Performance of Multinational Companies - Essay Example

1.0 Extra Financial Factors Multinational companies are defined as business firms that operate in two or more countries with international sales and a multinational mix of managers and owners. This definition alone carries with it implications and ramifications that differentiates with the financial arrangements of a domestically based firm. First and foremost in the consideration is that no countries have the same currency denominations. For example, an American firm operating in Japan will expect that its sales income is in terms of yen for that certain country. Companies from the United Kingdom operating in China will expect that their payments for locally sourced supplies and other logistics will be in Chinese Yuan. Because currency exchange rates fluctuate on a daily (minute-to-minute) basis, clean and easy apples-to-apples comparisons of U.S. dollars to Euros or Yen may not be possible, especially with systems that deal with data on an intraday basis. Tracking the profitability of products in varying markets will fall short of expectations unless data stores and currency tables that contain detailed exchange rates and valuation dates are properly integrated into the general warehouse or operational data store. Many currencies will be tracked against other currencies - the simplest being home currency versus the single currency of the trade/deal/transaction - using parallel fields for each denomination in the appropriate warehouse tables. Thus, if a transaction took place in Japan (in Yen), multiple fields that represent the event would have both U.S. dollars and Yen denominations that communicate up-to-date or restated exchange rates. The business firm must also be aware that the location of the transaction does not always unequivocally define the currency of the transaction. Many financial events such as currency swaps and spots will fall into this category, making it more laborious to correctly portray the financial picture of the business. Unexpected changes in the values of foreign currencies can affect the profitability of doing business internationally by unexpectedly changing the home currency value of future foreign currency-denominated cash inflows and outflows. This implies that organizations will need to consider implementing foreign exchange “hedging” strategies to mitigate the adverse consequences of unexpected and profit-reducing exchange rate changes. Suffice it to say that organizations may wish to seek the assistance of available expertise in the banking or brokerage communities to design and implement a foreign exchange hedging strategy. As a related point, international operations entail the accumulation of short-term and long-term assets and liabilities that must be managed. Differences in economic conditions from country to country may oblige management to treat foreign assets and liabilities differently from domestic assets and liabilities. An obvious example is provided by countries where there is some significant risk of governments imposing restrictions on the transfer of foreign-held funds out of their countries. In such circumstances, foreign companies will find it inadvisable to hold accounts receivables and other short-term assets for as long as they might ordinarily hold such assets in their home market. This problem is compounded by the difference in accounting procedures that is applicable in the country although the fundamental principles are not that varied. International firms will also different economic and legal ramifications. For example, the other country may have different taxes and wages required as compared to the mother country. In effect, they may need some modifications in their cash inflows and outflows providing additional categories or deleting some items. Other such examples can be cited, but the main point, again, is that international business management extends to virtually all aspects of the financial management activity in more or less subtle ways 2.0 Forecasting Country Risks The field of forecasting is concerned with approaches to determining what the future holds. It is also concerned with the proper presentation and use of forecasts. Forecasts may be conditional. That is, if policy A is adopted then X is likely, but if B is adopted then Y is most likely to occur. Often forecasts are of future values of a time-series; for example, the number of babies that will be born in a year, or the likely demand for compact cars. As with all inquiries, the knowledge where forecasting country risks come from is “research.” In brief, you need to know about the relevant causal relationships. The knowledge of various theories will prove to be helpful. For example, in many situations it is useful to know the economic theory that an increase in the price of a thing will tend to lead to a decrease in demand for it, and vice versa. Experts will tend to know about evidence from prior research, such as which causal (explanatory) variables are important, and the direction and magnitude of relationships. The analysis of risks falls into two categories. One is trends, the other is current but compared characteristics. In the case of trends, the matter is relatively simple, although perhaps somewhat deceptive. If there is a record of expropriation, the new investor obviously needs to be concerned. If the current government of a host country has previously nationalized foreign industry, potential investors obviously need to pay attention to the possibility that they, too, could be nationalized. Similarly, a history of civil strife and especially the occurrence of ongoing wars indicate a high likelihood that direct damage could occur to the investment or that contracts could be repudiated under war circumstances. The second approach is to examine current societal attributes and the circumstances under which losses have occurred before, either in that same country or others like it. If high levels of ethnic tension are often followed by open ethnic conflict, for example, that civil strife could result in damage to businesses or in forced abandonment of the investment, as happened in 1994 in Algeria. There are broad categories which are needed to be analyzed for determining country risks. These include an assessment of the legal risks such as lack of precision in the legislation and possibility of change in the legislation. Monetary risks comprise of issues such as exchange rate fluctuations, non-convertibility of the local currency into foreign currencies, and non-transferability. Economic risk analysis includes investigation on macroeconomic factors such interest rates and Gross Domestic Product. One cannot also do away with political risk analysis such as expropriations, nationalizations, non-compliance with the contract and inefficiency of administrative authorities. There is also a need to investigate interference risks or the tendency of public authorities to take a direct intervention in the management of the project. Lastly, the forecaster could also include in the forecasts a note on force majeure events such as natural risks, industrial risks, internal socio-political risks and risks of war or armed conflict. Forecasting methods can be classified first as either subjective or objective. Subjective (judgmental) methods are widely used for important forecasts. Objective methods include extrapolation (such as moving averages, linear regression against time, or exponential smoothing) and econometric methods (typically using regression techniques to estimate the effects of causal variables). The decision to which method will be used depends on the situation and some companies would usually have their internal forecast models that they deemed to be appropriate. 3.0 Globalization of Financial Markets Investing abroad has been a fundamental part of institutional investor’s strategy for quite some time now, but now globalization of financial markets has given the traditional investor a chance to take advantage of the opportunities abroad. Over the last few years, especially since the U.S. recession in 2001-2002 when U.S. equities struggled, investors have looked for opportunities elsewhere. Many have migrated to international investments due to a great deal of hype regarding their ability to add value and diversification to traditional portfolios. It is commonly states that if you haven’t added international investments to your portfolio, you are already behind the curve. Most experts attribute globalization of financial markets to improvements in communication, transportation, and information technologies. For example, not only currencies, but also stocks, bonds, and other financial assets can be traded around the clock and around the world due to innovations in communication and information processing. A three-minute telephone call from New York City to London in 1930 cost more than $300 (in year 2000 prices), making instant communication very expensive. Today the cost is insignificant. The advances in communication and information technologies have helped slash the cost of processing business orders by well over 90 percent. Using a computer to do banking on the Internet, for example, costs the banking industry pennies per transaction instead of dollars by traditional methods. Over the last third of the 20th century the real cost of computer processing power fell by 35 percent on average each year. Vast amounts of information can be processed, shared, and stored on a disk or a computer chip, and the cost is continually declining. People can be almost anywhere and remain in instant communication with their employers, customers, or families 24 hours a day, 7 days a week, or 24/7 as it has come to be known. Further developments in mobile communications technology and Wireless Fidelity (wireless access to the internet) have enabled the instant communication between investors and financial markets. Increases in open financial markets and financial product innovation have also played important roles in the globalization of financial markets. The globalization and integration of international financial markets has provided liquidity for smaller investors to enter international markets that were once considered taboo because of their high risk. Not only do these innovations make it easier to provide sound investments for investors, but it increases the ability for the less-developed nations to “catch up” quicker than previously thought possible therefore increasing the opportunities available abroad. Some international markets which have been touted as having a higher degree of risk because of political instability, lack of financial infrastructure and vulnerability to large swings in the nation’s economy have now become relatively stable and investor friendly. As time has passed, the once “too risky” international markets have become much more mainstream as a diversification tool for traditional investment portfolios. 4.0 Major Economic and Financial Factors for Forecasting Before establishing operations in a foreign market, multinational corporations see it fit that they evaluate the economic profile of the country. Although it is difficult to generalize about what makes any foreign market a good fit with an organization’s sustainable competitive advantages, there are certain attributes of foreign markets that are bound to be relevant to most organizations considering an international expansion. Several of these broad initial criteria are the following: Total GDP, GDP per capita, Total population demography, Political stability, Climate/topography, Transportation/logistical systems, Tariff/non-tariff barriers and Government laws and regulations. A larger and wealthier market generally makes the market more attractive as a target for international expansion. A relatively large middle-class is also generally a desirable feature of a market, since it implies the existence of a broad group of potential buyers for many products. Of course, if the organization’s products are targeted at narrowly defined customer groups, e.g. medical devices used by elderly people, other demographic features may be more important than the share of the population that is middle-class, e.g. the share of the population aged 65 and older. Most companies would prefer considering microeconomic attributes after having first screened potential markets using a set of broader criteria such as those that I have listed as broad initial criteria. This is because it is ordinarily much more difficult and costly to obtain information about microeconomic attributes such as the number and size distribution of competitors than it is to get information about attributes such as total population, per capita income and so forth. It therefore seems desirable to use broad criteria as an initial basis for screening potential foreign markets. Then management can focus on a relatively small number of potentially attractive foreign markets for purposes of doing a more detailed microeconomic analysis of each market’s profit potential. If the broader economic attributes of a potential market seem favorable and, in addition, offer a promising fit with the organization’s sustainable competitive advantages, the next plausible analytical step for management is to estimate the sales and profit potential of that market. Several microeconomic considerations are particularly relevant to such an analysis and include: a) competitors’ product prices and characteristics, b) market structure such as number of rivals, size of distribution of rivals and barriers to entry, c) distribution channel structure (access to customers) and d) customer segments. The investor could investigate on more specific issues. This would include risks such as insolvency of the buyer, risk of protracted default or the failure of the buyer to pay the amount due within six months after the due date, risk of non-acceptance and surrendering economic sovereignty. There are also political risks (which would influence economic conditions) that must be taken into consideration such as the risk of cancellation or non-renewal of export or import licenses, conflict risks, risk of expropriation or confiscation of the importers company, risk of the imposition of an import ban after the shipment of the goods, transfer risk or the imposition of exchange controls by the importers country or foreign currency shortages. The World Bank currently has a numerical measure/ ratings in determining the ‘business friendliness’ of countries. An analysis of the financial factors would include analyzing trends and issues in the following: Commodities/Futures, Derivatives, Equity concepts, Money markets, Exchange rates, fixed income, Financial Indexes, Stock markets, and Commitment of Traders Data when available. 5.0       Volatility of Exchange Rates             Volatility is defined as the degree to which a certain variable changes value over time. The larger the magnitude of a variable change, or the more quickly it changes over time, the more volatile it is. Exchange rate volatility is often attributed to three factors: volatility in market fundamentals, changes in expectations due to new information, and speculative "bandwagons". Volatility in market fundamentals, such as the money supply, income and interest rates, affects exchange rate volatility because the level of the exchange rate is a function of these fundamentals. For example, large changes in the money supply can lead to changes in the level of the exchange rate. Changes in the level of the exchange rate in turn imply exchange rate volatility. Changes in expectations about future market fundamentals or economic policies also affect exchange rate volatility. When market participants receive new information, they alter their forecasts of future economic conditions and policies. Exchange rates based on these forecasts will also change, thereby leading to exchange rate volatility. For example, news about a change in monetary policy may cause market participants to revise their expectations of future money supply growth and interest rates, which could alter the level and hence the volatility of the exchange rate. In addition to being affected by expectations of future fundamentals and policies, volatility is also affected by the degree of confidence with which these expectations are held. For instance, if traders are uncertain about their forecasts of future economic conditions, they are more likely to revise their currency positions once new information becomes available. These revisions to currency positions in turn imply an increase in the frequency, and hence in the volatility, of exchange rate changes. In brief, exchange rate volatility tends to rise with increases in market uncertainty about future economic conditions and tends to fall when new information helps resolve market uncertainty. Finally, exchange rate volatility can be caused by speculative bandwagons or speculative exchange rate movements unrelated to current or expected market fundamentals. For example, if enough speculators buy dollars because they believe the dollar will appreciate, the dollar could appreciate regardless of fundamentals. If it then becomes apparent that market fundamentals will not sustain such an appreciation, active selling by the same speculators could cause the dollar to depreciate. Swings in the value of the dollar arising from such speculative forces can contribute to exchange rate volatility.             The degree of economic activity by which confidence and expectations may be based is also influenced by the political climate and social conditions of the country. Political crisis such as a coup d’ etat (military takeover) could cause panic and flight of investors carrying along with them huge amounts of capital. Perhaps good examples of the way social upheavals are influencing exchange rates are the weakening of the currency after a terrorist activity such as the way the US dollar declined after the September 11 bombing of the World Trade Center . Of course, it doesn’t have to be confined to the activities within the nation but may also be brought about by arrangements or conflicts between nations. For example, there are many studies establishing the relationship between oil price increases imposed by the Oil and Petroleum Exporting Countries (OPEC) and the resulting fluctuations in exchange rates. To prevent excessive swings from occurring or preventing it from happening at all, the Central Bank of the nation may intervene. However, opinions differ on whether central banks can stabilize exchange rates. Some analysts believe central bank intervention can reduce exchange rate volatility by stopping speculative attacks against a currency. Other analysts, though, believe central bank intervention may increase volatility if the intervention contributes to market uncertainty or encourages speculative attacks against the currency. In any case, exchange rate volatility is undesirable. Regardless of its origin, there are several reasons why authorities may want to reduce exchange rate volatility. One reason is that volatility may impede international investment flows. By adding risk to the rate of return on a foreign asset, exchange rate volatility may reduce investment in foreign financial assets. In addition, companies may be reluctant to build a new plant or purchase a foreign company if exchange rate uncertainty reduces the expected profits from such projects. As a result, exchange rate volatility could disrupt the efficient allocation of resources in the world economy by creating a disincentive for investment capital to move abroad. Another reason why authorities may want to reduce volatility is that it may adversely affect international trade. Volatile exchange rates create uncertainty about the revenues to be earned on international transactions. Such volatility could force companies to add a risk premium to the costs of goods they sell abroad. If these costs are passed on to consumers in the form of higher prices, the demand for traded goods could decrease. In addition, firms themselves may be more reluctant to engage in international trade if exchange rate volatility adds an extra risk to their profits. References: Wolf, Martin (2004). Why Globalization Works. Yale: Yale University Press Read More