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MULTINATIONAL BUSINESS FINANCE THIRTEENTH EDIT ION
David K. EITEMAN
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About the Authors
About the Authors
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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
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
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
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
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
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
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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
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.
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
Interbank Market (LIBOR )
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.
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
Costa Rica South Africa
Johannesburg Bombay Hyderabad Bangalore
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,
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
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.
Greater Foreign Investment
Greater Foreign Presence
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
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.
The Twin Agency Problems Limiting
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
! 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
(Incorporated in Bermuda with limited liability) (Stock Code: 2689)
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
2003 2004 2005 2006 2007 2008 0%
Sales (000s Rmb) Return on Sales (%)
Return on Sales = Net Income
Source: Nine Dragons Paper.
NPD’s Growing Sales and Profitability
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 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)
Shandong Huatai Paper Company Ltd.
Kith Holdings Limited
Samson Paper Holdings Limited
Lee & Man Paper Manufacturing Limited
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
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.
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.
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.
When global financial markets ground to a halt in September and October 2008 and the economic crisis spread around the globe, consumers stopped buying, Chinese exports slowed, and sales of containerboard plummeted. NDP’s export orders declined 50%, sales revenue dropped, and the burden of debt grew notice- ably heavier. Analysts became increasingly nervous. As price pressure from raw materials continued and NDP’s margins fell, final customers started fighting higher con- tainerboard and box prices. On October 13, Fitch down- graded NDP to BB+. NDP was now speculative grade, junk bond status.
NDP’s Chinese New Year 2009
We understand that all NDP’s banks have postponed for one year all earnings-based debt covenant ratios. We see this as a significant positive for shareholders as it should allow management enough time to restore confidence
6/30/2003 6/30/2004 6/30/2005 6/30/2006 6/30/2007 6/30/2008
Operating Cash Flow
NDP’s Capex and Operating Cash Flow
CHAPTER 1 Current Multinational Challenges and the Global Economy22
and restructure its Rmb14.7 bn in debt, of which half is due in two years.
—“Nine Dragons Paper,” Morgan Stanley, January 29, 2009, p. 1.
Following new rumors of the company’s possible bank- ruptcy, on December 29, 2008, NDP announced that it would delay Rmb1.5 billion in capital expenditure planned for the 2009 fiscal year. The company reassured analysts and shareholders that by late 2010 or early 2011 the paperboard markets would rebound. NDP also moved quickly to repur- chase $16 million of its own notes and reported it would prepay $100 million of an existing $350 million syndicated loan and HK$720 million of a HK$2.3 billion credit line.
The debt restructuring had mixed results for NDP’s outlook. The partial repayment on the two loan facilities convinced NDP’s bankers to allow the debt covenants on the loan facilities to be relaxed for one year. In turn, NDP’s costs under the loan facilities would reflect new higher spreads commensurate with its fallen credit rating. Its actions quelled the tempest somewhat, but not much, and not for long. NDP’s share price, after recovering a bit in December 2008, started falling once again in January 2009, as shown in Exhibit 5. Two days later on January 15, NDP issued a profit warning, revising sales and profit forecasts downward (see Exhibit 1). The ratings agencies responded with another downgrade, Fitch pushing NDP’s outstanding notes down to BB–. Rumors of the company’s potential bankruptcy were widespread.
By mid-February, many investment analysts were start- ing to reverse their recommendations on NDP shares. A few argued that the company’s share price had over- reacted, and the company simply “had to be worth more” than what it was currently trading at. As more and more analysts endorsed the strategic and financial changes announced and implemented by management, the share price gradually rose. There were early signs that the Chi- nese economy was recovering from the recession quickly, margins were stabilizing, and that boded well for NDP’s earnings and cash flows.
In mid-March, however, the analysts were stunned once again. In a briefing held by Mrs. Cheung, NDP announced it was re-instituting capex plans which had been shelved only three months before.
. . . we are concerned about the heavy reliance on bank borrowing in its current capital structure. Whilst the US$165 mn buyback of its senior notes and the relax- ation of loan covenants in its syndicated term loans were positive catalysts for shareholders, in our view, we believe investors today are now asking what the company is doing to cut total debt, and at the meeting management failed to provide any new strategies.
—Morgan Stanley, March 18, 2009.
Estimates of earnings for the year would once again have to be revised downward (as seen in the March 18, 2009 revision in Exhibit 6). The higher capital expenditures
HK$28 NDP Share Price (HK$)
NDP’s IPO March 2006 Rumors of
potential bankruptcy increase
NDP’s record high of HK$26 in September 2007
NDP’s Share Price (ending April 30, 2009; weekly)
23Current Multinational Challenges and the Global Economy CHAPTER 1
EXHIBIT 6 The Evolution of Earnings, Cash Flow, and Debt Analysis of Nine Dragons Paper
Rmb (millions) 2007 2008
Maintain Sept 17,
Downgrade Dec 16,
Upgrade Jan 29,
Downgrade Feb 19, 2009 2009e
Debt Concern Mar 18,
Net sales 9,838 14,114 20,837 14,691 14,691 14,522 14,517 Cost of goods manufacturing (7,201) (11,341) (16,849) (12,886) (12,779) (12,482) (12,468)
EBITDA 2,637 2,773 3,988 1,805 1,912 2,040 2,049 Percent of sales 26.8% 19.6% 19.1% 12.3% 13.0% 14.0% 14.1%
Depreciation & amoritization (370) (507) (914) (800) (807) (848) (829)
EBIT 2,267 2,266 3,074 1,005 1,105 1,192 1,220 Percent of sales 23.0% 16.1% 14.8% 6.8% 7.5% 8.2% 8.4%
Interest (105) (102) (795) (887) (887) (556) (480)
Pre-tax Profit (EBT) 2,162 2,164 2,279 118 218 636 740 Percent of sales 22.0% 15.3% 10.9% 0.8% 1.5% 4.4% 5.1%
EBITDA 2,637 2,773 3,988 1,805 1,912 2,040 2,049 Less taxes paid (93) (263) (296) (15) (28) (44) (22) Less net financial (272) (102) (814) (918) (918) (588) (1,057) Less working capital (1,517) (1,012) (1,202) (691) 1,500 602 599
Operating Cash Flow 755 1,396 1,676 181 2,466 2,010 1,569
Capex (5,345) (9,601) (2,950) (1,500) (1,700) (2,800) (4,450) Acquisitions (208) (208) (208) (208) — — — Disposals & other 28 — 20 31 31 31 31
Investing Cash Flow (5,525) (9,809) (3,138) (1,677) (1,669) (2,769) (4,419)
Equity raised 2,011 — — — — — — Debt raised 1,795 8,594 2,950 1,350 (1,000) (500) 2,000 Dividends (199) (495) (495) (224) (224) (224) (224) Other 119 171 — (452) (12) (17) (17)
Financing Cash Flow 3,726 8,270 2,455 674 (1,236) (741) 1,759
Net Changes in Cash (1,044) (143) 993 (822) (439) (1,500) (1,091)
FREE CASH FLOW
Operating Cash Flow 755 1,396 1,676 181 2,466 2,010 1,569 Less capex (5,345) (9,601) (2,950) (1,500) (1,700) (2,800) (4,450)
Free Cash Flow (FCF) (4,590) (8,205) (1,274) (1,319) 766 (790) (2,881)
Payables 1,767 3,839 2,941 2,280 4,316 4,232 4,221 Borrowings 6,632 14,685 14,865 16,265 13,915 13,575 16,369 Other liabilities 328 544 39 91 532 527 527
Total Liabilities 8,727 19,068 17,845 18,636 18,763 18,334 21,117
Shareholders equity 11,513 13,272 14,426 13,090 13,178 14,419 13,706 Minority interest 123 274 243 334 334 334 334
Total Liabilities and Equity 20,363 32,614 32,514 32,060 32,275 33,087 35,157
Net Debt 5,007 13,396 13,458 15,858 13,124 13,845 16,231 Net Debt / Equity 43.5% 100.9% 93.3% 121.1% 99.6% 96.0% 118.4% Interest Cover (EBITDA x) 9.7 27.2 4.9 2.0 2.1 3.5 1.9 Gearing (Debt/Equity) 58% 111% 103% 124% 106% 94% 119% Debt / EBITDA (5x or less) 2.51 5.30 3.73 9.01 7.28 6.65 7.99 EBIT / Interest (4x or more) 21.59 22.22 3.87 1.13 1.25 2.14 2.54
Source: Compiled by authors from “Nine Dragons Paper,” Morgan Stanley, September 17, 2008, December 16, 2008, January 29, 2009, February 10, 2009, February 19, 2009, and March 18, 2009.
24 CHAPTER 1 Current Multinational Challenges and the Global Economy
would now result in both higher depreciation charges and higher interest expenses for their funding.
Cash Flow Concerns
Nine Dragon’s earnings are very sensitive to prices of both recycled paper and containerboard. Fluctuations in these prices could lead to material changes in earn- ings. With current net debt to equity close to 100%, the company relies on bank borrowings to finance part of its working capital and capex. Should the banks unex- pectedly withdraw their facilities, the company may encounter liquidity problems. In addition, the company’s earnings growth is based on expansion plans. If the com- pany is unable to obtain sufficient funding, the expansion may fall short of the company’s target.
—Morgan Stanley, January 29, 2009, p. 6.
The focus of analyst concerns over NDP’s prospects was the impact of declining sales and margin on its ability to service its large debt burden. Morgan Stanley’s frequent revision and reevaluation of NDP’s key cash flow drivers and drains over the first quarter of 2009 is illustrated in Exhibit 5. Key issues included the following:
! Earnings. NDP’s primary source of ongoing cash flow was earnings, and as measured by EBITDA (Earnings before interest, taxes, depreciation and amortization), margins and earnings would be negatively impacted by the current paperboard market decline and higher input costs.
! Interest Expenses. Debt costs in the form of interest expenses were clearly rising rapidly as a result of con- tinued high-debt levels and the higher interest rates which followed from credit downgrades.
! Capex. NDP’s massive asset expansion had brought about both its market dominance and its never-ending need for debt. Initially, management had announced postponement of capital expenditure plans in an attempt to calm bankruptcy fears.
QUESTIONS 1. Globalization and the MNE. The term globalization
has become widely used in recent years. How would you define it?
2. Assets, Institutions, and Linkages. Which assets play the most critical role in linking the major institutions that make up the global financial marketplace?
3. Eurocurrencies and LIBOR. Why have eurocurrencies and LIBOR remained the centerpiece of the global financial marketplace for so long?
4. Theory of Comparative Advantage. Define and explain the theory of comparative advantage.
5. Limitations of Comparative Advantage. Key to understanding most theories is what they say and what
! Debt. The debt-carrying capacity of NDP was the primary source of debate in the current recession- ary environment. The company’s debt/equity ratio, its gearing, was extremely high and potentially lethal in a recessionary environment amid a global finan- cial crisis, with credit so tight that many banks had stopped answering the phone. Analysts agreed across the board that NDP needed to reduce debt—now.
The March announcement of higher capex, now revised upward to Rmb 4.45 bn, would result in both higher depre- ciation charges and higher interest expenses. It would again commit the company to a large negative free cash flow for the 2009 year, and would probably result in NDP carrying higher debt levels well into 2010 and 2011 while the world economic environment was predicted to remain fragile. As the global economic crisis continued in 2009, many of NDP’s customers had simply disappeared. More than 670,000 Chinese businesses had failed in 2008, and early 2009 had been just as bad. Could NDP be next?
Our future path of development may remain thorny ahead, but armed with the shared confidence and cour- age throughout the Group to overcome and conquer, we are poised to act even more diligently and powerfully to prepare for the next global economic recovery . . .
—“Chairlady’s Statement,” 2008/09 Interim Report, Nine Dragons Paper (Holdings) Limited.
1. How does Mrs. Cheung think? What does she believe in when it comes to building her business?
2. How would you summarize the company’s financial status? How does it reflect the business development goals and strategies employed by Mrs. Cheung?
3. Is NDP in trouble? How would your answer differ if you were an existing shareholder, a potential investor, or an analyst?
25Current Multinational Challenges and the Global Economy CHAPTER 1
4. Trade at France’s Domestic Price. France’s domestic price is 2 containers of toys equals 7 cases of wine. Assume China produces 10,000 containers of toys and exports 400 containers to France. Assume France in turn produces 7,000 cases of wine and exports 1,400 cases to China. What happens to total production and consumption?
5. Trade at Negotiated Mid-Price. The mid-price for exchange between France and China can be calculated as follows. What happens to total production and consumption?
they don’t. Name four or five key limitations to the theory of comparative advantage.
6. Trident’s Globalization. After reading the chapter’s description of Trident’s globalization process, how would you explain the distinctions between international, multinational, and global companies?
7. Trident, the MNE. At what point in the globalization process did Trident become a multinational enterprise (MNE)?
8. Trident’s Advantages. What are the main advantages that Trident gains by developing a multinational presence?
9. Trident’s Phases. What are the main phases that Trident passed through as it evolved into a truly global firm? What are the advantages and disadvantages of each?
10. Financial Globalization. How do the motivations of individuals, both inside and outside the organization or business, define the limits of financial globalization?
PROBLEMS Comparative Advantage Problems 1–5 illustrate an example of trade induced by comparative advantage. They assume that China and France each have 1,000 production units. With one unit of produc- tion (a mix of land, labor, capital, and technology), China can produce either 10 containers of toys or 7 cases of wine. France can produce either 2 cases of toys or 7 cases of wine. Thus, a production unit in China is five times as efficient compared to France when producing toys, but equally effi- cient when producing wine. Assume at first that no trade takes place. China allocates 800 production units to building toys and 200 production units to producing wine. France allocates 200 production units to building toys and 800 pro- duction units to producing wine.
1. Production and Consumption. What is the production and consumption of China and France without trade?
2. Specialization. Assume complete specialization, where China produces only toys and France produces only wine. What would be the effect on total production?
3. Trade at China’s Domestic Price. China’s domestic price is 10 containers of toys equals 7 cases of wine. Assume China produces 10,000 containers of toys and exports 2,000 containers to France. Assume France produces 7,000 cases of wine and exports 1,400 cases to China. What happens to total production and consumption?
Toys (containers/ unit) Wine (cases/unit)
China—output per unit of production input
France—output per unit of production input
China—total production inputs
France—total production inputs
Americo Industries—2010 Problems 6 through 10 are based on Americo Industries. Americo is a U.S.-based multinational manufacturing firm, with wholly owned subsidiaries in Brazil, Germany, and China, in addition to domestic operations in the United States. Americo is traded on the NASDAQ. Americo cur- rently has 650,000 shares outstanding. The basic operating characteristics of the various business units are as follows:
Business Performance (000s, local currency)
U.S. Parent Company (US$)
Brazilian Subsidiary (reais, R$)
German Subsidiary (euros, €)
Chinese Subsidiary (yuan, ¥)
Earnings before taxes (EBT)
$4,500 R$6,250 4,500 ¥2,500
Corporate income tax rate
35% 25% 40% 30%
Average exchange rate for the period
— R$1.80/$ €0.7018/$ ¥7.750/$
6. Americo Industries’ Consolidate Earnings. Americo must pay corporate income tax in each country in which it currently has operations.
26 CHAPTER 1 Current Multinational Challenges and the Global Economy
INTERNET EXERCISES 1. International Capital Flows: Public and Private. Major
multinational organizations (some of which are listed below) attempt to track the relative movements and magnitudes of global capital investment. Using these Web pages and others you may find, prepare a two- page executive briefing on the question of whether capital generated in the industrialized countries is finding its way to and from emerging markets. Is there some critical distinction between “less developed” and “emerging”?
The World Bank www.worldbank.org
European Bank www.ebrd.org for Reconstruction and Development
2. External Debt. The World Bank regularly compiles and analyzes the external debt of all countries globally. As part of their annual publication on World Development Indicators (WDI), they provide summaries of the long-term and short-term external debt obligations of selected countries online like that of Poland shown here. Go to their Web site and find the decomposition of external debt for Brazil, Mexico, and the Russian Federation.
The World Bank/data www.worldbank.org/data
3. World Economic Outlook. The International Monetary Fund (IMF) regularly publishes its assessment of the prospects for the world economy. Choose a country of interest and use the IMF’s current analysis to form your own expectations of its immediate economic prospects.
IMF Economic Outlook www.imf.org/external/ index.htm
4. Financial Times Currency Global Macromaps. The Financial Times provides a very helpful real-time global map of currency values and movements online. Use it to track the movements in currency.
Financial Times http://markets.ft.com/ft/ markets/currencies.asp
a. After deducting taxes in each country, what are Americo’s consolidated earnings and consolidated earnings per share in U.S. dollars?
b. What proportion of Americo’s consolidated earn- ings arise from each individual country?
c. What proportion of Americo’s consolidated earn- ings arise from outside the United States?
7. Americo’s EPS Sensitivity to Exchange Rates (A). Assume a major political crisis wracks Brazil, first affecting the value of the Brazilian reais and, subsequently, inducing an economic recession within the country. What would be the impact on Americo’s consolidated EPS if the Brazilian reais were to fall in value to R$3.00/$, with all other earnings and exchange rates remaining the same?
8. Americo’s EPS Sensitivity to Exchange Rates (B). Assume a major political crisis wracks Brazil, first affecting the value of the Brazilian reais and, subsequently, inducing an economic recession within the country. What would be the impact on Americo’s consolidated EPS if, in addition to the fall in the value of the reais to R$3.00/$, earnings before taxes in Brazil fell as a result of the recession to R$5,8000,000?
9. Americo’s Earnings and the Fall of the Dollar. The dollar has experienced significant swings in value against most of the world’s currencies in recent years. a. What would be the impact on Americo’s consoli-
dated EPS if all foreign currencies were to appreci- ate 20% against the U.S. dollar?
b. What would be the impact on Americo’s consoli- dated EPS if all foreign currencies were to depreci- ate 20% against the U.S. dollar?
10. Americo’s Earnings and Global Taxation. All MNEs attempt to minimize their global tax liabilities. Return to the original set of baseline assumptions and answer the following questions regarding Americo’s global tax liabilities: a. What is the total amount—in U.S. dollars—which
Americo is paying across its global business in cor- porate income taxes?
b. What is Americo’s effective tax rate (total taxes paid as a proportion of pre-tax profit)?
c. What would be the impact on Americo’s EPS and global effective tax rate if Germany instituted a cor- porate tax reduction to 28%, and Americo’s earn- ings before tax in Germany rose to €5,000,000?
Corporate Ownership, Goals, and Governance
Gerald L. Storch, CEO of Toys ‘R’ Us, says all CEOs share the same fundamental goals: enhance the value for the customer, maximize return to the shareholders, and develop a sustainable competitive advantage. “Largely, I believe that the differences are more subtle than what I’ve read in many articles. On a day-to-day basis, I do the same thing. I get to work every morning. I try to make the company better.”
—“Public Vs. Private,” Forbes, September 1, 2006.
This chapter examines how legal, cultural, political, and institutional differences affect a firm’s choice of financial goals and corporate governance. The owner of a commercial enter- prise, and his or her specific personal and professional interests, has a significant impact on the goals of the corporation and its governance. We therefore examine ownership, goals, and governance in turn. The chapter concludes with the Mini-Case, Luxury Wars—LVMH vs. Hermès, the recent struggle by Hermès of France to remain family controlled.
Who Owns the Business? We begin our discussion of corporate financial goals by asking two basic questions: 1) Who owns the business? and 2) Do the owners of the business manage the business themselves?
Exhibit 2.1 provides a type of taxonomy of commercial enterprises— highlighting the sometimes rather confusing nomenclature used in ownership identity. The exhibit expressly concerns commercial enterprises, those organizations created for the conduct of business. The first distinction is between public ownership, where the state, government, or civil society owns the organization, and private ownership, which includes individuals, partners, families, or the modern publicly traded widely held organization.
It is important to reconfirm that public ownership is ownership of organizations that are created distinctly for the purpose of commercial activities, rather than the multitude of other social, civil, and regulatory activities of government. Those for business, often termed State Owned Enterprises (SOEs), are today in many countries, the dominant form of busi- ness entity. One example is the Saudi Arabian Oil Company, Saudi Aramco, the national oil company of Saudi Arabia and the world’s largest oil and gas company. Saudi Aramco is owned by the Saudi Arabian government.
28 CHAPTER 2 Corporate Ownership, Goals, and Governance
The common assumption made by people when discussing a “company” or a “business” is that of the privately owned enterprise presented in Exhibit 2.1. These companies are created by entrepreneurs who are typically either individuals or a small set of partners. In either case, they may be members of a family. (Do not forget that even Microsoft started as the brainchild of two partners, Bill Gates and Paul Allen.)
Publicly Traded Shares Regardless of core origins—public or private—today’s global marketplace has both organiza- tional forms traded in the public market. In addition to the usual suspects such as ExxonMobil and IBM, widely publicly traded and held private enterprises, there are many other SOEs that are also publicly traded. For example, China National Petroleum Corporation (CNPC), the government parent company of PetroChina, has shares listed and traded on stock exchanges in Shanghai, Hong Kong, and New York.
Some firms, either initially private or public, may choose in time to go public via an initial public offering, or IPO. Typically, only a relatively small percentage of the company is initially sold to the public, anywhere from 10% to 20%, resulting in a company that may still be con- trolled by a small number of private investors or SOEs, but now with public shares outstand- ing. Over time, some companies may sell more and more of their equity interests into the public marketplace, possibly eventually becoming totally publicly traded. Alternatively, the private owner or family may choose to retain a major share but does not have explicit control. Possibly, as has been the case in recent years, a firm reverses direction, reducing the shares outstanding; or in the case of an acquisition, being taken completely private once again. For example, in 2005 a very large private firm, Koch Industries (U.S.), purchased all outstanding shares of Georgia-Pacific (U.S.), a very large publicly traded forest products company. Koch took Georgia-Pacific private. An added consideration is that even when the firm’s ownership is publicly traded, it may still be controlled by a single investor or a small group of investors, including major institutional investors. This means that the control of the company is much like the privately held company, and therefore reflects the interests and goals of the individual investor or family. A continuing characteristic of many emerging markets is the dominance
Purpose is not for profit, but for civil services
Purpose is hybrid of profit and civil services
Purpose is for profit
Partially publicly traded
Private company Partnership
A Taxonomy of Commercial Enterprises
29Corporate Ownership, Goals, and Governance CHAPTER 2
of family-controlled firms, although many are simultaneously publicly traded. And as shown in Global Finance in Practice 2.1, family-controlled firms all over the world, including France, may outperform publicly traded firms. The Mini-Case at the end of this chapter highlights another of these family-based enterprises.
As discussed later in this chapter, something else of significance results from the initial sale of shares to the public: The firm becomes subject to many of the increased legal, regulatory, and reporting requirements in most countries surrounding the sale and trading of securities. In the United States, for example, going public means the firm will now have to disclose a sizable degree of financial and operational detail, publish this information at least quarterly, comply with Securities and Exchange Commission (SEC) rules and regulations, and comply with all the specific operating and reporting requirements of the specific exchange on which it is traded.
Separation of Ownership from Management One of the most complex issues in global financial management of the enterprise, be it public or private, is the separation of ownership from management. Hired or professional manage- ment may be characteristic of any ownership structure, but is most often observed in SOEs and widely held publicly traded companies. This separation of ownership from management raises the possibility that the two entities will not be aligned in their business and financial objectives. This is the so-called agency problem.
The United States and United Kingdom have been two country markets characterized by widespread ownership of shares. Management may own some small proportion of stock in their firms, but largely management is a hired agent of widely held firms. In contrast, many firms in many other global markets are characterized by controlling shareholders such as
GLOBAL FINANCE IN PRACTICE 2.1
Family-Controlled Firms in France Outperform the Public Sector
Translation: “Why do family firms outperform the CAC 40 index?”
Among the major industrial countries, France has the high- est number of family businesses (about 65% of the CAC 40 firms are family owned versus only about 24% in the U.K.). This includes Bouygues, Dassault, Michelin and Peugeot. Over the 1990–2006 period, French family firms generated a 639% return to their owners, whereas the major French index, the
CAC 40, returned only 292%. This family-owned firm domi- nance is attributed to three factors: 1) they focus on the long- term; 2) they stick to their core business; and 3) because the owners are closer to management, fewer conflicts arise between management and ownership (fewer agency problems in the terminology of Finance).
Source: Le Figaro, June 2007.
30 CHAPTER 2 Corporate Ownership, Goals, and Governance
government, institutions (e.g., banks in Germany), family (e.g., in France, Italy, and through- out Asia and Latin America), and consortiums of interests (e.g., keiretsus in Japan and chae- bols in South Korea).
In many of these cases, control is enhanced by ownership of shares with dual voting rights, interlocking directorates, staggered election of the board of directors, takeover safeguards, and other techniques not used in the Anglo-American markets. However, the recent emer- gence of huge equity funds and hedge funds in the United States and the United Kingdom has led to the privatization of some very prominent publicly traded firms.
The Goal of Management As companies become 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 from the perspective of top management, as well as the role of corporate governance.
What do investors want? First, of course, investors want performance: strong predict- able earnings and sustainable growth. Second, they want transparency, accountability, open communications and effective corporate governance. Companies that fail to move toward international standards in each of these areas will fail to attract and retain inter- national capital.
—“The Brave New World of Corporate Governance,” LatinFinance, May 2001.
An introductory course in finance is usually taught within the framework of maximizing share- holders’ wealth as the goal of management. In fact, every business student memorizes the concept of maximizing shareholder value sometime during his or her college education. This rather rote memorization, however, has at least two major challenges: 1) It is not necessarily the accepted goal of management across countries to maximize the wealth of shareholders— other stakeholders may carry substantial weight and 2) It is extremely difficult to carry out. Creating value is—like so many lofty goals—much easier said than done.
Although the idea of maximizing shareholder wealth is probably realistic both in theory and in practice in the Anglo-American markets, it is not always exclusive elsewhere. Some basic differences in corporate and investor philosophies exist between the Anglo-American markets and those in the rest of the world. Therefore, one must realize that the so-called uni- versal truths taught in basic finance courses are actually culturally determined norms.
Shareholder Wealth Maximization Model The Anglo-American markets have a philosophy that a firm’s objective should follow the shareholder wealth maximization (SWM) model. More specifically, the firm should strive to maximize the return to shareholders, as measured by the sum of capital gains and dividends, for a given level of risk. Alternatively, the firm should minimize the risk to shareholders for a given rate of return.
The SWM theoretical model assumes as a universal truth that the stock market is efficient. This means that the share price is always correct because it captures all the expectations of return and risk as perceived by investors. It quickly incorporates new information into the share price. Share prices, in turn, are deemed the best allocators of capital in the macro economy.
The SWM model also treats its definition of risk as a universal truth. Risk is defined as the added risk that the firm’s shares bring to a diversified portfolio. The total operational risk of the firm can be eliminated through portfolio diversification by the investors. Therefore, this unsystematic risk, the risk of the individual security, should not be a prime concern for
31Corporate Ownership, Goals, and Governance CHAPTER 2
management unless it increases the prospect of bankruptcy. Systematic risk, the risk of the market in general, cannot be eliminated. This reflects risk that the share price will be a func- tion of the stock market.
Agency Theory. The field of agency theory is the study of how shareholders can motivate management to accept the prescriptions of the SWM model.1 For example, liberal use of stock options should encourage management to think like shareholders. Whether these inducements succeed is open to debate. However, if management deviates too much from SWM objectives of working to maximize the returns to the shareholders, then the board of directors should replace them. In cases where the board is too weak or ingrown to take this action, the disci- pline of the equity markets could do it through a takeover. This discipline is made possible by the one-share-one-vote rule that exists in most Anglo-American markets.
Long-Term Versus Short-Term Value Maximization. During the 1990s, the economic boom and rising stock prices in the United States and abroad exposed a flaw in the SWM model, especially in the United States. Instead of seeking long-term value maximization, several large U.S. corporations sought short-term value maximization (e.g., the continuing debate about meeting the market’s expected quarterly earnings). This strategy was partly motivated by the overly generous use of stock options to motivate top management.
This sometimes created distorted managerial incentives. In order to maximize growth in short-term earnings and to meet inflated expectations by investors, firms such as Enron, Global Crossing, Health South, Adelphia, Tyco, Parmalat, and WorldCom undertook risky, decep- tive, and sometimes dishonest practices for the recording of earnings and/or obfuscation of liabilities, which ultimately led to their demise. It also led to highly visible prosecutions of their CEOs, CFOs, accounting firms, legal advisers, and other related parties. This destructive short- term focus by both management and investors has been correctly labeled impatient capitalism. This point of debate is also sometimes referred to as the firm’s investment horizon in reference to how long it takes the firm’s actions, its investments and operations, to result in earnings.
In contrast to impatient capitalism is patient capitalism, which focuses on long-term shareholder wealth maximization. Legendary investor Warren Buffett, through his invest- ment vehicle Berkshire Hathaway, represents one of the best of the patient capitalists. Buf- fett has become a billionaire by focusing his portfolio on mainstream firms that grow slowly but steadily with the economy such as Coca Cola. He was not lured into investing in the high growth but risky dot-coms of 2000 or the “high tech” sector that eventually imploded in 2001.
Stakeholder Capitalism Model In the non–Anglo-American markets, controlling shareholders also strive to maximize long- term returns to equity. However, they are more constrained by powerful other stakeholders. In particular, labor unions are more powerful than in the Anglo-American markets. Govern- ments interfere more in the marketplace to protect important stakeholder groups, such as local communities, the environment, and employment. Banks and other financial institutions are more important creditors than securities markets. This model has been labeled the stakeholder capitalism model (SCM).
Market Efficiency. The SCM model does not assume that equity markets are either efficient or inefficient. It does not really matter because the firm’s financial goals are not exclusively shareholder-oriented since they are constrained by the other stakeholders. In any case, the
1Michael Jensen and W. Meckling, “Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure,” Journal of Financial Economics, No. 3, 1976, and Michael C. Jensen, “Agency Cost of Free Cash Flow, Corporate Finance and Takeovers,” American Economic Review, 76, 1986, pp. 323–329.
32 CHAPTER 2 Corporate Ownership, Goals, and Governance
SCM model assumes that long-term “loyal” shareholders, typically controlling shareholders, should influence corporate strategy rather than the transient portfolio investor.
Risk. The SCM model assumes that total risk, that is, operating and financial risk, does count. It is a specific-corporate objective to generate growing earnings and dividends over the long run with as much certainty as possible, given the firm’s mission statement and goals. Risk is measured more by product market variability than by short-term variation in earnings and share price.
Single Versus Multiple Goals. Although the SCM model typically avoids a flaw of the SWM model, namely, impatient capital that is short-run oriented, it has its own flaw. Trying to meet the desires of multiple stakeholders leaves management without a clear signal about the trade- offs. Instead, management tries to influence the trade-offs through written and oral disclosures and complex compensation systems.
The Score Card. In contrast to the SCM model, the SWM model requires a single goal of value maximization with a well-defined score card. According to the theoretical model of SWM described by Michael Jensen, the objective of management is to maximize the total market value of the firm.2 This means that corporate leadership should be willing to spend or invest more money or capital if each additional dollar creates more than one dollar in the market value of the company’s equity, debt, or any other contingent claims on the firm.
Although both models have their strengths and weaknesses, in recent years two trends have led to an increasing focus on the shareholder wealth form. First, as more of the non– Anglo-American markets have increasingly privatized their industries, the shareholder wealth focus is seemingly needed to attract international capital from outside investors, many of whom are from other countries. Second, and still quite controversial, many analysts believe that shareholder-based MNEs are increasingly dominating their global industry segments. Nothing attracts followers like success.
Operational Goals It is one thing to say maximize value, but it is another to actually do it. The management objective of maximizing profit is not as simple as it sounds, because the measure of profit used by ownership/ management differs between the privately held firm and the publicly traded firm. In other words, is management attempting to maximize current income, capital appreciation, or both?
The return to a shareholder in a publicly traded firm combines current income in the form of dividends and capital gains from the appreciation of share price:
Shareholder return = P2 – P1 + D2
P2 – P1 P1
+ D2 P1
where the initial price, P1 is equivalent to the initial investment by the shareholder, P2 is the price of the share at the end of period, and D2 is the dividend paid at the end of the period. The shareholder theoretically receives income from both components. For example, over the past 50 or 60 years in the U.S. marketplace, a diversified investor may have received a total average annual return of 14%, split roughly between dividends, 2%, and capital gains, 12%.
Management generally believes it has the most direct influence over the first component— the dividend yield. Management makes strategic and operational decisions that grow sales and generate profits. Then it distributes those profits to ownership in the form of dividends. Capital
2Michael C. Jensen, “Value Maximization, Stakeholder Theory, and the Corporate Objective Function,” Journal of Applied Corporate Finance, Fall 2001, Volume 14, No. 3, pp. 8–21, p. 12.
33Corporate Ownership, Goals, and Governance CHAPTER 2
gains—the change in the share price as traded in the equity markets—is much more complex, and reflects many forces that are not in the direct control of management. Despite growing market share, profits, or any other traditional measure of business success, the market may not reward these actions directly with share price appreciation. Many top executives believe that stock markets move in mysterious ways and are not always consistent in their valuations. In the end, leadership in the publicly traded firm typically concludes that it is its own growth—growth in top-line sales and bottom-line profits—that is its great hope for driving share price upwards.
A privately held firm has a much simpler shareholder return objective function: maximize current and sustainable income. The privately held firm does not have a share price (it does have a value, but this is not a definitive market-determined value in the way in which we believe markets work). It therefore simply focuses on generating current income, dividend income, to generate the returns to its ownership. If the privately held ownership is a family, the family may also place a great emphasis on the ability to sustain those earnings over time while maintaining a slower rate of growth, which can be managed by the family itself. Without a share price, ‘growth’ is not of the same significance in strategic importance in the privately held firm. It is therefore critical that ownership and ownership’s specific financial interests be understood from the very start if we are to understand the strategic and financial goals and objectives of management. Exhibit 2.2 provides an overview of the variety of distinctive financial and managerial differences between publicly traded and privately held firms.
The privately held firm may also be less aggressive (take fewer risks) than the publicly traded firm. Without a public share price, and therefore the ability of outside investors to specu- late on the risks and returns associated with company business developments, the privately held firm—its owners and operators—may choose to take fewer risks. This may mean that it will not attempt to grow sales and profits as rapidly, and therefore may not require the capital (equity and debt) needed for rapid growth. One recent study by McKinsey found that private firms not only consistently used lower levels of financial leverage (averaging 5% less debt-to-equity) over the past decade, they also enjoyed a lower cost of debt (the average yield spread on corporate bonds being a full 32 basis points lower for family-owned firms).3
Operational Goals for MNEs. The MNE must be guided by operational goals suitable for vari- ous levels of the firm. Even if the firm’s goal is to maximize shareholder value, the manner in which investors value the firm is not always obvious to the firm’s top management. Therefore, most firms hope to receive a favorable investor response to the achievement of operational
3“The five attributes of enduring family businesses,” Christian Caspar, Ana Karina Dias, and Heinz-Peter Elstrodt, McKinsey Quarterly, January 2010, p. 6.
Limited in the past but increasingly available
Publicly Traded Privately HeldOrganizational Characteristic
Entrepreneurial No; stick to core competencies
Short-term focus on quarterly earnings
Yes; growth in earnings is critical
Good access to capital and capital markets
Professional; hiring from both inside & outside
Earnings to signal the equity markets
Minimal interests; some have stock options
Long-term or short-term focus
Focused on profitable growth
Quality of leadership
Role of Earnings (Profits)
Leadership are owners
Yes; do anything the owners wish
No; needs defined by owners earnings need
Highly variable; family run firms are lacking
Earnings to support owners and family
Yes; ownership and mgmt often one and the same
EXHIBIT 2.2 Public Versus Private Ownership
34 CHAPTER 2 Corporate Ownership, Goals, and Governance
goals that can be controlled by the way in which the firm performs, and then hope—if we can use that term—that the market will reward their results.
The MNE must determine the proper balance between three common operational finan- cial objectives:
1. Maximization of consolidated after-tax income 2. Minimization of the firm’s effective global tax burden 3. Correct positioning of the firm’s income, cash flows, and available funds as to country
These goals are frequently incompatible, in that the pursuit of one may result in a less desirable outcome of another. Management must make decisions about the proper trade-offs between goals (which is why managers are people and not computers).
Consolidated Profits. The primary operational goal of the MNE is to maximize consolidated profits, after-tax. Consolidated profits are the profits of all the individual units of the firm originating in many different currencies expressed in the currency of the parent company. This is not to say that management is not striving to maximize the present value of all future cash flows. It is simply the case that most of the day-to-day decision-making in global management is about current earnings. The leaders of the MNE, the management team who are implement- ing the firm’s strategy, must think far beyond current earnings.
For example, foreign subsidiaries have their own set of traditional financial statements: 1) a statement of income, summarizing the revenues and expenses experienced by the firm over the year; 2) a balance sheet, summarizing the assets employed in generating the unit’s revenues, and the financing of those assets; and 3) a statement of cash flows, summarizing those activities of the firm that generate and then use cash flows over the year. These finan- cial statements are expressed initially in the local currency of the unit for tax and reporting purposes to the local government, but they must be consolidated with the parent company’s financial statements for reporting to shareholders.
Public/Private Hybrids. The global business environment is, as one analyst termed it, “a messy place,” and the ownership of companies of all kinds, including MNEs, is not necessarily purely public or purely private. According to McKinsey’s recent study of global businesses:4
One-third of all companies in the S&P 500 index and 40 percent of the 250 largest com- panies in France and Germany are defined as family businesses, meaning that a family owns a significant share and can influence important decisions, particularly the election of the chairman and CEO.
In other words, the firm may be publicly traded, but a family still wields substantial power over the strategic and operational decisions of the firm. This may prove to be a good thing. As illustrated in Exhibit 2.3, the financial performance of family-based businesses (as measured by total returns to shareholders) in five different regions of the globe were superior to their nonfamily publicly traded counterparts.
Why do family-influenced businesses seemingly outperform the truly independents? The answer appears to be the same as that noted by Le Figaro in Global Finance in Practice 2.1. According to Credit Suisse, there are three key catalysts for the performance of stocks with significant family influence (SSFI): 1) management with a longer-term focus; 2) better
4“The five attributes of enduring family businesses,” Christian Caspar, Ana Karina Dias, and Heinz-Peter Elstrodt, McKinsey Quarterly, January 2010, p. 6.
35Corporate Ownership, Goals, and Governance CHAPTER 2
alignment between management and shareholder interests; and 3) stronger focus on the core business of the firm.
Publicly Traded Versus Privately Held: The Global Shift
Today, the public company is in trouble: the organisation that has been at the heart of capitalism for the past 150 years faces a loss of confidence in its Anglo-Saxon heartland and the rise of powerful challengers abroad. The number of companies listed on the major American stock exchanges has been declining relentlessly in recent years … America needs 360 new listings a year merely to maintain a steady state. But it has averaged only 170 a year since 2000—and even a Facebook-fueled IPO boom is not going to make up the difference.
—“Varied Company,” The World in 2012,The Economist, December 2011, p. 31.
Is the future of the publicly traded firm really in risk, or is it just that the U.S.-based publicly traded shares are on the decline? Exhibit 2.4 provides a broad overview of global equity list- ings, separating the number of listings between those on U.S. exchanges and all others.
Exhibit 2.4, based on listings data from the World Federation of Exchanges, raises a num- ber of questions about trends and tendencies across the global equity markets:
! Although global equity listings grew significantly over the past 20 years, they peaked in 2008. Although the true residual impact of the 2008–2009 global financial crisis is yet unknown, it is clear that the crisis, amid other factors, has stopped the growth of public share listings. At least for now.
10-year average total returns to shareholders by region
Source: Author presentation based on data presented in “The Five Attributes of Enduring Family Businesses,” Christian Caspar, Ana Karina Dias, and Heinz-Peter Elstrodt, McKinsey Quarterly, January 2010, p. 7. Index of public companies by region: France, SBF120; Western Europe, MSCI Europe; United States, S&P500; Germany, HDAX.
France Western Europe United States Germany
Family businesses Public company indexes
EXHIBIT 2.3 The Superior Performance of Family
36 CHAPTER 2 Corporate Ownership, Goals, and Governance
! The U.S. share of global equity listings has declined dramatically and steadily since the mid-1990s. At the end of 2010, of the 45,508 equities listed on 54 stock exchanges globally, U.S. listings comprised 5,016 of the total, or 11.0%. That was a dramatic decline from 1996, the peak year of total U.S. listings, when the U.S. comprised 8,783 of the global total of 26,368 listings, or 33.3%.
! U.S. public share listings fell by 3,767 (from 8,783 in 1996 to 5,016 in 2010), 42.9% over the 14-year period since its peak. Clearly, the attraction of being a publicly traded firm on a U.S. equity exchange had declined dramatically.
Listings Measurement New listings is the net change in equities listed on an exchange or exchanges. It is therefore the net result of exchange listing additions and delistings.
Listing Additions. Exchange listing additions arise from four sources: 1) initial public offerings (IPOs); 2) movements of share listings from one exchange to another; 3) spinouts from larger firms; and 4) new listings from smaller nonexchanges such as bulletin boards. Since movements between exchanges typically are a zero sum within a country, and spinouts and bulletin board movements are few in number, real growth in listings comes from IPOs.
Delistings. Delisted shares fall into three categories: 1) forced delistings, in which the equity no longer meets exchange requirements on share price or financial valuation; 2) mergers—in which two firms combine eliminating a listing; and 3) acquisitions, where the purchase results in the reduction of a listing. Companies entering into bankruptcy, or being major acquisition targets, make up a great proportion of delisting activity. Companies that are delisted are not necessarily bankrupt, and may continue trading over the counter.
U.S. listings peaked in 1996
Global Non-U.S. listings peaked in 2008
Global listings peaked in 2007
Source : Derived by author from statistics collected by the World Federation of Exchanges (WFE), www.world-exchanges.org.
EXHIBIT 2.4 The Superior Performance of Family
37Corporate Ownership, Goals, and Governance CHAPTER 2
Possible Causes in the Decline of Publicly Traded Shares The decline of share listings in the United States has led to considerable debate over whether these trends represent a fundamental global business shift away from the publicly traded corporate form, or something that is more U.S.-centric combined with the economic times.
The U.S. market itself may reflect a host of country specific factors. The cost and anti- competitive effects of Sarbanes-Oxley are now well documented and well known. Compli- ance with it and a variety of additional restrictions and requirements on public issuances in the United States have reduced the attractiveness of public listings. This, combined with the continued development and growth of the private equity markets, where companies may find other forms of equity capital without a public listing, are likely major contributors to the fall in U.S. listings over the last decade.
One recent study, which has garnered much attention, argued that it was not really the increasingly burdensome U.S. regulatory environment that was to blame, but rather a prolifera- tion of factors that caused the decline in market making, sales, and research support for small and medium-sized equities.5 Beginning with the introduction of online brokerage in 1996 and online trading rules in 1997, more and more equity trading in the United States shifted to ECNs, elec- tronic communication networks, which allowed all market participants to trade directly with the exchange order books, and not through brokers or brokerage houses. Although this increased competition reduced transaction costs dramatically, it also undermined the profitability of the retail brokerage institutions, which had always supported research, market making, and sales and promotion of the small- to medium-sized equities. Without this financial support, the smaller stocks were no longer covered (and possibly promoted) by the major equity houses. Without that research, marketing, promotion and coverage, their trading volumes and values fell.
Corporate Governance Although the governance structure of any company, domestic, international, or multinational, is fundamental to its very existence, this subject has become the lightning rod of political and business debate in the past few years as failures in governance in a variety of forms has led to corporate fraud and failure. Abuses and failures in corporate governance have dominated global business news in recent years. Beginning with the accounting fraud and questionable ethics of business conduct at Enron culminating in its bankruptcy in the fall of 2001, failures in corporate governance have raised issues about the very ethics and culture of business conduct.
The Goal of Corporate Governance The single overriding objective of corporate governance in the Anglo-American markets is the optimization over time of the returns to shareholders. In order to achieve this, good gov- ernance practices should focus the attention of the board of directors of the corporation on this objective by developing and implementing a strategy for the corporation, which ensures corporate growth and improvement in the value of the corporation’s equity.6 At the same time, it should ensure an effective relationship with stakeholders. A variety of organizations includ- ing the Organization for Economic Cooperation and Development (OECD) have continued to refine their recommendations about five primary areas of governance:
1. Shareholder rights. Shareholders are the owners of the firm, and their interests should take precedence over other stakeholders.
5“A Wake-Up Call for America,” by David Weild and Edward Kim, Grant Thornton, November 2009. 6This definition of the corporate objective is based on that supported by the International Corporate Governance Network (ICGN), a nonprofit organization committed to improving corporate governance practices globally.
38 CHAPTER 2 Corporate Ownership, Goals, and Governance
2. Board responsibilities. The board of the company is recognized as the individual entity with final full legal responsibility for the firm, including proper oversight of management.
3. Equitable treatment of shareholders. Equitable treatment is specifically targeted toward domestic versus foreign residents as shareholders, as well as majority and minority interests.
4. Stakeholder rights. Governance practices should formally acknowledge the interests of other stakeholders—employees, creditors, community, and government.
5. Transparency and disclosure. Public and equitable reporting of firm operating and financial results and parameters should be done in a timely manner, and available to all interests equitably.
These principles obviously focus on several key areas—shareholder rights and roles, disclosure and transparency, and the responsibilities of boards—which we will discuss in more detail.
The Structure of Corporate Governance Our first challenge is to understand what people mean when they use the expression “cor- porate governance.” Exhibit 2.5 provides an overview of the various parties and their responsibilities associated with the governance of the modern corporation. The modern corporation’s actions and behaviors are directed and controlled by both internal forces and external forces.
The internal forces, the officers of the corporation (such as the chief executive officer or CEO) and the board of directors of the corporation (including the chairman of the board), are
Equity Markets Analysts and other market agents
evaluate the performance of the firm on a daily basis
Board of Directors Chairman of the Board and members are accountable
for the organization
Management Chief Executive Officer (CEO) and his team run
Debt Markets Ratings agencies and other analysts review the ability of
the firm to service debt
Auditors and Legal Advisers Provide an external opinion
as to the legality and fairness of presentation and conformity to
standards of financial statements
Regulators SEC, the NYSE, or other
regulatory bodies by country
The Corporation (internal)
The Marketplace (external)
Corporate governance represents the relationship among stakeholders that is used to determine and control the strategic direction and performance of the organization.
EXHIBIT 2.5 The Structure of Corporate Governance
39Corporate Ownership, Goals, and Governance CHAPTER 2
those directly responsible for determining both the strategic direction and the execution of the company’s future. But they are not acting within a vacuum; they are subject to the constant prying eyes of the external forces in the marketplace who question the validity and soundness of their decisions and performance. These include the equity markets in which the shares are traded, the analysts who critique their investment prospects, the creditors and credit agencies who lend them money, the auditors and legal advisers who testify to the fairness and legality of their reporting, and the multitude of regulators who oversee their actions in order to protect the investment public.
The Board of Directors. The legal body that is accountable for the governance of the corporation is its board of directors. The board is composed of both employees of the organization (inside members) and senior and influential nonemployees (outside members). Areas of debate surrounding boards include the following: 1) the proper balance between inside and outside members; 2) the means by which board members are compensated for their service; and 3) the actual ability of a board to monitor and manage a corporation adequately when board members are spending sometimes less than five days a year in board activities. Outside members, often the current or retired chief executives of other major companies, may bring with them a healthy sense of distance and impartiality, which although refreshing, may also result in limited understanding of the true issues and events within the company.
Officers and Management. The senior officers of the corporation, the chief executive officer (CEO), the chief financial officer (CFO), and the chief operating officer (COO), are not only the most knowledgeable of the business, but also the creators and directors of its strategic and operational direction. The management of the firm is, according to theory, acting as a contractor—as an agent—of shareholders to pursue value creation. They are positively motivated by salary, bonuses, and stock options or negatively motivated by the risk of losing their jobs. They may, however, have biases of self-enrichment or personal agendas, which the board and other corporate stakeholders are responsible for overseeing and policing. Interestingly, in more than 80% of the companies in the Fortune 500, the CEO is also the chairman of the board. This is, in the opinion of many, a conflict of interest and not in the best interests of the company and its shareholders.
Equity Markets. The publicly traded company, regardless of country of residence, is highly susceptible to the changing opinion of the marketplace. The equity markets themselves, whether they are the New York Stock Exchange/Euronext, London Stock Exchange, or Mexico City Bolsa, should reflect the market’s constant evaluation of the promise and performance of the individual company. The analysts are those self-described experts employed by the many investment banking firms who also trade in the client company shares. They are expected (sometimes naïvely) to evaluate the strategies, plans for execution of the strategies, and financial performance of the firms on a real-time basis. Analysts depend on the financial statements and other public disclosures of the firm for their information.
Debt Markets. Although the debt markets (banks and other financial institutions providing loans and various forms of securitized debt like corporate bonds), are not specifically interested in building shareholder value, they are indeed interested in the financial health of the company. Their interest, specifically, is in the company’s ability to repay its debt in a timely manner. Like equity markets, they must rely on the financial statements and other disclosures (public and private in this case) of the companies with which they work.
Auditors and Legal Advisers. Auditors and legal advisers are responsible for providing an external professional opinion as to the fairness, legality, and accuracy of corporate financial statements. In this process, they attempt to determine whether the firm’s financial records and
40 CHAPTER 2 Corporate Ownership, Goals, and Governance
practices follow what in the United States is termed generally accepted accounting principles (GAAP) in regard to accounting procedures. But auditors and legal advisers are hired by the firms they are auditing, leading to a rather unique practice of policing their employers. The additional difficulty that has arisen in recent years is that the major accounting firms pursued the development of large consulting practices, often leading to a conflict of interest. An auditor not giving a clean bill of health to a client could not expect to gain many lucrative consulting contracts from that same firm in the near future.
Regulators. Publicly traded firms in the United States and elsewhere are subject to the regulatory oversight of both governmental organizations and nongovernmental organizations. In the United States, the Securities and Exchange Commission (SEC) is a careful watchdog of the publicly traded equity markets, both of the behavior of the companies themselves in those markets and of the various investors participating in those markets. The SEC and other similar authorities outside of the United States require a regular and orderly disclosure process of corporate performance in order that all investors may evaluate the company’s investment value with adequate, accurate, and fairly distributed information. This regulatory oversight is often focused on when and what information is released by the company, and to whom.
A publicly traded firm in the United States is also subject to the rules and regulations of the exchange upon which they are traded (New York Stock Exchange/Euronext, American Stock Exchange, and NASDAQ are the largest). These organizations, typically categorized as self-regulatory in nature, construct and enforce standards of conduct for both their member companies and themselves in the conduct of share trading.
Comparative 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 their significance.7 This assures that corporate governance practices will differ across countries, economies, and cultures. As described in Exhibit 2.6, though, the various corporate governance regimes may be classified by regime. The regimes in turn reflect the evolution of business ownership and direction within the countries over time.
7For a summary of comparative corporate governance, see R. La Porta, F. Lopez-de-Silanes, and A. Schleifer, “Corporate Ownership Around the World,” Journal of Finance, 54, 1999, pp. 471–517. See also A. Schleifer and R. Vishny, “A Survey of Corporate Governance,” Journal of Finance, 52, 1997, pp. 737–783, and the winter 2007 issue, Volume 19 Number 1, of the Journal of Applied Corporate Finance.
Regime Basis Characteristics Examples
Market-based Efficient equity markets; Dispersed ownership
United States, United Kingdom, Canada, Australia
Family-based Management and ownership is combined; Family/majority and minority shareholders
Hong Kong, Indonesia, Malaysia, Singapore, Taiwan, France
Bank-based Government influence in bank lending; Lack of transparency; Family control
Government-affiliated State ownership of enterprise; Lack of transparency; No minority influence
Source: Based on “Corporate Governance in Emerging Markets: An Asian Perspective,” by J. Tsui and T. Shieh, in International Finance and Accounting Handbook, Third Edition, Frederick D.S. Choi, editor, Wiley, 2004, pp. 24.4–24.6.
EXHIBIT 2.6 Comparative Corporate Governance Regimes
41Corporate Ownership, Goals, and Governance CHAPTER 2
Market-based regimes, like that of the United States, Canada, and the United Kingdom, are characterized by relatively efficient capital markets in which the ownership of publicly traded companies is widely dispersed. Family-based systems, like those characterized in many of the emerging markets, Asian markets, and Latin American markets, not only started with strong concentrations of family ownership (as opposed to partnerships or small investment groups which are not family-based), but also have continued to be largely controlled by f amilies even after going public. Bank-based and government-based regimes are those reflecting markets in which government ownership of property and industry has been the constant force over time, resulting in only marginal “public ownership” of enterprise, and even then, subject to significant restrictions on business practices.
These regimes are therefore a function of at least four major factors in the evolution of corporate governance principles and practices globally: 1) the financial market development; 2) the degree of separation between management and ownership; 3) the concept of disclosure and transparency; and 4) the historical development of the legal system.
Financial Market Development. The depth and breadth of capital markets is critical to the evolution of corporate governance practices. Country markets that have had relatively slow growth, as in the emerging markets, or have industrialized rapidly utilizing neighboring capital markets (for example, Western Europe), may not form large public equity market systems. Without significant public trading of ownership shares, high concentrations of ownership are preserved and few disciplined processes of governance are developed.
Separation of Management and Ownership. In countries and cultures in which the ownership of the firm has continued to be an integral part of management, agency issues and failures have been less problematic. In countries like the United States, in which ownership has become largely separated from management (and widely dispersed), aligning the goals of management and ownership is much more difficult.
Disclosure and Transparency. The extent of disclosure regarding the operations and financial results of a company vary dramatically across countries. Disclosure practices reflect a wide range of cultural and social forces, including the degree to which ownership is public, the degree to which government feels the need to protect investor’s rights versus owner- ship rights, and the extent to which family-based and government-based business remains central to the culture. Transparency, a parallel concept to disclosure, reflects the visibility of decision-making processes within the business organization.
Historical Development of the Legal System. Investor protection is typically better in countries in which English common law is the basis of the legal system, compared to the codified civil law that is typical in France and Germany (the so-called Code Napoleon). English common law is typically the basis of the legal systems in the United Kingdom and former colonies of the United Kingdom, including the United States and Canada. The Code Napoleon is typically the basis of the legal systems in former French colonies and the European countries that Napoleon once ruled, such as Belgium, Spain, and Italy. In countries with weak investor protection, controlling shareholder ownership is often a substitute for a lack of legal protection.
Note that we have not mentioned ethics. All of the principles and practices described so far have assumed that the individuals in roles of responsibility and leadership pursue them truly and fairly. That, however, has not always been the case.
Family Ownership and Corporate Governance Although much of the discussion about corporate governance concentrates on the market- based regimes (see Exhibit 2.6), family-based regimes are arguably more common and more
42 CHAPTER 2 Corporate Ownership, Goals, and Governance
important worldwide, including the United States and Western Europe. For example, in a study of 5,232 corporations in 13 Western European countries, family-controlled firms represented 44% of the sample compared to 37% that were widely held.8
Recent research indicates that, as opposed to popular belief, family-owned firms in some highly developed economies typically outperform publicly owned firms. This is true not only in Western Europe but also in the United States. A recent study of firms included in the S&P500 found that families are present in fully one-third of the S&P500 and account for 18% of their outstanding equity. (An added insight is that firms possessing a CEO from the family also perform better than those with outside CEOs.) Interestingly, it seems that minority shareholders are actually better off, according to this study, when a member of the dominant family influences the firm’s direction.9
Another study based on 120 Norwegian, founding family-controlled and nonfounding family-controlled firms, concluded that founding family control was associated with higher firm value. Furthermore, the impact of founding family directors on firm value is not affected by corporate governance conditions such as firm age, board independence, and number of share classes. The authors also found that the positive relation between founding family ownership and firm value is greater among older firms, firms with larger boards, and particularly when these firms have multiple classes of stock.10 It is common for Norwegian firms (and firms based in many European and Latin American countries) to have dual classes of stock with differential voting rights.
Failures in Corporate Governance Failures in corporate governance have become increasingly visible in recent years. The Enron scandal in the United States is well known. In addition to Enron, other firms that have revealed major accounting and disclosure failures, as well as executive looting, are WorldCom, Parmalat, Global Crossing, Tyco, Adelphia, and HealthSouth.
In each case, prestigious auditing firms, such as Arthur Andersen, missed the violations or minimized them possibly because of lucrative consulting relationships or other conflicts of interest. Moreover, security analysts and banks urged investors to buy the shares and debt issues of these and other firms that they knew to be highly risky or even close to bankruptcy. Even more egregious, most of the top executives who were responsible for the mismanagement that destroyed their firms, walked away (initially) with huge gains on shares sold before the downfall, and even overly generous severance packages.
It appears that the day of reckoning has come. The first to fall (due to its involvement with Enron) was Arthur Andersen, one of the former “Big Five” U.S. accounting firms. However, many more legal actions against former executives are underway. Although the corruption scandals were first revealed in the United States, they have spread to Canada and the European Union countries.
8Mara Faccio and Larry H.P. Lang, “The Ultimate Ownership of Western European Corporations,” Journal of Financial Economics, 65 (2002), p. 365. See also: Torben Pedersen and Steen Thomsen, “European Pat- terns of Corporate Ownership,” Journal of International Business Studies, Vol. 28, No. 4, Fourth Quarter, 1997, pp. 759–778. 9Ronald C. Anderson and David M. Reeb, “Founding Family Ownership and Firm Performance from the S&P500,” The Journal of Finance, June 2003, p. 1301. 10Chandra S. Mishra, Trond Randøy, and Jan Inge Jenssen, “The Effect of Founding Family Influence on Firm Value and Corporate Governance,” Journal of International Financial Management and Accounting, Volume 12, Number 3, Autumn 2001, pp. 235–259.
43Corporate Ownership, Goals, and Governance CHAPTER 2
Good Governance and Corporate Reputation Does good corporate governance matter? This is actually a difficult question, and the realistic answer has been largely dependent on outcomes historically. For example, as long as Enron’s share price continued to rise, questions over transparency, accounting propriety, and even financial facts were largely overlooked by all of the stakeholders of the corporation. Yet, eventually, the fraud, deceit, and failure of the multitude of corporate governance practices resulted in the bankruptcy of the firm. It not only destroyed the wealth of investors, but the careers, incomes, and savings of so many of its basic stakeholders—its own employees. Ultimately, good governance should matter.
One way in which companies may signal good governance to the investor markets is to adopt and publicize a fundamental set of governance policies and practices. Nearly all publicly traded firms have adopted this approach, as is obvious when visiting their corporate Web sites. This has also led to a standardized set of common principles, as described in Exhibit 2.7, which might be considered a growing consensus on good governance practices. Those practices—board composition, management compensation structure and oversight, corporate auditing practices, and public disclosure—have been accepted by a growing stakeholder audience.
Good corporate governance depends on a variety of factors, one of which is the general governance reputation of the country of incorporation and registration. As concern over the quality of corporate governance rose in the years following Enron and other failures, a number of governance ranking services and indexes developed. These services, including ISS/RiskMet- rics, Audit Integrity, Governance Metrics International (GMI), and The Corporate Library (TCL), to name but a few, use a multitude of quantitative and nonquantitative disclosures by publicly traded firms to rank firms on their corporate governance. Exhibit 2.8 presents selected recent rankings by another such firm, IR Global.
In principle, the idea is that good governance (at both the country and corporate levels) is linked to cost of capital (lower), returns to shareholders (higher), and corporate profitability (higher). An added dimension of interest is the role of country governance as it may influence
EXHIBIT 2.7 The Growing Consensus on Good Corporate Governance
Although there are many different cultural and legal approaches used to corporate governance worldwide, there is a growing consensus on what constitutes good corporate governance.
! Composition of the Board of Directors. The Board should have both internal and external members. More importantly, it should be staffed by individuals of real experience and knowledge, not only of their own rules and responsibilities, but also of the nature and conduct of the corporate business.
! Management Compensation. There should be a management compensation system aligned with corporate performance (financial and otherwise), with significant oversight by the board and open disclosure to shareholders and investors.
! Corporate Auditing. There should be independent auditing of corporate financial results on a meaningful real-time basis. An audit process with oversight by a Board committee composed primarily of external members would be an additional significant plus.
! Public Reporting and Disclosure. Timely public reporting of both financial and nonfinancial operating results may be used by investors to assess the investment outlook.
This should also include transparency and reporting around potentially significant liabilities. A final international note of caution: The quality and credibility of all internal corporate practices on good governance, however, are still subject to the quality of a country’s corporate law, its protection of both creditor and investor rights, including minority shareholders, and the country’s ability to provide adequate and appropriate enforcement.
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EXHIBIT 2.8 IR Global Rankings: The Top 30
Company Country Industry Score Company Country Industry Score
Danske Bank Denmark Financials 92.50 PHILIPS Netherlands Industrials 80.00
América Latina Logística
Brazil Industrials 91.75 Cameco Canada Basic Materials 79.75
BASF Germany Basic Materials 89.75 Grupo Pão de Açúcar
Brazil Consumer Services
Homex Mexico Consumer Services 89.50 Cielo Brazil Technology 79.50
Bayer AG Germany Health Care 87.25 JSL S.A. Brazil Industrials 79.50
GOL Linhas Aéreas Inteligentes
Brazil Consumer Services 87.25 Microsoft USA Technology 79.50
ThyssenKrupp Germany Basic Materials 85.50 SulAmérica S.A. Brazil Financials 79.40
Marfrig Brazil Consumer Goods 85.00 Land Securities UK Financials 79.25
TURK TELEKOM Turkey Telecommunications 83.75 METRO GROUP USA Consumer Services
Life Technologies USA Health Care 82.00 Rossi Residencial Brazil Industrials 78.75
PotashCorp Canada Basic Materials 81.75 Petrobras Brazil Oil & Gas 78.25
Royal DSM N.V. Netherlands Basic Materials 81.25 Energisa Brazil Utilities 78.00
adidas AG Germany Consumer Goods 80.50 Infosys Technologies
India Technology 77.75