Finance Policies and Strategies of Multinational Enterprise - Essay Example

Dear Shareholders: Our company is a multinational enterprise (MNE) operating in a challenging global environment. Doing business over a wide geographical reach has benefits, but it exposes MNEs like us to risks associated with raising capital that constantly threaten to increase costs, lessen profits, and make the work of maximising shareholder value difficult. Allow me to familiarise you with the basic finance policies and strategies that guide our company in managing these risks so we can bring down our costs of equity, debt, and capital. Actively managing financial risks allows us to continue doing what we do best - designing and selling great products - instead of just reacting to problems linked to events beyond our control. These risks arise due to the unavoidable effects that some political and natural events have on currency exchange and interest rates. When one of the countries where we operate slides into an economic crisis, for example, government might impose exchange or currency controls, affecting our cash flow, profits, and funds transfer mechanisms and creating potentially adverse effects on our finances and stock price. Using recent events as our reference point, I will outline what our global finance teams are doing to mitigate the negative effects of some key financial risks we face. Critical Business Events The following events in countries where we operate have brought about risks that impact on our business performance: The US dollar has depreciated against most major currencies. The Brazilian economy is strong and our subsidiary would like to expand manufacturing capacity but lacks sufficient retained earnings to finance it. A major competitor in France has reduced prices and our labour costs in France are high and unlikely to be negotiated lower. Borrowing rates in Brazil are higher than in the UK, US, and Europe. The inflation rate in the US is rising. Global stock markets are extremely volatile. The Euro is forecast to rise against the pound sterling over the next year. These seemingly unconnected events are potential threats because of financial risks, but they are also a source of business opportunities if we manage those risks well. Financial, Political, Country and other Risks These risks arise both from the likelihood that something good will not happen or that something bad will happen (Read and Kaufman, 1997, p. 112). Financial risks are those that threaten the efficiency of the worldwide movement of money and profits amongst our affiliated companies through internal transfer mechanisms (Shapiro, 2003, p. 26). We are exposed to this risk that have several types, amongst which the most relevant given the events just outlined are currency, credit, inflation, and market risks. Although most of the critical events are non-political in nature, their effects on the respective national economies may cause political risks that we must address. Our cost of capital and debt is affected by fluctuations in exchange and interest rates, inflation, and stock market volatility. We also need to manage transaction exposures, the possibility of incurring gains or losses on sales, purchases, and investment decisions entered into and denominated in foreign currencies (Eiteman et al., 2004, p. 155-176). International Finance Strategies Risks are uncertainties and sources of anxiety we need to deal with. Most business and financial risks are caused by outside events and changes in economic variables (GDP growth, commodity prices, interest rates, foreign exchange rates, and stock prices) over which we have virtually no control (Froot et al., 1994). Our inability to control these events, however, does not mean we cannot manage their effects. We manage the consequences of financial risks by adjusting our operational, financial, and investment strategies. Some risks we can take and others we cannot. We monitor and evaluate those risks we can take, like expanding in a growing though quirky Brazilian market and the volatility of worldwide stock markets. Some of our strategies in the past, like the cross-border listings of our stocks, have been profitable, with the benefits of giving us access to domestic capital and lessening the adverse effects of exchange and interest rate risks outweighing the costs of compliance with government regulations, threats to ownership, and market volatility. Besides, having a wide investor base in four different countries has kept our stock price relatively high (Merton, 1987). Another strategy that has proven beneficial for us is judiciously varying the financial structure (mixture of debt and equity in the balance sheet) of our subsidiaries to capitalise on opportunities to lower taxes, reduce financing costs and risk, and to take advantage of several market imperfections. We can borrow when interest rates are low and pay off high interest debts. We can borrow in countries where interest rates are low (Euro zone) and use the funds to invest and expand a subsidiary where the economy is strong (Brazil). Differences in tax incentives amongst countries also allow us to maximise our profits and use the funds to subsidise our operations in subsidiaries where costs are rising (France). These transactions will, of course, take into account exchange rate movements so that we do not negate gains from interest rate differentials by losses from varying currency rates. Currency depreciation makes imports more expensive, but exports become more attractive, so our ideal strategy would be to encourage our subsidiary in France where the currency is appreciating to import supplies from the U.S., where the dollar is depreciating. This will have a positive effect on profits in both our subsidiaries in the U.S. and France. Stock market volatility is bad if we are selling shares, but it is beneficial if we want to buy shares to gain greater control of our subsidiaries, especially if we foresee threats of domestic control by other parties. We can also take advantage of volatility to raise capital by buying our shares when prices are low and selling them when they recover. After all, we are in the best position to know our profitability and whether our shares are priced rightly. The traditional view of firm valuation on which the stock price is based relies on net present value of all future cash flows, but by determining the impact of different inflation, interest, and currency exchange rates on the operations of our subsidiaries and managing our financial resources well by addressing risks, we can determine the optimal level of our fund movements within the company's internal fund transfer mechanisms so as to maximise the value of our firm and, hence, our shareholder value and stock price. Key Objective: Maximise Value There are risks we cannot take, so we need to put in place an international financing strategy designed to make the remittances within the company efficient by minimising our financing costs, reducing the riskiness of operating cash flows, and achieving the right global financial structure (Shapiro, 2003). This design of our financing strategy is guided by a focus on maximising shareholder value (Drucker, 1955) by earning the highest profits at the least costs, managing our financial risks and using our funds with greater efficiency. Core Financial Policies We have identified four core policies to unify our understanding of international finance strategy and our appetite for risk management. 1. Minimise Weighted Average Cost of Capital (WACC): We are doing this through internationalisation of our firm's ownership structure, the sourcing and application of debt and equity funds from different countries where we have our subsidiaries to take advantage of market imperfections that result in interest and exchange rate differentials. Our subsidiaries take on domestic debt and equity, at reasonable levels, to minimise the over-all risk to the firm's finances brought about by events over which we have no control. 2. Pay the Price of Risk Management: Financial risk management is like insurance policy; it costs something. We need to pay that price, just as we pay for accident insurance, for our peace of mind and to protect the company and our shareholders from the worst that could happen. We also commit to evaluate every single risk and pay the best and just price as part of good governance (Tirole, 2001). 3. Exercise Good Management: We manage our risks guided by a clear set of financial policies. This allows our subsidiaries to mitigate risks and exploit synergies that are good for the company. A unified financial risk management strategy lessens the threat that arbitrageurs can manipulate our stock prices (Kahneman and Riepe, 1998). 4. Risk Assessment: A key aspect of our financial strategy is risk assessment by the finance directors of our subsidiaries and headquarters. All finance directors have the task of monitoring and evaluating events worldwide that would affect our profitability, allowing management to assess risks so as to carry out the best strategy that will maximise value (Sharpe, 1991). Looking at the events just outlined, how should we adjust our operating, investment, and financing strategies Our Risk Management Strategies We face a complex and challenging web of risks we need to manage and, in the light of recent developments in France, we can add political risks to this simmering brew (Economist, 2006). Currency risks arise from the depreciation of the U.S. dollar and the strengthening of the Euro against the sterling. Dollar depreciation lowers our U.S. profits as imports by our U.S. subsidiary become more expensive. Euro appreciation has a mixed effect: it increases profits in pounds sterling but lowers costs of imported supplies by our French subsidiary. This makes products made in but sold outside the Euro zone less competitive as appreciation results in a corresponding depreciation in other foreign currencies. Appreciation threatens to make future Euro debt exposures more expensive. Interest risk results from variations in interest rates in Brazil, where rates are highest and where investment funds are needed, compared to the U.K., U.S., and Europe. We face inflation risk in the U.S., increasing our cost of doing business there and raise interest rates, as the U.S. Federal Reserve uses monetary policy to fight inflation by tightening money supply (Samuelson and Nordhaus, 2005, p. 401). This rise in interest rates and the tightening of money supply to the U.S. economy will dampen dollar depreciation, as demand for U.S. dollars in the currency markets increases (Samuelson and Nordhaus, 2005). Market risk due to stock market volatility worldwide is a risk we can manage. The political risk in France is due to controversies in labour market prices and policies. We do not foresee any relief in the near future, so we need to find access to lower cost supplies for our products assembled and sold there. The political risks in Brazil (CIA, 2006) are something we can confidently handle. We are working closely with our global network of banks and financial teams to design a variety of instruments that will take advantage of these developments and capitalise on the changing conditions of the financial markets. Aside from looking for ways to tap the international bond markets with a menu ranging from plain vanilla to complex multiple currency bonds, we are also looking into the use of derivatives to minimise losses (Shapiro, 2003, p. 154). An Appendix explains these instruments for your guidance. Foreign Investment Decision However, one transaction requires intervention from headquarters. There is a way to satisfy the need of our Brazilian subsidiary to expand capacity and our French subsidiary to access lower-priced parts to stay competitive in the Euro market. Discussions with our French subsidiary allowed us to craft a solution that takes advantage of low-interest rates in Europe. Our French subsidiary will issue a Euro-denominated bond, investing the proceeds in our Brazilian subsidiary in exchange for a supply agreement to be secured with a series of forward contracts. This decision includes the need to downscale and re-engineer our supply chain in France. The Euro profits from cost savings our French subsidiary would derive from taking these steps will be sufficient to meet future obligations from the bond issue. The next twelve months promise to be full of challenges and changes. In a world of change, the key to global competitiveness is our ability to adjust to change and uncertainty at a faster rate (Shapiro, 2003, p. 11). With clear and robust policies and strategies to guide us, every one of our workers - you can count me amongst them - will be driven each day to make our company the great one we want and expect it to be. Bibliography CIA (Central Intelligence Agency) (2006). The world factbook: Brazil. Updated 29 March 2006. Retrieved 3 April 2006, from Drucker, P. F. (1955). The practice of management. New York: Harper & Row. Economist, The (2006). A tale of two Frances. The Economist, 1-7 April, p. 22-24. Eiteman, D.K., Stonehill, A.I., and Moffett, M.H. (2004). Multinational business finance, 10th ed. New York: Addison-Wesley. Froot, K.A., Scharfstein, D.S. and Stein, J.C. (1994). A framework for risk management. Harvard Business Review, November-December, p. 91-102. Hull, J. (2000). Options, Futures, and Other Derivatives, 4th ed. New York: Prentice Hall. Kahneman, D. and Riepe, M. W. (1998). Aspects of investor psychology. Journal of Portfolio Management, 24 (4), p. 52-65. Merton, Robert C. (1987). A simple model of capital market equilibrium with incomplete information. Journal of Finance, 42, 483-511. Read, C. and Kaufman, S. (Eds.) (1997). CFO: Architect of the corporation's future, by the Price Waterhouse Financial & Cost Management Team. New York: Wiley & Sons. Samuelson, P.A. and Nordhaus, W.D. (2005). Economics, 18th ed. New York: McGraw-Hill. Shapiro, A. (2003). Multinational financial management, 7th ed. New York: Prentice Hall. Sharpe, W.F. (1991). The arithmetic of active management. Financial Analysts' Journal, 47 (1), p. 7-9. Stiglitz, J.E. (1981). Credit rationing in markets with imperfect information. American Economic Review, 71 (3), p. 393-410. Tirole, J. (2001). Corporate governance. Econometrica, 69 (1), p. 1-35. Appendix: Derivatives and Risk Management (Sources: Eiteman et al., 2004; Shapiro, 2003; Hull, 2000) Derivatives derive their value from some underlying asset such as a stock, bond, or currency, index, or reference rates. The four types of derivatives contracts - futures, forwards, swaps, and options - are commonly used to manage currency and interest rate risks Derivatives are an effective way of hedging financial risks. A futures contract is an order you place in advance to buy or sell an asset or commodity. This form of derivative, which refers to any contract where you agree today on the price of a future delivery, has been used in business for centuries. The price is fixed when you place the order, but you do not pay for the asset until it is delivered. This protects the buyer from inflation risk because the amount of the payment has already been fixed. It may also protect the seller in case the price of the goods goes down for some reason, say over-supply. This, however, does not protect either party from currency risk. A forward contract is similar to a futures contract, except that forward contracts are traded whilst futures contracts are not. A forward contract may be based on a futures contract, but whereas a futures contract is priced according to the selling price of the goods, a forward contract is priced much lower depending on the projected cost advantage of buying the futures contract. Forward contracts for currencies, bonds, and commodities are bought and sold in exchanges. A swap is a back-to-back financial transaction where two counterparties agree to exchange financial obligations. Swaps are effective against interest rate, currency, and inflation risks. Just like forward contracts, the counterparties to the swap promise to pay the price for a future agreement, but unlike forward contracts, both parties assume an underlying obligation. Swaps can also be used to exchange interest rates (floating to fixed), exchange both currencies and interest rates (fixed dollar loans to floating Euro loans), or exchange commodities prices. An option is like an insurance policy and gives one party the choice to buy (using a call option) or sell (put option) an asset on a given date at a certain price, or to decide not to do so if it is not financially attractive. Options are of two styles: European, which can be cashed in or exercised only when they expire, and American, which can be exercised any time during the option's life. Read More