Multinational Enterprises
Lecture 1
Forms of Business Organizations
Goal of a business is to earn profits
Sole Proprietorship - one person owns / operates business
Business is dissolved when owner dies
Most numerous business in the U.S.
Farms, restaurants, hotels, grocery stores, etc.
Partnership - two or more people own a business
Accounting and law firms
General Partnership - other partners are liable for the actions of any partner, such as stealing, fraud, etc.
Creditors can go after other partners
Example - a partner secretly applies for a bank loan, steals the money, and leaves the country
Limited liability partnership - creditors cannot go after the personal assets of the partners
Corporations
Approximately 20% of businesses are corporations, and they dominate businesses activity
Shareholders own the corporation through stock
Corporate managers should
Maximize stock prices
Maximize the shareholders' wealth
Maximize a firm's value
Corporations
Initial Public Offer (IPO) - a private company transforms into a corporation
Usually company's founder is a majority shareholder
Founder becomes a millionaire or billionaire over night
Charter - legal document that establishes a corporation as a legal person
Three parties
Shareholders - own the corporation
Meet once a year to elect the board of directors
One share equals one vote
Shareholder could be another corporation
Usually majority shareholder elects himself or herself to the board of directors
Board of Directors - control the corporation
Set corporate policy
Declare dividends
Appoint the upper management to run the day to day operations of the corporation
Benefits of a corporation
Raise substantial amount of financial capital
Enter foreign countries and dominate international trade
Have special departments that handle operations in a foreign country
Requires many specialists in laws, taxes, etc. for different countries
Has limited liability
Stockholders are not liable for a corporation's debt
They can only lose the value of stock, i.e. their investment
Can easily transfer ownership
Stockholder can buy or sell shares on a stock exchange
Have continuity of life; they can live forever theoretically
Do not have mutual agency relationship
Shareholders cannot bind a corporation to contracts
Problems of corporations
Corporations are heavily regulated
File many reports with government
Corporations may encourage this!
Makes it more difficult for a new company to enter a market
Corporations are taxed twice
Corporations pay taxes on profits, i.e. net income
Stockholders receive profit from corporation as dividends
Stockholder’s income subject to income taxes
Types of stock
Common stock - shareholders can vote at stockholder meetings
Preferred stock - shareholders cannot vote at stockholder meetings
Preferred shareholders receive their dividends before common shareholders
If corporation is liquidated, then preferred shareholders come before the common shareholders
Why issue preferred stock?
Common shareholders do not dilute their control of the corporation by issuing preferred stock
Types of preferred stock
Cumulative preferred stock - stockholders receive all past due dividends before common stockholders
Protective preferred stock - corporation must deposit part of its profits into a fund to pay preferred stockholders
Redeemable stock - corporation has the right to buy back the stock in the future
Convertible stock - a preferred stockholder can convert their stock into common stock on a specific date
Bond - a standardized loan to a corporation
Investors can easily buy / sell bonds in a market
Bondholder has two rights
Corporation must pay interest
Corporation must repay the bond's face value on the maturity date
If a corporation bankrupts and is dissolved
Must pay taxes first
Bondholders and other loans come second
Preferred shareholders come third
Common shareholders are last
Corporations create complex structures
Reason - regulations, taxes, and lawsuits
If lawyers sue a corporations subsidiary, then the parent corporation can spin off the subsidiary, and let the legal sharks eat it
Example - a judge sued a dry cleaner's for $65 million for losing his pants
Example - Halliburton owned Brown and Root
Brown and Root was liable for asbestos claims
Halliburton sold it off to protect itself
Corporations establish headquarters in tax havens
Bahamas and Cayman Islands - low taxes, little regulations, and strong confidentiality laws
Corporation moves assets and liabilities around to reduce tax burden
Tax evasion
A business or person did an activity that generates a tax
If he or she does not pay, then this is tax evasion
The punishment is fines and prison
Greece has a severe tax evasion problem
Tax avoidance
A business or person structures an activity to avoid legally paying a tax
Since the 2007 Great Recession - tax authorities are becoming aggressive at collecting for tax avoidance
Example - tax inspectors in Italy board yachts as the dock in Italian ports
Stockholders want a good return on their investment
shareholder return = dividend yield + capital gains
Managers can influence dividend yield
Usually 2% per year
dividend yield = 100*dividend / stock price
Managers have little influence on capital gains
Usually 12% per year
Severe stock market declines can cause capital losses
Examples - many stocks took a beating in 2000 and 2008
capital gains = 100*(stock price2 - stock price1)/stock price1
Example
Apple's currently stock price is $669.72
Apple paid a $266 per share dividend, which is the first since 1995
Apple's stock price was $381.32 a year ago
Dividend yield is 0.397%
Capital gain is 75.63%
Total return is 76.0%
Corporate Fraud
1. Enron bankrupted in 2001
Special Purpose Entities (SPE)
Companies / subsidiaries
Shell company - exists only on paper, or office has one desk and filing cabinet
Off-balance sheet companies
Enron used SPEs to improve its financial statements artificially
Enron invested in many power plants around the world
Some investments went bad, and Enron sold its bad investments to its SPEs
Balance sheet looks better
Can get more loans
Enron invested in more power plants around the world
Enron hid $25 billion in debt
SPE
Funded by Enron stock
As Enron stock price rose, the SPE's finances were healthy
Enron's stock peaked at $90 per share
As Enron stock price fell to less than a $1 in 2000, then SPE's accumulated large losses
Enron hid the losses
Recession occurred in 2001
A recession always reveals an organization's weakness
Enron tried to get more bank loans
Enron employees had their pensions invested in Enron stock
Most overlooked the SPEs, including the following:
Auditor, Arthur Anderson
Law firm
Regulators such as the Securities and Exchange Commission (SEC)
U.S. government passed the new law, Sarbanes-Oxley Act in 2002
CFOs and CEOs must sign the firm's financial statements
Increase transparency
Transparency - outsiders can accurately assess a firm's true finances
Enron - "a black box"
Non-transparent government - tends to be corrupt
Laws and rules are not written down; tend to be vague, etc.
Bureaucrats have wide discretion to approve licenses, etc.
Did the new federal law fix any thing?
The scale of fraud became much larger during the 2008 Financial Crisis
The United States experienced a real estate housing bubble, 2000 - 2007
Lehman Brothers used exotic derivatives and bought expensive real estate at the peak of the bubble
Credit Default Swaps
Collateralized Debt Obligations
Bank and bond debt was $768 billion
Assets were $639 billion, but falling fast as the property bubble deflated
Lehman Brothers closed its door after 158 years of business
2. Countries differ in corporate structure and planning
U.S. corporations focus on short-term profits
Problems with corporate fraud
Japanese Keiretsu - tend to focus on long-term profits and market shares
Keiretsu - a conglomerate of many companies with a bank as a member
Bank grants low interest loans to partner companies
Similar in South Korea, Germany, and Russia
Popular in the former communistic countries
Government forms a joint venture company with foreign companies
Foreign companies bring technology and management expertise
Government retains control over company
Prone to corruption - if company cannot compete, then government uses its power to protect company
3. Principal-Agent Problem - two related parties have different incentives which conflict with each other
Corporation separates the managers from the owners (i.e. stockholders)
Managers are supposed to:
Maximize profits
Maximize the return to the shareholders
Increase shareholder value
Managers may not act in the best interest of the owners
Managers want high salaries, benefits, etc.
Example 1
U.S. Investment banks were partnerships; very careful with money
During 1990s, investment banks were converted to corporations
Managers gambled and took high risks
Shareholders lost their stock value during 2008 Financial Crisis
Example 2 - GM cancelled its stock, and its shareholders lost everything in 2008
A family owned corporation may reduce the principal-agent problem
Stockholders and top management are the same people
Examples: Walmart and Microsoft
Tend to earn high returns
Management has better vision, oversight, etc.
Law of Comparative Advantage
1. Multinational corporations
Multinational corporation - corporation is incorporated in one country, and has one or more operations and offices in foreign countries
British Petroleum, General Electric, Toshiba, and Wal-Mart
Multinational enterprise - includes businesses where government forms a joint venture with a corporation
Enterprises go international to make profits
Have a choice - export to country or relocate production to a foreign country
Why does a firm chose investment over exports?
Government offers subsidies and tax breaks
Dubai and China have free trade zones
Few regulations and low taxes
Gain access to technology from another country
India has software programmers
Indians work for lower wages than Americans and Europeans
A company that produces within a foreign country automatically avoid tariffs and import quotas
Reduce transportation costs - more processing in closer proximity
Example - sugarcane is bulky to ship
Sugar mills extract and purify the sugar, which is exported to foreign markets
Gain access to new markets and more consumers
Coca-Cola and McDonald's
A company investing in a foreign country could lead to future expansion
A company opens a branch in Moscow, Russia. Company could expand to other Russian cities or other Russian-speaking countries
A company could reduce economic exposure
Economic exposure - changes to a company's profits because an economic factor changed, such as inflation, interest rate, or exchange rate
If a country produces and sells within the same country, changes in the exchange rate impact its profits less
A company diversifies its business by expanding into foreign countries
Some markets grow quickly, while other markets experience weak growth
Require important raw materials for production
Example - Bolivia possesses half the world's supply of lithium, which is used to make laptop batteries
Firms relocate there to extract and purify lithium
Reduce production costs - many companies relocated to China and Mexico, because the wages are lower relative to productivity
A company outsources its production to another company to lower its costs
Example, Microsoft outsourced its production of X-box consoles to Flextronics, a Singaporean company
Flextronics outsourced production to a Chinese manufacturing plant
Political Safety - companies relocate to countries that are business friendly
Bahamas, Dubai, Singapore, etc.
2. Markets are defined as two types
Mature economies - United States and Europe
Very competitive
Difficult to make money
Emerging Market Economies - countries that are opening up to markets
China, India, and Mexico - opening to more markets
Emerging markets can be very profitable, but entail greater risk
Requirements
Open Market place
Government must allow free markets and allow free movement of capital, labor, and technology
Strategic Management
Management has the ability to compete and develop new products and services
Adapt products and services to different cultures
Access to capital
International activities require financing
Government must allow the free movement of money
Corporations can issue more stock, bonds, or receive bank loans
3. Multinational firms are more complicated
Businesses transfer resources like machines, equipment, and labor and transfers products and services between different countries
Enterprises are exposed to exchange rate risks and credit risks
Enterprises have other exposures too like country risk (or political risk)
Example 1 - Hugo Chavez in Venezuela nationalized foreign companies
Government seizes assets and companies without compensation
Example 2 - Kazakhstan - former communistic country
President Nazarbayev opened the economy up to free markets in early 1990s
After 2008, Kazakhstan is reverting to Soviet rules and practices
Kazakh government nationalized a petroleum company
International investment plummeted
4. Comparative advantage - how two countries can benefit from trade, even though one country could be large and produce everything
David Ricardo
Show how two countries benefit from trade
Assumptions
Both countries are at full employment (i.e. on production possibilities curve)
PPCs are straight line (no losses occur when moving resources from industry to industry
Works with curved PPCs
U.S.A. and Mexico produce both tomatoes and cars
No trade - set production at the half way point
Autarky - no trade
U.S. produces 25 tomatoes and 50 cars
Mexico produces 30 tomatoes and 15 cars
Total production is 55 tomatoes and 65 cars
Comparative advantage - countries specialize in production of products which they have low opportunity costs
Important because a large country like the U.S. that can produce everything at low cost can still benefit from trade with a small country with higher costs
Related to slopes of the PPC
Complete specialization - U.S.A. produces all cars and Mexico produces all tomatoes
PPCs are straight lines
Total production is 100 cars and 60 tomatoes
Gain in production of 35 cars and 5 tomatoes
Need more trade theory to show how countries divide up the extra production
Limitations
Capital and technology can easily flow from one country to another
Outsourcing - a firm sends out part of its production to another firm in another country
Communication and transportation costs are decreasing