International corporate finance
COLLEGE OF BANKING AND FINANCIAL STUDIES
Bsc. Accounting, Auditing and Finance
Semester – 6
International Corporate Finance
Chapter 1 – Global Financial Environment and managing multinational Procedures.
Learning Outcome
• To understand the nature and benefits of globalization in the context of global financial environment.
• To explain why multinational corporations the key players are in international economic competition today.
• To explain the approaches taken by multinational firms in Managing Multinational procedures.
Introduction • Globalization stands for the idea of integrating the world marketplace, creating a so-
called “borderless world” for goods and services. In addition, to some extent, we already have such a world.
• Consider physical communications (mail, the telephone, the Internet, and airline and ocean shipping networks); entertainment (film and TV, music, news, and sports); economic and business exchange (banking and insurance networks, dependable foreign exchange and stock markets, and reciprocal trade arrangements
• The increasing economic integration of goods, services, and financial markets presents opportunities and challenges for governments, business firms, and individuals. Although business operations in countries across the globe have existed for centuries, the world has recently entered an era of unprecedented worldwide production and distribution.
• Worldwide production and distribution are critical for the survival of the multinational corporation (MNC),its ability to produce products and sell them at a profit.
• International finance is an integral part of total management and cuts across functional boundaries because it expresses inputs, outputs, plants, and results in monetary terms.
The Global Financial Market Place
• Business – Domestic, international, global – involves the interaction of individuals and individual organizations for the exchange of product and services, and capital through markets. The global capital markets are critical for this exchange.
Globalization
• Globalization is the word used to describe the growing interdependence of the world’s economies, cultures, and populations, brought about by cross-border trade in goods and services, technology, and flows of investment, people, and information. Countries have built economic partnerships to facilitate these movements over many centuries
• https://www.piie.com/microsites/globalization/what-is- globalization.html ( Video on the benefit of having globalization in today’s world)
Main Causes of Globalization
• Improved transport, making global travel easier. For example, there has been a rapid growth in air-travel, enabling greater movement of people and goods across the globe.
• Containerisation, From 1970, there was a rapid adoption of the steel transport container. This reduced the costs of inter-modal transport, making trade cheaper and more efficient.
• Improved technology which makes it easier to communicate and share information around the world. E.g. internet. For example, to work on improvements on this website, I will go to a global online community, like elance.com. There, people from any country can bid for the right to provide a service. It means that I can often find people to do a job relatively cheaply because labour costs are relatively lower in the Indian sub-continent.
• Growth of multinational companies with a global presence in many different economies.
• Growth of global trading blocks which have reduced national barriers. (e.g. European Union, NAFTA, ASEAN)
• Reduced tariff barriers encourage global trade. Often this has occurred through the support of the WTO.
• Firms exploiting gains from economies of scale to gain increased specialisation. This is an essential feature of new trade theory.
• Growth of global media. • Global trade cycle. Economic growth is global in nature. This means
countries are increasingly interconnected. (e.g. recession in one country affects global trade and invariably causes an economic downturn in major trading partners.)
• Financial system increasingly global in nature. When US banks suffered losses due to the sub-prime mortgage crisis, it affected all major banks in other countries who had bought financial derivatives from US banks and mortgage companies.
• Improved mobility of capital. In the past few decades, there has been a general reduction in capital barriers, making it easier for capital to flow between different economies. This has increased the ability for firms to receive finance. It has also increased the global interconnectedness of global financial markets.
• Increased mobility of labour. People are more willing to move between different countries in search for work. Global trade remittances now play a large role in transfers from developed countries to developing countries.
The Globalization Process
• Global Transition 1 : Moving from the domestic phase to the international phase.
The Globalisation Process
• Global Transition 2 : The international trade phase to the Multinational Phase.
The Limits to Financial Globalization
Multinational Corporation
A multinational corporation (MNC) is a company engaged in producing and selling goods or services in more than one country. It ordinarily consists of a parent company located in the home country and at least five or six foreign subsidiaries, typically with a high degree of strategic interaction among the units.
An enterprise operating in several countries but managed from one (home) country. Generally, any company or group that derives a quarter of its revenue from operations outside of its home country is considered a multinational corporation
A global company is a generic term used to describe an organization that attempts to standardize and integrate operations worldwide in all functional areas. Here are three possible definitions of a global company — an organization that attempts to ;
1. Have a worldwide presence in its market;
2. Integrate its operations worldwide;
3. Standardize operations in one or more of the company’s functional areas.
Categories of MNC
(1) a multinational, decentralized corporation with strong home country presence,
(2) a global, centralized corporation that acquires cost advantage through centralized production wherever cheaper resources are available,
(3) an international company that builds on the parent corporation's technology or R&D, or
(4) a transnational enterprise that combines the previous three approaches.
Characteristics of MNE’s
• World wide operations
• Create maximum operations
• Advanced technology
• High efficiency
• Monopolistic markets https://www.investopedia.com/terms/m/monopolisticmarket.asp
• Product / service organization
• Ownership and control
Entry Modes of going International ( Globalization Process)
Advantages and Disadvantages of MNC to Host countries
ADVANTAGES DISADVANTAGES
1. The investment level, employment level, and income level of the host country increases due to the operation of MNC’s.
1. MNC’s may transfer technology which has become outdated in the home country.
2. The industries of host country get latest technology from foreign countries through MNC’s.
2. As MNC’s do not operate within the national autonomy, they may pose a threat to the economic and political sovereignty of host countries.
3. The host country can reduce imports and increase exports due to goods produced by MNC’s in the host country. This helps to improve balance of payment.
3. MNC’s may kill the domestic industry by monpolising the host country’s market.
4. The domestic traders and market intermediaries of the host country gets increased business from the operation of MNC’s. Level of industrial and economic development increases due to the growth of MNC’s in the host country.
4. In order to make profit, MNC’s may use natural resources of the home country indiscriminately and cause depletion of the resources.
5.MNC’s break protectionism, curb local monopolies, create competition among domestic companies and thus enhance their competitiveness.
5. A large sums of money flows to foreign countries in terms of payments towards profits, dividends and royalty.
Advantages and Disadvantages of MNC in home countries
ADVANTAGES DISADVANTAGES
1. MNC’s create opportunities for marketing the products produced in the home country throughout the world.
1. MNC’s transfer the capital from the home country to various host countries causing unfavourable balance of payment.
2. They create employment opportunities to the people of home country both at home and abroad.
2. MNC’s may not create employment opportunities to the people of home country if it adopts geocentric approach.
3. It gives a boost to the industrial activities of home country
3. As investments in foreign countries is more profitable, MNC’s may neglect the home countries industrial and economic development.
4. MNC’s help to maintain favourable balance of payment of the home country in the long run.
5. Home country can also get the benefit of foreign culture brought by MNC’s
Principles of Global Finance
The seven important principles of Global finance that explains why a multinational company performs better than a domestic companies;
1. Risk and Return trade off
2. Market Imperfections
3. Portfolio effects (diversification)
4. Comparative Advantage
5. Internationalization Advantage
6. Economies of Scale
7. Valuations
Risk and Return Trade off
• An investor’s risk-return tradeoff function is based on the standard economic concepts of utility theory and opportunity sets. An opportunity set shows different combinations of business opportunities, which make the investor equally happy in terms of risk-return tradeoffs.
• Companies can benefit from an expanded opportunity set as they venture into global markets. It seems reasonable to assume that international business is riskier than domestic business. However, this is not necessarily true, because returns on foreign investments are not highly positively correlated with returns on domestic investments. In other words, may be less risky than companies that operate strictly within the boundaries of any one country.
• Consequently, to minimize risk, companies should diversify not only across domestic projects but also across countries. Possible revenue opportunities from international business are also larger than possible revenue opportunities from purely domestic business.
• MNCs can locate production in any country of the world to maximize their profits and raise funds in any capital market where the cost of capital is the lowest. MNCs may see another advantage from currency gains. These two factors — lower risks and larger profitability for international business — suggest the possibility that an MNC can achieve a better risk-return trade off than a domestic company
Market Imperfections • Perfect competition exists when sellers of goods and services have complete freedom of entry into and exit out of any
national market.
• Under such a condition, goods and services would be mobile and freely transferable. The unrestricted mobility of goods and services creates equality in costs and returns across countries.
• This cost-return uniformity everywhere in the world would remove the incentive for foreign trade and investment.
• Factors of production, such as land, capital, and technology, are unequally distributed among nations. Even with such comparative advantages, however, the volume of international business would be limited if all factors of production could be easily transferred among countries.
• The real world has imperfect market conditions where resources available for the production of goods are somewhat immobile.
• The trend toward a global economy through the World Trade Organization and the European Union will undoubtedly remove market imperfections that restrict the international flows of goods and services.
• However, a variety of barriers still impede free movements of goods, services, and financial assets across national boundaries. These barriers include government controls, excessive transportation and transaction costs, lack of information, and discriminatory taxation.
• Consequently, companies can still benefit from imperfections in national markets for factors of production, products, and financial assets.
• In other words, imperfect national markets create a variety of incentives for companies to seek out international business. For example, Japanese automakers, such as Toyota, established automobile transplants in the United States to avoid US trade restrictions.
Portfolio Effects ( Diversification) • The portfolio effect states that as more assets are added to a portfolio, the risk of the total portfolio
decreases.
• This principle explains much of the rationale for large MNCs to diversify their operations not only across industries but also across countries and currencies.
• Some MNCs, such as Nestl´e of Switzerland, have operations in countries as varied as the United States, Japan, Hong Kong, France, Russia, Mexico, Brazil, Vietnam, Nigeria, and North Korea. Because it is impossible to predict which countries will outperform other countries in the future, these companies are “hedging their bets.”
• Domestic investment projects tend to correlate less with foreign investment projects than with other domestic projects. As a result, international diversification is more effective than domestic diversification.
• The economic cycles of different countries, such as the United States and Europe, do not tend to be totally synchronized. On the other hand, most domestic projects tend to be highly correlated with each other because they depend on the same state of economy.
• The energy operations of ExxonMobil in Saudi Arabia, for example, may be hurt if world oil prices unexpectedly take a nosedive. However, this might be offset by its operations in energy consuming countries such as China.
• Overall, the MNC earns its desired rate of return even if the profitability of its investment in individual countries may not be that predictable
Comparative Advantage
• You have perhaps heard on the news that the Japanese are US competitors in the global economy. In some ways this is true, because American and Japanese companies produce many of the same goods. Ford and Toyota compete for the same customers in the market for automobiles. However, trade between the United States and Japan is not like a sports contest, where one team wins and the other team loses. In fact, the opposite is true. Trade between two countries can make each country better off.
• The classical argument for free trade is based on the principle of comparative advantage. Assume that US workers are better at producing computer software than workers in China and that Chinese workers are better at producing shoes than workers in the United States. Comparative advantage states that trade between the two countries – the United States exporting software and China exporting shoes – can boost living standards in both. This is because the United States has comparative advantage in producing software while China has comparative advantage in producing shoes. Trade allows countries to specialize in what they do best and to enjoy a greater variety of goods and services. At the same time, companies earn profits from trade because most trade is carried out by individual companies.
Comparative Advantage
The ability of a firm or individual to produce goods and/ or service at a lower opportunity cost than other firms or individuals. A comparative advantage gives a company the ability to sell goods and services at a lower price than its competitors.
Opportunity Cost
The loss of potential gain from other alternatives when one alternative is chosen.
Formula to calculate opportunity cost = ( Units Sacrificed/ Units gained)
• Example
Assuming that India and Nepal are given the same amount of resources to produce two products. Following are the production details.
Assumption –( 1 ton = 900 kg)
Calculate which country has the comparative advantage of producing ;
a. Chocolate
b. Textiles
Country Chocolate Textiles
India 1 ton 4000 Yards
Nepal 4 tons 1000 yards
Answer
Answer
Sources of comparative advanatge
• Difference in Climate
• Differences in the available amount of factors of production
• Differences in technology.
Internationalization Advantage • Why do some companies prefer to export while others build overseas manufacturing
facilities? When a company expands its operations national borders for the first time, it tends to exploit a foreign market through exports.
• An export-oriented strategy serves a company well for some time. However, to become part of a global market, a company should have a world presence. Because the world presence cannot be sustained by exports alone, the company should eventually invest.
• The advantages of internationalization influence companies to invest directly in foreign countries. These advantages depend on three factors: location, ownership, and internationalization.
• BP has ownership advantages, such as technology, marketing expertise, capital, and brand names. Venezuela has location advantages, such as crude oil, abundant labor, and low taxes. Thus, BP has built oil refineries in Venezuela. These factories magnify both the wages of workers in Venezuela and profits of BP from the use of its technology and capital. These magnified portions of location advantages and ownership advantages are called internationalization advantages. These internationalization advantages allow MNCs to enjoy superior earnings performance over domestic companies
Economies of Scale • Economies of scale take place due to a synergistic effect, which is said to exist
when the whole is worth more than the mere sum of its parts.
• When companies produce or sell their primary product in new markets, they may increase their earnings and shareholder wealth due to economies of scale.
• Companies can gain from greater economies of scale when their real capital and monetary assets are deployed on a global basis. The expansion of a company’s operations beyond national borders allows it to acquire the necessary management skills and spread existing management skills over a larger operation.
• There are also opportunities to eliminate duplicate facilities and consolidate the functions of production and marketing. In addition, MNCs can raise funds at the lower cost of capital and reduce the pool of money without loss in the level of production. These types of operating and financial economies along with better management can cause an MNC to increase its profit margin and reduce its risks as well
Valuation • The valuation principle states that the value of an asset is equal to the present value of
its expected earnings. Because the values of all assets stem from streams of expected earnings, all such assets are valued in essentially the same way.
• First, the earning is estimated. Second, the required rate of return for each earning is established. Third, each earning is discounted by its required rate of return, and these present values are then summed to find the value of the asset. Alternatively, the value of an entire firm is determined by dividing the firm’s earnings after taxes or net cash flows by its required rate of return.
• The value of an MNC is usually higher than the value of a domestic company for two reasons. First, studies show that MNCs earn more profits than domestic companies. Second, earnings of larger companies are capitalized at lower rates.
• The securities of MNCs have better marketability than those of domestic companies. MNCs are also better known among investors. These factors lead to a lower required rate of returns and higher price-earnings ratios.
• When MNCs attempt to maximize their overall company value, they also face various constraints. Those constraints that hamper an MNC’s efforts to maximize its stockholder wealth include large agency costs and environmental differences.
Planning for success in the new VUCA business world • Today we live in a constant period of uncertainty, fuelled by factors
such as globalisation, worldwide economic challenges and climate change, to name but a few. Many organisations and indeed, senior level executives, are struggling to stay afloat and aligned in what is increasingly being referred to as the VUCA nature of today’s global business environment.
What does VUCA mean?
• Volatile - Change is violent and uncontrollable.
• Uncertain -The future is unpredictable, making it hard to prepare for.
• Complex - With so much going on, things can often feel chaotic and confused.
• Ambiguous - We lack clarity because it's hard to know what the root cause of the problem is.
Turn VUCA to your advantage using these four steps...
A VUCA environment can be dangerously disruptive. So, it's vital that we know how to cope.
• Counter volatility with vision -Create a compelling vision and values for your people. This will give them a clear focus and help them to react quickly to change.
• Meet uncertainty with understanding - What are your competitors doing? What's new in your industry? When you're "in the know" you'll be able to anticipate threats and take advantage of new opportunities.
• React to complexity with clarity - Be crystal clear when you communicate, and promote teamwork and collaboration. This will give people a clear direction, and encourage them to solve complex problems together.
• Fight ambiguity with agility - Stay adaptable, even during uncertain times. Encourage people to learn new skills, stimulate debate, and embrace creativity.
• https://www.youtube.com/watch?v=gVPZDn2v_Kg