization Process 9

Summary Points 13 MINI-GASE: Porsche Changes Tack 13

Questions s¢ Problems & Internet Exercises 19

Chapter 2 Financial Goals and Corporate Governance 22

Who Owns the Business? 22

What Is the Goal of Management? 24

Corporate Governance 28

Summary Points 40

MIRI-GASE: Govemance Failure at Enron 41 Questions Problems Intemet Exercises 45

Chapter 3 The International Monetary System 50

History of the International Monetary System 50

Contemporary Currency Regimes 56

Emerging Markets and Regime Choices 62

The Birth of a European Currency:The Euro 64

Exchange Rate Regimes: What Lies Ahead? 69

Summary Points 70

MINI-CASE: The Revaluation of the Chinese Yuan 71

Questions & Problems # Internet Exercises 74

Chapter 4 International Business Transactions: The Balance of Payments 78

Typical Balance of Payments Transactions: China 79 Fundamentals of Balance of Payments Accounting 80 The Accounts of the Balance of Payments 81

The Capital and Financial Account 83

The Balance of Payments in Total 89

The Balance of Payments Interaction with Key Macroeconomic Variables 91

Trade Balances and Exchange Rates 94

Capital Mobility 97

Summary Points 99 MINI-GASE: Turkey's Kriz (A): Deteriorating Balance of Payments 160 Questions a Problems a# internet Exercises 102

Chapter 5 Current Multinational Financial Challenges:

The Credit Crisis of 2007-2009 106 The Sceds of Crisis: Subprime Debt 106

‘The Transmission Mechanism: Securitization and Derivatives of Securitized Debt 109

The Fallout:The Crisis of 2007 and 2008 120

PART II

The Remedy: Prescriptions for an Infected Global Financial Organism 129

Summary Points 131

MINI-CASE: Letting Go of Lehman Brothers 132

Questions @ Problems # Internet Exercises 134

Foreign Exchange Theory and Markets 137

Chapter 6 The Foreign Exchange Market 138

Geographical Extent of the Foreign Exchange Market 138

Functions of the Foreign Exchange Market 139

Market Participants 140

‘Transactions in the Interbank Market 142

Foreign Exchange Rates and Quotations 148

Summary Points 156

MINI-CASE: The Venezuelan Bolivar Black Market 157

Questions 88 Problems s Internet Exercises 160

Chapter 7 international Parity Conditiens 164

Prices and Exchange Rates 164

Interest Rates and Exchange Rates 172

Forward Rate as an Unbiased Predictor of the Future Spot Rate 181

Prices, Interest Rates, and Exchange Rates in Equilibrium 183

Summary Points 184

MINI-CASE: Currency Pass-Through at Porsche 185

Questions 28 Problems & Internet Exercises 186

Appendix: An Algebraic Primer to Intemational Parity Conditions 193

Chapter 8 Foreign Currency Derivatives 197

Foreign Currency Futures 198

Currency Options 201

Foreign Currency Speculation 203

Option Pricing and Valuation 210

Currency Option Pricing Sensitivity 213

Prudence in Practice 221

Summary Points 222

WiINI-CASE: Warren Buffett's Love-Hate Relationship with Denvatwes 223

Questions a& Problems @ Internet Exercises 226

Appendix: Currency Option Pricing Theory 230

Chapter $ Interest Rate and Currency Swaps 234

Defining Interest Rate Risk 234

Management of Interest Rate Risk 237

‘Trident Corporation: Swapping to Fixed Rates 245

Currency Swaps 246

‘Trident Corporation: Swapping Floating Dollars into Fixed Rate Swiss Francs 247

Counterparty Risk 249

Summary Points 250

MINI-GASE: McDonald's Corporation’s British Pound Exposure 251

Questions 2 Problems # Internet Exercises 252

Chapter 10 Foreign Exchange Rate Determination and Forecasting 256

Exchange Rate Determination: The Theoretical Thread 257

The Asset Market Approach to Forecasting 260

PART It

PART Iv

Contents

Disequilibrium: Exchange Rates in Emerging Markets 262

Illustrative Case: The Asian Crisis 262

Illustrative Case: The Argentine Crisis of 2002 265

Forecasting in Practice 270

Summary Points 274

MINI-GASE: JPMorgan Chase's Forecasting Accuracy 274

Questions m Problems & Internet Exercises 276

Foreign Exchange Exposure 281

Chapter 11 Transaction Exposure 282

‘Types of Foreign Exchange Exposure 282

Why Hedge? 284

Measurement of Transaction Exposure 287

Trident’s Transaction Exposure 289

Management of an Account Payable 297

Risk Management in Practice 299

Summary Points 300

MINI-CASE: Xian-Janssen Pharmaceutical (China) and the Euro 301

Questions a Problems a internet Exercises 303

Appendix: Complex Options 312

Chapter 12 Operating Expesure 320

Attributes of Operating Exposure 320

Illustrating Operating Exposure: Trident 322

Strategic Management of Operating Exposure 326

Proactive Management of Operating Exposure 329

Contractual Approaches: Hedging the Unhedgeable 336

Summary Points 337

MINI-CASE: Toyota's European Operating Exposure 338

Questions a8 Problems i intemet Exercises 340

Chapter 13 Translation Exposure 344

Overview of Translation 344

‘Translation Methods 347

‘Translation Example: Trident Europe 350

Comparing Translation Exposure with Operating Exposure 355

Managing Translation Exposure 355

Summary Points 359

MINI-CASE: LaJolla Engineering Services 360

Questions = Problems a Internet Exercises 362

Financing the Global Firm 365

Chapter 14 The Globat Cost and Availability of Capital 366

Weighted Average Cost of Capital 368

The Demand for Foreign Securities: The Role of International Portfolio Investors 373

The Cost of Capital for MNEs Compared to Domestic Firms 379

Solving a Riddle: Is the Weighted Average Cost of Capital for MNEs Really Higher Than for Their

Domestic Counterparts? 380

Summary Points 382

MINI-CASE: Novo Industri A/S (Novo} 383

Questions a Problems a4 Intemet Exercises 387

PART V

Chapter 15 Sourcing Equity Globally 391

Designing a Strategy to Source Equity Globally 392

Foreign Equity Listing and Issuance 395

Effect of Cross-Listing and Equity Issuance on Share Price 397

Barriers to Cross-Listing and Selling Equity Abroad 399

Alternative Instruments to Source Equity in Global Markets 400

Summary Points 404

SAINI-CASE: Petrobras of Brazil and the Cost of Capital 404

Questions @ Problems sx Internet Exercises 408

Chapter 16 Sourcing Debt Globally 410

Optimal Financial Structure 410

Optimal Financial Structure and the MNE 411

Financial Structure of Foreign Subsidiaries 414

International Debt Markets 418

Summary Points 424

MINI-CRSE: Tirstrup BioMechanics (Denmark): Raising Dollar Debt 424

Questions Problems # Internet Exercises 426

Foreign Investment Decisions 431

Chapter 17 International Portfolio Theory and Diversification 432

International Diversification and Risk 432

Internationalizing the Domestic Portfolio 435

National Markets and Asset Performance 441

Summary Points 446

MINI-CASE: |s Modem Portfolio Theory Outdated? 447

Questions a1 Problems # Inlemet Exercises 448

Chapter 18 Foreign Direct investment Theory and Political Risk 452 Sustaining and Transferring Competitive Advantage 452

The OLI Paradigm and Internalization 455

Deciding Where to Invest 457

How to Invest Abroad: Modes of Foreign Involvement 458

Foreign Direct Investment Originating in Developing Countries 462

Foreign Direct Investment and Political Risk 464

Assessing Political Risk 465

Firm-Specific Risks 466

Country-Specific Risks: Transfer Risk 469

Country-Specific Risks: Cultural and Institutional Risks 472

Global-Specific Risks 476

Summary Poinls 479

SMINI-CASE: Mattel’s Chinese Sourcing Crisis of 2007 480

Questions m Problems Internet Exercises 483

Chapter 19 Multinational Capital Budgeting 487

Complexities of Budgeting for a Foreign Project 488

Project versus Parent Valuation 489

Illustrative Case: Cemex Enters Indonesia 490

Real Option Analysis 502

Project Financing 503

Summary Points 505

MIRI-GRSE: ‘Trident’s Chinese Market Entry—An Application of Real Option Analysis 505

Questions 22 Problems # Internet Exercises 07

PART VI

Contents

Managing Multinational Operations 513

Chapter 20 Multinational Tax Management 514

Tax Principles 514

Transfer Pricing 522

Tax Management at Trident 524

Tax Haven Subsidiaries and International Offshore Financial Centers 525

Summary Points 527

MINL-CASE: Stanley Works and Corporate Inversion 527

Questions & Problems # Internet Exercises 531

Chapter 21 Working Capital Management 535

Trident Brazil’s Operating Cycle 535

Trident’s Repositioning Decisions 537

Constraints on Repositioning Funds 539

Conduits for Moving Funds by Unbundling Them 539

International Dividend Remittances 540

Net Working Capital 542

International Cash Management 548

Financing Working Capital 552

Summary Points 556

MINI-CASE; Honeywell and Pakistan International Airways 557

Questions #¥ Problems 8 Internet Exercises 559

Chapter 22 Gtobal Petroleum Development: Fiscal Regimes and Funding 565 Financing Petroleum Development 566

MINI-CASE: Petroleum Development and the Curse of Oil 590

‘Questions a Problems # Internet Exercises 593

Answers to Selected Problems 595

Glossary 598

index 610

Credits 627

International Business Transactions:

The Balance of Payments

CHAPTER 5

Current Multinational Financial Challenges:

The Credit Crisis of 2007-2009

Globalization and

the Multinational Enterprise

I define globalization as producing where it is most cost-effective, selling where it is most profitable, and sourcing capital where it is cheapest, without worrying about national boundaries

—Narayana Murthy, President and CEO, Infosys

This book is about international financial management with special emphasis on the

muttinational enterprise The multinational enterprise (MNE) is defined as one that has operating subsidiaries, branches, or affiliates located in foreign countries It also includes firms in service activities such as consulting, accounting, construction, legal, advertising, entertainment, banking, telecommunications, and lodging

MNEs are globally headquartered Many of them are owned by a mixture of domestic and foreign shareholders The ownership of some firms is so dispersed internationally that they are known as transnational corporations.T’ 2 transnationals are usually managed from

a global perspective rather than from the perspective of any single country

Although Multinational Business Finance emphasizes MNEs, purely domestic firms

also often have significant international activities These include the import and export of

products, components, and services Domestic firms can also license foreign firms to

conduct their foreign business They have exposure to foreign competition in their domestic market 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 Tisks related to trade payments

Multinational Business Finance is written in English and usually uses the U.S doliar in

its exposition However, we have tried to make it relevant for all multinational enterprises

by using numerous non-U.S,-based MNEs We will use the term multinational enterprise {MNE) throughout this text for two very important reasons 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, the term enterprise is used instead of 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

Globalization and Creating Value in the Multinational Enterprise 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 marketplace; 2) high quality strategic management, and 3) access to capital As shown in Exhibit 1.1, any MNE attempting to create value would need to combine these three critical elements composing the sides of the firm value pyramid

An Open Marketpiace

Market 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 market economics

in any country, and many countries have yet to find the magical mix

value It is not something that has yet been quantified or captured; as any business student

Creating Firm Value in Global Markets

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

of all three sides of the global pyramid: an open marketplace; access fo affordable

capital and high-quality strategic management

CHAPTER 1 Globalization and the Multinational Enterprise

knows, if computers could strategize and manage, companies wouldn't hire people (or students)

Access to Capital

Open markets and insightful leadership is all for nought, however, if the MNE 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 markets 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 III shown in

Exhibit 1.1, is representative of the degrees of depth, breadth, and sophistication accessible

by the MNE For example:

® General Electric (USA) may be considered a resident of Level HI It is a global

MNE 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 marketplaces in the world

§ Cemex (Mexico) may be an example of a resident of Level Il A rapidly growing

competitor in its global industry, it is based in Mexico, which is rapidly emerging as

a market economy of nearly limitless potential Yet Cemex is still sometimes hampered in its access to ready and affordable capital to support its business goals

= The Haier Group (China) may be representative of an MNE resident in Level 1 of the value pyramid Although highly successful and an MNE to be reckoned with in

a growing number of marketplaces, Haier is still struggling to overcome barriers and limitations of all three critical elements from its Chinese base

As 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 elements —the three sides of the pyramid — with the level of economic development and openness of the countries of their business activities The mini-case on Porsche at the end of the chapter will challenge the reader to determine where it might fall within the architecture of the value pyramid

As we shall see throughout this book, the global economy is seeing an unprecedented

growth in the resident MNEs in the value pyramid, and the size and shape of the pyramid tomorrow is probably limitless We now move to the underlying principle driving the growth

of the global business— comparative advantage

The Theory of Comparative Advantage

The theory of comparative advantage provides a basis for explaining and justifying international trade in a model world assumed to enjoy free trade, perfect competition, no uncertainty, costless information, and no government interference The theory’s origins lie in the work of Adam Smith, and particularly with his seminal book The Wealth of Nations published in 1776 Smith sought to explain why the division of labor in productive activities, and subsequently international trade of those goods, increased the quality of life for all citizens Smith based his work on the concept of absolute advantage, where every country

should specialize in the production of that good it was uniquely suited for More would be

National Multinational or ‘A-National’?

When Isaac Merritt Singer set up a branch of his sewing

machine maker in Paris in 1855, he probably did not think he

was blazing a trail US companies would still be following

more than 150 years jater Singer's expansion in France

turned the New York-based company into the first US

muitinational, pioneering a business model that would be

adopted by other icons of American capitalism, from Ford to

Standard Oil to General Electric But perhaps the most

important legacy of Singer’s daring move was that it worked:

within six years of the French opening, foreign sales had

exceeded US revenues It is a lesson not lost on today's

corporate leaders,

Over the past three months, blue-chips such as General

Electric, the conglomerate, IBM, the technology giant, and

UPS, the logistics group, have hitched a ride on a global

economy growing faster than the US By contrast,

companies that depend on domestic consumers such as

Wal-Mart, the retait bell-wether, and Home Depot, the do-it-

yourself chain, have released disappointing results and

gloomy predictions

But if foreign earnings have helped US multinationals

stave off a fall in profitability, the question is whether the

current reliance on the rest of the world is just a cyclical

phase or the harbinger of a transformation in corporate

America Could the importance of overseas markets

destroy—as Sam Palmisano, IBM's chief executive, has

argued—the old multinational model whereby companies

decentralised manufacturing and sales operations but kept

key functions such as ihe executive office, research and

product design in the “home country"? And if so, are some

US companies ready to become truly “transnational” by

scattering their top executives around the world?

At first sight, there are significant cyclical forces behind

the recent rise of US muttinationals—forces, in other words,

that coutd 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 easier for US exporters to sell to the world and boosting the dotlar value of overseas eamings 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 revolutions at

companies mean, in the words of Steve Mills, head of IBM’s globat software business, that “things cannot go back ta the

way they were”, will more companies 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 Palmisanos 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 tums, 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 comer of the world.” In other words, global aspirations 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 Multinalional or

‘A-National’?,” Francesca Guerrera, Financial Times, August 16, 2007, p.7

produced for less Thus, by each country specializing in products for which it possessed absolute advantage, countries could produce more in total and exchange products—trade— for goods that were cheaper in price than those produced at home

David Ricardo, in his work On the Principles of Political Economy and Taxation published in 1817, sought to take the basic ideas set down by Adam Smith a few logical steps further Ricardo noted that even if a country possessed absolute advantage in the production

of two products, it might still be relatively more efficient than the other country in one good’s product than the other Ricardo termed this comparative advantage Each country would then possess comparative advantage in the production of one of the two products, and both countries would then benefit by specializing completely in one product and trading for the other

CHAPTER 1 Globalization and the Muhinational Enierprise

Although international trade might have approached the comparative advantage model during the nineteenth century, it certainly does not today, for a variety of reasons Countries

do not 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 Government 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 between countries, rather than only indirectly through traded goods and services This

direct flow occurs between related subsidiaries and affiliates of multinational firms, as well as

between unrelated firms via loans, and license and management contracts Even labor flows between countries such as immigrants (legal and illegal) within the European Union and other unions

Modern 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 development

competence, educational levels of available workers, energy resources, consumer demand for

brand name goods, mineral and raw material availability, access to capital, tax differentials,

supporting infrastructure (roads, ports, and communication facilities), and possibly others

Although the terms of trade are ultimately determined by supply and demand, the process by which the terms are set is different from that visualized in traditional trade theory

‘They are determined 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 United Kingdom to the United States, to Japan, to Hong Kong, to Taiwan, and to China The classical model of comparative advantage also did not 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,

remains an unrealistic limiting case, just as perfect competition is a limiting case in

microeconomic theory

Supply Chain Outsourcing: Comparative Advantage Today

Comparative advantage is still a relevant theory to explain why particular countries are most suitable for exports of goods and services that support the global supply chain of both MNEs and domestic firms The comparative advantage of the twenty-first century, however, is one that is based more on services, and their cross border facilitation by telecommunications and the Intermet 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

Many locations for supply chain outsourcing exist today Exhibit 1.2 presents a geographical overview of this modern 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

29011-0ã0P87 304 Global Outsourcing of Comparative Advantage

MNEs based in many industrial countries are outsourcing intellectual

functions to providers based in traditional emerging market countries

services compared to their own other industries Remember that it takes a relative advantage

in costs, not 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 MNEs and independent companies If you own a Hewlett- Packard computer and call the customer support center number for help, you are likely to reach a call center in India Answering your call will be a knowledgeable Indian software engineer or programmer who will “walk” you through your problem India has a large number of well-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 corner of the globe

From financial back-offices in Manila, to information technology engineers in Hungary, modern telecommunications now take business activities to labor rather than moving labor

to the places of business

Cc What Is Different about Global Financial Management?

Exhibit 1.3 details some of the main differences between international and domestic financial management These component differences include institutions, foreign exchange and political risks, and the modifications required of financial theory and financial instruments International financial management requires an understanding of cultural, historical, and institutional differences such as those affecting corporate governance Although both

CHAPTER 1 Globalization and the Multinational Enterprise

Each foreign country is unique and not aways

institutions understood by MNE management

Corporate governance Foreign countries’ regulations and institutional Regulations and institutions are well known

practices are all uniquely different

Foreign exchange risk MNEs face foreign exchange risks due to their Foreign exchange risks from import/export and

subsidiaries, as well as import/export and foreign _loreign competition {no subsidiaries)

competitors

Political risk MNEs face political risks because of their foreign Negligible political risks

- subsidiaries and high profile Modification of domestic MNEs must modify finance theories like capital ‘Traditional financial theory applies

finance theories budgeting and cost of capital because of foreign

complexities

Modification of domestic MNEs utilize modified financial instuments such as Limiled use of financial instruments and derivatives

financial instruments options, futures, swaps, and letters of credit because of fewer foreign exchange and political

MNEs also face other risks that can be classified as extensions of domestic finance

theory For example, the normal domestic approach to the cost of capital, sourcing debt and equity, capital budgeting, working capital management, taxation, and credit analysis needs to

be modified to accommodate foreign complexities Moreover, a number of financial instruments that are used in domestic financial management have been modified for use in international Snancial management Examples are foreign currency options and futures, interest rate and currency swaps, and letters of credit

The main theme of this book is to analyze how a multinational 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 domestic 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 multinational operations But first we need to clarify the unique value proposition and advantages which

the MNE was created to exploit

Market Imperfections: A Rationale for the Existence

of the Multinational Firm

MNEs strive to take advantage of imperfections in national markets for products, factors of production, and financial assets Imperfections in the market for products translate into market opportunities for MNEs Large international firms are better able to exploit such competitive factors as economies of scale, managerial and technological expertise, product

differentiation, and financial strength than are their local competitors In fact, MNEs thrive

best in markets characterized by international oligopolistic competition, where these factors are particularly critical In addition, once MNEs have established a physical presence abroad,

they are in a better position than purely domestic firms to identify and implement market

opportunities through their own internal information network

Why Do Firms become Multinational?

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

1 Market seekers produce in foreign markets either to satisfy local demand or to

export to markets other than their home market U.S automobile firms manufacturing in Europe for local consumption are an example of market-seeking

motivation Porsche, a European automaker 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

factors 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, German, Dutch, and Japanese firms have purchased 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,

Hong Kong firms invested heavily in the United Kingdom, Canada, the United

States, 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 market 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 that try to preempt a market before competitors can get established in it, or capture raw material sources and deny them to competitors

The Globalization Process

Trident is a hypothetical U.S-based firm that will be used as an illustrative example throughout the book to demonstrate the globalization process—the structural and managerial changes and challenges experienced by a firm as it moves its operations from domestic to global

Global Transition I: Trident Moves from the Domestic Phase

to the International Trade Phase

Trident is a young firm that manufactures and distributes an array of telecommunication devices Its initial strategy is to develop a sustainable competitive advantage in the US market 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 1.4 shows Trident

10

CHAPTER 1 Globalization and the Multinational Enterprise

Trident Corporation: Initiation of the Globalization Process

Phase One: Domestic Operations

Ali payments in U.S dollars

All credit risk under U.S law

Are Mexican suppliers Are Canadian buyers dependable? creditworthy?

Will Trident pay US$ or ‘Will payment be made

Mexican pesos? in US$ or C$?

Phase Two: Expansion into International Trade

Trident was founded by James and Edgar 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 investment 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 management sought to create value for its shareholders

As Trident became a visible and viable competitor in the U.S market, strategic opportunities arose to expand the firm’s market reach by exporting product and services to one or more foreign markets The North American Free Trade Area (NAFTA) made trade with Mexico and Canada attractive This second phase of the globalization process is shown

in the lower-half of Exhibit 1.4 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 management over and above the traditional requirements of the domestic-only business 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

N nh g

currencies As the value of currencies change from minute to minute in the global marketplace, 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 more important than ever Reducing the possibility of non-payment for exports and non-delivery

of imports becomes one of two main financial management 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 more 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 manufacturing operations abroad or by licensing foreign firms to produce and service Trident’s products The multitude of issues and activities associated with this second larger global transition is the true purpose of this book

Trident’s continued globalization will require it to identify the sources of its competitive 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 1.5 These alternatives include the creation of foreign sales offices, the licensing of the company name and everything associated with it, and

@ Trident's Foreign Direct Investment Sequence

12 CHAPTER 1 Globalization and the Muttinational Enterprise

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 markets increases Jt may now own its own distribution and production facilities, and ultimately, may want to acquire other companies 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 marketplace in which

capital may flow freely, capital will increasingly flow and support countries and companies

based on the theory of comparative advantage Since the mid-twentieth century this has indeed been the case as more and more countries have pursued 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 influence and self-enrichment of organizational

insiders

One possible representation of this process can be seen in Exhibit 1.6 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

XH tRỨT, The Poiential Limits of Financial Globalization

‘There is a growing debate over whether many of the insiders and rulers of organizations

with enterprises globally ase taking actions consistent with creating firm value or consistent

with increasing their own personal stakes and power

Actions of Ruters Higher Firm Value

of Sovereign Stales (possibly iower

4 insider value)

Lower Firm Value ¥

(possibly higher Actions of

insider value) To Comporate Insiders

If these influential insiders are building personal wealth over that 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, Stuiz, Journal of Applied Corporate Finance, Volume 19 Number 1, Winter 2007, pp 8~16

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

Stulz, Journal of Applied Corporate Finance, Volume 19, Number 1, Winter 2007, pp 8-15

throughout this book, this barrier to international finance may indeed be increasingly troublesome

This growing dilemma is also something of a composite of what this book is about The three fundamental elements —financial theory, global business, and management beliefs and actions—combine to present either the problem or the solution to the growing debate over the benefits of globalization to countries and cultures worldwide The mini-case on Porsche sets the stage for our debate and discussion Are the controlling family members of this company creating value for themselves or their shareholders?

SUMMARY POINTS

® The creation of value requires combining three critical

elements: 1) an open marketplace; 2) high quality

strategic management; and 3) access to capital

®# The basic theory, comparative advantage, and its

Tequirements should be considered for the explanation

and justification for international trade and commerce

& The theory of comparative advantage provides a basis

for explaining and justifying international trade in a

model world assumed to enjoy free trade, perfect

competition, no uncertainty, costless information, and

no government interference

@ International financial management requires an

understanding of cultural, historical, and institutional

differences such as those affecting corporate

governance

@ Although both domestic firms and MNEs are exposed

to foreign exchange risks, MNEs alone face certain

unique risks, such as political risks, that are not

normally a threat to domestic operations

@ MNEs strive to take advantage of imperfections in

national markets for products, factors of production,

and financial assets

“Yes, of course we have heard of shareholder value But

that does not change the fact that we put customers first,

then workers, then business partners, suppliers, and

dealers, and then shareholders.”

—Dr Wendelin Wiedeking, CEO, Porsche,

Die Zeit, April 17,2005

4% Large international firms are better able to exploit”

such competitive factors as economies of scale,

managerial and technological expertise, product

differentiation, and financial strength than are their local competitors

® A firm may first enter into international trade

transactions, then international contractual

arrangements such as sales offices and franchising, and

ultimately the acquisition of foreign subsidiaries It is at this final stage that it truly becomes a multinational

enterprise (MNE)

4 The decision whether or not to invest abroad is driven

by strategic motives, and may require the MNE to

enter into global licensing agreements, joint ventures,

cross-border acquisitions, or Greenfield Investments

If influential insiders in corporations and sovereign

states pursue their own personal agendas which may

increase their personal power, influence, or wealth,

then capital will not flow into these sovereign states and corporations In turn, this will create limitations to globalization in finance

Porsche Changes Tack’

Porsche had always been different Statements by Porsche leadership, like the one shown here, always made Veselina (Vesi) Dinova nervous about the company’s attitude

about creating shareholder value The company 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

1Copyright ©2007 Thunderbird School of Global Management Alll rights reserved This case was prepared by Professor Michael H Moffett for the purpose of classroom discussion only.

14 CHAPTER 1

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

presented Was Porsche continuing to develop an

organizational focus on shareholder value, or was it

returning to 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 retumed

the company to both status and profitability since taking

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 manufacturing 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 Piéch 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, participated 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 Germany, the United Kingdom,

and the United States, 14% were held by the Porsche and

Piếch families, and 36% were held by small private

investors As noted by the Chief Financial Officer, Holger

Hiirter, “As long as the two families hold on to their stock

portfolios, 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 independent

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 specific requirement of

Sarbanes-Oxley that senior management sign off on the

financial results of the company personally as being

Globalization and the Multinational Enterprise

inconsistent with German law (which it largely was) and illogical for management to accept Management had also Jong been critical of the practice of quarterly reporting, and had in fact been removed from the Frankfurt Exchange’s stock index in September 2002 because of its refusal to report quarterly financial results

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

reported record profits for the 10th consecutive year (see

Exhibit 1) Returns were so good and had grown so

steadily that the company had paid out a special dividend

of €14 per share in 2002, in addition to increasing the size

of the regular dividend There was a continuing concern that management came first In the words of one analyst

“ , we think there is the potential risk that management may not rate shareholders’ interests very highly.” The compensation packages of Porsche’s senior management team were nearly exclusively focused on current year profitability (83% of executive board compensation was performance-related pay), with no management incentives or stock option awards related to the company’s share price,

Porsche's Growing Portfolio

Porsche had three major vehicle platforms: the premier

Iuxury sports car, the 917; the competitively priced Boxster

roadster; and the recently introduced off-road sport utility vehicle, the Cayenne Porsche had also recently announced that it would be adding a fourth platform, the Panamera, which would be a high-end sedan to compete

with Jaguar, Mercedes, and Bentley

911 The 911 series was still the focal point of the Porsche

brand, but many believed that it was growing old and due

for replacement Sales had seemingly peaked in 2001/02, and failen back more than 15% in 2002/03 The 911 had always enjoyed nearly exclusive ownership of its market segment Prices continued to be high, and margins were some of the very highest in the global auto industry for production models The 911 was the only Porsche model that was manufactured and assembled in-house

Boxster The Boxster roadster had been introduced in

1996 as Porsche’s entry into the lower price end of the

sports car market The Boxster was also considered an anticyclical move because the traditional 911 was so 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 segment

Boxster sales volumes had peaked in 2000/01

Cayenne The third major platform innovation was

Porsche’s entry into the sports utility vehicle (SUV)

Note: EBIT = eamings before interest and tax

—— Operating Income (EBM)

2001 402 23 2005

28 Operating Margin (EBIT/Sales)

segment, the Cayenne Clearly at the top end of the

market (2002/03 Cayenne sales averaged more than

$70,000 each), the Cayenne had been a very quick success,

especially in the SUV-crazed American market It, was

considered the most successful new product Jaunch in

auto history The Cayenne’s success had been even more

dramatic given much pre-launch criticism that the market

would not support such a high-priced SUV, particularly

one that shared a strong bloodline with the Volkswagen

(VW) Touareg The Porsche Cayenne and VW Touareg

shared a common chassis, and in fact were both

manufactured at the same factory in Bratislava, Slovakia

Porsche shipped the Cayenne chassis to its facility in

Leipzig where the engine, drive train, and interior were

combined in final assembly

Panamera On July 27, 2005, Porsche announced that it

would proceed with the development and production of a

fourth major model—the Panamera The name was

derived from the legendary Carrera Panamericana long-

distance road race held for many years in Mexico The

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

sports coupe, and would compete with the premium sedan

models Pricing was expected to begin at $125,000, rising

to $175,000 Production was scheduled to begin in 2009 at

a scale of 20,000 units per year

The Most Profitable Automoblie

Company 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 retum 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, however,

had been the subject of substantial debate in recent years

as upwards of 40% of operating earnings were thought to

be derived from currency hedging, Porsche’s cost-base was

purely European euro; it produced in only two countries,

Germany and Finland, and both were euro area members

Porsche believed that the quality of its engineering and

16 CHAPTER 1 Giobalization and the Muttinational Enterprise

Retum on Invested Capital (ROIC) for

Operating Margin _ Sales EBIT Eurupean Autpmaker (wiliog) EBIT Taxes After-tax

‘Source: “European Autos," Deutsche Bank, July 20, 2005; *Porscha,” Deutsche Bank, September 26, 2005; Thomson Analytics: author estimates

“Invested Capital" = tolal stockholders’ equity + gross interest-bearing debi Capital tumover = sales / Invested capital ROXG (retum on invested capita)

= EBIT - taxes / Invested capital

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, 40%

US dollar, 10% British pound sterling, and 5% other

(primarily the Japanese yen and Swiss franc)

Porsche’s ieadership had undertaken a very aggressive

currency hedging strategy beginning in 2001 when the

euro was at a record low against the U.S dollar In the

following years these financial hedges (currency

derivatives) 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 unpredictable

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 2, was 15.15% This

was clearly superior to all other European automakers,

This ROIC reflected Porsche’s two-pronged financial

strategy: 1) superior margins on the narrow but selective

product portfolio and 2) leveraging the capital and

capabilities of manufacturing partners in the development

and production of two of its three products The company

had successfully exploited the two primary drivers of 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 2, 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 nurnover

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 2 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 (undistributed to

shareholders) and new debt issuances (raising 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 capital 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

Porsche's Velocity, Margin, and ROIC

Margin and ROIG

— Yekciy — ROIC {Operating Margin x Velocity) Operating Margin

‘Operating margin = (EBIT — Taxes}/(Sales)

invesied capital = Cash + Net working capital + Net fixed assets

accumulation of cash Vesi was concemed that using this

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

company’s actual performance Porsche’s minimal 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 €1

billion investment to design and manufacture the new

Panamera would be largely funded by the company itsel£

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 introductions, 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 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

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 approximately 30 per cent of Porsche’s sales volume In the words of Porsche's

President and CEO: “Making this investment, we seek to secure our business relations with Volkswagen and make a significant contribution to our own future plans

on a lasting, long-term basis.” Porsche is in a position to

finance the acquisition of the planned share in

Volkswagen through its own, existing liquidity After

careful examination of this business case, Porsche is confident that the investment will prove profitable for both parties.

18 CHAPTER †

The planned acquisition is to ensure that there

will not be a hostile takeover of Volkswagen by investors

not committed to Volkswagen’s long-term interests In

the words of Porsche’s President and CEO: “Our

planned investment is the strategic answer to this risk

We wish in this way to ensure the independence of the

Volkswagen Group in our own interest This ‘German

solution’ we are seeking is an essential prerequisite for

stable development of the Volkswagen Group and,

accordingly, for continuing our cooperation in the

interest of both Companies.”

—“Acquisition of Stock to Secure Porsche’s

Business,” Porsche AG (press release),

September 25, 2005

Porsche would spend approximately €3 billion to take

a 20% ownership position in VW This would make

Porsche VW’s single largest investor, slightly larger than

the government of Lower Saxony, It clearly eliminated

any possible hostile acquisitions that may have been on

the horizon (DaimlerChrysler was rumored to have been

interested in raiding VW) The announcement was met by

near universal opposition

The family linkages between the two companies were

well known Ferdinand K Piéch, one of the most

prominent members of the Piéch family, which along with

the Porsche family controlled Porsche, was the former

CEO (he retired in 2002) and still Chairman of

‘Volkswagen He was the grandson of Ferdinand Porsche,

the founder of Porsche Accusations of conflict of interest

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 Wulff, VW’s board member

representing the state of Lower Saxony where VW was

headquartered, publicly opposed the investment by

Porsche In the eyes of many, the move by Porsche was a

feturn to German corporate cronyism

For years, “Deutschland AG” was emblematic of the

cosy network of cross-shareholdings and shared non-

executive directorships that insulated Germany from

international capitalism Wendelin Wiedeking, Porsche's

chief executive, himself invoked the national angle,

saying this “German solution” was essential to secure

VW, Europe's largest carmaker, against a possible

hostile takeover by short-term investors

—“Shield for corporate Germany or a family

affair? VW and Porsche close ranks,” Financial

Times, Tuesday, September 27, 2005, p 17

Globalization and the Multinational Enterprise

Germany, although long known for complex networks

of cross-shareholdings, had effectively unwound most of these in the 1990s This move by Porsche and VW was seen

as more of a personal issue—Ferdinand Piéch—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 63 billion, this was an enormous investment 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 retums 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 Piéch 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 lumbering and struggling mass-producer? That was the question that some alarmed shareholders asked this week when Porsche, the world’s most profitable carmaker,

announced plans to buy 20% 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 fossilized German management A deal with friendly compatriots from Porsche might

rescue VW 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

Case Questions

1 What strategic decisions made by Porsche over recent years had given rise to its extremely high return on

invested capital?

*The resulting ownership structure of Volkswagen in October 2005 was: 18.53% Porsche; 18.2% State of Lower Saxony;

13.0% Volkswagen; 8.58% Brandes Investment Partners; 3.5% Capital Group; and 38.19% widely distributed.

2 ‘esi wondered if her position on Porsche might have

to distinguish between the company’s ability to

generate results for stockholders versus its

- willingness to do so What do you think?

Globalization and the MNE The term globalization

has become very widely used in recent years How

would you define it?

Globalization and Value Creation, What does an

MNE need in order for it to create value through the

globalization process?

Value Creation and the Concept of Capitalism How

does the concept of capitalism actually apply to the

globalization process of a business, as it moves from

elemental to multinational stages of development?

Theory of Comparative Advantage Define and

explain the theory of comparative advantage

Limitations of Comparative Advantage Key to -

understanding most theories is what they say and

what they don’t What are four or five key limitations

to the theory of comparative advantage?

Trident’s Globalization After reading this chapter’s

description of Trident’s globalization process, how

would you explain the distinctions between

international, multinational, and global companies?

Trident, tre MNE At what point in the globalization

process did Trident become a multinational

enterprise (MNE)?

‘Trident’s Advantages What are the main advantages

that Trident gains by developing a multinational

presence?

Trident’s Phases What are the main phases that

‘Trident passed through as it evolved into a truly

global firm? What are the advantages and

disadvantages of each?

Financial Globalization How do the motivations of

individuals, both inside and outside the organization

or business, define the limits of financial

globalization?

PROBLEMS

Comparative Advantage

Problems 1-5 illustrate an example of trade induced by

comparative advantage They assume that China and

3 Is pursuing the interests of Porsche’s controlling

families different from maximizing the returns to its

public share owners?

France each have 1,000 production units With one unit of production (a mix of land, labor, capital, and technology), China can produce either ten containers of toys or seven cases of wine France can produce either two containers of toys or seven cases of wine Thus, a production unit in

China is five times as efficient compared to France whene

producing toys, but equally efficient when producing wine Assume at first that no trade takes place China allocates

800 production units to building toys and 200 production units to producing wine France allocates 200 production

units to building toys and 800 production units to

producing wine

1

3

ChinaS dơneslc price - ˆ”

France's domestic price

Production and Consumption What is the

production and consumption of China and France without trade?

Specialization Assume complete specialization, where China produces only toys and France produces only wine What would be the effect on total production?

Trade at China’s Domestic Price China’s domestic Plice is ten containers of toys equals seven cases of

wine Assume China produces 10,000 containers of

toys and exports 2,000 containers to France Assume

France produces 7,000 cases of wine and exports

1,400 cases to China What happens to total production and consumption?

Trade at France’s Domestic Price France’s domestic Price is two containers of toys equals seven cases of

wine Assume China produces 10,000 containers of

toys and exports 400 containers to France Assume France in tum produces 7,000 cases of wine and exports 1,400 cases to China What happens to total

production and consumption?

Trade at Negotiated Mid-price The mid-price for

exchange between France and China can be calculated as follows:

What happens to total production and consumption?

20 CHAPTER 1 Globalization and the Multinational Enterprise

Luzon Industries—2007

Problems 6 through 10 are based on Luzon Industries

Luzon is a U.S-based multinational manufacturing firm,

with wholly owned subsidiaries in Brazil, Germany, and

China, in addition to domestic operations in the United

States Luzon is traded on the NASDAQ Luzon currently

has 650,000 shares outstanding The basic operating

characteristics of the various business units are as follows:

Braz = Germany China

$)_{reaks, RS) (euros, €) twa 0

$4,500 R$6,250 €4,500 2,500 income tax rate 35% 25% 40% 30%

Average

exchange rate

for period _ R9i.80/8 €0.7018/$ Y7.760/$

*6 Luzon Corporation’s Consolidated Earnings Luzon

T7

+9,

must pay corporate income tax in each country in

which it currently has operations

a After deducting taxes in each country, what are

Luzon’s consolidated earnings and consolidated

earnings per share in U.S dollars?

b What proportion of Luzon’s consolidated earnings

arise from each individual country?

c What proportion of Luzon’s consolidated earnings

arise from outside the United States?

Luzon’s EPS Sensitivity to Exchange Rates (A)

Assume a major political crisis wracks Brazil, first

affecting the value of the Brazilian reais and,

subsequently, inducing an economic recession within

the country What would be the impact on Luzon’s

consolidated EPS if the Brazilian reais were to fall to

R§2.00/$, with all other earnings and exchange rates

remaining the same?

Luzon’s EPS Sensitivity to Exchange Rates (B)

Assume a major political crisis wracks Brazil, first

affecting the value of the Brazilian reais and,

subsequently, inducing an economic recession within

the country What would be the impact on Luzon’s

consolidated EPS if, in addition to the fall in the value

of the reais to R$3.00/$, earnings before taxes in

Brazil felt as a result of the recession to R$5,800,000?

Luzon’s Earnings and the Fall of the Dollar, The U.S

dollar has experienced significant swings in value

against most of the world’s currencies in recent years

10

a What would be the impact on Luzon’s con- solidated EPS if ali foreign currencies were to

appreciate 20% against the U.S dollar?

b What would be the impact on Luzon’s

consolidated EPS if all foreign currencies were to

depreciate 20% against the U.S dollar?

Note: Calculate the percentage changes by dividing the initial currency value by (J + the percentage change) to calculate the new currency value

Luzon’s Earnings and Global Taxation All MNEs attempt to minimize their global tax liabilities Return to the original set of baseline assumptions

and answer the following questions regarding

Luzon’s global tax liabilities

a What is the total amount—in U.S dollars—which

Luzon is paying across its global business in corporate income taxes?

b What is Luzon’s effective tax rate on a global basis (total taxes paid as a percentage of pre-tax

profits)?

c What would be the impact on Luzon’s EPS and

global effective tax rate if Germany instituted a

corporate tax reduction to 28%, and Luzon’s

eamings before tax in Germany rose to

£5,000,000?

INTERNET EXERCISES

1, International Capital Flows: Public and Private Major multinational organizations (some of which

follow) attempt to track the relative movements and

magnitudes of global capital investment Using the

following Web pages and others, prepare a two-page

executive briefing on the question of whether capital generated in the industrialized countries is finding its way to the less developed and emerging markets Is there some critical distinction between “less developed” and “emerging”?

The World Bank www.worldbank.org/ OECD www.oecd org!

European Bank for Reconstruction www.ebrd.org/

International Management and Strategy Consultan- cies The management consulting industry has been one of the primary resources utilized by MNEs throughout the world in the 1990s to design and develop their corporate strategies The following Web Pages provide some insight into the industry, the job opportunities available for professionals in

consulting, as well as some interesting features such and find the decomposition of external debt for

as the Boston Consulting Group’s online interactive Brazil, Mexico, and the Russian Federation:

case study: ‘The World Bank www.worldbank.org/data

A.T Kearney wwwatkeamey.com/

100,000 Bain and Company www.rec.bain.com/

Booze, Allen & Hamilton wwwbah.com/ 90,000 k

Boston Consulting Group wwwbcgcom/

80,000 :

McKinsey & Company www.mckinsey.com/

40,000 -

External Debt The World Bank regularly compiles 20,000 :

and analyzes the external debt of all countries °

globally As part of their annual publication on World 0 nce | â a

Development Indicators (WDI), they provide er 2004 2003-2002

summaries of the long-term and short-term external BB Long-lerm dent Short-term debt —— bdemai debL debt obligations of selected countries online like that

of Poland shown here Go to the following Web site Country: Potand; Data are in millions

2

Financial Goals and Corporate Governance

Gerald L Storch, CEO of Toys ‘R’ Us, says all CEOs share the

same fundamental goals: enhance the value for the customer, maxi- mize return to the shareholders, and develop a sustainable compet- itive advantage “Largely, I believe that the differences are more subtle than what I’ve read in many articles On a day-to-day basis, I

do the same thing I get to work every morning I try to make the

company better.”

—*Public Vs Private,” Forbes, September 1, 2006

This chapter examines how cultural, legal, political, and institutional differences affect a

firm’s choice of financial goals and corporate governance

Who Owns the Business?

We begin our discussion of financial goals by asking a sequence of two basic questions: 1) who owns the business? and 2) do the owners of the business manage the business them- selves? Most companies are created by entrepreneurs who are either individuals or a small set of partners In either case they may be the members of a family (Do not forget that even Microsoft started its existence as the brain-child of two partners, Bill Gates and Paul Allen.)

As shown in Exhibit 2.1, companies begin on the left-hand side as ownership version A, a

100% privately held business

Over time, however, some firms may choose to go public via an initial public offering,

or IPO Typically, only a relatively small percentage of the company is initially sold to the public, resulting in a company that may still be controlled by a small number of private investors, but who also have public shares outstanding, which are generating a market- based share price on a daily basis This is ownership version B, as shown in Exhibit 2.1

Whether the ownership structure ever actually moves from version B to C or D is very case specific Some companies may sell more and more of their equity interests into the public marketplace, possibly eventually becoming totally publicly traded Or the private owner or family may choose to retain a major share but does not have explicit control

Possibly, as has been the case in recent years, a firm that has reached ownership versions C

TH Who Owns the Business?

‘Who owns the business—whetier it’s privately held or publicly traded —has a significant

impact on the relationship between ownership and operational ownership

A B hủ D

20%

Publicly Traled 80% N idely held? uhinly

(widely held?) raded

(widely held?) 100% 100%

leki Traded family?) 80% (widely held?)

Privately

i wy

family) Held

(farnily?)

‘Although most businesses begin their lives as 100% privately held, often by a family, some firms

go public gradually Often selling only 20% equity interest publicly at first, some seit greater and

greater equity interests to the public markets, possibly becoming 100% publicly iraded

Recently, however, many fis in the US and UK markets have begun somewhat reversing the

process, with private equity funds buying all outstanding shares, taking the firm private once more

or D may move back toward B or even A as the company becomes owned outright by a pri-

vate owner For example, in late 2005 a very large private firm, Koch Industries (U.S.), purchased all outstanding shares of Georgia-Pacific (U.S.), a very large publicly traded forest products company Koch took Georgia-Pacific private

An added consideration is that even when the firm’s ownership is publicly traded, it may still be controfled by a single investor or a small group of investors, including major institu- tional investors This means that the control of the company is much like the privately held company, and therefore reflects the interests and goals of the individual investor And as shown in Global Finance in Practice 2.1, family controlled firms all over the world, including France, may outperform publicly traded firms

As discussed in the “Corporate Governance” section later in this chapter, something else

of significance results from the initial sale of shares to the public: the firm becomes subject

to many of the increased legal, regulatory, and reporting requirements in most countries sur- rounding the sale and trading of securities In the United States, for example, going public means the firm will now have to disclose a sizable degree of financial and operational detail, publish this information at least quarterly, comply with Securities and Exchange Commission (SEC) rules and regulations, and comply with all the specific operating and reporting requirements of the specific exchange on which it is traded Obviously, the move to public trading of shares comes with a lot of luggage!

Separation of Ownership from Management

“The change in ownership from version A to B or C or D in Exhibit 2.1 carries with it another major change—the possibility that the firm is managed by hired professionals, not owners This raises the possibility that ownership and management may not be perfectly aligned in their business and financial objectives, the so-called agency problem

24 CHAPTER 2 Financial Goals and Corporate Governance

Translation: “Why do family firms outperform the CAC 40

index?”

Among the major industrial countries, France has the

highest number of family businesses (about 65% oí the CAO

40 firms are family owned versus only about 24% in the UK)

This includes Bouygues, Dassault, Michelin and Peugeot

‘Over the 1990-2006 period, French family firms generated a

639% return to their owners, whereas the major French

Family Controtled Firms in France Outperform the Public Sector

index, the CAC 40, returned only 292% This family owned firm dominance is attributed to three factors: 1) they focus on

the long-term; 2) they stick to their core business; and 3) because the owners are closer to management, fewer con-

flicts arise between management and ownership (fewer

agency problems in the terminology of Finance)

‘Source: Le Figaro, June 2007

trolling shareholders are as follows:

Government (for example privatized utilities)

% ~~ Institutions (such as banks in Germany)

®& Family (such as in France and Asia) Consortiums (such as keiretsus in Japan and chaebols in South Korea)

Control is enhanced by ownership of shares with dual voting rights, interlocking direc-

torates, staggered election of the board of directors, takeover safeguards, and other tech-

niques not used in the Anglo-American markets However, the recent emergence of huge

equity funds and hedge funds in the United Kingdom and the United States has led to the privatization of some very prominent publicly traded firms

What Is the Goal of Management?

As Trident becomes more deeply committed to multinational operations, a new constraint develops—one that springs from divergent worldwide opinions and practices as to just what the firms’ overall goal should be from the perspective of top management, as well as the role

of corporate governance