Multinational business finance 13e

n We have integrated emerging market content, highlighting both the promise and challenges of financial management in a global marketplace where the future likely rests with these count

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As the field of multinational financial management has evolved, so has the content of

Multina-tional Business Finance Both institutions and markets are changing, and as a result, this edition focuses on the multitude of financial management challenges faced by the business leaders of tomorrow, with three points of emphasis

n Organizations of all kinds Multinational enterprises (MNEs) applies to organizations

of all kinds—publicly traded, privately held, state-run, and state-owned enterprises (SOEs)—all forms that permeate global business today

n Emerging markets Firms from all countries and all markets are looking to the

economic drivers of the global economy today, the emerging markets These country markets present many specific risks, opportunities, and challenges for business and multinational finance

n Financial leadership The leaders of MNEs face numerous foreign exchange and

political risks These risks can be daunting; but if properly understood, they present opportunities for creating value These risks and opportunities are most effectively understood in the context of the global business itself, and the ability of management

to integrate the strategic and financial challenges that business faces

The success of all multinationals, however, continues to depend on their ability to recognize and benefit from imperfections in national markets for products, production factors, and financial assets As in previous editions, we perceive the multinational enterprise to be a unique institution that acts as a catalyst and facilitator of international trade, and as an important producer and distributor in host countries where its subsidiaries are located

Audience

Multinational Business Finance, thirteenth 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 or graduate level as well as in executive education courses

A prerequisite course or experience in corporate finance or financial management is ideal However, we review the basic finance concepts before we extend them to the multinational case We also review the basic concepts of international economics and international business.Over many years and many editions, as language translations and sales have expanded,

we have observed a widening global audience for this book We continue to try to service this greater global audience with multicountry companies and markets in theoretical applications,

examples, Mini-Cases, and Global Finance in Practice features, as seen in the business and

news press (including anecdotes and illustrations)

Organization

This edition of Multinational Business Finance is more concise, but it includes several new

subjects We accomplished this by integrating a number of previous topics along financial management threads The book comprises six parts, unified by the common thread of the

globalization process by which a firm moves from a domestic to a multinational business orientation.

n Part 1 introduces the global financial environment

n Part 2 explains foreign exchange theory and markets

n Part 3 analyzes foreign exchange rate exposure

n Part 4 explores the financing of the global firm

n Part 5 analyzes foreign investment decisions

n Part 6 examines the management of multinational operations

New in the Thirteenth Edition

Although we hesitate to use a common tag line, the thirteenth edition could be called the

new normal Today, the developed or industrialized countries see slower growth, poorer job opportunities, and a growing insecurity about their competitiveness in the global marketplace, while the rapidly expanding emerging markets and their major players represent an increas-ingly larger piece of the global pie

In this new world, the MNEs not only depend on the emerging markets for cheaper labor, raw materials, and outsourced manufacturing, but also they increasingly depend on those mar-kets for sales and profits These markets—whether they are labeled as BRICs (Brazil, Russia, India, China) or some other popular label—represent the majority of the earth’s population and therefore consumers These markets are also home to many of the world’s most rapidly developing multinational enterprises

We have attempted to capture this evolution through a number of principles, practices, and features:

n We have increased the clarity of principles and practices at the core of multinational finance—to accentuate the purpose behind the book’s title

n We have integrated emerging market content, highlighting both the promise and challenges of financial management in a global marketplace where the future likely rests with these countries, cultures, and their new players

n We have expanded our coverage of global financial crises to go beyond the credit crisis of 2007–2009 to the current sovereign debt and financial crisis raging across Europe

n We have presented 12 new Mini-Cases The majority are inclusive of emerging

mar-ket business The Global Finance in Practice features follow the same themes.

To create a shorter, succinct text for today’s more complex courses, we have merged and integrated some concepts and chapters, and we have revised other chapters

n Chapters on currency derivatives—futures, options, and swaps—have been combined

to facilitate study

n Chapters on translation exposure and operating (economic) exposure have been revised to capture industry’s growing interest and concern about these currency-based company exposures

n Chapters on the financial structures and capital sourcing strategies employed

by multinational firms have been restructured and reorganized for a tighter presentation

A final note on style The subject of international finance is sophisticated, evolving, and rich in history We have tried to bridge the past and future by using a mix of currency nota-tions and symbols, including both the increasingly common three-letter currency codes—USD, CNY, GBP, EUR—and the currency symbols of the past—$, ¥, £, €—which live on in mod-ern media Who knows, we may be re-introducing historical currency designations like the drachma and lira in future editions!

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 All instructor resources are available for down-load from the online catalog page for this book (www.pearsonhighered.com/irc)

n Instructor’s Manual The Online Instructor’s Manual, prepared by the authors,

con-tains answers to Case questions and end-of-chapter questions Excel® solutions for the 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 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

n Test Bank The Test Bank, prepared by Curtis J Bacon of Southern Oregon

Uni-versity, contains more than 700 multiple choice and true/false questions The multiple choice questions are labeled by topic and category—recognition, conceptual, and ana-lytical The test bank is available for download from the Instructor Resource Center

n 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 http://wpslive.pearsoncmg com/cmg_instructor_testgen_1/

n PowerPoint Presentation The PowerPoint presentation slides, prepared by Curtis

J Bacon of Southern Oregon University, provide lecture outlines and selected ics from the text for each chapter The PowerPoint presentation is also available for download from the Instructor Resource Center

(www.pearsonhighered.com/eite-man) contains access to chapter exhibits, Internet exercises, and glossary flashcards Instructors have access to spreadsheet solutions for all problems from the Instructor Resource Center

International Editions

Multinational Business Finance is used throughout the world to teach students of international finance More than two-thirds of the book’s sales volume now occurs outside North America, which is distinct considering that it is used at more than 200 universities in North America alone It is published in a number of foreign languages including Chinese, French, Spanish, Indonesian, Portuguese, and Ukrainian

Acknowledgments

We are very thankful for the many detailed reviews and suggestions from numerous leagues, including chapter reviews and answers to a comprehensive questionnaire by more

col-than 100 adopters and nonadopters The final version of Multinational Business Finance

reflects most of these suggestions The survey reviewers were anonymous; the detailed reviewers were as follows:

Yong-Cheol Kim, University of

Wisconsin-Milwaukee

Yen-Sheng Lee, Bellevue University

Robert Mefford, University of San Francisco John Petersen, George Mason University Rahul Verma, University of Houston-Downtown

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

Green Mountain College

Yoon Shik Park

George Washington University

Harvey Poniachek

New York University

Yash Puri

University of Massachusetts at Lowell

Sheryl Winston Smith

Industry (present or former affiliation)

First Interstate Bank of Oregon

Inevitably woven into the fabric of our book are ideas received from faculty and students at institutions all over the world where we have taught:

n Our home universities of University of California, Los Angeles; Oregon State versity; University of Hawaii; and Thunderbird

Uni-n Our visiting stints at the Hong Kong University of Science and Technology; sity 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 Admin-istration, Finland; Indian School of Business, Hyderabad; Institute for the Devel-opment of Executives, Argentina; National University of Singapore; International Centre for Public Enterprises, Yugoslavia; Beijing Institute of Chemical Engineering and Management, China; and Dalian University of Science & Technology, China

Univer-n Consulting assignments in Argentina, Belgium, Canada, Denmark, Finland, mala, Hong Kong, Indonesia, Japan, Kazakhstan, Malaysia, Mexico, the Netherlands, Norway, People’s Republic of China, Peru, Singapore, Sweden, Taiwan, the United Kingdom, and Venezuela.

Guate-We want to thank some key individuals from Pearson who have worked diligently on this thirteenth edition: Donna Battista, Jill Kolongowski, Emily Biberger, Meredith Gertz, and Jill Dougan Jen Roach, from PreMedia Global, also provided much-appreciated assistance

In addition, Gillian Hall, our outstanding project manager at The Aardvark Group, deserves our utmost gratitude

Finally, we dedicate this book to our parents, the late Wilford and Sylvia Eiteman, the late Harold and Norma Stonehill, and Bennie Ruth and the late Hoy Moffett, who gave us the motivation to become academicians and authors We thank our wives, Keng-Fong, Kari, and Megan, for their patience through the years as we prepared this edition

Pacific Palisades, California D.K.E

Arthur I 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 the 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 western 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 Univer-sity of California, Berkeley (1965) He was awarded honorary doctorates from the Aarhus School of Business (Denmark, 1989), the Copenhagen Business School (Denmark, 1992), and Lund University (Sweden, 1998)

He has authored or coauthored nine books and twenty-five other publications His

articles 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,

Euro-pean Management Journal , The Investment Analyst (U.K.), Nationaløkonomisk Tidskrift

(Denmark) , Sosialøkonomen (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 Eco-nomics 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 ics and Management in China, and Western Finance Association

Econom-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

articles 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 in Finance at the 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 Univer-sity 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

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 (Eco-nomics) from the University of Colorado, Boulder (1983); and 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

Interna-tional Financial Management and Accounting , Contemporary Policy Issues, Brookings

Dis-cussion 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 in multinational business with Michael Czinkota and Ilkka Ronkainen, International

Business (7th Edition) and Global Business

Part I Global Financial Environment 1

Chapter 1 Current Multinational Challenges and the Global Economy 2

Chapter 2 Corporate Ownership, Goals, and Governance 27

Chapter 3 The International Monetary System 59

Chapter 4 The Balance of Payments 87

Chapter 5 The Continuing Global Financial Crisis 122

Part II Foreign Exchange Theory and Markets 157

Chapter 6 The Foreign Exchange Market 158

Chapter 7 International Parity Conditions 185

Chapter 8 Foreign Currency Derivatives and Swaps 216

Part III Foreign Exchange Exposure 245

Chapter 9 Foreign Exchange Rate Determination and Forecasting 246

Chapter 10 Transaction Exposure 275

Chapter 11 Translation Exposure 309

Chapter 12 Operating Exposure 326

Part IV Financing the Global Firm 349

Chapter 13 The Global Cost and Availability of Capital 350

Chapter 14 Raising Equity and Debt Globally 376

Chapter 15 Multinational Tax Management 415

Part V Foreign Investment Decisions 439

Chapter 16 International Portfolio Theory and Diversification 440

Chapter 17 Foreign Direct Investment and Political Risk 460

Chapter 18 Multinational Capital Budgeting and Cross-Border Acquisitions 490

Part VI Managing Multinational Operations 527

Chapter 19 Working Capital Management 528

Chapter 20 International Trade Finance 556 Answers to Selected End-of-Chapter Problems 582

Glossary 586

Index 603

Credits 626

Financial Globalization and Risk 2 The Global Financial Marketplace 3 The Theory of Comparative Advantage 9 What Is Different About International Financial Management? 11 Market Imperfections: A Rationale for the Existence of the Multinational Firm 12 The Globalization Process 13

Summary Points 17

MInI-Case: Nine Dragons Paper and the 2009 Credit Crisis 17 Questions n Problems n Internet Exercises 24

Who Owns the Business? 27 The Goal of Management 30

Summary Points 49

MInI-Case: Luxury Wars—LVMH vs Hermès 49 Questions n Problems n Internet Exercises 54

History of the International Monetary System 59 IMF Classification of Currency Regimes 66 Fixed Versus Flexible Exchange Rates 68

A Single Currency for Europe: The Euro 70 Emerging Markets and Regime Choices 74 Exchange Rate Regimes: What Lies Ahead? 77

Summary Points 78

MInI-Case: The Yuan Goes Global 79 Questions n Problems n Internet Exercises 84

Typical Balance of Payments Transactions 88 Fundamentals of Balance of Payments Accounting 88 The Accounts of the Balance of Payments 90

The Capital and Financial Accounts 92 Breaking the Rules: China’s Twin Surpluses 97 The Balance of Payments in Total 99

The Balance of Payments Interaction with Key Macroeconomic Variables 101 Trade Balances and Exchange Rates 104

Capital Mobility 106

Summary Points 112

MInI-Case: Global Remittances 113 Questions n Problems n Internet Exercises 117

Chapter 5 The Continuing Global Financial Crisis 122

The Credit Crisis of 2008–2009 122 Global Contagion 132

The European Debt Crisis of 2009–2012 138

Summary Points 150

MInI-Case: Letting Go of Lehman Brothers 151 Questions n Problems n Internet Exercises 153

Part II Foreign Exchange Theory and Markets 157

Geographical Extent of the Foreign Exchange Market 158 Functions of the Foreign Exchange Market 160

Market Participants 160 Transactions in the Foreign Exchange Market 163 Size of the Foreign Exchange Market 166 Foreign Exchange Rates and Quotations 168

Summary Points 177

MInI-Case: The Saga of the Venezuelan Bolivar Fuerte 178 Questions n Problems n Internet Exercises 180

Chapter 7 International Parity Conditions 185

Prices and Exchange Rates 185 Exchange Rate Pass-Through 192 The Forward Rate 194

Prices, Interest Rates, and Exchange Rates in Equilibrium 202

Summary Points 204

MInI-Case: Emerging Market Carry Trades 205 Questions n Problems n Internet Exercises 206 Appendix: An Algebraic Primer to International Parity Conditions 212

Foreign Currency Futures 217 Option Pricing and Valuation 226 Interest Rate Derivatives 231

Summary Points 235

MInI-Case: McDonald’s Corporation’s British Pound Exposure 236 Questions n Problems n Internet Exercises 237

Part III Foreign Exchange Exposure 245

Exchange Rate Determination: The Theoretical Thread 248 Currency Market Intervention 252

Disequilibrium: Exchange Rates in Emerging Markets 255 Forecasting in Practice 263

Summary Points 268

MInI-Case: The Japanese Yen Intervention of 2010 269 Questions n Problems n Internet Exercises 271

Chapter 10 Transaction Exposure 275

Types of Foreign Exchange Exposure 275 Trident’s Transaction Exposure 280

Summary Points 290

MInI-Case: Banbury Impex (India) 291 Questions n Problems n Internet Exercises 295 Appendix: Complex Option Hedges 301

Overview of Translation 309 Translation Methods 310 U.S Translation Procedures 312 Trident Corporation’s Translation Exposure 313 Trident Corporation’s Translation Exposure: Income 314

Summary Points 320

MInI-Case: LaJolla Engineering Services 320 Questions n Problems 323

Trident Corporation: A Multinational’s Operating Exposure 326 Measuring Operating Exposure: Trident Germany 331

Strategic Management of Operating Exposure 336 Proactive Management of Operating Exposure 337

Summary Points 343

MInI-Case: Toyota’s European Operating Exposure 343 Questions n Problems n Internet Exercises 346

Part IV Financing the Global Firm 349

Chapter 13 The Global Cost and Availability of Capital 350

Financial Globalization and Strategy 350 The Demand for Foreign Securities: The Role of International Portfolio Investors 358 The Cost of Capital for MNEs Compared to Domestic Firms 363

The Riddle: Is the Cost of Capital Higher for MNEs? 365

Summary Points 366

MInI-Case: Novo Industri A/S (Novo) 367 Questions n Problems n Internet Exercises 371

Designing a Strategy to Source Capital Globally 376 Optimal Financial Structure 378

Raising Equity Globally 381 Depositary Receipts 385 Private Placement 391 Foreign Equity Listing and Issuance 392 Raising Debt Globally 395

Chapter 15 Multinational Tax Management 415

Tax Principles 416

Summary Points 430

MInI-Case: The U.S Corporate Income Tax Conundrum 430 Questions n Problems n Internet Exercises 434

Part V Foreign Investment Decisions 439

Chapter 16 International Portfolio Theory and Diversification 440

International Diversification and Risk 440 Internationalizing the Domestic Portfolio 443 National Markets and Asset Performance 448 Market Performance Adjusted for Risk: The Sharpe and Treynor Performance Measures 450

Summary Points 453

MInI-Case: Portfolio Theory, Black Swans, and [Avoiding] Being the Turkey 454 Questions n Problems n Internet Exercises 456

Chapter 17 Foreign Direct Investment and Political Risk 460

Sustaining and Transferring Competitive Advantage 460 Deciding Where to Invest 465

How to Invest Abroad: Modes of Foreign Involvement 466 Political Risk 469

Part VI Managing Multinational Operations 527

Trident Brazil’s Operating Cycle 528 Trident’s Repositioning Decisions 530 Constraints on Repositioning Funds 531 Conduits for Moving Funds by Unbundling Them 532 International Dividend Remittances 533

Net Working Capital 534 International Cash Management 540 Financing Working Capital 546

Summary Points 549

MInI-Case: Honeywell and Pakistan International Airways 549 Questions n Problems n Internet Exercises 552

Chapter 20 International Trade Finance 556

The Trade Relationship 556

The Trade Dilemma 558

Benefits of the System 559

Key Documents 561

Example: Documentation in a Typical Trade Transaction 566

Government Programs to Help Finance Exports 568

Forfaiting: Medium- and Long-Term Financing 572

Summary Points 574

MInI-Case: Crosswell International and Brazil 575

Questions n Problems n Internet Exercises 579

Answers to Selected End-of-Chapter Problems 582

Glossary 586

Index 603

Credits 626

Global Financial

Environment

ChaptEr 1

Current Multinational Challenges

and the Global Economy

Current Multinational Challenges and the Global Economy

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.

The subject of this book is the financial management of multinational enterprises (MNEs) MNEs are firms—both for profit companies and not-for-profit organizations—that have operations in more than one country, and conduct their business through foreign subsidiar-ies, branches, or joint ventures with host country firms

MNEs are struggling to survive and prosper in a very different world than in the past Today’s MNEs depend not only on the emerging markets for cheaper labor, raw materials, and outsourced manufacturing, but also increasingly on those same emerging markets for sales and profits These markets—whether they are emerging, less developed, developing, or BRICs (Brazil, Russia, India, and China)—represent the majority of the earth’s population, and therefore, customers And adding market complexity to this changing global landscape

is the risky and challenging international macroeconomic environment, both from a term and short-term perspective, following the global financial crisis of 2007–2009 How to identify and navigate these risks is the focus of this book

long-  long- Financiallong- Globalizationlong- andlong- Risk

Back in the halcyon pre-crisis days of the late 20th and early 21st centuries, it was taken

as self evident that financial globalisation was a good thing But the subprime crisis and eurozone dramas are shaking that belief Never mind the fact that imbalances amid globalisation can stoke up bubbles; what is the bigger risk now—particularly in the eurozone—is that financial globalisation has created a system that is interconnected

in some dangerous ways.

—“Crisis Fears Fuel Debate on Capital Controls,”

Gillian Tett, The Financial Times, December 15, 2011.

2

The theme dominating global financial markets today is the complexity of risks associated with financial globalization—far beyond whether it is simply good or bad, but how to lead and manage multinational firms in the rapidly moving marketplace.

n The international monetary system, an eclectic mix of floating and managed fixed exchange rates today, is under constant scrutiny The rise of the Chinese renminbi

is changing much of the world’s outlook for currency exchange, reserve currencies, and the roles of the dollar and the euro (see Chapter 3)

n Large fiscal deficits plague most of the major trading countries of the world, including the current eurozone crisis, complicating fiscal and monetary policies, and ultimately, interest rates and exchange rates (see Chapters 4 and 5)

n Many countries experience continuing balance of payments imbalances, and in some cases, dangerously large deficits and surpluses—whether it be the twin surpluses enjoyed by China, the current account surplus of Germany amidst a sea of eurozone deficits, or the continuing current account deficit of the United States, all will inevi-tably move exchange rates (see Chapters 4 and 5)

n Ownership, control, and governance changes radically across the world The publicly traded company is not the dominant global business organization—the privately held

or family-owned business is the prevalent structure—and their goals and measures

of performance differ dramatically (see Chapter 2)

n Global capital markets that normally provide the means to lower a firm’s cost of capital, and even more critically increase the availability of capital, have in many ways shrunk in size, openness, and accessibility by many of the world’s organizations (see Chapters 1 and 5)

n Today’s emerging markets are confronted with a new dilemma: the problem of being the recipients of too much capital—sometimes Financial globalization has resulted

in the flow of massive quantities of capital into and out of many emerging markets, complicating financial management (Chapters 6 and 9)

These are but a sampling of the complexity of topics The Mini-Case at the end of this

chapter, Nine Dragons Paper and the 2009 Credit Crisis, highlights many of these MNE issues

in emerging markets today As described in Global Finance in Practice 1.1, the global credit

crisis and its aftermath has damaged the world’s largest banks and reduced the rate of nomic growth worldwide, leading to higher rates of unemployment and putting critical pres-sures on government budgets from Greece to Ireland to Portugal to Mexico

eco-  Theeco- Globaleco- Financialeco- Marketplace

Business—domestic, international, global—involves the interaction of individuals and vidual organizations for the exchange of products, services, and capital through markets The global capital markets are critical for the conduct of this exchange The global financial crisis

indi-of 2008–2009 served as an illustration and a warning indi-of how tightly integrated and fragile this marketplace can be

Assets, Institutions, and Linkages

Exhibit 1.1 provides a map to the global capital markets One way to characterize the global financial marketplace is through its assets, institutions, and linkages

Global Capital Markets: Entering a New Era

The current financial crisis and worldwide recession have

abruptly halted a nearly three-decade-long expansion of

global capital markets From 1980 through 2007, the world’s

financial assets—including equities, private and public debt,

and bank deposits—nearly quadrupled in size relative to

global GDP Global capital flows similarly surged This growth

reflected numerous interrelated trends, including advances in

information and communication technology, financial market

liberalization, and innovations in financial products and

ser-vices The result was financial globalization.

But the upheaval in financial markets in late 2008 marked a

break in this trend The total value of the world’s financial assets

fell by $16 trillion to $178 trillion, the largest setback on record

Although equity markets have bounced back from their recent

lows, they remain well below their peaks Credit markets have

healed somewhat but are still impaired.

Going forward, our research suggests that global tal markets are entering a new era in which the forces fueling growth have changed For the past 30 years, most of the overall increase in financial depth—the ratio of assets to GDP—was driven by the rapid growth of equities and private debt in mature markets Looking ahead, these asset classes in mature mar- kets are likely to grow more slowly, more in line with GDP, while government debt will rise sharply An increasing share of global asset growth will occur in emerging markets, where GDP is ris- ing faster and all asset classes have abundant room to expand.

capi-Source: Excerpted from “Global Capital Markets: Entering a New Era,”

McKinsey Global Institute, Charles Rosburgh, Susan Lund, Charles Atkins, Stanislas Belot, Wayne W Hu, and Moira S Pierce, McKinsey & Company, September 2009, p 7.

Assets The assets—the financial assets—which are at the heart of the global capital markets are the debt securities issued by governments (e.g., U.S Treasury Bonds) These low-risk or risk-free assets then form the foundation for the creating, trading, and pricing of other finan-cial assets like bank loans, corporate bonds, and equities (stock) In recent years, a number of exhibiT 1.1

The global capital market is a collection of institutions (central banks, commercial banks, investment banks, not for

profit financial institutions like the IMF and World Bank) and securities (bonds, mortgages, derivatives, loans, etc.),

which are all linked via a global network—the Interbank Market This interbank market, in which securities of all

kinds are traded, is the critical pipeline system for the movement of capital.

The exchange of securities—the movement of capital in the global financial system—must all take place through

a vehicle—currency The exchange of currencies is itself the largest of the financial markets The interbank market,

which must pass-through and exchange securities using currencies, bases all of its pricing through the single most

widely quoted interest rate in the world—LIBOR (the London Interbank Offered Rate).

Global Capital Markets

additional securities have been created from the existing securities—derivatives, whose value

is based on market value changes in the underlying securities The health and security of the global financial system relies on the quality of these assets

Institutions The institutions of global finance are the central banks, which create and control each country’s money supply; the commercial banks, which take deposits and extend loans to businesses, both local and global; and the multitude of other financial institutions created to trade securities and derivatives These institutions take many shapes and are subject to many different regulatory frameworks The health and security of the global financial system relies

on the stability of these financial institutions

Linkages The links between the financial institutions, the actual fluid or medium for exchange, are the interbank networks using currency The ready exchange of currencies in the global marketplace is the first and foremost necessary element for the conduct of financial trading, and the global currency markets are the largest markets in the world The exchange

of currencies, and the subsequent exchange of all other securities globally via currency, is the international interbank network This network, whose primary price is the London Interbank Offered Rate (LIBOR), is the core component of the global financial system

The movement of capital across borders and continents for the conduct of business has existed in many different forms for thousands of years Yet, it is only within the past 50 years that these capital movements have started to move at the pace of an electron, either via a phone call or an email And it is only within the past 20 years that this market has been able

to reach the most distant corners of the earth at any moment of the day This market has seen

an explosion of innovative products and services in the past decade, some of which proved, as

in the case of the 2008–2009 crisis, somewhat toxic to the touch

The Market for Currencies

The price of any one country’s currency in terms of another country’s currency is called a foreign currency exchange rate For example, the exchange rate between the U.S dollar ($

or USD) and the European euro (€ or EUR) may be stated as “1.4565 dollar per euro” or simply abbreviated as $1.4565/€ This is the same exchange rate as when stated “EUR1.00

= USD1.4565.” Since most international business activities require at least one of the two parties in a business transaction to either pay or receive payment in a currency, which is dif-ferent from their own, an understanding of exchange rates is critical to the conduct of global business

A quick word about currency symbols As noted, USD and EUR are often used as the symbols for the U.S dollar and the European Union’s euro These are the computer sym-bols (ISO-4217 codes) used today on the world’s digital networks The field of international finance, however, has a rich history of using a variety of different symbols in the financial press, and a variety of different abbreviations are commonly used For example, the British pound sterling may be £ (the pound symbol), GBP (Great Britain pound), STG (British pound sterling), ST£ (pound sterling), or UKL (United Kingdom pound) This book will also use the simpler common symbols—the $ (dollar), the € (euro), the ¥ (yen), the £ (pound)—but be warned and watchful when reading the business press!

Exchange Rate Quotations and Terminology Exhibit 1.2 lists currency exchange rates for Thursday, January 12, 2012, as would be quoted in New York or London The exchange rate listed is for a specific country’s currency—for example, the Argentina peso against the U.S dollar—Peso 3.9713/$, the European euro—Peso $5.1767/€, and the British pound—Peso 6.1473/£ The rate listed is termed a “mid-rate” because it is the middle or average of the rates currency traders buy currency (bid rate) and sell currency (offer rate)

Argentina peso Ps ARS 4.3090 5.5143 6.6010

The U.S dollar has been the focal point of most currency trading since the 1940s As a result, most of the world’s currencies have been quoted against the dollar—Mexican pesos per dollar, Brazilian real per dollar, Hong Kong dollars per dollar, etc This quotation convention

is also followed against the world’s major currencies as listed in Exhibit 1.2 For example, the Japanese yen is commonly quoted as ¥83.2200/$, ¥108.481/€, and ¥128.820/£

Quotation Conventions Several of the world’s major currency exchange rates, however, low a specific quotation convention that is the result of tradition and history The exchange rate between the U.S dollar and the euro is always quoted as “dollars per euro” ($/€), $1.3036/€

fol-as listed in Exhibit 1.2 Similarly, the exchange rate between the U.S dollar and the British pound is always quoted as $/£, for example, the $1.5480/£ listed under “United States” in Exhibit 1.2 Many countries that were formerly members of the British Commonwealth will commonly be quoted against the dollar as U.S dollars per currency (e.g., the Australian or Canadian dollars)

Eurocurrencies and LIBOR

One of the major linkages of global money and capital markets is the Eurocurrency market and its interest rate known as LIBOR Eurocurrencies are domestic currencies of one country

on deposit in a second country Eurodollar time deposit maturities range from call money and overnight funds to longer periods Certificates of deposit are usually for three months or more and in million-dollar increments A Eurodollar deposit is not a demand deposit; it is not created on the bank’s books by writing loans against required fractional reserves, and it can-not be transferred by a check drawn on the bank having the deposit Eurodollar deposits are transferred by wire or cable transfer of an underlying balance held in a correspondent bank located within the United States In most countries, a domestic analogy would be the transfer

of deposits held in nonbank savings associations These are transferred by the association writing its own check on a commercial bank

Any convertible currency can exist in “Euro-” form Note that this use of “Euro-” should not be confused with the new common European currency called the euro The Eurocur-rency market includes Eurosterling (British pounds deposited outside the United Kingdom); Euroeuros (euros on deposit outside the euro zone); Euroyen (Japanese yen deposited outside Japan) and Eurodollars (U.S dollars deposited outside the United States) The exact size of the Eurocurrency market is difficult to measure because it varies with daily decisions made by depositors about where to hold readily transferable liquid funds, and particularly on whether

to deposit dollars within or outside the United States

Eurocurrency markets serve two valuable purposes: 1) Eurocurrency deposits are an cient and convenient money market device for holding excess corporate liquidity; and 2) the Eurocurrency market is a major source of short-term bank loans to finance corporate working capital needs, including the financing of imports and exports

effi-Banks in which Eurocurrencies are deposited are called Eurobanks A Eurobank is

a financial intermediary that simultaneously bids for time deposits and makes loans in a currency other than that of the currency in which it is located Eurobanks are major world banks that conduct a Eurocurrency business in addition to all other banking functions Thus, the Eurocurrency operation that qualifies a bank for the name Eurobank is in fact

a department of a large commercial bank, and the name springs from the performance of this function

The modern Eurocurrency market was born shortly after World War II Eastern pean holders of dollars, including the various state trading banks of the Soviet Union, were afraid to deposit their dollar holdings in the United States because these deposits might be attached by U.S residents with claims against communist governments Therefore, Eastern

Euro-European holders deposited their dollars in Western Europe, particularly with two Soviet banks: the Moscow Narodny Bank in London, and the Banque Commerciale pour l’Europe

du Nord in Paris These banks redeposited the funds in other Western banks, especially in London Additional dollar deposits were received from various central banks in Western Europe, which elected to hold part of their dollar reserves in this form to obtain a higher yield Commercial banks also placed their dollar balances in the market because specific maturities could be negotiated in the Eurodollar market Such companies found it financially advanta-geous to keep their dollar reserves in the higher-yielding Eurodollar market Various holders

of international refugee funds also supplied funds

Although the basic causes of the growth of the Eurocurrency market are economic ciencies, many unique institutional events during the 1950s and 1960s helped its growth

effi-n In 1957, British monetary authorities responded to a weakening of the pound by imposing tight controls on U.K bank lending in sterling to nonresidents of the United Kingdom Encouraged by the Bank of England, U.K banks turned to dollar lending

as the only alternative that would allow them to maintain their leading position in world finance For this they needed dollar deposits

n Although New York was “home base” for the dollar and had a large domestic money and capital market, international trading in the dollar centered in London because of that city’s expertise in international monetary matters and its proximity in time and distance to major customers

n Additional support for a European-based dollar market came from the balance of payments difficulties of the U.S during the 1960s, which temporarily segmented the U.S domestic capital market

Ultimately, however, the Eurocurrency market continues to thrive because it is a large international money market relatively free from governmental regulation and interference

Eurocurrency Interest Rates: LIBOR In the Eurocurrency market, the reference rate of interest is LIBOR—the London Interbank Offered Rate LIBOR is now the most widely accepted rate of interest used in standardized quotations, loan agreements or financial deriva-tives valuations LIBOR is officially defined by the British Bankers Association (BBA) For example, U.S dollar LIBOR is the mean of 16 multinational banks’ interbank offered rates

as sampled by the BBA at 11 a.m London time in London Similarly, the BBA calculates the Japanese yen LIBOR, euro LIBOR, and other currency LIBOR rates at the same time in London from samples of banks

The interbank interest rate is not, however, confined to London Most major tic financial centers construct their own interbank offered rates for local loan agreements These rates include PIBOR (Paris Interbank Offered Rate), MIBOR (Madrid Interbank Offered Rate), SIBOR (Singapore Interbank Offered Rate), and FIBOR (Frankfurt Inter-bank Offered Rate), to name but a few

domes-The key factor attracting both depositors and borrowers to the Eurocurrency loan market

is the narrow interest rate spread within that market The difference between deposit and loan rates is often less than 1% Interest spreads in the Eurocurrency market are small for many reasons Low lending rates exist because the Eurocurrency market is a wholesale market, where deposits and loans are made in amounts of $500,000 or more on an unsecured basis Borrowers are usually large corporations or government entities that qualify for low rates because of their credit standing and because the transaction size is large In addition, overhead assigned to the Eurocurrency operation by participating banks is small

Deposit rates are higher in the Eurocurrency markets than in most domestic currency markets because the financial institutions offering Eurocurrency activities are not subject to

many of the regulations and reserve requirements imposed on traditional domestic banks and banking activities With these costs removed, rates are subject to more competitive pressures, deposit rates are higher, and loan rates are lower A second major area of cost avoided in the Eurocurrency markets is the payment of deposit insurance fees (such as the Federal Deposit Insurance Corporation, FDIC, and assessments paid on deposits in the United States).  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, cost-less 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 national trade of those goods, increased the quality of life for all citizens Smith based his work

inter-on the cinter-oncept of absolute advantage, where every country should specialize in the productiinter-on

of that good it was uniquely suited for More would be 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

pub-lished 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 produc-tion 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 trad-ing for the other

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 parative 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

com-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 into the United States (legal and illegal), immigrants 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 oped 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.

devel-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 consum-ers, producers, and political leaders Complete specialization, however, remains an unrealistic limiting case, just as perfect competition is a limiting case in microeconomic theory

Global Outsourcing of Comparative AdvantageComparative 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 Internet The source of a nation’s comparative advantage, however, still is created from the mixture of its own labor skills, access to capital, and technology Many locations for supply chain outsourcing exist today

Exhibit 1.3 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

China

Eastern Europe

Russia Philippines

Shanghai

London Paris Berlin

MNEs based in many industrial countries are outsourcing intellectual

functions to providers based in traditional emerging market countries.

importing these 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 mer 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 telecom-munication 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

program-  program- Whatprogram- isprogram- Differentprogram- aboutprogram- internationalprogram- Financialprogram- 

Management?

Exhibit 1.4 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 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 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, exhibiT 1.4

Concept International Domestic

Culture, history and institutions Each foreign country is unique and not

always understood by MNE management Each country has a known base caseCorporate governance Foreign countries’ regulations and

institutional practices are all uniquely different

Regulations and institutions are well known

Foreign exchange risk MNEs face foreign exchange risks due to

their subsidiaries, as well as import/export and foreign competitors

Foreign exchange risks from import/export and foreign competition (no subsidiaires)

Political risk MNEs face political risk because of their

foreign subsidiaries and high profile Negligible political risksModification of domestic finance theories MNEs must modify finance theories like

capital budgeting and the cost of capital because of foreign complexities

Traditional financial theory applies

Modification of domestic financial

instruments

MNEs utilize modified financial instruments such as options, forwards, swaps, and letters of credit

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

What Is Different About International Financial Management?

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 financial 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 an MNE’s financial management evolves

as it pursues global strategic opportunities and new constraints emerge In this 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 that the MNE was created to exploit And as

noted by Global Finance in Practice 1.2, the objectives and responsibilities of the modern

multinational have grown significantly more complex in the twenty-first century

   Market imperfections: a Rationale for the existence

of the Multinational FirmMNEs 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

Global Finance in PRacTice 1.2

Corporate Responsibility and Corporate

Sustainability

Sustainable development is development that meets the

needs of the present without compromising the ability of

future generations to meet their own needs.

—Brundtland Report, 1987, p 54.

What is the purpose of the corporation? It is increasingly

accepted that the purpose of the corporation is to certainly

create profits and value for its stakeholders, but the

respon-sibility of the corporation is to do so in a way that inflicts no

costs on society, including the environment As a result of

globalization, this growing responsibility and role of the

corpo-ration in society has added a level of complexity to the

leader-ship challenges faced by the twenty-first century firm.

This developing debate has been somewhat hampered

to date by conflicting terms and labels—corporate goodness,

corporate responsibility, corporate social responsibility (CSR),

corporate philanthropy, and corporate sustainability, to list but a few Much of the confusion can be reduced by using a guiding principle—that sustainability is a goal, while responsibility is an obligation It follows that the obligation of leadership in the mod- ern multinational is to pursue profit, social development, and the environment, all along sustainable principles.

The term sustainable has evolved greatly within the text of global business in the past decade A traditional primary objective of the family-owned business has been the “sustain- ability of the organization”—the long-term ability of the company

con-to remain commercially viable and provide security and income for future generations Although narrower in scope than the con- cept of environmental sustainability, there is a common core thread—the ability of a company, a culture, or even the earth, to survive and renew over time.

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 categories:

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

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

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

man-agerial expertise For example, German, Dutch, and Japanese firms have purchased U.S.-located electronics firms for their technology

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

These five types of strategic considerations are not mutually exclusive Forest products firms seeking wood fiber in Brazil, for example, may also find a large Brazilian 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 lished in it, or capture raw material sources and deny them to competitors

estab-  Theestab- Globalizationestab- Process

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

through-to the International Trade PhaseTrident 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 U.S mar-ket 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 1.5 shows Trident in its early domestic phase

Trident sells its products in U.S dollars to U.S customers and buys its manufacturing and service inputs from U.S suppliers, paying U.S dollars The creditworth of all suppliers

and buyers is established under domestic U.S practices and procedures A potential issue for Trident at this time is that although Trident is not international or global in its operations, some of its competitors, suppliers, or buyers may be This is often the impetus to push a firm like Trident into the first transition of the globalization process, into international trade Trident was founded by James 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 the New York Stock Exchange, Trident’s management sought to create value for its shareholders.

As Trident became a visible and viable competitor in the U.S market, strategic ties 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 1.5 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

opportuni-globalization process as the International Trade Phase.

Exporting and importing products and services increases the demands of financial agement 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

man-in foreign currencies, accept payment man-in foreign currencies, or pay suppliers man-in foreign rencies 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

cur-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

exhibiT 1.5

Mexican Suppliers Canadian Buyers

Are Mexican suppliers dependable?

Will Trident pay US$ or Mexican pesos?

All payments in U.S dollars.

All credit risk under U.S law.

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

Trident Corporation

(Los Angeles, USA)

Phase Two: Expansion into International Trade

U.S Suppliers

Phase One: Domestic Operations

Trident Corp: Initiation of the Globalization Process

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 ization 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

global-of issues and activities associated with this second larger global transition is the real focus global-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 invest-ment sequence—as shown in Exhibit 1.6 These alternatives include the creation of foreign sales offices, the licensing of the company name and everything associated with it, and the manufacturing and distribution of its products to other firms in foreign markets

As Trident moves farther down and to the right in Exhibit 1.6, the degree of its physical presence in foreign markets increases It 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

Production Abroad

Control Assets Abroad

Exploit Existing Competitive Advantage Abroad

Production at Home:

Exporting

Licensing Management Contract

Acquisition of a Foreign Enterprise Acquisition of a Foreign Enterprise

Greenfield Investment

Trident’s Foreign Direct Investment Sequence

The Limits to Financial GlobalizationThe 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 1.7 If influential ers in corporations and sovereign states continue to pursue the increase in firm value, there will be a definite and continuing growth in financial globalization But, if these same influential insiders pursue their own personal agendas, which may increase their personal power and influence or personal wealth, or both, then capital will not flow into these sovereign states and corporations The result is the growth of financial inefficiency and the segmentation of globalization outcomes—creating winners and losers As we will see throughout this book, this barrier to international finance may indeed be increasingly troublesome

insid-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 sets the stage for our debate and discussion Are the controlling family members of this company creating value for themselves or their shareholders?

We close this chapter—and open this book—with the simple words of one of our colleagues

in a recent conference on the outlook for global finance and global financial management

Welcome to the future This will be a constant struggle We need leadership, citizenship, and dialogue.

—Donald Lessard, in Global Risk, New Perspectives and Opportunities, 2011, p 33.

exhibiT 1.7

The Twin Agency Problems Limiting Financial Globalization

Actions of Rulers

of Sovereign States

Higher Firm Value

(possibly lower insider value)

Lower Firm Value

(possibly higher

insider value)

Actions of Corporate Insiders

There is a growing debate over whether many of the insiders and rulers of organizations with enterprises globally are taking actions consistent with creating firm value or consistent with increasing their own personal stakes and power.

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

The Potential Limits of Financial Globalization

n The creation of value requires combining three critical

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

stra-tegic management; and 3) access to capital.

n The theory of comparative advantage provides a basis

for explaining and justifying international trade in a

model world assumed to enjoy free trade, perfect

com-petition, no uncertainty, costless information, and no

government interference.

n International financial management requires an

understanding of cultural, historical, and

institu-tional differences, such as those affecting corporate

governance.

n 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

nor-mally a threat to domestic operations.

n MNEs strive to take advantage of imperfections in

national markets for products, factors of production,

and financial assets.

n 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.

n A firm may first enter into international trade actions, then international contractual arrangements, such as sales offices and franchising, and ultimately the acquisition of foreign subsidiaries At this final stage it truly becomes a multinational enterprise (MNE).

trans-n 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.

n 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 cor- porations This will, in turn, create limitations to global- ization in finance.

Rumors about this relatively secret company abound

Share prices fell below $1 in November Following some

action on the stock, and at the request of the Hong Kong

stock market, the company had to issue a number of

press releases denying rumors of acquisitions or other

agreements It also denied rumors that its Chinese mills

had taken market-related downtime Finally, a

spokes-man said the company had no “liquidity problems.”

—“Five Companies to Watch,” G Rodden, M

Rushton, F Willis, PPI, January 2009, p 21.

“This time is really different Large and small are all

affected In the past, the big waves would only wash away

the sand and leave the rocks Now the waves are so big,

even some rocks are being washed away.”

—Cheung Yan, Chairwoman of Nine Dragons

Paper, “Wastepaper Queen: Letter from China,”

New Yorker, 30 March 2009, p 8.

Incorporated in Hong Kong in 1995, Nine Dragons Paper (Holdings) Limited had become an international power- house in the paper industry The company produced a port- folio of paperboard products used in consumer product packaging The company had expanded rapidly, its capital expenditure growing at an average annual rate of 120% for the past five years.

But in January 2009, the company had been forced to issue a profit warning (Exhibit 1) Squeezed by market con- ditions and burdened by debt, Nine Dragons Paper (NDP), the largest paperboard manufacturer in Asia and second largest in the world, had seen its share price plummet As the economic crisis of 2008 had bled into 2009, NDP’s sales had fallen Rumors had been buzzing since October that NDP was on the very edge of bankruptcy Now, in April 2009, more than one analyst was asking “Will they

go bust?”

1 Copyright 2011 © Thunderbird School of Global Management All rights reserved This case was prepared by Professor Michael fett and Brenda Adelson, MBA ’08, for the purpose of classroom discussion only, and not to indicate either effective or ineffective management.

Mof-The Wastepaper Queen

Cheung Yan, or Mrs Cheung as she preferred, was the

visionary force behind NDP’s success Her empire was

built from trash—discarded cardboard cartons to be

precise The cartons were collected in the United States

and Europe, shipped to China, then pulped and

remanu-factured into paperboard NDP customers then used the

paperboard to package goods for shipment back to the

United States and Europe, returning them to their origins

Born in 1957, Mrs Cheung came from a modest family

background She had started as an accountant for a

Chi-nese trading company in Hong Kong, and then started her

own company after her employer went under Her

com-pany was a scrap paper dealer, purchasing scrap paper in

Hong Kong and mainland China and selling it to Chinese

paper manufacturers Paper in China was of generally poor

quality, made from bamboo stalk, rice stalk, and grass The

locally collected wastepaper didn’t meet the needs of paper

manufacturers as a raw input In Europe and the United

States, however, paper was made from wood pulp, which

produced a higher quality paper (United States companies

use a higher percentage of pulp, while Chinese companies

use more recovered paper) Realizing that by capturing the

wastepaper stream in the United States and Europe she

could provide a higher quality product to her customers

in China, Mrs Cheung moved to the United States in 1990

to start another company, American Chung Nam

Incor-porated (ACN).

One of the first companies to export wastepaper from

the United States to China, ACN started by collecting

wastepaper from dumps, then expanded its network to include waste haulers and wastepaper collectors Mrs Cheung negotiated favorable contracts with shipping com- panies whose ships were returning to China empty ACN soon expanded abroad and became a leading exporter of recovered paper from Europe to China as well By 2001, ACN had become the largest exporter, by volume, of freight from the United States In other words, nobody

in America was shipping more of anything each year where in the world.

any-The Chinese economic miracle that began in the late 1990s rose through exports of consumer goods which needed a massive amount of packaging material Within

a few years, the demands for packaging far outgrew what domestic suppliers could provide In 1995, Mrs Cheung founded Nine Dragons Paper Industries Company in Dongguan, China By 1998, the first papermaking machine was installed, a second in 2000, and a third in 2003 By

2008, NDP had 22 paperboard manufacturing machines

at six locations in China and Vietnam As illustrated by Exhibit 2, sales and profits soared.

NDP’s Products

Containerboard is used for exactly what it sounds like: taining products in shipping between manufacturing and market As illustrated in Exhibit 3, the containerboard value chain is a consumer-driven market, with consumer purchases of products driving the demand for packaging and containers and insulation worldwide Companies like NDP purchase recovered pulp paper from a variety of raw

con-exhibiT 1

(Incorporated in Bermuda with limited liability)

(Stock Code: 2689)

ANNOUNCEMENT PROFIT WARNING

The Board wishes to inform the shareholders of the Company and potential investors that it is expected the Group will record a substantial reduction in its unaudited consolidated net profit arising from normal operations for the six months ended 31 December 2008 as compared to that for the corresponding period in 2007 due to the substantial decrease in the selling prices

of the Group’s products and the rising cost of raw materials.

Shareholders of the Company and potential investors are advised to exercise caution in dealing in shares of the Company.

NPD’s Profit Warning (14 January 2009)

0 2,000,000 4,000,000 6,000,000 8,000,000 10,000,000 12,000,000 14,000,000 16,000,000

Sales (000s Rmb) Return on Sales (%)

Return on Sales = Net Income

Sales

Source: Nine Dragons Paper.

NPD’s Growing Sales and Profitability

Input prices have been very

volatile in recent years

NDP sources 60% of its

OCC from American Chung

Nam (ACN) owned by Mrs.

Cheung

Raw material costs make up

60% of cost of goods sold

Large quantities of water

and electricity required in

manufacture

Containerboard Manufacturers

Containerboard co’s typically pass along cost changes due to highly fragmented box manufacturers NDP & Lee & Man control roughly 25% of the total Chinese market Sales mix has shifted to domestic market in recent years (78% domestic in

Lee & Man Paper Manufacturing Limited

Box Manufacturers

Also able to pass along prices to customers as container costs make up a relatively small percentage

of total product cost of final customer

Manufacturing needs to occur near customers due to high cost of transport of low value goods

Companies:

Hop Fung supplies manufacturing sector in Hong Kong and the Pearl River Delta

D&B Database returns

3892 paperboard box manufacturers (NAICS 32221) in China

Consumer Product Companies

Highly cyclical with consumer spending Market in China has been shifting to a domestic orientation as Chinese incomes and consumption patterns grow

Chinese economy, domestic economy, recovered rapidly from the 2008 recession suffered by most nations globally

Nine Dragons Paper

Chinese Containerboard Value Chain