1
Chapter One
Globalization and the
Multinational Firm
Chapter Objectives:
Understand why it is important to study international finance.
Distinguish international finance from domestic finance.
1-0
What’s Special about “International” Finance?
Chapter One Outline
p
Goals for International Financial Management
Globalization of the World Economy
Multinational Corporations
Organization of the Textg
Summary
What’s Special about
“International” Finance?
Foreign Exchange Risk
Political Risk
Market Imperfections
Expanded Opportunity Set
1-2
Mutinational
Mutinational Corporate Balance SheetCorporate Balance Sheet Assets
Assets LiabilitiesLiabilities
Global Financial Market Global Financial Market
C t / C t / GG tt SS itiiti Global Product Market
Global Product Market Cash Outlay Cash Outlay Corporate Manager Corporate Manager (Agent) (Agent)
OVERVIEW : INTERNATIONAL FINANCIAL MANAGEMENT
Assets
Assets LiabilitiesLiabilities Short Term
Short Term Short TermShort Term Curent
Curent AssetsAssets Current LiabilitiesCurrent Liabilities Long Term
Long Term Long TermLong Term Land
Land DebtDebt
Plant Plant Equipment
Equipment Equity (Owner)Equity (Owner)
Corporate /
Corporate / GovtGovt SecuritiesSecurities Bonds Bonds Stock Stock Cash Outlay Cash Outlay Cash Revenue Cash Revenue Cash Expense Cash Expense Net Cash Flows Net Cash Flows
Shareholder’s Wealth Maximization Shareholder’s Wealth Maximization
Capital Budgeting Capital Budgeting Maximize: Maximize: Cost of Capital Cost of Capital Minimize: Minimize: C t f D bt C t f D bt
Shareholder s Wealth Maximization Shareholder s Wealth Maximization
(Agency Problems) (Agency Problems)
NPV / IRR
NPV / IRR Cost of DebtCost of Debt
Cost of Equity Cost of Equity
* Foreign Currency Market & Exchange Rates * Foreign Currency Market & Exchange Rates
* Foreign Exchange (FX) Risk * Foreign Exchange (FX) Risk
* International Trade, BOP, Flow of Funds & Exchange * International Trade, BOP, Flow of Funds & Exchange
Rates Rates * Government’s Role * Government’s Role * International Parity Conditions * International Parity Conditions
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
FX Risk: In-Class Exercise
For each one of the four companies, indicate if the net cash flows will increase, decrease, or not change 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.
Market Imperfections
What’s Special about
“International” Finance?
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.
The bearer stock was more expensive.e be e s oc w s o e 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.
Nestlé’s Foreign Ownership Restrictions
12 000 12,000 10,000 8,000 6,000 4,000 SF Bearer share R i t d h 2,000 0 11 20 31 9 18 24Source: Financial Times, November 26, 1988 p.1. Adapted with permission.
Registered share
1-10
The Example of Nestlé’s Market Imperfection
Following this, the price spread between the two
f h d d i ll
types of shares narrowed dramatically.
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 widely viewed as a haven from such risk.
The Nestlé episode illustrates both the importance of considering market imperfections and the peril of political risk.
Expanded Opportunity Set
What’s Special about
“International” Finance?
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 t
investors.
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 0 (1492 Discovery of America – 1800):
Globalization 1.0 (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):
Key driver: triple convergencey p g
Computing
High Speed Data Transfer Work Flow Software
Key players: individuals and companies skilled at exploiting the three medium (see the
The focus of the text is to equip the reader with the
Goals for International Financial
Management
“intellectual toolbox” of an effective global manager—but what goal should this effective global manager be working toward?
Maximization of shareholder wealth? or
or
Other Goals?
1-14
Maximize Shareholder Wealth
Long accepted as a goal in the Anglo-Saxon g p g g countries, but complications arise.
Who are and where are the shareholders?
In what currency should we maximize their wealth?
Maximize Shareholder’s Wealth
Discounted Cash Flow Valuation Model:
Value = E CF$, = t t t n k 1 1 where E (CFe e (C $ t$,t ) = expected cash flows to be ) e pected cas o s to be 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% Year 1 Year 2 Cash flow $ 10,000 $ 10,000 Value = 10,000 / (1.10)1+ 10,000 / (1.10)2 9091 + 8265 = 9091 + 8265 = $ 17, 356
Maximize Shareholder’s Wealth
with FX Risk
Valuing International Cash Flows
E CF E ER
m
Value = E CF, E ER , = j t j t j t t n k 1 1 1where E (CFj,t ) = expected cash flows denominated
in currency j to be received by the
U S t t th d f i d t
U.S. parent at the end of period t 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 Exchange Rate Risk New International Opportunities
More Exposure to Political Risk More Exposure to Foreign Economies
Value = E CF , , E ER = j t j t j m t t n k 1 1 1Valuation Example 2: MNC
K = 10%
Year 1 Year 2
Cash flow Exchange Rate 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 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 Year 2
Cash flow Exchange Rate 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
Other Goals
In other countries shareholders are viewed as merely one y 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
i lik E W ldC d Gl b l
at companies like Enron, WorldCom, and Global 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 t f t i th
importance of corporate governance i.e. the financial and legal framework for regulating the relationship between a firm’s management and its shareholders.
Other Goals
These types of issues can be much more serious in yp 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 they cannot be
No matter what the other 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
Deregulation of Financial Markets
Emergence of Globalized 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 10 more countries joined the
In May 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.
Euro Area
A i I l d Austria, Belgium, Cyprus, Finland, France, Germany Ireland, Italy, Luxembourg, Malta, The Netherlands, Portugal Germany, Greece, Portugal, Slovenia, Spain 1-28Value of the Euro in U.S. Dollars
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 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 2005 the end of the era of quotas
On January 1, 2005 the end of the era of quotas on imported textiles ended.
NAFTA
The North American Free Trade Agreement
(NAFTA) ll f h i i di
(NAFTA) calls for phasing out impediments 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
the enterprise.
Often spurs a tremendous increase in cross-border investment.
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 produce nation, financial capital from 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
Definition: a comparative advantage exists when
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 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
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
The Geometry of Comparative Advantage
Textiles A production possibilities curve shows the various amounts
180
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
300
Food into the production of food, they could produce as much
as 300 million pounds of food.
Country A can produce any combination of food and textiles between these two points.
1-38
The Geometry of Comparative Advantage
Textiles
180
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.
300
Food 60
The Geometry of Comparative Advantage
Textiles
The production possibilities of country B are such that if
180 240
p p y
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 pounds of food.
1,200 300 Food 900 60 200 p 1-40
The Geometry of Comparative Advantage
Textiles
180 240
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.
1,200 300 Food 900 60 200 600 80 1-41
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 and a net importer of food Country A will be a net exporter of textile to Country 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 Country A enjoys a comparative advantage in textiles
180 240
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
300 Food 900 60 200 600 80
Geometrically, a comparative advantage exists
because the slopes of the production possibilities differ.
The Geometry of Comparative Advantage
Textiles If the countries specialize according to their comparative
180 240
advantage, then country A should make textiles and trade for food, while country B should grow food and trade for textiles. 300 Food 900 60 200 600 80 1-44
The Geometry of Comparative Advantage
Textiles Before trade, if both countries made only textiles, the
bi d d i ld b 420 illi d f
420
180 240
combined production would be 420 million yards of textiles = 240 + 180. Before trade, if both countries made only food, the
combined production would be 1,200 million pounds of food = 900 + 300. 1,200 300 Food 900 60 200 600 80 1-45
The Geometry of Comparative Advantage
Textiles Th bi d d ti ibiliti f t 420 180 240The combined production possibilities curve of country A and B without trade are shown in the green line.
1,200 300 Food 900 60 200 600 80 1-46
The Geometry of Comparative Advantage
Textiles
Before trade, the combined production is 800 million lbs
420
180 240
, p
of food and 140 million yards of textiles.
1,200 300 Food 800 900 60 200 600 80 140
The Geometry of Comparative Advantage
Textiles County B can produce food at a lower opportunity cost, so
420
240
y p pp y
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.
180 1,200 300 Food 800 140 900 60 200 600 80 1-48
The Geometry of Comparative Advantage
Textiles
Th bi d d ti ibiliti ith t d
420
180 240
The combined production possibilities curve with trade is composed of the original curves joined as shown.
1,200 300 Food 800 140 900 60 200 600 80 1-49
The Geometry of Comparative Advantage
Textiles
The gains from trade are shown by the increase in
420
180 240
g f y
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.
1,200 300 Food 800 140 900 60 200 600 80 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
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 and a net importer of C from Japan US will be a net exporter of F to 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) 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
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 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
Power Parity
Source: www.wolframalpha.com
GDP Per-Capita Ranking
Worldwide GDP Growth Trend: 1991-2007
Source: www.wolframalpha.com
Current US Interest Rates
Source: www.wolframalpha.com
US Inflations Rate: Long & Short Term Trend
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
$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
