Foundations of multinational financial management pdf

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Fundamentals of

Multinational Finance Sixth Edition

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Fundamentals of

Multinational Finance Sixth Edition

MICHAEL H. MOFFETT Thunderbird School of Global Management at Arizona State University

ARTHUR I. STONEHILL Oregon State University and University of Hawaii at Manoa

DAVID K. EITEMAN University of California, Los Angeles

New York, NY

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Library of Congress Cataloging-in-Publication Data

Names: Moffett, Michael H., author. | Stonehill, Arthur I., author. | Eiteman, David K., author. Title: Fundamentals of multinational finance / Michael Moffett, Arthur Stonehill, David Eiteman. Description: 6th edition. | New York, NY : Pearson, [2017] Identifiers: LCCN 2017014647 | ISBN 9780134472133 Subjects: LCSH: International business enterprises—Finance. | International finance. | Foreign exchange. Classification: LCC HG4027.5 .M64 2017 | DDC 332/.042—dc23 LC record available at https://lccn.loc.gov/2017014647

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Preface The subject of this book is the financial management of multinational enterprises (MNEs)— multinational financial management. 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 branches, foreign subsidiaries, or joint ventures with host country firms.

Fundamentals of Multinational Finance, Sixth Edition, reflects the juxtaposed forces of an increasingly digital global marketplace and a resurgence of nationalist culture and identity. Financial forces, markets, and management are in many ways at the crux of this challenge. This edition has been revised to reflect a business world trying to find a new balance between new business startups like the micro-multinational, a maturing China, a separatist Britain (Brexit), and an attempt by governments globally to channel, regulate (and tax) multinational firms that continue to grow in stature and strength. The book focuses on the challenges faced in multinational financial management—with three points of emphasis.

■■ Organizations. Multinational enterprises (MNEs) applies to organizations of all kinds— the publicly traded, the privately held, the state-run, the state-owned organizations—all forms that permeate global business today. Who owns and operates the organization alters its goals and therefore its management.

■■ Markets. Country players in the emerging world are rapidly taking their place as both producers and consumers on an equal basis with the industrial countries and their tradi- tional corporate components. Although they may still be categorized as emerging, they are the economic drivers and primary challenges for global finance and global financial management.

■■ Leadership. Individuals in positions of leadership within these organizations and markets are faced with a changing global landscape in which emerging market finance is no longer on the outer edge of financial management, but moving to its core. These leaders of MNEs face numerous foreign exchange and political risks that are actually more volatile, with global capital moving in and out of countries at an ever-increasing rate.

These risks can be daunting but they also present opportunities for creating value if prop- erly understood and managed. In the end, the primary question is whether business leaders are able to integrate the global strategic and financial challenges that business faces.

New in the Sixth Edition Our primary challenge with the Sixth Edition is to strike a balance between our growing success with the Fifth Edition and the relevant and exacting recommendations by selected reviewers—the innovator’s dilemma. Surveys of adopters were extremely useful in this revision, and a number of specific developments included.

■■ . All chapters are structured around a series of pedagogical Learning Objectives aligned with the platform for Fundamentals of Multinational Finance’s teaching.

■■ Interest Rate Risk and Swaps. A new chapter has been introduced that details the various interest rate risks of the MNE and the practical use of interest rate and cross–currency swaps.

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■■ The Impossible Trinity. A core international financial principle, the Impossible Trinity’s use as a unifying theoretical link across multiple subjects and chapters has been expanded.

■■ The Foreign Exchange Market and Digital Trade. New material in this edition explores in depth how the changing structure of the global foreign exchange market—trading, com- munication, and settlement—is posing challenges for private players and public regulators and overseers.

■■ International Taxation. Integrally linked to a world of digital commerce, multina- tional tax management continues to rise in its significance in multinational financial management. We have greatly expanded our coverage of this truly critical financial man- agement topic.

■■ Political Risk and Financial Losses. The chapter on foreign direct investment and political risk has been revised to reflect the growing use of restrictions on convertibility, transfer- ability, and the possibility of repudiation or expropriation.

■■ New and Edgier Mini-Cases. Eleven of the 18 Mini-Cases are completely new to the Sixth Edition, and explore many of the edgier debates rising between global business, social policy, and corporate social responsibility. Topics include Argentine debt and vulture investors, Apple’s global profit positioning and tax structure, Brexit and its potential impact on Rolls-Royce, Volkswagen’s governance structure and its defeat device “ strategy,” political risk in Kazakhstan’s oil and gas industry, and crowdfunding startups in Kenya, to name but a few.

■■ Expanded Quantitative Applications. We have worked diligently to increase the quantita- tive elements across subjects and chapters to push students to explore the depth of analysis and comprehension.

■■ End-of-Chapter Assessment. Questions and Problems are revised throughout and aligned with .

Fundamentals of Multinational Finance, Sixth Edition, however, retains and revises con- tinuing forces of change as seen in the growing dominance of China’s economy and currency, the disruptive financial forces of quantitative easing and near-zero interest rates, and the chal- lenge of the multinational firm to navigate foreign exchange risks.

International finance is a subject of sophistication, constant change, yet rich in history. We have tried to bridge the traditional business practices with digital practices with a mix of currency notations and symbols throughout the book, using both the common three-letter cur- rency codes—USD, CNY, EUR—with the traditional currency symbols—$, ¥, £, €—which are seeing a resurgence as countries like Russia and Turkey have introduced new “currency identities” of their own.

Audience Fundamentals of Multinational Finance, Sixth Edition, is aimed at university-level courses in international financial management, international business finance, international finance, and similar titles. It can be used at either the undergraduate or graduate level as well as in executive education and corporate learning courses.

A prerequisite course or experience in corporate finance or financial management would be ideal. However, we review the basic finance concepts before we extend them to the

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multinational case. We also review the basic concepts of international economics and inter- national business.

We recognize the fact that a large number of our potential adopters live outside of the United States and Canada. Therefore, we utilize a significant number of non-U.S. examples, Mini-Cases, and Global Finance in Practice examples seen in the business and news press (anecdotes and illustrations).

Organization Fundamentals of Multinational Finance, Sixth Edition, has been redesigned and restruc- tured for tightness—critical elements of the field but in a much shorter delivery framework. This has been accomplished by integrating a number of previous topics along financial management threads. The book is in five parts, the parts unified by the common thread of the globalization process by which a firm moves from a domestic to a multinational busi- ness orientation.

■■ Part 1 introduces the global financial environment ■■ Part 2 explains foreign exchange theory and markets ■■ Part 3 explores foreign exchange rate exposure ■■ Part 4 details the financing of the global firm ■■ Part 5 analyzes international investment decisions

Pedagogical Tools To make Fundamentals of Multinational Finance, Sixth Edition, as comprehensible as possible, we use a large number of proven pedagogical tools. Again, our efforts have been informed by the detailed reviews and suggestions of a panel of professors who are recognized individually for excellence in the field of international finance, particularly at the undergraduate level. Among these pedagogical tools are the following:

■■ A student–friendly writing style combined with a structured presentation of material, begin- ning with learning objectives for each chapter, and ending with a summarization of how those learning objectives were realized.

■■ A wealth of illustrations and exhibits to provide a visual parallel to the concepts and content presented. The entire book utilizes a multicolor presentation which we believe provides a visual attractiveness that contributes significantly to reader attention and retention.

■■ A running case on a hypothetical U.S.-based firm, Trident Corporation, provides a cohesive framework for the multifaceted globalization process, and is reinforced in several end-of- chapter problems.

■■ A Mini-Case at the end of each chapter illustrates the chapter content and extends it to the multinational financial business environment. And as noted, 11 of the 18 are new to the Sixth Edition.

■■ Global Finance in Practice boxes in every chapter to illuminate the theory with accounts of actual business practices. These applications extend the concepts without adding to the length of the text itself.

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■■ Every chapter has a number of end of chapter exercises requiring the use of the Internet, while a variety of Internet references are dispersed throughout the chapters in text and exhibits.

■■ A multitude of end-of-chapter Questions and Problems, which assess the students’ under- standing of the course material. All end-of-chapter Problems are solved using spreadsheet solutions. Selected end-of-chapter Problem answers are now included at the back of the book.

A Rich Array of Support Materials A robust package of materials for both instructor and student accompanies the text to facili- tate learning and to support teaching and testing.

■■ . Fundamentals of Multnational Finance, Sixth Edition, is now available with . , a fully integrated homework and tutorial system, solves one of

the biggest teaching problems in finance courses: providing students with unlimited practice homework problems along with a structured blueprint for studying the material.

offers:

■■ Textbook problems online ■■ Algorithmically generated values for more practice ■■ Partial credit ■■ Personalized study plans ■■ Extra help for students ■■ Online gradebook

End-of-chapter Questions and Problems that provide assessment and practice oppor- tunities are available in . Internet exercises, glossary flash cards, and Web links are also available in .

■■ Online Instructor’s Manual. The Online Instructor’s Manual, prepared by the authors with assistance from Shannon Donovan at Bridgewater State University, contains complete answers to all end-of-chapter Questions, Problems, and chapter Mini-Cases. All quantitative end-of-chapter Problems are solved using spreadsheets, which are also available online.

■■ Online Test Bank. The Online Test Bank, revised by Brian Nethercutt, contains over 1,200 multiple-choice and short-essay questions. The multiple-choice questions are labeled by topic and by category— recognition, conceptual, and analytical types.

■■ Computerized Test Bank. The Test Bank is also available in Pearson Education’s Test- Gen Software. Fully networkable, it is available for Windows and Macintosh. TestGen-EQ’s graphical interface enables instructors 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 in a preferred order. The TestGen plug-in auto- matically grades the exams, stores the results on a disk, and allows the instructor to view and print a variety of reports.

■■ Online Mini-Case PowerPoint Presentations. Each of the 18 Mini-Cases has a stand-alone PowerPoint presentation available online.

■■ Online PowerPoint Presentation Slides. The extensive set of PowerPoint slides provides lecture outlines and selected graphics from the text for each chapter.

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■■ Web Site. A dedicated Web site at www.pearsonhighered.com/moffett contains selected solutions and spreadsheets for end-of-chapter Problems and other bonus material.

All of the teaching resources are available online for download at the Instructor Resource Center at www.pearsonhighered.com/irc.

International Editions Fundamentals of Multinational Finance and Multinational Business Finance have been used throughout the world to teach students of international finance. Our books are published in a number of foreign languages including Chinese, French, Spanish, Indonesian, Portuguese, and Ukrainian.

Acknowledgments The authors are very thankful for the many detailed reviews of previous editions and sug- gestions from a number of colleagues. The final version of Fundamentals of Multinational Finance, Sixth Edition, reflects most of the suggestions provided by these reviewers. The survey reviewers were anonymous, but the detailed reviewers were:

Dev Prasad, University of Massachusetts Lowell Anand M. Vijh, University of Iowa, Tippie College of Business Yoon S. Shin, Loyola University Maryland Raymond M. Johnson, Auburn University Montgomery Cheryl Riffe, Columbus State Community College

We would also like to thank all those with Pearson who have worked so diligently on this edition. In addition, Gillian Hall, our outstanding project manager at The Aardvark Group, deserves much gratitude.

Finally, we would like to dedicate this book to our parents, Bennie Ruth and the late Hoy Moffett, the late Harold and Norma Stonehill, and the late Wilford and Sylvia Eiteman, who gave us the motivation to become academicians and authors. We thank our wives, Megan, Kari, and Keng-Fong, for their patience while we were preparing Fundamentals of Multinational Finance.

Glendale, Arizona M.H.M. Honolulu, Hawaii A.I.S. Pacific Palisades, California D.K.E.

About the Authors Michael H. Moffett Michael H. Moffett is Continental Grain Professor in Finance at the Thunderbird School of Global Management, where he has been since 1994. He has also held teaching or research appointments at Oregon State University (1985–1993); the University 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 Eco- nomics and Business Administration (Finland); the International Centre for Public Enterprises (Yugoslavia); and the University of Colorado, Boulder.

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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. (Economics) from the University of Colorado, Boulder (1983); and Ph.D. (Economics) from the University of Colorado, Boulder (1985).

He has authored, co-authored, or contributed to a number of books, articles, and other publications. He has co-authored two books with Art Stonehill and David Eiteman, Multinational Business Finance, and this book, Fundamentals of Multinational Finance. 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 Inter- national Financial Management and Accounting, Contemporary Policy Issues, Brookings Discussion Papers in International Economics, and others. He has contributed to a number of collected works including the Handbook of Modern Finance, the International Account- ing and Finance Handbook, and the Encyclopedia of International Business. He is also co- author of a number of books in multinational business with Michael Czinkota and Ilkka Ronkainen, International Business (7th edition) and Global Business (4th edition). Profes- sor Moffett has also published extensively in the oil and gas industry including The Global Oil and Gas Industry: Strategy, Finance, and Management, with Andrew Inkpen, Managing Human Resources in the Oil & Gas Industry, with Steve Werner and Andrew Inkpen, and The Global Oil and Gas Industry: Stories From The Field, with Andrew Inkpen and Kannan Ramaswamy.

Arthur I. Stonehill 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 Busi- ness 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 was 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 the University 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 co-authored 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, European Management Journal, The Investment Analyst (U.K.), Nationaløkonomisk Tidskrift (Denmark), Sosialøko- nomen (Norway), Journal of Financial Education, and others.

David K. Eiteman 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 appoint- ments 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 Economics and Business Administration (Finland), University of Hawaii at Manoa, Univer- sity of Bradford (U.K.), Cranfield School of Management (U.K.), and IDEA (Argentina). He is

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a former president of the International Trade and Finance Association, Society for Economics and Management in China, and Western Finance Association.

Professor Eiteman received a B.B.A. (Business Administration) from the University of Michigan, Ann Arbor (1952); M.A. (Economics) from the University of California, Berkeley (1956); and a Ph.D. (Finance) from Northwestern University (1959).

He has authored or co-authored 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.

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Brief Contents

PART 1 Global Financial Environment 1 Chapter 1 Multinational Financial Management: Opportunities and Challenges 2

Chapter 2 The International Monetary System 28

Chapter 3 The Balance of Payments 60

Chapter 4 Financial Goals and Corporate Governance 90

PART 2 Foreign Exchange Theory and Markets 121 Chapter 5 The Foreign Exchange Market 122

Chapter 6 International Parity Conditions 152

Chapter 7 Foreign Currency Derivatives: Futures and Options 186

Chapter 8 Interest Rate Risk and Swaps 210

Chapter 9 Foreign Exchange Rate Determination and Intervention 241

PART 3 Foreign Exchange Exposure 271 Chapter 10 Transaction Exposure 272

Chapter 11 Translation Exposure 301

Chapter 12 Operating Exposure 321

PART 4 Financing the Global Firm 349 Chapter 13 Global Cost and Availability of Capital 350

Chapter 14 Funding the Multinational Firm 377

Chapter 15 Multinational Tax Management 407

Chapter 16 International Trade Finance 438

PART 5 Foreign Investments and Operations 463 Chapter 17 Foreign Direct Investment and Political Risk 464

Chapter 18 Multinational Capital Budgeting and Cross-Border Acquisitions 489

Answers A-1

Glossary G-1

Index I-1

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Contents PART 1 Global Financial Environment 1

Chapter 1 Multinational Financial Management: Opportunities and Challenges 2 1.1 Financial Globalization and Risk 3 1.2 The Global Financial Marketplace 4 GLOBAL FINANCE IN PRACTICE 1.1 The Rocketing Swiss Franc 8 1.3 The Theory of Comparative Advantage 11 1.4 What Is Different About International Financial Management? 12 GLOBAL FINANCE IN PRACTICE 1.2 The Peso, Dollar, Yen—and Pokémon Go 13 1.5 The Globalization Process 15 GLOBAL FINANCE IN PRACTICE 1.3 Corporate Responsibility and Corporate Sustainability 19 Summary Points 19 MINI-CASE: Crowdfunding Kenya 20 Questions 23 Problems 23 Internet Exercises 27

Chapter 2 The International Monetary System 28 2.1 History of the International Monetary System 28 GLOBAL FINANCE IN PRACTICE 2.1 Hammering Out an Agreement at Bretton Woods 31 GLOBAL FINANCE IN PRACTICE 2.2 SDR Expanded to Include Chinese Renminbi 32 2.2 Fixed Versus Flexible Exchange Rates 38 2.3 The Impossible Trinity 38 2.4 A Single Currency for Europe: The Euro 40 2.5 Emerging Markets and Regime Choices 42 GLOBAL FINANCE IN PRACTICE 2.3 Nigeria Undermines Currency Exchange Innovation 46 Summary Points 50 MINI-CASE: Iceland—A Small Country in a Global Crisis 51 Questions 56 Problems 56 Internet Exercises 58

Chapter 3 The Balance of Payments 60 3.1 Fundamentals of BOP Accounting 61 3.2 The Accounts of the Balance of Payments 63 GLOBAL FINANCE IN PRACTICE 3.1 The Global Current Account Surplus 65 GLOBAL FINANCE IN PRACTICE 3.2 A Country’s Net International Investment Position (NIIP) 68 3.3 BOP Impacts on Key Macroeconomic Rates 71 3.4 Trade Balances and Exchange Rates 72 3.5 Capital Mobility 75 Summary Points 80 MINI-CASE: Global Remittances 81 Questions 85 Problems 86 Internet Exercises 89

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Chapter 4 Financial Goals and Corporate Governance 90 4.1 Ownership 90 GLOBAL FINANCE IN PRACTICE 4.1 Why Did Apple Start Paying a Dividend and Raising Debt? 97 4.2 Publicly Traded Versus Privately Held: The Global Shift 99 4.3 Corporate Governance 102 GLOBAL FINANCE IN PRACTICE 4.2 Why Did Dell Go Private? 102 GLOBAL FINANCE IN PRACTICE 4.3 Italian Cross-Shareholding and the End of the Salatto Buono 107 GLOBAL FINANCE IN PRACTICE 4.4 Is Good Governance Good Business Globally? 109 Summary Points 110 MINI-CASE: Volkswagen’s Defeat Devices and Stakeholder Control 111 Questions 115 Problems 116 Internet Exercises 119

PART 2 Foreign Exchange Theory and Markets 121

Chapter 5 The Foreign Exchange Market 122 5.1 Functions of the Foreign Exchange Market 122 5.2 Structure of the Foreign Exchange Market 123 GLOBAL FINANCE IN PRACTICE 5.1 Bankhaus Herstatt and Herstatt Risk 124 GLOBAL FINANCE IN PRACTICE 5.2 Malware, Bangladesh Bank, and Banker’s Hours—2016 130 5.3 Transactions in the Foreign Exchange Market 131 GLOBAL FINANCE IN PRACTICE 5.3 The FX Global Code of Conduct 2016 131 5.4 Foreign Exchange Rates and Quotations 136 Summary Points 144 MINI-CASE: The Venezuelan Bolivar Black Market 144 Questions 147 Problems 148 Internet Exercises 151

Chapter 6 International Parity Conditions 152 6.1 Prices and Exchange Rates 153 GLOBAL FINANCE IN PRACTICE 6.1 The Immiseration of the North Korean People—The “Revaluation”

of the North Korean Won 155 6.2 Interest Rates and Exchange Rates 159 GLOBAL FINANCE IN PRACTICE 6.2 Was 2016 the Year of Textbook Failure? 161 6.3 Forward Rate as an Unbiased Predictor of the Future Spot Rate 169 GLOBAL FINANCE IN PRACTICE 6.3 Hungarian Mortgages 170 6.4 Prices, Interest Rates, and Exchange Rates in Equilibrium 171 Summary Points 173 MINI-CASE: Mrs. Watanabe and the Japanese Yen Carry Trade 173 Questions 176 Problems 177 Internet Exercises 181 Appendix: An Algebraic Primer to International Parity Conditions 183

Chapter 7 Foreign Currency Derivatives: Futures and Options 186 7.1 Foreign Currency Futures 187 7.2 Currency Options 189 GLOBAL FINANCE IN PRACTICE 7.1 Euro-Renminbi (EUR-RMB) Options Growth 191 GLOBAL FINANCE IN PRACTICE 7.2 The New Zealand Kiwi, Key, and Krieger 197

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7.3 Option Pricing and Valuation 197 Summary Points 202 MINI-CASE: KiKos and the South Korean Won 203 Questions 205 Problems 206 Internet Exercises 208

Chapter 8 Interest Rate Risk and Swaps 210 8.1 Interest Rate Foundations 210 GLOBAL FINANCE IN PRACTICE 8.1 The Trouble with LIBOR 211 GLOBAL FINANCE IN PRACTICE 8.2 European Sovereign Debt 216 8.2 Interest Rate Risk 217 8.3 Interest Rate Futures and FRAs 220 8.4 Interest Rate Swaps 222 GLOBAL FINANCE IN PRACTICE 8.3 Procter & Gamble and Bankers Trust 230 Summary Points 231 MINI-CASE: Argentina and the Vulture Funds 231 Questions 236 Problems 236 Internet Exercises 240

Chapter 9 Foreign Exchange Rate Determination and Intervention 241 9.1 Exchange Rate Determination: The Theoretical Thread 242 GLOBAL FINANCE IN PRACTICE 9.1 Technical Analysis of the JPY/USD Rate (Jan 2011–Feb 2014) 245 9.2 Currency Market Intervention 246 GLOBAL FINANCE IN PRACTICE 9.2 Rules of Thumb for Effective Intervention 249 9.3 Disequilibrium: Exchange Rates in Emerging Markets 251 GLOBAL FINANCE IN PRACTICE 9.3 The European Monetary System’s “Snake in a Tunnel” 252 GLOBAL FINANCE IN PRACTICE 9.4 Was George Soros to Blame for the Asian Crisis? 255 9.4 Forecasting in Practice 257 Summary Points 261 MINI-CASE: Russian Ruble Roulette 262 Questions 264 Problems 265 Internet Exercises 269

PART 3 Foreign Exchange Exposure 271

Chapter 10 Transaction Exposure 272 10.1 Types of Foreign Exchange Exposure 272 10.2 Why Hedge? 273 GLOBAL FINANCE IN PRACTICE 10.1 Hedging and the German Automobile Industry 276 10.3 Transaction Exposure 276 10.4 Transaction Exposure Management: The Case of Ganado 278 GLOBAL FINANCE IN PRACTICE 10.2 Currency Losses at Greenpeace 281 GLOBAL FINANCE IN PRACTICE 10.3 Forward Rates and the Cost of Hedging 286 10.5 Risk Management in Practice 287 GLOBAL FINANCE IN PRACTICE 10.4 The Credit Crisis and Option Volatilities in 2009 288 Summary Points 289 MINI-CASE: China Noah Corporation 289 Questions 295 Problems 295 Internet Exercises 300

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Chapter 11 Translation Exposure 301 11.1 Overview of Translation 301 11.2 Translation Methods 304 11.3 Ganado Corporation’s Translation Exposure 308 GLOBAL FINANCE IN PRACTICE 11.1 When the Hedge Becomes the Problem 309 GLOBAL FINANCE IN PRACTICE 11.2 Foreign Subsidiary Valuation 312 11.4 Managing Translation Exposure 312 GLOBAL FINANCE IN PRACTICE 11.3 Foreign Currency Hedge Accounting 314 Summary Points 314 MINI-CASE: McDonald’s, Hoover Hedges, and Cross-Currency Swaps 315 Questions 317 Problems 318 Internet Exercises 319

Chapter 12 Operating Exposure 321 12.1 A Multinational’s Operating Exposure 321 GLOBAL FINANCE IN PRACTICE 12.1 Expecting the Devaluation—Ford and Venezuela 324 12.2 Measuring Operating Exposure: Ganado Germany 326 12.3 Strategic Management of Operating Exposure 330 GLOBAL FINANCE IN PRACTICE 12.2 Do Fixed Exchange Rates Increase Corporate Currency Risk

in Emerging Markets? 331 GLOBAL FINANCE IN PRACTICE 12.3 The United Kingdom and Europe: Trans-Channel Currency Shifts 332 12.4 Proactive Management of Operating Exposure 333 GLOBAL FINANCE IN PRACTICE 12.4 Hedging Hogs: Risk Sharing at Harley-Davidson 336 Summary Points 339 MINI-CASE: Brexit and Rolls-Royce 339 Questions 343 Problems 344 Internet Exercises 347

PART 4 Financing the Global Firm 349

Chapter 13 Global Cost and Availability of Capital 350 13.1 Financial Globalization and Strategy 350 GLOBAL FINANCE IN PRACTICE 13.1 Ferrari’s IPO—The Potential of the Prancing Horse 352 13.2 International Portfolio Theory and Diversification 354 13.3 The Role of International Portfolio Investors 360 GLOBAL FINANCE IN PRACTICE 13.2 Emerging Market Growth Companies—IPOs and Corporate

Governance 361 GLOBAL FINANCE IN PRACTICE 13.3 Culture and Investment Behavior 364 13.4 The Cost of Capital for MNEs Compared to Domestic Firms 364 Summary Points 368 MINI-CASE: Novo Industri A/S (Novo) 368 Questions 372 Problems 372 Internet Exercises 376

Chapter 14 Funding the Multinational Firm 377 14.1 Designing a Strategy to Source Capital Globally 378 14.2 Optimal Financial Structure 379 14.3 Raising Equity Globally 382 14.4 Depositary Receipts 385 GLOBAL FINANCE IN PRACTICE 14.1 The Planned Directed Equity Issue of PA Resources of Sweden 385

Contents

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xix

14.5 Private Placement 390 14.6 Raising Debt Globally 392 14.7 Financing Foreign Subsidiaries 393 GLOBAL FINANCE IN PRACTICE 14.2 Islamic Finance 394 GLOBAL FINANCE IN PRACTICE 14.3 Financial Structure of a Russian Joint Venture 398 Summary Points 399 MINI-CASE: Petrobrás of Brazil and the Cost of Capital 399 Questions 402 Problems 403 Internet Exercises 406

Chapter 15 Multinational Tax Management 407 GLOBAL FINANCE IN PRACTICE 15.1 The Impact of Tax on Business Decisions 408 15.1 Tax Principles and Practices 408 GLOBAL FINANCE IN PRACTICE 15.2 The Panama Papers 415 GLOBAL FINANCE IN PRACTICE 15.3 Offshore Profits and Dividend Repatriation 417 15.3 Google: An Illustrative Case of Profit Repositioning 425 GLOBAL FINANCE IN PRACTICE 15.4 Hewlett-Packard’s Offshore Cash and Staggered Loan Program 426 15.4 Global Tax Competitiveness 427 Summary Points 429 MINI-CASE: Apple’s Global iTax Strategy 430 Questions 434 Problems 435 Internet Exercises 437

Chapter 16 International Trade Finance 438 16.1 The Trade Relationship 438 16.2 Key Documents 443 GLOBAL FINANCE IN PRACTICE 16.1 Florence—The Birthplace of Trade Financing 445 16.3 Government Programs to Help Finance Exports 449 16.4 Trade Financing Alternatives 450 GLOBAL FINANCE IN PRACTICE 16.2 Factoring in Practice 452 16.5 Forfaiting 453 Summary Points 455 MINI-CASE: Crosswell International and Brazil 456 Questions 459 Problems 459 Internet Exercises 461

PART 5 Foreign Investments and Operations 463

Chapter 17 Foreign Direct Investment and Political Risk 464 17.1 The Foreign Direct Investment Decision 464 17.2 Structural Choices for Foreign Market Entry 465 GLOBAL FINANCE IN PRACTICE 17.1 Drugs, Public Policy, and the Death Penalty 471 17.3 Political Risk: Definition and Classification 471 17.4 Financial Impacts of Political Risk 472 17.5 Political Risk Mitigation 476 GLOBAL FINANCE IN PRACTICE 17.2 Selective Examples of Expropriation in the Global Oil and Gas Industry 477 GLOBAL FINANCE IN PRACTICE 17.3 Structuring Incentives in Foreign Direct Investments 482 Summary Points 482 MINI-CASE: Tengiz—The Definition of Political Risk 483 Questions 486 Internet Exercises 487

Contents

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xx

Chapter 18 Multinational Capital Budgeting and Cross-Border Acquisitions 489 18.1 Complexities of Budgeting for a Foreign Project 490 18.2 Illustrative Case: Cemex Enters Indonesia 493 GLOBAL FINANCE IN PRACTICE 18.1 Venezuelan Currency and Capital Controls Force Devaluation of Business 503 18.3 Real Option Analysis 505 18.4 Project Financing 506 18.5 Cross-Border Mergers and Acquisitions 507 GLOBAL FINANCE IN PRACTICE 18.2 Values Change: GE Appliances and Electrolux 509 GLOBAL FINANCE IN PRACTICE 18.3 Statoil of Norway’s Acquisition of Esso of Sweden 513 Summary Points 513 MINI-CASE: Elan and Royalty Pharma 514 Questions 518 Problems 518 Internet Exercises 521

Answers A-1

Glossary G-1

Index I-1

Contents

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PART

1 Global Financial Environment CHAPTER 1 Multinational Financial Management: Opportunities and Challenges

CHAPTER 2 The International Monetary System

CHAPTER 3 The Balance of Payments

CHAPTER 4 Financial Goals and Corporate Governance

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2

1 Multinational Financial Management: Opportunities and Challenges

The subject of this book is the financial management of multinational enterprises (MNEs)—multinational financial management. MNEs are firms—both for-profit compa- nies and not-for-profit organizations—that have operations in more than one country and conduct their business through branches, foreign subsidiaries, or joint ventures with host country firms. That conduct of business comes with challenges as suggested by the following news release from Procter & Gamble Co. (P&G), an American multinational consumer goods company:

“The October–December 2014 quarter was a challenging one with unprecedented cur- rency devaluations,” said Chairman, President and Chief Executive Officer A.G. Lafley. “Virtually every currency in the world devalued versus the U.S. dollar, with the Russian Ruble leading the way. While we continue to make steady progress on the strategic trans- formation of the company—which focuses P&G on about a dozen core categories and

The objects of a financier are, then, to secure an ample revenue; to impose it with judgment and equality; to employ it economically; and, when necessity obliges him to make use of credit, to secure its foundations in that instance, and forever, by the clearness and can- dor of his proceedings, the exactness of his calculations, and the solidity of his funds. —Edmund Burke, Reflections on the Revolution in France, 1790, p. 467.

LEARNING OBJECTIVES 1.1 Understand how financial globalization alters the risks of multinational business

1.2 Explore the structures of the global financial marketplace

1.3 Consider how the theory of comparative advantage applies to multinational business

1.4 Examine how international financial management differs from domestic financial management

1.5 Discover the steps and stages of the globalization process

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CHAPTER 1 Multinational Financial Management: Opportunities and Challenges 3

70 to 80 brands, on leading brand growth, on accelerating meaningful product innova- tion, and increasing productivity savings—the considerable business portfolio, product innovation, and productivity progress was not enough to overcome foreign exchange.” —P&G News Release, January 27, 2015.

P&G is not alone. It is a brave new world, a new world in which digital startups may become multinational enterprises in hours—the micro-multinational, where the number of publicly traded companies on earth is shrinking, where the most challenging competitors are arising from emerging markets, and where more and more value is being created by ‘idea firms.’ The global marketplace is seeing radical change, with Brexit, the United Kingdom’s choice to exit the European Union and with the Chinese economy, the economic engine of the global economy for the past decade, now showing early signs of aging and slowing. Other seismic shifts are changing corporate identities, such as the growing role of the Chinese currency, the renminbi, the increasing number of firms in higher-tax environments, like the United States, reincorporating in lower-tax environments—so-called corporate inversion—and acquisitions of old industrial firms by companies from India, Vietnam, South Africa. The global financial crisis of 2008–2009 is far in the past, but central banks in Europe, the United States, and Japan have pushed interest rates to zero or in some cases below zero in an attempt to prevent industrial economies from backsliding into recession, although this may be starting to change. Capital is flowing again at an ever-increasing pace—although the flow is both into and out of economies—and currency volatility is growing, not slowing.

How to identify and navigate these risks and many others is the focus of this book. These risks may all occur on the playing field of the global financial marketplace, but they are still a question of management—of navigating complexity in pursuit of the goals of the firm and all of its varied stakeholders.

This first chapter provides a brief overview of the global financial landscape including foreign currency markets and financial institutions. We then explore the foundations of com- parative advantage, those forces differentiating international from domestic finance. We con- clude our introductory overview with the alternative paths firms may take in going global. The chapter concludes with a Mini-Case, Crowdfunding Kenya, that examines how the Internet and financial innovation is opening the emerging market world to global capital and its potential benefits.

1.1 Financial Globalization and Risk Back in the halcyon pre-crisis days of the late 20th and early 21st centuries, it was taken as self evident that financial globalization was a good thing. But the subprime crisis and eurozone dramas are shaking that belief . . . what is the bigger risk now—particularly in the eurozone—is that financial globalization has created a system that is interconnected in some dangerous ways. —“Crisis Fears Fuel Debate on Capital Controls,” Gillian Tett, Financial Times, December 15, 2011.

The discussion dominating global financial markets today is centered around the complexity of risks associated with financial globalization—the discussion goes far beyond whether such globalization is simply good or bad, and encompasses ways to lead and manage multinational firms in the rapidly moving marketplace. The following is but a sampling of risks that must be considered and managed.

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PART 1 Global Financial Environment4

■■ The international monetary system, an eclectic mix of floating and managed fixed exchange rates, is under constant scrutiny. The rise of the Chinese renminbi is changing much of the world’s outlook on currency exchange, reserve currencies, and the roles of the dollar and the euro (see Chapter 2).

■■ Large fiscal deficits, including the continuing eurozone crisis, plague most of the major trading countries of the world, complicating fiscal and monetary policies, and, ultimately, leading to the use of negative interest rates in an attempt to stimulate economies and pro- tect currencies (see Chapter 3).

■■ 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, or the continuing current account deficits of the United States and United Kingdom, all will inevitably move exchange rates (see Chapter 3).

■■ Ownership and governance vary dramatically across the world. The publicly traded com- pany is not the dominant global business organization—the privately held or family-owned business is the prevalent structure—and goals and measures of performance vary across business models (see Chapter 4).

■■ 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 and have become less open and accessible to many of the world’s organizations (see Chapter 2).

■■ Today’s emerging markets are confronted with a new dilemma: the problem of first being the recipients of capital inflows, and then of experiencing rapid and massive capital out- flows. Financial globalization has resulted in the ebb and flow of capital into and out of both industrial and emerging markets, greatly complicating financial management (Chapters 5 and 8).

1.2 The Global Financial Marketplace Business—domestic, international, global—involves the interaction of individuals and indi- 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 of 2008–2009 served as an illustration and a warning of how tightly integrated and fragile this marketplace can be.

Assets, Institutions, and Linkages Exhibit 1.1 provides an overview of the global capital markets. One way to characterize the global financial marketplace is through its securities and institutions, all linked through the interbank market.

Securities. The securities—financial assets—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 securities form the foundation for the creation, trading, and pricing of other financial securities like bank loans, corporate bonds, and equities (stock). In recent years, a number of additional securities—derivatives—have been created from existing securities, the value of which is based on market value changes of the underlying securities. The health and security of the global financial system relies on the quality of these securities.

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CHAPTER 1 Multinational Financial Management: Opportunities and Challenges 5

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.

Interbank 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 market. 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 currencies 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 the velocity of these capital movements has increased to the pace of an electron in the digital marketplace. 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. The result has been an explosion of innovative products and services—some for better and some for worse.

EXHIBIT 1.1 Global Capital Markets

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).

Bank

Mortgage Loan

Corporate Loan

Corporate Bond

Bank

Interbank Market (LIBOR )

Bank

Public Debt

Private Debt

Private Equity

Central Banks Institutions

Currency Currency Currency

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PART 1 Global Financial Environment6

The Market for Currencies The price of any one country’s currency in terms of another country’s currency is called a for- eign currency exchange rate. For example, the exchange rate between the U.S. dollar (indicated by the symbols $ or USD) and the European euro (€ or EUR) may be stated as “1.0922 dollar per euro” or simply abbreviated as $1.0922/€. This exchange rate can also be stated as “EUR1.00 USD1.0922.” 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 that is different from their own, an understanding of exchange rates is critical to the conduct of global business.

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 symbols (ISO-4217 codes) used today on the world’s digital networks. The financial press, however, has a rich history of using a variety of different symbols, and a variety of different abbreviations are commonly used. For example, the British pound sterling may be indicated by £ (the pound symbol), GBP (Great Britain pound), STG (British pound sterling), ST£ (pound sterling), or UKL or UK£ (United Kingdom pound). This book uses both the simpler common symbols—the $ (dollar), the € (euro), the ¥ (yen), the £ (pound)—and the three letter ISO codes.

Exchange Rate Quotations and Terminology. Exhibit 1.2 lists currency exchange rates for August 12, 2016, as would be quoted in New York or London. Each exchange rate listed is for a specific country’s currency against the U.S. dollar, the euro, and the British pound—for example, exchange rates listed for the Argentine peso are Peso 14.6325 = 1.00 U.S. dollar, Peso 16.578 = 1.00 Euro, and Peso 18.9241 = 1.00 British pound. The rate listed is termed a “mid- rate” because it is the middle or average of the rates at which currency traders buy currency (bid rate) and sell currency (offer rate).

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 con- vention is also followed against the world’s major currencies, as listed in Exhibit 1.2. For example, the Japanese yen is commonly quoted against the dollar, euro, and pound, as in ¥100.95 = $1.00, ¥112.82 = ;1.00, and ¥130.50 = £1.00.

Quotation Conventions. Several of the world’s major currency exchange rates follow a spe- cific 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” or $/€. For example, $1.1179 listed in Exhibit 1.2 for “United States.” Similarly, the exchange rate between the U.S. dollar and the British pound is always quoted as “dollars per pound” or $/£. For example, $1.2933 listed for “United States” in Exhibit 1.2. In addition, countries that were formerly members of the British Commonwealth will often be quoted against the U.S. dollar, as in U.S. dollars per Australian dollar.

Percentage Change in Spot Rates Assume that the Mexican peso has recently changed in value from MXN 16.00 = USD 1.00 to MXN 20.00 = USD 1.00. If your home currency is the U.S. dollar (USD), what is the percent change in the value of the Mexican peso (MXN)? The calculation depends upon the designated home currency.

Foreign Currency Terms. When the foreign currency price (the price, MXN) of the home currency (the unit, USD) is used, Mexican pesos per U.S. dollar in this case, the formula for the percent change (%∆) in the foreign currency becomes

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CHAPTER 1 Multinational Financial Management: Opportunities and Challenges 7

EXHIBIT 1.2 Selected Global Currency Exchange Rates

August 12, 2016 Country Currency Symbol Code

Currency to equal 1 Dollar

Currency to equal 1 Euro

Currency to equal 1 Pound

Argentina peso Ps ARS 14.6325 16.3578 18.9241

Australia dollar A$ AUD 1.2996 1.4528 1.6807

Brazil real R$ BRL 3.1573 3.5296 4.0833

Canada dollar C$ CAD 1.2943 1.4469 1.6739

Chile peso $ CLP 648.19 724.6152 838.30

China yuan ¥ CNY 6.6446 7.4280 8.5934

Czech Republic koruna Kc CZK 24.1708 27.0206 31.2599

Denmark krone Dkr DKK 6.6557 7.4404 8.6077

Egypt pound £ EGP 8.8766 9.9231 11.4800

Euro euro € EUR 0.8945 1.0000 1.1569

India rupee Rs INR 66.8550 74.7376 86.4631

Indonesia rupiah Rp IDR 13,121.00 14,668.05 16,969.31

Israel shekel Shk ILS 3.8058 4.2545 4.9219

Japan yen ¥ JPY 100.905 112.802 130.500

Kenya shilling KSh KES 101.40 113.36 131.14

Malaysia ringgit RM MYR 4.0285 4.5035 5.2100

Mexico new peso $ MXN 18.2317 20.3813 23.5789

New Zealand dollar NZ$ NZD 1.3825 1.5455 1.7879

Nigeria naira N= NGN 320.250 358.009 414.177 Norway krone NKr NOK 8.2090 9.1768 10.6166

Philippines peso P= PHP 46.6050 52.1000 60.2739 Poland zloty — PLN 3.8167 4.2667 4.9361

Russia ruble RUB 64.7975 72.4375 83.8022

Singapore dollar S$ SGD 1.3445 1.5030 1.7388

South Africa rand R ZAR 13.4402 15.0248 17.3821

South Korea won W KRW 1,103.35 1,233.44 1,426.95

Sweden krona SKr SEK 8.4359 9.4305 10.9101

Switzerland franc Fr. CHF 0.9733 1.0881 1.2588

Taiwan dollar T$ TWD 31.3680 35.0665 40.5680

Thailand baht B THB 34.7675 38.8668 44.9646

Turkey lira YTL TRY 2.9504 3.2982 3.8157

United Kingdom pound £ GBP 0.7732 0.8644 1.0000

Ukraine hrywnja — UAH 25.0500 28.0035 32.3970

Uruguay peso $U UYU 28.7350 32.1230 37.1628

United States dollar $ USD 1.0000 1.1179 1.2933

Venezuela bolivar fuerte Bs VEB 9.9900 11.1679 12.9200

Vietnam dong d VND 22,301.00 24,930.44 28,841.80

Special Drawing Right — — SDR 0.7162 0.8006 0.9262

Note that a number of different currencies use the same symbol (for example, both China and Japan have traditionally used the ¥ symbol, which means “round” or “circle,” for yen and yuan, respectively. All quotes are mid-rates, and are drawn from the Financial Times.

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PART 1 Global Financial Environment8

%∆ = Begin rate-End rate

End rate * 100 =

MXN 16.00-MXN 20.00 MXN 20.00

* 100 = -20.00%

The Mexican peso fell in value 20% against the dollar. Note that it takes more pesos per dollar, and the calculation resulted in a negative value, both characteristics of a fall in value.

Home Currency Terms. When the home currency price (the price, USD) for a foreign cur- rency (the unit, MXN) is used—the reciprocals of the foreign exchange quotes above—the formula for the percent change in the foreign currency is:

%∆ = End rate-Begin rate

Begin rate * 100 =

USD 0.05000-USD 0.06250 USD 0.06250

* 100 = -20.00%

The calculation yields the identical percentage change, a fall in the value of the peso by -20%. Many people find the home currency terms calculation to be the more “intuitive,” because it reminds them of a general percentage change calculation (ending less begin- ning over beginning), however one must be careful to remember that these are exchanges of currency for currency, and the currency that is designated as the home currency is significant.

2015 Fall of the Argentine Peso. The fall in the Argentine peso in 2015 serves as a clear example of percentage change. On December 16, 2015, the government of Argentina announced it would lift currency controls—it would no longer restrict the ability of its citizens to move money out of the country. Over the next 24 hours, as Argentinians took advantage of this new freedom, the value of the Argentine peso fell from ARG 9.7908 per U.S. dollar to 13.6160, as pesos poured into the foreign exchange markets.

%∆ = Begin rate-End rate

End rate * 100 =

ARG 9.7908-ARG 13.6160 ARG 13.6160

* 100 = -28%

After the 28% drop in the value of the peso against the U.S. dollar, the peso stabilized. But a fall in its value of that magnitude, 28%, was both dramatic and devastating. Change itself is a characteristic of exchange rates as seen in Global Finance in Practice 1.1.

GLOBAL FINANCE IN PRACTICE 1.1

to 1 euro. To preserve this value, the Bank would inter- vene in the market by buying euros with Swiss francs anytime the market exchange rate threatened to hit the floor.

In late 2014, the markets continued to push the Swiss franc’s value up against the euro (which means pushing its exchange value to lower than 1.20 Swiss francs per euro). The Swiss Central Bank continued to intervene, buying euros with Swiss francs and accumulating more and more euros in its reserves of foreign currency. The Bank had also set central bank interest rates at negative levels—yes, negative. This meant that the Bank charged depositors to hold Swiss

The Rocketing Swiss Franc

The Swiss franc has been fighting its appreciation against the European euro for years. Switzerland is not a member of the European Union and its currency has been one of the world’s most stable for over a century. However, Swit- zerland’s economy and currency are completely enclosed within the eurozone.

In 2011, in an attempt to stop the Swiss franc from continuing to grow in value against the euro (to stop its appreciation), the Swiss Central Bank announced a “floor” on its value against the euro of 1.20 Swiss francs

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CHAPTER 1 Multinational Financial Management: Opportunities and Challenges 9

Eurocurrencies and Eurocurrency Interest Rates One of the major linkages of global money and capital markets is the eurocurrency market.

Eurocurrencies. Eurocurrencies are domestic currencies of one country on deposit in a second country. For example, a U.S. dollar deposit in a British bank, a eurodollar deposit, is one type of eurocurrency. Banks will pay interest on these deposits—eurocurrency interest— depending on the agreed upon maturity—a period ranging from overnight to more than a year or longer. Eurocurrency deposits are digitally transferred between banks.

The eurocurrency market serves two valuable purposes: (1) eurocurrency deposits are an efficient 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.

Any convertible currency can exist in “euro” form. Note that this use of the “euro” prefix should not be confused with the European currency called the euro. The eurocurrency mar- ket includes eurosterling (British pounds deposited outside the United Kingdom); euroeuros (euros on deposit outside the eurozone); euroyen (Japanese yen deposited outside Japan), and eurodollars (U.S. dollars deposited outside the U.S.).

On the morning of January 15, 2015, the Swiss Cen- tral Bank shocked the markets by announcing that it was abandoning the 1.20 floor and cutting interest rates fur- ther (more negative). It had concluded that with the forth- coming monetary expansion from the ECB, there was no longer any way to keep the floodgates closed. The Swiss franc, as illustrated, appreciated versus the euro in min- utes. For two of the world’s major currencies, it was a very eventful day.

franc deposits, an effort to dissuade investors from exchang- ing any currency, including the euro, for Swiss francs.

But the European Union’s economies continued to struggle, and early reports of economic activity in 2015 were showing further slowing. Investors wished to exit the euro fearing its future fall in value. The European Cen- tral Bank added to investor anxiety when it announced that it would be undertaking expansionary government debt purchases—quantitative easing—(expansionary monetary policy) to kick-start the sluggish EU economy.

0.85

0.90

0.95

1.00

1.05

1.10

1.15

1.25

1.20

Swiss francs (CHF) = 1 European euro (EUR)

Morning of 15 January 2015 (Zurich)

Swiss floor at 1.20 At 9:25 a.m. on Jan 15, 2015, in a surprise move, the Swiss Central

Bank announces it is “discontinuing the minimum exchange rate of 1.20

per euro”

At 9:53 a.m. Swiss franc hits 0.887, then falls back

(+26.14% in 28 minutes)

Stabilizes at CHF 1.04 = EUR 1.00 30 minutes later

= +26.14% against the euro CHF 1.210 – CHF 0.887

CHF 1.210

8:5 0

8:5 4 8:5

7 9:0

0 9:0

4 9:0

8 9:1

1 9:1

4 9:2

5 9:2

8 9:3

2 9:3

5 9:3

9 9:4

3 9:4

6 9:5

0 9:5

3 9:5

7 10

:00 10

:04 10

:08 10

:11 10

:15 10

:18 10

:22 10

:25 10

:29 10

:33 10

:36 10

:40 10

:43 10

:45 10

:50 10

:54 10

:58 11

:01

Closing rate on Jan 15, 2015, is CHF 1.024 = EUR 1.00, a 14.74%

appreciation of the Swiss franc versus the euro in one trading day

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PART 1 Global Financial Environment10

Banks in which eurocurrencies are deposited are called eurobanks. A eurobank is a finan- cial intermediary that simultaneously bids for time deposits and makes loans in a currency other than that of its home currency. Eurobanks are major world banks that conduct a euro- currency 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 European 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 those deposits might be attached by U.S. residents with claims against communist governments. Therefore, Eastern Europeans 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 advantageous 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 efficien- cies, many unique institutional events during the 1950s and 1960s contributed to its growth.

■■ 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 alter- native that would allow them to maintain their leading position in world finance. For this they needed dollar deposits.

■■ 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.

■■ 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. The reference rate of interest in the eurocurrency market is the London Interbank Offered Rate, or LIBOR. LIBOR is the most widely accepted rate of interest used in standardized quotations, loan agreements, or financial derivatives valuations. The use of interbank offered rates, however, is not confined to London. Most major domes- tic financial centers construct their own interbank offered rates for local loan agreements. Examples of such rates include PIBOR (Paris Interbank Offered Rate), MIBOR (Madrid Interbank Offered Rate), SIBOR (Singapore Interbank Offered Rate), and FIBOR (Frankfurt Interbank Offered Rate), to name just a few.

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

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CHAPTER 1 Multinational Financial Management: Opportunities and Challenges 11

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 pres- sures, deposit rates are higher, and loan rates are lower. A second major area of cost savings associated with eurocurrency markets is that deposit insurance (such as the Federal Deposit Insurance Corporation, FDIC) and other assessments paid on deposits in the United States, for example, are unnecessary.

1.3 The Theory of Comparative Advantage 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 uncertainty, costless information, and no government interference. The theory’s origins lie in the work of Adam Smith, and particularly his seminal book, The Wealth of Nations, published in 1776. Smith sought to explain why the division of labor in productive activities, and subsequently international trade of goods produced, increased the quality of life for all citizens. Smith based his work on the concept of absolute advantage, with every country specializing in the produc- tion of those goods for which it was uniquely suited. More would be produced for less. Thus, with each country specializing in products for which it possessed absolute advantage, coun- tries could produce more in total and trade for goods that were cheaper in price than those produced at home.

In his work, On the Principles of Political Economy and Taxation, published in 1817, David Ricardo 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 production of two goods, it might still be relatively more efficient than the other country in one good’s production than the production of the other good. Ricardo termed this comparative advantage. Each coun- try would then possess comparative advantage in the production of one of the two products, and both countries would 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 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 comparative 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 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 can flow between countries to varying degrees, such as immigrants into the European Union from North Africa and the Middle East, and then in turn between states in the EU.

Modern factors of production are more numerous than in this simple model. Factors con- sidered in the location of production facilities worldwide include managerial skills, a depend- able legal structure for settling contract disputes, research and development competence,

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PART 1 Global Financial Environment12

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 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 does not 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 pure theory of comparative advantage, 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 that the problem of equitable distribution of the benefits can be solved to the satisfaction of consumers, producers, and political leaders. Complete specialization, however, remains an unrealistic limiting case, just as perfect competition is a limiting case in microeconomic theory.

Comparative 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, is still the mixture of its own labor skills, access to capital, and technology.

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 com- posed 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 programmer 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 interna- tional telecommunication networks today further enhances the comparative advantage of an Indian location.

The extent of global outsourcing is already reaching every corner of the globe. From financial back offices in Manila, to information technology engineers in Hungary, modern telecommunications now bring business activities to labor rather than moving labor to the places of business.

1.4 What Is Different About International Financial Management? Exhibit 1.3 details some of the main differences between international and domestic financial management. These component differences include institutions, corporate governance, foreign exchange, and political risks, and the modifications required of financial theory and financial instruments. As illustrated in Global Finance in Practice 1.2, the foreign exchange risks impact all businesses.

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CHAPTER 1 Multinational Financial Management: Opportunities and Challenges 13

GLOBAL FINANCE IN PRACTICE 1.2

Crystal’s payment would go to Niantic (U.S.), the pri- mary developer of Pokémon Go. Nintendo of Japan would only receive its share of the sale proceeds after being converted from U.S. dollars to Japanese yen (JPY or ¥). In January, the spot exchange rate between the dollar and the yen was ¥119.00/$, so Nintendo could have earned ¥116.60 on the sale to Crystal Gomez in January.

Nintendo proceeds in ¥Jan 2016 = Proceeds$ * Spot rate(¥/$) = $0.9798 * ¥119.00/$ = ¥116.60

Unfortunately for Nintendo, by August the Mexican peso was down to Ps18.75/$, and the dollar was down to ¥102.50/$, so the yen proceeds from Crystal’s purchase had fallen by 25.5%, from ¥116.60 to only ¥92.93.

Nintendo proceeds in ¥Aug 2016 = Ps17

Ps18.75/$ * ¥102.50/$

= ¥92.93

So as the original launch date slid from January to late July, exchange rates moved against Nintendo, taking a big bite out of the company’s projected profits.

The Peso, Dollar, Yen—and Pokémon Go The launch of Pokémon Go had been a bit delayed, from January to July 2016, but it was highly successful when it did finally hit the market. By August people all over the world were wandering about with their phone in hand in search of Poké- stops and Pokémon. But despite all its success, for one of its owners—Nintendo of Japan (holding part interest)—it was not proving to be all that profitable. The problem was exchange rates. The Japanese yen had been gaining in value against most of the world’s currencies including the U.S. dollar. And in turn, many emerging market country currencies, like the Mexican peso, had been weakening against the dollar.

Consider the case of Crystal Gomez of Mexico City. Crystal purchased 100 Pokécoins for 17 Mexican pesos (MXN or Ps). The price of the Pokécoins in U.S. dollars in January 2016 would have equaled $0.9798 when con- verted to U.S. dollars (USD or $) at the spot exchange rate of Ps17.35/$ in January 2016.

PriceJan 2016$ = Price in pesos

Spot exchange rate in pesos per dollar

= Ps17

Ps17.35/$ = $0.9798

Multinational 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 1.3 What Is Different About International Financial Management?

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 case

Corporate governance Foreign countries’ regulations and institu- tional 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 subsidiaries)

Political risk MNEs face political risk because of their foreign subsidiaries and high profile

Negligible political risks

Modification 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 instru- ments such as options, forwards, swaps, and letters of credit

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

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PART 1 Global Financial Environment14

capital budgeting, working capital management, taxation, and credit analysis need to be modi- fied to accommodate foreign complexities. Moreover, a number of financial instruments that are used in domestic financial management have been modified for use in international finan- cial management. Examples are foreign currency options and futures, interest rate and cur- rency 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 as new constraints emerge. In this chapter, we introduce the challenges and risks associated with Ganado Corporation (Ganado), a com- pany we use as an example throughout this book. Ganado is a company evolving from being domestic in scope to becoming truly multinational. The discussion includes 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.

Market Imperfections: A Rationale for the Existence of the Multinational Firm MNEs 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.

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:

1. Market seekers produce in foreign markets either to satisfy local demand or to export 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 country. 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 in Taiwan, Malaysia, and Mexico is an example of this motivation.

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

5. Political safety seekers acquire or establish new operations in countries that are 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 anticipa- tion 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.

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CHAPTER 1 Multinational Financial Management: Opportunities and Challenges 15

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 estab- lished in it, or capture raw material sources and deny them to competitors.

1.5 The Globalization Process Ganado is a hypothetical U.S.-based firm that is used as an illustrative example throughout the book to demonstrate the phases of 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: Domestic Phase to the International Trade Phase Ganado 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 1.4 shows Ganado in its early domestic phase.

Ganado 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 Ganado at this time is that, although Ganado 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 Ganado into the first phase of the globalization process—into international trade. Ganado was founded in Los Angeles by James Winston in 1948 to make telecommunications equip- ment. 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 for capital led to its initial

EXHIBIT 1.4 Ganado Corp: Initiation of the Globalization Process

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 (domestic)

U.S. Buyers (domestic)

Phase One: Domestic Operations

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PART 1 Global Financial Environment16

public offering (IPO) in 1988. As a U.S.-based publicly traded company on the New York Stock Exchange, Ganado’s management sought to create value for its shareholders.

As Ganado became a visible and viable competitor in the U.S. market, strategic opportu- nities arose to expand the firm’s market reach by exporting products and services to one or more foreign markets. The North American Free Trade Agreement (NAFTA) made trade with Mexico and Canada attractive. This second phase of the globalization process is shown in the lower half of Exhibit 1.4. Ganado responded to these globalization forces by importing inputs from Mexican suppliers and making export sales to Canadian buyers. We define this phase 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 in two ways. First, direct foreign exchange risks are now borne by the firm. Ganado may now need to quote prices in foreign currencies, accept payment in foreign currencies, or pay suppliers in foreign currencies. As the values of currencies change from minute to minute in the global marketplace, Ganado will increasingly 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 a key financial management task during the international trade 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 Ganado is successful in its international trade activities, the time will come when the globaliza- tion process will progress to the next phase. Ganado 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 Ganado’s products. The multitude of issues and activities associated with this second, larger global transition is the real focus of this book.

Ganado’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 glob- ally. A variety of strategic alternatives are available to Ganado—the foreign direct investment sequence—as shown in Exhibit 1.5. These alternatives include the creation of foreign sales offices, the licensing of the company name and everything associated with it, and the manu- facturing and distribution of its products to other firms in foreign markets. As Ganado moves further down and to the right in Exhibit 1.5, the extent of its physical presence in foreign mar- kets increases. It may now own its own distribution and production facilities, and ultimately, it may want to acquire other companies. Once Ganado owns assets and enterprises in foreign countries it has entered the multinational phase of its globalization.

The Multinational Enterprise’s Consolidated Financial Results Ganado will create more and more foreign subsidiaries as it expands globally. Some MNEs may only have one foreign subsidiary, while others, like Johnson & Johnson (U.S.), have nearly 200. Each subsidiary will have its own set of financial statements and results (income state- ment, balance sheet, and statement of cash flow). Each subsidiary is also likely operating in a different currency, subject to differing tax rates, accounting practices such as depreciation, and a multitude of other financial parameters. The company, however, must periodically consoli- date all those financial results and report them in the currency of its home country.

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CHAPTER 1 Multinational Financial Management: Opportunities and Challenges 17

EXHIBIT 1.5 Ganado’s Foreign Direct Investment Sequence

Greater Foreign Investment

Greater Foreign Presence

Production Abroad

Control Assets Abroad

Exploit Existing Competitive Advantage Abroad

Production at Home: Exporting

Licensing Management Contract

Change Competitive Advantage

Trident and Its Competitive Advantage

Wholly Owned SubsidiaryJoint Venture

Acquisition of a Foreign Enterprise Acquisition of a

Foreign Enterprise Greenfield Investment

Exhibit 1.6 illustrates a simplified income statement consolidation for Ganado. Assum- ing that U.S.-based Ganado has two foreign subsidiaries, one in Europe and one in China, in addition to its U.S. operations, it converts the various income statement items to U.S. dollars from euros and Chinese renminbi at the average exchange rate for each currency pair for the period (in this case the year). As we will see in later chapters, this process results in a num- ber of currency risks and exposures, as exchange rates may change in ways that increase or decrease consolidated results.

The Limits to Financial Globalization 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 increasing influence and self-enrichment of organizational insiders.

One possible representation of this process can be seen in Exhibit 1.7. If influential insiders 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 become increasingly troublesome.

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PART 1 Global Financial Environment18

EXHIBIT 1.7 The Limits of Financial Globalization

The Twin Agency Problems Limiting

Financial Globalization

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.

Actions of Rulers of Sovereign States

Higher Firm Value (possibly lower insider value)

Lower Firm Value (possibly higher

insider value) Actions of

Corporate Insiders

Source: Constructed by authors based on “The Limits of Financial Globalization,” Rene M. Stulz, Journal of Applied Corporate Finance, Vol. 19, No. 1, Winter 2007, pp. 8–15.

EXHIBIT 1.6 Selected Consolidated Income Results for Ganado (U.S.)

As a U.S.-based multinational company, Ganado must consolidate the financial results (in this case sales and earnings from the income statements) of its foreign subsidiaries. This requires converting foreign currency values into U.S. dollars.* For the year shown, Ganado generated 57% of its global sales in the United States, with those U.S. sales making up 93% of its consolidated profits. The financial results of the foreign subsidiaries change over time due both to changes in the subsidiaries financial performance and to translating those results back to US$ at exchange rates that change over time.

Sales

Country Currency Sales

(millions) Avg Exchange Rate for Year

Sales (millions US$) Percent of Total

United States U.S. dollar ($) $300 $300 57%

Europe European euro (€) €120 $1.12 = ;1.00 $134 26%

China Chinese renminbi (¥) ¥600 ¥6.60 = $1.00 $91 17%

$525 100%

Earnings

Country Currency Earnings (millions)

Avg Exchange Rate for Year

Earnings (millions US$) Percent of Total

United States U.S. dollar ($) $28.6 $300 93%

Europe European euro (€) $10.5 $1.12 = ;1.00 $12 4%

China Chinese renminbi (¥) $71.4 ¥6.60 = $1.00 $11 3%

$323 100%

* This is a simplified consolidation. Actual consolidation accounting practices require a number of specific line item adjustments not shown here.

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CHAPTER 1 Multinational Financial Management: Opportunities and Challenges 19

Summary Points ■■ The creation of value requires combining three criti-

cal elements: (1) an open marketplace; (2) high-quality strategic management; and (3) access to capital.

■■ The theory of comparative advantage provides a basis for explaining and justifying international trade in a model world of free and open competition.

■■ International financial management requires an under- standing of cultural, historical, and institutional differ- ences, 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 nor- mally a threat to domestic operations.

■■ MNEs strive to take advantage of imperfections in national markets for products, factors of production, and financial assets.

■■ 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.

■■ 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 corporations. This will, in turn, create limitations to globalization in finance.

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. And as highlighted by Global Finance in Practice 1.3, the objectives and responsibilities of the modern multinational enter- prise have grown significantly more complex with these elements.

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.

GLOBAL FINANCE IN PRACTICE 1.3

goodness, corporate responsibility, corporate social responsibility (CSR), corporate philanthropy, and corporate sustainability, to list but a few. 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 modern multinational is to pursue profit, social development, and the environment, all along sustain- able principles.

The term sustainability has evolved greatly within the context of global business in the past decade. A tradi- tional primary objective of the family-owned business has been the “sustainability of the organization”—the long- term ability of the company to remain commercially viable and provide security and income for future generations. Although narrower in scope, the concept of environmental sustainability shares a common core thread—the ability of a company, a culture, or even the earth, to survive and renew over time.

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 accepted that the purpose of the corporation is to certainly create profits and value for its stakeholders, but the responsibility of the corporation is to do so in a way that inflicts no costs on society, including the environment. As a result of globaliza- tion, this growing responsibility and role of the corporation in society has added a level of complexity to the leadership challenges faced by the multinational firm.

This developing controversy has been somewhat ham- pered to date by conflicting terms and labels—corporate

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PART 1 Global Financial Environment20

EXHIBIT A The Capital Lifecycle

Capital Structure

Time

Stage

Capital Source

Proof of Concept

Founder

Pre-Seed

Friends and Family

(Angel Financing)

Seed Startup

Valley of Death

Early Stage

Second Stage

Venture Capital Rounds

Late Stage

Growth and Maturity Revenue

Private Equity and Institutional Finance

(bank loans, securitized debt, securitized equity)

Operating Cash Flow

Profit

Startup

…… All Equity ……................................................. Introduction of Debt ……...…........... Increasing Debt

— Crowdfunding —

MINI-CASE

Crowdfunding Kenya1 The concept of crowdfunding has a number of parallels in traditional Kenyan culture. Harambee is a long-used prac- tice of collective fundraising for an individual obligation like travel or medical expenses. Another Kenyan practice, chama, involves group fundraising for loans or investments by private groups. In either case, they have strong links to the fundamental principle of a community. In the case of crowdfunding, it is an online community.

Crowdfunding is an Internet-enabled method of rais- ing capital for business startups without going through the arduous, costly, and time-consuming process of traditional equity capital fundraising. The rapid growth in crowdfund- ing over recent years has been based primarily in the major industrial country markets of North America and Western Europe where there is a highly organized, developed, and deep financial sector, but a sector that often shuts out the small, innovative, non-traditional entrepreneur.

The concept of raising funds from a large crowd or group is not new. It is a technique that has been employed by individuals, organizations, and even governments for centuries. Beethoven and Mozart both raised funds for their work through pre-creation subscriptions. The United States

1Copyright © 2015 Thunderbird School of Global Management at Arizona State University. All rights reserved. This case was prepared by Professor Michael H. Moffett for the purpose of classroom discussion only. The author would like to thank Sherwood Neiss of Crowdfunding Capital Advisors for helpful comments.

and France both used an early form of crowdfunding fund raising to construct the Statue of Liberty. But crowdfunding’s real potential may now lie in funding new business startups in emerging markets—markets where the capital sources and institutions available to small and medium enterprises (SMEs) within the country may be limited. If crowdfund- ing can provide access to capital that many entrepreneurs need, tapping a larger more affordable cross-border financial ecosystem, then business, economic, and social development in the emerging markets may be able to take a great step forward. Kenya is one country attempting to pilot the effort.

The Capital Lifecycle The ability of a startup business to access affordable capital through the early stages of its lifecycle has been the focus of a multitude of financial innovations in the past two decades. But until recently, there have been a number of gaps in the capital lifecycle—the institutions and sources of capital available to an enterprise as it evolves—putting many startup businesses at risk.

Exhibit A illustrates the capital lifecycle of a for-profit enterprise. An entrepreneur—the founder—puts up his own money in the first stage, the proof of concept. This is

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CHAPTER 1 Multinational Financial Management: Opportunities and Challenges 21

Crowdfunding Principles I believe that crowdfunding may have the potential to help catalyze existing efforts to create entrepreneurial cultures and ecosystems in developing nations. Develop- ment organizations like the World Bank and other insti- tutions will play an ongoing role to act as “trusted third parties” in creating these new models of funding and providing mentorship, capacity building as well as ongo- ing monitoring and reporting. —Steve Case, Chairman and CEO, Revolution, and Founder, America Online2

Crowdfunding began as an online extension of the pre-seed stage in which traditional financing relies upon friends and family to pool funds to finance business development. It seeks to connect an extended group of interested investors, still based on friends and family—the so-called crowdfunding ecosystem—directly with startups in need of seed capital. It attempts to open up these funding channels by bypassing the traditional regulatory and institutional barriers, restric- tions, costs, and burdens, that capital raising carries in every country around the globe.

Crowdfunding structures typically fall into any one of four categories: donation-based, rewards-based, loan or debt-based, or equity-based.3

1. Donation-based. Non-profit foundations often employ crowdfunding methods to raise funds for causes of all kinds. Contributors receive nothing in return for their gifts other than positive emotional and intellectual gratification.

2. Rewards-based. In rewards-based crowdfunding efforts contributors receive a perk, a benefit, a T-shirt, a ticket, a back-stage pass, some small form of reward. One highly successful platform using this structure is Kickstarter, a U.S.-based arts and project-based fundraiser. As with donation-based funds, there is no guarantee of the proj- ect’s execution or success, and no return on the invest- ment other than a small reward, perk, or token benefit.

3. Debt-based. Debt-based or lending-based crowd- funding efforts provide capital to individuals and organizations in need of growth capital in return for repayment of principal. Micro-finance organizations like Grameen Bank have long used this structure suc- cessfully to fund entrepreneurial efforts particularly in emerging markets. The investor is typically promised repayment of principal, but often—as is the case of kiva.org, no payment of interest is made by the bor- rower or paid to the “investor.”

4. Equity-based. Investors gain a share of ownership in the project or company. These are enterprise funding

2 Crowdfunding’s Potential for the Developing World, infoDev/The World Bank, by Jason Best, Sherwood Neiss, and Richard Swart, Crowdfunding Capital Advisors (CCA), 2013. 3 “Issue Brief: Investment-Geared Crowdfunding,” CFA Institute, March 2014.

followed by further pre-seed capital typically funded from friends and family, or in some cases, angel financing from angel investors. Angel investors are individuals or small groups of professional investors who invest at the earli- est stages of business development, playing the role of a “guardian angel.” The principle is to provide the capital to move the business opportunity further along while still protecting the interests of the entrepreneurial owners. This is often referred to as the pre-seed stage of business development.

It is immediately after this, in the Seed Startup, that many firms fail to advance in their development due to a gap of available capital and capital providers. This gap, often referred to as the Valley of Death, occurs at a critical period in which the firm is building and moving toward operational launch. But without operating activities, and therefore revenues and cash flows, additional investors and access to capital is scarce. It is this gap that crowdfunding has filled in many industrial country markets.

Following their launch, promising businesses often pursue venture capital for financing rapid growth—the venture capital rounds. Venture capitalists (VCs) are invest- ment firms focused on taking an equity position in new businesses that are showing revenue results, but may not yet be positive in terms of cash flow or profitability. VCs focus their attention on businesses that are considered to have high growth potential but need capital now to acquire the scale and assets needed to pursue the growth opportunity.