Chapter 1

1. Chapter 1 Financial Goals and Corporate Governance

2. The Globalization Process:Learning Objectives • Consider how globalization process moves a business from domestic focus to financial relationships and composition global in scope • Learn what the implications of phase one of globalization – the international trade phase – means for the risks and returns of a business • Examine how the continuing globalization process extends from international trade to multinational operations to global activities

3. The Globalization Process:Learning Objectives • Discover what three major corporate currency exposures arise from multinational business • Examine how financial and operational goals are perceived in a global context • Witness how globalization affects corporate governance of the organization and how it creates value for its stakeholders • Investigate failures in global corporate governance

4. The Globalization Process • The globalization process is the structural and managerial changes and challenges experienced by a firm as it moves from domestic to global in operations • We will examine the case of Trident, a young firm that manufactures and distributes an array of telecommunication devices • Trident’s initial strategy is to develop a sustainable competitive advantage in the U.S. market • Trident is currently constrained by its small size, other competitors, and lack of access to cheap capital

5. U.S. Suppliers (domestic) U.S. Buyers (domestic) Trident Corporation (Los Angeles, USA) The Globalization Process Phase One: Domestic Operations All payments in US dollars; All credit risk under U.S. law

6. The Globalization Process • In Phase One, Trident is not itself international or global in its operations • However, some of its competitors, suppliers or buyers may be • This is one of the key drivers pushing Trident into Phase Two, the first transition of the globalization process • This is the Global Transition I: The Domestic Phase to The International Trade Phase

7. Trident Corporation (Los Angeles, USA) Mexican Suppliers Canadian Buyers Are Mexican suppliers dependable? Will Trident pay US$ or Mexican pesos? Are Canadian buyers creditworthy? Will payment be made in US$ or C$? The Globalization Process Phase Two: Expansion into International Trade

8. Phase One: Domestic Operations U.S. Suppliers (domestic) U.S. Buyers (domestic) All payments in US dollars; All credit risk under U.S. law Trident Corporation (Los Angeles, USA) Mexican Suppliers Canadian Buyers Are Mexican suppliers dependable? Will Trident pay US$ or Mexican pesos? Are Canadian buyers creditworthy? Will payment be made in US$ or C$? Phase Two: Expansion into International Trade Trident Corp: Phases Combined

9. The Globalization Process • In the International Trade Phase, Trident responds to globalization factors by importing inputs from Mexican suppliers and making exports sales to Canadian buyers • Exporting and importing products and services increases the demands of financial management over and above the traditional requirements of the domestic-only business

10. The Globalization Process • First, direct foreign exchange risks are now borne by the firm • Pricing and payments may be in different currencies • The value of these foreign currency receipts and payments can change, creating a new source of risk • Second, the evaluation of the credit quality of foreign buyers and sellers is now more important than ever; this is known as credit risk management • Potential for non-payment of exports and non-delivery of imports • Differences in business and legal systems and practices

11. The Globalization Process • If Trident is successful in its international trade activities, it will soon need to establish foreign sales and service affiliates • This step is often followed by establishing manufacturing operations abroad or by licensing foreign firms to produce and service Trident’s products • This is the Global Transition II: The International Trade Phase to The Multinational Phase

12. The Globalization Process • Trident’s continued globalization will require it to identify the sources of it competitive advantages • This variety of strategic alternatives available to Trident is called the foreign direct investment sequence which include the creation of foreign sales offices, licensing agreements, manufacturing, etc. • Once Trident owns assets and enterprises in foreign countries it has entered the multinational phase of globalization

13. Greater Foreign Presence Greater Foreign Investment Foreign Direct Investment Sequence Trident and its Competitive Advantage Change Competitive Advantage Exploit Existing Competitive Advantage Abroad Production at Home: Exporting Production Abroad Licensing Management Contract Control Assets Abroad Joint Venture Wholly-Owned Subsidiary Greenfield Investment Acquisition of a Foreign Enterprise

14. Foreign Direct Investment • As Trident increases its foreign presence and level of foreign investment its management team must: • Develop knowledge of the global financial environment • Understand foreign exchange theory and markets • Manage foreign exchange exposures including transaction, operating and translation exposures • Gain access to global equity and debt markets by globalizing the cost and availability of capital • Continue to make strategic and financial foreign investment decisions • Manage multinational operations

15. Trident Europe (Hamburg, Germany) Trident Brazil (Sáo Paulo, Brazil) Trident China (Shanghai, China) Cross-Border Acquisition Greenfield Investment Joint Venture Investment Trident Corporation (Los Angeles, USA) Greenfield Investment Cross-Border Acquisition Joint Venture Investment A long-term physical investment in productive capability in that country Identification, valuation, tender, and post-acquisition management of an existing going-concern Combining investment capital and managerial know-how to reach specific opportunities Foreign Investment Decisions

16. Foreign Investment Decisions Trident Corporation (Los Angeles, USA) Does the foreign investment truly build value for shareholders? What is the company’s global expansion strategy? Will the new business unit stand on its own or be integrated with global operations? What is the company willing to pay to pursue its strategy? Analysis of Foreign Investment or Acquisition Valuation Issues Governance Issues What are the expected local currency cash flows to occur over time? Who currently owns it? Is it a privatization, a divestiture, a greenfield investment? What are these expected cash flows worth in US dollars? Will the project be wholly owned or a joint venture?

17. Foreign Investment Decisions Trident USA (Los Angeles, USA) Trident Europe (Hamburg, Germany) Currency: US dollar ($) Tax rate: 35% 2004 Earnings before tax (EBT): $ 4.5 million Currency: Euros (€) Tax rate: 45% 2004 EBT: € 4.5 million Avg exchange rate: $ 1.20/€ 2004 EBT in US$: $ 5.4 million Trident Corporation (Los Angeles, USA) Trident China (Shanghai, China) Trident Brazil (Sáo Paulo, Brazil) Currency: Chinese renminbi (Rmb) Tax rate: 30% 2004 EBT: (Rmb 2.5 million) Avg exchange rate: Rmb 8.20/$ 2004 EBT in US$: ($ 0.305 million) Currency: Brazilian real (R$) Tax rate: 25% 2004 EBT: R$ 6.25 million Avg exchange rate: R$ 3.00/$ 2004 EBT in US$: $ 2.083 million

18. What is the Goal of Management? • As Trident becomes more deeply committed to multinational operations, a new constraint develops – one that springs from divergent worldwide opinions and practices as to just what the firms’ overall goal should be: • Shareholder Wealth Maximization – As characterized by Anglo-American markets • Corporate Wealth Maximization – As characterized by Continental European and Japanese markets

19. The Goal of Management • Shareholder Wealth Maximization • A firm should strive to maximize the return to shareholders (those individuals owning equity shares in the firm) • This view defines risk in a very strict financial sense • Risk is defined as the added risk a firm’s shares bring to a diversified portfolio (a fully diversified portfolio represents systematic risk) • The added firm-specific risk is known as unsystematic risk

20. The Goal of Management • Corporate Wealth Maximization • A view that all a corporations stakeholders (employees, management, suppliers, local community, local/national government and creditors) need to be considered in addition to the equity holders • The goal is to earn as much as possible in the long run, but to retain enough to increase the corporate wealth for the benefit of all • The definition of corporate wealth is much broader than just financial wealth, it includes technical, market and human resources as well

21. Shareholders Shareholders Firm (management) Main Bank Firm (management) Banks Employees The Goal of Management “Impatient Capital” “Patient Capital” The Non-Anglo-American Model has come under increasing criticism for its lack of accountability to equity investors – its shareholders – while focusing on the demands of too diffuse a group of stakeholders. The Anglo-American Model has been frequently criticized as focusing on short-term profitability rather than long-term growth.

22. Corporate Governance • The relationship among stakeholders used to determine and control the strategic direction and performance of an organization is termed corporate governance • The corporate governance of the organization is therefore the way in which order and process is established to ensure that decisions are made and interests are represented – for all stakeholders - properly

23. Corporate Governance • The single overriding objective of corporate governance in the shareholder wealth model is the optimization over time of the returns to shareholders • The most widely accepted statement of good corporate governance (established by the OECD) focus on the following principles; • The rights and equitable treatment of shareholders • The role of stakeholders in corporate governance • Disclosure and transparency • The responsibilities of the board

24. The Structure of Corporate Governance Equity Markets Analysts and other market agents evaluate the performance of the firm on a daily basis The Marketplace (external) The Corporation (internal) Debt Markets Ratings agencies and other analysts review the ability of the firm to service debt Board of Directors Chairman of the Board and members are accountable for the organization Auditors Provide an external opinion as to the fairness of presentation and conformity to standards of financial statements Management Chief Executive Officer (CEO) and his team run the company Regulators SEC, the NYSE, or other regulatory bodies by country Corporate governance represents the relationship among stakeholders that is used to determine and control the strategic direction and performance of the organization.

25. Corporate Governance • The origins of the need for a corporate governance process arise from the separation of ownership from management, and from the varying views by culture of who the stakeholders are and of what significance • A governance regime (system) is a function of; • Financial market development • The degree of separation between management and ownership • The concept of disclosure and transparency

26. Corporate Governance • Market-based regimes (U.S. and U.K.) are characterized by relatively efficient capital markets with dispersed ownership • Family-based regimes (Asia, Latin America) involve strong concentrations of family ownership • Bank-based and government-based regimes result in only marginal public ownership and sometimes significant restrictions on business practices

27. Corporate Governance • Does good governance matter? • Certainly, as in the case of Enron, many of the improprieties were overlooked as long as the company’s share price continued to rise • However, after the fall of Enron, and the substantial losses sustained by investors, employees and society as a whole, many would say that corporate governance matters a lot

28. The Value of Good Governance How much more (what premium) would you be willing to pay for a share in a ‘good governance’ company in the following countries? Source: “McKinsey Global Investor Opinion Survey on Corporate Governance, 2002,” McKinsey & Company, July 2002.

29. Potential Responses to Shareholder Dissatisfaction Possible Action Popular Term Remain Quietly Disgruntled The Past Sell the Shares Walk-Away Shareholder Dissatisfaction Change Management Shareholder Activism Initiate a Takeover Maximum Threat What counts is that the management of a publicly-quoted company, and its board of directors, know that the company can become the subject of a hostile takeover bid if they fail to perform.

30. Mini Case: The Failure of Corporate Governance at Enron • On December 2, 2001, Enron Corporation filed for bankruptcy protection under Chapter 11 • Enron failed as a result of a complex combination of business and governance failures • How did the system allow this to happen? • Why did the many structures and safeguards within the U.S. corporate governance system not catch, stop, or prevent the failure of Enron? • Please review the case, and the following exhibit in preparation for the case questions.

31. Enron’s Earnings by Segment (IBIT, millions) * IBIT is income before interest and taxes

32. Mini Case Questions: The Failure of Corporate Governance at Enron • Which parts of the corporate governance system (internal and external) failed Enron the most? • How could individual stakeholders and/or components of the corporate governance system have prevented the problems at Enron? How could they have acted to resolve these problems? • Do you believe this was an isolated incident, or are we to expect more collapses like Enron’s in the future? Why? • Will recent changes in Corporate Governance law help?

33. Summary of Learning Objectives • Financial management is an integral part of a firm’s strategy. This course analyzes how a firm’s financial management tasks evolve as it pursues global strategic opportunities and new constraints unfold • The evolution of firms from domestic to multinational is called the globalization process. A firm may enter into international trade transactions, then international contractual arrangements and ultimately the acquisition of foreign subsidiaries. This final stage is when a firm truly becomes a multinational

34. Summary of Learning Objectives • This globalization process results in a firm becoming increasingly influenced by exchange rate movements and other global political and economic forces in general • The decision whether or not to invest abroad may require the MNE to enter into global licensing agreements, joint ventures, acquisitions or Greenfield investments

35. Summary of Learning Objectives • Three major currency exposures arising from the conduct of multinational business that impact all firms are transaction, operating and translation exposure • The definitions of return and risk are not universally accepted. Indeed they may be culturally-denominated norms that vary by country • In Anglo-American markets, shareholder wealth maximization model is the norm. In non-Anglo-American markets, the corporate wealth model is the norm. Distinct differences exist as to how these models treat return and risk

36. Summary of Learning Objectives • As MNEs become more dependant on global capital markets for financing they may need to modify their policies of corporate governance. • A trend exists for firms resident in non-Anglo-American markets to move toward being more “stockholder friendly” while Anglo-American markets are moving toward being more “stakeholder friendly”

37. Summary of Learning Objectives • The relationship among stakeholders used to determine and control the strategic direction and performance of an organization is termed corporate governance • Dimensions of corporate governance include agency theory; composition and control of boards of directors; and cultural, historical, and institutional variables • Failures in corporate governance, especially in the United States, have recently been in the spotlight and have been given partial blame for the decline in value of the U.S. stock markets

38. Summary of Learning Objectives • Shareholders who are dissatisfied with their firm’s performance typically have four choices: remain quietly disgruntled; sell their shares; change management; or initiate a takeover • The recent failures in corporate governance in the United States have spawned a flurry of government and private initiatives to prevent the same kind of failures in the future • The United States has already reacted; passing the Sarbanes-Oxley act in 2002

39. Exhibit 1.1 What is Different About International Financial Management?

40. Exhibit 1.2 Trident Corp: Initiation of the Globalization Process

41. Exhibit 1.3 Trident’s Foreign Direct Investment Sequence

42. Exhibit 1.4 Trident’s Potential Risks and Returns Multiply with Global Operations

43. Exhibit 1.5 Trident’s Evaluation of Global Investments

44. Exhibit 1.6 The Currency and Tax Environments of Trident Corporation and Its Foreign Subsidiaries

45. Exhibit 1.7 The Corporate Wealth and Shareholder Wealth Maximization Models as Practiced in Anglo-American and Non-Anglo-American Markets

46. Exhibit 1.8 The Structure of Corporate Governance

47. Exhibit 1.9 Comparative Corporate Governance Regimes

48. Exhibit 1.10 The Value of Good Governance

49. Exhibit 1.11 Board Composition and Compensation, Fortune 100

50. Exhibit 1.12 Potential Responses to Shareholder Dissatisfaction