Week Nine - Strategic ing Issues In Multinational Corporations 2o6i2n

Week Ten

Strategic ing Issues in Multinational Corporations

McGraw-Hill/Irwin

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Strategic ing Issues in Multinational Corporations Learning Objectives Explain the role played by ing in formulating multinational business strategy. 2. Demonstrate and understanding of multinational capital budgeting. 3. Describe the factors that influence strategy implementation within a multinational corporation. 4. Discuss the role of ing in implementing multinational business strategy. 5. Identify the issues involved in the design and implementation of an effective performance evaluation system within a multinational corporation. 12-2

Strategy  Strategies are large scale plans that reflect the desired direction of the company.  Strategy formulation involves determining organizational goals and strategies to achieve those goals.  Strategy implementation involves managerial efforts to influence employees to attain organizational goals.  Managerial influence is also referred to as management control.  ing has a significant role to play in strategy formulation and implementation.

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ing and Strategy Formulation  Information is a key ingredient in the strategy formulation process providing information about both internal and external factors.  This involves analysis of customer, market, and competitor information, risk assessment.  It also includes financial expressions of firm strategy and preparation of budgets.  Capital budgeting is an important part of strategy formulation.

Learning Objective 1

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ing and Strategy Formulation Budgeting  Budgeting is the primary use of ing information in strategy formulation.  Budgeting assists in strategy formulation by providing managers with information about short-term and long-term planning responsibilities.  Budgeting also provides expectations against which future results can be judged.

Learning Objective 1

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Capital Budgeting Overview  The fundamental concepts of capital budgeting are the same in either a domestic or international context.  Large, long-term investments are referred to as capital investments.  Capital budgeting is a key activity in selecting capital investments.  Capital budgeting involves three steps: project identification and definition, evaluation and selection, and monitoring and review.

Learning Objective 2

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Capital Budgeting Steps in capital budgeting  Project identification and definition provides a clear basis for understanding the project and predicting the associated cash flows.  Evaluation and selection involves identifying cash flows and then using one or more of the capital budgeting methods to evaluate the project.  Monitoring and review involves updating the analysis and project plan during the implementation stage.

Learning Objective 2

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Capital Budgeting Capital budgeting techniques    

Payback period. Return on investment. Net present value. Internal rate of return.

Learning Objective 2

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Capital Budgeting Payback period  Represents the length of time it takes to recoup the initial investment.  Equal to the initial investment amount divided by the annual after-tax cash flows.  The project will be accepted if the payback period does not exceed a predetermined length.  The primary weaknesses of this method are that it ignores the time value of money, and it ignores the total profitability of the project.

Learning Objective 2

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Capital Budgeting Return on investment  Represents an average annual return on the initial investment.  Equal to the average annual net income divided by the initial investment.  The project will be accepted if the return on investment exceeds a predetermined rate.  The primary weaknesses of this method are that it ignores the time value of money, and it ignores possible cash outlays subsequent to initial investment.

Learning Objective 2

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Capital Budgeting Net present value  Equal to the present value of net future cash flows less the initial investment.  Requires the estimate of minimum rate of return to be used as the discount rate.  The project will be accepted if the net present value is equal to or greater than zero.  The primary weaknesses of this method are that it cannot be used for comparing projects of different sizes and that it tends to be biased toward large investments.

Learning Objective 2

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Capital Budgeting Internal rate of return  Represents the discount rate that results in a net present value of zero.  It is equal to the discount rate that causes the net present value of future cash flows to equal the initial investment.  The project will be accepted if the IRR is greater than the companies desired rate of return (hurdle rate).  The primary weaknesses of this method are that it sometimes requires unrealistic assumptions about reinvestment of funds, and manual calculation is difficult.

Learning Objective 2

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Multinational Capital Budgeting  Capital budgeting in an international context is complicated by several factors.  These factors relate primarily to the risk associated with future cash flows.  These risks are generally categorized as political risk, economic risk, and financial risk.  Taxes, import duties, dividend restrictions, and cash flow limitations imposed by governments also must be considered.

Learning Objective 2

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Multinational Capital Budgeting Political Risk  This refers to the likelihood that political events will impact cash flows.  Nationalization and expropriation of assets is an extreme type form of political event.  Political risk is also associated with changes in foreign exchange controls, repatriation restrictions, tax rules, and labor laws.  This risk can vary significantly from one country to another.

Learning Objective 2

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Multinational Capital Budgeting Economic Risk  This refers to the likelihood that changes in the host country economy will impact cash flows.  Inflation is the most significant of economic risks.  Inflation affects the ability of the local population to purchase goods and also impacts the overall cost structure of a business.  There are also costs associated with manager time and effort to respond to inflation.

Learning Objective 2

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Multinational Capital Budgeting Financial Risk  This refers to the likelihood that changes currency values, interest rates and other financial factors will impact cash flows.  Foreign exchange risk is also a component of financial risk.  Whether to evaluate the project based on host country or parent country cash flows is affected by foreign exchange risk.

Learning Objective 2

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Strategy Implementation Management control  The management control system is the primary mechanism for implementing and evaluating the effectiveness of strategy.  ing is involved in management control primarily through its role in operating budgets and performance evaluation.  Operating budgets provide a link between strategy and performance.  A number of organizational and cultural factors influence management control.

Learning Objectives 3 and 4

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Strategy Implementation Factors affecting strategy implementation  Organizational structure affects strategy implementation.  Different forms of organizational structures include: ethnocentric, polycentric, and geocentric.  Ethnocentric firms use an approach that assumes that the cultural background of the firm is universal.  Polycentric firms consider the culture of the host country to be most important and adopt it.

Learning Objectives 3 and 4

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Strategy Implementation Factors affecting strategy implementation  Geocentric firms often consist of units that play very distinct roles. These roles include: global innovator, integrated player, implementer, and local innovator.  Levels of control and delegation are factors that influence management control system type.  One major type of management control system is bureaucratic control which employs a significant amount of structure.  The other major type is cultural control which is more informal and less structured.

Learning Objectives 3 and 4

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Performance Evaluation Major aspects of performance evaluation  The measure or measures of performance.  Classification of the foreign operation as cost, profit or investment center.  t or separate evaluation of the foreign operation and the manager of the operation.  The profit measurement method.

Learning Objective 5

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Performance Evaluation Performance evaluation measures  Financial measures are based directly on financial statement data.  Examples include net profit, return on investment and comparison of budgeted to actual profit.  Nonfinancial measures are based on data not obtained directly from financial statements.  Examples include market share, relationship with host country government, and labor turnover.

Learning Objective 5

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Performance Evaluation Performance evaluation – Balanced scorecard  This approach gives “balanced” consideration to both financial and nonfinancial measures.  It considers the perspectives of four stakeholder groups.  Shareholder’s perspectives are considered by financial performance measures.  The internal business perspective is reflected in business process measures.  Innovation and learning perspectives and customer’s perspectives are also considered.

Learning Objective 5

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Performance Evaluation Responsibility centers  The idea of responsibility centers is to identify the activities that individual units perform and for which they should be held able.  Cost centers are responsible for producing output using a certain amount of resources.  Profit centers are responsible for costs and revenues.  Investment centers have the responsibilities of a profit center plus responsibility for investment decisions.  Return on investment (ROI) is the most common performance measure for an investment center. Learning Objective 5

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Performance Evaluation Separating managerial and unit performance  In an international context a number of factors exist that cause a disconnect between manager performance and unit performance.  These factors that the manager cannot control are known as uncontrollable items.  Responsibility ing implies that managers should not be held able for uncontrollable items.  Uncontrollable items include those controlled by the parent, the host government, or controlled by others.

Learning Objective 5

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Performance Evaluation Choice of currency in measuring profit  Profit can be measured in either the local currency or parent currency.  Local currency is appropriate if the subsidiary is not expected to pay parent currency dividends.  Otherwise, parent currency is appropriate.  When parent currency is used, the company also must choose a translation method.  Further, a decision must be made about whether to include the translation adjustment in the profit measure.

Learning Objective 5

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Performance Evaluation Translation to parent currency  Since the translation is for internal purposes, financial ing standards need not be followed.  Likewise, the inclusion of the translation adjustment in the profit measure is based on internal needs rather than ing standards.  One factor in this decision is whether the adjustment reflects the impact of exchange rates on parent currency cash flows.  A second factor whether the local manager has the authority to hedge against exchange rate changes.

Learning Objective 5

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Performance Evaluation Choice of currency in operational budgeting  Operational budgets often include budget-to-actual comparisons.  The international context adds an element of complexity due to exchange rate fluctuations.  Exchange rates may change during the period between making the budget and recording profits.  The three available exchange rates are: actual at time of budget, projected at time of budget, actual at end of budget period.

Learning Objective 5

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Performance Evaluation Budget and actual rate combinations  Lessard and Lorange (1977) illustrated five budget and actual exchange rate combinations.  Three combinations involve using the same exchange rate for both budget and actual translations.  A fourth combination translates the budget at the actual rate at the time of budget and translates actual results using the actual rate at the end of period.  A fifth combination translates the budget using a projected end of period rate and translates actual results using the actual rate at the end of period.

Learning Objective 5

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Performance Evaluation Implementing performance evaluation  The success of a performance evaluation system depends on a number of factors. These include:      

Integration of the system with the overall business strategy. of actual results and revision of budget. Comprehensiveness of the set of performance measures. Organizational buy-in. Reasonableness of budgeted measures. Understandability and simplicity of the system.

Learning Objective 5

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Performance Evaluation Cultural considerations in management control  One of the objectives of a management control system is to influence human behavior.  People in different cultures will react differently to aspects of management control systems.  Japan is a more collectivist than the United States.  Management control mechanisms designed in the U.S. to assign individual responsibility will not work as effectively in Japan.

Learning Objective 5

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Example of International Capital Budgeting Lomax Ltd. is an international company based in Australia which manufactures tractors. It is considering building a plant in Hong Kong. The project is expected to cost HK20 Million and is expected to generate HK$9Million per year for 3 years. Spot Rate

HKD5 =1AUD OR AUD0.2 = 1HKD Risk free rate is as follows: Australia : 5% Hong Kong : 7% The company’s required return is 10%. Should this project be undertaken? 12-31

Method One – The Home Currency Approach  Convert all HK$ cash flows to AUS$ and then discount at 10% to find the NPV in AUS$.  We have to come up with the future exchange rates to convert HK$ to AUS$.

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Method One – The Home Currency Approach  Uncovered interest rate parity E (st) = So x 1 + [( RHK –RA )] t E (st) = Expected future exchange rate RHK = Risk-free rate in H.K. = 7% RA = Risk-free rate in Aus = 5% So = Spot rate = HKD5 =1 AUD

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Method One – The Home Currency Approach E (st)

= = YR 1 2 3

5x 1 + ( 0.07-0.05) 5 x 1.02 t

t

EXP. EXCHANGE RATE HKD5 x 1.021 = HKD5.1 HKD5 x 1.022 = HKD5.202 HKD5 x 1.023 = HKD5.306

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Convert All HKD to AUD YR

CASH FLOW IN HKD

0 1 2 3

(HKD20M) HKD 9M HKD 9M HKD 9M

EXPECTED EXCHANGE RATE / / / /

HKD5.0 HKD5.1 HKD5.202 HKD5.306

NPV @ 10% = AUD0.32Million

CASH FLOW IN AUD

= = = =

(-$4.00m) $1.76m $1.73m $1.70m

PV FACTOR

PV

x x x x

(-4) 1.60 1.43 1.29

1 0.909 0.826 0.761

NPV + 0.32

======

Accept since NPV is +

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Method Two – The Foreign Currency Approach  Determine the required return on HK Investments and then

discount the HKD Cash flow to find the NPV in HKD. Then convert this HKD NPV to AUD NPV.  We need to convert the 10% AUD return to the equivalent HK required return.

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Method Two – The Foreign Currency Approach SOLUTION The different in the nominal rates as follows:RFC - RHC =

7% - 5% = 2%

The discount rate to be used to evaluate the project will be 10% + 2% (Inflation risk in HK)

= 12%

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Method Two – The Foreign Currency Approach YR

HK$ CASH FLOW

0 1 2 3

(-HK$20) HK$ 9 HK$ 9 HK$ 9

(12%) PV FACTOR x x x x

1 0.893 0.797 0.712 NPV :

PV (-HK$20) HK$ 8.037 HK$ 7.173 HK$ 6.408 HK$ 1.618M

Convert to AUS$ at the spot rate of HKD5/AUD NPV IN AUD = HKD1.618 ÷ 5 = AUD0.32 Since the NPV is positive, the project can be accepted. 12-38

Exercise A company in Singapore intends to built a plant in Indonesia. The initial cost of investment is IDR800million and the investment is expected to generate IDR320million per year for 3 years. Spot Rate at the date of investment: IDR10,000 = SGD1 The risk free rate in Indonesia is 8% and 6% in Singapore. The firm’s required rate of return is 12%.

Required: Should the company make this investment? Prepare you answer using Method One and Method Two. 12-39

Exercise from Textbook • Page 560, Question 1 – 14 • Quiz for Final Exam Revision (10%) • Translation of Foreign Financial Statement • Analysis of Foreign Financial Statement • Strategic ing Issues in Multinational Corporation Format: 1. Two calculations questions 2. 6 Essay questions – 3 from Analysis of Foreign Financial Statement and 3 from Strategic ing Issues in Multinational Corporation 12-40