DAY 1

Global Financial Environment

The Globalization Process

Learning Objectives
Consider how globalization process moves a business
from domestic focus to financial relationships and
composition global in scope
The implications of phase one of globalization the
international trade phase on the risks and rewards of
a business
Examine process as it moves from international trade
to multinational operations

The Globalization Process

Learning Objectives
Discover three major currency exposures that arise
from doing business on a multinational level
How globalization affects corporate governance and
the creation of value for stakeholders

The Globalization Process

The globalization process is the structural and
managerial changes and challenges experienced by a
firm as it moves from domestic to global in
operations

Global Transition I
Trident moves from the domestic phase to the
international trade phase

The Globalization Process

Phase One: Domestic Operations
U.S. Suppliers
(domestic)

All payments in US dollars;

All credit risk under U.S. law

Trident Corporation
(Los Angeles, USA)

U.S. Buyers
(domestic)

The Globalization Process

Trident may not be global or international itself, yet

its competitors, suppliers and buyers may be working

across borders
This is often a key driver to push a firm like Trident
into first phase international trade

The second half of this phase is the international trade

phase

The Globalization Process

Phase Two: Expansion into International Trade

Trident Corporation
(Los Angeles, USA)

Mexican Suppliers
Are Mexican suppliers dependable?
Will Trident pay US$ or Mexican pesos?

Canadian Buyers
Are Canadian buyers creditworthy?
Will payment be made in US$ or C$?

Trident Corp: Initiation of Globalization

Phase One: Domestic Operations
U.S. Suppliers
(domestic)

All payments in US dollars;

All credit risk under U.S. law

U.S. Buyers
(domestic)

Trident Corporation
(Los Angeles, USA)

Mexican Suppliers
Are Mexican suppliers dependable?
Will Trident pay US$ or Mexican pesos?

Canadian Buyers
Are Canadian buyers creditworthy?
Will payment be made in US$ or C$?

Phase Two: Expansion into International Trade

The Globalization Process

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

The Globalization Process

Global Transition II
The move from the international trade phase to the
multinational phase
If Trident is successful in international trade then the
time will come for the next step in the globalization
process
Trident will eventually need to establish foreign sales
and services affiliates
This step is followed by the establishment of
manufacturing operations or licensing agreements
abroad

The Globalization Process

Global Transition II
Tridents continued globalization will require it to
identify the sources of it competitive advantages
This variety of strategic alternatives available to
Trident is called the foreign direct investment
sequence

These alternatives include the creation of foreign sales

offices, licensing agreements, manufacturing, etc.

Once Trident owns assets and enterprises in foreign

countries it has entered the multinational phase of
globalization

Foreign Direct Investment Sequence

Trident and its
Competitive Advantage

Change
Competitive Advantage

Greater Foreign Presence

Exploit Existing Competitive

Advantage Abroad

Production at Home:
Exporting

Production Abroad

Licensing
Management Contract

Greater
Foreign
Investment

Joint Venture

Greenfield
Investment

Control Assets
Abroad

Wholly-Owned
Subsidiary

Acquisition of a
Foreign Enterprise

Foreign Exchange Exposure

Due to the fact that more cash flows are denominated in

foreign currencies, Trident and other corporations must
manage these new exposures

There are three main foreign exchange exposures that must be

managed by multinationals
Transaction Exposure comes from cash flows associated from
payments and receivables in foreign currencies
Operating Exposure comes from the changes in cash flows caused
by an unexpected exchange change in exchange rates
Translation Exposure is an accounting exposure associated with
the restatement of foreign currency denominated financial
statements

Foreign Exchange Exposure

Moment in time when
exchange rate changes

Accounting exposure
Changes in reported owners equity
in consolidated financial statements
caused by a change in exchange rates

Operating exposure
Changes in cash flows due to
unexpected changes in exchange rates

Transaction exposure
Impact of settling outstanding obligations entered into before change
in exchange rates but to be settled after change in exchange rates
Time

Financing the Global Firm

The Globalization Process

Trident responds to globalization factors by importing inputs from

Mexican suppliers and making exports sales to Canadian buyers

This stage is called the international trade phase

Exporting and importing products increases the demands and requirements

of a domestic only business
The first is direct foreign exchange risks borne by Trident
Trident may have to quote prices and receive payments in foreign currencies

As Trident prospers at home and abroad, it confronts a constraint on

further growth access to cheap and plentiful capital

This can be overcome by accessing global debt and equity markets while
maintaining an optimal financial structure
The strategy of globalizing the cost & availability of capital is a critical one
for firms wishing to reach true global competitiveness

Foreign Investment Decisions

Foreign investment decisions combine both strategy

and finance
This strategy of expanding operations abroad leads to
a corporations transition into a multinational
enterprise

An MNE is defined as a firm that has operating

subsidiaries in countries outside of its home
production and market

These firms also face evaluation of foreign located

projects using a capital budgeting framework

Foreign Investment Decisions

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

Foreign Investment Decisions

Trident Europe

Trident Brazil

Trident China

(Hamburg, Germany)

(So Paulo, Brazil)

(Shanghai, China)

Greenfield
Investment

Cross-Border
Acquisition Investment

Joint Venture
Investment

Trident Corporation
(Los Angeles, USA)

Greenfield
Investment

Cross-Border
Acquisition

A long-term physical
investment in productive
capability in that country

Identification, valuation,
tender, and post-acquisition
management of an existing
going-concern

Joint Venture
Investment
Combining investment
capital and managerial
know-how to reach
specific opportunities

Foreign Investment Issues

Other issues that firms face when expanding abroad
are

Corporate Governance the different corporate

cultures encountered when dealing with firms abroad
Global Portfolio Diversification the management of
the risks and rewards needed to understand the various
foreign operations and their affects on the domestic
firms results

Managing Multinational Operations

Thus far the focus on Tridents expansion into international

markets has been on operations and financing, but the issue of
management has not been addressed
Trident must also address the issue of maximizing
shareholder value

Trident must minimize its worldwide burden of taxation

Through transfer pricing (the prices charged on sales of goods
between units of Trident itself globally), Trident can reduce its
global tax liabilities
Trident can also assess charges from the parent (US) to the
subsidiaries (foreign) in the form of license fees and royalties
Trident must also consider the cash flow effects of blocked funds
(governmental regulations that hinder the movement of capital out
of a country)

The Goal of Management

Two different points of view on the goal of
management

The Anglo-American markets believe that a firms

objective should be to maximize shareholder wealth
These countries include the US, Canada, Australia,
United Kingdom

Shareholder believes that markets are efficient and that

prices are correct
Follow financial theory about markets efficiency,
systematic and unsystematic risk

The Goal of Management

The Continental European and Japanese markets
believe that a firms objective should be to maximize
corporate wealth
These countries include the EU, Japan and Latin
American countries

Definition of corporate wealth is broader than AngloAmerican viewpoint that wealth is strictly financial
A corporations role in wealth maximization includes
the firms technical, market and human resources
Considerations as to the implications of strategic moves
affecting all parties, human resources, towns, state, etc.

The Goal of Management

Impatient Capital
Shareholders

Firm
(management)

Banks

Employees

The Anglo-American Model has been

frequently criticized as focusing on
short-term profitability rather than
long-term growth.

Patient Capital
Shareholders

Main Bank

Firm
(management)

The Non-Anglo-American Model

has come under increasing criticism
for its lack of accountability to equity
investors its shareholders while
focusing on the demands of too
diffuse a group of stakeholders.

Corporate Governance
These two approaches focus around the issue of
corporate governance

Corporate Governance is the method by which an

organization establishes order among various

stakeholders to ensure that decisions are made and
interests are represented in line with the firms stated
objectives
These include failures (Enron), poor performance
(AT&T), and emerging markets (China)

As a result, companies are moving towards model of

one share, one vote in their corporate structures

The MNC and its Environment

In recent years, international finance has become an

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

Long-Term Investment
and Financing Decisions (cont.)

Capital Structure

Because of their greater access to capital, MNCs have lower

costs of long-term financing.

Some studies have suggested that MNCs have higher debt ratios,
while other studies have found the opposite to be true.

Part of this might be explained that MNCs based in different

countries and regions may have access to currencies and
markets, resulting in variances in capital structures for these
MNCs.

The MNC and its Environment (cont.)

The MNC and its Environment (cont.)

During the 1990s, three important trading

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

The MNC and its Environment (cont.)

In 1991, the Mercosur Group of South America, including the

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

The MNC and its Environment:

Legal Forms of Business

In many countries outside the U.S., operating foreign

subsidiaries can take two forms similar to a U.S. corporation.
In German-speaking nations, the two forms are the
Aktiengesellschafts (A.G.) or the Gesellschaft mit beschrankter
Haftun (GmbH).
In many other countries, the similar forms are Societe
Anonymes (S.A.) or Societe a Responsibilite Limitee (S.A.R.L.).

The MNC and its Environment:

Legal Forms of Business (cont.)

One major difference however, is that it is often essential to

enter into joint-ventures with private investors or with
government-based agencies in the host country.
Such joint-venture laws can result in a substantial degree of
management control by host countries and may result in
disagreements among the partners as to the distribution of
profits, the portions to be allocated for reinvestment, and the
remittance of profits.

The MNC and its Environment: Financial

Markets

During the past two decades the Euromarketwhich

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

The MNC and its Environment: Financial

Markets

In addition, a variety of new financial instruments including currency and

interest rate swaps, forward contracts, options contracts, and international
commercial paper have been created to facilitate international trade and
finance.

The Euromarket is still dominated by the U.S. dollar.

However, other currencies such as the Euro, Swiss Franc, Japanese Yen,
and British Pound have increased in importance.

Risk: Exchange Rate Risk

Exchange rate risk is the risk caused by varying exchange

rates between two currencies.
The foreign exchange rate between the U.S. dollar (US$) and
Swiss Franc (SF) is expressed as follows:

US$1.00
= SF1.4175
The usual exchange
rate quotation
in international markets is
given as SF1.4175/US$.
SF1.00 = US$0.7055

Risk: Exchange Rate Risk (cont.)

Under the current system of floating exchange rates, the

value of any two major currencies with respect to one another
is allowed to fluctuate on a daily basis.

For smaller country currencies, however, exchange rates are

fixed or semi-fixed with respect to one of the major
currencies.

The spot exchange rate is the rate of exchange between any

two currencies on a given day.

Risk: Exchange Rate Risk (cont.)

The forward exchange rate is the rate of exchange between two currencies
at some specific future date.

These rates and their relationships can be described as shown in Figure

18.2 on the following slide.

Although a number of factors can influence exchange rate movements, by

far the most important influence is differing inflation rates between two
currencies, where the currency with the higher rate of inflation will decline
relative to the country with the lower rate.

Insert Figure 18.2 here

Risk: Exchange Rate Risk (cont.)

Although several economic and political factors influence

foreign exchange rate movements, by far the most important
explanation for long-term changes is differing inflation
between
two countries.
Countries that experience high inflation rates will see their
currencies decline in value (depreciate) relative to the
currencies of countries with lower inflation rates.

Risk: Exchange Rate Risk (cont.)

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

Risk: Exchange Rate Risk (cont.)

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

Risk: Exchange Rate Risk (cont.)

Multinational companies face exchange rate risk under either fixed or

floating-rate systems.
Consider the following floating-rate example.

MNC, Inc. a multinational manufacturer of dental drills, has

a subsidiary in Great Britain (U.K.) that at the end of 2006
had the financial statements shown in Table 18.3. The
figures for the balance sheet and income statement are
given in the local currency, British Pounds (). Using an
exchange rate of 0.70/US$ for December 31, 2006, MNC
has translated the statements into U.S. dollars.

Risk: Exchange
Rate Risk (cont.)

Risk: Exchange Rate Risk (cont.)

It is also useful to describe the difference between accounting

exposure and
economic exposure.
Accounting exposure is the risk resulting from the effects of
changes in foreign exchange rates on the translated value of a
firms financial statements.
Perhaps more importantly, economic exposure is the risk
resulting from the effects of changes in foreign exchange rates
on the firms value.

Risk: Exchange Rate Risk (cont.)

In general, it is possible for management to insure

against these risks and exposures through hedging.

The decision as to whether management will hedge
and the extent to which they do depends largely upon
managements attitude toward risk.

Risk: Political Risks

Political risk results from the discontinuity or seizure of an

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

Risk: Political Risks (cont.)

Although many least developed and developing nations present great

opportunities for MNCs, these nations are also more unstable and more
politically risky than their developed nation counterparts.

Table 18.4 on the following slide shows some of the approaches that
MNCs use to cope with political risk.

The negative approaches are generally used by firms in attractive

industries such as oil, gas, and mining.

The best approaches are positive approaches, which have, which have
both economic and political aspects.

Risk: Political Risks (cont.)

Long-Term Investment
and Financing Decisions

Foreign Direct Investment

Foreign Direct Investment (FDI) is the transfer of capital,

managerial, and technical assets from an MNCs home country to

a host country.

An MNC can be a 100% equity participant (resulting a wholly-

owned subsidiary) or less (leading to a joint venture project with

foreign participants).

FDI projects are subject not only to business, financial, inflation,

and exchange rate risk, but also to the additional element of
political risk.

Long-Term Investment
and Financing Decisions (cont.)

Investment Cash Flows and Decisions

A number of factors must be considered when estimating cash

flows in foreign projects.
First, elements relating the parent companys investment in a
subsidiary and the concept of taxes must be considered.
Also, the parent must consider the risk that the repatriation of
cash flows will be blocked.
Finally, the risk of international cash flows must also be
considered.

Long-Term Investment
and Financing Decisions (cont.)

Long-Term Debt

An international bond is a bond that is initially sold outside the

country of the borrower and often distributed in several
countries.

A foreign bond is an international bond that is sold primarily in

the country of the currency of issue.

A Eurobond is an international bond that is sold primarily in

countries other than the country of the currency in which the
issue is denominated.

Long-Term Investment
and Financing Decisions (cont.)

Equity Capital

One way for MNCs to raise equity is the have the parents stock
distributed internationally and owned by shareholders in
different countries.

In recent years, the Euroequity market has continued to evolve

and develop.

The Euroequity market is the capital market around the world

that deals in international equity issues.

London has become the center of Euroequity activity.

Short-Term Financial Decisions

Like purely domestic firms, MNCs have access to accounts

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

Short-Term Financial Decisions (cont.)

The Eurocurrency market is the portion of the Euromarket

that provides short-term, foreign-currency financing to
subsidiaries of MNCs.

Unlike borrowing in domestic markets, where only one

currency and a nominal interest rate is involved, financing in
the Euromarket may involve several currencies and both
nominal and effective interest rates.

Short-Term Financial Decisions (cont.)

Effective interest rates in the international context, is the rate equal to the
nominal rate plus (or minus) any forecast appreciation (or depreciation) of
a foreign currency relative to the currency of the MNC parent.

A multinational plastics company, International Molding, has

subsidiaries in Switzerland (Swiss Franc, SF) and Japan (Japanese
Yen, ). Based on each subsidiarys forecast operations, the shortterm financial needs (in US$) are as follows:
Switzerland: $80 million excess cash to be invested (lent)
Japan: $60 million funds to be raised (borrowed)

Short-Term Financial Decisions (cont.)

On the basis of all available information, the parent firm has
provided each subsidiary with figures given as shown below:

Short-Term Financial Decisions (cont.)

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

Short-Term Financial Decisions:

Cash Management

In its international cash management, the MNC can

respond to exchange rate risk by hedging its

undesirable cash and marketable securities exposures
or by certain adjustments in its operations.
Hedging strategies are techniques used to offset or
protect against risk.
These strategies are summarized in
Table 18.5 on the following slide.

Short-Term Financial Decisions:

Credit and Inventory Management

Because MNCs compete for the same global markets, it is

essential that they offer attractive credit terms to potential
customers.

With respect to inventory management, MNCs must consider a

number of factors related to both economics and politics,
including exchange rate fluctuations, tariff and non-tariff
barriers, and varying laws and regulations.

Mergers and Joint Ventures

International mergers and joint ventures, especially those

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

Mergers and Joint Ventures (cont.)

Foreign direct investments (FDI) in the U.S. have also gained

popularity in recent years.

Most FDI comes from Britain, Canada, France, the

Netherlands, Japan, Switzerland, and Germany and is
concentrated in manufacturing, petroleum, and trade/service
sectors.

Developing countries, too, have been attracting FDI and a

number of these nations have adopted specific policies and
regulations aimed at controlling the inflows of foreign
investments.

Summary of Learning Objectives

Financial management is an integral part of a firms strategy.

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

Summary of Learning Objectives

Three major currency exposures arising from the conduct of

multinational business that impact all firms are transaction,
operating and translation exposure
The definitions of return and risk are not universally accepted.
Indeed they may be culturally-denominated norms that vary by
country
In Anglo-American markets, shareholder wealth maximization
model is the norm. In non-Anglo-American markets, the
corporate wealth model is the norm. Distinct differences exist
as to how these models treat return and risk

Summary of Learning Objectives

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