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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.