Summarize the following in 2 to 3 pages: · Discuss issues raised concerning Sanders’ approach in connection with the sale to Brown and Massey. · Include some of the other options that Sanders may have
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the following in 2 to 3 pages:
· Discuss issues raised concerning Sanders’ approach in connection with the sale to Brown and Massey.
· Include some of the other options that Sanders may have considered other than the $2,000,000 cash price.
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· Explain the reasons for regulatory control over financial markets.
Let’s assume Colonel Sanders obtained a six-month loan of $150,000 Canadian dollars from an American bank to finance the acquisition of a building for another Canadian franchise in Quebec province. The loan will be repaid in Canadian dollars. At the time of the loan, the spot exchange rate was U.S. $0.8995/Canadian dollar and the Canadian currency was selling at a discount in the forward market. The contract after six months (face value = C$150,000 per contract) was quoted at U.S. $0.8930/Canadian dollar.
· Explain how the American bank could lose on this transaction assuming no hedging.
· Assume the bank does hedge with the forward contract, what is the maximum amount it can lose?
Summarize the following in 2 to 3 pages: · Discuss issues raised concerning Sanders’ approach in connection with the sale to Brown and Massey. · Include some of the other options that Sanders may have
21 International Financial Management LEARNING OBJECTIVES LO 21-1 A multinational corporation is one that crosses international borders to gain expanded markets. LO 21-2 A company operating in many foreign countries must consider the effect of exchange rates on its profitability and cash flow. LO 21-3 Foreign exchange risk can be hedged or reduced. LO 21-4 Political risk must be carefully assessed in making a foreign investment decision. LO 21-5 The potential ways for financing international operations are much greater than for domestic operations and should be carefully considered. Today the world economy is more integrated than ever, and nations depend on one another for many valuable and scarce resources. The United States is dependent on China for textiles and Canada, Venezuela, and Saudi Arabia for oil; China is dependent on the United States and other Western countries for technology and heavy machinery. The World Trade Organization has made it easier for many countries to trade their goods and services without tariffs and import duties, and the economic laws of competitive advantage are at work. Countries like the United States, with a well-educated workforce, provide leading technological products while developing economies such as those in India and China, with large populations and low-cost labor, provide much of the world’s labor-intensive goods such as textiles, clothing, and assembled technology products. Additionally, the United States, Canada, and Mexico have instituted the North American Free Trade Association (NAFTA), which has increased trade among those three countries. This growing interdependence necessitates the development of sound international business relations, which will enhance the prospects for future international cooperation and understanding. It is virtually impossible for any country to isolate itself from the impact of international developments in an integrated world economy. Therefore, world politics continue to play a role in economic development. Many Latin and South American countries are moving toward more socialist economies and are increasing trade with China while maintaining strong ties to their European trading partners. In an ever-more-connected world, international trade will become still more important. We were reminded by the events of September 11, 2001, the occurrence of tsunamis and hurricanes, and the ebola outbreak of 2014 that terrorism, war, infectious disease, and weather can not only cause economic impacts for short periods of time, but can have catastrophic effects on localized economies or specific industries. With financial markets becoming more global, a major impact in one area of the world can affect economies thousands of miles away. The capital markets are so integrated that world events such as a currency crisis, government defaults on sovereign debt, or terrorism can cause stock and bond markets to suffer emotional declines well beyond the expected economic impact of a major event. Page 656 Even when stock and bond markets are relatively stable and free of crisis, companies still have to pay attention to the currency markets. These currency markets impact imports and exports between countries and therefore affect sales and earnings of all companies doing business internationally, whether the company is Japan’s Sony, Germany’s Volkswagen, or the United States’ Intel. These companies do quite a bit of their business in the three largest and most liquid currencies in the world: the U.S. dollar, the euro, and the Japanese yen. In January 1999, 11 countries from the European Union adopted the euro as their currency, which fully replaced their previous domestic currencies in January 2002. With the addition of Croatia in 2013, the European Union has grown to 28 countries, 19 of which use the euro as their official currency. These 19 countries are referred to as the “Eurozone.” In the past, it seemed certain that European Union members would continue to discard their national currencies and adopt the euro. However, economic crises in several European countries are leading some to question the practicality of remaining in the Eurozone. Greece, for example, found that one early benefit of participating in the Eurozone was easier access to international bond markets. However, just because it is easy to borrow does not mean that it is prudent to do so. Greece now finds it impossible to repay all of its euro debt, and it cannot devalue its currency. Unless other governments bail Greece out, the country is likely to default on its debt, and it may leave the Eurozone as well. Over the next few years, we will see whether monetary integration continues in Europe or whether some countries leave the Eurozone. Figure 21-1 presents the value of the British pound against the dollar and also the value of the euro against the dollar. Even though Great Britain is a member of the European Union, it has not adopted the euro as its domestic currency but continues to use the pound. Figure 21-1 shows that the British pound and the euro move up and down against the U.S. dollar in unison. Looking at the trend lines for the euro and the pound, understand that when the trend lines are falling, the dollar is rising. In other words, the dollar buys more euros or pounds. When the trend lines are rising, the dollar is falling. We can think about this in a different way. At the peak of the dollar (low for the euro) in 2001, one euro would buy about $0.84 and at the low of the dollar (peak of the euro) in April 2008, one euro would buy $1.60. This $0.76 swing was a 90.4 percent increase in the value of the euro relative to the dollar. From 1999 to 2002, U.S. companies doing business in Europe had to translate their euros into fewer and fewer dollars, so their foreign earnings in dollar terms were negatively affected by the falling euro. But as the euro rose against the dollar, the trend reversed itself. Figure 21-1 One U.S. dollar to the British pound and euro Sources: 2015 Federal Reserve Bank of St. Louis: research.stlouisfed.org. Page 657 When financial panics occur, investors usually prefer to hold dollars because the dollar is widely viewed as a stable and safe currency. During the global financial panic that began in late 2008, the dollar rose dramatically in value relative to the British pound and the euro. Notice in Figure 21-1 that between July 2008 and March 2009, the British pound lost over 30 percent of its value relative to the dollar. Thus in early 2009, when U.S. companies began reporting their 2008 year-end earnings, U.S. companies reported a decrease in earnings from European operations because the euro was translated into fewer dollars. While the falling euro and pound (rising dollar) made European vacations more affordable to Americans, it also put U.S. companies who export to Europe at a competitive disadvantage. American-made goods became more expensive to Europeans who pay for their products in pounds or euros. The significance of international business corporations becomes more apparent if we look at the size of foreign sales relative to domestic sales for major American corporations. Table 21-1 shows companies such as Coca-Cola with foreign sales of 57.0 percent, McDonald’s with foreign sales of 68.5 percent, and other companies with large percentages of foreign sales. Table 21-1 International sales of selected U.S. companies Foreign Sales (% of Total Sales) Fiscal Year-End Coca-Cola 57.0 31-Dec-14 ExxonMobil 62.3 31-Dec-14 General Electric 52.0 31-Dec-14 IBM 65.5 31-Dec-14 Johnson & Johnson 53.2 31-Dec-14 JPMorgan Chase 25.6 31-Dec-14 McDonald’s 68.5 31-Dec-14 Microsoft 50.0 30-Jun-14 Procter & Gamble 64.6 30-Jun-14 Just as foreign operations affect the performance of American businesses, developments in international financial markets also affect our lifestyles. If you took a trip to Europe in April 2011, you would have received about 0.68 euros per dollar. But if you took a second trip four years later, in April 2015, your dollar would get you 0.94 euros, an increase of almost 39 percent. On the other hand, Europeans traveling to the United States would have suffered a 39 percent decline in purchasing power. The value of currencies changes on a daily basis, occasionally by significant amounts, and often reversing directions. For example, after the euro rose against the dollar for several years, it plunged by 17 percent in the first months of 2010 over concerns that Greece and other European countries might default on their sovereign debt. This chapter deals with the dimensions of doing business worldwide. We believe it provides a basis for understanding the complexities of international financial decisions. Such an understanding is important if you work for a multinational manufacturing firm, a large commercial bank, a major brokerage firm, or any firm involved in international transactions. The Multinational Corporation: Nature and Environment Page 658 The focus of international financial management has been the multinational corporation (MNC). One might ask, just what is a multinational corporation? Some definitions of a multinational corporation require that a minimum percentage (often 30 percent or more) of a firm’s business activities be carried on outside its national borders. For our understanding, however, any firm doing business across its national borders is considered a multinational enterprise. Multinational corporations can take several forms. Four are briefly examined. Exporter An MNC could produce a product domestically and export some of that production to one or more foreign markets. This is perhaps the least risky method—reaping the benefits of foreign demand without committing any long-term investment to that foreign country. Licensing Agreement A firm with exporting operations may get into trouble when a foreign government imposes or substantially raises an import tariff to a level at which the exporter cannot compete effectively with the local domestic manufacturers. The foreign government may even ban imports at times. When this happens the exporting firm may grant a license to an independent local producer to use the firm’s technology in return for a license fee or a royalty. In essence, then, the MNC will be exporting technology, rather than the product, to that foreign country. Joint Venture As an alternative to licensing, the MNC may establish a joint venture with a local foreign manufacturer. The legal, political, and economic environments around the globe are more conducive to the joint venture arrangement than any of the other modes of operation. Historical evidence also suggests that a joint venture with a local entrepreneur exposes the firm to the least amount of political risk. This position is preferred by most business firms and by foreign governments as well. Fully Owned Foreign Subsidiary Although the joint venture form is desirable for many reasons, it may be hard to find a willing and cooperative local entrepreneur with sufficient capital to participate. Under these conditions, the MNC may have to go it alone. For political reasons, however, a wholly owned foreign subsidiary is becoming more of a rarity. The reader must keep in mind that whenever we mention a foreign affiliate in the ensuing discussion, it could be a joint venture or a fully owned subsidiary. As the firm crosses its national borders, it faces an environment that is riskier and more complex than its domestic surroundings. Sometimes the social and political environment can be hostile. Despite these difficult challenges, foreign affiliates often are more profitable than domestic businesses. A purely domestic firm faces several basic risks, such as the risk related to maintaining sales and market share, the financial risk of too much leverage, the risk of a poor equity market, and so on. In addition to these types of risks, the foreign affiliate is exposed to foreign exchange risk and political risk. While the foreign affiliate experiences a larger amount of risk than a domestic firm, it actually lowers the portfolio risk of its parent corporation by stabilizing the combined operating cash flows for the MNC. This risk reduction occurs because foreign and domestic economies are less than perfectly correlated. Page 659 Foreign business operations are more complex because the host country’s economy may be different from the domestic economy. The rate of inflation (or deflation) in a foreign country will almost certainly be different than in the United States. The rules of taxation are different. The structure and operation of financial markets and institutions also vary from country to country, as do financial policies and practices. The presence of a foreign affiliate benefits the host country’s economy. Foreign affiliates have been a decisive factor in shaping the pattern of trade, investment, and the flow of technology between nations. They can have a significant positive impact on a host country’s economic growth, employment, trade, and balance of payments. The growth of MNCs has also reduced geopolitical risk and improved world peace. Countries with trade ties are less likely to go to war against one another. These positive contributions, however, are occasionally overshadowed by allegations of wrongdoing. For example, some host countries have charged that foreign affiliates subverted their governments and caused instability of their currencies. The less developed countries (LDCs) have, at times, alleged that foreign businesses exploit their labor with low wages. The multinational companies are also under constant criticism in their home countries where labor unions charge the MNCs with exporting jobs, capital, and technology to foreign nations while avoiding their fair share of taxes. Despite all these criticisms, multinational companies have managed to survive and prosper. The MNCs are well positioned to take advantage of imperfections in the global markets. Furthermore, since current global resource distribution favors the MNCs’ survival and growth, it may be concluded that multinational corporations are here to stay. Foreign Exchange Rates Suppose you are planning to spend a semester in London studying the culture of England. To put your plan into operation you will need British currency—that is, British pounds (£)—so you can pay for your expenses during your stay. How many British pounds you can obtain for $1,000 will depend on the exchange rate at that time. The relationship between the values of two currencies is known as the exchange rate. The exchange rate between U.S. dollars and British pounds is stated as dollars per pound or pounds per dollar. For example, the quotation of $2.00 per pound is the same as £0.50 per dollar (1/$2.00). At this exchange rate you can purchase 500 British pounds with $1,000. A quick Internet search for “foreign exchange rates” or just “fx rates” will deliver multiple sources of up-to-the minute exchange rate data. Figure 21-2 depicts Canadian dollars, Japanese yen, Swiss francs, and Swedish kronor because they are used by some of the United States’ major trading partners. This figure shows the amount of each currency that one can exchange for one U.S. dollar. There is no guarantee that any currency will stay strong relative to other currencies, and the dollar is no exception. Several factors have combined to strengthen the U.S. dollar relative to the euro and the British pound since 2007. The first factor was a “flight to quality” during the financial crisis that began late in that year. However, continued weak European growth and fear for the stability of many eurozone countries has continued to depress the euro (lift the dollar). This strengthening may only be temporary. Of particular concern is the unsustainably high U.S. budget deficit. On the other hand, the United States is not the only country that must address unsustainable policies. Many other countries run large budget deficits or have policies in place that may reduce future economic growth. Such policies may lead to a weakening of those countries’ currencies, and a relative strengthening of the dollar. Page 660 Figure 21-2 Exchange rates to the dollar Source: 2015 Federal Reserve Bank of St. Louis, research.stlouisfed.org. Financial managers should always pay close attention to exchange rates and any changes that might be forecast. Factors Influencing Exchange Rates The present international monetary system consists of a mixture of “freely” floating exchange rates and fixed rates. The currencies of the major trading partners of the United States are traded in free markets. In such a market, the exchange rate between two currencies is determined by the supply of, and the demand for, those currencies. This activity, however, is subject to intervention by many countries’ central banks. Factors that tend to increase the supply or decrease the demand schedule for a given currency will bring down the value of that currency in foreign exchange markets. Similarly, the factors that tend to decrease the supply or increase the demand for a currency will raise the value of that currency. Since fluctuations in currency values result in foreign exchange risk, the financial executive must understand the factors causing these changes in currency values. Although the value of a currency is determined by the aggregate supply and demand for that currency, this alone does not help financial managers understand or predict the changes in exchange rates. Fundamental factors, such as inflation, interest rates, balance of payments, and government policies, are important in explaining both the short-term and long-term fluctuations of a currency value. Page 661 Purchasing Power Parity In theory, a parity between the purchasing powers of two currencies should establish the rate of exchange between the two currencies. Suppose it takes $1.00 to buy one dozen apples in New York and 1.25 euros to buy the same apples in Frankfurt, Germany. Then the rate of exchange between the U.S. dollar and the euro should be €1.25/$1.00 or $0.80/euro. If prices of apples double in New York while the prices in Frankfurt remain the same, the purchasing power of a dollar in New York should drop 50 percent. Consequently, you should be able to exchange $1.00 for only €0.625 in foreign currency markets (or receive $1.60 per euro). Currency exchange rates tend to vary inversely with their respective purchasing powers to provide the same or similar purchasing power in each country. This is called the purchasing power parity theory. When the inflation rate differential between two countries changes, the exchange rate also adjusts to correspond to the relative purchasing powers of the countries. Interest Rates Another economic variable that has a significant influence on exchange rates is interest rates. As a student of finance, you should know that investment capital flows in the direction of higher yield for a given level of risk. This flow of short-term capital between money markets occurs because investors seek equilibrium through arbitrage buying and selling. If investors can earn 6 percent interest per year in Country X and 10 percent per year in Country Y, they will prefer to invest in Country Y, provided the inflation rate and risk are the same in both countries. Thus interest rates and exchange rates adjust until the foreign exchange market and the money market reach equilibrium. This interplay between interest rate differentials and exchange rates is called the interest rate parity theory. Balance of Payments The term balance of payments refers to a system of government accounts that catalogs the flow of economic transactions between the residents of one country and the residents of other countries. (The balance of payments statement for the United States is prepared by the U.S. Department of Commerce quarterly and annually.) It resembles the cash flow statement presented in Chapter 2 and tracks the country’s exports and imports as well as the flow of capital and gifts. When a country sells (exports) more goods and services to foreign countries than it purchases (imports), it will have a surplus in its balance of trade. Over the last several decades, Japan, through its aggressive competition in world markets, has been exporting more goods than it imports and has been enjoying a trade surplus for quite some time. Since the foreigners who buy Japanese goods are expected to pay their bills in yen, the demand for yen and, consequently, its value, increases in foreign currency markets. On the other hand, continuous deficits in the balance of payments are expected to depress the value of a currency because such deficits would increase the supply of that currency relative to the demand. Page 662 Government Policies A national government may, through its central bank, intervene in the foreign exchange market, buying and selling currencies as it sees fit to support the value of its currency relative to others. Sometimes a given country may deliberately pursue a policy of maintaining an undervalued currency to promote cheap exports. In some countries, the currency values are set by government decree. Even in some free market countries, the central banks fix the exchange rates, subject to periodic review and adjustment. Some nations affect the foreign exchange rate indirectly by restricting the flow of funds into and out of the country. Monetary and fiscal policies also affect the currency value in foreign exchange markets. For example, expansionary monetary policy and excessive government spending are primary causes of inflation, and continual use of such policies eventually reduces the value of the country’s currency. Sometimes government policies are at odds with economic reality. In early 2015 Venezuela had two official exchange rates of 6.3 or 12 bolivares to the dollar, depending on what goods were being purchased by the person seeking to exchange bolivares for dollars. In truth, only people with political connections could get these rates. On the black market, where most currency transactions actually took place, 190 bolivares were needed to buy a dollar. Other Factors A pronounced and extended stock market rally in a country attracts investment capital from other countries, thus creating a huge demand by foreigners for that country’s currency. This increased demand is expected to increase the value of that currency. Similarly a significant increase in demand for a country’s principal exports worldwide is expected to result in a corresponding increase in the value of its currency. In recent years, Australia has enjoyed significantly increased exports to China and other Asian countries. In particular, coal, copper, and natural gas have been exported. While it once required 1.5 AUD to buy a U.S. dollar, in 2013 only 0.97 AUD were required to buy a U.S. dollar. As Asian economies slowed in 2014, Australian exports declined, and so did the AUD. By 2015 it required 1.3 AUD to purchase one U.S. dollar. Political turmoil in a country often drives capital out of the country into stable countries. A mass exodus of capital, due to the fear of political risk, undermines the value of a country’s currency in the foreign exchange market. Venezuela’s bolivar lost almost two-thirds of its value against the dollar between 2010 and 2013 due to political turmoil. Although a wide variety of factors that can influence exchange rates has been discussed, a few words of caution are in order. All of these variables will not necessarily influence all currencies to the same degree. Some factors may have an overriding influence on one currency’s value, while their influence on another currency may be negligible at that time. Spot Rates and Forward Rates Page 663 When you look into a major financial newspaper (e.g., The Wall Street Journal), you will discover that two exchange rates exist simultaneously for most major currencies— the spot rate and the forward rate. The spot rate for a currency is the exchange rate at which the currency is traded for immediate delivery. For example, you walk into a local commercial bank and ask for Swiss francs.1 The banker will indicate the rate at which the franc is selling, say SF 0.9727/$. If you like the rate, you buy 972.70 francs with $1,000 and walk out the door. This is a spot market transaction at the retail level. The trading of currencies for future delivery is called a forward market transaction. Suppose IBM Corporation expects to receive SF 97,270 from a Swiss customer in 30 days. It is not certain, however, what these francs will be worth in U.S. dollars in 30 days. To eliminate this uncertainty, IBM calls a bank and offers to sell SF 97,270 for U.S. dollars in 30 days. In their negotiation, the two parties may agree on an exchange rate of SF 0.9718/$. This is the same as $1.0290/SF. The 0.9718 quote is in Swiss francs per dollar. The reciprocal or 1.0290 is in dollars per Swiss franc. Since the exchange rate is established for future delivery, it is a forward rate. After 30 days, IBM delivers SF 97,270 to the bank and receives $100,000. The difference between spot and forward exchange rates, expressed in dollars per unit of foreign currency, may be seen in the following typical values: Rates* Swiss Franc (SF) ($/SF) UK Pound ($/£) Spot $1.0281 $1.4779 30-day forward 1.0290 1.4776 90-day forward 1.0316 1.4770 180-day forward 1.0358 1.4762 *As of 2015. The forward exchange rate of a currency is slightly different from the spot rate prevailing at that time. Since the forward rate deals with a future time, the expectations regarding the future value of that currency are reflected in the forward rate. Forward rates may be greater than the current spot rate (premium) or less than the current spot rate (discount). The preceding table shows the forward rates on the Swiss franc were at a premium in relation to the spot rate, while the forward rates for the British pound were at a discount from the spot rate. This means the participants in the foreign exchange market expected the Swiss franc to appreciate relative to the U.S. dollar in the future and the British pound to depreciate against the dollar. The discount or premium is usually expressed as an annualized percentage deviation from the spot rate. The percentage discount or premium is computed with the following formula: For example, the 90-day forward contract in Swiss francs, as previously listed, was selling at a 1.362 percent premium: while the 90-day forward contract in British pounds was trading at a −0.244 percent discount: Normally the forward premium or discount is between 0.1 percent and 5 percent. Page 664 The spot and forward transactions are said to occur in the over-the-counter market. Foreign currency dealers (usually large commercial banks) and their customers (importers, exporters, investors, multinational firms, and so on) negotiate the exchange rate, the length of the forward contract, and the commission in a mutually agreeable fashion. Although the length of a typical forward contract may generally vary between one month and six months, contracts for longer maturities are not uncommon. The dealers, however, may require higher returns for longer contracts. Cross Rates Because currencies are quoted against the U.S. dollar in The Wall Street Journal, sometimes it may be necessary to work out the cross rates for currencies other than the dollar. For example, on April 13, 2015, the Swiss franc was selling for $1.0231 and the British pound was selling for $1.46596. The cross rate between the franc and the pound was 1.43294 (francs/pound). In determining this value, we show that one dollar would buy 0.97747 francs (1/1.0231) and a pound was equal to 1.46596 dollars. Thus 0.97747 Swiss francs per dollar times 1.46596 dollars per pound equaled 1.43293 Swiss francs per pound. To determine if your answer is correct, you can check a currency cross rate table such as that shown in Table 21-2. There you will see the cross rate between the Swiss franc and the British pound was, in fact, 1.43294 on April 13, 2015. This very minor difference is normal. GBP along the side stands for British pound and CHF across the top stands for Swiss franc. As in this example, the cross rates for various currencies will not always be perfectly synchronized, but they will be very close because arbitrageurs would quickly buy and sell currencies that had cross rates that deviated from the relationship described. These arbitrageurs would earn risk-free returns while pushing the market back to equilibrium cross rates. Table 21-2 has currency rates for two periods approximately five years apart (the top and middle of the table). Comparing the rates for the two time periods shows that the U.S. dollar (top line) rose against the world’s most important currencies (the euro, the British pound, and the Japanese yen) as well as against both the Canadian dollar and the Australian dollar. Only the Swiss franc rose significantly relative to the U.S. dollar. Low taxes, sound financial institutions, and high levels of public safety and education have made Switzerland a preferred place both to do business and to safeguard wealth for rich people from all over the world. Managing Foreign Exchange Risk When the parties associated with a commercial transaction are located in the same country, the transaction is denominated in a single currency. International transactions inevitably involve more than one currency (because the parties are residents of different countries). Since most foreign currency values fluctuate from time to time, the monetary value of an international transaction measured in either the seller’s currency or the buyer’s currency is likely to change when payment is delayed. As a result, the seller may receive less revenue than expected or the buyer may have to pay more than the expected amount for the merchandise. Thus the term foreign exchange risk refers to the possibility of a drop in revenue or an increase in cost in an international transaction due to a change in foreign exchange rates. Importers, exporters, investors, and multinational firms are all exposed to this foreign exchange risk. Page 665 The international monetary system has undergone a significant change since 1971 when the free trading Western nations basically went from a fixed exchange rate system to a “freely” floating rate system. For the most part, the new system has proved its agility and resilience during the most turbulent years of oil price hikes and hyperinflation of the last two decades. The free market exchange rates have responded and adjusted well to these adverse conditions. Consequently, the exchange rates have fluctuated over a much wider range than before. The increased volatility of exchange markets has forced many multinational firms, importers, and exporters to pay more attention to the function of foreign exchange risk management. Table 21-2 Key currency cross rates USD = United States dollar EUR = European monetary unit GBP = Great Britain pound JPY = Japanese yen CHF = Swiss franc CAD = Canadian dollar AUD = Australian dollar NZD = New Zealand dollar HKD = Hong Kong dollar SGD = Singaporean dollar Source: www.fxstreet.com/rates-charts/exchange-rates/. Page 666 The foreign exchange risk of a multinational company is divided into two types of exposure: accounting or translation exposure and transaction exposure. An MNC’s foreign assets and liabilities, which are denominated in foreign currency units, are exposed to losses and gains due to changing exchange rates. This is called accounting or translation exposure. The amount of loss or gain resulting from this form of exposure and the treatment of it in the parent company’s books depend on the accounting rules established by the parent company’s government. In the United States, the rules are spelled out in the Statement of Financial Accounting Standards (SFAS) No. 52. Under SFAS 52 all foreign currency–denominated assets and liabilities are converted at the rate of exchange in effect on the date of balance sheet preparation. An unrealized translation gain or loss is held in an equity reserve account while the realized gain or loss is incorporated in the parent’s consolidated income statement for that period. Thus SFAS 52 partially reduces the impact of accounting exposure resulting from the translation of a foreign subsidiary’s balance sheet on reported earnings of multinational firms. Finance in ACTION Global Coca-Cola Manages Currency Risk The Coca-Cola Company is the world’s largest beverage company. Based in Atlanta, Georgia, Coca-Cola had worldwide sales of over $46 billion in 2014. Nearly 60 percent of these sales were outside the United States. Coke’s sales are spread across North America, Latin America, Asia, Europe, and Africa. Although most of its sales and its costs are in foreign countries, Coke reports earnings to its mostly American shareholders in U.S. dollars. It is not surprising that Coke works hard to manage its foreign currency risk. The largest currency positions that it manages include the euro, Japanese yen, Mexican peso, and Brazilian real. Overall, Coke used 70 functional currencies along with the U.S. dollar in 2014. Coke has used derivatives such as forward currency contracts and currency options to buy these currencies in advance and to short them (meaning it has agreed in advance to deliver currency that it does not yet possess). Sometimes these derivative positions are worth billions of dollars, but it would be an error to think of Coca-Cola as gambling. In a recent annual report, Coca-Cola states, Our Company uses derivative financial instruments primarily to reduce our exposure to adverse fluctuations in foreign currency exchange rates, interest rates, commodity prices and other market risks. We do not enter into derivative financial instruments for trading purposes. As a matter of policy, all of our derivative positions are used to reduce risk by hedging an underlying economic exposure. Because of the high correlation between the hedging instrument and the underlying exposure, fluctuations in the value of the instruments are generally offset by reciprocal changes in the value of the underlying exposure. The Company generally hedges anticipated exposures up to 36 months in advance; however, the majority of our derivative instruments expire within 24 months or less. Virtually all of our derivatives are straightforward over-the-counter instruments with liquid markets. We monitor our exposure to financial market risks using several objective measurement systems, including a sensitivity analysis to measure our exposure to fluctuations in foreign currency exchange rates, interest rates, and commodity prices. From this statement, it is clear that a hedge is not meant to be speculative or to make money based on expectations of currency fluctuations. Coca-Cola hedges to protect cash flows that are arising in the ordinary course of its international business. Many other companies are in this same situation. It is important to distinguish between trading for a profit (speculating) and locking in a position (hedging). Derivative contracts often get a bad reputation as risky because a few financial officers have used them to speculate, rather than to hedge. However, large non-financial companies, like Coca-Cola, use derivatives mostly to minimize risk. However, foreign exchange gains and losses resulting from international transactions, which reflect transaction exposure, are shown in the income statement for the current period. As a consequence of these transactional gains and losses, the volatility of reported earnings per share increases. Three different strategies can be used to minimize this transaction exposure. Page 667 1. Hedging in the forward exchange market. 2. Hedging in the money market. 3. Hedging in the currency futures market. Forward Exchange Market Hedge To see how transaction exposure can be covered in forward markets, suppose Electricitie de France, an electric company in France, purchases a large generator from the General Electric Company of the United States for 822,400 euros on February 21, 2017, and GE is promised the payment in euros in 90 days. Since GE is now exposed to exchange rate risk by agreeing to receive the payment in euros in the future, it is up to General Electric to find a way to reduce this exposure. One simple method is to hedge the exposure in the forward exchange market with a 90-day forward contract. On February 21, 2017, to establish a forward cover, GE sells a forward contract to deliver the 822,400 euros 90 days from that date in exchange for $1,000,000. On May 22, 2017,2 GE receives payment from Electricitie de France and delivers the 822,400 euros to the bank that signed the contract. In return, the bank delivers $1,000,000 to GE. Money Market Hedge A second way to eliminate transaction exposure in the previous example would have been to borrow money in euros and then convert it to U.S. dollars immediately. When the account receivable from the sale is collected three months later, the loan is cleared with the proceeds. In this case, GE’s strategy consists of the following steps. On February 21, 2017: 1. Borrow 806,275 euros—(822,400 euros/1.02) = 806,274.51 euros—at the rate of 8.0 percent per year for three months. You will borrow less than the full amount of 822,400 euros in recognition of the fact that interest must be paid on the loan. Eight percent interest for 90 days translates into 2.0 percent. Thus 822,400 euros is divided by 1.02 to arrive at the size of the loan before the interest payment. 2. Convert the euros into U.S. dollars in the spot market. Then on May 22, 2014 (90 days later): 3. Receive the payment of 822,400 euros from Electricitie de France. 4. Clear the loan with the proceeds received from Electricitie de France. The money market hedge basically calls for matching the exposed asset (account receivable) with a liability (loan payable) in the same currency. Some firms prefer this money market hedge because of the early availability of funds possible with this method. Page 668 Currency Futures Market Hedge Transaction exposure associated with a foreign currency can also be covered in the futures market with a currency futures contract. The International Monetary Market (IMM) of the Chicago Mercantile Exchange began trading in futures contracts in foreign currencies on May 16, 1972. Trading in currency futures contracts also made a debut on the London International Financial Futures Exchange (LIFFE) in September 1982. Other markets have also developed around the world. Just as futures contracts are traded in corn, wheat, hogs, and beans, foreign currency futures contracts are traded in these markets. Although the futures market and forward market are similar in concept, they differ in their operations. To illustrate the hedging process in the currency futures market, suppose that in May Bank of America considers lending 500,000 pesos to a Mexican subsidiary of a U.S. parent company for seven months. The bank purchases the pesos in the spot market, delivers them to the borrower, and simultaneously hedges its transaction exposure by selling December contracts in pesos for the same amount. In December when the loan is cleared, the bank sells the pesos in the spot market and buys back the December peso contracts. The transactions are illustrated for the spot and futures market in Table 21-3:3 Table 21-3 Currency futures hedging While the loan was outstanding, the peso declined in value relative to the U.S. dollar. Had the bank remained unhedged, it would have lost $1,950 in the spot market. By hedging in the futures market, the bank was able to reduce the loss to $1,300. A $650 gain in the futures market was used to cancel some of the $1,950 loss in the spot market. These are not the only means companies have for protecting themselves against foreign exchange risk. Over the years, multinational companies have developed elaborate foreign asset management programs, which involve such strategies as switching cash and other current assets into strong currencies, while piling up debt and other liabilities in depreciating currencies. Companies also encourage the quick collection of bills in weak currencies by offering sizable discounts, while extending liberal credit in strong currencies. Foreign Investment Decisions Page 669 Literally thousands of U.S. firms operate in foreign countries through one or more foreign affiliates. Several explanations are offered for the moves to foreign soil. First, with the emergence of trading blocs in Europe, American firms feared their goods might face import tariffs in those countries. To avoid such trade barriers, U.S. firms started manufacturing in foreign countries. The second factor was the lower production costs overseas. Firms were motivated by the significantly lower wage costs prevailing in foreign countries. Firms in labor-intensive industries, such as textiles and electronics, moved some of their operations to countries where labor was cheap. Third, superior American technology gave U.S. firms easy access to oil exploration, mining, and manufacturing in many developing nations. A fourth advantage relates to taxes. The U.S.-based multinational firms can postpone payment of U.S. taxes on income earned abroad until such income is actually repatriated (forwarded) to the parent company. This tax deferral provision can be used by an MNC to minimize its tax liability. Some countries, like Israel, Ireland, and South Africa, offer special tax incentives for foreign firms that establish operations there. The decision to invest in a foreign country by a firm operating in an oligopolistic industry is also motivated by strategic considerations. When a competitor undertakes a direct foreign investment, other companies quickly follow with defensive investments in the same foreign country. Foreign investments undertaken by U.S. soft drink companies are classic examples of this competitive reaction. Wherever you find a Coca-Cola subsidiary in a foreign country, you are likely to see a Pepsi affiliate also operating in that country. Page 670 International diversification also reduces a company’s overall risk. The basic premise of portfolio theory in finance is that an investor can reduce the risk level of a portfolio by combining those investments whose returns are less than perfectly positively correlated. In addition to domestic diversification, it is shown in Figure 21-3 that further reduction in investment risk can be achieved by also diversifying across national boundaries. Portfolios with international stocks in Figure 21-3 show a lower standard deviation compared to pure U.S. stock portfolios. It is argued, however, that institutional and political constraints, language barriers, and lack of adequate information on foreign investments prevent investors from diversifying across nations. Multinational firms, on the other hand, through their unique position around the world, derive benefits from international diversification.4 Figure 21-3 Risk reduction from international diversification While U.S.-based firms took the lead in establishing overseas subsidiaries during the 1950s and 1960s, European and Japanese firms started this activity in the 1970s and have continued into the new century. Chinese companies arrived later to the game, but these firms have also expanded into international markets. The flow of foreign direct investment into the United States has proceeded at a rapid rate. These investments employ millions of people. It is evident that the United States is an attractive site for foreign investment. In addition to the international diversification and strategic considerations, many other factors are responsible for this inflow of foreign capital into the United States. Increased foreign labor costs in some countries and saturated overseas markets in others are partly responsible. In Japan, an acute shortage of land suitable for industrial development and a near total dependence on imported oil prompted some Japanese firms to locate in the United States. In Germany, a large number of paid holidays, restrictions limiting labor layoffs, and worker participation in management decision making caused many firms to look favorably at the United States. Political stability, large market size, access to advanced technology, and a highly educated workforce are other primary motivating factors for firms to establish operations in the United States. Not only do foreign investors make direct investments in U.S. commercial enterprises, foreign investors in the U.S. Treasury bond market have been bankrolling enormous budget deficits that the government has been running up. When the U.S. government began falling $150 to $200 billion into the red on an annual basis in the 1980s, many analysts thought this would surely mean high inflation, high interest rates, and perhaps a recession. They also were sure there would be a “shortage of capital” for investments because of large government borrowing to finance the deficits. For the most part, foreign investors from China, Japan, Western Europe, Canada, and elsewhere have bailed the government out by supplying the necessary capital. Of course, this means the United States is more dependent on flows of foreign capital into the country. We must satisfy our “outside” creditors or face the unpleasant consequences. During the last three decades, we have gone from being the largest lender in the world to the largest borrower. This debt places an enormous burden on future generations of American taxpayers. Analysis of Political Risk Page 671 Business firms tend to make direct investments in foreign countries for a relatively long time. This is because of the time necessary to recover the initial investment. The government may change hands several times during the foreign firm’s tenure in that country; and, when a new government takes over, it may not be as friendly or as cooperative as the previous administration. An unfriendly government can interfere with the foreign affiliate in many ways. It may impose foreign exchange restrictions, or the foreign ownership share may be limited to a set percentage of the total. Repatriation (transfer) of a subsidiary’s profit to the parent company may be blocked, at least temporarily; and, in the extreme case, the government may even expropriate (take over) the foreign subsidiary’s assets. The multinational company may experience a sizable loss of income or property, or both, as a result of this political interference. Many once well-known U.S. firms, like Anaconda, ITT, and Occidental Petroleum, have lost hundreds of millions of dollars in politically unstable countries. Over the last 30 years, more than 60 percent of U.S. companies doing business abroad suffered some form of politically inflicted damage. Therefore, analysis of foreign political risk is important to multinational firms. The best approach to protection against political risk is to thoroughly investigate the country’s political stability long before the firm makes any investment in that country. Companies use different methods for assessing political risk. Some firms hire consultants to provide them with a report of political risk analysis. Others form their own advisory committees (little state departments) consisting of top-level managers from headquarters and foreign subsidiaries. After ascertaining the country’s political risk level, the multinational firm can use one of the following strategies to guard against such risk: 1. One strategy is to establish a joint venture with a local entrepreneur. By bringing a local partner into the deal, the MNC not only limits its financial exposure but also minimizes antiforeign feelings. Having a “politically connected” local partner can be very valuable. 2. Another risk management tactic is to enter a joint venture with larger firms from other countries. For example, an energy company may pursue its oil production operation in Zaire in association with Royal Dutch Petroleum and Nigerian National Petroleum as partners. The foreign government will be more hesitant to antagonize a number of partner firms of many nationalities at the same time. 3. When the perceived political risk level is high, insurance against such risks can be obtained in advance. Overseas Private Investment Corporation (OPIC), a federal government agency, sells insurance policies to qualified firms. OPIC promotes American investment in third world countries by insuring against losses due to inconvertibility into dollars of amounts received in a foreign country. Policies are also available from OPIC to insure against expropriation and against losses due to war or revolution. For example, OPIC insures the Rwanda properties of Westport, Connecticut–based Tea Importers Inc. During the five-year Rwandan civil war, the company’s tea-processing factory was destroyed, and OPIC paid claims on insurance against political violence. These payments allowed Tea Importers to rebuild and resume production after the war and helped to revive the Rwandan economy. Private insurance companies, such as Lloyds of London, American International Group Inc., CIGNA, and others, issue similar policies to cover political risk. Political risk umbrella policies do not come cheaply. Coverage for projects in “fairly safe” countries can cost anywhere from 0.3 percent to 12 percent of the insured values per year. Needless to say, the coverage is more expensive or unavailable in troubled countries. OPIC’s rates are lower than those of private insurers, and its policies extend for up to 20 years, compared to three years or less for private insurance policies. Financing International Business Operations Page 672 When the parties to an international transaction are well known to each other and the countries involved are politically stable, sales are generally made on credit, as is customary in domestic business operations. However, if a foreign importer is relatively new or the political environment is volatile, or both, the possibility of nonpayment by the importer is worrisome for the exporter. To reduce the risk of nonpayment, an exporter may request that the importer furnish a letter of credit. The importer’s bank normally issues the letter of credit, in which the bank promises to subsequently pay the money for the merchandise. For example, assume Archer Daniels Midland (ADM) is negotiating with a South Korean trading company to export soybean meal. The two parties agree on price, method of shipment, timing of shipment, destination point, and the like. Once the basic terms of sale have been agreed to, the South Korean trading company (importer) applies for a letter of credit from its commercial bank in Seoul. The Korean bank, if it so desires, issues such a letter of credit, which specifies in detail all the steps that must be completed by the American exporter before payment is made. If ADM complies with all specifications in the letter of credit and submits to the Korean bank the proper documentation to prove that it has done so, the Korean bank guarantees the payment on the due date. On that date, the American firm is paid by the Korean bank, not by the buyer of the goods. Therefore, all the credit risk to the exporter is absorbed by the importer’s bank, which is in a good position to evaluate the creditworthiness of the importing firm. The exporter who requires cash payment or a letter of credit from foreign buyers of marginal credit standing is likely to lose orders to competitors. Instead of risking the loss of business, American firms can find an alternative way to reduce the risk of nonpayment by foreign customers. This alternative method consists of obtaining export credit insurance. The insurance policy provides assurance to the exporter that should the foreign customer default on payment, the insurance company will pay for the shipment. The Foreign Credit Insurance Association (FCIA), a private association of U.S. insurance firms, provides this kind of insurance to exporting firms. Funding of Transactions Assistance in the funding of foreign transactions may take many forms. Eximbank (Export-Import Bank) This agency of the U.S. government facilitates the financing of U.S. exports through its various programs. In its direct loan program, the Eximbank lends money to foreign purchasers of U.S. goods such as aircraft, electrical equipment, heavy machinery, computers, and the like. The Eximbank also purchases eligible medium-term obligations of foreign buyers of U.S. goods at a discount from face value. In this discount program, private banks and other lenders are able to rediscount (sell at a lower price) promissory notes and drafts acquired from foreign customers of U.S. firms. Corporate subsidies are controversial, and Congressional authorization for the bank lapsed on July 1, 2015. Several companies like GE and Boeing began to move some production overseas, citing Congress’s failure to reauthorize the bank. These actions put pressure on Congress to renew the charter, but as of late 2015, the bank’s future remains uncertain. Loans from the Parent Company or a Sister Affiliate Another source of funds for a foreign affiliate is its parent company or its sister affiliates. In addition to contributing equity capital, the parent company often provides loans of varying maturities to its foreign affiliate. Although the simplest arrangement is a direct loan from the parent to the foreign subsidiary, such a loan is rarely extended because of foreign exchange risk, political risk, and tax treatment. Instead the loans are often channeled through an intermediary to a foreign affiliate. Parallel loans and fronting loans are two examples of such indirect loan arrangements between a parent company and its foreign affiliate. A typical parallel loan arrangement is depicted in Figure 21-4. Page 673 Figure 21-4 A parallel loan arrangement In this illustration of a parallel loan, an American firm that wants to lend funds to its Dutch affiliate locates a Dutch parent firm, which needs to transfer funds to its U.S. affiliate. Avoiding the exchange markets, the U.S. parent lends dollars to the Dutch affiliate in the United States, while the Dutch parent lends guilders to the American affiliate in the Netherlands. At maturity, the two loans would each be repaid to the original lender. Notice that neither loan carries any foreign exchange risk in this arrangement. In essence both parent firms are providing indirect loans to their affiliates. A fronting loan is simply a parent’s loan to its foreign subsidiary channeled through a financial intermediary, usually a large international bank. A schematic of a fronting loan is shown in Figure 21-5. Figure 21-5 A fronting loan arrangement In the example, the U.S. parent company deposits funds in an Amsterdam bank and that bank lends the same amount to the U.S. firm’s affiliate in the Netherlands. In this manner, the bank fronts for the parent by extending a risk-free (fully collateralized) loan to the foreign affiliate. In the event of political turmoil, the foreign government is more likely to allow the American subsidiary to repay the loan to a large international bank than to allow the same affiliate to repay the loan to its parent company. Thus the parent company reduces its political risk substantially by using a fronting loan instead of transferring funds directly to its foreign affiliate. Page 674 Even though the parent company would prefer that its foreign subsidiary maintain its own financial arrangements, many banks are apprehensive about lending to a foreign affiliate without a parent guarantee. In fact, a large portion of bank lending to foreign affiliates is based on some sort of a guarantee by the parent firm. Usually, because of its multinational reputation, the parent company has a better credit rating than its foreign affiliates. The lender advances funds on the basis of the parent’s creditworthiness even though the affiliate is expected to pay back the loan. The terms of a parent guarantee may vary greatly, depending on the closeness of the parent–affiliate ties, parent–lender relations, and the home country’s legal jurisdiction. Eurodollar Loans The Eurodollar market is an important source of short-term loans for many multinational firms and their foreign affiliates. Eurodollars are simply U.S. dollars deposited in foreign banks. Although a substantial portion of these deposits are held by European banks or European-based branches of U.S. commercial banks, the prefix “euro” is somewhat misleading because the foreign bank does not need to be located in Europe. Since the early 1960s, the Eurodollar market has established itself as a significant part of world credit markets. The participants in these markets are diverse in character and geographically widespread. Hundreds of corporations and banks, mostly from the United States, Canada, Western Europe, and Japan, are regular borrowers and depositors in this market. U.S. firms have more than doubled their borrowings in the Eurodollar market during the last decade. The lower costs and greater credit availability of this market continue to attract borrowers. The lower borrowing costs in the Eurodollar market are often attributed to the smaller overhead costs for lending banks and the absence of a compensating balance requirement. Most Eurodollar transactions occur between large banks. Banks with an excess of deposits, relative to profitable lending opportunities, lend their excess funds to other banks who have an excess of opportunities but a shortage of funds. These interbank loans are often priced using the London Interbank Offered Rate (LIBOR). Other Eurodollar borrowers are typically charged a premium above the LIBOR. Interest rates on these loans are calculated by adding a premium to the basic rate. The size of this premium varies from 0.25 percent to 0.50 percent, depending on the customer, length of the loan period, size of the loan, and so on. For example, Northern Indiana Public Service Company obtained a $75 million, three-year loan from Merrill Lynch International Bank. The utility company paid 0.375 points above LIBOR for the first two years and 0.50 points above for the final year of the loan. Over the years, borrowing in the Eurodollar market has been one-eighth to seven-eighths of a percentage point cheaper than borrowing at the U.S. prime interest rate. For information on the LIBOR price fixing scandal, see Chapter 8. Lending in the Eurodollar market is done almost exclusively by commercial banks. Large Eurocurrency loans are often syndicated by a group of participating banks. The loan agreement is put together by a lead bank, known as the manager, which is usually one of the largest U.S. or European banks. The manager charges the borrower a once-and-for-all fee or commission of 0.25 percent to 1 percent of the loan value. A portion of this fee is kept by the lead bank, and the remainder is shared by all the participating banks. The aim of forming a syndicate is to diversify the risk, which would be too large for any single bank to handle by itself. Multicurrency loans and revolving credit arrangements can also be negotiated in the Eurocurrency market to suit borrowers’ needs. Page 675 Eurobond Market When long-term funds are needed, borrowing in the Eurobond market is a viable alternative for leading multinational corporations. The Eurobond issues are sold simultaneously in several national capital markets, but denominated in a currency different from that of the nation in which the bonds are issued. The most widely used currency in the Eurobond market is the U.S. dollar. These bonds are dollar-denominated, but they are issued outside the United States. Eurobond issues are underwritten by an international syndicate of banks and securities firms. Eurobonds of longer than seven years in maturity generally have a sinking-fund provision. Disclosure requirements in the Eurobond market are much less stringent than those required by the Securities and Exchange Commission (SEC) in the United States. Furthermore, the registration costs in the Eurobond market are lower than those charged in the United States. In addition, the Eurobond market offers tax flexibility for borrowers and investors alike. In fact, many Eurobonds are unregistered bearer bonds. Since no record of the bond’s ownership is kept by the issuer, these bonds are attractive to foreign owners who wish to evade taxes in their home country. All these advantages of Eurobonds, and particularly bearer bonds, enable the borrowers to raise funds at a lower cost. Nevertheless, a caveat may be in order with respect to the effective cost of borrowing in the Eurobond market. When a multinational firm borrows by issuing a foreign currency–denominated debt issue on a long-term basis, it creates transaction exposure, a kind of foreign exchange risk. If the foreign currency appreciates in value during the bond’s life, the cost of servicing the debt could rise. Many U.S. multinational firms borrowed at an approximately 7 percent coupon interest by selling Eurobonds denominated in Deutsche marks and Swiss francs in the late 1980s and early 1990s. Nevertheless, these U.S. firms experienced an average debt service cost of approximately 13 percent, which is almost twice as much as the coupon rate. This increased cost occurred because the U.S. dollar fell with respect to these currencies. Therefore, currency selection for denominating Eurobond issues must be made with extreme care and foresight. To lessen the impact of foreign exchange risk, some recently issued Eurobond issues were denominated in multicurrency units. International Equity Markets The entire amount of equity capital comes from the parent company for a wholly owned foreign subsidiary, but many foreign affiliates are not owned completely by their parent corporations. To avoid nationalistic reactions to wholly owned foreign subsidiaries, such multinational firms as ExxonMobil, General Motors, Ford, and IBM sell shares to worldwide stockholders. It is also believed that widespread foreign ownership of the firm’s common stock encourages the loyalty of foreign stockholders and employees toward the firm. Thus selling common stock to residents of foreign countries not only is an important financing strategy but is also a risk-minimizing strategy for many multinational corporations. Page 676 As you have learned in Chapter 14, a well-functioning secondary market is essential to entice investors into owning shares. To attract investors from all over the world, reputable multinational firms list their shares on major stock exchanges around the world. Over 500 foreign companies are listed on the New York Stock Exchange. Even more foreign firms would sell stock issues in the United States and list on the NYSE and NASDAQ were it not for the tough and costly disclosure rules in effect in this country and enforced by the Securities and Exchange Commission. Many foreign corporations, such as BP, Unilever, Honda, Hitachi, Sony, Rio Tinto, DeBeers, and the like, accommodate American investors by issuing American Depository Receipts (ADRs). All the American-owned shares of a foreign company are placed in trust in a major U.S. bank. The bank, in turn, will issue its depository receipts to the American stockholders and will maintain a stockholder ledger on these receipts, thus enabling the holders of ADRs to sell or otherwise transfer them as easily as they transfer any American company shares. ADR prices tend to move in a parallel path with the prices of the underlying securities in their home markets. Finance in ACTION Global Political Risk in Argentina Companies face political as well as business and financial risks when they expand into foreign markets and invest internationally. Political risks include those associated with the policies of a current regime as well as those that may arise due to possible changes in leaders or direction. Investors want to maximize their returns for a given level of risk, so recognizing political risk is an important component of overall risk assessment. An example of political risk affecting private businesses arose recently in Argentina, where the government decided to expropriate the assets of the country’s largest oil company, YPF. YPF is a subsidiary of Spanish multinational firm Repsol. President Cristina Fernandez de Kirchner, along with influential legislators, led the nationalization efforts. They contended YPF was under-investing in Argentina to keep supplies low and prices artificially high. Of course, this is something that YPF denies vehemently. The expropriation was a result of Argentine attitudes toward the profits and motives of foreign companies. This comes on the heels of the nationalization of Argentine Airlines and also the private pensions of Argentine companies and citizens. Furthermore, many in Argentina feel their sovereign debt default in 2001–2002 was a result of free-market policies, thus souring attitudes toward free enterprise. This example shows that political risks may have major effects on capital flows globally. As one analyst asked regarding Argentina’s nationalization policy, “Who wants to invest in a country where the government expropriates private property from one day to the next?” Many multinational companies will probably avoid investing in Argentina because they are afraid that they may become the next Repsol. Clearly, political factors are a risk that needs to be assessed when analyzing the total risk-return trade-off that companies face—particularly when investing abroad. Sources: http://www.nytimes.com/2012/04/19/world/americas/dismay-over-argentinas-nationalization-plan.html?_r51. http://www.reuters.com/article/2012/05/04/us-argentina-ypf-idUSBRE8421GV20120504. Page 677 Looking elsewhere around the world, U.S. firms have listed their shares on the Toronto Stock Exchange and the Montreal Exchange. Similarly, more than 50 U.S. firms have listed their shares on the London Stock Exchange. To obtain exposure in an international financial community, listing securities on world stock exchanges is a step in the right direction for a multinational firm. This international exposure also brings an additional responsibility for the MNC to understand the preferences and needs of heterogeneous groups of investors of various nationalities. The MNC may have to print and circulate its annual financial statements in many languages. Some foreign investors are more risk-averse than their counterparts in the United States and prefer dividend income over less certain capital gains. Common stock ownership among individuals in countries like Japan and Norway is relatively insignificant, with financial institutions holding substantial amounts of common stock issues. Institutional practices around the globe also vary significantly when it comes to issuing new securities. Unlike in the United States, European commercial banks play a dominant role in the securities business. They underwrite stock issues, manage portfolios, vote the stock they hold in trust accounts, and hold directorships on company boards. In Germany, the banks also run an over-the-counter market in many stocks. The International Finance Corporation Whenever a multinational company has difficulty raising equity capital due to lack of adequate private risk capital in a foreign country, the firm may explore the possibility of selling partial ownership to the International Finance Corporation (IFC). This is a unit of the World Bank Group. The International Finance Corporation was established in 1956 and is owned by 184 member countries of the World Bank. Its objective is to further economic development by promoting private enterprises in developing countries. The profitability of a project and its potential benefit to the host country’s economy are the two criteria the IFC uses to decide whether to assist a venture. The IFC participates in private enterprise through buying equity shares of a business, providing long-term loans, or a combination of the two for up to 25 percent of the total capital. The IFC expects the other partners to assume managerial responsibility, and it does not exercise its voting rights as a stockholder. The IFC helps finance new ventures as well as the expansion of existing ones in a variety of industries. Once the venture is well established, the IFC sells its investment position to private investors to free up its capital. Some Unsettled Issues in International Finance As firms become multinational in scope, the nature of their financial decisions also becomes more complex. A multinational firm has access to more sources of funds than a purely domestic corporation. Interest rates and market conditions vary between the alternative sources of funds, and corporate financial practices may differ significantly between countries. For example, the debt ratios in many foreign countries are higher than those used by U.S. firms. A foreign affiliate of an American firm faces a dilemma in its financing decision: Should it follow the parent firm’s norm or that of the host country? Who must decide this? Will it be decided at the corporate headquarters in the United States or by the foreign affiliate? This is a matter of control over financial decisions. Dividend policy is another area of debate. Should the parent company dictate the dividends the foreign affiliate must distribute, or should it be left completely to the discretion of the foreign affiliate? Foreign government regulations may also influence the decision. Questions like these do not have clear-cut answers. The complex environment in which the MNCs operate does not permit simple solutions. Obviously each situation has to be evaluated individually, and specific guidelines for decision making must be established. Such coordination, it is to be hoped, will result in cohesive policies in the areas of working capital management, capital structure, and dividend decisions throughout the MNC network. Page 678 SUMMARY A significant proportion of earnings for many American companies comes from overseas markets. In general, international business operations have been more profitable than domestic operations, and this higher profitability is one factor that motivates business firms to go overseas to expand their markets. U.S. multinational firms have played a major role in promoting economic development and international trade for several decades, and now foreign firms have started to invest huge amounts of capital in the United States. Brand-name companies such as Sony, Coca-Cola, Heineken, McDonald’s, Nestlé, and BMW are famous the world over. When a domestic business firm crosses its national borders to do business in other countries, it enters a riskier and more complex environment. A multinational firm is exposed to foreign exchange risk in addition to the usual business and financial risks. International business transactions are denominated in foreign currencies, and the rate at which one currency unit is converted into another is called the exchange rate. In today’s global monetary system, exchange rates of major currencies fluctuate freely and on occasion are volatile. For example on October 7, 1998, the Japanese yen fell over 6 percent versus the U.S. dollar due to adverse economic circumstances; this was a record one-day movement against the U.S. dollar. These floating exchange rates expose multinational business firms to foreign exchange risk. To deal with this foreign currency exposure effectively, the financial executive of a MNC must understand foreign exchange rates and how they are determined. Foreign exchange rates are influenced by differences in inflation rates among countries, differences in interest rates, governmental policies, and the expectations of the participants in the foreign exchange markets. The international financial manager can reduce the firm’s foreign currency exposure by hedging in the forward exchange markets, in the money markets, and in the currency futures market. Foreign direct investments are usually quite large, and many of them are exposed to enormous political risk. Although discounted cash flow analysis is applied to screen the projects in the initial stages, strategic considerations and political risk are often the overriding factors in reaching the final decisions about foreign investments. Political risk could involve negative policy decisions by a foreign government that discriminate against foreign firms. Political risk could also be the possibility of a country defaulting on sovereign debt—such as Russia did in 1998—or it could be a country’s economic policies that have negative impacts on the economy such as inducing high inflation or a recession, high unemployment, and social unrest. Political events are hard to forecast, and this makes analyzing a foreign investment proposal more difficult than analyzing a domestic investment project. Page 679 Financing international trade and investments is another important area of international finance that one must understand to raise funds at the lowest cost possible. The multinational firm has access to both the domestic and foreign capital markets. The Export–Import Bank finances American exports to foreign countries. Borrowing in the Eurobond market may appear less expensive at times, but the effect of foreign exchange risk on debt servicing costs must be weighed carefully before borrowing in these markets. Floating common stock in foreign capital markets is also a viable financing alternative for many multinational companies. The International Finance Corporation, which is a subsidiary of the World Bank, also provides debt capital and equity capital to qualified firms. These alternative sources of financing may significantly differ with respect to cost, terms, and conditions. Therefore, the financial executive must carefully locate and use the proper means to finance international business operations. LIST OF TERMS euro 656 multinational corporation 657 exchange rate 659 purchasing power parity theory 661 interest rate parity theory 661 balance of payments 661 spot rate 662 forward rate 663 cross rates 664 foreign exchange risk 664 translation exposure 665 transaction exposure 666 currency futures contract 667 repatriation 670 expropriate 670 Overseas Private Investment Corporation (OPIC) 671 letter of credit 672 Foreign Credit Insurance Association (FCIA) 672 Eximbank 672 parallel loan 673 fronting loan 673 Eurodollars 674 London Interbank Offered Rate (LIBOR) 674 Eurobond 675 American Depository Receipts (ADRs) 676 International Finance Corporation (IFC) 677 DISCUSSION QUESTIONS 1. What risks does a foreign affiliate of a multinational firm face in today’s business world? (LO21-3 & 21-4) 2. What allegations are sometimes made against foreign affiliates of multinational firms and against the multinational firms themselves? (LO21-1) 3. List the factors that affect the value of a currency in foreign exchange markets. (LO21-2) 4. Explain how exports and imports tend to influence the value of a currency. (LO21-2) 5. Differentiate between the spot exchange rate and the forward exchange rate. (LO21-2) 6. What is meant by translation exposure in terms of foreign exchange risk? (LO21-2) 7. What factors would influence a U.S. business firm to go overseas? (LO21-1) 8. What procedure(s) would you recommend for a multinational company in studying exposure to political risk? What actual strategies can be used to guard against such risk? (LO21-4) Page 680 9. What factors beyond the normal domestic analysis go into a financial feasibility study for a multinational firm? (LO21-4) 10. What is a letter of credit? (LO21-5) 11. Explain the functions of the following agencies: (LO21-5) Overseas Private Investment Corporation (OPIC) Export–Import Bank (Eximbank) Foreign Credit Insurance Association (FCIA) International Finance Corporation (IFC) 12. What are the differences between a parallel loan and a fronting loan? (LO21-5) 13. What is LIBOR? How does it compare to the U.S. prime rate? (LO21-5) 14. What is the danger or concern in floating a Eurobond issue? (LO21-5) 15. What are ADRs? (LO21-5) 16. Comment on any dilemmas that multinational firms and their foreign affiliates may face in regard to debt ratio limits and dividend payouts. (LO21-5) PRACTICE PROBLEMS AND SOLUTIONS Cross rates (LO21-2) 1. Suppose a Swedish krona is selling for $0.1286 and a Maltan lira is selling for $2.8148. What is the exchange rate (cross rate) of the Swedish krona to the Maltan lira? Adjusting returns for exchange rates (LO21-2) 2. An investor in the United States bought a one-year New Zealand security valued at 200,000 New Zealand dollars. The U.S. dollar equivalent was $100,000. The New Zealand security earned 15 percent during the year, but the New Zealand dollar depreciated 5 cents against the U.S. dollar during the time period ($0.50/NZD to $0.45/NZD). After transferring the funds back to the United States, what was the investor’s return on his $100,000? Determine the total ending value of the New Zealand investment in New Zealand dollars and then translate this value to U.S. dollars by multiplying by $0.45. Then compute the return on the $100,000. Solutions 1. One dollar is worth 7.776 Swedish kronor (1/0.1286), and one Maltan lira is worth 2.8148 dollars. Thus 7.776 Swedish kronor per dollar times 2.8148 dollars per Maltan lira equals 21.89 Swedish kronor per Maltan lira. 2. Initial value × (1 + earnings) 200,000 × 1.15 = 230,000 New Zealand dollars New Zealand dollars × 0.45 = U.S. dollars equivalent 230,000 × 0.45 = 103,500 U.S. dollars equivalent Page 681 PROBLEMS Selected problems are available with Connect. Please see the preface for more information. Basic Problems Spot and forward rates (LO21-2) 1. The Wall Street Journal reported the following spot and forward rates for the Swiss franc ($/SF): Spot $0.8202 30-day forward $0.8244 90-day forward $0.8295 180-day forward $0.8343 a. Was the Swiss franc selling at a discount or premium in the forward market? b. What was the 30-day forward premium (or discount)? c. What was the 90-day forward premium (or discount)? d. Suppose you executed a 90-day forward contract to exchange 100,000 Swiss francs into U.S. dollars. How many dollars would you get 90 days hence? e. Assume a Swiss bank entered into a 180-day forward contract with Bankers Trust to buy $100,000. How many francs will the Swiss bank deliver in six months to get the U.S. dollars? Cross rates (LO21-2) 2. Suppose a Polish zloty is selling for $0.3414 and a British pound is selling for 1.4973. What is the exchange rate (cross rate) of the Polish zloty to the British pound? That is, how many Polish zlotys are equal to a British pound? Purchasing power theory (LO21-2) 3. From the base price level of 100 in 1979, Saudi Arabian and U.S. price levels in 2008 stood at 200 and 410, respectively. If the 1979 $/riyal exchange rate was $0.26/riyal, what should the exchange rate be in 2008? Suggestion: Using purchasing power parity, adjust the exchange rate to compensate for inflation. That is, determine the relative rate of inflation between the United States and Saudi Arabia and multiply this times $/riyal of 0.26. Continuation of purchasing power theory (LO21-2) 4. From the base price level of 100 in 1981, Saudi Arabian and U.S. price levels in 2010 stood at 250 and 100, respectively. Assume the 1981 $/riyal exchange rate was $0.46/riyal. Suggestion: Using the purchasing power parity, adjust the exchange rate to compensate for inflation. That is, determine the relative rate of inflation between the United States and Saudi Arabia and multiply this times $/riyal of 0.46. What would the exchange rate be in 2010? Intermediate Problems Adjusting returns for exchange rates (LO21-2) 5. An investor in the United States bought a one-year Brazilian security valued at 195,000 Brazilian reals. The U.S. dollar equivalent was 100,000. The Brazilian security earned 16 percent during the year, but the Brazilian real depreciated 5 cents against the U.S. dollar during the time period ($0.51 to $0.46). After transferring the funds back to the United States, what was the investor’s return on her $100,000? Determine the total ending value of the Brazilian investment in Brazilian reals and then translate this Brazilian value to U.S. dollars. Then compute the return on the $100,000. Page 682 Adjusting returns for exchange rates (LO21-2) 6. A Peruvian investor buys 150 shares of a U.S. stock for $7,500 ($50 per share). Over the course of a year, the stock goes up by $4 per share. a. If there is a 10 percent gain in the value of the dollar versus the Peruvian nuevo sol, what will be the total percentage return to the Peruvian investor? First determine the new dollar value of the investment and multiply this figure by 1.10. Divide this answer by $7,500 and get a percentage value, and then subtract 100 percent to get the percentage return. b. Instead assume that the stock increases by $7, but that the dollar decreases by 10 percent versus the nuevo sol. What will be the total percentage return to the Peruvian investor? Use 0.90 in place of 1.10 in this case. Advanced Problem Hedging exchange rate risk (LO21-3) 7. You are the vice president of finance for Exploratory Resources, headquartered in Houston, Texas. In January 20X1, your firm’s Canadian subsidiary obtained a six-month loan of 150,000 Canadian dollars from a bank in Houston to finance the acquisition of a titanium mine in Quebec province. The loan will also be repaid in Canadian dollars. At the time of the loan, the spot exchange rate was U.S. $0.8995/Canadian dollar and the Canadian currency was selling at a discount in the forward market. The June 20X1 contract (face value = C$150,000 per contract) was quoted at U.S. $0.8930/Canadian dollar. a. Explain how the Houston bank could lose on this transaction assuming no hedging. b. If the bank does hedge with the forward contract, what is the maximum amount it can lose? WEB EXERCISE Chapter 21 deals with international finance and the decisions that companies have to make when operating in a foreign country. The Overseas Private Investment Corporation (OPIC) is a U.S. agency that helps U.S. companies that operate in developing economies. Its website has a great deal of information about doing business in a foreign country and excellent links to the 140 countries in which it has relationships. 1. Go to www.opic.gov. Go to “Who We Are” and click on “Overview.” Describe OPIC’s mission. 2. Go to “What We Offer” and click on “Political Risk Insurance.” Describe the types of political risks that can be covered. 3. Go back to “What We Offer” and click on “Financial Products.” Describe the business size that qualifies for “Small and Medium-Enterprise Financing” and then describe the types of projects that can be funded. May other co-lenders be involved? 4. Click on “Investment Funds.” Are equity funds targeted to firms in developing countries? Note: Occasionally a topic we have listed may have been deleted, updated, or moved into a different location on a website. If you click on the site map or site index, you will be introduced to a table of contents that should aid you in finding the topic you are looking for. Page 683 APPENDIX | 21A Cash Flow Analysis and the Foreign Investment Decision Direct foreign investments are often relatively large. As we mentioned in the chapter, these investments are exposed to some extraordinary risks, such as foreign exchange fluctuations and political interference, which are nonexistent for domestic investments. Therefore, the final decision is often made at the board of directors level after considering the financial feasibility and the strategic importance of the proposed investment. Financial feasibility analysis for foreign investments is basically conducted in the same manner as it is for domestic capital budgets. Certain important differences exist, however, in the treatment of foreign tax credits, foreign exchange risk, and remittance of cash flows. To see how these are handled in foreign investment analysis, let us consider a hypothetical illustration. Tex Systems Inc., a Texas-based manufacturer of computer equipment, is considering the establishment of a manufacturing plant in Salaysia, a country in Southeast Asia. The Salaysian plant will be a wholly owned subsidiary of Tex Systems, and its estimated cost is 90 million ringgits (2 ringgits = $1). Based on the exchange rate between ringgits and dollars, the cost in dollars is $45 million. In addition to selling in the local Salaysian market, the proposed subsidiary is expected to export its computers to the neighboring markets in Singapore, Hong Kong, and Thailand. Expected revenues and operating costs are as shown in Table 21A-1. The country’s investment climate, which reflects the foreign exchange and political risks, is rated BBB (considered fairly safe) by a leading Asian business journal. After considering the investment climate and the nature of the industry, Tex Systems has set a target rate of return of 20 percent for this foreign investment. Salaysia has a 25 percent corporate income tax rate and has waived the withholding tax on dividends repatriated (forwarded) to the parent company. A dividend payout ratio of 100 percent is assumed for the foreign subsidiary. Tex Systems’ marginal tax rate is 30 percent. It was agreed by Tex Systems and the Salaysian government that the subsidiary will be sold to a Salaysian entrepreneur after six years for an estimated 30 million ringgits. The plant will be depreciated over a period of six years using the straight-line method. The cash flows generated through depreciation cannot be remitted to the parent company until the subsidiary is sold to the local private entrepreneur six years from now. The Salaysian government requires the subsidiary to invest the depreciation-generated cash flows in local government bonds yielding an aftertax rate of 15 percent. The depreciation cash flows thus compounded and accumulated can be returned to Tex Systems when the project is terminated. Although the value of ringgits in the foreign exchange market has remained fairly stable for the past three years, the projected budget deficits and trade deficits of Salaysia may result in a gradual devaluation of ringgits against the U.S. dollar at the rate of 2 percent per year for the next six years. Page 684 Note that the analysis in Table 21A-1 is primarily done in terms of ringgits. Expenses (operating, depreciation, and Salaysian income taxes) are subtracted from revenues to arrive at earnings after foreign income taxes. These earnings are then repatriated (forwarded) to Tex Systems in the form of dividends. Dividends repatriated thus begin at 5.25 ringgits (in millions) in year 1 and increase to 18.75 ringgits in year 6. The next item, gross U.S. taxes, refers to the unadjusted U.S. tax obligation. As specified, this is equal to 30 percent of foreign earnings before taxes (earnings before Salaysian taxes).1 For example, gross U.S. taxes in the first year are equal to: Table 21A-1 Cash flow analysis of a foreign investment Earnings before Salaysian taxes 7.00 30% of foreign earnings before taxes 30% Gross U.S. taxes 2.10 From gross U.S. taxes, Tex Systems may take a foreign tax credit equal to the amount of Salaysian income tax paid. Gross U.S. taxes minus this foreign tax credit are equal to net U.S. taxes payable. Aftertax dividends received by Tex Systems are equal to dividends repatriated minus U.S. taxes payable. In the first year, the values are: Dividends repatriated 5.25 Net U.S. taxes payable −0.35 Aftertax dividends received by Tex Systems 4.90 Page 685 The figures for aftertax dividends received by Tex Systems are all stated in ringgits (the analysis up to this point has been in ringgits). These ringgits will now be converted into dollars. The initial exchange rate is 2.00 ringgits per dollar, and this will go up by 2 percent per year.2 For the first year, 4.90 ringgits will be translated into 2.45 dollars. Since values are stated in millions, this will represent $2.45 million. Aftertax dividends in U.S. dollars grow from $2.45 million in year 1 to $7.92 million in year 6. The last two rows of Table 21A-1 show the present value of these dividends at a 20 percent discount rate. The total present value of aftertax dividends received by Tex Systems adds up to $15.45 million. Repatriated dividends will be just one part of the cash flow. The second part consists of depreciation-generated cash flow accumulated and reinvested in Salaysian government bonds at a 15 percent rate per year. The compound value of reinvested depreciation cash flows (10 million ringgits per year) is: 10 million ringgits 8.754* = 87.54 million ringgits after six years *Future value at 15 percent for six years (from Appendix C at the end of the book). These 87.54 million ringgits must now be translated into dollars and then discounted back to the present. Since the exchange rate is 2.21 ringgits per dollar in the 6th year (fourth line from the bottom in Table 21A-1), the dollar equivalent of 87.54 million ringgits is: 87.54 million ringgits ÷ 2.21 = $39.61 million The $39.61 million can now be discounted back to the present by using the present value factor for six years at 20 percent (Appendix B). The final benefit to be received is the 30 million ringgits when the plant is sold six years from now.3 We first convert this to dollars and then take the present value. 30 million ringgits ÷ 2.21 = $13.57 million The present value of $13.57 million after six years at 20 percent is: The present value of all cash inflows in dollars is equal to: Present value of dividends $15.45 million Present value of repatriated accumulated depreciation 13.27 Present value of sales price for plant 4.55 Total present value of inflows $33.27 million The cost of the project was initially specified as 90 million ringgits, or $45 million. In the following calculation, we see the total present value of inflows in dollars is less than the cost, and the project has a negative net present value. Total present value of inflows $33.27 million Cost 45.00 Net present value ($11.73 million) Page 686 Problem Cash flow analysis with a foreign investment (LO21-2) 21A–1. The Office Automation Corporation is considering a foreign investment. The initial cash outlay will be $10 million. The current foreign exchange rate is 2 ugans = $1. Thus the investment in foreign currency will be 20 million ugans. The assets have a useful life of five years and no expected salvage value. The firm uses a straight-line method of depreciation. Sales are expected to be 20 million ugans and operating cash expenses 10 million ugans every year for five years. The foreign income tax rate is 25 percent. The foreign subsidiary will repatriate all aftertax profits to Office Automation in the form of dividends. Furthermore, the depreciation cash flows (equal to each year’s depreciation) will be repatriated during the same year they accrue to the foreign subsidiary. The applicable cost of capital that reflects the riskiness of the cash flows is 16 percent. The U.S. tax rate is 40 percent of foreign earnings before taxes. a. Should the Office Automation Corporation undertake the investment if the foreign exchange rate is expected to remain constant during the five-year period? b. Should Office Automation undertake the investment if the foreign exchange rate is expected to be as follows? Year 0 $1 = 2.0 ugans Year 1 $1 = 2.2 ugans Year 2 $1 = 2.4 ugans Year 3 $1 = 2.7 ugans Year 4 $1 = 2.9 ugans Year 5 $1 = 3.2 ugans 1 While Switzerland is a European country, it is not a member of the European Union, and it does not use the euro as its official currency. 2February 21, 2017, to May 22, 2017, represents 90 days. 3For purposes of this example, we assumed the peso was trading at a discount in the futures market. Had it been trading at a premium, the hedge would have been even more attractive. 4International mutual funds also have helped investors diversify across national borders. 1If foreign earnings had not been repatriated, this tax obligation would not be due. 2The 2 percent appreciation means the dollar is equal to an increasing amount of ringgits each year. The dollar is appreciating relative to ringgits, and ringgits are depreciating relative to the dollar. Since Tex Systems’ earnings are in ringgits, they are being converted at a less desirable rate each year. Big Tex may eventually decide to hedge its foreign exchange risk exposure. 3Capital gains taxes are not a necessary consideration in foreign transactions of this nature.
Summarize the following in 2 to 3 pages: · Discuss issues raised concerning Sanders’ approach in connection with the sale to Brown and Massey. · Include some of the other options that Sanders may have
1 The Goals and Activities of Financial Management LEARNING OBJECTIVES LO 1-1 The field of finance integrates concepts from economics, accounting, and a number of other areas. LO 1-2 A firm can have many different forms of organization. LO 1-3 The relationship of risk to return is a central focus of finance. LO 1-4 The primary goal of financial managers is to maximize the wealth of the shareholders. LO 1-5 Financial managers attempt to achieve wealth maximization through daily activities such as credit and inventory management and through longer-term decisions related to raising funds. LO 1-6 The financial turmoil that roiled the markets between 2001 and 2012 resulted in more regulatory oversight of the financial markets. 3M is one of those companies that is more adept than others at creating products, marketing those products, and being financially astute. 3M is the world leader in optical films, industrial and office tapes, and nonwoven fabrics. Consumers may recognize 3M as the maker of Post-it notes, Scotch tape, and sponges, in addition to thousands of other diverse products such as overhead projectors and roofing granules. The company has always been known for its ability to create new products and markets, and, at times, as much as 35 percent of its sales have been generated from products developed in the previous five years. To accomplish these goals, 3M’s research and development has to be financed, the design and production functions funded, and the products marketed and sold worldwide. This process involves all the functions of business. Did you ever stop to think about the importance of the finance function for a $32 billion multinational company like 3M where 64 percent of sales are international? Someone has to manage the international cash flow, bank relationships, payroll, purchases of plant and equipment, and acquisition of capital. Financial decisions must be made concerning the feasibility and profitability of the continuous stream of new products developed through 3M’s very creative research and development efforts. The financial manager needs to keep his or her pulse on interest rates, exchange rates, and the tone of the money and capital markets. To have a competitive multinational company, the financial manager must manage 3M’s global affairs and react quickly to changes in financial markets and exchange rate fluctuations. The board of directors and chief executive officer rely on the financial division to provide a precious resource—capital—and to manage it efficiently and profitably. If you would like to do some research on 3M, you can access its home page at www.3m.com. If you would like to understand more about how companies make financial decisions, keep reading. Page 3 The Field of Finance The field of finance is closely related to economics and accounting, and financial managers need to understand the relationships between these fields. Economics provides a structure for decision making in such areas as risk analysis, pricing theory through supply and demand relationships, comparative return analysis, and many other important areas. Economics also provides the broad picture of the economic environment in which corporations must continually make decisions. A financial manager must understand the institutional structure of the Federal Reserve System, the commercial banking system, and the interrelationships between the various sectors of the economy. Economic variables, such as gross domestic product, industrial production, disposable income, unemployment, inflation, interest rates, and taxes (to name a few), must fit into the financial manager’s decision model and be applied correctly. These terms will be presented throughout the text and integrated into the financial process. Accounting is sometimes said to be the language of finance because it provides financial data through income statements, balance sheets, and the statement of cash flows. The financial manager must know how to interpret and use these statements in allocating the firm’s financial resources to generate the best return possible in the long run. Finance links economic theory with the numbers of accounting, and all corporate managers—whether in production, sales, research, marketing, management, or long-run strategic planning—must know what it means to assess the financial performance of the firm. Many students approaching the field of finance for the first time might wonder what career opportunities exist. For those who develop the necessary skills and training, jobs include corporate financial officer, banker, stockbroker, financial analyst, portfolio manager, investment banker, financial consultant, or personal financial planner. As we progress through the text, you will become increasingly familiar with the important role of the various participants in the financial decision-making process. A financial manager addresses such varied issues as decisions on plant location, the raising of capital, or simply how to get the highest return on x million dollars between 5 o’clock this afternoon and 8 o’clock tomorrow morning. Evolution of the Field of Finance Like any discipline, the field of finance has developed and changed over time. At the turn of the century, finance emerged as a field separate from economics when large industrial corporations in oil, steel, chemicals, and railroads were created by early industrialists such as Rockefeller, Carnegie, Du Pont, and Vanderbilt. In these early days, a student of finance would spend time learning about the financial instruments that were essential to mergers and acquisitions. By the 1930s, the country was in its worst depression ever, and financial practice revolved around such topics as the preservation of capital, maintenance of liquidity, reorganization of financially troubled corporations, and the bankruptcy process. By the mid-1950s finance moved away from its descriptive and definitional nature and became more analytical. One of the major advances was the decision-oriented process of allocating financial capital (money) for the purchase of real capital (long-term plant and equipment). The enthusiasm for more detailed analysis spread to other decision-making areas of the firm—such as cash and inventory management, capital structure theory, and dividend policy. The emphasis also shifted from that of the outsider looking in at the firm, to that of the financial manager making tough day-to-day decisions that would affect the firm’s performance. Page 4 Modern Issues in Finance Modern financial management has focused on risk-return relationships and the maximization of return for a given level of risk. The award of the 1990 Nobel prize in economics to Professors Harry Markowitz and William Sharpe for their contributions to the financial theories of risk-return and portfolio management demonstrates the importance of these concepts. In addition, Professor Merton Miller received the Nobel prize in economics for his work in the area of capital structure theory (the study of the relative importance of debt and equity). These three scholars were the first professors of finance to win Nobel prizes in economics, and their work has been very influential in the field of finance over the last 50 years. Since then, others have followed. Finance continues to become more analytical and mathematical. New financial products with a focus on hedging are being widely used by financial managers to reduce some of the risk caused by changing interest rates and foreign currency exchange rates. As a counterbalance to more quantitative analysis, the psychology of financial decision making, called behavioral finance, has become more widely taught in the classroom. Amos Tversky and Daniel Kahneman were pioneers in the psychology of cognitive bias in the handling of risk. The risk-return trade-off decision is an important concept in finance and economics. Tversky died in 1996, but Kahneman received the Nobel prize in economics in 2002 for his work with Tversky. While increasing prices, or inflation, have always been a key variable in financial decisions, it was not very important from the 1930s to about 1965 when it averaged about 1 percent per year. However, after 1965 the annual rate of price increases began to accelerate and became quite significant in the 1970s when inflation reached double-digit levels during several years. Inflation remained relatively high until 1982 when the U.S. economy entered a phase of disinflation (a slowing down of price increases). The effects of inflation and disinflation on financial forecasting, the required rates of return for capital budgeting decisions, and the cost of capital are quite significant to financial managers and have become more important in their decision making. Risk Management and a Review of the Financial Crisis The impact of the financial crisis that started in 2008 lingered into 2013 and early 2014, but by the end of 2014 the U.S. economy was growing at close to 2.5 percent real GDP. This crisis resulted in government intervention to save the banking system, followed by legislation (and new regulations) to reduce banks’ willingness to take on too much risk. In this brief introduction, we want to emphasize risk management issues. Risk management will have a strong focus over the next decade as the result of the financial crisis that began with the housing bubble in the early part of the new millennium. The unwillingness to enforce risk management controls at most financial institutions allowed the extension of credit to borrowers who had high-risk profiles and, in too many cases, no chance of paying back their loans. In addition to the poor credit screening of borrowers, quantitative financial engineers created portfolios of mortgage-backed securities that included many of these risky loans. The rating agencies gave these products high credit ratings (AAA), so investors, including sophisticated institutional investors, thought the assets were safe. As the economy went into a recession and borrowers stopped making their loan payments, these mortgage-backed securities fell dramatically in value, and many financial institutions had huge losses on their balance sheets, which they were forced to write off with mark-to-market accounting standards. In some cases, the write-offs reduced bank capital to precarious levels or even below the minimum required level, forcing the banks to raise more capital. Page 5 To make matters more complicated, new unregulated products called credit default swaps (CDS) were created as insurance against borrowers defaulting on their loans. These credit default swaps were backed by some of the same financial institutions that lacked enough capital to support the insurance that they guaranteed. Liquidity dried up, markets stopped working, and eventually the government stepped into the breach by forcing mergers and infusing capital into the financial institutions. By fall 2008, Bear Stearns, the fifth-largest investment bank, was forced to merge with JPMorgan Chase, a strong bank. By September 15, 2009, Lehman Brothers, the fourth-largest investment bank, declared bankruptcy, and even Merrill Lynch had to be saved by merging with Bank of America. The Federal Deposit Insurance Corporation seized Washington Mutual on September 25, and again JPMorgan Chase was called on to take over the operations of the biggest bank failure in U.S. history. As the markets continued to disintegrate, the Federal Reserve provided $540 billion to help money market funds meet their redemptions. The crisis continued into 2009, and by February Congress agreed on a $789 billion stimulus package to help keep the economy afloat. Both Chrysler (in April) and General Motors (in June) filed for bankruptcy, and by September 2009, with the help of the Federal Reserve, money and capital markets became more stable and began to function properly. This crisis created the longest recession since the Great Depression and forced financial institutions to pay more attention to their risk controls. Money became tight and hard to find unless a borrower had a very high credit rating. Chief executives who had previously ignored the warnings of their risk management teams now gave risk managers more control over financial transactions that might cause a repeat of the calamity. The Dodd–Frank Act In response to the financial crisis, Congress passed the Dodd–Frank Act, officially known as the Wall Street Reform and Consumer Protection Act of 2010. The act purports to promote financial stability by improving accountability and transparency in the overall financial system, protecting taxpayers by improving the stability of large, diversified financial institutions, and protecting consumers from abusive practices in the financial services industry. Dodd–Frank is the first major financial regulatory change in the United State since the Great Depression. Page 6 Dodd–Frank has many different sections, and rather than listing each section by title, we provide an overview of the law and its areas of impact. The act created the Financial Stability Oversight Council and the Office of Financial Research within the Treasury Department. These offices are intended to identify systematic risks, reduce moral hazard, and maintain the stability of the U.S. financial system. The law provides for the orderly liquidation or bankruptcy of non-bank financial companies, including broker-dealers and insurance companies. It also consolidates different regulators into fewer federal entities so that it is more difficult for financial firms to pick the least burdensome regulator. Hedge funds and other investment advisors are now required to register with the Security Exchange Commission. Dodd–Frank also established the Federal Insurance Office within the Treasury Department to oversee the insurance industry and streamline state-based insurance regulation. The act contains the controversial Volcker Rule, which limits the amount of speculative investing a regulated and federally insured depository institution can engage in. This limits large financial institutions from having proprietary, in-house hedge funds and private equity investments. Because much of the financial crisis was blamed on derivative securities, especially credit default swaps, the law requires that over-the-counter derivatives such as credit default swaps be cleared through formal exchanges and regulated either by the SEC or CFTC (Commodity Futures Trading Commission). A large part of Dodd–Frank deals with consumer protection and the powers of the newly created Bureau of Consumer Financial Protection. The oversight given to the Bureau of Consumer Financial Protection allows it to dictate the fees that banks charge and the types of products they offer. This power in the hands of a regulator has been widely criticized in the banking community as an attack on free markets. Several issues have arisen since the act was signed into law. While Dodd–Frank outlines several broad goals and assigns regulatory responsibility, the actual rulemaking and implementation have been largely left to the different agencies charged with enforcement. The actual agency-level rulemaking has been delayed as the different regulators attempt to design regulations that conform to the letter of the law. Further, there is a large gray area in the actual activities that are treated as distinct by Dodd–Frank. For instance, the limits on proprietary trading by federally insured financial institutions, also known as the Volcker Rule, assumes that there is a clear distinction between market-making activities and proprietary trading when this is not always the case. New laws often have unintended consequences and are amended or fine-tuned many years later. Many banks and financial institutions have complained that the Volcker Rule has reduced market liquidity to the point that some securities don’t have enough buyers and sellers to create prices. The new Republican Congress of 2015 has promised to fix some of the unintended consequences, but time will tell if they are able to pass legislation removing some of the rules handcuffing financial institutions. The Impact of Information Technology The Internet has been around for a long time, but only in the 1990s did it start to be applied to commercial ventures as companies tried to get a return on their previous technology investments. The rapid development of computer technology, both software and hardware, turned the Internet into a dynamic force in the economy and has affected the way business is conducted. The rapid expansion of the Internet has allowed the creation of many new business models and companies such as Amazon.com, eBay, Facebook, Netflix, Twitter, and Google. It has also enabled the acceleration of e-commerce solutions for “old economy” companies. These e-commerce solutions include different ways to reach customers—the business to consumer model (B2C)—and more efficient ways to interact with suppliers—the business to business model (B2B). Page 7 Ralph S. Larsen, former chairman and CEO of Johnson & Johnson said in 1999, “The Internet is going to turn the way we do business upside down—and for the better. From the most straightforward administrative functions, to operations, to marketing and sales, to supply chain relationships, to finance, to research and development, to customer relationships—no part of our business will remain untouched by this technological revolution.”1 So far he has been right. For a financial manager, e-commerce impacts financial management because it affects the pattern and speed with which cash flows through the firm. In the Internet’s business to business model (B2B), orders can be placed, inventory managed, and bids to supply product can be accepted, all online. The B2B model can help companies lower the cost of managing inventory, accounts receivable, and cash. Where applicable we have included examples throughout the book to highlight the impact of e-commerce and the Internet on the finance function. Activities of Financial Management Having examined the field of finance and some of its more recent developments, let us turn our attention to the activities financial managers must perform. It is the responsibility of financial management to allocate funds to current and fixed assets, to obtain the best mix of financing alternatives, and to develop an appropriate dividend policy within the context of the firm’s objectives. These functions are performed on a day-to-day basis as well as through infrequent use of the capital markets to acquire new funds. The daily activities of financial management include credit management, inventory control, and the receipt and disbursement of funds. Less routine functions encompass the sale of stocks and bonds and the establishment of capital budgeting and dividend plans. As indicated in Figure 1-1, all these functions are carried out while balancing the profitability and risk components of the firm. Figure 1-1 Functions of the financial manager Page 8 Finance in ACTION Managerial The Endangered Public Company An article in The Economist describes the decline of the public company in the United States. It states that the number of public companies in the United States has fallen 38 percent since 1997 and 48 percent in Britain. In addition, the number of initial public offerings (IPOs) in America declined from an average of 311 per year in the 1980–2000 period to 99 per year in the 2001–2011 period, with only 81 in 2011. The Economist points out that Mark Zuckerberg of Facebook didn’t really want to take his firm public, but because of U.S. law, his hand was forced in a sense. If a U.S. company has more than 500 shareholders, it is required to publish quarterly financial reports just as if it were a publicly listed company. So while Zuckerberg took Facebook public, he structured the company so that he kept most of the voting rights. This is not unusual with family-owned companies. The Ford family has managed to maintain control of Ford Motor Company with a 40 percent controlling vote. The burdens of regulation have grown heavier for public companies since the collapse of Enron in 2001 and the fraud perpetrated by Bernie Ebbers at WorldCom. Corporate executives complain that it is impossible to focus on the long term when institutional investors and shareholders seem to value short-term results. The result is that privately held companies are making a comeback. Companies like ToysRUs, J. Crew, and even McGraw-Hill Education, the publisher of this text, are privately held. Other types of business organizations have arisen. For example, one-third of America’s tax reporting businesses now classify themselves as partnerships. These partnerships can come in various forms such as limited liability limited partnerships (LLLPs), publicly traded partnerships (PTPs), real estate investment trusts (REITs), and private partnerships such as those of most private equity partnerships that own whole companies that are not publicly traded. In emerging market foreign countries, state-owned enterprises (SOEs) are quite common as these countries emerge from controlled economies to more open economies. For example, SOEs make up 80 percent of China’s companies, 62 percent of Russia’s companies, and 38 percent of Brazil’s companies. State-owned enterprises are politically protected and often are central to a country’s economy. One such example is Gazprom in Russia, the biggest natural gas company. The question for the future is will these new forms of businesses continue to multiply while publicly held companies continue to decline, or is this just a reaction to the financial crisis and the slow growth period of 2000 to 2012. Source: “The Endangered Public Company: The Big Engine That Couldn’t,” The Economist, May 19, 2012, pp. 27–30. The appropriate risk-return trade-off must be determined to maximize the market value of the firm for its shareholders. The risk-return decision will influence not only the operational side of the business (capital versus labor or Product A versus Product B) but also the financing mix (stocks versus bonds versus retained earnings). Forms of Organization The finance function may be carried out within a number of different forms of organizations. Of primary interest are the sole proprietorship, the partnership, and the corporation. Sole Proprietorship The sole proprietorship form of organization represents single-person ownership and offers the advantages of simplicity of decision making and low organizational and operating costs. Most small businesses with 1 to 10 employees are sole proprietorships. The major drawback of the sole proprietorship is that there is unlimited liability to the owner. In settlement of the firm’s debts, the owner can lose not only the capital that has been invested in the business, but also personal assets. This drawback can be serious, and you should realize that few lenders are willing to advance funds to a small business without a personal liability commitment. Page 9 The profits or losses of a sole proprietorship are taxed as though they belong to the individual owner. Thus if a sole proprietorship makes $50,000, the owner will claim the profits on his or her tax return. (In the corporate form of organization, the corporation pays a tax on profits, and then the owners of the corporation pay a tax on any distributed profits.) Approximately 72 percent of the 30 million business firms in this country are organized as sole proprietorships, and these produce approximately 4.2 percent of the total revenue and 10.0 percent of the total profits of the U.S. economy. Partnership The second form of organization is the partnership, which is similar to a sole proprietorship except there are two or more owners. Multiple ownership makes it possible to raise more capital and to share ownership responsibilities. Most partnerships are formed through an agreement between the participants, known as the articles of partnership, which specifies the ownership interest, the methods for distributing profits, and the means for withdrawing from the partnership. For taxing purposes, partnership profits or losses are allocated directly to the partners, and there is no double taxation as there is in the corporate form. Like the sole proprietorship, the partnership arrangement carries unlimited liability for the owners. While the partnership offers the advantage of sharing possible losses, it presents the problem of owners with unequal wealth having to absorb losses. If three people form a partnership with a $10,000 contribution each and the business loses $100,000, one wealthy partner may have to bear a disproportionate share of the losses if the other two partners do not have sufficient personal assets. To circumvent this shared unlimited liability feature, a special form of partnership, called a limited liability partnership, can be utilized. Under this arrangement, one or more partners are designated general partners and have unlimited liability for the debts of the firm; other partners are designated limited partners and are liable only for their initial contribution. The limited partners are normally prohibited from being active in the management of the firm. You may have heard of limited partnerships in real estate syndications in which a number of limited partners are doctors, lawyers, and CPAs and there is one general partner who is a real estate professional. Not all financial institutions will extend funds to a limited partnership. Corporation In terms of revenue and profits produced, the corporation is by far the most important type of economic unit. While only 20 percent of U.S. business firms are corporations, 83 percent of sales and 70 percent of profits can be attributed to the corporate form of organization. The corporation is unique—it is a legal entity unto itself. Thus the corporation may sue or be sued, engage in contracts, and acquire property. A corporation is formed through articles of incorporation, which specify the rights and limitations of the entity. A corporation is owned by shareholders who enjoy the privilege of limited liability, meaning their liability exposure is generally no greater than their initial investment.2 A corporation also has a continual life and is not dependent on any one shareholder for maintaining its legal existence. Page 10 A key feature of the corporation is the easy divisibility of the ownership interest by issuing shares of stock. While it would be nearly impossible to have more than 10,000 or 20,000 partners in most businesses, a corporation may have several hundred thousand shareholders. For example, General Electric has 10.0 billion shares of common stock outstanding with 54.0 percent institutional ownership (pension funds, mutual funds, etc.), while Microsoft with 8.2 billion shares outstanding has 71.0 percent institutional ownership. The shareholders’ interests are ultimately managed by the corporation’s board of directors. The directors may include key management personnel of the firm as well as directors from outside the firm. Directors serve in a fiduciary capacity for the shareholders and may be liable for the mismanagement of the firm. After the collapse of corporations such as Enron and WorldCom due to fraud, the role of outside directors became much more important, and corporations were motivated to comply with more stringent corporate governance laws mandated by Congress. Outside directors may make from $5,000 per year for serving on the board of small companies, but directors serving on the boards of S&P 500 companies earn fees of more than $250,000 per year, on average. Directors serving on the audit and compensation committees are frequently paid additional fees. Because the corporation is a separate legal entity, it reports and pays taxes on its own income. As previously mentioned, any remaining income that is paid to the shareholders in the form of dividends will require the payment of a second tax by the shareholders. One of the key disadvantages to the corporate form of organization is this potential double taxation of earnings. In 2003 Congress diminished part of this impact by lowering the maximum tax rate on dividends from 38.6 percent to 15 percent. However, tax rates on dividends for high-income individuals were raised to 23.8 percent beginning in 2013. There is, however, one way to completely circumvent the double taxation of a normal corporation, and that is through formation of an S corporation. With an S corporation, the income is taxed as direct income to the stockholders and thus is taxed only once as normal income, similar to a partnership. Nevertheless, the shareholders receive all the organizational benefits of a corporation, including limited liability. The S corporation designation can apply to corporations with up to 100 stockholders. The limited liability company (LLC) has become a popular vehicle for conducting business because of its highly flexible structure. An LLC is not technically a corporation, but like a corporation it provides limited liability for the owners. LLCs can be taxed as sole proprietorships, partnerships, corporations, or S corporations, depending upon elections made by the owners. While the proprietorship, traditional partnership, and various forms of limited partnerships are all important, the corporation is given primary emphasis in this text. Because of the all-pervasive impact of the corporation on our economy, and because most growing businesses eventually become corporations, the effects of most decisions in this text are often considered from the corporate viewpoint. Page 11 Corporate Governance As we learned in the previous section, the corporation is governed by the board of directors, led by the chairman of the board. In many companies, the chairman of the board is also the CEO, or chief executive officer, of the company. During the three-year stock market collapse of 2000–2002, many companies went bankrupt due to mismanagement or, in some cases, financial statements that did not accurately reflect the financial condition of the firm because of deception as well as outright fraud. Companies such as WorldCom reported over $9 billion of incorrect or fraudulent financial entries on their income statements. Many of the errors were found after the company filed for bankruptcy, when new management came in to try and save the company. Enron also declared bankruptcy after it became known that its accountants kept many financing transactions “off the books.” The company had more debt than most of its investors and lenders knew about. Many of these accounting manipulations were too sophisticated for the average analyst, banker, or board member to understand. In the Enron case, the U.S. government indicted its auditor, Arthur Andersen, and because of the indictment, the Andersen firm was dissolved. Because of these accounting scandals, there was a public outcry for corporate accountability, ethics reform, and a demand to know why the corporate governance system had failed. Again, in the financial crisis in 2007–2009 it appeared that boards of directors didn’t understand the risk that their management had taken in extending mortgages to high credit risks. Even senior management didn’t understand the risk embodied in some of the mortgage-backed securities that their organizations had bought for investments. This total lack of risk management oversight continued to put a focus on corporate governance issues. With the Internet bubble and financial crisis coming so close together, many questioned the ability of large companies and financial institutions to regulate themselves. Why didn’t the boards of directors know what was going on and stop it? Why didn’t they fire members of management and clean house? Why did they allow such huge bonuses and executive compensation when companies were performing so poorly? One result of the financial crisis was the passing of the Wall Street Reform and Consumer Protection Act of 2010 (Dodd–Frank), as discussed earlier in the chapter. The issues of corporate governance are really agency problems. Agency theory examines the relationship between the owners and the managers of the firm. In privately owned firms, management and owners are usually the same people. Management operates the firm to satisfy its own goals, needs, financial requirements, and the like. However, as a company moves from private to public ownership, management now represents all the owners. This places management in the agency position of making decisions that will be in the best interests of all shareholders. Because of diversified ownership interests, conflicts between managers and shareholders can arise that impact the financial decisions of the firm. When the chairman of the board is also the chief executive of the firm, stockholders recognize that the executive may act in his or her own best interests rather than those of the stockholders of the firm. In the prior bankruptcy examples, that is exactly what happened. Management filled their own pockets and left the stockholders with little or no value in the company’s stock. In the WorldCom case, a share of common stock fell from the $60 range to $.15 per share and eventually ended up being worthless. Because of these potential conflicts of interest, many hold the view that the chairman of the board of directors should be from outside a company rather than an executive of the firm. Page 12 Because institutional investors such as pension funds and mutual funds own a large percentage of stock in major U.S. companies, these investors are having more to say about the way publicly owned corporations are managed. As a group they have the ability to vote large blocks of shares for the election of a board of directors. The threat of their being able to replace poorly performing boards of directors makes institutional investors quite influential. Since pension funds and mutual funds represent individual workers and investors, they have a responsibility to see that firms are managed in an efficient and ethical way. The Sarbanes–Oxley Act Because corporate fraud during the Internet bubble had taken place at some very large and high-profile companies, Congress decided that it needed to do something to control corrupt corporate behavior. The major accounting firms had failed to detect fraud in their accounting audits, and outside directors were often not provided with the kind of information that would allow them to detect fraud and mismanagement. Because many outside directors were friends of management and had been nominated by management, there was a question about their willingness to act independently in carrying out their fiduciary responsibility to shareholders. The Sarbanes–Oxley Act of 2002 set up a five-member Public Company Accounting Oversight Board with the responsibility for establishing auditing standards within companies, controlling the quality of audits, and setting rules and standards for the independence of the auditors. It also puts great responsibility on the internal audit committee of each publicly traded company to enforce compliance with the act. The major focus of the act is to make sure that publicly traded corporations accurately present their assets, liabilities, and equity and income on their financial statements. Originally, there were complaints about the cost of implementing the act and concerns about its effectiveness. After getting systems in place to monitor activity, many companies found the results to be more positive than negative. Goals of Financial Management Let us look at several alternative goals for the financial manager as well as the other managers of the firm. One may suggest that the most important goal for financial management is to “earn the highest possible profit for the firm.” Under this criterion, each decision would be evaluated on the basis of its overall contribution to the firm’s earnings. While this seems to be a desirable approach, there are some serious drawbacks to profit maximization as the primary goal of the firm. First, a change in profit may also represent a change in risk. A conservative firm that earned $1.25 per share may be a less desirable investment if its earnings per share increase to $1.50, but the risk inherent in the operation increases even more. A second possible drawback to the goal of maximizing profit is that it fails to consider the timing of the benefits. For example, if we could choose between the following two alternatives, we might be indifferent if our emphasis were solely on maximizing earnings. Page 13 Both investments would provide $3.50 in total earnings, but Alternative B is clearly superior because the larger benefits occur earlier. We could reinvest the difference in earnings for Alternative B one period sooner. Finally, the goal of maximizing profit suffers from the almost impossible task of accurately measuring the key variable in this case: profit. As you will observe throughout the text, there are many different economic and accounting definitions of profit, each open to its own set of interpretations. Furthermore, problems related to inflation and international currency transactions complicate the issue. Constantly improving methods of financial reporting offer some hope in this regard, but many problems remain. A Valuation Approach While there is no question that profits are important, the key issue is how to use them in setting a goal for the firm. The ultimate measure of performance is not what the firm earns, but how the earnings are valued by the investor. In analyzing the firm, the investor will also consider the risk inherent in the firm’s operation, the time pattern over which the firm’s earnings increase or decrease, the quality and reliability of reported earnings, and many other factors. The financial manager, in turn, must be sensitive to all of these considerations. He or she must question the impact of each decision on the firm’s overall valuation. If a decision maintains or increases the firm’s overall value, it is acceptable from a financial viewpoint; otherwise, it should be rejected. This principle is demonstrated throughout the text. Maximizing Shareholder Wealth The broad goal of the firm can be brought into focus if we say the financial manager should attempt to maximize the wealth of the firm’s shareholders through achieving the highest possible value for the firm. Shareholder wealth maximization is not a simple task because the financial manager cannot directly control the firm’s stock price, but can only act in a way that is consistent with the desires of the shareholders. Since stock prices are affected by expectations of the future as well as by the current economic environment, much of what affects stock prices is beyond management’s direct control. Even firms with good earnings and favorable financial trends do not always perform well in a declining stock market over the short term. The concern is not so much with daily fluctuations in stock value as with long-term wealth maximization. This can be difficult in light of changing investor expectations. In the 1950s and 1960s, the investor emphasis was on maintaining rapid rates of earnings growth. In the 1970s and 1980s, investors became more conservative, putting a premium on lower risk and, at times, high current dividend payments. In the early and mid-1990s, investors emphasized lean, efficient, well-capitalized companies able to compete effectively in the global environment. But by the late 1990s, there were hundreds of high-tech Internet companies raising capital through initial public offerings of their common stock. Many of these companies had dreams but little revenue and no earnings, yet their stock sold at extremely high prices. Some in the financial community said that the old valuation models were dead, didn’t work, and were out of date; earnings and cash flow didn’t matter anymore. Alan Greenspan, then chairman of the Federal Reserve Board, made the now famous remark that the high-priced stock market was suffering from “irrational exuberance.” By late 2000, many of these companies turned out to be short-term wonders. A few years later, hundreds were out of business. The same scenario played out with the housing bubble of 2001–2006, which collapsed in 2007. The financial problems that followed carried on into 2012, and while stock prices recovered from their bottom in 2009, investors remained more conservative, causing valuations to be depressed from former highs. However, by April of 2015, the Dow Jones Industrial Average hit an all-time high, and investors were asking whether the market had gotten ahead of itself as corporate revenues stalled and earnings growth slowed. Page 14 Management and Stockholder Wealth Does modern corporate management always follow the goal of maximizing shareholder wealth? Under certain circumstances, management may be more interested in maintaining its own tenure and protecting “private spheres of influence” than in maximizing stockholder wealth. For example, suppose the management of a corporation receives a tender offer to merge the corporation into a second firm; while this offer might be attractive to shareholders, it might be quite unpleasant to present management. Historically, management may have been willing to maintain the status quo rather than to maximize stockholder wealth. As mentioned earlier, this is now changing. First, in most cases “enlightened management” is aware that the only way to maintain its position over the long run is to be sensitive to shareholder concerns. Poor stock price performance relative to other companies often leads to undesirable takeovers and proxy fights for control. Second, management often has sufficient stock option incentives that will motivate it to achieve market value maximization for its own benefit. Third, powerful institutional investors are making management more responsive to shareholders. Social Responsibility and Ethical Behavior Is our goal of shareholder wealth maximization consistent with a concern for social responsibility for the firm? In most instances the answer is yes. By adopting policies that maximize values in the market, the firm can attract capital, provide employment, and offer benefits to its community. This is the basic strength of the private enterprise system. Nevertheless, certain socially desirable actions such as pollution control, equitable hiring practices, and fair pricing standards may at times be inconsistent with earning the highest possible profit or achieving maximum valuation in the market. For example, pollution control projects frequently offer a negative return. Does this mean firms should not exercise social responsibility in regard to pollution control? The answer is no—but certain cost-increasing activities may have to be mandatory rather than voluntary, at least initially, to ensure that the burden falls equally over all business firms. However, there is evidence that socially responsible behavior can be profitable. For example, 3M estimates that its Pollution Prevention Pays (3P) program has had financial benefits as well as social benefits. This program has been in place for over 34 years and during this time has prevented the release of more than 3.8 billion pounds of pollutants and saved over $1.7 billion. See the nearby box for more about how 3M is a socially responsible citizen. Page 15 3M Company—Good Corporate Citizen Finance in ACTION Managerial Given that stock market investors emphasize financial results and the maximization of shareholder value, does it makes sense for a company to be socially responsible? Can companies be socially responsible and oriented toward shareholder wealth at the same time? We think so, and while the results of social responsibility are hard to measure, the results of creating goodwill and high employee morale can often create cost savings and a motivated and highly productive workforce. 3M is a manufacturing company and therefore uses large quantities of raw material and has tons of waste from its production processes. How it deals with these issues says a lot about the company’s social responsibility. The company has the following programs in place to deal with sustainability issues: Eco-Efficiency Management, Climate Change & Energy Management, Pollution Prevention, Water Management, and Reducing Waste. 3M is a leading company in the Dow Jones Sustainability Index and in May 2007 was awarded the first annual Clean Air Excellence Gregg Cooke Visionary Program Award by the U.S. Environmental Protection Agency. The company has focused on the environment and social responsibility since 1960. 3M has pursued a series of five-year plans, and between 2000 and 2010, it either met or exceeded its goals. For example, one goal was to reduce volatile air emissions indexed to net sales by 25 percent, and it achieved a reduction of 58 percent. A goal to reduce waste to net sales by 25 percent was also exceeded. 3M has further reduced worldwide greenhouse gas emissions between 1990 and 2011 by 95 percent. In 2011 3M was recognized for the eighth year in a row by the U.S. Environmental Protection Agency and the U.S. Department of Energy and was awarded the Sustained Excellence Award for Energy Management. While sustainability and environmental issues are important issues for social responsibility, other activities are also important. 3M promotes community involvement and has traditionally given more than 2 percent of its pretax profits to well-defined programs related to the environment, education, arts and culture, and health and human services. You can view 3M’s goals for 2015 at http://solutions.3M.com/. www.3m.com Unethical and illegal financial practices on Wall Street by corporate financial “dealmakers” have made news headlines from the late 1980s until the present. For example, Bernie Madoff and his Ponzi scheme made headlines in the latter part of the decade. Insider trading occurs when someone uses information that is not available to the public to profit from trading in a company’s publicly traded securities. This practice is illegal and is protected against by the Securities and Exchange Commission (SEC). Sometimes the insider is a company manager; other times it is the company’s lawyer, investment banker, or even the printer of the company’s financial statements. Anyone who has knowledge before public dissemination of that information stands to benefit from either good news or bad news. Trading on private information serves no beneficial economic or financial purpose to the public. It could be argued that insider trading hurts the average shareholder’s interests because it destroys confidence in the securities markets by making the playing field uneven for investors. If participants feel the markets are unfair, it could destroy firms’ ability to raise capital or maximize shareholder value. Page 16 The penalties for insider trading can be severe—there is a long history of insider traders who have gone to prison. In the 1980s, Ivan Boesky, Dennis Levine, and Michael Milken were all sent to jail for their insider trading. More recently, Roger Blackwell, a professor and marketing consultant, was convicted in 2005 of tipping off his family and friends about a forthcoming Kellogg purchase of Worthington Foods. Jeffrey Skilling, former CEO of Enron, was convicted of insider trading and was sentenced to 24 years in prison. Samuel Waksal, the founder of ImClone, a pharmaceutical company, was jailed for family sales of ImClone stock in 2000 before a negative review of a promising drug was made public by the Food and Drug Administration. In cases like Waksal’s, his shares were sold before the bad news was announced and the selling investors were able to avoid large losses. This same behavior also sent Martha Stewart, the homemaking expert, to prison. More recently, since 2010, hedge funds have been under attack by the U.S. government. Several funds have been indicted for insider trading. An article in The Wall Street Journal stated, “Some legal specialists say authorities appear to be seeking to criminalize typical market behavior, such as hedge funds vying to gain an edge by gathering intelligence on a company from a wide range of sources. The issue is blurry because insider trading isn’t defined by statute. The dividing line between criminal and legitimate behavior has evolved in cases stretching back decades, as courts interpreted the antifraud provisions of securities law enacted after the 1929 stock market crash.”3 Ethics and social responsibility can take many different forms. Ethical behavior for a person or company should be important to everyone because it creates an invaluable reputation. However, once that reputation is lost because of unethical behavior, it is very difficult to get back. Proof of this comes from insider trading cases against hedge funds that proved not to stand up in court, but nevertheless, the hedge funds went out of business because just the whiff of bad behavior forced them to close their doors. Some companies are more visible than others in their pursuit of these ethical goals, and most companies that do a good job in this area are profitable, save money, and are good citizens in the communities where they operate. The Role of the Financial Markets You may wonder how a financial manager knows whether he or she is maximizing shareholder value and how ethical (or unethical) behavior may affect the value of the company. This information is provided daily to financial managers through price changes determined in the financial markets. But what are the financial markets? Financial markets are the meeting place for people, corporations, and institutions that either need money or have money to lend or invest. In a broad context, the financial markets exist as a vast global network of individuals and financial institutions that may be lenders, borrowers, or owners of public companies worldwide. Participants in the financial markets also include national, state, and local governments that are primarily borrowers of funds for highways, education, welfare, and other public activities; their markets are referred to as public financial markets. Corporations such as Coca-Cola, Nike, and Ford, on the other hand, raise funds in the corporate financial markets. Page 17 Structure and Functions of the Financial Markets Financial markets can be broken into many distinct parts. Some divisions such as domestic and international markets, or corporate and government markets, are self-explanatory. Others such as money and capital markets need some explanation. Money markets refer to markets dealing with short-term securities that have a life of one year or less. Securities in these markets can include commercial paper sold by corporations to finance their daily operations, or certificates of deposit with maturities of less than one year sold by banks. Examples of money market securities are presented more fully in Chapter 7. Capital markets are generally defined as markets where securities have a life of more than one year. Although capital markets are long-term markets, as opposed to short-term money markets, it is common to break down the capital markets into intermediate markets (1 to 10 years) and long-term markets (greater than 10 years). The capital markets include securities such as common stock, preferred stock, and corporate and government bonds. Capital markets are fully presented in Chapter 14. Now that you have a basic understanding of the makeup of the financial markets, you need to understand how these markets affect corporate managers. Allocation of Capital A corporation relies on financial markets to provide funds for short-term operations and for new plant and equipment. A firm may go to the markets and raise financial capital either by borrowing money through a debt offering of corporate bonds or short-term notes, or by selling ownership in the company through an issue of common stock. When a corporation uses financial markets to raise new funds, called an initial public offering or IPO, the sale of securities is said to be made in the primary market by way of a new issue. After the securities are sold to the public (institutions and individuals), they are traded in the secondary market between investors. It is in the secondary market that prices are continually changing as investors buy and sell securities based on their expectations of a corporation’s prospects. It is also in the secondary market that financial managers are given feedback about their firms’ performance. How does the market allocate capital to the thousands of firms that are continually in need of money? Let us assume that you graduate from college as a finance major and are hired to manage money for a wealthy family like the Rockefellers. You are given $250 million to manage and you can choose to invest the money anywhere in the world. For example, you could buy common stock in Microsoft, the American software company, or in Nestlé, the Swiss food company, or in Cemex, the Mexican cement company; you could choose to lend money to the U.S. or Japanese governments by purchasing their bonds; or you could lend money to ExxonMobil or British Petroleum. Of course these are only some of the endless choices you would have. Page 18 How do you decide to allocate the $250 million so that you will maximize your return and minimize your risk? Some investors will choose a risk level that meets their objective and maximize return for that given level of risk. By seeking this risk-return objective, you will bid up the prices of securities that seem underpriced and have potential for high returns and you will avoid securities of equal risk that, in your judgment, seem overpriced. Since all market participants play the same risk-return game, the financial markets become the playing field, and price movements become the winning or losing score. Let us look at only the corporate sector of the market and 100 companies of equal risk. Companies with expectations for high return will have higher relative common stock prices than companies with poor expectations. Since the securities’ prices in the market reflect the combined judgment of all the players, price movements provide feedback to corporate managers and let them know whether the market thinks they are winning or losing against the competition. Those companies that perform well and are rewarded by the market with high-priced securities have an easier time raising new funds in the money and capital markets than their competitors. They are also able to raise funds at a lower cost. Go back to that $250 million you are managing. If ExxonMobil wants to borrow money from you at 5 percent and Chevron is also willing to pay 5 percent but is riskier, to which company will you lend money? If you chose ExxonMobil, you are on your way to understanding finance. The competition between the two firms for your funds will eventually cause Chevron to offer higher returns than ExxonMobil, or they will have to go without funds. In this way, the money and capital markets allocate funds to the highest-quality companies at the lowest cost and to the lowest-quality companies at the highest cost. In other words, firms pay a penalty for failing to perform competitively. Institutional Pressure on Public Companies to Restructure Sometimes an additional penalty for poor performance is a forced restructuring by institutional investors seeking to maximize a firm’s shareholder value. As mentioned earlier, institutional investors have begun to flex their combined power, and their influence with corporate boards of directors has become very visible. Nowhere has this power been more evident than in the area of corporate restructuring. Restructuring can result in changes in the capital structure (liabilities and equity on the balance sheet). It can also result in the selling of low-profit-margin divisions with the proceeds of the sale reinvested in better investment opportunities. Sometimes restructuring results in the removal of the current management team or large reductions in the workforce. Restructuring also has included mergers and acquisitions of gigantic proportions unheard of in earlier decades. Rather than seeking risk reduction through diversification, firms are now acquiring greater market shares, brand name products, hidden assets values, or technology—or they are simply looking for size to help them compete in an international arena. The restructuring and management changes at Hewlett-Packard, McGraw-Hill, and Tribune Corporation during the last decade were a direct result of institutional investors affecting change by influencing the boards of directors to exercise control over all facets of the companies’ activities. Without their attempt to maximize the value of their investments, many of the above-mentioned restructuring deals would not have taken place. And without the financial markets placing a value on publicly held companies, the restructuring would have been much more difficult to achieve. Some companies, like Starbucks, restructured because the founder and large stockholder came back and refocused the company after a dramatic drop in the stock price. Others, like American Airlines, were forced to restructure because of bankruptcy. Page 19 Internationalization of the Financial Markets International trade is a growing trend that is likely to continue. Global companies are becoming more common and international brand names like Sony, Coca-Cola, Nestlé, and Mercedes Benz are known the world over. McDonald’s hamburgers are eaten throughout the world, and McDonald’s raises funds on most major international money and capital markets. The growth of the global company has led to the growth of global fund raising as companies search for low-priced sources of funds. In a recent annual report, Coca-Cola stated that it conducted business in 200 countries and 73 different currencies and borrowed money in yen, euros, and other international currencies. This discussion demonstrates that the allocation of capital and the search for low-cost sources of financing are now an international game for multinational companies. As an exclamation point, consider all the non-U.S. companies who want to raise money in the United States. More and more foreign companies have listed their shares on the New York Stock Exchange, and hundreds of foreign companies have stock traded in the United States through American Depository Receipts (ADRs). We live in a world where international events affect economies of all industrial countries and where capital moves from country to country faster than was ever thought possible. Computers interact in a vast international financial network, and markets are more vulnerable to the emotions of investors than they have been in the past. The corporate financial manager has an increasing number of external impacts to consider. Future financial managers will need sophistication to understand international capital flows, computerized electronic funds transfer systems, foreign currency hedging strategies, and many other functions. Information Technology and Changes in the Capital Markets Technology has significantly impacted capital markets. In particular, trading costs for securities have been driven down. Firms and exchanges at the front of the technology curve have created tremendous competitive pressures on organizations that initially resisted change. As a result, many stock markets and brokerage firms have merged, often across international borders, in an attempt to remain viable. In the late 1990s and early 2000s, advances in computer technology stimulated the creation of electronic communications networks (ECNs). These electronic markets had speed and cost advantages over traditional markets and took market share away from the New York Stock Exchange. If you can’t beat them, join them, so the New York Stock Exchange merged with Archipelago, the second-largest ECN. The NASDAQ stock market, which was already an electronic market, bought Instinet, the largest ECN, from Reuters and merged their technology platforms. Page 20 Additionally, the cost pressures and the need for capital caused the major markets to become for-profit publicly traded companies. The first to go public was the Chicago Mercantile Exchange, followed by NASDAQ, the NYSE, and the Chicago Board of Trade. Once these exchanges became publicly traded, they were able to use their shares for mergers and acquisitions. In 2007, the New York Stock Exchange merged with EuroNext, a large European exchange, and became a global market. In 2012 the NYSE/EuroNext was bought by ICE, the Intercontinental Exchange. ICE was a young but very successful electronic exchange specializing in derivative products and commodities. NASDAQ merged with the OMX, a Nordic stock exchange. Because the OMX is considered a leader in trading technology, it has over 35 stock exchanges worldwide using its technology. In 2007, the Chicago Board of Trade and the Chicago Mercantile Exchange merged, and so the trend to bigger and more global markets with low-cost structures continues. The future will likely bring an increased emphasis on globalization of markets through technology. Another area where the Internet has played its role is in the area of retail stock trading. Firms like Charles Schwab, E*TRADE, TD Ameritrade, and other discount brokerage firms allow customers to trade using the Internet and have created a competitive problem for full-service brokers such as Merrill Lynch and Morgan Stanley. These discount firms have forced the full-service retail brokers to offer Internet trading to their customers, even though Internet trading is not as profitable for them as trading through their brokers. Another change that has squeezed profits for market makers is the change to price quotes in decimals rather than the traditional 1/16, 1/8, 1/4, and 1/2 price quotes. The trend is to a lower-cost environment for the customers and a profit squeeze on markets and brokers. These issues and others will be developed more fully in the capital market section of the text. Format of the Text The material in this text is covered under six major headings. We will progress from the development of basic analytical skills in accounting and finance to the utilization of decision-making techniques in working capital management, capital budgeting, long-term financing, and other related areas. A total length of 21 chapters should make the text appropriate for one-semester coverage. We aim to present a thorough grounding in financial theory in a highly palatable and comprehensive fashion—with careful attention to definitions, symbols, and formulas. The intent is to enable students to develop a thorough understanding of the basic concepts in finance. Parts 1. Introduction This section examines the goals and objectives of financial management. The emphasis on decision making and risk management is stressed, with an update of significant events influencing the study of finance. Page 21 2. Financial Analysis and Planning First, we have the opportunity to review the basic principles of accounting as they relate to finance (financial statements and funds flow are emphasized). Understanding the material in Chapter 2 is a requirement for understanding the topics of working capital management, capital structure, cost of capital, and capital budgeting. Additional material in this part includes a thorough study of ratio analysis, budget construction techniques, and development of comprehensive pro forma statements. The effect of heavy fixed commitments, in the form of either debt or plant and equipment, is examined in a discussion of leverage. 3. Working Capital Management The techniques for managing the short-term assets of the firm and the associated liabilities are examined. The material is introduced in the context of risk-return analysis. The financial manager must constantly choose between liquid, low-return assets (perhaps marketable securities) and more profitable, less liquid assets (such as inventory). Sources of short-term financing are also considered. 4. The Capital Budgeting Process The decision on capital outlays is among the most significant a firm will have to make. In terms of study procedure, we attempt to carefully lock down “time value of money” calculations, then proceed to the valuation of bonds and stocks, emphasizing present value techniques. The valuation chapter develops the traditional dividend valuation model and examines bond price sensitivity in response to discount rates and inflation. An appendix presents the supernormal dividend growth model, or what is sometimes called the “two-stage” dividend model. After careful grounding in valuation practice and theory, we examine the cost of capital and capital structure. The text then moves to the actual capital budgeting decision, making generous use of previously learned material and employing the concept of marginal analysis. The concluding chapter in this part covers risk-return analysis in capital budgeting, with a brief exposure to portfolio theory and a consideration of market value maximization. 5. Long-Term Financing Here we introduce you to U.S. financial markets as they relate to corporate financial management. We consider the sources and uses of funds in the capital markets—with warrants and convertibles covered, as well as the more conventional methods of financing. The guiding role of the investment banker in the distribution of securities is also analyzed. Furthermore, we encourage you to think of leasing as a form of debt. 6. Expanding the Perspective of Corporate Finance A chapter on corporate mergers considers external growth strategy and serves as an integrative tool to bring together such topics as profit management, capital budgeting, portfolio considerations, and valuation concepts. A second chapter on international financial management describes the growth of the international financial markets, the rise of multinational business, and the related effects on corporate financial management. The issues discussed in these two chapters highlight corporate diversification and risk-reduction attempts prevalent in the new century. Page 22 LIST OF TERMS financial capital 3 real capital 4 capital structure theory 4 inflation 4 disinflation 4 credit default swaps (CDS) 5 Dodd–Frank Act 5 sole proprietorship 8 partnership 9 articles of partnership 9 limited liability partnership 9 corporation 9 articles of incorporation 9 S corporation 10 limited liability company (LLC) 10 agency theory 11 institutional investors 12 Sarbanes–Oxley Act 12 shareholder wealth maximization 13 insider trading 15 financial markets 16 public financial markets 17 corporate financial markets 17 money markets 17 capital markets 17 primary market 17 secondary market 17 restructuring 18 DISCUSSION QUESTIONS 1. How did the recession of 2007–2009 compare with other recessions since the Great Depression in terms of length? (LO1-3) 2. What effect did the recession of 2007–2009 have on government regulation? (LO1-3) 3. What advantages does a sole proprietorship offer? What is a major drawback of this type of organization? (LO1-2) 4. What form of partnership allows some of the investors to limit their liability? Explain briefly. (LO1-2) 5. In a corporation, what group has the ultimate responsibility for protecting and managing the stockholders’ interests? (LO1-2) 6. What document is necessary to form a corporation? (LO1-2) 7. What issue does agency theory examine? Why is it important in a public corporation rather than in a private corporation? (LO1-4) 8. Why are institutional investors important in today’s business world? (LO1-4) 9. Why is profit maximization, by itself, an inappropriate goal? What is meant by the goal of maximization of shareholder wealth? (LO1-4) 10. When does insider trading occur? What government agency is responsible for protecting against the unethical practice of insider trading? (LO1-1) 11. In terms of the life of the securities offered, what is the difference between money and capital markets? (LO1-5) 12. What is the difference between a primary and a secondary market? (LO1-5) 13. Assume you are looking at many companies with equal risk. Which ones will have the highest stock prices? (LO1-3) Page 23 14. What changes can take place under restructuring? In recent times, what group of investors has often forced restructuring to take place? (LO1-5) 15. How did the Sarbanes–Oxley Act impact corporations’ financial reports? (LO1-6) 16. Name the departments, offices, or agencies that were created by the Dodd–Frank legislation. (LO1-6) WEB EXERCISE 1. Ralph Larsen, former chairman and CEO of Johnson & Johnson, was quoted in this chapter concerning the use of the Internet. Johnson & Johnson has been one of America’s premier companies for decades and has exhibited a high level of social responsibility around the world. Go to the Johnson & Johnson website at www.jnj.com. 2. Click on “Our Caring.” Scroll down and click on “Our Credo Values.” Now scroll to the bottom of the page and download the Credo as a PDF under the “Our Credo” link. Read the first two paragraphs and write a brief summary of the credo. Return to the home page and click on “Investors.” Then scroll down and click on the most recent Annual Report (“Annual Report and Proxy Statements”). 3. Scroll down the Annual Report until you see “Consolidated Statement of Earnings” for the last few years. 4. Compute the percentage change between the last two years for the following (numbers are in millions of dollars): a. Sales to customers. b. Net earnings. c. Earnings per share. 5. Generally speaking, is Johnson & Johnson growing by more or less than 10 percent per year? Note: Occasionally a topic we have listed may have been deleted, updated, or moved into a different location on a website. If you click on the site map or site index, you will be introduced to a table of contents that should aid you in finding the topic you are looking for. 1Johnson & Johnson 1999 Annual Report, p. 4. 2An exception to this rule is made if shareholders buy their stock at less than par value. Then they would be liable for up to the par value. 3S. Pulliam, M. Rothfeld, and J. Strasburg, “Hedge Funds Raided in Probe,” The Wall Street Journal, November 22, 2010.
Summarize the following in 2 to 3 pages: · Discuss issues raised concerning Sanders’ approach in connection with the sale to Brown and Massey. · Include some of the other options that Sanders may have
Copyright © 2017 by University of Phoenix. All rights reserved. Week 4 Case Study FIN/486 Version 6 1 * This case was prepared by Robert J. Fitzpatrick, Bellarmine College, Louisville Kentucky. Copyright © 2017 McGraw -Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw -Hill Education. KFC and the Colonel* Introduction The story of Kentucky Fried Chicken is the story of Colonel :arland Sanders. The “Colonel,” however, was not a real colonel and Sanders was not even a Kentucky native. He was, nevertheless, a prime example of the resiliency of the human spirit because he demonstrated that, even at 66 years of age, after a series of financial fiascoes, it is still not too late to become a business success and a millionaire. After having lived in obscurity during the first six decade s of his life, his benign, bewhiskered countenance became the best -known living advertising symbol throughout the world. Although he was often tough and curt with his employees and associates, he loved children and he donated much of his time and fortune t o helping young people. Unpredictable and sometimes erratic in his personal and business dealings, he was unfailingly dedicated to hard work and to the perfection of details. Active until December 1980, when he died at the age of 90, he was a living exampl e of his own philosophy, “A man will rust out faster than he’ll wear out:” this was :arland D. Sanders, the kindly curmudgeon who founded Kentucky Fried Chicken. Harland Sanders was born in Henryville, Indiana, a small town about 17 miles north of Louisvi lle, Kentucky. When he was five or six years old his father died, leaving his mother to raise him and two younger children. What appeared to be a disaster prepared Harland for his future success, because as the oldest child in the family Harland had to tak e over some of the duties of the household, including some of the cooking. Preparing meals under his mother’s direction helped to provide him with the know -how on which he would capitalize many years later. “= cooked just like Mom did, and later when = wen t into the restaurant business = just kept doing it the same way,” he said in an interview in his later years. When Harland was 12, his mother remarried, but his new stepfather did not take kindly to his inherited brood. In fact, on one occasion, he kicked Harland. Hurt by such harsh treatment, Harland left Henryville and found a job working on a farm in Greenwood, Indiana. At this time he also attended school, but he dropped out of the seventh grade. He said later that it was the mathematics that did him in. Sanders’ First Restaurant —Success and Failure Like the phoenix that rises from the ashes, Harland managed to rise again. He moved to Corbin, Kentucky, and took over a Shell station at a rather desirable location. When he heard one traveler exclaim, “The re ain’t no decent place to eat around here,” he began serving meals in a small room attached to the service station. The station was rechristened “Sanders Shell Station and Café,” and, as the food service area was well received and expanded, it was again renamed, “Sanders Café and Shell Station.” :e hired Nell Ray as a waitress, who was succeeded by her sister Claudia Ledington Price. The latter would become one of his most trusted employees and many years later his second wife. (Sanders’ earlier travels a nd many jobs had brought an end to his first marriage, to Josephine King.) Copyright © 2017 by University of Phoenix. All rights reserved. Week 4 Case Study FIN/486 Version 6 2 * This case was prepared by Robert J. Fitzpatrick, Bellarmine College, Louisville Kentucky. Copyright © 2017 McGraw -Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw -Hill Education. With the continued success of his restaurant, Harland decided to add a motel, Sanders Motor Court. But cooking was his first love, and chicken was the main item on the menu. The onl y problem was that frying chicken took about 30 minutes, which he felt was a long time to keep customers waiting. Therefore, he began to experiment with a pressure cooker to cut down on the cooking time, seeking at the same time to keep flavor, moisture, and consistency. Finally, through trial and error, he was able to reduce the cooking time to eight or nine minutes. The significance of the success of this experiment is noted by the fact that one of Colonel Sanders’ early pressure cookers is on display at the head office of KFC in Louisville. =n addition to the process using the pressure cooker, however, much of the success of Sanders’ chicken was his famous recipe. On one occasion in filling an order for some 500 box lunches, he tried a somewhat different recipe with 11 spices. The food was so well received that he decided to use the recipe regularly. Sanders admitted later that he had used spices that could be found in almost any kitchen and that it was just the proportions that make the difference. He al ways kept the recipe a secret and even today, according to one reliable report, only two executives at the KFC head office have access to the exact formula. Sanders’ first appearance on the national scene was the recognition he received by Duncan :ines, wh o had made a stop in Corbin and mentioned the excellent Kentucky fried chicken in his “Adventures in Good Eating.” With this added success, Sanders expanded the restaurant to accommodate 142 customers. Later he was offered $165,000 for the restaurant, but he turned down the offer. Again misfortune struck. In 1955 a new north -south interstate highway (I -75) was routed to bypass Corbin. As a result, Sanders’ business dwindled and in 1956 he was forced to sell out for $75,000. After paying off his debts, he fo und himself scraping bottom. He was 66 years old, drawing about $125 a month in Social Security, and left with very little capital. Franchising and Success at Last He still had a form of capital —two, in fact —the famous recipe for fried chicken and a tremen dous capacity for work. He had also ventured briefly into franchising. A few years earlier, in 1952, he had sold the rights to his recipe to Leon (“Pete”) :arman of Salt Lake City and, at the time that Sanders had been forced to sell his restaurant in Corb in, Harman had some 14 restaurants operating successfully in Salt Lake City, all using the famous recipe with 11 herbs. In effect, the operations in Utah had been a good test market for Sanders’ chicken on a broader scale. With his monetary capital deplete d, Sanders realized he could not open another restaurant, but he did realize that with what capital he had, he could try to sell rights or franchises to his special recipe, which had been successful at two locations. So, at age 66, when most men would have retired, Sanders hit the road to sell his then not -so -famous recipe. In order to make the sale, Sanders would stop at a restaurant, prepare the chicken free, using the special recipe, and then let the owner decide whether he wished to acquire a franchise. The fee was Copyright © 2017 by University of Phoenix. All rights reserved. Week 4 Case Study FIN/486 Version 6 3 * This case was prepared by Robert J. Fitzpatrick, Bellarmine College, Louisville Kentucky. Copyright © 2017 McGraw -Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw -Hill Education. rather modest —four cents per chicken (later increased to five cents). Sanders often tried the chicken himself after preparing it, so he generally got at least one free meal at each stop. Even early in his attempt to sell franchises, Sanders al ways looked for a quality restaurant —one that would maintain his reputation for a fine product. Perhaps as the result of the Michelin tire experience, Sanders decided to adopt a new image, that of the Kentucky Colonel. He had actually been appointed a Kent ucky Colonel by Governor Rudy Laffon in the early 1930s. The appointments are made rather generously by most governors, and the duties of the colonels include mainly responding to the call to attend the pre -Derby gala dinner and the post -Derby barbecue, wi th the proceeds going to some charities in Kentucky. No particular uniform is furnished or required. Sanders, therefore, designed his own: a white suit and black string tie. He grew a moustache and goatee, and, since his hair was on the reddish side, he dy ed it white to complete the appearance of a “colonel.” Later , Sanders was accompanied by Claudia Ledington Price, who had worked for him in Corbin at his restaurant and whom he married in 1949. To add to the “Old Kentucky” touch, she appeared on his busine ss calls wearing an antebellum gown, until finally, when the volume of business had grown, she remained at Sanders’ office in Kentucky to manage the paperwork. By 1960, roughly four years after he had begun selling his franchises actively, Sanders had an e stimated 200 outlets under franchise in the United States and half a dozen in Canada —all of this mainly the result of the work of one individual. As the ownership of the company was not publicly held, financial results of Sanders’ operations did not have t o be made public. =t is estimated; however, that Sanders’ profits before taxes were in the neighborhood of $100,000 in 1960. By 1963, there were some 600 franchised outlets in the United States and Canada, and annual profits were estimated at $300,000 befo re taxes. Enter John Young Brown, Jr. At this point, Sanders was 73 years of age and still running his company practically single -handedly. Even with his tremendous drive and energy, he may have wondered how long he could continue to operate on his own. Th rough John Young Brown, Sr., a well -known Kentucky politico, he became acquainted with John Y. Brown, Jr., whom he hired to do some legal work for him. Although a lawyer by profession, John Y., Jr., was actually a super salesman. In order to work his way t hrough the University of Kentucky, he had sold encyclopedias; and by the time he was a senior he was making $25,000 a year. (He would, in fact, go on later to become governor of Kentucky.) When John Y., Jr., discovered that Sanders had no salesmen on the r oad other than himself, he is said to have remarked, “With my sales background, = began to think what you could do with this business if you had a really aggressive sales program,” which perhaps was not giving much credit to the Colonel. Under the original arrangement between Sanders and Brown, Brown would set up a barbecue business under the unlikely name of Porky Pig’s. :e would attempt to spin off franchises from the original operation. Brown soon realized, however, that chicken, not pork, was in the pot at the end of the rainbow. Brown felt that the Colonel might be persuaded to part with his creation if he could be Copyright © 2017 by University of Phoenix. All rights reserved. Week 4 Case Study FIN/486 Version 6 4 * This case was prepared by Robert J. Fitzpatrick, Bellarmine College, Louisville Kentucky. Copyright © 2017 McGraw -Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw -Hill Education. convinced that the business would be carried on successfully. In order to make an offer that would be sufficiently attractive to Sanders, ho wever, Brown needed more capital than he personally had available. He, therefore, arranged to get some financial support from Jack Massey, a Nashville millionaire. Sale of KFC to Brown and Massey Brown and Massey began discussing the possibility of buying the company from Sanders. The Colonel’s first reaction was to snarl, stomp, grumble, and curse. Brown emphasized that, even if the Colonel sold them the company, he would be retained to continue to promote sales and to be its goodwill ambassador. After som e further discussion, Sanders —apparently without any fine -line calculations on his part —said, “Well, =’ve been giving it some thought, and = think that two million dollars sounds about right.” Brown and Massey at first considered making a counteroffer, but finally decided that, rather than risk losing the deal, they would tell the Colonel that two million also sounded right to them. Sanders apparently did not talk over the proposed deal with Claudia, who, in effect, had been his closest advisor. She said la ter that, if she had been consulted, she would have advised against selling at that time. The Colonel also did not consult with the members of his office staff in Shelbyville. Moreover, he had perhaps already come to the conclusion that no one on the staff had sufficient talent to keep the company going without him. That staff had been selected primarily on the basis of nepotism and friendship, rather than on administrative ability. Lee Cummings, the Colonel’s nephew, and :arland Adams, his grandson, handle d shipments. Several others helped with the office work. Claudia helped to keep the Colonel in touch with problems at the office when he was on the road. However, there was apparently no one with the experience and talent needed to succeed the Colonel in t he overall direction of the business. The Colonel did want to talk with Pete Harman, his original franchisee, before he came to a final decision. All three, Sanders, Brown, and Massey, went out to Salt Lake City to discuss the sale with Harman. The latter indicated the move was a wise one —one that would avoid possible bickering among the Colonel’s family and franchisees by offering a continuity of leadership and a firm central control. Following :arman’s advice, the Colonel agreed to sign a contract for the sale. Under the final agreement, dated February 18, 1964, the Colonel was to receive $500,000 by mid -April 1964 and would receive the remaining $1.5 million over a five -year period. In addition, he would be made a director of the company and serve as an ambassador of goodwill and as the principal public relations man. For his services, he was to receive initially a salary of $40,000 a year. Later this would be increased to $75,000 and then to $125,000. Brown and Massey may have had misgivings from time to time about the Colonel’s goodwill efforts. Sanders, after having visited certain franchises, was quoted as having said that their gravy “tasted like wallpaper paste.” :owever, whenever Sanders appeared on TV or on the screen in movies, sales jumped. Copyright © 2017 by University of Phoenix. All rights reserved. Week 4 Case Study FIN/486 Version 6 5 * This case was prepared by Robert J. Fitzpatrick, Bellarmine College, Louisville Kentucky. Copyright © 2017 McGraw -Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw -Hill Education. In th e negotiations prior to the final signing of the contract, the Colonel had been offered 10,000 shares of stock as partial payment for KFC, but he declined the offer, commenting in his characteristic and colorful fashion that “stock is just like toilet pape r.” :e also said “= thought it best to sell [for cash] so that =’d have my estate liquid and = could handle it myself. This way = can do something for my grandchildren and perpetuate the company, too.” The Colonel, however, did not part with the entire company for the 2 million. He retained the rights to the franchises in Canada, where he had formed a separate company. Remembering his early days, he directed that all the profits from this operation should go to aid orphaned boys. He also retained his rig hts to Florida for his daughter, Margaret. Pete Harman was to retain his rights to Utah and Montana, and the rights to franchises in England were also excluded from the original package. Following the takeover of the administration from Sanders, Brown assu med the immediate direction of the company, even though Massey had the largest financial interest. Under Brown’s aggressive promotion, sales almost doubled and profits more than doubled from 1965 to 1966, as follows: Gross Income Net Income (after -tax) Ea rnings Per Share 1965 …………………………. $8.5 million $1.5 million $0.79 1966 …………………………. $15.0 million $3.5 million $1.80 In 1966, following this spectacular showing, Brown and Massey decided to go public and sell stock to outsiders. The share price opened at $15 and soared to $100. In 1968, the stock was split two for one and an offering of a new issue of some 600,000 shares went for $63 per share. John Y. Brown, Jr.’s, Other Ventures As successful as he was with Kentucky Fried Chicken, however, John Y. Brown, Jr., was not able to duplicate his efforts in fields other than fried chicken. There are no Porky Pig’s restaurants still in existence. The purchase of :. Salt’s Fish and Chips (a British version of fried fish and french fried potatoes) also proved unsuccessful. An attempt to sell roast beef in the KFC outlets also failed. Zantigo’s, a try at going Mexican, resulted in the sale of that company to another fast -food firm. Brown also tried using something closer to Colonel Sanders’ formula. :e would locate the best hamburger i n the country and duplicate it. The result was Ollie’s Trolley. Ollie had made what were supposed to be fantastic hamburgers in Florida, and “trolleys” similar to the early food diners were set up throughout Louisville to market the hamburger. The trolley, however, did not work for the most part, as there is only one remaining Ollie’s Trolley still operating in Louisville. Copyright © 2017 by University of Phoenix. All rights reserved. Week 4 Case Study FIN/486 Version 6 6 * This case was prepared by Robert J. Fitzpatrick, Bellarmine College, Louisville Kentucky. Copyright © 2017 McGraw -Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw -Hill Education. Even an attempt to create a chain of Colonel Sanders Inns failed. A prototype was built near the KFC home office in Louisville, but it w as sold not too long thereafter to a hotel -motel chain. Subsequent Sales of KFC to Heublein, Reynolds, and PepsiCo The success of the Kentucky Fried Chicken business, however, can be measured, at least in part, by the subsequent sales of the business as an entity. In July 1971, KFC was sold to Heublein, Inc., for a total of $280 million. This was only seven years after the company had been bought from the Colonel for $2 million. In July 1982, R.J. Reynolds Industries purchased Heublein for $1.3 billion, the purchase made partly in cash and partly in stock of RJR. It is not possible, however, to determine what part of the purchase price applied to KFC, which was included as part of the deal. In October 1986, R.J. Reynolds did sell KFC as a separate entity to Pepsico for $841 million. At the time, Pete :arman, the second largest franchise holder of KFC, said that they were a kind of family, and “We don’t want to be sold again.” All of this may seem to indicate that the Colonel did “do chicken right.” :is flair for salesmanship and his ability to create an attractive image were important factors in creating a successful business —also his famous recipe and his emphasis on quality. The question that will always remain, however, is: Should he and could he have made a more profitable deal when he sold his company to Brown and Massey?
Summarize the following in 2 to 3 pages: · Discuss issues raised concerning Sanders’ approach in connection with the sale to Brown and Massey. · Include some of the other options that Sanders may have
Summarize the following in 2 to 3 pages: Discuss issues raised concerning Sanders’ approach in connection with the sale to Brown and Massey. Include some of the other options that Sanders may have considered other than the $2,000,000 cash price. Explain the reasons for regulatory control over financial markets. Let’s assume Colonel Sanders obtained a six-month loan of $150,000 Canadian dollars from an American bank to finance the acquisition of a building for another Canadian franchise in Quebec province. The loan will be repaid in Canadian dollars. At the time of the loan, the spot exchange rate was U.S. $0.8995/Canadian dollar and the Canadian currency was selling at a discount in the forward market. The contract after six months (face value = C$150,000 per contract) was quoted at U.S. $0.8930/Canadian dollar. Explain how the American bank could lose on this transaction assuming no hedging. Assume the bank does hedge with the forward contract, what is the maximum amount it can lose?
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