Company Goals And Functions Of Financial Management

words, management should strive to increase the corporate wealth for the benefit of all constituents.

There are a number of compelling reasons for management to focus on stockholder wealth maximization. First, because stockholders are the owners of the company, management has a fiduciary obligation to act in their best interests. Second, stockholders provide the risk capital that protects the welfare of other constituents. Third, stockholder wealth maximization — a high stock price — provides the best defense against a hostile takeover or a forced corporate restructuring. Fourth, if a company enhances shareholder value, it is easier for the company to attract additional equity capital. For these and other reasons, many financial economists believe that stockholder wealth maximization is the only way to maximize the economic welfare of all constituents (Shapiro 2003).

1.2.2 The functions of the international financial manager

In order to achieve the firm's primary goal of maximizing stockholder wealth, the financial manager performs three major functions: (1) financial planning and control (supportive tools); (2) the efficient allocation of funds among various assets (investment decisions); and (3) the acquisition of funds on favorable terms (financing decisions).

Financial planning and control Financial planning and control must be considered simultaneously. For purposes of control, the financial manager establishes standards, such as budgets for comparing actual performance with planned performance. The preparation of these budgets is a planning function, but their administration is a controlling function.

The foreign-exchange market and international accounting play a key role when an MNC attempts to perform its planning and control function. For example, once a company crosses national boundaries, its return on investment depends on not only its trade gains or losses from normal business operations but also on exchange gains or losses from currency fluctuations. For example, Thailand's chemical giant Siam Cement PCL incurred a foreign-exchange loss of $517 million in the third quarter of 1997 due to currency turmoil in Asia during the second half of 1997. The company had $4.2 billion in foreign loans, and none of it was hedged. The exchange loss wiped out all the profits that the company earned between 1994 and 1996 (Glain 1997).

International reporting and controlling have to do with techniques for controlling the operations of an MNC. Meaningful financial reports are the cornerstone of effective management. Accurate financial data are especially important in international business, where business operations are typically supervised from a distance.

Allocation of funds (investment) When the financial manager plans for the allocation of funds, the most urgent task is to invest funds wisely within the firm. Every dollar invested has alternative uses. Thus, funds should be allocated among assets in such a way that they will maximize the wealth of the firm's stockholders.

There are 200 countries in the world where large MNCs, such as General Electric and the Royal Dutch/Shell Group, can invest their funds. Obviously, there are more investment opportunities in the world than in a single country, but there are also more risks. International financial managers should consider these two simultaneously when they attempt to maximize their firm's value through international investment.

Acquisition of funds (financing) The third role of the financial manager is to acquire funds on favorable terms. If projected cash outflow exceeds cash inflow, the financial manager will find it necessary to obtain additional funds from outside the firm. Funds are available from many sources at varying costs, with different maturities, and under various types of agreements. The critical role of the financial manager is to determine the combination of financing that most closely suits the planned needs of the firm. This requires obtaining the optimal balance between low cost and the risk of not being able to pay bills as they become due.

There are still many poor countries in the world. Thus, even Citigroup, the world's largest bank in 2003, cannot acquire its funds from 200 countries. Nevertheless, MNCs can still raise their funds in many countries thanks to recent financial globalization. This financial globalization is driven by advances in data processing and telecommunications, liberalization of restrictions on cross-border capital flows, and deregulation of domestic capital markets. International financial managers use a puzzling array of fund-acquisition strategies. Why? The financial manager of a purely domestic company has just one way to acquire funds — instruments that have varying costs, different maturities, and different types of agreements. The financial manager of an MNC, on the other hand, has three different ways to acquire funds: by picking instruments, picking countries, and picking currencies.

The changing role of the financial manager The role of the financial manager has expanded in recent years. Instead of merely focusing on the efficient allocation of funds among various assets and the acquisition of funds on favorable terms, financial managers must now concern themselves with corporate strategy. The consolidation of the corporate strategy and the finance function — a fundamental change in financial management — is the direct result of two recent trends: the globalization of competition and the integration of world financial markets facilitated by improved ability to collect and analyze information. For example, financial managers increasingly participate in corporate strategic matters — from basic issues such as the nature of their company's business to complex issues such as mergers and acquisitions.

The chief financial officer as strategic planner is emerging. In an era of heightened global competition and hard-to-make-stick price increases, the financial fine points of any new strategy are more crucial than ever before. Many finance chiefs can provide that data, as well as shrewd judgment about products, marketing, and other areas. The key place where everything comes together is finance. In a recent survey by headhunters Korn/Ferry International, Fortune 100 chief financial officers almost unanimously described themselves as "more of a partner with the Chief Executive Officer (CEO)" than they used to be.

O 1.3 Multinational Companies and their Performance

1.3.1 What is a multinational corporation?

In 1963, the term "multinational corporation" became a household term after a cover story about the institution in Business Week. Ever since, international business guided by MNCs has prospered as a result of the need for poor countries to develop, the end of the Cold War, privatiza tion of state-owned businesses and banks, and the growing economic power of the global triad - Asia, the USA, and Europe (Baker 1997). There are approximately 60,000 multinational companies in the world with 500,000 foreign affiliates. These multinational companies and their foreign affiliates account for roughly 25 percent of global output, one third of it in host countries (The Economic Report of the President to Congress 2004). In the twenty-first century, these MNCs are expected to play an even greater role in international business, because they have the know-how, money, and experience.

The World Book Encyclopedia defines a multinational corporation (MNC) as "a business organization that produces a product, sells a product, and provides a service in two or more countries." The US Department of Commerce defines an American MNC as "the US parent and all of its foreign affiliates." A US parent is a person, resident in the USA, who owns or controls a minimum of 10 percent voting equity in a foreign firm. "Person" is broadly defined to include any individual, branch, partnership, associated group, association, estate, trust, corporation, other organization, or any government entity. A foreign affiliate is a foreign business enterprise in which a US person owns or controls a minimum of 10 percent voting equity. A majority-owned foreign affiliate is a foreign affiliate in which the combined ownership of all US parents exceeds 50 percent.

Donald Lessard (1991), a professor of international finance at MIT, classifies all MNCs into three groups: (1) international opportunists — companies that focus on their domestic markets but engage in some international transactions; (2) multi-domestic competitors — companies committed to a number of national markets with substantial value added in each country, but with little cross-border integration of activities; and (3) global competitors — companies that focus on a series of national and supranational markets, with substantial cross-border integration of activities.

1.3.2 From multinational company to global company

What Lessard called "a global competitor" has come to be known as a global company, a generic term used to describe an organization that attempts to standardize and integrate operations worldwide in all functional areas. Here are three possible definitions of a global company — an organization that attempts to:

1 Have a worldwide presence in its market.

2 Integrate its operations worldwide.

3 Standardize operations in one or more of the company's functional areas.

For example, if a company designs a product with a global market segment in mind and/or depends on many countries for the production of a product, it qualifies as a global company. In this type of company, the development of capabilities and the decisions to diffuse them globally are essentially made in the company's home office. Some people believe that a global company must possess all these three characteristics. Critics of this definition say that there is no global company by that definition (see Global Finance in Action 1.2).

Global Finance in Action 1.2

Is Globalization Myth or Reality?

The answer to this question depends on whether you look at globalization in tangible terms (i.e., production and trade volumes) or in intangible terms (i.e., information and knowledge). Professor Alan R. Rugman, at Indiana University in Bloomington, Indiana, argues that multinational business enterprises (MNEs) - which are the agents of international business - largely operate within their home-based markets in each part of the "triad" of North America, the European Union, and Japan/Asia. Empirical evidence suggests that even the 20 most "international" MNEs (those with the highest ratio of foreign-to-total sales) are mainly home-triad based in their activities.

Globalization has been defined in business schools as producing and distributing goods and services of a homogeneous type and quality on a worldwide basis - simply put, providing the same output to countries everywhere. To back up their claims, some analysts often point to the fact that foreign sales account for more than 50 percent of the annual revenues of companies such as Dow Chemical, ExxonMobile, and IBM. Accurate as they may be, those figures do not explain that most of sales of "global" companies are made on a "triad" regional basis. For example, more than 85 percent of all automobiles produced in North America are built in North American factories; over 90 percent of the cars produced in the EU are sold there; and more than 93 percent of all cars registered in Japan are manufactured domestically. The same holds true for specialty chemicals, steel, energy, transportation, and heavy electrical equipment. Furthermore, MNEs cannot develop homogeneous products for world markets or dominate local markets no matter how efficient production techniques are. MNEs have to adapt their products for the local market. For example, there is no worldwide, global car. Rather, there are regionally based American, European, and Japanese factories that are supported by local regional suppliers.

"Rugman's perspective is based on homogeneity of markets and comparative advantage concepts whereby commodity and unskilled labor markets are major drivers of world trade and commerce," Professor Paul Simmons, at Florida State University in Tallahassee, Florida, points out. "Unfortunately, this perspective is more suited to trade concepts of the 18th and 19th centuries where economists argued the value of absolute and comparative advantage." Market homogeneity is not the major determinant of globalization; it is market interdependence Supply and demand imbalances create linkages between markets. A standardized product or service in all markets is only one of several options available to satisfy those linkages. A definition of globalization that focuses on the ability of firms to leverage certain resources and compete in worldwide markets suggests that globalization does exist in interdependent markets.

Global branding is an illustrative example. Whether franchising or product branding, firms seek interconnectivity throughout their competitive domains to leverage their intangible assets. Everyone is familiar with McDonald's. Strict control of key operational aspects in food preparation and delivery are consistent globally despite varied additions to menu offerings that accommodate local tastes and customs. McDonald's expects customer experiences in any of its locations to generate certain expectations between locations because of its brand identity. Thus, the interdependence of knowledge and information among the various locations are circuital to McDonald's competitive success. The most relevant definition of globalization, therefore, is the ability to transfer information and knowledge globally. Products and services may be produced, delivered, and traded on a regional basis, but global diffusion of knowledge makes this possible. Globalization exists because bits and bytes - that is, process knowledge and other intangible assets - can be transferred globally at minimal costs. The result is greater integrated trade flows.

Sources: Alan M. Rugman, "Multinational enterprises are regional, not global," Multinational Business Review, Spring 2003, pp. 3—12; Alan M. Rugman, "The myth of global strategy," AIB Newsletter, Second Quarter 2001, pp. 11-14; and Paul Simmonds, "Globalization: another viewpoint," AIB Newsletter, Second Quarter 2001, pp. 15-16.

1.3.3 The performance of multinational companies

Evidence indicates that US MNCs earn more money as they boost their presence in foreign markets. In 1974, for example, Business International reported that 90 percent of 140 Fortune 500 companies surveyed achieved higher profitability on foreign assets. This trend continued into the 1990s, but the percentage of those companies with higher profitability on foreign assets has declined in recent years (Ball et al. 2004). The US Department of Commerce found that the return on assets for nonfinancial US MNCs has exceeded the return on assets for all US non-financial companies from 1989 to 2003, but that the excess of the return on assets for US MNCs over the return on assets for US domestic companies has declined since 1991. Apparently, the cost and competition drivers to globalization have reduced the differences between overseas and home-country profits, but all analysts predict that US MNCs will earn more money than US domestic companies for years to come.

Foreign-based companies with a higher degree of international business have also experienced superior performance in recent years. Foreign-owned companies in the world's most highly developed countries are generally more productive and pay their workers more than comparable locally owned businesses, according to the Organization for Economic Cooperation and Development (OECD). The Paris-based organization also says that the proportion of the manufacturing sector under foreign ownership in European Union countries rose substantially during the 1990s, a sign of increasing economic integration. The finding underlines the increasing importance in the world economy of large companies with bases scattered across the globe. Gross output per employee, a measure of productivity, in most OECD countries, tends to be greater in multinational companies than in locally owned companies (Marsh 2002). Why do multinational companies perform better than domestic companies? In the following section, we attempt to answer this important question.

O 1.4 Principles of Global Finance

The primary objective of this book is to help the reader understand basic principles of global finance. Before we advance too far into the material, perhaps it would be helpful to take a brief look at some of these principles so that you may see where we are heading.

As discussed earlier, the financial manager has three major functions: financial planning and control, the acquisition of funds, and the allocation of funds. However, each of these three functions shares most principles of global finance and their relationships. Seven important principles of global finance are introduced in this section. In addition, these principles should help you understand why MNCs perform better than domestic companies.

1.4.1 The risk-return trade-off

The maximization of stockholder wealth depends on the trade-off between risk and profitability. Generally, the higher the risk of a project, the higher is the expected return from the project. For example, if you are offered a chance to invest in a project that offers an extremely high rate of return, you should immediately suspect that the project is very risky.

The risk—return trade-off does not apply to 100 percent of all cases, but in a free enterprise system, it probably comes close. Thus, the financial manager must attempt to determine the optimal balance between risk and profitability that will maximize the wealth of the MNC's stockholders. Figure 1.1 shows how the financial manager assesses the various risk—return trade-offs available and incorporates them into the wealth maximization goal. Given the risk—return tradeoffs, various financial decisions are made to maximize stockholder wealth. Practically all financial decisions involve such trade-offs. Such decisions include foreign-exchange risk management, global reporting and controlling, global financing decision, and global investment decision.

An investor's risk—return trade-off function is based on the standard economic concepts of utility theory and opportunity sets. An opportunity set shows different combinations of business opportunities, which make the investor equally happy in terms of risk—return trade-offs.

Companies can benefit from an expanded opportunity set as they venture into global markets. It seems reasonable to assume that international business is riskier than domestic business. However, this is not necessarily true, because returns on foreign investments are not highly positively correlated with returns on domestic investments. In other words, MNCs may be less risky than companies that operate strictly within the boundaries of any one country. Consequently, to minimize risk, companies should diversify not only across domestic projects but also across countries.

Possible revenue opportunities from international business are also larger than possible revenue opportunities from purely domestic business. MNCs can locate production in any country of the world to maximize their profits and raise funds in any capital market where the cost of capital is the lowest. MNCs may see another advantage from currency gains. These two factors — lower risks and larger profitability for international business — suggest the possibility that an MNC can achieve a better risk—return trade-off than a domestic company.

Figure 1.2 shows that international business pushes out the opportunity set, thus allowing MNCs to reduce risk, increase return, or attain both. As shown in figure 1.2, we can think of three possible cases in which international operations are better than domestic operations. Relative to US project A, international project B has the same return but less risk; international project C has the same risk but higher return; and international project D has higher return but less risk.

YES Initiate plan t

Plan = goal

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  • goldilocks
    What is the functions of a manager in a purely corporation?
    8 years ago

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