Finance

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Chapter 10 Finance Accounting
Learning Objectives

• 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

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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

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Overview of globalfinancial 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.

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Figure 11.1 Overview of global financial markets
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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 worlds 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

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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

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From fixed to floating exchange rates
international diversity
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Monetary policy among IMF member states, 2006
Source IMF (2006) Monetary policy framework,
www.imf.org
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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

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Figure 11.4 The US dollars decline against
other major currencies, 200206
Source Financial Times, 6 December 2006
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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

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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.

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Figure 11.5 Internal and external factors in
the Asian financial crisis
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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

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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.
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Figure 11.6 Amounts outstanding on interest
rate and currency swaps
Source Financial Times, 19 June 2007
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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.

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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.

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Figure 11.7 Number of listed companies on major
stock exchanges, 2006
Source World Federation of Exchanges (2007)
Statistics, www.world-exchanges.org
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Figure 11.8 Leading exchanges shares of total
share trading by value, 2006
Note Global total US69,829,943.7 millions
Source World Federation of Exchanges (2007)
Statistics, www.world-exchanges.org
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Figure 11.9 Shifting investments of worldwide
pension funds
Source Financial Times, 10 October 2005
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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
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Figure 11.10 A comparison of equity and debt
financing for private and public companies
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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.
• MA 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 MA
  deals which would result in market dominance.

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Cross-border mergers and acquisitions by
companies in developed and developing economies
Source UNCTAD (2006) Cross-border MA sales by
region and economy of purchaser, www.unctad.org
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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.

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Growth in hedge funds
Source Financial Times, 27 April 2007
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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 companys 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.

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Figure 11.13 Influences on national accounting
practices
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• Case studies
• 11.1 Sparks fly in Mittal Steels takeover of
  Arcelor (page 417)
• 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. Mittals 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 Mittals main means of gaining
shareholder consent. His promise to reduce his
control also influenced them to accept his bid.
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• Case studies
• 11.1 Sparks fly in Mittal Steels takeover of
  Arcelor (page 417)
• 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. Two-thirds 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. Mittals 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.
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• Case studies
• 11.1 Sparks fly in Mittal Steels takeover of
  Arcelor (page 417)
• 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.
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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.