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Chapter 10
Finance & Accounting
To gain an overview of the functioning
of the international monetary system
To understand the nature of foreign exchange operations
To 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 groups
To evaluate changes taking place in
international accounting
Aims of the lecture
To gain an overview of the functioning of the
international monetary system
To understand the nature of foreign exchange
operations
To 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
groups
To evaluate changes taking place
in international accounting
Overview of global
financial 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
Stock
exchanges
• Shares (stock)
• Corporate
bonds
Derivatives
trading
• Options
• Futures
• Swaps
Bond markets
• US Treasuries
• Corporate bonds
• Foreign bonds
Global
financial
markets
Commodities
markets
• Futures
• Spot trades
Foreign
Exchange
markets
• Spot indices
• Forwards
• Swaps
• Options
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 rates
Post-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
Managed
float
Fixed by
international
agreement or
national
authorities
No
separate
national
currency
• Agreement
within the
Eurozone
Pegged
exchange
rate
•Fixed peg
•Fixed bands
•Crawling peg
also MundellFleming model
Currency
board
Independently
floating
Monetary policy among
IMF member states, 2006
Source: 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 swaps
Source: 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 finance
Debt/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 issues
National differences in accounting standards must be
taken into account by international business.
For the MNE, translation of financial statements involves
translation risk, as...
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.
̶
Aims 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. Twothirds 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, the
management 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 a
developing country with weak institutional environment, was very different from
the 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.
Conclusions
Businesses 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.