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Chapter 01

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Chapter 01
Comparative Corporate Governance and Financial Goals
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Comparative Corporate Governance and Financial Goals
Multinational Enterprise (MNE)Multinational Business FinanceGoal of ManagementShareholder Wealth MaximizationStakeholder Capitalism ModelComparative Corporate GovernanceCurrency Terminology
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The Multinational Enterprise (MNE)
A multinational enterprise (MNE) is defined as one that has operating subsidiaries, branches or affiliates located in foreign countries.The ownership of someMNEsis so dispersed internationally that they are known as transnational corporations.Thetransnationalsare usually managed from a global perspective rather than from the perspective of any single country.
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Multinational Business Finance
While multinational business finance emphasizesMNEs, purely domestic firms also often have significant international activities:Import & export of products, components and servicesLicensing of foreign firms to conduct their foreign businessExposure to foreign competition in the domestic marketIndirect exposure to international risks through relationships with customers and suppliers
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Global Financial Management
There are significant differences between international and domestic financial management:Cultural issuesCorporate governance issuesForeign exchange risksPolitical RiskModification of domestic finance theoriesModification of domestic financial instruments
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The Goal of Management
Maximization of shareholders’ wealth is the dominant goal of management in the Anglo-American world.In the rest of the world, this perspective still holds true (although to a lesser extent in some countries).In Anglo-American markets, this goal is realistic; in many other countries it is not.There are basic differences in corporate and investor philosophies globally.In this context, the universal truths of finance become culturally determined norms.
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Shareholder Wealth Maximization
In a Shareholder Wealth Maximization model (SWM), a firm should strive to maximize the return to shareholders, as measured by the sum of capital gains and dividends, for a given level of risk.Alternatively, the firm should minimize the level of risk to shareholders for a given rate of return.Assumptions ofSWM:TheSWMmodel assumes as a universal truth that the stock market is efficient.An equity share price is always correct because it captures all the expectations of return and risk as perceived by investors, quickly incorporating new information into the share price.Share prices are, in turn, the best allocators of capital in the macro economy.
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Shareholder Wealth Maximization – Continued
Assumptions of SWM – Continued:The SWM model also treats its definition of risk as a universal truth.Risk is defined as the added risk that a firm’s shares bring to a diversified portfolio.Therefore the unsystematic, or operational risk, should not be of concern to investors (unless bankruptcy becomes a concern) because it can be diversified.Systematic, or market, risk cannot however be eliminated.
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Shareholder Wealth Maximization – Continued
Agency theory is the study of how shareholders can motivate management to accept the prescriptions of theSWMmodel.Liberal use of stock options should encourage management to think more like shareholders.If management deviates too extensively fromSWMobjectives, the board of directors should replace them.If the board of directors is too weak (or not at “arms-length”) the discipline of the capital markets could effect the same outcome through a takeover.This outcome is made more possible in Anglo-American markets due to the one-share one-vote rule.
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Shareholder Wealth Maximization – Continued
Long-term versus short-term value maximizationLong-term value maximization can conflict with short-term value maximization as a result of compensation systems focused on quarterly or near-term results.Short-term actions taken by management that are destructive over the long-term have been labeled impatient capitalism.This point of debate is often referred to a firm’s investment horizon (how long it takes for a firm’s actions, investments and operations to result in earnings).In contrast to impatient capitalism is patient capitalism.This focuses on long-termSWM.Many investors, such as Warren Buffet, have focused on mainstream firms that grow slowly and steadily, rather than latching on to high-growth but risky sectors.
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Stakeholder Capitalism Model
In this context, a firm should treat shareholders on a par with other corporate interest groups, such as management, labor, the local community, suppliers, creditors and even the government.This model, also called the stakeholder capitalism model focuses on earning as much as possible in the long-run while retaining enough to increase the corporate wealth for the benefit of all interest groups.Assumptions ofSCM:TheSCMmodel does not assume that equity markets are either efficient or inefficient.In fact, market efficiency does not matter as the firm’s financial goals are not exclusively shareholder-oriented.This model assumes that long-term “loyal” shareholders should influence corporate strategy, not transient investors.TheSCMmodel assumes that total risk, operating and financial risk, does count.
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Stakeholder Capitalism Model – Continued
Although theSCMmodel avoids the impatient capitalism as seen in theSWM, it has its own flaw in that management is tasked with meeting the demands of multiple stakeholders.This leaves management without a clear signal about the tradeoffs, which management tries to influence through written and oral disclosures and complex compensation systems.While both forms of wealth maximization have their strengths and weaknesses, two trends in recent years have led to a focus on theSWMmodel.As non Anglo-American markets privatize their industries theSWMmodel becomes more important in the overall effort to attract foreign capitalMany analysts believe that shareholder-basedMNEsare increasingly dominating their global industry segments
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Corporate Governance
The single overriding objective of corporate governance is the optimization over time of the returns to shareholders.In order to achieve this goal, good governance practices should focus the attention of the board of directors of the corporation by developing and implementing a strategy that ensures corporate growth and improvement in the value of the corporation’s equity.The most widely accepted statement of good corporate governance practices are established by the OECD:The corporate governance framework should protect shareholders rights.The corporate governance framework should ensure the equitable treatment of all shareholders.Stakeholders should be involved in corporate governance.Disclosure and transparency is critical.The board of directors should be monitored and held accountable for what guidance it gives.
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Comparative Corporate Governance
These regimes are a function of:Financial market developmentsDegree of separation between managers and ownersDisclosure and transparencyHistorical development of the legal system
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Failures in Corporate Governance
Failures in corporate governance have become increasingly visible in recent years.In each case, prestigious auditing firms missed the violations or minimized them, presumably because of lucrative consulting relationships or other conflicts of interest.In addition, security analysts urged investors to buy the shares of firms they knew to be highly risky (or even close to bankruptcy).Top executives themselves were responsible for mismanagement and still received overly generous compensation while destroying their firms.
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Corporate Governance Reform
Within the United States and the United Kingdom, the main corporate governance problem is the one treated by agency theory: with widespread share ownership, how can a firm align management’s interest with that of the shareholders?Because individual shareholders do not have the resources or the power to monitor management, the U.S. and U.K. markets rely on regulators to assist in the agency theory monitoring task.Outside the U.S. and U.K., large, controlling shareholders are in the majority – these entities are able to monitor management in some ways better than the regulators can.
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The Sarbanes-Oxley Act
This act was passed by the US Congress during 2002 and has three major requirements:CEOs of publicly traded companies must vouch for the veracity of published financial statements;Corporate boards must have audit committees drawn from independent directors;Companies can no longer make loans to corporate directors, andCompanies must test their internal financial controls against fraudPenalties have been spelled out for various levels of failure.Most of its terms are appropriate for the US situation, but some terms do conflict with practices in other countries.
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Currency Terminology
Foreign currency exchange rate or exchange rate is the price of one country’s currency in units of another currency or commodity (gold or silver).If a government determines the exchange rate for its currency then exchange rate system is called fixed or managed exchange rate systemThe rate at which the currency is fixed or pegged called is called par valueIf government does not interfere then the system is called flexible or floatingSpot exchange rate is the quoted price for foreign exchange to be delivered at once, or in two days for interbank transactions.How can you interpret $1.2670/€?
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Currency Terminology – Continued
Devaluation of a currency refers to a drop in foreign exchange value of a currency that is pegged to gold or another currency.The opposite is revaluationWeakening, deterioration, or depreciation of a currency refers to a drop in the foreign exchange value of a floating currency.The opposite is strengthening or appreciationSoft or weak describes a currency that is expected to devalue or depreciate relative to major currencies.Hard or strong describes a currency that is expected to revalue or appreciate relative to major trading currencies.Eurocurrencies are domestic currencies of one country on deposit in a bank in a second country.Eurodollar – dollar deposits overseasEuroyen– yen deposits outside Japan
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Currency Terminology – Continued
Foreign Exchange Rates & Quotations – Direct and Indirect QuotesA direct quote is a home currency price of a unit of a foreign currencySfr1.6000/$ is a direct quote in SwitzerlandAn indirect quote is a foreign currency price of a unit of the home currencySfr1.6000/$ is an indirect quote in the US,$0.6250/Sfris a direct quote in the US and an indirect quote in Switzerland
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Chapter 01