International Finance - Lecture 1

Forms of Business Organizations
Multinational Enterprises Lecture 1

Goal of a business is to earn profits Sole Proprietorship - one person owns / operates business Business is dissolved when owner dies Most numerous business in the U.S. Farms, restaurants, hotels, grocery stores, etc. Partnership - two or more people own a business Accounting and law firms General Partnership - other partners are liable for the actions of any partner, such as stealing, fraud, etc. Creditors can go after other partners Example - a partner secretly applies for a bank loan, steals the money, and leaves the country Limited liability partnership - creditors cannot go after the personal assets of the partners Corporations Approximately 20% of businesses are corporations, and they dominate businesses activity Shareholders own the corporation through stock Corporate managers should Maximize stock prices Maximize the shareholders' wealth Maximize a firm's value
Corporations
Initial Public Offer (IPO) - a private company transforms into a corporation Usually company's founder is a majority shareholder Founder becomes a millionaire or billionaire over night Charter - legal document that establishes a corporation as a legal person Three parties Shareholders - own the corporation Meet once a year to elect the board of directors One share equals one vote Shareholder could be another corporation Usually majority shareholder elects himself or herself to the board of directors Board of Directors - control the corporation Set corporate policy Declare dividends Appoint the upper management to run the day to day operations of the corporation Benefits of a corporation Raise substantial amount of financial capital Enter foreign countries and dominate international trade Have special departments that handle operations in a foreign country Requires many specialists in laws, taxes, etc. for different countries Has limited liability Stockholders are not liable for a corporation's debt They can only lose the value of stock, i.e. their investment Can easily transfer ownership Stockholder can buy or sell shares on a stock exchange Have continuity of life; they can live forever theoretically Do not have mutual agency relationship Shareholders cannot bind a corporation to contracts Problems of corporations Corporations are heavily regulated File many reports with government Corporations may encourage this! Makes it more difficult for a new company to enter a market Corporations are taxed twice Corporations pay taxes on profits, i.e. net income Stockholders receive profit from corporation as dividends Stockholder’s income subject to income taxes Types of stock Common stock - shareholders can vote at stockholder meetings Preferred stock - shareholders cannot vote at stockholder meetings Preferred shareholders receive their dividends before common shareholders If corporation is liquidated, then preferred shareholders come before the common shareholders Why issue preferred stock? Common shareholders do not dilute their control of the corporation by issuing preferred stock Types of preferred stock Cumulative preferred stock - stockholders receive all past due dividends before common stockholders Protective preferred stock - corporation must deposit part of its profits into a fund to pay preferred stockholders Redeemable stock - corporation has the right to buy back the stock in the future Convertible stock - a preferred stockholder can convert their stock into common stock on a specific date Bond - a standardized loan to a corporation Investors can easily buy / sell bonds in a market Bondholder has two rights Corporation must pay interest Corporation must repay the bond's face value on the maturity date If a corporation bankrupts and is dissolved Must pay taxes first Bondholders and other loans come second Preferred shareholders come third Common shareholders are last Corporations create complex structures Reason - regulations, taxes, and lawsuits If lawyers sue a corporations subsidiary, then the parent corporation can spin off the subsidiary, and let the legal sharks eat it Example - a judge sued a dry cleaner's for $65 million for losing his pants Example - Halliburton owned Brown and Root Brown and Root was liable for asbestos claims Halliburton sold it off to protect itself Corporations establish headquarters in tax havens Bahamas and Cayman Islands - low taxes, little regulations, and strong confidentiality laws Corporation moves assets and liabilities around to reduce tax burden Tax evasion A business or person did an activity that generates a tax If he or she does not pay, then this is tax evasion The punishment is fines and prison Greece has a severe tax evasion problem Tax avoidance A business or person structures an activity to avoid legally paying a tax Since the 2007 Great Recession - tax authorities are becoming aggressive at collecting for tax avoidance Example - tax inspectors in Italy board yachts as the dock in Italian ports Stockholders want a good return on their investment shareholder return = dividend yield + capital gains Managers can influence dividend yield Usually 2% per year dividend yield = 100dividend / stock price Managers have little influence on capital gains Usually 12% per year Severe stock market declines can cause capital losses Examples - many stocks took a beating in 2000 and 2008 capital gains = 100(stock price ₂ - stock price ₁)/stock price ₁ Example Apple's currently stock price is $669.72 Apple paid a $266 per share dividend, which is the first since 1995 Apple's stock price was $381.32 a year ago Dividend yield is 0.397% Capital gain is 75.63% Total return is 76.0%
Corporate Fraud
1. Enron bankrupted in 2001 Special Purpose Entities (SPE) Companies / subsidiaries Shell company - exists only on paper, or office has one desk and filing cabinet Off-balance sheet companies Enron used SPEs to improve its financial statements artificially Enron invested in many power plants around the world Some investments went bad, and Enron sold its bad investments to its SPEs Balance sheet looks better Can get more loans Enron invested in more power plants around the world Enron hid $25 billion in debt SPE Funded by Enron stock As Enron stock price rose, the SPE's finances were healthy Enron's stock peaked at $90 per share As Enron stock price fell to less than a $1 in 2000, then SPE's accumulated large losses Enron hid the losses Recession occurred in 2001 A recession always reveals an organization's weakness Enron tried to get more bank loans Enron employees had their pensions invested in Enron stock Most overlooked the SPEs, including the following: Auditor, Arthur Anderson Law firm Regulators such as the Securities and Exchange Commission (SEC) U.S. government passed the new law, Sarbanes-Oxley Act in 2002 CFOs and CEOs must sign the firm's financial statements Increase transparency Transparency - outsiders can accurately assess a firm's true finances Enron - "a black box" Non-transparent government - tends to be corrupt Laws and rules are not written down; tend to be vague, etc. Bureaucrats have wide discretion to approve licenses, etc. Did the new federal law fix any thing? The scale of fraud became much larger during the 2008 Financial Crisis The United States experienced a real estate housing bubble, 2000 - 2007 Lehman Brothers used exotic derivatives and bought expensive real estate at the peak of the bubble Credit Default Swaps Collateralized Debt Obligations Bank and bond debt was $768 billion Assets were $639 billion, but falling fast as the property bubble deflated Lehman Brothers closed its door after 158 years of business 2. Countries differ in corporate structure and planning U.S. corporations focus on short-term profits Problems with corporate fraud Japanese Keiretsu - tend to focus on long-term profits and market shares Keiretsu - a conglomerate of many companies with a bank as a member Bank grants low interest loans to partner companies Similar in South Korea, Germany, and Russia Popular in the former communistic countries Government forms a joint venture company with foreign companies Foreign companies bring technology and management expertise Government retains control over company Prone to corruption - if company cannot compete, then government uses its power to protect company 3. Principal-Agent Problem - two related parties have different incentives which conflict with each other Corporation separates the managers from the owners (i.e. stockholders) Managers are supposed to: Maximize profits Maximize the return to the shareholders Increase shareholder value Managers may not act in the best interest of the owners Managers want high salaries, benefits, etc. Example 1 U.S. Investment banks were partnerships; very careful with money During 1990s, investment banks were converted to corporations Managers gambled and took high risks Shareholders lost their stock value during 2008 Financial Crisis Example 2 - GM cancelled its stock, and its shareholders lost everything in 2008 A family owned corporation may reduce the principal-agent problem Stockholders and top management are the same people Examples: Walmart and Microsoft Tend to earn high returns Management has better vision, oversight, etc.
Law of Comparative Advantage
1. Multinational corporations Multinational corporation - corporation is incorporated in one country, and has one or more operations and offices in foreign countries British Petroleum, General Electric, Toshiba, and Wal-Mart Multinational enterprise - includes businesses where government forms a joint venture with a corporation Enterprises go international to make profits Have a choice - export to country or relocate production to a foreign country Why does a firm chose investment over exports? Government offers subsidies and tax breaks Dubai and China have free trade zones Few regulations and low taxes Gain access to technology from another country India has software programmers Indians work for lower wages than Americans and Europeans A company that produces within a foreign country automatically avoid tariffs and import quotas Reduce transportation costs - more processing in closer proximity Example - sugarcane is bulky to ship Sugar mills extract and purify the sugar, which is exported to foreign markets Gain access to new markets and more consumers Coca-Cola and McDonald's A company investing in a foreign country could lead to future expansion A company opens a branch in Moscow, Russia. Company could expand to other Russian cities or other Russian-speaking countries A company could reduce economic exposure Economic exposure - changes to a company's profits because an economic factor changed, such as inflation, interest rate, or exchange rate If a country produces and sells within the same country, changes in the exchange rate impact its profits less A company diversifies its business by expanding into foreign countries Some markets grow quickly, while other markets experience weak growth Require important raw materials for production Example - Bolivia possesses half the world's supply of lithium, which is used to make laptop batteries Firms relocate there to extract and purify lithium Reduce production costs - many companies relocated to China and Mexico, because the wages are lower relative to productivity A company outsources its production to another company to lower its costs Example, Microsoft outsourced its production of X-box consoles to Flextronics, a Singaporean company Flextronics outsourced production to a Chinese manufacturing plant Political Safety - companies relocate to countries that are business friendly Bahamas, Dubai, Singapore, etc. 2. Markets are defined as two types Mature economies - United States and Europe Very competitive Difficult to make money Emerging Market Economies - countries that are opening up to markets China, India, and Mexico - opening to more markets Emerging markets can be very profitable, but entail greater risk Requirements Open Market place Government must allow free markets and allow free movement of capital, labor, and technology Strategic Management Management has the ability to compete and develop new products and services Adapt products and services to different cultures Access to capital International activities require financing Government must allow the free movement of money Corporations can issue more stock, bonds, or receive bank loans 3. Multinational firms are more complicated Businesses transfer resources like machines, equipment, and labor and transfers products and services between different countries Enterprises are exposed to exchange rate risks and credit risks Enterprises have other exposures too like country risk (or political risk) Example 1 - Hugo Chavez in Venezuela nationalized foreign companies Government seizes assets and companies without compensation Example 2 - Kazakhstan - former communistic country President Nazarbayev opened the economy up to free markets in early 1990s After 2008, Kazakhstan is reverting to Soviet rules and practices Kazakh government nationalized a petroleum company International investment plummeted 4. Comparative advantage - how two countries can benefit from trade, even though one country could be large and produce everything David Ricardo Show how two countries benefit from trade Assumptions Both countries are at full employment (i.e. on production possibilities curve) PPCs are straight line (no losses occur when moving resources from industry to industry Works with curved PPCs U.S.A. and Mexico produce both tomatoes and cars No trade - set production at the half way point Autarky - no trade U.S. produces 25 tomatoes and 50 cars Mexico produces 30 tomatoes and 15 cars Total production is 55 tomatoes and 65 cars Comparative advantage - countries specialize in production of products which they have low opportunity costs Important because a large country like the U.S. that can produce everything at low cost can still benefit from trade with a small country with higher costs Related to slopes of the PPC Complete specialization - U.S.A. produces all cars and Mexico produces all tomatoes PPCs are straight lines Total production is 100 cars and 60 tomatoes Gain in production of 35 cars and 5 tomatoes Need more trade theory to show how countries divide up the extra production Limitations Capital and technology can easily flow from one country to another Outsourcing - a firm sends out part of its production to another firm in another country Communication and transportation costs are decreasing