Finance and the Multinational Firm: The New Role

Explain what has led to the era of the multinational corporation. In the search for profits, U.S. corporations have been forced to look beyond our countrys borders. This movement has been spurred on by the collapse of communism and the acceptance of the free market system in third world countries. All this has taken place at a time when information technology has experienced a revolution brought on by the personal computer and the Internet. Concurrently, the United States went through an unprecedented period of deregulation of industries. These changes resulted in the opening of new international markets, and U.S. firms experienced a period of price competition here at home that made it imperative that businesses look across borders for investment opportunities. The end result is that many U.S. companies, including General Electric, IBM, Walt Disney, and American Express have restructured their operations to expand internationally. The bottom line is what you think of as a U.S. firm may be much more of a multinational firm than you would expect. For example, Coca-Cola earns over 80 percent of its profits from overseas sales and more money from its sales in Japan than it does from all its domestic sales. This is not uncommon. In fact, in 2008, 45 percent of the sales of S&P 500 listed companies came from outside the United States. In addition to U.S. firms venturing abroad, foreign firms have also made their mark in the United States. You need only look to the auto industry to see what changes the entrance of Toyota, Honda, Nissan, BMW, and other foreign car manufacturers have had on the auto industry. In addition, foreigners have bought and now own such companies as Brooks Brothers, RCA, Pillsbury, A&P, 20th Century Fox, Columbia Pictures, and Firestone Tire & Rubber. Consequently, even if we wanted to, we couldnt keep all our attention focused on the United States, and even more important, we wouldnt want to ignore the opportunities that are available across international borders.

Concept Check
1. What has brought on the era of the multinational corporation? 2. Has looking beyond U.S. borders been a profitable experience for U.S. corporations?

Summary
This chapter outlines the framework for the maintenance and creation of shareholder wealth, which should be the goal of the firm and its managers. The goal of maximization of shareholder wealth is chosen because it deals well with uncertainty and time in a real-world

environment. As a result, the maximization of shareholder wealth is found to be the proper goal for the firm.

Identify the goal of the firm.

Understand the five basic principles of finance and business, the consequences of forgetting those basic principles of finance, and the importance of ethics and trust in business. The five basic principles of finance are: 1. Cash Flow Is What Mattersincremental cash received and not accounting profits drives value. 2. Money Has a Time Valuea dollar received today is more valuable to the recipient than a dollar received in the future. 3. Risk Requires a Rewardthe greater the risk of an investment, the higher will be the investors required rate of return, and, other things remaining the same, the lower will be its value. 4. Market Prices Are Generally RightFor example, product market prices are often slower to react to important news than are prices in financial markets which tend to be very efficient and quick to respond to news. 5. Conflicts of Interest Cause Agency ProblemsLarge firms are typically run by professional managers who own a small fraction of the firms equity. The individual actions of these managers are often motivated by self-interest, which may result in managers not acting in the best interests of the firms owners. When this happens, the firms owners will lose value. While not one of the five principles of finance, ethics and trust are also essential elements of the business world, and without them, nothing works.

Describe the role of finance in business. Finance is the study of how people and businesses evaluate investments and raise capital to fund them. There are three basic types of issues that are addressed by the study of finance: (1) What long-term investments should the firm undertake? This area of finance is generally referred to as capital budgeting. (2) How should the firm raise money to fund these investments? The firms funding choices are generally referred to as capital structure

decisions. (3) How can the firm best manage its cash flows as they arise in its day-to-day operations? This area of finance is generally referred to as working capital management.

Distinguish between the different legal forms of business. The legal forms of business are examined. The sole proprietorship is a business operation owned and managed by an individual. Initiating this form of business is simple and generally does not involve any substantial organizational costs. The proprietor has complete control of the firm but must be willing to assume full responsibility for its outcomes. The general partnership, which is simply a coming together of two or more individuals, is similar to the sole proprietorship. The limited partnership is another form of partnership sanctioned by states to permit all but one of the partners to have limited liability if this is agreeable to all partners. The corporation increases the flow of capital from public investors to the business community. Although larger organizational costs and regulations are imposed on this legal entity, the corporation is more conducive to raising large amounts of capital. Limited liability, continuity of life, and ease of transfer in ownership, which increase the marketability of the investment, have contributed greatly in attracting large numbers of investors to the corporate environment. The formal control of the corporation is vested in the parties who own the greatest number of shares. However, day-to-day operations are managed by the corporate officers, who theoretically serve on behalf of the firms stockholders.

Explain what has led to the era of the multinational corporation. With the collapse of communism and the acceptance of the free market system in third world countries, U.S. firms have been spurred on to look beyond their own boundaries for new business. The end result has been that it is not uncommon for major U.S. companies to earn over half their income from sales abroad. Foreign firms are also increasingly investing in the United States.

Key Terms
Agency problem 7 Capital budgeting 11 Capital structure decision 11 Corporation 13 Efficient market 6

Financial markets 11 General partnership 13 Incremental cash flow 4 Limited liability company (LLC) 14 Limited partnership 13 Opportunity cost 5 Partnership 13 Sole proprietorship 12 S-corporation 14 Working capital management 11

Review Questions

All Review Questions and Study Problems are available in MyFinanceLab. 1-1. What are some of the problems involved in implementing the goal of maximization of shareholder wealth? 1-2. Firms often involve themselves in projects that do not result directly in profits. For example, IBM and ExxonMobil frequently support public television broadcasts. Do these projects contradict the goal of maximization of shareholder wealth? Why or why not? 1-3. What is the relationship between financial decision making and risk and return? Would all financial managers view riskreturn trade-offs similarly? 1-4. What is the agency problem and how might it impact the goal of maximization of shareholder wealth? 1-5. Define (a) sole proprietorship, (b) partnership, and (c) corporation. 1-6. Identify the primary characteristics of each form of legal organization. 1-7. Using the following criteria, specify the legal form of business that is favored: (a) organizational requirements and costs, (b) liability of the owners, (c) the continuity of

the business, (d) the transferability of ownership, (e) management control and regulations, (f) the ability to raise capital, and (g) income taxes. 1-8. There are a lot of great business majors. Check out the Careers in Business Web site at www.careers-in-business.com. It covers not only finance but also marketing, accounting, and management. Find out about and provide a short write-up describing the opportunities investment banking and financial planning offer. 1-9. Like it or not, ethical problems seem to crop up all the time in finance. Some of the worst financial scandals are examined on the Financial Scandals Web site www.ex.ac.uk/~RDavies/arian/scandals/classic.html. Take a look at the write-ups dealing with The Credit Crunch, The Dot-Com Bubble and Investment Banks and Bernard L. Madoff Investment Securities. Provide a short write-up on these events. 1-10. We know that if a corporation is to maximize shareholder wealth, the interests of the managers and the shareholders must be aligned. The simplest way to align these interests is to structure executive compensation packages appropriately to encourage managers to act in the best interests of shareholders. However, has executive compensation gotten out of control? Take a look at the Executive Pay Watch Web site at www.aflcio.org/corporatewatch/paywatch to see to whom top salaries have gone. What are the most recent total compensation packages for the head of Oracle (ORCL), Home Depot (HD), Disney (DIS), and ExxonMobil (XOM)?

Mini Case
The final stage in the interview process for an assistant financial analyst at Caledonia Products involves a test of your understanding of basic financial concepts. You are given the following memorandum and asked to respond to the questions. Whether you are offered a position at Caledonia will depend on the accuracy of your response. To: Applicants for the position of Financial Analyst From: Mr. V. Morrison, CEO, Caledonia Products Re: A test of your understanding of basic financial concepts and of the corporate tax code Please respond to the following questions: a. b. What is the appropriate goal for the firm and why? What does the riskreturn trade-off mean?

c. Why are we interested in cash flows rather than accounting profits in determining the value of an asset? d. What is an efficient market and what are the implications of efficient markets for us?

e. f. g.

What is the cause of the agency problem and how do we try to solve it? What do ethics and ethical behavior have to do with finance? Define (1) sole proprietorship, (2) partnership, and (3) corporation.

(Foundations of Finance for Ashford University, 7th Edition. Pearson Learning Solutions p. 15). <vbk:9781256064961#outline(9.6)>

chapter.

Finance and the Multinational Firm: Efficient Financial Markets and Intercountry Risk

Understand the relationships among the multinational firm, efficient financial markets, and intercountry risk. In this chapter we have discussed and demonstrated that the United States has a highly developed, complex, and competitive system of financial markets that allows for the quick transfer of savings from people and organizations with a surplus of savings to people and organizations with a savings deficit. Such a system of robust and credible financial markets allows great ideas (such as the personal computer) to be financed and increases the overall wealth of the given economy. One major reason underdeveloped countries are indeed underdeveloped is that they lack a financial market system that has the confidence of those who must use itsuch as the multinational firm. The multinational firm with cash to invest in foreign markets will weigh heavily the integrity of both the financial system and the political system of the prospective foreign country. A lack of integrity on either the financial side or the political stability side retards direct investment in the lesser-developed nation. Consider the Walt Disney Company, headquartered in Burbank, California. Disney common stock trades on the NYSE (DIS), although the firm has significant overseas real investments such as Disneyland Paris Resort, Tokyo Disneyland, Hong Kong Disneyland, and Shanghai Disneyland. Disney has confidence in Chinas financial markets and those of western Europe and Japan. Disney would be less inclined to invest in a country like North Korea because it is less politically and financially stable.

Concept Check
1. Identify one major reason why underdeveloped countries remain underdeveloped.

Summary
This chapter centers on the market environment in which corporations raise long-term funds, including the structure of the U.S. financial markets, the institution of investment banking, and the various methods for distributing securities. It also discusses the role interest rates play in allocating savings to ultimate investment.

Describe key components of the U.S.financial market system and the financing of business. Corporations can raise funds through public offerings or private placements. The public market is impersonal in that the security issuer does not meet the ultimate investors in the financial instruments. In a private placement, the securities are sold directly to a limited number of institutional investors.

Understand the role of the investment-banking business in the context of raising corporate capital. The primary market is the market for new issues. The secondary market represents transactions in currently outstanding securities. Both the money and capital markets have primary and secondary sides. The money market refers to transactions in short-term debt instruments. The capital market, on the other hand, refers to transactions in long-term financial instruments. Trading in the capital markets can occur in either the organized security exchanges or the over-the-counter market. The money market is exclusively an overthe-counter market.

Understand private debt placements and flotation costs. The investment banker is a financial specialist involved as an intermediary in the merchandising of securities. He or she performs the functions of (1) underwriting, (2) distributing, and (3) advising. Major methods for the public distribution of securities include (1) the negotiated purchase, (2) the competitive bid purchase, (3) the commission or bestefforts basis, (4) privileged subscriptions, and (5) direct sales. The direct sale bypasses the use of an investment banker. The negotiated purchase is the most profitable distribution method to the investment banker. It also provides the greatest amount of investment-banking services to the corporate client. Today, there are no major stand-alone investment bankers.

Be acquainted with recent interest rate levels.

Privately placed debt provides an important market outlet for corporate bonds. Major investors in this market are (1) life insurance firms, (2) state and local retirement funds, and (3) private pension funds. Several advantages and disadvantages are associated with private placements. The financial officer must weigh these attributes and decide if a private placement is preferable to a public offering.

Explain the fundamentals of interest rate determination and the popular theories of the term structure of interest rates. Flotation costs consist of the underwriters spread and issuing costs. The flotation costs of common stock exceed those of preferred stock, which, in turn, exceed those of debt. Moreover, flotation costs as a percent of gross proceeds are inversely related to the size of the security issue. On July 30, 2002, President Bush signed into law the Sarbanes-Oxley Act of 2002. Its intended purpose as stated in the act is to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes. The financial markets give managers an informed indication of investors opportunity costs. The more efficient the market, the more informed the indication. This information is a useful input about the rates of return that investors require on financial claims. In turn, this becomes useful to financial managers as they estimate the overall cost of capital the firm will have to pay for its financing needs. From Principle 3: Risk Requires a Reward, you know that the rates of return on various securities are based on the risks that investors face when they invest in those securities. In addition to a risk-free return, investors will want to be compensated for the potential loss of purchasing power resulting from inflation. Moreover, investors require a greater return the greater the default risk, maturity premium, and liquidity premium are on the securities being analyzed.

Understand the relationships among the multinational firm, efficient financial markets, and intercountry risk. A system of robust and credible financial markets allows great ideas to be financed and increases the overall wealth of a given economy. The multinational firm with cash to invest in foreign markets will weigh heavily the integrity of both the financial system and the political system of the prospective foreign country where the proposed investment project will be domiciled. A lack of integrity on either the financial side or the political stability side retards direct investment in a less-developed nation.

Key Terms

Angel investor 20 Capital market 19 Default-risk premium 34 Direct sale 28 Dutch auction 28 Flotation costs 30 Futures market 23 Inflation-risk premium 34 Initial public offering, IPO 22 Investment banker 25 Liquidity preference theory 42 Liquidity premium 34 Market segmentation theory 42 Maturity premium 34 Money market 22 Nominal (or quoted) rate of interest 34 Opportunity cost of funds 31 Organized security exchange 23 Over-the-counter market 23 Primary market 22 Private placement 21 Privileged subscription 27 Public offering 21 Real rate of interest 35 Real risk-free interest rate 35

Seasoned equity offering, SEO 22 Secondary market 22 Spot market 23 Syndicate 26 Term structure of interest rates 39 Unbiased expectations theory 41 Underwriters spread 25 Underwriting 25 Venture capital firm 21 Venture capitalist 20 Yield to maturity 39

Review Questions

All Review Questions and Study Problems are available in MyFinanceLab. 2-1. Distinguish between the money and capital markets. 2-2. What major benefits do corporations and investors enjoy because of the existence of organized security exchanges? 2-3. What general criteria does an organized exchange examine to determine whether a firms securities can be listed on the exchange? (Specific numbers are not needed here but rather areas of investigation.) 2-4. Why do you think most secondary-market trading in bonds takes place over the counter? 2-5. What is an investment banker, and what major functions does he or she perform? 2-6. What is the major difference between a negotiated purchase and a competitive bid purchase? 2-7. Why is an investment-banking syndicate formed?

2-8. Why might a large corporation want to raise long-term capital through a private placement rather than a public offering? 2-9. As a recent business school graduate, you work directly for the corporate treasurer. Your corporation is going to issue a new security and is concerned with the probable flotation costs. What tendencies about flotation costs can you relate to the treasurer? 2-10. Identify three distinct ways that savings are ultimately transferred to business firms in need of cash. 2-11. Explain the term opportunity cost with respect to the cost of funds to the firm. 2-12. Compare and explain the historical rates of return for different types of securities. 2-13. Explain the impact of inflation on rates of return. 2-14. Define the term structure of interest rates. 2-15. Explain the popular theories for the rationale of the term structure of interest rates.

Study Problems
2-1. (Calculating the default-risk premium) At present, 10-year Treasury bonds are yielding 4% while a 10-year corporate bond was yielding 6.8%. If the liquidity premium on the corporate bond was 0.4%, what is the corporate bonds default-risk premium? 2-2. (Real interest rates: financial analysts method) The CFO of your firm has asked you for an approximate answer to this question: What was the increase in real purchasing power associated with both 3-month Treasury bills and 30-year Treasury bonds? Assume that the current 3-month Treasury bill rate is 4.34 percent, the 30-year Treasury bond rate is 7.33 percent, and the inflation rate is 2.78 percent. Also, the chief financial officer wants a short explanation should the 3-month real rate turn out to be less than the 30-year real rate. 2-3. (Inflation and interest rates) What would you expect the nominal rate of interest to be if the real rate is 4 percent and the expected inflation rate is 7 percent? 2-4. (Inflation and interest rates) Assume the expected inflation rate to be 4 percent. If the current real rate of interest is 6 percent, what ought the nominal rate of interest be? 2-5. (Calculating the maturity premium) At present, the real risk-free rate of interest is 2%, while inflation is expected to be 2% for the next two years. If a 2-year Treasury note yields 4.5%, what is the maturity premium for this 2-year Treasury note?

2-6. (Term structure of interest rates) You want to invest your savings of $20,000 in government securities for the next 2 years. Currently, you can invest either in a security that pays interest of 8 percent per year for the next 2 years or in a security that matures in 1 year but pays only 6 percent interest. If you make the latter choice, you would then reinvest your savings at the end of the first year for another year. a. Why might you choose to make the investment in the 1-year security that pays an interest rate of only 6 percent, as opposed to investing in the 2-year security paying 8 percent? Provide numerical support for your answer. Which theory of term structure have you supported in your answer? b. Assume your required rate of return on the second-year investment is 11 percent; otherwise, you will choose to go with the 2-year security. What rationale could you offer for your preference?

Mini Case
On the first day of your summer internship, youve been assigned to work with the Chief Financial Officer (CFO) of SanBlas Jewels Inc. Not knowing how well trained you are, the CFO has decided to test your understanding of interest rates. Specifically, she asked you to provide a reasonable estimate of the nominal interest rate for a new issue of Aaa-rated bonds to be offered by SanBlas Jewels Inc. The final format that the chief financial officer of SanBlas Jewels has requested is that of equation (2-1) in the text. Your assignment also requires that you consult the data in Table 2-2. Some agreed-upon procedures related to generating estimates for key variables in equation (2-1) follow. a. The current 3-month Treasury bill rate is 2.96 percent, the 30-year Treasury bond rate is 5.43 percent, the 30-year Aaa-rated corporate bond rate is 6.71 percent, and the inflation rate is 2.33 percent. b. The real risk-free rate of interest is the difference between the calculated average yield on 3-month Treasury bills and the inflation rate. c. The default-risk premium is estimated by the difference between the average yield on Aaa-rated bonds and 30-year Treasury bonds. d. The maturity premium is estimated by the difference between the average yield on 30-year Treasury bonds and 3-month Treasury bills. e. SanBlas Jewels bonds will be traded on the New York Bond Exchange, so the liquidity premium will be slight. It will be greater than zero, however, because the secondary market for the firms bonds is more uncertain than that of some other jewel sellers. It is estimated at 4 basis points. A basis point is one one-hundredth of 1 percent.

Now place your output into the format of equation (2-1) so that the nominal interest rate can be estimated and the size of each variable can also be inspected for reasonableness and discussion with (Foundations of Finance for Ashford University, 7th Edition. Pearson Learning Solutions p. 42). <vbk:9781256064961#outline(10.7)>