1. INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Fifth Edition Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin

2. Chapter Objectives: Understand why it is important to study international finance. Distinguish international finance from domestic finance. 1 Chapter One Globalization and the Multinational Firm 1-1

3. What’s Special about “International” Finance? Goals for International Financial Management Globalization of the World Economy Multinational Corporations Summary Chapter One Outline 1-2

4. Why do we need to study “international” financial management. We are now living in a highly globalized and integrated world economy. Continued liberalization of international trade is certain to further internationalize consumption patterns around the world. Not only consumption but also production of goods and services (thanks to MNCs) are globalized. Recent movement is the integration of financial markets. With a global shift all economic functions are now highly globalized. 1-3

5. What’s Special about “International” Finance? Financial management in an international setting. Financial management mainly concers with how to optimally make various financial decisions: Investment, financing, dividend policy, working capital management. In order to achieve corporate objectives which are?....... Foreign Exchange Risk Political Risk Market Imperfections Expanded Opportunity Set 1-4 Sovereign nations have the right and power to issue currencies, formulate their own economic policies, impose taxes, regulate movement of people, goods and capital.

6. What’s Special about “International” Finance? Foreign Exchange Risk The risk that foreign currency profits may evaporate in dollar terms due to unanticipated unfavorable exchange rate movements. Suppose $1 = ¥100 and you buy 10 shares of Toyota at ¥10,000 per share. One year later the investment is worth ten percent more in yen: ¥110,000 But, if the yen has depreciated to $1 = ¥120, your investment has actually lost money in dollar terms. 1-5

7. What’s Special about “International” Finance? Foreign Exchange Risk: Why Flactuation? Since the early 1970s, when fixed exchange rates were abandoned. 1-6

8. What’s Special about “International” Finance? Political Risk Sovereign governments have the right to regulate the movement of goods, capital, and people across their borders. These laws sometimes change in unexpected ways. (changes in tax rules, expropriation etc.) MNC and investors should be aware of political risk when they invest in those countries w/o a tradition of the rule of law. 1-7

9. Market Imperfections Legal restrictions on the movement of goods, people, and money Transactions costs Shipping costs Tax arbitrage All this imperfections will affect the MNCs to locate production overseas. MNCs are the gifts of these imperfections. What’s Special about “International” Finance? 1-8

10. The Example of Nestlé’s Market Imperfection Nestlé used to issue two different classes of common stock bearer shares and registered shares. Foreigners were only allowed to buy bearer shares. Swiss citizens could buy registered shares.(voting diff.) The bearer stock was more expensive. On November 18, 1988, Nestlé lifted restrictions imposed on foreigners, allowing them to hold registered shares as well as bearer shares. 1-9

11. Nestlé’s Foreign Ownership Restrictions 12,000 10,000 8,000 6,000 4,000 2,000 0 11203191824 Source: Financial Times, November 26, 1988 p.1. Adapted with permission. SF Bearer share Registered share 1-10

12. The Example of Nestlé’s Market Imperfection Following this, the price spread between the two types of shares narrowed dramatically. This implies that there was a major transfer of wealth from foreign shareholders to Swiss shareholders. Foreigners holding Nestlé bearer shares were exposed to political risk in a country that is widely viewed as a haven from such risk. The Nestlé episode illustrates both the importance of considering market imperfections and the peril of political risk. 1-11

13. Expanded Opportunity Set Firms can locate production in any country or region of the world to maximize their performance and raise funds in any capital market where the cost of capital is the lowest. They also benefit from greater economies of scale. It doesn’t make sense to play in only one corner of the sandbox. True for corporations as well as individual investors. International diversification) What’s Special about “International” Finance? 1-12

14. The focus of the text is to equip the reader with the “intellectual toolbox” of an effective global manager—but what goal should this effective global manager be working toward? Maximization of shareholder wealth? or Other Goals? Goals for International Financial Management 1-13

15. Maximize Shareholder Wealth Long accepted as a goal in the Anglo-Saxon countries, but complications arise. Who are and where are the shareholders? In what currency should we maximize their wealth? 1-14

16. Other Goals In other countries shareholders are viewed as merely one among many “stakeholders” of the firm including: Employees Suppliers Customers In Japan, managers have typically sought to maximize the value of the keiretsu 系列 —a family of firms to which the individual firms belongs. 1-15

17. An example of keiretsu NameBankMajor group companies Mitsubishi Mitsubishi BankMitsubishi Bank (until 1996) Bank of Tokyo- Mitsubishi(1996–2005) Bank of Tokyo-Mitsubishi UFJ (2006– ) Bank of Tokyo- Mitsubishi Bank of Tokyo-Mitsubishi UFJ Mitsubishi CorporationMitsubishi Corporation, Kirin Brewery, Mitsubishi Electric, Mitsubishi Fuso, Mitsubishi Motors, Nippon Yusen,Nippon Oil, Tokio Marine and Fire Insurance, Nikon, Mitsubishi Chemical, Mitsubishi Estate, Mitsubishi Heavy Industries, Mitsubishi Rayon Co., Ltd., Mitsubishi Materials Corp., Mitsubishi Paper Mills Ltd., Pacific Consultants International Ltd.Kirin BreweryMitsubishi ElectricMitsubishi FusoMitsubishi MotorsNippon YusenNippon OilTokio Marine and Fire InsuranceNikonMitsubishi ChemicalMitsubishi EstateMitsubishi Heavy IndustriesMitsubishi Rayon Co., Ltd.

18. Other Goals As shown by a series of recent corporate scandals at companies like Enron, WorldCom, and Global Crossing, managers may pursue their own private interests at the expense of shareholders when they are not closely monitored. These calamities have painfully reinforced the importance of corporate governance i.e. the financial and legal framework for regulating the relationship between a firm’s management and its shareholders. (agency problem)+ Parmalat 1-17

19. Other Goals These types of issues can be much more serious in many other parts of the world, especially emerging and transitional economies, such as Indonesia, Korea, and Russia, where legal protection of shareholders is weak or virtually non-existing. No matter what the other goals, they cannot be achieved in the long term if the maximization of shareholder wealth is not given due consideration. 1-18

20. Globalization of the World Economy: Major Trends: the buzzword. Emergence of Globalized Financial Markets Emergence of the Euro as a Global Currency Trade Liberalization and Economic Integration Privatization 1-19

21. Deregulation of Financial Markets 27 Oct, 1986 “big bank” elimination of fixed brokerage commissions in LSE like May Day in 1975 in the US coupled with Advances in technology have greatly reduced information and transactions costs (cost index of computing power 100 in 1960 0.5 in 1999) which has led to: Financial Innovations, such as Currency futures and options Multi-currency bonds Cross-border stock listings International mutual funds Emergence of Globalized Financial Markets 1-20

22. Tokyo Stock Exchange(1985), LSE (1986) began admitting foreign firms as full members to their capital markets. Major changes allowed London to be the financial center. Glass Steagall Act, in the USA, restricted commercial banks from investment banking activities. Not in Europe Developing countries started to allow foreigners to directly invest in their financial markets. Technology allowed cross border listing, facilitating international invesment. (order processing and settlement internationally) Emergence of Globalized Financial Markets 1-21

23. Emergence of the Euro as a Global Currency A momentous event in the history of world financial systems. Currently more than 300 million Europeans in 16 countries are using the common currency on a daily basis. In May 2004, 10 more countries joined the European Union and adopted the euro. The “transaction domain” of the euro may become larger than the U.S. dollar’s in the near future. 1-22

24. Euro Area (Mundell, OCA) Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, The Netherlands, Portugal, Slovenia, Spain Slovakia ( 1 Ocak 1999) 1-23

25. Value of the Euro in U.S. Dollars 1-24

26. Economic Integration 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. Mercantilism suggests that the ruling government should advance these goals by playing a protectionist role in the economy; by encouraging exports and discouraging imports, notably through the use of tariffs and subsidies Protectionist countries are now increasingly pursuing free market and open economy policies because of the gains from international trade. (specialization in the production, David Ricardo, theory of comparative advantage.) 1-25

27. Liberalization of Protectionist Legislation The General Agreement on Tariffs and Trade (GATT,1947) a multilateral agreement among member countries has reduced many barriers to trade. (continuing with rounds, now Doha) WTO replaced the GATT. The World Trade Organization (WTO) has the power to enforce the rules of international trade. On January 1, 2005 the end of the era of quotas on imported textiles ended. This is an event of historic proportions (dimensions). 1-26

28. NAFTA The North American Free Trade Agreement calls for phasing out impediments (barriers) to trade between Canada, Mexico and the United States over a 15-year period beginning in 1994. For Mexico, the ratio of export to GDP has increased dramatically from 2.2% in 1973 to 29% in 2006. The increased trade has resulted in increased numbers of jobs and a higher standard of living for all member nations. 1-27

29. Privatization The selling off state-run enterprises to investors is also known as “De-nationalization”. Often seen in socialist economies in transition to market economies. By most estimates this increases the efficiency of the enterprise. Often spurs (drives) a tremendous increase in cross- border investment. Benefits: brings hard currency to pay debts+increase in the productivity 1-28

30. Multinational Corporations A firm that has incorporated on one country and has production and sales operations in other countries. There are about 60,000 MNCs in the world. Many MNCs obtain raw materials from one nation, financial capital from another, produce goods with labor and capital equipment in a third country and sell their output in various other national markets. 1-29

31. Top 10 MNCs 1General ElectricUnited States 2Vodafone Group PLCUnited Kingdom 3General MotorsUnited States 4British Petroleum Co. PLCUnited Kingdom 5Royal Dutch/Shell GroupUK/Netherlands 6ExxonMobile CorporationUnited States 7Toyota Motor CorporationJapan 8Ford Motor CompanyUnited States 9TotalFrance 10Eléctricité de FranceFrance 1-30

32. Multinational Corporations They obtain financing from major money centers around the world in many different currencies to finance their operations. They create job opportunities around the world. They benefit from economy of scale by spreading R&D, pooling global purchasing power over suppliers utilizing their know how globally So, they can use cheap labor while they gain access to special R&D in advanced countries. 1-31

34. End Chapter One …the following slides cover the appendix to chapter 1. 1-33

35. Definition: a comparative advantage exists when one party can produce a good or service at a lower opportunity cost than another party. Underlying theory’s assumptions of Free trade between nations Factors of production (land, labor, technology, and capital) are relatively immobile. The Theory of Comparative Advantage (comparative vs. relative advantage) 1-34

36. The Geometry of Comparative Advantage Consider the example given in appendix 1A. There are two countries, A and B, who can each produce only food and textiles. Initially they do not trade with one another. 1-35

37. The Geometry of Comparative Advantage 300 Food Textiles 180 A production possibilities curve shows the various amounts of food or textiles that each country can make. The production possibilities of country A are such that if they concentrated 100% of their resources into the production of textiles, they could produce 180 million yards of textiles. If country A chose to concentrate 100% of their resources into the production of food, they could produce as much as 300 million pounds of food. Country A can produce any combination of food and textiles between these two points. 1-36

38. The Geometry of Comparative Advantage 300 Food Textiles 180 60 200 As a practical matter, the citizens of country A must choose a point along their production possibilities curve; initially they choose 200 million pounds of food, and 60 million yards of textiles. 1-37

39. The Geometry of Comparative Advantage 1,200300 Food Textiles 180 900 240 60 200 The production possibilities of country B are such that if they concentrated 100% of their resources into the production of textiles, they could produce 240 million yards of textiles. If country B chose to concentrate 100% of their resources into the production of food, they could produce as much as 900 million pounds of food. 1-38

40. The Geometry of Comparative Advantage 1,200300 Food Textiles 180 900 240 60 200 600 As a practical matter, the citizens of country B must choose a point along their production possibilities curve; initially they choose 600 million pounds of food, and 80 million yards of textiles. 80 1-39

41. The Geometry of Comparative Advantage 300 Food Textiles 180 900 240 60 200600 80 Country A enjoys a comparative advantage in textiles because they have to give up food at a lower rate than B when making textiles. Put another way, country B enjoys a comparative advantage in food because they have to give up textiles at a lower rate than A when making more food. Geometrically, a comparative advantage exists because the slopes of the production possibilities differ. 1-40

42. The Geometry of Comparative Advantage 300 Food Textiles 180 900 240 60 200600 80 If the countries specialize according to their comparative advantage, then country A should make textiles and trade for food, while country B should grow food and trade for textiles. 1-41

43. The Geometry of Comparative Advantage 1,200 300 Food Textiles 420 180 900 240 60 200600 80 Before trade, if both countries made only textiles, the combined production would be 420 million yards of textiles = 240 + 180. Before trade, if both countries made only food, the combined production would be 1,200 million pounds of food = 900 + 300. 1-42

44. The Geometry of Comparative Advantage 1,200300 Food Textiles 420 180 900 240 60 200600 80 The combined production possibilities curve of country A and B without trade are shown in the green line. 1-43

45. The Geometry of Comparative Advantage 1,200300 Food Textiles 420 800 180 900 240 60 200600 80 Before trade, the combined production is 800 million lbs of food and 140 million yards of textiles. 140 1-44

46. The Geometry of Comparative Advantage 1,200300 Food Textiles 420 800 140 900 240 60 200600 80 County B can produce food at a lower opportunity cost, so let B produce the first 900 million pounds of food. Country A can produce textiles at a lower opportunity cost, so let them produce the first 180 million yards of textiles. 180 1-45

47. The Geometry of Comparative Advantage 1,200300 Food Textiles 420 800 140 180 900 240 60 200600 80 The combined production possibilities curve with trade is composed of the original curves joined as shown. 1-46

48. The Geometry of Comparative Advantage 1,200300 Food Textiles 420 800 140 180 900 240 60 200600 80 The gains from trade are shown by the increase in consumption available—an extra 100 million pounds of food and 40 million yards of textiles are now available in excess of the pre-trade consumption. 1-47

49. Arguments in Favor of Free Trade Both partners gain from trade: we have more material goods. “Freedom” in a good thing in itself. In this case consumers freedom to choose imported goods and producers freedom to choose to sell to foreigners. 1-48

50. End Appendix One 1-49