Value

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cHAPTER 1 current Multinational challenges andthe Global Economy

U.S. Dollar-Denominated lnterest Rates

1-Month Maturities

U.S. Prime Rate 6 00%

Certificate of Deposit Rate 0 400%

LIBOR 0.260% London lnterbank Offer Rate

London interbank rates apply to the buying

and'selling of eurodollar deposits between banks in the international markets.

Notes: Average rates for MaY 201 1. U.S. Federal Funds target rale = o O"/"4 25"/"

Eurodollar DePosit Offer Rate

I ) Eurodollar SPread )

Eurodollar DePosll Bid Bate

0.275%

o.255%rii*:. ig'

t,

*

d! iri

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e :: . ;l:

Eurodollar deposits are dollar-denominated accounts in financial institutions oulside of

the united states.

rter- dely )riv- For

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the ein

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Ioan /een rket isa

90n that ze is

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Deposit rates are higher in the eulocurrency malkets than in most domesti:c currency

markets because the finicial institutions offering eurocurrency activities are not subject to

murry of the regulations and reserve requiremen-ts imposed on traditional domestic banks

and banking activities. with these costs removed, raies are subject to mole competitive

pressures, d*eposit rates are higher, and loan rates are lower. A second majol area of cost

avoided in the eurocurrency niarkets is the payment of deposit insurance fees (such as the

Federal Deposit lnsurance" Corporation, FDIb, and assessments paid on deposits in the

United States). Exhibit 1.3 illustrates how eurodollar deposit and loan rates' including dollar

LIBOR and LIBID rates, compare with traditionai domestic interest rates'

The Theory of Comparative Aclvantage The theory of comparative advantage provides a basis for explaining and

justifying interna-

tional trade in a model world assumed to enjoy free trade, perfect competition' no uncer-

tainty, costless information, and no gou"rn*".ri interference' The theory's origins lie in the

work of Adam Smith, anJ particutarly with his seminal book TheWealth of Nations published

in 1776-Smith sought io explain why the division of labor in productive activities' and subse-

quently international trade of those goods, increased the quality of life for all citizens' Smith

based his work on ihe concept ol abiolute advantage,wheie every country should specialize

in the production of that good it was uniquely suited for' More would be produced for less'

10 PAfil" 1 Global Financial Environment

Thus. by each country specializing in products for which it possessed absolute ad,vantage, 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 Politicat Econonzy anrl Taxotion pub- lished in 18i7, sought to take the basic ideas set down by Adam Smith a ferv iogical 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 aclt,antctge. 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 trading for the other.

Although international trade might have approached the comparative advantage model during the nineteenth century, it certainly does not today, for avariety ofreasons. Countries do not appear to specialize only in those products that could be most efficiently produced by that country's particuiar factors of production. Instead, governments interfere rvith compara- tive advantage for a variety of economic and political reasons, such as to achieve full employ- ment, economic development, national self-sufficiency in defense-related industries, and protection of an agricultural sector's way of life. Government interference takes the form of tariffs, guotas, 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 develop- ment 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 devel- oped and reahze 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.

Nevertheless, although the world is a long way from the classical trade model, the gen- eral 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 consumerq producers, and political leaders. Complete specialization, however, remains an unrealistic limiting case, just as perfect competition is a limiting case in microeconomic theory.

I :.

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.ri

cHAFTERlCurrentMultinationalChallengesandtheGlobalEconomy

rb- rps uc- 'in rch .wo uct

'del ries tbv 1ra-

,oY-

and rof

and this 11 as

ows ants

tors :rial lop- mer , tax and

the )ory.

:vel- rtive rited rtive and

, and

gen- true Lbe :d to tion, case

Supply ehain CIutsour*ing: Ccmparative Adv*ntage Tcday

comparative advantage is still a relevant theory to explain why particular countries are most

suitable for exporrs "t

gr.a, and services that suppori the global supply chain of b::1MNEs

and domestic firms. fft"" "o*p-ative advantug"-of the twenty-first century' howevet' ls one

that is based more on services, and their "roSS iord"' 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 1'4 presents a geograph-

ical overview of this -odein'reincarnation of tlde-based comparative advantage' To prove

that these countries ,h;;i;;p""ialize in the activities shown you would need to know how

costly the same activities would be in the countries that are importing these services com-

pared to their own other industries. Remember that it takes a relative advantage in costs' not

lurt ut cbsolute advantage,to create comparative advantage'

For example, India iu, d"o"topea a trignty efficient ind low-cost software industry' This

inOurtry supplies not o"fy,n" "r"uiion of custlm software, but also call centers for customer

support, and other information technology r"rui""t.lt" Indian software industry is co*posed

of subsidiaries of MNEs and independent companies' If you own.a Hewlett-Packard computer

and call the customet *pp"" ""nt", "u*t* Ioi help, you are likely to reach a call center in

India. Answering your cati witt be a knowledgeable Indian software engineer or programmer

who will ,.walk you ,fr*"gh" your probleti. tnOlu has a large number of well-educated'

English-speaking technical-experts *^to urtfuid only a.fraction of the salary and overhead

earned by their IJ.S. counterparts. The overcapacity and low cost of international telecommu-

nication networks today furiher enhances ttre comparative advantage of an Indian location'

Eastern Europe

China London

I

Philippines\"/ \\ Manila

,",,"J '/lun''*''"'""

FX.- \ *on,"'.,"u/ !::",::"" \soutnnt'ic"

\ irndia' t San Jose

t BorL,uy

1

' "n?'t 1l'7vg ,.CtOfS

/ Budapest Berlin

\\shanghai -\ ,/ -

t\ \ Russia

Guadalajara Johannesburg Hyderabad Bangalore

MNEs based in many industrial countries are outsourcing intellectual

functlons to providers based in tradiiionai emetging market countries

12 FAfi'f i Global Financial Environment

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, mod-

ern telecommunications now take business activities to labor rather than moving labor to the

places of business.

1#i:at ls Different aE:mat{ Gl*bal Financi;e[ l'4anagcffineilg? Exhibit 1.5 details some of the main differences between international and domestic financial management. These component differences include institutions, foreign exchange and poiiti-

cai 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 domes-

tic firms and MNEs are exposed to foreign exchange risks, MNEs alone face certain unique

risks, such as political risks, that are not normaliy a threat to domestic operations. MNEs also face other risks that can be classified as extensions of domestic finance the-

ory. For example, the normal domestic approach to the cost of capital, sourcing debt and

equity, capital tudgeting, working capital management, taxation, and credit analysis needs to

be modified to accommodate foreign complexities. Moreover, a number of financial instru-

ments that are used in domestic financial management have been modified for use in interna-

tional financial management. Examples are foreign currency options and futures, interest

rate and currency swaps, and letters of credit. The main theme oi this book is to analyze horv a multinational enterprise's financial man-

agement evolves as it pursues global strategic opportunities and new constraints emerge. In this

cilapter, we will take a brief look at the challenges and risks associated with Tiident Corpora-

tio; (Tiident), a company evolving from domestic in scope to being truly multinational.The dis- cussion wiil include ihe constraints that a company will face in terms of managerial goals and

governance as it becomes increasingiy involved in multinational operations. But first we need

io clarify the unique value proposition and advantages that the MNE was created to exploit.

And as noted by bUnA Fiianie in Practice 1.2,the objectives and responsibilities of the mod-

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

@ CcrBt and c

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fut

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costs ( globali: poratic leaders

TI to dat€ corpor,

corpor,

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a cult

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i Concept

What ls Different about lnternational Financial Management?

lnternational Domestic Culture, history and insUtutions

Corporate governance

Foreign exchange risk

Political risk

Modification of domes- tic finance theories

Modiflcation of domes- tic financial instruments

Each foreign country is unique and not always understood by MNE management

Foreign countries' regulations and rnstrtutional practices are all uniquely different

MNEs face foreign exchange risks due to their

subsidiaries, as well as impod/expod and foreign competitors

MNEs face poliiical risks because of their foreign

subsidiaries and high Prollle

MNEs must modiiy finance theories like capital budget-

ing and cost of capital because of foreign complexities

MNEs utilize modified financial instruments such as

options, futures, swaps, and letters of credit

Each country has a known base case

Regulations and institutions are well known

Foreign exchange risks from import/expod and

foreign competition (no subsidiaries)

Negligible political risks

Traditional financial theory applies

Limited use of financial instrurnents and derivatives

because of fewer foreign exchange and political risks

c H A P T E l? 1 current Multinational challenges and the Global Economy

be.

rd- .he

rnd reS-

lue

he- rnd sto .ru- na- 'est

eorporate HesPonsibilitY and eorporate $ustainabilitY

Sustainable development is development that meets the

needs of the present without compromising the ability of

future generations to meet their own needs,

-Brundttand Report, 1987, P.54.

What is the purpose of the corporation? lt is increasingly accepted that the purpose of the corporation is to certainly

create profits and value for its stakeholders, but the respon-

sibility of Ihe 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 cor-

poration in society has added a level of complexity to the

leadership challenges faced by the twenty-first ceniury firm'

This developing debate has been somewhat hampered

to date by conflicting terms and labels-corporate goodnxs'

corporate responsibility, corporate social respons/b//ly (CSR)'

corporate philanthropy, and corporate sustainability, to list but

a few. Much of the confusion can be reduced by using a guid-

lng principle-that susfarnability is a goal, while responsibility is an obligation. lt follows that the obligation of leadership in

the modern multinational is to pursue profit, social develop- ment, and the environment, all along sustainable principles'

The term sustainable has evolved greaily within the con-

text of global business in the past decade. A traditional pri-

mary objective of the family-owned business has been the "sustainability of the organization"-the long-term ability of

the company to remain commerclally viable and provide security and income ior future generations. Although nar- rower in scope than the concept of environmental sustainabil-

ity, there is a common core thread-the ability of a company'

a culture, or even the earth, to survive and renew over time'

The Triple Bottom-Line

, . . batancing economic growth, social development' and environmental protection, so that future generations

are not compromised by actions taken today

- 2OOB S u stai n ab ility Report, ExxonMobil Corporation.

Nearly two decades ago a number of large corporations

began to refine their publicly acknowledged corporate objective as "the pursuit of the triple bottom line'" This tripte

bottom line - profitability, sociat responsibility, and environ -

mental sustainability-was considered an enlightened development of modern capitalism. What some critics referred to as a softer and gentler form of market capital-

ism, was a growing acceptance on the pad of the corpora-

tion for doing something more than generating a financial

profit.

There have been a variety of theoretical rationalizations

for this more expanded view of corporate responsibilities, one

of which divides the argurnents along tvvo channels, the economic channeland the moral channel'

Q The economic channel argues that by pursuing corpo- rate sustainability obiectives the corporation is actually

still pursuing profitability, bui is doing so with a more intel-

ligent longer-term perspective-sometimes refened to as

"enlightened self-interest." lt has realized that a responsi-

ble organization must assure that its actions over time'

whether or not required by law or markets, conducts its

business in a way which does not reduce future choices'

* The moral channelargues that since the corporation has all the rights and responsibilities of a citizen, it also has

the moral responsibility to act in the best interests of

society and society's future, regardless of its impacts on

profitability. This argument assumes that in some instances, doing the 'right thing' may have explicit costs'

even to shareholders

Our Commitment to corporate respansibility is unwa-

vering, even during economic downturns' Taking a

proactive, integrated approach to managing our impact

on local communities and the environment not only benefits people and our planet, but is good for our busi-

ness. Making corporate responsibility an integral parl of

lntet's strategy heips us mitigate risk, build strong rela-

tionships with our stakeholders, and expand our market

oPPortunities.

-Letter from our CEO, lntet 20AB Corp;sr67s Responsibitity Report, p' 3

.an-

this )ra- dis- and eed loit. Lod-

:!l

I j :.

risks

h€aerE<c€ Xxmp:erfee€i*als: A Raei*t?ags fl'or tE:e frxis€enec qlf tEa* &deaEtimati*s:al Fie"era MNEs strive to take advantage of imperfections in national markets for products, factors

of

production, and financial ass""tr. Impeifections in the market for products translate into mar-

Let opportunities {or MNEs. Large international firms are better able to expioit such compet-

itive factors as economies of scale, managerial and technological expertise, product differentiation, and financial strength than arJtheir local competitors' In fact, MNEs thrive

best in markets characterized by international oligopolistic competition, where these factors

14 PART i Global Financial Environment

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 internai information network.

Why ** Firms becom* fl"{ultinati*nal? Strategic motives drive the decision to invest abroad and become an MNE. These motives can be summarized under the following categories:

1. Market seekers produce in foreign markets either to satisfy local demand or to expoil to markets other than their home market. U.S. automobile firms manufacturing in Europe for local consumption are an example of market-seeking motivation.

2. Raw material seekers extract raw materials wherever they can be found, either for export or for further processing and sale in the country in which they are found-the host coun- try. Firms in the oil, mining plantation, and forest industries fall into this category.

3. Production efficiency seekers produce in countries where one or more of the factors of production are underpriced relative to their productivity. Labor-intensive production of electronic components inTaiwan, Malaysia, and Mexico is an example of this motiyation.

4. Knowledge seekers operate in foreign countries to gain access to technology or manage- rial expertise. For example, German, Dutch, and Japanese firms have purchased U.S.- located electronics firms for their technology.

5. Political safety seekers acquire or establish new operations in countries that are consid- ered unlikely to expropriate or interfere with private enterprise. For example, Hong Kong firms invested heavily in the United States, United Kingdom, Canada, and Aus- tralia in anticipation of the consequences of China's 1997 lakeover 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. Exam- ples of the latter are investments that try to preempt a market before competitors can get established in it, or capture raw material sources and deny them to competitors.

The G!*balizaticn Frereess Tiident is a hypothetical U.S.-based firm that will be used as an illustrative example through- 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.

&l*bal Transitisrx l: Trident fuloves from the *sntestie Fhase t* the Er:ternationei Trade Pha*e Tiident 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 1.6 shows Tiident in its early domestic phase.Tiident 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

CHAPTER 1 Current Multinational Challenges and the Global Economy

d, et

ii

.:

ffiltrxtrf Trident Corporation: tnitiation of the Gtobatization process

US Suppliers (domestic)

Phase One: Bomestic Operations

All payments in US dollars. All credit risk under US law.

US Buyers :. (domestic)

iii##=.Fiw;:E

Canadian Buyers,

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

to )e

rrt

n-

of of n.

Mexican Suppliers,

;_i :: r i:i.?:i;:r:,:q,iit:a*,:iii3:ir::j

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

Phase Two: Expansion into lnternalional Trade

Triclent Corporation

).-

d- 1g

.s-

ry.

:ts

a

{e r'e

r/e

n- et

all suppliers and buyers is established under domestic U.S. practices and procedures. A poten- tial issue for Tiident at this time is that although Tiident 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 Tiident into the first transition of the globalization process, into international trade.

Tiident was founded by James and Edgar 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, r'equired 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, Tiident's management sought to create value for its shareholders.

As Tiident became a visible and viable competitor in the U.S. market, strategic opportu- nities arose to expand the firm's market reach try exporting product and services to one or more foreign markets. The North American Free Tiade Area (NAFTA) made trade with Mexico and Canada attractive. This second phase of the globalization process is shown in the lower-half of Exhibit 1.6. Tiident responded to these globalization forces by importing inputs from Mexican suppliers and making export sales to Canadian buyers. We define this stage of the globalization process as the International Trade Phase.

Exporting and importing products and services increases the demands of financial man- agement over and above the traditional requirements of the domestic-only business. First, direct foreign exchange risks are now borne by the firm. Tiident may now need to quote prices in foreign currencies, accept payment in foreign currencies, or pay suppliers in foreign currencies. As the value of currencies change from minute to minute in the global market- place, Tiident will now experience significant risks from the changing values associated with these foreign currency payments and receipts.

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

h- ES

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of ts tS

of

76 Global Financial Environment

Trident's Foreign Direct lnvestment Sequence

/lZ/fVlzr 2l-rzzz/zlzzgzzzzzzzzgzzzzzzZ.tat))stzzr)zaredjlJicdilz)z/ezza/iozd banzesS as bu1-ers and suppliet's are new, suuiect to differing business practices and

legal systems, and

generallr, more chalienging to assess.

i:-*::-i ir':;ll:,::ii:-rl: t.' ,:'.,. l:ti,l: :-' -:.;- ' ' ': j j ii::-i:: i:i':,:::+ :''.':

If Tridentis successful in its international trade activities, the time will come v'hen the global' ization process wiil progress to the next phase' Trident rvili soon need to establish foreign

sales and service affiiiates. This step is often followed by estabiishing manufacturing opera-

tions abroad or by licensing foreignfirms to produce and service Tiident's products' The mul-

titude of issues and activitls associated rvith this second larger global transition is the real

focus of this book. Tiident,s continued giobalization will require it to identify the sources of its competi-

tive advantage, and with that knowledge, expand its intellectual capital and physical pres-

ence globail-y. A variety of strategic alternatives are available to Tiident-lhe foreign direct investment seqttence-as shorvn in Exhibit 1.7. These alternatives include

the cre-

ation of foreign sales offices, the licensing of the company name and everything associated

with it, and the manufacturing and distiibution of its products to other firms in foreign

markets.AsTi.ident moves farther dorvn and to the right in Exhibit 1.7,lhe degree of its

physical presence in foreign markets increases. It may now own its own distribution and

proOu.tion facilities, and ultimately, may want to acquire other companies' Once Tiident

owns assets and enterprises in foreign countries it has entere d the multinational phase of

its globalization.

Trident and lts Competitive Advantage Greater

Foreign Presence

Change Competitive Advantage ,::i:j::i.r"::.i.:i :i:. r:'r:.*i:i:t::1-;p'?:::M :., rri: ;.n

Greater Foreign lnvestment

Exploit Existing ComPetitive Advantage Abroad

I

Production at Home: Exporiing

Licensing Management Contract

Joint Venture Wholly Owned

SubsidiarY

Greenlield lnvesiment

Acquisition ol a Foreign EnterPrise

,t |;:|:'ii.:i

ls,

rd

i, I' j A i )-f i,, ili i Current Multinational Challenges and the Global Economy 77

Th* i-irriit* t* Fir:***i*l *l*t**iie*ti*n The 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 1.8. If influential insid- 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 influen- tial insiders pursue their own personal agendas, which may increase their personal power and influence or personal rvealth, 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 iosers. As we will see throughout this book, this barrier to international finance may indeed be increasingly troublesome.

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 antl 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 famiiy members of this company cre- ating value for themselves or their shareholders?

ine potentiai Liritr or Financial Globalization

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

i1-

ln 'a-

rl- :al

ti- ls- gn

ed .gn its

.nd rnt 'of

Actions of Rulers of Sovereign States

I

Lower Firm Value (possibly higher

insider value)

: : (PossiblY lower .i inslder value)

TheTwin Agency Problems Limiting

Financial Globalization

Y

Actions of Corporate Insiders

e

lf 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.

Soulce: Constructed by authors based on "The Limits of Financial Globaiization," Rene M. Stulz, Journal of Applied Corporate Finance, Volume 19, Number 1, Winter 2002, pp. B-15.