BBK3273 International Finance

Transcription

1 BBK3273 International Finance Prepared by Dr Khairul Anuar L1: International Financial Environment

2 Contents 1. Multinational Corporations 2. BRICS 3. The Global Capital Markets 4. Global Capital Markets: Entering a New Era 5. Agency Problems in Managing the MNC 6. Management Structure of MNC 7. Why Firms Venture into International Business 8. How Firms Engage in International Trade 9. Uncertainty Surrounding MNC Cash Flows 10. The Potential Limits of Financial Globalization 11. Summary 2

3 1. Multinational Corporations Multinational corporations (MNCs) are those corporations with operations in more than one country. MNCs include for profit, non-profit firms, and NGOs. Today, MNCs rely on emerging markets for raw materials, cheaper labor, and outsourced manufacturing. MNCs also rely on emerging markets for sales and profits. The flow of funds from MNCs to is shown in Figure 1. 3

4 1. Multinational Corporations Figure 1: Flow of Funds from MNCs 4

5 2. BRICS BRICS is the acronym for an association of five major emerging national economies: Brazil, Russia, India, China and South Africa. The BRICS members are all developing or newly industrialized countries, but they are distinguished by their large, fastgrowing economies, and significant influence on regional and global affairs; all five are G-20 members. As of 2013, the five BRICS countries represent almost 3 billion people, with a combined nominal GDP of US$14.8 trillion, and an estimated US$4 trillion in combined foreign reserves. 5

6 3. The Global Capital Markets The global capital market is a collection of institutions comprising central banks, investment banks, not for profit institutions like the International Monetary Fund (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. Refer to Figure 2 which depicts the global capital market below. 6

7 3. The Global Capital Markets Figure 2: The Global Capital Markets Source: Moffet et al. 7

8 3. The Global Capital Markets The exchange of securities, that is, the movement of capital in the global financial system, must all take place through a vehicle, which is the currency. The exchange of currency is itself the largest of the financial system. The interbank market, which must pass-through and exchange securities using currencies, bases all its pricing through the single most widely quoted interest rate in the world the London Interbank Offer Rate (LIBOR). 8

9 4. Global Capital Markets: Entering a New Era The global capital markets expanded from to quadruple the size of global GDP. The 2008 financial crises however reduced the value of global financial assets by $16 trillion. The decline of global equity market, specifically the equity market is depicted in Figure 3. Looking ahead financial assets are expected to grow more inline with GDP, government debt will increase, and GDP will rise faster in emerging market countries. 9

10 Trends in Global Equity and Bond Markets, Figure 3: World Equity and Stock Markets (Trillions of USD) Stock Market Debt Market

11 5. Agency Problems in Managing the MNC 1. Managers are expected to make decisions that will maximize the shareholder wealth. However, managers may act to serve their own personal interest. Eg. A decision to establish a subsidiary in one location versus another may be based on the location s appeal to a particular manager rather than on its potential benefits to shareholders. A decision to expand a subsidiary may be motivated by a manager s desire to achieve more compensation rather than to enhance the value of the MNS. 2. Finance decisions are influenced by other business discipline functions: Marketing Management Accounting and information systems 11

12 Agency Costs 5. Agency Problems in Managing the MNC Agency cost is the cost of ensuring that managers maximize shareholder wealth Agency costs are normally higher for MNCs than for purely domestic firms for several reasons: Monitoring managers of distant subsidiaries in foreign countries is more difficult. Foreign subsidiary managers raised in different cultures may not follow uniform goals. Sheer size of larger MNCs can create large agency problems. Some non-u.s. managers tend to downplay the shortterm effects of decisions. 12

13 Control of Agency Problems 5. Agency Problems in Managing the MNC Parent control of agency problems The parent corporation of an MNC may be able to prevent agency problem with proper governance. Parent corporation should clearly communicate the goals for each subsidiary to ensure managers focus on maximizing the value of the subsidiary. Corporate control of agency problems MNC s can institute various forms of corporate control that can help prevent agency problems. The entire management of the MNC must be focused on maximizing shareholder wealth. 13

14 Control of Agency Problems 5. Agency Problems in Managing the MNC Sarbanes-Oxley Act (SOX) in the US The recent failures in corporate governance in the US have spawned a flurry of government and private initiatives to prevent the same kind of failures in the future The United States has already reacted; passing the Sarbanes-Oxley act in 2002 Sarbanes Oxley (SOX) has four major requirements: 1. Signature Clause CEOs and CFOs must vouch for accuracy of the published financial statements 2. Firm audit and compensation committees must be comprised of independent/outside directors 3. Loans by the firm to corporate officers and directors are prohibited 4. Internal controls must be tested for protection against financial fraud 14

15 Control of Agency Problems 5. Agency Problems in Managing the MNC Sarbanes-Oxley Act (SOX) in the US There are examples well-known corporations (eg Enron and Worldcom) in which large MNCs were able to alter their financial reporting so that investors would not be aware of their financial problems. SOX ensures a more transparent process for managers to report on the productivity and financial condition of their firm. Malaysian corporate fraud: Transmile Group Bhd the company which had overstated its revenue by RM530 million 15

16 6. Management Structure of MNC The magnitude of agency costs can vary with the management style of the MNC. Centralized (Figure 4) Allows managers of the parent to control foreign subsidiaries and therefore reduce the power of subsidiary managers. This can reduce agency costs. Decentralized (Figure 5) Gives more control to subsidiary managers who are closer to the subsidiary s operation and environment. This style is more likely to lead to higher agency costs because subsidiary managers may make decisions that do not focus on maximizing the value of the entire MNC. 16

17 Exhibit 1.1a Management Styles of MNCs 6. Management Structure of MNC Figure 4: Centralized Structure 17

18 Exhibit 1.1b Management Styles of MNCs 6. Management Structure of MNC Figure 5: Decentralized Structure 18

19 Why Firms Pursue International Business 7. Why Firms Venture into International Business Theory of Competitive Advantage: specialization increases production efficiency. Imperfect Markets Theory: factors of production are somewhat immobile providing incentive to seek out foreign opportunities. Product Cycle Theory: as a firm matures, it recognizes opportunities outside its domestic market. Refer Figure 6. 19

20 7. Why Firms Venture into International Business Figure 6: International Product Cycle 20

21 8. How Firms Engage in International Trade 1. International trade 2. Licensing 3. Franchising 4. Joint Ventures 5. Acquisitions of existing operations 6. Establishing new foreign subsidiaries 21

22 8. How Firms Engage in International Trade 1. International Trade Relatively conservative approach that can be used by firms to penetrate markets (by exporting) obtain supplies at a low cost (by importing). Minimal risk no capital at risk The internet facilitates international trade by allowing firms to advertise their products and accept orders on their websites. 22

23 8. How Firms Engage in International Trade 2. Licensing Obligates a firm to provide its technology (copyrights, patents, trademarks, or trade names) in exchange for fees or some other specified benefits. Allows firms to use their technology in foreign markets without a major investment and without transportation costs that result from exporting Major disadvantage: difficult to ensure quality control in foreign production process 23

24 8. How Firms Engage in International Trade 3. Franchising Obligates firm to provide a specialized sales or service strategy, support assistance, and possibly an initial investment in the franchise in exchange for periodic fees. Allows penetration into foreign markets without a major investment in foreign countries. 24

25 Joint Ventures 8. How Firms Engage in International Trade 4. Joint venture A venture that is jointly owned and operated by two or more firms. A firm may enter the foreign market by engaging in a joint venture with firms that reside in those markets. Allows two firms to apply their respective cooperative advantages in a given project. 25

26 Acquisitions of Existing Operations 8. How Firms Engage in International Trade 5. Acquisitions of Existing Operations Acquisitions of firms in foreign countries allows firms to have full control over their foreign businesses and to quickly obtain a large portion of foreign market share. Subject to the risk of large losses because of larger investment. Liquidation may be difficult if the foreign subsidiary performs poorly. 26

27 Establishing New Foreign Subsidiaries 8. How Firms Engage in International Trade 6. Establishing New Foreign Subsidiaries Firms can penetrate markets by establishing new operations in foreign countries. Requires a large investment Acquiring new as opposed to buying existing allows operations to be tailored exactly to the firms needs. May require smaller investment than buying existing firm. 27

28 Summary of Methods 8. How Firms Engage in International Trade Any method of increasing international business that requires a direct investment in foreign operations is referred to as direct foreign investment (DFI) International trade and licensing usually not included Foreign acquisition and establishment of new foreign subsidiaries represent the largest portion of DFI. 28

29 8. How Firms Engage in International Trade Refer to Figure 7. The first diagram reflects an MNC that engages in international trade. International cash flows result from paying for imports or receiving cash flow from exports. The second diagram reflects an MNC that engages in some international arrangements. Outflows include expenses such as expenses incurred from transferring technology or funding partial investment in a franchise or joint venture. Inflows are receipts from fees. The third diagram reflects an MNC that engages in direct foreign investment. Cash flows exist between the parent company and the foreign subsidiary. 29

30 Exhibit 1.3 Cash Flow Diagrams for MNCs 8. How Firms Engage in International Trade Figure 7: Cash Flow Diagrams for MNCs Source: Moffet et al. 30

31 9. Uncertainty Surrounding MNC Cash MNC Flows Cash Flows Exposure to international economic conditions If economic conditions in a foreign country weaken, purchase of products decline and MNC sales in that country may be lower than expected. Exposure to international political risk A foreign government may increase taxes or impose barriers on the MNC s subsidiary. Exposure to exchange rate risk If foreign currencies related to the MNC subsidiary weaken against the U.S. dollar, the MNC will receive a lower amount of dollar cash flows than was expected. A higher level of uncertainty increases the return on investment required by investors and the MNC s valuation decreases. 31

32 How Uncertainty Affects the MNC s cost of Capital 10. The Potential Limits of Financial Globalization The growth in the influence and self-enrichment of corporate insiders Figure 8 illustrates the agency problems 32

33 How Uncertainty Affects the MNC s cost of Capital 10. The Potential Limits of Financial Globalization Figure 8: The Potential Limits of Financial Globalization 33

34 11. Summary The main goal of an MNC is to maximize shareholder wealth. When managers are tempted to serve their own interests instead of those of shareholders, an agency problem exists. MNCs tend to experience greater agency problems than do domestic firms. Proper incentives and communication from the parent may help to ensure that subsidiary managers focus on serving the overall MNC. International business is justified by three key theories. 1. The theory of comparative advantage suggests that each country should use its comparative advantage to specialize in its production and rely on other countries to meet other needs. 2. The imperfect markets theory suggests that because of imperfect markets, factors of production are immobile, which encourages countries to specialize based on the resources they have. 3. The product cycle theory suggests that after firms are established in their home countries, they commonly expand their product specialization in foreign countries.

35 11. Summary The most common methods by which firms conduct international business are international trade, licensing, franchising, joint ventures, acquisitions of foreign firms, and formation of foreign subsidiaries. Methods such as licensing and franchising involve little capital investment but distribute some of the profits to other parties. The acquisition of foreign firms and formation of foreign subsidiaries require substantial capital investments but offer the potential for large returns. The valuation model of an MNC shows that the MNC s value is favorably affected when its expected foreign cash inflows increase, the currencies denominating those cash inflows increase, or the MNC s required rate of return decreases. Conversely, the MNC s value is adversely affected when its expected foreign cash inflows decrease, the values of currencies denominating those cash flows decrease (assuming that they have net cash inflows in foreign currencies), or the MNC s required rate of return increases.