Chapter 1
Financial Goals and
Corporate Governance
• In this course we shall study International Financial
Management with emphasis on MNE
• MNE: Multinational Enterprise
• MNE is a firm that has operating subsidiaries,
branches or affiliates located in foreign countries.
• MNEs are owned by a mixture of domestic and foreign
shareholders. As the MNE grows, the ownership of
some of these firms become so dispersed that they are
called Transnational Corporations.
• MNEs are called enterprise because as businesses
move into many emerging markets, they enter into joint
ventures, strategic alliances or simply operating
agreements with enterprises which may not be publicly
traded or even privately owned (and therefore, not
corporations), but actually part of government.
Why it is important to study the MNEs?
• MNEs face significant foreign exposure and
risk.
• Firms with total domestic operations may not
have to face direct foreign exposure still they
face indirect financial risk through their
relationship with customers and suppliers.
• It has, therefore, became increasingly
important even for the managers of a totally
domestic operations to also learn about
international financial risk, especially those
related to foreign exchange rates and the credit
risks related to trade payments.
The Globalization Process
• The globalization process is the structural and
managerial changes and challenges experienced by a
firm as it moves from domestic to global in operations
• We will examine the case of Trident, a young firm that
manufactures and distributes an array of
telecommunication devices
– Trident’s initial strategy is to develop a sustainable
competitive advantage in the U.S. market
– Trident is currently constrained by its small size, other
competitors, and lack of access to cheap capital
The Globalization Process
Phase One: Domestic Operations
U.S. Suppliers
(domestic)
All payments in US dollars;
All credit risk under U.S. law
Trident Corporation
(Los Angeles, USA)
U.S. Buyers
(domestic)
The Globalization Process
• In Phase One, Trident is not itself international
or global in its operations
• However, some of its competitors, suppliers or
buyers may be
• This is one of the key drivers pushing Trident
into Phase Two, the first transition of the
globalization process
• The above was Global Transition I: The
Domestic Phase to The International Trade
Phase
The Globalization Process
Phase Two: Expansion into International Trade
Trident Corporation
(Los Angeles, USA)
Mexican Suppliers
Are Mexican suppliers dependable?
Will Trident pay US$ or Mexican pesos?
Canadian Buyers
Are Canadian buyers creditworthy?
Will payment be made in US$ or C$?
Trident Corp: Phases Combined
Phase One: Domestic Operations
U.S. Suppliers
(domestic)
All payments in US dollars;
All credit risk under U.S. law
U.S. Buyers
(domestic)
Trident Corporation
(Los Angeles, USA)
Mexican Suppliers
Are Mexican suppliers dependable?
Will Trident pay US$ or Mexican pesos?
Canadian Buyers
Are Canadian buyers creditworthy?
Will payment be made in US$ or C$?
Phase Two: Expansion into International Trade
The Globalization Process
• In the International Trade Phase, Trident
responds to globalization factors by importing
inputs from Mexican suppliers and making
exports sales to Canadian buyers
• Exporting and importing products and services
increases the demands of financial
management over and above the traditional
requirements of the domestic-only business
The Globalization Process
• First, direct foreign exchange risks are now borne by
the firm
– Pricing and payments may be in different currencies
– The value of these foreign currency receipts and
payments can change, creating a new source of risk
• Second, the evaluation of the credit quality of foreign
buyers and sellers is now more important than ever;
this is known as credit risk management
– Potential for non-payment of exports and non-delivery of
imports
– Differences in business and legal systems and practices
The Globalization Process
• If Trident is successful in its international trade
activities, it 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
• This is Global Transition II:
The International Trade Phase to
The Multinational Phase
The Globalization Process
• Trident’s continued globalization will require it
to identify the sources of it competitive
advantages
• This variety of strategic alternatives available
to Trident is called the foreign direct
investment sequence which include the
creation of foreign sales offices, licensing
agreements, manufacturing, etc.
• Once Trident owns assets and enterprises in
foreign countries it has entered the
multinational phase of globalization
Foreign Direct Investment Sequence
Trident and its
Competitive Advantage
Change
Competitive Advantage
Greater Foreign Presence
Exploit Existing Competitive
Advantage Abroad
Production at Home:
Exporting
Production Abroad
Licensing
Management Contract
Greater
Foreign
Investment
Joint Venture
Greenfield
Investment
Control Assets
Abroad
Wholly-Owned
Subsidiary
Acquisition of a
Foreign Enterprise
Foreign Direct Investment
• As Trident increases its foreign presence and level of
foreign investment its management team must:
– Develop knowledge of the global financial
environment
– Understand foreign exchange theory and markets
– Manage foreign exchange exposures including
transaction, operating and translation exposures
– Gain access to global equity and debt markets by
globalizing the cost and availability of capital
– Continue to make strategic and financial foreign
investment decisions
– Manage multinational operations
Foreign Investment Decisions
Trident Europe
Trident Brazil
Trident China
(Hamburg, Germany)
(Sáo Paulo, Brazil)
(Shanghai, China)
Greenfield
Investment
Cross-Border
Acquisition
Joint Venture
Investment
Trident Corporation
(Los Angeles, USA)
Greenfield
Investment
Cross-Border
Acquisition
A long-term physical
investment in productive
capability in that country
Identification, valuation,
tender, and post-acquisition
management of an existing
going-concern
Joint Venture
Investment
Combining investment
capital and managerial
know-how to reach
specific opportunities
Foreign Investment Decisions
What is the company’s
global expansion strategy?
Trident Corporation
(Los Angeles, USA)
Will the new business unit stand
on its own or be integrated
with global operations?
What is the company willing
to pay to pursue its strategy?
Valuation Issues
Does the foreign investment
truly build value for
shareholders?
Analysis of Foreign
Investment or Acquisition
Governance Issues
What are the expected
local currency cash flows
to occur over time?
Who currently owns it? Is it
a privatization, a divestiture,
a greenfield investment?
What are these
expected cash flows worth
in US dollars?
Will the project be
wholly owned or a
joint venture?
Foreign Investment Decisions
Trident USA
Trident Europe
(Los Angeles, USA)
(Hamburg, Germany)
Currency:
US dollar ($)
Tax rate:
35%
2004 Earnings before tax
(EBT):
$ 4.5 million
Currency:
Euros (€)
Tax rate:
45%
2004 EBT:
€ 4.5 million
Avg exchange rate:
$ 1.20/€
2004 EBT in US$: $ 5.4 million
Trident Corporation
(Los Angeles, USA)
Trident China
Trident Brazil
(Shanghai, China)
(Sáo Paulo, Brazil)
Currency: Chinese renminbi (Rmb)
Tax rate:
30%
2004 EBT:
(Rmb 2.5 million)
Avg exchange rate:
Rmb 8.20/$
2004 EBT in US$:
($ 0.305 million)
Currency:
Brazilian real (R$)
Tax rate:
25%
2004 EBT:
R$ 6.25 million
Avg exchange rate:
R$ 3.00/$
2004 EBT in US$: $ 2.083 million
What is the Goal of Management?
• As Trident becomes more deeply committed to
multinational operations, a new constraint
develops – one that springs from divergent
worldwide opinions and practices as to just
what the firms’ overall goal should be:
– Shareholder Wealth Maximization – As
characterized by Anglo-American markets
– Corporate Wealth Maximization – As
characterized by Continental European and
Japanese markets
The Goal of Management
• Shareholder Wealth Maximization
– A firm should strive to maximize the return to
shareholders (those individuals owning equity
shares in the firm)
– This view defines risk in a very strict financial
sense
– Risk is defined as the added risk a firm’s shares
bring to a diversified portfolio (a fully diversified
portfolio represents systematic risk)
– The added firm-specific risk is known as
unsystematic risk
The Goal of Management
• Corporate Wealth Maximization
– A view that all a corporations stakeholders
(employees, management, suppliers, local
community, local/national government and
creditors) need to be considered in addition to
the equity holders
– The goal is to earn as much as possible in the
long run, but to retain enough to increase the
corporate wealth for the benefit of all
– The definition of corporate wealth is much
broader than just financial wealth, it includes
technical, market and human resources as well
The Goal of Management
“Impatient Capital”
Shareholders
Firm
(management)
Banks
Employees
The Anglo-American Model has been
frequently criticized as focusing on
short-term profitability rather than
long-term growth.
“Patient Capital”
Shareholders
Main Bank
Firm
(management)
The Non-Anglo-American Model
has come under increasing criticism
for its lack of accountability to equity
investors – its shareholders – while
focusing on the demands of too
diffuse a group of stakeholders.
Corporate Governance
• The way stakeholders determine and control
the strategic direction and performance of an
organization is termed corporate governance
• The corporate governance of the organization
is therefore the way in which order and process
is established to ensure that decisions are
made and interests are represented – for all
stakeholders - properly
Goal of Corporate Governance
• The single overriding objective of corporate
governance in the shareholder wealth model is the
optimization over time of the returns to shareholders
• The most widely accepted statement of good corporate
governance (established by the OECD) focus on the
following principles;
–
–
–
–
The rights and equitable treatment of shareholders
The role of stakeholders in corporate governance
Disclosure and transparency
The responsibilities of the board
The Structure of Corporate
Governance
The Marketplace
The Corporation
(external)
Equity Markets
Analysts and other market agents
evaluate the performance
of the firm on a daily basis
(internal)
Board of Directors
Chairman of the Board and
members are accountable
for the organization
Debt Markets
Ratings agencies and other
analysts review the ability
of the firm to service debt
Auditors
Management
Chief Executive Officer (CEO)
and his team run the company
Corporate governance represents the relationship among
stakeholders that is used to determine and control the
strategic direction and performance of the organization.
Provide an external opinion
as to the fairness of presentation
and conformity to standards of
financial statements
Regulators
SEC, the NYSE, or other
regulatory bodies by country
Corporate Governance
• The origins of the need for a corporate
governance process arise from the separation
of ownership from management, and from the
varying views by culture of who the
stakeholders are and of what significance
• A governance regime (system) is a function of;
– Financial market development
– The degree of separation between management
and ownership
– The concept of disclosure and transparency
Corporate Governance
• Market-based regimes (U.S. and U.K.) are
characterized by relatively efficient capital
markets with dispersed ownership
• Family-based regimes (Asia, Latin America)
involve strong concentrations of family
ownership
• Bank-based and government-based regimes
result in only marginal public ownership and
sometimes significant restrictions on business
practices
Corporate Governance
• Does good governance matter?
• Certainly, as in the case of Enron, many of the
improprieties were overlooked as long as the
company’s share price continued to rise
• However, after the fall of Enron, and the
substantial losses sustained by investors,
employees and society as a whole, many
would say that corporate governance
matters a lot
The Value of Good Governance
How much more (what premium) would you be willing to pay for a share in a ‘good
governance’ company in the following countries?
40%
35%
30%
25%
20%
15%
10%
5%
M
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Source: “McKinsey Global Investor Opinion Survey on Corporate Governance, 2002,” McKinsey & Company, July 2002.
Potential Responses to
Shareholder Dissatisfaction
Possible Action
Popular Term
Remain Quietly Disgruntled
The Past
Sell the Shares
Walk-Away
Change Management
Shareholder Activism
Initiate a Takeover
Maximum Threat
Shareholder
Dissatisfaction
What counts is that the management of a publicly-quoted company, and its
board of directors, know that the company can become the subject of a hostile
takeover bid if they fail to perform.
Mini Case: The Failure of
Corporate Governance at Enron
• On December 2, 2001, Enron Corporation filed for
bankruptcy protection under Chapter 11
• Enron failed as a result of a complex combination of
business and governance failures
• How did the system allow this to happen?
• Why did the many structures and safeguards within the
U.S. corporate governance system not catch, stop, or
prevent the failure of Enron?
• Please review the case, and the following exhibit in
preparation for the case questions.
Enron’s Earnings by Segment
(IBIT, millions)
$2,500
$2,000
$1,500
$1,000
$500
$0
-$500
1996
Transp & Dist
1997
Wholesale Energy
* IBIT is income before interest and taxes
1998
Retail Energy
1999
Broadband
2000
E&P
Other
Mini Case Questions: The Failure
of Corporate Governance at Enron
• Which parts of the corporate governance system
(internal and external) failed Enron the most?
• How could individual stakeholders and/or components
of the corporate governance system have prevented
the problems at Enron? How could they have acted to
resolve these problems?
• Do you believe this was an isolated incident, or are we
to expect more collapses like Enron’s in the future?
Why?
• Will recent changes in Corporate Governance law
help?