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Globalization and the
Multinational Firm
1
Chapter One
Chapter Objectives:
Understand why it is important to study
international finance.
Distinguish international finance from domestic
finance.
1-0
Chapter One Outline






What’s Special
p
about “International” Finance?
Goals for International Financial Management
Globalization of the World Economy
Multinational Corporations
Organization
g
of the Text
Summary
1-1
1
1/18/2011
What’s Special about
“International” Finance?




Foreign Exchange Risk
Political Risk
Market Imperfections
Expanded Opportunity Set
1-2
OVERVIEW : INTERNATIONAL FINANCIAL MANAGEMENT
Corporate Manager
(Agent)
Global Product Market
Cash Outlay
Cash Revenue
Cash Expense
Net Cash Flows
Capital Budgeting
Maximize:
NPV / IRR
Mutinational Corporate Balance Sheet
Assets
Short Term
Curent Assets
Long Term
Land
Plant
Equipment
Liabilities
Short Term
Current Liabilities
Long Term
Debt
Global Financial Market
C
Corporate
t / Govt
G t Securities
S
iti
Bonds
Stock
Equity (Owner)
Shareholder’s
Shareholder s Wealth Maximization
(Agency Problems)
Cost of Capital
Minimize:
C t off Debt
Cost
D bt
Cost of Equity
* Foreign Currency Market & Exchange Rates
* Foreign Exchange (FX) Risk
* International Trade, BOP, Flow of Funds & Exchange
Rates
* Government’s Role
* International Parity Conditions
* Measuring and Managing FX Risk
* Raising & Investing Capital in a Global Market
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What’s Special about
“International” Finance?

Foreign Exchange Risk




The risk that foreign currency profits may evaporate in
dollar terms due to unanticipated unfavorable exchange
rate movements.
Suppose $1 = ¥100 and you buy 10 shares of Toyota at
¥10,000 per share.
One year later the investment is worth ten percent more
in yen: ¥110,000
But, if the yen has depreciated to $1 = ¥120, your
investment has actually lost money in dollar terms.
1-4
Yen and Euro: 1990 - 2001
3
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FX Risk: In-Class Exercise
For each one of the four companies, indicate if the net
cash flows will increase, decrease, or not change
during both the 1994-95 and the 1996-97 periods,
based on the plots of Yen and Euro prices:
1994-95
1996-97
Ford is a net seller of automobiles in Europe and Japan
Exxon is a net buyer of raw material and services from UK
American Motors has no export/import with other countries
Most shoes that Nike sells in Japan is produced in Europe
What’s Special about
“International” Finance?

Political Risk

Sovereign governments have the right to regulate the
movement of goods, capital, and people across their
borders. These laws sometimes change in unexpected
ways.
1-7
4
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What’s Special about
“International” Finance?

Market Imperfections
 Legal restrictions on the movement of goods,
people, and money
 Transactions costs
 Shipping costs
 Tax arbitrage
1-8
The Example of Nestlé’s Market Imperfection

Nestlé used to issue two different classes of
common stock bearer shares and registered
shares.




Foreigners were only allowed to buy bearer shares.
Swiss citizens could buy registered shares.
Thee bearer
be e stock
s oc was
w s more
o e expensive.
e pe s ve.
On November 18, 1988, Nestlé lifted restrictions
imposed on foreigners, allowing them to hold
registered shares as well as bearer shares.
1-9
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Nestlé’s Foreign Ownership Restrictions
12 000
12,000
10,000
Bearer share
SF
8,000
6,000
4,000
R i t d share
Registered
h
2,000
0
11
20
31
9
18
24
Source: Financial Times, November 26, 1988 p.1. Adapted with permission.
1-10
The Example of Nestlé’s Market Imperfection

Following this, the price spread between the two
types off shares
h
narrowed
d dramatically.
d
i ll



This implies that there was a major transfer of wealth
from foreign shareholders to Swiss shareholders.
Foreigners holding Nestlé bearer shares were
exposed to political risk in a country that is
widely viewed as a haven from such risk.
risk
The Nestlé episode illustrates both the importance
of considering market imperfections and the peril
of political risk.
1-11
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What’s Special about
“International” Finance?

Expanded Opportunity Set
 It doesn’t make sense to play in only one
corner of the sandbox: Consumption,
Production, Financing, and Investment.
 True for corporations as well as individual
i
investors.
t
 Businesses are operating in “A Flat World”
1-12
A Flat Worldview
Three Phases of Globalization (from the book, “The World is Flat” by Thomas
Friedman)
 Globalization 1
1.0
0 (1492
(1492, Discovery of America – 1800):



Key driver: muscle power (e.g., military, horsepower, wind, steam power)
Key players: countries and governments
Globalization 2.0 (1800, Industrial Revolution – 2000):

Key driver: efficiencies associated with Industrial revolution, mostly due to breakthrough in:




transportation: steam engines, rail road,
telecommunication: telegraphs, telephone, computer, satellites, fiber optics, emails, early www
Key players: multinationals tapping into new markets, sources of labor and raw material.
Globalization 3.0 (Post-2000):

Keyy driver: triple
p convergence
g




Computing
High Speed Data Transfer
Work Flow Software
Key players: individuals and companies skilled at exploiting the three medium (see the
attachment: Dell’s Production System).
7
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Goals for International Financial
Management



The focus of the text is to equip the reader with the
“intellectual toolbox” of an effective global
manager—but what goal should this effective
global manager be working toward?
Maximization of shareholder wealth?
or
Other Goals?
1-14
Maximize Shareholder Wealth

Longg accepted
p as a ggoal in the Anglo-Saxon
g
countries, but complications arise.
 Who are and where are the shareholders?
 In what currency should we maximize their
wealth?
1-15
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Maximize Shareholder’s Wealth
Discounted Cash Flow Valuation Model:
n
E  CF$, t 
t =1
1  k t
Value = 
where
e e E (C
(CF$,t
expected
pected cash
cas flows
o s to be
$t) = e
received at the end of period t
n = the number of periods into the future in
which cash flows are received
k = the required rate of return by investors
Valuation Example 1: Domestic Firm
K = 10%
Cash flow
Year 1
Year 2
$ 10,000
$ 10,000
Value = 10,000 / (1.10)1 + 10,000 / (1.10)2
= 9091 + 8265
= $ 17, 356
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Maximize Shareholder’s Wealth
with FX Risk
Valuing International Cash Flows

m
 E  CF j , t   E  ER j , t 
n 
 j 1
Value =  
t =1
1  k t





where E (CFj,t ) = expected cash flows denominated
in currency j to be received by the
U S parentt att th
U.S.
the end
d off period
i dt
E (ERj,t ) = expected exchange rate at which
currency j can be converted to
dollars at the end of period t
k = the weighted average cost of capital of
the U.S. parent company
Maximize Shareholder’s Wealth
with FX Risk (2)
New International Opportunities
More Exposure to Foreign Economies
More Exposure to Exchange Rate Risk
More Exposure to Political Risk

 m
 j1 E  CF j , t   E  ER j , t 
Value =  
t =1
1  k  t

n




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1/18/2011
Valuation Example 2: MNC
K = 10%
Year 1
Cash flow
Exchange Rate
Year 2
Cash flow
Exchange Rate
Dollar
100,000
100,000
Mexican Peso
100,000
$0.10
100,000
$0.08
British Pound
20,000
$2.00
20,000
$2.50
CF (Yr 1): 100,000+ 100,000 * 0.10 + 20,000 * 2.00 = $150,000
CF (Yr 2): 100,000+ 100,000 * 0.08 + 20,000 * 2.50 = $158,000
Value = 150,000 / (1.10)1 + 158,000 / (1.10)2 = $266,943
MNC Valuation: In-Class Exercise
K = 12%
Year 1
Cash flow
Exchange Rate
Year 2
Cash flow
Exchange Rate
Dollar
25,000
22,000
Swiss Franc
100,000
$0.70
120,000
$0.80
German Mark
60,000
$0.50
80,000
$0.60
CF (Yr 1): 25,000+ 100,000 * 0.70 + 60,000 * 0.50 = $125,000
CF (Yr 2): 22,000+ 120,000 * 0.80 + 80,000 * 0.60 = $166,000
Value = 125,000 / (1.12)1 + 166,000 / (1.12)2 = $243,941
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Other Goals

In other countries shareholders are viewed as merelyy one
among many “stakeholders” of the firm including:




Employees
Suppliers
Customers
In Japan, managers have typically sought to maximize the
value of the keiretsu—a family of firms to which the
individual firms belongs.
1-22
Other Goals


As shown by a series of recent corporate scandals
at companies
i like
lik Enron,
E
WorldCom,
W ldC
andd Global
Gl b l
Crossing, managers may pursue their own private
interests at the expense of shareholders when they
are not closely monitored.
These calamities have painfully reinforced the
i
importance
t
off corporate
t governance i.e.
i the
th
financial and legal framework for regulating the
relationship between a firm’s management and its
shareholders.
1-23
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1/18/2011
Other Goals


These types
yp of issues can be much more serious in
many other parts of the world, especially emerging
and transitional economies, such as Indonesia,
Korea, and Russia, where legal protection of
shareholders is weak or virtually non-existing.
No matter what the other goals,
goals they cannot be
achieved in the long term if the maximization of
shareholder wealth is not given due consideration.
1-24
Globalization of the World Economy:
Major Trends




Emergence of Globalized Financial Markets
Emergence of the Euro as a Global Currency
Trade Liberalization and Economic Integration
Privatization
1-25
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Emergence of Globalized Financial Markets



Deregulation of Financial Markets
coupled with
Advances in Technology
have greatly reduced information and
transactions costs, which has led to:
Financial Innovations, such as




Currency futures and options
Multi-currency bonds
Cross-border stock listings
International mutual funds
1-26
Emergence of the Euro as a Global Currency




A momentous event in the history of world
financial systems.
Currently more than 300 million Europeans in 15
countries are using the common currency on a daily
basis.
In May 2004,
2004 10 more countries joined the
European Union and adopted the euro.
The “transaction domain” of the euro may become
larger than the U.S. dollar’s in the near future.
1-27
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1/18/2011
Euro Area
Austria,
A
i
Belgium,
Cyprus,
Finland,
France,
Germany
Germany,
Greece,















IIreland,
l d
Italy,
Luxembourg,
Malta,
The Netherlands,
Portugal
Portugal,
Slovenia,
Spain
1-28
Value of the Euro in U.S. Dollars
1-29
15
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Economic Integration


Over the past 50 years, international trade
increased about twice as fast as world GDP.
There has been a sea change in the attitudes of
many of the world’s governments who have
abandoned mercantilist views and embraced free
trade as the surest route to prosperity for their
citizenry.
1-30
Liberalization of Protectionist Legislation




The General Agreement on Tariffs and Trade
(GATT) a multilateral agreement among member
countries has reduced many barriers to trade.
The World Trade Organization has the power to
enforce the rules of international trade.
On January 1,
1 2005 the end of the era of quotas
on imported textiles ended.
This is an event of historic proportions.
1-31
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NAFTA



The North American Free Trade Agreement
(NAFTA) calls
ll ffor phasing
h i out iimpediments
di
to
trade between Canada, Mexico and the United
States over a 15-year period beginning in 1994.
For Mexico, the ratio of export to GDP has
increased dramatically from 2.2% in 1973 to 29%
i 2006.
in
2006
The increased trade has resulted in increased
numbers of jobs and a higher standard of living
for all member nations.
1-32
Privatization




The selling off state-run enterprises to investors is
also known as “Denationalization”.
Often seen in socialist economies in transition to
market economies.
By most estimates this increases the efficiency of
the enterprise
enterprise.
Often spurs a tremendous increase in cross-border
investment.
1-33
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Multinational Corporations



A firm that has incorporated on one country and
has production and sales operations in other
countries.
There are about 60,000 MNCs in the world.
Many MNCs obtain raw materials from one
nation financial capital from another,
nation,
another produce
goods with labor and capital equipment in a third
country and sell their output in various other
national markets.
1-34
Top 10 MNCs
1
General Electric
United States
2
Vodafone Group PLC
United Kingdom
3
General Motors
United States
4
British Petroleum Co. PLC
United Kingdom
5
Royal Dutch/Shell Group
UK/Netherlands
6
ExxonMobile Corporation
United States
7
Toyota Motor Corporation
Japan
8
Ford Motor Company
United States
9
Total
France
10
Eléctricité de France
France
1-35
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The Theory of Comparative Advantage

Definition: a comparative advantage exists when
one party can produce a good or service at a lower
opportunity cost than another party.
1-36
Comparative Advantage: Example
Consider two countries, A and B. Suppose the output per unit of capital in each country
for two products, Textile and Food, is as follows:
Textile (T)
Food ( F )
Country A
1.8
3.0
Country B
2.4
9.0
Suppose each country has 100 units of capital, and can use it to produce either Textile or
Food. Then the total output will be:
Country A
1.8 x 100 = 180 units of textile
3.0 x 100 = 300 units of food
Country B
2.4 x 100 = 240 units of textile
9.0 x 100 = 900 units of food
Combined
420
1200
Suppose each country allocates 1/3 (or 33.33) of their capital to textile and 2/3 (or 66.67) of
their capital to food, then the total output will be:
Country A
1.8 x 33.33 = 60 units of textile
3.0 x 66.67 = 200 units of food
Country B
2.4 x 33.33 = 80 units of textile
9.0 x 66.67 = 600 units of food
Combined
140
800
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The Geometry of Comparative Advantage
Textiles
180
A production possibilities curve shows the various amounts
of food or textiles that each country can make.
The production possibilities of country A are such that if
they concentrated 100% of their resources into the
production of textiles, they could produce 180 million
yards of textiles.
If country A chose to concentrate 100% of their resources
into the production of food, they could produce as much
as 300 million pounds of food.
300
Food
Country A can produce any combination of
food and textiles between these two points.
1-38
The Geometry of Comparative Advantage
Textiles
As a practical matter, the citizens of country A must
choose a point along their production possibilities curve;
initially they choose 200 million pounds of food, and 60
million yards of textiles.
180
60
Food
200 300
1-39
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The Geometry of Comparative Advantage
Textiles
240
180
The pproduction possibilities
p
of countryy B are such that if
they concentrated 100% of their resources into the
production of textiles, they could produce 240 million
yards of textiles.
If country B chose to concentrate 100% of their resources
into the production of food, they could produce as much
as 900 million ppounds of food.
60
Food
200 300
900
1,200
1-40
The Geometry of Comparative Advantage
Textiles
As a practical matter, the citizens of country B must
choose a point along their production possibilities curve;
initially they choose 600 million pounds of food, and 80
million yards of textiles.
240
180
80
60
Food
200 300
600
900
1,200
1-41
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1/18/2011
Comparative Advantage: Example (contd)
Total Output Per Worker
Textile (T)
Food (F)
Country A
1.8
3.0
Country B
2.4
9.0
Opportunity Cost
Cost of Textile (in terms of Food)
Cost of Food (in terms of Textile)
Country A
1 T = 3.0 / 1.8= 1.67 units of F
1 F = 1.8 / 3.0 = 0.6 units of T
Country B
1 T = 9.0 / 2.4= 3.75 units of F
1 F = 2.4/ 9 = 0.267 units of T
Country A will be a net exporter of textile to Country B
B, and a net importer of food
Country B
Country B will be a net exporter of food to Country A, and a net importer of textile
from Country A
Both countries will trade with each other only when:
The price of one unit of textile is between 1.67 and 3.75 units of food
The price of one unit of food is between 0.6 and 0.267 units of textile
The Geometry of Comparative Advantage
Textiles
240
180
80
60
Country A enjoys a comparative advantage in textiles
because they have to give up food at a lower rate than B
when making textiles.
Put another way, country B enjoys a comparative
advantage in food because they have to give up textiles
at a lower rate than A when making more food.
Geometrically, a comparative advantage exists
Geometrically
because the slopes of the production
possibilities differ.
Food
200 300
600
900
1-43
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The Geometry of Comparative Advantage
Textiles
If the countries specialize according to their comparative
advantage, then country A should make textiles and trade
for food, while country B should grow food and trade for
textiles.
240
180
80
60
Food
200 300
600
900
1-44
The Geometry of Comparative Advantage
Textiles
420
240
180
Before trade, if both countries made only textiles, the
combined
bi d production
d i would
ld be
b 420 million
illi yards
d off
textiles = 240 + 180.
Before trade, if both countries made only food, the
combined production would be 1,200 million
pounds of food = 900 + 300.
80
60
Food
200 300
600
900
1,200
1-45
23
1/18/2011
The Geometry of Comparative Advantage
Textiles
Th combined
The
bi d production
d ti possibilities
ibiliti curve off country
t
A and B without trade are shown in the green line.
420
240
180
80
60
Food
200 300
600
900
1,200
1-46
The Geometry of Comparative Advantage
Textiles
Before trade,, the combined pproduction is 800 million lbs
of food and 140 million yards of textiles.
420
240
180
140
80
60
Food
200 300
600
800 900
1,200
1-47
24
1/18/2011
The Geometry of Comparative Advantage
Textiles
420
Countyy B can pproduce food at a lower opportunity
pp
y cost, so
let B produce the first 900 million pounds of food.
Country A can produce textiles at a lower
opportunity cost, so let them produce the first 180
million yards of textiles.
240
180
140
80
60
Food
200 300
600
800 900
1,200
1-48
The Geometry of Comparative Advantage
Textiles
The combined
Th
bi d production
d ti possibilities
ibiliti curve with
ith trade
t d
is composed of the original curves joined as shown.
420
240
180
140
80
60
Food
200 300
600
800 900
1,200
1-49
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1/18/2011
The Geometry of Comparative Advantage
Textiles
420
The ggains from
f
trade are shown byy the increase in
consumption available—an extra 100 million pounds of food
and 40 million yards of textiles are now available in excess of
the pre-trade consumption.
240
180
140
80
60
Food
200 300
600
800 900
1,200
1-50
Arguments in Favor of Free Trade


Both partners gain from trade: we have more
material goods.
“Freedom” in a good thing in itself.

In this case consumers freedom to choose imported
goods and producers freedom to choose to sell to
foreigners.
g
1-51
26
1/18/2011
Comparative Advantage: In-class Exercise
Total Output Per Worker
Food ( F )
Clothing ( C )
US
2
1
Japan
3
9
Opportunity Cost
Cost of F (in terms of C)
Cost of C (in terms of F)
US
1 F = 1 / 2 = 0.50 C
1 C = 2 / 1 = 2.00 F
Japan
1 F = 9 / 3 = 3.00 C
1 C = 3 / 9 = 0.33 F
US will be a net exporter of F to Japan
Japan, and a net importer of C from Japan
Japan will be a net exporter of C to US, and a net importer of F from US
Both countries will trade with each other only when:
The price of one unit of F, is between 0.50 C and 3.00 C, or
The price of one unit of C, is between 2.00 F and 0.33 F
Comparative Advantage:
In-class Exercise (cont)
Opportunity Cost
Cost of F (in terms of C)
Cost of C (in terms of F)
US
0.50 C (seller)
2.00 F (buyer)
Japan
3.00 C (buyer)
0.33 F (seller)
US
Japan
1 C = 3.00 F
Unacceptable
Acceptable
1 F = 0.40 C
Unacceptable
Acceptable
1 C = 0.25 F
Acceptable
Unacceptable
1 F = 2.00 C
Acceptable
Acceptable
1 F = 4.00 C
Acceptable
Unacceptable
1 C = 1.50 F
Acceptable
Acceptable
27
1/18/2011
Comparative Advantage: In-class Exercise 2
Total Output Per Worker
Food ( F )
Clothing ( C )
US
400
10
Germany
1000
20
Opportunity Cost
Cost of F (in terms of C)
Cost of C (in terms of F)
US
Germany
US
Germany
1 C = 35 F
U
/
A
U
/ A
1 F = 0.04 C
U
/
A
U
/ A
1 F = 0.01 C
U
/
A
U
/ A
1 C = 52 F
U /
A
U
/ A
Economic Fundamentals: US
and Worldwide
28
1/18/2011
GDP Ranking: With & Without Purchasing
Power Parity
Source: www.wolframalpha.com
GDP Per-Capita Ranking
Source: www.wolframalpha.com
29
1/18/2011
Worldwide GDP Growth Trend: 1991-2007
Source: www.wolframalpha.com
US Treasure Bill Rate: Long & Short Term Trend
Source: www.wolframalpha.com
30
1/18/2011
Current US Interest Rates
Source: www.wolframalpha.com
US Inflations Rate: Long & Short Term Trend
Source: www.wolframalpha.com
31
What is Opportunity Cost?
In an economy with limited resources we always have to give up (or trade-off)
something to have more of something else. Economists use the opportunity cost
concept to analyze trade-offs between goods. Opportunity cost measures the number
of units of a certain good one must give up in order to obtain an extra unit of another
good. So, with our limited budgets, if we have to sacrifice two slices of pizzas to
afford an extra pitcher of beer, then the opportunity cost of a pitcher of beer is two
pizza slices!
Let us say that you want to measure the price (or cost) of one good (for example,
candy bars) in terms of another good (for example, postage stamps). Suppose one
dollar can buy two candy bars or four postage stamps. Now let us suppose that you
eliminate money!
Then we can say that one candy bar is equal to 2 (= 4 / 2) postage stamps. That is,
the opportunity cost of a candy bar is two postage stamps, or one candy bar costs
two postage stamps. We can think of candy bar as the good and postage stamps as
money. If we buy candy bars, we will have to pay two postage stamps for each, and
if we sell one we will receive two postage stamps in return.
We can also say that one postage stamp is equal to 0.5 (= 2 / 4) candy bars. That is,
the opportunity cost of a postage stamp is ½ a candy bar, or one postage stamp costs
½ a candy bar. In this case, we are assuming that postage stamps are the goods and
candy bars are money. So, if we buy postage stamps we will have to pay ½ a candy
bar for each, and if we sell one we will also receive ½ a candy bar for each.
You may have noticed that when we calculate the opportunity cost of an item, we
use a ratio. In that ratio, the denominator is always the number associated with the
item whose opportunity cost we are calculating.
Therefore, the opportunity cost of good X in terms of good Y
= # of units of Y / # of units of X
Or
1 unit of good X = (# of units of Y / # of units of X)
Here are several examples of how to calculate the opportunity costs of two products based on the
relationships between them:
Product # 1
Product # 2
Opportunity costs
$ 1 buys 2 candies
$1 buys 4 stamps
$1,000,000 buys 4 cars
$1,000,000 buys 10 boats 1 car = 10/4 = 2.5 boats
1 boat = 4/10 = 0.4 cars
Output/hour = 25
calculators
Output/hour = 5
computers
1 calculator = 5/25 = 0.2
computers
1 computer = 25/5 = 5
calculator
1 worker can produce
8000 lbs of wheat
1 worker can produce
2000 lbs of cotton
1 lb of wheat = 2000/8000 =
0.25 lbs of cotton
1 lb of cotton = 8000/2000 = 4
lbs of wheat
1 candy = 4/2 = 2 stamps
1 stamp = 2/4 = 0.5 candies