CFS W1 Desai (08) "The Finance Function
in a Global Corporation"
1 . Intro
- Financing in the Internal Capital
Market
- Managing Risk Globally
- Global Capital Budgeting
- Creating a Global Finance Function
How can CFOs ensure that their global finance
operations make the most of the opportunities
at their disposal? At a minimum, they
must inventory their financial capabilities and
ensure their adaptation to institutional variation
and their alignment with organizational
goals. To achieve this, a global finance function
must do three things well:
a. Establish the appropriate geographic locus
of decision making
b. Create a professional finance staff that rotates
globally
c. Codify priorities and practices that can be
adapted to local conditions.
a. Historically, the finance functions in large U.S.
and European firms have focused on cost control,
operating budgets, and internal auditing.
b. . Rather
than simply make aggregate capital-structure
and dividend decisions, for example, they also
have to wrestle with the capital structure and
profit repatriation policies of their companies’
subsidiaries.
c. Capital budgeting decisions and
valuation must reflect not only divisional
differences but also the complications introduced
by currency, tax, and country risks.
d. Incentive
systems need to measure and reward
managers operating in various economic and
financial settings.
e. The existence of what amounts to internal
markets for capital gives global corporations a
powerful mechanism for arbitrage across national
financial markets.
f. But in managing
their internal markets to create a competitive
advantage, finance executives must delicately
balance the financial opportunities they offer with the strategic opportunities and challenges
presented by operating in multiple institutional
environments, each of which has it own
legal regime and political risks.
g. There is also a
critical managerial component: What looks
like savvy financial management can ruin
individual and organizational motivation.
h. As
we’ll see in the following pages, some of the
financial opportunities available to global
firms are affected by institutional and managerial
forces in three critical functions:
- financing,
- risk management, and
- capital budgeting.
a. Because
interest is typically deductible, a CFO can significantly
reduce a group’s overall tax bill by borrowing
disproportionately in countries with
high tax rates and lending the excess cash to operations
in countries with lower rates.
b. CFOs can
also exploit tax differences by carefully timing and sizing the flows of profits from subsidiaries
to the parent.
c. However, tax is not the only relevant
variable: Disparities in creditors’ rights
around the world result in differences in borrowing
costs. As a consequence, many global
firms borrow in certain foreign jurisdictions or
at home and then lend to their subsidiaries.
d. Multinational firms can also exploit their
internal capital markets in order to gain a
competitive advantage in countries when
financing for local firms becomes very expensive.
When the Far East experienced a currency
crisis in the 1990s, for example, and
companies in the region were struggling to
raise capital, a number of U.S. and European
multinationals decided to increase financing
to their local subsidiaries. This move allowed
them to win both market share and political
capital with local governments, who interpreted
the increased financing as a gesture of
solidarity.
e. But the global CFO needs to be aware of
the downside of getting strategic about fi-
nancing in these ways. Saddling the managers
of subsidiaries with debt can cloud their
profit performance, affecting how they are
perceived within the larger organization and
thereby limiting their professional opportunities.
f. Similar considerations should temper
companies’ policies about the repatriation of
profits. For U.S. companies, tax incentives dictate
lumpy and irregular profit transfers to
the parent. But many firms choose to maintain
smooth flows of profits from subsidiaries
to the parent because the requirement to
disgorge cash makes it harder for managers to
inflate their performance through fancy accounting.
g. Finally, letting managers rely too
much on easy financing from home saps their
autonomy and spirit of enterprise, which is
why many firms require subsidiaries to borrow
locally, often at disadvantageous rates.
a. The existence of an internal capital market
also broadens a firm’s risk-management options.
For example, instead of managing all
currency exposures through the financial market,
global firms can offset natural currency
exposures through their worldwide operations.
Let’s say a European subsidiary purchases
local components and sells a finished
product to the Japanese market. Such operations
create a long position in the yen or a short position in the euro. That is, those operations
will become stronger if the yen appreciates
and weaker if the euro appreciates. This
exposure could be managed, in part, by offsetting
exposures elsewhere in the group or by
having the parent borrow in yen so that movements
in the yen asset would be cancelled by
movements in the yen liability.
b. Given this potential for minimizing risk, it
might seem perverse that many multinationals
let local subsidiaries and regions manage their
risks separately. General Motors is a case in
point. Even though its treasury function is
widely regarded as one of the strongest pools
of talent within the company—and one of the
best corporate treasury functions worldwide—
GM’s hedging policy requires each geographic
region to hedge its exposures independently,
thereby vitiating the benefits of a strong, centralized
treasury. Why duplicate so many hedging
decisions? Because forcing a business’s
hedging decisions to correspond to its geographic
footprint gives GM more-accurate
measurements of the performance of the individual
business unit and of the managers
running it.
c. In a related vein, companies often limit—in
arbitrary and puzzling ways—their considerable
expertise in managing currency exposures.
Many firms require finance managers to
follow “passive” policies, which they apply in a
rote manner. For example, GM actively measures
various exposures but then requires 50%
of them to be hedged with a prescribed ratio of
futures and options. Firms adhere to these passive
strategies because they limit the degree to
which financial managers can undertake positions
for accounting or speculative reasons. So
although functioning in the global environment
calls for considerable financial expertise,
organizational strategy requires that expertise
to be constrained so that financial incentives
don’t overwhelm operating ones.
a. In addition to exploiting the de facto internal
financial market to mediate between their operations
and the external financial markets,
CFOs can add a lot of value by getting smarter
about valuing investment opportunities.
When energy giant AES began to develop global
operations, in the early 1990s, managers
applied the same hurdle rate to dividends
from around the world that they used for domestic power projects, despite the different
business and country risks they faced. That
approach made risky international investments
look a lot more attractive than they
really were.
b. The company’s subsequent attempts to improve
its capital-investment decision process
illustrate the organizational challenges CFOs
face as they move from domestic to foreign
markets. In order to improve the quality of
valuations, AES required managers to incorporate
sovereign spreads into their discount
rates. Sovereign spreads measure the difference
between the rates at which two countries
can borrow in the same currency, and
they are widely tacked on to discount rates in
order to adjust for country risk. Although this
method created the semblance of tremendous
precision, it came with some curious incentives,
particularly for managers charged with
securing deals in emerging markets. Knowing
that their projects would face very high discount
rates, managers forecasted inflated cash
flows to compensate. For managers keen to
complete transactions, as some at AES were,
excessive penalties and precision can result in
a less robust process.
c. In extreme cases, the gaming that takes
place in a formalized process can undermine
the company’s strategy. Consider Asahi Glass,
one of the first Japanese corporations to rigorously
implement Economic Value Added systems worldwide in order to increase capital
efficiency. Asahi set country-specific discount
rates based on typical risk measures, including
sovereign spreads. The result, however, was
that managers overinvested in Japan (because
of very low discount rates) and underinvested
in emerging markets (because of very high
ones). Once again, adopting a narrowly financial
approach led to an outcome directly at
odds with the company’s strategic objectives.
In response, Asahi made a series of adjustments
to reconcile its initial, purely financial
approach to discount rates with its broader
organizational goals.
d. The moral of these stories is that formal
methods of valuation and capital budgeting—
which work quite well in a domestic context,
where the variables are well understood—
must be refined as companies globalize. Firms
need to make sure that their finance professionals
actively discuss potential risks with the
country managers who best understand them.
The example of GM’s approach
to hedging makes clear that a finance
function must locate decision making at a geographic
level where other strategic decisions
are made. Even if centralizing decisions can
generate substantial savings, these might need
to be sacrificed to ensure that the finance
function reflects the degree of centralization
appropriate for the firm overall. Highly centralized
firms can have a large finance function
at headquarters that effectively dictates decision
making for all subsidiaries; such an arrangement
can capitalize on many financial
arbitrage opportunities without sacrificing organizational
goals substantially. Decentralized
organizations, in which country managers are
paramount, must replicate some financial decision
making at the country level.
Leading companies recruit and
rotate financial managers in the same way that they do marketing and operational talent.
If companies groom a network of finance
professionals who are comfortable in various
environments—and have rotated through positions
at the country, region, and corporate
levels—the dynamic between the financial
headquarters, where most expertise resides,
and the subsidiary can be a powerful resource
in difficult times. Drug giant Novartis is an example.
In 2001, the company had to decide
whether to continue financing its Turkish subsidiary,
which had repeatedly delayed payment
to Novartis during periods of crisis. On
the numbers alone, the decision would have
been straightforward: Force the managers to
fund locally or deny shipments of life-saving
drugs to the subsidiary. Complicated negotiations
ensured that the subsidiary would continue
to operate, capitalize on the weakness of
its competitors, and ultimately pay back the
parent. A successful outcome was achieved
only because of the trust built up over many
years between finance managers at headquarters
and those in Turkey, many of whom had
spent time at Novartis subsidiaries around
the world.
It is tempting to
stipulate that cash repatriation policies or
investment criteria be applied universally.
Such a requirement, however, can sacrifice
opportunities that arise locally. Similarly, strategic objectives, as in the Asahi example,
may demand flexibility in investment analyses.
Smart companies, therefore, formulate
policies centrally with an understanding that
local idiosyncrasies and strategic imperatives
may require exceptions. Specifying the process
for making exceptions, such as instituting
a standing committee of finance professionals
to review possibilities, is critical to ensuring
that deviations from the norm are properly
managed.
- Conclusion
Forty years ago, most firms didn’t have CFOs,
and the finance function was usually staffed
by controllers. As external markets have become
more demanding in terms of performance
and their requirements for disclosure,
the finance function has become more prominent.
Now that multinational companies have
their own internal capital markets, the finance
function must graduate to a more strategically
engaged level. A globally competent finance
department is one that understands how to
reconcile the firm’s financial, managerial,
and institutional priorities across its business
units. Does yours?