1. International Financial Environment.ppt 33464h

International Finance I [CFI4102] B.Com Finance

International Financial Management Prepared by Edson Mbedzi

1

Course Outline 1.

International Finance & introduction to multinational business.

2.

International Flow of Funds

3.

The Foreign Exchange Market

4.

Forecasting Exchange Rate Movements

5. 6.

International Financial Markets Foreign Direct Investment

2

Topic Objectives

• To identify the main goal of the MNC and conflicts with that goal;

• To describe the key theories that justify international business; and

• To explain the common methods used to conduct international business.

• Explain world opportunities that promote the relevance of International business.

3

• International

International Business Management business is conducted through

multinational

corporations.

• Involves international investing and financing decisions. • Starts with simple attempt to export products to a particular country

or imports from a foreign manufacturer, but over time recognise additional foreign opportunities and eventually establish subsidiaries in foreign countries.

• Important to companies not involved in international business as well, to evaluate how foreign competitors will be affected by movements in exchange rates, foreign interest rates, labour costs, inflation etc.

• Key international business financing decisions: • Whether to pursue new business in a particular country • Whether to expand business in a particular country

4

The International Business Multinational Corporation (MNC)

Foreign Exchange Markets

Exporting & Importing Product Markets

Dividend Remittance & Financing

Subsidiaries

Investing & Financing International Financial Markets 5

Goal of the MNC • The commonly accepted goal of an MNC is to maximize shareholder wealth. • The role of international finance is to integrate all local and foreign operations in a way that maximise firm value taking into all operational, economic and country risks involved.

• For corporations with shareholders who differ from their managers, a conflict of goals can exist - the agency problem.

• Agency costs are normally larger for MNCs than for purely domestic firms, but can vary with the management style of the MNC. (1) Monitor costs – overlook of managerial activities, such as audit costs; (2) Restructuring costs (e.g. to limit managerial behaviour - board of directors and, (3) Opportunity costs (4) Bonding

6

Managing Agency Costs • Various forms of corporate control can reduce agency problems; (1) performance-based incentive plans (stock compensation), (2) direct monitoring/intervention by shareholders, (3) the threat of firing, and (4) the threat of hostile takeover. As MNC managers attempt to maximize their firm’s value, they may be confronted with various environmental, regulatory, or ethical constraints.

7

Theories of International Business Why are firms motivated to expand their business internationally – hence Importance of International Finance?

1. Theory of Comparative Advantage 

Specialization by countries can increase production efficiency based on relative implicit cost/opportunity cost reasoning (David Ricardo, 1817).

8

1. The Theory of Comparative Advantage David Ricardo: Principles of Political Economy (1817) •Extends free trade argument. •Efficiency of resource utilization leads to more productivity. •Look to see how much more efficient, if only comparatively efficient, then import. •Makes better use of resources. •Trade is a positive-sum game. Ricardo’s theory suggests that comparative advantage arises from differences in productivity Assumptions and limitations Driven only by maximization of production and consumption. Only 2 countries engaged in production and consumption of just 2 goods. Does not take into the transportation costs. 9 Only one resource, that is labour is in use (that too, non-

1. The Theory of Comparative Advantage •

•

In the Table the USA has a total absolute advantage in the production of both cars and beef over Zimbabwe.

Cars

Beef

USA

2

8 tonnes

Zimbabwe

1

6 tonnes

According to Adam smith there is no benefit from specialisation, nonetheless according to Ricardo’s explanation, when countries decide what to produce or not they consider relative cost or implicit cost reasoning illustrated below. 10

1. The Theory of Comparative Advantage USA has lower opportunity cost ratio in the production of cars while Zimbabwe is better in the production of beef. To produce 1 car the USA requires 4 tonnes of beef equivalent while Zimbabwe requires 6 tonnes instead. On the other hand, for Zimbabwe to produce 6 tonnes of beef it foregoes 1 car, while USA foregoes 1 car to produce only 4 tonnes.

USA Zimbabwe

Cars 8/2=4 6/1=6

Beef 2/8=0.25 1/6=0.17

Thus USA produces cars and export to Zimbabwe while Zimbabwe produces more beef and exports to the USA. Both Zimbabwe and USA benefit from specialisation and trade if a mutually beneficial trading ratio is established. Let us suppose 1 car is exchanged for 5 tonnes of beef in the international markets, both the USA and Zimbabwe still gain from trade. 11 Therefore both countries benefit provided the international market price

Implications of the Ricardian Model • Diminishing returns: – More a country produces, at some point, will require more resources. • However: – Free trade can increase a country’s production resources, and – Increase the efficiency of resource utilization. • International trade will only be of benefit if comparative advantage exists, that is, if opportunity costs differ between two countries. 12

Theories of International Business Implications of comparative advantage to international markets • International trade benefit if comparative advantage exists, that is, if opportunity costs differ between two countries. •Countries will only benefit from international business if international market prices lie between the opportunity costs of the countries concerned.

13

Theories of International Business 2. Imperfect Markets Theory •

Goods differ in their factor requirements. Cars require more capital per labour than furniture and aircraft requires more than cars. Thus goods can be ranked by their factor intensity.

•

Countries differ in factors endowments; some have more capital than others. Thus countries can be ranked by factor abundance.

•

The markets for the various production are “imperfect.”

resources

used

in

 Legal restrictions on movement of goods, people, and money  Transactions costs  Shipping costs  Tax arbitrage opportunities NB: See the hec

14

2a. Heckscher (1919)-Olin (1933) Theory • Goods differ in their factor requirements. Cars require more capital per labour than furniture and aircraft requires more than cars. Thus goods can be ranked by their factor intensity. • Countries differ in factors endowments; some have more capital than others. Thus countries can be ranked by factor abundance. • Export goods that intensively use factor endowments which are locally abundant. – Corollary: import goods made from locally scarce factors. • Patterns of trade are determined by differences in factor endowments not productivity. • , focus on relative advantage, not absolute advantage.

15

2a. Heckscher-Ohlin theory Ricardo’s theory suggests that comparative advantage arises from differences in productivity. Eli Heckscher and Bertil Ohlin argued that comparative advantage arises from differences in national factor endowments – the extent to which a country is endowed with resources like land, labor, and capital. The Heckscher-Ohlin theory predicts that countries will export goods that make intensive use of those factors that are locally abundant, while importing goods that make intensive use of factors that are locally scarce.

16

Assumptions of the H-O Theory •The model is hypothesised on two countries, two sectors and two inputs (labour and capital), thus sometimes called the 2x2x2 model. •It assumes that endowments of labour and capital differ across countries. •It assumes perfectly competition goods market. •Firms maximise profits (MR=MC). •People demand both goods and tastes are the same in both countries. Called the existence of homothetic preferences in both countries and it entails that the preferences of the consumers in both countries are convex to the origin when considered in of the indifference curves analysis. •It assumes perfect substitutability of factors. Both inputs of labour and  Kquickly Y can y capital are used to produce both goods and be reallocated to y ; Ly    X  x K ; L x x (food and clothing). i.e. either of the sectors



•Assumes a constant return to scale (CRS) production function. Thus, in both countries there is the same state of technology (homogeneity of17 1 st

Returns to Scale One important characteristic of production function is the response of output to equi-proportional changes in both inputs. Returns to scale can be depicted using isoquants. The distance between isoquants represents the extent to which output of a good scales up or down in response to changes of factors of production. A major assumption of the production function is that of the Constant Returns to Scale (CRTS). This assumption is also called the Homogeneity of 1st degree and illustrated as follows:

 Definition of CRTS: Let > 0, given that X = ƒ (K, L), then this equation is said to be K X   kK ;if: L  homogeneity ofdegree , where k is the degree of homogeneity or homogeneous degree.



Using the equation, if K = 1, then such a function is said to be homogeneous. Such a function defines constant returns to scale. A more formal macroeconomics definition states that constant returns to scale prevails 18 if capital and labour are scaled up by factor , the output is also increased

X

Constant Returns to Scale of



X

The doubling of factors capital K and labour L leads to output X to double. This depicts the production function which is homogeneous of degree 1 (CRTS). Two important Notes The slopes of the isoquants along any ray from the origin under conditions of homogeneity are equal. The value of k determines the spacing between isoquants. NB: Also note the difference between returns to scale and the law of 19 diminishing

Heckscher (1919)-Olin (1933) Theory… We define factor endowments in of the factor ratios between stocks of K and L in the two countries. If K/L ratio is greater in home country H than in foreign country F, then country H is relatively K-abundant (labour-scarce) while country F is Labundant (capital-scarce). The physical symbolically measure is as follows:

K K  LH LF

--------------------------------------------1

20

Heckscher (1919)-Ohlin (1933) Theory… The theory can be explained in of factors price ratios as below and note the change in equality sign when factors prices are used. The physical symbolically measure is as follows:

PK PK  PLH PLF--------------------------------------------2 The Ohlin's theory concludes that: The basis of international trade is the difference in commodity prices in the two countries. Differences in the commodity prices are due to cost differences which are the results of differences in factor endowments in two countries. A capital rich country specializes in capital intensive goods & exports them. While a Labour abundant country specializes in labour intensive goods & exports them. 21

Heckscher-Ohlin vs Ricardo •

Economists prefer Heckscher on theoretical grounds but is a relatively poor predictor of trade patterns.

•

Ricardo’s Comparative Advantage Theory, regarded as too limited for predicting trade patterns, actually predicts them with greater accuracy.

•

In the end, differences in productivity may be the key to determining trade patterns.

22

Conclusion of H-O Theory The Ohlin's theory concludes that: •The basis of international trade is the difference in commodity prices in the two countries. •Differences in the commodity prices are due to cost differences which are the results of differences in factor endowments in two countries. •A capital rich country specializes in capital intensive goods & exports them. While a Labour abundant country specializes in labour intensive goods & exports them.

23

2b. The Specific-Factor Model or New Trade Theory Modern international trade economists are interested in models that go beyond the H-O model. The H-O assumption of free factor mobility between industries is only attainable in the long-run (long enough to allow conversion of a factor from one industry to another). Capital is fixed in its sectorial usage (Specific-Factor Model) Time is required for capital mobility between diverse industries for physical capital to depreciate in one industry and for new investment to take place in another. Economists distinguish between: Short-run: a period of time in which at least one factor is fixed in the production function, corresponding to capital specificity theory. Long-run: a period of time in which all factors are variable in the production functions; thereby corresponding to the inter-sectorial factor 24 mobility.

2b. The Specific-Factors Model Assumptions Similar Assumptions to H-O Model •Two goods are produced with production functions that exhibit Constant Rate of Returns (CRTS). •Two factors of production are required for both production functions. •Tastes are homogeneous and identical for all consumers which allowed the representation of preferences by the Community Indifference Curves (CICs). Different Assumptions to H-O Model Only labour is homogeneous and common to the two production functions, but capital is fixed by industry in the short-run.

25

The production functions of the model are shown below: The production functions of the model are shown below: X   x R x ; L x 

Y   y S y ; Ly 

The above production functions are assumed to be homogeneous of the 1st degree and also increasing functions of both inputs. It is also assumed that positive outputs are a product of positive inputs of both factors. The economy is assumed to have fixed total supply of both K and L and these two constraints are represented by equation below:

K  Kx  Ky

L  Lx  Ly

It is also assumed that the two processes use all the available K and L, that full employment is assumed. Based on the factor supply of equations above, we deduce the following equations under the specific factors model:

R  Rx

S  Sy

L  Lx  Ly

26

Implications of the Specific-Factor Model The 3 equations above show that the entire available stock of factor R is used to produce good X while the entire endowment of factor S is used to produce commodity Y. Thus return to capitals R and S are “r” and “s” respectively due specificity of K. The return to labour, L is “w”, which is the same for both industries due to free mobility of L. The model then can be simplified as a theory with two goods and three factors.

27

Implications for Trade & Business •

Location implications: makes sense to disperse production activities to countries where they can be performed most efficiently.

•

First-mover implications: It pays to invest substantial financial resources in building a first-mover, or early-mover, advantage.

•

Policy implications: promoting free trade is generally in the best interests of the home-country, although not always in the best interests of the firm. Even though, many firms promote open markets.

28

Theories of International Business

3. Product Cycle Theory 1 Firm creates product to accommodate local demand.

2 International trade

Firm exports product to accommodate foreign demand.

4a Firm differentiates product from competitors and/or expands product line in foreign country.

or 4b Firm’s foreign business declines as its competitive advantages are eliminated. [Exit]

3 FDI Firm establishes foreign subsidiary to establish presence in foreign country and possibly to reduce costs.

29

Product Life-Cycle Theory & Trade •

As products mature, both location of sales and optimal production changes.

•

Affects the direction and flow of imports and exports.

•

Globalization and integration of the economy makes this theory less valid.

30

Product Cycle Model and Trade 1. Firms keep production close to the market Aid decisions; minimize risk of new product introductions Demand not based on price yet; low production cost not an issue1 2. Limited initial demand in other advanced countries Exports more attractive than production there initially. 3. With demand increase in advanced countries Production follows there. 4. With demand expansion elsewhere Product becomes standardized production moves to low production cost areas Product now imported to original country and to advanced countries 31

Product Lifecycle Model and trade

32

Examples of products that are currently at different stages of the product life-cycle Sector IT

Communicati on Banking

INTRODUCT ION 4rd generation mobile phones Econferencing iris-based personal identity cards

GROWTH

MATURITY

DECLINE

Portable DVD Personal Players Computers

Typewriters

Email

Faxes

Smart cards

Credit cards

Handwritten letters Cheque books

33

The international PLC

New product development What is new product? • Major stages in new product development • Original products • Product improvements • Product modifications • New brands that the firm develops through its own research and development efforts

34

Major stages in new product development Marketing Strategy Development Concept Development and Testing Idea Screening Idea Generation

Business Analysis Product Development

Market Testing

Commercialization

35

Probability of Success

Overall probability of success

=

Probability of technical completion

+

Probability of commercialization given technical completion

Probability of economic success given commercialization

+

+

Probability of International Expansion 36

International Business Methods • International Trade - a relatively conservative approach involving exporting and/or importing.

• Licensing - provision of technology in exchange for fees or some other benefits.

• Franchising - provision of a specialized sales or service strategy, assistance, and possibly an initial investment in the franchise in exchange for periodic fees.

• t Ventures - t ownership and operation by two or more firms. • Acquisitions of Existing Operations • Establishing New Foreign Subsidiaries Any method of increasing international business that requires a direct investment in foreign operations normally is referred to as a direct foreign investment (DFI). 37

International Business Opportunities Cost-benefit Evaluation for Purely Domestic Firms versus MNCs Purely Domestic Firm

Marginal Return on Projects

MNC MNC Purely Domestic Firm

Marginal Cost of Capital

Appropriate Size for Purely Domestic Firm

X

Asset Level of Firm

Appropriate Size for MNC

Y 38

International Opportunities • Global Opportunities in Globalized Financial Markets Deregulation of Financial Markets coupled with Advances in Technology have greatly reduced information and transactions costs, which has led to: Financial Innovations, such as Currency futures and options Multi-currency bonds Cross-border stock listings International mutual funds

39

International Business Opportunities • Growth in World Trade •

Over the past 50 years, international trade increased about twice as fast as world GDP.

•

There has been a sea change in the attitudes of many of the world’s governments who have abandoned mercantilist views and embraced free trade as the surest route to prosperity for their citizenry.

•

The General Agreement on Tariffs and Trade-GATT (later replaced with WTO) a multilateral agreement among member countries has reduced many barriers to trade.

40

International Business Opportunities • Opportunities in Europe – – –

Single European Community Act of 1987 Removal of the Berlin Wall in 1989 Single currency system in 1999

•

Currently more than 320 million Europeans in 17 countries are using the common currency on a daily basis (Belgium, , Greece, Spain, , Ireland, Italy, Luxembourg, the Netherlands, Austria, Portugal, Slovenia, Slovakia, Estonia, Finland, Malta, and Cyprus).

•

The “transaction domain” of the euro may become larger than the U.S. dollar’s in the near future

41

International Business Opportunities • Opportunities in Latin America ¤

•

North American Free Trade Agreement (NAFTA) of 1993

The North American Free Trade Agreement (NAFTA) calls for phasing out of impediments to trade between Canada, Mexico and the U.S. over a 15-year period. For Canada, the ratio of exports to GDP has increased dramatically from 19.2% in 1973 to 45.2% in 2003. The increased trade will result in increased numbers of jobs and a higher standard of living for all member nations.

Opportunities in Asia Significant growth expected for China Asian economic crisis in 1997-1998 42

Exposure to International Business Risk • Exposure to Exchange Rate Movements –

exchange rate fluctuations affect cash flows and foreign demand.

– The risk that foreign currency profits may evaporate in home currency due to unanticipated unfavorable exchange rate movements. e.g. dollar.

i) Recent surge in Canadian dollar value against

US

ii) SA’s Shoprite loses in Malawi due the devaluation of the Malawi currency.

43

Exposure to International Business Risk • Exposure to Foreign Economies 

Foreign economic conditions affect demand, and therefore cash flows.

• Exposure to Political Risk 

political actions affect cash flows.



Sovereign governments have the right to regulate the movement of goods, capital, and people across their borders. These laws sometimes change in unexpected ways.

e.g. i) Chinese ban on canola imports from Canada in 2002. ii) Complaints in South Africa about the Brazilian chicken imports in January 2013. 44

Top 10 MNCs by Revenues 2011 1

Wallmart

United States

2

Exxon Mobile Corporation

United States

3

Royal Dutch/Shell Group

Netherlands/ UK

4

BP

UK

5

Sinopec

China

6

Toyota Motor Corporation

Japan

7

Petro China

China

8

Total Fina SA



9

Chevron

United States

Japan Post Holdings

Japan

10

45

Overview of an MNC’s Cash Flows Profile A: MNCs focused on International Trade

U.S.based MNC

$ for products

U.S. Customers

$ for supplies

U.S. Businesses

$ for exports

Foreign Importers

$ for imports

Foreign Exporters

46

Overview of an MNC’s Cash Flows Profile B: MNCs focused on International Trade and International Arrangements

U.S.based MNC

$ for products

U.S. Customers

$ for supplies

U.S. Businesses

$ for exports

Foreign Importers

$ for imports

Foreign Exporters

$ for service cost of service

Foreign Firms 47

Overview of an MNC’s Cash Flows Profile C: MNCs focused on International Trade, International Arrangements, and Direct Foreign Investment

U.S.based MNC

$ for products

U.S. Customers

$ for supplies

U.S. Businesses

$ for exports

Foreign Importers

$ for imports

Foreign Exporters

$ for service cost of service

Foreign Firms

funds remitted funds invested

Foreign Subsidiaries 48

Valuation Model for an MNC

• Domestic Model n

Value = 

t =1

E  CF$, t 

 1  k

t

where E (CF$,t ) = expected cash flows to be received at the end of period t. n = the number of periods into the future in which cash flows are received. k = the required rate of return by investors. 49

Valuation Model for an MNC Valuing International Business Cash Flows



m







n

E  CFj , t   E  ER j , t    j  1

Value =  

t =1



 1  k



t

 

where E (CFj,t ) = expected cash flows denominated in currency j to be received by the U.S. parent at the end of period t. E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t. parent

k = the weighted average cost of capital of the U.S. company.

50

Valuation Model for an MNC Impact of New International Opportunities on an MNC’s Value More Exposure to Foreign Economies More Exposure to Exchange Rate Risk

Business Cycles Inflation Income levels Interest rates

  E  CF   E  ER     



n

Value =   t =1



m

j 1

 

Political Risk Transfer Risk Expropriation Risk Regulatory Risk Delivery Risk

j, t

j, t

Translation Exposure Transaction Exposure Economic Exposure

1  k 



t

 

More Exposure to Country Risk 51

Example Consider an MNC based in the US with operations in Mexico and RSA. The firm expects cash flows of $1 500 000 from local business, 1 000 000 Mexican peso from Mexico subsidiary and 1 billion rand from RSA at the end of period 1. Assuming the future exchange rate of the peso is expected to be $0.09 and that of the rand is expected to be $0.125. The expected weighted average cost of capital of the MNC is 8%, the value of the firm is:  V 

n





 1,5

 t 1







million  1 million (0.09)  1 billion (0.125) 

1  0.08 1

   

V = (1500 000+ 90 000+125 000 000)/1.08 Thus, Value of the Firm = $117 212 962.96

52

Mini Case: Nike’s Decision Nike, a U.S.-based company with a globally recognized brand name, manufactures athletic shoes in such Asian developing countries as China, Indonesia, and Vietnam using subcontractors, and sells the products in the U.S. and foreign markets. The company has no production facilities in the United States. In each of those Asian countries where Nike has production facilities, the rates of unemployment and underemployment are quite high. The wage rate is very low in those countries by the U.S. standard; hourly wage rate in the manufacturing sector is less than one dollar in each of those countries, which is compared with about $18 in the U.S. In addition, workers in those countries often are operating in poor and unhealthy environments and their rights are not well protected. Understandably, Asian host countries are eager to attract foreign investments like Nike’s to develop their economies and raise the living standards of their citizens. Recently, however, Nike came under a worldwide criticism for its practice of hiring workers for such a low pay, “next to nothing” in the words of critics, and condoning poor working conditions in host countries. 53

Group 1 Assignment a)Using relevant literature, provide a theoretical framework for international business. b)Evaluate and discuss various ‘ethical’ as well as economic implications of Nike’s decision to invest in the Asian countries. c)Is the exploitation and plundering of resources by MNCs in developing countries responsible for their slow economic growth? d)What can be done by host countries to reduce the level of exploitation by foreign MNCs without compromising FDI?

54