International corporate finance

COLLEGE OF BANKING AND FINANCIAL STUDIES

Bsc. Accounting, Auditing and Finance

Semester – 6

International Corporate Finance

Chapter 2 – Introduction to Corporate Finance and Governance

Learning Outcome

• To critically evaluate the importance of Corporate Finance and Governance in the multinational perspective.

Corporate Finance

Corporate finance is the division of finance that deals with how corporations deal with funding sources, capital structuring, and investment decisions. Corporate finance is primarily concerned with maximizing shareholder value through long and short-term financial planning and the implementation of various strategies.

Traditional Approach Vs

Modern Approach

Importance of Corporate Finance

• Corporate finance is important when deals with financial prediction, monetary management, fund procurement, budgeting, credit administration and investment appraisal.

• Investment analysis, or as popularly known as capital budgeting determines the amount of investment in value-adding projects.

• Also it assesses whether or not the corporation’s long-term assets are worth investing. If the approval comes through, finance manager does his calculation and decides whether to finance that investment with equity or debt capital.

Approaches to achieve wealth maximisation

Managing a company’s working capital efficiently by striking a balance between the need to maintain liquidity and the opportunity cost of holding liquid assets;

■ Raising finance using the most appropriate mixture of debt and equity in order to minimise a company’s cost of capital;

■ Using NPV to assess all potential investment projects and then accepting all projects with a positive NPV;

■ Adopting the most appropriate dividend policy, which reflects the amount of dividends a company can afford to pay, given its level of profit and the amount of retained earnings it requires for reinvestment;

■ Taking account of the risk associated with financial decisions and where possible guarding against it, e.g. hedging interest and exchange rate risk.

Development in Corporate Finance

Introduction to Corporate Governance

• Corporate governance is mainly associated to the arrangement of rights and obligations between the stakeholders involved in the business.

• Strong corporate governance requires processes to ensure that executives uphold the rights and interests of company stakeholders, as well as to keep those stakeholders responsible for behaving professionally in terms of maintaining, producing and distributing the resources accumulated in the business

Corporate Governance

• The Cadbury Report 1992 provides a useful definition:

‘The system by which companies are directed and controlled’.

The primary objective of sound corporate governance is to contribute to improved corporate performance and accountability in creating long-term shareholder value

An expansion might include:

• 'in the interests of shareholders' highlighting the agency issue involved

• 'and in relation to those beyond the company boundaries' or

• 'and stakeholders' suggesting a much broader definition that brings in concerns over social responsibility.

To include these final elements is to recognise the need for organisations to be accountable to someone or something.

• Governance could therefore be described as:

'the system by which companies are directed and controlled in the interests of shareholders and other stakeholders’.

Corporate Governance

Corporate governance as the collection of control mechanisms that an organization adopts to prevent or dissuade potentially self-interested managers from engaging in activities detrimental to the welfare of shareholders and stakeholders.

At a minimum, the monitoring system consists of a board of directors to oversee management and an external auditor to express an opinion on the reliability of financial statements.

In most cases, however, governance systems are influenced by a much broader group of constituents, including owners of the firm, creditors, labor unions, customers, suppliers, investment analysts, the media, and regulators

Corporate Scandal

A corporate scandal can occur any time there is evidence of unethical behaviour, negligence or third- party interference that impacts a company’s reputation.

As we will see, this can include evidence of ‘creative’ accounting, dodgy business practices, data breaches or anything that damages the environment.

The need for Corporate governance

Providing a business case for governance is important in order to enlist management support. Corporate Governance is claimed to bring the following benefits:

• It is suggested that strengthening the control structure of a business increases accountability of management and maximises sustainable wealth creation.

• Institutional investors believe that better financial performance is achieved through better management, and better managers pay attention to governance, hence the company is more attractive to such investors.

• The above points may cause the share price to rise - which can be referred to as the "governance dividend" (i.e. the benefit that shareholders receive from good corporate governance).

• Additionally, a socially responsible company may be more attractive to customers and investors hence revenues and share price may rise (a "social responsibility dividend"

Corporate Governance in a global organization • Some of the greatest challenges in the administration of a global

corporations have a lot to do with corporate governance.

• To the degree that a corporation participates in subsidiaries or its own subsidiaries overseas, it would be subject to a range of legal, regulatory and cultural responsibilities related to corporate governance in the country of destination.

• Objectives such as accountability, the elimination of conflicts of interest between parties (between shareholders and management, between small and large shareholders, between staff, managers, etc.), the effective distribution of finite capital or the encouragement of creativity are among the objectives of good corporate governance, among others.

Principle – Agent concept

• A substantial part of corporate governance analysis is focused on a universal paradigm illustrated in the principal-agent concept.

• The core principle of this framework is that managers and shareholders have separate access to firm-specific knowledge, and managers as shareholder agents (principals) may participate in self- serving actions that could be counterproductive to the maximization of shareholders’ wealth.

• This stream of analysis describes circumstances in which the interests of owners and managers are likely to diverge and suggests mechanisms that may minimize the self-serving actions of managers.

Principle – Agency Problem- Multinational context • In the context of Multinational Corporations, corporate governance literature

shows that the degree of internationalization of the company is a significant determinant of the complexity it faces.

• Next, institutional gaps enhance both the expertise of senior management team experts and the uncertainty around the behaviour of managers. This adds to the classic main-agency dilemma between insiders and the management of the foreign-invested company, where outside owners are unable to track or assess managerial business decisions and results.

• In this climate, MNC investors must focus on financial controls and financial performance-based management compensation to ensure that management priorities are matched with the interests of the shareholders.

• Second, from an information-processing standpoint, the global design of MNC processes raises the difficulty of transactions and impacts how administrators handle information while designing a business strategy. This can lead to strategic mistakes even when the interests of management and shareholders are matched.

Agency theory – Management Vs Stakeholders

• Agency theory is a theory that deals with the conflict of interest between managers and shareholders.

• Managers are considered the agents of the owners. Stockholders delegate decision-making authority to managers on the condition that the agents will act in the stockholders’ best interest.

• However, it has often been argued that the objectives of managers may differ from those of the firm’s stockholders. Because the stockholders of most MNCs today are well diversified, the control of these companies is separated from ownership.

• This situation allows managers to act in their own best interest rather than in the best interest of the stockholders. Thus, some managers may be concerned with their own welfare, such as their own income, power, self-esteem, and prestige. The welfare of managers, therefore, could be increased by management decisions that tend to lower stockholder wealth

Corporate Governance and Multinational Enterprises Due to its characteristics of operating business in many countries with the parent company as the core, multinational enterprises are different from other independent commercial companies, so they have many particularity in governance issues.

1. The Particularity of Parent-Subsidiary Company Governance • First and the foremost, owing to its multi-level and multi-legal features, the holding

corporation (parent company) of a global company varies from the governance goals of a single organization.

• Its governance objective is not limited to performance enhancement and cost minimization, but also focuses on concentrating more on the management objective of extensionality, namely to create stable partnership between the parent -subsidiary partnership, not just to play the role of control and direction of the parent company and to represent the independence of the subsidiary, to be applied in the enterprise decision.

• Secondly, the conventional single organization is governed by a vertical governance path, while the multi-dimensional governance path of global corporations is defined by a fluid system and a shared collaborative governance of parent and subsidiary companies.

• Lastly, there is a need to coordinate the needs of the parent and affiliate companies, but all of them must be subject to the maximization of the overall interests. In this premise, the board of directors of the subsidiary corporation claims to be responsible for the subsidiary company, but in reality it is responsible for the parent company as a whole.

2.The Parent company’s Regulation and Restraint system. • The parent corporation retains full control of the companies, but there are conflicts of

interest between them.

• As an individual portion, the subsidiary business wants to make use of such independent alternatives. Proper settlement of this matter would allow the parent company and the affiliate to play the better part.

• How the partnership between the parent company and the subsidiary company is balanced depends on the control relationship between the parent company and the subsidiary.

• First of all, indirect influence plays a huge role. In other words, the parent corporation retains and maintains control of the bulk of the board of directors of the subsidiary company.

• Second, there’s direct influence too, meaning the overall control of the holding corporation over its subsidiaries.

• Third is hybrid operation. Flexible steps should be taken between the two forms referred to above, based on the particular condition of the host nation and the subsidiaries.

3.Governance Structures have gone International • The governance structure of domestic companies is based on

domestic company law, while foreign corporate governance is largely based on the Anglo-American model and the German model.

• However, multinational companies have crossed the boundaries of countries at a geographical level, and the government system has transcended national character. Yet as an economic entity, multinational corporations need to be in charge.

• At present, the lack of an international legislative system for the governance of transnational corporations and a domestic regulatory structure for transnational corporations are not rigorous, leading to a slowdown in the governance of multinational corporations.

Advantages of Corporate Governance Strong corporate governance will make a good business a great one. Leaders of every sector are at the helm of their respective sectors, largely due to excellent corporate governance activities.

1. Compatibility with the law.

• With corporate governance in effect, complying with different legislation is taken care of easily, as corporate governance requires guidelines, regulations and policies that allow a company to remain consistent during and run without any hassle or legal implications.

2. Minor Punishments and Fines.

• As the regulatory enforcement element is taken care of credit with corporate ethics activities, businesses are willing to save money on needless fines and compliance and potentially divert these assets to company goals in order to reach higher standards.

3. Improves Management.

• Since there is a framework in place for how the organization functions, the day-to-day operation of the entity, the monitoring of the operations and the fulfilment of the goals can become much simpler. The work environment often takes care of itself on the basis of sound corporate governance concepts that promote collaboration, unity, productivity and a drive for success.

4. Reputation and Relationship

• Companies with sound corporate governance are able to retain customers and foreign financiers with relative ease, on the basis of their strong standing and brand value. Transparency, which is the process of exchanging key organizational knowledge with clients, is one of the foundations of corporate governance. This strengthens the bond between the corporation and its owners and sows the seeds of trust between the business and community at large.

5. Less disputes and Frauds:

• The rules instilled in the workplace enable workers to be morally mindful of any situation they experience, thereby eliminating the risk of deception and dispute between employees.

Disadvantages of Corporate Governance When it comes to the matter of smaller companies, there may be a bit of an issue where owners may act as directors and administrators, and there may be no distinction as well. Keeping this in mind, this gives rise to:

1. The Burden of being legally compliant:

• Corporates usually have lots of regulations that need to be met, attracting various legislations depending on their business. Corporate governance guarantees ethical enforcement, but comes at a very high price.

2. Higher Costs:

• Administrative expenses for businesses requiring corporate governance are rather exorbitant, given all the criteria that needs to be met. Some of the documents that need to be kept in check are stock sales and acquisitions, legal compliance reports, annual registration.

3. Maintenance of Separation:

• Notwithstanding the size of the company, all formalities and specifications must be complied with without reservation. Failure to comply with these laws leaves an organization with considerable visibility, such as a corporate veil piercing, where the distinct legal identity of a business is overlooked in order to explain what is happening behind closed doors.

4. The Disagreement between the Principal and the Agent

• Big companies have made it a common practice to select a well-known boss, one with a clear record of day-to-day business activities. Unfortunately, this gives rise to a confrontation between owners and management, all of whom may have very different goals and viewpoints. This also leads to a clash between the two, impacting the overall ability of the organization to function in a smooth and productive fashion.