The Competitive Advantage of Global Finance

Relatively few multinational companies truly understand or take advantage of international finance. Professor Mihir A. Desai tackles the subject in a new book, International Finance: A Casebook. Here’s a Q&A.
by Sean Silverthorne

As waves of globalization wash across the business world, tremendous new opportunities for financing and investment present themselves to savvy enterprises. In a new casebook, HBS professor Mihir A. Desai discusses the numerous challenges and opportunities facing firms as they make these decisions. In the process, he shows how organizations can best equip themselves to take advantage of potential sources of competitive advantage that arise in the global setting.

In International Finance: A Casebook, Desai provides case studies on how large multinational firms (such as AES Power, Asahi Glass, Dow, General Motors, Nestlé, and Petrobras) and smaller entrepreneurial firms (such as the U.K.'s AIFS and China's BabyCare) undertake critical financing, investment, risk management, and incentive management issues to take full advantage of this global setting. Through real case examples the CFOs of these firms face various issues—including management of exchange rate risk, how to structure their internal capital markets, how to do capital budgeting worldwide, and how to respond to varying regulatory and tax incentives. The book takes a firm-centric approach, focusing on the issues managers face as they operate in the complicated world of international finance.

Desai notes that there is tremendous heterogeneity in firm responses to the opportunities and obstacles created by worldwide operations. In this e-mail interview, Desai discusses the growing opportunities in global finance, common mistakes made by international managers, and the development of his book for readers interested in "the opportunities of managing in a global setting."

Sean Silverthorne: International Finance and its case studies explore various dimensions of financial decision making in a globalizing world. What does the book add to the literature that you felt was lacking?

Mihir Desai: Recent waves of globalization have had several distinct effects on firms that have not been addressed by many academics. First, rapidly integrating markets have extended firms across borders. The share of U.S. corporate profits attributable to foreign operations has escalated from 5 percent in the 1960s to 30 percent today. Second, multinational firms, once characterized as a web of autonomous subsidiaries serving local markets, are more likely to have globally-integrated production processes. Third, as a consequence of these developments, these firms now face a wide variety of governmental regulations and institutional environments around the world. In short, tightly integrated global operations with a rising reliance on foreign operations are the rule rather than the exception.

In contrast to this reality of global firms, most finance scholarship and pedagogic material conceives of firms as being entirely locally focused and ignores the many questions prompted by global operations. International considerations are typically only featured by investigating differences in financing and investment patterns across countries or by investigating listing decisions across borders. In both cases, firms are presumed to be entirely local. The limited understanding of multinational finance we had was from survey evidence, including the work of the Harvard Multinational Project that concluded in the 1970s. So, I wanted to address this vacuum and explore how firms operated in this richer, global setting.

Q: What kinds of questions arise today for the CFOs and general managers of multinational firms? How does the book go about addressing them?

A: The cases explore the full spectrum of questions that arise within the multinational firm, and include: How do I value a firm with assets around the world that are exposed to different country risks and currencies? When should I share ownership with a local partner? How should I evaluate managers that are operating in very different economic and financial settings? How should I measure exposures arising from international operations? What is the appropriate way to think about the cost of capital for the worldwide operations of a single firm? The CFOs that manage global financial operations, the general managers working within these firms, and the intermediaries advising or providing capital to these firms must all increasingly wrestle with these questions.

Recent waves of globalization have had several distinct effects on firms that have not been addressed by many academics.

The book is structured so that tools are built early on and then applications and complications follow. The first module is purely about markets and provides the basics about exchange rates and asset pricing in a global economy. Modules 2 through 4 consider how firms are impacted by these global markets and how major cross-border financial and investment decisions are made within a firm. Module 5 considers how differences across countries create financing opportunities for firms. Finally, Modules 6 and 7 consider how distinctive institutional environments change financing decisions and how governmental decision makers can influence managerial decisions. In short, the modules have been sequenced to progress from markets to firms to institutions so that complexities are gradually layered on.

The major decisions that managers confront in multinational financial management are addressed in Modules 2, 3, and 4 and these modules are the core of the casebook. The cases in these modules illustrate the range of issues that arise in multinational financial management—from managing foreign currency exposures to determining a subsidiary's capital structure to valuing an investment in a risky country—and the managerial and environmental considerations that make multinational financial decision making so challenging. As such, these materials are the most distinctive materials in the course. The materials in the first module are more innovative in their pedagogic approach as they take material that is usually taught through textbooks (international macroeconomics) and enliven them in a managerial setting. The materials in the last three modules are innovative as they provide a platform for exploring some of the lessons that have emerged from recent waves of scholarship in international corporate finance on the role of institutions in dictating financing choices.

Q: Your materials illustrate the fact that cross-border investment and financing provide sizable opportunities for companies that understand this complex environment. What are some of the lessons from your case materials about how firms can make the most of these opportunities and manage their way through this more complicated setting? What kinds of mistakes are firms making?

A: There's a remarkable level of heterogeneity out there on how firms are structuring their worldwide operations and how cognizant they are of these opportunities.

The first common mistake that I came across is that "one size fits all." This strategy effectively sacrifices many opportunities due to an unwillingness to explore how differences in regulatory environments, institutional environments, and tax rules can create opportunities or obstacles. For example, one of the cases discusses how a U.S. firm took its domestic capital budgeting practices and just applied them without modification. In the process, the firm almost went bankrupt. Similarly, many financing decisions have to be tailored to the environment of the subsidiary rather than be applied generically through a worldwide system of subsidiaries.

The second common mistake is the "too clever by half" approach. There is a common temptation to overemphasize every financial and pecuniary angle on these decisions without understanding that these decisions happen within firms. As a result, these decisions must incorporate other organizational objectives and managerial interests. For example, tax optimization can be a powerful tool but can also create performance evaluation and incentive problems.

Many financial practices out there excessively penalize foreign activities when these operations represent true opportunities.

A final type of mistake is what I call the "innocents abroad" mistake. This mistake can be manifest in many ways but is characterized by the disjunction between negative perceptions of foreign activities and the realities of the opportunities that these foreign operations represent. Many financial practices out there excessively penalize foreign activities when these operations represent true opportunities. The best managers and firms combine a detailed understanding of the relevant finance with an appreciation of the organizational and institutional considerations that most also influence their decisions.

Q: Why did you decide to pursue an analysis of these decisions through cases?

A: As I began on the path to explore these financial decisions, it became clear that conventional methods were insufficient. Public financial records provide limited, if any, insight into how firms structure their worldwide operations given limited disclosure requirements. To crack open the multinational firm and study these decisions, new data sources and nontraditional methods were required. In parallel with my course development efforts, I have been working with C. Fritz Foley and James R. Hines Jr. to exploit the unique opportunity provided by confidential, government-collected data on U.S. multinationals. This source effectively provides income statements and balance sheets for all subsidiaries of all U.S. multinational firms.

The course development research provides an alternative means of understanding these decisions that is highly complementary to the large-sample research in several ways. First, the cases in the book serve as manifestations and validation of some of the lessons of large-sample empirical research. For example, the case discussing Dow Chemical's expansion in Argentina and its performance subsequent to the devaluation demonstrates how multinational firms can access worldwide product markets and capital markets when local firms are most disadvantaged, as described in "Financial Constraints and Growth." Similarly, the discussion of the ownership decisions and financial policies employed for Shanghai General Motors provide an opportunity to discuss the results from "The Costs of Shared Ownership" and "A Multinational Perspective on Capital Structure and Internal Capital Markets" on how subsidiary ownership and financing decisions reflect managerial, tax, and hedging motivations. As such, these cases serve as a platform for teaching the lessons from the large-sample research.

Second, the cases of the course have served to inspire further research questions pursued through large-sample empirical research. For example, the puzzles raised by the Stanley Works case opened up the line of inquiry on the corporate governance role of taxation. The Czech Mate case series prompted an academic paper that frames the lessons from the case on the differential access to investor protections created by bilateral investment treaties within the broader debate on the convergence of corporate governance protections. As such, several cases have provided the foundation for academic papers that have extended and reinforced the ideas from the cases.

Finally, cracking open the multinational firms through these cases serves to illuminate aspects of financial decision making that are simply not accessible through large sample research. For example, the capital budgeting practices of multinational firms, particularly with respect to emerging markets, are not directly observable through large-sample research. The AES and Dow cases demonstrate the inconsistencies in traditional methods for incorporating country risk and provide an alternative method for considering these risks. Hedging decisions provide a second example. Such decisions are extremely hard to investigate given the limited nature of disclosure, other than at very high levels of aggregation. Exploring how specific exposures are measured, compared, and managed—as in the AIFS and GM cases—allows students and scholars to unpack the determinants of decisions that are otherwise only measured imprecisely, if at all, at the firm level. In particular, managerial motivations—including accounting objectives or incentive management—that might guide hedging decisions can be investigated in a way that large-sample evidence typically precludes.

Q: Who is your target audience?

A: As this is a casebook, it is primarily targeted at instructors who are considering adopting the course materials and can use the teaching notes to really teach the material in the fullest possible way. Having said that, an inquisitive reader who wants a perspective on how finance works in this richer global setting will find lots of food for thought about how to fully harvest the opportunities of managing in a global setting.