Business Analytics

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YO19_Excel_Ch01_Assessment_TCO_Instructions.docx

Grader – Instructions Excel 2019 Project

YO19_Excel_Ch01_Assessment_TCO

 

Project Description:

Most people own, or will at some time own, an automobile. Few actually take the time to calculate what owning an automobile actually costs, in other words the total cost of ownership. This is an important calculation for both individuals and for businesses. In this project, you will complete the development of an automobile total cost of ownership worksheet for your supervisor, Jan Bassy, CFO at your place of employment.

 

Steps to Perform:

Step Instructions Points Possible
1 Start Excel. Download and open the file named Excel_Ch01_Assessment_TCO.xlsx. Grader has automatically added your last name to the beginning of the filename. Save the file to the location where you are storing your files. 0
2 Rename Sheet1 Documentation and then rename Sheet2 AutoTCO 1.6
3 To ensure there are no blank worksheets in the workbook, delete the Sheet3 worksheet. 0.8
4 In the AutoTCO worksheet, enter the values as shown below into the specified cells: Data Item Cell Value Miles Driven / year E4 15000 Fuel Cost / Gallon E5 3.15 MPG E6 29 1.8
5 To create a worksheet title, merge and center the worksheet heading across cell range A1:F1. 2
6 To save yourself time, copy and paste data to other cells within a worksheet or workbook. Select cell range C16:C22, and then copy the selected range to the Clipboard. Paste the copied range to cell range D16:F16. Note, you are copying and pasting the formulas in cell range C16:C22. 2
7 Select cell range B15:C15. Using the fill handle, copy the range through cell F15. 2
8 Insert a row above row 15 to allow space to add a descriptive title to the section. 2
9 In cell B15, type 5-year Total Cost of Ownership Analysis Apply Center Across Selection to cell range B15:F15. 1.6
10 In cell D6, insert the note Miles per gallon 1
11 Headers and footers can add more information to a worksheet. Add the File Name code in the left footer of both the AutoTCO and Documentation worksheets. 1.2
12 In the Documentation worksheet, enter the values as shown below into the specified cells: C8 Completed Ms. Bassy’s Automobile Total Cost of Ownership worksheet B20 AutoTCO 0.8
13 At times text in a cell can be longer than the width of the cell. Wrapping the text in a cell will allow the text to stack within the cell. In cell C8 of the Documentation worksheet, apply Wrap Text. 0.4
14 Changing the widths of columns can enhance the look of a worksheet. On the AutoTCO worksheet, change the width of Column A to 20 Change the width of Columns B:F to 12. 0.8
15 Documentation worksheets are usually the last (right) sheet of a workbook. Move the AutoTCO worksheet to the left of the Documentation worksheet to make the Documentation worksheet the last worksheet in the workbook. 0.6
16 Prepare the worksheets for printing by changing the orientation of the AutoTCO worksheet to Landscape Orientation. For the Documentation worksheet, set the orientation to Landscape Orientation. On the Documentation worksheet, set the page scaling to Fit All Columns on One Page. 1.4
17 Save and close the Excel_Ch01_Assessment_TCO workbook. Exit Excel. Submit the file as directed. 0
Total Points 20

 

Created On: 05/16/2020 1 YO19_Excel_CH01_Assessment – TCO 1.0

McDonald_Excel_Ch01_Assessment_TCO.xlsx

Sheet1

Kallio Auto Sales
Create Date By Whom Description Workbook Name
5/18/22 Jan Bassy Automobile TCO Analysis Excel_Ch01_Assessment_TCO.xlsx
Mod. Date By Whom Mod. Description Last Version Backup Name
Author: VERSION BACKUP NAME : Before modifying any worksheet, save the original workbook with the following name format: Original name_yyyymmdd
Create Date Sheet Name Creator Purpose
5/18/22 Sheet2 Jan Bassy 5-year TCO for an automobile

Sheet2

Automobile Total Cost of Ownership Calculator
Model: Impala LT
Purchase Price: $ 31,115 Miles Driven / year:
% Down Payment: 10% Fuel Cost / Gallon:
Annual Interest Rate: 4.75% MPG:
Loan Term (months): 60 Oil Change Miles: 5,000
5-year Residual Value: 50% Oil Change Cost: $ 35
License Cost: $ 125 Purchase Tax Rate: 5%
Ins. Increase / Year 2% Paperwork Fees: $ 150
Year 1 2 3 4 5
Depreciation Rate: 35% 20% 17% 15% 13%
Maintenance: 0% 0% 0% 3% 4%
Year 1 Year 2
Depreciation: $5,445.13 $3,111.50
Financing: $1,220.46 $973.71
Taxes & Fees: $1,675.18 $125.00
Fuel: ERROR:#DIV/0! ERROR:#DIV/0!
Insurance: $1,200.00 $1,224.00
Maintenance: $0.00 $0.00
TOTAL COST: ERROR:#DIV/0! ERROR:#DIV/0!

Sheet3

Analysis for Financial Management

/in /by

Robert C. Higgins

Analysis for Financial Management E l e v en t h Ed i t i o n

 

 

Analysis for Financial Management

 

 

The McGraw-Hill/Irwin Series in Finance, Insurance, and Real Estate

Stephen A. Ross Franco Modigliani Professor of Finance and Economics Sloan School of Management Massachusetts Institute of Technology Consulting Editor

FINANCIAL MANAGEMENT Block, Hirt, and Danielsen Foundations of Financial Management Fifteenth Edition Brealey, Myers, and Allen Principles of Corporate Finance Eleventh Edition Brealey, Myers, and Allen Principles of Corporate Finance, Concise Second Edition Brealey, Myers, and Marcus Fundamentals of Corporate Finance Eighth Edition Brooks FinGame Online 5.0 Bruner Case Studies in Finance: Managing for Corporate Value Creation Seventh Edition Cornett, Adair, and Nofsinger Finance: Applications and Theory Third Edition Cornett, Adair, and Nofsinger M: Finance Third Edition DeMello Cases in Finance Second Edition Grinblatt (editor) Stephen A. Ross, Mentor: Influence through Generations Grinblatt and Titman Financial Markets and Corporate Strategy Second Edition Higgins Analysis for Financial Management Eleventh Edition Kellison Theory of Interest Third Edition

Ross, Westerfield, and Jaffe Corporate Finance Tenth Edition Ross, Westerfield, Jaffe, and Jordan Corporate Finance: Core Principles and Applications Fourth Edition Ross, Westerfield, and Jordan Essentials of Corporate Finance Eighth Edition Ross, Westerfield, and Jordan Fundamentals of Corporate Finance Eleventh Edition Shefrin Behavioral Corporate Finance: Decisions That Create Value First Edition White Financial Analysis with an Electronic Calculator Sixth Edition

INVESTMENTS Bodie, Kane, and Marcus Essentials of Investments Ninth Edition Bodie, Kane, and Marcus Investments Tenth Edition Hirt and Block Fundamentals of Investment Management Tenth Edition Jordan, Miller, and Dolvin Fundamentals of Investments: Valuation and Management Seventh Edition Stewart, Piros, and Heisler Running Money: Professional Portfolio Management First Edition Sundaram and Das Derivatives: Principles and Practice Second Edition

FINANCIAL INSTITUTIONS AND MARKETS Rose and Hudgins Bank Management and Financial Services Ninth Edition

Rose and Marquis Financial Institutions and Markets Eleventh Edition Saunders and Cornett Financial Institutions Management: A Risk Management Approach Eighth Edition Saunders and Cornett Financial Markets and Institutions Sixth Edition

INTERNATIONAL FINANCE Eun and Resnick International Financial Management Seventh Edition

REAL ESTATE Brueggeman and Fisher Real Estate Finance and Investments Fourteenth Edition Ling and Archer Real Estate Principles: A Value Approach Fourth Edition

FINANCIAL PLANNING AND INSURANCE Allen, Melone, Rosenbloom, and Mahoney Retirement Plans: 401(k)s, IRAs, and Other Deferred Compensation Approaches Eleventh Edition Altfest Personal Financial Planning First Edition Harrington and Niehaus Risk Management and Insurance Second Edition Kapoor, Dlabay, and Hughes Focus on Personal Finance: An Active Approach to Help You Achieve Financial Literacy Fifth Edition Kapoor, Dlabay, and Hughes Personal Finance Eleventh Edition Walker and Walker Personal Finance: Building Your Future First Edition

 

 

Analysis for Financial Management

Eleventh Edition

ROBERT C. HIGGINS Marguerite Reimers

Emeritus Professor of Finance The University of Washington

with

JENNIFER L. KOSKI John B. and Delores L. Fery

Faculty Fellow Associate Professor of Finance The University of Washington

and

TODD MITTON Ned C. Hill Professor of Finance Brigham Young University

 

 

ANALYSIS FOR FINANCIAL MANAGEMENT, ELEVENTH EDITION

Published by McGraw-Hill Education, 2 Penn Plaza, New York, NY 10121. Copyright © 2016 by McGraw-Hill Education. All rights reserved. Printed in the United States of America. Previous editions © 2012, 2009, and 2007. No part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written consent of McGraw-Hill Education, including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance learning.

Some ancillaries, including electronic and print components, may not be available to customers outside the United States.

This book is printed on acid-free paper.

1 2 3 4 5 6 7 8 9 0 DOC/DOC 1 0 9 8 7 6 5

ISBN 978–0–07–786178–0 MHID 0–07–786178–7

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All credits appearing on page or at the end of the book are considered to be an extension of the copyright page.

Library of Congress Cataloging-in-Publication Data

Higgins, Robert C. Analysis for financial management/Robert C. Higgins ; with Jennifer Koski and Todd Mitton.—

Eleventh edition. pages cm.—(The McGraw-Hill/Irwin series in finance, insurance, and real estate)

ISBN 978-0-07-786178-0 (alk. paper) 1. Corporations–Finance. I. Title. HG4026.H496 2016 658.15’1—dc23

2014040006

The Internet addresses listed in the text were accurate at the time of publication. The inclusion of a website does not indicate an endorsement by the authors or McGraw-Hill Education, and McGraw- Hill Education does not guarantee the accuracy of the information presented at these sites.

 

 

In memory of my son

STEVEN HIGGINS

1970–2007

 

 

vi

Preface xi

PART ONE Assessing the Financial Health of the Firm 1

1 Interpreting Financial Statements 3

2 Evaluating Financial Performance 39

PART TWO Planning Future Financial Performance 79

3 Financial Forecasting 81 4 Managing Growth 115

PART THREE Financing Operations 141

5 Financial Instruments and Markets 143

6 The Financing Decision 195

PART FOUR Evaluating Investment Opportunities 237

7 Discounted Cash Flow Techniques 239

8 Risk Analysis in Investment Decisions 289

9 Business Valuation and Corporate Restructuring 343

GLOSSARY 393 SUGGESTED ANSWERS TO

ODD-NUMBERED PROBLEMS 405 INDEX 437

Brief Contents

 

 

Preface xi

PART ONE ASSESSING THE FINANCIAL HEALTH OF THE FIRM 1

Chapter 1 Interpreting Financial Statements 3 The Cash Flow Cycle 3 The Balance Sheet 6

Current Assets and Liabilities 11 Shareholders’ Equity 12

The Income Statement 12 Measuring Earnings 12

Sources and Uses Statements 17 The Two-Finger Approach 18

The Cash Flow Statement 19 Financial Statements and the

Value Problem 24 Market Value vs. Book Value 24 Economic Income vs. Accounting Income 27 Imputed Costs 28

Summary 31 Additional Resources 32 Problems 33

Chapter 2 Evaluating Financial Performance 39 The Levers of Financial Performance 39 Return on Equity 40

The Three Determinants of ROE 40 The Profit Margin 42 Asset Turnover 44 Financial Leverage 49

Is ROE a Reliable Financial Yardstick? 55 The Timing Problem 56 The Risk Problem 56

The Value Problem 58 ROE or Market Price? 59

Ratio Analysis 62 Using Ratios Effectively 62 Ratio Analysis of Stryker Corporation 63

Summary 71 Additional Resources 72 Problems 73

PART TWO PLANNING FUTURE FINANCIAL PERFORMANCE 79

Chapter 3 Financial Forecasting 81 Pro Forma Statements 81

Percent-of-Sales Forecasting 82 Interest Expense 88 Seasonality 89

Pro Forma Statements and Financial Planning 89

Computer-Based Forecasting 90 Coping with Uncertainty 94

Sensitivity Analysis 94 Scenario Analysis 95 Simulation 96

Cash Flow Forecasts 98 Cash Budgets 99 The Techniques Compared 102 Planning in Large Companies 103 Summary 105 Additional Resources 106 Problems 108

Chapter 4 Managing Growth 115 Sustainable Growth 116

The Sustainable Growth Equation 116 vii

Contents

 

 

viii Contents

Too Much Growth 119 Balanced Growth 119 Under Armour’s Sustainable Growth Rate 121 “What If” Questions 122

What to Do When Actual Growth Exceeds Sustainable Growth 122

Sell New Equity 123 Increase Leverage 125 Reduce the Payout Ratio 125 Profitable Pruning 126 Outsourcing 127 Pricing 127 Is Merger the Answer? 127

Too Little Growth 128 What to Do When Sustainable Growth

Exceeds Actual Growth 129 Ignore the Problem 130 Return the Money to Shareholders 130 Buy Growth 131

Sustainable Growth and Pro Forma Forecasts 132

New Equity Financing 132 Why Don’t U.S. Corporations Issue More

Equity? 135 Summary 136 Additional Resources 137 Problems 138

PART THREE FINANCING OPERATIONS 141

Chapter 5 Financial Instruments and Markets 143 Financial Instruments 144

Bonds 145 Common Stock 152 Preferred Stock 156

Financial Markets 158 Venture Capital Financing 158 Private Equity 160 Initial Public Offerings 162

Seasoned Issues 163 Issue Costs 168

Efficient Markets 169 What Is an Efficient Market? 170 Implications of Efficiency 172

Appendix Using Financial Instruments to Manage Risks 174

Forward Markets 175 Speculating in Forward Markets 176 Hedging in Forward Markets 177 Hedging in Money and Capital Markets 180 Hedging with Options 180 Limitations of Financial Market Hedging 183 Valuing Options 185

Summary 188 Additional Resources 189 Problems 191

Chapter 6 The Financing Decision 195 Financial Leverage 197 Measuring the Effects of Leverage on a

Business 201 Leverage and Risk 203 Leverage and Earnings 206

How Much to Borrow 208 Irrelevance 208 Tax Benefits 210 Distress Costs 211 Flexibility 215 Market Signaling 217 Management Incentives 220 The Financing Decision and Growth 221

Selecting a Maturity Structure 224 Inflation and Financing Strategy 225

Appendix The Irrelevance Proposition 225

No Taxes 226 Taxes 228

Summary 230 Additional Resources 231 Problems 232

 

 

Contents ix

PART FOUR EVALUATING INVESTMENT OPPORTUNITIES 237

Chapter 7 Discounted Cash Flow Techniques 239 Figures of Merit 240

The Payback Period and the Accounting Rate of Return 241

The Time Value of Money 242 Equivalence 247 The Net Present Value 248 The Benefit-Cost Ratio 250 The Internal Rate of Return 250 Uneven Cash Flows 254 A Few Applications and Extensions 255 Mutually Exclusive Alternatives and Capital

Rationing 259 The IRR in Perspective 260

Determining the Relevant Cash Flows 260

Depreciation 262 Working Capital and Spontaneous

Sources 264 Sunk Costs 265 Allocated Costs 266 Cannibalization 267 Excess Capacity 268 Financing Costs 270

Appendix Mutually Exclusive Alternatives and

Capital Rationing 272 What Happened to the Other

$578,000? 273 Unequal Lives 274 Capital Rationing 277 The Problem of Future Opportunities 278 A Decision Tree 279

Summary 280 Additional Resources 281 Problems 282

Chapter 8 Risk Analysis in Investment Decisions 289 Risk Defined 291

Risk and Diversification 293 Estimating Investment Risk 295

Three Techniques for Estimating Investment Risk 296

Including Risk in Investment Evaluation 297 Risk-Adjusted Discount Rates 297

The Cost of Capital 298 The Cost of Capital Defined 299 Cost of Capital for Stryker Corporation 301 The Cost of Capital in Investment Appraisal 308 Multiple Hurdle Rates 309

Four Pitfalls in the Use of Discounted Cash Flow Techniques 311

The Enterprise Perspective versus the Equity Perspective 312

Inflation 314 Real Options 315 Excessive Risk Adjustment 321

Economic Value Added 322 EVA and Investment Analysis 323 EVA’s Appeal 325

A Cautionary Note 326 Appendix Asset Beta and Adjusted Present

Value 326 Beta and Financial Leverage 327 Using Asset Beta to Estimate Equity

Beta 328 Asset Beta and Adjusted Present Value 329

Summary 332 Additional Resources 333 Problems 335

Chapter 9 Business Valuation and Corporate Restructuring 343 Valuing a Business 345

Assets or Equity? 346

 

 

x Contents

Dead or Alive? 346 Minority Interest or Control? 348

Discounted Cash Flow Valuation 349 Free Cash Flow 350 The Terminal Value 351 A Numerical Example 354 Problems with Present Value Approaches to

Valuation 357 Valuation Based on Comparable Trades 357

Lack of Marketability 361 The Market for Control 362

The Premium for Control 362 Financial Reasons for Restructuring 364

The Empirical Evidence 372 The Cadbury Buyout 374 Appendix The Venture Capital Method of

Valuation 376 The Venture Capital Method—One

Financing Round 377

The Venture Capital Method—Multiple Financing Rounds 380

Why Do Venture Capitalists Demand Such High Returns? 382

Summary 384 Additional Resources 385 Problems 386

Glossary 393 Suggested Answers to

Odd-Numbered Problems 405 Index 437

 

 

xi

Preface

Like its predecessors, the eleventh edition of Analysis for Financial Man- agement is for nonfinancial executives and business students interested in the practice of financial management. It introduces standard techniques and recent advances in a practical, intuitive way. The book assumes no prior background beyond a rudimentary, and perhaps rusty, familiarity with financial statements—although a healthy curiosity about what makes business tick is also useful. Emphasis throughout is on the managerial im- plications of financial analysis.

Analysis for Financial Management should prove valuable to individuals interested in sharpening their managerial skills and to executive program participants. The book has also found a home in university classrooms as the sole text in Executive MBA and applied finance courses, as a compan- ion text in case-oriented courses, and as a supplementary reading in more theoretical finance courses.

Analysis for Financial Management is my attempt to translate into another medium the enjoyment and stimulation I have received over the past four decades working with executives and college students. This experience has convinced me that financial techniques and concepts need not be abstract or obtuse; that recent advances in the field such as agency theory, market sig- naling, market efficiency, capital asset pricing, and real options analysis are important to practitioners; and that finance has much to say about the broader aspects of company management. I also believe that any activity in which so much money changes hands so quickly cannot fail to be interesting.

Part One looks at the management of existing resources, including the use of financial statements and ratio analysis to assess a company’s finan- cial health, its strengths, weaknesses, recent performance, and future prospects. Emphasis throughout is on the ties between a company’s oper- ating activities and its financial performance. A recurring theme is that a business must be viewed as an integrated whole and that effective financial management is possible only within the context of a company’s broader operating characteristics and strategies.

The rest of the book deals with the acquisition and management of new resources. Part Two examines financial forecasting and planning with par- ticular emphasis on managing growth and decline. Part Three considers the financing of company operations, including a review of the principal security types, the markets in which they trade, and the proper choice of security type by the issuing company. The latter requires a close look at fi- nancial leverage and its effects on the firm and its shareholders.

 

 

Part Four addresses the use of discounted cash flow techniques, such as the net present value and the internal rate of return, to evaluate invest- ment opportunities. It also deals with the difficult task of incorporating risk into investment appraisal. The book concludes with an examination of business valuation and company restructuring within the context of the ongoing debate over the proper roles of shareholders, boards of directors, and incumbent managers in governing America’s public corporations.

An extensive glossary of financial terms and suggested answers to odd- numbered, end-of-chapter problems follow the last chapter.

Changes in the Eleventh Edition Readers familiar with earlier editions of Analysis for Financial Management will notice a number of changes here. Most important, two talented young teachers and scholars have joined me in preparing the eleventh edition. Jennifer Koski, a colleague at the University of Washington, and Todd Mitton, at Brigham Young University, have done yeomen’s work ushering the book into the digital era. I much appreciate their many contributions. You should expect their responsibilities to grow in any future editions.

A second noteworthy change is the book’s partnership with McGraw- Hill’s Connect. As the following section explains in more detail, Connect is the lynchpin of the publisher’s digital initiative. Combining elements of computerized instruction and electronic publishing, it promises signifi- cant benefits to readers and instructors alike. I am anxious to watch McGraw-Hill turn this promise into reality. There will undoubtedly be bumps along the way, but I am confident we are on the right path.

Other more conventional changes and refinements in the eleventh edi- tion include:

• An introductory discussion of crowdfunding and its possible future. • A new treatment of present value calculations, gracefully introducing

computer spreadsheets as the principal means for solving present value problems, while eliminating reference to present value tables.

• Explicit discussion of present value problems involving uneven cash flows. • Enhanced ‘recommended resources’ at the end of each chapter,

including two-dimensional bar codes (QR codes) and recommended mobile apps for Android and iOS devices.

• Added discussion of payout policy, illustrated by Apple Inc.’s recent experience.

• Updated details on the impact of U.S. regulation on financial manage- ment, including the Dodd-Frank Act and the JOBS Act of 2012.

• Better integration of T-accounts and financial statements. • Use of Stryker Corporation, a leading medical technology company, as

an extended example throughout the book.

xii Preface

 

 

McGraw-Hill’s Connect connect.mheducation.com

McGraw-Hill’s Connect® is an online assess- ment solution that connects students with the

tools and resources they’ll need to achieve success. Connect allows faculty to create and deliver exams easily with selectable test bank items. Instruc- tors can also build their own questions into the system for homework or practice. Readers have access to the student resources that accompany this text, as well as McGraw-Hill’s adaptive self-study technology in Learn- Smart and Smartbook.

Connect supports this book in several important ways. The student re- sources include:

• Excel spreadsheets referenced in end-of-chapter problems. • Supplementary chapter problems and suggested answers. • Complimentary software programs described in Additional Resources

at the end of several chapters.

If you are not enrolled in a course using Connect, you can access these stu- dent resources with a free trial by following the instructions accompanying the access code acquired with the book. I encourage you to download these items now for later use. If you are enrolled in a Connect course, ask your instructor for your Connect course URL to access the course resources.

Intended primarily for instructor use, the Connect Instructor Library houses, among other things: • A test bank. • PowerPoint presentations. • An annotated list of suggested cases to accompany the book. • Suggested answers to even-numbered problems.

To access the Instructor Library, log in to your Connect course, select the “Library” tab, and then select “Instructor Resources.”

Connect’s adaptive learning resources, LearnSmart and Smartbook, promise to speed and enrich your mastery of the book by creating a per- sonalized, flexible program of study.

For more information about Connect, LearnSmart, or Smartbook, go to connect.mheducation.com, or contact a McGraw-Hill sales representative. For 24-hour support you can e-mail a Product Specialist or search Frequently Asked Questions at mhhe.com/support. Or for a human, call 800-331-5094.

A word of caution: Analysis for Financial Management emphasizes the ap- plication and interpretation of analytic techniques in decision making. These techniques have proved useful for putting financial problems into perspective and for helping managers anticipate the consequences of their

Preface xiii

 

 

actions. But techniques can never substitute for thought. Even with the best technique, it is still necessary to define and prioritize issues, to mod- ify analysis to fit specific circumstances, to strike the proper balance be- tween quantitative analysis and more qualitative considerations, and to evaluate alternatives insightfully and creatively. Mastery of technique is only the necessary first step toward effective management.

I am indebted to Andy Halula of Standard & Poor’s for providing timely updates to Research Insight. The ability to access current Compustat data on CD continues to be a great help in providing timely examples of current practice. I also owe a large thank you to the following people for their in- sightful reviews of the 10th edition and their constructive advice. They did an excellent job; any remaining shortcomings are mine not theirs.

Bruce Campbell Franklin University Charles Evans Florida Atlantic University, Boca Raton Jaemin Kim San Diego State University, San Diego Inayat Ullah Mangla Western Michigan University, Kalamazoo

John Strong College of William & Mary Andy Terry University of Arkansas, Little Rock Marilyn Wiley University of North Texas Jaime Zender University of Colorado, Boulder

I appreciate the exceptional direction provided by Chuck Synovec, Noelle Bathurst, Melissa Caughlin, Dheeraj Chahal, and Mary Jane Lampe of McGraw-Hill on the development, design, and editing of the book. Bill Alberts, David Beim, Dave Dubofsky, Bob Keeley, Jack McDonald, George Parker, Megan Partch, Larry Schall, and Alan Shapiro have my continuing gratitude for their insightful help and support throughout the book’s evolu- tion. Thanks go as well to my daughter, Sara Higgins, for writing and editing the accompanying software. Finally, I want to express my appreciation to students and colleagues at the University of Washington, Stanford University, IMD, The Pacific Coast Banking School, The Koblenz Graduate School of Management, The Gordon Institute of Business Science, The Swiss International Business School ZfU AG, Boeing, and Microsoft, among others, for stimulating my continuing interest in the practice and teaching of financial management.

I envy you learning this material for the first time. It’s a stimulating intellectual adventure.

Robert C. (Rocky) Higgins Marguerite Reimers Emeritus Professor of Finance

Foster School of Business University of Washington

rhiggins@uw.edu

xiv Preface

 

 

P A R T O N E

Assessing the Financial

Health of the Firm

 

 

 

C H A P T E R O N E

Interpreting Financial Statements

Financial statements are like fine perfume; to be sniffed but not swallowed. Abraham Brilloff

Accounting is the scorecard of business. It translates a company’s diverse activities into a set of objective numbers that provide information about the firm’s performance, problems, and prospects. Finance involves the in- terpretation of these accounting numbers for assessing performance and planning future actions.

The skills of financial analysis are important to a wide range of people, including investors, creditors, and regulators. But nowhere are they more important than within the company. Regardless of functional specialty or company size, managers who possess these skills are able to diagnose their firm’s ills, prescribe useful remedies, and anticipate the financial conse- quences of their actions. Like a ballplayer who cannot keep score, an op- erating manager who does not fully understand accounting and finance works under an unnecessary handicap.

This and the following chapter look at the use of accounting information to assess financial health. We begin with an overview of the accounting prin- ciples governing financial statements and a discussion of one of the most abused and confusing notions in finance: cash flow. Two recurring themes will be that defining and measuring profits is more challenging than one might ex- pect, and that profitability alone does not guarantee success, or even survival. In Chapter 2, we look at measures of financial performance and ratio analysis.

The Cash Flow Cycle

Finance can seem arcane and complex to the uninitiated. However, a comparatively few basic principles should guide your thinking. One is that a company’s finances and operations are integrally connected. A company’s

 

 

activities, method of operation, and competitive strategy all fundamentally shape the firm’s financial structure. The reverse is also true: Decisions that appear to be primarily financial in nature can significantly affect company operations. For example, the way a company finances its assets can affect the nature of the investments it is able to undertake in future years.

The cash flow–production cycle shown in Figure 1.1 illustrates the close interplay between company operations and finances. For simplicity, suppose the company shown is a new one that has raised money from owners and creditors, has purchased productive assets, and is now ready to begin operations. To do so, the company uses cash to purchase raw mate- rials and hire workers; with these inputs, it makes the product and stores it temporarily in inventory. Thus, what began as cash is now physical in- ventory. When the company sells an item, the physical inventory changes back into cash. If the sale is for cash, this occurs immediately; otherwise, cash is not realized until some later time when the account receivable is collected. This simple movement of cash to inventory, to accounts receiv- able, and back to cash is the firm’s operating, or working capital, cycle.

4 Part One Assessing the Financial Health of the Firm

FIGURE 1.1 The Cash Flow–Production Cycle

Cash

Ch ang

es in

equ ity

Ch ang

es in

lia bil

itie s

Ta xes

Int ere

st

Di vid

end s

Inventory

Accounts receivable

Fixed assets

Cash salesP ro

du cti

on

Collection of credit sales

D epreciation

In ve

stm ent

 

Cre dit

sa les

 

 

 

Another ongoing activity represented in Figure 1.1 is investment. Over a period of time, the company’s fixed assets are consumed, or worn out, in the creation of products. It is as though every item passing through the business takes with it a small portion of the value of fixed assets. The accountant rec- ognizes this process by continually reducing the accounting value of fixed assets and increasing the value of merchandise flowing into inventory by an amount known as depreciation. To maintain productive capacity and to fi- nance additional growth, the company must invest part of its newly received cash in new fixed assets. The object of this whole exercise, of course, is to ensure that the cash returning from the working capital cycle and the investment cycle exceeds the amount that started the journey.

We could complicate Figure 1.1 further by including accounts payable and expanding on the use of debt and equity to generate cash, but the fig- ure already demonstrates two basic principles. First, financial statements are an important window on reality. A company’s operating policies, production techniques, and inventory and credit-control systems fundamentally de- termine the firm’s financial profile. If, for example, a company requires payment on credit sales to be more prompt, its financial statements will reveal a reduced investment in accounts receivable and possibly a change in its revenues and profits. This linkage between a company’s operations and its finances is our rationale for studying financial statements. We seek to understand company operations and predict the financial consequences of changing them.

The second principle illustrated in Figure 1.1 is that profits do not equal cash flow. Cash—and the timely conversion of cash into inventories, ac- counts receivable, and back into cash—is the lifeblood of any company. If this cash flow is severed or significantly interrupted, insolvency can occur. Yet the fact that a company is profitable is no assurance that its cash flow will be sufficient to maintain solvency. To illustrate, suppose a company loses control of its accounts receivable by allowing customers more and more time to pay, or suppose the company consistently makes more mer- chandise than it sells. Then, even though the company is selling mer- chandise at a profit in the eyes of an accountant, its sales may not be generating sufficient cash soon enough to replenish the cash outflows re- quired for production and investment. When a company has insufficient cash to pay its maturing obligations, it is insolvent. As another example, suppose the company is managing its inventory and receivables carefully, but rapid sales growth is necessitating an ever-larger investment in these assets. Then, even though the company is profitable, it may have too little cash to meet its obligations. The company will literally be “growing broke.” These brief examples illustrate why a manager must be concerned at least as much with cash flows as with profits.

Chapter 1 Interpreting Financial Statements 5

 

 

To explore these themes in more detail and to sharpen your skills in using accounting information to assess performance, we need to review the basics of financial statements. If this is your first look at financial ac- counting, buckle up because we will be moving quickly. If the pace is too quick, take a look at one of the accounting texts recommended at the end of the chapter.

The Balance Sheet

The most important source of information for evaluating the financial health of a company is its financial statements, consisting principally of a balance sheet, an income statement, and a cash flow statement. Although these statements can appear complex at times, they all rest on a very sim- ple foundation. To understand this foundation and to see the ties among the three statements, let us look briefly at each.

A balance sheet is a financial snapshot, taken at a point in time, of all the assets the company owns and all the claims against those assets. The basic relationship, and indeed the foundation for all of accounting, is

Assets � Liabilities � Shareholders’ equity

It is as if a herd (flock? column?) of accountants runs through the busi- ness on the appointed day, making a list of everything the company owns, and assigning each item a value. After tabulating the firm’s assets, the ac- countants list all outstanding company liabilities, where a liability is simply an obligation to deliver something of value in the future—or more collo- quially, some form of an “IOU.” Having thus totaled up what the com- pany owns and what it owes, the accountants call the difference between the two shareholders’ equity. Shareholders’ equity is the accountant’s estimate of the value of the shareholders’ investment in the firm just as the value of a homeowner’s equity is the value of the home (the asset), less the mort- gage outstanding against it (the liability). Shareholders’ equity is also known variously as owners’ equity, stockholders’ equity, net worth, or simply equity.

It is important to realize that the basic accounting equation holds for individual transactions as well as for the firm as a whole. When a firm pays $1 million in wages, cash declines $1 million and shareholders’ equity falls by the same amount. Similarly, when a company borrows $100,000, cash rises $100,000, as does a liability named something like loans outstanding. And when a company receives a $10,000 payment from a customer, cash rises while another asset, accounts receivable, falls by the same figure. In each instance the double-entry nature of accounting guarantees that the basic accounting equation holds for each transaction, and when summed across all transactions, it holds for the company as a whole.

6 Part One Assessing the Financial Health of the Firm

 

 

To see how the repeated application of this single formula underlies the creation of company financial statements, consider Worldwide Sports (WWS), a newly founded retailer of value-priced sporting goods. In Jan- uary 2014, the founder invested $150,000 of his personal savings and added another $100,000 borrowed from relatives to start the business. After buying furniture and display fixtures for $60,000 and merchandise for $80,000, WWS was ready to open its doors.

The following six transactions summarize WWS’s activities over the course of its first year.

• Sell $900,000 of sports equipment, receiving $875,000 in cash, with $25,000 still to be paid.

• Pay $190,000 in wages, including the owner’s salary.

• Purchase $380,000 of merchandise at wholesale, with $20,000 still owed to suppliers, and $30,000 worth of product still in WWS’s inven- tory at year-end.

• Spend $210,000 on other expenses, such as utilities and rent.

• Depreciate furniture and fixtures by $15,000.

• Pay $10,000 interest on WWS’s loan from relatives and another $40,000 in income taxes to the government.

Table 1.1 shows how an accountant would record these transactions. WWS’s beginning balance, the first line in the table, shows cash of $250,000, a loan of $100,000, and equity of $150,000. But these numbers change quickly as the company buys fixtures and an initial inventory of mer- chandise. And they change further as each of the listed transactions occurs.

Chapter 1 Interpreting Financial Statements 7

TABLE 1.1 Worldwide Sports Financial Transactions 2014 ($ thousands)

Assets � Liabilities � Equity

Accounts Fixed Accounts Loan from Owners’ Cash Receivable Inventory Assets � Payable Relatives Equity

Beginning Balance 1/1/14 $ 250 � $100 $ 150 Initial purchases (140) 80 60 � Sales 875 25 � 900 Wages (190) � (190) Merchandise purchases (360) 30 � 20 (350) Other expenses (210) � (210) Depreciation (15) � (15) Interest payment (10) � (10) Income tax payment (40) � (40)

Ending Balance 12/31/14 $ 175 $25 $110 $ 45 � $20 $100 $ 235

 

 

Abstracting from the accounting details, there are two important things to note here. First, the basic accounting equation holds for each transaction. For every line in the table, assets equal liabilities plus owners’ equity. Second, WWS’s year-end balance sheet across the bottom of the table is just its be- ginning balance sheet plus the cumulative effect of the individual transac- tions. For example, ending cash on December 31, 2014 is the beginning cash of $250,000 plus or minus the cash involved in each transaction. Incidentally, WWS’s first year appears to have been a decent one: Owner’s equity is up $85,000 over the year, on top of whatever the owner paid himself in salary.

To further convince you that the bottom row of Table 1.1 really is a balance sheet, the table below presents the same information in a more conventional format.

Worldwide Sports Balance Sheet, December 31, 2014 ($ thousands)

Cash $175 Accounts payable $ 20 Accounts receivable 25 Total current liabilities 20 Inventory 110 Loan from relatives 100

Total current assets 310 Equity 235 Fixed assets 45 Total liabilities and

Total asssets $355 Shareholders’ equity $355

If a balance sheet is a snapshot in time, the income statement and the cash flow statement are videos, highlighting changes in two especially im- portant balance sheet accounts over time. Business owners are naturally interested in how company operations have affected the value of their in- vestment. The income statement addresses this question by partitioning the recorded changes in owners’ equity into revenues and expenses, where revenues increase owners’ equity and expenses reduce it. The difference between revenues and expenses is earnings, or net income.

Looking at the right-most column in Table 1.1, WWS’s 2014 income statement looks like this. Note that the $85,000 net income appearing at the bottom of the statement equals the change in shareholders’ equity over the year.

Worldwide Sports Income Statement, 2014 ($ thousands)

Sales $900 Wages 190 Merchandise purchases 350 Depreciation 15

Gross profit $345 Other expenses 210 Interest expense 10

Income before tax $125 Income taxes 40

Net income $ 85

8 Part One Assessing the Financial Health of the Firm

 

 

Chapter 1 Interpreting Financial Statements 9

The focus of the cash flow statement is solvency, having enough cash in the bank to pay bills as they come due. The cash flow statement provides a detailed look at changes in the company’s cash balance over time. As an organizing principle, the statement segregates changes in cash into three broad categories: cash provided, or consumed, by operating activities, by investing activities, and by financing activities. Figure 1.2 is a simple schematic diagram showing the close conceptual ties among the three principal financial statements.

To illustrate the techniques and concepts presented throughout the book, I will refer whenever possible to Stryker Corporation. If you or a relative have ever contemplated a hip or knee replacement, you probably know Stryker. The firm is a leading medical technology company with an especially strong position in orthopedic products. It derives about 60 per- cent of its revenue from the sale of hip and knee replacements and 40 per- cent from medical and surgical equipment—known in the trade as “medsurg.” The company competes in over 100 countries and produces almost 60,000 products and services in 29 facilities throughout the globe.

Headquartered in Kalamazoo, Michigan, with annual sales of over $9 billion, Stryker trades on the New York Stock Exchange and is a mem- ber of the Standard & Poor’s 500 Stock Index. The firm was founded in 1946 by Homer Stryker, a practicing orthopedist, and was originally known as The Orthopedic Frame Company, changing its name to Stryker Corporation in 1964. In 1979, Stryker went public and commenced an extended period of remarkably rapid growth. Beginning in 1976, Stryker’s average compound growth rate in earnings per share exceeded 20 percent per annum for over 30 years, and its corporate mantra became “20 per- cent growth forever.” Recent years have been more challenging, how- ever, as maturing products, the financial crisis, and the medical device excise tax tied to ObamaCare have taken their toll.

FIGURE 1.2 Ties among Financial Statements

Assets at beginning

Cash Shareholders’ Equity

= +Liabilities at beginning Equity at beginning

Assets at end = +Liabilities at end

O pe

ra tin

g

In ve

st in

g

Fi na

nc in

g

Equity at end

Balance sheets

Cash flow statement

Income statement

E xp

en se

s

R ev

en ue

s

See stryker.com. Follow Investors > Financial informa- tion for financial statements.

© Stryker.

 

 

Tables 1.2 and 1.3 present Stryker’s balance sheets and income state- ments for 2012 and 2013. If the precise meaning of every asset and liability category in Table 1.2 is not immediately apparent, be patient. We will discuss many of them in the following pages. In addition, all of the accounting terms used appear in the glossary at the end of the book.

Stryker Corporation’s balance sheet equation for 2013 is

Assets � Liabilities � Shareholders’ equity $15,743 million � $6,696 million � $9,047 million

10 Part One Assessing the Financial Health of the Firm

See nysscpa.org/ glossary for an exhaustive glossary of accounting terms.

TABLE 1.2 Stryker Corporation, Balance Sheets ($ millions)*

December 31 Change in 2012 2013 Account

Assets Cash $ 1,395 $ 1,339 $ (56) Marketable securities 2,890 2,641 (249) Accounts receivable, less reserve for possible losses 1,430 1,518 88 Inventories 1,265 1,422 157 Other current assets 1,168 1,415 247

Total current assets 8,148 8,335

Gross property, plant, and equipment 2,232 2,497 265 Less accumulated depreciation and amortization 1,284 1,416 132

Net property, plant, and equipment 948 1,081 133

Goodwill and intangible assets, net 3,566 5,833 2,267 Other assets 544 494 (50)

Total assets $13,206 $15,743

Liabilities and Shareholders’ Equity Long-term debt due in one year 16 25 9 Taxes payable 70 131 61 Trade accounts payable 288 314 26 Accrued compensation 467 535 68 Accrued expenses 1,035 1,652 617

Total current liabilities 1,876 2,657

Long-term debt 1,746 2,739 993 Other long-term liabilities 987 1,300 313

Total liabilities 4,609 6,696

Common stock 38 38 Additional paid-in capital 1,098 1,160 Retained earnings 7,461 7,849

Total shareholders’ equity 8,597 9,047 450

Total liabilities and shareholders’ equity $13,206 $15,743

*Totals may not add due to rounding.

 

 

Current Assets and Liabilities By convention, U.S. accountants list assets and liabilities on the balance sheet in order of decreasing liquidity, where liquidity refers to the speed with which an item can be converted to cash. Thus among assets cash, marketable securities, and accounts receivable appear at the top, while land, plant, and equipment are toward the bottom. Similarly on the liabil- ities side, short-term loans and accounts payable are toward the top, while shareholders’ equity is at the bottom.

Accountants also arbitrarily define any asset or liability that is expected to turn into cash within one year as current and all others assets and liabil- ities as long term. Inventory is a current asset because there is reason to believe it will be sold and will generate cash within one year. Accounts payable are short-term liabilities because they must be paid within one year. Note that over half of Stryker’s assets are current, a fact we will say more about in the next chapter.

Chapter 1 Interpreting Financial Statements 11

TABLE 1.3 Stryker Corporation, Income Statements ($ millions)

January 1 to December 31

2012 2013

Net sales $8,657 $9,021 Cost of goods sold 2,604 2,762

Gross profit 6,053 6,259

Selling, general, and administrative expenses 3,501 4,077 Research, development, and engineering expenses 471 536 Depreciation and amortization 277 307

Total operating expenses 4,249 4,920

Operating income 1,804 1,339

Interest expense 63 83 Other nonoperating expense 36 44

Total nonoperating expenses 99 127

Income before income taxes 1,705 1,212 Provision for income taxes 407 206

Net income $1,298 $1,006

A Word to the Unwary Nothing puts a damper on a good financial discussion (if such exists) faster than the suggestion that if a company is short of cash, it can always spend some of its shareholders’ equity. Equity is on the liabilities side of the balance sheet, not the asset side. It represents owners’ claims against existing assets. In other words, that money has already been spent.

 

 

Shareholders’ Equity A common source of confusion is the large number of accounts appearing in the shareholders’ equity portion of the balance sheet. Stryker has three, beginning with common stock and ending with retained earnings (see Table 1.2). Unless forced to do otherwise, my advice is to forget these dis- tinctions. They keep accountants and attorneys employed, but seldom make much practical difference. As a first cut, just add up everything that is not an IOU and call it shareholders’ equity.

The Income Statement

Looking at Stryker’s operating performance in 2013, the basic income statement relation appearing in Table 1.3 is

Revenues � Expenses � Net income

Cost of Operating Nonoperating Net Net sales � goods sold � expenses � expenses � Taxes � income

$9,021 � $2,762 � $4,920 � $127 � $206 � $1,006

Net income records the extent to which net sales generated during the accounting period exceeded expenses incurred in producing the sales. For variety, net income is also commonly referred to as earnings or profits, frequently with the word net stuck in front of them; net sales are often called revenues or net revenues; and cost of goods sold is labeled cost of sales. I have never found a meaningful distinction between these terms. Why so many words to say the same thing? My personal belief is that accountants are so rule-bound in their calculations of the various amounts that their creativ- ity runs a bit amok when it comes to naming them.

Income statements are commonly divided into operating and nonoper- ating segments. As the names imply, the operating segment reports the results of the company’s major, ongoing activities, while the nonoperating segment summarizes all ancillary activities. In 2013 Stryker reported oper- ating income of $1,339 million and nonoperating expenses of $127 million, consisting largely of interest expense.

Measuring Earnings This is not the place for a detailed discussion of accounting. But because earnings, or lack of same, are a critical indicator of financial health, several technical details of earnings measurement deserve mention.

12 Part One Assessing the Financial Health of the Firm

 

 

Chapter 1 Interpreting Financial Statements 13

Accrual Accounting The measurement of accounting earnings involves two steps: (1) identify- ing revenues for the period and (2) matching the corresponding costs to revenues. Looking at the first step, it is important to recognize that revenue is not the same as cash received. According to the accrual principle (a cruel principle?) of accounting, revenue is recognized as soon as “the ef- fort required to generate the sale is substantially complete and there is a reasonable certainty that payment will be received.” The accountant sees the timing of the actual cash receipts as a mere technicality. For credit sales, the accrual principle means that revenue is recognized at the time of sale, not when the customer pays. This can result in a significant time lag between the generation of revenue and the receipt of cash. Looking at Stryker, we see that revenue in 2013 was $9,021 million, but accounts re- ceivable increased $88 million. We conclude that cash received from sales during 2013 was only $8,933 million ($9,021 � $88 million). The other $88 million still awaits collection.

Depreciation Fixed assets and their associated depreciation present the accountant with a particularly challenging problem in matching. Suppose that in 2015, a company constructs for $50 million a new facility that has an expected productive life of 10 years. If the accountant assigns the entire cost of the facility to expenses in 2015, some weird results follow. Income in 2015 will appear depressed due to the $50 million expense, while income in the fol- lowing nine years will look that much better as the new facility contributes to revenue but not to expenses. Thus, charging the full cost of a long-term asset to one year clearly distorts reported income.

The preferred approach is to spread the cost of the facility over its ex- pected useful life in the form of depreciation. Because the only cash outlay associated with the facility occurs in 2015, the annual depreciation listed as a cost on the company’s income statement is not a cash outflow. It is a noncash charge used to match the 2015 expenditure with resulting revenue. Said differently, depreciation is the allocation of past expenditures to future time periods to match revenues and expenses. A glance at Stryker’s income statement reveals that in 2013, the company included a $307 million non- cash charge for depreciation and amortization among their operating ex- penses. In a few pages, we will see that during the same year, the company spent $195 million acquiring new property, plant, and equipment.

To determine the amount of depreciation to take on a particular asset, three estimates are required: the asset’s useful life, its salvage value, and the method of allocation to be employed. These estimates should be based on economic and engineering information, experience, and any other objective

 

 

data about the asset’s likely performance. Broadly speaking, there are two methods of allocating an asset’s cost over its useful life. Under the straight- line method, the accountant depreciates the asset by a uniform amount each year. If an asset costs $50 million, has an expected useful life of 10 years, and has an estimated salvage value of $10 million, straight-line depreciation will be $4 million per year ([$50 million � $10 million]�10).

The second method of cost allocation is really a family of methods known as accelerated depreciation. Each technique charges more deprecia- tion in the early years of the asset’s life and correspondingly less in later years. Accelerated depreciation does not enable a company to take more depreciation in total; rather, it alters the timing of the recognition. While the specifics of the various accelerated techniques need not detain us here, you should recognize that the life expectancy, the salvage value, and the al- location method a company uses can fundamentally affect reported earn- ings. In general, if a company is conservative and depreciates its assets rapidly, it will tend to understate current earnings, and vice versa.

Taxes A second noteworthy feature of depreciation accounting involves taxes. Most U.S. companies, except very small ones, keep at least two sets of fi- nancial records: one for managing the company and reporting to share- holders and another for determining the firm’s tax bill. The objective of the first set is, or should be, to accurately portray the company’s financial performance. The objective of the second set is much simpler: to mini- mize taxes. Forget objectivity and minimize taxes. These differing objec- tives mean the accounting principles used to construct the two sets of books differ substantially. Depreciation accounting is a case in point. Re- gardless of the method used to report to shareholders, company tax books will minimize current taxes by employing the most rapid method of de- preciation over the shortest useful life the tax authorities allow.

This dual reporting means that actual cash payments to tax authorities usu- ally differ from the provision for income taxes appearing on a company’s in- come statement, sometimes trailing the provision and other times exceeding it. To illustrate, Stryker’s $206 million provision for income taxes appearing on its 2013 income statement is the tax payable according to the accounting techniques used to construct the company’s published statements. But be- cause Stryker used different accounting techniques when reporting to the tax authorities, taxes actually paid in 2013 were lower than this amount. To confirm this fact, note that Stryker has a tax account on the liabilities side of its balance sheet labeled “taxes payable,” a short-term liability. The liability reflects tax obligations incurred in past periods but not yet paid. The net change in this balance sheet account during 2013 indicates that

14 Part One Assessing the Financial Health of the Firm

 

 

Stryker’s tax liability rose $61 million over the year, so that taxes paid must have been $61 million less than the provision for taxes appearing on the income statement. Stryker’s aggressive deferral of tax obligations incurred during the year resulted in a 2013 tax payment less than the tax obligation appearing on its income statement. Here is the detailed accounting with figures in millions:

Provision for income taxes $206 − Increase in taxes payable 61____

Taxes paid $145

At the end of 2013, Stryker’s net tax liability appearing on its balance sheet was $131 million. This sum represents money Stryker must pay tax authorities in future years, but in the meantime can be used to finance the business. Tax deferral techniques create the equivalent of interest-free loans from the government. In Japan and other countries which do not allow the use of separate accounting techniques for tax and reporting purposes, these complications never arise.

Research and Marketing Now that you understand how accountants use depreciation to spread the cost of long-lived assets over their useful lives to better match revenues and costs, you may think you also understand how they treat research and marketing expenses. Because research and development (R&D) and mar- keting outlays promise benefits over a number of future periods, it is only logical that an accountant would show these expenditures as assets when they are incurred and then spread the costs over the assets’ expected use- ful lives in the form of a noncash charge such as depreciation. Impecca- ble logic, but this isn’t what accountants do, at least not in the United States. Because the magnitude and duration of the prospective payoffs from R&D and marketing expenditures are difficult to estimate, ac- countants typically duck the problem by forcing companies to record the entire expenditure as an operating cost in the year incurred. Thus, al- though a company’s research outlays in a given year may have produced technical breakthroughs that will benefit the firm for decades to come, all of the costs must be shown on the income statement in the year incurred. The requirement that companies expense all research and marketing ex- penditures when incurred commonly understates the profitability of high-tech and high-marketing companies and complicates comparison of American companies with those in other nations that treat such expendi- tures more liberally.

Chapter 1 Interpreting Financial Statements 15

 

 

16 Part One Assessing the Financial Health of the Firm

Defining Earnings Creditors and investors look to company earnings for help in answering two fundamental questions: How did the company do last period, and how might it do in the future? To answer the first question it is important to use a broad-based measure of income that includes everything affecting the com- pany’s performance over the accounting period. However, to answer the second question we want a narrower income measure that abstracts from all unusual, nonrecurring events to focus strictly on the company’s steady state, or ongoing, performance.

The accounting profession and the Securities and Exchange Commission obligingly provide two such official measures, known as net income and operating income, and require companies to report them on their financial statements.

Net income, or net profit, is the proverbial “bottom line,” defined as total revenue less total expenses. Operating income is profit realized from day-to-day operations excluding taxes, interest income

and expense, and what are known as extraordinary items. An extraordinary item is one that is both unusual in nature and infrequent in occurrence.

For a variety of sometimes-legitimate reasons, corporate executives and business analysts have increasingly argued that these official income measures are inadequate or inappropriate for their purposes and have encouraged a whole cottage industry devoted to creating and promoting new, improved earnings measures. Here are some of the more popular ones:

Pro forma earnings, also known as adjusted earnings, core earnings, or ongoing earnings, are total revenues less total expenses, omitting any and all expenses the company believes might cloud investor perceptions of the true earning power of the business. If this sounds vague, it is. Each company has license to decide what expenses are to be ignored, and to change its mind from year to year. The SEC requires only that the company reconcile its preferred earnings measure with the closest official number in its annual report. In the first three quarters of 2001, during the depths of the dot-com bust, the 100 largest firms traded on the NASDAQ stock exchange reported aggregate pro forma earnings of $20 billion. For the same period, they reported losses according to Generally Accepted Accounting Principles of $82 billion.a In the recent financial crisis, S&P 500 companies reported aggregate 2008 pro forma earnings per share of over $60, while the corresponding figure under GAAP was below $20.b In 2013, our featured company, Stryker Corporation, highlighted “adjusted” net earnings of $1.6 billion, some 60 percent above the comparable GAAP figure, due principally to large product liability claims which the company chose to consider nonrecurring.

EBIT (pronounced E-bit) is earnings before interest and taxes, a useful and widely used measure of a business’s income before it is divided among creditors, owners, and the taxman.

EBITDA (pronounced E-bit-da) is earnings before interest, taxes, depreciation, and amortization. EBITDA has its uses in some industries, such as broadcasting, where depreciation charges may routinely overstate true economic depreciation. However, as Warren Buffett notes, treating EBITDA as equivalent to earnings is tantamount to saying that a business is the commercial equivalent of the pyramids—forever state-of-the-art, never needing to be replaced, improved, or refurbished. In Buffett’s view, EBITDA is a number favored by investment bankers when they cannot justify a deal based on EBIT.

EIATBS (pronounced E-at-b-s) is earnings ignoring all the bad stuff, which is the earnings concept too many executives and analysts appear to prefer.

a “A Survey of International Finance,” The Economist, May 18, 2002, p. 20. b “Chart of the Day: Here’s How You Should Think About ‘Adjusted’ Earnings.” Sam Ro, Business Insider, December 26,

2013, Businessinsider.com/gaap-vs-non-gaap-earnings-eps-2013-12.

 

 

Chapter 1 Interpreting Financial Statements 17

Sources and Uses Statements

Two very basic but valuable things to know about a company are where it gets its cash and how it spends the cash. At first blush, it might appear that the income statement will answer these questions because it records flows of resources over time. But further reflection will con- vince you that the income statement is deficient in two respects: It includes accruals that are not cash flows, and it lists only cash flows associated with the sale of goods or services during the accounting period. A host of other cash receipts and disbursements do not appear on the income statement. Thus, Stryker Corporation increased its investment in accounts receivable by $88 million in 2013 (Table 1.2) with little or no trace of this buildup on its income statement. Stryker also increased long-term debt by almost $1 billion with little effect on its income statement.

To gain a more accurate picture of where a company got its money and how it spent it, we need to look more closely at the balance sheet or, more precisely, two balance sheets. Use the following two-step procedure. First, place two balance sheets for different dates side by side, and note all of the changes in accounts that occurred over the pe- riod. The changes for Stryker in 2013 appear in the rightmost column of Table 1.2. Second, segregate the changes into those that generated cash and those that consumed cash. The result is a sources and uses statement.

Here are the guidelines for distinguishing between a source and a use of cash:

• A company generates cash in two ways: by reducing an asset or by increasing a liability. The sale of used equipment, the liquidation of inventories, and the reduction of accounts receivable are all reductions in asset accounts and are all sources of cash to the company. On the liabilities side of the balance sheet, an increase in a bank loan and the sale of common stock are increases in liabilities, which again generate cash.

• A company also uses cash in two ways: to increase an asset account or to reduce a liability account. Adding to inventories or accounts receivable and building a new plant all increase assets and all use cash. Conversely, the repayment of a bank loan, the reduction of accounts payable, and an operating loss all reduce liabilities and all use cash.

Because it is difficult to spend money you don’t have, total uses of cash over an accounting period must equal total sources.

 

 

Table 1.4 presents a 2013 sources and uses statement for Stryker Corporation. It reveals that the company got over one-third of its cash from increased long-term borrowing and, in turn, used almost 80 percent of the cash to increase net goodwill and intangible assets, reflecting size- able acquisitions, as we will soon discuss further.

The Two-Finger Approach I personally do not spend a lot of time constructing sources and uses state- ments. It might be instructive to go through the exercise once or twice just to convince yourself that sources really do equal uses. But once beyond this point, I recommend using a “two-finger approach.” Put the two

18 Part One Assessing the Financial Health of the Firm

TABLE 1.4 Stryker Corporation, Sources and Uses Statement, 2013 ($ millions)*

Sources

Reduction in cash 56 Reduction in marketable securities 249 Reduction in other assets 50 Increase in long-term debt due in one year 9 Increase in taxes payable 61 Increase in trade accounts payable 26 Increase in accrued compensation 68 Increase in accrued expenses 617 Increase in long-term debt 993 Increase in other long-term liabilities 313 Increase in total shareholders’ equity 450

Total sources $2,892

Uses

Increase in accounts receivable 88 Increase in inventories 157 Increase in other current assets 247 Increase in net property, plant, and equipment 133 Increase in net goodwill and intangible assets 2,267

Total uses $2,892

*Totals may not add due to rounding.

How Can a Reduction in Cash Be a Source of Cash? One potential source of confusion in Table 1.4 is that the reduction in cash and marketable securities in 2013 appears as a source of cash. How can a reduction in cash be a source of cash? Simple. It is the same as when you withdraw money from your checking account. You reduce your bank balance but have more cash on hand to spend. Conversely, a deposit into your bank account increases your balance but reduces spendable cash in your pocket.

 

 

Chapter 1 Interpreting Financial Statements 19

balance sheets side by side, and quickly run any two fingers down the columns in search of big changes. This should enable you to quickly observe that the majority of Stryker’s cash came from long-term debt, retained earnings, and increased accrued expenses and most of it went to finance new acquisitions. In 30 seconds or less, you have the essence of a sources and uses analysis and are free to move on to more stimulating activities. The other changes are largely window dressing of more interest to accountants than to managers.

The Cash Flow Statement

Identifying a company’s principal sources and uses of cash is a useful skill in its own right. It is also an excellent starting point for considering the cash flow statement, the third major component of financial statements along with the income statement and the balance sheet.

In essence, a cash flow statement just expands and rearranges the sources and uses statement, placing each source or use into one of three broad cate- gories. The categories and their values for Stryker in 2013 are as follows:

Category Source (or Use) of Cash

($ millions)

1. Cash flows from operating activities $1,886 2. Cash flows from investing activities ($2,217) 3. Cash flows from financing activities $275

Double-entry bookkeeping guarantees that the sum of the cash flows in these three categories equals the change in cash balances over the accounting period.

Table 1.5 presents a complete cash flow statement for Stryker Corpora- tion in 2013. The first category, “cash flows from operating activities,” can be thought of as a rearrangement of Stryker’s financial statements to elimi- nate the effects of accrual accounting on net income. First, we add all non- cash charges, such as depreciation and amortization, back to net income, recognizing that these charges did not entail any cash outflow. Then we add the changes in current assets and liabilities to net income, acknowledging, for instance, that some sales did not increase cash because customers had not yet paid, while some expenses did not reduce cash because the company had not yet paid. Changes in other current assets and liabilities, such as in- ventories, appear here because the accountant, following the matching prin- ciple, ignored these cash flows when calculating net income. Interestingly, the cash generated by Stryker’s operations was over 80 percent more than

 

 

the firm’s income. A principal reason for the difference is that the income statement includes a $43.4 million noncash charge for depreciation.

If cash flow statements were just a reshuffling of sources and uses statements, as many textbook examples suggest, they would be redun- dant, for a reader could make his own in a matter of minutes. A chief at- traction of cash flow statements is that companies reorganize their cash flows into new and sometimes revealing categories. To illustrate, Stryker’s cash flow statement in Table 1.5 reveals that during 2013 it paid dividends of $401 million, repurchased $317 million of its common

20 Part One Assessing the Financial Health of the Firm

TABLE 1.5 Stryker Corporation, Cash Flow Statement, 2013 ($ millions)*

Cash Flows from Operating Activities Net income $ 1,006 Adjustments to reconcile net income to net cash provided by operating activities:

Depreciation and amortization 307 Deferred income taxes 23 Stock-based compensation expense 76 Restructuring charges 50 Changes in assets and liabilities:

Increase in accounts receivables (89) Increase in inventories (77) Increase in accounts payable 1 Increase in accrued expenses and other liabilities 657 Decrease in accrued income taxes (124) Other 56

Net cash provided by operating activities 1,886

Cash Flows from Investing Activities Capital expenditures (195) Acquisitions (2,320) Net decline in investments 298 Net cash used by investing activities (2,217)

Cash Flows from Financing Activities Repurchase of common stock (317) Dividends paid (401) Long-term debt issuance, net of retirements 1,005 Other financing activities 13 Effect of exchange rate changes on cash (25) Net cash provided by financing activities 275

Net increase (decrease) in cash (56) Cash at beginning of year 1,395 Cash and marketable securities at end of year $ 1,339

*Totals may not add due to rounding.

 

 

Chapter 1 Interpreting Financial Statements 21

stock, and invested $195 million in new capital expenditures. This is the only place in its financial statements where these basic activities are even mentioned.

A second attraction of a cash flow statement is that it casts a welcome light on firm solvency by highlighting the extent to which operations are generating or consuming cash. Stryker’s cash flow statement in 2013 in- dicates that cash flow from operating activities exceeded net income by a hearty 80 percent, due principally to an increase in something called “accrued expenses and other liabilities.” This is a lot of money for such an innocuous sounding account. Additional digging reveals that the in- crease reflects additions to a reserve account to honor anticipated prod- uct liability claims. In mid-2012, Stryker voluntarily recalled several hip replacement products due to their tendency to cause metal ion poison- ing in some patients. Used in about 20,000 people, remedial treatment requires replacing the failed hip. A year later, with the number of law- suits climbing above 900, Stryker announced it was adding some $600 million to the reserve. From an accounting perspective, this involves adding $600 million to selling, general, and administrative expenses and increasing accrued expenses and liabilities by a like amount. Because this build-up is a noncash charge until patient claims are actually paid, it does not diminish cash flow from operations and must thus be added back to net income.

Why Are The Numbers Different? Stryker’s sources and uses statement in Table 1.4 tells us that inventories rose $157 million in 2013; yet its cash flow statement in Table 1.5 says that inventories increased only $77 million over the same period. Nor is this an isolated example. Many of the apparently identical quantities differ from one statement to the other. Why the difference?

Here are two possible answers. Companies often divide changes in current assets and liabilities into two parts: those attributable to existing activities, and those due to newly acquired businesses, with the first appearing in cash flows from operating activities and the second in cash flows from in- vesting activities. By pushing as much of the increase into investing activities as possible, Stryker enhances its recorded cash generated by operating activities—an appealing outcome. The second answer involves exchange rates. Stryker has assets and liabilities of various types scattered all over the world. To construct a consolidated balance sheet, its accountants translate the company’s foreign-denominated accounts into U.S. dollars at the then prevailing exchange rates. As a result, the balance sheet changes we observe on their consolidated statements are due at least in part to changing currency values. However, because the currency-induced changes are not cash flows until the assets or liabilities are brought home, Stryker omits them from the numbers appearing on its cash flow statement.

Are these answers complicated? Yes. Do the manipulations described add to our understanding of Stryker’s performance? I doubt it.

 

 

Another noteworthy entry on Stryker’s cash flow statement is “stock- based compensation expense,” which contributed $76 million to cash flow from operations in 2013. After a long and bitter battle among businesses, Congress, and accounting regulators, employee stock options are finally, and correctly, classified as an expense. However, they are not a cash flow, neither when they are given to the employee nor when she converts them into company stock. So they too must be added back to net income when calculating cash flow from operations. If you are wondering how stock op- tions can be an expense when the firm never seems to have to pay any cash to anyone, the answer is that they are a cost to shareholders, who see their ownership percentage diluted as employees acquire shares without paying full value for them.

Some analysts maintain that net cash provided by operating activi- ties, appearing on the cash flow statement, is a more reliable indicator of firm performance than net income. They argue that because net in- come depends on myriad estimates, allocations, and approximations, devious managers can easily manipulate it. Numbers appearing on a company’s cash flow statement, on the other hand, record the actual movement of cash, and are thus seen to be more objective measures of performance.

There is certainly some merit to this view, but also two problems. First, low or even negative net cash provided by operating activities does not necessarily indicate poor performance. Rapidly growing businesses in particular must customarily invest in current assets, such as accounts receivable and inventories, to support increasing sales. And although such investments reduce net cash provided by operating activities, they do not in any way suggest poor performance. Second, cash flow state- ments turn out to be less objective, and thus less immune to manipula- tion than might be supposed. Here’s a simple example. Suppose two companies are identical except that one sells its product on a simple open account, while the other loans its customers money enabling them to pay cash for the product. In both cases, the customer has the product and owes the seller money. But the increase in accounts receivable recorded by the first company on each sale will lower its cash flows from operating activities relative to the second, which can report the cus- tomer loan as part of investing activities. Because the criteria for appor- tioning cash flows among operating, investing, and financing activities are ambiguous, subjective judgment must be used in the preparation of cash flow statements.

Much of the information contained in a cash flow statement can be gleaned from careful study of a company’s income statement and balance sheet. Nonetheless, the statement has three principal virtues. First, accounting

22 Part One Assessing the Financial Health of the Firm

 

 

neophytes and those who do not trust accrual accounting have at least some hope of understanding it. Second, the statement provides more accurate in- formation about certain activities, such as share repurchases and employee stock options than one can infer from income statements and balance sheets alone. Third, it casts a welcome light on cash generation and solvency.

Chapter 1 Interpreting Financial Statements 23

What Is Cash Flow? So many conflicting definitions of cash flow exist today that the term has almost lost its meaning. At one level, cash flow is very simple. It is the movement of money into or out of a cash account over a period of time. The problem arises when we try to be more specific. Here are four common types of cash flow you are apt to encounter.

Net cash flow � Net income � Noncash items

Often known in investment circles as cash earnings, net cash flow is intended to measure the cash a business generates, as distinct from the earnings—a laudable objective. Applying the formula to Stryker’s 2013 figures (Table 1.5), net cash flow was $1,462 million, equal to net income plus depreci- ation, and other noncash charges.

A problem with net cash flow as a measure of cash generation is that it implicitly assumes a busi- ness’s current assets and liabilities are either unrelated to operations or do not change over time. In Stryker’s case, the cash flow statement reveals that changes in a number of current assets and lia- bilities contributed $424 million in cash. A more inclusive measure of cash generation is therefore cash flow from operating activities as it appears on the cash flow statement.

Cash flow from operating activities � Net cash flow ± Changes in current assets and liabilities

A third, even more inclusive measure of cash flow, popular among finance specialists is

Total cash available for distribution to owners and creditors Free cash flow �

after funding all worthwhile investment activities

Free cash flow extends cash flow from operating activities by recognizing that some of the cash a business generates must be plowed back into the business, in the form of capital expenditures, to support growth. Abstracting from a few technical details, free cash flow is essentially cash flow from operating activities less capital expenditures. As we will see in Chapter 9, free cash flow is a fundamental determinant of the value of a business. Indeed, one can argue that the principal means by which a company creates value for its owners is to increase free cash flow.

Yet another widely used cash flow is

A sum of money today having the same value Discounted cash flow �

as a future stream of cash receipts and disbursements

Discounted cash flow refers to a family of techniques for analyzing investment opportunities that take into account the time value of money. A standard approach to valuing investments and busi- nesses uses discounted cash flow techniques to calculate the present value of projected free cash flows. This is the focus of the last three chapters of this book.

My advice when tossing cash flow terms about is to either use the phrase broadly to refer to a general movement of cash or to define your terms carefully.

 

 

24 Part One Assessing the Financial Health of the Firm

Financial Statements and the Value Problem

To this point, we have reviewed the basics of financial statements and grappled with the distinction between earnings and cash flow. This is a valuable start, but if we are to use financial statements to make informed business decisions, we must go further. We must understand the extent to which accounting numbers reflect economic reality. When the accountant tells us that Stryker Corporation’s total assets were worth $15,743 million on December 31, 2013, is this literally true, or is the number just an artifi- cial accounting construct? To gain perspective on this issue, and in anticipa- tion of later discussions, I want to conclude by examining a recurring problem in the use of accounting information for financial decision making.

Market Value vs. Book Value Part of what I will call the value problem involves the distinction between the market value and the book value of shareholders’ equity. Stryker’s 2013 balance sheet states that the value of shareholders’ equity is $9,047 million. This is known as the book value of Stryker’s equity. However, Stryker is not worth $9,047 million to its shareholders or to anyone else, for that matter. There are two reasons. One is that financial statements are largely transactions based. If a company purchased an asset for $1 million in 1950, this transaction provides an objective measure of the asset’s value, which the accountant uses to value the asset on the company’s balance sheet. Unfortunately, it is a 1950 value that may or may not have much relevance today. To further confound things, the accountant attempts to reflect the gradual deterioration of an asset over time by periodically sub- tracting depreciation from its balance sheet value. This practice makes sense as far as it goes, but depreciation is the only change in value an American accountant customarily recognizes. The $1 million asset pur- chased in 1950 may be technologically obsolete and therefore virtually worthless today; or, due to inflation, it may be worth much more than its original purchase price. This is especially true of land, which can be worth several times its original cost.

It is tempting to argue that accountants should forget the original costs of long-term assets and provide more meaningful current values. The prob- lem is that objectively determinable current values of many assets do not exist, and it is probably not wise to rely on incumbent mangers to make the necessary adjustments. Faced with a choice between relevant but subjective current values and irrelevant but objective historical costs, accountants opt for irrelevant historical costs. Accountants prefer to be precisely wrong than approximately right. This means it is the user’s responsibility to make any adjustments to historical-cost asset values she deems appropriate.

For more of fair value account- ing and many other account- ing topics, see cfo.com.

 

 

Prodded by regulators and investors, the Financial Accounting Stan- dards Board, accounting’s principal rule-making organization, increas- ingly stresses what is known as fair value accounting, according to which certain assets and liabilities must appear on company financial statements at their market values instead of their historical costs. Such “marking to market” applies to selected assets and liabilities that trade actively on fi- nancial markets, including many common stocks and bonds. Proponents of fair value accounting acknowledge it will never be possible to eliminate his- torical- cost accounting entirely, but maintain that market values should be used whenever possible. Skeptics respond that mixing historical costs and market values in the same financial statement only heightens confusion, and that periodically revaluing company accounts to reflect changing mar- ket values introduces unwanted subjectivity, distorts reported earnings, and greatly increases earnings volatility. They point out that under fair value accounting, changes in owners’ equity no longer mirror the results of com- pany operations but also include potentially large and volatile gains and losses from changes in the market values of certain assets and liabilities. The gradual movement toward fair value accounting was initially greeted with howls of protest, especially from financial institutions concerned that the move would increase apparent earnings volatility and, more menac- ingly, might reveal that some enterprises are worth less than historical-cost financial statements suggest. To these firms the appearance of benign sta- bility is apparently more appealing than the hint of an ugly reality.

To understand the second, more fundamental reason Stryker is not worth $9,047 million, recall that equity investors buy shares for the future income they hope to receive, not for the value of the firm’s assets. Indeed, if all goes according to plan, most of the firm’s existing assets will be con- sumed in generating future income. The problem with the accountant’s measure of shareholders’ equity is that it bears little relation to future in- come. There are two reasons for this. First, because the accountant’s num- bers are backward-looking and cost-based, they often provide few clues about the future income a company’s assets might generate. Second, com- panies typically have a great many assets and liabilities that do not appear on their balance sheets but affect future income nonetheless. Examples in- clude patents and trademarks, loyal customers, proven mailing lists, supe- rior technology, and, of course, better management. It is said that in many companies, the most valuable assets go home to their spouses in the evening. Examples of unrecorded liabilities include pending lawsuits, in- ferior management, and obsolete production processes. The accountant’s inability to measure assets and liabilities such as these means that book value is customarily a highly inaccurate measure of the value perceived by shareholders.

Chapter 1 Interpreting Financial Statements 25

 

 

It is a simple matter to calculate the market value of shareholders’ equity when a company’s shares are publicly traded: Simply multiply the market price per share by the number of common shares outstanding. On December 31, 2013, Stryker’s common shares closed on the New York Stock Exchange at $75.14. With 378 million shares outstanding, this yields a value of $28,403 million, or 3.1 times the book value ($28,403/$9,047 million). This figure is the market value of Stryker’s equity, often known as its market capitalization or market cap.

Table 1.6 presents the market and book values of equity for 15 repre- sentative companies. It demonstrates clearly that book value is a poor proxy for market value.

Goodwill There is one instance in which intangible assets, such as brand names and patents, find their way onto company balance sheets. It occurs when one company buys another at a price above book value. Suppose an acquiring firm pays $100 million for a target firm and the target’s assets have a book value of only $40 million and an estimated replacement value of only $60 million. To record the transaction, the accountant will allocate $60 million of the acquisition price to the value of the assets acquired and assign the remaining $40 million to a new asset commonly known as

26 Part One Assessing the Financial Health of the Firm

Fair Value Accounting and the Financial Crisis of 2008 The financial crisis of 2008 revealed several quirks and problems with fair value accounting. Among the quirks is fair value’s treatment of company liabilities. Many financial institutions saw the market value of their publicly traded debt plummet during the crisis as investors lost faith in the institutions’ ability to honor their obligations—clearly bad news. Yet fair value accounting forced the organiza- tions to report this drop in value as a gain on the theory that it would now cost them that much less to repurchase and retire the debt. Similarly, when the crisis eased and debt values rose, the same institutions found themselves recording losses as the cost of repurchase went up. As one example, investment bank Morgan Stanley reported a $5.5 billion gain in 2008 on declining debt values, fol- lowed in 2009 by a $5.4 billion loss as the price of their debt recovered.

More worrisome, some observers maintain that fair value accounting may actually have con- tributed to the crisis. They argue that panic selling during the collapse made observed market prices more an indicator of investor fears than of asset values. Moreover, they claim that reliance on these distressed prices to value assets set in motion a vicious cycle whereby falling prices prompted cred- itors to demand payment of the debt, increased collateral, or increased equity relative to debt, all of which forced the debtors into more panic selling. While not abandoning fair value accounting, this criticism has forced accountants and regulators to allow managers some discretion in estimating fair values in distressed markets.c

cFor more on this topic, see Christian Laux and Christian Leuz “The Crisis of Fair Value Accounting: Making Sense of the Recent Debate,” Accounting, Organizations and Society, April 2009. Available at ssrn.com/abstract=1392645.

 

 

“goodwill.” The acquiring company paid a handsome premium over the fair value of the target’s recorded assets because it places a high value on its unrecorded, or intangible, assets. But not until the acquisition creates a piece of paper with $100 million written on it is the accountant willing to acknowledge this value.

Looking at Stryker Corporation’s balance sheet in Table 1.2 under the heading “goodwill and intangible assets, net,” we see that the company has $5,833 million of goodwill, its largest single asset and 37 percent of total assets. To put this number in perspective, the median ratio of good- will and intangible assets to total assets among Standard & Poor’s 500 in- dustrial companies—a diversified group of large firms—was 22 percent in 2013. Express Scripts Holding Company, a health care management com- pany, topped the list with a ratio of 81 percent.1

Economic Income vs. Accounting Income A second dimension of the value problem is rooted in the accountant’s dis- tinction between realized and unrealized income. To anyone who has not

Chapter 1 Interpreting Financial Statements 27

TABLE 1.6 The Book Value of Equity Is a Poor Surrogate for the Market Value of Equity, December 31, 2013

Value of Equity Ratio, Market ($ millions) Value to

Company Book Market Book Value

Aetna Inc. 14,026 27,154 1.9 Apache Corp. 33,396 32,829 1.0 Coca-Cola Co. 33,173 170,181 5.1 Delta Air Lines Inc. 11,643 29,502 2.5 Duke Energy Corp. 41,330 50,281 1.2 Facebook Inc. 15,470 153,431 9.9 General Motors Co. 39,498 51,630 1.3 Google Inc. 87,309 374,288 4.3 Harley-Davidson Inc. 3,009 14,651 4.9 Hewlett-Packard Co. 27,269 61,452 2.3 Intel Corp. 58,256 128,218 2.2 Stryker Corp. 9,047 28,403 3.1 Tesla Motors Inc. 667 25,658 38.5 United States Steel Co. 3,348 3 ,995 1.2 Walmart Stores Inc. 76,255 247,098 3.2

1For many years, accounting authorities required companies to write goodwill off as a noncash expense against income over a number of years. Now they acknowledge that most goodwill is not necessarily a wasting asset and only requires a write-down when there is evidence the value of goodwill has declined. There is no offsetting provision requiring the write-up of goodwill when values appear to have risen. If this sounds vague and capricious, I agree.

 

 

studied too much accounting, income is what you could spend during the period and be as well off at the end as you were at the start. If Mary Siegler’s assets, net of liabilities, are worth $100,000 at the start of the year and rise to $120,000 by the end, and if she receives and spends $70,000 in wages during the year, most of us would say her income was $90,000 ($70,000 in wages � $20,000 increase in net assets).

But not the accountant. Unless Mary’s investments were in marketable securities with readily observable prices, he would say Mary’s income was only $70,000. The $20,000 increase in the value of assets would not qual- ify as income because the gain was not realized by the sale of the assets. Be- cause the value of the assets could fluctuate in either direction before the assets are sold, the gain is only on paper, and accountants generally do not recognize paper gains or losses. They consider realization the objective evidence necessary to record the gain, despite the fact that Mary is proba- bly just as pleased with the unrealized gain in assets as with another $20,000 in wages.

It is easy to criticize accountants’ conservatism when measuring in- come. Certainly the amount Mary could spend, ignoring inflation, and be as well off as at the start of the year is the commonsense $90,000, not the accountant’s $70,000. Moreover, if Mary sold her assets for $120,000 and immediately repurchased them for the same price, the $20,000 gain would become realized and, in the accountant’s eyes, become part of income. That income could depend on a sham transaction such as this is enough to raise suspicions about the accountant’s definition.

However, we should note three points in the accountant’s defense. First, if Mary holds her assets for several years before selling them, the gain or loss the accountant recognized on the sale date will equal the sum of the annual gains and losses we nonaccountants would recognize. So it’s really not total income that is at issue here but simply the timing of its recognition. Second, accountants’ increasing use of fair value accounting, where at least some as- sets and liabilities are revalued periodically to reflect changes in market value, reduces the difference between accounting and economic income. Third, even when accountants want to use fair value accounting, it is ex- tremely difficult to measure the periodic change in the value of many assets and liabilities unless they are actively traded. Thus, even if an accountant wanted to include “paper” gains and losses in income, she would often have great difficulty doing so. In the corporate setting, this means the accountants frequently must be content to record realized rather than economic income.

Imputed Costs A similar but subtler problem exists on the cost side of the income statement. It involves the cost of equity capital. Stryker’s accountants acknowledge that

28 Part One Assessing the Financial Health of the Firm

 

 

in 2013 the company had use of $9,047 million of shareholders’ money, measured at book value. They would further acknowledge that Stryker could not have operated without this money and that this money is not free. Just as creditors earn interest on loans, equity investors expect a return on their in- vestments. Yet if you look again at Stryker’s income statement (Table 1.3), you will find no mention of the cost of this equity; interest expense appears, but a comparable cost for equity does not.

While acknowledging that equity capital has a cost, the accountant does not record it on the income statement because the cost must be imputed, that is, estimated. Because there is no piece of paper stating the amount of money Stryker is obligated to pay owners, the accoun- tant refuses to recognize any cost of equity capital. Once again, the ac- countant would rather be reliably wrong than make a potentially inaccurate estimate. The result has been serious confusion in the minds of less knowledgeable observers and continuing “image” problems for corporations.

Following is the bottom portion of Stryker’s income statement as pre- pared by its accountant and as an economist might prepare it. Observe that while the accountant shows earnings of $1,006 million, the economist records a profit of only $101 million. These numbers differ because the economist includes a $905 million charge as a cost of equity capital, while the accountant pretends equity is free. (We will consider ways to estimate a company’s cost of equity capital in Chapter 8. Here, for illustrative purposes only, I have assumed a 10 percent annual equity cost and applied it to the book value of Stryker’s equity [$905 million � 10% � $9,047 million].)

($ millions) Accountant Economist

Operating income $1,339 $1,339 Interest expense 83 83 Other nonoperating expenses 44 44 Cost of equity 905 Income before taxes 1,212 307 Provision for taxes 206 206

Accounting earnings $1,006 Economic earnings $ 101

The distinction between accounting earnings and economic earnings might be only a curiosity if everyone understood that positive accounting earnings are not necessarily a sign of superior or even commendable per- formance. But when many labor unions, Occupy Wall Streeters, and politicians view accounting profits as evidence that a company can afford higher wages, higher taxes, or more onerous regulation, and when most

Chapter 1 Interpreting Financial Statements 29

 

 

managements view such profits as justification for distributing handsome performance bonuses, the distinction can be an important one. Keep in mind, therefore, that the right of equity investors to expect a competitive return on their investments is every bit as legitimate as a creditor’s right to interest and an employee’s right to wages. All voluntarily contribute scarce resources, and all are justified in expecting compensation. Remember too that a company is not shooting par unless its economic profits are zero or

30 Part One Assessing the Financial Health of the Firm

International Financial Reporting Standards A danger inherent in any cross-country comparison of accounting numbers is that accountants in different countries may not keep score by the same rules. Happily, this problem has diminished greatly over the past decade or so, and what optimists might call international accounting standards are emerging. The European Union took the lead in this initiative as part of its much broader effort to hammer out a common, integrated marketplace among member countries. After some 30 years of study, debate, and political wrangling, the accounting initiative became a reality on January 1, 2005, when all 7,000 publicly traded companies in Europe dumped their national accounting rules in favor of the newly designated International Financial Reporting Standards (IFRS). Today, over 100 coun- tries on six continents have adopted IFRS, either directly or by aligning national rules to the interna- tional standards. Conspicuously absent from the earlier adopters have been the United States and Japan who are, nonetheless, working at their own pace to join the club, or at least become affiliate members.

For many years, U.S. accounting authorities viewed American accounting rules as the gold stan- dard to which other countries could only aspire, and their approach to international accounting standards was to invite the rest of the world to adopt theirs. But accounting scandals in the early 2000s and the ensuing collapse of the accounting firm Arthur Andersen have made Americans a bit more humble about their accounting rules and a bit more willing to compromise.

A major barrier to greater transatlantic cooperation on accounting standards has been differing philosophical perspectives on the role such standards should play. The European philosophy is to articulate broad accounting principles and to charge accountants and executives to prepare com- pany accounts consistent with the spirit of those principles. Concerned that principles alone would leave too much room for manipulation, the American approach has been to lay down voluminous, detailed rules defining how each transaction is to be recorded and to demand strict conformance to the letter of those rules. Ironically, this rules-based philosophy seems to have backfired, for rather than limiting manipulation, the American “bright-line” approach appears to have encouraged it by shifting some executives’ focus from preparing fair and accurate statements to figuring out how best to beat the rules. The argument “we didn’t break any rules, so we must be innocent” appears to have been an enticing one.

One response to the breakdown in U.S. accounting standards was passage of the Sarbanes- Oxley Act of 2002, which among other changes requires chief executives and chief financial officers to personally attest to the appropriateness of their company’s financial reports. Another was to take the European, broad-brush approach more seriously. Indeed, there was a time some 10 years ago when it appeared that U.S. regulators and accounting authorities were about to name a date-certain when the United States would adopt IFRS. Today this no longer appears likely. Instead, U.S. and in- ternational accounting authorities appear intent on integrating the two standards on a piecemeal basis over an extended period. Not a single standard perhaps, but at least a workable compromise.

 

 

Chapter 1 Interpreting Financial Statements 31

greater. By this criterion, Stryker had a decent but not fantastic year in 2013. On closer inspection, you will find that many companies reporting apparently large earnings are really performing like weekend duffers when the cost of equity is included.

We will look at the difference between accounting and economic prof- its again in more detail in Chapter 8 under the rubric of economic value added, or EVA. In recent years, EVA has become a popular yardstick for assessing company and managerial performance.

In sum, those of us interested in financial analysis eventually develop a love-hate relationship with accountants. The value problem means that financial statements typically yield distorted information about company earnings and market value. This limits their applicability for many impor- tant managerial decisions. Yet financial statements frequently provide the best information available, and if we bear their limitations in mind, they can be a useful starting point for analysis. In the next chapter, we consider the use of accounting data for evaluating financial performance.

SUMMARY

1. The cash flow cycle • Describes the flow of cash through a company. • Illustrates that profits and cash flow are not the same. • Reminds a manager she must be at least as concerned with cash flows

Global Finance Case Study Questions

/in /by

GLOBAL BUSINESS

Third Edition

Mike W. Peng, Ph.D. Jindal Chair of Global Business Strategy

Executive Director, Center for Global Business Jindal School of Management University of Texas at Dallas

Fellow, Academy of International Business

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To Agnes, Grace, and James

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Preface ix

About the Author xix

Part 1 Laying Foundations 1

Chapter 1: Globalizing Business 2

Chapter 2: Understanding Formal Institutions: Politics, Laws, and Economics 32

Chapter 3: Emphasizing Informal Institutions: Cultures, Ethics, and Norms 62

Chapter 4: Leveraging Resources and Capabilities 92

PengAtlas 1 118

Integrative Cases 124

Part 2 Acquiring Tools 139

Chapter 5: Trading Internationally 140

Chapter 6: Investing Abroad Directly 174

Chapter 7: Dealing With Foreign Exchange 204

Chapter 8: Capitalizing on Global and Regional Integration 232

PengAtlas 2 264

Integrative Cases 270

Part 3 Strategizing around the Globe 285

Chapter 9: Growing and Internationalizing the Entrepreneurial Firm 286

Chapter 10: Entering Foreign Markets 310

Chapter 11: Managing Global Competitive Dynamics 336

Chapter 12: Making Alliances and Acquisitions Work 364

Chapter 13: Strategizing, Structuring, and Learning around the World 394

PengAtlas 3 424

Integrative Cases 428

Part 4 Building Functional Excellence 465

Chapter 14: Competing on Marketing and Supply Chain Management 466

Chapter 15: Managing Human Resources Globally 492

Brief Contents

iv

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Brief Contents v

Chapter 16: Financing and Governing the Corporation Globally 522

Chapter 17: Managing Corporate Social Responsibility Globally 552

PengAtlas 4 578

Integrative Cases 582

Glossary 598

Name Index 607

Organization Index 617

Subject Index 621

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Preface ix

About the Author xix

Part 1 Laying Foundations 1

Chapter 1: Globalizing Business 2

What Is Global Business? 4

Why Study Global Business? 10

A Unified Framework 14

What Is Globalization? 18

Global Business and Globalization at a Crossroads 21

Organization of the Book 25

Chapter 2: Understanding Formal Institutions: Politics, Laws, and Economics 32

Understanding Institutions 35

What Do Institutions Do? 36

An Institution-Based View of Global Business 38

Political Systems 40

Legal Systems 43

Economic Systems 47

Debates and Extensions 48

Management Savvy 54

Chapter 3: Emphasizing Informal Institutions: Cultures, Ethics, and Norms 62

Where Do Informal Institutions Come From? 64

Culture 65

Cultural Differences 70

Ethics 78

Norms and Ethical Challenges 80

Debates and Extensions 81

Management Savvy 84

Chapter 4: Leveraging Resources and Capabilities 92

Understanding Resources and Capabilities 94

Resources, Capabilities, and the Value Chain 96

From SWOT to VRIO 100

Debates and Extensions 104

Management Savvy 109

Part 1 Integrative Cases 124

1.1 Coca-Cola in Africa 124

1.2 Whose Law Is Bigger: Arbitrating Government-Firm Disputes in the EU 126

1.3 Fighting Counterfeit Motion Pictures 128

1.4 Brazil’s Embraer: From State-Owned Enterprise to Global Leader 131

1.5 Microsoft in China 136

Part 2 Acquiring Tools 139

Chapter 5: Trading Internationally 140

Why Do Nations Trade? 143

Theories of International Trade 145

Realities of International Trade 158

Debates and Extensions 163

Management Savvy 166

Chapter 6: Investing Abroad Directly 174

Understanding the FDI Vocabulary 176

Why Do Firms Become MNEs by Engaging in FDI? 180

Realities of FDI 186

How MNEs and Host Governments Bargain 190

Debates and Extensions 192

Management Savvy 195

Chapter 7: Dealing with Foreign Exchange 204

What Determines Foreign Exchange Rates? 206

Evolution of the International Monetary System 214

Strategic Responses to Foreign Exchange Movements 218

Debates and Extensions 221

Management Savvy 225

Table of Contents

vi

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Chapter 11: Managing Global Competitive Dynamics 336

Competition, Cooperation, and Collusion 339

Institutions Governing Domestic and International Competition 343

Resources Influencing Competitive Dynamics 346

Attacks, Counterattacks, and Signaling 350

Local Firms versus Multinational Enterprises 351

Debates and Extensions 352

Management Savvy 356

Chapter 12: Making Alliances and Acquisitions Work 364

Defining Alliances and Acquisitions 367

Institutions, Resources, Alliances, and Acquisitions 368

Formation of Alliances 374

Evolution and Dissolution of Alliances 376

Performance of Alliances 378

Motives for Acquisitions 379

Performance of Acquisitions 383

Debates and Extensions 384

Management Savvy 386

Chapter 13: Strategizing, Structuring, and Learning around the World 394

Multinational Strategies and Structures 396

How Institutions and Resources Affect Multinational Strategies, Structures, and Learning 404

Worldwide Learning, Innovation, and Knowledge Management 408

Debates and Extensions 412

Management Savvy 415

Part 3 Integrative Cases 428

3.1 Wikimart: Building a Russian Version of Amazon 428

3.2 Private Military Companies 431

3.3 Amazon, Bookoff, and the Japanese Bookselling Industry 435

3.4 Huawei’s Intellectual Property War 438

3.5 Is A Diamond (Cartel) Forever? 446

3.6 The TNK-BP Joint Venture 452

Chapter 8: Capitalizing on Global and Regional Integration 232

Global Economic Integration 234

Organizing World Trade 237

Regional Economic Integration 240

Regional Economic Integration in Europe 242

Regional Economic Integration in the Americas 248

Regional Economic Integration in the Asia Pacific 250

Regional Economic Integration in Africa 252

Debates and Extensions 253

Management Savvy 256

Part 2 Integrative Cases 270

2.1 Canada and the United States Fight Over Pigs 270

2.2 Foreign Direct Investment in the Indian Retail Industry 272

2.3 The Fate of Opel 274

2.4 Jobek do Brasil’s Foreign Exchange Challenges 276

2.5 The EU–Korea Free Trade Agreement 279

Part 3 Strategizing around the Globe 285

Chapter 9: Growing and Internationalizing the Entrepreneurial Firm 286

Entrepreneurship and Entrepreneurial Firms 289

Institutions, Resources, and Entrepreneurship 289

Growing the Entrepreneurial Firm 293

Internationalizing the Entrepreneurial Firm 298

Debates and Extensions 301

Management Savvy 303

Chapter 10: Entering Foreign Markets 310

Overcoming the Liability of Foreignness 312

Where to Enter? 315

When to Enter? 318

How to Enter? 320

Debates and Extensions 326

Management Savvy 329

Contents vii

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3.7 Geely’s Acquisition of Volvo 455

3.8 Hilton Welcomes Chinese Travelers at Home and Abroad 459

Part 4 Building Functional Excellence 465

Chapter 14: Competing on Marketing and Supply Chain Management 466

Three of the Four Ps in Marketing 468

From Distribution Channel to Supply Chain Management 474

The Triple As in Supply Chain Management 475

How Institutions and Resources Affect Marketing and Supply Chain Management 478

Debates and Extensions 481

Management Savvy 483

Chapter 15: Managing Human Resources Globally 492

Staffing 495

Training and Development 500

Compensation and Performance Appraisal 502

Labor Relations 505

Institutions, Resources, and Human Resource Management 506

Debates and Extensions 511

Management Savvy 513

Chapter 16: Financing and Governing the Corporation Globally 522

Financing Decisions 525

Owners 526

Managers 528

Board of Directors 532

Governance Mechanisms as a Package 534

A Global Perspective 536

Institutions, Resources, and Corporate Finance and Governance 538

Debates and Extensions 543

Management Savvy 544

Chapter 17: Managing Corporate Social Responsibility Globally 552

A Stakeholder View of the Firm 555

Institutions, Resources, and Corporate Social Responsibility 561

Debates and Extensions 568

Management Savvy 569

Part 4 Integrative Cases 582

4.1 ESET: From a “Living-Room” Firm to a Global Player in the Antivirus Software Industry 582

4.2 Dallas Versus Delhi 586

4.3 Microfinance: Macro Success or Global Mess? 587

4.4 Sino Iron: Engaging Stakeholders in Australia 589

4.5 Foxconn 595

Glossary 598

Name Index 607

Organization Index 617

Subject Index 621

viii Contents

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Preface

The first two editions of Global Business aspired to set a new standard for interna- tional business (IB) textbooks. Based on the enthusiastic support from students and instructors in Australia, Brazil, Britain, Canada, China, Egypt, France, Hong Kong, India, Indonesia, Ireland, Israel, Lithuania, Malaysia, Puerto Rico, Russia, Slovenia, South Africa, South Korea, Taiwan, Thailand, and the United States, the first two editions achieved unprecedented success. A Chinese translation is now available and a European adaptation (coauthored with Klaus Meyer) has been suc- cessfully launched. In short, Global Business is global.

The third edition aspires to do even better. It continues the market-winning framework centered on one big question and two core perspectives pioneered in the first edition, and has been thoroughly updated to capture the rapidly moving research and events of the past few years. Written for undergraduate and MBA students around the world, the third edition will continue to make IB teaching and learning more (1) engaging, (2) comprehensive, (3) fun, and (4) relevant.

More Engaging As an innovation in IB textbooks, a unified framework integrates all chapters. Given the wide range of topics in IB, most textbooks present the discipline in a fashion that “Today is Tuesday, it must be Luxembourg.” Very rarely do authors address: “Why Luxembourg today?” More important, why IB? What is the big ques- tion in IB? Our unified framework suggests that the discipline can be united by one big question and two core perspectives. The big question is: What deter- mines the success and failure of firms around the globe? To address this question, Global Business introduces two core perspectives, (1) the institution-based view and (2) the resource-based view, in all chapters. It is this relentless focus on our big question and core perspectives that enables this book to engage a variety of IB topics in an integrated fashion. This provides unparalleled continuity in the learning process.

Global Business further engages readers through an evidence-based approach. I have endeavored to draw on the latest research rather than the latest fads. As an active researcher myself, I have developed the unified framework not because it just popped up in my head when I wrote the book. Rather, this is an extension of my own research that consistently takes on the big question and leverages the two core perspectives.1

1 For the big question, see M. W. Peng, 2004, Identifying the big question in international business research, Journal of International Business Studies, 35: 99–108. For the institution-based view, see M. W. Peng, S. L. Sun, B. Pinkham, & H. Chen, 2009, The institution-based view as a third leg for a strategy tripod, Academy of Management Perspectives, 23(3): 63–81; M. W. Peng, D. Wang, & Y. Jiang, 2008, An institution-based view of international business strategy: A focus on emerging economies, Journal of International Business Studies, 39: 920–936. For the resource-based view, see M. W. Peng, 2001, The resource-based view and international business, Journal of Management, 27: 803–829.

ix

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x Preface

Another vehicle to engage students is debates. Most textbooks present knowledge “as is” and ignore debates. But obviously our field has no shortage of debates. It is the responsibility of textbook authors to engage students by introducing cutting- edge debates. Thus, I have written a beefy “Debates and Extensions” section for every chapter.

Finally, this book engages students by packing rigor with accessibility. There is no “dumbing down.” No other competing IB textbook exposes students to an article on how to save Europe by the Managing Director of the International Monetary Fund (In Focus 8.1), a commentary on China’s ten years in the World Trade Organization by the US Ambassador to China (Emerging Markets 8.1), and a Harvard Business Review article on China’s outward foreign direct investment (authored by me—Emerging Markets 6.1). These are not excerpts but full-blown, original articles—the first in an IB (and, in fact, in any management) textbook. These highly readable short pieces directly give students a flavor of the original insights.

More Comprehensive Global Business offers the most comprehensive and innovative coverage of IB topics available on the market. Unique chapters not found in other IB textbooks are:

Chapter 9 on entrepreneurship and small firms’ internationalization. Chapter 11 on global competitive dynamics. Chapter 16 on corporate finance and governance. Chapter 17 on corporate social responsibility (in addition to one full-blown

chapter on ethics, cultures, and norms, Chapter 3). Half of Chapter 12 (alliances and acquisitions) deals with the inadequately

covered topic of acquisitions. Approximately 70% of market entries based on foreign direct investment (FDI) around the world use acquisitions. Yet, none of the other IB textbooks has a chapter on acquisitions—clearly, a missing gap.

The most comprehensive topical coverage is made possible by drawing on the latest and most comprehensive range of the research literature. Specifically, I have accelerated my own research, publishing a total of 30 articles since 2010 after I finished the second edition.2 I have drawn on such latest research to inject cutting- edge thinking into the third edition.

In addition, I have also endeavored to consult numerous specialty journals. For example, the trade and finance chapters (Chapters 5–7) draw on the American Eco- nomic Review, Journal of Economic Literature, and Quarterly Journal of Economics. The entrepreneurship chapter (Chapter 9) consults with the Journal of Business Venturing and Entrepreneurship Theory and Practice. The marketing and supply chain chapter (Chapter 14) draws heavily from the Journal of Marketing, Journal of International Mar- keting, and Journal of Operations Management. The corporate finance and governance chapter (Chapter 16) is visibly guided by research published in the Journal of Finance and Journal of Financial Economics.

The end result is the unparalleled, most comprehensive set of evidence-based insights on the IB market. While citing every article is not possible, I am confident

2 All my articles are listed at www.mikepeng.com and www.utdallas.edu/~mikepeng. Go to “Journal Articles.”

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Preface xi

that I have left no major streams of research untouched. Feel free to check the Name Index to verify this claim.

Finally, the third edition of Global Business continues to have a global set of cases contributed by scholars around the world—an innovation on the IB market. Virtually all other IB textbooks have cases written by book authors. In comparison, this book has been blessed by a global community of case contributors who are based in Austria, Brazil, China, France, Germany, Hong Kong, India, and the United States. Many are experts who are located in, or are from, the countries in which the cases take place. For example, we now have a Brazil case penned by a Brazil-based author (see the Integrative Case on Jobek do Brasil), and two China cases written by China-based authors (see the Integrative Cases on Geely’s acquisition of Volvo and Sino Iron in Australia). This edition also features a Russia case contributed by the world’s top two leading experts on Russian management (see the Integrative Case on Wikimart). The end result is an unparalleled, diverse collection of case materials that will significantly enhance IB teaching and learning around the world.

More Fun If you fear that this book must be very boring because it draws so heavily on cur- rent research, you are wrong. I have used a clear, engaging, conversational style to tell the “story.” Relative to rival books, my chapters are generally more lively and shorter. Some reviewers have commented that reading Global Business is like read- ing a “good magazine.” A large number of interesting anecdotes have been woven into the text. In addition to examples from the business world, non-traditional (“outside-the-box”) examples range from ancient Chinese military writings to mu- tually assured destruction (MAD) strategy during the Cold War, from Shakespeare’s The Merchant of Venice to Tolstoy’s Anna Karenina. Popular movies such as A Few Good Men, Devil’s Advocate, and Legally Blonde are also featured. In addition, numerous Opening Cases, Closing Cases, and In Focus boxes spice up the book. Check out the following fun-filled features:

Partying in Saudi Arabia (Chapter 3 Opening Case) Adding value to the dirtiest job online (In Focus 4.2) Why are US exports so competitive? (Chapter 5 Opening Case) A sticky business in Singapore (In Focus 5.1) Cry for me, Argentina (Chapter 6 Closing Case) The Greek tragedy (Chapter 8 Closing Case) The world’s best place to make Viagra (In Focus 10.1) A fox in the hen house (In Focus 11.2) Brazil’s Whopper deal (Emerging Markets 12.2) Mickey goes to Shanghai (Chapter 13 Opening Case) Wolf wars (Chapter 17 Closing Case) Milton Friedman goes global (Emerging Markets 17.1)

There is one Video Case from BBC News to support every chapter. While vir- tually all competing books have some videos, none has a video package that is so integrated with the learning objectives of every chapter.

Finally, as a new feature introduced since the second edition, PengAtlas allows you to conduct IB research using informative maps and other geographic and cultural literacy tools to enhance your learning.

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xii Preface

More Relevant So what? Chapters in most textbooks leave students to figure out the crucial “So what?” question for themselves. In contrast, I conclude every chapter with an action-packed section titled “Management Savvy.” Each section has at least one table (or one teachable slide) that clearly summarizes the key learning points from a practical standpoint. No other competing IB book is so savvy and so relevant.

Further, ethics is a theme that cuts through the book, with at least one “Ethical Dilemma” feature and a series of Critical Discussion Questions on ethics in each chapter. Finally, many chapters offer career advice for students. For example:

Chapter 1 In Focus 1.3 directly addresses a question many students would ask: What language and what fields should I study?

Chapter 4 develops a resource-based view of the individual—that is, about you, the student. The upshot? You want to make yourself into an “untouch- able” who adds valuable, rare, and hard-to-imitate capabilities indispensable to an organization. In other words, you want to make sure your job cannot be outsourced.

Chapter 15 offers tips on how to strategically and proactively invest in your career now—as a student—for future international career opportunities.

What’s New in the Third Edition? Most importantly, the third edition has (1) highlighted the executive voice by draw- ing more heavily from CEOs and other business leaders, (2) dedicated more space to emerging economies, and (3) enhanced the quantity and variety of cases.

First, since Global Business aims to train a new generation of global business lead- ers, the third edition has featured more extensive quotes and perspectives from global business leaders. These are longer and more visibly prominent break-out quotes—not merely single quotes typically embedded (or “buried”) in paragraphs. In Chapter 1 alone, you will enjoy such insightful quotes from (1) GE’s current chairman and CEO and (2) GE’s former chairman and CEO. In later chapters, the following global business leaders will share their thoughts with you:

Applied Materials’ human resource executive Argentina’s president Bayer North America’s CEO Dow Chemical’s CEO IBM’s CEO IBM’s chief procurement officer IMF’s managing director—a full article TNK-BP’s chairman and CEO and Alfa Group’s founder US Ambassador to China—a full article US Secretary of Justice (representing the Department of Justice’s challenge of AT&T’s proposed merger with T- Mobile) US Secretary of Treasury (on the US-China Strategic and Economic Dialogue) Whole Foods’ co-founder and CEO WTO’s director-general

Second, this edition builds on Global Business’s previous strengths by more prom- inently highlighting global business challenges in and out of emerging economies. This is both a reflection of the global realities in which emerging economies have

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Preface xiii

played a more prominent role and a reflection of my own strong research interest in emerging economies. Specifically, in the third edition, (1) a new Emerging Markets in- chapter feature is launched in every chapter, and (2) 18 out of 23 (78%) of the longer Integrative Cases deal with emerging economies (including one case on Central and Eastern Europe, two cases each on Africa, Brazil, Russia, and India, and six on China).

Third, in response to students’ and professors’ enthusiasm about the wide- ranging and globally relevant cases in previous editions, the third edition has fur- ther enhanced the quantity and variety of cases. The number of Integrative Cases has increased from 15 to 23—a 53% increase. The variety has also been enhanced not only in terms of the geographic diversity noted above, but also in terms of the mix of longer cases and shorter cases. In addition, I have pushed myself to partici- pate more actively in case writing. Therefore, I am very proud to report that of the 23 Integrative Cases in the third edition, I personally wrote 10 (43%). This com- pares very favorably to the one Integrative Case out of a total of 15 that I personally authored in the second edition (representing a mere 7%).

Of course, in addition to these new features, every chapter has been thoroughly updated. Of the 23 Integrative Cases, 19 (83%) are new to this edition. PengAtlas maps have also been updated to capture the latest statistics.

The new BBC News Video Cases provide current, real-world examples of key course topics. The set covers such diverse countries as Brazil, China, Cuba, Dubai, India, Thailand, and Uruguay, and features a broad array of industries from high- tech manufacturing to goat farming.

Support Materials A full set of supplements is available for students and adopting instructors, all de- signed to facilitate ease of learning, teaching, and testing.

Global Business CourseMate. Cengage Learning’s Global Business CourseMate brings course concepts to life with interactive learning, study, and exam prepara- tion tools that support the printed textbook. Through this website, available for an additional fee, students will have access to their own set of PowerPoint® slides, flashcards, and games, as well as the Learning Objectives and Glossary for quick reviews. A set of auto-gradable, interactive quizzes (prepared by Timothy R. Muth of Florida Institute of Technology) will allow students to instantly gauge their comprehension of the material. The quizzes are all tagged to the book’s Learn- ing Objectives, Bloom’s taxonomy, and national standards. Finally, Global Business CourseMate includes interactive maps that delve more deeply into key concepts presented in the book.

Product Support Website. The flashcards, Learning Objectives, and Glossary are available for quick reference on our complimentary student product support website.

Webtutor on BlackBoard® and Webtutor on WebCT.™ Available on two differ- ent platforms, Global Business Webtutor enhances students’ understanding of the material by featuring the Opening Cases and Video Cases, as well as the Glossary, study flashcards, and interactive maps that delve more deeply into key concepts presented in the book.

CengageNOW™ Course Management System. Designed by instructors for instructors, CengageNOW™ mirrors the natural teaching workflow with an

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xiv Preface

easy-to-use online suite of services and resources, all in one program. With this system, instructors can easily plan their courses, manage student assignments, automatically grade, teach with dynamic technology, and assess student progress with pre- and post-tests tagged to course outcomes and national standards. For students, study tools include flashcards, PowerPoint® slides, media quizzes, guided cases, and a set of quizzes based on interactive maps that enhance comprehen- sion of the material and develop cultural and geographic literacy. Diagnostic tools create a personalized study plan for each student that focuses their study efforts. CengageNOW™ operates seamlessly with WebCT™, Blackboard®, and other course management tools.

Global Economic Watch. Cengage Learning’s Global Economic Watch helps instructors bring these pivotal current events into the classroom through a powerful, continuously updated online suite of content, discussion forums, testing tools, and more. The Watch, a first-of-its-kind resource, stimulates discussion and understanding of the global downturn with easily integrated teaching solutions:

A thorough overview and timeline of events leading up to the global economic crisis are included in the ebook module, Impact of the Global Economic Crisis on Small Business

A content-rich blog of breaking news, expert analysis, and commentary— updated multiple times daily—plus links to many other blogs

A powerful real-time database of hundreds of relevant and vetted journal, newspaper, and periodical articles, videos, and podcasts—updated four times every day

Discussion and testing content, PowerPoint® slides on key topics, sample syllabi, and other teaching resources

History is happening now, so bring it into the classroom with The Watch at www.cengage.com/thewatch.

Instructor’s Resource CD (IRCD). Instructors will find all of the teaching resources they need to plan, teach, grade, and assess student understanding and progress at their fingertips with this all-in-one resource for Global Business. The IRCD contains:

Instructor’s Manual—This valuable, time-saving Instructor’s Manual in- cludes comprehensive resources to streamline course preparation, including teaching suggestions, lecture notes, answers to all chapter questions, and Integrative Case discussion guides. Also included are discussion guidelines and answers for the Video Cases, prepared by Carol Decker.

Test Bank—The Global Business Test Bank in ExamView® software allows instructors to create customized texts by choosing from 35 True/False, 35 Multiple Choice, and at least 8 short answer/essay questions for each of the 17 chapters. Ranging in difficulty, all questions have been tagged to the text’s Learning Objectives, Bloom’s taxonomy, and other national standards to ensure that students are meeting the course criteria.

PowerPoint® Slides—This comprehensive set of more than 250 Powerpoint® slides will assist instructors in the presentation of the chapter material, en- abling students to synthesize key global concepts.

Global Business DVD. Perhaps one of the most exciting and compelling bonus features of this program, these 17 short and powerful video clips, produced by BBC

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Preface xv

News, provide current and relevant real-world examples. The set covers such di- verse countries as Brazil, China, Cuba, Dubai, India, Thailand, and Uruguay, and features a broad array of industries from high-tech manufacturing to goat farming.

Instructor Product Support Website. For those instructors who prefer to access supplements online, the Instructor’s Manual, PowerPoint® slides, and Test Bank are also available through the instructor’s product support website.

Acknowledgments As Global Business launches its third edition, I first want to thank all the customers— professors, instructors, and students around the world who have made the book’s success possible. A special thank-you goes to my friend and colleague, Klaus Meyer (China Europe International Business School), who spearheaded the develop- ment of International Business, which was tailored for European (or, more broadly, European, Middle Eastern, and African [EMEA]) students. Klaus has made Global Business more global.

At UT Dallas, I thank my colleagues Dan Bochsler, Larry Chasteen, Tev Dalgic, Van Dam, Greg Dess, Dave Ford, Richard Harrison, Maria Hasenhuttl, Charlie Hazzard, Marilyn Kaplan, Seung-Hyun Lee, Elizabeth Lim, John Lin, Livia Markóczy, Joe Picken, Roberto Ragozzino, Orlando Richard, Jane Salk, Mary Vice, Eric Tsang, and Habte Woldu, as well as the supportive leadership team—Hasan Pirkul (dean), Varghese Jacob (associate dean), and Greg Dess (area coordinator). I also thank my two PhD students, Brian Pinkham (now at Texas Christian University) and Steve Sauerwald, for their research assistance. Three PhD students (Canan Mutlu, Brian Pinkham, and Weichieh Su) and five MBA students (Simon Ebenezer, Matthew Lafever, Katie Metzler, Katie Ryan, and Chris Spartz) authored excellent case materials.

At South-Western Cengage Learning, I thank the “Peng team:” Erin Joyner, Publisher; Michele Rhoades, Senior Acquisitions Editor; Jennifer King, Developmen- tal Editor; Emily Nesheim and Tamborah Moore, Senior Content Project Managers; Jonathan Monahan, Marketing Manager; Stacy Shirley, Senior Art Director; and Tamara Grega, Editorial Assistant.

In the academic community, I thank Ben Kedia (University of Memphis) for inviting me to conduct faculty training workshops in Memphis every year since 1999, and Michael Pustay (Texas A&M University) for co-teaching these workshops with me—widely known as the “M&M Show” in the IB field. Discussions with over 200  colleagues who came to these faculty workshops over the last decade have helped shape this book into a better product. I also appreciate the meticulous and excellent comments from the reviewers:

Nadeem M. Firoz (Montclair State University) Andrew Fleck (Fox Valley Technical College) Anna Helm (George Washington University) P. Michael McLain (Hampton University) Mark Quinn (Xavier University of Louisiana) Al Saber (Friends University) Sudhir Sachdev (Farmingdale State College)

Continued thanks to the reviewers of the previous editions:

Syed Ahmed (Cameron University) Richard Ajayi (University of Central Florida, Orlando)

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xvi Preface

Basil Al-Hashimi (Mesa Community College) Verl Anderson (Dixie State College of Utah) Peter L. Banfe (Ohio Northern University) Lawrence A. Beer (Arizona State University) Tefvik Dalgic (University of Texas at Dallas) Tim R. Davis (Cleveland State University) George DeFeis (Monroe College, Bronx) Ping Deng (Maryville University) Norb Elbert (Eastern Kentucky University) Joe Horton (University of Central Arkansas) Samira Hussein (Johnson County Community College) Ann L. Langlois (Palm Beach Atlantic University) Lianlian Lin (California State Polytechnic University, Pomona, California) Ted London (University of Michigan) Martin Meznar (Arizona State University, West) Dilip Mirchandani (Rowan University) Timothy R. Muth (Florida Institute of Technology) Don A. Okhomina (Fayetteville State University) William Piper (Alcorn State University) Charles A. Rarick (Barry University) Tom Roehl (Western Washington University) Bala Subramanian (Morgan State University) Gladys Torres-Baumgarten (Kean University) Susan Trussler (University of Scranton) William R. Wilkerson (University of Virginia) Attila Yaprak (Wayne State University)

In addition, I thank many colleagues who provided informal feedback to me on the book. Space constraints here force me to only acknowledge colleagues who wrote me since the second edition, since colleagues who wrote me earlier were thanked in earlier editions.

Paul Beamish (University of Western Ontario, Canada) Santanu Borah (University of North Alabama, USA) Thierry Brusselle (Chaffey Community College, USA) Lauren Carey (University of Miami, USA) Ping Deng (Maryville University, USA) Todd Fitzgerald (Saint Joseph’s University, USA) Dennis Garvis (Washington and Lee University, USA) John Gerace (Chestnut Hill College, USA) Mike Geringer (Ohio University, USA) C. Gopinath (Suffolk University, USA) Charlie Hazzard (University of Texas at Dallas, USA) Chad Hilton (University of Alabama, USA) Anisul Islam (University of Houston, USA) Basil Janavaras (Minnesota State University, USA) Marshall Shibing Jiang (Brock University, Canada) Somnath Lahiri (Illinois State University, USA) Ann Langlois (Palm Beach Atlantic University, USA) Lianlian Lin (California State Polytechnic University, USA) Dong Liu (Georgia Institute of Technology, USA)

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Preface xvii

David Liu (George Fox University, USA) Ted London (University of Michigan, USA) Charles Mambula (Langston University, USA) Daniel McCarthy (Northeastern University, USA) Hemant Merchant (Florida Atlantic University, USA) Debmalya Mukherjee (University of Akron, USA) Asmat Nizam (Universiti Utara, Malaysia) Kenny Oh (University of Missouri at St. Louis, USA) Eydis Olsen (Drexel University, USA) Sheila Puffer (Northeastern University, USA) Gongming Qian (Chinese University of Hong Kong, China) David Reid (Seattle University, USA) Surekha Rao (Indiana University Northwest, USA) Al Rosenbloom (Dominican University, USA) Anne Smith (University of Tennessee, USA) Clyde Stoltenberg (Wichita State University, USA) Steve Strombeck (Azusa Pacific University, USA) Sunny Li Sun (University of Missouri at Kansas City, USA) Qingjiu (Tom) Tao (James Madison University, USA) Vas Taras (University of North Carolina at Greensboro, USA) Rajaram Veliyath (Kennesaw State University, USA) Jose Vargas-Hernandez (Universidad de Guadalajara, Mexico) Loren Vickery (Western Oregon University, USA) George White (Old Dominion University, USA) Habte Woldu (University of Texas at Dallas, USA) Richard Young (Minnesota State University, USA) Wu Zhan (University of Sydney, Australia)

I also want to thank three very special colleagues: Liu Yi (Shanghai Jiaotong University), Xie En, and Wang Longwei (Xi’an Jiaotong University) in China. They loved the book so much that they were willing to endure the pain of translating it into Chinese. Their hard work has enabled Global Business to reach wider audiences globally. For the third edition, 28 colleagues graciously contributed cases:

Christoph Barmeyer (Passau University, Germany) Dirk Michael Boehe (Insper Institute of Education and Research, Brazil) Charles Byles (Virginia Commonwealth University, USA) Peggy Chaudhry (Villanova University, USA) Jessica Chelekis (University of Southern Denmark, Denmark) Yuan Yi Chen (Hong Kong Baptist University, China) Zhu Chen (PFC Energy, Beijing, China) Simon Ebenezer (University of Texas at Dallas, USA) Juan España (National University, USA) Steven Globerman (Western Washington University, USA) Matthew Lafever (University of Texas at Dallas, USA) Ulrike Mayrhoder (University Lyon 3, France) Daniel McCarthy (Northeastern University, USA) Katie Metzler (University of Texas at Dallas, USA) Klaus Meyer (China Europe International Business School, China) Susan Mudambi (Temple University, USA) Canan Mutlu (University of Texas at Dallas, USA)

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xviii Preface

Brian Pinkham (Texas Christian University, USA) Sheila Puffer (Northeastern University, USA) Katie Ryan (University of Texas at Dallas, USA) Arnold Schuh (Vienna University of Economics and Business, Austria) Chris Spartz (University of Texas at Dallas, USA) Charles Stevens (University of Wyoming, USA) Weichieh Su (University of Texas at Dallas, USA) Sunny Li Sun (University of Missouri at Kansas City, USA) Michael Young (Hong Kong Baptist University, China) Yanli Zhang (Montclair State University, USA) Alan Zimmerman (City University of New York, USA)

In addition, the work of the following prominent authors was reprinted to grace the pages of this book:

Rohit Deshpande (Harvard Business School) and Anjali Raina (HBS India Research Center, India)—coauthor of “The Ordinary Heroes of the Taj” Mikhail Fridman (TNK-BP and Alfa Group, Russia)—chairman and CEO of TNK-BP and founder of Alfa Group Vijay Govindarajan and Chris Trimble (Dartmouth College)—coauthor of Reverse Innovation Christine Lagarde (International Monetary Fund)—Managing Director of the IMF Gary Locke (US Embassy, Beijing, China)—US Ambassador to China Michael Porter (Harvard Business School) and Mark Kramer (FSG)—coauthor of “Creating Shared Value” Jack Welch and Suzy Welch (BusinessWeek)—Jack is the retired chairman and CEO of GE and Suzy is a former editor of Harvard Business Review

Last, but by no means least, I thank my wife Agnes, my daughter Grace, and my son James—to whom this book is dedicated. I have named Agnes CEO, CFO, CIO, CTO, and CPO for our family, the last of which is coined by me, which stands for “chief parenting officer.” When the first edition was conceived, Grace was three, and James one. When the second edition came out, Grace declared a career inter- est in being a rock star, and James a race car driver. Now my ten-year-old Grace, already a voracious reader and writer, can help me edit, and my eight-year-old James can help me enter grades. Grace is writing and editing her 17th short story, called My Magic Life, and James is very interested in creating Lego models. For now, Grace wants to be a lawyer, and James a banker. As a third-generation professor in my family, I can’t help but wonder whether one (or both) of them will become a fourth-generation professor. To all of you, my thanks and my love.

MWP

December 1, 2012

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About the Author

Mike W. Peng is the Jindal Chair of Global Business Strategy at the Jindal School of Management, University of Texas at Dallas, a National Science Foundation CAREER Award winner, and a Fellow of the Academy of International Business. He is also Executive Director of the Center for Global Business, which he founded. At UT Dallas, he has been the number-one contributor to the 45 top journals tracked by Financial Times, which has ranked UT Dallas as a top-20 school in research world- wide and its MBA and EMBA programs increasingly in the top tier.

Professor Peng holds a bachelor’s degree from Winona State University, Minnesota, and a PhD degree from the University of Washington, Seattle. Between 2005 and 2011, he was the first Provost’s Distinguished Professor at UT Dallas, a chair position that was created to attract him to join the faculty. He had previously been an associate professor (with tenure) at the Ohio State University. Prior to that, he had served on the faculty at the Chinese University of Hong Kong and the University of Hawaii. He has taught in five states in the United States (Hawaii, Ohio, Tennessee, Texas, and Washington) as well as China, Hong Kong, and Vietnam. He has also held visiting or courtesy appointments in Australia, Britain, China, Denmark, Hong Kong, and the United States. In addition to these countries, he has presented papers in Austria, Brazil, France, Germany, Japan, Macau, Puerto Rico, Singapore, South Korea, Switzerland, and Taiwan.

Professor Peng is one of the most prolific and most influential scholars in inter- national business (IB). During the decade 1996–2006, he was the top-seven con- tributor to IB’s number-one premier outlet: Journal of International Business Studies. His research is also among some of the most widely cited—both the United Nations and the World Bank have cited his work. A Journal of Management article found him to be among the top 65 most widely cited management scholars, and an Academy of Management Perspectives study found him to be the fourth most influential manage- ment scholar both inside and outside of academia (measured by academic citations and non-edu Google webpages) among professors who obtained their PhD since 1991. Overall, Professor Peng has published over 100 articles in leading journals, over 30 pieces in non-refereed outlets, and five books. Since the launch of Global Business’s second edition, he has published not only in top IB journals, such as the Academy of Management Journal, Journal of International Business Studies, Journal of World Business, and Strategic Management Journal, but also in leading outlets in op- erations ( Journal of Operations Management), entrepreneurship ( Journal of Business Venturing and Entrepreneurship Theory and Practice), and human resources (Interna- tional Journal of Human Resource Management).

Professor Peng’s market leading textbooks, Global Business, Global Strategy, and GLOBAL, are studied in over 30 countries and have been translated into Chinese, Spanish, and Portuguese. A European adaptation, International Business (with Klaus Meyer), has been successfully launched.

Professor Peng is active in leadership positions. He has served on the edito- rial boards of AMJ, AMR, JIBS, JMS, JWB, and SMJ, and guest-edited a special

xix

co ur

te sy

o f

M ik

e P

en g

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xx About the Author

issue for the JMS. At the Academy of International Business (AIB), he co-chaired the AIB/JIBS Frontiers Conference in San Diego (2006), guest-edited a JIBS special issue (2010), chaired the Emerging and Transition Economies track for the Nagoya conference (2011), and chaired the Richard Farmer Best Disserta- tion Award Committee for the Washington conference (2012). In 2012, he was elected to be a Fellow of the AIB, joining a distinguished group of about 80 senior scholars who made most significant contributions to IB. At the Strategic Manage- ment Society (SMS), he was elected to chair the Global Strategy Interest Group. He also co-chaired the SMS Special Conference on China in Shanghai (2007). He served one term as Editor-in-Chief of the Asia Pacific Journal of Management. During his editorial tenure, he managed the doubling of submission numbers and the successful bid to enter the Social Sciences Citation Index (SSCI), which reported APJM’s first citation impact to be 3.36 and rated it as the top 18 among 140 management journals for 2010.

Professor Peng is also an active consultant, trainer, and keynote speaker. He has provided on-the-job training to over 300 professors. He has consulted and been a keynote speaker for multinational enterprises (such as AstraZeneca, Berlitz, KOSTA, Nationwide, SAFRAN, and Texas Instruments), non-profit organiza- tions (such as Greater Dallas Asian American Chamber of Commerce and World Affairs Council of Dallas-Fort Worth), educational and funding organizations (such as Harvard University Kennedy School of Government, Hong Kong Research Grants Council, National Science Foundation of the United States, Social Sciences and Humanities Research Council of Canada, and the University of Memphis), and national and international organizations (such as the US-China Business Council, US Navy, and World Bank).

Professor Peng has attracted close to $1 million in external funding. His hon- ors include a National Science Foundation CAREER Grant, a US Small Business Administration Best Paper Award, a (lifetime) Distinguished Scholar Award from the Southwestern Academy of Management, and a (lifetime) Scholarly Contribu- tion Award from the International Association for Chinese Management Research. He has been quoted in The Economist, Newsweek, Dallas Morning News, Smart Business Dallas, Atlanta Journal-Constitution, The Exporter Magazine, The World Journal, Business Times (Singapore), Sing Tao Daily (Vancouver), and Brasil Econômico (São Paulo), and on the Voice of America.

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Laying Foundations

Chapters 1 Globalizing Business

2 Understanding Formal Institutions: Politics, Laws, and Economics

3 Emphasizing Informal Institutions: Cultures, Ethics, and Norms

4 Leveraging Resources and Capabilities

p a r t

1 D

ig ita

l A rt

/S pi

rit /C

or bi

s

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Learning Objectives

After studying this chapter, you should be able to

1-1 explain the concepts of international business and global business, with a focus on emerging economies.

1-2 give three reasons why it is important to study global business.

1-3 articulate one fundamental question and two core perspectives in the study of global business.

1-4 identify three ways of understanding what globalization is.

1-5 state the size of the global economy and its broad trends and understand your likely bias in the globalization debate.

F.P.O.

Chapter

1 In

di a

P ic

tu re

s R

M /D

in od

ia P

ho to

s/ A

la m

y Li

m ite

d

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Globalizing Business

In 1994, when Mahindra & Mahindra (M&M) arrived in the United States, it was already a powerhouse in its native India. The company, founded as a steelmaker in 1945, had entered the agriculture market nearly 20 years later, partnering with International Harvester to manufacture a line of sturdy 35-horsepower tractors under the Mahindra name.

The Mahindra tractors became very popular in India. They were affordably priced and fuel efficient, two qualities highly valued by thrifty Indian farmers, and the machines were sized appropriately for small Indian farms. Over the years, M&M continued to in- novate to perfect its offerings, and its tractors prolif- erated throughout India’s vast agricultural regions. The Mahindra brand became well established and respected. By the mid-1990s, the company was one of India’s top tractor manufacturers—and it was ready for new challenges. The lucrative US market beckoned.

When Mahindra USA (MUSA) opened for busi- ness, Deere & Company—famous for its John Deere brand—was the dominant player. Deere’s bread and butter were enormous machines ranging as high as 600 horsepower for industrial-scale agribusiness. Rather than trying to develop a product that could com- pete head-on with Deere, M&M aimed for a smaller agricultural niche, one in which it could grow and make the most of its strengths.

Mahindra figured its little tractor would be perfect for hobby farmers, landscapers, and building contractors. The machine was sturdy, extremely reliable, and priced to sell. With a few modifications for the US market—such as supersized seats and larger brake pedals to accommo- date larger American bodies—Mahindra was good to go.

But the company was far from home and hardly a household name. The few Americans who had heard of the brand thought of it variously as “red,” “foreign,” or “cheap.” Even domestic competitors were barely aware of the newcomer. Deere gave more of its atten- tion to Case and New Holland than to Mahindra. Fly- ing below the radar, MUSA decided to make its mark through personalized service.

MUSA built close relationships with small dealer- ships, particular family-run operations. Rather than saddle dealers with expensive inventory, MUSA allowed them to run on a just-in-time basis, offering to deliver a tractor within 24 to 48 hours of receiving the order. MUSA also facilitated financing. In return, Mahindra benefited from the trust the dealers enjoyed in their communities.

MUSA also built close relationships with custom- ers. Some 10% to 15% of M&M tractor buyers got phone calls from the company’s president, who asked whether they were pleased with the buying experience and their new tractors. The company also offered special incentives—horticultural scholarships,

O p e n i n g C a s e

EmErging markEts: Mahindra & Mahindra versus John Deere

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4 Part One Laying Foundations

for example—to neglected market segments such as female hobby farmers.

This high-touch strategy paid off handsomely. MUSA’s US sales growth averaged 40% per year from 1999 to 2006. This prompted David C. Everitt, president of Deere’s agricultural division, to remark that Mahindra “could someday pass Deere in global unit sales.”

Deere responded with short-lived—and seemingly desperate—cash incentives to induce Mahindra buy- ers to trade for a Deere. This had the unintended effect of promoting M&M’s brand (“And we didn’t even pay for it,” said Anjou Choudhari, CEO of M&M’s farm equipment sector from 2005 to 2010). Mahindra fired back with an ad featuring the headline: “Deere John, I have found someone new.”

As Mahindra enjoyed growing success in America, Deere struggled to gain a foothold in India. Unlike

Mahindra, which had innovated both its product and its processes for the US market, Deere tried to tempt Indian farmers with the same product that had under- written its success at home. The strategy did not work, and Deere was forced to re-engineer its thinking as well as its product.

“We gave a wake-up call to John Deere,” noted Choudhari. “Our global threat was one of the motiva- tions for Deere to design a low-horsepower tractor—in India and for India.”

In the meantime, M&M has become the number- one tractor maker worldwide, as measured by units sold.

Source: This case was written by Professors Vijay Govindarajan and Chris Trimble (both at the Tuck School of Business, Dartmouth College). It was an excerpt from V. Govindarajan & C. Trimble, 2012, Reverse Innova- tion (pp. 10–11), Boston: Harvard Business Review Press.

How do firms such as Mahindra & Mahindra and Deere compete in India, the United States, and elsewhere? What determines the success and failure of these firms—and numerous others—around the world? This book will address these and other impor- tant questions on global business.

1-1 What Is Global Business? 1-1a Defining International Business and Global Business Traditionally, international business (IB) is defined as a business (or firm) that en- gages in international (cross-border) economic activities. It can also refer to the action of doing business abroad. The previous generation of IB textbooks almost always takes the foreign entrant’s perspective. Consequently, such books deal with issues such as how to enter foreign markets and how to select alliance partners. The most frequently discussed foreign entrant is the multinational enterprise (MNE), de- fined as a firm that engages in foreign direct investment (FDI) by directly investing in, controlling, and managing value-added activities in other countries.1 Using our Opening Case, traditional IB textbooks would focus on how MNEs such as Deere enter India by undertaking FDI there. MNEs and their cross-border activities are, of course, important, but they only cover one side of IB—the foreign side. Students educated by these books often come away with the impression that the other side of IB—namely, domestic firms—does not exist. Of course, that is not true. Do- mestic firms such as Mahindra & Mahindra do not just sit around in the face of foreign entrants. Domestic firms actively compete and/or collaborate with foreign entrants such as International Harvester. Sometimes strong domestic firms such as Mahindra & Mahindra have also gone overseas themselves. Overall, focusing on the foreign entrant side captures only one side of the coin at best.2

There are two key words in IB: international (I) and business (B).3 However, many previous textbooks focus on the international aspect (the foreign entrant) to such an extent that the business part (which also includes domestic business) almost

Learning Objective Explain the concepts of international business and global business, with a focus on emerging economies.

1-1

International business (IB)

(1) A business (or firm) that engages in international (cross- border) economic activities and/ or (2) the action of doing busi- ness abroad.

Multinational enterprise (MNE)

A firm that engages in foreign direct investment (FDI).

Foreign direct investment (FDI)

Investment in, controlling, and managing value-added activities in other countries.

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Chapter 1 Globalizing Business 5

disappears. This is unfortunate, because IB is fundamentally about B in addition to being I. To put it differently, the IB course in the undergraduate and MBA curri- cula at numerous business schools is probably the only one with the word “business” in its title. All other courses you take are labeled management, marketing, finance, and so on, representing one functional area but not the overall picture of business. Does it matter? Of course! It means that your IB course is an integrative course that has the potential to provide you with an overall business perspective (rather than a functional view) grounded in a global environment. Consequently, it makes sense that your textbook should give you both the I and B parts, not just the I part.

To cover both the I and the B parts, global business is defined in this book as business around the globe—thus, the title of this book is Global Business (not IB). In other words, global business includes both (1) international (cross-border) busi- ness activities covered by traditional IB books and (2) domestic business activities. Such deliberate blurring of the traditional boundaries separating international and domestic business is increasingly important today, because many previously national (domestic) markets are now globalized.

Consider the competition in college textbooks, such as this Global Business book you are studying now. Not long ago, competition among college business textbook publishers was primarily on a nation-by-nation basis. The Big Three—South-Western Cengage Learning (our publisher, which is the biggest in the college business textbook market), Prentice Hall, and McGraw-Hill—primarily competed in the United States. A different set of publishers competed in other countries. As a result, most textbooks studied by British students would be authored by British professors and published by British publishers, most textbooks studied by Brazilian students would be authored by Brazilian professors and published by Brazilian publishers, and so on. Now South- Western Cengage Learning (under British and Canadian ownership), Pearson Pren- tice Hall (under British ownership), and McGraw-Hill (still under US ownership) have significantly globalized their competition, thanks to the rising demand for high- quality business textbooks in English. Around the globe, they are competing against each other in many markets, publishing in multiple languages and versions. For in- stance, Global Business and its sister books, Global Strategy, GLOBAL (paperback), and International Business (an adaptation for the European market), are published by dif- ferent subsidiaries in Chinese, Spanish, and Portuguese in addition to English, reach- ing customers in over 30 countries. Despite such worldwide spread of competition, in each market—down to each school—textbook publishers have to compete locally. In other words, no professor teaches globally, and all students study locally. This means that Global Business has to win adoption from every class, every semester. Overall, it becomes difficult to tell in this competition what is international and what is domestic. Thus, “global” seems to be a better word to capture the essence of this competition.

1-1b Global Business and Emerging Economies Global Business also differs from other books on IB because most focus on competi- tion in developed economies. Here, by contrast, we devote extensive space to com- petitive battles waged throughout emerging economies, a term that has gradually replaced the term “developing countries” since the 1990s. Another commonly used term is emerging markets (see PengAtlas Map 1.1). How important are emerging economies? Collectively, they now contribute approximately 45% of the global gross domestic product (GDP), as shown in Figure 1.1. Note that this percentage is adjusted for purchasing power parity (PPP), which is an adjustment to reflect the dif- ferences in cost of living (see In Focus 1.1). Using official (nominal) exchange rates

Global business

Business around the globe.

Emerging economies

A term that has gradually re- placed the term “developing countries” since the 1990s.

Emerging markets

A term that is often used in- terchangeably with “emerging economies.”

Gross domestic product (GDP)

The sum of value added by resident firms, households, and governments operating in an economy.

Purchasing power parity (PPP)

A conversion that determines the equivalent amount of goods and services that different currencies can purchase.

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6 Part One Laying Foundations

Figure 1.1 The Contributions of Emerging Economies Relative to Developed Economies (World %)

80 90 10060 7050403020100

Developed economies

FDI outflows

GDP (nominal exchange rates)

Exports of goods and services

FDI inflows

GDP (purchasing power parity)

Population

BRIC Emerging economies excluding BRIC

Sources: Data extracted from (1) United Nations, 2011, World Investment Report 2011, New York and Geneva: UN; (2) World Bank, 2012, World Development Indicators database, Washington: World Bank. All data refer to 2011.

GDP, GNP, GNI, PPP—there is a bewildering variety of acronyms that are used to measure economic develop- ment. It is useful to set these terms straight before pro- ceeding. Gross domestic product (GDP) is measured as the sum of value added by resident firms, households, and governments operating in an economy. For exam- ple, the value added by foreign-owned firms operating in Mexico would be counted as part of Mexico’s GDP. However, the earnings of non-resident sources that are sent back to Mexico (such as earnings of Mexicans who do not live and work in Mexico and dividends received by Mexicans who own non-Mexican stocks) are not in- cluded in Mexico’s GDP. One measure that captures this is gross national product (GNP). More recently, the World Bank and other international organizations have used a new term, gross national income (GNI), to supersede GNP. Conceptually, there is no difference between GNI and GNP. What exactly is GNI/GNP? It comprises GDP plus income from non-resident sources abroad.

While GDP, GNP, and now GNI are often used as yardsticks of economic development, differences in cost of living make such a direct comparison less mean- ingful. A dollar of spending in, say, Thailand can buy a lot more than in Japan. Therefore, conversion based on purchasing power parity (PPP) is often necessary.

The PPP between two countries is the rate at which the currency of one country needs to be converted into that of a second country to ensure that a given amount of the first country’s currency will purchase the same volume of goods and services in the second country (see Chapter 7 for details). According to the In- ternational Monetary Fund (IMF), the Swiss per capita GDP is $81,161 based on official (nominal) exchange rates—higher than the US per capita GDP of $48,387. However, everything is more expensive in Switzerland. A Big Mac costs $6.81 in Switzerland versus $4.20 in the United States. Thus, Switzerland’s per capita GDP based on PPP becomes $43,370—lower than the US per capita GDP based on PPP, $48,387 (the IMF uses the United States as benchmark in PPP calculation). On a worldwide basis, measured at official exchange rates, emerging economies’ share of global GDP is approxi- mately 26%. However, measured at PPP, it is about 43% of the global GDP. Overall, when you read statis- tics about GDP, GNP, and GNI, always pay attention to whether these numbers are based on official exchange rates or PPP, which can make a huge difference.

Sources: Based on (1) Economist, 2012, Big Mac index, January 14: 93; (2) Economist, 2006, Grossly distorted picture, February 11: 72; (3) International Monetary Fund, 2012, World Economic Outlook, April, Washington, DC: IMF.

Setting the Terms Straight IN Focus 1.1

Gross national product (GNP)

GDP plus income from non- resident sources abroad.

Gross national income (GNI)

GDP plus income from non- resident sources abroad. GNI is the term used by the World Bank and other international organizations to supersede the term GNP.

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Chapter 1 Globalizing Business 7

without adjusting for PPP, emerging economies contribute about 26% of the global GDP. Why is there such a huge difference between the two measures? Because the cost of living (such as housing and haircuts) in emerging economies tends to be lower than that in developed economies. For instance, one dollar spent in Mexico can buy a lot more than one dollar spent in the United States.

Table 1.1 lists the 33 countries that are classified as “developed economies.” The rest of the world (more than 150 countries) can be broadly labeled as “emerging economies.” Of these emerging economies, Brazil, Russia, India, and China—commonly referred to as BRIC—command more attention. As a group, they generate 17% of world exports, absorb 16% of FDI inflows, and contribute 28% of world GDP (on a PPP basis). Commanding a lion’s share, BRIC contrib- ute 62% of the GDP of all emerging economies (on a PPP basis). BRIC also generate 8% of world FDI outflows. MNEs from BRIC (such as Mahindra & Mahindra in the Opening Case) are increasingly visible in making investments and acquiring firms around the world.4 Clearly, major emerging economies (es- pecially BRIC) and their firms have become a force to be reckoned with in global business.5 In addition to BRIC, other interesting terms include BRICS (BRIC + South Africa), BRICM (BRIC + Mexico), and BRICET (BRIC + Eastern Europe and Turkey).

Does it make sense to group so many countries with tremendous diversity in terms of history, geography, politics, and economics together as “emerging economies”? As compared to developed economies, the label of “emerging econo- mies,” rightly or wrongly, has emphasized the presumably homogenous nature of so many different countries. While this single label has been useful, more recent research has endeavored to enrich it.6

Specifically, the two dimensions illustrated in Figure 1.2 can help us differenti- ate various emerging economies.7 Vertically, the development of market-supporting political, legal, and economic institutions has been noted as a crucial dimension of

BRIC

Brazil, Russia, India, and China.

Table 1.1 Classifying Developed Economies versus Emerging Economies

33 developed economies as classified by the International Monetary Fund (IMF)

Australia Hong Kong Portugal

Austria Iceland Singapore

Belgium Ireland Slovak Republic

Canada Israel Slovenia

Cyprus Italy South Korea

Czech Republic Japan Spain

Denmark Luxembourg Sweden

Finland Malta Switzerland

France Netherlands Taiwan

Germany New Zealand United Kingdom

Greece Norway United States

All the other 149 economies are classified by the IMF as emerging economies

Source: IMF, www.imf.org. The IMF recognizes 182 countries and economies. It labels developed economies “advanced economies” and labels emerging economies “emerging and developing economies.”

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8 Part One Laying Foundations

institutional transitions in many emerging economies.8 Horizontally, the develop- ment of infrastructure and factor markets is also crucial.

Stereotypical or traditional emerging economies suffer from both the lack of institutional development and the lack of infrastructure and factor market development. Most emerging economies 20 years ago would have fit this descrip- tion. Today, some emerging economies that have made relatively little progress along these two dimensions (such as Belarus and Zimbabwe) still exist.

However, a lot has changed. A great deal of institutional development and in- frastructure and factor market development have taken place. Such wide-ranging development has resulted in the emergence of a class of mid-range emerging econo- mies that differ from both traditional emerging economies and developed econ- omies. For example, the top down approach to government found in China has facilitated infrastructure and factor market development. But China’s political and market institutions tend to be underdeveloped relative to physical infrastructure. Alternatively, India has strong political institutions supporting market institutions (although there is still significant corruption in government bureaucracies). While Indian government policy reforms have facilitated better market institutions and associated economic development, world-class physical infrastructure is lacking. In the middle area of Figure 1.2, Brazil and Russia can be placed as examples. In these mid-range emerging economies, there are some democratic political institutions (despite the recent setback in Russia—see Chapter 2 Opening Case) and some in- frastructure and factor market development. Finally, some economies have clearly graduated from the “emerging” phase and become what we call “newly developed economies.” South Korea may be an exemplar country as it has more balanced development in both institutional development and infrastructure/factor markets.

1-1c Base of the Pyramid and Reverse Innovation The global economy can be viewed as a pyramid (Figure 1.3). The top consists of about one billion people with per capita annual income of $20,000 or higher.

Mid-Range Emerging

Economies (e.g., INDIA)

Mid-Range Emerging

Economies (e.g., CHINA)

Traditional Emerging

Economies (e.g., BELARUS)

Less

Infrastructure and Factor Market Development In

st it

ut io

na l D

ev el

o p

m en

t

More

W ea

k St

ro ng Newly

Developed Economies

(e.g., SOUTH KOREA)

Figure 1.2 A Typology of Emerging Economies

Source: Adapted from R. Hoskisson, M. Wright, I. Filatotchev, & M. W. Peng, 2013, Emerging multinationals from mid-range economies: The influence of institutions and factor markets, Journal of Management Studies (in press).

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Chapter 1 Globalizing Business 9

These are mostly people who live in the developed economies in the Triad, which consists of North America, Western Europe, and Japan. Another billion people earning $2,000 to $20,000 per year make up the second tier. The vast majority of humanity—about five billion people—earn less than $2,000 per year and com- prise the base of the pyramid (BOP). Most MNEs focus on the top and second tiers and end up ignoring the base of the pyramid.9 An increasing number of such low- income countries have shown a great deal of economic opportunities as income levels have risen (see the Closing Case). More Western MNEs, such as GE, are in- vesting aggressively in the base of the pyramid and leveraging their investment to tackle markets in both emerging and developed economies.

One interesting recent development out of emerging economies is reverse innovation—an innovation that is adopted first in emerging economies and then diffused around the world.10 Traditionally, innovations are generated by Triad-based multinationals with the needs and wants of rich customers at the top of the pyramid in mind. When such multinationals entered lower-income economies, they tended to simplify the product features and lower the prices. In other words, the innovation flow is top down. However, as Deere & Company found out in India, its large-horsepower tractors designed for American farmers were a poor fit for the very different needs and wants of Indian farmers. Despite Deere’s efforts to simplify the product and reduce the price, the price was still too high in India. Instead, Mahindra & Mahindra brought its widely popular small-horsepower tractors that were developed in India to the United States, and carved out a growing niche that eventually propelled it to be the world’s largest tractor maker by units sold (see the Opening Case). In response, Deere abandoned its US tractor designs and “went native” in India, by launching a local design team charged with developing something from scratch—with the needs and wants of farmers in India (or, more broadly, in emerging economies) in mind. The result was a 35-horsepower tractor that

Triad

North America, Western Europe, and Japan.

Base of the pyramid (BoP)

Economies where people make less than $2,000 per capita per year.

Reverse innovation

An innovation that is adopted first in emerging economies and is then diffused around the world.

Base of the Pyramid Per capita GDP/GNI < $2,000

Approximately five billion people

Second Tier Per capita GDP/GNI $2,000–$20,000

Approximately one billion people

Top Tier Per capita GDP/GNI > $20,000

Approximately one billion people

Sources: Adapted from (1) C. K. Prahalad & S. Hart, 2002, The fortune at the bottom of the pyramid, Strategy+Business, 26: 54-67; (2) S. Hart, 2005, Capitalism at the Crossroads (p. 111), Philadelphia: Wharton School Publishing.

Figure 1.3 The Global Economic Pyramid

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10 Part One Laying Foundations

Table 1.2 Why Study Global Business?

Enhance your employability and advance your career in the global economy

Better preparation for possible expatriate assignments abroad

Stronger competence in interacting with foreign suppliers, partners, and competitors and in working for foreign-owned employers in your own country

was competitive not only with Mahindra in India, but also in the United States and elsewhere. In both cases, the origin of new innovations is from the base of the pyramid. The flow of innovation is bottom up—in other words, reverse innovation.

The reverse innovation movement suggests that emerging economies are no longer merely low-cost production locations or attractive new markets (hence the term “emerging markets”). They are also sources of new innovations that may not only grow out of BOP markets, but also have the potential to go uphill to penetrate into the top of the global economic pyramid. In a Harvard Business Review article, Jeff Immelt, chairman and CEO of a leading practitioner of reverse innovation, GE, noted:

To be honest, the company is also embracing reverse innovation for defensive rea- sons. If GE doesn’t come up with innovations in poor countries and take them glob- al, new competitors from the developing world—like Mindray, Suzlon, Goldwind, and Haier—will. . . GE has tremendous respect for traditional rivals like Siemens, Philips, and Rolls-Royce. But it knows how to compete with them; they will never destroy GE. By introducing products that create a new price-performance paradigm, however, the emerging giants very well could. Reverse innovation isn’t optional; it is oxygen.11

As advised by GE’s Immelt, today’s students—and tomorrow’s business leaders— will ignore the opportunities and challenges at the base of the pyramid at their own peril. This book will help ensure that you will not ignore these opportunities.

1-2 Why Study Global Business? Global business (or IB) is one of the most exciting, most challenging, and most relevant subjects offered by business schools. Why study it? There are at least three compelling reasons why you should study global business—and study hard (Table 1.2).

First, mastering global business knowledge helps advance your employability and career in an increasingly competitive global economy. Take a look at the Open- ing Day Quiz in Table 1.3. Can you answer all the questions correctly? If not, you will definitely benefit from studying global business.

The answer to Question 1 is empirical—that is, based on data. You should guess first and then look at the label of your shirt yourself or ask a friend to help you. The key here is international trade. Do you wear a shirt made in your own country or another country? Why?

In Question 2, smart students typically ask whether the mobile device (such as a smartphone or an iPad) means the motherboard or the components. My answer is: “I mean the whole device, all the production that went into making

Learning Objective Give three reasons why it is important to study global business.

1-2

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Chapter 1 Globalizing Business 11

the machine.” Then some students would respond: “But they could be made in different countries!” My point exactly. Specifically, the point here is to appreciate the complexity of a global value chain, with different countries making different components and handling different tasks. Such a value chain is typically managed by an MNE, such as Apple, Dell, Foxconn, HP, Lenovo, or Samsung. The capabilities necessary to organize a global supply chain hints at the importance of resources and capabilities—one of the two key themes of this book.

Question 3 is deceptively simple. Unfortunately, 100% of my own students— ranging from undergraduates to PhDs—miss it. Surprise! The Group of 20 (G-20) only has 19 member countries. The 20th member is the European Union (EU)—a regional bloc, not a single country (see PengAtlas Map 1.1). Ideally, why the G-20 is formed in such an interesting way will make you more curious about how the rules of the game are made around the world. In this case, why are 19 countries in, but numerous others are out? What is special about the EU? Why are other regional blocs not included in the G-20? What about the G-7? What about other groups of countries (see Figure 1.4)? A focus on the rules of the game—more technically, institutions—is another key theme of the book.

Question 4 will really frighten you. Some students would typically clarify: “Do you mean the few security guards looking after the closed plant?” “Not necessarily,” I would point out. “The question is: How many jobs will be kept by the company?” Students would eventually get it: even adding a few jobs as security guards at the closed plant, the most optimistic estimates are that only 30 to 50 jobs may be kept. Yes, you guessed it, these jobs typically are high-level positions such as the CEO, CFO, CIO, factory director, and chief engineer. These managers will be sent by the MNE to start up operations in an emerging economy. You need to realize that in a 2,000-employee plant, even if you may be the 51st-highest-ranked employee, your fate may be the same as the 2,000th employee. You really need to work hard and work smart to position yourself as one of the top 50 (preferably one of the top 30). Doing well in this class and mastering global business knowledge may help make it happen.

Group of 20 (G-20)

The group of 19 major countries plus the European Union (EU) whose leaders meet on a biannual basis to solve global economic problems.

Table 1.3 Opening Day Quiz

1. Which country made the shirt you are wearing? 2. Which country made your mobile communication device? (A) China (A) China (B) Malaysia (B) Germany (C) Mexico (C) Singapore (D) Romania (D) Taiwan (E) US (E) US

3. How many countries does the G-20 have? 4. A 2,000-employee manufacturing plant is closing in a developed economy, and production is moving to an emerging economy. How many of the 2,000 jobs will the company keep?

(A) 0 (B) 5–10 (C) 10–20 (D) 20–30 (E) 30–50

(A) 20 (B) 21 (C) 22 (D) 19 (E) 18

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12 Part One Laying Foundations

In addition to the first reason to equip you with relevant knowledge, the second compelling reason why you should study global business is related to Question 4. Because many ambitious students aspire to join the top ranks of large firms, expertise in global business is often a prerequisite. Today, it is increasingly difficult, if not impossible, to find top managers at large firms without significant global competence. Of course, eventually hands-on global experience, not merely knowledge acquired from this course, will be required. However, mastery of the knowledge of, and demonstration of interest in, global business during your education will set you apart as a more ideal candidate

to be selected as an expatriate manager (or “expat”)—a manager who works abroad—to gain such an experience (see Chapter 15 for details).

Thanks to globalization, low-level jobs not only command lower salaries but are also more vulnerable. However, high-level jobs, especially those held by expats, are both financially rewarding and relatively secure. Expats often command a signifi- cant international premium in compensa- tion—a significant pay raise when work- ing overseas. In US firms, an expat’s total compensation package is approximately $250,000 to $300,000 (including perks and benefits; not all is take-home pay). When they return to the United States after a tour of duty (usually two to three

Expatriate manager

A manager who works abroad, or “expat” for short.

International premium

A significant pay raise when working overseas.

Brazil

India

South Africa

Brunei Cambodia Indonesia

Laos Malaysia Myanmar

Philippines Singapore Thailand Vietnam

Italy France

Germany Japan

UK Canada

USA

Shanghai Co-op Organization

BRIC

IBSA ASEAN +3G7

Kazakhstan Kyrgyztan Tajikistan

Uzbekistan

Russia

China

Argentina Australia Mexico Turkey

European Union

G20

Japan

South Korea

Figure 1.4 Country Groupings in the 21st Century

Source: Adapted from C. Dhanaraj & T. Khanna, 2011, Transforming mental models on emerging markets (p. 696), Academy of Management Learning and Education, 10(4): 684-701. G7 = Group of Seven; G20 = Group of Twenty; BRIC = Brazil, Russia, India, and China; IBSA = India-Brazil-South Africa Dialogue Forum; Shanghai Co-op Orga- nization = Shanghai Co-operation Organization; ASEAN = Association of Southeast Asian Nations. © Academy of Management.

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What are some of the benefits you may enjoy as an expatriate manager?

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Chapter 1 Globalizing Business 13

years), a firm that does not provide attractive career opportunities to experi- enced expats often finds that they are lured away by competitor firms. Competi- tor firms also want to globalize their business, and tapping into the expertise and experience of these former expats makes such expansion more likely to succeed. And yes, to hire away these internationally experienced managers, competitor firms have to pay an even larger premium. This indeed is a virtuous cycle.

This hypothetical example is designed to motivate you to study hard so that someday, you may become one of these sought-after globe-trotting managers. But even if you don’t want to be an expat, we assume that you don’t want to join the army of the unemployed due to factory closings and business failures.

Lastly, even if you do not aspire to compete for the top job at a large company and instead work at a small firm or are self-employed, you may find yourself dealing with foreign-owned suppliers and buyers, competing with foreign-invested firms in your home market, or perhaps even selling and investing overseas. Alternatively, you may find yourself working for a foreign-owned firm, your domestic employer acquired by a foreign player, or your unit ordered to shut down for global consoli- dation. Any of these is a likely scenario, because approximately 80 million people worldwide—including 18 million Chinese, six million Americans, and one million British—are employed by foreign-owned firms. Understanding how global business decisions are made may facilitate your own career in such firms. If there is a stra- tegic rationale to downsize your unit, you want to be prepared and start polishing your résumé right away. In other words, it is your career that is at stake. Don’t be the last in the know!

In short, in this age of global competition, “how do you keep from being Bangalored or Shanghaied” (that is, having your job being outsourced to India or China)?12 To avoid the fate humorously portrayed in Figure 1.5, a good place to

Figure 1.5 Jobs Outsourced

Source: Harvard Business Review, 2012, April: 34.

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14 Part One Laying Foundations

start is to study hard and do well in your IB course. Also, don’t forget to put this course on your résumé!

1-3 A Unified Framework Global business is a vast subject area. It is one of the few courses that will make you appreciate why your university requires you to take a number of seemingly unrelated courses in general education. We will draw on major social sciences, such as economics, geography, history, political science, psychology, and sociology. We will also draw on a number of business disciplines, such as strategy, finance, and marketing. The study of global business is thus very interdisciplinary. It is quite easy to lose sight of the forest while scrutinizing various trees or even branches. The subject is not difficult, and most students find it to be fun. The number-one student complaint (based on previous student feedback) is that there is an overwhelming amount of information. Honestly, this is also my number-one complaint as your author. You may have to read and learn this material, but I have to bring it all together in a way that is understandable and in a (relatively) compact book that does not go on and on and on for 900 pages.

To make your learning more focused, more manageable, and (hopefully) more fun, in this section we will develop a unified framework (shown in Figure 1.6). This will provide great continuity to facilitate your learning. Spe- cifically, we will discipline ourselves by focusing on only one most fundamen- tal question and two core perspectives. A fundamental question acts to define a field and to orient the attention of students, practitioners, and scholars in a certain direction. Our “big question” is: What determines the success and fail- ure of firms around the globe?13 To answer this question, we will introduce only two core perspectives throughout this book: (1) an institution-based view and (2) a resource-based view.14 The remainder of this section outlines this framework.

Learning Objective Articulate one fundamental question and two core perspectives in the study of global business.

1-3

Fundamental question: What determines the success and failure

of firms around the globe? Resource-based view:

Firm-specific resources and

capabilities

Institution-based view: Formal and informal

rules of the game

Figure 1.6 A Unified Framework for Global Business

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Chapter 1 Globalizing Business 15

1-3a One Fundamental Question What is it that we do in global business? Why is it so important that practically all students in business schools around the world are either required or recommended to take this course? While there are certainly a lot of questions to raise, a relentless interest in what determines the success and failure of firms around the globe serves to focus the energy of our field. Global business is fundamentally about not limit- ing yourself to your home country. It is about treating the entire global economy as your potential playground (or battlefield). Some firms may be successful domesti- cally but fail miserably overseas. Other firms successfully translate their strengths from their home markets to other countries. If you were expected to lead your firm’s efforts to enter a particular foreign market, wouldn’t you want to find out what drives the success and failure of other firms in that market?

Overall, the focus on firm performance around the globe defines the field of global business (or IB) more than anything else. Numerous other questions and topics all relate in one way or another to this most fundamental question. There- fore, all chapters in this book will be centered on this consistent theme: What de- termines the success and failure of firms around the globe?

1-3b First Core Perspective: An Institution-Based View15

An institution-based view suggests that the success and failure of firms are enabled and constrained by institutions. By institutions, we mean the rules of the game. Doing business around the globe requires intimate knowledge about both formal rules (such as laws) and informal rules (such as values) that govern competition in various countries. If you establish a firm in a given country, you will work within that country’s institutional framework, which consists of the formal and informal institutions that govern individual and firm behavior. Firms that do not do their homework and thus remain ignorant of the rules of the game in a certain country are not likely to emerge as winners.

Formal institutions include laws, regulations, and rules. For example, Hong Kong’s laws are well-known for treating all comers, whether from neighbor- ing mainland China (whose firms are still technically regarded as “non-domestic”) or far-away Chile, the same as they treat indigenous Hong Kong firms. Such equal treatment enhances the potential odds for foreign firms’ success. It is thus not sur- prising that Hong Kong attracts a lot of outside firms. Other rules of the game discriminate against foreign firms and undermine their chances for success. India’s recent attraction as a site for FDI was only possible after it changed its FDI regula- tions from confrontational to accommodating. Prior to 1991, India’s rules severely discriminated against foreign firms. As a result, few foreign firms bothered to show up, and the few that did had a hard time. For example, in the 1970s, the Indian gov- ernment demanded that Coca-Cola either hand over the recipe for its secret syrup, which it does not even share with the US government, or get out of India. Painfully, Coca-Cola chose to leave India. Its return to India since the 1990s speaks volumes about how much the rules of the game have changed in India.

Informal institutions include cultures, ethics, and norms. They also play an important part in shaping the success and failure of firms around the globe. For example, individualistic societies, particularly the English-speaking countries such as Australia, Britain, and the United States, tend to have a relatively higher level of

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16 Part One Laying Foundations

entrepreneurship as reflected in the number of business start-ups. Why? Because the act of founding a new firm is a widely accepted practice in individualistic societ- ies. Conversely, collectivistic societies such as Japan often have a hard time foster- ing entrepreneurship. Most people there refuse to stick their neck out to found new businesses because it is contrary to the norm.16

Overall, an institution-based view suggests that institutions shed a great deal of light on what drives firm performance around the globe.17 Next, we turn to our second core perspective.

1-3c Second Core Perspective: A Resource-Based View18

The institution-based view suggests that the success and failure of firms around the globe are largely determined by their environments. This is certainly correct. Indeed, India did not attract much FDI prior to 1991 and Japan does not nurture a lot of internationally competitive start-ups because of their institutions. However, insightful as this perspective is, there is a major drawback. If we push this view to its logical extreme, then firm performance around the globe would be entirely determined by environments. The validity of this extreme version is certainly ques- tionable.

The resource-based view helps overcome this drawback. While the institution- based view primarily deals with the external environment, the resource-based view focuses on a firm’s internal resources and capabilities. It starts with a simple observa- tion: In harsh, unattractive environments, most firms either suffer or exit. However, against all odds, a few superstars thrive in these environments. For example, despite the former Soviet Union’s obvious hostility toward the United States during the Cold War, PepsiCo began successfully operating in the former Soviet Union in the 1970s (!). Most of the major airlines have been losing money since September 11, 2001. But a small number of players, such as Southwest in the United States, Ryanair in Ireland, and Hainan Airlines in China, have been raking in profits year after year. In the fiercely competitive fashion industry, Zara has been defying gravity (see In Focus 1.2). How can these firms succeed in such challenging environments? What is special about them? A short answer is that PepsiCo, Southwest, Ryanair, Hainan, and Zara must have certain valuable and unique firm-specific resources and capabilities that are not shared by competitors in the same environments.

Doing business outside one’s home country is challenging. Foreign firms have to overcome a liability of foreignness, which is the inherent disadvantage that foreign firms experience in host countries because of their non-native status.19 Just think about all the differences in regulations, languages, cultures, and norms. Think about the odds against Mahindra & Mahindra when it tried to eat some of John Deere’s lunch in the American heartland (see the Opening Case). Against such significant odds, the primary weapons that foreign firms such as Mahindra & Mahindra employ are overwhelming resources and capabilities that can offset their liability of foreignness.20 Today, many of us take it for granted that the best-selling car in the United States rotates between the Toyota Camry and the Honda Civic, that Coca-Cola is the best-selling soft drink in Mexico, and that Microsoft Word is the world’s number-one word-processing software. We really shouldn’t. Why? Because it is not natural for these foreign firms to dominate non-native markets. These firms must possess some very rare and powerful firm-specific resources and capabilities that drive these remarkable success stories and are the envy of their rivals around the globe. This is a key theme of the resource-based view, which

Liability of foreignness

The inherent disadvantage that foreign firms experience in host countries because of their non- native status.

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Chapter 1 Globalizing Business 17

Zara is one of the hottest fashion chains. Founded in 1975, Zara’s parent, Inditex, has become a lead- ing global apparel retailer. Since its initial public of- fering (IPO) in 2001, Inditex quadrupled its sales (to $19.1 billion or €13.8 billion) and profits. It doubled the number of its stores of eight brands, of which Zara contributes two-thirds of total sales. Zara succeeds by first breaking and then rewriting industry rules— also known as industry norms.

Rule number one: The origin of a fashion house usually carries some cachet. However, Zara does not hail from Italy or France—it is from Spain. Even within Spain, Zara is not based in a cosmopolitan city like Barcelona or Madrid. It is headquartered in Arteixo, a town of only 25,000 people in a remote corner of northwestern Spain that a majority of this book’s readers would have never heard of. Yet, Zara is active not only throughout Europe, but also in Asia and North America. As of 2012, the total number of stores is over 4,200 in 64 countries. Zara stores occupy some of the priciest top locations: Champs-Elysées in Paris, Ginza in Tokyo, Fifth Avenue in New York, Galleria in Dallas, and Huaihai Road in Shanghai.

Rule number two: Avoid stock-outs (a store run- ning out of items in demand). Zara’s answer? Occa- sional shortages contribute to an urge to buy now. With new items arriving at stores twice a week, experienced Zara shoppers know that “If you see something and don’t buy it, you can forget about coming back for it because it will be gone.” The small batch of merchandise during a short window of opportunity for purchasing motivates shoppers to visit Zara stores more frequently. In London, shop- pers visit other stores an average of four times a year, but frequent Zara 17 times a year. There is a good reason to do so: Zara makes about 20,000 items per year, about triple what Gap does. “At Gap, everything is the same,” says one Zara fan, “and buying from Zara, you’ll never end up looking like someone else.”

Rule number three: Bombarding shoppers with ads is a must. Gap and H&M spend on average 3% to 4% of their sales on ads. Zara begs to differ: It

devotes just 0.3% of its sales to ads. The high traffic in the stores alleviates some needs for advertising in the media, most of which only serves as a reminder to visit the stores.

Rule number four: Outsource. Gap and H&M do not own any production facilities. However, out- sourcing production (mostly to Asia) requires a long lead time, usually several months. Again, Zara has decisively deviated from the norm. By concentrating (more than half of) its production in-house (in Spain, Portugal, and Morocco), Zara has developed a super- responsive supply chain. It designs, produces, and delivers a new garment to its stores worldwide in a mere 15 days, a pace that is unheard of in the industry. The best speed the rivals can achieve is two months. Outsourcing may not necessarily be “low cost,” be- cause errors in prediction can easily lead to unsold in- ventory, forcing retailers to offer steep discounts. The industry average is to offer 40% discounts across all merchandise. In contrast, Zara sells more at full price and, when it discounts, it averages only 15%.

Rule number five: Strive for efficiency through large batches. In contrast, Zara intentionally deals with small batches. Because of its flexibility, Zara does not worry about “missing the boat” for a season. When new trends emerge, Zara can react quickly. More interestingly, Zara runs its supply chain like clock- work with a fast but predictable rhythm: Every store places orders on Tuesday/Wednesday and Friday/ Saturday. Trucks and cargo flights run on established schedules—like a bus service. From Spain, shipments

Zara Deviates from Industry Norms IN Focus 1.2

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18 Part One Laying Foundations

focuses on how winning firms acquire and develop such unique and enviable resources and capabilities and how competitor firms imitate and then innovate in an effort to outcompete the winning firms.

1-3d A Consistent Theme Given our focus on the fundamental question of what determines the success and failure of firms around the globe, we will develop a unified framework by organiz- ing the material in every chapter according to the two core perspectives, namely, the institution-based and resource-based views. With our unified framework—an innovation in IB textbooks—we will not only explore the global business “trees,” but also see the global business “forest.”

1-4 What Is Globalization? Globalization, generally speaking, is the close integration of countries and peoples of the world. This abstract five-syllable word is now frequently heard and debated. Those who approve of globalization count its contributions to include greater eco- nomic growth and standards of living, increased technology sharing, and more extensive cultural integration. Critics argue that globalization undermines wages in rich countries, exploits workers in poor countries, grants MNEs too much power, and destroys the environment. So, what exactly is globalization? This section out- lines three views on globalization, recommends the pendulum view, and introduces the idea of semiglobalization.

1-4a Three Views on Globalization Depending on what sources you read, globalization could be

a new force sweeping through the world in recent times a long-run historical evolution since the dawn of human history a pendulum that swings from one extreme to another from time to time

An understanding of these views helps put the debate about globalization in perspective. First, opponents of globalization suggest that it is a new phenomenon

Learning Objective Identify three ways of understanding what globalization is.

1-4

Globalization

The close integration of coun- tries and peoples of the world.

reach most European stores in 24 hours, US stores in 48 hours, and Asian stores in 72 hours. Not only do store staff know exactly when shipments will arrive, regular customers know it too, thus motivating them to check out the new merchandise more frequently on those days, which are known as “Z days” in some cities.

Zara has no shortage of competitors. Why has no one successfully copied its business model of “fast fashion”? “I would love to organize our business like

Inditex [Zara’s parent],” noted an executive from Gap, “but I would have to knock my company down and rebuild it from scratch.” This does not mean Gap and other rivals are not trying to copy Zara. The question is how long it takes for rivals to out-Zara Zara.

Sources: Based on (1) BusinessWeek, 2009, 100 best global brands, September 28: 44-60; (2) BusinessWeek, 2006, Fashion conquis- tador, September 4: 38-39; (3) Economist, 2012, Fashion forward, March 24: 63-64; (4) K. Ferdows, M. Lewis, & J. Machuca, 2004, Rapid-fire fulfillment, Harvard Business Review, November: 104-110; (5) www.zara.com.

IN Focus 1.2 (continued)

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Chapter 1 Globalizing Business 19

beginning in the late 20th century, driven by recent technological innovations and a Western ideology focused on exploiting and dominating the world through MNEs. The arguments against globalization focus on environmental stress, social injustice, and sweatshop labor but present few clearly worked-out alternatives to the present economic order. Nevertheless, anti-globalization advocates and protesters often argue that globalization needs to be slowed down, if not stopped.21

A second view contends that globalization has always been part and parcel of human history. Historians are debating whether globalization started 2,000 or 8,000 years ago. The earliest traces of MNEs have been discovered in Assyrian, Phoenician, and Roman times.22 International competition from low-cost countries is nothing new. In the first century a.d., the Roman emperor Tiberius was so concerned about the massive quantity of low-cost Chinese silk imports that he imposed the world’s first known import quota of textiles.23 Today’s most successful MNEs do not come close to wielding the historical clout of some MNEs, such as Britain’s East India Company during colonial times. In a nutshell, globalization is nothing new and will probably always exist.

A third view suggests that globalization is the “closer integration of the countries and peoples of the world which has been brought about by the enormous reduction of the costs of transportation and communication, and the breaking down of artificial barriers to the flows of goods, services, capital, knowledge, and (to a lesser extent) people across borders.”24 Globalization is neither recent nor one-directional. It is, more accurately, a process similar to the swing of a pendulum.

1-4b The Pendulum View on Globalization The pendulum view probably makes the most sense because it can help us under- stand the ups and downs of globalization. The current era of globalization origi- nated in the aftermath of World War II, when major Western countries committed to global trade and investment. However, between the 1950s and the 1970s, this view was not widely shared. Communist countries, such as China and the Soviet Union, sought to develop self-sufficiency. Many non-communist developing coun- tries, such as Brazil, India, and Mexico, focused on fostering and protecting do- mestic industries. But refusing to participate in global trade and investment ended up breeding uncompetitive industries. In contrast, four developing economies in Asia—Hong Kong, Singapore, South Korea, and Taiwan—earned their stripes as the “Four Tigers” by participating in the global economy. They became the only economies once recognized as less developed (low-income) by the World Bank to have subsequently achieved developed (high-income) status (see Table 1.1).

Inspired by the Four Tigers, more and more countries and regions—such as China in the late 1970s, Latin America in the mid-1980s, Central and Eastern Europe in the late 1980s, and India in the 1990s—realized that joining the world economy was a must. As these countries started to emerge as new players in the world economy, they become collectively known as “emerging economies.” As a result, globalization rapidly accelerated.

However, globalization, like a pendulum, is unable to keep going in one direc- tion. Rapid globalization in the 1990s and the 2000s saw some significant back- lash. First, the rapid growth of globalization led to the historically inaccurate view that globalization is new. Second, it created fear among many people in devel- oped economies that they would lose jobs. Emerging economies not only seem

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20 Part One Laying Foundations

to attract many low-end manufacturing jobs away from developed economies, but they also increasingly appear to threaten some high-end jobs. Finally, some factions in emerging economies complained against the onslaught of MNEs, alleging that they destroy local companies as well as local cultures, values, and environments.

While small-scale acts of vandalizing McDonald’s restaurants are reported in a variety of countries, the December 1999 anti-globalization protests in Se- attle and the September 2001 terrorist attacks in New York and Washington have been undoubtedly the most visible and most extreme acts of anti-globalization forces at work. As a result, international travel was curtailed, and global trade and investment flows slowed in the early 2000s. Then in the mid-2000s, however, worldwide GDP, cross-border trade, and per capita GDP all soared to historically high levels.

Unfortunately, the party suddenly ended in 2008. The 2008–2009 global economic crisis was unlike anything the world had seen since the Great De- pression (1929–1933). The year 2008 showed, for better or worse, how intercon- nected the global economy has become. Deteriorating housing markets in the United States, fueled by unsustainable subprime lending practices, led to mas- sive government bailouts of financial services firms. Initially, most of the world probably shared the sentiment expressed by Brazilian President Luiz Inacio Lula da Silva that the crisis would be “Bush’s crisis” (referring to President George W. Bush) and would have nothing to do with “us.” However, the crisis quickly spread around the world, forcing numerous governments to bail out their own troubled banks. Global output, trade, and investment plummeted, while unemployment skyrocketed. The 2008–2009 crisis became known as the Great Recession. Rightly or wrongly, many people blamed globalization for the Great Recession.

After unprecedented intervention in developed economies where governments ended up being many banks’ largest shareholders, confidence was growing that the global economy had turned the corner and that the recession was ending.25 How- ever, starting in 2010, the Greek debt crisis and then the broader PIGS debt crisis (“PIGS” refers to Portugal, Ireland or Italy, Greece, and Spain) erupted. Fiscally more responsible EU countries that adopted the euro as the common currency, such as Germany and France, felt compelled to bail out the countries in crisis. The already slow recovery in Europe thus became slower, and unemployment hovered at very high levels (see Chapter 8).

Overall, economic recovery is likely to be slow in developed economies, whereas emerging economies are likely to rebound faster. The recession reminds all firms and managers of the importance of risk management—the identification and as- sessment of risks and the preparation to minimize the impact of high-risk, unfor- tunate events.26 As a technique to prepare and plan for multiple scenarios (either high risk or low risk), scenario planning is now extensively used by firms around the world.27 For example, many European firms have been preparing for a possible (but unlikely) scenario that Greece (or Germany) may leave the euro zone. As far as the direction of economic globalization is concerned, the recovery may see more protectionist measures, since the stimulus packages and job creation schemes of various governments often emphasize “buy national” (such as “buy American”) and “hire locals.” In short, the pendulum is swinging back.

Like the proverbial elephant, globalization is seen by everyone yet rarely com- prehended. The sudden ferocity of the 2008–2009 crisis surprised everybody— ranging from central bankers to academic experts. Remember all of us felt sorry

Risk management

The identification and assess- ment of risks and the preparation to minimize the impact of high- risk, unfortunate events.

scenario planning

A technique to prepare and plan for multiple scenarios (either high or low risk).

Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

 

 

Chapter 1 Globalizing Business 21

when we read the story of a bunch of blind men trying to figure out the shape and form of the elephant. We really shouldn’t. Although we are not blind, our task is more challenging than the blind men who study a standing animal. Our beast— globalization—does not stand still and often rapidly moves, back and forth (!). Yet, we try to live with it, avoid being crushed by it, and even attempt to profit from it. Overall, relative to the other two views, the view of globalization as a pendulum is more balanced and more realistic. In other words, globalization has both rosy and dark sides, and it changes over time.

1-4c Semiglobalization Despite the debate over it, globalization is not complete. Do we really live in a glo- balized world? Are selling and investing abroad just as easy as at home? Obviously not. Most measures of market integration, such as trade and FDI, have recently scaled new heights but still fall far short of pointing to a single, globally integrated market. In other words, what we have may be labeled semiglobalization, which is more complex than extremes of total isolation and total globalization. Semiglobal- ization suggests that barriers to market integration at borders are high but not high enough to insulate countries from each other completely.28

Semiglobalization calls for more than one way of doing business around the globe. Total isolation on a nation-state basis would suggest localization—a strategy of treating each country as a unique market. So an MNE marketing products to 100 countries will need to come up with 100 versions of local cars or drinks. This approach is clearly too costly. Total globalization, on the other hand, would lead to standardization—a strategy of treating the entire world as one market. The MNE in our previous example can just market one version of “world car” or “world drink.” But the world obviously is not that simple. Between total isolation and total globalization, semiglobalization has no single right strategy, resulting in a wide variety of experimentations. Overall, (semi)globalization is neither to be opposed as a menace nor to be celebrated as a panacea; it is to be engaged.

Finance

/in /by

-8-

 

 

 

 

 

CARREFOUR S.A.

 

 

 

Synopsis and Objectives

 

In August 2002, the French retail giant Carrefour S.A. is considering alternative currencies for raising (euros) EUR750 million in the eurobond market. Carrefour’s investment bankers provide various borrowing rates across four different currencies. Despite the high nominal coupon rate and the lack of any material business activity in the United Kingdom, the British-pound issue appears to provide the lowest cost of funds if the exchange rate risk is hedged.

 

The case is designed to serve as an introduction to topics in international finance. Topics of discussion include foreign-currency borrowing, interest-rate parity, currency risk exposure, derivative contracts (in particular forward and swap contracts), and currency risk management. Students are tasked with exploring (1) motives for borrowing in foreign currencies, (2) the exposure created by such financing policy, and (3) strategies for managing currency risk.

 

 

Suggested Questions for Advance Assignment to Students

 

1. Why should Carrefour consider borrowing in a currency other than euros?

2. Assuming the bonds are issued at par, what is the cost in euros of each of the bond alternatives?

3. Which debt issue would you recommend and why?

 

 

Hypothetical Teaching Plan

 

1. What is going on at Carrefour?

2. Is the Swiss-franc issue, at 3⅝%, a “no-brainer”?

3. What can a firm do to manage the exchange-rate risk of foreign-currency borrowing?

4. Using appropriate forward rates, what is the cost of borrowing in Swiss francs? British pounds? U.S. dollars? What should Carrefour do?

 

As reference material, broad empirical evidence of the managerial question in the case can be found in Matthew R. McBrady and Michael J. Schill, “Foreign currency denominated borrowing in the absence of operating incentives” Journal of Financial Economics 86 (October 2007): 145–177 and Matthew R. McBrady, Sandra Mortal, and Michael J. Schill, “Do firms believe in interest-rate parity?” working paper, Darden Graduate School of Business Administration, University of Virginia, Charlottesville.

 

 

Case Analysis

 

1. What is going on at Carrefour?

 

Carrefour is a massive retailer (Europe’s largest) with strong but selective expansion prospects internationally (case Exhibit 1). The company has a history of funding its capital needs through securities denominated in many different currencies (case Exhibit 3), and is sophisticated in managing currency risk. Carrefour currently has a EUR750 million capital need that the company intends to meet through the eurobond market.[footnoteRef:1] This offering represents approximately 11% of Carrefour’s bond portfolio. Carrefour’s investment bank has provided market borrowing rates in euros and three foreign currencies. [1: Bob Bruner suggests using the case to develop various facets of the eurobond market: (1) the eurobond market is an external market, outside the regulatory jurisdiction of any one country; (2) the bonds so issued are in unregistered form (i.e., the owner’s name is not cited on the face of the bond itself); (3) coupon payments are made annually, rather than semiannually, as is the custom in the United States; (4) the bonds are issued on an unsecured basis, which effectively limits the demand in this market to only the highest-quality issuers; and (5) the international bond market is huge. In the 1980s, the eurobond market ballooned in trading, new issues, and outstandings, concurrently with the globalization of financial sourcing by governments and corporations.]

 

Using the prevailing exchange rates, the borrowing alternatives for Carrefour can be specified as

 

1. Borrow EUR750 million at 5.25%

2. Borrow (British pounds) GBP471 million at 5.375%

3. Borrow (Swiss francs) CHF1,189.75 million at 3.625%

4. Borrow (U.S. dollars) USD735 million at 5.5%

 

If Carrefour borrows in a currency other than the euro, the company can generate its EUR750 million capital need by converting the foreign currency proceeds to euro at the prevailing spot rates of GBP0.628/EUR, CHF1.453/EUR, and USD0.980/EUR.

2. Is the Swiss-franc issue, at 3⅝%, a “no-brainer”?

 

The Swiss-franc bonds work well as a foil for interest-rate parity. The instructor can ask why Carrefour would ever want to borrow at any rate higher than 3.625%. To go into the specific detail of the alternatives, the instructor can solicit the series of euro payments from the euro bond and the Swiss-franc payments from the Swiss-franc bond (see Exhibit TN1). If one assumes that the future Swiss-franc payments can be converted into euros at the current spot rate of CHF1.453/EUR, the Swiss-franc bond is a “no-brainer.” Astute students will respond to this argument with concerns about the exchange-rate risk exposure. Carrefour will be happy with the decision if the exchange rate stays above the current exchange rate (Swiss-franc depreciation). If, however, the exchange rate declines (Swiss-franc appreciation), Carrefour will have to pay back the debt by buying more expensive francs. If the currency appreciates enough, the borrowing gains will be offset by the exchange-rate losses. The instructor can capture the exchange-rate risk of the Swiss-franc borrowing with the payoff diagram in Exhibit TN2.

 

If students are new to exchange rates, it is worth spending some time on interpreting the trends in Exhibit 6 to understand what is meant by appreciation and depreciation of exchange rates. In the end, students should be comfortable with understanding which direction in exchange rates represents borrowing cost reduction and which direction represents borrowing cost increases. Because exchange rates tend to be volatile, the perceived wisdom is that the exchange-rate risk commonly offsets any potential borrowing gains from nominal interest rate differentials. A common phrase that captures the hazards of accepting foreign-currency risk to achieve interest rate differentials is “picking up nickels in front of bulldozers.” Despite the exchange rate risk, there are plenty of case examples of firms and traders that borrow in currencies with low interest rates and invest in currencies with high interest rates. This strategy is known as the “carry trade.”

 

3. What can a firm do to manage the exchange-rate risk of foreign-currency borrowing?

 

This challenge motivates the appeal of the forward contract. With exposure to the future exchange rate, students can see the risk management gains from buying a forward contract that locks in a particular exchange rate. Exhibit TN3 shows graphically how the forward contract offsets the currency risk exposure of the foreign-currency debt obligation.

 

To motivate interest-rate parity, the instructor can invite a class member (the banker) to play the role of the counterparty to the Carrefour forward contract. To motivate the example, the instructor can encourage the student to come up with a one–year forward rate off the top of their head (one that is not the correct forward rate). Once the improper forward rate is established, the instructor can invite another student (the arbitrageur) to propose an investment strategy based on the banker’s forward rate and the prevailing inter-bank rates (Exhibit 8). Suppose the banker selects a forward rate of CHF1.5/EUR as the one-year forward rate. Since this rate is well above the proper forward rate of 1.419, the appropriate arbitrage strategy is to

Now

· Borrow CHF1,000 at 1.125%

· Convert the proceeds into euros at the spot rate of 1.453 and invest EUR688 at 3.514%

In one year

· Collect the EUR712 at maturity [EUR688(1 + 3.514%)]

· Convert the proceeds into francs at the forward rate of 1.5 to give CHF1,068

· Payoff the franc loan of CHF1,011 [CHF1,000(1 + 1.125%)]

· Keep the difference of CHF57 from the arbitrage trade [CHF1,068 − CHF1,011]

 

Since this trade is risk-free, the arbitrageur is likely to be motivated to put more money into this trade than CHF1,000.

 

In determining forward rates, the students should come to recognize that a fair forward rate is likely to avoid such arbitrage opportunities and reflect a condition of interest-rate parity. If franc interest rates are lower than euro interest rates, parity requires the franc/euro forward rate to impound franc appreciation that offsets the interest-rate difference. This discussion motivates the interest-rate parity condition:

 

 

 

where fchf/eur is the T-period franc-to-euro forward exchange rate, Schf/eur is the prevailing franc-to-euro spot exchange rate, and Rchf,t and Reur,t are the T-period inter-bank interest rate for the franc and euro, respectively.

 

Since the late 1980s, foreign-currency obligations of this nature are hedged in the swap market. The typical swap hedge entails a package of three swap contracts. The first swap contract is a foreign-currency interest-rate swap that exchanges fixed-rate payments for floating-rate payments. The swap contract is quoted as the fixed rate (e.g., 6%) over the maturity of the swap (e.g., 10 years). The second swap is a currency swap contract that exchanges the foreign-currency floating rate for the domestic-currency floating rate. Lastly, the party exchanges the domestic-currency floating rate for the fixed rate using another interest-rate swap, but this time in the domestic currency. The package of swaps generates a contract that takes a fixed-rate obligation in one currency into a fixed-rate obligation in another currency. Using the three-swap package provides more flexibility in achieving more combinations of currency and maturity hedges with fewer numbers of specific contracts. Reviewing the mechanics of swap contracts may be beyond the scope of an introductory class.

 

4. Using the parity forward rates, what is the cost of borrowing in Swiss francs? British pounds? U.S. dollars? What should Carrefour do?

 

Exhibit TN1 shows the calculations required to determine the debt cash flows in euros of the various currency bonds. Because the calculations of the forward rates are tedious, the instructor may choose simply to focus on the forward rates for years 1 and 10. Because the difference between borrowing rates varies over the yield curve, the forward-rate calculations are based on the respective swap-curve maturities. Once the forward rates are calculated, the debt cash flows in euros can be computed as the foreign-currency obligation divided by the forward rate. The internal rate of return for the debt cash flows finally captures the euro borrowing cost of 5.25% in euros, 5.03% in pounds, 5.24% in francs, and 5.28% in dollars.

 

The similarity of the euro-based borrowing rates can be used to emphasize that nominal coupon rates mean little. Without knowing the schedule of forward rates, it is impossible to say that the franc is a “no-brainer” or that the U.S. dollar is a “nonstarter.”

 

Barring other considerations, the British-pound issue is materially preferable to the alternatives, with a small but meaningful savings in covered borrowing costs. In a EUR750 million offering, the 0.22% borrowing-rate difference represents an annual reduction in financing costs of EUR1.65 million.[footnoteRef:2] The difference in borrowing costs represents a quasi-arbitrage opportunity for Carrefour and other borrowers. [2: The borrowing-cost difference of EUR1.65 million is calculated as EUR750 million × (5.25% − 5.03%).]

 

 

Epilogue

 

On September 17, 2002, Carrefour issued a GBP500 million 10-year eurobond at 5⅜. Carrefour paid joint underwriters Morgan Stanley and UBS-Warburg a 3.25% gross spread on the deal and a 0.125% selling concession. Concurrently, Carrefour hedged the currency risk with a portfolio of currency and interest rate swap contracts. During the subsequent year the pound depreciated about 10% against the euro.

 

 

 

-5-

 

 

 

 

This teaching note was prepared by Professor Michael J. Schill. The managerial issues and lessons in the case draw heavily from an antecedent case, “Emerson Electric Company” (UVA-F-0771), by Robert F. Bruner. Copyright 2005 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation. Rev. 1/09.

Exhibit TN1

CARREFOUR S.A.

Debt Cash Flows in Target Currency and Euros

(in millions)

 

 

  Debt Cash Flows in Target Currency     Forward Rates     Debt Cash Flows in Euros
  EUR GBP CHF USD     GBP/EUR CHF/EUR USD/EUR     EUR GBP CHF USD
0 750.00 471.00 1089.75 735.00     0.628 1.453 0.98     750.00 750.00 750.00 750.00
1 (39.38) (25.32) (39.50) (40.43)     0.633 1.419 0.967     (39.38) (40.02) (27.83) (41.82)
2 (39.38) (25.32) (39.50) (40.43)     0.638 1.395 0.96     (39.38) (39.69) (28.32) (42.10)
3 (39.38) (25.32) (39.50) (40.43)     0.643 1.373 0.961     (39.38) (39.40) (28.76) (42.07)
4 (39.38) (25.32) (39.50) (40.43)     0.646 1.353 0.964     (39.38) (39.18) (29.20) (41.92)
5 (39.38) (25.32) (39.50) (40.43)     0.648 1.333 0.97     (39.38) (39.06) (29.63) (41.69)
6 (39.38) (25.32) (39.50) (40.43)     0.648 1.314 0.976     (39.38) (39.04) (30.06) (41.41)
7 (39.38) (25.32) (39.50) (40.43)     0.648 1.296 0.984     (39.38) (39.06) (30.48) (41.10)
8 (39.38) (25.32) (39.50) (40.43)     0.648 1.279 0.991     (39.38) (39.10) (30.89) (40.77)
9 (39.38) (25.32) (39.50) (40.43)     0.647 1.263 1.001     (39.38) (39.15) (31.28) (40.39)
10 (789.38) (496.32) (1129.25) (775.43)     0.645 1.248 1.011     (789.38) (769.07) (904.99) (767.10)
Borrowing rate 5.25% 5.38% 3.63% 5.50%             IRR 5.25% 5.03% 5.24% 5.28%

 

 

 

 

-6-

 

 

 

 

 

 

Exhibit TN2

CARREFOUR S.A.

Payoff Diagram of Debt Obligation in Euros

 

 

Payoff in EUR

 

 

CHF /EUR

CHF obligation

EUR obligation

0

−750 m

 

 

 

 

 

Exhibit TN3

CARREFOUR S.A.

Payoff Diagram of Debt Obligation and Forward Contract in Euros

 

 

CHF/EUR

CHF obligation

EUR obligation

0

−750 m

Gain on forward contract

Net position

 

 

 

T

T

EUR

T

T

CHF

EUR

CHF

T

EUR

CHF

R

R

f

s

)

1

(

)

1

(

,

,

/

/

+

+

=