Multinational business finance 13th edition pdf

Multinational Business Finance 13th Edi Eiteman David

MULTINATIONAL BUSINESS FINANCE THIRTEENTH EDIT ION

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MULTINATIONAL BUSINESS FINANCE THIRTEENTH EDIT ION

David K. EITEMAN

University of California, Los Angeles

Arthur I. STONEHILL

Oregon State University and the University

of Hawaii at Manoa

Michael H. MOFFETT

Thunderbird School of Global Management

Editor-in-Chief Editorial Project Manager Editorial Assistant Senior Marketing Manager Senior Managing Editor Senior Production Project Manager Permissions Specialist/Project Manager Permissions Editor Art Director Cover Designer Cover Image Senior Manufacturing Buyer Media Production Project Manager Production Coordination Composition and Art Creation Copy Editor Proofreader Indexer

Library of Congress Cataloging-in-Publication Data

Copyright © 2013, 2010, 2007, 2004 by Pearson Education, Inc.

www.pearsonhighered.com
Multina- tional Business Finance

! Organizations of all kinds.

! Emerging markets.

! Financial leadership.

Audience Multinational Business Finance

Global Finance in Practice

Organization Multinational Business Finance

Preface

Preface

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New in the Thirteenth Edition

new normal

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Global Finance in Practice

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Preface

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A Rich Array of Support Materials

! Instructor’s Manual.

! Test Bank.

! Computerized Test Bank.

! PowerPoint Presentation.

! Companion Web Site.

International Editions Multinational Business Finance

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Preface

Acknowledgments

Multinational Business Finance

Yong-Cheol Kim University of Wisconsin-Milwaukee

Yen-Sheng Lee Bellevue University

Robert Mefford University of San Francisco John Petersen George Mason University Rahul Verma University of Houston-Downtown

Otto Adleberger Essen University, Germany

Alan Alford Northeastern University

Stephen Archer Willamette University

Bala Arshanapalli Indiana University Northwest

Hossein G. Askari George Washington University

Robert T. Aubey University of Wisconsin at Madison

David Babbel University of Pennsylvania

James Baker Kent State University

Morten Balling Arhus School of Business, Denmark

Arindam Bandopadhyaya University of Massachusetts at Boston

Ari Beenhakker University of South Florida

Carl Beidleman Lehigh University

Robert Boatler Texas Christian University

Gordon M. Bodnar John Hopkins University

Nancy Bord University of Hartford

Finbarr Bradley University of Dublin, Ireland

Tom Brewer Georgetown University

Michael Brooke University of Manchester, England

Robert Carlson Assumption University, Thailand

Kam C. Chan University of Dayton

Chun Chang University of Minnesota

Sam Chee Boston University Metropolitan College

Kevin Cheng New York University

It-Keong Chew University of Kentucky

Frederick D. S. Choi New York University

Jay Choi Temple University

Nikolai Chuvakhin Pepperdine University

Mark Ciechon University of California, Los Angeles

J. Markham Collins University of Tulsa

Alan N. Cook Baylor University

Kerry Cooper Texas A&M University

Robert Cornu Cranfield School of Management, U.K.

Roy Crum University of Florida

Steven Dawson University of Hawaii at Manoa

David Distad University of California, Berkeley

Gunter Dufey University of Michigan, Ann Arbor

Mark Eaker Duke University

Rodney Eldridge George Washington University

Imad A. Elhah University of Louisville

Vihang Errunza McGill University

Cheol S. Eun Georgia Tech University

Mara Faccio University of Notre Dame

Larry Fauver University of Tennessee

Joseph Finnerty University of Illinois at Urbana- Champaign

William R. Folks, Jr. University of South Carolina

Lewis Freitas University of Hawaii at Manoa

Preface

Anne Fremault Boston University

Fariborg Ghadar George Washington University

Ian Giddy New York University

Martin Glaum Justus-Lievig-Universitat Giessen, Germany

Deborah Gregory University of Georgia

Robert Grosse Thunderbird

Christine Hekman Georgia Tech University

Steven Heston University of Maryland

James Hodder University of Wisconsin, Madison

Alfred Hofflander University of California, Los Angeles

Janice Jadlow Oklahoma State University

Veikko Jaaskelainen Helsinki School of Economics and Business Administration

Benjamas Jirasakuldech University of the Pacific

Ronald A. Johnson Northeastern University

John Kallianiotis University of Scranton

Fred Kaen University of New Hampshire

Charles Kane Boston College

Robert Kemp University of Virginia

W. Carl Kester Harvard Business School

Seung Kim St. Louis University

Yong Kim University of Cincinnati

Gordon Klein University of California, Los Angeles

Steven Kobrin University of Pennsylvania

Paul Korsvold Norwegian School of Management

Chris Korth University of South Carolina

Chuck C. Y. Kwok University of South Carolina

John P. Lajaunie Nicholls State University

Sarah Lane Boston University

Martin Laurence William Patterson College

Eric Y. Lee Fairleigh Dickinson University

Donald Lessard Massachusetts Institute of Technology

Arvind Mahajan Texas A&M University

Rita Maldonado-Baer New York University

Anthony Matias Palm Beach Atlantic College

Charles Maxwell Murray State University

Sam McCord Auburn University

Jeanette Medewitz University of Nebraska at Omaha

Robert Mefford University of San Francisco

Paritash Mehta Temple University

Antonio Mello University of Wisconsin at Madison

Eloy Mestre American University

Kenneth Moon Suffolk University

Gregory Noronha Arizona State University

Edmund Outslay Michigan State University

Lars Oxelheim Lund University, Sweden

Jacob Park Green Mountain College

Yoon Shik Park George Washington University

Harvey Poniachek New York University

Yash Puri University of Massachusetts at Lowell

R. Ravichandrarn University of Colorado at Boulder

Scheherazade Rehman George Washington University

Jeff Rosenlog Emory University

David Rubinstein University of Houston

Alan Rugman Oxford University, U.K.

R. J. Rummel University of Hawaii at Manoa

Mehdi Salehizadeh San Diego State University

Michael Salt San Jose State University

Roland Schmidt Erasmus University, the Netherlands

Lemma Senbet University of Maryland

Alan Shapiro University of Southern California

Hany Shawky State University of New York, Albany

Hamid Shomali Golden Gate University

Vijay Singal Virginia Tech University

Preface

Sheryl Winston Smith University of Minnesota

Luc Soenen California Polytechnic State University

Marjorie Stanley Texas Christian University

Joseph Stokes University of Massachusetts- Amherst

Jahangir Sultan Bentley College

Lawrence Tai Loyola Marymount University

Kishore Tandon CUNY—Bernard Baruch College

Russell Taussig University of Hawaii at Manoa

Lee Tavis University of Notre Dame

Sean Toohey University of Western Sydney, Australia

Norman Toy Columbia University

Joseph Ueng University of St. Thomas

Gwinyai Utete Auburn University

Harald Vestergaard Copenhagen Business School

K. G. Viswanathan Hofstra University

Joseph D. Vu University of Illinois, Chicago

Mahmoud Wahab University of Hartford

Masahiro Watanabe Rice University

Michael Williams University of Texas at Austin

Brent Wilson Brigham Young University

Bob Wood Tennessee Technological University

Alexander Zamperion Bentley College

Emilio Zarruk Florida Atlantic University

Tom Zwirlein University of Colorado, Colorado Springs

Industry (present or former affiliation)

Paul Adaire Philadelphia Stock Exchange

Barbara Block Tektronix, Inc.

Holly Bowman Bankers Trust

Payson Cha HKR International, Hong Kong

John A. Deuchler Private Export Funding Corporation

Kåre Dullum Gudme Raaschou Investment Bank, Denmark

Steven Ford Hewlett Packard

David Heenan Campbell Estate, Hawaii

Sharyn H. Hess Foreign Credit Insurance Association

Aage Jacobsen Gudme Raaschou Investment Bank, Denmark

Ira G. Kawaller Chicago Mercantile Exchange

Kenneth Knox Tektronix, Inc.

Arthur J. Obesler Eximbank

I. Barry Thompson Continental Bank

Gerald T. West Overseas Private Investment Corporation

Willem Winter First Interstate Bank of Oregon

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!

Preface

!

Arthur I. Stonehill

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 Euro- pean Management Journal The Investment Analyst (U.K.) Nationaløkonomisk Tidskrift (Denmark) Sosialøkonomen (Norway) Journal of Financial Education

David K. Eiteman

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,

Michael H. Moffett

About the Authors

About the Authors

Journal of Financial and Quantitative Analysis Journal of Applied Corporate Finance Journal of International Money and Finance Journal of Interna- tional Financial Management and Accounting Contemporary Policy Issues Brookings Dis- cussion Papers in International Economics

Handbook of Modern Finance International Accounting and Finance Handbook Encyclopedia of International Business

International Business Global Business

PART I Global Financial Environment 1

PART II Foreign Exchange Theory and Markets 157

PART III Foreign Exchange Exposure 245

PART IV Financing the Global Firm 349

PART V Foreign Investment Decisions 439

PART VI Managing Multinational Operations 527

Brief Contents

PART I Global Financial Environment 1

Chapter 1 Current Multinational Challenges and the Global Economy 2

Summary Points 17 MINI-CASE: Nine Dragons Paper and the 2009 Credit Crisis 17 Questions ! Problems ! Internet Exercises 24

Chapter 2 Corporate Ownership, Goals, and Governance 27

Summary Points 49 MINI-CASE: Luxury Wars—LVMH vs. Hermès 49 Questions ! Problems ! Internet Exercises 54

Chapter 3 The International Monetary System 59

Summary Points 78 MINI-CASE: The Yuan Goes Global 79 Questions ! Problems ! Internet Exercises 84

Chapter 4 The Balance of Payments 87

Summary Points 112 MINI-CASE: Global Remittances 113 Questions ! Problems ! Internet Exercises 117

Contents

Contents

Chapter 5 The Continuing Global Financial Crisis 122

Summary Points 150 MINI-CASE: Letting Go of Lehman Brothers 151 Questions ! Problems ! Internet Exercises 153

PART II Foreign Exchange Theory and Markets 157

Chapter 6 The Foreign Exchange Market 158

Summary Points 177 MINI-CASE: The Saga of the Venezuelan Bolivar Fuerte 178 Questions ! Problems ! Internet Exercises 180

Chapter 7 International Parity Conditions 185

Summary Points 204 MINI-CASE: Emerging Market Carry Trades 205 Questions ! Problems ! Internet Exercises 206 Appendix: An Algebraic Primer to International Parity Conditions 212

Chapter 8 Foreign Currency Derivatives and Swaps 216

Summary Points 235 MINI-CASE: McDonald’s Corporation’s British Pound Exposure 236 Questions ! Problems ! Internet Exercises 237

PART III Foreign Exchange Exposure 245

Chapter 9 Foreign Exchange Rate Determination and Forecasting 246

Summary Points 268 MINI-CASE: The Japanese Yen Intervention of 2010 269 Questions ! Problems ! Internet Exercises 271

Contents

Chapter 10 Transaction Exposure 275

Summary Points 290 MINI-CASE: Banbury Impex (India) 291 Questions ! Problems ! Internet Exercises 295 Appendix: Complex Option Hedges 301

Chapter 11 Translation Exposure 309

Summary Points 320 MINI-CASE: LaJolla Engineering Services 320 Questions ! Problems 323

Chapter 12 Operating Exposure 326

Summary Points 343 MINI-CASE: Toyota’s European Operating Exposure 343 Questions ! Problems ! Internet Exercises 346

PART IV Financing the Global Firm 349

Chapter 13 The Global Cost and Availability of Capital 350

Summary Points 366 MINI-CASE: Novo Industri A/S (Novo) 367 Questions ! Problems ! Internet Exercises 371

Chapter 14 Raising Equity and Debt Globally 376

Summary Points 400 MINI-CASE: Korres Natural Products and the Greek Crisis 401 Questions ! Problems ! Internet Exercises 406 Appendix: Financial Structure of Foreign Subsidiaries 411

Contents

Chapter 15 Multinational Tax Management 415

Summary Points 430 MINI-CASE: The U.S. Corporate Income Tax Conundrum 430 Questions ! Problems ! Internet Exercises 434

PART V Foreign Investment Decisions 439

Chapter 16 International Portfolio Theory and Diversification 440

Summary Points 453 MINI-CASE: Portfolio Theory, Black Swans, and [Avoiding] Being the Turkey 454 Questions ! Problems ! Internet Exercises 456

Chapter 17 Foreign Direct Investment and Political Risk 460

Summary Points 485 MINI-CASE: Corporate Competition from the Emerging Markets 486 Questions ! Internet Exercises 487

Chapter 18 Multinational Capital Budgeting and Cross-Border Acquisitions 490

Summary Points 513 MINI-CASE: Yanzhou (China) Bids for Felix Resources (Australia) 514 Questions ! Problems ! Internet Exercises 521

PART VI Managing Multinational Operations 527

Chapter 19 Working Capital Management 528

Summary Points 549 MINI-CASE: Honeywell and Pakistan International Airways 549 Questions ! Problems ! Internet Exercises 552

Contents

Chapter 20 International Trade Finance 556

Summary Points 574 MINI-CASE: Crosswell International and Brazil 575 Questions ! Problems ! Internet Exercises 579

Answers to Selected End-of-Chapter Problems 582

Glossary 586

Index 603

Credits 626

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Global Financial Environment

CHAPTER 1 Current Multinational Challenges and the Global Economy

CHAPTER 2 Corporate Ownership, Goals, and Governance

CHAPTER 3 The International Monetary System

CHAPTER 4 The Balance of Payments

CHAPTER 5 The Continuing Global Financial Crisis

PART I

1

Current Multinational Challenges and the Global Economy

I define globalization as producing where it is most cost-effective, selling where it is most profitable, and sourcing capital where it is cheapest, without worrying about national boundaries.

—Narayana Murthy, President and CEO, Infosys.

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

MNEs are struggling to survive and prosper in a very different world than in the past. Today’s MNEs depend not only on the emerging markets for cheaper labor, raw materials, and outsourced manufacturing, but also increasingly on those same emerging markets for sales and profits. These markets—whether they are emerging, less developed, developing, or BRICs (Brazil, Russia, India, and China)—represent the majority of the earth’s population, and therefore, customers. And adding market complexity to this changing global landscape is the risky and challenging international macroeconomic environment, both from a long- term and short-term perspective, following the global financial crisis of 2007–2009. How to identify and navigate these risks is the focus of this book.

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 globalisation was a good thing. But the subprime crisis and eurozone dramas are shaking that belief. Never mind the fact that imbalances amid globalisation can stoke up bubbles; what is the bigger risk now—particularly in the eurozone—is that financial globalisation has created a system that is interconnected in some dangerous ways.

—“Crisis Fears Fuel Debate on Capital Controls,” Gillian Tett, The Financial Times, December 15, 2011.

2

CHAPTER 1

3Current Multinational Challenges and the Global Economy CHAPTER 1

The theme dominating global financial markets today is the complexity of risks associated with financial globalization—far beyond whether it is simply good or bad, but how to lead and manage multinational firms in the rapidly moving marketplace.

! The international monetary system, an eclectic mix of floating and managed fixed exchange rates today, is under constant scrutiny. The rise of the Chinese renminbi is changing much of the world’s outlook for currency exchange, reserve currencies, and the roles of the dollar and the euro (see Chapter 3).

! Large fiscal deficits plague most of the major trading countries of the world, including the current eurozone crisis, complicating fiscal and monetary policies, and ultimately, interest rates and exchange rates (see Chapters 4 and 5).

! 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 amidst a sea of eurozone deficits, or the continuing current account deficit of the United States, all will inevi- tably move exchange rates (see Chapters 4 and 5).

! Ownership, control, and governance changes radically across the world. The publicly traded company is not the dominant global business organization—the privately held or family-owned business is the prevalent structure—and their goals and measures of performance differ dramatically (see Chapter 2).

! 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, openness, and accessibility by many of the world’s organizations (see Chapters 1 and 5).

! Today’s emerging markets are confronted with a new dilemma: the problem of being the recipients of too much capital—sometimes. Financial globalization has resulted in the flow of massive quantities of capital into and out of many emerging markets, complicating financial management (Chapters 6 and 9).

These are but a sampling of the complexity of topics. The Mini-Case at the end of this chapter, Nine Dragons Paper and the 2009 Credit Crisis, highlights many of these MNE issues in emerging markets today. As described in Global Finance in Practice 1.1, the global credit crisis and its aftermath has damaged the world’s largest banks and reduced the rate of eco- nomic growth worldwide, leading to higher rates of unemployment and putting critical pres- sures on government budgets from Greece to Ireland to Portugal to Mexico.

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 a map to the global capital markets. One way to characterize the global financial marketplace is through its assets, institutions, and linkages.

4 CHAPTER 1 Current Multinational Challenges and the Global Economy

GLOBAL FINANCE IN PRACTICE 1.1

Global Capital Markets: Entering a New Era

The current financial crisis and worldwide recession have abruptly halted a nearly three-decade-long expansion of global capital markets. From 1980 through 2007, the world’s financial assets—including equities, private and public debt, and bank deposits—nearly quadrupled in size relative to global GDP. Global capital flows similarly surged. This growth reflected numerous interrelated trends, including advances in information and communication technology, financial market liberalization, and innovations in financial products and ser- vices. The result was financial globalization.

But the upheaval in financial markets in late 2008 marked a break in this trend. The total value of the world’s financial assets fell by $16 trillion to $178 trillion, the largest setback on record. Although equity markets have bounced back from their recent lows, they remain well below their peaks. Credit markets have healed somewhat but are still impaired.

Going forward, our research suggests that global capi- tal markets are entering a new era in which the forces fueling growth have changed. For the past 30 years, most of the overall increase in financial depth—the ratio of assets to GDP—was driven by the rapid growth of equities and private debt in mature markets. Looking ahead, these asset classes in mature mar- kets are likely to grow more slowly, more in line with GDP, while government debt will rise sharply. An increasing share of global asset growth will occur in emerging markets, where GDP is ris- ing faster and all asset classes have abundant room to expand.

Source: Excerpted from “Global Capital Markets: Entering a New Era,” McKinsey Global Institute, Charles Rosburgh, Susan Lund, Charles Atkins, Stanislas Belot, Wayne W. Hu, and Moira S. Pierce, McKinsey & Company, September 2009, p. 7.

Assets. The assets—the financial assets—which are 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 assets then form the foundation for the creating, trading, and pricing of other finan- cial assets like bank loans, corporate bonds, and equities (stock). In recent years, a number of

EXHIBIT 1.1

Bank

Mortgage Loan

Corporate Loan

Corporate Bond

Bank

Interbank Market (LIBOR )

Bank

Public Debt

Private Debt

Private Equity

Central Banks Institutions

Currency Currency Currency

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).

Global Capital Markets

5Current Multinational Challenges and the Global Economy CHAPTER 1

additional securities have been created from the existing securities—derivatives, whose value is based on market value changes in the underlying securities. The health and security of the global financial system relies on the quality of these assets.

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.

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 network. 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 borders 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 these capital movements have started to move at the pace of an electron, either via a phone call or an email. 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. This market has seen an explosion of innovative products and services in the past decade, some of which proved, as in the case of the 2008–2009 crisis, somewhat toxic to the touch.

The Market for Currencies The price of any one country’s currency in terms of another country’s currency is called a foreign currency exchange rate. For example, the exchange rate between the U.S. dollar ($ or USD) and the European euro (€ or EUR) may be stated as “1.4565 dollar per euro” or simply abbreviated as $1.4565/€. This is the same exchange rate as when stated “EUR1.00 = USD1.4565.” 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, which is dif- ferent from their own, an understanding of exchange rates is critical to the conduct of global business.

A quick word about 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 sym- bols (ISO-4217 codes) used today on the world’s digital networks. The field of international finance, however, has a rich history of using a variety of different symbols in the financial press, and a variety of different abbreviations are commonly used. For example, the British pound sterling may be £ (the pound symbol), GBP (Great Britain pound), STG (British pound sterling), ST£ (pound sterling), or UKL (United Kingdom pound). This book will also use the simpler common symbols—the $ (dollar), the € (euro), the ¥ (yen), the £ (pound)—but be warned and watchful when reading the business press!

Exchange Rate Quotations and Terminology. Exhibit 1.2 lists currency exchange rates for Thursday, January 12, 2012, as would be quoted in New York or London. The exchange rate listed is for a specific country’s currency—for example, the Argentina peso against the U.S. dollar—Peso 3.9713/$, the European euro—Peso $5.1767/€, and the British pound—Peso 6.1473/£. The rate listed is termed a “mid-rate” because it is the middle or average of the rates currency traders buy currency (bid rate) and sell currency (offer rate).

EXHIBIT 1.2 Selected Global Currency Exchange Rates

January 12, 2012 Country Currency Symbol Code

Currency to equal 1 Dollar

Currency to equal 1 Euro

Currency to equal 1 Pound

Argentina peso Ps ARS 4.3090 5.5143 6.6010

Australia dollar A$ AUD 0.9689 1.2413 1.4859

Bahrain dinar — BHD 0.3770 0.4825 0.5776

Bolivia boliviano Bs BOB 6.9100 8.8428 10.5855

Brazil real R$ BRL 1.7874 2.2873 2.7380

Canada dollar C$ CAD 1.0206 1.3061 1.5635

Chile peso $ CLP 502.050 642.473 769.090

China yuan ¥ CNY 6.3178 8.0849 9.6783

Colombia peso Col$ COP 1,843.30 2,358.87 2,823.75

Costa Rica colon C// CRC 508.610 650.869 779.141

Czech Republic koruna Kc CZK 20.0024 25.5970 30.6416

Denmark krone Dkr DKK 5.8114 7.4368 8.9024

Egypt pound £ EGP 6.0395 7.7288 9.2519

Hong Kong dollar HK$ HKD 7.7679 9.9405 11.8996

Hungary forint Ft HUF 241.393 308.910 369.789

India rupee Rs INR 51.6050 66.0389 79.0537

Indonesia rupiah Rp IDR 9,160.0 11,722.1 14,032.2

Iran rial — IRR 84.5000 231.8950 89.1256

Israel shekel Shk ILS 3.8312 4.9027 5.8690

Japan yen ¥ JPY 76.7550 98.2234 117.581

Kenya shilling KSh KES 87.6000 112.102 134.195

Kuwait dinar — KWD 0.2793 0.3574 0.4278

Malaysia ringgit RM MYR 3.1415 4.0202 4.8125

Mexico new peso $ MXN 13.5964 17.3993 20.8283

New Zealand dollar NZ$ NZD 1.2616 1.6145 1.9327

Nigeria naira N NGN 162.050 207.375 248.244

Norway krone NKr NOK 6.0033 7.6824 9.1965

Pakistan rupee Rs. PKR 90.1050 115.3070 138.0320

Peru new sol S/. PEN 2.6925 3.4456 4.1247

Phillippines peso P PHP 44.0550 56.3772 67.4879

Poland zloty — PLN 3.4543 4.4204 5.2916

Romania new leu L RON 3.3924 4.3425 5.1983

Russia ruble R RUB 31.6182 40.4618 48.4360

Saudi Arabia riyal SR SAR 3.7504 4.7994 5.7452

Singapore dollar S$ SGD 1.2909 1.6520 1.9775

South Africa rand R ZAR 8.0743 10.3326 12.3690

South Korea won W KRW 1,158.10 1,482.02 1,774.09

Sweden krona SKr SEK 6.9311 8.8698 10.6178

Switzerland franc Fr. CHF 0.9460 1.2106 1.4492

Taiwan dollar T$ TWD 29.9535 38.3315 45.8858

Thailand baht B THB 31.8300 40.7329 48.7604

Tunisia dinar DT TND 1.5184 1.9431 2.3261

Turkey lira YTL TRY 1.8524 2.3706 2.8377

United Arab Emirates

dirham — AED 3.6733 4.7007 5.6271

United Kingdom pound £ GBP 1.5319 0.8354

Ukraine hrywnja — UAH 8.0400 10.2888 12.3165

Uruguay peso $U UYU 19.4500 24.8902 29.7955

United States dollar $ USD 1.2797 1.5319

Venezuela bolivar fuerte Bs VEB 4.2947 5.4959 6.5790

Vietnam dong d VND 21,035.0 26,918.5 32,223.5

Euro euro € EUR 1.2797 1.1971

Special Drawing Right

— — SDR 0.6541 0.8370 1.0019

Note that a number of different currencies use the same symbol (for example both China and Japan have traditionally used the ¥ symbol, yen or yuan, meaning round or circle). That is one of the reasons why most of the world’s currency markets today use the three-digit currency code for clarity of quo- tation. All quotes are mid-rates, and are drawn from the Financial Times, January 12, 2012.

6

7Current Multinational Challenges and the Global Economy CHAPTER 1

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 convention is also followed against the world’s major currencies as listed in Exhibit 1.2. For example, the Japanese yen is commonly quoted as ¥83.2200/$, ¥108.481/€, and ¥128.820/£.

Quotation Conventions. Several of the world’s major currency exchange rates, however, fol- low a specific 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” ($/€), $1.3036/€ as listed in Exhibit 1.2. Similarly, the exchange rate between the U.S. dollar and the British pound is always quoted as $/£, for example, the $1.5480/£ listed under “United States” in Exhibit 1.2. Many countries that were formerly members of the British Commonwealth will commonly be quoted against the dollar as U.S. dollars per currency (e.g., the Australian or Canadian dollars).

Eurocurrencies and LIBOR One of the major linkages of global money and capital markets is the Eurocurrency market and its interest rate known as LIBOR. Eurocurrencies are domestic currencies of one country on deposit in a second country. Eurodollar time deposit maturities range from call money and overnight funds to longer periods. Certificates of deposit are usually for three months or more and in million-dollar increments. A Eurodollar deposit is not a demand deposit; it is not created on the bank’s books by writing loans against required fractional reserves, and it can- not be transferred by a check drawn on the bank having the deposit. Eurodollar deposits are transferred by wire or cable transfer of an underlying balance held in a correspondent bank located within the United States. In most countries, a domestic analogy would be the transfer of deposits held in nonbank savings associations. These are transferred by the association writing its own check on a commercial bank.

Any convertible currency can exist in “Euro-” form. Note that this use of “Euro-” should not be confused with the new common European currency called the euro. The Eurocur- rency market includes Eurosterling (British pounds deposited outside the United Kingdom); Euroeuros (euros on deposit outside the euro zone); Euroyen (Japanese yen deposited outside Japan) and Eurodollars (U.S. dollars deposited outside the United States). The exact size of the Eurocurrency market is difficult to measure because it varies with daily decisions made by depositors about where to hold readily transferable liquid funds, and particularly on whether to deposit dollars within or outside the United States.

Eurocurrency markets serve two valuable purposes: 1) Eurocurrency deposits are an effi- cient 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.

Banks in which Eurocurrencies are deposited are called Eurobanks. A Eurobank is a financial intermediary that simultaneously bids for time deposits and makes loans in a currency other than that of the currency in which it is located. Eurobanks are major world banks that conduct a Eurocurrency 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 Euro- pean 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 these deposits might be attached by U.S. residents with claims against communist governments. Therefore, Eastern

8 CHAPTER 1 Current Multinational Challenges and the Global Economy

European holders 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 advanta- geous 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 effi- ciencies, many unique institutional events during the 1950s and 1960s helped 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 alternative 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: LIBOR. In the Eurocurrency market, the reference rate of interest is LIBOR—the London Interbank Offered Rate. LIBOR is now the most widely accepted rate of interest used in standardized quotations, loan agreements or financial deriva- tives valuations. LIBOR is officially defined by the British Bankers Association (BBA). For example, U.S. dollar LIBOR is the mean of 16 multinational banks’ interbank offered rates as sampled by the BBA at 11 A.M. London time in London. Similarly, the BBA calculates the Japanese yen LIBOR, euro LIBOR, and other currency LIBOR rates at the same time in London from samples of banks.

The interbank interest rate is not, however, confined to London. Most major domes- tic financial centers construct their own interbank offered rates for local loan agreements. These rates include PIBOR (Paris Interbank Offered Rate), MIBOR (Madrid Interbank Offered Rate), SIBOR (Singapore Interbank Offered Rate), and FIBOR (Frankfurt Inter- bank Offered Rate), to name but 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 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

9Current Multinational Challenges and the Global Economy CHAPTER 1

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 pressures, deposit rates are higher, and loan rates are lower. A second major area of cost avoided in the Eurocurrency markets is the payment of deposit insurance fees (such as the Federal Deposit Insurance Corporation, FDIC, and assessments paid on deposits in the United States).

The Theory of Comparative Advantage The theory of comparative advantage provides a basis for explaining and justifying international trade in a model world assumed to enjoy free trade, perfect competition, no uncertainty, cost- less information, and no government interference. The theory’s origins lie in the work of Adam Smith, and particularly with his seminal book The Wealth of Nations published in 1776. Smith sought to explain why the division of labor in productive activities, and subsequently inter- national trade of those goods, increased the quality of life for all citizens. Smith based his work on the concept of absolute advantage, where every country should specialize in the production of that good it was uniquely suited for. More would be produced for less. Thus, by each country specializing in products for which it possessed absolute advantage, countries could produce more in total and exchange products—trade—for goods that were cheaper in price than those produced at home.

David Ricardo, in his work On the Principles of Political Economy and Taxation pub- lished in 1817, 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 produc- tion of two products, it might still be relatively more efficient than the other country in one good’s product than the other. Ricardo termed this comparative advantage. Each country would then possess comparative advantage in the production of one of the two products, and both countries would then benefit by specializing completely in one product and trad- ing 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 com- parative 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 flows between countries such as immigrants into the United States (legal and illegal), immigrants within the European Union, and other unions.

Modern factors of production are more numerous than in this simple model. Factors considered in the location of production facilities worldwide include local and managerial skills, a dependable legal structure for settling contract disputes, research and development competence, educational levels of available workers, energy resources, consumer demand for brand name goods, mineral and raw material availability, access to capital, tax differentials, supporting infrastructure (roads, ports, and communication facilities), and possibly others.

Although the terms of trade are ultimately determined by supply and demand, the process by which the terms are set is different from that visualized in traditional trade theory. They are determined partly by administered pricing in oligopolistic markets.

10 CHAPTER 1 Current Multinational Challenges and the Global Economy

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 did not really address certain other issues such as the effect of uncertainty and information costs, the role of differentiated products in imperfectly competitive markets, and economies of scale.

Nevertheless, although the world is a long way from the classical trade model, the 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 the problem of equitable distribution of the benefits can be solved to the satisfaction of consum- ers, producers, and political leaders. Complete specialization, however, remains an unrealistic limiting case, just as perfect competition is a limiting case in microeconomic theory.

Global Outsourcing of Comparative Advantage 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, still is created from the mixture of its own labor skills, access to capital, and technology. Many locations for supply chain outsourcing exist today.

Exhibit 1.3 presents a geographical overview of this modern reincarnation of trade-based comparative advantage. To prove that these countries should specialize in the activities shown you would need to know how costly the same activities would be in the countries that are

China

Eastern Europe

Russia Philippines

Mexico

Costa Rica South Africa

United States

IndiaMonterrey

Guadalajara

Shanghai

London

Paris

Berlin Budapest

Moscow

San Jose

Johannesburg Bombay Hyderabad Bangalore

Manila

MNEs based in many industrial countries are outsourcing intellectual functions to providers based in traditional emerging market countries.

EXHIBIT 1.3 Global Outsourcing of Comparative Advantage

11Current Multinational Challenges and the Global Economy CHAPTER 1

importing these services compared to their own other industries. Remember that it takes a relative advantage in costs, not just an absolute advantage, to create comparative advantage.

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 composed 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 program- mer 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 international telecom- munication networks today further enhances the comparative advantage of an Indian location.

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

What Is Different About International Financial Management? Exhibit 1.4 details some of the main differences between international and domestic financial management. These component differences include institutions, foreign exchange and political risks, and the modifications required of financial theory and financial instruments.

International financial management requires an understanding of cultural, historical, and institutional differences such as those affecting corporate governance. Although both 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 1.4

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 institutional 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 subsidiaires)

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 instruments such as options, forwards, swaps, and letters of credit

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

What Is Different About International Financial Management?

12 CHAPTER 1 Current Multinational Challenges and the Global Economy

capital budgeting, working capital management, taxation, and credit analysis needs to be modified to accommodate foreign complexities. Moreover, a number of financial instruments that are used in domestic financial management have been modified for use in international financial management. Examples are foreign currency options and futures, interest rate and currency 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 new constraints emerge. In this chapter, we will take a brief look at the challenges and risks associated with Trident Corporation (Trident), a company evolving from domestic in scope to being truly multinational. The discussion will include the 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. And as noted by Global Finance in Practice 1.2, the objectives and responsibilities of the modern multinational have grown significantly more complex in the twenty-first century.

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.

GLOBAL FINANCE IN PRACTICE 1.2

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 increasingly accepted that the purpose of the corporation is to certainly create profits and value for its stakeholders, but the respon- sibility of the corporation is to do so in a way that inflicts no costs on society, including the environment. As a result of globalization, this growing responsibility and role of the corpo- ration in society has added a level of complexity to the leader- ship challenges faced by the twenty-first century firm.

This developing debate has been somewhat hampered to date by conflicting terms and labels—corporate goodness, corporate responsibility, corporate social responsibility (CSR),

corporate philanthropy, and corporate sustainability, to list but a few. Much of the 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 mod- ern multinational is to pursue profit, social development, and the environment, all along sustainable principles.

The term sustainable has evolved greatly within the con- text of global business in the past decade. A traditional primary objective of the family-owned business has been the “sustain- ability 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 than the con- cept of environmental sustainability, there is a common core thread—the ability of a company, a culture, or even the earth, to survive and renew over time.

13Current Multinational Challenges and the Global Economy CHAPTER 1

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 produc- tion 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 man- agerial expertise. For example, German, Dutch, and Japanese firms have purchased U.S.-located electronics firms for their technology.

5. Political safety seekers acquire or establish new operations in countries that are 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 anticipation 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.

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.

The Globalization Process Trident is a hypothetical U.S.-based firm that will be used as an illustrative example through- out the book to demonstrate the globalization process—the structural and managerial changes and challenges experienced by a firm as it moves its operations from domestic to global.

Global Transition I: Trident Moves from the Domestic Phase to the International Trade Phase Trident 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 1.5 shows Trident in its early domestic phase.

Trident 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

14 CHAPTER 1 Current Multinational Challenges and the Global Economy

and buyers is established under domestic U.S. practices and procedures. A potential issue for Trident at this time is that although Trident 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 Trident into the first transition of the globalization process, into international trade. Trident was founded by James Winston in Los Angeles in 1948 to make telecommunications equipment. The family-owned business expanded slowly but steadily over the following 40 years. The demands of continual technological investment in the 1980s, however, required that the firm raise additional equity capital in order to compete. This need led to its initial public offering (IPO) in 1988. As a U.S.-based publicly traded company on the New York Stock Exchange, Trident’s management sought to create value for its shareholders.

As Trident became a visible and viable competitor in the U.S. market, strategic opportuni- ties arose to expand the firm’s market reach by exporting product and services to one or more foreign markets. The North American Free Trade Area (NAFTA) made trade with Mexico and Canada attractive. This second phase of the globalization process is shown in the lower half of Exhibit 1.5. Trident responded to these globalization forces by importing inputs from Mexican suppliers and making export sales to Canadian buyers. We define this stage of the globalization process as the International Trade Phase.

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

Second, the evaluation of the credit quality of foreign buyers and sellers is now more important than ever. Reducing the possibility of non-payment for exports and non-delivery of imports becomes one of two main financial management tasks during the international trade

EXHIBIT 1.5

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

Trident Corp: Initiation of the Globalization Process

15Current Multinational Challenges and the Global Economy CHAPTER 1

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 Trident is successful in its international trade activities, the time will come when the global- ization process will progress to the next phase. Trident 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 Trident’s products. The multitude of issues and activities associated with this second larger global transition is the real focus of this book.

Trident’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 globally. A variety of strategic alternatives are available to Trident—the foreign direct invest- ment sequence—as shown in Exhibit 1.6. These alternatives include the creation of foreign sales offices, the licensing of the company name and everything associated with it, and the manufacturing and distribution of its products to other firms in foreign markets.

As Trident moves farther down and to the right in Exhibit 1.6, the degree of its physical presence in foreign markets increases. It may now own its own distribution and production facilities, and ultimately, may want to acquire other companies. Once Trident owns assets and enterprises in foreign countries it has entered the multinational phase of its globalization.

EXHIBIT 1.6

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

Trident’s Foreign Direct Investment Sequence

16 CHAPTER 1 Current Multinational Challenges and the Global Economy

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 growth in the influence and self-enrichment of organizational insiders.

One possible representation of this process can be seen in Exhibit 1.7. If influential insid- ers in corporations and sovereign states continue to pursue the increase in firm value, there will be a definite and continuing growth in financial globalization. But, if these same 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 be increasingly troublesome.

This growing dilemma is also something of a composite of what this book is about. The three fundamental elements—financial theory, global business, and management beliefs 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. The Mini-Case sets the stage for our debate and discussion. Are the controlling family members of this company creating value for themselves or their shareholders?

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.

EXHIBIT 1.7

The Twin Agency Problems Limiting

Financial Globalization

Actions of Rulers of Sovereign States

Higher Firm Value (possibly lower insider value)

Lower Firm Value (possibly higher insider value)

Actions of Corporate Insiders

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.

Source : Constructed by authors based on “The Limits of Financial Globalization,” Rene M. Stulz, Journal of Applied Corporate Finance, Volume 19 Number 1, Winter 2007, pp. 8–15.

The Potential Limits of Financial Globalization

17Current Multinational Challenges and the Global Economy CHAPTER 1

SUMMARY POINTS

! The creation of value requires combining three critical elements: 1) an open marketplace; 2) high-quality stra- tegic management; and 3) access to capital.

! The theory of comparative advantage provides a basis for explaining and justifying international trade in a model world assumed to enjoy free trade, perfect com- petition, no uncertainty, costless information, and no government interference.

! International financial management requires an understanding of cultural, historical, and institu- tional 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 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.

! 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.

! A firm may first enter into international trade trans- actions, then international contractual arrangements, such as sales offices and franchising, and ultimately the acquisition of foreign subsidiaries. At this final stage it truly becomes a multinational enterprise (MNE).

! 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 cor- porations. This will, in turn, create limitations to global- ization in finance.

Rumors about this relatively secret company abound. Share prices fell below $1 in November. Following some action on the stock, and at the request of the Hong Kong stock market, the company had to issue a number of press releases denying rumors of acquisitions or other agreements. It also denied rumors that its Chinese mills had taken market-related downtime. Finally, a spokes- man said the company had no “liquidity problems.”

—“Five Companies to Watch,” G. Rodden, M. Rushton, F. Willis, PPI, January 2009, p. 21.

“This time is really different. Large and small are all affected. In the past, the big waves would only wash away the sand and leave the rocks. Now the waves are so big, even some rocks are being washed away.”

—Cheung Yan, Chairwoman of Nine Dragons Paper, “Wastepaper Queen: Letter from China,”

New Yorker, 30 March 2009, p. 8.

Incorporated in Hong Kong in 1995, Nine Dragons Paper (Holdings) Limited had become an international power- house in the paper industry. The company produced a port- folio of paperboard products used in consumer product packaging. The company had expanded rapidly, its capital expenditure growing at an average annual rate of 120% for the past five years.

But in January 2009, the company had been forced to issue a profit warning (Exhibit 1). Squeezed by market con- ditions and burdened by debt, Nine Dragons Paper (NDP), the largest paperboard manufacturer in Asia and second largest in the world, had seen its share price plummet. As the economic crisis of 2008 had bled into 2009, NDP’s sales had fallen. Rumors had been buzzing since October that NDP was on the very edge of bankruptcy. Now, in April 2009, more than one analyst was asking “Will they go bust?”

MINI-CASE Nine Dragons Paper and the 2009 Credit Crisis1

1Copyright 2011 © Thunderbird School of Global Management. All rights reserved. This case was prepared by Professor Michael Mof- fett and Brenda Adelson, MBA ’08, for the purpose of classroom discussion only, and not to indicate either effective or ineffective management.

18 CHAPTER 1 Current Multinational Challenges and the Global Economy

The Wastepaper Queen Cheung Yan, or Mrs. Cheung as she preferred, was the visionary force behind NDP’s success. Her empire was built from trash—discarded cardboard cartons to be precise. The cartons were collected in the United States and Europe, shipped to China, then pulped and remanu- factured into paperboard. NDP customers then used the paperboard to package goods for shipment back to the United States and Europe, returning them to their origins. Born in 1957, Mrs. Cheung came from a modest family background. She had started as an accountant for a Chi- nese trading company in Hong Kong, and then started her own company after her employer went under. Her com- pany was a scrap paper dealer, purchasing scrap paper in Hong Kong and mainland China and selling it to Chinese paper manufacturers. Paper in China was of generally poor quality, made from bamboo stalk, rice stalk, and grass. The locally collected wastepaper didn’t meet the needs of paper manufacturers as a raw input. In Europe and the United States, however, paper was made from wood pulp, which produced a higher quality paper (United States companies use a higher percentage of pulp, while Chinese companies use more recovered paper). Realizing that by capturing the wastepaper stream in the United States and Europe she could provide a higher quality product to her customers in China, Mrs. Cheung moved to the United States in 1990 to start another company, American Chung Nam Incor- porated (ACN).

One of the first companies to export wastepaper from the United States to China, ACN started by collecting

wastepaper from dumps, then expanded its network to include waste haulers and wastepaper collectors. Mrs. Cheung negotiated favorable contracts with shipping com- panies whose ships were returning to China empty. ACN soon expanded abroad and became a leading exporter of recovered paper from Europe to China as well. By 2001, ACN had become the largest exporter, by volume, of freight from the United States. In other words, nobody in America was shipping more of anything each year any- where in the world.

The Chinese economic miracle that began in the late 1990s rose through exports of consumer goods which needed a massive amount of packaging material. Within a few years, the demands for packaging far outgrew what domestic suppliers could provide. In 1995, Mrs. Cheung founded Nine Dragons Paper Industries Company in Dongguan, China. By 1998, the first papermaking machine was installed, a second in 2000, and a third in 2003. By 2008, NDP had 22 paperboard manufacturing machines at six locations in China and Vietnam. As illustrated by Exhibit 2, sales and profits soared.

NDP’s Products Containerboard is used for exactly what it sounds like: con- taining products in shipping between manufacturing and market. As illustrated in Exhibit 3, the containerboard value chain is a consumer-driven market, with consumer purchases of products driving the demand for packaging and containers and insulation worldwide. Companies like NDP purchase recovered pulp paper from a variety of raw

EXHIBIT 1

(Incorporated in Bermuda with limited liability) (Stock Code: 2689)

ANNOUNCEMENT

PROFIT WARNING

The Board wishes to inform the shareholders of the Company and potential investors that it is expected the Group will record a substantial reduction in its unaudited consolidated net profit arising from normal operations for the six months ended 31 December 2008 as compared to that for the corresponding period in 2007 due to the substantial decrease in the selling prices of the Group’s products and the rising cost of raw materials.

Shareholders of the Company and potential investors are advised to exercise caution in dealing in shares of the Company.

NPD’s Profit Warning (14 January 2009)

19Current Multinational Challenges and the Global Economy CHAPTER 1

EXHIBIT 2

0

2,000,000

4,000,000

6,000,000

8,000,000

10,000,000

12,000,000

14,000,000

16,000,000

2003 2004 2005 2006 2007 2008 0%

5%

10%

15%

20%

25%

Sales (000s Rmb) Return on Sales (%)

Return on Sales = Net Income

Sales

Source: Nine Dragons Paper.

NPD’s Growing Sales and Profitability

EXHIBIT 3

Raw Material Suppliers

OCC (old corrugated cardboard) or recovered paper makes up 90% of volume

Pulp paper about 10% of volume

Input prices have been very volatile in recent years

NDP sources 60% of its OCC from American Chung Nam (ACN) owned by Mrs. Cheung

Raw material costs make up 60% of cost of goods sold

Large quantities of water and electricity required in manufacture

Containerboard Manufacturers

Containerboard co’s typically pass along cost changes due to highly fragmented box manufacturers

NDP & Lee & Man control roughly 25% of the total Chinese market

Sales mix has shifted to domestic market in recent years (78% domestic in 2008, only 49% in 2005)

Companies:

Shandong Huatai Paper Company Ltd.

Kith Holdings Limited

Samson Paper Holdings Limited

Lee & Man Paper Manufacturing Limited

Box Manufacturers

Also able to pass along prices to customers as container costs make up a relatively small percentage of total product cost of final customer

Manufacturing needs to occur near customers due to high cost of transport of low value goods

Companies:

Hop Fung supplies manufacturing sector in Hong Kong and the Pearl River Delta

D&B Database returns 3892 paperboard box manufacturers (NAICS 32221) in China

Consumer Product Companies

Highly cyclical with consumer spending

Market in China has been shifting to a domestic orientation as Chinese incomes and consumption patterns grow

Chinese economy, domestic economy, recovered rapidly from the 2008 recession suffered by most nations globally

Nine Dragons Paper

Chinese Containerboard Value Chain

CHAPTER 1 Current Multinational Challenges and the Global Economy20

material suppliers (e.g., American Chung Nam, ACN, Mrs. Cheung’s own company), to manufacture container- board. The containerboard is then sold to a variety of box manufacturers, most of which are located near the final customer, the consumer product companies.

NDP produced three different types of containerboard: linerboard (47% of 2008 sales), corrugated medium (28% of sales), and corrugated duplex (23% of sales). Linerboard, light brown or white in color, is the flat exterior surface of boxes used to absorb external pressures during transport. Corrugated containerboard is the wavy fluted interior used to protect products in shipment. Corrugated medium, also light brown in color, has a high stack strength and is light- weight, saving shippers significant shipping costs. Corru- gated duplex is glossy on one side, high in printability, and is used in packaging of electronics, cosmetics, and a variety of food and beverages. These three products made up 98% of sales in 2008, with pulp and specialty paper making up the final 2% of sales.

Expansion

The market waits for no one. If I don’t develop today, if I wait for a year, or two or three years, to develop, I will have nothing for the market, and I will miss the opportunity.

—Cheung Yan, Chairwoman of Nine Dragons Paper, “Wastepaper Queen: Letter from China,”

New Yorker, 30 March 2009, p. 2.

Since its founding in 1995, the company had continuously expanded production capacity. By 2008, NDP had three paperboard manufacturing plants in China: Dongguan, in Guangdong Province in the Pearl River Delta; Taicang, in Jiangsu Province in the Yangtze River Delta region; and Chongqing, in Sichuan Province in western China. All three were strategically located close to consumer goods manufacturers and shipping ports. NDP also had three other major investments in parallel with paperboard man- ufacturing, buying a specialty board producer in Sichuan Province, a pulp manufacturer in Inner Mongolia, and a joint venture in a pulp manufacturer and paper mill in Binh Duong Province, Vietnam.

Even with NDP and competitor expansions, the demand for paperboard in China surpassed production. In 2005, Chinese manufacturers produced nearly 28 million tonnes of containerboard, yet consumption equaled 30 mil- lion tonnes. Domestic manufacturers had been narrowing the output gap, yet there was still an unmet need. Despite being the largest containerboard manufacturing country in the world, China remained a net importer. By 2008, NDP was the largest paperboard manufacturer in Asia.

Expansion came at a cost. A paper-making machine can cost anywhere from $100 to $200 million to purchase and set up, and then take up to two years before reaching optimal productivity. NDP operated its own electrical power plants, loading, and transportation services, had entered into sev- eral joint ventures to supply wood pulp, and held long-term agreements for wastepaper supply. Though registered in Bermuda, corporate offices remained in Hong Kong.

Containerboard manufacturing is both energy intensive and water use intensive. To secure power supplies, NDP constructed coal-fired co-generation power plants to sup- ply its plants in Dongguan, Taicang, and Chongqing. With these plants, the cost of generating power was approxi- mately one-third less than electricity purchased from the regional power grid.

The company owned and operated its own transporta- tion infrastructure, including piers and unloading facilities, railway spurs, and truck fleets. The company received ship- ments of raw materials, including recovered paper, chemi- cals, and coal, at its own piers in Taicang and Chongqing, and at the Xinsha Port in Dongguan. These facilities took advantage of ocean and inland waterway transportation, reducing port loading and unloading charges and allowing the company to avoid transportation bottlenecks.

From the beginning, the company invested in the most advanced equipment available, importing papermaking machines from the U.S. and Italy. Each plant was con- structed with multiple production lines, allowing flexible configuration. This allowed NDP to respond to changing customer demands, offering a diversified product portfolio with options including product types, sizes, grades, burst indices, stacking strengths, basis weights, and printability. NDP had become an innovation leader in the industry, with equipment utilization rates consistently averaging 94%, far surpassing the industry average.

Although now publicly traded, the family still controlled the business. Mrs. Cheung and her husband held 72% of the company’s stock, with family members holding a number of the executive positions in the company: Mrs. Cheung was Chairman; her husband, Ming Chung Liu, was Chief Execu- tive Officer; her brother Zhang Cheng Fei was a general man- ager; and her son, Lau Chun Shun, was an executive director.

Financing Expansion

Why are we in debt? she asked. . . . I took a high level of risk because that is the preparation for the future, so that we will be first in the market when things change.

—Cheung Yan, Chairwoman of Nine Dragons Paper, “Wastepaper Queen: Letter from China,” New

Yorker, 30 March 2009, p. 2.

21Current Multinational Challenges and the Global Economy CHAPTER 1

Although sometimes difficult, NDP had historically been able to fund its growing capital expenditures with a com- bination of operating cash flow and debt. But as the rate of expansion grew even faster, and the company’s capital expenditures ballooned as illustrated in Exhibit 4, it became obvious that the company would need to restructure its financial base. Mrs. Cheung devised a second strategic plan.

Initial Public Offering. The first step was an initial pub- lic offering (IPO). In March 2006, NDP offered 25% of the company’s equity, one billion shares, at an offer price of HK$3.40 per share. The official offering was oversub- scribed as a result of intense investor interest. The company then exercised an over-allotment option through its joint underwriters, Merrill Lynch and BNP Paribas Peregrine, issuing an additional 150 million shares in a private place- ment to a select set of Hong Kong-based investors. The added shares raised an additional HK$490 million ($63.2 million) after fees, raising the total issuance to HK$3.9 bil- lion ($504 million), representing 27.7% of the company’s ownership.

NDP’s shares (HK:2689) began trading on the Hong Kong stock exchange in March 2006 and within six months were a constituent stock of the Hang Seng Composite Index. Following the highly successful IPO, Mrs. Cheung was now the richest woman in China.

Raising Debt. The proceeds from the IPO allowed NDP to retire a large portion of its accumulated debt. But the respite from debt concerns was short-lived. As

Mrs. Cheung increased the rate of asset growth, the company’s debt again began to grow. NDP once again generated a negative free cash flow (operating cash flow less capex as illustrated in Exhibit 4). In April 2008, NDP issued $300 million in senior unsecured notes, notes which Fitch initially rated BBB–, the very edge of investment grade. Fitch cited a multitude of factors in its rating: the current economy, raw material price increases, supply risk, and the company’s aggressive capital expenditure program.