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P A R T

1
Global Financial
Environment
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C H A P T E R 1
Globalization
and the Multinational
Enterprise
L E AR NI NG OBJ E C T I VE S

Examine the requirements for the creation of value

Consider the basic theory, comparative advantage, and its requirements for the
explanation and justification for international trade and commerce

Discover what is different about international financial management

Detail which market imperfections give rise to the multinational enterprise

Consider how the globalization process moves a business from a purely domestic
focus in its financial relationships and composition to one truly global in scope

Examine possible causes to the limitations to globalization in finance


MI NI - C AS E I NT RODUCT I ON
Porsche Changes Tack
After reading this chapter, you will be able to debate the question posed by this chap-
ters main mini-case entitled Porsche Changes Tackwhether Porsches new strategy
will increase or decrease its returns to its shareholders.
Porsches financial resultsincluding returns to shareholdershad been the envy of the
automobile industry for a decade. It was indeed the worlds most profitable automobile com-
pany. Porsches CEO, Dr. Wendelin Wiedeking, had been credited with clarity of purpose and
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3 Chapter 1: Globalization and the Multinational Enterprise
sureness of execution. As one colleague described him: He grew up PSD: poor, smart, and
driven. He was now rich, smart, and riding.
Porsches strategy had been unique among high-end European automakers. It had cho-
sen to remain largely Germany-based (or more accurately European-based). Unlike Mercedes
or BMW, it had chosen not to build manufacturing facilities in its largest single market, the
United States. Instead, it maintained all manufacturing and assembly in Europe, but did so
with corporate partners in different ways. The Boxster, what some called the poor mans
Porsche, was manufactured by Valmet of Finland under an outsourced manufacturing agree-
ment. The Porsche Cayenne, the $80,000 sport utility vehicle, was largely assembled on the
Volkswagen Touareg assembly line in Bratislava in the Slovak Republic. Porsche had achieved
some of the highest returns on invested capital in the auto industry by using other peoples
money.
But Porsche had just announced two strategic initiatives, which seemingly were a com-
pletely new competitive direction. It would begin the design and development of a fourth
auto model, the Panamera, but would do so completely in-house, using its own money and
own facilities. Simultaneously, it shocked the markets by spending more than 3 billion to
acquire a controlling interest in what was considered one of Europes worst automobile com-
paniesVolkswagen. Shareholders and analysts alike were aghast. What was this company
doing?
To check your understanding, read the chapter and the mini-case in its entirety
(the complete mini-case is located toward the end of this chapter), and then answer the
case questions at the end.
T
his book is about international financial management with special emphasis on
the multinational enterprise. The multinational enterprise (MNE) is defined as
one that has operating subsidiaries, branches, or affiliates located in foreign coun-
tries. It also includes firms in service activities such as consulting, accounting, con-
struction, legal, advertising, entertainment, banking, telecommunications, and lodging.
MNEs are globally headquartered. Many of them are owned by a mixture of
domestic and foreign shareholders. The ownership of some firms is so dispersed inter-
nationally that they are known as transnational corporations. The transnationals are
usually managed from a global perspective rather than from the perspective of any sin-
gle country.
Although Fundamentals of Multinational Finance emphasizes MNEs, purely
domestic firms also often have significant international activities. These include the
import and export of products, components, and services. Domestic firms can also
license foreign firms to conduct their foreign business. They have exposure to foreign
competition in their domestic market. They also have indirect exposure to interna-
tional risks through their relationships with customers and suppliers. Therefore,
domestic firm managers need to understand international financial risk, especially
those related to foreign exchange rates and the credit risks related to trade payments.
Fundamentals of Multinational Finance is written in English and usually uses the
U.S. dollar in its exposition. However, the authors have tried to make it relevant for all
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Global Financial Environment
multinational enterprises by using numerous nonU.S.-based MNEs. We will use the
term multinational enterprise (MNE) throughout this text for two very important rea-
sons. First, the term multinational is used rather than international because we will
focus on the third phase of the globalization process in which firms operate businesses
in many different countries. Second, we use the term enterprise instead of corporation
because as businesses move into many emerging markets, they will enter into joint ven-
tures, strategic alliances, or simply operating agreements with enterprises that may not
be publicly traded or even privately owned (and therefore not corporations), but actu-
ally extensions of government.
Globalization and Creating Value
in the Multinational Enterprise
I define globalization as producing where it is most cost-effective, selling where it is
most profitable, and sourcing capital where it is cheapest, without worrying about
national boundaries.
Narayana Murthy, President and CEO, Infosys
Global business, like any business, is the social science of managing people to organize,
maintain, and grow the collective productivity toward accomplishing productive goals,
typically to generate profit and value for its owners and stakeholders. Reaching that
goalbuilding firm valuerequires combining three critical elements: 1) an open mar-
ketplace; 2) high quality strategic management; and 3) access to capital. As shown in
Exhibit 1.1, any MNE attempting to create value would need to combine these three
critical elements composing the sides of the firm value pyramid.
Mature
Economies
Rapidly Developing
Countries
Emerging Market Countries
Level III
Level II
Level I
Open
Marketplace
Strategic
Management
Access to
Capital
Building
Firm Value
The challenge to building firm valuevalue for all stakeholders including stockholders,
corporate stakeholders, and social communityis in the expansion and development
of all three sides of the global pyramid: an open marketplace; access to
affordable capital; and high-quality strategic management.
EXHI BI T 1 . 1
Creating Firm Value in Global Markets
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5 Chapter 1: Globalization and the Multinational Enterprise
An Open Marketplace
Market economics is the fundamental condition for value creation. The MNE has little
opportunity to thrive and grow if it is not operating within a marketplace that allows
free movement and competition of labor, capital, technology, and the spirits of innova-
tion and entrepreneurship. The rapid economic development of China, and the many
businesses arising within China today, are ready examples of the power of the increas-
ingly open marketplace. There are, however, many complexities to fostering healthy
market economics in any country, and many countries have yet to find the magical mix.
Strategic Management
Although the ability to compete in a marketplace is a requirement, the ability to see
business opportunities, and then to design, develop, and execute a corporate strategy
through all levels of leadership and management is needed to create value. Although
the basic elements of innovation and entrepreneurship are probably embedded in the
human DNA, good strategy and management are not. Yet insightful strategy and
adept leadership is critical to creating value. It is not something that has yet been
quantified or captured; as any business student knows, if computers could do it, they
wouldnt hire you.
Access to Capital
Open markets and insightful leadership is all for nought, however, if the MNE cannot
gain ready access to affordable capital. It is the capital that allows the investment
needed to obtain the technology, execute the strategy, and expand across global mar-
kets. It is the capital in capitalism; it is the ability of the enterprise to reach out and
obtain resources from outside of the firm to pursue the firms vision and create the
value for all of the key stakeholders in the enterprise itself, and subsequently for the
community and society of which it is an integral element.
The level of development of these three combined elements, Levels IIII shown in
Exhibit 1.1, is representative of the degrees of depth, breadth, and sophistication acces-
sible by the MNE. For example:

General Electric (USA) may be considered a resident of Level III. It is a global


MNE with widely recognized strategic leadership and management quality, ready
access to cheap and plentiful capital, and a key competitor in the most competitive
and open marketplaces in the world.

Cemex (Mexico) may be an example of a resident of Level II. A rapidly growing


competitor in its global industry, it is based in Mexico, which is rapidly emerging as
a market economy of nearly limitless potential. Yet Cemex is still sometimes ham-
pered in its access to ready and affordable capital to support its business goals.

The Haier Group (China) may be representative of an MNE resident in Level I of


the value pyramid. Although highly successful and an MNE to be reckoned with
in a growing number of marketplaces, Haier is still struggling to overcome barri-
ers and limitations of all three critical elements from its Chinese base.
As described in Global Finance in Practice 1.1, the evolution of the domestic company
to multinational and a-national is generating significant benefits for all stakeholders.
These three firms are residents of the pyramid. Their positions in the pyramid are
the result of the complex interaction of the three key elementsthe three sides of the
pyramidwith the level of economic development and openness of the countries
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Global Financial Environment
Global Finance in Practice 1.1
When Isaac Merritt Singer set up a branch of his
sewing machine maker in Paris in 1855, he probably
did not think he was blazing a trail US companies
would still be following more than 150 years later.
Singers expansion in France turned the New York-
based company into the first US multinational, pio-
neering a business model that would be adopted by
other icons of American capitalism, from Ford to
Standard Oil to General Electric. But perhaps the
most important legacy of Singers daring move was
that it worked: within six years of the French open-
ing, foreign sales had exceeded US revenues. It is a
lesson not lost on todays corporate leaders.
Over the past three months, blue-chips such as
General Electric, the conglomerate, IBM, the technol-
ogy giant, and UPS, the logistics group, have hitched
a ride on a global economy growing faster than the
US. By contrast, companies that depend on domestic
consumers such as Wal-Mart, the retail bell-wether,
and Home Depot, the do-it-yourself chain, have
released disappointing results and gloomy predic-
tions.
But if foreign earnings have helped US multina-
tionals stave off a fall in profitability, the question is
whether the current reliance on the rest of the world
is just a cyclical phase or the harbinger of a transfor-
mation in corporate America. Could the importance
of overseas markets destroyas Sam Palmisano,
IBMs chief executive, has arguedthe old multina-
tional model whereby companies decentralised
manufacturing and sales operations but kept key
functions such as the executive office, research and
product design in the home country? And if so, are
some US companies ready to become truly transna-
tional by scattering their top executives around the
world?
At first sight, there are significant cyclical forces
behind the recent rise of US multinationalsforces,
in other words, that could change in the near future.
First, the dollar has lost nearly a third of its value
against Americas largest trading partners over the
past seven years, making it easier for US exporters to
sell to the world and boosting the dollar value of
overseas earnings. Second, US multinationals have
been boosted by global economic growth, which has
largely been driven by emerging markets hungry for
infrastructure and consumer goodstwo of America
Incs strongest suits.
But even if economic changes and internal revolu-
tions at companies mean, in the words of Steve Mills,
head of IBMs global software business, that things
cannot go back to the way they were, will more com-
panies abandon national allegiance and become
truly a-national? Big Blueas IBM is known
claims to be just that, with operations in more than
150 countries and key functions spread around the
world. Its head of procurement, for example, is based
in Shenzhen, China, half a world away from Mr
Palmisanos headquarters in Armonk, New York.
Ours is a boundary-less way of thinking, says Mr
Mills.
However, many US chief executives regard such
moves as impractical, if not outright dangerous. They
argue that being rooted in the US is not only an
insurance policy in case the globalisation tide turns,
but also a way of maintaining order and focus in
increasingly complex and dispersed enterprisesof
letting everybody know where the buck stops and
who is in charge. Jeffrey Immelt, who heads GE, one
of the most global companies in the US, recently
distilled this view: Were an American company but
in order to be successful weve got to win in every
corner of the world. In other words, global aspira-
tions tinged with national pridewhich Singer
would have understoodis just as recognisable
today among US business leaders.
Source: Excerpted from US Companies Choose: National
Multinational or A-National?, Francesco Guerrera, Financial Times,
August 16, 2007, p. 7.
of their business activities. The Porsche mini-case at the end of the chapter will chal-
lenge the reader to determine where it might fall within the architecture of the value
pyramid.
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National Multinational or A-National ?
7 Chapter 1: Globalization and the Multinational Enterprise
As we shall see throughout this book, the global economy is seeing an unprece-
dented growth in the resident MNEs in the value pyramid, and the size and shape of
the pyramid tomorrow is probably limitless. We now move to the underlying principle
driving the growth of the global businesscomparative advantage.
The Theory of Comparative Advantage
The theory of comparative advantage provides a basis for explaining and justifying
international trade in a model world assumed to enjoy free trade, perfect competition,
no uncertainty, costless information, and no government interference.
1
The theory con-
tains the following features:

Exporters in Country Asell goods or services to unrelated importers in Country B.

Firms in Country A specialize in making products that can be produced relatively


efficiently, given Country As endowment of factors of production; that is, land,
labor, capital, and technology. Firms in Country B do likewise, given the factors of
production found in Country B. In this way the total combined output of A and B
is maximized.

Because the factors of production cannot be moved freely from Country A to


Country B, the benefits of specialization are realized through international trade.

The way the benefits of the extra production are shared depends on the terms of
trade, the ratio at which quantities of the physical goods are traded. Each countrys
share is determined by supply and demand in perfectly competitive markets in the
two countries. Neither Country A nor Country B is worse off than before trade,
and typically both are better off, albeit perhaps unequally.
An Example of Comparative Advantage
For an example of the benefits of free trade based on comparative advantage, assume
that Thailand is more efficient than Brazil at producing both sports shoes and stereo
equipment. With one unit of production (a mix of land, labor, capital, and technology),
efficient Thailand can produce either 12 shipping containers (ctrs) of shoes or 6 ship-
ping containers of stereo equipment. Brazil, being less efficient in both, can produce
only 10 containers of shoes or 2 containers of stereo equipment with one unit of input.
These production capabilities are as follows:
A production unit in Thailand has an absolute advantage over a production unit in
Brazil in both shoes and stereo equipment. Nevertheless, Thailand has a larger relative
advantage over Brazil in producing stereo equipment (6 to 2) than shoes (12 to 10). As
long as these ratios are unequal, comparative advantage exists.
Production Capability
Containers of
sports shoes
Containers of
stereo equipment
Thailand has 1,000 production units: 12 containers/unit 6 containers/unit
Brazil has 1,000 production units: 10 containers/unit 2 containers/unit
1
The theory of comparative advantage was first proposed by David Ricardo in Principles of Political
Economy, 1817.
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Assume that no trade takes place, and each country divides its own production
units between shoes and stereo equipment. Each country elects to allocate 300 pro-
duction units to shoes and 700 production units to stereo equipment, resulting in the
production and consumption outcomes in the top half of Exhibit 1.2.
Now assume complete specialization. Thailand produces only stereo equipment
and Brazil produces only shoes. World production would be higher for both shoes and
stereo equipment, as shown in the bottom half of Exhibit 1.2.
Clearly, the world in total is now better off because there are now 10,000 contain-
ers of shoes instead of just 6,600. And there are 6,000 containers of stereo equipment
instead of just 5,600. But distribution is quite distorted. The Thais now tap bare feet to
their music, and the Brazilians dance during Carnival with good shoes but no recorded
music!
Trade can resolve this distribution problem. Assume initially that trade between
Thailand and Brazil takes place at the ratio of 2 containers of shoes for 1 container of
stereo equipment. This exchange rate of 2 containers of shoes for 1 container of stereo
equipment is Thailands domestic price; that is, the ratio of trade within Thailand
should it produce both items and not engage in international trade. Assume further that
Thailand exports 1,800 containers of stereo equipment to Brazil and imports 3,600 con-
tainers of shoes from Brazil. The situation would be as shown in Exhibit 1.3.
EXHI BI T 1 . 2
The Theory of Comparative Advantage: A Numerical Example of Brazil and Thailand
Production if No Trade
Shoe Production (ctrs) Stereo Production (ctrs)
Thailand produces and consumes 300 12 = 3,600 700 6 = 4,200
Brazil produces and consumes 300 10 = 3,000 700 2 = 1,400
Total world production and consumption 6,600 5,600
Complete Specialization
Shoe Production (ctrs) Stereo Production (ctrs)
Thailand produces only stereo equipment 1,000 6 = 6,000
Brazil produces only shoes 1,000 10 = 10,000
Total world production and consumption 10,000 6,000
EXHI BI T 1 . 3
Trade at Thailands Domestic Price
For each container of stereo equipment exported, Thailand imports two containers of shoes from Brazil
Shoe Production
plus/minus trade (ctrs)
Stereo Production
plus/minus trade (ctrs)
Thailand produces 6,000 containers of stereo
equipment and exports 1,800 containers 0 + 3,600 = 3,600 6,000 1,800 = 4,200
Brazil produces 10,000 containers of shoes and
exports 3,600 containers 10,000 3,600 = 6,400 0 + 1,800 = 1,800
World production and consumption 10,000 6,000
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9 Chapter 1: Globalization and the Multinational Enterprise
At this price all gains go to Brazil, which consumes 6,400 containers of shoes
(instead of 3,000 with no trade) and consumes 1,800 containers of stereo equipment
(instead of 1,400 with no trade). Thailands consumption, 3,600 containers of shoes and
4,200 containers of stereos, is just as it was with no trade. Thailand has gained nothing
from trade at this price although it has lost nothing either!
Assume now that trade takes place at Brazils domestic price of 5 containers of
shoes for each container of stereo equipment. This is shown in Exhibit 1.4. At Brazils
internal price, all gains go to Thailand, which now consumes 7,000 containers of shoes
(instead of 3,600 with no trade) and 4,600 containers of stereo equipment (instead of
4,200 with no trade). Brazils consumption, 3,000 containers of shoes and 1,400 con-
tainers of stereo equipment, is the same as with no trade. Brazil has gained nothing
from trade at this pricealthough neither has it lost anything.
Now let trade take place at a price in between Thailands domestic price of 2-to-1
and Brazils domestic price of 5-to-1. Assume that free bargaining leads to a price of 4-
to-1, as seen in Exhibit 1.5. At any price between the boundaries of 2-to-1 and 5-to-1,
both countries benefit from specializing and trading. At a 4-to-1 price, Thailand con-
sumes 2,800 more containers of shoes as well as 200 more containers of stereo equip-
ment than it has consumed with no trade. Brazil consumes 600 more containers of
shoes as well as 200 more containers of stereo equipment than it has consumed with
no trade. Total combined production of both shoes and stereo equipment has increased
through the specialization process, and it only remains for the exchange ratio to deter-
mine how this larger output is distributed between the two countries.
EXHI BI T 1 . 4
Trade at Brazils Domestic Price
For each container of stereo equipment exported, Thailand imports five containers of shoes from Brazil.
Shoe Production
plus/minus trade (ctrs)
Stereo Production
plus/minus trade (ctrs)
Thailand produces 6,000 containers of stereo
equipment and exports 1,400 containers 0 + 7,000 = 7,000 6,000 1,400 = 4,600
Brazil produces 10,000 containers of shoes and
exports 7,000 containers 10,000 7,000 = 3,000 0 + 1,400 = 1,400
World production and consumption 10,000 6,000
EXHI BI T 1 . 5
Trade at a Price Reached by Free Bargaining
For each container of stereo equipment exported, Thailand imports four containers of shoes from Brazil.
Shoe Production
plus/minus trade (ctrs)
Stereo Production
plus/minus trade (ctrs)
Thailand produces 6,000 containers of stereo
equipment and exports 1,600 containers 0 + 6,400 = 6,400 6,000 1,600 = 4,400
Brazil produces 10,000 containers of shoes and
exports 6,400 containers 10,000 6,400 = 3,600 0 + 1,600 = 1,600
World production and consumption 10,000 6,000
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Limitations of Comparative Advantage
Although international trade might have approached the comparative advantage
model during the nineteenth century, it certainly does not today, for the following
reasons:

Countries do not appear to specialize only in those products that could be most
efficiently produced by that countrys particular factors of production. Instead,
governments interfere with comparative advantage for a variety of economic and
political reasons, such as to achieve full employment, economic development,
national self-sufficiency in defense-related industries, and protection of an agricul-
tural sectors way of life. Government interference takes the form of tariffs, quo-
tas, and other non-tariff restrictions.

At least two of the factors of production, capital and technology, now flow directly
and easily between countries, rather than only indirectly through traded goods and
services. This direct flow occurs between related subsidiaries and affiliates of
multinational firms, as well as between unrelated firms via loans, and license and
management contracts. Even labor flows between countries such as immigrants
into the Untied States (legal and illegal), immigrants within the European Union,
and possibly other economic unions.

Modern factors of production are more numerous than in this simple model.
Factors considered in the location of production facilities worldwide include local
and managerial skills, a dependable legal structure for settling contract disputes,
research and development competence, educational levels of available workers,
energy resources, consumer demand for brand name goods, mineral and raw mate-
rial availability, access to capital, tax differentials, supporting infrastructure (roads,
ports, communication facilities), and possibly others.

Although the terms of trade are ultimately determined by supply and demand, the
process by which the terms are set is different from that visualized in traditional
trade theory. They are determined partly by administered pricing in oligopolistic
markets.

Comparative advantage shifts over time as less developed countries become more
developed and realize their latent opportunities. For example, over the past 150
years comparative advantage in producing cotton textiles has shifted from the

The classical model of comparative advantage did not really address certain other
issues such as the effect of uncertainty and information costs, the role of differen-
tiated products in imperfectly competitive markets, and economies of scale.
Nevertheless, although the world is a long way from the classical trade model, the
general principle of comparative advantage is still valid. The closer the world gets to
true international specialization, the more world production and consumption can be
increased, provided the problem of equitable distribution of the benefits can be solved
to the satisfaction of consumers, producers, and political leaders. Complete specializa-
tion, however, remains an unrealistic limiting case, just as perfect competition is a lim-
iting case in microeconomic theory.
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United Kingdom to the United States, to Japan, to China Hong Kong, to China
Taiwan, and to China.
19


11 Chapter 1: Globalization and the Multinational Enterprise
Supply Chain Outsourcing:
Comparative Advantage Today
Comparative advantage is still a relevant theory to explain why particular countries
are most suitable for exports of goods and services that support the global supply chain
of both MNEs and domestic firms. The comparative advantage of the twenty-first cen-
tury, however, is one that is based more on services, and their cross border facilitation
by telecommunications and the Internet. The source of a nations comparative advan-
tage, however, still is created from the mixture of its own labor skills, access to capital,
and technology.
relative advantage
absolute advantage, to create comparative advantage.
For example, India has developed a highly efficient and low-cost software indus-
try. This industry supplies not only the creation of custom software, but also call cen-
ters for customer support, and other information technology services. The Indian
software industry is composed of subsidiaries of MNEs and independent companies. If
you own a Hewlett-Packard computer and call the customer support center number
for help, you are likely to reach a call center in India. Answering your call will be a
knowledgeable Indian software engineer or programmer who will walk you through
Moffett3e_01 1/10/08 3:37 PM Page 11
Many locations for supply chain outsourcing exist today. To prove that these
countries should specialize in the activities shown you would need to know how costly
the same activities would be in the countries that are importing these services compared
in costs, not
just an
to their own other industries. Remember that it takes a
your problem. India has a large number of well-educated, English-speaking technical
experts who are paid only a fraction of the salary and overhead earned by their U.S.
counterparts. The overcapacity and low cost of international telecommunication net-
works today further enhances the comparative advantage of an Indian location.
The extent of global outsourcing is already reaching out to every corner of the
globe. From financial back-offices in Manila, to information technology engineers in
Hungary, modern telecommunications now take business activities to labor rather than
moving labor to the places of business.
What Is Different about Global Financial Management?
Exhibit 1.7 details some of the main differences between international and domestic
financial management. These component differences include institutions, foreign
exchange and political risks, and the modifications required of financial theory and
financial instruments. Global Finance in Practice 1.2 offers one famed economists
views on how different social, institutional, and political factors combine to alter the
prospects of business in many countries.
International financial management requires an understanding of cultural, histor-
ical, and institutional differences such as those affecting corporate governance.
Although both domestic firms and MNEs are exposed to foreign exchange risks,
MNEs alone face certain unique risks, such as political risks, that are not normally a
threat to domestic operations.
21

12 PART 1
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Global Financial Environment
MNEs also face other risks that can be classified as extensions of domestic finance
theory. For example, the normal domestic approach to the cost of capital, sourcing debt
and equity, capital budgeting, working capital management, taxation, and credit analy-
sis needs to be modified to accommodate foreign complexities. Moreover, a number
of financial instruments that are used in domestic financial management have been
EXHI BI T 1 .7
What Is Different about International Financial Management?
Concept International Domestic
Culture, history
and institutions
Each foreign country is unique and not
always understood by MNE management
Each country has a known base case
Corporate
governance
Foreign countries regulations and institutional
practices are all uniquely different
Regulations and institutions are well
known
Foreign exchange
risk
MNEs face foreign exchange risks due to
their subsidiaries, as well as import/export
and foreign competitors
Foreign exchange risks from import/ export
and foreign competition (no subsidiaries)
Political risk MNEs face political risks because of their
foreign subsidiaries and high profile
Negligible political risks
Modification of
domestic finance
theories
MNEs must modify finance theories like
capital budgeting and cost of capital
because of foreign complexities
Traditional financial theory applies
Modification of
domestic financial
instruments
MNEs utilize modified financial instruments
such as options, futures, swaps, and letters of
credit
Limited use of financial instruments and
derivatives because of fewer foreign
exchange and political risks
Moffett3e_01 1/10/08 3:37 PM Page 12
modified for use in international financial management. Examples are foreign cur-
rency options and futures, interest rate and currency swaps, and letters of credit.
The main theme of this book is to analyze how a multinational enterprises finan-
cial management evolves as it pursues global strategic opportunities and new con-
straints emerge. In this opening chapter, we will take a brief look at the challenges and
risks associated with Trident Corporation (Trident), a company evolving from domes-
tic in scope to being truly multinational. The discussion will include the constraints that
a company will face in terms of managerial goals and governance as it becomes
increasingly involved in multinational operations. But first we need to clarify the
unique value proposition and advantages which the MNE was created to exploit.
Market Imperfections: A Rationale for
the Existence of the Multinational Firm
MNEs strive to take advantage of imperfections in national markets for products, fac-
tors of production, and financial assets. Imperfections in the market for products trans-
late into market opportunities for MNEs. Large international firms are better able to
exploit such competitive factors as economies of scale, managerial and technological
expertise, product differentiation, and financial strength than are their local competi-
tors. In fact, MNEs thrive best in markets characterized by international oligopolistic


13 Chapter 1: Globalization and the Multinational Enterprise
Global Finance in Practice 1.2
The Mystery of Capital Deepens
In 1981 about 1,800 families occupied a stretch of
wasteland in the municipality of Quilmes on the out-
skirts of Buenos Aires. The squatters lacked legal title
to their new place in the sun, but they did not lack for
tenacity. They outlasted Argentinas military junta,
which tried several times to evict them, and in 1984,
after the return of democracy, the provincial govern-
ment passed a law expropriating the land from its
rightful owners so that the squatters could enjoy for-
mal ownership of it.
This is a tale that would warm the heart of
Hernando de Soto, a Peruvian economist, celebrated
by this newspaper and many others for his book The
Mystery of Capital (2000), and for his vigorous
efforts to extend secure property rights to the poor.
In his book, Mr de Soto argues that the poor have
more assetsshacks, stalls, plotsthan you might
think. But because they lack title to these assets, they
cannot pass them on, divide them up, or offer them
as collateral for a loan to expand their makeshift
businesses and fully express their entrepreneurial
energies. Their assets remain embalmed as dead
capital.
But the victory of the Buenos Aires squatters was
only partial. Eight of the former landowners
accepted the governments compensation in 1986,
one did not relent until 1998, and the remaining four
are still contesting it in Argentinas Dickensian
courts. As a result, several hundred families now own
their land, but their neighbours still squat uneasily
on theirs. This is unfortunate for the squatters, but a
rare opportunity for economists to test the power of
property rights. Sebastian Galiani of San Andres
University and Ernesto Schargrodsky of Torcuato di
Tella University believe the case provides a natural
experiment. The families lucky enough to win title
can be compared with a ready-made control group:
the otherwise identical families that did not. This
makes it possible for the study to distinguish cause
and effect; to isolate the impact of title from all the
other confounding factors.
The results of the experiment are mixed. Secure
land rights do encourage the poor to build their
nests. But even in a relatively advanced country such
as Argentina, title is not enough in itself to animate
the dead capital interred in land and property. The
landowning families invested more in their homes,
which had noticeably better walls and roofs. But the
titled households enjoyed no better access to bank
loans, credit cards or bank accounts, and only 4% of
them acquired a mortgage.
Disappointing, but not surprising. Argentine
banks tend to lend only to workers with high wages
and a stable job. Titled or not, the former squatters
still fell well below the official poverty line. The cost
of making and enforcing a loan contract might
exceed the modest sums they were able to borrow.
Source: Abstracted from The Mystery of Capital Deepens, The
Economist. London: Aug 26, 2006, p. 66.
Moffett3e_01 1/10/08 3:37 PM Page 13
competition, where these factors are particularly critical. In addition, once MNEs have
established a physical presence abroad, they are in a better position than purely
domestic firms to identify and implement market opportunities through their own
internal information network.

14 PART 1
|
Global Financial Environment
Why Do Firms Become Multinational?
Strategic motives drive the decision to invest abroad and become an MNE. These
motives can be summarized under the following five categories.
1. Market seekers produce in foreign markets either to satisfy local demand or to
export to markets other than their home market. U.S. automobile firms manufac-
turing in Europe for local consumption are an example of market-seeking moti-
vation. Porsche, a European automaker discussed in this chapters mini-case, has
chosen not to follow this path.
2. Raw material seekers extract raw materials wherever they can be found, either for
export or for further processing and sale in the country in which they are found
the host country. Firms in the oil, mining, plantation, and forest industries fall into
this category.
3. Production efficiency seekers produce in countries where one or more of the fac-
tors of production are underpriced relative to their productivity. Labor-intensive
production of electronic components in China Taiwan, Malaysia, and Mexico is an
example of this motivation.
4. Knowledge seekers operate in foreign countries to gain access to technology or
managerial expertise. For example, German, Dutch, and Japanese firms have pur-
chased U.S.-located electronics firms for their technology.
5. Political safety seekers acquire or establish new operations in countries that are
considered unlikely to expropriate or interfere with private enterprise. For exam-
ple, Hong Kong SAR firms invested heavily in the United States, United Kingdom,
Canada, and Australia in anticipation of the consequences of Chinas 1997
takeover of the British colony.
These five types of strategic considerations are not mutually exclusive. Forest
products firms seeking wood fiber in Brazil, for example, may also find a large
Brazilian market for a portion of their output.
In industries characterized by worldwide oligopolistic competition, each of the
above strategic motives should be subdivided into proactive and defensive investments.
Proactive investments are designed to enhance the growth and profitability of the firm
itself. Defensive investments are designed to deny growth and profitability to the firms
competitors. Examples of the latter are investments that try to preempt a market
Moffett3e_01 1/10/08 3:37 PM Page 14
before competitors can get established in it, or capture raw material sources and deny
them to competitors.
The Globalization Process
Trident is a hypothetical U.S.-based firm that will be used as an illustrative example
throughout the book to demonstrate the globalization processthe structural and
managerial changes and challenges experienced by a firm as it moves its operations
from domestic to global.
15 Chapter 1: Globalization and the Multinational Enterprise
Global Transition I: Trident Moves from the
Domestic Phase to the International Trade Phase
Trident is a young firm that manufactures and distributes an array of telecommunica-
tion devices. Its initial strategy is to develop a sustainable competitive advantage in the
U.S. market. Like many other young firms it is constrained by its small size, competi-
tors, and lack of access to cheap and plentiful sources of capital. The top half of Exhibit
1.8 shows Trident in its early domestic phase. Trident sells its products in U.S. dollars to
U.S. customers and buys its manufacturing and service inputs from U.S. suppliers, pay-
ing U.S. dollars. The creditworth of all suppliers and buyers is established under domes-
tic U.S. practices and procedures. A potential issue for Trident at this time is that
although Trident is not international or global in its operations, some of its competi-
tors, suppliers, or buyers may be. This is often the impetus to push a firm like Trident
into the first transition of the globalization process, into international trade.
Mexican Suppliers Canadian Buyers
Are Mexican suppliers
dependable?
Will Trident pay US$ or
Mexican pesos?
All payments in U.S. dollars.
All credit risk under U.S. law.
Are Canadian buyers
creditworthy?
Will payment be made
in US$ or C$?
Trident Corporation
(Los Angeles, USA)
Phase Two: Expansion into International Trade
U.S. Suppliers
(domestic)
U.S. Buyers
(domestic)
Phase One: Domestic Operations
EXHI BI T 1 . 8
Trident Corporation:
Initiation of the
Globalization
Process
Moffett3e_01 1/10/08 3:37 PM Page 15
Trident was founded by James and Edgar Winston in Los Angeles in 1948 to make
telecommunications equipment. The family-owned business expanded slowly but
steadily over the following 40 years. The demands of continual technological invest-
ment in the 1980s, however, required that the firm raise additional equity capital in
order to compete. This need led to its initial public offering (IPO) in 1988. As a U.S.-
based publicly traded company on NASDAQ, Tridents management sought to create
value for its shareholders.
As Trident became a visible and viable competitor in the U.S. market, strategic
opportunities arose to expand the firms market reach by exporting product and ser-
vices to one or more foreign markets. The North American Free Trade Area (NAFTA)
16 PART 1
|
Global Financial Environment
made trade with Mexico and Canada attractive. This second phase of the globalization
process is shown in the lower-half of Exhibit 1.8. Trident responded to these globaliza-
tion forces by importing inputs from Mexican suppliers and making export sales to
Canadian buyers. We define this stage of the globalization process as the International
Trade Phase.
Exporting and importing products and services increases the demands of financial
management over and above the traditional requirements of the domestic-only busi-
ness. First, direct foreign exchange risks are now borne by the firm. Trident may now
need to quote prices in foreign currencies, accept payment in foreign currencies, or pay
suppliers in foreign currencies. As the value of currencies change from minute to
minute in the global marketplace, Trident will now experience significant risks from
the changing values associated with these foreign currency payments and receipts. As
discussed in this chapters mini-case on Porsche, foreign exchange risks may result in
gains as well as losses!
Second, the evaluation of the credit quality of foreign buyers and sellers is now
more important than ever. Reducing the possibility of non-payment for exports and
non-delivery of imports becomes one of two main financial management tasks during
the international trade phase. This credit risk management task is much more difficult
in international business, as buyers and suppliers are new, subject to differing business
practices and legal systems, and generally more challenging to assess.
Global Transition II: The International
Trade Phase to the Multinational Phase
If Trident is successful in its international trade activities, the time will come when the
globalization process will progress to the next phase. Trident will soon need to estab-
lish foreign sales and service affiliates. This step is often followed by establishing man-
ufacturing operations abroad or by licensing foreign firms to produce and service
Tridents products. The multitudes of issues and activities associated with this second
larger global transition is the true purpose of this book.
Tridents continued globalization will require it to identify the sources of its com-
petitive advantage, and with that knowledge, expand its intellectual capital and physi-
cal presence globally. A variety of strategic alternatives are available to Tridentthe
foreign direct investment sequenceas shown in Exhibit 1.9. These alternatives include
the creation of foreign sales offices, the licensing of the company name and everything
associated with it, and the manufacturing and distribution of its products to other firms
in foreign markets. As Trident moves farther down and to the right in Exhibit 1.9, the
degree of its physical presence in foreign markets increases. It may now own its own
distribution and production facilities, and ultimately, may want to acquire other com-
Moffett3e_01 1/10/08 3:37 PM Page 16
panies. Once Trident owns assets and enterprises in foreign countries it has entered the
multinational phase of its globalization.
The Limits to Financial Globalization
The theories of international business and international finance introduced in this
chapter have long argued that with an increasingly open and transparent global mar-
ketplace, in which capital may flow freely, capital will increasingly flow and support
countries and companies based on the theory of comparative advantage. Since the mid-
twentieth century this has indeed been the case as more and more countries have pur-


17 Chapter 1: Globalization and the Multinational Enterprise
sued more open and competitive markets. But the past decade has seen the growth of
a new kind of limit or impediment to financial globalization: the growth in the influ-
ence and self-enrichment of organizational insiders.
2
One possible representation of this process can be seen in Exhibit 1.10. If influ-
ential insiders in corporations and sovereign states continue to pursue the increase in
firm value, there will be a definite and continuing growth in financial globalization.
But, if these same influential insiders pursue their own personal agendas, which may
increase their personal power and influence or personal wealth, or both, then capital
will not flow into these sovereign states and corporations. The result is the growth of
financial inefficiency and the segmentation of globalization outcomescreating win-
ners and losers. As we will see throughout this book, this barrier to international
finance may indeed be increasingly troublesome.
Greater
Foreign
Investment
Greater
Foreign
Presence
Production Abroad
Control Assets
Abroad
Exploit Existing Competitive
Advantage Abroad
Production at Home:
Exporting
Licensing
Management Contract
Change
Competitive Advantage
Trident and Its
Competitive Advantage
Wholly Owned
Subsidiary
Joint Venture
Acquisition of a
Foreign Enterprise
Acquisition of a
Foreign Enterprise
Greenfield
Investment
EXHI BI T 1 . 9
Tridents Foreign Direct Investment Sequence
2
This section draws upon the stimulating thoughts presented in The Limits of Financial Globalization,
Rene M. Stulz, Journal of Applied Corporate Finance, Volume 19, Number 1, Winter 2007, pp. 815.
Moffett3e_01 1/10/08 3:37 PM Page 17
This growing dilemma is also something of a composite of what this book is about.
The three fundamental elementsfinancial theory, global business, management
beliefs and actionscombine to present either the problem or the solution to the grow-
ing debate over the benefits of globalization to countries and cultures worldwide. The
mini-case on Porsche which follows sets the stage for our debate and discussionare
the controlling family members of this company creating value for themselves or their
shareholders?

18 PART 1
|
Global Financial Environment
The Twin Agency
Problems Limiting
Financial Globalization
There is a growing debate over whether many of the insiders and rulers of organizations
with enterprises globally are taking actions consistent with creating firm value or consistent
with increasing their own personal stakes and power.
If these influential insiders are building personal wealth over that of the firm, it will indeed
result in preventing the flow of capital across borders, currencies, and institutions to create
a more open and integrated global financial community.
Source: Constructed by authors based on The Limits of Financial Globalization, Rene M. Stulz,
Journal of Applied Corporate Finance, Volume 19 Number 1, Winter 2007, pp. 815.
Actions of Rulers
of Sovereign States
Higher Firm Value
(possibly lower
insider value)
Lower Firm Value
(possibly higher
insider value)
Actions of
Corporate Insiders
EXHI BI T 1 . 1 0
The Potential Limits
of Financial
Globalization
MI NI - C AS E
Porsche Changes Tack
3
Yes, of course we have heard of shareholder value.
But that does not change the fact that we put cus-
tomers first, then workers, then business partners,
suppliers, and dealers, and then shareholders.
Dr. Wendelin Wiedeking, CEO, Porsche, Die Zeit,
April 17, 2005.
Porsche had always been different. Statements by
Porsche leadership, like the one above, always made
Veselina (Vesi) Dinova nervous about the companys
attitude about creating shareholder value. The company
was a paradox. Porsches attitudes and activities were
like that of a family-owned firm, but it had succeeded in
creating substantial shareholder value for more than a
decade. Porsches CEO, Dr. Wendelin Wiedeking, had
been credited with clarity of purpose and sureness of
execution. As one colleague described him: He grew up
PSD: poor, smart, and driven.
Porsches management had created confusion in the
marketplace as to which value proposition Porsche pre-
sented. Was Porsche continuing to develop an organiza-
tional focus on shareholder value, or was it returning to
3
Copyright 2007 Thunderbird School of Global Management. All rights reserved. This case was prepared
by Professor Michael H. Moffett for the purpose of classroom discussion only.
Moffett3e_01 1/10/08 3:37 PM Page 18
19 Chapter 1: Globalization and the Multinational Enterprise
its more traditional German roots of German cronyism?
Simply put, was Porsches leadership pursuing family
objectives at the expense of its shareholders?
Porsche AG
Porsche AG was a publicly traded, closely held German-
based auto manufacturer. Porsches President and Chief
Executive Officer, Dr. Wendelin Wiedeking, had returned
the company to both status and profitability since tak-
ing over the company in 1993. Immediately after taking
over, he had killed the 928 and 968 model platforms to
reduce complexity and cost, although at the time this
left the company with only one platform, the 911.
Wiedeking had then brought in a group of Japanese
manufacturing consultants, in the Toyota tradition, who
led the complete overhaul of the companys manufac-
turing processes.
Although Porsche was traded on the Frankfurt Stock
Exchange (and associated German exchanges), control
of the company remained firmly in the hands of the
founding families, the Porsche and Pich families.
Porsche had two classes of shares, ordinary and
preference. The two families held all 8.75 million
ordinary sharesthe shares which held all voting
rights. The second class of share, preference shares, par-
ticipated only in profits. All 8.75 million preference
shares were publicly traded. Approximately 50% of all
preference shares were held by large institutional
investors in the United States, Germany, and the United
Kingdom, 14% were held by the Porsche and Pich fami-
lies, and 36% were held by small private investors. As
noted by the Chief Financial Officer, Holger Hrter, As
long as the two families hold on to their stock portfo-
lios, there wont be any external influence on company-
related decisions. I have no doubt that the families will
hang on to their shares.
Porsche was somewhat infamous for its indepen-
dent thinking and occasional stubbornness when it
came to disclosure and compliance with reporting
requirementsthe prerequisites of being publicly
traded. In 2002 the company had chosen not to list on
the New York Stock Exchange after the passage of the
Sarbanes-Oxley Act. The company pointed to the spe-
cific requirement of Sarbanes-Oxley that senior man-
agement sign off on the financial results of the
company personally as being inconsistent with German
law (which it largely was) and illogical for management
to accept. Management had also long been critical of
the practice of quarterly reporting, and had in fact been
removed from the Frankfurt Exchanges stock index in
September 2002 because of its refusal to report quar-
terly financial results.
But, after all was said and done, the company had
just reported record profits for the tenth consecutive
year (see Exhibit 1). Returns were so good and had grown
so steadily that the company had paid out a special div-
idend of 14 per share in 2002, in addition to increasing
the size of the regular dividend. There was a continuing
concern that management came first. In the words of
one analyst . . . we think there is the potential risk that
management may not rate shareholders interests very
highly. The compensation packages of Porsches senior
management team were nearly exclusively focused on
current year profitability (83% of executive board com-
pensation was performance-related pay), with no man-
agement incentives or stock option awards related to
the companys share price.
Porsches Growing Portfolio
Porsche had three major vehicle platforms: the premier
luxury sports car, the 911; the competitively priced
Boxster roadster; and the recently introduced off-road
sport utility vehicle, the Cayenne. Porsche had also
recently announced that it would be adding a fourth
platform, the Panamera, which would be a high-end
sedan to compete with Jaguar, Mercedes, and Bentley.
911. The 911 series was still the focal point of the
Porsche brand, but many believed that it was growing
old and due for replacement. Sales had seemingly
peaked in 2001/02, and fallen back more than 15% in
2002/03. The 911 had always enjoyed nearly exclusive
ownership of its market segment. Prices continued to be
high, and margins were some of the very highest in the
global auto industry for production models. The 911 was
the only Porsche model that was manufactured and
assembled in-house.
Boxster. The Boxster roadster had been introduced in
1996 as Porsches entry into the lower price end of the
sports car market. The Boxster was also considered an
anticyclical move because the traditional 911 was so
high-priced. The Boxsters lower price made it affordable
and less sensitive to the business cycle. It did, however,
compete in an increasingly competitive market seg-
ment. Boxster sales volumes had peaked in 2000/01.
Cayenne. The third major platform innovation was
Porsches entry into the sports utility vehicle (SUV) seg-
ment, the Cayenne. Clearly at the top end of the market
Moffett3e_01 1/10/08 3:37 PM Page 19
20 PART 1
|
Global Financial Environment
(2002/03 Cayenne sales averaged more than $70,000
each), the Cayenne had been a very quick success, espe-
cially in the SUV-crazed American market. It was consid-
ered the most successful new product launch in auto
history. The Cayennes success had been even more dra-
matic given much pre-launch criticism that the market
would not support such a high-priced SUV, particularly
one that shared a strong bloodline with the Volkswagen
(VW) Touareg. The Porsche Cayenne and VW Touareg
shared a common chassis, and in fact were both manu-
factured at the same factory in Bratislava, Slovakia.
Porsche shipped the Cayenne chassis to its facility in
Leipzig where the engine, drive train, and interior were
combined in final assembly.
Panamera. On July 27, 2005, Porsche announced that
it would proceed with the development and production
of a fourth major modelthe Panamera. The name was
derived from the legendary Carrera Panamericana long-
distance road race held for many years in Mexico. The
Panamera would be a premium class four-door four-
seat sports coupe, and would compete with the pre-
mium sedan models. Pricing was expected to begin at
$125,000, rising to $175,000. Production was scheduled
to begin in 2009 at a scale of 20,000 units per year.
The Most Profitable Automobile
Company in the World
Porsches financial performance and health, by auto
manufacturer standards, European or elsewhere, was
excellent. It was clearly the smallest of the major
European-based manufacturers with total sales of 6.4
billion in 2004. But, as shown in Exhibit 2, Porsche was
outstanding by all metrics of profitability and return on
invested capital. Porsches EBITDA, EBIT, and net income
margins were the highest among all European
automakers in 2004.
Foreign Exchange. Porsches financial results, how-
ever, had been the subject of substantial debate in
recent years as upwards of 40% of operating earnings
were thought to be derived from currency hedging.
Porsches cost-base was purely European euro; it pro-
duced in only two countries, Germany and Finland, and
both were euro area members. Porsche believed that
the quality of its engineering and manufacturing were
at the core of its brand, and it was not willing to move
production beyond Europe (BMW, Mercedes, and VW
had all been manufacturing in both the United States
and Mexico for years). Porsches sales by currency in
2004 were roughly 45% European euro, 40% U.S. dollar,
20.8%
17.9%
18.2%
18.0%
13.6%
12.0%
11.6%
7.0%
4.2%
2.0%
7,000
6,000
5,000
4,000
3,000
2,000
1,000
0
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
28%
24%
20%
16%
12%
8%
4%
0%
Note: EBIT=earnings before interest and tax.
Millions of euros () Operating Margin
Sales Operating Income (EBIT) Operating Margin (EBIT/Sales)
EXHI BI T 1
Porsches Growth
in Sales, Income,
and Margin
Moffett3e_01 1/10/08 3:37 PM Page 20
21 Chapter 1: Globalization and the Multinational Enterprise
10% British pound sterling, and 5% other (primarily the
Japanese yen and Swiss franc).
Porsches leadership had undertaken a very aggres-
sive currency hedging strategy beginning in 2001 when
the euro was at a record low against the US dollar. In the
following years these financial hedges (currency deriva-
tives) proved extremely profitable. For example, nearly
43% of operating earnings in 2003 were thought to
have been derived from hedging activities. Although
profitable, many analysts argued the company was
increasingly an investment banking firm rather than an
automaker, and was heavily exposed to the unpre-
dictable fluctuations between the worlds two most
powerful currencies, the dollar and the euro.
ROIC. It was Porsches return on invested capital
(ROIC), however, which had been truly exceptional over
time. The companys ROIC in 2004following Deutsche
Banks analysis presented in Exhibit 3, was 15.15%. This
was clearly superior to all other European automakers.
This ROIC reflected Porsches two-pronged financial
strategy: 1) superior margins on the narrow but selective
product portfolio; and 2) leveraging the capital and
capabilities of manufacturing partners in the develop-
ment and production of two of its three products. The
company had successfully exploited the two primary
drivers of the ROIC formula:
The first component, operating profits (EBIT, earnings
before interest and taxes) after-tax as a percent of
salesoperating marginwas exceptional at Porsche
due to the premium value pricing derived from its
global brand of quality and excellence. This allowed
Porsche to charge premium prices and achieve some of
the largest margins in the auto industry. As shown in
Exhibit 3, Porsches operating profits after-tax of 671
million produced an operating margin after tax of
10.55% (671 divided by 6,359 in sales), the highest in
the industry in 2004.
The second component of ROIC, the capital turnover
ratio (sales divided by invested capital)velocity
although quite high compared to other automakers in
the past, was one of the lowest in 2004 as seen in Exhibit
3. In recent years, however, invested capital had risen
faster than sales. But Porsche was not adding fixed
assets to its invested capital basis, but cash. The rising
cash balances were the result of retained profits (undis-
tributed to shareholders) and new debt issuances (rais-
ing more than 600 million in 2004 alone). As a result,
fiscal 2003/04 had proven to be one of Porsches poorest
years in ROIC. Porsches minimal levels of invested capi-
tal resulted fromsome rather unique characteristics.
Invested capital is defined a number of ways, but Vesi
used her employers standardized definition of cash plus
net working capital plus net fixed assets. Porsches
invested capital was growing primarily because of its
accumulation of cash. Vesi was concerned that using
ROIC =
EBIT after-tax
Sales
Sales
Invested Capital

EXHI BI T 2
Return on Invested Capital (ROIC) for European Automakers, 2004
Source: European Autos, Deutsche Bank, July 20, 2005; Porsche, Deutsche Bank, September 26, 2005; Thomson Analytics; author estimates. Invested
Capital = total stockholders equity + gross interest-bearing debt. Capital turnover = sales / Invested capital. ROIC (return on invested capital) = EBIT
taxes / Invested capital.
Operating Margin Invested Capital
European
Automaker
Sales
(millions) EBIT Taxes
EBIT
After-tax
Interest
Bearing Debt
Stockholders
Equity
Invested
Capital
Capital
Turnover ROIC
BMW 44,335 3,745 1,332 2,413 1,555 17,517 19,072 2.32 12.65%
DaimlerChrysler 142,059 4,612 1,177 3,435 9,455 33,541 42,996 3.30 7.99%
Fiat 46,703 22 29 51 24,813 5,946 30,759 1.52 0.17%
Peugeot 56,797 1,916 676 1,240 6,445 13,356 19,801 2.87 6.26%
Porsche 6,359 1,141 470 671 2,105 2,323 4,428 1.44 15.15%
Renault 40,715 2,148 634 1,514 7,220 16,444 23,664 1.72 6.40%
Volkswagen 88,963 1,620 383 1,237 14,971 23,957 38,928 2.29 3.18%
Moffett3e_01 1/10/08 3:38 PM Page 21
22 PART 1
|
Global Financial Environment
this measure of invested capital led to a distorted view
of the companys actual performance. Porsches mini-
mal fixed asset capital base resulted from the explicit
strategy of the company as executed over the past
decade.
Porsche Changes Tack
The summer and fall of 2005 saw a series of surprising
moves by Porsche. First, Porsche announced that the 1
billion investment to design and manufacture the new
Panamera would be largely funded by the company
itself. Although the introduction of the Panamera had
been anticipated for quite some time, the market was
surprised that Porsche intended to design and build the
carand its manufacturing facilitynearly totally in-
house. As opposed to the previous new product intro-
ductions, the Boxster and the Cayenne, there would be
no major production partner involved. Porsche CEO
Wendelin Wiedeking specifically noted this in his press
release: There are no plans for a joint venture with
another car maker. But to ensure the profitability of this
new model series we will cooperate more closely than
so far with selected system suppliers. The German
share of the value of the Panamera would be roughly
70%. Like the 911, Boxster, and Cayenne, the Panamera
would bear the Made in Germany stamp. The second
surprise occurred on September 25, 2005, with the
announcement to invest 3 billion in VW.
Porsche AG, Stuttgart, seeks to acquire a share of
approximately 20 per cent in the stock capital of
Volkswagen AG, Wolfsburg, entitled to vote. Porsche
is taking this decision because Volkswagen is now
not only an important development partner for
Porsche, but also a significant supplier of approxi-
mately 30 per cent of Porsches sales volume. In the
words of Porsches President and CEO: Making this
investment, we seek to secure our business relations
with Volkswagen and make a significant contribu-
tion to our own future plans on a lasting, long-term
basis. Porsche is in a position to finance the acquisi-
tion of the planned share in Volkswagen through its
own, existing liquidity. After careful examination of
this business case, Porsche is confident that the
investment will prove profitable for both parties.
... The planned acquisition is to ensure that... there
will not be a hostile takeover of Volkswagen by
investors not committed to Volkswagens long-term
interests. In the words of Porsches President and
13.8%
10.5%
11.7%
10.5%
6.4%
6.0%
6.4%
6.1%
3.7%
2.0%
2.5
2.0
1.5
1.0
0.5
0.0
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
20%
18%
16%
14%
12%
10%
8%
6%
4%
2%
0%
Operating margin = (EBIT Taxes)/(Sales). Invested capital = Cash + Net working capital + Net fixed assets.
Velocity=Sales/Invested Capital Margin and ROIC
1.91%
2.15%
2.12%
1.97% 1.99%
1.81%
8.0%
3.8%
12.9%
12.6%
11.9%
11.6%
12.5%
14.2%
1.19%
1.21%
4.91%
6.84%
9.6%
11.6%
Velocity ROIC (Operating Margin Velocity) Operating Margin
EXHI BI T 3
Porsches Velocity,
Margin, and ROIC
Moffett3e_01 1/10/08 3:38 PM Page 22
23 Chapter 1: Globalization and the Multinational Enterprise
CEO: Our planned investment is the strategic
answer to this risk. We wish in this way to ensure the
independence of the Volkswagen Group in our own
interest. This German solution we are seeking is an
essential prerequisite for stable development of the
Volkswagen Group and, accordingly, for continuing
our cooperation in the interest of both Companies.
Acquisition of Stock to Secure Porsches Business,
Porsche AG (press release), September 25, 2005.
Porsche would spend approximately 3 billion to
take a 20% ownership position in VW. This would make
Porsche VWs single largest investor, slightly larger than
the government of Lower Saxony.
4
It clearly eliminated
any possible hostile acquisitions that may have been on
the horizon (DaimlerChrysler was rumored to have been
interested in raiding VW.) The announcement was met
by near universal opposition.
The family linkages between the two companies
were well known. Ferdinand K. Pich, one of the most
prominent members of the Pich family, which along
with the Porsche family controlled Porsche, was the for-
mer CEO (he retired in 2002) and still Chairman of
Volkswagen. He was the grandson of Ferdinand Porsche,
the founder of Porsche. Accusations of conflict of inter-
est were immediate, as were calls for his resignation,
and the denial of Porsches request for a seat on VWs
board. Although VW officially welcomed the investment
by Porsche, Christian Wulff, VWs board member repre-
senting the state of Lower Saxony where VW was head-
quartered, publicly opposed the investment by Porsche.
In the eyes of many, the move by Porsche was a return to
German corporate cronyism.
For years, Deutschland AG was emblematic of the
cosy network of cross-shareholdings and shared
non-executive directorships that insulated Germany
from international capitalism. Wendelin Wiedeking,
Porsches chief executive, himself invoked the
national angle, saying this German solution was
essential to secure VW, Europes largest carmaker,
against a possible hostile takeover by short-term
investors.
Shield for corporate Germany or a family affair?
VW and Porsche close ranks, Financial Times,
Tuesday, September 27, 2005, p. 17.
Germany, although long known for complex net-
works of cross-shareholdings, had effectively unwound
most of these in the 1990s. This move by Porsche and VW
was seen as more of a personal issueFerdinand
Pichrather than a national issue of German alliances.
Many Porsche investors had agreed, arguing that if they
had wanted to invest in VW they would have done it
themselves. Although the arguments for solidifying and
securing the Porsche/VW partnership were rational, the
cost was not. At 3 billion, this was an enormous invest-
ment in a non-performing asset. Analysts concluded that
the potential returns to shareholders, even in the form of
a special dividend, were now postponed indefinitely.
The announcement of Porsches intention to take a
20% equity interest in VW was greeted with outright
opposition on the part of many shareholders in both
VW and Porsche. Major investment banks immediately
downgraded Porsche from a buy to a sell, arguing that
the returns on the massive investment, some 3 billion,
would likely never accrue to shareholders. Although
Porsche had explained its investment decision to be one
that would assure the stability of its future cooperation
with VW, many critics saw it as a choice of preserving
the stakes of the Porsche and Pich families at the
expense of non-family shareholders.
Why should a small and highly-profitable maker of
sports cars suddenly hitch its fortunes to a lumber-
ing and struggling mass-producer? That was the
question that some alarmed shareholders asked this
week when Porsche, the worlds most profitable car-
maker, announced plans to buy 20% stake in
Volkswagen (VW), Europes biggest carmaker. To
some critics of the deal, Porsches move looked like a
return to cosy, German corporatism at its worst.
Since January 2002, when a change in the law
encouraged German companies to sell their cross-
shareholdings in each other, free of capital gains tax,
new foreign shareholders have often shaken up fos-
silized German management. A deal with friendly
compatriots from Porsche might rescue VW from
this distasteful fate, particularly since foreign hedge
funds and corporate raiders have been rumored to be
circling VW.
Business: Keeping It in the Family,
The Economist, October 1, 2005.
4
The resulting ownership structure of Volkswagen in October 2005 was: 18.53% Porsche; 18.2% State of
Lower Saxony; 13.0% Volkswagen; 8.58% Brandes Investment Partners; 3.5% Capital Group; and 38.19%
widely distributed.
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24 PART 1
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Global Financial Environment
Examine the requirements for the creation of value

The creation of value requires combining three criti-


cal elements: 1) an open marketplace; 2) high quality
strategic management; and 3) access to capital.

Consider the basic theory, comparative advantage, and


its requirements for the explanation and justification
for international trade and commerce

The theory of comparative advantage provides a basis


for explaining and justifying international trade in a
model world assumed to enjoy free trade, perfect com-
petition, no uncertainty, costless information, and no
government interference.
Discover what is different about international financial
management

International financial management requires an under-


standing of cultural, historical, and institutional differ-
ences such as those affecting corporate governance.

Although both domestic firms and MNEs are exposed


to foreign exchange risks, MNEs alone face certain
unique risks, such as political risks, that are not nor-
mally a threat to domestic operations.
Detail which market imperfections give rise to the multi-
national enterprise

MNEs strive to take advantage of imperfections in


national markets for products, factors of production,
and financial assets.

Large international firms are better able to exploit such


competitive factors as economies of scale, managerial
and technological expertise, product differentiation,
and financial strength than are their local competitors.
Consider how the globalization process moves a business
from a purely domestic focus in its financial relationships
and composition to one truly global in scope

A firm may first enter into international trade transac-


tions, then international contractual arrangements such
as sales offices and franchising, and ultimately the
acquisition of foreign subsidiaries. It is at this final stage
that it truly becomes a multinational enterprise (MNE).

The decision whether or not to invest abroad is driven


by strategic motives, and may require the MNE to
enter into global licensing agreements, joint ventures,
cross-border acquisitions, or greenfield investments.
Examine possible causes to the limitations to globalization
in finance

If influential insiders in corporations and sovereign


states pursue their own personal agendas which may
increase their personal power, influence, or wealth,
then capital will not flow into these sovereign states
and corporations. This will in-turn create limitations to
globalization in finance.
Questions
1. Globalization and the MNE. The term globalization
has become very widely used in recent years. How
would you define it?
2. Globalization and Value Creation. What does an
MNE need in order for it to create value through the
globalization process?
3. Value Creation and the Concept of Capitalism. How
does the concept of capitalism actually apply to the
globalization process of a business, as it moves from
elemental to multinational stages of development?
4. Theory of Comparative Advantage. Define and
explain the theory of comparative advantage.
5. Limitations of Comparative Advantage. Key to
understanding most theories is what they say and
what they dont. What are four or five key limitations
to the theory of comparative advantage?
6. Tridents Globalization. After reading the chapters
description of Tridents globalization process, how
would you explain the distinctions between
international, multinational, and global companies?
Case Questions
1. What strategic decisions made by Porsche over
recent years had given rise to its extremely high
return on invested capital?
2. Vesi wondered if her position on Porsche might have
to distinguish between the companys ability to gen-
SUMMARY OF LEARNING OBJECTIVES
erate results for stockholders versus its willingness to
do so. What do you think.
3. Is pursuing the interests of Porsches controlling fam-
ilies different from maximizing the returns to its pub-
lic share owners?
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25 Chapter 1: Globalization and the Multinational Enterprise
What happens to total production and consumption?
Luzon Industries2007
Problems 6 through 10 are based on Luzon Industries.
Luzon is a U.S.-based multinational manufacturing firm,
with wholly owned subsidiaries in Brazil, Germany, and
China, in addition to domestic operations in the United
States. Luzon is traded on the NASDAQ. Luzon currently
has 650,000 shares outstanding. The basic operating char-
acteristics of the various business units is as follows:
Toys Wine
Chinas domestic price 10 to 7
Frances domestic price 2 to 7
Negotiated mid-price 6 to 7
(000s, local USA Brazil Germany China
currency) (dollars, $) (reais, R$) (euros, e) (yuan, Y)
Earnings
before tax
(EBT)
$4,500 R$6,250
4,500
Y2,500
Corporate
income tax
rate
35% 25% 40% 30%
Average
exchange
rate for
period
R$1.80/$
0.7018/$
Y7.750/$
7. Trident, the MNE. At what point in the globaliza-
tion process did Trident become a multinational
enterprise (MNE)?
8. Tridents Advantages. What are the main advan-
tages that Trident gains by developing a multina-
tional presence?
9. Tridents Phases. What are the main phases that
Trident passed through as it evolved into a truly
global firm? What are the advantages and disadvan-
tages of each?
10. Financial Globalization. How do the motivations of
individuals, both inside and outside the organization
or business, define the limits of financial globaliza-
tion?
Problems
Comparative Advantage
Problems 15 illustrate an example of trade induced by
comparative advantage. They assume that China and
France each have 1,000 production units. With one unit of
production (a mix of land, labor, capital, and technology),
China can produce either 10 containers of toys or 7 cases
of wine. France can produce either 2 cases of toys or 7
cases of wine. Thus, a production unit in China is five times
as efficient compared to France when producing toys, but
equally efficient when producing wine. Assume at first that
no trade takes place. China allocates 800 production units
to building toys and 200 production units to producing
wine. France allocates 200 production units to building
toys and 800 production units to producing wine.
1. Production and Consumption. What is the produc-
tion and consumption of China and France without
trade?
2. Specialization. Assume complete specialization,
where China produces only toys and France pro-
duces only wine. What would be the effect on total
production?
3. Trade at Chinas Domestic Price. Chinas domestic
price is 10 containers of toys equals 7 cases of wine.
Assume China produces 10,000 containers of toys
and exports 2,000 containers to France. Assume
France produces 7,000 cases of wine and exports
1,400 cases to China. What happens to total produc-
tion and consumption?
4. Trade at Frances Domestic Price. Frances domes-
tic price is 2 containers of toys equals 7 cases of wine.
Assume China produces 10,000 containers of toys
and exports 400 containers to France. Assume
France in turn produces 7,000 cases of wine and
exports 1,400 cases to China. What happens to total
production and consumption?
5. Trade at Negotiated Mid-price. The mid-price for
exchange between France and China can be calcu-
lated as follows:
*6. Luzon Corporations Consolidated Earnings. Luzon
must pay corporate income tax in each country in
which it currently has operations.
a. After deducting taxes in each country, what are
Luzons consolidated earnings and consolidated
earnings per share in U.S. dollars?
b. What proportion of Luzons consolidated earn-
ings arise from each individual country?
c. What proportion of Luzons consolidated earn-
ings arise from outside the United States?
7. Luzons EPS Sensitivity to Exchange Rates
(A). Assume a major political crisis wracks Brazil,
first affecting the value of the Brazilian reais and,
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subsequently, inducing an economic recession within
the country. What would be the impact on Luzons
consolidated EPS if the Brazilian reais were to fall to
R$3.00/$, with all other earnings and exchange rates
remaining the same?
8. Luzons EPS Sensitivity to Exchange Rates
(B). Assume a major political crisis wracks Brazil,
first affecting the value of the Brazilian reais and,
subsequently, inducing an economic recession within
the country. What would be the impact on Luzons
consolidated EPS if, in addition to the fall in the value
of the reais to R$3.00/$, earnings before taxes in
Brazil fell as a result of the recession to R$5,800,000?
*9. Luzons Earnings and the Fall of the Dollar. The U.S.
dollar has experienced significant swings in value
against most of the worlds currencies in recent years.
a. What would be the impact on Luzons consoli-
dated EPS if all foreign currencies were to appre-
ciate 20% against the U.S. dollar?
b. What would be the impact on Luzons consoli-
dated EPS if all foreign currencies were to depre-
ciate 20% against the U.S. dollar?
Note: Calculate the percentage changes by dividing
the initial currency value by (1 + the percentage
change) to calculate the new currency value.
10. Luzons Earnings and Global Taxation. All MNEs
attempt to minimize their global tax liabilities.
Return to the original set of baseline assumptions
and answer the following questions regarding
Luzons global tax liabilities.
a. What is the total amountin U.S. dollarswhich
Luzon is paying across its global business in cor-
porate income taxes?
b. What is Luzons effective tax rate on a global
basis (total taxes paid as a percentage of pre-tax
profits)?
c. What would be the impact on Luzons EPS and
global effective tax rate if Germany instituted a
corporate tax reduction to 28%, and Luzons
earnings before tax in Germany rose to
5,000,000?
Internet Exercises
1. International Capital Flows: Public and Pri-
vate. Major multinational organizations (some of
which follow) attempt to track the relative move-
ments and magnitudes of global capital investment.
Using these Web pages and others you may find, pre-
pare a two-page executive briefing on the question
of whether capital generated in the industrialized
countries is finding its way to the less developed and
emerging markets. Is there some critical distinction
between less developed and emerging?
The World Bank http://www.worldbank.org/
OECD http://www.oecd.org/
European Bank for http://www.ebrd.org/
Reconstruction
2. International Management and Strategy Consultan-
cies. The management consulting industry has been
one of the primary resources utilized by MNEs
throughout the world in the 1990s to design and
develop their corporate strategies. The following
Web pages provide some insight into the industry,
the job opportunities available for professionals in
consulting, as well as some interesting features such
as the Boston Consulting Groups online interactive
case study.
A.T. Kearney http://www.atkearney.com/
Bain and Company http://www.rec.bain.com/
Booze, Allen & Hamilton http://www.bah.com/
Boston Consulting Group http://www.bcg.com/
McKinsey & Company http://www.mckinsey.com/
3. External Debt. The World Bank regularly compiles
and analyzes the external debt of all countries glob-
ally. As part of their annual publication on World
Development Indicators (WDI), they provide sum-
maries of the long-term and short-term external debt
obligations of selected countries online like that of
Poland shown here. Go to their Web site and find the
decomposition of external debt for Brazil, Mexico,
and the Russian Federation.
The World Bank/data www.worldbank.org/data
100,000
80,000
60,000
40,000
20,000
0
2005 2004 2003 2002
Long-term debt Short-term debt
Country: Poland
Data are in millions
External debt
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