Complex Issues Faced by Multinationals due to Separation of Ownership and Control - Assignment Example

Finance Name: Institution: Date: Finance 1. In your own words define the separation of ownership and control based on Agency Theory.  Discuss some of the complex issues facing Multinational Enterprises that may arise due to this separation of ownership and control. Agency theory revolves around conflicting relationship between the principal of the business (owners i.e. stakeholders in the organization) & agents of the business (directors & other executives of the company). This theory looks at the principal- agent relationship from two angles. Goal When goals of principal & agent vary a great deal, the principal feels need to verify agents deed, but they can’t cross check whatever the agent does. This is because the principals delegate decision making authority to the agents, so as to facilitate smoother functioning of routine functions of the organization. Also, the agents normally tend to have profit maximization, stock market prices spurt e.t.c as their objectives (Forbes-Pitt, 2011). But the owners generally are keen to seek stable incomes & security of their capital invested in the company. Hence, principal & agent would generally have conflicting interests driving them apart. Risks When principal & agent both have totally contrasting view towards risk, both would end up taking up different actions. Generally the agents are assumed as risk takers; thus, the principals would want the agents to work in comparatively risk free aspects as per their view (Stremitzer, 2005). These contrasting views would affect the principal & agent relationship leading to conflict. Complex issues faced by multinationals due to separation of Ownership & control 1) Deviations from SWM (Shareholders Wealth Maximization) objectives This approach emphasizes importance of the capital invested by the principals. But due to lesser transparency, the owners (stakeholders) are actually unaware of what steps the agents are taking so as to take care of their wealth. Very good example would be Subprime crisis, where stakeholders were unaware of the practices adopted by the bank management (Junarsin, 2013). 2) Loyal majority controlling shareholders One more twist in the agency theory would be division of total stakeholders into majority & minority sections. These majority stakeholders have controlling interest in the company. Hence there are very little options available for the minority sections to check on the interests & actions of these majority stakeholders. 3) Corporate Governance practices Corporate Governance has been through reforms so as to check into these conflicting environments. With introduction of certain regulations like SOX (Sarbanes Oxley Act), the activities of the agents now are being revealed with closer look (US, 2002). But again this won’t solve the ancient problem of conflicting objectives of principals & agents. 2. Discuss in your own words, the functions of the foreign exchange market, market participants and transactions Foreign exchange market carries out 3 types of functions which are explained as below 1) Transfer Function The foreign exchange market is mainly required to carry out this function smoothly. The conversion of domestic currency into foreign currency would enable the dealers & traders to buy &sell their goods or services for money in the international market. This facility brings purchasing power in the hands of those who want to trade on international level. This function is facilitated by several instruments like bank drafts, telegraphic transfer etc. 2) Credit function Credit function is for facilitating the credit in the international markets. This facility allows the credit period to be given for payment for goods or services sold to the importer. This facility is generally carried out with the help of bills of exchange & other similar instruments, which are designed for certain time period. After expiry of this time period, the credit instruments are redeemed by the exporter at the rate of exchange as prevalent on the day. 3) Hedging function Hedging is a term used in context with the avoiding losses by taking action now. The importer & exporter would agree to trade on a future date at current price & more importantly at current rate of exchange prevalent. This hedging is carried out so as to secure the earnings (for exporter) & to stabilize the cash outflow (for importer). Foreign Exchange Market participants 1) Government & central banks Government plays active role in regulating & managing the foreign exchange market. Central banks are just an extended branch of the government which actually works on the fields. Important functions of the central bank would be maintaining the adequate foreign exchange reserves so as to maintain the domestic currency rate & to facilitate the importers to buy from foreign markets. 2) Banks & other financial institutions Banks & other institutions act as dealers act as foreign exchange dealers in the trading system. The banks would buy or sell the foreign exchange as required by the importer or exporter. 3) Hedgers The importers & exporters would ward off the insecurity attached to volatility in rate of foreign exchange, by entering into agreements. This would decrease the uncertainty with respect to foreign exchange rate changes. 4) Speculators Speculators are the traders who make profit by arbitraging in the foreign exchange markets. They keep an eye on foreign exchange markets & buy the undervalued currency & convert the same into another or home currency, which would result in profits or losses. Types of transactions in foreign exchange markets 1) Spot transactions – carried out at the rates currently prevalent. These transactions are squared off generally at most within 2 days. 2) Forward rate transactions – carried out at expected forward rates as estimated on the basis of demand supply of foreign exchange. Forward rates may be at discount, par or at premium. These rates are regulated by the government. 3) Futures – similar to forward market transactions except the size & maturity dates are standard & predetermined. These are exchange traded instruments. 4) Options – gives the trader right to buy or sell, but not obligation. There are 2 types of options – American & European. Option to buy is known as call & option to sell is known as put option. 5) Currency swaps – spot transactions are swapped with forward transactions 6) Arbitrage – buying & selling various foreign currencies with motive of making profit from such transaction. 3. Discuss in your own words, the theory of Purchasing Power Parity (PPP) and the difference between absolute purchasing power parity and relative purchasing power parity. Purchasing Power parity theory basically revolves around the rate of foreign exchange, which adjusts itself to match with other foreign currency so as to give rise to purchasing power within the said currency. This can be better explained with an example Suppose a pencil sells for @ $2 in United States , this price would be adjusted in India , where the pencil would be sold for INR 120 , entailing rate of INR60 per US $. This theory explains the basic function of any currency to render itself to be equivalent for any other country’s currency. This is basis for international trade, which facilitates the exchange of goods or services for money. Purchasing power parity can be calculated as follows Exchange rate = cost of goods in country 1 / cost of goods on country 2 Of course the cost of goods would pertain to a particular product, so that it would render the equivalent rate of exchange. This theory supports the balance in transaction where one side there is goods or services & on the other side there is equivalent money. There are two aspects of this theory 1) Absolute Purchasing Power Parity Absolute Purchasing power parity theory considers that the price levels are the main factors in positioning the exchange ratio between those countries. It describes exchange ratio between any countries to be the result of the comparison of the price levels in those countries under consideration. It is based on the concept of real price of any goods or services, which refers to the equivalent price of goods or services in the international market. This can be expressed as below Exchange ratio = P1 / P2 Where P1 = price levels of country 1 P2 = price levels of country 2 Let’s consider an example, where price of a pen is US $ 1 in US & price for the same pen in Japan would be 50 yens. So exchange rate will be calculated as below Yens per US $ = 50/1 = 50 yens per US $ But this theory holds some assumptions 1) Free tradability of goods & services in international markets 2) Price levels compared relate to same goods & services array 3) Price levels to be indexed to the same year 2) Relative Purchasing Power Parity This concept considers inflation levels to determine the exchange rates between the countries. This concept is conceived from the fact that inflation reduces the purchasing power, thereby changing the real price of goods or services offered. For example if the inflation rate revolves around 5% in the country, then purchasing power is reduced to the extent of 5% affecting the price levels of that country. This concept suggests that price levels are adjusted to inflation levels, so the exchange rate should also be adjusted for the differences in the inflation levels for the respective countries. It is calculated as follows Exchange Rate = R1 / R2 = (1+ I2) / (1+ I1) Where R1 = country 2 currency per one unit of currency of country 1 in the beginning R2 = country 2 currency per one unit of currency of country 1 in the end I2 = inflation rate for foreign country I1 = inflation rate for domestic country This concept would be explained better with an example Suppose that inflation rate levels in US revolves around 5% & inflation rate is around 8% in Japan .Exchange rate is 50 yens per US$.If we were to find out the rate at the end , then it would be calculated as follows R1 / R2 = (1+ I2) / (1+ I1) 50 / R2 = (1 +5%) / (1+8%) R2 = 51.4286 US $ 4. Happy Days (HDs) is a pet supplies company that is considering establishing a manufacturing plant and distribution facility in Australia through a wholly owned subsidiary.  The company is seeking advice from two different investment banks in Australia for projected estimates of costs of capital when it plans to list its Australian subsidiary on the ASX.  Using the estimates and assumptions outlined below, calculate the firm’s projected costs of debt, equity, and weighted average cost of capital.  Show all workings and formulas. Assumptions and Estimations OzzBank AustBank Components of beta (estimates):  Β Covariance of returns HDs and Market Covarjm 0.03888 0.05610 Variance of returns HDs σ2j 0.05760 0.09000 Variance of returns market σ2m 0.03240 0.04840 Other required measures Risk-free rate of interest krf 2.5% 2.5% HDs cost of debt in Aus market kd 6.5% 6.8% Market return, forward-looking km 10.0% 13.0% Corporate tax rate t 30.0% 30.0% Proportion of debt D/V 42.0% 38.0% Proportion of equity E/V 58.0% 62.0% Solution: 1) Calculation of Expected rate of return of equity Capital Asset pricing Model (CAPM) considers the expected rate of return on equity as follows ER = krf + Beta (krm – krf) Ozz Bank ER = krf + Beta (krm – krf) ER = 0.025 + 1.2 (0.10 – 0.025) ER = 0.115 = 11.5% Aust Bank ER = krf + Beta (krm – krf) ER = 0.025 + 1.16 (0.30 – 0.025) ER = 0.344 = 34.4% Where beta is calculated as follows Ozz bank - Beta = Covarjm / σ2m = 0.03888 / 0.03240 = 1.2 Aust bank - Beta = Covarjm / σ2m = 0.05610/0.04840 = 1.16 2) Projected cost of debt ED = cost of debt * (1-tax rate) Hence Ozz Bank – ED = 0.065 (1- 0.30) = 0.0455 = 4.55% Aust bank – ED = 0.068 (1-0.30) = 0.0476 = 4.76% 3) Weighted average cost of capital (WACC) = weight of equity *cost of equity +weight of debt *cost of debt (1-tax rate) Ozz bank – WACC = (58%*11.5%) + (42%*4.55%) = 0.0667 + 0.01911 = 0.08581 = 8.581% Aust bank – WACC = (62%*34.4%) + (38%*4.76%) = 0.21328 + 0.018088 =0.231368 = 23.1368% 5. John is interested in inter-bank arbitrage.  Suppose that the following exchange rates are available to him and that he may either buy or sell at these rates. Citibank, New York US dollars per euro 0.77495/€ Barclays Bank, London US dollars per pound sterling 0.67782/£ Deutsche Bank, Frankfurt Euros per pound sterling 0.89283/£   (a) Does an opportunity exist to profit from arbitrage between the three markets?  In other words, is triangular arbitrage possible?  Explain your answer in your own words and show all workings. Solution: Triangular Arbitrage possibility Arbitraging refers to making profit by foreign exchange conversion. So typically triangular arbitrage refers to situation where the trader would convert the domestic currency into other foreign currency, & again converts this foreign exchange into some other foreign currency. This conversion & reconversion of currency into & from foreign exchange gives rise to profit or loss as the case maybe, where profit on arbitrage = amount converted in home currency – amount invested. Given rates are as follows US dollars per euro = 0.77495/€ US dollars per pound = 0.67782/£ Euros per pound sterling = 0.89283/£ Suppose that we have €1000 to invest, then We shall purchase US dollars with them = €1000 *0.77495 = $774.95 Then we will buy pounds = $774.95 *(1/0.67782) = £1143.30 Then we will convert them again in Euros = £1143.30 *0.89283 = €1020.77 Arbitrage profit = Amount reconverted – amount invested = 1020.77- 1000 = €20.77 So there exists opportunity for arbitraging for Mr. John. (b) If John has US$1 million to arbitrage with, what would be the result (profit or loss) from triangular arbitrage?  Illustrate and explain your answer in your own words and show all workings Given rates are as follows US dollars per euro = 0.77495/€ US dollars per pound = 0.67782/£ Euros per pound sterling = 0.89283/£ Mr. John has US $ 1 million which he will convert in Euros Hence, US $ 1 million /0.77495 = €1,290,405 He will then convert these Euros into pounds Hence, €1,290,405 *0.77495/0.67782 =£1,475,316 He will then reconvert the ponds into US dollars So, £1,475,316 *0.89283 = $1,317,207 Therefore, Profit made by triangular arbitrage = $1,317,207 - $1,000,000 = $317,207 References Forbes-Pitt, K. (2011). The assumption of agency theory. London: Routledge. Stremitzer, A. (2005). Agency theory: Methodology, analysis : a structured approach to writing contracts. Frankfurt am Main: P. Lang. Junarsin, E. (2013). Executive compensation restrictions and shareholder wealth maximization during the financial crisis: Empirical evidence from U.S. bailed-out companies. United States. (2002). Sarbanes-Oxley Act in perspective. St. Paul, Minn.: Thomson West. References Read More