Chapter 10

Finance & Finance & AccountingAccounting

To gain an overview of the functioning of the international monetary systemTo understand the nature of foreign exchange operationsTo appreciate the role of global capital markets To identify and assess corporate financing options, including their impacts on managers and stakeholdersTo assess changes in corporate control, including the roles of hedge funds and private equity groups

To evaluate changes taking place in international accounting

Aims of the lectureAims of the lectureTo gain an overview of the functioning of the international monetary systemTo understand the nature of foreign exchange operationsTo appreciate the role of global capital markets To identify and assess corporate financing options, including their impacts on managers and stakeholders

To assess changes in corporate control, including the roles of hedge funds and private equity groupsTo evaluate changes taking place in international accounting

Overview of globalfinancial markets

Capital markets facilitate the raising of capital and borrowing needed by businesses.

Securities – financial instruments signifying ownership, debt or future rights, which can be traded.

Traditional securities – shares (stock); bonds (loans)

Newer types of securities – Derivatives, including options

Foreign exchange markets are the largest markets in global finance.

Figure 11.1: Overview of global financial markets

Globalfinancialmarkets

Bond markets• US Treasuries• Corporate bonds• Foreign bonds

Derivativestrading• Options• Futures• Swaps Commodities

markets• Futures• Spot trades

ForeignExchangemarkets• Spot indices• Forwards• Swaps• Options

Stockexchanges• Shares (stock)• Corporate

bonds

The international monetary system

The gold standard, 1870-1914

Bretton Woods agreement of 1944• Every currency fixed to the US$, which was itself

fixed in terms of gold• Reflected US status as the world’s strongest

economy• IMF founded to oversee global financial system

The breakdown of Bretton Woods in the 1970s,

when oil-producing countries gained in

economic importance Wider range of countries now

involved in international financial

flows

Determination of exchange ratesPost-Bretton Woods, under IMF oversight, flexibility and diversity in setting exchange rates

Managed float – government intervention as necessary

Pegged exchange rate – links currency to another currency

Currency board – a country guarantees it will convert the currency into another currency at a fixed rate

IMF policies seek stability, based on countries’ avoiding...

Currency misalignment

Excessive reserves

Government intervention to manipulate the currency

From fixed to floating exchange rates: international diversity

Currencyboard

Fixed by international agreement or national authorities

Managed float

No separate national currency

•Fixed peg•Fixed bands•Crawling peg

Pegged exchange rate

Independentlyfloating

• Agreement within the Eurozone

also Mundell

-Fleming m

odel

Monetary policy among IMF member states, 2006Source: IMF (2006) Monetary policy

framework, www.imf.org

Mundell-Fleming Optimum Area Model

Flexible wages

A central government acting as a transfer agent from rich to poor regions, especially during bad economic times

Mobility of labor

Free flow of knowledge

Free flow of capital

Figure 11.4: The US dollar’s decline against other major currencies, 2002–06

Source: Financial Times, 6 December 2006

Financial crises and their lessons• 1990s saw growth of emerging economies, with

liberalized markets and high growth rates which attracted investors

• But underlying weaknesses:

• Build-up of debt, often in dollars; weak banking systems

• Asian financial crisis

• Southeast Asian countries enjoyed export-led economic development – but incurred huge dollar-denominated debt and strains on local currencies.

• The lessons from the crisis:

– Need for independent regulation of banks

– Monetary policy to support confidence in the currency

How about the current global financial crisis that started in 2007?

In all probability, it reflects three problems that need to be addressed:

(1) excessive quantification without adequate basis in the world of real finance,

(2) increasing innumeracy of the corporate world, regulators and of public at large, and

(3) excessive liquidity in the economy.

Figure 11.5: Internal and external factors in the Asian financial

crisis

Foreign exchange transactions• The hedge – Tool which insures against adverse

currency movement.

• Types of transaction:

• Spot contract – settled on the day

• Forward contract – to carry out a transaction on a future date

• Option – gives the right, but not the obligation, to purchase on a future date at a specific exchange rate

• Swap – instrument by which a firm can customize terms by swapping them with another party

How the domestic interest (denoted by r¥ and r$ for Japan and the U.S. respectively) and inflation (I¥ and i$) rates affect the Spot (S¥$) and forward (f¥$) foreign exchange rates.

Figure 11.6: Amounts outstanding on interest rate and currency

swapsSource: Financial Times, 19 June 2007

Currency risk strategy• Transaction risk

• Where a firm buys or sells in a foreign currency, payment can fluctuate with the currency.

• Hedging strategy is helpful in these situations, but longer term strategies are needed if these transactions are frequent.

• For example, global sourcing must consider currency risk.

• Where a local subsidiary deals in the local currency, this can act as a natural hedge.

• Transfer pricing – managing pricing of products between subsidiaries, to maximize financial benefits.

Global capital markets• Trading in equities is carried out on stock

exchanges.

• Stock exchanges are regulated by national authorities.

• With increasing numbers of foreign investors and foreign IPOs, stock exchanges are becoming internationalized.

• Debt instruments, or bonds, are issued by both companies and governments.

• A bond (or debenture) is for a fixed term and offers regular interest payments – versus shares, where dividend payments are not guaranteed.

Figure 11.7: Number of listed companies on major stock exchanges, 2006

Source: World Federation of Exchanges (2007) Statistics,

www.world-exchanges.org

Figure 11.8: Leading exchanges’ shares of total share trading by value, 2006

Note: Global total = US$69,829,943.7 millions Source: World Federation of Exchanges (2007) Statistics, www.world-exchanges.org

Figure 11.9: Shifting investments of worldwide pension funds

Source: Financial Times, 10 October 2005

International corporate financeDebt/equity ratio – balance between debt financing and equity financing

Where debt financing prevails, creditors interests are key.

Where equity financing prevails, shareholder interests are key.

Private versus public companies

Figure 11.10: A comparison of equity and debt financing for

private and public companies

Cross-border mergers and acquisitions

• Acquisition involves the takeover of a company by another company or other organization, such as a government.

• The acquired company may be public or private.

• Merger involves two or more companies coming together as relative equals, forming a new company.

• M&A activities have been dominated by developed-country MNEs in the past, but emerging MNEs are now increasingly active in takeover markets.

• Competition law (national and EU) restricts M&A deals which would result in market dominance.

Cross-border mergers and acquisitions by companies in developed and developing economies

Source: UNCTAD (2006) Cross-border M&A sales by region and economy of purchaser, www.unctad.org

Hedge funds and private equity

• Hedge fund – investment fund active in all types of securities markets; noted for short-term, aggressive strategies.

• Private equity funds – investment fund managed on behalf of wealthy investors; fund managers invest in companies, usually with short-term gains in mind.

• The leveraged buyout (LBO) is a favoured strategy, targeted at underperforming companies.

• Both hedge funds and private equity groups involve high levels of risk, and have suffered losses in the credit crunch.

Growth in hedge funds

Source: Financial Times, 27 April 2007

International accounting issuesNational differences in accounting standards must be taken into account by international business.

For the MNE, translation of financial statements involves translation risk, as...

J Local currency accounts must be translated into the currency of the parent company’s home country.

General trend towards harmonization and simplification.

IFRS is gradually replacing national frameworks.

JAims to give a more accurate picture, based on consistency in definitions and treatment of income and assets.

Figure 11.13: Influences on national accounting practices

Case studies

11.1: Sparks fly in Mittal Steel’s takeover of Arcelor (page 417)

1. What were the hurdles Mittal had to overcome in his hostile bid for Arcelor?

Arcelor was viewed as a European champion. Its shareholders, managers and other stakeholders resisted a takeover. Mittal’s first bid was rejected, and a consequence was to send the share price upwards. Mittal was an outsider, and had a reputation of being autocratic. The close control he kept over companies he owned, together with weak corporate governance, did not appeal to Arcelor shareholders. Arcelor directors sought a rival bidder, but this attempt failed. Raising the bid price was Mittal’s main means of gaining shareholder consent. His promise to reduce his control also influenced them to accept his bid.

Case studies

11.1: Sparks fly in Mittal Steel’s takeover of Arcelor (page 417)

2. Assess the shareholder and stakeholder perspectives in the takeover battle and in the new company.

Shareholders will generally be won over if a takeover offer is high. The offer made by Mittal included shares in the new company as well as cash. Two-thirds of the price was paid in shares. This meant that shareholders became members of the new ArcelorMittal. Mittal himself, however, held over 43% of the new company, making him the dominant shareholder. In this situation, minority shareholders can well feel worried that they have little influence.Other stakeholders include managers and employees. For them, themanagement control exerted by Mittal constituted a concern. Mittal said he would step down as CEO, but after a few months, he resumed being CEO.

The authoritarian style with which he had become associated was at odds with the more consensual style of Arcelor. Mittal’s Indian background, based in adeveloping country with weak institutional environment, was very different fromthe European context. There was some concern that mining disasters which had resulted in numerous deaths in Mittal-owned mines in Kazakhstan were indicative of little heed of CSR.

Case studies

11.1: Sparks fly in Mittal Steel’s takeover of Arcelor (page 417)

3. What competitive advantage is now enjoyed by ArcelorMittal in global markets?

ArcelorMittal is dominant in the global steel industry. It is larger than the next three largest companies combined. Mittal is now in a position to buy even more competitors, enhancing his ability to control supply and prices. He sees this as an advantage, as he has suffered financially in the past from the volatilities in the steel market. However, if global demand falls, as is happening at present, the company will be vulnerable, despite its huge size.

ConclusionsBusinesses and national economies are increasingly integrated in global financial flows, which bring both benefits and risks.

Foreign exchange markets facilitate cross-border business transactions, which entail financial risk strategies.

Stock exchanges bring together companies and investors increasingly seeking international opportunities.

Companies have a wide range of increasingly internationalized capital-raising options, in both debt and equity financing,.

Cross-border mergers and acquisitions now encompass a wide range of players, including emerging MNEs.

Accounting standards are gradually moving away from national to international rules.